Corporate Securities Law Blog

The practice of marketing registered public offerings of debt securities with credit ratings information and related disclosure of issuer credit ratings in SEC filings will change with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank").
 

On July 21, 2010, the President signed into law (Public Law 111-203) the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). The Reform Act implements a sweeping regulatory overhaul of the financial, banking and mortgage industries and also addresses consumer protection. Included in the Reform Act, and which is the subject of this blog, are numerous new laws affecting executive compensation and corporate governance at publicly-held companies.

Background

Prior to the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on July 21, 2010, the definition of an "accredited investor" under Rule 215 of the Securities Act of 1933 and Rule 501 of Regulation D included a natural person with a net worth of at least $1 million, either individually or jointly with the investor's spouse, and the value of such investor's primary residence was included in the calculation of his or her net worth for purposes of determining "accredited investor" status.
 

On Wednesday, July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. We summarized the provisions of the new law applicable to public companies in a recent article.

On Thursday, July 15, 2010, the Senate passed the Dodd-Frank Wall Street Reform and Consumer Protection Act by a vote of 60-39. The bill passed in the House of Representatives on June 30, 2010. The legislation is expected to be signed into law by President Obama next week. The Dodd-Frank Act introduces wide-ranging reforms of the US financial regulatory system. The legislation calls for hundreds of rulemakings and studies, so the full impact will not be known for many years.
 

Mutual fund companies have traditionally argued that they are exempt from the whistleblower protections of the Sarbanes-Oxley Act (“SOX”) because the funds themselves do not have any employees. Massachusetts District Court Judge Douglas P. Woodlock soundly rejected that argument in a ruling issued March 31 and, in so doing, may have opened the door to a tidal wave of whistleblower suits against mutual fund companies.
 

In Hertz Corp. v. Friend, No. 08-1107, 2010 U.S. LEXIS 1897 (Feb. 23, 2010), the United States Supreme Court reversed the United States Court of Appeals for the Ninth Circuit’s holding that New Jersey-based Hertz Corporation (“Hertz”) was a citizen of the State of California for purposes of federal court diversity jurisdiction, rejecting the Ninth Circuit’s “business activities” test and instead adopting the corporate “nerve center” standard used by numerous other Circuits. In doing so, the Supreme Court established a single, uniform and clear interpretation of the phrase “principal place of business” for purposes of deciding a corporation’s citizenship status in disputes over whether diversity exists among parties to a lawsuit.
 

Directors of California corporations have, for years, struggled to understand the scope of their fiduciary duties when a corporation is insolvent versus when a corporation is in the “zone of insolvency.” While other states (particularly Delaware) have provided some recent guidance in this area[1], the California Court of Appeal recently provided some much needed clarification – including providing comfort to the decision making processes of directors who are considering various alternatives when a corporation enters into a zone of insolvency.

As we recently reported in our December 18, 2009 blog article, the SEC adopted substantial amendments on December 16, 2009 that significantly expand the executive compensation and corporate governance disclosure requirements for publicly held companies. These new rules were presumably adopted now in order to become effective for the 2010 proxy season but, as we noted in our blog, the SEC's adopting release did not provide much guidance regarding the effective dates of the new rules.
 

As anticipated, on December 16, 2009, the Securities and Exchange Commission ("SEC") presented investors and corporate governance reform advocates with a holiday gift by adopting substantial amendments to the executive compensation and corporate governance disclosure requirements for publicly held companies. The amendments reflect the SEC's efforts to increase investor awareness of companies' executive compensation practices and provide shareholders with a greater voice in their companies.
 

On November 12, 2009, the SEC announced that it had settled charges against SafeNet, Inc. and some of its former officers, employees and accountants, in connection with earnings management and options backdating schemes. This case represents the SEC's first enforcement action brought under Regulation G, and it provides important reminders to issuers on financial reporting practices.

The Internal Revenue Service (the "IRS") has issued final regulations regarding the information return and information statement requirements under Section 6039 of the Internal Revenue Code.  Section 6039 was amended in 2006 to require corporations to file an information return with the IRS (the "Return") and furnish a written information statement (the "Statement") to each employee who exercises incentive stock options ("ISOs") or sells or otherwise transfers shares acquired under an employee stock purchase plan ("ESPP") by January 31 following the year in which such transactions occur.  As we reported in our July 23, 2008 blog article, the IRS issued proposed regulations relating to these requirements in July 2008, which, among other things, relieved corporations of the requirement to file a Return for stock transfers that occurred during the 2007 and 2008 calendar years.
 

