We’ve blogged quite a bit over the past several years about the Delaware courts’ increasingly sympathetic approach to Caremark claims and their increasingly demanding view of what’s necessary for directors to fulfill their oversight responsibilities. This Wachtell memo addresses the implications of recent Caremark decisions. This excerpt discusses the role that books & records requests play in Caremark litigation and the resulting importance of properly structuring and documenting the board’s oversight efforts:
The increasing use of books and records demands by plaintiffs to plead their claims has been illustrated. Because the Delaware courts have long made clear—including inMarchandand Boeing—that Caremark requires a good faith effort by the board, not perfection, and that the board will only face liability if the evidence demonstrates that a board has not made a good faith effort to fulfill its duties, plaintiffs have sought books and records to sustain their difficult burden to plead a viable claim. When these books and records do not reflect that a company had in place a board structure that attended to core business and legal risks, the plaintiffs cite to that lack of effort in an effort to plead a complaint that cannot be dismissed on motion.
For these reasons, we have urged that companies ensure that their board-level committee structures address all mission critical risks and that the board’s efforts in holding meetings and receiving information in aid of its monitoring responsibilities are well documented. Taking these steps are beneficial on several levels. Most important, tone and involvement at the top on important compliance matters helps companies best position themselves to function safely and lawfully.
Because managing complex business entities invariably involves risks, these actions are also helpful in the event that something goes wrong despite the company’s good faith efforts at prevention. A documented board-level compliance system makes it much more difficult for a plaintiff to plead a viable Caremark claim. With increased attention to these subjects, two-thirds of the Caremark cases filed after Marchand have been dismissed on motion.
The blog goes on to discuss the role that proper structuring & documentation of the board’s oversight of mission critical played in Chancellor McCormick’s dismissal of Caremark claims in City of Detroit Police & Fire Retirement System v. Hamrock, (Del. Ch.; 6/22). It concludes by observing that Hamrock underscores the conclusion that directors face a very limited risk of personal liability if they “use their business judgment and work with management to put in place and attend in good faith to a sound compliance structure that addresses the company’s central risks, and documents its efforts in doing so.”
Wachtell Lipton will be well represented at our upcoming “Proxy Disclosure & 19th Annual Executive Compensation Conferences.” Former Delaware Chief Justice Leo Strine, who is currently Of Counsel at Wachtell, will participate in our “ESG Disclosures: Staying Out of Hot Water” panel & Wachtell Partner Sabastian Niles will participate in our “Next-Gen Activism: Are You Prepared?” panel. You won’t want to miss these or the other informative topics on our agenda, so be sure to sign up online, email sales@ccrcorp.com, or call 1-800-737-1271.
While we’re on the topic of Caremark and board oversight, be sure to check out this Bass Berry blog addressing the matters that should be considered when deciding how to provide board oversight of ESG initiatives and disclosures. The blog notes that approaches vary, and that many boards opt to have the full board provide that oversight. However, this excerpt says that there is a trend toward delegation:
For example, according to an EY study of Fortune 100 companies in 2021, 85% of the surveyed companies disclosed that a committee of the board oversaw environmental sustainability or corporate responsibility matters, compared to 78% in 2020. While these figures are likely higher among Fortune 100 companies than public companies as a whole, this increase between 2020 and 2021 reflects a trend toward greater board committee oversight of ESG matters occurring more generally among U.S. public companies.
Factors contributing to this trend include the SEC’s requirement for extensive board oversight under its proposed climate change disclosure rules, the increasing amount of time that boards are being required to devote to ESG issues, and the need in some cases for specialized expertise.
It’s not every day that the Delaware Chancery Court enjoins a company’s annual meeting of stockholders, but that’s what happened to UpHealth, a recently de-SPACed health care services company. According to this memo from Hunton Andrew Kurth’s Steve Haas, Vice Chancellor Will issued a bench ruling in late June enjoining the company’s annual meeting. Her decision was premised on her conclusion that the board’s likely breached its fiduciary duties by adopting a bylaw lowering the meeting’s quorum requirement.
The memo explains that stockholders allegedly holding a majority of the company’s voting power had entered into a voting agreement allowing a dissident to vote their shares, but the dissidents didn’t nominate a competing slate of directors before the deadline set by the company’s advance notice bylaw. The board’s co-chair, who was aligned with the dissident group, tried to have a special meeting called to repeal the bylaw, but that effort failed. In seeking to enjoin the annual meeting, the dissidents argued that argued that by lowering the quorum requirement from a majority to 1/3rd of the shares, the board prevented stockholders from blocking a quorum by refusing to attend the meeting, which in turn made it easier for the board to convene the meeting and elect its slate.
