Securities Mosaic® Blogwatch
April 24, 2014
Bankruptcy Court Lifts Stay to Allow D&O Insurer to Pay Individuals' Defense Expenses
by Kevin LaCroix

As those involved in D&O Insurance claims well know, a recurring D&O insurance problem is the question of whether or not the D&O insurer for a bankrupt company can pay the costs of the bankrupt company's former directors and officers incurred in defending claims against them. Disputes arise when the individuals seek to have the stay in bankruptcy lifted to allow the insurer to pay their defense expenses. Oftentimes creditors or the bankruptcy trustee will oppose lifting the stay, arguing that the D&O policy proceeds are assets of the bankrupt estate and should be preserved for the benefit of the estate or the creditors rather than expended paying the individuals' defense costs.

These issues were discussed in a recent case in the Bankruptcy Court for the District of Idaho. In a succinct March 25, 2014 opinion (here), Bankruptcy Court Judge Jim D. Pappas rejected the arguments of the bankruptcy trustee and ruled that the stay should be lifted to allow the D&O insurer to pay the fees that certain former officers of Hoku Corporation incurred in defending claims against them. Hat tip to the Jones, Lemon & Graham's D&O Digest Blog (here) for the link to the opinion. The D&O Digest's April 21, 2014 blog post about the opinion can be found here.


Hoku Corporation was a subsidiary of Tianwei New Energy Corporation. On July 2, 2013, Hoku filed a Chapter 7 bankruptcy petition. On August 20, 2013, JH Kelly LLC, the prime contractor for Hoku in the construction of a polysilicon plant in Pocatello Idaho, sued Tianwei and several former directors and officers of Hoku, alleging fraud, racketeering and other misconduct while JH Kelly was constructing the plant.

The individual directors and officers filed a motion in the bankruptcy proceeding requesting the bankruptcy court to determine that the proceeds of Hoky's D&O insurance policy were not property of Hoku's bankrupt estate, or in the alternative, granting relief from the automatic stay in bankruptcy to allow the D&O insurer to pay the individuals' costs of defending themselves in the JH Kelly lawsuit. The bankruptcy trustee filed an objection to the motion, arguing that the proceeds of the policy are assets of Hoku's bankruptcy estate, and arguing further that payment of the individual's defense fees would diminish the bankruptcy estate's potential recovery of its own claims under the Policy.

Hoku's D&O insurance policy, which had limits of liability of $10 million, included a so-called order of payments provision, specifying that

In the event of Loss arising from a covered Claim for which payment is due under the provisions of this policy, then the Insurer shall in all events:

(a) first, pay Loss for which coverage is provided under Coverage A and Coverage C of this policy; then

(b) only after payment of Loss has been made pursuant to Clause 22(a) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverage B(ii) of this policy; and then

(c) only after payment of Loss has been made pursuant to Clause 22(a) and Clause 22(b) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverages B(i) and D of this policy.

The bankruptcy or insolvency of any Organization or Insured Person shall not relieve the Insurer of any of its obligations to prioritize payment of covered Loss under this policy pursuant to this Clause 22.

The March 25 Ruling

In his March 25, 2014 order, the Bankruptcy Judge granted the directors' and officers' motion based on his determination that the individuals had shown cause for relief from the automatic stay under Section 362(d)(1) of the Bankruptcy Code.

After first noting that the question of whether or not the proceeds of a D&O Insurance policy are assets of a bankrupt insured company's bankruptcy estate is "an unsettled question," the Bankruptcy Judge turned to the question of whether or not the stay should be lifted, saying that "assuming without deciding, the proceeds of the Policy are property of the bankruptcy estate, the Court concludes that good cause has been shown by the Movants under Section 362(d) for relief [from] the automatic stay."

The Bankruptcy Judge determined that in considering whether or not the individuals had shown cause for lifting the stay that the Court should "balance the harm to the debtor if the stay is modified with the harm to the directors and officers if they are preventing for executing their rights to the defense costs." The Bankruptcy Judge noted further that "clear, immediate and ongoing losses to the directors and officers in incurring defense costs trumps only 'hypothetical or speculative' claims by the trustee."

The Bankruptcy Judge found that the individuals "are experiencing clear immediate and ongoing defense costs expenses," adding that under the priority of payments provision in the policy, payments under other coverage provisions of the policy were "subordinate" to payment under the Side A coverage provision under which the individuals sought to have their defense fees paid.

By contrast, the Bankruptcy Judge found that the "potential harm to the estate suggested by the Trustee consist of hypothetical, indeed perhaps speculative claims he might pursue against the Movants." The Bankruptcy Judge noted that other courts had criticized other bankruptcy trustees for seeking to prevent the payment of individual directors and officers defense fees under Side A.

"All things considered," the Bankruptcy Court said, "the potential harm to the bankruptcy estate inherent in granting the Movants relief is negligible." After noting that the policy's $10 million limit of liability provided "ample coverage," he concluded that the fees the individuals were incurring in defending the JH Kelly matter represented "a clear, immediate and actual harm that greatly outweighs any speculative and hypothetical harm to the bankruptcy estate."


The kinds of issues discussed here have been a feature of the D&O insurance claims environment for many years, since coverage for the corporate entity became a regular part of the typical D&O policy. When the corporate entity files for bankruptcy, the question that arises is whether as a result of the D&O policy's entity coverage the policy and its proceeds are assets of the estate. The practical solution that has evolved is that now when individuals want to have their defense fees paid, they will approach the bankruptcy court to obtain what has become known as a "comfort order" to allow the D&O insurer to pay the individuals' defense fees (as discussed in greater detail here).

