Securities Mosaic® Blogwatch
June 30, 2015
WilmerHale discusses how FINRA Allows Use of Related Performance Information in Communications Regarding Mutual Funds with Financial Intermediaries and Other Institutional Investors
by Matthew A. Chambers

On May 12, 2015, the staff of the Financial Industry Regulatory Authority (FINRA staff) issued an interpretive letter to Hartford Funds Distributors, LLC (Hartford Funds) that conditionally allows distributors of mutual funds to include certain types of related performance information in communications with institutional investors, including registered broker-dealers and investment advisers.1 In other words, mutual fund distributors for the first time may include related performance information in sales literature when selling or recommending mutual fund shares to institutional investors and communicating with financial intermediaries.

FINRA Rule 2210 generally governs communications with the public. Paragraph (d) of the rule includes general content standards. Historically, FINRA staff has taken the position that the presentation of related performance information in public communications regarding mutual funds is inconsistent with those content standards. In this context, related performance information generally means the performance of other accounts or funds that have similar investment policies, objectives and strategies and are managed by the same adviser. Many financial intermediaries believe that such related performance information is valuable for due diligence purposes in assessing the capabilities of a mutual fund's adviser. This is especially relevant where the adviser has been managing assets in the same strategy as the mutual fund and either the mutual fund is new (and therefore does not have its own performance record) or the mutual fund's performance record is shorter than that of the adviser. The FINRA staff position does not limit the use of related performance information to mutual funds that do not have performance records or that have only short-term performance records. However, for mutual funds that have performance records of at least one year, the fund’s performance record must be displayed more prominently than the related performance information in the institutional communications.

In 2003, FINRA staff stated that it would not object if a member firm included related performance information in sales materials for private funds relying on Section 3(c)(7) of the Investment Company Act of 1940, if that information was made available only to qualified purchasers, as defined in the Investment Company Act, subject to the general content requirements of NASD Rule 2210 (the predecessor rule to FINRA Rule 2210). However, FINRA staff had not ever agreed that related performance information could be included in communications regarding mutual funds. In part for that reason, many mutual funds chose to include related performance information in the prospectuses, but could not include the same information in sales literature.

Conditions of the Letter

In its request, Hartford Funds proposed to provide related performance information solely to institutional investors, subject to the following conditions:

    • The performance information may be provided only if it is the actual performance of all separate or private accounts or funds that (1) have substantially similar investment policies, objectives, and strategies, and (2) are managed or were previously managed by the same adviser or subadviser that manages the registered mutual fund that is the subject of an institutional communication (Related Performance Information).
    • Hartford Funds will provide materials containing Related Performance Information only to persons who qualify as "institutional investors" under FINRA Rule 2210(a)(4), excluding institutional investors who intend to share the Related Performance Information with persons other than institutional investors. (Rule 2210 defines institutional investor to include a bank, savings and loan association, insurance company, registered investment company, investment adviser registered with the Securities and Exchange Commission or a state securities commission, any other person with total assets of at least $50 million, governmental entity or subdivision thereof; an employee benefit plan that meets the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and has at least 100 participants, but not any participant of such a plan; a qualified plan, as defined in Section 3(a)(12)(C) of the Exchange Act, that has at least 100 participants, but not any participant of such a plan; a FINRA member or registered associated person of such a member; and a person acting solely on behalf of any institutional investor.)
    • The presentation of Related Performance Information will include all accounts described in the first condition (Related Accounts). If there are multiple Related Accounts, the investment performance of such accounts will be presented in a composite or a list in which the investment performance of each account will be displayed with equal prominence.
    • Any institutional communication with Related Performance Information will be clearly labeled "for use with institutions only, not for use with retail investors." The distributor will instruct institutional investors who receive such materials not to provide them to current or prospective customers or others who are not institutional investors.
    • The presentation of Related Performance Information will disclose the performance net of fees and expenses of Related Accounts, or net of a model fee that is the highest fee charged to any account managed in the strategy. If gross performance information is also provided, the institutional communication will disclose prominently that the performance information does not reflect the deduction of fees and expenses, different funds and accounts have different fees and expenses, and the Related Performance Information would have been lower to the extent the related funds or accounts were subject to higher fees and expenses. The fees and expenses of the registered mutual fund that is the subject of the institutional communication will be prominently disclosed and the fund’s performance information will reflect all fees and expenses. If the fees and expenses are higher than the fees and expenses of the Related Accounts, that fact will be disclosed.
    • Related Performance Information will include the performance of each related account, be for a period of at least one year and since the inception of the investment strategy, and be current as of the most recently ended calendar quarter.
    • Related Performance Information will be clearly labeled as such and contain clear disclosure of the applicable dates for the performance.
    • For a mutual fund in existence more than one year, its actual performance will be displayed more prominently than the Related Performance Information.
  • The institutional communications will disclose any material differences between the Related Accounts and the mutual fund that is the subject of the institutional communication.

