Appeal says Perelman’s MFW buyout ‘protections’ were illusory Kahn v. M&F Worldwide Corp. (Del.)
SETTLEMENT ISSUES 8
Agreement in Oracle suit needs insurer’s OK to pay $20 million in attorney fees
VOLUME 28, ISSUE 7 / OCTOBER 14, 2013
Directors and officers prevail in securities fraud, derivative challenges to China Automotive’s accounting practices Neal R. Marder, John E. Schreiber, Ali Rabbani and Shawn Obi of Winston & Strawn explain how they successfully defended a China-based auto parts maker in two parallel challenges to its accounting practices — including the Delaware Chancery Court’s rare dismissal with prejudice of a derivative suit. SEE PAGE 3
City of Roseville Employees’ Ret. Sys. v. Ellison (Del. Ch.)
INSIDER TRADING 9
Plaintiffs sat on Primedia merger insider-trading claims, KKR says In re Primedia Inc. S’holders Litig. (Del. Ch.)
BREACH OF DUTY 10 Judge tosses suit challenging Liberty Media’s Sirius takeover In re Sirius XM S’holder Litig. (Del. Ch.)
BOOKS & RECORDS 11 Investors want to root through books of China-based pig breeder Taylor Int’l Fund v. S. China Livestock (Del. Ch.)
SECURITIES FRAUD 12 Drugmaker seeks dismissal of suit over revenue forecast In re Incyte S’holder Litig. (D. Del.)
PRE-SUIT DEMAND 13 Split 6th Circuit panel says Tennessee courts would use Delaware law Lukas v. McPeak (6th Cir.)
ANALYSIS 14 Delaware’s corporate courts on brink of big change
Delaware justices lift injunction on Activision stock buyback A fast-tracked appeal has persuaded Delaware’s Supreme Court to kill a preliminary injunction ruling that could have sabotaged Vivendi SA’s $8.2 billion deal to sell most of its stake in Activision Blizzard Inc. back to the video game publisher. Activision Blizzard Inc. v. Hayes et al., No. 497, 2013, order issued (Del. Oct. 10, 2013). At oral argument Oct. 10, the publisher of the blockbuster video game series “Call of Duty” convinced the justices to let the deal go through before time runs out on financing agreements for Vivendi’s sale of 600 million of its Activision shares to the firm and a CEO-led investor group. In a rare same-day ruling, Chief Justice Myron T. Steele said the full court agreed that the buyback was not a business combination and so did not require a consenting vote by the Activision public shareholders. “We hold there is no reasonable possibility of success on the merits” for the plaintiffs, the chief justice wrote for the en banc court in a twopage order issued shortly after the close of oral argument. Activision’s expedited appeal quickly overturned Delaware Chancery Court Vice Chancellor J. Travis Laster’s Sept. 18 decision to temporarily halt that deal on the ground that the company failed to
The suit involves the sale of the stock of Activision Blizzard Inc., publisher of the video game series “Call of Duty.”
hold a required approval vote by the minority nonVivendi shareholders. Hayes v. Activision Blizzard Inc., No. 8885, 2013 WL 5293536 (Del. Ch. Sept. 18, 2013). It is extremely rare for the Delaware courts to hold up a corporate transaction where there is no evidence of gross misconduct or self-dealing. Shareholder Douglas Hayes successfully argued in the Chancery Court that the Activision directors CONTINUED ON PAGE 16
Directors and officers prevail in securities fraud, derivative challenges to China Automotive’s accounting practices By Neal R. Marder, Esq., John E. Schreiber, Esq., Ali Rabbani, Esq., and Shawn Obi, Esq. Winston & Strawn
Editor’s Note: We continue to solicit commentary by attorneys presenting the plaintiffs’ perspective on this case.
The directors and officers of China Automotive Systems Inc., a publicly traded Chinese reverse-merger company, recently secured significant victories in related federal securities fraud and shareholder derivative actions challenging the company’s accounting treatment for certain convertible notes it issued Feb. 15, 2008, that contained a compound embedded derivative component. Central to the plaintiffs’ claims in both cases was how China Automotive, a leading supplier of power-steering systems and component parts to China’s automotive industry, accounted for the convertible notes in its quarterly and annual financial statements that were filed by the company between 2009 and 2012. On March 17, 2011, China Automotive announced it would restate its financial statements for fiscal year 2009 and its unaudited financial statements for the first three quarters of 2010 to correct its accounting for the convertible notes. This announcement led to a drop in the company’s stock price, prompting the filing of a federal securities fraud class action in the U.S. District Court for the Southern District of New York, as well as a shareholder derivative lawsuit in the Delaware Court of Chancery.
