Wednesday, November 13, 2019
"It is clear, however, that shareholders do not have a right to show up at a special meeting and put forth a resolution as to matters, the general nature of which was not included in the notice of meeting." #corpgov https://t.co/sd1XyoWO4h— Stefan Padfield (@ProfPadfield) November 11, 2019
"growing number of CSR claims, whether founded or not, creates difficulties for stakeholders in distinguishing between truly positive business performance and companies that only appear to embrace a model of sustainable development" https://t.co/GCxbA2mUJ9 #corpgov #socent— Stefan Padfield (@ProfPadfield) November 7, 2019
Can "a board of a traditional Delaware corporation defend a decision not to outsource jobs & pay higher wages to reduce income inequality, while openly admitting that such policies will actually reduce stockholder value by reducing corporate profits?" No. [Cue "they can if ...."] https://t.co/r2ielxknhZ— Stefan Padfield (@ProfPadfield) November 8, 2019
"Imagine if FB were in the business of approving ... candidate claims about ... the efficacy of climate-change policy."; "FB could ban political ads altogether" but that "could favor incumbent politicians with large followings." https://t.co/laZU4eOFAV #corpgov— Stefan Padfield (@ProfPadfield) November 8, 2019
"I'd always have this vague hunch that things like sunk cost bias and, indeed, loss aversion, under certain circumstances couldn't really be described as a bias--because, first of all, evolution would have corrected them surely if they'd been that consistently bad." #corpgov https://t.co/Z2Emwx9NRh— Stefan Padfield (@ProfPadfield) November 11, 2019
Tuesday, November 12, 2019
As a professor, I love it when academic research is front-page news! So, I was delighted yesterday to see a piece there in the Financial Times, Academics accuse Morningstar of misclassifying bond funds (here – subscription required), on Huaizhi Chen, Lauren Cohen, and Umit G. Gurun’s recently posted SSRN article: Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds (here).
The gist of the article is that in deriving its risk classifications/ratings for bond funds, Morningstar’s rating system relies upon self-reported, summary data – often misreported – from bond mutual fund managers about the percentages of funds’ assets in different risk categories (AAA, AAA, B, etc.) rather than using it to supplement the data that those same funds file quarterly with the SEC. The authors explain that assets in equity funds are generally of the same security type (for example, common stock), but that this isn’t true in the case of bond funds, which are “more bespoke and unique” with differences “in yield, duration, covenants, etc. – even across issues of the same underlying firm.” (p.2) And while equity might have about 100 positions, bond funds generally have more than 600 issues. (p.2) So, in the case of fixed income funds, the role of information intermediaries such as Morningstar is incredibly important.
The article suggests that “[t]his misreporting has been persistent, widespread, and appears strategic – casting misreporting funds in a significantly more positive position than is in actuality.” (p.1) This matters because such misclassified funds then appear to perform better than others with the same risk classification and, not surprisingly, both retail and institutional investors increase their investment in these funds. (p.3) It also increases expense ratios. (p.5)
Interestingly, the authors comment “[s]tepping back, what makes this even somewhat more surprising is that the funds actually do report holdings directly to Morningstar, and these holdings line up almost perfectly with the SEC-downloaded holdings. Thus, it is literally that Morningstar uses the Summary Reports itself (and not the other data also delivered directly to it by funds) instead of taking the extra step of calculating riskiness itself that contributes to classification.” (p. 5-6). So, did Morningstar allegedly not “tak[e] the extra step” for reasons of cost, an unfortunate oversight, or another possible explanation? Note that the FT article quotes Morningstar as saying “We stand by the accuracy of our data and analytics, and we are reaching out to the authors with an offer to help understanding the data they used and to clarify the…methodologies we employ.”
If the article’s analysis is accurate, at least some funds must have been aware of the misclassifications. If so, what (if any) related responsibility (legal or ethical) might they have in this systemic issue? Assuming the article’s analysis is correct, I would imagine that lawsuits won’t be far behind. Stay tuned! For now, here’s the abstract:
We provide evidence that mutual fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, we provide the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios. Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky. This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds– outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level.
Monday, November 11, 2019
The above photo honors my father's U.S. Army service and my father-in-law's U.S. Army service, in each case, in the Korean War. I took a pause today to respect what they and so many others have done to serve our country. I hope that all veterans and their families and friends have enjoyed a Happy Veteran's Day.
With veteran legal service projects (some through student organizations, like our award-winning Vols for Vets organization at UT Law, a nonprofit supported by many in our community), including full-fledged law clinics (e.g., here and here and here and here and here), emerging across the country, I wondered whether there was any assistance outside the law school context, specifically for veterans who are entrepreneurs. I did find, through a page on the U.S. Veterans Administration (VA) website, that the Office of Small & Disadvantaged Business Utilization has a program for Veteran-Owned Small Businesses. Under the program, a veteran who owns a small business "may qualify for advantages when bidding on government contracts—along with access to other resources and support—through the Vets First Verification Program." A number of additional entrepreneurship programs exist under the auspices of the same VA office. Many can be found on the website for the Office of Small & Disadvantaged Business Utilization (noted above).
In my web travels, I also found a nifty national veteran's entrepreneurship program at the University of Florida Warrington School of Business. And at one of our sister UT system schools, the The University of Tennessee at Chattanooga, the business school--the Gary W. Rollins College of Business--has a Veterans Entrepreneurship Program. And it seems there is quite a bit more out there in the educational setting.
