Saturday, September 22, 2018

Let's talk more about CBS

Back when the CBS Board first decided to revolt against its controlling shareholder, Shari Redstone, I posted a collection of immediate thoughts.  My final one was:

[T]here’s a subtext in all of this, and it’s that Shari Redstone in particular is an untutored interloper, interfering in a business that she knows little about having finally managed to wrest control from her ailing – and often-estranged – father….It’s hard not to wonder about something of a gendered undercurrent in this kind of commentary, and that, in turn, taints CBS’s general depiction of Shari Redstone as a gossipy – and they don’t use that word but that is the implication when they allege that Redstone basically is saying mean things about people – busybody in corporate affairs.

In light of what transpired and came to light since then, I’m going to emphasize that point again.  Because there’s even more evidence today that the Board’s hostility to Redstone – and its support of Moonves – was tainted by (what I assume was unconscious) bias.  And now, after an expensive and pointless legal battle, terrible publicity, and a general waste of corporate resources, we have a cautionary tale about how sexism distorts and inhibits business judgment.

[More under the jump]

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September 22, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, September 15, 2018

Be careful what you wish for

Corporate managers have long complained about proxy advisory services, such as ISS, Egan-Jones, and Glass Lewis.  They argue that proxy advisors provide governance advice to companies – for a fee – and then make influential voting recommendations to client shareholders, functionally creating a kind of shakedown service (“Pay us and we’ll be able to recommend that shareholders vote in your favor; don’t, and who knows what we’ll do?”).  Corporations argue that shareholders don’t conduct their own analysis of issues anymore, and blindly vote with however proxy services recommend – giving them far too much power. 

There is plenty of reason to be skeptical of their complaints.  At least one study shows that most institutional investors take recommendations into account but ultimately make their own decisions.  And as John Coates recently testified before Congress on the issue, there is no evidence of a market failure necessitating congressional regulation, and regulation might make the industry more concentrated and less competitive, which is the exact opposite of what we should strive for.

I won’t deny that to the extent proxy advisory services potentially have conflicts, these should be known and their policies for cleansing should be clear.  But one cannot help but suspect that companies’ reasons for objecting to proxy advisors is the same as their objection to unions – it’s not conflicts or corruption, it’s that they overcome transactions costs of  a disaggregated constituency and facilitate coordination so as to create a countervailing power center.  Managers, in other words, just don’t want to be challenged – by anyone.

That said, corporate complaints have found a sympathetic ear among Republicans in Congress and now, apparently, in Jay Clayton at the SEC.  The SEC just announced that it was withdrawing two no-action letters from 2004 that have become the bete noire of corporate managers, in preparation for an upcoming Roundtable on the Proxy Process.  Clayton even went out of his way to issue a separate statement clarifying that staff guidance is non-binding, if we hadn’t gotten the message that anything done under previous administration is now suspect.

You can’t read the letters online, because apparently withdrawing them means making them inaccessible unless you have access to a legal database – and that, by the way, is just terrible practice from a transparency point of view; I’d rather they just be clearly marked as withdrawn.

That said, I will summarize (and embed the letters in this post, if I can get the tech to cooperate).  But first, some background – and this is going to get long, so I’m putting the rest behind a cut.

[More under the jump]

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September 15, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, September 8, 2018

The revolution will be marketed

I’ve been absolutely riveted by Nike’s decision to make Colin Kaepernick the face of its new ad campaign.  (I assume most readers are aware of the basics but here’s an article to catch you up if you need it.)  It’s a daring move, not just because of the controversy over Kaepernick himself, but also because of Nike’s relationship with the NFL: Nike is the official supplier of uniforms and sideline gear (a deal that was just extended through 2028), and presumably, in that capacity, Nike wants to keep the NFL popular and football fans happy.

So, there’s so much to chew over here.

We start with the ongoing tension between the fact that it is good marketing for companies to look like they care about various social causes – whatever those causes may be – and their fiduciary duty not to actually care about those things. (Assuming you buy into a shareholder primacy model, etc etc). 

My favorite example for my students is, well, this FT Alphaville blog post in reaction to Jamie Dimon’s ostentatious announcement that he was giving his employees a raise.  And then there’s Tax Exempt Lobbying, a new paper by Marianne Bertrand, Matilde Bombardini, Raymond J. Fisman, and Francesco Trebbi, finding that companies strategically direct charitable giving so as to please politicians that have control over their fates.

So on the one hand, it may be good business to promote Kaepernick, but Nike has to absolutely pretend that’s not really its motivation.

(More under the jump)

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September 8, 2018 in Ann Lipton | Permalink | Comments (4)

Monday, September 3, 2018

Connecting the Threads II - Laboring on Labor Day

Like many in the law academy, I find three-day holiday weekends a great time to catch my breath and catch up on work items that need to be addressed.  This Labor Day weekend--including today, Labor Day itself--is no exception to the rule.  I am working today, honoring workers through my own work.  My husband and daughter are doing the same.

This blog post and the announcement it carries are among my more joyful tasks for the day.  I have been remiss in not earlier announcing and promoting our second annual Business Law Prof Blog symposium, which will be held at The University of Tennessee College of Law on September 14.  The symposium again focuses on the work of many of your favorite Business Law Prof Blog editors, with commentary from my UT Law faculty colleagues and students.  This year, topics range from the human rights and other compliance implications of blockchain technology to designing impactful corporate law, with a sprinkling of other entity and securities law related topics.  I am focusing my time in the spotlight (!) on professional challenges in the representation of social enterprise firms.  More information about the symposium is available here.  For those of you who have law licenses in Tennessee, CLE credits are available.

I am looking forward to again hosting some of my favorite law scholars at this symposium.  I am sure some will blog about their presentations here (Marcia already has previewed her talk and summarized all of our presentations, and I plan to later blog about mine), Transactions (our business law journal) will publish the symposium proceedings, and videos will be processed and posted on UT Law's CLE website later in the year.  But if you are in the neighborhood, stop by and hear us all in person!  We would love to see you.


September 3, 2018 in Ann Lipton, Conferences, Current Affairs, Joan Heminway, Joshua P. Fershee, Marcia Narine Weldon, Stefan J. Padfield | Permalink | Comments (0)

Saturday, September 1, 2018

Should Corporate Lawyers and Business Law Professors Be Talking About DAOs?

Did I lose you with the title to this post? Do you have no idea what a DAO is? In its simplest terms, a DAO is a decentralized autonomous organization, whose decisions are made electronically by a written computer code or through the vote of its members. In theory, it eliminates the need for traditional documentation and people for governance. This post won't explain any more about DAOs or the infamous hack of the DAO in 2016. I chose this provocative title to inspire you to read an article entitled Legal Education in the Blockchain Revolution.

The authors Mark Fenwick, Wulf A. Kaal, and Erik P. M. Vermeulen discuss how technological innovations, including artificial intelligence and blockchain will change how we teach and practice law related to real property, IP, privacy, contracts, and employment law. If you're a practicing lawyer, you have a duty of competence. You need to know what you don't know so that you avoid advising on areas outside of your level of expertise. It may be exciting to advise a company on tax, IP, securities law or other legal issues related to cryptocurrency or blockchain, but you could subject yourself to discipline for doing so without the requisite background. If you teach law, you will have students clamoring for information on innovative technology and how the law applies. Cornell University now offers 28 courses on blockchain, and a professor at NYU's Stern School of Business has 235 people in his class. Other schools are scrambling to find professors qualified to teach on the subject. 

To understand the hype, read the article on the future of legal education. The abstract is below:

The legal profession is one of the most disrupted sectors of the consulting industry today. The rise of Legal Tech, artificial intelligence, big data, machine learning, and, most importantly, blockchain technology is changing the practice of law. The sharing economy and platform companies challenge many of the traditional assumptions, doctrines, and concepts of law and governance, requiring litigators, judges, and regulators to adapt. Lawyers need to be equipped with the necessary skillsets to operate effectively in the new world of disruptive innovation in law. A more creative and innovative approach to educating lawyers for the 21st century is needed.

For more on how blockchain is changing business and corporate governance, come by my talk at the University of Tennessee on September 14th where you will also hear from my co-bloggers. In case you have no interest in my topic, it's worth the drive/flight to hear from the others. The descriptions of the sessions are below:

Session 1: Breach of Fiduciary Duty and the Defense of Reliance on Experts

Many corporate statutes expressly provide that directors in discharging their duties may rely in good faith upon information, opinions, reports, or statements from officers, board committees, employees, or other experts (such as accountants or lawyers). Such statutes often come into play when directors have been charged with breaching their procedural duty of care by making an inadequately informed decision, but they can be applicable in other contexts as well. In effect, the statutes provide a defense to directors charged with breach of fiduciary duty when their allegedly uninformed or wrongful decisions were based on credible information provided by others with appropriate expertise. Professor Douglas Moll will examine these “reliance on experts” statutes and explore a number of questions associated with them.

Session 2: Fact or Fiction: Flawed Approaches to Evaluating Market Behavior in Securities Litigation

Private fraud actions brought under Section 10(b) of the Securities Exchange Act require courts to make a variety of determinations regarding market functioning and the economic effects of the alleged misconduct. Over the years, courts have developed a variety of doctrines to guide how these inquiries are to be conducted. For example, courts look to a series of specific, pre-defined factors to determine whether a market is “efficient” and thus responsive to new information. Courts also rely on a variety of doctrines to determine whether and for how long publicly-available information has exerted an influence on security prices. Courts’ judgments on these matters dictate whether cases will proceed to summary judgment and trial, whether classes will be certified and the scope of such classes, and the damages that investors are entitled to collect. Professor Ann M. Lipton will discuss how these doctrines operate in such an artificial manner that they no longer shed light on the underlying factual inquiry, namely, the actual effect of the alleged fraud on investors.

