Overview: The Fifth Circuit’s highly anticipated decision on December 31, 2024, in the Serta Simmons case has significant implications for borrowers and lenders in financial distress situations. The issue on appeal concerned an uptier transaction, a liability management exercise sometimes referred to as “lender-on-lender violence.” The Fifth Circuit’s opinion addresses the contractual viability of uptier transactions and the enforceability of related indemnities in bankruptcy plans, potentially reshaping the landscape for future financial restructurings.

Background: Serta Simmons Bedding, LLC, a major mattress manufacturer, entered into secured financing transactions in 2016 and 2020 with various lenders. Facing financial distress exacerbated by the COVID-19 pandemic, Serta engaged in an uptier transaction in 2020, which involved issuing new super-priority debt to certain lenders (prevailing lenders) in exchange for their existing debt. This move was contested by other lenders who did not participate in the transaction, leading to litigation over the validity of the uptier under the original loan agreements.

Key Points of the Decision:

  1. Uptier Transactions and Open Market Purchases:

    • The Fifth Circuit held that the 2020 uptier transaction was not a permissible “open market purchase” under the 2016 loan agreement. The court emphasized that an open market purchase must occur on a specific market generally open to various buyers and sellers, such as the secondary market for syndicated loans.

    • The court rejected broader definitions proposed by Serta and the prevailing lenders, which would have allowed almost any competitive transaction to qualify as an open market purchase, thereby undermining the specific procedures and protections intended by the loan agreement.

    • While the court focused on the terms of the particular loan agreement at issue, it did issue a broader warning: “[W]hile the loan market has seen an increase in contracts blocking uptiers … there are doubtless still many contracts with open market purchase exceptions to ratable treatment… Though every contract should be taken on its own, today’s decision suggests that such exceptions will often not justify an uptier.”

  2. Indemnities in Bankruptcy Plans:

    • The court found that the inclusion of an indemnity in Serta’s bankruptcy plan, which aimed to protect the prevailing lenders from liabilities arising from the 2020 uptier, was an impermissible end-run around the Bankruptcy Code.

    • Specifically, the indemnity violated 11 U.S.C. § 502(e)(1)(B), which disallows contingent claims for reimbursement where the claimant is co-liable with the debtor. The court held that the indemnity could not be justified as part of a plan settlement and that its inclusion resulted in unequal treatment of creditors, violating the Bankruptcy Code’s plan requirements.

Implications for Borrowers and Lenders:

  1. Scrutiny of Uptier Transactions:

    • The decision underscores the importance of adhering to the specific terms and procedures outlined in loan agreements. Borrowers and lenders must carefully evaluate whether proposed liability management strategies, such as uptiers, comply with contractual provisions and established market practices. They should not assume that an open market purchase exception will allow an uptier transaction to stand.

    • Lenders should be vigilant in reviewing loan agreements for clauses that could be exploited to justify non-pro-rata transactions and consider negotiating for explicit protections against such maneuvers.

  2. Enforceability of Indemnities:

    • The ruling highlights the limitations on including indemnities in bankruptcy plans. Borrowers and lenders must ensure that any indemnities or similar provisions in restructuring plans comply with the Bankruptcy Code and do not result in unequal treatment of creditors.

    • Lenders should be aware of the potential for indemnities to be challenged and invalidated, affecting their go-forward litigation risk arising out of dealings with bankruptcy borrowers.

Conclusion: The Fifth Circuit’s decision in the Serta Simmons case sets a precedent that could limit the ability of borrowers to engage in lender-on-lender violence through uptier transactions and restrict the use of indemnities in bankruptcy plans. Borrowers and lenders must navigate these legal constraints carefully to avoid disputes and ensure compliance with contractual and statutory requirements, lest their liability management exercises simply lead to further liabilities.

Consumer reporting agencies, furnishers, and end users must continuously monitor recent developments to remain compliant with their legal obligations under the Fair Credit Reporting Act.

The FCRA continues to be one of the most heavily litigated consumer protection statutes in the country, and companies should expect this to continue.

Read the full article on Bloomberg Law.

President Donald Trump’s return to the Oval Office is expected to reshape U.S. policies related to immigration. Many of those changes will impact U.S. employers, even those without employees on work visas. Here are the top five areas where we expect key changes impacting employers and how to prepare for them.

1. Increased Worksite Enforcement Actions and Raids by Immigration and Customs Enforcement (ICE), Investigations by Justice Department

Form I-9 Audits

ICE is expected to increase its number of Form I-9 audits across the board. Some geographic areas and industries, however, may be of greater interest to ICE. For example, more “immigrant-friendly” or “immigrant-heavy” states and businesses in the construction, agriculture, manufacturing, or hospitality industries are more likely to become targets due to their higher proportion of positions that traditionally do not require extensive training or education.

The Form I-9 serves to verify a worker’s identity and permission to work in the U.S. Employers must have a properly completed I-9 for every employee, all of which will be subject to review and potential fines in the event of a government audit. Some common violations committed by employers during I-9 completion include:

  • Failing to timely complete I-9s;

  • Requesting specific documents;

  • Requesting more documents than needed;

  • Rejecting acceptable documents;

  • Failing to properly capture electronic signatures; and

  • Failing to properly reverify certain employees’ permission to work after expiration.

Penalties can be as high as $2,789 for each I-9 with substantive violations and $27,894 for knowingly hiring/continuing to employ workers without authorization. Further, ICE is more likely to issue criminal penalties for a finding of knowingly hiring or continuing to employ unauthorized noncitizens, with harsher fines and/or six months imprisonment. Employees engaging in fraud or false statements, or otherwise misusing visas, immigration work permits, or identity documents may be fined and/or imprisoned up to five years.

To prepare for these investigations, employers can:

  • Conduct a professional I-9 audit and review the company’s I-9 (and E-Verify if applicable) practices. Obtain guidance on correcting paperwork violations and identifying systematic flaws to correct existing errors and avoid future violations;

  • Provide training to the employer’s HR team members completing I-9s as employer representatives;

  • Institute company policy to ensure fair and consistent I-9 practices as well as standard operating procedures in case of a site visit by ICE.

Worksite Raids

We expect more worksite raids with the use of Blackie’s warrants (civil search warrant often used by ICE agents to raid a workplace where they believe unauthorized workers are employed but do not have to provide specific names or descriptions of the individuals being sought). With Trump’s policy on cracking down on unauthorized workers in the U.S., far-reaching raids of this nature are more likely to occur.

2. Changes to Existing Humanitarian Programs

With anticipated changes to existing humanitarian programs, employees who hold employment authorization under Temporary Protected Status (TPS) and Deferred Action for Childhood Arrivals (DACA) may lose permission to work in the U.S. Such action may impact the operation of businesses who employ large numbers of these individuals.

Although employers are prohibited from terminating employees with this type of employment authorization while such authorization is still valid, companies should review their Forms I-9 and the supporting List A/B/C documents to determine the percentage of the workforce that might be affected and develop plans to minimize the impact of such changes to these humanitarian programs. Of course, employers should still avoid asking direct questions about the applicants’ citizenship status or national origin during the hiring process as refusing to hire certain workers due to their perceived citizenship status or national origin is prohibited.

3. Potential Gaps in Work Authorization for Foreign Nationals With Temporary Permission to Work

Some employees may have temporary Employment Authorization Documents (EADs) that need to be renewed by the employees, and timely reverified by employers before their current EADs expire. While such renewal applications are pending, most (but not all) employees in these circumstances can rely on the automatic extension period of up to 540 days. However, given that not all employees are eligible for the 540-day automatic extension period and that many of the employees authorized to work under an EAD are present in the U.S. pursuant to the above-mentioned humanitarian programs, employers should encourage any employees working pursuant to an EAD to submit their renewal applications as early as possible (usually up to 180 days before their work authorization documents expire). Although these EADs typically do not provide proof of lawful U.S. status, potential future changes to such programs may be implemented differently for those holding valid EADs. The new administration could also seek to change the regulations as well.

