Securities Mosaic® Blogwatch
April 23, 2015
Delaware Chancery Awards Investors $171 Million
by Jason M. Halper

On April 20, 2015, the Delaware Court of Chancery issued a decision awarding $171 million in damages to the common unitholders of a limited partnership against its general partner in connection with a "dropdown" transaction. The decision is the latest in a series of decisions by the Chancery Court concerning the conduct of directors and advisers in conflict of interest and/or sale of the company transactions. See also In re Rural/Metro Corp. S'holders Litig., No. 6350-VCL (Del. Ch. Oct. 10, 2014); Chen v. Howard-Anderson, No. 5878-VCL (Del Ch. April 8, 2014); In re Orchard Enter., Inc. S’holder Litig., No. 7840-VCL (Del. Ch. Feb. 28, 2014). The decision yet again highlights areas that should be of concern to boards and their advisers in such transactions.

Background

El Paso Pipeline concerns a series of related-party transactions known as dropdowns, in which a controlled entity purchases assets from its parent. In the energy industry, companies often "drop" terminal, storage and pipeline assets into a controlled limited partnership in order to obtain tax advantaged, low cost capital via the cash paid by the controlled entity for the asset. The El Paso Corporation ("EPC"), a natural gas and energy provider that has since been acquired by Kinder Morgan, controlled El Paso Pipeline Partners, L.P. ("El Paso Partners") through the ownership of its sole general partner (the "General Partner"). In March 2010, EPC executed the first of the challenged dropdowns, selling a 51% stake in one of its subsidiaries ("Elba"), a natural gas terminal and pipeline owner, to El Paso Partners for approximately $963 million in cash (the "Spring Dropdown"). Then, in November 2010, EPC sold El Paso Partners the remaining 49% interest, plus a 15% interest in another EPC subsidiary ("Southern") for $1.412 billion (the "Fall Dropdown").

Both of these transactions were evaluated and approved by a committee of three directors of the General Partner's board (the "Committee"). The Committee was advised on both occasions by outside counsel and a financial adviser, Tudor, Pickering, Holt & Co. ("Tudor").

In late 2011, plaintiff-unitholders in El Paso Partners sued the General Partner, challenging both the Spring and Fall Dropdowns and alleging that, in approving the transactions, the General Partner breached a provision of the limited partnership agreement (the "Agreement") requiring that the Committee members "subjectively believe" that the dropdowns were in the "best interests" of El Paso Partners. The Court granted defendants summary judgment as to the Spring Dropdown, but permitted the case to proceed as to the Fall Dropdown. After a bench trial, Vice Chancellor Laster found that the Committee members had not formed a subjective belief that the Fall Dropdown was in the best interests of El Paso Partners. The Court held that the Committee members "viewed [El Paso Partners] as a controlled company that existed to benefit [EPC]" and, consequently, failed to "vigorously" vet the deal or negotiate with EPC to obtain the best possible price. The Court also concluded that Tudor manipulated its financial analysis in order to make the transactions appear more favorable to El Paso Partners then in fact they were. The Court found that the General Partner breached the Agreement and awarded plaintiff-unitholders $171 million in damages.

Takeaways and Analyses

  • The Court found that the Committee members "subordinated their independently held views to [EPC's] wishes." In September, for instance, one member of the Committee emailed another that it was "really not in the best interests of [El Paso Partners] to have too much of its interests tied up" in Elba. The other Committee member replied, "it is as though you are reading my mind." These and similar comments "evidenced the Committee members' actual belief that it was not in the best interests of [El Paso Partners] to buy more of Elba in 2010." But, only two months later, those Committee members supported doing just that, approving El Paso Partners' acquisition of the remaining 49% of Elba. Based on this about-face, the Court concluded that the Committee had simply "caved in to" EPC's wishes. Additionally, during negotiations with EPC regarding the Fall Dropdown, the Committee members abandoned the price ranges that they had said in emails they believed were fair in favor of a higher range that obviously benefitted EPC. Again, the Court attributed this decision to the Committee members' "wanting to please [EPC] management" and "rationaliz[ing] away [their] objections...to satisfy [EPC's] desires."

An abrupt change of heart—whether by a member of a deal committee or a financial adviser-will invite sharp judicial scrutiny. Here, evidence showed that the Committee members had formed views on the fall transaction-and communicated those views to each other contemporaneous with their consideration of the transaction-but flip-flopped after speaking with and under pressure from EPC. Additionally, the Court found the Committee members' contemporaneous emails (which revealed a reluctance to acquire more of Elba) more persuasive than what it characterized as their different, "litigation-driven" testimony at trial. Although it should go without saying, counsel needs to carefully consider its litigation strategy and trial presentation in light of the powerful effect of contemporaneous writings and communications.

