April 17, 2010
The Lawsuit We've All Been Waiting For
The SEC is suing Goldman. As you can imagine, the blogosphere is on fire. I'll briefly highlight one post, add my two cents, then leave you to the links.
Over at the Glom, Erik Gerding explains why the SEC chose this as their "test case." Before getting there, he gives a nice brief bird's eye view:
At first blush, this case looks to take on a practice of Goldman and other banks that has been widely criticized in the media – selling asset-backed securities (ABSs) to investors then using credit default swaps to profit should those securities default. Which has been likened to a doctor taking out a life insurance policy on a patient.
Obviously, it is too soon to tell how this will turn out. And Goldman may well be vindicated. For my part, I'd just like to remind everyone that bubbles are not safe harbors. In other words, "everyone was doing it" is not a "get out of jail free" card (or, in this case, a "avoid a fine" card).
April 16, 2010
Graham on Banking Law
Ann Graham has posted Financial Institution Board Responsibilities Under the Microscope on SSRN with the following abstract:
In the wake of the financial crisis, boards of directors will find both regulators and shareholders focused on legal and ethical responsibilities of the board. How much direction and oversight should a board provide to management in its efforts to maximize profitability? What new requirements will the regulators impose and what actions will they take based on past board actions? Every financial crisis has brought a wave of enforcement actions. It is important for boards and their attorneys to anticipate and prepare for heightened regulatory attention.
Black on Financial Crises
William K. Black has posted Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises on SSRN with the following abstract:
“Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.” A single control fraud can cause greater losses than all other forms of property crime combined. This article addresses the role of control fraud in financial crises. Financial control frauds’ primary weapon is accounting. Fraudulent lenders produce exceptional short-term “profits” through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves. These exceptional “profits” defeat regulatory restrictions and turn private market discipline perverse. The profits also allow the CEO to convert firm assets for personal benefit through seemingly normal compensation mechanisms. The short-term profits cause stock options to appreciate. Fraudulent CEOs following this strategy are guaranteed extraordinary income while minimizing risks of detection and prosecution.
The optimization strategy causes catastrophic losses. The “profits” allow the fraud to grow rapidly by making bad loans for years. The “profits” allow the managers to loot the firm through exceptional compensation, which increases losses.
The accounting control fraud optimization strategy hyper-inflates and extends the life of financial bubbles. The finance sector is most criminogenic because of the absence of effective regulation and the ability to invest in assets that lack readily verifiable values. Unless regulators deal effectively with the initial frauds their record profits will produce imitators. Control frauds can be a combination of “opportunistic” and “reactive”. If entry is easy, opportunistic control fraud is optimized. If the finance sector is suffering from distress, reactive control fraud is optimized. Both conditions can exist at the same time, as in the savings and loan (S&L) debacle.
When many firms follow the same optimization strategy a financial bubble hyper-inflates. This further optimizes accounting control fraud because the frauds can hide losses by refinancing. Mega bubbles produce financial crises.
Vining on Chinese Corporate Law
Joseph Vining has posted The Effect of Economic Integration with China on the Future of American Corporate Law on SSRN with the following abstract:China's development into a world economic power and its continuing integration with the United States economy raise the question whether China's own history and the socialist context of its domestic corporate law may affect the meaning of business terms in use both internationally and in American domestic corporate law. Of particular interest is the question whether China's entry and impact may blunt the late-twentieth century effort in the United States to change the legal sense of the purpose of an American business corporation.
Means on Corporate Law
Benjamin Means has posted A Contractual Approach to Shareholder Oppression Law on SSRN with the following abstract:
According to standard law and economics, minority shareholders in closely held corporations must bargain against opportunism by controlling shareholders before investing. Put simply, you made your bed, now you must lie in it. Yet, most courts offer a remedy for shareholder oppression, often premised on the notion that controlling shareholders owe fiduciary duties to the minority or must honor the minority’s reasonable expectations. Thus, law and economics, the dominant mode of corporate law scholarship, appears irreconcilably opposed to minority shareholder protection, a defining feature of the existing law of close corporations.
