Saturday, December 3, 2022
When it comes to FTX, I’ll let the crypto people talk about the implications for that space generally, and I’m sure we all have our opinions on Samuel Bankman-Fried’s conduct – both before the collapse, and his endless apology tour afterwards – but what will live on for me is not any of that, but the 14,000 word hagiography that Sequoia had published on its website until very recently; they took it down after the bankruptcy declaration, though of course you can’t erase anything from the internet.
Sequoia has gotten a lot of flak for it not only for the fawning coverage, but because it revealed that Bankman-Fried actually was playing a video game during his pitch meeting. More than that, after FTX raised $1 billion in its B round, it apparently held a “meme round” of financing, and raised $420.69 million from 69 investors.
But what really stood out to me not just was the evidence of due diligence failure, but the fact that Sequoia intentionally, by their own volition, put this article on its own website. It wanted you to know that this was who they were funding, and this was the process they used. They believed this would give them credibility, perhaps with founders, perhaps with their own investors – and they may very well have been right.
I’ve previously blogged (twice!), and written an essay about, about how the changes to the securities laws create these situations (though, of course, macroeconomic changes are responsible as well, as this Financial Times article explains).
In particular, my point is that the securities laws cultivate investors with particular preferences, and that leads to particular corporate outcomes. As relevant here, in 1996, Congress gave the green light for private funds to raise unlimited amounts of capital, without becoming subject to registration under either the Securities Act or the Investment Company Act, so long as their own investors consist solely of persons with $5 million in assets. At the same time, Congress and the SEC also made it easier for operating companies to raise capital while remaining private, so long as they mostly limit their investor base to these newly supercharged private funds. The illiquid nature of the funding vehicles (necessitated by their private, non-tradeable status) encourages a short-termist orientation in search of a quick payout. Due to the high-risk nature of these investments, private funds invest in multiple firms in the expectation that most will fail but a few will become outsized hits. The result has been that one category of investor – wealthy, institutional, private, illiquid, risk-seeking, and with limited ability to express negative sentiment – has come to dominate the private markets. And that’s how you end up with Sequoia bragging about funding being based on obscene numbers rather than DCF models.
The securities laws are ultimately supposed to facilitate the efficient allocation of capital, but unfortunately, too much weight is being put on “let sophisticated investors make their own choices” and not enough on how these rules shape these sophisticated investors themselves and their preferences, which may not up end up aligning with society's preferences.
Saturday, November 19, 2022
Look there are two massive business stories right now - FTX and Twitter - and I have worked very, very hard to avoid learning anything about crypto, so Twitter it is.
Eventually there will be writing - so much writing - about all of this (me and everyone else), but as I type, it's being reported that there has been a massive exodus of Twitter employees who largely do not want to work for Elon Musk; Musk, in a paranoid fear of sabotage, locked all employees out of the offices until Monday before demanding they all fly to San Francisco for a meeting on Friday, and engineers responsible for critical Twitter systems left. Most of us who are actually on Twitter are waiting for one big bug to take the system down (I've set up an account, by the way, at Mastodon). And maybe that won't happen - maybe Musk will eventually turn things around - but he's certainly made things a lot more difficult for himself in the interim.
I'll save my bigger lesson musings for other formats, but for now, I'll make a minor point: the Delaware Court of Chancery did not, of course, order Musk to complete the deal, but he settled in the shadow of other broken deal cases and clearly saw the writing on the wall. Though there are only a few cases on point, Chancery has not hesitated to order reluctant buyers to complete mergers - in fact, I'm unaware of any case where an acquirer was found to be in breach and specific performance was not awarded - but in the first of these, IBP v. Tyson, Chancellor Strine agonized over the social dislocation that might be caused by forcing an unwilling buyer to complete a sale. Part of the reason he ultimately ordered specific performance was because the business case for the deal remained unchanged; as he put it:
A compulsory order will require a merger of two public companies with thousands of employees working at facilities that are important to the communities in which they operate. The impact of a forced merger on constituencies beyond the stockholders and top managers of IBP and Tyson weighs heavily on my mind. The prosperity of IBP and Tyson means a great deal to these constituencies. I therefore approach this remedial issue quite cautiously and mindful of the interests of those who will be affected by my decision….
[T]here is no doubt that a remedy of specific performance is practicable. Tyson itself admits that the combination still makes strategic sense. At trial, John Tyson was asked by his own counsel to testify about whether it was fair that Tyson should enter any later auction for IBP hampered by its payment of the Rawhide Termination Fee. This testimony indicates that Tyson Foods is still interested in purchasing IBP, but wants to get its original purchase price back and then buy IBP off the day-old goods table. I consider John Tyson's testimony an admission of the feasibility of specific performance…
Probably the concern that weighs heaviest on my mind is whether specific performance is the right remedy in view of the harsh words that have been said in the course of this litigation. Can these management teams work together? The answer is that I do not know. Peterson and Bond say they can. I am not convinced, although Tyson's top executives continue to respect the managerial acumen of Peterson and Bond, if not that of their financial subordinates.
What persuades me that specific performance is a workable remedy is that Tyson will have the power to decide all the key management questions itself. It can therefore hand-pick its own management team. While this may be unpleasant for the top level IBP managers who might be replaced, it was a possible risk of the Merger from the get-go and a reality of today's M A market.
The impact on other constituencies of this ruling also seems tolerable. Tyson's own investment banker thinks the transaction makes sense for Tyson, and is still fairly priced at $30 per share. One would think the Tyson constituencies would be better served on the whole by a specific performance remedy, rather than a large damages award that did nothing but cost Tyson a large amount of money.
Well, Elon Musk is an ... unusual ... buyer of companies, and I doubt we'll see his like again soon, but he's definitely illustrating a worst case scenario for forcing a merger over a buyer's objections. He famously performed no diligence on the company before signing the deal, and tried to back out immediately thereafter, so there was no point where he engaged in any serious analysis of Twitter's systems or planning for what he'd do with ownership. His whiplash changes to policies, his mistaken firings, and his basic misunderstanding of Twitter's business all demonstrate the dangers of selling a company to a buyer who is not prepared to run it.
Which begs the question whether Chancery will be more hesitant in future cases to order specific performance.
In Twitter's case, the parties had agreed to an unusually strong specific performance provision - which barred Musk from even contesting the propriety of specific performance were he found to be in breach - but whatever parties' contractual agreements, specific performance ultimately lies in the court's discretion, and the court has to decide whether it is an appropriate remedy. Though Delaware places great weight on parties' agreements that specific performance is appropriate and breach would cause irreparable harm, the court must also determine that the order "not cause even greater harm than it would prevent." What made the Twitter deal so uniquely high stakes was that the parties had also agreed that, in the absence of specific performance, the most Musk could be ordered to pay in damages was $1 billion, which was far less than the damage he had inflicted on Twitter in the interim and certainly less than what shareholders were owed. Had the court been unwilling to award specific performance, his bad behavior would, essentially, have been rewarded with a slap on the wrist.
Deal planners, I assume, know all of this, which makes me wonder if, going forward, there will be more uncertainty about enforcement, and whether merger agreements will be more likely to provide that knowing and intentional breaches can result in uncapped damages. At least that way, parties will be protected if they are concerned that Delaware courts - looking at the Twitter wreckage - might be less willing to order specific performance in the future.
Saturday, November 12, 2022
I previously posted about the increasing use by shareholders of proxy-exempt solicitations under Rule 14a-6(g). That rule allows shareholders who are not seeking proxy authority to solicit other shareholders without filing a proxy statement, but under some circumstances, any holder of more than $5 million of stock must file their written solicitation materials with the SEC. These days, however, even shareholders who do not need to file with the SEC choose to do so voluntarily, because EDGAR serves as a convenient and cheap mechanism by which materials can be distributed to other shareholders.
Well, Dipesh Bhattarai, Brian Blank, Tingting Liu, Kathryn Schumann-Foster, and Tracie Woidtke have just done a study of these solicitations: Proxy Exempt Solicitation Campaigns. They find that a variety of institutional investors make these filings, including public pension funds (38%), union funds (26%), and other institutions, including hedge funds (22%). The filings may be used to support shareholder proposals that are already on the ballot - and thus to exceed the 500-word limit for such proposals - and to oppose management proposals, such as director nominations and say-on-pay. And these filings are taken seriously: 74% of them are accessed by a major investment bank, and they appear to have an effect on voting outcomes and forced CEO turnover.
