Business Law Prof Blog

Davidoff on "how globalization increasingly allows companies to avoid United States taxes and regulation."

Over at DealBook, Steven Davidoff has posted "The Benefits of Incorporating Abroad in an Age of Globalization."  Davidoff uses Michael Kors Holdings as a case study demonstrating how companies are incentized to incorporate abroad in order to take advantage of tax savings, decreased regulatory burdens, and a decreased threat of shareholder litigation.  He notes further that this is not an isolated case, as "[p]rivate equity firms have been buying American companies with significant foreign operations and reorganizing them as foreign corporations."  To the extent that this creates problems for the U.S., he suggests that "[p]erhaps it is time for the United States to adopt a tax system more in line with the rest of the world."  What I found more interesting, however, was his suggestion that "American investors may be investing in Kors and other companies incorporated outside the United States without appreciating that they are not subject to the same United States laws that other publicly traded companies are."  This seems to me to be the crux of the debate about whether corporate regulation generally follows a race to the bottom or the top.  The greater the likelihood that signifcant portions of the investing community do not properly value the jurisdiction of incorporation, the greater the likelihood that the race is to the bottom rather than the top.

SJP

Good Business: An "Unless" Clause Means What It Says

The North Dakota Supreme Court recently determined in Beaudoin v. JB Mineral Services, LLC, that an "unless" clause in an oil & gas lease means what it says.  That is, unless the lessee makes the a specified payment by a specified date, the lease terminates.  The provision at issue required:

1. Notwithstanding anything to the contrary contained in said lease, it is agreed that said lease shall terminate as of120 business days from date of notarized signature (hereinafter referred to as the Termination Date) unless Lessee, on or before said Termination Date, shall pay or tender to the Lessor(s), or any successor bank, as a Supplemental Bonus Payment, the sum of Forty Five Dollars ($45.00) per net mineral acre owned by Lessor(s) and covered by said Lease. The payment or tender of said sum may be made by cash, check, or draft, mailed or delivered to the Lessor(s) or to said bank on or before said Termination Date.

2. If said supplemental bonus payment is timely paid or tendered, then said lease shall be and continue in full force and effect according to its terms. If such sum is not timely paid or tendered, then said lease shall terminate and be of no further force or effect as of the Termination Date. It is understood and agreed that Lessee has the right to, but is not obligated to, make said supplemental bonus payment. In the event said supplemental bonus payment is not made as set forth above and said lease has been filed in the records of said County and State, it is agreed that Lessee shall promptly execute and file of record a release of said lease.

As the Court notes, the clause doesn't require to lessee to make a payment. It simply provides that the lease will end unless the lessee acts.  The Court also explained that "the 'unless' clause was developed for the benefit of the lessee, and is strictly construed against the lessee even though harsh results may occur."  

I like this -- it is a contract with a clause for a specific purpose, and the court is enforcing it with gusto. I would note, too, that this is not a case where a mistake was claimed or where the lessee tried to comply, but somehow erred.  This was a case where the lessee made an argument that if, "[c]arried to its logical extreme . . .[would mean] the lessee would be allowed to effectively extend the termination date indefinitely [without actually making the requirement payment]." 

In a time where where many landowners and others are expressing concern about how oil and gas companies are treating those with whom they do business, here's at least one example where the lessor is likely to get what he or she bargained for.

--JPF 

Where’s the Data?: The Speculative Debate over High-Frequency Trading Regulation

Over the last few years, the SEC and the EU have toyed with the idea of regulating flash trading. They’ve floated a few tentative thoughts and proposals for public digestion, see, e.g., http://www.sec.gov/rules/proposed/2009/34-60684.pdf, but because of vigorous debate over the unquantified benefits and harms of high-frequency trades (and the sheer volume of trades and the proprietary automated programs such reforms may affect), it has been difficult for regulators to be decisive.

 

Many of the reforms thus far have been informational---aimed at facilitating transparency and gathering data for after-the-fact analysis, rather than banning any particular activity.  For example, in response to the May 6, 2010, flash crash, which many blamed on flash traders dropping out of the market and creating a liquidity vacuum, the SEC adopted a large trader rule earlier this year requiring broker-dealers to maintain records of transactions available for easy reconstruction of market activity and investigation into manipulative activity. http://www.sec.gov/news/press/2011/2011-154.htm. (It is currently trying to push for a consolidated audit trail for tracking orders across securities markets.)

 

Recently, with the EU’s October proposal for putting a financial transaction tax on stock and bond purchases, http://dealbook.nytimes.com/2011/09/27/europe-readies-plan-for-tax-on-financial-transactions/, the focus has turned back to substantive measures for discouraging high-frequency traders. Although anticipated to reduce the GDP, proponents seem to think it’s worth the cost to deter speculative transactions that allegedly do not contribute positive value to markets. The small tax percentage would be designed to curb the profitability of high-frequency traders, who would have to pay the transaction costs more often to pay for the volatility their activities may introduce into the market. Opponents express concern that without an all-or-nothing agreement between the major world markets, the tax would simply mean that the EU would scare away investors to other markets without such regulation. The regulation would have the potential effect of turning away trade volume without shielding their market from the volatility that may exist in other markets that still encourage high-frequency trading.