As I noted in a prior post (here), the granting of these types of comfort orders is now something of a "standard" procedure. However, even though these practices are now well established, and have been employed in such high profile proceedings as the Lehman Brothers bankruptcy (refer here) and the MF Global bankruptcy (refer here), trustees like the one here will continue to agitate on these issues. (Admittedly, other problems arose in those high profile cases but not with respect to the question of whether or not a comfort order was appropriate.)

Nevertheless we still have situations like this one where Trustees try to throw up roadblocks to the payment of individuals' defense fees based on the speculative notion that the policy proceeds need to be preserved for rights of recovery the Trustee not only has not established yet but even has not yet asserted. In that respect, I think there is something to the suggestion of the Bankruptcy Court here that bankruptcy trustees may warrant criticism for putting up these kinds of obstructions to the enforcement of contractual rights based on such speculative grounds.

I have always thought that these recurring problems are the result of a fundamental misconception of the D&O insurance policy. For obvious reasons, claimants and creditors want to establish that the D&O insurance policy exists for their protection and benefit. For less obvious reasons, some courts fall for this, which I have always found frustrating.

The fact is that insurance buyers purchase D&O insurance to protect the insured persons from liability. No one pays insurance premium as a charitable act for the benefit of prospective third party claimants. Liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants. The very idea that claimants who have not even established their right of recovery from the insureds should be able to deprive the insureds of their right to use their insurance to protect themselves stands the entire insurance proposition on its head.

All of that said, there are recurring issues involved with the administration of these kinds of comfort orders, particularly, as discussed here, when court insist on asserting so-called "soft caps" on the amount of defense fees that can be paid or otherwise requiring ongoing Court supervision.

April 24, 2014
SEC Settles Another Expert Network Insider Trading Case
by Tom Gorman

The Commission filed another settled insider trading case tied to its long-running expert network investigation. This time the action traces to the source of tips regarding Nvidia Corporation, Chris Choi. SEC v. Choi (S.D.N.Y. Filed April 23, 2014). It also names as relief defendants others from the expert network investigation including Diamondback Capital Management Capital, LLC, Level Global Investors, L.P., and Sigma Capital Management, LLC along with employees at those firms.

Chris Choi was employed at Nvidia as an accounting manager. He was friends with Hyung Lim who in turn was friends with Danny Kuo, a hedge fund manager at Whittier Trust Company. On three instances in 2010 and 2011 Mr. Choi furnished his friend inside information regarding a pending earnings announcement for his company. In each instance that information was passed to Mr. Kuo who caused the hedge fund employing him to trade. In one instance Mr. Kuo distributed the information not just to those at his fund but also on one occasion to others involved in the expert network investigation that traded.

The first tip involved the earnings announced by Nvidia, issued after the close of the market on May 7, 2009. At that time the results for the first quarter of 2010 were released. Beginning in early April 2009 Mr. Choi tipped his friend Mr. Lim about the upcoming financial results. The tip indicated that results might be substantially worse than expected.

Mr. Choi updated the tipped information later in the month. Indeed, as the time for the quarterly earnings announcement drew near, Mr. Choi continued to update the information. As a result Whittier sold shares of Nvidia and established a short position.

Mr. Kuo forwarded the information to others including Jesse Tortora at Diamondback, Spyridon Adondakis at Level Global and Jo Horvath at Sigma Capital. Each caused their firm to trade based on the information.

Following Nvidia's announcement that its financial results were worse than had been expected it share price fell. Each of the four funds had loses avoided and profits made of: Whittier, $144,000; Diamondback, $73,000; Sigma Capital, $500,000; and Level Global, $15.6 million.

The second tip concerned the financial results for third quarter 2010, announced November 5, 2009 after the close of the market. In this instances Mr. Choi tipped his friend Mr. Lin regarding the then pending financial results the day before the announcement. This time the information was positive - the results would be good. The day of the announcement Whittier, to whom the information had been passed, purchased a block of Nvidia's stock.

Nvidia announced results which exceeded expectations. The share price closed up substantially the next day. Whittier had trading profits of over $44,000.

The third tip involved the financial results for the third quarter of 2011, announced after the close of the market on November 11, 2010. Beginning nine days before the announcement Mr. Choi told Mr. Lim that the firm's results would be better than expected for the quarter. Later, prior to the announcement, he reconfirmed the information. That information was transmitted to Messrs. Adondakis and Tortora.

Whittier purchased Nvidia shares while in possession of the inside information. Following the earnings announcement the shares of the company increased significantly. Whittier had profits of $105,000.

Mr. Lim was paid $15,000 by Mr. Kuo who also provided him with inside information on another stock. Trading on that tip yielded him $11,000.

The complaint, which charges that Mr. Choi is responsible for the trading by Whittier and each of the other funds that traded, alleges violations of Exchange Act Section 10(b) and Securities Act Section 17(a). Mr. Choi resolved the charges, consenting to the entry of a permanent injunction prohibiting future violations of each of the Sections cited in the complaint. He also agreed to pay a civil penalty of $30,000 and to the entry of an order barring him from serving as an officer or director of a public company for five years.

