Monday, June 20, 2022
Having just come back from the first in-person National Business Law Scholars Conference since 2019 (at The University of Oklahoma College of Law, pictured here), I have many thoughts swirling through my head. I always love that conference. The people, whom I dearly missed, are a big part of that. And Megan Wischmeier Shaner was an awesome planning committee host. But the ideas that were shared . . . . Wow. So many great research projects were shared by these wonderful law teachers and scholars! Over time, I hope to share many of them with you.
But for today, I want to focus on one thing that I heard in a few presentations at the conference: that the shareholder wealth maximization norm is and always has been the be-all and end-all of corporate purpose and board decision making. I am posting on that topic today not only because of my engagement with the conference, but also because the issue is implicated in Ann's post on Saturday (Bathrooms are About Stakeholders) and by Stefan's post yesterday (ESG & Communism?). I want to focus on a part of Stefan's post (and Stefan, you may that issue with my remarks here, based on your response in the comments to your post), but I promise to work in a reference to Ann's post, too, along the way.
Like Paul, I am somewhat troubled by the connections made in abstract for the article featured in Stefan's post—albeit perhaps for different reasons. I will read the article itself at some point to learn more about the issues relating to the Fed. And I agree with Stefan's commentator Paul that the Elizabeth Warren reference in the abstract is a bit of a stalking horse. I want to address here, then, only the asserted corroboration of an “incipient trend” offered as an aside at the end of the abstract excerpted in Stefan's post.
As readers may know from my published work and commentary on the BLPB, I do not accept that there is a legal duty to maximize shareholder wealth embedded in corporate law. (Articles have pointed out that the shareholder wealth maximization mantra has not existed consistently over the course of corporate history, but I will leave commentary on that literature for another day.) Regardless, to be sustainable, a corporation must make profit that inures to the benefit of shareholders, while also understanding and being responsive to the corporation's other shareholder commitments—commitments that may vary from corporation to corporation. But that does not mean that the board must maximize shareholder wealth, especially in each and every board decision. (Let's leave Revlon duties aside, if you would, for these purposes.). It also does not mean that shareholder wealth is properly ignored in corporate decision making, but in my experience, few firms actually completely ignore short-term and long-term effects on shareholder wealth in making decisions.
In essence, the standard shareholder wealth maximization trope would have us believe that the board's task is too simple, as I have noted in some of my work. A compliant, functional board engaged in corporate decision making first needs to understand as well as it can the firm's business and the markets in which the firm operates and then needs to assess in that context how the corporation should proceed. Some of the board's decisions may require it taking a stand on what have (regrettably, imv) become highly politicized social justice and commercial issues. It involves weighing and balancing. It is hard work. But that is the board's job. The board may want to inform itself of which political party likes what (especially as it relates to its various constituencies), but the board's decisions ultimately need to be made in good faith on the basis of what, after being fully informed in all material respects, they collectively believe to be in the best interest of the corporation (including its shareholders).
Some folks seem to ignore that reality. Instead, they assume (in many cases without adequate articulated foundation) that a board is catering to or rejecting, e.g., ESG initiatives based on a political viewpoint. I have more faith in corporate boards than that. I urge people to check those assumptions before making them (and to leave their own political preferences behind in doing so). Although I have seen a few dysfunctional boards in my 37 years as a lawyer and law professor, I have seen many more that are looking out for the long-term sustainability of the firm for the financial and other benefit of shareholders. That does require that employee interests, customer/client interests, and the interest of other stakeholders be understood and incorporated into the board’s decision making. Ann seems to agree with this last point when she writes in her post that: "despite occasional rhetoric to the contrary, it may very well be profit-maximizing to bow to employee demands; it doesn’t mean the CEO is pursuing a personal political agenda, it simply means that restive employees make a company difficult to run."
In concluding, I do not see an “incipient trend” or any “diametric opposition” of the kind noted in the abstract posted by Stefan. I also see board (and overall corporate management) support for ESG—although I admittedly am not a fan of looking at all the E, S, and G together—as the probable acknowledgement of an economic or financial reality in or applicable to those firms. Economies and markets are changing, and firms that do not respond to those changes one way or another will not survive. And that will not inure to the benefit of shareholders or other corporate stakeholders. The Business Roundtable Statement on the Purpose of the Corporation acknowledges the importance of corporations in our local, national, and global economies and, in light of that, articulates management’s recognition of the need to create sustainable economic and financial symbiosis through the firm's decision making: “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.”
As scholars, we should recognize the realities of the boardroom and of firm management in general, which optimally involve complex, individualized decision-making matrices. Moreover, as we theorize about, and assess the policy objectives of, the laws we study and on which we comment, we should keep those realities in mind. Rather than assuming why boards (and C-suite officers, for that matter) act the way they do based on our theoretical and political viewpoints, we should interrogate their management decisions thoroughly, understanding and critiquing the actual bases for those decisions and, when possible, suggesting a "better way."
Thanks to the National Business Law Scholars Conference participants for their stimulating presentations and to Ann and Stefan for their posts. I hope that this post serves to illuminate my perspective on shareholder wealth maximization a bit. The conversation is important, even if a common understanding may not be forthcoming.
Saturday, June 18, 2022
Recently, the New York Times reported that Howard Schultz wants to rescind the open bathroom policy that Starbucks adopted in 2018. The backstory, as some may remember, is that two black men in Philadelphia were waiting to meet someone in a Starbucks and they sought to use the bathroom without buying anything. A store employee ended up calling the cops; they were arrested; protests ensued; and the company announced that anyone would be permitted to use Starbucks bathrooms going forward.
Now, however, Schultz is reconsidering that policy. Here’s what he said about it:
We serve 100 million people at Starbucks, and there is an issue of just safety in our stores in terms of people coming in who use our stores as a public bathroom, and we have to provide a safe environment for our people and our customers. And the mental health crisis in the country is severe, acute and getting worse.
Today, we went to a Starbucks community store in Anacostia, five miles from here, which is a community that unfortunately is emblematic of communities all across the country that are disenfranchised, left behind. And here’s Starbucks building a store for the community. Now, we had a round-table discussion with the manager and other people, and we were told that from 12 to 6 p.m. today — every day — there’s no one on the street. Why? Because people are afraid that their children are going to get shot — five miles from the White House.
I think we’ve got to provide better training for our people. We have to harden our stores and provide safety for our people. I don’t know if we can keep our bathrooms open.
Starbucks is trying to solve a problem and face a problem that is the government’s responsibility.
Let’s remember why the open-bathroom policy was adopted in the first place. I, for one, used Starbucks bathrooms for years without buying anything, well before 2018. That’s because a customer-only bathroom policy doesn’t actually mean that only customers can use the bathroom; it is, in practical effect, a policy of employee discretion, via selective enforcement. Some people who are not customers can use the bathroom, and some cannot. In general, we can surmise it will be black non-customers who are asked to leave; white non-customers will be permitted to go. Perhaps some degree of employee training may mitigate the racial impact of a closed-bathroom policy, but it’s unlikely to eliminate it entirely. So, Starbucks opened up its bathrooms.
Still, let’s assume Schultz is right, and the open-bathroom policy does, in fact, attract some people who are actual threats to Starbucks employees.
That means Starbucks has to balance stakeholder interests. Does it favor the employees and their safety? Or does it recognize the disparate racial impact of a closed-bathroom policy, and favor the public interest of keeping them available?
Right now, Starbucks is fighting off a union campaign; very likely, the profit-maximizing strategy is to favor the employees. This article, for example, reports safety as a key issue surrounding union organization.
This illustrates a couple of things. First, despite occasional rhetoric to the contrary, it may very well be profit-maximizing to bow to employee demands; it doesn’t mean the CEO is pursuing a personal political agenda, it simply means that restive employees make a company difficult to run. Second, as is often mentioned when stakeholder-governance is discussed, not all stakeholders have the same interests, and favoring some groups may wind up disfavoring others (which is one of the reasons shareholder primacists argue stakeholder governance is impractical; absent that profit-maximization decision rule, there’s no obvious way to choose among stakeholders).
But now, let’s complicate the narrative.
Is employee safety really Schultz’s motivation here? Starbucks does not have a janitorial staff; part of the job of being a barista is cleaning, including cleaning the bathrooms. I assume an open-bathroom policy means there is simply more work, and more unpleasant work, for the baristas. It wouldn’t at all surprise me if the union organizing campaign does not just include safety discussions, but also the question whether baristas should receive more pay, or more benefits, or whether stores should simply hire more staff, to deal with that extra work. Schultz, by closing the bathrooms, placates the employees on this point but also avoids additional expenditures by the company.
If that’s the real story here – and I don’t know that it is, I’m speculating – then what essentially is going on is that Starbucks’s original policy had a disparate racial impact, and remedying that problem is expensive. Schultz would rather just leave the racism in place; it’s cheaper.
That’s definitely a shareholder primacist approach, but it’s one where the company profits by externalizing the costs of doing business on to the public. And in particular, black members of the public.
Friday, June 10, 2022
The battle for Spirit Airlines is fascinating. Frontier offered to buy Spirit at a price of roughly $22 per share, payable mostly in Frontier stock. Then JetBlue swooped in with a topping bid of $33 per share in cash. Spirit's board maintained its preference for Frontier's bid, and Glass-Lewis recommended in favor of Frontier, but ISS recommended against. ISS's argument was, in part, that if shareholders liked the sector, they could take JetBlue's cash and reinvest it.
