September 17, 2011
Coates and Lincoln on Fulfilling the Promise of Citizens United
John Coates and Taylor Lincoln have posted “SEC Action Needed to Fulfill the Promise of Citizens United” over at the Harvard Forum. Here’s a brief excerpt:
[T]he Supreme Court’s Citizens United decision to let corporations spend unlimited sums in federal elections was premised on a pair of promises: Corporations would disclose expenditures, and shareholders would police such spending. Those promises remain unfulfilled …. The best chance to fulfill those promises may now rest with the SEC, which was recently petitioned to begin a rule-making process to require disclosure of political activity by corporations.
September 16, 2011
High School, Baseball, and Legal Education
The New York Times Magazine includes the article, What if the Secret to Success Is Failure?, by Paul Tough. The article begins with a discussion of New York City's Riverdale Country School, and talks about the educational philosophy of Dominic Randolph, the school's headmaster:
For the headmaster of an intensely competitive school, Randolph, who is 49, is surprisingly skeptical about many of the basic elements of a contemporary high-stakes American education. He did away with Advanced Placement classes in the high school soon after he arrived at Riverdale; he encourages his teachers to limit the homework they assign; and he says that the standardized tests that Riverdale and other private schools require for admission to kindergarten and to middle school are “a patently unfair system” because they evaluate students almost entirely by I.Q. “This push on tests,” he told me, “is missing out on some serious parts of what it means to be a successful human.”
The most critical missing piece, Randolph explained as we sat in his office last fall, is character — those essential traits of mind and habit that were drilled into him at boarding school in England and that also have deep roots in American history.
Sounds like high school education and legal education have some things in common. Any time we try to filter our assumptions based only on numbers, we're likely to be wrong a good part of the time. It's especially true when the numbers are indicators of potential, and not performance. To use a baseball analogy, it's often better look at a pitcher's ERA than the speed on the radar gun. It's nice to get the player with both (see, e.g., Justin Verlander), but you're often better with Tim Wakefield or Cole Hamels than Todd Van Poppel.
Furthermore, in addition to assessing potential, it also means we have the job of developing that talent. In teaching students to become lawyers, we need to ensure that we teach skills our students lack; hone, refine, and expand those skills they have, and of course, eliminate bad habits. A tall order, certainly, but possible. In fact, it's essential, and it's happening in many, if not all, law schools around the country (notwithstanding what some people may think). Still, we can do better, and we must.
How do we do that? Take a page from our own book: learn teaching skills that we lack; hone, refine, and expand those skills that we have; and of course, eliminate bad habits.
Politicians Discover The Need for Small Business Registration Exemptions
I have been writing for at least 15 years about the need for small business exemptions from the registration requirement of the Securities Act. I was not alone; many other people have pointed out how securities regulation strangles small-business entrepreneurship. But, with exception of a brief period of change at the SEC in the early 1990s, nothing has happened.
It now appears that change is coming. Politicians have "discovered" the problem and it is becoming increasingly clear that some action is going to be taken to exempt additional small business offerings. Here are some of the most recent developments:
- As I indicated in an earlier post, President Obama has come out in support of both a “crowdfunding” exemption from SEC registration requirements for firms raising less than $1 million (with individual investments limited to $10,000 or 10% of investors’ annual income)” and increasing the offering amount of the Regulation A exemption from $5 million to $50 million.
- Senators Jon Tester (D-Mont.) and Pat Toomey (R-Pa.) have introduced a bill to require the SEC to exempt securities offerings of up to $50 million. Issuers would be required to file audited financial statements with the SEC annually. The bill would also require the Comptroller General to study the impact of state blue sky law on Regulation A offerings.
- A subcommittee of the House Committee on Oversight and Government Reform just held hearings on the possibility of an exemption for crowdfunded offerings. A video of those hearings is available here.
- Meredith Cross, the director of the SEC’s Division of Corporate Finance, testified at the hearings that she believes the SEC will consider crowdfunding “in the near future.”
- Congressman Patrick McHenry (R-N.C.), the chair of the subcommittee that held the hearings, has introduced a bill that would exempt crowdfunded offerings from Securities Act registration. (A copy of that bill is here.)
It’s not clear what’s going to happen, or whether the changes will really benefit small businesses very much. If the current proposals are any indication of what is to come, I will probably spend the next fifteen years explaining why the new exemptions are still too costly for very small businesses. But some change seems inevitable.