China Automotive and its directors, through its counsel Winston & Strawn, have successfully defended against both actions. First, in May a federal district court denied class certification in the securities fraud action against the company and its officers and directors, finding, inter alia, that the plaintiffs were not entitled to a class-wide presumption of reliance on the basis of the “fraud on the market” theory because they failed to demonstrate that China Automotive stock (albeit listed on the Nasdaq since 1999) traded in an efficient market.
treatment for the convertible notes in question. According to the complaint, the defendants’ purported fraud was revealed to investors when the company announced that it would, and subsequently did, restate its previously issued financial statements to correct its accounting for the convertible notes, resulting in a drop in China Automotive’s stock price that allegedly cost the company’s shareholders millions of dollars. The complaint purported to assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.
Then, on Aug. 30 the Delaware Court of Chancery dismissed with prejudice a related shareholder derivative lawsuit on the ground that the plaintiff failed adequately to plead demand futility. The relevant facts, holdings and effects of the two decisions are discussed in turn below.
As with most putative class actions, the denial of class certification is likely to effectively terminate the litigation.
DENIAL OF CLASS CERTIFICATION IN FEDERAL SECURITIES ACTION In August 2012 Nancy and Robert George and Randall Whitman, purchasers of China Automotive securities, filed a putative class action, styled George v. China Automotive Systems Inc., in the U.S. District Court for the Southern District of New York, alleging that China Automotive, various of its officers and directors and its former auditor made false and misleading statements in securities filings related to the company’s accounting
(L-R) Neal R. Marder and John E. Schreiber are partners and Ali Rabbani and Shawn Obi are associates at Winston & Strawn in Los Angeles. The firm represented China Automotive and the individual defendants in both matters discussed in the commentary.
Specifically, the plaintiffs alleged that until Dec. 31, 2008, China Automotive was entitled to classify the convertible notes in question as equity and not as liabilities. A new accounting rule (EITF 07-05) went into effect as of Jan. 1, 2009, however, this rule required that the convertible notes thereafter be classified as liabilities. The plaintiffs alleged that, despite the new requirements of EITF 07-05, the defendants continued to classify the convertible notes as equity during all of 2009 and the first three quarters of 2010, resulting in a significant misstatement of earnings. According to the complaint, these alleged misstatements and omissions resulted in an “inflated” price for the company’s stock during the relevant time period. In April 2013 the plaintiffs filed a motion seeking to certify a class consisting of all purchasers of China Automotive securities from May 12, 2009, through and including March 17, 2011. On May 31, 2013, following oral argument and an evidentiary hearing, U.S. District Judge Katherine B. Forrest of
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the Southern District of New York denied class certification.1 The court’s opinion, subsequently issued July 3, held that the plaintiffs failed to satisfy Rule 23’s adequacy, typicality and predominance requirements.2 Specifically, Judge Forrest held that the plaintiffs did not carry their burden of showing that they were entitled to a classwide presumption of reliance on the basis of the fraud-on-the-market theory because they failed to establish that China Automotive’s stock, albeit listed on the Nasdaq, traded in an “efficient market.”3 In addition, the court noted that the lead plaintiffs were each subject to unique defenses that were based on their unusual trading activity (which included numerous “in and out” trades during the class period, as well as additional purchases made after the purported fraud was revealed), rendering them inadequate and atypical class representatives.4 As with most putative class actions, the denial of class certification is likely to effectively terminate the litigation.
The presumption of reliance is, however, just that — a presumption. It is rebuttable. The court’s decision with respect to market efficiency is particularly notable. Citing U.S. Supreme Court authority, Judge Forrest began her opinion by observing that reliance is an essential element of a private cause of action under Section 10(b) of the Securities Exchange Act, and Rule 10b-5 promulgated thereunder, because proof of reliance ensures that there is a “proper connection between a defendant’s misrepresentation and a plaintiff’s injury.”5 Recognizing the difficulties of proving direct reliance, in Basic Inc. v. Levinson, the Supreme Court first endorsed the fraud-on-the-market theory, which permits certain Rule 10b-5 plaintiffs to invoke a rebuttable presumption of reliance on material misrepresentations published to the general public.6 The fraud-on-themarket theory rests on the premise that “certain well-developed markets are efficient processors of public information” and therefore the price of a security at any given time reflects that information.7 The presumption of reliance is, however, just that — a presumption. It is rebuttable, and
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China Automotive announced that it would restate its financial statements for fiscal year 2009 and its unaudited financial statements for the first three quarters of 2010. This announcement led to a drop in the company’s stock price.
