Sidley Perspectives | APRIL 2016 • 1 IN THIS ISSUE SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE APRIL 2016 ANALYSIS DGCL Section 220: A Welcome Return to Fundamental Principles �������������������������� 1 A Practical Approach to Due Diligence in China ������������������������������� 4 NEWS JUDICIAL DEVELOPMENTS The Meaning of “Plainly Material” Post-Trulia ���������������������� 6 Importance of Precise Wording in M&A Anti-Reliance Clauses ����������������������� 7 “Controlling Stockholder” Designation is Contextual��������������������������� 7 Whether or Not to Disclose Investigations Depends on the Context��� 8 Supreme Court Holds That REIT Citizenship is Based on the Citizenship of Its Shareholders������������������� 9 SEC & REGULATORY DEVELOPMENTS SEC Grants No-Action Relief For “Substantially Implemented” Proxy Access Proposals ����������������������������� 9 SEC Under Increasing Pressure to Require Disclosure of Board Diversity����� 10 CORPORATE GOVERNANCE DEVELOPMENTS Senate Bill Seeks to Amend Beneficial Ownership Reporting Rules to Rein in Activist Hedge Funds��������������� 11 SIDLEY EVENTS������������������������������������������ 11 SIDLEY SPEAKERS������������������������������������� 12 SIDLEY RESOURCES���������������������������������� 12 ANALYSIS DGCL SECTION 220: A WELCOME RETURN TO FUNDAMENTAL PRINCIPLES By Jack B. Jacobs and Hille R. Sheppard1 In recent years, we have seen a large uptick in the number of “books and records” inspection demands brought by stockholders of Delaware corporations under Section 220 of the Delaware General Corporation Law. These stockholders—nearly always represented by plaintiffs’ firms—are responding to repeated exhortations from the Delaware courts that stockholder derivative actions should not be filed before gathering evidence under Section 220 to establish the demand futility needed to survive a Rule 23.1 motion to dismiss. Having advocated use of Section 220 as a “tool at hand” in order to meet the difficult burden of pleading demand excusal—and then justified Rule 23.1 dismissals of derivative actions for failure to heed this advice—it ill-behooved Delaware courts to insist on a narrow scope for Section 220 inspections, and in recent years Delaware courts seemed to broaden the relief available under Section 220. For example, in its 2014 Wal-Mart decision, the Delaware Supreme Court affirmed requiring the production of, among other things, materials from back-up tapes, emails for multiple custodians, and even privileged documents—all before the stockholder had stated an underlying fiduciary duty claim. 2 Two recent decisions by the Delaware Chancery Court, Amalgamated Bank v. Yahoo! Inc. and Chammas v. NavLink, Inc., suggest that the tide may be turning, as they provide corporations strong support for pushing back on expansive Section 220 demands that seek more than board minutes and materials presented to the board. 3 The Decisions Yahoo! A Yahoo! stockholder brought a Section 220 action in the Delaware Chancery Court to enforce its demand to inspect specified Yahoo! books and records for the stated purpose of investigating potential wrongdoing in the hiring and firing of Yahoo!’s Chief Operating Officer. After a trial on a paper record, the Court held that the plaintiff had “established a credible basis to suspect wrongdoing in connection with” the COO’s hiring and firing (including corporate waste) that warranted a further investigation. 1 Jack B. Jacobs is a senior counsel at Sidley who served on the Delaware Supreme Court from 2003 to 2014 and, prior to that, on the Delaware Chancery Court since 1985. Hille R. Sheppard is a partner in our Chicago office who co-leads Sidley’s global securities and shareholder litigation practice. The views expressed in this article are those of the authors and do not necessarily reflect the views of the firm. 2 Wal-Mart Stores, Inc. v. Ind. Elec. Workers Pension Tr. Fund IBEW, 95 A.3d 1264 (Del. 2014). 3 Amalgamated Bank v. Yahoo! Inc., C.A. 10774-VCL (Del. Ch. Feb. 2, 2016); Chammas v. NavLink, Inc., C.A. No. 11265- VCN (Del. Ch. Feb. 1, 2016). Sidley Perspectives | APRIL 2016 • 2 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Yahoo! and Chammas suggest that the extensive access to emails granted in the Wal-Mart case resulted from exceptional circumstances and provide reassurance that Wal-Mart was the exception rather than the rule with respect to email discovery under DGCL Section 220. Having established the plaintiff’s entitlement to inspection relief, the Court then addressed the proper scope of the inspection—an inquiry governed by two broad principles. First, the trial court must “tailor the inspection to the stockholder’s stated purpose.” Second, the party seeking inspection has the burden “to establish that each category of the books and records requested is essential and sufficient to [the party’s] stated purpose.” Applying those principles, the Court granted inspection of certain categories of requested documents, and limited or denied inspection of others. What is significant is the approach the Court used in highlighting and clarifying what does— and does not—constitute a proper application of Section 220. In so doing, the Court upheld the long-established principle that a Section 220 inspection “is not the equivalent of discovery in a plenary action,” and that the “two procedures are not the same and should not be confused.” The Court also cautioned that, “[u]nlike in plenary discovery, where the responding party bears the burden of limiting its scope, the burden in a Section 220 proceeding is on the party seeking production,” and that the Court “must tailor the production order to balance the interests of the stockholder and the corporation.” The Court further emphasized that “[t]he inspection should stop at the quantum of information that the court deems ‘sufficient’ to accomplish the plaintiff’s stated purpose….If the books and records are not ‘essential’ for the stockholder’s purpose, then the stockholder already has ‘sufficient’ information and the inspection can be denied as seeking materials beyond what is ‘needed to perform the task’.” The Court observed that “[t]he starting point—and often the ending point—for a sufficient inspection will be board level documents evidencing the directors’ decisions and deliberations, as well as the materials that the directors received and considered.” The Court also distinguished Wal-Mart on its facts, holding that “the facts of this case do not support the [broad] type of production that the Delaware Supreme Court approved [in Wal-Mart].” Finally, the Court decided that the books and records production would be conditioned on the plaintiff incorporating by reference into any later-filed derivative action complaint, “the full scope of the documents that [the corporation] has produced or will produce in response to the Demand.” That will “ensur[e] that any complaint that Amalgamated files will not be based on cherry-picked documents” and “that the plaintiff has not misrepresented [the actual document’s] contents and that any inference the plaintiff seeks to have drawn is a reasonable one.” With the produced documents incorporated by reference, a derivative complaint may, despite allegations to the contrary, be dismissed where the unambiguous language of documents upon which the claims are based contradicts the complaint’s allegations. Chammas In this second case, two founders of the corporation, who had been ousted as officers but remained as directors, filed a Section 220 action to inspect several categories of documents. The purpose of the requested inspection was not to investigate possible wrongdoing, but, rather, to determine whether and to what extent the other members of the board and management were improperly excluding the plaintiffs from board business and related communications. What is noteworthy is that the Court denied relief for several requested document categories because not all of the documents requested were “books and records” of the corporation. The first two categories the Court addressed were (1) documents and communications “concerning” the corporation between or among management and the board chairman or other directors (excluding plaintiffs) and (2) documents and communications between the board chairman and any other director (excluding plaintiffs). In this connection, the Court observed: Sidley Perspectives | APRIL 2016 • 3 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE The judicial narrowing of the scope of Section 220 relief in Yahoo! and Chammas should give Delaware corporations a powerful tool to resist overbroad Section 220 demands. While directors’ access to company books and records is broader than that of stockholders, the requested information itself must qualify as a book or record of the company before the Court will order its production. …any request for communications among corporate directors and officers must…encompass communications constituting books and records of the corporation, i.e., those that affect the corporation’s rights, duties, and obligations…Here, Plaintiffs have not shown that the broad range of private communications requested in Categories One and Two satisfy the…requirement above (italics added). The third requested category—communications among directors regarding the preparation and dissemination of allegedly falsified minutes (the minutes themselves having been produced)—was partially granted and partially denied. The Court held that communications among board members containing draft board meeting minutes constituted corporate books and records. However, communications between board members (excluding the secretary) concerning draft meeting minutes, where there was no claim that the communications amounted to official corporate business or otherwise affected the corporation’s rights or obligations, were not corporate books and records for Section 220 purposes. The final requested category was “all documents or communications relating to sales, marketing and operations” with respect to the company’s business and performance in specified Middle Eastern countries. That request, the Court held, exceeded the scope of Section 220 because “[m]ere communications between corporate officers and corporate clients, in the absence of…allegations [of wrongdoing], cannot properly be considered books and records of the company.” The Implications Although it is too early to predict how the teaching of these decisions will be applied in future cases, at this point some preliminary conclusions can safely be drawn. First, these two cases represent an effort to differentiate a Section 220 inspection from general discovery in plenary litigation, and return that statutory procedure to its original roots. Yahoo! does that rhetorically, by admonishing that Section 220 creates a limited remedy with a narrowly focused scope. Chammas does that analytically, by emphasizing that Section 220 permits inspection only of corporate books and records, and then defining “books and records” to enable the court clearly to differentiate between what inspection is permissible and what is not. One clear lesson is that “books and records” does not include all documents of whatever nature that happen to reside in the corporation’s files. Second, these decisions will give corporations tools to defend against overbroad invocations of Section 220 in an effort to obtain something akin to general discovery, and afford the Delaware courts guidance in parsing out the wheat from the chaff in future Section 220 cases. The judicial narrowing of the scope of Section 220 relief should help companies to negotiate appropriate parameters for Section 220 productions, deter the filing of overbroad Section 220 proceedings, and enable them to be resolved short of an evidentiary hearing and post-trial opinion. Third, Yahoo!, by conditioning Section 220 relief on a requirement