After rejecting the plaintiffs’ claims relating to the aborted effort to call a special meeting, the Court took up allegations that the board breached its fiduciary duties by enacting the quorum bylaw without a compelling justification. The Vice Chancellor held that the plaintiffs had a reasonable likelihood of success in proving these allegations and enjoined the meeting. This excerpt from the memo summarizes the Vice Chancellor’s reasoning:
The next issue was whether the board majority may have breached its fiduciary duties by amending the bylaws to lower the quorum requirement before the annual meeting. The court applied the Blasius test, which requires the board to show a compelling justification when it acts for the primary purpose of interfering with the stockholder franchise. Here, the court said the board majority was “changing the machinery of the election midstream . . . for the purpose of making it more difficult for the [majority] group of shareholders . . . from voting the incumbent slate down.” While the court did not question the board majority’s good faith, it nevertheless concluded that the plaintiffs had a reasonable probability of success in challenging the quorum change. As a result, the court entered a preliminary injunction against the meeting pending a trial on the matter.
The litigation ultimately settled, but the memo says that there are a number of key takeaways from it. These include the differing ways Delaware courts approach board actions taken “on a clear day” vs. those taken in the heat of a proxy contest & the importance those courts place on protecting stockholder voting rights – even if the exercise of those rights involving withholding shares from participating in a meeting. The memo also says that the decision is a reminder that Delaware’s demanding Blasius standard is alive and well when it comes to director actions that interfere with stockholder voting rights.
Yesterday, the SEC announced that it was proposing amendments to Form PF, which is a confidential reporting form that certain SEC-registered investment advisers to private funds are required to file. Here’s the 298-page proposing release and here’s the more manageable 2-page fact sheet. The SEC’s press release says that the proposed amendments, which are being proposed jointly with the CFTC, “are designed to enhance the Financial Stability Oversight Council’s (FSOC) ability to assess systemic risk as well as to bolster the SEC’s regulatory oversight of private fund advisers and its investor protection efforts in light of the growth of the private fund industry.”
This isn’t the type of SEC action we typically cover. Investment adviser regulation isn’t a high-priority topic for most of our members and – more importantly – what I know about it could fit inside a thimble. So, I wasn’t planning on blogging about the proposal until Liz flagged this WSJ article for me. The article says that, if adopted, the amendments would shed light on just how much exposure to crypto hedge funds have. That makes the proposal a little more interesting. Here’s an excerpt from the WSJ piece:
The collapse in cryptocurrency prices this year has left U.S. regulators scrambling to understand the risks that digital-asset markets could pose to the broader economy. They may soon enlist hedge funds in the effort.
The Securities and Exchange Commission issued a proposal Wednesday that would require large hedge funds to report their cryptocurrency exposure through a confidential filing known as Form PF. Created after the 2008 financial crisis, Form PF was designed to help regulators spot bubbles and other potential stability risks in the otherwise opaque ecosystem of private funds that manage money for wealthy individuals and institutions.
The potential addition of cryptocurrency data to the reporting requirements for hedge funds comes as the SEC and its sibling agency, the Commodity Futures Trading Commission, weigh a broader set of updates that would expand the scope of Form PF.
The proposing release suggests that currently, some filers apparently report crypto holdings as “cash or cash equivalents,” which makes no sense to me. The proposal would amend the term “cash and cash equivalents” to direct advisers to not include any digital assets under that category. Instead, the SEC proposes to define “digital assets” and require advisers to report them separately from other types of assets. Comments are due by the later of 30 days after the proposal is published in the Federal Register or October 11, 2022.
Earlier this year, I blogged about a 7th Cir. decision rejecting a claim that an exclusive forum bylaw could be used to preclude a plaintiff from filing a lawsuit premised on violations of Section 14(a) of the Exchange Act in federal court – which, since those claims can only be brought in federal court, would essentially preclude them from being brought anywhere. Recently, the 9th Cir. reached the opposite conclusion. Here’s what I recently said about that decision over on the DealLawyers.com Blog:
In Lee v. Fisher, (9th Cir.; 5/22), the 9th Circuit upheld a prior district court ruling dismissing federal disclosure claims and state law derivative claims on the basis of an exclusive forum bylaw designating the Delaware Court of Chancery as the exclusive forum for derivative suits. The Court reached that conclusion despite the fact that as a result of the application of the bylaw, the plaintiffs’ claims under Section 14(a) of the Exchange Act – which may only be asserted in federal court – would effectively be precluded.
