The International Law Firm of Fulbright & Jaworski - Corporate Governance
Harva R. Dockery, Daniel James Pirolo, Esther R. Quartarone, Jasper G. Taylor, III and Brian P. Teaff
May 17 2010
- Southern District of New York Addresses Derivative Demand Requirement in AIG Litigation
- Delaware Supreme Court Issues Opinion on Vote Buying and Bylaw Amendment Reducing Board Size
- Department of Labor Requests Public Comment on Applicability of Sarbanes-Oxley Act Whistleblower Protections to Employees of Subsidiaries
- DOJ Issues First FCPA Opinion Procedure Release of 2010
- FINRA Releases Guidance on Broker-Dealer Obligations in Regulation D Offerings
- IRS Releases Draft Schedule and Instructions for Reporting Uncertain Tax Positions
The United States District Court for the Southern District of New York recently had an opportunity to address the demand requirement in shareholder derivative cases under Delaware law in the consolidated litigation pending against American International Group, Inc. (“AIG”). In re American International Group Inc. Derivative Litigation, S.D.N.Y., No. 07-CV-10464 (March 30, 2010). In that litigation, plaintiff shareholder Louisiana Municipal Police Employees Retirement System (“LMPERS”) made a variety of allegations against the financial services company, including that AIG failed oversight of its credit default swaps insuring against the fault of mortgage backed securities, and that AIG imprudently approved an increase in its dividend and repurchased stock prior to the market crash in September 2008.
AIG moved to dismiss the consolidated litigation, arguing that LMPERS failed to make demand upon the AIG board of directors prior to filing the case, as required under Delaware law, and further failed to plead with particularity why demand would have been futile. LMPERS argued in response that its allegations regarding “director compensation, the director’s unwillingness to sue themselves, and the Company’s insurance policy exclusions” were sufficient to meet the particularity standard for purposes of pleading demand futility. The court, however, disagreed. The court first recounted the two tests for demand futility under Delaware law: (1) for claims alleging conscious board conduct, a plaintiff must allege particularized facts that create a reasonable doubt that the directors are disinterested and independent, or that the challenged transaction was a valid exercise of business judgment; and (2) for claims where there is no allegation of knowing conduct, a plaintiff must allege particularized facts creating a reasonable doubt that a majority of directors are disinterested and independent.” See generally Aronson v. Lewis, 473 A.2d 805 (Del. 1984); Rales v. Blasband, 634 A.2d 297 (Del. 1993). The court concluded that LMPERS “generalized allegations” failed to include the “particularized facts” necessary to create the reasonable doubt under either applicable test, and granted AIG’s motion to dismiss.
The Delaware Supreme Court recently issued its opinion in Crown EMAK Partners LLC v. Kurz, No. 64-2010 (Del. April 21, 2010), a case alleging illegal “vote buying” and challenging a bylaw amendment that sought to reduce the number of seats on the board below the number of currently sitting directors.
The Crown EMAK case involved a dispute between two groups vying for control of EMAK Worldwide, Inc. (“EMAK”). Prior to December 18, 2009, the board of EMAK consisted of six directors and one vacancy. One of the six directors resigned, and one of the competing groups, Take Back EMAK, LLC (“TBE”), delivered sufficient consents to remove two additional directors, reducing the number of previously-sitting directors to three, and filling three of the now vacant board seats with directors of their choice, bringing the total number of sitting directors back to six. The same consents removing directors and filling the vacancies amended a section of the EMAK bylaws by (1) reducing the number of board seats to three, and (2) if the number of sitting directors exceeded three, the EMAK CEO would call a special shareholders meeting to elect a third director, replacing the “extra” directors.
The first challenge pertained to the consents delivered by TBE. The opposing party argued that TBE obtained the consents through an illegal “vote-buying” agreement with a former employee and EMAK shareholder. The shares purchased by TBE’s principal were subject to a restricted stock grant agreement, which limited the ability of the shareholder to “transfer, sell, pledge, hypothecate or assign any shares of Restricted Stock” before March of 2011. In an effort to contract around that restriction, TBE obtained proxies for those shares as part of the purchase agreement, allowing TBE to vote the shares even if the transfer itself was not effected until a later date. The opposing party argued that this effort to split the voting rights and the equity itself constituted illegal “vote buying.” The Delaware Court of Chancery disagreed, finding that although TBE’s principal did not take immediate title to the shares, he did take on 100% of the economic risk of a change in value of those shares. Accordingly, the Court of Chancery concluded that, because the principal held the economic interest in the shares, “Delaware law presumes that he should and will exercise the right to vote.” Upon appeal, the Delaware Supreme Court affirmed, concluding that there was no improper “vote buying.” The Supreme Court also concluded, however, that the transfer of the economic interest and voting rights associated with the shares effectively constituted a transfer of the shares, and was therefore a violation of the restricted stock grant agreement. TBE’s principal, therefore, did not have the right to vote those shares.