Session 3: Lawyering for Social Enterprise

Professor Joan Heminway will focus on salient components of professional responsibility operative in delivering advisory legal services to social enterprises. Social enterprises—businesses that exist to generate financial and social or environmental benefits—have received significant positive public attention in recent years. However, social enterprise and the related concepts of social entrepreneurship and impact investing are neither well defined nor well understood. As a result, entrepreneurs, investors, intermediaries, and agents, as well as their respective advisors, may be operating under different impressions or assumptions about what social enterprise is and have different ideas about how to best build and manage a sustainable social enterprise business. Professor Heminway will discuss how these legal uncertainties have the capacity to generate transaction costs around entity formation and management decision making and the pertinent professional responsibilities implicated in an attorney’s representation of such social enterprises.

Session 4: Beyond Bitcoin: Leveraging Blockchain for Corporate Governance, Corporate Social Responsibility, and Enterprise Risk Management

Although many people equate blockchain with bitcoin, cryptocurrency, and smart contracts, Professor Marcia Narine Weldon will discuss how the technology also has the potential to transform the way companies look at governance and enterprise risk management. Companies and stock exchanges are using blockchain for shareholder communications, managing supply chains, internal audit, and cybersecurity. Professor Weldon will focus on eliminating barriers to transparency in the human rights arena. Professor Weldon’s discussion will provide an overview of blockchain technology and how state and nonstate actors use the technology outside of the realm of cryptocurrency.

Session 5: Crafting State Corporate Law for Research and Review

Professor Benjamin Edwards will discuss how states can implement changes in state corporate law with an eye toward putting in place provisions and measures to make it easier for policymakers to retrospectively review changes to state law to discern whether legislation accomplished its stated goals. State legislatures often enact and amend their business corporation laws without considering how to review and evaluate their effectiveness and impact. This inattention means that state legislatures quickly lose sight of whether the changes actually generate the benefits desired at the time off passage. It also means that state legislatures may not observe stock price reactions or other market reactions to legislation. Our federal system allows states to serve as the laboratories of democracy. The controversy over fee-shifting bylaws and corporate charter provisions offers an opportunity for state legislatures to intelligently design changes in corporate law to achieve multiple state and regulatory objectives. Professor Edwards will discuss how well-crafted legislation would: (i) allow states to compete effectively in the market for corporate charters; and (ii) generate useful information for evaluating whether particular bylaws or charter provisions enhance shareholder wealth.

Session 6: An Overt Disclosure Requirement for Eliminating the Duty of Loyalty

When Delaware law allowed parties to eliminate the duty of loyalty for LLCs, more than a few people were appalled. Concerns about eliminating the duty of loyalty are not surprising given traditional business law fiduciary duty doctrine. However, as business agreements evolved, and became more sophisticated, freedom of contract has become more common, and attractive. How to reconcile this tradition with the emerging trend? Professor Joshua Fershée will discuss why we need to bring a partnership principle to LLCs to help. In partnerships, the default rule is that changes to the partnership agreement or acts outside the ordinary course of business require a unanimous vote. See UPA § 18(h) & RUPA § 401(j). As such, the duty of loyalty should have the same requirement, and perhaps that even the rule should be mandatory, not just default. The duty of loyalty norm is sufficiently ingrained that more active notice (and more explicit consent) is necessary, and eliminating the duty of loyalty is sufficiently unique that it warrants unique treatment if it is to be eliminated.

Session 7: Does Corporate Personhood Matter? A Review of We the Corporations

Professor Stefan Padfield will discuss a book written by UCLA Law Professor Adam Winkler, “We the Corporations: How American Businesses Won Their Civil Rights.” The highly-praised book “reveals the secret history of one of America’s most successful yet least-known ‘civil rights movements’ – the centuries-long struggle for equal rights for corporations.” However, the book is not without its controversial assertions, particularly when it comes to its characterizations of some of the key components of corporate personhood and corporate personality theory. This discussion will unpack some of these assertions, hopefully ensuring that advocates who rely on the book will be informed as to alternative approaches to key issues.


September 1, 2018 in Ann Lipton, Compliance, Conferences, Contracts, Corporate Governance, Corporate Personality, Corporations, Current Affairs, Employment Law, Human Rights, Intellectual Property, International Business, Joan Heminway, Joshua P. Fershee, Law School, Lawyering, LLCs, Marcia Narine Weldon, Real Property, Shareholders, Social Enterprise, Stefan J. Padfield, Teaching, Technology, Web/Tech | Permalink | Comments (0)

Friday, August 31, 2018

When in doubt, I can always post about litigation limits in corporate governance documents

It's not that there isn't other news, it's just that this is swimming in warm water.  A few days ago, SurveyMonkey filed an S-1 for its forthcoming IPO, and there are a few things that jumped out at me.

First, there's a survey!



(Okay, I'm feeling a little attacked right now.)

Second, there's a warning!  I previously warned about warnings; poorly drafted ones can warn the registrant right out of a truth on the market/materiality defense if there's a subsequent securities fraud claim.  SurveyMonkey seems to get it right, though:


So, unlike warnings that have gotten issuers into trouble in the past, this one doesn't explicitly tell anyone not to rely on external information.  It's just warning you that external information isn't attributable to SurveyMonkey.

(Which, incidentally, highlights the artificiality of the entire exercise; does anyone seriously believe that from an investor/market perspective, there's any real difference between "you should only rely on us" language and "we have not authorized anyone else" language?)

And finally, as I promised in my subject line, there's the litigation limit:


Okay, so much to talk about here.  First, if you've been following along, you know that I've repeatedly posted about - and written one article and one book chapter discussing - the question whether corporate governance documents can limit federal securities claims.  My view is, they can't.  But, as I previously mentioned, that issue is currently being tested in Delaware, with oral argument currently scheduled for September 27, so we may have a clear answer soon (umm, well, after the appeal that I assume will follow whatever the Chancery court decides).

And this matters a heckuva lot, because funneling Securities Act claims into federal courts may not seem like much of a deal, but that's just a stalking horse for the more explosive question, namely, whether corporations can use their governance documents to require that federal securities claims be arbitrated, and likely, arbitrated individually rather than on a class basis.  That issue has seen a resurgence of interest, with SEC Commissioners current and former seeming to encourage the idea, and the Consumer Federation of America recently issuing a white paper arguing against it.  If Delaware decides - as I think it should - that litigation limits in corporate governance documents can only be applied to state claims, then it's difficult to see what mechanism companies could use to dictate the arbitration of federal claims, no matter what the SEC says. (Though I suppose they'll come up with something, but there will then be the question whether that "something" is a contract subject to the Federal Arbitration Act, etc, etc.)

Finally, I note that SurveyMonkey put its forum selection clause in its bylaws.  That's a change from other companies that recently went public, like Snap, Roku, Blue Apron, and Stitch Fix, all of which included the provisions in their charters where they would be much more difficult for shareholders to change (umm, also, some of those shareholders can't vote).  In any event, SurveyMonkey is implicitly giving its shareholders the option of repealing the bylaw if they want to (assuming SurveyMonkey's directors don't, you know, change it right back).

So, that's the state of play, and as far as I'm concerned the ball's now in Delaware's - not the SEC's - court.

August 31, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, August 25, 2018

A Tesla Riddle: When is 2/3 x 1156 < 300?

If you’re like me, you’ve been riveted by the Tesla drama and Elon Musk’s off-the-cuff, possibly Ambien-high, tweet announcing that he planned to take the company private at $420 per share, only to finally admit yesterday that, no, Tesla would stay public after all.

In any event, back when the idea was first floated, and investors (and, I assume, Musk’s counsel) demanded more information about this take-private scheme, Musk vaguely announced that he expected most shareholders – perhaps as many as two-thirds – would stay with the company, and roll over their shares into a special purpose vehicle.  He even invited shareholders to remain invested, writing, “I would like to structure this so that all shareholders have a choice. Either they can stay investors in a private Tesla or they can be bought out at $420 per share.”

Much has been written about this proposal, including all the reasons why it didn’t make financial sense, and the evidence that no, he never had funding or a plan, and now the SEC is investigating, and so forth, but there’s really one aspect I want to focus on, which is, the proposal never could have worked, because you can’t go private that way.

Companies incur the responsibility to periodically, and publicly, report on their financial status if they have a class of securities outstanding and traded by the public (with various definitions and trigger points for what that means).  In this case, we’re talking about public reporting obligations Tesla incurred by making its stock available to the public.  (A whole ’nother question might be whether the company would have maintained reporting obligations for its bonds, but let’s stick to stock for now.)

When that stock is no longer publicly held – which, under the Securities Exchange Act, means owned by fewer than 300 shareholders – the company has the option to “go dark” and cease reporting publicly.  So for Tesla to do this, it would have had to somehow get itself down to under 300 shareholders – while, according to Musk, still keeping most of the shareholder base.

His thinking, apparently, was that if one giant fund was created, and that fund held Tesla stock, and then two-thirds of Tesla’s current shareholders bought shares of the fund, then Tesla would have one shareholder – the fund – and would no longer have reporting obligations.

One potential problem with this idea is that then the fund would be considered public and might have its own reporting obligations, but leaving that point aside, the idea still wouldn’t fly.  Ordinarily, he’s right: if a fund or a vehicle or a trust holds shares in a company, it is considered a single holder for the purposes of a shareholder count.  This, in fact, is exactly what’s happened with Uber, as I previously posted: a couple of funds sprung up that bought Uber stock and sold fund shares to investors, thus allowing investors to gain exposure to a “private” company whose stock wouldn’t ordinarily be available to them.  But the SEC will only allow that if the funds are formed independently of the subject company.  As the SEC explained, they’ll look through to the fund’s real investors if the fund is simply a sham to evade reporting requirements, which is exactly what Musk announced that he planned to do.

