Business Law Prof Blog

Zoom Procedure

When covid first hit and we were all in lockdown, a number of courts held proceedings virtually rather than live.  Since then, questions have been raised about how the technology should continue to be used, given that it may make courts proceedings easier for litigants and witnesses to attend, but may also make it difficult to question hostile witnesses and present documentary evidence, as Scott Dodson, Lee Rosenthal, and Christopher Dodson discuss when weighing the benefits and drawbacks of Zoom proceedings. 

There has not been a ton of empirical work on this (yet), but David Horton found that arbitrations conducted with at least one Zoom hearings resulted in worse outcomes for plaintiffs.  And Jill Gross at Pace recently posted an analysis of customer win rates in FINRA arbitration.  She found that early in the pandemic, customers who had at least one Zoom hearing fared substantially worse than customers who proceeded entirely live, though, as the pandemic wore on, the two became virtually indistinguishable.  At least one explanation might be that, over time, customers were able to choose “mixed” formats more easily, where only one or two witnesses appeared by Zoom and most were live, making the Zoom category of cases indistinguishable from live ones.  Another might simply be that customers had a Zoom learning curve.  Mostly, though, she finds customers in general fared worse during lockdown, regardless of how hearings were conducted.

One question I have about Zoom, however, concerns not just the original hearings themselves, but the standard of review when the outcome is appealed.  Not long ago, VC Laster issued an opinion reviewing the conclusions of Master Patricia W. Griffin.  Reviews of Masters in Chancery are de novo, and VC Laster wrote, “The trial was recorded so that a constitutional judge could review the proceedings de novo.”  Because it was de novo review, VC Laster, among other things, engaged in credibility determinations regarding witnesses (see op. at 5, 14), which he was able to do because he was seeing exactly what Master Griffin had seen.

Ordinarily, of course, a standard thing for appellate courts to say is that trial judges are in a unique position to determine the credibility of a witness.  They do so even when the standard of review is de novo, see, e.g., State v. Emery, 2011 WL 3795021 (N.J. Sup. Ct. App. Div Aug. 29, 2011), and standards of review often shift from de novo to something more deferential if the question turns on determinations of credibility, see, e.g., State v. Godwin, 2004 WL 3217722 (Tex. Ct App. July 22, 2004); Burton v. State, 2007 WL 1417286 (Del. May 15, 2007).  The fact that trial judges view witnesses live when appellate courts cannot is one reason for deferential review in the first place.

So my question is, if hearings are held by Zoom, and recorded (and there’s certainly no reason not to record), should appellate standards of review change?  Or, perhaps more relevantly, will they change sub rosa even if they don’t change formally?

There's no joking in securities law

I’ve previously blogged about confusion regarding Section 10(b)’s requirement that a false statement be made “in connection with” a securities trade, when the speaker is a subsidiary of the securities’ issuer.  We have a new entry in the genre in In re Volkswagen AG Sec. Litig., 2023 U.S. Dist. LEXIS 43031 (E.D. Va. Mar. 14, 2023).

This case concerns Volkswagen’s stupid joke from two years ago where it announced that it was changing its name to “Voltswagen,” which roiled the stock for a couple of days until the company admitted that it was just kidding.  An equally stupid securities fraud lawsuit naturally followed, resulting in what is actually a fairly baffling dismissal.  Because whatever one thinks of the claim or its merits, the legal reasoning matters, not just for this case but for future cases. 

The setup:

Volkswagen is a German company, and its stock is not listed on a U.S. exchange.  Its “unsponsored” ADRs trade in the U.S. 

VWGoA is Volkswagen’s American subsidiary.  It is wholly owned by Volkswagen.

The original press release announcing the name change came from VWGoA and its officers, who posted it to the VWGoA website on March 29, 2021.  The press release was taken down, but news media got wind of it, and it popped back up again on March 30, 2021, including quotes from VWGoA’s CEO.  A Volkswagen twitter account – apparently controlled by VWGoA – also announced the change.  VWGoA’s Head of Technology confirmed the story to the Associated Press.  By the close of business on March 30, though, the press release was gone again, and the WSJ was reporting that it was all a joke.

The price of ADRs fell in response, and investors filed a Section 10(b) lawsuit against Volkswagen, VWGoA, VWGoA’s CEO, and VWGoA’s Head of Technology.

In dismissing the complaint, the court actually took the claims seriously, and conducted a thorough analysis of some of the knotty issues concerning Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010), but I think its reasoning faltered when it came to the ultimate holding.

The first issue: did plaintiffs allege a “domestic transaction” for Morrison purposes?  In Stoyas v. Toshiba Corp., 896 F.3d 933 (9th Cir. 2018), the Ninth Circuit held that if the ADRs are traded in the U.S., transactions in them are domestic for Morrison purposes.  If they are unsponsored – the subject company truly had no involvement in their creation – there might be a question whether the subject company’s false statements are made in connection with a domestic transaction, but the transaction itself remains domestic and subject to U.S. law.

The Volkswagen court followed this reasoning, and concluded that the plaintiffs’ ADR purchases were domestic.  (Recently, the district court in Toshiba held that even a domestic ADR purchase might be treated as “foreign” if it involved the creation of a new ADR via an overseas purchase of the underlying shares, Stoyas v. Toshiba Corp., 2022 WL 220920 (C.D. Cal. Jan. 25, 2022), but the Volkswagen court questioned that reasoning, see op. at *32 n.8, and in any event, found that such determinations were inappropriate on a motion to dismiss). 

So. Domestic purchase.

Next, the court turned to the potential liability of the Volkswagen parent.  And here, the court employed Janus Capital Grp., Inc. v. First Derivative Traders, 564 U.S. 135 (2011) to hold that the plaintiffs had not alleged sufficient facts to show that Volkswagen had exercised “ultimate authority” over the statements issued by VWGoA; therefore, Volkswagen had not “made” a statement for Janus purposes.

I mean, I could go on a riff about the artificiality of treating Volkswagen as distinct from its wholly-owned subsidiary, which the court recognized as being completely under the control of its parent, but the court gave the plaintiffs leave to replead on this and I’ll skip it. 

That left the liability of VWGoA and its officers.  The court agreed that the officers had acted at least recklessly when issuing the press release, their scienter could be attributed to VWGoA, and that plaintiffs had established materiality and loss causation. 

So, the court turned to the defendants’ arguments that, because the ADRs were unsponsored, any statements by VWGoA were not made “in connection with” ADR transactions.

The court first held that, given the relationship between the subsidiary and the parent, the statements by VWGoA were not so attenuated from securities of Volkswagen as to eliminate 10(b) liability.  Op. at *67. 

The court next held that, while it was possible that statements about underlying securities may not be made “in connection with” unsponsored ADRs, in this case, plaintiffs had sufficiently alleged that Volkswagen had had some approval power/involvement with the creation of the ADRs, such that statements about Volkswagen stock would also be “in connection with” its ADRs.  The court thus concluded, “because Plaintiffs have implicated a specific depositary institution, which has publicly confirmed it requires the approval of the foreign issuer prior to launching an unsponsored ADR program, Plaintiffs’ allegations provide a plausible basis that the alleged misstatement ‘touches’ or ‘coincides’ with ‘the purchase or sale of any other security in the United States.’” Op. at *70-71.

Finally, the court held that the statements themselves were distributed in a medium on which investors would rely: “Plaintiffs have adequately averred that VWGoA publicly disseminated a press release on multiple occasions and that such announcement was material. Not only did the announcement itself detail an upcoming significant rebranding effort by the Company across North America, but it also generated a widespread public response.  Given the alleged seriousness with which the market perceived the name change, it is entirely reasonable that investors would have relied upon the press release.” Op. at *71.

But did the claims against the VWGoA defendants survive?

They did not.  The court concluded:

This Court will not contravene Janus by holding that the statements of a non-publicly traded wholly-owned subsidiary and its employees may be actionable upon the parent issuer when the Amended Complaint fails to adequately plead that the alleged material misstatements may be attributed to the parent issuer. Without a plausible theory of liability ascribed to the issuer, Plaintiffs’ purchase or sale of Volkswagen ADRs cannot be said to “touch[]” or “coincide” with the alleged false statements of the Individual Defendants and VWGoA.

In sum, Plaintiffs have sufficiently alleged that Volkswagen continues to play an active role in the unsponsored ADR program and that it was reasonable for investors to rely upon those alleged false statements. But they have not sufficiently pleaded that the alleged false statements by the Individual Defendants and VWGoA “coincide” with or “touch[]” the ADRs purchased by Plaintiffs because the issuer of the underlying securities has not been shown to be liable under § 10(b).

Op. at *72-73.

I ... do not follow.  The court seems to be hung up on Volkswagen’s liability, when the question of the liability of VWGoA and its officers is distinct.  Why should VWGoA’s liability for false public statements turn on whether Volkswagen parent is liable?  We have three actors: VWGoA, its CEO, and its head of tech, all of whom, with scienter, made false statements about Volkswagen’s business – about, the court found, Volkswagen’s securities – in a medium on which investors would (and did) rely.  It’s now well-established – the court even says in its opinion, at *65-66 – that actors other than issuers can be liable for issuing fraudulent statements in connection with the issuers’ securities.  Analysts, auditors, brokers, all might lie about a company’s securities; the company may be entirely innocent, but that does not absolve the speaker.  If I adopt some kind of pseudonymous identity and go online and make false statements about a publicly traded security, I would surely expect the SEC to come after me, even if the issuer had nothing to do with it.  

Nonetheless, the court seemed to hold, that logic only extends to actors who are independent of the issuer.  It does not extend to actors who are related to the issuer, such as wholly owned subsidiaries.  Those speakers, uniquely, get a free pass.

In other words, VWGoA and its officers escape liability because there is both too much control by Volkswagen – it would contravene Janus to hold a controlled subsidiary liable for statements it actually made about its parent – and too little, because there was not enough control by Volkswagen to make Volkswagen the legal “maker” of the statements.

Notably, the court’s holding would seem to create an open season for subsidiaries to make false statements about parent companies – which is particularly bizarre because, earlier in its opinion, that’s exactly what the court wanted to avoid:

For purposes of standing, Plaintiffs’ fulsome allegations demonstrate the appropriateness of extending Rule 10b-5’s reach to securities of a parent company, when that parent company exercises substantial involvement over the day-to-day operations of a wholly-owned subsidiary alleged to have violated federal securities laws. If this were not so, issuers exercising such concrete control over their subsidiaries would never be legally responsible for the statements of their non-publicly traded wholly-owned subsidiaries. That would reward issuers with a scapegoat mechanism through their unlisted subsidiaries to avoid§ 10(b)’s remedial scheme.

Op. at *66-67. 

