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Corporate Quick Hit: PIPE Transactions; LLC Derivate Suits; Stealth Proxy Contests; "Best Efforts" Clauses;  Foreign Investments in U.S. on the Rise; Hart-Scott-Rodino Thresholds; Investment Advisors must Post Full Details on Web
February 2008
Authors: Irwin A. Kishner, Daniel A. Etna

SEC Taken to Task for Enforcement Actions in Connection with PIPE Transactions

A Pennsylvania federal district court thwarted the Securities and Exchange Commission (the "SEC") in its efforts to hold a hedge fund manager liable for violating registration requirements under the Securities Act of 1933, as amended (the "Securities Act"), in connection with short sales involving a private investment in public equity ("PIPE") transaction. 

In its lawsuit, the SEC charged a hedge fund operator with engaging in an unlawful trading scheme in order to avoid the registration requirements.  Specifically, the SEC's complaint alleged that the hedge fund manager sold the issuer's securities short and later covered with the shares obtained from the resale registration statement filed as part of the PIPE transaction—which according to the SEC violated Section 5 of the Securities Act.  The SEC also alleged that the hedge fund manager violated insider trading rules by trading in the issuer's shares prior to the PIPE transaction being publicly announced (despite having pledged not to do so).

The court rejected the SEC's unregistered securities claim without issuing an opinion explaining the basis for the ruling.  Given that the SEC has previously been rebuffed on similar type claims, it seems all the more likely that the SEC will seek to address the issue through rulemaking. 

The insider trading claim was dismissed without prejudice on account of the SEC having failed to properly plead the claim.  The SEC is expected to amend its insider trading claim and bring this claim before the court again.

SEC v. Berlacher, E.D. Pa., Civil Action No. 07-3800-ER (E.D. Pa. Jan. 23, 2008)

New York Court of Appeals Recognizes LLC Derivate Suits

Corporate shareholders and limited partners of partnerships have long had the right to sue derivatively—that is, on behalf of the corporation—for injuries suffered by the corporation.  In a 4-3 decision issued on February 14, 2008, the New York Court of Appeals held that members of limited liability companies also have that right and may sue derivatively on behalf of the limited liability company even though New York's Limited Liability Company Law does not provide for such derivative lawsuits.  

The Court explained that derivative suits had long been permitted at common law, before the right was codified in statute, and that limited partners similarly have the right to sue derivatively, both at common law and under New York's Partnership Law.  The majority found there was no reason not to apply the rule to limited liability companies as well.  A sharp dissent accused the Court of adopting a remedy that the Legislature had expressly rejected, stating that "[n]ever before has a majority of the Court read into a statute provisions or policy choices that the enacting Legislature unquestionably considered and rejected." 

This decision has significant legal and practical ramifications for all limited liability companies formed in New York.   Members—most likely minority members—will now be able to sue on behalf of the LLC for injuries allegedly done to the LLC by its fiduciaries, including its managing members.  But the decision does not set forth any procedure for these lawsuits or any guidance on what limitations might restrict a member's ability to sue.  Nor does the Court's decision address whether the right to bring such derivative lawsuits could be waived, for example, in the LLC's operating agreement.  So, while the decision creates an important new form of action as a matter of New York law,  the courts will have many issues to sort out in future cases.

Tzolis v. Wolff, 2008 WL 382345 (N.Y. Ct. of App., Feb. 14, 2008)

Stealth Proxy Contests: Is Evading Beneficial Ownership the Way?

A small group of "stealth investors" has taken advantage of an apparent loophole in the Regulation 13D beneficial ownership reporting requirements under the Securities Exchange Act of 1934, as amended, in order to set the stage for proxy contests without tipping off the targets or the market.  In order to facilitate transparency in the markets, Regulation 13D requires investors who "beneficially own" more than five percent of the equity securities of a public company to disclose their holdings in public filings.  Beneficial ownership is defined as the power to control the vote or the disposition of securities.  The stealth investors recently sought to use this definition to their advantage by entering into swap contracts with investment banks, whereby the investment banks purchase equity securities using the stealth investors' money, on the stealth investors' behalf.  Although the stealth investors have an economic stake in the securities, the investment banks are the beneficial owners of the securities on the issuer's books and records.  As a result, the stealth investors posit that they are not required to report under Regulation 13D and can instead secretly amass large equity stakes in connection with proxy contests.

The SEC is looking at the issue, but has not yet taken any action.  However, Rule 13d-3, which forms a part of Regulation 13D, provides that any contract entered into with the intention to evade beneficial ownership status will result in the investor being deemed a beneficial owner.  The investors may find out that their "loophole" is simply a loophole in enforcement, rather than lawmaking. We will report further developments in this area in future Herrick, Feinstein LLP publications.

