Friday, January 17, 2020
As part of what is apparently my continuing series on developments concerning the use of corporate bylaws and charter provisions to limit federal securities claims….
Earlier this month, the Delaware Supreme Court heard oral argument on whether corporations may include provisions in their charters and bylaws requiring that federal Section 11 claims be heard only in federal court (video of oral argument here; prior posts on this issue here and here and here and here… you get the idea)
Running parallel with that, Professor Hal Scott of Harvard Law School submitted a proposal under 14a-8 requesting that Johnson & Johnson adopt a bylaw requiring that all federal securities claims against the company be arbitrated on an individualized basis. As I blogged at the time, the SEC granted J&J’s request to exclude the proposal on the ground that it appeared that NJ, the state of incorporation – following what it believed to be Delaware law – did not permit federal claims to be governed by corporate charter/bylaw provisions. Scott filed a federal lawsuit over that, and the action was voluntarily stayed pending the Delaware Supreme Court’s ruling.
But Scott has not let the crusade rest. As I learned from Alison Frankel’s reporting, Intuit shareholders will vote on one of Scott’s securities arbitration proposals at their January 23 meeting. (I note that in this version of the proposal, Scott has corrected the text to acknowledge Canada’s existence – which he, ahem, previously overlooked)
Unlike J&J, Intuit did not seek to exclude the proposal from its ballot, but it does recommend that shareholders vote against. Intuit says:
we are not aware of any other U.S. public company that has adopted the bylaw sought by the proposal and the proponent’s pursuit of the adoption of an identical bylaw by another company is currently the subject of litigation. As a result, there is significant uncertainty as to whether the adoption of such a bylaw is prudent at this time. Given this continued uncertainty, we believe that the adoption of such a bylaw likely would expose Intuit to unnecessary litigation or other actions challenging the bylaw and its consequences. Such challenges would not only be economically costly, but also would divert management’s time and focus away from Intuit’s business.
So, several things.
First, another public company did have such a bylaw, sort of, as I discuss in my Manufactured Consent paper – that company was Commonwealth REIT. The bylaw did not bar class actions, though it did cover federal claims.
Second, Intuit’s objection is largely rooted in the uncertainty surrounding its legality. Which is probably why Scott recently filed a comment letter with the SEC regarding its proposed amendments to Rule 14a-8, in which he asks the Commission to permit resubmission of failed proposals “if legal or regulatory circumstances relevant to the proposal have materially changed since its last submission.” I assume he’s anticipating some losses, and wants to make sure he can resubmit these proposals if the Delaware Supreme Court - or anyone else (hint, hint) - rules his way.
Third, this is not the first time shareholders have had the opportunity to vote on arbitration bylaws. Back in 2012, Professor Adam Pritchard at Michigan assisted shareholders at Gannett, Pfizer, Google, and Frontier Communications in filing their own proposed arbitration bylaws. Pfizer and Gannett sought and received no-action relief to exclude the proposals, but Frontier and Google included them in their proxy statements (see here and here, respectively), though in both cases the companies recommended that shareholders vote against. And in both cases, the bylaws were defeated (see here and here, respectively – I mean, Google has controlling shareholders, it was sort of fait accompli, but even the A shares voted against, so.)
All of which is to say – I’m betting the bylaw fails at Intuit, but (1) I’m terrible at predictions and (2) that will not be the end. But for now, I guess, all eyes on January 23.
Saturday, January 11, 2020
Hey, everyone. Two very quick hits today. First, as any follower of this blog knows, I have been avidly following the Salzberg v. Sciabacucchi litigation (see prior posts here and here and here, etc), not because I care very much about whether corporations can select a federal forum for Section 11 claims, but because I think if corporations can use their charters and bylaws to select a federal forum for Section 11 claims, the next step is using charters and bylaws to adopt provisions requiring individualized arbitration of federal securities claims, and that opens up a whole new can of worms. (For newcomers, my article on the subject of arbitration clauses in corporate charters and bylaws is here).
In any event, on Wednesday, the Delaware Supreme Court heard oral argument on federal forum provision issue. I don't really have any insights about it - although the justices asked several questions at the beginning of each advocate's presentation, they were, for the most part, quiet - but if you want to see for yourself, the video is here.
Additionally, last week I had the opportunity to speak on a panel with Sean Griffith and Adriana Robertson, moderated by Jeremy Kidd, about the role of mutual funds in corporate governance. I'll straight up admit that I don't think I personally said anything you haven't already heard from me in this space - either in a post or a plugged article (like, ahem, my Family Loyalty essay on conflicts among mutual funds within a single complex) - but the video is worth watching if only to hear the views of my co-panelists. Sean describes his theory of when mutual funds should vote, and when they should abstain, or pass through their votes to retail shareholders (articulated in more detail in his paper, here), while Adriana discusses her research about how indexes don't really differ all that much from active management. It's definitely a treat to hear them describe their work (and to hear Adriana talk about her upcoming project at the very end.)
Saturday, January 4, 2020
Most readers are probably familiar with the case of Morrison v. Berry. There, Fresh Market was taken private by Apollo in a two-step tender offer. After the deal closed, a shareholder filed a lawsuit alleging that the directors had breached their duties and failed to obtain the best price for shareholders because Ray Berry, founder of Fresh Market and Chair of the Board, along with his son, colluded with Apollo to roll over their shares in the new company and rig the sales process in Apollo’s favor. Defendants contended that shareholders’ acceptance of Apollo’s offer cleansed any breaches under Corwin; therefore, the critical question was whether the shareholders were fully informed. VC Glasscock held that any omissions were immaterial as a matter of law, and the Delaware Supreme Court reversed, holding that omissions regarding the Berrys’ level of precommitment to Apollo were material.
After remand, the plaintiff filed a new complaint and the defendants renewed their motions to dismiss. And on December 31, VC Glasscock granted in part and denied in part those motions. In particular, he held:
(1) The directors other than Ray Berry were independent and disinterested, and neither the sales process nor the omissions evinced bad faith. In particular, enough was disclosed about Berry’s mendacity and the pressures facing the Board that any additional omissions could not have been intended to fool anyone, since, reading between the lines, shareholders could have sussed out the truth. (“If the Director Defendants’ intent was to ensure that the 14D-9 would entice stockholders to vote for the merger in the mistaken belief that the directors were unaware of activist pressure, or to hide that Berry’s weight was behind the Apollo bid, they did a poor job, indeed. So poor, I find, that a reasonable inference of bad faith in the omissions cannot be drawn.”). This, of course, is Glasscock’s way of reaffirming his original conclusion that the omissions were not material; the first time around, he held that enough was disclosed that shareholders did not require more details, and the second time around, he held that since so much was disclosed, the remaining omissions must not have been intentional deceptions.
(2) The plaintiff plausibly alleged that Ray Berry acted in bad faith and out of self-interest by misleading the Board about his relationship with Apollo.
(3) Two officer defendants (one of whom was also a director) were not protected by Fresh Market’s 102(b)(7) provision. Though the plaintiff did not plausibly allege they acted disloyally/in bad faith, the plaintiff did plausibly allege at least negligence with respect to the omissions. Again, however, Glasscock alluded to his earlier ruling: “another reasonable interpretation is that the 14D-9 represents a good faith but failed effort to make reasonable disclosures... As [one defendant] points out, I initially and erroneously determined that the omissions in the 14D-9 were not material.” But, since inferences on a motion to dismiss are drawn in favor of the plaintiff, these claims would survive – for now.
(4) Finally, the court reserved judgment on the plaintiff’s aiding and abetting claims. The plaintiff alleged that JP Morgan, Cravath, Apollo, and Ray Berry’s son Brett Berry all aided and abetted breaches by concealing Ray Berry’s discussions with Apollo, contributing to the omissions in the 14D-9, and by concealing from the Board that JP Morgan secretly fed Apollo information.
So, the things that stand out for me:
First, the case is being maintained, in part, due to the inability of corporate officers to exculpate negligence violations under 102(b)(7). Megan Shaner has written a lot about how officer duties are underdeveloped in Delaware law (see, e.g., Officer Accountability, 32 Ga. St. U.L. Rev. 355 (2016)); this case may become one of the few that permits an exploration of the subject.
