Securities Mosaic® Blogwatch
July 28, 2014
Texas Appellate Court Affirms Transocean Deepwater Horizon Derivative Suit Dismissal: An Interesting Angle on Corporate Inversion Transactions?
by Kevin LaCroix

In a July 24, 2014 opinion (here), an intermediate Texas appellate court, applying Texas law, affirmed the trial court's dismissal on forum non conveniens grounds of the Deepwater Horizon disaster-related shareholder derivative suit filed against Switzerland-domiciled Transocean Limited. The court's ruling is interesting in and of itself, but it may be even more interesting in light of the recent efforts of a number of U.S. companies to relocate their headquarters and tax domicile overseas through the increasingly controversial transaction known as a corporate inversion (for more background about which refer here).

Transocean had been founded as a U.S. company but it had after many decades of doing business in the U.S. moved its domicile overseas. It is now headquartered in Switzerland. In the shareholder derivative suit, the trial court dismissed the case, concluding that Switzerland was the more convenient forum for the plaintiff's derivative claims. The appellate court concluded that the trial court had not abused its discretion in dismissing the case on forum non conveniens grounds.

If the Texas courts' rulings in the Transocean Deepwater Horizon derivative suit are any indication, the many U.S. companies now moving their headquarters overseas through inversion transactions may not only realize significant taxation benefits but they may also succeed in reducing their susceptibility to shareholder derivative litigation in U.S. courts.


Transocean owned and operated the Deepwater Horizon drilling rig, located in the Gulf of Mexico. In April 2010, the rig exploded and ultimately sunk, resulting in the deaths of eleven workers as well as in a massive oil spill.

Transocean was founded in 1953 as a Delaware corporation headquartered in Houston. In 1999, the company became a Cayman Islands corporation, and in 2008 it reincorporated in Switzerland. Its stock continues to trade on American exchanges as well as on Swiss exchanges. The company's U.S. subsidiary, which is headquartered in Houston, has thousands of U.S. employees. Of the parent company's twelve directors, five live in Texas, three live in other U.S. states, one lives in Canada, and three in Europe. Only one of the European directors resides in Switzerland.

Margaret Richardson, a California resident, filed a derivative lawsuit against the Transocean board in Harris County (Texas) District Court. She alleged that the directors' actions had harmed the company by causing it to incur substantial costs, liability and reputational harm. She alleged that the directors had been aware or should have been aware of the history of safety, maintenance and regulatory compliance issues - both for the company as a whole and with respect to the Deepwater Horizon rig - yet failed to take corrective actions, while making false statements to shareholders about the company's safety and compliance record. The plaintiff asserted causes of action for breach of fiduciary duty, unjust enrichment and waste of corporate assets. The parties agree that because Transocean is a Swiss company, Swiss law applies to Richardson's claims.

The defendants moved to dismiss the plaintiff's action on forum non conveniens grounds. They stressed the difficulties the trial court would face in applying Swiss corporate law. The trial court granted the motion to dismiss and the plaintiff appealed.

The July 24 Opinion

On July 24, 2014, in an opinion by Justice Michael Massengale, a three-judge panel of the Court of Appeals of the First District of Texas affirmed the trial court's ruling, concluding that the trial court judge had not abused her discretion in granting the defendants' motion to dismiss on forum non conveniens grounds.

In contending that the trial court judge had abused her discretion in dismissing the suit, Richardson had emphasized Transocean's American origins; the substantial presence of its American subsidiary; the American residence of several of the company's directors; and the significant human, economic and environmental costs to Texas from the Deepwater Horizon disaster. She argued that Transocean's connections to Switzerland are "primarily tenuous corporate fictions," while the activities of the company's U.S. subsidiary affected the lives of thousands of Texans.

In assessing whether or not the trial court judge had abused her discretion, the appellate court assessed whether the trial court had considered all of the relevant private and public interest factors and whether the trial court's balance of the factors was reasonable.

Among the private interest factors, the appellate court considered the accessibility of the evidence and witnesses. Although the Deepwater Horizon disaster took place in the Gulf of Mexico, the actions of the directors at issue in the plaintiffs' derivative lawsuit "predominately took place in Switzerland." Accordingly, the appellate court said, while there may be circumstances that favor a Texas forum, "the trial court reasonably could have concluded based on other facts presented - most notably that this case concerns acts of corporate governance by the board of directors of a Swiss corporation that holds it meetings in Switzerland - that the balance of private-interest factors favored litigation in Switzerland."

The appellate court also concluded that the appellate record did not show that the trial court judge abused her discretion in weighing the public interest factors. The appellate court seemed to be particularly concerned with the problems associated with applying the law of Switzerland, a trilingual country and a civil-law jurisdiction with a code-based jurisprudence. The trial court said that given that Richardson's suit "concerns the internal affairs of a Swiss corporation" and that the plaintiff had failed to show that the stockholders had a particular connection with Texas, and given "the challenges of applying Swiss law in a complex, unsettled area," the trial court "could reasonably have concluded that the public interest factors favored litigation in Switzerland."


The Texas courts' consideration of these forum non conveniens issues very much reflected the specific circumstance presented, particularly the perceived difficulties for Texas courts in applying Swiss law. A different set of circumstances might well have produced a different outcome, notwithstanding the fact that the defendant company in a shareholder derivative suit is domiciled outside the U.S. Indeed, as discussed here, in at least one of the many other lawsuits that the Deepwater Horizon disaster produced, the Southern District of Texas refused to dismiss at least some of the common law damages claims of BP shareholders on forum non conveniens ground, even though English law governed the shareholders' claims. Clearly, the mere fact of a defendant company's non-U.S. domicile is not a universal safeguard against all U.S.-based shareholder litigation.