that any produced books and records be deemed “incorporated by reference” into any derivative complaint subsequently filed by the plaintiff, will protect the defendants from claims based on selective quotations or references to the documents produced under Section 220. That will help obviate wasteful motion practice that (1) forced defendants who sought to dismiss the complaint to file and rely on the selectively quoted documents and then (2) required them to litigate whether or not those documents were truly “incorporated by reference” into the derivative complaint. A loss on that issue would subject the defendants to the risk of their Sidley Perspectives | APRIL 2016 • 4 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Given the robust anticorruption campaign that is ongoing in China, foreign companies doing M&A deals in China should adopt a practical and comprehensive approach when conducting due diligence on Chinese targets, with a particular focus on a target’s compliance with Chinese and international anti-corruption laws. dismissal motion being converted into a motion for summary judgment. Yahoo! would eliminate both that wasteful intermediate step and the accompanying litigation risk it involved. In our view, allowing the court to consider the entire production—and not just snippets of documents selected by plaintiffs—may provide powerful protection for boards to defend against allegations that the board ignored “red flags.” In light of Yahoo!, companies may wish to reconsider their practices regarding minutes and board materials. More developed explanations in those documents—and particularly including references to solutions being implemented or that management is working on issues—may help the board show that it is not disqualified from considering a demand for having turned a “blind eye” to problems. A PRACTICAL APPROACH TO DUE DILIGENCE IN CHINA By Tom Deegan4 For many years following the opening of China’s M&A markets to foreign participants, corruption across many industries in China was rife and recognized as part of the business landscape. Accordingly, anti-corruption considerations were frequently given a low priority by those contemplating M&A transactions in China. However, given the high-profile nature of an ongoing robust anti-corruption campaign and the promotion of the “rule of law” as described below (which has seen both foreigners and nationals of the People’s Republic of China (PRC) investigated and imprisoned), conducting due diligence to identify bribery and corruption violations has now moved to the top of the list of priorities of most foreign companies doing deals in China. Based on our view of the China M&A market, this is unlikely to change any time soon. Background In response to widespread public concern over official corruption, the Chinese central government, under the leadership of President Xi Jinping, launched a comprehensive anti-corruption campaign in late 2012 that continues today. As part of the campaign, in October 2014 at the fourth Plenum of the Central Committee of the Communist Party of China, the Central Committee made promoting the “rule of law” (with socialist Chinese characteristics) a headline theme of the government’s strategic policy. In light of the ongoing and intensifying campaign and the promotion of the “rule of law,” foreign enterprises undertaking transactions in China need to familiarize themselves with the domestic regime and adopt a deeper and broader approach to due diligence so as to avoid getting unwittingly ensnared in the ongoing campaign. Muddying the waters of an already challenging due diligence backdrop is the 2009 amendment of Article 253(A) of the Criminal Law of the PRC. The amendment stipulated that working personnel of state agencies and organizations in the fields of finance, telecom, transportation, education or healthcare are potentially subject to up to three years in prison if they sell or illegally provide to others the personal information of citizens obtained during the course of such organizations’ performance of their official duties or provision of services. As such, the role of third-party due diligence compliance investigators, once regularly engaged by foreign enterprises, straddles an ambiguous position of legality for the investigators themselves and foreign parties who engage their services. While due diligence and investigative companies have continued to operate throughout China, their actions have gone further underground, especially in light of a spate of recent high-profile criminal proceedings against foreign and local compliance investigators premised upon breaches of the amendment for trading in “illegal personal information.” 4 Tom Deegan is a partner in the Corporate group in our Hong Kong office. The views expressed in this article are those of the author and do not necessarily reflect the views of the firm. Sidley Perspectives | APRIL 2016 • 5 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Recommendations When Undertaking Due Diligence in China In light of the current environment, we recommend the following practical approach to foreign enterprises undertaking due diligence and compliance investigations in China. Be Comprehensive Do not just look for unusually large transactions made in connection with the target business. Pay attention to small but steady and (when aggregated) significant amounts that are paid out over long periods of time (e.g., travel expenses). Also consider widening the scope of your due diligence by examining the target’s dealings with, among others: distributors, suppliers, advertising agencies, travel agents and event organizers. For example, we have advised clients to analyze trends in expense categories prone to manipulation and to benchmark such spending against similar industries to identify potentially problematic transactions. Investigate Both Within and Beyond the People’s Republic of China Undertake due diligence of any