That said, it’s not impossible that Musk would have been able to get Tesla down to fewer than 300 shareholders while maintaining two-thirds of the old shareholder base, in a manner of speaking (if he had the funding, and a plan, etc), but almost certainly some shareholders would have to be forced out, i.e., there would be no choice available to them.

The SEC has an odd way of counting shareholders.  If the shareholder keeps the shares titled in the name of his or her brokerage company, which most shareholders do, the brokerage company counts as the shareholder.  Because lots of beneficial owners of Tesla stock use the same set of brokerage companies, that means that the official count of Tesla shareholders is much lower than the real number.  In fact, Tesla’s latest 10-K says that Tesla has 168,919,941 shares of common stock outstanding, but only 1,156 shareholders of record.  Obviously, the true number of shareholders is much higher, but the official number is 1,156, because of the practice of holding shares through brokerage companies. 

So getting down to fewer than 300 shareholders is not so far-fetched.  To use an extreme example, if Musk offered a buyout and one-third of the shareholders accepted, but the remaining two-thirds all happened to hold their shares through, say, JP Morgan, Tesla could get itself down to a single shareholder of record. 

But here’s the rub:  I’m assuming that large institutional investors use a lot of the same large brokerage companies.  Which means, even though there are something like 886 institutional holders, the number for SEC purposes may in fact be much lower.  At the same time, though, retail shareholders hold 23% of Tesla stock.  I’m guessing that they also hold in a more far-flung set of brokerage companies, maybe even some hold in their own names, and of course, they each hold much smaller amounts of Tesla stock than do institutions.  So it’s very likely that, to get down to fewer than 300 shareholders, these are the ones Tesla would have to buy out.  And these are the shareholders who are unlikely to want to sell, because Tesla retail shareholders are a particularly devoted set of true believers.  Given a choice, many would likely to want to stay with the company.

They could, however, be forced out. For example, a company can do a reverse stock split at a very high ratio – like, 1 to 1,000 – and thereby cash out anyone who holds less than 1,000 shares.  After such a split, voila!  The company has fewer than 300 shareholders.  (Matt Levine discusses a recent example; and here’s a funny story from when Bacardi tried, and failed, the same trick).  If Tesla wanted to go that route, it could sort of keep two-thirds of its shareholders – in the sense that, the original holders of two-thirds of those 168,919,941 shares might still be in place – while bringing the official shareholder count down below 300.  But once again, the involuntary nature of that plan does not at all sound like what Musk was describing, and there’s no need to use a special purpose vehicle to accomplish it.

August 25, 2018 in Ann Lipton | Permalink | Comments (6)

Saturday, August 18, 2018

The Ninth Circuit Tries to Rein in Extraneous Documents in Securities Motions to Dismiss

I try to explain to people that the motion to dismiss in a securities case is a unique animal; the complaints, and the briefing, are not like motions to dismiss in any other area of law.  When it comes to securities cases – especially class actions – the motion to dismiss is really a mini motion for summary judgment.  This week, in a case called Khoja v. Orexigen Therapeutics, No. 16-56069, the Ninth Circuit tried to draw a line in the sand, but as far as I’m concerned, did not go nearly far enough.

It all begins with the Private Securities Litigation Reform Act, which heightens the pleading requirements in securities cases.  Among other things, the Act requires that plaintiffs “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” Additionally, plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted” intentionally or recklessly. 15 U.S.C. §78u-4.

As Hillary Sale has documented in the context of scienter pleading, and as I myself experienced over the course of my 1o-ish year-long career as a plaintiff-side securities litigator, over time, courts have incrementally raised the bar for what kinds of evidence they will accept as meeting these standards.  To some extent, there’s a kind of one-way ratchet effect: plaintiffs hit upon the idea of using confidential witnesses to bolster the complaint’s allegations, and pretty soon they became de rigueur, to the point where the lack of such sources is viewed as a weakness, and so forth.  Moreover, as Nancy Gertner pointed out in another context, the judicial habit of writing long opinions explaining the reasoning for dismissing a case – and often (though not always) writing shorter, brief orders when refusing to dismiss – creates a body of caselaw stacked against plaintiffs.  Point being, securities complaints are subject to an extraordinary degree of scrutiny not present for many other kinds of actions.

One aspect of securities pleading that has grown worse over time is courts’ willingness to consider materials beyond the four corners of the complaint.  Though the general rule is that on a motion to dismiss, courts can only consider the complaint itself, there are two significant exceptions.  First, courts may consider “matters of which a court may take judicial notice,” and second, courts may consider “documents incorporated into the complaint by reference.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007).  The principles behind these rules are relatively uncontroversial.  Judicial notice is supposed to be a relatively narrow category: Rule 201 permits notice of facts “not subject to reasonable dispute” because they “can be accurately and readily determined from sources whose accuracy cannot reasonably be questioned.”  Meanwhile, the “incorporated by reference” doctrine was intended to prevent plaintiffs from cherry-picking from documents – like, selecting part of a quote and leaving out the qualifier so as to create a false impression of what the defendant said.

But these narrow exceptions to the general rule against looking beyond the complaint have been stretched to the breaking point in securities litigation.  Today, it is common for defendants to submit hundreds of pages of supplemental material on a motion to dismiss.  Using one or both of these exceptions, courts consider SEC filings, court filings, press releases, federal agency reports, news articles, analyst reports, stock prices, accounting standards, patent applications, complaints and briefs in other cases, to name a few examples (See, e.g., Wolfe v. Aspenbio Pharma, 2012 WL 4040344 (D. Colo. Sept. 13, 2012); Carlucci v. Han, 2012 WL 3242618 (E.D. Va. Aug. 7, 2012); In re XenoPort, Inc. Sec. Litig., 2011 WL 6153134 (N.D. Cal. Dec. 12, 2011); In re MBIA, Inc. Sec. Litig., 700 F. Supp. 2d 566 (S.D.N.Y. 2010); Wilamowsky v. Take-Two Interactive Software, Inc., 818 F. Supp. 2d 744 (S.D.N.Y. 2011); In re American Apparel, Inc. S’holder Litig., 2012 WL 1131684 (C.D. Cal. Jan. 13, 2012); In re Seracare Life Sciences, Inc., 2007 WL 935583 (S.D. Cal. Mar. 19, 2007); In re White Elec. Designs Corp. Sec. Litig., 416 F. Supp. 2d 754 (D. Ariz. 2006)).  Honestly, the supply of extraneous material is endless. 

Partly, this is because plaintiffs cite and identify many sources to satisfy the particularity standards (thus opening the door for defendants to introduce documents “referenced”), and partly, this is because the fraud on the market context – with its vague articulation of what counts as publicly available information – invites introduction of any document that might, in any sense, be deemed publicly available.  And partly, this is because so much of these disputes play out in SEC filings - which are at least noticeable as publicly-filed regulatory documents - it’s easy for defendants to drop a Tolstoy novel’s worth of them into an appendix.

From my perspective, the problem, really, is less that these documents are introduced at all than the matters for which they are introduced, namely, what they purport to establish.  And that’s where the Khoja case comes in.

First –and perhaps most usefully – in Khoja, the Ninth Circuit simply made clear that it is important for district courts to think carefully about why they are considering a document and what its relevance is.  In my experience, when faced with hundreds of exhibits produced by defendants (and often little pushback from plaintiffs, because of page limitations and because fighting too hard about authentic documents appears too defensive), district courts often simply say they are generally noticing the documents, without explaining what, precisely, they are considering and why.  The Khoja decision demonstrates that this is insufficient: If the district court is relying on a document submitted by the defendants to dismiss a complaint, it should explain its reasoning.

Next, Khoja makes clear that when it comes to judicial notice, courts should articulate what, exactly, they are noticing.  Identifying the document is not sufficient: That a document was filed with a public agency may be noticeable; that the document demonstrated the agency had knowledge of a particular fact by a particular date may also be noticeable.  But the truth of facts asserted within those documents, or the implications of those documents, are not judicially noticeable facts.  Courts need to make the appropriate distinctions.

Here’s where I think the Ninth Circuit did not go far enough.  Usually for these kinds of documents – even ones never cited by plaintiffs – courts notice them for the purpose of making assumptions about what “the market” knew and when it was known, or how the stock price reacted.  This is the nub of the problem.  Some nominally “public” documents – like obscure court filings – may or may not have had an impact on the market, depending on whether they came to traders’ attention: courts cannot make assumptions without further evidence.  Further, a document purporting to “reveal the truth” to the market may seem straightforward, but it’s difficult to say how the market interpreted the document without resort to even further evidence of analyst reports, news articles, and so forth, all of which may not be before the court.  And price impact?  Without expert analysis, what counts as impact (or what may have been confounded by other news) is impossible to tell.  The motion to dismiss is not the appropriate stage at which to resolve these disputes.

There is also often a danger that courts will accept the facts in these documents as truthful.  SEC reports of insider stock sales, for example; yes, they were filed, but they cannot be assumed (on a motion to dismiss) to represent a complete and accurate portrait of the defendants’ trading history.  (The story is different if the plaintiffs themselves cite the document for that purpose - discussed below). 

Okay, that’s judicial notice.  A separate and distinct basis for a court to consider an extraneous document is when the plaintiffs themselves incorporated the document by reference.  In this scenario, the Ninth Circuit set different ground rules.  First, the complaint must “refer[]extensively to the document or the document forms the basis of the plaintiff’s claim” to be considered at all.  Second, according to the Ninth Circuit, unlike in judicial notice, the contents of an incorporated document may be assumed to be truthful, but “it is improper to assume the truth of an incorporated document if such assumptions only serve to dispute facts stated in a well-pleaded complaint.” 

