Category Archives: Financial Reporting

Financial Reporting, Law Firm, Litigation Management, Middle Market Business, Risk Management

NJ Appellate Division Rules Shareholders Can Inspect Board Minutes

An August 17, 2010 New Jersey decision may be negative for businesses in New Jersey despite what on the surface is  a win for a large corporation.   In Cain v. Merck & Co., Inc., the New Jersey Appellate Division addressed whether the New Jersey Business Corporation Act entitles shareholders to inspect the minutes of the board of directors and the minutes of executive committees, and if so, the breadth of that right of inspection.  According to the court, resolution of these questions:  centers on the proper construction of N.J.S.A. 14A:5-28(4) of the Act. In pertinent part, that statute allows shareholders, upon proof of a “proper purpose,” to examine “the books and records of account, minutes, and record of shareholders of a corporation.” N.J.S.A. 14A:5-28(4).

In what appears to be a case of first impression in New Jersey, the Appellate Division concluded that the qualified right of inspection under the statute extends to the minutes of the board of directors and the executive committee – and not just to the minutes of the shareholder meeting.   The court, however, limited this right of inspection to only those portions of the board minutes that address their “proper purpose.”  In other words, shareholders are “not entitled to examine the minutes in order to explore unsubstantiated allegations of general mismanagement.”

It is not clear whether Merck will appeal given that it, in effect, won its alternative argument, namely that the review should be limited to discussions related to a study conducted by Merck rather than a broader review that on its face does not have such a  “proper purpose.”  According to a Merck spokesman, “we’re evaluating our next steps.” 

If left as binding authority, this decision may have huge ramifications for large and public businesses in New Jersey.   As it stands, the decision extends the reach of the statute – which appears on its face to be limited to shareholder meetings – to the much more deliberative board meetings of a corporation.  It gives litigants a new tool and may cause directors to be more restrained when providing advice given their decision-making process may now be opened up to a much greater extent.  Moreover, this obviously potentially increases the liability of directors and officers so there may be a potential increase in claims – with a resulting increase in D&O insurance premiums.   Although the lower court did recognize that the minutes should be redacted for privileged material, now that the door is open, future judges will have free reign to decide what is deemed “a proper purpose” or privileged material.   In other words, there is no guarantee a future judge won’t allow the fishing expedition rejected by the Appellate Division in this case.

Financial Reporting, Intellectual Property, Middle Market Business

Business Method Patents Live on Another Day: Bilski Decided by SCOTUS

Today’s Bilski v. Kappos decision rejected having a Federal Circuit test for determining patentable subject matter as a “knock out” test for business methods.  If affirmed, this Machine-or-Transformation Test (if applied as the sole test) would have likely rejected all business method patent applications.  As it stands, the United States is the only country that allows for business method patents.  After today’s United States Supreme Court decision, that remains the case.

In today’s decision, the Court ruled that “business methods” can be patentable if they meet the requirements set forth in longstanding precedent notwithstanding the fact they do not “recite a particular machine or apparatus, nor transform any article into a different state or thing.”  Although the Court ruled that the Machine-or-Transformation Test remains as a helpful tool when resolving patentable subject matter questions, it should not be considered a “knock-out” test.

This is a huge win for financial institutions and software companies with strong patent portfolios — as well as those law firms who help build and protect those portfolios.

Accounting Firm, Financial Reporting, Network Security, Privacy, Risk Management

CyLab Survey: Corporate Protection of Digital Assets Not a Priority

The recently released Carnegie Mellon CyLab 2010 Corporate Governance survey confirms that there is little change in senior management’s views towards data security – it’s not really a priority.   The CyLab annual survey, which measures board and management attitudes towards the protection of digital assets, is based upon results received from respondents at the board or senior executive level from Fortune 1000 companies.   Given public filing requirements, you would think protection of digital and related intangible assets – which now comprise the bulk of a firm’s value – would be a top of mind issue.  It’s not. 

When asked to identify their boards’ three top priorities, “improving computer and data security” was not selected by 98% of the respondents.  The respondents also indicated that their boards were not “actively addressing” IT operations or vendor management.  In essence, privacy and security of data inside or at outside vendors is receiving little oversight from management.  

Interestingly, 65% of the respondents also indicated that their boards were not reviewing their companies’ insurance coverage for data risks even though most standard policies offer little or no coverage.   Standing alone, this approach may not be an example of sound business judgment given the availability of specific insurance policies able to cover loss or destruction of digital assets. 

Not quite sure if this survey is a real wake up call or not.  The only thing for certain is that these attitudes are hardly what one would consider a best practice.  Sarbanes Oxley Section 404 requires a “top down” audit on internal controls which should provide some guidance on how digital assets are protected.  Indeed, under 15 U.S.C. § 7262(a), the Section 404 report must “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.”  It is difficult to see how management can in good conscious sign off on these assessments while still maintaining that “improving computer and data security” is not a priority.  

