Saturday, September 26, 2020
The SEC made its long-awaited revisions to Rule 14a-8, which dramatically increase the dollar investment requirements, add a new prohibition on allowing shareholders to aggregate their holdings to meet those requirements, prohibit shareholder representatives from advancing proposals on behalf of more than one shareholder per meeting, and raise the resubmission thresholds, among other things. In practical effect, these rules make it much more difficult for retail shareholders – who are unlikely to hold $15K or $25K of a single company’s stock in their portfolio – to advance proposals. And, as Yaron Nili and Kobi Kastiel have documented, retail shareholders (and specific retail shareholders at that) have been the driving force behind a large number of proposals. They find that – despite critics’ claims that these “gadflies” are advancing a personal agenda – their proposals frequently win majority support. Thus, important corporate governance innovations have been driven, in part, by proposals advanced by retail investors.
Retail investors are not the only ones who advance proposals, though; pension funds do, as well. That’s where the Department of Labor comes in. As I previously blogged, the DoL has proposed new rules that would sharply limit ERISA plans’ ability to participate in corporate governance; assuming the rule goes into effect, that would knock out another source of proposals (and voting support for them).
So who’s left?
ESG/sustainability-focused funds sometimes advance proposals, and that’s a growing field. We know, however, that funds’ commitments to ESG – and their involvement in governance – varies tremendously, and so only a handful of funds may be participating in this space.
That leaves unusually wealthy/concentrated retail investors, and public pension funds, which are not subject to ERISA.
What about ordinary mutual funds? Up until now, ordinary mutual funds never advance proposals, though they will vote in favor of them. Nili and Kastiel argue that funds’ operate under various conflicts that make them uncomfortable taking the lead. As I previously blogged, these funds actually supported the new restrictions (and even more draconian changes to the resubmission rules that were not enacted); this is because, I believe, they are not only subject to public scrutiny as to how they cast their votes, but they are also on the receiving end of proposals, and would like to relieve that pressure. And when it comes to the Big Three and other large managers, it’s not as though they need a proposal to get management’s attention; they’re more than capable of quietly demanding operating changes if they want them. Proposals are more likely to be a vehicle for shareholders who do not have that kind of influence individually.
Thus, one of the immediate effects of the rule change may be to take mutual funds out of the spotlight; their governance interventions (or lack thereof) will become immediately less transparent to investors and the public, and less easy to monitor. Which is ironic, considering the Commission’s expressed concern about funds that sell a false narrative about their sustainability efforts.
Another irony is that many proposals seeks disclosure of more sustainability information – precisely the information the SEC has refused to require be disclosed because, the Commissioners have argued, relevant information varies from company to company. Proposals are used to obtain company-specific information, and now that avenue will be narrowed, if not entirely closed.
I suspect, though, that ESG activists are a creative bunch, and we will see new proponents entering the space. In a crowded ESG field, for example, some funds may find that advancing proposals can burnish their public reputations and attract new investment. One possibility would be to proceed the way the proxy access project did, by advancing proposed bylaws that would lower the investment threshold at each company on a case-by-case basis. Big Three opposition would be a serious stumbling block, but considering how much BlackRock and State Street, in particular, tried to hide their support for the new restrictions behind the Investment Company Institute, they might be persuaded to support at least limited, expanded access at specific companies.
Friday, September 18, 2020
Two weeks ago, I wrote about the role of compliance officers and general counsel working for Big Pharma in Where Were the Gatekeepers- Part 1. As a former compliance officer and deputy general counsel, I wondered how and if those in-house sentinels were raising alarm bells about safety concerns related to rushing a COVID-19 vaccine to the public. Now that I’ve watched the Netflix documentary “The Social Dilemma,” I’m wondering the same thing about the lawyers and compliance professionals working for the social media companies.
The documentary features some of the engineers and executives behind the massive success of Google, Facebook, Pinterest, Twitter, YouTube and other platforms. Tristan Harris, a former Google design ethicist, is the star of the documentary and the main whistleblower. He raised concerns to 60 Minutes in 2017 and millions have watched his TED Talk. He also testified before Congress in 2019 about how social media companies use algorithms and artificial intelligence to manipulate behavior. Human rights organizations have accused social media platforms of facilitating human rights abuses. Facebook and others have paid billions in fines for privacy violations. Advertisers boycotted over Facebook and hate speech. But nothing has slowed their growth.
The documentary explicitly links the rising rate of youth depression, suicide, and risk taking behavior to social media’s disproportionate influence. Most of my friends who have watched it have already decreased their screen time or at least have become more conscious of it. Maybe they are taking a cue from those who work for these companies but don’t allow their young children to have any screen time. Hmmm …
I’ve watched the documentary twice. Here are some of the more memorable quotes:
”If you’re not paying for the product, then you’re the product.”
“They sell certainty that someone will see your advertisement.”
“It’s not our data that’s being sold. They are building models to predict our actions based on the click, what emotions trigger you, what videos you will watch.”
“Algorithms are opinions embedded in code.”
”It’s the gradual, slight, imperceptible change in our own behavior and perception that is the product.”
“Social media is a drug.”
”There are only two industries that call their customers ‘users’: illegal drugs and software.”
”Social media is a marketplace that trades exclusively in human futures.”
”The very meaning of culture is manipulation.”
“Social media isn’t a tool waiting to be used. It has its own goals, and it has its own means of pursuing them.”
“These services are killing people and causing people to kill themselves.”
“When you go to Google and type in “climate change is,” you will get a different result based on where you live … that’s a function of … the particular things Google knows about your interests.”
“It’s 2.7 billion Truman Show. Each person has their own reality, their own facts.”
“It worries me that an algorithm I worked on is increasing polarization in society.”
“Fake news on Twitter spreads six times faster than real news.”
“People have no idea what is true and now it’s a matter of life and death.”
“Social media amplifies exponential gossip and exponential hearsay to the point that we don’t know what’s true no matter what issue we care about.”
“If you want to control the operation of a country, there’s never been a better tool than Facebook.”
"The Russians didn't hack Facebook. What they did was use the tools Facebook created for legitimate advertisers and legitimate users, and they applied it to a nefarious purpose."
“What [am I] most worried about? In the short term horizon? Civil War.”
“How do you wake up from the matrix when you don’t know you’re in the matrix”?
“You could shut down the service and destroy . . . $20 billion in shareholder value and get sued, but you can’t in practice put the genie back in the model.”
“We need to accept that it’s ok for companies to be focused on making money but it’s not ok when there’s no regulation, no rules, and no competition and companies are acting as de facto governments and then saying ‘we can regulate ourselves.’ “
“There’s no fiscal reason for these companies to change.”
This brings me back to the beginning of my post. We’ve heard from former investors, engineers, and algorithm magicians from these companies, but where were and are the gatekeepers? What were they doing to sound the alarm? But maybe I’m asking the wrong question. As Ann Lipton’s provocative post on Doyle, Watson, and the Purpose of the Corporation notes, “Are you looking at things from outside the corporation, in terms of structuring our overall legal and societal institutions? Or are you looking at things from inside the corporation, in terms of how corporate managers should understand their jobs and their own roles?”
If you’re a board member or C-Suite executive of a social media company, you have to ask yourself, what if hate speech, fake news, polarization, and addiction to your product are actually profitable? What if perpetuating rumors that maximize shareholder value is the right decision? Why would you change a business model that works for the shareholders even if it doesn’t work for the rest of society? If social media is like a drug, it’s up to parents to instill the right values in their children. I get it. But what about the lawyers and the people in charge of establishing, promoting, and maintaining an ethical culture? To be clear, I don’t mean in any way to impugn the integrity of lawyers and compliance professionals who work for social media companies. I have met several at business and human rights events and privacy conferences who take the power of the tech industry very seriously and advocate for change.
The social media companies have a dilemma. Compliance officers talk about “tone at the top,” “mood in the middle,” and the “buzz at the bottom.” Everyone in the organization has to believe in the ethical mandate as laid out and modeled by leadership. Indeed, CEOs typically sign off on warm, fuzzy statements about ethical behavior in the beginning of the Code of Conduct. I’ve drafted quite a few and looked at hundreds more. Notably, Facebook’s Code of Conduct, updated just a few weeks ago, has no statement of principle from CEO Mark Zuckerberg and seems very lawyerlike. Perhaps there’s a more robust version that employees can access where Zuckerberg extols company values. Twitter’s code is slightly better and touches more on ethical culture. Google’s Code states, “Our products, features, and services should make Google more useful for all our users. We have many different types of users, from individuals to large businesses, but one guiding principle: “Is what we are offering useful?”’ My question is “useful” to whom? I use Google several times a day, but now I have to worry about what Google chooses to show me. What's my personal algorithm? I’ve been off of Facebook and Instagram since January 2020 and I have no plans to go back.
Fifty years ago, Milton Friedman uttered the famous statement, “There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” The social media companies have written the rules of the game. There is no competition. Now that the “Social Dilemma” is out, there really isn’t any more deception or fraud.
Do the social media companies actually have a social responsibility to do better? In 2012, Facebook’s S-1 proclaimed that the company’s mission was to “make the world more open and connected.” Facebook’s current Sustainability Page claims that, “At Facebook, our mission is to give people the power to build community and bring the world closer together.” Why is it, then that in 2020, people seem more disconnected than ever even though they are tethered to their devices while awake and have them in reach while asleep? Facebook’s sustainability strategy appears to be centered around climate change and supply chain issues, important to be sure. But is it doing all that it can for the sustainability of society? Does it have to? I have no answer for that. All I can say is that you should watch the documentary and judge for yourself.
September 18, 2020 in Ann Lipton, Compliance, Corporate Governance, Corporate Personality, Corporations, CSR, Current Affairs, Ethics, Family, Film, Human Rights, Lawyering, Management, Marcia Narine Weldon, Psychology, Shareholders, Television | Permalink | Comments (0)
Thursday, September 17, 2020
Sherlock Holmes aficionados distinguish between literary criticism that is “Watsonian” in perspective, and criticism that is “Doylist.” As any fan knows, the stories were written by Arthur Conan Doyle as a first-person narrative; they purport to be the work of John Watson, who is recounting the exploits of his brilliant friend and sometime-roommate, Sherlock Holmes. Fans who analyze the stories, then, have a choice: They can take an “outsider” perspective and discuss them as works of fiction authored by the real-life person Arthur Conan Doyle, or they can take an “in-universe” perspective and discuss them as the actual literary product of John Watson, unreliable narrator. Depending on which viewpoint you adopt, you may end up in strikingly different conversations. For example, a Doylist might look at inconsistencies in how Watson’s wife is described throughout the series, and attribute them to the multi-year period over which the stories were published; a Watsonian might argue that Watson was covering for a gay relationship with Holmes and couldn’t keep his lies straight. Neither viewpoint is incorrect, but the two fans are talking past each other; in order to communicate, they have to define the relevant playing field.
That’s how I feel about a lot of the conversations currently surrounding corporate purpose, especially the ones you see in popular media.
We’ve had a lot of soul-searching recently about whether corporations should be run to benefit society overall, or whether they should be run to benefit their shareholders alone. But that conversation is incoherent unless you first clarify your perspective. Are you looking at things from outside the corporation, in terms of structuring our overall legal and societal institutions? Or are you looking at things from inside the corporation, in terms of how corporate managers should understand their jobs and their own roles?
From a societal, or Doylist, perspective, I don’t think there’s any dispute that corporations exist to serve the community as a whole. We charter corporations, we create rules for their operation, we develop infrastructure to facilitate investing, all because we believe that on balance, corporations are (or can be) a net good. They are an efficient way of doing business, which means they contribute to innovation and economic development, provide necessary (or even just enjoyable) goods and services, generate wealth not only for investors, but also for workers and governments (through tax payments). They can provide outlets for creativity and generally contribute to human flourishing. That is the social purpose of a corporation.
But corporations harness and coordinate labor and capital on a potentially global scale, and thus are very powerful tools. Any form of power can be misused. Corporations might exploit and injure workers, or consumers, or the environment, perhaps to the point where the benefits are not worth the costs. Thus, we need to arrange our societal institutions to minimize these harms, and maximize the benefits.