Conclusion

The interpretation takes effect immediately, meaning that mutual funds and their distributors may now provide Related Performance Information to financial intermediaries and institutional investors without concern that FINRA staff will deem the communications to violate Rule 2210. This should enable mutual fund groups to provide more meaningful information to those intermediaries and institutional investors to enable them to evaluate mutual fund products.

ENDNOTES

[1] WilmerHale represented Hartford Funds in connection with this letter.

The full and original memorandum was published by WilmerHale on May 18, 2015 and is available here.


June 30, 2015
Supreme Court Addresses Direct v. Derivative Claim in Contractual Context
by Francis Pileggi

NAF Holdings, LLC v. Li & Fung (Trading) Limited, Del. Supr., No. 641, 2014 (Del. June 24, 2015). This Delaware Supreme Court decision held that a party has a direct claim to pursue a breach of contract action for a contract to which it is a party in order to enforce its own contractual rights. The claim does not become a derivative claim simply because there may be a related injury to a corporation as well.

Highlights:

This en banc decision was presented as a question of law certified by the U.S. Court of Appeals for the Second Circuit arising out of an appeal from a decision by the U.S. District Court for the Southern District of New York. The very lengthy articulation of the issue presented by the Second Circuit was summarized by the Supreme Court as a question of Delaware law answered in the following formulation: "A promisee-plaintiff may bring a direct suit against a promisor for damages suffered by the plaintiff resulting from the promisor's breach, notwithstanding that: (i) the third-party beneficiary of the contract is a corporation in which the promisee-plaintiff owns stock; and (ii) the promisee-plaintiff’s loss derives indirectly from the loss suffered by the third-party beneficiary corporation."

The Supreme Court determined to be inapplicable the decision in Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d 1031, 1039 (Del. 2004), which the District Court for the Southern District of New York misapplied, according to the Supreme Court. Some of the nuggets from the decision of the Delaware Supreme Court include the following:

"A party to a commercial contract may sue to enforce its contractual rights directly, without proceeding by way of a derivative action. Tooley and progeny do not, and were never intended to, subject commercial contract actions to a derivative suit requirement."

An important initial question for these issues is: "Does the plaintiff seek to bring a claim belonging to her personally or one belonging to the corporation itself?"

The District Court for the Southern District of New York misconstrued Delaware law and applied Tooley in a "decontextualized manner."

The opinion is replete with citations to cases that support the important principle in Delaware law of freedom of contract, and the fundamental principle of contract law that parties to a contract bound by its terms have a corresponding right to enforce them. The court also added that Delaware law "seeks to promote reliable and efficient corporate laws in order to facilitate commerce." See generally State v. Tabasso Homes, Inc., 28 A.2d 248, 252 (Del. Gen. Sess. 1942) ("...the right to contract is one of the great, inalienable rights accorded to every free citizen....")

The Supreme Court concluded its opinion by clarifying its holding as follows: "...a suit by a party to a commercial contract to enforce its own contractual rights is not a derivative action under Delaware law."

June 30, 2015
Some Lessons from BlackRock, Vanguard and DuPont
by See Editor's Note
Editor's Note:

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here) and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

Recent statements by the CEOs of BlackRock and Vanguard rejecting activism and supporting investment for long-term value creation and their support of DuPont in its proxy fight with Trian, prompt the thought that activism is moving in-house at these and other major investors and a new paradigm for corporate governance and portfolio oversight is emerging.

An instructive statement by the investors is that they view a company's directors as their agents; that they want to know the directors and have access to the directors; that they want their opinions heard; and that their relations with the company and their support for its management and board will depend on appropriate discussion of, and response to, their opinions.

The investors want to engage with the directors on a regular basis. They suggest that the company have a program or process for regular engagement. One suggestion is a shareholder relations committee of the board. Other suggestions range from directors accompanying management on investor visits; to directors attending investor day programs and being available to the investors; to the lead director being the liaison for communication. The investors are not wedded to any one form of engagement and are content to leave that to the company and its board.