Special Purpose Vehicles (SPVs) incorporated outside of the PRC (e.g., British Virgin Islands and/or Cayman Islands entities). Offshore SPVs have long been used to hold onshore interests in China, although most only exist to hold the business interests in China that will ultimately become the listing vehicle in any initial public offering. It is, therefore, important to keep such entities in focus when undertaking due diligence. There have been instances when such entities have been exploited to avoid China’s strict foreign exchange controls and, as such, make illegal payments in violation of Chinese law. Know Your Target and Industry It is critical to know your target and the industry in which it operates. Questions to ask include: What are the profit projections of the target? Are they realistic relative to the industry/market in which the target operates? Are there individuals who always exceed expectations irrespective of the market? Foreign investors should also keep a close eye on the policy orientation of the relevant sector in which they are seeking to invest. For example, the investor should be wary if the business is in an industry that does not thrive without the blessing of the government, which can cover a range of aspects. A rigorous analysis around these questions will help to mitigate unexpected (and unwanted) surprises. Investigate the Target’s Existing Anti-Corruption/Compliance Regimes The international reach of U.S. and U.K. anti-corruption laws are extensive and have been robustly enforced. Therefore, in undertaking due diligence in China, an investor should ask: Does the target Chinese entity comply with the provisions of the U.S. Foreign Corrupt Practices Act (FCPA) and the U.K.’s Bribery Act? Moreover, and equally important, does the target comply with China’s own anti-corruption laws, such as the Anti-Unfair Competition Law and the Criminal Law? Consideration about compliance with Chinese anti-corruption laws is sometimes overlooked by foreign enterprises, which are much more familiar with the concepts enshrined in the FCPA and the Bribery Act. However, sanctions under China’s own anti-corruption regime, especially in light of the ongoing campaign, can be more farreaching and damaging to the potential new owners and their executives. If the target company is compliant with the above-mentioned anti-corruption regimes, it will have in place a thorough anti-corruption framework that covers not just the conduct of compliance investigations, but also internal controls designed to prevent corrupt conduct. Sidley Perspectives | APRIL 2016 • 6 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE The Delaware Chancery Court has recently ruled that supplemental disclosures addressing alleged conflicts of interest among several deal participants and management’s free cash flow projections satisfied Trulia’s “plainly material” standard. NEWS5 JUDICIAL DEVELOPMENTS The Meaning of “Plainly Material” Post-Trulia As discussed in the February issue of Sidley Perspectives, in In re Trulia, Inc. Stockholder Litigation (Del. Ch. Jan. 22, 2016), the Delaware Chancery Court mapped a new path for how it wants disclosure-based M&A litigation claims processed, indicating those claims should either be adjudicated through an adversarial proceeding in a preliminary injunction context, or addressed in “the preferred scenario” of a mootness fee proceeding (in-Court or privately negotiated). The Court also warned that if asked to approve disclosure-based settlements in the future, it will continue to be increasingly vigilant in applying its independent judgment on the reasonableness of any such settlement, noting it would be disfavored unless the disclosures address “plainly material” misrepresentations or omissions benefitting stockholders. On the meaning of “plainly material,” the Court noted it “should not be a close call.” Two recent holdings provide initial guidance as to the type of disclosures the Court will view as “plainly material” and “not…a close call.” In Haverhill Retirement System v. Richard A. Kerley, et al. (Del. Ch. Feb. 9, 2016), the Court declined to approve a partial settlement of disclosure-based litigation. It did not reject the proposed settlement; it simply determined that, given the partial nature and timing vis-à-vis the remainder of the litigation, it was not comfortable severing certain claims from other, possibly interrelated, claims involved. As a result, the litigation continues. More relevant, however, is that Vice Chancellor Laster noted that supplemental disclosures obtained as part of the proposed partial settlement involving alleged conflicts of interest at the board, management, financial advisor, significant stockholder and legal counsel levels “would seem to easily satisfy” Trulia’s “plainly material” standard given “it’s truly amazing how the information that was put out so dramatically changed the total mix of information.” In In re BTU International, Inc. Stockholders Litigation (Del. Ch. Feb. 18, 2016), Chancellor Bouchard approved a disclosure-based settlement in what appears to be the first Courtapproved settlement post-Trulia. The litigants had entered into a proposed settlement earlier in 2015 as the Court began shifting the paradigm on disclosure-based settlements. Mindful of the changing environment, the parties moved to re-cut the settlement terms (e.g., narrowing the release, limiting counsel fees to $325,000). The supplemental disclosures plaintiffs obtained had added information on: (1) BTU management’s free cash flow projections if BTU were merged, restructured, or remained standalone, (2) conflicts of BTU executives in negotiating post-merger employment arrangements before the deal process began and (3) BTU’s waiver of standstill agreements with third-party bidders. While the Chancellor noted he was approving the settlement in part since it initially had been filed preTrulia, he also determined the added disclosures met Trulia’s “plainly material” standard. The Chancellor also reiterated the Court’s preference that assessments on the materiality of disclosure be made in the context of adversarial proceedings before the Court, and suggested that parties should follow the path outlined in Trulia. The parameters of disclosure the Court views as “plainly material” will be drawn further in future cases and proceedings, but these early Court statements point to some emerging contours. 