Friday, January 14, 2022

The battle’s done, and we kinda won

Okay, here I go, diving into Seafarers Pension Plan v. Bradway, recently out of the Seventh Circuit.  The appeal was argued in November 2020, which means this opinion took about 100 years to come down in Seventh Circuit time, and, well, to be honest, I’m not sure they worked out all the kinks.

I blogged extensively about the district court decision in this case here (although in the interests of full disclosure I should probably mention I spoke with the plaintiffs’ attorneys about the appeal, after the blog post went up).  The too-short version is that Boeing had a bylaw purporting to require that all derivative actions be filed in Delaware Chancery.  Plaintiffs filed a derivative action in federal court alleging Exchange Act claims under Section 14(a).  According to the plaintiffs, the Boeing defendants solicited shareholder votes in favor of their own reelection and compensation with false statements in the corporate proxy about the development of the 737 Max.  Boeing moved to dismiss in favor of Chancery due to the bylaw.   This was awkward because state courts, like Delaware Chancery, do not have jurisdiction to hear Exchange Act claims, and so enforcement of the bylaw in this case would be tantamount to a waiver of the claim.  But the Exchange Act prohibits predispute waiver of claims, and so the plaintiffs argued that the bylaw was invalid as applied here.

The district court ruled in Boeing’s favor and dismissed.  The plaintiffs appealed to the Seventh Circuit and, simultaneously, filed an action in Delaware Chancery alleging that the bylaw, as applied here, violated Delaware law.  The Delaware case (Docket No. 2020-0556-MTZ) was stayed in favor of the Seventh Circuit, and last week, the Seventh Circuit reversed and remanded, by a 2-1 vote, with Judge Easterbrook dissenting.

[Warning: Very long discussion under the cut, which will get unfortunately into the legal weeds at times, can’t be helped]

Continue reading

January 14, 2022 in Ann Lipton | Permalink | Comments (2)

Saturday, January 8, 2022

Corporate scienter: was that so hard?

Edit: After I drafted this post, the Seventh Circuit finally decided Seafarers Pension Plan v. Bradway.  I blogged about the district court decision in that case here, and maybe I will eventually find the strength to draft a full blog post on CA7’s new decision reversing the district court, but in case I don’t because I’m screaming on the inside and nothing matters anymore, here’s my tweet thread on the subject

Meanwhile, back to today's intended post: 


I’ve blogged here a couple of times about courts’ struggles to evaluate allegations of scienter against a corporate defendant in a securities fraud case, and in particular, the problem of conflating pleading standards with the substantive definition of scienter.

Which is why I was so happy to see the court get it right in Acerra v. Trulieve Cannabis Corp., 2021 WL 6197088 (N.D. Fla. Dec. 30, 2021); all the more impressively done because, as far as I can tell from the briefing, the plaintiff didn’t make much of a corporate scienter argument and instead focused on the scienter of individual defendants.

The essence of the plaintiffs’ claim was that a medical marijuana company misled investors about the quality of its grow facilities.  The court dismissed allegations based on certain statements for failure to allege falsity; when that was done, a single actionable statement remained, namely, that Trulieve’s website falsely represented that its products were “hand-grown and specially cultivated in a state-approved, climate-controlled environment to ensure purity and safety. We leave nothing to chance while letting nature do her work.”

At that point, the court turned to the question of scienter, and concluded that plaintiffs failed to show that the individual defendants – the company’s CEO and CFO – drafted or even knew about the website text; thus, the corporate defendant could not be held liable vicariously based on the officers’ misconduct.  But the court did not stop there; it added:

Trulieve could of course be held liable based on acts or omissions not just of the named individual defendants but also based on acts or omissions of another officer or employee, so long as the officer or employee acted with the requisite state of mind. But here, as in Mizzaro [v. Home Depot, Inc., 544 F.3d 1230 (11th Cir. 2008)], the plaintiffs have not alleged scienter of the corporate defendant based on the knowledge or intent of any other officer or employee. The second amended complaint does not allege the existence of any individual, whether known or unknown, who both drafted or approved the website’s “climate-controlled” statement and acted recklessly or with intent to defraud. And it is by no means obvious—there is no “strong inference”—that any such person exists. The second amended complaint gives no reason to believe any single person must both have been aware of the website’s precise language, on the one hand, and aware of precisely what kind of facilities were out in the field.

I don’t have an opinion on whether the court reached the right outcome on these facts, but the analysis is exactly what I’d hoped courts would undertake.  The court asked whether the complaint created a strong inference that any agent of Trulieve, acting with scienter, drafted the false statement; the court entertained the possibility that such an agent might not be a defendant, and might exist even if their identity was unknown to the plaintiffs at pleading; recognized that corporate liability might attach if such an agent did exist; but concluded that the complaint did not raise a strong inference of that possibility.

I’m so pleased.

January 8, 2022 in Ann Lipton | Permalink | Comments (0)

Saturday, January 1, 2022

The New Orleans academics and the $124 toothpaste

Honestly, the most interesting business news I've seen during this liminal time between Christmas and New Year's is this story from my local New Orleans paper.  Four academics - from Tulane, LSU, and the University of New Orleans - joined together to form a ... well, a gourmet toothpaste company.  Which apparently became quite popular, recommended by Gwyneth Paltrow and sold in Harrod's and luxury stores in Dubai. Three of the four founders are now suing the CEO for fraud and misuse of company funds:

the lawsuit says worrying signs were accumulating, including Sadeghpour's persistent refusal to move operations from his parents' home on 8th Street in Metairie, a few blocks from the Lakeway business complex, to offices rented in the BioInnovation Center on Canal Street.

When the board members would meet at Sadeghpour's house on Wednesdays, they started to get uneasy about the fact the company's sales stagnated after 2018 at the $1 million mark....The lawsuit says the other board members noticed an accumulation in Sadeghpour's home of Japanese pottery and other high-end art.

The lesson, apparently, is that if you're the CEO of a small business and you're spending company funds on personal luxuries, it's probably best not to hold board meetings at your home.  But, according to one the plaintiffs, "We wanted him to move this business out of his kitchen but he refused... It seems he wanted to have the convenience of walking down his stairs in his robe at his leisure and have his assistant go to the Whole Foods and get him breakfast every morning."

Happy New Year, everyone!

January 1, 2022 in Ann Lipton | Permalink | Comments (0)

Saturday, December 25, 2021

If it’s too good to be true…

In recent years, there’s been a lot of talk about the macro effects of consolidation in the asset management industry, whereby a handful of managers own stock in just about everything.  In particular, several scholars have argued that these massive investors “own the economy,” and therefore internalize any externalities generated by the antisocial behavior of an individual portfolio company.  Therefore, the theory goes, these firms have an interest in reducing sources of systemic risk, like climate change, or potentially racial inequality.  See, e.g., Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1 (2020); John C. Coffee, The Future of Disclosure: ESG, Common Ownership, and Systematic Risk; Jim Hawley & Jon Lukomnik, The Long and Short of It: Are We Asking the Right Questions? Modern Portfolio Theory and Time Horizons, 41 Seattle U. L. Rev. 449 (2018).

There were always some kinks in the theory.  Most obviously, concerns have been raised that asset managers encourage less competition among portfolio firms, to the detriment of customers and labor.  See, e.g., Miguel Anton, Florian Elder, Mireia Gine, & Martin C. Schmalz, Common Ownership, Competition, and Top Management Incentives; Zohar Goshen & Doron Levit, Common Ownership and the Decline of the American Worker.  I’ve written about how the theory sits uneasily with our concepts of corporate governance, and glosses over the fact that these investments are held in different funds which may not all have identical interests.

Still, law professors like myself find it attractive because at the end of the day, it provides a justification for more stakeholder-focused business practices without challenging the underpinnings of shareholder primacy or the structure of the modern corporation.  We get to have our cake and eat it too.  No wonder, then, that the Chair of MSCI said that ESG investing is a mechanism to “protect capitalism. Otherwise, government intervention is going to come, socialist ideas are going to come.”  At the end of the day, ESG investing is an incredibly mild intervention that leaves our corporate regulatory system intact.

Which is why two new papers, The Limits of Portfolio Primacy, by Roberto Tallarita, and Systemic Stewardship with Tradeoffs, by Marcel Kahan and Edward Rock, are so important.  Both take a hard look not only at the ways in which this theory is out of sync with current corporate governance standards, but also at more practical realities – namely, the actual investments of large asset managers, and the ways in which they do not, in fact, own the economy, while many of the worst corporate actors are beyond their influence.

And on that note … happy Christmas to everyone who celebrates (and to those of us who just enjoy the festive atmosphere)!  I hope everyone is having a wonderful (safe, healthy!) holiday season.

December 25, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, December 18, 2021

Punctilio of Honor Most Sensitive

Today I’m posting to call everyone’s attention to In re Kraft-Heinz Co. Derivative Litigation, decided by Vice Chancellor Will earlier this week.

This is a demand excusal case and there may be a lot that’s interesting about it but I’m focusing on one specific aspect.

Kraft-Heinz was 27% owned by Berkshire Hathaway, 24% owned by 3G (which had operational control), and 49% owned by public shareholders.  Berkshire and 3G each got to nominate 3 members of the 11 member board, and they had a shareholder agreement whereby they promised to vote for each other’s designees, and not take action to “to effect, encourage, or facilitate” the removal of the other’s designees.

Kraft-Heinz started to perform poorly and 3G sold 7% of its stake just before a disappointing earnings announcement.  Shareholders filed a derivative lawsuit alleging that 3G traded on nonpublic information, naming 3G and its board designees as defendants, and the critical question was whether the 11-person board was majority disinterested for demand purposes. That question, in turn, turned on whether Berkshire’s nominees – one of whom was a Berkshire director, one of whom was a director of several Berkshire subsidiaries and the CEO of one  – could objectively consider whether to bring a lawsuit against 3G. 

The plaintiffs alleged that Berkshire and 3G together formed a control group, but the court did not consider that relevant one way or another; i.e, whether they were or they weren’t, the critical question was the disinterestedness/independence of Berkshire’s board nominees vis a vis 3G, and that question did not turn on their control group status.

The court said the Berkshire members were disinterested and independent, notwithstanding the shareholder agreement.  Per the court, the agreement did not bind Berkshire not to sue 3G and its board nominees – only to refrain from removing them – and the Berkshire nominees were not themselves parties to that agreement anyway.   Plus, Berkshire Hathaway does not exactly need to rely on 3G to have access to investment opportunities.

Okay, so why is this interesting?

Conceptually, it’s not dissimilar from the problem that faced the court in Patel v. Duncan, which I blogged about here.  That case also involved a publicly traded company controlled by two private equity firms that had a shareholder agreement to select 60% of the board nominees.  One of the firms engaged in an interested transaction with the company, and the way the case was framed, the critical question was whether the firms jointly consisted a control group such that the transaction could only be cleansed via MFW procedures, but substantively what it came down to was whether the court believed that the first PE firm could be objective about transactions in which the second firm had a financial interest.  The court believed objectivity was possible, and though the plaintiff argued that the two firms had a tacit quid pro quo – where each would approve the other’s interested transactions – the court found no evidence of such an agreement other than the existence of an interested transaction with the first firm, approved a year earlier, and dismissed the case.

As I blogged at the time, shareholder agreements in publicly-traded firms are increasingly common, and one very popular structure involves agreements among PE firms with respect to a company that they take public but retain continuing control over.  Which means we can expect to see more questions arise concerning how disinterested one firm can truly be when it comes to matters involving its co-venturer.

I mean, sure, in one sense, each firm may have an incentive to police the behavior of the other (unless, as alleged in Patel, they have a joint agreement to loot the company), but if we take the more nuanced approach to dependence that the Delaware Supreme Court has recently pursued, it seems much more likely that one firm will try, within at least some limits, to placate  the other rather than allow disagreements to spill into litigation and boardroom friction, especially if they expect to do future deals together.

Vice Chancellor Will believed that Berkshire didn’t need 3G to do future deals – and so that would not be a factor in assessing Berkshire’s objectivity – but Berkshire’s brand is being a nondisruptive shareholder; the last thing it wants to do is get a reputation for public squabbles with co-investors.  Plus, 3G had substantive control of the company; Berkshire may have worried about its ability to find a replacement with whom it could also partner if 3G’s malfeasance were established.  And that doesn’t even get into the question whether VC Will correctly evaluated the effect of the shareholder agreement on the behavior of the Berkshire nominees (at least one of whom, as a Berkshire subsidiary CEO, is functionally a Berkshire employee).

Anyway, this is a problem that’s going to recur, which means Delaware needs to offer more considered guidance about the appearance of bias that may stem from shareholder agreements, and the legal consequences that follow.

December 18, 2021 in Ann Lipton | Permalink | Comments (2)

Saturday, December 11, 2021

Third Time's the Charm?

Whenever I want to complain about my boredom with blogging the latest developments in Arkansas Teachers’ Retirement System v. Goldman, I think to myself, at least I’m not as bored as Judge Crotty of the SDNY.  And Judge Crotty made that clear this week in his opinion re-certifying the class (for a third time).

