Category Archives: News

Widener Law Students Place Highly in Nationwide Online Transactional Law Competition

Three Widener Law students on the Transactional Law Competition Team recently placed highly in a nationwide online competition hosted by LawMeets.

Over 800 registered participants, ranging from law students at schools such as Berkeley and John Marshall, to practicing attorneys and even a group of investment bankers from one of the big investment banks participated in the LawMeets course, which consisted of four exercises over two intensive weeks. The results of those exercises were then peer-reviewed and ranked.

Second-year student Deniz Uzel placed 9th in “the anatomy of an acquisition agreement” and an astonishing 1st in the “due diligence” assignment, bringing her overall rank to 20th place. Second-year student Randy MacTough placed 13th and 21st in two of the online assignments: “the anatomy of an acquisition agreement” and “indemnification.” Second-year student Amber Marsano placed 4th in the “indemnification” assignment.

LawMeets is an educational program founded by by Professor Karl Okamoto, the Director of the entrepreneurship law program at Drexel University’s Earle Mack School of Law. LawMeets offers students an opportunity to improve their lawyer-client skills by addressing hypothetical client problems with short video responses that are voted on by their peers. Legal experts then offer critiques of the highest rated student responses.

The entire Widener Law community congratulates Deniz, Randy, and Amber on their impressive work!


Delaware Supreme Court’s Latest Non-Pronouncement on Fiduciary Duties in Limited Liability Companies

Professor Luke M. Scheuer

The Delaware Supreme Court’s November 7 opinion in Gatz Properties, LLC v. Auriga Capital Corp. has left open the question of whether the Delaware’s Limited Liability Company Act (the “LLC Act”) imposes default fiduciary obligations on a limited liability company’s (an “LLC”) managers.  In Gatz, the Supreme Court affirmed the Court of Chancery’s opinion and held that a company’s manager had breached its contractual fiduciary duties to minority members under the company’s LLC agreement.  However, in a blistering rebuke, the Supreme Court rejected as “dictum without any precedential value” the Court of Chancery’s conclusion that the manager had breached default fiduciary duties under the LLC Act.  The Court further “decline[d] to express any view regarding whether default fiduciary duties apply as a matter of statutory construction.”

The decision is problematic for practitioners and investors who have assumed that in the LLC context, fiduciary obligations exist unless they are disclaimed in a company’s LLC agreement.  Going forward, attorneys will undoubtedly inform their business clients (both managers and investors) that any fiduciary obligations should be addressed in an LLC agreement.  However, unrepresented investors may be caught off-guard because fiduciary duties are a basic element of all other business forms.  As the LLC becomes the default form for new businesses (including small businesses that are often formed without legal counsel), many less well advised investors may assume that managers have a minimum level of responsibility and not realize that they are required to include language in the LLC agreement to create such obligations.

The ruling is also part of a line of cases that contrasts the high standard historically required for those managing business entities with the low modern standard.  The great Benjamin Cardozo articulated fiduciary duties in the following high minded terms: “[n]ot honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior . . . the level of conduct for fiduciaries [has] been kept at a level higher than that trodden by the crowd.”  In the intervening 80 years, fiduciary duties have been watered down to the point where they are bare minimal standards that can be waived (or might not even exist as a default) for LLCs.  The Court may be correct that the Delaware legislature is the best group to decide the default fiduciary duty issue.  Until they do, Delaware is placing LLC investors at risk for the benefit of managers, and is encouraging the degradation of business culture.

A blog entry on the oral argument before the Supreme Court was previously posted to this site by Ben Chapple (Widener Law ’13).