This Article contends that a more nuanced theory of contract — freed from the limiting assumptions of standard law and economics — offers a persuasive justification for judicial protection of vulnerable minority shareholders. Moreover, although courts often describe the shareholder relationship in fiduciary terms, contract theory provides a more coherent explanation of current doctrine. The “contractarian” objection to shareholder protection poses a false choice between fairness and autonomy: by enforcing the implicit contractual obligations of good faith and fair dealing, courts protect minority shareholders from oppression and, at the same time, advance the values of private ordering.
The Business Judgment Rule and Public Benefit
Maryland is now the first state with "benefit corporation" legislation, which requires companies formed under the act to consider stakeholder interests as part of the corporate mission. In addition, the law allows the benefit corporation to set a course to pursue specific public benefit purposes. Examples include seeking carbon neutrality, giving 50% of profits to charity, and using only local suppliers.
The law was supported and initially drafted by B Lab, which is "a nonprofit organization dedicated to using the power of business to solve social and environmental problems," and William H. Clark, Jr., a partner at Drinker Biddle and Reath LLP, in Philadelphia. Not ironically, Mr. Clark was also the primary drafter of the North Dakota Publicly Traded Corporations Act, a shareholder friendly governance option. Mr. Clark was hired in 2005 by a group of shareholder activists, including Carl Icahn, to draft the North Dakota act.
I am not sure what think about this benefit corporation legislation. I can understand how expressly stating such public benefits goals might have value and provide both guidance and cover for a board of directors. However, I am skeptical it was necessary.
Not to overstate its binding effects today, but we learned from Dodge v. Ford that if you have a traditional corporation, formed under a traditional certificate of incorporation and bylaws, you are restricted in your ability to “share the wealth” with the general public for purposes of “philanthropic and altruistic” goals. But that doesn't mean current law doesn't permit such actions in any situation, does it?
If a corporation were to form today, stating as its purpose in the certificate specific goals of creating a sustainable profitable business that would consider all stakeholders as part of the process, is that not permissible? What if we take it a step further and state that the corporation is formed on the belief that the best way to create a long-term and profitable business is to create loyalty to the company through generous giving to charity, reasonable prices, high wages, and thoughtful environmental stewardship? In addition, the certificate could add that the board of directors, in carrying out their duties, must consider the corporate purpose as part of their business judgments.
Frankly, although it would provide unambiguous notice to investors, I am not sure such language even needs to be in the certificate or bylaws. It seems to me that a board could simply determine that, after careful and thoughtful information gathering and analysis, it was their business judgment that considering public benefit is in the long-term goals of the corporation and its shareholders because the company will fill a specific niche in the market, rendering it a more profitable, more stable entity, in the long-term for the shareholders.
There is no requirement I can recall that says a company must maximize profits on a day-to-day basis. (Excluding Revlon duties, of course, for auction situations.) And, if the company is not trying to make any money, this benefit corporation law is not needed, either. We already have the 501(c)(3).
I’m not really against the law, and I think it has some nice ideas behind it. I am just not sure it fills much of a corporate governance void.
April 15, 2010
If the law prof thing doesn't work out ....
What's on your career alternative bucket list?
For law profs, there is of course always the possibility of returning to practice. But is that what you dream about? Readers of this blog will likely guess that poker pro is on my list. But there is another possibility: DJ!
There's just one problem--I don't actually know how to DJ. But luckily the Wall Street Journal ran a front page story about a French college for disc jockeys: the Ecole des DJ. Trouble is, they have a bad attitude (IMHO). Apparently, they believe that: "A DJ's job is to make people dance, not just play music you like." Sorry, but I'm going to be playing House music I like--and if you don't like it you can find another DJ.
This brings me to my current personal email signature line, which I stole from a dear friend who happens to be an artist:
Art is supposed to be self-indulgent. If the focus is on pleasing the consumer, then you are not finding a voice--you are developing a brand.