So this is fascinating. The rule, adopted in 1992, at least as I always understood it, was intended to ensure that all shareholders receive the same information, and to allow that information to be publicly vetted, so that large shareholders can't lobby others in secret (and away from management prying eyes). But with modern computerized filings, the rule has been, functionally, hacked, to serve as a low-cost mechanism by which shareholders can communicate with other shareholders - and shareholders find it useful. That's a good thing, and it tells us that maybe the SEC should in fact be more proactive in sponsoring platforms for shareholder communication. Obviously, there are plenty of electronic forums today where shareholders congregate, but these are generally thought to appeal to retail shareholders and may have a high noise to signal ratio. Now that the SEC knows it can provide an easy distribution mechanism for more formalized communications, I wonder if it's worth building out that possibility even more.
Saturday, November 5, 2022
Back in September, I posted about the Buzzfeed case that I was watching in Delaware Chancery. Well, now a decision has issued, and the whole situation remains intriguing.
In Buzzfeed v. Anderson, employees of privately-held Buzzfeed signed an arbitration agreement with the company concerning their employment, and also received equity compensation. Buzzfeed went public via a SPAC merger, whereby the old private company became the subsidiary of the publicly-traded SPAC. Employees’ equity comp was converted into stock of the new, publicly traded entity, but, through a series of unfortunate events, they were unable to trade for the first few days. That cost them a lot, because the stock price plummeted immediately thereafter. Relying on their employment agreements, the employees brought mass arbitration claims against the public company and several insiders. Those defendants then sued in Delaware for a declaration that they were not bound by the arbitration agreement, and that in fact the employees were bound to bring any claims in Delaware, because the new, publicly traded entity had a forum selection provision in its charter.
In her decision, Vice Chancellor Zurn held that the arbitration clause did not apply to the company defendants (now plaintiffs in the Delaware action; it gets confusing). The entity the employees had sued was the publicly traded parent of their former employer; the parent had not signed the arbitration agreement. The insiders, as well, had not signed the agreement, which was between the employees and private-Buzzfeed. VC Zurn observed that the insiders might have had rights, as nonsignatories, to force the employees into arbitration if they had sued in court, but it didn’t work the other way around. Op. at 23-24.
I’m not an arbitration expert, so this doctrine was new to me and just highlights the Kafka-esque nature of how arbitration contracts work these days.
But! What actually interested me was the effect of the forum-selection provision.
As I’ve previously mentioned, I recently posted a new paper to SSRN: Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine, forthcoming in the Wake Forest Law Review. It’s about how the internal affairs doctrine is encroaching on other areas of law, including employment law, and the Buzzfeed case seemed like a perfect example. Here you had employees suing about a compensation dispute, and their employment claims were (according to the company defendants) converted into shareholder claims by virtue of a charter provision, over which the employees had no control, that operated to override their for-real contracts.
The problem with Buzzfeed though, from my perspective, was that the substantive claims of the employees – the ones they actually filed in their arbitrations – were pretty explicitly rooted in their status as stockholders. They brought claims under Section 11 of the Securities Act (which is a little strange because, as I understand it, the whole issue here was that the employees’ shares were not registered when they were supposed to be). They explicitly invoked the companies’ status as a Delaware corporation to argue that Delaware law applied. It was only later, when they got to court in Delaware, that they tried to recast their claims as related to their employment, and therefore not subject to the charter forum provision.
So. I didn’t mention the case in my Inside Out paper, but I was curious to see what VC Zurn would do with it. And she kind of split the baby.
There were two separate arguments: The employees claimed Delaware had no personal jurisdiction over them, and therefore this case was simply improperly filed; and the company defendants claimed that the employees were bound bring any disputes in Delaware.
On the former argument, VC Zurn found that the employees had consented to suit in Delaware via the forum provision and therefore she had jurisdiction to hear the dispute, Op. at 39-43, but on the latter, she held that until the employees’ lodged their claims in a court, she could not determine if they fell within the forum provision, Op. at 47-48.
Those holdings are … difficult to reconcile. If she has not determined whether the claims substantively fall within the forum provision, how can she know whether the employees “agreed” to be sued in Delaware via the forum provision? As best I can tell, the holding had to do with her interpretation of the employees’ arguments; the employees argued that their claims were not covered under the forum provision for the purposes of whether they had to bring their claims in Delaware, but not for jurisdictional purposes. Op. at 40-41.
Anyway. As it stands, I’m not sure there are any grand lessons (other than, as I previously posted, the hot mess that was the SPAC frenzy), but I will continue to keep an eye on things to see where they go from here.
Saturday, October 29, 2022
I posted earlier this week with a plug for my new paper on the internal affairs doctrine and an update on the Lee v. Fisher forum selection bylaw litigation in the Ninth Circuit, so I've just got a quick hit for today.
Unless you've been living in a cave, you know that Musk closed his purchase of Twitter on Thursday night; as of Friday, the stock had been delisted. The litigation over whether Twitter lied about its business has come to a halt....
....or has it?
You may recall that in August, a Twitter whistleblower - Peiter Zatko - came forward as a whistleblower about Twitter's internal business operations. Elon Musk amended his complaint in Chancery to incorporate Zatko's claims, alleging that the problems Zatko identified - such as a failure to comply with an FTC settlement - represented additional fraudulent actions on Twitter's part that allowed Musk to terminate the deal.
What you may have missed, though, is that shortly after Zatko went public, the Rosen Law Firm filed a securities class action, Baker v. Twitter, C.D. Cal. 22-cv-06525, based on Zatko's allegations. The complaint names several Twitter executives - including Jack Dorsey - and Twitter itself as a defendant. (It also, amusingly, appears to have accidentally cut-and-pasted allegations from an Activision complaint.)
And as far as I can tell, there is no reason why that suit should not continue. There has to be a lead plaintiff, of course, and an amended complaint, but legally, it persists against the named executives and now the Musk-owned Twitter. Better yet, though there may be problems with loss causation depending on how Twitter's stock moved on any given day, there's really no reason the amended complaint couldn't beef up allegations about spam and misleading mDAU figures, relying not only on the Zatko complaint, but also on the confidential Twitter data that Musk revealed when he filed his own complaints in Chancery.
Which means, Musk may be stuck arguing to a court that there were never any problems, let alone mDAU problems, at Twitter at all.
We all look forward to the CW allegations from any recently-fired Twitter personnel.
Tuesday, October 25, 2022
On Sunday, I posted a new paper to SSRN, forthcoming in the Wake Forest Law Review. It's called Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine, and it covers a lot of territory I've touched on in blog posts, namely, litigation-limiting bylaws, the Salzberg decision, California's board diversity law, and issues regarding the internal affairs doctrine and LLCs. Here is the abstract:
The internal affairs doctrine provides that the law of the organizing state will apply to matters pertaining to a business entity’s internal governance, regardless of whether the entity has substantive ties to that jurisdiction. The internal affairs doctrine stands apart from other choice of law rules, which usually favor the jurisdiction with the greatest relationship to the dispute and limit parties’ ability to select another jurisdiction’s law. The doctrine is purportedly justified by business entities’ unique need for a single set of rules to apply to governance matters, and by the efficiency gains that flow from allowing investors and managers to select the law that will govern their relationship.
The contours of the internal affairs doctrine have never been defined with precision, but several recent developments have placed new pressures on the doctrine’s boundaries. These include: (1) states’ attempts to regulate the governance structures of businesses that operate within their borders in order to benefit non-investor constituencies, such as diversity requirements for corporate boards; (2) the growing prevalence of LLCs, which – because of their flexible, contractual structure – blur the lines between investment relationships and employment relationships; (3) the increasing use of shareholder agreements, which are governed by contractual rules, and not infrequently the rules of a jurisdiction other than the one in which the business entity is organized; and (4) jurisprudence permitting the charters and bylaws of Delaware corporations to include provisions that govern litigation based on non-Delaware law.
This Essay explores modern challenges to the coherence of the internal affairs doctrine, and recommends alternatives.
Of course, one of the cases I tackle in the paper is Lee v. Fisher, which I blogged about when the district court and appellate decisions issued. Briefly, the district court enforced Gap's forum selection bylaw that purported to move a Section 14(a) derivative claim to Delaware Chancery, which had no jurisdiction to hear it; on appeal, the Ninth Circuit affirmed.
Well, obviously reacting to the persuasive case I made in my paper, twenty-four hours after I posted, the Ninth Circuit vacated its Lee v. Fisher decision, and agreed to rehear the matter en banc. I've updated my paper with a footnote to reflect the new development, which is probably all I'll do for now, since a new decision is unlikely to issue before publication.
