Back in August, Professor Scheuer discussed the first whistleblower award issued by the SEC here. Following a recent whistleblower award development, Susan Lyon from NerdWallet authored a blog post titled, Understanding the New SEC Whistleblower Program: Breaking down the Largest Whistleblowing Rewards in U.S. history. In this post, Susan discusses how the IRS recently paid a former UBS banker Bradley Birkenfeld $104 million for his role as a whistleblowing informant, who provided the IRS with valuable insider information, resulting in a giant settlement with UBS. Susan explains,

The Dodd-Frank Act’s whistleblower program, established under the SEC, is the most recent attempt at strengthening and speeding up federal whistleblower programs.  While the DOJ, SEC, and IRS continue to push forth their own whistleblowing programs, the debate concerning proper retribution and consequences for such informants rages on.

Susan turned to five experts with the question: Is the SEC’s new program working, and is it better than the old IRS program? One expert—Institute Director and Professor of Corporate and Business Law Lawrence Hamermesh—provided the following insight:

“Clearly the one thing that Congress saw and wanted to fix was an insufficient incentive system for whistleblowers who had witnessed corporate misconduct.  So they decided to effectively hold out a ‘carrot’ – a portion of the money recovered as a result of any information the whistleblower provided.

The big question is how this will interact with internal corporate grievance and reporting programs already in place.  Firms were afraid the SEC program would take the wind out of their sails, but instead the program may actually bolster internal practices because the same person can now both report internally and to the SEC.  The commission did an admirable job setting up a reasonable balance between them to harmonize the two mechanisms.  We’ve now seen two claims addressed but the SEC can’t say much more about how well the program is working without threatening whistleblower anonymity.”

The remaining four experts include: (1) Tom Devine, Legal Director of the Governmental Accountability Project, who explains how the SEC has implemented the gold standard of whistleblower programs by protecting the whistleblower from industry retaliation; (2) Eva Marie Carney, Partner at RK&O LLP and former Assistant General Counsel at the SEC, who highlights the advantages of being able to anonymously report fraud to the SEC; (3) Professor Richard Moberly, Associate Dean at the University of Nebraska School of Law, who notes the unique aspects of the SEC program set up by Dodd-Frank in providing both strong retaliation protection as well as financial incentives; and (4) Professor Geoffrey Rapp, the Harold A. Anderson Professor of Law and Values at the University of Toledo College of Law, who draws attention to the key differences between SEC, IRS and FCA whistleblower programs.

To review Susan’s post and view the experts’ commentary, please visit here.

Ben Chapple (Widener Law ’13) attended the oral argument on September 19, 2012, before the Delaware Supreme Court in Gatz Properties v. Auriga Capital Corp.  (No. 148, 2012).  This is the case in which Chancellor Strine’s opinion concluded, following a lengthy analysis, that members and managers of a Delaware LLC owe fiduciary duties to the LLC by default, and that such duties exist unless excluded by the LLC agreement.

Ben files the following dispatch, and makes two predictions about the outcome:  (1) the Court may avoid deciding what standard of judicial review applies in the case, by holding that the result would be unaffected even if the entire fairness standard does not apply; and (2) the Court will likely determine that the defendant contractually owed fiduciary duties under the LLC agreement, and therefore it is unnecessary to decide whether such duties exist by default.

*          *          *

In the opinion below, the Court of Chancery held that a majority owner and manager of a LLC (“Gatz”) breached his fiduciary duties when he attempted to obtain ownership interests of the minority members in bad faith.  In deciding the case, Chancellor Strine found that traditional fiduciary duties of care and loyalty apply to LLCs unless the parties contract them away; thus, it was held that there are “default” fiduciary duties. As a result of this holding, many academics and practitioners have closely followed this appeal, anticipating that the Supreme Court will finally weigh in on this interesting issue, which was the subject of an online symposium here late last year. What follows is a brief overview of the oral argument and a couple predictions about the Court’s holding.