Spirit's argument was that the combination with Frontier not only stood a greater chance of surviving antitrust review, but there would be substantial operating synergies such that the combined entity would be expected to outperform the sector in the long term.
There was some interesting jousting over the reverse break fees if DoJ refused either combination - including Jet Blue's highly unusual offer to pay part of the break fee in cash as a special dividend to Spirit shareholders as soon as they voted for a deal between Spirit and JetBlue (I mean, it's kind of complicated given the numbers floating around, JetBlue offered $33, then lowered it to $30 when it made a tender offer for Spirit, and then added back $1.50 as a prepay on the break fee, which means one has to query whether the current JetBlue structure counts as vote-buying) - but ultimately, leaving aside antitrust risk, the fundamental question to shareholders is whether they can reinvest the extra cash offered by JetBlue (including potentially in the Jet Blue/Spirit combination itself) more profitably than whatever long term appreciation in the stock price they could expect from a combined Frontier/Spirit entity.
Which is why this column in the Wall Street Journal stood out for me:
The bidding war over Spirit Airlines shows why “stakeholder capitalism” is a hard sell for investors.
On Wednesday, the U.S. carrier postponed a shareholder meeting scheduled for Friday that would have included a vote on the acquisition bid made by its competitor Frontier Airlines. Spirit’s board of directors retains a strong preference for this merger, which seems like a perfect cultural fit, over a rival one proposed by JetBlue Airways. But the board’s latest move betrays hesitation that shareholders might not put the same value on non-pecuniary factors.
…[S]haring DNA is precisely what could make a Spirit-Frontier combination successful. Both carriers’ networks are similar and complementary: Only in 2% of routes did they compete fiercely for market share in 2021, a data analysis shows. Conversely, JetBlue’s higher-cost model is a harder fit.
Spirit shareholders might still get their cake and eat it too if the company wrangles more concessions out of Frontier before the rescheduled June 30 vote. If not, they face a dilemma between more money in the short term and a stake in a merged company that could, speculatively, offer higher longer-term returns.
The situation illuminates two distinct ways of understanding capitalism. First is the standard “shareholder theory” popularized by Milton Friedman, which gives primacy to measurable investment returns and laments the “agency problem” of executives serving other priorities. The second, sees professional managers wresting control from shareholders—a phenomenon documented by business historian Alfred Chandler, among others, since at least the 1920s—as necessary for the survival of corporations. It links with the “stakeholder theory” in which firms should serve all involved parties.
Literally nowhere in Spirit’s pitch to investors does Spirit suggest that the Frontier transaction is anything but shareholder value-maximizing. Nothing in Spirit's argument has anything to do with the merger's effect on nonshareholder interests. In fact, Spirit’s position is not unlike the position of the Time board when it rejected Paramount’s bid in favor of a merger with Warner – and in that case, the Delaware Supreme Court famously gave the Time board leeway to pursue a long term strategic vision. So, you know, unless you believe the Delaware courts are stakeholderists now, the mere fact that corporate directors want to reconstitute the entity rather than cash out does not a stakeholder-merger make.
What does the columnist mean by "stakeholderism," then? Apparently, he means something like the idea that managing for the long term is, in fact, value-maximizing for shareholders, in part because the long-term view theoretically includes building relationships with, and thereby benefitting, other constituencies. That version of stakeholderism is often used to defend managerial control against shareholder interference (while staving off business regulation). The irony of this concept of "stakeholderism" is that it is often opposed by other stakeholderists, including stakeholderists who share a vision of long-term value creation as benefitting all parties, because they object to giving management that much discretion.
Professor Steve Bainbridge chimed in with a different definition of stakeholderism. He pointed out that the JetBlue flight attendants’ union opposes a merger with Spirit on the ground that it will cost jobs, while the union that represents both Frontier and Spirit favors a merger between those companies, and he concludes that a true stakeholder investor would follow the union recommendation. He predicts that shareholders are only motivated by profit and won’t pursue the union position, which he implicitly associates with the absence of shareholder wealth-maximization.
Notice, then, that Prof. Bainbridge's definition of stakeholderism is very different than the one offered in the Wall Street Journal. In his view, it's not about managerial control or long-term value maximization; it's about whether shareholders are willing to sacrifice profits in order to benefit nonshareholder constituencies. But whatever the unions' position, this is not really the choice that the shareholders in this instance are being asked to confront. I.e., this is not a salient part of the pitch to investors.
That said, it's possible the reason the union position is not part of the pitch to investors is because no one thinks investors would find the unions' preferences persuasive (or, worse, they think that shareholders would do the opposite of what unions want). But that's entirely consistent with the stakeholderism-as-profit-sacrificing theory, because profit-sacrificing stakeholderism is a movement for change; the whole point is that it functions as an objection to the way the current system operates. In a case like this, the argument often concludes there is an actual agency problem between the institutional investors who vote the shares, and the retail shareholders who they represent. If that’s right, the fact that the institutions who own Spirit Airlines – 70% of the stock - may vote for the JetBlue deal tells us very little. That’s precisely why so many academics argue that institutions should determine retail preferences before voting, and why the SEC wants greater disclosure from funds that market themselves as ESG. I mean, at this point I'd kind of be remiss if I didn't mention that Prof. Bainbridge just recently signed a letter arguing that institutional investors do not share the preferences of their own beneficiaries, and recommended that those beneficiaries be polled as to their true preferences, so he's familiar with this line of reasoning.
Now, to be fair, I share Prof. Bainbridge's view that, faced with a takeover bid at a premium that favors shareholders over everyone else, shareholders as a group are unlikely to reject it in order to benefit nonshareholder constituencies. That dynamic is, in fact, is why we're losing local news coverage in this country. But to give the stakeholder argument its due, if shareholders really did force companies to operate with a view to benefitting nonshareholder constituencies, consistently and across the board, we'd also see fewer rapacious takeover bids in the first place, because the acquirer would expect that its own shareholders would refuse to let it enact its rapacious wealth-maximizing plans.
Which means, there's not a whole lot in the Spirit battle that sheds light on the stakeholderism debate. This fight is more of a throwback to Paramount: as between the board and the shareholders, who gets to decide the future of the company, and the timeline for achieving it?
Tuesday, June 7, 2022
Comment Letter of Securities Law Scholars on the SEC’s Authority to Pursue Climate-Related Disclosure
This post alerts everyone to a comment letter, drafted by Jill Fisch, George Georgiev, Donna Nagy, and Cindy Williams (signed by the four of them and 26 other securities law scholars, including yours truly and Ann Lipton), affirming that the Securities and Exchange Commission’s recent proposal related to the enhancement and standardization of climate-related disclosures for investors is within its rulemaking authority. The letter was filed with the Commission yesterday and has been posted to SSRN. The SSRN abstract is included below.
This Comment Letter, signed by 30 securities law scholars, responds to the SEC’s request for comment on its March 2022 proposed rules for the “Enhancement and Standardization of Climate-Related Disclosures for Investors” (the “Proposal”). The letter focuses on a single question—whether the Proposal is within the SEC’s rulemaking authority—and answers this question in the affirmative.
The SEC’s authority for the Proposal is grounded in the text, legislative history, and judicial interpretation of the federal securities laws. The letter explains the objectives of federal regulation and demonstrates that the Proposal’s requirements are properly understood as core capital markets disclosure in the service of those objectives. The statutory framework requires the SEC to adjust and update the content of the federal securities disclosure regime in response to the evolution of the economy and markets, and, in recent decades, the SEC has done so to require disclosures on a variety of subjects from Y2K readiness, to cybersecurity, to human capital management, to the effects of the Covid-19 pandemic. Rules mandating climate-related disclosure fit with this pattern of iterative modernization. Such rules do not represent a foray into new and uncharted territory, since the SEC has a long history of requiring disclosure on environmental and climate-related topics dating back more than 50 years. Finally, the federal securities laws do not impose a materiality constraint on the SEC’s authority to promulgate climate-related disclosure requirements.
The Comment Letter therefore concludes that the SEC has the statutory authority to promulgate the Proposal, and that the climate-related disclosure rules under consideration are consistent with close to nine decades of regulatory practice at the federal level and with statutory authority dating back to 1933 that has been repeatedly reaffirmed by Congress and the courts.
There is more that has been, can, and will be said about the Commission's rulemaking proposal as a matter of process and substance. But I will leave that for another day. For now, we just wanted you to know about the filing of the letter and offer you an easy way to find it and review it.
Saturday, May 28, 2022
But a few days ago, he published this Op-Ed in the Wall Street Journal:
ESG is a pernicious strategy, because it allows the left to accomplish what it could never hope to achieve at the ballot box or through competition in the free market. ESG empowers an unelected cabal of bureaucrats, regulators and activist investors to rate companies based on their adherence to left-wing values.
