Gary L. Azorsky, co-chair of Cohen Milstein’s Whistleblower/ False Claims Act practice group, along with co-chair Jeanne A. Markey, and Raymond M. Sarola, submitted a comment letter to the Securities and Exchange Commission (SEC) in response to the SEC’s proposed whistleblower program rules, 87 Fed. Reg. 9280 (Feb. 18, 2022) (the “Proposed Rules”).
Cohen Milstein represents individuals who submit claims under the SEC’s whistleblower Program. We are well aware of the valuable role that whistleblowers play in facilitating the enforcement of the federal securities laws. We believe that certain of the amendments to the whistleblower program contained in the Proposed Rules will benefit the SEC, whistleblowers, and ultimately all participants in the U.S. capital markets by providing clear incentives to individuals with information regarding securities law violations to provide that information to the SEC and to any other whistleblower program that is implicated by such violations.
Related Actions – Rule 21F-3(b)(3)
We support the SEC’s efforts to replace the current “Multiple-Recovery Rule” (Rule 21F3(b)(3)) with a new approach that strengthens the incentives that the SEC presents to whistleblowers. There is no policy reason why whistleblowers should be penalized merely because the information that they provided to the SEC and that led to a related action recovery may also qualify them for an award under a different whistleblower program. Such a penalty, which may arise under the Multiple-Recovery Rule when the SEC determines that another whistleblower program has a closer relationship to the related action but would provide a lower award than the SEC would provide, creates a disincentive to whistleblowers in precisely those situations in which the government has determined whistleblowers are of particular importance (i.e., situations in which multiple whistleblower programs are implicated).
While each of the proposed alternatives represent improvements over the Multiple-Recovery Rule, we believe the SEC should select the Whistleblower’s Choice Option. This is the only “principal” alternative that fully ensures that whistleblowers are not penalized when their information leads to a related action recovery that implicates both the SEC’s and another agency’s whistleblower program.1 The Comparability Approach would result in such a penalty in situations in which the other whistleblower program was found to be “comparable” and has the “more direct or relevant connection” to the related action yet provides for a smaller award than the SEC would provide. And the Topping-Off Approach would retain the potential for this penalty in situations where the SEC’s covered action award was at or near the 30% statutory maximum. Under the Whistleblower’s Choice Option, the SEC would only consider the existence of the alternative award program at the payment stage.2 We therefore believe it would be appropriate and efficient to clarify in proposed Rule 21F-3(b)(3)(v) that the whistleblower’s obligation to inform the SEC that he or she has applied for an award from an alternative award program arises at the payment stage.3 We also suggest that the SEC specify the process by which a whistleblower should provide this notice, such as by creating a specific form or online mechanism. We are concerned that the language of proposed Rule 21F-3(b)(3)(v) may cause confusion among whistleblowers and their counsel as to when the obligation to inform the SEC is triggered4 and how notice should be provided.
Consideration of the Dollar Amount of Awards – Rule 21F-6
We support the addition of proposed paragraph (d) to Rule 21F-6. Our experience representing whistleblowers is consistent with the experience of the SEC that large awards increase the awareness of, and incentives to participate in, the SEC’s whistleblower program. We can also confirm that the SEC is wise to be concerned that discretionary authority to consider the dollar amount to reduce the size of awards adds uncertainty and decreases confidence in the award process. Whistleblowers should believe that they will be rewarded, not penalized, for the time and personal risk inherent in presenting information to the SEC concerning those frauds that cause the greatest investor harm and most significantly undermine faith in the U.S. capital markets. The proposed paragraph (d) to Rule 21F-6 would appropriately communicate this important message to whistleblowers. Thank you in advance for your consideration of the comments expressed in this letter. Should you have any questions regarding these comments or any other issues related to the SEC’s whistleblower program, please contact our Whistleblower Practice Group through its cochairs, Gary L. Azorsky or Jeanne A. Markey, or attorney Raymond M. Sarola, at (267) 479- 5700.
A copy of the letter can be found here.
Cohen Milstein’s Whistleblower and False Claims Act practice group has decades of combined experience successfully pursuing whistleblower cases under the federal and state false claims act statutes, and claims under the whistleblower programs of the SEC, IRS, and CFTC.
By Jeanne A. Markey and Raymond M. Sarola
In his State of the Union address, President Biden expressed concern with the growing — and troubling — trend of private equity ownership and operation of nursing homes and the inherent risk it presents to care of their residents. Between 2010 and 2019, such equity deals in health care nearly tripled in value, from $42 billion to $120 billion, totaling $750 billion over the last decade.
That staggering number represents thousands of hospitals, nursing homes, travel nurse companies, behavioral health programs, and other health care settings in every state. The profit-making goals of private equity are, in many ways, at odds with the needs of patients and the rules of government-financed health care programs. In fact, since 2013, private equity-owned health care companies have paid more than $500 million to settle claims of overcharging government health care programs.
Though there is always a profit motive when private investors acquire a company, private equity firms in the realm of health care should be viewed with skepticism. In this industry, the “product” at issue is a person’s health, not a computer or a bicycle pump. The business model of these companies — its goals, structure, and the operation of portfolio companies — combine to incentivize short-term profits at the expense of all other considerations. The result is that patients, communities, and even entire health care systems can suffer.
Fortunately, the government, aided by whistleblowers, has an invaluable tool in the False Claims Act, which allows it to prosecute fraud and protect the interests of patients and taxpayers.
Private equity firms are asset managers that raise capital from institutional and accredited investors and use that capital to obtain significant, often controlling, equity interests in private operating companies. Using the influence granted by their equity interest to direct the major business decisions of these companies, these firms seek to improve their financial condition and business prospects with the ultimate goal of selling the companies to the public through an IPO or to a strategic buyer at a profit that generates above-market returns to the firm and its investors.
