FIFTH CIRCUIT WEIGHS IN ON “SECURITIES” DEFINITION

Whether or not certain interests in investment contracts qualify as securities have long been subject to the test set forth in SEC v. W.J. Howey, 328 U.S. 293 (1946). At the end of June, the Fifth Circuit provided additional guidance on one of the Howey factors—whether the investors expect to profit “solely from the efforts of” others.

Securities and Exchange Commission v. Arcturus Corp., et al, No. 17-10503, 2019 WL 2622534 (5th Cir. June 27, 2019) came to the Fifth Circuit on appeal from the district court’s grant of the SEC’s motion for summary judgment holding that the interests in oil and gas drilling joint ventures at issue were securities. The defendants had sold interests in several oil and gas drilling projects to investors, had not registered the interests as securities, and the SEC brought this civil enforcement action.

The Fifth Circuit’s analysis walks through the factors from Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981) used in determining whether investors expect to profit solely from a third-party’s efforts, analyzes how the facts of this case fit into those factors, concludes that fact issues precluding summary judgment, and reverses the grant of summary judgment and remands the case for trial.

Under Williamson, an investor is dependent solely on efforts of others when: “(1) an agreement among the parties leaves so little power in the hands of the partner or venture that the arrangement, in fact, distributes power as would a limited partnership; or (2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venture is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership of venture powers.” Williamson, 645 F.2d at 424. Here, the district court held investors had no real control because any powers granted were illusory, investors lacked experience because the interests were marketed through a broad cold-calling campaign, and investors were reliant on the managers because the manager controlled the assets and a replacement manager would not have access to those assets. Arcturus, No. 17-10502, 2019 WL 2622534 at *5.

The Fifth Circuit analyzed each of the Williamson factors at length, eschewing a cookie-cutter approach to applying the definition of “securities” and instead highlighting that the nuances and realities of a given business venture and its participants play key roles in determining whether the interest is a security.

For example, when evaluating the powers of the parties, the Court highlighted that the joint venture agreement allowed investors to remove the managers with a 60% vote and that almost all of the Managers’ powers were subject to veto by the investors. Arcturus, No. 17-10502, 2019 WL 2622534 at *8-9. The Court also highlighted that there was evidence that investors held votes and, in so doing, actually exercised the powers granted in the joint venture agreement. Id. at *9. The Court also evaluated the voting structure of the venture, how the investors received information, how the investors communicated with each other and the number of investors. Id. *9-12. Likewise for the other Williamson factors, the Court went into great factual detail and determined that fact issues existed to preclude summary judgment due to a mixed and/or incomplete record on issues such as the experience of the investors (there was only evidence in the summary judgment record as to the experience of about 25 of the 340 investors) and whether the managers were effectively irremovable due to their control of the assets. Id. at *13-18.

In short, the Arcturus opinion provides a map for transactions and litigation alike to explain the pertinent facts that would inform the determination of whether interests in a joint venture are securities. It provides a clear message that whether an interest is a security is an inquiry that must be made based on the facts of any given business arrangement and which litigants should be prepared to support with evidence in order to make their case.

FINANCIAL CHOICE ACT: CHANGES IN GOVERNMENTAL SECURITIES REGULATION MAY BE COMING

While you might have heard that the House has passed a bill that would repeal portions of the Dodd-Frank Act (a bill enacted in July 2010 in the wake of the Great Recession to provide additional government regulation of the financial industry), you might not have heard that the nearly 600 page “Financial CHOICE Act of 2017” (H.R. 10) has provisions covering a broad range of topics that could have a significant impact on government regulatory agencies as well as require a number of specific changes to the Securities and Exchange Commission. While these changes will only take effect if or when the Senate passes the Financial Choice Act, the Financial Choice Act is a bill worth monitoring to see what changes may come. A few of the more notable changes proposed in the bill include:

