Saturday, March 25, 2017
This semester, I’m teaching a seminar on the financial crisis. And because my specialty is corporate and securities law, not property, I brought in a ringer – in the form of Chris Odinet of Southern University Law Center – to talk to my class about the Mortgage Electronic Registration System (MERS) and foreclosures. MERS is a private organization that mortgage bankers have used to track mortgage assignments in the age of securitization, but after the housing bubble burst, it wreaked havoc in the foreclosure process because of sloppy recordkeeping and its inconsistency with the traditional manner in which interests in land have been recorded. See generally Christopher Lewis Peterson, Two Faces: Demystifying the Mortgage Electronic Registration System's Land Title Theory, 53 Wm. & Mary L. Rev. 111 (2011).
As Chris Odinet described it to my class, MERS was formed when several financial institutions (including, as it turns out, the Mortgage Bankers Association, Fannie Mae, Freddie Mac, the Government National Mortgage Association, the Federal Housing Administration, and the Department of Veterans Affairs) decided that publicly recording mortgage assignments in county property offices was too expensive and cumbersome. Instead, these institutions decided to form a shell corporation that would “own” all mortgage interests. Then, instead of formally transferring mortgages from one financial institution to another, MERS would electronically track transfers of ownership. That way, expensive and anachronistic paper recording systems could be bypassed, and mortgages could be quickly transferred to meet the needs of the age of securitization.
It occurred to me that this is exactly what occurred with stock ownership. Stock transfers, too, used to be conducted via paper endorsements, which created a literal paper crisis in the 1960s. See In re Appraisal of Dell. In response, Congress and the SEC adopted a system of “share immobilization,” namely, that almost all stock today is actually owned by a company called DTC. DTC is owned by broker dealers, and DTC electronically tracks which shares are allocated to which brokerage. Those brokerages, in turn, allocate the shares among their clients.
After class, I looked into the history, and it turns out I wasn’t wrong to draw the comparison: MERS was actually explicitly modeled on DTC. See Phyllis K. Slesinger & Daniel McLaughlin, Mortgage Electronic Registration System, 31 Idaho L. Rev. 805 (1995). But – and I suppose hindsight is 20/20 – it’s easy to see why the stock transfer system could not simply be wholesale transferred to mortgages, which is precisely why MERS has created so many headaches.
For starters, the share immobilization system was mandated by Congress, to deal with a federally-regulated system of stock ownership. As a result, the regulatory system adapted to the change, and federal rules were created to allow a “look-through” to the beneficial owner of the security instead of focusing on the formal record holder. See, e.g., 17 C.F.R. § 240.14a-13. Nothing like that happened with MERS, because it was created without the imprimatur of any legislative or regulatory body. As a result, there are no formal procedures that permit a look past MERS to the beneficial owner of the mortgage, which is part of the reason why MERS’s legal status has been so uncertain.
Relatedly, MERS often includes only the name of the servicer in its system, and does not require its members to record transfers between mortgagees (although, Chris tells me, MERS recently has tried to improve its practices in this regard). As a result, MERS records simply do not contain information about who actually owns the mortgage, and these private transfers create opportunities for confusion and mischief. By contrast, stock transfers are heavily regulated, and settlement is required by SEC rule – within 3 days (soon to become 2).
Beyond these regulatory points, mortgage ownership is simply more complex than stock ownership. A stock transfer is a personal property transfer. There is a relatively minimal ongoing relationship with the issuing corporation – more on that below – but for the most part, it’s just property being transferred from A to B.
Mortgages, however, involve transfers between lenders, who must carry on complex and financially significant relationships with borrowers and servicers. Payments from the borrower must be made and applied to the loan; two-way lines of communication must be maintained; in extreme cases, foreclosures must be managed. On top of that, arcane rules govern the distinction between the mortgage itself and the note that represent the debt. It is precisely in these areas that MERS has broken down.
Additionally, America has long had a commitment to creating public, transparent records of interests in real estate, including the chain of title; MERS destroyed that by creating an opaque system that fails to keep track of past transfers. Stock ownership, by contrast, has never been publicly accessible, and the only area where chain of title is relevant is Section 11 (which, incidentally, has also been undermined by DTC).
That said, even the DTC-share immobilization system has been plagued by recordkeeping and legal problems; it is simply that at the end of the day, these problems are far less devastating to the lives of individual people than are the problems with MERS.
For example, stock ownership does involve an ongoing relationship with the issuing corporation (though one far more attenuated than in the ongoing relationships between borrowers and lenders in a mortgage loan), and errors/gaps in recordkeeping can affect that relationship. Marcel Kahan and Edward Rock wrote about the “Hanging Chads of Corporate Voting,” detailing how voting procedures may be inadequate to keep up with share immobilization. Moreover, the DTC system – which operates at the federal level – has created uncertainty with respect to state-level recordkeeping systems. See In re Appraisal of Dell; Dole Case Illustrates Problems in Shareholder System.
But ultimately, a lost or miscounted shareholder vote, or even lost payments in a merger, are peanuts compared someone losing their home in a legally defective foreclosure, or simply the inability of a homeowner to develop a workout plan.
Perhaps fundamentally, then, the difference is about the power imbalances. The corporate issuer of stock - the constant at the center of shifting shareholder bases - ultimately is the one with control over resources; shareholders' rights and powers are fairly minimal. By contrast, the "issuer" of the mortgage note - the individual borrower who remains constant at the center of shifting lenders - is the most vulnerable player in the lending system, at the mercy of a rotating cast of sophisticated mortgagees and servicers. A trading scheme like DTC/share immobilization, designed to accommodate those with very little power vis a vis the obligor, is not one that will do justice when the power relationships are reversed.
Point being, there were a lot of red flags - that might have been evident earlier - in trying to privately model a mortgage transfer system on the federally-mandated system for transferring stock, but here we are. The banks weren't wrong about the problems with dealing with local recording systems in today's economy; but a true fix will require public mandates and coordination across all jurisdictions.
Saturday, March 18, 2017
One of the hottest topics in business news today is the Snap IPO.
It’s the biggest tech IPO in some time (although some smaller ones apparently will be close behind), the company has so far been losing money and its growth has slowed, and oh yeah – its public shares do not have any voting rights.
