Business Law Prof Blog

A Tale of Two Meme Stock Class Certification Decisions

This week, we got two denials of class certification in 10b-5 securities cases involving meme stocks.  The first concerned Bed Bath and Beyond, the second concerned a fintech called Rocket Companies, which is not one of your more famous meme stocks, but apparently met the definition for 2 days out of a 2-and-a-half month class period.  One case presented a refreshingly accurate application of current doctrine.  The other presented a clarifying illustration of the doctrinal mess created by the Supreme Court’s decision in Goldman Sachs v. Arkansas Teacher Retirement System and its subsequent interpretation by the Second Circuit.

[More under the jump]

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Zymergen

The SEC recently settled an enforcement action against Zymergen for making false projections about its business.  Prior to its IPO in April 2021, many of these projections were given directly to analysts.  Zymergen did not include the projections in its registration statement, because companies are strictly liable to investors for false statements in a registration statement under Section 11 of the Securities Act, and so they generally try to avoid making projections that may turn out to be overly optimistic.  Instead, Zymergen gave the false projections to analysts, so the analysts would take the projections, and use them in building their models, which they would pass on to investors with a recommendation of some sort.

One question then, is, if the SEC had not brought an enforcement action, could Zymergen have been liable to investors for passing on bad info to analysts?

The answer is, maybe not.  Certainly not under Section 11, which only applies to information in a registration statement.  And maybe not under Section 10(b), the general antifraud statute, because Stoneridge v. Scientific-Atlanta holds that public investors are not deemed to “rely” on behind-the-scenes conduct that’s filtered to the public through the false statements of another entity.  (But see Janus Capital Group, Inc. v. First Derivative Traders, raising the possibility, without deciding, that statements to analysts are public for 10(b) purposes).

Could the analysts themselves be liable for passing on targets based on false projections?  Certainly not under Section 10(b), unless they knew or were reckless about falsity, because Section 10(b) only applies to intentional frauds.

What about under Section 12, which imposes negligence liability for anyone who distributes a false offer for the sale of securities (which could theoretically apply to Zymergen, as well?)

It’s complicated.  The Supreme Court has narrowed the application of Section 12 in ways that are somewhat convoluted, and might preclude liability here, though in the pre-IPO context it's hard to say.  But a second issue concerns whether the research report could be considered an offer in the first place.  Maybe so, except in the JOBS Act of 2012, Congress legislated an exception to the definition of offer, so that any research report is not an offer if it concerns an IPO of an emerging growth company.  So, because Zymergen (like most IPOs) was an emerging growth company, the analysts themselves were free to distribute Zymergen’s false information, without fear of Section 12 liability; they could only be liable if they themselves acted intentionally under Section 10(b). 

The combination creates some… well, troubling incentives, especially for analysts who work for investment banks that are part of the selling group and therefore may feel some pressure to offer positive coverage.  The analyst report itself won’t trigger negligence liability as a false Section 12 prospectus (because of the carveout), shareholders who read the analyst report (probably) can’t sue Zymergen under 10(b) (because of Stoneridge), and neither Zymergen, nor the underwriters who might even employ the analyst, will be liable under Section 11 for false statements in the registration statement, because those false statements were by hypothesis carved out of the registration statement to be farmed out by the analysts instead.

Now, after the dot com scandals of the early 2000s, the SEC procured settlements from the largest investment banks to separate their underwriting and research segments and new FINRA rules also required such separation but, you know, the Zymergen situation does raise the question whether this is the correct balance, especially since I gather it is fairly common practice for pre-IPO firms to share revenue guidance with analysts, in the expectation those analysts will present the information to investors.

On this point, I note that Zymergen’s registration statement contains the following standard language:

We are responsible for the information contained in this prospectus. We and the underwriters have not authorized anyone to provide any information or to make any representations other than those contained in this prospectus or in any free writing prospectuses prepared by us or on our behalf. We and the underwriters take no responsibility for any other information that others may provide you.

The SEC doesn’t mention it; still, it’s weird to me that these companies are permitted to filter their projections through analysts in hopes of flogging an IPO, while simultaneously publicly disclaiming any of that analysis.

That said, investors did, in fact, identify some allegedly false statements that were directly included in Zymergen’s registration statement, and those are the subject of an ongoing securities case under Section 11.  So … all’s well that ends well?

And finally, the latest Shareholder Primacy podcast is up.  This time me and Mike Levin talk TripAdvisor (pending before the Delaware Supreme Court) and 14a-4 shareholder proposals.  Available on Spotify, Apple, and YouTube. 

Climate Change and Wahed Invest, a Reprise

A while ago, I posted about an SEC enforcement action against Wahed Invest.  Wahed Invest is a religious investment advisor that purported to select and monitor investments to ensure compliance with Shari’ah law.  In fact, according to the SEC, it did not in fact have policies in place to assess ongoing Shari’ah law compliance,  

At the time, I noted that I had not before seen an enforcement action based on false nonfinancial representations – that were nonetheless material to investors’ nonfinancial goals - and I compared it to the then-proposed climate change rule’s consideration for the nonfinancial goals of investors.  Specifically, the proposed rule justified, in part, its requirement that companies disclose GHG emissions on the ground that some investors have made net-zero commitments, regardless of whether the emissions data would be financially material to the operating company.

Well, this morning, I learned about a new SEC enforcement action against Inspire Investing.  Like Wahed, Inspire is a religious investment advisor, and like Wahed, it purported to engage in a “biblically responsible” investment strategy that required it to use sophisticated data analysis to ensure no companies in its ETFs engaged in certain prohibited activities.  In fact, its methods were far more slipshod than it represented, resulting in a number of verboten companies being included in its funds.

So, once again, the SEC took action to protect investors’ nonfinancial goals, i.e., it adopted a concept of materiality that originated from investors’ values, but was not tied to financial values.

Which is useful to consider in light of the final climate change rules.  Not only is the GHG emissions disclosure requirement softened to focus solely on materiality to the company (previously, that was only for disclosure of Scope 3 emissions, which requirement is eliminated entirely), but the references to investor net zero commitments – investor financial goals – is (as far as I can tell, it’s a very long document) gone. 

(To be fair, a lot of institutions have left the alliances that previously were committed to net zero goals, and one alliance has disbanded entirely, but a lot of that movement happened after the rules were finalized and some investors maintain their commitments).

Point being, we are in a world where apparently materiality for the purposes of assessing fraud can include nonfinancial information, but for the purpose of affirmative disclosure requirements, its status remains uncertain.

And another thing...

The latest episode of my Shareholder Primacy podcast with Mike Levin is up; this one deals with Moelis/SB313 and advance notice bylaws.  Links on Spotify, Apple, and YouTube.

What the world needs is a new podcast, amirite?

Well, Hurricane Francine passed through New Orleans, and left me with power (yay!) but no internet (boo!), which means I'm relatively helpless.

Still, I'll take this opportunity to announce that I've started a podcast, Shareholder Primacy, with Mike Levin (The Activist Investor).  We're still working out what it wants to be, but our first episode is up (here on Apple, here on Spotify, here on YouTube) addressing the status of the Tesla compensation case, and the implications of the universal proxy.

Also, I'm very proud of this meme I made:

 

In Which Elon Musk Once Again Becomes a Classroom Hypothetical

This time, it’s Brazil.

If you’re not following the saga, the story is apparently that ex-Twitter, now controlled by Elon Musk (not the CEO, though; you can’t even really say he’s the owner without qualifying about the interests of other investors and – don’t forget – the debtholders), ignored the order of Brazilian Supreme Court Justice Alexandre de Moraes to remove certain accounts associated with hate speech and misinformation.  Apparently out of fear that Twitter’s Brazilian employees would be arrested, Twitter shut down its Brazilian offices.  At that point, Twitter was out of compliance with a Brazilian requirement that a legal representative be present in the country.  So, Justice de Moraes ordered that access to Twitter be blocked throughout Brazil.  (Legal challenges to that order continue)

That’s not great for Twitter, but it turns out, it was even worse for Starlink, a wholly-owned subsidiary of Musk-controlled SpaceX, because the Justice ordered that Starlink’s financial accounts be frozen in order to force payment of fines owed by Twitter.  Musk at first insisted that he would not block access to Twitter via Brazilian Starlink, then – on that point – relented.  Shortly thereafter, it was reported SpaceX was evacuating its personnel from the country.  As the Wall Street Journal put it, “Starlink’s entanglement in a dispute originally about X is a stark illustration of how some government officials around the world may draw few distinctions between enterprises that Musk runs.”