A Summary of the 28th Annual Francis G. Pileggi Distinguished Lecture in Law “Unsettled and Unsettling Issues in Corporate Law”

On November 9, 2012, the Delaware Journal of Corporate Law, with the Institute, hosted the 28th Annual Francis G. Pileggi Distinguished Lecture in Law. This year’s lecturer was Professor Lyman P.Q. Johnson. Professor Johnson has taught at Washington and Lee University School of Law since 1985—holding the Robert O. Bentley Professorship since 1995—and beginning in 2008, he was appointed to the faculty of the University of St. Thomas School of Law in Minneapolis, where he currently serves as the LeJeune Distinguished Chair in Law. Professor Johnson’s lecture was titled Unsettled and Unsettling Issues in Corporate Law. The lecture revisited two fundamental issues in corporate law: (1) the central role of the business judgment rule (BJR) in fiduciary litigation, and (2) whether there is a mandated corporate purpose. The majority of the lecture was devoted to the former issue, but Professor Johnson discusses both issues in great detail in his forthcoming article that will be published in Volume 38 of the Delaware Journal of Corporate Law.

Following an introduction by Delaware Supreme Court Justice Henry duPont Ridgely, the lecture began with Professor Johnson acknowledging that the law surrounding the BJR is “seemingly settled,” in that it is clear that the rule applies to directors. He went on to note, however, that it is less clear whether the BJR applies to officers or controlling shareholders. Professor Johnson continued by discussing how this deeply entrenched rule has evolved over the last three decades through the decisions in Sinclair (1971), Aronson (1984), and Cede (1991). The professor argued that it is inappropriate to adhere to a rule of law simply because it has been used for a long period and has proposed a rethinking of the BJR, ultimately arguing that the rule is unnecessary and should be deemphasized.

Professor Johnson articulates six reasons in support of this thesis. First, he argues that the BJR is under inclusive, so it should not serve as a “unified vessel.” Further to this point, he stated that fiduciary duties are broader in scope, and therefore are the more appropriate focus. Second, he asserts that the BJR is a maxim of historical accident that grafted the duty of care into the BJR framework. Professor Johnson believes that this fiduciary duty should be showcased, not engrafted with the BJR. Third, the professor contends that emphasizing fiduciary duties over the BJR still provides ample deference to the directors. To this end, he argues that there is no need for an Aronson or Sinclair presumption because ample deference and business latitude remains by maintaining the gross negligence standard. Fourth, he believes that elevating the focus to fiduciary duties streamlines the analysis and rationales with other areas of law; he cited, for example, agency law where you would only need to ask two questions: (1) did a fiduciary duty exist?, and (2) if so, was that duty breached? Fifth, Professor Johnson asserts that emphasizing the BJR “hinders optimal conduct” through depriving directors of having an affirmative duty because the rule presumes that the director complied with his or her fiduciary duties. Sixth, and perhaps closely tied to his fourth point, he argues that elevating fiduciary duties over the BJR will facilitate a better understanding of corporate law for those who do not specialize in the subject matter, i.e. law students and many out-of-state practitioners who practice Delaware corporate law.

To put it modestly, some of those in attendance were a bit taken aback by Professor Johnson’s proposal, particularly the part relating to removing the presumption afforded by the BJR. One attendee of note, former-Vice Chancellor Stephen Lamb, expressed concern that denying directors the presumption will increase the number of meritless suits, and then proceeded to ask if the professor had considered this effect, and if so, whether a heightened pleading standard would be an appropriate solution. Professor Johnson acknowledged that he did not take into account these considerations, but stated that he will consider the implication before his forthcoming article goes to press. The Institute’s director, Professor Lawrence Hamermesh, also asked Professor Johnson what, if any, past decisions would have a different outcome under his proposed model that elevates fiduciary duties over the BJR. Professor Johnson responded that he could not think of a case where the result would be altered; however, the process to reach the result would be more streamlined under his proposed approach.

Annual Meetings and Audited Financials: State/Federal Competition or Cooperation?

Vice Chancellor Glasscock’s November 5, 2012 opinion in Rich v. Fuqi International, Inc. addresses the recurrent and fascinating exercise in federalism that arises when state law requires a corporation to convene an annual meeting of stockholders, but federal law forbids the necessary solicitation of proxies due to the corporation’s inability to supply the required audited financial statements. The ostensible collision makes for interesting reading, and Francis Pileggi’s blog entry on the opinion is a good place to start.

