Business Law Prof Blog

Still more to talk about at CBS

I’m assuming most readers know the backstory here, but CBS and Viacom are both controlled by NAI, which in turn is controlled by Shari Redstone.  NAI owns nearly 80% of the voting stock of each company; the rest of the voting shares are publicly traded but held by a small number of institutions.  The bulk of each company’s capitalization, however, comes from no-vote shares, which are also publicly traded.

Redstone has long sought a merger of the two companies, which has been perceived as a boon to Viacom and a drag on CBS.  That’s why, when she proposed a merger in 2018, the CBS Board revolted and tried to issue new stock that would dilute NAI’s voting control.  That case resulted in a settlement whereby Redstone promised not to propose a merger for two years unless the CBS independent directors raised the issue first.  By sheerest coincidence, as luck would have it, mere months after the settlement was reached and the CBS board restructured, CBS and Viacom announced that they had reached an agreement and would merge by the end of 2019.

Of course, the immediate question among academics was whether, if the merger did proceed, Redstone would shoot for MFW-cleansing, which would require conditioning the deal on the approval of the disinterested shares.  And if Redstone did try to cleanse, would she give the no-vote shares the chance to vote?  Or would she try to cleanse with only the voting shares that are not held by NAI?  If the latter, would Delaware courts really permit a deal to be cleansed by the vote of unaffiliated shares representing such a small fraction of the total capitalization, especially when the no-vote shares have no say at all?

Sadly for those of us in the nosebleed seats, those questions are not going to be answered, because Redstone refused to condition the deal on any kind of unaffiliated shareholder vote (one of the points of objection among the 2018 CBS Board) – which is important for where we are now.

Where we are now is that a holder of CBS’s no-vote shares is (inevitably) seeking books and records in order to determine if there was wrongdoing in connection with the proposed deal.  (Spoiler: The shareholder thinks there was wrongdoing).  CBS and Viacom refused to provide all of the documents sought, leading to a lawsuit, and ultimately VC Slights’s recent opinion in Bucks County Employees Ret. Fund v. CBS.  Slights concluded that there was a “credible basis to suspect wrongdoing,” and granted the plaintiff access to a broad array of documents, if not everything identified in the initial requests.

There’s a lot that’s of interest here, including details that I didn’t see reported previously (they may have been, if so I missed it) suggesting Redstone influenced the transaction, by, among other things, pressuring what Slights describes as the “purportedly” unaffiliated CBS committee and offering increased compensation to CBS’s Chair and CEO in exchange for his support.  So, interested readers should really review the entire opinion.  That said, I’m going to highlight what I believe to be the most critical aspects:

(1) There is strong evidence that Redstone sought the merger as a mechanism of using CBS to bail out/shore up the failing Viacom. For example, after Redstone sought – and was refused – a merger in 2016, she complained that “the failure to get the deal done ha[s] caused Viacom to suffer,” admitted that she favored a deal because Viacom’s stock was “tanking,” and vowed to accomplish a merger by a “different process.”  Slights seemed quite persuaded by this evidence, and, of course, it will bolster claims of CBS stockholders that the deal was unfair to them.

(2) Following VC McCormick’s opinion in Kosinski v. GGP, Slights determined that the mere fact that CBS made no attempt to adhere to MFW cleansing was itself evidence of wrongdoing for Section 220 purposes.  That interests me for a few reasons.  First, it extends MFW into a novel space: previously, its purpose was to trigger business judgment review for controlling shareholder transactions, but now it will also be used to “cleanse” for the purpose of avoiding a 220 demand.  Moreover, as I’ve previously noted, the definition of a controlling shareholder transaction is itself malleable, and that malleability can be used to evade the strictures of Corwin.  Going forward, though the CBS/Viacom merger is very clearly a controlling shareholder transaction, I can imagine that in future cases, uncertainty as to whether a controlling shareholder is present in the first instance will wind up weighing in plaintiffs’ favor as they attempt to gain access to corporate records.