So, all of this has the makings of a great introductory classroom discussion of corporate separateness, enterprise liability, and veil-piercing.  I have no idea what the law on this is in Brazil, but let’s talk about how we’d analyze this under American law.

(more under the jump)

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14a-8 alternatives

Not a whole lot going on this week in terms of legal developments, so I thought I'd reach back to an older post of mine, where I talked about a case pending before the Fifth Circuit regarding 14a-8.  The original petitioner, the National Center for Public Policy Research, argued that the SEC engages in viewpoint discrimination when it issues no-action letters; an intervenor challenged the entire basis for Rule 14a-8 as unauthorized by statute and unconstitutional to boot.  The SEC, for its part, addressed these substantive arguments but concentrated most of its energies on arguing that no-action letters are not final orders subject to challenge in the first place.

Normally, I'd assume a case like this wouldn't have much chance of succeeding, but it's the Fifth Circuit, which tends to take an entrepreneurial approach to issues like corporate rights, standing, and administrative authority.  Even then, I'd say the petitioners were likely out of luck, because the panel turned out to be Jones, Douglas, and Dennis - meaning, two Democrats and a Republican - and, indeed, only Judge Jones demonstrated any sympathies for the petitioners during oral argument.  But! The last time sec reg ended up before a 2-1 Democratic panel of the Fifth Circuit, the Democrats' ruling in favor of the NASDAQ's diversity rule was taken en banc where its prospects apparently are rather dim.

So what happens if Rule 14a-8, at least in the form we know it, dies?

Well, that brings me to the United Mine Workers' tactic against Warrior Met.  As Mike Levin described in his Activist Investor blog here, United Mine Workers took advantage of the universal proxy rule to run a shareholder proposal proxy contest.  That is, because it can now list incumbent director candidates on its own proxy card, that's just what it did - it offered several shareholder proposals (14a-8 would limit it to just one), ignored all of Rule 14a-8's other strictures, filed its own proxy materials, sent out proxy cards, and hired a vendor to collect them.  Having done that, Warrior Met was backed into a corner and forced to include the proposals in its own proxy materials - because otherwise it risked losing control over, and insight into, how proxy cards collected by Mine Workers were being voted or if they were being returned at all.  The expenses for this entire effort by the Mine Workers totaled just $15,000, which sounds very feasible for at least some repeat-player proposal proponents.  It also may just scratch the surface of what the universal proxy enables in the future.

But that, of course, assumes the proposal is one that United Mine Workers can, in fact, bring to the floor - i.e., state corporate law has to allow shareholders to raise these proposals at a shareholder meeting and vote on them, before anything else can happen.  Mohsen Manesh lays out the argument for how corporations can - via bylaw or charter provisions - limit shareholders' power to make proposals in the first place, which would not only prohibit United Mine Workers' tactic, but also limit the use of 14a-8 (which is only supposed to enable shareholders to exercise their state-law created governance rights).  If he's right, and if companies/management take advantage of that ability, we could lose a lot of shareholder proposals entirely (and a major source of entertainment for corporate academia).  Prof. Manesh explains that companies might not want to limit shareholders' ability to bring proposals - maybe investors would be annoyed if their rights were curtailed that way - but, as I previously observed, there wasn't much pushback when Exxon sued its own shareholders over a proposal, so maybe there's space for companies to rid themselves of proposals entirely.

Lebovitch on DGCL § 122(18)

As you may recall, Ann and I got a bit wound up last summer about the Delaware General Assembly's consideration of Delaware S.B. 313 (and, within it, the proposed addition of § 122(18) of the General Corporation Law of the State of Delaware ("DGCL")). We each offered brief oral testimony and even wrote letters to the Delaware House Judiciary Committee, which you can find here and here.

A comrade in that effort, Mark Lebovitch, has taken time to reflect a bit on the crazy summer that brought a new and troubling corporate purpose to Delaware's venerable corporate law and to prognosticate about the future impact of DGCL § 122(18).  The result?  Soap Opera Summer: Five Predictions About DGCL 122(18)’s Effect on Delaware Law and Practice.  The abstract follows.

Predictability and stability are often cited as leading reasons for why Delaware’s corporate law system is world renowned and widely emulated, giving the First State dominance in the competition for domiciling business entities. The first half of 2024 was anything but predictable and stable in Delaware’s legal community. Rarely has an amendment to the Delaware General Corporation Law (“DGCL”) triggered as much public debate as SB 313, which became effective as of August 1, 2024. The crux of the dispute turned on identifying the greater risk to Delaware’s standing as the global leader in corporate law – a few recent judicial opinions that would have forced certain market practices to change, or the legislative fix seeking to nullify those opinions.

This article focuses on the most controversial aspect of SB 313. New DGCL Section 122(18) overrides the Court of Chancery’s February 23, 2024, Opinion in West Palm Beach Firefighters’ Pension Fund v. Moelis & Company ("Moelis"), by broadly allowing corporate boards to contractually delegate to any stockholder or prospective stockholder the power to cause the company to act or refrain from acting in almost any manner, including many decisions normally reserved for the board itself. Now that the debate about recent cases and new legislation is over, this article takes the opportunity to assess how the new law will actually affect Delaware’s corporate law doctrine and litigation practice. Looking beyond the atypical drama of the past six months, this article offers five subtle (but hopefully not boring) predictions and observations about how new Section 122(18) is likely to affect the corporate world going forward.

Time will tell whether Mark gets the predictions "right" or not.  In the meantime, I am prepared for the eventual advent of legal challenges.  Like Mark, I see them coming . . . .

Three Things Make a Post

Thing One:  I jotted!  Which is to say, I wrote a Jotwell review of Hilary Allen’s Interest Rates, Venture Capital, and Financial Stability, forthcoming in the University of Illinois Law Review.  Her paper is here, and you can find my review here.

Thing Two:  I have a new paper-ish thing.  As y’all know, I’ve been keeping an eye on litigation-limiting bylaw and charter provisions, including – as I previously posted – the Ninth Circuit’s en banc decision in Lee v. Fisher, which permitted The Gap to enforce a forum selection bylaw directing derivative Section 14(a) claims to Delaware’s Court of Chancery – even though that court has no jurisdiction to hear Section 14(a) claims.  In practical effect, then, the bylaw operated as a waiver of the federal claim.

That decision cited a draft version of an article by Professors Mohsen Manesh and Joseph Grundfest, Abandoned and Split But Never Reversed: Borak and Federal Derivative Litigation, in which they defended such bylaws.  The article was published in the Business Lawyer late last year, and is available here.

Anyhoo, I now have a (very short) reply to Professors Manesh and Grundfest, also forthcoming in the Business Lawyer, called Not Dead Yet.  The Reply is available here, and this is the abstract: 

In their article, Abandoned and Split, But Never Reversed: Borak and Federal Derivative Litigation, Professors Mohsen Manesh and Joseph Grundfest argue that corporations should be permitted to waive derivative Section 14(a) claims in their constitutive documents, partly because such claims are duplicative of other causes of action, and partly because of the weakness of the original Supreme Court case to recognize them. In this Reply, I defend the continuing vitality of the derivative Section 14(a) cause of action, and its necessity as a source of investor protection

But! Mine is not the last word; Mohsen and Joe will have a reply to my reply in the same issue.  When that’s public, I’ll edit this post with a link.

Thing Three:  The Lee v. Fisher case was one of a series of cases arguing that companies were lying about their efforts to diversify their boards.  Another such case was brought against Qualcomm, and it was dismissed by a federal district court in 2021.

The plaintiff in that case then sought books and records in Delaware, and relied on those to file a state law complaint, which once again alleged that the company lied about its efforts to diversify when seeking director candidates.  This time, however, the complaint was brought for breach of state law fiduciary obligations rather than federal proxy fraud, and the claim was direct rather than derivative.  Not long ago, Vice Chancellor Laster dismissed that claim in a bench ruling. 

The transcript is worth a read.  Among other things, VC Laster explicitly (though not unsurprisingly) held that directors only have a duty to maximize firm value.  Demographic diversity may further that goal by fostering innovation; demographic diversity may also further that goal by inspiring the confidence of stakeholders, who would otherwise lose faith if they “only see very few people who look like them.”  But boards have discretion to make their own judgment as to the financial value that diversity provides.

