The International Law Firm of Fulbright & Jaworski - Corporate Governance
Daniel James Pirolo, Darryl Wade Anderson, Steven I. Suzzan, Robin Preussel Phillips and Johnathan C. Bolton
August 17, 2010
- U.S. Supreme Court Rules on the Constitutionality of Sarbanes-Oxley and the PCAOB
- Supreme Court Limits the Ability of Foreign Plaintiffs to Assert Securities Claims
- SEC Seeks SOX Clawbacks from Officers Not Accused of Misconduct
- Newly Passed Dodd-Frank Wall Street Reform and Consumer Protection Act
- Trust Enablement, Inc. Discusses Director Support Survey Results
- Delaware Chancery Court Dismisses Aiding and Abetting Claims Against Acquiror
On June 28, 2010, the Supreme Court ruled that the structure of the Public Company Accounting Oversight Board (“PCAOB”) is unconstitutional, but the holding was limited and is not likely, as a practical matter, to affect the PCAOB’s operations going forward. See Free Enterprise Fund v. Public Co. Accounting Oversight Bd., No. 08-861, __ U.S. __, 2010 WL 2555191 (U.S. June 28, 2010). As previously reported in the June 2, 2009 and December 22, 2009 issues of Corporate Governance At-A-Glance, the case challenged the constitutionality of the PCAOB, a regulatory body created under the Sarbanes-Oxley Act of 2002 (”SOX”) with the power to oversee and instate rules governing accounting firms that audit public companies.
Dodd-Frank Wall Street Reform
and Consumer Protection Act
The PCAOB is structured so that the Securities and Exchange Commission (the “SEC”) has oversight of the PCAOB, but can only remove members of the PCAOB for good cause. In turn, the commissioners of the SEC can only be removed by the President for good cause. The petitioners argued that this structure and SOX were unconstitutional because SOX conferred executive powers on the PCAOB without giving the President that ability to directly or indirectly remove members of the PCAOB, which violated the principle of separation of powers.
The Supreme Court agreed with the petitioners and held that the structure of the PCAOB was unconstitutional. However, the Supreme Court further held that the provisions of SOX limiting the SEC’s power to remove members of the PCAOB were severable from the rest of SOX, and, therefore, that the unconstitutional portions of SOX could be struck down while the rest of SOX remained in effect. As a result, other than the SEC’s new power to generally remove members of the PCAOB, regardless of cause, there is no change to SOX. It is unlikely that the Supreme Court’s holding will have any substantial effect on the future application of SOX or the future conduct of the PCAOB.
On June 24, 2010, the United States Supreme Court held in Morrison v. National Australia Bank Ltd., No. 08-1191, __ U.S. __, 2010 WL 2518523 (U.S. June 24, 2010), that Section 10(b) of the Securities Exchange Act provides no cause of action to plaintiffs who purchase non-U.S.-listed securities outside the United States. The plaintiffs in Morrison were Australian residents who purchased shares of National Australia Bank on the Australian Stock Exchange Limited. The bank later announced more than $2 billion in writedowns associated with a Florida-based mortgage servicing subsidiary called HomeSide Lending, Inc.
Plaintiffs filed suit on behalf of a proposed class of foreign purchasers in the Southern District of New York against National Australia, HomeSide and several National Australia and HomeSide executives, alleging, among other things, that National Australia’s company-wide financial statements were materially inaccurate. The district court granted dismissal and the Second Circuit affirmed, holding that it lacked subject-matter jurisdiction because the “heart of the alleged fraud” – i.e., the issuance of National’s allegedly false financial statements to investors – occurred overseas. See Morrison v. Nat’l Aus. Bank Ltd., 547 F.3d 167, 175-76 (2d Cir. 2008).
The Supreme Court affirmed the dismissal on an 8-0 vote, with Justice Sonia Sotomayor not participating. Writing for a five-justice majority, Justice Antonin Scalia rejected the Second Circuit’s more flexible “conduct” and “effects” tests – which potentially allowed foreign purchasers to bring claims if the defendants’ alleged wrongful conduct occurred in the United States or had a “substantial effect” in the United States or on U.S. citizens – in favor of a bright-line “transactional” rule strictly limiting Section 10(b)’s reach to “transactions in securities listed on domestic exchanges” and “domestic transactions in other securities. . . . .” 2010 WL 2518523, at *11.
Accordingly, plaintiffs may no longer pursue Section 10(b) claims for transactions in securities not listed on a U.S. exchange that are not purchased or sold within the United States.
On June 9, 2010, the United States District Court for the District of Arizona ruled that Section 304 of the Sarbannes-Oxley Act of 2002 does not require personal misconduct by a company's CEO or CFO to enable the SEC to seek a clawback of compensation after an accounting restatement. The case is SEC v. Jenkins, No. 2:09-cv-1510-GMS, __ F. Supp. 2d __, 2010 WL 2347020 (D. Ariz. June 9, 2010).
