Corporate Securities Law Blog

THIRD CIRCUIT APPLIES TELLABS TO REJECT MOTIVE AND OPPORTUNITY TEST IN FAVOR OF A "HOLISTIC APPROACH" TO PLEADING SCIENTER IN SECURITIES FRAUD ACTIONS

In Institutional Investors Group v. Avaya, Inc., 2009 U.S. App. LEXIS 9110 (3d Cir. April 30, 2009), a panel of the United States Court of Appeals for the Third Circuit applied the United States Supreme Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), for the first time to existing case law in the Third Circuit. In Tellabs, the Supreme Court held that a plaintiff who seeks to bring a claim for securities fraud under the Private Securities Litigation Reform Act (the “Reform Act”) must plead an inference of scienter that is “cogent and at least as compelling as any opposing inference of non-fraudulent intent.” [See blog article on Tellabs.] In Avaya, the Third Circuit held that the standard articulated in Tellabs requires courts to review scienter holistically, and not through analysis of any individual allegation of scienter, though the court did confirm that the Reform Act’s particularity requirement for pleading scienter remains a determinative factor when conducting this analysis.

]]> In Avaya, a putative class of shareholders alleged that Avaya, Inc. (“Avaya”), a seller of communications products and services, through its chief executive officer (“CEO”) and chief financial officer (“CFO”) (1) affirmatively denied that unusual price competition occurring in the market was hurting the company’s profit margins (the “pricing pressure statements”), and (2) issued false of misleading financial projections despite knowing they were impossible to fulfill (the “forecasting statements”). The district court granted defendants’ motions to dismiss, holding that plaintiffs had failed plead scienter with adequate particularity as to both sets of statements. The Third Circuit reversed as to the pricing pressure statements but affirmed as to the forecasting statements.

The Third Circuit reversed dismissal of claims related to the pricing pressure statements, finding that under Tellabs plaintiffs had pled particularized facts that, when viewed holistically, supported strong inference of scienter. The pricing pressure allegations arose out of representations by Avaya’s CFO that the company’s pricing environment was “not significantly different” than it had been in past years. The CFO reiterated this assurance three times, during analyst calls, when responding to specific questions regarding the company’s pricing strategy relative to others in the same industry who had made pricing cuts. Avaya subsequently missed its revenue projections for the quarter. While the company denied that the miss occurred because of its discounting policies, Lehman Brothers reported that the company had offered unusually aggressive discounts for its mid-range products and allegations from confidential witnesses confirmed these reports.

The Third Circuit held that plaintiffs had adequately pled knowledge or recklessness by the CFO. The court noted that Tellabs required it to make “a practical judgment about whether, accepting the whole factual picture painted by the Complaint, it is at least as likely as not that defendants acted with scienter.”

The court began this analysis by revisiting existing Third Circuit law governing allegations of motive and opportunity. Previously, the Third Circuit had permitted scienter to be pled based on such allegations even in the absence of other particularized allegations of knowledge or recklessness. This standard had been, and still is, applied by the Second Circuit even after Tellabs. See, e.g., ECA & Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co., 553 F.3d 187, 198-99 (2d Cir. 2009). In Avaya, the Third Circuit parted ways with the Second Circuit and held that, under Tellabs, allegations of motive and opportunity, standing alone, were insufficient to support a strong inference of scienter. The court held, however, that when accompanied by other particularized facts, allegations of motive and opportunity could contribute to an inference of scienter.

The Third Circuit then considered the effect of Tellabs on allegations attributed to confidential witnesses. In an earlier decision, the Seventh Circuit had reasoned that, under Tellabs, such allegations had to be “discounted” because they were susceptible to more compelling non-culpable explanations. In Avaya, the Third Circuit disagreed with the Seventh Circuit and reaffirmed existing Third Circuit law holding that detailed allegations from witnesses alleged to have been in a position to know about the statements attributed to them, and which were corroborated by other allegations in the complaint, could contribute to a strong inference of scienter. The court further noted that this view was in accord with that followed by both the Sixth and Ninth Circuits when applying Tellabs to confidential witness allegations.

The Avaya court held that the confidential witness allegations further were strengthened by the fact that the operating margins reaffirmed by the CFO were “central” to Avaya’s business. The court explained that, based on the “content and context” of the statements, the CFO either must have known his statements were false when made or was reckless for making the statements without first verifying their accuracy. Taken as a whole, then, the court determined that the allegations related to the pricing pressure statements were subject to an inference of recklessness that was at least as strong as any competing non-culpable inference.

The Third Circuit, however, affirmed the district court’s dismissal of allegations relating to the Company’s forecasting statements. Plaintiffs argued that the statements — that Avaya was “on track to meet [its] goals for the year” — did not fall within the Reform Act’s safe harbor provision because they were not forward looking. The Third Circuit disagreed, explaining that the statements “do not justify the financial projections in terms of any particular aspect of the company’s current situation, they say only that, whatever the situation is, it makes the future projection attainable.” Because the statements were forward looking, the Third Circuit held, plaintiffs were required to plead particularized facts establishing that the statements were made with actual knowledge of their falsity and not with mere recklessness. The court then found that plaintiffs had failed to meet this standard because, when viewed holistically, the allegations in the complaint gave rise to an inference of recklessness that was stronger than any competing inference of actual knowledge.

In addition to creating a split between the Second and Third Circuit on the use of motive and opportunity, the Avaya creates a split between the Ninth Circuit and Third Circuits when applying Tellabs. As the court in Avaya noted, the weight of post-Tellabs authority in the Ninth Circuit instructs courts to “undertake two separate inquiries,” first determining whether “any of plaintiff’s allegations, standing alone are sufficient to create a strong inference of scienter,” and then determining whether the complaint, as a whole, supports the requisite strong inference of scienter. See Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981 (9th Cir. 2009) [blog article on Zucco Partners]; Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156 (9th Cir. 2009) [blog article on Rubke]. In Avaya, however, the Third Circuit appears to have elected to apply the “holistic” standard, only, without requiring that any particular category of allegations, viewed in isolation, be sufficiently particularized to survive review.

For further information, please contact John Stigi at (213) 617-5589 or Christina Costley at (805) 879-1818.

New TARP Executive Compensation Guidance and a Call for Further Reform in Executive Compensation Practices

June 10,2009 marked an extraordinary day of announcements affecting executive compensation for both recipients of financial assistance from the Troubled Asset Relief Program (“TARP”) and other publicly held companies, including:

The U.S. Department of the Treasury (“Treasury”) issued a statement outlining the Administration’s expectations and planned legislative proposals for executive compensation reform for publicly held companies.
The Securities and Exchange Commission (“SEC”) announced it will soon be proposing new expanded compensation disclosure rules that could take effect in time for the 2010 proxy season.
The Treasury issued regulations providing its much anticipated guidance on standards for executive compensation and corporate governance for TARP recipients.
The Treasury established an Office of the Special Master for TARP Executive Compensation (the “Special Master”).

]]> The coordinated issuance of these executive compensation rules and guidelines by various agencies of the federal government demonstrates that executive compensation reform is an important part of the Obama Administration's agenda. The continuing evolution of corporate governance standards and best practices for compensation programs and the associated disclosure of such arrangements is likely to continue to be a fact of life for public companies. Moreover, the imposing array of executive compensation standards and requirements established for TARP recipients illustrates the government’s resolve to preempt any perception of excessive compensation at companies receiving TARP assistance and also to promote better pay for performance practices at other companies as well.

Treasury’s Guidelines for Executive Compensation Reform

Due to the Treasury’s view that executive compensation practices were a contributing factor to the on-going financial crisis, the Treasury announced a broad-based set of principles for publicly held companies. These principles are:

Compensation plans should be tied to performance in order to link the incentives of executives and other employees with long-term value creation. To align with such long-term value creation, performance-based pay should be conditioned on a wide range of internal and external metrics, not just stock price.
Compensation, including compensation for more than just the top executives, should be structured to account for the time horizon of risks. Similar to the first principle, the objective is to align the compensation to the long-term health of the enterprise.
Compensation practices should also be aligned with sound risk management. Compensation committees should conduct and publish risk assessments of pay packages to ensure that they do not encourage imprudent risk-taking. Providing greater authority to a company's risk managers may become a by-product of this principle.
Golden parachutes and supplemental retirement packages should be reexamined so as to ensure proper alignment of the interests of executives and shareholders. Again, the objective is to ensure that poor performance is not rewarded.
Transparency and accountability in the process of setting compensation should be promoted.

Treasury’s Planned Legislative Proposals

To help promote the fifth principle of transparency and accountability, the Administration will seek legislation to give the SEC the authority to implement two new requirements: (i) shareholder “Say on Pay” and (ii) enhancement of the independence of compensation committees. The Treasury also released two “fact sheets” providing further details on these two initiatives.

The contemplated “Say on Pay” legislation would give the SEC the authority to require non-binding annual “say on pay” votes for public companies. Shareholders would then have the right to, among other things, approve (or disapprove): golden parachute compensation, annual compensation for the top five named executive officers, and executive pay packages as disclosed by the public company in its annual proxy statement.

The contemplated enhancement of the independence of compensation committees would direct the SEC to promulgate rules requiring companies listed on national securities exchanges to meet more exacting standards for independence. In particular, the compensation committee members would need to meet the stricter independence standards required of audit committee members as imposed by the Sarbanes-Oxley Act of 2002. In addition, the compensation committee would have authority to retain counsel and consultants. Further, the SEC will be directed to establish standards regarding the independence of the compensation counsel and consultants used by the compensation committee.

