Saturday, September 24, 2016
I’m sure I’m not alone in having followed the spectacular fall of Theranos over the past year. Elizabeth Holmes was a fairytale come to life – and now, the main question seems to be whether she intentionally defrauded her investors and the public, or whether she was simply in denial about the limitations of her technology.
(I personally don’t see the two as mutually exclusive – many fraudsters lie in the expectation that they can soon turn things around and no one will be any the wiser. In this case, there’s just too much evidence that Holmes was consciously evasive when questioned about her technology for me to believe that she wasn’t intentionally misleading people)
It’s probably too tempting to try to draw lessons from the Theranos debacle, but there are some interesting issues it raises.
First, I wonder whether Theranos is an argument for or against initiatives like the JOBS Act that make it easier for companies to raise large amounts of capital without holding an IPO.
On the one hand, because Theranos never went public, the fallout was contained; we haven’t seen the spectre of thousands of retail investors directly or indirectly losing their pensions.
On the other hand, Theranos illustrates exactly why we subject companies to the IPO process. There were, apparently, plenty of red flags right from the beginning, which caused the most savvy venture capitalists to steer clear of it. If the company had been forced to file an S-1 and subject it to general scrutiny, the problems might have been uncovered a lot sooner, and a lot of the damage prevented. If the company had been forced to file an S-1 before raising such large amounts of capital, it probably never would have raised the capital at all.
If nothing else, then, Theranos highlights the inadequacy of the accredited investor definition.
The second aspect of Theranos that I find fascinating is that a young woman was able to pull off this kind of fraud. It’s no secret that women in general have a hard time raising start up capital; in general, it’s the province of white men – relying on a pedigree and an image – to bewitch investors so thoroughly. Yet somehow Elizabeth Holmes was able to sell a convincing story built on technobabble and a romantic story. It’s almost heartening, in a dark sort of way – how far we’ve come! – but more seriously, I worry that Holmes will now serve as a cautionary tale for investors considering companies helmed by women.
With all that said, I'm filled with glee at the prospect of the movie – which apparently will star Jennifer Lawrence, under the direction of Adam McKay (who also directed The Big Short). That’s going to be a hoot!
Wednesday, September 21, 2016
The enticing facts of insider trading have me writing about the topic again (see an earlier post here) as the US Supreme Court prepares to hear oral argument in Salman v. US on October 5th. In Salman, the Supreme Court is asked to draw some careful lines in the questions: what benefit counts and how to prove such a benefit under Dirks v. SEC.
Recall that in Dirks, the Supreme Court focused the test on whether an insider benefitted—either by trading or by tipping in exchange for a benefit from the person to whom she tipped material nonpublic information. After Dirks, the 10b inquiry is whether the insider breached a duty by conveying the information for the insider’s personal benefit, and whether the tippee knows or at least should know of the breach. The Court explained that even in a case against a tippee who trades "Absent some personal gain [by the insider], there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach [by the tippee]."
The Salman case highlights a circuit split: the Second Circuit case United States v. Newman and the Ninth Circuit's ruling in Salman. In Salman, the question is whether prosecutors had to prove that the brother-in-law, Maher Kara, disclosed nonpublic securities information in exchange for a personal benefit. Is it enough that the insider and the tippee shared a close family relationship or must there be direct evidence as required in Newman?
The Ninth Circuit framed the benefit requirement inquiry, established in Dirks, as a gift of confidential information to a trading relative or a friend. The prosecution offered direct evidence of nonpublic information as a gift. The Ninth Circuit, and the Government, relied upon this passage in Dirks:
There may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.
The Second Circuit read the Dirks benefit test more narrowly, saying it required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.”
So what is the right answer? The Government lamented the Newman decision as "dramatically limit[ing] the Government’s ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.” Whereas others (see here) have criticized the Government's position in Newman and the subsequent basis of the Salman ruling as reviving the “parity of information” standard rejected by Supreme Court in both Chiarella and Dirks. Focusing on friendship and defining it broadly weakens the benefit test advanced in Dirks.
As someone who teaches insider trading and has followed the fascinating case facts for years, I am looking forward to oral argument and see the next step in the evolution of insider trading. Co-blogger Ann Lipton tee'd up the Salman case in her post earlier this week with her usual whit and charm.
Saturday, September 17, 2016
As part of my “scared straight” strategy for teaching insider trading, I like to tell my students horror stories of attorneys who have been caught up in scandals (as well as the collective *facepalm* reaction of the bar, which is as much due to the stupidity of the schemes as to their immorality).
Last year, I recounted the curious case of Robert Schulman and King Pharmaceuticals.
Schulman was an attorney representing King Pharmaceuticals, and he learned that the company would soon be acquired by Pfizer. He told his friend and investment adviser, Tibor Klein, who promptly purchased King shares for himself and his clients (some of which were allocated to Schulman’s account). All told, Klein generated about $328K in profits.
The SEC charged Klein with insider trading in 2013. Interestingly, the SEC did not accuse Schulman of tipping; instead, the SEC’s theory was that Schulman had gotten tipsy at dinner and shot off at the mouth, ultimately blurting out, “It would be nice to be King for a day.” (When I tell my students this part, I imagine how that might have been said – presumably, with an exaggerated wink and heavy emphasis on the word “King”). Klein, having been given the information in confidence, wronged Schulman by misappropriating it for his own use.