In some ways, the disenfranchisement of Snap’s shareholders is the natural culmination of the dual-class share structures that have been popular with tech companies for a while. But Snap is obviously taking things to extremes. With no votes, there are no proxy statements. Most of that information will be disclosed in Snap’s 10-K, but it also means there will be no say-on-pay votes and no shareholder proposals. Sure, these are – or tend to be – nonbinding anyway, but Snap has shut down the mechanism by which shareholders as a group initiate conversations with the companies in which they invest.
Some commenters call Snap a one-off; after all, even now, Snap’s shares have fallen well below their first day trading price, and analyst reaction has been less than enthusiastic. But Snap is still trading higher than its offering price (at least for now), and Snap’s founders made hundreds of millions just from the IPO itself, without sacrificing control of the company – plenty of incentive for new players to try to replicate Snap’s results. The matter has caused enough concern that the SEC has begun to examine it, though it’s unclear what – if anything – they expect to be able to do. (I mean, the SEC’s power to directly regulate voting rights is a bit limited, but theoretically listing standards for NYSE and NASDAQ could be modified.).
One of the most interesting developments, at least to me, is the effort by institutional investors to have Snap excluded from major indexes (with a parallel effort across the pond); otherwise, they’d be forced to buy Snap’s shares despite their objections to Snap’s structure, and Snap would get a bit of a boost in its stock price - along with a class of shareholders who cannot vote with their feet. I don’t know what the indexes are likely to do, but if they include Snap, will that open a space for alternative indexes that exclude no-vote shares – like Snap and perhaps Google Class C? I have to admit, that would be an elegant free market solution.
One other interesting aspect of the Snap IPO concerns the nature of its shareholders: millennials. Apparently, millennials have snapped up Snap shares, eager to invest in a company that plays such a role in their lives. Snap doesn’t love them quite as much, of course, but if you view investing as consumption rather than a way to profit, I suppose it’s no worse than any other recreational activity.
In fact, there’s a whole startup devoted to encouraging consumers to buy stock in their favorite companies – and the companies will pay your brokerage fees. (Joan posted earlier about a similar type of program at Domino's Pizza.) The theory is, stockholder-consumers are more loyal customers (and, I assume, more pliant voters), so it’s worth it to companies to cultivate a consumer shareholder base. It happened before, that retail investors helped management fend off attacks; I wonder if the next would-be Snap might consider a less draconian approach to shareholder voting, but a more aggressive approach to marketing shares to its user base.
Saturday, March 11, 2017
A couple of days ago, Marcia put out a call for business movie/TV recommendations. A perennial favorite on such lists is the 1983 classic, Trading Places. That movie is about two brothers who make a bet to see whether they can pluck a man off the street and - by providing him with the proper environment - turn him into a successful commodities trader. Its stature is such that a real-life statutory amendment, intended to plug the regulatory loophole exploited by the film's characters, is colloquially known as the "Eddie Murphy rule." The CFTC first exercised its authority under the new rule in 2015.
Well, apparently the movie was just as inspiring to business aficionados in 1983 as it remains today. After seeing the film, two prominent commodities traders of the era, Richard Dennis and William Eckhardt, decided to reenact the brothers' experiment. (Except, rather than kidnap a homeless criminal and then frame one of their own employees for dealing PCP, Dennis just took out an ad in the newspaper). Dennis selected people with a certain affinity for numbers and probability, but with no formal education in commodities, and trained them to trade. The experiment panned out: most of the participants (dubbed Turtles, for reasons that remain the subject of myth) not only generated extraordinary profits for Dennis and themselves, but eventually left for successful Wall Street careers.
The tale is recounted in the book The Complete Turtle Trader, and in this Bloomberg podcast. For the podcast hosts, the unbelievable part of the story is how the methods taught to the Turtles are apparently still in use today - and remain profitable, for anyone disciplined enough to stick to them. I'll add that I also find it kind of unbelievable that anyone decided to risk millions of their own dollars to reenact the events of Trading Places, but, to be fair, it is a very good movie.
Saturday, March 4, 2017
This Saturday, I point you to a colorful long read: Sheelah Kolhatkar’s deep dive into William Ackman’s short bet against Herbalife. Unabashedly sympathetic to Ackman, the article describes how Herbalife was brought to his attention (there are analyst firms that just identify shorting opportunities? Who knew? Please don’t answer that everybody knew; that would be embarrassing) and ultimately ended up as something of a crusade to expose what Ackman believes is a pyramid scheme. (And the FTC believes is a scheme that is awfully like a pyramid scheme but without actually using those words.) According to Kolhatkar, Ackman and his people want to make money, sure, but they also want to expose a fraud that – like Trump’s universities (a comparison Kolhatkar explicitly makes) – robs desperate people of their savings.
The article describes the titanic battle between Herbalife and Ackman (Herbalife’s CEO is described as having an “air of PTSD”), including how Ackman even tried to enlist Latino civil rights groups to advocate on his behalf. It’s reminiscent of that time the NAACP involved itself in the epic battle over debit card swipe fees.
Ackman has held on to this bet for a while, combatting other investors and Herbalife’s own extensive public relations campaign. In a few months, however, the settlement that Herbalife reached with the FTC will take effect, and Herbalife will be forced to ensure that most of its sales are made to actual retail customers, and not distributors hoping to resell the product. One question mark raised by the piece is whether the settlement will finally allow Ackman’s bet to pay off, or whether Herbalife will manage to survive, perhaps by focusing its operations in other countries, where the settlement doesn’t apply.
Saturday, February 25, 2017
It's Mardi Gras season here in NOLA, so I'm afraid I've been a little distracted. It's hard to concentrate when this is what's going on a block away ....
So, for this Saturday, I offer you a game: The Unicorn Startup Simulator. The goal is to reach a billion dollar valuation while keeping your employees happy - it took me a few tries, but I managed it. Good luck!
Saturday, February 18, 2017
In 1995, the Private Securities Litigation Reform Act revamped the procedures applicable to class action lawsuits alleging claims under the federal securities laws.
Concerned about frivolous, attorney-driven litigation, Congress mandated that once a class action complaint is filed, the court must appoint a “lead plaintiff” to take control of the case. This, it was believed, would be preferable to the old tradition of simply giving control of the case to the first plaintiff to file a complaint. The lead plaintiff would be selected based on factors similar, but not quite identical, to those involved in selecting a class representative, using a more preliminary, less searching inquiry than might be expected for class certification. See 15 U.S.C. §78u-4; Topping v. Deloitte Touche Tohmatsu CPA, 95 F. Supp. 3d 607 (S.D.N.Y. 2015).