Moreover, the President’s Working Group on Financial Markets will provide an annual review of compensation practices to monitor whether such practices are creating excessive risks. The Treasury is also encouraging experts in the field to conduct reviews to identify best practices, emerging positive and negative trends and call attention to unseen risks.

SEC’s Planned Proposal of Expanded Compensation Disclosure Rules

The SEC announced that it will soon be proposing new expanded compensation disclosure rules which will compel companies to analyze how compensation impacts risk taking and the implications for long term corporate health. Specifically, the SEC will be considering several proposals including requiring public companies to provide fuller disclosure on:

How a company, and its board, manages risks in its executive compensation program.
A company’s overall compensation approach and how its incentive structures take into account the potential long term effects on the company.
Compensation consultant independence and conflicts of interest; and
Director nominees, including their experience, qualifications to serve on the board or committees, and why a board has chosen its particular leadership structure.

These planned proposals dovetail with the SEC’s June 10, 2009 proposed rule (17 CFR Parts 200, 232, 240, 249 and 274) that is intended to remove impediments so shareholders may more effectively exercise their rights to nominate and elect directors.

Treasury’s Executive Compensation Guidance to TARP Recipients

The Treasury also issued a revised Interim Final Rule 31 CFR Part 30 (“IFR”) providing further guidance on the corporate governance and executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (“EESA”), as amended by the American Recovery and Reinvestment Act of 2009 (“ARRA”). Details of the original executive compensation EESA provisions can be found in our October 21, 2008 Blog Article. The IFR supersedes its two predecessor IFRs that were previously released in January 2009 and October 2008, respectively. The updated IFR implements ARRA's executive compensation provisions which generally replaced the original provisions that were enacted under EESA in October 2008. The new guidance not only clarifies certain details related to ARRA’s executive compensation restrictions and standards, but it also provides additional new standards pursuant to its authority granted by ARRA. Note, the IFR applies not only to public companies but also to privately held TARP recipients.

The IFR's new standards include:

A prohibition on tax gross-ups to senior executive officers and the next twenty most highly compensated employees;
A requirement of disclosure and a narrative description of, and justification for, any perquisites, with total value exceeding $25,000, provided to any employee subject to ARRA’s bonus limitations; and
Mandatory disclosure of any compensation consultant engaged by the company or its compensation committee, including a narrative description of the services provided and the use of any “benchmarking” procedures in the consultant’s analysis.

Below is a listing of other executive compensation items addressed in the IFR, in addition to the three new standards outlined directly above, which generally apply to all TARP recipients:

Limits on executive compensation that exclude incentives for senior executive officers (“SEO”) to take unnecessary and excessive risks that threaten the value of the TARP recipient;
Requirement for the recovery of any bonus, retention award, or incentive compensation paid to a SEO or the next twenty most highly compensation employees based on materially inaccurate statements of earnings, revenues, gains or other criteria;
Prohibition on making any golden parachute payment to a SEO or any of the next five most highly compensated employees;
Prohibition on the payment or accrual of bonus, retention award, or incentive compensation to SEOs or certain highly compensated employees, subject to certain exceptions for payments made in the form of long-term restricted stock;
Prohibition on employee compensation plans that would encourage manipulation of earnings reported by the TARP recipient to enhance an employee’s compensation;
Establishment of a compensation committee of independent directors to meet semi-annually to review employee compensation plans and the risks posed by these plans to the TARP recipient;
Adoption of a company-wide excessive or luxury expenditures policy;
Compliance with federal securities rules and regulations regarding the submission of a non-binding resolution on SEO compensation to shareholders; and
Appointment of a Special Master to approve compensation plans of certain TARP recipients and to provide guidance to other TARP recipients.

Moreover, the IFR also establishes compliance reporting and recordkeeping requirements covering the various executive compensation and corporate governance standards. The principal executive officer and principal financial officer of a TARP recipient must provide certain certifications in their annual report on Form 10-K and to the Treasury (for public companies) and to the primary regulatory agency and Treasury for other entities. Providing false information or certifications may subject the entity or individual to criminal penalties.

While the IFR is effective as of June 15, 2009, i.e., the date the IFR was published in the Federal Register, public comments can be submitted to the Treasury on the topics addressed in the IFR through August 14, 2009.

Treasury’s Special Master for TARP Executive Compensation

The Treasury also announced the appointment of a Special Master for TARP Executive Compensation. In this role, the Special Master will, among other things, have broad authority over the compensation for all executive officers and the 100 most highly paid employees of TARP participants who are receiving "exceptional financial assistance", including the power to reject compensation pay plans deemed excessive. Exceptional financial assistance is deemed to currently cover all entities participating in the Programs for Systemically Significant Failing Institutions, the Targeted Investment Program, or the Automotive Industry Financing Program. The Special Master also has the authority to interpret ARRA's executive compensation requirements and shall review bonus/retention payments made before ARRA's enactment to certain employees of all TARP recipients to ensure that such payments are not inconsistent with ARRA or contrary to public interest. The Special Master has the responsibility and ability to seek reimbursement of those payments which the Special Master has determined do not satisfy these requirements.

The Special Master will apply a set of principles to determine whether the TARP recipients have designed executive compensation to maximize shareholder value and protect taxpayer interests, including whether compensation:

Avoids fostering unnecessary/excessive risk taking;
Allows a company to be competitive, recruit/retain valued employees and is able to repay its TARP obligations;
Is appropriately allocated between types of pay (e.g., salary, long-term incentive pay, retirement), and form of payment, with an emphasis on long-term pay for senior level positions;
Is performance-based, determined through tailored metrics that provide goals whose attainment is not guaranteed, and which accounts for a greater portion of total compensation for positions with higher levels of responsibility;
Is comparable to peers; and
Properly values the employee's overall current/future contributions to the employer.

In summary, the IFR imposes executive compensation requirements that are quite extensive and compliance with all of these rules will likely involve a material change in a TARP recipient's compensatory processes and practices. Moreover, the Administration clearly would like its executive compensation principles to be adopted as best practices for those companies which are not receiving TARP assistance. As “Say on Pay” legislation and enlarged proxy statement disclosures are likely to become a reality, public companies may now want to examine and make changes as appropriate to their existing compensation processes, structures, programs and disclosures in order to be prepared for the impending expansion of executive compensation rules and disclosures.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988 or Nicole Lee at (415) 774-2998.

City of Los Angeles Tax Penalty Amnesty Program

The City of Los Angeles Office of Finance recently implemented a Tax Penalty Amnesty Program (the "Program") that allows businesses that have not registered with the Office of Finance, or that have unpaid taxes or underreported gross receipts, to avoid a penalty of up to 40% of the tax due for tax periods ending on or before July 31, 2009. Additionally, no criminal action will be brought against any taxpayer that participates in the Program. The Program began May 1, 2009, and will be available through July 31, 2009.

]]> The following city taxes qualify for amnesty:

Business Tax
Telephone, Electricity and Gas Users Taxes
Commercial Tenant's Occupancy Tax
Transient Occupancy Tax
Parking Occupancy Tax

In order to qualify for the Program, a taxpayer must file an application with the Office of Finance on or before July 31, 2009, and must comply with the following conditions:

File completed tax statements or returns for all periods and taxes for which the taxpayer has not previously filed, or file amended tax statements or returns for all periods for which the taxpayer underreported the taxes due;
Pay in full all taxes and interest due; and
Pay all costs and fees (excluding penalties) incurred and due with respect to the collection of any delinquent taxes.

To encourage participation in the Program, the Office of Finance announced that following the end of the amnesty period, it will vigorously pursue a range of enforcement actions, including the imposition of an additional 10% negligence penalty; expanded audit programs; whistleblower programs; referrals to outside collection and reporting agencies; and publication of taxpayer debt.

If you would like more information about the Program and how to apply, please contact a member of the Sheppard Mullin tax group.

Delaware Court Confirms LLC Managers And Members Owe Fiduciary Duties And Duties Of Good Faith And Fair Dealing

A recent Delaware Court opinion, Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, Case No. 3658-VCS (Del. Ch. Apr. 20, 2008), provides important guidance regarding whether and to what extent managers and members of a limited liability company (“LLC”) organized in Delaware owe duties to the LLC and its members. Section 18-1101(c) of the Delaware Limited Liability Company Act provides that “To the extent that…a member or manager...has duties (including fiduciary duties) to a limited liability company,…the member’s or manager’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” However, in Bay Center, the Chancery Court held that where the LLC is silent or ambiguous as to the duties members and managers owe to each other, they will be subject to the traditional fiduciary duties that directors of a Delaware corporation owe. It also imposed the duties of good faith and fair dealing on the manager of the LLC to perform its management functions in good faith. Therefore, the Bay Center decision is important in that it underscores the necessity of LLC participants that do not want to be subject to traditional fiduciary duties to clearly and unambiguously modify or eliminate these duties in the LLC operating agreement.