Second, I am discomfited by the suggestion that the court’s initial mistake in concluding that the omissions were immaterial might be relevant to a determination of defendants’ scienter. The logic, apparently, is that if a court innocently believed these facts to be immaterial, corporate officers and directors may have operated under the same good faith misapprehension.
Leaving aside the difference in context – corporate insiders know far more about the business, the shareholders’ priorities, and the details of any omissions than a judge does (especially on a motion to dismiss) – I wonder how far the logic could extend. After all, in securities cases under Section 10(b), it’s not uncommon to see dismissals on materiality grounds that are reversed on appeal. Does the initial dismissal suggest that an inference of scienter is defeated, especially given the higher pleading standards for a 10(b) case? Couldn’t you draw exactly the opposite inference, i.e., if corporate insiders actually know a fact, and intentionally leave it out of a narrative but do hint at its existence (making “partial and elliptical disclosures,” in the Delaware Supreme Court’s phrasing), doesn’t that suggest they were strategically playing coy about the facts?
(I am also reminded of In re Ceridian Corp. Securities Litigation, 542 F.3d 240 (8th Cir. 2008), where the errors in the defendant company’s financial statements were so overwhelming that the court figured the mistakes must have been inadvertent; no intelligence could have designed them.)
Third, the court rejected the plaintiff’s allegation that director and CEO Richard Anicetti was motivated to keep the buyout price low because if he stayed with the company, he’d be compensated based on whether Apollo earned particular multiples of invested capital (MOIC) – payments that would become increasingly lucrative the less that Apollo paid Fresh Market stockholders. Now, compensation tied to MOIC is a new tactic that Guhan Subramanian and Annie Zhao recently identified as having been adopted by private equity buyers to manipulate corporate management; here, however, Glasscock wasn’t buying the argument, in part because any such moves on Anicetti’s part would have cost him up front, to the extent he received a lower price for his own shares. Still, I expect we’ll continue to see litigation over the practice.
And ... yeah, I don’t have a pithy wrap-up here, but I do think the aiding-and-abetting determinations will be interesting.
Saturday, December 28, 2019
I’ve previously blogged about – and written an essay about – how one of the knock-on effects of Corwin and MFW is to increase the distance between the treatment of controlling shareholder transactions, and other transactions, under Delaware law. As a result, the outcome of many a motion to dismiss turns solely on the presence or absence of a controlling shareholder – which puts increasing pressure on the definition of control in the first place. In particular, I’ve argued, courts uncomfortable with Corwin’s Draconian effects may be tempted to expand the definition of control in order to avoid early dismissals of cases that smack of unfairness.
The latest example of the genre comes by way of Vice Chancellor McCormick’s ruling on the motion to dismiss in Garfield v. BlackRock Mortgage Ventures et al. There, an enterprise organized as an “Up-C” sought to transform itself into an ordinary corporation, largely for the benefit of the two founding investors, BlackRock and HC Partners, as well as several directors and corporate officers. The question was whether the transaction was fair to the public stockholders, who overwhelmingly voted in favor of the deal. If BlackRock and HC Partners were not deemed to be controllers, the stockholder vote would cleanse the deal under Corwin and the case would be dismissed; if they were, the court would be permitted to substantively examine the transaction’s fairness.
Together, BlackRock and HC Partners controlled 46.1% of the vote, had Board representation, and had blocking rights; thus, the court easily found that if they acted together, they had control. The critical question was whether they had, in fact, agreed to act in concert, or whether they simply had concurrent, but independent, interests in the transaction. For these sorts of inquiries, the standard on which Delaware courts have settled is that to constitute a group, the putative controllers must be “connected in some legally significant way—such as by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.”
To determine whether this standard was met, McCormick looked for both transaction-specific facts suggestive of an agreement, as well as historical facts indicting that the defendants had agreed to coordinate in the past. Here, BlackRock and HC Partners’s long history of coordinated involvement with the company, coupled with their critical roles in approving the reorganization, created an inference of concerted action. As a result, the plaintiff had plausibly alleged the presence of a controlling group, and Corwin did not apply. Motion to dismiss denied.
So, there are a couple of things that interest me here.
First, it’s another example of “controller-creep.” The cases on which McCormick relied, Sheldon v. Pinto, 2019 WL 4892348 (Del. Oct. 4, 2019) and In re Hansen Medical Shareholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018), also identified “historical” ties as a factor to consider when inferring the presence of an agreement among putative members of a control group, but in those cases, the courts demanded that plaintiffs identify multiple investments in multiple companies – and refused to infer an agreement without them. Here, by contrast, McCormick found a history just due to the defendants’ investment in this single company.
Second, there are many areas of law where the presence of an agreement among parties, rather than simply concurrent self-interest, is critical (13D filings, antitrust law, RICO), and courts therefore have to closely examine the defendants’ behavior to see if such an agreement can be inferred. There seems to be little cross-pollination in the caselaw, however (though in Hansen, one “historical” factor used to infer the existence of an agreement was a 13D filing from a previous venture), and to be honest, that’s how it should be – there are different policies at play in different areas of law, not to mention different legal standards on a motion to dismiss, and it makes sense courts would therefore approach the analyses differently. That said, in the Garfield briefing, I detect efforts by the BlackRock defendants in particular to import antitrust concepts into the controlling shareholder inquiry, via the suggestion that agreements can only be inferred if there’s evidence that the parties sacrificed their immediate self-interest in service of a larger goal. Correctly, I think, McCormick chose not to pursue that argument.
Third, though, I get back to my problem with this entire line of precedent, which is well-illustrated by this case. We’re talking about a transaction structured to benefit a small number of shareholders with outsized voting power and management control; BlackRock and HC Partners had veto rights and were intimately involved in the planning stage even before the presentation to the Board. If the goal is to protect the public stockholders, why on earth should it matter whether these two formally agreed to act together? Whether they did or they didn’t wouldn’t make the transaction any less favorable to them, or any less coercive to the public stockholders. And that’s because control exists on a spectrum, not as an on/off switch, and two large investors with concurrent interests, board representation, and 46.1% of the voting power are just as threatening to the public stockholders, and exert just as much influence, whether they’ve formally agreed to act together or not. Plus, recall that the whole (purported) reason controlling shareholder transactions cannot be cleansed by a shareholder vote is that we presume shareholders are afraid to buck a controller. Shareholders can’t be intimidated by a secret agreement they know nothing about; if we were truly serious about inquiring into shareholder coercion, we’d be asking about shareholder perceptions of an agreement, not whether there actually was one. So what we’re seeing, again, is how the “controlling shareholder” legal analysis imposed by Corwin/MFW is often divorced from the underlying business reality, which ultimately leads courts down a garden path of irrelevance.
Saturday, December 21, 2019
I have previously commented that many investments describe themselves as “sustainable” or “ESG” (environmental, social, governance) focused, without much standardization as to what those terms mean – and I’ve criticized the SEC for failing to step in to create a set of uniform definitions.
Many investment firms have been touting new products as socially responsible. Now, regulators are scrutinizing some funds in an attempt to determine whether those claims are at odds with reality.
The Securities and Exchange Commission has sent examination letters to firms as record amounts of money flow into ESG funds. These funds broadly market themselves as trying to invest in companies that pursue strategies to address environmental, social or governance challenges, such as climate change and corporate diversity.
But there have been critics of the growth in these funds. Some argue investment funds should focus solely on returns, and some firms have faced questions about how strictly they adhere to ESG principles….
One letter the SEC sent earlier this year to an investment manager with ESG offerings asked for a list of the stocks it had recommended to clients, its models for judging which companies are environmentally or socially responsible, and its best- and worst-performing ESG investments, ….
The SEC also homed in on proxy voting in the letter, which some investors say is a powerful tool that can be used to influence a company’s governance and might show how an investment fund is carrying out its ESG goals. The letter asked for proxy voting records and documents that related to how the adviser decided to vote on an ESG issue….
