Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC charged former Hertz CEO and Chairman Mark Frissora with aiding and abetting the company in its filing of inaccurate financial statements and disclosures.  Frissora agreed to settle the charges and repay Hertz nearly $2 million in incentive-based compensation.  Frissora did not admit or deny the allegations.

Select portions of the SEC complaint are discussed below.

Inaccurate Earnings Guidance

According to the SEC complaint, In late September 2013, Hertz’s internal analysis projected the company’s 2013 earnings results at $1.72 per share, below the earnings per share forecast of $1.78 to $1.88 per share Hertz had announced in February 2013.

On September 26, 2013, Hertz issued a press release and publicly filed a slide deck revising the company’s prior earnings guidance. The new guidance reduced Hertz’s projected 2013 earnings to a range ten cents lower than the prior guidance: $1.68 to $1.78 per share.

Over the next two weeks, Frissora learned that new internal analyses and data forecasted Hertz’s earnings performance to fall below the low end of the revised guidance range.

Frissora then led an initiative to try to enable the Company to “claw” its way back to its previously projected earnings performance.

By the end of October 2013, Frissora learned that, despite certain identified savings (often through reduced expenses) from that initiative, a Hertz internal estimate for 2013 still projected earnings per share at $1.66, two cents below the low end of the revised guidance range.

That month, Frissora directed subordinates to determine why Hertz’s internal estimates of earnings-per-share had changed so quickly.

One analysis Frissora received determined that the September 2013 revision had been flawed in part and that methodological errors had occurred.

With Frissora’s approval, Hertz filed a Form 8-K report on November 5, 2013, which reaffirmed Hertz’s guidance range of $1.68 to $1.78 earnings per share.

Also, on November 5, 2013, Frissora held an earnings call. 68. On the call, an analyst asked Frissora about Hertz’s reaffirmation of its earnings guidance range. The analyst sought clarification as to whether the company might be “tracking at the low end of guidance” or whether there is something “that maybe you can talk about in the call that maybe upside to where you thought?”

Frissora responded: Yes, we gave you a balanced message, and every comment was weighted, so the best thing I can tell you is it is what it is. What I gave you [the earnings range] is – there’s no conservative. There’s no aggression. It’s kind of where we see the lay of the land right now.

In early 2014, Hertz reported actual 2013 earnings of $1.63 per share.

Hertz’s Failure to Adequately Disclose Its Extension of Planned Holding Periods

During the second through fourth quarters of 2013, Frissora caused Hertz to extend the planned holding periods for a significant portion of its U.S. rental car fleet without properly disclosing the change and its positive short-term and potentially negative long-term financial impact.

Prior to this period, most of the cars in Hertz’s U.S. rental fleet had planned holding periods of 20 months. In other words, Hertz had estimated that it would maintain these cars in its rental fleet for 20 months before replacing them.

During the second through fourth quarters of 2013, Frissora decided to extend the planned holding periods for a large part of Hertz’s U.S. car rental fleet to either 24 or 30 months.

Frissora’s extensions resulted in Hertz’s having longer planned holding periods for portions of its rental fleet than those of many other major car rental companies.

For Hertz, these extended holding periods had a short-term accounting benefit: the extensions spread out the required depreciation expense Hertz would incur on its cars over a longer time period, thus lowering the depreciation expense overall for each quarter.

At the same time, extended holding periods had long-term business risks, including that older cars were likely to require more costly maintenance and could negatively impact Hertz’s premium brand.

Under the Financial Account Standards Board (“FASB”) Accounting Standards, which Hertz was required to comply with in order to have its financial statements accord with GAAP, a reporting company during the relevant time should have disclosed this type of planned holding period extension to investors in the company’s financial statements.

Specifically, FASB Accounting Standards Codification Topic 250-10-50-4, provides in relevant part that a company must disclose the effect on net income of a change in an accounting estimate that affects several future periods, such as a change in service lives for depreciable assets. That standard further requires that, if a change in an estimate does not have a material effect in the period of the estimate change but is reasonably certain to have a material effect in later periods, the company’s financial statements for the period in which the estimate change occurred must describe that estimate change.

In 2013, Hertz did not adequately disclose its decision to extend the planned holding periods for substantial portions of its fleet.

On July 29, 2013, Frissora held an earnings conference call with analysts who covered Hertz Holdings’ stock. At the time, Hertz had already extended holding periods on many of its top models.

When an analyst asked Frissora on the call how long the company was planning to hold its cars and “if that assumption has changed relative to the beginning of the year,” Frissora answered: “I don’t think there has been any assumption changes. I think we’re in pretty good shape on length, in terms of how long we’re holding cars.”