4. Heightened Scrutiny on Visa Petitions

Purportedly to encourage the hiring of U.S. workers and to curtail perceived abuses of the employment-based immigration programs, Trump’s first term saw a dramatic increase in the issuance of Requests for Evidence (RFEs) coupled with a refusal to defer to prior approvals. Although the Biden administration just published its final rule to codify the policy of deferral to prior approvals along with other substantial changes to the H-1B program, employers filing immigration sponsorship petitions on behalf of their employees (such as H-1B and L-1 petitions) should expect to see heightened scrutiny once again resulting in more RFEs. Specifically, we may see the following actions:

  • Attempts to limit the deference given to prior approvals, resulting in more difficult and lengthier processing for renewals;

    • As mentioned above, the Biden administration’s codification of the deference policy (to take effect on January 17, 2025, just before Trump takes office) asserts that “adjudicators generally should defer” to prior approvals to promote consistency and efficiency. However, in addition to using the qualifier “generally,” the updated regulations broadly provide that deference need not be given if there was a material error, a material change in circumstances or eligibility, or material information adversely impacting eligibility.

  • Higher standards and increased scrutiny applied to employment-based visa petitions such as H-1B and L-1 petitions and to applications filed by F-1 students working pursuant to CPT, OPT, or STEM OPT, thereby resulting in more RFEs which may lead to denials.

    • The recent final rule includes provisions relating to H-1B eligibility, including the definition of and the criteria required for a specialty occupation. The new administration will likely leverage these new provisions to make it more challenging for U.S. employers to pursue these visa classifications.

Given these recent changes as well as the recent discourse regarding the H-1B program that has erupted over the past week, it remains to be seen how the employment-based nonimmigrant programs including the H-1B classification will be affected by the transition into the Trump administration. As a best practice, employers are still encouraged to file any petition renewals as early as possible (180 days before the expiration date) and upgrade pending petitions to premium processing (if applicable) before the anticipated heightened scrutiny is implemented. Employers also should consider initiating green card sponsorship for foreign workers earlier than before due to expected delays and changes.

5. Increased Scrutiny and Delays at Ports of Entry, U.S. Embassies/Consular Posts Abroad, and Travel Bans on Countries

Employees relying on work-authorized nonimmigrant status such as H-1B and L-1 may face issues in obtaining new visas at U.S. embassies and consulates abroad (Department of State) and experience a stricter review process at entry (Customs and Border Protection). These obstacles may result in:

  • Increased delays and denials due to higher scrutiny;

  • Requests to provide more documentation;

  • Detailed review of applicant’s social media to search for inconsistencies and misrepresentations;

  • Elimination of interview waivers at consulates.

Additionally, we may see a return and expansion of travel bans on nationals from certain countries (mostly Muslim countries) to all “high risk” countries.

Employees working pursuant to immigration sponsorship should take a conservative approach to traveling outside the U.S. When traveling, employees should be sure to have the necessary documents (e.g., I-797 approvals, endorsed Forms I-129S) as well as supplemental documentation (e.g., recent pay statements with employer’s name). Due to the unpredictability of the timing of any changes implemented by the new Trump administration, employees currently outside the U.S. should consider returning to the U.S. before January 20.

If you have any questions or require further information, please contact a member of Troutman Pepper Locke’s Immigration team. Our Immigration Team will be hosting a webinar to discuss this information in more detail and answer any questions you may have. A formal invitation will be sent out shortly with the webinar details.

The Delaware General Corporation Law (§ 102(b)(7)) has been amended, effective August 1, 2022, to permit exculpation of corporate officers, but in a more limited way than the exculpation of directors that has long been permitted. Unlike directors, officers may be exculpated by a provision in the certificate of incorporation only from personal liability to stockholders, but not from an action by or in the right of the corporation. Officers are subject to the same limitations on exculpation that apply to directors (i.e., breach of the duty of loyalty, acts or omissions not in good faith or involving intentional misconduct or a knowing violation of law, and receipt of an improper personal benefit).

Exculpation of officers can be important because there has been a recent trend to include officers and others in breach of fiduciary duty lawsuits brought against directors, as well as to make claims against directors who also serve as officers in their capacity as officers.

Because the exculpation must be in the certificate of incorporation, stockholder action would be required for existing corporations to exculpate their officers. This may prove difficult for existing public corporations, at least until more experience develops. However, exculpation of officers should be considered for new corporations, corporations before they go public and any other corporation, such as controlled corporations, for which stockholder approval likely can be obtained.

The form of exculpation provision is likely to track the existing exculpation of directors, whether in a new provision covering officers or by modifying an existing provision that already covers directors. The following is a typical form of exculpation provision modified to include officers:

No director or officer of the Company shall be liable to the Company or its stockholders for monetary damages for breach of fiduciary duty as a director or officer, except to the extent such elimination or limitation of liability is not permitted under the Delaware General Corporation Law as presently in effect or as the same may hereafter be amended. No amendment or repeal of this provision shall apply to or have any effect on the liability of any director or officer of the Company for any acts or omissions of such director or officer occurring prior to such amendment or repeal.

The full text of the amendments to §102(b)(7), along with other changes made to the Delaware General Corporation Law at the same time, is available at this link.

If you have any questions about these changes, your regular Locke Lord contact or any of the authors can discuss these matters with you.

The Securities and Exchange Commission (“SEC”) has recently brought several enforcement actions that directly or indirectly involved lawyers. These actions provide reminders to lawyers of their professional responsibility in representing clients, including in connection with giving legal opinions and responding to auditors. The professional responsibility of lawyers has recently been the focus of both the SEC and the Delaware courts.[1]

Synchronoss and its General Counsel

On June 7, 2022, the SEC announced a settled enforcement action against Synchronoss Technologies, Inc. charging it and several of its senior employees with accounting fraud for improperly recognizing revenue on multiple transactions and misleading the company’s auditors.[2] The employees charged included the company’s general counsel, who also settled charges that he misled the auditors regarding two of the transactions.[3]

One of the transactions involved a purported sale of a license to a customer that the company booked as revenue despite the customer’s communicating several times that there was no agreement and no commitment on its part. The SEC order states that the general counsel reviewed the communications and responses that did not dispute the customer’s statements and remained silent at an audit committee meeting when the CFO explained to the audit committee and the auditors that issues with unbilled receivables were due to “management changes” at the customer but did not advise them that the customer disputed having any commitment. According to the order, the general counsel also prepared and signed the minutes of the meeting that he knew or should have known would be shared with the auditors.

The other transaction involved an acquisition and a sale of a license on the same day, with the accounting issue being whether the license sale was a separate transaction under the applicable accounting standard. If a separate transaction, the license sale could be accounted for under generally accepted accounting principles for that type of transaction (e.g., revenue could be recognized); if not, it would be considered part of the acquisition consideration and accounted for under acquisition accounting as a reduction of purchase price. Although the license sale purported to be to settle claims of infringing Synchronoss’ patents, the SEC order states that the general counsel knew or should have known that the acquisition and license were negotiated together, with the acquisition contingent on the license sale, and that Synchronoss had not identified patent infringement claims until after negotiation of the acquisition began. The SEC states that the general counsel made misleading representations to the auditor to support treating the license sale as a separate transaction without providing the information that would have been material to determining to treat the license sale not as revenue but as an adjustment to the purchase price of the acquisition.