In enacting the scheme, Congress left a number of questions unanswered. Like, what is the relationship between the lead plaintiff and the class rep? Does the lead plaintiff position disappear once class reps are appointed? It’s not an issue that comes up often, since most lead plaintiffs seek class rep status, and those that don’t tend to cooperate with any class reps who are eventually appointed.
Another unanswered question was, what if there’s no suitable lead? See In re Cavanaugh, 306 F.3d 726, 731 n.7 (9th Cir. 2002) (raising the possibility). You might say, then the case can’t proceed as a class action, but class certification is supposed to be a different process; it’s one thing to use the lead plaintiff selection process to find – as the statute puts it – the “most adequate plaintiff”; it’s quite another to use the process to deny class certification without so much as a Rule 23 hearing.
Which brings me to the curious case of Finocchiaro et al v. NQ Mobile, Inc. et al, Docket No. 1:15-cv-06385 (S.D.N.Y.). The original class action complaint identified several named plaintiffs – all individuals, rather than institutional investors – but only one person sought lead plaintiff status. That applicant was rejected by the court, on the grounds that he had previously sent obscene and threatening letters to the defendants. The same attorneys sought, and received, an extension of time to find a second lead plaintiff, and recently filed a new motion seeking lead plaintiff status for another one of the individuals named in the complaint. That motion is (unsurprisingly) opposed by the defendants, who argue that the substitute lead is also unsuitable.
I have no idea how the court will come out on that argument; possibly the court will accept the new lead and all awkward questions will be averted. But it does beg the question: if no suitable lead plaintiff can be found, what happens to the case?
Saturday, February 11, 2017
As most readers probably know, one of the problems that led to the crisis was a gradual deterioration in the quality of the credit ratings issued by agencies like Moody's and Standard & Poor's. The basic charge has been that the agencies, paid by the issuers, had an incentive to issue inflated ratings. If they did not, the issuer would simply turn to another agency. The competition for business among agencies was destructive and corrupted the integrity of the rating.
There have been lots of proposals to reform the process - everything from greater disclosure to disgorgement of profits - but Howard Esaki and Lawrence J. White have a simpler idea. They would simply create a rule that if the issuer goes to more than one ratings agency, the issuer is required to drop (or not pay for) the most lenient rating.
They have a couple of variations, but the basic idea is the same - ratings agencies won't compete to give the most lenient rating if the most lenient rating is never used or paid for. They focus specifically on securitizations, and the amount of subordination each agency requires for the top ratings, because (in their view) this is the aspect of the process that needs the most intervention.
I gotta admit, it sounds like this would be a pretty elegant and effective solution.
Saturday, February 4, 2017
It's a drive-by this week, but I wanted to call your attention to the recent Delaware Chancery decision in In re Merge Healthcare Inc. Stockholders Litigation. The plaintiffs challenged IBM's acquisition of Merge, alleging that a 26% Merge shareholder counted as a controller and was conflicted. Therefore, the shareholder vote in favor of the merger could not cleanse the deal under Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015).
Vice Chancellor Glasscock rejected the argument. Assuming (without deciding) that the 26% shareholder counted as a controller, he concluded that because the shareholder's interests were aligned with those of the public shareholders - among other things, the alleged controller had no unusual need for liquidity/a fire sale - no heightened scrutiny was required and the stockholder vote in favor of the deal was sufficient to cleanse the transaction.
Of particular interest: It turns out that the Merge corporation did not have a 102(b)(7) exculpatory clause in its charter, which potentially exposed its board to damages for duty of care violations (though, ultimately, the stockholder vote was sufficient to cleanse any problems). I didn't even know that was a thing that could happen.
In other news, the business media is aflutter with reports of Trump's new executive order, which would roll back the Department of Labor's new "fiduciary rule," requiring brokers to adhere to fiduciary standards when giving investment advice to retirement plans. Quoth Gary Cohn, the White House National Economic Council director, "We think it is a bad rule. It is a bad rule for consumers. This is like putting only healthy food on the menu, because unhealthy food tastes good but you still shouldn’t eat it because you might die younger." Um, there may be legitimate reasons to object to the rule - namely, the argument (however spurious) that one way or another, you pay for investment advice, and the old way is cheaper - but treating investment advice like a consumption good is ... not among them.
Saturday, January 28, 2017
I’ve previously posted about Delaware’s vulnerability – namely, to the extent it tries to police shareholder litigation through procedural rather than substantive legal standards, it is vulnerable to losing disputes to other jurisdictions that have rules deemed more favorable by litigants. Plaintiffs and defendants can reach sweetheart merger settlements in jurisdictions that examine the terms less searchingly; defendants can win a dismissal of all claims filed by weak plaintiffs in one jurisdiction and estop stronger plaintiffs who bring suit in Delaware.
So, for example, Delaware encourages derivative plaintiffs to seek books and records under Section 220 before bringing a lawsuit, but that takes time. A plaintiff in another jurisdiction might simply file a lawsuit right away, and if that suit is dismissed, the dismissal can preclude the Delaware plaintiff– which only gives the Delaware plaintiff less incentive to seek books and records in the first place.
Well, until now. In Cal. State Teachers Ret. Sys. v. Alvarez, 2017 WL 239364 (Del. 2017), that exact scenario occurred in the long-running action against Wal-Mart for violations of the foreign corrupt practices act in Mexico. While the Delaware plaintiffs sought books and records to bolster a derivative claim, federal plaintiffs in Arkansas ploughed ahead using public information, only to see their suit dismissed for failure to plead demand futility. And Delaware Chancery concluded that the Arkansas ruling was res judicata against the Delaware plaintiffs.
Not so fast, said the Delaware Supreme Court last week. Following VC Laster's analysis in In re EZCORP Inc. Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016), the Supreme Court expressed concern that, as a matter of constitutional due process, until demand futility is established, any single group of plaintiffs represents only its own interests, and not the interests of the corporation. Therefore, they bind only themselves – not the corporation – in any litigation, and a dismissal of one claim cannot preclude a subsequent claim.