The history, as I’ve previously blogged, was that plaintiffs alleged Goldman violated Section 10(b) with anodyne statements about its ethics and ability to manage conflicts among its varied client base, and these were revealed to be false in a few financial-crisis-era scandals about conflict-ridden CDO sales.  The plaintiffs’ theory was that Goldman had a reputation for managing its conflicts well, which was baked into the stock price, and these statements maintained its stock price at those inflated levels, until the truth was disclosed and the stock price dropped.  Goldman’s main defense has been that the statements were too vague, generic, content-less, etc to matter to investors.  It tried that argument on a motion to dismiss, and then a motion for reconsideration of the motion to dismiss, and then on a motion for interlocutory appeal of the denial of the motion for reconsideration, and then at class cert, and then on an appeal of the class cert decision to the Second Circuit – where it finally won a remand! – and then at the remanded class cert hearing, and then before the Second Circuit again on an appeal of the second class cert opinion, and then before the Supreme Court – where it won again! – and then on remand back to the Second Circuit – score! – and then back to Judge Crotty where … this week, it lost again.

Throughout all of this, Goldman’s argument morphed.  At first, the argument was that its statements were so vague that they could not, as a matter of law, have impacted stock prices.  When that failed before Judge Crotty, Goldman instead offered factual evidence via expert reports that these particular statements were so generic that shareholders ignored them.  When Judge Crotty rejected the expert’s evidence as unpersuasive, Goldman went back to arguing before the Second Circuit that the statements were legally incapable of impacting stock prices.  By the time the case was actually before the Supreme Court, the argument was that the Second Circuit had erroneously held that genericness cannot be part of the factual inquiry when examining price impact, and therefore the Circuit had failed to take into account the generic nature of the statements, in addition to other factual evidence, when it reviewed Judge Crotty’s class cert decision.  The Supreme Court held that it was not clear whether the Second Circuit had so held – and if the Second Circuit had held that, it shouldn’t have have – and kicked it back down.

The Supreme Court’s decision was … maddening.  As I blogged at the time, it seemed to shift the burden of proof to plaintiffs in cases involving “price maintenance” theories, and introduced loss causation into the class certification decision – even though in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011), the Court had held that loss causation should not be considered at class certification.

Which is what Judge Crotty had to deal with when the same evidence was before him, again, and his exasperation was clear.

First, he emphasized that nothing in any of the appellate opinions had overruled his prior factual determinations about the strength of the expert evidence, and he reiterated those findings: namely, that Goldman’s price drops were associated with revelations of the truth about its conflicts, that market commentary at the time reiterated the importance of Goldman’s ability to manage its conflicts, and that the revelations that caused the price drops were far more specific and credible than earlier purported disclosures that had not caused any price drops.  As he put it, “Since the updated direction from the Supreme Court and Second Circuit has no bearing on these factual findings, the Court here reiterates, and restates, its grounds only in brief.” Op. at 17.

Second, pace Vivendi, he held that to determine whether Goldman’s statements maintained the artificial inflation in its stock price, the proper comparator was not what would have happened if Goldman had remained silent, but what would have happened if it had told the truth.  If it had told the truth about its inability to manage conflicts, investors would have devalued the stock.

Third, he even looked to what would have happened if Goldman had remained silent, and found the statements still maintained the stock price because “in a marketplace where, according to Defendants, dozens of Goldman competitors and other blue-chip corporations routinely make statements ‘indistinguishable’ from some of the alleged misstatements, it seems unlikely that Goldman's conspicuous failure to conform-…would be irrelevant to investors.”  Op. at 24-25.

I’ve made that argument before; in my paper, Reviving Reliance, I said:

The articulated rationale for many puffery holdings—that the statements are too similar to those offered by other companies to carry much weight in the minds of investors—is not only unpersuasive, but is something of a self-fulfilling prophecy. Corporations frequently make disclosures similar to those of other companies, from representations that their financial statements comply with Generally Accepted Accounting Principles to declarations that a merger price is “fair” to shareholders, and yet none of these statements are declared to be puffery on grounds of ubiquity. Moreover, in a world where computer programs analyze corporate SEC filings so as to instantly trade on even minute data changes, if a corporation did not, for example, proclaim itself to exhibit “financial discipline” when all of its competitors did, investors would likely take the absence seriously.  As
a result, when courts treat all such statements as equally meaningless, they provide no incentive for corporations to refrain from making them when they are no longer truthful.

Along these lines, as I pointed out in a previous post, Goldman was making statements about its integrity and conflicts management long before the class period – at a time when, by hypothesis, the statements were true.  Can you even imagine how the market would have reacted if those statements suddenly disappeared?

Judge Crotty went further, though.  Displaying extreme skepticism of the idea that corporations generally issue happy talk that has no effect on investors, he added: “This Court is hard-pressed to understand why statements such as those at issue here would have achieved such ubiquity in the first place were they incapable of influencing (including by maintaining) a company’s stock price.” Op. at 24.

And now I have to pause and note how radical Crotty’s holdings are, even if, ahem, they make perfect sense.  That’s because the inquiry into materiality/puffery/genericness what-have-you in securities cases is usually divorced from any honest attempt to assess the role these statements actually play in the market; as I’ve repeatedly blogged, materiality inquiries often seem more like backdoor attempts to distinguish claims based on poor governance from claims based on fraud than empirical evaluations of evidence. (Which is also a point I’ve also made in both Reviving Reliance and my paper Fact or Fiction: Flawed Approaches to Evaluating Market Behavior in Securities Litigation.)  Quoting, ahem, me, “what we call ‘harm’ and ‘damage’ for the purpose of private securities fraud lawsuits have become so artificial that it no longer seems as though we’re even trying to measure the actual real-world effects of fraud.”; see also Fact or Fiction (describing “the cavernous distance between judicial measures of harm and the underlying reality”).  So it is genuinely striking to see a judge examine actual market behavior instead of pursuing some broader policy regarding what Section 10(b) ought to be about.

Which is why I fully expect Goldman’s next 23(f) appeal to argue that Crotty’s analysis contradicts the Supreme Court because he treated genericness as a point in favor of price impact instead of against it.

Anyway, the final striking aspect of Judge Crotty’s opinion is this:  Even though technically, plaintiffs are meant to have a presumption of price impact, and defendants have the responsibility of rebutting that presumption, Crotty took the Supreme Court at its word and seemed to place an initial burden on plaintiffs to establish a connection between the final stock price drop and the earlier false statements in order to win that “presumption.”  To wit, he began his analysis with the heading “Plaintiffs’ Persuasive Evidence of Price Impact,” explained that evidence, and concluded, “The Court credits Dr. Finnerty’s conclusions, and finds that Plaintiffs have presented compelling evidence that the alleged misstatements in fact impacted Goldman's stock price.”  Op. at 16-17.  Only after finding plaintiffs had established price impact did he turn to defendants’ evidence, concluding they had “failed to rebut the Basic presumption… Neither [of defendants’ experts] persuasively undermine these findings”  Op. at 17.

See what he did there?  He made the plaintiffs prove price inflation and only then turned to whether defendants’ had met their burden of rebuttal, all while paying lipservice to the idea that there was some kind of “presumption” in plaintiffs’ favor at work.  And I can’t say he’s wrong, precisely, because that was in fact the Supreme Court’s suggestion.

More than anything else, though, what offends me aesthetically about this case and makes me want to scream “IT’S NOT FAIR!!” at the top of my lungs – before I remember that we live in a cold, cruel world and fairness is a fairytale – is how Goldman was permitted to change its argument before the Supreme Court in order to revive a claim that it had made before the district judge, lost, and then abandoned on appeal – and instead of dismissing the writ as improvidently granted, the Court rewarded Goldman for that bait-and-switch with yet another bite at the apple. 

The other notable thing: The factual evidence, at least as Judge Crotty describes it, presents a pretty compelling case that yes Goldman’s statements mattered: Goldman did have a strong reputation, the truth did damage that reputation and make people worried for Goldman’s future, and the statements at the very least maintained that reputation because Goldman couldn’t suddenly have been silent on the topic without raising questions.  And that’s evidence we probably would never have seen but for Crotty’s denial of the original motion to dismiss, when another judge likely would have granted it.  Which you would think would make future courts hesitant to casually dismiss claims based on a seat-of-the-pants judgment that no reasonable investor would have taken certain statements seriously.

But it won’t.

December 11, 2021 in Ann Lipton | Permalink | Comments (2)

Saturday, December 4, 2021

Third Party Reliance

This case came out of the Second Circuit a couple of months ago, and it’s still bugging me, so it’s the subject of today’s blog post.  I speak of Loreley Financing (Jersey) No. 3 Limited v. Wells Fargo Securities, LLC, 13 F.4th 247 (2d Cir. 2021)

The case itself is one of the last arising out of the financial crisis, featuring familiar names like Magnetar and Wing Chau.  And the allegations were standard for cases of this type:  Loreley, a German investment vehicle, invested in CDOs, and alleged that the structuring bank – Wachovia at the time, Wells Fargo as its successor – did not tell it the truth about how the assets were selected.  Loreley claimed it was defrauded under New York common law (not Section 10(b), because if you’re not relying on the fraud-on-the-market theory and you’re not trying to bring claims as a class, state fraud law will almost always be more favorable).  The district court granted summary judgment to Wells Fargo, and Loreley appealed. 

Before the Second Circuit, there were two issues.  The first concerned whether there were any misrepresentations at all; the court agreed that there were arguably at least some misrepresentations alleged with respect to one of the CDOs.  The second concerned the element of reliance, because Loreley itself did not actually communicate with Wachovia and did not receive any false information.  Instead, its investment advisor did. 

Loreley was actually formed by the investment advisor, IKB.  And IKB was in charge of vetting assets for the fund.  IKB presented its recommendations, and Loreley made the actual purchase without doing any independent research.  Thus, it was IKB – not Loreley – that received the false information, and Wells Fargo argued that for that reason, Loreley itself did not “rely” on any misrepresentations under New York law.

Shockingly, to me, the Second Circuit held in favor of Wells Fargo.  The court, summarizing its understanding of New York law, held that  “Loreley—which did not communicate directly with the defendants—bases its fraud claims on IKB’s reliance. Yet New York law does not support such a theory of third-party reliance....The reliance element of fraud cannot be based on indirect communications through a third party unless the third party acted as a mere conduit in passing on the misrepresentations to a plaintiff.”

That is … nutty.  No fund ever reviews information directly; they always rely on investment advisors who act on their behalf.  That’s the whole point; funds themselves are shells, with the real work being done by an investment advisor.

But instead of recognizing that fact, the Second Circuit made a big deal out of the orthogonal point that IKB conducted significant independent analysis before passing its recommendation on to Loreley.  That’s not entirely irrelevant, for sure. If IKB’s recommendation was based on its own analysis and not the fraud, then IKB didn’t rely, and IKB’s nonreliance is imputed to the funds.

But that’s not what the Second Circuit held.  The Second Circuit’s point was that Loreley itself never received the false information because it only received IKB’s analysis, and from that concluded that even if IKB’s analysis on Loreley’s behalf was in fact influenced by the fraud, Loreley did not rely on that fraud itself.  If that is the rule, no fund would ever be able to bring a fraud claim.

For example, off the top of my head, consider the Volkswagen case, which I blogged about here.  Since that post, the Ninth Circuit on appeal rejected the district court’s conclusion the case involved omissions, and therefore held that Affiliated Ute’s presumption of reliance would not apply, but as relevant here, in that case, it was investment advisor, not the institutional investor itself, who reviewed the materials. 

After all, that’s part of the reason why qualified institutional buyers and accredited investors are permitted to invest in unregistered offerings; we assume wealthy investors are capable of hiring professional advisors who will vet things for them. 

The Second Circuit claimed that its decision was dictated by Pasternack v. Lab. Corp. of Am. Holdings, 27 N.Y.3d 817 (2015).  In that case, the plaintiff had to get a drug test to maintain flight certification and he alleged the lab misrepresented the results to the FAA.  When he couldn’t get his certification, he sued the lab for fraud.  In that context, the New York Court of Appeals held there was no reliance. 

The Second Circuit also cited Securities Investor Protection Corp. v. BDO Seidman, 95 N.Y.2d 702 (2001), which presented a similar kind of scenario.  BDO Seidman audited a broker-dealer and communicated its financial condition to the NASD.  The NASD was charged with, among other things, notifying SIPC of any problems with a regulated broker-dealer.  As it turns out, BDO Seidman gave the firm a clean audit even though the firm was engaged in shenanigans, and the firm ultimately went bankrupt.  SIPC was then forced to cover the claims of the broker-dealer’s customers, and it sued BDO Seidman for fraud and negligent misrepresentation.  The court held that because the audits were not performed for SIPC, and were never communicated to SIPC, SIPC had not relied on the audits.