Yes!  I agree!  But still, the court says there’s no liability even for the subsidiary that made the statements, with scienter.

In any event, the plaintiffs have leave to replead (including to replead Volkswagen’s involvement in the whole thing), so we’ll see what happens.

Everything is a Security

This week, NYAG Letitia James filed a complaint against KuoCoin, a crypto exchange, for various violations of NY law, including running an unregistered commodities and securities exchange, and acting as an unregistered securities broker.

The allegations focus on three different crypto assets: Luna, TerraUSD, and Ether.  In particular, James claims that Ether is both a commodity and a security – the latter allegation necessary to support the claim that Kuo should have registered as a securities broker.

Now, as we all know, the SEC and the CFTC have generally taken the view that Ether is a commodity, not a security, but Ether’s shift to a proof-of-stake model has raised questions about whether Ether’s status should change under federal law.  James highlights the proof-of-stake model in her briefing in support of a petition for a permanent injunction against KuoCoin.  But more interestingly, she argues in the alternative that Ether is a security under New York State’s prehistoric Waldstein test, articulated in In re Waldstein, 160 Misc. 763 (Sup. Ct, Albany Cnty. 1936).  That test says a security is “any form of instrument used for the purpose of financing and promoting enterprises, and which is designed for investment.”

Waldstein has, according to Westlaw, been cited in a total of 32 cases since it was articulated in 1936, and in many of those cases, it’s mentioned but not really applied.  When it is applied, it seems to have been used in conjunction with Howey and/or Reves, and it seems courts often conclude that the instrument under consideration comes out the same way under all tests.  See, e.g., People v. Van Zandt, 981 N.Y.S.2d 275 (Sup Ct., Bronx Cnty. 2014); Xerox Corp v. New York State Tax Appeals Tribunal, 973 N.Y.S.2d 458 (App. Div. Third Dep’t 2013); People v. First Meridian Planning, 614 N.Y.S.2d 811 (App. Div. Third Dep’t 1994); All Seasons Resorts v. Abrams, 68 N.Y. 2d 81 (1986).  But this time, James is using Waldstein in a manner that (might) diverge from how at least federal agencies have interpreted Howey, which begs the question whether New York courts will hold that Waldstein and Howey are different, and/or that Waldstein is still good law.  Mostly, though, this is a lesson for my students that though we focus on Howey and Reves in class, states can have entirely different definitions of what counts as a security for the purposes of state regulation.

Much Ado About Nothing

After VC Laster held that officers have Caremark duties, and can be the subject of derivative suits for violating them, there was a flurry of commentary to the effect that this would radically expand legal liability, open corporate officers up to a host of new lawsuits, and generally represented a bold new direction in Delaware law.  Now, of course, he’s done what was the most predictable thing in the world: He dismissed the claims on grounds of demand futility.   Which demonstrates there was nothing radical – or even particularly new – about his opinion originally.

So, the backstory:

The McDonald’s plaintiffs alleged that the directors of the company, its CEO, and its “Chief People Officer,” David Fairhurst, created and/or ignored a culture of pervasive sex discrimination and sexual harassment.  Fairhurst in particular was alleged to have done nothing about employee reports of harassment, to have tolerated a culture where employees feared reporting harassment, to have cultivated a “party atmosphere” that encouraged harassment, and ultimately to have engaged in sexual harassment himself.  Matters were so bad that there were coordinated EEOC complaints, nationwide employee walkouts, and inquiries from U.S. Senators.

On January 26, VC Laster held that if the allegations were true as to Fairhurst, then Fairhurst had violated his fiduciary duties to the corporation under Caremark by failing to identify the problem, attempt to redress it, and report matters to the board.  Fairhurst also violated his duties by personally engaging in illegal conduct – harassment – for his own benefit.  

On March 1, VC Laster issued a second opinion dismissing all claims against the directors on grounds of demand futility, with an additional order that claims against Fairhurst were also dismissed on demand futility grounds (that order is available on the docket, but is not currently on the court’s public website).

So, when it comes to the claims against Fairhurst, which were the ones that inspired the handwringing, it’s important to distinguish two separate issues which were collapsed in some of the reporting.  One is, what were Fairhurst’s duties to his employer?  The other is, assuming he violated those duties, can shareholders bring lawsuits over it?

Starting with Fairhurst’s obligations, the main concern was about Caremark duties and whether VC Laster unduly expanded them.  Now, sure, there’s an ongoing larger debate about why we have Caremark duties and what their function is or should be – compare Stephen M. Bainbridge, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight with Elizabeth Pollman, Corporate Oversight and Disobedience – but in this case, I think the label “Caremark” obscured more than it illuminated.  Fairhurst was the human resources guy.  His literal function – his actual responsibilities, what he was hired to do – was to handle employee relationships.  The most basic aspects of his job were to ensure the company was complying with employment and labor laws, and generally to maintain a good or at least tolerable company culture.  And he, quite flagrantly, did not do his job.

Professor Bainbridge (no fan of Caremark liability in the first place), was particularly vexed that VC Laster’s opinion expanded Caremark duties to mere garden variety lawbreaking instead of “mission critical” lawbreaking.  I think that misapprehends the point of the “mission critical” label, and this is something that VC Laster elucidates in his March opinion dismissing claims against the director defendants.  “Mission critical” was intended to identify things that are important enough to the company that they deserve board-level attention, and, in particular, things where the board should be affirmatively setting up a reporting system even in the absence of notice of a problem.  I.e., “mission critical” is how we know whether it’s a Big Thing or a little thing, and we don’t expect board members to constantly monitor little things even before they become Big Things, because being a board member is only a part time gig.  “Mission critical,” in other words, is how we define the scope of the board’s non-delegable oversight duties at the outset.  It is how we define the board’s actual job.

But Fairhurst was an officer, not a board member, and he had a different job.  Even if I concede that avoiding sexual harassment would not have been “mission critical” for McDonald’s at the board level, it absolutely was “mission critical” for Fairhurst.  We can call it Caremark, but we can also call it Fairhurst’s job description.  When it came to Fairhurst’s sphere of authority, this was not a little thing, it was a Big Thing.  If Fairhurst had been charged with keeping the copiers supplied with toner, and he ignored that job, it also would have been “mission critical” for him.  Which is why, in the January opinion, VC Laster made clear that when it comes to officers, who (unlike board members) do not have responsibility for the whole company, Caremark duties are shaped by their particularized spheres of authority.  

After that, we are in Agency 101 territory, or, more specifically, Restatement (Third) of Agency § 1.01 territory, namely, that agents are fiduciaries who consent to act under the principal’s control.  I can’t think of an agency principle in the world more fundamental than that agents should not flagrantly ignore their assigned responsibilities. 

So, yes, of course, the Chief People Officer violated his fiduciary duties to the company when he decided that he just wasn’t going to do his job, resulting in – I cannot emphasize this enough – nationwide employee walkouts.  The only surprising thing about the whole mess is that, in the Year of Our Lord 2022 (when this was briefed), Fairhurst even made the argument that, as Chief People Officer, he had no duty to prevent sexual harassment, and further, that he expected a court would accept that argument and write it down and publish it where other people could see it.

But then there’s the next question, which is, if he did violate his duties, can shareholders be the ones to bring the lawsuit?  And on this, again, VC Laster got it exactly right, exactly the way I explain it to my students, and it surprises me that anyone could think otherwise. 

Namely, we all experience little torts every day.  Someone bumps into us on the street; a delivery is late, or wrong; the dry cleaner loses our clothes.  We (usually) make a decision not to sue over these things, because it would be expensive to do so, or time-consuming, or the tortfeasor is judgment proof, or a lawsuit would expose us to embarrassing discovery.  Instead, we handle matters other ways.  We lump it, or we complain to the manager, or we refuse to do business with the vendor again.  Companies are in the same boat – sure, they could sue every employee who makes a mistake or steals some petty cash, but sometimes, most of the time, it makes more sense to handle matters with a firing or some other form of internal discipline.  And boards are charged with making those decisions, just as they’re charged with other aspects of managing the company.

But occasionally, we don’t actually trust that boards can make that decision fairly.  When?  Well, most obviously, when the board members themselves were the tortfeasors.  But there might be other situations, such as when board members have close relationships with the tortfeasors.  In those scenarios, shareholders get to substitute their judgment for that of the board, and bring the lawsuit in the company’s name.  And that’s what a derivative lawsuit is.  Not every defendant in a derivative lawsuit is a board member, or even an officer – a while ago, for example, shareholders of HealthSouth brought a derivative lawsuit against the company’s auditor, on the ground that the auditor had breached its contract with the company by failing to catch all the accounting fraud.  See Ernst & Young, LLP v. Tucker ex rel. HealthSouth Corp., 940 So. 2d 269 (Ala. 2006).

The demand requirement of Rule 23.1 is how we sort out situations where we can and can’t trust the board to decide whether the company should bring a lawsuit – and that is how we ensure that imposing duties on corporate officers will not result in an explosion of liability, not by limiting their duties in the first place.  And that is exactly what happened in McDonald’s.  Fairhurst violated his duties to the company (and very possibly his employment contract).  That potentially triggered liability to the company, in the same way that any employee who abandons his responsibilities would be liable for damages caused.  But, ultimately, boards decide when a lawsuit is the most appropriate method of discipline, and VC Laster concluded that shareholders did not have a good reason to think that the board could not make that decision in this case.

That also takes care of another objection to VC Laster’s original ruling, namely, the part where he held Fairhurst violated his duties by engaging in sexual harassment personally.  Any agent violates their duties when they engage in misconduct; this is the kind of thing I teach in the beginning of a BizOrgs class.  The agent might also violate his employment agreement, behave negligently, or do any of a thousand other things that could trigger either contract or tort liability to his principal, just as Ernst & Young might have violated its contract with HealthSouth by conducting a negligent audit.  A finding that there is liability as between the employee (or the contractor) and the company is entirely unremarkable.  The rubber meets the road when it comes to what the principal decides to do about those things, and in particular, who makes that decision.  When that law changes, it’ll be notable.

I did a podcast!

Quick post today to mention that I did a podcast!  Evan Epstein of UC Law San Francisco hosts a regular podcast called "Boardroom Governance" for which he's interviewed everyone who has anything to do with corporate issues - academics, practitioners, board members, you name it.  Recently, he was kind enough to invite me for an interview.  It was a great discussion, covering everything from Twitter v. Musk (of course), to the McDonald's decision, to Sam Bankman-Fried, to public benefit corporations, to Domino's pizza.

You can give it a listen here (and at that link there's a handy index, if you want to jump to particular points).