While I do believe that some aspects of ESG are financial (climate change is a clear example), others seem to be more of an expression of moral value (and apparently at least some investors view it that way). In that sense, it is an attempt to accomplish what cannot be achieved at the ballot box. Some surveys show support for gun control measures that reach nearly 90%; a majority of Americans support greater action on climate change, and a majority want to keep abortion available under at least some circumstances. Yet increasingly, our political leaders fail to adopt policies that the populace supports; the ballot box is simply not an available tool. It's no wonder, then, that voters turn to corporations as a source of power that at least appears to be more responsive to public pressure. Far from a distortion of free markets, though, it is the ultimate expression of them, because the entire theory is that investment dollars can be used to force social change. This is why Jonathan Macey calls the ESG movement "radically libertarian," and the head of MSCI defended ESG as a mechanism to "protect capitalism. Otherwise, government intervention is going to come, socialist ideas are going to come."
The best way to eliminate ESG, then, is to reform our political system to make it more responsive to voters.
Saturday, May 21, 2022
The world seems to be fascinated with Musk’s antics in connection with the Twitter acquisition (I have to pay attention; it’s my job), and in particular, a question that seems to be coming up a lot is, “Why isn’t the SEC doing anything?” The answer, of course, is that none of this has anything to do with the SEC. Yes, sure, Elon Musk didn’t file a form on time, and, now that we have the preliminary proxy, it seems the forms he did file were false in that they claimed he had no designs on a merger when in fact he absolutely did have designs on a merger, but delayed 13D/13G filings have never been a high priority for the SEC and in most cases have been met with a small fine. The rest of it – Musk’s arguable violation of the merger agreement by tweeting confi info and disparaging everyone in sight, and his fairly transparent attempt to back out of his obligations with pretextual excuses about spambots – simply are not the SEC’s bailiwick. That’s Delaware’s problem, which dictates the fiduciary duties of Twitter board members, and whose law governs the merger agreement. And Delaware doesn’t act sua sponte, like a regulatory agency; it responds only when someone brings a lawsuit. Which Twitter may or may not ultimately do. (Its shareholders certainly will; one suit’s brewing, more will likely be forthcoming).
But there’s a deeper issue here, which is that the complete failure of anyone to rein Musk in really undermines the perception that there is a general rule of law that applies to everyone. That’s why everyone’s asking why the SEC isn’t acting, even though this isn’t really the SEC’s responsibility to address.
I mean, sure, you kind of know in a cynical way that rich people play by their own rules, but there’s a difference between believing that intellectually and viscerally experiencing it, day by day, as it plays out in Twitter.
And maybe that perception is misguided in this case – as I just said, there really isn’t a basis for any regulatory authority to get involved here, though the SEC could create headaches by demanding more disclosures in the proxy – but Musk’s brazen disregard of his contractual obligations almost certainly flows from his history of ignoring rules and experiencing no meaningful consequences. And of course, the more he does it, the more he develops an army of admirers who become less likely to hold him to account in the next iteration of the game.
Uninformed observers may be misunderstanding the specifics, but they’re right on the general principle. Like, I don’t think it’s entirely coincidental that Musk is publicly defying obligations under Delaware law right after a Delaware court said – in practical effect – that he is a business genius who is largely entitled to skip all the niceties of Delaware procedure.
And that’s the danger of each individual player – a Delaware court, a particular regulatory agency, a merger partner – each deciding that Musk is too irascible, too smart, too wealthy, too talented, to rein in. It collectively communicates a very specific lesson about who has to comply with the law, and who doesn’t. That harms everyone, but no one actor has an incentive or even the jurisdiction to address it.
That said, on a long enough timeline, well....
Saturday, May 14, 2022
So of course, after I drafted this post about Chancellor McCormick’s decision in Coster v. UIP Companies, the Ninth Circuit came down with a decision affirming the district court opinion in Lee v. Fisher. I blogged about that case here; the short version is, the district court enforced a forum selection bylaw that required derivative 14(a) claims to be litigated in Delaware Chancery, despite the fact that Delaware Chancery has no jurisdiction to hear 14(a) claims. Based on Ninth Circuit precedent, the district court held that the Exchange Act’s antiwaiver provision was not a clear enough statement of a federal public policy against forum selection to prohibit enforcement of the bylaw. The Ninth Circuit, on appeal, agreed (you know the drill by now; no one engaged the question whether the bylaw is the equivalent of a contractual agreement, naturally). By affirming the district court’s decision, the Ninth Circuit sort of - but not exactly - created a split with the Seventh Circuit’s decision in Seafarer's Pension Plan v. Bradway; I say “sort of” because – as I explained in my post about the Bradway decision, here – most of the Seventh Circuit’s logic refusing to enforce such a bylaw was rooted in its interpretation of Delaware law, rather than federal law. The Ninth Circuit largely refused to engage with the Delaware law analysis, and instead focused on federal law, because it concluded that the Lee v. Fisher plaintiff had waived arguments about Delaware law.
Upshot: In the Ninth Circuit, it is now possible for a company to completely opt out of Exchange Act liability by unilaterally adopting a bylaw saying so, as long as the bylaw doesn’t use the word “waiver” and instead uses the words “forum selection” and “Delaware Chancery.”
That’s probably all I have to say about that for now, despite my general creeping horror, unless I change my mind (saving it for a ranting article that one day will go up on SSRN), so back to what I originally intended to post about....
Recently, Chancellor McCormick issued her opinion in on remand in Coster v. UIP Companies. Coster is a somewhat unusual case for Delaware, in that it involves a closely-held corporation governed via longstanding personal ties, rather than a public entity, or at least one sponsored by arm’s length VC/PE capital. Two founding members of UIP each held 50% of its stock; when one died, his widow, Marion Coster, received his share. The remaining founder and UIP employees tried to negotiate with Coster to buy her out, but they could not reach a deal; the parties deadlocked and could not agree on board members; and finally, Coster sought the appointment of a custodian. In response, the remaining founder caused UIP to sell a chunk of stock to a longtime employee/holdover director. Once the sale was complete, the founder and the employee together had majority voting control, breaking the deadlock and diluting Coster’s stake.
Coster challenged the sale and, after a trial, McCormick concluded that though the defendants were interested in the sale, and had effectuated it to break the deadlock and thwart Coster’s move for a custodian, the transaction had nonetheless been “entirely fair” to Coster and the company because the board ran a reasonable process and the employee had paid a fair price.
On appeal, the Delaware Supreme Court seemed to leave undisturbed McCormick’s conclusion that the transaction had been “entirely fair,” but nonetheless held that, given the board’s entrenching motives, McCormick should additionally have evaluated whether the defendants had engineered the sale in order to entrench themselves and thwart Coster’s voting rights, in violation of Blasius Industries, Inc. v. Atlas Corp, 564 A.2d 651 (Del. Ch. 1988) – adding an interesting footnote acknowledging that while some have questioned the relationship of Blasius to Unocal, none of the parties had made that argument and so the court would not engage it, see Op. at n.66.
That in and of itself highlights a very odd aspect of the doctrine: the Delaware Supreme Court’s decision may be read to mean that a transaction can both be “entirely fair” and represent an inequitable interference with voting rights. If that’s right, and since “entire fairness” is usually described as the most rigorous standard of review, the Supreme Court decision may mean that Blasius exists on something like a different scale, independent of the financial aspects of corporate action. Or maybe the Delaware Supreme Court, recognizing that conceptual oddity, left the relationship of Blasius to “entire fairness” somewhat vague. In the Court’s words:
the Court of Chancery fully supported its factual findings and legal conclusion that the board sold UIP stock to Bonnell at a price and through a process that was entirely fair. Thus, we will not disturb this aspect of the court’s decision. But the court also held that its entire fairness analysis was the end of the road for judicial review. …In our view, the court bypassed a different and necessary judicial review where, as here, an interested board issues stock to interfere with corporate democracy and that stock issuance entrenches the existing board. As explained below, the court should have considered Coster’s alternative arguments that the board approved the Stock Sale for inequitable reasons, or in good faith but for the primary purpose of interfering with Coster’s voting rights and leverage as an equal stockholder without a compelling reason to do so….
And later in the opinion
under Blasius, even if the court finds that the board acted in good faith when it approved the Stock Sale, if it approved the sale for the primary purpose of interfering with Coster’s statutory or voting rights, the Stock Sale will survive judicial scrutiny only if the board can demonstrate a compelling justification for the sale. That the court found the Stock Sale was at an entirely fair price did not substitute for further equitable review when Coster alleged that an interested board approved the Stock Sale to interfere with her voting rights and leverage as an equal stockholder.
So I suppose this could be read to mean that Blasius is, in fact, part of the entire fairness analysis, and McCormick erred by stopping with process/price. I’m not really sure, and I’m not sure the Supreme Court wanted me to be sure.
In any event, on remand, Chancellor McCormick elaborated on her factual findings. In particular, she highlighted that the board’s actions were defensive moves intended to thwart the damaging actions of Coster, who was the aggressor. Specifically, after insisting on a buyout at an unreasonable price, Coster sought to have unqualified nominees seated on UIP’s board. When the board refused, she sought a custodian who would have had significant powers to upend UIP’s entire business model and damage its revenue streams. Along the way, she refused meaningful negotiation with board members who tried in good faith to accommodate her. At the same time, the stock sale to the employee had been in the works for a while, so by going ahead with it, the board managed to both address the Coster problem and reward someone who had long been a critical asset to the company. Under these circumstances, McCormick felt that the board had shown it had a compelling justification for its actions under Blasius.