Saturday, October 22, 2022
In prior posts, I've plugged a couple of legal history articles, essentially offering different accounts of how the corporation, with its distinctive features, came to be. In particular, I highlighted Margaret Blair's piece on how corporate law is inextricably tied to state recognition, and Taisu Zhang's and John Morley's paper on how modern corporate features are tied to a developed state capable of adjudicating the rights of far flung investors with consistency.
Into this mix I'll introduce Robert Anderson's new paper, The Sea Corporation, forthcoming in the Cornell Law Review, demonstrating that the features we think of as defining the corporate form - limited liability, tradeable shares, entity shielding, separate personality, and centralized management selected by the equity owners - were all associated with admiralty law for centuries before the development of the modern corporation, embodied in the form of the ship's personality. Anderson points out that, to some extent, these were necessary given the realities of maritime commerce: when a ship docked in a foreign port, identifying and litigating against its distant owners was nearly impossible. Therefore, creditors necessarily could only bring an in rem action against the ship itself; if the claims were less than the ship's value, the owners could be relied upon to appear in court to collect the residual. Otherwise, creditors would be left only to collect against the ship's assets. Anderson also highlights that maritime law addresses a problem that has vexed corporate scholars, namely, how to deal with limited liability and involuntary creditors (like tort victims). Some have suggested these creditors should receive priority of payment over voluntary ones; he points out that maritime law operates in just this manner and may provide guidance in the corporate sphere.
Anyway, here's the abstract:
Over the two centuries the corporation has become the dominant form of business organization, accounting for more productive assets than all other business forms combined. Yet the corporation is relatively young for a legal institution of such economic importance. As late as the middle of the nineteenth century, most business was still conducted through partnerships, with corporations active only in a few industries. Only in the ensuing decades did restrictions ease allowing the corporation to secure its economic dominance.
Commentators widely attribute the corporation’s success to a set of features thought to be unique to the corporation, including limited liability, transferable shares, centralized management, and entity shielding. Indeed, the consensus among economic and legal historians is that these essential corporate features created a unique economic entity that rapidly displaced the obsolete partnership.
This Article argues that these economic features were not unique to the corporation, nor did they first develop in the business corporation. Over many centuries, the maritime law developed a sophisticated system of business organization around the entity of the merchant ship, creating a framework of legal principles that operated as a proto-corporate law. Like modern corporate law, this maritime organizational law gave legal personality to the ship, limited liability, transferable shares, centralized management, and entity shielding. The resulting “sea corporations” were the closest to a modern corporation that was available continuously throughout the 17th through early 19th centuries in Europe and the United States.
The fact that maritime law developed all the most important features of corporate law offers important lessons for business organizational law itself. The parallel development of the same characteristics, with different and independent mechanisms, is strong evidence of the economic importance of the features of the modern corporation. The maritime law employed a unique device—the maritime lien—to achieve the same economic results as the nascent corporation. The key turn was the use of a property mechanism, rather than the contract mechanisms of partnership law, to implement in rem attributes. The vessel is property come to life in the eyes of the law, developing a form of legal personhood. Viewed in this broader context, the corporation is not a unique institutional solution to recurrent economic problems; it was a convenient vehicle for expanding and generalizing a set of economic solutions.
This new organizational theory of maritime law provides potentially important lessons for both maritime law and business organizations law. First, the theory provides a guiding principle for otherwise disorganized features of maritime law. It suggests that courts should explicitly interpret maritime law as a form of business entity law, keeping maritime law’s distinctive purposes, but drawing from the rich theoretical insights of law of other business associations to inform its unique institutions. At the same time, the long history of maritime law as business organization law provides hints for enduring challenges in corporate law, such as externalities of limited liability on involuntary creditors, such as tort creditors. Here, maritime law provides time-tested solutions, providing a system that provides priority for such creditors over contract creditors, solving one of corporate law’s most vexing problems.
Saturday, October 15, 2022
A lot of people are talking about this complaint against Meta, filed by James McRitchie, alleging that the Board violates its fiduciary duties to diversified shareholders because it seeks to maximize profits at Meta individually while externalizing costs that impact shareholders’ other investments. The complaint further argues that the Board, whose personal holdings in Meta are undiversified, labors under a conflict with respect to diversified investors (seeking, apparently, to avoid the business judgment rule and obtain higher scrutiny of the Board’s actions).
The “universal ownership” theory of corporate shareholding has got a lot of traction recently; as I previously blogged, it’s appealing because it suggests that corporations can be forces for social good without actually changing anything about the structure of corporate law.
That said, academic champions of the theory do not necessarily argue in terms of fiduciary duty – that is, they aren’t claiming that either as a normative or descriptive matter, corporate boards are legally obligated to maximize wealth for shareholders at the portfolio level – instead, they tend to elide those kinds of claims and simply argue that as a matter of power, diversified investors have sufficient stakes and influence to control board behavior in this regard.
The problem with making the argument from the legal perspective, as Marcel Kahan and Ed Rock point out, is that it is not terribly compatible with corporate law as it is currently structured.
That comes through very clearly in the McRitchie complaint, which is brought both directly and, in the alternative, derivatively.
As a direct claim, the plaintiffs are only arguing that they are injured in their nonshareholder capacities – that is, with respect to the aspects of their existence other than their investment in Meta, namely, their existence as shareholders in other companies. The Board of Meta obviously has no duty to maximize the wealth of these shareholders in their nonshareholder capacities, any more than it has a duty to maximize the wealth of corporate employees by paying them larger salaries, simply because the employees might also be shareholders.
As a derivative claim, it fails because derivative claims by definition allege harm to the corporate entity, and the complaint is very explicit that the Board’s actions do not harm Meta, but instead maximize its value (at the expense of others).
That said, the complaint highlights the underlying tension in corporate law, namely, the question whether directors’ fiduciary duty is to advance the interests of a kind of abstract notion of a shareholder (in which case, directors’ duties are a matter of government policy rather than private ordering), or instead, whether the duty is – or should be – to advance the interests of the actual shareholders who actually make investment and voting decisions.
It is worth noting, by the way, that these tensions are also playing out in the context of federal disclosure requirements. The SEC’s proposed climate change disclosure rule does, to some extent, take into account the preferences of diversified investors who want a portfolio-eye view:
Investors have noted that climate-related inputs have many uses in the capital allocation decision-making process including, but not limited to, insight into governance and risks management practices, integration into various valuation models, and credit research and assessments. Further, we understand investors often employ diversified strategies, and therefore do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across registrants.
Commissioner Peirce, however, objects:
The Commission justifies its disclosure mandates in part as a response to the needs of investors with diversified portfolios, who “do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across registrants.” Not only does this justification depart from the Commission’s traditional company-specific approach to disclosure, but it suggests that it is appropriate for shareholders of the disclosing company to subsidize other investors’ portfolio analysis. How could a company’s management possibly be expected to prepare disclosure to satisfy the informational demands of all the company’s investors, each with her own idiosyncratic portfolio? The limiting principle of such an approach is unclear.
Saturday, October 8, 2022
Last week, the Second Circuit issued an interesting decision on the scope of Section 10(b) standing in Menora Mivtachem Insurance v. Furtarom, 2022 WL 4587488 (2d Cir. Sept. 30, 2022). IFF is a U.S. publicly traded company that purchased Frutarom, which also traded publicly but outside the U.S.. Frutarom lied about its business, and these lies were incorporated into IFF’s S-4 issued in connection with the merger. The truth came out, and IFF’s stock price fell. Stockholders of IFF tried to sue Frutarom, now a wholly-owned IFF subsidiary, for making false statements in connection with IFF’s stock. The Second Circuit held that under Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the plaintiffs had no standing because they did not buy stock in the precise company being lied about. As the Second Circuit put it:
Under Plaintiffs’ “direct relationship” test, standing would be a “shifting and highly fact-oriented” inquiry, requiring courts to determine whether there was a sufficiently direct link…Section 10(b) standing does not depend on the significance or directness of the relationship between two companies.
Rather, the question is whether the plaintiff bought or sold shares of the company about which the misstatements were made…The fact that this case involved a merger instead of the sale of a business unit and that IFF incorporated some of Frutarom’s misstatements in its SEC filings and investor presentations does not change the analysis here. Plaintiffs did not purchase securities of the issuer about which misstatements were made….
