Business Law Prof Blog

An Argument for Self-Certification under Rule 506(c) and the New Crowdfunding Exemption

The SEC’s new Rule 506(c) exemption, mandated by the JOBS Act, allows issuers to solicit anyone to purchase securities, through public advertising or otherwise, as long as they only sell to accredited investors (or investors that the issuer reasonably believes are accredited investors). For most individuals, accreditor investor status depends on the investor’s annual income and net worth.

The crowdfunding exemption added by the JOBS Act allows issuers to sell securities to anyone, accredited or not, but the amount of securities each investor may purchase depends on the investor’s net worth and annual income. (For more on the new crowdfunding exemption, see my article here.)

Because of these requirements, it is important under both exemptions to know the net worth and annual income of each investor.

NOTE: Many people are referring to Rule 506(c) as “crowdfunding” but the actual crowdfunding exemption is something different. Brokers and others selling under Rule 506 began calling that crowdfunding as a marketing ploy to capitalize on the popularity of crowdfunding. Some academics have adopted that usage, which I think is unfortunate and only leads to confusion.

The simplest way to deal with these requirements would be to allow investors to self-certify. If an investor tells the issuer his net worth is $1.5 million, the issuer should be able to assume this is correct, unless the issuer has reason to suspect otherwise. This is not, unfortunately, the SEC’s approach in Rule 506(c). The SEC still has not adopted the rules required to implement the new crowdfunding exemption, but it’s unlikely to take this simple self-certification approach in those rules either.  

In a Rule 506(c) offering, Rule 506(c)(2)(ii) requires “reasonable steps” to verify that any natural person who purchases is an accredited investor. The issuer may do that verification itself, or it may rely on written representations from registered broker-dealers, registered investment advisers, licensed attorneys, or CPAs that they have taken reasonable steps to verify the investor’s status.

Under the non-exclusive safe harbor in Rule 506(c)(2), those reasonable steps could include review of, among other things, the investor’s tax filings, bank statements, brokerage statements, credit report, tax assessments, and appraisal reports. Obtaining and reviewing this information will increase the cost of using the exemption and force investors to divulge confidential financial information that they would probably prefer to keep to themselves.

Why not self-certification? Obviously, people might lie. I might exaggerate my income or net worth in order to qualify to invest in a Rule 506(c) offering or to purchase more securities in an offering pursuant to the crowdfunding exemption. Securities would be sold under Rule 506(c) to investors who aren't supposed to buy them. In crowdfunding offerings, investors could buy more securities than they're supposed to buy.

But these requirements are designed to protect the investors. If I choose to lie about my status, why shouldn’t I forfeit that protection? Why should the issuer be burdened with additional costs just because some investors are willing to lie? As long as the issuer acts in good faith and has no reason to know an investor is lying, what’s the argument for punishing the issuer by denying the exemption? If we want to discourage people from lying about their net worth and annual income, we should punish the liars, not the innocent issuer.

Salazar and Raggiunti on Comparative CEO Pay

Arguably related to the SEC’s recently proposed CEO pay ratio rules, Alberto Salazar and John Raggiunti have posted “Why Does Executive Greed Prevail in the United States and Canada but Not in Japan? The Pattern of Low CEO Pay and High Worker Welfare in Japanese Corporations” on SSRN.  Here is the abstract:

According to a list of the 200 most highly-paid chief executives at the largest U.S. public companies in 2013, Oracle’s Lawrence J. Ellison remained the best paid CEO and earned $96.2 million as total annual compensation last year. He has received $1.8 billion over the past 20 years. The lowest paid on the same list is General Motors’ D. F. Akerson who earned $11.1 million. The average national pay for a non-supervisory US worker was $51,200 last year and a CEO made 354 times more than an average worker in 2012. Hunter Harrison, Canadian Pacific Railway Ltd., was the best paid CEO in Canada for 2012 and received $49.2-million as total annual compensation, significantly higher than the 2011 best paid CEO, Magna’s F. Stronach who received $40.9 million. In 2011, the average annual salary was $45,488 and Canada’s top 50 CEOs earned 235 times more than the average Canadian. These executive pay practices contrast with the growing inequality in Canada, recently illustrated with the finding that 40% of Indigenous children live in poverty. In contrast, Japan’s highest paid CEO is Nissan Motor Co.’s Carlos Ghosn who earned 988 million yen (US$10.1 million) in the year ended March 2013, little changed from the previous year and modestly improved from his US$ 9.5 million compensation for 2009. That does not even put him among the top 200 most highly-paid U.S. company chiefs and the top 20 best paid CEOs in Canada for 2012. Why are Japanese CEOs paid considerably less than their American or Canadian counterparts? This essay argues that the activism of long-term oriented institutional investors such as banks and the tying of executive pay to worker welfare in the context of a culture of intolerance to excessive executive compensation explain to a great extent the development of a pattern of low executive pay in Japan. The Japanese experience also demonstrates that lower executive compensation does not result in compromising firm performance and is a necessary condition to build a stakeholder-friendly corporation. For example, the CEO of Toyota (world’s biggest automaker), Akio Toyoda, earned 184 million yen ($1.9 million) in 2012, a 35 percent increase from the previous year. He is the lowest-paid chief of the world’s five biggest automakers and led Toyota to generate the highest return last year among the top five global automakers. Toyota’s outlook for increasing profit prompted the automaker to approve the biggest bonus for workers in the last years. Alan Mulally, Ford Motor’s chief and the best paid among the top five, took home $21 million in 2012.