Except it seemed to me that the SEC never really believed Schulman’s claim that he had never intended to tip his friend. Why? Because most of the time, when the SEC files a complaint that involves nonparties, the SEC is careful to conceal their names. (For example) If necessary, the SEC might describe them as Person A or Witness B, that kind of thing.
But not in the King case. There, the SEC could not have been more forthcoming with Schulman’s name, which it repeated ad nauseam throughout the complaint – along with the potentially career-destroying details of his drunkenness, and his desire to impress his friend as a “big shot.” So it always struck me that the subtext here was, if the SEC couldn’t prove that Schulman intended to tip his friend, by god, it was going to embarrass him as much as it could.
Well, it took another three years, but the SEC has finally gotten its man, in a way: the Brooklyn US Attorney has charged both Schulman and Klein with criminal insider trading, with potential penalties of up to 20 years in prison.
King for a day, under a sword of Damocles.
Saturday, September 10, 2016
I’m finding the controversy over the Epipen price increases fascinating, because of its hoist-by-their-own-petard quality.
When Mylan acquired Epipen in 2007, it wasn't a particularly popular product. Then Mylan started a heavy marketing push, which included increasing awareness of the dangers of allergies, publicizing how Epipen could save lives in emergencies, and lobbying for legislation requiring that Epipens be stocked in public places as an emergency health device, like defibrillators. Because Mylan did a tremendous job of persuading the public that the Epipen was a critical medical device, it was able to raise prices dramatically - and now, having convinced everyone and his mother that Epipens are indispensable, the company is getting backlash for price gouging on this life-saving technology (not to mention becoming the target of investigations and lawsuits over, among other things, Medicaid fraud and state law antitrust violations).
Haskell previously posted about the Epipen situation, and connected the issue to the shareholder wealth maximization norm in corporate law. Going further, he asked whether, from a policy perspective, we particularly want to encourage some other sort of stakeholder model for the healthcare industry.
I guess my point is, the issue is not just price increases; it extends to profit motive in determining what counts as a health threat in the first place.
Further to that, it’s worth highlighting that the FDA has been easing its prior restrictions on off-label drug marketing, out of concerns that suppressing the dissemination of truthful information may violate corporate free speech rights. That has ominous implications for the pharmaceutical industry – why would companies go through extensive hoops to expand a drug’s labeling when they can get it approved for a single use, and then just market it for everything else? – and it also makes me wonder when we’re going to see more First Amendment challenges to securities regulation.
Saturday, September 3, 2016
At this point, it almost feels like I’ve been following the securities fraud case against Halliburton my entire career. I was grimly amused when I heard that the Fifth Circuit had granted an interlocutory appeal – again! – to hear a challenge to class certification – again! and I diligently tracked the docket on Bloomberg, only for it to belatedly sink in that – wait a minute, I actually live in New Orleans now. I can go see the oral argument in person, live, in color.
So I did.
It was … interesting.
[More under the jump]
Saturday, August 27, 2016
I’ve been fascinated by the efforts of various state attorneys general to investigate Exxon for securities fraud on the ground that its climate change denial misleads investors about the risks of investing in the company. Exxon has filed a lawsuit in Texas to halt the inquiries, arguing that they infringe on its free speech rights, and Congressman Lamar Smith, head of the House science committee, has subpoenaed the attorneys general involved, to determine if this is a coordinated political attack on the company. The dispute has even made it into the Democratic party platform, which states that “All corporations owe it to their shareholders to fully analyze and disclose the risks they face, including climate risk. … Democrats also respectfully request the Department of Justice to investigate allegations of corporate fraud on the part of fossil fuel companies accused of misleading shareholders and the public on the scientific reality of climate change.”
An investigation by the Virgin Islands was dropped; as far as I know, both the New York and Massachusetts investigations continue, and investigations by other states. Exxon’s lawsuit remains pending.
It’s not a new idea, to claim that securities regulation impinges on free speech rights – the DC Circuit struck down part of the SEC’s conflict minerals rule on just that ground – but usually these arguments are aimed at rules that require issuers to speak, or prohibit issuers from making truthful statements. The Exxon case is unusual because it comes in the context of, well, false statements.
At the same time, though, one cannot help but suspect that the real concern isn’t investors, but the nature of Exxon’s participation in public political debates.
[More under the jump]
Saturday, August 20, 2016
Upper level classes start next week, and I am scrambling to prepare. So for my post, I’ll just drop some quick links to things I found interesting this week:
First, a nice long read for Saturday: How Lending Club’s Biggest Fanboy Uncovered Shady Loans. This is a deep dive into the story of a retail investor who dug into Lending Club’s loan data – and discovered that Lending Club was padding its loan data before the company confessed publicly. He also seems to have discovered a pattern of repeat borrowers that the company has never disclosed.
Second, here is an editorial by a Deutsche Bank risk-officer-turned-SEC-whistleblower who says he is rejecting his reward, out of disgust that the company – and its shareholders – will be paying the fines that rightly should be charged to the company’s executives. He blames the SEC's “revolving door,” pointing out that top SEC lawyers had formerly been employed by Deutsche Bank (though they were recused from the investigation). The gesture would be slightly more impressive if it didn’t turn out that most of his reward is going to his lawyers, the experts he hired, and his ex-wife as part of his divorce settlement, and he doesn’t have the legal power to turn it down. But he totally would if he could.*
Third, the jurors in the Sean Stewart insider trading trial report that their deliberations took a long time because they couldn't quite decide if the defendant received a "personal benefit" under United States v. Newman standards by passing tips to his father. Obviously, whether a "benefit" is even necessary for a relationship this close is something that the Supreme Court is set to determine in Salman v. United States; in the meantime, it seems as though courts in New York are stuck asking about the quid pro quo between fathers and sons. Harsh, man. Couldn't the prosecutors have just argued that the father gave his son life?