  • The Court found that, in negotiating the Fall Dropdown, "the Committee members consciously disregarded the learning they supposedly gained from the Spring Dropdown." After the Spring Dropdown was consummated, the market responded negatively-common units of El Paso Partners traded down 3.6% on the news. In response to the market reaction, one of the members of the Committee wrote to his colleagues that "next time we will have to negotiate harder." However, the Court found that the Committee did not attempt to "negotiate harder" in connection with the Fall Dropdown. While the Committee asked for and received a 3% ($48 million) reduction in the asking price, overall it did not make "the types of arguments that one would expect a motivated bargainer to make." For example, the Committee did not advocate for a lower price in the fall based on the fact that El Paso Partners was acquiring a minority stake. Additionally, the Committee did not cite the "deterioration in the [liquefied natural gas] market" since the spring as a basis to reduce the price. And, when the deal closed, El Paso Partners ended up paying $31 million more for the 49% stake than the parties had previously agreed upon, thereby negating most of the 3% price reduction (an outcome attributable to the Committee’s failure to analyze and negotiate separate prices for the two assets at issue in the Fall Dropdown).

This aspect of the decision recalls the saying "Fool me once, shame on you. Fool me twice, shame on me." The Committee realized that it had agreed to an unfavorable deal in connection with the Spring Dropdown. However, the Committee did not take that lesson to heart and alter its bargaining strategy to avoid the same mistakes in connection with the Fall Dropdown. When negotiating a transaction, a committee and its advisers need to negotiate forcefully on behalf of the entity they represent and take into account developments following prior comparable deals.

  • The Court observed that while the Committee members were outside directors who met the NYSE's audit committee independence standards, two had significant ties to EPC. Each had been a high ranking executive at EPC or an affiliate and still had a significant portion of his net worth tied up in the company. These relationships called the Committee's independence into question. The Court also recognized that Tudor, the financial adviser, was retained "as a matter of course" for each of the dropdowns involving El Paso Partners, had engaged in "back-channel" discussions with EPC concerning these transactions-thereby circumventing the Committee-and structured its fee so it was contingent on a dropdown being consummated.

This decision underscores the importance a court will attribute to the existence of a truly independent deal committee. Although this case was examined under a contractual standard (as opposed to the standards typically applied in public company deals such as the business judgment rule or entire fairness), the Court was clearly bothered by the Committee's connections to the parent company. Directors should take care to ensure that deal committee members do not have material ties to the controlling or counter party and are afforded and exercise sufficient discretion to negotiate forcefully on behalf of the entity they represent.

  • The Court found that the Committee had failed to inform itself about relevant, potentially comparable transactions in assessing whether El Paso Partners was paying a fair price in the Fall Dropdown. In February 2010, EPC was offered the opportunity to purchase a 30% interest in a Mississippi natural gas terminal at a price that implied a multiple of 9.1x 2010 EBITDA (which was significantly lower than the multiple proposed by EPC in connection with the Fall Dropdown). EPC declined to purchase the 30% interest and the CEO characterized the opportunity as "not a pretty picture." Then, shortly after the Spring Dropdown had been consummated, another energy company had sold a 30% interest in an arguably comparable liquefied natural gas entity for $104 million. The Committee, however, seemingly did nothing to inform itself about why EPC had passed on the opportunity to purchase an interest in a natural gas asset or the details of the $104 million transaction.

One way to determine whether the Fall Dropdown was in the best interests of the partnership was to analyze similar deals. The fact that the Committee and its advisers knew about but failed to investigate transactions that might be comparable was significant to the Court. In discussing this issue, it stated that the Committee members "consciously disregarded" their own views and available information. Directors and advisers need to unearth and understand relevant information, and certainly not turn a blind eye to comparable transactions.

  • The Court also found that the Committee members were focused on the wrong metric: "[r]ather than concluding that the Fall Dropdown was in the best interests of [El Paso Partners], the Committee members determined that [the transaction] was accretive." In this context, an "accretive" transaction is one that increases earnings per share. At trial, one of the Committee members explained that "our job was to look out for the best interests of the unaffiliated unitholders" and the paramount consideration was to "increas[e] cash distributions to the unitholders." The Court disagreed, finding that "[a]n accretion analysis says nothing about whether the buyer is paying a fair price" because "anyone can make a deal look accretive just by playing with the consideration used." In becoming "myopically" fixated on short-term accretion to the unitholders and ignoring the deal's long-term potential to add value, the Committee "failed to carry out their known contractual obligation to determine whether the Fall Dropdown was in the best interests of [El Paso Partners]."
In evaluating a potential transaction, the Committee was charged with determining whether the deal is in the "best interests" of the organization. To Vice Chancellor Laster, however, "best interests" did not mean "short term profits" for a business that was continuing as a going concern. Rather, the Committee should have assessed whether the transaction added long term value. Here, the Committee did not identify any economic benefit to the limited partnership other than an increase in short-term cash flows.