Settlement Scuttles Anticipated Guidance on "Best Efforts" Clauses

On February 8, 2008, Alliance Data Systems ("ADS") announced that it had dismissed without prejudice its lawsuit against an affiliate of The Blackstone Group ("Blackstone") in connection with Blackstone's alleged attempt to withdraw from a multi-billion dollar acquisition of ADS.  Blackstone sought to withdraw after being unable to satisfy a closing condition regarding approval of the acquisition by the Office of the Comptroller of the Currency.  Blackstone had agreed to use its reasonable "best efforts" to obtain the approval.  This lawsuit was being monitored closely by many in expectation of the Delaware courts shedding some light on the degree of efforts required to be expended under a "best efforts" clause—a clause commonly used, but with little legal precedent for its application. 

Foreign Investments in the U.S. on the Rise; Increased Scrutiny to Follow

Foreign investments in U.S. companies have been steadily on the rise as the dollar has weakened.  In a recent report by Thomson Financial, the amount of inbound cash from foreign sources doubled from the previous fourth quarter—illustrating that U.S. companies are attractive targets, or alternatively, attractive investments to foreign investors. This phenomenon has not been limited to corporate mergers and acquisitions activity, as a flood of foreign buyers (and foreign money) have also entered into some of America's top real estate markets.

As the volume of foreign funds being poured into the U.S. economy continues to grow, the attention of regulators and other government officials have also increased, especially in regards to "sovereign-wealth funds" (large government controlled investment pools). Some estimates indicate the there are approximately three dozen sovereign-wealth funds, with about $2 trillion in assets.  By some estimates, these funds' assets could reach as much as $12-13 trillion in the next seven years, depending largely on the state of the global economy.

In the past few months, several foreign governments have made large investments in some of America's most elite financial institutions, including venerable names such as Morgan Stanley and Citigroup. These highly publicized investments have placed sovereign-wealth funds squarely in the sights of regulators and legislators in Washington.  Some lawmakers have suggested that the Committee on Foreign Investment in the United States, a special federal panel, review transactions not only posing national security risks, but transactions affecting economically strategic areas as well.  The Treasury Department has opposed extending review of foreign investments into areas that affect economic security as opposed to national security, though it says it will continue to monitor growing foreign investments in the financial and other sectors of the economy.

FTC Issues Revised Hart-Scott-Rodino Thresholds

The Federal Trade Commission ("FTC") recently announced revised thresholds for the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act").  The HSR Act requires that parties to a proposed stock or asset acquisition that exceeds certain thresholds file pre-merger notification reports with the FTC and the Antitrust Division of the Department of Justice and then observe a statutorily prescribed waiting period (usually 30 days) prior to closing the transaction.

Pursuant to Section 7A of the Clayton Act, the FTC is required to revise the HSR Act thresholds annually based on the change in the U.S. gross national product.  The new thresholds were published in the Federal Register on January 29, 2008 and will go into effect on February 28, 2008.

The primary changes are increases in the "size of transaction" and the "size of person" tests under the HSR Act. Currently, the "size of transaction" test provides that an acquisition of voting securities or assets may be reportable if such securities or assets are valued in excess of $59.8 million, and either of the acquired or acquiring party has annual net sales or total assets of at least $12 million, while the other party has annual net sales or total assets of at least $119.6 million.  Moreover, the size of the parties is irrelevant if the value or size of the transaction exceeds $239.2 million.  The revised HSR Act thresholds increase the size of transaction test to $63.1 million and size of person test to $12.6 million and $126.2 million, respectively.  In addition, the limit with respect to the overall value or size of a transaction has been increased to $252.3 million.

The revisions to the HSR Act thresholds will also increase the notification thresholds for acquisitions of additional voting securities from the same party.  Notification will now be required at each of the following thresholds (i) $63.1 million; (ii) $126.2 million; (iii) $630.8 million; (iv) 25% of the voting securities if the value of such voting securities exceeds $1,261.5 million; and (v) 50% of the voting securities if their value exceeds $63.1 million.

The thresholds that determine filing fees have also been revised, although the fees themselves remain the same.  Under the new thresholds, acquiring persons in transactions valued above $63.1 million and up to $126.2 million must pay a filing fee of $45,000, while acquiring persons in transactions valued above $126.2 million and up to $630.8 million must pay a filing fee of $125,000.  Acquiring persons must pay a filing fee of $280,000 for transactions valued at or above $630.8 million.

SEC Asks Investment Advisors to Post Full Details on Web

The SEC recently proposed rule amendments requiring investment advisors to prepare and deliver to clients and prospective clients a narrative brochure written in plain English.  Brochures would be made available to the general public through the SEC sponsored Investment Advisor Public Disclosure website.  The narrative would publicly disclose to investors more detailed information about an investment advisor's business practices, conflicts of interest and disciplinary history.

Federal regulations first called for expanded online disclosure from advisors in 2000, but the idea proved controversial and the SEC eventually settled on a requirement for advisors to provided basic information online, leaving details in printed brochures.

SEC Rel. No. 2008-19 (Feb. 13, 2008)

For more information on these issues or other corporate matters, please contact:

Irwin A. Kishner at 212.592.1435 or
Daniel A. Etna at 212.592.1557 or 

Copyright © 2008 Herrick, Feinstein LLP.  Corporate Quick Hit  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. Prior results do not guarantee a similar outcome.