This all seems like a good start. I am sure with more digging, I could find more. I was admittedly gratified, however, to see that Forbes published a piece on free support programs for veteran entrepreneurs. I was hoping to see a bunch more of that kind of thing . . . . Maybe next year?
Again, I send abundant and heartfelt thanks to all of our veterans for their service.
Sunday, November 10, 2019
I have a new(ish) essay that focuses on the concept of eliminating the fiduciary duty in an LLC, as permitted by Delaware law, and what that could mean for future parties. The paper can be found here (new link). When parties A and B get together to create an LLC, if they negotiate to eliminate their fiduciary agreements as to one another, I’m completely comfortable with that. They are negotiating for what they want; they are entering into that entity and operating agreement together of their own free will. So there may be differences in bargaining power—one may be wealthier than the other or have different kinds of power dynamics—but they are entering into this agreement fully aware of what the obligations are and what the options are for somebody in creating this entity.
My concern with eliminating fiduciary obligations comes down the road. That is, how do we make sure that if people are going to disclaim the fiduciary duty of loyalty, particularly, what happens if this change is made after formation? In such a case, I like to look at our traditional partnership law, which says there are certain kinds of decisions, at least absent an agreement to the contrary, that have to go to the entire group of entity participants. That is, a majority vote is not sufficient; there is essentially a minority veto.
I like the freedom of contract elimination of fiduciary duties provides, but I also am sensitive to the risks such eliminations can provide. Thus, I argue that Delaware (and other states allowing reduction or elimination of the duty of loyalty) should require an express statement about the fiduciary duties (when modified from the default) and an express statement of how those duties can be modified, whether expanding, restricting, or eliminating the duties. To protect against the predatory modification of fiduciary duties, I believe that states should include a statutory requirement that changes to fiduciary duties must be express. Here’s my proposal:
Any limited liability company agreement that provides for a modification of the default rules for what constitutes a breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company, whether to expand, restrict, or eliminate those duties, must expressly state if the modifications are intended to expand, restrict, or eliminate the duties. Any limited liability company agreement that allows the modification of fiduciary duties must state expressly how those modifications can be made and by whom. Absent such any such statement, fiduciary duties may only be modified by agreement of all the members.
Supporting freedom of contract has value, but I also think we need to account for the fact that we did not traditionally allow for the elimination of fiduciary duties. As such, we should make sure that those participating in LLCs should know both what they signed up for initially, and also if the entity has provided the opportunity for a majority to make a fundamental change to traditional duties. This balance, I think, is essential to protecting investor expectations while still allowing for entities to develop the model that best serves the members’ goals.
Saturday, November 9, 2019
In recent years, there has been a lot of discussion over the problem of “common ownership,” namely, the fact that the giant institutional investors who dominate today’s markets tend to own stock in everything, and this may be a good thing but can also be bad if it encourages collusive behavior among competing firms linked by the same set of shareholders.
What has received less attention is the effect of common ownership on shareholder voting and corporate transactions. When a handful of large shareholders own stock in two merging partners – say, Tesla and SolarCity (not a hypothetical, incidentally) – they may vote for less-than-optimal deals on one side in order to benefit their holdings on the other side.
There are two implications to this: First, these cross-holdings may incentivize corporate managers to pursue nonwealth maximizing transactions when cross-holders are a significant part of the shareholder base (and may call into question the disinterestedness of large shareholders for Corwin cleansing purposes). And second, very often, these institutional shareholders are actually mutual funds, with cross-holdings not in a single fund, but in multiple funds across a fund family. Yet their voting patterns (or the actions of their portfolio firms) suggest that their influence is geared towards maximizing wealth across the family as though the investments were all part of a single portfolio, which is a potential violation of their duties to each individual fund.
I’ve written about both of these issues: the former in Shareholder Divorce Court (where I describe the Tesla situation) and the latter in Family Loyalty: Mutual Fund Voting and Fiduciary Obligation, but at the time, I only had a limited set of empirical studies to draw upon.
All of which is a long way of saying that two new studies were recently posted to SSRN, and they reach conclusions similar to those of the earlier studies.
First, there’s Dual-Ownership and Risk-Taking Incentives in Managerial Compensation, by Tao Chen, Li Zhang, and Qifei Zhu. They find that institutional investors who own stock and bonds in the same firm are more likely to favor managerial compensation policies that minimize incentives for risk-taking, as compared to institutional investors who own stock alone. Significantly, they find this effect at the mutual fund family level, suggesting that mutual funds are setting voting policy to maximize wealth at their funds collectively, without differentiating policies that might benefit some funds more than others.
Second, there’s Common Ownership and Competition in Mergers and Acquisitions, by Mohammad (Vahid) Irani, Wenhao Yang, and Feng Zhang. Similar to those who find that firms with common owners compete less in their product markets, the authors find that firms with common owners compete less in the takeover market, so that common ownership across potential acquirers of a target firm reduces the likelihood that the target will receive a competing bid, and increases returns to acquirers upon announcement of a bid (though the cross-ownership does not seem to effect target bid premiums or target returns). And, at least as I understand their methodology, these results are identified at the fund family level.
Anyhoo, this is a fascinating area and I very much hope we see more empirical work along these lines.
