What's New in Corporate Governance and Securities Law - October 18, 2019


Corporate Governance and Securities Law Developments

Directors Can Be Held Liable for Failure to Oversee “Mission Critical” Regulatory Compliance

On October 1, the Delaware Court of Chancery refused to dismiss a shareholder derivative suit accusing the directors of Clovis Oncology of failing to adequately oversee the company's compliance with "mission critical" regulatory requirements. Clovis was a "monoline" biopharma company with no products, no sales revenue, and only a single promising lung cancer drug in its pipeline. The plaintiffs filed their suit after the drug failed to obtain FDA approval following "serial non-compliance" with clinical trial protocols and associated FDA regulations, which led to a massive stock price drop, private securities litigation that ultimately settled, and an SEC consent decree with civil penalties.

In refusing to dismiss the lawsuit, the Court of Chancery noted the Delaware Supreme Court's decision in Marchand v. Barnhill (discussed in our previous newsletter here), which underscored "the importance of the board's oversight function when the company is operating in the midst of a 'mission critical' regulatory compliance program." The Court also noted that Marchand"makes clear" that where a company operates in a "mission critical" regulatory environment, "the board's oversight function must be more rigorously exercised." In light of Marchand, and in light of documents cited by the plaintiffs (which were obtained via a books and records demand under 8Del. C.§ 220) showing discrepancies between the information the board received regarding the company's compliance with clinical trial protocols and the Company's public statements about the results of those trials, the Court of Chancery found that the plaintiffs had adequately alleged that "the Board consciously ignored red flags that revealed a mission critical failure to comply" with those protocols and associated FDA regulations, and that "this failure of oversight caused monetary and reputational harm" to Clovis.

Takeaway:The Clovis decision (i) underscores the importance of board-level efforts to oversee compliance with regulatory mandates, particularly where compliance issues are critical to a single-product company, and (ii) counsels caution in the handling of books and records demands after a corporate trauma that is likely to lead to shareholder litigation.

Link to decision.

Termination Fee May Not Be Sole Remedy for Termination of Merger Agreement

In September, the Delaware Court of Chancery held in Genuine Parts Co. v. Essendant Inc.that a buyer could sue a seller who terminated a merger agreement for damages even though (i) the buyer accepted the seller's payment of the termination fee under the merger agreement, and (ii) the merger agreement generally provided that the termination fee would be the "exclusive remedy" for any termination of the merger agreement. In Genuine Parts, Essendant and Genuine Parts entered into a merger agreement pursuant to which Essendant would acquire Genuine Parts. Shortly before Genuine Parts entered into the agreement, Sycamore Partners made an all cash offer to acquire Essendant. Essendant did not inform Genuine Parts of that pre-signing offer and, post-signing, Genuine Parts alleged that Essendant breached the "no shop" clause in the merger agreement. Ultimately, the Essendant board of directors found that the Sycamore proposal was a superior proposal, terminated the merger agreement with Genuine Parts, and paid Genuine Parts a termination fee. Genuine Parts accepted the termination fee but then sued Essendant for breach of contract and damages beyond the termination fee. Essendant moved to dismiss on the basis that payment of the termination fee (and Genuine Parts' acceptance of the fee) provided the exclusive remedy for any breach of the merger agreement.

In denying Essendant's motion to dismiss, the Court emphasized that the merger agreement's provision providing that the termination fee was the exclusive remedy required a termination by Essendant "in accordance with" and "pursuant to" its right to terminate the merger agreement for a superior proposal. That right, in turn, depended on compliance with the conditions that (i) the superior proposal "did not arise from any material breach of" the "no shop" by Essendant. Accordingly, the Court found that the merger agreement left "room" for Genuine Parts to argue that the exclusive remedy provision did not apply because the Essendant board breached the "no shop" provision. According to the Court, absent express and unconditional contractual language making receipt of the termination fee exclusive of other legal or equitable remedies, acceptance of the termination fee did not by itself foreclose Genuine Parts' right to sue Essendant for damages beyond the termination fee. The Court then held that Genuine Parts' complaint pled facts which plausibly alleged a material breach of the merger agreement's no shop clause.

