Securities Mosaic® Blogwatch
October 24, 2016
Chancery Dismisses Challenge to Board's Dissolution Plan
by Francis Pileggi

Alexandra D. Rogin, an Eckert Seamans’ associate, prepared this overview.

A recent Chancery opinion held that stockholder approval and the business judgment rule barred fiduciary duty claims against a board that dissolved the company. The Huff Energy Fund, L.P. v. Gershen, C.A. No. 11116-VCS (Del. Ch. Sept. 29, 2016)

Background: The Delaware Court of Chancery recently dismissed a stockholder’s breach of contract and fiduciary claims against a dissolving company. This action stems from Defendant Longview Energy Company’s ("Longview") decision to dissolve Longview after the company sold a significant portion of its assets. Plaintiff, The Huff Energy Fund ("Huff"), was the largest Longview stockholder, holding approximately 40% of Longview’s common stock. Huff brought suit to challenge the dissolution.

A Shareholders Agreement (the "Agreement") between Huff and Longview required an unanimous vote of the Board for any act having "a material adverse effect on the rights of [Longview’s stockholders], as set forth in" the Agreement. The Agreement also provided Longview with the right of first offer if Huff were to transfer any shares, and provided that the company would continue to exist and remain in good standing under the law.

The sale and dissolution plan at issue was approved by the Longview Board and shareholders, over the abstention of one Huff board designee.

Huff’s Allegations: Huff alleged that Longview breached the Agreement because the dissolution had "a material adverse effect" on its right to transfer its Longview stock to Longview. Accordingly, Huff alleged that the Board’s decision was subject to the unanimity requirement. Additionally, Huff asserted that dissolution violated the obligation to "continue to exist." Finally, Huff brought a fiduciary claim against the Board for adopting the dissolution plan without exploring more favorable alternatives in violation of Revlon, and as an unreasonable response to a perceived threat in violation of Unocal.

Court’s Analysis: The court first held that the individual Board defendants could not be liable for breach of contract because they signed the Agreement as company representatives, and not in their individual capacities. Additionally, Huff failed to adequately plead a tortious interference claim, as the allegations were improperly raised for the first time in briefing.

Next, the Court held that Huff failed to plead breach of contract against the Board. Huff argued that the unanimity requirement applied to any act effecting any right referenced in the contract. However, the Court found that Huff’s interpretation contradicted common sense. Huff’s interpretation would unreasonably subject all extra-contractual "rights" to the unanimity requirement, solely because they were referenced in relation to another right actually created by the Agreement. Therefore, because the Agreement did not create a "right of transferability" for Huff, but instead allowed Longview the right of first offer, the Court rejected Huff’s argument that the dissolution vote violated the Agreement.

The Court also found that dissolution itself did not breach the Agreement’s provision requiring Longview to "continue to exist and [] remain in good standing under [the law]." The provision was merely a commitment to remain in good standing as a Delaware corporation, and not a "commitment to exist ‘come what may,’" as Huff asserted. Huff’s interpretation was also unreasonable in light of other contract provisions referencing a potential merger or sale.

Next, the Court found that there was no fiduciary violation in approving the transaction. Huff failed to plead that the Board was not disinterested and independent. That the dissolution plan provided severance pay to certain directors, that some members had personal friendships, and that one member acted with alleged "animosity" towards Huff did not indicate that the Board was "interested" in the transaction to a degree that would rebut the business judgment rule. Regardless, despite Huff’s allegations toward individual Board members, Huff failed to plead that a majority of the Board that approved the transaction were not independent. Thus, entire fairness did not apply.

The Court next turned to Huff’s Revlon and Unocal arguments. Revlon did not apply because the applicable policy concerns were absent. Specifically, the adoption of the plan did not constitute a "final stage" transaction or effect a "change of control." Similarly, Unocal did not apply. The Court noted that Huff "cite[d] no cases…indicating either that (1) the adoption or filing of a certificate of dissolution or (2) the board’s ‘perception’ that a shareholder posed a threat to any individual director’s ‘power’ over the corporation implicates the ‘omnipresent specter’ lingering in those instances where Unocal scrutiny has been invoked."


Therefore, the Court held that Huff failed to plead any contractual breach or fiduciary violations. The Court also noted the significance of the shareholder vote in addition to Board approval. Even if enhanced scrutiny applied, "the Longview stockholders’ [informed] approval cleansed the transaction thereby irrebuttably reinstating the business judgment rule." Accordingly, the Court invoked the business judgment rule and dismissed Huff’s complaint in its entirety.

October 25, 2016
CEO Pay Ratio and Income Inequality: Perspectives for Compensation Committees
by Blaine Martin, Ira Kay
Editor's Note: Ira Kay is a Managing Partner and Blaine Martin is a Consultant at Pay Governance LLC. This post is based on a Pay Governance memorandum. Related research from the Program on Corporate Governance includes The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers, and Urs Peyer (discussed on the Forum here).

At a recent Compensation Committee meeting, a director remarked, “As we discuss our CEO’s target compensation for next year, we need to remember that there is an ongoing debate about income inequality.” Income inequality and executive compensation are two of the most controversial issues in modern American economic and political discourse. The forthcoming mandated disclosure of the CEO pay ratio will link these two issues directly in the boardroom.

Many critics blame the rise in inequality over the past 20 years partially or heavily on the rise in public company CEO compensation. These critics use the “300 to 1” large company CEO pay multiple compared to average US employee pay as both the primary symptom and the definition of inequality. Inequality is more precisely and typically defined in economics as the percentage of total national income earned by the top percentages of households or taxpayers (e.g., top 1% or top .1%). Using this definition, it is well‐documented that US income inequality, historically among the highest relative to other developed countries, has continued to increase significantly. CEO pay also rose over that period.