Corporate purpose debates are not about those principles – on which, I suspect, everyone agrees. The debate about corporate purpose is a debate about method. If we agree that corporations exist to benefit society, and if we agree that we need some kind of legal and/or market structure to ensure this occurs, what does that structure look like?
And this is when we switch to the Watsonian perspective, from within the corporation itself. And here, the question is, is it better that corporate managers understand themselves to be servants of society, and manage the corporation to effectuate that purpose? Or is it better if managers understand themselves to be serving investors, while other societal institutions – regulation, contract law, and the like – protect the rest of society?
This is a point I’ve made repeatedly, most recently in Beyond Internal and External, but also in Not Everything is About Investors, and I’m hardly the first to do so. For example, though Henry Hansmann’s & Reinier Kraakman’s essay, The End of History for Corporate Law, has received its share of ribbing for being a bit premature, it lays out this framework very neatly, while arguing that society overall benefits if managers focus on investors, while we reserve other types of regulation to protect non-investor constituencies.
Unless these premises are understood by everyone in the conversation, it devolves into the same incoherence one would expect from a Doylist discussing Watson’s marriages with a Watsonian. So, for example, the New York Times recently published a retrospective on Milton Friedman, with soundbites from assorted businesspeople and academics. You will, I’m sure, be shocked to learn that every business person included argues that corporations should be run to benefit all stakeholders.
Now, there’s a certain banality to this exercise – what CEO is going to say “screw my customers, I’m all about the stock price”? – but more importantly, there is no dispute that corporations should operate to benefit all stakeholders; the issue is how do we make that happen. One method – and only one method – is to rely on managerial largesse to distribute surplus to shareholders and stakeholders alike. (We’ll call this the “Martin Lipton” method*) But there are other mechanisms to constrain corporate behavior besides managerial largesse, and it’s impossible to talk about the merits of such largesse without acknowledging those mechanisms and discussing how they function. The question, properly framed, isn’t whether CEOs should consciously operate their companies to serve society, but what are the options we have for making sure they do so, and which mechanisms are more effective than others, and why? If CEO altruism is one of our options, is it better or worse than other possibilities, and if we are going to rely on altruism, what institutions do we need to generate that altruism and channel it appropriately?
Which is why I find the NYT piece so frustrating, because it’s got the Doylists and the Watsonians all mixed together as though they’re talking about the same thing. Many of the academics are Doylistically describing the types of societal structures we need to corral corporate power and ensure that capitalism benefits everyone. Meanwhile, Starbucks’s Howard Schultz, Home Depot’s Ken Langone, J&J’s Alex Gorsky, and BlackRock’s Larry Fink, among others, take the Watsonian view, which is to say, they argue what all businesspeople argue: CEOs should run the company with a view toward serving shareholders because you cannot serve shareholders without serving the rest of society. From Watson’s perspective, if the CEO is focused on maximizing profits, s/he will make good products that consumers want to buy, and create good jobs that attract high-quality employees, which satisfies Doyle’s desire for a better society overall.
But by focusing on the Watsionian viewpoint and eliding the Doylist challenge of the academics, these businesspeople avoid any test of the very specific factual claim that undergirds their argument: that the interests of shareholders and the interests of other stakeholders are aligned. And in order for that to be true – that shareholders cannot profit unless the rest of society benefits – nonshareholder constituencies must be sufficiently powerful Doylistically to extract a price for corporate malfeasance. They must have, in Galbraith’s words, countervailing power, from labor unions, a strong regulatory system, consumer advocacy groups, and so forth.
That line of thinking yields two possibilities: We can maximize the benefits provided by corporations, and minimize their harms, by strengthening these countervailing institutions, or we can do it by weakening corporations. The latter, for example, was long the goal of antitrust law, and it’s why there’s so much advocacy around limiting corporate political donations.
Which brings me to Jens Dammann and Horst Eidenmueller, who have written a pair of papers that arguing that co-determination (whereby employees, as well as shareholders, get to vote for corporate directors) may not strengthen corporate functioning but instead weaken it, by creating a type of separation of powers within the corporate form, and that itself may be net beneficial to society. I made a similar point in Beyond Internal and External, where I argued that the regulatory system shapes shareholders to have divergent preferences in a manner akin to the separation of powers. The separation of powers has two Watsonian functions. The first is that it encourages a variety of incentives and goals among corporate managers, which encourages a broader perspective in corporate decisionmaking. The second is that it impedes any kind of corporate action in the first place, by making it more difficult for corporations to reach a consensus. In that vein, certain kinds of corporate governance reforms – elimination of dual-class stock, separating chair and CEO roles, and so forth – seem less about ensuring good (profit-maximizing) governance than creating friction in governance, because by impeding the corporation’s ability to act, we necessarily strengthen other constituencies.
Okay, yeah, so just imagine I have a pithy conclusion here. Whatever, it’s a blog post.
Saturday, September 12, 2020
I write briefly to call attention to the opinion in SEB Investment Mgmt v. Align Tech., 2020 U.S. Dist. LEXIS 164661 (N.D. Cal. Sept. 9, 2020), partially dismissing a 10(b) action against Align Technology, the manufacturer of Invisalign teeth-straightening products. Plaintiffs alleged, among other things, that the company’s financial projections were false for failing to consider what would happen when its patents expired and competitors entered the space. The court rejected this claim on the ground that the projections were protected by the PSLRA’s safe harbor, which insulates forward-looking statements if they are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” 15 U.S.C. § 78u-5. According to the PSLRA’s legislative history, “boilerplate warnings will not suffice.... The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected.” Thus, in the Align case:
The Court agrees with Defendants that the statement was accompanied by adequate warnings. Defendants explain that, at the beginning of the investor call, Align’s representative stated:
As a reminder, the information that the presenters discuss today will include forward-looking statements, including statements about Align’s future events, product outlook and the expected financial results for the third quarter of 2018. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We’ve posted historical financial statements, including the corresponding reconciliations and our second quarter conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information.
The warning, in turn, thus explicitly incorporated risks identified in written filings with the SEC, specifically with respect to “competition, promotions, and decreased ASP.” …
Defendants are correct that substantially similar disclaimers have repeatedly been held by the Court to be a sufficient “meaningful cautionary statement” for purposes of the PSLRA Safe Harbor. For example, in In re Fusion-io, Inc. Securities Litigation, the Court found sufficient a disclosure at the beginning of an earnings call “that forward-looking statements were predictions based on current expectations and assumptions, that these expectations and assumptions involved risks and uncertainties, and [that] referred listeners to Fusion’s registration statements and reports filed with the SEC.” No. 13-CV-05368-LHK, 2015 WL 661869, at *13 (N.D. Cal. Feb. 12, 2015). Similarly, in McGovney v. Aerohive Networks, Inc., the Court found sufficient a disclaimer at the beginning of a call “that the call would contain ‘forward-looking statements’ that involve a ‘number of risks and uncertainties,’ and that investors should reference the ‘Risk Factors and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our recent annual report on Form 10-K and quarterly report on Form 10-Q.’“ McGovney v. Aerohive Networks, Inc., 367 F. Supp. 3d 1038, 1061 (N.D. Cal. 2019).
Moreover, these cautionary statements are virtually identical to language approved by the Ninth Circuit as “meaningful cautionary language” for purposes of the PSLRA Safe Harbor. See, e.g., Police Ret. Sys. v. Intuitive Surgical, Inc., 759 F.3d at 1059-60 (approving cautionary language in earnings call warning that comments may contain forward-looking statements, that such statements may differ based on “certain risks and uncertainties,” and referring listeners to “the company’s [SEC] filings”); In re Cutera Sec. Litig., 610 F.3d 1103, 1112 (9th Cir. 2010) (approving cautionary language at beginning of earnings call that remarks contained forward-looking statements “concerning future financial performance and guidance,” and that “Cutera’s ability to continue increasing sales performance worldwide could cause variance in the results.”) (internal quotation marks omitted).
Plaintiff’s arguments to the contrary are unpersuasive. For example, Plaintiff argues that these warnings were “boilerplate risk disclosures” that were thus too generic. Opp’n at 17. However, as explained above, this Court as well as the Ninth Circuit has found substantially similar disclosures to be adequate cautionary statements.
See, these warnings are exactly like the warnings of every other company for past 10 years; therefore they’re not generic!
(Yes, apparently the defendants made reference to the SEC filings, which may have had more detail, but the court seemed entirely unconcerned with the contents of those filings.)
Suffice to say, when warnings for “risks and uncertainties” and that “[a]ctual results may vary significantly” are held not to be boilerplate, we really have given up on the concept of “meaningful cautionary statements” altogether. Which really goes to show that there’s something very incongruous about relying on precedent to determine whether a risk warning passes muster under the PSLRA in the first place. These warnings are supposed to be tailored to each company’s circumstances; that one company’s warning, concerning particular statements at a particular time, satisfied the PSLRA, should have little relevance to the sufficiency of the warnings of a completely different company, facing different risks, and often operating in an entirely different industry.
In fact, I previously blogged about a paper that purports to show that judges, and the SEC, reward longer, more generic warnings, which only encourages companies to copy the warnings of their industry peers.
To be fair, the SEC has been trying to improve the situation. In its latest amendments to Regulation S-K, the SEC is now requiring that a summary of risk factors be provided if the full list is particularly lengthy, and that issuers group their risk factors by topic, with generally-applicable risk factors to be included in a “General Risk Factors” category. So, I guess we’ll see whether that makes a difference, either to issuers or to regulators.
Friday, September 4, 2020
I Just Read the Department of Labor's New ERISA Voting Proposals and Boy Are My Fingers Tired (from typing)
I’ve talked before in this space about how regulation of ERISA plans and ERISA plan voting is really part of a larger debate about the proper role of shareholders in corporate governance, and even whether the purpose of the corporation is to maximize shareholder value. And a few weeks ago, I blogged about how the Department of Labor had proposed new rules/interpretations to limit ESG investing for ERISA-governed retirement plans, and promote investments in private equity.
Apparently to honor Labor Day, the DoL took it a step further this week to limit ERISA plans’ ability to vote their shares, in large part because – it says – of excess costs due to “the recent increase in the number of environmental and social shareholder proposals introduced. It is likely that many of these proposals have little bearing on share value or other relation to plan interests…”
A lot of words after the jump. So many words.
Saturday, August 29, 2020
When the Delaware Supreme Court decided Marchand v. Barnhill, a lot people wondered – including, ahem, me – whether it heralded a new approach to Caremark claims. Among other things, Caremark claims tend to be successful – if at all – upon a showing that the Board either participated in, or simply disregarded, illegality (in Elizabeth Pollman’s phrasing, were disobedient). Claims that the Board simply did not monitor sufficiently tend to be more of a theoretically possibility than a lived reality, or at least, that was the case until Marchand. Given the facts of Marchand, I speculated at the time that the choice to find potential liability on the basis of lack of monitoring was motivated by some desire to beef up the law in this area.
Which is why I found the decision in Teamsters Local 443 Health Services & Insurance Plan v. John G. Chou interesting, because to me, it reads like VC Glasscock, at least, plans to tread gingerly.
The plaintiffs alleged that AmerisourceBergen (“ABC”) violated the law in connection with its pharmaceutical business. For those keeping score, I must clarify that the allegations do not involve ABC’s violations of law in connection with the distribution of opioids – that case is pending before the Delaware Supreme Court with respect to a Section 220 dispute. Instead, this ABC case involves violations of law in connection with the distribution of cancer medication. Apparently, one of ABC ‘s subsidiaries had an entire business model of skimming the excess “overfill” medication off of cancer med vials, and then repackaging and selling it – lucrative for the subsidiary, but also extraordinarily dangerous and quite illegal because of the potential for contamination. Eventually, the whole thing ended in Specialty (one of ABC’s operating segments) pleading guilty to criminal charges and settling civil ones.
Glasscock began his analysis with a fun (for us law professors) summary of the theoretical issues surrounding Caremark claims:
The facts of Caremark claims ... often invoke judicial sympathies. Frequently, the facts of the case involve corporate misconduct that has led to material suffering among customers, or to the public at large. A judge in the Caremark context must be careful to remember the issues before her. At issue is not whether specific or society-wide victims may themselves receive a remedy for corporate misconduct. Instead, the issue is whether the corporation, whose directors have allegedly allowed it to commit bad acts, should itself recover damages that ultimately inure to the benefit of the corporate owners, its stockholders. This unusual posture raises the question of whether Caremark liability is merely a branch of fiduciary liability designed to make the beneficiaries of that duty whole for breach, or whether it should be seen also as a blunt but useful tool to encourage good corporate citizenship. That question is for academic discussion, not judicial resolution; again, a judge in equity must be mindful that it is the corporation, not that corporation’s victims, to whom any recovery will flow.