April 24, 2014
Cybersecurity: "Heartbleed" as a Risk Factor?
by Broc Romanek

As noted by this WSJ blog by James DeGraw and Lisa Rachlin of Ropes & Gray, companies have been pounded by the latest widespread cybersecurity threat - "Heartbleed," which is a fundamental flaw of OpenSSL - a popular, widely-used tool for encrypting Internet communications. Doing a quick search on Edgar, I can find no SEC filing that includes the term "Heartbleed." Perhaps it's a little early and eventually there might will be some risk factors and other disclosures.

I tend to think that, unless a company had a particular "cyber incident" - to use the SEC's parlance - related specifically to the Heartbleed OpenSSL flaw, a risk factors disclosure in this area might be more generalized. For example, it might describe risks inherent in relying for cyber risk mitigation on third party or open source software that might contain undetected flaws (i.e. Heartbleed).

Corp Fin's guidance in this area - CF Disclosure Guidance: Topic 2 (Cybersecurity) - notes that "cyber incidents can result from... unintentional events," which might include prolonged exposure from security flaws such as Heartbleed, which remained undetected by companies for years. The guidance also notes that cybersecurity risk disclosure must adequately describe the nature of material risks, which might include "risks related to cyber incidents that may remain undetected for an extended period."

The bottom line is that - unfortunately - securities lawyers will need to learn more about security breaches and cybersecurity threats as they have been a routine part of our daily life with no end in sight. Learn more in our "Security Breaches" Practice Area...

Mauri Osheroff Retires! Nearly the Last of a Generation

Sad to hear that long-time Associate Director Mauri Osheroff has retired after 40 years of service. Her many accomplishments are documented in this press release. Mauri is one of the last of a generation that led the Division from an era of no computers to a future that no one could imagine. A kind and well-informed soul, she will be missed. I remember first meeting Mauri in 1987 when I was an intern in Corp Fin and she was serving as Deputy Chief Counsel and came in to do a training session. She knew so much even back then!

Will Regulation A+ Make the Grade? Explanation of Comments Received by the SEC

NASAA and others are up in arms about the state preemption controversy brought on by the SEC's Regulation A+ proposal. Check out this 24-page memo by McGuireWoods that parses the comment letters received by the SEC so far. Here's NASAA's comment letter...

- Broc Romanek

April 24, 2014
CSR -- and other Disclosure as "Compelled Speech": The US and the EU Consider Very Different Approaches
by Celia Taylor

The fate of compelled commercial speech is the subject of great uncertainty in the US at the moment given two recent decisions by the U.S. Court of Appeals for the D.C. Circuit.  As many previous posts have discussed,  (herehere, here, and here), the conflict minerals rules issued by the SEC was subject to many legal challenges, including one based on the First Amendment.  It its decision of April 14th the Court of Appeals upheld many aspects of the conflicts minerals rule but struck down the requirement that issuers must disclose if it cannot determine that its products are "DRC conflict free."   Under the rule, that disclosure must be made in the issuer's filing with the SEC and made to the public on the company's website. In striking down this provision of the rule the Court of Appeals agreed with the National Association of Manufacturers that such a disclosure was not factual, but ideological in nature, and that it was not targeted at preventing consumer deception.

The critical issue in the First Amendment portion of the case turned on the appropriate level of review.  The U.S. Supreme Court held in Zauderer v. Office of Disciplinary Counsel that government can constitutionally require disclosures of a "purely factual" nature which are "reasonably related to the State's interest in preventing deception of consumers." The Court has repeatedly reaffirmed Zauderer, most recently in the 2010 case Milavetz, Gallop & Milavetz, P.A. v. U.S., where Justice Sotomayor wrote for a unanimous Court that a low level of scrutiny applies only in cases where the compelled speech is "directed at misleading commercial speech."  Because the "conflict free" labeling requirement went beyond that, the rule was subject to heightened scrutiny of Central Hudson.

At the same time as issuing the opinion, the Clerk of the D.C. Circuit issued an order staying the mandate in NAM v. SEC until seven days after disposition of a request for rehearing or rehearing en banc. This means that the court's decision has not yet taken legal effect. Because NAM's Administrative Procedures Act challenge failed, it is possible that both parties could seek rehearing.  Each party has 45 days in which to file a rehearing petition.  So far, neither has.

As noted by the dissenting opinion in NAM v. SEC, another case currently pending the same circuit, American Meat Institute v. U.S. Dep't of Agriculture, raises comparable issues.   In that case the AMI argued that Department of Agriculture rules requiring country of origin labeling compelled speech in violation of the First Amendment because the rules were not aimed at preventing the deception of consumers.   A three judge panel of the Court of Appeals found that Zauderer encompassed interests beyond preventing customer confusion and upheld law.  Thereafter the D.C. Circuit vacated the panel decision and ordered en banc review.  Oral argument is set for May j19th.  

The outcome of these cases will have significant impact on many types of disclosures including but not limited to labeling regarding genetically modified organisms, child labor practices and many others.

At the same time that is seems likely that at least the DC Circuit is willing to uphold some First Amendment challenges to compelled commercial speech, the European Union is taking steps in the opposite direction.  On April 15th the European Parliament adopted  the Directive on disclosure of non-financial and diversity information to require large companies and groups to disclose information on policies, risks and results as regards environmental matters, social and employee-related aspects, respect for human rights, anti-corruption and bribery issues, and diversity on boards of directors.