Key Takeaways

  • While the income inequality controversy started as a sociological and public policy debate, Compensation Committees should have a strong understanding of the relationship between public company executive compensation and income inequality.
  • The impending disclosure of the ratio of CEO to median employee pay in 2018 proxy statements, as required under Dodd‐Frank, will dramatically bring such discussions into the Compensation Committee in the near future. Supporters of the CEO pay ratio believe that this disclosure will reduce “excessive” CEO pay and lower the pay multiple.
  • Many blame “overpaid’ executives subject to weak boards and poor corporate governance for being the primary cause of US income inequality. This is not accurate. While corporate executives are paid well, public company executives represent a smaller portion of the highest .1% in more recent times than they did in the mid-1990s.
  • Additionally, for the top .1%, growth in public company executive compensation actually lags the growth in private company executive pay and finance professional pay over the same 13‐year time period.
  • Pay Governance’s analyses of realizable pay for performance indicate that pay‐for‐performance is operating among US companies.
  • Improvements in corporate governance practices combined with similar executive pay levels and designs for private company executives suggest that high levels of public company CEO pay are not the result of corporate governance failure.
  • Further, widespread investor support for say-on-pay votes in the past six years indicate broad investor support of the current executive compensation regime.
  • We make strong arguments that the CEO pay ratio for a particular company will be indicative of market-driven industry, size and performance factors rather than a failure of corporate governance.
  • As Compensation Committees consider the context of inequality issues and executive compensation decisions, Committees should focus on robust corporate governance practices, independent advice, and the company’s strategy for addressing the disclosure of the ratio of CEO to median employee pay in 2018.

CEO pay at the largest companies in the US over the past 30 years has grown much faster than average wages—approximately 10.8% versus 4.2% in nominal dollars. This is the mechanical explanation for the current differential between CEO and average worker pay—the well-known 300:1 ratio. However, growth in this differential was not an “overnight event.” The rising ratio was the result of very different long-term labor market factors which yielded consistent high single digit or low double digit pay increases for top managers over several decades combined with lower wage growth for workers with less valued skills in the market. But is this economic reality the result of failed corporate governance? We explicitly explore this issue below.

How much of the increase in inequality has been caused by CEO pay, and is this a failure of corporate governance? This post will provide some insights for directors and others into the answers to these questions in the context of the SEC’s mandated disclosure of the ratio of CEO to median employee pay.


Informed commentary on inequality, including the Conference Board’s recent paper, “Tackling Economic Inequality, Boosting Opportunity: A Blueprint for Business,” cites globalization and technological advancement (e.g., office and manufacturing automation) as two driving forces of the recent increase in income inequality in the US. While both phenomena have made material goods more affordable for US consumers, they have also resulted in wage growth that lags the growth in productivity for those workers not participating in high-skill, technology-oriented labor markets or global commerce.

Many commentators cite “excessive” executive pay as one of the primary causes of income inequality. Such “excessive” executive pay, they argue, has been created or at least enabled by low/declining marginal tax rates in concert with poor corporate governance practices (e.g., cronyism between the board and the CEO).

For valid reasons, directors may be inclined to focus on the governance of their own company’s executive compensation programs and ignore the public debate on inequality, some of which is flawed. However, the public discourse can and does enter the board room when directors must consider the media implications of executive compensation decisions.

Most importantly and directly, the SEC’s mandate that public companies disclose the ratio of CEO pay to median employee pay in 2018 proxies will bring the discussion of income inequality further into the Compensation Committee. Supporters of the pay ratio believe that this disclosure will reduce excessive CEO pay at many companies, allegedly caused by weak governance. Their theory is that this reduction will lower the 300:1 large company pay multiple thereby reducing inequality; this theory was the genesis of the Dodd-Frank CEO pay ratio. Further, income inequality and the ratio of CEO pay to average US worker wage have been cited in at least one shareholder proposal requesting supplemental reporting on the CEO to employee pay ratio and an explanation from the company regarding whether broad-based layoffs or pay cuts warrant changes to executive pay.

Therefore, it is critical that Compensation Committee members maintain a perspective and philosophy from which to govern executive compensation in a world where income inequality is a major public policy issue. This viewpoint addresses several key questions and criticisms regarding the economics, corporate governance and structure of executive compensation as they relate to the broader issue of income inequality.

Question 1: Is the recent increase in US income inequality caused primarily by the increase in the number of public company executives in the top .1% of earners?

No, not primarily. Clearly, corporate executives have among the highest paying jobs in the US economy (along with lawyers, finance professionals, entertainers and athletes), and growth in executive pay levels of corporate executives at publicly-traded companies explains some of the increase in income inequality in the US. Nevertheless, a definitive study on the occupations of high income taxpayers demonstrates that the compensation of public company executives is not the primary cause of the increase in inequality.

Corporate executives are a shrinking minority of .1% income earners

Many critics argue that the large increase in executive pay has been a major cause of the increase in income inequality. Thomas Piketty, the author of the recent seminal and controversial book on income inequality states, “The final and perhaps most important point in need of clarification is that the increase in very high incomes and very high salaries primarily reflects the advent of ‘supermanagers,’ that is, top executives of large firms who have managed to obtain extremely high, historically unprecedented compensation packages for their labor.”

A prominent study by economist Jon Bakija on the individuals composing the top 1% and .1% of the income distribution by occupation up until 2005 provides valuable insight into the role that corporate executive pay plays in the .1% of total incomes. The study finds that public company executives comprise an important minority—20% in 2005—of the share of the top .1%. However, the relative share of public company executives in the top .1% declined substantially over the prior decade—from 28% in 1993 (see Table 1 below). This decline in the share of public company executives in the .1% of the taxable income distribution occurred concurrently with the share of private company executives and finance professionals increasing as a portion of the .1% over the same time period (to 21% and 18%, respectively, in 2005). Many critics erroneously conflate the increase in income forprivate company executives and finance professionals with public company executives. The growth of the size of the financial sector is a valid public policy question, but it is an issue that is beyond the ken of this paper and should not be part of the corporate governance debate that resulted in the CEO pay ratio mandate.

Table 1: Percentage of Taxpayers in .1% of Income Distribution by Occupation

Question 2: Alternatively, is the recent increase in US income inequality caused primarily by the increase in the aggregate pay levels of public company executives in the top 1% and .1% of earners?

No. The data in Table 1 shows that it is not the increase in the relative number of executives in the top .1% that is the primary cause of the increase in income inequality for the top .1%. Next we explore whether the increases in the aggregate pay levels of the highest paid public company executives is a primary cause of the increase in income inequality.

