Securities Mosaic® Blogwatch
November 25, 2015
Too Big to Tax? Vanguard and the Arm's Length Standard
by Reuven Avi-Yonah

Vanguard is the world's largest complex of mutual funds, with over $3 trillion in assets under management, including $215 billion added in 2014. Vanguard's main attraction to investors is its low costs. Profs. Freeman and Brown (2000) report that the advisory fees charged by the Vanguard Group "tend to present lower expense ratios than the rest of the mutual fund industry" because "Vanguard funds are run on the same basis as most companies in the economy: boards are unswervingly devoted to making as much money as possible...for shareholders [of the funds]. Stated differently, Vanguard funds are uncontaminated by the conflict of interest that affects most of the rest of the fund industry." Michael Rawson, a Morningstar analyst, told the Financial Times in May 2015 that "[i]t is phenomenal that a single company could represent almost 20 percent of the US mutual fund industry. But they have done it through offering products that are consistently lower cost than other funds".

The main reason for Vanguard's lower fees than, for example, the fees charged by Fidelity (its closest rival) is that Vanguard has a unique structure, approved by the SEC in 1975: The investment manager (Vanguard Group Inc., or VGI) is owned by the Vanguard domestic mutual funds (the Funds) in proportion to Net Asset Value. This structure, Profs. Freeman and Brown argue, means that there is no conflict of interest between VGI and the Funds, while every other mutual fund complex has the advisor charging too much because it puts the interest of shareholders of the advisor ahead of investors that are shareholders of the funds.

Profs. Coates and Hubbard (2007) have argued that this situation should result in investors moving from other funds to Vanguard, and the recent phenomenal growth of Vanguard suggests that they were right. But there is a problem: As David Danon, a former Vanguard in-house tax lawyer, has argued in a lawsuit filed in 2013, the Vanguard structure directly contravenes the arm's length standard of Treas. Reg. 1.482-1(b)(1) because VGI provides services to the Funds "at cost", i.e., without charging an arm’s length profit.

VGI and its domestic subsidiaries are taxable corporations under Subchapter C of the Code. The Funds are RICs and therefore are not taxable at the Fund level if they meet the requirements of Subchapter M of the Code, including distributing 90% of their income to Fund investors annually. VGI is wholly-owned by the US Funds in proportion to their NAV. The Vanguard Board of Directors is identical to the Trustees of the Funds.

The Treasury regulations state that "[t]he purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer." The Vanguard Group is a "controlled" taxpayer in relation to the Funds because the Funds own VGI (which in turn owns the other corporations in the Vanguard Group).

The Treasury regulations go on to state that "[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result)."

Treas. Reg. 1.482-9 provides methods to determine taxable income in connection with a controlled services transaction (a transaction involving the provision of services between controlled taxpayers). Treas. Reg. 1.482-9(a) requires controlled taxpayers to charge an arm’s length price for services provided to other controlled taxpayers. Under Treas. Reg. 1.482-9(b), controlled taxpayers must provide services at a profit unless they meet the requirements of the "services cost method", which permits them to provide certain narrowly defined services "at cost" without a markup.

Under Treas. Reg. 1.482-9(b)(2), in order for the services cost method to apply, all the requirements of that section must be met, including that it is not precluded from being a covered service under the business judgment rule of Treas. Reg. 1.482-9(b)(5).

Under Treas. Reg. 1.482-9(b)(5), "[a] service cannot constitute a covered service unless the taxpayer reasonably concludes in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group, as defined in § 1.482-1(i)(6). In evaluating the reasonableness of the conclusion required by this paragraph (b)(5), consideration will be given to all the facts and circumstances." Vanguard’s own promotional materials emphasize that the "at cost" pricing of the services provided by the Vanguard Group to the Funds is the "key competitive advantage" of the Funds in attracting and retaining investors. Moreover, it is clear that the investment advisory services provided by VGI to the Funds are the "core capability" of VGI.

Once it is established that the services provided by the Vanguard Group to the Funds are not eligible for the services cost method, the next task is to establish an appropriate mark-up. Morningstar publishes summaries of expense ratio trends. Based on their data, the average expense ratio for Vanguard (if it included a profit component like other mutual fund complexes) should be between 0.71-0.82% of NAV, rather than around 0.2% of NAV as reported by Vanguard. Based on this data the report I submitted to the IRS on September 21, 2015, concluded that Vanguard owes $34.6 billion for 2007-2014.

Under current law, the IRS has the legal ammunition it needs to tax Vanguard on billions of dollars in annual income. So the question remains: Will the IRS be willing to take on many millions of investors? Or is Vanguard too big to tax? Since the IRS (so far) has not publicly acted, this question remains open at present. But there is a good chance that the IRS will determine that Vanguard is liable for tens of billions in taxes, and that its fees will have to be raised to cover this liability, erasing some (but not all) of its competitive advantage over its rivals.

The preceding post comes to us from Reuven S. Avi-Yonah, the Irwin I. Cohn Professor of Law and Director, International Tax LLM Program at the University of Michigan Law School. The post is based on his recent article, "Too Big to Tax? Vanguard and the Arm’s Length Standard", which is available here.


