Delaware courts have acknowledged, however, that the shareholder’s right to obtain corporate records must be balanced against the board’s right to manage the company’s business without undue interference. Accordingly, where a shareholder requests mundane company materials like stock ledgers or shareholder lists, the company generally must produce. But where the shareholder seeks more sensitive company records, the law puts the burden on the shareholder to show why the production is necessary.

To meet that burden, a shareholder seeking company materials must:

• articulate a “proper purpose” for their books and records request, or one that is reasonably related to a legitimate interest as a shareholder and is not adverse to the corporation’s best interests;
• if the purpose is to investigate or prosecute alleged wrongdoing, offer evidence to show there is a credible basis to believe mismanagement occurred; and
• explain why each category of documents sought is “essential” to fulfill the stated purpose.

Determining whether a shareholder request satisfies these requirements is a fact-intensive question, and should be informed by the broad body of Section 220 case law. When responding, companies should also consider whether

• the documents being sought are subject to a discovery stay in ongoing shareholder or class action litigation;
• a confidentiality agreement is necessary to ensure the documents are properly maintained; or
• producing of materials beyond the letter of the request could help explain away the shareholder’s concerns.

Because a Section 220 books and records request is often the first step toward shareholder litigation, companies should be thoughtful in their response, and be sure that both shareholder and company concerns are considered before any production occurs.

To read the full JD Supra article, please click here.

FIRREA was enacted in response to the Savings and Loan debacle of the 1980s, as well as the fraud scandals that emerged during that era. The statute includes a clause imposing a civil penalty for mail and wire fraud and other violations “affecting a federally insured financial institution.” Until recently the civil penalty provision has been ignored by prosecutors, leaving courts without occasion to decide what exactly the statute means by “affecting” a financial institution.

In United States v. Countrywide Financial Corporation, civil division prosecutors argued that Bank of America and Countrywide’s allegedly fraudulent sale of mortgage-backed securities to Fannie Mae and Freddie Mac “affected” themselves by exposing the banks to risk of loss due to repurchase requirements. Prosecutors also claimed that other federally insured financial institutions were indirectly “affected” because they invested in Fannie Mae and Freddie Mac, which purportedly lost money on the mortgage-backed securities that they purchased from Bank of America and Countrywide. Judge Rakoff apparently accepted at least one of these arguments, as he denied the motion to dismiss in his summary order, promising to explain his rationale in a future written opinion.

Judge Rakoff’s full opinion will be eagerly awaited by lawyers and financial industry professionals alike, as it will shed greater light on the scope of a civil penalty clause that was rarely in use until now. The decision could very well fuel a new series of mortgage banking and other fraud claims against financial institutions, as a broad interpretation of FIRREA will enhance prosecutors’ ability to succeed on these allegations. This is because FIRREA carries a ten-year statute of limitations, which will allow prosecutors to raise allegations that would otherwise have been barred by the shorter statute of limitations applicable to fraud claims. And, under FIRREA, prosecutors need only establish their allegations “by a preponderance of the evidence.” This latter provision will enable prosecutors to prevail on claims too weak for success under a criminal statute.

Bottom line: The story of FIRREA is just beginning to heat up. Stay tuned.

One way in which a board can insulate its decision-making process is to employ a special committee of independent, outside directors to evaluate and negotiate any potential sale. Although boards are not required by law to use special committees when brokering change of control transactions, Delaware courts have repeatedly held that the use of a special committee can be powerful evidence of a fair and adequate process. That is especially true where (i) the contemplated transaction is with a controlling stockholder or (ii) a majority of the directors are conflicted, two situations where courts will employ the even-more exacting “entire fairness” standard of review. As the Delaware Supreme Court recently noted, “the effective use of a properly functioning special committee of independent directors” is an “integral” part “of the best practices that are used to establish a fair dealing process.”

What constitutes a “properly functioning” special committee of independent directors? Beyond the threshold requirement that the committee members be independent – i.e., have no material relationships that might influence their business judgment – and have no disabling financial interest in the transaction, Delaware courts have asked the following questions, among others, to determine the effectiveness of a special committee:

• Who selected the committee members? Courts have criticized special committees whose members were selected by conflicted directors.
• How many directors are on the committee? Courts will place more trust in a multiple-member committee.
• What is the scope of the committee’s authority? Courts are more likely to credit the use of a special committee if the committee is given full decision-making authority regarding the transaction at issue, including the power to negotiate and to say “no” to the transaction.
• What were the committee’s resources? Courts have noted that special committees should have the power and resources to retain independent advisors, including legal and financial advisors.