 

Despite the liquidity arguments in favor of high-frequency trading, both sides of the debate have to at least admit that whatever benefits that come from HFT are incidental---a product of historical coincidences rather than the intended effects of reasoned policy. According to the SEC, Regulation NMS’s Rule 602 exception, which permits this nonpublic flash-trading side market to exist, employs language that has remained unaltered since 1978. http://www.sec.gov/rules/proposed/2009/34-60684.pdf. Its original intent was to facilitate manual trading on exchange floors and to exclude “ephemeral” exchanges and cancellations because it would be impractical to include these deals in the consolidated quotation data. But these assumptions have changed with a highly automated trading environment, and there is a concern that the flash trading market is a significant enough one to elicit fears that we are creating a two-tiered market where the public does not have access to information on the best prices. And it doesn’t seem quite right to characterize one approach as pro-market or pro-innovation, as opposed to another, merely because of one’s unease with further regulation or upsetting the large amounts invested in proprietary trading algorithms based on the status quo. The advantages of the flash traders do not come from new insights into market value; it is a product of innovators taking advantage of carveouts in the current public price reporting regime, arbitraging the advantages of the unregulated at the expense of the regulated.

 

But despite calls for prompt action, perhaps the sluggish regulatory response isn’t such a bad thing for now, given the absence of consensus or data. There are a lot of proposals on the table, and part of the difficulty of creating a good response to all of the claimed ills of flash trading is the “black-box” nature of the proprietary algorithms and the difficulty of reverse engineering how any particular algorithm functions to create liquidity advantages or volatility crises. And aside from the actual logical effects of such trading, how should we measure causality when it comes to perceptions: loss of public confidence or the discouragement of small-time investors at what they believe to be a rigged system? I’ve been rummaging around the Internet for data to back up conclusions about causality, but such data seems quite elusive. And furthermore, even discussion of methodology---how we should begin to gather useful data separating out confounding variables and establishing useful comparison points---seems hard to come by. (The CFTC Commissioner suggested getting high-frequency traders to register and cooperate in disclosing information to the government to help regulators evaluate the effect of their activities http://www.cftc.gov/PressRoom/SpeechesTestimony/opachilton-53.)

 

In the absence of governmental regulation, various exchanges are experimenting with their own rules of minimizing the volatility effects of flash trading (e.g., circuit breaker rules, clerical error checks, and even outright bans of flash trading). Perhaps the lack of uniformity, for now is a good thing, allowing for regulatory experimentation that could lead to comparative data. (For example, if we took a sample basket of stocks and banned flash trading in those stocks, would we see a noticeable market preference in those stocks? Over time, would we see a difference in liquidity in some types of trades over others?)  This problem, itself, was created by unanticipated effects of regulation; we might as well take a studied approach the second time around before unsettling a market that has adapted to the rule.

 

HC

 

One More Thought -- Does Anyone Own the Packers?

Professor Bainbridge reasonably asked what I actually thought about whether the Green Bay Packers stock is a security. I said it's not under federal securities law, but that I think it should be.  Then I had one other thought -- who really "owns" the Packers?  Professor Bainbridge noted in his post Owning the Green Bay Packers, that his first weekend went well. Of course, as he has said, he really is the "proud owner of 1 share of stock in Green Bay Packers, Inc."  By his own standards, anyway, the good professor is not actually an owner of the Packers.  

Back in March of 2010, Professor Bainbridge let me know: Once more with feeling: Shareholders Don't Own the Corporation.  As he explained: 

There is no entity or thing capable of being owned. Granted, because the shareholders hold the residual claim on the corporation's assets, their deal with the corporation has certain ownership-like rights. But they have only those rights specified by their contract, as that contract is embodied in state corporate law and the firm's organic documents. 

So, to recap, the Packers sale of stock provides neither a security nor ownership of the Packers. So what is it?  The stock grants the right to attend an annual meeting and vote on a few things, but provides very few "ownership-like rights."  Is it really just an expensive piece of paper?  It must be a little more than that, because even though people feel good about a donation to Goodwill and other such groups, they don't frame the receipt. (Maybe some people do, I guess, but I'm assuming not.) 

Ultimately, then, it is this simple: Packers "stock" is a contract that provides the right to vote for the members of the Board of Directors, amendments to the Article of Incorporation, certain mergers or sales, and dissolution, at a price of $250 per vote.  

With that settled, on to the next issue:  With the Delaware Chancery Court having filled Chancellor Chandler's seat, when does Professor Bainbridge join the Packers board, as permitted under the bylaws? Assuming he'd accept such a nomination, consider that campaign launched.  Their quarterback is a West Coast guy.  Why not add a similarly situated director?

--JPF 

A Reason People Hate Corporate Lawyers or Why the Packers Should Be an LLC

On Friday, I asked whether the sale of Green Bay Packers stock should be considered a security.  A few people asked whether I really think the Packers stock could be a security. The answer, under Wisconsin law, is almost certainly no, especially given that that Green Bay Packers, Inc., "is organized as a Wisconsin nonprofit stock corporation." And that's probably the case for almost any other state, too, and under federal law.  

But just because the outcome is pretty clear, it doesn't mean that there aren't policy implications that are worth thinking about. I think the biggest one is this: lawyers and business people should say what they mean. Mixing marketing and corporate law is not always a good idea. I find it more than a little silly that the cover of the Packers offering documents says: 

Green Bay Packers, Inc.

Common Stock Offering Document

COMMON STOCK DOES NOT CONSTITUTE AN INVESTMENT IN “STOCK” IN THE COMMON SENSE OF THE TERM. PURCHASERS SHOULD NOT PURCHASE COMMON STOCK WITH THE PURPOSE OF MAKING A PROFIT.

So, you see, the word stock without quotes is different than stock with quotes.  In my view, you shouldn't call something stock if it's not stock, even if you can under securities laws.  There's no doubt that the Landreth court, interpreting Forman, said that stock is not a security just because the company said it issued stock:

[I]n Forman we eschewed a "literal" approach that would invoke the [Securities] Acts' coverage simply because the instrument carried the label "stock." Forman does not, however, eliminate the Court's ability to hold that an instrument is covered when its characteristics bear out the label. 