What they can’t do, of course, is explicitly lie to shareholders in their proxy statement, or omit material information, which is what the plaintiff was alleging.  And here was the second interesting point: VC Laster noted that a voting rights claim based on a misleading or incomplete proxy statement is not, per se, subject to the business judgment rule.  As he put it, “Directors have a duty to disclose material information, but there is no separate standard of review that overlays that obligation, such as the business judgment rule…. [I]n a case involving stockholder action, a plaintiff need only plead two elements: First, that there was a request for stockholder action, and certainly there was here.  These were elections of directors. And second, that there was a material misrepresentation or omission.”

With that set up, however, he found that Kiger had not in fact stated facts that made it reasonably conceivable that Qualcomm misled shareholders about its diversity efforts, and that was the end of that.

NVIDIA

In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA), which dramatically heightened the pleading burden for plaintiffs bringing securities fraud cases.  At the same time, the PSLRA also instituted a mandatory stay on discovery until resolution of any motions to dismiss, which means plaintiffs have to use their own investigation – relying on public information, confidential sources, and the like – to draft a complaint that is sufficiently particular to satisfy PSLRA standards.

In 2002, Steve Bainbridge and Mitu Gulati published How Do Judges Maximize? (The Same Way Everybody Else Does – Boundedly): Rules of Thumb in Securities Fraud Opinions.  The paper explained that, given the high pleading standards of the PSLRA, judges deciding motions to dismiss lighten the workload by coming up with various rules of thumb for determining whether a complaint pleads materiality or scienter.  For example, they identified the puffery doctrine (presuming that investors treat vague statements of optimism as immaterial), the bespeaks caution doctrine (predictions of the future are immaterial if they are caveated by warnings of future uncertainty), and fraud by hindsight (refusing to draw inferences about what the company knew at an earlier time due to negative disclosures at a later time), as new bright line rules that judges employ to dismiss complaints, disconnected from the general fact pattern.

I can add a bunch more.  For example, a refusal to infer knowledge from one’s position in the company (except in generally rare instances where the “core operations” doctrine kicks in), a refusal to treat bonuses and similar compensation as a motive for fraud, a refusal to treat corporate departures as indicative of fraud unless there are “particularized allegations connecting the departures to the alleged fraud,” In re Hertz Global Holdings, 905 F.3d 106 (3d Cir. 2018), and a refusal to treat insider trades by non defendants as indicative of scienter (an issue I blogged about here).  These are more “rules” for complaints that, I’d argue, contradict our common sense understanding of how to go about inferring other people’s states of mind on a day to day basis just, you know, as a consequence of living as human beings on this planet.

Additionally, a couple of years ago, I published Fact or Fiction: Flawed Approaches to Evaluating Market Behavior in Securities Litigation, which identified still more rules of thumb that judges have developed over time.  For example, when addressing loss causation, courts often require revelation of the fact of falsity (rather than a revelation of problems traceable to the fraud), and will further hold that notice of an investigation, without more, categorically cannot cause a loss. 

You see the problem.  The question whether a complaint pleads falsity or a strong inference of scienter or loss causation or materiality is a holistic factual inquiry; but as these rules build up, pleading or litigating a securities case becomes about whether plaintiffs have complied with an increasingly arcane set of rules.  I like to quote then-Chief Judge William Young from 1999, describing the PSLRA as a “Byzantine pleading code …for securities actions.”  In re Number Nine Visual Tech. Corp., 51 F. Supp. 2d 1 (D. Mass. 1999).

Which is what I was thinking about when going over NVIDIA’s opening brief in NVIDIA Corporation v. E. Ohman J:or Fonder AB, currently pending before the Supreme Court. 

The plaintiffs pled falsity by relying, in part, on an expert report that drew inferences based on market information.  The assumptions and inferences on which the report was based were in the complaint.  Nonetheless, NVIDIA seeks to have the Supreme Court adopt a bright line rule that an expert opinion does not constitute an allegation of fact sufficient to satisfy PSLRA pleading standards.  NVIDIA also challenges the market evidence and factual assumptions that underlay the report as too generic.  Finally, NVIDIA admits that sometimes expert reports may be helpful, but here, the complaint rests too much on the expert report alone, so that the other facts surrounding it are not sufficient.

I see no way the Supreme Court can give NVIDIA what it wants without either acting as a district court and weighing this specific complaint and these specific allegations without regard for future cases, or - more likely - adding more artificial rules to securities pleadings.  Expert reports are still pretty rare in complaints, but if the rule is you can’t have them be the sole support of a complaint, then we’ll see endless litigation over what counts as “sole” (especially since, in this very case, the plaintiffs offer additional allegations).  And if plaintiffs can’t use expert reports that draw inferences based on detailed market information, can they use short seller reports that do the same?  (The Ninth Circuit, for example, has held that short seller reports analyzing public information may be a basis for alleging loss causation if they involve “extensive and tedious research involving the analysis of far-flung bits and pieces of data.” In re BofI Holding, Inc. Securities Litigation, 977 F.3d 781 (9th Cir. 2020)).

If plaintiffs can’t use short seller reports, what happens if the plaintiffs’ attorneys draw inferences based on public information – does that go too far?  Suddenly what started out as a simple rule about experts becomes whole new categories of prohibited inferences being added to the list.  And ruleification ends up obscuring the ultimate inquiry, namely, whether there is a sufficient basis to infer that the defendants’ statements were false.

There’s a similar issue with respect to the other question presented in this case, which is about pleading scienter.  In NVIDIA, the plaintiffs offer a lot of circumstantial evidence of scienter, plus make allegations regarding the existence of documents allegedly reviewed by the defendants, but the plaintiffs haven’t seen the documents so they can’t plead their exact contents.  NVIDIA wants the Court to adopt a bright line rule that the contents of the documents must be described, because “Plaintiffs built their entire scienter case around NVIDIA’s internal documents and data.  By choosing this route, Plaintiffs were required by the PSLRA’s pleading standards to allege with particularity what those documents and sources said and how they supported Plaintiffs’ preferred inference of scienter.”  Which means, were the Court to accept NVIDIA’s argument, the next step is litigation over what counts as the “entire” case, and how much description of a document is enough, and how much support a generally-described document can provide when there are other allegations of scienter.  The argument becomes about the contours of the rule, not whether the substantive standard for pleading scienter is met.

Securities complaints are now hundreds of pages long – and sometimes, ironically, dismissed for being too long and confusing, because Goldilocks-like, they must be just right.  See, e.g., Macovski v. Groupon, Inc., 2021 WL 1676275 (N.D. Ill., Apr. 28, 2021).  (Apparently, plaintiffs must also take a class in narrative exposition before they can survive a motion to dismiss.)  Selecting a lead plaintiff takes months, drafting an amended complaint typically is 60 days or so after that, plus another 60 for the motion to dismiss, 60 for the opposition, and 30-60 for a reply – weeks or months before an oral argument and god knows how long before a decision, and all of this before there’s been any discovery.  By the time you get to depositions, witnesses will be able to say “I don’t remember” and be completely credible.  The last thing this system needs is more up front rules about what plaintiffs can and cannot plead.

Ninth Circuit Follows Frutarom

Previously, I blogged about Mivtachem Insurance v. Furtarom, 54 F.4th 82 (2d Cir. 2022), where the Second Circuit held that false statements about a target company - most of which were included in the acquiring company's S-4 - were not made "in connection with" sales of the acquirer's securities, and therefore, purchasers of the acquirer's stock did not have standing to bring Section 10(b) claims against target company officers.

Inevitably, the same thing came up in a pair of cases about SPACs, where purchasers in the publicly-traded SPAC entity wanted to bring claims based on pre-merger false statements about the target company.  A New York district court, following Frutarom, denied the claims; a California district court rejected the Second Circuit's reasoning (and dismissed the claims on other grounds, namely, that at the time of the false statements it wasn't clear that the target company really was going to be a target company).