  • In very strong terms, the Court took issue with the role played by the General Partner’s financial adviser, finding that "Tudor's work product further undermined any possible confidence in the Committee." In addition to engaging in suspicious "back-channel" communications with EPC (an entity it did not represent), the Court found that Tudor did not fairly evaluate the Fall Dropdown and instead "manipulated its presentations [to the Committee] in unprincipled ways to justify the deal." Among other criticisms, the Court found:
    • Tudor did not use "appropriate numbers for its [discounted cash flow] analysis": When it valued the 49% Elba interest, Tudor used El Paso Partner's cost of capital rather than the cost of capital for the entity it was acquiring. The Court found that there was no basis for doing so because the "the measure of risk inherent in the cash flows" should be derived from the asset being purchased, not the acquirer. And by using the cost of capital for El Paso Partners, a domestic pipeline business, Tudor did not capture the risks associated with an "import terminal."
    • Tudor manipulated the discount rate: In performing its analysis of previous dropdowns, Tudor’s report included a discount rate range between 8% and 14.5%. While Tudor claimed to have used the same inputs for the Fall Dropdown, Tudor "cut off the upper bound at 12%...[and] could not provide any explanation for this [change]."
    • Tudor manipulated the precedent transaction analysis: In the report prepared for the Spring Dropdown, Tudor had divided its precedent transactions in separate minority-acquisition and majority-acquisition groups (depending on whether El Paso Partners purchased a majority or minority stake in the EPC subsidiary being sold). For the Fall Dropdown, where El Paso Partners purchased a minority 49% interest, "Tudor lumped all of the precedents together without calling the change to the Committee's attention and explaining it."

Ultimately, the Court found that Tudor had simply "crafted a visually pleasing presentation designed to make the dropdown of the moment look as attractive as possible." In other words, "Tudor's real client was the deal, and the firm did what it could to justify the Fall Dropdown, get to closing, and collect its contingent fee."

The Court described the "real work of an adviser to a committee" as "helping...develop alternatives, identify arguments, and negotiate with the controller." Obviously, the Court concluded that Tudor did not do that here. As in Rural/Metro and Chen, the Chancery Court will view with great skepticism any effort to rig a financial analysis to fit a preordained conclusion. A court's assessment of a committee's evaluation of a transaction will be adversely impacted, perhaps fatally, when there is evidence of this type of manipulation by a financial adviser that goes unquestioned by a committee.

April 24, 2015
Delaware Court Faults Committee Process & Advisory Work in Finding Lack of Good Faith
by See Editor's Note

Editor's Note:

William Savitt is a partner in the Litigation Department of Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Savitt, Jonathan M. Moses, and Ryan A. McLeod. 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.

On April 20, 2015, the Delaware Court of Chancery entered a $171 million post-trial judgment after finding a master limited partnership overpaid for assets from its parent. In re El Paso Pipeline Partners L.P. Derivative Litig., C.A. No. 7141-VCL (Del. Ch. Apr. 20, 2015).

On April 20, 2015, the Delaware Court of Chancery entered a $171 million post-trial judgment after finding a master limited partnership overpaid for assets from its parent. In re El Paso Pipeline Partners L.P. Derivative Litig., C.A. No. 7141-VCL (Del. Ch. Apr. 20, 2015).

The case concerned a 2010 "dropdown" transaction in which El Paso Pipeline Partners L.P. purchased assets from its controlling parent entity, El Paso Corporation. The limited partnership agreement governing the MLP permitted such transactions so long as they were approved by a conflicts committee whose members believed in good faith that the transaction was in the best interests of the MLP. After the parent proposed a dropdown transaction, the MLP's committee retained legal and financial advisors and negotiated revised terms. Although the committee members initially expressed reservations about aspects of the proposed transaction in light of an earlier dropdown deal, each testified that he ultimately concluded that the transaction was in the best interests of the MLP, stressing that it was immediately accretive to the holders of the MLP's common units. After receiving a fairness opinion from its financial advisor, the committee approved the transaction and litigation ensued.

After trial, the Court of Chancery declined to credit the committee members' testimony as to their own state of mind, holding that the directors did not hold a good faith view that the transaction was in the MLP's best interests. The Court criticized the committee for "fixat[ing] myopically on accretion," for failing to make "the types of arguments that one would expect a motivated bargainer to make" in the negotiations, for failing to learn from past negotiating failures with its controlling parent entity, and for merely "[going] through the motions" before capitulating to "a determined controller." Thus, notwithstanding the trial testimony, the Court concluded that the committee members "consciously disregarded their own independent and well-considered views about value" in approving the dropdown. The Court further held that the committee's financial advisor, motivated by the prospect of "future business" from the controller, "manipulated its presentations in unprincipled ways." The Court found that the advisor "did not use appropriate numbers" in its analyses but instead "did what it could to justify the [d]ropdown, get to closing, and collect its contingent fee." The Court thus rejected the advisor's evaluation work and adopted the lower valuation proffered by the plaintiff's expert.

