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Corporate Quick Hit: Bear Stearns Acquisition, Bond Default Claim, Adoption of International Financial Reporting Standards, Credit for Extraordinary Cooperation,  Rules on Credit-Rating Firms, Partnership Debt-for-Equity Exchanges
December 2008
Authors: Irwin A. Kishner, Daniel A. Etna

New York Court Applies Delaware Business Judgment Rule to Shareholder Challenge to Bear Stearns Acquisition

A New York Supreme Court consolidated shareholder class action lawsuit challenging the consideration received by shareholders of the Bear Stearns Companies, Inc. ("Bear Stearns") in connection with the Federally-assisted merger (the "Merger") of Bear Stearns with JPMorgan Chase & Co. was recently dismissed.

In their suit, the shareholders claimed that Bear Stearns' board of directors had violated its fiduciary duties by failing to act in the best interests of the company in negotiating the Merger consideration.  The Merger agreement was negotiated over an extremely short period of time.  Throughout the negotiation process, the board was under intense time pressure to reach an agreement in order to prevent a "run on the bank" and a potential insolvency.

In dismissing the shareholders' claim, the court concluded that the board's decision approving the terms of the Merger was protected under Delaware law by the business judgment rule.  This rule creates a "presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." 

In applying the business judgment rule to the board's actions, the court noted that "in response to a sudden and rapidly-escalating liquidity crisis, Bear Stearns' directors acted expeditiously to consider the company's limited options.  They attempted to salvage some $1.5 billion in shareholder value and averted a bankruptcy that may have returned nothing to the Bear Stearns' shareholders, while wreaking havoc on the financial markets." 

This decision is a strong endorsement of the protections afforded to the directors of a Delaware corporation faced with the challenges posed by the current turbulent economic conditions.

In re Bear Stearns Litigation, No. 600780/08

Eighth Circuit Rejects Bond Default Claim for Failure to Timely File SEC Reports

In an unprecedented federal appeals court decision, the Eighth Circuit recently ruled that the failure of a bond issuer, UnitedHealth Group ("UGH"), to timely file periodic reports with the Securities and Exchange Commission ("SEC") did not constitute a default under the bond indenture.  UHG failed to timely file a quarterly report with the SEC due to a review of UGH'S financial affairs being conducted by a committee of independent directors in response to a UGH stock option backdating practice.

Less than two weeks later, UHG received a notice of default from the bond trustee.  The notice of default alleged that UHG violated a provision of the bond indenture that requires UHG to "cause copies of all current, quarterly and annual financial reports . . . which [UHG] is then required to file with the [SEC] . . . to be filed with the [bond trustee] . . . within 15 days of filing with the [SEC]." 

The lower court granted UGH's summary judgment motion and the bond trustee appealed to the Eight Circuit.  The Eighth Circuit found the bond trustee's reliance on the phrase "then required to file" was misplaced in terms of imposing an obligation to file timely reports.  The Eighth Circuit ruled that such phrase simply referred to the types of reports required to be filed by UHG, not the deadlines of such reports. 

The Eighth Circuit is the first Federal appeals court to address this issue.

UnitedHealth Group, Inc. v. Wilmington Trust Co., 2008 WL 5047669 (C.A.8 (Minn.))

Proposed Roadmap towards the Adoption of International Financial Reporting Standards for U.S. Public Companies

The SEC recently published a proposed roadmap (the "Roadmap") outlining its potential adoption of International Financial Reporting Standards ("IFRS") as the basis for financial reporting in the United States.  This possible transition reflects the ongoing SEC goal of having financial information presented in one universally accepted form that investors worldwide will understand.  According to the Roadmap, IFRS may replace generally accepted accounting principles ("GAAP") as the mandatory financial reporting standard for all U.S. issuers by the end of 2016.  The final decision will be made by the SEC in 2011 after evaluating, among other things, the improvements made in IFRS and the process by which its standards are set.

Although mandatory adoption of IFRS will not be certain until 2011, the Roadmap permits certain large, well-seasoned U.S. companies to begin filing reports prepared with IFRS as early as next year. 

