Corporate AlertNovember 2014
The Herrick Advantage
This November, Herrick hosted several exciting events, including one for emerging hedge fund managers. Our featured keynote speaker, Michael Tew, Co-Founder and Partner, Quantx Management LLP, and several panelists talked about attracting early stage capital, building infrastructure and developing sound operational and risk controls.
Also this month, Herrick partners Irwin A. Kishner, Daniel A. Etna and Stephen D. Brodie spoke at our What's the Catch? Minor League Baseball Team Acquisition and Financing event. They joined our guest panelists, Stephen Corcoran from Webster Bank, N.A., Larry Freedman from Mandalay Baseball Properties and Larry Grimes of The Sports Advisory Group, in a lively discussion about significant changes in Minor League Baseball, which are resulting in escalating team purchase prices and valuations.
On October 20, 2014, the Securities Industry and Financial Markets Association ("SIFMA") published Principles for Effective Cybersecurity Regulatory Guidance (the "Guidance") to emphasize cybersecurity as a top priority for the financial industry and provide regulators and agencies with the industry's perspective of how best to protect operations and clients from cyber threats.
Currently, there is a proliferation of different government and private sector security standards that creates confusion in the industry and "fosters an environment in which noncompliance is at risk." At the heart of SIFMA's Guidance, are the 10 "principles" it puts forth, intended to "facilitate the dynamic partnership between financial regulators and industry that is essential for each to achieve their shared goals of protecting infrastructure and the assets and data of the public."
The principles call for the harmonizing of regulations for greater effectiveness and interagency cooperation. Throughout the Guidance, SIFMA consistently advocates for the use and adoption of the National Institute of Standards and Technology Cyber Security Framework as a starting point for harmonizing regulations. It also suggests the establishment of an interagency working group that facilitates the coordination of ideas, standards and feedback across all government and industry entities, to improve uniformity in regulatory standards and foster public-private industry collaboration.
The principles also emphasize the need for practicality and flexibility in regulatory obligations. Protection standards cannot be one-size-fits-all. Regulators need to remember that small, medium and large-sized financial firms face different threats and have different business models, resources and budgets. For instance, SIFMA cautions that small and midsized firms often do not have the resources to have in-house data storage and infrastructure architects, often outsourcing these services to unregulated third-party providers. The principles recommend increasing pressure by regulators on providers servicing financial industry members to meet regulatory standards. Any regulation or guidance needs to be flexible to fit a wide range of firms and take into account real-world applications.
Information sharing is another area the principles discuss. Interagency and inter-industry knowledge sharing should be embraced as threat trends and patterns can be more easily detected when government and industry members collaborate in data and infrastructure analysis. Additionally, if an attack were to happen to one financial firm, it would be beneficial to alert other similar firms susceptible to similar cyber-attacks and make known how the attack occurred. However, strong privacy and oversight protections must be built into the process for information sharing to be an asset.
Furthermore, the principles encourage regulators to increase the knowledge and skill of their examiners to match the new and changing needs of the industry. In effecting this principle, FINRA announced late last month that it is intensifying scrutiny of cybersecurity practices at brokerage firms in 2015 by hiring technology savvy examiners to help boost its efforts.
"Cyber-attacks are increasing in frequency and sophistication, and it is critical that the industry and government collaborate to mitigate these threats," states Kenneth E. Bentsen, Jr., SIFMA president and CEO, emphasizing the importance of a collaborative approach to cybersecurity. "We appreciate that the public sector has embraced this partnership and we will continue to offer our insights to help them in their work."
Delaware Court of Chancery Declines to Dismiss Fiduciary Claim Against Directors for Waiver of Lock-Up
The Delaware Court of Chancery recently declined to dismiss a claim brought by the shareholders of Zynga, Inc., a maker of online social games, for breach of the fiduciary duty of loyalty against four of the eight directors of the company for waiving a post-IPO lock-up restriction that allowed the directors to sell some of their stock in a secondary offering two months before the expiration of the lock-up. As a result of the waiver of the lock-up, the directors were able to sell a portion of their shares at twice the price of the stock at the expiration of the lock-up period, while other stockholders were still bound to the original 165-day lock-up. In declining to grant the motion to dismiss, the Court held that it was reasonable to believe that the decision to restructure the lock-up periods provided the directors engaged in the restructuring an unfair benefit, thus constituting a self-interested transaction. The Court also rejected the defendants' argument that the directors' obligations only arose pursuant to the contractual terms of the lock-up, and that no fiduciary duty claims should be attached to the lock-up agreements. In the other allegation in the suit, the Court granted the defendants' motion to dismiss the claim of aiding and abetting against Zynga's underwriters, holding that it could not be reasonably inferred that the underwriters knowingly participated in the directors' breach of their fiduciary duties.