(3) In 2018, when CBS first tried to use nuclear tactics to avoid the merger, I said: “the main purpose of these legal skirmishes may be less to actually limit NAI’s power than to create an extraordinarily persuasive record that any attempt Shari Redstone may make to combine CBS and Viacom will be accomplished over the objection of the independent directors, and in violation of her duties as a controller.” That prediction has proved accurate; Slights explicitly read CBS’s 2018 resistance to the deal as evidence that the new deal proposed in 2019 was unfair to the CBS minority shareholders.  As he put it, “a straight line can be drawn between Redstone’s previous attempts to merge Viacom with CBS, which CBS maintained just one year ago ‘presents a significant threat of irreparable and irreversible harm to [CBS] and its stockholders[,]’ and the current attempt to combine these companies. This logical nexus is further evidence of wrongdoing…”

In short, the 2018 CBS Board – and Les Moonves – lost the battle, but may very well have won the war.

ICYMI: #corpgov Midweek Roundup (Nov. 27, 2019)

"This Article ... concludes that, contrary to the predictions of both [supporters and critics], the benefit corporation has not, apparently, resulted in much change at all." 7 Tex. A&M L. Rev. 73 #corpgov #socent

— Stefan Padfield (@ProfPadfield) November 24, 2019

"CEOs that signed on to Business Roundtable statement are still about maximizing profits in one revealing way—their statement on corporate wokeness says nothing about exorbitant CEO pay" https://t.co/pPVS9MvoJN #corpgov

— Stefan Padfield (@ProfPadfield) November 28, 2019

"the heavily-litigated personal benefit test found in Dirks may not apply to a charge of insider trading under §1348" #corpgov https://t.co/oj4O9uWdic

— Stefan Padfield (@ProfPadfield) November 27, 2019

"The 'marketplace of ideas' metaphor in 1A law is usually traced to the famous dissenting opinion of Justice Oliver Wendell Holmes in Abrams v. United States."; "often paired with the concurring decision of Justice Louis Brandeis in Whitney v. California" 24 Comm. L. & Pol'y 437 pic.twitter.com/thG8R20luu

— Stefan Padfield (@ProfPadfield) November 24, 2019

"As the Citizens United court also explained, the cases it overruled were themselves in tension with an older line of cases .... Thus, Citizens United can plausibly be understood as restoring the overall fabric of prior law." https://t.co/5QUEAf39IF #corpgov

— Stefan Padfield (@ProfPadfield) November 22, 2019

Another Paper Call: U. of Michigan 6th Annual Junior Scholars Conference

The University of Michigan Law School invites junior scholars to attend the 6th Annual Junior Scholars Conference, which will be held on April 17-18, 2020, in Ann Arbor, Michigan. The conference provides junior scholars with a platform to present and discuss their work with peers, and to receive detailed feedback from senior members of the Michigan Law faculty. The Conference aims to promote fruitful collaboration between participants and to encourage their integration into a community of legal scholars. The Junior Scholars Conference is intended for academics in both law and related disciplines. Applications from graduate students, SJD/PhD candidates, postdoctoral researchers, lecturers, teaching fellows, and assistant professors (pre-tenure) who have not held an academic position for more than four years, are welcomed.

Applications are due by January 3, 2020.  Conference flyer here: Download CfP for Michigan Law 2020 Junior Scholars Conference

Further information can be found at the Conference website: https://www.law.umich.edu/events/junior-scholars-conference/Pages/2020conference.aspx

Call for Papers: Law and Ethics of Big Data

I want to wish all BLPB readers a Happy Thanksgiving!

Below, I've excerpted information about the upcoming Law and Ethics of Big Data research symposium.  The call for papers is here: Download BIG DATA CALL FOR PAPERS March 27-28 2020 at GA Tech

Law and Ethics of Big Data

Hosted and Sponsored by: Cecil B. Day Program for Business Ethics Machine Learning @ Georgia Tech (ML@GATECH)Georgia Institute of Technology, Scheller College of Business Co-Hosted by: Virginia Tech Center for Business Intelligence Analytics The Department of Business Law and Ethics, Kelley School of Business March 27th and 28th 2020 at the Scheller College of Business, Georgia Institute of Technology, Atlanta, GA

Abstract Submission Deadline: February 1, 2020

We are pleased to announce the research colloquium, “Law and Ethics of Big Data,” at the Scheller College of Business, Georgia Institute of Technology, Atlanta, GA, co-hosted by Professor Deven R. Desai, Assistant Professor Angie Raymond of Indiana University, and Professor Janine Hiller of Virginia Tech.