Unlike the SEC action against RPM International Inc. and its general counsel,[4] this action did not involve an audit response letter addressing a loss contingency. Instead, this action raises the question of the extent to which a lawyer is responsible for other accounting determinations, such as a complex subject like revenue recognition. We should bear in mind that this was a settled action, with the sanctions being such that the general counsel’s agreeing to a settlement, as in the RPM matter, is understandable. Nevertheless, the action emphasizes the importance of the need for lawyers to be sensitive to the information provided to the audit committee and the auditors in connection with their involvement in accounting decisions made by their companies.

Ernst &Young Order Involving Cheating On CPA Exams

On June 28, 2022, the SEC announced the settlement of charges against Ernst & Young LLP (“EY”) for cheating by its audit professionals on CPA exams and for withholding evidence of misconduct from the SEC during its investigation of the matter.[5] EY agreed to pay a $100 million penalty, the largest ever against an audit firm, and to undertake remedial measures to fix the firm’s ethical issues and deficient quality controls.

The SEC action is based upon a significant number of EY audit professionals, over multiple years, cheating on CPA exams by using answer keys and sharing them with colleagues. Ironically, the cheating took place on the ethics exams required of CPAs to confirm that they understand their ethical responsibilities in performing their essential role as gatekeepers in the public interest. In addition, many other EY professionals who knew of the cheating failed to report it. EY had experienced a similar though less widespread  problem several years earlier, which it had sought to address.

To make matters worse in the SEC‘s view, EY withheld the misconduct from the SEC during its investigation by giving the impression in its response that it did not have any current issues with cheating and then by failing to correct that misleading response.

The actions of EY in responding to the SEC cannot be fully understood, however, without also reading SEC Commissioner Peirce’s dissenting statement.[6] Although she supported the enforcement action against EY for the cheating, she was concerned with some of the remedial measures imposed on EY for its failure to correct a response to an SEC voluntary information request, especially when the response appeared to be correct when given. According to Commissioner Peirce’s statement, following a June 19, 2019 settlement with another accounting firm relating to cheating on CPA exams using information improperly shared by former Public Company Accounting Oversight Board (“PCAOB”) personnel, the SEC launched a general industry inquiry, with EY receiving a voluntary request for information about any ethics or whistleblower complaints regarding testing. In accordance with the SEC’s aggressive deadline, EY responded the next day, June 20, disclosing five past incidents but no current issue. On the same day as receipt of the SEC request (June 19), an EY employee reported to a manager that an EY professional had emailed that employee answers to a CPA ethics exam. The report was escalated to EY’s human resources group but the senior EY attorneys who reviewed EY’s June 20 response to the SEC were apprised of the report “no later than June 21”, which was after the June 20 response. EY commenced an internal investigation which uncovered the cheating and significant misconduct and, nine months later, when it completed the internal investigation and developed a plan to address the problem, informed the PCAOB, which in turn notified the SEC.

The issue identified by Commissioner Peirce is the responsibility of lawyers responding to an SEC voluntary request for information to correct previously provided information based on later-learned information while an internal investigation is underway to determine the extent of the problem and develop solutions. She also was troubled by the settlement’s remedy that EY conduct an independent review, overseen by an independent consultant, of EY’s disclosure failures relating to the SEC’s June 19 information request, including whether any member of EY’s executive team, General Counsel‘s Office, compliance staff, or other employees contributed to EY’s failure to correct its misleading submission, with the independent consultant to have full access to EY’s privileged information. The independent consultant also has final authority as to any employment actions (i.e., disciplining or firing) or other remedial steps. Commissioner Peirce characterizes this remedial provision as an “implicit directive to find attorneys and compliance personnel to blame for not complying with a non-existent obligation to correct the June 20 submission . . . .”

There obviously are lessons in the EY order on how to respond to and deal with the SEC during the course of an investigation, especially when the response is voluntary. The order also highlights the challenge of dealing with information while the nature and scope of that information is evolving, for example because an internal investigation initiated as a result of a whistleblower complaint is ongoing. This is a similar situation to the one faced when responding to auditors about government investigations, such as one initiated by a whistleblower qui tam complaint under the False Claims Act, which was the situation involved in the RPM enforcement matter.[7]

Hamilton Investment Counsel and its Chief Compliance Officer

On June 30, 2022, the SEC announced a settled enforcement action against Hamilton Investment Counsel, LLC, a registered investment advisor, and its principal and chief compliance officer (“CCO”) for failure to adequately implement its compliance program in connection with one of Hamilton’s investment advisor representatives engaging to the detriment of customers in undisclosed outside business activities that were required to be reported under Hamilton’s compliance policy.[8]

In supporting the settled enforcement action, Commissioner Peirce took the opportunity to outline the considerations relevant, in her view, to charge a CCO with responsibility for compliance violations by the CCO‘s firm, which is the party with the compliance obligation. In doing so, she referenced that New York City Bar Association Compliance Committee’s proposed Framework[9] that focused on whether the CCO’s conduct was not just “debatably inappropriate” but rather was “wildly inappropriate” or demonstrated a “wholesale failure” to carry out compliance responsibilities.[10] Commissioner Peirce analyzed the Hamilton CCO‘s conduct against the following questions identified in the Framework:

  • Did the CCO not make a good faith effort to fulfill his or her responsibilities?
  • Did the wholesale failure relate to a fundamental or central aspect of a well-run compliance program at the registrant?
  • Did the wholesale failure persist over time and/or did the CCO have multiple opportunities to cure the lapse?
  • Did the wholesale failure relate to a discrete specified obligation under the securities law or the compliance program at the registrant?
  • Did the SEC issue rules or guidance on point to the substantive area of compliance to which the wholesale failure relates?
  • Did an aggravating factor add to the seriousness of the CCO’s conduct?

It is not the purpose of this article to assess whether the particular facts in this SEC enforcement action justified the charges against the Hamilton CCO as measured under the Framework. Rather, the enforcement order and Framework  should be helpful in considering the professional responsibility of lawyers and their exposure to SEC enforcement actions, especially by having in mind the questions included in the Framework. This is both because CCOs often are lawyers and because those questions can be relevant in assessing more generally the professional conduct of lawyers in connection with a client’s compliance with legal requirements. That assessment relates to the concerns noted above raised by SEC Commissioner Lee in questioning whether lawyers are adequately fulfilling their professional responsibilities when they engage in  “goal-directed” lawyering as illustrated,  according to Commissioner Lee, by the conduct of the lawyers who gave the opinion described in the Bandera decision.[11]

This article was originally published in Business Law Today, a publication of the American Bar Association Business Law Section, on October 28, 2022.

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[1] ‎ In addition to the recent enforcement actions described in this article, SEC Commissioner Lee in remarks on March 5, 2022 focused on whether lawyers were fulfilling their professional responsibilities and suggested that the SEC should consider doing more to establish minimum standards for lawyers practicing before the SEC as authorized by section 307 of the Sarbanes-Oxley Act of 2002 in addition to the SEC’s Part 205 Rules adopted in 2003 requiring up-the-ladder reporting. See Commissioner Allison Herren Lee, Send Lawyers, Guns and Money: (Over-) Zealous Representation by Corporate Lawyers (remarks at PLI’s Corporate Governance – A Master Class 2022, March 4, 2022), available at https://www.sec.gov/news/speech/lee-remarks-pli-corporate-governance-030422#.YiYojNPNu-c.mailto. In her remarks, Commissioner Lee referred to the legal opinion addressed in the Delaware Court of Chancery Bandera decision as an example of “goal-directed” lawyering. See Bandera Master Fund LP v. Boardwalk Pipeline Partners, LP., 2021 WL 5267734 (Del. Ch. Nov. 12, 2021), on appeal to the Delaware Supreme Court (No.1, 2022). For articles discussing the Bandera decision, see Fotenos & Keller, Delaware Court Finds Legal Opinion Fails to Meet Opinion Standards, IN OUR OPINION, Spring 2022, at 7, and Field and Smith, Observations on the Delaware Chancery Decision in Bandera Master Fund LP v. Boardwalk Pipeline Partners, LP, IN OUR OPINION, Spring 2022, at 20.