In 2008, the SEC adopted Rule 200.30-1(e)(18) in an effort to avoid the ostensible collision in a way that gave effect to the legitimate goals of both state and federal law. Simply put, the Rule permits the Director of the Division of Corporation Finance to exempt an issuer from the demands of Rules 14a-3(b) and 14c-3(a), where the corporation demonstrates that it:

(i) Is required to hold a meeting of security holders as a result of an action taken by one or more of the applicant’s security holders pursuant to state law;
(ii) Is unable to comply with the requirements of Rule 14a-3(b) or Rule 14c-3(a) … ;
(iii) Has made a good faith effort to furnish the audited financial statements before holding the security holder meeting;
(iv) Has made a determination that it has disclosed to security holders all available material information necessary for the security holders to make an informed voting decision in accordance with Regulation 14A or Regulation 14C (§§240.14a-1 – 240.14b-2 or §§240.14c-1 – 240.14c-101 of this chapter); and
Absent a grant of exemptive relief, it would be forced to violate either state law or the rules and regulations administered by the Commission.

The defendant corporation (Fuqi International) was originally sued over two years ago, having failed to convene an annual meeting since July 2008. Unable to obtain audited financial statements, Fuqi persuaded the plaintiff stockholder on multiple occasions to defer his application for relief, but the plaintiff’s patience evidently wore out earlier this year, and on June 1, 2012 he successfully obtained a formal order compelling the meeting.

Note that until this point, Fuqi’s request to the SEC staff to exempt it from the pertinent proxy rules was more than arguably a non-starter under Rule 200.30-1(e)(18), because Fuqi was not yet under legal compulsion in the stockholder action to convene an annual meeting. The Vice Chancellor’s order, however, directed Fuqi to again formally seek an exemption from the SEC, this time with an order in hand. According to Fuqi, the SEC has not yet acted on that application, leaving the company in a position of being required to solicit proxies by no later than November 17, as necessitated by the order of the Court of Chancery, but doing so at risk of violating the proxy rules.

In that context, Fuqi went back to the Vice Chancellor, not directly seeking an extension of any sort, but seeking relief permitting it to appeal to the Delaware Supreme Court, via partial judgment or certification of an interlocutory appeal. It is this application that the Vice Chancellor denied. As I read his opinion, he essentially lost patience with the extended delay in convening the meeting that Delaware law requires, and he partly blamed Fuqi for not fully pressing its exemptive application to the SEC until this June:

It also bears mentioning that Fuqi has caused the very uncertainty it now seeks to resolve. Fuqi chose to withdraw its 2011 exemption request because SEC staff purportedly suggested that a formal opinion denying the exemption would prejudice Fuqi in the SEC’s investigation into Fuqi’s original financial restatement. In withdrawing its application, Fuqi made a tactical decision to forego obtaining a formal decision from the SEC. Given that Fuqi was in the midst of negotiating this action, Fuqi was presumably aware that the lack of a final SEC decision was an important consideration of the Court’s decision in Newcastle Partners, and Fuqi should be prepared to accept the consequences of its choice.

I can see how this analysis could be frustrating to Fuqi: it’s being placed in a difficult position, and not having been subject to an order compelling it to convene meeting, there was arguably nothing it could have done before June 1, 2012 to formally pursue an exemptive application with the SEC.

But rather than criticize the Vice Chancellor, Fuqi, or the Commission, let’s step back a bit and ponder how a sensible, coordinated state and federal response to the situation should proceed – instead of proceeding as an exercise in brinksmanship, with both state and federal authorities asserting priority for their respective roles and policy concerns.

First, let’s acknowledge the utility of the Commission’s approach in adopting Rule 200.30-1(e)(18): at the very least, it affords a way for the Commission to set aside any inflexible unwillingness to permit a stockholder meeting to go forward in the absence of audited financial statements. That’s a good thing, as the Vice Chancellor reminds us, because “a stockholder’s right to a meeting is especially strong when financial management is so questionable as to delay the provision of audited financial statements for three full years.”