Senior SEC officials have sometimes expressed concern that focusing too narrowly on corporate morality could undermine a money manager’s duty to act in the best interest of clients. That could become a problem for pension funds pursuing ESG strategies if their retirees and beneficiaries aren’t as interested in sustainability but are nevertheless locked into funds’ investment choices, Republican SEC Commissioner Hester Peirce said last year.
Ms. Peirce has criticized ESG for having no enforceable or common meaning.
“While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled,” she said in a speech last year to California State University Fullerton’s Center for Corporate Reporting and Governance….
Notice there are two separate ideas here, and the article blurs them together. One idea is that retail investors can’t tell what they’re buying when a fund is labeled “ESG.” Another idea is that funds should not be permitted to elevate “sustainability” metrics over wealth maximization, even if investors would prefer they did. And that confusion goes to the heart of my problem with the ESG label as applied to funds. It can mean at least three things:
(1) I morally/ethically do not want to profit off of some kind of activities, and therefore, even if they would maximize my returns, I don’t want to invest in them;
(2) I am hoping to use my investment dollars to encourage certain kinds of socially responsible activities that might not otherwise get sufficient funding, and I am willing to accept sub-par returns to do that (“impact investing”); or
(3) I believe ESG metrics are one mechanism for maximizing returns because social responsibility is ultimately profitable.
Now, within these categories, there are lots of questions. Like, if you’re willing to accept below-market returns in order to make socially responsible investments – either for ethical reasons, or because you’re hoping to make an impact – what counts as an ethical investment, or an unethical one? What kinds of “impact” do you want to have – i.e., how will you define the kinds of beneficial projects that otherwise would not be funded but for your social responsibility considerations? And how far below market are you willing to go? Is there a point where you’ll give up and say hey, I’ll go all in on Exxon if it’ll put food on the table?
Additionally, before investors can make any kind of ESG-investment, they need metrics that describe the characteristics of a particular instrument, so that they understand what it means to say a particular project or instrument is “green” or environmentally-friendly or “sustainable.” That’s why Europe is working toward a taxonomy that would categorize different projects according to their environmental impact. Notably, Europe is explicit that these categorizations are based on the greenness of the project for the purpose of advancing environmental goals; they are not categorizations based on an idea that green projects are somehow long-run more profitable. That determination, and its relevance to a particular investor or asset manager, is left to the investor, who will now simply be informed as to whether a project that says it has certain environmental effects really in fact has those effects.
In the US, of course, we don’t have any kind of labeling system – you can call any project green or sustainable and no one will stop you, which is why market actors will pay actual cash money for a clear assessment of the environmental impact of specific projects. And because the SEC has apparently given up on developing standardized metrics in favor of, I dunno, preventing shareholders from communicating their priorities to portfolio companies, Europe’s going to be the market leader here.
(For the record, I’m not at all persuaded by Commissioner Peirce’s claim that the SEC’s hands are tied because financial reporting is more reliable than ESG reporting; as I previously argued, modern financial reporting standards are the product of a nearly century-old public-private partnership spurred by the federal securities laws. Regulation creates the standardization; it’s not necessarily the other way around.)
But even after an instrument is accurately described in terms of its environmental and social effects, investors can’t decide whether those effects add up to “buy” “hold” or “sell” without a clear sense of why they’re asking about those effects in the first place, namely, their higher order strategy: Are they asking so they can follow their morals, so they can make an impact, or because they think ESG is wealth-maximizing? Because until you know that, you don’t know what to do with a specific green, green-ish, or brown investment opportunity.
And in the US, we don’t even have that higher order labeling system. Europe, again, is ahead of us: UK’s Investment Association recently put out a framework that tries to distinguish between these categories, and urged asset managers to label funds accordingly. But there’s no common language in the US.
And the reason there isn’t, I’d argue, is because there are a lot of different groups who have an interest in obscuring the distinctions. Just as individual companies like to claim they have a broader social purpose in order to free themselves from responsibility to one constituency (i.e., shareholders and regulators), asset managers, as well, want to earn the higher fees that come with the ESG label while avoiding any of the commitments associated with it. See, e.g., Dana Brakman Reiser & Anne M. Tucker, Buyer Beware: Variation and Opacity in ESG and ESG Index Funds (forthcoming Cardozo L. Rev.). Meanwhile, various advocacy and interest groups have their own (obvious) reasons to try to convince investors that it is entirely costless to insist on socially-responsible behavior from their portfolio companies.
All of which is to say, to the extent the SEC wants to make sure that ESG funds are clear on their strategy – THIS FUND IS FOR PEOPLE WHO WILL SACRIFICE WEALTH FOR MORALS, AT LEAST UP TO A POINT, AND HERE IS OUR PLAN versus THIS FUND IS FOR PEOPLE WHO BELIEVE THEY CAN DO WELL BY DOING GOOD, AND HERE IS OUR PLAN – I am all for it and believe it would be a great improvement in the marketplace.
But there’s a second issue that I’ve discussed in this space, namely, are funds even permitted to sacrifice wealth to achieve other goals? Normally, you’d think, if a retail investor understands what they’re doing, why shouldn’t they be able to choose a fund that prioritizes morals over money? But the latest suggestions from the Trump administration are that, at least to the extent the fund is regulated by ERISA, namely, it’s a private retirement fund, those choices are flat-out prohibited.
And if that’s what the SEC is after, well, I have to ask – what does the SEC have against markets?
Saturday, December 14, 2019
Alon Brav, Matthew Cain, and Jonathan Zytnick have a fascinating new paper analyzing the voting behavior of retail shareholders (and I linked to it once before but I'm pretty sure since then it's been updated with a lot of new data). Bottom line: They got access to the votes cast by retail shareholders from 2015 and 2017 and made a lot of interesting findings, including:
Retail votes matter. Collectively, they have as much influence on outcomes as the Big Three (Vanguard, BlackRock, and State Street).
Expressed as a proportion of the shareholder base, retail shareholders hold a higher percentage of small firms than large ones, and their participation in voting is higher in small firms.
Retail shareholders are more sensitive to management performance than the Big Three; they are more likely to turn out, and more likely to vote against management, when companies have underperformed. The Big Three, by contrast, are less sensitive to performance in terms of voting behavior.
Retail shareholder voting has an observable cost/benefit component. Retail shareholders vote more often when their economic stake is greater; when management has underperformed; in controversial votes; and when they live in a zip code less associated with labor income (suggesting more time to devote to their portfolio).
Retail shareholders with higher stakes in the subject firm are more likely to vote in favor of management proposals and against shareholder proposals as compared to institutions; by contrast, retail shareholders with lower stakes are less likely to vote at all, but when they do vote, they’re more likely support shareholder proposals – particularly for the largest firms.
So what are the implications of all of this?
Well, first, I’m struck by how everyone from the Progressives (Adolf Berle, William Riley) to modern thinkers like Einer Elhauge have assumed that the separation of ownership and control would lead shareholders to be less concerned about corporate social responsibility – the theory being that as shareholders feel less responsible for corporate behavior, they’ll shed morality in favor of wealth maximization. Yet, at least according to this data, smaller stakes and thus greater separation leads shareholders to greater support for social responsibility (i.e., shareholder proposals, many of which trend along these lines). Which makes its own sense: shareholders with smaller stakes may identify more as laborers, community members, etc than as shareholders, and feel less of an economic hit when companies sacrifice profits to benefit these other groups. Plus, these results may not mean the general principle is wrong, exactly; the argument was always that dispersed shareholders were absentee landlords, and Brav, Cain, and Zytnick find precisely that, in that lower stakes are correlated with lesser involvement in governance. Still, these findings are some counterweight to the assumption that dispersion breeds lack of social conscience.
Beyond that, we can ask what these findings suggest for those who would seek to enhance retail shareholder voice. For example, some have argued in favor of technological tweaks that would make it easier for retail shareholders to vote. What would the effects be? Well, it depends on who you think these nonvoters are. Perhaps, like the retail voters in the study, they’d turn out to be more attentive to corporate performance, less supportive of underperforming managers, and less supportive to shareholder proposals, than the current crop of voters – but again, as Brav, Cain, and Zytnick suggest, the infrequent voters are not the same as the frequent voters, and technological fixes may boost infrequent voters specifically. Thus, changes that enhance retail participation may in fact result in greater support for ESG initiatives.