[2] In the Matter of Synchronoss Technologies, Inc., Release No. 34-95049 (June 7, 2022), avail. at https://www.sec.gov/litigation/admin/2022/34-95049.pdf.

[3] In the Matter of Ronald Prague, Esq., Release No. 34-95055 (June 7, 2022), avail. at https://www.sec.gov/litigation/admin/2022/34-95055.pdf.

[4] For prior discussions of the RPM enforcement action, see Alan J. Wilson, Settlement Reached in Long-Running RPM Enforcement Action, IN OUR OPINION, Winter 2020-2021, at 14; Stanley Keller, Update on Dealing with Government Investigations in Audit Responses, IN OUR OPINION, Spring 2018, at 17, and Stanley Keller, Dealing With Government Investigations in Audit Responses, IN OUR OPINION, Fall 2016, at 14.‎

[5] In the Matter of Ernst & Young LLP, Release No. 34-95167 (June 28, 2022),‎ avail. at https://www.sec.gov/litigation/admin/2022/34-95167.pdf.

[6] Commissioner Hester M. Peirce, When Voluntary Means Mandatory and Forever: Statement on In the Matter of Ernst & Young LLP (June 28, 2022), avail. at https://www.sec.gov/news/statement/peirce-statement-ernst-and-young-062822.‎

[7] See supra, note 4.‎

[8] In the Matter of Hamilton Investment Counsel, LLC and Jeffrey Kirkpatrick, Release No. 34-95189 (June 30, 2022), avail. at https://www.sec.gov/litigation/admin/2022/34-95189.pdf.

[9] ‎New York City Bar Association Compliance Committee, Framework for Chief Compliance Officer Liability in the Financial Sector (June 2, 2021), avail. at https://www.nycbar.org/member-and-career-services/committees/reports-listing/reports/detail/framework-for-chief-compliance-officer-liability. ‎

[10] Commissioner Hester M. Peirce, Chief Compliance Officer Liability: Statement on In the Matter of Hamilton ‎Investment Counsel LLC and Jeffrey Kirkpatrick (July 1, 2022), avail. at ‎ https://www.sec.gov/news/statement/peirce-statement-hamilton-investment-counsel-070122.

[11] See supra, note 1.

This article describes two recent Delaware decisions relevant to the Model Business Corporation Act (the “MBCA”). One of those decisions relates to a board’s determination of the availability of surplus to support distributions to stockholders, and the other upholds, at the motion to dismiss stage, a claim that the directors breached their fiduciary duty by not taking action in response to a stockholder’s demand. In addition, this article describes recent decisions in MBCA states addressing the meaning of “fair value” and the application of director liability shields to exculpate directors from monetary liability. The MBCA is the basis for the corporation statute of at least 36 states.

DETERMINING SURPLUS TO SUPPORT DISTRIBUTIONS

Corporations often make distributions to stockholders by way of dividends and stock buybacks. For private equity–backed companies, it is not unusual to see leveraged recaps in which the corporation borrows funds to make distributions to the private equity investors. These distributions raise the question for a board of directors of whether the corporation has sufficient funds that are legally available to permit a lawful distribution under the corporate statute. The failure to satisfy the statutory requirement for distributions can result in personal liability for the directors. Determining the funds legally available for distributions can be challenging.

Delaware and MBCA Distribution Laws

Sections 160 and 173 of the Delaware General Corporation Law (the “DGCL”) set the limits on a Delaware corporation’s power to repurchase stock and issue dividends. Section 160 provides that no corporation may purchase or redeem its shares when the capital of the corporation is impaired or would be impaired as a result of such purchase or redemption. A repurchase impairs capital if the funds used for the repurchase exceed the amount of the surplus.[1] Sections 170 through 173 impose similar requirements for the payment of dividends. Section 170 provides that a board of directors may declare and pay dividends on shares of the corporation’s capital stock either (i) out of its surplus (within the meaning of section 154) or (ii) if there is no surplus, out of the corporation’s net profits for the fiscal year in which the dividend is declared or the preceding fiscal year—so-called “nimble dividends.” The term “surplus” generally means the excess of the corporation’s total assets over the sum of the total liabilities and capital of the corporation (usually the aggregate par value of its outstanding shares). If the test for a lawful distribution or dividend is not met, the directors face personal liability under section 174, which is not subject to exculpation by a charter provision permitted by section 102(b)(7). However, a director is “fully protected” under section 172 from personal liability if he or she relied in good faith upon the corporation’s records or upon its officers, employees, board committees, or experts in determining that the corporation had adequate surplus to support the distribution or dividend.

The MBCA follows a similar approach to the DGCL, although with more statutory precision and some notable differences. Under section 6.40(c), distributions, which include dividends in the MBCA’s terminology, may not be made if the corporation would not be able to pay its debts as they become due in the usual course of business (the “equity insolvency test”) or its total assets would be less than the sum of its total liabilities and the amount that would be required to satisfy the preferential rights that the holders of senior classes or series of shares would have upon dissolution (the “balance sheet test”). MBCA section 6.40(d) provides that the board of directors may base its determination either on the corporation’s financial statements prepared using accounting principles reasonable in the circumstances, which would include those prepared in accordance with generally accepted accounting principles (GAAP), or on a fair valuation or other method reasonable in the circumstances. Under section 7.32, a director approving the improper distribution is personally liable to the corporation for the excess amount if it is established that the director did not meet the standards of conduct in section 8.30, which require that a director act in good faith and in a manner that the director reasonably believes to be in the best interests of the corporation (the so-called duties of care and loyalty). Section 8.30(e) offers protection for directors by providing that a director is entitled to rely on information, opinions, reports, or statements, including financial statements, prepared or presented by officers or employees, lawyers, accountants, or other advisers, or a board committee, so long as the director does not know that reliance is unwarranted.

Challenges to Distributions

When a distribution is challenged, it is usually because the board of directors used the present value [2] of the corporation’s assets to determine surplus rather than the amounts reflected on the corporation’s financial statements, which are usually lower. For example, a board might use the current appraised value of real estate even though that real estate is carried on the financial statements at its historic cost less accumulated depreciation. The Delaware Supreme Court has held that a board can use present value in determining surplus as long as it does so in good faith and on a consistent basis.[3] However, what if the board instead relies on the amounts shown on the corporation’s GAAP financial statements?

The Chemours Decision

The Delaware Court of Chancery addressed this question and provided important guidance in the case of In re The Chemours Company Derivative Litigation.[4] The Chemours Company (“Chemours”) was spun-off by the E.I. DuPont de Nemours Company (“DuPont”) in 2015. In the spin-off Chemours assumed certain environmental liabilities of DuPont, which Chemours subsequently claimed to be vastly in excess of the amount that DuPont had stated. This dispute was settled by DuPont’s agreeing to share the environmental liabilities. After the spin-off, Chemours made a series of stock repurchases and dividend payments based upon the board’s determination that Chemours had adequate surplus based upon the amount of the contingent environmental liabilities reflected on its audited financial statements. The plaintiffs, claiming that demand on the board was excused because it would be futile, brought a derivative action challenging these distributions and dividends as exceeding the available surplus, specifically alleging that the board should have used the amount of the contingent environmental liabilities actually expected rather than relying on the amount shown on the audited balance sheet. To support this allegation, the plaintiffs cited Chemours’ own allegations in its dispute with DuPont. Under GAAP, specifically FASB ASC 450–20 (formerly FAS No. 5), only contingent liabilities that are probable and reasonably estimable are accrued and reflected as liabilities on the financial statements.[5] If a material contingent liability is not probable but is reasonably possible, footnote disclosure is required. Footnote disclosure is also required even if a contingent liability is reasonably possible or probable but is not presently estimable.

