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 28, 2011
"Shareholder Primacy" in Delaware Still Only Matters When Buyers Benefit
Steven Davidoff notes, For Wall Street Deal Makers, Sometimes It Pays to Be Bad. He focuses on J.Crew’s $3 billion buyout management buyout and Del Monte Foods’ $5.3 billion acquisition by KKR, Vestar Capital Partners and Centerview Capital. Davidoff notes that a Delaware court found J Crew management's behavior to be “icky” and another Delaware court heavily criticized the Del Monte deal. Nonetheless, the deals went forward.
Davidoff says that the current state of the law makes it hard to come up with a penalty to to deal with bad behavior. He explains:
[T]he problem is what to do about the penalty. Depriving shareholders of a buyout, even at a bad price, would punish them.
He's right, but if you go back to poison pill cases, see, e.g., the Airgas decision, you can see that Delaware courts are willing to deprive shareholders of a buyout, as long as management wants to keep the deal from shareholders, even for an all-cash deal. As I have noted before, "I can't see a good justification for not presenting an all-cash offer to shareholders once . . . ample time has been given to entice other potential bidders into the game."
Anyway, I share Professor Davidoff's view that we need a good penalty, but I happen to think the big issue is that there is a lack of willingness, not ability. I mean, Delaware courts are really, really good at this corporate governance thing.
Maybe the answer to create a sort of shareholder's business judgment rule for all-cash deals. That is, after adequate time for gathering other offers has passed, we add a blanket rule that all, all-cash deals that offer a premium over the current trading price will be presented to shareholders (along with management's explanantions and recommendations). This would operate like a sort of all-cash Revlon trigger. I can imagine a scenario where shareholders might choose the wrong option in such a case, but I think part of shareholder primacy includes, from time to time, respecting possible shareholder stupidity.
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 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 27, 2011
Facebook about to go public?
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.
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 17, 2011
"[C]onstrained by Delaware Supreme Court precedent"?
Following up on both Elizabeth's post announcing that Chief Justice Myron T. Steele of the Delaware Supreme Court would be speaking at Stanford, and Josh's post on the Glom's Masters Forum on Chancellor William B. Chandler III's contributions to the Delaware Chancery Court, I note the following:
Over at the Glom, Afra Afsharipour discusses Chancellor Chandler's Airgas decision and notes that "like other commentators … I expected that Chancellor Chandler would uphold the pill. What I didn’t quite expect was Chancellor Chandler’s frank articulation of how decades of Delaware case law on the poison pill essentially gave him no choice but to reach the result that he did."
Meanwhile, a report from a recent panel discussion on cross-border issues in mergers and acquisitions notes that Chief Justice Steele interprets the case law differently:
Steele took issue with the view that the Chancery is constrained in its ability to remove a pill in the appropriate circumstances. He suggested that if the chancellor had found facts that were inconsistent with it being reasonable to keep the pill in place, an injunction against maintaining the pill could be issued under Delaware law. Where there is a battle of valuations, rather than the defence of a long-term strategy, a case can be made for removing the pill and letting the shareholders decide.
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
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.
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 04, 2011
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.
October 22, 2011
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:
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
October 19, 2011
The Zapata of Acquisitions?: Special Committees Must Act Like Third Parties
As noted in an earlier post, a Delaware court (pdf here) determined that Southern Peru Copper Corp.'s directors were improper (to the tune of $1.2 billion in damages) in following its special committee's recommendation to purchase Minera for $3.1 billion in Southern Peru stock. The court explained that the special committee violated its fiduciary obligations by not leveraging its position in the same way a third party would in that situation. The court explains:
In other words, the Special Committee did not respond to its intuition that Southern Peru was overvalued in a way consistent with its fiduciary duties or the way that a third-party buyer would have. As noted, it did not seek to have Grupo Mexico be the buyer. Nor did it say no to Grupo Mexico’s proposed deal. What it did was to turn the gold that it held (market-tested Southern Peru stock worth in cash its trading price) into silver (equating itself on a relative basis to a financially-strapped, non-market tested selling company), and thereby devalue its own acquisition currency. Put bluntly, a reasonable third-party buyer would only go behind the market if it thought the fundamental values were on its side, not retreat from a focus on market if such a move disadvantaged it. If the fundamentals were on Southern Peru’s side in this case, the DCF value of Minera would have equaled or exceeded Southern Peru’s give. But Goldman and the Special Committee could not generate any responsible estimate of the value of Minera that approached the value of what Southern Peru was being asked to hand over.