Defendant’s Arguments

On appeal, Gatz argued that LLCs are creatures of contract, not common law, and the LLC agreement at issue was unambiguous in its terms that certain conflict transactions were appropriate. Gatz further argued that the Court of Chancery implicitly applied the entire fairness standard, and that decision was contrary to terms of the LLC agreement. Justice Ridgely responded by asking Gatz’s counsel, “Wouldn’t the case be the same even without the entire fairness standard?” Counsel replied that the “prism” through which one views the facts makes a considerable difference, and the burden shift associated with the entire fairness standard was devastating to Gatz’s case.  To this end, Gatz argued that because Chancellor Strine turned a “safe harbor” provision—section 15 of the LLC agreement[1]—into an entire fairness provision, the legal prism should be corrected. Gatz asserted that reading entire fairness into section 15 is inappropriate because if the parties intended to limit transactions they would have done so contractually, which, Gatz contends, they did not. Gatz explained that although the LCC agreement imposed fiduciary duties—for example, as a result of section 15—section 16[2], as written, should have prevented the application of those duties in present case. Gatz argued that although the LLC agreement does not explicitly state that no fiduciary duties apply to certain conflict transactions, under Delaware law the applicable standard that is contractually identified should be enforced and respected by the courts. At the end of Gatz argument, Justice Jacobs stated, “Since [Gatz] conceded that some fiduciary duties apply, to that extent it was unnecessary for the trial court to interpret the LLC statute about default fiduciary duties.” Gatz responded, briefly, by reiterating his previous point that although the LLC agreement imposed fiduciary duties, section 16 of the agreement prevented the application of the duties in the case sub judice.

Plaintiffs’ Arguments

The appellee, Auriga Capital Corp. (“Auriga”), focused its portion of the argument on the contention that Gatz waived the claim that fiduciary duties did not apply—by default or otherwise. Auriga asserted that Gatz repeatedly admitted, throughout pre-trial stages, that fiduciary duties applied and it, like Chancellor Strine, relied on these representations. Auriga asserted that fiduciary duties, whether based on contract or common law, are the same—(1) the duty of loyalty, and (2) the duty of care—and based on the facts of the case, the Court does not need to address whether duties exist by default because they existed by contract, namely as a result of section 15. Additionally, Auriga stated that the “law review” portion of the trial court’s opinion—relating to whether fiduciary duties exist by default—was not addressed by the parties below, and therefore the Court should not decide this issue because it was not “vigorously debated” at trial.

Two Predictions

(1) Based on Justice Ridgely’s question—”Wouldn’t the case be the same even without the entire fairness standard?”—the Court may avoid deciding this issue by holding that the result of the case is unaffected regardless of whether the entire fairness standard applies; and (2) the Court, consistent with avoiding this issue, will likely limits its analysis by determining that Gatz contractually owed Auriga fiduciary duties as a result of section 15 of the LLC agreement, and therefore it is unnecessary to decide whether they exist by default.

The annual report of the Institute of Delaware Corporate and Business Law is now available here. We’ve already begun a busy year of programming (see this report on last week’s visit by Prof. Mohsen Manesh of the University of Oregon School of Law.)

We previously reported here on the voting results on proxy access shareholder proposals during the main proxy season. In the last couple months there have been three additional votes (at Forest Laboratories, Medtronic and H&R Block). As the updated voting tabulation reflects, these three most recent votes didn’t add much to any argument that the SEC’s now-invalidated 3 year/3% ownership thresholds gave shareholders less than they would have voted for themselves: we’re talking favorable votes of 8% or less of the outstanding shares, and less than 10% of the shares actually voted. That compares to the 46%-51% approval levels at Nabors Industries and Chesapeake Energy for proposals that pretty much tracked the SEC’s threshholds.