The Court did not so hold definitively, though; it simply remanded to Chancery for further consideration of the issue.
This is certainly a dramatic solution to the problem of multiforum shareholder litigation. Prior proposals have suggested a more searching inquiry into the adequacy of the first plaintiff; this approach, however, would mean that in derivative actions, no plaintiff is ever precluded by another plaintiff’s failure to plead demand futility. Talk about firing off a canon to kill a bug.
It still leaves Delaware in a precarious position, because it rests wholly on federal constitutional law – and there’s no telling how federal judges will rule once they get hold of the problem. They certainly don’t have the same interests in protecting Delaware law that Delaware has.
Saturday, January 21, 2017
I’ve been waiting for The Founder to open for months. Starring Michael Keaton as Ray Kroc, it tells the story of the founding of McDonald’s restaurants. As business junkies and professors know, McDonald’s was an innovation: it created the modern franchise, identical restaurants run by individual entrepreneurs in locations across the country and, eventually, the world. It also represented a critical development in the history of fast food, transferring the assembly line from the factory floor to the kitchen. Most basic business classes talk a lot about McDonald’s, because the franchise system – and the degree of control that McDonald’s corporate exercises – raise interesting questions about agency law and the definition of employment.
[Spoilers under the cut, not very if you already know the story]
Saturday, January 14, 2017
A couple of months ago, investors in Theranos filed a class action complaint seeking damages for fraud and negligent misrepresentation under California law. Theranos is based in California; presumably, the plaintiffs intend to argue that any false statements emanated from California and therefore California law covers even out of state purchases. See Diamond Multimedia Systems, Inc. v. Superior Court, 19 Cal. 4th 1036 (Cal. 1999).
The reason this interests me is because it’s rare – not unheard of, of course, but rare – to see fraud-based securities class actions concerning securities that are not publicly traded. SLUSA eliminated the possibility for most companies, but SLUSA alone isn’t the problem; the other hurdle is the difficulty of establishing reliance on a classwide basis, as even before SLUSA, fraud-on-the-market doctrine was largely limited to Section 10(b) claims.
California law, however, is different from most states’, because California’s blue sky law explicitly permits claims for deceit based on price distortion. See Mirkin v. Wasserman, 5 Cal. 4th 1082 (Cal. 1993); Cal. Corp. Code, §§ 25400, 25500.
It will be interesting to see if that’s how the Theranos class plans to approach matters; the difficulty will be establishing that, for example, Investor A’s willingness to purchase stock on such-and-such terms had the effect of distorting the price for other investors, outside the context of an efficient market.
The complaint also alleges certain causes of action, like statutory and common law fraud, that do require actual reliance and do not permit a price-distortion substitute. But investors are also in luck for that, as well; there is a fair amount of precedent for the principle that when similar misrepresentations are made to purchasers, and those misrepresentations are important to the transaction, the mere fact that the purchaser chose to engage in the transaction creates a presumption of reliance. That is, certain kinds of misrepresentations are so fundamental to a purchase that it is difficult to imagine anyone would have engaged in the transaction if they were not relying upon them. Courts in the Ninth Circuit have repeatedly embraced this principle. See, e.g., In re First Alliance Mortg. Co., 471 F.3d 977 (9th Cir. 2006); Poulos v. Caesars World, Inc., 379 F.3d 654 (9th Cir. 2004).
In Theranos’s case, different investors may have heard different statements at different times – the class period stretches for over 3 years – which puts a crimp in the plaintiffs’ case, but presumably all of the statements basically were about the efficacy of Theranos’s product. And since this was a one-product company, it’s not a stretch to assume that all investors expected that the product, you know, actually worked.
Of course, this is just the complaint; it’s possible that Theranos will be able to introduce doubt into the mix by, among other things, presenting evidence of disclaimers/warnings/etc that raise questions about whether each investor relied on the same information.
But that’s the class cert issue; I’ll be interested to see the kinds of arguments defendants raise in their motion to dismiss, due next week.
Saturday, January 7, 2017
A couple of months ago, Snapchat’s parent announced that the company would hold an IPO in 2017 – the largest and most high-profile IPO since Alibaba in 2014. Given the sluggish IPO market, as well as Snapchat’s general name recognition and tech cachet, the announcement was a big deal.
But it’s possible there’s going to be a monkey in the wrench. On January 4, a former Snapchat employee (fired after 3 weeks) filed a lawsuit alleging two of Snapchat’s metrics – and which ones are redacted from the complaint – were fraudulently manipulated in order to inflate Snapchat’s valuations to private investors and in anticipation of the IPO. (The redactions are due to concerns that the allegations are covered by the plaintiff’s confidentiality agreement). The unredacted portions of the complaint allege that the company never built an appropriate team to analyze its metrics, and that the employee was illegally fired in retaliation for blowing the whistle.
Snapchat has given a statement to the media denying the allegations as the fictional creations of a “disgruntled former employee.”
Though the redactions are extensive, the complaint does offer at least a hint of what’s at stake. In Paragraph 24, the complaint lists certain “key performance metrics” for all social media applications. These are Daily Active Users, Monthly Active Users, User Retention Rate, Active User Growth Rate, Registration Completion Rate, Installations, Frequency, Session Length, and Average Revenue Per User. It’s impossible to know whether the two allegedly fraudulent Snapchat metrics are in this group, but these are probably the best hint we have. And these are significant numbers for Snapchat; it has claimed daily and monthly users in excess of Twitter, and – though not on the list in the complaint – has claimed daily video views in excess of Facebook (and that was before Facebook admitted it view counts were wrong).
So this will be an interesting story to watch going forward; until it’s resolved, it could spook potential IPO investors, and may even prompt investigation by Snapchat’s pre-IPO investors.
One point of interest: Apparently, the plaintiff signed an arbitration agreement with Snapchat, and has designed his claims to get around it (and, I assume, make sure his complaint was picked up by the media to pressure the company). According to the complaint, the arbitration agreement permits both parties to seek preliminary injunctions in court – and so, the plaintiff is seeking an injunction to force Snapchat to stop spreading allegedly false stories claiming that he was fired for incompetence. The plaintiff has separately filed an arbitration claim seeking lost wages and damages.