So, first thing to note is why this matters. Normally, if plaintiffs bought stock in the parent, they’d sue the parent. But here, at least some of the false statements issued before the merger, when the parent is not responsible for the subsidiary’s misconduct. Post-merger, through a combination of agency and scienter theories, it’s tough to show that the parent company is liable for the false statements of a subsidiary. See my blog post about Plumbers & Steamfitters Local v. Danske Bank; see also Pugh v. Tribune Co., 521 F.3d 686 (7th Cir. 2008), and in fact, those kinds of allegations were dismissed in this very case. And despite the Second Circuit’s reservation that state law may permit claims here, the only likely remedy under state law would be a derivative action by parent company stockholders – which of course wouldn’t benefit anyone who had sold their shares since the truth was revealed, and, again, would not work without a showing of scienter at the parent level, to excuse demand.
Which leaves the subsidiary as the only viable defendant. But, as above, the Second Circuit narrowly construed the subsidiary’s statements to be about the subsidiary, and not about the parent – even when the subsidiary’s statements (presumably with the subsidiary’s permission) were included in merger documents associated with the parent.
So, first, let’s just point out the incongruence of treating statements in a prospectus for the sale of the acquirer’s stock as not being about the acquirer.
Leaving that aside, though, this issue comes up repeatedly. In Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Inc., 369 F.3d 27 (2d Cir. 2004), for example, Nortel was JDS Uniphase’s largest customer, and issued stock to JDS in exchange for a business unit. When Nortel collapsed in fraud, JDS shareholders tried to sue Nortel on the grounds that the false statements had affected JDS Uniphase’s price. They were rebuffed because Nortel’s statements were about Nortel, not JDS Uniphase. Not long ago, though, a district court held that Juul might be liable to Altria’s shareholders for misstatements about its own business, seeing as how Altria was a 35% shareholder of Juul at the time. See Klein v Altria Group, 2021 WL 955992 (E.D. Va. Mar. 12, 2021). And in Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000), the Third Circuit held that shareholders of a target company in a proposed, but unconsummated, stock-for-stock merger might be able to sue the acquirer and its auditor for a fraud discovered before the deal closed, on the ground that the acquiring company’s inflated performance affected the stock price of the target.
The Second Circuit’s decision here may – or may not – be at odds with Semerenko. Formally, the Third Circuit’s decision was not based on “standing” but on construction of Section 10(b)’s language prohibiting fraud “in connection with” the purchase or sale of a security, which the Second Circuit here took as permission to disregard its holding: “Nortel rejected Cendant as persuasive authority, so Plaintiffs’ attempt to invoke Cendant to argue that other courts have allowed plaintiffs in their circumstances to sue is unavailing. In any event, as we noted in Nortel, Cendant did not discuss standing.” That’s a little weird, because the standing requirement of Blue Chip is rooted in 10(b)’s “in connection with” language. More generally, Semerenko has often been understood as representing the general principle that if two companies are closely related, a false statement about one is actionable by shareholders of the other.
I’ve previously written about the artificiality of how the fraud on the market doctrine is applied in modern cases, because there are so many judicially-created rules that limit what is supposed to be a court’s empirical inquiry into how frauds affect securities trading, and this is (sort of) another addition to the pile. Leaving aside the fear that this allows, say, public companies to wink-wink-nudge-nudge induce related private companies to make false statements about their businesses, knowing that shareholders of the public company will be blocked from suing anyone at all, it’s fairly obvious that false statements by a target company about its business will affect the trading price of its acquirer. That’s why the statements go in the acquiring company’s SEC filings in the first place. Of course, when it comes to securities trading, everything affects everything else and certainly it’s reasonable to place limits on the connections one draws from one company to another – a point I made when discussing this issue in connection with “shadow” insider trading – but there’s a difference between requiring a close nexus, and creating a bright line rule that bars lawsuits of this kind. Let alone a bright line rule that somehow excludes statements made in a prospectus for the sale of stock purchased by the plaintiff.
That said, even a “nexus” rule may be applied strangely; in this case, Judge Pérez in concurrence would have applied a nexus rule, but she still found a nexus was lacking because the plaintiffs had not shown a direct relationship between the false statements of Furtarom and IFF’s stock price. If required disclosures in an SEC registration statement are not enough to show that kind of relationship on a motion to dismiss, I’m really confused about what we’re all doing here.
It's also worth pointing out some sparring between the majority opinion and the concurrence that does not bear on the direct holding. The majority justified its refusal to permit standing here on the grounds that judicially created private rights of action, such as the right under Section 10(b), should be narrowly construed. The concurrence, however, appeared to be concerned that the majority’s broad language could be taken to apply outside the 10(b) context, and warned that the opinion should not be taken to mean that all implied private rights of action should be read narrowly.
Saturday, October 1, 2022
Since there’s absolutely nothing of interest happening in the business world these days, I figure it’s a good time to tell the story of how I tried to reject an arbitration clause when buying a car.
It was 2013, and I’d just moved to Durham, North Carolina to become a Visiting Assistant Professor at Duke. It was quite the move; other than for schooling and clerkships, I’d spent my entire life – including my legal career – in New York City. I’d never owned a car or really even driven one before; I had to take driving lessons in advance. And when I arrived in Durham, I spent the first week frantically researching cars – there’s a difference between make and model, who knew? – before forming my preferences (namely, inexpensive, good gas mileage, and very very safe, to give myself a fighting chance in the all-but-inevitable crash. And small, so I’d also have a fighting chance at staying in a single lane).
I looked at a mix of new cars and used cars before settling on a bright red Kia Rio, gently used from a previous life as a rental. (Me on test drives is a whole ‘nother story; imagine my barely-licensed self driving around car salespeople who are trying desperately to be polite and engaging and also to survive the encounter).
And that’s when the haggling began. I’d done my research about cars and car prices, and back and forth we went. It had been raining, I was pretty soaking wet, and the showroom was heavily air conditioned, but that didn’t stop me from an extended negotiation – prolonged by the sales guy repeatedly saying he had to “check with the manager” and disappearing into a back room, presumably to take a break and otherwise put on a display of great reluctance. I took advantage of the time to talk to an insurance broker and arrange for coverage, since I’d be driving the car off the lot once the sale was concluded.
Finally, after maybe an hour of this, we struck a deal, and they led me into the back to close. There was an identity check, and then a long series of contracts to sign, where they pointed out various provisions and I had to initial each separately. And then we got to the arbitration agreement for any disputes with the dealership.
I said, I don’t want to sign an arbitration agreement.
The dude was shocked, not sure how to respond. He said, hesitantly, “Okay, that’s your right,” and we crossed that provision off. I handed over my cheque.
We moved all my things into my new car, and they agreed they’d return my rental for me. They put a dealer’s license plate onto the Kia, and I started to drive it off the lot.
At that point, the manager of the dealership came running, running out of the building, waving his hands and telling me to stop. I stopped.
He told me they couldn’t sell it to me without an arbitration agreement.
In retrospect, my reaction should have been “You already did.” But I was too kind.
Instead, we unwound the entire thing. We put my things back in the rental, got rid of the dealer’s plate, tore up the contracts – at that point, the safe had closed on a time lock, so they couldn’t open it up to return my cheque, but they agreed to mail it to me. I called the insurance company to cancel the policy, and I drove away.
The next day, I went to a different dealer to buy my second choice car, a brand new blue Hyundai Accent. I looked over the paperwork carefully – noted that the manufacturer’s manual had an arbitration clause, but you could opt out within 30 days – signed on the dotted line, and I had my car. The same car I drive today.
When I got home from the dealer, I went over the paperwork again. And that’s when I noticed, on one of the faded carbon copies of something I’d signed, printed very very faintly on the back, was a dealer arbitration clause.
Saturday, September 24, 2022
Senators Reed, Warren, and Cortez Masto recently introduced a bill to expand Section 12(g) of the Exchange Act. The bill, as I understand it, would require that private companies with WKSI-level private valuation, or $5 bill in revenue plus 5,000 employees, would become reporting companies.
I couldn't find announcements from the sponsoring senators about the purpose of the bill, but there is this floor statement from Sen. Reed:
[T]hese companies have incredible influence over our society and way of life. ... It should be alarming when private companies can become extremely large and influential in our economy and raise unlimited amounts of capital from an unlimited number of investors, while circumventing the basic disclosure and governance requirements that Congress sought to apply...
I wrote a whole article on how securities disclosures are nominally intended for investors, but they are used by other audiences, and the distortive effects of attempting to hijack the securities disclosure system for the benefit of stakeholders. My point is not that stakeholders don't deserve disclosure - far from it! - but instead that we should openly create a stakeholder disclosure system rather than continue to filter stakeholder-oriented disclosures through the SEC.
This bill ... illustrates the problem.
