Business Law Prof Blog

NCWOL Claims for Clearinghouse Shareholders?

This past week, I had occasion to return to the Financial Stability Board’s (FSB) recent Consultative document, Guidance on financial resources to support CCP resolution and on the treatment of CCP equity in resolution (Guidance), which I wrote a brief post about several weeks ago (here).  In doing so, I spent more time thinking about the possibility of clearinghouse shareholders raising “no creditor worse off than in liquidation” (NCWOL) claims in a resolution scenario.  I’m struggling with this idea.  Shareholders are not creditors.  I’ve decided to research this issue more and plan to write a short article.  Stay tuned.

The Guidance notes the principle:

that in resolution CCP [clearinghouse] equity should absorb losses first, that CCP equity should be fully loss-absorbing, and that resolution authorities should have powers to write down (fully or partially) CCP equity. 

It also notes that:

actions in resolution that expose CCP equity to larger default or non-default losses than in liquidation under the applicable insolvency regime could, based on the relevant counterfactual, enable equity holders to raise NCWOL claims.  This may be inconsistent with the other Key Attributes principle that equity should be fully loss absorbing in resolution.  This may also raise moral hazard concerns by allowing equity holders to maintain their equity interest in a CCP post resolution while participants are made to bear losses.

I’ll provide a very brief bit of background in this post and encourage readers interested in learning more about this area to review my work on clearinghouses (for example, here and here). 

Most clearinghouses – for example ICE Clear Credit, a clearinghouse for CDS, and CME Clearing, a clearinghouse within CME Group – are now part of publicly traded global exchange group structures.  Historically, clearinghouses were owned by their users/participants.  Post Dodd-Frank, some clearinghouses, including the two just noted, have been designated as systemically significant financial market utilities (here). 

Over a long period of time, clearinghouses have proven themselves to be robust risk management institutions.  However, they can and have failed.  Clearinghouses can experience losses due to the default of a clearing member(s), due to non-clearing member default issues (for example, cybersecurity problems, investment or custody losses, operational problems etc.), or due to a combination of both default and non-default issues.

Clearinghouses have rulebooks (contractual arrangements between the clearinghouse and clearing members/participants) that delineate how losses will be handled in the event that a clearing member were to default.  Typically, clearinghouse default waterfalls in rulebooks direct that if the defaulting member’s performance bond (initial margin) does not cover its obligations, then a limited amount of funds contributed by the clearinghouse itself would be used to cover losses, and then any remaining losses would be covered by a common default fund which all clearing members are required to contribute to.  Were the default fund to be exhausted, rulebooks generally permit clearinghouses to make an additional “cash call” to members.  Were losses then still outstanding, the clearinghouse would initiate a recovery process. 

Clearing members have called for clearinghouses to put additional capital at risk in this default waterfall structure (here) and to be required to hold additional capital.  There is an obvious tension/conflict of interest between clearing members of a publicly traded clearinghouse being largely responsible for default losses and the clearinghouses's shareholders benefiting from the clearinghouse’s profits and managing its risk.  Of course, if clearinghouses were owned by their users as they were historically, this conflict of interest would not exist.  An alternative to the remutualization of clearinghouses would be for the clearinghouse to be responsible for any default losses that exceeded the defaulting member’s initial margin.  From my perspective, this would make a lot more sense.   I'm unaware of other examples in which the customers (clearing members) of a publicly traded institution, rather than its shareholders, are responsible for losses created by other customers.   

Were a systemically important clearinghouse to become distressed, a resolution authority (RA) could step in – perhaps prior to the completion of the clearinghouse’s recovery process – to ensure the continuity of the clearinghouse’s operations and financial market stability.  Systemically important clearinghouses are too critical to fail.  Were the RA to take actions resulting in the shareholders experiencing larger losses than they would “in liquidation under the applicable insolvency regime,” there is a concern that such action by the RA could “enable equity holders to raise NCWOL claims.”  I would think that this concern would largely disappear if the odd situation of having customers paying for the losses of other customers at a publicly traded institution did not exist or if clearinghouses were owned by their users. 

At least for now, in my pre-NCWOL claims by clearinghouse shareholders article world, it’s unclear to me why given that shareholders are not creditors that shareholders would (or should) be able to make credible “NCWOL” claims as shareholders in resolution.  I understand that a RA could step in before a clearinghouse recovery process were complete and that shareholders might lose more than they would were the rulebook procedures followed.  I also understand that clearinghouse rulebooks generally require clearing members – rather than shareholders – to absorb the majority of the losses from the default of a clearing member.  But at the end of the day, shareholders are simply not creditors.  Perhaps if it were clear ex-ante that clearinghouse shareholders would be unable to make NCWOL claims in a clearinghouse resolution, it might help to rationalize the incentive conflicts in the clearinghouse area.  If clearinghouse shareholders want to make “no shareholder worse off than in liquidation” claims, then the case should be made for that.

Sometimes I blog in ways that ignore the chaos of our current political moment. This is not one of those times.

Both as a corporate governance scholar and an American citizen, I’ve spent the last few days riveted by Twitter’s decision to go to war with the President of the United States.

And it was a decision; after Twitter posted its first fact-check of a Trump tweet, its VP of Global Communications said, “We knew from a comms perspective that all hell would break loose.”

All hell did.  Trump responded with an executive order (whose legal effect is, ahem, questionable), and Twitter’s stock price plummeted.  But Twitter doubled-down, hiding a Trump tweet for glorifying violence, and doing the same when the White House twitter account repeated the same quote.

We’ve talked a lot here about corporate political stances, and – especially in the context of Nike and Colin Kaepernick -- how despite appearances, they’re often justifiable on a theory of shareholder value maximization.

A similar argument could be made about Twitter’s conduct.  It has come under increasing pressure to control its platform; trolls and bots and harassment by some users have driven away others.  Trump’s tweets about Joe Scarborough specifically led to a torrent of criticism, essentially begging Twitter to hold Trump to the same standards as any other user.  Twitter’s efforts to impose discipline – on any chaos agent, including the President – could easily be viewed as part of a larger strategy to ensure that the platform remained usable for everyone else.  Merely choosing to join battle may attract users and attention, which is Twitter’s main asset.

At the same time, Twitter’s actions here feel different.  They feel like an recognition of civic responsibility, to keep political discourse civil and truthful, regardless of whether that is the most profitable course for the company.

Facebook, of course, has ostentatiously distanced itself from Twitter, proclaiming on Fox News that it does not  want to be an “arbiter of truth.” (well, not anymore). 

The Wall Street Journal recently reported that Facebook dropped its own initiative to minimize polarization and political falsehoods on its platform, in part because “some proposed changes would have disproportionately affected conservative users and publishers, at a time when the company faced accusations from the right of political bias.”  Shira Ovide, commenting in the New York Times, wrote, “If Facebook made these decisions on the merits, that would be one thing. But if Facebook picked its paths based on which political actors would get angry, that should make people of all political beliefs cringe….there should be a line between understanding the political reality and letting politics dictate what happens on your site.”