And then there’s the question of requiring mutual funds to pass through votes to beneficial owners. That’s been proposed by a number of academics, including Caleb Griffin, Sean Griffith (for certain types of votes), Jennifer Taub, and Dorothy Lund, and has – as I understand it – even been suggested even by Bernie Sanders, who wants to ban asset managers from voting workers’ retirement fund shares unless they are following instructions (though it’s unclear to me whether he envisions straight pass through or more like a separate workers’ organization that sets voting policy). And here we have the same question: We might imagine the silent retail shareholders would become more like the retail shareholders who vote today, in which case they’d oppose ESG proposals and would be more hawkish on management performance as compared to institutional investors, or they might be more like the infrequent/lower stakes retail voters of today, who support ESG but barely bother to vote at all. Or they might be something entirely different: as Jill Fisch, Annamaria Lusardi, and Andrea Hasler note, investors whose only market exposure is a 401(k) plan are far less financially sophisticated than other investors. Presumably these are mutual fund investors whose voices would be promoted by a pass-through regime, and they might have particularly idiosyncratic preferences, if they have preferences at all.
We might also ask whether the retail voters from 2015 to 2017 are reflective of the retail voters of 2020, or 2021. As I previously pointed out, new technologies may encourage greater retail ownership, and these new traders may have entirely different preferences, especially if – as some data suggests – they treat stock trading as more of a leisure pastime than an investment opportunity.
But my big takeaway is this: I’ve previously argued that we should have more disclosure of the identity of voting shareholders, and, in particular, votes of high-vote shares and insiders should be distinguished from the votes of low-vote shares and unaffiliated investors. Brav, Cain, and Zytnick have convinced me that retail shareholders have a distinct point of view, as well, and – to the extent consistent with these voters’ privacy – their votes should be disclosed separately, as well.
Saturday, December 7, 2019
One of the biggest corporate law battles today concerns the appropriate role of institutional investors – and especially mutual funds – in corporate governance. There has been increasing concern expressed in the academy that mutual funds – especially index funds – don’t have sufficient incentives to oversee their portfolio companies, and/or that mutual fund complexes have become so huge that they dominate the economy. The concerns are rising to a level where the funds themselves are responding; witness, for example BlackRock’s attempted defenses here and here. And, of course, we have the SEC’s sneak attack on institutional power via proposed regulation of proxy advisors.
Which is why I found Fatima-Zahra Filali Adib’s new paper, Passive Aggressive: How Index Funds Vote on Corporate Governance Proposals, so interesting. She studies index fund voting behavior and contribution to corporate value by focusing on the “close call” votes, i.e., ones that narrowly pass or narrowly fail. She finds that index fund support is associated with value enhancement, and that these votes are not dictated by the proxy advisors (rebutting arguments that institutions blindly follow advisor recommendations). On the other hand, she also finds that ISS recommendations are not well correlated with value-enhancement, at least on the “close calls” – a point supporting the claim that proxy advisors do not know what they’re doing.
Also, fascinatingly – in direct response to those who claim that index funds do not have resources or incentives to devote to corporate governance – she concludes that funds allocate more resources to the “close call” proposals, apparently in anticipation that these are the ones where their votes will be pivotal. Her proxy for resource allocation is the fact that the fund voted against management (which suggests more attention to the issue). Bottom line is, funds are more likely to vote with management if they are “busy” – i.e., there are a lot of other proposals that require fund managers’ attention – but they are not more likely to vote with management, no matter how busy they are, if the vote is a close call. The voting behavior also suggests that index funds identify problem firms and continue to devote resources to them over time.
Anyway, that’s just a summary – there’s a lot here to dig into.
Saturday, November 30, 2019
I’m assuming most readers know the backstory here, but CBS and Viacom are both controlled by NAI, which in turn is controlled by Shari Redstone. NAI owns nearly 80% of the voting stock of each company; the rest of the voting shares are publicly traded but held by a small number of institutions. The bulk of each company’s capitalization, however, comes from no-vote shares, which are also publicly traded.
Redstone has long sought a merger of the two companies, which has been perceived as a boon to Viacom and a drag on CBS. That’s why, when she proposed a merger in 2018, the CBS Board revolted and tried to issue new stock that would dilute NAI’s voting control. That case resulted in a settlement whereby Redstone promised not to propose a merger for two years unless the CBS independent directors raised the issue first. By sheerest coincidence, as luck would have it, mere months after the settlement was reached and the CBS board restructured, CBS and Viacom announced that they had reached an agreement and would merge by the end of 2019.
Of course, the immediate question among academics was whether, if the merger did proceed, Redstone would shoot for MFW-cleansing, which would require conditioning the deal on the approval of the disinterested shares. And if Redstone did try to cleanse, would she give the no-vote shares the chance to vote? Or would she try to cleanse with only the voting shares that are not held by NAI? If the latter, would Delaware courts really permit a deal to be cleansed by the vote of unaffiliated shares representing such a small fraction of the total capitalization, especially when the no-vote shares have no say at all?
Sadly for those of us in the nosebleed seats, those questions are not going to be answered, because Redstone refused to condition the deal on any kind of unaffiliated shareholder vote (one of the points of objection among the 2018 CBS Board) – which is important for where we are now.
Where we are now is that a holder of CBS’s no-vote shares is (inevitably) seeking books and records in order to determine if there was wrongdoing in connection with the proposed deal. (Spoiler: The shareholder thinks there was wrongdoing). CBS and Viacom refused to provide all of the documents sought, leading to a lawsuit, and ultimately VC Slights’s recent opinion in Bucks County Employees Ret. Fund v. CBS. Slights concluded that there was a “credible basis to suspect wrongdoing,” and granted the plaintiff access to a broad array of documents, if not everything identified in the initial requests.
There’s a lot that’s of interest here, including details that I didn’t see reported previously (they may have been, if so I missed it) suggesting Redstone influenced the transaction, by, among other things, pressuring what Slights describes as the “purportedly” unaffiliated CBS committee and offering increased compensation to CBS’s Chair and CEO in exchange for his support. So, interested readers should really review the entire opinion. That said, I’m going to highlight what I believe to be the most critical aspects:
(1) There is strong evidence that Redstone sought the merger as a mechanism of using CBS to bail out/shore up the failing Viacom. For example, after Redstone sought – and was refused – a merger in 2016, she complained that “the failure to get the deal done ha[s] caused Viacom to suffer,” admitted that she favored a deal because Viacom’s stock was “tanking,” and vowed to accomplish a merger by a “different process.” Slights seemed quite persuaded by this evidence, and, of course, it will bolster claims of CBS stockholders that the deal was unfair to them.
(2) Following VC McCormick’s opinion in Kosinski v. GGP, Slights determined that the mere fact that CBS made no attempt to adhere to MFW cleansing was itself evidence of wrongdoing for Section 220 purposes. That interests me for a few reasons. First, it extends MFW into a novel space: previously, its purpose was to trigger business judgment review for controlling shareholder transactions, but now it will also be used to “cleanse” for the purpose of avoiding a 220 demand. Moreover, as I’ve previously noted, the definition of a controlling shareholder transaction is itself malleable, and that malleability can be used to evade the strictures of Corwin. Going forward, though the CBS/Viacom merger is very clearly a controlling shareholder transaction, I can imagine that in future cases, uncertainty as to whether a controlling shareholder is present in the first instance will wind up weighing in plaintiffs’ favor as they attempt to gain access to corporate records.
(3) In 2018, when CBS first tried to use nuclear tactics to avoid the merger, I said: “the main purpose of these legal skirmishes may be less to actually limit NAI’s power than to create an extraordinarily persuasive record that any attempt Shari Redstone may make to combine CBS and Viacom will be accomplished over the objection of the independent directors, and in violation of her duties as a controller.” That prediction has proved accurate; Slights explicitly read CBS’s 2018 resistance to the deal as evidence that the new deal proposed in 2019 was unfair to the CBS minority shareholders. As he put it, “a straight line can be drawn between Redstone’s previous attempts to merge Viacom with CBS, which CBS maintained just one year ago ‘presents a significant threat of irreparable and irreversible harm to [CBS] and its stockholders[,]’ and the current attempt to combine these companies. This logical nexus is further evidence of wrongdoing…”
In short, the 2018 CBS Board – and Les Moonves – lost the battle, but may very well have won the war.
