Pomerantz LLP

January/February 2015

SEC Reverses Its Own Whole Foods Ruling

ATTORNEY: H. Adam Prussin

As we have been reporting for years, corporate America has been at war with activist investors who want the right of “proxy access,” which would allow them to propose nominees for director that can appear on the companies’ own proxy statements. Not too long ago, the SEC backpedaled from a proposed rule that would have granted automatic proxy access to investors who had held a certain percentage of the company’s outstanding shares for an extended period of time. This proposal is now in seemingly eternal limbo.

Instead, investors have sought to put the issue of proxy access to a shareholder vote on a company by company basis. For example, Scott M. Stringer, the New York City comptroller and overseer of five city pension funds with $160 billion in assets, recently put forward proposals at 75 companies that would allow shareholders to nominate directors. In response to these and other similar efforts, some companies have tried to pre-empt those requests by proposing, instead, their own watered-down version of similar proposals – typically with much higher threshold requirements the shareholder would have to meet. An SEC rule states that a shareholder proposal can be excluded if it “directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.”

Whole Foods is a case in point. A Whole Foods investor proposed that investors holding 3 percent of the grocer’s shares for at least three years be allowed to nominate directors at the company. Whole Foods asked for permission to exclude the proposal last fall, saying that it planned to put its own proposal on director elections to a shareholder vote. Under management’s proposal, an investor interested in nominating directors had to own a far larger stake and to have held it for much longer than in the investor’s proposal.

In its original ruling, issued December 1, the SEC staff granted a no action letter to Whole Foods, allowing it to exclude the shareholder proxy access proposal. Shortly afterwards, 18 other companies asked for no action letters permitting them to do the same. This caused a backlash from institutional investors who viewed this tactic as a too-convenient way for companies to avoid putting more aggressive proxy access proposals to a shareholder vote, and who began asking the SEC to revisit its Whole Foods decision.

On January 16, the SEC announced that it had reversed its Whole Foods decision. In a public statement, SEC Commissioner Mary Jo White said that questions had arisen about “the proper scope and application” of the SEC rule on which its staff had relied when making the decision. She also said she had directed the staff to review the rule and report its findings to the full commission. While its review is underway, the SEC said it would make no rulings on requests for no action letters involving shareholder proposals that are similar to those made by management.

Many view this development as handwriting on the wall, predicting that this preemption tactic is going to be prohibited or at least severely curtailed. Still, without a ruling one way or the other just yet, companies will have to decide for themselves whether to include such proposals in their upcoming proxy statements this spring.


Agencies Shifting Many Enforcement Actions to In-House Administrative Courts

ATTORNEY: Emma Gilmore

The Securities and Exchange Commission and the Commodity Futures Trading Commission have recently signaled that they intend to bring many future enforcement actions in administrative courts rather than federal courts. Kara Brockmeyer, the chief of the Division’s Foreign Corrupt Practices Act Unit, said at a legal conference in Washington held in October that bringing cases as administrative proceedings “is the new normal.”

While both venues have always been available for such actions, the Dodd-Frank Act expanded the powers of administrative courts, allowing them to impose remedies similar to those available in federal court, including the imposition of monetary penalties. The shift has stirred a flurry of public debates on the fairness of the administrative procedures.

Critics argue that the administrative procedure mechanism deprives defendants of constitutional and procedurals advantages, as discovery is limited (essentially precluding depositions, except to preserve evidence); the Federal Rules of Evidence do not apply (even hearsay is admissible); and there is no right to a jury. Those critics also point out that the initial factfinder is an SEC employee, and is therefore presumably biased in the SEC’s favor. They argue that while a defendant can appeal the administrative decision to a federal court of appeals, the court is likely to defer to the administrative agency. Among the fierce critics of such administrative proceedings is Southern District of New York Judge Jed S. Rakoff, who, in a speech last November, argued that “the law in such cases would effectively be made, not by neutral federal courts, but by SEC administrative judges,” saying that administrative proceedings are compromised by “informality” and “arguable unfairness.”