Anyway, the California case, which involved the Lucid de-SPAC, was just appealed to the Ninth Circuit and the Ninth Circuit ... followed the Second Circuit's rule.  In Max Royal LLC v. Atieva, it held:

As noted above, Blue Chip limits standing to “purchasers or sellers of the stock in question.” 421 U.S. at 742.  Plaintiffs contend that the “stock in question” is “the security about which Plaintiffs allege injury,” and not necessarily a security of the company that made the alleged misrepresentations. Plaintiffs further contend that the “Blue Chip rule merely checks whether plaintiffs allege injury from the purchase or sale of a security” and that standing is determined based on “whether the security plaintiff purchased is sufficiently connected to the misstatement.” For several reasons, we conclude that Plaintiffs’ construction of standing is inconsistent with Blue Chip. …

Plaintiffs ignore the plain language of Blue Chip and assert that Section 10(b) standing extends to any stockowner who claims that the misstatements of another person or company negatively affected the value of the owner’s stock. Under Plaintiffs’ desired formulation of the standard, hypothetical plaintiffs would need only to have purchased a security—any security—to satisfy the purchaser-seller requirement. But Plaintiffs’ interpretation of the securities laws would vastly expand the boundaries of Section 10(b) standing and contradict the express limiting purpose of the Birnbaum Rule. The Supreme Court has cautioned that Section 10(b) does not “provide a cause of action to the world at large,” and “should not be interpreted to provide a private cause of action against the entire marketplace in which the issuing company operates.” Stoneridge, 552 U.S. at 162 (cleaned up) (quoting Blue Chip, 421 U.S. at 733 n.5)….

We agree with the Second Circuit’s reasoning in Menora and likewise reject Plaintiffs’ “sufficiently connected” test. The Supreme Court adopted a bright-line rule for standing—even at the risk of it being “arbitrary” in some cases—to avoid the type of “endless case-by-case” analysis contemplated by Plaintiffs....

It is undisputed that the securities about which Defendants allegedly made misrepresentations were those of Lucid. Under the Birnbaum Rule, Plaintiffs would need to have purchased or sold Lucid stock to have standing to bring this action under Section 10(b). Here, Plaintiffs did not purchase or sell Lucid stock, as Lucid was a privately held company during the relevant period. Plaintiffs purchased CCIV stock, but their complaint does not allege that anyone made misrepresentations about CCIV stock. Because Plaintiffs did not purchase or sell the securities about which the alleged misrepresentations were made, Plaintiffs lack standing under Section 10(b).

That CCIV later acquired Lucid does not change our analysis.

One interesting point about the Ninth Circuit's reasoning is that the court added, "If Congress wants to treat SPAC acquisitions differently than traditional mergers, it has the authority to do so."

Except the SEC, anyway, did do so - inapplicable to this transaction, but applicable to transactions going forward, the SEC adopted new rules requiring target company officers to sign the registration statement issued in connection with the de-SPAC transaction.  And in the adopting release, it said:

Given that the target company therefore is, in substance, an “issuer” of securities in a de-SPAC transaction regardless of transaction structure, the Commission proposed to amend Instruction 1 to the signatures section of both Form S-4 and Form F-4 to require that, when the SPAC would be the issuer filing the registration statement for a de-SPAC transaction, the term “registrant” would mean not only the SPAC but also the target company....

As discussed in more detail below, it is our view that in a de-SPAC transaction the target company is an issuer of securities under section 2(a)(4) of the Securities Act, and, therefore, the target company along with its required officers and directors must sign a registration statement filed by a SPAC or another shell company for the de-SPAC transaction, because both in substance and by operation of new Securities Act Rule 145a, the target company is issuing or proposing to issue securities in a de-SPAC transaction, regardless of the transaction structure....

Now, the SEC was explicitly contemplating Section 11 liability, not 10(b) liability, and it therefore was talking about the S-4 rather than statements made outside the securities filings, but that might be the kind of thing that ... informs ... a court's analysis, no?

I also wonder how this reasoning impacts SEC v. Panuwat, i.e., the "shadow" insider trading case, which I previously blogged about here.  That case also involved information about one company being used to trade in the securities of another company - and after trial, a jury found the trader liable.  I assume Panuwat will cite Max Royal on appeal, though I suppose the Ninth Circuit might limit its holding to private Section 10(b) actions.

Anyway, here's Marc Steinberg and Antonio R. Partida criticizing Frutarom. 

Miscellany

This week I just direct your attention to various items.

First, the NYSE recently proposed a rule change that would exempt closed end funds from the requirement of holding annual shareholder meetings.  Closed-end funds are frequently the subject of activist attacks – here I blogged about a Second Circuit case that struck down a takeover defense measure in a Nuveen fund – so a rule change here would be, you know, significant.  Anyway, here is the link to the comments the SEC has received, and the one I found particularly useful, was by the Working Group on Market Efficiency and Investor Protection in Closed-End Funds, which is a collection of law and business professors.

Second, Project 2025 is all in the news these days as a preview of what a second Trump administration might look like, and it turns out, there are proposals for changes to the federal securities laws.

We have the usual conservative stuff, like, get rid of disclosure requirements pertaining to “social, ideological, political, or ‘human capital’ information that is not material to investors’ financial, economic, or pecuniary risks or returns.”  Obviously, the issue here, unaddressed in the document, is that most commenters would agree that only financially material information should be required; the disagreement is over what that means.  And that becomes very obvious in the document, because it singles out the climate change disclosure rules as expensive and therefore ripe for repeal, but it never argues that they require disclosure of immaterial information (though to be fair, the document is full of proposals to repeal climate change-related regulation, and I haven’t read all of it; maybe somewhere else there’s an argument that climate change is financially immaterial).

Anyway, there’s also a proposal that three SEC commissioners be permitted to override the Chair with respect to placing items on the agenda, and pace Jarkesy, they’d allow defendants to choose whether their cases are heard in federal court or administrative courts (which incidentally seems similar to a proposal by Christopher Walker and David Zaring, though their paper is not cited). 

Digital assets would be commodities unless the holder has a contractual right to a share of earnings, or, in the case of liquidation, a claim on the assets.

They’d also simplify firm categories to public, private, and small (based on public float or – interestingly, beneficial owners rather than street name owners), and remove accreditation requirements.  Which as I understand it would functionally mean that companies could choose whether to file registration statements or not.  Intriguingly, however, they do propose to:

Abolish Rule 144 and other regulations that restrict securities resales and instead require a company that has sold securities to provide sufficient current information to the market to permit reasonable investment decisions and secondary sales.

I’m not sure how that proposal interacts with the earlier proposal to segment the market cleanly into public, private, and small firms, but there you go. 

Third, a historian at the University of Delaware, Professor Dael Norwood, is researching Delaware’s history of permitting corporations to vote in local elections; he’s blogged about his findings here and here.

And finally, here is a story about how the new trend of retail stores locking up products is backfiring, because it makes it harder for customers to actually, you know, buy stuff.  What intrigues me is how it seems as though stores are making these decisions based more on vibes than actual data, and rejecting the obvious solutions like hiring more staff to police the aisles (or even just to open the cabinets).  Efficient markets are supposed to force corporate managers to make more reasoned choices, no?  But apparently the heuristic “employees are an expense, do everything but hire people” is very tough to combat.  Even at companies like Walmart, which adopt pay for performance metrics.

Special Committees of One

Special committees in Delaware have an important role for cleansing various kinds of conflicted transactions, everything from negotiating controlling shareholder deals to vetting derivative lawsuits.  There is no rule regarding committee size; the Board can populate a committee with as many or as few people as it wants.

That said, Delaware caselaw suggests that courts will be somewhat suspicious of special committees consisting of only one member.  That member must be “'like Caesar's wife… above reproach.” Gesoff v. IIC Industries, 902 A.2d 1130 (Del. Ch. 2006).  In Gesoff, VC Lamb stated that a single member special committee would get “a higher level of scrutiny,” and noted that in that case, the special committee member deferred too much to a controlling shareholder – something that might not have happened if a “moderating influence,” via a second member, had been available.

Since then, however, a couple of decisions have blessed the actions of single-member special committees.

And then came the Delaware Supreme Court’s decision in In re Match Group Derivative Litigation, which held that – at least when a corporation attempts to cleanse a controlling shareholder transaction – all special committee members, and not just a majority of them, must be independent.

Which raises the question: in controlling shareholder situations, should boards create committees of one?

Independence is assessed after the fact, and especially in recent years – as the Delaware courts have become more nuanced in their analysis – it’s not always obvious who will count as independent after the fact.  The more members you add to a committee, the more chance that, later, a court will determine one of them was not independent.

And though there’s a lot of language in Delaware opinions about gimlet eyes being cast on single-member committees, it’s not exactly clear what the discount rate is.

Anyway, this is obviously an issue in Tornetta v. Musk; there, the “ratification” procedure involved a committee of one, and it’s not clear how Chancellor McCormick will approach the matter.  There are a lot of different directions she could go – she could say that ratification simply isn’t possible, she could say that Musk was only a controlling shareholder for the purposes of the original package and not for the ratification, or anywhere in between.  But Tornetta is an unusual situation in a lot of ways; I’m wondering what the calculus will be going forward for more traditional transactions.