Thursday, November 7, 2019
Tomorrow, we'll host the first (and possibly annual) Corporate Governance Summit at the University of Nevada, Las Vegas William S. Boyd School of Law for public company directors and others involved in the corporate governance space. Greenberg Traurig is co-hosting the event with us. They, and some of the dedicated staff at UNLV, have done so much of the heavy lifting to get the event together. I'm incredibly grateful for the work the team has put into this. We've assembled a strong mix of panelists including directors, officers, law professors, and corporate lawyers.
We've pulled together a series of panels focusing on hot topics this year. We've got:
- Basic Legal Duties
- Cyber-security and Oversight
- Shareholder Activism
- Social Media
- Sexual Harassment
As I'm looking at the topics we're hitting tomorrow, I'm also thinking ahead. Many of these issues will probably still be significant next year. What do we think the broader trends will be in the next five to ten years? My early sense is that stakeholder governance will draw more and more attention. If we do decide to give non-shareholder stakeholders more voice in corporate governance, I'm not yet sure about the most efficient way to do that.
Wednesday, November 6, 2019
"A proxy advisor who provides voting recommendations ... that ... lack bias may significantly increase a company’s intrinsic value and its stock price. However, if a recommendation ... was created with significant bias, then it may significantly decrease its value." https://t.co/fzuHxhvfyN— Stefan Padfield (@ProfPadfield) November 3, 2019
"we examine the effect of the Supreme Court’s decision in Morrison v. National Australia Bank Ltd. We find that the description of Morrison as a steamroller, substantially ending litigation against foreign issuers, is a myth." https://t.co/n1YaeO5fgd #corpgov— Stefan Padfield (@ProfPadfield) November 4, 2019
"In 2019, shareholders submitted over 380 Environmental and Social-related proposals to S&P 1500 companies; 160 of these proposals reached a vote." https://t.co/UxKez1Fu2O— Stefan Padfield (@ProfPadfield) November 3, 2019
"Under current Delaware case law, courts have allowed Caremark claims to proceed where evidence exists to infer that ... the directors engaged in disobedience by knowingly managing legal risk or flouting, violating, or ignoring the law." https://t.co/DRtNy9YpAO #corpgov— Stefan Padfield (@ProfPadfield) November 5, 2019
"a 'down round' ... entitles the holders of this ratchet provision ... to additional shares that place them in the same ... economic position as if the IPO had priced at a level equal to the last private-equity round valuation" #corpgov https://t.co/7nGZY5vqml— Stefan Padfield (@ProfPadfield) November 6, 2019
Tuesday, November 5, 2019
Professor Kathryn Judge recently posted an essay, The New Mechanisms of Market Inefficiency (here), forthcoming in the Journal of Corporation Law. It is a fascinating read, in addition to being a beautifully written piece. As a banking law scholar, I’m familiar with the concept of and demand for information insensitive assets/money-like assets/safe assets/money (overlapping terms, as Judge notes). However, this essay challenged me to think more deeply about the delicate interplay in financial markets between such assets and “information sensitive” ones, and about mechanisms fostering market efficiency and those supporting market inefficiency. For example, Judge explains that “in order to produce some assets that are insensitive to information, markets also produce other subordinated assets that are backed by the same pool of assets and that are very sensitive to changes in the value of those assets. As a result, domains of ‘information insensitivity’ are almost always nested on top of information sensitive domains and the border between the two is far from stable.” (p.6)
Ultimately, this essay’s purpose is not to answer a number of “fundamental and as yet unanswered questions about the health and functioning of today’s capital markets” (p.4), but rather to reveal their importance, and lay a foundation for asking them. For legal scholars working in this area, and thinking about important and interesting issues to tackle next, Judge’s essay would be a great place to start. Here’s the abstract:
Mechanisms of market inefficiency are some of the most important and least understood institutions in financial markets today. A growing body of empirical work reveals a strong and persistent demand for “safe assets,” financial instruments that are sufficiently low risk and opaque that holders readily accept them at face value. The production of such assets, and the willingness of holders to treat them as information insensitive, depends on the existence of mechanisms that promote faith in the value of the underlying assets while simultaneously discouraging information production specific to the value of those assets. Such mechanisms include private arrangements, like securitization structures that repackage cash flows from debt instruments to produce new financial instruments that are less risky and more opaque than the underlying debt, and public ones, like the rules allowing many money market mutual funds to use a net asset value of $1.00. This essay argues that recognizing these mechanisms of market inefficiency as such is a critical first step in devising policy interventions that achieve desired aims. This runs counter to the instincts of many market regulators, like the Securities and Exchange Commission, and academics who have often assumed that markets should be structured to promote information generation and efficiency.
The essay further shows, however, that defenders of the information-insensitive paradigm have failed to provide a robust institutional account of how those mechanisms can remain robust across different states of the world or the government support required if they cannot. When an adverse shock or other signal raises questions about the value of the assets underlying an information-insensitive instrument, market participants can refuse, en masse, to treat those instruments as safe. Unless the government or some other actor can provide credible information about the value of the underlying assets or financial support that renders such information irrelevant, widespread market dysfunction can follow. When that happens, the very mechanisms of market inefficiency that had enabled a market to develop can exacerbate dysfunction. Following Ronald Gilson and Reineer Kraakman’s admonishment that institutions always matter, this essay calls for the development of rich institutional accounts of how the mechanisms of market inefficiency work, when and how they can fail, and what these dynamics reveal about the role regulators should play in these domains.