November 25, 2015
WilmerHale reports ALJ Dismisses FTC's LabMD Complaint for Lack of Actual or Probable Consumer Harm from Cybersecurity Incidents
by Jonathan G. Cedarbaum, D. Reed Freeman, Jr., Heather Zachary, Benjamin A. Powell and Leah Schloss

On Friday, November 13, Federal Trade Commission ("FTC" or the "Commission") Chief Administrative Law Judge ("ALJ") D. Michael Chappell issued an Initial Decision in In the Matter of LabMD, Inc. (FTC Docket No. 9357), dismissing the Commission's Complaint against LabMD, Inc. ("LabMD"), upon a finding that the FTC had failed to "demonstrate a likelihood that [LabMD's] computer network will be breached in the future and cause substantial computer injury."1The ALJ held that showing consumer harm is merely possible is insufficient to prove unfairness under Section 5(n) of the FTC Act.


The FTC's Administrative Complaint against LabMD alleged two "security incidents," which the Commission's Complaint blamed on LabMD's alleged failure to provide reasonable and appropriate security for personal information. The first alleged incident asserted in the complaint occurred in 2008, when data security company Tiversa Holding Company informed LabMD that one of LabMD's reports containing personal information was available through a peer-to-peer file-sharing application.

The second alleged incident occurred in 2012, when documents containing personal information were found in the possession of individuals who subsequently pleaded "no contest" to identity theft charges.


With respect to the first alleged incident, the ALJ found that the evidence introduced by Commission Counsel failed to prove that either (1) "the limited exposure of the [data] file has resulted, or is likely to result, in any identity-related harm" or (2) "embarrassment or similar emotional harm is likely to be suffered from the exposure." He determined that even if there were any harm, it would be subjective or emotional harm, which is insufficient to constitute "substantial injury," as required to meet the standard of proof in Section 5(n) of the FTC Act, in the absence of evidence of any tangible injury.2

Next, the ALJ concluded that the Commission Counsel had failed to prove a causal connection between the second alleged incident and any failure of LabMD to reasonably protect data on its computer networks, because the Commission Counsel had failed to show the documents at issue had actually been maintained on, or taken from, those networks. ALJ Chappell further found that Commission Counsel had "failed to prove that this exposure has caused, or is likely to cause, any consumer harm."3

Finally, the ALJ rejected Commission Counsel's "argument that identity theft-related harm is likely for all consumers whose personal information is maintained on LabMD's computer networks, even if their information has not been exposed in a data breach, on the theory that LabMD's computer networks are 'at risk' of a future data breach," because the evidence failed to "assess the degree of the alleged risk, or otherwise demonstrate the probability that a data breach will occur."4

Next Steps and Implication

The Initial Decision is almost certainly not final, as Commission Counsel will likely appeal the decision to the full Commission, which will issue a final decision that could then be appealed by LabMD, if the Commission rules against LabMD, to the United States Court of Appeals for the DC Circuit. And the facts of the case here are certainly factually distinguishable from others (such as the enforcement action against Wyndham Hotels) where there has been a data breach and at least some alleged actual loss to consumers. However, this opinion is significant for a number of its findings.

Inadequate security alone is not enough. The opinion forcefully questions the FTC's practice of bringing enforcement actions based on alleged inadequate security alone, without evidence of the actual likelihood (rather than the mere possibility) of consumer harm. The FTC staff has brought such cases in the past, and several companies have entered into consent orders (often with burdensome third-party audit and other requirements) based on such allegations. This opinion calls such cases into doubt, and, at least while this Initial Decision is pending appeal, may discourage FTC efforts to bring such types of enforcement actions.

Allegations of consumer injury must be supported by evidence. The ALJ found no evidence of consumer harm as a result of LabMD's alleged failure to employ reasonable security measures, and found the Commission Counsel's response-that consumers may not discover they have been victims of identity theft, or that possible harm is sufficient—unsatisfactory. The ALJ noted the absence of any evidence of harm after the passage of many years, and Commission Counsel's reliance on expert testimony, which "essentially only theorizes how consumer harm could occur."5This finding is particularly interesting in light of the current split in the courts regarding the type of consumer injury required to support standing in data breach class actions.6

Questions of fairness of the adjudicative process. The procedural history of this case was complex, and the Commission itself directly resolved a number of important issues prior to the case reaching the ALJ. The ALJ repeatedly suggested that the Commission's direct involvement in the adjudication, displacing the ALJ, raises questions about fairness of FTC administrative processes. Such blunt criticism on this issue, by the Commission's chief ALJ no less, is striking and unusual. His critique is also relevant to a broader ongoing debate about the adequacy and fairness of agency enforcement actions brought before ALJs rather than in Article III courts.


