December 31, 2011
Litigation Pointer: Don't Mess With the Judge's Holiday
The Financial Times headline reads: Rakoff accuses SEC of misleading federal court. Stephen Bainbridge provides relevant commentary here and here. I thought I'd provide a taste of Judge Rakoff's order (emphasis added; hat tip: WSJ Blog):
On December 16, 2011, the SEC filed its original motion before this Court … seeking a stay pending appeal. The SEC expressly made the motion returnable December 30, 2011. Nonetheless, in the interest of expediting consideration of the motion, the Court, sua sponte … promised to … consider the matter on a more expedited basis than that originally proposed by the SEC. … The Court then spent the intervening Christmas holiday considering the parties' positions and drafting an opinion, so that it could file it on December 27, i.e., the first business day after the Christmas holiday (well before the December 30th date on which the SEC had originally made the motion returnable and well before any further proceedings in the case).
On December 27th, at around noon, without any notice to this Court and without inquiring as to when the Court was going to issue its decision, the SEC filed an “emergency motion” in the Court of Appeals, seeking a stay pending appeal or, in the alternative, a temporary stay, and representing that the motion was unopposed by Citigroup….
As the reason for proceeding on an emergency basis, the SEC stated that Citigroup had only until January 3, 2012 to answer or move to dismiss the underlying Complaint, and that “[i]f Citigroup files its answer, denying some or all of the allegations in the complaint, or if Citigroup moves to dismiss, challenging the complaint's legal sufficiency, it will disrupt a central negotiated provision of the consent judgment pursuant to which Citigroup agreed not to deny the allegations in the complaint.” This statement would seem to have been materially misleading ….
There appears to have been a similar misleading of this Court….
Accordingly, the Court is filing this Supplemental Order, both to make the Court of Appeals aware of this background and to attempt to prevent similar recurrences. Specifically, the parties are hereby ordered to promptly notify this Court of any filings in the Court of Appeals by faxing copies of any such filings to this Court immediately after they are filed in the Court of Appeals. In addition, this Court will send a copy of this Supplemental Order, as well as the Memorandum Order that it supplements, to the Court of Appeals with a request that they be furnished to the motions panel hearing the stay motion on January 17, 2012.
December 29, 2011
15% Contingency Fee Award Spurs Discussion
The Wall Street Journal Law Blog discusses the $300 million plaintiffs’ attorneys’ fees awarded by a Delaware court in the Southern Peru Copper Corporation Shareholder Derivative Litigation here. (Our own Josh Fershee previously commented on the merits of this case here.) Stephen Bainbridge noted a few days ago that “there are a lot of folks in Delaware who are happily expecting this decision to encourage plaintiffs to come back to Delaware.” He quotes Jonathan Macey and Geoffrey Miller as explaining that “in Delaware well-intentioned judges can be expected to devise legal rules requiring that Delaware lawyers be consulted when important decisions are to be made. Moreover, if Delaware judges believe that the state judicial system well serves Delaware corporations, they will be more likely to approve rules that stimulate litigation in the Delaware courts.” But the Macey and Miller quote that caught my attention was this one: “The members of the Delaware Supreme Court are drawn predominantly from firms that represent corporations registered in Delaware.” Just for the fun of it I decided to search for this quote in other law reviews on Westlaw. Here’s what I found:
1. The inability of any province to fashion a provincial jurisprudence is also a function of the manner in which judges are appointed. In Delaware, as in other states, judges are state appointees. This ensures that the state can choose judges who will be sympathetic to corporate managers. As Macey & Miller (1986, p. 502) observe, “[t]he members of the Delaware Supreme Court are drawn predominantly from firms that represent corporations registered in Delaware. The bar and the judiciary are tied together through an intricate web of personal and professional contacts.” As a result, Delaware “judges are specialized in resolving corporate law disputes and as a consequence, the state can offer firms access to a system of corporate law rules that is stable, predictable and sophisticated relative to that of other states” (Macey & Miller, 1986, p. 500). Moreover, because judicial appointments are a state matter, the state can decline to renew the appointment of a judge who does not decide cases in a manner suitably sympathetic to corporate concerns. Douglas J. Cumming & Jeffrey G. MacIntosh, The Role of Interjurisdictional Competition in Shaping Canadian Corporate Law, 20 Int'l Rev. L. & Econ. 141, 157 (2000).