Monday, November 4, 2019
I approached with some curiosity the Securities and Exchange Commission's recent shareholder proposal guidance in Staff Legal Bulletin No. 14J ("SLB 14J"). My interest in this topic stems from my past life as a full-time lawyer in private practice. During that time, I both wrote shareholder proposals and wrote no-action letters to the Securities and Exchange Commission ("SEC") to keep shareholder proposals out of corporate proxy statements.
In SLB 14J, the SEC clarifies its application of the "ordinary business" exception to the inclusion of a shareholder proposal under Rule 14a-8. Specifically, "[t]he Commission has stated that the policy underlying the 'ordinary business' exception rests on two central considerations. The first relates to the proposal’s subject matter; the second relates to the degree to which the proposal 'micromanages' the company." I want to share the SEC's guidance with you on the latter.
The idea of shareholders micromanaging most public firms is almost laughable. Yet, certain shareholder proposals do get somewhat specific in their direction of the firm and its resources.
In considering arguments for exclusion based on micromanagement, . . . we look to whether the proposal seeks intricate detail or imposes a specific strategy, method, action, outcome or timeline for addressing an issue, thereby supplanting the judgment of management and the board. [A] proposal, regardless of its precatory nature, that prescribes specific timeframes or methods for implementing complex policies, consistent with the Commission’s guidance, may run afoul of micromanagement. In our view, the precatory nature of a proposal does not bear on the degree to which a proposal micromanages. . . .
This makes some sense to me, yet this guidance may not be as easy to apply as the SEC may think. Here is the SEC's example of an excludable proposal:
For example, this past season we agreed that a proposal seeking annual reporting on “short-, medium- and long-term greenhouse gas targets aligned with the greenhouse gas reduction goals established by the Paris Climate Agreement to keep the increase in global average temperature to well below 2 degrees Celsius and to pursue efforts to limit the increase to 1.5 degrees Celsius” was excludable on the basis of micromanagement. In our view, the proposal micromanaged the company by prescribing the method for addressing reduction of greenhouse gas emissions. We viewed the proposal as effectively requiring the adoption of time-bound targets (short, medium and long) that the company would measure itself against and changes in operations to meet those goals, thereby imposing a specific method for implementing a complex policy.
I am note sure how I feel about the characterization of this proposal as excludable. Is the described proposal about reporting or about "prescribing the method for addressing the reduction of addressing reduction of greenhouse gas emissions"? Well, maybe a little of each . . . . What do you think?
During my time in active, full-time law practice, the format and content of Rule 14a-8 changed a number of times. It appears that the SEC may be poised to make another change--one more fundamental than enhanced guidance. According to one recent report, the SEC may announce as early as tomorrow "changes . . . to make it harder for shareholders to file proposals, and harder for proposals to be eligible for re-filing in subsequent years." Stay tuned for that possible announcement.
[Note: All footnote references in the quotations used in this post have been omitted.]
Saturday, November 2, 2019
It wasn’t terribly long ago (okay, fine, it was 23 years ago, I’m dating myself) when Friends aired this:
I’m guessing that depiction of stock trading was accurate for most people; it wasn’t that it was necessarily hard to open a brokerage account and trade, it was simply that most people didn’t quite understand the mechanics of how to go about it. Even with online trading, you still have to go out of your way to seek opportunities to trade. But what happens if stock trading is one of several simple options presented when people open up an app that they use every day?
That question is apparently about to be answered: Square, the payments app, recently announced that it will begin permitting free stock trades on its platform, setting itself up as a competitor to Robinhood. And the part that interests me isn’t simply the prospect of free trading, but the prospect of easy trading, accomplished with all the forethought of a candy bar purchase in the grocery check out aisle.
I suppose retail shareholders will never replace institutions for sheer size, but enough could enter the market to make some difference. Will their uninformed trades create new opportunities for hedge funds to profit – perhaps by reducing some of the distortions introduced by indexing? Will we see something like a “consumer premium,” whereby retail traders favor household names, companies they prefer because they patronize?
Will corporations try to cultivate retail shareholder bases? It is generally believed retail shareholders are more passive about voting, and more likely to vote with management when they do cast a proxy ballot; if the retail market surges, I can imagine corporations reaching out to these shareholders. Stock splits might come back in vogue, to attract retail investors who are disinclined toward impulse purchases of stocks priced in the $2000 range (even with the possibility of fractional trading).
Will we see a more vigorous effort to involve retail shareholders in the voting process? Will there be special mechanisms to enable retail shareholders to ask questions of executives on conference calls? Will we see more proxy solicitations like this one?
If we do, will retail shareholders use default voting arrangements and technological tools to oppose ESG related proposals? Or will an influx of casual retail shareholders result in greater ESG support? Will a cottage industry of retail proxy advisors sprout up – especially nonprofits with an agenda (i.e., “download the Sierra Club’s default voting instructions, compatible with the Square app!”)
If there are more retail shareholders in the market, will Delaware reconsider cases like Corwin, which are predicated on the existence of a highly institutionalized shareholder base?
I suppose it’s all a thought experiment for now but I do wonder how technological ease of stock trading has the potential to reshape the market.
Thursday, October 31, 2019
A new report from the Global Financial Literacy Excellence Center sheds some light on how workplace-only investors differ from others. The report identifies workplace-only investors as persons "who only have retirement accounts through their employers." These are people who do not invest outside of these workplace-affiliated accounts. They account for about 15% of the total population studied in the report. As a group, about 53% of workplace-only investors are women. In contrast, the report identifies active investors as persons who have investment accounts in addition to any workplace accounts. This accounts for 43% of the population studied. Another 42% simply don't have any investments--employment or otherwise.
