May 14, 2011
LinkedIn's IPO: Debating the Corporate Governance Structure
Following up on Josh's post about the teaching opportunities presented by the Ed Shultz lawsuit, I thought I'd summarize some of what Steven Davidoff and John Carney have recently written about the planned LinkedIn IPO, which also has the potential to serve as a useful teaching case study.
Davidoff has posted a couple of pieces over at DealBook discussing what he sees as a number of management-friendly governance structure provisions. In the first, he focuses on the proposed dual-class structure, which would essentially allow co-founder Reid Hoffman to retain control of the business even if his ownership stake drops significantly below a majority. This is so because he will own Class B shares that carry 10 votes as opposed to the one-vote Class A shares being offered to the public. Notes Davidoff:
In 1988, the Securities and Exchange Commission responded to shareholder complaints by trying to outlaw dual-class stock, but the rule was struck down a year later by a federal court. The stock exchanges then adopted their own rules forbidding a company from adopting dual shares after it listed. This ended the ability of management to adopt this structure to fight off a hostile bid. The exchanges, however, allowed a big exception: a company can go public with a dual-class share structure.
The tension here, of course, is between (a) the benefits of allowing those who have successfully managed the business to the point of making it IPO-worthy to continue to exercise control even after significantly reducing their equity stake, and (b) effectively disenfranchising public shareholders in a way that creates opportunities for value-destroying self-dealing. Here, Davidoff points out that:
A study in 2008 by Paul A. Gompers, Joy L. Ishii and Andrew Metrick found evidence of this self-interest. The authors found that dual-class stock could destroy value where the holders had a much more significant voting interest than an economic one.
One obvious response to the criticism of dual-class stock is that the market will take the structure into account in valuing the offering. In making this point, Carney points out that the market may actually have some good reasons to favor such a structure:
[W]hat Davidoff and the governance types don't see is that "good" corporate governance may be too costly for its alleged benefits. And government policy is constantly making it costlier. Consider, for instance, recently proposed changes in proxy access rules and "say on pay." These increase the ability of special interest groups, including union-controlled pension funds, to cut deals with management to the detriment of outside shareholders. Dual class companies may avoid this problem. Similarly, dual class companies can better avoid the short term "beat the quarter" thinking that debilitates so much of corporate America.
Davidoff notes, however, that there may be reason to question the market's efficiency on this point:
Why is LinkedIn adopting these mechanisms? The most likely reason is that it can get away with it, particularly since this will be a hot I.P.O. Institutional Shareholder Services, the influential proxy advisory service, does not provide a rating of corporate governance until the company is public. The reason is that many of I.S.S.’s customers — institutional shareholders — are going to flip shares acquired in an I.P.O., and therefore do not scrutinize the company’s corporate governance provisions at the going-public stage.
In my opinion, this is just another area where we likely need more empirical evidence of investor behavior. I imagine behavioral economists would be able to identify a number of cognitive biases that set up investors to undervalue the risk of a variety of corporate governance structures.
In his second piece, Davidoff goes on to examine a number of other potentially problematic features of LinkedIn's corporate governance structure, including the presence of a staggered board (which Davidoff notes is effectively permanent in light of the dual-class structure and relevant voting requirements), bylaw notice / choice of forum provisions, and acceptance of Delaware's anti-takeover statute protections.
All in all, there is easily enough here to fill an entire review session at the end of a Corporations class.
May 13, 2011
MSNBC's Ed Schultz Lawsuit -- A Nice Intro to BA Review
MSNBC's Ed Schultz has been sued by a former associate who claims Schultz agreed to be his partner, then backed out. When I saw the reports, I could not help but think about all the first month of Business Associations issues the lawsuit raises.
Schultz is a radio personality who moved into television, and allegedly worked with an NBC broadcast engineer. The case has all sorts of good contract, partnership, and corporate opportunity issues.
