November 5, 2011
A couple of weeks ago the Wall Street Journal ran an article entitled "Trust Me." The article asserted that:
Infamous frauds and financial crises have wrecked the public's faith in business in recent years, leading many companies to try to repair the damage by emphasizing codes of ethics. But we do not have a crisis of ethics in business today. We have a crisis of trust.
Later on, the author suggested that:
Spirals of distrust often begin with miscommunication, leading to perceived betrayal, causing further impoverishment of communication, and ending in a state of chronic distrust. Clear and transparent communication encourages the same from others and leads to confidence in a relationship.
I have argued elsewhere that courts have in recent years excaberated this problem of distrust by routinely labeling misstatements "immaterial." In other words, the judges in 10b-5 cases tell investors that even if we assume the CEO intentionally lied about the company's prospects in order to defraud investors there is no recourse because no "reasonable" investor would consider the statement important. The article is entitled, "Immaterial Lies: Condoning Deceit in the Name of Securities Regulation." Here is the abstract:
The financial crisis of 2008-2009 is once again raising the issue of investor trust and confidence in the market.... The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust. This Article argues that one of the ways courts can do this is by curtailing their over-dependence on materiality determinations as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that there will be no relief for shareholders even if the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality “safety valve” doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, the routine categorization of managerial misstatements as immaterial in order to dismiss frivolous suits creates a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, the dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with the problem of frivolous suits without having to rule on the issue of materiality.
November 4, 2011
Americans for Financial Reform Conference: Evaluating The Volcker Rule
Next week, the Americans for Financial Reform are sponsoring an event on the Volcker Rule. It looks like an interesting opportunity. I look forward to the outcome. Here's the announcement:
Wednesday, November 9th, 9:30 to 1:00
Location – Hart Senate Office Building, Room 902
Presented By: Americans for Financial Reform
You are invited to join Americans for Financial Reform for a discussion of the recently released Volcker Rule proposal. This centerpiece rule of the Dodd-Frank Act is designed to separate risky proprietary speculation from core functions of the financial system, and will affect our largest banks in areas ranging from compensation to investment management. The discussion will feature outside experts as well as key Congressional architects of the rule. Speakers will consider potential benefits of the Volcker Rule for the stability and effectiveness of the financial system and evaluate the strengths and weaknesses of the proposed rule.
Senator Carl Levin of Michigan
Senator Jeff Merkley of Oregon
Anthony Dowd: Chief of Staff, Office of Paul A. Volcker; Former General Partner, Charter Oak Capital Partners
Nick Dunbar: Editor of “Bloomberg Risk”, author of “Inventing Money: the Story of Long-Term Capital Management” and “The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street… and Are Ready to Do It Again”
Gerald Epstein: Professor of Economics, University of Massachusetts at Amherst; Co-Director, Political Economy Research Institute
William Hambrecht: Founder, Chairman, and CEO, W.R. Hambrecht & Co.
Kimberley Krawiec: Katherine Robinson Everett Professor of Law, Duke University Law School; expert on “rogue traders”
Matthew Richardson: Charles Simon Professor of Applied Financial Economics, New York University Stern School of Business; Editor of “Regulating Wall Street: Dodd-Frank and the New Architecture of Global Finance”
House Votes to Eliminate General Solicitation Restriction From Rule 506
Yesterday was a big day for securities exemptions in the House of Representatives. In addition to passing the crowdfunding bill I already blogged about. the House passed a bill directing the SEC to eliminate the prohibition on general solicitation or advertising from the Rule 506 exemption. A copy of the bill is available here. As with the crowdfunding bill, the vote was bipartisan and resounding (413-11).
The prohibition of general solicitation, as interpreted by the SEC staff, prevents issuers from offering securities to investors with whom they do not have a preexisting relationship. The policy reason for this restriction is unclear. If the purchasers to whom the issuer sells are accredited or sophisticated, as required by Rule 506, it’s unclear why it should matter whether the issuer or its selling agents knew those purchasers before the offering began. Securities practitioners and scholars have been calling for the elimination of the general solicitation restrictions for years.