This quote generated a series of rebuttals from another friend who is finishing up his Ph.D. in Philosophy at Harvard (apparently, the question: "What is art?" is serious ponder fodder for philosophers). What do you think?
Speaking of comments, my colleague over at the Akron Law Cafe, Brant Lee, has generated quite a few of them with his recent post: Facts about inequality. As I understand him, he basically is asking at what point the American Dream becomes a lottery ticket. In other words, one version of the U.S. social contract is that we forgo any meaningful safety net for the poor in exchange for seemingly limitless upside for the wealthy. The consideration that gets the poor to go along with this contract is the possibility that they too might join the wealthy if they just work hard enough. Lee points out that there is data to suggest this consideration may be illusory.
Purely by coincidence, I happened to watch Michael Moore's "Capitalism: A Love Story" recently. In the movie, Moore references a 2006 Citigroup memo that discusses investment strategies designed to take advantage of the fact that the U.S. is essentially what the memo refers to as a plutonomy: an economy "powered by the wealthy, who aggrandize larger chunks of the economy to themselves." (The quoted language is apparently from a 2005 memo.) The related point the memo makes is that democracy is actually a potential drag on a plutonomy because at some point the poor may exercise their right to vote and change the rules of the game for the rich. (For more on the Citigroup memo, go here.)
Then today we get news on a report on Iceland's financial crisis that criticizes:
Iceland's three biggest banks -- Landsbanki, Kaupthing and Glitnir -- for creating a system that benefited powerful businessmen and banking tycoons at the expense of creditors and shareholders.
Of course, there are very compelling alternative formulations of our social contract. But at least the news out of Iceland provides some cold comfort to those who buy the version discussed above--it's not just a U.S. thing.
April 14, 2010
Amerson on Transnational Corporations
Jena Martin Amerson has posted What's in a Name? Transnational Corporations as Bystanders Under International Law on SSRN with the following abstract:Transnational corporations (TNCs) are unique in the international arena. They are not state actors, and do not create law as state actors do. Neither however, are they like individuals, who having been the victim of human rights abuses too often in the past, now command their own special protections under international human rights law. Rather, under the doctrine of international law, TNCs stand alone. Despite this, TNCs – with their vast economic, multi-jurisdictional influence – wield an enormous amount of power in the international social, economic and legal arena. To that extent, a gap exists in international law that has not yet sufficiently addressed this issue.
This paper offers a new perspective for examining transnational corporations; by using the term “bystander” to describe the role that TNCs have created for themselves, I hope to shift the debate concerning current accountability mechanisms for TNCs under international law. Starting from this bystander framework, I examine the various accountability approaches that are being advocated regarding TNCs under international law and discuss how using a bystander framework can offer solutions that are grounded in the theoretical paradigm that is being used by TNCs themselves.
When It Comes to Investing, Income Matters More than Worth
Last week, North Dakota Securities Commissioner Karen Tyler was gracious enough to visit my Business Associations II class to discuss securities issues in the state and around the country. She provided a great overview of the issues her department faces most often, discussed recent enforcement actions, and helped explain many of the practical implications related to representing issuers in the state.
As part of the discussion, she noted that the Regulation D Rule 506 securities exemption has been the source of some issues leading to investigations and actions. That discussion led me to revisit with my class Rules 501, 505, and 506, and consider some of the recent proposals to modify those rules.
A little background: The Securities Act of 1933 requires a company that wants to offer or sell securities to register those securities with the SEC unless the company finds a registration exemption. Various exemptions under the '33 Act for such registration can be found in Regulation D. Two of those exemptions, Rules 505 and 506 allow unlimited sales of the exempt securities to any number of "accredited investors," as defined under Rule 501 of Regulation D. A small part of the recent Senate and House financial reform bills involve proposed amendments to Rule 501 definition of "accredited investors."