*okay, I might be being unfair; his award is in excess of $8 million, so even after paying off everyone else, he may be rejecting a sizeable sum. Still, it's funny that he's trying to turn down money that, um, belongs to his ex-wife.
Saturday, August 13, 2016
One of the more interesting aspects of state corporate law – and Delaware law in particular - is the blurring of the line between substantive regulation and procedural regulation. Delaware gives corporate directors a great deal of leeway ex ante to structure transactions as they see fit, but if they structure them in a way that arouses suspicions – like, for example, failing to create an independent committee to negotiate a deal with a controlling shareholder – Delaware increases judicial scrutiny of the transaction, which, in practical terms, means that when the inevitable class action is filed, the defendants cannot win a quick dismissal on the pleadings. The “carrot” that Delaware offers directors to adopt best practices is the possibility of a quick, cheap dismissal of claims. Delaware regulates, in part, via threats of civil procedure.
This particular mode of regulation was on full display in In re Trulia, Inc. Stockholder Litig., 129 A.3d 884 (Del. Ch. 2016). There, Chancellor Bouchard held that Delaware would only approve disclosure-only settlements in deal class actions where the new disclosures were “plainly material.” Note, this is not the substantive standard for disclosures – it is not the standard necessary to win at trial. It is not the standard that an individual plaintiff would have to meet. It is only the standard for the settlement of a merger class action.
Which immediately begged the question: What happens if another state is entertaining a merger case involving a Delaware company? Does the Trulia standard count as a substantive rule of law, subject to the internal affairs doctrine, or a procedural one, that varies based on the forum?
It’s a critical issue, obviously, because if Trulia does not apply outside of Delaware, it will be very easy for plaintiffs and defendants to reach collusive settlements in foreign fora.
Well, we now have some answers, though they point in different directions: In Vergiev v. Cooper, a New Jersey state court held that Trulia is a substantive rule of law, and thus it applies even for cases brought outside of Delaware. (Opinion here; Alison Frankel blogs here). And just a few days ago, the Seventh Circuit applied Trulia in a case involving an Illinois corporation - implicitly suggesting that Trulia is a procedural (but persuasive) rule. Either way, it appears Trulia is on its way to general acceptance in the context of merger litigation.
That said, this only partly takes care of part of the problem of destructive competition among plaintiffs’ firms; as I’ve blogged before, there is still no real cure for the problem of plaintiffs who compete by racing to a settlement. Forum selection bylaws are not necessarily a panacea, because defendants can waive them – which may allow them to strategically pick off stronger plaintiffs and settle with weaker ones. The next step, therefore, is coming up with something like an MDL process for corporate litigation (a suggestion that others have made, see, e.g., Minor Myers, Fixing Multi-Forum Shareholder Litigation, 2014 U. Ill. L. Rev. 469; Elizabeth Cosenza, The Persistent Problem of Multi-Forum Shareholder Litigation: A Proposed Statutory Response to Reshuffle the Deck, 10 Va. L. & Bus. Rev. 413 (2016)).
Saturday, August 6, 2016
Saturday, July 30, 2016
For reasons that don’t need exploring at this juncture, I was in the mood to rewatch two big business movies of the 1980s: The Secret of My Success (dir. Herbert Ross, 1987) and Working Girl (dir. Mike Nichols, 1988).
Eighties business movies are something of their own minigenre – see, e.g., Trading Places, Wall Street, and Baby Boom – but the reason Secret of My Success and Working Girl are worth comparing is that they basically tell the same story, but with the genders flipped.
Both films are about young business naïfs (Michael J. Fox and Melanie Griffith, respectively), who have jobs at the bottom of the corporate ladder (mail room, secretary). Frustrated that their talents and skills are being overlooked, both impersonate corporate executives, colonizing vacant offices and aggressively pursuing their innovative business strategies. There is plenty of farce as they juggle their dual identities, and both enter into conflicted romances with executives who have been taken in by the charade. Ultimately, their identities are revealed but their talents recognized, and they are rewarded with the jobs (and love interests) they deserve.
But despite the nearly mirror-image plots, the two could not be more different in social message.
In The Secret of My Success, Michael J. Fox plays a young college graduate, raised in farm country and new to the big city. He’s been hired for a junior executive position but when he arrives on his first day, he finds his job has disappeared in a wave of layoffs. He is can’t find new work because of his lack of experience, and because employers are only interested in hiring minority women, not white men.
His parents suggest he seek a job from a distant uncle, who just happens to head a multinational conglomerate. The uncle puts him in the mailroom – an indignity not to be borne – which is what prompts Fox to embark on his grand ruse. It turns out that he has greater insight, smarts, and diligence than any of his colleagues.
In other words, according to this movie, even though Fox is just out of college with no work experience, he is entitled to a management job on the strength of nepotism, and it is the height of injustice that he’s expected to work his way up through corporate ranks.
In Working Girl, by contrast, Melanie Griffith plays a girl from the wrong side of the tracks (Staten Island), who has been trying to climb the corporate ladder for years. She fought through night school to get her degree; since then, she’s struggled at a variety of low-status business jobs, trying to learn whatever she could along the way. What’s held her back, explicitly, is sexism and classism. When she ultimately snaps and begins her ruse, it’s because the game is stacked against her – as she puts it at the end of the film: “You can bend the rules plenty once you get upstairs but not while you’re trying to get there, and if you’re someone like me, you can’t get there without bending the rules.” Notably, she’s talented and insightful, but the movie revolves around the fact that she has one particular good idea – unlike Fox, who essentially is ready to restructure the company after a couple of months.