A fundamental aspect of private equity is that, unlike traditional asset managers, they play active roles in the governance of their portfolio companies, a feature reflected in the considerable fees that private equity firms obtain from their investors. While equity-focused mutual funds have management fees that generally hover around 1% of assets under management, private equity funds commonly charge “2 and 20,” referring to a 2% management fee and 20% of profits above an agreed-upon threshold. Investors pay these high fees because these firms do not merely identify companies in which to invest, but also manage the operations of those companies for their own financial benefit.
At least four additional attributes of the private equity business model are relevant to understanding the incentives that tilt these firms toward emphasizing short term profits:
Private equity firms do not acquire portfolio companies for the long haul. The funds formed by private equity firms generally have a life span of five to seven years, meaning that from the time a private equity firm makes a new investment it is “on the clock” to improve the financial results of that company to make it attractive to a new buyer.
Individuals employed by private equity firms are typically appointed to sit on the boards of portfolio companies and to fill in as, or hand pick, the CEO and other senior executives, giving the equity firm multiple means of directing key business strategies.
Private equity investments often involve raising substantial amounts of debt financing to obtain a controlling interest in a company, secured by that company’s assets, which can leave the operating company with a significant debt burden on its cash flow that increases the risk of a future bankruptcy.
The combination of leveraged investments in companies with the one-sided performance fee that rewards private equity firms for profitable investments but does not penalize them for unprofitable ones creates a distorted structure that incentivizes these firms to select risky investments and to operate them in a risky fashion.
When private equity buys a health care company, patients often pay the price. A 2021 study concluded that private equity ownership increases the short-term mortality of nursing home residents by 10%, which represents more than 20,000 lives lost during a 12-year period, likely due to lowered nursing-staff-to-resident ratios and the diversion of patient care funding to private equity owners. An investigation by USA Today and Newsy found that when private equity firms acquire an interest in dental practices treating Medicaid patients, often children, those practices tend to incentivize dentists to increase the volume of procedures, regardless of medical necessity.
Just last month the Private Equity Stakeholder Project issued a report concluding that expansion of these companies into behavioral health services for vulnerable and at-risk youth has led to safety issues, quality of care issues, and even “horrific conditions” when short-term profits trump other considerations.
The Department of Justice and attorneys general in many states have begun to police the actions of private equity firms that cause portfolio companies to submit false claims to the government health care programs, and the False Claims Act has been their chosen enforcement tool. For example, in October 2021, the Massachusetts attorney general used the state’s False Claims Act to obtain a $25 million settlement from the private equity owners of a health care company following an earlier 2018 settlement with the company itself for $4 million. The government claimed that South Bay Mental Health Center submitted claims to Medicaid for mental health care services that were provided to patients by unlicensed, unqualified, and improperly supervised staff. The allegations directed at its private equity owners were that they knew of the company’s fraudulent scheme, held a majority of the seats on the company’s board, and yet failed to take the necessary steps to correct it.
Several effective strategies exist for deterring private equity from putting profits ahead of patients. First, the Securities and Exchange Commission can impose enhanced disclosure requirements on the investments and activities of private equity funds, a concept in which it has recently expressed interest. As Supreme Court Justice Louis Brandeis observed more than 100 years ago, “Sunlight is said to be the best of disinfectants.” Stronger disclosure requirements would increase transparency and bring more wrongdoing to light.
Second, the False Claims Act can be an effective tool in policing the actions of private equity firms that cause portfolio companies to submit false claims for payment to Medicare and Medicaid. It is increasingly being successfully used by the government and whistleblowers, who are often company insiders. This trend reflects the reality that private equity can both control and be complicit in fraudulent conduct.
Third, during the investigation phase of a false claims matter in which the health care company being targeted is owned by private equity, discovery directed at the private equity firm — and not just the health care company — should be encouraged. Due diligence memos and files, monthly portfolio updates disseminated to investors, and business plans revealing the firm’s strategies and timeline for enhancing the value of the portfolio company, for example, could all be immensely useful to understanding the nature and scope of the fraud alleged and the private equity firm’s role in perpetuating and profiting from that fraud.
As private equity firms further encroach upon the health care industry, it is essential that their activity is closely monitored for fraud and patients’ best interests are protected and prioritized.
Jeanne A. Markey is partner at Cohen Milstein Sellers & Toll PLLC and co-chair of the firm’s Whistleblower/False Claims Act practice group. Raymond M. Sarola is of counsel at Cohen Milstein and a member of the same practice group.
Access Private Equity, Health Care, and Profits: It’s Time to Protect Patients in full.
December 9, 2020
By not paying recovering addicts for their work, residential programs don’t provide the most effective approach to healing patients. Plus, it’s illegal.
By D. Michael Hancock, former assistant administrator for the U.S. Department of Labor’s Wage and Hour Division, and Joseph M. Sellers, partner at Cohen Milstein Sellers & Toll.
Addiction and substance abuse are destroying lives, communities and families all across America. The skyrocketing levels of addiction to opiates, alcohol and other substances make it critically important that effective treatment programs are available for those in need. Respect and dignity for those struggling to fight a nasty disease will be essential to save lives and reduce the number of families torn apart.
Substance abuse programs help in a variety of ways. Some residential programs facilitate the healing process by requiring patients to work full-time jobs as the central feature of the therapy. According to a report published in July by Shoshana Walter, an investigative journalist who has reported extensively on rehab programs that rely on unpaid work, at least 300 work rehab programs in 44 states are attended by over 60,000 recovering substance abusers every year.
Evidence-based studies of therapeutic communities demonstrate that work can be an important part of a holistic treatment program when tailored to a person’s skills and aptitude. Such work tends to build on existing strengths and reinforce the value of the individual. However, some research argues that it is not the work itself that provides effective treatment but rather accountability in the form of drug and alcohol testing and paid work. One prominent researcher is quoted as saying: “I’m not sure that it’s right to say that work is a powerful incentive. Paid work is a powerful incentive. It’s probably the money that’s the most important thing.”
But many of the workers in these rehab programs are not receiving pay. By not paying recovering drug and alcohol abusers, these programs do not provide the most effective approach to healing patients. Moreover, such arrangements are wrong — and illegal.
