Saturday, April 10, 2021
The Eastern District of Pennsylvania recently issued a lengthy opinion, largely refusing to dismiss a Section 10(b) complaint alleging that Energy Transfer LP made a series of misstatements about certain pipelines that were under construction. See Allegheny County Employees’ Ret. Sys. v. Energy Transfer LP, 2021 WL 1264027 (E.D. Pa. Apr. 6, 2021). There’s probably a lot worth examining here but I’m actually just going to use it as a jumping off point to talk about the PSLRA safe harbor.
The safe harbor insulates forward-looking statements from private securities fraud liability if:
(A) the forward-looking statement is—
(i) identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement; or…
(B) the plaintiff fails to prove that the forward-looking statement--
(i) if made by a natural person, was made with actual knowledge by that person that the statement was false or misleading; …
(2) Oral forward-looking statements
In the case of an oral forward-looking statement …the requirement set forth in paragraph (1)(A) shall be deemed to be satisfied--
(A) if the oral forward-looking statement is accompanied by a cautionary statement—
…(ii) that the actual results might differ materially from those projected in the forward-looking statement; and
(i) the oral forward-looking statement is accompanied by an oral statement that additional information concerning factors that could cause actual results to materially differ from those in the forward-looking statement is contained in a readily available written document, or portion thereof;
(ii) the accompanying oral statement referred to in clause (i) identifies the document, or portion thereof, that contains the additional information about those factors relating to the forward-looking statement; and
(iii) the information contained in that written document is a cautionary statement that satisfies the standard established in paragraph (1)(A).
15 U.S.C 78u-5.
There are certain preconditions, then, for safe harbor protection based on cautionary language: first, that the statements be identified as forward-looking explicitly, and second, that the cautionary language be included in a written document, or incorporated by reference if made orally.
In Energy Transfer, the court concluded that while some of defendants’ forward-looking statements qualified for safe harbor protection based on cautionary language, some did not meet the preconditions, see 2021 WL 1264027, at *5, *9, and went on to conclude that the plaintiffs had adequately alleged claims based on some of the unprotected ones.
The reason this intrigues me is that, as far as I know, courts have been rather free with allowing defendants to claim the protection of the safe harbor even if they fail to meet the preconditions (for example, if they fail to incorporate the warnings by reference in an oral statement, or try to incorporate by reference for a written one), so long as the cautionary language appears somewhere in a public document. The Seventh Circuit laid out the rationale in Asher v. Baxter Int’l, 377 F.3d 727 (7th Cir. 2004). (Disclosure: I was one of the attorneys representing the plaintiffs in Asher v. Baxter). In that case, the Seventh Circuit said:
When speaking with analysts Baxter’s executives did not provide them with …directions to look in the 10–K report for the full cautionary statement. It follows, plaintiffs maintain, that this suit must proceed with respect to the press releases and oral statements even if the cautionary language filed with the SEC in registration statements and other documents meets the statutory standard.
…[T]his is not a traditional securities claim. It is a fraud-on-the-market claim. None of the plaintiffs asserts that he read any of Baxter's press releases or listened to an executive's oral statement. Instead the theory is that other people (professional traders, mutual fund managers, securities analysts) did the reading, and that they made trades or recommendations that influenced the price. In an efficient capital market, all information known to the public affects the price and thus affects every investor. …
When markets are informationally efficient, it is impossible to segment information as plaintiffs propose. They ask us to say that they received (through the price) the false oral statements but not the cautionary disclosures. That can’t be; only if the market is inefficient is partial transmission likely, and if the market for Baxter's stock is inefficient then this suit collapses because a fraud-on-the-market claim won't fly.
The problem with that logic, though, is that PSLRA safe harbor protection is not predicated on the idea that cautionary statements will impact prices in the same way as the initial false statement and thereby nullify the effects of the lie. True, the common law bespeaks caution doctrine insulates all forward looking statements if cautionary language renders them immaterial, Harden v. Raffensperger, Hughes & Co., 65 F.3d 1392 (7th Cir. 1995), but the PSLRA standards are more forgiving. Defendants need only identify “important factors that could cause actual results to differ materially from those in the forward-looking statement,” 15 U.S.C. § 78u-5(c)(1)(A)(i), and “[f]ailure to include the particular factor that ultimately causes the forward-looking statement not to come true will not mean that the statement is not protected by the safe harbor.” H.R. Conf. Rep. No. 104-369, at 44 (1995).
Under the PSLRA, then, courts rarely, if ever, test whether the cautionary language was sufficient to offset the misleading effects of the projection. This is precisely why some courts have described the safe harbor as a “license to defraud,” In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187 (1st Cir. 2005) – because even if the cautionary language is insufficient to nullify the effects of the false statement – so that, by hypothesis, markets were actually misled by the projection – defendants may still be protected.
Given that, the Seventh Circuit’s invocation of the fraud-on-the-market doctrine seems inapposite, because the cautionary language that suffices to trigger safe harbor protection isn’t really about ensuring that prices fully incorporate the risks associated with false projections, or at least, that’s not its primary function. Plus, Congress enacted the PSLRA in response to what it perceived as abusive class actions - if it wanted to distinguish between the preconditions for fraud-on-the-market actions and other actions, it certainly could have done so.
If all that’s right, then what does the safe harbor do?
Well, I’m not a fan of the safe harbor but if I am going to justify it, I’d say the formalities associated with the safe harbor could prompt mindfulness on the part of corporate actors. They have extra protection for projections – so they’ll be more inclined to make them – but they also know they can’t simply speak off-the-cuff; they must take care to include the warnings. That enforced thoughtfulness may itself serve as some kind of protection against statements that aren’t rooted in reality, and it’s why the Seventh Circuit, in my view, was wrong to ditch the formalities. Also, if defendants were truly held to the requirement that they identify which exact statements they believed to be forward-looking as a precondition of claiming protection via cautionary language, I think that would spare everyone a lot of litigation and force corporate speakers to be clearer about their claims.
Anyway, in related news, Acting Corp Fin Director John Coates recently delivered a speech on the safe harbor and SPACs. Going public via SPAC, rather than traditional IPO, is all the rage right now, apparently at least in part because while traditional IPOs are excluded from safe harbor protection entirely, the de-SPAC merger is not. Specifically, the safe harbor says:
this section shall not apply to a forward-looking statement… that is… made in connection with an initial public offering...
15 U.S.C. 78u-5(b)(2)(D).
That regulatory distinction has led to some companies to offer wildly optimistic projections about SPAC acquisitions, a lot of which do not, ahem, come true.
Coates’s speech was notable in that he not only objected to the differential regulatory treatment on policy grounds – as he explained, companies going public for the first time pose particular risks to investors no matter what method they use to do so – but he also suggested that, read broadly, the existing safe harbor exclusion for initial public offerings might also be read to exclude de-SPAC transactions. Full quote:
[T]he PSLRA’s exclusion for “initial public offering” does not refer to any definition of “initial public offering.” No definition can be found in the PSLRA, nor (for purposes of the PSLRA) in any SEC rule. I am unaware of any relevant case law on the application of the “IPO” exclusion. The legislative history includes statements that the safe harbor was meant for “seasoned issuers” with an “established track-record.”…
The economic essence of an initial public offering is the introduction of a new company to the public. It is the first time that public investors see the business and financial information about a company….
If these facts about economic and information substance drive our understanding of what an “IPO” is, they point toward a conclusion that the PSLRA safe harbor should not be available for any unknown private company introducing itself to the public markets. Such a conclusion should hold regardless of what structure or method it used to do so. The reason is simple: the public knows nothing about this private company. Appropriate liability should attach to whatever claims it is making, or others are making on its behalf...
[A]ll involved in promoting, advising, processing, and investing in SPACs should understand the limits on any alleged liability difference between SPACs and conventional IPOs. Simply put, any such asserted difference seems uncertain at best.
It should be noted that Commissioner Hester Peirce tweeted her (tentative) disagreement with his reading of the statute, but if he’s right, it would mean that all these companies who thought their cautionary language insulated them from liability … were, you know, wrong.
Saturday, April 3, 2021
When Goldman Sachs petitioned the Supreme Court to grant certiorari from the Second Circuit’s affirmance of a class certification grant, it described the case as having “enormous legal and practical importance,” and later reiterated that it would be “hard to overstate the legal and practical importance of this case.”
By the time we got to oral argument, though … not so much.
I blogged about Goldman Sachs v. Arkansas Teacher Retirement System when it was before the Second Circuit (see here and here), but I only minimally discussed the Supreme Court iteration, in part because I couldn’t figure out what the legal issue was, other than that Goldman thought Amgen Inc. v. Connecticut Ret. Plans & Tr. Funds, 568 U.S. 455 (2013) was wrongly decided.
Well, that was my mistake, because it’s clear now that in fact, Goldman does not think that Amgen was wrongly decided, and the legal issue is that it doesn’t like the fact that it lost in the Second Circuit Court of Appeals.
That was evident in the briefing, in which it invited the Supreme Court to review the expert evidence submitted to the district court and reweigh it in its favor. (Seriously. Check out the Reply Brief at 8-9, 19-21)
Goldman does have a whole separate argument about Federal Rule of Evidence 301 and who has the burden of production/persuasion when it comes to the issue of reliance at class certification. This idea was first proposed, as far as I can tell, in an article by Wendy Couture, but was rejected by the Second Circuit in Waggoner v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017). I won’t weigh in on that piece except to say that most Justices – with Alito and Gorsuch as exceptions – did not seem interested, but then, it’s hard to say with remote arguments because there isn’t room for the kind of back and forth you get with in-person presentations. So it’s possible the Rule 301 argument here is a wild card, but I don’t know anything about it and will therefore skip it.
So, all that aside, what’s going on here?
The plaintiffs alleged that Goldman falsely claimed to adhere to high ethical standards when managing its conflicts of interest, and that these statements were revealed to be false when various governmental entities filed enforcement actions. Goldman argued that its statements were immaterial as a matter of law, and when it lost on that argument, it argued at class certification that these statements were too generic to have had any impact on the price of its securities. The district court found that Goldman had not rebutted the presumption of price impact and certified the class. Goldman appealed to the Second Circuit, where it argued that the “generic” nature of the statements defeated class certification as a matter of law in any case where the plaintiffs argued that the false statements maintained stock prices rather than initially inflating them. The Second Circuit, by a 2-1 vote, rejected that claim as inconsistent with Amgen.
Before the Supreme Court, Goldman’s argument underwent a makeover. As you can see from the transcript, it abandoned any claim that, at the class certification stage, courts should determine whether statements are too generic to impact price as a matter of law, whether in the price maintenance context or anywhere else. Instead, it argued that “genericness” is a relevant fact to be considered at class certification in service of the price impact inquiry, along with any other evidence on the subject. Goldman’s claim was not that courts should revisit the question of materiality at class cert – which tests what a hypothetical reasonable investor would have thought about the statements – but that in weighing whether the statements actually had an effect on prices, it is legitimate for courts to consider the generic nature of the statements at issue. And it further argued that the Second Circuit erred by rejecting the notion that genericness can ever be considered as relevant to the price impact inquiry.
In other words, Goldman drew a distinction between materiality, which concerns whether there is a “substantial likelihood” that a “reasonable investor” would have traded on the information, and price impact, which concerns whether there actually was an effect on stock prices. See Petitioners’ Brief at 32. All relevant facts, said Goldman, should be part of the impact inquiry, and genericness is a relevant fact even if it is also relevant to materiality.