Anyway, here’s the updated tabulation:
2012 proxy access votes (updated September)

 Linn Energy, LLC, SEC No-Action Letter (publicly available Aug. 30, 2012),

 2012 SEC No-Act. Lexis 428, 2012 WL 3835914

Professor Larry D. Barnett

In Linn, a Delaware limited-liability company (company #1) that had issued NASDAQ-listed securities to raise capital for its business operations[i] created a separate Delaware limited-liability company (company #2) that would also issue NASDAQ-listed securities.  Tax-exempt entities, as well as persons located outside the United States, were deterred by U.S. tax law from investing in the securities of company #1 because under U.S. tax law the company was deemed a partnership.  The tax disincentive would not exist for these entities/persons if they invested in the securities of company #2, however, because company #2 would be classified as a corporation.  Company #2 would sell its securities publicly and use the money received from the sale to acquire newly issued securities of company #1, thereby enlarging the investor base of company #1 and providing company #1 with additional capital.  Company #2 would have no long-term assets other than securities issued by company #1, and its short-term assets would be cash or cash-equivalents.  The raison d’etre of company #2, therefore, was to provide a conduit for investments in company #1:  Through ownership of the securities of company #2, persons disadvantaged by U.S. tax law when they directly owned the securities of company #1 could indirectly own the securities of company #1 and avoid the tax consequences of direct ownership.  Because the arrangement had specific features that attempted to equalize the governance and economic positions of investors in the two companies, the position of investors in company #1 and the position of investors in company #2 would differ mainly in terms of U.S. tax law.

An issuer of securities that qualifies as an investment company is required by § 7(a) of the Investment Company Act (“Act”) to register with the Securities and Exchange Commission.  Company #2, as an issuer of securities that invested in securities, evidently satisfied § 3(a)(1) of the Act, the section that specifies the activities and assets that define an investment company.  The request for a no-action letter submitted to the Commission thus focused on whether company #1 was an investment company under § 3(a)(1) and argued that it was not.  However, in responding to the request, the S.E.C. Division of Investment Management exempted not only company #1 but also company #2 from § 7(a).[ii]  Regrettably, the Division only provided assurance that it would not recommend enforcement action under the Act.  No explanation of pertinent law was explicitly given.  Indeed, the Division pointed out that it was not “express[ing] any legal or interpretive conclusion on the issues presented.”

Law-specific reasoning for a resolution of an issue of law under the Investment Company Act is typically absent from no-action letters written by the Division of Investment Management.  In this regard, then, Linn is not unusual.  However, the reply of the staff is notable for what the Division asserted in a footnote.  Specifically, the footnote stated that the position taken by the Division in the instant case applied to, and only to, company #1 and company #2.  Warning that “no other entity may rely on this position,” the Division observed that the two companies and their proposed arrangement were involved in a situation that had a “very fact-specific nature.”  In the view of the Division, its decision dealt with a situation that had unique attributes and hence could not — and should not — be generalized to other settings.

The warning given by the Division should be considered in conjunction with the omission by the Division of its reasoning on whether § 3(a)(1) applied to company #1.  The request for a no-action letter had presented a detailed analysis in support of the contention that company #1 was not an investment company.  According to the request, company #1 did not meet the criteria established either by § 3(a)(1)(A) or by § 3(a)(1)(C).  When it exempted company #1 from § 7(a), did the Division believe that company #1 failed to satisfy one or more of the criteria in each of these sections and hence was not an investment company?  Or did the Division think that company #1 qualified as, or might qualify as, an investment company under § 3(a)(1)(A) or § 3(a)(1)(C) but conclude that the proposed arrangement did not undermine the purposes of the Act?  One of two routes could thus have been taken in reaching the conclusion that enforcement action was unnecessary under § 7(a) with respect to company #1.  Although the route that the Division actually followed is unknown, the warning given by the Division in its reply may be evidence that the second route was chosen, i.e., that the staff thought that company #1 was or might be an investment company, but on policy grounds ruled that the two companies were entitled to an exemption from § 7(a).  Such a warning has traditionally been uncommon in no-action letters,[iii] and its inclusion in the instant letter is plausibly an indicator that the staff anticipated that the purposes of the Act would be subverted if the position it took could be widely followed by investment companies.