Saturday, December 31, 2016
Happy (Almost) New Year! As 2016 draws to a close, I offer three quick hits of interesting recent business law developments:
First: The endlessly-running case of Erica P. John Fund v. Halliburton has finally settled! Halliburton has been a particular obsession of mine lo these past 6 years or so, and I even attended the Fifth Circuit oral argument held in September. (My report of that argument is here, where I link to my prior blog posts on the subject). I'm sort of sad to see it go, even though I found many of the opinions frustrating. In any event, Alison Frankel has a nice retrospective of the case, including how David Boies ended up as lead attorney for the plaintiffs after the death of his daughter, the previous lead.
Second: I previously posted about Facebook's move to create a nonvoting class of stock, essentially as a mechanism to allow Mark Zuckerberg to have his cake and eat it too (i.e., divest his stock while still maintaining voting control). The move was duly approved by an independent special committee, but - as was recently revealed in a shareholder lawsuit - one of the committee members appears to have been a double agent. According to the plaintiffs, Marc Andreessen kept Zuckerberg informed of the committee's deliberations, even going so far as to text Zuckerberg realtime advice on his negotiations during a conference call with the committee. He apparently contacted Zuckerberg to tell him what the committee's main concerns were, and to warn him what the committee planned to do. He also apparently kept Zuckerberg informed of his progress in persuading the recalcitrant committee member - Erskine Bowles - to accept the proposal. You can read articles about it here and here, or just pull the recently unsealed August 30 brief from In re Facebook Inc Class C Reclassification Litigation, 12286-VCL, but either way, I smell business law exam scenarios. (Maybe I shouldn't have said that.) Notably, Andreessen's loyalty to Zuckerberg, despite his nominal independence, is exactly the kind of thing that apparently has Strine's - and the Delaware Supreme Court's - attention.
Third: Surprise! The Tenth Circuit just held that the SEC's ALJ's are "inferior officers" and therefore their current method of appointment is unconstitutional. The decision creates a circuit split with the DC Circuit in Raymond J. Lucia Companies v. SEC, 832 F.3d 277 (D.C. Cir. 2016), and pretty much assures Supreme Court review - possibly with a newly-appointed justice of Trump's choosing. And that makes me wonder whether we're about to witness some radical changes to the structure of the administrative state.
Here's to 2017 - there will be no shortage of change to keep us busy!
Saturday, December 24, 2016
I previously posted in praise of Sandys v. Pincus for its excellence as a teaching tool – which meant that its reversal was inevitable, as occurred days after classes concluded. (Same with the Salman v. United States decision, though that changed little; naturally; we won’t even what get into what changes midstream when I’m teaching Securities Regulation). The reversal itself is quite interesting, though, as the latest entry in the Delaware Supreme Court’s developing jurisprudence on friendship/social ties as a basis for director disqualification. And, strikingly for Delaware, it generated a dissent.
In Sandys, the basic dispute involves a secondary offering by the social-media game company Zynga. The plaintiffs filed a derivative lawsuit alleging that the secondary offering was designed to allow major insiders – including the controlling shareholder, himself a member of the Zynga board – to cash out before a disappointing earnings announcement. As a result, the secondary offering materials were alleged to have omitted critical facts about the company, ultimately exposing Zynga to a securities fraud lawsuit.
The Chancery decision held that demand was not excused, resting in large part on the court’s conclusion that the directors who were not directly implicated in the scheme were sufficiently independent of those who were to be able to consider the plaintiffs’ demand. The court found that numerous business and social ties among the directors were not sufficient to call these directors’ impartiality into question.
When I taught the case, I told my students that Delaware is largely persuaded by two things: blood and money.
Well, I’m going to have to revise that lesson.
On appeal, the Delaware Supreme Court – per Chief Justice Strine – held that the fuzzy half-business/half-social ties alleged by the plaintiffs were, in fact, sufficient to suggest that the directors were conflicted. (After first excoriating the plaintiffs for failing to pursue a Section 220 request – I don’t know what kind of competitive pressures the plaintiffs may have been under in this particular case, but let’s just say Delaware’s gonna have to do some retooling if it wants that advice to stick. See also Lawrence Hamermesh & Jacob Fedechko, Forum Shopping in the Bargain Aisle: Wal-Mart and the Role of Adequacy of Representation in Shareholder Litigation.)
First, one director co-owned an airplane with her husband, and with the controlling shareholder. The court held that an airplane is such an unusual asset, requiring such “close cooperation in use,” that joint ownership suggests an “intimate personal friendship” sufficient to call the director’s impartiality into question.
Second, two other directors were partners at Kleiner Perkins, a firm with a 9.2% stake in Zynga. Kleiner Perkins had also invested in a company started by the controlling shareholder’s wife, and had invested in a third company that also counted one of the other Zynga secondary-offering sellers (himself also a Zynga director) as one of its investors.
These interrelationships did not make the directors beholden to the controlling stockholder and other sellers in the financial sense, but, the court concluded, were evidence of a “network” of “repeat players” who had created a “mutually beneficial ongoing business relationship.” This created “human motivations” that called the directors’ impartiality into question. Additionally, the court noted that Zynga had not classified these directors as independent for NASDAQ purposes, a determination that itself deserved deference, and had particular relevance in a case, like this one, involving potential wrongdoing by the controlling stockholder.
Justice Valihura dissented. She believed that without more details of the size and scope of the Kleiner Perkins investments, or the financial or personal significance of the co-owned airplane, these relationships could not be used to challenge the directors’ impartiality.
Sandys is thus the latest in a line of Strine decisions pushing Delaware law toward greater legal recognition of the fact that structural coziness may make directors reluctant to accuse each other of wrongdoing. This has always been a delicate area; it’s fair to say that any human being who has lived some time among other humans understands the kind of bias that these relationships may generate, but courts have always feared that formal recognition of them would open the floodgates to frivolous/damaging litigation, and force judges to engage in impossible determinations as to the exact point at which friendship becomes compromising. Strine, plainly, believes that the law has overcorrected – i.e., the complete failure to recognize these informal relationships creates an intolerable artificiality in how questions of conflict are examined, and he’s pushing the law in a new direction.
(If I had to guess, I'd also say that Strine recognizes that as Delaware becomes a mini-SEC for transactions on which shareholders vote - i.e., disclosure becomes the only requirement - Delaware's relevance may hinge on its ability to stake out territory for vigorous court oversight that can't be cured by disclosure.)