This would be another welcome change if it becomes law. Kudos to Congressman Kevin McCarthy for introducing this bill.
Houses Passes a Crowdfunding Bill
Yesterday, the House of Representatives voted to approve H.R. 2930, the Entrepreneur Access to Capital Act. The bill, introduced by Congressman Patrick McHenry, would establish a federal securities law exemption for crowdfunding. The 407-17 bipartisan vote came shortly after the Obama administration released a statement suporting the bill.
The basic structure of the bill passed yesterday is similar to what Representative McHenry originally proposed. The offering amount is limited to $1 million, or $2 million if the issuer provides investors with audited financial statements. (The limit in the original bill was $5 million, with no special rule for issuers providing financials.) And each investor may invest annually up to the lesser of $10,000 or 10% of the investor’s annual income, with issuers allowed to rely on investors’ self-certifications of their income. As a result of a couple of floor amendments yesterday, all of those dollar amounts are subject to adjustment for inflation.
However, the final bill adds a lot of detail that didn’t appear in the original bill. Many of those changes track recommendations I have made in my article on crowdfunding. (Full disclosure: One of Representative McHenry’s legislative assistants contacted me shortly after the original bill was introduced asking for suggestions regarding possible changes. However, I was not involved in drafting the revised bill.)
Here are the additional requirements. If the securities are sold through an intermediary, such as a crowdfunding site, the intermediary is responsible for fulfilling these requirements. If the securities are sold directly by the issuer, the issuer is responsible, and the issuer must also disclose its interest in the offering.
- Disclosure and Testing Requirements. The bill requires warnings to investors about the speculative nature and risk of small business offerings. Before investing, investors must answer questions demonstrating an understanding of (1) the risk of investing in startups, (2) the risk of illiquidity, and (3) such other matters as the SEC deems appropriate.
- Funding Goals and Closing Offerings. The issuer must state a funding target and a deadline for reaching that target. No funds may be drawn by the issuer until it reaches at least 60% of the target amount.
- Information Requirements. Both the SEC and investors must be provided with information about the issuer, including its address and the names of its principals. Information about the target amount of the offering, the deadline for reaching that target, the offering’s purpose, and the intended use of the proceeds must also be provided. When the offering is completed, the SEC must be provided with a notice that indicates the aggregate offering amount and the number of purchasers.
- State Access to Information. The SEC must make the information it receives under the exemption available to the states.
- SEC Access. The SEC must be given investor-level access to the crowdfunding web site.
- Background Check. The intermediary, if one is used, must do a background check on the issuer’s principals.
- Disqualifications. The SEC is required to enact rules to disqualify certain issuers and intermediaries, similar to the rules section 926 of the Dodd-Frank Act requires the SEC to add to Rule 506 of Regulation D.
- Communications Channel. The issuer, or the intermediary if one is used, must establish a means for communication between the issuer and investors.
- Cash Management. Cash management functions must be outsourced to a broker or depositary institution.
- Books and Records. Both the issuer and the intermediary are required to maintain such books and records as the SEC deems appropriate.
- Fraud Protection.The issuer, or the intermediary if one is used, must take “reasonable measures to reduce the risk of fraud.”
- No Investment Advice. The issuer, or the intermediary if one is used, may not offer investment advice.
- Resales. Resales are prohibited for one year, except for sales to accredited investors or back to the issuer.
- Protection from Treatment as Brokers. The bill protects intermediaries operating crowdfunding sites from being treated as brokers under federal law. As a result of a couple of floor amendments, the bill probably would not protect crowdfunding sites from being treated as brokers under state law.
- Exchange Act Reporting Threshold. Crowdfunding investors will not count against the 500-shareholder floor that triggers Exchange Act reporting.
- Integration Protection. The bill provides that nothing in the exemption “shall be construed as preventing an issuer from raising capital through methods not described” in the exemption. This language is a little ambiguous, but I believe it is designed to preclude crowdfunding offerings from being exempted with offerings pursuant to other exemptions.