At this point, the plaintiffs agreed with Goldman that genericness is a relevant fact to be considered by courts as part of the price impact inquiry, subject to appropriate expert evaluation. And, the plaintiffs pointed out, Goldman actually submitted evidence in this case to the district court that the genericness of the statements meant that there was no price impact – there was a whole expert report on the subject. But the district court certified the class despite that report. See Resp. Brief at 11-12.
Which meant, the disagreement between the parties boiled down to whether (1) the Second Circuit had erred by rejecting the notion that genericness is relevant if not dispositive and (2) whether the Supreme Court should itself reweigh the evidence and determine that Goldman’s carried the day.
Let’s assume (2) is off the table. Come on.
The question then is whether the Second Circuit, considering Goldman’s appeal from the district court’s class cert decision, improperly refused to allow the generic nature of the statements to play any role in the price impact inquiry.
And that depends on how you read the Second Circuit’s opinion.
On the one hand, the Second Circuit held: “Whether alleged misstatements are too general to demonstrate price impact has nothing to do with the issue of whether common questions predominate over individual ones.” Ark. Teachers Ret. Sys. v. Goldman Sachs, 955 F.3d 254 (2d Cir. 2020).
Sounds pretty definitive, right? The Second Circuit seems here to be clearly rejecting the notion that genericness should even be part of the evidence.
On the other hand, the Second Circuit made those statements in response to arguments by Goldman that genericness should be determinative of the price impact inquiry.
Which is why the Solicitor General admitted that the Second Circuit could be read either way – maybe it meant that genericness is categorically irrelevant, but maybe it meant only to reject Goldman’s argument at the time that genericness was dispositive. See Brief of U.S. at 26; see also Transcript at 45-46.
So the parties are functionally reduced to fighting over what the Second Circuit meant, and whether the Supreme Court should vacate the Second Circuit’s opinion for a do-over, or whether the Supreme Court should affirm but clarify that it understands the Second Circuit to not have categorically barred the introduction of evidence of genericness at the class certification stage.
Let’s just say that on this question, I’m with Justice Breyer: “this seems like an area that the more that I read about it, the less that we write, the better….”
Saturday, March 27, 2021
This week, I offer brief comments on a couple of different things:
1. I’ve previously blogged about courts that stretch the definition of “forward-looking statement” in order to preclude defendants from claiming the protections of the PSLRA safe harbor. But probably the more common scenario runs in the other direction. Behold Police and Fire Retirement System of Detroit v. Axogen, 2021 WL 1060182 (M.D. Fla. Mar. 19, 2021), where the plaintiffs alleged that Axogen claimed that the potential demand for its medical products was very large because of the sheer number of nerve repair surgeries performed every year in the U.S. As it turned out, far fewer surgeries were performed annually; in effect, the plaintiffs argued that Axogen overstated the size of its market. Here’s what the court said in its dismissal order:
Plaintiff … [focuses] in particular on statements made in Axogen’s offering materials and elsewhere that a certain number of people in the United States “each year...suffer” traumatic PNI [peripheral nerve injuries], which “result in over 700,000 extremity nerve repair procedures,” and that “[t]here are more than 900,000 nerve repair surgeries annually in the U.S.” Plaintiff argues these statements refer to “present existing conditions.” But the number of injuries occurring “each year” reflects an ongoing state of affairs extending from the present into the future, rather than an observable state of affairs in existence at the specific point in time when the statement is made. Such a statement cannot be determined to be true or false by reference to “present existing conditions,” and is therefore analogous to other present tense statements the Eleventh Circuit has held to be forward-looking.
Thus is a representation about ongoing conditions - the number of nerve repair surgeries performed annually - transformed into a projection about future nerve repair surgeries. The court did not even appear to consider whether a reader would interpret Axogen’s statements as implying recent past annual figures in this range (a range that, according to the plaintiffs, was wildly inflated).
The problem here is that, in the Seventh Circuit’s words, “Investors value securities because of beliefs about how firms will do tomorrow, not because of how they did yesterday.” Wielgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989); see also Glassman v. Computervision Corp., 90 F.3d 617 (1st Cir. 1996). Any representation of current conditions is relevant to investors because they will extrapolate from that to predict future conditions, but if that were enough to make the statement “forward-looking,” well, everything would be protected by the safe harbor.
2. Tesla is being sued again, this time by a stockholder who claims that Elon Musk’s … colorful … behavior on Twitter violates his settlement with the SEC, is a threat to corporate value, and that the Board’s failure to rein him in represents a violation of its duty of good faith (and hey, as I was drafting this very post Musk did it again). While I’m sure there are many things one could say about the lawsuit, the part that struck me was where the plaintiff alleged that the Board is dependent on Musk, in part, because Musk is indemnifying its members for any legal liability. As the plaintiff puts it:
the Board is insured, and thus indemnified, by Musk personally for a majority of the harm caused by Musk alleged herein. The Board cannot be considered independent in any way from Musk in these circumstances. Musk could refuse to pay out the ‘insurance policy’ if the Board elected to proceed with an investigation of him, and the Board would have every incentive to abandon that investigation.
It is my understanding from Tesla’s SEC filings that the personal indemnification arrangement ended in 2020 and the Board now has an ordinary insurance policy, but the plaintiff is, as I read it, claiming that Musk still provides the coverage for certain acts that occurred in 2020. The insurance arrangement raised a lot of eyebrows when it was first disclosed, and at the time I wondered what its legal significance would be for Board dependence. I now look forward to finding out.
(I should note that when the indemnification agreement was first disclosed, Tesla claimed that Musk’s performance was nondiscretionary, but that still raises questions about what Musk can and can’t dispute - and how interested the Board is in ensuring his solvency).
3. WeWork! In addition to the news that the plans to go public are back on – this time via SPAC – it’s the subject of another lawsuit, this time by the former shareholders of a private company that WeWork acquired, using its own stock as currency. Unsurprisingly, the former shareholders argue that various WeWork officers, including Adam Neumann, overstated the value of WeWork shares when negotiating the deal. What is surprising, to me anyway, is that the claims are solely brought under Section 10(b) of the Exchange Act. Section 10(b) claims are very difficult to bring – apart from the higher pleading standards of the PSLRA, they are also relatively narrow in terms of the type of conduct that is deemed prohibited. Their only real advantage over state claims – whether common law or even blue sky – is their availability for secondary market purchases, and the fraud-on-the-market presumption of reliance. So I’m wondering why the plaintiffs elected to bring claims solely under Section 10(b), in a case where neither of these advantages are relevant.
4. Insider trading! A guy named Jason Peltz was recently indicted for insider trading and related offenses, arising out of trades in companies rumored to be the subject of takeover interest. What makes this indictment unusual, however, is that it claims that an unnamed Reporter for a “financial news organization” was one of Peltz’s sources, providing Peltz with information about upcoming news stories. (The indictment tactfully declines to name the Reporter or the news organization, but the stories are identified with sufficient particularity that deducing his identity is a relatively simple task). So here’s the thing: Though Peltz is charged under 10b-5 for “misappropriating” confidential information, the indictment makes no reference to fiduciary obligations or the duty of trust and confidence. Meaning, it’s unclear whether the claim is that Peltz misappropriated information from the Reporter, or whether the claim is that the Reporter misappropriated from his publication and intentionally tipped Peltz (echoing the dispute at the heart of United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986)). On this point, I note that nothing in the indictment suggests any kind of longstanding close friendship between the Reporter and Peltz, but the indictment does mention that the scheme began when Peltz obtained inside information about a takeover bid, purchased the target’s stock, and then tipped the Reporter, who was able to publish a scoop (causing the target’s stock price to rise, and allowing Peltz to cash out).
And ... that’s all!
Saturday, March 20, 2021
A speculative frenzy appears to have taken hold of markets, extending to everything from GameStop shares to sports cards and anything blockchain (again). Caught up in the mania are SPACs – specifically the blank-check firms trading before an acquisition target has been identified.
The difficulty, as the Financial Times recently reported, is that retail shareholders caught up in the SPAC craze aren’t necessarily interested in voting their shares when it comes time to consummate a merger. Worse, a large number of them may have sold their shares after the record date, leaving no one to actually cast the ballot.
Which is why Switchback Energy Acquisition Corporation recently issued the most extraordinary press release:
- Stockholders as of the Close of Business on December 16, 2020 Should Vote Their Shares Even if They No Longer Own Them
Switchback Energy Acquisition Corporation (NYSE: SBE) (“Switchback”) today announced that it convened and then adjourned, without conducting any other business, its virtual Special Meeting of Stockholders to February 25, 2021 at 10:00 a.m., Eastern time (the “Special Meeting”), to allow for more time for stockholders to vote their shares to reach the required quorum and approve the required proposals….
Switchback has received overwhelming support for the Business Combination. At the time the Special Meeting was convened, approximately 99.9% of the proxies received had been voted in favor of the transaction. However, since holders of approximately 45% of the outstanding shares submitted proxies to vote, the necessary quorum of a majority of the outstanding shares was not present. Switchback requests that any investor who held shares of stock in Switchback as of the close of business on December 16, 2020 and has not yet voted do so as soon as possible in order to avoid additional delays….
Can I still vote if I no longer own my shares?
Yes, if you owned shares as of the close of business on December 16, 2020, the record date for the Special Meeting, you can still vote your shares even if you no longer own them.
This is, I must say, quite remarkable. I mean, there have long been concerns about “empty voting,” i.e., casting ballots for shares in which you have no economic interest, including casting ballots for shares that have since been sold. See, e.g., Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 S. Cal. L. Rev. 811, 835 (2006). Here, everyone’s assuming that the vote was a mere formality and the reason the shares were not voted was that retail shareholders are indifferent, but what if some shareholders disfavored the merger? Pushing the deal through with the ballots of former shareholders would hardly be fair to them.
Which gets to the legal question of whether this is even okay. Delaware has vaguely suggested, you know, maybe not. For example, in In re Appraisal of Dell, 2015 WL 4313206 (Del. Ch. July 13, 2015), VC Laster held:
even the right to control how shares vote transfers with the shares, notwithstanding the legal expedient of the record date, because the subsequent holder can compel the seller to issue him a proxy (assuming the seller can be identified)
In support, he cited Commonwealth Assocs. v. Providence Health Care, Inc., 641 A.2d 155 (Del. Ch. 1993), where Chancellor Allen expressed “doubt” that a contract for the sale of shares that allowed the seller to retain the right to vote would be “be a legal, valid and enforceable provision, unless the seller maintained an interest sufficient to support the granting of an irrevocable proxy with respect to the shares.” See also In re Canal Construction Co., 182 A. 545 (Del. Ch. 1936) (“As between a transferror who has parted with all beneficial interest in stock and his transferee, the broad equities are all in favor of the latter in the matter of its voting. While the transferee may not himself be qualified to vote because he had not caused the stock to be registered in his name …, it does not necessarily follow that the transferror may exercise the voting right in defiance of the transferee's wishes. So far have courts recognized the equity of the true owner of stock to control its voting power as against the registered holder, that the latter has been required to deliver a proxy to the former.”); In re Giant Portland Cement Co., 21 A.2d 697 (Del. Ch. 1941) (“A mere nominal owner naturally owes some duties to the real beneficial or equitable owner of the stock; and even if the right to demand a proxy is not exercised, if the vendor exercises his legal right to vote in such a manner as to materially and injuriously affect the rights of the vendee, he is, perhaps, answerable in damages in some cases.”)