Takeaway: The Genuine Parts decision reinforces the need for deal lawyers to carefully consider how termination provisions will actually operate upon receipt of a topping bid, and in the event of subsequent litigation by the losing bidder. Sellers should negotiate for express and unconditional contractual language making receipt of the termination fee exclusive of other legal or equitable remedies, so as to prevent losing bidders from later arguing that an alleged breach of a “no shop” or other related provision allows the bidder to seek damages beyond the termination fee.

Link to decision.

Stockholder Approval Alone Insufficient to "Cleanse" Controller's Compensation Package

In Kahn v. M&F Worldwide Corp.("MFW"), the Delaware Supreme Court held that, in the context of a squeeze-out merger, controlling shareholders can obtain business judgment review – rather than entire fairness – if they employ the dual protections of requiring the affirmative vote of a majority of the disinterested shares, and requiring that the deal be negotiated at the outset by a fully-empowered independent board committee. On September 20, in a decision denying a motion to dismiss shareholders' challenge to the Tesla Motors board's award of a massive compensation package to Elon Musk, the Delaware Court of Chancery extended MFW applicability to all transactions involving a controlling shareholder. Musk's compensation package was approved by a vote of the unaffiliated Tesla stockholders but did not satisfy the full set of MFW preconditions (i.e., it was not negotiated by an independent committee, etc).

The question before the Court was whether stockholder approval alone can cleanse a compensation award to a controller (and thus avoid entire fairness review), or whether instead MFW procedures are required. The Court held that MFW procedures are always required when a controller is involved, and if those procedures are not followed, the transaction—whether it is a squeeze-out merger or an executive compensation package—will be subjected to entire fairness review. The Court recognized that "nothing in MFW or its progeny would suggest the Supreme Court intended to extend the holding to other transactions involving controlling stockholders," but concluded that this "does not mean, however, that MFW's dual protections cannot provide useful safeguards" in other contexts, such as executive compensation.

Link to decision.

When Must a Company Disclose a Government Investigation?

Companies that face non-public government investigations frequently confront challenging questions regarding whether and when to disclose the existence of the investigation, how much to disclose, and any duty to update the disclosure as the investigation proceeds. In a recently settled action against Mylan, the SEC provides some perspective regarding its views on when public companies should disclose government investigations. The SEC alleged that Mylan committed disclosure violations for failing to timely disclose an otherwise confidential DOJ investigation into whether Mylan overcharged Medicaid for its largest revenue and profit generating product, the EpiPen. The DOJ investigation resulted in Mylan agreeing to pay $465 million to settle the investigation. The SEC alleged that a number of factors should have put Mylan on notice that it was required to disclose the existence of the DOJ's investigation and to take a provision for losses under GAAP in connection with DOJ's investigation, including (i) the DOJ's decision not to close a serious investigation, (ii) the existence of a tolling agreement with the DOJ, and (iii) Mylan's presentation to the DOJ on the question of damages if it were to be found liable.

Takeaway: Companies are not automatically required to disclose an investigation upon learning of it. Unfortunately, there is also no bright line rule regarding when and whether a company must disclose an investigation that has not yet resulted in a final determination that charges should be brought. The Mylan settlement outlines some of the factors the SEC will consider in determining whether a company should have disclosed a non-public government investigation.

Link to SEC complaint.

Merger Objections Suits and "Mootness" Fees

Disclosure-only settlements of M&A class actions have received increased scrutiny since decisions like the Delaware Court of Chancery’sTrulia opinion in 2016. That decision lambasted the then-prevalent practice of shareholder-plaintiffs bringing M&A strike suits and then quickly exchanging broad, classwide releases for supplemental disclosures of questionable value and fee awards to plaintiffs’ counsel. As a result, the path to quickly resolving M&A class actions has shifted toward individual plaintiffs agreeing to dismiss their claims without prejudice to other class members in exchange for supplemental disclosures and “mootness fees.”