The investors want independent oversight by a balanced board of effective directors that has appropriate skill sets to properly discharge its responsibilities. They expect the board to arrange meaningful evaluations of its performance and to regularly refresh its membership. They expect "best practices" corporate governance and compensation keyed to performance and shareholder returns.

The investors want the company to proactively communicate its business strategy to its shareholders, and to keep them advised of developments and problems. Vanguard suggests that directors think like activists "in the best sense" and question management's blind spots and the board's own blind spots. To aid in that effort, Vanguard suggests that the board bring in a sell-side analyst who has a sell recommendation. The investors will not accept that there is insufficient time for engagement and discussion of the business or that SEC Reg FD forecloses meaningful discussion.

The investors expect the company to hear out an activist hedge fund that takes a meaningful position in its shares. But Vanguard says, "It doesn't mean that the board should capitulate to things that aren't in the company's long-term interest. Boards must take a principled stand to do the right thing for the long-term and not acquiesce to short-term demands simply to make them go away."

As activism moves in-house at major investors and the new paradigm becomes pervasive, the influence of the activist hedge funds and ISS and Glass-Lewis will shrink and will be replaced by the policies, evaluations and decisions of the major investors. While this will be a welcome relief from the short-termism imposed by the activist hedge funds, it raises a new fundamental question—how will investors use their power? This remains to be seen. It is not likely that activism and short-termism will totally disappear, but I'm comfortable that the influence of major investors will be more favorable to shareholders generally and to the Nation's economy and society, than the self-seeking personal greed of hedge fund activists.

June 30, 2015
Delaware Insiders Give Insights on Delaware's New Fee-Shifting Legislation
by Francis Pileggi

An insider's view of the recent Delaware legislation banning fee-shifting bylaws is provided by Professor Lawrence Hamermesh and Norman Monhait as published in this post from the Institute of Delaware Corporate and Business Law. This is must reading for anyone who seeks to understand the nuances of this new legislation. In sum, the good professor co-authors the article with one of deans of the corporate litigation bar in Delaware, both of whom played a lead role in drafting the fee-shifting legislation that was just signed by the governor. They explain why this new law does not address the issue of fee-shifting bylaws in the context of claims based on the federal securities law.

About the authors: Mr. Monhait is the immediate past chair, and Professor Hamermesh a prior chair and a member, of the Council of the Delaware State Bar Association's Corporation Law Section. The Council each year proposes legislation to update the Delaware corporate and related statutes, including the recently passed fee-shifting and forum selection bills. The views expressed here, however, are solely those of the authors, and do not necessarily represent the views of the Association, the Section, or its Council.

June 30, 2015
Obamacare and Administrative Law: Overturning the Chevron Doctrine
by J Robert Brown Jr.

In the area of administrative law, few principles are as hallowed as Chevron deference.  Under the doctrine, courts must accept any "reasonable" interpretation by an agency of ambiguous language in a statute.  The doctrine "is premised on the theory that a statute's ambiguity constitutes an implicit delegation from Congress to the agency to fill in the statutory gaps." FDA v. Brown & Williamson Tobacco Corp., 529 U. S. 120, 159 (2000). 

The idea, however, that Congress intended agencies to interpret ambiguous statutes is a fiction.  The reason for the doctrine is more about policy.  The approach reduces judicial involvement in the interpretation of statutes. Moreover, by deferring to agencies, the courts in effect make the executive branch responsible for the resulting interpretation.  In doing so, an unhappy electorate can ensure some degree of accountability.

Whatever the underlying rationalization, courts are stuck with the obligation to defer to agencies, at least where the reasonable interpretation is articulated in the form of rulemaking.  Where courts do not like an agency's interpretation, they either must find that the statute was not ambiguous or the resulting interpretation was unreasonable.

In King v. Burwell, the most recent Obamacare decision, the Court (per Chief Justice Roberts) added another avenue for courts wanting to avoid administrative deference.  In that case, the Court had to interpret language in the Affordable Care Act that provided tax credits to persons purchasing insurance through "an Exchange established by the State".  The IRS had promulgated a rule that extended tax credits to those obtaining insurance over either a state or federal exchange.    