Work-Life Balance: Meditation

A friend recently asked me to suggest some books that might help him improve his meditation practice.  Operating under the assumption that if the topic is appropriate for the Wall Street Journal ("Doctor's Orders: 20 Minutes Of Meditation Twice a Day"), then it's good enough for this blog, I thought I'd pass on my suggestions to interested readers.  The first 3 make up my personal list of "classics," and the last is a shameless plug for a book of edited dharma talks I wrote based on my year of studying under sensei Ji Sui Craig Horton of the Cleveland Buddhist Temple.  While my suggestions all focus on Buddhist/Zen meditation, there are certainly more "generic" approaches to learning about meditation -- for example, one might visit the website for the Center for Contemplative Mind in Society, which seeks to transform higher education "by supporting and encouraging the use of contemplative/introspective practices and perspectives to create active learning and research environments that look deeply into experience and meaning for all in service of a more just and compassionate society" (I was made aware of this source while attending a panel discussion on "Engagement, Happiness, and Meaning in Legal Education and Practice").  Regardless, here is my promised recommended reading list:

• Zen Mind, Beginner's Mind
  
• Everyday Zen
  
• The Heart of Buddhist Meditation
  
• Sun Breaks Through Gray Skies: The Dharma Lives in Cleveland

Peter Huang on Why the Law Is So Perverse

Peter Huang recently published a review of Leo Katz’s “Why the Law Is So Perverse” in 63 Journal of Legal Education 131 (you can download the paper via SSRN here).  I have only briefly skimmed the paper, but I believe there is much of value here for corporate law scholars. The following excerpt is from the introduction:

This book is an imaginative tour of legal paradoxes that are related to the field of social choice, which studies the aggregation of preferences. In a non-technical and accessible way, Katz discusses many complex and subtle ideas, using the language of legal cases, doctrines and theories. As he notes on page 6, some legal scholars have applied social choice theory to analyze diverse and fundamental legal issues. Two recent examples are how social choice illuminates the reasonable person standard in torts and other areas of law and the notion of community standards underlying the doctrine of good faith performance in contract law…. Katz's book explicates four fundamental legal paradoxes as the logical consequence of the perspective that legal doctrines entail multi-criteria decision-making. This means that each of these foundational doctrines is logically related to a voting paradox and its corresponding literature in social choice. Katz aptly describes the four legal puzzles he analyzes by choosing as titles to the four parts of his book these four questions: Why does law prohibit certain win-win transactions? Why are there so many loopholes in the law? Why does so much of law have a dichotomous nature? Why does the law not criminalize all that society morally condemns?

Importantly, Peter adds a valuable appendix entitled, “A Brief Social Choice Primer for Legal Scholars,” which he describes as follows:

This appendix provides legal scholars a guide to social choice in general and four distinguished impossibility theorems in particular. It offers motivating examples and precise statements of those impossibility theorems. The conventional interpretations for these theorems and the field of social choice are negative in the sense that most commentators view social choice theory as mathematically proving that no voting procedure is fair. These commentators include legal scholars applying impossibility theorems and concluding that difficulties are unavoidable with all collective or group decision-making processes. There is a vast social choice literature full of extensions and refinements of these and other impossibility theorems. Current social choice research tends to be philosophical or technical. Katz's book mostly eschews the technical and emphasizes the philosophical. This appendix does the opposite, while still avoiding mathematical details and emphasizing conceptual understanding. Additionally, it highlights research by Donald Saari and his coauthors that explains what goes wrong in these impossibility theorems and provides benign interpretations and positive versions of them.

Do Corporations Have a Duty to Respect Human Rights? The View from Government, Investors and Academia

I have spent the past two days at West Virginia University attending a conference entitled “Business and Human Rights: Moving Forward and Looking Back.” This was not a bunch of academic do-gooders fantasizing about imposing new corporate social responsibilities on multinationals. The conference was supported by the UN Working Group on Business and Human Rights, and attendees and speakers included the State Department (which has a dedicated office for business and human rights), the Department of Labor, nongovernmental organizations, economists, ethicists, academics, members of the extractive industry (defined as oil, gas and mining), representatives from small and medium sized enterprises (“SMEs”), Proctor and Gamble, and Monsanto.

Professor Jena Martin organized the conference after the UN Working Group visited West Virginia earlier this year to learn more about SMEs and human rights issues. She invited participants to help determine how to ground the 2011 UN Guiding Principles on Business and Human Rights into business practices and move away from theory to the operational level. The nonbinding Guiding Principles outline the state duty to protect human rights, the corporate duty to respect human rights, and both the state and corporations' duty to provide judicial and non-judicial remedies to aggrieved parties.  Transnational corporations applauded the Principles when they were released perhaps because they are completely voluntary, but also perhaps because those specific Principles that focused on due diligence on human rights impacts in the supply chain were drafted after years of consultation with businesses around the world.

The UN Working Group has the daunting task of rolling out the Guiding Principles to over 80,000 companies and their suppliers in 192 countries.  Dr. Michael Addo of the Working Group confirmed that the conference was the first of its kind in the US where such a broad coalition of those affected by and thinking about these issues had convened to talk about how the Principles can work in the real world.  Participants discussed the risk management issues associated with human rights due diligence including avoiding reputational harm; addressing investor and regulatory pressure; facing internal pressures (recruiting and employee morale); and improved efficiency for project planning, forecasting and value preservation.  Other topics included strategies for transnational human rights litigation after the Supreme Court’s Kiobel decision, which significantly limited access to foreign litigants on jurisdictional grounds; the use of supplier codes of conduct as contractual vehicles; using contracts to implement the Principles; antitrust implications of consortiums working together to address human rights issues with suppliers; the benefits of hard law versus “soft law”  (voluntary initiatives) in the human rights arena; how the US Government is using its laws, trading leverage, procurement and investing power to support the Principles both domestically and internationally; and recent steps in the European Union to implement the Principles.

