Category: Litigation

Another Caremark case survives a challenge

In In re The Boeing Company Derivative Litigation, Vice Chancellor Morgan Zurn of the Delaware Court of Chancery opened her opinion this way:
“A 737 MAX airplane manufactured by The Boeing Company…crashed in October 2018, killing everyone onboard; a second one crashed in March 2019, to the same result. Those tragedies have led to numerous investigations and proceedings in multiple regulatory and judicial arenas to find out what went wrong and who is responsible. Those investigations have revealed that the 737 MAX tended to pitch up due to its engine placement; that a new software program designed to adjust the plane downward depended on a single faulty sensor and therefore activated too readily; and that the software program was insufficiently explained to pilots and regulators. In both crashes, the software directed the plane down. The primary victims of the crashes are, of course, the deceased, their families, and their loved ones. While it may seem callous in the face of their losses, corporate law recognizes another set of victims: Boeing as an enterprise, and its stockholders.”
Do the directors bear any responsibility for these losses? The question before the Court in this derivative litigation was whether the plaintiff stockholders—New York and Colorado public pension funds—had adequately alleged, under In re Caremark International Inc. Derivative Litigation and Marchand v. Barnhill, that, as a result of the directors’ “complete failure to establish a reporting system for airplane safety,” or “their turning a blind eye to a red flag representing airplane safety problems,” the board faced a “substantial likelihood of liability for Boeing’s losses.” In a 103-page opinion, the Court concluded that the answer was yes—on both bases. (Other claims regarding the company’s officers and the board’s handling of the CEO’s retirement and compensation were dismissed.) It’s worth noting that this case is one of several Caremark claims in recent years to survive dismissal (see, e.g., this PubCo post). In Marchand, then-Chief Justice Strine remarked that Caremark presents a very high hurdle, observing that “Caremark claims are difficult to plead and ultimately to prove out,” and constitute “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” (See this PubCo post.) In light of this series of decisions, you have to wonder—at least with regard to matters that involve “essential and mission-critical” risk and safety issues—if that’s still the case.

SEC charges attorney rendering legal opinions with violations of Section 5

Attorneys who may think they can give short shrift to those pesky legal opinions to transfer agents might think twice after reading this complaint, SEC v. Frederick Bauman, filed on September 8, 2021, in the federal district court in Nevada.   As described in the SEC’s litigation release, the SEC charged Bauman “with playing a critical role as an attorney who facilitated the unregistered sale of millions of shares of securities by two groups engaged in securities fraud.” According to the SEC’s complaint, between 2016 and August 2019, Bauman issued at least a dozen legal opinions to transfer agents advising that certain shares of four public companies were unrestricted and freely tradeable and that the holders of the shares were not affiliates of the public company issuers. However, the SEC alleged, the shareholders were actually part of groups that controlled those issuers, which made them affiliates under the securities laws. In “each instance where Bauman’s opinion letters violated Section 5,” the SEC alleged, “he lacked a reasonable basis for representing that the shareholders were not affiliates.” The complaint charged that the sales by these control groups were unregistered and violated Section 5 of the Securities Act and that Bauman violated Sections 5(a) and 5(c) of the Securities Act.

SEC charges Kraft Heinz with improper expense management scheme

On Friday, the SEC announced settled charges against Kraft Heinz Company, its Chief Operating Officer and Chief Procurement Officer for “engaging in a long-running expense management scheme that resulted in the restatement of several years of financial reporting.” According to the SEC’s Order regarding the company and the COO, as well as the SEC’s complaint against the CPO, the company employed a number of expense management strategies that “misrepresented the true nature of transactions,” including recognizing unearned discounts from suppliers, maintaining false and misleading supplier contracts and engaging in other accounting misconduct, all of which resulted in accounting errors and misstatements. The misconduct, the SEC contended, was designed to allow the company to report sham cost savings consistent with the operational efficiencies it had touted would result from the 2015 merger of Kraft and Heinz, as well as to inflate EBITDA—a critical earnings measure for the market—and to achieve certain performance targets. And, once again, charges of failure to design and implement effective internal controls played a prominent role. After the SEC began its investigation, KHC restated its financials, reversing “$208 million in improperly-recognized cost savings arising out of nearly 300 transactions.” According to Anita B. Bandy, Associate Director of Enforcement, “Kraft and its former executives are charged with engaging in improper expense management practices that spanned many years and involved numerous misleading transactions, millions in bogus cost savings, and a pervasive breakdown in accounting controls. The violations harmed investors who ultimately bore the costs and burdens of a restatement and delayed financial reporting….Kraft and its former executives are being held accountable for placing the pursuit of cost savings above compliance with the law.” KHC agreed to pay a civil penalty of $62 million. Interestingly, this case comes on the heels of an earnings management case brought by the SEC against Healthcare Services Group, Inc. for alleged failures to properly accrue and disclose litigation loss contingencies. 