In the fall of 2009, the SEC filed a civil suit under Section 304 of SOX, seeking to “claw back” compensation from Maynard L. Jenkins, the former CEO of CSK Auto Corp. While the SEC has deployed Section 304 against officers accused of wrongdoing in many cases filed after SOX was enacted, the Jenkins case is unusual in that Jenkins had not been accused of any wrongdoing.
Ruling on Jenkins’ motion to dismiss, the court sided with the SEC and held that the SEC need not allege wrongdoing when seeking disgorgement under the clawback provision of SOX. Section 304 provides that if an issuer “is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws,” the CEO and CFO shall reimburse the issuer for any bonus or other incentive-based or equity-based compensation received, and any profits realized from the sale of the securities of the issuer, during the 12-month period following issuance of the original financial report.
The Dodd-Frank Wall Street Reform and Consumer Protection Act has been passed by both Houses of Congress and the President signed it into law on July 21, 2010. Fulbright & Jaworski lawyers have analyzed many of the most controversial provisions of this more than 2,000 page piece of legislation, including many provisions that will be must-reading for clients confronting corporate governance issues. A collection of the several analyses put together by leading practitioners in the field at Fulbright can be found at Fulbright's Financial Reform Analysis page. We invite you to visit this page for the most up-to-date coverage of how this new legislation will affect your company and its officers and directors.
Trust Enablement, Inc., a company providing consulting services to help organizations to optimize the trust of their stakeholders, recently announced the results of its survey that asked corporate directors if they feel they are receiving sufficient support to perform their duties. It received 59 responses, primarily from directors at for-profit corporations that were non-executive directors. The company reported that it continues to receive and seek responses and will analyze additional data as it is received.
Overall, the survey results indicate that directors believe that their boards could benefit from more director engagement, professional development and information resources. At the same time, the survey indicates that corporate boards are hesitant to invest in director development resources.
Specific findings of particular interest include the following:
- Three quarters of the board members surveyed do not have a director development budget. Those boards that do have some budget provide for just over $8,000 per director, but only about half of such amount is spent and is typically used to provide informal director education, such as seminars and workshops.
- Most directors report that they arrive to board meetings fully prepared, but close to one-third of directors reported that they were only occasionally or rarely prepared.
- The majority of directors reported they only rarely or occasionally make use of additional resources beyond directors’ briefing binders, although they also reported either occasionally or frequently having unanswered questions during their preparation for meetings.
- More than 40% of directors report that at least one or a few other directors on their board are insufficiently engaged at meetings and in the board’s work and have insufficient knowledge to perform their duties. However, two-thirds report that all or most directors demonstrate professionalism in the boardroom.
- Almost half of the board members surveyed reported that at least one or a few directors do not apply appropriate board procedures at meetings nor make use of sufficient information sources, with more than a quarter reporting the same for all or most directors.
- Directors surveyed ranked formal and informal director education as the most desired resources to help directors do their job. According to the survey results, there is also interest in having access to support services from corporate staff, self-serve online information and research services, live on-demand director support resources and access to external experts.
On July 16, 2010, the Delaware Chancery Court dismissed claims by a disgruntled common shareholder that the acquiring company aided and abetted the target firm’s board of directors’ breach of their “Revlon” duties to maximize stockholder value in the case of Morgan v. Cash, Del. Ch.,C.A. 5053-VCS (July 16, 2010).
The Morgan case involved a dispute by a former common stockholder of Voyence, Inc., a small software company, who challenged a merger in which only the preferred stockholders received consideration as a part of the $42 million purchase price paid by Voyence’s acquiror, EMC Corporation. As a result of the merger, which occurred in October 2007, Voyence became a wholly-owned subsidiary of EMC with the support of written consents filed by the preferred shareholders.
The plaintiff alleged that Voyence’s directors breached their fiduciary duties to shareholders by failing to take reasonable steps to maximize shareholder value in the deal. See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1985) (defining directors’ duty in a sale of control context as the duty to take reasonable steps to achieve the highest value reasonably available for stockholders). The plaintiff alleged that Voyence’s directors (who each held preferred shares or were designees of preferred shareholders) accepted a “low offer” from EMC in order to benefit themselves at the expense of Voyence's common shareholders. In addition to the breach of fiduciary duty claims against the directors, the plaintiff alleged that EMC aided and abetted Voyence’s directors in their breaches of fiduciary duties.
The plaintiff claimed that EMC Corp. was “complicit” in the directors’ breaches of fiduciary duties in connection with the merger because:
- EMC attempted to “buy off” management's support for its offer by promising them employment with the post-merger entity; and
- EMC “exploited conflicts of interest” between Voyence’s directors and the common shareholders. The Court found that “reasonable inferences drawn from the facts alleged in [plaintiff’s] complaint [could not] sustain either of those two theories” and dismissed Morgan’s aiding and abetting claims for two reasons.