Section 12(g) disclosures are currently tied to the number of investors a firm has, on the theory that when investors are sufficiently dispersed, they need mandatory disclosure. This bill, by contrast, would require disclosure based solely on size, even, I take it, if a firm has only a handful of investors. I think size is a great trigger for disclosure - it's what I recommended in my paper! - but it only makes sense if your audience is stakeholders. And though Sen. Reed's full floor statement does nod to investor needs, his interest in protecting stakeholders seems to be the real motivator here. But the mindset that somehow only investors are entitled to holistic disclosure forced him and his co-sponsors to try to filter still more stakeholder-disclosure through a securities disclosure system that is not designed for their needs.
Saturday, September 17, 2022
A while back, I blogged about a securities fraud case where the only lead plaintiff applicant was rejected on the grounds that he had sent harassing letters to the defendants. Ultimately, in that case, no alternative lead plaintiff ever completed a new application, and the case did not proceed as a class. Instead, several investors proceeded on an individualized basis, and their claims were eventually dismissed.
Well, it happened again: in Bosch v. Credit Suisse Group, 22-cv-2477 (ENV), Magistrate Judge Roanne Mann held that the only proposed lead plaintiff – with a $621 stake – simply did not have enough interest in the case to justify appointment as lead.
This is a bit more unusual than the earlier case I blogged about, though, because the denial wasn’t based on misconduct, but simply dollar value of losses. The judge reasoned that, according to the PSLRA, the lead plaintiff must make a “prima facie showing that its claims satisfy the typicality and adequacy requirements of Rule 23,” and then held that a $621 loss rendered the plaintiff inadequate: “This Court is not satisfied that Jimenez has a sufficient interest in the litigation to vigorously pursue the claims of the class.”
The problem is, it’s pretty well established that a small financial stake by itself is not sufficient to render a plaintiff inadequate under Rule 23. See Federal Practice & Procedure § 1767. In other words, though Judge Mann purported to rely on Rule 23(a)’s adequacy requirement, she in fact created a much more stringent adequacy requirement that seems more to be rooted specifically in the PSLRA. As she put it:
under the PSLRA, the lead plaintiff must have a substantial stake in the litigation to ensure it has the ability and incentive to control counsel. Institutional investors, in particular, were thought by Congress to have the sophistication and ability to control complex litigation. Indeed, the principal focus of the PSLRA, as reflected in its legislative history, was that large institutional investors, and not class action counsel, would make the strategic decisions in the litigation….Although an institutional investor need not always be chosen as lead plaintiff, an individual investor should have comparable ability and motivation to control the litigation.
Though she cited other decisions where courts rejected small-dollar investors for the lead plaintiff spot, in all of those cases, there were other plaintiffs available; I am unaware of other decisions that simply refused to appoint any lead due to the perceived small stake of the only applicant.
As I mentioned in my prior post, this reveals one of the critical ambiguities in the PSLRA: it is unclear what the relationship is supposed to be between the lead plaintiff and the class representative, and it is concerning that class treatment might be denied without a full class certification hearing, and in the face of an available plaintiff who apparently satisfies Rule 23’s standards.
I am somewhat sympathetic to the idea that if there’s no one with a real interest in the case who wants the lead plaintiff spot, the case simply should not proceed as a class action, but on the other hand, the literal point of the class action device – its highest and best use – is to aggregate small dollar claims that would otherwise be impractical to bring.
That said, Judge Mann did highlight an additional fact, beyond the applicant’s small stake, suggesting inadequacy:
in response to the Court’s Order of September 8, 2022, directing the movant to file a copy of his retainer agreement with Pomerantz LLP, see Scheduling Order (Sept. 8, 2022), Jimenez filed a retainer agreement bearing the same date as the Court’s Order, with a fee provision strongly favoring counsel over the putative class, see [Sealed] Retainer Agreement, DE #20. It may reasonably be inferred that no retainer agreement existed until the Court directed its production and that Jimenez failed to negotiate a fee arrangement that favors the class he seeks to represent. Simply put, Jimenez has not demonstrated that he would adequately represent the interests of class members.
And maybe that’s enough to tip it over the edge.
Saturday, September 10, 2022
It’s pending in Delaware Chancery, C.A. 2022-0357-MTZ; VC Zurn heard oral arguments July 26, and presumably a decision will soon be forthcoming.
Buzzfeed was a private company that was taken public via SPAC. Many of its employees were paid in stock and stock options, but – as was widely reported – on the first day of trading after the merger, they found themselves unable to place sell orders. By the time it was all straightened out, Buzzfeed’s stock price had dropped significantly, and now those employees are suing Buzzfeed, its managers, and transfer agent. They sought to bring their claims in a mass arbitration as required by their employment agreements, but Buzzfeed filed a declaratory judgment action in Delaware Chancery, arguing that because the employees’ claims are tied to their status as Buzzfeed stockholders, they are bound by the forum selection provision that was inserted into Buzzfeed’s charter when it went public, requiring that all such actions be brought in Delaware courts.
It's actually a complex case, in part because the publicly traded entity – the one with the forum selection provision – is not the entity that employed the plaintiffs. The employing entity was merged into a shell corporation and is now a subsidiary of the publicly traded entity, and in the merger, the employees’ private company stock was converted into the stock of the public parent.
And things get even more complex than that – there are issues regarding the exact nature of the claims that the employees have (are they suing as employees, or as stockholders?), which Buzzfeed managers – of which entity – are responsible for any problems, and so forth, but for now, I actually want to point out one specific aspect of the dispute, and that’s why the employees were unable to trade their shares in the first instance.
As alleged in the pleadings, as a private company, Buzzfeed had multiple classes of stock (this is why Carta was created: to help private companies manage their cap tables, because the different classes of stock can get very complex). And many of its employees received as compensation the same class of stock that the founder received, namely Class B stock. When Buzzfeed decided to go public, it was also decided that Class B stock would carry 50 votes per share (to maintain founder control). Of course, Class B stock would not publicly trade, so in the merger, only Class A stock was actually registered with the SEC. The employees were not, allegedly, made aware of the distinction. As a result, when employees holding Class B stock tried to sell their shares, they couldn’t – those shares were not registered! Instead, they first had to convert their shares to Class A stock, which was doable, but time consuming, and that delay was critical.
So the real question, here, is how did this happen? I.e., how did ordinary line employees end up with stock carrying 50 votes per share? I don’t know, of course, but the best I can figure is that this is a fairly dramatic example of the well, sloppiness, that has characterized some SPAC deals, which John Coates talks about here. As he explains, a lot of the problems with SPACs – such as misaccounting for warrants – did not arise out of new issues, but simply arose out of shoddy work, and once people took a closer look at what had been done, they finally caught the errors. Buzzfeed may present a particularly egregious example of the problem.
Saturday, September 3, 2022
Back in July, I blogged about the unprecedented dispute between Ben & Jerry’s and its sole shareholder, Unilever, regarding the sale of Ben & Jerry’s products in Israeli-occupied territories. When Ben & Jerry’s was sold to Unilever, Unilever entered into a shareholders’ agreement with Ben & Jerry’s, whereby it promised that the board of directors would be largely self-perpetuating (i.e., continuing directors would nominate their successors), and the board would have authority to maintain the company’s social mission. Unilever, via its CEO selection, would have authority over financial and operational decisions. When the Ben & Jerry’s board objected to selling the company’s products in the West Bank, Unilever decided to transfer the entire West Bank business to an Israeli operator, bringing their spheres of authority into conflict: was this a social decision, or an operational one? Ben & Jerry’s, under the direction of the board, sought a preliminary injunction to stop the transfer, arguing that it was the former; Unilever opposed on the grounds that it was the latter.
In my earlier blog post, I wrote about the unusual nature of the arrangement and the ambiguity surrounding the real parties in interest. That ambiguity was not directly at issue in the judge’s decision on the preliminary injunction but – in a subtle way – it ended up being implicated.
To receive a preliminary injunction, Ben & Jerry’s needed to show that it was threatened with “irreparable harm” if Unilever proceeded with the sale while the case was pending, and that the public interest would be served by an injunction. The harm that Ben & Jerry’s identified involved damage to its reputation, its prospective goodwill, and to “brand integrity,” in part due to confusion by consumers over responsibility for the actions taken. Ben & Jerry also cited loss of authority over its brand, and loss of its “corporate independence in dictating its Social Mission” as additional harms. Ben & Jerry’s claimed that it would lose its ability to use its own products to make protest statements; for example, in Australia it refused to serve two scoops of the same flavor ice cream, to protest the country’s ban on same-sex marriage. The new Israeli owners might not advance the same messages, or would launch products with different messages, ones that Ben & Jerry’s disagreed with. As for the public interest, Ben & Jerry’s argued that the popularity of the benefit corporation form shows that there is a societal good that flows from permitting corporations to advance social missions.