]]> Background

The Bay Center decision arises out a failed condominium project in Emeryville, California. The project was a venture of two entities, Bay Center LLC (“Bay Center”), and Emery Bay PKI, LLC (“PKI”), the latter of which was owned and managed by Alfred E. Nevis. In November 2005, Bay Center and PKI formed Emery Bay Member, LLC (“Emery Bay”), of which PKI was appointed the managing member. The limited liability company agreement of Emery Bay provided that PKI “shall manage and conduct” the affairs of Emery Bay. Pursuant to a separate Development Management Agreement, Emery Bay ETI, LLC, an affiliate of Mr. Nevis (the “Development Manager”), was required to conduct specific day-to-day management of the project. A wholly-owned subsidiary of Emery Bay was the only counterparty to this agreement. Under the limited liability company agreement of Emery Bay, PKI had the “power and authority” to cause the Development Manager to perform its obligation under the Development Management Agreement. Neither Bay Center nor any entity its controlled was a party to the Development Management Agreement.

Emery Bay obtained a third party loan (the “A&D Loan”) which Mr. Nevis personally guaranteed (the “Nevis Guarantee”). In consideration for transferring the real property to the project, Emery Bay issued an unsecured note to Bay Center (the “Bay Center Note”). Emery Bay subsequently defaulted on the A&D Loan. Bay Center alleged that Emery Bay, through Mr. Nevis and PKI, secretly renegotiated the A&D Loan, resulting in the diversion of cash flow from the project that was earmarked to repay the Bay Center Note in order to avoid triggering the Nevis Guarantee and capital calls to PKI. The project also suffered from a number of other problems, including budget overruns, vendor complaints, poor sales and vandalism, which Bay Center alleged were breaches of the Development Management Agreement. The project eventually failed in December 2007.

In its complaint, Bay Center sought monetary damages from Mr. Nevis and the entities he controlled, PKI, the Development Manager and Emery Bay, by claiming, among other things, breaches of duties of good faith and fair dealing and fiduciary duties. Bay Center claimed that PKI breached its duty of good faith by failing to exercise its authority as manager of Emery Bay to ensure the performance of the Development Management Agreement and the Bay Center Note. Bay Center claimed that Mr. Nevis breached his fiduciary duties by renegotiating the A&D Loan to advantage himself personally at the expense of Emery Bay. The defendants moved to dismiss these claims.

The Chancery Court denied the defendants’ motion to dismiss because Bay Center sufficiently stated claims for breaches of the duties of good faith and fair dealing and fiduciary duties. The court held that (i) PKI had an implied duty to exercise its authority as manager of Emery Bay to cause it to enforce performance of the Development Management Agreement in good faith and (ii) Mr. Nevis, the individual who managed Emery Bay through PKI, had a fiduciary duty not to use his control over Emery Bay’s assets to benefit himself at Emery Bay’s expense.

Good Faith and Fair Dealing

Although the Chancery Court acknowledged that Delaware courts employ the implied covenant of good faith sparingly in complex commercial agreements, it also recognized the occasional necessity of implying contract terms to ensure the parties’ reasonable expectations are fulfilled. Under the express terms of the Emery Bay limited liability company agreement, PKI had the obligation to manage Emery Bay and the discretion to cause the performance of the Development Management Agreement and the Bay Center Note. The court focused on the fact that Emery Bay’s breach of the Bay Center Note by diverting funds benefited only Mr. Nevis because it prevented triggering capital calls by PKI and the Nevis Guarantee. Also, the decision not to pursue claims against the Development Manager was a conflicted one, as Mr. Nevis was on both sides of it. By failing to ensure the proper performance of these obligations, the parties’ intent to develop a profitable housing complex was frustrated. The Chancery Court therefore read into the limited liability company agreement an implied covenant of good faith and fair dealing and held that PKI was required “to carry out these functions in good faith, meaning it could not engage in arbitrary or unreasonable conduct that had the effect of preventing Bay Center from receiving the fruits of the bargain.”

Fiduciary Duties

Next, the Chancery Court turned to the claim of breach of fiduciary duties. The court acknowledged that the Delaware Limited Liability Company Act gives parties wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties. It also noted that the Delaware Limited Liability Company Act is silent on what fiduciary duties members of an LLC owe. The Emery Bay limited liability company agreement contained seemingly contradictory provisions as to what duties the members owed to each other. One the one hand, it provided that “The Members shall have the same duties and obligations to each other that members of a [Delaware] limited liability company have to each other” while on the other hand it also provided that “Except for any duties imposed by [the limited liability company agreement]…each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties....” The court resolved the apparent ambiguity by reasoning that the former provision could most reasonably be read as an intention to impose traditional fiduciary duties (i.e., fiduciary duties that directors of a Delaware corporation) on the members and the latter provision as an intention to eliminate only those duties that are not traditional fiduciary duties or are otherwise not expressly contemplated by the agreement.

The court then concluded that PKI’s conduct as a member of Emery Bay in diverting funds that were earmarked for payment to Bay Center in order to avoid capital calls and triggering the Nevis Guarantee, if true, were sufficient to support a claim for a breach of fiduciary duties. However, it is noteworthy that the court also extended to Mr. Nevis certain fiduciary duties, even though he was neither a member nor officer of Emery Bay. The court acknowledged prior precedent that an affiliate who exerts control over the assets of an entity may have fiduciary duties to that entity, although the scope of these duties has not been fully delineated. Noting that Mr. Nevis was alleged to have caused Emery Bay to make cash sweeps to satisfy the renegotiated A&D Loan for his own benefit, the court determined that a reasonable inference existed that Mr. Nevis used his own control over Emery Bay’s assets to shield himself from personal liability at the expense of Bay Center in breach of his fiduciary duties. As such, it denied the defendants’ motion to dismiss.

This decision confirms what many practitioners already suspected: that unless the parties agree otherwise, members and managers of LLCs owe traditional fiduciary duties to the LLC. Nonetheless, it does highlight the importance of drafting with clarity the parties intentions with respect to whether, and to what extent, duties may be owed in the context of an LLC.

For further information, please contact Jason Northcutt at (202) 218-6860.

Modifications of home loans under government program will not adversely affect REMICs

The IRS recently issued "safe harbor" guidance that home loans modified under the Home Affordable Modification Program (HAMP) will not adversely affect real estate mortgage investment conduits (REMICs). Without this guidance, payments from the US government to lenders and servicers of home loans under HAMP may have resulted in a 100% penalty tax and may have jeopardized the securitization vehicle's tax-advantaged classification as a REMIC.

]]> According to the Treasury Department, HAMP will help up to 4 million at-risk homeowners avoid foreclosure by allowing modifications to eligible mortgages through a matching program and various incentive payments, thereby reducing homeowners' monthly mortgage payments.

For further information, contact Matthew Richardson at mrichardson@sheppardmullin.com or (213) 617-4222.

Delaware Supreme Court Reverses Chancery Court's Lyondell Decision, Provides Guidance Regarding Application of Revlon Doctrine

On Wednesday, March 25, 2009, the Delaware Supreme Court issued an opinion reversing the Chancery Court's decision in Ryan v. Lyondell Chemical Co., 2008 WL 2923427 (Del. Ch. July 29, 2008). We posted about the Chancery Court decision on the Corporate and Securities Law Blog here. In reversing the Chancery Court decision, the Delaware Supreme Court granted summary judgment in favor of Lyondell’s directors and in doing so held that a board of directors determination to adopt a “wait and see” approach in response to an unsolicited takeover bid was subject to the business judgment and that Revlon duties did not apply until the Board began negotiating with the bidder. This case provides important guidance for directors of Delaware corporations in discharging their fiduciary duties in connection with company sales.

]]> Certain Lyondell stockholders (including the named plaintiff, Walter E. Ryan) initiated a complaint challenging a $13 billion all-cash merger and alleged that the Lyondell directors breached their "fiduciary duties of care, loyalty and candor…and…put their own personal interests ahead of the interests of the Lyondell stockholders." The Lyondell directors moved for summary judgment. On July 29, 2008, the Court of Chancery granted summary judgment on all claims except two: (1) whether Lyondell's directors had acted in good faith in fulfilling their Revlon duties and (2) whether the deal-protection measures in the merger agreement were preclusive. The Supreme Court accepted the directors’ application for certification of an interlocutory appeal in September 2008.

Before the merger at issue, Lyondell Chemical Company was the third-largest independent, publicly-traded chemical company in North America. Dan Smith was Lyondell’s Chairman and CEO. Lyondell’s other ten directors were independent and were experienced and sophisticated businesspeople. Basell AF is a privately-held Luxembourg polyolefin company controlled by Leonard Blavatnik (through his ownership of Access Industries). In May 2007, more than one year after Lyondell rejected an unsolicited bid from Blavatnik of $26.50-$28.50 per share of Lyondell, Access Industries obtained rights to purchase 8.3% of Lyondell's shares and filed a Schedule 13D indicating Blavatnik's interest in possible transactions with Lyondell. Immediately following the Schedule 13D filing, Lyondell's Board convened a special meeting. Although the Board recognized that the Schedule 13D filing signaled Lyondell was "in play" (Lyondell's stock price jumped more than 12% on the day the filing was made public), the Board decided to take a "wait and see" approach, but took no steps to value the Company, retain a financial advisor or develop a response strategy should a possible acquisition be proposed.

