VC Investors Prevail in Copyright Infringement Claims involving Veoh Networks

A series of recent decisions dismissing copyright claims allow Veoh Networks and its investors to breathe a short sigh of relief. The first decision last August, in a case brought by adult site IO Group, ruled that Veoh was entitled to the safe harbor under the DMCA and was not infringing. In December, in a different case brought by Universal Music, the court again sided with Veoh, finding that is was entitled to the safe harbor even though, technically, its streaming process did result in some “copying” within the meaning of the Copyright statute.

Most recently, in early February, a sharply worded decision by the Central District of California dismissed Universal Music’s claims against Veoh investors (Shelter Capital, Spark Capital and Torrante) for contributory and vicarious copyright infringement. UMG Recordings v. Veoh Networks Inc., 2009 WL 334022 (C.D.Cal). (The investors were added as defendants a year after the initial action against Veoh was filed). This decision is potentially significant because it shows a court’s unwillingness to pierce the corporate veil and go after deeper pockets in the copyright context – something that many investors have feared since the 2004 Napster case against Hummer Winblad – and presents a bit of a roadmap on how future claims may be constructed (and how to hedge against them).

After the Napster fallout and the lawsuits against Bertelsmann and Hummer Winblad resulting from their investment in Napster, many investors grew fearful that an investment in a user generated content (UGC) based business, such as Youtube or Veoh, could expose them to “aiding and abetting” claims for copyright infringement. In fact, it quickly became market for many investors to expand the scope of their indemnification agreements to demand that their portfolio companies indemnify the investors as shareholders, and not just the investor directors who served on the boards of these companies. Three years later, these concerns are finally coming to roost, albeit in a different economic, social and technological marketplace.

Per the roadman in Bertelsmann, the plaintiffs in Veoh alleged that the investors “controlled” Veoh by holding three of five board seats, providing all of their operational capital and making decisions all of the Company’s major decisions, including those relating to its content offerings. Assuming all that to be true, the court rejected the claims on the ground that they could not state a claim. The following are some nuggets from the decision:

> Membership on a Board of Directors necessarily and inherently entails making almost all these [operational] decisions. "To allow for derivative copyright liability merely because of such membership could invite expansion of potential shareholder liability for corporate conduct, without meaningful limitation."

> There is no common law duty for investors (even ones who collectively control the Board) “to remove copyrighted content,” in light of the DMCA.

> The court extensively distinguished the Bertelsmann decision, thereby limiting its future application, on a number of specific facts absent here. Most importantly, in that case the investors proceeded to invest and control Napster after the liability issues had been going on for two years and then did not stop the conduct after taking over. Therefore, prospective investors in a company where a copyright lawsuit is actually pending would be well advised to consider whether the indemnification agreement (which they are probably ultimately paying for) is going to serve its ultimate purpose.

> The court dismissed the vicarious liability claim – which requires a defendant to have a direct financial interest in the infringing conduct – by holding that a “profit from their investments through the sale of Veoh to a potential acquiring company or through a public offering… is too far removed from the alleged infringement to be considered a “direct” financial interest.” This should be compared against potential direct benefits mentioned by the court, such as where investors may receive fees paid by customers or advertisers, or even a dividend or distribution from those revenues. Therefore, investors considering a recapitalization or an early distribution of profits should consider this issue as part of their analysis.

First Circuit Court Surprises Media Lawyers with Controversial Decision in Libel Case

A recent decision by the 1st Circuit against Staples, Inc. surprised many media lawyers by holding that truth is not an absolute defense to a libel claim. It held that a truthful statement may give rise to a cause of action by a private-figure plaintiff if it was made maliciously. The decision departs from decades worth of jurisprudence establishing truth as an absolute defense to a defamation claim.