Don't Say Anything

As you may be aware, a Disney shareholder, Kenneth Simeone, has filed a Section 220 action in Delaware Chancery seeking books and records pertaining to Disney’s announcement in early 2022 that it opposed Florida’s “Don’t Say Gay” law, HB 1557. 

Before the law was passed, Disney’s CEO, Robert Chapek, told employees that the company would not take a public position on the law.  That decision infuriated Disney employees, who, among other things, began staging walkouts in protest.  Ultimately, Chapek reversed course and publicly stated that Disney opposed the law.

In the wake of that announcement, Governor Ron DeSantis and the Florida legislature voted to dissolve Disney’s self-governed Reedy Creek Improvement District, although they later walked back their actions by maintaining the district but transferring control to Florida political appointees.  Chapek was fired by the board (likely for a host of reasons), and former CEO Robert Iger was restored to his old role.

Anyway, Simeone claims that he has a credible basis to suspect that Disney’s public opposition to the law was the result of mismanagement and breach of fiduciary duty.  In particular, he claims that Disney’s officers and directors may have put their personal political preferences ahead of shareholder interests, and that therefore he is entitled to further information to investigate.  Among other things, he seeks information about whether any of the directors are beholden to LGBTQ+ rights organizations, or whether they are beholden to directors who are.  The case is set for trial in Delaware, Simeone v. The Walt Disney Co., No. 2022-1120-LWW.

So, first, let’s just state the obvious: Disney facially had a legitimate business reason for its opposition to the law.  The company had become ungovernable, and silence was becoming a public relations nightmare.  That doesn’t mean Chapek handled things well or even competently, nor is it a statement about anyone’s true motivation; it’s simply that there was a patently legitimate reason for the about-face. 

What’s also obvious is that this 220 action was undertaken to punish Disney for expressing a (liberal) political opinion, and to deter other corporations from doing the same.   The difficulty from Delaware’s perspective is that, especially after AmerisourceBergen v. Lebanon County Employees’ Retirement Fund, the bar for obtaining books and records is very low.  The shareholder does not have to establish a viable claim for breach of fiduciary duty; investigating mismanagement is enough, if only because evidence of mismanagement might be used to run a proxy contest or otherwise communicate with other shareholders about further courses of action.  The shareholder does not have to articulate any particular plan of action after obtaining such evidence; in a mismanagement investigation, Section 220 does not require that shareholders identify the “ends” to which they might apply the materials.  And though courts have rejected demands in the past when there was reason to suspect the shareholders’ motivations were pretextual or based on personal political beliefs, the fact that a petitioner might harbor such beliefs does not itself undermine an otherwise-legitimate request for materials.  Therefore, it seems that Delaware Chancery will be in the difficult position of having to do three things simultaneously: Dismiss the action, without setting new standards that make legitimate claims difficult to bring, while also making clear that Delaware is not a forum for bullying companies that make political statements with which some segment of the public disagrees.

But there’s another insidious aspect to this dispute.  Simeone’s brief lays out a truly convincing case that DeSantis’s actions against Disney were explicit retaliation for its speech, in violation of the First Amendment.  And yet the legal argument Simeone makes is, to comply with their fiduciary duties and otherwise properly manage the company, Disney’s officers and directors should have anticipated unconstitutional action by the governor of Florida and modified their behavior accordingly.

And it gets worse.  Simeone is not, as far as I know, in any way affiliated with the State of Florida, but other investors are.  DeSantis has already implied he would manipulate Florida’s public pension funds into initiating litigation against any portfolio companies that anger him; imagine if he retaliated against a company for expressing opposition to him and then caused Florida’s own fund (or even funds sponsored by sympathetic states) to bring lawsuits claiming the company was at fault for bringing about the very harm his own administration inflicted.

That said, from a pure shareholder primacy/wealth maximization point of view, I’m not sure Simeone is wrong; Disney has no right even to stand up for its own freedom of speech, unless there is a business purpose for doing so.  Unless, of course, there’s a general public policy principle that corporate directors are not obligated to manage the company in anticipation of overtly unconstitutional action by U.S. government officials.

Another LLC/Employment case

As I've mentioned repeatedly in this space, I recently posted a new paper to SSRN: Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine, forthcoming in the Wake Forest Law Review.  The paper is about the uncertain boundary between matters subject to the internal affairs doctrine, and matters subject to ordinary choice of law analysis, and one of the issues I tackle concerns LLC agreements.  Specifically, LLCs have increasingly included employment provisions in their operating agreements, leaving Delaware courts in somewhat of a quandary as to whether the operating agreement is subject to the internal affairs doctrine - and thus Delaware law - or whether instead it should be treated as an employment contract, subject to ordinary choice of law analysis. (I also blogged about one such case here; as longtime readers are aware, stuff I muse on in blog posts often ends up in papers).

Anyhoo, this is why VC Will's new opinion in Hightower Holding LLC v. Gibson is so striking.  There, partners in a financial advisory firm sold their interests to Hightower, and were made LLC members and principals in Hightower.  The LLC agreement contained a noncompete clause and selected Delaware law; so did a separate "protective agreement" signed by the partners.  You can guess what happened next.  One partner quit and started a competing firm, and Hightower sued to stop him.  VC Will's opinion refusing to enjoin the partner is striking for what it does not do, namely, even so much as mention the internal affairs doctrine.  Instead, the opinion treats the entire dispute as an ordinary contractual matter, concludes that Alabama has the greater interest in the dispute notwithstanding the selection of Delaware law, and ultimately holds that the noncompetes are likely invalid. 

I don't disagree with that decision, of course, but the failure even to consider the role of the internal affairs doctrine sits uneasily alongside some of Delaware's other caselaw - and the meta issue is just how far we can go in treating LLCs like ordinary contracts for choice of law purposes.  If LLCs are not subject to the internal affairs doctrine and still manage to sail along just fine, how necessary is the internal affairs doctrine itself (often justified on the grounds that absolute chaos would result if it were abandoned)?

Statutory Sellers in the Age of Social Media

Section 12 of the Securities Act gives a right of rescission to purchasers of illegally unregistered securities, and purchasers of securities sold by means of a false prospectus. See 15 U.S.C. § 77l.  Although the right of action has existed since 1933, its exact contours have always been somewhat hazy.  But now, in the age of social media – with the potential for widespread promotion of unregistered and/or fraudulent investments (lately, cryptocurrencies) – interpretations of Section 12 are getting a work out, and the legal ground may be shifting.

So, the background.  Section 12 provides:

(a)In general

Any person who—

(1) offers or sells a security [without meeting registration requirements]

(2) offers or sells a security (… by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

shall be liable… to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

In Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court addressed what it means to be a “seller” under Section 12, such that one can be held liable.  First, one is a seller if one actually passes title to the subject security in a transaction with the plaintiff.  Remote sellers, i.e., persons who passed title back in a chain of sales that led to the sale to the plaintiff, are not liable.

Second, one is a seller if one “solicits” the sale to the plaintiff, even if the soliciting person did not actually pass title.  The Court explained that brokers, for example, or agents of the seller, can be held liable under Section 12, and the critical question is whether the soliciting person acted for his own financial gain, or the financial gain of the seller.  If the soliciting person was merely offering gratuitous advice to the buyer, however, he would not come within the scope of Section 12.  The Court rejected a test that would make liability turn on whether the defendant’s “participation in the buy-sell transaction is a substantial factor in causing the transaction to take place.”  As the Court put it, “§ 12's failure to impose express liability for mere participation in unlawful sales transactions suggests that Congress did not intend that the section impose liability on participants' collateral to the offer or sale.”  The Court further elaborated, “The ‘purchase from’ requirement of § 12 focuses on the defendant's relationship with the plaintiff-purchaser. The substantial-factor test, on the other hand, focuses on the defendant's degree of involvement in the securities transaction and its surrounding circumstances.”

This test for “seller” status under Section 12 is now known as the “statutory seller” requirement, and in the aftermath of Pinter, all courts agree that whether a plaintiff proceeds under Section 12(a)(1) – for unregistered securities – or 12(a)(2) – for false prospectuses, the seller requirement remains the same.

So, two routes to liability under Section 12.  Transfer of title – which is usually easy to spot – or solicitation.  But what is a solicitation?  In a bunch of cases interpreting Pinter, courts latched on to the “defendant's relationship with the plaintiff-purchaser” language to hold that statutory sellers must have direct contact with the plaintiff, or at least some kind of active relationship with the plaintiff, to become liable.  See, e.g., Holsworth v. BProtocol Foundation, 2021 WL 706549 (Feb. 22, 2021). This often came up in the context of registered offerings, where plaintiffs suing for false prospectuses were informed that participation in the preparation of offering materials is not “solicitation” for Section 12 purposes, unless there was some kind of direct relationship between the preparer and a particular purchaser.  Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996); Mass. Mut. Life Ins. Co. v. Residential Funding Co., LLC, 843 F. Supp. 2d 191 (D. Mass. 2012); Braun v. Ontrak, 2022 WL 5265052 (Cal. Super. Oct. 4, 2022); Citiline Holdings v. iStar Fin., 701 F. Supp. 2d 506 (S.D.N.Y. 2010); Rosenzweig v. Azurix Corp., 332 F.3d 854, 871 (5th Cir. 2003); Baker v. SeaWorld Entertainment, 2016 WL 2993481 (S.D. Cal. Mar. 31, 2016); In re Westinghouse Sec. Litig., 90 F.3d 696 (3d Cir. 1996); Freeland v. Iridium World Comms., 2006 WL 8427320 (D.D.C. Sept. 15, 2006); In re Deutsche Telekom AG Sec. Litig., 2002 WL 244597 (S.D.N.Y. Feb. 20, 2002).

But now we have social media!  And more and more investment opportunities are being advertised through mass communications (sometimes, in Regulation A offerings, which are subject to Section 12 liability for false communications).  A bunch of these are, of course, cryptocurrencies, where the issue isn’t just false prospectus communications, but unregistered sales.  All of which makes a flat rule of personal communication somewhat unsatisfying.

Recently, the Ninth and Eleventh Circuit reversed district court rulings that direct communication was necessary.  Both Circuits held that mass social media communications that urge particular investments can trigger Section 12 liability to all affected purchasers.  See Wildes v. Bitconnect, 25 F.4th 1341 (11th Cir. 2022); Pino v. Cardone Capital, 55 F.4th 1253 (9th Cir. 2022); see also Owen v. Elastos Foundation, 2021 WL 5868171 (S.D.N.Y. Dec. 9, 2021); Balestra v. ATBCoin LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019).

Notice the shift, then.  For some courts, preparing a prospectus for a registered offering was not deemed to involve sufficient solicitation to trigger Section 12 liability - but now other courts are saying that urging purchases on social media is sufficient.  Someone’s got to give.