While no doubt driven by the specific facts of this case, the Court's willingness to discredit the committee's testimony about its own subjective opinions further emphasizes the importance of contemporaneous documentation of deal negotiations and processes. The decision also continues the recent trend of Delaware's intense scrutiny of financial advisors and reaffirms the special need for careful process in controller transactions, even in the context of transactions involving MLPs where the entire fairness doctrine typically does not apply.

April 24, 2015
Chancery to Decide Advancement Issue for CEO of Coal Mining Company
by Francis Pileggi

The Delaware Court of Chancery is scheduled to hear post-trial oral argument in connection with its expected ruling on a claim for advancement of the ex-CEO of Massey Energy, a coal mining company, who is scheduled to go on trial for criminal charges in connection with the death of 29 minors. One of the issues is whether an agreement can modify rights otherwise mandated (once triggered) by Section 145 of the Delaware General Corporation Law. Recent Chancery decisions on advancement have shown judicial impatience with companies that do not pay advancement when the court determines that those payments are required. Past decisions have found some provisions in agreements that purport to limit advancement to be in conflict with the provisions of Section 145. Those same decisions have described this type of corporate litigation to be both contentious and expensive.

Frank Reynolds of Thomson Reuters has written a helpful overview with background details on the case. A few days ago I provided a link to a chapter I wrote on recent key decisions about advancement cases around the country (including Delaware).

The post Chancery to Decide Advancement Issue for CEO of Coal Mining Company appeared first on Delaware Corporate and Commercial Litigation Blog.

April 24, 2015
This Week In Securities Litigation (Week ending April 24, 2015)
by Tom Gorman

The Department of Justice unsealed criminal charges against a U.K. trader who is alleged to have contributed to the flash crash almost five years ago. The trader is alleged to have manipulated the market for certain instruments on the CME in Chicago.

Actions brought by the SEC this week largely reflect the broken-windows enforcement approach being followed by the agency. They include two stop order proceedings, three offering fraud actions, a proceeding based on MSRB Rules involving a sale to one customer, an action for failing to make filings after going dark for a period, another for not properly preparing reports for the board of trustees of certain funds and one centered on a conflict by a portfolio manger.

SEC

Whistleblowers: The Commission awarded over $1 million to a compliance professional for information that proved beneficial in an enforcement action.

Remarks: Commissioner Michael Piwowar delivered remarks at the University of South Carolina and UNC-Charlotte 4th Annual Fixed Income Conference, Charlotte, N.C. (April 21, 2015). The Commissioner addressed current challenges in the fixed income market (here).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 0 civil injunctive cases and 9 administrative actions, excluding 12j and tag-along proceedings.

Stop Order: In the Matter of the Registration Statement of International Precious Metals, Inc., Adm. Proc. File No. 3-16511 (April 23, 2015). The Order alleges that the registration statement for the firm, which claims to have one officer and director, is false and misleading because it has not disclosed its officers and directors and control person. The matter will be set for hearing.

Stop Order: In the Matter of the Registration Statement of Kismet, Inc., Adm. Proc. File No. 3-16510 (April 23, 2015) is a proceeding in which the firm claims to be dependent on the efforts of one person. The firm has failed to respond when served with an investigative subpoena on three dates. The subpoena sought the testimony of the sole officer and director. The matter will be set for hearing.

Touting: In the Matter of Huston American Energy Corp., Adm. Proc. File No. 3-1600 (August 4, 2014) is a previously filed action which names in the caption the firm, John Terwilliger, its CEO, and Undiscovered Equities, Inc., a public relations firm, and its President, Kevin McKnight. The Respondents are Undiscovered Equities and Mr. McKnight. The Order alleges that in 2009 Huston American publicized on its website that it had entered into a contract with Undiscovered Equities to increase the awareness of the investment community about Huston American. Other publicity repeated the claim. The amount of compensation was not disclosed. The proceeding was resolved with an undertaking by Mr. McKnight not to enter into any arrangements such as the one here for five years. In addition, each Respondent consented to the entry of a cease and desist order based on the Section cited in the Order. Mr. McKnight will pay a civil penalty of $22,500. Initially Mr. McKnight and Undiscovered Equities were charged in the Order alleging the offering fraud described below.

Offering fraud: In the Matter of Houston American Energy Corp., Adm. Proc. File No. 3-16000 (Filed August 4, 2014) is a previously filed action which initially named as Respondents each person listed in the caption of the action discussed above. In this Order, which is the settlement, only Huston American and Mr. Terwilliger are named as Respondents. The Order alleged an offering fraud as detailed here. Houston American and Mr. Terwilliger resolved the proceeding, consenting to the entry of a cease and desist order based on Securities Act Section 17(a) and Exchange Act Section 10(b) and 20(b). Mr. Terwilliger will pay a civil money penalty of $150,000 while the company will pay $400,000.