Most rehab programs that require work act essentially as temp agencies, farming the rehab residents out to commercial enterprises. The work is often for third parties, such as tree trimming services, dairies, poultry processing plants or oil refineries. The wages are remitted not to the workers but to the rehab centers. In many cases, these workers are not receiving the benefits of a hard day’s work, working for no pay, no Social Security credits, no unemployment insurance payment, with all of the fruits of their labor accruing to the treatment centers.
Other rehab-affiliated programs, notably the Salvation Army, have their patients perform grossly underpaid work for their commercial enterprises — if they did not have this captive workforce, they would have to seek labor from the open market.
Work programs that require residents to work jobs that produce goods or services for enterprises operating in the broader economy are obligated to ensure that those working are protected by employment laws. Minimum wage and overtime laws apply even if the employers claim they are not covered by these requirements because of their charitable status, as determined by a unanimous 1985 Supreme Court ruling. The decision stated that even if workers did not consider themselves to be employees, “minimum wage, overtime, and record-keeping requirements of the Fair Labor Standards Act” applied to all workers “engaged in the commercial activities of a religious foundation.” The same rules apply to nonreligious charities that engage in commercial activities.
The purposes of these protections are to guarantee a floor under which wages cannot fall to safeguard workers from having to compete based on substandard conditions, as well as to protect businesses that compete with them from unfair competition. These goals are not in any way incompatible with the goals of substance abuse treatment programs. Furthermore, there is no evidence that third-party employers are paying less to the rehab centers than they would to workers secured through temp agencies.
One of the fundamental principles underlying wage and hour law is that neither workers nor businesses should be forced to compete based on substandard wages. In fact, the Fair Labor Standards Act was put in place largely in recognition that the most vulnerable workers need protection because they are largely without power to demand fair treatment on their own.
Addiction treatment programs that require work must abide by the law and protect recovering abusers as members of the workforce. Otherwise, these workers, and the other workers and businesses competing with them, suffer the very harm Congress set out to prevent.
We owe these workers the protection of the law, but more than that, we owe them the respect and the dignity that are signified by paying someone an honest day’s pay for an honest day’s work.
The article is availabe at NBC Think.
By Julie Goldsmith Reiser, co-chair of Cohen Milstein’s Securities Litigation & Investor Protection practice, and Lori Nishiura Mackenzie, co-founder of the Stanford VMware Women’s Leadership Innovation Lab.
The NFL’s Rooney Rule, requiring that at least one person of color be interviewed for head coaching vacancies, has lost its effectiveness in the NFL but should still be used by corporate boards to improve diversity, say Julie Goldsmith Reiser, partner at Cohen Milstein, and Lori Nishiura Mackenzie, co-founder of the Stanford VMware Women’s Leadership Innovation Lab. They offer guidance on using it purposefully and authentically.
With the NFL plagued by years of scandal and backlash for its treatment of Black players, it comes as no surprise to see owners back in the spotlight battling a discrimination lawsuit. Former Miami Dolphins head coach Brian Flores sued the NFL and three teams for racial discrimination, sparking much larger conversations about diversity in hiring and the NFL’s “Rooney Rule.”
The NFL implemented the Rooney Rule in 2003, requiring that at least one person of color be interviewed as part of the hiring process for vacancies in head coaching positions. It appeared to work. From 2001 to 2005, the number of Black head coaches in the NFL, while still small, tripled from two to six. After more than a decade of success resulting in nearly 25% representation of Black coaches in the NFL, the rule undeniably faltered from 2017 to 2019, with the percentage of Black head coaches dropping from 21.9% to 9.4%, where it remains today.
As an attorney who works with shareholders to hold companies accountable promoting diversity, equity, and inclusion in the workplace and a strategist who helps companies thrive through building communities with strong cultures, we recommended that companies adopt an evolved version of the Rooney Rule for their own efforts to diversity corporate boards.
There are a number of lessons that corporate boards should draw from the NFL’s experience with the Rooney Rule to avoid similar backsliding.
A True Commitment Is Essential
We continue to believe the Rooney Rule can work if it evolves and is part of a broader, authentic commitment to diversity.
First, how did the rule lose effectiveness? The interview process now appears to reflect tokenism where White team owners interview Black candidates only to avoid a fine from the NFL, not because the Black coaches have a legitimate chance to secure a head coach position. Research shows that when there is only one minority candidate in a pool of four finalists, their odds of being hired are statistically zero.
While interviewing just one candidate from an underrepresented group does not change the status quo, interviewing at least two has a greater likelihood of leading to change. Interviewers are less likely to see any particular candidate as “the Rooney Rule” applicant and instead, consider their qualifications. And since the candidates are indeed qualified, just overlooked due to biases, their skills can now shine. A truly diverse slate can also help the candidate’s performance and help interviewers be fair.
The revised Rooney Rule of at least two candidates (or even better, 50%) from underrepresented groups is a crucial step in the right direction. But for boards to succeed in their efforts to diversify, they must shift from a compliance mindset to one of truly valuing diversity. Then they must create the processes to prevent biases from creeping into their decision making, focusing on continual improvement rather than a one-time, quick fix.
How to Support Diversity Efforts
Here are some ways to support diversity efforts in the boardroom.
Focus on Skills, Not Titles
An anonymized skills matrix, such as the NYC Boardroom Accountability matrix, allows the search committee to assess important skills across all existing, and then prospective, board members.
This can be effective for two reasons. First, it allows boards to assess candidates based on their unique skills, not broad-based experience such as prior board experience or titles, such as having been a CEO or board member for another company. With women and people of color in low numbers on boards and in the CEO seat, this can open the door to more candidates.
Second, it can help boards more effectively identify what they need, which can lead to a more productive interview process. Boards should also retain a neutral party to populate the skills matrix of prospective board members in an anonymized way, to minimize implicit gender and racial bias.