To the extent that the applicable language in the statute was ambiguous (something that the Court found), the interpretation adopted by the IRS was, under a traditional Chevron approach, entitled to deference.  The Supreme Court, however, disregarded the traditional presumption.  As the Court noted:

  • In extraordinary cases, however, there may be reason to hesitate before concluding that Congress has intended such an implicit delegation." Ibid. [FDA v. Brown & Williamson Tobacco Corp., 529 U. S. 120, 159 (2000)] This is one of those cases. The tax credits are among the Act's key reforms, involving billions of dollars in spending each year and affecting the price of health insurance for millions of people. Whether those credits are available on Federal Exchanges is thus a question of deep "economic and political significance" that is central to this statutory scheme; had Congress wished to assign that question to an agency, it surely would have done so expressly. It is especially unlikely that Congress would have delegated this decision to the IRS, which has no expertise in crafting health insurance policy of this sort. This is not a case for the IRS. [citations omitted]

In conducting the analysis directly, the Court provided some certainty.  Reasonable interpretations by agencies can be changed and, so long as they remain reasonable and are not arbitrary, will be upheld.  See Perez v. Mortgage Bankers Association.  A future IRS could in theory conclude that only those obtaining insurance over a state established exchange would be entitled to credits.  So long as reasonable (and not arbitrary), a court would be obligated under Chevron to uphold the position.  By deciding to resolve the ambiguities in the statute, the majority in King deprived the IRS of any future discretion to change the interpretation.  

On the other hand, the Court opened the door to future decisions disregarding the Chevron presumption. Since the presumption is already a fiction, it will not be hard for future parties to make a credible case that Congress did not intend to leave the authority to construe ambiguity with the relevant agency.  In those circumstances, an agency's "reasonable" interpretation would no longer be entitled to deference.   

June 30, 2015
Conflicting Shareholder Proposals: Are Companies Asking for a Trump Card?
by Broc Romanek

Here's a blog from Adam Kanzer of Domini Social Investments based on his recent comment letter sent to the SEC:

According to a series of letters submitted on behalf of the issuer community, including a joint letter submitted by five prominent law firms, the original intent of Rule 14a-8(i)(9) and its successor formulations was to prohibit a very specific abuse of process by shareholders – the use of 14a-8 to solicit votes in opposition to management proposals ("counter proposals"). This would amount to a circumvention of the SEC's solicitation rules. It is therefore clear that the exemption was based on the sequencing of proposals, and was intended to be used infrequently. The rule, however, is now applied where such abuses have not even been alleged. The issuer community is seeking an extremely broad and unreasonable reading of the subsection.

The law firms' assertion that the sequencing of the proposals "is not a consideration encompassed by the text of the rule" ignores their own assertions about the history of the rule. The rule is grounded in a prohibition on counter proposals offered by shareholders, and a counter proposal must come second.

In addition to sequencing, public notice is also critical. Unless management has publicly announced its intention to submit a particular proposal to a vote before the proposal filing deadline-including the terms of that proposal-a shareholder proposal cannot be considered a solicitation "opposing a proposal supported by management." This is largely a hypothetical abuse of process that is generally not available to shareholders, except, perhaps, on rare occasions (Northern States Power Company (July 25, 1995)(Shareholder proposal requesting that the board of directors require management to negotiate a more equitable merger agreement excludable as ‘counter to a proposal to be submitted by management.') This subsection was presumably crafted to deal with those rare occasions. So rare, in fact, that they were deemed to be an "abuse" of process.

In reality, the shareholder proposal either accidentally coincides with a management proposal on the same topic, or management responds to the shareholder proposal with a proposal of its own. Neither situation can be considered an "abuse" by shareholders, as suggested by the 1982 Release.

Issuers are asking Staff to interpret (i)(9), a rule designed to address counter proposals by shareholders, to permit the exclusion of shareholder proposals any time a counter proposal has been offered by management. Not only does this reverse the intent of the subsection, as explained by the law firm letter, it eliminates the concept of a 'direct conflict' from the rule and converts what was intended to be a narrow exemption to deal with a rare abuse of process into a trump card to be used at management's discretion.

Establishing a clear, bright line approach to 14a-8(i)(9), consistent with the wording of the rule, would dramatically reduce the opportunity for gamesmanship and avoid the need for SEC Staff to delve into those perilous waters. Our recommended approach, first suggested by the Council of Institutional Investors and endorsed by CalPERS and CalSTRS - non-binding proposals cannot "conflict" with management proposals – would satisfy issuers' and proponents' need for clarity and would eliminate any meaningful legal conflicts that "conflicting" proposals may create. Our proposal to permit conflicting binding proposals to be re-characterized as non-binding proposals would eliminate the need for any investigation into issuer or shareholder motives, while preserving both shareholder democracy and management’s right to submit alternative proposals to a vote.

Proxy Access Proposals: The Latest Stats

This Skadden memo is the first memo – of what likely will be many – with comprehensive coverage of the voting results for proxy access shareholder proposals this proxy season. We’ll be posting all of them in our "Proxy Access" Practice Area. Check it out!