The report finds that financial literacy levels differ by type of investor and that a financial literacy gap exists between active investors and workplace-only investors. While most people get basic asset-pricing questions wrong, "workplace-only investors exhibited an even lower understanding of asset pricing." They also exhibited lower understanding on diversification questions.
More and more people now find themselves automatically enrolled in retirement accounts. They begin to regularly invest this way with each pay period. It doesn't surprise that many people who have invested this way do not develop the same level of financial literacy as others who invest more actively.
The findings make me consider whether the basic account opening forms used by brokerage firms accurately capture the true experience of investors. Someone who accumulated securities in a 401k for 20 years might be classified as having 20 years of investing experience. Yet a workplace-only investor probably should not be treated as an experienced investor simply because an employers automatic retirement savings plan accumulated securities for 20 years. It may make sense to break these workplace-only investors out from active investors on account opening forms.
On November 8, Professor Kristin Johnson of Tulane will host Tulane Law School’s 2019 Gamm Comparative Law and Justice Symposium, focusing on The Implications of Artificial Intelligence for a Just Society. The rise of artificial intelligence introduces efficiencies and new opportunities in finance, employment, education, criminal law enforcement risk assessments, national security and the automation of the various professions, including the development of smart contracts and the automation of various skills associated with the practice of law. Recursive learning and neural networks enable machine learning algorithms to adapt beyond simple instructions and independently assess data in decision-making processes. Early evidence indicates, however, that learning algorithms may operate in a manner that leads to unfair, biased or unethical and in some cases, discriminatory outcomes.
The Gamm Symposium will explore these normative concerns and proposed solutions including proposals demanding algorithmic accountability or, more specifically, proposals encouraging explainability and transparency. Advancing the discussion beyond traditional proposals, the Symposium concludes with a panel exploring the lack of gender balance in the technology industry and capital investment in women-lead technology firms.
The event is free and open to the public, though registration is required. More information is available here.
Wednesday, October 30, 2019
"Basically, ... Lipton and Savitt are accusing Strine and other 'accomplished jurists such as Chancellor Chandler, Chancellor Allen, and Justice Moore' [of] not understanding what they wrote," #corpgov https://t.co/vf6EJ1upQa— Stefan Padfield (@ProfPadfield) October 28, 2019
"This Article studies the first systemic implementation of proxy access and finds that while proxy access was rarely used to nominate directors, it was used indirectly — as a bargaining tool — to improve board diversity." https://t.co/G1FRR81XgE #corpgov— Stefan Padfield (@ProfPadfield) October 24, 2019
"Traditionally, the SEC has studied information leaks prior to merger announcements and identified numerous instances of insider trading. Our paper suggests that regulators should also assess the trading history of a stock surrounding the announcement of a breach." #corpgov https://t.co/hzdV9ayS2I— Stefan Padfield (@ProfPadfield) October 24, 2019
"Reuniting ownership and control ... the leveraged buyout ... helped reform management practices in ... U.S. companies. Due to mounting competitive pressures, however, private equity is finding relatively fewer underperforming companies to fix." https://t.co/XZNIUZtM2D #corpgov— Stefan Padfield (@ProfPadfield) October 24, 2019
Tuesday, October 29, 2019
“Big banks do not usually gang up to demand more financial regulation, least of all with asset managers in tow.” That’s the first sentence of Gillian Tett’s recent piece, Banks are right to say that clearing houses are ripe for reform, in the Financial Times (here – subscription required). Her title and lead sentence are spot on. That should be worrisome to all. Tett’s piece centers on a white paper, A Path Forward for CCP Resilience, Recovery, and Resolution (here), released on October 24, 2019, by nine financial institutions (Allianz Global Investors, BlackRock, Citi, Goldman Sachs, Societe Generale, JPMorgan Chase & Co., State Street, T.RowePrice, and Vanguard). Tett states: “the current status quo around clearing houses is worrying.” As BLPB readers know, I agree.
The white paper calls for “enhanced risk management standards and aligning incentives through requirements for meaningful CCP [clearinghouse] own capital for covering both default and non-default losses and recapitalization resources.” (p.1) It highlights the incentive misalignment present in many clearinghouses given their publicly-traded, shareholder ownership status: “Although CCP shareholders take 100% of the returns a CCP earns from clearing revenues, they bear only a small portion of the losses the CCP incurs as a result of a default.” (p.10) Many of its recommendations are not new, but some are. These include: a clearing member voting mechanism in recovery; ex-ante provision of financial resources for resolution; and, the possibility of “long-term debt that could be bailed in for recapitalization.” (p.1)
While I generally agree with the white paper’s recommendations, I don’t think they go far enough. As I’ve posted before on clearinghouses (here, here, here, here) and will do so in the future, I’ll just highlight a few things. First, while increasing clearinghouse capital is a step in the right direction towards better incentive alignment, it’s only a start. The ownership structure itself of these institutions needs to be addressed. If clearinghouses were owned by their members – as they were historically – the incentive misalignment between members and owners would largely diminish. However, as I’ve noted in Incomplete Clearinghouse Mandates (here), even if clearinghouses are all member-owned, this doesn’t solve the problem of who ultimately holds the extreme tail risk of these institutions. In a previous post (here), I pointed out parallels between clearinghouses and the residential mortgage giants, Fannie Mae and Freddie Mac, whose exit from government ownership is still pending more than a decade after the financial crisis. Let’s not go down the same route in the clearinghouse space.