Curate a Diverse Interview Committee
Not only will diversity on the committee lead to better decision making; it can also reduce biases. Being from an underrepresented group does not automatically make a person less biased, but because women and people of color have often experienced bias, they are more likely to practice techniques to block it.
And having a diverse committee can support the candidates in moving past stereotype threat to imagining that they could truly belong on the board and contribute in a meaningful way.
Move From a ‘Quick Fix’ to Inclusion
These proposals can lead to a stronger hiring process, but the work does not end here. Once a candidate is chosen, companies should commit to ongoing efforts to support the new member with a thoughtful onboarding process that aims to fully integrate the new board member.
The board should also engage in designing inclusive norms and educate incumbent members about the value of hearing from different viewpoints in order to truly benefit from the increased diversity.
Research and experience show that diversity efforts must be intentionally incorporated and customized into the recruitment process to make lasting, meaningful change.
A six-year study by Credit Suisse reflected that companies with women directors on their boards outperformed shares of their peers with all-male boards by 26%. Likewise, a Morgan Stanley study found that U.S. companies with three or more female directors outperformed the earnings of companies without female directors by 45% per share.
These outcomes show that representation yields stronger performance—a metric that surely the NFL owners care about too.
Expert Analysis
Last October, the U.S. Equal Employment Opportunity Commission launched its new initiative on artificial intelligence and algorithmic fairness. In doing so, EEOC Chair Charlotte Burrows affirmed that while
[a]rtificial intelligence and algorithmic decision-making tools have great potential to improve our lives, including in the area of employment … the EEOC is keenly aware that these tools may mask and perpetuate bias or create new discriminatory barriers to jobs. We must work to ensure that these new technologies do not become a high-tech pathway to discrimination.
While the EEOC has been considering issues raised by the use of AI and big data in employment since at least 2016, its current initiative is its first effort to update federal employment decision-making guidance to account for new AI technologies that continue to proliferate amid social distancing policies.
The initiative will culminate with issuing technical assistance and guidance on algorithmic fairness.
While the EEOC’s guidance is welcome, voluntary standards are not enough to address the serious challenges posed by the use of AI in employment decision making.
New AI decision-making technology, including fully automated recruiting, resume screening and even video interviewing, continues to gain popularity with employers, but applicants often do not even know that their resume or videoed interview is being reviewed by AI, rather than human resources.
This lack of transparency is of particular concern because AI decision-making algorithms carry known risks of discriminating on the basis race or gender.
For example, in 2018, Amazon.com Inc. found that its AI hiring software downgraded resumes that included the word “women” and those of candidates from all-women’s colleges because the company had not hired enough female engineers and computer scientists for the AI to see women as viable candidates.
Similarly, a 2018 study found that Face++ and Microsoft AI, facial recognition software products that analyze candidates’ emotions for desirable traits, have been shown to assign Black men more negative emotions than their white counterparts.
As observed by the Brookings Institute, “[l]eft unchecked, these biases in automated systems result in the unjustified foreclosure of opportunities for candidates from historically disadvantaged groups.”
While facially neutral AI selection tools that adversely affect groups of applicants because of race or gender are good candidates for application of long-standing disparate impact analysis under existing Title VII standards, there is a significant missing link: employees and job applicants frequently do not know that they have been reviewed by AI at all, let alone know any details about how the algorithm works, which can leave them unable to frame their claims.
Currently, there are no federal laws or regulations that specifically require that employers inform employees or job applicants when they are being evaluated using AI. This means that employees and applicants typically lack the necessary awareness to challenge discrimination caused by these technologies.
States and cities nationwide have begun to fill this gap by considering and adopting legislation to require that employers disclose any use of AI decision-making tools, and in some cases adopt specific standards that employers must meet if they are going to use AI decision-making technologies.
Most recently and comprehensively, on Dec. 9, 2021, D.C. Attorney General Karl Racine introduced legislation that would prohibit legal entities that gross at least $15 million annually from making algorithmic decisions on the basis of actual or perceived race, color, religion, national origin, sex, gender identity or gender expression.
This proposed bill would make it illegal to use any AI practice that has an adverse effect against an individual or class based on demographic traits, not only in employment, but also in decisions about housing, education and public accommodations, including credit, health care and insurance. This proposal also requires entities using AI to inform consumers about what personal information they collect from consumers and how that information affects their decision-making.
The proposal comes on the heels of passage of a new law in New York City late last year, which regulates employers’ use of AI decision-making technologies. The New York City law prohibits employers from using automated decision-making tools for employment screening unless the tool used is subject to “an impartial evaluation by an independent auditor” on an annual basis, that checks for adverse impact, and the results of the audit published on the employer’s website.
Starting in January 2023, companies will be required to disclose to job applicants how AI technology was used in the hiring or promotion process, and must also allow candidates to request alternative evaluative approaches like having a human process their application. New York City will become the first city to impose fines for undisclosed or biased AI use by employers, charging up to $1,500 per violation.
Previously, but more narrowly, Illinois passed H.B. 2557, which requires employers to disclose when AI is used in a video interview and allows interviewees the option to have their data deleted after being interviewed. Maryland followed Illinois and passed H.B. 1202, which prohibits the use of facial recognition during preemployment interviews until an employer receives the consent of the applicant.
Legislation was introduced in California, but it died in committee. S.B. 1241 would have required AI used in hiring to be audited annually, something like the NYC statute.
However, S.B. 1241 also would have created a presumption that an employer’s decision relating to hiring or promotion based on a test or other selection procedure is not discriminatory if the employer conducted a validity study showing the selection procedure was job related, and if annual reviews showed that the use of the selection process resulted in an increase in hiring of a protected class as compared to the pre-implementation workforce.
In other words, if an employer had a distorted workforce due to a history of discrimination, it could continue to discriminate using new algorithmic tools, so long as the new tool discriminated a little bit less than the employer had in prior years.
Also, the employer would be protected from a finding of discrimination under state law unless a plaintiff proved by the heightened clear and convincing evidence standard that the employer had reason to believe that the selection device would cause disparate impact before it began using the new process.