Just the same, the most salient factor in the Texas courts' consideration of these issues was the fact that Transocean was headquartered outside the U.S and that as a result the law of company's domicile governed the shareholder claimant's derivative lawsuit. These same considerations resulted in the dismissal on forum non conveniens grounds of the Deepwater Horizon disaster-related shareholders' derivative lawsuit that had been filed against the board of BP; in January 2013, the Fifth Circuit affirmed the district court's dismissal of the BP derivative lawsuit, as discussed here.

These dismissals of purported shareholders' derivative lawsuits on forum non conveniens grounds are of course interesting in and of themselves, for what they say about the relative insusceptibility of non-U.S. domiciled companies to U.S.-based derivative litigation.

But I find these dismissals, particularly the dismissal of the Transcocean lawsuit, even more interesting in light of the recent wave of corporate inversion transactions, in which U.S.-based companies merge with non-U.S. companies and then move their corporate headquarters to the target company's location. The primary motivation for these transactions is tax-related, as the lower corporate tax rates applicable in many non-U.S. jurisdictions can result in a substantial tax savings for the acquiring company.

The Transocean case shows that in addition to the intended tax benefits, a company's move to a foreign domicile through a corporate inversion transaction may also reduce the susceptibility of the company's board to certain types of shareholder litigation.

Transocean itself had started as U.S. company and had maintained a U.S. headquarters for over four decades. Even though the company's U.S. subsidiary maintained substantial operations and employed thousands of workers in the U.S., because the company was based outside the U.S. and because its significant board activities took place outside the U.S., the courts of its home jurisdiction were held to be a more convenient forum than a U.S. court for a shareholder derivative lawsuit. Because shareholder litigation is far less well-established outside the U.S., the company's board, as a result of the company's non-U.S. domicile, arguably faces a much reduced exposure to these kinds of shareholder suits than as a U.S.-based company.

There may be many substantial tax-related reasons for companies to engage in the type of corporate inversion transaction that is all the rage these days. (I suspect that tax considerations were behind Transocean's overseas move as well, but the appellate court's opinion is silent about the reasons for the company's move.) But along with the tax considerations there may be additional benefits as well - that is, that the potential liability exposures of the acquiring company may be reduced by taken on the non-U.S. domicile of the target company.

As noted above in connection with the BP shareholder common law damages claims, the fact that a company is based outside the U.S. is not an all-purpose defense against all U.S.-based shareholder suits. Nevertheless, the Transocean example shows that a company's move to a non-U.S. headquarters can reduce the potential liability exposures of the company's board, at least with respect to shareholder derivative litigation.

July 28, 2014
Though Delaware Legislature Has Tabled Action, Upcoming Judicial Review of Fee-Shifting Bylaws Seems Likely
by Kevin LaCroix

The Delaware Supreme Court stirred up quite a bit of controversy earlier this year in the ATP Tours, Inc. v. Deutscher Tennis Bund case when it upheld the facial validity of a fee-shirting by law. The bylaw provided that an unsuccessful shareholder claimant in intracorporate litigation would have to pay his or her adversaries' cost of litigation. The controversy seemed headed for a swift resolution when the Delaware General Assembly quickly moved to act on a measure that would have limited the Supreme Court's ruling to non-stock corporations (meaning that it wouldn't apply to Delaware stock corporations). However, as discussed here, the legislature tabled the measure and now it will not be acted upon until at least January 2015.

In light of the uncertain state and indefinite future of fee-shifting bylaws under Delaware law, many lawyers have been counseling caution. For example, a July 11, 2014 memo from the Wilson Soninsi firm (here) states that in light of "uncertain fate of fee-shifting bylaws" companies should adopt a "wait and see attitude." Going to the heart of the matter, the memo further states that "we do not believe that directors of most Delaware corporations should adopt any specific fee-shifting bylaw at this time," as companies adopting a fee-shifting bylaw now could "face the possibility of later statutory amendments intended to undercut those provisions, potential investor opposition, and possible litigation risks."

But while the prudent course for companies considering these bylaws arguably is to await further action by the Delaware General Assembly next year, at least a few companies have gone ahead and adopted some version of a fee shifting bylaw. As detailed in Tom Hals's July 7, 2014 Reuters article entitled "U.S. Companies Adopt Bylaws That Could Quash Some Investor Lawsuits" (here), at least six companies have adopted fee-shifting bylaws. Interestingly, among these companies are two - Biolase, Inc. and Hemispherix Biopharma, Inc. - that adopted bylaws with the obvious intent of seeking to address specific ongoing doing disputes in which each of the companies is involved.

Because of the targeted nature of these bylaws and because of the ongoing disputes, it is possible that Delaware's courts will be called upon to consider the validity of each of the company's respective bylaws even before the Delaware legislature acts on the pending legislation next year.


As discussed in a July 22, 2014 Law 360 article (here, subscription required) Hemispherx adopted its fee-shifting bylaw in response to an ongoing shareholder derivative lawsuit. The plaintiffs filed the lawsuit in June 2013, seeking to invalidate $2.5 million in bonuses paid to board members in November 2012. The plaintiffs contend that the bonuses were not permissible under the board members' employment agreements.

On July 10, 2014, Hemispherx's board adopted a fee shifting bylaw attempting to impose a retroactive requirement holding shareholder plaintiffs liable for all the defendants' costs in the event that the plaintiffs are not successful on all of their claims. The bylaw, which is detailed here, applies to any securityholder who after July 3, 2014 "initiates, asserts, maintains or continues" a derivative action or breach of fiduciary action against any current or past director, officer or securityholder and who is not successful on the merits. The bylaw also provides that the company can require a shareholder claimant to "post a surety" for the expenses incurred in defending the action.