He then distinguished between the two flavors of Caremark: failure to monitor, and actively ignoring evidence of illegality:
Caremark claims can take two forms. A so-called “prong one” claim arises where “the directors utterly failed to implement any reporting or information system or controls.” Under “prong one,” “a director may be held liable if she acts in bad faith in the sense that she made no good faith effort to ensure that the company had in place any system of controls.” A “prong two” claim, on the other hand, arises where “having implemented such a system or controls, [the directors] consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” To state a “prong two” Caremark claim, the Plaintiffs must “plead [particularized facts] that the board knew of evidence of corporate misconduct—the proverbial ‘red flag’—yet acted in bad faith by consciously disregarding its duty to address that misconduct.”
The Chou plaintiffs alleged both types of claims. With respect to failure to monitor, they claimed that Specialty was entire outside of ABC’s board-level compliance program, and ABC’s Audit Committee – which was responsible for compliance – was aware of that fact. Specifically, one of ABC’s officers commissioned a report from Davis Polk regarding ABC’s compliance, and Davis Polk reported its findings to the Audit Committee:
Important implications of Davis Polk’s findings were that Specialty was not integrated into ABC’s compliance and reporting function, and that oversight responsibilities were being left to officers and directors of the various ABC subsidiaries.
In the aftermath of the Davis Polk Report the Board and the Audit Committee did not follow through on Davis Polk’s recommendations. Indeed, [the relevant subsidiaries] were kept out of ABC’s compliance programs for the entire period of the [illegal program]....
This is the stuff that Marchand directly implicates, and therefore should be a slam dunk for liability, at least at the pleading stage, right?
Glasscock expressly declined to rule on whether the plaintiffs had stated a failure to monitor claim (though he did acknowledge a “lax approach (at best) to compliance,” slip op. at 70. Instead, he sustained the complaint solely on the ground that ABC had ignored red flags of illegal activity.
The Davis Polk report, he pointed out, was not simply evidence of failure to monitor; it was its own kind of red flag, at least when combined with other evidence. As he put it, the report put the Board on notice of “gaps in Specialty’s compliance, making the later red flags all the more consequential.” Slip op. at 57.
The other red flags? There was a qui tam lawsuit regarding the illegal conduct, which the Board necessarily knew about because it was disclosed in ABC’s 10-Ks, which the Board signed. The defendants claimed that the Board responded to those allegations – it did not consciously disregard them – but Glasscock concluded that the Board’s responses were in fact to a different qui tam case that potentially involved other drugs. Slip op. at 60-61. Board minutes showed some discussion of the relevant matter, but not necessarily any remedial action. Therefore, it was reasonably conceivable that the Board took no action in response to the suit.
And, there was a subpoena from federal prosecutors, which the Board necessarily knew about because it was also disclosed in the 10-Ks. And though the 10-Ks said the Board was responding to the subpoena, that didn’t necessarily mean the Board was investigating the underlying conduct. Slip op. at 67 (“[i]t is reasonably conceivable that ABC could respond to the subpoena, in the way of handing over the information requested, without taking any action with regard to the reason why the United States Attorney’s Office was asking for information…. I find that the absence of any discussion of the subpoena by the Board is sufficient to make reasonable the inference the Plaintiffs ask me to draw, that is, even after receiving the subpoena the Board did nothing to correct the underlying mission critical compliance shortcomings.”)
You know what was not a red flag though? The fact that the FDA received and executed a search warrant of the subsidiary’s operations in 2012. Why? Because there was no evidence the Board was aware of it. Unlike the other red flag allegations, the search was never mentioned in a 10-K. See slip op. at 66 (“It is not reasonable to infer that the Board consciously ignored a red flag with regard to the search warrant, because there is no well-pled allegation that the Board had knowledge of the search warrant or the raid, and hence the scienter required to adequately plead bad faith is absent.”).
In other words, just as Marchand seemed motivated to find potential Caremark liability based on a lack of monitoring, Glasscock seems pretty motivated to do the opposite. By sticking to the Board admissions of knowledge (while reading their actions extremely narrowly), Glasscock was able to cabin the case into well-trod Caremark ground, without the need to venture into the new territory explored in Marchand.
That said, Glasscock couldn’t quite escape one telling conclusion, which I imagine will be cited in many a future plaintiff’s brief going forward: “Calling attention to the hiring of law firms to review alleged illegality, without more, is insufficient to refute well-pled allegations that the Board failed to address mission critical compliance risks.” I.e., asking for a legal review? Does not satisfy Caremark.
And that’s where we are.
Saturday, August 22, 2020
This week, I want to call attention to two recent Delaware decisions involving disputes over the meaning of contractual language in merger agreements, because I find the purity of the interpretive questions posed to be aesthetically pleasing.
First up, we have Schneider National Carriers v. Kuntz, where the court denied cross motions for summary judgment on the grounds that the contract was ambiguous. Schneider acquired all of the stock of W&S in exchange for upfront cash payments and earnouts pegged to meeting certain annually-increasing EBITDA targets over the following three years. As is common in earnout arrangements, Schneider agreed to certain operating covenants, the most critical of which was a covenant that Schneider would, during each Measurement Period, “cause one or more of the Acquired Companies to acquire, in the aggregate, not less than sixty (60) class 8 tractors.”
The question for the court was whether this language meant that Schneider should actually grow the total number of tractors by 60, or could those 60 include replacements for tractors that were retired? If the latter, Schneider was in compliance; if the former, not so much, because Schneider retired more tractors than it acquired. In the end – as one would expect if assets were shrinking – the acquired companies did not meet their EBITDA targets, leading to the lawsuit.
At this point I have to pause to admire the beauty of the problem. It is sheer elegance in its simplicity.
The court had earlier determined the language to be ambiguous in cross-motions for judgment on the pleadings, so now, at the summary judgment stage, it looked to extrinsic evidence. And what was this evidence? Well, there was a lot of testimony regarding oral negotiations – and unsurprisingly, each side offered differing accounts – so the real action was in the documents. And that showed that the EBITDA targets themselves were based on projections that assumed tractor growth. And growth was actually written into Schneider’s early drafts of the stock purchase agreement, but somewhere along the way, Schneider deleted reference to growth while maintaining reference to acquiring 60 tractors, and the sellers never called Schneider on it.
The court’s takeaway from all of this was that factual questions remained, and I suppose that’s not unreasonable, but … come on. If you’re a seller looking for an earnout, and all of your negotiations are focused on the post-merger conduct of the business, are you going to agree to a provision that theoretically gives the buyer complete freedom to discard all the tractors in the fleet – which consisted of several hundred tractors at the time of the acquisition – so long as 60 new ones are purchased? Probably not. I mean, even if you assume that Schneider could only retire tractors based on some concept of “good faith” or business continuity, why would anyone specify that precisely 60 tractors had to be added if they anticipated the possibility of a relatively unconstrained offsetting decrease? Sixty additions are meaningless if you have no idea how many are being eliminated.
A more cynical interpretation would be that the buyer deleted critical language as drafts were exchanged and hoped—correctly—that sellers would not notice the significance until it was too late. But, we’ll see what happens as the case goes forward.
Moving on, we have RoundPoint Mortgage Servicing Corp. v. Freedom Mortgage Corp. RoundPoint was in the business of originating, refinancing, and servicing residential mortgage loans, and almost all of its stock was held by RPFG. Freedom agreed to acquire RoundPoint at a valuation of 7.5% above RoundPoint’s book value just before closing, minus $4,150,000. In practical effect, then, and excluding the $4 million deduction, every dollar by which RoundPoint’s book value increased meant an increase in payments to RPFG of that amount, plus 7.5%.
RoundPoint was concerned that it might have to pay certain margin calls before closing, and – because the merger agreement did not permit it to sell assets – would have insufficient liquidity to do so. As a result, Freedom agreed in Section 7.02 of the Merger Agreement to allow RPFG to lend RoundPoint the necessary funds, but closing required that RoundPoint “shall have repaid, all amounts outstanding under the RPFG Facility.”
The problem was that after RPFG advanced those funds to RoundPoint, it simply forgave most of the debt. By doing so, RPFG functionally added what appears to have been over a hundred million dollars to RoundPoint’s book value, which, of course, meant Freedom was obligated to pay RPFG 7.5% over that amount.
Freedom argued that unless RoundPoint repaid the full amounts loaned – regardless of any formal debt forgiveness – Freedom was relieved of its closing obligations. Was it?
Here, we have a delightful dispute over emphasis: is the critical phrase “shall have repaid,” so that if RoundPoint did not actually repay the amounts loaned, the condition is not satisfied? Or is the critical phrase “all amounts outstanding,” so that the condition is satisfied so long as there is no outstanding debt to RPFG?
A trial was held solely on Section 7.02, with additional proceedings regarding the rest of the Agreement to be held later. And, based solely on that Section, without reference to other provisions, the court held for RoundPoint. In the court’s view, “If the intent was to ensure that debt be repaid and not forgiven, that intent is expressed poorly … [B]ecause Section 7.02(f), as most naturally read, does not impose a restriction on debt forgiveness, and because the Merger Agreement shows that where the parties sought to impose such restrictions they knew how to do so, I find that the parties did not intend Section 7.02(f) to prohibit forgiveness of debt under the RPFG Facility.” The court allowed that – after examination of the remainder of the merger agreement – it might come out differently.
Now, again, color me skeptical. At first, the contract capped the total amount of RPFG’s loan at $40 million, but as RoundPoint’s assets deteriorated and the margin calls increased, Freedom repeatedly authorized RPFG to raise the limit. Yet under RoundPoint’s reading, RPFG had the unfettered option to require total repayment, or none, or anywhere in between, always with the knowledge that Freedom would pay 7.5% on top of every dollar of debt forgiveness. Which means that as a practical matter, to accept RoundPoint’s argument, you have to believe that the more the company's value declined, the more that Freedom agreed to pay. If that’s the correct interpretation, I don’t see why you’d even bother calling these loans to RoundPoint at all; they’re more like exceptionally seller-friendly purchase price adjustments.
And the court understood all of that, but nevertheless found RoundPoint’s reading more “intuitive.”*
In any event, I go through this exercise because I am charmed by the classroom-ready pristineness of the dispute in each case. I’m also amused by the tolerance of Delaware courts for contract interpretations that would hand limitless discretion to one party to decide how much to screw over the other. But, well, that’s contracts for you; I’ll just go back to my corporate law corner where we talk about equity and fairness and duty.
*There is a smidge more to it; apparently, in the course of litigation, RPFG offered to forego the 7.5% premiums on the forgiven debt, but Freedom still sought to avoid closing. And presumably that’s because even without the premiums in the mix, Freedom would still be stuck paying a book value increased by RPFG’s capital infusions for a business that had significantly declined. The court figured that viewed through a good-faith-and-fair-dealing lens, it wasn’t clear whether the missing covenant would have required full repayment by RoundPoint, or whether it would have required something more along RPFG’s foregone-premiums compromise. And without that clarity, there was no term the court could imply into the deal.
Saturday, August 15, 2020
In Juul Labs v. Grove, Vice Chancellor Laster held that inspection rights are a matter of internal affairs, and therefore California’s Section 1601, which grants inspection rights to shareholders of California corporations and foreign corporations with headquarters in California, is invalid as applied to Delaware corporations.
There are a lot of policy implications here, because Juul arose in the context of a private company that required shareholders to waive their inspection rights under Delaware law. Assuming Delaware treats that waiver as valid – and Laster did not reach that question – critical sources of information could be denied to private company investors. And, as I previously blogged about the Juul dispute, if Delaware finds such contractual waivers valid, the next step is for companies to insert them into their charters and bylaws. If that’s valid – and after Salzberg v. Sciabacucci, it could be – it would mean that 220 inspection rights could be left a functional dead letter for both private and public companies.