And even on the internet, what kind of communications qualify?  That part’s still not entirely clear.  In the social media cases, the defendants created and sold particular investments and hawked them relentlessly, and that was found to be a solicitation.  Which brings us to Underwood v. Coinbase Global, Inc., 2023 U.S. Dist. LEXIS 17201 (S.D.N.Y. Feb. 1, 2023).

There, a class of plaintiffs alleged that many of the cryptotokens available for sale on the Coinbase exchange were, in fact, unregistered securities, and brought a battery of claims against Coinbase, including claims under Section 12 for unregistered sales.  The plaintiffs actually tried to establish liability under both of Pinter’s definitions of seller – they sued Coinbase for transferring title, and for soliciting sales.

So, let’s start with the title transfer allegations.  As we all know, in securities class actions, the original complaints are filed, consolidated, and then a notice is issued alerting other potential plaintiffs of the case.  Any plaintiffs (the original ones, or new ones) may then petition the court for “lead plaintiff” status.  The court appoints a lead, and (usually) appoints that lead’s chosen counsel as lead counsel, and a new, consolidated complaint is filed.  That consolidated complaint becomes the operative complaint for the case.  And, because the original plaintiffs may not be appointed lead, the early pleadings tend to be very sparse placeholders, in anticipation of a more detailed pleading to come after the leads are selected.

In Coinbase, however, there was no battle for lead status – after the original complaint was filed, one other plaintiff and one other law firm joined with the original plaintiffs/counsel, and they were all appointed lead together, after which they filed the amended complaint.

As is typical in these situations, the amended complaint was much longer and more detailed than the original complaint.  But, crucially, the original complaint had alleged that traders on the Coinbase exchange trade with each other, and Coinbase facilitates the exchange.  The amended complaint alleged that Coinbase acts as a market maker, buying directly from one user to sell to another, and vice versa – which would make it a statutory seller for Section 12 purposes under Pinter’s first prong.

Judge Engelmayer refused to accept the amended complaint’s allegations.  Citing circuit authority, he held that when an amended complaint contains factual allegations that contradict the facts alleged in earlier complaints, the new allegations may be rejected.  And he buttressed that holding by pointing out that the user agreement cited in the original complaint – but not the amended version – described Coinbase as merely facilitating transactions between users without trading itself.

I mean … I have no idea how Coinbase arranges its transactions, but, considering how securities class actions are organized, Judge Engelmayer’s holding is a little concerning, because the whole point is that early complaints are not drafted with the same kind of care as the consolidated complaint.  That’s not ideal, but it’s an inevitable byproduct of the lead plaintiff process, and the lead plaintiff process is – for its flaws – one of the best things to come out of the PSLRA.  And, in this case, a new plaintiff and new firm joined the action.  I don’t know the history there but it’s certainly possible neither had anything to do with the original complaint, and became part of the action because of the notice – precisely as the PSLRA intended.  It’s troubling that these new parties might be bound by mistakes – perhaps flat out errors – made by the original filers.

But let’s move on to the second prong of Pinter, concerning solicitation liability.  Plaintiffs alleged that Coinbase made money on trades – satisfying Pinter’s requirement that the solicitation be motivated by the defendant’s financial gain – and that Coinbase participated in “airdrops” of particular new token offerings, wrote news stories on price movements of particular tokens, and linked to news stories about them.

This, according to Judge Engelmayer, was not sufficient to qualify as solicitation under Pinter:

To hold a defendant liable under Section 12 as a seller, a purchaser such as plaintiffs must, therefore, demonstrate its direct and active participation in the solicitation of the immediate sale…. the AC's allegations regarding Coinbase's "solicitation" of the transactions involving the Tokens fail, because they do not describe conduct beyond the "collateral" participation that Pinter and its progeny exclude from Section 12 liability.  … These activities of an exchange are of a piece with the marketing efforts, "materials," and "services" that courts, applying Pinter’s second prong, have held insufficient to establish active solicitation by a defendant.

I’m not even saying this decision is wrong, exactly, but the line between participating in promotional “airdrops” and linking to articles about price movements, and urging purchases through YouTube and Instagram (as occurred in some of the social media cases where plaintiffs were allowed to proceed), is a fuzzy one – and that’s exactly what the Supreme Court was trying to avoid in Pinter.  See 486 U.S. at 652 (“the substantial-factor test introduces an element of uncertainty into an area that demands certainty and predictability”).

Anyway, it’s an area where the law is rapidly developing so … stay tuned.

Exercise Caution: Why Cautionary Statements May Misdirect

I have had the good fortune of talking to friend-of-the-BLPB Frank Gevurtz about some of his illuminating "takes" on Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, a decision we all wrestle with, it seems, in one way or another.  I recently ran into Frank (at the AALS Annual Meeting), and he informed me that some of those thoughts have made their way into a full-length article.  That article, Important Warning or Dangerous Misdirection: Rethinking Cautions Accompanying Investment Predictions, was recently posted to the Social Science Research Network (SSRN) and is available here.  The abstract follows.

We are constantly bombarded with cautions warning us of dangers to our health or wellbeing. Sometimes, however, cautions increase the danger. This article addresses one example: cautions warning investors of the risks that predictions regarding corporate performance will not pan out.

Here, the danger is investors falling prey to trumped up predictions of corporate performance, the result of which is to misallocate resources, increase the cost of capital for honest businesses, and create a drag on the overall economy. This article shows how the typical cautions accompanying predictions of corporate performance facilitate rather than avoid this danger by misdirecting both investors and courts from looking at what they should: the credibility of the speaker in giving the prediction.

To solve this problem, this article introduces a radically different approach to determining the legal impact of cautions accompanying predictions of corporate performance. This is to distinguish between cautions alerting investors to problems with the speaker’s credibility in giving the prediction versus those that simply list various risks that might lead the prediction to not pan out. The article thereby provides a roadmap for courts to replace their current misguided focus on the wrong type of cautions in the numerous cases raising the issue of when cautions serve as a defense to claims of securities fraud based upon a failed prediction.

Although Frank's draft article is ultimately directed at judicial decision-making, there is much in it for use by others.  I have been teaching materiality law and lore to my Securities Regulation students this past week.  So much of this article is relevant to our discussions.  In the article, Frank writes about (among other things) the bespeaks caution doctrine and the Private Securities Litigation Reform Act safe harbor for forward-looking statements, both of which are part of my materiality coverage.  I am finishing talking about these aspects of materiality litigation tomorrow.

While I am on the topic of materiality , I also want to thank BLPB co-editor Ann Lipton for her great post on Saturday on Tesla and Basic.  I use the Securities Regulation text coauthored by her, Jim Cox, Bob Hillman, and Don Langevoort (thanks for that, too, Ann!), which allows for a robust coverage of materiality.  The Tesla trial has been on our minds and in our classroom.  I am adding Ann's blog post to the mix.

Tesla and Basic

One of the bigger securities stories these days is the “taking Tesla private at 420” trial going on right now, simply because it’s so rare to have a securities fraud class action trial at all.  And this one is even more bizarre because the judge has already granted summary judgment to plaintiffs on two key elements: falsity and scienter.

As readers of this blog are no doubt aware, in August 2018, Musk tweeted “Am considering taking Tesla private at $420. Funding secured.”  A couple of hours later he tweeted “Investor support is confirmed. Only reason why this is not certain is that it’s contingent on a shareholder vote,” linking to this blog post.  The blog post elaborated that Musk “would like to structure this so that all shareholders have a choice. Either they can stay investors in a private Tesla or they can be bought out at $420 per share” – a merger structure that never made sense legally.   Eventually Tesla backtracked with a blog post announcing that the company would remain public.

The plaintiffs now allege – and the jury is being asked to decide whether – those two tweets were fraudulent.

According to the jury instructions on file with the court, the jury will be told that in order to find Musk liable, they must find:

1) Elon Musk and/or Tesla made untrue statements of a material fact in connection with the purchase or sale of securities;

2) Elon Musk and/or Tesla acted with the necessary state of mind (i.e., knowingly or with reckless disregard for the truth or falsity of the statements);

3) Elon Musk and/or Tesla used an instrument of interstate commerce in connection with the sale and/or purchase of Tesla securities;

4) Plaintiff justifiably relied on Elon Musk and/or Tesla’s untrue statements of material fact in buying or selling Tesla securities during the Class Period; and

5) Elon Musk and/or Tesla’s misrepresentations caused Plaintiff to suffer damages.

And finally, the jury will be told to assume that both tweets were false, and that Musk acted with reckless disregard as to whether they were true.

That means one of the critical unresolved issues – and one that is central to Musk’s defense – is the element of materiality.

Now, that may seem odd, since the tweets were obviously material.  The market reacted wildly to them, so much so that Tesla trading was briefly halted on the NASDAQ.  (Although see my earlier post on that).

But that’s not the kind of materiality Musk means.

In fact, materiality as an element of a 10(b) claim has two different dimensions.  First, was the false statement material?  And second, were the undisclosed facts material – that is, was the difference between the true state of affairs, and the one portrayed by the defendant, material to investors?

To put it another way, these days, doctrines like puffery play an awfully big role in securities class actions, as many cases are brought based on undisclosed misconduct.  A scandal emerges; there is no doubt that the facts of the scandal – previously hidden from the market – are material to investors.  But silence about scandalous facts is not itself fraudulent; the plaintiffs need to show how the market was misled about these facts.  So, plaintiffs argue that certain high-level statements about ethics and legal compliance were false; courts are then asked to evaluate whether those statements were likely to influence investors.  These are disputes about whether the allegedly false statements themselves were material, in a situation where the undisclosed facts undoubtedly were.

But suppose a company overstates its quarterly earnings by $100.  This is a situation where the statement – an earnings report – was undoubtedly material (and false); what is in question is whether the undisclosed fact – that the earnings were false by a mere $100 – was material.  Investors likely would not see any material difference between the reported figure and the true figure. 

That’s the essence of Musk’s argument in the Tesla trial.  The judge has already ruled that funding was not secured, and investor support was not confirmed, so Musk claims that a handshake arrangement with the Saudi Public Investment Fund, and perhaps the availability of funding from other sources, ensured that funding was sufficiently far along that investors would not have drawn a distinction between “funding secured” and disclosure of the full truth.

That concept of “materiality” is, in fact, the heart of what was at issue in Basic v. Levison, 485 U.S. 224 (1988), the Supreme Court case that defined what materiality means for the purposes of Section 10(b).  There, Basic had engaged in discussions regarding a possible merger with Combustion Engineering, but when asked about it, Basic’s President told investors that no negotiations were underway, and that he was unaware of any reason for the “abnormally heavy trading activity” in Basic stock. This was all, of course, false, and the question was whether the undisclosed facts – the true state of merger negotiations – were material to investors.  Defendants argued for a bright-line rule, that until an agreement in principle is reached, any merger negotiations should be deemed automatically immaterial.  The Supreme Court rejected that argument, holding instead that materiality exists where there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available.”