Delaware Bans "Loser Pays" Bylaws & Authorizes Exclusive Forum Bylaws

The Delaware Governor has signed the latest Delaware amendments into law, taking effect on August 1st. On DealLawyers.com, we're posting memos in our "Exclusive Forum Bylaws" Practice Area (also see this blog about whether the new law impacts federal class actions). And here’s the intro from this Cooley blog:

On June 24, 2015, the Governor of Delaware signed into law amendments to the Delaware General Corporation Law proposed by the Delaware Bar's Corporation Law Council and overwhelmingly passed by the Legislature regarding fee-shifting and forum selection provisions in Delaware governing documents. (See this post and this post.) More specifically, the amendments invalidate, in Delaware charters and bylaws, fee-shifting provisions in connection with internal corporate claims. "Internal corporate claims" are claims, including derivative claims, that are based on a violation of a duty by a current or former director or officer or stockholder or as to which the corporation law confers jurisdiction on the Court of Chancery. These claims include claims arising under the DGCL and claims of breach of fiduciary duty by current or former directors or officers or controlling stockholders of the corporation, or persons who aid and abet those breaches. However, as discussed in this post, federal securities class actions are not included. In addition, the new provision is not intended to prevent these types of provisions in a stockholders agreement or other writing signed by the stockholder against whom the provision is to be enforced.

The amendments also expressly authorize the adoption of exclusive forum provisions for internal corporate claims, as long as the exclusive forum is in Delaware. Although the amendment does not address the validity of a provision that selects, as an additional forum, a forum other than Delaware, the synopsis indicates that it "invalidates such a provision selecting the courts in a different State, or an arbitral forum, if it would preclude litigating such claims in the Delaware courts." A different result is possible where there is a provision in a stockholders' agreement or other writing signed by the stockholder against whom the provision is to be enforced. In addition, an exclusive forum may not be "enforceable if the Delaware courts lack jurisdiction over indispensable parties or core elements of the subject matter of the litigation," and the amendment in not intended to preclude evaluation of whether the terms or manner of adoption of the exclusive forum provisions "comport with any relevant fiduciary obligation or operate reasonably in the circumstances presented." Deputy Secretary of State Richard J. Geisenberger said 99.6% of companies that have a forum-selection bylaw choose Delaware as the preferred venue. And, no surprise, Delaware wants cases involving Delaware corporations to be tried in Delaware.

– Broc Romanek

June 30, 2015
SEC Sanctions KKR Over Fee Allocations
by Tom Gorman

The SEC filed its first action involving a private equity fund and broken deal expenses. By the time the Commission discovered the question the firm realized it did not have a disclosure policy, retained a consultant to study the issue and adopted a policy. Nevertheless, to settle the proceeding the firm was required to pay disgorgement and a $10 million penalty. In the Matter of Kohlberg Kravis Robert & Co. L.P.¸Adm. Proc. File No. 3-16656 (June 29, 2015).

Respondent KKR is a private equity firm specializing in buyout and other transactions. For its Flagship PE Funds and other advisory clients the firm advises and sources potential investments. The firm also provides investment management and administrative services to its private equity funds for a management fee. In addition, the firm raises capital from co-investors for its private equity transactions.

KKR incurs significant investment expenses sourcing investment opportunities. The firm is reimbursed directly from portfolio companies for expenses incurred with successful transactions. For broken deal expenses it is reimbursed through fee sharing arrangements with its funds. Consistent with the applicable limited partnership agreements, and those for the Flagship 2006 Fund LPA, KKR shared a portion of its monitoring, transaction and break-up fess with the 2006 Fund. Under the fee sharing arrangement KKR received 20% of the fees and economically bore 20% of the broken deal expenses. However, the 2006 Fund's LPA and offering materials did not include any express disclosure that KKR did not allocate broken deal expenses to its co-investors despite the fact that they participated in, and benefited from, KKR's general sourcing transactions.

From 2006 through 2011 KKR allocated broken deal expenses by geographic region where the potential deal was sourced. Thus it allocated broken deal expenses related to potential North American investments to the 2006 Fund. Before 2011 however the firm did not allocate or attribute any of those expenses to co-investors.

In June 2011 KKR concluded that it lacked a written policy governing its broken deal expenses. Over the next few months a policy was drafted, memorializing its allocation methodology. At the same time the firm decided to make an allocation of broken deal expenses to co-investment vehicles.