Those cases were about disputes between the transferor and the transferee regarding the manner in which shares would be voted, but it should also be noted that in the context of “vote-buying” allegations, Delaware has suggested that it is illegitimate to divorce economic interest in shares from the voting rights attached to them. See Crown EMAK Partners, LLC v. Kurz, 992 A.2d 377 (Del. 2010).
Anyhoo, we can add this to the growing list of “concerns about SPACs,” which is why the SEC is reportedly taking a closer look. Of course, if the world is finally opening up post-covid, speculative trading may also subside, and the problem may take care of itself.
Saturday, March 13, 2021
By now, you’ve probably seen that the SEC filed a lawsuit against AT&T for, allegedly, violating Regulation FD by selectively leaking information about an upcoming earnings announcement in 2016. According to the complaint, in previous quarters, AT&T had disappointed the market by announcing earnings below analysts’ consensus expectations; when it realized it was going to do so again, its Investor Relations department began contacting the analysts with high expectations in order to dampen their optimism. The result was a lowered consensus estimate, and when AT&T did announce its 1Q2016 results, they actually came in slightly above expectations.
AT&T disputed the charges with a curious statement:
The evidence could not be clearer – and the lack of any market reaction to AT&T's first quarter 2016 results confirms – there was no disclosure of material nonpublic information and no violation of Regulation FD.
Well, yeah, genius, because the point of the scheme was to prevent a market reaction to AT&T’s first quarter 2016 results.
But what really strikes me about the whole situation is that it’s as clear an example as you can imagine of a company apparently violating the securities laws for the explicit purpose of trying to avoid a negative market reaction rather than to induce a positive one.
That’s important because in recent years, defendants in Section 10(b) actions have tried to cast doubt on the viability of the “price maintenance” theory of fraud, i.e., the theory that some fraudulent actions are designed not to push prices upward, but to withhold negative information so that prices can be maintained at existing levels. Defendants have argued that statements that merely maintain prices are not material to investors and/or have no impact on prices, and therefore cannot form the basis of a fraud claim. Happily, most courts have rejected that argument, but it’s getting a new workout now before the Supreme Court in Goldman Sachs v. Arkansas Teachers’ Retirement System (my most recent blog post on that case is here; it links to earlier ones). There, the defendants are not explicitly arguing that price maintenance theory is illegitimate, but they are suggesting there is something suspicious about it that warrants extra scrutiny:
Critically, respondents conceded that the challenged statements did not increase Goldman Sachs’ stock price when made. Instead, respondents relied on the increasingly popular “inflation-maintenance” theory—a theory this Court has never endorsed—to assert that the statements maintained the stock price at a previously inflated level….
The inflation-maintenance theory already seriously impedes a defendant’s ability to rebut the Basic presumption. The theory allows plaintiffs to rely on the presumption even if there is no evidence that a misstatement increased the stock price when it was made. Nor do plaintiffs need to identify what statement (if any) inflated the price in the first place.
Some of Goldman’s amici are attacking the theory more directly. To wit.
Happily, a group of former SEC officials have filed a brief in support of the plaintiffs that is almost entirely devoted to defending the inflation-maintenance theory, and highlighting how important it’s been to SEC enforcement actions.
(In case anyone cares, I also signed on to a law professors’ brief in support of the plaintiffs, here).
To bring this back to AT&T, obviously, AT&T is not accused of fraud, or doing anything to mislead the market, but its alleged conduct demonstrates the lengths to which companies will go in order to avoid negative market shocks; it should be utterly unsurprising that many frauds are designed precisely to minimize market reaction, and defendants in those cases shouldn’t be rewarded for success.
That said, as Matt Levine points out, in AT&T’s case specifically, the whole kerfuffle raises interesting questions about what kinds of information move the market or are material to it. If AT&T’s stock price stayed flat after its earnings announcement because the company had already lowered analysts’ expectations, you would expect to see a downward drift in the stock price before the announcement, when AT&T was quietly walking it down. I eyeballed its stock prices during that period and - without running a statistical analysis or comparing it to peer companies or anything - it doesn’t seem like the revisions to analyst estimates was having much of an effect. That could be for any number of reasons - my eyeballs may not be sensitive enough to the detect the pattern, or maybe these analysts were already known to get things wrong and their estimates weren’t baked into the stock price - but it’s amusing that (AT&T thought, at least) the difference between a negative market reaction and no reaction was not the earnings themselves, but what analysts had said about them the day before. In fact, the market appears to have been a lot more sanguine about analyst commentary than AT&T was.
Which, ahem, doesn’t mean that nonpublic information AT&T’s upcoming earnings was not material; just that it confirmed market expectations, no matter what analysts said. If anything wasn’t material here, it was the analysts.
The Goldman case is set for oral argument on March 29.
Saturday, March 6, 2021
Judge Rakoff’s decision in In re Nine West LBO Securities Litigation, 2020 WL 7090277 (S.D.N.Y. Dec. 4, 2020) is all the rage these days. The short version is that Nine West was taken private in a leveraged buyout by Sycamore; as part of the deal, allegedly the Sycamore buyers caused the company to sell the profitable subsidiaries to its own affiliates for less than they were worth, and the whole thing ended in Nine West’s bankruptcy. In the wake of all of this, the debtholders (many of whom held debt that predated the sale), via the litigation trustee, sued Nine West’s former directors – the ones who had approved the sale – for violating their fiduciary duties by negotiating a deal that would result in the company’s bankruptcy. Last year, Judge Rakoff refused to dismiss the claims, in a decision that spawned a thousand law firm updates about directors’ duties when selling the company.
But what I find interesting is how little anyone – including Judge Rakoff – seems to have interrogated the legal question of to whom the directors’ fiduciary duties were owed.
The classic Delaware formulation is that directors owe a duty to advance the best interests of the “corporation and its stockholders.” Firefighters’ Pension Sys. Of Kansas City v. Presidio, 2021 WL 298141 (Del. Ch. Jan. 29, 2021). Drill down a little further, and you discover that “the corporation” is equated with stockholders. See, e.g., North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) (“When a solvent corporation is navigating in the zone of insolvency…directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.”); Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173 (Del. 1986) (“A board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders. However, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.”). Under these precedents, the directors’ duties are to maximize stockholder wealth. Full stop.
Normally, it would be a proposition too obvious to articulate that of course if directors are to maximize shareholder wealth, a subsidiary obligation is to try to avoid bankruptcy. But that’s because normally, bankruptcy harms the stockholders – they’re the ones left with worthless stock. But, pace Revlon and Gheewalla, you’d think that if the stockholders themselves eagerly – nay, joyfully – court bankruptcy, because they’re being bought out at $15 per share and they don’t really care what happens after that, the directors have satisfied their duties and nothing more needs be said. The whole point of Revlon, after all, is that there is such a thing as a endgame transaction, after which shareholders exit the company and fiduciary duties cease.
But even in Delaware, where the law is probably clearest, I’m not sure that’s accurate. When a corporation is insolvent, the creditors have standing on behalf of the company to sue directors for breach of fidicuary duty. See Gheewalla, 930 A.2d at 101. And what precisely are the duties of the directors in this scenario? Per VC Laster, they are the same duties that directors always have, namely, “the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants.” Quadrant Structured Products Co., Ltd. v. Vertin, 102 A.3d 155 (Del. Ch. 2014). If directors’ duties, generally, are to benefit residual claimants, that presumably means they have a duty to avoid bankruptcy in the first place even if shareholders would prefer it. But all that just highlights the difficulty with pinning fiduciary duties to residual claimants – all claimants are residual claimants, depending on the firm’s moment in its life cycle.
But Nine West was not incorporated in Delaware; it was incorporated in Pennsylvania. And, among other things, Pennsylvania has a constituency statute, which states that in discharging their duties to “the corporation,” Pennsylvania directors may (but are not obligated) to consider the effects of an action on all corporate constituencies. See 15 Pa. Cons. Stat. § 1715. Meaning that whatever else directors’ duties are, they do not include a duty to maximize value to stockholders, whether in a sale scenario or at any other time. Which is why Nine West’s litigation trustee argued that Pennsylvania law does not require maximizing value to “short-term” shareholders (although that still leaves maddeningly vague what to do when even the interests of long-term shareholders conflict with those of creditors), and the director-defendants argued that no duty to creditors would attach until the actual point of insolvency (never mind that they themselves had allegedly occasioned the insolvency).
Which is how matters stood when the case came before Judge Rakoff.
Rakoff chose not to engage in any of this. Instead, he simply declared that the directors’ duties were to the company, but quite explicitly treated the company as having different constituencies, namely, stockholders and creditors. For example, the director defendants tried to argue that any claims against them were res judicata because when the buyout was first proposed, stockholders brought a derivative claim on the company’s behalf arguing that the deal undersold the company, and that claim was settled. Rakoff rejected the argument in part because the stockholder plaintiffs – though they had acted on the company’s behalf – had not adequately represented the interests of creditors, who were now represented on the company’s behalf by the bankruptcy litigation trustee
Having thus recognized that “company” interests may be represented either by stockholders or by creditors – but that these two groups are distinct and often at odds – Rakoff went on to conclude that the Nine West directors had neglected their duties to the company by failing to investigate the effects of the deal on the company, and, in particular, failing to investigate the possibility that the transactions would harm the company by leaving it insolvent. He further held that the Nine West directors had aided and abetted the fiduciary breaches of the Sycamore directors – who took over after the merger – by assisting them with their plan to sell off the profitable assets, which would bankrupt the company.
By focusing on the company, Rakoff obscured the implications of his holding regarding the true parties in interest. He did not say so explicitly, but the import is that if directors had investigated, and had recognized (correctly) that the deal would leave Nine West bankrupt, but also believed that the price would benefit Nine West’s shareholders, they would still have violated their duties to the company by consciously choosing to leave the company insolvent.
Thus, in this scenario, Rakoff believed the directors’ fiduciary duties prohibited them from elevating shareholders over creditors. But he didn’t cite any law for this point – not even Pennsylvania’s constituency statute (which by my read gives directors considerable discretion to decide which constituencies to favor). It’s just what necessarily follows from his reasoning.
Nine West is, then, a real-world example of the “two masters” problem that is frequently used to justify shareholder primacy. And Judge Rakoff’s opinion rejects shareholder primacy in favor of a stakeholder view of the corporation, with fiduciary duties that follow.
Here’s my take: Usually, we can avoid asking whether directors must take Action A or Action B because matters are not obviously a zero-sum game; directors are taking risks, and different constituencies may benefit more or less from those risks. Yes, shareholders may benefit from risk-taking more than creditors, but it is by no means obvious that the risk won’t pay off for everyone, and exercising business judgment means deciding how to act under conditions of uncertainty.
But the Nine West problem presents things in starker terms: Accepting the allegations as true, it was clear at the outset that the buyout would benefit shareholders at the expense of creditors, because part of the plan was to undersell the profitable Nine West assets to Sycamore affiliates, where they would be out of creditors’ reach. If that hadn’t been part of the plan, this might simply have been a gamble as to how much debt the company could support; because it was part of the plan, there was an unusually clear choice: cooperate in a scheme to remove assets from creditors’ grasp and pay off the shareholders for their participation, or – don’t.
So the question then becomes, do directors’ duties to shareholders include evading obligations to debtholders?