The Court addressed whether the plaintiffs had met the burden of proving that demand was futile because a majority of the Chemours directors faced a substantial likelihood of liability. In so doing, the Court addressed the substance of the claims and found that the plaintiffs had failed to plead specific facts implying that the directors faced a substantial likelihood of liability because of the distributions, and therefore the plaintiffs were not entitled to bring the derivative action without first making a demand on the board.

The Court began its analysis of the likelihood of liability by observing that boards of directors have broad authority to determine the amount of a corporation’s surplus and, in that connection, the method of determining surplus. Therefore, the Court said that it would defer to the board’s calculation of surplus “so long as [the directors] evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud”— i.e., that the values “reasonably reflect present values.” The Court ruled that the board was not required to depart from GAAP in determining the corporation’s reserves for contingent liabilities in the calculation of the corporation’s surplus. Accordingly, the Court found that the directors were not “willful or negligent” as required to subject them to liability under section 174. The Court also found that the directors were “fully protected” under section 172 in relying on the corporation’s financial statements, consulting with management and financial advisors, and receiving presentations on the environmental liabilities. Finally, the Court found that the plaintiffs’ general claim of breach of fiduciary duty, apart from liability for improper distributions, did not result in a substantial likelihood of liability because any such liability was subject to exculpation as permitted by section 102(b)(7), absent bad faith, which the plaintiffs did not plead with particularity.

Applicability to MBCA

The Court’s approach to distributions and dividends in the Chemours opinion is consistent with the approach of the MBCA, as explained in the Official Comment to section 6.40. The Chemours opinion gives directors considerable flexibility, and therefore protection from liability, in making determinations of the corporation’s surplus to support decisions on dividends and other distributions to stockholders. This allows directors to determine present values, such as the current fair market value of the corporation’s assets, and in some cases to use reserves for contingent liabilities reflected in a corporation’s GAAP financial statements. The Official Comment to section 6.40 states that “[t]he determination of a corporation’s assets and liabilities for purposes of the balance sheet test of section 6.40(c)(2) and the choice of the permissible basis on which to do so are left to the judgment of its board of directors.” Similar to Delaware law, the Official Comment to section 6.40 indicates that “[o]rdinarily a corporation should not selectively revalue assets,” but “should consider the value of all its material assets,” and similarly, “all of a corporation’s material obligations should be considered and revalued to the extent appropriate and possible.” Section 6.40 authorizes the use of financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances and, consistent with the Chemours decision, also authorizes any other “method of determining the aggregate amount of assets and liabilities that is reasonable in the circumstances.” This means that “a wide variety of methods may be considered reasonable in a particular case even if any such method might not be a ‘fair valuation’ or ‘current value’ method.”

These determinations under both the DGCL and the MBCA need to be made in good faith, and to demonstrate good faith boards of directors should follow a careful and considered process. That process should be recorded as part of the minutes.

Although reliance on financial statements can protect directors from personal liability for improper distributions, directors dealing with contingent liabilities, whether operating under the DGCL or the MBCA, will want to go beyond the amounts shown in the financial statements. In order to comply with their fiduciary duties, they also should consider the broader information included in any footnote disclosures required under the applicable accounting standards, even if liability for a breach of those duties may be covered by an exculpation provision in the charter.

DETERMINING FAIR VALUE IN APPRAISAL PROCEEDINGS

The primary issue in an appraisal proceeding is the determination of the fair value of the shares held by shareholders exercising their appraisal rights. Section 13.01 of the MBCA defines “fair value” for purposes of appraisal proceedings based on “[t]he value of the corporation’s shares … using customary and current valuation concepts and techniques generally employed for similar businesses in the context of a transaction requiring appraisal … and without discounting for lack of marketability or minority status….” This definition gives a court considerable discretion to consider various methodologies including, as applicable, the deal price, unaffected share price analysis, comparable precedent transactions, a comparative company analysis, asset valuations, and a discounted cash flow (DCF) analysis. The method or methods that may be used can vary based upon the circumstances of the particular transaction, and the favored methods have changed over time.

Recently, the Supreme Court of North Carolina in Reynolds American Inc. v. Third Motion Equities Master Fund Ltd.[6] had the opportunity for the first time to interpret the provisions of the North Carolina version of the MBCA to determine if the North Carolina Business Court properly determined the fair value of the shares in an appraisal proceeding of the tobacco company, Reynolds American, which was acquired by British American Tobacco. The Business Court determined that the fair value of the shares did not exceed the deal price of $59.64 plus interest that had been paid to the dissenting shareholders and therefore no further payments were required.

In upholding the Business Court decision, the North Carolina Supreme Court, in an extensive and detailed analysis, cites freely to the well-developed body of Delaware decisional appraisal law and significantly defers to the exercise of discretion by the Business Court in determining fair value based on the evidence before it. In particular, the Court held that the Business Court’s primary reliance on the deal price was justified, even though the acquisition of Reynolds American by a large, but non-controlling shareholder was not actively marketed. The Business Court used other factors, including indicia of a robust deal process and various other “customary and current valuation concepts and techniques” to confirm that the deal price was indicative of the fair value.

By extensively citing to the well-developed body of Delaware law on determining fair value in an appraisal proceeding, the North Carolina Supreme Court provides support for using the Delaware decisions as relevant precedent for determining fair value under the MBCA, notwithstanding the differences in the appraisal provisions between the two corporate statutes.

A final issue addressed by the Court was the dissenting shareholders’ claim that they were entitled to additional interest under the North Carolina counterpart of MBCA section 13.30(e). Although acknowledging that the provision is “ambiguous,” the Court held that it would be nonsensical and contrary to the legislative intent to award an interest windfall and encourage “appraisal arbitrage” when no additional payment on the shares was due.

DETERMINING FAIR VALUE FOR PURCHASE IN LIEU OF DISSOLUTION

Section 14.34 of the MBCA permits a corporation in a proceeding for judicial dissolution under section 14.30(a)(2) to elect to purchase the petitioning shareholder’s shares at their “fair value.” If the parties cannot agree on the price and terms of the purchase, the court is required to determine the fair value of the shares and the terms and conditions of the purchase, including whether payments may be made in installments and whether to award any expenses. However, the MBCA does not define “fair value” for purposes of section 14.34 or refer in section 14.34 or in the Official Comment to the definition of “fair value” for appraisal purposes in section 13.01.

In Bohack v. Benes Service Co.[7] the Nebraska Supreme Court addressed the meaning of fair value under the provision of the Nebraska Model Business Corporation Act (“NMBCA”) comparable to section 14.34. The Court began by deciding to look to the appraisal provisions of the NMBCA for guidance as to the meaning of fair value in section 14.34. Section 13.01 requires that the fair value of a corporation’s shares be determined using “customary and current valuation concepts” and “without discounting for lack of marketability or minority status.” Although the Official Comment to section 13.01 states that the “specialized” definitions in section 13.01 apply only to chapter 13, the Court stated that it was not foreclosed from looking to the definition in section 13.01. It noted that the Official Comment was not adopted as part of the NMBCA but went on to observe that in the earlier version of the Official Comment, there was a statement that a court applying section 14.34 might find it useful to consider valuation methods applicable to an appraisal proceeding. That statement is no longer in the Official Comment to section 14.34 in the 2016 Revision of the MBCA. Although the Court noted on this issue and on the discounts issue discussed below that the Nebraska legislature did not adopt the Official Comment, it recognized that the Official Comment is a relevant resource in interpreting the statutory provisions. This reflects the general approach of courts in other states where the Official Comment has not been formally adopted as part of the state’s corporation statute. Some states make it a practice to mention in their legislative history that the Official Comment to the MBCA should be considered in interpreting the statute.