The new rules will only apply to large companies with more than 500 employees and should impact approximately 6 000 large companies and groups across the EU. Companies will be required to disclose "information necessary for an understanding of their development, performance, position and impact of their activity, rather than a fully-fledged and detailed report. Furthermore, disclosures may be provided at group level, rather than by each individual affiliate within a group."  Under the Directive, companies may choose how best to make their disclosures and may use international, European or national guidelines which they consider appropriate (for instance, the UN Global Compact, ISO 26000, or the German Sustainability Code).

Large listed companies will be required to provide information on their board diversity policy, including, but not limited to, age, gender, educational and professional background. Disclosures will set out the objectives of the policy, how it has been implemented, and the results. Companies which do not have a diversity policy will have to explain why not.

In order to become law, the Commission's proposal needs to be adopted jointly by the European Parliament and by the EU Member States in the Council (Following today's adoption by the European Parliament, the Council is expected to formally adopt the proposal in the coming weeks.  Thereafter the EU member states will have two years to implement the requirements in their national legislation.  Each member state may grant exemptions from the reporting requirements.  Already efforts are underway in some member states to protest the legislation, notably in Germany where the BDI trade association for German businesses argues that the legislation is unnecessary, because more and more firms are already producing reports on corporate social responsibility (CSR) without being forced into it.  "In recent years, the number of companies in Germany who publish annual sustainability or CSR reports on a purely voluntary basis has steadily increased," said Holger Losch, a member of the BDI's executive board.

Thus the European Union may soon be a far cry away from the US position on compelled commercial speech - at least if American Meat Institute goes the way of the NAM v. SEC.  Even if American Meat is more nuanced it seems hard to imagine US disclosure regulations reaching as far as those proposed under the EU Directive especially given the statement in the NAM v SEC opinion that "Congress [could] not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the "securities" label.

Much uncertainty remains in each of the US and EU as to the ultimate outcome of the divergent approaches to non-financial disclosure regulation.  The varying approaches will provide interesting opportunities for empirical comparisons - even as they lead to frustration for issuers.

April 23, 2014
SEC Issues Guidance on Use of Social Media in Offerings and Proxy Fights
by Trevor Norwitz

Editor's Note: Trevor Norwitz is a partner in the Corporate Department at Wachtell, Lipton, Rosen & Katz, where he focuses on mergers and acquisitions, corporate governance and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Norwitz, Sabastian V. Niles, Eitan S. Hoenig, and Matthew I. Danzig.

The SEC staff has released new guidance regarding the use of social media such as Twitter in securities offerings, business combinations and proxy contests (as a senior SEC official telegraphed at the Tulane Corporate Law Institute conference). Until now, SEC legending requirements have restricted an issuer's ability to communicate electronically using Twitter or similar technologies with built-in character limitations before having an effective registration statement for offerees, or definitive proxy statement for stockholders (as the legends generally exceed the character limits). Companies using Twitter and similar media with character limits can now satisfy these legend requirements by using an active hyperlink to the full legend and ensuring that the hyperlink itself clearly conveys that it leads to important information. Although the SEC guidance does not provide example language, hyperlinks styled as "Important Information" or "SEC Legend" would seem to satisfy this standard. Social media platforms that do not have restrictive character limitations, such as Facebook and LinkedIn, must still include the full legend in the body of the message to offerees or stockholders.

The new guidance will enhance the ability of market participants to use character-limited social media like Twitter to disseminate information to investors, which is likely to be especially welcome in high-tech industries where such media are an increasingly vital communications platform. Dueling Tweets have featured prominently in recent activism campaigns and proxy fights involving high-tech companies, most notably eBay's defense against a proxy contest launched by Carl Icahn.

Proxy participants (including directors and officers) must remember that "solicitation" is broadly defined by the SEC and can reach every written communication designed to lead to the giving or withholding of a proxy, including individual Tweets and even, according to SEC staff interpretation, Retweets that forward third parties' views, which are treated as though the Retweeter had written the text of the original Tweet. Every solicitation made before the definitive proxy statement is sent to stockholders must include the required Exchange Act Rule 14a-12 legend (which can now be provided by hyperlink) and be filed with the SEC on the day of first use, and is also subject to Exchange Act Rule 14a-9 antifraud rules and Regulation FD. Companies must therefore coordinate closely with officers and directors to ensure compliance.

The SEC's new guidance on proxy solicitation enables not only issuers but also activist hedge funds and governance activists to use social media in their proxy fights and attacks against a company's board and management before filing and mailing a proxy statement. Companies and their boards will have to be prepared to defend against such attacks and might consider establishing a social media rapid-response team in order to improve their own social media profiles, leverage their networks of friendly followers, and ensure that all participants are coordinated with the company's messaging in the case of an attack.

April 23, 2014
The Informational Role of Internet-Based Short Sellers
by R. Christopher Small

Editor's Note: The following post comes to us from Lei Chen of the Department of Accounting at the London School of Economics and Political Science.

Despite serious concerns about the quality of auditing and financial reporting of U.S.-listed Chinese firms, the SEC and the PCAOB have been unable to provide sufficient or timely information to U.S. investors due to resource constraints, the confidentiality rules underlying the PCAOB disciplinary proceedings, and no access to relevant work papers of Chinese auditors. In the paper, The Informational Role of Internet-Based Short Sellers, which was recently made publicly available on SSRN, I focus on a new breed of information intermediary, i.e. Internet-based short sellers that have emerged in response to such regulatory loopholes and severe information asymmetry. Based on hand-collected Internet reports released during the 2009-2012 period by short sellers that target U.S.-listed Chinese firms, I find that these short sellers provide substantial information both directly and indirectly to investors.