5 The following Sidley attorneys contributed to the research and writing of the pieces in this section: Steven M. Bierman, Claire H. Holland, John K. Hughes, Alex J. Kaplan, Daniel A. McLaughlin and Andrew W. Stern. We appreciate their contributions. Sidley Perspectives | APRIL 2016 • 7 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE For an anti-reliance clause to be effective in barring a fraud claim, it must be drafted as a statement made by the aggrieved party that it did not rely on representations made outside of the acquisition agreement. Importance of Precise Wording in M&A Anti-Reliance Clauses In FdG Logistics LLC v. A&R Logistics Holdings, Inc. (Del. Ch. Feb. 23, 2016), the Delaware Chancery Court held that a seller will not be able to disclaim buyer’s reliance on representations or statements made by seller outside the acquisition agreement unless the agreement contains a clear statement from the buyer that it has not relied on the statements, as opposed to simply a disclaimer from seller. FdG arose from a private equity firm’s acquisition of A&R Logistics Holdings, Inc. by merger. In response to an initial post-closing claim on behalf of A&R’s selling securityholders, buyer counterclaimed, including for fraud-in-the-inducement and rescission arguing that sellers, during deal diligence, concealed illegal and improper activities on the part of A&R pre-signing. On sellers’ motion to dismiss, the court rejected sellers’ argument that buyer’s fraud counterclaims were barred since they were based on extra-contractual statements. Chancellor Bouchard noted “[t]he integration clause…merely states in general terms that the merger agreement constitutes the entire agreement between the parties, and does not contain an unambiguous statement by buyer disclaiming reliance on extra-contractual statements.” He added “[b]ecause the language of…the merger agreement does not contain this type of unambiguous anti-reliance disclaimer by buyer, those provisions are not sufficient to preclude its common-law fraud claim relating to the pre-merger materials.” Chancellor Bouchard traced prior precedents and distinguished the Court’s recent ruling in Prairie Capital III, L.P. v. Double E Holding Corp. (Del. Ch. Nov. 24, 2015) where a seller successfully barred fraud claims based on extra-contractual statements. He noted that the language at issue in that case “reflected an affirmative expression by the aggrieved buyer that it had relied only on the representations and the warranties in the purchase agreement,” whereas there was no such statement by buyer in FdG as opposed to simply an “exclusive representations” clause from seller disclaiming extra-contractual information. FdG reminds that, when negotiating M&A agreements, “critical language” is needed to limit liability from fraud claims based on extra-contractual information, and anti-reliance clauses must include a clear statement coming from the aggrieved party that it has not relied on statements or information outside the contract. “Controlling Stockholder” Designation is Contextual Calesa Associates, L.P. v. American Capital, Ltd. (Del. Ch., Feb. 29, 2016) is the Delaware Chancery Court’s latest ruling assessing when a minority stockholder may be considered a “controlling stockholder.” In the procedural setting of a motion to dismiss, the court ruled there was a reasonable inference that a majority of the board was under the influence of, or shared a special interest with, a 26% stockholder. American Capital, Ltd. had earlier invested in Halt Medical, Inc., obtaining two of five board seats and a blocking right on future third-party investments. Subsequently, Halt obtained a secured third-party loan, and American thereafter allegedly secretly purchased the note and security interest involved. Later, American allegedly blocked Halt from accepting a thirdparty investment and, without other financing sources, Halt accepted a $20 million highinterest rate loan from American and American gained a third board seat. When American demanded repayment on debt owed, Halt was forced into a capital restructuring whereby (1) Halt cancelled its preferred stock and common and preferred stock warrants, (2) American loaned Halt $73 million in exchange for new preferred and common stock and (3) Halt adopted a management incentive plan giving certain employees a percentage of proceeds if Halt were sold. As a result, American’s ownership rose from 26% to 66%, and it obtained four of seven board seats. The Delaware Chancery Court reaffirmed in Calesa that the determination of “controlling stockholder” status is a highly factspecific inquiry which takes into account not only the stockholder’s level of equity ownership but also its actual influence over the board with respect to the transaction. Sidley Perspectives | APRIL 2016 • 8 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Minority stockholders alleged American and director defendants breached fiduciary duties that a controlling stockholder owes minority investors by forcing Halt into a deal that diluted minority stockholders to American’s advantage. The Court reminded that a “stockholder is controlling, and owes fiduciary duties to the other stockholders, if it owns a majority interest in or exercises control over the business…”. The Court found a majority of the board was not disinterested or lacked independence, determining that three directors were affiliated with American entities financing the transaction and stood to gain personally