So, this is interesting because it speaks to a hypothesized but – as far as I can tell – never before seen set of circumstances in Delaware law. Namely, when is it okay to issue stock to dilute someone’s existing voting power because they threaten to use that power in a damaging way? Note that this is not the same as a poison pill; the pill gives advance warning to investors that if they acquire more shares, they may be diluted. Here, by contrast, the dilution was to an existing interest, with no warning, based solely on the inequitable actions they sought to take.
The possibility that a board might be justified in taking such action has been raised before. Specifically – as I blogged when discussing CBS’s proposal to take similar action with respect to Shari Redstone – in Mendel v. Carroll, 651 A.2d 297 (Del. Ch. 1994), the court held that maybe a board might under some circumstances be justified in taking such an action against a threatening controller. The Mendel dicta has been repeated over the years, but this is, to my knowledge, the first time that a Delaware court has actually approved a board in fact taking such action. Though, as I highlighted in that earlier blog post, a New York court interpreting Delaware law approved a dilutive issuance intended to force the sale of Bear Stearns to JP Morgan at the height of the financial crisis – which, among other things, demonstrated that Delaware was happy to pass that hot potato to New York in order to avoid taking responsibility for throwing America’s markets into chaos by blocking the action.
But until now, no Delaware court (I think) has actually given the go-ahead in a particular set of facts; the court in CBS itself held that it was not necessary for the board to dilute Shari Redstone’s interest because any fiduciary breaches on her part could be remedied on a case-by-case basis.
Which means the lesson here is not simply that there are some corporate actions that survive Blasius review, but also that there is at least one set of facts that permits the issuance of new shares for the explicit purpose of diluting an existing holder who represents a threat to the company’s future.
Saturday, May 7, 2022
As everyone knows by now, in In re Tesla Motors Stockholder Litigation, VC Slights refrained from engaging all the meaty doctrinal issues. He did not decide whether Elon Musk is a controlling shareholder of Tesla; he refused even to decide whether a “controller” is a different thing than a “controlling shareholder,” see Op. at 81 n.377. He didn’t decide whether the Board was majority independent, going so far as to raise the possibility that even a board that operates under serious conflicts may nonetheless “prove” their independence at trial, see Op. at 81 n.378. He did not decide whether passive investors’ stakes on both sides of a merger may render them not disinterested for cleansing purposes, see Op. at 63 n.311. Instead, he found it easier to conclude that Tesla’s acquisition of SolarCity was entirely fair, rather than engage with all the thorny legal questions the case raised.
That was sort of a surprise (though you can’t help but wonder how much of that was hindsight, see Op. at 126-27). Yet in many respects, it was ultimately a very Delaware sort of decision.
It has long been observed that while liability is rarely imposed on Delaware fiduciaries, the Delaware judicial system has its own method of discipline, namely, through reputational sanctions. Ed Rock described this phenomenon in Saints and Sinners: How Does Delaware Corporate Law Work?; as he tells it, Delaware decisions are parables of good managers and bad managers, and operate as a kind of “public shaming” for those who violate these norms. See also Omari S. Simmons, Branding the Small Wonder: Delaware’s Dominance and the Market for Corporate Law (discussing the Disney case; “even where a decision does not result in liability for board members, embarrassing details of corporate dysfunction may tarnish a company's reputation. Reputational risk is another salient reason for boardrooms to pay attention to Delaware court pronouncements.”).
That’s not a bad description of the Tesla decision. Though VC Slights had apparently a great deal of admiration for Elon Musk’s strategic vision and business expertise, he also offered harsh criticism over Tesla’s refusal to adopt an independent process for negotiating the deal. See Op. at 86-87. He even explicitly acknowledged Delaware law as functioning through parable, see id., and, as punishment for the board’s laxity, he refused to award Musk costs. See Op. at 131. These criticisms should strike fear into the hearts of corporate managers (or their insurers) everywhere: all of these litigation expenses, from the motion to dismiss through discovery through summary judgment to trial, could have been avoided had the Tesla board simply adopted cleansing measures from the outset. And that’s supposed to be the takeaway for future boards.
But will that work?
In his article, Ed Rock acknowledged that celebrity managers might not care about Delaware’s opprobrium, not when they stand to earn riches by ignoring it. Instead, he pointed out that most public corporations have a bureaucratic set of directors, who will be responsive to Delaware’s censure even when particular managers are not. As he put it:
MBOs, overnight, provided the opportunity for the senior managers to become very rich, to go from being bureaucrats to entrepreneurs . Under such circumstances , one can expect that some managers might rather quickly become indifferent to the criticism of the judges. The possibility of becoming seriously rich sometimes has that effect.
How did the courts respond? In the MBO cases, one sees a subtle shift of attention from the managers to the special committee. Although the potential gains to managers in MBOs might lead them to develop resistance to the deterrent effect of public shaming, the members of the special committee had no such prospects. They were not getting rich. They were simply trying to do their best as outside directors. One would predict that such actors are likely to be far more susceptible to the kind of influence that Delaware opinions exert than the managers. The Delaware courts, perhaps sensing this, focused much of their attention-both in the opinions and in extrajudicial utterances-on influencing the conduct of the special committees.
Note, now, a surprising implication of this analysis. If the success of Delaware's method for constraining or encouraging managers to act on behalf of shareholders depends critically on a separation of ownership and control , with the greater susceptibility to reputational effects that agents have in comparison to principals, then the system is likely to be less suitable for corporations not characterized by this separation, such as closely held corporations.
If that’s right, Tesla – and Elon Musk – are particularly poorly suited for the “Delaware way.” Not only is Musk himself indifferent to Delaware’s criticism, but his public board – stacked with allies and close associates – is structured very much like his private ones, making it more akin to the structure of a closely-held company. See, for example, this New York Times article about how Musk retains tight control over his companies, including by populating boards and managerial positions with his allies.
One could obviously argue that in the end, it hardly matters so long as Musk is benefitting his shareholders. But leaving aside the problem of counterfactuals (what if a more independent board would have improved shareholder returns even more?) another possibility is that other CEOs take Musk as a role model – especially in a time when companies are staying private for longer, as founders are feted as auteurs, as most IPOs feature dual-class stock, as even ostensibly “independent” directors are compensated with millions of dollars’ worth of stock – and not all of these stories will end happily for shareholders. There is a real question whether Musk is simply an outlier, or whether the model public company on which the Delaware ethos is built is transforming into a different kind of institution that requires different policing.
Saturday, April 30, 2022
Look, I know the Tesla/SolarCity decision just came down, and I’m, like, contractually obligated to blog about it, but to tell you the truth, this was the last week of classes, exams are next week, and I just got back from a conference thing, so comments on the Tesla decision will have to wait (though, yes, I did appreciate the wink in footnote 377).
So, proxy solicitations. Specifically, the Eighth Circuit’s decision in Carpenters’ Pension Fund of Illinois v. Neidorff, 30 F.4th 777 (8th Cir. 2022), which I was alerted to by the Deal Lawyers’ blog.
In Neidorff, the plaintiffs brought a derivative Section 14(a)/Rule 14a-9 claim alleging that Centene Corporation solicited a vote in favor of a merger by way of a misleading proxy statement that failed to disclose known problems with the target company. Rule 14a-9 prohibits proxy statements from:
containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.
In this case, the preliminary proxy statement was filed on August 19, 2015, the final proxy statement was filed on September 21, 2015, and the vote was taken on October 23, 2015. The Eighth Circuit decision is very light on the specific allegations (and the briefs, as far as I can tell, are under seal), but apparently among them was the claim that even if the proxy statement was true as of September 21, the defendants violated Rule 14a-9 by failing to update it with newly discovered facts before the shareholder vote. In response to that argument, the Eighth Circuit held:
As to Appellants’ argument that the failure to update the Proxy Statement rendered it materially misleading, Appellants have not cited, and we have not found, any authority supporting the proposition that § 14(a) requires a company to update its proxy statement. Moreover, this argument is inconsistent with the text of Rule 14a-9(a), which provides that a proxy statement may not contain “any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact,” 17 C.F.R. § 240.14a-9(a) (emphasis added), and the language of the Proxy Statement itself, which provides in all capital letters that neither Centene nor Health Net intends to update the Proxy Statement and that both companies disclaim any responsibility to do so, R. Doc. 79-3, at 118.
For the reasons set forth above, Appellants have failed to plead facts showing that the Proxy Statement contained a material misrepresentation or omission and, consequently, have failed to plead particularized facts demonstrating that at least half of the Board faces a substantial likelihood of liability on their § 14(a) claim.
The reason I find this incredible is that there is ample precedent for the notion that proxy statements must be updated to avoid being false. This is because, unlike, say, a 10-K, which represents a snapshot in time - and thus will rarely be rendered “false” due to a failure to update with subsequent information - a proxy statement is supposed to provide the basis of action on a particular date, namely, the shareholder meeting. If proxy statements do not have to be up to date as of the meeting, they will not serve their primary purpose of providing shareholders with sufficient information to cast their ballots. Thus, in Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281 (2d Cir. 1973), the Second Circuit held, “we cannot suppose that management can lawfully sit by and allow shareholders to approve corporate action on the basis of a proxy statement without disclosing facts arising since its dissemination if these are so significant as to make it materially misleading, and we have no doubt that Rule 14a-9 is broad enough to impose liability for non-disclosure in this situation.” See also SEC v. Parklane Hosiery, 558 F.2d 1083 (2d Cir. 1977) (quoting Gerstle).