Another federal judge, Lewis A. Kaplan of the Southern District of New York, takes a decidedly different view. He recently held that a defendant’s right to appeal to a federal court at the end of the procedure would suffice to address any injustice or due process violations committed in the administrative proceeding. He concluded that “Congress has provided the SEC with two tracks on which it may litigate certain cases. Which of those paths to choose is a matter of enforcement policy squarely within the SEC’s province,” and the SEC is “especially competent…to determin[e] which…cases are appropriately brought in a district court and which in an administrative proceeding.” (emphasis in original).

In similar vein, the SEC’s Enforcement Division Director Andrew Ceresney defended the agency’s recent shift. “It’s not the case there is no more activity in district court; there is. Having said that, it is certainly the case we’re going to use [administrative] proceedings more often. Why is that? Because Congress gave us the authority under Dodd-Frank to obtain the same remedies in administrative proceedings as we can obtain in district courts,” Ceresney said. He argued at a November 7 conference sponsored by the Practicing Law Institute (“PLI”) that the administrative proceedings process is not only fair to defendants, but also constitutes a more efficient means to reach a resolution. dministrative proceedings are relatively fast, with rulings usually handed down within 300 days of the case being filed, as opposed to years for the typical federal-court case. Ceresney insisted that cases are heard by judges who are seasoned, sophisticated fact finders in the securities field.

At that same PLI conference, CFTC’s Enforcement Division Director Aitan Goelman said a streamlined enforcement proceeding is necessary because his agency is financially constrained and does not have the money to engage in lengthy litigations. The CFTC is mulling a “best-offer” settlement agreement very early in the proceeding in hopes of streamlining the resolution of enforcement disputes.

Another likely reason for the forum shift may be, as the Wall Street Journal recently reported, that the SEC’s win rate in recent years is “considerably higher” in administrative forums than in federal courts. In the 12 months through September 2014, the SEC won all six contested administrative hearings where verdicts were issued, but only 61%—11 out of 18—federal-court trials. Previous years showed the same pattern: the agency won nine of 10 contested administrative proceedings in the 12-month period through September 2013 and seven out of seven in the 12 months through September 2012, according to SEC data. The SEC won 75% and 67%, respectively, of its trials in federal court in those years.

Given the SEC’s success rate in such forum, this shift can prove beneficial to private litigants. Assuming the administrative procedures are fair and do not violate a defendant’s due process rights (and given the administrative law judges’ specialized knowledge of securities laws), appeals courts are likely to affirm the administrative law decisions. SEC-favorable decisions can in turn be employed as highly persuasive authority by private plaintiffs in actions brought against distinct defendants but under analogous fact patterns.


Court Upholds Our Claims Challenging Going Private Transactions

ATTORNEY: Gustavo F. Bruckner

When a controlling shareholder, who also happens to be the CEO of the company, proposes to take the company private, the situation is ripe for abuse. That’s exactly what we believe occurred in the case of Zhongpin Inc., a Delaware company headquartered in China.

In 2013 Xianfu Zhu, Zhongpin’s CEO, who owned 17.3% of the company’s shares, offered to acquire all shares of the company that he did not own for $13.50 per share. Even though there was another, higher offer for the company on the table, Zhu refused to raise his price, stating that he would not remain as CEO if an alternate bidder acquired a majority stake, would not engage in discussions with third-party investors interested in acquiring the company and would withdraw his proposal if the special committee of the Board formed to consider his offer did not approve it within several days.

The special committee retained Barclay’s Bank to act as financial advisor on the transaction, but it later resigned without ever rendering a fairness opinion. Nonetheless, the special committee approved the deal, and a tiny majority of unaffiliated shareholders ratified it.

Pomerantz is co-lead counsel representing shareholders in a class action in Delaware that seeks damages for investors injured by this self-dealing transaction. Defendants moved to dismiss our action, arguing that Zhu was not a controlling shareholder of Zhongpin because he owned only 17.3% of its shares, and that he therefore did not owe fiduciary duties to other shareholders.