The direct/derivative distinction strikes again

In November 2021, Hertz authorized a buyback of its stock.  The effect of the buyback to was transform CK Amarillo from a 39% stockholder – who also had board seats – into a 56% stockholder.

Public stockholders of Hertz sued, alleging that the Hertz directors violated their fiduciary duties by transferring control of Hertz to CK Amarillo, without requiring that CK Amarillo pay a control premium.

One critical question was: Is this claim direct or derivative?

Normally, claims arising out of stock buybacks are derivative claims.  And normally, when a stockholder continues to hold shares in the entity, and nothing has changed about those share characteristics, and the stockholder was not asked to vote on anything, claims arising out of corporate action are derivative.  And just recently, the Delaware Supreme Court decided Brookfield Asset Management, Inc. v. Rosson, 261 A.3d 1251 (Del. 2021), where it held that if a company sells new shares to a controlling stockholder on the cheap, the claim is derivative, not direct – overruling Gentile v. Rossette, 906 A.2d 91 99 (Del. 2006), which held the claim is both.

But, as I argued in my paper, The Three Faces of Control, Brookfield also implied that claims would in fact be direct if the corporate action caused someone who wasn’t a controller to become one, or if the corporate action gave new control rights to someone who hadn’t had them before.  I wrote:

This appears to have been a rather backhanded way of holding that, if an equity issuance did result in a shift from an uncontrolled status to a controlled one, shareholders would be permitted to bring claims for breach of fiduciary duty directly, rather than derivatively....

Additionally, the Brookfield court also seemed to have endorsed the notion that equity issuances might give rise to direct claims even if they did not result in the creation of a new controlling shareholder, so long as they ended up redistributing specific control rights away from the public shareholders

On June 20, in a bench ruling in Cascia v. Farmer, 2023-0520, Chancellor McCormick preliminarily agreed, holding that the plaintiffs could sue both directly and derivatively.  She stated that she might revisit matters later in the case, but for the purposes of a motion to dismiss:

Brookfield appeared to leave open the possibility that a transfer of control might give rise to dual-natured claims. The Court expressly stated in Brookfield that Gentile was overruled only "[t]o 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."

The high court also noted, again, that there was no "practical need for the Gentile carve-out" in part because other legal theories "provide a basis for a direct claim for stockholders to address fiduciary duty violations in a change of control context." Here, plaintiff's case is about the harm resulting from a change of control….

Look, I recognize that this is a clarification of Brookfield that I don't know that our Court has given before. And at base, I'm unwilling to reach a definitive ruling on this factual and legal issue at the pleading stage.  But you-all will have litigation ahead and many opportunities to convince me otherwise. At this stage, given the pleading-friendly standard we apply to plaintiffs, I'm denying the motion to dismiss the direct claims ….

So, obviously, I think this is the correct decision, but in the wake of SB 313, it’s more than that.

Suppose a board hands new control rights to someone via the use of a stockholder agreement. Under my interpretation of Brookfield, which Chancellor McCormick has now tentatively endorsed at least in part, challenges to that action may, at least on some occasions, be brought directly rather than derivatively. And it will be interesting to watch courts untangle when the rights are significant enough to be one or the other.

Advance notice bylaws: the Delaware Supreme Court weighs in

This is my second blog post this week because I am procrastinating.

Anyway, a while back I blogged about Kellner v. AIM Immunotech, where VC Will invalidated certain advance notice bylaws that had been amended in the middle of a heated proxy contest.  The difficulty was that the case was heard on an expedited basis, in advance of the shareholder meeting, so that Will could determine if the dissident's nominees could stand for election.  And the dissident was ... not great.  The campaign had been orchestrated by a convicted felon who tried to hide his involvement, and the dissident had submitted some false information in response to the bylaw requests.  At the same time, though, the bylaws had been adopted as a blocking mechanism, and some were unintelligible.  

In that context, Will held that four of the amended bylaws failed enhanced scrutiny, but two could stand.  She concluded that the board had acted with a proper purpose - to obtain information so that it could fairly evaluate a director-nominee - but that several of the onerous bylaw amendments were disproportionate to the threat posed.  With respect to one bylaw, which was unreasonably broad, Will blue penciled it back to the original, pre-amendment version and held that the dissident had failed to comply with it.  For that reason, as well as some less important instances of false information submitted in connection with the remaining bylaws, she held that the dissident's nominees could not be considered at the meeting.

On appeal, the Delaware Supreme Court took a different approach and reversed Will's factual findings while denying that it had reversed her factual findings.

First, the Delaware Supreme Court held (and we should all take note of this for future cases) that advance notice bylaws may be evaluated for invalidity, and separately for inequity.  A validity challenge is a facial challenge, and relatively narrow: quoting ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Court held "A facially valid bylaw is one that is authorized by the Delaware General Corporation Law (DGCL), consistent with the corporation’s certificate of incorporation, and not otherwise prohibited."  The fact that it might operate inequitably or unlawfully in some circumstances is not sufficient to render the bylaw invalid.

On that analysis, the Court found that one amended AIM bylaw was invalid, because it was unintelligible: "The bylaw, with its thirteen discrete parts, is excessively long, contains vague terms, and imposes virtually endless requirements on a stockholder seeking to nominate directors....An unintelligible bylaw is invalid under 'any circumstances.'"

The other bylaws, however, were found to be facially valid.  But, they still had to be "twice-tested" in equity.  And that test is the enhanced scrutiny test, as articulated in Coster v. UIP Companies, 300 A.3d 656 (Del. 2023).  First, the board must identify a threat and act in good faith; second, the board's response must be proportional.

In this case, the Court found that the totality of the amended bylaws - which were exceptionally broad, required information potentially unknown to the nominee, were ambiguous, unreasonable, and ultimately at odds with the board's stated purpose of information-collection - suggested that the board did not, in fact, act with a proper purpose when amending them.  Instead, the purpose was to block the dissident entirely.  When it comes to proxy contests, boards may try to inform stockholders, but they can't substitute their own judgment for the stockholder vote; therefore, all of the bylaws (including the two that Will did not find to be unreasonable) had to be stricken.  They were all fundamentally tainted by the board's bad faith:

In the middle of a proxy contest, the AIM board adopted one unintelligible bylaw and three unreasonable bylaws. It then used the Amended Bylaws to reject Kellner’s nomination notice...The unreasonable demands of most of the Amended Bylaws show that the AIM board’s motive was not to counter the threat of an uninformed vote. Rather, the board’s primary purpose was to interfere with Kellner’s nomination notice, reject his nominees, and maintain control. As the product of an improper motive and purpose, which constitutes a breach of the duty of loyalty, all the Amended Bylaws at issue in this appeal are inequitable and therefore unenforceable.

So what's funny here is that the Court claims it's relying on Will's own factual findings - she was the one who found the bylaws unreasonable, she was the one who dropped stray comments like "The provision seems designed to preclude a proxy contest for no good reason," which the Delaware Supreme Court repeatedly quoted - to conclude the board acted with an improper purpose.  But that absolutely was not what Will found, after trial!  She explicitly held the opposite:

AIM’s Board had an objective of obtaining transparency from a stockholder seeking to nominate director candidates...The Board made a reasonable assessment, in reliance on the advice of counsel, that this information-gathering objective was threatened...the Board sought to prevent “the types of manipulative, misleading, and improper conduct” experienced in 2022 from happening again.....

The Board has proven that its actions served proper corporate objectives.  Specifically, it sought to obtain full and fair disclosure so that it could adequately evaluate a nomination and that stockholders could cast informed votes....

Anyway. That part is just drama.

The substantive issue is this: Remember Will's dilemma.  Both sides had behaved badly.  If the bylaws were struck entirely, the corporation would be unprotected against a lying bad faith actor.  That's why she felt the need to blue-pencil one bylaw, by restoring an older version, and measure the dissident's compliance against that bylaw.  Which struck me as a very odd solution, and I wondered how the Delaware Supreme Court would address the problem.