Now, before these cases, one could argue that something labeled "stock" is always a security, as per § 2(1) of the 1933 Act:

"The term `security' means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . . investment contract, voting-trust certificate,. . . or, in general, any interest or instrument commonly known as a `security.' " 15 U. S. C. § 77b(1).

In Landreth, the court cited Louis Loss, Fundamentals of Securities Regulation 211-212 (1983), providing the following excerpt:

It is one thing to say that the typical cooperative apartment dweller has bought a home, not a security; or that not every installment purchase `note' is a security; or that a person who charges a restaurant meal by signing his credit card slip is not selling a security even though his signature is an `evidence of indebtedness.' But stock (except for the residential wrinkle) is so quintessentially a security as to foreclose further analysis." 

And, in fact, before Landreth, SEC v. C. M. Joiner Leasing Corp., 320 U. S. 344 (1943) indicated that notes or bonds could possibly be deemed securities "by proving [only] the document itself."  The Forman court said that interpretation was dictum as to stock, and the Landreth confirmed that was not true for stock (leaving that question as to notes and bonds "until another day"). Thus, the Supreme Court said, we must look to the economic realities to determine whether stock is a security.  

Which bring me back to this: If the Packers are really just selling a $250 (plus handling) certificate (suitable for framing), they shouldn't call it stock.  And they shouldn't start their offering letter: "Dear Future Owner of the World Champion Green Bay Packers." It should say: "Dear Future Owner of a Certificate saying 'World Champion Green Bay Packers.'"

 In my view, the Packers are using the sense of ownership to secure investors and people who have a connection with the team.  I think that's fine; I actually rather like the idea.  But I don't like the idea that they can use the term stock, the sense of ownership, provide voting rights and the opportunity to attend Annual Meetings, restrict gifting or sales, and then disclaim that what they are selling is a security simply because the primary upside is that past purchases helped "ensure the team survived and remained in Green Bay" and the new purchases will fund an "expansion [that] has been designed to keep the crowd noise in the stadium and maximize our home-field advantage."  

So, I admit my argument is largely academic (a luxury I have), but I do think there is value in not allowing people to muddy the waters.  Suppose, for the sake of argument, the Packers committed a massive fraud and used the money to invest in Greek debt. The debt tanks, the Packers can't have a stadium upgrade, and the home field advantage begins to fade.  The team suffers, and shareholders sue under 10b-5.  The court says, nope, you didn't buy a security because you only had voting rights, without ecomomic rights. The court would probably be right under Landreth (notice my continuing, apparently unavoidable, hedge).  And it would be reasonable under the actual terms of the offering document, if you read it. But it would still make a bunch of lawyers and judges look like jerks.   

To me, this would all be better done as an LLC, with a granting of an owership unit clearly defining the terms.  Then it's plainly (or should be) contractual, and it's not stock, and we have very little problem with confusion with traditional stock or other securities. Frankly, isn't that confusion the main reason the Packers are calling it stock?  I think so.  This is just one more reason we should start respecting and using the LLC for creative entities, and leave the off-the-rack stuff for corporations.

[Update: Professor Bainbridge wanted an answer to the real question of whether Packers stock is a security.  My answer is that I don't think a federal court would find this to be a security, especially with the appropriate disclaimers that have been made. But I reserve my right to think they should.  In the interest of full disclosure, I am a life-long Lions fan.]

--JPF

Is Stock in the Green Bay Packers a Security?

Building on my business law and the NFL geekdom:  The Green Bay Packers recently offered to sell 250,000 shares at $250 per share.  See here:  http://packersowner.com/.  The opportunity to own a portion of any major sports team is a big deal. Just ask Professor Bainbridge -- he even reconsiderd his allegiance to that team from Washington now that he is an owner of one share of the Packers. Of course, as merely a shareholder, he has no fiduciary obligations not to root for his old team.  There's just very little upside. 

The Packers Offering Document is available here.  The Packers make very clear:

The Common Stock does not constitute an investment in “stock” in the common sense of the term because (i) the Corporation cannot pay dividends or distribute proceeds from liquidation to its shareholders; (ii) Common Stock is not negotiable or transferable, except to family members by gift or in the event of death, or to the Corporation at a price substantially less than the issuance price, under the Corporation’s Bylaws; and (iii) Common Stock cannot be pledged or hypothecated under the Corporation’s Bylaws. COMMON STOCK CANNOT APPRECIATE IN VALUE, AND HOLDERS OF COMMON STOCK CANNOT RECOUP THE AMOUNT INITIALLY PAID FOR COMMON STOCK, EITHER TROUGH RESALE OR TRANSFER, OR THROUGH LIQUIDATION OR DISSOLUTION OF THE CORPORATION. 

The Offering Document further makes clear their view of the securities law issue:

Because the Corporation believes Common Stock is not considered “stock” for securities laws purposes, it believes offerees and purchasers of Common Stock will not receive the protection of federal, state or international securities laws with respect to the offering or sale of Common Stock. In particular, Common Stock will not be registered under the Securities Act of 1933, as amended, or any state or international securities laws.

Okay, but can they just do that?  I'll concede at the outset that it's unlikely a court would find this to be a security, but it's not (or shouldn't be) a foregone conclusion. Like partnerships or agency relationships, just because the participants disclaim something, it doesn't mean the court will agree.  As the court in Chandler v. Kelley, 141 S.E. 389 (Va. 1928), explained in the agency context, even where the parties "denied the agency . . . the relationship of the parties does not depend upon what the parties themselves call it, but rather in law what it actually is." 