Short sellers' reports have an immediate effect on stock prices of targeted firms, and the magnitude of such an effect can be explained by the timeliness and quality of the information contained in the reports. Non-targeted firms experience negative spillover upon short sellers' coverage, especially when they have shared the same non-Big 4 auditors as targeted firms. In the long run, the stock prices of most targeted firms do not recover, and the realized stock returns are highly correlated to short sellers' implied stock returns. Short sellers' coverage is likely to be followed by class action lawsuit and SEC enforcement. I also find that short sellers are more likely to cover the firms that show impressive operating and stock performances, and that have already displayed red flags in financial reporting quality. Overall, by exploiting the unique setting of U.S.-listed Chinese firms, I show that Internet- based short sellers overcome the limitations of regulators. This paper contributes to both the literature on the role of media as an information intermediary and the literature on short selling. Last, my research also adds to current discussion of more intensive, mandated disclosure of short interest.

This paper focuses on U.S.-listed firms and covers the reports from 2009-2012, which limit the generalizability of my findings. To enhance our standing of Internet-based short sellers, broader samples need to be adopted. For instance, in response to recent accounting debacles at Chinese firms, the PCAOB has intensified its dialogue with both the China Securities Regulatory Commission and the Ministry of Finance. Further research might examine whether the role of short sellers targeting Chinese firms has weakened due to such regulatory initiatives. Moreover, Internet-based short sellers certainly extend their coverage to other firms and have become more active after establishing the reputation with successful bearish calls on Chinese companies. It will be interesting to examine their impact on non-Chinese firms and their selection of targets, given less severe information asymmetry in other settings.

A voluminous literature has examined the effects of the tone or sentiment expressed in a variety of information outlets such as annual reports, analyst reports, media news, and the Internet. So far, this line of research is based on an analysis of texts, and has ignored non-text elements such as pictures, audio, and video. Short sellers' reports contain considerable non-text information. For example, when exposing the fraud of Sino Clean Energy, short sellers present dozens of photos and hours of surveillance videos of its plants that show no meaningful production. As I documented, reports that present first-hand evidence, which is normally in the form of pictures, audio or video, cause the most drastic market reactions. However, any dictionary or linguistic algorithm used in this literature would fail to capture the sentiment in such a report. Therefore, a fruitful area for future research could be the role of non-text information conveyed by information intermediaries in financial markets.

The full paper is available for download here.

April 23, 2014
A Corporate Right to Privacy
by Elizabeth Pollman

The following post comes to us from Elizabeth Pollman, Associate Professor, Loyola Law School, Los Angeles, and is based on her forthcoming article in the Minnesota Law Review entitled "A Corporate Right to Privacy." The full paper is available here.

The debate over the scope of constitutional protections for corporations has heated up with law scholars from a variety of fields weighing in on Citizens United and Hobby Lobby. Despite the volume of commentary and analysis on these important cases and the issues they raise, other areas concerning the nature and scope of corporate rights have been left unexplored. This article takes up one of those unexplored questions - whether corporations have, or should have, a constitutional right to privacy.

The Supreme Court has never squarely answered whether corporations have a constitutional right to privacy - either under its decisional autonomy or informational privacy line of cases. Scholars and courts sometimes cite United States v. Morton Salt, a case from 1950, as establishing that corporations have no constitutional right to privacy, but that wasn't the holding of the case and it pre-dated the Court's privacy jurisprudence. In the more recent AT&T v. FCC case, AT&T claimed a "personal privacy" exemption under FOIA to prevent the public disclosure of its documents. However, as AT&T made no constitutional privacy claims, the Court decided the case as a matter of statutory interpretation. Meanwhile, other federal and state courts have split on the corporate privacy issue, with some courts rejecting claims out of hand or with flawed reasoning, and some courts recognizing a limited right to corporate privacy in contexts like discovery and subpoenas, but without delineating the scope of the right.

After establishing the open question, the article attempts to find a path forward by examining why corporations receive any constitutional protection and how the Supreme Court has made these determinations in the past. Although the Court has not articulated a consistent framework, it has nonetheless often relied on a rationale of corporations as associations of persons from whom rights can be derived. The article traces the Court's jurisprudence to illustrate this derivative basis for corporate rights, and it gives a taste of a more detailed analysis and study of the issue that Margaret Blair and I have been working on in another forthcoming article (The Derivative Nature of Corporate Constitutional Rights, forthcoming William & Mary Law Review 2015). The Court has not accorded rights to corporations qua corporations; rather, the Court has recognized that a corporation can be accorded protections in order to protect the rights of individuals associated through the corporate form. Thus, the article asserts that in determining whether to accord a right to a corporation, we must look to whether the purpose of the right is served by according it to the corporation in question - that is, whether it is necessary to protect natural persons - and if the right is of a type that inheres only in an individual capacity or if it can be held derivatively.

One of the key insights that comes with articulating this approach is that the derivative nature of corporate rights requires paying attention to distinctions between different corporations. While some corporations can be understood as associations of their members, from whom a right could be derived, other corporations cannot be fairly regarded as representing any particular natural person or group of natural persons.