The district court denied the preliminary injunction, on the ground that Ben & Jerry’s failed to show a threat of irreparable harm. Here’s what the court said:
The injunctive relief sought cannot issue on the basis of a hypothetical scenario involving several speculative steps, namely that (1) new products will be introduced, (2) those products will seek to convey a particular message, and (3) the new owners then will market those products to convey a contrary message.
The harm of customer confusion regarding Ben & Jerry’s positions is also remote. Ben & Jerry’s has offered no evidence of such confusion or the impact of the alleged confusion. If anything, media reports and this very lawsuit evince Ben & Jerry’s position on the issue. Further, the products sold in Israel and the West Bank will use no English trademarks….
Notice how the court – and to some extent even Ben & Jerry’s – approached this problem. It was treated as an image issue; Ben & Jerry’s did not want to be associated with certain social messages, and the court found there was no irreparable harm because it was unlikely that the public would in fact have those associations.
But a corporate social mission is not about, or at least not exclusively about, projection of an image. It is a moral stance that allows participants in the corporate enterprise – shareholders, specifically, when it comes to benefit corporations – to avoid having to contribute personally to a project that they believe causes injury in the world. It’s very much like the idea behind the Supreme Court’s decision in Hobby Lobby, namely, that corporate owners should not be forced to put their capital behind something they find morally abhorrent. The public image may matter, but it is secondary; the goal is to not use one’s resources to inflict harm, and certainly not to profit from it.
But that was a difficult, if not impossible, claim for Ben & Jerry’s to make as a corporate entity – and one that the district court entirely failed to perceive – because as a corporation, it only has the moral interests of the humans it represents. And, as my prior post explains, it’s entirely unclear from this arrangement who those humans are supposed to be; it certainly isn’t the single shareholder, Unilever (or the natural persons who invest in Unilever).
Friday, August 26, 2022
I’ll admit it – I frequently choose blog post topics based on what I can write quickly, and since obviously I’ve been following the Twitter case closely, that’s the topic for today.
This post is really meant as an explainer of the legal state of play; lawyers who have been following closely probably already know most of this, but for anyone else, this is for you.
It’ll be really, really long, so I cut
Saturday, August 20, 2022
A while back, when the Twitter/Musk mishegoss was just gearing up, there was a whole political aspect to the thing whereby conservatives accused Twitter’s board of intentionally stonewalling Musk’s takeover bid in order to advance their liberal commitments. At the time, I said that it was comforting to know that whatever legal battles resulted, they would be decided by the relatively neutral principles extant in Delaware law.
Which is why I was so pleased to see Is Corporate Law Nonpartisan?, by Ofer Eldar and Gabriel Rauterberg, forthcoming in the Wisconsin Law Review, pop up on SSRN. The authors use Carney v. Adams – the case where the Supreme Court considered, but did not decide, whether Delaware’s party-balance mandate for its judiciary violates the First Amendment – as a jumping off point, and from there conclude that many states’ corporate law is shaped by their party politics. Delaware, by contrast, has been able to compete successfully for corporate charters because of its deliberately nonpartisan approach, which assures dispersed shareholders that their interests will not be subrogated to those of concentrated local stakeholders. They also point out that Delaware can maintain this nonpartisan commitment in part because it’s such a small state, and substantively hosts so few businesses, which prevents local interests from hijacking the political process.
(To circle this back to Twitter, now it’s Musk resisting the purchase and Twitter trying to force it through. Ken Paxton of Texas, apparently trying to ingratiate himself with Musk, has announced an investigation to back up Musk’s claims that Twitter lied in its securities filings. How much do you imagine Twitter’s shareholders appreciate that?)
This system is certainly beneficial to Delaware in some ways but we may question how well this serves Delaware’s residents overall. Delaware’s population is majority-Democratic, and, in addition to its role in generating corporate law, the state has all the usual issues associated with statehood, including criminal disputes, property disputes, and so forth. One might reasonably ask whether it’s good for Delaware’s residents that the state has an ongoing commitment to, essentially, elevate a minority party within the judiciary. On this, it’s worth going back to the important role that Delaware courts played in school desegregation, as highlighted in Omari Simmons’s paper, Chancery’s Greatest Decision: Historical Insights on Civil Rights and the Future of Shareholder Activism, 76 Wash. & Lee L. Rev. 1259 (2019). Delaware does more than just corporate law. Though, I suppose, if Delaware’s residents are being mildly disenfranchised, not having to pay sales tax takes some of the sting out of it.
Saturday, August 13, 2022
Hi, so first, if you're reading this, you probably already noticed, but for what it's worth, it appears that email notifications of new posts have entirely stopped. So, if you've been following us via email up until now, please be aware you'll need to switch to another method - I personally use Feedly to keep track of blog updates.
With that out of the way, obviously, my specialty is corporate and securities law, and one of the odder things about this space is that while it has incredibly well-developed standards for evaluating and litigating fraud claims, those standards are very different from the standards for fraud claims in other areas of law.
I was reminded of this when I read the decision denying a motion to dismiss in Fishon v. Peloton Interactive, 2022 U.S. Dist. LEXIS 143930 (S.D.N.Y. Aug. 11, 2022). Fishon is a consumer fraud action brought under New York law against Peloton for misrepresenting the breadth of its song catalog. Defendants argued, among other things, that the plaintiffs could not prove they had heard any misrepresentations, and therefore they had not been injured. The court rejected that argument, holding:
a plaintiff can also plead both injury and causation under GBL §§ 349 and 350, by alleging that the defendant’s misleading or deceptive advertising campaign caused a price premium, that the price premium was charged both to those who saw and relied upon the false representations and those who did not, and that, as a result of the price premium, plaintiff was charged a price she would not otherwise have been charged but for the false campaign….
These cases persuade the Court that, while a reliance- or exposure-based theory of injury is one way to plead that a defendant’s misrepresentation caused harm, it is not the only way. The operative question is whether a plaintiff suffered an injury because of a defendant’s misrepresentation; it is not whether that injury was tied to plaintiff’s reliance on the misrepresentation. Plaintiffs have alleged that Defendant made misrepresentations that would have mislead a reasonable consumer, that those misrepresentations were consumer-facing and had broad impact, and that as a result of those widespread misrepresentations that mislead reasonable consumers, they paid higher costs. By alleging that they paid a higher price—“increased costs”—for their products because of Defendant’s widespread misrepresentations about the value of the product, Plaintiffs have pleaded an injury that was attributable to Defendant’s alleged misrepresentation, regardless whether they ever personally saw the representation.
That’s fraud on the market. It’s fraud on the market in a consumer action. And, in fact, this kind of holding is not unusual; there are cases with similar holdings under other states’ consumer protection laws. See, e.g., Hasemann v. Gerber Prod. Co., 331 F.R.D. 239 (E.D.N.Y. 2019); Nelson v. Mead Johnson Nutrition Co., 270 F.R.D. 689 (S.D. Fla. 2010). What’s striking here is that a securities fraud plaintiff would absolutely not be able to recover under similar facts, because there has been no showing of market efficiency. And, in fact, courts have rejected attempts by securities fraud plaintiffs to use fraud-on-the-market for primary market transactions, which are of course akin to consumer purchases. See, e.g., Freeman v. Laventhol & Horwath, 915 F.2d 193 (6th Cir. 1990).
What’s the difference? It appears to me that, doctrinally, the reason for the difference is that the consumer protection statutes at issue require causation, but they do not require reliance. So plaintiffs are permitted to argue that a lie generally increased prices, but they don’t have to argue that any consumer subjectively believed that price to be indicative of the product’s value.
That’s different than in the securities context. Securities fraud requires a showing of reliance. Fraud-on-the-market therefore permits two separate and independent presumptions that benefit plaintiffs. First, that false statements impact prices, and second, that investors subjectively believe those prices represent something when they purchase. There’s lots of debate over what, exactly, they’re supposed to subjectively believe, and this “subjective” component has been the subject of academic criticism, see, e.g. Donald C. Langevoort, Judgment Day for Fraud-on-the-Market: Reflections on Amgen and the Second Coming of Halliburton, 57 Ariz. L. Rev. 37 (2015); James D. Cox, Understanding Causation in Private Securities Lawsuits: Building on Amgen, 66 Vand. L. Rev. 1719 (2013); John C.P. Goldberg & Benjamin Zipursky, The Fraud on the Market Tort, 66 Vand. L. Rev. 1755 (2013), but it is real. And it means that, for example, when plaintiffs bring 10(b) claims against underwriters and accountants for a fraudulent offering, they are told:
The security's promoter and other entities involved in the issuance, such as the underwriter, the auditor, and legal counsel—the very entities often charged with fraud—cannot be reasonably relied upon to prevent fraud.