That’s such an odd statement.  Facebook isn’t a state actor, it’s a private company, and a private company exists to benefit shareholders, which, among other things, may mean placating politicians – right?

And yet when these things come up, I often see people offering takes like these:

 

pic.twitter.com/mdFxy4qIoN

— Bad Legal Takes (@BadLegalTakes) May 27, 2020

They’re wrong, but also – they’re kind of right, in the popular sense that large corporations often have public responsibilities and therefore the public demands their decisionmaking reflect public values.

But then there’s Scott Rosenberg’s view that Facebook’s hands-off policy is analogous to a government neutrally facilitating free speech, while Twitter is behaving more like a property owner trying to maintain order in its mall.

The flaw in Rosenberg’s analogy is that Facebook is not a neutral platform; the point of the Wall Street Journal piece is that Facebook’s own algorithms privilege certain types of speech over others in order to maximize user engagement – much like a mall owner who makes sure there are plenty of amenities on the property so no one ever leaves.

That said, I often experience this kind of gestalt switch when I think about corporate social responsibility; categorizing the behavior as privately oriented or publicly oriented is often simply a matter of perspective.  Large corporations are, in fact, a hybrid of the two, a product of both public systems and individual choices.  Which is why it’s so hard to put the conflict here into a neat little box.

Draft State Whistleblower Legislation

The North American Securities Administrators Association just released proposed model whistleblower legislation.  At first glance, the legislation looks similar to the federal whistleblower bounty program enacted as a part of Dodd-Frank, only at the state level:

Among other provisions, the proposed model act provides a state’s securities regulator with the authority to make monetary awards to whistleblowers based on the amount of monetary sanctions collected in any related administrative or judicial action, up to 30 percent of the amount recovered. The model act also would protect whistleblower confidentiality, prohibit retaliation by an employer against a whistleblower, and create a cause of action and provide relief for whistleblowers retaliated against by their employer.

NASAA seeks comments by June 30, 2020.  Hopefully, they'll get plenty of insightful comments informed by studying the flaws with the SEC's bounty program. 

As Andrew Jennings pointed out to me, the language seems to track the federal language.  This may generate some of the the same difficulties for internal reporters.  At the federal level, whistleblowers who try to work within the organization to fix a problem do not receive the same protection from retaliation as those that go directly to the SEC. 

Although federal law may make it difficult for states to include an anti-arbitration provision for retaliation claims, states should probably also think about where any anti-retaliation claim will be heard.  It may be valuable to have state regulator insight into those hearings somehow, particularly if the main idea is to get information to state regulators.

ICYMI: #corpgov Midweek Roundup (May 27, 2020)

If you have trouble viewing the embedded Tweets, please try a different browser (I recommend Internet Explorer).

It's been 11 weeks since the WHO declared the coronavirus outbreak a pandemic, and the NBA cancelled games. As of this writing, the NY Post reports: Total cases globally = 5,589,626; Deaths = 350,453.

"Commerce Department to Add Two Dozen Chinese Companies ... to the Entity List"; "The entities, based in China, Hong Kong, and the Cayman Islands, represent a significant risk of supporting procurement of items for military end-use in China." https://t.co/d47Q0Q7uwk #corpgov

— Stefan Padfield (@ProfPadfield) May 22, 2020

8 Chinese companies "are complicit in human rights ... abuses committed in China’s campaign of repression, mass ... detention, forced labor & high-technology surveillance against Uighurs, ... Kazakhs, & other members of Muslim minority groups" https://t.co/Q3j3COXQ9b #corpgov

— Stefan Padfield (@ProfPadfield) May 22, 2020

If our lockdowns turn out to have been misguided, what biases might be to blame? A disdain for markets and capitalism? A devotion to centralized planning and "experts"? You can likely add to the list. "Do Lockdowns Work? Mounting Evidence Says No" https://t.co/sIIyrsTESC #corpgov

— Stefan Padfield (@ProfPadfield) May 25, 2020

If your cost-benefit-analysis concludes you can afford to roll 100s through Walmart hourly, but you can't afford a single church service under any conditions, then your CBA is anti-religious. #corpgov https://t.co/xyTndaJYu2

— Stefan Padfield (@ProfPadfield) May 25, 2020

"The Deshpande Symposium is an annual gathering ... focused on accelerating innovation and entrepreneurship across the college and university environment." #corpgov https://t.co/QEoKBT5UJV

— Stefan Padfield (@ProfPadfield) May 23, 2020

2021 AALS Annual Meeting - Section on Business Associations Additional Call for Papers

Yesterday, I posted the AALS Section on Business Associations Call for Papers for the New Voices in Business Law program.  Today, I am posting the section's general call for papers, which focuses on a very salient topic: Corporate Boards in the Age of COVID-19.  There certainly is a lot that we can say about that from the advisory, compliance, and litigation (prevention and management) angles.

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Call for Papers for the
Section on Business Associations Program on
Corporate Boards in the Age of COVID-19

2021 AALS Annual Meeting

The AALS Section on Business Associations is pleased to announce a Call for Papers for its program at the 2021 AALS Annual Meeting in San Francisco, California. The topic is Corporate Boards in the Age of COVID-19. Up to three presenters will be selected for the section’s program.

The COVID-19 pandemic has put corporate boards under tremendous stress. In the midst of unprecedented financial and operational challenges, boards must comply with legal obligations that are often complex, uncertain, and contested. This panel will explore the impact of COVID-19 on the corporate board. How should boards exercise their oversight and disclosure responsibilities during these times? Should boards reevaluate the corporate purpose, especially considering the increased vulnerability of employees and other stakeholders? Should boards rethink their dividends and stock buyback policies? And, as market instability continues, how should boards approach planned transactions and use defensive mechanisms? We hope to facilitate a robust conversation that connects corporate law theory to the immediate challenges facing corporate boards.

Submission Information:

Please submit an abstract or a draft of an unpublished paper to Jessica Ericsson, [email protected], on or before August 3, 2020. Authors should include their name and contact information in their submission email but remove all identifying information from their submission.

Papers will be selected after review by members of the Executive Committee of the Section. Authors of selected papers will be notified by August 28, 2020. Presenters will be responsible for paying their registration fee, hotel, and travel expenses.

Please direct any questions to Jessica Erickson, University of Richmond School of Law, at [email protected].

Remembering Those Who Died in Service to Our Country

As we close out the holiday weekend, I offer simple words of respect, admiration, and thanks for those who have sacrificed their lives for all of us.  Amidst the barbecues and beer and whatnot, it is sometimes difficult to remember that we take today to honor our fallen heroes.  Although I spent today working (grades for all courses due tomorrow!), I took time out to remind myself that life is not all about business law prof'ing and contemplate the importance of the day.

The photo above (taken by my brother last year) depicts a gravestone honoring one of our family's military heroes.  He did not die in combat, but he was wounded and received the Congressional Medal of Honor.  Although we honor those kinds of commitments more directly on Veteran's Day, I was thinking about him today--and about the thin line that divides life and death, especially in times of military conflict.