1 In the Matter of LabMD Inc., Docket No. 9357 (Nov. 13, 2015) at 88, available here.
2 Id. at 13.
3 Id.
4 Id. at 13-14.
5 Id. at 52-53.
6 For example, this past July, in the class action suit against Neiman Marcus following its payment card breach, the Seventh Circuit found that preventive costs that cardholders might incur, such as credit monitoring subscriptions and replacement card fees, "easily" qualify as concrete injuries sufficient for the plaintiffs to establish standing to sue. Remijas v. Neiman Marcus Group, LLC, 794 F.3d 688, 694 (7th Cir. July 20, 2015). Prior to the Remijas decision, a number of district courts dismissed breach-related class actions, citing the holding in Clapper v. Amnesty Int'l USA, 133 S.Ct. 1138 (2013), a non-breach related case which found that "allegations of possible future injury are not sufficient" to establish standing, but that standing instead requires that harm be "certainly impending"-a standard which those courts found had not been met in the data breaches cases. See, e.g., In re ZAPPOS.COM, Inc., Customer Data Security Breach Litigation, 2015 WL 3466943 (D. Nev. June 1, 2015): Lewert et al. v. P.F. Chang's China Bistro, Inc., 2014 WL 7005097 (N.D. Ill. Dec. 10, 2014).

The full memorandum was originally published by WilmerHale on November 16, 2015, and is available here.

November 25, 2015
Navigating the Cybersecurity Storm in 2016
by Paul Ferrillo, Weil Gotshal
Editor's Note:

Paul A. Ferrillo is counsel at Weil, Gotshal & Manges LLP specializing in complex securities and business litigation. This post is based on a summary of a Weil publication; the complete publication is available here.

“Our nation is being challenged as never before to defend its interests and values in cyberspace. Adversaries increasingly seek to magnify their impact and extend their reach through cyber exploitation, disruption and destruction.”

-Admiral Mike Rogers, Head of US Cyber Command September 9, 2015

A very recent article in the UK publication The Guardian, entitled “Stuxnet-style code signing of malware becomes darknet cottage industry,” [1]raises the specter of bad actors purchasing digital code signatures, enabling their malicious code to be viewed as “trusted” by most operating systems and computers. Two recent high profile hacks utilized false or stolen signatures: Stuxnet, the code used to sabotage the Iranian nuclear program, allegedly jointly developed by America and Israel, and the Sony hack which was allegedly perpetrated by the government of North Korea. Both of these instances involve sovereign states, with effectively unlimited resources.

The Guardian article raises an interesting question that many in the cyber security industry have talked about this year, but have not discussed openly. To wit, “What if cyber maliciousness toolkits were to become available not just to nation-states (like they generally were before) but to ordinary cyber criminals and cyber gangs that might not have nation-state backing?” Or the random teenager living at home who is bored with his school work, and decides to do something more interesting one day? Doesn’t this fact indicate that the stakes have been raised now even higher with the “more public” availability of these cyber attack tool kits, leaving attackers of all kinds with a potential huge return on a relatively meager investment if they were to pull off a successful attack? The answer, like Admiral Rogers notes above, is probably “Yes, Sir. Roger that!” The next logical question is, “So now what do we do?”

For the past year we extensively researched the most important cybersecurity issues facing United States boards of directors of public and private companies, and private equity and hedge fund managing directors. We did this not to critique or comment, but because in our view it is time to raise our cybersecurity game given the cyber threat actors and cyber threat vectors we are facing today. Though there have been some tremendously helpful articles written, none of them were in the same place, and many of them were written in “tech-speak,” well beyond the bounds of comprehension of a mere mortal director (or even a mere mortal lawyer).

One of the more common complaints we heard was that the area of cybersecurity was too difficult to comprehend, too fast moving to catch up, and so far from being intuitive that directors did not have a good handle on what were the most important issues they were facing, and what were most important questions they should be asking of their company’s executives and IT resources in order to help guide their company through the cybersecurity storm.

We are proud to announce the very recent publication of our book, Navigating the Cybersecurity Storm: A Guide for Directors and Officers. Founded upon many principle-based approaches like ISO 27001 or more recently the National Institute of Standards and Technology (“NIST”) Cybersecurity Framework, our book sets forth in “plain-English” format the most important cybersecurity questions that directors should be asking when faced with areas like cloud computing, cybersecurity federal and state regulatory and compliance issues (like those being generated today by the U.S. Securities and Exchange Commission (“SEC”) and the U.S. Federal Trade Commission), information privacy issues for multi-national companies, and cyber insurance issues. These are not easy issues to address. There are probably no “right” answers to any of the questions we set forth in the chapters. But without knowing the right questions to ask, corporate and fund directors might be left on the bench during one of the most important periods of our lives—when the companies they guide are facing some of the most important threats to their corporate reputations, and indeed their corporate existence, they might ever face.

The book has multiple chapters covering most cybersecurity issues a board may face during their quarterly board meetings. Two of the most critical chapters deal with the NIST Cybersecurity Framework, and cybersecurity incident response planning. Why are they most critical? First, the NIST Cybersecurity Framework is probably the “de facto” if not “de jure” framework in the United States. It has been adopted by the U.S. Government, its agencies, and is required to be followed by its contractors. And it is referenced by many federal regulatory authorities, such as the SEC’s Office of Compliance, Inspections and Examinations. The Framework sets forth many cornerstone issues of cybersecurity. Probably the most important issue in the Framework is a relatively simple one: “What are my most important data and informational assets, how do I rank them in terms of value, where are they located, and how am I protecting them today?” Indeed, if I don’t know what are my most important assets and where they are located, then how can I consider better ways to protect them?