September 15, 2011
Unauthorized Trading at UBS
UBS, the big Swiss banking firm, announced today that it had lost $2 billion as a result of unauthorized trading by one of its traders. (Yes, that’s $2 billion.) UBS did not name the alleged wrongdoer, but news reports indicate that British police have arrested Kweku Adoboli, a UBS trader in London. Follow the links for stories from CNN, the Wall Street Journal, and the New York Times.You might also enjoy the BBC's Q & A on how unauthorized trading occurs and what can be done about it.
This is the fourth billion-dollar unauthorized trading loss that I’m aware of. Barings Bank lost over a billion dollars in 1995; Sumitomo Corporation lost $2.6 billion in 1996; and Societe Generale lost over $6 billion in 2008.
No compliance system, no matter how well designed, is perfect. Some fraud and unauthorized trading is going to leak through the controls. And, if derivatives are involved, it’s easy to lose a lot of money quickly. But $2 billion? It is going to be interesting to see exactly what sort of reporting and oversight measures UBS had in place and how those controls were skirted. I’m sure UBS’s directors and officers are anxiously consulting their attorneys this morning to see if they have any potential liability for allowing this to happen.
UBS is a Swiss company, so U.S. corporate law doesn’t apply. If UBS were a Delaware corporation, its directors would have an obligation to assure themselves that “information and reporting systems exist . . . that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board . . . to reach informed judgments concerning both the corporation’s compliance with law and its business performance.” In Re Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). However, the board is not liable just because the company’s compliance system fails to catch wrongdoing. As long as the directors decide in good faith that the company’s compliance system is adequate, they are protected by the business judgment rule. Caremark says that “only a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists” is grounds for liability.
- Small Business and Skills Shortage: “In August, 33% of small businesses reported having few or no qualified applicants for job openings ….”
- With New Technology, Start-Ups Go Lean: “New businesses are getting off the ground with nearly half as many workers as they did a decade ago, as the spread of online tools and other resources enables start-ups to do more with less.”
September 14, 2011
Facebook, Happiness, and the Stock Market
Color me skeptical, but I haven't looked at it that closely. Yigitcan Karabulut has. Here is his abstract for a draft paper, Can Facebook Predict Stock Market Activity?:
This paper revisits the relation between investor sentiment and stock market activity using a novel and direct measure for sentiment. Specifically, I use Facebook's Gross National Happiness which captures investor sentiment on a daily basis using content from the individual status updates of almost 100 million Facebook users in the US. I document that Facebook sentiment has the ability to predict statistically significant and economically meaningful changes in the daily returns and trading volume in the US equity market. For instance, a one-standard deviation increase in Facebook sentiment predicts an increase in market returns equal to 12 basis points over the next day. Moreover, I also find an incremental ability of Facebook sentiment to forecast returns among small-cap and growth stocks that is consistent with the noise trader models.
Of course, I can't look at it very closely, because the paper is not available on SSRN (just the abstract), but an overview of the paper is available here, via CXO Advisory Group, LLC. CXO runs their own, simplified test, concluding that
evidence from simple tests on available data indicates little or no power for changes in Facebook Gross National Happiness for the U.S. to predict U.S. stock market returns.
Either way, given the enormous influence of social networking, it would seem something could be learned. I'm more interested in the micro-level impacts. I'd be curious to see the impact of key corporate information being disseminated via Facebook or Twitter. And whether a company have any effect on the market response to key information releases by controlling some aspect of social networking and related discussions. I'm sure some companies are looking into, but I suspect they aren't going to share what they find.
September 12, 2011
CML V, LLC v. Bax Strikes An Ambiguously Unambiguous Tone
As I reported last week, the Supreme Court of Delaware decided CML V, LLC v. Bax on September 2, 2011. I promised a follow up with my take, so here it is: The Court got the outcome right, but it relies too much on the wrong rationale for the outcome.
On appeal, CML argued that the Delaware Limited Liability Company Act does not eliminate standing for creditors seeking to bring derivative actions on behalf of insolvent LLCs (in 6 Del. C. §§ 18-1001 and 18-1002). The defendants, in turn, asserted that the LLC Act exclusively limited standing to LLC “member[s]” or “assignee[s]” as stated in 6 Del. C. § 18-1002. The Delaware Supreme Court agreed with the defendants, finding that language of the LLC Act was clear and unambiguous, and thus deprived the creditors standing.
I'm okay with that result, but I'm troubled by what I view is an overstatement of part of the rationale. The Court explains that CML claimed the legislature intended 6 Del. C. §§ 18-1001 and 18-1002 to rephrase the language of the Delaware General Corporate Law, which the Delaware Supreme Court has concluded does allow creditors standing to sue insolvent corporations derivatively. CML was thus arguing that the Delaware legislature "merely intended to take the corporate rule of derivative standing for creditors of insolvent corporations and apply it in the LLC context." The Court disagrees, and states: "When statutory text is unambiguous, we must apply the plain language without any extraneous contemplation of, or intellectually stimulating musings about, the General Assembly’s intent."