According to a July 22, 2014 Wall Street Journal Law Blog post (here), the shareholder plaintiffs in the Hemispherx derivative suit have asked the court to invalidate the bylaw, arguing that it unfairly saddles them with financial risk. The plaintiffs argue that the company has "changed the rules in the middle of the game to place the plaintiffs and their counsel at risk not only for their own litigation costs, but for all litigation costs of the defendants back to the beginning of the case."

The blog post quotes the company's general counsel as saying that the bylaw was adopted to protect the money-losing developmental stage biotech company's "scare resources," noting that the bonuses at issue were intended to "encourage and reward hard work" and came after an 18-month period in which no bonuses were paid. The company's outside counsel added that whatever the debated merits of fee-shifting bylaws, the right to adopt such a bylaw now exists and companies can use the bylaw "as a sword against cases that corporations themselves deem to be empty and frivolous."


Biolase also adopted its bylaw in response to an ongoing dispute, but its bylaw is even more specifically targeted to address the dispute than the one adopted by Hemispherx. As discussed in a detailed July 8, 2014 post on Alison Frankel's On the Case blog (here), Biolase adopted its fee-shifting bylaw as the latest step in an ongoing dispute with its former Chairman and CEO, Frederico Pignatelli, whom the company's board ousted in June after months of legal wrangling over the composition of the company's board.

At the same meeting at which the board ousted Pignatelli, it adopted a fee-shifting bylaw. But the bylaw Biolase adopted involves an interesting variant. Instead of applying to any shareholder claimant, the Biolase bylaw applies only to current or former directors (or anyone acting at their behest) who assert unauthorized claims against the board. In her blog post, Frankel quotes a company spokesman as saying that the bylaw was narrowly tailored in the hope of avoiding additional litigation expenses after the bitter fight to oust Pignatelli.

Pignatelli has already made it clear he is ready to continue the fight. As reflected here, Pignatelli has sent a books and records request to the company "relating to suspected wrongdoing, mismanagement and corporate governance failures by the company's board of directors." From the statements of Pignatelli's counsel that Frankel quotes in her blog post, it appears that Pignatelli is primed to challenge the Biolase fee-shifting bylaw, which Pignatelli's counsel says is "clearly designed to chill actions taken to protect all shareholders and hold the board accountable for misconduct."


There would seem to be a pretty good chance that between the Hemispherix case and the Biolase case that at least one and possibly two Delaware courts will have to address the question of a validity of a fee-shifting bylaw for Delaware stock corporations, perhaps before the Delaware legislature acts on the pending legislation next year.

The question the courts will be called upon to address with respect these companies' bylaws is whether or not the Delaware Supreme Court's decision in the ATP Tour case compels a conclusion that the companies' respective fee-shifting bylaws are valid and enforceable. A threshold issue the courts will have to address is whether the Delaware Supreme Court's decision, which involved a non-stock corporation, also applies to stock corporations. Although many commentators have assumed that the decision is equally applicable to stock corporations, no court has yet made that determination.

Another issue that the courts will have to address is whether the bylaws, even if valid, are enforceable. As discussed here, the Delaware Supreme Court said in the ATP Tour case that whether a fee-shifting bylaw is enforceable depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that are otherwise facially valid will not be enforced if adopted or used for inequitable purposes. Specifically, the Court said a fee-shifting bylaw "may be enforceable if adopted by the appropriate corporate procedures and for a proper corporate purpose."

The claimants in the disputes with Hemispheryx and Biolase may try to argue that the respective bylaws were not adopted for proper corporate purposes but rather were merely means to try to deprive the claimants of their rights to seek legal redress through the courts. On this point, it is interesting to note that the Delaware Supreme Court specifically said that on the question of what might constitute an "improper purpose" that "the intent to deter litigation... is not invariably an improper purpose." Fee shifting provisions "by their nature, deter litigation." The intent to deter litigation "would not necessarily render the bylaw unenforceable in equity."

The developments in these cases will be closely watched. As Alison Frankel said in her post about the Biolase bylaw, if Pignatelli, the former Biolase CEO, is unsuccessful in challenging the validity or enforceability of the bylaw, "more public corporations will be emboldened to enact loser pays provisions." Either way, the outcome of the courts' considerations of these issues could affect the Delaware legislature's consideration of the pending legislation next year, as regardless of the outcome one side or the other is likely to pick up ammo to use in the debates surrounding the merits of the legislation - and of fee-shifting bylaws.

When the Delaware legislature tabled the proposed legislation, it seems as if the topic of fee-shifting bylaws would lie dormant until next year. For better or worse, that will not be the case. Instead, there could possibly be some significant developments before the legislature takes up the issue again.

The Halliburton Decision and D&O Insurance: One of the many questions being asked in the wake of the U.S. Supreme Court's decision last month in the Halliburton case is what the decision's implications are for D&O insurance. Readers interested in thinking about this issue will want to read the July 25, 2014 Law 360 article by Roberta Anderson of the K&L Gates law firm entitled "Your D&O Insurance Policy Post-Halliburton" (here, subscription required).

After summarizing and reviewing the Court's holding, Anderson considers that decision's D&O insurance coverage implications. Anderson also analyzes the likely insurance issues associated with the Court's holding that defendants may present absence of price impact evidence to try to defeat class certification. She specifically reviews current insurer initiatives to address the costs for event studies that defendants will use to show the absence of price impact. Anderson's interesting article provides a good summary of the relevant issues.