Finally, assuming the very good probability that most organizations have already been hacked at least once, our incident response chapter might be the most important one in the book. [2]Deploying robust antivirus software along with hardware and systems to detect anomalous activity on networks are prudent steps, but not enough. Time, effort and money must be invested to build and test a robust incident response plan to enable an organization to respond to a cybersecurity event effectively, maintain business operations and recover to full functionality as soon as possible. Sony Pictures as an organization was down for 3 weeks without having either computers or a functional phone system. This chapter should help all directors understand the cyber incident response planning process, the very critical element of cooperating with law enforcement, and potential and mandatory disclosure obligations relating to a sophisticated cybersecurity breach. Though this chapter is multi-faceted, its theme is practical: Use peacetime wisely! Prepare and plan for a cybersecurity breach well ahead of an incident, practice your plan (and different potential threats associated with today’s cyber security threat vectors such as, e.g. DDoS attacks) and be prepared to not only react, but proactively act to limit the potential damage associated with a cyberattack in order to preserve not only the corporation’s reputation, but the trust and confidence of its customer and investors. Armed with the knowledge contained in this accessible book, directors can confidently execute their duty of care with regard to cybersecurity in an informed manner. That truly, at the end of the day, is what this book is all about.


[1] This article is available at
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[2] It was written with the guidance of Austin Berglas, a former Assistant Special Agent in Charge of the Cyber Operations Division of the New York Field Office of the Federal Bureau of Investigations. See
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November 25, 2015
Rural/Metro and Disclosure Settlements
by Joel Friedlander, Friedlander & Gorris
Editor's Note:

Joel E. Friedlander is President of Friedlander & Gorris, P.A. This post relates to Mr. Friedlander’s recent article, How Rural/Metro Exposes the Systemic Problem of Disclosure Settlements. This post is part of the Delaware law series; links to other posts in the series are available here.

There is no aspect of merger and acquisitions litigation more pervasive or significant than the disclosure settlement. It is the mechanism by which stockholder claims are conclusively resolved for approximately half of all public company acquisitions greater than $100 million. [1]For that half of major acquisitions, the contracting parties and their directors, officers, affiliates, and advisors receive a court-approved global release of known and unknown claims relating to the merger in exchange for supplemental disclosures to stockholders prior to the stockholder vote. [2]The supplemental disclosures have no impact on stockholder approval of the merger. Nevertheless, in almost every such case, class counsel for the stockholder plaintiff receives a court-approved six-figure fee award for having conferred a benefit on the stockholder class.

Over the past year, the possible elimination of disclosure settlements has become a topic of discussion among academics, jurists, and the bar. The seeming impetus for this potential upheaval in merger and acquisition litigation was a law review article based on an empirical study finding that supplemental disclosures have no effect on stockholder voting, [3]plus the litigation efforts of a co-author of that article, Professor Sean J. Griffith. He has objected to disclosure settlements on the grounds that the supplemental disclosures are worthless and the global releases are pernicious.

A December 2014 decision by the Supreme Court of the State of New York stridently rejected a proposed settlement. Professor Griffith represented the objector, and the opinion cited a draft of the law review article he co-authored. [4]A month later, the Supreme Court of the State of New York rejected another disclosure settlement, following the reasoning of the earlier opinion. [5]

In July 2015, Vice Chancellor Laster of the Delaware Court of Chancery rejected on broad grounds a proposed disclosure settlement involving Aeroflex Holding Corporation (“Aeroflex“). [6]That transcript ruling referenced the same law review article co-authored by Professor Griffith and the two decisions in New York. It also urged continuation of a recent “trend in which the Court of Chancery looks carefully at these settlements.” [7]In September 2015, Vice Chancellor Glasscock approved a disclosure settlement that Professor Griffith had objected to, but stated that the global release might have been rejected as overbroad but for “the reasonable reliance of the parties on formerly settled practice in this Court.” [8]When rejecting a disclosure settlement involving Aruba Networks, Inc. (“Aruba Networks“) in October 2015, Vice Chancellor Laster referred to disclosure settlements as a “real systemic problem” in which “pseudo-litigation” has created a “misshapen legal regime.”[9]

In Section I of my article, How Rural/Metro Exposes the Systemic Problem of Disclosure Settlements, I place the current controversy over disclosure settlements in a wider historical frame. For a generation, disclosure settlements have flourished despite widespread recognition that supplemental disclosures have little value. I surmise that Vice Chancellor Laster’s call in Aeroflex and Aruba Networks for a halt to the routine approval of disclosure settlements was influenced in significant part by his oversight of In re Rural/Metro Corporation Stockholders Litigation (“Rural/Metro”) from early 2012 through early 2015.

