Quarterly State Compliance Review

By now everyone is familiar with the federal legislative response to Enron and the other corporate scandals — namely, the Sarbanes-Oxley Act. But how have the states responded? After all, the states have been, and remain, principally responsible for corporate governance. The following is a brief review of the most recent legislative responses to the corporate scandals from some of the more important incorporation states.

State Responses to Corporate Frauds

California

California has been the most active state in passing laws designed to prevent accounting frauds and to punish wrongdoers. Three such bills went into effect on Jan. 1 of this year. S.B. 523 created a civil penalty not exceeding $1 million for a corporation that fails to notify the state and its shareholders of certain acts of an officer or director of which it has actual knowledge, including the making of a material mis-statement about the corporation's stock value. S.B. 777 prohibits employers from retaliating against employees who refuse to participate in illegal activities and imposes a civil penalty on corporate employers not exceeding $10,000 for each violation. A.B. 1031 increased the penalties for violating California's securities laws to conform them to the penalties imposed by the Sarbanes-Oxley Act for similar violations. There is also a bill pending (A.B. 1000) that would amend the provisions of the California Corporation Code requiring publicly traded corporations to disclose certain information in their Annual Statements. The amendments affect the disclosures concerning services by auditors and bankruptcies, and the definitions of certain terms.

Delaware

Delaware has not amended its General Corporation Law in response to the corporate scandals. However, it did amend its civil procedure code to increase its ability to exercise personal jurisdiction over corporate officers. S.B. 126 provided that every nonresident who, after Jan. 1, 2004, accepts appointment or serves as an officer in a Delaware corporation is deemed to have consented to the appointment of the corporation's registered agent as his or her agent upon whom service of process may be made in actions brought in Delaware by or against the corporation in which the officer is a necessary or proper party, or against the officer for violation of his or her duty. (“Officer” is defined to include the president, CEO, COO, CFO and certain other high-ranking positions.)

Illinois

S.B. 1530, effective Jan. 1 of this year, prohibits a business from bidding or entering into a contract with the state of Illinois or any state agency if it or any officer, director, or other managerial agent has been convicted of a felony under Sarbanes-Oxley or the Illinois Securities Law during the previous 5 years.

New York

New York has not passed any new corporate governance laws, but there are several bills currently in the state legislature that bear watching. A.B. 8794 would increase protections for whistleblowers employed by private employers. S.B. 4836 would require the president or CEO and treasurer or CFO of a not-for-profit corporation to sign and verify the accuracy of the corporation's annual report. S.B. 4843 would permit an action to be brought against a corporate director or officer who commits commercial bribery or who alters or falsifies any financial information resulting in an increase in his or her compensation. The plaintiff would be entitled to a judgment of three times the amount of the compensation or the economic harm to the corporation, whichever is greater.

State Court and Legislative Roundup

There was a great deal of judicial and legislative activity dealing with corporations during the last quarter. The following are highlights of this activity.

In the State Courts

Delaware Supreme Court Announces Test for Distinguishing Between Direct and Derivative Stockholder Suits

Tooley v. Donaldson, Lufkin, & Jenrette, Inc., No. 84,2003 (Delaware Supreme Court, April 2, 2004), involved a purported class action brought by minority stockholders in a Delaware corporation, alleging that the corporation's directors breached their fiduciary duties by agreeing to postpone the closing date of a tender offer. The stockholders claimed damages representing the time-value of money lost through a 22-day delay in closing. The Chancery Court dismissed the suit on the grounds that the claims were derivative. The Chancery Court's analysis of whether the suit was direct or derivative focused on the concept of the “special injury.” The court's premise was that in order to bring a direct claim, the stockholders had to have experienced a special injury – that is, a wrong separate and distinct from that suffered by other stockholders or a wrong involving a contractual right of the stockholders.

On appeal, the Delaware Supreme Court disapproved the use of the concept of special injury as a tool in analyzing whether a claim is direct or derivative. Instead, the court held that this analysis must be based solely on the following factors: 1) who suffered the alleged harm – the corporation or the suing stockholder individually, and 2) who would receive the benefit of the recovery or other remedy. In applying that test to this case, the court held that there was neither a direct nor a derivative claim as there was no assertion of injury to the corporation or to any rights of the plaintiffs.