This would have set up terrible incentives for employers if state law were the only law they were subject to, but this attempted safe harbor would have offered no protection against Title VII claims that would have been facilitated by the law’s requirements to collect and maintain data. Hopefully, California does a better job on its next attempt.
These examples from Illinois, Maryland, New York, D.C. and California are only a start. Other states are likely to consider legislation in this area as well.
Indeed, Iowa Attorney General Tom Miller, the incoming president of the National Association of Attorneys General, has said his presidential initiative will focus on technology consumer protection, including algorithms that may manipulate or harm consumers.
Employers and employees concerned about the import of these AI hiring tools should pay attention not only to the EEOC’s initiative, but to legislative initiatives in state houses nationwide. Given the variety of approaches states and cities have taken, federal action that could bring some uniformity may gain more support.
By Carol V. Gilden, Richard A. Speirs, and Amy Miller
In December 2019, the Seafarers Pension Plan (“Seafarers”), represented by Cohen Milstein, filed a derivative action in federal district court in Chicago under Section 14(a) of the Securities Exchange Act of 1934 (“Exchange Act”), alleging that The Boeing Company’s (“Boeing”) board members and officers made materially false and misleading statements about the development and operation of the 737 MAX airplane in Boeing’s 2017, 2018, and 2019 proxy materials. Seafarers alleged that these false and misleading statements caused stockholders to re[1]elect directors who for years had countenanced the poor oversight of passenger safety, regulatory compliance, and risk management during the 737 MAX’s development, to approve Boeing’s executive compensation plans, and to reject a shareholder proposal to separate the CEO and Chair positions, thereby causing massive harm to Boeing.
Boeing’s directors and officers moved to dismiss, seeking to enforce Boeing’s forum bylaw, which strips federal courts of their exclusive jurisdiction over derivative Exchange Act claims by designating the Delaware Court of Chancery—a state court without jurisdiction over these federal claims— as the exclusive jurisdiction for all derivative claims asserted on Boeing’s behalf. The district court agreed, and the Seafarers Pension Plan appealed the decision to the United States Court of Appeals for the Seventh Circuit. In January 2022, a panel of the Seventh Circuit issued a 2-1 opinion, Seafarers Pension Plan v. Bradway, No. 20-2244, — F.4th — (7th Cir. 2022) (“Seafarers”), reversing the district court’s decision to enforce Boeing’s forum bylaw against the Seafarers’ derivative Section 14(a) claims and finding the bylaw unenforceable under both Delaware and federal law.
The Seventh Circuit held that “[b]ecause the federal Exchange Act gives federal courts exclusive jurisdiction over actions under it, applying the bylaw to this case would mean that plaintiff’s derivative Section 14(a) action may not be heard in any forum. That result would be contrary to Delaware corporation law, which respects the non-waiver provision in Section 29(a) of the federal Exchange Act, 15 U.S.C. § 78cc(a).” Notably, the anti-waiver provision in the Exchange Act prevents parties from opting out of that federal law in favor of state law, regardless of any similarities between the laws.
The Seventh Circuit found Delaware law, including Section 115 of the Delaware General Corporation Law (“DGCL”), prohibits Delaware corporations from using a forum bylaw to “foreclose entirely” a stockholder’s derivative action under Section 14(a). The Seventh Circuit found two key phrases in Section 115 determinative: “consistent with applicable jurisdictional requirements” and “courts in this State.” First, the Seventh Circuit held that as applied, Boeing’s bylaw violates Section 115 because it is “inconsistent with” the Exchange Act’s jurisdictional requirement providing for cases to be heard in federal court. As support for this reading of the statute, the Seventh Circuit cited Section 115’s synopsis, stating, “Section 115 is also not intended to authorize a provision that purports to foreclose suit in a federal court based on federal jurisdiction, nor is Section 115 intended to limit or expand the jurisdiction of the Court of Chancery….” Second, the Seventh Circuit explained that references to courts “in” a state include both state and federal courts located in the state, as opposed to courts “of” a state. The Seventh Circuit also noted that the Delaware Supreme Court’s decision in Salzberg v. Sciabacucchi, 227 A.3d 102 (Del. 2020), supported this interpretation, stating, “Salzberg expressly presumed the reference to ‘courts in the state’ in the bylaws authorized by the new Section 115 included federal courts,” and pointing out that Boeing’s bylaw did not include federal courts. Further, the Seventh Circuit rejected the defendants’ argument that Salzberg allows such a bylaw under Section 109(b) of the DGCL, emphasizing that Salzberg stressed the “harmony between Delaware corporation law and federal securities laws” when it stated: “This Court has viewed the overlap of federal and state law in the disclosure area as ‘historic,’ ‘compatible,’ and ‘complimentary.’”
Turning to federal law, the Seventh Circuit distinguished federal cases where the federal courts had enforced forum provisions in international agreements, including the seminal U.S. Supreme Court decision, M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972). Notably, the Seventh Circuit stated that “Bremen differs from this case most importantly in that it involved a purely private contractual dispute” and did not involve a federal claim or a federal statute with a non[1]waiver provision like Section29(a) of the Exchange Act. The Seventh Circuit further reasoned that in international business transactions, the “presumptive validity” of choice of law and forum provisions offer predictability. However, extending forum provisions to “domestic investments” where the provisions waive federal securities rights and remedies and limit available remedies to those under state law “would undermine the pivotal decisions by Congress in 1933 and 1934 to assume the dominant role in securities regulation after decades of ineffective state regulation.” The Seventh Circuit also looked to the U.S. Supreme Court’s warning in Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth Corp., 473 U.S. 614 (1985) that “in the event that the choice-of-forum and choice[1]of-law clauses operated in tandem as a prospective waiver of a party’s right to purse statutory remedies for antitrust violations, we would have little hesitation in condemning the agreement as against public policy.”