Both Pasternak and SIPC present common problems in fraud claims: the plaintiff didn’t rely on the false information, but someone else did, and that third party reliance ended up harming the plaintiff.  It comes up a lot for short-sellers, for example: The defendant lies publicly about its financial condition, and the short-seller knows it’s lying, but because the market is fooled, the short-seller is still forced to cover its position at inflated prices.  Can the short-seller satisfy the element of reliance in a Section 10(b) claim?  That’s something of an unsettled question, see discussion in Christine Hurt & Paul Stancil, Short Sellers, Short Squeezes, and Securities Fraud

In fact, in a way, all of fraud-on-the-market is a kind of third party reliance.  The plaintiff did not necessarily hear the lie, but the market did, and that affected the plaintiff. 

But in these scenarios, the “market” is not acting on the investor’s behalf.  Just like NASD was not acting on SIPC’s behalf, and the FAA was certainly not acting on Pasternak’s behalf.  It is therefore a very different kind of problem than the one presented in Loreley Financing, where Loreley employed a financial advisor, the advisor relied on a misrepresentation, and then made a recommendations based on that misrepresentation.  The financial advisor should not even count as a third party in this context – the financial advisor is acting on Loreley’s behalf and therefore is an extension of Loreley itself.  It’s the “on Loreley’s behalf” that’s the key here and it’s a distinction that the Second Circuit completely elided.

Now, to be sure, IKB did not have discretion to actually make the investment decision for Loreley; Loreley ultimately made the investment decision.  (There does not appear to be any information about how often Loreley rejected IKB’s recommendations).  And in the briefing, there was some skirmishing among the parties about whether IKB was technically acting as Loreley’s agent – Loreley said it was, Wells Fargo said it was not – but what’s notable about the Second Circuit’s opinion was that it did not care.  The court’s holding was not based on some kind of hypothesized distance between IKB’s recommendation and Loreley’s investment; the court accepted that IKB was hired by the funds to vet investments (and in fact was Loreley’s sponsor), and that still was not enough for the Second Circuit to impute IKB’s reliance to Loreley.


December 4, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, November 27, 2021

It's the time of year when there's a shortage of business news -

- but happily there's no shortage of news about holiday-themed shortages.

For starters, Christmas tree supplies are tight, and this is both a covid problem and a climate change problem:

The American Christmas Tree Association has said this year’s supply of real Christmas trees will be squeezed by the summer’s heat dome in the Pacific Northwest, while supplies of artificial trees, largely coming from China, will be affected by the same shipping and labor problems plaguing many industries.

And apparently some of the problems can be blamed on ... *squints* ... Lehman Brothers?

Hundley of the National Christmas Tree Association said there is one reason for the tighter stocks this year that has nothing to do with the pandemic or the world’s supply chain headaches: During the financial crisis of 2008, many growers didn’t have the capital to plant a lot of trees, and national plantings dipped.  “The previous financial crisis caused fewer to be planted, so we don’t have an oversupply right now. It’s a supply that matches demand,” he said. 

It also seems that covid has come for Santa:

The pandemic hit the Santa Claus community hard, for obvious reasons: Many of the men who play the role are at high risk in the covid-19 pandemic, because of their age. The Santa physique (see: "bowl full of jelly") tends to check off a not-so-nice list of potential co-morbidities, starting with a high BMI.

“Several hundred Santas and Mrs. Clauses, over the last 18 months, have passed away, and it’s just a tragedy,” says Allen, though he cautions that not all of those deaths may have been attributable to covid-19. Other Santas, wary of the risks of being around germy, potentially unvaccinated children, have decided to sit yet another pandemic holiday out, or retire.

Santa Tim Connaghan, who goes by the honorific “National Santa” for his role in major parades and as the Santa for Toys for Tots, surveys his brethren annually and reports that 18 percent of the surviving Santas are taking the year off. He is taking fewer bookings this year to spend more time with family....

Connaghan has deployed Santa’s wife in areas where no Santa can be found…. But, she, too, is in short supply.

Apparently, this means people have to accept stripped-down Santas without luxury add-ons:

Bryant signed a contract for $320 for two hours of a fake-bearded Santa — “If we wanted one with a real beard, it would have been like, a hundred dollars more.”

And then there's the most troubling situation of all:

A dire shortage in glass bottles is forcing some winemakers to let wine age in wooden barrels for too long, which can lead to the drink tasting "like a sawmill," Phil Long, the owner of Longevity Wines in Livermore, California, told Insider.

Long has cobbled together a supply of bottles by purchasing extra glass from wineries with some to spare, and has even resorted to buying bottles bearing another vineyard's name....

Chris Wachira, owner of Wachira Wines, said her business hasn't been able to send wine to members of their wine club because they don't have enough glass bottles to pour the wine into.

Happily, this is one crisis I know how to solve.

November 27, 2021 in Ann Lipton | Permalink | Comments (1)

Monday, November 22, 2021

JP Morgan Sued Elon Musk’s Tesla For Breach Of Contract: How Did I Predict It? - Lécia Vicente (Guest Post)

Friend-of-the-BLPB Lécia Vicente sent along the following post, which I thought our readers might find interesting, especially in light of the blog's prior posts on Elon Musk and his conduct (including those from Ann and me, like this one--citing to many others--and that one).  Enjoy!  Comment, as desired.  I have my own comments, which I will share in due course.

And (in this week of giving thanks) I offer gratitude to Lécia for bringing this post to us!  (You may remember that she guest blogged with us last December--almost a year ago.  Where did the time go?)


On November 6th 2021, Elon Musk polled his Twitter followers to determine if he should sell 10% of his stake in his company, Tesla. He wrote, “[m]uch is made lately of unrealized gains being a means of tax avoidance, so I propose selling 10% of my Tesla stock. Do you support this?”

On November 8th 2021, two days after Musk’s tweet, I tweeted the following question, "[c]an Musk actually be sued if he doesn’t follow through on his pledge to sell?” Initially, I was more concerned about securities law. Based on Musk’s tweets, shareholders might be misled to sell, meaning that Musk could be sued for misrepresentation. Similar scenarios of securities fraud involving Tesla and Elon Musk have happened before. In addition, Musk’s tweets could trigger claims of breach of contractual duties. A week after my tweet, on November 15th 2021, JP Morgan filed a complaint against Tesla for breach of contractual duties. I guess I predicted it.

Specifically, in JP Morgan Chase Bank, National Association, London Branch v. Tesla, Inc, JP Morgan is suing for the Tesla CEO’s tweet on August 7th 2018 when he stated “Am considering taking Tesla private at $420. Funding secured.” This statement came from the chair of Tesla’s board of directors and controlling shareholder. While the tone and seriousness of the announcement is debatable, JP Morgan took it seriously. Seriously enough to sue.

On February 27th 2014 and March 28th 2014, JP Morgan entered a series of agreements with Tesla in which JP Morgan would buy Tesla stock warrants at a specified “strike price.” Additionally, the warrants maintained an adjustment clause in case of an announcement of a significant corporate transaction involving Tesla, such as an acquisition. The purpose of the adjustment clause was to protect the parties from adverse economic effects. The 2021 Warrants expired between June and July 2021.

As explained in the complaint, in a Form 8-K filed on November 5th 2013, Tesla identified Elon Musk’s personal Twitter account “as a source of material public information about the company” and encouraged investors to review that account. The complaint also stated that:

Because the tweet violated NASDAQ rules requiring at least 10 minutes’ advance notice before a listed corporation publicly disclosed a going-private transaction, NASDAQ temporarily halted trading in Tesla’s stock following Mr. Musk’s tweet, evidencing that the exchange considered the tweet to constitute an announcement by the company itself.

After Mr. Musk’s tweet, Tesla’s Chief Financial Officer, its head of communications, and its General Counsel drafted an email—attributed to Mr. Musk—detailing the going-private plan. The email was sent to Tesla employees and published the same day on both Mr. Musk’s Twitter account and Tesla’s blog (which Tesla had also designated as a source of material public information about the company). In the email, and in a series of tweets responding to his Twitter followers, Mr. Musk elaborated on his plans to take Tesla private. He concluded in a tweet that “Investor support is confirmed. Only reason why this is not certain is that it’s contingent on a shareholder vote.”

That same day, in response to various inquiries from research analysts, Tesla’s head of investor relations confirmed that Mr. Musk’s tweet signified a “firm offer” to take Tesla private that was “as firm as it gets.” Specifically, she wrote in response to press inquiries about the tweet:

  • “I can only say that the first Tweet clearly stated that ‘financing is secured.’ Yes, there is a firm offer.”
  • “[A]part from what has been tweeted and what was written in a blog post, we can’t add anything else. I only wanted to stress that Elon’s first tweet, which mentioned ‘financing secured’ is correct.”
  • “The very first tweet simply mentioned ‘Funding secured’ which means there is a firm offer. Elon did not disclose details of who the buyer is . . . .  I actually don’t know [whether there is a commitment letter or a verbal agreement], but I would assume that given we went full-on public with this, the offer is as firm as it gets.”

It turns out that Elon Musk’s announcement of an acquisition was false. However, JP Morgan and all the banks that had entered similar contracts with Tesla, namely Goldman Sachs, did not know that at the time of the announcement. Still, JP Morgan adjusted the terms of the 2021 Warrants as a result of Tesla’s announcement of acquisition and, later, its abandonment of the transaction on August 24th 2018. JP Morgan considered that such adjustments were contractually required. Tesla refused to settle and pay in full what JP Morgan claimed Tesla owed as a result of the adjustments. JP Morgan ended up suing Tesla for $162,216,628.81, to be precise, for breach of contractual duties.

So, did Elon Musk’s tweet on August 7th 2018 constitute an announcement of an acquisition? Was it a “firm offer” to enter into a contract?”

Interestingly, JP Morgan’s complaint resonates with Johnson v. Capital City Ford, a case decided by the Louisiana Court of Appeal, in 1955. In Johnson v. Capital City Ford Co., the Court had to determine whether a unilateral declaration of will like an advertisement constituted a firm offer. Capital City Ford found itself with a surplus of 1954 Fords. To get rid of them, the company placed an advertisement in the local newspaper, the gist of which was “[c]ome in, buy a 1954 Ford and, when the new models come in, we will let you trade in the 1954 model for a 1955 model at no extra charge.”

In response to the announcement, Johnson went to Capital City’s lot, picked out a 1954 model, and bought it. When the new models arrived a short time later, Johnson returned to the Capital City lot and demanded a trade. Capital City refused, claiming that the advertisements “were not intended as offers, but merely as invitations to come in and bargain.”

The Court advanced the following major premises: (1) A newspaper advertisement may constitute an offer, acceptance of which will consummate a contract and create an obligation in the offeror to perform according to the terms of the published offer. (2) An offer to be effective, need not be addressed to determinate offerees; it can, instead, be addressed to the public at large. (3) Whether a particular advertisement is an offer, rather than an invitation to make an offer or enter negotiations, depends on “the legal intention of the parties and the surrounding circumstances.” (4) If the meaning of a declaration of will is doubtful or uncertain due to “want of explanation” that the declarer should have given or from “any other negligence of fault of his,” then “the construction most favorable to the other party shall be adopted.”

The Court held the advertisement was an offer. To a reader, the wording of the advertisement denoted a bona fide offer, and it was certain and definite enough to constitute a legal offer. If Capital City Ford really intended the advertisement not as an offer but as an invitation to make an offer, it should have said something to that effect. The advertisement created a risk of uncertainty through its ambiguous statements. Therefore, the onus was on Capital City Ford to clear up the ambiguity. Since the company did not do so, the Court construed the advertisement against Capital City.

In Johnson v. Capital City Ford, the Court applied another case R. E. Crummer & Co v. Nuveen et al. (1945). In Crummer & Co v. Nuveen, the US Court of Appeals for the Seventh Circuit had to decide if a notice published in a regular paper circulated among municipal bond dealers was a mere solicitation for offers to sell the bonds or an offer to purchase them. The notice reads as follows:

For the convenience of bondholders who may wish to surrender their bonds, the Board […] has arranged to provide funds for the purchase of the above described bonds at par and interest to December 1, 1941. Holders may send their bonds to the Manufacturers Trust Company for surrender pursuant to such terms.

The plaintiff was the owner and holder of $458,829 principal amount of the bonds, dated June 1st 1940 and due June 1st 1970. The defendants arranged with the Manufacturers Bank of New York (“Bank”) to deposit funds necessary to cover all such bonds presented for payment pursuant to the terms of the notice. The plaintiff, in reliance on the notice, delivered its bonds to the Bank on December 11th 1941. However, the Bank refused to pay the principal amount as provided by the notice. The plaintiff attempted to sell the bonds to other parties at par, but the bid for them was substantially less than par resulting in damages of $35,000. The defendants moved to dismiss the complaint on the grounds that the notice was merely a solicitation for offers to sell the bonds and not an offer to purchase them.

The US Court of Appeals maintained:

We cannot believe that the ordinary business man could be expected to read the advertisement as an invitation to send bonds from wherever he might be to New York on the chance that when they got there the advertiser would accept his offer to enter into negotiations for the purchase of the bonds. Rather, we think the wording of the advertisement is such as to show "an intent to assume legal liability thereby." [emphasis added].

In other words, the US Court of Appeals considered the notice as an offer to purchase bonds and not a mere solicitation for offers to negotiate the sale of bonds.