This earnings call was followed by a series of Hertz filings, signed and/or certified by Frissora. On August 2, 2013, Hertz Holdings and Hertz Corp. filed, respectively, the Hertz Holdings Q2 2013 10-Q and the Hertz Corp. Q2 2013 10-Q (together, the “Hertz Q2 2013 10-Qs”).

On November 7, 2013, Hertz Holdings and Hertz Corp. filed, respectively, the Hertz Holdings Q3 2013 10-Q and the Hertz Corp. Q3 2013 10-Q (together, the “Hertz Q3 2013 10-Qs”).

The Hertz Q2 2013 10-Qs and the Hertz Q3 2013 10-Qs failed to disclose the holding period extensions and their impact on depreciation.

In March 2014, Hertz filed the Hertz 2013 10-Ks, which claimed that “our approximate average holding period for a rental car was eighteen months in the United States.”

During 2013, the weighted average of all planned holding periods across Hertz’s U.S. fleet had increased from 21 to almost 25 months.

Hertz’s statement about the 18-month average failed to explain that Hertz had calculated that average by using the age of the cars Hertz had disposed of—not from the planned holding periods that Hertz had extended for portions of the fleet.

The MD&A portion of the same Form 10-Ks made some references to longer holding periods—generally listing “extended holding periods” as one of several factors causing an increase in maintenance costs and stating that the “holding periods” for Hertz’s cars ranged from 4 to 36 months, a broader range than the 4 to 28 months disclosed in its Form 10-K for the prior year. But the 10-Ks failed to disclose that Hertz had made a business decision to extend planned holding periods or the scale of the shift to longer planned holding periods.

In late 2014, after Frissora had left Hertz, Hertz’s new management reverted back to shorter planned holding periods.

Manti Holdings, LLC, et al. v. Authentix Acquisition Company, Inc. considered whether a “loser pays” fee-shifting provision in a stockholders’ agreement violated Delaware law.  In 2008, the Petitioners had all held stock in a prior entity, Authentix, Inc. That year, Authentix, Inc. merged into Authentix Acquisition Company Inc, or Authentix, with two new shareholders—The Carlyle Group and J.H. Whitney & Co.—as the new majority owners. In order to achieve the merger, the Petitioners, the new stockholders, and Authentix negotiated the Stockholders Agreement of Authentix, which was also the Respondent in this action.  Also as a condition of the 2008 merger, the Petitioners agreed to roll over their interest in Authentix, Inc. into Authentix. Along with the Petitioners, Respondent Authentix was itself a party to the Stockholders Agreement and the surviving corporation in the merger.

Petitioners had previously sought appraisal rights with respect to their stock resulting from the merger.  The Delaware Court of Chancery held that appraisal rights were waived in the stockholders’ agreement.  Respondent sought its legal fees as a result of a fee-shifting provision in the stockholders’ agreement.

The fee-shifting provision at issue provided:

“In the event of any litigation or other legal proceeding involving the interpretation of this [Stockholders] Agreement or enforcement of the rights or obligations of the Parties, the prevailing Party or Parties shall be entitled to recover reasonable attorneys’ fees and expenses in addition to any other available remedy.”

The Petitioners did not contest that the Stockholders Agreement provided a clear contractual obligation for the losing party to pay fees incurred by the prevailing party to enforce the contract against them. Instead, they argued that the contractual fee-shifting provision was unenforceable against them, for reasons having to do with statutory precedence, public policy, and equity.

The Court noted in ATP Tour, Inc. v. Deutscher Tennis Bund, the Delaware Supreme Court reaffirmed that fee-shifting by contract, in exception to the American Rule, under which each litigant bears her own legal fees, was enforceable self-ordering by contractual parties. ATP also held a fee-shifting bylaw was facially valid.

In reaction to ATP, the Delaware legislature enacted §§ 102(f) and 109(b) of the DGCL, which proscribe fee-shifting provisions in corporate charters and bylaws with respect to intra-corporate litigation, in recognition of the chilling effect such loser-pays provisions could have on the enforcement by stockholders of fiduciary duties. The Petitioners argued that by extension or analogy, §§ 102(f) and 109(b) prohibited the contractual fee-shifting that the Respondent sought to employ.

The Petitioners noted that our law observes a hierarchy of authority for documents concerning shareholder rights: the DGCL comes first, then the charter, then the bylaws, then contracts. Provisions in lower-order documents cannot trump those in higher-order documents. The Petitioners pointed to the fee-shifting prohibitions of §§ 102(f) and 109(b), and argued based on these sections that enforcing a “loser pays” provision in a contract between a corporation and stockholders violates the hierarchy described above and is thus unenforceable.