Public company executives’ pay growth below private company executives’ growth

The same data set from Bakija referenced above shows the trends of the incomes for the various professional groups representing the .1% of income earners—see Table 2. Specifically, the 7.8% twelve year [1993-2005] annualized increase in aggregate taxable income for the public company executives, while higher than the

6.2% growth in total gross income, was much lower than the 11.4% annualized increase in incomes for private company executives, the 12.6% increase for finance professionals, and the 10.8% increase for all of the .1% income bracket excluding public company executives.

Some critics doubt the competitiveness of the corporate executive labor market based simply on absolute aggregate compensation levels or the historical increase in pay for public company executives. However, the fact that public company executive income growth lags the income growth of other groups in the .1% income distribution suggests that the growth in public company executive pay, and the governance context in which it is set, is not out of line with other high income earners.

Table 2: Percentage of the .1% of the National Income (AGI) by Occupation

Question 3: Is CEO pay aligned with the performance of their employer?

Yes. An important consideration in the inequality/CEO pay debate is whether the pay of executives is aligned with the performance of the company that he or she manages. This is arguably the key factor that is under the control of the Compensation Committee. The objective reality is that the vast majority of companies are doing an excellent job of ensuring such alignment.

Our firm’s compensation consulting experience and research show that executive pay is highly aligned with company performance. Further, market data on public company pay philosophies indicate that most public companies today target executive pay opportunity at the median of a peer group of similarly-sized companies and rely almost exclusively on actual company performance to determine the amount of pay ultimately realized or realizable. Pay Governance has conducted many 3-year studies of CEO realizable pay-for-performance for numerous industries and for all S&P 500 CEOs, plus a 10-year period study. All of these studies confirm that strong pay-for-performance alignment is operating among US public companies.

Question 4: Have corporate governance failures caused excessive executive compensation levels at public companies, thus exacerbating the inequality issue?

Generally, no. Many critics, when pressed for a mechanism by which corporate executive compensation is set inappropriately, cite flawed corporate governance as the driving force behind executive compensation growth. These criticisms have two aspects: too much focus on creating shareholder value [rather than adding other stakeholders] and specific policy flaws in the governance process that weaken board oversight on executive pay. We present several perspectives on the US corporate governance climate that refute these claims. In fact, governance has improved substantially over the past 20 years, the same period during which executive pay increased. Further, shareholders appear highly satisfied with the US executive pay model which is heavily linked to the creation of shareholder value.

Has US Corporate Governance Improved Substantially over the Past 20 Years?

Yes. Using numerous standardized and researched metrics, US corporate governance has improved and public companies have addressed many prior criticisms. These improvements in governance best practices include: a significant increase in shareholder outreach; an increase in the percentage of independent directors; annual elections for directors; more separate chairs and near universal prevalence of lead directors; independent board nominating committees; elimination of “poison pills”; enhanced proxy disclosure and proxy access; among others. Specifically, in executive compensation governance, there have also been many changes/improvements responding to shareholders, proxy advisors and political pressures: say on pay votes; elimination of single trigger stock acceleration and excise tax gross-ups at a change in control; reduced pensions; introduction of anti-hedging and anti-pledging policies; increases in performance vesting for stock grants; introduction of clawbacks; etc. While some of these are disputed as true enhancements, taken in total, US corporate governance has improved significantly while executive pay has increased. These improvements are a direct rebuttal to the “weak governance of CEO pay” explanation of inequality.

Private Companies With Direct Owner Representation Have Similar Executive Pay Growth

Some critics argue that poor governance by public company Boards and Compensation Committees has caused the excessive growth in public company executive compensation. However, as illustrated in Table 2, the 11.4% income growth for private company executives in aggregate (relative to 7.8% for public company executives) refutes the arguments criticizing public company governance. Private company executive compensation is set either by individual private company shareholders or a Committee of private equity managers who hold a direct stake in the financial success of the companies. Said another way, there is no separation between the shareholders (principals) and the Committee setting pay for the executives. Even in this supposedly superior governance environment, income for highly-paid private company executives, in aggregate, grew faster than those for public company executives. This suggests that private equity owners, just like public company shareholders and the Boards that represent them, believe that using large amounts of performance-based equity grants is the best way to align executive management’s personal interests with the financial interests of the owners of the company.

Collectively, these are strong arguments that the CEO pay ratio for a particular company will be indicative of market-driven industry, size and performance factors rather than a failure of corporate governance.

Question 5: Are shareholders dissatisfied with the US executive pay model?

No. Corporate shareholders certainly appear to agree with the current executive compensation structure. As a group they have provided an advisory vote in favor of executive compensation programs at the vast majority of companies. Specifically, there have been only 290 failed say-on-pay votes among 13,758 say-on-pay votes for Russel 3000 companies—a failure rate of just 2.1% —over the past six years. This is a stunning statistical indicator of shareholder support. Even ISS, the influential proxy advisor to institutional investors, recommends a “for” vote for nearly 90% of companies. These statistics indicate that the shareholders are highly supportive of the current pay-for-performance model for US public companies overall. This support appears to include the broad emphasis on incentives for shareholder value creation that most US companies utilize. CEO pay ratios need to be viewed in the context of this broad shareholder support.

Table 3: Historical Say-on-Pay (SOP) Votes Among Russell 3000 Companies

Considerations for Compensation Committees in Evaluating their CEO Pay Ratio

The conclusion of our research is that relatively high executive compensation at public companies, allegedly enabled by compliant boards, is not the primary explanation for rising income inequality in the US.