Corporations, including publicly-traded companies may wish to review their procedures for addressing unclaimed stock in light of a recent California Supreme Court decision. In Azure Limited v. I-Flow Corp (Dkt. No. S164884, July 16, 2009), the Court held that a corporation holding unclaimed stock, which failed to send a shareholder notice of potential escheat prior to issuing a duplicate stock certificate to the state controller in accordance with the Unclaimed Property Law (Cal. Civ. Proc. Cd. §§1500-1582) (the "UPL"), was liable for damages equal to the difference between the amount for which the controller sold the stock and the stock's value at the time of the shareholder's claim for return.
 

In Biltmore Assocs., LLC v. Twin City Fire Insurance Co., 2009 WL 1976071 (9th Cir. July 10, 2009), the United States Court of Appeals for the Ninth Circuit applied the “insured versus insured” exclusion, common in directors’ and officers’ insurance policies (“D&O insurance”), to prevent a creditors’ trust from collecting on a D&O insurance policy under a claim assigned to it from a debtor-in-possession. The Ninth Circuit held that a post-bankruptcy debtor-in-possession should be treated as the same entity as a pre-bankruptcy corporation for purposes of the D&O insurance policy. Because the underlying claim was brought by the debtor-in-possession against directors and officers of the company, the “insured versus insured” exclusion prevented any assignee of the debtors’ claim against the insurance company from collecting. The court held that the trustee of the creditors’ trust stood in the debtor’s shoes for the purposes of the action and, because the debtor-in-possession was still an insured under the D&O policy, the trustee could not collect on the claim.

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.

Governor Schwarzenegger today vetoed AB2944. The bill would have provided that directors may consider the interests of specific corporate constituencies in addition to the shareholders. For a more detailed description of this legislation, see our earlier article here. In his veto message to the California State Assembly, the Governor noted that        "[w]hile this bill proposes a new model of corporate governance consisting of a package of many intriguing concepts, it is just that; a package of concepts that could produce unknown ramifications and the need for which have not been fully demonstrated." For further information, please contact Peter M. Menard at (213) 617-5483.

The NYSE and Nasdaq each recently amended the definition of "independent director" to increase from $100,000 to $120,000 the amount of compensation that an independent director may receive from a listed company in a 12-month period.  In addition, the NYSE amended the definition of "independent director" to allow an immediate family member of an independent director to be employed by the company's auditor provided the immediate family member is not a partner of the auditor or working on the company's audit.

Seven Sheppard Mullin Corporate Partners have been named Best Lawyers in America for 2009.  David Bosko, Larry Braun, Robert Copeland, Tom Hopkins, Richard Kintz, Peter Menard and Mike Moore received this distinguished honor.  In addition to our Corporate Partners, 39 Partners from our Antitrust; Entertainment, Media and Technology; Finance and Bankruptcy; Government Contracts and Regulated Industries; Intellectual Property; Labor and Employment; Land Use and Natural Resources; Litigation; Real Estate; Tax and White Collar Practice Groups were named Best Lawyers in America for 2009.

In Schoon v. Troy Corporation, 948 A.2d 1157 (Del. Ch. 2008), the Delaware Chancery Court held that a former director is not entitled to advancement rights where a later board-approved amendment to the corporation’s by-laws cut off such rights. This case is important for all directors and officers who are concerned about liability coverage after leaving a company or resigning from the board of directors.

Proposed legislation in California would expressly provide that directors may consider the interests of specific corporate constituencies in addition to the shareholders.  This legislation seeks to promote corporate social responsibility by removing the threat of shareholder lawsuits against directors who consider the interests of certain constituencies which may be inconsistent with the interests of the corporation's shareholders.  The bill further seeks to clarify the directors' standard of care in connection with acquisitions.  However, the bill is ambiguous as to whether it applies only to corporations formed under the laws of California or also applies to so-called "quasi-California corporations," corporations with significant ties to California.

