The players in the case were Chinese.  During settlement negotiations, the defendant not only rejected the plaintiff’s demand of $675,000, but also countered with a demand that the plaintiff pay it $444,444.44.  Apparently, the number four is very unlucky in the Chinese culture.  It is pronounced the same way as the word for death.  Accordingly, the Chinese plaintiff could have interpreted the demand as a death threat.  The parties and courts stopped short of saying the demand was an actual death threat, but the number was still a highly threatening figure.

Fascinating stuff!

In a manner reminiscent of the Delaware case I recently blogged about, which holds that LLC managers are not potentially liable to creditors in the zone of insolvency (unlike corporate officers and directors), the court in Cook relied on the plain language of the statute, which states:

“The president and treasurer of a corporation and any officers or agents having the management of such corporation shall be deemed to be the employers of the employees of the corporation within the meaning of this section. Every public officer whose duty it is to pay money, approve, audit or verify pay rolls, or perform any other official act relative to payment of any public employees, shall be deemed to be an employer of such employees, and shall be responsible under this section for any failure to perform his official duty relative to the payment of their wages or salaries, unless he is prevented from performing the same through no fault on his part.”

The court reasoned that the statute explicitly refers to corporations, and limited liability companies are not corporations.  It acknowledged that the Legislature’s failure to make the Wage Act apply to LLCs may be an “unfortunate oversight,” but it is the Legislature’s place to correct that oversight if so, not the court’s.

The take away?  If you are establishing a business, LLCs may have some liability protection advantages that corporations do not — at least for the time being.

This rule is entirely different than the rule applicable to Delaware corporations, which permits the creditors of insolvent corporations to step into the shoes of the shareholders and bring derivative claims against the company’s officers and directors.  So at least in Delaware, the operators of an insolvent LLC enjoy a greater degree of safety from derivative claims than do corporate officers and directors.  This may be the right result under the statute, but it does not make a lot of sense from a policy standpoint.

As part of the auction process, both parties agreed not to submit a bid outside the auction process.  Bidders were also required to reach an agreement with the company that managed all of the trust properties under long term management contracts, Sunrise Senior Living, Inc. (“SSL”).  HCP was unable to reach an agreement with SSL, in part due to HCP’s hard ball negotiation tactics and in part due to issues between HCP and SSL arising out of another real estate portfolio.  In any event, HCP  was forced to withdraw from the auction process, and Ventas submitted the only bid, which the trust accepted.

HCP then made a separate, higher but conditional bid, which it announced to the market in a press release.  It failed to inform the public that its bid was contingent on reaching a deal with SSL, which it had previously been unable to do, and there was evidence that HCP intentionally misled the market in order to force Ventas to pay more for the trust assets.  HCP’s plan succeeded, and Ventas was forced to increase its bid by 10%, or just over $101 million.

The Sixth Circuit not only affirmed the judgment for Ventas, but vacated a ruling in HCP’s favor that the jury could not award punitive damages.  The Court remanded the case for further proceedings on whether to award punitive damages against HCP.

The legal principles in this case really are not all that novel, but the factual description of what happened is a really fun read.  Hard ball indeed!

The dispute centered around the interaction between the Fund’s limited partnership agreement (“LP Agreement”) (hedge funds are generally structured as limited partnerships and the investors buy a limited partnership interest) and the seed investor agreement (“Seeder Agreement”). The LP Agreement provided that the Fund could invoke gating provisions to prevent withdrawal of more than 20% of the Fund’s total assets in any 6-month period. Because the seed investor provided 99.9% of the Fund’s total capital, if applicable these gating provisions could tie up the Fund’s money for a long time.

The Seeder Agreement locked in the investor for 3 years, after which it was entitled to withdraw all its money. The Fund argued that the LP Agreement governed after the 3-year period. The investor argued that the Seeder Agreement modified the terms of the LP Agreement for it as a large and strategic investor. The court agreed with the investor.

Interesting bits:

Even if a fiduciary has a contractual right, the court will review how it used that right to see if it complied with its fiduciary duties.

The directors of a corporation that serves as the general partner of a limited partnership owe fiduciary duties to the limited partners.

The evidentiary rule excluding from evidence at trial settlement communications will not necessarily exclude a settlement communication that includes threats of misconduct if the other party does not settle. See the companion decision, Paige Capital Management, LLC v. Lerner Master Fund, LLC, 22 A.2d 710 (Del. Ch. 2011) (“it would be a very strange and novel idea that the law would condone a plaintiff in a litigation calling the defendant and threatening to kill his dog if he does not settle the suit simply because that statement took place against the backdrop of litigation, whether active or contemplated”).

In SEC v. Gabelli, the U.S. Court of Appeals for the Second Circuit reversed a defense judgment, holding that half truths are actionable and the SEC’s action was timely because it was brought within five years of its discovery of the misconduct. The core allegations were that the defendants favored a particular investor in a Gabelli mutual fund, allowing it to engage in market timing in exchange for investing in a Gabelli hedge fund. Market timing is a practice where sophisticated investors can take advantage of market pricing inefficiencies. It is legal but harms other fund investors. Gabelli represented to the public that it was policing marketing timing and preventing it. This representation was true as far as went, except with regard to the favored client.