The issue of addressing regulatory and investor pressure was particularly interesting to me, and I addressed it in my remarks (which I will blog about separately when my paper is complete). But here are some facts I shared with the audience. US investors, international stock exchanges and governments increasingly value information on environmental, social and governmental (“ESG”) factors. As of 2012, the governments or stock exchanges of 33 countries require or encourage some form of ESG reporting. Earlier this year, the European Union proposed a directive on nonfinancial disclosure, which would require large companies to report annually on their major environmental, social and economic impacts.

The US government is farther behind than the Europeans but is catching up. The Federal Acquisition Regulations now require prospective contractors and subcontractors to certify that they are not engaging in a variety of human trafficking activities in supplying end products, and require changes in contractual clauses and compliance programs as well as cooperation with audits and investigations. Since 2012, certain companies in California have had to publicly disclose their efforts to eliminate human trafficking and slavery from their supply chains. 

Investors also seek nonfinancial information. Bloomberg publishes corporate ESG data for over 5,000 companies utilizing 120 ESG factors.  Currently, 95% of the Global 250 issues sustainability reports, which generally include impacts on the environment, society and the general economy. But these reports may be of limited utility to investors because industries may view materiality differently. To address this gap, the Sustainability Accounting Standards Board ("SASB") is a 501(c)(3) organization developing standards for publicly-traded companies in the United States in ten sectors from 89 industries so that they can disclose material sustainability information (including human rights) in 10-K and 20-F filings by 2015. Once completed, the SASB framework, which adopts the SEC definition for materiality, may have significant impact because its advisory council consists of the former chair of FASB, who was also an IASB board member, institutional investors, academics, several large corporations, representatives from most of the major investment banks as well Institutional Shareholder Services (“ISS”), the influential proxy advisory firm. According to today's SASB newsletter, thus far over 850 people representing five trillion in market capital and 12 trillion in assets under management have participated in working groups. The materiality standards for the health care industry have been downloaded over 730 times since they were released at the end of July.

As more companies begin to incorporate the Guiding Principles and consider human rights in their enterprise risk management programs and not just as line items in a sustainability report, business practices will start to change because investors and members of the public will demand it.  This year a pension fund filed shareholder proposals with three companies related to the Guiding Principles. All of them failed, including one in which a company indicated that they were already conducting the kind of diligence that the Principles recommend. ISS has issued guidance specifically on human rights impacts. It’s time for directors and executives to start considering their human rights footprint in anticipation of future requests for disclosures from investors, the government, regulators and the general public.

 

 

Ready, set, GO

Next week (September 29^th to be exact) an experimental free-trade zone in Shanghai will open, the first of its kind in mainland China.  The free trade zone boasts the possibility for relaxed trade and foreign investment standards.  Just how radical the free trade zone will be in its implementation is unknown, and will unfold as the operations being.  Allowing telecommunications companies to compete with state-owned providers, lifting bans on video game sales, liberalizing interest rates, and enhancing currency convertibility are among the stated goals of the free trade zone.  Additionally, a Hong Kong newspaper (note: Hong Kong is itself a free trade zone) reported yesterday that Facebook, Twitter, the New York Times and other previously banned websites will be allowed to operate within the free trade zone.

Enhancing currency convertibility is a broader goal of China, which has stated its intention for the renminbi to be fully convertible by 2015.  Currency convertibility may in turn elevate the renminbi to reserve currency status, where the central banks of other countries hold the renminbi.  Reserve currencies—the leader of which is the U.S. dollar and also includes the Swiss franc, the Japanese yen, the sterling pound and the euro—benefit the issuing country by reducing the transaction costs for international commerce by eliminating exchange rate conversion risks and reduced borrowing costs.  With China’s export economy, attaining reserve status could mean big business and big bucks.

The free trade zone also has potential implications for the U.S. and Chinese stock markets.  For starters, the Chinese stock market has been climbing in the wake of the free trade zone news, and climbed again yesterday on the heels of the internet accessibility news.  The Chinese market, while presently still considered instable, has seen tremendous growth since the 2005 reforms of non-tradeable stock, and backed by the second largest economy in the world stands poised as “the” emerging market.  For domestic companies and U.S. exchanges, the free trade zone presents opportunities as well.  For example, Microsoft is the first U.S. company that has announced a joint venture with a Chinese technology company in order to offer video game consoles in the free trade zone, consoles like the Xbox, which have been banned since 2000.  If the free trade zone signals greater access to the Chinese consumer markets on a broader scale, this could mean a large market expansion for many U.S. companies.

-Anne Tucker

Stock Market to Fall 40%?

Over at the New York Times Dealbook,  the man responsible for a $6 billion hedge funds says just that in an article by Alexandra Stevenson: 

Mr. Spitznagel, the founder of Universa Investments, which has around $6 billion in assets under management, says the stock market is going to fall by at least 40 percent in one great market “purge.” Until then, he is paying for the option to short the market at just that point, losing money each time he does.