The Delaware Supreme Court, however, did not address the problem.  It was not acting in the middle of a proxy contest; by the time of the appeal, the shareholder meeting was over.  So, in light of the fact that Will had found the dissident behaved badly, the Delaware Supreme Court simply said no further relief was warranted:

We also note that, according to the Court of Chancery, Kellner submitted false and misleading responses to some of the requests.  Given the court’s countervailing findings about Kellner’s and his nominees’ deceptive conduct, no further action is warranted. The judgment of the Court of Chancery is affirmed in part and reversed in part. The case is closed.

Okay ... nothing needs to be done because there's no proxy contest anymore.  But what about in future Kellners?  What do you do when both sides behave badly?

Well, the Court says that if the Board acts for a proper purpose, but is overly aggressive, then Chancery can choose to enforce parts of bylaws as equity demands:

if the bylaws were adopted for a proper purpose but some of the advance notice provisions were disproportionate to the threat posed and preclusive, the Court of Chancery has the discretion to decide whether to enforce, in whole or in part, the bylaws that can be applied equitably

.... it may be necessary to assess how bylaws work together, but one problematic bylaw does not invalidate others when the board has a proper motive. Overbroad invalidation would be extreme and unnecessary when the board acted with proper motive to protect a legitimate corporate interest. 

That discretion does not seem to apply, though, if the Board is not acting for a proper purpose, i.e., when it's simply trying to block a dissident - even if the dissident really is a for real threat, in the ordinary (criminal) sense of the word.  Then, the lack of a proper purpose seems to mean defenses, including advance notice bylaws, can't be employed, and stockholder protection is left solely to ... I guess (yikes) the federal securities laws.

Anyway, the takeaways then are: (1) improper purpose will completely kill a defensive strategy, with no room for courts to uphold the strategy in part, and (2) the fact of improper purpose can be inferred from nature of the strategy itself.  This plays out very differently in proxy contests than in tender offers, of course; in tender offers, the desire to block the offeror is not an improper purpose; in the context of proxy contests, blocking a dissident from running the contest (as opposed to educating shareholders), is off the table.  

If only this case had existed a couple of years ago

In 2022, I published an article about discrimination against women capital providers.  The thesis was that oppression and discrimination against women as investors is an unrecognized category; employment law, of course, recognizes discrimination against women employees, and family law recognizes that women may be financially disadvantaged within relationships and tries to make allowances for that.   But business law does not have a vocabulary to recognize how invidious discrimination and interpersonal dynamics may work against women, and that’s a problem, in part because business law is often called upon to fill in the gaps in situations that employment and family law don’t cover.

In my article, one of the examples I used was Horne v. Aune, 121 P.3d 1227 (Wash. Ct. App. 2005), in which a man and a woman – in a romantic relationship – bought a house together.  They intended merely to live in the house, but they formalized their ownership in a partnership agreement.  When the relationship terminated – because the man was charged criminally after shoving the woman and assaulting her son – the court relied on general partnership principles to determine how to dispose of the property, without considering the broader context of the relationship.

Anyway, that was what I was thinking about when I read Gibson v. Konick, recently decided by VC Will in Delaware Chancery.   A man and a woman decided to purchase a house together for their personal use.  They did so through an LLC, in which they each had 50% interest.  Both contributed to the purchase price, and both were required to pay down the mortgage.  The relationship eventually soured, leaving it to LLC law to determine how their joint property would be handled.

If this really were a pure LLC business relationship, I’d shrug, but that wasn’t the situation – this was a romantic relationship being filtered through an LLC, and there were implications of the kind of power imbalances that employment law and family law recognize, but business law does not.  In this case, the man was 29 years older than the woman, and an attorney.  He drafted the LLC agreement, which he represented to her as “standard,” but which in fact contained terms that disadvantaged her, including a waiver of inspection rights, a waiver of the woman’s right to participate in LLC management, and a forfeiture of her economic rights if she withdrew from the LLC or attempted to transfer her interest.

All of this meant that when the relationship ended, the man was able to: (1) deny the woman any access to the property and the LLC joint bank account; (2) insist that she not sell her interest; (3) refuse to buy her interest, but (4) require that she continue to make her share of the payments on the mortgage.  The man refused to take her calls, and when she attempted to visit him to discuss the property, he insisted she was trespassing, making any communication or negotiation impossible.   As VC Will put it, the woman had “been deprived of the upside while she continues to pay costs, with no guarantee of recovering them.”

The woman ultimately sued for judicial dissolution under 6 Del. C. § 18-802.  That statute permits dissolution “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.”

Of course, there was no actual business being conducted by this LLC – that was the whole point – so instead VC Will concluded that the “purpose of enjoying the home over the long-term” had been “frustrated” by the couple’s breakup, and the deadlock between the two members meant that it was “no longer reasonably practicable to maintain the LLC.”  Therefore, dissolution was warranted, notwithstanding the fact that the LLC agreement would have required a unanimous vote of the membership to dissolve.

That certainly seems like a fair resolution to me, but, my point is, it also reflects the awkwardness of trying to shoehorn what was fundamentally a family dispute into laws designed for business relationships.  There really should be a better framework.

Market idealism

I am perpetually, endlessly amused by how courts navigate the tension between the presumption of market efficiency inherent in the fraud on the market doctrine, and the actual reality that markets may be generally efficient, but there are all kinds of blips and imperfections.  The Supreme Court acknowledged as much in Halliburton Co. v. Erica P. John Fund, Inc., but it still creates difficulties for the doctrine.

Case in point:  Fagen et al. v. Enviva, which was just decided in the District of Maryland.  Plaintiffs accused Enviva of greenwashing by, among other things, falsely claiming that its wood pellets were sourced from “low value” wood, such as tree trimmings and underbrush, rather than whole trees.  When the truth was revealed – partially through a short attack, and then through exposure on a conservation website – Enviva’s stock price dropped.

Enviva defended against the claim by pointing to various public filings where it admitted that its low value wood included some whole trees deemed unsuitable for sawmilling, such as small ones, or ones with defects.  Which of course sounds very reasonable, except there’s the pesky stock price drop that accompanied the disclosure.  So, on a motion to dismiss, the court held:

Plaintiff’s argument that drops in stock prices suggest individual investors’ ignorance of the truth, is irrelevant to the court’s ultimate inquiry about the reasonable investor’s knowledge….even if Mr. Keppler and Mr. Calloway indeed lied that Enviva does not source wood fiber from whole trees, the Category C Statements are immaterial in light of the total mix of information available revealing Enviva’s use of whole trees.

This is hardly the first time a court has held that the beliefs of actual investors are irrelevant when gauging injury to the Platonic form of investor whose interests are actually protected by the securities laws, but it is one of the most blatant.

Further on the subject of courts’ willingness to jettison cases on the assumption that publicly disclosed information must have offset any lies, there’s In re Ocugen Securities Litigation, 2024 WL 1209513 (3d Cir. Mar. 21, 2024), decided a few months ago by the Third Circuit.  Ocugen, a pharmaceutical company, contracted with an Indian company to develop a Covid drug in 2020.  It was then alleged to have made several overly optimistic statements about its ability to obtain an FDA Emergency Use Authorization, and its stock dropped when the truth was revealed.

The Third Circuit held that “information about the quality of the Indian COVAXIN study and the FDA’s guidance concerning study protocols and diversity was readily available to any reasonable investor,” and therefore, any false statements were immaterial. In a footnote, the court noted, “to the extent there were questions about whether the study adhered to proper protocols, the amended complaint observes that the issue was reported in the Indian media before the class period even began.”  Without further discussion, then, the Third Circuit apparently concluded that pre-class period reports in Indian media are sufficient to offset any misrepresentations to US market participants. 

Now, to be fair, the Third Circuit was vague about whether its holding was based on market efficiency, or whether it was doing a simple Basic “total mix of information” analysis.  But if the holding was simply about the “total mix,” was the court really saying, on a motion to dismiss, and with no further discussion or analysis, that reports in Indian media are part of the total mix of information available to US traders?  And if the holding was efficiency-based, the Third Circuit was certainly assuming a high level of it. 

(As a side note, I’ll observe that in 10(b) cases, courts frequently adopt a blanket rule that when the pre-class period statements are false, they are not actionable – without much analysis as to why that should be so.  See In re Refco, 503 F. Supp. 2d 611, 643 n.27 (S.D.N.Y. 2007).  Truthful ones, though, are apparently sufficient to offset any lies.).