My heart goes out to all who have lost family and friends in the line of battle or otherwise in service to our country.  May those lost servants rest in peace.  And may those who remain take pride in their ultimate sacrifice.

2021 AALS Annual Meeting - Section on Business Associations Call for Papers

Call for Papers

AALS Section on Business Associations

New Voices in Business Law

January 5-9, 2021, AALS Annual Meeting

The AALS Section on Business Associations is pleased to announce a “New Voices in Business Law” program during the 2021 AALS Annual Meeting in San Francisco, California. This works-in-progress program will bring together junior and senior scholars in the field of business law for the purpose of providing junior scholars with feedback and guidance on their draft articles.

FORMAT:  Scholars whose papers are selected will provide a brief overview of their paper, and participants will then break into simultaneous roundtables dedicated to the individual papers.  Two senior scholars will provide commentary and lead the discussion about each paper.

SUBMISSION PROCEDURE:  Junior scholars who are interested in participating in the program should send a draft or summary of at least five pages to Professor Megan Shaner at [email protected] on or before Friday, August 21, 2020.  The cover email should state the junior scholar’s institution, tenure status, number of years in their current position, whether the paper has been accepted for publication, and, if not, when the scholar anticipates submitting the article to law reviews.  The subject line of the email should read: “Submission—Business Associations WIP Program.”

Junior scholars whose papers are selected for the program will need to submit a draft to the senior scholar commentators by December 16, 2020.

ELIGIBILITY:  Junior scholars at AALS member law schools are eligible to submit papers.  “Junior scholars” include untenured faculty who have been teaching full-time at a law school for ten or fewer years.  The Committee will give priority to papers that have not yet been accepted for publication or submitted to law reviews. 

Pursuant to AALS rules, faculty at fee-paid non-member law schools, foreign faculty, adjunct and visiting faculty (without a full-time position at an AALS member law school), graduate students, fellows, and non-law school faculty are not eligible to submit.  Please note that all presenters at the program are responsible for paying their own annual meeting registration fees and travel expenses.

A Holiday Weekend Potpourri

The World Bank and IMF recently released a joint note, COVID-19: The Regulatory and Supervisory Implications for the Banking Sector (here).  It’s a great resource for those focused on banking, offering “a set of high-level recommendations that can guide national regulatory and supervisory responses to the COVID-19 pandemic” and “an overview of measures taken across jurisdictions to date.”  Annex 1: Overview of Statements and Guidance Provided by Standard-Setting Bodies in Response to the COVID-19 Pandemic is a particularly helpful reference.  

Yesterday’s post by Ann Lipton about DoorDash and pizza arbitrage reminded me that food is a really fun, relatable topic for legal/classroom discussion, especially in a transactional or entrepreneurial law course.  In the current issue of Food & Wine, I enjoyed “From the Lawyer’s Desk,” a short blurb attached to the article, Positive Partnerships One reason why chefs are partnering with hotels to open restaurants? Risk reduction, in which hospitality lawyer, Jasmine Moy, discussed common chef-hotel partnership deals.  Unfortunately, I couldn’t find a link to this for readers, but I did see other legally oriented possibilities (for example, Don’t Open a Restaurant Until You Read This).   

Breath.  Both Joan Heminway and I have posted about the importance of paying attention to your breath (here).  Whether you’re blogging, barbecuing, biking, prepping a summer course or just chilling this weekend, you can’t go wrong in paying attention to your breath: The Healing Power of Proper Breathing.

I want to wish all BLPB readers a very happy, healthy Memorial Day weekend! 

Above all this Memorial Day weekend, I want to remember, honor, and thank all of the brave military men and women who died while serving our country. 

The Meaning of We, Part Deux

So, this blog post about DoorDash and pizza arbitrage has been making the internet rounds; you’ve probably already seen it, but if not, it’s well worth a read.  It highlights some of the irrationalities of the platform-food-delivery business – irrationalities that have resulted in losses despite the fact that the pandemic has caused business to boom.  UberEats and GrubHub are now considering a merger, and I suppose their lack of profit might be interpreted as the result of predatory pricing, which would raise antitrust concerns, but honestly it looks more like they are just having trouble making the business model work. 

So what struck me about the blog post was this:

You have insanely large pools of capital creating an incredibly inefficient money-losing business model. It's used to subsidize an untenable customer expectation. You leverage a broken workforce to minimize your genuine labor expenses. The companies unload their capital cannons on customer acquisition, while this week’s Uber-Grubhub news reminds us, the only viable endgame is a promise of monopoly concentration and increased prices. But is that even viable?  

Third-party delivery platforms, as they’ve been built, just seem like the wrong model, but instead of testing, failing, and evolving, they’ve been subsidized into market dominance. Maybe the right model is a wholly-owned supply chain like Domino’s. Maybe it’s some ghost kitchen / delivery platform hybrid. Maybe it’s just small networks of restaurants with out-of-the-box software. Whatever it is, we’ve been delayed in finding out thanks to this bizarrely bankrolled competition that sometimes feels like financial engineering worthy of my own pizza trading efforts.

The more I learn about food delivery platforms, as they exist today, I wonder if we’ve managed to watch an entire industry evolve artificially and incorrectly.

That’s pretty much the argument I made in my earlier post, The Meaning of We.  Loosening of the securities laws has, I think, resulted in a distorted and inefficient allocation of capital toward exploitative and ultimately unproductive businesses.  Now, it’s true – GrubHub and Uber are both publicly traded companies today – but they got their start due to piles of private investment, and that momentum has carried them through into the public markets.  From where I sit, the expanded ability of companies to raise capital privately has only facilitated particular kinds of biases and short-sightedness among a very small segment of the investor base, resulting in real, and damaging, effects in the broader economy.  Perhaps this is a problem that will resolve itself - with the implosion of SoftBank, perhaps private markets will simply get smarter - but I suspect that this is more a problem of the people who make decisions in private markets, and their biases and incentives.  Regulators are increasingly focusing their attention on investor sophistication with respect to individual transactions, and neglecting the broader macroeconomic purposes of the securities regulation regime.

Dead Investors Tell No Tales - Expunging Information After a Customer Passes

I've written about the expungement process stockbrokers now use to suppress public information before.   We know that brokers who receive expungements are statistically more likely to cause harm than the average broker--about 3.3 times as likely to cause harm.  We also know that customers usually don't get much notice before an expungement hearing will held.  We also know that brokers have used claims for nominal damages to cut costs and ensure that only a single arbitrator will hear the matter.

But I had not yet realized another problem with the system.  Brokers often succeed at expunging information after more than six years have passed.  Generally, a broker should not be able to secure an arbitration award recommending expungement after more than six years from the occurrence or event giving rise to the claim has passed.  I suppose some arbitrators might buy an argument that the presence of the information in the public record creates a type of continuing harm and that the claim continues to arise.  It's a bit like arguing that a scar from a twenty-year old injury means you should be able to sue about it because seeing the scar continues to harm you.  Of course, many brokerage firm defendants simply don't care whether a former broker secures an expungement or not and will not even raise the issue with an arbitrator.