And I still don’t have a clear answer, but what is true is that on the one hand, directors (at least in Delaware) may not break the law even if it’s intended to benefit shareholders, In re Massey Energy Co., 2011 WL 2176479 (Del. Ch. May 31, 2011) (“Delaware law does not charter law breakers. Delaware law allows corporations to pursue diverse means to make a profit, subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue ‘lawful business’ by ‘lawful acts.’), but on the other hand, in Delaware, directors may efficiently breach a contract if it benefits shareholders, see Frederick Hsu Living Trust v. ODN Holding, 2017 WL 1437308 (Del. Ch. Apr. 14, 2017) (“the fact that a corporation is bound by its valid contractual obligations does not mean that a board does not owe fiduciary duties when considering how to handle those contractual obligations; it rather means that the directors must evaluate the corporation’s alternatives in a world where the contract is binding. Even with an iron-clad contractual obligation, there remains room for fiduciary discretion because of the doctrine of efficient breach. Under that doctrine, a party to a contract may decide that its most advantageous course is to breach and pay damages. Just like any other decision maker, a board of directors may choose to breach if the benefits (broadly conceived) exceed the costs (again broadly conceived).”).
In other words, in a world where statutory law is “law” that the corporation may not break, but contract law is not “law” with a similar prohibition, I … do not know what to do with debt agreements subject to, among other things, bankruptcy’s prohibitions on fraudulent and preferential transfers, etc.
So really, it would be so much easier if bankruptcy law, tort law, and contract law were to solve this problem, and spare corporate law the trouble.
(For more discussion of consequences of shareholder primacy in the bankruptcy context, see Jared A. Ellias & Robert Stark, Bankruptcy Hardball, 108 Cal. L. Rev. 745 (2020)).
Saturday, February 27, 2021
Last week, I blogged about the dominance of Delaware organizational law and its implications for the laws of other states. Which is why I was so interested to when Omari Scott Simmons posted his new paper, The Federal Option: Delaware as De Facto Agency, which takes a (sort of) different view. He argues that Delaware has become de facto federal agency, delegated by the federal government the power to make corporate law nationally, and that this system works well for now, though there might be circumstances where federal chartering – and the structural oversight that would come with it – might be appropriate. These could include situations where companies have received governmental bailouts, or where companies have committed significant wrongdoing and subject themselves to federal oversight as part of their settlement.
Of course, the concerns I’ve expressed in my posts are of a slightly different order – they’re about Delaware organizational law extending beyond the boundaries of internal affairs (and Delaware’s ability to define those boundaries in the first place) – but still, it’s an interesting holistic look at Delaware’s role in the corporate governance ecosystem. Here is the abstract:
Despite over 200 years of deliberation and debate, the United States has not adopted a federal corporate chartering law. Instead, Delaware is the “Federal Option” for corporate law and adjudication. The contemporary federal corporate chartering debate is, in part, a referendum on its role. Although the federal government has regulated other aspects of interstate commerce and has the power to charter corporations and, pursuant to its Commerce Clause power, preempt Delaware, it has not done so. Despite the rich and robust scholarly discussion of Delaware’s jurisdictional dominance, its role as a de facto national regulator remains underdeveloped. This article addresses a vexing question: Can Delaware, a haven for incorporation and adjudication, serve as an effective national regulator? Following an analysis of federal chartering alternatives, such as the Nader Plan, the Warren Plan, the Sanders Plan, and other modes of regulation, the answer is yes, but with some caveats and qualifications. Delaware’s adequate, if imperfect, performance as a surrogate national regulator of corporate internal affairs argues against the upheaval of the existing corporate law framework federal chartering would bring. Even in the contemporary moment where longstanding concerns about corporate power, purpose, accountability, and the uneasy relationship between corporations and society are amplified, Delaware can continue to perform an important agency-like role in collaboration with federal regulators, and regulated firms. A deeper examination comparing the merits of federal corporate chartering with Delaware’s de facto agency function illuminates the potential of existing and future reforms. This article concludes that federal chartering proposals have an important impact despite not being adopted for centuries. First, federal chartering proposals encourage policymakers to look beyond the status quo toward greater hybridization in regulatory design. Second, elements of previous federal chartering proposals have historically become successful “à la carte” reforms or part of other successful reform measures. Third, federal chartering proposals provide value as a bargaining tool where the threat of more intrusive federal regulation makes other reform methods more palatable to diverse corporate constituencies.
Saturday, February 20, 2021
I’ve previously expressed concern about Delaware organizational law intruding into other states’ spaces. A new entry into the genre is VC Slights’s opinion in AG Resource Holdings, LLC, et al. v. Thomas Bradford Terral.
In AG Resource Holdings, Thomas Terral cofounded an LLC called AG Resource Management. The business was eventually bought out by a private equity firm and restructured as a holding company, AG Resource Holdings LLC, that wholly owned the operating subsidiary, AG Resource Management LLC. Terral was designated as one of several managers of the LLCs, and also was an officer.
Terral’s contractual obligations were embodied in separate agreements. First, he had an Employment Agreement, which had various noncompetes, and a Delaware choice of law clause. Second, the LLC agreements themselves required him to act in good faith and not compete, and chose Delaware law, and Delaware forums, to resolve any disputes.
Terral was fired after it was discovered he was planning to compete with the companies, and he filed a complaint in Louisiana seeking to have the noncompete in the Employment Agreement declared unenforceable. Terral’s argument – which a Louisiana court accepted on a motion for a preliminary injunction – was that because the work was performed in Louisiana, Louisiana law naturally governed the Employment Agreement, and under Louisiana law both the noncompete and the Delaware choice of law clause were unenforceable.
The companies then sued in Delaware seeking to enforce the agreements.
Examining all of this, Slights agreed that, in the absence of the choice of law clause, Employment Agreement was governed by Louisiana law as the state with the greatest interest. Louisiana would not have permitted employees to waive Louisiana law, or waive the right to compete (at least not in the way the agreement was drafted), therefore, those provisions were unenforceable. For that reason, the Louisiana court action took precedence over the Delaware action. So, the companies’ action to enforce the Employment Agreement was stayed in favor of the Louisiana action.
But the LLC agreements were a different story. First, Terral had not sued under those agreements in Louisiana, so those issues were not before the Louisiana courts. More importantly, though, those agreements were part of “the constitutive documents of a Delaware entity,” and even in the absence of choice of law/forum clauses, Delaware law would control by default. And under those agreements, Terral had agreed to act in good faith and not to compete, and the companies had the right to enforce those agreements in Delaware. As Slights put it:
Moreover, while Louisiana may possess a public policy interest in regulating the actions of employers toward employees within that state, Louisiana has no interest in regulating the governance or internal affairs of a Delaware entity. And, while LA. STAT. ANN. § 23:921(L) provides that, under Louisiana law, non-competes within LLC agreements will be subject to nearly identical restrictions as those within employment contracts, there is no indication that Louisiana purports to extend those restriction to fiduciaries acting within Delaware LLCs.
To state the distinction most directly, the claims under the Employment Agreement rest on Terral’s conduct as employee (regardless of whether he occupied a fiduciary status), while the claims under the LLC Agreement rest on Terral’s status as a member of the Company’s Board of Managers. In drawing this distinction, I acknowledge there may be some overlap in the litigation and adjudication of claims arising under the Employment Agreement on the one hand, and the LLC Agreements on the other, and further acknowledge there is at least some risk of inconsistent outcomes. Nevertheless, as discussed here, Terral is alleged to have engaged in wrongful conduct as a “manager” and “officer” of a Delaware entity. The Company is entitled to litigate that claim in this Court.
All of that contains a surface level appeal, but the problem is – at least as described in the opinion (it’s possible there’s more nuance to the underlying documents) – the LLC Agreements obligated Terral to basically do the same things as the Employment Agreement, as part of a relationship that substantively would be characterized as an employment relationship. If that’s right, then it shouldn’t matter whether the LLC Agreements are labeled “LLC Agreements” or “Employment Agreements” or “Ishkabibble,” they are substantively contracts for employment and should carry with them the same restrictions. If Terral, as someone who performs management services for the companies, is legally barred from waiving his right to compete under Louisiana law, then it shouldn’t matter what document the impermissible restriction is contained in.
I mean, it’s absolutely possible that Terral had different responsibilities and legal rights as a member of the LLCs Board of Managers, and as an employee of the company, making it possible to distinguish between the different contracts, but if so, nothing in the opinion itself explains what the differences would be.
To put it another way, if someone is labeled an LLC “manager,” does that mean their relationship with the LLC is necessarily a question of Delaware organizational/entity law, or is there some particular type of relationship that is more appropriate for regulation under business organizational law rather than employment law, and if so, what is the scope of that relationship?
Interestingly, VC Laster confronted a somewhat similar situation a few months ago in Focus Financial Partners v. Holsopple. There, an employee working out of California received as compensation certain units of a Delaware LLC. As a condition of his employment, he signed “unit agreements” regarding the transfer of the units, which contained various noncompete/nonsolicit clauses, and stated they were governed by Delaware law with a Delaware forum selection clause. Additionally – and I’m simplifying, there were amendments over time, it was a whole thing – the LLC itself had an operating agreement with a Delaware forum selection clause.
There was eventually a dispute over whether Holsopple had violated the noncompetes, and Focus Financial sued in Delaware. The only way that Delaware would have personal jurisdiction over Holsopple was through the choice of forum/law provisions of the unit agreements and the operating agreement. Holsopple, however, claimed that these provisions were all part of his employment contract, his employment contract (in the absence of these agreements) would be governed by California law, and California law would render them unenforceable. Laster agreed. Notwithstanding the fact that the provisions did not appear in the employment agreement per se – they appeared in unit transfer agreements and the LLC operating agreement – they were functionally part of his employment contract.
Now, Laster had an easier time of it than did Slights in AG Resource Holdings, because Holsopple was not a manager of the LLC. In fact, as Laster pointed out, “the units generally did not have ‘any voting or other consent or approval rights.’ Focus Parent is a manager-managed LLC in which holders of units have minimal rights.” But that only begs the question whether – going back to to AG Resource Holdings – Slights should have conducted a more searching inquiry of Terral’s powers and responsibilities to determine if even his “manager” role was functionally that of an employee.
Notably, in Focus Financial, Laster had a very interesting footnote where he anticipated the corner into which Delaware had boxed itself:
Delaware court have confronted with increasing frequency situations in which parties have attempted to use choice-of-law provisions selecting Delaware law to bypass the substantive law of sister states. In this court, the conflicts most often involve agreements containing restrictive covenants. … This court has also confronted a conflict between agreements selecting Delaware’s contractarian regime and the substantive law of a foreign jurisdiction. … Other Delaware courts have confronted similar issues in other contexts. …Because Delaware’s role as a chartering jurisdiction depends on other states deferring to the application of Delaware law to the internal affairs of entities, the increasing frequency with which parties use Delaware law to create conflicts with the substantive law of other jurisdictions raises significant public policy issues for this state. See Diedenhofen-Lennartz v. Diedenhofen, 931 A.2d 439, 451–52 (Del. Ch. 2007) (“If we expect that other sovereigns will respect our state’s overriding interest in the interpretation and enforcement of our entity laws, we must show reciprocal respect.”).
The point is, Delaware’s increasingly contractual approach to entity is organization is putting pressure on the boundaries of the internal affairs doctrine. Also relevant here is the growing prevalence of shareholder agreements – studied by Gabriel Rauterberg in this paper and Jill Fisch in this one – which may very well select a law other than Delaware’s, so that the entity is organized under Delaware law but crucial governance matters are controlled by the law of another state. See, e.g., KT4 Partners v. Palantir Technologies (shareholder may obtain books and records under Section 220 to investigate violations of stockholder agreements governed by California law). These are going to create thorny choice-of-law issues going forward and, I worry, undermine the utility of the internal affairs doctrine itself.
