Financial Services Alert - August 31, 2010

Last week, the Supreme Judicial Court of Massachusetts (the “SJC”) resolved an unsettled question of Massachusetts law regarding the circumstances under which a Massachusetts corporation or business trust can obtain dismissal of derivative litigation under the business judgment rule.  A federal appellate decision from late last year had suggested that a Massachusetts corporation could rely on the business judgment rule to obtain dismissal of derivative litigation only if the corporation’s board had rejected the shareholder demand before suit was filed.  Examining the issue in the context of a derivative suit filed against the trustees of a registered investment company organized as a Massachusetts business trust, the SJC rejected that view, holding that the business judgment rule serves as a basis for dismissal of derivative litigation for a Massachusetts corporation or business trust regardless of when rejection of the demand occurs. 

Derivative Litigation under the Massachusetts Business Corporation Act.  In 2004 Massachusetts adopted a comprehensive revision of its Business Corporation Act (the “MBCA”).  Among other things, the revised statute included new provisions requiring shareholders to make a demand on a corporation’s board in all cases before filing a derivative lawsuit, and set forth a procedure by which the corporation could obtain dismissal if (among other things) a majority of independent directors determines in good faith after a reasonable inquiry that maintenance of the action would not be in the best interest of the corporation.  See Mass. G. L. c. 156D, § 7.44.

The Rejection of the Demand Letter and Related Litigation.  In this case, a shareholder served a demand letter on the board of trustees of a group of mutual funds organized as a Massachusetts business trust.  The independent trustees began an investigation into the demand’s allegations, but before the investigation was complete, the shareholder filed a derivative action in federal court in Manhattan.  Six weeks later, the independent trustees completed their investigation and rejected the shareholder demand.  In July 2007, the federal district court dismissed the lawsuit under the new procedure set forth in the MBCA.  The shareholder appealed to the U.S. Court of Appeals for the Second Circuit, arguing that this procedure did not apply because the statute referred to a derivative proceeding “commenced after rejection of a demand” and his lawsuit was commenced before the demand was rejected.  The Second Circuit suggested that the statutory language supported the shareholder’s argument, but certified the issue to the SJC because no Massachusetts court had yet addressed it.

The SJC’s Decision.  On August 23, 2010, the SJC issued a decision that, after analyzing the statute’s language, structure, and purpose, concluded that the statute enables a corporation to obtain dismissal under the business judgment rule using the new statutory procedure regardless of whether the demand is rejected before or after commencement of the lawsuit. The SJC also clarified that the derivative suit provisions in the MBCA apply not just to Massachusetts corporations, but also to Massachusetts business trusts, a form of organization used by many mutual funds.  Halebian v. Berv., SJC-10641 (Mass. Aug. 23, 2010).  Click here for a copy of the decision. 

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Goodwin Procter represented the business trust and its independent trustees before the Supreme Judicial Court of Massachusetts.

At its open meeting on August 25, 2010, the SEC voted to adopt amendments (the “Amendments”) to the proxy rules under the Securities Exchange Act of 1934 (the “1934 Act”) that facilitate shareholder nomination of directors by requiring a company to include shareholder nominees in its proxy statement and card (collectively “proxy materials”) relating to the election of directors, provided certain conditions in new Rule 14a-11 under the 1934 Act are met.  The Amendments also revise Rule 14a-8 under the 1934 Act, principally to codify prior SEC staff positions regarding an issuer’s ability to exclude certain shareholder proposals relating to director elections and to eliminate an issuer’s ability to exclude a shareholder proposal that relates to a procedure for the nomination or election of directors in reliance on Rule 14a-8(i)(8).  The release adopting the Amendments is available here.

Issuers Affected and Compliance Dates.  The Amendments apply to all 1934 Act reporting companies, including investment companies, other than companies whose only public securities are debt securities.  The compliance date is 60 days after publication of the Amendments in the Federal Register except for “smaller reporting companies,” which may delay complying with Rule 14a-11 until three years after the compliance date.