In late October 2011 KKR engaged a third party consultant to review the its fund expense allocation practice. Effective January 1, 2012 the firm revised its broken deal expense allocation methodology following the consultant's review. A new methodology was implemented which allocated part of the expenses to partner vehicles and other co-investors.

In 2013 OCIE conducted a compliance exam which included a review of expense allocations. During the examination KKR refunded its Flagship PE Funds a total of $3.26 million in certain broken deal expenses that had been allocated to them from 2009 to 2011.

Prior to the institution of the new policy KKR did not allocate any share of broken deal expenses to its co-investors, with certain exceptions. Likewise, the firm did not expressly disclose in the LPAs or related materials that it did not allocate or attribute broken deal expenses to co-investors. As a result KKR misallocated $17.4 million in broken deal expenses between its Flagship PE Funds and co-investors, thereby breaching its fiduciary duty as an investment adviser, according to the Order. The Order alleges violations of Advisers Act Sections 206(2) and 206(4)-7.

Respondent resolved the matter, consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, they agreed to pay disgorgement of $14,165,968 (net broken deal expenses), prejudgment interest and a penalty of $10 million.

June 29, 2015
Watch this 3-minute video on Reference Retriever version 2
by Chris Hitt

As we noted in this blog a couple of weeks ago, the new and greatly enhanced version of the Reference Retriever tool on Lexis Securities Mosaic is live. Users who access SEC EDGAR filings through Securities Mosaic now have instant access to most filings or exhibits referred to in other filings, including those incorporated by reference. All it takes is a couple of clicks of your mouse to retrieve the referenced document.

To see the feature in action, you can watch this three-minute video on RR v.2. Or, if you prefer to have your own personal guided tour, click here to schedule a live training with one of our product specialists.

We'd love to hear your feedback on the new feature!

June 29, 2015
Delaware Court: Seating Board Designee Subject to Reasonable Conditions Not a Breach
by See Editor's Note
Editor's Note:

Steven Epstein is a partner and Co-Head of the Mergers & Acquisitions practice at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication authored by Mr. Epstein, Robert C. Schwenkel, John E. Sorkin, and Gail Weinstein. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In Partners Healthcare Solutions Holdings, L.P. v. Universal American Corp. (June 17, 2015), the Delaware Chancery Court granted summary judgment to defendant Universal American Corp. ("UAM"), rejecting the contentions of one of UAM's largest stockholders, Partners Healthcare Solutions Holdings ("Partners"), that UAM had breached a board seat agreement by imposing conditions on the seating of Partners' designee to the UAM board that were not provided for in the agreement. Partners, a subsidiary of a private equity firm, acquired its stake in UAM through, and the board seat agreement had been entered into in connection with, UAM's acquisition of a subsidiary of Partners (the "Portfolio Company"). The dispute relating to the seating of Partners' board designee arose at the same time that UAM and Partners were involved in a separate fraud litigation arising from the Portfolio Company's performance after the merger.

Key Points
  • Unusual facts; no change in the basic rights of stockholders designating directors under board seat agreements. The facts in UAM were not typical in that the ongoing simultaneous fraud litigation between the parties created an unusual conflict of interest and confidentiality issue relating to the board designee (and may also have created animus that prevented them from resolving the board seat issue without litigation). Notwithstanding the court's rejection of the plaintiff stockholder's claims in UAM, the decision does not alter the basic rights of private equity firms or other stockholders under board seat agreements to have their board designees seated, to recover damages incurred if the company breaches the agreement, or to be reimbursed for legal fees to the extent the agreement so provides.
  • Board may impose conflict of interest and confidentiality conditions not specified in a board seat agreement if required by its fiduciary duties. The decision confirms, however, that a company will not be in breach of a board seat agreement when it agrees to seat a stockholder’s designee but the board, in the exercise of its fiduciary duties, imposes reasonable conditions relating to conflicts of interest and confidentiality of company information that were not provided for in the board seat agreement.
  • Other reasonable conditions not specified in a board seat agreement may also be upheld. Depending on the circumstances, where a board seat agreement is silent with respect to certain conditions, we expect that a court also would likely uphold a board's imposing reasonable conditions (i) that are applicable to all directors or (ii) for which the company has a strong legitimate need and which do not have a disabling or significant negative effect on the stockholder’s designation rights.
Background

UAM, which was a public company, entered into a merger agreement in 2012 with the Portfolio Company (a subsidiary of Partners), through which Partners became one of the largest stockholders of UAM. Partners and its affiliates (together) were granted the contractual right to designate one director of UAM so long as they continued to hold at least a 5% equity stake. The only condition set forth in the board seat agreement was that the designee be "independent" under applicable stock exchange rules. The designee was seated on the board promptly after the merger. Almost immediately after the merger, Partners' performance suffered a significant decline and UAM sued Partners and its representatives (including the board designee) for fraud.