• Enhancement of SEC civil penalties for violations of securities laws including tripling the amount of monetary fines when the penalty is tied to illegal profits and permitting penalties equal to investor loss in cases involving “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.”
• Requiring all financial regulators to complete a cost-benefit analysis of any new regulation.
• Creating a process to permit a recipient of a Wells notice to appear before the Commission in-person.
• Publication of an updated enforcement manual outlining the SEC’s policies and procedures.
• Repealing the authority of the SEC to prohibit persons from serving as officers or directors. Amending the Investment Company Act of 1940 to heighten the pleading standard and require a security holder of a registered investment company to state with particularity all facts forming the basis of their breach of fiduciary claim under Section 36(b) and raising the burden from a “preponderance of the evidence” standard to a “clear and convincing evidence” standard.

Looking forward, it is clear that changes could be coming. Those changes could greatly impact how federal securities regulations are created, enforced, and even litigated. We’ll be keeping an eye on this bill to see what come to fruition and so should you.

INDEPENDENCE AND DISINTERESTEDNESS: A MATTER OF PRACTICAL REALITY AND HUMAN NATURE TO BE INVESTIGATED PRE-SUIT

In shareholder derivative litigation, one of the earliest questions for a plaintiff is whether the directors of a company are sufficiently independent and disinterested to consider a shareholder demand or whether pre-suit demand is excused. In Delaware, demand excusal is provided for by Court of Chancery Rule 23.1. In a recent Delaware Supreme Court decision, Sandys v. Pincus, authored by Chief Justice Strine, the Court confronted this question and highlighted that: (1) courts must consider real-life dynamics and human nature when deciding whether directors are independent and disinterested and (2) plaintiffs should conduct an inquiry into director independence prior to filing, including utilizing the statutory procedures for books and records requests. Sandys v. Pincus, No. 157, 2016, 2016 Del. LEXIS 627 (Del. Dec. 5, 2016).

Sandys was a derivative action filed by shareholders of Zynga, Inc. The complaint asserted the CEO and other managers and directors were granted an exception to a company rule preventing insider sales of shares until three days after an earnings announcement. Taking advantage of this exception, insiders sold 20.3 million shares at $12 per share. Immediately after the earnings announcement, the price dropped to $8.52 per share. Within three months after the earnings announcement, the share value had fallen to $3.18 per share. The complaint alleged wrongdoing by the directors who approved this exception.

The Court of Chancery dismissed the complaint for failure to adequately plead demand excusal under Rule 23.1. In evaluating the independence and disinterestedness of Zynga’s nine directors, the Court of Chancery found that only two of those directors, the two who sold shares under the exception, were interested.

The Delaware Supreme Court reversed. In its opinion, the Court analyzed the independence and disinterestedness of three additional directors and determined that when looking at the real-world implications of their relationships to the Zynga CEO, who benefitted greatly from this exception, there was a reasonable doubt that these directors could have properly exercised independent and disinterested business judgment in responding to a pre-suit demand. The Court characterized one director, Ellen Siminoff, as a “close family friend of the CEO” relying almost entirely on the fact that Siminoff co-owned a private plane with the CEO. The Court analogized this co-ownership to family ties that, as a part of human nature, would call into question Siminoff’s independence and disinterestedness because jointly owning an airplane was an uncommon relationship with high expenses requiring a great deal of cooperation between Siminoff and the CEO. The Court also found that there was a reasonable doubt that directors John Doerr and William Gordon were independent or disinterested. This determination was based in part on the fact that Doerr and Gordon were partners in a venture capital firm that owned 9.2% of Zynga and that also invested in a company co-founded by the Zynga CEO’s wife. The Court, however, focused most heavily on the fact that Zynga did not consider Doerr or Gordon to be independent directors under the NASDAQ listing rules.

