SECURITIES LAW - ELEVENTH CIRCUIT HOLDING ILLUMINATES NEED FOR UNIFORM ENFORCEMENT OF FEDERAL SECURITIES LAW - FREEDMAN V. MAGICJACK VOCALTEC LTD., 963 F.3D 1125 (11TH CIR. 2020).

• Author: Duhamel, Spencer

The primary purpose of corporate law is to govern contract, agency, and property laws in the context of corporations. (1) However, the primary objectives of American securities law is to ensure financial transparency and prohibit deceit within the sale or exchange of securities. (2) In Freedman v. magicJack Vocaltec Ltd., (3) the Eleventh Circuit Court of Appeals decided whether a shareholder-alleged violation of federal securities law, SEC Rule 14a-9 and [section] 20(a) of the Securities Exchange Act of 1934, constitutes a direct or derivative shareholder claim. (4) As a matter of first impression, the Court held (1) Israeli law controls analysis and (2) the claim is derivative and not direct. (5)

Appellee magicJack Vocaltec Ltd. (magicJack) was a public company incorporated in the country of Israel, but with the state of Florida serving as its principal place of business. (6) MagicJack provided "consumer Voice-over-Internet-Protocol (VolP) cloud-based telecommunication services." (7) The central dispute in Freedman arose out of two solicited proxy statements, leading to the reelection of members of magicJack's board and approval of takeover and severance packages for directors in the event of a change of control. (8) Freedman, the plaintiff shareholder and appellant, filed a class action on behalf of himself and a subgroup of shareholders for material misrepresentations and omissions in two proxy statements which, if true, would violate SEC Rule 14a-9 and [section] 20(a) of the Securities Exchange Act of 1934. (9)

MagicJack issued the first challenged proxy statement on March 15, 2017 (March 15 proxy statement), which was solicited to secure votes for the upcoming director election. (10) Freedman argued that the March 15th proxy statement was "designed to 'entrench' the magicJack directors in office... decepti[tively]." (11) It is also important to note that magicJack received, "Bidder A's bona fide $9.50 buyout offer" in February 2017. (12) MagicJack issued the second challenged proxy statement on June 23, 2017 (June 23 proxy statement) in anticipation of a special meeting vote to decide on "financial incentives and severance pay provisions tied to a completion of a change-in-control transaction." (13)

In November of 2017, magicJack entered into a sale agreement (B. Riley Transaction) with B. Riley Financial Inc. (B. Riley) to sell magicJack for $8.71 per share. (14) The B. Riley Transaction was consummated in November of 2018. (15)

Freedman originally brought a direct suit in the U.S. District Court for the Southern District of Florida on August 11, 2017 against magicJack, magicJack's subsidiary YMax Corp., and nine other individuals who were either current or former directors of the company. (16) Freedman amended his complaint and magicJack moved to dismiss; Freedman then amended his complaint a second time (the second amended complaint or SAC). (17) After Freedman filed the SAC, magicJack again moved to dismiss the case and the district court granted the motion on the grounds that the claim was derivative and that Israeli law was the proper controlling authority. (18) Freedman appealed to the U.S. Court of Appeals for the Eleventh Circuit. (19) The Eleventh Circuit held, as a matter of first impression, for claims brought under federal law, federal courts should look to the law of the state of incorporation to determine whether an action is direct or derivative because it implicates state law corporate powers. (20) Upon review, the Eleventh Circuit, applying Israeli law to its analysis, found the claim to be derivative and therefore dismissed the case. (21)

The distinction between direct versus derivative claims dictates many aspects of a proceeding, including who can sue, how to plead, what can be recovered, and to whom recovery is granted. (22) At a fundamental level, in direct actions, the corporation takes action that results in direct harm to a single shareholder or particular subgroup of shareholders. (23) On the other hand, derivative claims are applicable when all shareholders are equally harmed by a corporation's conduct. (24)