Many of these changes make sense, but I find a few of bill’s provisions troublesome.
- Fraud-Reduction Measures. What exactly are “reasonable measures to reduce the risk of fraud?” The answer is important because the exemption is conditioned on such steps being taken. A purchaser or the SEC might be able to argue after the fact that the sales violated the Securities Act because insufficient steps were taken to reduce the risk of fraud.Also, if a crowdfunding website doesn't take such steps, could it be liable for any fraud?
- The Consequences of Non-Compliance. This raises a more general problem with the bill as written. It says the exemption is available “provided that” all of the requirements are met. Any violation, no matter how minor and no matter how many purchasers it affects, could cause an issuer to lose the exemption. If, for example, something on an intermediary’s web site could be construed as investment advice, that could destroy the exemption for all the issuers who used that site. This kind of problem caused the SEC to add “reasonable basis” and “insignificant deviation” provisions to Regulation D. Similar protection is needed here.
- Other Cost-Increasing Measures. The key to a successful exemption for the very small offerings to which crowdfunding appeals is keeping the cost low. A number of the new requirements—background checks, recordkeeping requirements, disclosure and information requirements—are going to add to the cost of using the exemption. I think that some of those requirements aren’t worth their cost.
- Resales. Finally, I am worried about the prohibition on resales. As I argue in my article, this is a trap for the unsophisticated purchasers crowdfunding is likely to attract. It’s especially troublesome if resales are deemed to destroy the issuer’s exemption.
Nevertheless, the bill is a huge step in the right direction, and Representative McHenry and his staff should be congratulated for moving the debate along. I’m especially happy to see that the Congressman held the line on state preemption (except for the broker issue mentioned above), which I feel is key to a useful crowdfunding exemption. I think the states have a vital role to play in antifraud enforcement, but complying with state registration requirements would be too costly for these small offerings.
It will be interesting to see what happens in the Senate. If Obama continues to support the bill, we may soon have a crowdfunding exemption.
November 3, 2011
Welcome Contributing Editor Anne Tucker
We are very pleased to announce that Anne Tucker has agreed to continue blogging with us as a contributing editor. So, you can expect to see at least one post a week from her going forward. The masthead should be updated shortly, but in the meantime: Welcome! We're very fortunate to have you on board.
I have blogged from time to time about the crowdfunding phenomenon and the possibility of using crowdfunding for small business capital formation. See, for example, here and here. I have also written an article, available here, proposing a crowdfunding exemption from federal securities law registration requirements.
Political momentum seems to be building in support of some sort of crowdfunding exemption, although what its exact features will be is still unclear. Here are some recent developments:
1. The Jobs and Competitiveness Council created by President Obama in January recently endorsed crowdfunding, at least in a very general way. The Committee’s interim report proposes that “smaller investors be allowed to use ‘crowd-funding’ platforms to invest small amounts in early-stage companies.” The Council’s full report, which provides no further details, is available here.
2. H.R. 2930, a crowdfunding bill introduced by Congressman Patrick McHenry, has been amended and reported to the full House. The amended bill is here. I’ll provide a more detailed discussion of that bill tomorrow.
3. I have been asked to speak on crowdfunding at the annual SEC Forum on Small Business Capital Formation on November 17. I’m impressed that the SEC is willing to invite a longstanding critic like me to speak; it’s like the Democratic National Committee inviting Herman Cain to present a keynote. But I’m a longtime fan of the forum itself; many sensible recommendations have come from those annual meetings, although the SEC usually fails to act on those recommendations. If you’re interested in the forum, more information is available here.
November 2, 2011
"Europe: How bad will it get?"
Today I attended a terrific event hosted by the Rock Center for Corporate Governance at Stanford on whether the Eurozone will survive in the present form. It seems the answer to this post's titular question is that it's going to get real bad.