from the deal. The fourth director (Halt’s CEO) was found to be beholden to American because he knew rejecting the restructuring would lead to Halt’s collapse and the loss of his job and, just prior to the transaction, his salary doubled and he was made eligible to participate in the new incentive plan. Calesa reminds that assessments of “controlling stockholder” status are guided by context-specific facts and not solely by numerical determinations. Whether or Not to Disclose Investigations Depends on the Context Do public companies need to tell their stockholders that the SEC or another government agency is investigating them? A recent decision from the federal district court in the Southern District of New York concluded that a company, in the particular circumstances presented in that case, had no duty to disclose an ongoing SEC investigation, including receipt of a Wells Notice warning that the SEC was considering an enforcement action. However, in another recent case, the U.S. Court of Appeals for the Second Circuit cautioned that Item 303 of SEC Regulation S-K requires companies to describe in their periodic reports any known material trends or uncertainties—which may include regulatory and criminal investigations that are sufficiently advanced and serious to be material. These decisions suggest that companies need not automatically disclose investigations in every case, but should carefully weigh the stage of the investigation and the company’s potential liability. The defendants in In re Lions Gate Entertainment Corp. Secs. Litig., 2016 WL 297722 (S.D.N.Y. Jan. 22, 2016) received a Wells Notice regarding a series of defensive transactions designed to thwart a tender offer, but did not disclose the SEC investigation or the receipt of the Wells Notice until after it had settled the investigation two years later. The court, noting that there is no general duty to disclose government investigations, concluded that the penalty paid to the SEC was not material in size and that the investigation did not otherwise trigger disclosure under applicable SEC rules, and dismissed a federal securities fraud complaint challenging the nondisclosure. The plaintiffs have appealed that dismissal. The defendant company in Indiana Pub. Ret. Sys. v. SAIC, Inc., No. 14-4140-cv (2d Cir. Mar. 29, 2016) faced a more advanced and more serious investigation. A kickback scheme with a subcontractor on a government contract had led to internal suspensions and investigative reports, public statements by the government that the contract was being re-evaluated, a criminal complaint against an employee of the defendant and an indictment related to the project. Given these facts and the materiality of the contract and related business, the Second Circuit concluded that the complaint pleaded facts showing that the company actually knew at the time of its 10-K filing that it faced a material uncertainty due to the investigation. The court distinguished this from the situation in Lions Gate, which it described as “a run-of-the-mill civil enforcement investigation by the SEC,” finding that the defendant in SAIC “was aware that it faced serious, ongoing criminal and civil investigations that exposed it to potential criminal and civil liability and that ultimately did result in criminal charges and substantial liability.” The lesson of these decisions is that whether or not and when to disclose an investigation depends on the context, including the stage and seriousness of the investigation and management’s best assessment of the materiality of a negative outcome to the company. Apart from the determination as to whether disclosure is legally required, companies may decide to voluntarily disclose investigations for investor relations or other reasons. Lions Gate builds upon a 2012 decision in which the same court held that an issuer did not have a duty to disclose the receipt of a Wells Notice (Richman v. Goldman Sachs Group, Inc. (S.D.N.Y. 2012)). Sidley Perspectives | APRIL 2016 • 9 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Practitioners should keep Americold in mind when structuring transactions involving non-corporate entities and drafting dispute resolution provisions in deal documents. Supreme Court Holds That REIT Citizenship is Based on the Citizenship of Its Shareholders Federal courts can hear lawsuits filed under federal law and class actions covered by the Class Action Fairness Act or the Securities Litigation Uniform Standards Act. But many of the civil cases in federal court are state-law suits (e.g., breach of contract or products liability) that only qualify for federal court jurisdiction due to diversity of citizenship (i.e., the opposing parties are from different states). Even if both parties agree to a federal forum, a court cannot hear the case without jurisdiction. Since 1844, when determining diversity, the U.S. Supreme Court has treated corporations— like individuals—as a citizen of the state where the corporation “lives” (its principal place of business), as well as the state where it is incorporated. The citizenship of its shareholders is irrelevant. Other business entities like partnerships, however, have not been treated as separate from their members: they are citizens of every state where a partner is a citizen. In practice, this means such entities are often unable to use diversity jurisdiction to access federal court. Federal courts have generally applied the same rule to all non-corporate entities, including Delaware LLCs. The U.S. Supreme Court, in Americold Realty Trust v. ConAgra Foods, Inc. (U.S. Mar. 7, 2016), appears to have shut the door on granting other entities the citizenship status of corporations. Americold held that the citizenship for diversity purposes of a real estate investment trust (REIT) under Maryland law is the citizenship of all its members, including its shareholders. Looking at Maryland law, the Court viewed the REIT’s shareholders as