If the above reasoning is correct, what might explain the concern of the staff?  In granting the request of the two companies, the Division exempted from registration not just company #1, but also company #2.  Company #2, however, seems to have been an investment company.  Therefore, company #2, like company #1, was able to avoid the obligations that the Act imposes on a registered investment company, and company #1 was not subject even to the restrictions that the Act places on an affiliate of a registered investment company.

Vehicles for collective investments in securities became much more numerous in the United States during the past three decades, as seen in the graph in the Appendix infra,[iv] and they are now of inestimable significance to the U.S. financial system.[v]  As a result, the formulation of law on investment companies can have major consequences for the country — consequences that are economic and, at least as importantly, consequences that are social.[vi]  Unless exemptions from the registration requirement of the Act are granted sparingly, the goals that Congress established for the Act are unlikely to be achievable.  With this in mind, the staff may have placed the warning in the reply because it harbored doubts, or at least was uncertain, about the contention that company #1 was not an investment company.[vii]  Company #1, therefore, may have been an investment company, as was company #2.  If so, the exemption of both companies from registration as investment companies could have been prompted by a pair of specific considerations that alleviated the concern of the staff — the securities issued by company #1 had already been sold publicly, and company #2 would be an alter ego of company #1.[viii]  Assuming that the exemption was based on these considerations, the grounds for the exemption were indeed narrow, and Linn is likely to have helped the Act maintain its social productivity, the main function of law in a democracy.[ix]

This post is authored by Benjamin Chapple.

On September 6, 2012, Institute Professor Juliet Moringiello gave a CLE presentation titled “Why (Not) Chapter 9?“.  Professor Moringiello explained that in the past two years there have been a number of notable Chapter 9 bankruptcies, involving municipalities such as: Central Falls, Rhode Island, Harrisburg, Pennsylvania, Jefferson County, Alabama, and Mammoth Lakes, California.

The professor explained that Chapter 9 bankruptcies are rarely filed in large part for two reasons: (1) a paucity in case law creates uncertainty regarding how the bankruptcy will result; and (2) the statutory eligibility requirements of 11 U.S.C. § 109(c). One eligibility requirement to note is that the municipality must be specifically authorized by state law, or by a competent state government official or organization before it can file for bankruptcy.  While twenty four states have no authorizing legislation, and one state—Georgia—has legislation prohibiting Chapter 9 bankruptcies, the level at which the remaining twenty five states are authorized varies. It was explained that this authorization requirement is in place to address Tenth Amendment concerns, because a municipality is a creature of its states and entering bankruptcy places the municipality under the jurisdiction of the federal government.

Professor Moringiello’s presentation also identified and explained the delicate constitutional balance that exists between the federal and state government—specifically as a result of the Tenth Amendment, Contracts Clause, and Bankruptcy Clause. After addressing the constitutional implications of Chapter 9 bankruptcies, non-bankruptcy debt collection alternatives were discussed.

Professor Moringiello explained throughout her presentation that most interested parties advocate for either state or federal control; thus, finding that there cannot be state and federal cooperation. Professor Moringiello discussed the deficiencies of relying on Chapter 9 alone, and concluded that currently Chapter 9 is an incomplete rehabilitation tool.  Chapter 9 is incomplete because (1) Code sections outside of Chapter 9 apply in Chapter 9 only if included under § 901, and therefore Chapter 9 does not incorporate all of the provisions of Chapters 1, 3 and 5; (2) in Chapter 9 bankruptcies the municipality (debtor) maintains exclusive control over its filing, plan, and use of its assets; and (3) unlike other types of bankruptcy, there is no possibility that a trustee or examiner will be appointed.