The Court rejected this argument noting nothing in the plain language of §§ 102(f) or 109(b) prohibited the fee-shifting Respondent sought to enforce. The plain terms of these sections referred only to certificates of incorporation and bylaws and not to contracts.

In addition, the Court noted the expressed legislative intent shows that stockholder agreements were specifically carved out from these statutory prohibitions.  The Bill synopsis provided for § 102(f) and § 109(b) of the DGCL states that those statutes are “not intended, however, to prevent the application of such [fee-shifting] provisions pursuant to a stockholders agreement or other writing signed by the stockholder against whom the provision is to be enforced.”

Finally, the Court noted the context of the fee-shifting at issue—litigation over stockholders’ contractual agreement to waive appraisal rights—was not perceived by the Vice Chancellor to be the legislature’s animating concern. The matter before the Court did not involve an underlying allegation of breach of fiduciary duty, which was perceived to be the legislature’s focus in prohibiting fee-shifting in charters and bylaws. A contractual fee-shifting provision for a losing allegation of breach of duty could have a perverse chilling effect on the exercise of stockholders’ common law rights to the loyalty and care of corporate fiduciaries. But that question was not before the Court, only whether the fee-shifting provision was valid with respect to the waiver of appraisal rights.

The Court also rejected Petitioners’ arguments that the surviving corporation was not the intended beneficiary of the fee-shifting provision and corporations are not proper parties to stockholders’ agreements based on the same rational that supported the waiver of appraisal rights.

ISS has launched its 2021 Annual Policy Survey.  Generally, the survey is the first step in ISS’ annual benchmark policy development process.

This year, the survey is structured to include questions related to ISS policy guidance released earlier this year in response to the COVID-19 pandemic, AGM formats, and stakeholder expectations regarding compensation and adjustments to incentives.  Additionally, it also elicits feedback on a global level related to climate change risk, sustainable development goals, auditors and audit committees, and racial and ethnic diversity on corporate boards. U.S. topics include independent board chairs.

In addition to the annual survey, ISS will continue to conduct a variety of regionally-based, topic-specific roundtable discussions gathering broad input from investors, company directors and others that will also factor into the update and development of ISS’ benchmark policy guidelines for 2021.

Proxy voting advice businesses, or PVABs, have come to play an important role in the proxy voting process by providing an array of voting services that can help investment advisers and institutional investor clients manage their substantive and procedural proxy voting needs. ISS and Glass Lewis are the two most well-known PVABs.

In recent years, public companies, which the SEC often refers to as registrants, investors and others have expressed concerns about PVABs. These concerns have focused on the accuracy and soundness of the information and methodologies used to formulate PVABs’ recommendations as well as potential conflicts of interest that may affect those recommendations. Given PVABs’ potential to influence the voting decisions of investment advisers and other institutional investors, who often vote on behalf of others, the SEC has expressed concern about the risk of PVABs providing inaccurate or incomplete voting advice (including the failure to disclose material conflicts of interest) that could be relied upon to the detriment of investors. In light of these concerns, the SEC proposed amendments to the federal proxy rules in November 2019.

As discussed here, the SEC initially proposed, amongst other things, that a PVAB provide registrants a limited amount of time to review and provide feedback on the PVAB’s proposed advice before it was disseminated to the PVAB’s clients. This review and feedback period was to be followed by a final notice of voting advice, which would include any revisions to the advice made by the PVAB as a result of the review and feedback period. Finally, the SEC proposed that registrants also be given the option to request that the PVAB include in their proxy voting advice a hyperlink or other analogous electronic medium directing the recipient of the advice to a written statement prepared by the registrant that sets forth its views on the advice.

The final rules adopted by the SEC take a different approach. The SEC gave great weight to the comments of the two largest PVABs, ISS and Glass Lewis. The PVABs argued the SEC proposal was too complex and there would be many practical hurdles to implement the proposal and suggested the SEC adopt a principles-based rule instead.

The final principle-based rules adopted by the SEC require PVABs to take certain actions to maintain a statutory exemption from the information and filing requirements of the Federal proxy rules. Specifically PVABs must comply with certain disclosure and procedural requirements, including disclosure of material conflicts of interest in their proxy advice, and adopt and publicly disclose certain written policies and procedures.

Any PVAB seeking to rely on the applicable exemptions to the proxy rules under the SEC’s newly adopted rules must include in their voting advice prominent disclosure of:

  • Any information regarding an interest, transaction, or relationship of the PVAB that is material to assessing the objectivity of the proxy voting advice; and
  • Any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction, or relationship.

The “materiality” threshold under the conflict of interest requirements are intended to provide a PVAB with the ability to apply its judgment and knowledge of facts to determine the materiality of conflicts that might pose a risk to the objectivity of its advice.

