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Corporate Alert: New Guidance on Materiality Standard, Delaware Chancery Court Clarifies Rights to Books and Records, SEC Proposes Rules on Compensation Arrangements, Delaware Chancery Court Provides Guidance on Top-Up Options, Delaware Chancery Court Rules Board of Directors Has Power to Defeat an Inadequate Tender Offer, Supreme Court Rules Against Privacy Rights
March 2011
Authors: Edward B. Stevenson, Irwin A. Kishner

The Herrick Advantage

Herrick is a recognized leader in middle market M&A transactions. A recent example of our work: We advised Unilever in its $215 million acquisition of Colgate-Palmolive Company's Colombian laundry detergent business. This deal was covered in various media outlets, including the AmLaw Daily. To read its coverage, please click here. This comes on the heels of Herrick winning InterContinental Finance Magazine's Legal Excellence Awards 2011 for Law Firm of the Year for Mergers & Acquisitions in North America.

New Guidance on Materiality Standard Under Federal Securities Law

The Second Circuit has provided new guidance on what "material" means under Section 11 and Section 12(a)(2) of the Securities Act of 1933, which prohibit material misstatements and omissions in registration statements and prospectuses.

Investors in a 2007 IPO by The Blackstone Group, L.P., a financial advisory firm and one of the largest independent alternative asset managers, sued Blackstone, alleging that it made material misstatements and omissions in its prospectus and registration statement in connection with the IPO. Specifically, the investors claimed that Blackstone did not adequately disclose risks associated with its investments in FGIC Corp., which issued credit default swaps in connection with residential subprime mortgage backed securities, and Freescale Semiconductor, Inc., which recently lost its exclusive contract with Motorola.  The investors further claimed that Blackstone did not adequately disclose general risks facing the fund due to the general downturn in the subprime residential mortgage market.

Courts analyze whether a reasonable investor would have considered certain facts significant in making an investment decision, and whether there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information available. A plaintiff need not assert that the investor would have acted differently if the disclosure were made, but only that such disclosure would have been significant in the investor's decision to invest. Courts and the SEC have accepted 5% as the materiality threshold (based on the percentage of which an investment represents the company's total assets under management), but courts look to both quantitative and qualitative factors in assessing materiality (e.g., whether the omission concealed unlawful transactions or relates to a significant aspect of the issuer's business, whether there is a significant market reaction to the public disclosure of omitted information or whether the omission changed a loss into income, or vice versa).

The court rejected the defendant's motion to dismiss, stressing that the pleading burden under Sections 11 and 12(a)(2) with respect to materiality is relatively minimal and provided new guidance for assessing materiality in two respects. First, the court held that issuers have a duty to disclose relevant information to investors notwithstanding that such information may be public knowledge.  Second, the court held that the 5% threshold for materiality can be measured at a business segment level as opposed to a firm-wide level, stating that "[e]ven where a misstatement or omission may be quantitatively small compared to a registrant's firm-wide financial results, its significance to a particularly important segment of a registrant's business tends to show its materiality."

This ruling will make it more difficult for defendants to dismiss Section 11 or 12(a)(2) claims on materiality grounds. The decision also lowers the threshold for proving materiality by allowing plaintiffs to focus on a single business sector of the issuer, which effectively allows plaintiffs to work with a lower denominator in getting to the 5% materiality threshold.

Landmen Partners, Inc. v. The Blackstone Group, L.P., No. 09-4426, slip op. at 1 (2d Cir. Feb. 10, 2011)

Delaware Chancery Court Clarifies Rights to Books and Records of LLC Member

The Delaware Chancery Court has made an important ruling regarding the right to inspect the books and records of a Delaware limited liability company. Plaintiff Max Sanders loaned $2 million to a member of Ohmite Holding, LLC, and received a security interest in the member's units as collateral. The member later transferred the units to Sanders and Sanders became a member of Ohmite. During the period from when the loan was made until Sanders became a member, Ohmite issued additional units causing Sanders' units to become significantly diluted. After becoming a member, Sanders made a formal demand for the books and records, to determine why the units were diluted, the value of his interest and the performance of Ohmite's management. Ohmite denied the request, claiming that Sanders did not offer a "proper purpose" and did not have the power to make a demand for the books and records that related to events that pre-dated his membership.

Section 18-305(a) of the Delaware Limited Liability Company Act provides a member of an LLC with the right, upon reasonable demand for any purpose reasonably related to the member's interest as a member of the LLC, to inspect its books and records. The court found that Sanders' rights were coextensive with Section 18-305 of the LLC Act because Ohmite's LLC Agreement did not limit those rights. The court observed that the extensive case law surrounding the rights of a shareholder to books and records of a corporation under Delaware General Corporation Law Section 220 are often considered by analogy in the LLC context. Likewise, the following basic rules apply: (1) there must be a "proper purpose" for the inspection; (2) that proper purpose must be reasonably related to such person's interest as a member; and (3) the requested books and records must be reasonably required to fulfill the stated purpose.

Delaware cases have established several proper purposes in this context, including valuation of one's ownership interest and investigation of potential wrongdoing and mismanagement. Note that to satisfy this proper purpose, one need not prove wrongdoing. Rather, it suffices in this context to merely present a "credible basis" to suspect wrongdoing and from which the court may "infer" wrongdoing that would warrant further investigation.

Since Sanders was seeking to value his interest, and the documents he requested were necessary for him to fulfill that purpose, the court granted summary judgment to Sanders and determined that Sanders had a proper purpose for inspecting the books and records regardless of whether such books and records pre-dated when Sanders formally acquired member status. Although, a member seeking such access must show a proper purpose and the burden is on the member to show that the proper purpose is reasonably related to that person's interest as a member, this case is significant since a Delaware LLC may not be able to deny access to books and records solely based on when a person became a member, absent specific restrictions in the company's LLC Agreement. Delaware LLCs that are concerned about members seeking access to books and records for periods that pre-date their membership status may want to address those rights and provide for limitations of that right in their LLC Agreements.

