April 2012

It is a basic tenant of corporate law that directors of a corporation are not liable for business decisions as long as the directors acted with a reasonable level of care in making these decisions. This is referred to as “the business judgment rule.” Because directors are not guarantors of corporate success, the business judgment rule specifies that a court will not review the business decisions of directors who performed their duties (1) in good faith; (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner the directors reasonably believe to be in the best interests of the corporation. As part of their duty of care, directors have a duty not to waste corporate assets by overpaying for property (e.g., 100% of the stock of a target company in an acquisition) or employment services. The business judgment rule is very difficult to overcome and courts will not disregard it absent, among other things, a showing of fraud or misappropriation of corporate funds.

One of the landmark cases in this area of law was Smith v. Van Gorkam, which was decided by the Delaware Supreme Court in 1985. In that case, the board of directors of TransUnion approved a merger with Marmon Group without consulting outside experts as to the fairness of the price to be paid to TransUnion shareholders, rather, the board relied on the recommendations company’s CEO and CFO, neither of whom made any substantive attempt to determine the actual value of TransUnion. Additionally, the board did not inquire as to the process used by the CEO and CFO in determining the merger consideration. As a result, the Delaware Supreme Court found that the directors of TransUnion were grossly negligent in carrying out their fiduciary duties to the company. Because of this, the board was found not to have satisfied their duty of care and were therefore not entitled to the presumptions and protections of the business judgment rule. Ultimately, the TransUnion board agreed to pay $23.5 million in damages resulting from their fiduciary duty breaches.

The facts of Facebook’s recently announced acquisition of Instagram (as reported by the Wall Street Journal) are strikingly similar to the Van Gorkam case. Allegedly, Facebook’s CEO Mark Zuckerberg and Instagram’s CEO Kevin Systrom worked out the details of the acquisition privately over the course of 3 days at Mr. Zuckerberg’s home. Once the details were finalized for the $1 billion acquisition, the deal was presented, without notice, to the Facebook board of directors who approved the deal, likely without outside expert advice as to the fairness of the transaction. According to several reports, the board vote was largely symbolic because Zuckerberg has control of 57% of the voting power of the company. Facebook directors were likely put in a precarious Continue Reading Could directors be personally liable if Facebook paid too much for Instagram?

On April 16th, the Securities and Exchange Commission’s Division of Corporation Finance issued 17 Frequently Asked Questions pertaining to Title I of the JOBS Act.

The FAQs address some of the threshold questions on how to apply the JOBS Act to emerging growth companies such as how to determine if your company is deemed an “Emerging Growth Company” and how to interpret the scaled disclosures permitted under the JOBS Act.

One of the most well-known and popular Internet companies, Groupon, Inc., has again encountered significant accounting problems. These problems appear to be potentially severe. This situation is very negative for Groupon, but it also has troubling ramifications for the entire technology industry and especially for technology companies that have recently gone public. There is also some doubt about Groupon’s ability to successfully maintain and grow its business model. Only time will tell if Groupon can successfully fix these problems and move forward, but it is clear that the company needs to do a much better job of managing its accounting and public company reporting functions and its internal controls processes as well as the way in which it responds to related crisis situations.

The focus of Groupon’s recent problems is the substantial restatement of its operating results for the fourth quarter of 2011. This was a critical reporting period for the company as it was the first full reporting period since the company’s IPO in November 2011. This revision reduced the company’s fourth quarter revenues by $14.3 million and increased its net loss by $22.6 million. These revisions also affected the company’s 2011 annual financial statements. While these revised numbers alone would be cause for concern, Groupon also disclosed in its press release on these issues that it had identified a material weakness in its internal controls systems. This is a major red flag for any company, and it was made worse by Groupon’s past history of accounting problems and restatements of financial results.

The effects of this situation were magnified since the company’s IPO had only occurred about five months ago, and that process had been marred by substantial changes to the company’s financial results. Under pressure from the Securities and Exchange Commission during the IPO process, Groupon was forced to abandon a strange accounting metric that attempted to exclude certain significant marketing expenses. Use of this metric substantially increased the company’s revenues. When the company’s calculations were revised to incorporate these marketing expenses, its total revenues were reduced by about 50%. This situation was also made worse by its timing – it occurred right in the middle of the IPO review process. Groupon’s IPO prospectus can be found here.

The timing of this accounting problem made it even more critical that Groupon “get it right” in connection with its accounting and financial reporting. To have yet another significant accounting problem surface in the very next quarter’s results is a huge blow to the company. The situation became much more serious when it became evident that problems existed with its internal controls system – this was no longer just a numerical mistake, but had extended to a deeper accounting process problem.