In the case of merger negotiations, this would require courts to evaluate how probable the transaction appeared to be at the time.  Nascent discussions might be immaterial, but board level indicia of interest, such as active negotiations or instructions to investment bankers, might be very material to investors, even if there was no certainty that a deal would ultimately be reached. 

What’s ironic, then, is that the Tesla trial is the literal mirror image of Basic.  In Basic, a CEO denied merger negotiations, and the relevant question was whether those negotiations were far enough along to create a material distance between his denials and the true state of affairs.  In In re Tesla, Inc. Securities Litigation, the CEO declared an imminent merger, and the question is whether the underlying negotiations were sufficiently embryonic to create a material distance between his tweets and the true state of affairs.

Well, that was inevitable

A couple of months ago, I blogged about Menora Mivtachem Insurance v. Frutarom, 54 F.4th 82 (2d Cir. 2022).  There, a public company issued new stock in connection with a merger, and the S-4 contained false information about the target, supplied by the target.  The truth came out, the stock price fell, and shareholders sued the target and some of its officers under 10(b).  In that context, the Second Circuit held that the plaintiffs, who had purchased shares in the publicly-traded acquirer and not the target itself, did not have "standing" to pursue claims against the target defendants.

The original decision issued on September 30; on November 30, the Second Circuit issued some minor revisions to its ruling (deleting, as far as I can tell, language that suggested that the defendants in a 10(b) action must be agents of the subject company, i.e., that plaintiffs couldn't sue if a stranger to a company made false statements about it and caused plaintiffs to make a purchase of that company's stock).

The plaintiffs sought rehearing, and one of the arguments they made was that the Menora reasoning was so broad that purchasers of shares in a SPAC would be unable to sue managers of a target company for false statements made in connection with the de-SPAC transaction.  The Second Circuit denied the petition, and so, right on cue, defendants in the Lucid SPAC case pending in the Northern District of California cited Menora to argue that the plaintiffs had no standing to pursue their claims. The court rejected Menora - and even its predecessor, Nortel - in an extensive analysis of Blue Chip and standing requirements for 10(b) actions:

Blue Chip focused on the unique problem that arises when a plaintiff’s claim is based on inaction and when it is likely that oral testimony will be the primary, or only, evidence. That problem does not exist here or in Nortel. The transactions of plaintiffs in both cases are anchored by the time of the transactions and the amount and value of securities bought or sold....

Based on this Court’s survey, Nortel’s holding regarding standing has been considered in seven decisions outside of the Second Circuit. All but one of these decisions apply Nortel with little or no commentary on the Second Circuit’s reasoning.  The one case to address Nortel’s standing analysis (notably, the one court in the Ninth Circuit that has considered Nortel) concludes that the “Second Circuit’s rationale in that decision is problematic” and not supported by extensive reasoning.” Zelman, 376 F. Supp. 2d at 962.

Further, at least two of these decisions are no longer in line with the Second Circuit’s approach after Menora. Nortel had suggested in dicta that if two companies had a “direct relationship” such as that created during a merger, that plaintiffs who purchased one company may have standing to sue based on misrepresentations of the other party to the merger.  Menora held that there is no such exception. Two cases outside of the Second Circuit had found plaintiffs had standing under the “direct relationship” exception. It is unclear if, faced with the issue again, these courts would follow the Second Circuit’s current approach....

The Court also sees no benefit from limiting standing as defendants suggest. The goal of such a limitation appears to be to ensure Section 10(b) actions are only brought where a defendant’s conduct is meaningfully related to the plaintiff’s harm. This is already accomplished by the elements of Section 10(b) claims, which include that a misrepresentation must be material and made “in connection with” the purchase or sale of a security. Not only would defendants’ standing rule be redundant, it would conflict with Section 10(b) materiality analysis, under which a misrepresentation is material and actionable where “a reasonable investor’s decision would conceivably have been affected” by it.

In re CCIV/Lucid Motors Securities Litigation, 4:21-cv-09323 (N.D. Cal. Jan. 11, 2023).  The court did, however, grant the motion to dismiss on materiality grounds, because when the plaintiff purchased shares in the SPAC, neither the SPAC nor Lucid had acknowledged that a merger was likely.  I can't find the decision on Westlaw or Lexis, but here's a Law360 article about it.

Anyhoo, as I've said before, I'm not sure how much longer SPACs will be a thing, but it seems we have a bit of a disagreement among courts that's likely to recur in different contexts.

 

 

A tale of two Primedia claims (or is it?)

This is sort of arcane, but I am fascinated by two decisions that came out of Delaware this week from VC Laster and VC Glasscock.  They are remarkably similar in facts and result, but travel slightly different paths to get there.

The first case, Harris v. Harris, concerned a family corporation.  The mother was alleged to have systematically looted the company and – aware that a books-and-records action was likely to be filed by her children – forced through a merger with a shell New Jersey entity.  After the merger, all of the former shareholders of the old corporation now held identical interests in the new corporation, which was the same in every respect, except for the new state of organization.

The second case, In re Orbit/FR Stockholders Litigation, concerned a corporation with private equity investors.  The controller, a French corporation, was alleged to have systematically looted the company, and then effectuated a cash squeeze out merger in order to avoid any potential claims for breach of fiduciary duty.

Because in both cases, the minority stockholders no longer held shares in the looted entity – they held shares in the reorganized entity in Harris, and cash in Orbit/FR – the controller argued they had lost standing to pursue fiduciary claims based on pre-merger conduct.

Now, as background, in In re Primedia, Inc. Shareholders Litigation, 67 A.3d 455 (Del. Ch. 2013), VC Laster held that when derivative claims are extinguished in a merger, the shareholders of the old corporation may be able to bring direct claims arguing that the merger consideration was unfair due to failure to value the derivative claims and include them in the merger consideration.  To succeed on a Primedia claim, the plaintiff must plead the existence of viable pre-merger derivative claims, that were material in the context of the merger, and that the buyer would not pursue the claims therefore no value was received for them.  The Delaware Supreme Court adopted the Primedia framework in Morris v. Spectra Energy P’rs (DE) GP, LP, 246 A.3d 121 (Del. 2021).

In Orbit/FR, the controlling shareholder argued that the plaintiffs could not meet the pleading requirements of Primedia, in large part because any derivative claims that could have been brought against the controller were time-barred – shareholders should have brought the claims earlier and did not, therefore, they had no value, therefore, they did not need to be valued in the merger.  The shareholder-plaintiffs argued that what shareholders did or didn’t do was beside the point; the claims belonged to the company, and a controlling shareholder can’t time-bar claims against itself by having the controlled board refuse to bring them.

All of that is in the briefing, but isn’t addressed by VC Glasscock, who side-stepped it by concluding that Primedia is the wrong framework.  (He did address a laches argument but – this is confusing – it was a different laches argument, one concerning the fact that the plaintiffs had actually substituted in for earlier plaintiffs who filed a suit in 2018 and then attempted to settle for amounts that the new plaintiffs deemed inadequate).

In Glasscock’s view, Primedia is reserved for cases where a third party buys the company, has no interest in pursuing the old derivative claims, and therefore does not pay for them.  He noted there are “stringent” requirements for pleading such a claim, “in light of the general rule that the derivative asset had transferred to the acquiror, and was not retained by the former stockholders.”

Orbit/FR, however, was more like a straightforward entire fairness case, in which a controller stood on both sides of the transaction.  The shareholders had never filed a breach of fiduciary duty claim against the controller for its premerger conduct; instead, the only claim was that the controller looted the company and then effectuated an unfair merger, in part because it bought out its own liability for no value.  Per Glasscock, “to the extent the existence of a pre-merger litigation asset, held by Orbit, contributes to a finding of the unfairness of the merger, that unfairness is not extinguished via the merger; it is created by the merger.”  The plaintiff had adequately pled an unfair merger, and therefore it would be appropriate for the court to assess fairness in light of all of the assets of the acquired company, including its choses in action.

So. Primedia did not apply; plaintiffs’ claims survived the motion to dismiss.

Harris was bit more complex, in that the minority-shareholder-plaintiffs really did plead premerger fiduciary breaches against their mother, the controlling shareholder, in addition to other claims.  In that context, VC Laster also invoked Primedia, but, in his view, though Primedia itself involved a third party buyer, its logic was descended from the squeeze-out case of Merritt v. Colonial Foods, Inc., 505 A.2d 757 (Del. Ch. 1986), where a controller effectuated a merger for the purpose of eliminating derivative claims, and the minority shareholders were permitted to use those claims to demonstrate the unfairness of the merger price.  In Laster’s view, then, Primedia is simply a specific instance of a general rule that when a merger eliminates derivative claims, those claims are treated as assets of the target company and the fairness of the merger is assessed accordingly.  And, further demonstrating that he believed Primedia simply to be an extension of earlier caselaw, Laster noted that the plaintiffs might not need to show that the value of the claims was material in light of the overall merger consideration – as Primedia suggests – if the unfairness of the merger can be pled by other means:

In Parnes, the Delaware Supreme Court did not hold that a stockholder only could assert a direct claim challenging a merger by pleading facts indicating that the value of the diverted proceeds were so large as to render the price unfair. The Delaware Supreme Court instead recognized more broadly that a stockholder could assert a direct claim challenging a merger if the facts giving rise to what otherwise would constitute a derivative claim led either to the price or to the process being unfair. In Primedia, the court identified this dimension of Parnes and explained that “[t]here is a strong argument that under Parnes, standing would exist if the complaint challenging the merger contained adequate allegations to support a pleadings-stage inference that the merger resulted from an unfair process due at least in part to improper treatment of the derivative claim.”

Using the Primedia framework, Laster, like Glasscock in Orbit/FR, went on to find that the minority stockholders in Harris could pursue their claims as a direct attack on the fairness of the merger. 

So the cases reached the same result, but differed on the applicability of Primedia.  Do these divergent approaches make much of a difference?  Possibly.  Glasscock seemed to think Primedia requires the pleading of very specific elements, so categorizing a claim as “Primedia” or “not Primedia” really matters for whether a complaint is sufficient; the Primedia pleading burden was avoided in Orbit/FR by viewing the case through the simple lens of whether the plaintiffs had alleged facts that made it reasonably conceivable that a controlling shareholder freezeout merger was unfair.  Laster, by contrast, did not view Primedia so narrowly; though he found the formal elements met in Harris, he also went out of his way to note that Primedia’s test is really just a mechanism for assessing whether unfairness has been pled.