What’s particularly striking here is that – as Justice Valihura’s dissent makes clear – Sandys goes much further than its predecessor, Del. County Emples. Ret. Fund v. Sanchez. In Sanchez, the allegedly conflicted director had a 50-year friendship with the interested party as well as a strong financial dependency; the Sandys relationships are nowhere near that scale. So Delaware – presumably at Strine’s urging – seems to be in the process of some rather aggressive redrawing of the lines. Where those lines will end up remains to be seen.
I may still teach the Chancery decision in my business class, though – it’s just so useful, with charts, and you can make alternative hypothetical charts and ask how the case might have come out differently. But then I’ll have to either talk the students through the reversal, or assign them the relevant excerpts.
That's all! Wishing everyone a happy erev Chanukah and erev Christmas!
Monday, December 19, 2016
In her post on Saturday, co-blogger Ann Lipton offered observations about possible legal issues resulting from the President-Elect's tweets regarding public companies. She ends her post with the following:
So, it's all a bit unsettled. Let's just say these and other novel legal questions regarding the Trump administration are sure to provide endless fodder for academic analysis in the coming years.
Today, I take on a somewhat related topic. I briefly explore the President-Elect's conflicting interests through the lens of a corporate law advisor. For the past few weeks, the media (see, e.g., here and here and here) and many folks I know have been concerned about the potential for conflict between the President-Elect's role as the POTUS, public investor and leader of the United States, and his role as "The Donald," private investor and leader of the Trump corporate empire.
The existence of a conflicting interest in an action or transaction is not, in and of itself, fatal or even necessarily problematic. In a number of common situations, fiduciaries have interests in both sides of a transaction. For example, a business founder who serves as a corporate director and officer may lease property she owns to the corporation. What matters under corporate law is whether the fiduciary's participation in the transaction on both sides results in a deal made in a fully informed manner, in good faith, and in the bests interests of the corporation. Conflicting interests raise a concern that the fiduciary is or may be acting for the benefit of himself, rather than for and in the best interest of the corporation.
Corporate law generally provides several possible ways to overcome concerns that a fiduciary has breached her duty because of a conflicting interest in a particular action or transaction:
- through good faith, fully informed approval of the action or transaction (e.g., after disclosure of information about the nature and extent of the conflicts) by either the corporation's shareholders or members of the board of directors who are not interested in the transaction; and
- through approval of a transaction that is entirely fair--fair as to process and price.
See, e.g., Delaware General Corporation Law Section 144. Yet, if I believe what I read, no similar processes exist to combat concerns about actions or transactions in which the POTUS has or may have conflicting interests. In particular, to the extent one does not already exist, should a disinterested body of monitors be identified or constituted to receive information about actual and potential conflicting interests of the POTUS and approve the action or transaction involving the conflicting interests? Perhaps the Office of Government Ethics ("OGE") already has something like this in place . . . . If it does, then both the public media and I are underinformed about it. While there seems to be OGE guidance on the President-Elect's nominees for executive branch posts (see, e.g., here and here) and on overall executive branch standards of conduct (see here), I have not found or read about anything applicable to the President-Elect or POTUS.
In making these observations, I recognize that our federal government is different in important ways from the corporation. I also understand that the leadership of a country/nation is different from the leadership of a corporation. Having said that, however, conflicting interests can have similar deleterious effects in both settings. The analogy I raise here and this overall line of inquiry may be worth some more thought . . . .
Saturday, December 17, 2016
One of the more … striking ... habits of President-Elect Trump is his tendency to use Twitter to attack specific companies that have displeased him in some way. For example, after the CEO of Boeing criticized him, he tweeted:
Boeing is building a brand new 747 Air Force One for future presidents, but costs are out of control, more than $4 billion. Cancel order!— Donald J. Trump (@realDonaldTrump) December 6, 2016
After Vanity Fair published a scathing review of Trump Grill, he tweeted:
Has anyone looked at the really poor numbers of @VanityFair Magazine. Way down, big trouble, dead! Graydon Carter, no talent, will be out!— Donald J. Trump (@realDonaldTrump) December 15, 2016
And other times, Trump seems to simply be reacting to whatever he sees on the news.
These tweets might explicitly threaten to harm their targets through the exercise of government power – such as the threat to cancel Boeing’s Air Force One contract – but even if they don’t, the implicit possibility is there. As a result, Trump’s tweets move the market. Boeing’s stock reacted negatively to Trump’s tweet (though it rebounded). Shares of Lockheed Martin dropped dramatically after Trump criticized one of its fighter jets as too expensive.
Wall Street traders have begun building a Trump tweet effect into their models. One anecdotal report says that compliance departments have lifted bans on trader Twitter usage, aware that presidential-tweet monitoring is now a necessary part of the job.
The Wall Street Journal even published a blog post recommending four proactive steps all businesses take in anticipation of a Trump twitter attack.
All of this has prompted some accusations of market manipulation and insider trading. For example, it’s been reported that some lucky trader started dumping shares of Lockheed Martin six minutes before Trump tweeted, though that could simply be the result of hedge funders correctly predicting where Trump would tweet next.
For the sake of argument, let’s say that Trump’s tweet attacks – at least some of them – are calculated to drive down stock prices in order to allow someone (maybe Trump himself, maybe someone in his circle) to make a profit. Is there anything illegal here?
[More under the jump]
Monday, December 12, 2016
It used to be that Friday night was Domino's Pizza night in our house . . . . My, how things change if one lets 15-20 years slip by unnoticed. No more of that in our house!
I guess Domino's is doing OK without us, however. Third quarter 2016 financial results for Domino's Pizza, Inc., a Delaware corporation with common stock listed on the New York Stock Exchange, were favorable as compared to the firm's 2015 results, accordingly to the most recent quarterly earnings release. Somebody's eating a lot of Domino's pizza, even if it isn't the Heminway family.
Apparently, Domino's wants to share the wealth--with its customers. Co-blogger Haskell Murray pointed this recent press item out to me and co-blogger Ann Lipton in an email message last week, knowing full well that we both were or would be interested. He was right. Ann may have more to say on this in a later post. (She also noted that other firms are adopting consumer benefit plans similar to the Domino's plan I describe here today.)