Working Girl, then, is about forcing open the doors of the business world to people who have historically been locked out; Secret of My Success is about how, well, people who look like Michael J Fox are just naturally entitled to great jobs.
I’m not saying the politics of Working Girl are above reproach – Sigourney Weaver’s evil-businesswoman character ultimately bears the brunt of the film’s criticism, blunting the feminist message – but the movie goes out of its way to indict the business world for excluding people who don’t begin life with privilege. Secret of My Success does the other thing.
Saturday, July 23, 2016
It looks like the Fifth Circuit is becoming increasingly isolated.
After the Supreme Court decided Dura Pharmaceuticals, Inc. v. Broudo, 544 US 336 (2005), a circuit split developed as to how plaintiffs can satisfy the element of loss causation in a Section 10(b) action.
All circuits agree that loss causation can be shown via “corrective disclosures” – some kind of explicit communication to the market that prior statements were false, followed by a drop in stock price.
However, as I’ve discussed before, there has been an alternative theory that plaintiffs can use to show loss causation, even without an explicit corrective disclosure. The theory is usually described as “materialization of the risk.” It requires the plaintiff to show that the fraud concealed some condition or problem that, when revealed to the market, caused the stock price to drop, even if the market was not made aware that the losses were due to fraud. For example, a company may report a slowdown in sales, causing its stock price to fall, while concealing the fact that the slowdown was due to an earlier period of channel stuffing. By the time the channel stuffing is revealed, it may communicate no new information about the company’s prospects, so the stock price remains unmoved. Under a materialization of the risk theory, the price drop upon disclosure of the fall in sales would be sufficient to allege loss causation.
The Fifth Circuit has rejected materialization of the risk theory, requiring some kind of communication to the market that the earlier statements were false. The Ninth Circuit generally has done the same, but there’s enough wiggle room in its caselaw that it agreed to hear an interlocutory appeal in Mineworkers’ Pension Scheme, et al v. First Solar Incorporated, et al, No. 15-17282, to resolve the issue.
And this week, in Ohio Public Employees Ret. Sys. v. Federal Home Loan Mortgage Corporation et al. - the long-running crisis-era case alleging that Freddie Mac concealed its exposure to bad mortgage loans - the Sixth Circuit joined the vast majority of circuits in holding that materialization of the risk is sufficient to satisfy the element of loss causation (quietly glossing over earlier caselaw that had seemed to endorse the corrective disclosure standard). Among other things, the Sixth Circuit expressed concern that companies will easily be able to evade liability if liability is functionally predicated on a corporate confession of wrongdoing. That’s a reasonable concern: as Barbara A. Bliss, Frank Partnoy, and Michael Furchtgott have found, in the wake of Dura, corporations have adopted disclosure strategies aimed at masking the cause of stock price reactions, allowing them to reduce litigation risk. (I blogged about an earlier version of the paper here).
Saturday, July 16, 2016
You may have seen the news that Gretchen Carlson, a former Fox News anchor, is suing Roger Ailes, the Fox News Chair and CEO, for sexual harassment and retaliation. One of the interesting things about the case is that – like a lot of people – Carlson has an arbitration clause in her contract requiring her to arbitrate all claims arising out of her employment
So how is she able to bring this case?
Well, Carlson is suing Ailes personally – not Fox News. Her argument is that her arbitration agreement is with Fox News alone; Ailes is not a signatory to the agreement, and cannot benefit from it.
I first have to note that this argument is only available to Carlson at all because Ailes is wealthy, and (I assume) covered by insurance; most employees in similar situations don’t have the option of suing only their harasser (rather than their employer), because most individual harassers are likely to be judgment proof.
Beyond that, is Carlson right? Is this a way around her arbitration agreement?
Well, according to Richard Frankel, there is a split of authority as to whether arbitration agreements to extend to agents of the signatories in their individual capacities, even when those agents were never parties to the agreement. See Richard Frankel, The Arbitration Clause as Super Contract, 91 Wash. U. L. Rev. 531 (2014). So there’s a real question as to whether Ailes has the right to enforce Carlson’s arbitration agreement, even though he was not a party to it.
Carlson’s attorneys are not giving up the fight so quickly, though. They claim – with at least some support, see Arnold v. Arnold Corp., 920 F.2d 1269 (6th Cir. 1990) – that even when arbitration clauses extend to corporate agents, they only extend to actions taken by the agent in their capacity as agent; they do not cover actions taken by the agent on their own behalf. In this case, Carlson’s attorneys apparently intend to claim that Ailes was not acting on Fox News’s behalf when he harassed Carlson, even though he may have been an agent of Fox for the purposes of retaliation. Thus, the former claims need not be arbitrated, even if the latter claims must be.