An October 4, 2019 Law 360 article entitled “Plaintiffs Firms Follow Easy Merger Money to Federal Court” takes a look at the small group of plaintiffs’ law firms that are the most active in filings these kinds of cases and obtaining mootness fees, in a process that at least one federal district judge has characterized as no better than a “racket.” As the Law 360 article notes, these dismissals and fee payments face “little scrutiny from judges” as a result of which the practice surrounding these mootness fee cases “amounts to a shakedown with little benefit beyond lining attorneys’ pockets.”According to the article, professors who wrote a soon-to-be published paper about the practice estimate that mootness fees generated more than $23 million for plaintiffs’ lawyers in 2017. The fees typically run between $50,000 and $300,000 per challenged merger, although the professors said recent cases suggest the range may have narrowed to between $50,000 and $150,000. Before the Trulia opinion, an average 97% of merger challenges were brought in state courts such as the Delaware Court of Chancery, according to Cornerstone Research’s review of 2018 M&A litigation released on September 17. Last year, the figure for state courts fell to 34% as the percentage of federal court challenges surged to 91%. The shift from state courts to federal courts is driven by the perception held by plaintiffs’ attorneys that federal judges are less likely to scrutinize mootness fee applications.

Link to Law360 article.

Link to Cornerstone Research’s review of 2018 M&A Litigation.

Stockholder's Voluntary Sale of Stock Forecloses Ability to Assert Both Derivative and Direct Claims for Breach of Fiduciary Duty

On August 19, the Delaware Court of Chancery dismissed a shareholder lawsuit alleging direct and derivative claims for breach of fiduciary duties against a company's board of directors because the shareholders sold their shares back to the company in a voluntary repurchase transaction.The shareholder-plaintiffs conceded that, under 8 Del. C.§ 327, which imposes a continuous ownership requirement in derivative suits, they lost their ability to maintain derivative claims when they sold their shares back to the company. But they insisted that they could still maintain direct claims for their own benefit. The Court rejected this argument, holding that, like the right to assert a derivative claim, the right to assert a direct claim is a property right associated with the shares, and thus unless the seller and buyer agree otherwise, the ability to assert a direct claim and to benefit from any remedy passes with the shares to the buyer. The Court noted that if a seller wishes to retain a subset of the rights associated with transferred shares, such as the right to assert a direct claim, then the parties to the transaction must provide specifically for that outcome.

Link to decision.

Transaction in Which VC Firms Receive the Entirety of the Sale Consideration Is Subject to Entire Fairness Review, At Least in the Early Stages of Litigation

On October 11, the Delaware Court of Chancery granted in part, and denied in part, a motion to dismiss litigation brought by two director-shareholders challenging Pro Performance Sports' $40 million sale of substantially all of its assets to a third party. Under the transaction, Steelpoint Capital Partners, who held over 55% of the combined voting shares and appointed three of the six members of the company's board of managers, would receive the entirety of the sale consideration, and the common holders would be "out of the money." The Court dismissed most of plaintiffs' claims, except for their claim for breach of fiduciary duty. The plaintiffs argued that the entire fairness standard of review applied to the transaction, which would prevent the dismissal of the fiduciary duty claim at the pleading stage, because a majority of the directors who approved the transaction was interested or lacked independence. The Court agreed, holding that the plaintiffs adequately alleged that: (i) one director was interested because, in the transaction, he received a one-time severance payment equal to two years of his salary; and (ii) the three director-appointees of Steelpoint lacked independence from Steelpoint, which was conflicted with respect to the transaction. The Court noted that the Steelpoint-appointed directors were alleged to be owners or employees of Steelpoint, which is sufficient at the pleading stage to show that directors lacked independence from the VC firm. The Court further held that the plaintiffs had adequately alleged that Steelpoint was conflicted with respect to the transaction, because a "VC firm's ability to receive their liquidation preference could give the VC directors a divergent interest in the [transaction] that conflicted with the interests of the common" holders.