Second, the white paper argues that clearinghouses should generally be responsible for non-default losses. I agree. However, as I’ve noted before, both types of losses could occur in close proximity. Hence, it could be very difficult in practice to separate them out to allocate any losses in the case of investor-owned clearinghouses. Finally, as I write about in forthcoming research, clearinghouses are self-regulatory organizations (SROs). Presumably, they would be acting in a regulatory capacity in a recovery scenario as it is arguably the analog to government action in a resolution scenario. Exchanges, as SROs, are generally entitled to regulatory immunity for actions taken in a regulatory capacity (for more on exchange immunity, see here). At the same time, the recovery of an investor-owned, distressed clearinghouse is also inherently a commercial endeavor. It is fundamentally about the survival of the clearinghouse, and potentially the exchange group structure itself. So, it could be very difficult in practice to separate regulatory from commercial action for purposes of regulatory immunity. Given this consideration, investor-owned clearinghouses could have less incentive to be circumspect about recovery decisions that might adversely impact members.
Tett refers to a “trenchant letter” from the Systemic Risk Council to the Financial Stability Board “demanding action” on clearinghouses. Paul Tucker, who chairs the Council, is the former Deputy Governor of the Bank of England. In closing, I recommend that readers interested in understanding more about the centrality of clearinghouses in financial markets read a 2014 speech by Tucker: Are Clearing Houses the New Central Banks? If the answer to Tucker's question is yes, that says it all!
Monday, October 28, 2019
The recent Tennessee Court of Appeals decision in Mulloy v. Mulloy has me thinking. Here is the case synopsis:
Two brothers formed a limited liability company to own and lease a commercial property. When the tenant sought to expand, both brothers sought to find a suitable space for the tenant to lease. The younger of the two brothers found a property that would ideally suit the tenant’s needs, a fact that was communicated to his brother. The older brother purchased the property through a newly created limited liability company without his younger sibling’s involvement. The older brother’s new limited liability company then leased the new property to the tenant. The younger brother brought a derivative suit against his brother and the newly formed limited liability company, claiming usurpation of a corporate opportunity belonging to the limited liability company that the brothers had formed together and tortious interference with business relationships. The younger brother also claimed unjust enrichment. Following a trial, the chancery court found in favor of the older brother and his newly formed limited liability company and dismissed the complaint. After our review of the record, we affirm.
The facts are quite a bit more complex than that. But you get the idea.
First, let me make Josh Fershee's point for him: limited liability company (LLC) members cannot usurp "corporate" opportunities, since they are not corporations. Indeed, the court in Mulloy repeatedly refers to the doctrine in that way and cites to corporate law precedent we all know and love. This despite an accurate citation to Tennessee's statutory standard for the usurpation of LLC opportunities: requiring members to hold in trust for the LLC "any property, profit or benefit derived by the member in the conduct . . . of the LLC’s business, or derived from a use by the member of the LLC’s property, including the appropriation of any opportunity of the LLC.” Tenn. Code Ann. § 48-249-403(b)(1).
But the big surprise for me was "we affirm." Why? I just kept thinking of Meinhard v. Salmon. Apart from he fact that this case involves a Tennessee LLC and two brothers, the material facts are substantially similar. Yet, the result is different. The Mulloy court reasons that the property acquisition opportunity at issue was not the LLC's, but rather the older brother's (even though the brothers' jointly owned LLC existed to lease property to a specific tenant--the same tenant to which the older brother rents the new property--property that the younger brother originally identified). The court references facts that do help the older brother here. But something just smells wrong about this. The lack of candor in this situation is particularly disturbing.
So, that set me to wondering if there was a way to get that "punctilio of an honor, the most sensitive" back into the judicial sightline. Immediately, I thought of Anderson v. Wilder--a 2003 Tennessee Court of Appeals case in which the court applies the close corporation shareholder fiduciary duties under Massachusetts corporate law to members in a Tennessee LLC. However, it then occurred to me that Anderson was decided under Tennessee's "old" LLC Act; but the LLC in Mulloy opted into Tennessee's modernized, "new" LLC Act, which became effective on January 1, 2006. The new LLC Act is modeled in part on the Revised Uniform Limited Liability Company Act and provides as follows, in pertinent part (in Tenn. Code Ann. § 48-249-403(a) and (b) (emphasis in italics added)):
- "The only fiduciary duties a member owes to a member-managed LLC and the LLC's other members and holders are the duty of loyalty and the duty of care . . . ."
- "A member's duty of loyalty to a member-managed LLC and the LLC's other members and holders of financial rights is limited to the following: (1) To account to the LLC and to hold as trustee for it any . . . benefit derived by the member in the conduct . . . of the LLC's business, or derived from a use by the member of the LLC's property, including the appropriation of any opportunity of the LLC . . . ."
These statutory provisions would appear to foreclose an argument that members of an LLC organized under the new LLC Act have a fiduciary duty of utmost good faith and loyalty to each other under Anderson (or otherwise at common law). Much as I hate to admit it, that's the way a court should, and likely would, see this.
What do you think? Is my concern about the holding in the appellate court opinion in Mulloy warranted? Or do we treat the Mulloy brothers like "big boys" and agree with the appellate and trial courts? Your views are welcomed. I am looking for some creative arguments here . . . .