In Rural/Metro, my law firm, currently named Friedlander & Gorris, P.A., but then named Bouchard Margules & Friedlander, P.A. (“F&G”), and co-counsel, Robbins, Geller, Rudman & Dowd LLP (“Robbins Geller”), objected to a seemingly routine disclosure settlement presented by Faruqi & Faruqi LLP (“Faruqi”) in connection with the June 2011 sale of Rural/Metro Corporation (“Rural/Metro”) to an affiliate of Warburg Pincus, LLC. We identified unexplored liability issues and submitted an expert affidavit on valuation. Vice Chancellor Laster issued a January 2012 transcript ruling rejecting the disclosure settlement, but characterizing the question as a “very close call.”[10]

Upon replacing Faruqi as class counsel, F&G and Robbins Geller litigated damages claims at significant expense. On the eve of a May 2013 trial, we entered into partial settlements for a total of $11.6 million. In 2014, we obtained post-trial rulings that the sole non-settling defendant, RBC Capital Markets, LLC (“RBC”), aided and abetted breaches of fiduciary duty by the director defendants and was liable for damages of $76 million plus pre- and post-judgment interest (i.e., over $93 million as of February 2015). RBC’s appeal of that final judgment has been fully briefed and argued in the Delaware Supreme Court and is now sub judice.

The outcome of the Rural/Metro litigation in the Court of Chancery calls into question the major premise of disclosure settlements—that a global release of claims in exchange for supplemental disclosures is justified, supposedly because it safely can be assumed that the released damages claims challenging the transaction under Revlon and its progeny (i.e., claims that a board of directors failed to act reasonably or in good faith during a sale process to obtain the highest price reasonably available) [11]have been investigated and analyzed and have been found to be weak. In Rural/Metro, original class counsel recommended the release of damages claims in exchange for supplemental disclosures (and payment of a legal fee not to exceed $475,000). Replacement class counsel spent over $1,683,000 [12]investigating the same facts and litigating the same damages claims, and recovered, subject to appeal, over $105 million.

In Section I of this article, I discuss the history of disclosure settlements and postulate that the Rural/Metro litigation prompted a decisive break with an era of routine approval of disclosure settlements. I believe the progress of the Rural/Metro litigation helps explain the sua sponte rejection of two disclosure settlements by Vice Chancellor Laster in 2014, [13]as well as his subsequent call in Aeroflex and Aruba Networks for the end of the routine approval of disclosure settlements.

In Section II of this article, I discuss the contrast between the disclosure settlement phase and the post-disclosure settlement phase of Rural/Metro and how that contrast sheds light on policy issues raised by the routine approval of disclosure settlements. I argue that a generation of routine disclosure settlements has undermined in various respects the proper functioning of a system for the judicial enforcement of fiduciary duties:

  • The widespread availability of disclosure settlements has led to the creation of a two-tier stockholder-plaintiff bar with very different approaches to litigating the same type of case. One tier of firms has adopted a business model of entering into disclosure settlements and thereby collecting risk-free fee awards near the outset of a case. These firms release Revlon claims after a purported investigation of their viability, even though they have no demonstrated track record of pursuing Revlon claims for significant monetary relief. Another tier of firms does not present disclosure settlements to the Court of Chancery, and instead litigates preliminary injunction motions and seek damages on Revlon In an unknown number of cases, firms in the disclosure settlement bar are releasing valuable Revlon claims. Firms in the disclosure settlement bar are also able to bargain for an economic share of a case in exchange for standing down in the competition for appointment of lead counsel, since otherwise a leadership contest would consume critical weeks during the pendency of a transaction that would be better utilized pursuing fact discovery.
  • The widespread availability of disclosure settlements created perverse pressures on transactional counsel and defense counsel. Lawyers for target corporations and their fiduciaries, financial advisors and purchasers rationally expect that much M&A litigation can be resolved by means of a disclosure settlement. This knowledge lessens the influence of transactional counsel to uncover or police conflicts of interest while a sale process or transaction is pending and to ensure the prompt, full disclosure of material facts. When litigation begins, defense counsel are incentivized to devote their talents to drafting supplemental disclosures amenable to a negotiated resolution, and guiding litigation along a path of least judicial oversight. Successful merits-based litigation by plaintiff’s counsel empowers transactional counsel to avoid, police, and disclose conflicts of interest. Disclosure settlements do not.
  • Routine disclosure settlements impede the development of the law. In the many cases disposed of by means of a disclosure settlement, the Court of Chancery is not deciding whether certain facts are material and must be disclosed, or whether there exists a probability of success on a Revlon claim on a motion for preliminary injunction, or whether a Revlon claim is reasonably conceivable on a motion to dismiss. Instead, the Court is generating transcript rulings impervious to appellate review about whether a given disclosure is “helpful” and what fee award it is worth. In the absence of definitive adjudication, the law of disclosure settlements remains unclarified, the same disclosure issues recur, and numerous opportunities to develop Revlon law are lost.

Disclosure settlement practice operates as a shadow, parallel legal system within the Court of Chancery competing for judicial resources with a full docket of adversarial litigation. The institutionalization of routine disclosure settlements parodies the procedures for adjudicating claims of breach of fiduciary duty.

The complete publication is available here.