Brokers are securing arbitration awards removing information dating back many many years, some involving complaining customer who have now passed away.  For example a broker recently secured an arbitration award (Docket Number 19-01639) recommending expungement for an incident dating back to the early 2000s.  Although the award does not provide substantial information, the arbitrator concluded that an unauthorized trading claim on his record was "not true" on account of the following evidence:

The evidence (including a receipt confirming the return of the relevant stock certificates to the Customer) showed that the alleged trading and sale of securities was authorized by the Customer. Claimant sent her a letter explaining the proposed sale of her securities which was reviewed by the NPC's Compliance Department prior to being sent. According to Claimant's testimony, a while after her complaint was filed, the Customer retained an attorney to determine if there was a basis for filing a legal action against Claimant. The attorney met with Claimant and informed Claimant that there was no basis for any legal action by the Customer.

Apparently, the broker testified that the complaining customer hired a lawyer.  And then the customer's lawyer met with the broker and told him that the customer had no basis for any claim against him.  This strikes me as odd that an attorney hired by someone else would advise the broker about the Customer's options.  

Of course, this doesn't mean that the complaining customer's claim was "false," it might just be that there were not any damages.  I don't know.  It all strikes me as very odd.  And you can't ask the complaining customer, she passed away.

If you review the broker's BrokerCheck report today, you will see that a customer alleged he engaged in "UNAUTHORIZED TRADING OF SECURITIES, REGARDING SALE OF SECURITIES. NO DAMAGE AMOUNT SPECIFIC."  You will also see his comment responding to the allegation: 

ON NOVEMBER 1, 2002, IN A MEETING WITH CLIENT AND HER BENEFICIARY, WE DISCUSSED RE-POSITIONING HER STOCK PORFOLIO TO GENERATE MORE INCOME. WE AGREED ON EVERYTHING. CLIENT SIGNED FORMS TO REPOSITION THE PROCEEDS. CLIENT ASKED THAT THE SALES OCCUR AFTER MONDAY. AFTER NOT HEARING ANYTHING TO THE CONTRARY, I SOLD THE STOCK LATE ON TUESDAY, NOVEMBER 5, 2002.

If the broker completes the next step in the process and secures a court order confirming this arbitration award, the information will be deleted from public records.  Ultimately, I don't know what happened--and the complaining customer has passed on so she can't tell you.  But if you had to trust your life's savings to stockbrokers, would you want to know about some of these past complaints so you could take it into account?  Do you want someone who will make absolutely sure you really want to execute a trade before doing it?

 

ICYMI: #corpgov Midweek Roundup (May 20, 2020)

If you have trouble viewing the embedded Tweets, please try a different browser (I recommend Internet Explorer).

It's been ten weeks since the WHO declared the coronavirus outbreak a pandemic, and the NBA cancelled games. As of this writing, the NY Post reports: Total cases globally = 4,897,492; Deaths = 323,285.

"In its 2018 report on comment letter trends, Ernst & Young (EY 2018) notes that 12 percent of comment letters reference a registrant’s disclosures associated with state sponsors of terrorism, making SST the seventh most common topic in 2018." #corpgov https://t.co/RaPD71q53P

— Stefan Padfield (@ProfPadfield) May 19, 2020

COVID-19 or the lockdowns? "COVID-19 had a marked impact on M&A in April, extending the decline observed in March across all measures. Globally, the number of deals decreased by 24.2%, to 2,036, and total deal value decreased by 44.3%, to $118.34 billion." #corpgov https://t.co/rtzxAJkn11

— Stefan Padfield (@ProfPadfield) May 19, 2020

If "labor markets & product markets are competitive, the shareholder primacy & stakeholder paradigms would lead to identical corporate policies. When these markets are not competitive" interventions should complement, not substitute for, long-term SH value maximization. #corpgov https://t.co/FdxkGWvuOv

— Stefan Padfield (@ProfPadfield) May 18, 2020

Some governors have treated religion "the way you might treat going to a movie"; "less essential than say, hardware stores." That is "impermissible." Religious worship is "one of the most highly protected of all constitutional rights." https://t.co/yaQLn2fI7Z #corpgov

— Stefan Padfield (@ProfPadfield) May 17, 2020

Can "entrepreneurship education and training ... bridge the gender gap in entrepreneurship"? Study finds "positive effects on ... long-term outcomes." https://t.co/nyJENMK0F5 #corpgov

— Stefan Padfield (@ProfPadfield) May 19, 2020

Teaching Moment: LLCs Don't Have "Corporate" Name Endings

I am teaching Business Associations this summer, and I am excited to get back in the classroom. Well, I was. Instead, I am teaching in virtual class room via Zoom.  I am still glad to be interacting with students in a teaching capacity, but I sure miss the classroom setting. I am glad, though, to have this experience so I am closer to what this has been like for our students and faculty.  I still have the benefit of my colleagues experiences, students who have been in the online learning environment, and a little time to plan, so it's better for me than it was for everyone in March. Still, there is quite a learning curve on all of this. 

Over the past several years, I have asked students to create a fictional limited liability company (LLC) for our first class.  It does a number of things. To begin, it connects them with a whole host of decisions businesses must make in choosing their entity form.  It also introduces them to the use of forms and how that works.  I always give them an old version of the form. This year, I used 2017 Articles of Organization for a West Virginia Limited Liability Company. It does a couple of things.  There is an updated form (2019), so it gives me a chance to talk about the dangers of using precedent forms and accepting what others provide you without checking for yourself.  (Side note: I used West Virginia even though I an in Nebraska, because Nebraska doesn't have a form. I use this one to compare and contrast.) 

In addition, I like my students to see how most businesses start with entity choice and formation -- by starting one.  It leads to some great conversations about limited liability, default rules, member/manager management choices, etc. Each year, I have had at least one person opt-in for personal liability, for example, for all members.

I also, which will shock no one, use the form to discuss the distinct nature of LLCs and how they are NOT corporations.  And yet, the West Virginia LLC form tries to under cut me at each turn.  For example, the form requires that the LLC name choose a "corporate name ending."  From the instructions: 

Enter the exact name of the company and be sure to include one of the required corporate name endings: “limited liability company,” “limited company,” or the abbreviations “L.L.C.,” “LLC,” “L.C.,” or “LC.” “Limited” may be abbreviated as “Ltd.” and “Company” may be abbreviated as “Co.” [WV Code §31B-1-105] Professional companies must use “professional limited liability company,” “professional L.L.C.,” “professional LLC,” “P.L.L.C.,” or “PLLC.” [WV Code §31B-13-1303] 

Seriously, people.  LLC are not corporate.  In fact, choosing a corporate name ending would be contrary to the statute.  