Due to the success of this multi-year event that is in its seventh year, the colloquium will be expanded and we seek broad participation from multiple disciplines; please consider submitting research that is ready for the discussion stage. Each paper will be given detailed constructive critique. We are targeting cross-discipline opportunities for colloquium participants, and the Scheller and ML@GATECH community has expressed interest in sharing in these dialogues. A non-inclusive list of topics that are appropriate for the colloquium include: Technical Realities of Transparency, Best Practices for Ethical Gathering and Use of Data and/or Algorithm Construction, Machine Learning for Good, Ethics of Data Commons, Ethical Principles for the Internet of Things, Health Privacy and MHealth, Employment and Surveillance, National Security, Civil Rights and Data, Smart Cities and Privacy, Cybersecurity and Big Data, and Data Regulation. We seek a wide variety of topics and methods (e.g., law, computer science, empirical, sociological, anthropological, etc.) that reflect the broad ecosystem created by ubiquitous data collection and use, and its effect in society. 

 

What if . . . . Delaware and Mrs. Pritchard

Many of us teach Francis v. United Jersey Bank, 432 A. 2d 814 (N.J. 1981), in Business Associations courses as an example of a substantive duty of care case.  The case involves a deceased woman, Lillian Pritchard, who, in her lifetime, did nothing as a corporate director to curb her sons' conversions of corporate funds.  The court finds she has breached her duty of care to the corporation, stating that:

Mrs. Pritchard was charged with the obligation of basic knowledge and supervision of the business of Pritchard & Baird. Under the circumstances, this obligation included reading and understanding financial statements, and making reasonable attempts at detection and prevention of the illegal conduct of other officers and directors. She had a duty to protect the clients of Pritchard & Baird against policies and practices that would result in the misappropriation of money they had entrusted to the corporation. She breached that duty.

Id. at 826.  In sum:

by virtue of her office, Mrs. Pritchard had the power to prevent the losses sustained by the clients of Pritchard & Baird. With power comes responsibility. She had a duty to deter the depredation of the other insiders, her sons. She breached that duty and caused plaintiffs to sustain damages.

Id. at 829.

Francis is followed in our text by a number of additional fiduciary duty law cases, including Delaware's now infamous Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), Stone v. Ritter, 911 A.2d 362 (Del. 2006), and In re Walt Disney Derivative Litigation, 907 A 2d 693 (Del. 2005).  In covering these cases and discussing them with students during office hours, I became focused on the following passage from the Disney case:

The business judgment rule . . . is a presumption that "in making a business decision the directors of a corporation acted on an informed basis, . . . and in the honest belief that the action taken was in the best interests of the company [and its shareholders]." . . . .

This presumption can be rebutted by a showing that the board violated one of its fiduciary duties in connection with the challenged transaction. In that event, the burden shifts to the director defendants to demonstrate that the challenged transaction was "entirely fair" to the corporation and its shareholders.

In re Walt Disney Co. Derivative Litigation, 907 A.2d 693, 746-47 (Del. Ch. 2005).  I have some significant questions about the application of the "entire fairness" standard of review in certain types of cases.  In thinking those through with some of my colleagues (including a few of my co-bloggers), I realized I was curious about the answer to a related question: How would the Francis case be pleaded, proven, and decided as a breach of duty action under Delaware law?  

I have my own ideas.  But before I share them, I want yours.  How would you categorize/label the breach(es) of duty as a matter of Delaware law?  What standard of conduct and liability would you expect a Delaware court to apply as a matter of Delaware law?  And what standard of review would you expect that court to use?  Leave your ideas on any or all of the foregoing in the comments, please!