I don’t think the court is wrong here, exactly, but the standard should be articulated more precisely.  Certainly, not every document relied on by plaintiffs can be assumed to be truthful (what if the plaintiffs alleged the document was a false press release?)  What the court is grappling with is the scenario where plaintiffs use a document as the basis for an allegation, so that the plaintiffs themselves implicitly accept it as truthful.   For example, the plaintiffs may rely on a news article, or a government report, that purports to describe the “true facts” at the company at the time the defendants made the allegedly fraudulent statements.  A tempting rule of thumb is that the plaintiffs should accept the bitter with the sweet: if they themselves are alleging the document has accurately described the facts, then defendants should also be able to rely on it for that purpose.

But some of these documents may be long, or complex, or contain different anecdotes and explanations for different time periods.  It is overinclusive to say that if plaintiffs rely on one specific description in one part of a document, then all other parts of the document should also be treated as truthful for 12(b)(6) purposes, including for the purpose of injecting entirely new facts into the motion to dismiss. 

My experience with this comes from the mortgage-crisis era cases that dominated the latter part of my career.  We would sometimes rely on something like the FCIC Report – which is 662 pages long – or even Michael Lewis’s The Big Short, which is only a few hundred pages long.  We might cite a total of 10 pages, but we were occasionally met with an argument that the entire document should be considered by the court, and assumed to be truthful in all respects – even though we, as plaintiffs, were only basing our allegations on limited excerpts.

In my view, this is difficult balancing act for courts: Cherry picking may be unfair – if plaintiffs rely on a story, necessary parts of the story should not be ignored.  But at the same time, unrelated sections of the document should not be assumed to be true for 12(b)(6) purposes merely because the plaintiffs relied on a few, separate portions.

What it comes down to is, the complaint is a highly selective set of allegations – no doubt.  But so are documents submitted by defendants in rebuttal.  When the defendants’ documents add necessary context to the specific facts being alleged by plaintiffs, so that those facts are rebutted or recontextualized, it is appropriate to consider them on a motion to dismiss.  Past that – that’s why we have summary judgment and, eventually, trial.


August 18, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, August 11, 2018

When Sinclair Met the FCC

As many readers are likely aware, the proposed acquisition of Tribune Media Company by Sinclair Broadcast Group fell through when the FCC referred the matter to an administrative hearing, thus creating a nearly-insurmountable roadblock to closing.  On Thursday, Tribune filed a complaint against Sinclair in Delaware alleging that Sinclair breached the merger agreement by failing to use its best efforts to win regulatory approval.  The complaint is an entertaining read and regardless of the outcome, I’m quite certain it will prove to be a vivid classroom example of best efforts clauses in the merger context. 

The basic gist of the complaint is that Sinclair agreed to use its best efforts to win regulatory approval, and it was entirely foreseen by the parties that the relevant regulators – the Justice Department and the FCC – would want divestments in 10 specific markets.  Nonetheless, Sinclair stonewalled the DOJ (at one point actually telling the Assistant Attorney General “sue me”), and submitted sham divestment plans to the FCC that involved, well:

selling WGN-TV in Chicago to Steven Fader, a close associate of [Sinclair Executive Chair David] Smith’s in a car dealership business who had no experience in broadcasting. Sinclair also proposed the sale of WPIX, a New York station, to Cunningham Broadcasting Corporation, a company that owns numerous television stations that are operated by Sinclair employees under joint sales and shared services agreements, has tens of millions of dollars in debt guaranteed by Sinclair, and had been controlled by the estate of Smith’s late mother until January 2018.

…When Sinclair’s applications were subject to public comment, opponents of the divestitures revealed facts that Sinclair had failed to disclose to the FCC …. For example, Sinclair had not told the FCC, in its applications, that Smith owned the controlling interest in Fader’s car dealership company, and that Cunningham’s controlling shares had been sold at a suspiciously low price only months earlier to a Sinclair associate with re-purchase options held by Smith’s family members.

All of which, predictably, submarined the merger and breached Sinclair’s obligations to Tribune.

Now, I have no idea what exactly happened, but I can imagine a cynical story.  The cynical story goes something like, Sinclair is a conservative media organization and the merger was favored by Trump.  The FCC’s Chair, Ajit Pai, up until now had bent over backwards to accommodate Sinclair, up to and including loosening regulations that allowed the merger to proceed.  (Currently, Pai is under investigation by the FCC’s inspector general to determine if these regulatory maneuvers were impermissibly timed to benefit Sinclair).  As a result – and knowing that the Trump administration is not renowned for its religious devotion to the minutiae of regulatory procedure – when Sinclair signed the merger agreement, it reasonably believed that its best efforts would not in fact, require it to divest anything (an expectation that may have gotten support from past practice), and was completely blindsided when matters went the other way (as was, apparently, Washington).  Certainly, there have been reasonable grounds to believe that this administration occasionally intrudes upon agency decisionmaking.

There’s also a story where the merger was denied because it strengthen a competitor to Fox News, Trump’s favorite network, though I don’t believe the historical evidence bears that out.

Either way, if Sinclair were to make an argument along these lines – not that I expect it to, this is a thought experiment – how should the contract itself be interpreted?

Essentially, this is the conundrum that Delaware Chief Justice Leo Strine anticipated when he spoke earlier this year at the Tulane Corporate Law Institute.  As I wrote at the time:

[R]eferencing the then-current dispute between Broadcom, Qualcomm, and CFIUS … he explained that judges often have to make difficult decisions about the interpretation of closing conditions that involve regulatory approvals.  In the past, judges could at least be confident that, whether you agree with the regulator or not, regulation was not being done “sideways.”  If, however, regulation is going to be used for other than its original purposes – such as for protectionist purposes – that will affect how courts address after-the-fact disputes about why deals fell through.

In other words, Delaware judges have to have faith in the legitimacy of the regulatory process in order to evaluate these kinds of disputes; without it, it becomes much harder to interpret “best efforts” clauses that involve entanglement with federal regulators.

August 11, 2018 in Ann Lipton | Permalink | Comments (0)

Friday, August 3, 2018

More on Crypto

As most readers of this blog are likely aware, the theory behind initial coin offerings and “smart” contracts is that the code itself is entirely transparent and self-executing; the terms of the contract are set in the programming, thus eliminating the need for enforcement mechanisms or for messy legal disputes over interpretation.  The code dictates the agreement, and the code enforces it; investors curious about terms of an investment can simply read the code and have utter certainty as to the nature of the agreement. 

As Matt Levine described it, “If you invest your Ether in a smart contract, you’d better be sure that the contract says (and does) what you think it says (and does).  The contract is the thing itself, and the only thing that counts; explanations and expectations might be helpful but carry no weight.”  Primavera De Felippi and Aaron Wright dubbed this system “lex cryptographica.”

But problems arise when the code diverges from the white paper summary typically distributed to potential purchasers.  Famously, for example, in the case of one project known as the DAO, a “flaw” in the code allowed a “hacker” to steal Ether currency from investors.  Or did it?  Matt Levine explained, “The descriptions didn't matter; only the code did. The descriptions didn't allow for today's hack, but the code did. (By definition! If the code could be hacked, the code allowed for the hack.) Any vulnerabilities in the DAO's code were not flaws in the code; they were flaws in the descriptions -- which were purely for entertainment purposes.”

Which brings us to Coin-Operated Capitalism, a new paper by Shaanan Cohney, David Hoffman, Jeremy Sklaroff & David Wishnick.  They compare the white paper descriptions to the actual code underlying the fifty top grossing ICOs in 2017, and conclude that the two regularly diverge on three critical aspects: whether there are any supply restrictions on the assets, whether there are transfer restrictions on assets distributed to insiders, and whether the code can be modified.  Signifcantly, the authors also found no evidence that these misdescriptions in any way harmed the initial capital raise or affected trading prices thereafter, suggesting that – as the authors conclude – “no one reads smart contracts.”

These results present a challenge to crypto evangelists who hope smart contracts will eventually replace legal institutions, and lend further support for the notion that the demand for ICOs is based on a speculative frenzy rather than any true demand for the products or companies underlying the sales.

August 3, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, July 28, 2018

Saturday Movie Blogging: Sorry to Bother You

The indie hit Sorry to Bother You was recently described as “the most overtly anticapitalist feature film made in America.”

Riffing off the well-documented phenomenon that people respond to telephone calls based on the perceived race of the caller, Sorry to Bother You tells the story of a young black man, Cassius Green – Cash is Green, get it? – who goes from rags to riches by using his “white voice” for telemarketing.  As Cash climbs the corporate ladder, he is torn between his newfound prosperity and loyalty to his old friends.

But that bare description of the film’s premise is hardly preparation for the surreal dystopian fantasy that follows.  The plot is nearly beyond description, but most of the action centers on WorryFree, a labor contracting company that offers its employees dormitory-style housing and cafeteria-tray meals in exchange for lifetime work commitments – an arrangement deemed not to be slavery after congressional investigation.  A proto-anarchist movement struggles to disrupt WorryFree’s operations and unionize Cash’s workplace, but mass media and viral marketing allow even the protests to be commodified and sold as entertainment.  As such, the film dramatizes the concept of narcotizing dysfunction, where knowledge of an issue is substituted for action to oppose it.  Ultimately, the message is that in a capitalist society, all labor is slavery; some settings are simply more luxurious than others.  Therefore, the only solution is a militant class solidarity.