But actually, the interesting part here for me is the procedural aspect. Now, the exact contours of the internal affairs doctrine have always been unclear – see, e.g., Mohsen Manesh, The Contested Edges of Internal Affairs – but Delaware’s decision on this was … overdetermined. Delaware has always had a much broader view of the scope of the internal affairs doctrine than other states – particularly California – and this is not the first time Delaware has held that California’s corporate code is invalid as applied to Delaware entities. See VantagePoint Venture P’rs 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005). But California never seems to get its own chance to weigh in, because as soon as a Delaware company gets a hint that a shareholder plans to invoke its rights under California law, the company runs to file a declaratory action in Delaware. That’s what happened in VantagePoint, and when the shareholder filed its own action in a California court, California stayed its own proceedings in favor of the first-filed Delaware action.
Here, a similar scuffle occurred. The Juul shareholder first had to make a demand for inspection under California law, which put the company on notice that a dispute was in the offing. The company immediately filed a declaratory judgment action in Delaware – arguing, among other things, that because the company had a forum selection clause in its charter requiring that internal affairs disputes be heard in Delaware, and because inspection rights are governed by the internal affairs doctrine, any California court would be powerless to weigh in. The shareholder subsequently filed an action in California, but California stayed its ruling in favor of Delaware case. See Grove v. Adam Bowen, Superior Court of Californa, CGC20582059. That left the field free for Laster to hold that inspection rights are part of internal affairs, California’s law did not apply, and no suit could be filed in California. And that holding is now presumably immune from attack in California courts, even though there is California precedent for the idea that Section 1601 does not deal with internal affairs. See Valtz v. Penta Investment Corp., 139 Cal. App. 3d 803 (Ct. App. 1983).
I suppose if California courts really want to get in the middle of this, they could refuse to stay their own actions and rush to reach a judgment before Delaware does, but for now it seems like only Delaware is going to get a say. And that’s going to be especially true if forum selection provisions in corporate governance documents extend beyond internal affairs – as the Delaware Supreme Court held they can in Salzberg – so that the forum choice in future cases does not depend on that initial “internal affairs” determination, while simultaneously functioning as a waiver of any challenge to personal jurisdiction over the shareholder in a Delaware court.*
And I, for one, would really like to hear what another state thinks.
*Which, by the way, just highlights the importance of the question whether other states accept Salzberg and agree that forum choices in corporate constitutive documents are binding even for noninternal affairs questions. Because if a company has a charter provision that says all information disputes must be heard in Delaware, and other states accept that as binding contractually, then even if a California court wants to decide whether Section 1601 governs internal affairs or not, and is theoretically able to reach the question before it becomes res judicata in Delaware, it still won’t be able to hear the case. So, all eyes on Dropbox.
Friday, August 14, 2020
As an academic and consultant on environmental, social, and governance (ESG) matters, I’ve used a lot of loaded terms -- greenwashing, where companies tout an environmentally friendly record but act otherwise; pinkwashing, where companies commoditize breast cancer awareness or LGBTQ issues; and bluewashing, where companies rally around UN corporate social responsibility initiatives such as the UN Global Compact.
In light of recent events, I’ve added a new term to my arsenal—wokewashing. Wokewashing occurs when a company attempts to show solidarity with certain causes in order to gain public favor. Wokewashing isn’t a new term. It’s been around for years, but it gained more mainstream traction last year when Unilever’s CEO warned that companies were eroding public trust and industry credibility, stating:
Woke-washing is beginning to infect our industry. It’s polluting purpose. It’s putting in peril the very thing which offers us the opportunity to help tackle many of the world’s issues. What’s more, it threatens to further destroy trust in our industry, when it’s already in short supply… There are too many examples of brands undermining purposeful marketing by launching campaigns which aren’t backing up what their brand says with what their brand does. Purpose-led brand communications is not just a matter of ‘make them cry, make them buy’. It’s about action in the world.
The Black Lives Matter and anti-racism movements have brought wokewashing front and center again. My colleague Stefan Padfield has written about the need for heightened scrutiny of politicized decisions and corporate responses to the BLM movement here, here, and here, and Ann Lipton has added to the discussion here. How does a board decide what to do when faced with pressure from stakeholders? How much is too much and how little is too little?
The students in my summer Regulatory Compliance, Corporate Governance, and Sustainability course were torn when they acted as board members deciding whether to make a public statement on Black Lives Matter and the murder of George Floyd. As fiduciaries of a consumer goods company, the “board members” felt that they had to say “something,” but in the days before class they had seen the explosion of current and former employees exposing companies with strong social justice messaging by pointing to hypocrisy in their treatment of employees and stakeholders. They had witnessed the controversy over changing the name of the Redskins based on pressure from FedEx and other sponsors (and not the Native Americans and others who had asked for the change for years). They had heard about the name change of popular syrup, Aunt Jemima. I intentionally didn’t force my students to draft a statement. They merely had to decide whether to speak at all, and this was difficult when looking at the external realities. Most of the students voted to make some sort of statement even as every day on social media, another “woke” company had to defend itself in the court of public opinion. Others, like Nike, have received praise for taking a strong stand in the face of public pressure long before it was cool and profitable to be “woke.”
Now it’s time for companies to defend themselves in actual court (assuming plaintiffs can get past various procedural hurdles). Notwithstanding Facebook and Oracle’s Delaware forum selection bylaws, the same lawyers who filed the shareholder derivative action against Google after its extraordinary sexual harassment settlement have filed shareholder derivative suits in California against Facebook, Oracle, and Qualcomm. Among other things, these suits generally allege breach of the Caremark duty, false statements in proxy materials purporting to have a commitment to diversity, breach of fiduciary duty relating to a diverse slate of candidates for board positions, and unjust enrichment. Plaintiffs have labeled these cases civil rights suits, targeting Facebook for allowing hate speech and discriminatory advertising, Qualcomm for underpaying women and minorities by $400 million, and Oracle for having no Black board members or executives. Oracle also faces a separate class action lawsuit based on unequal pay and gender.
Why these companies? According to the complaints, “[i]f Oracle simply disclosed that it does not want any Black individuals on its Board, it would be racist but honest…” and “[a]t Facebook, apparently Zuckerberg wants Blacks to be seen but not heard.” Counsel Bottini explained, “when you actually go back and look at these proxy statements and what they’ve filed with the SEC, they’re actually lying to shareholders.”
I’m not going to discuss the merits of these cases. Instead, for great analysis, please see here written by attorneys at my old law firm Cleary Gottlieb. I’ll do some actual legal analysis during my CLE presentation at the University of Tennessee Transactions conference on October 16th.
Instead, I’m going to make this a little more personal. I’m used to being the only Black person and definitely the only Black woman in the room. It’s happened in school, at work, on academic panels, and in organizations. When I testified before Congress on a provision of Dodd-Frank, a Black Congressman who grilled me mercilessly during my testimony came up to me afterwards to tell me how rare it was to see a Black woman testify about anything, much less corporate issues. He expressed his pride. For these reasons, as a Black woman in the corporate world, I’m conflicted about these lawsuits. Do corporations need to do more? Absolutely. Is litigation the right mechanism? I don’t know.
What will actually change? Whether or not these cases ever get past motions to dismiss, the defendant companies are likely to take some action. They will add the obligatory Black board members and executives. They will donate to various “woke” causes. They will hire diversity consultants. Indeed, many of my colleagues who have done diversity, equity, and inclusion work for years are busier than they have ever been with speaking gigs and training engagements. But what will actually change in the long term for Black employees, consumers, suppliers, and communities?
When a person is hired or appointed as the “token,” especially after a lawsuit, colleagues often believe that the person is under or unqualified. The new hire or appointee starts under a cloud of suspicion and sometimes resentment. Many eventually resign or get pushed out. Ironically, I personally know several diversity officers who have left their positions with prestigious companies because they were hired as window dressing. Although I don’t know Morgan Stanley’s first Chief Diversity Officer, Marilyn Booker, her story is familiar to me, and she has now filed suit against her own company alleging racial bias.
So I’ll keep an eye on what these defendants and other companies do. Actions speak louder than words. I don’t think that shareholder derivative suits are necessarily the answer, but at least they may prompt more companies to have meaningful conversations that go beyond hashtag activism.
August 14, 2020 in Ann Lipton, Compliance, Consulting, Corporate Governance, Corporate Personality, Corporations, CSR, Current Affairs, Delaware, Financial Markets, Management, Marcia Narine Weldon, Shareholders, Stefan J. Padfield | Permalink | Comments (0)
Saturday, August 1, 2020
Gabriel Rauterberg has just posted a fascinating new paper, The Separation of Voting and Control: The Role of Contract in Corporate Governance. It’s about shareholder agreements, and in particular, the fact that they are surprisingly common not only in private companies, but also in public companies. These agreements typically involve a founder and/or institutional investors like private equity funds, and contain various provisions related to corporate control, such as promises to support certain director nominees, and veto power over various types of corporate actions. As Rauterberg explains, shareholder agreements grant the parties far more freedom to order their arrangements than do bylaws and charter provisions; corporate constitutive documents, for example, could not guarantee board seats for specific nominees.
Rauterberg points out that these raise interesting questions under Delaware law, especially with respect to whether these agreements improperly end-run around mandatory corporate governance provisions. This is particularly so when the corporation itself is a party to the agreement, and the board is bound to take certain actions, like recommend a particular board nominee to shareholders or include a nominee on a particular committee. As he puts it:
The tapestry of corporate law draws fundamental contrasts – between control rights and contractual rights, between the types of rights held by creditors (generally, promissory and fixed) and by equity (generally, residual and discretionary), between internal and external, and ultimately, turning on all of the above, between those who do and do not owe fiduciary duties and those who do and do not receive fiduciary protection. It is simple to state why shareholder agreements challenge this picture: They grant significant corporate power to the paradigmatic “internal” patron – shareholders – but in a way that is fixed, external, and contractual, rather than routed through the board.
On this, I have to point out that preferred stock raises similar challenges. As William Bratton and Michael Wachter have explained, “Preferred stock sits on a fault line between two great private law paradigms, corporate law and contract law.” That fish-or-fowl problem has made Delaware courts quite uncomfortable with preferred shareholder rights; Bratton and Wachter go on to note that cases involving the rights of preferreds follow a simple maxim: “The preferred always lose.”; see also Victor Brudney (“For more than half a century the courts have systematically, if not uniformly, upheld the commons’ view of the scope of its discretion to act opportunistically toward the preferred stockholders under the preferreds' investment contract or the statutes that the contract is said to incorporate.”)
The other interesting point that Rauterberg makes has to do with who counts as a controlling shareholder. That’s a topic I’ve revisited a lot in this space – most recently here – and it’s an issue for Rauterberg as well. Most companies with shareholder agreements also identify as controlled companies, but a significant minority do not, which is ultimately going to be a challenge that lands in Delaware’s lap. Indeed, a couple of weeks ago I posted about Lemonade, which went public as a benefit corporation under Delaware law. Lemonade’s two founding shareholders each hold just under 30% of Lemonade’s votes, and they have a shareholder agreement with Softbank – which has another 21% – that the three together will decide on the disposition of Softbank’s votes. But Lemonade does not at this time identify itself as a controlled company. So that’s going to be something to watch if litigation arises.
Saturday, July 25, 2020
I’m finding the district court’s decision in Marcu v. Cheetah Mobile, 2020 WL 4016645 (S.D.N.Y. July 16, 2020) fascinating, not because it’s wrong on the law – it isn’t, in my view, at least with respect to its falsity determination – but because it illustrates the artificiality of a lot of securities fraud litigation.
Cheetah Mobile is a Chinese company that develops apps that used to be downloadable from Google Play. It went public on the NYSE in 2014, and quickly developed a reputation for poor quality products that used intrusive advertisements and interfered with the functioning of users’ phones. In 2017, a short-seller accused it of fabricating revenue and clicks, and in 2018, Buzzfeed exposed that 7 of its 18 apps were engaged in a type of clickfraud scheme that improperly credited Cheetah Mobile with referrals to other apps. Google removed the offending apps, and earlier this year, apparently fed up with Cheetah’s behavior, booted it from its platform entirely.