While the Court acknowledged that characterization for the NASDAQ listing rules is not dispositive in every case, the Court afforded great weight to Zynga’s determination that Doerr and Gordon lacked independence. While the Delaware Supreme Court reversed the Court of Chancery’s dismissal under Rule 23.1, the Delaware Supreme Court highlighted that the plaintiff had made the demand excusal determination more difficult by not conducting more pre-suit investigation or pleading more particularized facts as to the directors’ lack of independence. In particular, the Delaware Supreme Court emphasized that, while plaintiff made a pre-suit books and records request, the plaintiff had only sought books and records relating to the transaction he sought to redress. The Court said that plaintiff should have also used the books and records request to investigate the independence of the board. Companies should, therefore, expect prospective shareholder derivative plaintiffs to make greater use of books and records requests to inquire as to the independence of directors prior to filing.

LAW FIRM SUED FOR BUSINESS LOST FROM CLIENT TO CLIENT- A CAUTIONARY TALE

A long-time insurance company client of Greenberg Traurig has sued the law firm, KPMG, and ten other defendants under conspiracy and other theories in district court in the Southern District of Florida, case number 9:16-cv-80618. The law firm had assisted plaintiff with the development of an offshore insurance product. The Complaint alleges defendants helped form a competitive insurance company that stole clients from plaintiff forcing the plaintiff into a receivership.

Three allegations in the Complaint provide a cautionary tale for both lawyers and their clients. Plaintiff asserts there was an oral agreement at the relationship’s inception that the law firm would not represent a competitor of plaintiff. A complete written client agreement should fully address such issue for the benefit of both sides.

Some of the law firm invoices had numerous redactions. Redactions would usually seem incompatible with the duties of the law firm.

Finally, the Complaint asserts Greenberg Traurig provided plaintiff crucial tax opinions for four years then declined to give needed updates thereafter while doing tax opinions for the competitor. There is a suggestion that the refusal was a result of plaintiff failing to pay its legal invoices. The value of including in a client agreement a clear-cut right to terminate the relationship cannot be overstated.

SEC’S ANNUAL REPORT ON THE DODD-FRANK WHISTLEBLOWER PROGRAM POINTS TO EXPANDING RESPONSE TO PROGRAM—MORE WHISTLEBLOWER TIPS AND MORE AWARDS TO WHISTLEBLOWERS

On November 16, 2015, the SEC released its Annual Report to Congress on the Dodd-Frank Whistleblower Program. The Report touts the success of the Whistleblower Program by highlighting its receipt of over 4,000 tips in fiscal year 2015. This number is up 8% from fiscal year 2014, 20% from fiscal year 2013, and 30% from fiscal year 2012. The Report also emphasizes that out of 130 award claims, 8 whistleblowers were awarded a total of more than $37 million in fiscal 2015. This $37 million is a substantial percentage of the $54 million paid to 22 whistleblowers since the new whistleblower rules went into effect in August 2011. Additionally, the Report highlights that whistleblowers come from all sorts of different places. In fiscal year 2015, whistleblower tips came from every state and 61 foreign countries. In particular, the number of different foreign countries from which tips originated points to the international growth of the program. Surprisingly, less than one half of all whistleblower tips came from corporate insiders. According to the Report, those non-insiders include victimized investors and individuals with a “personal relationship with the alleged wrongdoer.”

Also of interest is that almost 4 out of 5 whistleblowers stated that they raised their concern internally before going to the Commission or that their supervisors were aware of their concerns before they went to the Commission. This may shed additional light on the reasoning behind the SEC’s August 4th release of a rule interpretation supporting its view that a person who reports possible wrongdoing internally, but not to the SEC, is still protected as a “whistleblower” on which we have previously blogged. Click here to read the prior post.

In addition to touting the numerical success and growth of the Program, the Report highlights the whistleblower program’s involvement with Enforcement staff in helping ensure individuals feel safe reporting to the Commission without fear of reprisal from their employer. In pursuit of that end, the Commission brought charges under Rule 21F-17(a) against a company for including language in confidentiality agreements that impeded whistleblowers from reporting to the Commission by prohibiting employees from discussing the substance of interviews they gave in internal investigations without approval of the company’s legal department. Further, 2015 saw the Commission’s first successful anti-retaliation enforcement action under the Dodd-Frank Act stemming from a whistleblower’s original information. That whistleblower received a 30% award, the statutory maximum, for providing the Commission with original information that led to the successful enforcement action.

