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Corporate Quick Hit: Breach of Duty in Seeking Private Equity Buyers, Exchange Act, Bonuses Subject to "Entire Fairness" Scrutiny, Rule Pertaining to Broker-Dealers is Vacated, Auditors Liable for Securities Law Violations, No D&O Coverage for Settlement Amounts Representing Misappropriated Funds
April 2007
Authors: Irwin A. Kishner, Daniel A. Etna

Delaware Board of Directors Likely Breached Duty in Seeking Only Private Equity Buyers

The Delaware Chancery Court recently enjoined a shareholder vote on a proposal to sell the company. The court ruled that the board of directors likely breached certain fiduciary duties, known as "Revlon duties," to obtain the best price when selling the company because it limited its search to only private equity buyers. As a result, potential strategic buyers were not considered.

The court rejected the board's argument that a "post-signing market check" where any further potential buyers might come forward with offers would work with a thinly traded, micro-cap company. The fact that one approach to selling a company has been approved by the court in the past is no guarantee that the same approach "is reasonable in other circumstances that involve very different market dynamics."

In re Netsmart Tech. Inc. Shareholders Litigation, C.A. No. 2563- VCS (Del. Ch. Ct., 03/14/07).

SEC Establishes New Rules to Make It Easier for Foreign Issuers to Deregister Under the Exchange Act

The high cost of complying with the Sarbanes-Oxley Act and other reporting requirements has caused many foreign issuers of securities in U.S. markets to consider deregistering from the Securities Exchange Act of 1934. Under the current rules, a foreign issuer may exit the Exchange Act registration and reporting regime if the class of the issuer's securities has fewer than 300 record holders who are U.S. residents.

The SEC recently adopted new rules making it easier and faster for foreign issuers to withdraw their equity securities from U.S. markets. Under the new rules, which will take effect by mid-year, foreign issuers may deregister under the Exchange Act if trading in their equity securities is 5 percent or less of worldwide trading in the same securities over the previous 12 months. About 29 percent of the approximately 1,200 foreign issuers registered under the Exchange Act would qualify to leave immediately once the new rules take effect.

SEC Rel. No. 34-55540 (03/27/07).

Delaware Court Holds Director and Executive Transaction Bonuses Subject to "Entire Fairness" Scrutiny

The Delaware Chancery Court recently ruled that a transaction bonus received by a former president was subject to "entire fairness" scrutiny, not "business judgment" scrutiny, which gives great deference to compensation decisions made by independent compensation committees or boards of directors. In this case, the board of directors unanimously voted to grant a $3 million bonus in connection with a corporate restructuring, along with bonuses to all other board members and certain non-director employees. Vice Chancellor Stephen Lamb held that all members of the board were interested in the bonuses paid because even independent directors on the compensation committee received bonus payments. As such, the bonus decision was taken out of the realm of business judgment scrutiny to a standard of review by the court which asked whether the bonus payments were entirely fair, in procedure and substance, to the corporation.

The court found that the bonus paid to the former president was not entirely fair to the corporation (all other defendants settled prior to the decision). Of particular import to the court was a report submitted to the compensation committee by an executive compensation consulting firm. Although Section 144(e) of the Delaware General Corporation Law states that directors shall be "fully protected" when they rely on reports by experts chosen with reasonable care, the court found that the executive compensation consulting firm initially rejected the bonus amounts proposed by management and only submitted its report after further meetings with management, and failing to find comparable transaction bonus structures at other corporations. The court found that the circumstances surrounding the report brought it out of the protective realm of 144(e) and squarely into the "entire fairness" review. The court cautioned that when directors and officers are authorizing their own bonuses, the Delaware courts will be "particularly cognizant [of] the need for careful scrutiny."

The former president was ordered to disgorge the entire $3 million bonus and was held liable for his share (as among the other directors) of the costs of the litigation committee investigation that led to the litigation and his share of the bonuses paid to non-director employees. The court also rejected the former president's argument for contribution from the original co-defendants, holding that doctrines of common law and statutory contribution are inapplicable to interested transactions resulting in disgorgement.

Valeant Pharmaceuticals International v. Jerney, Del. Ch., C.A. No. 19947 (2007).