Certainly it's true that the Packers stock could fail some elements of the Howey test, which says something is a security when there is "a contract, transaction or scheme whereby a person invests money, in a common enterprise, and is led to expect profits solely from the efforts of the promoter or a third party.” SEC v. WJ Howey Co., 328 US 293 (1946).  So here, the failure would be be that the purchaser is not led to expect profits.  

In 1985, the Supreme Court determined in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985):

[T]he fact that instruments bear the label “stock” is not of itself sufficient to invoke the coverage of the Acts. Rather, we concluded that we must also determine whether those instruments possess “some of the significant characteristics typically associated with” stock, id., at 851, 95 S.Ct., at 2060, recognizing that when an instrument is both called “stock” and bears stock's usual characteristics, “a purchaser justifiably [may] assume that the federal securities laws apply,” id., at 850, 95 S.Ct., at 2059. We identified those characteristics usually associated with common stock as (i) the right to receive dividends contingent upon an apportionment of profits; (ii) negotiability; (iii) the ability to be pledged or hypothecated; (iv) the conferring of voting rights in proportion to the number of shares owned; and (v) the capacity to appreciate in value.

The Packers' stock only has one of these characteristics -- the voting rights.  But stock comes with two essential rights:  economic rights and voting rights.  It's clear that non-voting preferred stock is still stock, even though the purchasers of that stock have given up their voting rights to enhance their economic rights.  Why can't it work the other way?  While I admit all "non-voting" stock I have seen has some conversion right or a right to vote if dividends are not paid for a certain period of time, it's not clear to to me it necessarily has to be that way.

Furthermore, under the Howey test, traditionally the "profit expectation" prong is very low. Tax-mitigation arrangements, for example, can be deemed securities.  It's really a question of whether there is some benefit conferred on the investor, not how the bottom-line profit is calculated.  The Packers' offering site provides this:

Judge Rakoff and the Citigroup Settlement Rejection

A journalist asked me some questions via email regarding Judge Rakoff's rejection of the Citigroup settlement.  (DealBook has the opinion, as well as an overview, here.)  Here are a couple of my responses:

I believe Judge Rakoff’s obvious frustration with the SEC practice of routinely entering into these sorts of agreements where the other side neither admits nor denies any wrongdoing is part of a growing trend.  One might even go so far as to see a connection to the Occupy Movement, which at least in part seems to be protesting a perceived “crony capitalism” wherein government regulates big business by way of wink-and-nod processes that leave both sides happy and the average citizen worse off.  (I’m not alone in making this connection.  Jonathan Macey had this to say at Politico (HT: Bainbridge): “The victory that Rakoff gave to the Occupy Wall Street movement Monday came from the federal courthouse — not far from Zucotti Park, the lower Manhattan headquarters of OWS.”; “Adopting the language of the Occupy Wall Street movement, Rakoff ruled that if judges do not have enough information on which to base their decisions, then the deployment of judicial power ‘serves no lawful or moral purpose and is simply an engine of oppression.’”)

I am somewhat ambivalent about the decision.  On the one hand, I recognize that there are good reasons for entering into these types of settlements.  Defendants like Citigroup have strong incentives to settle without admitting any wrongdoing in order to avoid those admissions being used against them in later private proceedings.  Meanwhile, the SEC has strong incentives to settle because of the costs and risks inherent in litigation.  On the other hand, while the agreements appear to make sense for the SEC and the defendants, it is much less clear whether they make sense for shareholders and the public.  The SEC suggests that there would be much less money available to return to investors if its power to enter into these sorts of agreements were to be curtailed.  One may question, however, whether the routine use of these agreements does not in some way foster more injury to investors and the public in the long run, since there is at least some message being sent to the alleged wrongdoers in these cases that they will avoid any meaningful personal penalty for similar conduct in the future.  One particular issue that I think needs to be examined more closely is the public’s perception of these settlements.  I have heard the SEC defend its practices in these cases by saying they support investor confidence.  I’m not so sure about that, and if the SEC is making decisions based at least in part on that presumption it is something that should be empirically tested.  Personally, I think the public has grown more and more suspicious of these deals—so I find that particular justification to carry little weight, if it doesn’t in fact cut the other way.

SJP

Facebook about to go public?

Rumor has it that Facebook may soon file to go public (see here and here). A lot of curious eyes will be on its S-1 and valuation. 

It will be interesting to compare the valuation for the IPO with recent prices in the secondary markets. The SharesPost ticker currently has Facebook at $31/sh ($73 billion implied value) and the social media giant's stock is listed at the top of the "most active" list.

--Elizabeth Pollman

Super Committee Failure a Super Short?

It appears that the Super Committee is giving up and going home. Apparently the idea of compromise and actually being accountable for budget cuts is more appalling than the idea of asking Congress to bailout the Super Committee for their ineffectiveness.  As CNN/Money explains:

The "automatic" budget cuts that were supposed to deter super-committee members from punting won't actually kick in until 2013. And that gives Congress more than 13 months to modify the law.

There will be tremendous pressure to do so.

Athough the market implication of failure to reach a compromise are not clear (at least to some), the early feedback is that the market doesn't like it, as this morning's headline, Dow Sinks 300 Points, explains.

So I got to thinking, does anyone benefit from not reaching a deal?  Certainly anyone who thought a failure to reach a deal would send the market lower could short the market. I think a lot of people expected that such a failure would drive the market lower.  What about people who knew a deal would fail?  Like members of the Super Committee and their staffs?  

Professor Bainbridge has been sharing his and others' views on congressional insider trading recently, see, e.g., here and here, so maybe that's why it's on my mind.  I can't help but wonder, did anyone of those key people take a short position on the market last week before news of the likely failure started to leak out? And does it matter?  