July 28, 2014
SEC Charges Seattle Firm and Owner With Misusing Client Assets for Vacation Home and Vintage Automobile
by Alexa Astarita

The SEC charged the owner of a Seattle-based investment advisory firm with fraudulently misusing client assets to make loans to himself to buy a luxury vacation home and refinance a rare vintage automobile.  

An SEC investigation found that the owner of the firm used assets from the portfolio of a senior citizen client to fund $3.1 million in personal loans without telling her or obtaining her consent.  The loans were not in the best interest of the client and significantly favored the owner, who provided no collateral, had no set pay-off dates, and paid most of the interest at the prime rate (which banks typically provide their most credit-worthy customers).  He also improperly directed an investment fund managed by his firm to make more than $4.5 million in loans and investment purchases to facilitate personal real estate deals and fend off claims from disgruntled clients.  He diverted more than $500,000 from the fund to pay settlements to disgruntled clients.

The owner and the firm, who eventually paid back the diverted funds and personal loans, agreed to settle the SEC's charges and pay more than $340,000 in disgorgement and prejudgment interest to the individual client and the investment fund, representing ill-gotten gains that the owner retained even after he paid back the loans.  He and his firm also agreed to pay a $250,000 penalty, and he will be barred from the securities industry for at least five years.  The firm will wind down its operations with oversight from an independent monitor.

"Investment advisers have a fiduciary duty to act in the best interest of advisory clients and disclose all material conflicts of interests," said Jina L. Choi, director of the SEC's San Francisco Regional Office.  "[This man] instead took advantage of his clients and misused more than $8 million of their assets for his own personal gain." 

For more information, visit:SEC Charges Seattle Firm and Owner With Misusing Client Assets for Vacation Home and Vintage Automobile

July 28, 2014
Document-Comparison Etiquette: A Lively "Redlining" Dialogue
by Broc Romanek

The numerous comments after this short "Adams Drafting" blog about high-stakes redlining practices is a dialogue that only a lawyer could love. Check it out. You can tell I've been "banking" this blog for years...

I gotta mention that Max & Mark Webb are retiring after a fine career in Corp Fin. I wish them well. Great guys!

Sample Reps & Warranties: Conflict Minerals

As I'm scrambling to get out of here on an "email-less" vacation for two weeks, I thought I would cheat and blog this item that I used on the Blog on Friday: Recently, we got the question from a member who was marking up a definitive agreement for the purchase of target company - a manufacturer of metal products - whom they believed to be utilizing conflict minerals. The member asked "Has anyone seen and reps and warranties being given for the use/non-use of conflict minerals in stock purchase agreements and, if so, what is being represented/warranted?"

My response was: These reps are pretty boilerplate. In the first example below, note that Oracle/Micros has a covenant that the seller has undertaken commercially reasonable efforts to eliminate conflict minerals from its supply chain:

- Oracle/Micros (covenant Section 5.23)
- Allergan/MAP Pharmaceuticals (see Section 3.29)
- Valeant/OBAGI Medical (see Section 4.5)
- Met-Pro/CECO Environmental (see Section 4.7(e))
- Citrix Systems/Bytemobile (see Section 2.32)
- Salix Pharmaceuticals/Santarus (see Section 5.26)

- Broc Romanek

July 28, 2014
Market Structure Reform and the SEC (Part 2)
by J Robert Brown Jr.

Professor Coffee, in his piece in the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term, raises structural concerns with the market and asserts that the SEC has been slow to implement reforms. As he colorfully notes: "[T]he SEC has studied high frequency trading at length, but seems unable to do much more than re-arrange the deck chairs on the Titanic." He then offers an explanation of sorts. The answer is not capture.

  • Some will allege that the SEC has been "captured," but that charge seems misplaced in this context, because the industry is itself intensely divided. The exchanges are doubtful about the "maker/taker" system that has become dominant in the wake of Regulation NMS, and the Securities Industry and Financial Markets Association ("SIFMA"), the industry trade group, wants major reforms. But the dark pools are largely owned by major banks, who have a different agenda.

Instead, the answer is workload and a predilection for the status quo.

  • Thus, the SEC's inactivity seems better explained by two factors: (1) the SEC has been overextended by the demands of implementing Dodd-Frank and thus avoids issues that it can sidestep; and (2) in the field of market regulation, the SEC's staff tends to worship at the Shrine of the Status Quo. Whatever practices have become prevalent are assumed to be efficient. But trading has evolved very rapidly since the adoption of Regulation NMS in 2007, and it is far from clear that any natural equilibrium has been reached. 

Capture, of course, need not be by the entire industry but can be by a particular segment. So a divided industry does not preclude capture.

The explanation of worship of the status quo, however, overlooks a great deal. The Commission has indicated serious concern with market structure issues. The absence of any significant proposals to date have a number of likely explanations.

First, the area is exceedingly complex. Identifying problems and solutions is not always easy.  Second, the Commission is divided politically; this probably makes consensus on reforms difficult. Third, there is almost certainly real concern that "reforms" may generate negative consequences that exceed any benefits. After all, a number of areas of concern are explained or at least influenced by the existing regulatory construct. Maker-taker payments, for example, operate within the caps on access fees in Regulation NMS. Significant changes will almost certainly have unintended consequences.

Fourth, the very division within the securities industry makes reform difficult. The Commission is at its best when implementing regulatory reform that reflects industry consensus. A consensus can ensure that no single sector bears the brunt of systemic reform. That is not the case here. Many of the proposed reforms would disproportionately affect particular segments of the securities industry.