Compensation Committees must continue to govern executive compensation levels and designs to motivate the executive team to maximize shareholder value in the context of the broader public debate on income inequality and executive compensation. Committees cannot and should not directly address the criticism regarding the “300 to 1” large company CEO pay multiple compared to average US employee pay. However, Committees should maintain focus on best practice executive compensation governance, and consider whether additional information or analysis on internal pay equity may be helpful, as they evaluate their own CEO pay ratio:

  1. Ensure that competitive executive compensation opportunity levels are monitored annually against the median of an appropriately-sized peer group. This will provide a robust context for the CEO pay ratio.
  2. Ensure that executive compensation program design provides appropriate pay-for-performance linkage, including setting challenging performance goals and providing the majority of compensation in long-term equity.
  3. Apply best-practice compensation policies including robust stock ownership guidelines, clawback provisions, and prohibitions on hedging and pledging company shares to further link executive income and wealth to the performance of the company.
  4. Maintain strong corporate governance practices including nominating directors using an independent Nominating Committee, using independent compensation consultants and legal counsel, and holding executive sessions at each Compensation Committee meeting.
  5. Ensure that all employees are competitively and appropriately paid relative to the profitability, fairness and economics of the company.
  6. Consider whether the Compensation Committee should review supplemental analyses related to the CEO pay ratio and broad-based pay practices (e.g., comparison of executive versus broad-based pay increases, review of number of employees covered under benefit programs, and review of pay ratio and median employee data to peers).
  7. Consider how the Company will address and explain the disclosure of the ratio of CEO to median employee pay in the 2018 proxy. Since supporters of the CEO pay ratio believe that this disclosure will reduce “excessive” CEO pay caused by weak governance, companies may need to be explicit in responding to this theory. The data and analysis presented here could help in this regard.

The complete publication, including footnotes, is available here.

October 24, 2016
Culpable Participation in Fiduciary Breach
by Deborah DeMott
Editor's Note: Deborah DeMott is David F. Cavers Professor of Law at Duke Law School. This post is based on a forthcoming article by Professor DeMott. This post is part of the Delaware law series; links to other posts in the series are available here.

To instigate a fiduciary’s breach of duty or otherwise participate in that breach constitutes a tort when the action is done purposefully or knowingly and causes injury to the beneficiary of the fiduciary duty. This proposition of accessory liability is well settled in tort doctrine but not prominent in prior scholarship in the United States. To some observers, it was jarring when this component of tort doctrine was applied in recent years to investment bankers who serve as advisors to target boards in M&A transactions. In particular, the tort became newly prominent when the Delaware Supreme Court underlined its potential impact in late 2015 by affirming a $76 million judgment against an M&A advisor in RBC Capital Markets v. Jervis, an action brought by the target’s former shareholders. In my article I explicate the elements of the tort and situate it within the broader landscape of contemporary tort law. From this perspective, the outcome in RBC Capital Markets stems from the application of settled law, not doctrinal innovation. Nor is it novel that the culpability of a target’s directors, premised on gross negligence, is not identical to the advisor’s stance as an intentional tortfeasor. Likewise, it is not novel that an accessory’s liability does not depend on whether the primary wrongdoer will be liable for money damages, as corporate directors typically are not when their conduct amounts to no more than gross negligence.

The article also examines the salience of tort claims when the underlying duty is characterized, not as fiduciary, but instead as an expressly non-fiduciary governance duty created by contract through an entity’s organizational documents, as Delaware law permits for non-corporate entities such as partnerships and LLCs. When a third party instigates or participates in a breach of a non-fiduciary governance duty—for example, when an advisor knowingly manipulates an asset valuation to facilitate a decision-maker’s approval of a related-party transaction—the duty that’s breached by the decision-maker is not a fiduciary duty but one created or imposed by contract. Although relatively untested in application in governance contexts, the tort of wrongful interference with contract is a plausible candidate as a theory of accessory liability.

Like culpable participation in a breach of fiduciary duty, wrongful interference with contract is an intentional tort. Both torts are premised on an actor’s decision to participate, in some fashion, in another actor’s breach of duty. For both torts, liability requires that the accessory actor’s conduct be informed by knowledge of the primary duty or its breach and that the conduct make a causally significant contribution to the wrong suffered by the party to whom the primary actor owes a duty. And both torts underscore the foundational significance of duty in tort law: actors subject to liability on accessory theories do not owe duties that replicate those of the primary wrongdoer to the beneficiary. Accessory actors, by committing intentional torts, breach duties they themselves owe. As a consequence, mere inaction (albeit knowledgeable) is not a basis for these forms of accessory liability.

Framing these forms of accessory liability within tort law more generally helps to illustrate the distinctive forms of wrongdoing that they represent: such accessories intervene in situations—not of their making—in which one party owes another a duty, with the consequence that the party owed the primary duty is left worse off. The accessory actors on whom the essay focuses resemble inversions of rescuers, who gratuitously intervene as strangers to a situation in which another is in peril, with the objective of preventing harm or mitigating its consequences for the person in peril. Accessory wrongdoers, in contrast, knowingly act to cause another to breach a duty and, if they succeed, the person to whom the primary duty is owed is left worse off.

One striking quality of the opinion in RBC Capital is the Supreme Court’s detailed elaboration of the underlying facts, although none of the defendant’s arguments on appeal challenged any findings of fact by the Court of Chancery. The detailed factual narrative undergirds a premise of the Supreme Court’s conclusion that the defendant’s conduct met the scienter requirement essential to accessory liability. Indeed, both the Supreme Court and the Court of Chancery characterized that conduct as “fraud on the board,” through conduct that actively misled the client’s directors to sell the company for less than it was worth and to breach their duties of disclosure to shareholders. The Supreme Court’s opinion also underscores the centrality of duty analysis. The Court of Chancery characterized M&A advisors as “gatekeepers,” which could imply an affirmative duty—likely ranging beyond the terms of any contract between the advisor and its client—to safeguard the client’s interests from negligent conduct by its directors. The Supreme Court disagreed, emphasizing the role of contract in defining the terms under which a client engages an M&A adviser. But the Supreme Court continued: regardless of contractual terms, an advisor has an obligation not to act contrary to the interests of the client’s board of directors by conduct that undermines its own advice. Such an obligation stems from the general duty not to engage in conduct that constitutes an intentional tort, for example through knowingly misrepresentations that mislead the client’s directors. Closely bound as it is to factual specifics, RBC Capital does not delimit the scope of knowing assistance that suffices for accessory liability, leaving open the status of advisor misconduct that falls short of “fraud on the board” but knowingly assists directors’ breaches of duty. In any event, framing the inquiry within contemporary tort law is crucial to understanding applicable principles.