The film is uneven and a bit slow to get going; some of the earlier scenes, especially, feel like filler.  That said, most of it packs quite a wallop.  Particularly standout moments include a party where, after “passing” as white to achieve professional advancement, Cash must perform a grotesque modern minstrel to curry favor with white society, as well as just about any scene in which Cash’s girlfriend, an avant-garde performance artist with an endless supply of sexually explicit and/or violent homemade apparel, makes an appearance.

As one review put it, “one of the secondary pleasures of watching ‘Sorry to Bother You’ is sifting through its possible influences.”  Reviewers have compared it to a host of other satires of capitalism and race relations, but if you ask me, Sorry to Bother You is the spiritual descendant of Little Shop of Horrors

Of course, Little Shop of Horrors is a lot less radical, and doesn’t have a racial message (unless that message is, “our Skid Row exists in a nearly all-white alternate universe”), but similarly tells the phantasmagoric story of a nebbishy guy who finds capitalist success via Faustian bargain.  I’d also argue that they have a somewhat similar visual aesthetic in their depiction of slum life and the petite bourgeoisie.

In sum, it’s difficult to imagine a film capturing the current zeitgeist as well as Sorry to Bother You.  So, if you’re not getting enough of that in your ordinary life – or you just want to see a version of it starring prettier people – it’s worth checking out.

July 28, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, July 21, 2018

Managers Behaving Badly

This has been a banner week for embarrassing corporate manager stories.  In addition to the sudden resignation of Texas Instruments CEO Brian Crutcher for unspecified code-of-conduct violations (echoing the earlier, sudden firing of Rambus CEO, also for unspecified conduct violations) and Paramount’s firing of Amy Powell for racist commentary, Tesla’s Elon Musk ran into public relations trouble after a revelation that he donated to a Republican PAC, from which he cannily diverted attention by accusing one of the Thai cave diving rescuers of pedophilia.  Meanwhile, Papa John’s Founder and Chair John Schnatter – who previously was forced to resign as CEO after white nationalists were too enthusiastic about his condemnation of the NFL and protesting football players – was revealed to have used a racist slur on a conference call designed to prevent his racism from creating PR disasters.  That incident caused the Board to strip him of his chairperson title and remove his face from marketing materials, while the University of Louisville took his name off of its stadium.  Later, Forbes published an expose on the sexist and unprofessional culture at Papa John’s that he enabled – which incidentally confirms Ben Edwards’s post linking corporate cultures that tolerate sexual harassment to corporate cultures with other kinds of dysfunction.

Schnatter plans to fight to have his position restored.  Meanwhile, there’s no sign that shareholders or the Board of Tesla plans to remove Elon Musk, but shareholders are certainly beginning to chafe at his relentless attention-seeking

In both the Musk and Schnatter cases, the shareholders may have minimal options.  Schnatter owns roughly 30% of Papa John’s stock, and he has not resigned from the Board.  It is unclear what the next steps are going to be but he may be tough to oust, and may even be able to regain his Chair position.  (It would be awfully entertaining if he was forced to mount a proxy contest to maintain his seat but I assume one way or another it won’t come to that).  Meanwhile, Musk, who owns around 21% of Tesla’s stock, was deemed to be a controlling shareholder by a Delaware court, and thus would also be difficult to dislodge even if shareholders were so inclined.  Moreover, both Schnatter and Musk are paid in additional stock, which only increases their hold over their respective companies.  When Schnatter was CEO, roughly half of his compensation came in equity; as a director, his compensation package is smaller but still includes equity.  Musk shareholders, meanwhile, recently approved a massive equity award that could be worth as much as $50 billion if Musk meets certain milestones.

(Of course, it’s not impossible to get rid of a troublesome board member with a large but minority position -– as American Apparel can attest – but it isn’t a picnic, either).

Now, the trend of paying corporate executives in stock rather than cash is relatively recent; it took off in the 1990s as a way of aligning executives’ interests with shareholders’ interests.  And there are arguments about it back and forth – some say it encourages short-termism, others respond by saying you can have long term vesting schedules that alleviate that effect, there are disputes about how to design pay packages so they reward shareholder return rather than market conditions, etc – but one remaining concern might be that stock awards result in greater managerial control over their companies and therefore insulate them from shareholder discipline.

So, I ask – and I’ll admit, there are a lot of people who have thought very deeply about executive compensation and appropriate incentives, and I am … not one of them, so this may be either unhelpful or banal – but since dual-class stock is all the rage, have we considered paying corporate executives at least partially in nonvoting stock?  It could be structured to have all of the economic benefits of ordinary stock, and even automatically convert into voting stock as soon as the executive transfers it to a nonaffiliate (assuming, of course, the stock comes with the same restrictions/vesting schedules etc that ordinarily accompany such awards to prevent short-termism).  That way, corporate executives would be rewarded financially for increasing shareholder value, but their control over their companies would not be tightened.  The thinking here is that corporate execs already have plenty of control – they don’t need more – and shareholders may want to reward their financial performance without simultaneously further insulating them from market discipline. 

(To be sure, managers’ control doesn’t come from stock compensation alone – in Papa John’s case, for example, it appears that Schnatter increased his control from 27% to 30% in part through aggressive corporate buybacks, in which he did not participate, than through awards directly.)

But it seems like this is something worth trying.  Sure, there are plenty who argue that managers/founders should have more voting control so that they have room to innovate – here’s the latest paper I saw on that subject, which says yes but only under certain conditions – but that’s not usually the goal of stock compensation, which may unhelpfully conflate two separate things, namely, economic compensation and insider voting power.

July 21, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, July 14, 2018

Whither Controllers?

Several months ago, I posted about the Chancery decision finding Elon Musk to be a controlling shareholder of Tesla for the purposes of Corwin v. KKR Financial Holdings, 125 A.3d 304 (2015), despite the fact that he held only a 22% stake.  The decision took into account both Musk’s stock holdings and his other mechanisms of influence.

One of the reasons the decision stood out was because, while there is a long history in Delaware of considering both voting power and other factors to determine controlling shareholder status, after a certain point, you have to wonder whether the “stockholder” piece is doing any work, and whether instead the question should just be whether someone has effective control, either of the corporation generally or of a particular business decision.

Well, last week, we took a few steps more toward answering that question in Basho Technologies Holdco B, LLC et al v. Georgetown Basho Investors, LLC et al.  There, plaintiffs contended that a minority stockholder was a “controller” for purposes of owing fiduciary duties to the corporation.  Vice Chancellor Laster agreed, based on a holistic inquiry that took into account, among other things, the stockholder’s contractual rights via preferred stockholdings, its use of those rights (to block alternative transactions), its control over certain board members, and those members’ conduct.

But that’s not the important part.  The important part is that Laster laid out a test for “controller” that appears to depend minimally – if it all – on voting power.  As Laster put it:

If a defendant wields control over a corporation, then the defendant takes on fiduciary duties, even if the defendant is a stockholder who otherwise would not owe duties in that capacity. One means of establishing that a defendant wields control sufficient to impose fiduciary duties is for the plaintiff to show that the defendant has the ability to exercise a majority of the corporation’s voting power.  A defendant without majority voting power can be found to owe fiduciary duties if the plaintiff proves that the defendant in fact “exercises control over the business and affairs of the corporation.” …

To show that the requisite degree of control exists generally, a plaintiff may establish that a defendant or group of defendants exercised sufficient influence “that they, as a practical matter, are no differently situated than if they had majority voting control.”  One means of doing so is to show that the defendant, “as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes.”

It is impossible to identify or foresee all of the possible sources of influence that could contribute to a finding of actual control over a particular decision. Examples include, but are not limited, to: (i) relationships with particular directors that compromise their disinterestedness or independence, (ii) relationships with key managers or advisors who play a critical role in presenting options, providing information, and making recommendations, (iii) the exercise of contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths, and (iv) the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier.  Lending relationships can be particularly potent sources of influence, to the point where courts have recognized a claim for lender liability when a lender exercises influence over a company that goes “beyond the domain of the usual money lender” and, while doing so, acts negligently or in bad faith.

Broader indicia of effective control also play a role in evaluating whether a defendant exercised actual control over a decision. Examples of broader indicia include ownership of a significant equity stake (albeit less than a majority), the right to designate directors (albeit less than a majority), decisional rules in governing documents that enhance the power of a minority stockholder or board-level positon, and the ability to exercise outsized influence in the board room, such as through high-status roles like CEO, Chairman, or founder Invariably, the facts and circumstances surrounding the particular transaction will loom large.

All of which begs the question whether stockholder status is necessary at all.  Are pure lenders, or pure board members, potential controllers?  Or is stockholder status a nominal necessity, so that one share is sufficient to begin the inquiry into controller status?  These questions are left unanswered by Laster’s opinion. 

Now, to be fair, no one who has ever studied Martin v. Peyton or Gay Jensen Farms v. Cargill in their Business Associations class would be surprised to learn that a lending relationship may ultimately transform into a control relationship, with associated duties.  That said, it is still striking that Laster concluded that the particular stockholder in Basho was a “controller” for fiduciary purposes without even mentioning how much voting power the controller had, other to say that it was less than a majority.  This nominal controller also did not have more than two appointees to a multi-member board.  Nonetheless, its contractual rights were sufficient to trigger, in Laster’s view, fiduciary duties.

And that just raises more questions.  For example, does a controlling stockholder – versus a controller by any other means – have any special status in this formulation, on the theory that controlling stockholders are uniquely invulnerable to challenge?  Or is control the only relevant inquiry?  And if control by any means is all that is necessary, can Laster’s analysis square with Corwin?  There, the Delaware Supreme Court refused to find controller status where a nominal stockholder nonetheless had complete contractual control of the corporation’s business.