If so, it's not at all clear it would be illegal to do. It is pretty clear to me, though,  at a minimum, it would be very scummy.  

--JPF

The question that won't go away: Are boards simply not up to the task?

It often strikes me as somewhat of an emperor-has-no-clothes moment when I explain to my students that, in this era of too-big-to-fail, we continue to entrust oversight of institutions that have the potential to cripple the entire global economic system to folks who are doing so on very much of a part-time basis, and with some minor distractions to boot (like running their own TBTF enterprise as CEO).  I was reminded of this when I read Steven Davidoff's post, A Board Complicit in MF Global’s Bets, and Its Demise.  After pointing out that the failure of oversight in this case was not due to lack of expertise or knowledge, Davidoff suggests that perhaps "boards are inherently unable to do the job we want of them: to oversee the company and counteract the influence of its chief executive."  As a possible solution, Davidoff suggests that "[i]f the board members were to be penalized for their failures through forfeiture of their own compensation, perhaps directors would [be more] focused on creating a stronger risk management culture."  I have my doubts that we could ever implement any such system that wouldn't be left as anything other than a shell after Delaware got done with it.  Perhaps the answer lies in part in doing more of what some have suggested we do in the area of Securities Regulation--that is, stop pretending we have more oversight than we actually do and let the capital market discounting begin.

SJP

The Value of IPOs

Businessweek says: Groupon, Beware: Of 25 Hot IPOs, 20 Tanked Later. 

The New York Times Dealbook says: Bankers Reap Windfall in Groupon I.P.O.. 

And Carl Richards at the New York Times Bucks Blog concurs: Think Twice About That ‘Hot’ New I.P.O.  Richards explains: 

And in case there is any doubt, almost every study I can find on the performance of I.P.O.’s shows the same thing:

-- Looking at 1,006 I.P.O.’s that raised at least $20 million from 1988 to 1993, Jay Ritter, a University of Florida finance professor, showed that the median I.P.O. underperformed the Russell 3000 by 30 percent in the three years after going public. The same analysis showed that 46 percent of I.P.O.’s produced negative returns.
-- Another study focused on I.P.O.’s issued in 1993 and their performance through mid-October 1998. The average I.P.O. returned just one third as much as the S&P 500 Index. Over half traded below their offering price and one third went down more than 50 percent.
-- A study by what was then U.S. Bancorp Piper Jaffray looked at 4,900 I.P.O.’s from May 1988 to July 1998. By July 1998, less than one third of the new issues were above their initial offering. Even more startling, almost a third were no longer traded (that is, they went bankrupt, got acquired or were no longer traded on an active market).
-- Of 1,232 I.P.O.’s issued from 1988 to 1995, 25 percent closed on the first day of trading below the initial offer price. Adding insult to injury, “extra hot” I.P.O.’s, the ones that rose 60 percent or more on their opening day, performed the worst over the long term and underperformed the market by 2 to 3 percent a month during the next year.

So the math says it’s a bad idea — but we keep doing it. Maybe it is the word “hot” that gets us excited. 

That, or maybe we're unduly influenced by companies like Morgan Stanley, Goldman Sachs and Credit Suisse.  Those companies were the co-lead underwriters for Groupon's I.P.O., and they scored $29,120,000 in fees.  The 14 underwriters collectively gained $42 million in fees from the offering. Nice work, if you can get it. 

--JPF

Immaterial Lies

A couple of weeks ago the Wall Street Journal ran an article entitled "Trust Me."  The article asserted that:

Infamous frauds and financial crises have wrecked the public's faith in business in recent years, leading many companies to try to repair the damage by emphasizing codes of ethics. But we do not have a crisis of ethics in business today. We have a crisis of trust.

Later on, the author suggested that:

Spirals of distrust often begin with miscommunication, leading to perceived betrayal, causing further impoverishment of communication, and ending in a state of chronic distrust. Clear and transparent communication encourages the same from others and leads to confidence in a relationship.

I have argued elsewhere that courts have in recent years excaberated this problem of distrust by routinely labeling misstatements "immaterial."  In other words, the judges in 10b-5 cases tell investors that even if we assume the CEO intentionally lied about the company's prospects in order to defraud investors there is no recourse because no "reasonable" investor would consider the statement important.  The article is entitled, "Immaterial Lies: Condoning Deceit in the Name of Securities Regulation."  Here is the abstract:

The financial crisis of 2008-2009 is once again raising the issue of investor trust and confidence in the market.... The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust. This Article argues that one of the ways courts can do this is by curtailing their over-dependence on materiality determinations as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that there will be no relief for shareholders even if the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality “safety valve” doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, the routine categorization of managerial misstatements as immaterial in order to dismiss frivolous suits creates a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, the dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with the problem of frivolous suits without having to rule on the issue of materiality.

SJP

Reporting Back From the Ohio Securities Conference

Yesterday, I had the privilege of participating in a panel discussion at the 2011 Ohio Securities Conference entitled, "Dodd-Frank: One Year Later."  A complete list of the panelists, along with a link to related material follows:

Barbara Black: How to Improve Retail Investor Protection After the Dodd-Frank Wall Street Reform and Consumer Protection Act

Eric Chaffee: The Dodd-Frank Wall Street Reform and Consumer Protection Act: A Failed Vision for Increasing Consumer Protection and Heightening Corporate Responsibility in International Financial Transactions

Stefan Padfield: The Dodd-Frank Corporation: More than a Nexus of Contracts

Geoffrey Rapp (moderator): Legislative Proposals to Address the Negative Consequences of the Dodd-Frank Whistleblower Provisions: Written Testimony Submitted to the U.S. House Committee on Financial Services

SJP

Pendulum Swing in the Market

At the end of the second quarter, Goldman Sachs reported a $1.85 per share earnings and Bank of America reported a per share decrease of $.99 after an $8.8 billion loss.  Today, the tables have turned with the third quarter filings.  Goldman Sachs is reporting a $.85 per share loss after a $428 million loss and Bank of America is reporting a $.56 per share gain after a $6.8 billion profit.  The Bank of America turn around may be short lived, however, as the boost in earnings is due, in part, to certain asset sales boosting cash and "one-time accounting adjustments."  Bank of America also remains exposed to investment risks ($485 million) in Greece.  Goldman Sachs, on the other hand, attributes the deflated earnings to a bad investment in the Industrial and Commercial Bank of China that resulted in a $1 billion loss and low returns in other equities.  