Saturday, February 13, 2021
Almost exactly one year ago, I blogged about an unusual books and records lawsuit involving Facebook. The plaintiffs were seeking documents pertaining to Facebook’s $5 billion settlement with the FTC, on the theory that Facebook had improperly agreed to pay larger fines in order to protect Mark Zuckerberg, personally, from liability. That, the plaintiffs claimed, was an interested transaction involving a controlling shareholder, subject to entire fairness review if not cleansed using MFW procedures.
As I said at the time, the reason this struck me as novel was because the entire lawsuit depended on Delaware’s slow evolution of thinking surrounding controlling shareholder transactions, and highlighted the box Delaware has put itself in. Is it true that any controlling shareholder transaction gets entire fairness review absent MFW procedures? Because if the controlling shareholder involved in day-to-day operations, that’s a very broad rule, and if that’s not the rule, what kinds of transactions qualify?
Anyhoo, VC Slights just issued his opinion in the 220 action and the remarkable thing about it is that it says … nothing.
I mean, it says something, obviously, it holds that (1) plaintiffs may obtained non-privileged electronic communications pertaining to the settlement and (2) plaintiffs have not – yet – shown a need for privileged communications, though I gather that may change depending on what comes of the electronic production. But none of that strikes me as breaking new ground in Section 220 law, or anything; what leaps out is how very. carefully. nothing in the opinion weighs in on the merits of the potential claim here, i.e., how Delaware should review the FTC settlement itself.
To some extent, I suppose, that’s probably because Facebook never made any arguments in its briefing about the merits, i.e., whether the plaintiffs had actually identified a potential breach of fiduciary duty. Which is, you know, correct – the Delaware Supreme Court recently said in no uncertain terms that a 220 action is not the place to litigate the merits of a potential claim, and VC McCormick suggested she might impose fee-shifting as a sanction for companies stonewalling on that issue.
But Facebook’s brief was filed before those cases were handed down, at a time when most companies were trying to use Section 220 to obtain a back door merits dismissal. Yet Facebook … did not.
Which suggests to me that everyone – VC Slights, Facebook, and certainly the plaintiffs – recognize what a hot potato they have here. Which is why I’m keeping a close eye on this one.
(We can save for another time a discussion of the value of a system where you litigate for a year to get the documents that you may use to file a complaint.)
Friday, February 5, 2021
After Ben posted about the GameStop Affair last week, Joan predicted that the saga would be a “great gift to law professors.” That seems about right, because here I am with a post about the subsidiary issue of Robinhood, or rather, Robinhood’s platform.
FINRA just issued a report on its current Risk Monitoring and Examination Activities, which highlights certain areas that FINRA will be investigating going forward. It doesn’t mention Robinhood by name, but it flags some of Robinhood’s practices for special attention and, in particular, its game-like user interface. In specific, it says:
we are increasingly focused on communications relating to certain new products, and how member firms supervise, comply with recordkeeping obligations, and address risks relating to new digital communication channels. This focus includes risks associated with app-based platforms with interactive or “game-like” features that are intended to influence customers, their related forms of marketing, and the appropriateness of the activity that they are approving clients to undertake through those platforms (e.g., under FINRA Rule 2360 (Options)).
While such features may improve customers’ access to firm systems and investment products, they may also result in increased risks to customers if not designed with the appropriate compliance considerations in mind. Firms must evaluate these features to determine whether they meet regulatory obligations to…comply with any Reg BI and Form CRS requirements if any communications constitute a “recommendation” that requires a broker-dealer to act in a retail customer’s “best interest”…
Brokers must act in the customer’s best interest when making investment recommendations. Interfaces that encourage more trading simply to generate revenue for the platform – rather than based on a personalized assessment of the customer’s needs – aren’t going to comply with that standard, so the question is whether these kinds of encouragements are, in fact, recommendations.
This is an issue more broadly for electronic platforms that use algorithms to do everything from bringing certain items to the customer’s attention to providing responses to customer-initiated searches. For example, Regulation Crowdfunding creates a new kind of entity known as a Funding Portal; basically, a website where investors can browse available offerings by issuers. Funding Portals are exempt from broker-dealer registration as long as they limit their activities, including refraining from giving investment advice or making any investment recommendations.
The problem is that when you’re talking about a website, where algorithms determine the order in which investments appear on a page and which ones are highlighted at a particular time and which ones pop up when you type in search words, it’s very hard to tell what counts as “investment advice.” Is it “advice” to say “These investments are trending”? To say “These companies have been profitable for a year”? Does it matter if the customer first searched for these criteria, or if they just popped up on the screen, unprompted? What if the platform itself contains suggested search criteria?
The SEC tried to address this problem in Regulation CF Rule 402(b), which permits portals to highlight particular offerings based on “objective criteria.” The adopting release contains a long discussion of the issues, and as you can see, this is ... not easy to resolve.
Back to Robinhood. As readers are probably aware, Massachusetts is currently suing Robinhood over its interface, and that’s the gravamen of the complaint as well: That Robinhood’s interface is functionally making recommendations to customers when it highlights particular securities based on purportedly objective criteria, like “100 most popular,” “Food and Drink,” and so forth. The app even says things like “Can’t decide which stocks to buy? Check out the most popular stocks.”
And then, of course, there’s the question whether more subtle aspects of the platform – like confetti graphics congratulating customers on a trade – are encouraging more trading and therefore are also, in a sense, making recommendations (i.e., a recommendation of churning).
All of which is to say, this is apparently what FINRA plans to confront going forward.
Finally, I’ll add, if it turns out the Robinhood interface was designed with little regard for FINRA’s rules, it might turn out to be relevant that Robinhood’s CEO is not registered with FINRA, and there’s a legitimate question whether he’s improperly managing Robinhood’s operations. Per CNN:
Unless granted an exemption, FINRA generally requires that the CEOs of registered broker-dealers be registered with the agency….
The CEO of a parent company that owns a broker-dealer does not necessarily need to be registered.
In this case, Tenev is the CEO of Robinhood Markets, the parent company that is not registered with FINRA. Robinhood Markets owns a broker-dealer and a clearing broker.
Robinhood told CNN Business that Tenev does not directly manage the FINRA-registered leaders of the broker-dealer or clearing broker — but declined to say who does. None of Tenev's direct reports appear to be registered with FINRA. …
So, we can perhaps put that on the list of issues as well.
Saturday, January 30, 2021
Paul Mahoney and Adriana Robertson just posted a fascinating new paper arguing that many index providers are, in fact, investment advisers under the legal definition, and therefore should be deemed to owe fiduciary duties to the mutual funds who license their indices.
The paper builds on Robertson’s earlier work studying index funds, including her finding that many indices are “bespoke”; they are created in order to be licensed to a single fund. Notice how the fees work in that scenario: the fund itself can charge a low management fee for a purported “passive” fund, and then bundled with other fees is an additional fee to license the index – often created by an affiliate of the fund. And, in fact, she finds that ETFs that call themselves passive but license an index from an affiliate charge higher fees than those that do not use an affiliated license provider.
Anyhoo, the new paper with Mahoney takes this to the next logical conclusion: in these kinds of cases, the index provider is serving as an investment adviser to the fund, and should be regulated that way.
Saturday, January 23, 2021
Courts really don’t like it when you intentionally issue false projections in order to make a merger look better
So much so, it seems, that they will go out of their way to make sure a securities fraud claim survives a motion to dismiss.
I speak of In re Mindbody Securities Litigation, 2020 WL 5751173 (SDNY Sept. 25, 2020) and Karri v. Oclaro, 2020 WL 5982097 (N.D. Cal. Oct. 8, 2020).
The problem for courts in this context is that projections of future performance are protected by the PSLRA safe harbor. Which means, faced with plausible allegations that corporate insiders were talking down the stock’s potential in order to persuade shareholders to accept a bad deal, courts feel they need to find some other basis on which to sustain the claim.
In Mindbody – the facts of which are also colorfully described in a related Chancery action for breach of fiduciary duty – that basis turned out to be the defendants’ statements about the value of the merger consideration relative to the (artificially low) stock price. The defendants were alleged to have intentionally lowballed their earnings guidance in order to sink the stock, so that the merger offer would seem generous by comparison. But by the end of the quarter, defendants had in their possession the true earnings figures, and confirmation that their earlier projections had been too pessimistic. The court wouldn’t allow a straight-up projections claim to proceed, but it did hold that the proxy materials contained an “actionable omission because Defendants’ statements about Vista’s 68% ‘premium’ implied that Mindbody had no non-public information that would materially affect its share price…. Here, the 68% measuring stick would only have been informative to shareholders if the Defendants believed that the December share price was an accurate reference point. By invoking the ratio of Mindbody’s share price to Vista's offer, Defendants impliedly warranted that, to their knowledge, the share price as of December 21, 2018, was not undervalued.”
Get it? The court wouldn’t allow a lawsuit based on the false projections themselves – and didn’t want to just come right out and say there was a duty to update the false guidance (indeed, it denied so holding) – so, it threaded the needle by treating references to a premium as their own, present-tense half-truths about the true value of the stock.
But that’s nothing compared to the contortions in Oclaro. There, again, plaintiffs alleged that defendants lowballed projections in order to drive the stock down, thus justifying the merger. There, again, the court held that false projections were protected by the PSLRA safe harbor. But what wasn’t protected were valuation estimates derived from the projections, or representations about how the projections were prepared, including representations that they were prepared in good faith, and those claims were allowed to proceed.
Now, defining “forward-looking” has always been something of a challenge in securities cases, but saying the projection is protected by the safe harbor but the valuation based on that projection is not protected is some next-level hairsplitting.
It’s like the fact/opinion distinction, which I’ve complained about before; the line is something that philosophers struggle with, let alone judges, and it’s absurd that courts allow so much to turn on which way the die falls. Everything in financial reporting is based on estimates, often future estimates, and in that context, attempting to distinguish fact from opinion from projection is meaningless; they’re all part of one process. That’s why, for example, the PSLRA safe harbor excludes from its protections any statements that are “included in a financial statement prepared in accordance with generally accepted accounting principles,” and why courts get it wrong when they characterize GAAP financial statements as matters of opinion.
Saturday, January 16, 2021
I’ve previously lamented the blurring of the lines of corporate and contract law, usually arising in the context of forum selection provisions in bylaws or charters that are treated as indistinguishable from ordinary contracts. My most recent post on this concerned the dismissal of a Section 11 case against Uber; shortly thereafter, another California court dismissed claims against Dropbox, in a decision which I may or may not discuss in more detail at a later date.
As Kyle Wagner Compton, author of the invaluable Chancery Daily, recently brought to my attention, in Mack v. Rev Worldwide, VC Zurn went in the opposite direction. The plaintiff, John Mack (yes, that John Mack) argued that he was not bound to the forum selection clauses contained in certain Notes that he held because he had not assented to them. Zurn held that he had agreed to provisions that allowed the Notes to be amended by a vote of a majority of the noteholders, and he was thus bound by clauses added through that process. On that holding I express no opinion. What does grab me, however, is that Zurn supported this decision by reference to the forum selection bylaw cases, including Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), finding them to be an appropriate analogy.
Except, as I keep pointing out, Boilermakers rested explicitly on the statutory scheme that details the conditions and limits on directors’ power to adopt bylaws, including directors’ fiduciary obligations. See id. at 954, 956, 959. That’s very different from a contractual agreement that details the mechanisms by which the contract can be amended. And though Zurn did acknowledge that her analogy was not perfect, it represents a further erosion of judicial recognition of the differences between the two regimes.