Are SPACs really “investment companies”?

Not according to 49 major law firms! Earlier this month, a shareholder of Pershing Square Tontine Holdings, Ltd., filed derivative litigation against the company’s board, its sponsor and other related companies, contending that the company, a SPAC organized by a billionaire hedge-fund investor, is really an investment company that should be registered under the Investment Company Act of 1940 and that its sponsor is really an investment adviser that should be registered under the Investment Advisers Act of 1940. Had they registered, so the argument goes, they would have been subject to substantial regulation regarding the rights of the SPAC’s shareholders and the form and amount of the SPAC managers’ compensation. According to the complaint, under the ICA, “an Investment Company is an entity whose primary business is investing in securities. And investing in securities is basically the only thing that PSTH has ever done.” The complaint sought “a declaratory judgment, damages, and rescission of contracts whose formation and performance violate” the ICA and IAA. What’s especially notable about the litigation—aside from its novel premise—is that the plaintiff’s lawyers include Yale law professor John Morley and Robert Jackson, an NYU law professor and former SEC Commissioner.  Now, a group of 49 major law firms—including Cooley—have issued a joint statement pushing back on the plaintiff’s claims, asserting that there is no legal or factual basis for the allegation that SPACs are investment companies.

SEC charges healthcare services company engaged in earnings management

Yesterday, the SEC announced settled charges against Healthcare Services Group, Inc., a provider of housekeeping and other services to healthcare facilities, its CFO and its controller, for alleged failures to properly accrue and disclose litigation loss contingencies—accounting and disclosure violations that “enabled the company to report inflated quarterly [EPS] that met research analysts’ consensus estimates for multiple quarters.”  This action is the result of SEC Enforcement’s “EPS Initiative, which uses risk-based data analytics to uncover potential accounting and disclosure violations caused by, among other things, earnings management practices.” Gurbir Grewal, the new Director of Enforcement, warned that the SEC will continue to leverage its “in-house data analytic capabilities to identify improper accounting and disclosure practices that mask volatility in financial performance, and continue to hold public companies and their executives accountable for their violations.” The company paid $6 million to settle the action. The SEC Order makes the matter of accruing for loss contingencies sound simple and straightforward, implying that the company’s behavior involved “big bath” accounting and other earnings management practices, and that may well be the case in this instance.  However, in many cases, deciding whether, when and what to disclose or accrue for a loss contingency is not so clear cut and can often be a challenging exercise.

Petition filed for review of SEC approval of Nasdaq board diversity rule

It should hardly come as a surprise to anyone that the new Nasdaq board diversity rule (see this PubCo post) would be challenged in the courts. The rule was approved by the SEC on Friday, August 6. On Monday. August 9, the Alliance for Fair Board Recruitment filed a slim petition under Section 25(a) of the Exchange Act in the Fifth Circuit Court of Appeals—the Alliance has its principal place of business in Texas—for review of the SEC’s final order approving the Nasdaq rule. The petition itself is not particularly revealing, but it’s notable that the petitioner is also the most recent plaintiff challenging California’s two board diversity laws.

Is this insider trading?

On Tuesday, the SEC announced that it had filed a complaint in the U.S. District Court charging a former employee of Medivation Inc., an oncology-focused biopharma, with insider trading in advance of Medivation’s announcement that it would be acquired by a big pharma company.  But it’s not what you might think.  The employee didn’t trade in shares of Medivation or shares of the acquiror, nor did he tip anyone about the transaction.  No, according to the SEC, he used the information about his employer’s acquisition to purchase call options on a separate biopharma company, Incyte Corporation, which the SEC claims was comparable to Medivation.  According to the SEC, the employee made that purchase based on an assumption that the acquisition of Medivation at a healthy premium would probably boost the share price of Incyte. Incyte’s stock price increased after the sale of Medivation was announced.  The SEC charged that the employee breached his “duty to refrain from using Medivation’s proprietary information for his own personal gain” and traded ahead of the announcement, in violation of Rule 10b-5.  Will the SEC succeed or is the factual basis of the charge just too attenuated?