2. Although judges obviously are more isolated from interest group influences than legislators, Delaware's justices are likely to reflect the interests of the corporate bar. The most obvious source of sympathy is the judicial selection process. As described earlier, the Delaware bar plays a central role in selecting justices, and it can be expected to recommend individuals who have a natural affinity to the corporate bar. This natural inclination is amply borne out by even a cursory look at who is ordinarily selected to sit on the supreme court. Nearly all of the justices, both currently and as a historical matter, were members of the Delaware bar before donning judicial robes. David A. Skeel, Jr., The Unanimity Norm in Delaware Corporate Law, 83 Va. L. Rev. 127, 158 (1997) (quoting Macey & Miller in accompanying footnote).
Not exactly ringing endorsements of objectivity.
December 24, 2011
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.
December 24, 2011 in Corporate Governance, Current Affairs, Government and Business, International Business, Investing, Mergers & Acquisitions, Musings, Politics, Securities Markets, Securities Regulation | Permalink | Comments (0)
December 17, 2011
More Citigroup Settlement Musings
I'm continuing my email interview with a journalist regarding Judge Rakoff's Citigroup settlement decision (see my prior post on this here), and among other things I was asked whether I was surprised by the SEC's decision to appeal the ruling. Here is part of my response:
I was not surprised by the appeal, but it does set up an interesting conflict. On the one hand, the SEC is likely correct that requiring an admission of facts in order for a settlement to be approved in these types of cases is unprecedented. On the other hand, Judge Rakoff seems to be stating an obvious truth when he asserts that he cannot carry out his duty of determining whether the settlement is "fair, reasonable, adequate, and in the public interest" without some facts upon which to render this decision. I think the following quote from Judge Rakoff's opinion is right on point:
"Here, the S.E.C.'s long-standing policy—hallowed by history, but not by reason—of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact…. The S.E.C., by contrast, took the position that, because Citigroup did not expressly deny the allegations, the Court, and the public, somehow knew the truth of the allegations. This is wrong as a matter of law and unpersuasive as a matter of fact."
I think the Second Circuit will feel a great deal of pressure to overturn Judge Rakoff's decision, but it will be interesting to see how it resolves this issue if in fact it does reverse.
12/18 UPDATE: Prof. Bainbridge is surprised by the appeal.
December 16, 2011
A Note to the SEC: Don't Just Take Some Case and Hope
On Dec. 14, 2011, a reporter for ProPublica, Jesse Eisenger, wrote the following article for New York Times Dealbook: In Hunt for Securities Fraud, a Timid S.E.C. Misses the Big Game. In it, he argues:
Does the Securities and Exchange Commission suffer from trialphobia?
Ever since Judge Jed S. Rakoff rejected the S.E.C.’s settlement with Citigroup over a malignant mortgage securities deal, the agency has been defending its policy to settle securities fraud cases. But the public wants a “Law & Order” moment, and who can blame them?
. . . .
But so far, there’s been no civil trial in a major case directly related to the biggest economic fiasco of our time: the financial crisis.
Two days later, the Dealbook, from authors Azam Ahmed and Ben Protess, provides this: S.E.C. Sues 6 Former Top Fannie and Freddie Executives, which reports that the SEC seems to have answered Mr. Eisenger's call:
The Securities and Exchange Commission has brought civil actions against six former top executives at the mortgage giants Fannie Mae and Freddie Mac, saying that the executives did not adequately disclose their firms’ exposure to risky mortgages in the run-up to the financial crisis.
The case is one of the most significant federal actions taken against top executives at the center of the housing bust and ensuing financial crisis.
Obviously, this case would have been in works long before last Wednesday, so the timing is something of a coincidence, and it's not as though Mr. Eisenger is the first person to question where the SEC is on this. But I sure hope that this case is proceeding because the SEC thinks it's proper to move forward, and not because they think they need to bring a case, any case, forward.
I bristle at the idea that an agency, law enforcement or regulatory, would purse a case simply because "the public wants a 'Law & Order' moment." I know, of course, that many prosecutors seek cases primarily to raise their profile and send a message, but that doesn't mean it's right. I undertand what he's saying, but I don't care for Mr. Eisenger's recommended use of authority. He explains:
To overcome its greatest fear, the S.E.C needs to realize that it can win even if it loses. A trial against a big bank could be helpful regardless of the outcome. It would generate public interest. It would put a face on complex transactions that often are known only by abbreviations or acronyms. Litigation would cost the bank money, too. And it could cast the way Wall Street does business in such an unflattering light that even if the bank won, it might bring about better behavior.