Link to decision.

Institutional Investors are Adopting More Stringent Standard for Overboarding

While ISS and Glass Lewis's voting policies still provide for a five-board limit for non-employee directors, large asset managers, including Vanguard, BlackRock, and Legal and General Investment Management, have enhanced their voting guidelines to provide for a four-board limit according to a July 2019 report by ISS Analytics. In addition, the report also highlights the fact many institutional shareholders do not permit CEOs to serve on more than three boards, including the CEO's company. This is largely due to increased board responsibilities, an increased emphasis on board quality and risk management and more disclosure around individual roles and responsibility on boards. In response, more companies may adopt stricter corporate governance guidelines limiting the number of outside boards.


There is an Increased Focus on Human Capital Management by the SEC

In August 2019, the SEC proposed rule amendments that would, among other things, require companies to include human capital resources as a disclosure topic in the business section of a company's Form 10-K, including "any human capital measures or objectives that management focuses on in managing the business, to the extent such disclosures would be material to an understanding of the registrant's business." This proposed rule was largely driven by increased pressure on the SEC from institutional investors. The SEC cited to a 2017 rule making petition from a group of 25 institutional investors representing over $2.8 trillion in assets, requesting the SEC to require companies to disclose information about their human capital management policies, practices and performance. The SEC also noted in a press release that the amendments would "modernize and improve our disclosure framework, including recognizing that intangible assets, and in particular human capital, often are a significantly more important driver of value in today's global economy." Companies should consider the impact of such disclosure on their shareholders and other constituents, including employees and customers, and whether they should submit any comments regarding their views on the proposed rules to the SEC.


Business Roundtable Redefines the Purpose of a Corporation to Promote All Stakeholders

The Business Roundtable is a non-profit association based in Washington, D.C. whose members are CEOs of major U.S. companies. In August 2019, the Business Roundtable announced the release of a new Statement on the Purpose of a Corporation that was signed by 181 CEOs, which commits them to lead their companies for the benefit of all stakeholders, which includes customers, employees, suppliers, communities and shareholders, rather just shareholders. Since 1978, the Business Roundtable had previously endorsed the notion that corporations exist primarily to serve shareholders. Many institutional shareholders lent their support for the updated Business Roundtable Statement, citing the positive impact this commitment will have on long-term value creation. However, the Council of Institutional Investors (CII) criticized the BRT's statement noting that: "The BRT statement suggests corporate obligations to a variety of stakeholders, placing shareholders last, and referencing shareholders simply as providers of capital rather than as owners. CII believes boards and managers need to sustain a focus on long-term shareholder value. To achieve long-term shareholder value, it is critical to respect stakeholders, but also to have clear accountability to company owners."


SEC Issues New Guidance on Proxy Voting Advice Issued by Proxy Advisors

In August 2019, the SEC provided guidance to assist investment advisers in fulfilling their proxy voting responsibilities, which discusses, among other things, what measures investment advisers can take to ensure that they are acting in a client's best interest and the issues they should consider when engaging a proxy advisory firm. In addition, the SEC issued an interpretation that proxy voting advice provided by proxy advisory firms generally constitutes a "solicitation" under the proxy rules and therefore, is subject to the antifraud provisions of the proxy rules. Consequently, when issuing proxy voting advice, proxy advisory firms should not make materially false or misleading statements or omit material facts that would be required to make the voting advice not misleading. Accordingly, the SEC stated that proxy advisors should consider disclosing:

  • The methodology used to formulate their voting recommendations;
  • Third-party sources of information that are not contained in issuers' public filings; and
  • Any material conflicts of interest that arise in the context of providing the proxy voting advice.

It is unclear whether this will significantly address the concern of most public companies, which is that the proxy advisors have too much influence over investment advisors.