Saturday, November 23, 2019
Recently, these stories caught my eye:
Neptune Energy Group Ltd. said that preparing to go public, possibly within the next two years, means it has to explain to potential investors how its fossil fuel-based business model is sustainable.
The company is putting together an ESG strategy, a term encompassing environmental, social and governance issues, which it will publish along with its annual report in April. The move reflects growing concern about climate change among investors in the sector, many of whom are demanding a stronger response from oil producers amid a gradual shift toward cleaner energy….
John Browne [the former BP Plc chief] who helped create the largest privately held oil company in Europe -- Wintershall DEA --- has said an ESG strategy is now crucial to attracting investment.
Indeed, even oil behemoth Saudi Aramco has been touting its relatively low carbon intensity -- the level of emissions per unit of energy produced -- to woo investors to its initial public offering.
Credit rating companies are muscling their way into the burgeoning world of responsible investing, purchasing smaller outfits that provide environmental, social and governance (ESG) scores….
The 159-year-old ratings provider is also leaving the door open for more acquisitions in the future, as data is “enormously important” for companies that want to lead in the sector…
The explosion of investment products that are marketed as being environmentally and socially responsible is fueling the demand for ESG data and scores….
ESG ratings have been mostly used by investment-grade bond and loan issuers who tie their sustainability performance to transaction terms or pricing. This year, usage of ESG scores started to spread to leveraged loans, collateralized loan obligations,…
Global investor enthusiasm for saving the planet has helped spur record issuance of green bonds. It’s also driving a surge in third-party verification that proceeds from the debt sales are actually destined for environmentally friendly projects, as fears of “greenwashing” mount….
Sustainalytics issued 35% more second-party opinions for green bonds in the third-quarter of this year compared to the same period a year ago. That included a 20-page opinion on Verizon’s green bond framework before the phone giant sold $1 billion in green bonds in February.
The benefit of getting the second party opinion outweighed the cost, according to Kee Chan Sin, Verizon’s assistant treasurer….
Some borrowers are going a step further and asking auditors to review the use and management of proceeds, as well as reporting after the bond is issued. Assurance that funds raised are being allocated to the right projects could help the market grow, said Kristen Sullivan, sustainability and KPI services leader at Deloitte, which provides assurance to green bond issuers.
Some investors are also doing their own audits.
It is obvious that investors are clamoring for reliable ESG data – at the very least regarding climate change vulnerability – and they are desperate enough to be willing to pay for it. This is not some kind of social cause movement; these investors are seriously, financially concerned about the long-term viability of certain industries and industrial practices.
Still, due to coordination problems, there’s a lack of standardization of metrics, and a lack of comparability of data.
Which is why I stand in absolute amazement that (at least some) SEC Commissioners take all this as evidence that the SEC should not develop a disclosure framework, because the current metrics are too inconsistent. We would normally take that as a sign of the need for coordination by regulators. After all, when the federal securities laws were passed in 1933 and 1934, there wasn’t much in the way of accounting standards – it took a federally mandated disclosure regime coupled with decades of cooperation with the private sector to settle on a unified framework.
I mean, I suppose it’s great business for the private ratings industry, which gets to sell investors different analyses, but isn’t that kind of standardization the raison d’etre of the securities disclosure regime?
Saturday, November 16, 2019
I've frequently been asked to express a view on the spectacular decline of WeWork. Is there a broader lesson here? Or is this just a bizarre one-off?
I actually think there are a few lessons, and for this week’s post, I’ll start with the one about securities regulation and capital allocation.
One of the primary purposes of securities regulation is to ensure the efficient allocation of capital. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717 (1984); see also Benjamin Edwards, Conflicts and Capital Allocation, 78 Ohio St. L. J. 181 (2017). SEC Chair Jay Clayton recently gave a speech in which he emphasized that the SEC is “not in the business of dictating a company’s strategic capital allocation decisions,” which is true – the SEC’s job is not to tell market actors where or how to invest – but the SEC is responsible for creating a disclosure regime that facilitates efficient capital allocation via investors’ choices. And by that measure, the securities laws are failing.
As we all know, the securities laws – both through statutory revisions (JOBS Act) and regulatory interpretation – have made it easier for companies to raise capital without public disclosure. The theory is that wealthy, institutional investors can bargain for the information they need to make an intelligent investment decision. But – as others have pointed out – when capital is raised privately, optimistic sentiment can be expressed but negative sentiment cannot. I’ll go further: Because private-market investors are a small group, they have strong incentives to keep their negative opinions to themselves lest they be shut out of future deals. Meanwhile, mutual funds have made a deep dive into the private markets, and agency costs infect those decisions: active managers, hoping to improve their market relative to competitors, may well think it would be worse to miss out on a great deal than to make a bad bet that puts their fund on par with everyone else’s.
The result is a bubble of private company valuations that meets reality only when it comes time to go public, as recent experience has demonstrated. But the injuries are not experienced by these sophisticated investors alone; they’re experienced by all of the other actors whose lives are affected by the allocation of capital to doomed business models.
The New York Times just published an expose on the havoc SoftBank has wreaked internationally by dumping cash into unprofitable startups, which have then gone on to persuade small business owners and independent contractors around the world to upend their plans in hopes of opportunities that never materialize. Violent and/or fire-laden protests have resulted in Indonesia, India, and Colombia. Obviously, many of these investments were outside of the scope of American securities regulation, but not all of them, and they serve as a cautionary tale of the consequences when capital is allocated to poorly-designed businesses. In this, SoftBank is not alone; American venture capital firms have been pouring money into U.S. startups, well beyond amounts that the companies themselves have requested; some founders apparently feel that if they don’t accept venture capital money they don’t need, the VCs will simply invest in a competitor and drive them out of business. See also Sheelah Kolhatkar, WeWork’s Downfall and a Reckoning for SoftBank (“The fact that the Vision Fund flooded its companies with capital made it difficult for other startups or traditional companies with even a modicum of fiscal discipline to compete.”)
It’s not just the investors or even the founders who suffer; the effects are felt throughout the economy. SoftBank’s ill-considered bet on WeWork has upended real estate markets on two continents and that doesn’t even get into the effects on employees; even WeWork’s janitorial staff was paid in stock.
Now, I’ve argued that the securities disclosure regime should not be broadly interpreted to encompass the interests of all actors in society; securities disclosure is, at its core, for investors, and if we’re worried about other corporate constituencies – and we should be – we should design a disclosure system for their needs. But even within the confines of securities disclosure, efficient allocation of capital should be one of the central goals. And the overwhelming evidence is that, wherever the appropriate line between privatization and “publicization,” the American system has gone too far in the direction of the private.
Saturday, November 9, 2019
In recent years, there has been a lot of discussion over the problem of “common ownership,” namely, the fact that the giant institutional investors who dominate today’s markets tend to own stock in everything, and this may be a good thing but can also be bad if it encourages collusive behavior among competing firms linked by the same set of shareholders.
What has received less attention is the effect of common ownership on shareholder voting and corporate transactions. When a handful of large shareholders own stock in two merging partners – say, Tesla and SolarCity (not a hypothetical, incidentally) – they may vote for less-than-optimal deals on one side in order to benefit their holdings on the other side.
There are two implications to this: First, these cross-holdings may incentivize corporate managers to pursue nonwealth maximizing transactions when cross-holders are a significant part of the shareholder base (and may call into question the disinterestedness of large shareholders for Corwin cleansing purposes). And second, very often, these institutional shareholders are actually mutual funds, with cross-holdings not in a single fund, but in multiple funds across a fund family. Yet their voting patterns (or the actions of their portfolio firms) suggest that their influence is geared towards maximizing wealth across the family as though the investments were all part of a single portfolio, which is a potential violation of their duties to each individual fund.