By contrast, though, let’s look at the Ninth Circuit’s decision in In re Genius Brands Securities Litigation, 2024 WL 1804408 (9th Cir. Apr. 5, 2024). There, a television production company lied about the number of times one of its shows aired on Nickelodeon Jr, and the truth was disclosed in a short report.  The Ninth Circuit rejected defendants’ argument that the truth was already public on Nickelodeon’s website, because:

The shareholders attached to their complaint several printouts of the webpage on Nickelodeon Jr.’s website that features the broadcast schedule. The printouts covering the week of March 18, 2020, span over twenty-five pages and reflect no fewer than 377 show listings. A shareholder hoping to fact check Genius’s March 17 claim that Nickelodeon Jr. aired Rainbow Rangers twenty-six times per week would have no easy time doing so. She would have to go onto Nickelodeon Jr.’s website, find the schedule webpage, sift through hundreds of listings for shows like  Bubble Guppies and Team Umizoomi, and tally up the handful of Rainbow Rangers listings.

We also note that the shareholder’s task would be considerably more difficult retrospectively because it appears that the Nickelodeon Jr. schedule webpage is updated daily or every other day….

For that reason, the shareholders have plausibly alleged that the truth became known through the Hindenburg Report,

Thus, in Genius Brands, the Ninth Circuit displayed much more comfort with a kind of imperfect efficiency, even in a fraud on the market claim.

Chevron? I don't even know Ron

Lotta handwringing today about the demise of Chevron, and I can’t begin to predict the ultimate fallout, but from the narrow perspective of securities, it doesn’t feel like it’s played much of a role in some time. 

Case in point: The Fifth Circuit’s recent decision striking down SEC rules governing private investment funds.

As the court notes, for a long time, private investment companies and their advisers were exempt from Investment Company Act/Investment Advisors Act regulation.  However, in 2010, Dodd Frank amended the IAA to require that even private fund advisers register with the SEC, and make and disseminate reports according to SEC rule.  The reports required must include, among other things, information on “valuation policies and practices of the fund;... side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors.”

As part of those amendments, Dodd-Frank made another statutory change.  Prior to Dodd-Frank, there existed 15 U.S.C. §80b-11, titled “Rules, regulations, and orders of Commission,” which broadly gave the SEC the power to “make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this subchapter.”

Dodd-Frank added a new subsection, 211(h), which provides:

The Commission shall—

(1) facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers, including any material conflicts of interest; and

(2) examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.

Relying on its authority under 211(h), the SEC promulgated the private fund adviser rules, which, among other things, required disclosure to fund investors of any preferential treatment given to other investors, required quarterly financial disclosures, and required fairness opinions for continuation funds.

Now, one can argue with the wisdom of the SEC’s approach – here are some papers that do just that – but you’d think the rules would at least be within the SEC’s power to “facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers, including any material conflicts of interest; and … promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.”

But you would be wrong, at least according to the Fifth Circuit.

The Fifth Circuit recognized that “at first blush” the text of 211(h) would seem to authorize the rules, but immediately pivoted to holding that the language could not “be construed in a vacuum.”

What was missing, then?   If you look at the actual text of Dodd Frank – that is, the full 800-odd page bill – you see that the provisions providing for private fund registration are in a separate section than the amendments that added 211(h).  And the amendments that added 211(h) are part of a larger subsection that largely deals with retail customers (including statutory amendments that specifically reference “retail customers”).

So, concluded the Fifth Circuit, even though the text of 211(h) makes no reference to retail, even though Congress specifically named retail when making changes to the statute aimed at retail, even though many of the new private fund rules were aimed at practices (like side letters and valuation) specifically singled out by Congress when requiring private fund registration, because the 211(h) catch-all power granting the SEC authority to protect investors – in the statutory section titled “Rules, regulations, and orders of Commission” – is in a section of the 800-odd page bill dealing with retail, that meant 211(h) only granted the SEC authority to regulate relationships with retail customers.

Nowhere, of course, did the Fifth Circuit cite Chevron, or even accord any pretense of deferring to the SEC’s interpretation of the actual words of the statute (which even the Fifth Circuit agrees “at first blush” authorizes the private fund rules) – and the SEC, presumably anticipating the futility, did not even cite Chevron in its briefing.

Anyway, the upshot here is that we’ve been living in a post-Chevron, post-deference world for sec reg for quite some time.  And it’s a world where the SEC can’t engage in even the most pedestrian rulemaking.

Fiduciary Duties Trump Contracts?!

Many in the business law world have been following the saga involving the adoption of  S.B. 313 by Delaware's General Assembly last week.  S.B. 313 adds a new § 122(18) to the General Corporation Law of the State of Delaware (DGCL) that broadly authorizes corporations to enter into free-standing stockholder agreements (not embodied in the corporation's charter) that restrict or eliminate the management authority of the corporation's board of directors.  See my blog posts here and here and others cited in them, as well as Ann's post here.

In the floor debate on S.B. 313 last Thursday in the Delaware State House of Representatives, a proponent of the legislation stated that fiduciary duties always trump contracts.  That statement deserves some inspection in a number of respects.  I offer a few simple reflections here from one, limited perspective.

The historical centrality of corporate director fiduciary duties (which were the fiduciary duties referenced on the House floor) is undeniable.  Those who have taken business associations or an advanced business course with me over the years know well that I emphasize in board decision making that the directors’ actions must be both lawful and consistent with their fiduciary duties in order to be legally valid and enforceable.  I doubt my teaching is exceptional in that regard.

But the floor debate involved a different kind of tangle between legal obligations and fiduciary duties than exists in the board decision-making context in which corporate action is written on a tabula rasa.  The comment made in last Thursday’s legislative session responded to the suggestion that a board of directors may later decide to breach a contract that is lawful and was approved by the board in a manner that is consistent with director fiduciary duty compliance.  That scenario involves board action to disregard the terms of an agreement—by authorizing and directing the corporation to breach a legal obligation of the corporation because the directors have, in good faith and with due care, determined that the breach of contract is in the best interest of the corporation.

This type of board action is certainly not unprecedented.  An example from my practice immediately springs to mind: no-shop, non-solicitation, and related clauses in business combination (M&A) agreements.  These provisions may be (or at least appear to be) lawful and compliant with director fiduciary duties when made but may interfere with a target board’s fiduciary duties if the board later determines it has a fiduciary obligation to engage in interactions with a potential transactional partner in violation of that type of deal protection provision. 

The resolution of this issue in the M&A context has largely been contractual.  Fiduciary outs of various kinds have been common in M&A agreements for decades.  (I gave my first CLE talk on them back in the 1980s.)  Through these provisions, directors consider and prepare in advance for the potentiality of a later conflict between the deal protection obligations of the corporation and their fiduciary duties to the corporation.  Properly drafted, fiduciary outs help  protect the legal validity and enforceability of the original contract from future challenge and preserve the board’s legal right to respond to new circumstances without breaching the contract.

As those who work in this space well know, a watershed case involving deal protection provisions is Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003). In its Omnicare opinion, the Delaware Supreme Court assesses the validity of a merger agreement that effectively locked up a majority of the votes needed to approve the merger.  The merger agreement did not include a fiduciary out provision. The directors had no ability to terminate the merger agreement or nullify its terms to comply with their fiduciary duties without breaching the contract.  The court found the deal protections invalid and unenforceable.

Proponents of S.B. 313 clearly state that a corporation's exercise of its authority to enter into stockholder agreements under § 122(18) will be subject to challenge if the directors breach their fiduciary duties to the corporation in approving a stockholder agreement or in later authorizing the corporation's performance under that agreement.  If the corporation's directors are found to be in breach, the stockholder agreement then may be found invalid or unenforceable.  The prospect of that occurring in the stockholder agreement context is as real as it is in the M&A deal protection context.

Perhaps, then, fiduciary outs are a best practice that should grow out of the new DGCL § 122(18).  If the parties truly intend for fiduciary duties to trump the contract (as the bill proponents have claimed) and we can anticipate challenges in that regard based on the nature of the agreement, stockholder agreements should provide in advance for the eventuality of a conflict.  Otherwise, a stockholder agreement authorized under DGCL § 122(18) may be found either invalid ex post because the board’s original approval of the agreement may later be determined to have been a breach of the directors’ fiduciary duties (for failure to include a fiduciary out, as in Omnicare) or unenforceable in litigation over a board decision to breach or refrain from breaching the agreement in the face of a perceived fiduciary duty conundrum related to the corporation’s performance under the terms of the agreement.  A well-crafted fiduciary out (which would undoubtedly be somewhat bespoke, as it should be in the M&A context, based on the nature of the corporation’s obligations in the contract) should help avoid litigation, or at least enable its early dismissal, in the event of either type of legal claim.