First, the broadcast engineer, Michael Queen, was a cameraman for Meet the Press. Queen was told by Tim Russert that he could pitch the show to other networks, as long as NBC had the first opportunity to consider it.
Next, Queen says he fronted $11,500 for taping a pilot episode for the proposed show, among other expenses. In addition, according to one report,
In an email quoted in the complaint, Schultz wrote on April 5, 2008, that “any TV deal will obviously involve you. I will not do a TV deal without your involvement and that includes a financial involvement. Rest assured we are together on this,” Queen’s lawsuit purports.
Schultz never signed an official agreement, Queen admits. But in emails, he made promises amounting to an enforceable contact, he alleges in the lawsuit.
Finally, according to Queen, MSNBC contacted Schultz directly about a show, at which time Schultz paid Queen $12,000 for the pilot expenses. Queen alleges that the payment was ordered by MSNBC.
Is it a partnership? Perhaps, but without a term it could be ended at any time, without penalty. Of course, if the timeline about the repayment and other facts are accurate, I think any court would be hard pressed to say that the partnership (again, if there was one) was not in force when MSNBC contacted Schultz. Sounds an awful lot like Meinhard v. Salmon to me.
Apparently NBC got their shot at the deal, so there doesn't appear to be a problem on the corporate opportunity front, but maybe there is an issue.
Is there a contract? It sure seems like there could be, but there are concerns. It appears there is a fairly clear understanding of the basic deal terms, but the amount of the fee sharing is not deteremined. Not a problem if they were partners (default rules are available) but could be a contract-only problem. There seems to be a strong reliance claim here for Queen, especially if all the alleged expenses can be shown.
What else am I missing?
May 12, 2011
Even More Insider Trading Prosecutions?
Forgive me for another post today after my long diatribe on federal securities law, but I will be traveling on Friday, so consider this an early Friday post. A couple of weeks ago, I argued that the government has better things to do with its limited securities regulation enforcement dollars than prosecuting insider trading cases. I'm afraid it's going to get worse before it gets better.
Today's Wall Street Journal argues that the guilty verdict in the Raj Rajaratnam case is likely to lead to even more insider trading investigations and prosecutions. The article quotes former federal prosecutor Robert Mintz, who says, "This conviction will undoubtedly embolden prosecutors, and we can expect more of these cases in the future."The article also argues that the Manhattan U.S. Attorney will "ramp up prosecutorial methods once reserved for mob and terrorism cases."
I wish the government would spend a little more resources on mob and terrorism cases and a little less on insider trading. I don't know about you, but I'm more worried about mobsters and terrorists. Even within the world of securities regulation, there are many better ways to spend those scarce enforcement dollars. It wasn't insider trading that caused the recent economic problems. It wasn't insider trading that caused Enron and WorldCom to collapse. And it won't be insider trading that causes the next big corporate failure.
"This deal is essentially a bet on the U.S. [online poker] market opening up."
A couple of weeks ago I commented that a cynic might be tempted to view the recent prosecutions of online poker sites as the first step toward fully regulated online poker in the U.S.:
I have a friend who grew up in Cleveland Heights back in the 60s, and he likes to tell a story about how the cops came in and busted up the local number-running ring because gambling was illegal ... shortly thereafter the state started generating revenue by selling lottery tickets in Cleveland Heights and throughout Ohio. While it is hard to predict with any certainty, my best guess is that we will have some form of federal and/or state regulated online poker in place within the next 18 months. A number of states (as well as the District of Columbia) are already actively pursuing establishing regulated intrastate sites (I believe the potential annual national tax revenue is estimated to be in the billions). I'm not suggesting this is some sort of organized conspiracy. Rather, a confluence of events and opportunity. However, as always, it is ultimately too soon to tell.