I’ve written about both of these issues: the former in Shareholder Divorce Court (where I describe the Tesla situation) and the latter in Family Loyalty: Mutual Fund Voting and Fiduciary Obligation, but at the time, I only had a limited set of empirical studies to draw upon.
All of which is a long way of saying that two new studies were recently posted to SSRN, and they reach conclusions similar to those of the earlier studies.
First, there’s Dual-Ownership and Risk-Taking Incentives in Managerial Compensation, by Tao Chen, Li Zhang, and Qifei Zhu. They find that institutional investors who own stock and bonds in the same firm are more likely to favor managerial compensation policies that minimize incentives for risk-taking, as compared to institutional investors who own stock alone. Significantly, they find this effect at the mutual fund family level, suggesting that mutual funds are setting voting policy to maximize wealth at their funds collectively, without differentiating policies that might benefit some funds more than others.
Second, there’s Common Ownership and Competition in Mergers and Acquisitions, by Mohammad (Vahid) Irani, Wenhao Yang, and Feng Zhang. Similar to those who find that firms with common owners compete less in their product markets, the authors find that firms with common owners compete less in the takeover market, so that common ownership across potential acquirers of a target firm reduces the likelihood that the target will receive a competing bid, and increases returns to acquirers upon announcement of a bid (though the cross-ownership does not seem to effect target bid premiums or target returns). And, at least as I understand their methodology, these results are identified at the fund family level.
Anyhoo, this is a fascinating area and I very much hope we see more empirical work along these lines.
Saturday, November 2, 2019
It wasn’t terribly long ago (okay, fine, it was 23 years ago, I’m dating myself) when Friends aired this:
I’m guessing that depiction of stock trading was accurate for most people; it wasn’t that it was necessarily hard to open a brokerage account and trade, it was simply that most people didn’t quite understand the mechanics of how to go about it. Even with online trading, you still have to go out of your way to seek opportunities to trade. But what happens if stock trading is one of several simple options presented when people open up an app that they use every day?
That question is apparently about to be answered: Square, the payments app, recently announced that it will begin permitting free stock trades on its platform, setting itself up as a competitor to Robinhood. And the part that interests me isn’t simply the prospect of free trading, but the prospect of easy trading, accomplished with all the forethought of a candy bar purchase in the grocery check out aisle.
I suppose retail shareholders will never replace institutions for sheer size, but enough could enter the market to make some difference. Will their uninformed trades create new opportunities for hedge funds to profit – perhaps by reducing some of the distortions introduced by indexing? Will we see something like a “consumer premium,” whereby retail traders favor household names, companies they prefer because they patronize?
Will corporations try to cultivate retail shareholder bases? It is generally believed retail shareholders are more passive about voting, and more likely to vote with management when they do cast a proxy ballot; if the retail market surges, I can imagine corporations reaching out to these shareholders. Stock splits might come back in vogue, to attract retail investors who are disinclined toward impulse purchases of stocks priced in the $2000 range (even with the possibility of fractional trading).
Will we see a more vigorous effort to involve retail shareholders in the voting process? Will there be special mechanisms to enable retail shareholders to ask questions of executives on conference calls? Will we see more proxy solicitations like this one?
If we do, will retail shareholders use default voting arrangements and technological tools to oppose ESG related proposals? Or will an influx of casual retail shareholders result in greater ESG support? Will a cottage industry of retail proxy advisors sprout up – especially nonprofits with an agenda (i.e., “download the Sierra Club’s default voting instructions, compatible with the Square app!”)
If there are more retail shareholders in the market, will Delaware reconsider cases like Corwin, which are predicated on the existence of a highly institutionalized shareholder base?
I suppose it’s all a thought experiment for now but I do wonder how technological ease of stock trading has the potential to reshape the market.
Saturday, October 26, 2019
The Laundromat is Steven Soderbergh’s (and Netflix’s) loose adaptation of James Bernstein’s nonfiction book, Secrecy World: Inside the Panama Papers, illustrating the conduct facilitated by shell companies and the lawyers who supply the paperwork. Both in style and substance, it echoes Adam McKay’s The Big Short – which is why every. single. review. draws that comparison, and so will I – but sadly, I found it neither as entertaining nor as coherent.
The Laundromat takes the form of multiple vignettes regarding people whose lives are touched by the shell entities facilitated by the lawyers at Mossack Fonseca, with Gary Oldman and Antonio Banderas narrating as Mossack and Fonseca, respectively. They break the fourth wall as they offer tuxedo-clad, cynical descriptions of the services the firm provides.
Despite shoutouts to 1209 North Orange and its 285,000 companies – as well as the confession, I assume truthful, that Soderbergh has companies at that location – the film never really offers an explanation of precisely what shell companies do for their owners. That was one of the things I thought The Big Short attempted reasonably well: It took the complexity of the financial crisis and made a decent stab of explaining it in an entertaining way (my prior review here). The Laundromat tells us that these companies are stuffed with (illict) assets and that they offer privacy, but never goes further than that.
In fact, what explanations the film does offer are somewhat contradictory. We’re told that shell companies facilitate legal tax evasion, but the vignettes have nothing to do with tax evasion; they have to do with fraud, bribery, and other crimes. Moreover, multiple characters – including Mossack and Fonseca – end up in jail, so it’s clear that somebody did something illegal and the shell companies couldn’t protect them.
The truth, of course, is that shell entities have a variety of purposes, and can be used for both legal and illegal purposes, but that’s far too complex a story to portray on film, leaving The Laundromat’s explanations muddled and – from a pedagogical point of view – deeply disappointing.
At the same time, the movie doesn’t really stand on its own simply as a movie, divorced from the intricacies of the scandal that inspired it. The vignettes are half-finished, because they exist only as vehicles to illustrate the broader point about how wealthy people shield themselves from liability to the masses, which means that the failure to effectively so illustrate dooms the entire project.
Friday, October 18, 2019
I watched the Netflix documentary American Factory, about the labor relationships at a Chinese-owned auto glass factory in Dayton, Ohio. (For anyone unaware, the movie was produced by the Obamas). It’s a fascinating film for anyone interested either in business or labor issues.
The movie begins when the old GM plant is closed in the midst of the financial crisis, throwing thousands of people out of work. The plant is later purchased by Fuyao, a Chinese company. They’re hiring, but at much lower wages than the old factory, and they openly state they do not want any unionization. They are also sending over Chinese workers to work alongside the Americans. Despite the pay cut, American workers in this economically-depressed area are happy for the job; we can see the transformation made in people’s lives.
At first, the American workers and the Chinese workers bond; the Americans invite the Chinese over to parties, enjoy introducing them to American culture, and so forth. But the film then depicts something of a culture clash between the Americans and the Chinese.
The Chinese expect far more obedience from their workforce, longer working hours, and they seem baffled by American regulations – everything from environmental/safety to labor regulation. They openly state they want to hire younger workers (age discrimination!) and plan to fire labor organizers (labor violation!). Americans complain about unsafe working conditions and pollution, and obviously feel as that the Chinese supervisors – unfamiliar with American standards – are unsympathetic to their concerns. At one amusing/painful moment, the Chinese receive instructions from their supervisors about how American workers have unusually delicate sensibilities and need to be flattered into performing.
Later, in a jarring sequence, the American factory supervisors visit China. Among other things, workers regularly perform dangerous tasks without any safety equipment, and put on demonstrations of obedience and satisfaction, in sharp contrast to the increasing dissatisfaction of the American workers. Which isn’t to say the Chinese are necessarily any happier than the Americans – some Chinese workers talk about how they almost never get to see their families because of their long hours – but they are expected to put on a display of unity.
So there certainly are these cultural differences, which the film illustrates.
It does not actually strike me that in substance the Chinese-owned American factory is, in fact, run very differently than an American factory. Which is to say, the Chinese clearly are not sensitive to American laws, which is why they admit to extraordinarily illegal actions on camera; an American factory owner would be more savvy. But American bosses fire labor organizers, and violate safety laws, and demand unpaid overtime, and offer non-union laborers low wages, and replace workers with automation, all the time. In fact, to fight the labor agitation, the Chinese bring in an American consultant. Someone snuck a microphone into the meeting that the consultant held with the workers, and we hear all the standard lines from the anti-union playbook; none of this is unique to Chinese factory owners.