A recent Stanford University study casts doubt on the validity of the corporate governance ratings provided by Institutional Shareholder Services (ISS) and its principal competitors.

Governance rating firms seek to measure the effectiveness of a public company's corporate governance.  They maintain that this rating is predictive of the company's future performance.

Stanford's study claims to be the first objective analysis of the predictive value of corporate governance ratings.  It examined more than 15,000 ratings of 6,827 separate companies from 2005 to 2007.

In In re Netsmart Technologies, Inc. Shareholders Litigation, C.A. No. 2536-VCS (Del. Ch. Mar. 14, 2007), Vice Chancellor Strine held that the shareholder plaintiffs demonstrated a probability of success on the merits of their claim that the Netsmart board of directors failed to fulfill their Revlon duties in considering and approving a cash sale of the company to two private equity firms.  The Court determined that the board’s decision not to conduct a broad market canvass for strategic acquirers, and instead focus the search for acquirers solely on private equity firms, did not appear to be reasonable under the circumstances.  The Court also held that the post-signing “market check” recommended by the company’s financial advisers was not appropriate for a small-cap company like Netsmart, thus was far too passive to have been effective in mitigating the narrowness of the pre-signing market canvass.  This decision provides guidance to boards when considering a sale to a private equity firm — an increasingly common situation affecting boards of directors of public companies throughout the country.

The SEC and PCAOB have taken significant new steps to implement promised reforms to the implementation of Section 404 of the Sarbanes-Oxley Act, which has been widely perceived to be unduly expensive and burdensome.  On May 23, 2007, the SEC approved new interpretive guidance for management’s assessment of internal controls, and amendments to certain Section 404 related rules.   The new guidance provides a principles-based framework intended to help public companies strengthen their internal control over financial reporting while reducing unnecessary costs, particularly for smaller companies.  On May 24, 2007, the PCAOB voted to adopt Auditing Standard No. 5 to replace its previous internal control auditing standard, Auditing Standard No. 2.

The SEC today announced that the staff would recommend an amendment to the proxy access rules to respond to the issues raised in AFSCME v. AIG, and scheduled an open meeting on October 18 to consider the recommendation. In making the announcement, the chairman of the SEC noted that shareholder rights in the proxy process "are best secured under a consistent national application of Rule 14a-8 to shareholder proposals" and that the SEC would schedule public comment and final consideration of the proposal "to allow a final rule to go into effect in time for the 2007 proxy season."

In AFSCME v. AIG, the Court of Appeals for the Second Circuit today provided a powerful impetus to the efforts of institutional shareholders to expand proxy access. The court’s decision does not directly grant shareholders the right to present their own slates of director nominees in the company’s proxy statement. However, it does challenge the long-standing interpretation of Rule 14a-8(i)(8) as permitting a company to exclude a shareholder proposal granting shareholders increased proxy access. If the SEC fails to respond to the court’s decision by clarifying or amending Rule 14a-8(i)(8), shareholder activists predict a surge in shareholder proposals to establish liberal proxy access procedures on a company-by-company basis.

The U.S. Sarbanes-Oxley Act of 2002 ("SOX") requires audit committees of public companies to establish procedures for the anonymous submission by employees of that company of concerns related to accounting and financial matters. Multinational corporations, however, have to be careful to consider data protection, labor and human rights legislation in the EU and other countries in the design of their whistleblower programs. 

In January 2006, the SEC staff rejected the argument of Hewlett-Packard Company that it could exclude from its proxy statement a stockholder proposal to adopt a majority vote standard in the election of directors. Hewlett-Packard had argued that it could exclude the proposal under the SEC proxy rules because its existing voting policy "substantially implemented" the proposal. At its annual meeting on March 15, 2006, 53.0% of the votes present voted against the proposal, 43.5% voted for the proposal and 3.5% abstained.

Senator Richard Alarcon (D: San Fernando Valley) has introduced a bill that would require a company incorporated in California to elect directors by a majority of the votes cast in an uncontested election. The bill codifies a majority vote standard similar to those already adopted by Intel Corporation, Dell Inc., PepsiCo, Inc., Texas Instruments and others.

Two standards are emerging in the push to replace the current plurality vote standard in the election of directors.