The Seventh Circuit majority rejected the dissent’s “novel proposal” to allow a “Delaware state court to hear a derivative action under Section 14(a), despite the Exchange Act’s provision for exclusive federal jurisdiction” as inconsistent with Delaware law, the Exchange Act’s anti-waiver provisions, and U.S. Supreme Court decisions. Accordingly, the Seventh Circuit held that Boeing’s forum provision, as applied, “was contrary to Delaware corporation law and federal securities law” because it deprived the federal courts of their exclusive authority to hear derivative Exchange Act claims.
The Seventh Circuit’s decision is an important win for investors. It tells companies they cannot use a forum bylaw to close the courthouse doors to investors asserting federal only derivative claims.
Fiduciary Focus
Shareholder Advocate Winter 2022
Last November, the Massachusetts Pension Reserves Investment Board (“MassPRIM”) approved $1 billion in investments for emerging and diverse managers over the next two years. MassPRIM’s announcement represented part of the fund’s broader $96 billion strategy to meet its FUTURE initiative, which seeks to substantially increase allocation to diverse and emerging managers to at least 20 percent of assets under management. The FUTURE initiative was created to help MassPRIM meet diversity goals originally established in a bill championed by Massachusetts State Treasurer Deborah Goldberg, who chairs MassPRIM. Treasurer Goldberg said that “by investing $1 billion into emerging-diverse program, [PRIM] is taking important steps in addressing the inequities endemic in the financial sector.”
Goldberg’s FUTURE initiative is the most recent example of public employee pension funds’ leadership and prioritization of diversity in investments. Efforts by public funds to diversify investment managers can be traced to early adopters like the New York Common Retirement Fund (“NYSCRF”), the California Public Employees Retirement System (“CalPERS”), and the California State Teachers’ Retirement System (“CalSTRS”). The emerging managers program established by the $248 billion NYSCRF in 1994 has $6.7 billion in commitments, for example.
Efforts by both public and private institutional investors to improve their records of hiring diverse asset managers appeared to gain new urgency following the nationwide protests over racial inequality sparked by the murder of George Floyd by a Minneapolis police officer.
In October 2020, Illinois State Treasurer Michael Frerichs led a national effort urging Russell 3000 companies to disclose racial, ethnic, and gender data about their board of directors. In September 2020, Connecticut State Treasurer Shawn Wooden partnered with the Ford Foundation to put together a coalition of CEOs “to advance social change, racial justice, and greater economic prosperity for all.”
On the private investment side, Vanguard said in December 2020 that it would vote against directors who do not push for more racial and gender diversity on their company’s boards. In December 2021, BlackRock, the world’s largest asset manager, announced that its 2022 proxy voting guidelines would push U.S. companies to “aspire to 30% diversity” on their boards of directors and encourage them to include least two women directors and at least one director from an underrepresented group on their boards. BlackRock defined underrepresented groups as those including “individuals who identify as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, or Native Hawaiian or Pacific Islander; individuals who identify as LGBTQ+; individuals with disabilities; and veterans.” That same month, Goldman Sachs updated its proxy policies to say it expected large corporations—those listed in the S&P 500 and FTSE 100—“to have at least one diverse director from an underrepresented ethnic minority group on their board” and all public companies with boards larger than 10 members to include at least two women directors. And in his 2022 letter to portfolio company boards, State Street Global Advisors (“SSGA”) CEO and President Cyrus Taraporevala reiterated SSGA’s “belief that strong, capable, independent boards exercising effective oversight are the linchpin to create long-term shareholder value.” Announcing an enhancement to State Street’s gender diversity policy, Taraporevala said SSGA was prepared to vote against board leaders if their companies did not have at least one female director by 2022 and 30 percent female representation in 2023. He also repeated SSGA’s pledge to expand its diversity focus to include race and ethnicity, pledging “voting action against responsible directors” of S&P 500 and FTSE 100 companies that do not have a “person of color” on their boards or failed to disclose information about their boards’ racial and ethnic makeups.
Despite the historical efforts by pension funds to diversify investment managers and the more recent developments of both public and private institutional investors to diversify company board of directors, however, some institutional investors remain reluctant to embrace the concept of diversity. The argument falls back to economist Milton Friedman who argued in a 1970 New York Times article that the social responsibility of businesses should focus on increasing profits, not “providing employment” or “eliminating discrimination.” More recently, The Wall Street Journal’s editorial board referred to such diversity initiatives as “virtue signaling at the expense of someone else.” In other words, they believe diversity falls outside an institutional investor’s fiduciary duty to maximize risk-adjusted returns for its beneficiaries.
Yet there are several strong arguments that pension funds can square their long and established pursuit of diversifying investment managers while meeting their fiduciary duties.
First, extensive research suggests that corporate diversity results in better financial performance. The Carlyle Group, a private equity manager, found a positive correlation between board diversity and profits among the companies it holds in its investment portfolio. The Carlyle Group’s study, which examined the last three years of financial results, showed that companies with at least two diverse directors out-earned less diverse companies by 12 percent per year on average. Using 2019 data, meanwhile, Global management firm McKinsey & Company (“McKinsey”) found that companies in the top quartile for racial and ethnic diversity on executive teams were 33 percent more likely to have above-average profitability than companies in the bottom quartile. Consulting firm FSG recently conducted a six-month study of 12 leading companies and found these companies generated new sources of growth and profit by advancing racial equity.
Second, evidence suggests that diversity creates better governance and informs better decision-making. Research indicates that diverse groups perform better than like-minded groups because such diversity results in more careful information processing that’s absent in homogenous groups.
Diversity has another benefit, too: diverse firms can help mitigate risk. Studies have found that diverse board of directors, particularly those with gender diversity, approve less financially risky policies than homogenous board of directors. Furthermore, diversity can help reduce litigation risks. In 2020 alone, the United States Equal Employment Commission secured $440 million from victims of discrimination. Such discrimination can also harm the reputation of a company or institutional investor.