The steady growth of the whistleblower program in terms of number of tips, dollar amount of awards, and geographic diversity of where tips originate seem to point to the continued expanded response to the Program.

Click here to read the entire Annual Report.

FIFTH CIRCUIT PROVIDES GUIDANCE ON CLASS CERTIFICATION

The Fifth Circuit Court of Appeals recently provided guidance on class certification related to securities fraud claims. On September 8, 2015, the Fifth Circuit released its opinion in Ludlow et al v. BP, P.L.C. et al, a case stemming from the 2010 Deepwater Horizon oil spill, where plaintiffs alleged BP made misstatements in violation of section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5. In that opinion, the Fifth Circuit affirmed the district court in certifying one class of plaintiffs and in refusing to certify another class of plaintiffs based on whether the methodology presented for determining class damages for each class was a “sound methodology” applicable “across the entire class” as required by the Supreme Court’s decision in Comcast Corp. v. Behrend.

The two proposed classes were those claiming damages based on pre-spill misrepresentations by BP (the “Pre-spill Class”) and those claiming damages based on post-spill misrepresentations by BP (the “Post-spill Class”). The Pre-spill Class claimed that BP’s alleged misstatements regarding the efficacy of its safety procedures created an impression that the risk of a catastrophic failure was lower than it actually was and deprived investors of the opportunity to decide whether to invest in light of the heightened risk. The Post-spill Class complained of BP’s misrepresentation as to the magnitude of the spill, even as internal BP estimates showed that the magnitude was much higher than was being publicly disclosed.

The district court refused to certify the Pre-spill Class, but certified the Post-spill Class. The Fifth Circuit affirmed based on its analysis of the class damage models in comparison to Comcast’s requirement that a damage model must be “susceptible of measurement across the entire class for purposes of Rule 23(b)(3).” The Fifth Circuit noted that the Pre-spill Class’s damages theory hinged on a determination that each plaintiff would not have bought BP stock at all were it not for the alleged misrepresentations. The Fifth Circuit explained that this would require an individualized inquiry as some investors would be less risk averse than others and might have still invested, even if in smaller amounts. In light of this, the Pre-spill Class’s damages theory could not provide an adequate measure of class-wide damages under Comcast. In contrast, the Fifth Circuit noted that Post-spill Class’s damages theory was sufficient under Comcast despite BP’s attack that the expert report on which plaintiffs relied said it was “possible” that BP’s stock price would have declined to a specified level if the true spill rate had been released earlier because Comcast requires a “sound” methodology and not certainty.

WHAT’S IN A NAME--TEXAS SUPREME COURT CLARIFIES WHAT CONSTITUTES A “SECURITY”

Oftentimes we rely on a particular name or label to define what something is. When dealing with the Texas Securities Act and determining whether or not a particular offering is a “security,” calling it something else is not enough. The Supreme Court of Texas will look at the economic ramifications of the offering and decide whether the offering is a “security.” If the offering was a “security,” there can be steep repercussions.

Life Partners has been engaged in the business of buying existing life insurance policies from those whose lives the policies insure, and then selling interests in those policies to others for over 20 years. These transactions are referred to as “life settlements” when the insured is elderly or “viatical settlements” when the insured is terminally ill. Life Partners has consistently marketed these offerings as something other than securities—“life settlements” and “viatical settlements.”

Last week, the Supreme Court of Texas issued its opinion in Life Partners, Inc. v. Arnold et al, No. 14-0226 ruling that Life Partners, Inc.’s product was an “investment contract” and thus a “security” under the Texas Securities Act. Under the Texas Securities Act, a “security” is defined broadly as “any limited partner interest in a limited partnership, share, stock, treasury, stock, . . . investment contract, or any other instrument known as a security, whether similar to those herein referred to or not.” In its opinion, the Supreme Court of Texas clarified that (1) “the Texas Securities Act’s definition of ‘securities’ must be construed broadly to maximize the protection it provides to investors, while focusing on the economic realities of the transaction regardless of any labels or terminology the parties may have used”; (2) an “investment contract” for the purposes of the Texas Securities Act “means a contract transaction, or scheme through which a person pays money to participate in a common venture or enterprise with the expectation of receiving profits, under circumstances in which the failure or success of the enterprise, and thus the person’s realization of the expected profits, is at least predominately due to the entrepreneurial or managerial, rather than merely ministerial or clerical, efforts of others”; and (3) “the entrepreneurial or managerial efforts that are relevant to this inquiry . . . include those that are made prior to the transaction as well as those that are made after.”

