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Corporate Alert: NYSE Seeks to Tighten Rules for Reverse Mergers, Delaware Court of Chancery Upholds Transfer of Voting Interests, Second Circuit Addresses Economic Duress Claim Against Lender, Delaware Supreme Court Says No To Creditor Derivative Suits, IRS Proposes Regulations Regarding Performance-Based Compensation Exemption
September 2011
Authors: Irwin A. Kishner, Edward B. Stevenson

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NYSE Seeks to Tighten Rules for Reverse Mergers

The Public Company Accounting Oversight Board (the "PCAOB") has raised concerns about the financial statements of companies formed as a result of reverse mergers between Chinese operating companies and shell companies, whose securities are registered in the United States. A reverse merger allows Chinese operating companies to gain a U.S. market listing and access to the U.S. capital markets, while avoiding the scrutiny of the initial public offering process. In a study issued earlier this year, the PCAOB highlighted the increasing number of Chinese reverse mergers, with approximately 159 such mergers occurring between January 1, 2007, and March 31, 2010. The PCAOB also expressed concerns about the auditing of Chinese reverse merger companies' financial statements and listed factors that may have a negative impact on these audits, including (i) the need to understand the local language, (ii) reliance on local audit firms to conduct a portion of the work, (iii) additional travel time and expenses, and (iv) the need to understand the company's local business environment.

Similarly, the SEC has voiced concerns about Chinese reverse merger companies. The SEC recently suspended the U.S. listing of several Chinese reverse merger companies and also issued a warning to investors about investing in such companies. The SEC echoed the findings of the PCAOB, noting the risk of an ineffective audit of a Chinese reverse merger company's financial statements. More specifically, the SEC advised investors to be especially careful when investing in a reverse merger company and to thoroughly research the company – including ensuring there is accurate and up-to-date information – before deciding to invest.

In light of these concerns, the NYSE is proposing to require a series of "seasoning requirements" that would effectively delay the listing of reverse merger companies. The proposed rules require reverse merger companies to trade for at least one year in the U.S. over-the-counter market, or on another U.S. exchange or regulated foreign exchange, prior to listing on the NYSE. Reverse merger companies would also be required to maintain a minimum share price of $4 for an extended period, and to file audited financial statements and an annual report with the SEC. Under the proposed rules, the NYSE would be empowered to selectively impose additional requirements on a particular reverse merger company in the NYSE's discretion, based on particular concerns like a weakness in the reverse merger company's internal controls. These rules are designed to address the concerns raised by the PCAOB and SEC by allowing time to adequately ensure the reliability of a company's operations and financial reporting.

NYSE Amex Equities (formerly known as the American Stock Exchange), which lists more reverse merger companies than the NYSE, has proposed similar rules. Both proposals were filed with the SEC in August and are subject to SEC approval before going into effect. The Nasdaq Stock Market submitted a similar rule proposal to the SEC in April, which is still pending.

Delaware Court of Chancery Upholds Transfer of Voting Interests Between Members Without Consent of Third Member

The Delaware Court of Chancery approved the transfer of a limited liability company membership interest, including both the economic and voting rights associated with that interest, to an existing member of the company without the consent of a third member. Omniglow LLC, a Delaware limited liability company, had three members: (1) Plaintiff, Achaian, Inc., owned 20%, (2) the Randye M. Holland and Stanley M. Holland Trust owned 30%, and (3) Defendant, Leemon Family LLC, owned 50% interest. As a result of a dispute among the members regarding the management of the company, Holland transferred its entire 30% interest to Plaintiff. Plaintiff then filed suit seeking to dissolve the company, asserting that there was a 50/50 deadlock with respect to its management. Leemon opposed the motion, arguing, among other things, that Holland could not transfer its voting rights without Leemon's consent.

The Delaware Limited Liability Company Act provides that the transferee of a limited liability company interest receives only an economic interest in the LLC, unless the operating agreement provides otherwise. The Court found that the operating agreement allowed a member to transfer its entire membership interest, including both economic and voting rights, to another existing member without obtaining consent of all members. The operating agreement provided that a member was permitted to transfer all or any portion of its "Interest," which term was defined as the "entire ownership interest of the member." The Court interpreted the term "entire ownership interest of the member" to include both economic and voting rights. Although another provision of the operating agreement required the approval of each existing member before a member could be admitted, the Court found that such provision applied only to the admission of new members and not to existing members, and, thus, did not apply in this case.

Achaian, Inc. v. Leemon Family LLC, 2011 WL 3505361(Del. 2011)

Second Circuit Addresses Economic Duress Claim Against Lender

The U.S. Court of Appeals for the Second Circuit has addressed an economic duress claim by a borrower against a lender regarding provisions of a forbearance agreement entered post-default. The Second Circuit held in favor of the lender and set out a useful framework for analysis of economic duress claims against lenders under New York law, stating that contracts will only be invalidated in extreme and extraordinary cases.