Now it appears we have at least some further evidence from the market that this may well be the case. Casino City Times reports that, "Reno-based IGT has offered $115 million to acquire a Swedish technology company that operates one of the world's largest online poker networks and supplies online gaming products and services to the industry." The story goes on to quote Roth Capital Partners gaming analyst Todd Eilers as saying that, "This deal is essentially a bet on the U.S. market opening up.... We believe it's only a matter of time before the U.S. market opens up with a push at both the federal and state levels."
Meanwhile, a related story is developing onshore that I can only describe as dripping with irony. Casino development in Ohio has halted, despite voter support for the projects via a constitutional amendment, because Ohio Governor Kasich (R) wants to increase the taxes on the casinos. The Cleveland Plain Dealer reports:
Kasich has said often in the last several weeks that th[e previously approved] fees are not enough and the operations should do more to help the financially struggling state. "You like to ask people to step up and help us in tough times," he said last month.
Federal Securities Law: A Plea for Simplification
It's past time we do something about federal securities law. I don't mean a new exemption or changes to a few rules. I mean a complete rewrite of federal law. First enacted 75+ years ago, the federal securities laws have grown into a complex morass that is totally inaccessible to business people without the intervention of sophisticated securities law specialists.
Federal securities law is based primarily, but not exclusively, on four statutes: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. Those statutes cover literally hundreds of pages, and the regulations associated with those statutes are even more extensive. Size alone is an issue; it’s not surprising that someone might get lost in all that detail. But the complexity lies in more than just the magnitude of the enterprise as a whole.
Consider one small, but important, provision, subsection 5(b)(1) of the Securities Act. Section 5(b)(1) says, in its entirety:
It shall be unlawful for any person, directly or indirectly –
(1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this subchapter, unless such prospectus meets the requirements of section 10 of this Act; . . .
Understanding exactly what this small subsection does and does not prohibit requires a circuitous traipse through the statute and the SEC rules. First, one has to deal with the lengthy interstate commerce language at the beginning of the subsection—what exactly does it mean to “make use of any means or instruments of transportation or communication in interstate commerce or of the mails”? The statute provides little guidance.
But, putting that jurisdictional issue aside, one must next determine what a “prospectus” is. There’s a lengthy definition in section 2(a)(10) of the statute, with two exceptions to that definition which depend on when the communication is made and what the communication includes. The section 2(a)(10) definition and exceptions require statutory side trips into section 2(a)(3) to determine what an “offer” is and to determine exactly what section 10(a) requires. But the journey to define a prospectus is incomplete without looking at the SEC’s view on what constitutes an offer—which, not surprisingly given that it’s the SEC, does not require that one actually ask people to buy a security, or even mention that one is offering securities, for that matter. It’s enough to “condition the market.” And there are a multitude of rules providing that certain communications either are not prospectuses or are not offers at all: Rules 134, 134A, 134B, 135, 135A, 135B, 137, 138, 139, 139A, 167, 168, and 169, although I’m sure I missed a few.
Let’s assume you’ve waded through the rules and cases, and what you’re transmitting is a prospectus. You’re not done yet. It’s not a violation if the prospectus you’re transmitting “meets the requirements of section 10” of the Securities Act. When you look at section 10, you find two things. First, section 10(a) says that a prospectus must include most of the information contained in the registration statement, with a cross-reference to two statutory schedules listing what the registration statement must include. But don’t be misled by that—the SEC has exercised its statutory power to change what must be in the registration statement, so those statutory schedules are obsolete. You have to look at the SEC forms instead.
The SEC has also exercised the power granted in section 10(b) to approve other communications for purposes of section 5(b)(1), so it’s back to the rules. Rule 430 and 431 are relatively straightforward, but God help anyone who stumbles into the Rule 164/433 combination. Whether a communication falls within the Rule 433 safe harbor can depend on, among other things:
(1) whether the issuer has filed a registration statement, Rule 433(a);
(2) characteristics of the company issuing the securities, such as its size and how long it has been a reporting company, Rule 433(b);
(3) the content of the communication, Rule 433(b)(2)(i), (c);
(4) who is making the communication, Rule 433(d), (f);
(5) where the information in the communication originally came from, Rule 433(d)(1)(i)(B), (h)(2);
(6) whether the information in the communication is otherwise available to the general public, Rule 433(d)(8)(ii); and
(7) whether the issuer or anyone else associated with the offering paid for the communication, Rule 433(b)(2)(i), (f)(1)(i).