Fifth, some of the complaints about high frequency trading have a luddite feel. At least some of the advantages of HFT arise out of advances in technology. Any regulatory intervention needs to prevent harmful practices without unnecessarily restricting technological advances.    

Finally, the Commission knows that anything it does will potentially be subject to litigation (although hopefully the change in the make-up of the D.C. Circuit should reduce concerns with this possibility) and hearings on the Hill. 

This is not to say that Eric Schneiderman and private law suits don't have a role in prodding the SEC. They do. Schneiderman has been at the forefront of raising the advance peak problem whereby high frequency traders receive information before the rest of the market (his pressure on wire services to end advance disclosure is an example). The Lanier case illustrates some of the problems associated with the distribution of proprietary data by exchanges before it appears in the CTS.

So the cases are less about changing the worshiping practices of the SEC and more about pointing the Agency in the right direction.

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here

July 27, 2014
SEC Charges Hedge Fund Adviser for Prohibited Transactions and Retaliating Against Whistleblower
by Yaron Nili, Co-editor, HLS Forum on Corporate Governance and Financial Regulation

Editor's Note: The following post comes to us from David A. Vaughan and Catherine Botticelli, Partners at Dechert LLP, and is based on a Dechert legal update authored by Mr. Vaughan, Ms. Botticelli, Brenden P. Carrol, and Aaron D. Withrow.

The U.S. Securities and Exchange Commission (SEC or Commission) issued a cease and desist order on June 16, 2014 (the Order) against Paradigm Capital Management, Inc. (Paradigm) and its founder, Director, President and Chief Investment Officer, Candace King Weir (Weir).[1] The Order alleged that Weir caused Paradigm's hedge fund client, PCM Partners L.P. II (Fund), to engage in certain transactions (Transactions) with a proprietary account (Trading Account) at the Fund's prime broker, C.L. King & Associates, Inc. (C.L. King). Paradigm and C.L. King were allegedly under the common control of Weir. The Order further alleged that, because of Weir's personal interest in the Transactions and the fact that the committee designated to review and approve the Transactions on behalf of the Fund was conflicted, Paradigm failed to provide the Fund with effective disclosure and failed effectively to obtain the Fund's consent to the Transactions, as required under the Investment Advisers Act of 1940 (Advisers Act).

In addition, the Order alleged that Paradigm retaliated against a whistleblower who had notified the SEC of the Transactions. According to the SEC, the Order represents the first case filed under the Commission's new authority to bring enforcement actions against those that retaliate against whistleblowers. [2]

The Order directed Paradigm and Weir to, among other things, disgorge to certain Fund investors $1,700,000, which represented the approximate amount of administrative fees the Fund paid in connection with the Transactions. [3] The Order also directed Paradigm and Weir to pay a $300,000 civil penalty and prejudgment interest.

The Transactions and Alleged Violations of Advisers Act Section 206(3)

Background. According to the Order, Weir owned 73% of Paradigm and had ultimate control of, and decision-making authority for, Paradigm. Further, Weir owned 99% of the entity serving as the Fund's general partner and approximately 73% of C.L. King.

The Order alleged that, from at least 2009 through 2011, Weir caused the Fund to engage in a trading strategy designed to reduce Fund investors' tax liability. In part, the strategy involved selling to the Trading Account certain securities that had unrealized losses. The sales were made at prevailing market prices, and the resulting realized trading losses were allegedly used to offset the Fund's realized gains. The Transactions were executed using C.L. King's trading systems, and C.L. King did not charge a markup or commission on the Transactions. In some instances, Weir caused the Fund to later repurchase certain of the securities initially sold to the Trading Account.

Section 206(3) of the Advisers Act makes it unlawful for an investment adviser, directly or indirectly, "[a]cting as principal for his own account, knowingly to sell any security to or purchase any security from a client... without disclosing to such client in writing before the completion of the transaction the capacity in which he is acting and obtaining the consent of the client to such transaction." Because Weir controlled both Paradigm and C.L. King, the Transactions involved an investment adviser, for its own account, [4] knowingly purchasing securities from, and (in some instances) selling securities to, a client. Recognizing this issue, Paradigm established a conflicts committee to review and approve each Transaction on behalf of the Fund. However, as described below, the makeup of the committee allegedly resulted in insufficient disclosure and consent for purposes of Section 206(3).

"Conflicted" Conflicts Committee. The Order alleged that, because Weir owned and controlled the Fund's general partner and shared in the trading profits and losses resulting from the Transactions through her ownership in C.L. King, disclosure directly to Weir would be insufficient and she could not provide effective consent to the Transactions on behalf of the Fund.

According to the Order, the conflicts committee established to review each Transaction on behalf of the Fund consisted of Paradigm's Chief Compliance Officer, who reported directly to Paradigm's board of directors (including Weir), and Paradigm's Chief Financial Officer (CFO), who reported directly to Weir. The CFO also served as C.L. King's chief financial officer. The Order alleged that the CFO was in a "conflict situation" - and thus, the conflicts committee was itself conflicted - because during the CFO's evaluation of each Transaction, he was also monitoring the Transaction's impact on C.L. King's net capital, in his capacity as C.L. King's chief financial officer. [5]

Because both Weir and the conflicts committee were allegedly conflicted, disclosure of the Transactions to either Weir (as a controlling person of the Fund's general partner) or the conflicts committee was allegedly insufficient for purposes of Section 206(3). Similarly, because of these conflicts, neither Weir nor the conflicts committee allegedly could provide consent on behalf of the Fund that was adequate for purposes of Section 206(3). As a result, according to the SEC, the Transactions were effected without sufficient consent or disclosure and, thus, violated Section 206(3). [6]

Whistleblower Retaliation

In March 2012, Paradigm's then-head trader (Whistleblower) voluntarily notified the SEC of the Transactions. Four months later, the Whistleblower notified Weir and another C.L. King officer that he had reported potential securities law violations to the SEC. Shortly thereafter, according to the Order, Paradigm embarked on a series of adverse employment actions against the Whistleblower that ultimately resulted in the Whistleblower resigning from Paradigm.

