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On Tuesday, the SEC held its Roundtable on Short Selling (you can still catch the archive of the four hour session), where the Commission solicited the views of a variety of interested parties, including representatives of public companies, broker-dealers, SROs, funds and academics. In her opening remarks, Chairman Schapiro noted that short selling has outpaced any other issue “in terms of the number of inquiries, suggestions and expressions of concern.” Chairman Schapiro noted that an evaluation of short sale regulation is a priority for the Commission.

As could be expected, the views expressed on short selling were diverse and there was not necessarily a lot of common ground. The one exception is with respect to naked short selling, where the panelists lauded the SEC’s efforts in 2008 to try to address abusive naked short selling. As for other issues, representatives of the investment industry seemed to favor the less dramatic individual stock circuit breaker approach, while some issuer representatives seemed to favor market-wide measures. One of my favorite quotes from the session was from William O’Brien, CEO of the stock trading platform Direct Edge, who said of broad scale short selling restrictions: “Nobody likes being stung by a bee, but you don’t kill all the bees and then wonder why all the flowers have died.” Yet another issue that received some attention was the cost and time that would be necessary to implement any new short sale regulations.

With the Roundtable out of the way, now it is time for the SEC to start considering the comments and narrowing down the options to one workable approach. The comment period closes June 19.

If you are looking for a more “blow-by-blow” account of the Roundtable, then you should check out the tweets of SEC Investor Ed on twitter. Staff in the Office of Investor Education and Advocacy at the SEC are busy twittering away, including providing an account of the Roundtable in 140 character increments.

Short Sale Studies: Mixed Results from Last Year’s Emergency Actions

The SEC recently posted a study performed by its Office of Economic Analysis regarding the impact of last July’s ban on naked short selling of the securities of 19 large financial institutions. After comparing the performance of the securities subject to the ban to control groups of securities not subject to the ban, the SEC’s economists concluded that “imposing a pre-borrow requirement may have had the intended effect of reducing fails but may have resulted in significant costs on all short sellers even those whose actions were not related to fails.”

With another perspective, Abraham Lioui recently published an EDHEC-Risk Position Paper presenting a study of last year’s short sale bans. Lioui notes in the Summary:

“As a result, short sellers perhaps did not really merit the punishment that, by simply banning the shorting of the shares of financial institutions, the market authorities recently meted out. It also seems (and this study confirms it) that the shares that were the object of the ban were relatively unaffected by it. All the same, this drastic measure cast the market authorities in a particularly negative light. After all, the reasons for this measure are unclear, a lack of clarity that adds to the bewilderment of the market. The market, of course, reacted accordingly.

The ban on short selling was followed by a sharp rise in the volatility of the markets, and on the stock markets concerned the impact of the ban was systematic; the impact on volatility was greater than that of the financial crisis. In general, the risk/return possibilities of investors worsened. And although it is hard to substantiate the impact on the volatility of the shares, the rise in the volatility of these shares, which is undeniable, is a result of the rise in idiosyncratic risk and thus of the noise in the markets. As a consequence, share prices deviate yet more from their fundamental value. Finally, the desired effect on market trends has not been achieved (no reduction of the negative skewness of returns is being observed) and there is no evidence of the possible impact of this measure on extreme market movements. What is clear is that stock market indices now have components that are subject to different rules, differences that make them even less representative and relevant.”

New Delaware Decision: Reaffirmation of Pre-Suit Demand Precluding Challenge to Board Independence

Here is some commentary from Brad Aronstam of Connolly Bove Lodge & Hutz: Recently, the Delaware Court of Chancery issued this letter opinion in FLI Deep Marine LLC v. McKim (C.A. No. 4138-VCN) affirming the well-settled principle that shareholders making a demand upon a board of directors concede the independence of a majority of the board and, as such, will be precluded from later arguing that demand should be excused because the directors were conflicted. While this holding is far from revolutionary, the action involved atypical facts that warrant attention by practitioners counseling boards and shareholders in this common setting.

The minority shareholders of Deep Marine Technology alleged that the Company’s majority shareholders and their designees had looted the Company. Rather than pleading demand futility based upon the board’s lack of independence, the minority shareholders made a pre-suit demand requesting that the Company’s directors take immediate action to, among other things, investigate the alleged wrongdoing and bring appropriate action to recover the funds wrongfully diverted from the Company. The directors responded to the demand the following day by forming a special committee comprised of two directors – who themselves were accused of wrongdoing – to investigate the allegations of the demand. Three weeks later, “before the special committee had completed its investigation and before the Board took any action concerning the demand,” the minority shareholders filed suit alleging that demand was futile and should be excused.

As noted by Vice Chancellor Noble, “[t]he requirement of demand effectuates the ‘cardinal precept’ that directors manage the business and affairs of the corporation.” Delaware could “hardly be clearer” that a plaintiff’s pre-suit demand “conclusively concede[s] the independence of the Board, and . . . preclude[s] [the shareholder] from [later] arguing that demand should be excused because the directors are conflicted.”

The Court rejected the plaintiffs’ request for an exception to this “well-settled” rule on the grounds that “the Board and its special committee [we]re comprised of allegedly conflicted directors” and thus “the Board’s consideration of their demand [wa]s ‘a farce meant to giver the illusion of independence where none exists.'” While recognizing that the plaintiffs “might well be correct” concerning the alleged lack of independence and disinterestedness among the board given the Complaint’s allegations, the Court categorized the plaintiffs’ decision to make a demand as “inexplicable” and “improvident.” The Court refused to “grant the plaintiffs relief from a strategic decision they now regret,” as doing so would “part ways with established Delaware law.” The Court implied that it might have reached a different decision if the plaintiffs could establish that “their plea . . . [was] based on new information” concerning the Board’s lack of independence.

The decision reaffirms that shareholders who make a demand cannot later (absent new information) challenge director independence and wrestle control of potential claims from a special committee prior to that committee’s findings (if at all). Shareholders must therefore continue to think long and hard about whether to make a demand or allege demand futility.

Practitioners should also note that although the Court refused to endorse a specific timetable for a special committee to conduct and complete its investigation (see Op. at 11 noting that “whether the board has taken more than a reasonable amount of time to conduct its investigation is a fact question, and one for which no formula exists”), a committee should be prepared to offer a “persuasive reason” for the length of its investigation.

– Dave Lynn