The SEC has also made clear that companies must update their proxy statements to ensure they are accurate as of the date of the shareholder vote. See SEC Release No. 34-23789, 1986 WL 722059 (“When there have been material changes in the proxy soliciting material or material subsequent events (in contrast to routine updating), an additional proxy card, along with revised or additional proxy soliciting material, should be furnished to security holders … to permit security holders to assess the information and to change their voting decisions if desired.”); SEC Release No. 34-16343, 1979 WL 173161 (“Even in a situation wherein a statement when made was true and correct, and is rendered incorrect due to a change in circumstances or other subsequent event, appropriate action should be taken to correct the misstatement prior to the meeting….Rule 14a-9 has been construed by courts to require either that proxy solicitation materials which have become false and misleading should be corrected or that other steps be taken to ensure that shareholders not vote on matters on the basis of incomplete or inaccurate information.”).
Further to this, Stephen Quinlivan at Stinson compiled this list of typical SEC comments on merger proxy statements. I’ve excerpted out a relevant one:
We note the disclosure on page X that ABC does not intend to revise its projections. Please revise this disclosure, as publicly available financial projections that no longer reflect management’s view of future performance should either be updated or an explanation should be provided as to why the projections are no longer valid.
I realize a lot of this precedent is kind of old, but I have no reason to think it’s no longer good law, which makes the Eighth Circuit’s decision here bit of an eyebrow-raiser (assuming it meant what I think it meant, because, again, the opinion is light on details).
Friday, April 22, 2022
I guess we’re talking about Elon Musk again.
If you’re like me, you’re kind of gratified by the general public’s new fascination with corporate law, but, of course, to those of us who live here, it’s obvious that while all of the maneuvering so far is colorful, it’s bog standard legally, and the Twitter board’s actions in adopting a poison pill were not only totally unremarkable, but arguably necessitated by their fiduciary duties. (So that they would have time to explore other alternatives; so that they could assess the seriousness of Musk’s offer and attempt to negotiate a higher one; so that they could prevent Musk from obtaining control – or sufficient control to block superior alternatives – simply through open market purchases, etc). Nonetheless, that has not prevented a lot of people who should know better from saying silly things:
Twitter enacted poison pill; our thoughts-TWTR going down the poison pill path is a predictable defensive measure for the Board to go down that will not be viewed positively by shareholders given the potential dilution and acquisition unfriendly move. Likely challenged in Courts— Dan Ives (@DivesTech) April 15, 2022
If the current Twitter board takes actions contrary to shareholder interests, they would be breaching their fiduciary duty.— Elon Musk (@elonmusk) April 14, 2022
The liability they would thereby assume would be titanic in scale.
(for that last, maybe Musk is thinking of his own potential exposures for fiduciary duty claims)
That said, it cannot be denied that the issue of Musk’s potential control of Twitter – and the changes he may make to content moderation – are of great political importance. Musk has suggested that he would like to loosen content restrictions, and several conservatives, who argue that their views are censored on Twitter, have cheered Musk’s proposal for that reason alone. Ron DeSantis, who has been aggressively leaning into the culture wars, has gone so far as to declare that not only has the Twitter board violated its duties by resisting Musk’s proposal, but that he hopes to cause Florida’s state pension fund – which is invested in Twitter – to sue.
All of which spotlights a couple of fairly basic things about corporate law, but they are worth teasing out.
First, corporate law matters for reasons that go beyond finance; for good or for ill, whoever has control over Twitter will also have a great deal of control over the global political discourse. That inescapable fact makes the argument for shareholder primacy – that corporate law should only concern itself with investor welfare – ring somewhat hollow.
Second, though, and in some degree of tension with the first, I’ve joked here before about Delaware controlling the world, but part of the reason that academics and others have tolerated and/or championed Delaware’s outsized influence is because it’s probably the closest thing we will have to a neutral. It would go too far to say Delaware law is apolitical – it does, in fact, have a shareholder-centric focus, which elevates capital above other constituencies – but we can trust that whatever disputes arise over Musk’s bid for Twitter, they will be litigated according to familiar legal standards that were not developed to appease any particular constituency on the right-left spectrum.
Update: And now congressional Republicans are demanding that the Twitter board preserve all communications pertaining to Musk’s offer, which... pretty much proves my point.
Saturday, April 16, 2022
I really enjoyed Matthew Wansley’s new paper, Moonshots, forthcoming in the Columbia Business Review. He focuses on the complicated incentives involved in performing “moonshot” research, that is, highly risky projects that could dramatically advance a field, but that will take years to develop. He argues that the venture carveout structure – whereby a startup has public company parents alongside other private investors, and employee incentive ownership, is designed to mitigate the various conflicts and agency costs that would exist among the players, and uses autonomous driving as the major case study.
I haven’t seen much about corporate investment in outside entities – though I gather there has been more written in the business literature, the only other legal paper I’m familiar with is Jennifer Fan’s Catching Disruptions: Regulating Corporate Venture Capital, 2018 Colum. Bus. L. Rev. 341, which offers a detailed descriptive account of how corporate venture capital functions and how it differs from traditional venture capital. But the two papers together convince me that this is a phenomenon that needs more attention in the legal scholarship.
Thursday, April 7, 2022
By now, I’m sure everyone is very much aware that Elon Musk took a giant stake in Twitter, was late filing his Schedule 13G (and failed to include a certification that he intended to hold passively), was added to Twitter’s board, and updated his Schedule 13G to a 13D, leaving a question whether he should have been filing on 13D all along. Once Musk did reveal his stake, Twitter’s stock price shot up.
The SEC has not historically policed the Schedule 13G/Schedule 13D filing requirements with great vigor, though Gary Gensler has highlighted the potential harm to traders/markets when they trade in ignorance of the presence of a potential activist investor; see also United States v. Bilzerian, 926 F.2d 1285 (2d Cir. 1991) (“Section 13(d)’s purpose is to alert investors to potential changes in corporate control so that they can properly evaluate the company in which they had invested or were investing.” (quotations and alterations omitted)).
Matt Levine asks whether this means Elon Musk engaged in insider trading, since he managed to save maybe $143 million by continuing to amass Twitter stock before finally revealing his holdings.
I’m going to ask something else: do the traders who sold between the time he was supposed to file the 13G, and the time he actually filed it, have a claim? And it seems pretty much, yes they do.
And boy howdy this got long, so, under the cut it goes:
Saturday, April 2, 2022
So the SEC dropped a couple of hundred pages of proposed new rules governing SPAC transactions.
I’d say the rules fall into three categories:
First, there are the ones meant to harmonize the regulatory framework for SPACs and for more traditional IPOs, both in terms of requiring disclosures akin to those in the IPO context, and in terms of imposing similar liability regimes, so that SPAC target companies will be vulnerable to Section 11 liability, financial advisors that shepherd the de-SPAC process will be treated as underwriters, and the PSLRA safe harbor will be unavailable for de-SPAC related projections.
(That last point is tricky: As the SEC acknowledged in its release, and as Professor Amanda Rose points out in a paper, because the de-SPAC is a merger, companies may essentially be required to include projections, like the ones that underlie financial advisors’ opinions, in their proxy statements. Which would mean, unlike in a traditional IPO, there would be no minimizing liability exposure simply by failing to include projections in the SEC filings. Couple that with Section 11 liability and it could be pretty intense. That said, the SEC is proposing to require issuers to include climate-related forward-looking information in registration statements, where no safe harbor would apply, so there is that to even the scales.).
Second, there are the ones meant to address the particular pathologies of SPACs, namely, their conflicts of interest, which encourage sponsors to pursue even bad deals over liquidation, and the dilution that public shareholders suffer as a result of the promote, the redemptions, and the warrants. And the SEC deals with these the way it deals with most things: extensive new disclosure requirements, including ones regarding conflicts, dilution, and SPAC-specific requirements for the basis of any projections. Many of these, drawn from the take-private rules, are disclosures meant more to force governance improvements than to actually reveal information, like disclosure of the fairness of the transaction, whether a majority-of-the-minority vote is required, and whether the independent directors had their own counsel to negotiate the deal on behalf of public stockholders.
Third, there’s the investment company thing. Professors Robert Jackson and John Morley have filed lawsuits against a couple of SPACs arguing that their variation from the SPAC structure – or just their delay in finding a merger partner– rendered them investment companies. The SEC proposes to formalize when a SPAC will avoid becoming an investment company, namely, if they keep the current form (no variations, like Bill Ackman proposed), sign a deal in 18 months, and close in 24.
Now, we all know that the SPAC market has cooled significantly; it operated like a speculative bubble for a while, along with meme stocks and joke cryptocurrencies, but a lot of that sheen has worn off, which means we may see less … umm… hasty work in the future and fewer outlandish projections, even without the new rules.