A putative class of Cheetah investors brought Section 10(b) claims shortly after the Buzzfeed expose, alleging that Cheetah misled investors about its business practices. The district court dismissed the case in large part because the plaintiff could not identify any false statements. The company accurately described its revenues – even if some portion of those revenues were generated through the clickfraud scheme – and accurately described its users’ experiences with its products. As the court put it:
Nor do Plaintiffs plausibly allege that the challenged statements regarding revenue and profit derived from the apps are misleading. “[A] violation of federal securities laws cannot be premised upon a company’s disclosure of accurate historical data.” In re Sanofi Sec. Litig., 155 F. Supp. 3d 386, 404 (S.D.N.Y. 2016). …That said, a statement may be misleading if it describes the factors that influence the reported figures but omits the fact that one such factor is the alleged misconduct. For example, in In re VEON Ltd. Securities Litigation, No. 15-CV-8672 (ALC), 2017 WL 4162342 (S.D.N.Y. Sept. 19, 2017), the plaintiffs alleged securities fraud on the ground that the defendant had concealed that it had paid bribes to receive favorable treatment in Uzbekistan. Notably, the court held that “references to sales and subscriber numbers in Uzbekistan” were not, in themselves, misleading. Id. at *6. By contrast, assertions that growth in the Uzbekistani market was due to “the improving macroeconomic situation, product quality and efficient sales and marketing efforts” were misleading because the “growth also was due to bribe[ry].” Id.; see also In re Braskem S.A. Sec. Litig., 246 F. Supp. 3d 731, 758-61 (S.D.N.Y. 2017) (holding that a list of reasons for the low price the defendant had paid for a good was plausibly misleading because it omitted a “key factor, the bribery-affected side deal” with the supplier and therefore amounted to “a classic half-truth”)…
…[Cheetah’s] disclosures did “not put the source of [Cheetah Mobile’s] success at issue.” In re KBR, Inc. Sec. Litig., No. CV H-17-1375, 2018 WL 4208681, at *5 (S.D. Tex. Aug. 31, 2018) (emphasis added). That is, they did not “put the circumstances surrounding” the means by which Cheetah Mobile’s apps generated revenue “‘in play’ — by, for instance, touting some legitimate competitive advantage or specifically denying wrongdoing — but instead merely report[ed] the facts that some of the reported revenue and income came from ‘increased progress,’ or ‘increased activity’ . . . and the like — reports that Plaintiffs do not contend were false.” Id.
Plaintiffs come closer to the mark with respect to Defendants’ disclosures explaining the drivers of revenues and profits from mobile apps, but here too they ultimately fall short. Specifically, Plaintiffs take issue with Cheetah Mobile’s representations that it “generate[d] online marketing revenues primarily by referring user traffic and selling advertisements on our mobile and PC platforms.” SAC ¶ 49 (emphasis omitted). Cheetah Mobile also articulated its “belie[f] that the most significant factors affecting revenues from online marketing include[d],” inter alia, “a large, loyal and engaged user base,” which “results in more user impressions, clicks, sales or other actions that generate more fees for performance-based marketing,” and “the fee rate [Cheetah Mobile] receive[d] per click or per sale.” Id.; see also id. ¶¶ 63, 72, 79 .… At first glance, these statements appear akin to those found actionable in In re VEON Ltd. … But there is a critical difference: The disclosures here did not, explicitly or implicitly, rule out other factors playing a role in generating revenue. To the contrary, by using words such as “primarily” and “most significant,” Defendants overtly acknowledged that other factors might play a role. To be sure, the statements did unmistakably imply that any unstated factors played a minor role relative to the stated factors. But Plaintiffs allege no facts suggesting, let alone showing, that implication to be false.
2020 WL 4016645, at *5 (some quotations omitted).
The court here is correctly summarizing existing caselaw: Accurate reporting of past financial results – even if those results were achieved by illegal or improper means – is not misleading, but it becomes misleading if those results are falsely attributed to legitimate factors. Here, Cheetah hedged just enough to make its disclosures technically truthful; Cheetah did not rule out clickfraud, it just, you know, emphasized everything else.
That is insane.
Does anyone seriously think that investors were any less misled because Cheetah only said its loyal user base was mostly responsible for its revenues? Are we to believe that there is such a big difference between mostly responsible and just, responsible, full stop, that it would have made a difference to a single trader?
I call this kind of thing a Rumpelstiltskin game; it only counts if the exact magic words are used; if not, case dismissed. Like the Supreme Court’s decision in Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 575 U.S. 175 (2015) – which invited issuers to couch every statement with the phrase “I believe” in order to have it treated legally as a matter of opinion rather than a representation of fact – these decisions allow defendants to escape liability with a slight rephrase that, in context, is unlikely to have much substantive impact on the listener.
That said, Cheetah is an example of a broader issue I frequently revisit here, which is the doctrinal distortion caused by courts’ continued attempts to distinguish between fraud claims – covered by federal law – and governance claims, which are supposed to be the purview of state law. Companies are allowed to engage in bad behavior under the federal securities laws; they’re just not permitted to lie about it. By contrast, poor management is policed by state fiduciary standards. The line between the two is often very difficult to parse, especially when a fairly anodyne statement conceals pervasive corporate dysfunction.
So in Cheetah’s case, the problem for the court was, yes, there’s little difference between statements like “our success is mainly attributable to our loyal user base” and “our success is attributable to our loyal user base,” but in reality, it’s not clear that investors would care about either statement. It’s an app company; of course it makes money from users. Investors are looking at the revenue stream, and if they’re fooled, it’s because they’re making certain assumptions about business regularity. As I wrote in my article, Reviving Reliance, in these cases, “it is not so much the company’s statements, but its business model that acts as a fraud on shareholders; its mere existence on the market in the guise of a legitimate investment” is the fraud.
And yeah, we have a concept for that: “Fraud-created-the-market.” But most courts have rejected that theory, so plaintiffs are stuck hunting for isolated misstatements.
But – and here’s the rub – consider Cheetah Mobile in another light. If we’re going to be honest about it, do we think that any investor really assumed a Chinese mobile app developer distributing programs like “Battery Doctor” and “Speed Booster” operated regularly? Just how fooled were they likely to be? Yes, Google kicked them off the platform, but there’s a good argument that this was less because Google suddenly discovered problems than because Google changed, especially in an altered political environment. We might say that anyone who invests in a skeevy mobile app company notorious for crapware pretty much knows what they’re getting. Which is, in a sense, exactly why the fraud-created-the-market theory proved unmanageable, and we’re stuck playing Rumpelstiltskin.
Saturday, July 18, 2020
A few of us have blogged about benefit corporations here from time to time; they’re a controversial business form, in part because there are disputes about whether they actually are materially different from the ordinary corporate form, and in part because of flaws in states’ adopting legislation.
The basic issue here is that, as we all know, the business judgment rule is robust enough that corporate directors are perfectly free, as a practical matter, to pursue a stakeholder-oriented mission without the need of any special form. The reason they do not has little to do with their formal legal obligations, and everything to do with the market for corporate control: If directors do not put shareholders first, their companies may become ripe for a takeover and they may be voted out of office.
In theory, benefit corporations could solve a shareholder collective action problem. Let’s assume, as some theorize, that given the choice, many shareholders would actually prefer not to maximize their own welfare but instead to share those gains with other stakeholders. The problem is, they may experience defection in their own ranks. Over time, some shareholders may change their minds and prefer to keep all excess profits; or, they may fear other shareholders will do so. As a result, at any given time, individual shareholders may sell their shares to a profit maximizer (a hedge fund, etc), who ultimately takes control and abandons the stakeholder-oriented mission.
The benefit corporation form, then, could theoretically precommit shareholders to remaining true to their original purpose. But that only works if there are credible bonding mechanisms.
In Delaware, one bonding mechanism was the statutory requirement that companies could only adopt, or abandon, benefit corporation status by a 2/3 vote of the shareholders (more on that below). This requirement ensured a hedge fund would have to acquire a supermajority stake before abandoning a benefit corporation’s altruistic mission. But locking shareholders into the form wouldn’t have much of an effect unless the form itself offered a meaningful commitment to stakeholderism.
That’s why Delaware has an additional bonding mechanism, namely, that directors are legally required to balance the interests of all stakeholders when managing the corporation. The problem – and this is well discussed in the literature – is that the mechanisms for enforcing this requirement are rather meager. Many states, Delaware included, also require directors of benefit corporations to issue reports on the actions they have taken to advance public benefits, but Haskell Murray has found that many benefit corporations simply don’t issue the reports.
So, if you assume a rapacious hedge fund wanted to take over a benefit corporation and profit by abandoning its social mission, the 2/3 vote requirement might impede the fund from obtaining enough shares to formally convert the company’s status, but the fund could still gain enough votes to steer decisionmaking in a more rapacious direction, with very little to fear in terms of legal reprisal.
As a result, some companies have chosen to obtain certification as a B-Corp. B-Lab is a private organization that certifies that companies have complied with its standards for pursuing a stakeholder oriented mission, i.e., B-Corp certification. This third-party certification does not create legal obligations for directors, but may serve as some kind of assurance to shareholders that a particular company remains committed to its social purpose.
The reason I’m mentioning all of this now is that given the weaknesses inherent in benefit-corporation status, we have not seen many standalone publicly-traded benefit corporations, especially ones organized in the United States. (Or, for that matter, B-Corps – Etsy famously abandoned its B-Corp status not long after going public, exactly as the theory of shareholder defection would predict). Laureate Education is one of the very few publicly-traded benefit corporations, and it maintains its status with dual-class stock that gives control to a single entity, Wengen Alberta (that entity, however, is controlled by several private equity firms and, well … you get the feeling Laureate’s benefit-corp status is less about stockholders deciding to share profits than a recognition that, given Laureate’s business model, publicly doing good really is necessary to do well). There’s also Amalgamated Bank, which – as a bank incorporated in New York – cannot formally adopt benefit-corporation status but recently amended its articles of incorporation to make the same kind of commitment. Amalgamated, like Laureate, is also not depending on its charter to enforce that commitment, though; it’s 40% owned by unions.
And now, two new companies are joining this list.
First up is the insurance company Lemonade, which went public earlier this year. Lemonade is an odd duck; one would not ordinarily think of an insurance company as a natural fit for benefit corporation status, but it describes its public mission thusly:
This corporation’s public benefit purpose is to harness novel business models, technologies and private-nonprofit partnerships to deliver insurance products where charitable giving is a core feature, for the benefit of communities and their common causes.
In short, Lemonade donates some of the premiums it receives to charities designated by policyholders. And how does Lemonade expect to be able to maintain its commitment to this benefit once its shares are freely-tradeable? With a combination of extensive inside ownership and antitakeover devices. The co-founders control more than half the votes, and they’ve reached an agreement with Softbank – which controls another 21% – to decide with Softbank how Softbank’s shares will be voted. There’s a staggered board and various other garden-variety antitakeover provisions (advance notice procedures, no written consent, shareholders can’t call meetings, directors can adopt poison pills, 2/3 vote requirement for shareholders to amend bylaws and various charter provisions). Lemonade also has regulatory protections:
Under applicable state insurance laws and regulations, no person may acquire control of a domestic insurer until written approval is obtained from the state insurance commissioner following a public hearing on the proposed acquisition.
Second, we have Vital Farms, which just unveiled its S-1 last week. Vital Farms is an “ethical food company that is disrupting the U.S. food system,” and is also incorporated as a Delaware public benefit corporation:
The public benefits that we promote, and pursuant to which we manage our company, are: (i) bringing ethically produced food to the table; (ii) bringing joy to our customers through products and services; (iii) allowing crew members to thrive in an empowering, fun environment; (iv) fostering lasting partnerships with our farms and suppliers; (v) forging an enduring profitable business; and (vi) being stewards of our animals, land, air and water, and being supportive of our community
But again, Vital Farms is not relying on PBC status to commit to its purpose; instead, insiders own 61.7% of the company and, like Lemonade, it has a staggered board and similar antitakeover provisions.
My point here is that benefit-corporation status is not, in fact, serving as a commitment device for any of these companies; instead, to remain true to their mission, these companies are relying on more mundane types of insulation from the market for corporate control. But that kind of insulation carries the same risk as any other entrenchment device; the companies will pursue stakeholder interests only so long as their managers feel it in their interests to do so. The benefit-corporation form is not doing much work.