The form continues: 

13. a. The purpose(s) for which this limited liability company is formed is as follows (required): [Describe the type(s) of business activity which will be conducted, for example, “real estate,” “construction of residential and commercial buildings,” “commercial painting,” “professional practice of law" (see Section 2. for acceptable "professional" business activities). Purpose may conclude with words “…including the transaction of any or all lawful business for which corporations may be incorporated in West Virginia.”] (final emphasis added)

Finally, the instructions state that

[t]he principal office address need not be in WV, but is the principal place of business for the company. This is generally the address where all corporate documents (records) are maintained.(final emphasis added)

My students know from day one this matters to me, and it's not just semantics. My (over) zealousness helps underscore the importance of entity decisions, and the unique opportunities entities can provide, within the default rules and as modified. My first day, I always make sure students see this at least twice: "A thing you have to know. LLCs are not Corporations!" 

Is it overkill? Perhaps, we all have our things.

Oh, and it's time for West Virginia to add a 2020 update to the LLC form.  

National Business Law Scholars 2020 - Update; Virtual Workshop

This post updates my March 23 post on the 2020 National Business Law Scholars Conference.

After much deliberation, the planning committee for the National Business Law Scholars Conference has determined to cancel this year’s in-person event and instead host a virtual workshop on the original scheduled conference dates (June 18-19).  The workshop will consist of moderated paper panels featuring the work of those who submitted proposals for the 2020 conference and desire to participate. We also hope to host a discussion session focusing on online teaching and perhaps one or more feature programs on business law in the COVID-19 era.  

Each registrant for the 2020 conference who submitted an accepted proposal will receive a message in short order asking whether they want to participate in the virtual conference.  Relatively rapid responses to this query will be requested.  A workshop schedule, together with related logistics information will be constructed from those responses and circulated to participants.

As you may recall, the conference this year was scheduled to be held at The University of Tennessee College of Law.  We plan to hold the 2021 National Business Law Scholars Conference at UT Law in Knoxville next June.  We will determine the exact dates for next year's conference in the coming months.  

All of us on the planning committee (listed below) are grateful to all who registered for this year's conference for their patience as we considered options and made the determination to "go virtual."  We look forward to getting everyone together in person next year when we anticipate that conditions will be more safe and stable.  We know that health and safety are paramount for all.  We also know that business law scholars engage in productive discussions that push each other's work forward when we join forces.  We understand that electronic communication is no substitute for an in-person event, but we hope that our 2020 virtual forum responds adequately to both health and safety concerns and the desire to engage with and advance business law research and writing until we can next get together in the same physical place.

Afra Afsharipour (University of California, Davis, School of Law)
Tony Casey (The University of Chicago Law School)
Eric C. Chaffee (The University of Toledo College of Law)
Steven Davidoff Solomon (University of California, Berkeley School of Law)
Joan MacLeod Heminway (The University of Tennessee College of Law)
Kristin N. Johnson (Tulane University Law School)
Elizabeth Pollman (University of Pennsylvania Carey Law School)
Jeff Schwartz (University of Utah S.J. Quinney College of Law)
Megan Wischmeier Shaner (University of Oklahoma College of Law)

Advertisements and Retail Investing

It’s long been blackletter law that a Section 10(b) claim can be rooted in statements that are not targeted to the company’s investors, and are not specifically about the health of the company, so long as investors rely on them, or the speaker should have expected such reliance.  See, e.g., In re Carter-Wallace, Inc. Sec. Litig., 150 F.3d 153 (2d Cir. 1998); Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000).  As a result, even product advertisements and other consumer-facing material can form the basis of a securities fraud claim.  Notably, in the recent case of Roberts v. Zuora Inc. et al., 2020 WL 2042244 (N.D. Cal. Apr. 28, 2020), the plaintiffs based their 10(b) claims both on the company’s statements to investors and its general product advertisements, and the court – denying a motion to dismiss – drew no distinction between the two.

Which is why I thought Background Noise? TV Advertising Affects Real Time Investor Behavior by Jura Liaukonyte and Alminas Zaldokas was so interesting (you can read the paper at this SSRN link, and their summary at CLS Blue Sky Blog here).  In the paper, the authors find that after a television advertisement for a product airs, searches for the manufacturer’s SEC filings increase, as does trading volume in the manufacturer’s stock.  The findings validate the caselaw; it seems retail investors, at least, regularly consider product advertisements when deciding what stocks to buy.

 The broader issue, though, arises when we’re not talking about an individual fraud claim, where a particular investor can attest that he or she relied on some specific piece of information, but a fraud on the market action, when the Carter-Wallace principle translates to the rule that just about any statement made by the defendant in any context to any audience may trigger securities fraud liability, so long as it was, in some sense, “public.”  The plaintiffs generally do not prove that investors really did rely on the misstatements; rather, it becomes the defendants’ burden to prove the opposite (which may be, literally, impossible to do).  As a result, when the statements are far removed from investment context, courts may grope for a limiting principle, and arrive at doctrinally inconsistent results to get there. 

That’s always how I’ve always understood the result in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), anyway.  There, mutual fund prospectuses contained false information about fund policies, but the plaintiffs brought their claims not on behalf of fund investors, but on behalf of investors in the publicly-traded fund sponsor, who – it was claimed – misled its own investors about how it administered its funds.  Based on my experience as a plaintiffs’ attorney, I am quite confident that the reason the plaintiffs relied on mutual fund prospectuses to make an argument about the fund sponsor was that they looked, as hard as they could, for false statements made directly by the fund sponsor itself, and were unable to find any.  So they were forced to make the argument that buyers of the sponsor’s stock made their investment decisions based on the policies identified in the fund prospectuses.  And because that argument seems like a stretch but difficult to challenge factually, the Supreme Court took the easier route and simply said the fund sponsor was not responsible for the prospectuses.  Would the Court have reached the same result if investors in the funds had brought the same claim?  I suspect not – which is likely why the Court backtracked in Lorenzo v. SEC, 138 S.Ct. 2650 (2018).

Anyhoo, for those interested in more discussion along these lines, see Donald Langevoort’s papers Reading Stoneridge Carefully: A Duty-Based Approach to Reliance and Third Party Liability under Rule 10b-5 and Lies without Liars? Janus Capital and Conservative Securities Jurisprudence. 

Bar Exams in a Pandemic Plus "Limited Liability Corporations" on the Nevada Bar

States are struggling to figure out the right approach to administering bar exams in the middle of a pandemic.  Nevada has proposed moving to an online bar exam over the summer.  You can find the Nevada proposal and my comment letter here.  There are thoughtful comments from law professors including Claudia Angelos (NYU), Judith Wegner (UNC & Carnegie Report), Debby Merritt (OSU), Andi Curcio (GSU), Carol Chomsky (MN), Sara Berman (now AccessLex), and Eileen Kaufman (Touro), Steven Silva (TMCC), and Lori Johnson (UNLV).  Hopefully we can find a way to administer a fair exam without putting anyone at undue risk.

But I wanted to flag another issue about the Nevada bar exam, one near and dear to Joshua Fershee's heart.  Nevada's official subject matter outline for the Nevada bar calls for exam takers to know about "Limited Liability Corporations."  It's listed as a subheading within "Corporations." I checked the Nevada corporation code, and no such entity exists.  The closest we get is Chapter 86 for limited liability companies.  As Fershee has explained again and again and again and again and again, limited liability companies are not corporations.  There is not real difference between saying "corporation" and "limited liability corporation. It’s a very, very common mistake.