That said, the SPAC form still suffers from inherent incentives for SPAC sponsors to merge even with poor-quality firms. Sure, yes, the sponsor will prefer a high-quality target to a poor-quality one, but sometimes a high-quality target is hard to find, and in those instances, the sponsor would prefer the chance of a payout with the poor-quality firm to liquidation.
Professors Michael Klausner and Michael Ohlrogge have a paper where they discuss at length how sponsor earnouts – which are supposed to mitigate these conflicts by only allowing sponsors to receive additional shares if the post-merger trading price hits certain targets – are almost comically weak. They offer some suggestions for reform, for example, by encouraging more cash investment by the sponsor and shortening the earnout time periods, though they admit their proposals would only remove incentives for extremely bad deals, and not incentives for just, you know, mildly bad ones. I was fortunate enough to see Michael Ohlrogge present this paper (and Amanda Rose present hers) at Vanderbilt’s Law & Business Conference in March, and one of the things he mentioned was that it’s easy to incentivize people to work hard to find a good deal, but it’s more difficult to incentivize people to admit failure.
Which made me think that this problem is not unlike the lead plaintiff/counsel problem in securities cases. I previously talked about this here, and the issue is that plaintiffs’ attorneys in securities class actions are incentivized to seek lead counsel status, with an institutional client as a proposed lead plaintiff, relatively early in the case, before expending the time and funds on a full investigation. Once they’ve secured the lead spot, that’s when the real investigatory work begins, but at that point, even if the investigation turns up nothing, it’s very hard to admit that, drop the case, and confess error to the client. So, they’re incentivized to pursue cases that, by then, even they know are pretty weak.
I don’t have a solution for this problem in the securities class action context but I can offer one for SPACs, though even I’m not sure I like it: If we want to incentivize a behavior, we have to actually incentivize it. In this case, if the behavior we want to encourage is getting sponsors to seek liquidation when there are no good mergers to be had, then maybe there needs to be a payout for that. Smaller than what they’d get for a good merger, obviously, and we’d need layers of independent-review protections to ensure that sponsors made serious efforts to identify a likely target, and the money would have to come out of the liquidation payments to investors (which would make the SPAC form less attractive for that reason alone, but also might encourage greater diligence from the initial investors), but at the end of the day, maybe the way to get people to admit failure is to pay them to do it.
Sunday, March 27, 2022
The following post comes to us from George Georgiev at Emory Law. It follows quite nicely on Ann's post yesterday on Climate Change and Wahed Invest. I know a bunch of us will be commenting over time on the SEC's climate change release, and we are grateful that George has offered his ideas here. Please note that more of the post is below the fold and can be accessed by clicking on the "continue reading" jump link.
The SEC’s Climate Disclosure Proposal: Critiquing the Critics
George S. Georgiev
The SEC released its long-awaited Climate Disclosure Proposal a few days ago, on March 21, 2022. The Proposal is expansive, the stakes are high, and, predictably, the critical arguments that started appearing soon after the SEC kicked off this project a year ago are being raised ever more forcefully in preparation for a potential court challenge. A close review of the Proposal, however, suggests that it is firmly grounded within the traditional SEC disclosure framework that has been in place for close to nine decades. The Proposal is certainly ambitious (and overdue), but it is by no means extraordinary. This, in turn, suggests that challenges to the Proposal’s legitimacy ought to fail, even if certain aspects of the Proposal could stand to be improved as part of the ongoing rulemaking process.
This view is not universally held. In voting against the Proposal, SEC Commissioner Hester Peirce admonished that it “turns the disclosure regime on its head” and erects “a hulking green structure” that will “trumpet” a “revised mission” for the SEC: “‘protection of stakeholders, facilitating the growth of the climate-industrial complex, and fostering unfair, disorderly, and inefficient markets.’” This certainly sounds problematic—and, indeed, quite dramatic. But once we set aside the entertaining rhetorical flourishes, we see that many of the arguments against the Proposal misstate the applicable legal constraints and mischaracterize important aspects of the Proposal. Moreover, even though Commissioner Peirce goes out of her way to praise “the existing regulatory framework that for many decades has undergirded consistent, comparable, and reliable company disclosures,” her lengthy dissenting statement reveals that she actually opposes many important and established elements of the very framework she says she wants to conserve.
I will make the case that the SEC’s Climate Disclosure Proposal is in keeping with longstanding regulatory practice by examining several features of the traditional disclosure regime and the new Proposal. I will focus my analysis on arguments I’ve developed in prior research, certain other less-known arguments, and the particular aspects of the new Proposal. This piece is not intended to be comprehensive, and I want to note that the broader issue of ESG disclosure has generated extensive debate and much insightful analysis. As always, I welcome comments and amendments via email.
Shareholders, Stakeholders, and Expert Groups
The SEC’s Climate Disclosure Proposal immediately prompts the well-worn question: Is this disclosure intended for shareholders or for stakeholders? But posing this as a binary choice automatically shifts the terms of the debate in favor of opponents of climate-related disclosure, regardless of the actual content of the Proposal. Since climate change has society-wide implications, information about it will inevitably resonate beyond the boundaries of the disclosing firm and the capital markets, even when the focus is on financially-material disclosure relying on investor- and issuer-generated disclosure frameworks (as is the case here). The social resonance of climate-related disclosure can drown out its clear-cut financial relevance, render any proposed disclosure rule suspect, and lead to a situation that, when we stop and think about it, is quite illogical: A subject matter’s relevance to one audience (stakeholders) is used as an argument to cancel out the well-established relevance of that same subject matter to another audience (investors). This is a general vulnerability that applies not just to climate-related disclosure, but to other ESG disclosure as well. It is important to understand it and de-bias policymaking accordingly.
Commissioner Peirce’s dissenting statement deftly zeroes in on this vulnerability by asserting that the Proposal “tells corporate managers how regulators, doing the bidding of an array of non-investor stakeholders, expect them to run their companies” and “forces investors to view companies through the eyes of a vocal set of stakeholders, for whom a company’s climate reputation is of equal or greater importance than a company’s financial performance.” Reading this, one would think that the Proposal was written by the Sierra Club and the National Resources Defense Council—or by a D.C. bureaucrat, who, in Peirce’s telling, is both clueless and corruptible. Yet, nothing could be further from the truth.
The SEC’s Proposal draws on technical frameworks for financially-material disclosure developed by expert groups such as the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol. Take the TCFD, for example: Its members include representatives of mainstream investors (including BlackRock and UBS Asset Management), banks (JP Morgan, Citibanamex), insurance companies (Aviva, Swiss Re, Axa), giant industrial firms (BHP, Eni, Tata Steel, Unilever), rating agencies (Moody’s, S&P), accounting firms (Deloitte, E&Y), and others. Its secretariat is headed by a leader in the financial industry and capital markets, Mary Schapiro, who holds the unique distinction of having served as Chair of the SEC, Chair of the CFTC, and CEO of FINRA. And, for better or worse, no environmental NGOs or stakeholder organizations are represented on the TCFD. As its name suggests, the TCFD’s focus is on financial disclosures of the kind that investors require and use. The TCFD has generated an impressive roster of supporters and official adopters in just over six years, and, importantly, each of the “big three” (BlackRock, State Street, and Vanguard) has endorsed the TCFD framework.
Commissioner Peirce rightly points out that the SEC does not have the depth of expertise on climate-related matters that other, specialized regulators have. Such expertise, however, is not necessary here since the SEC is not setting GHG emission limits, calculating carbon trading prices, drawing up climate transition plans, or setting climate resilience standards for businesses. The SEC’s Proposal is limited to disclosure—and only disclosure—on a technical topic, and the SEC has decades-long experience handling disclosures on technical topics. For example, the SEC is not an energy regulator, but it drew up a specialized disclosure framework for oil and gas extraction activities in the 1970s (with help from expert groups, much like it has done here), and it has administered this framework successfully since then. As the composition of the economy has changed, the SEC has had to develop some expertise in cybersecurity disclosure, tech disclosure, and in other specialized areas. The Climate Disclosure Proposal does not veer away from this time-tested approach; the only difference is that it concerns a hot-button topic.
Statutory Authority and Regulatory Practice: Recalling Schedule A of the Securities Act
A central challenge to the Proposal is that it goes beyond the authority given to the SEC by Congress because the rules are too prescriptive, not rooted in “materiality” (more on which later), and because Congress has not directed the SEC to pursue rulemaking on this particular topic. A fair amount of debate has focused on what it means for the SEC to act as “necessary or appropriate in the public interest or for the protection of investors”—language that has been part of the securities laws since they were passed in the 1930s but that has not been tested in court.
Saturday, March 26, 2022
Not long ago, the SEC filed an enforcement action against robo-advisor Wahed Invest. Wahed Invest assured clients that it only selected investments that were compliant with a Shari’ah law. In fact, according to the SEC, in addition to many other fraudulent practices (it claimed to have funds it didn’t have; it claimed to rebalance and didn’t), it also failed to adopt policies and procedures to assure Shari’ah compliance. As the SEC put it:
While Wahed Invest advertised its adherence to Shari’ah compliant investing, Wahed Invest failed to adopt and implement written policies and procedures reasonably designed to address its Shari’ah advisory decision-making processes and compliance reviews and oversight.