Now, at least some courts have endorsed a concept of “concerted misconduct” that might preclude this kind of claim-splitting. See Christopher Driskill, Note, A Dangerous Doctrine: The Case Against Using Concerted-Misconduct Estoppel to Compel Arbitration, 60 Ala. L. Rev. 443 (2009). But more generally, I am concerned about the argument that employees are acting for their own gratification, and not on behalf of the employer, when they harass. Courts have long been suspicious of respondeat superior in the context of harassment claims, suggesting (as Carlson apparently intends to argue) that harassment represents a personal frolic rather than a mechanism for maintaining institutional barriers to the advancement of underprivileged groups. See Burlington Indus. v. Ellerth, 524 U.S. 742 (1998). That means that a court could accept Carlson's argument – particularly a court hostile to arbitration clauses – but perversely end up creating a lot of mischief for the many employees who rely on respondeat superior for any relief at all.
That said, there’s another aspect to this dispute that I find interesting. According to the rumour mill, Roger Ailes has long been targeted for ouster by Rupert Murdoch’s sons. If Fox News had been named as a defendant in Carlson’s suit, the company might have been forced to close ranks around Ailes. But – ironically – because Fox News is not a defendant, the company appears to have the option of leaving Ailes twisting in the wind, and Murdoch’s sons in particular may use the lawsuit as an excuse to get rid of Ailes once and for all.
Saturday, July 9, 2016
Speaking of tactics that managers use thwart shareholder activists -
Sean Griffith and Natalia Reisel have posted a new paper to SSRN, Dead Hand Proxy Puts, Hedge Fund Activism, and the Cost of Capital, analyzing the effects of dead hand proxy puts. These are loan covenants that allow the lender to require complete loan repayment in the event of a change of control that results from an actual or threatened proxy contest, and that cannot be waived by the borrower – i.e., the incumbent directors cannot settle with the dissident, give their blessing to the new directors, and thereby avoid the provisions (the “dead hand”).
Now my instinct on these provisions has always been that they improperly interfere with shareholder suffrage by insulating the incumbent board from the market for corporate control. I wondered whether these provisions were in fact valued by lenders, or whether they were inserted at the behest of management to protect themselves from challenge, with lender acquiescence/indifference.
But the authors find that these provisions do, in fact, have value to lenders – and thus to corporations. They are more likely to be adopted by firms that are potential targets of shareholder activists (unsurprising), and, critically, they lower the cost of the firm’s debt.
The authors also find that though the provisions tend to be found in loan agreements – where they can be easily waived or modified if the lenders believe a change of control will not imperil the loan – their presence may be valued by bondholders, who cannot use such provisions as easily because it is more difficult for them to overcome collective action problems to modify them later. (Question: is it likely activists would bargain with the lenders in advance, and make the lenders’ endorsement part of their platform when soliciting shareholders? Is that a thing activists do? I admit my ignorance. If not – if the activist intends to bargain after gaining control – that would be a helluva risk for shareholders to take.)
In any event, the upshot appears to be, directors can preempt a proxy fight and increase corporate value by adopting this kind of financial technology, which is different than the financial technology that activists would likely adopt, but - unlike typical activist tactics - benefits both shareholders and creditors.
The critical question, then, is whether the value to shareholders generated by these provisions is equal to the value that would be generated by a shareholder activist. The authors state that they will analyze this question in connection with an upcoming paper – and I look forward to seeing what they come up with.
Saturday, July 2, 2016
There have recently been several high profile news items about companies using dual class share structures.
First, Facebook announced that it would issue a class of nonvoting shares so that Mark Zuckerberg could maintain his control over the company via his supervoting shares, in a move reminiscent of a similar tactic by Google a couple of years ago.
(A fun game I like to play with my students: compare the stock prices of voting shares of Google with the prices of nonvoting shares, and then talk about the two, in light of the fact that Sergey Brin and Larry Page control the majority of the voting power regardless due to their supervoting shares.)
Second, Lionsgate announced it would be acquiring Starz, in a partially cash, partially stock deal. Because Starz has a dual class structure – with supervoting power held by John Malone – the arrangement involves Lionsgate creating a new class of nonvoting shares. Holders of Starz A shares will get cash and nonvoting Lionsgate shares, while holders of Starz B shares (e.g., Malone) get less cash, but both voting and nonvoting Lionsgate shares.
Third, Mondelez just made a bid to buy Hershey – one that could be blocked by the Hershey Trust that controls 80% of the voting power via dual class shares.
Dual class share structures are all the rage these days. The growing popularity of dual class structures suggests that as investors gain more power in the governance structure – via legal changes, and via the increasing concentration of share ownership – corporate managers are fighting back with new tools to cabin investors’ influence.
But dual class structures carry some fairly obvious dangers – some of which are now on full display in the show trials regarding Sumner Redstone and Viacom. In brief, Viacom has a dual class structure with most of the voting stock held by a company called National Amusements, which itself is controlled by Sumner Redstone. Redstone is 93 years old and recently ousted the Chair of Viacom, as well as other Viacom directors, setting up court battles in Delaware and Massachusetts regarding his competency.
With dual class structures' increasing popularity, I’m sure we can expect a lot more conflicts (and more development of the law). It will be interesting to see whether there will be enough institutional investor pushback to cabin their use, and/or create some standardized features (sunset provisions, limits on the creation of new nonvoting share classes, etc).
Saturday, June 25, 2016
Section 11 imposes liability for false statements in registration statements. See 15 U.S.C. §77k. Section 11 is distinctive in that the plaintiffs do not have to show fault on the part of any defendants - a sharp contrast with Section 10(b), which requires plaintiffs to prove that the defendants acted with scienter.
When it comes to imposing liability on corporate auditors who approve false financial statements, very often, Section 11 is the only viable option for plaintiffs. This is because it is very, very hard to show that auditors acted with scienter – especially at the pleading stage. When a company blows up, typically a lot of information becomes available that would help the plaintiffs demonstrate that there was fault within the corporate ranks. But it is far less typical for information to become available against the auditor. So Section 11 is really the only way for plaintiffs to go.