And how are we going to deal with complex capital structures?  Both Tesla and Basho dealt with shareholders who had “blocking” rights – i.e., not enough votes to control the Board and dictate corporate action, but enough to block actions with which they disagreed.  In Tesla’s case, this was because of a supermajority charter provision; in Basho, it was because a private company had issued multiple rounds of preferred financing with bespoke characteristics.  As more companies stay private longer – and as more issue nonvoting stock, and/or high-vote shares – Delaware is going to have to ask more complex questions regarding controlling status and what it precisely entails.  On this point, I note that in Third Point LLC v. Ruprecht, 2014 WL 1922029 (Del. Ch. May 2, 2014), the Chancery court determined that Sotheby’s could properly adopt a low-threshold poison pill in order to prevent a hedge fund from obtaining “negative” control, namely, the power to block corporate action, even if it could not generally control corporate policy.  Is that what counts as control now?  And does that mean – as recommended by Iman Anabtawi and Lynn Stout – that hedge funds now have fiduciary duties? (h/t Eric Goodwin for suggesting the possibility).  As I alluded to in my Tesla post, the questions take on a new urgency in the wake of Corwin and Kahn v. M&F Worldwide, 88 A.3d 635 (Del. 2014).

My final thought is, so much of corporate law these days has a back to the future quality.  Complex capital structures with multiple rounds of financing, different classes of stockholders with different rights – many of which are nonvoting – were once the norm.  Corporate control was relatively concentrated.  For example, when Berle & Means wrote The Modern Corporation, they raised the alarm that one-third of America’s wealth was concentrated among 1800 corporations and 200 men.

That changed.  With the federal regulation of the apparatus for securities issuance and trading, control over the Exchanges, and so forth, one-share-one-vote became the norm, as did dispersed share ownership and control.

Today, it feels like the pendulum has swung back the other way.  As Jan Fichtner, Eelke M. Heemskerk & Javier Garcia-Bernardo put it, “we witness a concentration of corporate ownership not seen since the days of J.P. Morgan and J.D. Rockefeller.” Hidden Power of the  Big  Three?  Passive  Index  Funds,  Re-Concentration  of  Corporate  Ownership, and  New  Financial  Risk, 19 Bᴜs. & Pᴏʟ. 238  (2017).  The statistics are well-known – and I talk about a lot of this in my new article, Shareholder Divorce Court (stealth plug! I am so stealthy!) – but, for example, BlackRock, State Street, and Vanguard together constitute the largest shareholder in 88% of the S&P 500, and 40% of all U.S. listed firms.  In 2005 ownership of the S&P 500 was so concentrated that in any hypothetical conflict between two member firms, 15% of the equity on either side would be held by institutions that preferred the other side to win.

Meanwhile, we’ve begun to depart from a one-share-one-vote norm as more companies offer private financing with different terms, and even maintain differential voting rights after going public.  Even fiduciary duties are up for debate again; they were a matter of some debate back in the early 1900s, they became standard, and now the fastest growing business form is the LLC, which allows fiduciary waivers.  It’s as though in many areas – corporate law being, ahem, but one – we’re going to have to learn the lessons of the 20th Century all over again.

July 14, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, July 7, 2018

Markets and Judicial Magical Thinking

One of the topics I’ve repeatedly discussed in this space is how layers of doctrine have been so piled on top of inquiries like materiality and loss causation in the Section 10(b) context that the legal analysis  has become completely unmoored from the ultimate factual inquiry, namely, did the fraud actually result in losses to investors.  As I put it in one post:

[A]ll of our measures of impact and harm and loss are, at this point, so far removed from reality as to border on complete legal fiction.  Materiality is a construct from case law, with numerous additional doctrines piled on to it by courts without any heed for actual evidence of how markets behave. …. [W]hat we call “harm” and “damage” for the purpose of private securities fraud lawsuits have become so artificial that it no longer seems as though we’re even trying to measure the actual real-world effects of fraud.  I believe private lawsuits are an essential supplement to SEC action but a system of fines or statutory damages would make so much more sense.

This week, I call attention to another recent example of the phenomenon.  In Mandalevy v. BofI Holding, 2018 WL 3250154 (S.D. Cal. June 19, 2018), the plaintiffs alleged that the defendant BofI Federal Bank lied about various money laundering offenses and falsely denied that federal authorities were looking into the matter, in violation of Section 10(b).  The court dismissed their claims on various grounds, including that the plaintiffs had failed to show that they had experienced any losses caused by the defendant’s false denial of an SEC investigation.  The plaintiffs alleged that BofI’s stock price dropped after publication of a New York Post article disclosing the SEC’s interest, but the court observed that the story was based on information that the reporter had obtained by making a FOIA request.  Information available via FOIA, the court concluded, is information generally available to the public, and, by extension, the market.  As a result, the article itself was deemed to have merely summarized previously-public information, and could not qualify as a corrective disclosure that revealed the truth.  As the court explained its reasoning:

The efficient market theory presumes that interested, “information-hungry” market participants are actively and continuously trading a company’s stock. Basic Inc. v. Levinson, 485 U.S. 224, 249 n.29 (1988). One obvious source of information about a particular company is its regulator, particularly when—as we have here—the company has denied the existence of a regulatory investigation in response to reports stating the contrary. The Court must assume that, in the nearly seven months between BofI’s denial [of the investigation] and the October 25 article, a market participant would have made the sensible step of asking the SEC whether BofI’s denial was accurate. The fact that a market participant would have had to jump through a bureaucratic hoop to obtain this information does not mean that the information was not “public.” To the contrary, the Court must assume that “information-hungry” market participants seeking an edge in trading BofI’s stock would expend at least some effort to obtain material information about the company. The Court’s understanding of an efficient market’s collective reach, in other words, cannot be limited to information one can find on Google….

Having been offered no reason to believe that any other market participant could not have made a FOIA request from the SEC about BofI prior to October 25, the Court must assume that he or she did. The CAC therefore fails to allege with particularity a revelation of the falsity of BofI’s March 31 statement.

Let’s take a moment to unpack the factual inferences here that the court is willing to draw at the 12(b)(6) stage: that unspecified investors made a FOIA request, that they got their response faster than the reporter’s own inquiry, and that they used that information to trade in sufficient quantities to completely offset the effects of the initial lie.  And that despite the fact that markets, apparently, can be expected to behave in this manner, these investors believed, ex ante, it would be cost-efficient to justify the time and expense of making the FOIA request in the first place so that they could exploit the information that the request – might! – reveal.

And, it should be noted, in drawing these inferences, the court remained untroubled by the fact that the stock did, in fact, drop upon publication of the Post article. 

Forgive me if I have a little trouble accepting – without any additional evidence – that markets are imbued with this kind of near-mystical perfection.  Indeed, as the Supreme Court made clear, they don’t need to be in order to justify the fraud on the market presumption.   Yet, as Stephen Bainbridge and Mitu Gutali put it, “federal judges are claiming--at least implicitly--a level of expertise about the workings of markets and organizations that, in some areas, not even the most sophisticated researchers in financial economics and organizational theory have reached.”  Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does—Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83 (2002).

To be fair, plenty of other courts approach market evidence with more humility.  For example, in Pub. Empls. Ret. Sys. of Miss., Puerto Rico Teachers Ret. Sys. v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014), the Fifth Circuit concluded that publicly-available raw data – later analyzed and reported in a Wall Street Journal article – could not be presumed to have impacted stock prices because “it is plausible that complex economic data understandable only through expert analysis may not be readily digestible by the marketplace.”  Similarly, in In re Massey Energy Co. Sec. Litig., 883 F. Supp. 2d 597 (S.D. W. Va. 2012), the court refused to presume that information in a public database was sufficiently available to the market to offset defendants’ lies about their safety record.  (Notably – as I previously posted – the Massey court’s intuition that raw data would not be easily digested by investors was subsequently validated by an empirical study of the impact on such information on stock prices.)

That said, despite my snarky subject line, the goal here is less to attack this particular opinion – which follows a line of similar cases that, while perhaps not quite as aggressive, are also willing to draw broad conclusions about market behavior on a thin record – than to question the value of this entire mode of analysis.  It seems increasingly likely that an alternative system that avoids judicial measures of market impact (like, for example, a system of a statutory damages) would better serve investors and deter misconduct.

July 7, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, June 30, 2018

Red Sky At Morning

One of the odd things about teaching business and securities in the Trump era is that it’s been one of the few areas of law that’s been left largely unchanged by this singularly, umm, disruptive presidency.

That may be about to change.

As most readers are likely aware, the Supreme Court recently ruled in Lucia v. SEC that SEC ALJs are inferior officers, and therefore must be appointed by the Commission directly (instead of, as has been traditional, by the SEC staff).  The SEC, anticipating this holding, altered its procedures to have the Commission ratify the staff’s selection.  But – even assuming the ratification is sufficient – the next obvious question is whether, as inferior officers, ALJs must have fewer restrictions on their removal – an issue that, it should be noted, the Solicitor General’s office urged the Court to resolve against the SEC.  This is a much bigger deal, because leaving aside questions about how such a deficiency would be remedied as a technical matter, without such protections, the impartiality of the ALJs – and thus the fairness and, I suspect, the constitutionality of the entire administrative adjudicative process – would be open to question.  Cf. Kent Barnett, Resolving the ALJ Quandary, 66 Vand. L. Rev. 797 (2013) (anticipating these issues).

But that’s only the beginning.

