This Document Contains Chapters 16 to 18 Chapter 16: Corporations OVERVIEW This chapter continues the unit’s coverage of business entities by examining the laws that govern the formation, structure, and operation of a corporation. The chapter also covers how corporations are formed, capitalized, taxed, and structured. Finally, the focus shifts to fiduciary duties of the officers, directors, and majority shareholders. Note that regulation of corporate securities and publicly-held corporation are covered in the next chapter. KEY LEARNING OUTCOMES Outcome Accreditation category Identify the sources and level of law governing formation, demonstrate an understanding of the corporation as a legally independent person, and give examples of liability for improper formation by a promoter. Knowledge, Analysis Understand the concept of a corporate veil and recognize circumstances under which a court will pierce the veil and the impact on the principals. Knowledge, Analysis, Critical thinking Provide the primary methods for capitalizing and taxing a corporation. Knowledge Describe the fundamental structure and roles for owners and managers of the corporate form of entity and demonstrate an understanding of the functions of each role and how the structure is governed. Knowledge, Analysis Identify the major fiduciary duties owed by insiders of a corporation to its shareholders, give examples of each duty, and apply the business judgment rule. Knowledge, Analysis, Critical thinking TEACHING OUTLINE A. Corporations [P.447] Teaching Tip: Media perception of “corporations” Students typically associate the word corporation with the multi-national, conglomerate powerhouses that dominate media headlines. Students benefit from the instructor pointing out that while the multi-national is an example of one type of corporation, that most businesses that choose the corporate form of entity are medium and small business owners. The relative ease and minimal cost to form a corporation make it an attractive entity even for a one-person business in some cases. Explaining that a corporation is a legal term describing a business entity, not a term that describes a type of business, and that many small business owners incorporate their business, is a logical place to begin this chapter. Points to emphasize: • A corporation is a fictitious legal entity that exists as an independent “person” separate from its principals. • Corporations are created through a state law filing, formation is governed through state statutes, and federal laws regulate the offering or trading of ownership interests to the public. • Categories of Corporations: The two major categories of corporation are those that are privately held and those that are publicly held. o Privately Held versus Publicly Held: Privately held corporations are those that do not sell ownership interests through sales via a broker to the general public or to financial institutions or investors and thus have substantial flexibility in terms of their internal operating procedures. • Even though many privately held corporations have a relatively small number of shareholders, there is no limit in terms of revenue. • When a privately held corporation wishes to sell their ownership interest via public stock exchanges, the principals pursue an Initial Public Offering and then continue their corporate existence as a publicly held corporation. o Other Categories: Corporations may also fall into one of the following categories: domestic, foreign, alien, nonprofit, public corporation, and professional corporations. • Formation: Promoter files articles of incorporation with a state authority that sets out the corporation’s name, purpose, number of shares issued, and address of the corporation’s headquarters in addition to filings with tax authorities according to state statutes. o Upon approval by the state authority, the corporation is legally recognized as a business entity. • Preincorporation Activity: Liability of Promoters: Generally, the personal promoter is personally liable where she knows (and the other party has no reason to know) that the corporation is not in existence on the day of the signing. o A promoter’s personal liability ceases at the moment that the corporation is formed and has adopted the contract. Case 16.1: Branch v. Mullineaux , 1010 NY Slip 31850 (N.Y. County) [P. 450] Facts: Branch agreed to provide $75,000 in short-term financing to three individuals, Mullineaux, Gefter, and Satsky (MGS), for purposes of starting up a venture called Stereo House in which the principals would profit by arranging parties in a luxury beach house in the Hamptons (Long Island, NY) and charging guests to attend these events. Branch entered into an agreement with MGS whereby they agreed that the yet-to-be-formed venture would pay back the money to Branch at an interest rate of 10% over four months. The venture was ultimately unsuccessful and Stereo House was unable to pay back the majority of loan. Issue: Are MGS liable for Stereo House liabilities as individuals under a theory of promoter liability? Ruling: Yes. The court ruled that because the agreement was executed prior to formation of the entity, MGS created individual liability to Branch. MGS were liable as individuals since promoters who execute pre-incorporation contracts in the name of a proposed corporation are personally liable on the contract unless the parties have agreed otherwise. Case Questions 1. What steps should MGS have taken to help limit their promoter liability? Answer: Use of specific agreement that made is clear that all pre-incorporation liabilities are liabilities of the corporation once the entity is formed (ratify the transactions). Also, MGS could have formed the corporation BEFORE entering into the financing. 2. Isn’t Branch’s loss a risk of doing business? Why should MGS be individually liable? Answer: Yes. However, the transaction at issue is a loan (Branch did not buy ownership) and therefore must be paid back as a liability. Since it was a pre-incorporation debt, the promoters assumed liability. • Choice of State of Incorporation: Despite some significant advantages for large publicly held corporations gained by incorporating in Delaware, most corporations are better served by incorporating in the state where they are headquartered. • Capitalization: Corporations may be funded through debt or through the selling of equity in a variety of forms. o Debt: Corporations often borrow money from either commercial lenders or private investors to fund day-to-day operations, and may also issue bonds or debentures for larger projects. o Equity: For modest amounts of funding, corporations may turn to private investors or groups of investors, and sometimes a corporation will hire a registered broker-dealer to issue securities. o Venture Capital Firms: Funding provided by a group of professional investors with substantial resources for use in a developing business. o Public Offerings: When a privately held corporation’s expansion plans require even more capital than can be raised using private investors they can convert into a publicly held corporation whereby they may raise equity by selling its shares to the general public and to financial institutions. • Initial Organizational Meeting: After the filings of incorporation, the principals typically hold an organizational meeting where the principals address such issues as the bylaws, board of directors and officers and issuance of shares. Concept Summary: Corporate Formation [P.453] • Commencement of Business and Corporate Formalities: Once the corporation has been properly formed and postformation organizational matters have been attended to, the corporation’s officers commence business operations and officers and directors have a responsibility to comply with corporate formalities (state statutory requirements regarding shareholders/directors meetings, filing annual reports, disclosures to shareholders, and updating bylaws). o Liability: In general, shareholders, directors, and officers of a corporation are insulated from personal liability in case the corporation runs up large debts or suffers some liability (referred to as the corporate veil). • The liability issue is tempered by personal guarantees from the principals and when the court pierces the corporate veil. o Personal Guarantees: Lenders almost always require a personal guarantee that allows the creditor to obtain a judgment against the personal assets of one or more shareholders in the event of a default by the corporation, frequently in addition to any collateral that is pledged by the shareholders or the corporation itself. • Taxation: Before selecting an appropriate form of entity, the parties try to anticipate the best way to minimize taxes while maintaining an appropriate degree of liability protection. o “C” corporations are considered a separate legal, taxable entity from the owners for income tax purposes and therefore are subject to double taxation (taxation occurs at the corporate level when income is earned and also at the individual level when dividends are distributed). o Corporations that qualify for an elect “Subchapter S” treatment offer pass-through tax treatment that offers the potential benefits of use of losses to limit tax liability and avoiding double taxation. o In order to qualify as an “S” corporation, the corporation must is subject to the following restrictions: limited classification, single class of stock, no corporate shareholders, limited scope of business, limited number and type of shareholders, 80 percent subsidiaries, and unanimous consent. • Figure 16.1: Taxation of C Corporations vs. S Corporations [P.455] Concept Summary: Corporate Form of Entity [P. 456] B. Structure, Management, and Operation [P.456] Chalk talk: Diagram for Corporate Structure Before I cover this section, I draw a simple figure on the board and insert arrows as I explain the role of each group. I have also found that students benefit from the same chart in understanding fiduciary duties owed by officers and directors. Points to emphasize: • Fundamentally, corporations are structured around an allocation of power based on three categories: shareholders, directors, and officers. • Shareholders: The owners of the corporation and act principally through electing and removing directors and approving or withholding approval of major corporate decisions. o Some corporations issue voting stock to some shareholders and nonvoting stock to other shareholders to ensure that a certain shareholder or group of shareholders can control the corporation while still allowing other shareholders the ability to receive payments from the corporation’s profit • Board of Directors: An independent body from the shareholders and officers that is responsible for the oversight and management of the corporation’s course of direction. o Election of Directors: Shareholders elect directors and the bylaws typically set out the term of office, the number of directors, and procedures and requirements for an election. o Removal of Directors: Directors may be removed by a shareholder vote with or without cause or, less frequently, by a court order (only for cause). o Meetings: Acts of the board of directors take place only at official meetings that occur at a regular annual or semiannual time as specified in the corporation’s bylaws or by statute, and the votes of a majority of directors that are present at a meeting or unanimous written consent are required to take action. o Committees: A small group of board members who are charged with oversight or to perform a given task and make a recommendation to the full board. • Officers: Those appointed by the board of directors to carry out the directors’ set course of direction through management of the day-to-day operations of the business in accordance with the bylaws. o President: Has the implied power to bind the corporation in ordinary business operation transactions and the oversight of nonofficer employees. o Vice President: Depending on the size and scope of the corporation, may have some limited implied authority. o Treasurer: Aside from the routine tasks of collecting the accounts receivable and paying the accounts payable, has little or no other implied authority. o Secretary: Has the implied authority to certify the records and resolutions of the company by affixing his signature. • Fiduciary Duties of Officers and Directors: Officers, directors, and controlling shareholders owe corporate shareholders the fiduciary duties of care and loyalty; breaching these duties may result in personal liability. o Duty of Care: First, the officer and director must always act in good faith; second, they must also act with the care that an objectively prudent person in a like position would exercise under similar circumstances; and third, they must carry out their duties in a manner that is reasonably calculated to advance the best interests of the corporation. • A director breaches her duty of care when she fails to fulfill her role in oversight through acting negligently, failing to act with diligence, or acting as a “rubber stamp.” • Directors can rely on the expertise and assurances of others to fulfill their duty of care so long as that reliance is reasonable in terms of the director’s belief in their competence. o