Section 21F(h) of the Securities Exchange Act of 1934 (Exchange Act) states that an employer may not "discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower... [i]n providing information to the Commission in accordance with this section." [7]

Upon learning that the Whistleblower had provided information to the SEC regarding the Transactions, Paradigm allegedly removed the Whistleblower from the trading desk and relieved him of his day-to-day trading and supervisory responsibilities. Paradigm also moved the Whistleblower to a different office building and instructed him to prepare a report concerning his disclosures to the Commission. The Whistleblower was later assigned to identify potential wrongdoing at the firm and, because Paradigm determined not to provide the Whistleblower with electronic access to its trading system, was given hard copies of more than 1900 pages of trading data to review in connection with the assignment. The Whistleblower was also tasked with consolidating multiple trading procedure manuals and proposing revisions to Paradigm's trading policies and procedures. These and other actions detailed in the Order allegedly constituted adverse employment actions in violation of Exchange Act Section 21F(h).

Considerations for Advisers after Paradigm

In light of this case, investment advisers that engage in principal trades may benefit from reviewing their policies and procedures for compliance with Advisers Act Section 206(3). To the extent any form of board or committee is used as a mechanism of providing disclosure to, or obtaining consent from, clients for principal trades, advisers may wish to consider the composition of such board or committee. In particular, advisers should consider whether the composition of such board or committee is sufficiently independent from the adviser (or its affiliates) to provide the necessary check on self-dealing that Section 206(3)'s requirements are intended to achieve. Investment advisers should also understand that, in Paradigm, the Transactions were apparently undertaken for the benefit of Fund investors (at prevailing market prices) and that the Transactions and the conflicts committee were disclosed. Notwithstanding the apparent lack of intent to defraud Fund investors, the composition of the conflicts committee nonetheless resulted in alleged violations of Section 206(3).

Investment advisers may also benefit from reviewing their policies and procedures concerning whistleblowers. Among other things, such policies and procedures should seek to ensure that the adviser's response to and management of a whistleblower situation is in accordance with all legal requirements and should sufficiently address the competing concerns and risks presented when a whistleblower has provided information to the Commission.


[1] In the Matter of Paradigm Capital Management, Inc., Investment Advisers Act Release No. 3857 (June 16, 2014).

[2] See SEC Charges Hedge Fund Adviser With Conducting Conflicted Transactions and Retaliating Against Whistleblower, U.S. Securities and Exchange Commission, Press Release (June 16, 2014).

[3] According to the SEC, Paradigm charged the Fund an administrative fee for, among other things, compliance-related expenses, including expenses associated with the conflicts committee's review of the Transactions.

[4] The SEC Staff has stated that an investment adviser's ownership of a significant interest (e.g., more than 25%) in a pooled investment vehicle may cause cross transactions involving such a pooled investment vehicle to be treated as principal transactions under Section 206(3). Whether such a transaction implicates Section 206(3) depends on the facts and circumstances of the transaction, including the extent of the ownership interest of the adviser and/or its controlling persons or other personnel of the adviser. See Gardner Russo & Gardner, SEC Staff No-Action Letter (pub. avail. June 7, 2006) at n.9 ("The Commission has deemed ownership interests of controlling persons of an investment adviser to be ownership interests of the adviser for purposes of Section 206(3) of the Advisers Act.")

[5] The Order did not address whether Paradigm's Chief Compliance Officer, who reported directly to Paradigm's board of directors (including Weir), was also in a "conflict situation."

[6] Paradigm's Form ADV Part 2A (Brochure) described the conflicts committee's role in reviewing and approving the Transactions on behalf of the Fund. However, the Paradigm Brochure failed to disclose that the CFO, as a member of the conflicts committee, also served as C.L. King's chief financial officer and was responsible for monitoring the Transactions' impact on C.L. King's net capital. As a result of this omission, according to the SEC, the Brochure's disclosure concerning the conflicts committee was deemed materially misleading.

[7] The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) established a whistleblower program that requires the Commission to pay an award to eligible whistleblowers who voluntarily provide the Commission with original information about a violation of the federal securities laws that leads to successful enforcement. For purposes of this provision, a "whistleblower" is "any individual who provides... information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission." Exchange Act Section 21F(a)(6).

July 27, 2014
SEC Charges ECN Operator For Failing To Protect Customer Data
by Tom Gorman

Fragmented markets, alternative trading systems and dark pools are increasingly a focus of discussion in the wake of repeated market outages. Interest in these venues has been intensified by the publication of Flash Boys and Dark Pools. To date only a few cases have been brought. See, e.g. In the Matter of Liquidnet, Inc., Adm. Proc. File No. 3-15912 (June 6, 2014)(ATS dark pool where confidential customer data used for marketing); In the Matter of eBX, LLC, Adm. Proc. File No. 3-15058 (Oct. 3, 2012)(informational edge given to another); In the Matter of Pipeline Trading Systems, LLC., Adm. Proc. File No. 3-1460 (Oct. 24, 2011)(concealed conflict re order filling process).

