Category: Corporate law

European Commission Considers Taking Over Cartel Investigations to Prevent Exploitation of German Law Loophole

Recently The National Law Review published an article by Martina Maier and Philipp Werner of McDermott Will & Emery regarding the European Commissions Investigation of a German Law Loophole:

Under German law, companies may escape cartel fines by undertaking an internal restructuring. The German competition authority has indicated a willingness to reallocate such cases to the European Commission, which can impose a fine on the corporate group regardless of any internal restructuring. Commission officials speaking at a conference have suggested recently that the Commission would be willing to take over cartel cases from EU Member States, even at a late stage in the proceedings, in order to fine undertakings for their anti-competitive behaviour.

Background

The German competition authority can impose fines on undertakings that have violated European competition law by forming a cartel. Under German law, if the undertaking ceases to exist, for example by merging with another undertaking, only in exceptional circumstances can the legal successors be held liable for the violation of Article 101 TFEU. For the legal successor to bear any liability for the anti-trust infringement, the restructured company must be identical, or nearly identical, to the company that committed the infringement, such as in the case of a mere change of the company’s name or its legal structure.

This has created a loophole that can be exploited by internally restructuring the legal entity that has committed the infringement so it ceases to exist and no other legal entity within the group is (nearly) identical. Companies may thus escape cartel fines by, for example, redistributing their assets to affiliated companies within the corporate group, or by merging with a sister company, even if the original company’s assets remain within the same group and under the control of the same ultimate parent company. This loophole has been confirmed explicitly by the German Supreme Court. Although Germany is currently amending its competition legislation, it is not yet clear whether the proposed changes will be sufficient to solve the problem.

In the European Union, due to the broad interpretation of the concept of an “undertaking”, as well as the possibility of holding parent companies jointly and severally liable, the European Commission has broad discretion when it comes to imposing fines on parent companies, so an internal restructuring does not present a solution for infringing companies.

Reallocation of Cases

According to the Commission Notice on cooperation within the Network of Competition Authorities, reallocation of cases should normally take place within a period of two months, starting from the date of the first information sent by the relevant national competition authority to the European Competition Network. In general, the competition authority that is dealing with a case at the end of the two month period should continue to handle the case until completion of the proceedings. Reallocation of a case after the two month period should only occur where the facts known about the case change materially during the course of the proceedings. After the two month period, the Commission should in principle initiate proceedings only in exceptional cases.

If the Commission initiates proceedings, the relevant authorities of the Member States are relived from their competence to apply Article 101 TFEU and Article 102 TFEU. This means, once the Commission has opened proceedings, national competition authorities cannot act under the same legal basis against the same agreement or practices by the same undertaking on the same relevant geographic and product market.

Despite these procedural concerns, the Commission seems to be willing to accept a late reallocation of cases in cooperation with the German competition authority. It is not clear how this principle could or will be extended to other Member States and whether it could be applied under different circumstances where a Member State is prevented from fining a cartelist due to the application of a national law.

© 2012 McDermott Will & Emery

Search Warrant Basics

Recently The National Law Review published an article from Risk Management Magazine a publication of the Risk and Insurance Management Society, Inc. (RIMS) regarding Search Warrants in the Office:

When armed government agents enter your office, seize your computers and talk to your employees, the business day has gotten off to a rough start. It only gets worse when the news shows video of agents in raid jackets carrying your eye-catching, focus group-tested logo. As the days go on, you are busy reassuring customers, vendors and employees that despite early reports and comments made by the government and your competitors, it is all going to be fine and you are going to get back to business as usual.

Presented with this hypothetical situation, many adopt a similar response: it won’t happen to me. But any business that operates in a heavily regulated area or partners with any federal agency needs to appreciate that government inquiries are simply part of operating in that space. The FBI is not the only investigative agency; it is just as likely that the Environmental Protection Agency or the Health and Human Services Office of the Inspector General will be at the front desk with a warrant in hand and a team ready to cart away the infrastructure and knowledge of your business. Will you be ready?

Good planning as part of a regular annual review can help settle nerves, avoid costly mistakes, and put you in the best defensive position should that fateful day come when the feds show up at your door. Follow this five-part plan and you will be much better off.

Summon the Team

Just as the agents did the morning before the search, you need to assemble your response team. The government has specialized people with individual roles and you need to have the same type of team. Some people on your team are there because you want them there. Others make the team because they sit at the reception desk or close to the front door. Either way, they are now on the same team.

The point person on the team has to be the in-house counsel. The agent may not let the receptionist place a series of calls, but the receptionist should be permitted to call the in-house counsel to notify her of the situation. From that point on, the command center shifts from the front desk to counsel’s desk.

The next call should be made from the company’s general counsel to outside criminal counsel. A general litigation or M&A background may be well suited for the company’s general needs, but on this day, the needs are quite different. Outside criminal counsel needs to begin the dialogue with the agent and the prosecutor, and should send someone to the scene if possible.

The response team should also include the heads of IT, security and communications. The IT officer must make sure that, as the search is conducted, intrusion into the system can be minimized so that the business may continue operation. If the IT officer is not permitted to assist with the search, it is critical that he observes all actions taken by the government related to any IT matters. This observation may be valuable at some point in the future if computer records are compromised or lost. This is just as important for information that may tend to show some violation of the law as it is for information that may support defense or a claim of actual innocence. The Computer Crime and Intellectual Property Section of the Criminal Division has produced a manual for the search and seizure of computer records and an expert can help evaluate law enforcement’s compliance with its own approved procedures.

If your company is a manufacturer or scientific production company where the question at issue may be the quality, characteristics or integrity of a product, it is important that you demand an equal sample from the same source and under the same conditions as those taken by the seizing agents. This is important so that your own experts can review a similar sample for your own testing in defense. If this is not possible given the type of product seized, your outside counsel will work with prosecutors and agents to assert your rights to preserve evidence for future testing. Just as the IT expert can be a helpful observer, a technical expert who observes the government sampling can also provide valuable insight into issues related to the sampling that may make a world of difference at some time in the future.

The communications expert is the final member of the team, but no less significant. She can be an important point of contact for media inquiries that will inevitably follow. It is vital to be able to communicate to your customers that you are still performing your daily support and that, as you address this matter, you will never take your eye off the customer’s needs and deadlines. With a disciplined response, many companies will survive a search warrant and government investigation. This process will help ensure that your customers are there for you when you get through this difficult time.

Depending on the size of your company, all of the response team roles may be performed by one or two people. Think of the function of the tasks that need to be accomplished instead of job titles alone. The other factor that you must consider at the outset is what role will these people have in the case going forward. Try and identify people who can perform these tasks but will be outside the case itself. If you know that the company lab has been under investigation, the lab director may be a target of the investigation. If that is the case, you do not want to have that employee serving as your only witness observing the search. Instead, an ideal observer might be the outside counsel’s investigator.

Execute a Pre-Established Plan

An important part of this response is that you have a pre-established plan that can be taught and disseminated instantaneously. The first rule of any plan is to not make matters worse. In this case that means, “Let’s not have anyone arrested for obstruction.” If the search team has a signed search warrant for your address, they have a lawful right to make entry.

Challenging the search warrant is for another day and both state and federal laws prohibit interfering with the execution of a search warrant. This is the time to politely object to the search and document what is happening. With a copy of the search warrant in hand, outside legal counsel may be able to challenge the scope of the search, but that is not an area where the novice should dabble.

While your specialized team members perform their tasks, the company is generally at a standstill while the search continues. Let your team members work and have the rest of your employees go home. You are shut down for the time being just as you would be any other time your business is closed. You do not want to allow employees to wander the halls and interact with agents. Off-hand comments that make it into a law enforcement report may distort the facts and be difficult to explain later.

Make sure that company employees understand what is happening and what their rights are in this situation. It is important to avoid interfering with the actual lawful execution of a search warrant; it is also unlawful to tell your employees to not speak to the agents. If they know they have a right to meet with a company-retained counsel of their own and have a right to remain silent at this point, it may go a long way in calming nerves.

Assert Privilege

This is not a difficult matter to explain, but it is critical: if there are documents that are covered by the attorney/client privilege or any other similar privilege, it is critical that you assert that privilege. One reason for the receptionist to be allowed to call company counsel is that there are materials that are covered by the privilege.