[1] See Olga Koumrian, Cornerstone Research, Shareholder Litigation Involving Acquisitions of Public Companies—Review of 2014 M&A Litigation. 1 & fig.1, 4 & fig. 5, 5 & fig. 6 (2015). (Discussed on the Forum here).
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[2] Typically, supplemental disclosures are the sole form of settlement consideration. Such settlements are sometimes known as “disclosure-only” settlements. In a relatively small number of cases, supplemental disclosures are accompanied by minor changes to the acquisition agreement. These settlements are sometimes known as “disclosure-plus” settlements. For convenience, I refer to both types of settlements as “disclosure settlements.”
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[3] Jill E. Fisch, Sean J. Griffith & Steven Davidoff Solomon, Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform, 93 Tex. L. Rev. 556 (2015) [hereinafter, “Confronting the Peppercorn Settlement”].
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[4] Gordon v. Verizon Communications, Inc., 2014 WL 7250212 (Sup. Ct. N.Y. Dec. 19, 2014).
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[5] City Trading Fund v. Nye, 9 N.Y.S. 592 (Sup. Ct. N.Y. 2015).
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[6] Acevedo v. Aeroflex Hldg. Corp., C.A. No. 7930-VCL, tr. (Del. Ch. July 8, 2015).
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[7] Id. at 67-68.
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[8] In re Riverbed Technology Inc. S’holder Litig., Cons. C.A. No. 10484-VCG, mem. op. at 15 (Del. Ch. Sept. 17, 2015).
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[9] In re Aruba Networks, Inc. S’holder Litig., Cons. C.A. No. 10765-VCL, tr. at 65, 70, 72 (Del. Ch. Oct. 9, 2015) [hereinafter “Aruba Networks”].
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[10] In re Rural/Metro Corp. S’holders Litig., Cons. C.A. No. 6350-VCL, tr. at 134 (Del. Ch. Jan. 17, 2012).
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[11] See Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242 (Del. 2009) (discussing “Revlon duties” and citing Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 182 (Del. 1986)). For convenience, I refer generally to damages claims as “Revlon claims,” without regard for other standards of review or precedents that may be applicable when a corporation is sold for cash.
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[12] This sum is compiled from the following affidavits filed in Rural/Metro: Randall J. Baron Aff. (Oct. 16, 2013) ($672,498.97); Joel Friedlander Aff. (Oct. 16, 2013) ($623,712.90); Randall J. Baron Aff. (Oct. 29, 2014) ($206,020.21); Joel Friedlander Aff. (Oct. 29, 2014) ($180,849.82).
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[13] Rubin v. Obagi Medical Products, Inc., C.A. No. 8433-VCL (Del. Ch. Apr. 30, 2014); In re Theragenics Corp. S’holders Litig., Cons. C.A. No. 8790-VCL (Del. Ch. May 5, 2014).
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November 25, 2015
Shedding Light on Dark Pools
by Luis Aguilar
Editor's Note:

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement at an open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today, [November 18, 2015], the Commission considers proposing much-needed enhancements to the regulatory regime for alternative trading systems ("ATSs") that trade national market system ("NMS") stocks. I will support these proposals because they could go a long way toward helping market participants make informed decisions as they attempt to navigate the byzantine structure of today’s equity markets.

The Role that ATSs Play in Our Markets Today

ATSs reportedly first appeared in the late 1960s, but they truly began to flourish after the Commission’s 2005 adoption of Regulation NMS. Today, there are more than 40 active ATSs registered with the Commission, and those that trade NMS stocks have, by some estimates, accounted for nearly 18% of all trading in those stocks at various times over the past two years.

That figure represents a more than fourfold increase since 2005, when ATSs accounted for roughly 4% of NMS stock trading. In fact, some ATSs now execute a larger portion of consolidated volume than smaller exchanges do. The ascendance of ATSs in recent years is the result of a confluence of factors, including a prolonged period of subdued market volatility and the ability of ATSs to offer certain advantages, such as attractive fee structures, price improvements, and faster processing speeds, among others.

Yet, perhaps the greatest catalyst for the rise of ATSs in recent years has been institutional investors' growing need to trade large blocks of stock without causing markets to move against them. This need is not new, but it has become increasingly acute with the advent of algorithmic trading strategies and the diminished order sizes that have resulted. ATSs responded to this need by offering ever more trading on an anonymous basis, and without displaying specific order information before trades occur. These types of ATSs have come to be known as "dark pools."

Dark pools initially portrayed themselves as havens from predatory traders. They achieved this, in part, by excluding high frequency traders, who supposedly use brute speed to front-run institutional investors’ large orders. Lured by this promise of safety, institutional traders embraced ATSs as a solution to their trading needs. Unfortunately, all too often the safety these investors sought proved illusory.

Bad Things Can Happen in the Dark

Attracting sufficient liquidity to achieve critical mass has proven a continuous challenge for many dark pools. They have addressed this existential problem in various ways. For example, many dark pool operators have allowed their own proprietary trading desks to have access to their pools, while other operators have allowed their affiliates to trade within their pools. And still other operators have given high-speed traders access to their dark pools, all in an attempt to ensure that ATS subscribers will find counterparties for their trades as quickly and consistently as possible.