Most importantly, to satisfy judicial scrutiny, a special committee must have a meaningful role in negotiating the terms of the transaction and be truly independent. Of course, there is no “one size fits all” method for insuring that every change of control transaction will pass judicial scrutiny, but by using a special committee of independent directors, boards are much more likely to defeat challenges to their deal-related business judgments.

The headline message from this proceeding is that the SEC found that the City had violated the securities laws through public statements made by public officials, as well as budget documents released during a certain time period, which allegedly failed to disclose material information about the City’s dire financial condition (primarily related to its obligations on certain waste-to-energy project bonds which the City had guaranteed). The reason these statements were deemed so significant is that during this period the City had fallen far behind in releasing its Comprehensive Annual Financial Reports (“CAFRs”), so that investors had no other available current financial information. The SEC used this proceeding and its Report of Investigation to re-emphasize the statements made in its 1994 Interpretive Guidance on the obligations of participants in the municipal securities markets, and its 1996 Report following the bankruptcy of Orange County, California, that statements made by public officials which might be “reasonably expected to reach investors and the trading markets” can be subject to antifraud rules, even when such statements are not part of a specific securities offering.

While this is the “headline,” it should be noted that the SEC also charged the City with violating Rule 10b-5 in connection with CAFRs which were eventually filed (a more conventional application of the Rule). It is also noteworthy that the underlying premise for much of the SEC case is that over a period of two years or so the City had repeatedly violated its contractual continuing disclosure obligations entered into pursuant to SEC Rule 15c2-12, relating to outstanding debt, to file annual financial reports within a certain time period, to file a notice that annual reports were not being filed on time, and to make certain other “material event” filings. As noted above, in that context, other statements made by City officials took on much greater importance. One could view this case, as well, as one of the first which seeks to punish an issuer (though indirectly) for repeated failures to comply with continuing disclosure obligations.

Janus established a bright-line rule. But the Southern District of New York, in particular, has split over whether Janus applies beyond the context of private actions brought under Rule 10b-5(b). In the most recent decision from that district to address the issue, SEC v. Garber, No. 12 Civ. 9339, 2013 WL 1732571 (S.D.N.Y. Apr. 22, 2013), Judge Shira A. Scheindlin deepened this divide.

In Garber, the SEC alleged that a group of defendants, including three individuals, purchased over a billion unregistered shares in penny stock companies and resold the shares while falsely claiming that the transactions were exempt from registration with the SEC. Id. at *1. The defendants allegedly obtained opinion letters, authored by outside attorneys, stating that the instruments at issue were securities (when in fact, according to the SEC, they were “akin to an ‘IOU’”). Id. at *2. According to the SEC, the individual defendants knew or were reckless in not knowing that the instruments “were not securities.” Id.

The defendants argued that the SEC’s fraud theory failed as to Rule 10b-5(b), under Janus, because the alleged misrepresentations had been “made” by the attorneys who wrote the opinion letters, not by the defendants. The court rejected this argument. First, the court held that Janus does not apply to SEC enforcement actions brought under Rule 10b-5(a) or (c), which “extend to claims based on schemes to defraud” and “do not focus on the ‘making’ of an untrue statement.” Id. at *4. On this point, the court agreed with two other decisions from the Southern District. See SEC v. Pentagon Capital Mgmt. PLC, 844 F. Supp. 2d 377, 422 (S.D.N.Y. 2012), as amended (Aug. 22, 2012) (Hon. Robert W. Sweet); SEC v. Boock, No. 09 Civ. 8261, 2011 WL 5417106, at *2 (S.D.N.Y. Nov. 9, 2011) (Hon. Denise Cote). The court distinguished another decision, SEC v. Kelly, which dismissed the SEC’s claim under Rule 10b–5(a) and (c) because “the SEC’s scheme liability claim” in that case was “premised on a misrepresentation”—and “neither defendant ‘made’ a misstatement as Janus requires.” 817 F. Supp. 2d 340, 344 (S.D.N.Y. 2011) (Hon. Colleen McMahon).

