Seventh Circuit Holds That A Demand on the Board of Directors Was Not Required

In a shareholder derivative lawsuit, the plaintiffs are the shareholders of the company. They bring a lawsuit against someone for wrongdoing. Because the proceeds of the case really belong to the corporation, a doctrine of corporate law has developed under which the plaintiffs must first "demand" that the directors of the corporation bring the lawsuit themselves. What happens when the directors themselves are accused of wrongdoing? Can they really be expected to comply with a demand that they sue themselves for money? Thus, under this exception, courts have held that the "demand" requirement is "excused" in certain cases. The Seventh Circuit has recently decided one such case.

See Westmoreland County Employee Retirement System v. Parkinson, Jr. et. al. No.12- 3342  (August 16, 2013).

According to the opinion, Baxter International had severe problems with a medical device called Colleague Infusion Pump (Pump). The Pumps were used to deliver intravenous fluids to patients. The Pumps had a range of difficulties over a period of years. At first Baxter worked diligently to fix the problems but then its efforts allegedly tapered off.  The FDA sent a series of warning letters to Baxter.

The plaintiff shareholders filed their lawsuit several years after the problems became known. By that time, about 200,000 Pumps were in use throughout the country. Plaintiffs sued 13 directors of Baxter and several corporate officers.  Plaintiffs made no demand before filing the lawsuit that the directors take action. According to the District Court the plaintiffs failed to show that demand was not necessary.  The district court dismissed the lawsuit.

The Seventh Circuit reversed and reinstated the case.



The defendants were directors and a few interested officers. The complaint alleged that the  defendants breached their fiduciary duties by consciously disregarding their duties to bring Baxter in compliance with a consent decree and applicable law.
 According to the court demand is necessary unless there is reasonable doubt that the directors are disinterested or the action was otherwise the product of a valid exercise of business judgment.

According to the Court if a director breaches his duty of loyalty he can not rely on the business judgment rule. The 7th circuit said that the Defendants gave up in trying to fix the pumps and threw in the towel. Baxter began to focus on the development of a new pump  and to a great extent did not continue to fix the problems with the old pump despite warnings of the FDA.

According to the 7th Circuit, the defendant directors actions fell outside the protection of the business judgment rule. The Court said ”the directors knew of the problem, having been warned but took no steps to remedy the situation.” The Court went on to say that there was a reasonable probability of a finding of bad faith by the directors.

The judgment of the district court was reversed.

Cases holding that the demand requirement was excused are rare, but significant.

Edward X. Clinton, Sr.

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Ninth Circuit Rejects Securities Fraud Claim By Purchasers of Hard Rock Hotel Condominiums

The case is captioned Salameh v. Tarsadia Hotel. It is an investment contract case, where the plaintiff alleges that certain contracts he signed were really securities and that the securities should have been registered under the Federal Securities laws.

The facts, from the plaintiffs' complaint, were as follows:

Forty plaintiffs signed contracts to purchase condominium units in a Hard Rock Hotel then under construction. Plaintiffs alleged that they were obligated also to sign Rental Management Agreements with Defendant Tarsadia in which Tarsadia would be the exclusive management agent for the hotel.

Plaintiffs alleged that they were not given keys to the units purchased and could not occupy the units for more than 28 days each year. Therefore, according to plaintiffs, the purchase should be viewed as an investment contract, not a purchase of real estate.

Plaintiffs alleged that Defendants did not comply with the Securities Act of 1933, Sections 12 (a) and Section 10 B of the Securities  Exchange act of 1934, the California Securities Law and were guilty of common law fraud.   

The District Court held that the defendants did not sell securities. It reasoned that the contract to purchase the condominium and the contract under which the hotel was to be managed were two separate contracts signed 15 months apart.

The 9th Circuit affirmed.

The 9th Circuit acknowledged that the both the Securities Act of 1933 and the Securities Exchange Act of 1934 defines the term security to include the  term “investment  contract” . The Court also noted that the term “investment contract” has been interpreted to include novel, uncommon devices.” The investment contract concept embodies a flexible rather than a static principle, one that is capable of adaptation to meet countless and variable schemes  by those who seek the use of the money of others  on the promise of profits. SEC v. Howey 328 U.S.281. The Court went on to say whether a real estate transaction is a security, substance governs, not label, or form. However, the Court held that the Condo Purchase and Management Agreements were not offered  as a package.