In Querub v. Moore Stephens Hong Kong, 2016 U.S. App. LEXIS 9213 (2d Cir. N.Y. May 20, 2016) (unpublished), the Second Circuit held that for Section 11 purposes, audit opinions are “opinions” in the manner described in Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S. Ct. 1318 (2015). This means that audit opinions can only be shown to be false – and liability based on them can only be imposed – if the plaintiffs show either that the auditors did not believe the opinion (the functional equivalent of scienter), or that the auditors left out critical facts regarding the manner in which the opinion was formed (which in most cases is likely to mean that the auditor failed to comply with Generally Accepted Accounting Standards (GAAS)).
It’s my view that this holding contradicts the text of Section 11.
Section 11, provides that if a registration statement contains a false statement or material omission, liability will lie against:
every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation which is used in connection with the registration statement, with respect to the statement in such registration statement, report, or valuation, which purports to have been prepared or certified by him...
On my reading, this language directs courts to ask whether the corporate financial statements are false. If they are, then liability is imposed on the auditor who “certified” the statements – automatically. The act of auditor certification of a false financial statement is what triggers liability, period. No further inquiry into the truth or falsity of the certification itself – independent of the underlying financial statement – is permitted.
But, the auditor is permitted to offer a defense. Auditors (who are “experts”) may avoid liability if they prove that:
as regards any part of the registration statement purporting to be made upon his authority as an expert or purporting to be a copy of or extract from a report or valuation of himself as an expert … he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading….
In other words, the auditor will not be liable if it believed the financial statements were true, based on a reasonable investigation. Presumably, the auditor will try to meet this standard by showing that it complied with GAAS, which itself would require a showing of good faith and professional due diligence. If the auditor makes that showing, it avoids liability.
The Second Circuit (and, I must confess, several other courts) undermine this scheme when they put the burden on the plaintiff to make an initial showing that there was a failure to comply with GAAS.
This is a problem that may be broader than audit certifications, and extend to the proper interpretation of Section 11 generally - occasioned not so much by Omnicare's definition of opinion falsity, but by its capacious definition of what counts as opinion in the first place - but in the context of audit opinions, the tension looms particularly large.
Now, one counterargument is that auditors do not “certify” financial statements any more. Certification is an old terminology; it fell out of favor several decades ago (after the passage of the Securities Act), to be replaced by the “opinion” phrasing, which more accurately reflects the fact that auditors don’t guarantee the accuracy of corporate financial statements. And indeed, today, SEC regulations dictate that auditors offer “opinions” (not certifications) of financial statements.
But to me, this is beside the point. As far as I know - and I'd be curious if anyone has any contrary evidence - these changes in terminology were never intended to change the liability scheme, let alone shift Section 11's burden of proof (something that presumably auditors could not do unilaterally).
Saturday, June 18, 2016
As Rodney Tonkovic discusses in more detail, the plaintiff in Fried v. Stiefel Labs, 814 F.3d 1288 (11th Cir. 2016), has petitioned the Supreme Court to delineate disclosure duties in the context of trading by private companies.
Richard Fried was the former CFO of Stiefel Labs, which was privately held. As an employee, he received stock as part of a pension plan. When he retired, he sold the stock back to Stiefel (I don’t know much about the market for Stiefel stock, but I’m guessing that, since it was privately held, Fried didn’t think he had many alternative options). Sadly for Fried, shortly after his sale, it was announced that Stiefel was being acquired by GlaxoSmithKline, and that negotiations had been in the works at the time of his sale. By selling to Steifel instead of waiting for GSK’s acquisition, he missed out on, roughly, an additional $1.62 million. He sued Stiefel, alleging that Stiefel had been obligated to disclose the negotiations to him at the time of his sale.
This is not something that comes up very often, but the case law that does exist tends to hold that insider trading principles apply both to private and public companies and, in particular, that when a company buys its own stock back from an employee, it has a duty to disclose material inside information. See, e.g., Castellano v. Young & Rubicam, Inc., 257 F.3d 171 (2d Cir. 2001); Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987).
The issue is a bit of a theoretical muddle, though, not least because it is the company – not a particular employee – who is doing the trading, and thus the precise fiduciary duty at issue is harder to nail down. The employee knows the price is not being set by the market generally, and the employee's expectations regarding the company's superior information depend - well - on the existing background legal regime of required disclosures. (The SEC filed a brief in a related case, where it argued that “where a company trades in its own stock it does have a duty to disclose material information or abstain from trading.” SEC Brief, Finnerty v. Stiefel Labs, 2013 WL 2903651, at *9-*10. This was an odd statement because that’s a hard case to make if the company is selling its stock, at least to the extent it’s relying on a Section 5 exemption.) So what the employee might reasonably expect, or rely upon - and thus be deceived by - is something of a moving target.
I’m not going to hazard a guess as to whether the Supreme Court is likely to grant cert in the Fried case– my track record on these sorts of predictions is embarrassingly terrible – but I will say that there are some uphill battles Fried may have to climb. First and most importantly, the Eleventh Circuit never actually decided the issue of whether a private corporation counts as an "insider" for insider trading purposes, because it rejected the claim on essentially technical grounds – i.e., that Fried should have requested jury instructions under 10b-5(a) or 10b-5(c), not 10b-5(b). The Circuit's failure to address the substantive issues detract from its utility as a vehicle for addressing the duties of a private corporation. Indeed, the “questions presented” in Fried’s petition do not even mention the Eleventh Circuit’s focus on the distinctions between 10b-5(a), (b), and (c) - which, as we know, are really important distinctions to the Supreme Court, see Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011).