Delaware Chancery Court Enjoins Stock Sale; Strikes Down Bylaw Amendments; Upholds Poison Pill

In Hollinger International, Inc. v. Black, C.A. No. 183-N (Delaware Chancery Court, February 26, 2004) the board of directors of a Delaware corporation decided that the corporation should enter into a Strategic Process in which it would pursue a range of transactions that would benefit the company and its shareholders, including a sale of the company or one or more of its major properties. The corporation entered into an agreement with its indirect controlling shareholder in that he agreed to devote his principal time and energy to pursuing the Strategic Process. He also agreed not to sell his controlling interest in the corporation's parent.

Despite that agreement, the shareholder entered into a contract to sell his shares in the parent. The buyers agreed to this transaction solely because they wanted to control a newspaper owned by the corporation. The buyers were unwilling to consider selling the corporation as a whole or any other strategic alternatives that would cause them to lose their control over the newspaper.

The board responded by forming a corporate review committee to consider what actions to take to prevent the sale. In response, the shareholder had the parent file written consents amending the corporation's bylaws to, among things, increase the quorum requirement for directors, require a unanimous vote of directors for various actions and abolish the corporate review committee.

The committee continued to meet and adopted a poison pill. The board also filed suit seeking a preliminary injunction against the sale of the parent's stock and a declaration that the bylaw amendments were invalid and the poison pill was valid.

The Chancery Court began by discussing whether the shareholder violated his fiduciary duties — an issue that was critical to the equitable sustainability of the bylaw amendments and poison pill. The court concluded that he did violate his fiduciary duties by not giving the corporation the opportunity to sell the newspaper, by giving false assurances that he was not shopping the parent and by giving the buyers confidential information.

The court then held that the bylaw amendments were invalid. The court noted that shareholders cannot adopt restrictions on the conduct of the board for inequitable purposes. Here, the bylaw amendments were adopted for the inequitable purposes of disabling the board and preventing it from completing the Strategic Process.

The court then upheld the poison pill. The court noted that the sale of the parent was the culmination of an improper course of conduct and would thwart the completion of a Strategic Process that was intended to maximize shareholder value. This threat justified a strong response and the poison pill was the most direct way the corporation could protect itself and pursue the Strategic Process.

Finally, the court found that the corporation was entitled to an injunction against the sale of its parent's stock as, without one, it would be practically impossible to rescind the deal, the Strategic Process would be undermined and the corporation would lose the opportunities the Strategic Process could develop.

New York Suit Against Martha Stewart Dismissed for Lack of Standing

Martha Stewart received some good news when the New York Supreme Court, Appellate Division, affirmed a lower court's order dismissing a purported class action by a shareholder against Stewart for lack of standing and failure to state a cause. The shareholder alleged that Stewart, the corporation's chairman and CEO, breached her fiduciary duty to the shareholders by her part in the ImClone insider trading scandal which, according to the plaintiff, resulted in damage to the corporation's primary asset — her name, reputation and associated goodwill, and damage to the proposed class members in the form of diminution in the value of their shares.

In Hahn v. Stewart, 773 N.Y.S. 2d 297 (Mem.), N.Y.A.D. 1 Dept., decided on March 23, 2004, the appellate court held that the complaint was properly dismissed on the ground that such allegations plead a wrong to the corporation only, for which a shareholder can only sue derivatively. The court also found that no grounds existed for granting leave to re-plead where the plaintiff sold his shares before instituting the action.

Nevada: Secretary of State May Revive Charter More Than 5 Years After Revocation

Nevada's corporation law requires corporations to file an annual list of officers and directors and designate a resident agent. Failure to file may result in the Secretary of State revoking the corporation's charter. Redl v. Heller, No. 40610 (Nevada Supreme Court) decided March 12, 2004, involved a breach of contract action filed against a Nevada corporation that failed to file its annual list after 1995, and consequently had its charter revoked. In 2002, the corporation applied for revival of its charter, which was granted by the Secretary of State. The plaintiff in the contract action petitioned for a writ of mandamus challenging the Secretary of State's revival of the charter on the grounds that the corporation law does not permit reinstatement of a charter that has been revoked for 5 consecutive years.