Notably, Delaware is adopting amendments to the DGCL that eliminate benefit corporations’ only real commitment device, namely, the 2/3 vote requirement necessary to shed benefit corporation status. With these amendments – which were, I believe?, only just signed into law – we really may as well just call them “corporations” and be done with it.
One final observation: it’s interesting to compare the risk factors in the prospectuses of Lemonade and Vital Farms – especially since publicly-traded benefit corporations are so rare that there isn’t much of a template. Lemonade notes the dual risks that its pursuit of stakeholder-oriented goals may diminish profits, and the fact that it may fail to achieve those goals may result in reputational harms that diminish profits. As Lemonade puts it, “There is no assurance that we will achieve our public benefit purpose or that the expected positive impact from being a public benefit corporation will be realized, which could have a material adverse effect on our reputation, which in turn may have a material adverse effect on our business, results of operations and financial condition.” Benefit-corp status is thus treated at least in part as a mechanism for pursuing shareholder wealth maximization on the “do well by doing good” theory.
Vital Farms, by contrast, while warning of the risk that it may fail to achieve its stakeholder benefits and suffer related reputational harm, mostly just highlights that benefiting stakeholders may ultimately result in some sacrifice of shareholder welfare: “While we believe our public benefit designation and obligation will benefit our stockholders, in balancing these interests our board of directors may take actions that do not maximize stockholder value.” Vital Farms does not, in other words, treat benefit corp status as itself contributing to shareholder value (via marketing or otherwise).
Friday, July 10, 2020
The Delaware Supreme Court has, shall we say, an uneven relationship with the concept of market efficiency.
For many years, it entirely ignored or even disdained the concept. See Verition Partners Master Fund Ltd. v. Aruba Networks, Inc, 2018 WL 922139, at *30 n.305 (Del. Ch. Feb. 15, 2018). However, beginning with DFC Glob. Corp. v. Muirfield Value P’rs, L.P., 172 A.3d 346 (Del. 2017), the Court began to endorse the concept in the context of appraisal proceedings, though the significance it placed on efficiency was not entirely clear. When Vice Chancellor Laster relied entirely on market efficiency to value shares for appraisal purposes, the Delaware Supreme Court rejected his analysis, emphasizing that market price is but one aspect of an appraisal valuation, and that “informational” market efficiency is not equivalent to “fundamental value” efficiency.
The Delaware Supreme Court’s new decision in Fir Tree Value Master Fund LP et al. v. Jarden Corporation seems to muddy the waters further.
Originally, VC Slights held that a target’s market price was the best evidence of standalone value, mainly because the other potential measures were lacking. The deal price was flawed because the target CEO had arguably run an inadequate process, and in any event, there were likely synergies to which the petitioners were not entitled. It was impossible to determine exactly how those synergies had influenced the deal price, so they could not simply be deducted, and the parties had wildly divergent DCF analyses. Under these conditions, VC Slights awarded petitioners the unaffected market price – which was, unsurprisingly, below the deal price.
On appeal, the Delaware Supreme Court affirmed. Most of the opinion emphasizes that Chancery courts have broad discretion to consider multiple valuation methods – including deal price and market price – and Slights did not abuse his when he determined that market price was most appropriate in this case. The court quoted its earlier holding in DFC, explaining, “Like any factor relevant to a company’s future performance, the market’s collective judgment of the effect of regulatory risk may turn out to be wrong, but established corporate finance theories suggest that the collective judgment of the many is more likely to be accurate than any individual’s guess.”
We might ask how well Jarden squares with Aruba. After all, in Aruba there were also synergies to discount, an unreliable sales process, and a concern about DCF calculations, but the Delaware Supreme Court rejected VC Laster’s reliance on market price. The Delaware Supreme Court explained itself in Aruba by saying that VC Laster erred by holding that he was compelled to rely on market price, when, in fact, other evidence was available. What really seemed to be troubling the court, though, was discomfort with a blanket endorsement of market efficiency, particularly because of the likelihood that acquirers have better information than the market in general. VC Slights’s Jarden opinion, by contrast, did not seem to the Supreme Court as categorical, and thus did not, ahem, take Delaware out of the public-company appraisal business entirely.
But the court didn’t leave things there.
In affirming VC Slights, the Delaware Supreme Court also cited an article by Jonathan Macey and Joshua Mitts, Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets, 74 Bus. Law. 1015 (2019). This was an odd choice, because that article strongly endorses the use of market price as a starting point for virtually all appraisal proceedings, and offers an extreme defense of market efficiency. In the section of the article quoted by the Delaware Supreme Court, Macey and Mitts write, “[B]ecause informational efficiency and fundamental efficiency are not the same thing, the share price of a company’s stock, even when informationally efficient, may diverge occasionally from the stock’s fundamentally efficient price. This divergence occurs, however, only when and to the extent that there is material nonpublic information that is not impounded in a company’s share prices.”
That is… not the same analysis as the one in DFC. The Mitts and Macey quote suggests that if a market is informationally efficient, courts should assume the market price reflects fundamental value unless there’s identifiable material nonpublic information, in which case price is adjusted accordingly. By contrast, DFC holds that market judgments can be wrong even if everyone’s working off the same information, though the collective judgment is probably right. DFC, in other words, allows for the possibility that markets may misapprehend the significance of the information with which they are supplied; in practical effect, it gives courts more wiggle room. And in Aruba, of course, the Delaware Supreme Court did not suggest that VC Laster should have awarded market price adjusted for nonpublic information.
More perplexingly, a second Jarden footnote quotes Mitts and Macey’s pronouncement that “Delaware Courts are correct in affording primacy to the [efficient capital market hypothesis] in valuation cases,” while contrasting with Lynn Stout on problems with the ECMH. Is the court … endorsing Mitts and Macey’s interpretation of its own caselaw, that market prices have “primacy”? I can’t really tell, but other aspects of the decision seem to take the Mitts and Macey view, because, in rejecting the petitioner’s challenge to the use of market prices, the court highlights (1) petitioners did not identify material nonpublic information and (2) differences among analysts reflected mere judgment differences rather than informational differences, which - in the court’s view - made them irrelevant. (See, e.g., op. at 32-33).
There are, of course, well-known difficulties with assuming that informationally-efficient markets reflect fundamental values. First, it’s hard to tell when you’re actually in such a market in the first place. That’s a longstanding problem in the fraud-on-the-market context, which is why the Supreme Court recently explained that perfect efficiency is not necessary for fraud-on-the-market plaintiffs. Mitts and Macey acknowledge this point in their article, and suggest that courts simply start with the inefficient prices and adjust them for any unaccounted-for information, but that presupposes that courts can detect such inefficiencies, detect the missing information, and make the appropriate adjustment.
The other problem is that of the irrational market, even when all information is clearly available. As I previously posted, we’re seeing precisely these kinds of markets right now, as retail traders turn to RobinHood to get their gambling fix and apparently engage in price manipulation for the lulz. As pandemic-related uncertainties cause wild gyrations in stock price, this is, perhaps, not the best moment for a full-throated endorsement of market efficiency. Mitts and Macey largely suggest that if markets are irrational in general, investors don’t deserve an appraisal remedy anyway, but I am not certain that view accords with Delaware precedent.
In any event, I don’t want to overstate things; in general, I think the takeaway from Jarden is likely to be that Chancery judges have leeway to use the evidence they think most appropriate to the situation, and unaffected market price is acceptable at least when deal-price-minus-synergies is incalculable. It’s just striking that, in support of this holding, the court quoted an article making, umm, the opposite argument, which may create uncertainty with respect to the great “deal price versus market price” debate.
Saturday, July 4, 2020
It seems we’re all talking about VC Laster’s recent opinion in In re Dell Technologies Class V Stockholder Litigation. Stefan posted about Laster’s taxonomy of coercion earlier this week; for me, I want to focus on another aspect of the case, the one that Stephen Bainbridge latched onto as indicative of his “director primacy” view.
The basic set up in Dell was that controlling shareholders – Michael Dell and Silver Lake – engineered a transaction whereby Dell would redeem Class V stock from its holders, and they wanted to cleanse the deal using Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) procedures to ensure it would receive business judgment review. To that end, they conditioned the transaction on special committee approval and unaffiliated shareholder approval. Dissatisfied stockholders sued, claiming that despite those efforts, the MFW conditions were not satisfied, and, for the purposes of a 12(b)(6) motion, Laster agreed.
Laster actually found that, as alleged, the departures from MFW were many and varied, but there’s one aspect in particular I want to focus on, namely, the curious role of the “stockholder volunteers.” After months of negotiation, the special committee reached a deal with the company that met with immediate objection from Class V stockholders. Rather than go back to the committee, Dell instead started negotiating directly with a selection of six large investors until a new deal was struck. At least according to the plaintiffs, the committee perfunctorily approved the revised deal, and it was that deal that was finally presented to the stockholders generally for their vote. When Class V shareholders sued, Dell argued that the committee-plus-stockholder negotiations were sufficient to satisfy MFW. In their view, this set up presented the best of all worlds: independent committee protection with direct input from sophisticated shareholders bargaining in their own interests.
Laster disagreed. He observed that corporate directors are the ones charged with protecting shareholder interests, and that task cannot be delegated to individual shareholders who have no fiduciary obligations to the company and do not have the information available to insiders. In so doing, he cited several academic articles (including, umm, one of mine, Shareholder Divorce Court) discussing how individual shareholders have private interests that may not match those of the shareholders collectively.
It was this portion of the opinion that Stephen Bainbridge highlighted as endorsing his “director primacy” theory, which posits that shareholders have a very subordinate role in corporate managerial decisionmaking, even in the context of large transactions.
The part that I’m interested in, however, is Laster’s attention to the varying incentives of even the “disinterested” stockholders. That’s what I was discussing in Shareholder Divorce Court, namely, how large institutional shareholders are likely to have cross-holdings that affect their preferences, and lead them to favor nonwealth maximizing actions at a particular company if they benefit the rest of the portfolio (after the article was published, I posted about additional empirical work in this area here). Laster has historically been especially sensitive to these kinds of conflicts. He authored In re CNX Gas Corp. S’holders Litig., 4 A.3d 397 (Del. Ch. 2010) (which I highlight in Shareholder Divorce Court), where T. Rowe Price was found to be “interested” for cleansing purposes because, across its mutual funds, it held stock in both a target and the acquiring company. Laster also wrote the opinion in In re PLX Tech. Stockholders Litigation, 2018 WL 5018535 (Del. Ch. Oct. 16, 2018), which I discussed here, where he concluded that a hedge fund’s “short-term” outlook caused its interests to differ from the other shareholders (even though those other shareholders had voted to put the hedge fund’s representatives on the company’s board). In his Dell opinion, Laster mentions another relevant type of cross-holding, namely, the distinction between investors who own both debt and equity, and investors who own equity alone.
The problem, though – as I discuss in Shareholder Divorce Court and What We Talk About When We Talk About Shareholder Primacy– is that if you’re going to recognize the heterogeneity of shareholder interest due to these different types of portfolio-wide investments, it’s unclear why a majority vote should be permitted to drag along the minority in a particular deal. Which conflicts will we recognize as generating bias, and which will we ignore? That’s the problem that cases like Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015) and MFW are forcing Delaware to confront. Laster’s far more willing to engage here; so far, other judges have, umm, avoided the issue. For example, Laster cites In re AmTrust Financial Services, Inc. Shareholder Litigation, 2020 WL 914563 (Del. Ch. Feb. 26, 2020), where a controller negotiated directly with Carl Icahn when it seemed shareholders were unlikely to approve a deal endorsed by the special committee, but, as Laster notes, Chancellor Bouchard refused to decide whether such actions forfeited MFW protection. Similarly – as I wrote about in Shareholder Divorce Court – VC Slights, entertaining a stockholder challenge to Tesla’s acquisition of SolarCity, failed to reach the question whether institutions like BlackRock who owned shares in both entities counted as “disinterested” votes for Corwin purposes.
In practical effect, it seems, Laster is less about director primacy than judicial primacy, in a way that often puts him at odds with other members of the Delaware judiciary. (See, e.g., my discussion of Salzberg v. Sciabacucchi, and the differing views of the nature of the corporation expressed by Laster and the Delaware Supreme Court). Because once you hold that shareholders are too biased to make decisions, that doesn’t necessarily lead to director primacy; instead, it creates more space for the judiciary to step in to protect the interests of the abstract notion of shareholder, distinct from the ones who actually cast ballots. Or perhaps, we should call it state primacy. Which was the point of my post last week (as well as the thesis of my post about the PLX case and my What We Talk About When We Talk About Shareholder Primacy essay. I do have a theme).