Professor Moringiello concluded that the optimal approach is for state and federal cooperation because state involvement, she argues, can ameliorate some of the Chapter 9 deficiencies noted above. Specifically, the professor advocates that states could, and should serve as a check on its municipality’s behavior since a trustee cannot be appointed.

 For information about future Institute Presentations, please visit the Events page.

In a short letter opinion dated August 31, the Court of Chancery in SEPTA v. Volgenau dismissed a claim that a completed merger should be invalidated because it provided for different treatment of shares of the same class of stock, in violation of a charter provision that “holders of each class of Common Stock will be entitled to receive equal per share payments or distributions.” According to the complaint, the allegedly controlling stockholder rolled a portion of his shares into equity ownership of the ongoing company, an option not provided to holders of other shares of the same class.

The opinion declined to dismiss a claim that the directors breached their fiduciary duties by approving a transaction that violated the company’s charter. But the court concluded that the merger itself was beyond legal challenge by a stockholder, because of Delaware General Corporation Law Section 124, which precludes stockholder challenges to corporate acts based on “the fact that the corporation was without capacity or power to do such act,” except in proceedings to enjoin the acts. And because the plaintiff did not seek to enjoin the merger, Section 124 barred its claim to invalidate that transaction.

I admit that this application of Section 124 took me by surprise. Two main considerations drove that reaction. First, I always understood that this statute only addresses claims of ultra vires – i.e., claims that the corporation had purported to act beyond its powers as conferred by the State. I suppose, though, that one could conceive of a transaction that is invalid because if fails to comport with limitations in the charter (or the statute itself, for that matter) as ultra vires. I never thought of it that way myself, however, because I tend to think of the question of ultra vires in terms of corporate purpose, and I would have thought that the now ubiquitous and all-encompassing purpose provisions in charters, based on statutes like Section 102(a)(3), eliminate any question whether the corporation’s purposes include a merger like the one at issue in SEPTA. In short, I wouldn’t have thought that either Section 124 or the concept of ultra vires has anything to do with the disparate treatment claim advanced in SEPTA.

Second, and in any event, if the opinion is correct, a whole lot of case law seems to be placed in doubt. Take the landmark case of Moran v. Household, for instance, in which the Delaware Supreme Court first upheld the poison pill. In that case, the defendant company famously issued rights to acquire stock. That act drew a host of challenges, all aimed at setting aside the issuance. Among those challenges was the assertion that the issuance was not authorized by statute. The Supreme Court rejected those challenges on the merits; but if Section 124 really precludes a stockholder challenge to a completed corporate act, the Supreme Court could have made its life a lot easier by simply invoking Section 124 and dismissing the case, or at least any claim to set aside the pill.

Lots of other cases would similarly become off limits to stockholders. Suppose a charter required a supermajority vote for a merger, and it was discovered after purported consummation of the merger that the requisite vote was lacking. Would Section 124 bar a stockholder challenge? Or suppose that a stock issuance violated a covenant in a charter provision precluding issuance of senior stock without consent of a particular class of outstanding shares? Would Section 124 bar a holder of such shares from challenging the issuance?

I appreciate the value of predictability in commercial affairs, and doctrines of repose, like laches, usefully limit the scope of judicial relief that could impair desirable certainty in business affairs. I can’t resist thinking, however, that the SEPTA opinion goes too far, because it risks unmooring Section 124 from achieving its limited purpose of reining in the ultra vires doctrine, and letting it become an impossible hurdle to legitimate stockholder challenges to corporate actions that violate the provisions of governing documents or statutes. Or conversely, a stockholder’s irreparable harm argument on a motion for a preliminary injunction could become a lot stronger: while mergers or other transactions may often be viewed as “scrambled eggs” once consummated and thus beyond rescission, a robust application of Section 124 would arguably go even further and place all or most all transactions beyond the reach of rescissory relief, at least in stockholder actions.