Late last year, in a victory for shareholders, Pomerantz successfully argued that even a 17.3% shareholding stake could be sufficient to assert control, and that the transaction therefore had to be evaluated under the “entire fairness” standard. The Chancery Court rejected the motion to dismiss and the case will proceed to trial.

Because they manage the business for the benefit of the shareholders, corporate directors and officers occupy a fiduciary relationship to both the corporation and its shareholders; but shareholders do not normally owe fiduciary duties to other shareholders. However, when a shareholder “controls” the company, courts have found that he or she owes similar duties as directors to the other shareholders. That is because a controlling shareholder can dominate and control the conduct of the Board and will be held to have indirectly acted in a managerial capacity and thus to have assumed the burden of fiduciary responsibility.

The issue of whether Zhu had control was therefore at the heart of defendants’ motion to dismiss. Under Delaware law, clearly a shareholder owning a majority of a corporation’s stock would be considered a controlling shareholder since with one share more than 50%, such a shareholder could place its own designees on the Board and assure every corporate decision is decided in its favor. Courts have found that some large holders, albeit less than majority holders, may still be considered controlling shareholders if they exert actual control over the Board. That is, they have the power to elect their slate of directors, to adopt or reject fundamental transactions proposed by directors or exercise control over the corporation’s business affairs.

The fact that Zhu was CEO and owned a 17.3% stake was not enough to give him control over the board. In fact, Delaware courts had previously dismissed similar claims of control in other cases where the allegedly controlling shareholder held such a small stake.

In our case, the court held that “Plaintiffs do not need to prove that Zhu was a controlling stockholder in order to withstand the motions to dismiss. Rather, Plaintiffs must plead facts raising the inference that Zhu could control Zhongpin.” The court also held that “while most owners of 17% of a corporation’s stock are not controllers, a plaintiff may argue that given the circumstances of a particular case, such a sizeable stockholder actually exercises control.”

Here the court held that the circumstances supported just such an inference. During the sales process, the company filed its annual report which stated that Zhu “has significant influence over our management and affairs and could exercise his influence against” the best interests of shareholders. The annual report referred to him as the “controlling shareholder” and also stated that as a result of his alliances, and pursuant to the company’s By-Laws, he could “exercise significant influence” over the company, including election of directors, selection of senior management, amount of dividend payments, the annual budget, changes in share capital and preventing a change of control. The court concluded that “Zhu exercised significantly more power than would be expected of a CEO and 17% stockholder” and that “one can reasonably conceive that Zhu could ‘control the corporation, if he so wishe[d].”  Under the circumstances, the court held, Zhu’s dominance “left the company with no practical alternatives other than to accept his proposal.”

This has implications for challenges to buy-out proposals submitted by controlling shareholders. Courts seek to protect minority shareholders from the whims and self-interest of controlling shareholders just as they do from the self-interest of corporate directors.

Typically when a shareholder, unhappy over the sale of the company, brings an action against the company’s board of directors to challenge the transaction, a court will defer to the business judgment of the company’s board of directors. The “business judgment rule,” as this protection is known, affords corporate officers and directors who are not subject to self-dealing conflicts of interest immunity from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence. In such a situation, the shareholder-plaintiff has the high burden of proving that the directors’ actions were not made in good faith in order to successfully challenge the transaction.

However, if the directors should have self-interests in the transaction, the burden shifts to the director-defendants to prove the “entire-fairness” of the transaction. The court will also impose the heightened scrutiny of the entire fairness standard of judicial review over the transaction.

Similarly, when a controlling shareholder engages in a self-dealing transaction with its controlled corporation, entire fairness review will apply. That is the standard the court applied here.