No doubt the extreme facts in this case drove the Court’s outcome. The case was brought by a former Staples employee who was terminated for “cause” submitting false expense reports. The termination took place after an extensive internal investigation that uncovered the fraud. After the termination, a manager issued an email to 1,500 Staples employees stating that the employee had been terminated for abusing the travel & expense policy. (The court’s commentary seems to suggest that the fact that employee was mentioned by name in this en masse email is what they thought a jury could consider to be malicious. Although the court held that there was no question that the statement in the email was true, it nonetheless allowed a libel claim to stand based on a 1902 law (G.L.c.231, sec. 92) that provides that truth is a justification for libel "unless malice is actually proved."

It is important to note, however, that this decision does not mean that Staples loses on this claim. The 1st Circuit remanded the case back to the US District Court for trial where a jury may still find that the manager’s email did not constitute malice.

Another interesting part of the decision deals with stock options. As part of the for “cause” termination, the employee’s vested stock options were terminated per the terms of the option plans. The agreements provided that whether or not termination is for cause would be “as determined by Staples, which determination shall be conclusive.” Finding no prior Mass. law on this issue, the 1st Circuit held it will not second guess the Company’s termination decision unless it finds that it was “arbitrary, capricious, or made in bad faith,” which in this case was based extensive internal investigation and therefore was allowed to stand.

In this market where layoffs are looming in just about every industry, this case underscores the importance of proper procedure (and tact) in handling terminations. Based on this decision, employers should be additionally cautious when handling any announcements internal or external and discussions regarding anyone being terminated, as well as in the context of giving references or referrals. And while not all employers have Staples’ budget to conduct internal investigations to find "cause", any determination of such a finding should be well documented.

Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or Restructuring

A recent decision by the Delaware Supreme Court, Gantler v. Stephens, C.A. No. 2392 (Del. January 27, 2009) (available here) provides new guidance for directors and officers on their fiduciary duties arising in connection with a possible corporate sale or restructuring. In Gantler, the Court held that directors and officers of an Ohio bank (the “Bank”) could be found to have breached their fiduciary duty by rejecting an opportunity to sell the Bank and instead pursuing a recapitalization that favored the insiders. The case was brought by a former director (Gantler) and minority shareholders of First Niles Financial, Inc. (“First Niles”), the Bank’s holding company.



In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one’s employment or directorship) are inherent and unavoidable, and if properly disclosed, would not result in a higher level of scrutiny from courts over board decisions. Gantler holds that this is not always true, and that specific facts can alter that position.



Specifically, where directors and/or officers are -- or with 20/20 hindsight, may be argued to be -- motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented. Failure to do so may prevent a board from being entitled to the business judgment rule and subject the directors and officers to a stricter standard that the actions meet the “entire fairness” test under Delaware law.



After a strong acquisition market, in August 2004, the First Niles board agreed to put the Bank up for sale and hired investment bankers to pursue the opportunity. Shortly thereafter, the managing officers of First Niles (and the Bank), several of whom were also directors, advocated that the Bank abandon the process and privatize the company by delisting from the NASDAQ SmallCap Market. The Bank received offers from three strategic purchasers, each considered by the bankers to be within the recommended range. Two offers made clear that the purchaser would terminate the incumbent First Niles board upon closing. In the months that followed, management did not respond to the bidders’ due diligence requests and delayed the process (resulting in the withdrawal of one bid, which was not disclosed to the board until after the fact) and continued to discuss the privatization proposal. In March 2005, notwithstanding a favorable opinion from the bankers as to one of the offers, the board voted 4 to 1 to reject the offer, with Gantler being the only dissenting vote, and turned its attention to the privatization plan.



In April 2005, management presented to the board its privatization proposal, which would reclassify the First Niles common stock held by holders of 300 or fewer shares into a new class of Series A Preferred Stock that would pay higher dividends and have the same liquidation preference as the common stock, but that would not have voting rights except in the event of a proposed sale of the company. In December 2005, the proposal was approved 3 to 1 by the Board, with Gantler again being the only dissenting vote. Shortly thereafter, Gantler was replaced on the Board by an officer of the company. The following June, the newly-composed First Niles Board unanimously approved a charter amendment to effect the reclassification and proceeded with the proxy solicitation process for shareholder approval. The proxy statement did disclose that the directors and officers had a conflict of interest with respect to the reclassification and the alternative transactions that the board had considered, including a business combination that was turned down.