A trial would show boldness. And when the S.E.C. found itself at the negotiating table again, it would feel a new respect.
You don't earn respect by being a bully, by making people jump through hoops, or by making them expend resources just because you can. You may earn fear and you will almost certainly earn disdain, but that's not the same thing.
I agree that the SEC shouldn't seek only cases it can win or settle. In fact, I think a lot of relatively "little guys" are getting forced into SEC fines and settlements right now, not because they necessarily did something wrong, but because they can't afford the fight. The SEC gets to report the settlements, which go down as wins over "corruption and fraud."
And I think there may be value in pursuing some of the big guys for fraud because some of them probably committed fraud. But you need to facts before you go hauling people into court. I'm all for pursuing fraud vigorously, but I'm not willing to let any regulator decide to mess with people's lives just because the public thinks someone needs to pay. Law enforcement and regulation only work if the right people pay for the wrongs they committed. So, SEC, don't just take some case and hope for it. Put together the right case, and then go for it.
December 15, 2011
Buell on the Potentially Perverse Effects of Corporate Civil Liability
Samuel W. Buell has posted "Potentially Perverse Effects of Corporate Civil Liability" on SSRN. Here is the abstract:
Inadequate civil regulatory liability can be an incentive for public enforcers to pursue criminal cases against firms. This incentive is undesirable in a scheme with overlapping forms of liability that is meant to treat most cases of wrongdoing civilly and to reserve the criminal remedy for the few most serious institutional delicts. This effect appears to exist in the current scheme of liability for securities law violations, and may be present in other regulatory structures as well. In this chapter for a volume on "Prosecutors in the Boardroom," I argue that enhancements of the SEC's enforcement processes likely would reduce the frequency of DOJ criminal enforcement against firms, an objective shared by many. Among other enforcement features, I address problems with the practice of accepting "neither admit nor deny" settlements in enforcement actions, a subject that has drawn greater attention since this chapter was published.
December 11, 2011
Beneish, Marshall & Yang on Collusive Directors
Messod Daniel Beneish, Cassandra D. Marshall, and Jun Yang have posted "Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy" on SSRN. Here is the abstract:
We use an observable action (non-executive directors’ insider trading) and an observable outcome (the market assessment of a board-ratified merger) to infer collusion between a firm’s executive and non-executive directors. We show that CEOs are more likely to be retained when both directors and CEOs sell abnormal amounts of equity before the delinquent accounting is revealed, and when directors ratify one or more value-destroying mergers. We also show that a good track record, higher innate managerial ability, and the absence of a succession plan make replacement more costly. We find retention is less likely when the misreporting is severe and directors fear greater litigation penalties from owners, lenders, and the SEC. Our results are robust to controlling for traditional explanations based on performance, founder status, corporate governance, and CFOs as scapegoats. Overall, our analyses increase our understanding of the retention decision by about a third; they suggest that financial economists consider collusive trading and merger ratification as additional means of assessing the monitoring effectiveness of non-executive directors.
December 09, 2011
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:
in the great American story
in hard work and determination
in ordinary people doing extraordinary things
in the possibilities when people pull together
in pride, passion and perseverance
in legendary excellence
/ become a shareholder in what you believe
That sure seems like an awful lot of benefit to me. And the new owners seem to agree.
December 03, 2011
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.
December 01, 2011
Stanford Law Review Online: Summe on Misconceptions About Lehman Brothers’ Bankruptcy
Over at the Stanford Law Review Online, Kimberly Summe has posted "Misconceptions About Lehman Brothers’ Bankruptcy and the Role Derivatives Played." Here is an excerpt, but the entire piece is well worth a read:
Misconception #1: Derivatives Caused Lehman Brothers’ Failure ….
At the time of its bankruptcy, Lehman Brothers had an estimated $35 trillion notional derivatives portfolio. The 2,209 page autopsy report prepared by Lehman Brothers’ bankruptcy examiner, Anton Valukas, never mentions derivatives as a cause of the bank’s failure. Rather, poor management choices and a sharp lack of liquidity drove the narrative of Lehman Brothers’ bankruptcy…..
Misconception #2: Regulators Lacked Information About Lehman Brothers’ Financial Condition
The Valukas report was explicit that regulatory agencies sat on mountains of data but took no action to regulate Lehman Brothers’ conduct…..
Misconception #3: Derivatives Caused the Destruction of $75 Billion in Value ….
