United States: Corporate Alert - October 2016

The Herrick Advantage

Kara Bingham, associate editor of The Hedge Fund Law Report, recently interviewed Herrick corporate partner Richard Morris about enhanced regulatory requirements hedge fund managers and fund marketers have faced since the 2008 financial crisis. In the interview, Rick discussed new disclosure requirements for state pension plan investors, recent enforcement trends, and new rules proposed or adopted by the SEC, FINRA, the Municipal Securities Rulemaking Board and state regulators. On October 19, Richard participated in a related panel discussion at the Third Party Marketers Association's Annual "Outsourced Marketing & Sales 2.0" conference.

Federal Appeals Court Decision Serves as a Warning to Guard Against Unexpected Indemnification Liability

The U.S. Circuit Court of Appeals for the Eighth Circuit, in applying an indemnification provision contained in a contract, ruled that the indemnifying party was obligated to indemnify the other party (the "indemnitee") for the indemnitee's own misconduct. The Court so ruled even though the contract did not contain specific language addressing misconduct. The indemnification claim arose after the indemnitee was sued by a third party for intentional misconduct.

The indemnification provision required the indemnifying party to indemnify the "indemnitee"

The Court found that the broad language contained in the indemnification provision created an obligation on the part of the indemnifying party to indemnify the indemnitee for its own alleged misconduct. This case serves as a "wake-up call" for the critical need for indemnification provisions to be properly considered and customized to fit the specific facts and circumstances surrounding the contract. As a matter of best practice, exclusions to indemnification coverage, such as fraud, misconduct or liability caused by the indemnitee's gross negligence, should be clearly specified in the contract.

Feed Mgmt. Sys., Inc. v. Comco Sys., Inc., No. 15-1739 (8th Cir. May 23, 2016)

Federal Appeals Court Decision Extinguishes Security Interest Relating to Credit Agreement Amendment and Restatement

The U.S. Circuit Court of Appeals for the Sixth Circuit held that an amended and restated loan and security agreement may have caused a novation of the initial loan and security agreement thereby extinguishing the lender's security interest. The Court found that the following provisions contained in the amended and restated loan and security agreement were sufficient to create a question of fact as to whether the lender and borrowers intended to effect a novation of the initial loan and security agreement:

• the statement that the amended and restated loan and security agreement was for "valuable consideration, the receipt and sufficiency of which are hereby acknowledged"
• the language that the amended and restated loan and security agreement "constitutes the entire agreement of borrowers and lender relative to the subject matter" thereof and would "supersede any and all prior oral or written agreements relating to the subject matter"
• the re-grant of the security interest under the amended and restated loan and security agreement

The Court's finding is troublesome given that the provisions identified by the Court are regularly contained in loan and security agreements.

In re Fair Finance Co., No. 15-3854 (6th Cir. Aug. 23, 2016)

Delaware Chancery Court Applies Business Judgment Rule to Going-Private Transaction

The Delaware Chancery Court refused to recognize a breach of fiduciary duty claim brought by former stockholders of a corporation that engaged in a going-private merger transaction. The transaction was effected by the controlling stockholders of the corporation. The claimants based their fiduciary duty claims on the following grounds:  (i) while the merger price represented a premium to market, it was lower than the price contained in a competing third party offer and (ii) the controlling stockholders' offer was conditioned upon not more than 10% of the minority stockholders exercising appraisal rights.

The Court applied the less stringent the business judgment standard of review, instead of the entire fairness standard, to the merger transaction. The Court found that the six requirements for application of the business judgment standard of review, as articulated by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., had been satisfied. These requirements consist of (i) the merger transaction being conditioned upon the approval of both a special committee and a majority of the minority stockholders; (ii) the special committee being independent; (iii) the special committee having complete discretion in the engagement of its advisors and the ability to freely say no to any proposed transaction; (iv) the special committee negotiated a fair price in a manner consistent with its duty of care; (v) the vote of the minority stockholders was informed; and (vi) there was no coercion in seeking approval of the merger transaction by the minority stockholders. Once business judgment review is invoked, the only claims that a court will entertain are those constituting waste and bad faith.