The article applies this insight and approach to the corporate privacy question, observing that because corporations exist along a spectrum - from large, publicly traded corporations constituted purely for business purposes to smaller organizations with social, political, or religious purposes - the existence of a corporate privacy right will and should vary. In most circumstances, and with respect to most corporations, according a privacy right would not serve the purpose of such a right because people are not involved in the corporation in a way that warrants that protection. Yet a categorical denial of privacy rights to corporations may also be unwise in our world of diverse corporations, particularly given the evolving and indeterminate concept of privacy.

Coming to this understanding requires grappling with what the constitutional right to privacy is aimed at protecting and whether privacy can be conceived of as including groups. Further, it requires looking into different types of corporations and examining whether there are persons involved who would have a privacy interest at stake that would be protected by granting the corporation a right to privacy. It is this sort of engagement with the different types of organizations operating through the corporate form that is needed for line-drawing in the realm of corporate constitutional rights. As it is often said in corporate governance, one size does not fit all.

April 23, 2014
Advisen Releases First Quarter 2014 Corporate and Securities Litigation Report
by Kevin LaCroix

Overall Filings of corporate and securities lawsuits during the first quarter of 2014 were at their lowest levels since before the financial crisis, according to the latest report from Advisen, the insurance information firm. The April 2014 report, which is entitled "D&O Claims Trends: 2014," can be found here. As discussed below, the report will also be the subject of an Advisen webinar at 11:00 am EDT on Thursday, April 24, 2014.

It is important to note that unlike other regularly published reports in this area, the Advisen report analyses filings patterns for more than just securities class action lawsuits. The information in the report encompasses a broad range of corporate and securities lawsuits, including securities class action lawsuits but also including other types of lawsuits as well, including regulatory and enforcement actions; breach of fiduciary duty lawsuits; and securities lawsuits not filed as class actions. In addition, the Advisen reports includes litigation activity both inside the outside the United States. The Advisen report also uses its own "counting" protocols. These important characteristics of the Advisen report account for the signficiant differences between the statistics and information discussed in the Adivsen report and the information found in other published reports.

The first quarter traditionally is a busier period during the calendar year for the filing of corporate and securities lawsuits. However, according to the report, there was a 35 percent decline in the number of new corporate and securities lawsuits filed during the first quarter of 2014 compared to the same quarter a year ago and a 17 percent decline from the final quarter of 2013. The 238 first quarter filing "events" noted in the Adivsen report "represent the lowest quarterly total since prior to the financial crisis."

Lawsuit filings were generally down across all categories of cases that Advisen follows during the first quarter. However, securities class action lawsuit filings were basically flat on a year-over-year quarterly basis, as there were 39 securities lawsuit filings in the first quarter of 2014, compared to 38 in the first quarter of 2013.

With the decline of other types of suits and with securities class action lawsuit filings remaining flat, the proportion that securities class action lawsuit filings represent of all corporate and securities filings increased in the first quarter. During the first quarter of 2014, securities class action lawsuits represented 17 of all corporate and securities lawsuit filings, which is the highest quarterly percentage since the third quarter of 2009. The report notes with respect to this percentage that "coming on the heels of two consecutive years of growth as a percentage of total events, this is a trend that is certainly worth following."

Consistent with the overall downward trend, the report notes that M&A litigation, which had surged in recent years, was down in the first quarter of 2014 at least on an absolute basis. Indeed, the total number of M&A lawsuits peaked in 2011 and have decreased materially over the two years following. The report does not consider whether or not the decline in the absolute numbers of M&A lawsuits is due to a decline in overall M&A activity or how the numbers of M&A lawsuits filed compared to the varying levels of M&A activity over the time period under consideration.

The financial services sector "continues to be a lightening rod for D&O related litigation." As has been the case in recent quarter, the financial services sector is the "leading target of new filings." Companies in the financial services sector were the target of new filings in 29 percent of the total. Other active sectors included consumer discretionary at 17 percent and health care at 13 percent.


Long time observers of corporate and securities claims activity know that lawsuit filings in this arena ebb and flow over time, and that the filings trends play out across multiyear periods, not on a quarterly basis. The fact that filings in any given quarterly period are "up" or "down" compared to a prior quarter or a year prior quarter may or may not tell you what you need to know to identify filing trends.

There are obviously a number of factors involved here. We are still coming out of the very active litigation period following the credit crisis, and while there may be many fewer credit crisis related lawsuit filings, many of the credit crisis cases are still playing out. If you talk to plaintiffs lawyers, they will tell you they are as busy as they have ever been. The relative number of quarterly filings may not mean the plaintiffs are inactive, it may only mean they are busy with other things.

One thing to keep in mind about apparently lower filing levels is that there have been short periods of apparently decreased filing activity in the past. For example, during the period from mid-2005 to mid-2007, there was a so-called "lull" in new securities lawsuit filings. However, the lull ended abruptly when the early fallout from the credit crisis started to hit, and we then moved into a period of very active litigation activity that lasted for several years. The point is that during the first quarter 2014, there were no events driving litigation activity, but if an event were to occure, there would likely soon be a swift upswing in new filings activity. In other words, it would be dangerous for anyone to presume that the apparently quiet first quarter of 2014 represents some kind of permanent downshift in the corporate and securities litigation arena. You can be sure that as soon as the next bandwagon appears, the plaintiffs' lawyers will be among the first to jump on.