The Nevada Supreme Court denied the petition. The court noted that the Nevada corporation law allows a revoked corporation to apply for either reinstatement or revival. Although the petitioner argued that reinstatement and revival are the same, the court noted that there are separate statutory provisions governing each and that while the reinstatement provision specifically provides that the Secretary of State may not reinstate a charter that has remained revoked for 5 years, the revival provision does not contain a similar restriction. The court also rejected the petitioner's argument that the Secretary of State should not have revived the corporation's charter because its application for revival failed to list its directors, as required by the statute. The court pointed out that the application contained all of the other required information. Therefore, the corporation substantially complied with the statute and it was within the Secretary of State's discretion to revive its charter.

In the State Legislatures

Utah: Formation of 'Corporations Sole' Prohibited

S.B. 144 provided that effective May 3, 2004, corporations sole may not be formed under the Corporations Code. (A “corporation sole” is a corporation formed for acquiring, holding or disposing of church or religious society property for the benefit of religion, for works of charity and for public worship.) The bill also provided that a corporation sole amending or restating its articles of incorporation on or after May 3, 2004 must continuously maintain with the Division of Corporations and Commercial Code, the name, title and Utah street address of an official representative.

Vermont: Corporate Dissolution and Withdrawal Fees Increased

H.B. 472, effective March 1, 2004, revised the fees for filing certain documents with the Secretary of State, including increasing the fee from $5 to $20 for filing articles of dissolution for a domestic corporation and filing a certificate of withdrawal for a foreign corporation.

Washington: Member Committees Authorized for Non-Profit Corporations

H.B. 2577, effective June 10, 2004, provided that a non-profit corporation may have one or more member committees. The creation, makeup, authority and operating procedures of any member committee must be addressed in the corporation's articles of incorporation or bylaws.

By now everyone is familiar with the federal legislative response to Enron and the other corporate scandals — namely, the Sarbanes-Oxley Act. But how have the states responded? After all, the states have been, and remain, principally responsible for corporate governance. The following is a brief review of the most recent legislative responses to the corporate scandals from some of the more important incorporation states.

State Responses to Corporate Frauds

California

California has been the most active state in passing laws designed to prevent accounting frauds and to punish wrongdoers. Three such bills went into effect on Jan. 1 of this year. S.B. 523 created a civil penalty not exceeding $1 million for a corporation that fails to notify the state and its shareholders of certain acts of an officer or director of which it has actual knowledge, including the making of a material mis-statement about the corporation's stock value. S.B. 777 prohibits employers from retaliating against employees who refuse to participate in illegal activities and imposes a civil penalty on corporate employers not exceeding $10,000 for each violation. A.B. 1031 increased the penalties for violating California's securities laws to conform them to the penalties imposed by the Sarbanes-Oxley Act for similar violations. There is also a bill pending (A.B. 1000) that would amend the provisions of the California Corporation Code requiring publicly traded corporations to disclose certain information in their Annual Statements. The amendments affect the disclosures concerning services by auditors and bankruptcies, and the definitions of certain terms.

Delaware

Delaware has not amended its General Corporation Law in response to the corporate scandals. However, it did amend its civil procedure code to increase its ability to exercise personal jurisdiction over corporate officers. S.B. 126 provided that every nonresident who, after Jan. 1, 2004, accepts appointment or serves as an officer in a Delaware corporation is deemed to have consented to the appointment of the corporation's registered agent as his or her agent upon whom service of process may be made in actions brought in Delaware by or against the corporation in which the officer is a necessary or proper party, or against the officer for violation of his or her duty. (“Officer” is defined to include the president, CEO, COO, CFO and certain other high-ranking positions.)

Illinois

S.B. 1530, effective Jan. 1 of this year, prohibits a business from bidding or entering into a contract with the state of Illinois or any state agency if it or any officer, director, or other managerial agent has been convicted of a felony under Sarbanes-Oxley or the Illinois Securities Law during the previous 5 years.