Lee v. Pincus, C.A., No. 8458-CB (Del. Ch. Nov. 14, 2014)
Delaware Supreme Court Held UCC-3 Termination Statement Effective Despite Mistake
In Official Comm. of Unsecured Creditors of Motors Liquidation Co. v. JPMorgan Chase Bank, N.A., the Delaware Supreme Court held that a termination statement is effective under the UCC (and thus the financing statement to which the termination statement relates ceases to be effective) if the secured party authorizes the filing to be made. The Delaware UCC contains no requirement that a secured party that authorizes such filing subjectively intends or otherwise understands the effect of such filing.
In 2008, a UCC-3 termination statement was filed with the Delaware Secretary of State on behalf of General Motors Corporation purporting to extinguish a security interest on the assets of General Motors held by a syndicate of lenders including JPMorgan to secure a $1.5 billion term loan. However, neither JPMorgan nor General Motors subjectively intended to terminate the term loan security interest when General Motors filed the termination statement. After General Motors filed for reorganization under Chapter 11 in 2009, a group of unsecured General Motors creditors commenced a proceeding against JPMorgan seeking a determination that the termination statement was effective rendering JPMorgan an unsecured creditor on par with the other unsecured creditors.
The Court held the UCC-3 termination statement effective and explained that it is fair for sophisticated transacting parties to bear the burden of ensuring that a termination statement is accurate when filed. The Court further stated that it would be inefficient for the UCC to make the effectiveness of a termination statement depend on whether the secured party subjectively understood the terms of its own filing or the effect the filing would have on the security interest. The Court emphasized that one of the most important roles the UCC plays is facilitating the efficient procession of commerce by permitting parties to rely in good faith on the plain terms of authorized public filings.
Official Comm. of Unsecured Creditors of Motors Liquidation Co. v. JPMorgan Chase Bank, N.A., C.A. No. 13-2187-bk (Del. Oct. 17, 2014).
Delaware Chancery Court Holds Financial Advisor Liable For Aiding and Abetting Directors' Breach of Fiduciary Duties
In a recent decision, In re Rural/Metro Corp. Stockholders Litigation, the Delaware Chancery Court held a financial advisor liable for $75.8 million in damages (representing 83% of the total damages) for aiding and abetting breaches of the duty of care by board members of Rural/Metro Corporation. The suit was brought by stockholders of Rural/Metro Corporation in connection with the sale of Rural/Metro Corporation to Warburg Pincus in 2011, alleging that the company was sold at a price below its fair value due to fiduciary duty breaches by the board and failure to make material disclosures by both the board and its financial advisor, RBC Capital Markets, LLC.
In an earlier decision, the Court determined that the shareholders suffered $93 million in damages, representing the difference between the value the shareholders received and Rural/Metro Corporation's going concern value. All of the defendants other than RBC entered into a settlement agreement. RBC subsequently sought contribution from the director co-defendants with respect to the damages awarded. Defendants who aid and abet a breach of fiduciary duty are jointly and severally liable for resulting damages. The Court held that under the Delaware Uniform Contribution Among Tortfeasors Act (DUCATA), RBC's claim for contribution was not, as the plaintiffs claimed, barred because RBC committed an intentional tort. However, the Court stated that the courts retain discretion to deny contribution under DUCATA if warranted by the facts of the case. The Court then found that RBC's contribution claim was barred by the equitable doctrine of unclean hands, because RBC committed a "fraud upon the board" by providing it with false information and failing to disclose its conflicts of interest. The Court explained "if RBC were permitted to seek contribution for these claims from the directors, then RBC would be taking advantage of the targets of its own misconduct."
DUCATA permits a finding of relative degrees of fault of joint tortfeasors in determining their share of damages. In order to qualify the directors as "joint tortfeasors," RBC had to establish that directors breached their duty of loyalty - RBC was only able to prove this for two directors who acted in a self-interested manner. The Court apportioned 83% of the damages to RBC, and the remainder to the two directors, finding that a majority of the damages were attributable to failure to disclose material information (for which RBC was solely responsible), a lesser portion to breaches of duty in connection with the approval of the merger (for which RBC could not seek contribution due to unclean hands), and another portion to initiating the sale process (for which RBC shared the damages with the two directors).
In re Rural/Metro Corp. Stockholders Litigation, C.A. No. 6350-VCK slip op. (Del. Ch. Oct. 10, 2014).
Delaware Chancery Court Offers Guidance on Dead Hand Proxy Puts in Loan Agreements
The Delaware Chancery Court recently denied motions to dismiss fiduciary duty claims against certain directors of Healthways, Inc. and aiding and abetting claims against SunTrust Bank, the administrative agent in connection with Healthways' credit facility. At the heart of the Court's ruling was the "dead hand proxy put" contained in Healthways' loan agreement.