Under the final rules, PVABs are also required to publicly disclose written policies and procedures reasonably designed to ensure that:

  • Registrants that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the PVAB’s clients; and
  • The PVAB provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by registrants that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).

The final rules do not dictate the manner or specific timing in which PVABs interact with registrants, and instead leaves it within the discretion of the PVAB to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. The rules do not require that the PVAB provide registrants or other soliciting persons with the opportunity to review proxy voting advice in advance of its dissemination to the businesses’ clients, although providing registrants with the opportunity to review their proxy voting advice in advance would satisfy the rules’ principle and is encouraged to the extent feasible.

The final rules include a non-exclusive safe harbor provision that, if followed, will give assurance to a PVAB that it has met the principles-based requirements of the new rules set forth in the first bullet point immediately above. In accordance with this safe harbor, a PVAB will be deemed to satisfy the final rules discussed above if it has written policies and procedures that are reasonably designed to provide registrants with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. Such policies and procedures may include conditions requiring that such registrants have (i) filed their definitive proxy statement at least 40 calendar days before the shareholder meeting, and (ii) expressly acknowledged that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and it will not be published or otherwise shared except with the registrant’s employees or advisers.

The final rules also include a safe harbor with respect to the requirements of the second bullet point immediately above. To satisfy this safe harbor, a proxy voting advice business must have written policies and procedures reasonably designed to inform clients who have received proxy voting advice about a particular registrant in the event that such registrant notifies the proxy voting advice business that the registrant either intends to file or has filed additional soliciting materials with the SEC setting forth its views regarding such advice. The safe harbor sets forth two methods by which the proxy voting advice business may provide such notice to its clients. It may either:

  • Provide notice on its electronic client platform that the registrant has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials (and include an active hyperlink to those materials on EDGAR when available); or
  • Provide notice through email or other electronic means that the registrant has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials (and include an active hyperlink to those materials on EDGAR when available).

PVABs are not required to comply with the final rules for solicitations regarding certain M&A transactions or contested matters.

PVABs are not required to comply with the final rules discussed above until December 1, 2021.

In Re Homefed Corporation Stockholder Litigation arose from a transaction in which Jefferies Financial Group Inc., the 70% stockholder of HomeFed Corporation, acquired the rest of the shares of the company in July 2019 by exchanging two of its shares for each share of HomeFed held by its minority stockholders. The transaction traced its roots back to 2017, when a HomeFed director proposed that Jefferies take HomeFed private in a 2:1 share exchange. In December 2017, a special committee of HomeFed’s board of directors was put in place to negotiate with Jefferies. The special committee paused its process in March 2018, when Jefferies told the special committee it was no longer interested in pursuing the transaction.

Over the next eleven months, despite indicating a lack of interest in a transaction, Jefferies engaged in direct discussions concerning a potential transaction with HomeFed’s largest minority stockholder (BMO), whose support was essential to get a deal done with the approval of the minority stockholders. In early February 2019, BMO indicated to Jefferies that it would support a 2:1 share exchange. Shortly thereafter, Jefferies formally proposed acquiring the rest of HomeFed’s shares in a 2:1 share exchange conditioned on obtaining the approval of a special committee and a majority of the minority stockholders. After some back and forth, the reactivated special committee ultimately approved the 2:1 share exchange that Jefferies originally proposed.

The primary issue before the court was whether the transaction complied with the framework set forth in Kahn v. M & F Worldwide Corp. (“MFW”) for subjecting a squeeze-out merger by a controlling stockholder to business judgment review rather than the entire fairness standard. Central to the case was whether Jefferies committed itself to the dual protections of MFW before engaging in substantive economic discussions concerning the transaction that anchored later negotiations and undermined the ability of the special committee to bargain effectively on behalf of the minority stockholders.

The court first considered whether the pause in negotiations in March 2018 put enough time and distance between subsequent negotiations around February 2019 so that the MFW protections were implemented in a timely manner. The court agreed with plaintiffs that the break in negotiations was not meaningful.  The board never dissolved the special committee, negotiations were only paused, negotiations continued with BMO and BMO ultimately supported the exchange ratio.

The timing of the two sets of negotiations was not the fatal flaw however, but how the final negotiations progressed. Jefferies engaged in a series of discussions with BMO until Jefferies received an indication of support for a 2:1 share exchange from BMO—whose support was essential to get a deal done with minority stockholder approval—as well as from a financial advisor and key stockholder before Jefferies agreed to the dual MFW protections. To be more specific, Jefferies received these indications of support in early February 2019 but did not agree to the MFW protections until, at the earliest, February 20, 2019, when it amended its Schedule 13D.