Conceptually, I do agree with Laster that there is really one unified concept here, namely, the extent to which a derivative claim is an asset of the target and whether its treatment renders the merger unfair to the selling stockholders.  The facts necessary to plead such a claim should be a separate issue that is adjusted as the circumstances warrant.

Another interesting point of note, though: In Harris, Laster also held that the minority plaintiffs satisfied the two exceptions that exist to the continuous holding rule for derivative standing.  As Laster pointed out, the continuous holding rule is waived if the merger is effectuated solely for the purpose of eliminating the derivative claims (known as the “fraud exception,” Ark. Tchr. Ret. Sys. v. Countrywide Fin. Corp., 75 A.3d 888 (Del. 2013)), and it is also waived if the merger is a mere reorganization of the old corporation with no substantive changes.  Here, that’s exactly what happened on both counts, but Laster concluded that it would be administratively simpler to treat this as a direct claim, and that’s what he did. 

Which means, among other things, we now have at least one example of a case where the fraud exception to the continuous holding rule was in fact met, which I think is – new? If there others, I don’t know what they are – feel free to let me know in the comments if it’s been done before.

Non-competes, and also SPACs

Couple of things this week.

First, the FTC proposed a new rule that would bar employers from requiring employees to sign noncompetes that extend post-employment.  It’s a very broad proposal; it applies to “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer,” and includes “a contractual term that is a de facto non-compete clause because it has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.”

The sole exception is for “a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets, when the person restricted by the non-compete clause is a substantial owner of, or substantial member or substantial partner in, the business entity at the time the person enters into the non-compete clause.”  A substantial owner must have at least a 25% interest in the entity. 

There’s lots to recommend a proposal like this – I’m not an expert in this area, but others have written about, for example, how Silicon Valley’s innovation may have been a result of California’s prohibition on non-competes.  

Right now, different states have different rules about the permissibility of non-competes, which is why – as I explore in my new paper, Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine (forthcoming in the Wake Forest Law Review) – companies are increasingly trying to avoid them by writing non-competes and other employment-like terms into business entity documents (like LLC operating agreements and LP agreements), and then making employees members/partners/managers, on the theory that the non-compete is now no longer a “labor” contract, but an equity/investment contract, subject to the law of the state of organization.  That means courts – and, usually, Delaware courts – are left trying to sort out what counts as really an equity agreement versus what counts as an employment agreement.

So I wonder whether the FTC’s proposed rule could run into the same problem that Delaware is experiencing right now.  A plain reading of the proposal suggests that the rule applies to any contractual term between a worker and employer, regardless of whether the term appears in a contract of employment or some other kind of contract – but, another part of the rule (the model language for employers giving notice to workers) refers specifically to “employment contracts.”   If the rule becomes law, I can imagine employers might try to introduce some ambiguity by distinguishing “worker” contracts from entity documents.  To discourage that kind of gamesmanship, the FTC may want to add some language to clarify.

Second, previously, I blogged about Delman v. GigAcquisitions3 LLC, concerning the GigCapital3 de-SPAC transaction.   Well, VC Will has just sustained fiduciary duty claims against the Sponsor and directors of GigCapital3.  Among other things, she accepted plaintiffs’ allegations that the proxy was misleading because it represented that the SPAC’s shares were worth $10 each, when in fact they’d be worth less due to warrants and transaction fees.  Notably, VC Laster reached a similar conclusion in another SPAC case a few months ago.

But that’s not all. 

VC Will also held that Corwin cleansing simply is not available for SPACs, even if the vote is fully informed, because shareholders can both vote in favor of the deal and exercise their redemption rights (in fact, many are incentivized to vote in favor and exercise the redemption, rather than force liquidation, because they also hold warrants).  This means, according to Will, “the structure of the Gig3 stockholder vote is inconsistent with the principles animating Corwin.”  She also held that the MFW framework would be a poor fit because “The MFW process was designed to protect minority stockholders from the retribution of a controlling stockholder engaged in a self-dealing transaction—specifically, a squeeze-out. Those fears are not realized in a SPAC merger; public stockholders can simply redeem their shares.”

At this point, I’m feeling rather chuffed because these are exactly the arguments I made in one of my blog posts about the case, and later in my essay, The Three Faces of Control, at note 88 and accompanying text.

That said, even with the inapplicability of the MFW framework, she held that, at least for pleading purposes, the Sponsor’s control over the SPAC’s business – and ties to the directors – made it a controlling shareholder, even with less than 25% of the voting power (which meant the Sponsor had fiduciary duties to the SPAC).

Anyway, I’d say this is all a really big deal for SPACs – they'd have to do some pretty radical restructuring to avoid board-level/sponsor conflicts that would permit business judgment review in the absence of shareholder ratification under Corwin (and that doesn’t even get into the thing where they openly advertise for shareholders to vote even if they’ve already sold their shares) – except for how I think SPACs may pretty much be done anyway so we’ll all wake up one day and wonder what that was all about. 

Ghosts of Christmas Past: WeWork Litigation

Everyone remember the WeWork debacle?  One interesting aspect is that although Adam Neumann is often mentioned in the same breath as Elizabeth Holmes and – these days – Samuel Bankman-Fried, Neumann was never charged with fraud, despite ballyhooed announcements of investigations.  If anything, that’s one of the more amazing things about the story: Neumann was able to incinerate billions of dollars while apparently explaining exactly what he planned to do and how he would do it.

Well, not exactly.  As I blogged in March 2021, one set of WeWork investors brought fraud claims against Neumann and other WeWork officers, namely former shareholders of a company called Prolific Interactive, which WeWork acquired for a combination of cash and WeWork stock.  The former Prolific shareholders claim that they were misled about the value of WeWork stock and sold their company too cheaply.  And, when they filed their complaint, I blogged that I didn’t understand why they had chosen to bring claims solely under Section 10(b) of the federal Exchange Act.  Section 10(b) is a very plaintiff-unfriendly statute.  Among other things, 10(b) claims are subject to the heightened pleading requirements of the PSLRA, and the scope of prohibited behavior is actually quite narrow (aiding and abetting claims, for example, are unavailable, and the definition of a primary violation can be something of a moving target).  Section 10(b) is only preferred by plaintiffs because it allows fraud-on-the-market liability, which most states’ common law does not.  The former Prolific shareholders, however, were not bringing a fraud-on-the-market case, so I didn’t understand why they were advancing claims under 10(b).

Well, on December 23, 2022, the District of Delaware finally dismissed the complaint (with leave to replead), see Emamian v. Neumann, No. 1:21-cv-00414, and from that opinion (as well as by reading some of the briefing), I got my answer.  (Sadly, the opinion is not available on Westlaw or Lexis as of this posting; you have to pull it from the docket).

When the plaintiffs signed the deal to receive WeWork stock in exchange for Prolific stock, the agreement contained a clause that disclaimed reliance on any representations outside of the agreement itself.  That disclaimer of reliance is enforceable under common law (or at least, under Delaware’s common law, see Abry Partners V, L.P. v. F & W Acquisition, 891 A.2d 1032 (Del. Ch. 2006), which likely applies here).  But some federal courts have held that anti-reliance clauses are not enforceable under Section 10(b), as they are too similar to a prohibited waiver of Exchange Act protection.  See AES Corp. v. Dow Chemical Co., 325 F.3d 174 (3d Cir. 2003). But see Cornielsen v. Infinium Capital Management, LLC, 916 F.3d 589 (7th Cir. 2019).

Sidebar: As I’ve previously blogged (here and here and here), the Ninth Circuit is right now considering whether a forum selection bylaw that shunts Exchange Act claims into a forum that has no jurisdiction to hear them is also the equivalent of a prohibited Exchange Act waiver.

In the Emamian case, though the contract disclaimed reliance on external representations, and the plaintiffs based their claims entirely on those.  Since the reliance waiver would have foreclosed claims under common law, they instead brought them under 10(b).

But!

Although some federal courts have been reluctant to give automatic effect to nonreliance clauses in 10(b) cases, they may hold that 10(b) requires plaintiffs to show that their reliance was justifiable, and a nonreliance clause may be evidence – though not dispositive – that any reliance on the disclaimed statements was not justifiable.  See O’Connor v. Cory, 2018 WL 5117197 (N.D. Tex. Oct. 19, 2018) (exploring the caselaw).  Beyond the issue of nonreliance clauses, the caselaw on what counts as “justifiable” reliance is somewhat mixed, especially since doctrines like “puffery” already serve the same function by eliminating any facially unreliable statements.  As a result, some courts have held that, since 10(b) is a fraud statute, plaintiffs have no affirmative duty to investigate defendants’ representations, Teamsters Local 282 Pension Fund v. Angelos, 762 F.2d 522 (7th Cir. 1985). 

The Third Circuit, however, requires some degree of diligence by the plaintiff, and so the Emamian court dismissed plaintiffs’ claims for failure to plead that they conducted a reasonable investigation – especially in light of the nonreliance clause and the length of the negotiations – but gave plaintiffs leave to replead on that issue.

That said, I’ll note something else: Although the court gave lip service to PSLRA pleading standards, it quite demonstrably did not require the same level of detail you’d expect in a fraud-on-the-market case by public company shareholders.  Though the court rejected plaintiffs’ claim that WeWork’s $110-per-share valuation was itself fraudulent for (for failure to plead scienter), the court did hold that plaintiffs had properly alleged that Neumann made false statements, with scienter, about WeWork’s “operations and business prospects.”  Yet the most that plaintiffs alleged along these lines was:

During these meetings [held from December 2018 to March 2019], Neumann discussed how valuable WeWork will be after its IPO as well as WeWork’s purported profitability, cash flow, and supposedly strong balance sheet at the time….

During the meetings and discussions leading up to WeWork’s acquisition of Prolific, Neumann and the other Defendants failed to disclose WeWork’s cash flow problems, massive operating losses, the unsustainable nature of the Company’s business model, Neumann’s self-dealing and erratic behavior, or that Neumann sold or was selling large blocks of his WeWork shares privately.

And, though it’s unclear whether the court considered these to be part of the fraud, Plaintiffs also made general allegations about WeWork’s public statements, such as:

Despite its growth, and the message it was presenting to the investing community that it was a tech start-up that was revolutionizing the workplace by bettering humanity and promoting community “wellness” and “kindness,” as it was later revealed, WeWork was nothing more than a subleasing company that captured the spread between long-term rental costs and short-term subleasing revenues for commercial office space.  WeWork claimed to be selling a membership “experience” that was “powered by technology designed to enable [WeWork’s] members to manage their own space, make connections among each other and access products and services.” But the reality is that WeWork simply offered a trendy desk and chair for monthly rent.