Setting aside the propriety of these approaches, their adoption suggests that the implacable need that dark pools have for liquidity has intensified certain conflicts of interest between them and their subscribers. The inability to properly manage these conflicts of interest has led the Commission to bring a number of enforcement actions against dark pool operators in recent years. For example, in 2011, the Commission brought an enforcement action against one dark pool operator for falsely advertising that no proprietary trading took place in its dark pool. In reality, one of the operator’s affiliates not only engaged in proprietary trading in the pool, but it also secretly enjoyed unfair informational advantages, which it used to front-run subscribers’ trades.

The lesson from this case, however, apparently fell on deaf ears. For just a few months ago, the Commission settled another enforcement action against one of the oldest dark pool operators because it, too, had failed to disclose that it was engaged in proprietary trading within its pool.

That dark pool operator also gave its proprietary trading desk an unfair informational edge over other subscribers, despite guidance from the operator’s compliance department that this was improper.

Of course, conflicts of interest come in many guises. For example, the Commission has brought enforcement actions against dark pools for failing to protect their subscribers’ confidential information. And, just last year, the Commission brought an enforcement action against one operator of a large dark pool because, among other things, it secretly offered high speed traders special order types that gave them an unfair advantage over other subscribers. Interestingly, this savvy dark pool operator knew how to play both sides of the fence. In addition to giving high frequency traders an unfair edge, this operator secretly allowed certain of its favored subscribers to avoid trading with those very same high frequency traders.

This dismal litany of misconduct by dark pool operators appears to have led at least some market participants to lose faith in the ability of dark pools that are operated by broker-dealers to provide a level playing field. Bereft of regulatory intervention, these market participants seem to be taking matters into their own hands. Nine of the largest asset managers have banded together to form their own dark pool, one that is operated by and open exclusively to institutional investors. According to reports, one of the goals of this new “buy-side institutions only” dark pool is to “eliminat[e] the types of profit driven conflicts of interest that have been seen in some existing venues.” This action by buy-side investors with approximately $14 trillion in assets under management seems to be a clear warning the markets aren’t working as well as they could, a warning that has gone unheeded for far too long.

Shining a Light on Dark Pools

A common thread running through the enforcement actions against dark pools is that market participants lack crucial information about how these ATSs function—and about the serious conflicts of interest they can harbor. Today, the Commission takes steps toward shedding much needed light onto dark pools by requiring certain ATSs to be more transparent, and by requiring them to undergo Commission review to ensure that they qualify for the exemption from registering as an exchange. The rules and amendments proposed today will require ATSs that trade most types of equities to furnish both investors and the Commission with much more detailed information about their operations. Importantly, many of the disclosures that today’s proposal would require should reveal the very types of conflicts of interest that lay at the heart of the enforcement actions brought against dark pools by the Commission and other regulators.

For example, the proposal would require operators of covered ATSs to disclose whether they or any of their affiliates are submitting trades to the ATS, either on a proprietary basis or otherwise. Covered ATSs would also be required to publicly disclose whether they or a subset of their subscribers enjoy any advantages over other subscribers, such as special order types and preferential access to trade information. The proposal would also require covered ATSs to disclose their policies and procedures for ensuring the confidentiality of subscribers’ information, and these ATSs would also have to identify the positions of employees and third parties that have access to this information.

The additional disclosures that would be required under today's proposal will go a long way toward enabling investors and broker-dealers to make more informed decisions about which ATSs they may wish to route their orders to. But the Commission should not stop there. Instead, the Commission should give careful consideration to whether additional measures are warranted. For example, are the conflicts of interest confronting many ATSs so intractable that ATSs should simply be prohibited from engaging in any activity other than operating the ATS?

In addition, the Commission should dust off its 2009 proposal regarding non-public trading, and determine whether the threshold for ATSs to display their orders should be lowered to account for their much larger role in today’s equity markets.

Additionally, I hope that the Commission will examine whether Regulation ATS should be expanded to include platforms that trade government securities exclusively, and what information those entities should publicly disclose about their operations. The release includes questions on these and other important issues, and I urge commenters to weigh in with their views so that the Commission will be able to pursue new rules with the benefit of the knowledge, views, and experiences of a variety of market participants.

The Road Ahead

Looking more broadly at our evolving market structure, it seems clear that ATSs will continue to play an important role in the coming years. Yet, the precise contours of that role, and the implications it may hold for investors, are not immediately evident. In particular, I think the Commission should explore certain issues as it seeks to better oversee our markets.