Rule 501 lists as accredited investors company insiders (promoters, officers, directors), banks and other investment companies, and a few other entities. With regard to "natural persons," Rule 501 provides that those with an individual net worth, or joint net worth with the person’s spouse, in excess of $1 million at the time of the purchase are accredited investors. Similarly, individuals with income exceeding $200,000 in each of the two most recent years (joint income with a spouse of more than $300,000 for those years) and a reasonable expectation of that income continuing are also accredited investors. Both the House and Senate bills propose increases of some sort on these "net worth" and "income" requirements.
We discussed the reasons behind, and the value of, a possible increase in those limits given that the numbers have not been increased since the 1980s. For what it's worth, the class seemed to lean toward the idea that the "net worth" investment number needs to increase, but the "income" number is fine. (Of course, that's what I think, so it's entirely likely I influenced the outcome.) Why? In current dollars, a person with $1 million in "net worth," with no job and no other significant income seems comfortable, but not "wealthy" or especially able to lose that investment. In contrast, people with the current Rule 501 annual income level still seem like people who can afford to lose significant sums of that earned money if they choose to put it at risk because they have a reasonable expectation they can earn it back. If the financial numbers are proxies for ability to absorb loss, and I think in part they are, this seems like the reasonable compromise.
April 13, 2010
Perceptions of the Supreme Court...
Following a post from earlier this week on the perception of personal agendas among Supreme Court Justices, I fear two events in the past decade may have both heightened such cynicism and polarized all future confirmation debates: 1) The partisan decision handed down in Bush v. Gore (2000), and 2) the testy confirmation of Justice Samuel Alito (January 2006). Comments on The New York Times opinion page from today readily demonstrate how strongly the public feels that appointments (if not decisions) have become but extensions of political dockets. See "The Caucus" (April 13, 2010).
I don't believe the present lack of faith in High Court independence is permanent, but I do believe that it will take a string of highly intellectual, apolitical decisions to reverse the tide of public perception. Might I suggest that the Court start by revisiting the misappropriation theory of insider trading liability? What started as a violation aimed at opportunistic Board members has morphed into an all-reaching blanket prohibition; in turn, that prohibition inspires asset freezes and actions against laymen and "relief defendants" all over the globe. Occasionally, a party of means fights long enough to have the stigma lifted (e.g., Mark Cuban). If the Court were to revisit US v. O'Hagan (1997), and scale back the prohibition to target industry and Boardroom professionals, such a move would belie ties to passions thriving on both the left and the right.
Let's cheer the sages...
While the (justifiable) finger-pointing over the financial Crisis is in full season, we would be remiss if we didn't celebrate the pros who got it right. Review of detailed warnings before 2007 not only belie claims that the heartaches were unforeseeable but also remind us that some public voices warrant more attention than others.
In the 1999 Congressional hearings on the Financial Services Act (which repealed Glass-Steagall), storied consumer advocate Ralph Nader decried - in specific manner - the resulting consolidation of the financial services industry. As discussed in a law review article shortly after the Act's passage:
The greatest potential risk of removing the legislative barriers created by Glass-Steagall and allowing commercial banks, investment banks, insurance companies, and securities underwriters to combine under one corporate entity, according to [Ralph] Nader, is the concentration of economic power in the hands of a few huge financial conglomerates. In the event of a severe economic downturn and the failure of one or more of these huge financial conglomerates such as Citigroup, taxpayers could be called upon to finance the bailout of these institutions through the Federal Deposit Insurance Corporation...
49 Drake L. Rev 671, 681 (2001).
Forget the Mayan calendar. I believe Mr. Nader deserves our collective attention as we look with fear to 2012.
April 12, 2010
The SEC Hears a Who
Last week, the SEC announced rules to tighten the process of originating asset-backed securities. See "S.E.C. Moves on Consumer Loan-Backed Bonds," New York Times, April 8, 2010. Unanimously adopted by the five Commissioners, the measures lessen the role of credit rating agencies while heightening the monetary risk of originators (colloquially referenced as "keeping skin in the game").