The amendments to the bylaws were also challenged. The Court of Chancery concluded that, while the consents validly removed two directors and filled three vacancies, the consents were ineffective to reduce the size of the board below the number of sitting directors because that would conflict with provisions of the Delaware General Corporation Law (“DGCL”) governing the removal of sitting directors. The Supreme Court agreed, and observed that DGCL Section 141(b) provides only three methods by which the term of a sitting director can be ended: (1) election and qualification of the director’s successor; (2) resignation, or (3) removal under DGCL 141(k). Accordingly, the Court concluded that the de facto removal of directors by eliminating board seats would be inconsistent with the requirements of DGCL 141(b).
Department of Labor Requests Public Comment on Applicability of Sarbanes-Oxley Act Whistleblower Protections to Employees of Subsidiaries
On April 15, 2010, the Department of Labor’s Administrative Review Board (the “ARB”) issued an order in the case of Carri Johnson v. Siemens Building Technologies, Inc., ARB No. 08-032, 2005-SOX-15, requesting amici curiae briefs on the issue of whether an employee of a non-public subsidiary of a publicly traded company may bring an action against the subsidiary under Section 806 of the Sarbanes-Oxley Act.
Section 806 protects employees of publicly traded companies who provide evidence of fraud from retaliation. The provision also provides a mechanism for whistleblowers to file a complaint with the Secretary of Labor seeking relief for illegal discharge or other discrimination. For years, Administrative Law Judges and courts have grappled with the question of whether Section 806 liability extends to actions against subsidiaries of publicly held companies, with conflicting results based on differing legal theories, as described in detail in the order. It appears that the ARB may be attempting to settle this issue once and for all in this case.
All briefs must be submitted to the ARB on or before July 15, 2010. The following are specific questions posed by the ARB:
- Is a subsidiary categorically covered under section 806 (e.g., Morefield/Walters)? If so, does the level of ownership of the subsidiary play a factor in that coverage?
- Under SOX’s whistleblower protection provision, must a non-publicly held subsidiary respondent be an agent of a publicly held company? What are the factors under a section 806 agency test?
- Is the integrated enterprise test applicable to section 806? If so, should the [ARB] consider the “centralized control of labor relations” the most appropriate factor?
- Is there any other theory under which you contend that subsidiaries would be covered under section 806? If so, explain.
On April 19, 2010, the U.S. Department of Justice (the “DOJ”) issued its first U.S. Foreign Corrupt Practices Act Opinion Procedure Release of the year. The Opinion Procedure Release process enables a person subject to the FCPA to solicit the DOJ’s response to a specific inquiry concerning FCPA compliance under a proposed factual scenario. Although the releases are not binding on third parties, they can serve as indications of the DOJ’s current positions on certain issues.
Release No. 10-01 was issued in response to a February 24, 2010 request from an undisclosed U.S. company that is a domestic concern under the FCPA (the “Requestor”). According to the Release, the Requestor entered into a contract with a U.S. government agency to perform work in a foreign country. The contract requires the Requestor to engage certain individuals to perform the work, including at least one individual who qualifies as a “foreign official” under the FCPA. The DOJ indicated it “does not presently intend to take any enforcement action with respect to the proposed service contract described in this request,” based on several representations of the Requestor, including the following:
- The U.S. government agency executed an agreement to furnish assistance to the foreign country.
- In order to provide such assistance, the U.S government agency entered into a contract with the Requestor to design, develop and construct a facility in the foreign country. This contract requires the Requestor to hire and compensate individuals in the foreign country.
- The foreign country identified an individual to serve as facility director based on his qualifications, and the U.S. government agency directed the Requestor to hire the individual. That individual is currently employed by a government agency of the foreign country, but he has no official authority or duties with respect to the facility.