The full article is available for download here.

October 24, 2016
Court Describes Board Duty of Oversight
by Francis Pileggi

The Delaware Court of Chancery recently provided an exemplary explanation of Delaware law on the requirements that must be met before directors can be found liable for breaching their duty of oversight. Reiter v. Fairbank, C.A. No. 11693-CB (Del. Ch. Oct. 18, 2016).

Key Background Facts: This case involved a claim that the board of directors of Capital One Financial Corporation breached its fiduciary duties of oversight in connection with its alleged failure to adequately monitor the bank’s activities in connection with check cashing services, and in particular, allegedly failed to monitor compliance with the federal laws and regulations regarding money laundering.

Key Legal Principles Addressed: The Court of Chancery found that the standard under Delaware law for imposing oversight liability, sometimes referred to as Caremark liability, requires evidence of bad faith, meaning that "the directors knew that they were not discharging their fiduciary obligations."

The court reasoned that this type of claim, often described as one of the most difficult to prevail upon in corporate litigation, failed to allege facts from which it reasonably may be inferred that the defendant directors consciously allowed Capital One to violate the federal requirements so as to demonstrate that they acted in bad faith. Specifically, the plaintiff failed to plead with particularity that a majority of the directors of Capital One faced a substantial likelihood of liability.

It would take more space than typically allocated for a blog post to recite the excellent recitations of the law by the court regarding the nuances and prerequisites of both: (1) the duties of oversight of the board of directors, which is part of the duty of loyalty, a subset of which is the duty of good faith; and (2) the prerequisites for a plaintiff to successfully allege a breach of the duty of oversight such that it will survive a motion to dismiss under either Rule 23.1 or 12(b)(6).

Several gems can be found on pages 14 and 15 of the slip opinion, in which the court explains that the Rales test applies in this context as opposed to the Aronson because in connection with a Caremark claim, it is the lack of action by a board or an alleged violation of the board’s oversight duties that must be examined as opposed to an allegedly improper decision.

In addition, the prerequisites that must be satisfied by a plaintiff alleging a Caremark claim are usefully enunciated in page 17 through 20 of the slip opinion.

I will provide a few selected excerpts, but those needing to know the nuances of Delaware law on this topic need to read the whole opinion.The court explained that in order to establish a breach by the directors of their fiduciary duty by failing to adequately implement controls and monitoring procedures, plaintiffs would need to show either:

"(1) That the directors knew, or (2) should have known that violations of law were occurring and, in either event, (3) that the directors took no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure approximately resulted in the losses complained of."

The opinion referred to the Delaware Supreme Court’s reinforcement of the Caremark framework for director oversight liability by clarifying that: "To impose personal liability on a director for failure of oversight requires evidence that the directors ‘knew that they were not discharging their fiduciary obligations.’" See footnote 48 and accompanying text.


October 25, 2016
Breaking up (Banks) is Hard to Do
by Alan M. White

The latest Wells Fargo bank scandal has rekindled debates about breaking up banks that are too big to fail, too big to manage or too big to comply.

Echoing the debate between Louis Brandeis and Teddy Roosevelt in the Progressive Era, politicians propose either to break up our huge banks — as Brandeis advocated — or to regulate them, which was Roosevelt’s position. Most Republican presidential primary candidates argued that, while the Dodd-Frank financial reform law overregulates small community banks, the law did not go far enough to eliminate the threat that the huge banks are too big to fail and will inevitably be bailed out in a future crisis. On the Democratic side, Bernie Sanders played the role of today’s Brandeis, while Clinton seems more aligned with TR. The candidates seemed unanimous in the belief that Dodd-Frank did not go far enough to address the hugeness of the megabanks.

Without new laws passed by Congress, what power would a new President and presidential appointees have to break up banks that are too big to fail?

The answer is, not much. Dodd-Frank limits additional growth and market power of the too-big banks, known as systemically important financial institutions (SIFIs), but grants the power to break up banks in only very limited situations. Most of that power is in the hands of the Federal Reserve Board or other bank regulators who serve fixed terms rather than being appointed at the will of the President. The Treasury Secretary is one of nine members of the Financial Stability Oversight Council (FSOC), but that body has mostly advisory powers.

Dodd-Frank allows involuntary breakups only for a financial institution in actual default, i.e. unable to pay its bondholders or depositors, under the orderly liquidation authority (OLA). The idea behind the OLA is that any bank, no matter how big, can be allowed to fail, and the OLA is a roadmap to reorganize or liquidate the failed bank. The OLA procedure does not offer any way to break up a bank that has not already failed.

Dodd-Frank does have a variety of industry concentration limits that affect additional bank growth. One is embodied in the Fed’s new Reg XX, which prevents one bank from acquiring another if the resulting bank would have more than 10 percent of the total deposits and other liabilities owed by all banks. Concentration limits, however, don’t provide any means for divesting past mergers and acquisitions.

Even before Dodd-Frank, the federal bank regulators had the power to order divestments, in the context of bank safety and soundness reviews, but only on the grounds of risk to the banks’ own depositors and creditors, not based on broader systemic risk (and certainly not based on repeated consumer protection violations, excessive political power or influence over regulators.)

The closest Dodd-Frank came to authorizing breakups of megabanks because they are too big to fail was Section 121 (the Kanjorski amendment). It allows the Federal Reserve Board, with the approval of two-thirds of the FSOC, to compel a break-up and divestiture of high-risk parts of a bank or financial institution if it poses a "grave threat" to the financial stability of the United States. The current Fed chair, Janet Yellen, is serving a four-year term that ends in 2018, and the other members of the Federal Reserve Board of Governors serve staggered 14-year terms. The FSOC has a few presidential appointees on it but a majority of its members cannot be removed at the will of the President. The President therefore has little ability to appoint those who have the power to enforce the Kanjorksi amendment, which was obviously the product of intense lobbying by the banks to make it extremely difficult to ever break up a bank solely because its size poses a systemic risk.