Business Judgment Rule: Protects officers and directors from liability for decisions that may have been unwise, but did not breach the duty of care. • In order for directors and officers to have protection under the business judgment rule, the director/officer must have exercised good faith, have no private financial self-interest, and must use diligence to acquire the best material information related to a proposed decision. Self-Check: Business Judgment Rule [P.462] Landmark Case 16.2 Smith v. Gorkom, 488 A.2d 858 (Del. 1985) [P.463] Facts: Van Gorkom was an officer, director, and shareholder of Trans Union, a publically traded corporation. He sought to sell his shares to an individual investor for $55 per share. Because his ownership was substantial, the transaction required the board’s approval, and though most of the other officers, including the CFO, opposed the sale on the basis that the price was too low given the value of the company, the board approved the transaction. A group of shareholders brought a lawsuit against the directors of Trans Union based on a breach of the duty of care that resulted in the stock being sold at a value well under its actual worth. The directors sought protection under the business judgment rule, claiming they relied on Van Gorkom’s representations and the NYSE stock price (previously never sold for higher than $39 per share). Issue: Did the directors satisfy their duty of care in approving the transaction in order to qualify for business judgment rule protection? Ruling: No. The directors have a duty to investigate all material facts of a proposed transaction before approving it in order to be afforded protection under the business judgment rule. Here, the board never even reviewed Van Gorkom’s agreement, nor had they undertaken anything more than a cursory inquiry into the actual value of the corporation. Answers to case questions: 1. Assume that the directors were highly sophisticated business executives. Should they have to consult others about issues where they already have sufficient knowledge (such as a company’s valuation)? Answer: Directors have a duty to be diligent in investigating any proposal, decision, or transaction and this includes, when appropriate, consulting outside experts. If the directors were highly sophisticated business executives with sufficient knowledge in determining a company’s valuation, they are not required to consult others. However, they must use diligence to acquire all material information related to a proposed decision. In the case at bar, the primary issue was not as to the sophistication of the executives, rather it was whether the directors informed themselves as to all information that was reasonably available to them. 2. Note that, in light of Van Gorkom, many states (including Delaware) passed statutes that extended the scope of the business judgment defense. Should the business judgment rule protect directors even when they failed to verify the statements of internal management concerning a corporate transaction that is being touted to officers as advantageous to the corporation? Answer: Under the RMBCA, directors may still fulfill their duty of care even though they did not personally verify the records or other information provided to them by internal management. Directors may rely on opinions, reports, statements, and financial records if these were presented by the officers of a corporation whom the director “reasonably believes to be reliable and competent in these matters.” As long as directors acted in good faith and with a reasonable and rational belief when relying on statements of internal management, then they should be protected under the business judgment rule in order to balance the interests in corporate decision making with the interests of shareholders. o Duty of Loyalty: Primarily focused on providing protection to shareholders in cases where a transaction occurs where the possibility of self-dealing is present • Prohibition against Certain Self-Dealing: Where an officer, director, or controlling shareholder has some personal financial stake in a transaction that the corporation is engaged in and the officer, director, or shareholder helps to influence the advancement of the transaction. • A self-dealing transaction is not a breach of the duty of loyalty so long as a majority of disinterested parties approved it after disclosure of the conflict. • Typically, the modern trend has been for courts to allow such transactions so long as they are, under the circumstances, fair to the corporation and performed in good faith. • Corporate Opportunity Doctrine: The duty of loyalty also requires disclosure and good faith when an insider learns of a potentially lucrative business opportunity that could enrich her individually, but is related to the corporation’s business. • Courts use several factors to determine when an opportunity belongs to a corporation and is therefore off-limits to insiders unless they have followed specific disclosure steps: (1) Did the corporation have a current or expected interest in the opportunity; (2) Is it fair to the corporation’s shareholders to allow another to usurp a certain interest; and (3) Is the opportunity closely related to the corporation’s existing or prospective business activities? • Insiders who become aware of a corporate opportunity belonging to the corporation must disclose the opportunity the corporation in total, and if the board rejects the opportunity, the insider is free to pursue the opportunity without liability. Concept Summary: Fiduciary Duties of Officers, Directors, and Controlling Shareholders [P.465] • Breach of Fiduciary Duty Lawsuits by Shareholders: Shareholders enforce their rights and fiduciary duties through the use of a lawsuit in the form of a shareholder’s derivative action or a shareholder direct action. o In a derivative suit, an individual shareholder (or a group of shareholders) brings a lawsuit against an insider in the name of the corporation itself. A direct action is when the shareholder brings the suit on her own behalf. o Limiting Director Liability: A corporate board typically has severally measures in place designed to limit their liability, including appointing oversight committees to monitor executive management, consulting with outside professional firms in decision making, and approving a limited liability provision in their corporate charter that eliminates any liability for ordinary negligence on the part of directors and officers. Case 16.3 H. Carl McCall, Trustee of the New York Common Retirement Fund, et al., Derivatively on Behalf of Columbia/HCA Healthcare Corporation v. Scott, et al., 239 F.3d 808 (6th Cir. 2001) [P. 466] Facts: McCall and other shareholders brought a derivative suit against Scott and all other officers and directors of Columbia, a healthcare corporation, alleging breach of fiduciary duty claims. The shareholders claimed that the board had intentionally and/or recklessly disregarded fraudulent activities of senior management, including management’s attempt to improperly boost revenue through systematic overbilling for a period of two years. The directors defended by citing a limited liability provision in their corporate charter that limited the liability of the directors in the case of an allegation of the breach of duty of care so long as they did not act in bad faith. Issue: Is Columbia’s limited liability provision valid given the circumstances? Ruling: No. Limited liability provisions in corporate charters are unenforceable in the face of gross, ongoing negligence by the directors to notice or investigate the illegal conduct of the corporation’s officers. Answers to case questions: 1. If the corporation’s officers have carefully covered up the wrongdoing, is it still fair to hold directors liable for failing to detect the illegal activities? Answer: In this case, the court focused on the magnitude and duration of the alleged wrongdoing in determining whether the failure of the directors to act constituted bad faith. If the corporation’s officers were so careful as to cover up the wrongdoing that it was never brought to the boards attention, and the board acted in good faith giving due attention under the circumstances, than the court may have upheld the limited liability provision. There is no fine line determining when the directors are liable for ordinary negligence, which is why limited liability provisions are a controversial method for limiting director liability. In this case however, it is apparent that the board was grossly negligent in their willful ignorance in the face of unusual audit information, notification of a federal investigation, and a story in the media regarding the officers’ practices. Moreover, given the procedure of a derivative action, the board was given a formal demand and still failed to take corrective action. 2. Is it ethical for directors to include a waiver of liability for shareholder suits in their corporate charter? Is it sound public policy for courts to recognize a limited liability provision in a charter? Why or why not? Answer: The ethical dilemma surrounding waivers of liability for shareholder suits can be argued either way. One could argue that it is not sound public policy for courts to recognize a limited liability provision charter because directors are charged with the responsibility to not only appoint officers but also to oversee the corporation. In this context, it only makes sense that they should not be able to waive liability for shareholder suits because they would essentially be accepting limited responsibility for their very role in the corporation. Conversely, there are equitable concerns that can be argued to support limited liability provisions in charters. Considering the hypothetical posed in the first case question, it would seem unfair to impose complete liability on directors for all negligence of officers when they are acting in good faith. Especially in larger corporations, the directors cannot possibly inquire into every risk posed by the conduct of the corporation’s officers. • Piercing the Corporate Veil: The corporate veil that shields the personal assets of principals from corporate debts and liabilities may be pierced in certain cases of inadequate capitalization, fraud, or failing to follow corporate formalities. -Still, courts are reluctant to discard the corporate entity. Case 16.4: Florence Cement Company v. Vittraino, 292 Mich. App. 461 (2011) [P. 466] Facts: Shelby Property Investors (“Shelby”) was a company engaged in developing and selling residential real estate that was chiefly managed by Essad, one of three principals in the entity. Florence Cement Company (“Florence”) contracted with Shelby to perform concrete and asphalt work at one of Shelby’s properties. Ultimately Shelby’s real estate venture did not yield a profit, but Shelby was able to pay all sub-contractors on the job except one- Florence. When Florence sued to recover $114,557 it was owed, Shelby was without assets. Florence sought to pierce Shelby’s corporate veil and hold the principals personally liable. Issue: Should the court pierce the corporate veil because Shelby: 1) was not an authentic business entity because of the principals’ mixing personal and business transactions, and 2) had engaged in fraud by misrepresenting facts to their bank concerning a loan used to pay sub-contractors? Ruling: Yes. The court pointed to Shelby’s company history which indicated that principals treated the their own liabilities as Shelby's liabilities and vice versa, intentionally undercapitalized Shelby, causing Shelby to be continuously insolvent, including at the time it contracted with Florence. Essad also falsified the sworn statement in the final loan draw request to the bank and this constituted use of Shelby for fraudulent purposes. Case Questions 1. What steps could Shelby’s principals could have taken to help prevent any piercing of their corporate veil? Answer: Separated the entities liabilities from personal liabilities; fully capitalize the entity; provide honest answers on the bank application. 2. If Essad had not committed the fraudulent bank transaction, would the court have allowed the veil to be pierced? Why or why not? Answer: It would have been a tougher case. The presumption is that the corporate form is valid unless the opposing party can show reasons to pierce. Courts have to make distinction between negligence in keeping records and actually discarding the corporate entity by the principals. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES Theory to Practice [P. 470] 1. Pharma is a privately-held corporation because they do not sell ownership interests through public markets such as the NYSE. To raise capital, Pharma may use debt (either a loan from a private investor or a commercial lender; issue a bond/debenture) or through equity (sale of ownership interest to existing or third parties). Pharma may sell stock in their venture to the public (without the use of public markets), but that process is heavily regulated by federal and state securities law. [Ties to Corporations: Categories; Capitalization]. 2. As presented in the facts, Pharma would be eligible to receive tax treatment as an “S” corporation, but the consent must be unanimous among the shareholders. Thus, if even one of the shareholders objects, Pharma may not elect “S” status. [Ties to Taxation]. 