I Hate Federal Partnership Law, But LLCs Are Still Not Corporations

Last Friday, a new opinion from the United States Court of Appeals for the First Circuit tackled a complex application of the Employee Retirement Income Security Act of 1974 (ERISA) law that required an analysis of “federal partnership law,” which assessed whether two entities had created a “partnership-in-fact, as a matter of federal common law.”  Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 16-1376, 2019 WL 6243370, at *5 (1st Cir. Nov. 22, 2019). I hate the idea of “federal partnership law,” but I concede it is a thing for determining certain responsibilities under the tax code and ERISA. I still maintain that rather than discussing federal entity law and entity type in these cases, we should instead be discussing liability under certain code sections as they apply to the relevant persons and/or entities.  Nonetheless, that’s not the state of the law.

Even though I don’t like the concept of federal partnership law, I can work with it. As such, I think it is fair to ask courts to respect entity types if they are going to insist on using entity types to determine liability. Alas, this is too much to ask.  Friday’s opinion explains:

The issue on appeal is whether two private equity funds, Sun Capital Partners III, LP (“Sun Fund III”) and Sun Capital Partners IV, LP (“Sun Fund IV”), are liable for $4,516,539 in pension fund withdrawal liability owed by a brass manufacturing company which was owned by the two Sun Funds when that company went bankrupt. The liability issue is governed by the Multiemployer Pension Plan Amendments Act of 1980 (“MPPAA”). Under that statute, the issue of liability depends on whether the two Funds had created, despite their express corporate structure, an implied partnership-in-fact which constituted a control group. That question, in the absence of any further formal guidance from the Pension Benefit Guaranty Corporation (“PBGC”), turns on an application of the multifactored partnership test in Luna v. Commissioner, 42 T.C. 1067 (1964).

Id. at *1 (emphasis added). The court continued: “To the extent the Funds argue we cannot apply the Luna factors because they have organized an LLC through which to operate SBI, we reject the argument. Merely using the corporate form of a limited liability corporation cannot alone preclude courts recognizing the existence of a partnership-in-fact.” Id. at *6. (emphasis added).

LLCs are not corporations, and they do not have a corporate form or structure! They are limited liability companies, which are totally different entities from corporations.  

It seems I am often saying this, but the court does seem to get to the right conclusion despite the entity errors:

The fact that the entities formally organized themselves as limited liability business organizations under state law at virtually all levels distinguishes this case from Connors and other cases in which courts have found parties to have formed partnerships-in-fact, been under common control, and held both parties responsible for withdrawal liability.

Id. at *8.

That courts tend to get it right, even when using improper entity language, does not mean it’s not a big deal. It simply means that judges (and their clerks) understand the distinctions between entities and entity types, even if their language is not perfect. That seems to be generally okay as applied in the individual cases before each court. However, these cases communicate beyond just the parties involved and could influence poor drafting decisions that could have impacts as between individual members/partners/shareholders down the road.  It sure would be great if  more courts would take the chance when there is an opportunity to be clear and precise. 

 

You Have One Job

Recently, these stories caught my eye:

Neptune Says Readying for IPO Means Readying Low-Carbon Strategy

Neptune Energy Group Ltd. said that preparing to go public, possibly within the next two years, means it has to explain to potential investors how its fossil fuel-based business model is sustainable.

The company is putting together an ESG strategy, a term encompassing environmental, social and governance issues, which it will publish along with its annual report in April. The move reflects growing concern about climate change among investors in the sector, many of whom are demanding a stronger response from oil producers amid a gradual shift toward cleaner energy….

John Browne [the former BP Plc chief] who helped create the largest privately held oil company in Europe -- Wintershall DEA --- has said an ESG strategy is now crucial to attracting investment.

Indeed, even oil behemoth Saudi Aramco has been touting its relatively low carbon intensity -- the level of emissions per unit of energy produced -- to woo investors to its initial public offering.

These Agencies Want to Check Who's Naughty and Who's Nice

Credit rating companies are muscling their way into the burgeoning world of responsible investing, purchasing smaller outfits that provide environmental, social and governance (ESG) scores….

The 159-year-old ratings provider is also leaving the door open for more acquisitions in the future, as data is “enormously important” for companies that want to lead in the sector…

The explosion of investment products that are marketed as being environmentally and socially responsible is fueling the demand for ESG data and scores….