Note that the court here was evaluating this case for entire fairness, and not considering the applicablity of the business judgment rule. Here, "the defendants with a conflicting self-interest [had to] demonstrate that the deal was entirely fair to the other stockholders." They failed.
The court specifically states, "[T]here is no need to consider whether room is open under our law for use of the business judgment rule standard in a circumstance like this, if the transaction were conditioned upon the use of a combination of sufficiently protective procedural devices." In essence, the court (appropriately) declines to answer here whether there might be a similar circumstance where the court might treat a special acquisition committee like a special litigation committee. If so, in this instance, I'm thinking a Zapata-like test might be the right call.
That is, when (like in Southern Peru) "a controlling stockholder stands on both sides of a transaction" (to parallel Zapata):
First, the Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions. . . . The corporation should have the burden of proving independence, good faith and a reasonable investigation, rather than presuming independence, good faith and reasonableness. . . . .
[Second, t]he Court should determine, applying its own independent business judgment, whether the [acquisition price was reasonable.] . . . The second step is intended to thwart instances where corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporate actions would simply [ratify an improper valuation to the detriment of disinterested shareholders.]
On the one hand, this might be over broad and limit the ability of a company to take advantage of an opportunity uniquely available to it by virtue of the controlling shareholder. Still, it seems to me that, just as in Southern Peru, the court is capable of making this assessment. If the special committee can justify the transaction, then it should have before supporting the deal. If not, the court will take a closer look. Note that this would only apply where there was a controlling shareholder on both sides of the transaction, and not in other arm's length deals, where the business judgment rule is the proper test.
Perhaps this is giving the court too much of a role, but I think they got it right in Southern Peru, and that may translate in other contexts, too.
October 18, 2011
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.
October 17, 2011
$1.236 Billion of Foreshadowing in Delaware
On October 14, 2011, Chancellor Strine issued the opinion, In re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS (Del. Ch. Oct. 14, 2011). As noted by Francis Pileggi, the opinion has more than 100 pages dedicated to explaining the myriad ways the company's directors breached their fiduciary duties.
When I first started reading the case, I couldn't help but think about receiving the opinion if I were an attorney on the case or one of the litigants. When I was in practice, it was FERC opinions or orders issued by an ALJ or the Commission, and I remember reading anxiously for hints in the first few paragraphs of where it was headed. This case had more than a billion dollars on the line, so I have to imagine everyone involved started reading it the moment they knew it was available.
So here's the start of In re Southern Peru Copper Corporation:
This is the post-trial decision in an entire fairness case. The controlling stockholder of an NYSE-listed mining company came to the corporation’s independent directors with a proposition. How about you buy my non-publicly traded Mexican mining company for approximately $3.1 billion of your NYSE-listed stock? A special committee was set up to “evaluate” this proposal and it retained well-respected legal and financial advisors.
The financial advisor did a great deal of preliminary due diligence, and generated valuations showing that the Mexican mining company, when valued under a discounted cash flow and other measures, was not worth anything close to $3.1 billion. The $3.1 billion was a real number in the crucial business sense that everyone believed that the NYSE-listed company could in fact get cash equivalent to its stock market price for its shares. That is, the cash value of the “give” was known. And the financial advisor told the special committee that the value of the “get” was more than $1 billion less.
Rather than tell the controller to go mine himself, the special committee and its advisors instead did something that is indicative of the mindset that too often afflicts even good faith fiduciaries trying to address a controller. Having been empowered only to evaluate what the controller put on the table and perceiving that other options were off the menu because of the controller’s own objectives, the special committee put itself in a world where there was only one strategic option to consider, the one proposed by the controller, and thus entered a dynamic where at best it had two options, either figure out a way to do the deal the controller wanted or say no.
As is probably clear, the special committee did not say no. And as you probably gathered, the court imposed roughly $1.236 billion in damages for their chosen course of action. There are 100 pages of explanation, but it was pretty clear where this one was going after about line four of the opinion.