Second Circuit Rains on Preet Bhahara’s Insider Trading Parade

ATTORNEY: Jennifer Sobers

Manhattan U.S. Attorney Preet Bharara has dedicated the last five years to cracking down on insider trading, putting dozens of Wall Street traders behind bars. He has had a nearly undefeated record, with over 80 convictions. But then, in December, came U.S. v. Newman, which reversed two convictions directly, led to the dismissal of four guilty pleas, and threatens to make future insider trading convictions far more difficult to obtain.

It seems inconceivable that in 2015 there is still no statute expressly prohibiting insider trading. Instead, courts have analyzed insider trading as a species of securities fraud. 

The Supreme Court has espoused two theories of insider trading – the classical and misappropriation theories. The classical theory applies when a corporate insider trades on, or discloses, confidential company information, in violation of his fiduciary duty to the company and its shareholders. This rule prevents corporate insiders from taking unfair advantage of uninformed shareholders.

The misappropriation theory applies when outsiders, who do not have any fiduciary duty or other relationship to a corporation or its shareholders, gain access to confidential corporate information and trade on it or leak it to others. If, for example, an employee of Company A learns that it intends to acquire company B, and misappropriates that information to trade in shares of Company B, he is culpable even though he owed no duty to shareholders of Company B. That is because he breached his fiduciary duty to his own company, the source of the information, by misusing it for his own purposes.

Courts have expanded insider trading liability to reach situations where the insider or misappropriator in possession of material nonpublic information (“tipper”) discloses the information to another person (“tippee”) who then trades on the basis of the information before it is publicly disclosed. Courts have held that the elements of tipping liability are the same regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. A tipper must have breached a fiduciary duty and must have received an improper benefit in exchange for leaking the information. Tippees, who are often Wall Street brokers, traders, and hedge fund executives, can also be liable for trading on leaked material non-public information if they knew that the leak was a breach of fiduciary duty. Some question remained, however, as to whether they also had to know that the tipper had received an improper benefit.

In Newman, decided in December, the Second Circuit rocked the insider trading legal landscape. The case involves tippees who were several layers removed from the original leak. The three-judge panel held that in order for a tippee in a “classic” insider trading case to be convicted she must have known not only that an insider disclosed the confidential information, but also that she received, in exchange, a significant personal benefit. In finding that evidence lacking here, the Court reversed the convictions of former Level Global Investors L.P. manager Anthony Chiasson and former Diamondback Capital Management, LLC manager Todd Newman, finding that there was no evidence they knew they were trading on information from insiders, or that those insiders received any benefit in exchange for such disclosures. And in a fairly bold step, the Second Circuit instructed the district court on remand to dismiss the Newman and Chiasson indictments with prejudice, as oppose to conducting a new trial.

The case turned on the fact that Newman and Chiasson were three or four levels removed from the corporate insiders who improperly leaked Dell and NVIDIA’s earnings numbers, and claimed that they had no idea that the information came from insiders, much less that those insiders had breached any duty by disclosing the information, or that they had received an improper benefit for disclosing it.

The district court did not instruct the jury that Newman and Chiasson, to be convicted, had to have known about a personal benefit received by the insider. The jury returned a verdict of guilty on all counts. The Second Circuit held that this was error, holding that the tippee had to know that the tipper disclosed confidential information in exchange for personal benefit. In rejecting the government’s position as a “doctrinal novelty,” the court concluded that disclosing confidential information, even if in breach of a fiduciary duty, is not enough, because “although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”

Newman will be a significant obstacle in many future prosecutions, particularly where, as in these cases, the tip was passed along by the original tippee to others both inside and outside the tippee’s organization. These recipients may have no idea who the original source of the information is, much less his motivations for leaking that information.

Compounding this difficulty is the court’s analysis of what does, and does not, constitute a “personal benefit” that triggers insider trading liability. In the past, some courts have been satisfied with de minimus showing of benefits, including such things as “friendship” as a culpable motivation. The Second Circuit obviously now requires more. The personal benefits received in exchange for the Dell tips were such intangible things as: the tipper giving career advice and assistance to the tippee, a fellow business school alumnus, which included discussing the qualifying examination in order to become a financial analyst, and editing the tipper’s resume and sending it to a Wall Street recruiter. The Second Circuit found that the evidence of personal benefit was even more scant in the NVIDIA chain, where the tipper and tippee were merely casual acquaintances who met through church and occasionally socialized together, and the tippee even testified during cross examination that he did not provide anything of value to the tipper in exchange for the information.