The Court rejected defendants’ argument that Jefferies’ discussions with BMO before the February 2019 offer did not pass the point of no return for invoking MFW’s protections because those discussions were “preliminary” and only involved “an unaffiliated minority stockholder with no ability or authority to bind the corporation or any other stockholder.” As noted in Dell, “MFW’s dual protections contemplate that the Special Committee will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work.” In addition to superior access to information, directors also owe fiduciary duties and, unlike minority stockholders, do not suffer from the collective action problem of disaggregated stockholders whereas minority stockholders are unencumbered by fiduciary duties (absent special circumstances) and may have divergent interests in a transaction, whether economic or otherwise.

In Murfey v WHC Ventures, LLC the Delaware Supreme Court interpreted the books and records provisions of three limited partnership agreements.  The plaintiff wanted Schedule K-1s attached to the partnerships’ tax returns.  The partnerships countered that the K-1s were not “necessary and essential” to plaintiffs’ valuation purpose. The Court of Chancery, based upon its history of interpreting the books and records provision of Delaware’s limited partnership statute in the same manner as the Delaware corporate statute, held that the K-1s were subject to the requirement that documents sought be “necessary and essential” to the stated purpose, and it found that the K-1s failed that “necessary and essential” test. The Delaware Supreme Court reversed.

The limited partnership agreements provided that limited partners could request:

  • the partnership tax returns, and
  • information related to the name, address, capital contributions, and partnership percentage of each limited partner.

The Delaware Supreme Court easily found the requested K-1s were within the scope of the limited partnership agreement. The Court also rejected defendants’ assertion that the requested documents needed to be “necessary and essential,” akin to requirements imposed to inspect corporate books and records. The limited partnership agreements did not expressly condition the limited partner’s inspection rights on satisfying a “necessary and essential” condition.  Given the obvious importance of tax return and partnership capital contribution information to the limited partnerships’ investors, as evidenced by the agreements, the Delaware Supreme Court was not persuaded that such a condition should be implied.

In HUMC Holdco, LLC et al v. MPT of Hoboken TRS, LLC et al, the Delaware Court of Chancery examined numerous complexities attendant to an alleged violation of a right of first refusal in an LLC Agreement in connection with a motion for judgment on the pleadings.  Among other things, Hoboken HUMC sued Hoboken MPT for breach of the right of first refusal in Hoboken Opco’s LLC Agreement. In an initial purchase agreement, Alaris Health was to to acquire Hoboken MPT’s membership interests in Hoboken Opco together with some real estate not owned by Hoboken Opco. After the real estate sales closed, the parties entered into a second purchase agreement which related to an acquisition of the membership interests only.

One central issue in the case was whether the right of first refusal encompassed only the sale of the membership interests or also included the sale of real estate.  Looking to Delaware precedent, the court found the only reasonable way to interpret the agreement was to limit the first refusal right to relate to the membership interest and not to extend it to property the LLC did not own. The reason was under the Delaware statute a limited liability company agreement relates to the affairs of a limited liability company and the conduct of its business.  The court did not enter judgement on the pleadings however because by combining the sale of the real estate and the membership interest the court could not determine which terms were to be matched.

The court also noted the following issues were disputed:

  • In connection with entering into the second purchase agreement, was the defendant entitled to withdraw its right of first refusal notice issued on connection with the first purchase agreement, or was the first notice irrevocable for the period of time the LLC agreement required it to remain open?
  • Should the defendant have given the first refusal notice prior to entering into a binding purchase agreement since by its terms the right of first refusal applied to “offers”?

Finally, plaintiff argued that the first purchase agreement specifically provided that Hoboken MPT could not consent to any amendments to the LLC Agreement “without the prior written consent of [Alaris].”  Plaintiff claimed that Hoboken MPT breached the LLC Agreement by providing consent rights to Alaris concerning amendments to the LLC Agreement.  According to the court the claim raised questions of law such as whether the transfer of consent rights of this nature constitutes a transfer of governance rights. The court did not rule on the matter because it had not been adequately breached.

City of Fort Myers General § Employees’ Pension Fund v Haley, which was commenced in the Delaware Court of Chancery, grew out of the merger of equals between Towers Watson & Co. and Willis Group Holdings Public Limited Company.   Although Towers had stronger performance and greater market capitalization, under the agreement’s terms, Willis stockholders were to receive the majority (50.1 percent) of the post-merger company. Towers stockholders were to receive a $4.87 per-share special dividend and would own the remaining 49.9 percent of the combined company.