The material delivered to plaintiffs do not allege that management agreement forthcoming.  The Court said that there was a significant time gap between the execution of the Condo Purchase Agreement and the Management Agreement The Court said that the two transactions were distinct. The Court went on to say that there was no reason why there could not be a market for ownership of a condo as a short term vacation home.

The Court said that taking all nonconclusionary allegations as true, Plaintiffs did not sufficiently allege claims under federal or state securities laws. The Court also went on to reject the common law fraud claims.

Although the Court made passing reference to  the amicus brief of the SEC,  it was not persuaded. The well-written and thoughtful brief of the SEC stated in part :

“The Commission believes that the district court, in determining that the hotel-room sales did not  sales of investment contracts, failed to give effect to the economic realities of the transaction as required by Supreme Court and Ninth Circuit precedents.

The Commission is concerned that the district court’s holding on the investment contract issue, unless reversed, would seriously erode the investor protection of the securities laws. It would impermissibly allow a promoter to avoid the coverage of these laws by (1) artificially dividing a single investment into ostensibly separate parts and (2) including a written disclaimer that falsely state that there is no investment exception.”

The brief also stated that (1) the sales agreements left the plaintiffs with so little use or control that it was obvious from the beginning that the defendants would exercise exclusive control to rent and operate the rooms; the reality of the defendant’s plan made if obvious from the outset that these  rooms would be necessary to serve as the hotels guest rooms; and  the hotel was under construction during the entire period, making the time gap between the room sales  and rental program inconsequential.

The Ninth Circuit rejected the arguments of the SEC:


"Plaintiffs' strongest argument that the two contracts, signed about a year apart, form a single transaction is their assertion that the "economic reality" shows that the two transactions are part and parcel of one scheme. They contend that the Purchase Contract, combined with external factors, such as the zoning ordinance, gave them no choice but to sign the Rental Management Agreement when it was later presented. This argument has some force. See Hocking, 885 F.2d at 1461; see also Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). But to accept this argument, we not only would have to ignore the large time gap between the two transactions that were executed with different entities, but also the fact that Plaintiffs' complaint is void of any allegation that they were induced to buy the condominiums by the Rental Management Agreement. The economic reality as we see it is that these two transactions were distinct. Moreover, Plaintiffs' economic-reality argument rests on the implicit assumption that the only viable use for the condominiums was as an investment property, but there is no plausible reason why there cannot be a viable market for owner-occupied hotel-condominiums for use as short-term vacation homes. See Brief of Amici Real Estate Roundtable & National Association of Realtors 3-6. This conclusion undercuts Plaintiffs' economic assumptions. See Forman, 421 U.S. at 858 (holding that a security does not exist "where [a consumer] purchases a commodity for personal consumption or living quarters for personal use")."

In my opinion, this is an unfortunate result that is not consistent with precedent Doubtless there were substantial losses suffered by the investors.

Edward X. Clinton, Sr.

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Illinois Court Rejects Law Firm's Claim Against Bank For Fraudulent Check

DIXON, LAUKITIS AND DOWNING, PC v. Bank, Ill: Appellate Court, 3rd Dist. 2013 - Google Scholar:

Over the past several years, lawyers have become victims to check scams. The scam works like this. The lawyer receives a fraudulent check and deposits the check in his trust account. The lawyer is unaware that the check is fraudulent. The lawyer deducts his legal fee from the check and remits the balance to the client. Two or three weeks later the bank discovers that the check is fraudulent and deducts the amount of the check back to the lawyer's account. The problem is that there is a time gap between when a check is deposited (Here May 25, 2011) and when the bank learns that the check is a fraud (here June 10, 2011). By writing checks on their trust account, the lawyers often unwittingly convert other client funds that they hold. They must then reach in their pockets and make good the losses to their clients.

Here the law firm was a victim of such a scam. It tried to sue the bank that dishonored the check, Busey Bank, but was unsuccessful.

The trial court rejected the law firm's negligence claim on the ground that the bank had no duty to the law firm. Instead, the parties' duties were set forth in the account agreement, which provided that the law firm bore the risk of loss until the final settlement of the check.  The account agreement provided: "Deposits - We will give only provisional credit until collection is final for any items, other than cash, we accept for deposit (including items drawn 'on us')."