Malack v. BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010). In other words, no matter the fraud’s effect on security prices, investors are not justified in believing those prices represent something significant in an inefficient market, and therefore they cannot use the fraud-on-the-market doctrine to satisfy the element of reliance.
To some extent, Section 11 claims are akin to consumer actions in this way; Section 11 claims, unlike 10(b) claims, do not require a showing of reliance, but they do require causation (with the burden of proof on defendants rather than plaintiffs). Thus, Section 11 claims are permitted even in inefficient markets, and the theory behind them - as the legislative history makes clear - is that false statements in a registration statement are likely to influence market prices. See 78 Cong. Rec. 10186 (1934) (“When an issue of securities is proposed, a banking house will investigate the financial statement of the corporation. Based upon the statements contained in the registration statement of the corporation, a banking house will offer the securities at a certain price. Therefore, the market value is fixed by the false statement of the corporation. The individual investor relies upon the investigation made by the banker. It is fair to assume that this situation continues until such time as the corporation makes available a statement showing its earnings for 12 months. Then the market value is influenced by the statement of actual earnings and not by the statements contained in the registration statement, which deceived the underwriter or banker and the investor.”); see also William O. Douglas & George E. Bates, The Federal Securities Act of 1933, 43 Yale L. J. 171 (1933) (“the registration statement will be an important conditioner of the market. Plaintiff may be wholly ignorant of anything in the statement. But if he buys in the open market at the time he may be as much affected by the concealed untruths or the omissions as if he had read and understood the registration statement.”)
I don’t think the cases are perfectly consistent with this doctrinal lineup, but it has some explanatory power, which means in some circumstances, consumers have an easier time alleging fraud-by-price-impact than investors do.
Saturday, August 6, 2022
Delaware recently amended its General Corporation Law to permit corporations to adopt charter provisions that would exculpate top officers, as well as directors, from damages liability associated with care violations.
The catch is, unlike with directors, officer liability can only be eliminated for direct shareholder claims – not claims brought by the corporation, including derivative claims. In other words, the amendments aren’t there to prevent officer liability; they’re there to prevent officer liability as dictated by shareholders. When directors decide officers should be liable – or shareholders can show directors are incapable of deciding – then officer liability may follow.
So this is a little different than the theory behind director exculpation. Director exculpation is a protection against the threat of frivolous lawsuits, to some extent, but it also functions so directors can substantively do their jobs without fear that they will be subject to ruinous liability for well meaning mistakes. That fear, it was posited, would deter people from wanting to be directors in the first place.
Officers, though, they aren’t exactly being protected from ruinous liability over their mistakes – the corporation/directors can still sue them for those. Which means there’s a lot less concern that officers won’t take the job if they can be held liable.
What are these amendments doing, then?
The protections being offered are only for direct claims. And, most of the time, direct claims only arise in one context: sale of the company.
Sure, shareholders can sometimes sue directly even for going concerns – oh look, here’s an example from Snap – but those claims are relatively rare, and even rarer still when officers would be potentially liable, and rarer still when monetary damages rather than an injunction would be on the table. So, most of the time, and in general, the proposed amendments serve one purpose: to exculpate officers for negligence in connection with the sale of the company.
And it goes further. Because if shareholders vote in favor of the deal, that by itself waives any fiduciary claims – except when disclosures are inadequate.
So this amendment is intended to address one specific scenario: one where officers are arguably negligent in the context of a sale of the company, and where disclosures were inadequate, in a manner that may have been relevant to voting shareholders.
And these claims will apparently be blocked both when they are frivolous, and when they are meritorious.
Of course, in order to get this protection, corporations will have to amend their charters. Relatively easy to do pre-IPO, but requiring the assent of public shareholders post-IPO. Leading to the question: Will they?
Why would shareholders care about this situation specifically? As above, it’s hard to imagine they’re worried about qualified officers refusing to serve, as was the case for the original 102(b)(7) protections. The sale of the company is an unusual event, and one where officers often have golden parachutes that offset any risk – so fear of this precise situation is unlikely to deter many officers from accepting the job in the first place.
Another possible concern is straight up litigation costs – litigation itself is expensive, sucks up the time of top management, and if we’re worried about frivolous suits or even nonfrivolous ones that won’t result in significant penalties, that might be a reason for shareholders to say the game is not worth the candle. That, too, was likely some of the motivation for 102(b)(7) as originally drafted.
But in a sale scenario, those costs are all borne ultimately by the acquiring company. In a cash sale, they won’t be borne by shareholders at all; in a stock sale, they’ll be borne somewhat, but even those expenses are attenuated. And sure, you can imagine maybe the buyer will pay less if the prospect of lawsuits is out there, or insurance costs will be higher – but those possibilities are so speculative that I genuinely wonder whether shareholders would benefit from exculpation, rather than prefer to have the option of bringing nonfrivolous claims for negligently-conducted mergers (where that negligence was concealed from them in advance), knowing that litigation costs will be paid by the acquirer.
That’s particularly true when you consider that a sale of company is a final period scenario – one where corporate officers know they will no longer be subject to shareholder discipline, and therefore are most at risk of abandoning their responsibilities.
Plus, keep in mind that sometimes, cases make it past pleading on narrow theories, but discovery provides grounds for more robust ones. Suppose keeping the negligence window open allows shareholders to sue over mergers that have a whiff of unfairness, which functionally allows further probing for more problems, which could reveal more serious defects that permit greater damages to selling shareholders? That, too, might be valuable for shareholders of the selling company.
All of which is to say, it’s not obvious to me that the same cost-benefit analysis that applies to Original Flavor 102(b)(7) would apply to the revised version. The specific scenarios where protections for officers are proposed are also scenarios that offer the greatest threat to shareholders, and where shareholders bear the least risk of frivolous litigation costs. And so it’s not obvious that shareholders of publicly traded companies would be wise to approve charter amendments that exculpate officers.
What about publicly traded companies with dual-class stock? Technically, they don’t need the assent of public shareholders to amend their charters, so they could just adopt officer-exculpation of their own accord, but (1) the public shareholders might then sue, on the grounds that this was an interested transaction intended to protect current insider/officers, and (2) dual-class companies may not be terribly worried about sale scenarios in the first place, and so have less interest in adopting these provisions.
Which leaves the IPO question: can companies simply go public with these provisions in their charters?
I mean, they can, surely, but the real question is will they pay a monetary price for doing so. If you think IPO markets are efficient, you’d assume that if public shareholders have no use for this change mid-stream, they’d extract some kind of price for it in IPO markets, which might dissuade the adoption altogether. I, personally, am less sanguine about the efficiency of IPO markets, however. That said, so many companies now go public with dual-class stock, they once again may not feel they need these protections.
All of which is to say: I’m really curious to see if public companies manage to amend their charters to exculpate officers, if IPO companies adopt officer exculpation, and if there’s an obvious divergence between the two. And, if we do see different companies adopting these things, I look forward to a financial analysis of whether they seem to affect pricing in a subsequent sale to an acquirer (who would be expected to bear the costs of shareholder litigation).
Saturday, July 30, 2022
As the world watches this unfold, I figured I’d blog this week to make a point I’ve expressed in other spaces (Twitter, etc), but I haven’t articulated here.
Where we are in this saga: Musk sent a letter to Twitter on July 8, publicly filed with the SEC, purporting to terminate the merger agreement due to what he claimed were three contract breaches by Twitter. First, Twitter falsely represented the amount of spam/bots on the platform; second, Twitter failed to provide information to Musk that was necessary to consummate the transaction (i.e., information about the amount of spam on the platform); third, Twitter failed to operate in the ordinary course by instituting a hiring freeze and laying off some employees.
Twitter filed a lawsuit against Musk on July 12 seeking specific performance, arguing that it had not breached the agreement and that Musk, himself, was in breach, by failing to use his best efforts to consummate the deal as he promised to do. (Links to case filings, by the way, are taken from this handy archive set up by Andrew Jennings.)
Musk filed an answer with counterclaims yesterday, but it’s under seal, so we’ll have to wait for a public version before we get a more complete account from him, but – at least based on what we know now – the dispute in this case is about who breached first.