ESG ratings have been mostly used by investment-grade bond and loan issuers who tie their sustainability performance to transaction terms or pricing. This year, usage of ESG scores started to spread to leveraged loans, collateralized loan obligations,…

Green Bonds Get Rubber-Stamped as Investors Question the Label

Global investor enthusiasm for saving the planet has helped spur record issuance of green bonds. It’s also driving a surge in third-party verification that proceeds from the debt sales are actually destined for environmentally friendly projects, as fears of “greenwashing” mount….

Sustainalytics issued 35% more second-party opinions for green bonds in the third-quarter of this year compared to the same period a year ago. That included a 20-page opinion on Verizon’s green bond framework before the phone giant sold $1 billion in green bonds in February.

The benefit of getting the second party opinion outweighed the cost, according to Kee Chan Sin, Verizon’s assistant treasurer….

Some borrowers are going a step further and asking auditors to review the use and management of proceeds, as well as reporting after the bond is issued. Assurance that funds raised are being allocated to the right projects could help the market grow, said Kristen Sullivan, sustainability and KPI services leader at Deloitte, which provides assurance to green bond issuers.

Some investors are also doing their own audits.

It is obvious that investors are clamoring for reliable ESG data – at the very least regarding climate change vulnerability – and they are desperate enough to be willing to pay for it.  This is not some kind of social cause movement; these investors are seriously, financially concerned about the long-term viability of certain industries and industrial practices.

Still, due to coordination problems, there’s a lack of standardization of metrics, and a lack of comparability of data.

Which is why I stand in absolute amazement that (at least some) SEC Commissioners take all this as evidence that the SEC should not develop a disclosure framework, because the current metrics are too inconsistent.  We would normally take that as a sign of the need for coordination by regulators.  After all, when the federal securities laws were passed in 1933 and 1934, there wasn’t much in the way of accounting standards – it took a federally mandated disclosure regime coupled with decades of cooperation with the private sector to settle on a unified framework.

I mean, I suppose it’s great business for the private ratings industry, which gets to sell investors different analyses, but isn’t that kind of standardization the raison d’etre of the securities disclosure regime?

Unpaid FINRA Arbitration Awards May Be Escalating

The broker-dealer community enjoys unusual influence over its regulation because Congress made an industry trade-association the primary regulator for broker-dealers.  FINRA's member firms elect much of its governing board and influence how FINRA will allocate its resources and set priorities.  This includes decisions about how many resources to devote to enforcement and supervision activities which might prevent significant investor losses.  Giving the industry collective responsibility for making harmed investors whole might cause the organization to devote more resources to enforcement and investor protection.

Unpaid arbitration awards may escalate if changing market conditions reveal that brokerage firms have sold investors interests in frauds and ponzi schemes.  Consider the recent case of Taylor Capital Management.  Taylor's representatives reportedly sold interests in  "an alleged $283 million loan fraud" run though a company known as 1 Global Capital.  The allegations remind me of the Woodbridge Ponzi scheme that collapsed last year.  Now that Taylor Capital Management has closed its doors, the investors harmed by its conduct may not be able to recover.  We may never know the true scope of the harm because investors won't file arbitration claims against an entity that cannot pay them.

It's difficult to know whether these early collapses will be isolated events or the beginning of a growing trend.  A strong stock market can hide misconduct and allow Ponzi schemes to continue longer than they would otherwise.  If the market reverses, it would not surprise me if we discovered that many more Ponzi schemes have developed and been fed by commission-chasing brokerage firms.

ICYMI: #corpgov Midweek Roundup (Nov. 20, 2019)

"A decade ago, South Dakotan trust companies held $57.3bn in assets. By the end of 2020, that total will have risen to $355.2bn." https://t.co/tiDCLXb2y8 #corpgov

— Stefan Padfield (@ProfPadfield) November 17, 2019

"an example of a successful 220 demand based on the court’s finding of: (1) A credible basis to investigate claims of breach of the duty of loyalty; &, (2) The rejection of the argument that ... the plaintiff ... was a mere proxy for plaintiff’s counsel" #corpgov https://t.co/47xWvHb5nQ

— Stefan Padfield (@ProfPadfield) November 18, 2019

"After the US Supreme Court decided in Green v. Santa Fe that merger challenges were the province of state law and not classic federal securities laws because they focused on fiduciary duty, not securities deceit and fraud, the Delaware state courts rose to prominence" #corpgov https://t.co/k0hLwO61Qg