Further, the Uniform Commercial Code, Section 4-214(a) "provides that a collecting bank may charge back a customer's account when the bank makes provisional settlement but does not receive final payment on an item if the collecting bank gives notice to its customer by midnight of the next banking day."

Here, the bank complied with Section 4-214(a) by giving prompt notice to the law firm that the check was fraudulent.

The appellate court affirmed the dismissal of the law firm's negligence action against the bank.

Comment: The lesson here is that if there is any doubt as to the validity of the check, the lawyer should wait until the bank confirms that collection is final before paying out the proceeds. Thus, the lawyer must wait before paying out the funds even if the client calls repeatedly and threatens to sue the lawyer or file a grievance with the ARDC. The case is clear - if you draw funds on a check before final settlement of the check (several weeks after the check is deposited) it is your fault if the check is a fraud. I agree with this result. Any other result would require the bank to act as an insurer for bad checks. That would inevitably lead to losses by the taxpayers.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Seventh Circuit Rejects Bank's Efforts To Sue Accountants

Bank of America, NA v. Knight, Court of Appeals, 7th Circuit 2013 - Google Scholar:

The Seventh Circuit has affirmed the dismissal of a complaint against an accounting firm employed by Knight Industries. In Illinois, there is a statute that governs accountant liability to third parties. The Bank is considered a third party because it did not hire the accounting firm directly. Instead, Knight Industries hired the accountants. The accountants "invoked the protection of 225 ILCS 450/30.1, which provides that an accountant is liable only to its clients unless the accountant itself committed fraud (which no one alleges here) or "was aware that a primary intent of the client was for the professional services to benefit or influence the particular person bringing the action" (§450/30.1(2))." The statute does not apply to a claim by the accountant's client against the accounting firm. Thus, had the bankruptcy trustee for Knight Industries brought the claim, the claim might have been successful.


The Seventh Circuit held that the complaint did not state a claim for fraud because the allegations in the complaint were vague and imprecise. The complaint did not set out specifically which parties were responsible for the wrongful conduct. The Bank was allowed to amend the complaint twice, but the complaint did not state a claim. The Seventh Circuit noted that "in court, as in baseball, three strikes and you're out."


Edward X. Clinton, Jr.

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New York Court Holds LLC Is Bound By Option Agreement

FUNDAMENTAL LLC v. CAMMEBY'S, 985 NE 2d 893 - NY: Court of Appeals 2013 - Google Scholar:

This is a simple breach of contract case. In 2006, the LLC granted an option to Cam Funding to allow Cam Funding "to acquire one third of Fundamental's membership units for a strike price of $1,000, provided the option was exercised on or before June 9, 2011. This agreement was signed by Forman, as manager of Fundamental, and was accepted and agreed to by Schron, as manager of Cam Funding, and Grunstein and Forman, the sole members of Fundamental."

Later the LLC amended its operating agreement in an effort to alter the terms of the option. Obviously, Cam Funding was not a member of the LLC and did not sign the operating agreement.The court explains:

"Fundamental relied on paragraph 3.3 of its operating agreement, dated December 22, 2005 and amended and restated September 3, 2009, which states that

"[a]dditional Interests shall not be issued except upon the consent of the Board of Managers [i.e., Grunstein and Forman] and the unanimous consent of the Members [i.e., Grunstein and Forman]. Upon the issuance of any additional Interests, the Person to whom such Interests are issued shall make a capital contribution to the Company in respect of such issuance in an amount equal to at least the fair market value per Interest so issued.""

The trial court held that the 2006 option agreement was binding and enforceable and that the subsequent amendment of the operating agreement did not nullify the option agreement. The trial court entered judgment in favor of the party exercising the option, Cammeby's. The appellate court affirmed the judgment.

Edward X. Clinton, Jr.

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Fraud and Proof of Reliance

In fraud cases, the plaintiff must prove, among other things, that she reasonably relied on the factual assertion made by the defendant.

All too often blue chip defendants turn around and argue that no one could ever rely on what they said because the assertions were puffery or because the plaintiff should have understood they were not telling the truth. These arguments are inconsistent and contradict the institution's claim that it is a credible institution whose word is worthy of consideration. Sometimes courts accept these arguments.