Robert Madsen from the Center of International Studies at MIT shed light on this quite dark subject. Madsen cut through all of the jargons and acronyms you might hear in discussions of sovereign solvency and the Eurozone crisis. He highlighted the following key issues:
- The structural flaws in the way the Eurozone was designed (the lack of a common business cycle, cultural barriers and other obstacles to labor mobility, the lack of a fiscal transfer mechanism, and issues with developing a shared political commitment)
- The massive increase in debt, public and private, in some European countries
- The cost of fixing the problem (in short: trillions, perhaps in the double digits)
As Madsen described the possible ways of moving forward, a palpable gloom hung over the room. A major financial restructuring seems unlikely. The present strategy of fiscal austerity and ad hoc measures is not promising. The other possibilities include preemptive changes to the Eurozone and some kind of delayed collapse. The takeaway: fasten your seatbelts.
The Rock Center website may have a video of the event soon.
Limited Liability as the Default
I recently covered a case on LLC formation in my Business Associations course: Water, Waste, & Land v. Lanham, 955 P.2d 997 (Colo. 1998). (The case is in this casebook, from Klein, Ramseyer, and Bainbridge.) In that case, an engineering firm performed work for an LLC, but was able to successfully hold one of the LLC’s owners individually liable for the debts. Here are the basics:
Water, Waste & Land performed work for a P.I.I., LLC (owned by Clark and Lanham). Clark failed to fill out and sign the contract between Water, Waste & Land and instead orally authorized the work. During the negotiation process, Clark gave Water, Waste & Land a business card that said only “P.I.I.”, and not “LLC.” The address on the card was a home address for Lanham. The Colorado Supreme Court determined that Clark was an agent for Lanham and held the LLC and Lanham (personally) for the bill.
The Colorado LLC act at the time required that any LLC clearly state that the company is an LLC or otherwise indicate it is a limited liability entity. The new statute retains this requirement. Colorado Statute 7-90-601. Entity name, provides:
(c) The entity name of a limited liability company shall contain the term or abbreviation "limited liability company", "ltd. liability company", "limited liability co.", "ltd. liability co.", "limited", "l.l.c.", "llc", or "ltd."
Under the law, then and now, the court got this right. Still, I can't help but think that a company in the same spot as Water, Waste & Land would be getting a bit of a windfall if this occurred today. If someone gives me a business card that says, “P.I.I.,” I know I’m dealing with an entity. I expect that most sane people would have a limited liability entity in this circumstance. Even if I'm not sure if I am dealing with an LLC, LLP, or corporation, if I want a personal guarantee, I should ask for it. Otherwise, I proceed at my own peril. (To be clear, this is different, in my view, without the business card, though this rule still applies.)
I’m not going so far as to say we should eliminate the notice requirement for limited liability entities. Still, I do think we would all be well served to assume we are dealing with limited liability entities and seek guarantees from individuals if that’s what we want. If we change our own default, we will likely be a lot happier with the outcome (or at least know we got the deal we bargained for).
November 1, 2011
The Myth of Choice
Thanks so much for the warm welcome to Business Law Prof Blog. I'm delighted to guest blog here this month.
One reason I enjoy reading blogs like this one is that it helps me find interesting books and articles. In that vein, I thought I'd share a new book that I've recently enjoyed--The Myth of Choice by Kent Greenfield.
Kent Greenfield is of course well known for his progressive critique of corporate law from his previous book, The Failure of Corporate Law.
In The Myth of Choice, Greenfield takes on a new topic--constraints on choice and decisionmaking. Greenfield draws on brain science, psychology, political theory, and various other disciplines to show the complexity of choice in the realms of public policy and personal life decisions. He argues that while much of our law and culture exalts and fixates on the idea of choice, many factors actually limit what we think of as choice. Limiting forces include the way the human brain works, cultural norms, the role of power and authority, and markets.
The book is a fun and thought-provoking read. It takes on heavy subjects like free will and the rhetoric of personal responsibility, while weaving in lots of anecdotes and examples that bring the subject matter to life and make it enjoyable reading. I loved the book and felt hungry to hear more about how these ideas apply to the business law realm. Are the book's insights consistent with the rationale for the business judgment rule? What are the implications for optimal decisionmaking environments for directors and managers? Board diversity? Etc.