The decision is interesting at a couple of levels. First, and in light of the Supreme Court’s recent decision in Janus Capital Group, Inc. v. First Derivative Traders (see blog post June 16, 2011), Gabelli reminds us that, to keep the securities industry honest, there are other liabilities and penalties other than private claims for securities fraud. Second, the case provides a useful discussion of the distinction between the discovery rule, which prevents a claim from accruing — and the statute of limitations from starting to run — until the fraud is discovered, and fraudulent concealment, which tolls the statute of limitations in non fraud cases where the defendant hides its wrongful conduct.

Egan filed suit alleging, among other things, claims under the Whistleblower Protection provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Egan had some hurdles to clear, however, to qualify as a whistleblower because he did not report the wrongdoing directly to the Securities and Exchange Commission (SEC), and TradingScreen is privately held.

The Court held that the information Egan reported was not of a kind that did not have to be reported to the SEC to give him whistleblower status. It was not a disclosure under the provisions of Sarbanes-Oxley, under the Securities Exchange Act or any other laws or regulations subject to the jurisdiction of the SEC.

The Court nevertheless held that he had adequately alleged that he acted “jointly” with Latham to report the conduct to the SEC. He was unable to state for certain that Latham had reported the conduct to the SEC, but stated that he believed it had, that his information led to the firm’s retention, and that they confirmed his allegations. (The court granted him leave to amend to shore up the allegations that Latham reported the misconduct to the SEC.)

The Egan v. TradingScreen decision is an interesting because it is an early effort to interpret the recent Dodd-Frank whistleblower legislation.

Last week in Kahn v. Kolberg Kravis Roberts & Co., L.P., the Delaware Supreme Court expanded the exposure to liability and the remedies for “Brophy” claims, which were only recently resuscitated by the very Chancery Court decision that the Supreme Court overruled in the Kahn v. KKR decision.

In Kahn v. KKR, the Court reviewed the dismissal of a derivative action based upon a motion to dismiss by the company’s special litigation committee. The Court agreed with the Chancery Court that the committee was independent, conducted a good faith investigation, and reached a reasonable conclusion. Nevertheless, because the Chancery also engaged in a purely discretionary analysis of the committee’s decision not to pursue a Brophy claim, which it affirmed, the Court also reviewed that decision for abuse of discretion. See Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) (standard of review for special litigation committee motion to dismiss). Because the Chancery Court may have relied on a recent decision in Pfeiffer v. Toll, 989 A.2d 683 (Del. Ch. 2010), which the Supreme Court in this opinion overruled, the Supreme Court reverse the Chancery Court decision and remanded for further proceedings.

A Brophy claim is a species of breach of fiduciary duty claim based upon a corporate insider’s profit from insider trading. The Kahn v. KKR decision is ironic because in Pfeiffer v. Toll, the defendants argued that the Brophy claim was no longer viable at all in light of federal securities law, which comprehensively governs and punishes insider trading. The Pfeiffer decision concluded that a Brophy claim remains a viable claim. It also, however, limited the use of the claim to instances where the corporation actually suffers harm and limited the remedies — rejecting disgorgement of profits as a remedy except in cases of actual fraud. These limitations harmonized the state law remedy with the federal regulatory framework. See Pfeiffer, 989 A.2d at 701 (“Properly focusing on harm to the corporation disposes of the defendants’ contention that Brophi is a misguided vehicle for recovering the same trading losses that are addressed by the federal securities laws.”).

The Kahn v. KKR decision overrules Pfeiffer to the extent it requires corporate harm. The problem with the Kahn v. KKR decision is that it does not address at all the tension thereby created with federal securities law. It barely mentions the core issue in Pfeiffer — how to harmonize a state law claim with the federal securities regulatory framework. By failing to analyze this issue, Kahn v. KKR overrules Pfeiffer without a properly sound analytical framework. See Pfeiffer v. Toll, 989 A.2d 683, 698-99 (Del. Ch. 2010). The Court acknowledges the thoughtfulness of the Pfeiffer decision without taking head on the important issues it dealt with. Readers familiar with the Pfeiffer decision will come away from the Kahn v. KKR decision with the distinct impression that it is just plain wrong.

Supreme Court Limits Securities Fraud Liability by Defining the “Maker” of a Misstatement.

On June 13, 2011, in Janus Capital Group, Inc. v. First Derivative Traders, a 5-4 Majority of the Supreme Court held that a mutual fund investment adviser cannot be held liable in a private action under Securities and Exchange Commission (SEC) Rule 10b-5 (17 CFR § 240.10b-5) for false statements included in its client mutual funds’ prospectuses, which it did not make.The issue was the meaning of the word, “make” – who makes a false statement when there is a complex constellation of related parties involved in writing it? Justice Thomas wrote the opinion in which Roberts, Scalia, Kennedy and Alito joined.

Janus Capital Group, Inc. (“JCG”) is a publicly traded company that formed the Janus family of mutual funds. The mutual funds are organized into a Massachusetts Business Trust, the Janus Investment Fund (the “Fund”). Janus Capital Management, LLC (“JCM”) is a wholly owned subsidiary of JCG, which the Fund retained to be its investment advisor and administrator.All of the officers of the Fund were also officers of JCM and the two entities also shared a board member.