The agreements JP Morgan entered with Tesla included an announcement event protection clause. An “announcement event” is contractually defined in the agreements as follows:

(i)        The public announcement of any Merger Event or Tender Offer or the announcement by the Issuer of any intention to enter into a Merger Event or Tender Offer,

(ii)       the public announcement by Issuer of an intention to solicit or enter into, or to explore strategic alternatives or other similar undertaking that may include, a Merger Event or Tender Offer or

(iii)      any subsequent public announcement of a change to a transaction or intention that is the subject of an announcement of the type described in clause (i) or (ii) of this sentence (including, without limitation, a new announcement relating to such a transaction or intention or the announcement of a withdrawal from, or the abandonment or discontinuation of, such a transaction or intention) (in each case, whether such announcement is made by Issuer or a third party);

provided that, for the avoidance of doubt, the occurrence of an Announcement Event with respect to any transaction or intention shall not preclude the occurrence of a later Announcement Event with respect to such transaction or intention. 

Did Tesla’s CEO manifest a plain and clear intention to make a firm offer to sell his stock? Were his tweets mere invitations to negotiate rather than firm offers? Was there consideration or any sort of reward if the potential offerees satisfied specified requirements? Was his August 7th 2018 tweet a promise to enter contracts to sell stock?

Potentially, Musk's tweet could be seen as an offer to sell his stock to his Twitter followers if it gave the public the right to acquire Tesla’s stock when Tesla sold them. In this scenario, if those who accepted the offer paid for the stock when it was sold, then a contract would have been formed. In addition, Musk’s tweet could be seen as a promise to sell stock. In this case, offerees have a right to demand that Musk sell the stock. If this is a promise Musk did not intend to keep, then the SEC can understandably view it as a false statement.

More important than Elon Musk’s behavior is the actions as a result from his tweet on August 7th 2018. Why did he do it? It is doubtful that the tweet was originally intended as an offer to sell stock. It is not clear if Tesla’s CEO’s intention was to have his Twitter followers contact him with an acceptance and form a contract. That investors feel strongly about Elon Musk’s tweets is not surprising. As Jeremy Grantham said in a 2019 interview to CNBC news channel, Tesla “is an extreme demonstration of growth.”

The bottom line is that there is space to explore what substantiates an offer-via-tweet in the context of corporate transactions such as initial public offerings, takeovers, mergers and acquisitions. Even if one concludes Musk did not provide a firm offer, the contractual terms of JP Morgan and Tesla’s 2021 Warrants help expand this interesting area of contract law.

*           *           *

Thank you to Nathan B. Oman, Rollins Professor of Law and Co-Director of the Center for the Study of Law and Markets at William and Mary Law for comments and fruitful interaction on this issue via Twitter.

November 22, 2021 in Ann Lipton, Contracts, Joan Heminway, Securities Regulation | Permalink | Comments (0)

Saturday, November 20, 2021

Public, But Limited

I’ve blogged a couple of times on the eroding distinction between private and public companies – “private is the new public,” as Matt Levine likes to say (though Prof. Ilya Beylin does not agree that the erosion is so drastic).  Which is why I was struck by the package of financial reforms endorsed this week by the House Financial Services Committee.

Among other measures, the Committee backed a restriction on the marketing of public companies – namely, SPACs – to retail investors.  Per the proposed legislation, no investment adviser or broker-dealer would be permitted to recommend, or even facilitate a trade in, a SPAC investment by an unaccredited investor unless either the “promote” is less than 5%, or the SPAC “makes such disclosures to the Commission as the Commission, by rule, may determine to be necessary or appropriate in the public interest or for the protection of investors.”

Now, this is kind of a weird requirement – what disclosures is the SEC supposed to mandate? Isn’t it already, like, mandating disclosures of everything it thinks is necessary or appropriate?  So, I don’t think this proposal – or, I suspect, a lot of the other proposals endorsed by the Committee – will actually become law.  That said, it’s interesting to me that the proposal functions not by placing new restrictions on SPACs before they can go public – it doesn’t say, no SPAC can go public with a promote greater than 5%, or even mandate additional disclosure requirements in the S-1 – but instead, it distinguishes among public companies.  Those that meet the requirements can be freely recommended and traded; those that do not will still be publicly traded, but, as a practical matter, will only be available to accredited investors.

This is not the first time such a move has been proposed; in 2019, the SEC wanted, in practical effect, to have retail investors take the equivalent of a financial literacy test before their brokers/investment advisers could sell them leveraged ETFs, though that proposal never went anywhere.

Over the years, Congress and the SEC have gradually expanded private companies’ ability to market and sell their securities to ever broader groups of investors; and now there also seem to be these impulses to simultaneously restrict the trading in public companies based on the same measures of sophistication that typically are used in private markets.  It's almost ridiculous to call companies “private” today, when you can go to a website that offers shares in pre-IPO companies, and depending on what type of investor you are, you’ll be given different investment opportunities.  And for the hot start-ups unavailable on those sites, well, in addition to the other secondary trading platforms out there for private company shares, Morgan Stanley is creating a new one that promises to be “friendlier” to corporate CEOs (what could possibly go wrong?).

In many ways, the system is gradually becoming what Stephen Choi recommended once upon a time, namely not so much treating companies as public or private, but instead treating investors as more or less qualified to transact. 

That, of course, is a radical rethinking of the current system, which tends to assume that it’s not simply a set of required disclosures, but a robust regulated market that protects investors; by segmenting opportunities, that market is fractured and cannot fulfill its function.  And, well, as is currently on display in a California courtroom, it does raise the question of how well we believe regulators can distinguish between sophistication and naivete among investors.

November 20, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, November 6, 2021

New essay by me: The Three Faces of Control. And, also, a new paper by Hamermesh, Jacobs, and Strine that is really required reading.

As the followers of this blog well know, I've written a lot about controlling shareholders.  There have been blog posts here, here, here, here, here, here, here, here, here, here, and here, and an essay, After Corwin: Down the Controlling Shareholder Rabbit Hole.  So, I finally posted a whole new essay to SSRN on the subject, called The Three Faces of Control.  It's very short; it's kind of a follow-up/sequel/coda/friendly amendment to After Corwin. Here is the abstract:

Controlling shareholders are subject to distinct legal obligations under Delaware law, and thus Delaware courts are routinely called upon to distinguish “controlling shareholders” from other corporate actors.  That is an easy enough task when a person or entity has more than 50% of the corporate vote, but when a putative controller has less than 50% of the vote – and is nonetheless alleged to exercise control over corporate operations via other means – the law is shot through with inconsistency.

What is needed is a contextual approach that recognizes that the meaning of control may vary depending on the purpose of the inquiry.  Under Delaware doctrine, the controlling shareholder label subjects that entity to unique legal treatment along three distinct dimensions.  First, controlling shareholders – unlike minority shareholders – have fiduciary duties to the corporation.   Second, interested transactions with controlling shareholders – unlike interested transactions with other fiduciaries – are subject to a unique cleansing regime in order to win business judgment deference from reviewing courts.   Third, when certain transactions involving sales of control are challenged in court, they may be treated as direct rather than derivative actions, even when similar transactions that do not involve control sales would be treated as purely derivative.

By teasing out these three aspects of the legal framework and analyzing them separately, courts can more closely attend to the reasons why control carries special significance, and ultimately develop a more rational and consistent set of definitions.  Most critically, courts may properly designate someone a controlling shareholder for some purposes, but not others. 

Frankly, if you've been following my posts on controlling shareholders, a lot of it will seem familiar.  I wrote the essay because I wanted to formalize my thinking rather than leave it all in the blog, and also to articulate an overall framework that is a little different from how I approached things in the After Corwin essay. 

But then, right after I drafted this here post announcing my paper, I discovered that Lawrence Hamermesh, Jack B. Jacobs, and Leo Strine posted their own general assessment of current trends in Delaware law, including controlling shareholder transactions.  They, ahem, cover a lot of the same ground that I do (and, I will admit, do so far more extensively), and their recommendations are the opposite of mine (which makes the whole thing more than a little awkward for me personally but here we are). 

Anyhoo, while my proposals would likely result in more scrutiny of interested transactions, they want less.  They think that Chancery erred by extending the MFW framework to all conflicted-controller transactions,  and instead would jettison the entire line of cases holding that interested transactions with controllers are inherently coercive.  They would allow all such transactions to be cleansed either by the disinterested directors or the disinterested shareholders (just like other interested transactions), with MFW reserved for cases where a shareholder vote is statutorily required.  They agree with the point I made in After Corwin that the MFW framework has created pressure to overdefine the category of controlling shareholders, but their solution is to limit MFW to a small group of cases, so that the controlling shareholder label does less work.  That's a possibility I raised in the conclusion of After Corwin, but I can't say it's what I recommend: they are very afraid of frivolous litigation, and very trusting of institutional shareholders and independent directors to defy controllers, but it seems to me that a lot of the problem here is that courts are looking at cases that are technically "cleansed" but just don't pass the smell test, and they want to let plaintiffs get a shot at discovery.  If there's injustice that courts feel they can't reach, I don't think the solution is to make it even harder for courts to get there. 

In any event, these ideas will absolutely get a workout pretty soon.  I previously posted about the Tesla trial; whatever the verdict, it will certainly be appealed, and the Delaware Supreme Court has never articulated how far MFW extends, even as Chancery has applied MFW to all conflicted controller transactions. To date, almost all of the MFW cases that the Delaware Supreme Court has addressed involved freeze-outs, and one, Olenik v. Lodzinski, 208 A.3d 704 (Del. 2019) (which I forgot when I talked about this in my Tesla post, whoops), did not involve a freeze-out, but did involve a complex transformative transaction that statutorily required shareholder votes to proceed.  Tesla, by contrast, involves Tesla's acquisition of SolarCity.  There was no statutory requirement of a shareholder vote on the deal, just the NASDAQ requirement that a majority of voting shareholders approve an equity issuance of that size.  (The company voluntarily adopted a disinterested-shareholder-approval requirement.) 

So, one way or another, in Tesla if not sooner, the Delaware Supreme Court will be called upon to decide how far MFW extends, and unless the Court ducks the whole issue by holding that the disclosures were deficient (in my Tesla post, I explain how that would work), it will either lean in and extend the MFW framework to a broader category of cases - all conflicted controller transactions, as Chancery has done, maybe something less categorical - or retrench and possibly even agree with Hamermesh, Jacobs, and Strine that we've moved past the idea that controlling shareholders inherently coerce shareholders by their mere presence.

I mean, I know where I'd place my bets as to which direction the Court will choose, but I guess we shall see.  I suppose it's helpful here that of all defendants in the world who are unlikely to settle anything, it's Elon Musk, so I don't think the Tesla case will be resolved that way.

What's also interesting about the Hamermesh, Jacobs, and Strine paper, by the way, is that they disagree with the Delaware Supreme Court's holding in United Food and Commercial Workers Union v. Zuckerberg, and in fact, they agree with what the plaintiffs in that case were arguing.  The plaintiffs argued that the Aronson test should apply if the demand board was the board that made the challenged decision, and that demand should be excused if the plaintiff was able to plead that the directors breached their duties with respect to the challenged decision, even if they were exculpated for that breach.  The theory here is, say there was an interested transaction that was approved by a majority independent board, but the board breached their duty of care in the process.  Under Zuckerberg, demand is not excused when challenging the underlying transaction; the plaintiffs in Zuckerberg argued it should be, because directors who breach their duties may not face monetary liability but they don't want to expose their flaws publicly and therefore won't consider demand fairly.  Hamermesh, Jacobs, and Strine agree with that position.

I'll also note that they highlight the tension between the assumption that controllers are so very scary we need special procedures to cleanse their interested transactions, and a demand-excusal test that assumes independent directors can fairly decide whether to sue a controller.  (That's something I talk about too, both in The Three Faces of Control at fn. 60, and in After Corwin at 1984-85.)  

There's a lot more in their paper; they're concerned about recent merger cases targeting corporate officers for care violations, and recommend amending 102(b)(7) to cover officers, and they want to reform section 220, among other things.  I don't know that all of their ideas will come to fruition but I rather suspect many will have a lot of influence in Delaware, so anyone interested in these subjects should take a look.

November 6, 2021 in Ann Lipton | Permalink | Comments (1)

Saturday, October 30, 2021

ESG and Shell

As has been widely reported, Third Point/Dan Loeb is arguing that Shell should split its green assets from the brown assets, on the theory that the brown assets are currently undervalued by the market.   According to the Third Point letter:

We believe all stakeholders would benefit from a plan to:


Match its business units with unique shareholder constituencies who may be interested in different things (return of capital vs. growth; legacy energy vs. energy transition)


This should involve the creation of multiple standalone companies.  For example, a standalone legacy  energy  business  (upstream,  refining  and  chemicals)  could  slow  capex beyond what it has already promised, sell assets, and prioritize return of cash to shareholders (which can be reallocated by the market into low-carbon areas of the economy).  A standalone LNG/Renewables/Marketing business could combine modest cash returns with aggressive investment in renewables and other carbon reduction technologies (and this business would benefit from a much lower cost of capital).  Pursuing a bold strategy like  this  would  likely  lead  to  an  acceleration  of  CO2  reduction  as  well  as  significantly increased returns for shareholders, a win for all stakeholders.