The problem I have with that is that section 327 of the DGCL provides as follows:
In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.
To my knowledge, there is no "operation of law" that transfers shareholders' stock to creditors of an insolvent corporation. In fact, in determining that creditors of an insolvent corporation can bring a derivative suit, the Delaware Supreme Court explained:
The corporation's insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation.
N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 Del. 2007) (footnote omitted). So the corporate creditors' right of standing is equitable, not statutory, under the DGCL. My reading of section 327 is that derivative claims are unambiguously reserved to shareholders. Thus, in my view, the Court is either saying that Gheewalla is wrongly decided or the Court vastly overstates the case when it says that "section 18-1002 is unambiguous, is susceptible of only one reasonable interpretation, and does not yield an absurd or unreasonable result." Give the contours of the law, and Delaware law specifically, CML's interpretation is entirely reasonable. CML's view is not right, in my view, but it is reasonable, because laws are should be considered in context.
The Court should have stuck with its earlier analysis, and stopped there:
Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.
Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore,logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests.
I know it could be argued that I'm picking nits here, but I think the Court should have rested on the proposition that the language of the LLC Act clearly excludes creditors from derivative standing, while acknowledging the same is true of the DGCL. In the analogous situation in corporate law, the Court determined that creditors of insolvent corporations have standing to sue derivatively. Because LLCs are different, and intended to be distinct entities from corporations, the Court declined to do so here.
It's not just that the statute is unambiguous; it's that LLCs are inherently different. And while a reasonable person may think LLCs should be analogous to corporations, the reality is that LLCs can be, but need not be, analogous to corporations. The nature of the LLC is such that those who form the LLC and do business with the LLC must contractually make the LLC analogous if that is what they desire. Default rules and gap fillers will not save the day in the LLC setting as they might in the corporate world.
I concede that my rationale leads to the same result, but the Delaware Supreme Court missed an opportunity to, once and for all, make clear that LLCs and corporations are wholly different entities. While it is of little consequence in this case, in future situations, courts may still miss that point, and again inappropriately apply corporate concepts where the statute is not so clear. As such, while much of the language from Vice Chancellor Laster's opinion below remains intact, the Supreme Court's focus on the unambiguous nature of the statute diminishes the tone. I would have stuck with the tone Vice Chancellor Laster captured in the last sentences explaining the rationale behind his opinion:
In light of the expansive contractual and statutory remedies that creditors of an LLC possess, it does not create an absurd or unreasonable result to deny derivative standing to creditors of an insolvent LLC. The outcome does not frustrate any legislative purpose of the LLC Act; it rather fulfills the statute’s contractarian spirit.
White House Endorses Crowdfunding Exemption
I have blogged before about crowdfunding—the use of the Internet to raise funds through small contributions from a large number of investors. See here, here, here, and here. I have written an article arguing that the SEC should exempt crowdfunding from the registration requirements of the Securities Act and should exempt crowdfunding sites from having to register as brokers or investment advisers.
Given the SEC’s history when it comes to small business exemptions, I have not been optimistic that such an exemption will come to pass. But President Obama just changed the odds. The White House has released a statement supporting a number of changes to the regulation of small business, including a crowdfunding exemption. According to the release “"The administration . . . supports establishing a “crowdfunding” exemption from SEC registration requirements for firms raising less than $1 million (with individual investments limited to $10,000 or 10% of investors’ annual income) and raising the cap on “mini-offerings” (Regulation A) from $5 million to $50 million.” That's all the release says; no further details are provided.
Both of these suggestions make sense, but the devil will be in the details. The crowdfunding proposal on which the administration’s proposed exemption is based imposes substantial disclosure and other regulatory requirements that would make crowdfunding too expensive for micro-businesses. As I explain in my article, a crowdfunding exemption that imposes substantial requirements at the issuer level won’t be very helpful. The administration proposal also doesn’t address preemption of state law; absent preemption, a federal crowdfunding exemption will be ineffectual. And the administration proposal doesn’t say a thing about whether crowdfunding sites will be exempted from treatment as brokers or investment advisers.
Nevertheless, the White House suggestions are a welcome baby step towards meaningful reform. A number of other changes are needed to make federal securities law friendly to small business: elimination of the general solicitation restriction in Regulation D; elimination or substantial modification of the integration doctrine; simplification or elimination of the restrictions on resale of exempted securities. Given the many obstacles to small business capital formation in federal securities law, it’s hard to see why the White House chose to focus on these two. But it’s a start.
September 11, 2011