SEC Rule Pertaining to Broker-Dealers is Vacated

The U.S. Court of Appeals for the D.C. Circuit recently vacated a rule adopted by the SEC in 2005 which deems certain broker-dealers not to be investment advisers. Rule 202(a)(11), promulgated under the Investment Advisers Act of 1940, excludes certain broker-dealers from the fiduciary requirements of the act even when they receive special compensation for investment advisory services. Prior to the adoption of the rule, a broker-dealer who performed investment advisory services was typically subject to the act unless (i) such services were solely incidental to its business as a broker-dealer and (ii) it received no special compensation therefor.

With the adoption of the rule, the SEC sought to broaden this exception by allowing a broker-dealer to charge an asset-based or fixed fee (rather than a commission, mark-up, or mark-down) for its investment advisory services and still remain outside the purview of the Act, provided it makes certain disclosures about the nature of its services. In vacating the rule, the Court held that the SEC exceeded its authority in allowing broker-dealers to receive special compensation for advisory services. Reasoning that the act does not authorize the SEC to except from the act any group that is already covered by another exception, the court found that an exception was already available to broker-dealers who did not receive special compensation for advisory services, thus preempting the rule.

Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. Mar. 30, 2007).

Second Circuit Finds That Auditors Are Primarily Liable for Securities Law Violations Under Section 10(b)

The Second Circuit Court of Appeals recently held that accountants have a duty (the "Duty to Correct") to take reasonable steps to correct or withdraw a previously certified opinion letter that contains false or misleading statements of which the auditors were aware when the opinion letter was issued or of which the accountant became aware or should have become aware at a later date. The penalty for accountants violating the Duty to Correct is to be held primarily liable for violating Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

Vacating and remanding the District Court's decision, the court held that an accountant will be held primarily liable for violating Section 10(b) and Rule 10b-5 if it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on its opinion; (4) fails to take reasonable steps to correct or withdraw its certified opinion and/or the underlying financial statements; and (5) all other requirements for liability are satisfied. The court limited the implication of the Duty to Correct to only those statements that are made in the opinion and financial statements certified by an accountant. The Court stated that accountants do not have a duty to disclose information collateral to the statements of accuracy and financial fact set forth in the certified documents. In addition, the Duty to Correct applies only to statements that were false or misleading at the time they were made (whether or not an accountant making such statements was aware that such statements were false or misleading at such time). No Duty to Correct exists with respect to a statement that was true and correct when made, but became false and misleading upon the occurrence of subsequent events.

Overton v. Todman & Co., CPAs, P.C., 2007 U.S. App. LEXIS 4239 (2d Cir. 2007).

No D&O Coverage for Settlement Amounts Representing Misappropriated Funds

On March 14, 2007, a Florida Federal district court, applying New York law, held that the amount paid by a corporation in settlement of a lawsuit alleging violations of Section 11 of the Securities Act of 1933 was not covered under its directors and officers liability insurance policies because the settlement amount represented the sum of money the corporation had wrongfully misappropriated from its shareholders. This decision continues a trend in which the courts recognize that the disgorgement of ill-gotten gains through securities violations do not fall within a D&O liability policy's definition of "loss."

In explaining its decision, the court used a bank's innocent calculation error as an analogy. If the bank acquires funds from a customer by mistake, it must return those funds to the customer. It cannot then seek reimbursement of the funds through its insurance policy. According to the court, the same principles apply to a settlement agreement that requires a corporation to reimburse its shareholders for funds wrongfully acquired from them. Such funds, even if innocently acquired, cannot be a part of a loss claim tendered to an insurer. An insured cannot seek reimbursement from its insurer for something which it never owned—it cannot lose what it never rightfully had.

CNL Hotels & Resorts, Inc. v. Houston Cas. Co., No. 6:06-cv-324-Orl-31JGG, 2007 U.S. Dist. LEXIS 17904 (M.D. Fla. Mar. 14, 2007).

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

Irwin Kishner at 212.592.1435 or ikishner@herrick.com
Daniel Etna at 212.592.1557 or detna@herrick.com

 Copyright © 2007 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.