Smith and Blavatnik met on July 9, 2007 to discuss an all-cash deal at $40 per share. When Smith responded that the price was too low, Basell raised the bid to $44-45 per share. Smith told Blavatnik he would present the bid to Lyondell's Board, but thought the Board would reject it, since Lyondell was not really on the market. Later that day, Basell offered $48 per share, which represented a 45% premium over the market price immediately before the Schedule13D filing, and a 20% premium over the then-current market price. The bid was not subject to a financing contingency, but was conditioned on Lyondell executing a merger agreement within seven days and agreeing to a $400 million break-up fee (slightly more than 3% of equity value).

The following day, July 10, the Board considered the $48 per share proposal and valuation materials prepared by Lyondell's management in a Board meeting lasting slightly less than one hour. At this meeting, the Board instructed Smith to obtain a written offer from Basell. Blavatnik agreed to the request, but imposed an additional demand that the Board give a firm indication of interest by the end of the day on July 11. The Lyondell Board met again on July 11, again for less than one hour, and discussed the Basell offer and how it compared to the benefits of remaining independent. The Board determined it was interested, authorized the retention of a financial advisor to prepare a fairness opinion, and instructed Smith to negotiate with Blavatnik. From July 12-15, the deal teams worked to meet the July 16 signing deadline. Lyondell's regular board meeting was held on July 12, and on that day the Board instructed Smith to try to negotiate better terms. Specifically, the Board was seeking a higher price, a "go-shop" provision to allow Lyondell to seek other buyers for a period after signing (with a 1% break-up fee during the "go-shop" period) and a reduced break-up fee after the "go-shop" period. Blavatnik agreed to reduce the break-up fee to $385 million (3% of equity value) but rejected the other requests. At a July 16 meeting, the Board considered the proposed merger agreement, which included a typical fiduciary-out clause, but also included a "no-shop" clause and matching rights for any superior proposals. The financial advisor opined that the price was fair and Lyondell was not likely to attract a higher price from the limited universe of companies that might have been interested in acquiring it. The Board voted to approve the merger and to recommend it to the stockholders. At a special meeting of the stockholders on November 20, 2007, more than 99% of the voted shares approved the merger. No other bidders for Lyondell emerged in the four month period between the board's approval of the merger and the stockholders' meeting.

In denying the Lyondell directors' motion for summary judgment, the Chancery Court was critical of the Board’s failure to respond to a filing that put the company "in play," the short, seven-day negotiating process for the actual deal, the failure to conduct a pre-signing market check, the failure to negotiate successfully for a post signing "go-shop," and deal protections including a 3% break-up fee and matching rights for a superior proposal. The Chancery Court also found that Ryan might have been able to prevail at trial on a claim that the directors had breached their duty of care. However, Lyondell’s charter included an exculpatory provision under 8 Del. C. § 102(b)(7) protecting the directors from personal liability for breaches of the duty of care. Therefore, the case turned on whether any arguable shortcomings of the directors implicated their duty of loyalty. Because the Chancery Court determined that the Board was independent and not motivated by self-interest or ill will, the sole issue for determination was whether the Lyondell directors were entitled to summary judgment on the claim that they had breached their duty of loyalty by failing to act in good faith. The Chancery Court denied summary judgment in order to obtain a more complete record before deciding whether the directors had acted in bad faith.

However, the Delaware Supreme Court held that the Chancery Court had reviewed the existing record under a mistaken view of the applicable law. The Supreme Court identified three factors contributing to the mistake.

First, the Chancery Court imposed Revlon duties (i.e., the duty seek the best available price in the sale of a company) on the Lyondell directors before they had either decided to sell, or before the sale became inevitable. The Chancery Court focused on the Board's actions during the two-month period after Blavatnik's Schedule 13D was filed. However, the Supreme Court cited Delaware case law holding that that "the duty to seek the best available price only applies when a company embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change of control." In this case, the directors were not required to act under Revlon until July 10, 2007, when they began negotiating the sale of Lyondell. Rather, the decision to "wait and see" was subject to the deferential business judgment rule.

Second, the Supreme Court held that the Chancery Court misread Revlon and its progeny as creating a set of requirements that must be satisfied during the sale process. The Chancery Court focused on the two months of inaction following the Schedule 13D filing. However, the Supreme Court stated that the relevant period for analyzing whether the Board satisfied its Revlon duties was the one week in which the directors were considering Basell’s offer. During that week, the directors met several times; they directed the CEO to try to negotiate better terms; they evaluated Lyondell's value, the offer price, and likelihood of obtaining a better price; and then they approved the merger. Because the Lyondell Board did not conduct an auction or a market check, nor did they demonstrate "impeccable" market knowledge, the Chancery Court was unable to conclude they had satisfied their Revlon duties. Pointing to the single Revlon duty - to get the best price for the stockholders at a sale of the company - the Supreme Court stated that no "court can tell directors exactly how to accomplish that goal, because they will be facing a unique combination of circumstances, many of which will be outside their control." The Supreme Court stated that it would have held that the directors did meet their burden under Revlon, even on the limited record before it, because the issue was whether the directors had acted in good faith, not whether they had satisfied their duty of care.

Third, the Chancery Court improperly equated an arguably imperfect attempt to carry out Revlon duties with a knowing disregard of duties that constituted bad faith. Bad faith will be found "if a fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." The Chancery Court decided that in order to satisfy Revlon duties, the directors must follow one of three paths – auction process, market check or impeccable market knowledge. However, the Supreme Court stated that Revlon imposes no legally prescribed steps for directors to follow. Thus, the Lyondell directors’ failure to take any specific steps during the sale process could not have demonstrated a conscious disregard for those duties. Only if the directors had knowingly and completely failed to undertake their duties would they have breached their duty of loyalty. Since the Lyondell directors were disinterested and independent, the Supreme Court held that "the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price." The Lyondell directors met several times to consider Basell’s offer, were generally aware of Lyondell’s value and knew the chemical company market. The directors solicited and followed the advice of their financial and legal advisors and attempted to negotiate a higher offer (even though Lyondell's financial advisor described the price as a "home run"). The Board approved the merger agreement because it was simply too good not to pass along to the stockholders for their consideration. Therefore, the Supreme Court held that the Lyondell directors did not breach their duty of loyalty by failing to act in good faith.

The Delaware Supreme Court's decision should be placed in perspective in light of the unique facts surrounding it. The Basell bid represented a 45% premium over the closing stock price of Lyondell immediately before the Schedule 13D; the transaction was approved by an independent and disinterested board; and the merger was additionally approved by more than 99% of the voting shares. The merger lacked the conflicts of interest that typically predicate challenges to mergers, and which lead to much more difficult questions of whether fiduciary duties have been satisfied in connection with merger transactions.

For further information, please contact Jason Northcutt at (202) 218-6860.

Notice about Section 338(h)(10) Elections and State Conformity

An election under section 338(h)(10) of the Internal Revenue Code is often used to characterize the sale of stock of an S corporation as a deemed sale of all of the corporation's assets. A proper federal election under section 338 will be deemed a proper election for California tax purposes, unless the taxpayer separately elects otherwise. The election will trigger corporate-level tax at the current rate of 1.5% on the hypothetical sale of assets arising from the election.

]]> The same is not necessarily true in other states, however. For example, the New York Tax Appeals Tribunal recently held that the fictitious deemed asset sale is not applicable to the sale of S corporation stock for New York tax purposes. (See In re Baum, N.Y. Tax App. Trib., Nos. 820837 and 820838, 2/12/09). As such, gain from the deemed asset sale may not be included in the net income of the S corporation for purposes of determining its New York state franchise tax and may not be passed through, pro rata, as New York source income to the shareholders of the S corporation. Conversely, the Georgia Court of Appeals recently held that a sale of S corporation stock coupled with a 338(h)(10) election triggers corporate-level tax for Georgia tax purposes on the deemed asset sale. (See Georgia Dept. of Rev. v. Trawick Construction Co., Ga. Ct. App., No. A08A2323, 2/23/09).

Whenever an S corporation involved in an acquisition is doing business outside of California, this factor should be considered in evaluating transaction structuring alternatives. Note that elections under section 338 are also available upon the sale of a subsidiary in a consolidated group and the relevant state tax treatment of such elections should also be considered.

For further information, contact Dawn Mayer at dmayer@sheppardmullin.com or (213) 617-4246.

HIPAA Statutory Changes Require Action Now by Providers, Plans and Their Business Associates

Sweeping changes to the obligations of providers, health plans and their service providers ("business associates") under HIPAA privacy and security rules were included in the American Recovery and Reinvestment Act of 2009. Previously only health plans and providers were covered under HIPAA and subject to the criminal and civil monetary penalties. Effective February 17, 2010, business associates are now directly covered. These new requirements will require amendments to all business associate agreements. Business associates must also draft policies and procedures to implement their obligations under the privacy and security standards. Immediate steps must be taken to prepare for implementation.

]]> Business associates are subject to direct regulation under the HIPAA security and privacy rules and will be subject to the same criminal and enhanced civil monetary penalties previously applicable only to covered entities. This means that business associates not only must draft the appropriate privacy and security policy and procedure documentation but must monitor such policies to demonstrate that the company has made all reasonable efforts to be in compliance.

New requirements for plans, providers and their business associates include notice to individuals of breaches of unsecured protected health information ("PHI") within sixty days of discovery of the breach. "Unsecured" PHI appears to mean PHI that is not encrypted. The Secretary of Health and Human Services will provide further guidance.