On the other hand, what if there’s no indication that the annual meeting will do anything other than re-elect incumbent directors in an uncontested vote? What if there’s no indication that a stockholder meeting would address concerns about inadequate leadership by the board or the senior officers of the company? In that circumstance, is the state interest in protecting the stockholder franchise a compelling consideration? Or does the Commission’s legitimate interest in promoting complete and accurate financial disclosures take priority in that circumstance, given investors’ general interest in the maintenance of such disclosures?

In an effort to answer these questions as they pertain to the present situation, I’d start by pointing out that I see nothing in the facts of the case indicating that the plaintiff holds a significant block of stock, nor anything indicating that the plaintiff intends to pursue or assist in the election of a competing slate of directors, or do anything else that would alter the composition of the board. In fact, the plaintiff and his counsel in the annual meeting suit are now pursuing a parallel derivative lawsuit in the Court of Chancery – nothing inherently wrong with that, but it’s not the usual technique for a stockholder attempting to promote a change in board composition. Anyway, and in a previous entry on this blog, I have questioned inflexible and undue obeisance to the idea that the annual meeting is indispensable.

In the pending situation, it may well be that Fuqi has satisfied the minimum requirements of Rule 200.30-1(e)(18), but surely the staff’s discretion in regard to exemptive applications doesn’t require that the exemption be granted in all cases where those minimum requirements are met. Surely the staff can and should evaluate how an exemption might or might not serve the larger interests of investors, as opposed to an abstract interest of stockholders in exercising the right to elect directors in an uncontested election.

From where I sit, then – a comfortable armchair – and based on the facts described in the Vice Chancellor’s opinion (and the facts not described there), I’d deny Fuqi’s exemption application, if I were the Director of the Division of Corporation Finance, and when Fuqi returns to the Delaware courts, as the Vice Chancellor’s order contemplated it could do, with a fully mature conflict of obligations, I’d stay the order compelling the convening of the annual meeting, subject to periodic review, unless and until it appeared that there was a reasonable prospect that the meeting would involve more than a formality of re-electing incumbent directors.

The SEC’s Report Under JOBS Act Section 504: A Shot Across the Bow at Public Company Governance Discourse?

The October 15, 2012 report by the SEC pursuant to Section 504 of the JOBS Act examines the question whether the Commission has sufficient enforcement authority to address evasions of Rule 12b5-1. The new report has some provocative nuggets in it:

1. Strikingly, it reports that about 87% of companies currently in the ’34 Act reporting system by virtue of Section 12(g) (having had more than 500 stockholders of record) would not become subject to those reporting requirements under the increased threshold adopted in the JOBS Act.

2. Lest anyone rush to the conclusion that this statistic is alarming, the report (in footnote 70) cites recent empirical studies that suggest that the likely contraction of the application of reporting requirements is a good thing: according to those studies, companies not subject to public reporting obligations obviously avoid “disclosure costs related to revealing information to competitors.” Less obviously, but more interestingly, “there is also evidence that private companies have less myopic investment strategies compared to their public peers, and are more sensitive in responding to new investment opportunities.”

3. The 500 nonaccredited investor limit added by the JOBS Act creates additional detection problems, where special purpose vehicles might be used to aggregate the holdings of multiple such investors.

The report ultimately concludes that there isn’t enough information at the moment to request additional enforcement authority. It’s important to note what the new report (understandably, given the Congressional mandate) does not ask: whether tying Exchange Act registration to numbers of record stockholders makes sense any more in an age where, as the report explains, “the vast majority of investors own their securities as a beneficial owner through a securities intermediary,” unlike the system in place when the number of record holders was chosen to determine applicability of the registration requirement.

The suggestion that private companies have “less myopic investment strategies compared to their public peers” is yet more evidence that conscientious investors and managers in public companies could stand to rethink and reshape the quality of discourse about corporate performance.

Susan Lyon Helps Readers Understand New SEC Whistleblower Program: Breaking Down the Largest Whistle-Blowing Rewards in U.S. History

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.


A Report on Oral Argument in Gatz Properties v. Auriga Capital Corp.

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.