Upon the merger’s public announcement, several segments of the investment community criticized the transaction as a bad deal for Towers and a windfall for Willis.  Proxy advisory firms recommended that the Towers stockholders vote against the merger, and one activist stockholder began questioning whether Towers’ management’s incentives were aligned with stockholder interests. The parties questioned whether Towers would be able to obtain stockholder approval.

Also after announcing the merger, ValueAct Capital Management, L.P., an institutional stockholder of Willis, through its Chief Investment Officer, Jeffrey Ubben, presented to John J. Haley, the Chief Executive Officer and Chairman of Towers who was spearheading the merger negotiations, a compensation proposal with the post-merger company that would potentially provide Haley with a five-fold increase in compensation. Haley did not disclose this proposal to the Towers Board.

In light of the uncertainty of stockholder approval, Haley renegotiated the transaction terms to increase the special dividend to $10 per share. Towers eventually obtained stockholder approval of the renegotiated merger. The transaction closed in January 2016, and the companies merged to form Willis Towers Watson Public Limited Company, or Willis Towers. Haley became the CEO of Willis Towers and was granted an executive compensation package with a long-term equity opportunity similar to ValueAct’s proposal.

Plaintiffs alleged that Haley breached his duty of loyalty by negotiating the merger on behalf of Towers while failing to disclose to the Towers Board the ValueAct compensation proposal provided by Ubben.  Plaintiffs alleged that the proposal misaligned Haley’s incentives at a critical juncture in the negotiations, and incentivized him to seek no more of a dividend than he believed necessary to secure the Towers stockholders’ approval.

The Court of Chancery dismissed the claims, holding that the business judgment rule applied because “a reasonable board member would not have regarded the ValueAct proposal as significant when evaluating the proposed transaction,” and further holding that plaintiffs had failed to plead a non-exculpated bad faith claim against the Towers directors.  For the reasons noted below, the Delaware Supreme Court reversed the Court of Chancery’s decision.

The Delaware Supreme Court noted the claims asserted against Haley focused on the conduct of a single director, and that in order to rebut the presumption of the business judgment rule, Plaintiffs must adequately allege that:

  • the director was “materially self-interested” in the transaction,
  • the director failed to disclose his interest in the transaction to the board, and
  • a reasonable board member would have regarded the existence of the director’s material interest as a significant fact in the evaluation of the proposed transaction.

The Court noted that “Material,” in this context, means that the information is “relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decision making.” The Court stated the other directors were aware of a potential conflict in that Haley would earn greater compensation after the merger.  However, the Court found the Plaintiffs adequately alleged that the undisclosed proposal altered the nature of the potential conflict that the Towers Board knew of in a material way. Specifically, the Plaintiffs alleged that the Board would have found it material that its lead negotiator had been presented with a compensation proposal having a potential upside of nearly five times his compensation at Towers, and that he was presented with this Proposal during an atmosphere of deal uncertainty and before they authorized him to renegotiate the merger consideration.

The Court rejected Defendants’ assertion that the alleged failure to disclose was not material because ValueAct’s presentation, even if deemed to have been a proposal, was not binding on anyone. The Court stated the fact that the proposal was a not concrete agreement and had milestones requiring “Herculean” efforts did not relieve Haley of his duty to disclose the proposal to the Towers Board, particularly in an atmosphere of considerable deal uncertainty.

The Court also concluded that Plaintiffs adequately alleged that Haley failed to inform the Towers Board of his deepened interest in the transaction. That Haley kept the Towers Board generally apprised of negotiations, as the Court of Chancery found, did not rebut Plaintiffs’ contention that Haley failed to adequately disclose his self-interest to the Board. While Haley may have discussed the compensation proposal with another officer, the officer was not a Board member.

Plaintiffs also adequately plead that a reasonable Board member would have regarded Haley’s material interest in the Proposal as a significant fact in evaluating the merger.  Plaintiffs alleged that a Board member who was also Compensation Committee Chair testified that “he would have wanted to know that Haley was discussing his compensation at the future company with Ubben and ValueAct, but did not receive such information, let alone information as to the magnitude of the raise that Haley stood to receive.”

Accordingly, the Delaware Supreme Court reversed the Court of Chancery’s opinion and remanded for further proceedings.

As this was before the Court on appeal of a motion to dismiss the Court did not make any finding that any Defendant breached a fiduciary duty.

The SEC previously issued an order that, subject to certain conditions, provided publicly traded companies with an additional 45 days to file certain disclosure reports.  The current relief provided public companies with a 45-day extension to file certain disclosure reports that would otherwise have been due on or before July 1, 2020.  In a public statement captioned “An Update on the Commission’s Targeted Regulatory Relief to Assist Market Participants Affected by COVID-19 and Ensure the Orderly Function of our Markets” the SEC noted the relief would not be extended because in their view it was not necessary. We encourage public companies to prepare for filing periodic reports for periods ended June 30, 2020 on a schedule that does not contemplate any relief from the SEC.