This Troutman Pepper memo notes that the 9th Cir.’s decision creates a conflict with the 7th Cir., which recently held in Seafarers Pension Plan v. Bradway, (7th Cir.; 1/22), that the provisions of the DGCL authorizing exclusive forum bylaws did not permit Exchange Act claims to be brought in a Delaware court, since the Exchange Act gives federal courts exclusive jurisdiction over those claims. This excerpt from the memo summarizes the implications of the circuit split:
The circuit split created by the Ninth Circuit’s and the Seventh Circuit’s divergent rulings has injected some uncertainty into a common practice among Delaware corporations in the context of derivative claims brought under the Exchange Act. The Seventh Circuit’s decision, which is friendly to derivative plaintiffs, partially upsets standard practice in corporate affairs — that is, deciding where derivative internal corporate disputes should be heard.
The Ninth Circuit’s decision, which is friendly to Delaware corporations, generates uncertainty by splitting with the Seventh Circuit. Naturally, would-be plaintiffs and defendants will likely forum shop to the extent possible and gravitate toward their respective safe harbors. This issue could become exacerbated to the extent other circuit courts contribute to the circuit split. In that event, the uncertainty would likely continue unless and until the Supreme Court has the opportunity to, and chooses to, resolve the burgeoning circuit split.
In the course of his recent blog about Staff comments on the war in Ukraine, Dave also noted that the Staff has been seeking additional disclosure on inflation & supply chain issues. Yesterday, Olga Usvyatsky tipped us off via Twitter that the SEC released a number of comment letters addressing those topics. Most of the comments focused on disclosure in the Risk Factors & MD&A sections of the filings. Here are excerpts from some of those letters that should give you a flavor of the general nature of the Staff’s comments:
“We note your risk factor indicating that inflation could affect your margin performance and financial results. Please update this risk factor if recent inflationary pressures have materially impacted your operations. In this regard, identify the types of inflationary pressures you are facing and how your business has been affected.”
“We note your discussion here and on page 26 of your April 3, 2022 Form 10-Q related to inflation that it could affect your prices, demand for your products, your profit margins. We further note your disclosure that your test and industrial automation businesses will be impacted by supply constraints, which are in turn impacted by inflation. Please update this risk factor in future filings if recent inflationary pressures have materially impacted your operations. In this regard, identify the types of inflationary pressures you are facing and how your business has been affected.”
“We note your risk factor here and throughout the filing related to supply constraints. We further note from your Form 8-K dated April 27, 2022 that you continue to encounter material constraints in most product areas and that you provide wider than normal Q2 guidance range reflects those supply challenges. Specify in future filings and in more detail whether these challenges have materially impacted your results of operations or capital resources and quantify, to the extent possible, how your sales, profits, and/or liquidity have been impacted.”
“Please consider including disclosures in future filings to discuss known trends or uncertainties resulting from mitigation efforts undertaken, if any, from your supply chain disruptions. Explain whether any mitigation efforts introduce new material risks, including those related to product quality, reliability, or regulatory approval of products.”
“Please discuss in future filings whether supply chain disruptions or inflation have materially affected your outlook or business goals. Specify whether these challenges have materially impacted your results of operations or capital resources and quantify, to the extent possible, how your sales, profits, and/or liquidity have been impacted. Revise also to discuss in future filings any known trends or uncertainties resulting from mitigation efforts undertaken, if any. Explain whether any mitigation efforts introduce new material risks, including those related to product quality, reliability, or regulatory approval of products.”
A few common themes emerge from these comments. First, the Staff is focusing the need to keep risk factor disclosure up to date, and companies would be well advised to consider whether updates are necessary in order to avoid falling into the hypothetical risk factor trap. Second, the Staff wants more detail in disclosures about how a company’s business is being affected by inflation or supply chain disruptions. Finally, MD&A disclosure about these issues needs to address not only their current impact, but also any “known trends or uncertainties” that may result from them or from the company’s mitigation efforts.
At its last meeting, FASB proposed several changes that would impact segment reporting. These include requiring disclosure of the title & position of its chief operating decision maker and enhanced disclosure of significant expenses. This excerpt from a WSJ article on the proposal summarizes the proposed changes to expense disclosure:
U.S. public companies would have to start breaking out big-ticket expenses incurred by their business divisions under a new proposal from the U.S. accounting standards-setter aimed at helping investors get a clearer view of financial performance. Companies usually split their operations into segments by business line or geography. They are required to disclose a measure of their profits or losses by operating segment in financial statements, but don’t have to go into much more detail.