These allegations would never support a Section 10(b) class action against a public company – indeed, reading the complaint, it seems that the plaintiffs’ main claim is that they were defrauded by the $47 billion company valuation (which allegations, again, the court rejected on scienter – not falsity - grounds). Which is probably why we haven’t seen the kinds of government actions surrounding WeWork as we've seen for other high-profile startup collapses; statements of valuation – with nothing more – are extremely hard to prove false, let alone intentionally so.

Which means, we can say that 10(b) cases may formally have tougher pleading standards than common law cases, but judges may be loathe to impose them outside the class action context.

Video of the Seventh Annual Berkeley Fall Forum on Corporate Governance

In early November, Berkeley held a 2-day forum on corporate governance, featuring a variety of A-list speakers including Chancellor McCormick and Vice Chancellor Glasscock.  I also participated on a panel with Adam Badawi to talk about everyone's favorite subject, Elon Musk's takeover of Twitter.  The videos from the event were just posted online, so for those of  you who couldn't watch it live - here's the link (also available here)!

Happy holidays, everyone. Stay warm!

The Meaning of FTX, Part Deux

A couple of weeks ago, I blogged about how the most striking aspect of the FTX saga was the lack of due diligence by FTX’s equity backers – and how proud they were of that fact, before everything came crashing down.

This week, we got a little more color on that, in the form of the SEC’s complaint against Samuel Bankman-Fried (like everyone else, for ease of reference, I’ll call him “SBF”).  The least surprising thing about the case is that the SEC focused not on the fraud perpetuated on crypto asset traders, but on the fraud perpetuated by SBF on investors in FTX.  That’s because the SEC only has jurisdiction over fraud committed in connection with securities trading, and it’s not always clear whether a particular crypto asset is, or is not, a security.  To sue SBF over fraud perpetuated on FTX customers, the SEC would have to perform the Howey test on an asset-by-asset basis for everything the customers traded – not exactly a feasible undertaking.  So, the SEC took the low-hanging fruit and sued to vindicate the rights of the stockholders in FTX.

Just one teensy problem.  Here are examples of the fraud, taken from the SEC’s complaint:

For the entire span of the Relevant Period, while raising money from equity investors, Bankman-Fried, and those speaking at his direction and on his behalf, claimed in widely distributed public forums and directly to investors that: FTX was a safe crypto asset trading platform; FTX had a comparative advantage due to its automated risk mitigation procedures….

FTX’s Terms of Service, which were publicly available on FTX’s website and accessible to investors, assured FTX customers that their assets were secure…

Similarly, FTX posted on its website a document entitled, “FTX’s Key Principles for Ensuring Investor Protections on Digital-Asset Platforms,” in which FTX represented that it “segregates customer assets from its own assets across our platforms.”…

Throughout the Relevant Period, Bankman-Fried made public statements assuring that customer assets were safe at FTX. For example, he stated in a tweet on or about June 27,  2022: “Backstopping customer assets should always be primary. Everything else is secondary.”  He likewise tweeted on or about August 9, 2021: “As always, our users’ funds and safety comes first. We will always allow withdrawals (except in cases of suspected money laundering/theft/etc.).”

Bankman-Fried also told investors, and directed other FTX and Alameda employees to tell investors, that Alameda received no preferential treatment from FTX. For example, Bankman-Fried told the Wall Street Journal in or around July 2022: “There are no parties that have privileged access.” Likewise, in a Bloomberg article published in or about September 2022, Bankman-Fried claimed that “Alameda is a wholly separate entity” than FTX. In the same article, Ellison is quoted as stating about Alameda: “We’re at arm’s length and don’t get any different treatment from other market makers.” Bankman-Fried made similar statements directly to investors…..

FTX invested significant resources to develop and promote its brand as a trustworthy company. For example, in materials provided to one investor in or around June 2022, FTX cultivated and promoted its reputation:

                    FTX has an industry-leading brand, endorsed by some of the most trustworthy public figures, including Tom Brady, MLB, Gisele Bundchen, Steph Curry, and                     the Miami Heat, and backed by an industry-leading set of investors. FTX has the cleanest brand in crypto…

Bankman-Fried repeatedly touted FTX’s automated risk mitigation protocols—which he called FTX’s “risk engine”—to the public, and prospective investors, as a safe and reliable way for crypto asset trading platforms to manage risk. Bankman-Fried promoted the concept of “24/7” automated risk monitoring as an innovative benefit of cryptocurrency markets, including at a hearing on or about December 8, 2021, to the U.S. House of Representatives Committee on Financial Services….

In a submission to the Commodity Futures Trading Commission, FTX touted its automated system, claiming that it calculated a customer’s margin level every 30 seconds; and that if the collateral on deposit fell below the required margin level, FTX’s automated system would sell the customer’s portfolio assets until the collateral on deposit exceeded the required margin level….

Bankman-Fried thus misled FTX’s investors by representing that its risk engine would protect FTX customer funds and would limit FTX’s exposure to any single customer….

Get it?  The majority of what the SEC alleges are not statements to investors; they were statements to the general public, to FTX customers, to Congress.  There are a couple of stray allegations about direct communications with investors – among other things, SBF at one point handed investors a printout of what the FTX website said, and there were some audited financials (mentioned briefly in paragraph 51; the SEC’s reticence over them suggests it’s not comfortable resting its entire case on those) – but there’s really not much direct investor communication at all, at least not before the collapse and SBF began looking for bailouts. 

Compare, for example, to the SEC’s complaint against Elizabeth Holmes.  Investors got media releases, sure, but they also got binders about purported relationships with big pharma, they got lab tours, they got information on clinical trials.  But there’s nothing like that in the case against SBF.

Now, that may be because everyone’s operating on a condensed timeline.  Maybe these are the statements the SEC could get at quickly, and it intends to supplement its complaint later (in which case, this blog post will quickly become irrelevant).  But at least for now, the overwhelming suggestion is that the SEC based its case on false public statements because SBF didn’t actually make any false private ones – investors bought FTX stock without demanding so much as an offering memorandum.

From a legal perspective, that may not be a problem, exactly.  In the context of private plaintiffs and fraud on the market, it’s well established that a statement may be “in connection with” a securities transaction so long as market analysts relied on it, even if the communication was not specifically directed to investors.  See In re Carter- Wallace Sec. Litig., 150 F.3d 153 (2d Cir. 1998).  As a result, private class action plaintiffs frequently base claims on advertisements targeted to customers, mainstream news appearances, and so forth.  So, in this case, even if SBF were to argue that he wasn’t talking to investors, he was talking to other audiences, the obvious rejoinder is that the whole reason investors were willing to invest on a song was because of FTX’s public reputation, carefully cultivated by SBF.

That said, if you already had the impression that the VC/private investment space is based more on “vibes” than financial models, the SEC’s complaint only provides more evidence.

In an alternate universe, the Twitter v. Musk dispute could have ended up like Anaplan

A former shareholder of Anaplan recently filed a lawsuit against several of its former officers and directors, alleging a variety of fiduciary breaches in connection with the company sale to Thoma Bravo (“TB”).

As you may recall from news reports at the time – or Matt Levine’s column – Anaplan signed a deal to sell itself to TB at $66 per share.  Then, the bottom fell out of the market, and suddenly that looked like a very generous price.  TB was stuck, though, until Anaplan screwed up by approving a bunch of new bonus payments to executives that violated the merger agreement’s ordinary course covenant.  That gave TB an excuse to threaten to walk away unless Anaplan agreed to a lower deal price, and the merger ultimately closed at $63.75 - a reduction of $400 million.

Pentwater Capital, a hedge fund with a substantial stake in Anaplan, is now suing, alleging that compensation committee directors, and the officers involved with the awards, breached their duties of loyalty and committed waste, and that the officers – including the company CEO, who was also Chair – acted with gross negligence. 

(Side note: to distinguish the CEO’s behavior in his capacity as officer, where he was not exculpated for negligence, from his behavior in his capacity as Chair, where he was, the complaint points out that he participated in Compensation Committee meetings, though he could not legally have been a member of that committee since NYSE requires that Compensation Committee members be independent).

And what leaps out to me from this suit is how Delaware law has taken some wrong turns.

First and most obviously, as I previously blogged, Delaware now permits officers, as well as directors, to be exculpated for negligence in connection with direct claims.  Though the Anaplan complaint tries to make out a claim for conscious wrongdoing, which would violate the duty of loyalty via bad faith action, that seems like a tall ask; there’s no argument that the excess compensation awards were self-dealing, only that they were obviously barred by the merger agreement, and that the defendants forged ahead heedlessly nonetheless.  Pentwater doesn’t even claim that the excess awards were actually material to TB or the merger agreement.  Instead, it admits that their significance was that they handed TB the excuse it needed to escape the deal, and claims that the defendants should have anticipated that TB would make use of any leverage it could.

So this, to me, is a scenario where negligence liability would help remedy a tangible harm inflicted on the shareholders.  But in future years, it’s likely that any officers who behave similarly will be entirely in the clear.  I’ll note that Pentwater makes much of the CEO’s golden parachute and other payments he received in connection with the merger – to the tune of over $250 million – but this is not like those cases where the CEO negotiates a bad deal to get his severance; here, the CEO already had a great deal on the table and no reason to blow it, especially since a lot of his payments were equity.  Still, the payments do suggest that there would be some justice in forcing him personally to make up a lot of what shareholders lost.

Second, this case highlights the fallacy of Corwin.  Because the biggest stumbling block for Pentwater is that shareholders approved the merger.  Of course they did!  The bottom fell out of the market; they weren’t going to get a better deal, even at the revised price.  That hardly means they wanted to cleanse the fiduciary breaches that cost them $400 million.  But Corwin requires that these two actions – approval of the substance of the deal, and ratification of the managers’ conduct – be bundled into a single vote.  Which is precisely the objection several commenters have raised with respect to Corwin, see, e.g., James D. Cox, Tomas J. Mondino, & Randall S. Thomas, Understanding the (Ir)relevance of Shareholder Votes on M&A Deals, 69 Duke L.J. 503 (2019).  In fact, as I previously blogged, VC Glasscock recently had the exact same intuition outside the Corwin context.  In Manti Holdings v. The Carlyle Group, 2022 WL 444272 (Del. Ch. Feb. 14, 2022), he held that shareholders did not waive their rights to bring fiduciary duty claims in connection with a merger merely because they signed a contract agreeing not to challenge the merger itself.  Because challenging a merger, and alleging fiduciary breaches in connection with a merger, are different things, as the Anaplan case highlights, but as Corwin conflates.