It is critical to make privilege claims at this juncture so that the agents are aware of the assertion and that they formally recognize it. This may simply mean that they put those documents in a different box for review by a team subject to judicial review at a time in the near future or it may mean that the team will review the materials for immediate decisions to be made on scene. Whatever procedure the agents have established can be reviewed later, but if you do not assert privilege now, it changes the options available to you as the proceedings go forward

Record the Search

Given the concerns of civil liability, it is not uncommon for agents to make a video recording of their entry and departure from the scene. Their goal is to document any damage that may have been caused by the lawful execution of the warrant. The agents also want to be able to document their professional execution of the warrant in the event that claims are raised at a later point. But that tape is going to stay in their custody and not be available for your team to review as you prepare the defense.

A video record of the search may provide a key piece of support to the defense that could not possibly be understood on the day of the search. However, this process must be handled in a very unassuming manner and with a clear understanding by the agents that you are doing it, and that, in the event there are undercover officers who are masked, that you will make no effort to record them. In some states, recording voice without consent of all parties is a felony, so this is a matter that you must review with outside counsel when you are developing your procedures for search warrant response. Again, you do not want to do anything to make your situation worse.

Collect Your Own Intelligence

Just as the agents are trying to learn about your operations, they will be giving you valuable information about their own operations and the focus of their investigation. Your first tasks are to determine who is in charge, document the names of the agents in attendance and note all the agencies involved in the search. This is information that you can gather directly by politely asking for the names of the agents and observing the insignia of the agents’ uniforms or badges around their necks.

The other opportunity available to you in this unique situation is the opportunity to listen to the language the agents use, the apparent hierarchy of the agents, and the small bits of casual conversation that may give you valuable insight into the goals of the search. As the day wears on, the agents will feel more comfortable around your response team and they will talk more freely. This is not to suggest that your team should attempt to interrogate the agents, however, because that will open a two-way dialogue that may lead to statements that are difficult to explain or put in context. The suggestion is simply that you serve as an active listener.

Help Establish Rapport

Throughout the day, the agents are going to be forming opinions about your company and your employees. Use this time to make a good impression about your company. A professional, disciplined response in a time of crisis sends a very different message than the one sent by yelling obstructionists. Even though the agents have quite a bit of information about you as their target, it may have all been gathered from third parties. This may be your opportunity to impress them and to help them question the veracity of your accusers. Remember that there will be meetings about your company, your executives and their futures, and the only people in those meetings will be the agents and the prosecutors. You want their memories of this day to weigh in your favor.

Risk Management Magazine and Risk Management Monitor. Copyright 2012 Risk and Insurance Management Society, Inc.

Liability for inside bridge rounds?

The National Law Review recently published an article by Michael D. DiSanto of Dinsmore & Shohl LLP regarding Inside Bridge rounds and their liability:

Imagine for a moment that you are the CEO of a venture-backed technology or services startup. The company is in the midst of a round of funding, and it is taking longer than anticipated for whatever reason. The cash coffers are unnervingly low, with payroll or other normal monthly expenses right around the corner.

Or maybe the situation is something different. Maybe the company isn’t a technology or services company at all. Maybe it is a manufacturing company and the first big order has just arrived. The company needs to lay out a pile of cash to scale up its team or otherwise secure the necessary raw materials to fulfill the order.

Whatever the case may be, who is the first person the CEO typically calls to alleviate the temporary cash crisis? That is an easy one. The CEO almost always reaches out to the member of the board of directors that represents the private equity fund that typically demonstrates the most support for the company. The conversation typically lasts a few minutes, as the pair hammer out standard (or maybe not so standard) terms for a bridge loan, and the cash coffers are reloaded a few short days later.

Problem solved, right? Not necessarily.

The company’s short-term cash flow problem is solved. Yet, in at least one part of the country, the venture capital funds funding the bridge loans and the director designees approving the transaction could face liability for a breach of the duty of loyalty, if the transaction does not pass the “entire fairness” test.

Did that grab your attention? It certainly grabbed mine.

The Seventh Circuit issued an opinion that, if adopted by California and Delaware, could turn the common practice of inside bridge loans on its head.

The facts of the case probably sound all too familiar to anyone involved with technology startups during the so-called “bubble burst” in 2000 and the global economic crisis that kicked into high gear in late 2008. Cadant was a technology startup incorporated under the laws of Delaware and backed by an investor syndicate lead by two well known venture funds —Venrock and J.P. Morgan. Cadant was facing dire straits in the fall of 2000. Unable to complete a round of preferred stock financing, Cadant sought a bridge loan from an outside investor group, as well as an inside proposal from Venrock and J.P. Morgan.

In late January 2001, the VCs funded an $11 million bridge loan at 10 percent interest and 90-day maturity. Cadant burned through those funds in no time, so the company went back to the deep pockets of its investor syndicate and raised another $9 million bridge from the VCs. This time, however, the bridge included a two-times liquidation preference and the published court opinion makes no mention about seeking a competing proposal.

The Cadant board at the time of both transactions consisted of seven directors. Four were designees of the VCs. The other three were “engineers without financial acumen” who were basically “at the mercy of the financial advice” they received from the four VC designees. The board reportedly relied on Eric Copeland, one of its directors and a Venrock principal, to negotiate the terms of the two bridge loans, despite the fact that Copeland had a clear conflict of interest.

The rest of the story isn’t difficult to predict. Cadant ultimately defaulted on both bridge loans and agreed to sell all of its assets for stock then valued at approximately $55 million. That amount was completely consumed by the liquidation preference of the preferred stockholders and the company’s outstanding debt. The common holders received nothing. Bankruptcy ensued and a liquidating trust brought suit against the VC funds and their director designees.

The Seventh Circuit held that a decision by VC representatives on a board to approve a loan was essentially self-dealing that could not be cured by a vote of majority of the disinterested directors where the interested directors set the terms of the deal. The deal, therefore, had to be evaluated under the entire fairness doctrine, which could raise liability questions when distressed companies do not go out and shop the offer to get a market check as to the fairness of the terms. Note also that the VC funds, while not owing a fiduciary to shareholders directly, faced liability under an aiding and abetting theory.

This opinion seems to be at odds with Delaware law that appears on its face to allow a majority of disinterested directors to approve the deal so long as it was fully and fairly disclosed. Note that the court applied Delaware law due to the internal affairs doctrine, since the company was incorporated in Delaware.

Courts outside of the Seventh Circuit are obviously not bound by this decision. But Judge Posner, the man who authored the opinion, is one of the most well respected and widely cited members of any judiciary. If the Delaware Chancery Court adopts a similar position on the issue, it could result in a dramatically change in the appetite for VCs to fund quick inside bridge rounds for distressed portfolio companies hoping to create some breathing room ahead of an equity round or exit.

What’s the BIG deal?

Judge Posner’s opinion won’t likely have a chilling effect on inside bridge rounds for Delaware corporations, nor should it. Instead, it should serve as a bit of a wakeup call companies and investors shooting from the hip when it comes to inside bridge rounds.

Two practice points jump off the pages of the opinion. First, directors should think twice before sitting on both sides of the negotiation table when a CEO comes asking for a bridge loan. Had one of the non-VC designees negotiated the terms with the VCs in this case, the case might not have survived a motion to dismiss.

Second, boards should be prepared to defend inside bridges under the “entire fairness” test. Performing some semblance of a market check, if possible, is one way to help avoid liability. You know what they say – the more the merrier when it comes to competing proposals.

It will be interesting to see if Delaware and other jurisdictions ultimately decide to adopt Judge Posner’s approach to dealing with inside bridge rounds.

© 2012 Dinsmore & Shohl LLP.

What is an LLC and How Does an LLC Work?

Featured recently in The National Law Review an article by Christopher J. Caldwell and Laura E. Radle of Varnum LLP regarding LLCs:

Varnum LLP

Many cottage owners have heard of others who have established a “Cottage LLC”. But what exactly does this mean? What is an LLC? How does an LLC which owns a cottage work and why would someone use an LLC to own his or her cottage?

Simply put, an LLC is a “limited liability company,” which has some features of both partnerships and traditional corporations. It provides greater liability protection than individual ownership and may have perpetual existence. However, an LLC is also somewhat simpler to manage than a traditional corporation.

In an LLC the owners are called members. The LLC can be controlled either by its members or by managers who are selected by the members. In family cottage situations, selecting one or two managers (who may be members) typically works best.