And that segues nicely into - happy July 4th, and the birth of the American government!
Saturday, June 27, 2020
The Department of Labor has been a busy bee.
First, it approved the use of private equity investments in 401(k) plans. The idea would be that workers would be able to invest in funds that invest in private equity funds; apparently, some funds are already on offer, and they also hold a small amount of publicly traded stock to satisfy liquidity concerns. Jay Clayton at the SEC endorsed the move, saying it would “provide our long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds as well as the benefit of selection and monitoring by ERISA fiduciaries.”
Second, the DOL proposed new rules to discourage the use of ESG investing with respect to ERISA-regulated retirement plans (and because many state pension funds are not covered by ERISA but follow its lead, the rules could extend much further). The proposed rules are not exactly a surprise; they follow guidance that the Trump Administration put out in 2018, and which I blogged about at the time. And – as I also blogged– in 2019, the Administration warned the DOL was continuing to examine the issue with a view to more action on this front.
So what are the implications?
First, though the private equity rules are championed by those who argue they will allow retail investors access to higher profits, it’s ironic that they come just when a new study shows that private equity investments are no more profitable than public markets, and almost concurrently with a new SEC warning of pervasive conflicts in the private equity industry that lead to hidden fees and unequal allocation of investment opportunities. Institutional investors in private equity funds have long complained to the SEC of the lack disclosure of these matters, and rather than respond to that, we’re apparently … going to open the 401(k) spigot. That, I think, will make private equity managers less accountable to investors and the public (why bargain with a union pension fund when you’re getting billions from a bunch of different funds layered through so many intermediaries that no one’s able to monitor things?) and more opaque.
Second, as I’ve talked about before, ESG can have a bunch of different meanings. Some use it as a stockpicking technique like any other, on the theory that socially responsible companies are valuable companies. Others use it for moral/impact reasons; they are willing to sacrifice at least some returns in order to adhere to their ethical commitments. When it comes to ERISA plans, the past several presidential administrations have all agreed that fiduciaries must only use ESG to advance the economic interests of plan beneficiaries; they are not permitted to use beneficiaries’ money to advance unrelated social goals. What’s been different over the years, however, is the standard of proof that fiduciaries must meet in order to incorporate ESG factors into their decisionmaking. The new rule imposes a very high standard, by explicitly directing that fiduciaries using ESG analysis “examine the level of diversification, degree of liquidity, and the potential risk-return in comparison with other available alternative investments that would play a similar role in their plans’ portfolios.” That requirement, unique to ESG, betrays a deep distrust of ESG investing, and will very likely dissuade at least some fiduciaries from engaging in ESG activity at all for fear of being unable to adequately justify their decisionmaking. And, critically, the rule does not merely apply to buying and selling securities; it also applies to other types of plan administration, including voting and engagement decisions. Which means, among other things, it targets union involvement with shareholder proposals.
It’s worth pointing out that the US’s approach here is precisely the opposite of the European approach, where the default assumption is that ESG factors should be considered as a part of prudent asset management. Recently, the SEC Investor as Owner Subcommittee recommended that the SEC “begin in earnest an effort to update the reporting requirements of Issuers to include material, decision-useful, ESG factors,” and part of the rationale was that the US risks letting other jurisdictions set the pace on these issues. The DOL’s proposed rule, I believe, will only accelerate the process of ceding leadership to the European Union.
Notably, in recent years, several commenters have pushed institutional investors to look beyond simple financial returns and consider to the overall welfare of their human beneficiaries when making investment decisions. David Webber has argued that pension funds should be able to allocate dollars in a way that benefits labor and unionization, Nathan Atkinson has argued that institutional investors should be mindful of the overall interests of their clients (as consumers, employees, etc), and former Chief Justice Strine has argued that institutional investors should concern themselves with the health and welfare of their human beneficiaries when casting proxy votes (the latter piece with Antonio Weiss). The proposed DOL rule would put the kibosh on that, at least for ERISA plans, explicitly mandating that plan fiduciaries evaluate “investments and investment courses of action based solely on pecuniary factors that have a material effect on the return and risk of an investment based on appropriate investment horizons and the plan’s articulated funding and investment objectives…”
The new rule also discourages including ESG funds in 401(k) plan menus. If the rule takes effect, ERISA fiduciaries would only be permitted to include such funds if they are chosen for their financial returns, with a special requirement that they document their reasoning. Those special recordkeeping requirements, of course, will make it difficult to include ESG funds in 401(k) plans at all. According to the DOL release, there aren’t many 401(k) plans that offer ESG investments now – maybe 9% of them do – but ESG funds are a growing segment of the market and there has been a lot of advocacy to expand 401(k) ESG offerings. This rule, if enacted, will likely dampen that effort. More broadly, it could discourage the development of any ESG funds, because these funds would be functionally unavailable both to 401(k) plans and to ERISA-covered pension plans. Notably, the rule has a capacious definition of ESG – it encompasses any fund that includes “one or more environmental, social, and corporate governance-oriented assessments or judgments in their investment mandates … or that include these parameters in the fund name” – so the rule’s knock-on effect may be to dissuade mutual funds from considering these factors at all (or at least mentioning them in their prospectuses). Which is significant, given that Larry Fink has said that he plans to “mak[e] sustainability integral to portfolio construction” in BlackRock funds.
The DOL rules, then, are of a piece with new SEC proposals to limit shareholder use of 14a-8 and expand retail access to private offerings. The rules, collectively, favor minimizing corporate accountability to investors and the general public in favor of opacity and unfettered management discretion. And the Administration seems to be encouraging short-term business models – private equity – over the long-term risk mitigation strategy of ESG, which is odd, because as I previously blogged, the Administration, like a lot of Delaware caselaw, has explicitly stated that the purpose of the corporation is to maximize long-term shareholder welfare.
(That said, it appears the Chamber of Commerce objects to the ESG proposal, on the ground that the recordkeeping requirements may prove a tempting target for plaintiffs raising fiduciary duty claims, and with that kind of opposition, we may see some changes before a formal enactment.)
Stepping back, it should be obvious none of this has anything to do with investor choice. The true tell is the rule regarding ESG fund inclusion in 401(k) plans. As I said the first time I blogged about this issue:
It’s all well and good to require that ERISA fiduciaries act solely in the economic interests of beneficiaries, on the assumption that this is what beneficiaries would likely want, and on the assumption that wealth maximization functions as “least common denominator” for beneficiaries’ otherwise conflicting interests.
But this reductionistic approach to defining beneficiary interests, adopted for the purpose of making them more manageable, should not stifle opportunities to accommodate the actual preferences of beneficiaries, especially when it is feasible to allow beneficiaries to sort themselves – like, say, when ESG-focused funds can be made available to those beneficiaries who are willing to sacrifice some degree of financial return to advance social goals. Providing these opportunities to beneficiaries who choose them inflicts no damage on the interests of beneficiaries solely interested in financial return, and, in fact, the principle that investors should be able to control their own retirement planning is (supposedly) the reason these types of ERISA platforms are offered in the first place.
The new guidance, then, seems less about protecting beneficiaries from politically-motivated fiduciaries than it is about forcing beneficiaries to participate in the political goals of the Trump administration, namely, minimizing shareholder participation in corporate governance, particularly when those shareholders advance (what are usually) liberal policy priorities.
To be sure, we don’t have a whole lot of funds that openly advertise their plan to sacrifice returns in favor of social goals; it’s a real issue that funds billing themselves as “ESG-focused” are not clear about their strategies, and that’s something the SEC is legit investigating. But assuming we can get full disclosure, and there is a demand for such funds, the DOL is dictating the choices of millions of investors, many of whom will have no other exposure to the market.
Which brings me to my main point, which is, all of these proposed changes simply highlight that it is inaccurate to the point of absurdity to describe the American corporate governance system as “private law.” State choices dictate the build of the business form, its accessibility to the public, the structure of investors themselves, and their preferences when allocating capital. That’s the thesis of my latest Essay, Beyond Internal and External, which argues that corporate governance is subject to pervasive regulation in a manner that directly effectuates public policy. If we’re going to have the state make these kinds of choices, we should at least own them, rather than cloak them in the language of “private ordering.”
Saturday, June 20, 2020
I drafted this post before, well, the SEC got dragged into the middle of an SDNY meltdown and that’s obviously way more interesting than what I was going to say, but I have this whole post already here so... here goes.
One of the big business news stories of the past week has been Hertz and its failed stock offering. (N.B.: Well, it seemed like a big deal when this post was originally drafted)
During the pandemic, stock markets have gyrated wildly, apparently driven in part by retail traders who, left without the opportunity to bet on sports, have turned to trading as an alternative form of gambling. They’re apparently encouraged by free trading apps and especially Robinhood, which – unlike other platforms which treat trading as srs bzns– gameifies the experience. As one trader put it, “With sports, if I throw $1,000 at something, I lose the whole thing real quick, but here if things go south you can cut your losses.”
That particular theory was sort of tested when it came to Hertz, which is in bankruptcy. Despite that fact, its stock started to climb, in what has been described as the equivalent of a Jackass sketch. Everyone understood there was almost no chance of the company actually generating value for shareholders, but the coordinated attention acted as something of a combination dare, Ponzi scheme, market manipulation, and performance art.
Hertz tried to take advantage of it all by selling new stock, figuring hey, this might be an easy way to pay off its creditors, and that all by itself seems to have burst the bubble; traders weren’t expecting anyone to take them seriously. But the plan was scotched when the SEC raised questions about the sufficiency of Hertz’s prospectus disclosures.
We are in the process of a reorganization under chapter 11 of title 11, or Chapter 11, of the United States Code, or Bankruptcy Code, which has caused and may continue to cause our common stock to decrease in value, or may render our common stock worthless.
And also here:
The price of our common stock has been volatile following the commencement of the Chapter 11 Cases and may decrease in value or become worthless. Accordingly, any trading in our common stock during the pendency of our Chapter 11 Cases is highly speculative and poses substantial risks to purchasers of our common stock. As discussed below, recoveries in the Chapter 11 Cases for holders of common stock, if any, will depend upon our ability to negotiate and confirm a plan, the terms of such plan, the recovery of our business from the COVID-19 pandemic, if any, and the value of our assets. Although we cannot predict how our common stock will be treated under a plan, we expect that common stock holders would not receive a recovery through any plan unless the holders of more senior claims and interests, such as secured and unsecured indebtedness (which is currently trading at a significant discount), are paid in full, which would require a significant and rapid and currently unanticipated improvement in business conditions to pre-COVID-19 or close to pre-COVID-19 levels. We also expect our stockholders’ equity to decrease as we use cash on hand to support our operations in bankruptcy. Consequently, there is a significant risk that the holders of our common stock will receive no recovery under the Chapter 11 Cases and that our common stock will be worthless.
Note how these disclosures were reported in the media:
This does not, in short, seem like a disclosure problem at all. And that means there’s a lot to think about.
First, there have been a lot of comparisons to the dot com bubble, and I agree, but in a very specific way. The internet bubble featured anonymous commenters who’d engage in pump-and-dumps – recommend a stock, watch everyone pile in, and sell out – but it wasn’t necessarily the case that anyone was fooled. People used the comments as a coordinating mechanism – which stock they’d all buy now – and play musical chairs to see who could make money and cash out before the crash. That’s how Donald Langevoort viewed the SEC’s case against Jonathan Lebed, anyway, and it definitely is an element of what’s happening here. (See this article about a website devoted to tracking Robinhood trades). So all that raises the question of how much transparency markets can really bear. (Cf. Matt Levine, writing about a different kind of transparency, in Too Much Information Can Be Bad)
Beyond that, the SEC’s interference betrays a rather surprising lack of faith both in market efficiency and investor autonomy, and thereby illustrates the SEC’s Janus-faced (heh) approach to investor protection. Recently, the SEC has been fairly aggressive in its insistence that disclosure is a cure-all, that markets are efficient and no one needs to be told anything twice, and that retail investors should have more access to private capital. At the same time, the SEC has resisted and denigrated the demands of actual investors regarding the types of information they need to make intelligent decisions. And now, apparently, the SEC is willing to step in to save Hertz investors from themselves – even when they act with full disclosure on a widely traded, exchange-listed (for now), stock. It seems the SEC has complete faith in efficient markets and investor wisdom, except when it doesn’t.