3. As president, Adams has the implied power to bind the corporation in ordinary business operation transactions. Adams is permitted to hire Elliot at his own discretion and without need for approval from the shareholders. Cornelius is a shareholder, but not an officer or director, and does not typically have the power to fire an employee such as Elliot. [Ties to Officers]. 4. Because Adams and Barker collectively own 70% of the stock, they can approve the sale for the assets without Cornelius’s approval. Some states have statutes that require higher percentages of shareholder approval for a sale of assets, but 70% is a majority position which can be used to make decisions about the corporation’s actions. [Ties to Structure Management and Operation]. 5. Adams and Barker may very well have breached their fiduciary duty (as officers and directors) to Cornelius by approving the sale so hastily. The employment agreements offered by MD could be the basis for shareholder’s claim that they violated prohibitions against self-dealing and breached their duty of loyalty. As directors, they had a duty of care and must act in good faith. There were several instances where Adams and Barker’s conduct may have constituted a breach of their fiduciary duty. [Ties Fiduciary Duties of Officers and Directors]. 6. The pre-requisites for asserting the business judgment rule are: 1) good faith, 2) no self-interest, 3) diligence in acquiring best information. Here Adams and Barker’s hasty decisions and conflict of interest via the employment agreement may very well prevent them from asserting the business judgment rule. [Ties to Business Judgment Rule]. 7. a) Derivative (typically used when a shareholder alleges a breach of fiduciary duty). b) Direct (typically used when shareholder is alleging some oppression of minority shareholders or when a question of voting rights is concerned). Manager’s Challenge [P.471] Sample answers to all Manager’s Challenge exercises are provided in the student and instructor’s versions of this textbook’s Web site. Case Summary 16.1: Piercing the Corporate Veil: Miner v. Fashion Enterprises, Inc. [P.471] 1. Who prevails and why? Answer: Fashion Enterprises prevails because there is no evidence that Fashion Enterprises engaged in fraud or wrongdoing. 2. What factors would the court weigh in deciding whether to pierce the veil? Answer: Courts will primarily weigh four factors in deciding whether to pierce the veil: (1) inadequate capitalization; (2) the nature of the claim; (3) evidence of fraud or wrongdoing; and (4) failure to follow corporate formalities. Case Summary 16.2: Corporate Veil Protection: Goldman v. Chapman [P. 471] 1. Who prevails and why? Answer: The court ruled in favor of Chapman because there was no basis for piercing the veil. 2. Did Chapman use the law to perpetrate an injustice? Answer: Chapman did not necessarily use the law to perpetrate an injustice, as the primary purpose of incorporating is to shield officers, directors and shareholders from personal liability. The fraud element in the courts analysis is what distinguishes an individual attempting to use the law to perpetrate an injustice from a simple business failure. 3. Is it fair that Goldman is stuck with a worthless judgment and that Chapman may simply start a new company for the next construction project? Answer: It may not be equitable that Goldman is stuck with a worthless judgment; however, Goldman could have taken precautions to prevent his present situation. First, he could have exercised due diligence before making the investment with Region. Additionally, knowing that Region is a corporation and Chapman is therefore shielded from liability via the corporate veil, Goldman could have required a personal guarantee. Such a guarantee would have allowed him to obtain a judgment against the personal assets of Chapman in the event of a default by Region. Case Summary 16.3: Shareholder Rights: Morrison v. Gugle [P.472] 1. Who prevails and why? Answer: Morrison prevails on the breach of fiduciary duty claim because Gugle’s failure to provide any information or access to the records was an oppressive attempt to prevent Morrison from having an equal opportunity in the corporation. 2. Does the president have the power to fire a fellow officer and director who is also half owner of the corporation? Answer: No, the president has implied power only in the oversight of nonofficer employees. Only the shareholders can remove a director and only a director can remove an officer in a traditional corporate structure. 3. What fiduciary duty, if any, was breached here? Answer: The duty of loyalty was breached here because it is intended to prevent oppression of minority shareholders and self-dealing. Case Summary 16.4: Business Judgment Rule: Grobow v. Perot [P.472] 1. Who prevails and why? Answer: The directors prevail because they acted in good faith, had no private financial self-interest, and used diligence to acquire the best material information related to a proposed decision in appointing a subcommittee to study possible alternatives. 2. What fiduciary duty is at issue? Answer: The duty of care is at issue because the shareholders are alleging that the directors are wasting corporate assets by acting negligently. Case Summary 16.5: Liability of Directors: Burdick v. Koerner [P.472] 1. Who prevails and why? Answer: The directors would prevail because absent any specific knowledge of the infringement by the directors, it would be unlikely that they acted negligently and in bad faith. 2. Does the corporate veil protect directors in these circumstances? Answer: Yes, the corporate veil insulates directors in these circumstances where the corporation suffers some liability and there is no evidence of fraud or wrongdoing whereby the veil can be pierced. Quick Assessment Questions (QAQs) 1. According to the Court in Smith v. Van Gorkom, which of the following is true? a. Delaware is the best choice of state of incorporation because their broad business judgment rule protection shields all directors from any liability. b. Directors can never rely on the expertise and assurances of others to fulfill their duty of care. c. The board of directors has the duty to investigate all material facts of a proposed transaction before approving it. d. The board of directors has the duty to consult with financial analysts prior to determining a company’s valuation. e. None of the above Answer: c 2. Which factor(s) do courts consider when determining whether or not to pierce a corporation’s protective veil? a. Evidence of fraud or wrongdoing b. The category of the corporation c. Inadequate capitalization d. a and c e. All of the above Answer: d 3. The formal incorporation process is set in motion when _______. a. The Initial Public Offering is filed b. The Articles of Incorporation are filed c. The Promoter Bylaws are filed d. The Corporation Agreement is filed e. An individual or group of individuals designate themselves as a corporation in carrying out a business venture Answer: b 4. A corporation is a fictitious legal entity that exists as an independent “person” separate from its principals. Answer: True 5. Subchapter S corporations are subject to double taxation. Answer: False 6. Officers of a corporation are those that manage the day-to-day operations of the business. Answer: True Chapter 17: Regulation of Securities, Corporate Governance, and Financial Markets OVERVIEW This is the final chapter in this unit and it provides comprehensive coverage of securities law. The approach is tailored to students who are not familiar with the securities market. The chapter begins with an overview of the market, the legal definition of a security, categories of securities, and regulation of securities issuance and transactions. Coverage then shifts to regulation of publicly-held companies and the financial markets including Sarbanes-Oxley, the TARP program, and the Wall Street Reform and Consumer Protection Act. KEY LEARNING OUTCOMES Outcome Accreditation Category Articulate factors that differentiate, and the laws that regulate, the primary and secondary securities markets. Knowledge Apply the legal test for what constitutes a security, distinguish between classifications of equity and debt instruments and give an example of each. Knowledge, Analysis, Critical thinking Describe the role of the Securities and Exchange Commission (SEC) in securities law compliance and enforcement Knowledge List the major categories of securities and transactions that are exempt from registration requirements. Knowledge Understand the ethical and legal duties of corporate insiders. Knowledge, Ethics Show an awareness of the impact of the Sarbanes-Oxley Act on a corporation’s officers and directors and its corporate governance and give examples of key protections afforded by regulation of the financial markets. Knowledge, Analysis, Critical thinking TEACHING OUTLINE A. Overview of the Securities Market [P.475] Points to emphasize: • Securities transactions occur in primary markets and secondary markets and are governed by federal and state securities law. • In the primary market, issuers raise capital by selling securities in public markets (to the general investment community) or in private placements (to limited groups of investors). • In the secondary market, investors trade already-issued securities to other investors in hopes of making a profit or preventing a loss. • Once a company has sold shares to the public, it becomes subject to extensive reporting requirements to federal regulators; however, some security transactions are exempt from full registration, and the law allows a fast-track system for securities that fall into the category of relatively small offerings or private placements. • Security Defined: Business owners and managers need a working knowledge or what instruments and transactions that federal and state laws define as a security and a security offering. o Federal Securities Law: Federal securities statutes define a security in two ways: (1) by recognizing specific forms of securities such as notes, stocks, treasury stocks, transferable shares, bonds, and debentures, and (2) by providing a catchall definition of other investment transactions in a more generic sense, including participation in profit sharing agreements; collateral trust certificates; preorganized certificates or subscriptions; investment contracts; and a fractional, undivided interest in gas, oil, or other mineral rights. • A security is any investment where a person gives something with an expectation of profit through the efforts of a third party. • Modern Application of the Howey Test: Courts now apply a sweeping standard including the investment itself, commonality, profit expectations, and the efforts of others. o Investment: May be cash or noncash where the investor’s primary motive is expectation of profit. o Commonality: An investment scheme satisfies this requirement either through horizontal commonality (multiple investors in a single transaction) or via vertical commonality (single investor in a single transaction). o Profit Expectations: The expectation of a return on investment must be the primary reason for the investment. o Efforts of Others: The efforts of the promoter(s) or agents of the promoter(s) must be the primary sources of revenue that resulted in the profits (modern rule: limited passive involvement by the investor is OK). Landmark Case 17.1 SEC v. W.J. Howey Co., 328 U.S. 293 (1946) [P.478] Facts: Howey owned large tracts of citrus acreage and offered an investment opportunity whereby investors could purchase a certain tract of the real estate and enter into an optional service agreement in which Howey would care for and harvest the citrus crop and those that signed would be given a percentage of the profits from the harvest. Approximately 80 percent of the investors entered into the service contract and the SEC charged Howey with several violations of federal securities law, alleging that the investment constituted a security subject to registration requirements. Howey argued that the transaction was simply a contractual agreement for a real estate purchase with an optional profit sharing opportunity and both the trial court and circuit courts of appeals agreed. Issue: Does Howey’s offering constitute an investment contract subject to federal regulation? Ruling: Yes. The court developed the Howey test as a four-part analysis for determining what constitutes a security subject to federal regulation. Courts examine whether the investment opportunity at issue is (1) an investment of money, (2) which is invested in a common enterprise, (3) the investor did so with expectations of profit, and (4) the profits were generated solely by the efforts of persons other than the investor. Answers to case questions: 1. Could Howey adjust the business model and retool the opportunity without triggering securities regulation? How? Answer: Howey could adjust the business model and retool the opportunity without triggering securities regulation. Here, he could have adjusted the optional service aspect of the agreement whereby Howey would offer limited management services to assist the investors rather than complete management, control and operation. In this circumstance, the profits would not be generated solely by the efforts of Howey. 