The rules and regulations of an LLC are set forth in the LLC’s operating agreement. The operating agreement can be as basic or as detailed as the members wish. At a minimum, when created for cottage ownership, the operating agreement should discuss the potential sale or transfer of the cottage, management responsibilities, contributions for expenses, potential for renting, scheduling of time, liability of the owners, and an exit strategy if one owner wants to end the relationship. The primary goal of the LLC – as addressed by the operating agreement – is to provide clear rules, rights and obligations for all of the members.

Cottage owners often need to use an entity that will provide a liability shelter (for example, if the cottage is rented to third parties). But the owners also need an entity that does not require a lot of time to maintain. And, most importantly, because cottage owners want to be able to tailor the operating agreement to fit their lifestyles, they need an entity that is flexible. The LLC has all of these attributes, making it a great match for cottage owners. And once an LLC is established, cottage owners will be able to focus on the fun part of their ownership, spending carefree and conflict-free time at the cottage.

© 2012 Varnum LLP

Indictments of Megaupload Are a Greater Threat to Web Users Than Piracy

Recently featured in The National Law Review was an article by Rachel Hirsch of  Ifrah Law regarding Megaupload Indictments:

 

 

 

In last week’s Megaupload indictment, the U.S. government has raised the debate over copyright infringement on the Web to a whole new level – treating the operators of one of the most popular sites on the Internet as if they were part of organized crime.

On January 19, 2012, a federal grand jury in the Eastern District of Virginia charged executives, founders and employees of Megaupload.com, one of the leading file-hosting services on the Web, with copyright infringement, conspiracy to commit racketeering and money laundering. The U.S. Department of Justice is charging that Megaupload.com caused over $500 million in lost revenue from “pirated” content such as music and movies. In addition, the government seized Megaupload’s domain names and shut down all of its sites, contending that Megaupload is an organization dedicated to copyright infringement.

These actions, more suitable to the type of steps that the government takes against an organized-crime enterprise dedicated to murder, theft and racketeering, are astonishing. The government seems to have ignored the fact that other popular content-sharing sites have successfully defended themselves in civil cases by using the safe harbor provisions of the Digital Millennium Copyright Act, which provide immunity to a site that promptly takes down infringing content.

Among those charged in the indictment were Megaupload founders Kim Dotcom and Mathias Ortmann, chief marketing and sales officer Fin Batato, and lead programmer Bram Van der Kolk. All four were arrested in Auckland, New Zealand. On Monday, the Auckland district court denied bail, making way for extradition proceedings that will likely be contested. In addition to the arrests, approximately 20 search warrants have also been executed within the United States and in eight additional countries. The Eastern District of Virginia has called for the seizure of 18 domain names associated with the site, and about $50 million in assets and targeted sites have been seized thus far.

The indictment is riddled with inconsistencies. On the one hand, the government asserts that Megaupload is not entitled to use the safe harbor provisions. According to the government, everything on the site was doctored to create a veneer of legitimacy, while its employees knew full well that the site’s main use was to distribute infringing content. Yet the government readily admits that it has Megaupload emails talking about using U.S. courts and lawyers to file actions against other “pirate” sites and that the site did take down illegal content and build an abuse tool. To top it all off, many big-name artists support the site, as evidenced by an entirely legal video posted on YouTube, which Megaupload tried to save in U.S. courts from takedown requests.

The 72-page indictment is not some knee-jerk reaction to the ongoing protests of proposed misguided legislation that would strengthen protections against piracy at severe costs to the Internet. This action was clearly in the works for some time. But the filing of a criminal case against one of the most popular sites in the world is remarkable to say the least, given that other popular content-sharing sites have never faced criminal charges for allegedly facilitating piracy. Indeed, when these other sites have been targeted in well-financed civil cases, they have successfully asserted defenses.

When Viacom filed its lawsuit against YouTube in 2007 based on charges that YouTube and its parent, Google were engaging in “massive intentional copyright infringement,” the government did not arrest YouTube or Google executives. In fact, the U.S. District Court for the Southern District of New York held that YouTube was shielded from liability in that case by the safe harbor provisions.

Similarly, when IO Group, Inc. filed a complaint against Veoh Networks for copyright infringement, the U.S. District Court for the Northern District of California held that Veoh’s video-sharing website was entitled to the protection of the safe harbor provision. In both cases, U.S. courts recognized that simply providing access to content did not equate to engaging in infringing activities.

Megaupload, an online storage and web hosting service site, counts itself in the same category as YouTube and Veoh — merely acting as a hosting company that provides access to content. By invoking the full wrath of U.S. criminal laws, the government is using tools that were never meant for this situation – and is potentially doing incalculable harm to thousands of Internet users and to the integrity of the Web itself.

© 2012 Ifrah PLLC

Going Private: U.S. Listed Chinese Companies

An article by  Sheppard Mullin’s Shanghai Office of  Sheppard, Mullin, Richter & Hampton LLP regarding U.S. Listed Chinese Companies That Want to Go Private was published recently in The National Law Review:

 

 

Many U.S. listed Chinese companies have their eye on going private, with a growing number of such transactions having recently closed. This is the combined result of the current weakness of the U.S. capital markets, significant losses in the value of many U.S. listed Chinese companies, and pessimistic market forecasts that have resulted in trading at values below what controlling shareholders, management or private equity firms may think certain companies are worth.

 

Why Companies May Go Private

 

  • To save costs. There are considerable costs associated with being listed on a U.S. exchange, including ongoing regulatory compliance and defending against shareholder lawsuits and other litigation. Further, in the case of leveraged buyouts, acquirers and targets may realize tax and accounting benefits of a more leveraged capital structure, as compared to a public company.
  • Strategic business reasons and the ability to manage the company. Private companies are not required to publicly disclose competitive information, are provided more flexible corporate governance, and can focus on business objectives rather than investor relations issues and the short-term pressures of appeasing shareholders. Moreover, a going private transaction can allow for the restructuring of a company’s businesses in ways that would adversely affect its stock prices in the short run if it remained a public company.
  • The ability to realize value. Going private may allow shareholders to realize a better price for their shares then they would otherwise realize from continuing to hold the shares or selling them on an exchange. Further, companies may go public because analysts consider a company’s share valuations to be low when compared to what the company could generate from other equity markets such as Hong Kong or Mainland China.

 

Challenges

 

Going private presents companies with challenges as well, including the inability to utilize the public markets to obtain immediate financing, a diminished public profile, and less transparency. Further, the going private process can be arduous and many such transactions are challenged in court.

 

Structures

 

A going private transaction may take various forms. Factors that influence the choice of structure include the need for outside financing, the composition of shareholders, and the likelihood of a competing bid for the company. Going private transactions are commonly structured as buyouts (either mergers or tender offers), and in some cases as reverse stock splits.

 

Special Committees

 

In order to mitigate litigation risks for the breach of fiduciary duties, boards need to ensure the fairness of a transaction to the company’s shareholders, particularly where transactions involve controlling shareholders. As such, it is common for a board to appoint a special committee of independent directors.

 

Listing in Mainland China or Hong Kong

 

Some companies plan subsequent listings in Hong Kong or Mainland China, where they speculate the valuation for their companies may be higher. For companies that were delisted or suspended from U.S. exchanges, the stigma associated with such could pose a challenge with respect to a subsequent listing, as stock exchanges and regulators require issuers to disclose their history.

 

Conclusion

 

Some basic questions that the directors and senior management of all U.S. listed Chinese companies should be asking themselves when considering going private, include: what is the most appropriate going private structure? What is a price that is demonstrably fair? Is the special committee of the board sufficiently independent? How should detailed records be maintained of board and special committee meetings, transaction negotiations and other proceedings? How can the risk of litigation be minimized?

Copyright © 2012, Sheppard Mullin Richter & Hampton LLP.

Preparation for 2011 Fiscal Year SEC Filings and 2012 Annual Shareholder Meetings

Published recently in The National Law Review an article by Megan N. Gates and Pamela B. Greene of  Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. regarding Year End SEC Filings and Shareholder meetings for 2012:

As our clients and friends know, each year Mintz Levin provides an analysis of the regulatory developments that impact public companies as they prepare for their fiscal year-end filings with the Securities and Exchange Commission (SEC) and their annual shareholder meetings. This memorandum discusses key considerations to keep in mind as you embark upon the year-end reporting process in 2012.1

Year 2 of Say-on-Pay. 