There are a few other possible tools to break up megabanks in Dodd-Frank. A SIFI that fails repeatedly to submit its "living will" plan for orderly liquidation can be ordered to divest, under Section 165(d). Last April, regulators rejected the living wills of five major banks, and ordered them back to the drawing board,, and the banks resubmitted their new and improved plans on October 4.. It remains to be seen whether the regulators will accept these new plans, or resort to the nuclear option of ordering divestments.

Simply being designated a SIFI can nudge institutions (like General Electric or MetLife) to break themselves up to avoid stricter regulatory capital and other rules, but that depends mostly again on independent bank regulators toughening the rules that govern the SIFIs. The Fed recently suffered a setback when a federal district court overruled its designation of MetLife as a SIFI.

In short, breaking up the too-big-to-fail banks will probably require the new President to get new legislation through Congress.

In a recent article, available here, I make the case for rethinking bank regulation on a public utility law model, which would allow regulators to restructure the banking industry, including through vertical and horizontal break-ups. I argue that banks provide essential infrastructure services, are heavily dependent on a variety of taxpayer subsidies and guarantees, and should be subject to more intensive supervision, not just to insure safety and soundness but to advance other public goals, as we do now with energy, transportation, and telecommunications companies.

This post comes to us from Professor Alan M. White of CUNY School of Law. It is based on his recent paper, "Banks as Utilities," available here.

October 25, 2016
Debevoise & Plimpton Discusses NY Guidance on Banks' Incentive Pay
by Gregory J. Lyons, Beth Pagel Serebransky, David L. Portilla, Alison E. Buckley-Serfass and Satish M. Kini

The New York State Department of Financial Services (the "Department") issued a guidance memorandum on October 11[1] requiring regulated New York-chartered banking institutions to align their incentive compensation practices with the general principles laid out in the Interagency Guidance on Sound Incentive Compensation Policies issued in 2010 (the "2010 Interagency Guidance").[2] Specifically, the Department’s guidance requires that incentive compensation arrangements, at a minimum, (1) appropriately balance risk and rewards, (2) be compatible with effective controls and risk management, and (3) be supported by effective corporate governance. The Department published this guidance on the heels of the record $100 million fine and other penalties levied against Wells Fargo by federal and other agencies, following a recent investigation of that bank’s sales practices and incentive compensation arrangements.

The two-page guidance memorandum notes that flawed compensation practices in the financial industry contributed to the financial crisis that began in 2007. The guidance advises that incentive compensation at regulated institutions should not be tied to employee performance indicators, such as the number of accounts opened, or the number of products sold per customer, without effective risk management, oversight and control. The guidance requires regulated financial institutions to ensure that there are appropriate controls for cross-selling or referral bonus arrangements, in particular, because these arrangements may result in conflicts of interest or the sale (or supervision of the sale) of affiliates’ products by inexperienced or unlicensed personnel.


The Department’s guidance applies to all New York state-chartered banks, savings banks and bank holding companies, as well as state-chartered credit unions, branches of foreign banks, foreign agencies and representative offices. It applies broadly across regulated banking institutions and its scope is not limited to large banking institutions or banks that meet a certain asset threshold.


The Department’s guidance follows several federal regulatory initiatives intended to limit risky incentive compensation practices at banking institutions. These include the 2010 Interagency Guidance, which provides principles-based guidance for compensation policies, procedures and processes at banking institutions under the agencies’ supervision, and, more recently, the proposed rules released in April 2016 under Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Proposed Rules under Section 956").

The Department’s guidance is expressly derived from the general principles of the 2010 Interagency Guidance and includes high level, directional advice—unlike the lengthy, prescriptive Proposed Rules under Section 956. Both the Department’s guidance, and the 2010 Interagency Guidance on which it is based, reflect an expectation that regulated financial institutions should apply the principles in a manner that is tailored to the business, risk profile and other attributes of each individual banking organization (i.e., larger organizations require more systematic and formalized policies, procedures and processes).

Rather than providing new or more detailed requirements, the Department’s guidance appears intended to serve as a reminder of the incentive compensation principles that banking institutions generally should have been taking into consideration and implementing since the release of the 2010 Interagency Guidance.


Regulated banking institutions appear to be required to immediately comply with the Department’s guidance on incentive compensation arrangements. State banking examiners will review incentive compensation arrangements as part of the Department’s regular risk-focused examination process. This will include a review of the processes in place to identify and deter misconduct, as well as a review of risk management, internal audit and board director oversight structures. To the extent banking institutions are not already doing so, they must immediately begin to maintain records for the Department’s examination that document (1) the structure and approval process of their incentive compensation arrangements and (2) the related risk management and oversight of such arrangements. Lack of compliance with the guidance may affect exam ratings or lead to other regulatory action.


[1] The guidance memorandum is available at the New York State Department of Financial Services website at

[2] This Interagency Guidance issued by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision is available at the website of the U.S. Department of the Treasury, Office of the Comptroller of the Currency, at:

This post comes to us from Debevoise & Plimpton LLP. It is based on the firm’s client update, "New York State Department of Financial Services Issues Guidance on Incentive Compensation in the Banking Sector," dated October 14, 2016, and available here.

October 25, 2016
Broadening Noteholders' Ability to Receive Redemption Premiums Following Indenture Defaults
by Gregory Fernicola, Michael Hong, Michael Zeidel, Stacy Kanter, Skadden
Editor's Note: Gregory Fernicola is a partner at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden publication by Mr. Fernicola, Michael Hong, Stacy Kanter, and Michael Zeidel.

In a decision issued on September 19, 2016, the U.S. District Court for the Southern District of New York ruled that bondholders were entitled to a “make-whole” redemption premium, as opposed to a repayment at par, following a default by the issuer under the related bond indenture. The decision raises important considerations for issuers of debt securities that contain similar provisions.

On September 19, 2016, the U.S. District Court for the Southern District of New York granted summary judgment to Wilmington Savings Fund Society, FSB, with respect to claims brought against Cash America International, Inc. in Wilmington Savings’ capacity as trustee under the indenture governing $300 million of Cash America’s outstanding notes. Wilmington Savings claimed that Cash America violated a covenant in the indenture when it disposed of 80 percent of a wholly owned subsidiary to its shareholders in the form of a dividend of the subsidiary’s stock. Wilmington Savings also claimed that the proper remedy for Cash America’s breach would be an award requiring Cash America to redeem the notes, including payment of the specified “make-whole” redemption premium under the indenture, as opposed to accelerating the maturity date and a repayment at the par value of the notes.