2. Recall from the facts that the service contract was optional and approximately 20 percent of the investors purchased the real estate only. Do those 20 percent of investors satisfy the four-part test? Was it enough to satisfy the test that all investors had the mere opportunity to enter into the service agreement? Answer: The 20 percent of investors who elected for only an interest in land do not satisfy the four-part test because Howey is uninvolved in the profit generation of the investment. It was enough to satisfy the test that all investors had the mere opportunity to enter into the service agreement because the Securities Act prohibits the offer as well as the sale of unregistered, non-exempt securities. Hence it is enough that the respondents merely offer the essential ingredients of an investment contract. Concept Summary: Modern Howey Test [P.477] Self-Check: The Howey Test: Do these opportunities constitute a securities offering under the Howey test? [P.478] B. Categories of Securities [P.479] Points to emphasize: • Securities fall into one of two general categories: equity or debt. • Equity Instruments: Represent an investor’s ownership interests where financial return on the investment is based primarily on the performance of the venture that issued the securities. o Common Stock: Form of equity instrument in which the equity owner is entitled to dividends based on the current profitability of the company. o Preferred Stock: A form of equity instrument that has less risk than common stock because it has certain quasi-debt features and whose holders have preference rights over common stockholders in receiving dividends from the corporation. • Debt Instruments: A common tool for raising capital including promissory notes, bonds, and debentures that represent a fixed rate of return regardless of the profitability of the corporation with repayment expected after a certain period of years. o Use of Bonds and Debentures: Bonds and debentures represent the borrowing of money from investors to raise capital for the corporate issuer of the debt instrument and investors expect fixed payments at regular intervals until the bond matures, at which time the face amount is paid to the investor. • Micro bonds streamline paperwork, reduce fees, and are appealing to smaller business ventures that wish to take advantage of bond financing in the $500K-1M range. C. Securities Regulation [P.480] Points to emphasize: • The underlying premise of all securities regulation is disclosure to protect investors and assure public confidence in the integrity of the securities market. • Securities and Exchange Commission (SEC): The independent regulatory agency charged with rulemaking, enforcement, and adjudication of federal securities laws. o The SEC has broad executive, legislative and judicial authority over securities issuance, transactions, investors, and brokers. o The SEC works closely with many other institutions, including Congress, other federal agencies, self-regulatory organizations, state securities regulators, and various private sector organizations. o The agency is composed of several divisions and departments (Figure 17.1: Structure of the Securities and Exchange Commission [P.482]) • EDGAR: The SEC’s public computer database that provides access to public corporation disclosures and filing required by federal securities laws. • The Securities Act of 1933: Covers the process of issuing or reissuing securities to the public by requiring registration and certain disclosures and authorizing the SEC to oversee the transactions. o Preregistration Documentation: Required documentation before registration includes a letter of intent, comfort letters, and an underwriting agreement. o Registration: The proposed issuer drafts a prospectus with disclosures and financial information and submits the statement to the SEC who reviews the registration statement over a period of ten days and may either (1) issue a refusal order during the ten day review period or issue a stop order after the review period whereby the proposed issuer must revise and resubmit; or (2) take no action and the registration becomes effective 20 days after the original SEC filing at which point the security may not be sold to the public (Table 17.1: Phases of Securities Registration [P.484]). o Exemptions from Registration: Common types of securities that are exempt include those for nonpublic offerings to a limited number of sophisticated investors, regulatory safe harbor offerings, commercial paper, securities of charitable organizations, annuities and other issues of insurance companies, government-issued securities, and securities issued by banks. • Securities laws also exempt certain transactions that an issuer may use to sell the security such as Regulation D exemptions for limited offers of a relatively small amount of money or offers made in a limited manner. • Private placement exempts an issuer from registration where the issuer only accepts investments from those who meet the standards for accredited investors. Teaching Tip: Exempt securities By this point in the material, students sometimes get the wrong impression about the regulation of the issuance of securities. It is important to point out that a substantial amount of issuance take place on an exempt basis. It is equally important for student to realize how important it is to work closely with counsel when considering the use of any type of security to raise capital—including a business plan. I like to remind students that distributing a business plan to potential investors could constitute a securities offering and subject them to liability. • Exemption from registration does not exempt issuers from appropriate disclosures to investors and financial transparency. o Liability for Violations: Penalties for violation of the act’s provisions include (1) rescission of the investment by the investor, (2) civil penalties and fines, and (3) incarceration for egregious cases (Table 17.2: ’33 Act Liabilities and Penalties [P.486]). o Defenses: Liability of penalties may be avoided by successfully asserting one of two defenses: (1) the omission or misrepresentation in the registration or offering was not material, or (2) the investor had knowledge about the omission or misrepresentation and proceeded with the investment assuming the risk. • If the violator is not actually the issuer of the stock but a third party involved in the transaction, that party may avoid liability by proving she acted with due diligence in verifying the veracity and completeness of the required disclosures. o Bespeaks Caution Doctrine: Defense if the issuer included specific and narrowly tailored cautionary disclosures in the prospectus. Case 17.2: Kaufman v. Trump’s Castle Funding, 7 F.3d 357 (3d Cir. 1993) [P. 487]. Facts Trump and his co-defendants offered securities to the public in order to finance the purchase, construction, and operation of the Trump Taj Mahal casino. The prospectus stated: “The Partnership believes that the funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and principal).” The prospectus also contained numerous cautionary statements including the intense competition in the casino industry and the absence of an operating history for the Taj Mahal. When Kaufman and other investors discovered that Trump and his co-defendants planned to file for reorganization under Chapter 11 of the bankruptcy code, they filed a suit alleging that the Taj Mahal offering’s prospectus contained material misstatements and omissions and constituted fraud. Issue: Do the cautionary statements that surrounded each representation bar any misrepresentation claim against Trump? Ruling: Yes. The court applied the “bespeaks caution” doctrine whereby cautionary language in a prospectus negates the materiality of an alleged misrepresentation. The court held that the defendants had included substantive statements that were tailored to address specific future projections and estimates or opinions in the prospectus. Case Questions 1. Kaufman claimed that the prospectus failed to disclose the fact that the average casino “win” would have to top $1.3 billion per day in order to pay the debt back. Should Trump have disclosed that fact? Do issuers have a duty to disclose negative information in the prospectus? Answer: It is difficult to take a specific allegation and analyze it out of context. But the bespeaks caution doctrine is triggered so long as Trump made disclosures relating to the competiveness of the casino industry in general. 2. Is the “bespeaks caution” doctrine consistent with the ’33 Act’s overall goal of transparency and disclosure in a securities issuance? Why or why not? Could the doctrine be modified to be more favorable to an investor? Answer: It is consistent in the sense that disclosure is the primary purpose of the Act. It is up to a court to decide whether the disclosure was specific or not. The doctrine might be modified to require more specific disclosures (such as the rate of failure for casinos) to protect investors. • The Securities Act of 1934: Regulates the sale of securities between investors after an investor purchased it from a business entity issuer by requiring registration with the SEC for issuers who wish to have their securities offered on a national exchange, and compelling all sellers of securities to fully disclose all pertinent details to potential investors. o Section 10(b): An expansive antifraud provision intended to cover all actions, conspiracies, or schemes that could potentially result in an investor being defrauded, damaged, or misled. o Insider Trading: When a corporate insider has access to certain information not available to the general investor public, the insider may not trade in their company’s stock on the basis of the inside information. Case 17.3: U.S. v. Bhagat, 436 F.3d 1140 (9th Cir. 2006) [P. 488] Facts: NVIDIA, a publicly-held corporation that manufactured graphics processors and media communication devices located in Silicon Valley, employed Bhagat as an engineer. On Sunday, March 5, 2000, the chief executive officer of NVIDIA sent an e-mail to all company employees announcing that NVIDIA had entered into a contract with Microsoft to develop and manufacture 3-D graphics for Microsoft’s X-Box. The company subsequently gave specific instructions to keep the information confidential imposed a trading blackout. Bhagat purchased a large quantity of NVIDIA stock—his largest purchase in three years. After the news about NVIDIA’s contract with Microsoft was released, NVIDIA’s stock rose sharply and Bhagat reaped a substantial profit Issue: Does the government have to prove that Bhagat read his e-mail prior to executing the trade in order to convict him of insider trading? Ruling: No. The court held that even without direct evidence that Bhagat read any of the e-mails prior to purchasing the stock, the jury was allowed to infer Bhagat’s insider knowledge by virtue of the fact that he had probably read his company e-mail upon entering the office as a normal, reasonable person would. The court rejected Bhagat’s contention that his trades were made on “general strength of the stock” and questioned his credibility based on his testimony at trial that he had tried to cancel the transaction once he read the trading blackout e-mail, but could not recall the branch of the brokerage house he called, nor the name, or even the gender, of the representative he spoke with. Case Questions 1. Is Bhagat liable as an insider even though he was a relatively low-level employee? Why? Answer: Yes. The definition of an insider is very broad and includes even low- level employees who have access to information not available to the general investing public. 