In recent years, more federal courts have dodged this question by turning to state corporate laws to decide whether a claim is direct or derivative in nature. (25) This approach is typically justified by arguing the powers of a corporation are governed by state law, so the distinction of direct versus derivative should be decided using state law. (26) According to the Supreme Court, "[a]pplication of [the law of the state of incorporation] achieves the need for certainty and predictability of result while generally protecting the justified expectations of parties with interests in the corporation." (27) However, the issue becomes more complicated when there is a purported violation of federal law--violation of securities laws included. (28)

The principal purposes of federal securities regulations are to protect unsuspecting investors from harm and to ensure adequate disclosure within the sale and exchange of securities. (29)

These purposes are evidenced through Congressional statute drafting designed with intentional broadness to include various types of securities transactions. (30) In order to achieve these goals outlined by Congress, uniform enforcement of the securities laws is necessary. (31)

In Freedman v. magicJack Vocaltec Ltd., the Eleventh Circuit Court of Appeals considered which law federal courts should look to when deciding whether a claim asserted under federal securities laws is direct or derivative. (32) The Eleventh Circuit Court of Appeals found that federal courts should look to the law of the state of incorporation to determine whether a claim asserted under federal law is direct or derivative. (33) In arriving at its conclusion, the Court analyzed whether the powers of the corporation are implicated, and subsequently determined that, because actions of directors or officers implicate powers of the corporation, then state law should apply. (34) The Court's reasoning stems from the shareholder's and director's reasonable expectations that their actions, with respect to the corporation, are subject to the laws of the state of the company's incorporation. (35)

Given that magicJack was incorporated under the laws of Israel, the Court looked to Israeli corporate law to determine whether the federal claim is direct or derivative. (36) Under Israeli corporate law, the question of direct versus derivative hinges on the type of relief sought and whether the damage is common to all shareholders. (37) The Court held that a misrepresentation of a solicited proxy statement damages all shareholders equally, constituting a derivative claim under both Florida and Israeli law. (38)

Though Israeli law was applied in this case, the Court mentioned that, if such claim were analyzed under Florida state law, "the result would be the same because the two bodies of law are consistent." (39) Ultimately, the Court held state law dictates whether a claim under federal securities law is direct or derivative in nature. (40)

Although state law does in fact govern the affairs of a corporation, the Freedman court mistakenly applied state corporate law to a federal securities law claim. (41) The Court reached its conclusion by reasoning that direct versus derivative analysis implicates the powers of the corporation, and because corporations are creatures of the state, then state law should determine whether the action is direct or derivative. (42) However, in order to afford investors the most protection possible when "certain responsibilities of directors with respect to stockholders" are implicated, federal securities laws should operate independent of state corporate law. (43) Thus, federal law should be applied when suing under federal securities law to decide whether the action is direct or derivative, consistent with the congressional intent of protecting the average investor, which is the basis for federal securities laws. (44)

Congress did not intend for securities laws to be dependent on a company's state of incorporation. (45) Congress enacted the securities laws specifically to "eliminat[e] serious abuses in a largely unregulated securities market." (46) Despite Congress' intent behind securities laws, the Court still applied state corporate law in the Freedman case, which ultimately deprived the Freedman subgroup of shareholders from relief. (47) This Court failed to recognize Freedman's central argument, which emphasized the key fact that it was only this specific subgroup of shareholders that was injured by the magicJack board through the denial of the right to an informed vote; which ultimately resulted in the subgroup having to accept a lower per share deal price. (48)

In reaching its decision to apply the law of the state of incorporation, the Court reasoned predictability and certainty are best achieved by applying state law. (49) Despite the Court's rationale, there is a strong argument to be made that enforcing securities laws by applying one uniform federal law, as opposed to numerous differing state laws, is a better strategy for ensuring predictability and certainty. (50) In addition, applying federal law to allegations of federal securities violations rectifies the undue burden on both corporate advisors and shareholders alike imposed through application of state law to federal securities claims. (51)

In Freedman v. magicJack Vocaltec Ltd., the Eleventh Circuit Court of Appeals decided whether state corporate law or federal law should control in deciding whether an alleged violation of federal securities law is direct or derivative in nature. Although the Court deferred to the corporation's business judgment, the Court's decision to apply state law to federal securities claims contradicts the main purpose of federal securities law by failing to extend sufficient credence to the interests of the unsuspecting, injured shareholders. Deciding...