In Janus v. AFSCME and NIFLA v. Becerra, the Supreme Court held that speech that was previously viewed as regulable – namely, required disclosures in the provision of health related services, and dues for union representation – instead would be subject to heightened scrutiny.  In both cases, the dissents pointed out that the Court’s reasoning would jeopardize a wealth of ordinary consumer – and securities – regulation.  As Justice Breyer put it, “In the name of the First Amendment, the majority today treads into territory where the pre-New Deal, as well as the post-New Deal, Court refused to go.”  Justice Kagan was even more blunt in her Janus dissent: “Speech is everywhere—a part of every human activity (employment, health care, securities trading, you name it).  For that reason, almost all economic and regulatory policy affects or touches speech. So the majority’s road runs long. And at every stop are black-robed rulers overriding citizens’ choices.”

And then there’s Masterpiece Cakeshop v Colorado Civil Rights Commission.  There, the Court largely avoided the free speech claim, but the majority opinion stated, “The free speech aspect of this case is difficult, for few persons who have seen a beautiful wedding cake might have thought of its creation as an exercise of protected speech. This is an instructive example, however, of the proposition that the application of constitutional freedoms in new contexts can deepen our understanding of their meaning.” – suggesting, again, the Court is inviting creative new First Amendment challenges to business regulation.  Indeed, a couple of years ago, John Coates empirically demonstrated the increasing use of the First Amendment to challenge business regulation.

As readers are likely aware, the SEC regulates in large part via required (and prohibited) speech.  After Citizens United, Larry Ribstein argued that some proposals for corporate governance and securities regulation might violate the First Amendment.  And, as it turns out, it was only three years ago that the SEC found itself in First Amendment crosshairs with respect to conflict minerals disclosures (umm, that link is to my post on the subject, and it anticipated that the DC Circuit would reconsider the matter en banc, which it … did not, so that only shows how seriously you should take my prognostications).  Rebecca Tushnet has more in-depth discussion of the conflict minerals case.  It seems to me that the SEC is long overdue for a First Amendment reckoning, and the climate has never been more ripe. 

Meanwhile, the Supreme Court has already granted cert to consider whether to reinvigorate the non-delegation doctrine, Justice Gorsuch has ostentatiously cast doubt on the viability of Chevron,* and Trump is expected to appoint a new conservative justice in the coming months – which will only encourage more aggressive litigation.  All of which suggests we’re about to see a rather dramatic dismantling of the regulatory state – including the SEC’s authority.

*although, to be fair, no one ever deferred much to the SEC anyway – which is like the Rodney Dangerfield of agencies – so Chevron’s fate may not end up making much difference to it.

June 30, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, June 23, 2018

These days, a knotty Janus problem almost seems like a comfort

The Supreme Court just granted cert in Lorenzo v. Securities & Exchange Commission to decide the scope of primary liability/scheme liability under the federal securities laws.  It’s an important issue and I’m glad that the Court seeks to clarify the law, but I have to say that procedurally speaking, this strikes me as an odd grant.

Below is way too long a post; it’s so much easier to write long than take the time to edit down, so forgive the extended backstory.  (Also, for the record, I pulled a lot of the citations from my  - very first! - real law review article, Slouching Towards Monell: The Disappearance of Vicarious Liability Under Section 10(b), which contains a long discussion of Janus, primary liability, and secondary liability, so, you know, enjoy if you’re into that).

[More under the jump]

Continue reading

June 23, 2018 in Ann Lipton | Permalink | Comments (0)

Friday, June 15, 2018

Beware of the Warning

Last week, a district court in California denied a motion to dismiss a securities fraud lawsuit brought by Snap shareholders.  See In re Snap Inc. Secs. Litig., 2018 U.S. Dist. LEXIS 97704 (C.D. Cal. June 7, 2018).  The shareholders alleged that the Snap IPO prospectus omitted certain critical information in violation of Sections 10(b) and 11, namely, information about the effect of competition from Instagram, and information about the risks posed by a lawsuit filed by an ex-employee – a lawsuit that I previously blogged about here (prior to the IPO, it should be noted).  There was also an additional claim regarding post-IPO statements, brought only under Section 10(b).

Among other things, the defendants argued that there was sufficient information in the public domain about both the Instagram risk, and the lawsuit risk, to render any nondisclosure immaterial as a matter of law.  The district court rejected that argument because Snap’s own prospectus contained the following language:

You should rely only on statements made in this prospectus in determining whether to purchase our shares, not on information in public media that is published by third parties.

Thus, in the district court’s view, Snap's own statements “counteracted” any contrary information made publicly available.

This is an issue that comes up with surprising frequency.  For example, when shareholders sued Facebook in the wake of its IPO, Facebook argued that information allegedly omitted from its prospectus had in fact been heavily publicized in the media.  At that point, the court hoist Facebook on its own petard, highlighting prospectus language that said, “In making your investment decision, you should not rely on information in public media that is published by third parties.  You should rely only on statements made in this prospectus in determining whether to purchase our shares.”  In re Facebook, Inc. IPO Sec. & Derivative Litig., 986 F. Supp. 2d 487 (S.D.N.Y. 2013).  This point also tripped up the defendants in Fresno Cty. Emples. Ret. Ass'n v. comScore, Inc., 268 F. Supp. 3d 526 (S.D.N.Y. 2017), and S.E.C. v. Bank of Am. Corp., 677 F. Supp. 2d 717 (S.D.N.Y. 2010).

What’s interesting in the Snap example, though, is that all of the prior cases involved claims that did not require proof of relianceFacebook involved Section 11 alone; comScore decided the issue in the context of Section 14; and Bank of America was a government enforcement action.  Snap represents the first time (that I’m aware) that this argument has prevailed even in the fraud-on-the market context – i.e., the context where you could imagine that disclaimer or no, some investors would price the extraneous information into the stock, thereby correcting any artificial inflation in the market price and defeating any allegation of reliance by most public purchasers. 

In any event, I gather that at least some companies have gotten wise and omitted or altered these kinds of non-reliance instructions.  I couldn’t find comparable language in the prospectuses for Roku and Dropbox at all (did I miss it?), and the Twitter prospectus – issued before the Facebook opinion, but in the midst of the Facebook briefing – says:

In making your investment decision, you should understand that we and the underwriters have not authorized any other party to provide you with information concerning us or this offering.

You should carefully evaluate all of the information in this prospectus. We have in the past received, and may continue to receive, a high degree of media coverage, including coverage that is not directly attributable to statements made by our officers and employees, that incorrectly reports on statements made by our officers or employees, or that is misleading as a result of omitting information provided by us, our officers or employees. We and the underwriters have not authorized any other party to provide you with information concerning us or this offering.

Note the distinction: It’s not telling investors not to rely on extraneous information, or even that all such information is false; it’s just saying some might be false, and none of it was authorized by Twitter.

Point being, I assume that whatever law firms haven’t gotten the message will soon enough.

June 15, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, June 9, 2018

New forthcoming article - Shareholder Divorce Court

This week, I plug my new article, Shareholder Divorce Court, available here on SSRN and forthcoming in the Journal of Corporation Law.  Here is the abstract:

Historically, shareholder power within the corporate form has been tightly constrained on the assumption that dispersed shareholders are too inexpert, and insufficiently invested in the business, to contribute positively to governance.  In recent years, however, the nature of shareholding has changed.  Whereas in the mid-twentieth century, most stock was held by individuals, today, most publicly traded stock is held by large institutions with significant stakes.  Corporate law has responded to the increasing sophistication of the shareholder base by expanding shareholder power, but doing so has created a new problem: shareholders have heterogeneous preferences, and when they conflict, the majority may exploit the minority.

The problems are particularly acute when it comes to mergers and acquisitions.  Large shareholders may have a variety of investments, and thus be conflicted in their preferences when it comes to merger terms.  Their greater influence within the corporate form may influence directors.  In this scenario, minority shareholders are left without an effective advocate for their interests, and therefore may be coerced into suboptimal transactions.

This Article proposes that if corporate law is retooled to grant shareholders more power, it should also facilitate “divorce,” namely, provide a mechanism for price discrimination among shareholders with different interests.  In particular, states can look to an old solution: the right of appraisal.  Appraisal permits a shareholder to petition a court for a judicial evaluation of the fair value of her shares.  Before falling into disuse, appraisal was one of the earliest remedies for addressing conflicting shareholder preferences.  In recent years, it has enjoyed a renaissance as a mechanism for deterring conflicted or unfavorable transactions.  This Article argues that with some modification, appraisal could also be used to satisfy the divergent preferences of a heterogeneous shareholder base.

The project was inspired by the increasing concentration of ownership among a handful of institutional investors, as well as numerous examples of mergers that depended on the votes of shareholders who held stakes in both target and acquirer.  I addressed the issue from the shareholder side in an earlier essay, Family Loyalty: Mutual Fund Voting and Fiduciary Obligation.  The new paper is a more in-depth examination of the implications on the corporate governance side.

June 9, 2018 in Ann Lipton | Permalink | Comments (0)

Saturday, June 2, 2018


Institutional shareholders are increasingly using their “voice” in matters of corporate policy, and, in particular, are taking an interest in “environmental, social, governance” (ESG) performance measures at their portfolio companies.  Investments are selected, and shareholders engage with management, using a variety of ESG metrics, often concerning matters like climate change, gender and racial diversity, and similar issues.  Though it’s often argued that some ESG engagement reflects the investors’ personal policy preferences rather than a sincere attempt to improve corporate performance, it seems that at least some ESG factors are, in fact, wealth maximizing.  It’s also been argued that many institutional investors have already diversified away their vulnerability to idiosyncratic risks and, by engaging on ESG matters, are attempting to protect themselves against systemic risks

Nonetheless, the trend has met with some criticism.  One set of concerns pertains to protection of retail investors to whom the institutional investors owe fiduciary duties – fear that their money is being used to advance social causes favored by the investment manager, rather than to benefit investors in the fund.