Sanders v. Ohmite Holding, LLC, C.A. No. 5145-VCL (Del. Ch. Feb. 21, 2011)

SEC Proposes Rules on Compensation Arrangements for Financial Institutions

The SEC has proposed a rule that would require certain financial institutions, including broker-dealers and investment advisers with assets of at least $1 billion, to disclose the structure of their incentive-based compensation practices.

Under the proposed rule, subject financial institutions would be required to file annual reports disclosing information about incentive-based pay, including a narrative description of the firm's compensation arrangements, a description of the firm's policies and procedures relating thereto and a statement of the specific reasons why the firm believes the structure of its incentive-based compensation practices will help prevent material financial loss. The proposed rule would apply to compensation payable to all executive officers, employees, directors and principal shareholders of covered financial institutions.

The rule would also require subject financial institutions with over $50 billion in assets to defer for three years at least 50% of any incentive-based compensation for executive officers. Compensation would be required to be adjusted for losses incurred by the firm over the deferral period.

The rule is currently pending approval by federal regulators. Upon approval, it will be published in the Federal Register and open to public comment for 45 days.

Chancery Court Provides Guidance on Top-Up Options

The Delaware Chancery Court has approved the use of the top-up option in connection with "two-step" acquisitions and provided guidance as to the features that should be included by companies when using top-up options in acquisitions. Top-up options in two-step acquisitions (which generally involve a tender offer followed by a back-end merger) allow an acquiror to purchase from the target an amount of shares that, when added to the shares already owned by the acquiror immediately following the tender offer, equals at least 90% of the target's outstanding stock on a fully diluted basis, thereby allowing the acquiror to consummate a short-form merger. 

The court has advised that top-up options should include the following features: (i) specific authorization from the target's board of directors with respect to the top-up option; (ii) the specific option terms set forth in the agreement evidencing the top-up option; (iii) cash consideration upon the exercise of the top-up option in an amount equal to the aggregate par value of the stock to be issued; (iv) a maximum cap on the number of shares that may be issued pursuant to the top-up option equal to the number of authorized but unissued shares of the target; and (v) an exclusion of the shares issued pursuant to the top-up option, as well as the consideration to be received upon exercise, from the appraisal conducted in connection with the acquisition.

This case is the latest in a series of recent opinions approving the use of the top-up option, which will likely lead to an increase in their use in connection with tender offers.

Olson v. ev3 et. al. C.A. No. 5583-VCL (Del. Ch. Feb. 21, 2011)

Delaware Chancery Court Rules that a Board of Directors Has the Power to Defeat an Inadequate Tender Offer

The Delaware Chancery Court has determined that in the context of a tender offer, a corporation's board of directors, and not its shareholders, has the authority to decide the adequacy of, and whether to accept, that tender offer. The court also determined that a board that has made a good faith reasonable determination that a tender offer is inadequate may block the tender offer via the use of a shareholder rights plan (a/k/a a poison pill) and a staggered board regardless of shareholder interest in acceptance of the offer.

In this case, the offeror asked the court to order the target company's board of directors to redeem the poison pill and allow its shareholders to decide for themselves whether they wanted to tender their shares to the offeror pursuant to the tender offer. The court ruled that because the target company's board made a reasonable and good faith determination, the target company suffered a legally cognizable threat in the form of an inadequate bid price, and because a majority of the target company's shareholders would likely tender their shares pursuant to the offer, the board was entitled to take defensive measures to block the offeror's bid.

The court's decision in this case supports prior Delaware case law affirming the use of a shareholder rights plan as a valid takeover defense.

Air Products and Chemicals, Inc. v. Airgas, Inc. et al, C.A. 5249-CC (Del. Ch. Feb. 15, 2011)

Supreme Court Rules Against Privacy Rights of Corporations

The U.S. Supreme Court ruled unanimously on March 1, 2011, that corporations do not have the same privacy rights as individuals when it comes to blocking requests for records under the Freedom of Information Act (FOIA).

Under FOIA, federal agencies must make records and documents publicly available upon request, subject to certain statutory exemptions.  Among the materials falling under these exemptions are law enforcement records that if disclosed "could reasonably be expected to constitute an unwarranted invasion of personal privacy." Here, the Federal Communications Commission (FCC) had documents that AT&T had provided as a result of a 2004 FCC investigation into potential overbilling of the government by AT&T. A trade association representing AT&T's competitors filed a FOIA request for those documents and AT&T sued to prevent the FCC from disclosing the documents.  Although the U.S. Court of Appeals for the Third Circuit sided with AT&T, finding that Congress has defined the term "person" to include corporations, on appeal the Supreme Court decided otherwise, holding that corporations do not have "personal privacy" for purposes of the FOIA exemption and that the Third Circuit had erred in extending those privacy rights to corporations.

In light of the decision, corporations, particularly those responding to government investigations, should be aware that competitors and potential plaintiffs can gain access to sensitive corporate information through FOIA and that they may not rely on the "personal privacy" exemption to prevent disclosure. Note that other exemptions, such as those protecting trade secrets and commercial or financial information, were not challenged in the case. Thus, corporations may still rely on other FOIA exemptions on a case-by-case basis and as applicable given the surrounding facts and circumstances.

FCC v. AT&T Inc., No. 09-1279, March 1, 2011

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

NY          Irwin Kishner at 212.592.1435 or
NJ          Edward Stevenson at 973.274.2025 or

Copyright © 2011 Herrick, Feinstein LLP. Corporate 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.