Offering fraud: In the Matter of Edward M. Daspin, Adm. Proc. File No. 3-16509 (April 23, 2015) is a proceeding which names as Respondents: Edward Daspin, founder and control person of the companies, Luigi Agostini, a director and COB of the companies, and Lawrence Lux, a director and CEO of the companies. Related entities include three companies and two entities that are consultants to the three companies. Beginning in December 2010, and continuing for another 18 months, two of the companies raised about $2.47 million from seven investors, at least $2 million of which was raised fraudulently. Mr. Daspin, the organizer of the scheme, targeted unemployed professional and solicited them for what was called a job interview. At the interview the executives were solicited to invest in the companies with a series of false statements. The companies never generated any revenue and quickly burned through the investor funds. The Order alleges violations of Exchange Act Sections 10(b) and 15(a) and Securities Act Sections 5(a), 5(c) and 17(a)(2) and (3). The action will be set for hearing.

Sale below minimum: In the Matter of State Trust Investments, Inc., Adm. Proc. File No. 3-16507 (April 23, 2015) is a proceeding which names the broker-dealer as a Respondent. The Order alleges that the firm sold non-investment grade bonds issued by the Commonwealth of Puerto Rico in violation of Municipal Securities Rulemaking Board Rule G-15(f) which sets a minimum denomination below which such bonds cannot be sold. Specifically, in March 2014 the firm made one sale of Puerto Rico bonds to a customer below the $100,000 minimum. The sale also violated MSRB Rule G-17 by not disclosing the minimum to the customer. To resolve the matter the firm consented to the entry of a cease and desist order based on the two MSRB Rules cited in the Order and to a censure. In addition, the firm will review the adequacy of its compliance procedures and pay a civil money penalty of $90,000.

Filings: In the Matter of W2007 Grace Acquisition I, Adm. Proc. File No. 3-16504 (April 22, 2015) is a proceeding which names the firm as a Respondent, a real estate investment entity that at one time was a reporting issuer. It went dark when the number of shareholders declined below 300, filing a Form 15 to suspend the requirement for filing periodic reports. Under Section 15(d) if the number of shareholders exceeds 300 on the first day of a fiscal year in the future, reports must be filed. Here the firm miscounted the number of shareholders as of January 1, 2014 by improperly treating certain distinct corporations and custodial accounts as single holders of record. The firm failed to begin making filings as required. The Order alleges violations of Exchange Act Section 15(d). To resolve the matter Respondent consented to the entry of a cease and desist order based on the Section cited in the Order, will resume filing periodic reports and agreed to pay a penalty of $640,000.

Required board reports: In the Matter of Kornitzer Capital Management, Inc., Adm. Proc. File No. 3-16503 (April 21, 2015) is a proceeding which names as Respondents the registered investment adviser and its CCO, Barry Koster. Kornitzer Capital managed certain funds which had a common board of trustees. Each year the board required a report analyzing the performance of the adviser. Mr. Koster prepared reports for the board beginning in 2010 and continuing through 2013. That report included expense allocation and represented that the adviser allocated employee compensation expenses based on estimated labor hours. In fact the estimates were manipulated to show consistent performance by the adviser. This violated Section 15(c) of the Investment Company Act. To resolve the matter each Respondent consented to the entry of a cease and desist order based on the Section cited in the Order. In addition, the adviser will pay a penalty of $50,000 while Mr. Koster will pay $25,000.