So while the framing device here is one of culture clash – and certainly the Americans and the Chinese experience it that way – it’s not clear that the substantive sources of disagreement would be any different no matter who owned the factory.
And that’s ultimately quite sad. Because we know from the start that the unionization effort is doomed, and the overall picture is one of an economic and legal system that simply is not designed to encourage that every single person be valued, and every single person be given a chance to flourish. Instead, the assumption underlying the system – in both countries – is that many human beings, perhaps most human beings, will be cogs in a larger machine, mere instruments to allow other people to thrive. On the American side, though, the rhetoric is at odds with that tragic reality.
Friday, October 11, 2019
When I begin teaching my Business students about corporations, I always start with a little information about Delaware. I tell them that Delaware has less than 0.3% of the U.S. population, it's physically the second smallest state in the country, and it has more registered businesses than people, among other facts.
Which is why I very much enjoyed reading Omari Simmons's paper, Chancery’s Greatest Decision: Historical Insights on Civil Rights and the Future of Shareholder Activism, which gave me a new appreciation for Delaware and its history. I was entirely unaware that one of the cases involved in the Supreme Court's famous Brown v. Board of Education decision was a ruling from Delaware Chancery. The paper gives a fascinating background of racial relations in the state and the events that led to Chancellor Seitz's ruling that Delaware's racially-segregated school system impermissibly discriminated against African-Americans. I'd had no idea of Delaware's involvement in the civil rights movement and I was delighted to learn of it. Here is the abstract:
This essay offers a historical account of the Delaware Court of Chancery’s greatest case, Belton v. Gebhart, a seminal civil rights decision. The circumstances surrounding the Belton case illuminate the limits and potential of shareholder activism to bolster civil rights in the modern context. They vividly illustrate how advancing civil rights requires a range of tactics that leverage public, private, and philanthropic resources. Shareholder activism works best as part of a multipronged activist strategy, not as a substitute for other types of activism. Examining a historical civil rights example is instructive for thinking about how shareholder activism might advance the modern civil rights agenda. Recognizing the complex challenges associated with advancing civil rights, this essay raises key questions about the nascent environmental, social, and governance (ESG) framework with which scholars, practitioners, and other observers must contend.
I guess the only thing I'll add is that, due to Chief Justice Strine's retirement, Governor Carney will be called upon to pick a successor, and many legal groups are urging that he consider a woman or person of color, given Delaware's heavily male, heavily white bench. I have no idea who the candidates are or the various considerations that will go into Governor Carney's decision; all I can say is that Delaware's judiciary is of unique national importance, and it would be gratifying to see it better reflect our country as a whole.
Friday, October 4, 2019
When the news came out that Volkswagen had used defeat devices in order to fool regulators into thinking that its cars complied with environmental standards, massive amounts of litigation followed, eventually consolidated into an MDL so sprawling that it literally took me over an hour – plus two calls to Bloomberg – just to get the docket sheet loaded on my computer.
One set of claimants are the bondholders who purchased in an unregistered 144A offering just before the scandal broke. These bondholders contend that the offering memoranda failed to disclose critical information about the regulatory risks Volkswagen faced, in violation of Rule 10b-5. They’ve just got one problem: They’d like to bring their claims as a class, but because the bonds did not trade in anything like an efficient market, they cannot make use of the fraud-on-the-market presumption of reliance. Instead, they’ve turned to Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), which holds that when a fraud consists of omissions rather than misstatements, reliance may be presumed.
Now, the first issue is, what counts as an omissions-based fraud? The fraud here included affirmative misstatements, and usually that would be enough prevent the use of Affiliated Ute. See, e.g., Waggoner v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017). However, in a recent opinion denying summary judgment to defendants, Judge Breyer of the Northern District of California ruled that in the Ninth Circuit, plaintiffs may invoke the Affiliated Ute presumption even when affirmative misstatements are in the mix, so long as the center of gravity of the case concerns an omission. See In re Volkswagen "Clean Diesel" Mktg., Sales Practices, & Prods. Liab. Litig., 2019 U.S. Dist. LEXIS 166832 (N.D. Cal. Sept. 26, 2019).
That’s intriguing enough on its own, because when I think of what kinds of cases are likely to be primarily about omissions, they’re likely to be what the defense bar is now calling “event driven litigation,” namely, the company did a bad bad thing, and concealed that fact, and the only misstatements are things like “we acted ethically” and “we’re in compliance with the law.” Treating those as Affiliated Ute cases could conceivably make them easier to bring, which, well, aside from annoying the defense bar, further blurs the line between cases based on mismanagement (not permitted under Rule 10b-5), and cases based on deception (which are). See Santa Fe Indus. v. Green, 430 U.S. 462 (1977). This is especially so because Judge Breyer does not explain exactly what was deceptive here if we’re focusing on the omissions rather than the misstatements. If failure to disclose really important bad things counts as deception, well, we may as well give up on Santa Fe* altogether. (These are issues I talk about a lot in my articles; if you’re interested, you can find discussions in Reviving Reliance, Slouching Towards Monell: The Disappearance of Vicarious Liability Under Section 10(b), and Searching for Market Efficiency).
But that’s actually not the part of the opinion I want to focus on. Because the Affiliated Ute presumption of reliance is rebuttable. If defendants can show that even if they had disclosed the relevant information, the plaintiff would still have invested, then the presumption of reliance falls away. And courts have held that when plaintiffs don’t even read the relevant documents, then, necessarily, disclosure would not have affected the plaintiffs’ behavior, so reliance is per se rebutted. QED. See Eckstein v. Balcor Film Investors, 58 F.3d 1162 (7th Cir. 1995); Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981).
Way back in my very first blog post here – I remember it like it was yesterday – we were all wondering whether the Supreme Court was going to overrule Basic and jettison the fraud-on-the-market doctrine entirely, and I was thinking about whether Affiliated Ute could work as a substitute. At the time, I asked:
I can’t help but wonder whether defendants have the right to rebut Affiliated Ute in situations where they would not or could not have disclosed the truth, such that the disclosure hypothetical is off the table. This could occur, for example, if the “truth” was that the defendants had engaged in antitrust violations, or other forms of illegal behavior….
If those cases came up in a world where fraud on the market is off the table, would courts accept Affiliated Ute in situations where disclosure was not an option, because it would be too devastating to the company or its managers?
And that is sort of what just happened in Volkswagen. Because the plaintiffs invoked Affiliated Ute, but naturally, the lead plaintiff couldn’t show its investment manager actually read the offering memoranda – because that never happens, and even if it had, an inquiry into the reading habits of all the investment managers in the class would make class certification impossible – and so the defendants claimed they had rebutted the Affiliated Ute presumption of reliance. At which point, Judge Breyer said:
In the run-of-the-mill omissions case, an investor’s failure to read the relevant disclosure documents could indeed be fatal. Having not read those documents, any additional disclosures in them would have been unlikely to come to the investor’s attention. As a result, it would be difficult for the investor to prove that he would have acted differently—and avoided the investment—if additional disclosures were made in those documents.
This is not a run-of-the-mill omissions case, however. The omitted facts detailed Volkswagen’s large-scale and long-running defeat-device scheme. When that scheme was disclosed to the public, in September 2015, it was front-page news and prompted congressional hearings, video apologies by Volkswagen executives, and hundreds of lawsuits. The disclosure also prompted Plaintiff’s investment manager to reevaluate Plaintiff’s investment in Volkswagen bonds and to sell those bonds for a loss within a month’s time.
If Volkswagen had disclosed its defeat-device scheme in its 2014 bond offering memorandum, instead of waiting until September 2015, the same publicity, and the same response by Plaintiff’s investment manager, would likely have followed. The scheme was so substantial and blatant that it is hard to fathom that its disclosure would have gone unnoticed by the investing public, and that Plaintiff’s investment manager would not have been made aware of it.