Finally, public pension funds can factor diversity as part of their fiduciary duty. The most recent guidance comes from the U.S. Department of Labor’s October 2021 proposed rule on duties of prudence and loyalty for investments. In the Department’s proposed rule, fiduciaries may give “appropriate consideration” of environmental, social, and governance (“ESG”) factors for investments when carrying out a risk-return analysis. Specifically, the proposed rule cites workplace diversity and inclusion as an example of ESG factors. The Department’s proposed rule then cites 15 different studies in which diversity has a material impact on employee recruitment and return, performance and productivity, and litigation. Among the studies and reports cited are the McKinsey and FSG ones discussed above.
For years, some scholars and others adhered to the idea that increasing diversity doesn’t meet fiduciary standards because it sacrifices beneficiaries’ financial interests in the name of a purely “social” goal. However, public pension funds like NYSCRF, CalPERS, and CalSTRS have long demonstrated the opposite: that institutional investors with more diverse staff, boards, and investment managers can make more money over the long term. As the country grapples with continuing gaps in opportunity for underrepresented populations, the need for diversity seems even more evident. As most recently demonstrated by MassPRIM’s FUTURE initiative, a well-designed program that considers diversity no longer raises any real fiduciary questions. Those questions have been answered by the Department of Labor’s proposed rules and associated studies. Now, the real question becomes whether more institutional investors will follow the lead of these public pension funds.
The Winter 2022 issue of the Shareholder Advocate includes:
- Reining in Abuse: SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans
- Groundbreaking Settlement Reached in Pinterest Shareholder Derivative Litigation – Molly J. Bowen
- Seventh Circuit Reverses Dismissal of Boeing Investors’ Derivative Action on Forum Bylaw Grounds – Carol V. Gilden, Richard A. Speirs, and Amy Miller
- Fiduciary Focus: Allocation to Diverse Investment Managers – Jay Chaudhuri
Download the Winter 2022 edition of the Shareholder Advocate (PDF).
For years, institutional investors have been clamoring to tighten the rules governing plans that allow corporate executives to buy and sell their own companies’ stock without incurring insider trading liability. On December 15, 2021, the SEC finally answered those calls and announced proposed amendments to Rule 10b5-1, which govern such plans. The SEC Commission’s three Democrats and two Republicans all voted for the proposed amendments, although some did not approve of every single proposal.
“We welcome these proposed amendments, which we have long supported after seeing time and time again how corporate insiders have abused the current rule,” said Steven J. Toll, co-chair of Cohen Milstein’s securities litigation practice group. Julie G. Reiser, the practice group’s other co-chair, concurred. “Many of the proposed changes will strengthen institutions’ ability to confront illegal insider trading in the courtroom,” she said.
Rule 10b5-1 and Its Abuse
Rule 10b5-1, which was adopted over 20 years ago in 2000, provides corporate insiders protection from insider trading claims if their trades were exercised according to a written pre-arranged plan that was devised before the executive was aware of any material non-public information (“MNPI”). Although these plans are not a prerequisite to an executive’s sale of stock, they have become widespread because they provide an effective shield against securities fraud lawsuits.
Instead of preventing trading on MNPI, critics say these plans can enable such behavior due to design loopholes. In some circumstances, for example, insiders create multiple overlapping plans and then cancel certain plans if they learn of MNPI that likely will increase the stock price. Incredibly, the current rules allow for the cancellation of a 10b5-1 plan even if the cancellation is based on MNPI.
Written to address these types of problems, the proposed SEC amendments fall into two main categories: (1) restrictions to the plans themselves and (2) disclosure requirements for the plans.
Proposed Restrictions on the Plans
One of the most popular proposed amendment is to require a “cooling off period” for any trades to take place after a plan has been created. Supporters of such a restriction include former SEC Chair Jay Clayton, who was appointed by President Trump.
Currently, an insider can create a 10b5-1 plan and then execute a trade based on that plan the same day. Under the new proposal, corporate officers or directors could not trade until 120 days after establishing a 10b5-1 plan. If the trading plan is entered into by an issuer, i.e., the company itself, the cooling off period would need to be only 30 days.
Another important amendment would “eliminate the affirmative defense for any trades by a trader who has established multiple overlapping trading arrangements for open market purchases or sales of the same class of securities.” This would eliminate the ability of insiders to game the system by setting up multiple plans and then later deciding to cancel certain plans that would execute trades that would result in losses.
Moreover, there is a proposal to sharply curtail the use of plans that are limited to a single-trade. Unlike what many envision Rule 10b5-1 plans to be, which is a set plan to sell securities at multiple, prearranged dates over an interval of time whether the stock is up or down, single-trade plans are set up to execute just a single trade at one moment in time. Some have argued single-trade plans are not “plans” at all, but more equivalent to a date-triggered order and should be completely prohibited under Rule 10b5-1. A recent Stanford study from January 2021 found that single[1]trade plans generally avoided losses of some four percent, indicating their abuse.1 Therefore, the SEC now proposes to limit their use to only one plan per 12-month period. Although the SEC does not propose banning single[1]trade plans, partly because they envision legitimate, one-time liquidity needs for such a plan, they did invite the public to make the case for a ban when submitting their comments.
Finally, while current rules require that the plans be entered into in good faith, a proposed amendment would require them to be operated in good faith. According to the SEC, this amendment “is intended to make clear that the affirmative defense would not be available to a trader that cancels or modifies their plan in an effort to evade the prohibitions of the rule or uses their influence to affect the timing of a corporate disclosure to occur before or after a planned trade under a trading arrangement to make such trade more profitable or to avoid or reduce a loss.”
Proposed New Disclosure Requirements
On the disclosure front, the proposed amendments would require issuers to disclose their policies and procedures on insider trading. The disclosure of such policies would be required annually and must also “provide detailed and meaningful information,” such as how the issuer ensures compliance.
In addition, issuers would need to disclose their option grant policies and exhibit a tabular showing of all option grants they made within 14 days of the disclosure of nonpublic information, while also disclosing the market price of the security the trading day before and after such release of information. These disclosures would make it easier to detect likely links between knowledge of MNPI and manipulated trades.