Shell argues – and apparently some of its large investors agree – that you can’t split them up that easily.  Part of the claim has to do with how the different sides of the business are integrated, and part of it has to do with cash flows, namely, that the brown assets are funding the green ones.  As Matt Levine points out, though, investors themselves could do that if they wanted to – they could take the cash they make from the brown assets and plough it back into green investments:

Loeb’s basic mechanism here is: Take the cash flows from legacy oil drilling, give them to shareholders, and let the shareholders invest them in clean energy if they want. Van Beurden’s is: Take the cash flows from legacy oil drilling and let him invest them in clean energy. In a sense this is the most traditional of all activist conflicts: Should corporate managers be trusted to plan for the long term, or should they give money back to shareholders and let the shareholders invest it elsewhere for the long term? Traditionally this conflict is about the financial value of the managers’ long-term plans. Now it’s also about who — oil-company executives or hedge-fund managers — has a better plan for the world’s transition to clean energy.

Except there’s actually more going on.

For starters, I just have to note that Loeb’s letter repeatedly mentions making Shell better for “all stakeholders,” and rapidly achieving decarbonization, which is apparently an attempt to appeal to ESG strategists and possibly take a leaf out of Engine No. 1’s playbook, but that’s actually not the strategy at all.  Loeb is in no way trying to make energy “greener.”

What he is doing, though, is regulatory arbitrage.  As he points out, Shell is getting demands to be greener from governments and the public generally.  As he says:

Some governments want Shell to decarbonize as rapidly as possible. Other governments want it to continue to invest in oil and gas to keep energy prices affordable for consumers. Europe paradoxically wants both!...

Shell has ended up with unhappy shareholders who have been starved of returns and an unhappy society that wants to see Shell do more to decarbonize.

(emphasis added)

Spinning off the brown assets shouldn’t alleviate that pressure – the pressure should just shift to the brown assets – but Loeb knows it won’t.  Because. I strongly suspect, the brown company would be private, or be taken private, or would sell a lot of assets to private vehicles, where there would be a lot fewer disclosure obligations and a lot less regulatory and public scrutiny, and the brown company would be able to market itself to a smaller group of equity investors who are perfectly happy to drill baby drill as long as it keeps the cash flows coming. 

This is why lots of public companies, under pressure from ESG activists, are just transferring brown assets to private companies where they get a lot less flak.

And that’s why BlackRock, for example, has argued that even private companies should be required to disclose climate information.  As I previously quoted BlackRock’s letter to the SEC, “To avoid regulatory arbitrage between public and private market climate-related disclosures, we believe that climate-related disclosure mandates should not be limited to public issuers.”

But there’s a deeper subtext here.  As I’ve previously written a book chapter about and posted about, ESG investing has different meanings.  Sometimes, it’s a theory of shareholder value – companies will be more profitable in the long run if they are more socially responsible – and sometimes, it’s a theory that even if it’s bad for the companies individually, they should be socially responsible, because that’s what investors want.  And investors might want oil companies not to maximize wealth because they are people who have to live on the planet and breathe air and not drown, or they might want it because the “bad” oil company is contributing to climate change that harms the rest of the portfolio, so that from a purely wealth maximizing perspective at the portfolio level, some companies should individually take a hit.

Anyhoo, Loeb’s attack on Shell is a test of these theories.  Because if ESG is about value at the company level, you’d expect investors to rally behind him – split Shell, let everyone pursue the projects they think are most valuable.  But if ESG is about stopping companies from doing bad but profitable things, investors should oppose his plan, because if the brown assets are hived off (likely into an opaque private vehicle) then ESG investors won’t be able to influence them. 

October 30, 2021 in Ann Lipton | Permalink | Comments (1)

Saturday, October 23, 2021

Still thinking about SPACs

No, not that SPAC.

Actually, I’m thinking about the SPAC I blogged about here, GigCapital3, which merged with Lightning Systems.  It’s the subject of a lawsuit in Delaware Chancery; the allegation is that the de-SPAC transaction was bad for the SPAC investors, and rushed through in order to benefit the sponsor, before the eighteen month deadline passed and the sponsor was forced to liquidate.

There are some claims that the proxy statement was misleading – I’ll get back to that – but one claim is that this was a bad deal, the SPAC shareholders would have been better off if the SPAC had simply liquidated, and it was approved and recommended by the board because they either benefitted personally or had ties to the sponsor. 

Ordinarily, if you claim that a conflicted board approved a bad deal, that claim is reviewed for entire fairness unless it’s cleansed.  And in this case, theoretically any board breaches were cleansed by the shareholder vote in favor of the merger.  To address that, the complaint claims that the SPAC sponsor was actually a controlling shareholder, suggesting that cleansing could only come via MFW protections.

The problem is, it’s really hard to transpose ordinary corporate concepts into the SPAC context.

Start with:  Every SPAC shareholder had the right to redeem their shares at the same price they’d get in liquidation.  So, if you put aside, for the moment, the piece about a misleading proxy statement, it’s not clear why it would matter whether the board chose a bad merger over liquidation; the SPAC shareholders are in the same position either way.  And absolutely, one could make an argument about shareholders relying on the board to make good judgments about this, the whole point of having a board is that shareholders believe they know better than the shareholders, and their recommendation in favor of a deal carries particular weight, etc etc, but Delaware’s Corwin decision allowing a particularly extreme degree of cleansing via shareholder vote has really undermined the idea that shareholders are dependent on board decisionmaking in that substantive way.  The message of Corwin is, once shareholders have full information, they don’t need the board at all.  Which means, in a SPAC, shareholders shouldn’t be affected by a board decision to go through with a bad merger because they can always choose to redeem instead.

So really, from the shareholder perspective, the issue is not bad deal versus liquidation.  It’s bad deal versus good deal, but the complaint doesn’t allege that a good deal was ever on the table; the bad deal was rushed through precisely because the board was out of time to find a better one.

Now consider whether the shareholder vote cleansed any fiduciary breaches on the part of the board.

As I previously posted, one problem in this context is that there’s so little shareholder voting in SPACs that some SPACs have resorted asking people who already sold their shares to vote in favor of the merger.  But the other more fundamental issue is that you can vote in favor of the merger and still redeem your shares.  And shareholders do this, because many shareholders also hold warrants to buy shares in the combined company; those warrants are worthless without a merger, but probably worth something even in a bad merger. 

This is one of the problems that Usha R. Rodrigues and Michael Stegemoller identify in the paper I highlighted a few weeks ago; they call it empty voting.

Given that, SPAC shareholders, on the whole, should actually prefer a bad deal over liquidation, if those are the only two choices.  Of course, as we know from Revlon and the note holders, the board could not and should not have worried about the warrant holders as warrant holders, even if some warrant holders were also shareholders, so saving the warrant holders could not legitimately be part of the board’s decisionmaking when it agreed to the deal.  But the SPAC shareholders may be thinking about their warrants, which means a vote in favor of the deal is meaningless; shareholders should either prefer a bad merger, or be rationally indifferent as between bad merger or liquidation.

And what that means is, it’s very hard to take the shareholder vote as some kind of Corwin ratification of the deal or the board’s conduct when it comes to SPACs; shareholders have an incentive to vote in favor if it’s a good deal, and they have an incentive to vote in favor if it’s a bad one.  Even if they think it’s bad, they have no incentive to vote no because they can redeem.  Corwin just doesn’t have the same role to play.

Take the SPAC at issue here.  Per the 8-K, they only barely had a quorum; out of 25,893,479 total shares, only 14,829,588 actually voted.  Those 14,829,588  voted overwhelmingly in favor of the deal, but – also per the 8-K – 29% of the outstanding shares chose to redeem, and some of those may also have voted in favor.  We don’t know.  But if they did, that’s as many as 7,509,108 shares redeemed out of 14,555,716 voted in favor.  If, say, all the redeemed shares also voted in favor (unlikely, but bear with me), more voted in favor and rejected the deal than not.  (For some reason, the complaint says only 5.8 million were redeemed; I don’t know why the discrepancy, it might be because I am not accounting for insider shares properly.  Whichever of us is right, it’s still a lot though.)

But if we can’t treat the shareholder vote as cleansing here, we certainly can’t apply MFW, which is (apparently) what the plaintiffs plan to argue when they claim the sponsor was a controlling shareholder.  Because the rationale for requiring MFW procedural protections when there’s a controller is that shareholders will be intimidated by the presence of a controller; they may fear the controller will retaliate against them if they vote the wrong way.  See, e.g., Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110 (Del. 1994).  But in a SPAC, what could the controller possibly do to them?  They can still redeem their shares, which is the same as a liquidation, which is what’s going to happen if the deal is rejected.

Which is why the main focus of the plaintiffs’ complaint in this case is not so much that the board breached its duties by approving a bad deal – though that’s alleged too – but the claim that the proxy statement was misleading, and shareholders were lulled into approving a bad deal and sticking with the company rather than liquidate or redeem.  Plus, shareholders are bringing this claim directly rather than derivatively, and the “we would have redeemed if we had only known” argument is kind of essential to make that work.

So, the complaint doesn’t really focus on the argument that Corwin can’t apply in a situation where you can both vote in favor and redeem your shares, and when they file their opposition to the motion to dismiss, plaintiffs may choose not to make that argument in their briefing, either, because it’s awkward to claim that shareholders were lulled into sticking with a bad deal while simultaneously pointing out how many, in fact, did not.

Which ultimately is unsatisfying because frankly I’d love to see the Delaware courts grapple with the question how ratification should work in this context.

October 23, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, October 16, 2021

Yet Another Controlling Shareholder Opinion

This week, I continue in my series of posts about controlling shareholders (prior posts here, here, here, here, here, here, here, here, here, and here) to call your attention to Patel v. Duncan, decided September 30.

Talos was a company backed by two private equity sponsors: Apollo and Riverstone. Apollo had 35% of the shares; Riverstone had 27%; and the rest were publicly traded.  Talos had a 10 member board, and Apollo and Riverstone had a shareholder agreement that guaranteed each would appoint 2 members, a fifth member would be jointly agreed upon, and the sixth member would be Talos’s CEO.  Of course, because their combined voting power exceeded 50%, there was no doubt their nominees would be included on the board.  As a result, the company’s SEC filings identified Talos as a “controlled company” for the purposes of NYSE rules; as the company put it, “We are controlled by Apollo Funds and Riverstone Funds. The interests of Apollo Funds and Riverstone Funds may differ from the interests of our other stockholders…. Through their ownership of a majority of our voting power and the provisions set forth in our charter, bylaws and the Stockholders’ Agreement, the Apollo Funds and the Riverstone Funds have the ability to designate and elect a majority of our directors.”

In 2018, Talos bought a troubled company that was heavily indebted to Apollo; as a result of this purchase, Apollo was nearly made whole on an investment that might otherwise have failed.  Then, in 2019, Talos bought certain assets from Riverstone, and it was this purchase that was alleged by a derivative plaintiff to have been unfair to the public stockholders.

When the Riverstone transaction was arranged, Riverstone’s 2 board nominees, both of whom were also Riverstone affiliates, were recused from the negotiation process. Additionally, one of Apollo’s nominees was recused, because of her associations with Riverstone.  So that left 7 directors to arrange the transaction, including the joint Riverstone-Apollo nominee, one Apollo nominee who was also an Apollo affiliate, and the CEO.  A representative of Riverstone and one of Apollo observed all Board meetings on the subject, without apparently speaking.  Under the original terms of the deal, Talos was supposed to pay for the Riverstone assets partially in common stock, but that issuance would have required approval of the common stockholders; as a result, the terms of the deal were changed so that Talos paid in a new form of preferred stock that would automatically convert to common.  The change was approved by Apollo and Riverstone in a written consent, the result of which was to avoid a shareholder vote and allow the deal to close more quickly. Per the court, “There was no Board meeting discussing, or resolution approving, the changing of these terms.”

The derivative plaintiff claimed that Talos overpaid for the Riverstone assets.  He argued that Apollo and Riverstone were controlling shareholders of Talos and had a kind of quid pro quo arrangement whereby each one would approve the other’s tainted deal.  Because Apollo and Riverstone together were controllers, the argument went, the two had fiduciary duties to Talos and the Riverstone deal was subject to entire fairness review. 

Vice Chancellor Zurn, however, rejected the argument that Apollo and Riverstone were bound together in a manner that would constitute a control group.   First, she looked at general ties between the two.  She disagreed that there was any significant historical relationship between the parties as had been found in other cases involving putative joint controllers, like In re Hansen Medical Shareholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018), and Garfield v. BlackRock Mortgage Ventures, 2019 WL 7168004 (Del. Ch. Dec. 20, 2019), such as a pattern of joint investments.  She also felt that the admission of controlled status under NYSE rules was “not as strong” as self-designations of controller status in Hansen and Garfield; for example in Hansen, the two funds had admitted to working as a group in a 13D filing pertaining to a different company.