Assuming, then, that Volkswagen’s evidence demonstrates that Plaintiff’s investment manager did not read the offering memorandum prior to purchasing the bonds, that evidence alone is insufficient to establish beyond controversy that Plaintiff’s investment manager would not have attached significance to the omitted facts about Volkswagen’s emissions fraud if those facts had been disclosed in the offering memorandum. As a result, Volkswagen has not rebutted Affiliated Ute’s presumption of reliance.
In other words, the plaintiff “relied” on the omissions in the documents, in the sense that the plaintiff could assume from the absence of scandal surrounding Volkswagen at the time of purchase that there was nothing scandalous disclosed in the memoranda. And that’s enough to satisfy Affiliated Ute.
To be honest – and this is something I talk about in that original blog post, as well as in Searching for Market Efficiency – I actually think this is the correct interpretation of the original Affiliated Ute case. The distinction between omissions-based frauds and affirmative-frauds is an odd one until you remember the full context of Affiliated Ute. The Court was trying to get at the idea that some omissions are so huge that they go to the heart of the deal – of course you would assume those facts were not present, merely by the regularity of the transaction – and that’s when it would be absurd to make the plaintiffs bear the affirmative burden to prove reliance.
And in Judge Breyer’s view, a huge scandal that dominates headlines has that same kind of quality.
*Oh why not:
Friday, September 27, 2019
There is a lot going on in VC Slights’s new opinion in Tornetta v. Musk, refusing to dismiss a shareholder suit challenging Elon Musk’s eye-popping compensation package.
In Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”), the Delaware Supreme Court held that, in the context of a squeeze-out merger, controlling shareholders can obtain business judgment review – rather than entire fairness – if they employ the dual protections of requiring the affirmative vote of a majority of the disinterested shares, and requiring that the deal be negotiated at the outset by a fully-empowered independent board committee.
Since then, there have been a lot of questions about MFW’s application, including whether MFW can/should be employed beyond the context of squeeze outs, which brings us to Tornetta.
Last year, Tesla granted Elon Musk a new compensation package that would award him as much as $55 billion in Tesla stock options, conditioned on achieving certain milestones. The package was approved by a vote of the unaffiliated Tesla stockholders, but did not satisfy the full set of MFW preconditions (i.e., it was not negotiated by an independent committee, etc). Thus, Tornetta filed a lawsuit challenging the award on the ground that (1) Musk is a Tesla controlling shareholder (2) the award is therefore an interested transaction subject to review for fairness and (3) the award was unfair. The claims were brought both directly and derivatively.
Now, the first interesting thing about this case is the number of issues that could have been raised on the motion to dismiss, but were not (though defendants may still raise them later).
Defendants could have, but did not, dispute that Musk was a controlling shareholder (likely because VC Slights previously concluded he was in a case challenging the Tesla/SolarCity merger – I’ll come back to that).
Defendants could have, but did not, dispute that the directors who approved the package were dependent on Musk.
Directors could have, but did not, move to dismiss for failure to make a demand on the board (more on that below).
Directors could have, but did not, move to dismiss on the ground that the claim could not be maintained as a direct action (again, more below).
As a result, the narrow question before Slights was simply whether stockholder approval alone can cleanse a compensation award to a controller, or whether instead MFW procedures are required. And he held that MFW procedures are always required when a controller’s interests conflict with those of the minority.
[More under the jump]
Friday, September 20, 2019
By now, regular readers of this blog are aware that I’ve been especially forceful in arguing that litigation limits in corporate charters and bylaws can only address matters of corporate internal affairs, and that federal securities claims are beyond their scope. Vice Chancellor Laster adopted a similar view in his Sciabacucchi v. Salzberg decision, where he invalidated charter provisions that purport to require that all Section 11 claims against the company be brought in federal court. Now that the matter is on appeal to the Delaware Supreme Court (Docket No. 346,2019) – and the opening brief is due today – a lot of articles about the scope of the internal affairs doctrine are dropping.
First up, we have Daniel B. Listwa & Bradley Polivka’s First Principles for Forum Provisions (Cardozo Law Review, forthcoming), in which the authors argue that Laster’s opinion erroneously focused on “territoriality” rather than “comity,” and that the suit should have been dismissed for lack of ripeness.
Next, there’s Mohsen Manesh with The Contested Edges of Internal Affairs (Tennessee Law Review, forthcoming), which explores the uncertainties surrounding the scope of the internal affairs doctrine, spotlighted both by the Sciabacucchi v. Salzberg decision and by California’s new board gender diversity mandate.
And then there’s The Limits of Delaware Corporate Law: Internal Affairs, Federal Forum Provisions, and Sciabacucchi, by Joseph Grundfest, which argues that Laster adopted a “novel” view of the internal affairs doctrine, inconsistent with both Delaware and U.S. Supreme Court precedent. This is interesting because his previous article, The Brouhaha Over Intra-Corporate Forum Selection Provisions: A Legal, Economic, and Political Analysis, 68 BUS. LAW. 370 (2013), co-authored with Kristen Savelle, stated that forum selection provisions “do not purport to regulate a stockholder’s ability to bring a securities fraud claim or any other claim that is not an intra-corporate matter” and that if they attempted to do so, courts could prevent it. That passage was relied upon by then-Vice Chancellor Strine in his decision upholding forum selection provisions that apply to state-law internal affairs claims in Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), and of course, Laster’s decision relied heavily on Boilermakers. In the new article, Grundfest acknowledges the tension and explains how his language has been taken out of context. See manuscript at n.345.
There’s also an interesting new empirical paper by Dhruv Aggarwal, Albert Choi, & Ofer Eldar, Federal Forum Provisions and the Internal Affairs Doctrine, which finds that after the Sciabacucchi v. Salzberg, firms with similar forum selection clauses in their constitutive documents experienced a stock price drop, suggesting that the market values such clauses. In light of these results, the authors argue that the internal affairs doctrine should be interpreted to permit them.
Point being, the Delaware Supreme Court has a lot of reading to do.
Saturday, September 14, 2019
Emily Strauss at Duke has posted a fascinating new paper, Crisis Construction in Contract Boilerplate (Law & Contemp. Probs., forthcoming). She examines how judges interpreted the boilerplate in RMBS contracts during the financial crisis, and finds that they relaxed their reading of certain provisions in order to enable injured investors to recover their losses, and then reverted to more strict readings when the crisis had passed.
Specifically, the RMBS contracts provided that the “sole remedy” available for loans that did not conform with quality specifications was for trust sponsors to repurchase the noncompliant loan. Of course, during the crisis, investors alleged that huge percentages of loans backing the trusts were noncompliant, and a loan-by-loan repurchase requirement would have been, as a practical matter, impossible to pursue. Strauss finds that judges interpreted the clause to permit investors to use sampling to identify noncompliant loans and claim damages, but only in the years following the crisis. By 2015, they reverted to a stricter reading of the contracts. She cites this an example of “crisis construction,” namely, the way that courts alter their readings of contracts during times of calamity in order to further some economic policy. (Strauss discusses that phenomenon in her paper, and Mitu Galati also describes it in this blog post spotlighting Strauss’s work ).
The part that really fascinates me, though, is how this trend strikes me as the opposite of what I experienced when I litigated these cases not as a matter of contract construction, but as a matter of securities law violations. As I posted a few years ago (with additional discussion here and here), I believe that courts adopted a narrow – and nonsensical – approach to class action standing when investors started suing en masse after the crisis, and they did so as a way of managing what would otherwise be incomprehensibly large liabilities for Wall Street’s major players. So I’m intrigued that when it came to securities liability, courts shut the door to plaintiffs, but when it came to contract liability, they opened it.
Saturday, September 7, 2019
A few weeks ago, we had an interesting opinion out of the 10th Circuit interpreting the scope of primary liability under Section 10(b) in the wake of the Supreme Court’s Lorenzo v. SEC decision. The short version is that in Malouf v. SEC, the Tenth Circuit found that scheme liability under Section 10(b) (and parallel provisions of Section 17(a) and the Investment Advisers Act) may be incurred when a defendant knowingly fails to correct someone else’s false statement. But matters are actually a bit more complicated.
More under the jump; warning, this post assumes basic familiarity with Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011) and Lorenzo. If you want that backstory, see this post on Janus and the Lorenzo cert grant and my discussion of the actual Lorenzo decision.