The switch in positions and the underlying reasons highlight the volatility that remains in the financial markets.

--Anne Tucker

 

Manesh on Contractual Freedom Under Delaware Alternative Entity Law

Mohsen Manesh has posted “Contractual Freedom under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs” on SSRN.  Here is the abstract:

Notwithstanding the ongoing academic debate, little is known empirically about how unincorporated alternative entities - LLCs and LPs - actually utilize the contractual freedom afforded under Delaware law. To what extent do alternative entities take advantage of contractual freedom to wholly eliminate fiduciary duties? And to what extent do alternative entities employ so-called “uncorporate” substitutes - certain contractual devices designed to discipline and incentivize mangers - in lieu of fiduciary duties? In response to calls for empirical evidence on this issue, this study analyzes the operating agreements of every publicly traded Delaware alternative entity in existence as of June 2011. This study, the first of its kind, provides a snapshot of contractual freedom as it is applied under Delaware alternative entity law.

In particular, this study finds that the use of fiduciary waiver and exculpation provisions among publicly traded Delaware alternative entities is widespread. Yet, despite the widespread use of such provisions, this study also finds that publicly traded alternative entities have either failed to adopt uncorporate substitutes or adopted uncorporate substitutes that only trivially constrain managerial discretion. Thus, this study suggests that publicly traded alternative entities have largely utilized the freedom of contract to reduce managerial accountability to investors without committing to significant offsetting constraints on managerial discretion.

SJP

What's Wrong With Picard v. Katz? Just About Everything.

Editor’s Note: The following post comes to us from Dr. Anthony Michael Sabino, a Professor in the Department of Law at The Peter J. Tobin College of Business at St. John’s University. (SJP)

WHAT’S WRONG WITH PICARD V. KATZ? JUST ABOUT EVERYTHING.

By

Anthony Michael Sabino, Professor of Law, St. John’s University, Tobin College of Business; Partner, Sabino & Sabino, P.C. 

    I have long been an admirer of Judge Jed Rakoff of New York’s Southern District.  Like many, I have long considered him to be the dean of the federal securities bar, at least as to its judicial contingent.  However, I found his latest decision, entitled Picard v. Katz,[1] to be so deeply mistaken, particularly as to its usurpation of settled bankruptcy law doctrine, that I can scant believe this is the same jurist.  Since an appeal is a near certainty, I can only look forward to the Second Circuit righting this wrong. 

    For the (few that remain) unacquainted, the plaintiff is Irving Picard, the trustee of the defunct investment advisory business of the infamous Bernard Madoff, now about two years into his 150 year prison sentence for masterminding the greatest Ponzi scheme of the new century.  Defendant “Katz” is Saul Katz, business partner of Fred Wilpon, and, along with Wilpon, an owner of Major League Baseball’s New York Mets.  All are defendants in the instant case.    

    The Wilpons and various of their enterprises were heavy investors with Madoff, and reaped many millions in profits over the years, some of those profits going to fund the Mets’ cash flow.  With the vast majority of those profits now proven to be fictitious, and the discovery that said “profits” were paid from monies deposited by subsequent Madoff victims, at bottom this litigation is all about Trustee Picard’s efforts to recover anywhere from $ 300 million to $ 1 billion from the Mets’ owners, based upon various theories, the paramount ones being “fraudulent conveyances,” as set forth in the Bankruptcy Code[2] and New York state law.[3]

    In addition to the above preface, let me be clear that, in this limited space, I am not addressing Judge Rakoff’s earlier decisions, both as to these parties and similarly situated Madoff defendants, where the court discarded somewhat “novel” theories that the Trustee claimed entitled him to recover up to a billion dollars from the Wilpons alone.  Rather, I am strictly confining myself to the new Katz decision, wherein Judge Rakoff tossed out causes of action so fundamental and traditional to litigation of this kind, that I was frankly aghast at the outcome.  My consternation is focused upon three key points.

    First, Judge Rakoff dismissed the “constructive fraud” count of the fraudulent conveyance claim.  Briefly, constructive fraud is proven by a straightforward and purely objective test, to wit, a simple arithmetical calculation of what you received as compared to what you paid.  By its nature, the early beneficiaries of a Ponzi scheme receive more than they paid in, and so easily fail the test.  Case law, including that of the Second Circuit, is clear that Ponzi beneficiaries unfailingly are liable to return false profits, since those monies came from subsequently defrauded investors.  Indeed, the Second Circuit’s most recent decision in the Madoff case, in validating Trustee Picard’s methodology for calculating the actual losses of Madoff’s victims, reflects that jurisprudence.[4]  Then how can Judge Rakoff’s decision be so at odds with those clear precedents?  Not for long, I hope.