- The Requestor engaged a subcontractor to, among other things, hire and compensate the staff at the facility. The subcontractor’s local subsidiary entered into a proposed service contract with the facility director.
- The proposed service contract has a one year term and provides for $5,000 per month in compensation. The facility director will be under the direction of the foreign country, not the Requestor, and it is anticipated that the facility director’s compensation will ultimately come from the foreign country. He will not perform any services on behalf of, or make any decisions affecting, the Requestor.
The DOJ noted with approval that the Requestor is contractually bound by an agreement with a U.S. government agency to hire and compensate the facility director, whom the Requestor did not select and whose official position is separate from his position as facility manager. Moreover, the individual will have no decision-making authority with respect to the Requestor, in his capacity as a foreign official or as the facility manager.
On April 20, 2010, the Financial Industry Regulatory Authority (“FINRA”) published Regulatory Notice 10-22 entitled “Regulation D Offerings: Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings.” The Notice serves as a reminder to issuers and broker-dealers alike that while securities offerings made under Regulation D of the Securities Act of 1933 are exempt from registration requirements under Section 5 of the Act, they are not exempt from the antifraud provisions of the federal securities laws.
FINRA issued the Notice in response to broker-dealer misconduct recently uncovered in a nationwide initiative involving several examinations and investigations of private placements, which was prompted by increased investor complaints and SEC actions halting certain Regulation D offerings. The Notice is intended to reinforce a broker-dealer’s obligation to conduct a reasonable investigation of an issuer and the securities it recommends in any private placement. The Notice also draws attention to red flags and supervisory requirements, underscores the obligation to evaluate the suitability of potential investors, and sets forth in detail exemplary reasonable investigation practices.
On January 26, 2010, in Announcement 2010-9, the Internal Revenue Service (“IRS”) announced its intention to largely set aside its policy of restraint and require business taxpayers to report uncertain tax positions on their U.S. federal income tax returns. On April 19, 2010, in Announcement 2010-30, the IRS released Draft Schedule UTP, Uncertain Tax Position Statement, a proposed form of the schedule on which affected taxpayers must report their uncertain tax positions, and Draft 2010 Instructions for Schedule UTP, the proposed instructions for completing Schedule UTP (collectively referred to as the “Drafts”). If the Drafts are finalized, affected taxpayers will be required to report uncertain tax positions beginning with the 2010 tax year.
Initially, only businesses that meet the following conditions will be required to disclose their uncertain tax positions: (1) the business is a corporation that files either a Form 1120, 1120F, 1120 L, or 1120 PC; (2) the corporation has assets equal to or exceeding $10 million; (3) the corporation or a related party issued an audited financial statement which covers all or a portion of the corporation’s operations for all or a portion of the corporation’s tax year; and (4) the corporation has one or more “uncertain tax positions.” For the 2010 tax year, the IRS does not plan to require pass-through entities, tax-exempt organizations, and other Form 1120 series filers to report their uncertain tax positions.
According to the Drafts, a tax position is uncertain if (a) at least 60 days before filing the tax return a reserve has been recorded with respect to that tax position, or at least 60 days before filing the tax return a decision was made not to record a reserve based on an expectation to litigate or an IRS administrative practice, and (b) the tax position has been taken by the corporation in a tax return for the current tax year or – subject to some transitional rules – a prior tax year.
Affected taxpayers must disclose on Schedule UTP: (1) the primary Internal Revenue Code sections relating to the uncertain position; (2) an indication of whether the position creates a permanent, temporary, or both a permanent and temporary difference from the financial accounting treatment of any item; (3) information about any pass-through entities involved in the position; (4) a “maximum tax adjustment;” and (5) a “concise description” of the uncertain tax position.
The Drafts provide that a concise description of an uncertain tax position “should not exceed a few sentences,” but should provide information “expected to apprise the IRS of the identity of the tax position and the nature of the uncertainty,” including what type of item the position is and the rationale behind it.
Although Announcement 2010-30 and the Drafts provide some clarification regarding uncertain tax position reporting requirements, a number of concerns about the requirements have been left unanswered. In particular, questions remain regarding how the IRS intends to use the information it gathers from the disclosures. The IRS is accepting comments on the Drafts and the new reporting requirements in general. Comments will be accepted through June 1, 2010.
Harva R. Dockery
Daniel James Pirolo
Esther R. Quartarone
Jasper G. Taylor, III
Brian P. Teaff