New York

New York has not passed any new corporate governance laws, but there are several bills currently in the state legislature that bear watching. A.B. 8794 would increase protections for whistleblowers employed by private employers. S.B. 4836 would require the president or CEO and treasurer or CFO of a not-for-profit corporation to sign and verify the accuracy of the corporation's annual report. S.B. 4843 would permit an action to be brought against a corporate director or officer who commits commercial bribery or who alters or falsifies any financial information resulting in an increase in his or her compensation. The plaintiff would be entitled to a judgment of three times the amount of the compensation or the economic harm to the corporation, whichever is greater.

State Court and Legislative Roundup

There was a great deal of judicial and legislative activity dealing with corporations during the last quarter. The following are highlights of this activity.

In the State Courts

Delaware Supreme Court Announces Test for Distinguishing Between Direct and Derivative Stockholder Suits

Tooley v. Donaldson, Lufkin, & Jenrette, Inc., No. 84,2003 (Delaware Supreme Court, April 2, 2004), involved a purported class action brought by minority stockholders in a Delaware corporation, alleging that the corporation's directors breached their fiduciary duties by agreeing to postpone the closing date of a tender offer. The stockholders claimed damages representing the time-value of money lost through a 22-day delay in closing. The Chancery Court dismissed the suit on the grounds that the claims were derivative. The Chancery Court's analysis of whether the suit was direct or derivative focused on the concept of the “special injury.” The court's premise was that in order to bring a direct claim, the stockholders had to have experienced a special injury – that is, a wrong separate and distinct from that suffered by other stockholders or a wrong involving a contractual right of the stockholders.

On appeal, the Delaware Supreme Court disapproved the use of the concept of special injury as a tool in analyzing whether a claim is direct or derivative. Instead, the court held that this analysis must be based solely on the following factors: 1) who suffered the alleged harm – the corporation or the suing stockholder individually, and 2) who would receive the benefit of the recovery or other remedy. In applying that test to this case, the court held that there was neither a direct nor a derivative claim as there was no assertion of injury to the corporation or to any rights of the plaintiffs.

Delaware Chancery Court Enjoins Stock Sale; Strikes Down Bylaw Amendments; Upholds Poison Pill

In Hollinger International, Inc. v. Black, C.A. No. 183-N (Delaware Chancery Court, February 26, 2004) the board of directors of a Delaware corporation decided that the corporation should enter into a Strategic Process in which it would pursue a range of transactions that would benefit the company and its shareholders, including a sale of the company or one or more of its major properties. The corporation entered into an agreement with its indirect controlling shareholder in that he agreed to devote his principal time and energy to pursuing the Strategic Process. He also agreed not to sell his controlling interest in the corporation's parent.

Despite that agreement, the shareholder entered into a contract to sell his shares in the parent. The buyers agreed to this transaction solely because they wanted to control a newspaper owned by the corporation. The buyers were unwilling to consider selling the corporation as a whole or any other strategic alternatives that would cause them to lose their control over the newspaper.

The board responded by forming a corporate review committee to consider what actions to take to prevent the sale. In response, the shareholder had the parent file written consents amending the corporation's bylaws to, among things, increase the quorum requirement for directors, require a unanimous vote of directors for various actions and abolish the corporate review committee.

The committee continued to meet and adopted a poison pill. The board also filed suit seeking a preliminary injunction against the sale of the parent's stock and a declaration that the bylaw amendments were invalid and the poison pill was valid.

The Chancery Court began by discussing whether the shareholder violated his fiduciary duties — an issue that was critical to the equitable sustainability of the bylaw amendments and poison pill. The court concluded that he did violate his fiduciary duties by not giving the corporation the opportunity to sell the newspaper, by giving false assurances that he was not shopping the parent and by giving the buyers confidential information.

The court then held that the bylaw amendments were invalid. The court noted that shareholders cannot adopt restrictions on the conduct of the board for inequitable purposes. Here, the bylaw amendments were adopted for the inequitable purposes of disabling the board and preventing it from completing the Strategic Process.