The report itself supplies a number of possible explanations for the quarterly downturn, some of which that are consistent with my remarks here. For example, the report speculates that the quarterly decline is "likely due to a combination of factors" including the "continued wind down of credit crisis litigation, fewer U.S. public company targets, and a limited number ability to settle due to fewer mediators." For sure, the wind down of the credit crisis litigation is a factor as is the historical decline in the number of publicly traded companies (there are 40 percent fewer public companies than in 1997).

There are a number of current factors that could point to an upswing in the future or that at least seem likely to drive future litigation activity. The first is the new Financial Fraud Task force that the new SEC commissioner has formed. The activities of this task force seem likely to drive not only increased enforcement activity, but also follow-on civil litigation as well. Another factor is the Dodd Frank whistleblower program, which also seems likely to produce increased enforcement activity and follow-on civil litigation. In addition, the upswing in IPO activity, which picked up steam in 2013 and has continued so far in 2014, is likely to lead to increased activity due to the heightened susceptibility of IPO companies to litigation activity.

A wild card in all of this is the Halliburton case now pending before the U.S. Supreme Court. Although based on the tenor of the oral argument it seems unlikely, it is still at least theoretically possible that the Supreme Court will throw out the "fraud on the market" theory. If that were to happen, it could be much harder for plaintiffs to pursue their claims. But while that might result in fewer class action filings, it could actually result in an increase in the number of filings, as more claimants pursue their claims as class action lawsuit. However, if, as seems likelier at this point, the Court adopts some middle course and doesn't throw out but instead modifies the way the fraud on the market presumption operates, that could have yet a different impact on securities class action lawsuit filings. Until we know for sure what the outcome of the pending case is, it is premature to speculate on what will change. It is possible that while are waiting, the plaintiffs are holding back - although there have been plenty of case filings while the Halliburton case has been pending and in fact securities class action filings during the first quarter of 2014 were level with the first quarter of 2013.

Quarterly Advisen Claims Seminar: At 11:00 am EDT on Thursday April 24, 2014, I will be participating in a webinar entitled "Quarterly D&O Claims Trends: Q1" to discuss the findings in the Advisen report and other important D&O claims trends. The panel will also include my good friends Steve Shappell of AON and Will Fahey from Zurich. Jim Blinn of Advisen will moderate the panel. For further information about the webinar and to register, please refer here.

April 23, 2014
Kahn v. M&F Worldwide
by Robert T. Miller

Let me begin by thanking Gordon Smith and the other organizers of the Conglomerate for inviting me to guest-blog here for the next two weeks.

As far as I can tell, little has been said here about the Delaware Supreme Court's decision last month in Kahn v. M&F Worldwide Corp. As many readers will already know, the case concerns the standard of review to be applied to the decision of a board of directors of a controlled corporation when the directors approve a freeze-out merger between the corporation and the controlling stockholder.

Under Weinberger v. OUP, Inc., 457 A.2d 701 (Del. 1983), freeze-out mergers were traditionally reviewed under the entire fairness standard with the burden of proof resting on the controlling stockholder. Under Kahn v. Lynch, 638 A.2d 1110 (Del. 1994), however, if the controlling stockholder can show either (a) the merger was approved by a well-functioning committee of independent directors, or (b) the merger was approved by a fully-informed, uncoerced vote of the majority of the minority stockholders, then the burden would shift to the plaintiff stockholders to show that the transaction was not entirely fair. Such transactions came to be known as Lynch transactions.

Following a suggestion in dicta by then Vice Chancellor Strine in In re Cox Communications Shareholders Litig., 879 A.2d 604 (Del. Ch. 2005), the Delaware Supreme Court has now held that if both procedural safeguards are adopted, then the transaction will be reviewed under the business judgment rule. More accurately, in the words of Justice Holland's opinion,

[I]n controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

The theory here is that combining a well-functioning independent committee and a fully-informed majority-of-the-minority vote replicates the standard structure for the approval of third-party mergers under DGCL Section 251 (i.e., board vote plus stockholder approval), and so the standard of review should be same as it would be for a third-party Section 251 merger.

Like almost everyone else, I find this a sensible outcome, but I want to note a few important points about the case that seem to have been overlooked in much of the commentary I have thus far seen.

To begin with, the mere shifting of the burden of proof in Lynch transactions, while not negligible, was of relatively minor value to controlling stockholders for two reasons. First, the burden was still on the controlling stockholder to demonstrate that one of the procedural safeguards had been adopted, and this required a significant amount of proof: for example, merely saying that a committee was composed of independent directors did not suffice to show that the directors really were independent. Second, even if the controlling stockholder prevailed on this issue, the standard remained entire fairness, and determining whether the transaction was entirely fair often could not be resolved even at the summary judgment phase. Hence, the controlling stockholder was in for a costly litigation. It may seem that M&F solves that problem, but this is not quite right. Rather, the burden is still first on the controlling stockholder to demonstrate the existence and effectiveness of both of the required procedural safeguards, and although Justice Holland emphasizes that this can sometimes be done at the summary judgment phase, it is easy to imagine that sometimes a trial will be required to determine issues of material fact.