The Court next determined that discounts for lack of marketability and minority status should not apply because they are excluded, with certain exceptions not applicable in this case, from the definition of fair value for appraisal purposes. It noted the distinction between “fair value” and “fair market value” in other Nebraska statutes. The Court declined to consider a statement in the Official Comment to an earlier version of the MBCA that a minority discount may be appropriate under section 14.34, a statement that is also no longer in the Official Comment to the 2016 Revision of the MBCA. The Court noted again that the Official Comment was not adopted as part of the NMBCA but went on to state that the Official Comment to the definition of fair value in Section 13.01 states that discounts for lack of marketability or minority status are inappropriate in most appraisal actions because they give the majority an opportunity to take advantage of the minority that is being forced to accept the transaction triggering the appraisal. The Court analogized an appraisal transaction to a forced buyout under section 14.34. However, the Court did not reference other parts of the extensive discussion in the earlier Official Comment identifying the differences between a proceeding under section 14.34 and an appraisal proceeding under chapter 13 that could affect the Court’s approach to determining fair value. Those differences include the relevance of liquidation value under section 14.34 when there is deadlock, the need for adjustments when the value of the corporation has been diminished by wrongful conduct of controlling shareholders, and the appropriateness in some circumstances of a minority discount. The earlier Official Comment made it clear that the approach to a valuation is very much dependent on the particular facts and circumstances, that a court in a proceeding under section 14.34 has considerable flexibility, and that using valuation methods relevant to judicial appraisal is permissible. The reasons for the Court’s unwillingness to consider portions of the earlier Official Comment that were not included in the Official Comment to the 2016 Revision are not entirely clear. The elimination or revision of a statement in an earlier Official Comment as part of the editorial process of the Corporate Laws Committee does not necessarily mean that the earlier statement was deemed incorrect or no longer relevant by the Committee. The reasons for editorial changes vary based upon the particular comment omitted or revised. In general, the editing of the Official Comment in the 2016 Revision was designed to streamline it and serve solely as a guide to the interpretation of the applicable statutory provisions and not necessarily because they were no longer considered relevant or correct.

The Court determined that a going concern value was appropriate in the circumstances because the corporation would be continuing in business. It then went into the details of the appropriate valuation methodology, which had unique aspects and which do not need to be recounted here.

DIRECTOR LIABILITY SHIELD

In Meade v. Christie[8], which involved a shareholder’s challenge to a going private merger, the Supreme Court of Iowa addressed the relationship of the Iowa counterparts of sections 8.30 and 8.31 of the MBCA and the application of the exculpation provisions authorized by section 2.02(b)(4) of the MBCA (referred to by the Court as the “director shield statute”), and the procedural requirements of those provisions. In its opinion reversing and remanding the trial court’s denial of a motion to dismiss by the director defendants, the Court referenced the Official Comment to the 2016 Revision of the MBCA and analyzed the differences between the exculpation provisions of the Iowa Business Corporation Act (the “IBCA”), which are based on those in the MBCA, and DGCL section 102(b)(7).[9]

The case involved a class action brought by a former shareholder of an Iowa insurance holding company who alleged that the directors breached their “fiduciary duties of care, loyalty, good faith, and candor” by approving the merger in “a flawed process that resulted in too low a price being paid to the minority shareholders.” The issue considered by the Court on appeal was whether the shareholder’s pleadings were sufficient to show that the IBCA’s counterpart of MBCA section 8.31 did not protect the directors from liability. The appeal also involved the issue of whether the claim was a direct or derivative claim but, because of its determination that the directors’ motion to dismiss should be granted, the Court did not have to reach the issue of whether the trial court was correct in finding that the claim was properly brought as a direct claim.

The Court began its analysis by discussing the standards of conduct for directors under section 8.30, describing them generally as a duty of care and a duty of loyalty. It then noted that, although section 8.30 provides the standards of conduct, section 8.31 sets forth the conditions for holding a director liable for money damages. Under section 8.31, a director is not liable unless the complainant establishes that an exculpatory provision in the corporation’s articles of incorporation authorized by section 2.02(b)(4) does not apply. Since the holding company had adopted an exculpatory provision that tracked the statutory authorization, the Court then analyzed whether the shareholder pled facts sufficient to show that one of the exclusions to exculpation, specifically “intentional infliction of harm on the corporation or the shareholders,” applied.

In reaching its conclusion that the shareholder’s allegations were insufficient to establish the “intentional infliction of harm” exclusion, the Court looked at the background of exculpation statutes, referring to the MBCA’s Official Comment, and compared the MBCA and Delaware exculpation provisions.

Citing the explanation of the Corporate Laws Committee for the addition of a director exculpation provision,[10] the Court noted that policymakers in the mid-1980s, concerned about qualified individuals declining to serve on boards of directors, began advocating for enhanced protections for corporate directors. These concerns arose out of court rulings that expanded directors’ personal liability for money damages, notably the Delaware decision in Smith v. Van Gorkom.[11] After Delaware and other states, including Iowa, amended their corporate statutes to permit director exculpation provisions, the MBCA was amended to further increase the protections for directors. Iowa amended its statute in 2003 to adopt the MBCA exculpation provision. The Court observed that the Delaware exculpation provision in section 102(b)(7), which excludes from exculpation “acts or omissions not in good faith or which involve intentional misconduct,” picks up a broader range of fiduciary misconduct than the narrower exclusion of “intentional infliction of harm” standard in the MBCA and the IBCA. Citing the Official Comment to section 2.02(b)(4) stating that the use of “intentional” refers to a specific intent to perform or fail to perform the acts with actual knowledge that it will cause harm, the Court stated that the MBCA standard would not exclude from exculpation claims of reckless conduct, conscious disregard of a duty, or intentional dereliction of a duty, all of which are excluded from exculpation in Delaware. Based on the MBCA’s higher bar for an exclusion from liability and the resulting heightened pleading requirement, the Court held that the shareholder’s allegations were insufficient to establish an “intentional infliction of harm on the corporation or the shareholders” by the directors. The Court observed that this result was consistent with the purpose of exculpation, to provide not only protection from liability but also to avoid the costs and stress of litigation. It also noted that shareholders who believe a merger buyout price is inadequate have the alternative remedy of appraisal rights under section 13.02.

DIRECTOR DUTIES IN ASSESSING DEMAND

Unlike Delaware, which has a demand required/demand excused approach to derivative actions, the MBCA follows a universal demand approach.[12] The fundamental premise for the universal demand requirement in the MBCA is that the board of directors should have an opportunity to assess demands and to act in the best interest of the corporation, subject to judicial oversight of its action. Underlying this premise is the requirement that directors fulfill their fiduciary duties in dealing with a demand.

In Garfield v. Allen,[13] the Delaware Court of Chancery considered a challenge by a stockholder of The ODP Corporation to an equity compensation award to the chief executive officer on the ground that it exceeded the limits of the equity compensation plan approved by the stockholders. The Court held that the complaint stated a claim for relief based on a breach of fiduciary duties by the directors in not correcting the violation after the stockholder sent a demand letter to the board calling attention to the issue.