Anyway, at least I’m not the only one concerned about this; here’s Mandatory Arbitration and the Boundaries of Corporate Law, by Asaf Raz, with further discussion of the distinction between the corporate legal framework and the contractual one.
Saturday, January 9, 2021
The past few days, I’ve been thinking a lot about the classic case of AP Smith Manufacturing Co. v. Barlow, 98 A.2d 581 (N.J. 1953).
Though it is often invoked as emblematic of the “stakeholder” theory of the corporation, large portions of Barlow read more like a particularly vigorous application of the business judgment rule. So long as corporate altruism could conceivably benefit the corporation, it will not be second-guessed. Thus, Barlow held that corporate donations to Princeton University were permissible because, among other things:
[Corporations] now recognize that we are faced with other, though nonetheless vicious, threats from abroad which must be withstood without impairing the vigor of our democratic institutions at home and that otherwise victory will be pyrrhic indeed. More and more they have come to recognize that their salvation rests upon sound economic and social environment which in turn rests in no insignificant part upon free and vigorous nongovernmental institutions of learning….[S]uch expenditures may likewise readily be justified as being for the benefit of the corporation; indeed, if need be the matter may be viewed strictly in terms of actual survival of the corporation in a free enterprise system….
[T]here is now widespread belief throughout the nation that free and vigorous non-governmental institutions of learning are vital to our democracy and the system of free enterprise and that withdrawal of corporate authority to make such contributions within reasonable limits would seriously threaten their continuance. Corporations have come to recognize this and with their enlightenment have sought in varying measures…to insure and strengthen the society which gives them existence and the means of aiding themselves and their fellow citizens. Clearly then, the appellants, as individual stockholders whose private interests rest entirely upon the well-being of the plaintiff corporation, ought not be permitted to close their eyes to present-day realities and thwart the long-visioned corporate action in recognizing and voluntarily discharging its high obligations as a constituent of our modern social structure.
Once you get past the anti-Communist rhetoric of the era, the point here is that corporations fundamentally rely on the stability of the nations in which they operate. Civil unrest, weak legal institutions, are bad for business. Or, as Matt Levine put it a few years ago:
If the president can, without consulting the courts or Congress, banish U.S. lawful permanent residents, then he can do anything. If there is no rule of law for some people, there is no rule of law for anyone. The reason the U.S. is a good place to do business is that, for the last 228 years, it has built a firm foundation on the rule of law. It almost undid that in a weekend. That’s bad for business.
So it isn’t surprising that business leaders have offered some forceful condemnation of recent efforts by some Republicans to subvert the results of the presidential election. Before January 6, the US Chamber of Commerce stated, “Efforts by some members of Congress to disregard certified election results in an effort to change the election outcome or to try a make a long-term political point undermines our democracy and the rule of law and will only result in further division across our nation.” Other business leaders signed a statement to the same effect.
After the President of the United States incited an attack on Congress in hopes of overturning election results, the Business Roundtable stated that “elected officials’ perpetuation of the fiction of a fraudulent 2020 presidential election is not only reprehensible, but also a danger to our democracy, our society and our economy.” The National Association of Manufacturers called for Vice Pence and the Cabinet to invoke the 25th Amendment and remove Trump from office, and the President of the American Petroleum Institute was quoted in the Washington Post saying that Trump was “unworthy of the office of being president.”
Beyond mere rhetoric, there’s been chatter about withholding campaign contributions from politicians who continue to provoke political instability. According to a director of Merck and Morgan Stanley, “Respect for the rule of law underlies our market economy.”
To be sure, there is some question as to how committed business leaders will remain to this stance. Business leaders have supported Trump throughout his presidency, distancing themselves during controversies only to re-embrace him when he cut taxes or regulations.
In a time when we debate whether corporations suffer from a “short-term” bias, trading social stability for favorable regulatory treatment may the ultimate expression of short-term thinking. Or, as David Gelles wrote in the New York Times, “[M]oney has a short memory.”
Meanwhile, Axe Body Spray would simply like to be removed from this narrative.
We'd rather be lonely than with that mob. AXE condemns yesterday's acts of violence and hate at the Capitol. We believe in the democratic process and the peaceful transition of power. https://t.co/vX727ZfvS8— AXE (@AXE) January 7, 2021
Saturday, January 2, 2021
I’ve previously written about Shari Redstone and the controversies surrounding Viacom and CBS; this week, VC Slights kindly gave me something new to blog about when he denied defendants’ motion to dismiss shareholder claims associated with the Viacom/CBS merger.
The CliffsNotes version is that due to a dual-class voting structure, Shari Redstone was the controlling shareholder of CBS and Viacom, and for several years fought to combine the two companies. Her dreams were finally realized in 2019 when the two merged in a stock-for-stock deal. Former Viacom shareholders sued, alleging that this was a transaction in which a controlling stockholder – Redstone – stood on both sides, and that the deal sold out the Viacom shareholders to benefit CBS and Redstone.
Normally, of course, deals in which a controlling stockholder has an interest are subject to entire fairness scrutiny unless they are cleansed in the manner prescribed by Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). Notwithstanding the failure to employ those protections here, the defendants creatively claimed that business judgment review was appropriate – and moved to dismiss on that basis – arguing that mere presence on both sides does not trigger heightened scrutiny; instead, plaintiffs must additionally show that the controller received a nonratable benefit, which did not happen in the CBS/Viacom merger.
To me, that’s kind of redundant; by definition, standing on both sides of a transaction means that the controller received something not available to the minority stockholders. In this case, Redstone was able to trade her CBS stock for shares in the combined entity – a benefit that Viacom stockholders did not share. (Well, okay, probably some Viacom stockholders did, but that’s a whole ‘nother issue I’ve talked about pretty endlessly).
VC Slights, however, was unsatisfied with leaving things there, perhaps because it begs the question why Redstone would have favored CBS over Viacom in the exchange ratio. And the answer to that, according to the plaintiffs, was because Redstone wanted Robert Bakish at Viacom to head the combined entity, and a favorable-to-CBS exchange ratio was the price that the CBS board demanded for installing him. Normally, it might be reasonable to trade merger consideration for a particular governance arrangement, so plaintiffs further argued that this arrangement was unfair to the Viacom stockholders because Bakish wasn’t worth the price. Redstone wanted him in place for personal reasons (to cement her control by installing an ally).
In any event, all of this left Slights with the question whether (1) standing on both sides is enough to trigger fairness scrutiny absent a nonratable benefit to the controller, and (2) if not, did plaintiffs allege enough of one?
What’s interesting here?
First, though Slights chose not to decide whether entire fairness must always apply when a controller stands on both sides, in discussing the question, he had something of an intriguing footnote. He wrote:
I note that Viacom and CBS’s dual-class structures, whereby NAI possessed more than 80% of the voting power but faced only 10% of the economic risk in both companies, commends Plaintiffs’ “mere presence” argument for careful consideration in this case. See David T. White, Delaware’s Role in Handling the Rise of Dual-, Multi-, and Zero-Class Voting Structures, 45 Del. J. Corp. L. 141, 153–54 (2020) (positing that in dual-class structures, “the owners of the majority voting rights in these companies are less concerned when riskier moves fail as compared to their counterparts at ‘one share-one vote’ corporations”); Lucian A. Bebchuk & Kobi Kastiel, The Perils of Small-Minority Controllers, 107 Geo. L.J. 1453, 1466 (2019) (observing that “small-minority controllers are insulated from market disciplinary forces [in dual-class companies] and thus lack incentives generated by the threat of replacement, which would mitigate the risk that they will act in ways that are contrary to the interests of other public investors”); id. (“[D]ualclass structures with small-minority controllers generate significant governance risks because they feature a unique absence of incentive alignment.”).
As we all know, dual class share structures are increasingly popular, and concerns have been raised that they present a challenge to Delaware corporate doctrine, which assumes that stockholders have economic incentives proportional to their interests and that a functioning market for corporate control justifies a deferential judicial stance. I could of course be overreading the footnote, but to me it suggests a hint of a step toward Delaware developing differential scrutiny for disputes involving dual-class shares, especially since the Note he cites by David White argues precisely that the business judgment rule is inapposite in dual-class cases.
Second, after concluding that Redstone’s personal interest in consolidating her control was a sufficient nonratable benefit justifying entire fairness scrutiny, he further held that plaintiffs had stated a claim against the controller for breach of fiduciary duty. But that left the question whether plaintiffs had also stated a claim against the directors on Viacom’s special committee for breaching their duties by, essentially, bowing to Redstone’s demands.
Now the interesting thing here is that plaintiffs did not allege that the Viacom directors were interested in the transaction themselves; the entire basis for the allegations of disloyalty arose from their obedience to Redstone.
Thus the question: Assuming plaintiffs have alleged facts to suggest a transaction was unfair due to a conflict, can they state a non-exculpated claim for breach of fiduciary duty against disinterested directors who were involved with that transaction, solely due to their dependence on the person with the conflict?
To answer that question, Slights quoted In re Cornerstone Therapeutics, Inc. Stockholder Litigation, 115 A.3d 1173 (Del. 2015):
To state “a non-exculpated claim for breach of fiduciary duty against an independent director protected by an exculpatory charter provision,” Plaintiffs must allege “facts supporting a rational inference that the director harbored self-interest adverse to the stockholders’ interests, acted to advance the self-interest of an interested party from whom they could not be presumed to act independently, or acted in bad faith.”
Cornerstone did say that, ‘tis true, but it still begs the question whether mere lack of independence is enough, or whether something more is required. (VC Glasscock asked that question in connection with a dispute over Oracle’s acquisition of NetSuite, and sought additional briefing on the matter. Which was never filed; the plaintiffs voluntarily dismissed their claims against the relevant defendants.)
Because here’s the thing. There’s dependence, and there’s dependence. There’s director dependence that comes from essentially agreeing to work for the controller rather than to work for the corporation, and there’s director dependence that comes from, you know, being unconsciously biased to favor a friend. That’s particularly true today, since Leo Strine worked so hard to expand the concept of director dependence to include “mutual affiliations” that would make it “difficult to assess [a person’s] conduct without pondering his own association with [that person],” In re Oracle Corp Deriv. Litig., 824 A.2d 917 (Del. Ch. 2003), and “relationships [that] give rise to human motivations compromising the participants’ ability to act impartially toward each other,” Sandys v. Pincus, 152 A.3d 124 (Del. 2016). Acquiescing to a controller’s demands comes very close to a “conscious disregard” for the director’s duties, or an intent to “act with a purpose other than that of advancing the best interests of the corporation.” Stone v. Ritter, 911 A.2d 362 (Del. 2006). Simple lack of objectivity, though, is much more like a good faith failure to recognize the flaws in one’s own judgment.
Which is why it is not obvious that there’s a blanket rule that dependence, alone, states a claim for disloyalty.
That said, Slights elided this issue, which he could do successfully because, although he framed his analysis in terms of director “dependence,” he actually found that plaintiffs had alleged a more serious kind of dependence – a “controlled mindset,” whereby they simply worked to advance Redstone’s goals. And that, coupled with other allegations about their relationship to Redstone, was enough to “plead reasonably conceivable breaches of the duty of loyalty.”
Third, the final interesting data point in Slights’s examination of director independence had to do with the legal significance of the directors’ fear that Redstone would fire them if they failed to do her bidding. Now, the doctrine is sort of confused when it comes to directors’ fear of being removed by a controller – in the context of derivative lawsuits, it’s not grounds for a finding of dependence unless the directors have a personal need to remain on the job; in the context of cleansing a controller conflict, we assume generally that directors fear removal.