The court also noted, in Garber, that, “[b]y the same logic, Janus would not affect claims under Section 17(a)(1)” of the Securities Act, “which prohibits ‘employ[ing] any device, scheme, or artifice to defraud.” Garber, 2013 WL 1732571 at *4. In this, the court again diverged from Kelly, 817 F. Supp. 2d at 346—but did not go as far SEC v. Stoker (which concluded that Janus does not apply to Section 17(a)(2), which refers to “obtain[ing] money or property by means of any untrue statement”), or Pentagon Capital Management, which held more broadly that Janus does not “apply to SEC enforcement actions brought pursuant to Section 17(a) of the Securities Act.” See Stoker, 865 F. Supp. 2d 457, 465 (S.D.N.Y. 2012) (Hon. Jed S. Rakoff); Pentagon Capital Mgmt. PLC, 844 F. Supp. 2d at 422 (Hon. Robert W. Sweet).

Garber may be of even more interest, however, for what Judge Scheindlin went on to find even if Janus applied. The court held that “[e]ven under Janus, the ‘making’ of” the statements in the opinion letters “could be attributed to [d]efendants” because they “solicited” the advisory opinion and “had ‘ultimate authority . . . over whether and how to communicate it,’ at least in the context of the alleged scheme.” Garber, 2013 WL 1732571 at *5. The court emphasized that the opinion letters did not have “the intended effect” until the defendants “presented the information in support of their ability to sell the penny stocks without registration.” Id. Whether other courts will adopt similar approaches in applying Janus will be very significant to the breadth of its impact.

Listing requirements for both the New York Stock Exchange  and NASDAQ provide basic checklists for directors independence, and state generally that directors cannot be employed by the company, cannot have family members who are employed by the company and cannot have a controlling interest in the company’s substantial business partners. But the exchanges’ listing requirements also contemplate that the question of independence is far broader than any checklist. The NYSE’s listing requirements further note that directors should have “no material relationship” with the Company; NASDAQ’S requirements state directors should have no relationship which “would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.”

Of course, what constitutes a “material relationship” or a relationship that “would interfere with the exercise of independent judgment” is inherently a fact-based question, and as such there are no bright-line rules to guide director retention. When evaluating director independence, factors that courts have considered include:

Close business or personal ties with other directors, controlling shareholders or third-parties with which the company does business;

• Ownership of Company stock;
• Service on multiple boards;
• Personal interests in company business deals, whether past or current;
• Excessive director compensation;
• Political affiliations;
• Other factors that could be said influence the director’s decision-making.

At bottom, the question of whether a director is independent must be evaluated on a case-by-case basis, and should involve careful consideration of the director’s background, business history and personal relationships.

Plaintiffs initially filed suit in the Delaware Court of Chancery in March 2011, asserting claims based on the company’s proposed acquisition (since completed) of Shine Group Ltd., a television and movie production company owned by the daughter of News Corp. Chairman Rupert Murdoch. According to plaintiffs, the News Corp. directors breached their fiduciary duties by permitting the purchase of Shine at an excessive price. The court later consolidated various related cases, and plaintiffs’ allegations expanded to include claims that the company’s directors failed to properly investigate the UK phone-hacking allegations that led to the demise of News Corp.’s News of the World.

Apart from its large cash value, the settlement is also notable for the wide-ranging corporate governance reforms that News Corp. has agreed to enact as part of the deal. The agreement calls for the establishment of a Compliance Steering Committee, to be responsible for setting compliance policies and overseeing their implementation, which must report at least quarterly to the Audit Committee, at least semi-annually to the independent directors, and at least annually to the full board. The board’s independent directors will approve a Chief Compliance Officer who will report directly to the Audit Committee, and the company will also establish an anonymous whistleblowing hotline. Finally, in what one commentator has called a “historic concession,” News Corp. has agreed to make annual public disclosures to its shareholders of political contributions made directly by the company to state or local candidates and various political organizations.

The agreement remains subject to court approval, and plaintiffs’ attorneys’ fees—which will be deducted from the $139 million settlement payment—are yet to be negotiated.

The Policy Statement identifies three forms of “extraordinary” cooperation that could result in audit firms and/or individuals receiving credit in enforcement investigations:

• self-reporting;
• remedial or corrective action; and
• substantial assistance.

According to the Board, “[a] firm or associated person may earn credit for self-reporting by making voluntary, timely and full disclosure of the facts relating to violations before the conduct comes to the attention of the Board or another regulator.” And, the sooner self-reporting is made, the more likely it will result in credit. The Board stressed, however, that self-reporting is “not eligible for cooperation credit” if it is “required by legal or regulatory obligations,” e.g., the auditor’s obligation under Section 10A of the Securities Exchange Act of 1934 to report a client’s illegal acts.