Notwithstanding how firms may perceive their Section 404 obligations, recognizing the potential “materiality” of computer security failings, Google, Intel, Symantec and Northrop Grumman recently added new warnings to their SEC filings informing investors of such risk.  The fact that some companies have come forward to detail recent breaches and the possibility of future breaches should indicate to other companies the need to address this reporting issue in a more proactive manner.  And, once risk disclosures are publicly made, the next obvious step is to ensure that proper protections are in place to address the risk.   Reporting uncoupled with affirmative preventive action is simply fodder for class action litigation the next time an event takes place.  What may be even worse is completely turning a blind eye to the entire problem.

Accounting Firm, Financial Reporting, Law Firm, Middle Market Business, Risk Management

Lehman, D&O Liability and Mark-to-Market Reporting

The Devil’s Casino, Vicky Ward’s first book, is the latest account of the fall of Lehman Brothers.  Released in April, this Lehman tome applies  a gossipy approach to storytelling.  Although we learn much about the shopping habits of some Lehman wives, repo transactions are nowhere to be found.   The book, however, becomes noteworthy when Ward details a September 9, 2008 meeting between JPMorgan’s Jamie Dimon and the Fed’s head Ben Bernake (on page 200) that purportedly directly led to JPMorgan’s request that Lehman provide $5 billion more in collateral. Less than a week later, Lehman filed its bankruptcy petition (the largest in US history) ostensibly given its lack of liquidity brought on by the collateral call of its clearing bank, JPMorgan. 

In a Report by Lehman’s bankruptcy examiner, dated March 11, 2010, the issue of JPMorgan’s collateral demand was analyzed and determined to be barely actionable.  The Report states: 

the Examiner concludes that the evidence may support the existence of a colorable claim – but not a strong claim – that JPMorgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman in September 2008.  A trier of fact would have to consider evidence that the collateral requests were reasonable and that Lehman waived any claims by complying with the requests.  

(Report of Anton R. Valukas, Examiner at page 1073)

On the heels of this Report and the Ward book, on May 27, 2010, the Lehman estate sued JPMorgan.  The suit takes a different position regarding the relationship between JPMorgan and Lehman by alleging that JPMorgan’s breach of duty was actionable. 

Unlike JPMorgan, Lehman’s board and officers were essentially given a free pass by Lehman’s bankruptcy estate as well as all regulators.  The Lehman Examiner’s Report actually spends much ink analyzing Delaware fiduciary law yet concludes numerous potential fiduciary lapses were not colorable claims.   On the other hand, a bank that potentially obtains crucial information from a third party (a governmental third party with a near real-time raw account of Lehman’s financial status) and merely seeks to protect its own interests, is forced to defend itself in a costly legal battle.   To many, it makes little sense that Lehman’s directors and officers were exonerated by regulators and Lehman’s bankruptcy Examiner.  Although the existing shareholder suits and claims made by those who sustained direct harm may eventually hit their mark, it is just not the same as potential jail time or a large personal SEC fine.  Not even close.  It is easy to argue that some Lehman folks should have paid with more than the inconvenience of a deposition.

If FASB had acted a bit more aggressively two years ago, maybe none of this would have even happened.  It would have been interesting to have seen FASB actually go through with its Exposure Draft of two years ago regarding FASB Statement 5 (loss contingency accounting) and FASB Statement 133 (hedging strategy accounting).  The vast opposition to the drafts caused FASB to abandon its plans.   Much of the opposition was typified in the McDermott Will & Emery letter that opined if the suggested changes to FASB Statement 5 were made, the opposing side to a filing entity would be able to learn litigation strategy.  If the proposed changes had matured (FASB Statement 5 has not changed since 1975) some of the decisions made by Lehman may have been altered or some of the actions may have been more cleanly delineated as wrongful.  Either way, there would have been more clarity regarding the propriety of their actions. 

As it stands, the Lehman saga provides some guidance to directors and officers looking to see how insulated they are from their financial accounting decisions.  They are pretty insulated given current standards. 

FASB may now be ready to change that dynamic.  It will revive the FASB Statement 5 Exposure Draft in the second quarter of 2010 – now with only a 30-day comment period.  And, FASB issued on May 26, 2010 an Exposure Draft that provides guidance regarding the financial reporting of derivative instruments and hedging strategies.  The overall approach taken moves towards a “mark-to-market” approach for derivative instruments that will have a “seismic effect” on how banks value loan portfolios beginning in 2013 (for large banks) and 2017 (for regional and community banks).  It remains to be seen what FASB will ultimately do given the negative comments it is certain to receive prior to the September 30, 2010 comment deadline.   The takeaway is that FASB  is finally taking a serious look at how companies report on loss contingencies and asset valuations.

All reporting companies – not just financial institutions – should obviously monitor how this and other related financial reporting initiatives evolve.   To a large degree, these accounting standards dictate the extent to which firms such as Lehman can push the envelope.  Although a widening of the reporting net may bring with it a separate set of problems, the change will certainly cause executives to think twice before being coy about a lack of liquidity.  As seasoned investors themselves, reporting officers should probably apply a “Would I want to know this information?” test the next time they are on the fence about the materiality of an item.  True mark-to-market reporting (not Lehman’s “mark-to-make believe” strategy) may bring on headaches for companies with many assets  having big value swings.  Nevertheless, it certainly seems to be part of the reporting standard of the future so you might as well get used to it.