On Friday the Commission added to its increasing number of cases in this area, filing an action against a unit of Citigroup, In the Matter of LavaFlow, Inc. Adm. Proc. File No. 3-15985 (July 25, 2014). Respondent LavaFlow, Inc. is a registered broker-dealer which is an indirect subsidiary of Citigroup Global Markets, Inc. It operates LavaFlow ECN, an electronic communications network which is a particular type of ATS. Generally, it functions as a marketplace for buyers and sellers of securities. LavaFlow ECN displays the top of its order book which is the best bid and best buy in the national market system. Other orders are not displayed.

In 2006 Lava Trading, a subsidiary of Citigroup, acquired the ECN which became known as LavaFlow ECN. Prior to that time Lava Trading had functioned as a technology services company. Its flagship product was ColorBook, software that provided smart order routing services for over 100 registered broker-dealers that used it to route their customer orders to execution venues. As a smart order router, ColorBook applied preprogrammed analytics that carried out an execution strategy. This distinguished ColorBook from an order router which generally allows an end user to submit an order to an execution venue.

When LavaFlow ECN was acquired, Lava Trading personnel believed they could use ColorBook to improve important functions of the ECN. Nevertheless, the services that ColorBook provided to customers remained distinct from those provided by LavaFlow ECN.

Initially, LavaFlow did not permit ColorBook to access and use information from the ECN direct subscriber non-display order flow when determining how to smart route orders. Beginning in March 2008, and continuing for the next three years, LavaFlow did permit ColorBook to access that information and use it for smart order routing decisions for customers who also were subscribers of the ECN. Thus if an ECN customer placed an order that would match a non-displayed order in the venue, ColorBook would route the customer order to the LavaFlow ECN with the expectation that the two orders would match.

LavaFlow did not obtain meaningful consent from its ECN subscribers to allow ColorBook to have access to direct subscriber non-displayed order flow information or to use it. While marketing materials indicated that ColorBook would be "exposed" to non-displayed order flow data, there was no procedure in place to ensure that subscribers reviewed this material. There is no indication that non-displayed orders were communicated to customers of the smart order routing business.

In June 2008 Lava Trading, which had been a registered broker-dealer since 2005, withdrew its registration. The next year Lava Trading entered into an agreement with LavaFlow under which the latter would receive all income associated with contractual arrangements that previously existed between Lava Trading and its customers. From August 2008 through February 2009 Lava Trading received transaction-based compensation for broker-dealer services, including about $1.8 million for orders handled by the smart order router.

The Order alleges willful violations of Rules 301(b)(2) and (10) of Regulation ATS and Exchange Act Section 15(a). Rule 301(b)(10) requires an ATS to establish adequate safeguards and procedures to protect subscribers' confidential trading information and to have adequate oversight. This rule was violated by permitting ColorBook to have access to the direct subscriber non-displayed order flow information and use it to make routing decisions. Rule 301(b)(2) requires an ATS to amend its Form ATS before implementing a material change to its operation. That form was not amended here regarding the access of ColorBook.

To resolve the proceeding LavaFlow consented to the entry of a cease and desist order based on the Rules and Section cited in the Order and to a censure. It also agreed to pay disgorgement of $1.8 million, prejudgment interest and a civil penalty of $2,850,000.

July 26, 2014
Timely Notice of Merger's Effective Date Reduces Litigation Risks in Delaware
by Yaron Nili, Co-editor, HLS Forum on Corporate Governance and Financial Regulation

Editor's Note: The following post comes to us from Jon E. Abramczyk, Partner and Member of the Corporate and Business Litigation Group at Morris, Nichols, Arsht & Tunnell LLP, and is based on a Morris Nichols publication. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Following a merger (or consolidation), Section 262 of the Delaware General Corporation Law ("DGCL") requires notice to be sent to any stockholder of record who has demanded appraisal informing that stockholder that the transaction was accomplished. For long-form mergers approved pursuant to a stockholder vote (i.e., under Section 251(c) of the DGCL), Section 262(d)(1) requires notice of the effective date of the merger to be sent within 10 days of the merger becoming effective. For mergers approved pursuant to Sections 228, 251(h), 253 or 267 of the DGCL (e.g., mergers approved by written consent, certain mergers following a tender or exchange offer, short-form mergers between parent and subsidiary corporations and short-form mergers between a non-corporation parent entity and its subsidiary corporation) the notice of the effective date is governed by Section 262(d)(2), which sets its own timing requirements.

Sometimes, however, in the bustle of closing the transaction and the transition that follows, sending notice of the effective date can be overlooked. In the current M&A environment, the number of appraisal demands is steadily increasing and stockholders are more frequently seizing on a company's failure to send timely notice, creating additional litigation risks related to the transaction.

In Kettleton Multi-Year Holdings LLC v. Sourcefire LLC, No. 9157-VCL (Del. Ch. Apr. 25, 2014) (Trans.), after the announcement of a merger between Sourcefire Inc. and Cisco Systems Inc., Kettleton (a Sourcefire stockholder) demanded appraisal and asked that the company send it notice of the effective date. The notice was sent seven days after the 10-day deadline set in Section 262(d)(1). When Kettleton filed its appraisal petition, it asserted a claim based on the late notice and moved for judgment on the pleadings on that claim.

For a proposed remedy, Kettleton relied principally on the Delaware Supreme Court's decision in Berger v. Pubco, 976 A.2d 132 (Del. 2009), which held that a statutory disclosure violation in the context of a Section 253 merger could trigger a quasi-appraisal proceeding, where all class members receive at least the merger consideration and potentially more, based on the Court's appraised value of the stock. The Court can also shift attorneys' fees in a quasi-appraisal proceeding. Kettleton argued that the late notice should likewise be remedied by requiring the surviving corporation to pay Kettleton the merger consideration upfront to protect itself if the appraised value was less than the merger price. Kettleton also asked that its fees be shifted to the surviving corporation. In essence, Kettleton sought to remove the risk of loss that exists in a statutory appraisal proceeding and thereby emulate certain features of a quasi-appraisal proceeding envisioned under Berger v. Pubco.