While the court’s decision with respect to the breach of contract claim involved a relatively straightforward analysis, the claim that the holders had a right to require Cash America to pay the premium was more complex and a question that required examination of the interplay between two provisions that are customary in indentures. The first is the provision allowing an issuer to optionally redeem notes prior to maturity by paying a redemption premium, generally designed to compensate holders for the lost value from future interest payments. The second is the provision allowing holders to accelerate the maturity of notes upon an event of default, which upon acceleration requires immediate payment of the full principal amount of the notes at par. The court noted the well-established provisions of New York law that preclude the payment of a redemption premium following an automatic acceleration of notes, most commonly seen in the bankruptcy context, but further noted that in the more atypical nonbankruptcy context, the interplay between the two provisions is less clear. Specifically, the question arises as to whether the acceleration provisions in an indenture are intended to be the exclusive remedies for such a default.

In making its determination in favor of Wilmington Savings, the court referred to decision of the U.S. Court of Appeals for the 2nd Circuit in Sharon Steel v. Chase Manhattan Bank, NA., 691 F.2d 1039 (2d Cir. 1982), in which the court found that the acceleration provisions in the applicable debt instrument did not bar security holders from seeking specific performance of the redemption provisions where the default resulted from “voluntary actions” by the issuer. The district court rejected Cash America’s arguments that the only remedy for an event of default under a plain reading of the indenture is acceleration, specifically referencing the customary provision allowing the trustee to enforce the performance of any provision under the indenture. The court also disagreed with Cash America’s interpretation of Sharon Steel as requiring some element of bad faith conduct, such as intentionally defaulting under the indenture to evade the payment of the redemption premium. Instead, the court stated that the analysis by the 2nd Circuit in Sharon Steel turned on the distinction between defaults arising from “voluntary actions” (such as the Cash America disposition) versus involuntary actions (such as bankruptcies), not subjective intent. The court also noted that the parties could have specifically included acceleration provisions that were self-operative and that Cash America could not “attempt to reap the benefit of something it did not bargain for.”

The court’s holding in this case raises important considerations for the many issuers of debt securities that contain similar provisions. By electing not to consider the subjective intent of the parties, the court’s interpretation of Sharon Steel seems to broaden the requirement for payment of a redemption premium to any voluntary action taken by an issuer that results in a default under an indenture, even if the issuer may have possessed a good faith belief that such action complied with the indenture. Such actions could include transfers of assets, affiliate transactions, the incurrence of debt or liens or the making of restricted payments, which often involve calculations and judgment. As a result, issuers may face increased litigation risk from noteholders seeking to challenge actions that could arguably result in defaults as well as increased costs associated with negotiating consents or waivers under existing instruments if, under either scenario, the expected return upon a default would include the value of a redemption premium. In addition, while the voluntary actions of the issuers in this case and in Sharon Steel related to significant transactions that appeared to be material to the noteholders, the court imported no such standard of materiality or significance to the applicability of the requirement. This could result in unintended and potentially inequitable repercussions in future decisions.

As the case law in this area continues to develop, it is important for issuers, underwriters and their respective counsel to consider the implications of this case law when drafting the related indenture provisions. Issuers also should consider such implications when interpreting the provisions of existing indentures, particularly when doing so in connection with proposed transactions. In light of this case law, issuers, underwriters and investors may want to focus closely on the language used in both existing bond indentures and indentures for new bond offerings.

October 25, 2016
Problems Using Aggregate Data to Infer Individual Behavior
by Clifford Holderness
Editor's Note: Clifford G. Holderness is Professor of Finance at the Carroll School of Management at Boston College and Visiting Professor of Finance at the Sloan School of Management at MIT. This post is based on a forthcoming article by Professor Holderness.

Many studies in finance and beyond compare firms and markets across countries. These studies have been influential, especially in the area of corporate governance. There is a rarely discussed—indeed hardly noticed—split in how researchers seek to explain differences in firms or individuals across countries. Some papers form country averages of a particular characteristic, such as the use of internal rather than external financing. These country averages are then used as the dependent variable in any empirical analysis. Other papers use the underlying firm observations as the unit of analysis. None of these papers discuss their decision to go one route or the other.

Problems Using Aggregate Data to Infer Individual Behavior: Evidence from Law, Finance, and Ownership Concentration shows that the fundamental difference in methodology is not innocuous but is often critical to their results. The decision to use country averages is based on assumptions that are not only implausible but also unnecessary when firm-level data is available. This calls into question the findings of many individual-firm hypotheses that have been studied with country averages. Among these topics are capital-structure choice, earnings management, and stock-price movements. The findings from these many diverse studies may not be wrong. They do, however, require re-analysis with individual-firm data.

I illustrate the fundamental differences between individual data analysis and aggregate data analysis with an influential finding from the law-and-finance literature, the inverse relation between legal protections for public market investors and the ownership concentration of public corporations. Understanding why ownership concentration varies around the world is central to many influential papers. All of the existing papers use country averages to find an inverse relation between investors’ legal protections and ownership concentration. These papers provide the empirical foundation for the now-influential proposition that large-percentage shareholders are a response to weak legal protections for public market investors.

My article illustrates how country averages and the underlying individual observations can produce very different results. It analyzes three measures of investors’ protection that are central to a broad literature (not just the law-and-ownership literature): (A) the rights of shareholders to sue corporate directors (the Anti-Director Rights Index of LLSV); (B) a common-law legal origin; and (C) legal prohibitions on self-dealing by corporate insiders (the Anti-Self-Dealing Index of DLLS). I confirm the existing-literature finding that there is a statistically significant inverse relation between each of these legal protections and country-averaged ownership concentration. But when the same data is used on an individual-firm basis, the Anti-Director Rights Index reverses sign, and both Legal Origins and the Anti-Self-Dealing Index become completely insignificant. These analyses use the same ownership data and regression specifications that were originally used in the literature to establish the claimed inverse relation between investors’ legal protections and ownership concentration.