SEC charges another company for misleading cybersecurity disclosure

It’s déjà vu all over again! On Monday, the SEC announced settled charges against Pearson plc, an NYSE-listed, educational publishing and services company based in London, for failure to disclose a cybersecurity breach. You might recall that just a few months ago, the SEC announced settled charges against another company for failure to timely disclose a cybersecurity vulnerability that led to a leak of data, with disclosure ultimately spurred by imminent media reports.  Is there a trend here? In this instance, it wasn’t just a vulnerability—there was an actual known breach and exfiltration of private data.  Nevertheless, Pearson decided not to disclose it and framed its cybersecurity risk factor disclosure as purely hypothetical.  The SEC viewed that disclosure as misleading and imposed a civil penalty on Pearson of $1 million.  The case serves as yet another reminder of the dangers of risk disclosures presented as hypothetical when those risks have actually come to fruition—a presentation that has now repeatedly drawn scrutiny in the context of cybersecurity disclosure.

SEC steps back from two of the 2020 amendments to the whistleblower rules

The SEC’s whistleblower program provides for awards in amounts between 10% and 30% of the monetary sanctions collected in an SEC action based on the whistleblower’s original information.  The program, which has been in place for more than ten years, is widely acknowledged to have been a resounding success. In September 2020, the SEC adopted a number of amendments to the whistleblower rules, some of which were quite controversial. In early August, SEC Chair Gary Gensler issued a statement indicating that he had directed the SEC staff to revisit the whistleblower rules, in particular, two of the amendments that had been adopted in 2020. (See this PubCo post.)  Gensler observed that concerns have been raised, including by whistleblowers as well as by Commissioners Allison Herren Lee and Caroline Crenshaw, that those amendments “could discourage whistleblowers from coming forward.”  Now, the SEC has issued a policy statement advising how the SEC will proceed in the interim while changes to those rules are under consideration.  Commissioners Hester Peirce and Elad Roisman were none too pleased with the SEC’s action here, questioning whether it might be part of a troubling pattern of unwinding actions taken by the last Administration.  They made their views known in this statement.

DOJ and SEC file fraud charges against Nikola CEO

Is there anything topical missing from this case? There’s a SPAC. There’s social media. There’s an unorthodox, charismatic CEO. There are electric vehicles. There are hydrogen trucks with drinking fountains using water produced by the trucks as a by-product of their hydrogen fuel cells—or not. And, there’s a DOJ criminal indictment and an SEC complaint. Yes, I’m talking about the case against Trevor Milton, the founder, former CEO and former executive chairman of Nikola Corporation, who was charged last week with “repeatedly disseminating false and misleading information—typically by speaking directly to investors through social media—about Nikola’s products and technological accomplishments,” according to the SEC press release.  What’s more, the DOJ charged, Milton exploited the SPAC structure with a “self-proclaimed media blitz” of false and misleading public statements during a period of time that, in an IPO setting, would have been considered a “quiet period.” In addition to civil SEC charges, Milton faces two counts of criminal securities fraud and one count of wire fraud, with maximum 20- and 25-year prison terms if convicted.  He pleaded not guilty. As described by the U.S. Attorney for the SDNY (with an appropriate vehicular metaphor), “[a]s alleged, Trevor Milton brazenly and repeatedly used social media, and appearances and interviews on television, podcasts, and in print, to make false and misleading claims about the status of Nikola’s trucks and technology.  But today’s criminal charges against Milton are where the rubber meets the road, and he now will be held accountable for his allegedly false and misleading statements to investors.” The case reinforces the point that fraudulent or misleading statements don’t have to be in a prospectus or 10-K to be actionable—social media will do just fine.  According to the Regional Director of the SEC’s Fort Worth Regional Office, “[p]ublic company officials cannot say whatever they want on social media without regard for the federal securities laws.  The same rules apply, and the SEC will hold those who make materially false and misleading statements accountable regardless of the communication channel they use.” Notably, this is the second recent case involving SEC charges of misleading claims in connection with a SPAC. (See this PubCo post.)