similar to the partners of a limited partnership, because the REIT’s property is held in trust for them, and even a trust relationship that is a separate legal entity under state law does not have the separateness of a corporation from its shareholders. More broadly, the Court noted that Congress, in writing the diversity jurisdiction statute, never expanded the grant of citizenship to include artificial entities other than corporations. The Court preferred to leave to Congress any re-examining of the distinction between corporations and other unincorporated entities. As a result, REITs, LLCs and other business entities that are not corporations will likely continue to lack the access that corporations have to federal court. SEC & REGULATORY DEVELOPMENTS SEC Grants No-Action Relief For “Substantially Implemented” Proxy Access Proposals As discussed in a previous Sidley Update, on February 12, 2016, the Staff of the SEC’s Division of Corporation Finance granted no-action relief to 15 companies that had sought to exclude shareholder proxy access proposals from their 2016 proxy statements on the grounds that they had been “substantially implemented” by the company. The SEC Staff granted no-action relief under Exchange Act Rule 14a-8(i)(10) to those companies, each of which adopted its own proxy access bylaw with a “3% for 3 years” ownership threshold mirroring the threshold requested by the proponent, even though the company-adopted proxy access bylaws deviated from the specific terms of the shareholder proxy access proposals in various other respects. On the same day, the SEC Staff denied no-action relief to three companies that implemented proxy access with a different ownership threshold (5%) than that sought by the proponent (3%). Since releasing that initial set of response letters, the SEC Staff has granted no-action relief on “substantial implementation” grounds to an additional 20 companies that sought to exclude shareholder proxy access proposals. In each case, the “3% for 3 years” ownership threshold in the company’s proxy access bylaw was consistent with the proposal. Sidley Perspectives | APRIL 2016 • 10 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE The SEC Staff will grant no-action relief on the basis of “substantial implementation” so long as the company’s proxy access bylaw matches the shareholder proposal’s ownership threshold (e.g., 3% for 3 years), even if the company’s bylaw deviates from other terms specified in the proposal (e.g., the limit on the size of the nominating shareholder group or the percentage of proxy access board seats). This development provides much-anticipated clarity to companies concerning their ability to exclude shareholder proxy access proposals by adopting their own proxy access provisions. It suggests that companies have some flexibility to adopt proxy access bylaws tailored to their particular circumstances so long as they track the ownership threshold and duration set forth in the shareholder proposal. Based on the recent SEC Staff determinations, no-action relief will be available even if the company’s proxy access bylaw (1) includes a limit on the number of shareholders that may aggregate to form a nominating group (e.g., 20 versus an unlimited number per the terms of the proposal) or (2) includes a lower percentage or number of board seats available to proxy access candidates than specified in the proposal (e.g., 20% (rounding down) versus “the greater of 25% of the board or two directors” per the terms of the proposal). Shareholder proponent James McRitchie has expressed his disappointment with the SEC Staff’s recent determinations, specifically its apparent conclusion that the provision regarding aggregating holdings is not an essential element of the shareholder proposal. He has announced plans to file binding bylaw resolutions in the future at companies that have adopted what he considers to be “proxy access lite bylaws” in an effort to “obtain the same robust proxy access promised under vacated Rule 14a-8(i)(10).” SEC Under Increasing Pressure to Require Disclosure of Board Diversity In November 2015, SEC Chair Mary Jo White gave a keynote address entitled “The Pursuit of Gender Parity in the American Boardroom” at the Women’s Forum of New York. In her speech, she described the organization’s stated goal of achieving at least 40% female representation on boards of Fortune 1000 and S&P 500 companies by 2025 as “within reach and an imperative.” In January 2016, Chair White commented at a conference that “diversity on boards I think is enormously important” and that it “adds value.” She also noted that she asked the SEC Staff to study whether additional SEC guidance or rulemaking related to board diversity is warranted. Earlier in January, Congresswoman Carolyn Maloney (D-NY) revealed the results of a Government Accountability Office report on board gender diversity that she had commissioned in May 2014. The report indicated that women make up just 16% of board seats at S&P 1500 companies, up from 8% in 1997. Even if women and men filled equal numbers of board seats beginning in 2015, the report estimated that it could still take at least 40 years to achieve parity. Rep. Maloney vowed to propose legislation aimed at correcting the underrepresentation highlighted in the report and accelerating the timeline for equal representation. On March 7, 2016, Rep. Maloney introduced the Gender Diversity in Corporate Leadership Act of 2016. Among other things, the bill directs the SEC to (1) adopt rules requiring proxy statement disclosure of the gender composition of a company’s directors and nominees and (2) establish a Gender Diversity Advisory Group comprised of representatives from the government, academia and the private sector to study and make recommendations with respect to “strategies to increase gender diversity” among public company boards and provide an annual report on the status of gender diversity on corporate