First Derivative represented a class of plaintiffs who owned shares in JCG, and alleged that the market had been misled in the Fund’s prospectuses, which represented the Fund would implement measures to curb market timing, which is legal but harms other Fund investors.JCG’s shares dropped sharply when the New York Attorney general sued JCG and JCM for allegedly entering into secret agreements to permit market timing in the Fund.First Derivative asserted claims against both JCM and JCG.The allegedly misleading prospectuses, however, were filed by the Fund.See 15 U. S. C. §§ 77e(b)(2), 80a-8(b), 80a-29(a)-(b); see also 17 CFR § 230.497 (imposing requirements on “investment companies”).

The U.S. District Court for the District of Maryland dismissed the complaint for failure to state a claim.The U.S Court of Appeals for the Fourth Circuit reversed, holding that the plaintiffs had alleged that JCG and JCM participated in drafting the misleading prospectuses and therefore made the challenged statements.

According to the majority opinion, “[f]or purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker. And in the ordinary case, attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by–and only by–the party to whom it is attributed.”(emphasis added).

The U.S. Government filed an amicus brief on behalf of the plaintiffs, but the Court rejected its contention that to “make” a statement should be synonymous with to “create” a statement.This would mean that providing false information to someone who makes the public statement would be a basis for liability.

The Court also rejected the more context dependent contention by the plaintiff that the Court should consider the special relationship between an investment adviser and a mutual fund – like a “playwright whose lines are delivered by an actor.”The majority opinion rejected this argument as an “invitation to disregard the corporate form.”The majority notes that Congress has elsewhere expressly provided in § 20(a) for “[e]very person who, directly or indirectly, controls any person liable” for violations of the securities laws.15 U. S. C. A. § 78t(a).

The Minority Opinion, written by Breyer and joined by Ginsburg, Sotomayor and Kagan, saw things quite differently.They would have ruled that “both language and case law indicate that, depending upon the circumstances, a management company, a board of trustees, individual company officers, or others, separately or together, might “make” statements contained in a firm’s prospectus–even if a board of directors has ultimate content-related responsibility.”

Indeed, the Minority Opinion is quite indignant:“But where can the majority find legal support for the rule that it enunciates? The English language does not impose upon the word ‘make’ boundaries of the kind the majority finds determinative. Every day, hosts of corporate officials make statements with content that more senior officials or the board of directors have “ultimate authority” to control. So do cabinet officials make statements about matters that the Constitution places within the ultimate authority of the President. So do thousands, perhaps millions, of other employees make statements that, as to content, form, or timing, are subject to the control of another.”

The Minority also rejects the contention that control person liability under Section 20(a) provides the appropriate potential remedy.Section 20(a) imposes liability on someone who “controls” another person who is primarily liable for a securities violation.Section 20(a), for example, cannot hold accountable a person who exploits an innocent person into making misstatements.“The possibility of guilty management and innocent board is the 13th stroke of the new rule’s clock. What is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true?”The Minority Opinion points out that the Majority decision might even prevent the SEC from enforcing aiding and abetting liability, if there is no liable primary statement maker.

The problem with bright-line rules rather than standards is that they can be both over inclusive and under inclusive – here, at least from a plaintiff’s point of view, the court has created a rule that is under inclusive – it excludes too many from potential liability as the “maker” of the statement.But as a practical matter, if a standard were applied here – opening up possible liability for a range of possible statement makers (e.g., attorneys and accountants working on the prospectus), the resulting uncertainty would likely lead to painful prospectuses, loaded down with even more disclaimers and caveats than they suffer from now.The spectrum of named defendants would expand in every lawsuit, the costs of securities litigation would rise, and the consequences would be far reaching.Although on the facts of the Janus case give the Minority real ammunition to fire at the Majority decision, if the Minority Opinion had held the day, the consequences would have been painful.

The Supreme Court announced its decision in Erica P. John Fund, Inc. v. Halliburton Co. today, resolving a split among the Circuit Courts of Appeals and holding that securities fraud plaintiffs do not need to prove loss causation in order to obtain class certification.

The issue revolved around the plaintiffs’ invocation of the fraud on the market theory, which affords them a rebuttable presumption of reliance on the challenged statements. The idea is that the “market price of shares reflects all publicly available information and, hence, any material misrepresentations.” Basic, Inc. v. Levinson, 485 U.S. 224, 246 (1988). To invoke the presumption, plaintiffs must show that the alleged misrepresentations were publicly known, that the stock traded in an efficient market, and that the transactions at issue took place between the time of the misrepresentation and the revelation of the truth. Halliburton, slip op. at 5-6.

They do not, however, have to prove loss causation, which the Supreme Court explains in Halliburton is a separate idea entirely. To prove loss causation, plaintiffs must show that the stock price dropped because of the correction of the prior misrepresentation, and not because of other factors in the market. Id. at 6. The Court declared that this proof has “no logical connection” to proving the facts necessary to invoke the fraud on the market theory.