As required by Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and related SEC rulemaking, public companies other than smaller reporting companies were required to include two new, non-binding resolutions in their proxy statements for their first shareholder meetings taking place on or after January 21, 2011. The first resolution, the “say-on-pay” vote, allows shareholders to vote whether to approve executive compensation as disclosed in the proxy statement pursuant to Item 402 of Regulation S-K. The second vote, referred to as the “say-on-frequency” vote, asks shareholders how often they want to conduct future say-on-pay votes: once a year, once every two years, or once every three years. For the 2011 proxy season, shareholders overwhelmingly voted in favor of annual votes on say-on-pay, as opposed to either of the other possible choices, making say-on-pay a yearly event for most companies. However, now that the first year is behind us, companies are not required and not expected to propose another say-on-frequency vote until their shareholder meetings taking place in 2017. Companies that qualify as “smaller reporting companies” will not be required to conduct the say-on-pay or say-on-frequency votes until the first annual or other meeting of shareholders at which directors are to be elected that occurs on or after January 21, 2013.2

For further detail on the final say-on-pay rules that were adopted last year, please review our client alert.

The advent of say-on-pay has caused companies to revisit how they write their compensation-related disclosure in their proxy statements, in particular the Compensation Discussion and Analysis (CD&A) section, with both advocacy and disclosure in mind. For the year ended December 31, 2011, 46 companies failed to receive a majority vote in favor of their executive compensation payments and practices, suggesting that executive compensation is more vulnerable than initially thought at some companies. While this percentage of failed votes is small compared to the number of companies conducting say-on-pay votes last year, it is still higher than most experts expected. In addition, say-on-pay has resulted in shareholder litigation against many of these companies and such suits name the board, compensation committee members, and executives in their suits.3 The allegations of several of the complaints filed generally claim that the directors breached their fiduciary duties in three different ways. The first alleged breach arises from allegations that the directors diverted corporate assets to the executives in a manner that put the executives’ interests ahead of those of the shareholders. The second alleged breach arises from allegations that the companies that have adopted “pay-for-performance” compensation policies failed to disclose in their proxy statements that the compensation awards were made notwithstanding or in contravention to the policies. Finally, the complaints also bring claims for corporate waste against the directors based on the alleged excessive size of the executive compensation awards. Given these claims, it is critical for companies to review their CD&A disclosure, especially with regard to a company’s pay-for-performance philosophy. Many companies have boilerplate compensation policy language that is vulnerable to being exploited by derivative plaintiffs and which is not necessary to provide an accurate and reasonable basis for a company’s compensation decisions. Companies should review the CD&A section of their proxy statements to ensure that it reflects the company’s actual executive compensation philosophy and accurately describes the rationale for payment of executive compensation.

The Dodd-Frank Act added a new requirement in the CD&A beginning this year relating to the say-on-pay vote taken last year. Item 402(b)(1) of Regulation S-K was amended to add section vii to the CD&A disclosure requirements to require a discussion as to whether and, if so, how the company has considered the results of the shareholder say-on-pay vote in determining compensation policies and decisions and, if so, how that consideration has affected the company’s executive compensation decisions and policies. In preparing for compensation committee meetings, companies should make sure the compensation committee is in a position to discuss and make recommendations on this new disclosure requirement, as the disclosure must specifically address what actions the company has taken to date. Companies should make sure their compensation committees have been provided with the following information well in advance of approving this year’s executive compensation:

  • the results of the shareholder vote on say-on-pay from the 2011 annual meeting and any information that the company has as to the specific shareholders that voted against say-on-pay; and
  • the 2011 Institutional Shareholder Services (ISS) Proxy Advisory Services report discussing its analysis of the company’s say-on-pay proposal.

In preparing for this year’s say-on-pay vote the compensation committee should consider:

  • how it defines “pay-for-performance” and whether the company has a good pay-for-performance story for 2011 backing up its executive compensation decisions;
  •  whether the company should reach out to shareholders who voted against the company’s say-on-pay proposal last year (and who are still shareholders) to determine what issues they had with the company’s compensation as many institutional shareholders have expressed their desire to engage with companies regarding their executive compensation policies as long as the discussion is not at the eve of the voting decision and preferably before the proxy season begins in earnest;
  • whether the company has had any significant changes to its shareholder base that could change the say-on-pay results for this year; and
  • whether ISS changes in how it will be determining whether a company has a pay for performance disconnect this year will have any effect on its recommendations for the 2012 proxy season.

Lastly, as companies enter this proxy season they need to be aware of how ISS will evaluate their say-on-pay proposals this year. ISS expects companies which received the support of less than 70% of the votes cast last year on say-on-pay to take specific action to address the concerns expressed by shareholders and expects to see substantive disclosure regarding the company’s response to shareholders’ opposition. If ISS is not satisfied with the changes made by the company, they will recommend a vote against compensation committee members as well as a vote against this year’s say-on-pay proposal. As it did last year, ISS will continue to review say-on-pay proposals by making a quantitative assessment of the CEO’s pay as compared to the company’s financial performance to initially identify underperforming companies. However, ISS has revised its approach and will measure the degree of alignment between the company’s total shareholder return rank and the CEO’s rank within the peer group4 as measured over a one-year (40% weight) and three-year (60% weight) period as well as the multiple of the CEO’s total pay relative to the peer group median. It will also measure the absolute alignment between the trend in CEO pay and a company’s total shareholder return (TSR) over the prior five fiscal years. These quantitative measures are to identify outlier companies that have demonstrated significant misalignment between CEO pay and company performance over time. In cases where alignment appears to be weak, further in-depth analysis will determine causal or mitigating factors, such as the mix of performance- and non-performance-based pay, grant practices, the impact of a newly hired CEO, and the rigor of performance programs.5

SEC Rules on Mandatory Proxy Access Have Been Vacated by the Courts but “Private Ordering” Lives On.

Despite the mandate provided by Section 971 of the Dodd-Frank Act and subsequent rulemaking by the SEC, shareholders’ ability to require companies to include shareholder nominees in companies’ own proxy statements was vacated by the United States Court of Appeals for the District of Columbia Circuit in July 2011.6 However, the amendments to Rule 14a-8 of the Securities Exchange Act of 1934, as amended (the Exchange Act), the rule addressing when a company must include a shareholder’s proposal in its proxy statement, were not affected by the court decision and became effective on September 20, 2011. As a result of amendments to Rule 14a-8, shareholders will now be able to propose nominees for director in a company proxy statement provided that a company’s by-laws allow for such action. This is known as “private ordering.” As a result, proxy access may become a reality if shareholders are successful in requiring companies to add by-law amendments allowing for shareholders to nominate directors in a company’s proxy statement. If a company’s by-laws allow shareholder proxy access for director nominations, then the same procedures must be followed as those that would have been followed had mandatory SEC proxy access survived under the Exchange Act. These procedures include Rule 14a-18, providing for disclosure regarding nominating shareholders and nominees submitted for inclusion in a company’s proxy material pursuant to applicable law or a company’s governing documents; Regulation 14N, which requires filings by certain nominating shareholders on a Schedule 14N; and amendments to Rule 14a-2(b) to facilitate shareholder director nominations. As of December 21, 2011, ISS had reported a total of 16 proxy access proposals submitted to companies with varying procedural provisions. It remains to be seen whether any of these proposals for by-law amendments to require proxy access will be adopted by companies or whether any company may instead choose to adopt its own preemptive proxy access by-law amendment to provide procedures more stringent than would be set forth in a shareholder by-law amendment proposal. We expect that like majority voting for directors, the momentum for proxy access will begin with larger companies and will continue to gain traction over the next few years.

SEC Issues Additional Guidance with Respect to Proposals Brought by Shareholders. 

The SEC staff issued Legal Bulletin No. 14F on October 18, 2011 providing new guidance on topics relating to shareholder proposals under Rule 14a-8 of the Exchange Act that to date had been unclear. The new guidance addresses issues on proof of share ownership for beneficial owners, submission of revised proposals, procedures for withdrawal of a no-action request for a proposal submitted by multiple proponents, and the use of e-mail to transmit information. This SEC Legal Bulletin, together with SEC Legal Bulletins 14-14E, contains important information for any company that receives a shareholder proposal.

Other Sections of the Dodd-Frank Act Are Still Subject to Rulemaking.