Of course, as a corporate finance/securities lawyer, I immediately had visions of Ralston Purina dancing in my head. (Not quite like visions of sugarplums, in this holiday season . . . . But I will take what I can get.) So, I went looking for a registration statement/prospectus. And I found what I sought! No Ralston Purina-like Section 5 violation here.
Domino's has filed a shelf registration statement on Form S-3 and a Rule 424(b)(5) prospectus with the SEC (both filed December 2, 2016). The plan of distribution is summarized in the prospectus in two short sentences: "The Piece of the Pie Program is just one of the ways we are giving thanks to our customers. Through the Plan, we are offering our eligible customers the opportunity to be entered into drawings for a chance to be selected to receive ten Shares."
The prospectus goes on to describe the way the plan operates plan in more detail. Here's a slice off the top:
Shares for the Plan will be purchased in the open market by Fidelity Brokerage Services LLC and o Fidelity Capital Markets,Fidelity or, at our election, provided by us to Fidelity out of our authorized but unissued shares and will be initially deposited in a custody account in the name of the Company (“Custody Account”). Open market purchases will be effected by Fidelity, with all Shares to be credited to the applicable participant’s Fidelity Account. Fidelity has full discretion as to all matters relating to open market purchases, subject to the terms of our agreement with them, including the number of Shares, if any, to be purchased on any day or at any time of day, the price paid for such Shares, the markets on which Shares are purchased (including on any securities exchange, in the over-the-counter market or in negotiated transactions) and the persons (including brokers and dealers) from or through whom such purchases are made.
The Plan is not designed for short-term investors, as participants will not have complete control over the exact timing of redemption transactions or the market value of our Common Stock redeemed pursuant to a Piece of the Pie Award under the Plan. See “—Timing of Purchases.” The Plan is designed primarily for customers who have a long-term perspective and affinity for the Company and its values.
Notably, Domino's is planning to use shares that it repurchases in the market as well as, perhaps, authorized and unissued shares. The use of market repurchases may signal management's belief that the market is undervaluing those shares. It also is a means of preventing dilution to existing stockholders. Public companies often use market purchases to fund dividend reinvestment and other equity-based employee benefit plans.
Customers can enroll in the plan on the Domino's Pizza app at no charge. Here's what the overall offering looks like:
. . . We have established the Plan to provide our eligible customers with the opportunity to be entered into drawings under the Plan to receive ten shares of our Common Stock as a thank you for being a loyal customer. Between December 5, 2016 and November 30, 2017 (the “Offer Period”), we will conduct 25 drawings per month. An eligible customer who has enrolled in the Plan prior to a particular drawing date will be automatically entered into that drawing. Eligible customers will not be eligible to participate in drawings occurring prior to the date of enrollment in the Plan. An eligible customer who is selected in a drawing to receive an award under the Plan will be presented with an offer (the “Offer”) to receive ten shares of our Common Stock (each a “Share” and collectively, the “Shares”) under the Plan (each a “Piece of the Pie Award”).
Redemptions of Piece of the Pie Awards will be fulfilled through Fidelity and will require that, as a condition to redemption of a Piece of the Pie Award, the selected eligible customer open a brokerage account with Fidelity into which the Shares can be deposited. Fidelity will obtain the Shares to be delivered upon redemption of Piece of the Pie Awards through open market purchases or, to the extent determined by the Company, delivery by the Company to Fidelity of newly-issued shares. A Piece of the Pie Award must be redeemed within 30 days of receipt, after which time such Piece of the Pie Award will expire if not previously redeemed. Piece of the Pie Awards are limited to ten Shares per selected eligible customer and no eligible customer may receive more than one Piece of the Pie Award. In order to enter for a chance to receive a Piece of the Pie Award, eligible customers must enroll in the Plan using their account on the Domino’s Pizza App or by registering on the www.dominos.com website. An eligible customer who enrolls in the Plan will only be eligible to participate in drawings occurring after the date of such enrollment.
I am a member of a bunch of consumer loyalty programs--for department and drug stores, restaurants, etc. But few businesses from which I buy goods and services have offered me the opportunity to invest. And none have offered me the opportunity to "win" an equity interest in a firm through a drawing sponsored by a consumer affinity program. Query whether, if equity-based consumer benefit plans like this one are successful and continued to be valued, an exemption like Rule 701 will be promoted in Congress and at the SEC to ensure there is a registration exemption available for these offerings.
I will leave it at that for now. But this is a phenomenon to watch, for sure. And it fits in nicely with my Securities Regulation course next semester. You never know where it might pop up . . . .
Saturday, December 10, 2016
As part of my ongoing effort to sample most pop cultural representations of corporate/business life, I’ve started watching SyFy’s Incorporated. Incorporated envisions a dystopian future where, due to global warming and related environmental catastrophes, the world’s governments have become bankrupt, and in their place, “multinational corporations have risen in power and now control 90% of the globe.”
We learn in the first episode that formal governments still exist, but in almost vestigial form; as a practical matter, multinational corporations are in charge. These corporations compete with each other for resources and market share. They target each other with espionage and sabotage; when one’s stock price falls, the others’ stock prices rise. Employees lead a comfortable life within the corporate compound, so long as they adhere to the rules set by their employers; outside of corporate compounds, life is poverty and anarchy.
I get where this show is coming from; I mean, fear of corporate control of government represents a particularly timely anxiety. And there are lots of sly jokes about today’s political environment – a television news report, for example, tells us that the “Canadian Prime Minister is constructing a fence after 2073 became a record year for illegal immigation. It is estimated that already 12 million US citizens live in Canada illegally.” Ha, ha. But the show perpetuates what I believe is the very damaging misconception that corporations can exist independent of government systems.
For example, it is clear that these corporations have shareholders, and that the shares trade publicly with prices that respond to new information. So, what legal rights do these shareholders have? How are they enforced? What are the regulations that govern the market in which shares trade, and who enforces those regulations? If corporate managers have that much power, why would anyone invest without fear of exploitation – and if there are limits on their power, so that investors are more confident, where do those limits come from?
The backstory of this universe – as described on the SyFy website – is that governments, under financial pressure, sold various police powers to corporations, and exempted them from taxation. The implication must therefore be that the government either taxes everyone else to pay the corporations for their service, or allows the corporations to charge private citizens. But by now, most people are unemployed and surviving as part of the underground economy; the U.S. government, at least, is unable to raise funds to pay for its operations. Wouldn’t the US dollar have collapsed? Wouldn’t it be replaced by corporate scrip?