In addition, there is a new expanded responsibility for accounting for disclosures of PHI. Covered entities with electronic health records and their business associates will now need to account for all disclosures for treatment, payment or healthcare operations. This requirement will significantly increase the compliance burden for providers, health plans and healthcare clearinghouses as well as their business associates.

In addition, the Act provides for:

new rights for individuals to restrict disclosure of their PHI for payment or health care operations when they pay their providers out of pocket and in full for the treatment;

prohibitions on the receipt of remuneration in exchange for access to PHI;
restrictions on certain marketing communications when remuneration is received;
addition of organizations, such as Regional Health Information Organizations, to the definition of business associates; and
a new tiered system of civil monetary penalties and enforcement by state Attorneys General for HIPAA violations.

The new HIPAA provisions statutory provisions, generally, become effective February 17, 2010 although the requirements for notification of a breach of unsecured PHI have an earlier effective date. The new civil monetary penalty provisions are immediately applicable to providers, health plans and healthcare clearing houses. The Secretary is directed to promulgate various regulations between now and August 2010 that will amplify on the statutory changes and implementation requirements.

For further information, contact Maureen Corcoran at mcorcoran@sheppardmullin.com or (415) 774-3216.

Ninth Circuit Affirms Dismissal of Securities Fraud Complaint Where Alleged Misrepresentations and Omissions in Tender Offer Documents Were Immaterial

In Rubke v. Capitol Bancorp Ltd., 2009 WL 69278 (9th Cir. Jan. 13, 2009), the United States Court of Appeals for the Ninth Circuit affirmed the dismissal of a class action complaint alleging violations of Section 11 of the Securities Act of 1933 and Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 through materially misleading statements and omissions in connection with a tender offer. The Ninth Circuit carefully considered each alleged misleading statement and omission, ultimately determining that none was actionable. The decision in Rubke highlights the types of statements and omissions that would not be viewed as materially misleading when made by a corporation in connection with a tender offer.

]]> At issue in Rubke was an exchange offer made by defendant Capitol Bancorp Ltd., (“Capitol” or “the Company”), a publicly traded bank holding company, to the shareholders of Napa Community Bank (“NCB”). In April 2005, Capitol attempted to acquire the minority shares of NCB (the “Exchange Offer”). The Company filed a registration statement with the SEC and sent all NCB shareholders an offer document. In the offer document, Capitol offered to exchange shares of NCB common stock with shares of Capitol at a rate of approximately 150% of the book value of the NCB common stock. The offer document was accompanied by two fairness opinions that concluded that the transaction was “fair from a financial point of view.” In connection with the Exchange Offer, a member of Capitol’s board of directors allegedly placed telephone calls to some of NCB’s minority shareholders and encouraged them to sell their shares to Capitol. After the Exchange Offer was completed, a subset of minority shareholders who had tendered their stock to Capitol filed a complaint, naming Capitol and its CEO as defendants, and asserting violations of the federal securities laws.

Plaintiffs alleged that Capitol was able to acquire NCB at a price below fair market value because of misrepresentations made by Capitol in the registration statement, the offer document and telephone calls. Specifically, plaintiffs alleged that (1) the fairness opinions Capitol relied upon were misleading because the shareholders had obtained a competing fairness opinion that concluded that the offer was unfair, and Capitol knew about this competing opinion; (2) the registration statement was misleading because it failed to mention that one year prior to the Exchange Offer, Capitol initiated a similar offer for shares of NCB’s holding company and paid approximately 167% of book value for those shares; (3) Capitol misrepresented NCB’s future income projections in the registration statement; (4) the offer document led investors to believe that they had an obligation to tender their shares to Capitol when in fact they did not; (5) the registration statement contained misleading references to a “premium” that caused shareholders to believe that accepting the tender offer would give them a premium on the shares’ fair value, rather than on the book value; and (6) Capitol made misleading statements in telephone calls to its minority shareholders.

Capitol moved to dismiss plaintiffs’ original and first amended complaints on the grounds that plaintiffs’ Section 11 claims failed to satisfy the pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedure and their Sections 10(b) and 14(e) claims failed to satisfy the pleading requirements of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). The district court granted both motions, and plaintiffs appealed.

The Ninth Circuit affirmed. The court held that in order to state claims under Sections 11, 10(b) and 14(e), plaintiffs were required to allege, with the particularity required by either Rule 9(b) (for the Section 11 claims) or the Reform Act (for Sections 10(b) and 14(e) claims), that Capitol made materially misleading statements and/or omissions in connection with the Exchange Offer. The court thus began by analyzing the alleged misrepresentations and omissions. The court turned first to plaintiffs’ allegation that the fairness opinions provided by Capitol were misleading. The Court noted that plaintiffs were required to allege with particularity that Capitol “believed the deal offered [to] the minority shareholders was unfair,” and held that the plaintiffs had failed to offer any factual allegations to support such an inference. Even though plaintiffs had obtained a competing fairness opinion which stated that Capitol’s Exchange Offer was unfair, the Court held that nothing in the complaint indicated that anyone at Capitol actually saw or assessed the shareholders’ competing fairness opinion.

The court turned next to plaintiffs’ allegation that the registration statement was misleading because it did not disclose that that Capitol had offered a higher book value for similar shares just a year before the Exchange Offer at issue. The court held that this allegations also failed because plaintiffs did not allege why the omitted information was false or misleading. The court noted, “[t]he fact that Capitol purchased a slightly different security nearly a year earlier for a slightly higher price was simply extraneous to the Exchange Offer.” The court also pointed out that information regarding the earlier offer was publicly available.

The court went on to consider plaintiffs’ allegation that the registration statement misrepresented NCB’s future income projections. Plaintiff had alleged the registration statement was misleading because it stated that “NCB’s profitability will increase,” and this did not adequately disclose NCB’s dramatic growth. The panel quickly dismissed this allegation, stating, “[t]his allegation merely squabbles about the adverbs used in the registration statement, and fails to indicate that the language used was false. Furthermore, there is no duty to disclose income projections in a prospectus.”

The court also rejected plaintiffs’ allegation that the offer document was misleading because it failed to disclose that the shareholders did not have any obligation to participate in the offer. The panel held that plaintiffs had failed to demonstrate that the allegation was misleading because there were other disclosures in the documents indicating that accepting the offer was optional.

The court considered and rejected the allegation that the registration statement misled shareholders into believing they would receive a premium on the shares’ fair value, as opposed to the book value. According to the court, “the language in the registration statement specifically referred to the ‘book value’ of the NCB shares, not a premium to the fair value of the shares.”

Plaintiffs’ final allegation was that Capitol made misleading statements in connection with phone calls placed to the minority shareholders before the offer expired. Considering this allegation, the court noted that plaintiffs alleged only that one board member, Dennis Pedisich, made such calls, and that plaintiffs had “failed to allege with particularly that Capitol or its officers either made similar calls themselves or exhorted Pedisich to make the calls.” Plaintiffs’ complaint merely alleged, based upon information and belief, that Pedisich was exhorted by Capitol’s CEO to call shareholders. This allegation failed, the court held, because plaintiffs did not reveal the sources of their information or otherwise explain how they knew that Capitol “exhorted” Pedisich to make the calls.

Having exhausted plaintiffs’ allegations and finding not one misleading statement or omission, the panel affirmed the district court’s dismissal of plaintiffs’ complaint with prejudice. Rubke provides useful guidance to drafters of tender offer materials, who must necessarily balance the interest in full and fair disclosure to shareholders against the burden to shareholders of wading through unduly voluminous offering materials.

For further information, please contact John Stigi at (213) 617-5589.

The COBRA premium subsidy under the American Recovery and Reinvestment Act of 2009 - What Employers and Plan Administrators need to know.

The American Recovery and Reinvestment Act of 2009 ("ARRA"), which President Obama signed into law on February 17, 2009, created a federal subsidy of the premiums payable by certain terminated employees for continuation coverage provided under employer-sponsored group health plans pursuant to the requirements of the Consolidated Omnibus Budget Reconciliation Act of 1985, as amended (also known as "COBRA"). The premium subsidy and new notification requirements under COBRA that apply to employers and plan administrators as a result of this legislation are summarized below.

]]> The COBRA Premium Subsidy

The subsidy covers 65% of the COBRA premiums that would otherwise be payable by "assistance eligible individuals" (defined below), which is paid by the employer and then generally recouped from the federal government via a credit against the employer's federal payroll taxes, or, alternatively, through a direct payment from the government . The COBRA premium subsidy is available to assistance eligible individuals for up to nine months and will generally apply to premiums paid for periods of coverage beginning on and after March 1, 2009. It is important to note that the COBRA premium subsidy is based on the premium actually charged to the assistance eligible individual, and thus, does not include amounts that a former employer has agreed to pay on behalf of the individual. The COBRA premium subsidy is no longer available once an assistance eligible individual becomes eligible for coverage under another group health plan or Medicare or otherwise is no longer eligible for COBRA continuation coverage. The subsidy applies to group health plans, but does not apply to plans that provide only dental, vision, counseling or referral services or health care flexible spending arrangements.