On the Wahed Invest Website, in its marketing materials, and in interviews, Wahed Invest extensively discussed the importance of its income purification process. For example, the Wahed Invest Website stated that Wahed Invest “go[es] the extra mile to ensure your wealth is pure” by creating a “unique annual purification report” for each robo-advisory client, which were provided to clients.
Despite these representations to clients and prospective clients, Wahed Invest had no written policies and procedures addressing how it would assure Shari’ah compliance on an ongoing basis or how it would calculate and report the purification of unpure income. Wahed Invest also failed to adopt policies and procedures to ensure Wahed obtained reasonable support for its Shari’ah-related marketing claims.
I am unaware of any other enforcement action by the SEC based on nonfinancial information provided to investors. I.e., there is no argument that the investors’ interest in Shari’ah compliant securities was traceable to any financial motive or expectation that Shari’ah investments would perform better; it arose because of investors’ religious preferences. I suppose in the long history of the securities laws and creative forms of fraud there must be other examples of enforcement actions like this, but I personally don’t know what they are.
Why am I mentioning this now?
Because on Monday, the SEC dropped 500-odd pages of proposed rules regarding climate change disclosures. And though (obviously aware of the likelihood of litigation), the release is chock full of references to the financial/business impacts of climate change, there is also this nugget:
several large institutional investors and financial institutions, which collectively have trillions of dollars in assets under management, have formed initiatives and made commitments to achieve a net-zero economy by 2050, with interim targets set for 2030. These initiatives further support the notion that investors currently need and use GHG emissions data to make informed investment decisions. These investors and financial institutions are working to reduce the GHG emissions of companies in their portfolios or of their counterparties and need GHG emissions data to evaluate the progress made regarding their net-zero commitments and to assess any associated potential asset devaluation or loan default risks. A company’s GHG emissions footprint also may be relevant to investment or voting decisions because it could impact the company’s access to financing or signal potential changes in its financial planning as governments, financial institutions, and other investors make demands to reduce GHG emissions
Notice that especially in the first part of the paragraph, the SEC appears to be taking into account the constraints of institutional investors to achieve their own climate-related goals (help achieve a net-zero economy), which may or may not be strictly about those investors’ ability to maximize their financial returns for investors. I mean, it’s hard to articulate – climate change is so disastrous that it obviously will have economic impacts, and so at a very high level any climate change regulation is investment regulation – but in more concrete terms, the SEC seems to be recognizing these investors’ own contributions to transitioning to a net-zero economy as investment goals.
I’m pointing this out because the idea that the SEC should respect investors’ nonfinancial tastes – not merely when prohibiting lies, as in Wahed Invest, but in required disclosures – is contestable. At the same time, though, some institutional investors may operate under regulatory mandates – including mandates from other countries – to work to achieve climate-related goals, and there would be something perverse about the SEC ignoring that mandate when determining the kind of information investors need.
So. I have no doubt these issues will be hashed out in great detail when the lawsuits begin, and maybe by then I’ll have finished reading all 500-odd pages.
Saturday, March 19, 2022
I’ve previously posted about problems in how courts determine whether a complaint pleads scienter under the standards of the PSLRA; last summer, I talked about courts’ unduly narrow use of evidence of insider trading, namely, to consider it only as a pecuniary motive for fraud, rather than as evidence of knowledge of a problem. Which is why I was very pleased to see the decision in Gelt Trading Ltd. v. Co-Diagnostics Inc., 2022 WL 716653 (D. Utah Mar. 9, 2022).
The claim is that Co-Diagnostics overstated the accuracy of its covid-19 tests, and its stock price fell when the truth was revealed. The complaint only alleged two false statements; the court dismissed claims based on one, but permitted claims based on a false press release – which was mostly attributed to the company, but also quoted Dr. Satterfield, the company founder/chief science officer – to proceed.
In evaluating the allegations of scienter, the court considered, among other things, that although Dr. Satterfield had not sold stock, others had. As the court put it:
multiple board members sold significant amounts of stock just as news outlets began to question the accuracy of Co-Diagnostics’ test. This suggests that at least some individuals within the company knew that the statements were misleading that the artificially propped up stock could soon crash. If other corporate officials knew this fact, presumably Satterfield—the company's Chief Science Officer—would have known the same.
That’s exactly the analysis I’d hoped courts would undertake. As I mentioned in my prior post, a desire to sell stock at inflated prices might be a cause of fraud, but it is also result of it, as insiders scramble to cash out before their wealth is destroyed. Even a non-defendant’s trades can tell us something about the kind of information that was available within the company, and thus can shed light on what the actual defendants knew when they spoke.
Saturday, March 12, 2022
I call your attention this week to Chief Judge Marbley’s opinion in in re FirstEnergy Securities Litigation, 2022 U.S. Dist. LEXIS 39308 (S.D. Ohio Mar. 7, 2022), sustaining the securities fraud complaint against FirstEnergy and various additional defendants. To some extent, the decision was unsurprising; Chief Judge Marbley sustained similar allegations in a parallel derivative 14(a) claim last year, but there are still some things here I want to highlight.
The basic claim is that FirstEnergy bribed Ohio politicians to secure a public bailout of failing nuclear plants, and lied about it to investors. When the scandal came to light, the fallout was dramatic, resulting in, among other things, a criminal case against FirstEnergy and a plunge in its stock price.
I’m going to talk about two aspects of the decision.
First, many of the public lies were relatively generic statements to the effect that FirstEnergy’s political donations and lobbying activities complied with all laws, and that the company had a system of internal controls to ensure that this was the case. (Sidebar: Speaking of generic statements, I assume everyone saw the news that the Second Circuit granted Goldman Sachs’s third 23(f) petition in the Arkansas Teachers case? I guess the third time wasn’t the charm, for the plaintiffs, anyway). Anyhoo, these are the kinds of statements that might under other circumstances be dismissed on puffery grounds, but the court focused here on how FirstEnergy’s shareholders cared enough about its lobbying to seek greater disclosure through a Rule 14a-8 proposal. FirstEnergy, in opposing that proposal, made some of the challenged statements. As the court put it, “Representations about the Company’s lobbying activities and legal compliance—which in other cases might be bland and innocuous—take on a different character when, as alleged, they were proffered in response to specific shareholder concerns and served to further the scheme through distraction and concealment.” Later in the opinion, in response to defendants’ challenges to materiality, the court said: “several of these compliance statements were offered as reasons to vote against a shareholder proposal for increased oversight of lobbying policies and payments. Context changes the meaning of those statements from aspiration to assurance; the speakers are claiming that increased oversight is not necessary because the Company is compliant and has effective controls. That assurance—which, importantly, helped to shield the scheme from detection—was misleading and more than mere ‘puffery’ or ‘corporate cheerleading.’”
Similarly, the court held that, in this context, the corporate “Code of Conduct and Director Code of Conduct, espousing ‘high ethical standards,’ ‘fair dealing,’ and ‘compliance with the law’” constituted actionable misstatements.
I am fascinated by these holdings. It’s a relatively novel use of the shareholder proposal mechanism (although I have to draw parallels to the Oracle court’s use of say-on-pay votes as evidence that a director who sat on the compensation committee, and ignored those votes, lacked independence Larry Ellison). There are so many shareholder proposals on ESG topics; political activities are a fairly routine subset. It would be fascinating if company opposition to these proposals was regularly treated as more material than ordinary company boilerplate, and thus became a backdoor way to strengthen Section 10(b) as a mechanism for policing ESG-like disclosures. (I have previously written that under current doctrine, 10(b) does not do a very good job of this).
And frankly, I thought by this point, most courts were treating corporate codes of conduct as immaterial as a matter of law. Usually, courts say something to the effect that codes of conduct are not promises, but merely “aspirational.” Here, the court engaged in what I believe is the proper analysis – it held that you can’t call something aspirational if you weren’t even trying to behave in accordance with the code, i.e., as the court put it “The Company’s Code of Conduct and Director Code of Conduct false or misleading in that they were presented to shareholders in proxy statements but allegedly were being disregarded intentionally by the Company and its senior management. The Company later would admit to violations of these policies in a series of executive firings.”
That’s the first thing.
Second is the use of scheme liability to draw in nonspeaking defendants. After Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), it seemed like nonspeaking defendants were free and clear of potential Section 10(b) liability, but then in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), the Supreme Court held that even nonspeakers might be liable for participation in a fraudulent scheme.
At the time, it was not obvious if this holding would redound to the benefit of private plaintiffs (as opposed to the SEC) given the constraints imposed by Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008), but since then, some claims have gotten through, and FirstEnergy is the latest example. The court held that certain officers who participated in the scheme by having discussions with the public officials who were bribed, overseeing media efforts, and coordinating political activities and lobbying, had potentially violated 10(b), and refused to dismiss claims against them. Relying on West Virginia Pipe Trades Health & Welfare Fund v. Medtronic, 845 F.3d 384 (8th Cir. 2016), the court held that the scheme consisted of producing a “public-facing product” (the bailout and the misleading nature of FirstEnergy’s support), and these behind-the-scenes activities contributed to that product. Notably, one of the defendants subject to this theory was the corporation’s general counsel and chief legal officer, who, quoting the court:
is alleged to have overseen “the Company’s fulfillment of its legal and ethical obligations, internal control policies and procedures and adherence to internal control, risk management and compliance guidelines,” and to have been terminated for “conduct” in support of the scheme as well as his failure to prevent it.