In upholding the claim, the Court noted that it was based on a “novel theory” that the Court accepted with “admitted trepidation” because it could permit plaintiffs in the future to create claims by sending demands to boards if those demands are not acted upon. Nevertheless, although historically a board’s rejection of a litigation demand has only affected parties who control the derivative claim and has not been held to be grounds for a separate breach of fiduciary duty claim, the Court found the logic of the claim in this case sound because it indicated a possible conscious failure of the directors to act that could equate to a knowing, wrongful action. The Court, however, urged caution in dealing with this as a basis for such claims going forward.[14]

This article originally appeared in the Winter 2022 issue of The Model Business Corporation Act Newsletter, the newsletter of the ABA Business Law Section’s Corporate Laws Committee. Read the full issue and previous issues on the Corporate Laws Committee webpage. Another article by the same author discussing several other recent Delaware decisions relevant to the MBCA appears in the Summer 2021 issue of The Model Business Corporation Act Newsletter. One of those decisions has been reversed by the Delaware Supreme Court, as discussed in an update also appearing in the Winter 2022 issue.

The views expressed in this article are solely those of the author and not Locke Lord LLP or its clients. No legal advice is being given in this article.

 

[1] See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 153 (Del. 1997).

[2] The Delaware courts use the phrase “present value” in this context to mean the current fair market value of the corporation’s assets, not the “present value” of the corporation’s future cash flows, as used in financial analyses.

[3] See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 155 (Del. 1997); see also Morris v. Standard Gas & Electric, 63 A.2d 577, 582 (Del. Ch. 1949).

[4] 2021 WL 5050285 (Del. Ch. Nov. 1, 2021). 

[5] This is the same standard that applies to lawyer audit response letters. 

[6] 379 N.C. 524 (2021).

[7] 310 Neb. 722, 2022 WL 128329 (2022).

[8] 974 N.W.2d 770 (Iowa 2022). See also Matthew G. Doré, Raincoat or Slicker Suit? An MBCA Director Shield Keeps Board Members Dry in Going Private Suit, Bus. Law Today (July 13, 2022), https://businesslawtoday.org/2022/07/raincoat-or-slicker-suit-mbca-director-shield-keeps-board-members-dry-going-private-merger-meade-v-christie/.

[9] Because the IBCA is based substantially on the MBCA, references herein are to the MBCA sections.

[10] Changes in the Revised Model Business Corporation Act – Amendment Pertaining to the Liability of Directors, 45 Bus. Law. 695, 696 (1990).

[11] 488 A.2d 858 (Del. 1985).

[12] See Should Demand Ever Be Excused in a Derivative Action? – The Universal Demand Requirement of the MBCA, MBCA Newsletter, Winter 2021, p. 2.

[13] 2022 WL 1641802 (Del. Ch. May 24, 2022).

[14] The claim in Garfield involved the alleged liability of the directors for a breach of their fiduciary duties under Delaware law. As noted in the discussion of the Meade v. Christie decision under “Director Liability Shield” above, the standards of conduct for directors under MBCA section 8.30 and the conditions for holding directors liable for monetary damages under MBCA section 8.31 are different.

 

On December 14, 2022, the SEC unanimously adopted cooling-off periods and other changes to how plans adopted under Rule 10b5-1 (“10b5-1 Plans”) will work going forward.  Executive officers and directors of public companies frequently use 10b5-1 Plans to conduct sales of their company’s stock at a time when they have material non-public information (“MNPI”) about the company or its securities, which is permitted if they entered into the plan at a time that they did not have MNPI and gave up control over the sales. The new rule changes require additional disclosures about 10b5-1 Plans in the issuer’s SEC filings, as well as include some changes to the short-swing profit recapture rules and required filings under Section 16 of the Securities Exchange Act.

The unanimous approval by the SEC Commissioners (see the Adopting Release here) followed some significant easing of requirements in the proposed rules initially issued last December (see the Proposing Release here), particularly by excluding 10b5-1 Plans of issuers themselves from application of the new rules.

Rule 10b5-1 Plan Amendments

The amendments to the Rule 10b5-1(c)(1) affirmative defense to insider trading liability include:

Cooling-off Periods:

10b5-1 Plans of executive officers and directors may not permit sales (or purchases) until the later of (1) 90 days following the adoption of the plan and (2) two business days following disclosure of the issuer’s financial results on Form 10-Q or Form 10-K, as applicable, for the fiscal quarter in which the plan was adopted, but not to exceed 120 days after adoption.  Modifying a 10b5-1 Plan results in a new cooling-off period.

10b5-1 Plans of others (excluding the issuer) may not permit sales (or purchases) for 30 days after adoption or modification.  For example, this limitation would apply to employees who are not executive officers.

No cooling-off period is required for 10b5-1 Plans adopted by issuers.

Other Conditions:

The rule changes add a requirement that executive officers and directors certify to the issuer that they are not aware of MNPI at the time of entering into or modifying a 10b5-1 Plan and that they are adopting the plan in good faith and not as a part of a plan or scheme to evade the rules.  In practice, most broker-dealer standard forms already included similar certifications.

The rule changes also specify that a person entering into a 10b5-1 Plan must have acted in good faith in using the plan to be eligible for the affirmative defense.

The rule changes exclude from the protection of Rule 10b5-1, with respect to any class of issuer securities, multiple overlapping 10b5-1 Plans and more than one single-trade 10b5-1 Plan in any 12-month period. Section 16 insiders will be required to check a box on their Form 4 and Form 5 filings to indicate whether the transactions were intended to be Rule 10b5-1 transactions and the date of adoption of the applicable 10b5-1 Plan.

New Issuer Disclosure Requirements

Companies must make annual disclosure of ‎ whether or not they have adopted insider trading policies and procedures ‎(with copies required to be filed as exhibits to the Form 10-K).   They must also make quarterly disclosure of any 10b5-1 Plans and other written trading arrangements used by their executive officers and directors‎, by providing a description of the material terms of the 10b5-1 Plans, including:‎

  • the name and title of the director or executive officer;‎
  • the date of adoption or termination of the 10b5-1 Plan;‎
  • its duration; and
  • the aggregate number of securities to be sold or purchased‎.‎

There is no requirement to disclose terms relating to the price at which the broker-dealer effecting ‎trades under the 10b5-1 Plan is authorized to trade.‎

As part of their annual executive compensation disclosure, companies must make additional disclosures about stock option awards made close in time to the release of MNPI.  The rule changes will require XBRL tagging of some of the disclosures.

Bona Fide Gifts of Stock Trigger Form 4 Filing

Currently, a Section 16 insider may make charitable contributions or other gifts of stock without reporting the gift until the Form 5 filing deadline 45 days after the fiscal year in which the gift is made.  The rule changes will require Section 16 insiders to report gifts on Form 4 within two business days of the gift.

Effective Dates of the Rule Changes

The rule changes take effect 60 days after publication of the adopting release in the Federal Register‎, or February 27, 2023. This includes the requirement to report gifts on Form 4.‎

The new disclosure requirements will apply to companies beginning with the first filing that covers the first full fiscal period that begins on or after April 1, 2023, so for calendar year U.S. companies, typically with the second-quarter Form 10-Q in the summer of next year.  Smaller reporting companies get an additional six months before the rule changes apply to them.

The Form 4 changes‎ relating to identification of 10b5-1 transactions ‎will apply to filings on or after April 1, 2023.

Takeaways

  • Executive officers and directors will want to take into account the consequences of the new cooling-off periods when considering sales of stock to diversify their holdings or to anticipate future expenses‎ and determine whether it is necessary or desirable to use a 10b5-1 Plan for the sale at all.
  • Broker-dealers will need to update their standard forms for 10b5-1 Plans to reflect the changes.
  • Companies should consider adopting a pre-clearance procedure (if they do not already use one) so that they will obtain information from their executive officers and directors about any new or modified 10b5-1 Plans.
  •  Companies should consider updating their policies covering trading in the company’s stock to reflect the changes.
  • Companies should also consider updating the manuals they provide executive officers and directors that describe Section 16 filing requirements and 10b5-1 Plans and providing related training to reflect the new requirements, particularly the Form 4 filing requirement for gifts.
  • Companies that now require use of 10b5-1 Plans for insider ‎transactions may want to revisit the extent to which such requirement should be continued in ‎view of the new cooling–off periods and enhanced disclosure requirements.‎
  • Companies may want to revisit the timing of their grants of stock options or add an internal guideline to check on timing of release of any MNPI before making those grants.