Your reactions to these musings are, as always, welcomed.  We will be operating in new territory here assuming the Governor of Delaware signs S.B. 313 into law (as he has signaled).  If I am missing an element of statutory or decisional law or strategic litigation practice that impacts my arguments, I would appreciate hearing about it.  Regardless, it is now time that we all think about how to address anticipated issues arising from the Pandora’s box that the Delaware General Assembly has opened.  That may include practice-oriented solutions to perceived legal questions or tensions as well as potential further adjustments to the DGCL.  As to the latter, I note that I raised in one of my earlier posts the desirability of looking at DGCL subchapter XIV in light of the provisions of DGCL § 122(18).  Perhaps that issue merits a subsequent post . . . .

C.R.E.A.M.

Some variations on a theme this week.

First, the Delaware legislature has now passed the amendments to the DGCL, which means that as of August 1, it will be legal for a company like Tesla, say, to contract with a shareholder like Elon Musk, say, to give him power to veto or demand specific AI initiatives, regardless of his particular financial stake in the company.  By contrast, at least as I read Texas law, such a contract would not be possible for Texas-organized entities, because Texas only permits agreements to restrict board discretion in nonpublic corporations.

Do you suppose this means Tesla will reincorporate back to Delaware?

Second, the Senate raked Boeing CEO Dave Calhoun over the coals this week.  Sen. Josh Hawley said: “I think you’re focused on exactly what you were hired to do.  You’re trying to squeeze every piece of profit out of this company. You’re strip mining it.”  He also posted to Twitter, “Boeing’s planes are falling out of the sky in pieces, but the CEO makes $33 million a year. What exactly is he getting paid to do?”  Meanwhile, at the hearing, Sen. Richard Blumenthal said, “Boeing needs to stop thinking about the next earnings call and start thinking about the next generation.”

So I, for one, am very glad to see in this polarized age that Democrats and Republicans can come together to endorse ESG.

I kid, I kid, of course they’re not endorsing ESG – they’re just endorsing a reduced focus on profit seeking in favor of corporate social responsibility.

For real, it reminds me of this clip of Katie Porter, that I like to show to my students.  In the clip, she establishes that a drug company executive would increase his bonus by increasing drug prices.  Which sounds bad, until you look at the results of the shareholder vote overwhelmingly approving his compensation package – which shareholders are required to approve due to – let me check this – ah right, congressional legislation and (federal) stock exchange listing rules.   Not to mention the pay-for-performance disclosures that, wait let me see – Congress also mandates.  If members of Congress are unhappy with how that’s worked out, they have some tools in the box beyond jawboning executives.

And third, Exxon.  Exxon, Exxon.  Exxon bypassed the SEC and sued its own shareholders to avoid putting another climate change shareholder proposal on the ballot – ironically, even though Engine No. 1’s purportedly climate-transition-focused directors are still right there on the board – and even after it got everything it wanted, still tried to press the case until Judge Pittman concluded there was no remaining controversy to adjudicate.  

In response, some institutional shareholders, including various state pension plans, organized a “vote no” campaign against Exxon’s directors.  They varied as to which directors – some urged voting no for all of them, and there were some who focused on Joseph Hooley and Darren Woods, while Glass Lewis urged voting no for Joseph Hooley alone.  Their argument was less about the merits of this specific climate change proposal than about the importance of preserving shareholder voice.  There was no possibility that these directors would lose their seats, but a strong protest vote against them might have indicated that shareholders supported the principle of being free to bring items to a vote.

And, well ….   There does seem to have been a slight dip in support for Woods and Hooley as compared to last year, but not by a whole lot.

All of which suggests that large institutional investors may mouth words about stewardship or whatever but they actually don’t want these kinds of public votes, and that’s partly because it puts them on record as taking positions (that can then become controversial), and partly because the largest investors don’t need formal avenues of input; they can simply make phone calls, and partly, perhaps, because many large investors have their own shareholders they want to fight off.

Which takes us right back to the DGCL amendments and the muted response from investor advocates.  As I mentioned before in “Take Three” of my Takes on the Tesla vote, investors do seem to be sending a signal, and it’s that they don’t really place much value on governance rights; let’s not forget they only started exercising them seriously after the SEC and the DOL largely required them to.

I Also Write Letters!

Further to Ann's post on Sunday sharing the text of her comment letter on Delaware's S.B. 313 (and more particularly the proposal to add a new § 122(18) to the General Corporation Law) and my post on § 122(18) last week, I share below the text of my comment letter to the Delaware State House of Representatives Judiciary Committee.  Although Ann and I each got one minute to deliver oral remarks at the hearing held by the Judiciary Committee on Tuesday, 60 seconds was insufficient to convey my overarching concerns--which represent a synthesis and characterization of selected points from my post last week.  The comment letter shared below includes the prepared remarks I would have conveyed had I been afforded additional time.

Madame Chair and Committee Members:

I appreciated the opportunity to speak briefly at today’s hearing. As I explained earlier today, although I am a professor in the business law program at The University of Tennessee College of Law, my appearance before the committee relates more to my nearly 39 years as a corporate finance practitioner, which has included bar work (most recently and extensively in the State of Tennessee) proposing and evaluating corporate and other business entity legislation. This letter expands on the virtual oral comments I offered at the hearing on the proposed addition of § 122(18) to the General Corporation Law of the State of Delaware (DGCL). My goal is simply to best ensure that the committee and the General Assembly are well informed about the significance of this proposed new section of the DGCL.

Both proponents and critics of proposed § 122(18) concur that the stockholder agreements that would be authorized by that provision can currently be accomplished in a corporation’s certificate of incorporation—the corporate charter. Indeed, as was alluded to in the testimony earlier today, current Delaware law expressly authorizes transferring governance authority from a corporation’s board of directors to its stockholders through charter amendments and through certificates of designation (instruments providing for new classes or series of stock) as well as for statutory close corporations, a status designated in the certificate of incorporation. As a result, questions raised at today’s hearing about why the new authority embodied in proposed DGCL § 122(18) is needed—or why it would be objectionable—are well taken. As I indicated in my oral testimony earlier today, the answer to those questions lies in public policy.

Current Delaware law on stockholder agreements promotes notice, transparency, and assent. Provisions in a Delaware corporation’s certificate of incorporation are matters of public record in the State of Delaware on which stockholders and prospective stockholders rely. They must be filed with the Delaware Secretary of State. Thus, Delaware’s corporate law currently requires that stockholders and potential future stockholders have public notice of any fundamental alteration in the statutory power of the board of directors to manage the corporation. Stockholder agreements like those authorized under proposed DGCL § 122(18) are not required to be filed with the state (although they would have to be filed with the U.S. Securities and Exchange Commission under the federal securities laws at some point after they are signed, for public companies). Moreover, under current Delaware law, if an amendment to the certificate of incorporation is required to achieve a shift in governance authority from the board of directors, then a stockholder vote is required. These requirements, which evidence Delaware’s public policies of notice, transparency, and assent, are what ultimately divide the supporters and detractors of proposed DGCL § 122(18). Your ultimate views on these policies—your determination as to whether they are important to the integrity of Delaware corporate law—should be strong factors in your determination of how to vote on proposed DGCL § 122(18). I submit that these policies should not be abandoned or reduced without careful consideration.

Last week, I wrote about my policy concerns relating to proposed DGCL § 122(18) in a blog post published on the Business Law Prof Blog. That post can be found here. Although my blog post was written for a different and broader legal audience (and therefore includes some technical legal references), it may be useful to you as additional statutory and judicial support for the positions I have taken in this letter and in my oral testimony. The post also includes several drafting observations relevant to the productive introduction of statutory authority for stockholder agreements that you may appreciate having.

I am grateful to have had the opportunity to share these insights with you today in writing and orally during the hearing this afternoon. I wish you well in your deliberations.

Very truly yours,

Joan M Heminway
Rick Rose Distinguished Professor of Law, The University of Tennessee College of Law
Member and Former Chair, Tennessee Bar Association Business Law Section
Former Chair and Member, Boston Bar Association Corporate Law Committee

The Delaware State House of Representatives may vote on the bill tomorrow (Thursday) afternoon.  It is the last item listed in the Main House Agenda for tomorrow's session.  I can only hope that the members of the House feel better informed after the House Judiciary Committee hearing on Tuesday.  I know many of us tried to ensure that they are well informed.