Second, she looked to transaction-specific ties.  She found no evidence for the purported quid pro quo other than the mere fact that the two transactions had taken place.  The shareholders’ agreement was no evidence of such an arrangement, because it only referred to director voting and did not make any promises regarding votes on other matters.  And the presence of Riverstone and Apollo representatives as observers in board meetings did not suggest any specific involvement in negotiations.

Thus, she concluded that Apollo and Riverstone were not sufficiently associated that their separate minority positions should be linked.  Given that, in their role as individual minority shareholders, they had no fiduciary duties to Talos that they could violate. The transaction with Riverstone was not subject to entire fairness review because Riverstone was not a controlling shareholder – or even a fiduciary – of Talos.

The problem I have with all of this starts with the standard announced by the Delaware Supreme Court in Sheldon v. Pinto Tech. Ventures, L.P., 220 A.3d 245 (Del. 2019).  According to that case, a controller exists “where the stockholder (1) owns more than 50% of the voting power of a corporation or (2) owns less than 50% of the voting power of the corporation but exercises control over the business affairs of the corporation.… [M]ultiple stockholders together can constitute a control group exercising majority or effective control, with each member subject to the fiduciary duties of a controller. To demonstrate that a group of stockholders exercises control collectively, the [plaintiffs] must establish that they are connected in some legally significant way—such as by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” 

Relying on cases like Garfield and Hansen, VC Zurn looked to the factors those courts had examined (transaction-specific ties, historical ties) to conclude that the Sheldon standard was not met.  But in Garfield and Hansen, the courts were trying to determine whether an agreement actually existed in the first place.  Here, it was not necessary to try to suss out whether there was an agreement, because Apollo and Riverstone admitted they had one.  All that was necessary was to determine whether the agreement they had gave them “more than 50% of the voting power of a corporation...exercising majority or effective control.”

Under the agreement they admitted to having, Apollo and Riverstone jointly had more than 50% of the vote, and they jointly agreed that they would use that voting power to select 6 members of a 10 member board.  Sure, they divvied it up – you vote for my nominee, I’ll vote for yours – but the fact remains, they had a “legally significant connection” – an actual, for real, disclosed contract – for dictating 60% of the directors.  Four of whom actually worked for Riverstone or Apollo; one of whom was the Talos CEO.  (Not that those ties matter, necessarily; imagine a single stockholder, with more than 50% of the vote, who nonetheless chose to select only nominally independent board members. That entity would absolutely be a controller.[1]  Therefore, it shouldn’t matter who Apollo and Riverstone chose to place on the board – the relevant point is that with more than 50% of the vote, they had an agreement to jointly select more than half the board members). 

True, their agreement did not give them transactional control over the particular purchase in question, but usually transactional control is treated as an alternative test for controller status; controller status also exists when someone controls the corporation in general.  See, e.g., In re Rouse Props., Inc., 2018 WL 1226015 (Del. Ch. Mar. 9, 2018).  And when it came to the corporation in general, Apollo and Riverstone straightforwardly, together, had “more than 50% of the voting power of a corporation,” and therefore “constitute[d] a control group exercising majority or effective control,” with all the legal consequences that follow.  The rest of it – their history, their involvement with the negotiations, the existence (or not) of a quid pro quo – is beside the point.

(Also, for what it’s worth, if you’re looking for evidence that they jointly executed the transaction, the fact that Apollo and Riverstone somehow changed the deal terms all on their own without involving the Board seems pretty significant.)

Anyway, all of this matters because, as scholars are now documenting, shareholder agreements in public companies are increasingly common, usually involving PE firms like Apollo and Riverstone.  They often provide for board seats, observation rights, and positions on key committees, among other things.  So it’s really, really important that courts come to a coherent, consistent position on how these agreements will be addressed, and as relevant here, when transactional control is going to be a necessary aspect of the controlling shareholder inquiry.


[1] For example, ViacomCBS has a majority independent board but – well, you know. 

October 16, 2021 in Ann Lipton | Permalink | Comments (0)

Monday, October 4, 2021

Connecting the Threads 2021 - My Thread in the Tapestry . . . .

Screen Shot 2021-10-04 at 7.36.06 PM

With my bum shoulder and a lot of work on our dean search cramping my style over the past few weeks, I have been remiss in posting about the 2021 Business Law Prof Blog Symposium, Connecting the Threads V.  The idea behind the name (and Doug Moll likes to riff on it--so have at it, Doug!) is that our bloggers here at the BLPB connect the many threads of business law in what we do--here on the blog and elsewhere.

Anyhoo (as Ann would say), as always, my BLPB co-bloggers did not disappoint in their presentations.  I know our students look forward to publishing many of the articles and the related commentaries in the spring book of our business law journal, Transactions: The Tennessee Journal of Business Law.  I also am always so proud of, and interested to hear, the commentary of my colleagues and students.  This year was no exception.

In the future, I will post more about the article that I presented.  But I will offer a teaser here, accompanied by the above screen shot from the symposium.  (It was "Big Orange Friday" on our campus.  The orange had to be worn.  Go Vols!)

The title of my presentation and article is Choice of Entity: The Fiscal Sponsorship Alternative to Nonprofit Incorporation.  A brief excerpt from the continuing legal education handout for the symposium presentation is set forth below (footnotes omitted).

[T]his presentation urges that competent, complete legal counsel on choice-of-entity for nonprofit business undertakings should extend beyond advising clients on which form of business entity best fits their needs and wants, if any. For many small business ventures that qualify for federal income tax treatment under Section 501(a) of the U.S. Internal Revenue Code of 1986, as amended (“IRC”), as religious, charitable, scientific, literary, educational, or other eligible organizations under Section 501(c)(3) of the IRC . . . , the time and expense of organizing, qualifying, managing, and maintaining a tax-exempt nonprofit corporation under state law may be daunting (or even prohibitive). Moreover, the structures imposed by business entity law may not be needed or wanted by the founders or promoters of the venture. Yet, there may be distinct advantages to entity formation and federal tax qualification that are not available (or not as easily available) to unincorporated not-for-profit business projects. These may include, for example, exculpation for breaches of performative fiduciary duties and limitations on personal liability for business obligations available to participants in nonprofit corporations under state statutory law and easier clearance of or compliance with initial and ongoing requirements for tax-exempt status under federal income tax law.

The described conundrum—the prospect that founders or promoters of a nonprofit project or business may not have the time or financial capital to fully form and maintain a business entity that may offer substantial identifiable advantages—is real. Awareness of this challenge can be disheartening to lawyer and client alike. Fortunately, at least for some of these nonprofit ventures, there is a third option—fiscal sponsorship—that may have contextual benefits. This presentation offers food for thought on the benefits of fiscal sponsorship, especially for arts and humanities endeavors.

Again, I will have more to say about this later, once the article is fully crafted.  But your thoughts on fiscal sponsorship--and examples, stories, and the like--are welcomed in the interim as I continue to work through the article.

October 4, 2021 in Ann Lipton, Conferences, Joan Heminway, Lawyering, Nonprofits, Research/Scholarhip | Permalink | Comments (0)

Saturday, October 2, 2021

Private Really is the New Public

A while back, I posted about how there’s been some institutional investor support for the proposal that the SEC require not only public companies, but private companies, disclose climate change information.

Usually, of course, private companies aren’t required to disclose things – especially to institutional investors – on the theory that institutional investors can themselves bargain for the information that they need.  (Yes, yes, there are kind of exceptions, like Securities Act Section 4(a)(7), etc).  But the SEC and Congress have been gradually expanding which companies count as private, raising concerns that not only that they have assumed too much sophistication on the part of institutions (for example, institutional investors themselves have complained about opacity among the PE funds in which they invest), but also that the SEC and Congress have ignored the benefits of creating a body of public information across a wide swath of companies.

Which is why this article grabbed me

The California Public Employees’ Retirement System and Carlyle Group Inc. helped rally a group of more than a dozen investors to share and privately aggregate information related to emissions, diversity and the treatment of employees across closely held companies. More firms and institutions are expected to join.

“We need to start a common language across all these participants so we can actually, in a sustained way, make some progress,” Carlyle Chief Executive Officer Kewsong Lee said in an interview. “By honing in on a set of common standards and common metrics, we start to standardize the conversations so we can really track progress. It’s really hard to do that right now.”

Blackstone Group Inc. and the Canada Pension Plan Investment Board, the country’s largest pension fund, are also part of the effort. Boston Consulting Group was tapped to aggregate the data.

Private-equity firms will be seeking to standardize and share data on greenhouse-gas emissions, renewable energy, board diversity, work-related injuries, net new hires and employee engagement. Calpers CEO Marcie Frost said she would like to see these metrics expand to include data such as C-suite diversity and employee satisfaction.

The article is framed as further evidence of a trend toward ESG investing, but for me the more relevant point is that investors are trying to band together to create a common pool of information about private companies that have been excepted from the public disclosure regime.  You could, I suppose, call that a triumph of private ordering; I take it as evidence of a fundamental failure of the securities disclosure system.  I suppose you could also tell a story about the privatization of what was once public infrastructure more generally, or the unholy marriage of privatization and environmentalism.

October 2, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, September 25, 2021

An Embarrassment of Riches: Slack, Brookfield, Activision, and the Death of Aronson

Sometimes, there’s not a whole lot new to blog about – and other times you get the Slack decision, the Brookfield decision, an SEC investigation of Activision, and Aronson’s demise all in a single week.  So in this post, I am going to tackle the first three and save United Food and Commercial Workers Union v. Zuckerberg for maybe another time, but if you really want to know my immediate reaction to the Zuckerberg case, I tweeted a thread here.  Professor Bainbridge also has a long blog post on the Zuckerberg decision here.


I previously blogged about this case here, and the short version is that Slack went public via direct listing, and filed a Securities Act registration statement for slightly fewer than half of the shares that became available to trade on the opening day, because the rest of the shares did not need to be registered in order to trade under Rule 144.  Stock purchasers claimed that the registration statement contained false statements in violation of Section 11 of the Securities Act; the question was whether they’d need to establish that theirs were the registered shares before they’d be able to bring a claim – an impossible task, which would functionally prevent any shareholders from bringing any Section 11 claims at all.  The district court said no, they did not have to do that, and earlier this week, the Ninth Circuit affirmed by a 2-1 vote

The Ninth Circuit’s logic was unexpected, to say the least.  The Court interpreted NYSE Listed Company Manual, Section 102.01B Footnote E, to mean that NYSE direct listings are legally not possible unless a Securities Act registration statement is filed.  According to the court:

Per the NYSE rule, a company must file a registration statement in order to engage in a direct listing.  See NYSE, Section 102.01B, Footnote E (allowing a company to “list their common equity securities on the Exchange at the time of effectiveness of a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares”) (emphasis added).... As indicated, in contrast to an IPO, in a direct listing there is no bank-imposed lock-up period during which unregistered shares are kept out of the market. Instead, at the time of the effectiveness of the registration statement, both registered and unregistered shares are immediately sold to the public on the exchange. See NYSE, Section 102.01B, Footnote E.  Thus, in a direct listing, the same registration statement makes it possible to sell both registered and unregistered shares to the public.

Slack’s unregistered shares sold in a direct listing are “such securities” within the meaning of Section 11 because their public sale cannot occur without the only operative registration in existence. Any person who acquired Slack shares through its direct listing could do so only because of the effectiveness of its registration statement….

Slack’s shares offered in its direct listing, whether registered or unregistered, were sold to the public when “the registration statement . . . became effective,” thereby making any purchaser of Slack’s shares in this direct listing a “person acquiring such security” under Section 11.

Now, the reason this is surprising is that the argument almost seems to have come out of nowhere.  It was not the basis for the district court’s decision, and though it was alluded to by the plaintiffs in their Ninth Circuit briefing, neither the defendants, nor their amici, seems to have addressed it, and the issue was only barely mentioned at oral argument.  And no one cited Section 102.01B Footnote E of the NYSE Listed Company Manual at all.

Plus, I gotta say, this is not the most convincing reading of the NYSE rules.  Here’s what the NYSE Listed Company Manual, Section 102.01B Footnote E, actually says:

Generally, the Exchange expects to list companies in connection with a firm commitment underwritten IPO, upon transfer from another market, or pursuant to a spinoff. However, the Exchange recognizes that some companies that have not previously had their common equity securities registered under the Exchange Act, but which have sold common equity securities in one or more private placements, may wish to list their common equity securities on the Exchange at the time of effectiveness of a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares, where such company is listing without a related underwritten offering upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements. …Consequently, the Exchange will, on a case by case basis, exercise discretion to list [such] companies …

That doesn’t sound like the NYSE is prohibiting direct listings in the absence of a Securities Act registration; it sounds more like the NYSE has not contemplated that an issuer might want to list without one.

Now, to be fair, maybe that doesn’t matter.  The NYSE, in creating its rules (which had to be approved by the SEC), only contemplated direct listings accompanied by a Securities Act registration statement, so that’s all that’s currently authorized.  Still, the legal effect of the registration statement was not, despite the Ninth Circuit’s holding, that it allowed the unregistered securities to trade publicly.  Rule 144 allowed them to trade publicly without any registration statement at all.  What the registration statement arguably allowed was for them to trade publicly on the Exchange, which is not the same thing.