— Stefan Padfield (@ProfPadfield) November 18, 2019

"we conducted an analysis of 50 equity joint venture legal agreements—drawn from across industries, geographies, and formation years—to see how the contracts address the [the duty of loyalty]. We found four basic approaches" https://t.co/RL9d5AIlpB

— Stefan Padfield (@ProfPadfield) November 17, 2019

"HP may also receive some pressure to merge from Carl Ichan, who owns a 4.24% stake in HP in addition to his 10.6% stake in Xerox" https://t.co/9ANKYVEyy6 #corpgov

— Stefan Padfield (@ProfPadfield) November 17, 2019

A few fintech regulation-related news items from today

Today, I read about at least two interesting fintech regulation-related news items.

First, the New York State Department of Financial Services “has granted a charter under New York Banking Law to Fidelity Digital Asset Services, LLC (FDAS), to operate as a limited liability trust company as part of the state’s rapidly growing virtual currency marketplace.” (here)

Second, CFTC Chairman Heath Tarbert published an op-ed, Fintech Regulation Needs More Principles, Not More Rules, in Fortune magazine (here).  The title aptly summarizes this short piece.  In general, I tend to agree with Tarbert that “a principles-based approach is the best way to govern this emerging market,” but that some areas, such as customer protection, might be “more suited to a rules-based approach.”  Tarbert also notes that “CFTC staff is currently considering how the core principles applicable to exchanges…and clearinghouses…can be better tailored for fintech,” and that “core principles have been central to our evaluation of clearinghouses that would clear derivatives resulting in delivery of Bitcoin” (information about ICE’s physically settled Bitcoin contracts here).

In a former post (here), I wrote:

A participant [at the December 2018 MRAC meeting] briefly remarked that clearinghouse default funds for crypto assets should be kept separate from default funds for other assets.  From my perspective, this makes complete sense, at least for the near future.  However, the CME explains: “Bitcoin futures will fall into CME’s Base Guaranty Fund for futures and options on futures, as any newly listed futures.”  The CME, Inc. (because of its division, CME Clearing) is a designated, systemically significant financial market utility under Title VIII of Dodd-Frank.  This issue of crypto asset clearing is itself worthy of its own post!    

In need of much more discussion – at least from my perspective – are the increased cryptocurrency-related offerings (including clearing) of some of the most important infrastructures in our global financial markets: trading exchange groups (and their clearinghouses).  I definitely still think crypto asset clearing deserves much more focus and its own post.  Maybe I’ll write that soon.  In the meantime, I’d love to see more debate by academics and others about the potential benefits and risks of the continued march down this path.      

Insider Trading Stories at UT Law

I was thrilled to be with so many wonderful colleagues and students (pictured above) at the Tennessee Journal of Law and Policy's symposium at UT Law last Friday.  The symposium, "Insider Trading: Stories from the Attorneys," featured presentations about famous and not-so-famous insider trading cases.  Presenters included Michael Guttentag (Loyola, Los Angeles), me, Jeremy Kidd (Mercer), Ellen Podgor (Stetson), John Anderson (Mississippi College), Eric Chaffee (Toledo), Kevin Douglas (Scalia), and Donna Nagy (Maurer).  The papers presented highlight a variety of salient issues (including observations about the impact of gender and sexual orientation in specific cases or types of cases) involving or touching insider trading regulation.  They are being published in 2020 by the Tennessee Journal of Law & Policy.

The idea for the symposium came from a Southeastern Association of Law Schools (SEALS) discussion session convened last summer by John and me.  I described it in this post.  Let me or John know if you are working in the insider trading area and would like to join us for our 2020 SEALS discussion group, "Insider Trading: Is It All about the Money?"  The SEALS conference is scheduled to be held July 30 - August 5, 2020.  The discussion is always lively!

Dear Florida: LLCs Are Still Not Corporations

It’s been a minute since I took some time to look at whether courts are still treating LLCs as corporations.  Spoiler alert: They are.  Last week, the Southern District of Florida gave a shining example:

Defendants argue that Vista, a limited liability corporation, is a citizen of any state of which a member of the company is a citizen for diversity purposes. Because the January 26, 2018 written agreement (“Agreement”) granted the PJM Defendants a 10% ownership interest in Vista, Defendants maintain that Vista is a Florida citizen by virtue of the PJM Defendants’ Florida citizenship, thereby destroying complete diversity. . . .