As has been widely reported, Musk’s arguments appear quite weak (with all due caveats about facts that may come out in the future, based solely on what has been publicly disclosed up until now, etc etc). Stephen Bainbridge has a good break down here, but quickly:
Let’s just get the ordinary course thing out of the way – at least in his opposition to Twitter’s motion to expedite, Musk didn’t seem to be pressing on it very hard, and the fact is, the merger agreement has very seller-friendly language in which Twitter only promised to use “commercially reasonable efforts to conduct the business of the Company and its Subsidiaries in the ordinary course of business.” Given the state of the economy and the industry, a hiring freeze and layoffs seems consistent with commercial reasonableness, and the Delaware Supreme Court has already suggested that what is “commercially reasonable” is gauged by references to peers, so it’s unlikely this has legs.
Which means the case is about the spam. Did Twitter misstate its spam? Or did it deny Musk information he was entitled to receive about spam?
Now, even if Twitter did misrepresent the amount of spam on the platform, that alone is not grounds to walk away; Musk would further have to show either that the misrepresentation was intentional, and that he relied on it (the common law rule about fraud in contracting), or that the misrepresentation (whether or not intentional) was so egregious that it caused a material adverse effect (which is the standard set forth in the merger agreement), and so far, there’s no evidence of any of that.
But there’s also a good argument that Twitter did not make any false representations about spam in the first place, and Musk cannot show that it did. There’s nothing in the merger agreement about spam; what the merger agreement says is that Twitter’s SEC filings are accurate. Here’s what those SEC filings say:
There are a number of false or spam accounts in existence on our platform. We have performed an internal review of a sample of accounts and estimate that the average of false or spam accounts during the fourth quarter of 2021 represented fewer than 5% of our mDAU [monetizable daily active users] during the quarter. The false or spam accounts for a period represents the average of false or spam accounts in the samples during each monthly analysis period during the quarter. In making this determination, we applied significant judgment, so our estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than we have estimated. We are continually seeking to improve our ability to estimate the total number of spam accounts and eliminate them from the calculation of our mDAU, and have made improvements in our spam detection capabilities that have resulted in the suspension of a large number of spam, malicious automation, and fake accounts. We intend to continue to make such improvements. After we determine an account is spam, malicious automation, or fake, we stop counting it in our mDAU, or other related metrics. We also treat multiple accounts held by a single person or organization as multiple mDAU because we permit people and organizations to have more than one account. Additionally, some accounts used by organizations are used by many people within the organization. As such, the calculations of our mDAU may not accurately reflect the actual number of people or organizations using our platform.
Notice here that Twitter is not making a specific representation about spam or bots; it’s representing that it conducts an analysis, that analysis reached a result, and that result could be wrong. Even if Musk got the data he wants, conducted his own analysis, and reached a different result, that still would not show that Twitter’s actual representation was false.
(The July 8 letter also alleged that Twitter continued to include accounts identified as spam in the mDAU despite claims not to do so, but I don’t see that allegation repeated in Musk’s Chancery filings so far. We’ll see if that pops up again in the answer).
As for Musk’s rights to information, he’s only entitled to information “for any reasonable business purpose related to the consummation of the transactions,” and even that with lots of caveats (Twitter can deny information if it would be disruptive, cause competitive harm, etc). And his demand for increasingly detailed spam information – Twitter is already providing him with reams of data – hardly seems like it falls in that category. (As Twitter argued in its complaint at ¶96, he wants this information to find an excuse to blow up the deal, not to close it).
In Delaware Chancery, the parties first sparred over a trial date – Musk wanted February, Twitter wanted September – and Chancellor McCormick decided that a five-day trial would be held in October.
Next, the parties sparred over the exact dates in October (Musk wanted the week of October 17, Twitter preferred October 10 but was amenable to October 17 with assurances that the trial length would remain 5 days), and McCormick ordered a trial from October 17-21.
But the important thing to note – and this is the reason I’m posting – is that the significance of these skirmishes is not the trial date per se. The significance is what the trial is about. Musk claims he needs a prolonged schedule in order to obtain data from Twitter and employ significant computing power/expertise to analyze it and identify spam. Twitter, by contrast, claims that no spam information is even necessary because it never made any representations about spam, and therefore this can all be resolved quickly. As Twitter’s counsel put it in a scheduling hearing on July 19, “When the Court consults page 5 of Twitter's 10-K, it will see that it says … Twitter has a system for monitoring false or spam accounts. It is a system that requires judgment. It yields the outcome that fewer than 5 percent of users are false or spam accounts, but it may well be wrong. The number, the disclosure expressly says, could be higher. That is what we are testing, Your Honor. And this does not require a recreation of all things known to humanity.”
And all this was also teed up in the parties’ arguments about trial dates; even though there’s very little difference between October 10 and October 17, both of them were simultaneously shoehorning in arguments over the scope of discovery. Musk accused Twitter of refusing to produce voluminous amounts of raw data; Twitter responded that Musk’s requests were “irrelevant to Twitter’s complaint and Musk’s asserted bases for attempting to terminate. The vast amount of data related to Twitter’s user activity and platform that Musk seeks has no apparent connection to any term of the merger agreement.”
McCormick was only being asked to set a schedule, but the subtext was, that schedule must be informed by the scope of discovery. McCormick clearly understood that, because in her order, she stated she had not “resolve[d] any specific discovery disputes, including the propriety of any requests for large data sets,” though she did limit the parties to 25 interrogatories (Twitter claims that Musk has already served 68 interrogatories, see ¶17). And, recognizing the sensitivity of discovery issues in this case, McCormick set out a procedure for the parties to try to address any discovery disputes before bringing them to the court, involving each side designating a Delaware lawyer to review its side’s privilege logs, and designating a lawyer who will serve as the party’s “Discovery Liaison.” Per The Chancery Daily, this procedure has been used before in a case with significant discovery disputes.
So McCormick has avoided weighing in on the scope of discovery thus far, without much of a record or briefing before her, though she has tilted towards Twitter’s view of the matter. Sooner or later, though, McCormick will likely have to decide a discovery motion regarding exactly the kind of data Twitter is required to produce. And while discovery disputes are usually rather ho-hum matters for those of us watching from the cheap seats, in this case, discovery could, as a practical matter, end the case. Twitter can and will argue that it need not produce extensive datasets because Musk has not demonstrated that the amount of spam on the platform is relevant to the merger agreement (or at the very least, because Musk already has the information he needs), and if McCormick agrees, she’s functionally cut the legs out from under Musk’s entire bases for claiming Twitter breached first. And while I wouldn’t read too much into a decision by McCormick that allows Musk some leeway on this, if she orders production of large amounts of new data, that suggests she thinks there may be some merit to Musk’s claims. (Or, at least, that she wants publicly to be seen as fair, and not provide a basis for Supreme Court reversal, in a high profile case. Hard to say.)
So. That’s my point. It’s not about the dates; it’s about how much this trial really will test Twitter’s spam counts. There’s a plausible path for Twitter to win long before trial begins, and schedules – and more importantly, discovery disputes – can be viewed through that lens.
Saturday, July 23, 2022
A while back, I posted about the SEC’s proposal to adopt new rules on private investment funds. Among other things, the SEC expressed concern about “side letters,” namely, tailored agreements with specific investors in particular funds, giving those investors preferential terms regarding information, redemption rights, and similar matters, as compared to other investors in the same fund.
Which is why it’s very timely that two new papers have been posted to SSRN conducting empirical analyses of what these side letters contain.
The first, Side Letter Governance, by Elisabeth de Fontenay and Yaron Nili and forthcoming in the Washington University Law Review, finds that side letters rarely offer financial preferences; instead, fund sponsors favor particular investors by other means, such as separate accounts and co-investment opportunities. They do, however, find that side letters have become overly complex and difficult to negotiate, in part because each investor wants to make sure that it is not placed at a disadvantage relative to other investors in the fund. They recommend, among other things, that all side letters be disclosed to other fund investors, and that certain provisions – concerning investors’ tax and regulatory concerns – be standardized across different investor types.
The second, Shadow Contracts, by Jessica S. Jeffers & Anne M. Tucker and forthcoming in the University of Chicago Business Law Review, focuses specifically on side letters in impact investing. They also conclude that side letters have become overly complex due to a lack of standardization and transparency, but point out that side letters associated with impact investing impose additional costs because investors have different idiosyncratic goals. They argue that the norms developed for private equity around confidentiality are a poor fit for the impact space, and, unlike de Fontenay and Nili, find that a significant percentage of side letters do confer financial benefits on favored investors, such as fee reductions and guaranteed co-investment opportunities.
With so much investment moving into the private space, it is critical that we have more visibility into how these markets operate; these papers provide valuable insight.