For purposes of this discussion, an "assistance eligible individual" means any qualified beneficiary (within the meaning of COBRA) that experiences an involuntary termination of employment (but not for reasons of gross misconduct) at any time during the period that begins with September 1, 2008 and ends with December 31, 2009, and that elects COBRA continuation coverage. A special election period is available for those individuals who do not have a COBRA election in effect on the date of ARRA's enactment but who would be assistance eligible individuals if such election were so in effect (the "Special Election Group"). The special election period for these individuals runs from February 17, 2009 (ARRA's enactment date) and ends sixty days after the plan administrator sends out the newly required notice of the new special election period. This means that the Special Election Group will have a new 60-day window in which to elect COBRA continuation coverage that will be effective with the first period of coverage beginning on or after February 17, 2009. Thus, for plans that provide and charge for COBRA continuation coverage on a monthly basis, such coverage will commence for the Special Election Group on March 1, 2009.

The subsidy begins to phase out for individuals and couples with annual adjusted gross income in the amounts of $125,000 and $250,000, respectively. The subsidy is completely phased out for individuals with an annual adjusted gross income of more than $145,000 and couples with an adjusted gross income of more than $290,000. Any individual that receives the subsidy during the year whose income exceeds the foregoing limits is required to repay the subsidy.

New Notice Requirement

Employers must provide notice to employees/former employees who experience a qualifying event during the period that begins with September 1, 2008 and ends with December 31, 2009 of the availability of the COBRA premium subsidy. This notice must include the following information:

A description of the qualified beneficiary's right to the premium subsidy and any conditions on the entitlement to the subsidy.
The forms necessary for establishing eligibility for the premium subsidy.
The name, address and telephone number necessary to contact the plan administrator and any other person maintaining relevant information in connection with the premium subsidy.
A description of the special election period that is available for those individuals who do not have a COBRA election in effect on the date of ARRA's enactment but who would be assistance eligible individuals if such election were so in effect.
A description of the qualified beneficiary's responsibility to notify the plan if he or she becomes eligible for coverage under another group health plan or for Medicare, and the penalties imposed under Section 6720C of the Internal Revenue Code for failure to do so.
A description of alternative COBRA coverage options, if the employer elects to provide them.[1]

ARRA requires the Department of Labor to publish a model notice within 30 days from ARRA's enactment for purposes of this new notice requirement.

Action Items For Employers and Plan Administrators

With the March 1, 2009 effective date fast approaching, the following is a list of action items that employers and plan administrators may find helpful in preparing for their new obligations under COBRA as amended by ARRA.

Identify employees/former employees (including their eligible spouses and/or dependents) that are eligible to elect COBRA continuation coverage who experienced involuntary terminations on or after September 1, 2008.
Review and update existing COBRA communications and notices. In particular, employers and plan administrators should focus on preparing a new notice meeting the requirements described above to be furnished to the Special Election Group.
Review and revise existing payroll systems and procedures to track and facilitate the COBRA premium subsidy payments.
Establish processes and procedures within the employer's human resources department and payroll system that will gather the information needed to accompany the employer's claim for the tax credit.
Determine the impact the COBRA premium subsidy will have on existing arrangements where the employer pays for all or a portion of a former employee's COBRA premiums.
To the extent applicable, coordinate with third-party COBRA administrators to clearly define the roles of each party with respect to the new responsibilities under COBRA.

If you have any questions regarding this information, please contact Martin J. Smith at (213) 617-5490 or Michael Chan at (213) 617-5537.

ANY TAX ADVICE HEREIN WAS NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND IT CANNOT BE USED BY ANY RECIPIENT, FOR THE PURPOSE OF AVOIDING ANY TAX PENALTIES THAT MAY BE IMPOSED ON ANY PERSON. THERE IS NO LIMITATION IMPOSED ON A RECIPIENT HEREOF BY THE AUTHOR HEREOF ON DISCLOSURE OF THE TAX TREATMENT OR TAX STRUCTURE OF ANY TRANSACTION. EXCEPT WITH PRIOR WRITTEN CONSENT OF THE AUTHOR, NOTHING HEREIN MAY BE USED OR REFERRED TO IN PROMOTING, MARKETING OR RECOMMENDING A PARTNERSHIP OR OTHER ENTITY, INVESTMENT PLAN OR ARRANGEMENT TO ANY PERSON.

[1] Employers have the option to permit assistance eligible individuals to elect a different COBRA health coverage option from the one they had been enrolled at the time of their termination of employment. This other group health plan coverage must be an option offered by the employer to active employees at the time the election is made and the premium for such coverage cannot be more expensive than the premium for coverage in which the individual was enrolled at the time of his or her qualifying event.

Tax Relief For Investment, Restructuring, Refinancing And Other Business Activity

On February 17, 2009, President Obama signed the American Recovery and Reinvestment Tax Act of 2009 ("ARRTA"). ARRTA contains significant potential Federal income tax relief for businesses. Some of the more important provisions are summarized in the remainder of this article.

]]>

Delayed Recognition of Debt Cancellation Income for Debt Repurchased, Replaced or Modified During 2009 or 2010. A corporation or business recognizes cancellation of debt income ("COD") when the taxpayer or a related party repurchases its debt for less than the amount outstanding or modifies or replaces the debt so it has a lower issue price. ARRTA allows the COD to be deferred until 2014 and recognized over the next five years through 2019. If deferral is elected, deductions for original issue discount ("OID") on direct or indirect replacement debt are similarly deferred. COD so deferred is accelerated into income upon cessation of business, liquidation, or sale of all or substantially all the assets of the business (or the day before it files a bankruptcy petition) or, in the case of an S corporation or partnership, upon sale, exchange or redemption of an interest or death of a shareholder or member.

Temporary Allowance of Deductions for OID on Modification or Exchanges Into High-Yield Discount Obligations. Corporations cannot deduct unpaid OID representing a yield higher than six percentage points over the applicable federal rate on debt with a term of 5 years or more. ARRTA temporarily suspends this disallowance for exchanges or modifications after September 1, 2008 and before December 31, 2008, provided the old debt itself was not a high-yield discount obligation, does not have contingent interest, and is not held by a person related to the issuer. Thus, such publicly traded debt can be exchanged without COD arising as a result of trading at a discount in the secondary market, and privately held debt can be modified debt so it has substantial OID without COD (such as due to deferring payments of interest). IRS can temporarily use higher rates to determine high-yield discount status.

Extension of Bonus Depreciation and Increase in Small Business Expensing. Businesses can deduct for regular and alternative minimum tax ("AMT") purposes 50% of the cost of most depreciable tangible personal property, computer software, qualified leasehold improvements and certain other property acquired and placed in service during 2009 as well as during 2008. Also, taxpayers can write-off immediately up to $250,000 of tangible personal property and computer software purchased during 2009, subject to phase out if such purchases exceed $800,000.

Extension of Election to Accelerate Pre-2006 AMT and Research Credits In Lieu of Bonus Depreciation. As under prior law, instead of bonus depreciation a corporation may elect to increase its limits on use of pre-2006 AMT and research credits up to the lesser of 6% thereof or $30 million. Different elections for 2008 and 2009 are allowed.

Preservation of NOLs Following Ownership Changes Pursuant to Loans Under EESA. The limitation on using net operating losses ("NOLs") of a corporation after a more than 50% ownership change does not apply to a change required under a loan agreement or commitment with Treasury under the Emergency Economic Stabilization Act of 2008 to rationalize costs, capitalization and capacity with respect to manufacturing workforce of, and supplies to, the corporation, or to certain later ownership changes, provided the corporation is not more than 50% held by one or related persons (other than a voluntary employees benefit association). IRS Notice 2008-83 is overturned for post‑January 16, 2009 deals not previously committed (Notice 2008-83 granted similar relief to banking institutions).

5-Year Carryback of NOLs for Smaller Business. A business with average gross receipts up to $15,000,000 for its prior three years may elect to carry back five years any NOL for its taxable year beginning or ending in 2008.

Temporary Suspension of S Corporation 10-Year Built-In Gain Rule. S corporations that have not been C corporations for more than seven years can sell built-in gain assets during 2009 or 2010 without incurring corporate-level tax, rather than having to wait until more than 10 years after electing S corporation status.

Expansion of Qualified Small Business Stock Rule for Investments Before 2012. For qualified small business stock acquired after enactment and before 2012 and held five years, 75% rather than 50% of gain will be excluded.

Numerous Other Business Incentives. ARRTA includes numerous other incentives for business investment and activity, including credits for hiring veterans and disconnected youth, expansion of industrial development and other tax-exempt bond provisions, credits for renewable energy products and projects, and many other new tax benefits.

Authored by:

John R. Bonn

(978) 594-0170

jbonn@sheppardmullin.com

Pursuant to applicable Treasury Regulations, we notify you that the information in the foregoing flyer does not constitute legal or tax advice, cannot be used for the purpose of avoiding any tax penalties that may be imposed on any person, and may not be used or referred to in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to any person. No limitation is hereby imposed on disclosure of tax treatment or structure of any transaction.

Ninth Circuit Limits the Scope of In-Term Covenants Not to Compete

In Comedy Club v. Improv West Associates the Ninth Circuit held that an in-term covenant not to compete (a covenant that continues during the term of a contract or relationship) in a Trademark License agreement was overbroad, but enforced a more limited version of the covenant. The Court held that while there is no exception in California's law against non-competition agreements for in-term covenants not to compete, they may be valid, at least in the context of a "franchise like" agreement.