In addressing the specific allegations made by the claimants, the court found that the special committee was independent and did not act in bad faith when it approved the lower-priced offer from the controlling stockholders over the higher-priced competing offer. The Court noted that the fact the price offered by the controlling stockholders was lower than the competing price was not sufficient to establish bad faith or inadequacy of consideration. The Court found a comparison of the two prices was inappropriate since the price offered by the controlling stockholders did not (and need not) reflect a control premium since the controlling stockholders already had control, while the competing offer included a control premium. Instead, the proper analysis should focus upon whether the price offered by the controlling stockholders, which applied a minority discount of approximately 23% to the competing offer, fell within a rational range of discounts and premiums when compared to the competing offer. The difference between the two prices contained in the offers was "not so facially large" to suggest that the special committee did not act independently from the controlling stockholders.

With respect to the appraisal condition, the Court found this condition provided the minority stockholders with a degree of control over the merger. In particular, if a sufficient number of minority stockholders disapproved of the merger price, (which applied a minority discount), they could exercise their appraisal rights and cause the controlling stockholders to consider whether to use the appraisal condition to terminate the merger.

In re Books-A-Million, Inc. Stockholders Litig., C.A. No. 11343-VCL (Del. Ch. Ct. Oct. 10, 2016)

Fantasy Stock Picking Game Violates Federal Securities Law

The U.S. Securities and Exchange Commission filed charges against Forcerank LLC for violations of Section 5 of the Securities Act of 1933 and Section 6 of the Securities Exchange Act of 1934 based upon its mobile phone games. In these games, the players predicted the order in which 10 securities would perform relative to each other. In each week-long game, players won points for each security based on the accuracy of their predictions. The players with the highest aggregate points received cash prizes at the end of the competition. Forcerank LLC retained 10% of the entry fees and obtained a data set about market expectations that it planned to market to hedge funds and other investors.

The SEC alleged that, for federal securities law purposes, (i) Forcerank LLC's agreements with its players were "security-based swaps" because they provided for a payment that was dependent on an event associated with a potential financial, economic or commercial consequence and based on the value of individual securities and (ii) such players were not "eligible contract participants."  In general, in order for an individual to qualify as an "eligible contract participant," he or she needs to have not less than $5 million invested on a discretionary basis. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank") limits the sale of security-based swaps to individuals ("Non-Participants") who are not "eligible contract participants" in two ways. First, Dodd-Frank amended Section 5 of the Securities Act of 1933 to make offers and sales of security-based swaps to Non-Participants unlawful without an effective registration statement covering the offering. Dodd-Frank also amended Section 6 of the Securities Exchange Act to require that all transactions in security-based swaps involving Non-Participants be effected solely on a national securities exchange. Without admitting or denying the SEC's allegations, Forcerank LLC settled the allegations by consenting to the entry of a cease-and-desist order and agreeing to pay a $50,000 civil penalty.

In the Matter of Forcerank LLC, SEC Rel. No. 33-10232 (Oct. 13, 2016)          

U.S. District Court for Southern District of New York Reinstates Fraudulent Transfer Claim

The U.S. District Court for the Southern District of New York (the "District Court") reinstated a fraudulent transfer claim to recover approximately $6.3 billion in distributions made in connection with the leverage buyout (the "LBO") of Lyondell Chemical. In prior judicial proceedings, the U.S. Bankruptcy Code's "safe harbor" provisions were used to defend fraudulent transfer challenges. These safe harbor provisions afford broad protection from challenges for payments made in connection with LBOs absent intentionally fraudulent conduct.

Lyondell Chemical filed for bankruptcy approximately two years after the closing of its LBO. In the bankruptcy court proceeding, a trustee for creditors sought to recover the distributions made to former Lyondell Chemical shareholders pursuant to the LBO on the basis that Lyondell Chemical's CEO had knowingly presented unattainable, overly optimistic financial projections supporting the LBO. The bankruptcy court refused to recognize the trustee's fraudulent transfer claim on the ground that an individual's intent can only be imputed to a corporation if the individual was "in a position to control the disposition of [the debtor's] property." The bankruptcy court then found that such authority was properly reserved under Delaware law to Lyondell Chemical's board of directors.

On appeal, the District Court reversed the bankruptcy court's dismissal of the fraudulent transfer claim. The District Court ruled that under Delaware agency law, corporations can be liable for the actions of its agents regardless of (i) the type of conduct at issue and (ii) whether the particular action is subject to approval by the board of directors. The District Court found the complaint supported a claim that Lyondell Chemical intended to hinder, delay or defraud creditors due to the inclusion of an allegation that the CEO, acting in his capacity as an agent of Lyondell Chemical, believed that harm to creditors was substantially certain to result from the LBO.

