10 Cases To Shape The 2007 Legal Landscape

Court rulings in Delaware and by federal judges across the country had an impact on a wide range of corporate-governance issues in 2006. Compliance Week has compiled overviews of 10 of the most important court decisions over the past year and gathered expert insights into the possible implications for companies in 2007 and beyond.

Business Judgment Of Directors

Lieberman

Benihana of Tokyo v. Benihana (Delaware Supreme Court; Aug. 24, 2006). The court held that a stock issuance authorized by a subsidiary corporation’s board of directors was lawful even though it diluted the parent company’s ownership. The court said that the subsidiary’s board properly exercised its business judgment and that such judgment should not be second-guessed. Ronald Lieberman, of the law firm Hunton & Williams, says all parent corporations should take lessons from this case. “They need to understand the boilerplate language that allows boards of the subsidiary to issue additional capital stock … gives blank-check discretion to the board of the subsidiary. The parent did not have the proper safeguards in place with rights of the shareholder voting or control of the board.”

Corporate Oversight By Directors

Kozlov

Stone v. Ritter (Delaware Supreme Court; Nov. 6, 2006). In what many consider to be the most important corporate-governance decision of the year, the Delaware Supreme Court for the first time articulated the standard for determining whether directors can be liable for failing to oversee employees who don’t fulfill their duties. The court rejected an attempt to “equate a bad outcome with bad faith” and stated that “the test of liability—lack of good faith as evidenced by a sustained or systematic failure of a director to exercise reasonable oversight—is quite high.” The decision cements the idea that there must be a sustained or systematic failure of oversight for directors to be liable, notes Herb Kozlov, a partner with the Reed Smith law firm. The ruling is expected to have implications for litigation over stock option backdating, as well as other types of shareholder and derivative litigation.

Director Indemnity

Brown v. LiveOps (Delaware Chancery Court; June 12, 2006). In this case, a company sued a former officer and director alleging that his new business used corporate trade secrets. The ex-director argued that the company was required to indemnify him for his legal expenses in defending the suit. The company countered that indemnification wasn’t required, because the suit was about the director’s conduct after he had left the company. The court, however, found that indemnification was required because the suit was related to his employment with the corporation. The case demonstrates the determination of Delaware courts to uphold contractual indemnity agreements, but, according to Kozlov, it also provides a practical tip for corporations: They can avoid indemnification costs if the contract explicitly excludes claims asserted directly by the company for wrongdoing.

Hedge Funds

Ladig

Polygon Global Opportunities Master Fund v. West Corp. (Delaware Chancery Court; Oct. 12, 2006). Efforts by hedge funds and others to get a look at corporate books prior to litigation suffered a defeat when the Chancery Court ruled that Section 220 of Delaware’s corporate code could not be used to get records from a company that had announced a merger. The court said that while a proper purpose for the information request did exist, the hedge fund already had enough information from public filings to determine whether to seek appraisal rights rather than accept a cash deal. The decision “may work to help public companies defeat information demands from opportunistic investors,” according to Peter Ladig, a corporate litigator with The Bayard Firm.

Liability Of Third-Party Corporate Vendors

In re Charter Communications Securities Litigation (8th U.S. Circuit Court of Appeals; April 11, 2006). Accounting firms, law firms, and other third-party vendors to corporations cannot be held liable in civil suits as “primary violators” of securities laws if they only had tangential involvement in the alleged fraud, the court ruled. A handful of lower courts had made it easier for third parties under the Securities and Exchange Act and Rule 10b-5. But the 8th Circuit said federal law was never meant to cover aiding and abetting claims in these situations, no matter how they were disguised by plaintiffs.

Proxy Proposals

American Federation of State, County and Municipal Employees v. American International Group (2nd U.S. Circuit Court of Appeals; Sept. 5, 2006). Shareholders can submit proposals concerning director nominations for inclusion in a proxy statement, the court held—rejecting the Securities and Exchange Commission’s longstanding interpretation of Rule 14a-8(i)(8), which governs situations where a company must include a shareholder proposal in a proxy statement. The SEC first tried to address shareholder access to the proxy in 2005, but failed to reach a consensus. Since the AIG decision, the Commission has twice postponed taking any new action but tentatively plans to issue any rule amendments in time for the 2007 proxy season.

Securities Litigation Uniform Standards Act

Merrill Lynch, Pierce, Fenner & Smith v. Dabit (U.S. Supreme Court; March 21, 2006). Shareholders who claim they held a security—but didn’t purchase or sell it—as a result of a fraudulent statement can’t bring class actions in state court to get around the federal Securities Litigation Uniform Standards Act. A unanimous U.S. Supreme Court said allowing such suits to go forward would be contrary to Congress’ intent in adopting SLUSA, which bars state class actions “in connection with the purchase or sale” of securities.

Kircher v. Putnam Funds Trust (U.S. Supreme Court; June 15, 2006). A party may not appeal a federal judge’s decision to remand a case to state court pursuant to SLUSA, the Court said, again, in a unanimous ruling. As a result of the Court’s decision, no appellate review is available if a federal judge concludes that SLUSA does not preclude a state class action and remands the matter for trial in state court.

Special Committees

Gesoff v. IIC Industries (Delaware Chancery Court; May 18, 2006). The case involved a squeeze-out merger resulting in what the court called a “plainly unfair price” for the minority shareholders. The special-committee procedure—comprised of a single director whose financial adviser was a small investment bank that had a continuing relationship with the parent—was “marked with grave examples of unfairness,” the court said. Kozlov, of Reed Smith, says the decision “illuminates what you can do wrong in setting up a special committee” and is an example of the expertise that Delaware courts bring to valuation issues.

Thompson Memo

United States v. Stein (U.S. District Court for the Southern District of New York; June 26, 2006). In an unprecedented ruling, Judge Lewis Kaplan lambasted federal prosecutors for pressuring KPMG to cut off legal support to 16 employees indicted for selling illegal tax shelters. Kaplan ordered the government not to consider KPMG’s payment of counsel fees for indicted employees and told the defendants they could file a claim against the accounting firm to have their legal fees reimbursed.

The ruling marked a major defeat in the government’s enforcement of the Thompson Memorandum, a Justice Department policy that said payment of individual employees’ legal fees is one criterion prosecutors should consider in deciding whether a company will face indictment. On Dec. 12, Deputy Attorney General Paul McNulty issued his own memo, rescinding the previous policy, saying that federal prosecutors only should consider the advancement of attorney fees in “extremely rare” cases. In doing so, however, McNulty cited the brief appealing Judge Kaplan’s ruling in Stein—leading some to conclude that the DoJ still considers its actions in that case appropriate.