After spending the entire day grading undergraduate business law exams, I drove to my son’s elementary school for our first parent-teacher conference. On my wife’s advice, I mostly just listened. My legal and academic training have given me “a very particular set of skills” that I can use to construct and deconstruct arguments in a way some people find combative, so my wife's advice was probably wise.
The parent-teacher conference for our kindergarten-aged son went well. Most important to me, it was clear that our son’s teacher already appeared to love him and seemed committed to helping him develop. But I worry about what our education system may do to my son. Only two months into formal school, my sweet son, who has been in speech therapy since age two, is already receiving grades. Granted, the grades are pretty soft at this point – 3 for mastery, 2 for on track to complete this year, 1 for behind schedule. I hope he will not get overly discouraged. I also know he will not receive nearly as much affirmation in school for his impressive, budding artistic skills as he would for a photographic memory.
This parent-teacher conference, coupled with a handful of especially weak student exams, prompted a lot of thoughts about grading over the past few days.
As a parent, and increasingly as a professor, I am becoming convinced that we (as a society) over-focus on grades and our grades largely miss what is truly important. As a parent, I feel a good deal of responsibility for the development of my children, and as a professor, I obviously think education is an important part of human development. But before my oldest son started kindergarten this August, I wrote down some of the traits I hope my children will develop before they leave our home. In alphabetic order, they include:
While it is tempting to fixate on quantifiable things, like grades, I am attempting to model, praise, and teach the character traits above. And sometimes “failure” will develop these character traits better than “success.” I am seeing this in my son. He has already struggled more academically than I did in my entire educational experience, but, perhaps because of this, he is already significantly ahead of me in compassion and kindness.
As educators, if we are wed to giving grades, why do we only grade such a narrow set of skills? (For a debate in The Chronicle of Higher Education on the usefulness of grades, see here: useful and not useful.) For example, why do we often regulate athletic, artistic, and communication-based courses to pass/fail or effort-based grades, but mark academic work with such relative precision? (One theory is that teachers and administrators are generally naturally gifted in academic pursuits, but are generally not as gifted in athletic, artistic and communication-based areas.) In middle school, for physical education class, we were graded, in part, on our 1-mile time. If I remember correctly, under 6:00 was a 100% and you failed if you ran over 12:00. While it was only maybe 10% of our overall PE grade, I can’t imagine that many schools do that these days. And I understand the arguments against doing so – namely, some students have a significant genetic advantage over other students in endurance running. That said, the same can be said for test-taking. For most students, both endurance running and test-taking can be improved, but some students face much higher hurdles than others.
All of this thinking about grading has not led me to any definite conclusions yet, but I welcome thoughts in the comments. And, in coming semesters, I may try to diversify my grading even more, to capture more skills and to challenge a wider range of students. (The students who are most harmed by our current system may actually be the straight-A students who find tests easy, but who never or rarely face assessment in their naturally weaker areas). I already include a group project and participation as parts of the grade in most of my classes, but I could probably expand this to a higher percentage of the overall grade. That said, I also think that grades should reflect the level of proficiency obtained, so I think substantive knowledge will and should remain important.
Saturday, October 26, 2019
The Laundromat is Steven Soderbergh’s (and Netflix’s) loose adaptation of James Bernstein’s nonfiction book, Secrecy World: Inside the Panama Papers, illustrating the conduct facilitated by shell companies and the lawyers who supply the paperwork. Both in style and substance, it echoes Adam McKay’s The Big Short – which is why every. single. review. draws that comparison, and so will I – but sadly, I found it neither as entertaining nor as coherent.
The Laundromat takes the form of multiple vignettes regarding people whose lives are touched by the shell entities facilitated by the lawyers at Mossack Fonseca, with Gary Oldman and Antonio Banderas narrating as Mossack and Fonseca, respectively. They break the fourth wall as they offer tuxedo-clad, cynical descriptions of the services the firm provides.
Despite shoutouts to 1209 North Orange and its 285,000 companies – as well as the confession, I assume truthful, that Soderbergh has 5 companies at that location – the film never really offers an explanation of precisely what shell companies do for their owners. That was one of the things I thought The Big Short attempted reasonably well: It took the complexity of the financial crisis and made a decent stab of explaining it in an entertaining way (my prior review here). The Laundromat tells us that these companies are stuffed with (illict) assets and that they offer privacy, but never goes further than that.
In fact, what explanations the film does offer are somewhat contradictory. We’re told that shell companies facilitate legal tax evasion, but the vignettes have nothing to do with tax evasion; they have to do with fraud, bribery, and other crimes. Moreover, multiple characters – including Mossack and Fonseca – end up in jail, so it’s clear that somebody did something illegal and the shell companies couldn’t protect them.
The truth, of course, is that shell entities have a variety of purposes, and can be used for both legal and illegal purposes, but that’s far too complex a story to portray on film, leaving The Laundromat’s explanations muddled and – from a pedagogical point of view – deeply disappointing.
At the same time, the movie doesn’t really stand on its own simply as a movie, divorced from the intricacies of the scandal that inspired it. The vignettes are half-finished, because they exist only as vehicles to illustrate the broader point about how wealthy people shield themselves from liability to the masses, which means that the failure to effectively so illustrate dooms the entire project.
Wednesday, October 23, 2019
[NOTE: You should see embedded Tweets. If you don't, please try a different browser.]