....

Mr. Spitznagel’s approach is unusual approach for a money manager: To invest with him, you’ve got to believe in a philosophy that is grounded in the Austrian school of economics (which originated in the early 20th century in Vienna). The Austrians don’t like government to meddle with any part of the economy and when it does, they argue, market distortions abound, creating opportunities for investors who can see them.

When those distortions are present, Austrian investors will position themselves to wait out any artificial effect on the market, ready to take advantage when prices readjust.

Apparently his primary reason for this coming purge, which he says is needed, is that the Fed will have to readjust its monetary policies at some point. When they do, he says, the purge will come.  

I am no expert in monetary policy, but I have wondered how long we can sustain an economy with interest rates so low.  My recollection was that one of the Fed's key powers was to be able to raise and lower interest rates to spur growth or temper inflation.  With interest rates this low, it seems that power is greatly restricted on both counts.  I tend not to be one who thinks the sky is falling, but there is at least some reason to believe it may be getting a bit cloudy.  

 

Why Bainbridge Teaches Business Associations by Entity

Yesterday, I asked whether the Business Associations course should be organized by entity or by topic. Steve Bainbridge explains here why he organizes the course by entity.

For alternative views, see the comments by Jeff Lipshaw and Josh Fershee to my original post.

Are We Teaching Business Associations Backwards?

Should we flip the way we teach Business Associations?

Last week I asked whether law schools are teaching the law of securities regulation, particularly Securities Act exemptions, backwards. I proposed that the current rule-by-rule approach be flipped to a more topical approach. This week, I'm asking the same question about Business Associations, but I'm much less sure of the correct answer.

The basic Business Associations course at most law schools today includes much more than the law of corporations. Most Business Associations courses cover partnerships and limited liability companies, and often limited partnerships and agency law as well. 

The leading publishers offer a number of business associations casebooks, but their basic organizational structure is the same: each entity is covered separately. A typical casebook might, for example, begin with partnership law, then cover the law of corporations, then limited liability companies. The topics covered for each entity are similar: formation, management, fiduciary duty, the liability of investors, exit rights, and so on. 

Why not flip this organizational structure and organize business associations courses by substantive topic rather than by entity? We could begin with a chapter on formation that discusses how all of the entities are created. A chapter on management would discuss how all of the entities are managed. A chapter on fiduciary duties would discuss the fiduciary duties of agents, partners, limited partners, corporate officers and directors, and the members and managers of LLCs. And so on, topic by topic.

This alternative approach would eliminate a lot of repetition, and foster discussion of the policies underlying the rules: Why are the fiduciary duties of partners different from the fiduciary duties of shareholders? Why do partners have the right to participate in the management of the business, but not shareholders? Much that can be said about, for example, corporate opportunity would also apply to business opportunities in the partnership and the LLC. The law may differ from entity, and often for good reason, but wouldn’t the policy reasons for those differences become more apparent if we discussed all the entities at the same time?

This approach would also make choice-of-entity concerns more apparent. Students would see how choice of entity does or does not matter with respect to each topic.

There would, however, be drawbacks, which is why I’m not sure of the correct answer. For one thing, it’s much easier pedagogically to deal with one entity at a time than to bounce around from statute to statute. And an entity-by-entity organization allows instructors to focus more on the relationships among the rules affecting a particular entity—for example, the relationship between the limited liability of shareholders and their limited participation in control.

In short, I’m not surprised that some authors choose to organize by entity. What surprises me is that all of the leading authors choose to organize by entity. Even if many professors prefer the entity-by-entity approach, surely there’s a market for at least one book that takes the alternative approach. But perhaps not. If my memory serves me, the late Larry Ribstein’s business associations book was at one time organized along topical lines, but he eventually changed to an entity-by-entity organization.

 

Can we “carve out a space within which … ethical culture — can play a meaningful role in constraining socially undesirable behavior” in corporations?

I recently came across a couple of seemingly related items that I thought might be of interest to our readers:

Awrey, Blair & Kershaw on the “Role for Culture and Ethics in Financial Regulation”

Dan Awrey, William Blair, and David Kershaw have posted “Between Law and Markets: Is There a Role for Culture and Ethics in Financial Regulation?” on SSRN.  Here is a portion of the abstract:

The limits of markets as mechanisms for constraining socially suboptimal behavior are well documented. Simultaneously, conventional approaches toward the law and regulation are often crude and ineffective mechanisms for containing the social costs of market failure. So where do we turn when both law and markets fail to live up to their social promise? Two possible answers are culture and ethics. In theory, both can help constrain socially undesirable behavior in the vacuum between law and markets. In practice, however, both exhibit manifest shortcomings.

To many, this analysis may portend the end of the story. From our perspective, however, it represents a useful point of departure. While neither law nor markets may be particularly well suited to serving as "the conscience of the Square Mile," it may nevertheless be possible to harness the power of these institutions to carve out a space within which culture and ethics — or, combining the two, a more ethical culture — can play a meaningful role in constraining socially undesirable behavior within the financial services industry. The objective of this article is to explore some of the ways which, in our view, this might be achieved.