The allegation that derivatives destroyed value is flatly at odds with the fact that derivatives were the biggest contributor to boosting recoveries for Lehman’s creditors....
Misconception #4: Insufficient Collateralization
Policymakers focused on collateralization as a derivatives risk mitigation technique. Collateralization of derivatives, however, has existed for twenty years….
Misconception #5: The Bankruptcy Code Is Not Optimal for Systemically Important Bankruptcies ….
[U]nder the current settlement framework, Lehman Brothers’ bankruptcy will be resolved in just over three years—a remarkable timeframe given that Enron’s resolution took a decade.
Policymakers also focused on the wrong entities for failure. Banks, the most likely candidates for application of Dodd-Frank’s orderly resolution authority, have in fact been the least likely to experience failures due to derivatives losses, in part because of their efforts to hedge exposures. The largest derivatives failures to date involved non-bank entities such as Orange County, the hedge fund Long-Term Capital Management, and AIG Financial Products—entities with fewer risk management and legal resources than banks and which are less likely to hedge exposure. These types of entities are not covered by Dodd-Frank.
An alternative vision for policymakers in the aftermath of Lehman Brothers’ bankruptcy would have involved greater consideration of how liquidity can become constrained so quickly, as in the commercial paper and repo markets, and an effort to mandate the type and amount of collateral provided in these asset classes. In addition, a clarion call mentality among regulators with respect to critical issues such as the size and makeup of a bank’s liquidity pool and an insistence on adherence to banks’ self-established risk tolerances should be actionable. Instead, policymakers overlooked some of the principal causes of Lehman Brothers’ bankruptcy….
November 23, 2011
Jordan on Business Roundtable v. SEC
My colleague Bill Jordan has written a review of the Business Roundtable v. SEC decision (striking down the SEC's proxy access rule) for his "News from the Circuits" column in the forthcoming 37 Administrative and Regulatory Law News 1. Here's an excerpt:
The court criticized the agency’s rejection of studies favoring the management position in favor of “two relatively unpersuasive studies” purportedly showing the value of the inclusion of dissident directors on corporate boards.
The court’s dismissive treatment of the SEC’s response to these studies contrasts sharply with the longstanding principle of judicial, deference to agency assessment of complex technical and scientific studies.... Note that the court considered itself qualified to determine that the studies relied upon by the SEC were “relatively unpersuasive.” This is not the language of arbitrary and capricious review or even of hard look review. This is the language of substantive judgment, even political judgment.
The contrast is particularly striking because this case essentially involved judgments about the value of democracy. In assessing electoral democracy, surely we assume that elections improve outcomes because they hold politicians accountable for their actions. It seems reasonable for the SEC to incorporate this fundamental principle of democratic institutions into the arena of shareholder democracy. At least a court should review such agency judgments – made by the politically accountable electoral branch of government rather than the unaccountable judiciary – with considerable deference. The D.C. Circuit’s review in this case was precisely the opposite. On one particular issue, the court characterized the agency’s explanation as “utterly mindless.”
It is difficult to determine the long-term significance of this decision. It suggests, among other things, that the D.C. Circuit (at least these three judges) consider themselves well qualified to second-guess agency decisions about issues of corporate structure and costs even if they should defer to agency decisions about scientific and technical issues.
November 21, 2011
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.
November 19, 2011
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.
November 14, 2011
Small Business and Securities Law: Senate Version
I have previously written about the legislation in the House to free small businesses from some of the restrictions of federal securities law. See here and here. The Senate is now starting to play catch-up.
1. Crowdfunding. Senator Scott Brown has introduced a bill to add a crowdfunding exemption to the Securities Act. S. 1791, available here, would exempt from Securities Act registration securities sold through a crowdfunding intermediary if (1) the offering amount is less than $1 million during any 12-month period and (2) no investor invests more than $1,000. The issuer would have to file a notice with the SEC and "disclose to investors all rights of investors, including complete information about the risks, obligations, benefits, history, and costs of offering." State registration requirements would be preempted. Senator Brown’s bill would also exempt crowdfunding intermediaries from being treated as brokers if they meet certain requirements. Senator Brown's bill is similar to, but certainly not identical to, the crowdfunding bill passed by the House.
2. General Solicitation. Senator John Thune has introduced a bill to elimination the prohibition against general solicitation and general advertising from Rule 506 of Regulation D. Thune’s bill, S. 1831, is available here.
