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Corporate Quick Hit: "Zone of Insolvency," LBO Structure, What's the Market Worth?, Regulation of Financial Services, Rights of Patent Holders, Underwriting Activity Immune From Antitrust Challenge, Music Downloads are not "Public Performances", Guidance on "Covered Employees"
June 2007
Authors: Irwin A. Kishner, Daniel A. Etna

Delaware Supreme Court Visits "Zone of Insolvency"

The Delaware Supreme Court has held that creditors of a Delaware corporation may not assert direct claims for breach of fiduciary duty against the corporation's directors, even if the breach allegedly occurs when the corporation is insolvent or in the "zone of insolvency." The court's decision upheld the Delaware Chancery Court's dismissal of a creditor's claim that the debtor corporation's directors breached their fiduciary duties by, among other things, allegedly permitting the depletion of the debtor corporation's assets while the corporation was insolvent or in the "zone of insolvency."

In reaching its decision, the court ruled that creditors of a corporation that is in the "zone of insolvency," but not actually insolvent, at the time of an alleged breach of fiduciary duty may not assert direct claims against directors. The court further ruled that, although creditors of a corporation that is actually insolvent at the time of an alleged breach of fiduciary duty have standing to assert derivative claims against directors, they too may not assert direct claims for breach of fiduciary duty. The court reasoned that permitting a corporation's creditors to bring direct claims would create a conflict between the duties of directors "to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors." In contrast, allowing a corporation's creditors to bring derivative actions in insolvent cases creates no such conflict, since a valid derivative claim seeks recovery of value belonging to the firm as a whole.

North Amer. Catholic Educational Programming Foundation v. Gheewalla, No. 521, 2006, 2007 Del. LEXIS 227 (Del. Sup. Ct. May 18, 2007)

New Twist in LBO Structure

The recently announced Harmon International Industries Inc. leveraged buy-out transaction has been structured in a non-traditional manner. Unlike traditional LBOs which result in the LBO sponsor and its affiliates owning all of the equity of the acquired company, the Harmon LBO affords Harmon stockholders with the opportunity to retain a minority equity interest. In particular, Harmon stockholders have the right, but not the obligation, to exchange up to approximately 12.5% of the Harmon shares for shares of stock of the newly formed acquiring parent company participating in the Harmon LBO. The shares issued to Harmon stockholders will be registered under federal securities laws and the issuer of the shares has agreed to file periodic reports with the SEC for at least two years following the closing of the LBO. Moreover, each exchange whereby a Harmon stockholder receives only stock is expected to qualify as a "tax-free Section 351 exchange," generally allowing the stockholder to defer at least a portion of its gain in the transaction.

What's it Worth? Third Circuit Looks to the Market

The Federal Court of Appeals for the Third Circuit (which encompasses Delaware), among other states supports the use of market valuation evidence in valuing a spun-off business for purposes of determining whether unpaid creditors could recover from the former parent corporation of a bankrupt subsidiary on fraudulent transfer and breach of fiduciary duty grounds.

In upholding the rejection of a fraudulent transfer claim, the Third Circuit ruled that the lower court's determinations of solvency, reasonably equivalent value and capital adequacy were properly determined by referring to the publicly traded subsidiary's market capitalization. At and after the time of the spin-off transaction at issue, the market capitalization of the subsidiary was well in excess of the borrowing proceeds and other consideration received by the parent corporation in connection with the transaction.

The Third Circuit agreed with the lower court's refusal to recognize the creditor's valuation experts, who assigned below-market values to the subsidiary's business. The Third Circuit's decision also reaffirmed a Delaware Supreme Court holding that the directors of a wholly owned, solvent subsidiary are required to act in the best interests of the parent corporation and its stockholders, and do not owe separate or conflicting fiduciary duties to the pre-spin subsidiary.

VFB LLC v. Campbell Soup Co., 482 F.3d 624 (3rd Cir. 2007).

New York State Commission to Modernize the Regulation of Financial Services

Governor Spitzer has issued an executive order establishing the New York State Commission to Modernize the Regulation of Financial Services. The Commission's goal is to review New York's financial services statutes, regulations, rules and policies.

Governor Spitzer's initiative comes on the heels of a study commissioned by Senator Charles E. Schumer and New York City Mayor Michael R. Bloomberg, which warns that the United States and New York City are at risk of losing their lead as a global financial hub, citing the regulatory burden of the Sarbanes-Oxley Act, excessive litigation and overlapping regulators.

The Commission will reexamine New York State's regulation of financial services firms, including insurance companies, banks and securities firms, in order to enhance New York's role as a leading financial center in the global marketplace. Formally, the Commission is charged with (i) identifying ways in which regulatory powers may be integrated, rationalized, and changed in order to promote economic innovation and protect consumers; (ii) recommending specific changes in statutes and regulations to promote competition and the business growth, while effectively protecting consumers and businesses from unfair or unethical practices; and (iii) ensuring that the benefits of all statutes and regulations outweigh the costs.