The Court denied Kettleton's motion, observing that while corporations must follow the DGCL, there was "no connection" between the notice violation and the remedy Kettleton sought. The Court noted that the purpose of an effective date notice is to permit a stockholder to calculate the 120-day window in which it must file its appraisal petition with the Court. Because Kettleton was the only stockholder that had demanded appraisal and because it had timely filed a petition, there was no injury to be remedied. But in so ruling, the Court cautioned that it was not foreclosing the possibility that a notice violation under Section 262 could result "in a substantial remedy."

Because the M&A market is already charged with an increasing number of appraisal demands, care should be taken to remove the additional risk to a buyer that sending an untimely Section 262 notice creates. In effectuating and closing a merger, the applicable provisions of the DGCL must be strictly followed, and sending the effective date notice should be on every deal counsel's post-closing checklist.

July 25, 2014
Delaware Supreme Court Requires Wal-Mart to Produce Privileged Documents
by Francis Pileggi

Wal-Mart Stores, Inc. v. Indiana Electrical Workers Pension Trust Fund IBEW, Del. Supr., No. 614, 2013 (July 23, 2014).

This Delaware Supreme Court en banc opinion requires Wal-Mart to produce documents about an alleged bribery scandal involving their Mexican subsidiary. The most noteworthy aspect of this decision, about which we will write more later, is that for the first time the Delaware Supreme Court directly addressed and recognized an exception to the rule that documents protected by the attorney/client privilege do not need to be produced. It is referred to as the Garner exception after a case of that name from the Fifth Circuit.

In this case, the Delaware high court said that the well-established attorney/client privilege does not apply, or is subject to an exception, if a stockholder needs the otherwise inaccessible information to sue a director for breach of fiduciary duty. A similar analysis was applied to documents otherwise protected by the work-product doctrine. This opinion will have lasting importance for corporate and commercial litigators regarding this topic.

Frank Reynolds of Thomson Reuters has published an insightful article on the case that provides a helpful overview.

Michael Scher of the FCPA Blog has written extensively on the background of this case.

July 25, 2014
Too Tangential
by Lyle Roberts

In its recent Chadbourne decision, the U.S. Supreme Court held that to be "in connection with" the purchase or sale of a security, an alleged securities fraud must involve "victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintaned an ownership interest in financial instruments that fall within the relevant statutory definition." Whether that requirement is met, of course, depends heavily on the particular facts at issue.

In Hidalgo-Velez v. San Juan Asset Management, Inc., 2014 WL 3360698 (1st Cir. July 9, 2014) the court addressed whether SLUSA preemption, which applies only to cases involving the purchase or sale of securities traded on a national exchange ("covered securities"), could be invoked if the plaintiffs were investors in a fund that promised to invest at least 75% of its assets "in certain specialized notes offering exposure to North American and European bond indices." As a threshold matter, the fund shares were not covered securities. The court found, however, that "the analysis does not invariably end there." To the extent that "the primary intent or effect of purchasing an uncovered security is to take an ownership interest in a covered security," the "in connection with" requirement could still be met.

The court held that in analyzing this issue, the "relevant questions include (but are not limited to) what the fund represents its primary purpose to be in soliciting investors and whether covered securities predominate in the promised mix of investments." In the instant case, it was clear the fund was marketed "principally as a vehicle for exposure to uncovered securities" (i.e., the specialized notes). Accordingly, the "in connection with" requirement was not met and SLUSA preemption did not apply.

Holding: Judgment of dismissal vacated, reversal of order denying remand, and remittal of case with instructions to return it to state court.

Quote of note: "As pleaded, the plaintiffs' case depends on averments that, in substance, the defendants made misrepresentations about uncovered securities (namely, those investments that were supposed to satisfy the 75% promise); that the plaintiffs purchased uncovered securities (shares in the Fund) based on those misrepresentations; and that their primary purpose in doing so was to acquire an interest in uncovered securities. Seen in this light, the connection between the misrepresentations alleged and any covered securities in the Fund's portfolio is too tangential to justify bringing the SLUSA into play."

7/28/2014 posts

The D&O Diary: Texas Appellate Court Affirms Transocean Deepwater Horizon Derivative Suit Dismissal: An Interesting Angle on Corporate Inversion Transactions?
The D&O Diary: Though Delaware Legislature Has Tabled Action, Upcoming Judicial Review of Fee-Shifting Bylaws Seems Likely
The Securities Law Blog: SEC Charges Seattle Firm and Owner With Misusing Client Assets for Vacation Home and Vintage Automobile Blog: Document-Comparison Etiquette: A Lively "Redlining" Dialogue
Race to the Bottom: Market Structure Reform and the SEC (Part 2)
HLS Forum on Corporate Governance and Financial Regulation: SEC Charges Hedge Fund Adviser for Prohibited Transactions and Retaliating Against Whistleblower
SEC Actions Blog: SEC Charges ECN Operator For Failing To Protect Customer Data
HLS Forum on Corporate Governance and Financial Regulation: Timely Notice of Merger's Effective Date Reduces Litigation Risks in Delaware
Delaware Corporate and Commercial Litigation Blog: Delaware Supreme Court Requires Wal-Mart to Produce Privileged Documents
The 10b-5 Daily: Too Tangential

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