Saturday, July 18, 2015
A few days ago, Vice Chancellor Laster issued an interesting opinion in In re Appraisal of Dell. He held that Delaware’s “continuous holder” requirement for appraisal litigation applies at the record holder level – that is, the level of DTC. Because in this case, due to a technical error, DTC transferred the ownership of the shares to the beneficial owners’ brokers’ names – the street names – the beneficial owners could not maintain their appraisal petition.
[More under the jump]
Matt Levine gives the most entertaining summary of the issue here, but what it comes down to is, once upon a time, stockholders actually received stock certificates with their names on them; when stock was bought and sold, paper notations would record the transfer. But as markets developed, paper transfers became impossible to manage. The system was in disarray; backlogs filled brokerage houses to literal bursting, with stacks of paper piled around office floors. In fact, for 6 months in 1968, the NYSE would shut down trading once a week to allow brokerages to catch up on their paperwork.
As a result, Congress directed the SEC to come up with an electronic system for tracking share ownership. Today, most shares are officially registered to a company called DTC, which simply makes an electronic notation on its books to indicate purchases and sales. And the purchases and sales it records are between brokerage houses. The brokerages then maintain records of which client “owns” what, with further electronic notations to denote transfers in or out of an account. From the stockholder’s perspective, he or she buys or sells stock, but officially, DTC remains the owner of record, unless a specific request is made for shares to be retitled in a particular name.
In the Dell case, the beneficial owners – i.e., the institutions we’d normally think of as the stockholders – held their shares continuously from their request for appraisal through the date of the merger, as Delaware law requires to maintain an appraisal petition. They also voted their shares against the merger, as Delaware law also requires. But due to a series of back office errors, the shares were retitled from DTC to the brokerage houses’ nominees before the merger closed. VC Laster held that this technical transfer – which involved no substantive alteration of legal rights – was enough to violate the requirement of continuous holding, as defined through Delaware precedent. Laster recognized that this was an absurd result, and practically begged the Delaware Supreme Court to change the law, so we can expect to see an appeal, and the only question is what the Delaware Supreme Court will do. The issue, as Laster points out, is critical not just in case of bizarre mistakes as occurred in Dell, but also because of appraisal arbitrage. Decisions in the Delaware Chancery court have relied on DTC’s ownership to hold that funds who acquired shares of a company after a merger vote, but before the merger occurred, could still seek appraisal, even without demonstrating that the specific shares they acquired had, prior to the vote, been voted against the merger (a task that would have been impossible, given the way stock ownership is recorded). It will be interesting to see how the Delaware Supreme Court determines the conditions under which record ownership (rather than beneficial ownership) will be recognized under Delaware law.
Notably, appraisal litigation is not the only area of law that is discordant with the current system for recording stock ownership. Section 11 of the Securities Act provides a remedy for investors who purchase stock that was issued pursuant to a false registration statement. In many instances, however, companies issue stock at different times in different ways – they may issue unregistered stock to company employees, or hold multiple offerings. Because stock transfers are made in the name of the brokerage house, and are rarely associated with the name of the individual stock purchaser -and because DTC remains the registered owner of the actual shares - investors who buy their stock after the pool has been “mixed” with stock from other issues will not, as a matter of law, be able to demonstrate that their specific shares were among those issued pursuant to the defective registration statement, and thus will be barred from bringing a Section 11 claim. Courts have held that this “tracing” requirement will bar Section 11 claims even when only very small amounts of stock from a separate issue has mixed in with stock from the faulty issue. See Hillary A. Sale, Disappearing Without A Trace: Sections 11 and 12(2) of the '33 Act.
In fact, over at the Harvard Forum on Corporate Governance, Boris Feldman of Wilson Sonsini recently recommended that corporations ease employee lock up agreements to defeat Section 11 litigation. The thinking is that if the employees trade even minute amounts of stock after the IPO, the company will be completely insulated from Section 11 claims. Feldman pitched his proposal as a mechanism for combatting “frivolous” Section 11 litigation, but in fact, it would defeat all Section 11 litigation, frivolous or meritorious. Kevin LaCroix argues that underwriters are unlikely to adopt Feldman's proposal for fear diluting post-IPO share value, but since even a peppercorn’s worth of shares destroys plaintiffs’ ability to trace, I’m sure underwriters could develop terms that would allow for strategic selling of employee shares without depressing the post-IPO trading price.
This is one of the reasons I’m so uncomfortable with the ways that the JOBS Act expanded options for companies to issue unregistered stock. If these companies do eventually hold IPOs, the existence of prior-issued shares will bar Section 11 claims. (A similar problem is posed by the new trend of companies staying private for longer periods, while they sell shares in private deals – it creates more opportunities for companies to insulate themselves from Section 11 litigation).
To be fair, there might be good policy reasons to limit Section 11, a statute that has not been substantively updated since amendments in 1934. Liability under Section 11 is narrow in some ways but very broad in others – there is no scienter requirement, there are no good faith defenses for issuers, the plaintiffs do not have to prove causation, and plaintiffs need not show they relied on the registration statement to bring a claim. Congress imposed this relatively strict liability because it envisioned the statute would apply to “new” companies, previously unknown to the market, for whom the registration statement would be a particularly potent source of information. Today, of course, established companies frequently hold new offerings of different kinds of securities. (When bonds or preferred shares, rather than common stock, are at issue, tracing is not a problem because the bonds/preferreds from each issue are not fungible like common stock. As a result, Section 11 is frequently used for bondholder actions. See James J. Park, Bondholders and Securities Class Actions). It’s possible that given the changes in markets since 1933, the protections of Section 11 are unnecessary for established companies holding secondary offerings, or for companies that have been “seasoned” through Regulation A+ offerings or extended periods of private financing. However, if those are the choices that are being made, they should be made explicitly, rather than through an accident of technological development.