In arriving at this ruling, the court relied on and interpreted federal precedent. However, the court notably departed from the precedent of the D.C. Circuit, as set forth in S.E.C. v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), determining that the assessment of whether the expected profits were due to the “efforts of others” could take into account pre-investment efforts. This expansion from looking only at post-investment efforts of others (which the D.C. Circuit had found “merely ministerial or clerical” and thus not causing “life settlements” and “viatical settlements” to be “investment contracts” or “securities”) to looking at both pre- and post-investment efforts of others could open the door to questions regarding how to draw the line on other investments between a security and non-security in the future.

DALLAS COURT OF APPEALS ASKED TO RULE ON STANDARDS FOR AWARDS OF ATTORNEYS’ FEES IN SHAREHOLDER DERIVATIVE LITIGATION

J.C. Penney Company, Inc. (“J.C. Penney”) has asked the Dallas Court of Appeals to reverse a ruling awarding $3.1 million in attorneys’ fees in a derivative lawsuit challenging executive compensation practices that J.C. Penney settled in exchange for the non-monetary benefit of certain corporate governance changes. In its appellate briefing, J.C. Penney argues that the derivative plaintiffs provided evidence at the trial court to support a lodestar calculation of only $558,123 in attorneys’ fees. J.C. Penney argues that the $3.1 million fee award is unreasonable because it constitutes 550% of the fees actually incurred by the derivative plaintiffs. The derivative plaintiffs, on the other hand, justify the $3.1 million award on the basis of their valuation of the non-monetary relief as representing at least $15.5 million in settlement value to J.C. Penney and its shareholders. Based on that valuation, the $3.1 million attorneys’ fee award represents only 20% of the value of the settlement.

In ruling on this appeal, the Dallas Court of Appeals will have the opportunity to provide guidance as to the appropriate means of calculating and awarding attorneys’ fees in shareholder derivative actions. From lodestar calculations to the application of multipliers to valuation of non-monetary settlements, there are an array of issues that give reason to keep an eye out for the Dallas Court of Appeals’ ruling.

Moreover, while J.C. Penney’s main argument is that the fee award was excessive in light of the work performed and the results achieved, it also points to TRCP 42(i)(2), which provides that attorneys’ fee awards are unavailable in class action settlements where the relief obtained for the class is non-monetary and only therapeutic in nature. At least two Texas appellate court decisions have held that TRCP 42(i)(2) precludes an award of attorneys’ fees when the settlement of a class action challenging a merger is based on non-monetary relief, such as additional disclosures regarding the transaction. While J.C. Penney did not argue that TRCP 42(i)(2) precludes attorneys’ fees altogether in this case—likely because the case was a derivative action, not a class action—it cited TRCP 42(i)(2) in arguing that the fees awarded were excessive in light of the lack of monetary relief obtained. Thus, any commentary by the Dallas Court of Appeals on J.C. Penney’s TRCP 42(i)(2) argument might provide interesting guidance as to whether the court will apply TRCP 42(i)(2) to preclude attorneys’ fees in future settlements of class action merger litigation that are based only on non-monetary relief.

This case is on appeal from the 193rd Judicial District Court of Dallas County, Texas, is pending before the Dallas Court of Appeals, and is captioned J.C. Penney Company, Inc. and Myron E. Ullman III, et al. v. Everett M. Ozenne, derivatively on behalf of J.C. Penney Company, Inc., No. 05-13-01601-CV.