"Yesterday, the Staff of the SEC ... provided additional guidance ... on two key considerations for excluding Rule 14a-8 SH proposals under the 'ordinary business' exception ...: the significance of the proposal’s subject matter and whether it seeks to 'micromanage' the company." https://t.co/1TOOOaaoIy— Stefan Padfield (@ProfPadfield) October 19, 2019
"we find that proxy advisory firms ... exercise significant influence over executive pay practices.... We also find that PAs are susceptible to conflicts of interest and generally use a 'one‐size‐fits‐all' approach to voting recommendations." https://t.co/4wIymTa313 #corpgov— Stefan Padfield (@ProfPadfield) October 17, 2019
"four central concepts that are widely discussed ... but loosely defined and poorly understood":— Stefan Padfield (@ProfPadfield) October 16, 2019
1: Good Governance
2: Board Oversight
3: Pay for Performance
4: Sustainability https://t.co/9tmzNzJM0g
"The five-year growth rate in CEO pay for the S&P 500 companies is 23 percent compared with the five-year TSR [total shareholder return] for the S&P 500 companies of 50 percent." https://t.co/3wjVyRuQ2w— Stefan Padfield (@ProfPadfield) October 12, 2019
Tuesday, October 22, 2019
Yesterday, my weekly SSRN search on the keyword “derivatives” returned a fascinating article: Vincent S.J. Buccola, Jameson K. Mah, and Tai Zhang’s The Myth of Creditor Sabotage (forthcoming in the U. of Chi. L. Rev. 2020). For years now, as researchers in this area know, much speculation has existed about the role of net-short creditors – those creditors for whom “a derivative payoff [as a result of a debtor’s failure would be] more than sufficient to offset a loss on the underlying investment” – potentially play in a debtor’s demise. Indeed, I’ve posted about Confining Lenders with CDS Positions. Largely missing from such debates, however, has been discussion of other market participants’ incentives. Indeed, as the authors state in their Introduction: “The problem with the sabotage story is not that it misapprehends net-short creditors’ incentives, but that it ignores everyone else’s.” So basic, yet so right. Thus far, legal scholarship has insufficiently focused on this critical consideration. In hopes of helping to reverse this shortfall, I highly encourage readers to review this article. It is posted on SSRN here and an abstract is below:
Since credit derivatives began to substantially influence financial markets a decade ago, rumors have circulated about so-called “net-short” creditors who seek to damage promising albeit financially distressed companies. A recent episode pitting the hedge fund Aurelius against broadband provider Windstream is widely supposed to be a case in point and has at once fueled calls for law reform and yielded an ostensible effigy of Wall Street predation.
This article argues that creditor sabotage is a myth. Net-short strategies work, if at all, by in effect burning money. When therefore an activist creditor shows its cards, as all activists must eventually do, it also reveals an opportunity for others to profit by thwarting the activist’s plans and saving threatened surplus from the ashes. We discuss three sources of liquidity that targeted firms could tap to block a saboteur — “net-long” derivatives speculators, the targets’ own investors, and bankruptcy. We conclude that it is exceedingly difficult for creditors to make money hobbling debtors and that there is little reason to believe anyone tries. We then examine the Windstream case and find, consistent with our theory, that the strongest reason for thinking Aurelius aimed at sabotage, namely that everyone says so, is weak indeed. Our analysis suggests that calls for law reform are addressed to a non-existent or at worst self-correcting problem. Precisely for this reason, however, the persistent appeal of the sabotage myth is a lesson in political rhetoric. A story needn’t be true for some to find it useful.
Monday, October 21, 2019
Given the number of corporate governance functions that can be conducted using blockchains, it seems appropriate to consider how business lawyers should respond to related challenges. Babson College's Adam Sulkowski and I undertook to begin to address this concern in an article we wrote for the Wayne Law Review's recent symposium, "The Emerging Blockchain and the Law." That article, Blockchains, Corporate Governance, and the Lawyer's Role, was recently released. An abstract follows.
Significant aspects of firm governance can (and, in coming years, likely will) be conducted on blockchains. This transition has already begun in some respects. The actions of early adopters illustrate that moving governance to blockchains will require legal adaptations. These adaptations are likely to be legislative, regulatory, and judicial. Firm management, policy-makers, and judges will turn to legal counsel for education and guidance.
This article describes blockchains and their potentially expansive use in several aspects of the governance of publicly traded corporations and outlines ways in which blockchain technology affects what business lawyers should know and do—now and in the future. Specifically, this article describes the nature of blockchain technology and ways in which the adoption of that technology may impact shareholder record keeping and voting, insider trading, and disclosure-related considerations. The article then reflects on implications for business lawyers and the practice of law in the context of corporate governance.
In the article, Adam and I do a fair amount of visioning. Based on the development of blockchain corporate governance we imagine, we conclude that business lawyers must both focus on understanding technology in the context of their clients' business operations and be proactive in providing legal advice relating to potential uses of the technology. We conclude that,
[i]n representing business clients, counsel have a critical role in thinking through all the implications of moving any governance function or process to a blockchain-based platform. It is especially important to help clients see, consider, and appreciate certain irrevocable consequences and legal risks, as well as potential opportunities. . . .
There is much for us all to learn in this area. A number of legal scholars are engaging in work that may be useful in better informing us. I, for one, try to attend as many of their presentations as possible as a means of better informing myself of what I need to know to teach corporate governance in the blockchain era. (We note in the article that blockchain corporate governance "impacts the job of legal educators and law schools.") I will continue to be on the lookout for additional work on blockchain corporate governance (and lawyering in an increasingly blockchain-driven world) and endeavor to highlight key things I find by posting about them here.