]]> Defendant Improv West ("Improv") is the founder and owner of the Improv Comedy Club trademark. It entered into an agreement with Comedy Club International ("CCI") providing that: 1) CCI had an exclusive right to use the "Improv" name to open comedy clubs in the United States, 2) CCI had to open four clubs a year for the first three years, and 3) CCI was prohibited from opening comedy clubs under any other name until the agreement expired in 2019.

CCI failed to open the requisite number of clubs. Improv immediately cancelled CCI's right to use the Improv name, began opening its own clubs, and sought to enforce the non-compete for the term of the agreement because CCI continued to run established Improv clubs. The arbitrator upheld the agreement in full, issuing an injunction preventing CCI from opening any comedy club, under any name, anywhere in the United States until 2019.

The Ninth Circuit held that the in-term covenant not to compete violated California Business and Professions Code section 16600. The Court noted that there is no exception to 16600 for in-term covenants, but the Court held that an in-term covenant not to compete could be valid under certain circumstances. Although the Court did not analyze or offer any particular circumstance, it did discuss several older cases dealing with franchise arrangements and "exclusive dealing" contracts. The Court neither limited the validity of in-term covenants to those situations, nor indicated when in-term non-competes in other contracts might also be valid.

The Court analogized CCI's contract to a franchise agreement and held that it would be enforceable if properly limited. However, the covenant, as written, effectively operated to put CCI out of the comedy club business until 2019. The breadth of the prohibition was illegal because, the court held, "in-term covenants not to compete cannot prevent a party from engaging in its business or trade in a substantial section of the market." Rather than strike the agreement outright, the Court modified the non-compete and ruled that CCI should be prohibited from opening a new comedy club only in any county where it already operates an Improv club.

The Court also took issue with the agreement's definition of "affiliate." The covenant prohibited CCI's "affiliates" from competing. However, the definition of "affiliate" was so broadly written that, as the Court put it, it included a CCI owner's "ex-wife and his ex-wife's cousins, nephews, uncles, and aunts." The Court limited the definition to officers, agents, servants, employees, attorneys, and "those persons in active concert or participation" with the enterprise.

There are several lessons to be drawn from Comedy Club. Any in-term covenant should be carefully limited to a reasonable territory. Generally, the geographic scope should be the territory where the company or companies are doing business during the agreement. The closer the relationship between the parties resembles a "franchise" or "exclusive dealing" contract, the more likely it is to be upheld. When drafting an in-term covenant, businesses should be cautious about using broad and sweeping language. Finally, the Courts analysis, as well as some language in a footnote, suggests that any post-term covenant not to compete will be invalid and unenforceable in California.

For further information, please contact Adam Tullman at (415) 774-2976.

Delaware Supreme Court Rejects Application Of Entire Fairness Scrutiny In Controlling Shareholder's Non-Coercive Offer

In Pfeffer v. Redstone, 2009 WL 188887 (Del. Jan. 23, 2009), the Delaware Supreme Court confirmed a Chancery Court holding that under Delaware law the heightened scrutiny of “entire fairness “ is not imposed on controlling shareholders, that make non-coercive tender or exchange offers to minority shareholders. The case arose out of the Viacom's spin off of Blockbuster. The plaintiffs alleged that Sumner Redstone and the other directors of Viacom and Blockbuster (as well as parent companies) breached duties of disclosure, care and loyalty in connection with a tender offer and related special dividend. The court rejected the application of “entire fairness” scrutiny to defendants’ Rule 12(b)(6) motion due to the non-coercive nature of Viacom’s proposed tender offer. The court went on to find that the complaint failed to adequately plead disclosure violations, despite actual misstatements and omissions by defendants, because plaintiffs failed to adequately plead the materiality of those misstatements and omissions.

]]> In 2004, Sumner Redstone owned a controlling stake in National Amusements, Inc. (“NAI”) which owned a 71% interest in what was then Viacom, Inc., and what is now known as CBS Corporation. At the time, Viacom held a vast majority of the equity and almost all of the voting power in video giant Blockbuster. Viacom determined that Blockbuster would perform better as a separate entity and, on February 10, 2004, announced the divestiture of 81.5% of its interest in Blockbuster. The divestiture involved two transactions forming the basis of the class action suit: (1) a special $5 dollar dividend paid to Blockbuster stockholders, including Viacom (the “Special Dividend”); and (2) an offer to Viacom stockholders to voluntarily exchange Viacom shares for Blockbuster shares (the “Exchange Offer”). On September 8, 2004, Viacom issued a prospectus that detailed the relevant terms of the Exchange Offer and, importantly, made certain disclosures about the nature of the Exchange Offer.

The Exchange Offer was successful and Blockbuster was spun out from Viacom. However, following the Exchange Offer, Blockbuster struggled to remain profitable. On March 9, 2006, following an SEC investigation, Blockbuster announced a restatement of reported 2003-2005 cash flows to correct a longstanding accounting error. Soon after, a class action was filed on behalf of Blockbuster shareholders who held shares at the time of the Blockbuster Special Dividend and on behalf of all Viacom shareholders who tendered Viacom shares for Blockbuster shares in the Exchange Offer.

Entire Fairness Rejected

At the Chancery Court, Plaintiffs alleged breach of the duties of disclosure, loyalty and care against Viacom’s board of directors, and breach of the duty of loyalty against controlling shareholder NAI. The Chancery Court granted the defendants’ motion to dismiss with prejudice, finding the complaint conclusory and poorly pleaded.

On appeal to the Delaware Supreme Court, plaintiffs maintained that the defendants’ complaint should have been reviewed under a stricter “entire fairness” standard on the ground that NAI, the controlling shareholder of Viacom, allegedly elevated its own financial interest over that of the class members, minority shareholders of Viacom. Plaintiffs appealed to the Delaware Supreme Court. Under Delaware law, the entire fairness standard requires defendants to prove the entire fairness of a subject transaction, which includes fair dealing and fair price.

In Pfeffer the Delaware Supreme Court held that the heightened scrutiny of “entire fairness “ is not imposed on controlling shareholders, like NAI, that make non-coercive tender or exchange offers to minority shareholders. The Court noted that the Exchange Offer prospectus issued by the Viacom board never recommended that Viacom shareholders participate in the tender offer. The prospectus also disclosed that NAI, which owned the majority of Viacom shares, would not participate in the Exchange Offer. In addition, the court found nothing to suggest that the directors who approved the Exchange Offer structured the transaction to put their own interests above those of Viacom or a specific group of Viacom shareholders.

Because “entire fairness” did not apply and the Court of Chancery’s ruling could only be reversed if, on further review, plaintiffs’ complaint adequately pleaded disclosure violations.

Claim of Breach of the Duty of Disclosure Not Legally Sufficient

The court acknowledged that a duty of disclosure is not an independent fiduciary duty, but only arises due to existing duties of care and loyalty. The court then addressed the four disclosure issues raised by plaintiffs on appeal.

First, plaintiffs argued that the fact that Blockbuster issued a corrective restatement of reported cash flows sufficiently alleged a breach of disclosure by Viacom at the time it issued the Exchange Offer prospectus. The complaint did not, however, adequately plead that a reasonable person would consider the accounting restatement important in deciding whether or not to tender Viacom shares for Blockbuster shares. Accordingly, the court found that the complaint failed to allege how the accounting restatement was material so as to constitute a cognizable claim.

Second, plaintiffs asserted that the Viacom board of directors knew or should have known of Blockbuster’s operational cash flow problems prior to the Exchange Offer. The court, however, found that plaintiffs failed to establish a reasonable inference that the Viacom board would have access to this information. Plaintiffs’ allegation that a cash flow analysis performed by a mid-level Blockbuster treasury manager would routinely be available to the board of directors of Blockbuster’s parent company, Viacom, was conclusory and not well-pleaded.

Third, plaintiffs argued that Viacom should have disclosed the pricing methodology used to set the Exchange Offer ratio (5.15 shares of Blockbuster for each Viacom share tendered). Under Delaware law, a board owes no duty to disclose pricing methodology for non-coercive voluntary tender offers, unless the board assumes a duty to offer a fair price or makes a partial disclosure that implies a fair price. Here, the Exchange Offer prospectus disclosed that the Viacom and Blockbuster boards offered no recommendations whether or not Viacom shareholders should participate in the Exchange Offer. The prospectus disclosed that the Exchange Offer was voluntary and non-coercive and never stated that the offering price was fair. Since Viacom shareholders could not have reasonably relied on the fairness of the exchange ratio, the court found methodology used to calculate the ratio was immaterial.

Fourth, plaintiffs contended that Viacom’s disclosure in the prospectus that a special committee recommended the Exchange Offer, without also disclosing the special committee members’ names, breached a disclosure duty. The court deemed the omission of the committee members’ names immaterial because there was no representation in the prospectus that the committee was independent of parent company NAI and because the prospectus’ language did not induce shareholders to rely on the special committees’ decision. Because the composition of the committee was immaterial, plaintiffs failed to allege a material omission by the defendants.

Claims of Breach of the Duty of Loyalty Not Legally Sufficient

The court further ruled that plaintiffs’ breach of loyalty claim against the Viacom board was deficient because plaintiffs never alleged that the Viacom directors stood on both sides of the Exchange Offer or that parent NAI or majority shareholder Redstone received unique financial benefits that were not also available to Viacom’s minority shareholders. The court likewise rejected Plaintiffs’ breach of loyalty claim against NAI because they did not establish a connection between omissions in the prospectus and any conduct on the part of NAI or a duty owed by NAI.