2. What role did Bhagat’s credibility play in this case? Answer: Bhagat’s testimony that he didn’t know about the deal and tried to cancel his stock order were beyond belief and helped the government prove that Bhagat was aware of the confidential X-Box information before he executed the trades. o Tipper-Tippee Liability: Both the tipper and tippee are liable for violating rule 10(b)(5) if (1) the information released by the tipper constituted a breach of the tipper’s fiduciary duty, (2) the tipper obtained some personal benefit by giving the tip, (3) the tippee knew or should have known that the information was wrongfully disclosed, and (4) the tippee benefited from the information. o Section 16: Provision of the ‘34 Act that imposes restrictions and reporting requirements on ownership positions and stock trades made by certain corporate insiders named in the statute to provide transparency and prohibit insiders from earning short swing profits. • Section 16(a) classifies any person who is an executive officer, a director, or a shareholder with 10 percent or more of ownership of the total stock as an insider and requires these insiders to file regular reports with the SEC disclosing stock ownership and trading of their company’s stock. • Section 16(b) is a limited liability statute that allows a corporation to recapture any short swing profits earned by an insider, even if the insider did not use any insider information or intend any stock manipulation in realizing the earnings. Case 17.4 SEC v. Switzer, et al., 503 F.Supp. 756 (W.D. Okla. 1984) [P.490] Facts: Switzer inadvertently overheard Platt, an executive at TIC, discuss highly confidential information about one of TIC’s subsidiaries, Phoenix, in a casual conversation with his wife while in the bleachers at a track meet. The next day Switzer convinced several investors to form a partnership for the purposes of purchasing large amounts of Phoenix stock, which neither Switzer and his partners ever heard of. Ultimately, Switzer and his partners earned a substantial profit from the purchase and sale of the stock and after an investigation, the SEC filed a complaint alleging that Switzer was a tippee in violation of rule 10(b)(5) of the ’34 Act. Issue: Did Switzer’s conduct meet the requirements of rule 10(b)(5) liability under the tipper-tippee theory? Ruling: No. It was not clear that Platt’s casual conversation with his wife constituted a breach of duty and Switzer and his partners had no reason to know if the information they received was material or confidential. Answers to case questions: 1. Although Platt did not intend on disclosing the information to Switzer, could Platt’s choice to discuss confidential corporate matters with his spouse in a public place where one could easily overhear him constitute the requisite breach of duty required for a tipper-tippee case? Answer: The court ruled that such inadvertent disclosure did not constitute the requisite breach of duty required for a tipper-tippee case. Though it may not be wise to discuss confidential corporate matters with his spouse in a public place, doing so is not a prima facie breach of fiduciary duty. In a tipper-tippee case, only when a disclosure is made for an “improper purpose” will such a “tip” constitute a breach of an insiders duty. 2. The SEC never appealed this case. Do you believe that the SEC prosecuted Switzer because of his high profile? Answer: It can reasonably be argued that the SEC prosecuted Switzer because of his high profile. For its regulation through enforcement to succeed, the SEC has to devise an efficient and visible course in pursuing those who violate security laws and in discouraging similar conduct by others in the future. Targeting high profile individuals, like Switzer, created publicity and plays a powerful role in deterring others from trading based on material non-public information. 3. Did Switzer’s partners have a legal and/or ethical duty to inquire about the source of Switzer’s information? Answer: Switzer’s partners did not have a legal duty to inquire about the source of Switzer’s information. As was the case here, Switzer and his partners were engaged in similar partnership transactions in the past, so they may very well rely on Switzer’s judgment in good faith as a sound investor based on prior relationships. However, it can be argued that they have an ethical duty to inquire about the source of the information. It is reasonable that some degree of suspicion arises when one asks another to purchase large amounts of stock in a short period of time with little notice. Nonetheless, Switzer and his partners could not have known that the information was material, non-public information disseminated by a corporate insider for an improper purpose. Business Ethics Perspective: ImClone Insider Tips: Ethical Dilemmas and Choices [P.491] • Other Important Federal Statutes: Other federal statutes are focused on protecting publicly held companies from frivolous litigation by investors. o Private Securities Litigation Reform Act of 1995(PSLRA): Made it more difficult to pursue litigation under the securities laws based solely on commentary by the company’s executives by providing safe harbors from lawsuits that shield the company and its officers and directors so long as the principals acted in good faith and disclosed all relevant facts. • In order for a shareholder to prevail in a suit based on statements of corporate executives that turned out to be incorrect or to be misrepresentations, the shareholder must prove scienter as an essential element of the case. Case 17.5 Tellabs, Inc. v. Makor Issues & Rights, LTD., 551 U.S. 308 (2007) [P.495] Facts: Shareholders of Tellabs filed a lawsuit alleging that Tellabs CEO Notebaert engaged in securities fraud in violation of §10(b) of the ’34 Act by knowingly misleading the public by making optimistic statements regarding the demand for their flagship product and overstated revenue projections. The shareholders alleged that Notebaert’s optimistic assessments promoted Tellab’s stock and not long after the statements, Tellabs disclosed that the demand for the product had significantly dropped and the revenue projections were substantially lowered. As a result, the stock price plunged from a high of $67, to a low of $15.87 overnight. The trial court dismissed the complaint after finding that the shareholders had not provided specific instances of Notebaert’s conduct that inferred scienter; however, the appellate court reversed, concluding that the shareholders had sufficiently alleged that Notebaert acted with the requisite state of mind. Issue: Did the trial court use the correct standards to ascertain the inference of scienter as an essential element of the case? Ruling: No. Under the PSLRA, the complaint must allege a strong inference of scienter, meaning that an inference of scienter must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent. Answers to case questions: 1. After reading this case, do you think that application of the PSLRA is consistent with balancing the rights of shareholders with curbing frivolous litigation? Answer: The application of the PSLRA is consistent with balancing the rights of shareholders with curbing frivolous litigation as is reflected in the Tellabs opinion. The court noted that consideration must be given to plausible nonculpable explanations for the defendant’s conduct (curbing frivolous litigation), as well as inferences favoring the plaintiff (the rights of the shareholders). Prior to the PSLRA, the rights of the shareholders consistently prevailed but as is seen in the court’s analysis, the application of the PSLRA provides a countermeasure that effectively balances these two interests. 2. Would you qualify Notebaert’s statements as intentionally misleading or just overly optimistic? What’s the difference? Answer: Based on the limited facts provided, it would be difficult to ascertain whether Notebaert’s statements were intentionally misleading or just overly optimistic. If Notebaert can justify his statements as a reasonable, good faith belief and he disclosed all relevant facts then it would be likely that they were just overly optimistic. Conversely, if the shareholders can offer cogent evidence that is at least as compelling as Notebaert’s inferences of nonfraudulent intent, then the court could find Notebaert’s statements as intentionally misleading. o Securities Litigation Uniform Standards Act of 1998: An amendment to the ’34 Act, intended to prevent a private party from instituting certain lawsuits in federal or state court based on the statutory or common law of any state that punishes “a misrepresentation or omission of a material fact” or the use of “any manipulative device or contrivance” concerning the purchase or sale of a covered security. • Securities Regulation by States: Blue-sky Laws: State securities laws intended to cover purely intrastate securities offerings and serve as an additional safeguard for investors when the federal government declines to exercise their jurisdiction over a particular securities offering. D. Regulation of Corporate Governance and Financial Markets [P.494] Points to emphasize: • Federal and state statutes also regulate certain internal corporate governance procedures of publicly held corporations to ensure public confidence in the publicly traded markets and to protect investors. • The Sarbanes-Oxley Act of 2002 (SOX Act): Intended to impose stricter regulation and controls of how corporations do business through regulation of three broad areas: auditing, financial reporting, and internal corporate governance. o Reforms in the Accounting Industry: The Public Company Accounting Oversight Board (PCAOB) is the body created by the SOX Act as an oversight for firms performing audits of public companies. • The SOX Act seeks to increase auditor independence through setting mandatory rotation of auditing partners, banning accounting firms from providing nonauditing consulting services for public companies for which it provides auditing, and restricting accounting firm employees involved in auditing from leaving the auditing firm to go to work for an audit client. o Financial Reporting: Certain corporate officers are responsible for certifying the accuracy and completeness of financial reports and disclosures. o Corporate Governance: The SOX Act requires a public corporation to form an audit committee, prescribes the composition of the committee, and imposes substantial responsibility on the committee to prevent and detect fraud. • The SOX Act also requires public companies to establish a code of ethics and conduct for its top financial officers, prohibits certain practices such as the lending of money to officers and directors, and requires officers and directors to disclose their own buying and selling of company stock within a certain time frame. • Enforcement under SOX: The expanded scope and methods of enforcing securities law under the SOX Act include: o Emergency Escrow: The establishment of an emergency escrow fund when the SEC intervenes into an extraordinary payment made by a company until further investigation is conducted. o Substantial Penalties: Enhanced criminal penalties for violations. o Whistle-blowers: Protection for whistle-blowers against any retaliation by the company. o Document Destruction Rule: Provisions to punish the destruction of evidence that might be relevant to the investigation of any violation of federal securities laws. o Conspiracy to Commit Fraud: Expanding the definition of securities fraud by outlawing any conspiracy to commit fraud. Concept Summary: Sarbanes-Oxley Act (SOX Act) of 2002 [P.498] • Troubled Assets Relief Program (TARP): A program established by the American Recovery and Reinvestment Act of 2009 to purchase assets and equity from financial institutions to strengthen the U.S. financial sector. • Compensation: The company’s compensation plan for senior executive officers cannot encourage manipulation of the reported earnings of a TARP recipient in order to enhance the compensation of the officers. • TARP recipients are restricted from paying or allowing the accrual of bonus, retention, or incentive pay for senior executives during the time when the recipient still owes any balance to the TARP fund. o Corporate Governance: TARP recipients must establish a compensation committee within its board of directors that is composed entirely of independent directors charged with the responsibility of evaluating executive compensation plans to be sure they are consistent with TARP regulations. • The law requires that TARP recipients hold a purely advisory shareholder vote on the approval of a compensation plan recommended by the compensation committee. o Luxury Expenditures: The board of directors of any TARP recipient must implement a companywide policy regarding excessive or luxury expenditures. o Repayment of TARP Funds: TARP recipients are required to apply for release from the program after showing that their assets are sufficient to continue operations and lending programs. Table 17.3: TARP Rules [P. 499] • Financial Market Regulation: Companies that do business in the financial markets are regulated by a complex structure of federal regulatory schemes that are enforced through a variety of administrative agencies and regulatory bodies. o Regulator Shopping: Occurred in certain sectors of the financial markets when a financial institution decided to convert its corporate organizational structure so that it could fall under the jurisdiction of a different administrative agency or regulatory body. • Recent Regulatory Reform of Financial Markets: Congress passed the Wall Street Reform and Consumer Protection Act (originally named the Restoring American Financial Stability Act of 2010) to overhaul the regulation of U.S. financial services and markets. o Financial Stability Oversight Council: The law creates a new independent body with a board of regulators to address dangerous risks to the global financial markets posed by risky investments or actions of large financial institutions. o The Consumer Financial Protection Bureau: Federal agency created by the law with direct oversight of companies providing mortgages, credit cards, saving accounts, and annuities. o Other Provisions: The law also proposes to (1) give shareholders greater power to limit executive officer compensation, (2) increase the authority and budget of the SEC for more enhanced oversight of sophisticated investment vehicles, (3) increase the power and oversight jurisdiction of the Federal Reserve, and (4) created an office of National Insurance. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES Theory to Practice [P. 502] 1. Since CRMC is already saddled with debt, they would probably choose to sell equity in a private placement context. The process of going public will be too lengthy and expensive to help CRMC reach their goal of aggressive expansion. A bond is a debt instrument and therefore CRMC would be unlikely to use a bond for additional financial needs. In this case, selling equity would likely be more in keeping with the company’s plans and current financial resources. [Ties to Categories of Securities]. 2. CRMC actions of sending out a business plan with a cover letter explaining how to purchase the stock is a securities offering and unless it contains appropriate disclosures and fits into an exemption category, the security must be registered under the ’33 Act. [Ties to The Securities Act of 1933]. 3. Because they are sending the business plan to a minimal number of people, it will likely fall into an exemption category. A private placement is one exemption that may fit here. It requires that the company only accepts investments from accredited investors. Offerings up to $5 million made solely to accredited investors in any 12-month period are exempt. However, even exempt offerings must contain appropriate disclosures. [Ties to Exemptions from Registration]. 4. This question is intended to spur discussion of the difference between overly optimistic representation and misrepresentations. Although the CRMC CEO, arguably, did not specifically provide false representations, some of the statements could be characterized as misleading and subject the company to liability for fraud. [Ties to Liability for Violations]. 5. In the Tellabs case, the Supreme Court made clear that under the PSLRA, the complaint must allege a strong inference of scienter. This means that the inference must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of non-fraudulent intent. In the CRMC case, the CEO’s statements about the timing of when the product would be available for market are suspect, but they may not be sufficient to meet the strong inference test in Tellabs. [Ties to Private Securities Litigation Reform Act of 1995]. 6. The statement in response to a question of when the Tectonic Board would be on store shelves and the statement about existing sales are clearly suspect. They may be part of a case of fraud, but the statements themselves are probably not enough to satisfy the scienter requirement because they can be characterized as an overly optimistic forecast. The statements would need to coupled with some other evidence that the CEO intended to deceive the investors such as falsifying financial records. [Ties to Private Securities Litigation Reform Act of 1995]. Manager’s Challenge Sample answers to all Manager’s Challenge exercises are provided in the student and instructor’s versions of this textbook’s Web site. Case Summary 17.1: Scienter: Nursing Home Pension Fund v. Oncale Corp. [P.503] 1. Does the timing of the insider sale and the release of the negative earnings statement constitute sufficient scienter to clear the PSLRA’s scienter hurdle? Answer: Yes, taken together, the timing of the unusual insider stock sale and the release of the negative earnings sufficiently raise an inference of scienter and provided a basis for the cause of action against Oracle. 2. Who prevails and why? Answer: The shareholders prevail because it seems apparent that Oracle violated §10(b) in failing to disclose all relevant facts in making overly optimistic forecasts because CEO Ellison sold nearly $1 billion of his personal stock in Oracle shortly before releasing the negative news about earnings. Case Summary 17.2: Material Misstatements: In re the Vantive Corporation Securities Litigation [P.504] 1. Were the forecasts sufficient to constitute a material misstatement of fact and an omission that violated securities laws? Explain. Answer: The forecasts were not sufficient to constitute a material misstatement of fact and an omission that violates securities laws because they were forward looking projections and simply optimistic rather than a specific intent to deceive, manipulate, or defraud investors. 2. Is Vantive protected by the PSLRA? Answer: Yes, Vantive is protected by the PSLRA because the shareholders would not be able to clear the hurdle of scienter in order to pursue their fraud claim against Vantive. Case Summary 17.3: Exempt Securities: Mark v. FSC Securities Corporation [P.504] 1. Should Mark prevail? Answer: Yes, Mark should prevail because the evidence indicates a public offering that is not exempt from registration and the safe harbor exemption does not apply because no reasonable person could determine what the issuers actually believed about the nature of each purchaser. 2. Is it relevant that FSC never reviewed the subscription agreement? Answer: Yes, in order to come within the Regulation D safe harbor, a defendant is required to offer evidence of the issuer’s reasonable belief as to the nature of each purchaser. Thus, for Regulation D, what the issuers knew and reasonably believed about each purchaser is critical. Case Summary 17.4: Good Faith in PSLRA: City of Philadelphia v. Fleming Companies, Inc. [P.505] 1. Who prevails and why? Answer: Fleming prevails because the principles acted in good faith and disclosed all relevant facts they were privy to at the time. 2. Should Fleming’s officers be protected by the PLSRA? Answer: Yes, Fleming’s officers should be protected by the PLSRA because they acted in good faith and the shareholders claim is frivolous. Quick Assessment Questions (QAQs) 1. According to the Court in SEC v. W.J. Howey Co, which of the following is true? a. An investment contract is a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter of a third party. b. An investment contract is a contract, transaction or scheme whereby a person invests his money in a common enterprise with the expectation of a profit solely upon the investor’s own efforts. c. An investment contract is not subject to securities regulation if it deals strictly with agricultural operations, such as citrus acreage. d. An investment contract is not subject to securities regulation if a profit sharing opportunity is provided on an optional basis. e. None of the above Answer: a 2. Which statute aims to solve specific mechanism failures in accounting methods and requires higher levels of fiduciary responsibilities for those involved in corporate governance? a. The Securities Act of 1933 b. The American Recover and Reinvestment Act of 2009 c. The Private Securities Litigation Reform Act of 1995 d. The Sarbanes-Oxley Act of 2002 e. The Restoring American Financial Stability Act of 2010 Answer: d 3. Which federal agency is charged with rulemaking, enforcement, and adjudication of federal security laws? a. Congress b. The Federal Reserve c. The Federal Trade Commission d. The Securities Exchange Commission e. None of the above Answer: d 4. A promissory note secured by a home mortgage is not a security. Answer: True 5. Exemption from registration does not exempt issuers from appropriate disclosures to investors and financial transparency. Answer: True 6. The Securities Act of 1933 regulates the sale of securities between investors after an investor purchased it from a business entity issuer. Answer: False UNIT FOUR FLEXERCISE: Business Judgment Defense [P. 506] Note to Instructor: This exercise is based on Shlensky v. Wrigley and Chicago National League Ball Club, 237 N.E. 2d 776 (Ill. App. Court 1968). Facts: Defendants are the famous William Wrigley, who owns 80% of the stock, and directors of the Chicago National League Ball Club, which is the company that owns the Chicago Cubs. Every other major league team had installed lights, Defendant did not install them for the Cubs because he was concerned that night baseball would be detrimental to the surrounding neighborhood and that, in Wrigley’s opinion, baseball was a daytime sport. Plaintiff argued that the team was losing money, and that other teams had higher attendance during the weekdays because they played at night. Shareholder plaintiffs argued that the Cubs would draw more people with weekday night games. Plaintiff asserts that Defendant’s first concern should be with the shareholders rather than the neighborhood. Issue: The issue is whether the court should be able to assert the business judgment rule absent a showing of fraud, illegality or a conflict of interest. Holding: Cubs win. The decision not to install lights at the ballpark was not a breach of duty but was rather a business judgment. The court cited some reasons why the light installation could be detrimental, such as lowering the property value of the park itself, a lack of proof on behalf of Plaintiff that financing would be available for lights and would be certain to be offset by increasing revenues. The directors are given the latitude to adopt a rational policy even if the policy chosen by the company may not be the wisest policy available. 1. Are the reasons given by the board for not installing lights legitimate? Was there any fraud or conflict of interest? Do the directors have any ethical responsibility to the surrounding neighborhood as secondary stakeholders? Answer: The questions of legitimacy is very subjective. The Cubs did not install lights because of concern that night baseball would be detrimental to the surrounding neighborhood and that, in Wrigley’s opinion, baseball was a daytime sport. There was no fraud or conflict of interest. The question of ethics to secondary stakeholders is also important—would night games have a negative impact on those who live around the stadium? 2. Does the business judgment rule require the board’s decision to be legitimate? Is that the same as “rational”? Why or why not? Answer: No. It doesn’t have to be legitimate, but only rational. That is a very low standard. For this case, the court accepted the notion that the Cubs had properly discussed and rejected the idea. 3. This case was decided before the landmark Smith v. Van Gorkom case in Chapter 16 (Page 463). How would you apply the holding in that case to these facts? Who would prevail? Answer: It may change the decision since the case raised the bar for business judgment. Directors have a duty to be informed at a higher level. In this case, it would mean gathering more evidence (e.g., empirical evidence of neighborhood impact, financial reasons etc.). 4. When deciding not to install lights, has the board and the majority shareholder put their own interests ahead of the corporation’s interest? Is that a breach of their fiduciary duty? Why or why not? Answer: It could be argued that the board’s interests were to save money by not installing lights. But the actions taken by the board were not a conflict of interest and could legitimately be justified as putting the corporation’s interests ahead of their individual interests even if the decision was wrong. 5. Is it possible that installing the lights would not increase the profitability of the team? If so, how does that impact your analysis? Answer: Yes. The Cubs made that argument. They argued that the costs of the lights would not necessarily be made up in increased revenue from ticket sales. Chapter 18: Administrative Law OVERVIEW This chapter begins a new unit of the textbook that is devoted to the regulatory environment of business. The chapter covers administrative law and the functions, scope, and limits on powers of administrative agencies. The chapter also examines ways in which administrative agencies are accountable to the public and the role of state administrative law. KEY LEARNING OUTCOMES Outcome Accreditation categories Explain the purpose of administrative law, list the primary functions of an administrative agency, and give examples of several administrative agencies that regulate business. Knowledge Identify and explain the steps used in administrative rulemaking. Knowledge Provide examples of the powers of administrative agencies in the areas of licensing, inspection and adjudication of regulatory violations Knowledge, Analysis Describe the limits on agency powers imposed the legislative, executive and judicial branches of the government, and give examples of federal public disclosure statutes that make administrative agencies more accountable to the public. Knowledge, Analysis, Critical thinking TEACHING OUTLINE A. Definition, Function, and Sources of Administrative Law [P.509 ] Points to emphasize: • Administrative law is a body of law, drawn from various sources, that defines, regulates and limits the exercise of authority by federal regulatory agencies. • Primary Functions of Administrative Agencies: Administrative agencies have a wide range of functions related to the formation, implementation, and enforcement of regulations intended to administer a federal law. o Policymaking: The legislative function charged to administrative agencies, whereby they create legally enforceable rules in order to fill in the details of a statute. • Administrative agencies use a system of adjudicatory bodies established within the administrative agency to decide cases that involve an alleged violation of the agency’s rules. o Investigation and Enforcement: Many administrative agencies have an agency enforcement division devoted to investigating alleged violations of the agency’s administrative regulations, monitoring compliance