My article shows that inferences change when the unit of analysis is the underlying individual-firm observations rather than country averages. There are three good reasons not to aggregate:

  1. Country averages cannot control for firm-level determinants.
  2. Country averages weight firms differently depending on the composition of the database used.
  3. Country averages distort standard errors by eliminating all within-country variation in ownership, creating a misleading impression with artificial clustering.

The wide use of country averages is surprising because there have been many warnings by statisticians over the years that aggregate data analysis can produce misleading inferences about individual units. These warnings started as early as Pearson et al. (1899) and Yule (1903) and have continued through the distinguished statistician David Freedman (2006a, p. 4028) who warns that “it is all too easy to draw incorrect conclusions from aggregate data.” These warnings triggered a decline in the use of averages as the unit of analysis in many other fields. In contrast, in finance the analysis of country averages has accelerated for reasons that are not articulated and probably not known by their practitioners.

The full article is available for download here.

October 25, 2016
Lindeen v. SEC: D.C. Circuit Denies Petitioners' Challenge to Regulation A-Plus Preemption
by Ryan Sharkey

In Lindeen v. SEC, 825 F.3d 646 (D.C. Cir. 2016), the United States Court of Appeals for the D.C. Circuit denied a consolidated petition for review of a challenge to the principles in Regulation A+ that preempted state law. 

In 2012, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”), which added section 3(b)(2) to the Securities Act of 1933 (“Securities Act”). Section 3(b)(2) directed the SEC to revamp Regulation A, a historically underutilized set of regulation exemptions to allow small businesses to increase their access to capital. Among other things, the provision provided that state law would be preempted with respect to shares sold to a “qualified purchaser” but left the definition of the term to the Commission. 

The SEC adopted Regulation A-Plus on March 25, 2015.  The Regulation created a new category of offerings up to $50 million and stipulated a number of investor safeguards (“Tier-2 Securities”). Regulation A-Plus also defined qualified-purchaser as “any person” purchasing securities in a Tier 2 offering.  Securities could be purchased either (1) by an “accredited investor”, or (2) by a non-accredited investor who refrains from purchasing securities valued at more than 10 percent of their worth or annual income.

Secretary William F. Gavin of the Massachusetts Securities Division and Commissioner Monica J. Lindeen of the Montana State Auditor Office (collectively, “Petitioners”) alleged that because the SEC declined to adopt a qualified-purchaser definition limited to investors with sufficient wealth, revenue, or financial sophistication to protect their interests without state protection, Regulation A-Plus failed both parts of the test for administrative deference stipulated in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 842-43 (1984). The Petitioners further alleged that Regulation A-Plus was arbitrary and capricious because it failed to adequately explain how it protected investors.

Step 1 of Chevron requires a showing of the ambiguity of the statute administered by the agency.   Petitioners argued the SEC’s qualified-purchaser definition, which did not restrict the sale of Tier-2 Securities to wealthy or sophisticated investors, contravened the plain meaning of the Securities Act. Specifically, Petitioners asserted the new qualified-purchaser definition (1) contradicted the exclusionary nature of the plain meaning of the word “qualified”, (2) the definition was not consistent with the public interest and the protection of investors, (3) the regulation renders the word “qualified” superfluous, (4) federal securities law had always linked the term “qualified” with investor wealth and sophistication, and (5) legislative history showed Congress intended for the SEC to limit the qualified-purchaser definition to one of a certain level of wealth or sophistication.

The court disagreed, reasoning when Congress explicitly authorized an agency to define a term, “it ‘necessarily suggests that Congress did not intend the word to be applied in its plain meaning sense.’”  Legislative history demonstrated that Congress had permitted the SEC to vary the definition depending upon the “categories of securities” involved and that Congress explicitly granted the SEC discretion to determine how to best protect the public and investors.

At Step 2 of Chevron, a court must defer to the agency’s interpretation so long as reasonable.  Petitioners asserted that (1) Congress’ preemptive purpose was not “clear and manifest” from the statute, (2) the SEC failed to provide a reasoned explanation for its definition, and (3) the SEC failed to explain why its definition changed from the one it had initially proposed in the rule-making process. The court again disagreed, reasoning that Congress’ decision to exempt “qualified purchasers” from state requirements was clear and manifest, the SEC had in fact provided a sufficient explanation of how its definition would provide a meaningful addition to existing capital formation options of smaller companies while maintaining important investor protections, and the SEC had no obligation to adopt the definition it had proposed at the outset of the rule-making process.

Finally, the court found that the interpretation was not arbitrary and capricious. A rule is arbitrary and capricious if an agency fails to consider factors required by the statute.  Section 2(b) of the Securities Act requires the SEC to to consider whether the action will promote efficiency, competition, and capital formation. 15 USC 77b(b).  The court found the SEC’s analysis of investor protections and mitigating costs on issuers to comply with these statutory obligations. The SEC did not have the data necessary to precisely quantify the risks of preemption for investors and the costs of state law compliance for issuers.

Accordingly, the consolidated petition for review was denied by the court.

The primary materials for this case can be found on the DU Corporate Governance website.

10/25/2016 posts

Delaware Corporate & Commercial Litigation Blog: Chancery Dismisses Challenge to Board's Dissolution Plan
The Harvard Law School Forum on Corporate Governance and Financial Regulation: CEO Pay Ratio and Income Inequality: Perspectives for Compensation Committees
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Culpable Participation in Fiduciary Breach
Delaware Corporate & Commercial Litigation Blog: Court Describes Board Duty of Oversight
CLS Blue Sky Blog: Breaking up (Banks) is Hard to Do
CLS Blue Sky Blog: Debevoise & Plimpton Discusses NY Guidance on Banks' Incentive Pay
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Broadening Noteholders' Ability to Receive Redemption Premiums Following Indenture Defaults
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Problems Using Aggregate Data to Infer Individual Behavior
Race to the Bottom: Lindeen v. SEC: D.C. Circuit Denies Petitioners' Challenge to Regulation A-Plus Preemption

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