Conflicts: In the Matter of BlackBock Advisors, LLC, Adm. Proc. File No. 3-16501 (April 20, 2015). The Order names as Respondents BlackRock Advisers, a registered investment adviser, and Bartholomew Battista, the firm's CCO. Daniel Rice III is a managing director and co-portfolio manager of energy sector assets held in BlackRock registered funds, private funds and separately managed accounts. His compensation derives in part from the management fees of the managed funds and separate accounts. In December 2006 Mr. Rice formed Rice Energy Irrevocable Trust to hold interests in Rice Energy, a name given to a then projected series of entities that would be formed. The next month Mr. Battista reviewed and discussed the matter with Mr. Rice. BlackRock concluded that the proposal did not present any conflict of interest. In February Mr. Rice formed the series of companies which were collectively known as Rice Energy. By March 2010 Rice Energy concluded a deal with ANR and formed a joint venture with Rice Energy. At the time of the deal funds and separate accounts managed by Mr. Rice held over two million shares of ANR stock. In January 2010 Mr. Rice told BlackRock that he wanted to serve on the board of directors of the joint venture. BlackRock's Legal and Compliance Department reviewed the matter and concluded that there were potential conflicts of interest in entering into the joint venture in view of the portfolio holdings managed by Mr. Rice. The deal also raised concerns regarding access to ANR specific information that could be beneficial to Mr. Rice rather than his clients. Nevertheless, BlackRock permitted Mr. Rice to continue under certain restrictions. There was no follow-up by the firm. BlackRock did not inform the boards of directors of the Rice-managed registered funds or advisory clients about Rice Energy. No disclosure was made. Disclosure came in June 2012 when the Wall Street Journal published three articles about Mr. Rice and Rice Energy. The Order alleges violations of Advisers Act Sections 206(2), engaging in a course of conduct which constitutes a fraud and deceit, and Section 206(4)-7, failing to adopt and implement reasonable procedures to prevent the violation. In addition, Respondents caused certain BlackRock funds to violate Investment Company Act Rule 38(a)-1(a) which requires registered investment companies, through their chief compliance officer, to provide a report at least annually to the fund's board of directors, addressing each material compliance matter that occurred since the date of the last report. To resolve the matter BlackRock agreed to a series of undertakings which include the retention of an independent compliance consultant who will prepare a report. The firm will adopt the recommendations. In addition, BlackRock consented to the entry of a cease and desist order based on the Sections cited in the Order. Mr. Battista also consented to the entry of a cease and desist order but based on Advisers Act Section 206(4) and a related rule and Investment Company Act Rule 38a-1. The firm agreed to pay a penalty of $12 million while Mr. Battista will pay $60,000. This is the first case to charge a violation of Investment Company Rule 38a-1.

Offering fraud: In the Matter of Russell C. Schalk, Jr., Adm. Proc. File No. 31555 (April 17, 2015); In the Matter of Joseph John Labadia, Adm. Proc. File No. 3-16499 (April 17, 2015). Mr. Schalk is currently a vice president of sales for Travel International. He is also the sole control person and a one third owner of Raintree Racing and the control person and CEO of a related entity, Raintree Farm. Mr. Labadia was an unregistered investment adviser who was a one third owner and member of the management committee of Raintree Racing. He is also a certified financial analyst and holds certain securities licenses. From 2007 through 2012 Messrs. Schalk and Labadia raised over $1.9 million from investors for Raintree racing. Investors were told that they were making short term principal protected investments in the venture which were characterized as loans. Investors were told that the current rate of return was 20% and that the venture was extremely low risk. Raintree Racing, however, lacked cash flow and did not have the financial ability to pay the promised 20% return. While investors were assured that their funds was a safe, over a three year period beginning in 2007, Mr. Schalk transferred about $668,000 from Raintree Racing to Raintree Farm. Some Raintree Racing investors were also offered the opportunity to invest in Raintree Farm. Investors did in fact purchase shares. The PPM, prepared by Mr. Schalk, failed to tell those investors that the Farm had a loss, minimal assets and was funded by Racing. From 2007 through 2011 Mr. Schalk also diverted about $220,000 from Raintree Racing and Raintree Farm accounts to his personal bank account. Mr. Labadia sold unregistered shares in a second venture, Atlanta Rehab, raising over $1.1 million. Atlanta Rehab investors were furnished with statements showing that the enterprise had an investment in Raintree Racing, valuing it at the offering price. At the time, a substantial portion of Atlanta Rehab funds were invested in Raintree Racing.

The Order in each proceeding alleges willful violations of Securities Act Sections 5(a), 5(c) and 17(a) and of Exchange Act Section 10(b). The Order as to Mr. Labadia alleges violations of Advisers Act Sections 206(1) and 206(2). Each Respondent settled, consenting to the entry of a cease and desist order based on the Sections cited in the Order in their respective action. Mr. Sahalk also agreed to pay disgorgement of $1,472,959, prejudgment interest and a third tier civil penalty of $1.6 million. An Administrative Law Judge will determine his ability to pay. Mr. Labadia is also barred from the securities business and from serving as an officer or director of a public company. He was ordered to pay disgorgement of $48,337 and prejudgment interest. Payment is suspended based on a sworn statement of an inability to pay.

Criminal cases

Investment fund fraud: U.S. v. Wessel (S.D.N.Y.) is an action in which Steven Wessel, who purported to be Chairman and Executive Managing Member of Steeplechase USA, LLC, an investment adviser, pleaded guilty to one count of securities fraud, one count of wire fraud and one count of aggravated identity theft. Mr. Wessel represented to an investor that his funds would be invested in securities. Subsequently, the investor was told that his $200,000 investment had appreciated substantially. In fact Mr. Wessel misappropriated it. When the investor demanded his funds back Mr. Wessel solicited a $550,000 from a second investor, claiming the funds would be used for financing a commercial real estate venture. In fact the funds were used to repay the firm investor with the balance being misappropriated. The date for sentencing has not been set.