with regulatory requirements, and recommending enforcement actions. o Licensing and Permitting: Some administrative agencies are responsible for licensing and permitting in a wide variety of areas, including licenses for professionals and industries. o Distribution of Federal Statutory Benefits to the Public: Agencies are involved in the application process and distribute benefits according to law. o Figure 18.1: U.S. Government Organization Chart [P.511] • Sources of Administrative Law: Administrative law is a combination of several different sources of law including the Constitution, the Administrative Procedures Act (APA), enabling statutes, and common law. o U.S. Constitution: Places limits on the type of powers that agencies may exercise and the methods that agencies may employ in carrying out their duties. o Administrative Procedures Act (APA of ‘46): A federal statute that imposes specific procedural structures and due process requirements on administrative agencies duties of rulemaking, adjudication, and other agency functions. o Enabling Statutes: Laws passed when Congress establishes an administrative agency, which is the source of the agency’s authority and describes the agency’s scope and jurisdiction over certain matters. o Common Law: While much of the common law has been codified through the APA, courts sometimes still refer to the common law in applying or interpreting the APA. B. Scope of Administrative Agency Power [P.512] Points to emphasize: • Administrative agencies have broad powers including rulemaking, enforcement, licensing, and adjudication. • Rulemaking: Agencies develop rules to be used in facilitating the government’s administration of the law. o Agency Study and Research: Agency-selected experts research and review issues as set forth in the enabling statute. o Notice: Publication of the Proposed Rule: Based on agency findings, the proposed rule is articulated and published in the Federal Register to give notice to those affected by the rule. • Agencies are required to publicly disclose any studies, reports, data, or other pertinent material that the agency relied upon in creating the proposed rule (Figure 18.2: Sample of Federal Register: Proposed Rules from the Environmental Protection Agency [P.514]). o Public Comment: Once the rule has been published, the APA requires that the agency must give time for parties to have an interest in the rule to respond directly to the agency with comments. o Protection of Small Business Owners: Under the Regulatory Flexibility Act of 1980, when an agency issues a rule that will have a significant economic impact on a substantial number of small entities, the agency must provide small businesses the opportunity to participate in the rulemaking. o Revision or Final Publication: After the comment period has ended, the agency may either revise the rule or simply publish the final rule in the Federal Register. • If revised, the rule need not be published for comment unless it is radically different from the original. • When publishing the final rule, the APA requires the agency to include “a concise general statement of basis and purpose” to ensure that the agency used a reasoned decision-making process that was not arbitrary or capricious, and once effective, the rule is called a regulation and becomes part of the Code of Federal Regulations (CFR). • In 1990, Congress passed the Negotiated Rulemaking Act, which provided an alternative to normal rulemaking policies in cases where it was possible that various cooperating parties could ultimately reach an agreement on the negotiated proposed rule. o Judicial Challenges: After a final rule is published, the APA allows adversely affected parties to challenge the rule in court; however, courts give great deference to the agency’s decisions. Case 18.1 American Medical Association v. United States Internal Revenue Service, 887 F.2d 760 (7th Cir. 1989) [P.516] Facts: The IRS proposed a rule concerning the allocation of membership dues paid to nonprofit organizations under which certain nondues revenue was to be treated as taxable revenue as determined by a seven-factor test. After the comment period, the IRS replaced the seven-factor test with a new three-factor method, which was published as a final rule without any additional comment period. This resulted in increased tax liability for AMA, a nonprofit corporation that chargers its members dues, and they brought a lawsuit claiming that the new three-factor allocation regulation was invalid because the IRS had never given the proper public notice required by the APA when they departed from their original seven-factor test. Issue: Is the IRS’s rule invalid because they did not provide an additional comment period when they departed from their original seven-factor test? Ruling: No. The IRS’s publication of the original proposed seven-factor rule was not binding on the agency and the IRS’s change in policy was a logical outgrowth of the original proposal and not a wholly new approach to the issue of proper allocation standards. Answers to case questions: 1. Under the logical outgrowth test used by the court, would the outcome have been different if the IRS simply published a proposed rule saying that they were going to alter the calculation of membership dues by tax-exempt organizations and did not provide further details or methods? Why or why not? Answer: The outcome may have been different if the IRS simply published a proposed rule saying that they were going to alter the calculation of membership dues by tax-exempt organizations and did not provide further details or methods. In this case of the altered initial proposal, the issue was only addressed in the most general terms and therefore the rule may be invalidated. The courts would find that a precise method or formula is not a logical outgrowth of a proposed rule containing an issue addressed in the most general terms. 2. Given the standard used by the court, can you think of an example of a charge that would not be considered a logical outgrowth provided that the appropriate notice is initially given? Answer: For example, if the IRS abandoned the seven-factor test all together and instead came up with a single standard not contained within the original test the court would not consider this a logical outgrowth provided that the appropriate notice is initially given. Similarly, if the IRS charged a published a rule that changed a pre-existing agency practice then the rule will be invalidated given the standard used by the court. Concept Summary: Steps in the Rulemaking Process [P.517] • Enforcement, Licensing, and Inspection: Courts are highly deferential to agencies prosecutorial discretion in deciding when and whom to regulate. o Administrative agencies also regulate and administer laws through the licensing process where they issue, renew, suspend, or revoke a license to conduct certain types of business. o Some agencies also monitor compliance with regulation by conducting inspections of businesses and individuals within their jurisdiction. o Agencies are held to a lower standard of probable cause to obtain an administrative warrant than if the government was obtaining a criminal warrant. o Also within the agencies’ enforcement powers is the right to require business subject to the agency’s jurisdiction to (1) keep certain records for inspection, (2) turn over relevant documents that may be useful in determining compliance with a particular rule, and (3) request statements or other information from the business’s principals or mangers. • Adjudication: Administrative agencies have the authority to adjudicate matters under their jurisdiction by holding a hearing between the government and private parties in front of an administrative law judge. o Federal courts have permitted agency adjudication when it occurs in the context of public rights disputes or when two private parties are disputing rights that arise out of an area of the agency’s jurisdiction. o Appeals: The losing party in an ALJ case generally has an automatic appeal to the administrative head of the agency, and an adverse decision from the agency may also be challenged in a federal trial court. Case 18.2 Trinity Marine Products v. Secretary of Labor Elaine Chao, 512 F.3d 198 (5th Cir. 2007) [P.519] Facts: Trinity’s managers initially turned OSHA compliance officers away when they arrived at the facilities of Trinity to conduct an inspection. OSHA returned with federal marshals and an administrative warrant and were granted access. Trinity later brought an action against OSHA, contending the warrant had been issued without probable cause. Trinity argued that refusal by a party to honor an administrative warrant should trigger a contempt of court proceeding to determine the validity of the warrant, but that the government may not use force or arrest to enforce an administrative warrant. Issue: Are agencies held to a lower standard of probable cause to obtain an administrative warrant than if the government were obtaining a criminal warrant? Ruling: Yes. The standards for probable cause are lower for administrative warrants than for criminal warrants and that federal statutes and case law allow administrative warrants to be executed using a reasonable degree of force. Answers to case questions: 1. Would Trinity’s case against OSHA have been stronger if the inspectors showed up with the marshals and forcibly searched the premises without first attempting to inspect without a warrant? Why or why not? Answer: The procedural issue of whether the inspectors and marshals forcibly searched the premises without first attempting to inspect without a warrant would make no difference. Once an administrative warrant is issued, regardless of whether the inspectors attempted to previously inspect without a warrant, that agency is allowed to “investigate and inspect without delay” and execute the warrant using a reasonable degree of force. 2. What are some examples of when the probable cause standard for administrative warrants would not be met? Answer: In issuing an administrative warrant, the judge will look for what most jurisdictions term “legitimate cause,” meaning that the agency has some sort of “valid public interest” in enforcing the regulation via search. Though such cause is extremely fact-intensive and different for each situation, a general example would be in cases where the agency randomly decides to search a business that is not pervasively regulated. Assuming that Trinity is not in an industry subject to regularly scheduled inspections pursuant to rule, if OSHA simply pulled their name off a random computer database and attempted to search the premises on that basis, the probable cause standard for administrative warrants would not be met. Concept Summary: Scope of Administrative Agency Power [P.520] C. Limits on Administrative Agencies [P.520] Points to emphasize: • The legislative, executive, and judicial branches all have various means of power that limit the authority of administrative agencies. • Executive Branch: From an administrative law perspective, the president’s power is derived from the Appointments Clause and direct powers through executive orders and, to a lesser degree, through budgetary control. o Appointments Clause: Although subject to confirmation by the Senate, the president has the exclusive right to nominate principal officers of independent agencies that report directly to the president. o Direct power: For the last several decades, presidents have exercised direct power over administrative agencies to accomplish the president’s public policy objectives. • Congress: Although the Supreme Court narrowed congressional review of agency actions in INS v. Chadha (1983), Congress still retains significant power to influence, amend, or void actions of an administrative agency. o Congress also has oversight over administrative agencies by virtue of the Senate’s power of advice and consent to appoint certain high-ranking officers. • Judicial Review: Courts will set aside any agency action that is inconsistent with the Constitution or if the agency has exceeded their statutory authority or agency actions have been taken without adhering to the statutorily established procedure. o Statutory Interpretation by Agencies: Courts apply the Chevron test where they first look to the language of the statutory authority given to the agency by Congress and if the agency’s interpretation or actions conflict with the plain language meaning of the statute, then a court may hold that agency’s interpretation or actions were unlawful. • If the statute is silent or ambiguous on the agency’s authority, the court applies the arbitrary and capricious standard to determine whether the agencies actions were lawful. o Applying the Arbitrary and Capricious Standard: Arbitrariness and capriciousness is found when the agency has taken action that is not based on a consideration of relevant factors given the information available at the time it took the action in question, including viable alternatives available to the regulatory agency, or a result of a clear error of judgment by the agency. • Although the power of courts to set aside an administrative agency’s action is clear, courts have traditionally been sparing in the use of this power. • In Motor Vehicle