The case involved a borrower who defaulted under the terms of its loan agreement with its lender, Wells Fargo. After the initial default and subsequent defaults by the borrower during the course of the following year, Wells Fargo entered into a series of forbearance agreements (five in total), pursuant to which Wells Fargo agreed not to exercise its default remedies and agreed to amend the terms of the loan (e.g., the interest rate was increased, additional fees were imposed and financial covenants were tightened). Each forbearance agreement also contained a general release of all claims against Wells Fargo by the borrower. The borrower eventually sold certain of its assets and paid the Wells Fargo loan, after which it sued Wells Fargo for damages and claimed, among other things, that the releases and other agreements contained in the forbearance agreements were unenforceable as they were entered into under economic duress.

The doctrine of economic duress is grounded on the principle that courts will not enforce an agreement in which one party unjustly took advantage of the economic necessities of another and thereby unlawfully threatened to cause an injury to that party. Under New York law, the elements of economic duress are: (1) a threat, (2) which was unlawfully made and, (3) which causes involuntary acceptance of contract terms (4) because circumstances permitted no other alternative. Here, although the borrower was in financial distress and agreed to higher interest rates, additional fees, more restrictive covenants and a broad release of claims against Wells Fargo, the Court found no economic duress, stating it was not enough to merely demonstrate financial pressure and unequal bargaining power. In holding that Wells Fargo was within its legal rights with respect to the terms of each forbearance agreement, the court found that a lender may permissibly assert its intention to exercise its legal rights and remedies and that such assertion is not an "unlawful threat," for purposes of analyzing claims for economic duress.

Interpharm Inc. v. Wells Fargo Bank National Association (2nd Cir. August 26, 2011), available at:

Delaware Supreme Court Says No To Creditor Derivative Suits in LLC Context

The Delaware Supreme Court has banned derivative suits by creditors of Delaware limited liability companies ("LLCs").

CML V, LLC ("CML") lent money to JetDirect Aviation Holdings LLC ("JetDirect"), a private jet charter service, which was later determined to be insolvent. Following JetDirect's insolvency and its subsequent default on CML's loan, CML asserted derivative claims against JetDirect's managers, arguing that they had breached their fiduciary duties to JetDirect (and to CML, as creditors to JetDirect) by approving a number of imprudent acquisitions that led to JetDirect's insolvency.

In affirming the Chancery Court's decision to deny CML standing to pursue the derivative claim, the court looked at the plain language of the Delaware Limited Liability Company Act (the "Act"), holding that Section 18-1002 of the Act expressly limits standing to bring derivative claims to holders of LLC membership interests and their assignees only, and that creditors have no such rights. The court reasoned that the Act is "clear, unequivocal and exclusive, and operates to deny derivative standing to creditors who are not members or assignees of membership interests." In comparison, the Delaware General Corporation Law does not limit standing in a derivative suit to stockholders only and grants to creditors, in certain insolvency situations, standing to bring derivative claims. Acknowledging that the limitation with respect to LLCs "might surprise wizened veterans of the debates over corporate creditor standing," the court pointed to the plain language of the Act, and the Delaware legislature's clear intention to allow interested parties to contractually define their relationship with each other, to justify its decision. As such, the court affirmed the Chancery Court's decision to grant JetDirect's motion to dismiss for lack of standing.

CML V, LLC v. Bax, C.A. No. 5373-VCL (Del. Supr. Sept. 2, 2011)

IRS Proposes Regulations Regarding Performance-Based Compensation Exemption

The Internal Revenue Service has issued proposed regulations with respect to the performance-based compensation exemption under Code Section 162(m). Generally, Section 162(m) disallows a deduction for annual compensation in excess of $1 million paid to certain "covered employees" (the principal executive officer and the three highest-paid executive officers other than the principal executive officer or the principal financial officer). Stock options or stock appreciation rights may qualify for an exemption from the deduction limit set forth in the current regulations under Section 162(m) for "performance-based compensation." The proposed regulations clarify that in order to qualify for the exemption (i) a plan must state a per-employee limitation on the number of shares that may be granted during a specified period; and (ii) the shareholder disclosure must include both the maximum number of shares for which grants may be made to each individual employee during a specified period and the exercise price of the options to satisfy the performance-based compensation exemption.

In addition, the current regulations provide new public companies temporary relief from Section 162(m)'s $1 million deduction limit for any compensation paid under a plan that existed prior to the company going public. The relief is available to new public companies with respect to compensation attributable to the exercise of a stock option or a stock appreciation right, or the vesting of restricted property, so long as the grant is made under a pre-existing plan during the transition period, even if the compensation is paid after the transition period has expired. The clarification explains that this relief only applies to stock options, stock appreciation rights and restricted property -- equity awards in other forms, such as restricted stock units or phantom stock, must be paid during the transition period in order to qualify for the transition relief. If finalized during 2011, these regulations could apply to the 2011 tax year.

For more information on the issues in this alert, or corporate matters generally, 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.