When the board designee resigned months later, Partners designated a successor (as it was contractually entitled to do). UAM was willing to seat the successor designee, but subject to the conditions that the designee (i) forego being represented in his capacity as a director by the same law firms (the "Law Firms") that were representing Partners against UAM in the fraud litigation and (ii) sign a confidentiality agreement providing that he would not share confidential company information with the Law Firms.

Partners sued for: specific performance-the seating of its designee without conditions; damages-based on an alleged loss in value of its equity interest due to actions taken by the UAM board while Partners was not involved on the board because of UAM's refusal to seat its designee; and reimbursement of legal costs-as provided for in the board seat agreement in the event of a breach of the agreement. The specific performance claim was ultimately settled by the parties, with both agreeing that the designee would be seated subject to (i) his signing a confidentiality agreement and (ii) the Law Firms creating ethical walls to segregate the lawyers representing the director designee and the lawyers involved in the fraud litigation. Partners then pursued the damages claim and the recovery of legal counsel fees. The court held that UAM had not breached the board seat agreement. Therefore, no damages were awarded and the recovery of legal fees provision was inapplicable.

Discussion

No breach of the board seat agreement. The court found that UAM had not breached the board seat agreement when the board imposed conditions "in a faithful exercise of its fiduciary duties, recogniz[ing] a conflict in the Designee engaging as counsel, in his capacity as a director and on behalf of UAM, the same counsel that was adverse to UAM in the fraud litigation." The court concluded: "UAM did not refuse to seat [the designee], but instead agreed to seat him once the problem of conflicted representation was solved. That cannot be said to be a breach of the board seat agreement." The court noted that, in any event, the designee, as a director of UAM, could not have shared confidential company information with the Law Firms without breaching his fiduciary duties.

Factual context was not typical—but it appears the result would have been the same in any event. We note that this was not a classic breach of a board seat agreement case. First, the board seat agreement dispute primarily related to confidentiality and legal representation issues that would not have existed but for the ongoing fraud litigation between the parties. Second, the parties had already settled the primary claim, with the stockholder having achieved its objective of having its designee seated on the board-based on a solution that the court characterized as having been an "obvious" path to settlement. Third, in previous proceedings, the court had already indicated its view that, even if it found the company had breached the agreement, the damages claim-which was based on an alleged loss of value in the shareholder's equity interest because it did not have a designee on the board for several months-did not appear to have a strong foundation. Thus, the real stakes involved in the case were only the legal counsel fees. It appears that the parties' animosity relating to the fraud litigation may have been the impetus for this litigation being continued after the board designee had been seated pursuant to the settlement. Notwithstanding the unusual context, we expect that the court would have applied the same basic principles in any event. Notably, however, the substance of the dispute arose due to the separate fraud litigation between the parties.

Damages claim for failure to seat board designee. During the period between the resignation of Partners' initial designee to the board and the seating of the successor designee pursuant to the parties' settlement, the UAM board repurchased $36 million of stock from another stockholder. Partners' claim for damages was based on its alleged loss from not having been given a right to participate in this repurchase. The court noted that, during the time Partners' initial designee had been on the board, the board had approved the repurchase of up to $40 million of stock, subject to future approval of specific terms, and, allegedly, the board had discussed that any "meaningful shareholder" would be given the right to participate by selling shares as well. (Presumably, Partners believed that its designee, if he had been on the board at the time, would have ensured that Partners had been given the right to participate.) The court, noting that the repurchase was at a price that was at a discount to the market price, characterized the damages claim as "quixotic".

Practice Points

Litigation over board seat agreements is rare. In our experience, parties to board seat agreements usually avoid disputes by specifying in the agreement the conditions that will apply to seating the designee and, in any event, usually can resolve issues that arise under these agreements without resorting to litigation. The court was critical of both parties in UAM for not having earlier implemented the "obvious" solution to the conflict of interest and confidentiality issue that they ultimately agreed to and that had been "in front of their noses" all the time (i.e., the Law Firms establishing ethical walls).