Following shareholder approval of the charter amendment, the plaintiffs brought suit in the Delaware Chancery Court alleging, among other things, that the board violated its various fiduciary duties by sabotaging due diligence and abandoning the sales process in favor of their own incumbency. In March 2008, the Chancery Court dismissed the case for failure to state a claim and the parties appealed.




In reversing the Chancery Court’s dismissal, the Supreme Court clarified several issues of Delaware corporate law, including the following:



§ Higher Scrutiny for Transactions with Potential Conflict of Interest. The Court agreed with the defendants that the Board’s duty in this case should be analyzed under the more favorable business judgment rule, as opposed to the “enhanced scrutiny” standard under Unocal.



However, the Court did hold that the business judgment presumption could be rebutted in this case because reasonable inferences of self interest could be drawn from the defendant directors’ and officers’ lack of cooperation with the due diligence requests and sabotaging of the bid process. In its analysis, the Court highlighted the specific conflicts arising from a sale of the Bank for each of the directors -- the potential loss of employment for the Chairman/CEO; and the loss of the Bank as a key client for businesses operated by two different directors. It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.



There can be little question that the extreme facts of this case heavily influenced the Court’s decision to rebut the presumption of good faith by the board, and that the outcome may have been different if the some of the “sabotaging” activity was not present and if the board deliberations regarding the sale proposals were more extensive. The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, “without discussion or deliberation.”



If directors or officers do have personal financial interests that diverge from the interests of other shareholders, a board should now be prepared for a higher standard of review of their actions. That said, Gantler should not be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed. Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of all shareholders.



Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel. Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities. Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in Gantler).



§ Fiduciary Duty of Officers equal to that of Directors. As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors. While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations.



§ Shareholder Ratification Limited. The Court also disagreed with the Chancery Court’s finding that the shareholder approval of the privatization plan, as submitted by the First Niles board and described in the proxy, “ratified” the prior actions of the board, absolving them of liability. To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine.



First, shareholder ratification is effective only where a “fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become more legally effective.” Therefore, where a shareholder vote is otherwise required – such as for the approval of a charter amendment or a merger – the shareholder vote does not carry any ratifying effect of the preceding board action.



Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.



Third, the effect of shareholder ratification does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment review (as opposed to the entire fairness test). Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.

Liability evolving for user-generated content

One of the greatest advances in our use of Web-based technology in the last decade – commonly referred to as “Web 2.0”, and now Web 3.0 around the corner – has been the outburst of online communities, collaboration among users and sharing of information and content. Today, household names like Craigslist help you find everything from Red Sox tickets and used lawnmowers to apartments and roommates. Facebook helps reconnect you with your past and Roommates.com and Match.com help find your future mates and partners. Thanks to Tributes.com – Monster.com founder Jeff Taylor’s most recent venture – even obituaries have become “social.”

Read the rest of this article here…

Delaware Supreme Court denies standing to directors to bring derivative action

A recent Delaware Supreme Court decision rules that directors who are not otherwise shareholders of a corporation do not have standing to bring a derivative claim on behalf of the corporation.

The case involved claims by the plaintiff director that the other directors of the corporation were controlled by a single shareholder, who was also the corporation's CEO and Chairman. The Court held that such standing was not expressly provided by the Delaware statute, and refused to judicially extend such standing pursuant to equitable doctrine.

The decision discusses commentary from the ALI (American Law Institute) specifically recommends that such standing be extended to directors. The Court refuses to adopt this standard in Delaware, while noting that the ALI proposal has only been adopted in one state, Pennsylvania. The Court also referenced the New York corporate statute as being unique in providing directors with a statutory right to sue other directors of the corporation. (I guess that's another reason not to incorporate in New York, if you need one).