This is one subsection in one statute—a very important subsection, admittedly, but still only one tiny part of the morass. And most of this comes from the same agency that has chided lawyers for their inability to write in “plain English.”
This is the rule of lawyers, not the rule of law. Anyone who tries to navigate through the Securities Act provisions without a sophisticated securities lawyer, either to register an offering or to avoid registration, will fail. They will violate the law--not “might” but “will.” Only SEC restraint has avoided wholesale prosecution of a large number of entrepreneurs. (The SEC must be too busy investigating and prosecuting insider trading.)
It’s time to have a set of offering and exemption rules that, even if they’re not accessible to the average lay reader, at least are understandable to a reasonably competent lawyer who isn’t versed in securities law. We need rules that entrepreneurs can understand—straightforward answers to the question of what they may or may not do in raising capital. If that means a complete rewrite of the statute, so be it.
Two Torpedoes in the Water: The Galleon Insider Trading Case
Yesterday, a federal jury in Manhattan returned a guilty conviction on 14 counts of insider trading against Raj Rajaratnam, a billionaire and founder of the Galleon Group hedge fund.
The Galleon Group prosecution, one of the largest securities fraud cases to date, involved a tangled web of inside, paid informants who provided non-publically available information to Galleon traders. Adam Smith, a former Morgan Stanley trader and top executive at Galleon who has plead guilty to insider trading, testified that a motto of the Galleon Group was to have "two torpedoes in the water"--diligent research and inside information because if one doesn't hit, the other one was likely to. The New York Times provides a great visual representation of the parties, their relationship, and the status of their prosecution here.
I have two points to make: the first is that the lasting impact of this case will happen in the appeals where issues such as fraud on the market and the scope of insider trading will have the chance to be revisited by courts. While the jury is in, it isn't the last word on this case. Second, expect to see a heightened revival of the debate regarding the efficacy and role of inside information cases. Is insider trading a practice that erodes the perception and integrity of the markets or are prosecutions such as this one with the Galleon Group simply a waste of government resources that keeps information from fully permeating the markets?
As you can imagine, there is extensive coverage, as well as commentary, regarding this case. A few good recap articles of the wildly entertaining facts of this prosecution include the following: NYT's Dealbook, WSJ, and WSJ's MarketBeat (compares Rajaratnam possible sentence with those of other Wall Street convicts). An annotated copy of the original criminal complaint against Raj Rajaratnam is also available here: Download Raj-Rajaratnam-Galleon-Criminal-Complaint-in-Plain-English
I have used this case to teach insider trading and fraud on the markets in my basic corporations class since the indictments were announced in the Fall of 2009. While not in any casebooks yet, the facts of this case and the resources available on-line make it a fun, interactive case to discuss with students. If you have any ideas or resources that you use to discuss this case in class, please share in the comments section.
May 11, 2011
Who'd notice a Ferrari?
Law.com reports that the Justice Department has tried and convicted the first company, Lindesy Manufacturing, of Foreign Corrupt Practices Act (FCPA) violations. According to the article:
A federal jury has found a California company and two of its senior executives guilty of violating the Foreign Corrupt Practices Act by paying bribes, including a $300,000 red Ferrari, to two officials from a state-owned electric utility company in Mexico.
Lindsey Manufacturing Co., Chief Executive Officer Keith Lindsey and Chief Financial Officer Steve Lee each was convicted on May 10 on all counts — one of conspiracy to violate the FCPA and five of FCPA violations.