Plaintiffs contend that Vista is a California corporation and complete diversity exists. In support, Plaintiffs proffer Vista’s California LLC records which show that Armen Temurian is the entity’s only member. Defendants argue that these records are self-serving, and that the plain language of the Agreement contradicts these records and establishes the PJM Defendants’ ownership in Vista.  . . .

The Agreement expressly recognizes that the PJM Defendants have obtained a 10% ownership of all Vista current and future direct and indirect entities, which contradicts Plaintiffs’ proffered California LLC records on their face. . . . Because Vista is a citizen of every state that any member is a citizen of, Vista is a citizen of Florida, which destroys diversity. The Court therefore does not have diversity jurisdiction over this matter.

ARMEN A. TEMURIAN, et al, Plaintiffs, v. PHILLIP A. PICCOLO, JR., et al, Defendants. Additional Party Names: George Foerst, Joseph Reid, K.F.I. Software, Kevin Dalton Johnson, Paul Morris, Travelada, LLC, Vista Techs. LLC, No. 18-CV-62737, 2019 WL 5963831, at *3-*4 (S.D. Fla. Nov. 13, 2019) (emphasis added).

The court seems to arrive at the correct conclusion, though without clearly and properly identifying the entities involved, it’s hard to be sure.  Note that here, according to the court, the defendants claim Vista is an LLC ( a limited liability company.) The Plaintiffs replied, the court says, that the company is a “California corporation.” If Vista is an LLC, as it seems to be, and it had members who were also Florida citizens, the court would be correct to find a lack of diversity jurisdiction. Still, it would be a big help if the court would help lay out the facts in an accurate way so that the facts more clearly lead to the legal outcome.

The Meaning of We

I've frequently been asked to express a view on the spectacular decline of WeWork.  Is there a broader lesson here?  Or is this just a bizarre one-off?

I actually think there are a few lessons, and for this week’s post, I’ll start with the one about securities regulation and capital allocation.

One of the primary purposes of securities regulation is to ensure the efficient allocation of capital. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System,  70 Va. L. Rev. 717 (1984); see also Benjamin Edwards, Conflicts and Capital Allocation, 78 Ohio St. L. J. 181 (2017).  SEC Chair Jay Clayton recently gave a speech in which he emphasized that the SEC is “not in the business of dictating a company’s strategic capital allocation decisions,” which is true – the SEC’s job is not to tell market actors where or how to invest – but the SEC is responsible for creating a disclosure regime that facilitates efficient capital allocation via investors’ choices.  And by that measure, the securities laws are failing.

As we all know, the securities laws – both through statutory revisions (JOBS Act) and regulatory interpretation – have made it easier for companies to raise capital without public disclosure.  The theory is that wealthy, institutional investors can bargain for the information they need to make an intelligent investment decision.  But – as others have pointed out – when capital is raised privately, optimistic sentiment can be expressed but negative sentiment cannot.  I’ll go further: Because private-market investors are a small group, they have strong incentives to keep their negative opinions to themselves lest they be shut out of future deals.  Meanwhile, mutual funds have made a deep dive into the private markets, and agency costs infect those decisions: active managers, hoping to improve their market relative to competitors, may well think it would be worse to miss out on a great deal than to make a bad bet that puts their fund on par with everyone else’s.

The result is a bubble of private company valuations that meets reality only when it comes time to go public, as recent experience has demonstrated.  But the injuries are not experienced by these sophisticated investors alone; they’re experienced by all of the other actors whose lives are affected by the allocation of capital to doomed business models.