3. Exchange Act Reporting Threshold. Senators Pat Toomey,Tom Carper, Mark Warner, and Mike Johanns have introduced a bill to raise the threshold above which companies have to file Exchange Act reports. Their bill, S. 1824, is available here. Currently, reporting is required for companies that don’t trade on an exchange if the company has $10 million in assets and a class of equity securities held of record by 500 or more persons. The bill would raise the number of recordholders from 500 to 2,000 and would also exclude securities received pursuant to an employee compensation plan exempted from Securities Act registration.
November 12, 2011
Ritter, Gao & Zhu on Decreasing IPOs
Jay R. Ritter, Xiaohui Gao & Zhongyan Zhu have posted “Where Have All the IPOs Gone?” on SSRN. Here is the abstract:
During 1980-2000, an average of 311 companies per year went public in the U.S. Since the technology bubble burst in 2000, the average has been only 102 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in U.S. IPO activity. We offer an alternative explanation. We posit that the advantages of selling out to a larger organization, which can speed a product to market and realize economies of scope, have increased relative to the benefits of remaining as an independent firm. Consistent with this hypothesis, we document that there has been a decline in the profitability of small company IPOs, and that small company IPOs have provided public market investors with low returns throughout the last three decades. Venture capitalists have been increasingly exiting their investments with trade sales rather than IPOs, and an increasing fraction of firms that have gone public have been involved in acquisitions. Our analysis suggests that IPO volume will not return to the levels of the 1980s and 1990s even with regulatory changes.
November 11, 2011
Crowdfunding and Securities Fraud
Thomas Hazen has just posted an article opposing a federal securities law exemption for crowdfunding. His paper, Crowdfunding, Social Networks, and the Securities Laws—The Inadvisability of a Specially Tailored Exemption Without Imposing Affirmative Disclosure Requirements, is available here.
Crowdfunding, as I have explained before, is the use of the Internet to raise funds through small donations from a large number of people. For more on the crowdfunding phenomenon, see one of my earlier posts here. For a detailed examination and an explanation of why I think small businesses should be able to sell securities through crowdfunding without registering their offerings. see my article, to be published in the Columbia Business Law Review this spring.
Hazen argues that a crowdfunding exemption would result in more securities fraud. I have explained how a crowdfunding exemption can be structured to reduce the risk of fraud. Hazen doesn't really discuss those ideas, but Hazen’s basic point is right. If the SEC or Congress creates a crowdfunding exemption, there will be more fraud. That conclusion, however, tells us nothing.
Allowing more securities offerings of any type—whether they are registered offerings, private offerings, or crowdfunded offerings—will result in more securities fraud and other investor losses. The only way to protect investors from securities fraud is to ban all sales of securities. We don’t do that because the other costs of such a policy would exceed the gains in fraud protection.
Unfortunately, Hazen stops at investor protection. Having concluded that there will be more fraud if we adopt a crowdfunding exemption, he doesn’t ask the important question: will the benefits of a crowdfunding exemption exceed its costs, including the possibility of additional fraud? I think the answer to that question is yes.
As I explain in my article, small businesses face a significant capital gap. The existing exemptions are simply too expensive for very small offerings, leaving very small startups with no effective outlet for capital. Hazen claims that the existing securities exemptions are sufficient. That may be true for larger businesses, but it clearly isn’t true for offerings by very small startups. Securities law is an impassable obstacle for many small businesses. The expense to comply with the existing exemptions is simply too great relative to the size of the offering.
A properly constructed crowdfunding exemption will make new sources of capital available to small startups, and I think that gain will outweigh the potential losses. Moreover, the risk to any particular investor is minimized by limiting the amount each investor may invest. On the whole, I think the benefit of the exemption will exceed its cost.
November 05, 2011
A couple of weeks ago the Wall Street Journal ran an article entitled "Trust Me." The article asserted that:
Infamous frauds and financial crises have wrecked the public's faith in business in recent years, leading many companies to try to repair the damage by emphasizing codes of ethics. But we do not have a crisis of ethics in business today. We have a crisis of trust.
Later on, the author suggested that:
Spirals of distrust often begin with miscommunication, leading to perceived betrayal, causing further impoverishment of communication, and ending in a state of chronic distrust. Clear and transparent communication encourages the same from others and leads to confidence in a relationship.