Manufacturing Association v. State Farm Mutual Automobile Association, the Court ruled that agency action was arbitrary and capricious if the agency had (1) relied on factors that Congress has not intended it to consider, or (2) failed to consider an important aspect of the problem, or (3) offered an explanation for its decision that runs counter to the evidence before the agency, or (4) is so implausible that it could not be ascribed to a difference in view or the product of agency expertise. Case 18.3. v. Federal Communications Commission v Fox Television Stations, Inc., 129 S. Ct. 1800 (2009) [P.524] Facts: The FCC had traditionally followed a restrained enforcement policy for the use of profanity in broadcasts when the indecent material was fleeting and isolated in nature, and applied its standards in 2003 when it ruled an acceptance speech including the phrase “this is really, really, f---ing brilliant” did not violate their policy. Subsequently, the FCC abruptly changed its course and instituted a zero-tolerance rule for any use of certain words that were inherently indecent no matter what the context or brevity. The FCC imposed fines on Fox for two incidents in 2003 and 2003 when during broadcasts of music award ceremonies one musician used a similar expletive in his acceptance speech and a presenter used two expletives. The lower courts invalidated the new standard on the basis that the agency had been arbitrary and capricious in their actions by adopting a new standard for the enforcement of profanity regulations involving the use of fleeting expletives. Issue: Was the FCC’s action arbitrary and capricious? Ruling: No. The Supreme Court reversed the appellate court’s decision and held that they had misapplied the arbitrary and capricious standard. The Court ruled that the agency’s actions to be rational and consistent with reasoned decision making. Answers to case questions: 1. Would the outcome of this case have been different if the FCC published its intent to charge its policy in the Federal Register, solicited public comments and opinions on the matter, and then decided to make the abrupt reversal in policy? Why or why not? Answer: If the FCC published its intent to change its policy in the Federal Register, solicited public comments and opinions on the matter, and then decided to make the abrupt reversal in policy, the outcome of this case may have been different. 2. Although the Court concluded that certain empirical data cannot be “marshaled”, couldn’t the FCC have provided studies, publications, etc., that examine the impact of indecent language on children? Shouldn’t the FCC be required to attempt to obtain empirical data? Answer: The Court was clearly concerned with restraining the agency’s authority by imposing a bright line test or requiring certain evidence. Self-Check: Arbitrary and Capricious [P.525] D. Public Accountability [P.526] Points to emphasize: • Congress makes agencies accountable to the public and makes their work as transparent as possible through statutorily authorized citizen’s suits as well as mandatory disclosure and open-meeting laws. • Private Citizen Suits: Citizen suits may be brought against a private party (as a violator) or against the administrative agency for failing to act consistent with the enabling statute’s requirements. o Citizen suits cannot be used to attack the substance of a regulation that has been properly promulgated. • Federal Disclosure Statutes: Administrative agencies are accountable to the public through transparency via public access to informational records held by the government and through disclosure requirements concerning open hearings and other business conducted by federal agencies. o Freedom of Information Act (FOIA): Requires agencies to publish certain matters and to allow public inspection of all other records created or obtained by the agency in the course of doing the agency’s work upon the request of an individual or agency. • The FOIA contains several categories of exceptions designed to protect legitimate interests including documents that contain (1) sensitive national defense or foreign policy information; (2) agency personnel matters or agency policies on purely administrative issues; and (3) trade secrets and privileged commercial information. o Government in the Sunshine Act: Requires that agencies announce their meetings at least one week in advance and open the meeting to the public unless the meeting falls within one of the exceptions. E. Administrative Law at the State Level [P.528] Points to emphasize: • State agencies also have broad executive, legislative, and adjudication discretion in matters of state administrative law and many state agencies exist to accomplish substantially the same objectives at a more micro level. • States often have their own versions of federal agencies and collaborate with federal agencies. CASE 18.4: Consumer Federation of America v. Department of Agriculture, 455 F.3d 283 (D.C. Cir. 2006) [P. 529] Facts: The United States Department of Agriculture (USDA) published notice of a proposed rule regulating exposure to Listeria, a dangerous, food-borne bacterium that can be found in ready-to-eat meat and poultry. USDA later issued an interim final rule that Consumer Federation of America (CFA) regarded as significantly weaker than the originally proposed rule. Seeking to learn whether USDA officials had met exclusively, or nearly exclusively, with industry representatives who favored the weakening of the original proposed rule, CFA filed a Freedom of Information Act (FOIA) request for access to the “public calendars" of five senior USDA officials and one USDA administrative assistant. Issue: Were the calendars “agency records” as defined in FOIA? Ruling: Yes. The D.C. Circuit Court of Appeals held that the five senior officials’ calendars were agency records under FOIA and were subject to public access. The court ruled that since the USDA calendars were continually updated, distributed to employees, and used to conduct agency business, the calendars were included under FOIA. The court also ruled that the administrative assistant’s calendar was not an agency record covered by FOIA because it was not distributed among senior officials and was more of a personal time schedule. Case Questions: 1. What did CFA expect to uncover through the use of FOIA? Answer: It is likely that the CFA sought whether agency officials had met with industry executives during a certain time frame which would support their theory that the regulations were changed due to industry pressure. 2. If government officials know that they will have to reveal their personal calendars, wouldn’t that potentially chill necessary debate within or outside the agency? Answer: That is an excellent counter-argument and one that Congress must take up. The court ruled based on the existing statute. END OF CHAPTER PROBLEMS, QUESTIONS AND CASES Theory to Practice [P. 530] 1. Because the regulation deals with air quality, the Environmental Protection Agency (EPA) would likely be the administrative agency involved. [Ties to Scope of Administrative Agency Power]. 2. The wood-burning pizza oven law that Congress passed is an example of an enabling statute. [Ties to Sources of Administrative Law]. 3. MLRG could challenge the rule under the Small Business Regulatory Enforcement Fairness Act (SBREFA). The law requires that, when an agency issues a rule that will have a significant economic impact on a substantial number of small entities, the agency must provide small businesses with the opportunity to participate in rulemaking with the goal of reducing the burden of the rule on small business owners. [Ties to Protection of Small Business Owners]. 4. The administrative agency does not have to publish the amended rule so long as the agency’s amendments were not a substantial or material alteration of the originally proposed rule. Courts use the “logical outgrowth” test to determine whether or not the agency must re-published a revised rule. [Ties to Rulemaking: Revision or Final Publication]. 5. MLRG could use the courts to challenge the rulemaking process as arbitrary and capricious is they can prove that the agency failed to use a reasoned decision-making process. [Ties to Judicial review]. 6. The Supreme Court has held that agencies need only to show that they used a reasoned analysis in their decision making. In FCC v. Fox, the Court ruled that scientifically certain criteria were not required in an agency’s analysis. [Ties to Judicial Review]. Manager’s Challenge [P.531] Sample answers to all Manager’s Challenge exercises are provided in the student and instructor’s versions of this textbook’s Web site: www.mhhe.com/melvin. Case Summary 18.1: Logical Outgrowth Test: Int’l Union, United Mine Workers of America v. Mine Safety and Health Admin. [P.532] 1. Is the maximum airflow rule a logical outgrowth of the proposed rule? Why or why not? Answer: The court would likely find that the maximum airflow rule is not a logical outgrowth of the proposed rule because the published maximum flow is outside of the original scope of the proposed minimum flow. 2. Is the agency required to republish the rule? Answer: Yes, if the agency’s revised rule is a substantial or material alteration of the originally proposed rule a second comment period is required. Case Summary 18.2: Arbitrary and Capricious: CBS Corp. v. Fed. Commc’n Comm’n [P.533] 1. Is the FCC’s decision arbitrary and capricious? Why or why not? Answer: Yes, the court found the FCC’s decision arbitrary and capricious because absent specifically addressing the issue, the FCC would be unable to provide evidence that a reasoned decision-making process was used. 2. Should CBS be found liable? Why or why not? Answer: CBS should not be found liable in this circumstance because the event could not have reasonably been foreseeable. Additionally, performers are independent contractors rather than employees, thus CBS is precluded from being held strictly liable absent proof of scienter. Case Summary 18.3: Judicial Review: Federal Express Corporation v. Holowecki [P.533] 1. Who prevails and why? Answer: Holowecki prevails and the EEOC’s interpretation of the definition of “charge” is upheld because the EEOC’s acted reasonably and within their statutory authority in interpreting the definition it has put in force. 2. Will the court defer to the EEOC interpretation? Answer: Yes, the agency is entitled to deference when it adopts a reasonable interpretation of regulations it has put in force. Deference is appropriate in matters of detail related to an agency’s administration of a statute. 3. What is the standard used by the courts in this case? Answer: The courts used the arbitrary and capricious standard in this case because that statute was silent on the agency’s authority. Case Summary 18.4: Ranchers Cattlemen Action Legal Fund United Stockgrowers of America v. U.S. Dept. of Agric. [P.534] 1. Is the decision arbitrary and capricious? Why or why not? Answer: No, the agency’s decision was not arbitrary and capricious because they fully considered the alternative possibilities and because the final rule did not anticipate an incidence rate of zero, these cases did little to impugn the USDA’s decision-making process. 2. Does the fact that the agency held several comment periods impact your analysis? Answer: Yes, the fact that the agency held several comment periods indicates that they engaged in a thorough review and considered different alternatives in their decision-making process. Case Summary 18.5: Citizens Suits: Gardner v. US Bureau of Land Management [P. 534] 1. Is Gardner challenging the substance of a regulation or how a regulation was promulgated? Answer: They are challenging how the regulation was promulgated to the extent that the suit challenged the BLM’s adherence to the process of reasoned decision-making. 2. What is Gardner’s main concern and what is he asking the court to do? Answer: Asking the court to review the BLM’s decision-making process to be sure that the steps taken were consistent with evidence and not arbitrary or capricious. Quick Assessment Questions (QAQs) 1. Which function(s) do administrative agencies provide? a. Rulemaking b. Licensing c. Adjudication d. a and c e. a, b, and c Answer: e 2. What is the standard used by the courts in judicial review when the statute is silent or ambiguous on the agency’s authority? a. Reasoned decision making standard b. Arbitrary and capricious standard c. Agency authority standard d. Reasonably prudent person standard e. None of the above Answer: b 3. Which source of law establishes an agency’s authority, scope, and jurisdiction over certain matters? a. Enabling statutes b. U.S. Constitution c. Administrative Procedures Act (APA) d. Common law e. All of the above Answer: a 4. Administrative law exits only at the federal level. Answer: False 5. Courts are highly deferential to agency decisions involving how and when the agency enforces a regulation. Answer: True 6. Citizens suits are used to attack the substance of a regulation that has been promulgated. Answer: False Solution Manual for The Legal Environment of Business: A Managerial Approach: Theory to Practice Sean P. Melvin, Michael A. Katz 9780078023804
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