Which gets to what I think was really the driving force behind the Ninth Circuit’s decision: policy.  As the Ninth Circuit explained:

interpreting Section 11 to apply only to registered shares in a direct listing context would essentially eliminate Section 11 liability for misleading or false statements made in a registration statement in a direct listing for both registered and unregistered shares. While there may be business-related reasons for why a company would choose to list using a traditional IPO (including having the IPO-related services of an investment bank), from a liability standpoint it is unclear why any company, even one acting in good faith, would choose to go public through a traditional IPO if it could avoid any risk of Section 11 liability by choosing a direct listing.  Moreover, companies would be incentivized to file overly optimistic registration statements accompanying their direct listings in order to increase their share price, knowing that they would face no shareholder liability under Section 11 for any arguably false or misleading statements.  This interpretation of Section 11 would create a loophole large enough to undermine the purpose of Section 11 as it has been understood since its inception.

And this is why the dissent is dissenting; in Judge Miller’s view, these policy considerations should not override the plain text of Section 11, which only permits claims by “any person acquiring such security,” meaning, “such security” as was registered on the faulty registration statement. 

Now, I suspect we’re not done here, because defendants will likely seek rehearing and/or certiorari, but if this is the final word, I note that the Ninth Circuit’s decision may have implications for ordinary IPOs, when issuers forego the traditional 180-day lockup and instead allow insiders to trade unregistered shares right away.  I previously blogged about this problem in connection with Robinhood’s IPO; per Law360, a lot of companies are now eliminating the traditional lockup.  Under prior law, one would expect the immediate trading of unregistered shares to bar, or at least inhibit, Section 11 claims, but by the Ninth Circuit’s logic, as I understand it, for these companies, the Securities Act registration statement is a necessary step to allow the unregistered shares to trade on the Exchange, and that might be enough to eliminate the tracing requirement.  The Ninth Circuit distinguished situations where shares were issued pursuant to more than one registration statement, see op. at 12, 14, but it also suggested – as other courts have held – that tracing is not an issue when the two registration statements contain identical misstatements, see op. at n.5; see also In re IPO Sec. Litig., 227 F.R.D. 65 (S.D.N.Y. 2004).  Point being, this decision, if it stands, could become the basis for eliminating the tracing requirement for exchange-traded shares so long as there has only been either one registration statement, or all registration statements contain identical misstatements.

What the Ninth Circuit decision does not resolve, though, is how losses/damages would be calculated in these kinds of situations, which – as I blogged in connection with Slack and Robinhood – remains an issue. 

My final observation is that the SEC could make most of this go away by refusing to accelerate the effectiveness of a registration statement for any issuer that does not agree to waive tracing defenses for shares purchased in the first 180 days.


Short version: Ordinarily, if a corporation issues new shares in exchange for inadequate consideration, this is a derivative harm to existing shareholders, but Gentile v. Rossette created an exception to that rule by holding that if the shares are issued to a controlling shareholder, who thereby increases his/her/its level of control, the harm is both direct and derivative.  Gentile sat uneasily amongst Delaware precedent for a long time, as Delaware courts increasingly narrowed its application, until finally, in Brookfield Asset Management v. Rosson, the Delaware Supreme Court eliminated it.  As the court put it:

Gentile is premised on the presence of a controlling stockholder that allegedly used its control to “expropriate” and extract value and voting power from the minority stockholders.  Controlling stockholders owe fiduciary duties to the minority stockholders, but they also owe fiduciary duties to the corporation.  The focus on the alleged wrongdoer deviates from Tooley’s determination, which turns solely on two central inquiries of who suffered the harm and who would receive the benefit of any recovery. That shift has led to doctrinal confusion in our law. The presence of a controller, absent more, should not alter the fact that such equity overpayment/dilution claims are normally exclusively derivative because the Tooley test does not turn on the identity of the alleged wrongdoer.

Still, this direct/derivative problem is not entirely settled because – as the Delaware Supreme Court pointed out – “To the extent the corporation’s issuance of equity does not result in a shift in control from a diversified group of public equity holders to a controlling interest, (a circumstance where our law, e.g., Revlon, already provides for a direct claim), holding Plaintiffs’ claims to be exclusively derivative under Tooley is logical and re-establishes a consistent rule that equity overpayment/dilution claims, absent more, are exclusively derivative …. we see no practical need for the ‘Gentile carve-out.’ Other legal theories, e.g., Revlon, provide a basis for a direct claim for stockholders to address fiduciary duty violations in a change of control context.”

In other words, if you’re a shareholder in a company without a controller, and directors sell enough of an interest to create a controller, then, even if there was no change in the character of the shares you personally hold, you can still bring a direct, Revlon-standard review challenge to that action.  Which to be honest I was not, until now, sure was a clear thing, though there have been some decisions that suggested as much.  See In re Coty Stockholder Litigation, 2020 WL 4743515 (Del. Ch. Aug. 17, 2020).  But I will say, given the malleability of the standard for what counts as control – see my numerous blog posts on the subject – any cases that arise will be hilarious to watch.  On the one hand, plaintiffs will want to argue that the party receiving the new stock was a controller already, so that the MFW standards for cleansing apply; on the other, plaintiffs will want to argue that the party receiving the new stock was not a controller already, in order to be able to bring claims directly.  And defendants will have the opposite incentives. 

I’ll also note that in Brookfield itself, plaintiffs offered the alternative argument that they had a direct claim because the company undersold shares to a 51% controller, in a manner that brought the controller’s holdings to 65%.  This was significant, claimed the plaintiffs, because certain charter provisions could only be amended upon a 2/3 vote, so increasing the controller’s power to that level gave the controller even more substantive control. 

And the Delaware Supreme Court did not reject the argument as a theoretical matter!  Meaning, it’s not only a direct claim if the company goes from no control to control; it’s a direct claim if the company goes from control to next-level control.  But, the Supreme Court said, the plaintiffs had not made their factual case here because 65% < 2/3. 

Which I have to say is pretty unconvincing; I mean, Delaware will accept that someone with 49% of the vote in a public company is a controller, because that additional 1% it needs will come from somewhere; I don’t see why the same argument couldn’t be used to say that 65% is functionally the same as 66% when it comes to public companies.  But that only highlights the problem here: once legal significance is attached to going from no control to control, or from control to next-level control, defining what we mean by control becomes very hard to do.

A final note on this: I previously blogged that in the Tesla trial, VC Slights could theoretically resolve the entire matter without ever deciding whether Elon Musk is, or is not, legally a controlling shareholder; as I said at the time, the only wrinkle that might force such a decision on him were the plaintiffs’ direct claims brought under a Gentile theory.  Now that that theory is kaput, it will be even easier for Slights to avoid the is-he-or-isn’t-he question, if the facts allow it and that’s something he wants to.


Activision Blizzard, according to reports, has a very serious sexual harassment/sex discrimination problem.  So serious that the California Department of Fair Employment and Housing filed a lawsuit after a 2-year investigation.  The EEOC has also been investigating the company since 2020.

Given all this, it’s no surprise that when the news broke, a shareholder lawsuit was filed against Activision, generally alleging that the company misrepresented its employment policies to investors.

What was more surprising, though, was the news that the SEC was investigating Activision, because usually that’s not the kind of fraud that the SEC gets involved with.  It’s hard to exactly articulate the difference, but the SEC tends to stay its hand when the allegation is that the company was doing non-financially bad things and did not disclose those bad things to investors.

What gives?

I have no special insight, of course, but if I had to guess, this is about the fact that the SEC only recently made the following addition to Item 101 of Regulation S-K:

(c) Description of business….

(2) Discuss the information specified in paragraphs …[(c)(2)(ii)] of this section with respect to, and to the extent material to an understanding of, the registrant's business taken as a whole, except that, if the information is material to a particular segment, you should additionally identify that segment….

(ii) A description of the registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant's business and workforce, measures or objectives that address the development, attraction and retention of personnel).

And indeed, in its 2020 10-K, filed in February 2021, Activision included these statements under the heading “Human Capital”:

Activision Blizzard takes an active role in the entirety of the employee lifecycle, from candidates to alumni. Recognizing that ours is a rapidly changing industry with constant technological innovation, we remain focused on attracting, recruiting, enabling, developing, and retaining a diverse and innovative employee population.

Diversity, Equity, and Inclusion (“DE&I”): We believe that a culture of inclusion and diversity enables us to create, develop, and fully leverage the strengths of our workforce to exceed players' and fans' expectations and meet our growth objectives. We remain committed to building and sustaining a culture of belonging, built on equitable processes and systems, where everyone thrives. By embedding DE&I practices and programs in the full employee lifecycle, we work to recruit, attract, retain, and grow world-class talent. Our employee resource groups play an active role in our DE&I efforts by building community and awareness. We also offer leadership and management development opportunities on the topics of unconscious bias and inclusive leadership and train our recruiting workforce in diverse sourcing strategies….

Compensation and Benefits: The main objective of our compensation program is to provide a compensation package that attracts, retains, motivates, and rewards top-performing employees that operate in a highly competitive and technologically challenging environment. We seek to do this by linking compensation (including annual changes in compensation) to overall Company and business unit performance, as well as each individual’s contribution to the results achieved. The emphasis on overall Company performance is intended to align our employee’s financial interests with the interests of our shareholders. We also seek fairness in total compensation by reference to external comparisons, internal comparisons, and the relationship between development and non-development, as well as management and non-management, remuneration. We believe in equal pay for equal work, and we continue to make efforts across our global organization to promote equal pay practices….

Employee Experience: We capture and act on the voice of our employees through regular company-wide pulse surveys. We emphasize to employees that this is their chance to “provide honest, candid feedback about their experience working for the company.” Our survey participation rates (regularly 75% or higher) demonstrate our collective commitment that Activision Blizzard remains a great place to work. The survey—and other forms of employee feedback—result in actionable steps that lead to positive improvements to the employee experience at the company-wide, business unit, and team levels. Our employee feedback is dynamic and relevant to our employees’ immediate needs. …

That … sounds rather at odds with a company that is alleged to have tolerated extreme levels of sexual harassment, discriminated against women in pay and promotion opportunities, and actively discouraged women from reporting their complaints to HR.  Notably, the California DFEH and EEOC investigations were well underway when this 10-K was filed, but I can’t find mention of either.

So if I had to guess, the SEC views this situation as potentially a way of communicating that no, it’s actually not kidding when it says that human capital disclosure is a required line item under Item 101 of Regulation S-K.

Assuming my speculations are correct, this is not about the SEC demanding that companies preemptively accuse themselves of uncharged wrongdoing; it’s not even about whether Activision’s practices ultimately turn out to be legal or illegal under California or federal law.  This is about the SEC, having recognized that in the knowledge economy, workforce management is an important contributor to corporate wealth, responded to investor demand by requiring a new level of transparency surrounding it.  And in the very first year after those requirements took effect, one digital company – exactly the type of knowledge/skills-based company that inspired the new requirements – may have blatantly misdescribed to investors the facts surrounding its internal policies.  And that possibility is what the SEC is looking into.

And - that’s as much as I can handle this week!

September 25, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, September 18, 2021

Rodrigues and Stegemoller on SPACs

There’s been so much interest in SPACs recently, I figured everyone should be aware of this new paper by Usha R. Rodrigues and Michael Stegemoller, SPACs: Insider IPOs.  One of the main points the authors make is that de-SPAC transactions represent a kind of “empty voting” scenario, where you can both vote in favor of the deal and redeem your shares for $10 – which is in fact what overwhelmingly occurs; the actual funds for the merger typically come from the simultaneous PIPEs.  As the authors point out, the regulations and practice governing SPACs did not always allow this; when SPACs first began to list on the NYSE, only shareholders who voted against the deal could redeem, and if redemptions exceeded a certain threshold, the deal would not close.  Shortly thereafter, however, regulations and practice evolved to allow all shareholders to redeem and to eliminate the conversion threshold.  The authors argue that the new practices are damaging to markets by allowing companies to go public on major exchanges before they are ready to do so.

Anyhoo, here is the abstract:

Proponents have hailed special purpose acquisition companies (SPACs) as the democratization of capitalism. In a SPAC, a publicly traded shell corporation acquires a private target, thereby taking it public in a manner that circumvents the rigors of a traditional initial public offering (IPO). Known as the “poor man’s private equity,” SPACs have been touted for giving the masses an otherwise rare chance to invest in private companies, and thereby reap the high returns usually reserved for the wealthy. Our original hand-collected data tell a different story.

We focus on two harms that SPACs present. First, they are singularly illiquid investments—even when nominally public, SPACs are generally owned and traded by the very few. Second, SPACs evolved to eliminate meaningful shareholder voice on the acquisition of a private target, using instead a species of “empty voting,” meaning that any such vote had no economic impact. By rendering the shareholder vote a nullity, SPACs can now virtually guarantee that a target will go public. This laxity of process creates the risk that subpar firms will trade side by side with quality public companies, tarnishing the market as a whole.