Jones & Mendenhall on Board “Oversight Responsibility for Workplace Culture”

Earl “Chip” Jones and Amy Mendenhall have posted “Do Directors Have an Oversight Responsibility for Workplace Culture?” on Boardmember.com.  Here is an excerpt:

Recent legislative, enforcement and compliance trends all suggest that corporate directors should focus on workplace culture and corporate compliance. Shareholder activists have shown increasing willingness to pursue actions to hold directors responsible when corporate scandal and executive misconduct impair shareholder value. Further, with the Dodd-Frank Wall Street Reform and Consumer Protection Act’s bounty program promising million-dollar incentives for whistleblowers who report corporate misconduct to the SEC and employee mistrust of management at an all-time high, those charged with steering the corporate ship cannot afford to ignore employee perceptions and on-the-ground effectiveness of compliance resources.

It is widely accepted that directors oversee the organization’s strategy. To do so, directors must understand how corporate culture and strategy interact in ways that affect organizational performance. To illustrate, Bain & Company’s 2011 Great Repeatable Model Study highlighted one way in which culture can impact the implementation of strategic goals: executives charge that managers are too risk averse. Yet, the executives do not know or appreciate that the managers’ risk aversion is often born of mistrust or the perception that support is lacking from those very executives. As part of their responsibility to oversee the CEO and organizational strategy, directors must address such impediments to achieving corporate goals.

 

Leib, Ponet & Serota on Mapping Public Fiduciary Relationships

Ethan J. Leib, David L. Ponet, and Michael Serota have posted “Mapping Public Fiduciary Relationships” on SSRN.  Here is the abstract:

Fiduciary political theorists have neglected to explore sufficiently the difficulty of mapping fiduciary-beneficiary relationships in the public sphere. This oversight is quite surprising given that the proper mapping of fiduciary-beneficiary relationships in the private sphere is one of the most longstanding and strongly contested debates within corporate law. After decades of case law and scholarship directed towards the question of to whom do a corporation’s directors or managers serve as fiduciaries, private law theorists remain deeply divided. This debate within private law should be of perennial interest to public fiduciary theorists because the cartography of public fiduciary relationships is essential to operationalizing the project. After all, it is only through identifying the relevant fiduciary and beneficiary that one is able to determine the precise contours of the fiduciary framework’s ethical architecture. As such, loose mapping of fiduciary-beneficiary relationships in the public sphere precludes a clear understanding of whose interests are pertinent to the public fiduciary’s representation, and what the public fiduciary is to do when beneficiaries’ interests collide. The purpose of this chapter, then, is to explore the central debate in corporate law about fiduciary-beneficiary relationships to help translate fiduciary principles into public law configurations.

Request for Proposals: Blurring Boundaries in Financial and Corporate Law

I received the following announcement in my inbox today, and felt the content would be of interest to readers of this blog even if they have no intention of attending the meeting or submiting a proposal.  For more information, go here.

We are pleased to announce the 2014 Midyear Meeting Workshop on Blurring Boundaries in Financial and Corporate Law, June 7-9, 2014 in Washington, D.C….

We invite you to submit a proposal to participate in this two-day program, which is designed to explore the various ways in which the lines separating distinct, identifiable areas of theory, policy, and doctrine in business law have begun to break down….. Proposals are due October 25, 2013, by e-mail, to [email protected].

Why Attend this Workshop? 

Understanding how capital is formed and transformed in today's economy and how financial risk is spread requires that scholars and students understand financial and corporate law and the theory and policy underlying the doctrine.  If scholars work solely within the traditional boundaries of any single field in the financial and corporate law spectrum, they risk having a parochial view of vital legal questions.  Indeed, each area of financial and corporate law faces a broader set of questions than it has historically engaged.   Securities regulation covers much more than initial public offerings.  The regulation of financial institutions can no longer concern itself primarily with deposit-taking banks (indeed, the label "banking law" seems now outdated).  Insurance regulation is no longer entrusted exclusively to state regulators, and those regulators can no longer ignore systemic risks or the modernization of consumer products and consumer protection strategies.  Business associations involve more than publicly traded corporations.  These are but a few examples....

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Should you think twice before using your cellphone or brushing your teeth? Congress and the SEC think so.- Part II

I first became interested in the Dodd-Frank conflict minerals law after leaving my former employer, which managed other companies’ supply chains, and while serving as a founding board member of Footprints Foundation, a nonprofit that works with rape survivors, midwives and hospitals in the Democratic Republic of Congo ("DRC") (see here). During a fact-finding mission for the foundation to the DRC in late 2011, I observed the law through two lenses-- both as a compliance officer who used to conduct audits around the world, and as a board member trying to determine whether this law would really help stem the unconscionable violence which I witnessed first-hand when I saw five massacred civilians lying on the road on my way to visit a mine.  (Note, my blog posts reflects my views only and should neither be attributed to Footprints nor my former employer).  My 2011 trip and subsequent research convinced me that the conflict minerals law could have unintended consequences that Congress had not sufficiently thought through, and that the SEC, in writing the rules, had not adequately addressed. For an article that describes the mining in the DRC today and some of the compliance successes and challenges see here. 

For these reasons, I signed on to an amicus brief along with two experts on Africa to the suit brought by the National Association of Manufacturers, the Chamber of Commerce and the Business Roundtable, who argue that the SEC’s rule: (1) failed to create a de minimis exception to the rule for trace amounts of minerals in products or the manufacturing process despite the authority to do so; (2) applied the wrong standard regarding whether minerals originated in the DRC; (3) erroneously included non-manufacturers within the law’s purview; (4) provided a flawed phase-in period for reporting that requires large manufacturers to report two years earlier than the smaller companies on which they may depend on for data; and (5) violated the First Amendment by requiring companies to state on their website that their products are “not DRC Conflict free,” which may not only taint their brands but  may also be false or misleading.  The business groups also discuss the significant expense, arguing that the SEC failed to conduct the legally required cost-benefit analysis.