Here, though, the question was whether fear of removal was enough to create dependence such that it suggested disloyalty on the directors’ part – which is a whole ‘nother question (one which, I would think, might actually raise the bar for a finding of dependence). And to answer that, Slights said that while he would not generally assume directors are dependent simply because they serve at the pleasure of the controller, it was not necessary for the plaintiffs to allege that these directors had an especial need for their positions in light of Redstone’s specific history of threatening to remove board members at Viacom and CBS who bucked her authority. The fact that they labored under that realized threat created an inference of dependence.
So takeaway here? The definition of dependence and its legal significance shifts across contexts – and depending on how the dual-class case law shapes up, the same may turn out to be true of control.
Saturday, December 26, 2020
The backstory: In the wake of WeWork’s collapsed IPO, SoftBank – which was one of WeWork’s significant investors – agreed to buy additional equity from the company, to complete a tender offer for a large amount of WeWork’s outstanding equity, and to lend WeWork $5.05 billion. It ended up buying the equity and the debt, but the tender offer fell through. At that point, WeWork – on the authority of the 2-person Special Committee who had negotiated the SoftBank deal – filed suit against SoftBank for breaching its obligations under the contract. The Board of WeWork – by then consisting of 8 people: the 2 members of the Special Committee, 4 others designated by and obligated to Softbank, and 2 more with SoftBank affiliations – appointed two new, ostensibly independent directors to serve as a new committee to investigate the litigation. One of the Special Committee members objected to the appointment; the other abstained from the vote.
The new committee was charged with determining whether the Special Committee had authority to sue SoftBank. To the utter shock of absolutely no one, they concluded that, in fact, the Special Committee had no such authority, that the Special Committee could not continue the lawsuit due to certain conflicts, and that in any event continuing the lawsuit was not in the best interests of the company. Critically, one of the conclusions that the new committee reached was that WeWork – the company – had little to gain from the litigation because it was the tendering stockholders, and not the company, who would benefit from the completion of SoftBank’s tender offer. Thus, the new committee sought to terminate the litigation. Bouchard was therefore confronted with warring committees, and had to decide whether the litigation against SoftBank would continue.
Probably the least interesting aspect of Bouchard’s decision was his determination that the test of Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) – originally developed to determine the propriety of allowing a special committee to terminate derivative litigation – would be used to evaluate the new committee’s decision here. That test requires that the court evaluate whether the new committee was independent acted in good faith, and conducted a reasonable investigation of the issues. Assuming it did so, the court must evaluate whether in its own “business judgment” the motion to terminate the litigation should be granted.
Here, Bouchard held that assuming the new committee was independent and acted in good faith, its investigation was not reasonable, because it ignored several facts that suggested the Special Committee had the authority to litigate against SoftBank and did not properly weigh the benefits against the burdens of completing the litigation. Bouchard also held that under Zapata’s second prong, in his judgment, the litigation should continue. Thus, he refused to allow the new committee to terminate the lawsuit.
In a companion opinion, he evaluated SoftBank’s motion to dismiss the WeWork/Special Committee complaint against it. Among other things, he held that WeWork had standing to sue over the failed tender offer, even though – as the new committee had also emphasized – the proceeds of the tender offer would go to tendering stockholders and not to the company itself.
What stands out here?
First, though Bouchard said he had “no reason to doubt” the good faith and independence of the new committee, I am not operating under such constraints. The 2-man committee was appointed for a two month term, for which each was paid $250K, and the expected outcome of their investigation was undoubtedly known to each of them. As Bouchard pointed out, they acted under significant constraints: not only were they on a clock, their limited mandate meant they could not, for example, take control of the litigation themselves and thus eliminate any purported conflicts under which the Special Committee acted. Truly independent directors, who were acting in good faith, might have refused such a charge, but these directors had no such qualms, and they reached exactly the conclusions that their patrons expected of them.
The entire circumstances of their appointment should, I would think, raise questions about their good faith and independence, and honestly, I wonder how often courts are willing to take at face value the conclusions of directors who are appointed for a particular purpose in the expectation they will reach a particular result. For example, I recall In re Oracle Corp. Derivative Litig., 824 A.2d 917 (Del. Ch. 2003), where two new ostensibly independent board members were appointed for the sole purpose of investigating claims against the incumbent board and concluded (again, shockingly) that the claims had no merit. The court decided – controversially – that the new board members were not independent, but did so because of preexisting ties to the company, and not because of the circumstances of their appointment.
There have previously been studies of how often board special committees conclude that derivative litigation against defendant board members has merit, and usually (but not always), they recommend dismissal. But what has not been studied, as far as I know, is how often new directors are appointed to create a special committee, whether they are more likely to recommend dismissal than incumbent directors, and whether courts are more or less likely to take their recommendations seriously. It’s possible sample sizes are just not big enough to draw conclusions, but I personally would be interested in an analysis of how new directors differ from incumbent directors in terms of their conclusions and/or the terms of their appointment.
I also note this: Delaware courts start with the presumption that corporate directors are so conscious of their fiduciary duties and so constrained by reputational concerns that they would not lightly betray their obligations for the crass material benefits that a board position can provide. But if that’s going to work, reputations have to mean something, and once damaged, they should not lightly be rehabilitated. Which is why I was so concerned by VC Zurn’s opinion in Rudd v. Brown. There, the plaintiffs alleged that an activist shareholder appointed a compliant director to a company’s board in order to force a merger. The plaintiffs claimed that this particular director lacked independence, because he had developed a sort of gun-for-hire reputation: activists had repeatedly appointed him, knowing he would champion acquisitions they favored. Zurn rejected the argument in a footnote:
Plaintiff also asserts in briefing that Brown had “a long history of being appointed to companies’ boards to push a merger or acquisition for short-term profit, including other companies that Engaged had targeted for a sale in the past.” Pl.’s Answering Br. at 37. Insofar as Plaintiff asserts that this gives rise to conflict, that assertion fails. Plaintiff provides no support for the proposition that a director is conflicted purely by virtue of his track record, and I am aware of none.
With this kind of precedent in hand, the newly-appointed WeWork directors had no worries that they were accepting a quarter-million dollars at the expense of their reputations with respect to future opportunities. But what if they had such concerns? What if appointing stockholders, as well, had to worry about directors’ past history of compliance? What if a past history of noncompliance helped burnish directors’ credentials as independent monitors? Wouldn’t that create a better system, where courts and minority stockholders had more faith in the special committee process?
Second, there’s the standing/harm issue. Both of Bouchard’s opinions – the one dealing with the new committee’s attempt at dismissal, and the one dealing with SoftBank’s dismissal motion – had to address the argument that WeWork the company was not harmed by SoftBank’s abandonment of the tender offer, since it was the individual stockholders, and not the company, who missed out. And this interests me because, in a roundabout way, it touches on the issue I raised a couple of weeks ago – namely, when a merger agreement falls through, is the harm to selling stockholders direct or is it derivative?
In this case, the new committee and SoftBank argued that the tendering stockholders did not have a direct claim against SoftBank for breach of contract because they were not parties to SoftBank’s contract with WeWork, and the contract itself specified there were no third party beneficiaries. They also argued that if the tendering stockholders had a problem with the termination of WeWork’s litigation, their remedy was a derivative action. See Op. at fn 253. And then they argued that WeWork was not in fact harmed by the termination of the tender offer because WeWork would not have collected the proceeds.
That is … quite the paradox.
Rather than fully engage this thorny question of who suffers a harm from a terminated stock sale, Bouchard concluded that WeWork as a company suffered a harm because if SoftBank increased its equity stake, it would have more of an interest in monitoring WeWork’s performance.
That is, I have to say, unsatisfying. I mean, by that logic, SoftBank would have the greatest interest in monitoring WeWork’s performance if it was planning to buy the whole company. But we know from Revlon that when there’s an offer to sell the whole company for cash, it’s an endgame transaction – we’re not worried about the company’s future after that point; instead, we’re worried about the selling stockholders.
Anyway, all of this just highlights to me that it’s a blip in the law, and perhaps unresolvable. At the end of the day, in a shareholder-wealth-maximization world, all harms to the company matter because they are harms to stockholders, and the direct/derivative distinction is not a fact of nature, but a policy judgment as to which types of claims should be handled by the board in the first instance and which should not. So it stands to reason there wouldn’t be complete doctrinal coherence for the edge cases.
Saturday, December 19, 2020
I’ve previously discussed the common ownership problem in this space, and it basically comes down to the fact that common ownership – institutional investors who own stock in a broad swath of companies, including competing companies – is a mixed bag. On the one hand, it may incentivize investors to address systemic risks, like climate change. On the other, it operates in tension with a corporate governance framework predicated on shareholder wealth maximization, and may incentivize anticompetitive behavior to the extent investors care less about competition within an industry than maximizing profits for the industry as a whole. And on the third hand, the mere fact that this kind of vast power over our economic system is exercised by only a handful of private players – whether used for good or for ill – may represent a political/democracy problem.
As a result, there have been proposals to break up the power of the largest fund families. For example, Lucian Bebchuk and Scott Hirst have proposed that fund families be limited to investing in 5% of any particular target company.
That’s not what’s on the table, however.
In two new releases, the FTC has proposed reinterpreting the Hart Scott Rodino Act. That Act requires pre-review by the government whenever an acquirer proposes to obtain a significant amount of the voting securities of another company to ensure that the acquisition would not be anticompetitive. How significant? It’s a numerical test that varies every year. For our purposes, though, what’s critical is that the requirements are softened when the investor is obtaining the securities “solely for the purpose of investment,” meaning, the acquirer “has no intention of participating in the formulation, determination, or direction of the basic business decisions of the issuer.” Institutional investors like mutual fund companies are exempt from HSR reporting if they obtain securities “solely for the purpose of investment” and hold less than 15% of the target.
The FTC is looking into whether it should redefine what “solely for the purpose of investment” means. Among other things, it is considering whether shareholders who participate in activities like “discussions of governance issues, discussions of executive compensation, or casting proxy votes” should no longer count as passive (and related rulemaking would ensure that holdings are considered at the family, rather than fund, level).
What the FTC is looking into, then, is whether the ordinary engagement activities of index funds (or indeed, any shareholder) would make them active holders subject to the full range of HSR reporting. They would not be prohibited from acquiring stock in companies that compete with each other. They would simply be required to file paperwork with the government and await the outcome of a review before they could complete sizeable transactions. Unless, of course, they agree to cease all attempts to engage with management.
Now, in general, I support the FTC’s attention to the problem of common ownership. But I think the level on which we need to be thinking is consolidation in the asset management industry, and to some extent, the statutory framework may not be well-suited to deal with that problem. I.e., from a consumer/retail investor standpoint, there are more mutual fund choices than ever, and fees are often quite low, so there may not be room for regulators to attack the problem by claiming asset management consolidation is itself anticompetitive. Which means, regulators may be stuck with focusing on how asset managers deal with portfolio companies, and the HSR Act itself draws a distinction between acquisitions “solely for the purpose of investment” and acquisitions for other purposes, so it’s a natural avenue for the FTC to pursue.
That said, though much of the research into common ownership does not try to explain why or how common ownership results in anticompetitive behavior by portfolio companies, at least one explanation is that shareholders in such companies are passive – i.e., they don’t prod management to improve their competitive position, leading to a lack of competition.