According to an LA Times report, the company hired a Mexican national who "used part of [his $5.9] commission to buy the power company official a $297,500 Ferrari, a $1.8-million yacht and to pay more than $170,000 of his credit card bills, prosecutors alleged."
I don't know how executives of state-owned utilities roll in Mexico, but it would seem a little odd that he or she would be driving a Ferrari. Obviously, the executive could be independently wealthy, and simply has the job to keep busy, but it's not exactly like splurging on a new BMW, which might seem extravagant, but not impossible to explain.
Andre Birotte Jr., the Los Angeles U.S. Attorney, says "Bribery is not a victimless crime. . . . Not only does it damage citizens' confidence in their own government, it also damages the integrity of the global marketplace." I'm inclined to agree. And, just as important, bribery is against the law.
So, someone noticed the Ferrari, and a jury has convicted the Lindsey Manufacturing executives. One question: What happened to this state employee?
May 10, 2011
Fox on Fraud-on-the-Market
Merritt B. Fox has posted Fraud-On-The Market Class Actions Against Foreign Issuers on SSRN with the following abstract:
This Article goes back to first principles to look at the basic policy concerns that are implicated by the extra territorial reach of fraud-on-the-market class actions. The resulting analysis suggests a simple, clear rule that can be shown likely to both maximize U.S. economic welfare and, by also promoting global economic welfare, foster good U.S. foreign relations as well. The U.S. law based class action fraud-on-the-market liability regime, I conclude, should not as a general matter be imposed upon any genuinely foreign issuer, even where the purchaser making the claim is a U.S. investor purchasing the share in a U.S. market or where significant conduct contributing to the misstatement occurs in the United States. An issuer is genuinely foreign if it has its economic center of gravity as an operating firm outside the United States. The only exception would be a foreign issuer that has agreed, as a form of bonding, to be subject to the U.S. liability regime, in which case all such claims against the issuer should be allowed, regardless of the nationality and residence of the purchasing plaintiff, the place where she executes the transaction, and the place or places where conduct contributing to the misstatement occurs.
- Eric C. Chaffee
Microsoft is reportedly in the final stages of negotiations to purchase Skype from its founders and Ebay for about $8.5 billion, when factoring in Skype's debt. (Recall that Ebay purchased Skype in 2005 for $2.6 billion.) While Skype filed registration statements last fall to launch an initial public offering, those plans were delayed once it began talks with suitors such as Google and Facebook. Gaining access to Skype's 683 million users and the internet-based phone/video infrasture could mean a big advantage for Microsoft in its on-going "strategic confrontation" with Google.
The deal could be officially announced today...if so, I will post an update. For now though, the best description of the talks can be found at NYT's Dealbook. Other technology news regarding Google, Apple, and LinkedIn can be found here.
May 9, 2011
Turning Law Students Into "Garage Guys"
I just read an interesting article by Gillian Hadfield, Equipping Garage Guys in Law, 70 Md. L. Rev. 484 (2011), available here. Hadfield, like many law professors, is struggling with how to teach students the legal problem-solving skills they will need to practice successfully in our rapidly changing world. Hadfield wants law schools to graduate “our own garage guys who can transform how we do law in the way that Apple and Google have transformed how we find information, connect with one another, and learn.”
Hadfield’s article describes three experiments he has tried in his area of expertise, contract law:
(1) A project where teams of law students and MBA students attempt to convert a dense legal document into something shorter and intelligible to a lay reader.
(2) The use of four-person teams in his basic Contracts course to advise clients on discrete problems.
(3) An Advanced Contracts class where four-person teams work on case studies.
It's interesting reading. I agree with Hadfield that we need to produce a generation of legal innovators—students who understand the business enterprise and can add value to what businesses are doing. I don’t know the best way to do that, particularly in a world of limited resources, but I hope law professors like Hadfield will continue to share what they are doing. We don’t all need to independently reinvent the wheel. And I commend the Maryland Law Review for publishing the article. It’s much more helpful to the profession than the latest trendy constitutional law theory.