Conclusions

The Pfeffer decision from the Delaware high court provides important guidance to practitioners. First, from the corporate prospective, a controlling shareholder in a tender offer that wants to avoid “entire fairness” should not make a recommendation that minority shareholders participate in the exchange. Any materials issued in connection with the tender offer should disclose that shareholder participation is voluntarily and non-coercive. Second, the court's ruling confirms that a plaintiff claiming breach of fiduciary duty in connection with tender offer disclosure must properly allege facts sufficient to indicate that the misstated or omitted information was material to the shareholders in making their decision on whether to tender their shares.

For further information, please contact John Stigi at (213) 617-5589.

Delaware Supreme Court Confirms that Directors' Fiduciary Duties of Loyalty and Care Apply Equally to Executive Officers

The Delaware Supreme Court's recent decision in Gantler v. Stephens, No. 132, 2008 (January 27, 2009), confirms that officers of Delaware corporations have the same fiduciary duties of loyalty and care as directors. This has important implications for non-director officers of Delaware corporations, in particular because, as the Court points out in a footnote, there is at present no statutory authorization for the exculpation of officers for monetary liability for breach of their duty of care. The Court also holds that a statutorily required shareholder vote, such as for the approval of a merger, does not constitute ratification of breaches of fiduciary duties. Delaware companies now need to revisit their internal processes and indemnification and insurance arrangements to be sure that their corporate officers are protected.

]]> The Delaware Court of Chancery had dismissed a complaint challenging a board's decision to take the company private after commencing a bidding process and rejecting the resulting proposals. The Supreme Court held that the plaintiffs had sufficiently alleged director self-interest and had rebutted the presumptions of the business judgment rule that in the normal situation protect a board's decision to reject a merger proposal. It found that management had "sabotaged" the due diligence process.

All three counts of the complaint had been dismissed for failure to state a claim by the Court of Chancery, holding that the business judgment rule, rather than the heightened Unocal or entire fairness standards, applied to the board's decision to abandon its sale process; that the subsequent proxy statement describing the proposed reclassification of shares that would in effect enable the company to "privatize" itself contained no material omissions or misstatements; and that the approval by a majority of the unaffiliated shares ratified the breaches of fiduciary duty.

The Supreme Court reversed. It found that the plaintiffs had plead facts to form a sufficient basis to conclude that a majority of the board acted disloyally and that the officer defendants should not have been dismissed. It found that the statement in the proxy that the board rejected the merger proposal after "careful deliberations" was materially misleading, noting the failure to discuss the defendants' conflicts of interest and the board's rejection of the merger proposal without any discussion. It found that the statutorily required stockholder vote to amend the company's certificate of incorporation could not also operate to ratify the challenged conduct of the interested directors and that the vote could not have been fully informed as required for ratification because the proxy contained a material misrepresentation

Tucked in the middle of the Supreme Court's opinion is the following:

That issue – whether or not officers owe fiduciary duties identical to those of directors – has been characterized as a matter of first impression for this Court. In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold.

Stephens, the Chairman, President and CEO, and Safarek, the Vice President and Treasurer (not a director) of the company, “sabotaged” the due diligence process initiated by the board of directors by thwarting bidders' attempt to obtain information to support their bids. Safarek was described as dependent on Stephens’ continued good will to retain his job and the benefits it generated. The Supreme Court wrote “[b]ecause Safarek was in no position to act independently of Stephens, it may be inferred that by assisting Stephens to “sabotage” the due diligence process, Safarek also breached his duty of loyalty. “

This formalizes what had been a long “articulated principle of Delaware law,” and footnote 37 puts a chilling fillip to the message:

That does not mean, however, that the consequences of a fiduciary breach by directors or officers, respectively, would necessarily be the same. Under 8 Del. C. § 102(b)(7), a corporation may adopt a provision in its certificate of incorporation exculpating its directors from monetary liability for an adjudicated breach of their duty of care. Although legislatively possible, there currently is no statutory provision authorizing comparable exculpation of corporate officers.

In light of this warning and the current outcry over various corporate officers’ insensitivities to the issues of compensation, disclosure and deal-making, it is appropriate for Delaware corporations to take the following actions:

Review the officer indemnification provisions in their by-laws and in the individual indemnification agreements with their officers, particularly in view of the recent Delaware decision that holds that by-law indemnification provisions can be altered to the detriment of former directors, and, most likely, former officers as well.
Review the language in their Directors and Officers Liability Insurance policy to assure that it provides adequate protection for claims of officer breach of duties of loyalty and care.
Institute robust policies in the due diligence and disclosure areas and assure that all affected officers are apprised of their fiduciary duties and the need to continuously assess potential conflicts of interests that, in hindsight, may create the appearance of a personal incentive to disregard, or breach, their fiduciary duties.

For further information, please contact John Mullan at (213) 617-5475.

Ninth Circuit Reaffirms Particularity Requirement In Securities Fraud Actions For Pleading Scienter

In Zucco Partners, LLC v. Digimarc Corp., 2009 WL 311070 (9th Cir. Feb. 10, 2009), the United States Court of Appeals for the Ninth Circuit reaffirmed that when pleading a claim for securities fraud under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”), plaintiffs are bound by prior Ninth Circuit authority that requires them to plead particularized facts giving rise to a strong inference that defendants knew, or were deliberately reckless in not knowing, that their statements were false when made. The viability of the Ninth Circuit’s particularity requirement has been the subject of much debate since the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). In Tellabs, the Court held that, in order to survive dismissal, plaintiffs must plead an inference of scienter that is “cogent and at least as compelling as any opposing inference of nonfraudulent intent.” [See blog article on Tellabs.] In South Ferry LP, No. 2 v. Killinger, 542 F.3d 776 (9th Cir. 2008), a panel of the Ninth Circuit suggested in dicta that Tellabs’ holistic analysis may have superseded the Ninth Circuit’s particularity requirement. [See blog article on South Ferry.] That same term, however, two other panels confirmed that the earlier cases governing scienter were controlling. See Metzler Inv. GMBH v. Corinthian Colleges, Inc., 540 F.3d 1049 (9th Cir. 2008) [blog article on Metzler]; Glazer Capital Management, LP v. Magistri, 549 F.3d 736 (9th Cir. 2008) [blog article on Glazer]. Now, with its most thorough decision to date on this issue, the Zucco court appears to have definitively resolved this question in favor of particularity, holding clearly that “Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions.”

]]> Zucco arose out of an announcement by the defendant corporation, Digimarc Corp. (“Digimarc”), that it was restating its financials to properly account for expenses associated with its internal software development. Following this announcement, plaintiffs brought suit for securities fraud, alleging that Digimarc and its former chief executive and chief financial officers knew, or were reckless in not knowing, that the company had improperly capitalized software development costs that should have been treated as operating expenses. The district court granted defendants’ motions to dismiss with prejudice on the grounds that plaintiffs had failed to plead scienter with particularity. Plaintiffs appealed, arguing that under Tellabs the Reform Act imposes no particularity requirement. The Ninth Circuit disagreed, explaining “[b]ecause we hold that the Court's decision in Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions, but instead only adds an additional ‘holistic’ component to those requirements, we affirm the district court's dismissal of the complaint with prejudice and hold that Zucco has failed to adequately plead a strong inference of scienter.”

The court in Zucco then went on to set forth a two pronged test for determining whether the inference of scienter pled by plaintiffs is sufficient to survive a motion to dismiss. The court held following Tellabs, we will conduct a dual inquiry: first, we will determine whether any of the plaintiff's allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a ‘holistic’ review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.” The Ninth Circuit further explained that the first prong of this test — which the court dubbed “segmented” — itself involved a dual inquiry, considering first whether the allegation of scienter was particularized, and second, whether the allegation was at least as strong as any opposite, competing inference.

Applying this test to allegations from certain “confidential witnesses,” the court analyzed each allegation in turn and then held that the majority of the allegations failed to contribute to a strong inference of scienter because the complaint did not “provide the requisite particularity to establish that certain statements of these confidential witnesses are based on the witness’ personal knowledge.” The court then considered the sole remaining confidential witness allegation, which it found was both pled with adequate particularity and was sufficient, standing alone, to demonstrate scienter. This allegation, however, the court rejected because it was contradicted by other allegations in the complaint.

After considering each allegation individually, the court then went on to analyze the complaint as a whole. Significantly, when engaging in this holistic analysis, the court did not consider allegations that, on segmented analysis, it deemed lacking in particularity or contradicted by the other allegations in the complaint. Instead, it focused its analysis solely on allegations like Digimarc’s public disclosures which, though insufficient individually to sustain a strong inference of scienter, were pled with adequate particularity. Even when viewed together, however, plaintiffs found these disclosures were insufficient to support the required strong inference of scienter.

In short, then, Zucco appears to resolve any ambiguity regarding Tellabs’ effect on existing Ninth Circuit case law. Following this decision, it appears well settled that plaintiffs who seek to plead a claim for securities fraud first must comply with existing Ninth Circuit precedent requiring that scienter be pled with particularity. It is only after plaintiffs meet this threshold burden of pleading particularized facts that the courts will move on to holistic review and weigh the inference supported by plaintiffs’ particularized allegations against any competing, non culpable, inference that they may support.

For further information, please contact John Stigi at (213) 617-5589 or Christina Costley at (805) 879-1818.