Comment on Rule 144 Changes

In an effort to facilitate companies with raising capital and complying with disclosure and reporting obligations, in December 2007 the SEC unanimously adopted amendments to Rule 144 to reduce the requirements on the resale of restricted securities. Among the significant changes, the new rules reduce the holding period and the resale restrictions applicable to holders of such securities. The SEC has stated that it believes the “amendments will increase the liquidity of privately sold securities and decrease the cost of capital for all issuers without compromising investor protection.” These amendments are effective February 15, 2008 and will apply to securities issued before and after that date. There are also changes to Rule 145, which are not discussed here.

Reduction of Holding Period and Resale Limitations

In general, the Securities Act of 1933 requires registration of offers and sales of securities unless an exemption is available. Rule 144 creates a safe harbor for the sale of securities by a person other than an issuer, underwriter, or dealer if certain conditions are met. In common practice, Rule 144 serves as the principal path to allow resales of “restricted securities” – those that were originally issued in private, unregistered transactions, under Regulation D or otherwise.
Under the existing regime, Rule 144 required an issuer’s affiliates (its directors, executive officers and significant beneficial owners) to hold their restricted securities of the issuer for at least one year before they could sell them. Any resale thereafter would be subject various limitations based on publicly available information on the issuer, the manner of sale, volume limitations and certain filing requirements. Non-affiliates of an issuer were subject to the same one-year holding requirement and subject to resale limitations during the following year. However, once securities were held by a non-affiliate for at least two years, the limitations would no longer apply and the securities could be freely resold.
Under the new rules, the holding period for restricted securities of public reporting companies was reduced from one year to six months. For non-affiliate holders of these securities, the new rules effectively eliminate after six months all resale restrictions other than the “current public information” requirement, and eliminate all resale restrictions after one year. Affiliates, however, will still need to comply with all resale limitations after they meet the six-month holding requirement.
For private companies, the holding period was effectively changed to one year. The SEC retained the one-year holding requirement for these companies out of their concern that “the market does not have sufficient information and safeguards with respect to non-reporting issuers.” After the one-year holding period is met, non-affiliates may sell their securities with no other resale limitations. While affiliates of these companies are subject to the same one-year holding period, their transactions will still continue to be subject to various resale limitations under Rule 144, including certain current public information requirements for non-reporting companies.
Based on significant comments from practitioners, one of the significant revisions from the amendments originally proposed in July 2007 was that the SEC chose not to adopt its proposal to suspend (or “toll”) the running of the holding period in the event of hedging of restricted securities. A previous tolling provision in the original Rule 144 was eliminated in 1990. Concerned that hedging activities significantly diminish a holder’s economic investment risk that serves as the basis for the holding period, the SEC again proposed that the holding period be tolled by up to six months for any short sales, puts or other hedging activities. Due to the overall concern over the burden placed on investors from complying with this regime and having to disclose information on their hedging transactions, the SEC has agreed not to adopt the tolling provisions, with the caveat that it will revisit the issue if hedging activities are abused.
Codification of SEC Staff Positions on Tacking
The SEC Staff has previously taken the position that tacking of prior holding periods is allowed in certain circumstances upon conversion or exchange of an issuer’s securities, including cashless exercise of options and warrants. The new rule provides that if the securities were originally acquired from an issuer solely in exchange for other securities of the same issuer, tacking will be allowed, even if the securities surrendered were not convertible or exchangeable by their terms. However, if the original securities did not permit cashless conversion or exchange by their terms and are later amended to cover this aspect, under the new rule tacking will not be allowed if the security holder provides consideration for the amendment other than solely securities of that issuer. In other words, if additional consideration is received for the amendment to provide for a cashless exercise feature, that consideration will be treated as a new investment decision by the holder and will restart the clock on tacking.
However, the new rules also codify that the grant of certain options or warrants that are not purchased for cash or property, such as the grant of employee stock options, does not create any investment risk and, therefore, in a cashless exercise of such options or warrants, the holder would not be allowed to tack the holding period and would be deemed to have acquired the underlying securities on the date of exercise and when the underlying shares were fully paid for.

WebbAlert added as a link

I recently started reading/following the posts on WebbAlert. Highly recommend their stories. I have linked a feed below.