Investment fund fraud: U.S. v. Kerye (E.D.N.Y.) is an action which named as defendants Diane Kaylor and Jason Kerye, former employees of Agape World, Inc. The two defendants played an instrumental role in seeking out the more than 3,800 investors who put about $370,000 in Agape World based on promises that their funds would be used for lending, were safe and that a high rate of return would be paid. In fact Agape World was largely a Ponzi scheme with few loans. When the fund collapsed there were about $147 million in investor losses. Nicholas Cosmo, the mastermind of the scheme, was previously sentenced to serve 25 years in prison. Following a four week jury trial the two defendants were found guilty of securities fraud, conspiracy, mail fraud and wire fraud. The date for sentencing has not been announced.

Manipulation: U.S. v. Bigelow (S.D.N.Y.) is an action against Dwayne Bigelow based on three pump-and-dump schemes. Specifically, Mr. Bigelow is alleged to have manipulated the shares of Emerging World Pharma, Inc., SMC Entertainment, Inc., and Sierra Resources Group, Inc., by having the firms engage in reverse mergers, retaining promoters to send e-mails touting the stock and then dumping his stock along with that of his coconspirators as the price rose. A superseding indictment contains one count of conspiracy, three counts of securities fraud and three counts of wire fraud. The case is pending.

Manipulation: U.S. v. Sarao, Case No. 1:15-cr-00075 (N.D. Ill. Filed Feb. 11, 2015). Defendant Navinder Singh Sarao is a futures trader from Hounslow, United Kingdom. A ten count criminal complaint charges him with wire fraud and commodities manipulation.

Mr. Sarao used an automated program to manipulate the market for E-Mini S&P 500 futures contracts on the Chicago Mercantile Exchange on May 6, 2010, contributing to the flash crash. The charging documents claim that Mr. Sarso employed a dynamic layering program in which he placed multiple orders simultaneously to sell at various price points to manipulate the market. The scheme created the appearance of market liquidity and substantial supply as well as an imbalance and pressure. When the market fell Mr. Sarao is alleged to have used futures contracts to repurchase at a lower price point. When it rose he took the opposite action. Another manipulative trading technique involved placing a large 2,000 lot sell order on one side of the market, executed another large order on the other side of the market and then cancelled the order. This created price movement which Mr. Sarao exploited, according to the criminal complaint. On May 6 five years ago as the price of the E-mini fell, the DJI followed. The Government is currently seeking extradition of Mr. Sarao from the U.K. to Chicago for trial.

April 24, 2015
The SEC's Coming Pay-for-Performance Proposal: My Eight Cents
by Broc Romanek

As I blogged yesterday, the SEC has calendared an open Commission meeting on Wednesday, April 29th to finally propose the pay-for-performance rules as required by Dodd-Frank. This rulemaking is important as it could become the new standard for measuring pay and performance.

We'll have to see what exactly the SEC proposes when the proposing release is out – but if it comes out in a form as expected, here are my 8 points of analysis:

1. Companies can get the data and crunch the numbers. I don't think that the actual implementation itself will be difficult.

2. But I think what could be particularly worrisome is having yet another metric to figure out what the CEO got paid and trying to explain all of it.

3. You know how companies have different schemes for granting equity, including type and timing. If the rules tend to try to fit everyone into a narrow bucket in order to try to line everyone up for comparability, and a company's program doesn't quite fit neatly into it, then the disclosure can get even more complicated.

4. There are two elements: compensation and financial performance. What is meant by "financial performance" for example? Maybe the SEC will just ask for stock price, maybe they'll go broader.

5. The most tricky part likely will be the explanation of what it all means – and how it works with the Summary Compensation Table.

6. I don't think it will be difficult to produce the "math" showing the relationship of realized/realizable pay relative to TSR and other financial metrics, so long as:

– There's a tight definition of realized pay

– We know what period to measure TSR (and if multiple periods can be used)

– We know what other performance measures can be included (if any) and if they can be as prominent in the disclosure as TSR

7. Another area of potential difficulty is explaining why there is not a tight or tighter correlation with TSR ("we use metrics other than TSR to drive our compensation; thus, the correlation is not very strong; on the other hand, our compensation is based on Revenue Growth and EBITDA Margin, and as Exhibit II demonstrates, the correlation is very significant").

In addition, Dodd-Frank has no requirement for a relative ranking, and companies will need to decide if TSR and Pay should be put in some type of relative context ("relative to our peers, our realizable pay was well below the peers; so even though compensation is not tightly aligned with stock price performance the last 3 years, we did not pay our bums very much).

8. I think what may be the most difficult to address is a requirement to discuss what the Compensation Committee plans to change – and why now that it has performed the analysis?