The Dodd-Frank Act contains several other sections that will impact companies’ proxy statements in coming years, including the requirements to provide disclosure on measuring pay for performance, the ratio between CEO compensation and other employees’ compensation, hedging of shares by employees and directors, clawback of “erroneously awarded compensation” and rules regarding compensation consultants and compensation committee independence.

However, these sections of the Dodd-Frank Act require that the SEC undertake rulemaking to implement them, and only the rules with respect to exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence and disclosure rules regarding compensation consultant conflicts have been proposed to date. The SEC does expect to finalize these proposed rules in the first half of the calendar year but it is unclear whether it will be in time for the 2012 proxy season. The SEC’s rulemaking calendar was recently revised to state that it expects to propose the rest of these corporate governance and disclosure rules required by the Dodd-Frank Act in the first half of the 2012 calendar year and adopt them in the July through December 2012 time frame, not within the time to take effect for the 2012 proxy season. We will update our clients and friends separately as these rules are proposed and issued.

Whistleblower Bounty System in Effect. 

The SEC’s rules under Section 922 of the Dodd-Frank Act, relating to bounties to be paid to whistleblowers who report information to the SEC about violations of the securities laws, took effect on August 12, 2011. These rules, which were the subject of hundreds of comment letters, put in place a system under which whistleblowers may benefit financially from contacting the SEC directly with allegations of federal securities fraud and other violations.

A new Office of the Whistleblower has been set up within the SEC, which is charged with receiving and reviewing reports directly from individuals of violations or potential violations of the federal securities laws. These reports can be submitted through a form on the SEC’s website, by e-mail, or by telephone.

These regulations have the potential to impact any issuer that has issued a security, regardless of whether that issuer is public, private, foreign, or domestic, or whether the security is equity or debt. As long as the situation about which a whistleblower makes a report constitutes a violation or potential violation of the federal securities laws, a whistleblower may bring a claim to the SEC in an effort to obtain a reward. Companies have expressed serious concerns about these rules, primarily because they are worried that the rules create a financial incentive for employees to circumvent a company’s internal compliance procedures and reporting mechanisms and contact the SEC directly with respect to a potential violation.

In order to be entitled to a whistleblower bounty, an individual must provide information that leads to the successful enforcement by the SEC of a matter resulting in sanctions that exceed $1 million. The bounty, by statute, is required to be paid in an amount between 10% and 30% of the funds that are recovered by the SEC in the matter. As a result, a whistleblower complaint needs to involve a reasonably significant claim in order to have the potential to result in a recoverable bounty. Also, the bounty is only available to an individual, and not to an issuer or other entity. Further, some individuals are ineligible to obtain a whistleblower bounty, including those who have client relationships with an issuer, such as an independent public accountant or a lawyer. Interestingly, the SEC does not exclude individuals who are involved in the wrongdoing itself from receiving a bounty, although any participation in the wrongdoing would factor into the determination of the size of the bounty awarded.

Whistleblower information, in order to qualify for the payment of a bounty, has to be submitted on a voluntary basis. Consequently, a person is not eligible for a bounty if he or she produced information as the result of a subpoena or request for information by the SEC. The individual must come forward with the information of their own volition, and the information has to be “original,” meaning it (1) must be derived from the independent knowledge or analysis of the whistleblower, (2) is not known to the SEC from any other source, and (3) is not exclusively derived from another public source such as an administrative hearing or news report. Hearsay and other forms of indirect evidence are not acceptable forms of evidence and cannot be used to support a whistleblower’s claim.

Other factors besides the culpability of the whistleblower can increase or decrease a whistleblower award pursuant to these rules. First, the information must be significant and not just incremental to information that the SEC already possesses. In addition, the size of an award may be larger if the whistleblower reports the wrongdoing internally through an issuer’s own compliance procedures and mechanisms before going to the SEC. There is no requirement, however, for a whistleblower to report internally before reporting to the SEC. A whistleblower may also make an initial report anonymously, but if the SEC investigation does result in the payment of an award, the person who made the report must reveal his or her identity to the SEC in order to receive the payment.

To protect whistleblowers against retaliation, the regulations contain an express anti-retaliation provision which mandates that an issuer may not retaliate against an employee for coming forward with a whistleblower report. To date, purported whistleblowers have brought a number of anti-retaliation claims as a result of the whistleblower rules, and the number of those claims is likely to increase as whistleblowers become more aware of the existence of these regulations.

Companies should take steps now to ensure that their employees are aware of internal reporting systems and compliance procedures for addressing potential violations of the federal securities laws. Employees should not learn about the concept of whistleblowing for the first time when they hear about the potential to claim a bounty for making a report to the SEC. Rather, they should have their employer’s own internal reporting system at the top of their minds, and think of using that system to report a problem if they see one. As part of preparations for fiscal year-end reporting in 2012, companies should remind employees that management is committed to full compliance with the federal securities regulations, and educate them as to the systems in place at the company to report any issues with compliance.

“Proxy Plumbing”. 

In July 2010, the SEC issued a concept release on the US proxy system.7 This release, which has come to be known as the “proxy plumbing” release, addresses three principal questions regarding the current proxy system in the United States: whether the SEC should take steps to enhance the accuracy, transparency, and efficiency of the voting process; whether the SEC’s rules should be revised to improve shareholder communications and encourage greater shareholder participation in the shareholder meeting process; and whether the voting power held by shareholders is aligned with the economic interest of such shares. No rulemaking has yet been issued by the SEC in response to this concept release, but we understand that the SEC is continuing to evaluate the issues it raised in that document. In addition the SEC is also looking at proxy advisory firms and the role they play in shaping shareholder votes. Although the SEC has no ability to regulate these firms, the SEC is concerned about the lack of competition and the sway they seem to have over the voting decisions made by many institutional investors.

SEC Cybersecurity Guidance.

On October 13, 2011, the staff of the SEC issued Corporation Finance (CF) Disclosure Guidance on Cybersecurity, a guidance document regarding disclosures of cybersecurity risks that may impact the issuers of securities.8 There has been an increase in cybersecurity attacks on issuers in many industries in recent years — attacks on an issuer’s networks, systems, computers, programs and data that can result in seizure or misappropriation of sensitive information about business partners, customers, and other parties. The Guidance provides direction to companies with regard to when the risks or consequences of those attacks must be disclosed to the public.

An issuer is generally required to disclose any material information related to its business that may impact an investor, including with regard to cybersecurity or cyber attacks. Information is considered to be material if there is a substantial likelihood that a reasonable investor would consider it important when contemplating an investment in a company. With respect to cybersecurity issues, there are certain scenarios in which disclosures may be material to an issuer and its investors. The Guidance notes that public companies are required to evaluate their cybersecurity risks and “consider the probability of cyber incidents occurring and the quantitative and qualitative magnitude of those risks, including the potential costs and other consequences resulting from misappropriation of assets or sensitive information, corruption of data or operational disruption.” Therefore, issuers who work with or have access to sensitive customer data or whose businesses would be seriously impacted by a computer security breach should consider disclosing the risk of cyber attacks and similar events in their disclosure documents.

The SEC also provided direction in the Guidance regarding disclosures which reference how an issuer should address potential cyber security risks, and the need to explain why the cost and consequences associated with doing so represents a material event. The SEC also addressed the need for disclosures if a cyber attack could materially affect the issuer’s products or services, customer relationships, and competitive conditions, as well as disclosure in the event of a pending legal proceeding regarding a cyber attack.

Where an issuer is required to incur substantial costs in order to protect against potential cybersecurity risks, the issuer may need to include references to those costs in the Management’s Discussion and Analysis (MD&A) section of its filings, as well as in footnotes to financial statements. Likewise, when a cyber attack occurs, litigation involving suppliers and customers could be costly; companies may need to disclose and explain these risks in addition to the consequences of the cyber attack itself. Finally, issuers are required to disclose the effectiveness of their disclosure controls and procedures in SEC filings; to the extent those controls and procedures are impacted by cyber attacks, an analysis of the consequences of those attacks for the controls and procedures may be required.

The Guidance does not impose any new disclosure requirements or make any changes to existing disclosure rules. The Guidance does, however, make it very clear that the SEC is strongly concerned about cybersecurity as a general concept. The purpose of the Guidance is to remind companies that they should be keeping this specific topic in mind when crafting disclosure within the existing framework of the SEC’s rules, especially when preparing disclosure in their Forms 10-K regarding risk factors, MD&A, the business description, financial statements, and legal proceedings.

Conflict Minerals Disclosure. 