[1] Section 15 of the agreement provides, in pertinent part,

Neither the Manager nor any other Member shall be entitled to cause the Company to enter . . . into any additional agreements with affiliates on terms and conditions which are less favorable to the Company than the terms and conditions of similar agreements which could be entered into with arms-length third parties, without the consent of a majority of the non-affiliated Members (such majority to be deemed to be the holders of 66-2/3% of all Interests which are not held by affiliates of the person or entity that would be a party to the proposed agreement

[2] Section 16 of the agreement provides,

No Covered Person [defined to include, “the Members, Manager, and the officers, equity holders, partners, and employees of such of the foregoing”] shall be liable to the Company, [or] any other Covered Person or any other person or entity who has an interest in the Company for any loss, damage or claim incurred by reason of any act or omission performed or omitted by such Covered Person in good faith in connection with the formation of the Company or on behalf of the Company and in a manner reasonably believed to be within the scope of the authority conferred on such Covered Person by this Agreement, except that a Covered Person shall be liable for any such loss, damage, or claim incurred by reason of such Covered Person’s gross negligence, willful misconduct, or willful misrepresentation.

Proxy Access Votes 2012 – A Summer Supplement

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)

Professor Barnett on SEC’s Recent No-Action Letter to Linn Energy, LLC

 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]



[i] Company #1 purchased and developed properties that contained substantial reserves of oil and natural gas.  All of its current property holdings were in the United States.

[ii] Even if it was not an investment company, company #1 would have been subject to § 17(d) of the Act and Rule 17d-1(a) under the Act as long as company #2 was an investment company and was required to register.  Joint undertakings by a registered investment company and its first- and second-tier affiliates are covered by § 17(d) and Rule 17d-1(a) when the affiliates are principals in the undertakings.  Because company #2 was controlled by company #1 and would own more than 5% of the outstanding voting securities of company #1, company #1 would be a first-tier affiliate of an investment company (company #2) pursuant to § 2(a)(3)(B) and § 2(a)(3)(C) of the Act.

[iii] In a search done on September 8, 2012 of the Lexis database of SEC no-action letters, I looked for the warning in letters that were issued under the Investment Company Act from calendar year 2000 onward.  The warning was not found before 2007, and of the 70 no-action letters that carried the warning, fully 90% appeared in 2008 and 2009.  Before and after 2009, consequently, few no-action letters issued under the Act included the warning.

[iv] The graph is limited to mutual funds, because as measured by assets under management, mutual funds are currently the most important type of U.S. investment company.  Infra note v.  The graph was prepared from data in Investment Company Institute, 2012 Investment Company Fact Book 134, 138 (52d ed. 2012), (last visited  Sept. 9, 2012).

[v] The latest data on the number and net assets of U.S. investment companies are given below by type of investment company.  The data in the columns and in the rows of the table are drawn from different points in time, but all of the time points are within the period from December 31, 2011 to July 31, 2012.

  Type of investment company            Number          Net assets
   Mutual funds             7,637

$12.340 trillion

   Closed-end funds             634       $ 0.250 trillion
   Exchange-traded funds            1,228       $ 1.192 trillion
   Unit investment trusts            6,022       $ 0.060 trillion


Source:  Investment Company Institute, and (last visited Sept. 8, 2012).

[vi] Larry D. Barnett, The Place of Law: The Role and Limits of Law in Society 49–63, 121–22 (2011).

[vii] The subsidiaries of company #1 were wholly owned, not majority-owned.  See §§ 3(a)(24), 3(a)(43) of the Act (defining “majority-owned subsidiary” and “wholly-owned subsidiary”).  The conclusion that company #1 was an investment company could thus have been based on § 3(a)(1)(C) of the Act, which requires inter alia that, to be an investment company, an entity must own, hold, or trade “investment securities.”  Under § 3(a)(2) of the Act, “investment securities” include securities issued by wholly owned subsidiaries.

Although an entity that qualifies as an investment company under § 3(a)(1)(C) may have an exemption from the status of investment company through § 3(b) of the Act, neither the incoming letter nor the staff reply mention, let alone discuss, § 3(b).

[viii] Being exchange-listed, the securities issued by company #2, as well as the securities issued by company #1, were by definition available to the public.

[ix] Barnett, supra note vi, at 198–204.