– Broc Romanek

April 24, 2015
BATS Exchange Open Letter: Calling for Lower Access Fees, More Disclosure
by Mark Proust

In early January, BATS Global Markets, Inc. ("BATS"), the third largest U.S. equity market operating four equities exchanges, suggested significant changes to the U.S. market structure in an open letter to the U.S. securities industry ("the industry"). BATS also indicated that it would petition the Securities and Exchange Commission ("SEC") to implement its proposed changes. 

BATS suggested open and constructive dialog about potential market structure between industry and the SEC as a key factor in improving the U.S. equity market for all investors, while still providing for appropriate competition among markets and market participants. BATS also noted the growing concern within the industry regarding the amount of trading done away from the displayed exchanges and the incentives brokers received for routing orders to one destination over another.  

Some market professionals have advocated for a "grand compromise" that would impose dramatic regulatory change in the form of a trade-at prohibition. This would force order flow to the exchanges in order to decrease access fees and ban exchange rebates for market participants. BATS believes this compromise would ultimately be harmful and more expensive to end investors. As the letter states:

BATS believes that a "grand compromise" between industry professionals would ultimately be harmful to end investors. While exchanges, including BATS, would stand to benefit from increased volume directed to them, and brokers would benefit from a reduction in exchange fees, investors will likely pay more both in the form of potentially wider spreads as well as fewer and inferior execution choices resulting from restrictions on competition.

As an alternative, BATS advocated for regulatory changes in the following areas: Access Fees, Order Handling Transparency, Small Trading Centers, and a revision to Regulation NMS. 

BATS favors a reduction in the access fee currently imposed in Regulation NMS. The Exchange proposed a reduction of close to 80% for certain liquid securities. BATS recommended that any liquidity rebate be less for highly liquid securities. It is proposed an access fee reduction for the most liquid securities from 30 cents per 100 shares ($0.0030) down to 5 cents per 100 shares ($0.0005). For less liquid securities, access fee caps would be tiered based on a security's characteristics. BATS argued that this approach would preserve the benefits of the current market structure while providing more opportunities to improve the trading experience for illiquid securities. Additionally, the access fee reduction in the most liquid securities would reduce incentives to route away from the exchanges. 

To better inform investors with respect to their brokers' order handling decisions, BATS proposed that all Alternative Trading Systems ("ATSs") should be required to provide customers with their rules of operation. This disclosure would include full descriptions of order types, pricing tiers, all forms of order-routing logic, and transparent participant eligibility guidelines. Using this information, institutional investors could better determine if a venue and/or order routing product met their trading needs. These transparency initiatives, in combination with the access fee reductions discussed above, provided a more "elegant" solution to bringing volume back to the exchanges than the "grand compromise."

According to BATS, all exchanges and ATSs, regardless of their size, have a significant competitive advantage by virtue of the "trade through rule." The trade through rule, under Regulation NMS, requires all market participants to do business with all execution venues that display orders to the market. BATS argues that while in some cases the marginal operating cost for a "new" exchange is near zero, market participants may incur substantial costs when trying to connect to these small venues. To combat this problem, BATS proposed a revision to Regulation NMS that provided until an exchange or other currently-protected market center achieved greater than 1% share of consolidated average daily trading volume in any rolling three-month period: (1) it should no longer be protected under the trade through rule; and (2) it should not share in/receive any NMS plan market data revenue. 

The result of implementing these provisions would serve two purposes. First, client costs in connecting to small exchanges and ATSs would potentially be reduced. This would give the small exchanges and ATSs flexibility to route around them if they chose to and also continue to protect displayed limit orders for the larger venues. Second, market data revenue that may be the basis for the continued operation of marginal venues would be taken away. 

The ultimate goal of BATS' letter is to generate feedback from the industry as well as garner support of its proposals before sending a petition of the proposed changes to the SEC.  

The primary materials for this post are available on the DU Corporate Governance Website.

December comment letter:

http://www.sec.gov/comments/4-657/4657-66.pdf

Jan. 6:

http://cdn.batstrading.com/resources/newsletters/OpenLetter010615.pdf 

Rulemaking petition:

https://www.sec.gov/rules/petitions/2015/petn4-680.pdf

View today's posts

4/24/2015 posts

Securities Litigation, Investigations and Enforcement: Delaware Chancery Awards Investors $171 Million
HLS Forum on Corporate Governance and Financial Regulation: Delaware Court Faults Committee Process & Advisory Work in Finding Lack of Good Faith
Delaware Corporate and Commercial Litigation Blog: Chancery to Decide Advancement Issue for CEO of Coal Mining Company
SEC Actions Blog: This Week In Securities Litigation (Week ending April 24, 2015)
CorporateCounsel.net Blog: The SEC's Coming Pay-for-Performance Proposal: My Eight Cents
Race to the Bottom: BATS Exchange Open Letter: Calling for Lower Access Fees, More Disclosure

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