And why are employees treated so well? In a world where corporations rule, the constituents are the shareholders – not the employees – so that’s who I’d expect to live in luxury. Certainly, today’s corporate theory would suggest that shareholder interests are somewhat adverse to those of employees, so that when shareholders are ascendant, employees suffer. The world of Incorporated is obviously a world with excess labor; why would corporations expend so many resources on their workers?
And who are the shareholders in this world, anyway? Today’s shareholders are – in large part – employees, who have pooled their retirement funds in either defined benefit or defined contribution plans. But with only a few multinational corporations – and the majority of the population shunted into the underground economy – that can’t be the system anymore. If corporations are supplying their employees with all of their needs (healthcare, food, housing, presumably retirement plans), it doesn’t seem like there would be much of an insurance market, let alone a need for 401(k) plans, so those investors have been eliminated.
But I keep coming back to the central problem: If corporations have supplanted governments, then at minimum, arbitration and trust and reputation and guilds must supplant regulation. That’s a fascinating vision of the future, but nothing in the show even hints at this direction. I realize that I’m now stealthily engaging relatively unoriginal debates about the nature of the corporation (artificial/concession, association, real) and the role of the state in constructing the corporate form, but the reality is that corporations are a product of their legal environment. Without something like law emanating from some external source, there is no corporation. To imagine corporations as independent of law fatally ignores the role of law in shaping the corporate form itself.
As a result, I find Incorporated not merely irksome, but actively damaging. It leads lay viewers to accept the current legal framework for the corporate form as baseline, or natural – instead of a set of affirmative regulatory choices. I’m not talking about particular salient issues, such as political donations or tax policy; I’m talking about fundamental aspects about the form itself, such as limited liability, the role of the shareholder in the governance structure, and the transferability of ownership interests. The form itself is inseparable from positive law, which means it is subject to change. Incorporated obscures that fact, and thus – rather than presenting a critique of the status quo – ultimately reinforces it.
Saturday, December 3, 2016
There are always policy questions about the degree to which public regulation should be enforced by government actors, by private actors, or by a combination of both. In securities law, for example, striking the right balance is a perennial debate.
Which is why I read with interest this New York Times story about efforts to combat counterfeiting in China.
China has a serious problem with counterfeit goods. To some extent, that kind of problem can be addressed via government enforcement actions; however, China also suffers from what one might describe as an extreme case of regulatory capture – namely, corruption at the local level that compromises enforcement efforts.
So China has turned to private enforcement, by bolstering its consumer protection laws: consumers who purchase counterfeit goods can get damages equal to several times the value of the product. And predictably, these laws have spawned a new profession: counterfeit hunting.
That by itself would not be so bad – why not let consumers, acting like private attorneys general, ferret out counterfeit goods? The problem is, since damages are based on the number of products purchased, hunters purchase counterfeits in large numbers, filling warehouses with them. They also target minor labeling errors as much as serious fraud.
In other words, they exhibit all of the problems inherent in private enforcement: failure to exercise discretion over where to direct resources, arbitraging claims/creating injuries (and failing to mitigate damage) in order to support a lawsuit. These are precisely the accusations that have been leveled at, for example, stockholder plaintiffs and appraisal arbitrageurs.
China is apparently considering a new law that would ban counterfeit hunting as a commercial activity – akin to PSLRA provisions that prohibit so-called professional plaintiffs. But given the unreliability of government enforcement in China, it strikes me that to do so would throw the baby out with the bathwater. Yet absent such measures, China’s left with an extreme version of a common problem: private plaintiffs don’t draw distinctions between serious problems and minor ones if the monetary payout is the same. That distinction is one that has to be drawn in the substantive law.
We do that in securities by, for example, imposing standing, reliance, and loss causation requirements on private plaintiffs that government does not have to satisfy, and allowing government to bring claims based on an expanded set of violations (e.g., aiding and abetting). And we've done that, in a roundabout way, with state law fiduciary claims: there is no government enforcement in that arena, which has led to increasing limitations on private liability (exculpatory provisions, demand requirements) with no corresponding expansion of state enforcement. But that regulatory gap has been rapidly filled at the federal level with fiduciary-like requirements (independent director requirements, books and records requirements, and so forth) that can only be enforced by regulators.
It's an imperfect system, of course; it'll be interesting to see how China grapples with the same problem.
Saturday, November 26, 2016
Okay, this post has nothing to do with the subject line; given the time of year, I just couldn’t resist.
(Maybe we’ll just characterize that episode of WKRP in Cincinnati as a demonstration of PR tactics gone wrong. See? There’s a business law hook).
Anyhoo, today I want to call attention to the phenomenon of the fake whistleblowing hotline.
As compliance becomes an increasingly large part of corporate operations – and a de facto reconfiguration of corporate governance standards – it seems that companies are fond of creating “whisteblowing hotlines” to demonstrate their commitment to compliance with the law. Public companies, in fact, are required to do so under Sarbanes-Oxley.
Which is why two recent news items are so disturbing. First, in connection with the Wells Fargo fake account scandal – on which both Anne Tucker and Marcia Narine Weldon recently posted– it turns out that employees who offered tips on the Wells Fargo whistleblowing hotline were quickly fired; meaning that the hotline itself operated as a kind of reverse-ethics test to weed out employees most likely to object to Wells Fargo’s practices.
And it turns out that Wyndham Vacation Ownership did the same thing. This company, which sells time shares using legally dubious tactics, also has an “integrity hotline” that it uses, apparently, to identify and fire salespeople who have integrity.
It strikes me that these incidents are particularly pernicious. They represent traps to catch employees who might be troubled by the company's behavior, while faking compliance with the law - a false compliance that may not easily be detected. And they imply a certain degree of premeditation: if you set up a hotline and then misuse it, presumably, you know what you're doing. I realize that federal and state laws provide penalties for retaliation against whistleblowers; I do wonder if there can be especially tough scrutiny of adverse employment decisions in the wake of utilization of company-established compliance procedures - like, perhaps, a presumption that punitive damages should be awarded. I’m not an expert in this area, though; does anything like this exist? Could it?