The Second Circuit decided that these facts do not evidence a tangible quid pro quo between tipper and tippee. That is, an inference of personal benefit based on the personal relationship between the tipper and tippee is not permissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. The government may not prove the receipt of personal benefit by the mere fact of a friendship, or that individuals were alumni of the same school or attended the same church. To hold otherwise, the court reasoned would render the personal benefit requirement a nullity.

Moreover, the Second Circuit found it inconceivable to conclude, beyond a reasonable doubt, that Newman and Chiasson were aware of a personal benefit, when tippees higher up in the tipping chains disavowed any such knowledge. The Court appeared even more skeptical about the liability of the tippees when the tippers themselves had not been criminally charged (and in the case of the Dell tipper, neither administratively nor civilly charged).

This Second Circuit decision may well lead to fewer insider trading prosecutions of remote tippees such as Newman and Chiasson. Already, a number of high-profile district court cases were put on hold awaiting this decision from the Second Circuit. For example, the sentencing of Danny Kuo, a former research analyst at Whittier Trust Co. who pleaded guilty to also trading on illegal tips and sharing information about Dell and NVIDIA, was adjourned on July 1 and rescheduled to within 48 hours of this Second Circuit decision. Kuo was two levels removed from the inside tipper in the NVIDIA chain, which although not as far down the chain as Newman and Chiasson, nevertheless, is remote enough to beg the question of whether Kuo knew the original tipper received a personal benefit from disclosing the insider information. To date, the parties are still considering the effects of the decision on Kuo’s case and have asked the judge for additional time to provide the court with a proposed course of action.

Most recently in January, a federal judge in Manhattan vacated the guilty pleas of four remote tippees charged with trading on inside information involving shares of IBM, and delayed the trial of a fifth man who pleaded not guilty, citing the Second Circuit opinion. Prosecutors in the case argued that because the confidential information came from an outside lawyer, the claim relied on the misappropriation theory of insider trading, to which the Newman decision did not apply. The judge disagreed, finding that the elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. The district judge further stated that the Second Circuit’s unequivocal statement on the point is part of a “meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading in this Circuit” and as such, the opinion “must be given the utmost consideration.” Bharara, perhaps confident that the district judge would not apply what he called “Newman’s novel holding” to this misappropriation case, conceded in an earlier letter to the judge that if the court found that Newman applies, then the court should dismiss the indictments because the government’s otherwise-sufficient proof would no longer suffice under the Newman definition of a personal benefit. The district judge has yet to decide whether the charges in that case should be dismissed.

The ripple effects of the Second Circuit decision are being felt outside of New York, as defendants in insider trading cases in Boston and California have already tried to take advantage of the ruling. Courts around the country may increasingly have to grapple with Newman, as they often look to the Second Circuit for guidance on insider trading.

Undoubtedly, this turn of events is what led Bharara to recently challenge the Second Circuit ruling. He requested both that the same panel of judges that issued the ruling revisit its decision and, as an alternative, for every judge on the United States Court of Appeals for the Second Circuit to hear the case, a process known as en banc review; and the SEC has also filed a brief supporting a reversal of Newman. In his petition, Bharara contended that the Court’s ruling “threatens the effective enforcement of the securities laws.” Specifically, he argued that the “panel’s erroneous definition of the personal benefit requirement will dramatically limit the government’s ability to prosecute some of the most common culpable and market threatening forms of insider trading.”

Some scholars are of the view that the insider trading landscape may be well-served by concrete laws. Courts very rarely grant en banc review, particularly where the panel’s decision was unanimous. It seems Bharara may welcome the Congressional support in his quest to prosecute inside traders at all levels.