Under a proposal from the Financial Accounting Standards Board, companies would have to disclose significant expenses in those divisions, which could cover things like labor, technology fees, rent or cost of goods sold.
In addition, FASB proposes to permit companies to report multiple measures of a segment’s profit or loss, so long as at least one of those measures is one that is most consistent with those used in measuring the corresponding amounts in the consolidated financial statements. FASB’s staff is drafting a proposed Accounting Standards Update and interested parties will have 75 days to comment on the proposal.
The front office of my favorite MLB team has a reputation for the effective use of analytics. Like most jaded Cleveland fans, I’ve often thought they’ve opted for that approach because the club has no money & data scientists are a lot cheaper than power hitters. Nevertheless, I give the Guardians’ brain trust a lot of credit for doing things like extracting some real value in exchange for an un-signable star like Francisco Lindor. Oh, and I also give them a lot of credit for not being the Browns brain trust. Don’t even get me started on those freakin’ guys. . .
Geez, where was I going with this – oh yeah, SEC Enforcement! Anyway, this Holland & Knight blog picks up on Liz’s recent blog about the trio of insider trading enforcement actions that the SEC brought late last month and details the role that data analysis tools may have played in each of those cases. If you read that blog, it’s hard not to conclude that when Big Brother has access to Big Data, insider trading is even dumber than it used to be.
Section 404 of the Sarbanes-Oxley Act requires companies to review their internal control over financial reporting and report whether or not it is effective. Non-accelerated filers are required to provide management’s assessment of the effectiveness of their ICFR, while larger companies are required to accompany that assessment with an attestation from their outside auditors.
Audit Analytics recently issued its annual report on the most recent round of auditor attestations & management-only assessments of ICFR. This recent blog reviews the results of the past 18 years of experience under SOX 404, and makes several interesting observations:
– In FY 2021, 5.8% of SOX 404(b) auditor attestations disclosed ineffective internal controls. In contrast, 23.7% of management reports and 41.9% of management-only reports disclosed ineffective controls. These percentages represent increases from the levels seen in FY 2020, across all three report types.
– The report includes a thorough breakdown of the control and accounting issues contributing to an ineffective control assessment. Notably, in FY 2021, a recurring control issue cited in adverse SOX 404 reports related to a lack of qualified accounting personnel. Other issues stem from this lack of highly trained company accounting professionals. This includes the inability to enforce a “segregation of duties” within the accounting function.
The blog notes that the significantly higher percentage of management-only reports disclosing ineffective controls reflect the demographics of companies required to file these reports. Large companies must file auditor attestations along with management reports on ICFR, while smaller companies are permitted to file management-only reports.
The recurring references to the lack of qualified accounting personnel are particularly troubling. Over the past few years, there have been numerous media reports about a potential shortage of accountants. It looks like the chickens have come home to roost on this issue this year, and that the shortage will continue to place stress on companies’ internal controls in the future.
A recent 2nd Circuit decision pared back the scope of the claims for which compensation may be received under Dodd Frank’s whistleblower provisions. Here’s the intro from this Sheppard Mullin blog on the decision:
In Hong v. SEC, No. 21-529 (2d Cir. July 21, 2022), the Court held that a person who provides the Securities and Exchange Commission (“SEC”) with information about potential securities laws violations is entitled to receive a whistleblower award under Section 21F of the Securities Exchange Act (15 U.S.C. § 78u-6) if the SEC itself brings a qualifying action, but not when the SEC shares the whistleblower’s information to other agencies who then bring an action in partial reliance upon it.
In this case, the whistleblower tipped the SEC off to some alleged shenanigans involving his employer bank’s portfolio of residential mortgage-backed securities. The SEC didn’t take action but shared his information with the DOJ & the Federal Housing Finance Agency. Ultimately, the bank settled with the agencies for $10 billion, so you can understand why this guy was hoping for a big payday.
However, the SEC contended that it wasn’t on the hook for whistleblower claims resulting from actions by other agencies. It said that in order for actions by other agencies to qualify as “related actions” under Section 21F, there must also be an underlying SEC action. The 2nd Circuit applied Chevron deference to the SEC’s interpretation of the scope of Dodd-Frank’s whistleblower provisions & ultimately ruled in the agency’s favor.
The blog says that the decision sets definitive limits on the reach of the Dodd-Frank Act’s whistleblower incentives and may also affect an individual’s assessment of whether to risk their career to come forward with information on potential wrongdoing.