Our amicus brief, filed yesterday, focused on the potential for unintended consequences, specifically a de facto boycott on the region. We maintain that the SEC erred in failing to consider whether its final rule would advance the law’s objective of weakening armed groups in the DRC (which in my view could include the national army, which has also been implicated in rapes), and that the SEC compounded that error by exercising its discretion in ways that render its rule more likely to harm legitimate economic activity in the DRC and benefit the very armed groups that Congress sought to stifle. In essence we believe that the law will lead many companies concerned about the cost, safety and administrative burdens of compliance to simply pull out of the DRC and source their minerals elsewhere.  This will leave even more miners out of work exacerbating poverty in a country where the per capita income was estimated at $210 USD per year in 2011.  While conditions are improving on the ground somewhat, I also personally know of companies that are looking to bolster their supply chains in other countries.

In a recent law review article I argued that given the corruption endemic in the country, companies could put themselves at risk of their middlemen violating anti-bribery statutes to get minerals out of the country with “proper” certifications. By failing to disclose illicit payments, companies could also violate Dodd-Frank §1504, the resource-extraction rule that requires certain companies to report on payments to governments. (Note-the SEC is now re-writing §1504 after a court vacated that rule). More important, focusing on corporate buying power while not addressing the needs for judicial, infrastructure and security sector reform will not solve the problem. Indeed, the Government Accounting Office issued a report in July indicating that infrastructure issues are hampering compliance. As we pointed out in our amicus brief, the GAO also noted that according to numerous government and NGO sources, the DRC is incapable of certifying various mines as outside the control of armed groups, regularly inspecting them, stemming corruption, or halting smuggling. Furthermore, based on my research, the fighting, looting and use of rape as a weapon of war in the DRC occurs not only because of a fight for minerals, but also because of deep-rooted political and ethnic rivalries and disputes over land rights, among other things.

As observers have written, depending on the success of Dodd-Frank §1502, Congress could choose to legislate on a number of resources that have questionable provenance- tin and palm oil from Indonesia, wood from countries that do not place a premium on sustainability, cobalt from illegal mines, and “dirty water.”  Will Congress direct the SEC to be the watchdog over corporate responsibility for human rights in the supply chain? Should the SEC, which is supposed to maintain fair and efficient markets, even be in the business of dealing with human rights issues? Are corporate governance disclosures the right mechanism? More generally, what level of responsibility should US-based transnational corporations have when operating abroad in weak or failing states? Hint- I believe that it’s more than the reader might think from these last two blog posts. I will comment on these and other topics from the West Virginia conference on business and human rights next week.

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Should you think twice before using your cellphone or brushing your teeth? Congress and the SEC think so.- Part I

Apple hasn’t released pre-order numbers yet for its highly anticipated iPhone 5s and 5c, but if media reports and my own call to the Apple Store are any indication, throngs of consumers will be lining up tomorrow to get the latest product.  It’s very likely that most of the customers have no idea of the highly successful campaign against Apple and other electronics manufacturers that led in part to Dodd-Frank §1502, the conflict minerals provision which is now up on appeal to the DC Circuit. Incorporated into Dodd-Frank only days before its passage, it aims to focus investor and consumer attention to potential corporate complicity in human rights abuses in the Democratic Republic of the Congo (“DRC”), a country where the United Nations recently deployed drones against rebel groups and where over five million have died due to civil wars, malnutrition, disease and poverty in recent years. Eighty thousand people were displaced from their villages due to fighting between rebels and the army in just the last month according to a report out today from the UN. A UN representative once called the country was once called the “rape capital of the world.”

The law affects an estimated 6,000 companies--almost half of all US publicly-traded companies-- and hundreds of thousands of suppliers worldwide because so many products use one of the four regulated minerals, often mined by hand, known as the ”3Ts +G”. Specifically, these are: (1) columbite-tantalite also known as tantalum, which is used for cell phones, computers, surgical implants and wind turbines; (2) cassiterite, or tin, used for coatings for food cans, solders, catalysts stabilizers, shoe soles and even fluoride compounds in toothpaste and mouthwash; (3) wolframite (tungsten) used for light bulbs, aerospace components, and machine tools; and (4) gold used as an electronic conductor, for jewelry, and in medical equipment, anti-lock brakes, stained glass, and home pregnancy kits (in nanoparticles). Anyone who buys thread or diapers is also using these minerals.

The rule  requires domestic and foreign companies regardless of size that file reports with the SEC to conduct due diligence and disclose the origin of minerals in their products from the DRC or adjoining countries to ensure that they are not funding rebel groups engaged in rape, torture, the use of child soldiers, exploitation of children and other activities that have, in part, led to one of the world’s largest and most protracted humanitarian crises.  Depending on the company's findings, the rule also requires a private sector audit and the filing of a Conflict Minerals Report that describes the due diligence. Large companies must file their first disclosures in May 2014 for activities occurring in calendar year 2013. Some companies have 10,000 to 50,000 suppliers and several layers in their supply chains. Their suppliers can have multiple levels and subcontractors within their own supply chains.

Significantly, the law does not prohibit the use of conflict minerals. It merely requires companies to disclose if they are using them or if they cannot determine whether or not their products are “DRC-conflict free.” This law relies on consumers and investors to pressure firms that depend on corporate social responsibility programs to enhance their images to change their business practices. Last week, the SEC received a petition for rulemaking requesting a temporary delay in disclosure and an alternative disclosure, due to the expense and time required to comply.