First, aside from the “unremarkable fact” that EMC offered Voyence's management modest compensation packages to stay on after the merger, the plaintiff’s complaint pointed to no other facts suggesting that there was an “unseemly quid pro quo” between EMC and Voyence’s directors to accept a low merger price in exchange for personal benefits.
Second, as to the claim that EMC exploited conflicts, the plaintiff alleged only that EMC knew that Voyence’s directors were all preferred stockholders or designees of preferred stockholders at the time of the offer. The plaintiff did not plead any other facts suggesting collusion between EMC and Voyence’s directors in the complaint. The court also noted that the complaint repeatedly alleged that EMC and Voyence negotiated “at arm's length” over the deal. The Court explained, “As an arm’s length bidder, EMC had no duty to pay more than market value simply because only by paying an above-market price would proceeds be available to Voyence's common stockholders. A bidder is entitled to negotiate price, and the bare allegation that the bidder paid consideration that did not result in payments to the target’s common stockholders provides, in itself, no rational basis to infer that the bidder was complicitous in a breach of fiduciary duty.” The Court explained, “It is not a status crime under Delaware law to buy an entity for a price that does not result in a payment to the selling entity’s common stockholders. But that is in essence all that the plaintiffs allege that EMC did wrong.”
In dismissing the aiding and abetting claim against EMC, the Court concluded, “What Morgan asks is that this court hold that the mere fact that a bidder knowingly enters into a merger with a target board dominated by preferred holders at a price that does not yield a return to common stockholders creates an inference that the bidder knowingly assisted in fiduciary misconduct by the target board. That is not and should not be our law, particularly when the plaintiff cannot even plead facts suggesting that the bidder was paying materially less, or in this case even anything at all less than, fair market value.” The Court noted the requirement in Malpiede v. Townson, 70 A.2d 1075, 1096 (Del. 2001), that the third party knowingly participate in the alleged breach—whether by buying off the board in a side deal or by actively exploiting conflicts in the board—to the detriment of the target’s stockholders.
The Court explained that it “would set a dangerous and irresponsible precedent” to conclude that “a claim for aiding and abetting against a bidder is stated simply because a bidder knows that the target board owns a material amount of preferred stock, knows that the target’s value is in a range where a deal might result in no consideration to the common stockholder, and that the bidder nonetheless insists on a price below the level that yields a payment to the common shareholders.” The Court stated, “If our law makes it a presumptive wrong for a bidder to deal with a board dominated by preferred stockholder representatives, then value-maximizing transactions will be deterred. It is hardly unusual for corporate boards to be comprised of representatives of preferred stockholders, who often bargain for representational rights when they put their capital up in risky situations.”
The court did not consider the plaintiff's claims against Voyence’s directors, which remain pending.
On July 14, 2010, the Securities and Exchange Commission voted unanimously to solicit public comments in connection with its first review in three decades of the proxy system that governs the way investors vote their shares in public companies. The U.S. proxy system governs the way in which investors vote their shares in a public company regardless of whether they attend shareholder meetings. There will be a 90-day public comment period for the concept release after it is published in the Federal Register. Read a copy of the concept release.
SEC Chairman Mary L. Schapiro stated, “The proxy is often the principal means for shareholders and public companies to communicate with one another, and for shareholders to weigh in on issues of importance to the corporation . . . [t]o result in effective governance, the transmission of this communication between investors and public companies must be timely, accurate, unbiased, and fair.”
Schapiro directed the SEC staff to undertake a comprehensive review of the proxy system in 2009, noting that since the last time the commission conducted such a review of proxy voting rules in 1976, major technological innovations, changes in stock ownership and new financial products have emerged. With significant changes in shareholder demographics, technology, and other areas, the Commission’s review of the U.S. proxy system will examine emerging issues that either did not exist or were not considered to be significant 30 years ago. The concept release states the SEC’s concerns relating to three principal questions:
- whether the SEC should take steps to enhance the accuracy, transparency, and efficiency of the voting process;
- whether SEC rules should be revised to improve shareholder communications and encourage greater shareholder participation; and
- whether voting power is aligned with economic interest and whether SEC disclosure requirements provide investors with sufficient information about this issue.
The concept release addresses specific issues such as “overvoting,” “undervoting” and “empty voting.” It also requests comments on issues related to proxy advisory firms, including whether such firms may be subject to liability for undisclosed conflicts of interest, may fail to conduct adequate research or may base recommendations on erroneous or incomplete facts. It further seeks comment on whether the current rules allowing beneficial owners to object to having their identities disclosed to issuers should be preserved. The release also looks for guidance on whether data-tagging proxy-related data, including information on executive compensation and director qualifications, might enhance a shareholder’s ability to analyze issuer disclosures to make informed voting decisions.
The concept release marks the first step in the SEC’s public review of the proxy voting system. The SEC said that any reforms will be aimed at promoting greater efficiency and transparency in the system.
Daniel James Pirolo
Darryl Wade Anderson
Steven I. Suzzan
Robin Preussel Phillips
Johnathan C. Bolton