A Little Perspective on Legal Fees and the Legal Profession
The Wall Street Journal reports that Goldman Sachs spent $700 million on legal fees last year, including $434 million for outside counsel. This is a lot of money, although I'd note that Goldman also had more than $39.16 billion in revenues for 2010 (10-k pdf here).
At the New York Times Dealbook, Professor Peter Henning discusses the high costs of internal inquiries, which are often related to SEC and Justice Department investigations. Professor Henning explains that some companies, like Avon, have broad indemnification policies for employees that require the company to cover legal expenses for any investigations related to their employment, as long as employees agree to repay the expenses if indemnification is not warranted at the conclusion of the case. These costs are so high, though, that the legal fees often can't be recovered, because the employee simply doesn't have the means to repay the obligation.
Professor Henning closes with this:
Legal fees could easily run into the millions of dollars for any individual defendant, all payable — at least initially — by Avon. While crime does not pay, it sure can be lucrative for law firms.
On the one hand, this is true. But I can't help but take issue with posture of such statements. We don't very often hear something like, "While cancer is unfortunate, it sure can be lucrative for doctors." I continue to bristle at statements that expand the "ambulance chaser" narrative into the corporate context and make lawyers look like opportunists who are seeking to capitalize on the misfortune of others. I feel like a lot of us, whether in practice or in the academy, have unwittingly bought into this narrative. I know I have at times, and I don't mean to pick unfairly on Professor Henning.
Of course, I know there are lawyers who are opportunists, but that is not at all a fair charcterization of the profession in my experience. Most attorneys I know really believe in providing good representation for their clients, and they worry about their clients' well being. Suppose a client comes in and says she has been working for a company conducting overseas business. She's trying (as she should) to expand the business into a new area. She takes a few people to dinner, buys a few drinks, and the next thing she knows, the Justice Department is investgiating a Foreign Corrupt Practices Act claim against her. When she sits down in your office, I don't think the first thought most lawyers have is -- Cha-Ching! Maybe I have just worked with and for some really good people (and I have), but that is simply not my experience.
I like the concept that the legal profession is a noble profession, and I still believe it is largely true. As attorneys, I admit we often don't live up to the highest ideals, but that's doesn't make it not true. Failure is a human trait, and it is not true only of those in the legal profession. Doctors and clergy, for example, have had their failures, too.
It's easy to get angry at laywers for legal fees, especially in the litigation context, because the costs are usually to protect something the client already thought was theirs. That's true whether it's a criminal case (even if the defendant wins, the cost is usually to keep his or her freedom). And it's true in the civil context (where the defendant might be suing to get the benefit of his or her bargain). And the client may very well be right. But, ulimately, it was usually not the lawyer who created the problem; it was the investigator or the counterparty or the client, or some combination of those.
I guess I'm just done with accepting the current narrative. I may be a little bit of an idealist, but I'm still proud of the profession I chose, even when I'm not always proud of those in the profession. I think that those of us who still believe in what we do, and why we do it, need to be careful with our language, and be more focused on the bigger picture than we have been when discussing our profession. After all, it's what good lawyers do.
May 8, 2011
Will you vote for the deal if we change the name?
Over at DealBook, Steven Davidoff has a nice breakdown of the on-going battle for the New York Stock Exchange. Items covered include the relevance of: (1) the record date, (2) currency exchange rates, and (3) post-deal naming commitments ("Expect Deutsche Börse to allow the NYSE name to be preserved in some way to burnish its American-friendly stance."). The pending vote is scheduled for July 7, and Davidoff writes that:
I am not aware of any significant transaction in which shareholders approved a deal of a company engaging in a strategic combination that was also subject to a hostile bid.... But this could be the one in which shareholders decide to go with the current bid.