Even leaving that point aside, because of the dearth of caselaw, the Court might reasonably say these issues need more development in the lower courts. And though Fried argues that this case involves the question whether 10b-5 prohibits trading in possession of material inside information, or only trading on the basis of inside information, that point was only mentioned by the Eleventh Circuit in passing, and it certainly has nothing to do with the far more interesting question of the duties owed by private companies repurchasing their stock.
But, as I said, I’m not going to try to predict what the Court is likely to do here. I’ll simply say that assuming the Supreme Court rejects Fried’s petition, it almost certainly will have other chances to get at these problems, because of the increasing tendency of companies to stay private for prolonged periods of time, and to go through multiple rounds of financing. As Bloomberg reports:
[T]he more money you have, the more information you get in private markets. Sven Weber launched the SharesPost 100 index fund in 2012 to let unaccredited investors (with a net worth below $1 million) own shares in late-stage startups, including DocuSign Inc., Spotify AB and Social Finance Inc., with a minimum investment of $2,500. He could only write $500,000 checks at first and it was hard to get information to gauge if he was getting a fair price. As the SharesPost 100 grew to 34 startup positions and $71 million under management, he got more access.
Weber said one Silicon Valley unicorn provided virtually no information when he was trying to purchase shares last year. Based on historical statements and publicly available documents like articles of incorporation, he invested anyway. During the past year, he increased his stake, got to know company executives and eventually convinced them to share quarterly revenue updates and forward-looking statements.
The differential access to information has attracted not only SEC attention, but also other lawsuits like Fried’s - and I'm assuming there will be more to follow. So the really interesting question is, when you invest in a private company, to what extent are you assuming the risk of this kind of informational asymmetry?
Thursday, June 9, 2016
I attended my first Law and Society meeting this year (made easier by the fact that it was held in New Orleans, my newly-adopted city!) And as Joan indicated in a prior post, she gave a presentation on her most recent project, tentatively titled “Pillow Talk, The Parent Trap, Sibling Rivalries, Kissing Cousins, and Other Personal Relationships in U.S. Insider Trading Cases.” And very shortly after she concluded, a news story dropped in my inbox about SEC v. Maciocio, involving two longtime friends charged in an insider trading scheme that lasted for several years.
The reason the case interests me is that I assume the SEC (and the DOJ in a parallel criminal complaint) are teeing it up in light of the pending Supreme Court case of Salman v. United States.
According to the SEC’s allegations, Maciocio worked for a pharmaceutical company that engaged in business dealings with several other companies. Hobson was his longtime childhood friend. The details of their relationship are described in the SEC’s complaint, including their days of Little League baseball, and daily phone calls and emails.
Hobson, as it turns out, was a securities broker. So, Maciocio tipped off Hobson whenever his employer struck a new business deal – as you do – allowing Hobson to reap nearly $200,000 in trading profits. Maciocio made similar trades himself.
But the striking thing about the complaint is that the SEC is extraordinarily vague in describing any personal benefit that Maciocio received from tipping Hobson. Maciocio profited from his own trades, of course, but in exchange for passing information to Hobson, the SEC only alleges that he received barely-described “investment advice” and “stock tips” – not much of a benefit, considering that Hobson was Maciocio’s broker and presumably would have given advice anyway. Beyond that, the SEC openly alleges that the tips were simply a “gift” to Maciocio’s “close personal friend.”
The reason this is striking, of course, is that in Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court - reacting to the extraordinarily bizarre facts before it - invented the rule that gratuitous tipping does not a Section 10(b) violation make.
So the critical question is, does friendship maintenance have legally cognizable value?
Well, that's what the Supreme Court is set to consider in Salman: whether “gift” of information is enough to count as a 10(b) violation, even in the absence of a concrete benefit to the tipper. In Salman, though, the giftee was a relative, and the law has a much harder time with the nebulous bonds of friendship. The difficulty is that without a grand theory of insider trading – which the law has yet to develop – it's not clear what kind of relationships suffice. The last thing we want is a case by case analysis about whether a friendship was close enough to count - creating uncertainty for everyone who trades - and there's no obvious reason why a tip to a casual buddy should somehow be less harmful to markets than a tip to a BFF. Then again, if friendship isn't enough, the government will make do with whatever benefit peppercorns it can find - steak dinners, anyone? - which hardly makes any more sense.
Point being, Joan – I look forward to seeing what you can make of all this!
Saturday, June 4, 2016
How much do we trust institutional investors to protect their interests?
Delaware law has gradually been inching toward a recognition that in a stock market dominated by institutional investors, old assumptions – about a dispersed, uninformed, and rationally passive shareholder base – must give way to a new recognition of shareholder sophistication and incentives.
You can see the tendrils of this growing awareness in, for example, opinions like Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), where the Delaware Supreme Court held that a shareholder vote in favor of a merger would act as a ratification of the directors’ conduct – a ruling that implicitly relied on an expectation of shareholder sophistication. See id. (“When the real parties in interest—the disinterested equity owners—can easily protect themselves at the ballot box by simply voting no, the utility of a litigation-intrusive standard of review promises more costs to stockholders in the form of litigation rents and inhibitions on risk-taking than it promises in terms of benefits to them.”) You can see it in then-Vice Chancellor Strine’s opinion in In re Pure Res. S'Holders Litig., 808 A.2d 421 (Del. Ch. 2002), where he held that controlling shareholder tender offers need not always be subject to entire fairness review, in light of the “increased activism of institutional investors and the greater information flows available to them” – which influenced later standards applied to the merger context. See Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014).