Remedial or corrective actions refer to “voluntary, timely and meaningful actions designed to reduce the likelihood and risk that similar violations will recur, as well as actions to correct violative conduct.” The Board gave several concrete examples of audit firm actions that might yield cooperation credit:

• “promptly and voluntarily modifying and improving … quality controls or other internal policies and procedures to prevent recurrence of the violative conduct”;
• “re-assigning or limiting the activities of those individuals responsible for violations,” including both audit team members and “persons in firm management”;
• “terminating or imposing discipline upon the responsible individuals” in appropriate cases;
• “promptly notifying [the] audit client or its audit committee (as appropriate) of the violative conduct and cooperating with the client”;
• “appropriately compensating those adversely affected by the firm’s violations.”

Finally, substantial assistance includes “timely and voluntarily providing information or documents that might not have been discovered absent that cooperation, or beyond that sought by the Board’s staff via accounting board demands and requests, and beyond what is required pursuant to legal and regulatory reporting requirements.” Examples include:

• “conducting a timely, thorough, objective and competent internal investigation into the violative conduct when it was discovered, and informing the [Enforcement] Division’s staff of the pertinent facts discovered in the internal investigation”; and
• “substantially assist[ing] another law enforcement authority’s [e.g., the SEC’s] investigative processes by self-reporting to that authority, or providing it with the facts discovered in an internal investigation.”

The Board did not state one way or the other whether disclosure of privileged information would result in either a greater chance of receiving credit for cooperation or receiving greater credit (e.g., no sanction as opposed to a lower sanction).

It is of some comfort that the Board has joined the Commission in going on the public record that providing cooperation may result in reduced or even no charges or sanctions. But, as always, the proof of the pudding will be in the tasting. At both the Commission and the Board, the specific instances in which the regulators have given credit for cooperation have been few and far between. And, in many of those instances, it is unclear exactly how much credit the company, firm or person received for cooperating. This is perhaps because, as the Board frankly noted in the Policy Statement, there is “some tension” between “encouraging (and crediting) extraordinary cooperation” and in holding entities and individuals “fully accountable for their violative conduct.” But, to the extent the regulators want to regularly receive the kind of “extraordinary” cooperation they seek, they need to make clear through actions as well as words that such cooperation will in fact be rewarded – tangibly and meaningfully.

Approval of the CR settlement was conditioned upon the outcome of the pending Second Circuit appeal in S.E.C. v. Citigroup Global Markets, Inc., 11-cv-5227 (2d Cir.). In Citigroup, Judge Rakoff (of the Southern District of New York) denied approval of the SEC’s proposed settlement of fraud charges against Citigroup. Rakoff’s opinion harshly critiqued the agency’s use of “no admission” settlements as imposing “substantial relief on the basis of mere allegations.” He questioned whether “no admission” settlements could be properly judged when the Court did not know the relevant facts and therefore “lack[ed] a framework for determining adequacy.” Both Citigroup and the SEC appealed Rakoff’s decision to the Second Circuit, where the decision remains pending.

While giving deference to the Second Circuit’s forthcoming ruling via the conditional approval, Judge Marrero noted that, given the current financial environment, district courts should scrutinize “neither admit nor deny” provisions in certain “extraordinary circumstances,” such as those alleged against CR. To do so, he suggested that a court should evaluate the magnitude of the harm, the extent to which the wrongdoers benefitted, and the severity of the alleged wrongful conduct in determining whether to accept or reject a settlement containing such a provision. Marrero recognized that “in many, if not most, cases, ‘neither admit nor deny’ provisions are essential” and therefore should not cause a settlement to be rejected.

The impact of Judge Marrero’s opinion will largely be determined by the Second Circuit’s decision in Citigroup. If the Second Circuit rejects the type of scrutiny proposed by Marrero, “neither admit nor deny” settlements will continue to be routinely approved. In light of the growing hostility towards such settlements, however, it is unlikely that the Second Circuit will place an outright ban on such review. Instead, it will likely allow courts to reject settlements where the allegations are “neither admitted nor denied,” at least in extraordinary circumstances.

If courts began rejecting “no admission” provisions, and instead required defendants to admit to wrongdoing, it would severely curtail the SEC’s ability to resolve cases. Litigants are often unwilling to admit wrongdoing not only because of reputational harm, but because of the impact on existing litigation, risk of inducing additional lawsuits, and preclusion of insurance coverage, among other things. Without “neither admit nor deny” settlements, the SEC would lack a significant component of its enforcement mechanism – the SEC settles an average of 680 cases per year, while only 15-20 go to trial.