absent applicability of the fraud-on-themarket theory, the requirement that Rule 10b-5 plaintiffs establish reliance ordinarily precludes class certification because individual issues of reliance will almost always overwhelm questions common to the class. In order to invoke the fraud-onthe-market presumption, a plaintiff must establish that the security in question traded on an efficient market. This is where the plaintiffs and their expert in the China Automotive case fell short. Judge Forrest noted that in analyzing market efficiency, courts generally refer to a series of factors set forth in Cammer v. Bloom, the most significant of which is a “cause and effect” relationship between unexpected, material public disclosures and changes in the securities’ price.8 Both the plaintiffs and defendants proffered experts on the issue of whether China Automotive’s stock traded in an efficient market. Each expert submitted written reports and testified at a live evidentiary hearing. In its July 3 opinion, the court concluded that the market-efficiency tests conducted by the plaintiffs’ expert were methodologically flawed and did not provide a reliable basis upon which to conclude that China Automotive’s stock traded in an efficient market.9 Among other things, Judge Forrest “[could] not help but note” that there were “numerous days” within the class period when news events did not result in a statistically significant price movement or, conversely, when a statistically significant
price movement was not associated with a relevant news event.10 These facts, the court noted, were more consistent with market inefficiency than efficiency.11 Accordingly, Judge Forrest held that the plaintiffs were not entitled to a class-wide presumption of reliance on the basis of the fraud-on-themarket theory. This determination provided one basis on which to deny their motion for class certification.
troubled by unusual trading engaged in by all three lead plaintiffs, including numerous post-“corrective disclosure” purchases — one of which occurred the very next day after China Automotive announced that it would issue a restatement — as well as repeated in-and-out transactions, including some in which the plaintiffs bought and sold China Automotive stock within the very same day.15 The court noted that such “purchases can both defeat typicality and adequacy as well as rebut the presumption that plaintiff relied on the alleged misrepresentations or the integrity of the market in making his or her purchases.”16 According to the court, the named plaintiffs thus subjected themselves to unique inquiries regarding their trading patterns and why they made investment decisions, whether the alleged fraud was in fact irrelevant to their purchase and sale decisions, and whether they profited on individual trades.17 Judge Forrest found that these inquiries would require considerable time and resources in discovery and at trial, to the potential detriment of absent class members, and would “threaten to become the focus of the litigation.”18 The court thus concluded that none of the three named plaintiffs satisfied Rule 23’s adequacy or typicality requirements and that class certification must be denied on that basis as well.
THE DELAWARE COURT OF CHANCERY’S DECISION ON DEMAND FUTILITY A shareholder derivative suit filed in the Delaware Court of Chancery by two other China Automotive investors met a similar fate. In that case, Garnett v. Chen, the plaintiffs accused China Automotive’s five directors (two inside and three independent) of breach of fiduciary duty on the basis of the same underlying facts related to the company’s accounting treatment for the convertible notes described above and the subsequent restatement of its financials. Specifically, the complaint alleged that the members of China Automotive’s board breached their fiduciary duties by failing to maintain adequate accounting controls and by utilizing improper accounting and auditing practices in connection with the convertible notes, leading to the company’s issuance of allegedly false and misleading statements. The complaint also accused the
two inside directors of insider trading and unjust enrichment. The defendants moved to dismiss the complaint under Delaware Court of Chancery Rule 23.1 on the basis of the plaintiffs’ failure to make a pre-suit demand on China Automotive’s board or to establish “demand futility” through allegations of particularized facts. On Aug. 30, 2013, after briefing and oral argument, Vice Chancellor John W. Noble granted the motion,19 dismissing the complaint with prejudice on the ground that demand was not excused under Rule 23.1. Among other things, the court found that the plaintiffs failed to allege any “particularized facts about the defendants’ knowledge of any “red flags” and that mere conclusory allegations of committee membership were not enough to infer bad faith on the part of the independent directors.20
There are three circumstances in which a director is not entitled to deference when considering a demand: •
The director faces a substantial threat of personal liability.
The director is interested.