All U.S. public companies, whether eligible for early adoption or not, should begin preparing for this eventual transition.  Converting to the new standard, will require retraining accounting staff, or finding CPAs with the relevant training, both potentially costly and time consuming processes.  Additionally, companies should consider the possible adoption of IFRS when entering into new contracts, or when evaluating existing contracts.  Many contracts that specifically reference GAAP will become impractical when and if IFRS becomes mandatory.

FINRA Provides Guidance Regarding Credit for Extraordinary Cooperation

The Financial Industry Regulatory Authority ("FINRA"), the largest non-governmental regulator of securities firms, recently published a notice setting forth four factors that it will consider when reviewing whether a member firm's compliance during the course of a regulatory investigation can be considered to be "extraordinary cooperation."  With respect to such investigations, a member's level of cooperation, can directly influence the outcome.  The four factors are (i) self-reporting of violations, (ii) extraordinary steps to correct deficient procedures and systems, (iii) extraordinary remediation to customers and (iv) providing substantial assistance to FINRA investigations.

SEC Tightens Rules on Credit-Rating Firms

The SEC recently adopted several changes to its credit rating rules first proposed in June 2008.  The new rules, which will become effective over the next six months, are aimed at revamping credit-rating nationally recognized ratings agencies.  These firms have been blamed for giving unjustifiably high ratings to mortgage-related products and then being slow to downgrade them once their credit quality worsened. The high credit ratings, particularly for structured financial products, were widely viewed as contributing to the credit crunch that has helped spark the financial crisis.

The new ratings rules effectively fall into three main categories: (i) conflict of interest prohibitions (firms are prohibited from rating debt they helped structure; analysts involved in ratings can't participate in fee negotiations; and analysts can't receive gifts or entertainment exceeding $25); (ii) disclosure rules (company-paid rating firms will be required to disclose publicly a random sample of 10% of its ratings, no later than six months after the rating); and (iii) new record keeping requirements (rating firms have to maintain a history of complaints against analysts; firms are required to record when an analyst's rating for structured finance debt differs from the rating implied by a quantitative model.)

Firms will also be required disclose statistics on upgrades, downgrades and defaults for each asset class they rate over one-, three- and ten-year periods.

SEC Press Release 2008-284 (Dec. 3, 2008)

Proposed Treasury Regulation Regarding Partnership Debt-for-Equity Exchanges

The Internal Revenue Service and Treasury Department issued proposed regulations addressing the tax consequences of debt-for-equity exchanges by partnerships, that is, transactions whereby a partnership transfers partnership interest to a creditor in satisfaction of the partnership's indebtedness.  Currently, the Internal Revenue Code requires that a partnership treat a debt-for-equity exchange as having satisfied the debt with an amount of money equal to the fair market value of the partnership interest transferred.  For example, if the debt was $500 and the fair market value of the partnership interest transferred to the creditor was $400, the partnership must record a cancellation of indebtedness income of $100 and the creditor must record a loss of $100. 

Under the proposed regulations, the fair market value of the partnership interest can, if certain requirements detailed below are met, be calculated at its "liquidation value." "Liquidation value" is defined as the amount of cash the creditor would receive for the newly-transferred partnership interest if, immediately after the transfer, the partnership sold all of its assets (including intangibles) for cash equal to the fair market value of those assets and then liquidated.  Further, the proposed regulations require the creditor to treat the transaction as a nonrecognition event.  In other words, the creditor will not record neither a gain nor a loss.  Instead the creditor's full basis in the debt will be carried over to the received partnership interest.  This treatment will not apply to the satisfaction of unpaid rent, royalties, interest (including original issue discount) or installment obligations.

The partnership must meet the following requirements in order to be allowed to use liquidation value as a measure of fair market value: (i) the partnership must determine and maintain capital accounts in accordance with prescribed capital accounts rules of REG 1.704 1(b)(2)(iv); (ii) the creditor, partnership and partners must all treat the fair market value as being equal to the liquidation value; (iii) the exchange must be an arm's length transaction; and (iv) there cannot be any subsequent redemptions of partnership interest as part of a plan which has the principal purpose of avoiding cancellation of indebtedness income.

These regulations will apply to debt-for-equity exchanges occurring on or after the date these regulations are published as final regulations in the Federal Register.

Internal Revenue Bulletin 2008-46 (Nov. 17, 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.