Conflict minerals-related disclosure is another highly controversial topic for which the SEC was required to issue rules under the Dodd-Frank Act. Section 1502 of the Dodd-Frank Act provides that the SEC shall require companies to disclose whether or not their products contain so-called “conflict minerals” — i.e., tin, gold, tantalum, or tungsten, from the Democratic Republic of Congo and neighboring countries. This provision was included in the Dodd-Frank Act at the request of legislators who believe that the process of mining for and producing these particular minerals in certain countries is contributing to a grave, ongoing humanitarian crisis in that region of Africa.

The SEC proposed rules on this topic in December 2010, and the Dodd-Frank Act had required the rules to be finalized by April 15, 2011. However, due to the strong resistance to the rules from a broad cross section of the business community, the rulemaking has been delayed and, as of January 2012, is still not yet final. The implementing rules as proposed provide that:

  • If “conflict minerals” are necessary to the functionality or production of a product manufactured, or contracted to be manufactured, by an issuer, the issuer would be required to disclose in its annual report whether the conflict minerals originated in the Democratic Republic of the Congo or an adjoining country.
  • If the answer is that they do originate in such countries, the issuer must furnish an exhibit to its annual report that includes, among other matters, a description of the measures taken by the issuer to exercise due diligence on the source and chain of custody of its conflict minerals.
  • These due diligence measures would include, but would not be limited to, an independent private sector audit of the issuer’s report conducted in accordance with standards established by the Comptroller General of the United States. Any issuer furnishing such a report would be required to certify that it obtained an independent private sector audit of its report, provide the audit report, and make its reports available to the public on its Internet website.

Of particular concern to the business community is the fact that there is no de minimis threshold for the disclosure, meaning that the presence of even trace amounts of the conflict minerals would need to be analyzed and reviewed for the purpose of this requirement. Further, from a practical standpoint, commenters have argued that companies with dozens or even hundreds of suppliers may find it unmanageably expensive and burdensome to gather this information from several steps back in the supply or production chain. The SEC convened a roundtable discussion on October 18, 2011 in order to obtain information from companies regarding this issue that could help the agency put some parameters around the rule to make it realistically manageable. However, as the final rules have not yet been released, we are still waiting to see what the SEC ultimately produces. In the meantime, companies engaged in manufacturing products in the electronics, medical device, aerospace, and computer industries, among others, should give some consideration to how they would address this requirement by reviewing supply contracts to determine the number and locations of suppliers they would need to contact for information in the event that the rules are passed essentially as written.

Internal Control over Financial Reporting. 

One positive development for smaller reporting companies contained in the Dodd-Frank Act was the permanent elimination of the requirement for such companies to provide an attestation report of their auditors with respect to their internal control over financial reporting in their annual reports on Form 10-K. All other companies have been and are still required to include those reports, pursuant to Section 404 of the Sarbanes-Oxley Act. In addition, all issuers, including smaller reporting companies, are required to include reports of their management as to the effectiveness of internal control over financial reporting.

2012 Periodic Report Filing Deadlines

For companies that qualify as large accelerated filers and have fiscal years ending on December 31, annual reports on Form 10-K are due 60 days after fiscal year-end (Wednesday, February 29, 2012).9Form 10-K reports continue to be due 75 days following fiscal year-end for accelerated filers10(Wednesday, March 15, 2012 for December 31 year-end companies) and 90 days after fiscal year-end for non-accelerated filers (Friday, March 30, 2011 for December 31 year-end companies).

In addition, Form 10-Q reports filed by accelerated filers and large accelerated filers continue to be due 40 days after the close of the fiscal quarter. The deadline for Form 10-Q reports for non-accelerated filers continues to be 45 days after the close of the fiscal quarter

These changes do not affect the existing proxy statement filing deadline of 120 days after fiscal year-end for companies that choose to incorporate by reference from their definitive proxy statements the disclosure required by Part III of the Form 10-K.

Companies should also note the extra day in the first quarter as this year is a leap year with February 29th as an added date.

Board of Director and Committee Membership

Each year as part of the year-end reporting process, we recommend that companies carefully examine the membership profiles of their board and board committees. Sarbanes-Oxley, the SEC rules issued under Sarbanes-Oxley, and the listing requirements of Nasdaq, NYSE, and NYSE Amex relating to board and committee membership requirements all impact who may serve.11 Mintz Levin has prepared a director independence and qualification checklist to assist with this analysis, and we encourage you to evaluate each director and director nominee to ensure continued compliance with these requirements.

Shareholder Approval of Equity Compensation Plans

Nasdaq, NYSE, and NYSE Amex all require shareholder approval for the adoption of equity compensation plans and arrangements for employees, directors, and consultants and for any material modification of such plans and arrangements, including the addition of new shares to a plan. Exemptions from the shareholder approval requirement continue to be available for inducement grants to new employees if such grants were approved by a compensation committee or a majority of the company’s independent directors, and if, promptly following each grant, a press release is issued specifying the material terms of the award, including the name of the recipient and the number of shares issued. In certain situations, exceptions to the requirement may also be available for a grant relating to an acquisition or merger. An exemption from the shareholder approval requirement is also available for certain tax-qualified, non-discriminatory employee benefit plans (such as plans that meet the requirements of Section 401(a) of the Internal Revenue Code and Employee Stock Purchase Plans meeting the requirements of Section 423 of the Internal Revenue Code), provided that such plans are approved by the issuer’s compensation committee or a majority of the issuer’s independent directors. Equity plans adopted prior to June 30, 2003 are unaffected under this rule, until a material modification is made to such a plan.

As noted above, companies considering option repricing programs in light of significant declines in their stock prices should note that such programs may require shareholder approval, depending on the terms of the equity compensation plan under which the options were granted. In the event that shareholder approval is required, the company will need to file a preliminary proxy statement with the SEC, which would not be required for approval of a new plan or an amendment to an existing plan.

Companies should review their existing equity compensation plans as part of their year-end reporting preparation in order to determine whether shareholder approval will need to be obtained for new plans or to determine increases in the numbers of shares available under old plans, option repricing programs, or material plan amendments. Since this is another area where ISS continues to weigh in heavily, both with respect to the number of shares to be authorized under the plan and with respect to some of the substantive disclosure within the plan itself, plenty of time should be allotted to drafting proposals on these matters.

Other Year-End Considerations

We also recommend that companies take the opportunity while planning their year-end reporting to consider what amendments may be necessary or desirable to their corporate documents over the coming year that may require shareholder approval. Some items to consider are:

  • Does the company have enough shares authorized under its certificate of incorporation to achieve all of its objectives for the year, including acquisitions for which it may want to use its stock as currency?
  • Does the company have adequate shares available under its equity compensation plans to last throughout the year?
  • Are there other material changes that should be made to the company’s equity compensation plans that would require shareholder approval?
  • Has the company reviewed its charter and by-laws to assess any anti-takeover measures in place?

To the extent that a company expects any proposal in its proxy statement to create controversy among its shareholder base, it may want to consider hiring a proxy solicitor to assist with the process of seeking the requisite shareholder vote.

In addition, in light of the say-on-pay, executive compensation, and governance rules described above, management and directors of public companies should annually consider the following questions, with a view to the disclosure that would flow from each answer.

Compensation Committe

Consider whether the company’s compensation policies and practices for all of the company’s employees, including non-executive officers, create risks that are reasonably likely to have a material adverse effect on the company.

  • Are there business units that carry a significant portion of the company’s risk profile?
  • Are there business units with compensation structured significantly differently from the other units within the company?
  •  Are there business units that are significantly more profitable or risky than others within the company?
  • Are there business units where compensation expenses are a significant percentage of the unit’s overall expenses?
  •  Does the company have compensation policies or practices that vary significantly from the overall risk and reward structure of the company and are not in alignment with the timing of the outcome on which the award was based?

Is the company using a compensation consultant for which disclosure would be required under these rules?

If the company is currently subject to the say-on-pay rules, is the CD&A written in a sufficiently compelling and persuasive manner?

Nominating Committee

»     Consider, for each director and nominee, the particular experience, qualifications, attributes, or skills that led the board to conclude that the person should serve as a director for the company and how the directors’ skills and background enable them to function well together as a board, as of the time that a filing containing this disclosure will be made with the SEC. Review the company’s current requirements regarding minimum qualifications to serve as a director that are currently set forth in the company’s proxy statement to make sure that the disclosure works with the current nominating committee policy.