That said, Pentwater knows all this and has seeded its complaint with potential end-runs around Corwin.  Starting with, it argues that the vote was coerced: “stockholders had a metaphorical gun to their head,” Pentwater alleges.  And, that’s not wrong, but defendants presumably will argue, not without force, that the “coercion” was simply that the shareholders liked the deal on the table and didn’t expect a better one would be forthcoming.  The facts may be extreme, but they’re the same as every other merger that Corwin deems cleansed; what this situation really highlights is just how unsatisfying Corwin is for that reason.

Pentwater also argues that the proxy materials were misleading because they didn’t make clear exactly how egregious the defendants’ conduct was, and how aware they were that they were in breach.  Which may be true – I have no idea – but the whole point of the coercion argument is that shareholders were forced to vote in favor anyway, which kind of suggests that those details were immaterial. 

Finally, Pentwater argues waste.  Pentwater makes the not unreasonable point that when a company is on the verge of being sold for cash, new retention awards add zero value to current shareholders.  Waste, of course, can only be approved with a unanimous shareholder vote, see Harbor Fin. Partners v. Huizenga, 751 A.2d 879 (Del. Ch. 1999), and while the vote in favor of the deal was nearly 99%, it wasn’t actually unanimous.

I actually can see this one having legs, especially if Pentwater can make the case that the defendants knew they violated the agreement or acted without heed of it.  Not only is the waste argument persuasive, but waste is useful from Delaware’s perspective because it would allow justice to be done in this particular case without forcing a confrontation with the paradoxes created by Corwin.  But that doesn’t mean the problems have gone away.

The Meaning of FTX

When it comes to FTX, I’ll let the crypto people talk about the implications for that space generally, and I’m sure we all have our opinions on Samuel Bankman-Fried’s conduct – both before the collapse, and his endless apology tour afterwards – but what will live on for me is not any of that, but the 14,000 word hagiography that Sequoia had published on its website until very recently; they took it down after the bankruptcy declaration, though of course you can’t erase anything from the internet.

Sequoia has gotten a lot of flak for it not only for the fawning coverage, but because it revealed that Bankman-Fried actually was playing a video game during his pitch meeting.  More than that, after FTX raised $1 billion in its B round, it apparently held a “meme round” of financing, and raised $420.69 million from 69 investors.

Such revelations have inspired a lot of criticisms of the due diligence process today, not only by Sequoia but also by other FTX investors like Ontario Teachers’ Pension Plan.

But what really stood out to me not just was the evidence of due diligence failure, but the fact that Sequoia intentionally, by their own volition, put this article on its own website.  It wanted you to know that this was who they were funding, and this was the process they used.  They believed this would give them credibility, perhaps with founders, perhaps with their own investors – and they may very well have been right.

I’ve previously blogged (twice!), and written an essay about, about how the changes to the securities laws create these situations (though, of course, macroeconomic changes are responsible as well, as this Financial Times article explains).

In particular, my point is that the securities laws cultivate investors with particular preferences, and that leads to particular corporate outcomes.  As relevant here, in 1996, Congress gave the green light for private funds to raise unlimited amounts of capital, without becoming subject to registration under either the Securities Act or the Investment Company Act, so long as their own investors consist solely of persons with $5 million in assets.   At the same time, Congress and the SEC also made it easier for operating companies to raise capital while remaining private, so long as they mostly limit their investor base to these newly supercharged private funds.  The illiquid nature of the funding vehicles (necessitated by their private, non-tradeable status) encourages a short-termist orientation in search of a quick payout.  Due to the high-risk nature of these investments, private funds invest in multiple firms in the expectation that most will fail but a few will become outsized hits.  The result has been that one category of investor – wealthy, institutional, private, illiquid, risk-seeking, and with limited ability to express negative sentiment – has come to dominate the private markets.   And that’s how you end up with Sequoia bragging about funding being based on obscene numbers rather than DCF models. 

The securities laws are ultimately supposed to facilitate the efficient allocation of capital, but unfortunately, too much weight is being put on “let sophisticated investors make their own choices” and not enough on how these rules shape these sophisticated investors themselves and their preferences, which may not up end up aligning with society's preferences.

Okay fine Twitter thoughts

Look there are two massive business stories right now - FTX and Twitter - and I have worked very, very hard to avoid learning anything about crypto, so Twitter it is.

Eventually there will be writing - so much writing - about all of this (me and everyone else), but as I type, it's being reported that there has been a massive exodus of Twitter employees who largely do not want to work for Elon Musk; Musk, in a paranoid fear of sabotage, locked all employees out of the offices until Monday before demanding they all fly to San Francisco for a meeting on Friday, and engineers responsible for critical Twitter systems left.  Most of us who are actually on Twitter are waiting for one big bug to take the system down (I've set up an account, by the way, at Mastodon).  And maybe that won't happen - maybe Musk will eventually turn things around - but he's certainly made things a lot more difficult for himself in the interim.

I'll save my bigger lesson musings for other formats, but for now, I'll make a minor point: the Delaware Court of Chancery did not, of course, order Musk to complete the deal, but he settled in the shadow of other broken deal cases and clearly saw the writing on the wall.  Though there are only a few cases on point, Chancery has not hesitated to order reluctant buyers to complete mergers - in fact, I'm unaware of any case where an acquirer was found to be in breach and specific performance was not awarded - but in the first of these, IBP v. Tyson, Chancellor Strine agonized over the social dislocation that might be caused by forcing an unwilling buyer to complete a sale.  Part of the reason he ultimately ordered specific performance was because the business case for the deal remained unchanged; as he put it:

A compulsory order will require a merger of two public companies with thousands of employees working at facilities that are important to the communities in which they operate. The impact of a forced merger on constituencies beyond the stockholders and top managers of IBP and Tyson weighs heavily on my mind. The prosperity of IBP and Tyson means a great deal to these constituencies. I therefore approach this remedial issue quite cautiously and mindful of the interests of those who will be affected by my decision….

[T]here is no doubt that a remedy of specific performance is practicable. Tyson itself admits that the combination still makes strategic sense. At trial, John Tyson was asked by his own counsel to testify about whether it was fair that Tyson should enter any later auction for IBP hampered by its payment of the Rawhide Termination Fee. This testimony indicates that Tyson Foods is still interested in purchasing IBP, but wants to get its original purchase price back and then buy IBP off the day-old goods table. I consider John Tyson's testimony an admission of the feasibility of specific performance…

Probably the concern that weighs heaviest on my mind is whether specific performance is the right remedy in view of the harsh words that have been said in the course of this litigation. Can these management teams work together? The answer is that I do not know. Peterson and Bond say they can. I am not convinced, although Tyson's top executives continue to respect the managerial acumen of Peterson and Bond, if not that of their financial subordinates.

What persuades me that specific performance is a workable remedy is that Tyson will have the power to decide all the key management questions itself. It can therefore hand-pick its own management team. While this may be unpleasant for the top level IBP managers who might be replaced, it was a possible risk of the Merger from the get-go and a reality of today's M A market.

The impact on other constituencies of this ruling also seems tolerable. Tyson's own investment banker thinks the transaction makes sense for Tyson, and is still fairly priced at $30 per share. One would think the Tyson constituencies would be better served on the whole by a specific performance remedy, rather than a large damages award that did nothing but cost Tyson a large amount of money.

Well, Elon Musk is an ... unusual ... buyer of companies, and I doubt we'll see his like again soon, but he's definitely illustrating a worst case scenario for forcing a merger over a buyer's objections.  He famously performed no diligence on the company before signing the deal, and tried to back out immediately thereafter, so there was no point where he engaged in any serious analysis of Twitter's systems or planning for what he'd do with ownership.  His whiplash changes to policies, his mistaken firings, and his basic misunderstanding of Twitter's business all demonstrate the dangers of selling a company to a buyer who is not prepared to run it.

Which begs the question whether Chancery will be more hesitant in future cases to order specific performance.

In Twitter's case, the parties had agreed to an unusually strong specific performance provision - which barred Musk from even contesting the propriety of specific performance were he found to be in breach - but whatever parties' contractual agreements, specific performance ultimately lies in the court's discretion, and the court has to decide whether it is an appropriate remedy.  Though Delaware places great weight on parties' agreements that specific performance is appropriate and breach would cause irreparable harm, the court must also determine that the order "not cause even greater harm than it would prevent."  What made the Twitter deal so uniquely high stakes was that the parties had also agreed that, in the absence of specific performance, the most Musk could be ordered to pay in damages was $1 billion, which was far less than the damage he had inflicted on Twitter in the interim and certainly less than what shareholders were owed.  Had the court been unwilling to award specific performance, his bad behavior would, essentially, have been rewarded with a slap on the wrist.

Deal planners, I assume, know all of this, which makes me wonder if, going forward, there will be more uncertainty about enforcement, and whether merger agreements will be more likely to provide that knowing and intentional breaches can result in uncapped damages.  At least that way, parties will be protected if they are concerned that Delaware courts - looking at the Twitter wreckage - might be less willing to order specific performance in the future.

 

 

 

Proxy Exempt Solicitations

I previously posted about the increasing use by shareholders of proxy-exempt solicitations under Rule 14a-6(g).  That rule allows shareholders who are not seeking proxy authority to solicit other shareholders without filing a proxy statement, but under some circumstances, any holder of more than $5 million of stock must file their written solicitation materials with the SEC.  These days, however, even shareholders who do not need to file with the SEC choose to do so voluntarily, because EDGAR serves as a convenient and cheap mechanism by which materials can be distributed to other shareholders.

Well, Dipesh Bhattarai, Brian Blank, Tingting Liu, Kathryn Schumann-Foster, and Tracie Woidtke have just done a study of these solicitations: Proxy Exempt Solicitation Campaigns.  They find that a variety of institutional investors make these filings, including public pension funds (38%), union funds (26%), and other institutions, including hedge funds (22%).  The filings may be used to support shareholder proposals that are already on the ballot - and thus to exceed the 500-word limit for such proposals - and to oppose management proposals, such as director nominations and say-on-pay.  And these filings are taken seriously: 74% of them are accessed by a major investment bank, and they appear to have an effect on voting outcomes and forced CEO turnover.

So this is fascinating.  The rule, adopted in 1992, at least as I always understood it, was intended to ensure that all shareholders receive the same information, and to allow that information to be publicly vetted, so that large shareholders can't lobby others in secret (and away from management prying eyes).  But with modern computerized filings, the rule has been, functionally, hacked, to serve as a low-cost mechanism by which shareholders can communicate with other shareholders - and shareholders find it useful.  That's a good thing, and it tells us that maybe the SEC should in fact be more proactive in sponsoring platforms for shareholder communication.  Obviously, there are plenty of electronic forums today where shareholders congregate, but these are generally thought to appeal to retail shareholders and may have a high noise to signal ratio.  Now that the SEC knows it can provide an easy distribution mechanism for more formalized communications, I wonder if it's worth building out that possibility even more.