Some Nevada lawyers have taken Nevada's relatively high failure rate as indicating that Nevada's bar exam is one of the most "rigorous." There are, of course, other possibilities to explain a higher failure rate.    

Academy of Legal Studies in Business (ALSB) Virtual Conference - Call for Participation

Details for the ALSB Annual Conference are here. 

The organization is primarily geared toward law faculty who teach in business schools, but we have presenters from practice and law school faculties from time to time as well.

The call for participation deadline is June 1, 2020.  And the virtual conference will be held August 2-7, 2020.

"Dear Mr. Fink": Stakeholder Governance Prioritizes Soothing "the political consciences of asset managers" Over Protecting Retirement Accounts

As reported here,

Thirty-one fellow CEOs wrote May 1 to BlackRock CEO Laurence Fink to argue that a publicly traded company is responsible to investors and shouldn’t engage in politics in the midst of an economic crisis.

What follows are some excerpts from the letter, which can be found in full here.

The word “stakeholder,” when used in this context, is intentionally nebulous. It can mean whatever the user chooses it to mean. And therefore, it means nothing....

any honest assessment of the successful “shareholder” model MUST acknowledge that it is inarguably stakeholder friendly as well. The distinction between the two models is purely cosmetic, an artificial construct purposefully fashioned to sow confusion and to permit its architects to pursue their own ends rather than those of American business.

In most cases, these ends are political. By adopting an explicitly “stakeholder”-centered model, activists are attempting to subvert the great American process of self-government, substituting their own views and beliefs for those of the people. By drawing a false distinction between shareholders and stakeholders, asset managers like BlackRock, CalPERS, and countless others intend to “target” corporations whose business models don’t meet their personal definitions of acceptable behavior. Whether done to intimidate corporations into toeing the vacuous and amorphous “sustainability” line, or to force “unacceptable” corporations out of business, the net effect is the same, namely the creation of an overtly ideological and extra-legal regulatory regime....

asset managers who capitalize on Americans’ inherent goodness and decency to push their own values under the headings of “sustainability” and “stakeholders,” are playing politics with OTHER PEOPLE’S MONEY. An asset or wealth manager’s primary fiduciary responsibility is to his CLIENTS… to manage the CLIENTS’ assets faithfully and in keeping with the CLIENTS’ needs, values, and risk tolerance. Substituting one’s own political predilections for the obligations owed to the clients is among the most offensive and irresponsible actions a manager can take. This is all the more the case when the manager is not chosen by the individual investor but dictated by law, as is the case with government employee retirement and pension plans.

Particularly now, in the age of COVID-19, the related economic collapse, and exponentially expanding state budget deficits, it is absolutely imperative that state and public employee pension funds – most of which were woefully underfunded BEFORE the collapse, during the longest bull market in history – NOT be used to soothe the political consciences of asset managers hired by the state or the government officials responsible for assigning those contracts. These are benefits that have been promised to workers and HAVE ALREADY BEEN EARNED. To risk them in pursuit of political trends and fads is the height of irresponsibility.

Corporate Governance in the COVID-19 Era

Maybe I am just sensitized to these media reports because of my research and teaching, but it seems that the COVID-19 pandemic has sparked new media interest in and engagement with corporate governance issues.  I have received four media calls in the past few weeks--two on background and two for source quotations.  That is an unusual rate of contact for me. Is anyone else noticing this?

Of course, there has been a lot to talk about.  Annual meetings already called and noticed to shareholders needed to move online.  As managers and employees moved out of workplaces to shelter at home, well-worn systems of decision-making and information dissemination--as well as the expectations of others in connection with them--changed or were challenged.  Filing and other deadlines became guidelines . . . .

The two media calls in which I was asked to provide background information related to

• increased or altered director and legal counsel attentiveness to drafting force majeure clauses and material adverse change/effect definitions in light of what we now know about COVID-19 and its effects and
• prospects for various kinds of shareholder derivative, direct, and class action litigation in light of COVID-19 and related board decision making.  

I was glad to be able to help the two journalists who called on these issues.  They had great questions; made me think.

The two articles in which I was quoted are both (regrettably) secured behind firewalls.  But if any of you are subscribers to Agenda, you will have access to them both.  I have linked to each below.  Both were written by Jennifer Williams-Alvarez.

The first piece, an April 22nd article entitled "Boards Adopt Emergency Bylaws for Critical Flexibility," put a spotlight on the potential utility of emergency bylaws in light of the pandemic.  I admitted that I now am more sensitive and sympathetic to emergency bylaws than I used to be.

Decades ago, Heminway says she would not have necessarily recommended that companies include an emergency bylaw provision when drafting corporate governance documents. But with the financial crisis, the attacks on the United States on Sept. 11, 2001, and the current Covid-19 crisis, she says she would now make the suggestion.

I wonder how many of you who have been in practice for "more than a minute" feel the same way.

The second article, "DPA Forces New Unknowns for Boards to ‘Triage’," posted on April 27, offered insights on the Defense Production Act, the subject of multiple executive memoranda and orders relying to product manufacturing and distribution over the past month.  This article picked up on a topic I wrote about here early last month.  Since Agenda focuses on issues of importance to corporate directors and those who work with them, the article explored various angles of interest in the Defense Production Act relating to corporate boards.  For example, we got into an extended conversation about public company reporting obligations and related information gathering and management.

Board members should think about disclosure responsibilities, says Heminway. For certain companies, such as manufacturers, an assessment must be made about whether it represents a material risk to repurpose operations or reprioritize contracts so that the government is at the front of the line, she says.

Between the two of us, we were able to find a few examples of COVID-19 Defense Production Act disclosures made in public filings with the U.S. Securities and Exchange Commission.  Our coverage of applicable mandatory disclosure obligations led to a brief conversation about how boards of directors gather information.

“What I worry about is the board exercising its fiduciary duties in this context,” Heminway says, referring to reporting responsibilities. “The main issues here are going to be duty of care issues,” a requirement that directors fully inform themselves of all material information, she notes.

“The amount of information available now is overwhelming, and it’s changing every day. The Defense Production Act is a piece of that,” says Heminway. “It’s part of what they need to be informed about.

The article covers a lot of ground overall and quotes from a number of sources, including former and current government employees.

I admit that I have been impressed by the level of interest and engagement of the journalists with whom I have been speaking.  What they and others like them are producing and publishing fueled my teaching during March and April (I assigned a number of articles to my students relating to COVID-19 and corporate governance) and is likely to continue to catalyze blog posts and, potentially, research projects as time goes on.  It is good to know that corporate governance questions are motivating useful media inquiries and publications during the COVID-19 crisis.  It also is nice to know that we law professors may be able to use our knowledge to help inform important constituencies during the pendency of the pandemic while, at the same time, expanding our own horizons.  A true win-win. 

New FSB Consultative Document on Clearinghouses (CCPs)

Last Monday, the Financial Stability Board (FSB) released the consultative document, Guidance on financial resources to support CCP resolution and on the treatment of CCP equity in resolution (here).  As readers know, I’ve written several times about clearinghouses, the central feature of the G20’s reforms to the over-the-counter derivative markets following the 2007-08 crises, implemented in the US in Dodd-Frank’s Title VII (for example, here and here).    