Another aspect of this story has to do with market efficiency in – as William Fisher once put it – “a time of madness.” As I said, it wasn’t just Hertz; there have been reports of retail traders playing stocks like a roulette wheel and even manipulating prices for the lulz. There have also been several securities fraud lawsuits filed since the lockdowns, particularly ones pertaining to the coronavirus. These are fraud-on-the-market cases, and they depend at least on market informational efficiency, if not fundamental value efficiency, which implies some amount of rationality. Will the evident irrationality of markets at this time affect the plaintiffs’ ability to certify a class?
It’s not an entirely crazy question; there is some precedent for courts treating market irrationality as evidence of inefficiency. See In re Initial Public Offering Securities Litigation, 260 F.R.D. 81 (S.D.N.Y. 2009) (“there is insufficient evidence of efficiency to permit the use of the Basic presumption with respect to trading during the quiet periods. To the contrary, the evidence indicates that the quiet periods were marked by chaotic pricing, irrational purchases, and market inefficiencies. [Plaintiffs’] own evidence demonstrates that the markets for the focus case shares were inefficient during the first weeks of trading. A purchaser of these securities during the relevant quiet period could not reasonably rely on the market price to reflect the market’s judgment of the security’s value. Therefore, the Basic presumptions cannot apply to these periods.”)
That said, the Supreme Court’s Halliburton v. Erica P. John Fund, 573 US 258 (2014), may have established a more forgiving standard for evaluating market efficiency, so we shall see.
But my final observation is this: All of this is kind of hilarious until you read these kinds of stories, where some 20-year-old Robinhood trader may have killed himself because he – mistakenly – believed he’d lost $700K. Additionally, the Twitterati is ablaze with anecdotal reports of teens and even pre-teens trading stocks in Robinhood, treating it as an alternative to Fortnite – and I can’t wait to see what happens if those kids are trading on margin. Now, Robinhood purports to require that accountholders be at least 18, so we have a bunch of questions: (1) are there really a bunch of children trading, or are those isolated examples no matter what Twitter says?; (2) are parents are intentionally giving their kids access to brokerage accounts, or are children just lying their way in?; and (3) just how robust are Robinhood’s age and suitability checks? Robinhood has now promised to improve its interface regarding options trading, to consider “additional criteria and education for customers seeking level 3 options,” and to, umm, make a “$250,000 donation to the American Foundation for Suicide Prevention.” So, yay?
Monday, June 15, 2020
The full schedule for the 2020 National Business Law Scholars Conference, which is being hosted on Zoom Thursday and Friday of this week, is now available. You can find it here. If and as additional changes are necessary, we will re-post.
As is always the case, the conference includes folks presenting work in a variety of areas of business law. These traditional paper panels are the heart of the conference. In addition, as I noted in my post last week, we are including three plenary sessions--one on "Business Law in the COVID-19 Era," one reflecting on teaching business law in the current environment, and one on current bankruptcy law and practice issues. There is something for almost everyone in the business law space in the conference program.
I am pleased and proud to note that several of my fellow bloggers from the Business Law Prof Blog are participating in the conference this year. They include (in addition to me): Colleen Baker, Ben Edwards, Ann Lipton, and Marcia Narine Weldon. I hope many of you will join us for all or part of the program and offer comments to colleagues on and relating to their work.
Thursday, June 11, 2020
So, this week we’re back to litigation-limiting corporate constitutive documents.
Where we last left things, the Delaware Supreme Court held in Salzberg v. Sciabacucchi, 2020 WL 1280785 (Del. Mar. 18, 2020), that Delaware law permits corporations to adopt charter provisions that would require plaintiffs bring Securities Act claims in a federal, rather than state, forum. I posted about that decision here, and argued that it left a number of unanswered questions about its application.
This week, we’re beginning to see the fallout.
In Seafarers Pension Plan v. Bradway, the plaintiff brought a derivative Section 14(a) action against the Boeing Company in the Northern District of Illinois. Plaintiff alleged that the company proxy statements contained false statements pertaining to the development of the 737 Max, and via these false proxy statements, defendants solicited shareholder votes in favor of their own reelection and compensation.
Boeing moved to dismiss on the ground that its bylaws provided that Delaware Chancery Court would be “the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the Corporation,” as well as the sole forum for “any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of the Corporation to the Corporation.”
Significantly, because Section 14(a) claims cannot be brought in Delaware Chancery – federal courts have exclusive jurisdiction – Boeing’s argument meant that the plaintiff would not be able to maintain its suit at all. As a result, the plaintiff argued that application of the bylaw to this lawsuit necessarily ran afoul of 15 U.S.C. § 78cc, which prohibits prospective waivers of 1934 Act obligations.
A parallel case, Chopp v. Bradway, 20-cv-00326-MN, involving derivative claims under Section 10(b), was filed in the District of Delaware. Boeing made the same arguments in favor of dismissal in that case as well. (Section 10(b) claims, like Section 14(a) claims, can only be brought in federal court). The plaintiff voluntarily dismissed that action before a decision could be reached, leaving only Seafarers.
On June 8, the Seafarers court agreed with Boeing and dismissed the derivative Section 14(a) claims. See Seafarers’ Pension Plan v. Bradway, No. 27, 19-cv-08095 (N.D. Ill. June 8, 2020). The decision is not currently available on Lexis or Westlaw though I assume it will turn up eventually.
[More under the jump]
Friday, June 5, 2020
This has not exactly been a week of great productivity on the subject of corporate governance theory
So instead, I’ll just say, like my co-blogger Stefan who posted yesterday, I’ve also been paying attention to corporate responses to protest movement. Because we’re both talking about that subject, I’ll just start by quickly reproducing the links that I gave Stefan in my comments on his post:
And one I forgot to add:
Anyhoo, as I said, I’ve been watching how corporations are responding, but unlike Stefan, I haven’t perceived silence at all - quite the opposite. But, what corporations are saying is interesting. These are the articles that captured my attention:
Corporate Voices Get Behind ‘Black Lives Matter’ Cause (“Some companies were more cautious in their approach. Target, which is based in Minneapolis and was hit by looting at a store there last week, described ‘a community in pain’ in a blog post but never mentioned the word ‘black.’”)
What CEOs Said About George Floyd’s Death (“Few companies talked about law enforcement or other forms of authority. Dell Technologies Inc. was the only company to use the words ‘police brutality.’”)
Adidas Voices Solidarity While Closing Its Stores (“Companies like Adidas and Nike have long paid black entertainers and athletes to pitch their products, and it is often black teenagers in the country’s largest cities who determine which brands are fashionable and subsequently sell big in the white suburbs. This is a particular bone of contention for black employees at Adidas…”)
#BlackoutTuesday: A Music Industry Protest Becomes a Social Media Moment (“Beyond the confluence of hashtags, some in the music industry questioned what was being done beyond promises for reflection and general statements of support.”)
‘Blackout Tuesday’ Prompts Debate About Activism and Entertainment (“Other celebrities voiced skepticism over the efforts and concern that it would dilute more urgent forms of activism.”)
Silent No More on Race, America's CEOs Fumble for Right Words (“Unlike syrupy messages in support of nurses and essential workers fighting the coronavirus pandemic or a call for unity after 9/11, there is no happy medium for a position on white privilege.”)
Brands Have Nothing Real to Say About Racism (“Facebook and Citibank weighed in, as did the gay dating app Grindr and even the cartoon cat Garfield.”)
Ben & Jerry’s pointed call to ‘dismantle white supremacy’ stands out among tepid corporate America statements (N.B.: take a moment to absorb that this article appears in the Washington Post Food section)
People On Nextdoor Say The Platform Censored Their "Black Lives Matter" Posts (“while the company may be officially saying that it supports the Black Lives Matter movement, this week, many of its volunteer moderators took a contrary position, stifling conversations about race, police, and protests while removing comments and postings with the very phrase the company had tweeted just three days ago.”)
Venture firms rush to find ways to support Black founders and investors (“Black entrepreneurs and investors are questioning the motivations of these firms, given the weight of evidence that shows inaction in the face of historic inequality in the technology and venture capital industry.”)
SoftBank launches $100M+ Opportunity Growth Fund to invest in founders of color (“Just a couple of weeks ago, the CEO and founder of one of its portfolio companies, Banjo, resigned after it was revealed that he once had ties to the KKK.”)
For more equitable startup funding, the ‘money behind the money’ needs to be accountable, too (“Consider that already, most VCs today sign away their rights to invest in firearms or alcohol or tobacco when managing capital on behalf of the pension funds, universities and hospital systems that fund them. What if they also had to agree to invest a certain percentage of that capital to founding teams with members from underrepresented groups?”)
A statement from [Brand]® pic.twitter.com/XT9tXF9hvz— Chris Franklin (@Campster) May 31, 2020
I’ll finish by noting that however tepid, many of the corporate statements do explicitly reference Black Lives Matter. And since even that sentiment was considered controversial a few years ago, we can safely conclude that the needle has moved.
Saturday, May 30, 2020
Sometimes I blog in ways that ignore the chaos of our current political moment. This is not one of those times.
Both as a corporate governance scholar and an American citizen, I’ve spent the last few days riveted by Twitter’s decision to go to war with the President of the United States.
And it was a decision; after Twitter posted its first fact-check of a Trump tweet, its VP of Global Communications said, “We knew from a comms perspective that all hell would break loose.”
All hell did. Trump responded with an executive order (whose legal effect is, ahem, questionable), and Twitter’s stock price plummeted. But Twitter doubled-down, hiding a Trump tweet for glorifying violence, and doing the same when the White House twitter account repeated the same quote.
We’ve talked a lot here about corporate political stances, and – especially in the context of Nike and Colin Kaepernick -- how despite appearances, they’re often justifiable on a theory of shareholder value maximization.
A similar argument could be made about Twitter’s conduct. It has come under increasing pressure to control its platform; trolls and bots and harassment by some users have driven away others. Trump’s tweets about Joe Scarborough specifically led to a torrent of criticism, essentially begging Twitter to hold Trump to the same standards as any other user. Twitter’s efforts to impose discipline – on any chaos agent, including the President – could easily be viewed as part of a larger strategy to ensure that the platform remained usable for everyone else. Merely choosing to join battle may attract users and attention, which is Twitter’s main asset.
At the same time, Twitter’s actions here feel different. They feel like an recognition of civic responsibility, to keep political discourse civil and truthful, regardless of whether that is the most profitable course for the company.
The Wall Street Journal recently reported that Facebook dropped its own initiative to minimize polarization and political falsehoods on its platform, in part because “some proposed changes would have disproportionately affected conservative users and publishers, at a time when the company faced accusations from the right of political bias.” Shira Ovide, commenting in the New York Times, wrote, “If Facebook made these decisions on the merits, that would be one thing. But if Facebook picked its paths based on which political actors would get angry, that should make people of all political beliefs cringe….there should be a line between understanding the political reality and letting politics dictate what happens on your site.”
That’s such an odd statement. Facebook isn’t a state actor, it’s a private company, and a private company exists to benefit shareholders, which, among other things, may mean placating politicians – right?
And yet when these things come up, I often see people offering takes like these:
They’re wrong, but also – they’re kind of right, in the popular sense that large corporations often have public responsibilities and therefore the public demands their decisionmaking reflect public values.
But then there’s Scott Rosenberg’s view that Facebook’s hands-off policy is analogous to a government neutrally facilitating free speech, while Twitter is behaving more like a property owner trying to maintain order in its mall.
The flaw in Rosenberg’s analogy is that Facebook is not a neutral platform; the point of the Wall Street Journal piece is that Facebook’s own algorithms privilege certain types of speech over others in order to maximize user engagement – much like a mall owner who makes sure there are plenty of amenities on the property so no one ever leaves.
That said, I often experience this kind of gestalt switch when I think about corporate social responsibility; categorizing the behavior as privately oriented or publicly oriented is often simply a matter of perspective. Large corporations are, in fact, a hybrid of the two, a product of both public systems and individual choices. Which is why it’s so hard to put the conflict here into a neat little box.