    In addition, constructive fraud, because it is an objective test, will survive where the “actual fraud” allegation, dependent upon subjective proof, will oft times fail.  Yet Katz is permitting the actual fraud allegations, the ones far more susceptible of being tossed for a lack of proof of the defendants’ state of mind, to proceed, while the more durable allegations, based upon simple math, are dismissed.  This makes no sense.  Lastly, Katz limits the fraudulent conveyance claims to the two year statute of limitations found under the Bankruptcy Code.  Wrong---Trustee Picard sued in parallel under New York’s fraudulent conveyance statutes, which provide a more liberal six year limitary period to reach back to recover fraudulent conveyances.  This misapplication of the correct statutory periods is sure to be corrected by the appellate court. 

    My second point of contention is Katz’s complete confusion of “settlement payments,” as defined in Title 11, with the ill gotten goods the Defendants allegedly received here.  The court immunizes the Defendants’ receipts from the Trustee’s allegations, by characterizing them as settlement payments from a broker.  That misses the mark by a country mile.  First, while the statutory definition of settlement payment is admittedly lucid, both the text and its history make clear as crystal that monies so paid are protected because they represent payments by brokers to customers as part of actual securities transactions. 

    That is not what happened here.  These defendants allegedly took out far more than they invested, based upon fictitious profits produced by Madoff’s fertile and devious imagination.  As we learned to our sorrow, Bernie Madoff never actually bought or sold any securities.  As such, monies received by these defendants are inapposite to the settlement payments (and the underlying transactions) the law is designed to protect.  Put another way, Congress wrote statutory protections for settlement payments into the Bankruptcy Code, at the behest of the legitimate securities industry, in order to protect the orderly flow of actual business.  Money paid out in a Ponzi scheme is light years away from that, and thus wholly undeserving and unintended for such protections.[5]

    Moreover, Katz is internally inconsistent in this regard.  It notes that Ponzi schemes such as Madoff’s transpire “without any actual securities trades taking place.”  Yet in the next paragraph it bestows statutory protection upon those same non-existent transactions.  If the transaction is a sham, how can it be deserving of the law’s “safe harbor”? 

    Third, Katz purportedly seeks to reconcile important provisions of the Bankruptcy Code with the federal securities laws, foremost from the latter body the Securities Investor Protection Act, called “SIPA.”  Having extensively litigated and written about the intersection of bankruptcy law with the federal securities statutes,[6]    I agree this is no small task.  But Katz does not provide an intersection; it gives us a train wreck.  For instance, Katz asserts that in this context “bankruptcy law is to be informed by federal securities law.”[7]  Yet what this opinion provides instead is an annihilation of the Bankruptcy Code in favor of misconstrued concepts of the securities laws.    

    Katz ignores that a SIPA liquidation of an investment firm (as is the case here with Madoff’s investment advisory business) is to be conducted in harmony and in conjunction with the Bankruptcy Code.  That is why the Code contains specific provisos for stockbroker liquidations, and SIPA cases are administered in bankruptcy courts by bankruptcy trustees.  Trustee Picard was not stripped of his traditional powers to recover fraudulent conveyances under bankruptcy or state law.  Nor are the securities laws to be construed to artificially restrict his powers.  This has long been the law of the Second Circuit, and things will surely be put to rights on the appeal (Trustee Picard’s attorneys have already indicated that an interlocutory appeal will be sought).[8]   

    In closing, Katz perpetrates a great wrong: first by utterly misunderstanding fraudulent conveyance law, particularly the aspect of “constructive fraud;” second, by misconstruing portions of the federal securities laws to immunize fraudulent conveyances from rightful recovery; and third, by crushing established bankruptcy and SIPA provisos via the misapplication of the federal securities laws. 

    The fortunate news is that the cases are legion, especially in the Second Circuit, in proof of the errors of Katz.  Surely a swift appeal will put this misbegotten decision to rest, and these defendants will find their exposure on the “constructive fraud” fraudulent conveyance counts will amount to nearly $300 million.[9]  We should yet see legitimate victims benefiting by recoveries from the recipients of fictitious profits paid out with their money. 

AMS/dal      

______________________________________

 

[1] ___ F.Supp.2d ___ (S.D.N.Y. Sept. 27, 2011) (11 Civ. 3605) (JSR). 

[2] 11 U.S.C. § 548.  The Bankruptcy Code is often referred to as “Title 11,” per its ordination in the U.S. Code.

[3] New York Debtor and Creditor Law (“D.C.L.”) § 270, et seq. 

[4] In re Bernard L. Madoff Investment Securities LLC, ___ F.3d ___ (2d Cir. August 16, 2011) (Jacobs, C.J.). 

[5] Compare Sabino, “Applying the Law of Fraudulent Conveyances to Bankrupt Leveraged Buyouts: The Bankruptcy Code’s Increasing Leverage Over Failed LBOs,” 69 North Dakota Law Review 15 (1993). 

[6] Sabino, “Failed Stockbrokers and the Bankruptcy Courts in the 21^st Century: Bringing Order to Chaos,” Annual Survey of Bankruptcy Law 2002 317 (West 2002). 

[7] Katz, slip op. at 14. 

[8] Parenthetically, Judge Rakoff claimed that he declined the defendants’ request to convert their Rule 12(b)(6) motion to dismiss to a motion for summary judgment pursuant to Rule 56.  Katz, slip op. at 13 n.8.  Yet I find that contradictory, as in pertinent part it appears to me the court is more according summary judgment on these claims than merely dismissing them. 

[9] Katz, slip op. at 11 n.6. 