Healthways entered into a credit agreement in 2010 that contained a "proxy put" provision pursuant to which a default would be triggered under the credit agreement in the event that, during any consecutive 24-month period, the Healthways board ceased to be composed of continuing directors. Subsequently, Healthways came under pressure from its stockholders and faced the risk of a proxy contest. In 2012 Healthways and SunTrust added a "dead hand" feature to the proxy put that treated directors elected as the result of an actual or threatened proxy fight, including directors elected by insurgent stockholders in 2014, as "non-continuing directors," even if such directors were subsequently approved by the continuing directors.
Pontiac General Employees Retirement System, a stockholder of defendant Healthways, brought suit claiming (i) that individual directors of Healthways violated their fiduciary duties by adopting the dead hand proxy put in light of an identified stockholder insurgency, the historical practice in the company's past credit arrangements, and the alleged lack of informed consideration and negotiation in connection with the dead hand proxy put feature and (ii) that SunTrust aided and abetted the breach of those fiduciary duties. The individual defendants moved to dismiss on the grounds that the fiduciary duty claim was not ripe because the proxy put had not been triggered and the debt had not yet been accelerated. The Court, drawing comparisons to similar rulings relating to poison pills, held that the fiduciary duty claims were ripe for adjudication because the deterrent effect of the proxy put and the fact that the non-continuing directors were treated differently than other directors constitute present injuries. SunTrust moved to dismiss the aiding and abetting claim on the grounds that it didn't "knowingly participate" in the breach of the fiduciary duties of the directors. The Court dismissed SunTrust's motion holding that there is "ample precedent" putting lenders on notice that proxy put provisions are "highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation over the credit agreement."
Even though the Court was ruling on motions to dismiss, borrower and lenders should consider themselves on notice that the Chancery Court will closely examine proxy puts, dead hand proxy puts, and similar credit agreement provisions, that the deterrent effect of such provisions may render a dispute ripe, and that such provisions may give rise to a breach of fiduciary duty claim.
Pontiac General Employees Retirement System v. Healthways, Inc., C.A. No. 9789-VCL (Del. Ch. October 14, 2014) (transcript ruling).
Controlling Stockholder Must Have Conflict to Trigger Entire Fairness
The Delaware Chancery Court recently dismissed a derivative suit challenging the merger of Crimson Exploration, Inc., and Contango Oil & Gas Co. The plaintiffs alleged that Crimson's largest stockholder, Oaktree Capital Management, L.P., in conjunction with other affiliates, constituted a control group, and breached their fiduciary duties by selling Crimson at below market value, and in consideration of side-benefits not shared with other stockholders. The Court found that even if Oaktree did in fact occupy a control position within Crimson's management, the complaint did not allege facts sufficient to find that Oaktree was conflicted in the transaction to rebut the business judgment rule. As such, the Court declined to review the merger under the entire fairness standard and dismissed the suit for failure to state a claim.
The plaintiffs contended that Oaktree, which owned 33.7% of Crimson's common stock, should be considered a controlling stockholder. Moreover, the Court found that the plaintiffs had "hinted in the Complaint" that Crimson and its affiliates constituted a control block. Absent the existence of a connection in some legally significant way, the Court refused to treat Crimson and its affiliates as a control group merely because of a mutual alignment of self-interest. Delaware courts will only treat a non-majority stockholder as a controller if they find that it exercises actual control over the board's decision about the challenged transaction. Although the Court was hesitant to conclude that the plaintiffs did not meet their burden to allege that Crimson was a controller in the pleading stage, it nonetheless found that the "overarching theory that Oaktree sought to exit its investment in Crimson, and, thus was willing to undersell its shares," lacked any specific allegations from which the Court could infer the existence of actual control.
The Court then determined whether Oaktree, as the assumed controller, engaged in a conflicted transaction that would trigger the entire fairness standard. In support of their allegation, the plaintiffs argued that Oaktree received a combination of disparate consideration for the merger through the prepayment of a loan, and receipt of a unique benefit not shared by all stockholders through a Registration Rights Agreement (the "RRA"). The Court found that while Oaktree was the holder of a significant percentage of a loan made to Crimson, there was no agreement to repay the debt early as a condition of merger, and declined to view mere anticipation of its repayment as equivalent to having a definitive term in the merger agreement. Similarly, the Court found that the RRA was neither a condition to merge, nor the product of a need for liquidity, and thus could not be a "sufficiently unique benefit" to implicate the entire fairness standard. The Court concluded that the plaintiffs failed to rebut the business judgment rule by creating a reasonable doubt that a majority of the board was disinterested and independent, and dismissed the action.
In re Crimson Exploration Inc. Stockholder Litigation, C.A. No. 8541-VCP, 2014 WL 5449419 (Del. Ch. Oct. 24, 2014).
For more information on the issues in this alert, or corporate matters generally, please contact:
Daniel Etna at +1 212 592 1557 or [email protected]
Copyright © 2014 Herrick, Feinstein LLP. This alert is published by Herrick, Feinstein LLP for information purposes only.
Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.