In re Lyondell Chemical Co., No. 16cv510 (S.D.N.Y. Oct. 5, 2016)

Delaware Chancery Court Address Timing of Merger Disclosure Claims

The Delaware Chancery Court ruled that claims based on the adequacy of merger disclosures are properly pursued prior to closing. In the case before the court, the claimant alleged that the acquiring company made inadequate disclosures regarding certain financial projections and its financial adviser's contingent-fee arrangement. These claims were filed subsequent to the closing of the merger. The Court dismissed the claims after finding the claimant failed to show that the directors breach their duty of loyalty by neglecting required tasks or deliberately withholding information. The Court advised that this rigorous standard applied only to post-closing claims. The Court explained that the application of such standard is intended to encourage the bringing of claims for misleading or faulty disclosure prior to the closing of the transaction in order to afford the Court with an opportunity to remedy colorable claims prior to the stockholder vote.

Nguyen v. Barrett, C.A. No. 11511-VCG (Del. Ch. Ct. Sept. 28, 2016)

Delaware Chancery Court Thwarts Directors Attempt to Merge Their Way Out of Liability

The Delaware Chancery Court refused to dismiss a derivative claim of unfair dealing brought against the directors of a property management company. The directors were alleged to have usurped a corporate opportunity for themselves by investing individually in a multi-billion dollar home rental company that the property management company helped to develop. The claimants sought to have the equity interests in the home rental company acquired by the directors assigned to the property management company. After receiving notice of the claim brought against the directors, the property management company entered into a merger agreement under which the unfair dealing derivative claim would be released.

In reviewing the claim, the Court applied the "entire fairness" doctrine given the interest of the directors in the home rental company. The entire fairness doctrine requires a showing that the merger was the product of both fair dealing and fair price. The directors argued that the value of the released derivative claim was not material and therefore should not be considered in the evaluation of whether a fair price was paid. The Court, however, disagreed with the finding that the released derivative claim had a value of approximately $4.65 million or roughly 5% of the merger consideration. Given the value of the released derivative claim, the Court was unwilling to permit the defendants to "end run" liability for the derivative claim through the use of a merger transaction.

In re Riverstone Nat'l, Inc. Stockholders Litig., Consol. C.A. No. 9796-VCG (Del. Ch. Ct. July 28, 2016)

FTC Changes Treatment of Debt for Hart-Scott-Rodino Act Purposes

The Federal Trade Commission will now include the value of all debt in determining whether the size of transaction threshold of $78.2 million is satisfied for purposes of the Hart-Scott-Rodino Act (the "HSR Act"). The HSR Act imposes pre-merger notification and reporting obligations on parties satisfying certain size requirements to an acquisition having a value in excess of $78.2 million. Previously, only debt incurred by the buyer to finance the acquisition was included in the calculation of the $78.2 million size of transaction threshold. The FTC's new position is that all debt (whether incurred by the buyer or seller) must be taken into account for purposes of calculating the size of the transaction threshold. This position recognizes that the obligor of the debt used to fund the acquisition is not of importance since the new debt will serve the same purpose regardless of the obligor. The FTC will continue to permit deductions from the size of transaction calculation to be made for existing debt that will be paid off at closing, consideration used to cash out options and warrants, the acquisition of non-voting stock, payment of executive officer retention bonuses and seller transaction expenses.

FTC Pre-Merger Office Advisory Bulletin (Oct. 6, 2016)

General Release Precludes Former Director from Exercising Options

The Delaware Chancery Court refused to permit a former director to exercise stock options to acquire shares worth millions of dollars for an exercise price of $135,000. The Court ruled that the former director was precluded from exercising the stock options as a result of the execution of a general release of claims by two entities affiliated with the former director in connection with the settlement of a New York state lawsuit. The general release did not contain any carve-out permitting the exercise of the options by the former director. The Court went on to find that the general release covered the former director due to his close association with the entities that signed the general release.

Geier v. Mozido LLC, C.A. No. 10931-VCS (Del. Ch. Ct. Sept. 29, 2016)

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