A parallel set of concerns has less to do with protecting fund beneficiaries than with protecting portfolio companies.  In the most charitable account, the fear is that inexpert fund managers will improperly meddle in corporate affairs, harming both their own beneficiaries and other shareholders.  In a less charitable account, corporate managers hope to avoid accountability to a powerful shareholder base by squelching institutional participation in governance (this is the account described in detail in David Webber’s new book, The Rise of the Working Class Shareholder, which Ben Edwards blogged about here).

The battle plays out to a large extent via federal securities regulation, in everything from the process for bringing shareholder proposals under Rule 14a-8 to new attempts to regulate proxy advisors.

And it also plays out in regulation of the funds themselves, many of which are retirement plans governed by ERISA.  Even those retirement plans that do not formally fall within ERISA’s ambit – local government plans, for example – may very well look to ERISA for guidance or best practices, making ERISA regulation a critical battlefield.  (Hence Anita Krug’s characterization of the Department of Labor as “the other securities regulator”).

Essentially, the critical question under ERISA has been, to what extent may fund administrators select investments based on ESG factors, and involve themselves in the corporate governance of portfolio companies?

Over the years, the DoL has issued a series of guidelines interpreting fiduciaries’ obligations under ERISA.  All emphasize that plan administrators must act to advance the economic interests of the beneficiaries, and may not subordinate those interests to “social” objectives.  That said, the Bush, Obama, and now Trump administrations have each put their own stamp their interpretation of an ERISA fiduciary’s obligations.  The Bush Administration’s 2008 interpretation emphasized, for example, that when voting proxies, “the responsible fiduciary shall consider only those factors that relate to the economic value of  the plan's investment … If the responsible fiduciary reasonably determines that the cost of voting (including the cost of research, if necessary, to determine how to vote) is likely to exceed the expected economic benefits of voting, ... the fiduciary has an obligation to refrain from voting.”  The Obama Administration, by contrast, stated that to the extent the Bush bulletin was interpreted to require a cost-benefit analysis for every vote or governance action, this was incorrect; instead, fiduciaries should generally vote unless there is a reason to believe costs exceed benefits, because – it would be assumed – most costs associated with a vote would be minimal.

The Obama Adminstration’s guidance was also more tolerant towards the plan involvement in corporate governance, and consideration of ESG factors in the administration of plan assets, than was the Bush Administration.  The Obama guidance stated that the Bush guidance might be “misinterpreted” to require specific cost-benefit analyses with respect to ESG factors, when in fact, fiduciaries may “recogniz[e] the long term financial benefits that, although difficult to quantify, can result from thoughtful shareholder engagement when voting proxies … or otherwise exercising rights as shareholders.”  The Obama bulletin went on to emphasize the growing recognition of the importance of ESG factors when making investment decisions, and the benefits of shareholder engagement.

But now the pendulum has swung back hard, via the Trump administration.  Trump’s bulletin warns, “Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits.”  The new bulletin further states that the Obama bulletin:

was not intended to signal that it is appropriate for an individual plan investor to routinely incur significant expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors. Similarly, the [Obama bulletin] was not meant to imply that plan fiduciaries, including appointed investment managers, should routinely incur significant plan expenses to, for example, fund advocacy, press, or mailing campaigns on shareholder resolutions, call special shareholder meetings, or initiate or actively sponsor proxy fights on environmental or social issues relating to such companies…. If a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager, that may well constitute the type of “special circumstances” that … warrant[] a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.

The new bulletin goes even further, by discouraging the inclusion of ESG funds within ERISA plans that permit plan beneficiaries themselves to choose among a menu of options.  Though the bulletin admits that fiduciaries may include ESG funds if plan participants request such an option, it also includes a footnote that contains a heck of a qualification:

in deciding whether and to what extent to make a particular fund available as a designated investment alternative, a fiduciary must ordinarily consider only factors relating to the interests of plan participants and beneficiaries in their retirement income. A decision to designate an investment alternative may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments

The bulletin also warns against making an ESG fund a “default” option based on “the fiduciary’s own policy preferences.”

So what does all this mean?

Well, if you want law firm guidance, here's some; there’s also a brief discussion in the Wall Street Journal.

As for me, I’ll start with the obvious: the back-and-forth makes clear that a larger debate about the proper role of shareholders in corporate governance is playing out across the stage of ERISA regulation, raising questions about the degree to which actual concern for plan beneficiaries is motivating the shifts (except, perhaps, in the very broadest sense that different administrations have different ideas about what balance of power will ultimately benefit shareholders generally).

Beyond that, the attempts to discourage the inclusion of ESG funds in ERISA plans strikes me as a peculiar elevation of legally constructed investor preferences over the, well, actual preferences of investors – what Daniel Greenwood dubbed “fictional shareholders.”

It’s all well and good to require that ERISA fiduciaries act solely in the economic interests of beneficiaries, on the assumption that this is what beneficiaries would likely want, and on the assumption that wealth maximization functions as “least common denominator” for beneficiaries’ otherwise conflicting interests. 

But this reductionistic approach to defining beneficiary interests, adopted for the purpose of making them more manageable, should not stifle opportunities to accommodate the actual preferences of beneficiaries, especially when it is feasible to allow beneficiaries to sort themselves – like, say, when ESG-focused funds can be made available to those beneficiaries who are willing to sacrifice some degree of financial return to advance social goals.  Providing these opportunities to beneficiaries who choose them inflicts no damage on the interests of beneficiaries solely interested in financial return, and, in fact, the principle that investors should be able to control their own retirement planning is (supposedly) the reason these types of ERISA platforms are offered in the first place. 

The new guidance, then, seems less about protecting beneficiaries from politically-motivated fiduciaries than it is about forcing beneficiaries to participate in the political goals of the Trump administration, namely, minimizing shareholder participation in corporate governance, particularly when those shareholders advance (what are usually) liberal policy priorities.

June 2, 2018 in Ann Lipton | Permalink | Comments (4)

Saturday, May 26, 2018

The difficulty with gauging materiality, part infinity

Risk factor disclosures are required under SEC rules, and encouraged under the PSLRA (which insulates from private liability forward-looking statements that are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” 15 U.S.C. § 78u-5).  The theory is that investors, armed with adequate warnings, can make intelligent decisions about how to value a company’s securities.

Both the SEC in its guidance, and Congress when passing the PSLRA, emphasized that “boilerplate” warnings are not helpful; investors must be given specific, tailored information about the firm-specific risks that the company faces.  For example, the SEC instructs firms, “Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered.”  17 C.F.R. § 229.303.  Meanwhile, in the PSLRA’s legislative history, the Conference Report states that “boilerplate warnings will not suffice.... The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected.”

Scholars have documented that firm-specific risk warnings are helpful to investors.  For example, a while ago I blogged about a study by Karen K. Nelson and Adam C. Pritchard documenting how risk factor disclosures may assist investors.

The difficulty is, how does one distinguish boilerplate risk factors from “meaningful” firm-specific ones?  The impossibility of that task has frustrated several courts, with the First Circuit calling the PSLRA’s safe harbor a “license to defraud,” In re Stone & Webster, Inc., Securities Litig., 414 F.3d 187 (1st Cir. 2005), and the Second and Seventh Circuits expressing bewilderment as to how the adequacy of cautionary language is to be assessed, Slayton v. American Exp. Co., 604 F.3d 758 (2d Cir. 2010); Asher v. Baxter Int’l, 377 F.3d 717 (7th Cir. 2004).

Scholars have also assailed the judiciary for adopting unrealistic standards of how investors read and interpret corporate disclosures, and, in particular, for overestimating ordinary investors’ ability to digest corporate disclosures and correctly incorporate them into their decisionmaking. David A. Hoffman, The “Duty” to Be a Rational Shareholder, 90 Minn. L. Rev. 537 (2006); Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does—Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83 (2002); Stefan J. Padfield, Is Puffery Material to Investors? Maybe We Should Ask Them, 10 U. PA. J. Bus. & Emp. L. 339 (2008).

A new study by Richard A. Cazier, Jeff L. McMullin, and John Spencer Treu supports scholars’ intuition – and courts’ frustration – by demonstrating that standards generated by judges and the SEC appear to encourage firms to include lengthier, less informative risk disclosures in their SEC filings, despite the fact that long, boilerplate warnings may actually harm firms by increasing their cost of capital.  In Are Lengthy and Boilerplate Risk Factor Disclosures Inadequate? An Examination of Judicial and Regulatory Assessments of Risk Factor Language, the authors demonstrate that in the event of a lawsuit, judges are more likely to find risk factors adequate if they are lengthier and more boilerplate.  Moreover, the SEC is less likely to issue a comment letter if the risk factors match those of peer companies rather than identify firm-specific risks.  In other words, the legal system encourages firms to adopt practices that are the opposite of what would benefit the market. 

At this point, I just have to quote myself – sorry! – from an earlier blog post:

[A]ll of our measures of impact and harm and loss are, at this point, so far removed from reality as to border on complete legal fiction.  Materiality is a construct from case law, with numerous additional doctrines piled on to it by courts without any heed for actual evidence of how markets behave. …. [W]hat we call “harm” and “damage” for the purpose of private securities fraud lawsuits have become so artificial that it no longer seems as though we’re even trying to measure the actual real-world effects of fraud.  I believe private lawsuits are an essential supplement to SEC action but a system of fines or statutory damages would make so much more sense.

(As long as I’m plugging myself, I’ve also proposed having distinct damages and liability regimes for investors who can prove actual reliance, since I think the fraud on the market context often leads courts astray).  But more immediately, here’s hoping the SEC takes notice of these findings and incorporates them into its practice.



May 26, 2018 in Ann Lipton | Permalink | Comments (7)