The noted public statement also provides a useful summary of the status of SEC relief on other matters related to COVID-19.

Stinson Webinar 

Stinson is holding a webinar on July 7, 2020, from 11:30 to 1:00 Central Daylight Time, on “Preparing the Second Quarter Form 10-Q in Light of COVID‑19 and Associated Issues.” You can register for the webinar here. We anticipate CLE being available for Arizona, Colorado, Kansas, Minnesota, Missouri and Texas.

The SEC’s Division of Corporation Finance (Division) has issued disclosure guidance in the form of CF Disclosure Guidance: Topic No. 9A addressing COVID-19 disclosure considerations regarding operations, liquidity and capital resources. The Guidance supplements CF Disclosure Guidance Topic 9 which provided the Division’s initial views on disclosure and other securities law obligations that companies should consider with respect to COVID-19 and related business and market disruptions.

In addition, the SEC’s Office of the Chief Accountant (OCA) issued a statement via its Chief Accountant, Sagar Teotia, regarding the continued importance of high-quality financial reporting in light of the significant impacts of COVID-19. OCA notes many public companies are now preparing for their next reporting cycle (e.g., second quarter financial reporting), and emphasizes that participants in the financial reporting system continue to play an important role in the functioning of our markets and in the collective national effort to mitigate the COVID-19 pandemic.

CF Disclosure Guidance: Topic No. 9A – COVID-19 Disclosure Considerations Regarding Operations, Liquidity, and Capital Resources

The Division continues to encourage companies to provide disclosures that allow investors to evaluate the current and expected impact of COVID-19 through the eyes of management and to proactively revise and update disclosures as facts and circumstances change. These disclosures should enable an investor to understand how management and the Board of Directors are analyzing the current and expected impact of COVID-19 on the company’s operations and financial conditions, including liquidity and capital resources.

Operations, Liquidity, and Capital Resources

The Division notes companies have undertaken and are generally in the process of making a diverse range of operational adjustments in response to the effects of COVID-19. These adjustments are numerous and include a transition to telework; supply chain and distribution adjustments; and suspension or modification of certain operations to comply with health and safety guidelines to protect employees, contractors, and customers, including in connection with a transition back to the workplace.  According to the Division, it is important that companies provide robust and transparent disclosures about how they are dealing with short- and long-term liquidity and funding risks in the current economic environment, particularly to the extent efforts present new risks or uncertainties to their businesses. While the Division has observed companies making some of these disclosures in their earnings releases, the guidance encourages companies to evaluate whether any of the information, in light of its potential materiality, should also be included in MD&A.

Much of CF Disclosure Topic 9A is comprised of a list of questions for companies to consider when formulating disclosures, such as:

  • What are the material operational challenges that management and the Board of Directors are monitoring and evaluating?
  • How is your overall liquidity position and outlook evolving? To the extent COVID-19 is adversely impacting your revenues, consider whether such impacts are material to your sources and uses of funds, as well as the materiality of any assumptions you make about the magnitude and duration of COVID-19’s impact on your revenues.
  • Are you at material risk of not meeting covenants in your credit and other agreements?
  • If you include metrics, such as cash burn rate or daily cash use, in your disclosures, are you providing a clear definition of the metric and explaining how management uses the metric in managing or monitoring liquidity?

Government Assistance – The Coronavirus Aid, Relief, and Economic Security Act (CARES Act)

The Division notes the CARES Act includes financial assistance for companies in the form of loans and tax relief in the form of deferred or reduced payments and potential refunds. Companies receiving federal assistance should consider the short- and long-term impact of that assistance on their financial condition, results of operations, liquidity, and capital resources, as well as the related disclosures and critical accounting estimates and assumptions. Questions to consider include:

  • How does a loan impact your financial condition, liquidity and capital resources?
  • Are you taking advantage of any recent tax relief, and if so, how does that relief impact your short- and long-term liquidity?
  • Does the assistance involve new material accounting estimates or judgments that should be disclosed or materially change a prior critical accounting estimate?

A Company’s Ability to Continue as a Going Concern

The Division’s guidance reminds management to consider whether conditions and events, taken as a whole, raise substantial doubt about the company’s ability to meet its obligations as they become due within one year after the issuance of the financial statements. Where there is substantial doubt about a company’s ability to continue as a going concern or the substantial doubt is alleviated by management’s plans, the Division notes that management should provide the appropriate respective disclosures in the financial statements and consider the following questions regarding the MD&A disclosure:

  • Are there conditions and events that give rise to the substantial doubt about the company’s ability to continue as a going concern? For example, have you defaulted on outstanding obligations? Have you faced labor challenges or a work stoppage?
  • What are your plans to address these challenges? Have you implemented any portion of those plans?