The Guidance’s title is a succinct encapsulation of its two-part focus.  In the first part, it uses a five-step process to evaluate the adequacy of a CPP’s resources and available tools to support its resolution (were that to prove necessary).  These steps include:

Step 1: identifying hypothetical default and non-default loss scenarios (and a combination of them) that may lead to resolution;

Step 2: conducting a qualitative and quantitative evaluation of existing resources and tools available in resolution;

Step 3: assessing potential resolution costs;

Step 4: comparing existing resources and tools to resolution costs and identifying any gaps; and

Step 5: evaluating the availability, costs and benefits of potential means of addressing any identified gaps.     

In the second part, the Guidance focuses on how to treat CCP equity in resolution.  A resolution of a CCP would be distinct from a “wind down” of the CCP.  Readers might ask why one would have to think about such a thing – equity will likely get wiped out, right?  Not necessarily.  Today, most CCPs are shareholder-owned, but the CCP users/customers (clearing members) are mostly on the hook for any losses resulting from a user’s default.  As I’ve written about in Incomplete Clearinghouse Mandates (here), this creates a foundational incentive problem because the shareholders benefit from the CCP’s profits, but the users are primarily responsible for any default losses. 

As the Guidance notes, in theory, CCPs could experience losses due to user defaults, non-default issues, or a combination of both.  How CCPs owned by shareholders will allocate losses between themselves and users in a “combination” scenario is completely unclear (allocation of non-default losses is also unclear in many cases) and should be addressed as I’ve noted before (here).  Should the combination scenario arise, I think loss allocation will prove to be an intractable problem. 

In reading the second part of the Guidance, one realizes how complicated and legally fraught the question of CCP equity could be in a resolution given the status quo.  Towards the end of the second part, the Guidance states that:

Based on the analysis undertaken in accordance with the previous sections, the relevant home authorities should address the challenges relating to CCP equity fully bearing losses in resolution. This may include, where possible, that home authorities having the relevant powers and authority require that CCPs modify their capital structures, rules or other governance documents in a manner that subordinates shareholders to other creditors or sets out the point at which equity absorbs losses in legally enforceable terms. This may also include identifying or proposing potential changes to laws, regulations or powers of the relevant supervisory, oversight or resolution authorities that would enable achieving the resolution objectives or limit the potential for NCWOL claims.

In the short term, the last sentence of this quote likely offers a more feasible approach to handling CCP equity than what I think would be a more sensible approach: addressing the ownership structure of these institutions.  This would almost certainly be much more difficult to implement in practice, but it’s ultimately a simpler, more sensible long-term solution for addressing CCP equity in resolution and for addressing loss allocation under a combination scenario.  Until we fix this foundational issue of ownership, we shouldn’t be surprised if the path of a distressed, systemically significant clearinghouse ultimately resembles that of the government‐backed mortgage lenders whose fate more than 11.5 years after entering government conservatorship still remains uncertain. Let’s not repeat this history!   

Who's a Controlling Stockholder: A New Twist

I’ve blogged a lot about the complexities of Delaware’s controlling-stockholder jurisprudence (here, here, here, here, here, and here), and written an essay on the subject.  The latest Chancery opinion on this issue, Gilbert v. Perlman, represents another, unusual, addition to the genre.

In Gilbert, Francisco Partners was the controlling stockholder of Connecture with a 56% stake.  During its tenure, however, it worked closely with Chrysalis Ventures, a firm that it had coordinated with in prior ventures, and who was the next largest Connecture blockholder with an 11% interest.  A Chrysalis partner, Jones, also served as Connecture’s Chair.  Eventually, Francisco proposed to buy out the minority Connecture shareholders in a deal that was neither conditioned on the approval of an independent director committee nor a majority of the minority shareholder vote. 

According to the proxy statement, the Connecture board, in the course of its internal deliberations, considered it important that Chrysalis support any proposed transaction.  Chrysalis suggested that it be permitted to roll over its shares in the new entity, which would, it believed, allow Francisco to bump up the price for the remaining minority shareholders.  A few days later, Jones asked for the same participation rights personally.  A deal on these terms was struck.  The unaffiliated shareholders, however, were unimpressed by the arrangement, voting only 9.9% in favor of the deal.  But their votes were unnecessary and the merger closed.

Two minority shareholders of Connecture filed suit alleging that Francisco, as controller, breached its fiduciary obligations.  Because Francisco had negotiated the deal with essentially no procedural protections for the minority, it was plain this was a transaction that would receive entire fairness review, and Francisco did not even bother moving to dismiss; instead, it simply answered the complaint.  The more complex allegations concerned Chrysalis and Jones: plaintiffs alleged that they had formed a control group with Francisco and thereby shared its fiduciary obligations, and it was that question that Vice Chancellor Glasscock addressed on Chrysalis’s and Jones’s 12(b)(6) motion.

First, Glasscock articulated the basic landscape.  As he put it:

Under Delaware law, “controlling stockholders are fiduciaries of their corporations’ minority stockholders.” That is, where a stockholder may control the corporate machinery to benefit itself, as by exercising voting control, it is a potential fiduciary. Where in fact it exerts such control, a controlling stockholder is bound by Delaware’s common law fiduciary duties of loyalty and care.  Conversely, stockholders who control only their own shares, and cannot exert corporate control, are owed fiduciary duties; they themselves are not obligated to act in the corporate interest….

It is also possible under Delaware law for several minority stockholders to band together to form a “control group.” In this situation, though none are individually controllers, because they act in consort to exercise collective control, the stockholders in the group owe fiduciary duties. To demonstrate the existence of a control group, it is insufficient to identify a group of stockholders that merely shares parallel interests. To form a control group, the stockholders must be “connected in some legally significant way—e.g., by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” By pooling resources in a plan by which they control the corporation, they become fiduciaries.

So, what if we have a controller who joins with minority shareholders?  Do those minority shareholders inherit the same fiduciary obligations of a controller merely by virtue of their agreement, or is more required?  Per Glasscock, we need more:

To create a control group, a controller must go beyond merely permitting participation by other stockholders in the transaction. Instead, the minority-holder’s participation must be material to the controller’s scheme to exercise control of the entity, leading to the controller ceding some of its control power to the minority-holders. In this way, the minority stockholders involved wield their own levers of power as part of the group; this control of the corporate machinery makes them fiduciaries. … [O]nly if the controlling stockholder shares or materially limits its own control power through an arrangement (such as a voting agreement) could a control group potentially be found….

In my view, where a controlling stockholder takes an action joined by minority stockholders, the latter can be deemed members of a control group, and thus fiduciaries, where two conditions exist. There must be an arrangement between the controller and the minority stockholders to act in consort to accomplish the corporate action, and the controller must perceive a need to include the minority holders to accomplish the goal, so that it has ceded some material attribute of its control to achieve their assistance. In order to survive a motion to dismiss, a plaintiff advancing this unusual theory must plead facts that permit a reasonable inference that these conditions exist.