I have argued elsewhere that courts have in recent years excaberated this problem of distrust by routinely labeling misstatements "immaterial." In other words, the judges in 10b-5 cases tell investors that even if we assume the CEO intentionally lied about the company's prospects in order to defraud investors there is no recourse because no "reasonable" investor would consider the statement important. The article is entitled, "Immaterial Lies: Condoning Deceit in the Name of Securities Regulation." Here is the abstract:
The financial crisis of 2008-2009 is once again raising the issue of investor trust and confidence in the market.... The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust. This Article argues that one of the ways courts can do this is by curtailing their over-dependence on materiality determinations as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that there will be no relief for shareholders even if the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality “safety valve” doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, the routine categorization of managerial misstatements as immaterial in order to dismiss frivolous suits creates a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, the dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with the problem of frivolous suits without having to rule on the issue of materiality.
November 04, 2011
House Votes to Eliminate General Solicitation Restriction From Rule 506
Yesterday was a big day for securities exemptions in the House of Representatives. In addition to passing the crowdfunding bill I already blogged about. the House passed a bill directing the SEC to eliminate the prohibition on general solicitation or advertising from the Rule 506 exemption. A copy of the bill is available here. As with the crowdfunding bill, the vote was bipartisan and resounding (413-11).
The prohibition of general solicitation, as interpreted by the SEC staff, prevents issuers from offering securities to investors with whom they do not have a preexisting relationship. The policy reason for this restriction is unclear. If the purchasers to whom the issuer sells are accredited or sophisticated, as required by Rule 506, it’s unclear why it should matter whether the issuer or its selling agents knew those purchasers before the offering began. Securities practitioners and scholars have been calling for the elimination of the general solicitation restrictions for years.
This would be another welcome change if it becomes law. Kudos to Congressman Kevin McCarthy for introducing this bill.
Houses Passes a Crowdfunding Bill
Yesterday, the House of Representatives voted to approve H.R. 2930, the Entrepreneur Access to Capital Act. The bill, introduced by Congressman Patrick McHenry, would establish a federal securities law exemption for crowdfunding. The 407-17 bipartisan vote came shortly after the Obama administration released a statement suporting the bill.
The basic structure of the bill passed yesterday is similar to what Representative McHenry originally proposed. The offering amount is limited to $1 million, or $2 million if the issuer provides investors with audited financial statements. (The limit in the original bill was $5 million, with no special rule for issuers providing financials.) And each investor may invest annually up to the lesser of $10,000 or 10% of the investor’s annual income, with issuers allowed to rely on investors’ self-certifications of their income. As a result of a couple of floor amendments yesterday, all of those dollar amounts are subject to adjustment for inflation.
However, the final bill adds a lot of detail that didn’t appear in the original bill. Many of those changes track recommendations I have made in my article on crowdfunding. (Full disclosure: One of Representative McHenry’s legislative assistants contacted me shortly after the original bill was introduced asking for suggestions regarding possible changes. However, I was not involved in drafting the revised bill.)
Here are the additional requirements. If the securities are sold through an intermediary, such as a crowdfunding site, the intermediary is responsible for fulfilling these requirements. If the securities are sold directly by the issuer, the issuer is responsible, and the issuer must also disclose its interest in the offering.
- Disclosure and Testing Requirements. The bill requires warnings to investors about the speculative nature and risk of small business offerings. Before investing, investors must answer questions demonstrating an understanding of (1) the risk of investing in startups, (2) the risk of illiquidity, and (3) such other matters as the SEC deems appropriate.
- Funding Goals and Closing Offerings. The issuer must state a funding target and a deadline for reaching that target. No funds may be drawn by the issuer until it reaches at least 60% of the target amount.
- Information Requirements. Both the SEC and investors must be provided with information about the issuer, including its address and the names of its principals. Information about the target amount of the offering, the deadline for reaching that target, the offering’s purpose, and the intended use of the proceeds must also be provided. When the offering is completed, the SEC must be provided with a notice that indicates the aggregate offering amount and the number of purchasers.
- State Access to Information. The SEC must make the information it receives under the exemption available to the states.
- SEC Access. The SEC must be given investor-level access to the crowdfunding web site.
- Background Check. The intermediary, if one is used, must do a background check on the issuer’s principals.
- Disqualifications. The SEC is required to enact rules to disqualify certain issuers and intermediaries, similar to the rules section 926 of the Dodd-Frank Act requires the SEC to add to Rule 506 of Regulation D.
- Communications Channel. The issuer, or the intermediary if one is used, must establish a means for communication between the issuer and investors.