The director is not independent.25
The plaintiffs alleged that each of the defendants faced a substantial threat of personal liability for breaching their fiduciary duties as directors of China Automotive through their inadequate oversight of the company’s accounting practices and their issuance of misleading financial statements that improperly valued the convertible notes. According to the plaintiffs, the defendants knew, or should have known, that the company’s statements about its financial condition contained material misstatements
The decision denying class certification appears to be the first of its kind in a federal securities fraud class action against a Chinese “reverse merger” company. In a shareholder derivative action, the claims are asserted on behalf of the company, not its shareholders. Accordingly, to proceed with such an action, a plaintiff must either first make a demand on the company’s board of directors that it pursue the claims in question or allege specific facts demonstrating that any such demand would have been futile because a majority of the company’s directors themselves face a substantial likelihood of liability based on the claims at issue and/or otherwise have a personal interest in the matter.21 The plaintiffs conceded that they did not make a demand on China Automotive’s board before filing the complaint.22 Under Delaware law, the test for whether demand is excused depends on whether the derivative complaint alleges that the current board of directors took wrongful action or wrongfully took no action.23 In this case, the allegations concerned board inaction, and therefore the court applied the analysis under Rales v. Blasband to determine “whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.”24
or omissions and did not act to correct these improper misrepresentations. With respect to the three independent directors, the complaint alleged that they were subject to a substantial threat of personal liability for breach of fiduciary duty by virtue of their membership on China Automotive’s audit and compensation committees, and/or were not independent for purposes of the demand futility analysis because they were allegedly beholden to the two inside directors. Vice Chancellor Noble rejected both contentions. Despite being styled otherwise, the court recognized that the plaintiffs’ allegations essentially amounted to a Caremark, or duty of oversight, claim, which is considered “possibly the most difficult theory in corporation law” to support a stockholder derivative action.26 In order to successfully plead a Caremark claim, there must be a prerequisite showing of bad faith, which requires particularized allegations of a “sustained or systematic failure of the board to exercise oversight.”27 The court rejected the plaintiffs’ contention that the independent directors faced a “substantial threat of personal liability” because of their roles on China Automotive’s audit and compensation committees, since the allegations of fact,
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even when viewed in the light most favorable to plaintiffs, contained no particularized allegation that the directors knew at the time that the company’s financial statements were false or that they had any direct or personal involvement in the company’s preparation of the financial statements. As the court stressed, “[m]ere membership on the audit committee is not enough for the court to infer bad faith.”28
Combined, the two decisions should effectively terminate all litigation against China Automotive and its board. Absent a substantial threat of personal liability for the three independent directors (who constituted a majority of the board), the plaintiffs could still have shown demand futility by providing particularized allegations that these three defendants were unable to consider a demand impartially because they were otherwise interested or not independent.29 Directors are interested for the purposes of demand futility if they “appear on both sides of a transaction [or] expect to derive any personal financial benefit from it in the sense of self-dealing.”30 A director may lack independence in the demand futility context if the director is so “beholden” to the interests of another such that the independence of the director’s discretion would be compromised.31 In this case, Vice Chancellor Noble found that none of the plaintiffs’ allegations suggested that these three directors were interested or conflicted by receiving a material benefit, since they had not been accused of insider trading or any other form of self-dealing.32 Furthermore, the court rejected the contention that any of the directors were
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so beholden to the inside directors as to threaten their independence. Because the court found that the plaintiffs had not made any particularized showing that any of the three independent directors (who together constituted a majority of the board) either faced a substantial likelihood of personal liability or were otherwise interested, pre-suit demand was not excused with respect to any of the claims asserted in the complaint.33 Accordingly, the action was dismissed with prejudice.
CONCLUSION The decision denying class certification in the federal securities action has received a significant amount of press. Given the bases for the court’s ruling, it appears to be the first of its kind in a federal securities fraud class action against a Chinese “reverse merger” company (i.e., one that acquires a public U.S. shell company and can thereby go public in the United States without conducting a formal initial public offering). These companies have come under intense scrutiny by regulators and the plaintiffs’ bar in recent years. The Delaware court’s decision dismissing the shareholder derivative lawsuit reinforces the primary role of the board of directors when it comes to claims asserted in a company’s name and makes clear that a shareholder who seeks to usurp the board’s role in this regard must meet a high pleading threshold. Combined, the two decisions should effectively terminate all litigation against China Automotive and its board relating to the company’s accounting treatment for the instruments in question and its related restatement of its financials. WJ
Id. at *2, citing Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 133 S. Ct. 1184, 1192 (2013). 6
485 U.S. 224, 241 (1988).
Id. at 241-249.
Id. at *9, citing 711 F. Supp. 1264, 1286-87 (D.N.J. 1989). 9