Alas for the plaintiffs, they were unable to make such a showing.  They definitely demonstrated the existence of an arrangement to act in concert – indeed, the parties disclosed in the proxy statement that they had entered into a voting agreement – and Chrysalis and Jones even received a nonratable benefit, namely, the right to rollover their stock.  But the plaintiffs did not show that Francisco needed them in any way, or ceded its power, such that they shared fiduciary obligations with Francisco.  As Glasscock put it:

if the Plaintiffs could have pled that Francisco Partners needed something material in way of its take-private scheme, and was accordingly willing to give up some material part of its control attributes to Chrysalis and Jones to get it, they may have adequately made the allegation that a control group existed here. The Complaint, however, points to neither quid nor quo—it describes nothing Francisco Partners needed or ceded to the Moving Defendants, other than the bare right to roll over shares.

The logic has a certain surface-level appeal.  With great power comes great responsibility, and absent power, the responsibility does not follow.  Therefore, gratuitous receipt of a controller’s largesse is not sufficient for the beneficiary to take on the controller’s responsibilities.

But beneath that simple maxim lies a raft of complexity. 

First, as a practical matter, we may have trouble identifying which test applies.  Recall, the rule is, in order to show that shareholders were working together – such that minority blockholders become controllers in the first instance – plaintiffs only need show the existence of an agreement.  The enhanced test, requiring that the controller actually engage in a quid pro quo with someone else, only comes into play once the existence of a controlling shareholder is established.  So imagine you have a large minority blockholder working with another, smaller blockholder.  If the larger minority blockholder is incapable of exercising control on its own, the two together will owe fiduciary obligations if they reach an agreement; if, however, the larger blockholder does exercise control on its own, an agreement is not sufficient; the plaintiff will need to show that some of that power was ceded to the smaller in order to bring a claim against the two together.  Given the inherent uncertainty associated with determining whether a minority blockholder exerts control in the first instance (see, ahem, my essay), you can already imagine the bizarre and conflicting set of incentives under which both plaintiffs and defendants will labor in order to make their cases at different stages of litigation.

Or, imagine you have three minority shareholders, any two of which are sufficient to control the entity.  If the three shareholders combine, is only the third subject to the enhanced test?  What if it’s not clear which are the “two” and which is the “third” – especially if the original two are alleged to have control from a minority (under 50%) position?

Maybe this is an angels-on-pinheads concern – after all, this scenario doesn’t come up much in general, and it probably doesn’t come up much with triad combinations – but we might further delve into what counts as a “benefit” to the controller that justifies a finding of a quid pro quo. 

Here, there was not simply an agreement to act in concert: the minority shareholders received a unique benefit in the transaction, namely, Chrysalis and Jones were given the opportunity to roll over their shares, which was significant for a merger that, by hypothesis, undervalued the minority stake. (The fact that Jones immediately jumped on the deal personally is further evidence that this opportunity had real value, to the detriment of the minority shareholders being squeezed out).

But that was not enough for Glasscock: He required that Francisco have received something of value in exchange.  What possibilities exist?

Here are some ideas.  Apparently, because it was buying fewer minority shares, Francisco was willing to pay more for them (though the financial logic of that is not clear) – which would place it in a stronger legal position both in the (inevitable) fiduciary lawsuit or in an appraisal action.  Plus, by maintaining good relations with Chrysalis, it avoided a lawsuit by Chrysalis itself - a significant threat, given that Jones was Chair of the Board and presumably knew where all the Francisco bodies were buried. 

Also, Connecture was an unusual controlled company in that, as far as I can tell, Francisco had only put 2 nominees on a 7 member board (though plaintiffs alleged it had close ties to the remaining members).  Chrysalis, of course, had the Chair.  If Francisco wanted to force a merger through over board/Chrysalis objections, it would have had to go through the process of replacing the existing board members, including Jones.  Could it have done so?  Surely, but it would have taken time and placed it in an even more precarious legal position later.  This is especially so given that, under federal law, Connecture was required to discuss the fairness of the proposed transaction in its proxy statement.  Imagine the difficulty of doing so if the Chair of the board did not agree, or had been forced out in some kind of prolonged dispute.

The point is, even a cursory review of the facts reveals how Francisco benefitted by keeping matters amicable with Chrysalis.  All of these possibilities suggest Chrysalis therefore had some control over the deal’s final shape; after all, the proxy statement itself stated that Chrysalis proposed higher minority shareholder consideration in exchange for its own participation.

So why aren’t these facts enough to meet Glasscock’s test?

One possibility is that this is simply a pleading matter.  If plaintiffs had framed the case with these benefits made explicit, perhaps they’d have survived a motion to dismiss, with further factual development to come after discovery. 

But if that’s the case, we might ask why this kind of pleading and proof are even necessary.  If a controller grants a boon to a minority shareholder as part of a conflict transaction, why can’t we assume the controller is getting some kind of “soft” benefit in exchange?  Why else would it ever agree to such an arrangement?  Why can’t we view the specter of this kind of quid pro quo as sufficiently omnipresent to forego the necessity of proof?  After all, we do that with controlling shareholder transactions generally; we assume that they are coercive to the minority even absent specific evidence that minority shareholders actually were coerced.  We could similarly assume that if a controller confers a valuable benefit on a specific minority shareholder in connection with an self-interested deal, it’s not acting out of graciousness.

So the alternative possibility is that these soft benefits – which facilitated the transaction but were not, perhaps, legally necessary to complete it – were not, in Glasscock’s view, significant enough to rate.  But if not, why not?  Does Glasscock require actual proof of the control ceded by the controller (beyond, apparently, Chrysalis’s actual involvement in setting the price for the minority shares)?  Or does Glasscock require different benefits to the controller?  What would those benefits be?

I guess my thinking is, the whole reason we subject controlling shareholder transactions to heightened scrutiny is because we cannot trust the ordinary market mechanisms for disciplining predatory behavior.  But that doesn’t mean controlling shareholders wield unconstrained power; as with anything else, their paths can be made rougher or smoother, and a smooth path may have value to the controller.  As a result, even minority blockholders may wield influence.  They can use that influence to ally themselves with the remaining minority, and thus make transactions more fair, or to ally themselves with controllers, in order to receive private benefits.  To the extent Delaware law is designed to encourage “good” behavior that minimizes the need for judicial intervention, shouldn’t the rules in this area incentivize those blockholders to either maintain an alignment of interests with the minority shareholders, or bear legal responsibility for them?

Glasscock’s framing of the inquiry suggests some skepticism toward the notion that a controller would ever cede power to a minority blockholder, so that a plaintiff must allege an unusually explicit arrangement before the scenario will be contemplated.  But, as I’ve repeatedly discussed in this space, control is not a simple on/off switch.  Even a 56% stockholder may encounter obstacles in a take-private deal despite its legal ability to force it through. Delaware’s repeated insistence on viewing control through a black/white lens glosses over the practical realities of how control is often exercised, putting its doctrine at odds with the underlying reality.