- Cash Management. Cash management functions must be outsourced to a broker or depositary institution.
- Books and Records. Both the issuer and the intermediary are required to maintain such books and records as the SEC deems appropriate.
- Fraud Protection.The issuer, or the intermediary if one is used, must take “reasonable measures to reduce the risk of fraud.”
- No Investment Advice. The issuer, or the intermediary if one is used, may not offer investment advice.
- Resales. Resales are prohibited for one year, except for sales to accredited investors or back to the issuer.
- Protection from Treatment as Brokers. The bill protects intermediaries operating crowdfunding sites from being treated as brokers under federal law. As a result of a couple of floor amendments, the bill probably would not protect crowdfunding sites from being treated as brokers under state law.
- Exchange Act Reporting Threshold. Crowdfunding investors will not count against the 500-shareholder floor that triggers Exchange Act reporting.
- Integration Protection. The bill provides that nothing in the exemption “shall be construed as preventing an issuer from raising capital through methods not described” in the exemption. This language is a little ambiguous, but I believe it is designed to preclude crowdfunding offerings from being exempted with offerings pursuant to other exemptions.
Many of these changes make sense, but I find a few of bill’s provisions troublesome.
- Fraud-Reduction Measures. What exactly are “reasonable measures to reduce the risk of fraud?” The answer is important because the exemption is conditioned on such steps being taken. A purchaser or the SEC might be able to argue after the fact that the sales violated the Securities Act because insufficient steps were taken to reduce the risk of fraud.Also, if a crowdfunding website doesn't take such steps, could it be liable for any fraud?
- The Consequences of Non-Compliance. This raises a more general problem with the bill as written. It says the exemption is available “provided that” all of the requirements are met. Any violation, no matter how minor and no matter how many purchasers it affects, could cause an issuer to lose the exemption. If, for example, something on an intermediary’s web site could be construed as investment advice, that could destroy the exemption for all the issuers who used that site. This kind of problem caused the SEC to add “reasonable basis” and “insignificant deviation” provisions to Regulation D. Similar protection is needed here.
- Other Cost-Increasing Measures. The key to a successful exemption for the very small offerings to which crowdfunding appeals is keeping the cost low. A number of the new requirements—background checks, recordkeeping requirements, disclosure and information requirements—are going to add to the cost of using the exemption. I think that some of those requirements aren’t worth their cost.
- Resales. Finally, I am worried about the prohibition on resales. As I argue in my article, this is a trap for the unsophisticated purchasers crowdfunding is likely to attract. It’s especially troublesome if resales are deemed to destroy the issuer’s exemption.
Nevertheless, the bill is a huge step in the right direction, and Representative McHenry and his staff should be congratulated for moving the debate along. I’m especially happy to see that the Congressman held the line on state preemption (except for the broker issue mentioned above), which I feel is key to a useful crowdfunding exemption. I think the states have a vital role to play in antifraud enforcement, but complying with state registration requirements would be too costly for these small offerings.
It will be interesting to see what happens in the Senate. If Obama continues to support the bill, we may soon have a crowdfunding exemption.
November 03, 2011
I have blogged from time to time about the crowdfunding phenomenon and the possibility of using crowdfunding for small business capital formation. See, for example, here and here. I have also written an article, available here, proposing a crowdfunding exemption from federal securities law registration requirements.
Political momentum seems to be building in support of some sort of crowdfunding exemption, although what its exact features will be is still unclear. Here are some recent developments:
1. The Jobs and Competitiveness Council created by President Obama in January recently endorsed crowdfunding, at least in a very general way. The Committee’s interim report proposes that “smaller investors be allowed to use ‘crowd-funding’ platforms to invest small amounts in early-stage companies.” The Council’s full report, which provides no further details, is available here.
2. H.R. 2930, a crowdfunding bill introduced by Congressman Patrick McHenry, has been amended and reported to the full House. The amended bill is here. I’ll provide a more detailed discussion of that bill tomorrow.
3. I have been asked to speak on crowdfunding at the annual SEC Forum on Small Business Capital Formation on November 17. I’m impressed that the SEC is willing to invite a longstanding critic like me to speak; it’s like the Democratic National Committee inviting Herman Cain to present a keynote. But I’m a longtime fan of the forum itself; many sensible recommendations have come from those annual meetings, although the SEC usually fails to act on those recommendations. If you’re interested in the forum, more information is available here.