If that’s right, narrowing the definition of “solely for the purpose of investment” could be the opposite of a solution. It could reward the very disengagement that facilitates the antitrust problem, and disincentivize mutual funds from participating in the kind of oversight that might prod greater competition.
Plus, I really cannot help but notice, it would also take mutual funds out of the business of policing executive pay, and ESG issues like climate change and diversity. Which would be well in keeping with the general Trump Administration hostility to these kinds of shareholder interventions.
Saturday, December 12, 2020
In 2018, a securities class action was filed against Allergan, alleging that the company concealed risks associated with breast implants. Boston Retirement System was appointed lead plaintiff, and the case survived a motion to dismiss. The court refused to certify the class, however, because of perceived misconduct by lead counsel Pomerantz. See In re Allergan PLC Sec. Litig., 2020 WL 5796763 (S.D.N.Y. Sept. 29, 2020).
Specifically, Judge McMahon held that Pomerantz had defied her original order appointing it as lead counsel by taking on another firm – Thornton – as a kind of shadow co-lead counsel. When Pomerantz was appointed, McMahon specifically rejected its request to name Thornton as co-lead because, in her words, “the involvement of multiple firms tends to inflate legal fees.” Despite her order, well:
Thornton has not only remained involved in this litigation, albeit under the rubric of “additional counsel,” but that it has effectively played the role of co-lead counsel – to the point that BRS’ corporate representative has testified under oath that Thornton’s responsibilities did not change at all in response to the lead plaintiff order. It is clear that Thornton has been fully involved in every aspect of this case to date. It has duplicated the efforts of Pomerantz by working on the CAC (it signed the pleading, so it has to have worked on it) and the motions to dismiss and for class certification (ditto), by joining in meet and confer sessions with defense counsel, participating in depositions, and by getting (and so obviously reviewing) all correspondence.
Moreover, I have learned, in connection with the prosecution of this motion, that the Pomerantz and Thornton firms have entered into an agreement to split any fee earned from the prosecution of this lawsuit almost down the middle. The agreement calls for the fee earned by lead counsel to be split with 55% going to Pomerantz and 45% to Thornton – a division that is so close to the firms’ original agreement of a 50-50 split, reached at a time when they anticipated being appointed co-lead counsel as to be a rather transparent substitute for co-lead counsel status. This amended agreement between the two firms was dated six days after BRS designated Pomerantz as lead counsel. The court was not informed about this arrangement, by BRS or anyone else.
This Court is not fooled by the rebranding of Thornton as “additional counsel.”
So, McMahon refused to allow Pomerantz and Boston Retirement System to continue to represent the class, and she reopened applications for lead plaintiff.
In response, one of the original movants – DeKalb County Pension Fund, represented by Faruqi & Faruqi – renewed its petition, along with several new movants, including Union Asset Management Holding AG represented by BLBG and the General Retirement System of Detroit represented by Abraham, Fruchter & Twersky.
On December 7, McMahon granted the DeKalb petition – despite the fact that other movants had larger losses, which is the typical requirement for lead plaintiff status – because she believed it would be improper to appoint a plaintiff who had not moved for lead status when the case was originally filed. And in her order, she specified:
DeKalb’s motion to have Faruqi and Faruqi appointed as lead class counsel is granted, on the condition that the Faruqi firm and none other serve as lead counsel and perform all services for which recompense may some day be sought.
Here’s the thing.
The way McMahon describes it, it does sound like Pomerantz and Thornton defied her original order, and that is certainly a legitimate grounds for refusing to appoint Pomerantz as class counsel.
But the fact is, in securities cases, plaintiffs’ firms always coordinate with other firms. Not necessarily as co-lead, but to perform tasks like routine discovery, or depositions in other cities, or smaller motion practice. Plaintiffs’ firms tend to have fewer attorneys than defense firms, and they often don’t have the staff to maximize the value of a large case without getting at least some additional assistance. And while I won’t deny that these arrangements, like any billing arrangement, may be abused, that isn’t necessarily the case; much of the work is legitimate, and takes some of the burden off the lead firm. When it comes to co-leads specifically, they may ultimately be valuable – I have no opinion on their general worth – but at least one way they may inflate fees is that every decision has to get approval from partners on both sides, which, while done in good faith, may add to the hours billed. But that isn’t a concern if additional counsel are brought on to handle discrete tasks.
Point being, even among the best plaintiffs’ firms, a complete bar on enlisting other firms could be burdensome.
Faruqi & Faruqi is … not among the best plaintiffs’ firms. In the merger context, they’ve been repeatedly accused of filing nuisance cases and settling for immaterial disclosures without engaging in meaningful discovery. Their recoveries in securities class actions, specifically, are less than spectacular.
That doesn’t mean they can’t prosecute the Allergan action effectively, but it does suggest they’d derive significant benefit from being able to obtain at least some assistance from other firms.
McMahon’s decision, in other words, may represent an appropriate rebuke to Pomerantz, but it is not in the best interests of the class.
And to me, it all highlights the fallacy of California Public Employees’ Retirement System v. ANZ Secs., Inc (which I blogged about here). There, the Supreme Court held that the filing of a securities class action does not toll the repose period for subsequently filed individual actions. Which means that any Allergan class member who trusted Pomerantz, but not Faruqi, to lead the litigation will have to worry about the clock if they want to file their own individual suit. And down the line, if Faruqi ultimately seeks to settle the action on the class’s behalf, dissatisfied class members can object but by then, they may not have any realistic chance of opting out; they’ll be stuck with whatever deal the court approves – a fact that will be known to both Faruqi and to the Allergan defendants at the outset of negotiations.
Friday, December 11, 2020
That's right - it's the moment we've all been waiting for. The Court has granted cert in Goldman Sachs v. Arkansas Teachers Retirement System. (Oh, I think there was some other stuff about not throwing out 20 million presidential votes in four states).
In any event, here are the questions presented by the petition:
(1) Whether a defendant in a securities class action may rebut the presumption of classwide reliance recognized in Basic Inc. v. Levinson by pointing to the generic nature of the alleged misstatements in showing that the statements had no impact on the price of the security, even though that evidence is also relevant to the substantive element of materiality; and (2) whether a defendant seeking to rebut the Basic presumption has only a burden of production or also the ultimate burden of persuasion.
Tuesday, December 8, 2020
Several weeks ago, I posted about VC Laster’s opinion in the busted Anthem-Cigna merger. Ever since then, I continued to mull the case and – in particular – I had questions about what might happen if the Cigna shareholders sued Cigna’s management over the deal’s failure. I planned to post about it as a hypothetical thought experiment, but then – what ho! – the Cigna shareholders did in fact file such a lawsuit – though, as I explain below, not quite the one I was contemplating.
Anyhoo, now I am finally getting around to posting my thoughts, though I’m almost hesitant to do so because I’m afraid the answer to my questions may be really obvious and I’m simply splattering my ignorance over the internet, but, well, that’s what blogging is for, so, here goes.
It all starts with Laster’s conclusions after the Anthem-Cigna trial. He found that Cigna’s CEO, David Cordani, intentionally tried to sink the deal by refusing to honor Cigna’s commitments under the merger agreement. And Cordani did so not out of concern for Cigna’s stockholders, but because he was resentful of not being chosen to lead to the combined entity. For example, after an agreement was struck – one that granted Anthem more board members and relegated Cordani to the COO role – Cigna’s chair congratulated Cordani on taking “the right step for our shareholders,” and Cordani responded, “Brain knows yes. Heart is heavy.” Later, Cordani emailed that though the deal was the “correct” outcome, he was “still struggling to accept it all.”
Sadly, that struggle was lost, which – according to Laster’s findings – led Cordani to embark on a campaign of sabotage. But Laster also concluded that the merger was doomed to fail for regulatory reasons regardless of Cordani’s behavior. And that failure was very expensive to Cigna’s stockholders; it cost them a 35% premium over market price.
What I’ve been trying to imagine, then, is what would happen if Cigna’s shareholders tried to sue Cordani for breaching his duty of loyalty, thus costing them valuable merger consideration. Leaving aside any issues about limitations periods, what result?
To begin, we have to determine whether this claim would be direct or derivative. Because if it’s derivative, we next have to ask if the stockholders would be estopped from bringing their claim in the right of the corporation. After all, Cigna litigated the case against Anthem, and took the position – on which it prevailed – that the merger was doomed to fail no matter what Cordani did. So, would Cigna (and thus any derivative plaintiff) now be bound by that finding? (Of course, the case is on appeal to the Delaware Supreme Court, so there could be a reversal, etc etc, but let’s assume the finding stands).
Preclusion would seem awfully unfair under these facts, because when Cigna litigated the Anthem case, its choices were made by its management – including Cordani – whose interests were not aligned with those of the stockholder-plaintiffs in my hypothetical loyalty action. Which really only suggests that perhaps this kind of claim should be direct in nature, because the harm isn’t to the corporate entity, but to shareholders themselves, in that they were unable to collect the merger consideration that should have been their due. But does that really state a direct claim?
In In re Coty Stockholder Litigation, 2020 WL 4743515 (Del. Ch. Aug. 17, 2020), a controlling shareholder increased its stake from 40% to 60% via tender offer, and when stockholders sued directly and derivatively (arguing certain process failures, and breach of a stockholders’ agreement regarding post-tender offer conduct), their claims were sustained. Defendants argued that any non-tendering stockholders were not harmed, since they continued to hold stock in a company with a controlling stockholder both before and after the deal. Chancellor Bouchard rejected that argument, recognizing as a direct harm the fact that the non-tendering stockholders – who held their shares throughout the transaction – “no longer have any expectation of receiving a control premium for their shares in a future buyout” (emphasis added).
Similarly, in Louisiana Municipal Police Employees’ Retirement System v. Fertitta, 2009 WL 2263406 (Del. Ch. July 28, 2009), stockholder plaintiffs were permitted to bring direct claims alleging that the company’s Chairman intentionally sank a merger with an entity that he controlled, which would have netted the shareholders a 41% premium over market price.
On the other hand, VC Zurn just decided Mark Gottlieb, et al., v. Jonathan Duskin, where shareholders alleged that the directors improperly rejected a merger offer with a 33% premium above the trading price. That case was brought directly, but Zurn determined that it should have been filed as a derivative action. See also In re NYMEX Shareholder Litigation, 2009 WL 3206051 (Del. Ch. Sept. 30, 2009) (“A breach of fiduciary duty that works to preclude or undermine the likelihood of an alternative, value-maximizing transaction is treated as a derivative claim because the company suffers the harm…”).
On the third hand, there’s the original Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), where an improper delay in receipt of merger consideration was held to state a direct claim – or would have, if the shareholders had a contractual right to payment, which they didn’t. Is that relevant here? Perhaps once the merger agreement was signed, Cigna shareholders had a contractual right – or something that would ripen into a contractual right – to consideration, which was personal to them, and Cordani interfered with that right by sabotaging the deal.
I don’t know how any of this would play out, and I’d be interested to hear any thoughts – especially if there’s some very obvious answer that I am missing. That said, when it comes to the actually-filed case against Cigna’s management, the plaintiff sidestepped all of these contortions. Instead of seeking damages in the form of lost merger consideration, the plaintiff claims that Cordani’s conduct caused the company to forfeit the reverse termination fee it otherwise would have obtained from Anthem due to the merger’s failure on regulatory grounds. That’s pretty clearly a derivative harm, and the best part is, the plaintiff would presumably be quite happy for estoppel to apply – because it matches up with Laster’s findings in the original trial quite nicely.