Eligible Shareholders.  A shareholder or group of shareholders (reference to a “nominating shareholder” meaning either) will be eligible to have a nominee included in a company’s proxy materials by (a) owning at least 3 percent of the total voting power of the company’s securities that are entitled to be voted on the election of directors at the meeting in question, as to which the nominating shareholder has both investment and voting power and (b) holding the required amount of qualifying securities for at least three years and continuing to own them through the meeting date.  A nominating shareholder holding the requisite securities with the intent of changing control of the company, or gaining a number of seats on the board of directors that exceeds the number of nominees the company would be required to include under Rule 14a-11 may not rely on Rule 14a-11.

Shareholder Nominees.  Rule 14a-11 does not permit a shareholder nominee whose candidacy or board membership would violate applicable state law, federal law or the applicable rules of a national securities exchange or national securities association (other than those relating to director independence).  For an issuer other than a registered investment company, a shareholder nominee must also meet the objective independence standards of the relevant national securities exchange or securities association that apply to directors generally.  For a registered investment company, a shareholder nominee meets Rule 14a-11’s independence standard if the nominee is not an “interested person” of the issuer within the meaning of the Investment Company Act of 1940.

As a general matter, the number of shareholder nominees under Rule 14a-11 is limited to no more than one nominee, or the number of nominees that represents up to 25 percent of the company’s board of directors (rounding down), whichever is greater. 

Disclosure and Notice Filings.  A nominating shareholder will be required to file Schedule 14N with the SEC and submit it to the company.  Schedule 14N filings, which will be publicly available, will include disclosure about voting securities held by the nominating shareholder, information about the nominating shareholder and shareholder nominee(s) similar to the disclosure currently required in a contested election, and descriptions of the nature and extent of the relationships between the nominating shareholder and nominee(s) and the company, among other things.

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A more in-depth look at the Amendments in a future edition of the Alert will provide more detail on the features of the Amendments described above and address other features of the Amendments such as procedures relating to the exclusion of shareholder nominees and additional exemptions from the proxy solicitation rules designed to accommodate nominating shareholder activities related to Rule 14a-11.

The National Futures Association (the “NFA”) announced that the amendments to Compliance Rule 2-30 and its associated Interpretive Notice will become effective January 3, 2011.  Compliance Rule 2-30 addresses “know-your-customer” and certain risk disclosure requirements for firms that are members of the NFA.  Generally, Compliance Rule 2-30 requires NFA Members to obtain information about their futures customers and provide each customer with appropriate risk disclosure prior to the time the customer opens a futures trading account or authorizes the NFA Member to direct trading in their account.

Once effective, the amendments to Compliance Rule 2-30 will broaden the scope of the Rule through a number of changes.  In addition to the individual customers currently covered by the Rule, the amendments will also cause the Rule to apply to each entity customer that is not an “eligible contract participant” as defined under Section 1a(12) of the Commodity Exchange Act (the “CEA”).  Generally, to qualify as an eligible contract participant an entity must be (i) an investment company, as defined under the Investment Company Act of 1940, (ii) a financial institution, (iii) an insurance company regulated by a state or foreign government, (iv) a commodity pool (a) with more than $5 million in assets and (b) operated by a person regulated under the CEA, or (v) a corporation, limited partnership or other entity with more than $10 million in assets.  The amendment will not affect NFA Members whose customers are eligible contract participants.

The amendments will require each NFA Member to request, annually, that each customer covered by Compliance Rule 2-30 notify the FCM of any material changes to the information previously obtained from the customer.  Further, after January 3, 2011, an NFA Member that currently solicits, and communicates with, a customer will be required to determine if additional risk disclosure is required to be provided based on any changed information from that customer.  Finally, an NFA Member will be prohibited from making customized trading recommendations to those customers whom the NFA Member has advised, or should have advised, that futures trading is too risky for them.