October 31, 2011
North Dakota Energy Law Symposium: Nov. 3
The North Dakota Law Review is hosting an Energy Law Symposium this Thursday, November 3, 2011. The symposium will feature a variety of perspectives, including insight from speakers representing the practicing bar, education (legal and otherwise), and government. The panelists will be discussing the economic, regulatory, environmental, and social issues facing the current energy boom, with a particular (though definitely not exclusive) emphasis on North Dakota and the western United States. Here's the agenda, including the list of distinguished speakers (plus me):
The North Dakota Energy Law Symposium is free and open to the public. It has been approved for 4 hours of CLE credit in North Dakota and 3.75 hours of CLE credit in Minnesota.
Schedule of Symposium Events
9:00 a.m. Welcome
Kathryn Rand, Dean, UND School of Law
9:05 a.m. Introduction to the Energy Law Symposium
9:15 a.m. Hydraulic Fracturing in North Dakota: The Environment and the Economy: Hydraulic Fracturing as the Intersection of Sustainability
11:10 a.m. Break
12:15 p.m. Break
1:15 p.m. Energy Extraction on Federal and Native American Land
- Professor LeRoy Paddock
- Professor Raymond Cross
Moderator: Joshua Fershee – Associate Dean
Presentation followed by 20 minutes of Q & A
2:35 p.m. Environmental Protections on Energy Extraction
- Heather Ash
- Professor John Nagle
Moderator Dr. Steve Benson – Director of Petroleum Eng. Dept., UND
Presentation followed by 20 minutes of Q & A
Nudge Pt. 2
At the beginning of the month I included my reading list and asked for recommendations from your own (still waiting on those dear sweet readers...). Included in my list was Cass Sunstein and Richard Thaler's Nudge. I am prone to fits of enthusiasm, but don't let that take anything away from the following statement: I LOVE THIS BOOK! It is informative, interesting, easy to read, and the best part is that you start seeing examples of the "nudge" provided by smart choice architecture in the world beyond the book.
One particularly interesting "story" from the book relates to energy usage. A study of 300 households in California tracked whether the energy consumption was above-average, below-average, or neutral. Once informed of their status, something interesting happened: "In the following weeks, the above-average energy users insignificantly decreased their energy use; the below-average energy users significantly INCREASED their energy use." The book goes on to call the energy consumption increase among the conservative users the "boomerang effect". The book cautions "[i]f you want to nudge people into socially desirable behavior, do not, by any means, let them know that their current actions are better than the social norm."
The same households were then given the same report regarding usage-- above-average, below-average, or neutral but this time with a supporting social cue in the form of a happy face for below-average users and a frown for above-average users.
Unsurprisingly, the above-average users showed an even larger decrease in consumption when given the information plus the social cue. "The most important finding was that when below-average energy users received the happy emotion, the boomerang effect completely disappeared!" When the consumption information was combined with the emotional "nudge" they didn't adjust their usage upward.
This is one of many well-researched, relevant, and interesting examples provided in the book. Whether you've read the book or not, the Nudge Blog is an excellent resource for current articles on and examples of choice architecture.
--Anne Tucker (ps. Happy Halloween!)
October 30, 2011
Welcome Guest Blogger Elizabeth Pollman
We here at the BLPB are very pleased to welcome Elizabeth Pollman on board for a month of guest blogging. Elizabeth Pollman is a fellow at the Rock Center for Corporate Governance at Stanford University. Before joining Stanford Law School as a fellow, Elizabeth was an associate at Latham & Watkins where she worked on a variety of corporate transactional and litigation matters. She also clerked for the Honorable Raymond C. Fisher of the Ninth Circuit Court of Appeals. Elizabeth’s recent scholarship includes Reconceiving Corporate Personhood, Utah L. Rev. (forthcoming 2011), and Citizens Not United: The Lack of Stockholder Voluntariness in Corporate Political Speech, 119 Yale L.J. Online 53 (2009). We're all very much looking forward to her posts, and thank her for taking the time the guest-blog with us.