We are the first to examine this absence of liquidity and shareholder power, both of which are products of SPACs’ domination by insiders. This Article’s original data on SPACs’ empty voting, delinquent public filings, and thin-to-nonexistent trading provide empirical evidence that a small group of insiders use SPACs to manipulate the merger process, free of traditional IPO safeguards. We conclude with a reform proposal to reunite shareholders’ economic interest with voting power. This potential reform addresses the concerns of liquidity and lack of selectivity, while also providing a viable alternative to the traditional IPO.

September 18, 2021 in Ann Lipton | Permalink | Comments (0)

Saturday, September 11, 2021

Howey, Reves, and a Common Law Comedy of Error

So, Coinbase has made a lot of noise recently about the SEC’s warning that its “Lend” product may be a security and thus subject to registration under the securities laws.

Its wounded blog post, not to mention the complaints from the CEO on Twitter, have attracted a good deal of mockery, but I actually want to use this as a jumping off point for a different discussion.

The Lend product, as I understand it, would allow Coinbase to lend certain cryptocurrency held by its clients to other actors; the borrowers will pay an interest rate to Coinbase, which Coinbase will share with clients, resulting in a guaranteed minimum 4% interest payment to the client.  Essentially, Coinbase wants to be a bank, and to treat its clients as depositors, without the bother of banking regulation.  Per Coinbase’s blog post, the SEC is “assessing our Lend product through the prism of decades-old Supreme Court cases called Howey and Reves....  These two cases are from 1946 and 1990.”  Leaving aside the baffled tone (Howey? Reves? What is this sorcery?), and the language designed to make me feel old (I still wear clothes I bought in 1990), what is interesting to me is that the SEC is using both tests

This is an unsettled area when it comes to the definition of a security.  Howey is used to determine whether an instrument is an “investment contract” as that term is used in the definition of a security contained in the Securities Act of 1933 and the Exchange Act of 1934; Reves is used to determine whether a “note” is a security as defined in those Acts.  And it’s not always clear which test applies when.  Technically, a “note” is a definite promise to pay a particular sum.  But in SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court used the Howey test for a sale-and-leaseback arrangement that included a promise to pay $82 per month, rather than the Reves test.  That leaves a fair degree of uncertainty as to how to determine whether new instruments count as “notes” in the first place so that the Reves test is appropriate.  Are the two tests alternatives?  Is one preferable to the other in some situations?  The answer isn’t clear.

And it matters because the tests themselves are similar but not identical.  Both consider whether the product is sold to many people or to a single person; both consider the purposes of the transaction, but Reves is a fuzzy multifactored balancing test whereas Howey requires that all elements be met.

Why is the law like this? 

It’s actually, as far as I can tell, the product of the sometimes dysfunctional development of the common law.  (Something I previously discussed in the context of United Food and Commercial Workers Union v. Zuckerberg.  In that blog post, I talked about a different example of the common law creating an unnecessary multiplicity of tests: Aronson and Rales.  I should add, though, that in that post, I was wrong in predicting what the plaintiffs would do; Zuckerberg is currently pending before the Delaware Supreme Court and the plaintiffs are arguing for a reinterpretation of Aronson that would distinguish it from Rales.).

So, back to securities: In 1946, the Supreme Court had to decide if interests in an orange grove constituted an investment contract/security, and it came up with the four-factored Howey test: investment of money, in a common enterprise, with the expectation of profit, due to the managerial efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

Nearly 30 years later, in 1975, the Supreme Court decided United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975).  In Forman, a New York City co-op was created as part of a program of low income housing.  To get an apartment in the co-op, you had to buy a share of “stock” in the corporation, but the stock itself had none of the features of traditional stock and mainly was used as a security payment for the apartment.  When the residents/stockholders sued, claiming they had been sold securities, the Supreme Court held that the stock was not “stock” as that term was meant in the securities laws, and then further held that it was not even an investment contract under the Howey test.  Why? Among other things, there was no expectation of profit as Howey envisioned.  As the Supreme Court put it:

By profits, the Court has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds. . . .

Lower courts did two things with this.  First, they decided that all instruments allegedly subject to the securities laws – stock, notes, anything else – would get the Howey test.  Second, they read Forman’s concept of profit narrowly, to mean that the expectation of profit had to be something like profits generated specifically from the success of the enterprise.  Fixed rates of return, especially at a market rate, would not count as “profit” because those amounts would be due to the investor regardless of whether the enterprise was a success or failure. 

And then came Reves v. Ernst & Young, 494 U.S. 56 (1990), with the question whether a demand note was a security.  The Eighth Circuit applied Howey and concluded that the fixed rate of return excluded it from the security definition. See Arthur Young & Co. v. Reves, 856 F.2d 52 (8th Cir. 1988) (“the interest rate was fixed by an established market rate. The demand noteholders did not participate in the Co-op's earnings by virtue of their ownership of the demand notes, nor was there any prospect of capital appreciation. Therefore, the demand noteholders did not expect a ‘profit’ as that term is defined in Howey.”)

But debt instruments often have fixed rates of return!!  It’s kind of the point!  If you do this, you end up with a lot of debt instruments being entirely uncovered by the securities laws!

So, off it goes to the Supreme Court.  And the Court – rather than interrogate the lower courts’ interpretation of Forman, see Reves, 494 U.S. at 68 n.4 – decides that notes should have an entirely different test.

Now there are two tests. Howey and Reves.  (Okay, three, if you think of Forman, and subsequently Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), as setting forth a definition of whether something is “stock”).

But we’re not done.  Because in SEC v. Edwards, the Court finally did confront the narrow definition of “profit” that courts were using for Howey. And there, applying Howey, it held that fixed rates of return can in fact be “profits.” 

But if the instrument has a fixed rate of return, there’s going to be a specific payment due at a particular time, and that might make it a note!

The whole point of Reves, I submit, was to get around an unduly narrow interpretation of Howey.  Once that interpretation changed, we’re left with two tests, no clear reason for them, and no clear guidance when one should apply and when it should be the other.

And that’s why the SEC is testing Coinbase’s Lend product – which involves a fixed rate of return – under both Reves and Howey.    

Anyway, here’s Adam Levitin on how Lend comes out under Howey and Reves.

September 11, 2021 in Ann Lipton | Permalink | Comments (2)

Saturday, August 28, 2021

Still Talking About Corporate Scienter

A couple of weeks ago, I posted about how courts are not terribly precise when evaluating allegations of corporate scienter in Section 10(b) claims.  Since then, a couple of cases were decided that provide some useful examples of the problem.

First up, there’s the Second Circuit’s Plumbers & Steamfitters Local v. Danske Bank, decided earlier this week.  Apparently, the Estonia subsidiary of Danse Bank got into trouble for money laundering, and the plaintiffs alleged this resulted in a number of false statements by Danse Bank itself.  The court dismissed all of the statement claims on various grounds, and then turned to the final allegations that, due to Estonia’s conduct, Danse Bank had engaged in a scheme to defraud.  The court rejected the claim in a few brief sentences:

At no point do [the plaintiffs] articulate with precision the contours of an alleged scheme to defraud investors, or which specific acts were conducted in furtherance of it. Instead, the claim rests upon the incorporation of the previous 140 pages of the pleading paired with the conclusory assertion that “Defendants carried out a common plan, scheme, and unlawful course of conduct that was intended to . . . deceive the investing public” and “artificially inflate the market price of Danske Bank ADRs.” App’x at 160. Money-laundering at a single branch in Estonia cannot alone establish that Danske Bank itself carried out a deceptive scheme to defraud investors. Absent some sort of enumeration of which specific acts constituted an alleged scheme in connection with the purchase or sale of securities, the Funds’ claim does not comply with the applicable heightened pleading standard and cannot go forward.

(emphasis added).

The court did not explain why a Danse Bank subsidiary is being treated as distinct from Danse Bank itself, or how one should assess Danse Bank’s actions and intent distinct from the behavior of its subsidiaries.  I can’t even say the decision was wrong, because I don’t know what standards the court used to reach it.

Next up, there’s Hurst v. Enphase Energy, 2021 WL 3633837 (N.D. Cal. Aug. 17, 2021), where, as relevant here, plaintiffs tried to demonstrate scienter by pointing out that several insiders made unusual sales prior to the end of class period disclosure.  The court rejected the argument by saying:

Defendants correctly highlight that seven of the eight identified insiders are not named in this action, and such sales are irrelevant to scienter.

No further analysis was provided; the court simply cited two other cases, Wozniak v. Align Tech., Inc., 2011 WL 2269418 (N.D. Cal. June 8, 2011) and In re Splash Tech. Holdings, Inc. Sec. Litig., 160 F.Supp.2d 1059 (N.D. Cal. 2001).  Wozniak, like the Enphase court, did not discuss the matter further. 

But let’s unpack this.

Insider trading is often described in 10(b) opinions as a “motive” to commit fraud – for example, in Splash, the court didn’t exactly say that nondefendants’ trades were never relevant, but it did suggest they’d only be relevant if there was evidence the trades were intended to manipulate the stock to assist their colleagues’ fraud.  But that is too broad brush. Insider trading may also be a result rather than a cause.  I.e., imagine a corporation where insiders are committing fraud for some reason – they feel pressure from stockholders or their bosses to get results, they have bonuses on the line, they’re afraid of losing their jobs, whatever it is.  Now they, and possibly other people in the organization, have inside information that the company is not in fact as successful as it pretends to be.  Anyone with this knowledge may decide to sell stock and cash in while they can; the sales, in this scenario, are not the reason for the fraud, but they do evidence someone’s knowledge that something in corporate reporting was amiss.  That knowledge may contribute to an inference of scienter, in the sense that information was known to someone demonstrating that the defendants’ public statements were false and would mislead investors.

Why, then, would nondefendants’ trades be relevant here?

There are a number of possibilities, and they depend on your theory of scienter.

In the simplest example, suppose the selling shareholders worked closely with the individual defendants who spoke publicly.  Or suppose they sat in the surrounding offices.  It might very well be a reasonable inference that if they knew something was amiss, the individual defendants – who worked with them – knew it as well.  Maybe it’s not a strong inference, maybe it doesn’t carry the day, but it’s not an irrational one and it hardly makes sense to dismiss the possibility with a bright line declaration that nondefendants’ sales are irrelevant.

But let’s say we’re talking about corporate scienter rather than individual scienter.  Now, again, nondefendant individual sales may be relevant here, but how they are relevant depends on your theory of how to attribute scienter to a corporation.

Suppose corporate scienter is gleaned from the overall functioning of the organization.  The fact that there is evidence that at least some insiders (maybe highly placed ones) had knowledge of the truth, and yet the company issued false statements despite that knowledge, may give rise to an inference of exactly the kind of communication breakdown that justifies treating the entity as though it behaved recklessly.

Or, suppose corporate scienter is based on the scienter of someone who – as some circuits have held – approved the false statement, or furnished information for inclusion.  These insiders may very well have done that.  Maybe they approved false statements, or supplied false information to someone else.  Their sales indicate knowledge of the truth; their actions permit their own scienter to be attributed to the entity.

Why not just name them as defendants, then?  Simple: Their internal involvement with corporate information flow may not be enough to constitute a false statement under Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), and though they may have participated in a scheme to defraud under Lorenzo v. SEC, 139 S. Ct. 1094 (2019), given how narrowly the Supreme Court has read reliance in the 10(b) context, see Stoneridge Inv. Partners LLC v. Scientific- Atlanta Inc., 552 U.S. 148 (2008), it’s not clear plaintiffs would be able to state a claim against them individually.  Thus, evidence of their knowledge contributes to an inference of scienter against the entity, but they are not proper defendants individually.

And, indeed, in Splash – which was cited by the Enphase court and held that the trades of nondefendants were irrelevant – the actual individuals who traded had been defendants earlier in the case, and were dismissed because plaintiffs could not show they had personally made any false statements.

Or! There is another possibility.  As I discussed in my post two weeks ago, some circuits have held that if truthful information was available to persons who played a role in approving or furnishing false information, etc, plaintiffs may be able to create a pleading stage inference that someone who approved or furnished false information acted with scienter, even if they cannot identify who that person is in their complaint.  And those allegations might create a strong inference of corporate liability for 12(b)(6) purposes, with the specific guilty agent to be identified later.

Insider sales by nondefendants may help contribute to that inference.  Maybe plaintiffs can’t show they were personally involved with generating the false statements, but there may be enough of them – highly placed – that you can infer at least one of them probably was.  Or, going back to the proximity issue, if they are adjacent to power, their knowledge may contribute to an inference that the truth was widely known at least among higher level people, so that, again, it is likely that at least one such person contributed to the false statements while knowing the truth.

I am not saying that any of these inferences were appropriate in Enphase – maybe not.  And how strong they are likely to be is necessarily going to vary case by case.  But the issue deserves more unpacking than a simple maxim that nondefendant sales are irrelevant to to scienter.

August 28, 2021 in Ann Lipton | Permalink | Comments (1)