Second, there is to my mind a serious ambiguity in the new doctrine. In the summary of its holding quoted above, the court says that, to receive the protection of the business judgment rule, the independent committee must have fulfilled "its duty of care in negotiating a fair price." This could mean simply that, in approving the merger, the committee fulfilled its duty of care in accordance with Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) - that is, before deciding to approve the merger, the committee had before it all the material information reasonably available. On the theory that the standard of review will be business judgment review when the usual conditions to the applicability of that standard have been replicated, it would seem logical that the duty of care demanded of the independent committee be this usual kind of care. But that is not quite what the court said, for it also refers to the committee's having "negotiat[ed] a fair price," which may suggest that something more is demanded than "process due care only," Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000) (emphasis in original), namely, that the board have obtained a fair price.

That result, of course, would entirely subvert the holding in the case, but the point is not so easily dismissed. Although a freezout merger does not involve a change of control (the controlling stockholder controls the corporation both before and after the transaction), if the merger consideration is cash, as it was in M&F, then the transaction represents the last opportunity for the minority stockholders to get a premium for their shares, and, in fact, such transactions are typically done at a premium. This implicates some of the concerns underlying Revlon: it would seem that, besides reviewing the level of care taken by the independent committee in the decision-making process, the court should also review its actions to determine whether it took reasonable steps to get the best price reasonably available for the minority stockholders. Obviously, the range of reasonably possible actions for an independent committee of a controlled corporation, especially when the controlling stockholder announces it has no desire to sell its shares, is much more limited than the range of actions available to a board of an independent company putting itself up for sale. But, it would still seem to me that the court should review the independent committee's actions under Revlon, taking account of the limits under which the committee is likely to operate. After all, in a Section 251 cash merger, the court reviews the transaction under Revlon, not just the business judgment rule.

Now, although it does not say that it is doing so, the court does seem to be applying some form of enhanced scrutiny to the actions of the independent committee. Thus, in determining whether the committee acted with due care, the court notes factors of clearly procedural significance (e.g., the number of meetings the committee held, its engagement and use of a financial advisor, etc.), but it also enumerates factors that seem to bear more on the substantive question of whether the committee got the best price reasonably available, including where the deal price fell in the financial advisor's valuation ranges, the extent to which the company's business was deteriorating, the fact that the committee was able to negotiate a modest increase in the price, and the committee’s studying alternative strategic transactions (presumably because, even though the controlling stockholder had announced it would not sell its shares in an alternative transaction, such alternative transactions could inform the committee's decision about the fairness of the price to be paid by the controlling stockholder). The inquiry that the court performs under the label of a due care inquiry seems much like a Revlon review.

Finally, there is the question of how M&F will affect the relative attractiveness, from a controlling stockholder's perspective, of so-called Siliconix transactions in which the controlling stockholder tenders for all the outstanding minority shares, hoping to get above the 90% threshold so that it can follow up the tender offer with a DGCL Section 253 short-form merger. See In re Siliconix Inc. Shareholders Litig., 2001 WL 716787 (Del. Ch. 2001). In such a transaction between stockholders, both of whom are free to act in their self-interest, the controlling stockholder has no duty to offer the minority stockholders a fair price, providing only that the controlling party makes appropriate disclosure and the tender offer is not coercive. Aside from alleging disclosure violations, there is usually little plaintiff stockholders can complain about in a Siliconix transaction, but since the controlling stockholder has to achieve the 90% threshold to make the whole deal worthwhile, such transactions can be difficult to complete if the controlling stockholder is starting from a relatively low percentage interest in the company or the price being offered is not especially attractive. On these important questions, see the fascinating papers by Subramanian here and Restrepo and Subramanian here.

April 23, 2014
Winship on SEC Settlements
by Eric C. Chaffee

Verity Winship has posted Policing Compensatory Relief in Agency Settlements on SSRN with the following abstract:

High profile rejections of proposed agency settlements have drawn new attention to judicial review of agency settlements, particularly in the context of the Securities and Exchange Commission. The discussion, however, generally ignores one important function of these settlements: compensation. When an agency acts as "public class counsel" by seeking compensatory relief, it represents two overlapping groups: the public and the injured individuals or entities that are being compensated. This essay argues that, as is the case with private representative actions, protections should be triggered when the rights of absent represented parties to their "day in court" are compromised. This may happen when, for instance, absent "class members" are precluded from bringing other related actions or their potential recovery is limited by the agency's action. This essay does not propose a wholesale import of private litigation mechanisms to the agency context or suggest that compensation is the sole or primary function of agency settlements. Rather, it provides content for the broad "fair, reasonable, and adequate" standard that judges currently use to review agency settlements, proposing that judicial review of compensatory relief focus on the adequacy of representation.

4/24/2014 posts

The D&O Diary: Bankruptcy Court Lifts Stay to Allow D&O Insurer to Pay Individuals' Defense Expenses
SEC Actions Blog: SEC Settles Another Expert Network Insider Trading Case Blog: Cybersecurity: "Heartbleed" as a Risk Factor?
Race to the Bottom: CSR -- and other Disclosure as "Compelled Speech": The US and the EU Consider Very Different Approaches
HLS Forum on Corporate Governance and Financial Regulation: SEC Issues Guidance on Use of Social Media in Offerings and Proxy Fights
HLS Forum on Corporate Governance and Financial Regulation: The Informational Role of Internet-Based Short Sellers
CLS Blue Sky Blog: A Corporate Right to Privacy
The D&O Diary: Advisen Releases First Quarter 2014 Corporate and Securities Litigation Report
Conglomerate: Kahn v. M&F Worldwide
Securities Law Prof Blog: Winship on SEC Settlements

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.
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