OCA Statement on Continued Importance of High-Quality Financial Reporting

Highlights of the OCA’s statement are set forth below.

Significant Estimates and Judgments; Reasonable Judgments

As noted in previous guidance, the OCA’s statement emphasizes that in connection with financial reporting responsibilities, many companies have been required to make significant judgments and estimates to address a variety of accounting and financial reporting matters.  According to the statement, OCA has consistently not objected to well-reasoned judgments that entities have made, and OCA will continue to apply this perspective.  Companies should ensure that significant judgments and estimates are disclosed in a manner that is understandable and useful to investors, and that the resulting financial reporting reflects and is consistent with the company’s specific facts and circumstances.

The Importance of Disclosure Controls and Procedures (DCP) and Internal Control over Financial Reporting (ICFR)

OCA continues to emphasize the importance of robust internal accounting controls to high-quality, reliable financial reporting.  Public companies are required to maintain DCP and ICFR.  In addition, management is required to evaluate the effectiveness of a public company’s DCP as of the end of each fiscal quarter, and the effectiveness of its ICFR at the end of each fiscal year.  OCA understands preparers have adapted, or are adapting, their financial reporting processes as they respond to the changing environment.  These changes may include consideration on how controls operate or can be tested and if there is any change in the risk of the control not operating effectively in a telework environment.  In addition, changes to the business and additional uncertainties may result in additional risks of material misstatement to the financial statements in which new or enhanced controls may need to be implemented to mitigate such risks.  OCA reminds preparers that if any change materially affects, or is reasonably likely to materially affect, an entity’s ICFR, such change must be disclosed in quarterly filings in the fiscal quarter in which it occurred.

Reminders about an Entity’s Ability to Continue as a Going Concern

Financial reporting pursuant to U.S. generally accepted accounting principles (GAAP) presumes a reporting entity has the ability to continue as a going concern.  OCA reminds preparers that in each reporting period, including interim periods, management should consider whether relevant conditions and events, taken as a whole, raise substantial doubt about the entity’s ability to meet its obligations as they become due within one year after the issuance of the financial statements.  In instances where substantial doubt about an entity’s ability to continue as a going concern exists, management should consider whether its plans alleviate such substantial doubt, and make appropriate disclosures to inform investors.  Such disclosures should include information about the principal conditions giving rise to the substantial doubt, management’s evaluation of the significance of those conditions relative to the entity’s ability to meet its obligations, and management’s plans to alleviate substantial doubt.  If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is not alleviated, additional disclosure is required.  OCA notes that GAAP requires such disclosure in the notes of the financial statements and this may be incremental to other disclosure requirements in filings with the Commission.

In addition, the statement notes auditors also have responsibility to evaluate an entity’s ability to continue as a going concern based on their knowledge of relevant conditions that exist at or occurred prior to the date of the auditor’s report.  Although a review of interim financial information is not designed to identify conditions or events that indicate substantial doubt about an entity’s ability to continue as a going concern, an auditor may become aware of such conditions or events in the course of performing review procedures.  In such cases, auditors should inquire with management and consider the adequacy of the relevant disclosures’ conformity with GAAP.  OCA reminds auditors that after performing such procedures, to the extent the auditor determines the relevant disclosure is inadequate such that it represents a departure from GAAP, the auditor should extend the procedures, evaluate the results and communicate as appropriate with the issuer and its audit committee.

Engagement with and the Vital Role of Audit Committees

The statement notes OCA has stressed many times in the past the key role that audit committees of companies play in the financial reporting system through their oversight of financial reporting, including ICFR and the external, independent audit process.  The statement reiterates OCA’s strong belief that the measures related to audit committees have proven to be some of the most effective financial reporting enhancements included in the Sarbanes-Oxley Act.

In these times of rapid change and increased uncertainty, OCA believes the need for the oversight role that audit committees play is as critical as ever.  The statement also highlights OCA’s view that the most effective audit committees are engaged, executing their responsibilities with diligence, and this engagement significantly enhances the financial reporting output.

Stinson Webinar 

Stinson is holding a webinar on July 7, 2020, from 11:30 to 1:00 Central Daylight Time, on “Preparing the Second Quarter Form 10-Q in Light of COVID‑19 and Associated Issues.” You can register for the webinar here. We anticipate CLE being available for Arizona, Colorado, Kansas, Minnesota, Missouri and Texas.