Regardless of the law’s fate in the US, companies that operate in Canada and the EU may face similar legislation. In some sense the proposed rules are broader than Dodd-Frank §1502  (e.g. applying to recycled and scrap metal) and in some cases more narrow (eg. the level of companies in the supply chain). The European Commission received recommendations from NGOs that seek legislation regarding all natural resources originating in any conflict-affected or high-risk areas worldwide. On the other hand, an August report by Oeko-Institut, an organization that guides policymakers in the EU, notes that (1) smuggling by armed groups in DRC has increased; (2) a comprehensive DRC policy that includes but does not rely solely on regulation of conflict minerals is the only way to provide meaningful assistance to the DRC; and that (3) extensive mandatory verification and reporting requirements based on downstream due diligence can cause “embargo reactions”  from those who source from the country. I agree and will discuss why in Part II.

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Worthless, Impossible, and Stupid

I just finished reading an interesting book on entrepreneurship, and I thought I would share it with the blog. It's Worthless, Impossible and Stupid: How Contrarian Entrepreneurs Create and Capture Extraordinary Value, by Daniel Isenberg.

Isenberg uses case studies to explode three myths: (1) that entrepreneurs must be innovators; (2) that entrepreneurs must be experts; and (3) that entrepreneurs must be young. He argues that successful entrepreneurship has three elements: (1) perceiving extraordinary value; (2) creating extraordinary value; and (3) capturing extraordinary value. (He obviously likes to group things into triplets.) All three are necessary for success. I, for example, might be able to think of a value creation opportunity but, since I have spent most of my life in the classroom, it's unlikely I could do much to create that value-turn the idea into reality.

But my favorite part of reading the book was seeing the many examples of successful entrepreneurs being told initially by venture capitalists and others that it just wouldn't work--that the idea was worthless, impossible, or stupid.

IPOs in 140 characters or less

EGCs lead IPOs due to JOBS Act’s relaxed SEC regs, like secret review filings, exempt exec. compensation and reduced financial disclosures.

For the record as a TWITTER novice, I had to look up the rules pertaining to the 140 character limit and make several attempts to compose a coherent sentence under the limit.  For a more thorough discussion...keep reading.

The latest news on the IPO market is that TWITTER has announced it has filed with the SEC.  Last week, Twitter tweeted (a cannibalistic concept in my mind at least), “We’ve confidentially submitted an S-1 to the SEC for a planned IPO. This Tweet does not constitute an offer of any securities for sale.”

 The JOBS Act, passed in April 2012, focused in part on easing access to capital for “smaller” companies. The JOBS act created a new category of issuer, emerging growth companies (EGCs), those with revenue less than $1 billion, and eased the registration regulatory burdens for IPOs.  (To recap:  “smaller” means less than $1 billion in revenue.)  The regulatory relief offered by the JOBS Act allowed for EGCs to (1) submit a confidential draft registration statement for nonpublic review by the SEC, (2) be exempt from disclosing for up to 5 years executive compensation and complying with say on pay votes, and (3) disclose 2 years instead of 3 years of financial statements.

 While the number of IPOs in 2013 hasn’t spiked, a majority of companies participating in IPOs have been EGCs and have taken advantage of the relaxed regulations available to them. In a report issued by Earnst & Young on the one-year anniversary of the JOBS Act, it stated that as of April 2013”

the IPO market has been dominated by EGCs, representing 83% of IPOs that went effective since April 2012. The majority of EGCs are taking advantage of the confidential review accommodation and reduced executive compensation disclosure relief available to EGCs.

The confidential initial filings have continued to be utilized by nearly every company that qualifies as an EGC, and Twitter is no exception.  The confidential draft registration statements have received some criticism for keeping the IPO pipeline shrouded in mystery and investors in the dark.  Investors will still have an opportunity to review the financials before Twitter or any EGC goes public, the timetable is just condensed under the new law.  Considering the speed with which the market can absorb, distribute, and analyze information, the condensed timeline shouldn’t pose too much of a problem, and is (according to an article in the New Yorker) consistent with the timeline previously applied to IPOs in the 1980’s like when Apple and Microsoft first went public.  If there is any concern for investors it should be over eliminating the third year of financial disclosures, not the ability to submit a confidential draft registration statement. 

 With these relaxed standards for EGCs, Twitter could mark the beginning of a tech-heavy end to the 2013 and start of the 2014 IPO season.  The market is watching for the following companies to join the ranks:

Square, Dropbox, Box, Living Social, Atlassian, Autotrader.com, and Coupons.com.

 For more information on the 2013 IPO record thus far, see:

 -Anne Tucker

Oregon Doesn’t Respect Operating Agreements or LLCs As Unique Entities

Okay, so maybe I am overstating that a bit, but it’s only a bit.  This is not exactly timely, as the following case was decided in the December 2012, but I was recently reviewing it as I taught these cases and helped update Unincorporated Business Entities (Ribstein, Lipshaw, Miller, and Fershee, 5th ed., LexisNexis). (semi-shameless plug).  Despite the passage of time, this case has, apparently, gotten me riled up again.  So here we go . . .    