The court then upheld the poison pill. The court noted that the sale of the parent was the culmination of an improper course of conduct and would thwart the completion of a Strategic Process that was intended to maximize shareholder value. This threat justified a strong response and the poison pill was the most direct way the corporation could protect itself and pursue the Strategic Process.

Finally, the court found that the corporation was entitled to an injunction against the sale of its parent's stock as, without one, it would be practically impossible to rescind the deal, the Strategic Process would be undermined and the corporation would lose the opportunities the Strategic Process could develop.

New York Suit Against Martha Stewart Dismissed for Lack of Standing

Martha Stewart received some good news when the New York Supreme Court, Appellate Division, affirmed a lower court's order dismissing a purported class action by a shareholder against Stewart for lack of standing and failure to state a cause. The shareholder alleged that Stewart, the corporation's chairman and CEO, breached her fiduciary duty to the shareholders by her part in the ImClone insider trading scandal which, according to the plaintiff, resulted in damage to the corporation's primary asset — her name, reputation and associated goodwill, and damage to the proposed class members in the form of diminution in the value of their shares.

In Hahn v. Stewart , 773 N.Y.S. 2d 297 (Mem.), N.Y.A.D. 1 Dept., decided on March 23, 2004, the appellate court held that the complaint was properly dismissed on the ground that such allegations plead a wrong to the corporation only, for which a shareholder can only sue derivatively. The court also found that no grounds existed for granting leave to re-plead where the plaintiff sold his shares before instituting the action.

Nevada: Secretary of State May Revive Charter More Than 5 Years After Revocation

Nevada's corporation law requires corporations to file an annual list of officers and directors and designate a resident agent. Failure to file may result in the Secretary of State revoking the corporation's charter. Redl v. Heller, No. 40610 (Nevada Supreme Court) decided March 12, 2004, involved a breach of contract action filed against a Nevada corporation that failed to file its annual list after 1995, and consequently had its charter revoked. In 2002, the corporation applied for revival of its charter, which was granted by the Secretary of State. The plaintiff in the contract action petitioned for a writ of mandamus challenging the Secretary of State's revival of the charter on the grounds that the corporation law does not permit reinstatement of a charter that has been revoked for 5 consecutive years.

The Nevada Supreme Court denied the petition. The court noted that the Nevada corporation law allows a revoked corporation to apply for either reinstatement or revival. Although the petitioner argued that reinstatement and revival are the same, the court noted that there are separate statutory provisions governing each and that while the reinstatement provision specifically provides that the Secretary of State may not reinstate a charter that has remained revoked for 5 years, the revival provision does not contain a similar restriction. The court also rejected the petitioner's argument that the Secretary of State should not have revived the corporation's charter because its application for revival failed to list its directors, as required by the statute. The court pointed out that the application contained all of the other required information. Therefore, the corporation substantially complied with the statute and it was within the Secretary of State's discretion to revive its charter.

In the State Legislatures

Utah: Formation of 'Corporations Sole' Prohibited

S.B. 144 provided that effective May 3, 2004, corporations sole may not be formed under the Corporations Code. (A “corporation sole” is a corporation formed for acquiring, holding or disposing of church or religious society property for the benefit of religion, for works of charity and for public worship.) The bill also provided that a corporation sole amending or restating its articles of incorporation on or after May 3, 2004 must continuously maintain with the Division of Corporations and Commercial Code, the name, title and Utah street address of an official representative.

Vermont: Corporate Dissolution and Withdrawal Fees Increased

H.B. 472, effective March 1, 2004, revised the fees for filing certain documents with the Secretary of State, including increasing the fee from $5 to $20 for filing articles of dissolution for a domestic corporation and filing a certificate of withdrawal for a foreign corporation.

Washington: Member Committees Authorized for Non-Profit Corporations

H.B. 2577, effective June 10, 2004, provided that a non-profit corporation may have one or more member committees. The creation, makeup, authority and operating procedures of any member committee must be addressed in the corporation's articles of incorporation or bylaws.