According to the plaintiffs, this defendant was eventually fired for ““inaction and conduct that the Board determined was influenced by the improper tone at the top.”
So. Let that be a lesson to you.
Saturday, March 5, 2022
CNBC recently reported on BlackRock’s previously-announced plan to permit pass-through voting for institutional investors in its index funds. According to the report, the plan will cover about 40% of those funds, which works out to about $1.92 trillion of assets.
It seems obvious to me that BlackRock is feeling the political/regulatory heat from its existing voting power – there’s been lots of GOP pushback on its climate policies, concerns about antitrust (including FTC proposals that would paralyze BlackRock with regulation), it gets protestors outside its offices due to its control over particular companies, all of which caused BlackRock to go on an – obviously failed – campaign to convince people that it does not hold the power it holds (as I described in my book chapter, ESG Investing, or if you can't beat 'em, join 'em). Pass through voting feels like BlackRock voluntarily giving up at least some of its tremendous influence in the face of that scrutiny. Or, to put it another way, perhaps that power does not translate into financial benefits to BlackRock, at least, not enough to make it worth the regulatory costs.
I have no idea how this will play out or what this will look like, but I have so many thoughts and questions. Here are a few, in no particular order:
1) Is this something investors will seek out, which will give BlackRock a competitive edge? The CNBC article linked above suggests so.
2) What are the fiduciary duties of institutions in this scenario? The article suggests many of them already have voting policies for shares they directly own, but if they don’t, or if BlackRock’s policy expands, how do institutions make this call? Do they decide whether the expense of determining their vote – maybe paying for a proxy advisor – is equal to the benefit? Do they have to choose BlackRock over another fund complex because of the benefits of pass through voting?
3) If an institution decides to cast its own votes, does it get a reduction on fees from BlackRock, since it’s no longer paying for voting services?
4) Will clients have the option of going with BlackRock on some issues and not others? Sean Griffith, for example, has proposed that pass through voting apply to ESG matters and not other kinds of votes, like mergers, where the fund has more expertise.
5) If so, will clients know in advance how BlackRock intends to vote? Will that be nonpublic information? There are proposals for better disclosure on mutual funds’ voting patterns; I gather clients may not always know how BlackRock is casting its votes, let alone know in advance of the vote itself, but that may be relevant information if there’s a pass-through option.
6) Also on lending: How will BlackRock manage the share lending program, given that votes often are sacrificed for the lending fees?
7) Speaking of disclosure of mutual fund voting, how will BlackRock disclose the pass through votes? Can BlackRock take advantage of the informational content of those votes before they are disclosed (leave aside any active trading that BlackRock handles; as Joshua Mitts points out, even passive funds can use information to dictate their share lending programs).
8) As the CNBC article points out, if BlackRock hands its voting power to its clients, it will lose leverage with portfolio companies and – due to the dispersed nature of its own client base – that’s leverage that will not be recaptured. So that may mean less shareholder power overall. Among other things, will Delaware react – by, for example, relaxing things like the Corwin doctrine?
9) If BlackRock maintains a significant amount of voting power, it presumably will continue to have some influence in the boardroom. Will its fiduciary duties be altered if it lobbies for governance changes that appear to be at odds with how the pass-through votes are cast?
That’s all I’ve got for starters - anything else?
Saturday, February 26, 2022
Previously, I posted about Margaret Blair’s paper on concession theory, where she argued that the state played an integral role in the development of the corporate form, disputing those who argue that corporations could be somewhat replicated via private contracting.
The latest entry in this genre is a new paper by Taisu Zhang and John Morley, The Modern State and the Rise of the Business Corporation. They adopt a somewhat narrower definition of corporation to mean something like a large, publicly traded, limited liability entity, and argue that its rise is necessarily linked to the development of a state apparatus capable of recognizing and enforcing the rights of disparate investors, including the development of a uniform, professionalized court system. They make their argument through a series of cross-cultural case studies, the most fascinating (and convincing) of which is 19th and early 20th century China. According to the paper, at this time, China’s economy had grown to the point where it needed something like the corporate form, and corporations were in fact statutorily authorized, but China’s weak central state meant that there were few takers. It wasn’t until the middle of the 20th century that China had sufficiently rebuilt its national government to make the corporate form more attractive.
Anyway, if this kind of historical analysis is your thing, Zhang & Morley’s paper offers a unique new analysis. Here is the abstract:
This article argues that the rise of the modern state was a necessary condition for the rise of the business corporation. A typical business corporation pools together a large number of strangers to share ownership of residual claims in a single enterprise with guarantees of asset partitioning. We show that this arrangement requires the support of a powerful state with the geographical reach, coercive force, administrative power, and legal capacity necessary to enforce the law uniformly among the corporation’s various owners. Other historical forms of rule enforcement—customary law or commercial networks like the Law Merchant—are theoretically able to support many forms of property rights and contractual relations, but not the business corporation. Strangers cannot cooperate on the scale and legal complexity of a typical corporation without a functionally modern state and legal apparatus to enforce the terms of their bargain. In contrast, social acquaintances operating within a closely-knit community could, in theory, enforce corporate charters without state assistance, but will generally not want to do so due to the institutional costs of asset partitioning in such communities.
We show that this hypothesis is consistent with the experiences of six historical societies: late Imperial China, the 19th century Ottoman Empire, the early United States, early modern England, the late medieval Italian city states, and ancient Rome. We focus especially on the experience of late Imperial China, which adopted a modern corporation statute in response to societal demand, but failed to see much growth in the use of the corporate form until the state developed the capacity and institutions necessary to uniformly enforce the new law. Our thesis complicates existing historical accounts of the rise of the corporation, which tend to emphasize the importance of economic factors over political and legal factors and view the state as a source of expropriation and threat rather than support. Our thesis has extensive implications for the way we understand corporations, private law, states, and the nature of modernity.
Saturday, February 19, 2022
I am so amused by this brief opinion in Manti Holdings v. The Carlyle Group.
The case is a continuation of Manti Holdings, LLC v. Authentix Acquisition Co. There, as many of you know, the Delaware Supreme Court held that a shareholder agreement among sophisticated investors in a private company could waive appraisal rights associated with a merger.
Well, the same shareholders who sought appraisal are now instead suing for breach of fiduciary duty in connection with the merger, and the defendants argued that the same shareholder agreement not only waived appraisal rights, but also waived the right to sue for breach of fiduciary duty. We know, of course, that you cannot waive fiduciary duties in corporate constitutive documents; the question for VC Glasscock was whether you can waive them in personally-negotiated shareholder agreements. Glasscock held that he did not need to reach that question, because even if such waiver was possible, the agreement here was not clear about it.
But his reasoning is what fascinates me.
The agreement required that shareholders “consent to and raise no objections against such transaction,” i.e., the merger, thus raising the question whether an action for fiduciary breach is the equivalent of not consenting, and raising an objection.
Glasscock concluded it was not, in part because the agreement delineated the types of actions that would be deemed objections and nonconsents (such as voting against the deal, and seeking appraisal), and waiver of fiduciary duties was not on the list. As he put it:
Had the drafters desired to eliminate fiduciary duties, they could have similarly enumerated such an explicit waiver. They did not. The Defendants attempt to sidestep this choice by arguing that Section 3(e) does not waive the fiduciary duties themselves, it just waives claims for fiduciary duty breaches regarding a Company Sale. That, I admit, is a distinction too fine for my legal palate. A right without an enforcement mechanism is an empty right; without the Authentix stockholders’ ability to police fiduciary duty breaches, the fiduciary duties owed to them would be illusory.
I mean, I don’t disagree, but aren’t Delaware fiduciary duties literally built on the concept that the standard of conduct is different than the standard of review? For example, in Frederick Hsu Living Trust v. ODN Holding Corporation, 2017 WL 1437308 (Del. Ch. Apr. 24, 2017), the court said:
When determining whether directors have breached their fiduciary duties, Delaware corporate law distinguishes between the standard of conduct and the standard of review. The standard of conduct describes what directors are expected to do and is defined by the content of the duties of loyalty and care. The standard of review is the test that a court applies when evaluating whether directors have met the standard of conduct.
The distinction matters because the standard of review is more forgiving of directors than the standard of conduct, see Chen v. Howard-Anderson, 87 A.3d 648 (Del. Ch. 2014), which as a practical matter means that some actions by directors are fiduciary breaches without any remedy at all.
But Glasscock was not finished. He then went on to say that “the language waives objections to the Sale itself; it does not waive objections to fiduciary duty breaches made in connection with the Sale.”
Which is completely logical! And completely contrary to the entire Corwin line of cases, which treat a vote in favor of a transaction as the equivalent of a waiver of claims for fiduciary breach! Which is exactly what scholars have been saying for years. 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 any event, I suppose none of that matters because despite claiming he would not do the thing, Glasscock then kind of went and did the thing. See footnote 45:
Finding such waiver [of duty] effective is a proposition that would blur the line between LLCs and the corporate form and represent a departure from norms of corporate governance, I note, even under the limited circumstances here, described above.
So, you know. Funny case.