»      Consider whether, and if so how, the nominating committee considers diversity in assessing director nominees. Consider whether to adopt a policy regarding the consideration of diversity in identifying nominees, how to implement the policy, and how to assess its effectiveness.

»      Consider the current governing structure of the board. Is it still appropriate for the company? Are revisions necessary or appropriate?

»      Revise the nominating committee charter, if necessary, based on the issues discussed above.

Full Board

Consider the board’s role in managing and overseeing the material risks facing a company. Has this role been effectively managed by the board? Should the role be delegated to a committee?

Endnotes

1  We invite you to review our memorandum from last year, which analyzed regulatory changes that were new for fiscal year 2010, and we would be happy to provide you with another copy upon request.

2  Smaller reporting companies are those that have less than $75 million in public float as of the last business day of their most recently completed second fiscal quarter.

3  For a further discussion regarding say-on pay litigation see our Client Advisory, dated July 18, 2011, entitled “Lessons Learned from Initial ‘Say-on-Pay’ Litigation, Plaintiffs’ Attorneys Start Utilizing ‘No’ Votes as a Basis for Claims Against Directors”.

4  The peer group is generally comprised of 14-24 companies that are selected by ISS using market cap, revenue (or assets for financial firms), and GICS industry group, via a process designed to select peers that are most similar to the company, and where the company is close to median in revenue/asset size.

5  The ISS 2012 policy in evaluating say-on-pay is available on the ISS website.

6  Specifically, Exchange Act Rule 14a-11, which sets forth the specific procedures and rules to be used to nominate a director, was vacated.

7  Concept Release on the U.S. Proxy System (Release No. 34-62495, July 14, 2010).

8  Securities and Exchange Commission, CF Disclosure Guidance: Topic No. 2, Cybersecurity (October 13, 2011).

9  Large accelerated filers are domestic companies that meet the following requirements as of their fiscal year-end:

·         have a common equity public float of at least $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2011);

·         have been subject to the reporting requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, for at least 12 months;

·         have previously filed at least one Annual Report on Form 10-K; and

·         do not qualify as smaller reporting companies under SEC rules.

10 Accelerated filers are those that meet all of the above tests but have a common equity public float of at least $75 million, but less than $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2011).

11 Please see our Client Advisory, dated November 2003, entitled “Changes to Corporate Governance Standards for Nasdaq-Listed Companies,” for a further description of these changes. We would be happy to provide you with a copy upon request.

©1994-2012 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

California Appellate Court Issues a Decision That Mutual of Omaha Insurance Agents Qualify as Independent Contractors as a Matter of Law

From a recent posting in the National Law Review an article by attorney Thomas R. Kaufman of Sheppard Mullin Richter & Hampton LLP regarding the way insurance companies treat their independent agents:

December 31, 2011, as a final act for the year, the First Appellate District of the California Court of Appeal issued a good appellate decision for employers on the issue of independent contractor status, Arnold v. Mutual of Omaha. The case creates a veritable roadmap for insurance companies on how to treat agents so that they maintain their status as independent contractors rather than employees.

The Key Facts

Ms. Arnold worked as a non-exclusive insurance agent for Mutual of Omaha, which meant she was authorized to sell their products but was free to (and did) sell products of other insurance companies. Nonetheless, she claimed she was actually an employee rather than an independent contractor (IC), and that she therefore was entitled to recover for reimbursement of expenses and waiting time penalties for unpaid final wages on behalf of herself and a purported class of similarly situated agents. The factual record was very strong for the defense as to the limited control Mutual of Omaha exercised over Arnold (and its other agents):

  1. The contract Arnold signed with Mutual of Omaha expressly stated that the parties understood it was an independent contractor agreement.
  2. Her chief duties were to procure and submit insurance applications, collect money, and service clients.
  3. She was compensated entirely on commissions for products sold, with a chargeback if money was uncollected or refunded.
  4. She received no performance evaluations and nobody at Mutual of Omaha monitored or supervised her work schedule.  Plaintiff decided when, where, and to whom she would market insurance.
  5. Although Mutual of Omaha provided some training on its products and sales techniques, it was not mandatory for ICs to take the training.  The only mandatory training was as to compliance with certain state insurance laws and regulations.
  6. Mutual of Omaha provided some office space if agents wanted to use it, but it was optional, and agents had to pay for the “workspace and telephone service.”  Mutual of Omaha also did not pay for business cards or any other business expenses, although it provided certain services for a fee if an IC wanted them.
  7. Under the IC agreement in place, either party could terminate the relationship at any time with or without cause, or if Arnold failed to sell a Mutual of Omaha product for 180 days.

On this record, the trial court granted summary judgment to Mutual of Omaha that Arnold was an independent contractor rather than an employee.  Arnold appealed.

What Makes the Case Noteworthy

The court of appeal affirmed, declaring that it was not even a close case.  As a preliminary matter, the court held the common law test of employee v. IC applies to claims under Labor Code Section 2802.  This is a multi-factor test (roughly 10 factors depending how you count them), codified in a decision called S.G. Borelli & Sons, Inc. v. DIR, 48 Cal. 3d 341 (1989).  This holding is not exactly earth-shaking as the plaintiff’s argument of statutory interpretation was not particularly cogent.  It is the summary judgment aspect of the case that makes it notable, because the case sets forth a pretty good roadmap of what an insurance company who wants to have independent contractor agents should follow to preclude a lawsuit that the agents are really employees.  The court pointed to the existence of undisputed facts on several specific issues as justifying summary judgment:

“After a careful review of the opposing evidence, we find nothing that raises a material conflict with the supporting evidence summarized above. The salient evidentiary points established Arnold used her own judgment in determining whom she would solicit for applications for Mutual’s products, the time, place, and manner in which she would solicit, and the amount of time she spent soliciting for Mutual’s products. Her appointment with Mutual was nonexclusive, and she in fact solicited for other insurance companies during her appointment with Mutual. Her assistant general manager at Mutual’s Concord office did not evaluate her performance and did not monitor or supervise her work. Training offered by Mutual was voluntary for agents, except as required for compliance with state law. Agents who chose to use the Concord office were required to pay a fee for their workspace and telephone service. Arnold’s minimal performance requirement to avoid automatic termination of her appointment was to submit one application for Mutual’s products within each 180-day period. Thus, under the principal test for employment under common law principles, Mutual had no significant right to control the manner and means by which Arnold accomplished the results of the services she performed as one of Mutual’s soliciting agents.”

The court mentioned that several other factors further tilted in Mutual of Omaha’s favor, but it appears that establishing undisputed facts on the above items would generally be sufficient to support summary judgment.  Furthermore, the court recognized that a plaintiff cannot avoid summary judgment simply by raising a triable issue of fact on one or two minor factors of IC status.  Rather, the court held that if a reasonable factfinder considering all of the evidence together could not conclude that the agent was an employee, the employer is entitled to judgment:

“The existence and degree of each factor of the common law test for employment is a question of fact, while the legal conclusion to be drawn from those facts is a question of law. (Harris v. Vector Marketing Corp. (N.D. Cal. 2009) 656 F.Supp.2d 1128, 1136.) Even if one or two of the individual factors might suggest an employment relationship, summary judgment is nevertheless proper when, as here, all the factors weighed and considered as a whole establish that Arnold was an independent contractor and not an employee for purposes of Labor Code sections 202 and 2802. (SeeVarisco, supra, 166 Cal.App.4th at p. 1106.)”

Copyright © 2011, Sheppard Mullin Richter & Hampton LLP.

10 Tips for Conducting an Internal Investigation

Recently posted in the National Law Review an article by Catherine Salmen Wright of  Dinsmore & Shohl LLP regarding conducting an internal investigation:

The recent news involving Penn State highlights how high the stakes can be when conducting an internal investigation. In fact, Penn State has hired former FBI director Louis Freeh to lead its internal investigation into alleged criminal conduct by a former employee. But while most employers do not face circumstances this challenging, the reality is that employers are presented with circumstances on a regular basis that must be investigated effectively to avoid significant legal liability.

Of course, this begs the question of when an employer needs to investigate. The simplest answer is when the employer has knowledge of misconduct. Misconduct can include a breach of an employer policy, violation of a drug or alcohol policy, theft or other criminal activity, or even misuse of company property. Employers should not, however, too narrowly construe what constitutes “knowledge,” which can include formal and informal complaints, information obtained during exit interviews, anonymous tips and third-party information.