Ribstein on Energy Law and Corporate Structure

Larry Ribstein has posted the abstract for Energy Infrastructure Investment and the Rise of the Uncorporation.  I haven't yet been able to get a copy of the paper (though I should have it this week), but the abstract is particularly intriguing:

While most large U.S. businesses have long been organized as corporations, a significant portion of our economy, including major parts of our energy infrastructure, are organized as other types of legal entities. These “uncorporations” include such business forms as Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs). Many practitioners have dismissed these alternative entities as merely tax devices and only peripherally important to mainstream business. But this view misses important features of the uncorporation that make it an important alternative in dealing with the “agency” costs that arise in public companies from separating managerial control from equity ownership. Corporate governance relies heavily on agents such as auditors, class action lawyers, judges, and independent directors to protect shareholders from managerial self‐interest. The obvious costs and defects of relying on these governance mechanisms have generally been seen as a reasonable price to pay for the benefits of the corporate form. But this conclusion depends on the availability and effectiveness of the alternative mechanisms for addressing agency costs. Uncorporations provide such an alternative by tying managers’ economic well‐being so closely to that of their firms that corporate monitoring devices become less necessary. Uncorporate governance mechanisms include managerial compensation that is based largely (if not entirely) on the firm’s profits or cash distributions, and restrictions on managers’ control of corporate cash through liquidation rights and requirements for cash distributions. Business people and policy makers should evaluate the potential benefits of uncorporations before concluding that the costs of corporate governance are an inevitable price of separating ownership and control in modern firms.

Most of my research and scholarship is in the energy law area (and related fields), and I'm particularly interested in how business and business structures impact the energy industry. I've been working on a piece arguing that large public energy companies would be more appropriate as private entities because the interests of management and shareholders lead to improper risk analysis and thus risk taking (leading to less efficiency and less profit), with BP's Deepwater Horizon blow out as a prime example  I look forward to reading the piece, but I fear that I have been, as they say, SSRN'd. Maybe I can build off this piece, but if my piece has been mooted, I take a little comfort in that fact that it was by a leader in the field like Larry Ribstein.  

--JPF

Michael Lewis Returns with Boomerang

Michael Lewis, the author of Moneyball and The Blind Side, among other things, has a new book about the cheap credit crisis.  An interview with National Public Radio is here.  There is also an excerpt of the book available here.  Rather than paraphrase Mr. Lewis, here is an excerpt of the excerpt, to give you an idea of where this book is headed:   

In Kyle Bass's opinion, the financial crisis wasn't over. It was simply being smothered by the full faith and credit of rich Western governments. I spent a day listening to him and his colleagues discuss, almost giddily, where this might lead. They were no longer talking about the collapse of a few bonds. They were talking about the collapse of entire countries.

And they had a shiny new investment thesis. It ran, roughly, as follows. From 2002 there had been something like a false boom in much of the rich, developed world. What appeared to be economic growth was activity fueled by people borrowing money they probably couldn't afford to repay: by their rough count, worldwide debts, public and private, had more than doubled since 2002, from $84 trillion to $195 trillion. "We've never had this kind of accumulation of debt in world history," said Bass. Critically, the big banks that had extended much of this credit were no longer treated as private enterprises but as extensions of their local governments, sure to be bailed out in a crisis. The public debt of rich countries already stood at what appeared to be dangerously high levels and, in response to the crisis, was rapidly growing. But the public debt of these countries was no longer the official public debt. As a practical matter it included the debts inside each country's banking system, which, in another crisis, would be transferred to the government. "The first thing we tried to figure out," said Bass, "was how big these banking systems were, especially in relation to government revenues. We took about four months to gather the data. No one had it."

I haven't read all of his books, but I always enjoy Mr. Lewis's writing.  I hope to get to this, as soon as I work my way through the two books I am currently reading: (1) Predictably Irrational: The Hidden Forces That Shape Our Decisions, by Dan Ariely, and (2) Straight Man: A Novel, by Richard Russo.  

--JPF

Forward-Looking Statements and the Business Judgment Rule

Berkshire Hathaway today announced that the Board of Directors has authorized the company "to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares."   (The press release PDF is here; H/T: Bloomburg Businessweek.)  The company explains:

In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.

The release, as it should, has its forward-looking statement safe harbor language about the uncertainty of any future performance. I have often wondered if releases such as these should also include a statement of the business judgment rule.  That is, the release explains: "If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."  Perhaps added to that should be the statement:  "And if we're wrong, the shareholders retaining their interests will have no recourse, because (1) they will have had the opportunity to participate in the repurchase or otherwise sell their shares  in the market and (2) the business judgment rule protects such decisions."  

Obviosuly, that's the state of the law generally, anyway, but perhaps pointing it out would have some effect on how shareholders view derivative suits down the road. By specifically reminding them of their options at the time of annoucement, it might just reduce later lawsuits predicated on disappointing results when the board of directors is not "correct."  Perhaps, but I admit, not likely.  

--JPF

Davidoff on Britain’s new takeover rules

Over at DealBook, Steven Davidoff provides some excellent analysis of Britain’s new takeover rules, which went into effect this past Monday.  The title of his post sums up his predictions:  “British Takeover Rules May Mean Quicker Pace but Fewer Bids.”

If this sort of thing interests you, you’ll definitely want to read the entire post—but I’ll note some of the highlights here.  First, Davidoff reports that a wide array of rules were originally considered by the Takeover Panel of Britain, but the most controversial of these (requiring a two-thirds vote, requiring disclosure upon acquisition of 0.5 percent, and disenfranchising shareholders who acquired shares after the offer was announced) were rejected.  Second, the rules that were adopted, “set up a nice dichotomy with the American takeover scheme”:

In the United States, targets can agree to large termination fees and provide extensive deal protections to an initial bid. Targets can also adopt a shareholder rights plan, or poison pill, which can prevent a company from acquiring the target. But in Britain none of these devices are allowed.

As mentioned above, Davidoff sees the net result of these new rules being less initial bids (because bidders will be entering the fray subject to more risks), but more competition for targets once bids are launched.

SJP