Recently, in United States v. McGraw Hill Companies and Standard and Poors Financial Services, LLC, 2013 U.S. Dist. Lexis 99961, the district judge refused to accept these arguments.

The United States sued S&P for fraud, for giving high ratings to mortgage backed securities. The issuers of those mortgage backed securities would pay S&P to rate the issue. S&P would then evaluate the creditworthiness of the issue and announce a final grade.

Why did the United States sue? Because in the recent financial crisis, the government was often left holding the bag when mortgage-backed securities proved worthless.

SP's major defense was that its statements were "puffery." The district court correctly recognizes the inconsistency in this argument. SP was paid to provide credit ratings for bond and other securities. SP is one of three companies that have the qualifications to do this work. SP opinions are relied upon by tens of thousands of market participants every day.

The district court explains: "Defendants lead off with a proposition that is deeply and unavoidably troubling when you take a moment to consider its implications. They claim that, out of all the public statements that S&P made to investors, issuers, regulators and legislators regarding the company's procedures for providing objective, data-based credit ratings that were unaffected by potential conflicts of interest, not one statement should have been relied upon by investors, issuers, regulators, or legislators who needed to be able to count on objective, data-based credit ratings."  The district court correctly rejected this argument and denied the motion to dismiss.

Under the law, subjective claims about a product are puffery. Claims like this are puffery: "Prices will never again be this low!" or "This is the best car for the money!" "When you buy a car from us, we treat you like family!"

When SP informed market participants that a certain bond issue had a AAA rating, it was not engaging in puffery. SP was giving its informed opinion as the creditworthiness of the issuer. If it was not giving an informed opinion, why was it charging so much money for "puffery?"

SP is a blue chip institution that made some bad judgments that cost the taxpayers a great deal of money. Investors and others had the right to rely on the integrity of its opinions.

Edward X. Clinton, Jr.

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Is A General Partnership Interest a Security?

CAN AN INSTRUMENT REFERRED TO AS  A GENERAL PARTNERSHIP INTEREST BE A SECURITY? 

This court answered the question with a "yes" answer?

SEC v. Louis v. Schooler and First Financial Planning Corporation, 12-cv-2164 (S.D. Cal. July 1, 2013).

The SEC filed a complaint against Schooler and the other Defendants alleging that they violated the anti fraud provisions of the Federal Securities Laws. The SEC also sought a temporary restraining order freezing assets and the appointment of a temporary receiver. The complaint alleges that defendants defrauded thousands of investors by selling 50 million dollars worth of general partnership units. The SEC alleged that the defendants sold $50 million of worth of general partnership interests "without disclosing material facts regarding the true value of the underlying land, the mortgages encumbering the properties, and when ownership of the underlying land was transferred from Defendants to the general partnerships." 

The district court granted the ex parte request for a temporary restraining order.

The SEC contended that the Schooler and the other defendants violated Section 5 of the Securities Act and Section 10(b) of the Exchange Act by failing to register the general partnership as a security.

The defendants then filed a motion to dissolve the TRO.

Over the years, there have been many attempts to avoid labeling an investment a security and therefore not subject to the remedies available to an investment under the Securities Laws.

In the Schooler case, the district court rejected Schooler’s arguments that the partnership interest was not a security.  The court ruled: 

The so called general partnership agreement leaves “so little in the hands of the investor that the investment is in fact a limited partnership interest. The court concluded that the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or the partners are so dependent on some unique entrepreneurial or managerial experience of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

According to the Court, the SEC pleaded  sufficient facts to establish the second and third factors, the Court reasoned that,  having already obtained a preliminary injunction, the SEC has presumptively met its burden to state a claim.

The court also noted that the SEC  alleged that the general partnership investors included a retired school teacher, a water filter salesman and a pharmacist.  The court concluded that these investors were not likely to be sophisticated investors. 

The motion to dismiss the TRO was denied. The writer predicts that there is little doubt that the SEC will prevail on the merits.

There have been numerous efforts to dodge the securities laws to avoid the  remedies that the securities laws provide. Such efforts frequently fail. The purpose of the securities law is to protect investors by requiring promoters to register the securities or to comply with one of the exceptions, such as Regulation D. 

Edward X. Clinton, Sr.

www.clintonlaw.net

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