Employers should also keep in mind that an internal investigation may become your defense in any subsequent litigation and therefore may be subject to significant scrutiny by the plaintiff, the plaintiff’s lawyer and possibly a jury. For example, in a sexual harassment lawsuit, the employer’s investigation is what typically shows that the employer exercised reasonable care to prevent and correct any harassing behavior. Another defense used by employers in wrongful termination lawsuits is the “honest belief” rule. Specifically, if the employer can show that it reasonably relied on the particularized facts that were before it at the time the decision was made, it can potentially avoid liability over a challenged decision. The investigation does not need to be perfect, but the employer must make a reasonably informed decision before taking an adverse employment action.

As a result, conducting an effective internal investigation is critically important. Every investigation comes with a unique set of facts and challenges, but the following 10 principles serve as a guide for conducting an effective investigation.

1. Determine the objectives and strategy for the investigation.

At the outset, employers must establish the objectives of the investigation. Questions that should be addressed include:

  • Are you trying to develop a complete record to justify a decision?
  • Are you attempting to avoid litigation?
  • What are your legal obligations?
  • Do you need an attorney involved?

Evaluating the answers to these questions will allow you to tailor your investigation.

2. Maintain confidentiality.

A guiding principle in any investigation is confidentiality, which employers should maintain to the extent possible. However, don’t promise what you can’t deliver. Absolute confidentiality when employees will be interviewed is virtually impossible. Also, employers need to be vigilant when it comes to thoroughness and promptness. For example, if you had to answer questions one year later in a deposition, can you give a reasonable explanation of why it took the amount of time it did to complete the investigation?

3. Determine if immediate actions need to take place to protect the workforce.

Based on what you know at the time the investigation begins, you may need to take immediate steps to protect the complaining party, alleged victim or the workforce in general. For example, an accused harasser may be put on a paid or unpaid leave, supervisory responsibilities could be changed or an employee could be temporarily transferred pending an investigation, but in no case should an employer penalize the alleged victim.

4. Review company policies.

Take an inventory of employer policies that may impact the investigation process. For example, a collective bargaining agreement may provide an employee the right to have a representative present at any interview.

5. Conduct a preliminary search of available records.

This includes reviewing personnel files and any documents relating to the misconduct. Act quickly to retrieve what electronic information is still available, including emails and text messages.

6. Select the appropriate personnel to conduct the investigation.

Investigators should be unbiased and unprejudiced — and perceived as such. Good investigators are skilled at setting people at ease and drawing out reticent witnesses in order to collect facts. They also need knowledge of company policies and procedures, the ability to maintain confidentiality and a level of authority consistent with the significance of the matter being investigated.

7. Control the interview process.

Obtaining detailed statements from interviews with the complaining party and the accused are a critical part of any investigation. Documentation should include the facts, not legal conclusions, or your interpretations and assumptions. Give witnesses ground rules: No conclusion has been reached, no reprisal will be taken, and no discussions about the interview are allowed with anyone.

8. Communicate throughout the process.

Many employers launch an investigation, only to fail to keep the complainant reasonably informed during the process. Unfortunately, this results in the complaining party believing their complaint was ignored, which may prompt them to involve an attorney.

9. Close the investigation properly.

Having invested the time and cost associated with the investigation, protect your investment by properly closing out the investigation. Make a decision, communicate the decision and document the process.

10. Ensure against retaliation.

Employees who make complaints may be legally protected from experiencing an adverse employment action. This includes complaints involving discrimination, harassment, safety violations, wage and hour violations and more. Do ensure against retaliation by continuing to monitor the situation.

As seen in the December 9th issue of Business Lexington.

© 2011 Dinsmore & Shohl LLP. All rights reserved.

In Ninth Circuit, Whistleblowers Not Exempt From Confidentiality Agreements

Posted in the National Law Review an article by attorney Anthony Navid Moshirnia of Sheppard, Mullin, Richter & Hampton LLP about blowing the whistle on alleged fraud against the Government does not entitle an employee to loot:

 

Blowing the whistle on alleged fraud against the Government does not entitle an employee to loot and disclose her employer’s records in violation of a confidentiality agreement – at least not in the Ninth Circuit. In an opinion handed down in March of this year, the Ninth Circuit refused to adopt a so-called “public policy exception to confidentiality agreements to protect [qui tam plaintiffs]” who misappropriate documents from their employers ostensibly to buttress claims brought under the federal False Claims Act (“FCA”). U.S. ex rel. Cafasso v. Gen. Dynamics C4 Sys., Inc., 637 F.3d 1047, 1061-62 (9th Cir. 2011). Though this opinion has been on the books since Spring, it remains relevant, and worth keeping an eye on, as it provides powerful ammunition against FCA plaintiffs that continue to tout the “public policy” exception as though it were unassailable.

After learning that her job at General Dynamics C4 Systems, Inc. (“General Dynamics”) was going to be terminated, but before leaving her employment, Mary Cafasso “copied almost eleven gigabytes of data from [her employer’s] computers in anticipation of bringing a qui tam action” under the FCA.  When it discovered what Ms. Cafasso had done, General Dynamics filed suit in Arizona state court, seeking return of its purloined documents through a temporary restraining order (“TRO”). Apparently to avoid complying with the TRO, which the state court granted, Ms. Cafasso filed “a conclusory six page complaint . . . alleg[ing] FCA violations and retaliation.” She then used the FCA action to persuade the Arizona court to vacate the TRO and stay General Dynamics’ lawsuit.

When Ms. Cafasso’s FCA complaint was unsealed, General Dynamics counterclaimed alleging, inter alia, breach of contract arising from Ms. Cafasso’s misappropriation of documents in violation of a confidentiality agreement. In opposition to General Dynamics’ motion for summary judgment, Ms. Cafasso argued that General Dynamics had failed to prove contract damages and that, even if it had, her conduct was permissible because “[p]ublic policy grants [a] Relator a privilege in gathering copies of documents as part of an investigation under the FCA and gives [a] Relator immunity from civil liability based on claims against her for so doing.” U.S. ex rel. Cafasso v. Gen. Dynamics C4 Sys., Inc., 2009 WL 1457036, *13 (D. Ariz. May 21, 2009).

The trial court dismissed both of Ms. Cafasso’s arguments. It found that damages were established by the stipulated damages clause in the General Dynamics confidentiality agreement. After reviewing the parties’ competing legal arguments, the trial court also found that “public policy does not immunize Cafasso, [who] confuses protecting whistleblowers from retaliation for lawfully reporting fraud with immunizing whistleblowers for wrongful acts made in the course of looking for evidence of fraud.” The court concluded that “[s]tatutory incentives encouraging investigation of possible fraud under the FCA do not establish a public policy in favor of violating an employer’s contractual confidentiality and nondisclosure rights.”

On appeal, Ms. Cafasso did not dispute that her actions violated her confidentiality agreement with General Dynamics, but nonetheless urged the Court to “adopt a public policy exception to enforcement of such contracts that would allow relators to disclose confidential information in furtherance of an FCA action.”  While noting that Ms. Cafasso’s position was not frivolous, and might apply “in particular instances for particular documents,” the Ninth Circuit found that Ms. Cafasso’s data removal was not privileged.

The Ninth Circuit appears to have relied on two factors to reach this conclusion: the scope and volume of the documents Ms. Cafasso took. With respect to scope, the Ninth Circuit faulted Ms. Cafasso’s “indiscriminate appropriation of documents,” referring to it as an “unselective taking [that included] attorney client privileged communications, trade secrets belonging to [General Dynamics] and other contractors, internal research and development information, sensitive government information, and at least one patent application that the Patent Office had placed under a secrecy order.”  The Court was also troubled by the fact that Ms. Cafasso had taken over 11 gigabytes of data, noting that “the need to facilitate valid claims does not justify the wholesale stripping of a company’s confidential documents.” In sum, the Ninth Circuit found that an “exception broad enough to protect the scope of Cafasso’s massive document gather in this case would make all confidentiality agreements unenforceable as long as the employee later files a qui tam action” – an unacceptable result.

While Cafasso stopped short of rejecting the public policy defense to data theft as a matter of law, it certainly provides a new avenue to FCA defendants attempting to prevent qui tam relators from benefitting from extrajudicial discovery.

Copyright © 2011, Sheppard Mullin Richter & Hampton LLP.