Conditions to seating a board designee. In each case, the parties should consider whether there are circumstances or concerns that necessitate specific provisions in the board seat agreement (or confidentiality agreement) to ensure that the parties' expectations are met. UAM confirms that, where the agreement is silent, a board that is willing to seat a stockholder's designee should be able to impose reasonable conditions relating to resolution of conflicts of interest and protection of confidential information. We expect that, depending on the circumstances, a court likely would uphold the imposition of other reasonable conditions as well. What is reasonable will be evaluated by a court based on the facts and circumstances. Where, as in UAM, the court's view is that a board's fiduciary duties require it to impose certain conditions, those conditions almost certainly will be upheld. Other conditions that probably would be deemed to be reasonable would be those that (i) are applied to all directors or (ii) have a strong legitimate purpose and do not significantly negatively affect the stockholder's right to designate a director. Companies should consider whether to specify these or other conditions. Stockholders should consider whether to specifically seek to exclude the application of certain conditions.

Remedies for breach of board seat agreement. As noted, in UAM, the court indicated that, even if UAM had breached the board seat agreement, the court likely would have rejected the stockholder's claim for damages that was based on an alleged loss of value of the stockholder's stake, given that the repurchase of shares that the stockholder was deprived of participating in had been effected at a price that was a discount to the market price. The extent to which a court may view a claim for damages based on a board's actions during the period that a company, in breach of a board seat agreement, does not seat the stockholder's designee will depend on the facts and circumstances of the particular case-including the extent to which the alleged loss can be shown to be related to the absence of the stockholder's designee. A stockholder may wish to consider seeking to include in a board seat agreement specified remedies for a breach by the company. These could include, for example, recovery of legal fees, liquidated damages, the right to designate additional designees, and/or an expansion of the circumstances under which the stockholder will continue to have the right to designate.

Waiver of conflict of interest provision and "Affiliate" definition: More precise drafting would have made the parties' expectations clear-but still would not have eliminated the board's concerns arising from its fiduciary duties. In UAM, Partners had argued that, in the merger agreement, UAM had waived any conflict of interest issue relating to the Law Firms' representation of Partners or its Affiliates, including Partners' board designee. The merger agreement waiver provision, by its terms, waived any conflict of interest of the Law Firms in representing Partners and its Affiliates, on the one hand, and UAM and its Affiliates, on the other hand, with respect to issues related to the merger agreement. The court found that the waiver provision did not apply to the Law Firms' representation of Partners' board designee. The court concluded that the merger agreement provision waived a conflict of interest in disputes between Partners and UAM—but that it did not apply "to sanction a UAM director's representation by counsel where that counsel also represents Partners in a dispute with UAM." The court also concluded that, in any event, Partners' designee was not an "Affiliate" of Partners under the (standard) definition included in the merger agreement-because the designee, by virtue of his fiduciary duties to UAM and its stockholders, was not under Partners' "control". We note that, in this case, even if the drafting of the conflict of interest waiver had clearly included the Law Firms' representation of Partners' board designee in his capacity as a director, and even if the drafting of the definition of "Affiliate" had clearly included the board designee as an Affiliate of Partners, the court likely still would have upheld the conditions imposed by UAM, as the court viewed those conditions as arising from "the Board's fiduciary interest in protecting confidential information from conflicted counsel."

Issues also arise after a stockholder designee is seated. While UAM involved issues relating to the seating of a stockholder's designee to a company's board, it should be noted that complex legal and practical issues often arise once a stockholder's designee is seated (many of which may also arise with respect to directors who are not designees under a board seat agreement)- including, possibly, conflict of interest, confidentiality, corporate opportunity, independence, duty of loyalty, regulatory (such as Section 16(b) and Reg. FD), antitrust, insider trading, and other issues. While it is well established that a stockholder's designee to a board owes his duties to the company and its stockholders, not to the stockholder who designated him, application of the general principle is not necessarily uncomplicated. These issues are generally less difficult when the designee is not related to or affiliated with the designating stockholder.

Governing law of exhibits to merger agreement. A governing law provision in an agreement attached as an exhibit to a merger agreement takes precedence over a governing law provision in the merger agreement that by its terms applies to the merger agreement and all of the exhibits and schedules thereto. In UAM, the merger agreement provided that the merger agreement and all of the exhibits and schedules thereto would be governed by Delaware law. The board seat agreement provided that it would be governed by New York law. The plaintiffs argued that-since the board seat agreement was an exhibit to, and its execution was a condition to closing of, the merger agreement-the board seat agreement was governed by Delaware law. The court disagreed, stating that "the explicit invocation of New York law in the Board Seat Agreement itself takes precedence."

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