If you have any questions about these changes, your regular Locke Lord contact or any of the authors can discuss these matters with you.

A number of Delaware corporations with two or more classes of common stock, especially SPACs (special purpose acquisition companies) that have completed deSPAC transactions, are discovering that they may not have properly approved charter amendments that increased their authorized shares of common stock. In Garfield v. Boxed, Inc. (Del. Ch. Dec. 22, 2022), the Delaware Court of Chancery ruled that under section 242(b)(2) of the Delaware General Corporation Law (DGCL) a SPAC with Class A and Class B Common Stock needed to have a separate Class A vote on a charter amendment that increased its authorized shares of Class A Common Stock. A Class A stockholder raised the issue before the stockholder vote and in response the company added a separate Class A vote.  The court decided that the stockholder added a substantial benefit by raising the issue, so its attorney was entitled to a fee award.

The Boxed decision raises the concern for many other companies whose deSPAC transactions  followed a similar approach. Section 242(b)(2) allows companies to opt out of a separate class vote for adding authorized shares to a class, but many SPACs did not have that provision  in their charters (the National Venture Capital Association form does contain that provision). Section 242(b)(2) also does not require a class vote for an increase of shares of a series within a class, but the court ruled in Boxed that the corporation’s certificate of incorporation established separate classes rather than separate series of common stock.

The uncertainty resulting from the Boxed decision has prompted a number of companies to petition  the Court of Chancery under DGCL section 205 to validate  their capital structures and subsequent corporate actions. These petitions are pending, with the first hearing on some of them scheduled for February 20. While the problem has been focused mainly on former SPACs, it is not limited to them and there are situations when ordinary corporations have taken similar actions based on treating separate classes of common stock as a single class.

There are two different situations to consider:

(i) a majority vote of both Class A and Class B shares voting together and of Class A shares voting separately was obtained, although no separate Class A vote was held or its need disclosed; and

(ii) a majority of Class A and Class B shares voting together was obtained but not a majority of Class A shares.

It might be possible to conclude that the stockholder approval in the first situation was legally sufficient despite the failure to hold a separate Class A vote and disclose to stockholders the need for that separate vote, as well as to conclude that the increase in Class A shares and their issuance in the deSPAC transactions and otherwise are unlikely to be invalidated on equitable grounds in the absence of evidence of any real prejudice resulting from the deficient actions. However, that has not been judicially decided. Consequently, many companies, to avoid uncertainty, are pursuing validation under DGCL section 205, which is anticipated to be obtained in short order. In the second situation, the alternative of concluding that the vote was legally sufficient is unavailable and therefore companies in that situation also are filing for relief under section 205. There is optimism that the Court of Chancery will use its broad authority under section 205 to validate those actions in that situation.

Public companies with this issue need to consider what to do about disclosure, about the status of shelf registration statements and about dealing with their auditors who, in some cases, have raised concerns about the effect of the uncertainties on the financial statements. Companies are filing Form 8-Ks (Lordstown Motors Corp; Lucid Group; ChargePoint Holding) to disclose the situation and the remedial steps being taken, including seeking court validation under DGCL section 205, and are suspending use of existing registration statements pending resolution of the problem. Law firms who have given Exhibit 5 validity opinions are relying for now on the client’s suspension of use of the registration statement without taking further action to withdraw the opinion in view of the anticipated curative actions in Delaware. Companies in the first situation described above are reserving for now on the question whether they can proceed on the basis that the stockholder approval was likely legally sufficient.

The question of the need for a class vote under Delaware law is not limited to the increase in authorized shares involved in the Boxed and similar situations described above. For example, there are lawsuits pending in Delaware (see, for example, complaints filed against Fox Corporation and Snap Inc.) claiming that a class vote was required for a charter amendment adding limited exculpation for officers, as now permitted under a recent amendment to DGCL section 102(b)(7), on the grounds  that adding such a provision adversely affects the rights of the holders of shares of that class. The Court of Chancery has yet to rule on these claims.

Takeaway

Companies with more than one class of common stock should review their prior actions to determine whether there are any concerns regarding the adequacy of the approvals that were obtained. If there are, they should consider what remedial steps to take. Public companies also should consider what disclosure to make and the status of any effective registration statements. They also should be dealing with their auditors about any concerns and the remedial steps being taken to address them.

Following our February 24 post, we learned that representatives of accounting firms sought advice from the SEC on whether they can rely solely on Section 205 Orders to confirm valid issuance of outstanding shares as to which there is uncertainty. We understand that they were informed by the SEC Chief Accountant that a Section 205 Order would not be sufficient and that they should request an opinion of counsel as to the shares being valid as of the time of their issuance.

We believe that should be unnecessary when the Section 205 Order itself states, as authorized by DGCL section 205(b)(8) and as those issued so far to address the Boxed uncertainty do, that the corporate actions and share issuances are validated as of the time they took place or the amendment authorizing the share increase was filed with the Delaware Secretary of State. We are hopeful that when the nature and effectiveness of the Section 205 Orders are made clear to the SEC and the accounting firms they will recognize that legal opinions add nothing to the Section 205 Orders issued by the Delaware Court of Chancery and are unnecessary.

On April 24, 2023, the SEC extended, for a short time, the deadline for the effectiveness of stock exchange listing requirements under the Dodd Frank Act that will require listed companies to adopt clawback policies for erroneously awarded compensation (see our prior blog post here).  The bottom line is that the prospect of an April effective date for the listing standards and a June deadline for issuers to adopt a compliant clawback policy has been postponed by 45 days. Unless stock exchanges amend their proposed rules, the deadline for issuers to adopt a clawback policy will likely be in early August.

The SEC’s adopting release that approved final rules requiring exchanges to implement listing rules on clawback policies specified that exchanges should file proposed listing standards within 90 days of the release’s publication in the Federal Register. It also stated that the listing standards must be effective no later than one year following that publication, and that listed companies will have 60 days from the effective date of the listing standards to adopt a compliant policy. The release was published on November 28, 2022, which implied an effective date for the listing standards no later than November 2023, and a deadline for listed companies to adopt their policies by January 2024.

The exchanges’ proposed listing requirements were published in the Federal Register on March 13, 2023. These included a deadline for issuers to adopt a clawback policy no later than 60 days from the SEC’s approval of the proposed listing standard – equating the SEC approval with the effective date. This raised a timing issue, since Section 19(b) of the Exchange Act requires that the SEC approve or disapprove a proposed stock exchange rule (or institute proceedings giving grounds for disapproval) no later than 45 days after the date of the proposed rule’s publication.  In other words, it created the prospect that the listing standards would become effective by April 27, 2023, requiring issuers to adopt a compliant clawback policy by June 26, 2023. Section 19(b) of the Exchange Act also permits the SEC to extend that 45-day period to 90 days if it determines that a longer period is appropriate.

The recent notice issued by the SEC states that the Commission finds it appropriate to provide a longer period to consider the rule, and that June 11, 2023 (90 days after the publication of the proposed exchange rules) is now the date by which the SEC will approve or disapprove the proposed changes to the listing requirements. This implies that August 10, 2023, will be the date by which issuers would be required to adopt a compliant clawback policy – still much earlier than most had anticipated in light of the November deadline in the statute.

It is possible that the exchanges may seek to amend their proposals in a way that extends the effective date of the listing requirements to a later date, but listed companies for now should be preparing to have their boards approve a compliant clawback policy by early August.

If you have any questions about the new listing standards, please contact your regular Locke Lord contact or any of the authors.