  • First, given that the average trade sizes on dark pools that trade equities have fallen to the same levels as those seen on lit exchanges, what is the future of block trading? Does that future differ for large-cap and smaller cap stocks? And does block trading need to be re-conceptualized to account for the algorithm-driven trading that dominates today’s markets? For example, should market participants redefine block trades as a percentage of average daily trading volume, rather than as a fixed number of shares?
  • Second, can ATSs attract sufficient liquidity to remain viable without engaging in the types of misconduct that have given rise to the enforcement actions I mentioned earlier? Can ATSs survive without the participation of high frequency and other algorithmic traders? If not, can ATSs facilitate meaningful block trading?
  • Third, does the current regulatory structure favor the expansion of dark pools? If so, what does this portend for the complexity and fragmentation of our equity markets? Should the Commission consider limiting the growth of equity ATSs, especially if that growth begins to threaten the quality of price discovery, as some studies suggest it might? Alternatively, should the Commission consider curbing the volume of orders that are executed in dark pools, as the second Directive on Markets in Financial Instruments, or MiFID II, will do for smaller orders in Europe? In any case, I think the Commission should monitor this European experiment, and see what lessons can be drawn.
  • Fourth, are ATSs the best model to facilitate block trading? If not, what other approaches might fare better? Why have recent efforts to establish trading venues for block trades failed to return block trading to pre-financial crisis levels, despite clear interest from market participants to engage in such trades?
  • And finally, can ATSs for fixed income securities potentially fill the vacuum created by the retrenchment of traditional broker-dealer activity in those markets?

Clearly, the relentlessly changing nature of our capital markets requires the Commission to be a proactive participant, knowledgeable and informed as to market innovations and trends. The public is not well-served when the SEC lacks information or is merely a passive observer. Today’s proposed rules will enable the Commission, our staff, and the public to have better visibility into what has been a murky segment of the market.

Ultimately, an informed regulator is a more effective regulator, and an effective regulator is vital for investor confidence and market integrity.


In conclusion, I will vote to approve these proposed rules and amendments because they mark a significant step forward in the Commission’s efforts to enhance the oversight of ATSs that play a vital role in today’s equities markets. I remain mindful, however, that there is still much work to do to ensure that investors have access to the types of disclosures they need in order to make informed decisions.

Lastly, I would like to call attention to the efforts of the Division of Trading and Markets, the Division of Economic and Risk Analysis, and the Office of General Counsel and to their hard work and diligence.

November 25, 2015
ISS: QuickScore 3.0 & Updated "Equity Plan Scorecard FAQ"
by Broc Romanek

A few days ago, ISS released QuickScore 3.0, which doesn't have too many tweaks. US subscribers will now be able to determine whether companies across the Russell 3000 allow for proxy access or the ability of shareholders to nominate directors. And this Mike Melbinger blog explains the updated "Equity Plan Scorecard FAQs":

ISS made a few changes to the its new EPSC tool (expect more), including: (a) renamed as "CIC Vesting," the Plan Features factor formerly known as "Automatic Single-Trigger Vesting" and changed the scoring levels plan provisions on the accelerated vesting of outstanding awards on a change in control; (b) increased the period required for full points with respect to the Post-Vesting/Exercise Holding Period Plan Feature to 36 months (versus 12 months previously); (c) re-named the "IPO" model as "Special Cases," to analyze companies with less than three years of disclosed equity grant data (generally, IPOs and bankruptcy emergent companies); (d) added a new Special Cases model that includes Grant Practice factors other than Burn Rate and Duration will apply to Russell 3000/S&P 500 companies; and (e) adjusted certain factor scores in ISS' proprietary scoring model. More to come on EPSC issues in future blogs.

Happy Holidays! A Little Zach Deputy…

Enjoy yourself! I'm going to be listening to the one man band of Zach Deputy...

Broc Romanek

November 24, 2015
Updated Compensation Peer Groups for ISS and Glass Lewis
by Terry M. Schpok & Nancy Sarmiento

Institutional Shareholder Services ("ISS") is now accepting updates to a company's list of self-selected peers until 8:00PM EST on December 11, 2015.  In determining the comparison group used by ISS in its evaluation of a company's pay-for-performance, ISS will consider the list of peers self-selected by the subject company.  If no updated peers are provided, ISS will consider the peers most recently disclosed by the company as of December 2015.  The current update period is available for companies with annual meetings between February 1, 2016 and September 15, 2016.  There will be a separate peer submission process in mid-2016 for companies with annual meetings after September 15, 2016.  For FAQs regarding ISS peer group selection methodology, please click here.  The form for submitting updated peers can be accessed here.

Equilar, used by Glass Lewis in its say-on-pay analysis, updates its peer groups in January and July of each year and is now accepting updates until December 31, 2015 for companies filing a proxy statement between January 15, 2016 and July 14, 2016.  Glass Lewis has indicated that it does not change the peer group selection it receives from Equilar.  Please click here for Equilar's peer group update FAQs and here to update a Company's list of self-selected peers on Equilar's peer group update portal.

View today's posts

11/25/2015 posts

CLS Blue Sky Blog: Too Big to Tax? Vanguard and the Arm's Length Standard
CLS Blue Sky Blog: WilmerHale reports ALJ Dismisses FTC's LabMD Complaint for Lack of Actual or Probable Consumer Harm from Cybersecurity Incidents
HLS Forum on Corporate Governance and Financial Regulation: Navigating the Cybersecurity Storm in 2016
HLS Forum on Corporate Governance and Financial Regulation: Rural/Metro and Disclosure Settlements
HLS Forum on Corporate Governance and Financial Regulation: Shedding Light on Dark Pools Blog: ISS: QuickScore 3.0 & Updated "Equity Plan Scorecard FAQ"
AG Deal Diary: Updated Compensation Peer Groups for ISS and Glass Lewis

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