Under the proposed rules, issuers would need to disclose each quarter any adoption or termination of Rule 10b5-1 plans by its directors, officers, or the issuer. Currently, issuers are not required to disclose such plans. In fact, executives do not even have to say whether the trades they report on SEC Form 4 were made pursuant to such a plan.
Public Response
The SEC has invited public comments to the proposed rules, which must be received within 45 days of their publication in the Federal Register. Although the proposed amendments were announced on December 15, 2021, they have yet to be published in the Federal Register, so the deadline clock has not yet started to tick.
So far, there have been very few substantive comments submitted through the formal process; most are terse statements from individuals. One of the most consequential comments comes from the Securities Industry and Financial Markets Association (“SIFMA”), which complained of the limited time allotted for public comments without providing any commentary on the proposed rules. SIFMA’s critique echoed one by Commissioner Elad Roisman the day the proposed amendments were announced. Roisman, one of the SEC’s two Republican members until he resigned effective January 21, said the 45-day limit was “shorter than our customary comment periods, which have typically been 90 or at least 60 days.” He also noted that the period for commentary falls over several major holidays.
Two Republican U.S. Senators followed with the same criticism in a letter to SEC Chairman Gary Gensler on January 10, 2022. Senators Pat Toomey (R[1]Pa.) and Patrick McHenry (R-N.C.) expressed dismay at the “unprecedented pattern” of issuing proposed rules with shorter comment periods, especially considering they were issued during the holiday season. They noted that customarily more time is allotted for public comments and that then-President Barack Obama recommended federal agencies allow at least 60 days and sometimes 120 days for commentary depending on the complexity of the issues. The SEC has so far refused to extend the 45-day period for comments, which starts after the proposed amendments are published in the Federal Register. In the past, the SEC would have published the proposed rules in the Federal Register by now, something that generally happens two to three weeks after an announcement.
The SEC, however, did reissue the proposed rule on January 13, 2022 without any substantive changes. It is not yet clear whether the delay in the proposed amendments’ publication in the Federal Register or its reissuance on January 13 is a way of extending the deadline without appearing to bend to outside pressure.
Although they have not yet provided a formal comment, the Council of Institutional Investors (“CII”) applauded the SEC for the proposed amendments, many of which were suggested in CII’s rule-making petition to the SEC nearly a decade ago.
1. See David F. Larcker, Bradford Lynch, Philip Quinn, Brian Tayan, and Daniel J. Taylor, Gaming the System: Three Red Flags” of Potential 10b5-1 Abuse, Stanford Closer Look Series, January 19, 2021.
Pinterest, Inc. has agreed to spend $50 million on workplace reforms to settle a lawsuit in which the lead plaintiff Employees’ Retirement System of Rhode Island (“ERSRI”), represented by Cohen Milstein, alleged the company’s leadership fostered a culture of racial and gender bias that caused financial and reputational harm to Pinterest. Cohen Milstein has filed with the court a motion for preliminary approval of the settlement on behalf of ERSI and other Pinterest shareholders.
Originally filed by Cohen Milstein on November 30, 2020, In re Pinterest Derivative Litigation, Lead Case No. 3:20-cv-08331- WHA, alleged that officers and directors, including Pinterest Chairman and Chief Executive Officer Ben Silbermann, CoFounder and Board of Directors (“Board”) member Evan Sharp, and Chief Financial Officer Todd Morgenfeld, breached their fiduciary duties by waste of corporate assets, abuse of control, and violation of Section 14(a) of the Securities Exchange Act of 1934.
Pinterest is an online visual discovery engine people use to find lifestyle inspiration, including ideas for recipes, home decor, style, travel destinations, and more. Pinterest launched in 2010 and has hundreds of millions of primarily female monthly active users around the world.
The case stems from an allegedly systematic culture, policy, and practice of illegal discrimination on the basis of race and sex at Pinterest that goes back to at least February 2018. Top Pinterest executives and members of its Board of Directors personally engaged in, facilitated, or knowingly ignored the discrimination and retaliation against people who spoke up and challenged the company’s white, male leadership clique. As a result of defendants’ illegal misconduct, the company’s financial position and its goodwill and reputation among its user base (which Pinterest’s success depends upon) were harmed and continued to be harmed.
Prior to filing the complaint, plaintiffs began to build their case by obtaining documents pursuant to a Section 220 books and records demand. After briefing an opposition to defendants’ motion to dismiss, the parties agreed to explore mediation and ultimately agreed to a settlement. The settlement is the first of its kind to embrace diversity goals around a company’s product. It also requires Pinterest to commit $50 million to a holistic set of workplace and board-level reforms designed to protect employees from discriminatory treatment and to promote diversity, equity, and inclusion (DEI) throughout its workplace and product. Key requirements of the settlement include:
Release of former employees from non-disclosure agreements (“NDAs”) who want to discuss the facts of their mistreatment.
The Audit Committee of Pinterest’s Board will be responsible for the implementation and oversight over certain reforms designed to create equal opportunities for employees.
A Board member will act as a co-sponsor with the CEO for diversity, equity, and inclusion initiatives, which will help ensure accountability exists for Pinterest’s top executives.
The company will conduct external bi-annual pay equity audits that review performance ratings, promotions, and compensation across gender and racial categories.
Diversity reports to shareholders will describe progress made in implementing pay equity and DEI goals
The settlement also requires enhancements to Pinterest’s recruiting, hiring, and training. Combined, these reforms will substantially increase the value of the company for its investors and help ensure its continued future growth, as well as improve the workplace experience for Pinterest’s employees.
“We pushed for these sweeping reforms to support Pinterest’s employees with a fair and safe workplace, and to strengthen the company’s brand and performance by ensuring that the values of inclusiveness are made central to Pinterest’s identity,” said Rhode Island General Treasurer Seth Magaziner on behalf of ERSRI. “This holistic approach will fundamentally support and positively impact Pinterest’s workplace culture in the years to come.”
A preliminary approval hearing is scheduled for January 27, 2022.