The New York Times just published an expose on the havoc SoftBank has wreaked internationally by dumping cash into unprofitable startups, which have then gone on to persuade small business owners and independent contractors around the world to upend their plans in hopes of opportunities that never materialize.  Violent and/or fire-laden protests have resulted in Indonesia, India, and Colombia.  Obviously, many of these investments were outside of the scope of American securities regulation, but not all of them, and they serve as a cautionary tale of the consequences when capital is allocated to poorly-designed businesses.  In this, SoftBank is not alone; American venture capital firms have been pouring money into U.S. startups, well beyond amounts that the companies themselves have requested; some founders  apparently feel that if they don’t accept venture capital money they don’t need, the VCs will simply invest in a competitor and drive them out of business. See also Sheelah Kolhatkar, WeWork’s Downfall and a Reckoning for SoftBank (“The fact that the Vision Fund flooded its companies with capital made it difficult for other startups or traditional companies with even a modicum of fiscal discipline to compete.”)

It’s not just the investors or even the founders who suffer; the effects are felt throughout the economy.  SoftBank’s ill-considered bet on WeWork has upended real estate markets on two continents and that doesn’t even get into the effects on employees; even WeWork’s janitorial staff was paid in stock.

Now, I’ve argued that the securities disclosure regime should not be broadly interpreted to encompass the interests of all actors in society; securities disclosure is, at its core, for investors, and if we’re worried about other corporate constituencies – and we should be – we should design a disclosure system for their needs.  But even within the confines of securities disclosure, efficient allocation of capital should be one of the central goals.  And the overwhelming evidence is that, wherever the appropriate line between privatization and “publicization,” the American system has gone too far in the direction of the private.

CEO Social Media Strategy & Corporate Governance

Recent news reports claim that T-Mobile CEO John Legere may be in discussions with WeWork for him to leave T-Moble to take over as CEO at WeWork.  Legere came to my attention because of social media ads featuring videos of him bedecked in T-Mobile gear and hawking its services.   You've probably seen the ads as well. By all accounts, T-Mobile has grown dramatically under his leadership.  Legere's name recognition and public visibility has also grown with the CEO becoming the ubiquitous face of the company.  In contrast, I cannot readily name or picture the CEOs of Verizon, Sprint, or AT&T.

T-Mobile may have spent millions to promote itself and also generate Legere's visibility and name recognition.  It's difficult to recall a T-Mobile advertisement without him in it. He now has about 6.5 million followers on Twitter.  In contrast, T-Mobile itself only has 1.2 million followers.  If he goes to WeWork, will his Twitter account go with him?  What does this mean for T-Mobile's brand?  Is using corporate resources to secure additional social media followers for yourself ever a breach of the duty of loyalty to the corporation?

This strikes me as a corporate governance issue that boards should be thinking about.  The celebrity CEO strategy comes with its own risks and rewards.  Recall George Zimmer, the former CEO of Mens Wearhouse.  When the Mens Wearhouse board ousted him as the CEO, the Mens Wearhouse also lost their key brand pitchman.

The possible loss of John Legere might be even bigger for T-Mobile.  Legere's Twitter account even made it into a T-Mobile 10-K.  It's referenced this way:

Investors and others should note that we announce material financial and operational information to our investors using our investor relations website, press releases, SEC filings and public conference calls and webcasts. We intend to also use the @TMobileIR Twitter account (https://twitter.com/TMobileIR) and the @JohnLegere Twitter (https://twitter.com/JohnLegere), Facebook and Periscope accounts, which Mr. Legere also uses as means for personal communications and observations, as means of disclosing information about us and our services and for complying with our disclosure obligations under Regulation FD. The information we post through these social media channels may be deemed material. Accordingly, investors should monitor these social media channels in addition to following our press releases, SEC filings and public conference calls and webcasts. The social media channels that we intend to use as a means of disclosing the information described above may be updated from time to time as listed on our investor relations website.

 

ICYMI: #corpgov Midweek Roundup (Nov. 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

Academics v Morningstar

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.”  Commentary on this article by Morningstar, Morningstar Stands Behind Its Fixed-Income Data and Fund Ratings, is here.  

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?  If 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.

Revised: 11/14/2019        

Celebrating Veterans, Including Veteran Entrepreneurs

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.

New Essay: An Overt Disclosure Requirement for Eliminating the Fiduciary Duty of Loyalty

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.   

Common Ownership Problems

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.

UNLV Corporate Governance Summit

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
• Compensation
• Social Media
• Diversity 
• 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.