Groupon’s management and public relations professionals have made these situations worse by not responding well. Management made optimistic statements about the company’s potential, even during the IPO “quiet period”. Management’s attitude and responses on the current accounting problems have been viewed by some commentators as flippant and dismissive. Management did not seem to understand the gravity of these problems and their possible ramifications, seemingly conveying that Groupon is a young, fast growing company, and that problems like this are going to happen. This is clearly not the response that the investment community was expecting, and this confluence of accounting and public relations problems has substantially damaged the company’s reputation and credibility. Groupon is regarded in some circles as not ready for the rigors and responsibilities of public company life.

Groupon had been extremely successful as a private technology company. It offered reduced price deals on a significant number of popular products and services at local levels. Consumers liked the discounts and price cuts that they could receive through the use of Groupon. Merchants and service providers accepted this process as a way to stimulate business and to introduce new potential customers to their products and services. Groupon has also historically offered a generous refund or cancellation right to purchasers of its services. The company’s business model has expanded, however, and it now includes discount coupons for much more highly priced goods and services. Where the original business model mainly focused on items such as meals, haircuts and similar low-priced items, the new and expanded model includes items with much higher prices, such as vacations and medical and surgical procedures. Groupon apparently extended the same generous cancellation or return policies on these higher priced items, but did not increase the amounts held in reserve to cover the refunds required in connection with the cancellation of these higher priced items. This led to the significant restatement of financial results and to the identification of the material weaknesses in the company’s financial controls discussed above.

One other factor that is concurrently hurting Groupon is the stated perception by some analysts that the company’s business model may not be sustainable or able to be successfully expanded to include bigger and higher-priced situations. It is too early to determine if this analysis is valid, but these accounting problems may have supported this negative business perception.

Groupon has also experienced some external negative events from these situations. The SEC has apparently instituted a preliminary probe into Groupon’s situation. This is troubling, especially after the controversy that resulted in the massive reduction (mandated by the SEC) of the company’s revenues during its IPO. It is unclear at this time whether the SEC’s involvement will extend further, perhaps to a full investigation of Groupon and its accounting and financial controls processes. A number of shareholder lawsuits have also been filed against the company. Regardless of the ultimate resolution of this SEC probe and these shareholder lawsuits, they are expensive and they divert management’s attention at a time when all hands need to be totally focused on business issues.

To Groupon’s credit, it now appears to be working on the remediation of these problems and the improvement of its internal controls processes. It has hired a large global accounting firm (in addition to its regular auditing firm) to specifically work on the improvement of its internal controls. This situation may be able to be fixed, but it will take a substantial amount of time and effort to rebuild Groupon’s credibility in the investment community. Groupon’s stock price is currently well below its IPO price, and further deterioration in the company’s market value will likely occur if the problems identified in this post are not fully acknowledged and corrected.

Groupon’s problems also quickly become problems for the entire technology community, and especially for web-based companies that have gone public. Since Groupon is such a recognizable company in this industry, anything it does (positive or negative) will have an effect on the entire technology industry. If many analysts conclude that Groupon is not ready to successfully operate as a public company because of its inability to manage its accounting processes or its failure to effectively acknowledge and respond to associated crisis situations, inevitably some of these negative consequences will affect other technology companies. Groupon needs to ensure that it clearly understands the gravity of these situations and that it develops and quickly executes mature and effective solutions to these problems. It also needs to ensure that such solutions are clearly communicated to the investment community in order to try to rebuild its credibility.

Although this was a news story that hit about six months ago, we saw very little coverage on, what we think, is a very novel alleged hostile takeover bid by organized crime. 

On October 26, 2011, a federal grand jury indicted Nicodemo S. Scarfo, an alleged member of the Lucchese crime family, Salvatore Pelullo, an alleged associate of the Lucchese and Philadelphia LCN families, and 11 other people, including five practicing lawyers and an accountant for allegedly taking over FirstPlus Financial Group, Inc. (OTC Markets: FPFX), a publicly traded mortgage company in Texas. 

According to the indictment, the men used both explicit and implicit threats of economic and physical harm to seize control of FirstPlus by replacing its existing board of directors and management with members who would further their interests. 

Based on the facts from the indictment, in 2007, the defendants falsely accused a director of financial improprieties, and threatened a lawsuit against the director unless the director agreed to persuade the existing directors and management to turn over control to the defendants.  Over the course of 2007 and 2008, according to the indictment, the men looted the company through various acquisitions of entities controlled by the defendants at inflated prices.  The defendants were indicted for securities fraud, wire fraud, money laundering, extortion, and obstruction of justice. 

No mention of whether the defendants ever filed a Schedule 13D.