Despite bringing to immediate fruition a number of concepts permeating proposals at the FDIC and in Congress, the measures - which would extend equally to public offerings and private placements - have already generated opposition. The Times article quotes a trade group leader as asking rhetorically, “Do very large institutional investors need investor protection from other financial institutions that sell them securities?”
Yes, they do. Isn't that exactly what this crisis has taught us? I can hear again my old Securities Regulation Professor, zealously trying to stir us from popular views on regulation: "Remember, the margin rules were put into place to protect Wall Street from Wall Street."
Kudos to the Commission for recalling (with the possible help of Dr. Seuss) that a victim's a victim, no matter how tall. As for the proposals, see http://www.sec.gov/news/press/2010/2010-54.htm.
Comments Welcome (Sort of)
Yesterday’s New York Times reported that a number of news outlets are rethinking their policies allowing anonymous comments on their Internet pages. The Washington Post is considering policy revisions, and both the Post and the New York Times have started requiring registration before comments may be posted.
The article also noted that the Cleveland Plain Dealer recently found that negative comments on its website about a local lawyer had been placed by someone using a local judge’s e-mail address. That lawyer was litigating cases before that judge at the time. (Oops.)
As someone who has a tendency to read comments to newspaper articles and other Internet postings, and often immediately regret it, I am not surprised that many sites are considering some kind of shift. It's also quite unfortunate that many sites have turned into mean-spirited discussion boards.
I find it truly unfortunate that some such comment forums have spiraled into angry, rant-filled pages because often other readers have a lot to offer in terms of legitimate criticism, additional support, or just a thoughtful spin. When I read an especially good article, thoughtful comments can provide a way to extend the conversation and perhaps share some of the feelings (good or bad) with other readers. This is one of the great benefits of the Internet. No longer is reading a newspaper article a largely solitary experience, unless you so choose.
Regardless of what the various sites do on this front, I think there is value in this overall conversation because it offers another great opportunity to discuss professionalism, both in the classroom and as a society. Through these conversations, perhaps one day we’ll all get better at recognizing the difference between what we can say and what we should say.
April 11, 2010
Black on Fiduciary Duty and Investment Advice
Barbara Black has posted Fiduciary Duty, Professionalism and Investment Advice on SSRN with the following abstract:
broker-dealers and investment advisers provide virtually identical
services, they are subject to different regulatory schemes and
standards. These sharp legal distinctions that do not comport with
reality have led to investor confusion and concern about the adequacy of
investor protection. The Obama administration’s Financial Regulatory
Reform includes proposals that would “establish a fiduciary duty for
broker-dealers offering investment advice and harmonize the regulation
of investment advisers and broker-dealers.” In addition, the Obama
proposal calls for the SEC to study the use of predispute arbitration
arguments in securities arbitration and to invalidate them if it would
be in the best interests of investors. As of March 25, 2010 Congress has
not enacted financial reform legislation. Although the bill passed by
the House and the bill approved by the Senate Banking Committee reflect
different approaches, any legislation that Congress ultimately enacts is
likely to address both these issues in some fashion, probably by
calling on the SEC to study them further.
Despite their consensus on the general concept of harmonized regulation, the broker-dealer and investment adviser industry groups are bitterly divided over how to accomplish this. In addition, the broker-dealer industry supports mandatory securities arbitration, while other groups call for its abolition. This paper seeks both to shed some light and remove some heat from these contentious debates. I make four arguments: 1. The fiduciary duty standard is not a useful standard for regulating the conduct of broker-dealers or investment advisers; the standard should be based on professionalism. 2. There are established standards of care and competence that should be applicable to both broker-dealers and investment advisers. 3. Without an explicit federal remedy for negligence, investors do not have adequate protection. 4. If Congress directs or encourages the SEC to invalidate predispute arbitration agreements, small investors are likely to be worse off.