Synectic Ventures I, LLC v. EVI Corp., 294 P.3d 478 (Or. 2012):  several investment funds organized as LLCs (the Synectic LLCs or LLCs).  The LLCs made a loan to the defendant corporation, EVI Corp. The loan agreement was secured by EVI’s assets, and provided that EVI would pay back $3 million in loans, plus 8% interest by December 31, 2004.  The loan agreement provided that if EVI obtained $1 million in additional financing by December 31, 2004, the loan amount would be converted into equity (i.e., EVI shares) and the security interest would be eliminated. If the money were not raised by the deadline, the LLCs could foreclose on EVI’s assets (mostly IP in medical devices). 

To make things interesting, the LLCs appointed Berkman the manager of the LLCs (thus, they were manager-managed LLCs). “At all relevant times, Berkman—the managing member of plaintiffs—was also the chairman of the board and treasurer of defendant [EVI].”  In mid-2003, the Synectic LLCs' members sought to have Berkman removed, and Berkman signed an agreement not to enter into new obligations for the LLCs without getting member approval. 

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A Brief Introduction to Me and My Energy Business: Law & Strategy Course

I (Josh Fershee) will follow up with a post of some (I hope) substance shortly, but I thought I’d take a moment to briefly re-introduce myself.   When I last wrote for BLPB, I was teaching at the University of North Dakota School of Law. Last fall, we made the move to West Virginia University College of Law.  (I say “we” because my wife (Kendra Huard Fershee) not only moved with me, but because she is also on the law faculty.)   I joined WVU as part of a university-wide energy-law expansion and work with the Center for Energy and Sustainable Development.

I teach business law courses and energy law courses, with most of my research relating somehow to energy business and regulation.  I teach Business Organizations, Energy Law Survey, Energy Business: Law & Strategy, and Energy Law and Practice.  I plan to add a Hydraulic Fracturing Seminar, too, in the near future. 

Of perhaps some interest to our readers, I have taught my Energy Business: Law & Strategy course once, and I plan to do so again in the spring.  I think it is a unique class, especially in the law school environment, with its focus on how law comes to be and how businesses are strategic in their use of law and regulation.  (Note: I am of the mind that this reality is important to understand whether you want to work for businesses and employ such strategies or if you want to work to limit businesses in the ability to do so.)  I have the students work in groups, and they draft a written final project, which they also present to the class. 

Below the jump, I provide the books, course description, goals, and assessment items for the course. I welcome any comments or suggestions for additional teaching materials or concepts. 

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Communicating with Clients

Forbes has a short, interesting article about communicating with clients. It's talking about business clients, but I think it has some relevance to lawyers. My main takeaway: be proactive.

Are We Teaching Securities Law Backwards?

It seems like almost everyone, including the President of the United States, has been offering grandiose ideas to reform legal education. Rather than add to that cacophony, I'm thinking on a micro-level, wondering how I might change my favorite course, Securities Regulation. I think we may be teaching securities registration exemptions backwards.

A very quick overview for those not versed in federal securities law: A company raising money by selling securities must register its offering with the SEC unless it has an exemption from the registration requirement. A number of exemptions are available and companies would prefer an exemption, ceteris paribus, because registration is very expensive.

In securities law practice, the analysis typically proceeds in this order:

Offering Details--Universe of Possible Exemptions--Modification of Offering--Particular Exemption.

The client presents the lawyer with a proposed offering. The client has typically already given some thought to the amount of money needed, the proposed offerees, and perhaps even the manner of offering to those people. The lawyer considers those constraints, considers the universe of possible exemptions and, perhaps after a modification to what the client wants, chooses a particular exemption.

This is also how securities professors like me often test their students on the exemptions. We present students with a proposed offering and ask them to advise the client concerning which exemptions, if any, are available for that offering, and what modifications need to be made to the client's proposal to fit those exemptions.

This is not, however, how most of us teach the subject. The leading casebooks typically present the material in this way:

Particular Exemption--Offering Details--Modification of Offering.

Each particular exemption is presented separately (except that the Regulation D exemptions are sometimes considered together). Students are then asked if particular offerings would fit within those exemptions.

Consider this alternative to the typical casebook approach. Begin with a very brief overview of each exemption, not more than a paragraph or two, just so students know where to look. Then, organize the material by offering details:

(1) Amount of the Offering. This issuer proposes to sell $2 million of securities. Which exemptions would be available?

(2) Offerees and Purchasers. This issuer proposes to offer to the general public. Which exemptions are available? This issuer proposes to limit its sales to wealthy investors; which exemptions are available?

(3) Manner of Offering. This issuer proposes to publish an advertising on the Internet. Which exemptions are available?

(4) Disclosure Requirements: This issuer doesn't want any mandatory disclosure. Which exemptions are available?

And so on. This may not be the best sequence, but you get the general idea.

I think this organization would force students to think more like securities lawyers: consider the facts (offering amount; characteristics of the offerees, etc.), look at the universe of possible exemptions, and determine which exemptions, if any are available.

The substance covered would be the same under each approach, but the alternative approach would be truer to the type of analysis required in practice (and on the exam). We would be teaching students how to do the analysis, instead of forcing them to learn it on their own.

This is all tentative thinking on my part, so I would be interested in your views. It always worries me when I disagree with the way everyone else is doing something. (I don't change my mind, but it does worry me.)  It may be that the best solution is just to buy each student one of these. (If my mother had bought one of these, my first reaction would have involved an ax. To the study carrel, not to my mother. I'm no Lizzie Borden.)

In my next post, I will discuss why I think the way we're teaching business associations may also be backwards.