boards. The bill was referred to the House Financial Services Committee for consideration. Also in early March, 10 Democratic members of Congress sent a letter to Chair White urging the SEC to act on a petition filed by nine large public pension funds in April 2015 asking the SEC to adopt rules requiring proxy statement disclosure of each director nominee’s gender, race and ethnicity. Sidley Perspectives | APRIL 2016 • 11 SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE The number of shareholder activism campaigns was at an all-time high in 2015, with a total of 507 campaigns compared to 292 in 2014, representing a 73.6% increase. — THOMSON REUTERS’ GLOBAL SHAREHOLDER ACTIVISM SCORECARD The SEC’s focus on this topic may continue to increase given Chair White’s recent remarks and the fact that SEC Commissioner nominee Lisa Fairfax has written extensively about the importance of enhancing gender and racial diversity on corporate boards. CORPORATE GOVERNANCE DEVELOPMENTS Senate Bill Seeks to Amend Beneficial Ownership Reporting Rules to Rein in Activist Hedge Funds On March 17, 2016, Senators Tammy Baldwin (D-WI) and Jeff Merkley (D-OR) introduced The Brokaw Act designed to increase transparency and oversight of activist hedge funds which have been associated with “short-termism” (i.e., extracting short-term gains at the expense of the corporation’s long-term interests). The bill was co-sponsored by Senators Bernie Sanders (I-VT) and Elizabeth Warren (D-MA). The bill seeks to address certain aspects of the current beneficial ownership reporting rules that are most frequently exploited by activist hedge funds. The sponsors of the bill note that the SEC has not yet used the authority granted to it under the Dodd-Frank Act to address abuses under the existing rules. If adopted, the bill would direct the SEC to make several amendments to the beneficial ownership reporting rules in Section 13(d) of the Securities Exchange Act. First, it would shorten the period for filing a Schedule 13D upon acquiring 5% of a company’s stock from 10 days to two business days. Second, it would expose the formation of “wolf packs” by revising the definition of “person” such that a group of coordinated activists with a collective ownership stake in excess of 5% would be required to report their holdings as a single group. (Under the existing rules, an activist that is part of a coordinated group is not subject to the reporting requirements so long as its individual ownership stake is below the 5% threshold and the aligned activists have not formed a “group” within the meaning of Section 13(d)(3).) Finally, the bill would direct the SEC to expand the definition of “beneficial ownership” to include derivatives (e.g., short positions) to ensure that activists cannot circumvent the reporting requirements by using such instruments. SIDLEY EVENTS Bay Area Life Sciences Roundtable April 13, 2016 | San Francisco, CA Sidley will host its Bay Area Life Sciences Roundtable: Crossing the Technology/Life Sciences Divide on April 13. The event is open to executives, investors, general counsel and company counsel. Anyone interested in attending should contact Elpidio Benitag at email@example.com or (415) 772-7409. Chicago General Counsel Roundtable June 7, 2016 | Chicago, IL Sidley will host its 9th annual General Counsel Roundtable in Chicago on June 7. The theme of the event is the increasing role of general counsel as business advisors. At the program, Sidley attorneys will (1) review recent significant Supreme Court decisions and discuss the implications of the Court’s changing composition, (2) lead an interactive session on cybersecurity, with a focus on preparedness, and (3) discuss other hot topics relevant to general counsel, such as proxy access, shareholder activism and the use of rep and warranty insurance in M&A transactions. This year’s keynote speaker is Ram Charan, a world- Sidley Perspectives | APRIL 2016 • 12 sidley.com Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Prior results described herein do not guarantee a similar outcome. 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SIDLEY SPEAKERS Hot Issues for Corporate Boards April 11, 2016 | New York, NY Holly Gregory, a partner in our New York office, will participate in a panel entitled Hot Issues for Corporate Boards at The Association of Corporate Counsel’s Mid-Year Meeting in New York City on April 11. Click here for more information. The Business Judgment Rule and the Board of Directors April 12, 2016 | New York, NY Jim Ducayet, a partner in our Chicago office, will participate in a panel entitled The Business Judgment Rule and the Board of Directors at The Association of Corporate Counsel’s Mid-Year Meeting in New York City on April 12. The presenters will (1) review recent case law on the business judgment rule, (2) discuss ways to advise boards regarding the business judgment rule and its application and (3) provide practical tips relating to drafting board minutes and record retention from a litigator’s perspective. Click here for more information. The Inner Workings of Activist Shareholders April 28, 2016 | Chicago, IL Tom Cole, a partner in our Chicago office, will chair a panel entitled The Inner Workings of Activist Shareholders at the 36th annual Ray Garrett Jr. Corporate and Securities Law Institute at Northwestern Pritzker School of Law in Chicago on April 28. John Kelsh, a partner in our Chicago office, will serve as the Institute Chair. Click here for more information. Hot Board Topics in 2016 June 20, 2016 | Stanford, CA Holly Gregory will participate in a plenary session entitled Hot Board Topics in 2016 at the 22nd annual Stanford Directors’ College at Stanford Law School on June 20. Click here for more information. SIDLEY RESOURCES An article entitled Planning for Leadership Succession and Unexpected CEO Transitions by Holly Gregory was published in the March 2016 edition of Practical Law’s The Governance Counselor.