You can also see it in Myron Steele’s recent lecture at Fordham, where he predicted that “it’s only a matter of time before substantive coercion is history. Because when you have a seventy-five percent institutional stockholder base, it’s not like you're their guardian. They’re perfectly capable of making their own decisions…” See 20 Fordham J. Corp. & Fin. L. 352 (2015).
But in In re Appraisal of Dell, 2016 Del. Ch. LEXIS 81 (Del. Ch. 2016), Vice Chancellor Laster pooh-poohed market judgments, embarking on a prolonged discussion about why shareholders – and even market analysts – might fail to recognize the value of new investments with long term payoffs, not even necessarily because they lack information, but because of what he deemed an “anti-bubble.” The most eyebrow-raising moment came when, in support of this thesis, he cited Martin Lipton’s blog posts at the HLS Forum and CLS Blue Sky. Martin Lipton**, of course, frequently argues that shareholders are uninformed and not to be trusted, in support of a general agenda of minimizing shareholder power and maximizing management discretion.
All of this just begs the question: if shareholders’ judgments are so untrustworthy, why do their votes in favor of a merger have such an immunizing effect?*
*the contradiction is made more obvious by Martin Lipton's recent blog post decrying the Dell decision; the irony, of course, is that Lipton's own arguments were used to justify the court's conclusion that shareholder valuations are unreliable.
**in case anyone was wondering, no relation.
Saturday, May 28, 2016
Public companies are required to report certain material events within 4 business days on Form 8-K. These events include such matters as the departure of directors or officers, the disposition of assets, or material impairment of assets.
In their paper Strategic Disclosure Misclassification, Andrew Bird, Stephen A. Karolyi, and Paul Ma find that in their 8-K filings, corporate managers seem to be taking a leaf from Roseanne’s bill paying system:
Specifically, Bird et al. find that companies frequently “misfile” their 8-Ks, categorizing them as miscellaneous “other” rather than properly identifying them in the appropriate category. “Misfiling” is particularly likely to occur for negative events, and during periods when investor attention is high - suggesting that misfilings are part of a strategic effort to deflect investor attention. Happily for corporate managers, the strategy is an effective one: misfiled 8-Ks not only receive less traffic, but they also have less stock price impact.
Roseanne would be so proud.
Saturday, May 21, 2016
Last week, Chancellor Andre Bouchard dismissed the derivative complaint filed against Walmart concerning the WalMex bribery scandal, on the grounds of issue preclusion: Earlier, a federal court in Arkansas had dismissed identical claims filed by a different set of plaintiffs.
The reason that the Arkansas decision came so much earlier than the Delaware decision was, of course, that the Arkansas plaintiffs filed their complaint without first exercising their inspection rights under Section 220. The Delaware plaintiffs did exercise their rights, as Delaware has repeatedly counseled plaintiffs should do, and fought Walmart for years over it – taking a trip to the Delaware Supreme Court as a result.
Standing alone, then, this case stands for the proposition that Delaware has no way of enforcing its own guidance to plaintiffs that they seek books and records before filing a derivative claim.
But there’s hope – because this is exactly the kind of destructive competition among plaintiffs’ firms that forum selection bylaws were meant to address. Had such a bylaw been in place, all of the plaintiffs could have been shunted into a Delaware forum.
Unfortunately, no. Because defendants have the freedom to ignore a forum selection bylaw if their interests are served by dealing with a weaker set of plaintiffs in a foreign forum.
I’ve expressed concern about this issue before, and my fears came to fruition in Gordon Niedermayer, et al. v. Steven A. Kriegsman, et al. and CytRx Corp., C.A. No. 11800-VCMR, tr. ruling (Del. Ch. May 2, 2016). There, the company waived its forum selection bylaw just in time to choose which group of plaintiffs with which to settle. When the Delaware plaintiffs challenged the waiver, the court upheld it: though the court warned directors against forum selection “gamesmanship,” it found no such gamesmanship here.
Though I'm not expressing an opinion on the particular ruling in CytRx, the situation stands as a warning of how Delaware procedural law - which is becoming as much a part of its corporate jurisprudence as its substantive standards - may be threatened. For example, in cases like In re Trulia Stockholder Litigation, 2016 WL 325008 (Del. Ch. Jan. 22, 2016), Delaware has declared a new war on “intergalactic releases” for meaningless disclosures in merger litigation – a move largely applauded by many commenters. But Trulia and cases like it will be reduced to rubble if plaintiffs can simply file in other jurisdictions, while defendants – seeking certainty that their deal is insulated from further challenge – waive forum selection bylaws as it suits them.
Indeed, according to a study by C. N. V. Krishnan, Steven Davidoff Solomon, & Randall S. Thomas, experienced defense counsel take advantage of the fact that doubtful merger agreements tend to result in challenges in multiple fora, reaching sweetheart settlements with the most amenable group of plaintiffs. In other words, the very weakness of the merger is what neuters the plaintiffs’ challenge: Lower premiums invite litigation by multiple firms, whom defendants can then play off each other.
If Delaware doesn’t come up with a way to manage this situation, the market will – and not to Delaware’s benefit.