The Commission is scheduled to issue its final report and recommendations by June 30, 2008.

New York Exec. Order No. 15 enacted May 29, 2007

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U.S. Supreme Court Cuts Back Rights of Patent Holders

The U.S. Supreme Court has clarified the "obviousness test" used to determine whether a patent should be issued. Patent law mandates that an invention cannot be patented if a "person having ordinary skill in the art" would consider it obvious.

"The results of ordinary innovation are not the subject of exclusive rights under the patent laws," Justice Anthony Kennedy wrote for the Court. "Were it otherwise, patents might stifle rather than promote the progress of useful arts." The Court held that the obviousness inquiry should be "expansive and flexible" and that the combination of a number of elements might be obvious to a person of "ordinary skill" even where there is no teaching, suggestion or motivation in the prior art to combine such elements.

In the case at issue, the Court ruled that the U.S. Court of Appeals for the Federal Circuit, which handles patent appeals, had failed to apply the obviousness test. The Federal Circuit had used a test whereby an invention was "obvious" if there was evidence in the "prior art" of "teaching, suggestion or motivation" to combine the elements.

KSR Int'l Co. v. Teleflex Inc., No. 04-1350, 2007 U.S. LEXIS 4745 (U.S. Sup. Ct. April 30, 2007)

U.S. Supreme Court Finds Underwriting Activity Immune From Antitrust Challenge

The U.S. Supreme Court reversed a U.S. Court of Appeals for the Second Circuit decision and dismissed a private antitrust suit that accused 10 leading investment banks of conspiring to fix prices for the initial public offerings of hundreds of technology companies during the 1990s. The allegations made against the defendant underwriters included (i) forming underwriting syndicates; (ii) setting the initial public offering price; (iii) allocating shares to investors; and (iv) refusing to sell shares to investors unless the investors also agreed to (a) purchase additional shares of that security later at higher prices; (b) pay high commissions on subsequent security purchases; and (c) purchase from the underwriters other less desirable securities. The Court found that the antitrust laws were inapplicable by reason of the SEC's authority to regulate all of the practices that were being challenged.

Credit Suisse Securities v. Billing, No. 05-1157, 2007 U.S. LEXIS 7724 (U.S. Sup. Ct. June 18, 2007)

New York Federal District Court Rules Music Downloads are not "Public Performances" under the Copyright Act

The U.S. District Court for the Southern District of New York has ruled that the act of downloading a music file does not constitute a "public performance" under U.S. copyright law. As a result, performance rights management organizations such as the American Society of Composers, Authors & Publishers ("ASCAP") do not have the right to receive performance-related royalties from an online service provider when a person downloads a music file from that provider. Service providers would still be required to pay royalties to such organizations in connection with reproduction-related licenses (otherwise known as "mechanical licenses").

ASCAP and other similar performance rights organizations license the broadcast of, and collect royalties on, all public performances of works created by the members these organizations represent. These organizations then distribute the collected royalties to the appropriate members.

While ASCAP argued that downloads should be treated the same as music "streaming" over the Internet, the Court disagreed. The Court found that the act of downloading a music file, which physically involves the copying of a file from one computer to another, more closely resembled a reproduction of a work, as opposed to a performance.

U.S. v. Amer. Soc. of Composers, Authors & Publisher etal., No. 41-1395, 2007 U.S. Dist. LEXIS 31910 (S.D.N.Y. Apr. 25, 2007)

IRS Updates Guidance on "Covered Employees" Subject to Section 162(m) Limitations

Section 162(m) of the Internal Revenue Code provides that a publicly held company is generally not allowed to deduct compensation with respect to any "covered employee" to the extent that the amount of that employee's compensation for the taxable year exceeds $1 million (subject to certain exceptions). The Internal Revenue Service has recently clarified Section 162(m) by stating the term "covered employees," includes only those employees who, as of the close of the employer's taxable year, are the (i) the principal executive officer, or an individual acting in that capacity, and (ii) among the three highest compensated officers for the taxable year (other than the principal executive officer or the principal financial officer). The principal financial officer, or an individual acting in that capacity, will not be a "covered employee" unless the principal financial officer also: (i) is acting as the principal executive officer as of the close of the employer's taxable year, or (ii) holds another officer position and is among the highest three compensated officers.

Int. Rev. Serv. Notice 2007-49 (June 4, 2007)

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

Irwin Kishner at 212.592.1435 or
Daniel Etna at 212.592.1557 or

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. Prior results do not guarantee a similar outcome.