Saturday, November 10, 2018
Jonathan Macey and Joshua Mitts have just posted an intriguing new article, Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets, regarding calculation of value for the purposes of an appraisal action.
As I’ve posted about previously (here and here), Delaware is in the midst of a judicial reinterpretation of its appraisal statute, placing new emphasis on market pricing for determining the value of publicly traded stock. Currently, one open question is whether “market” pricing refers to the deal price, assuming the process was relatively clean, or the unaffected trading price of the stock.
Macey & Mitts begin by agreeing with VC Laster’s opinion in Verition Partners Master Fund, Ltd., et al. v. Aruba Networks, Inc., that valuation should be based on the trading price, and not the deal price, and their discussion after is where things get interesting.
First, they point out that apparently, Delaware courts only will consider trading price relevant to an appraisal action if price is efficient. But they argue that even prices of stock that trades inefficiently would serve as a better indicator of value than more traditional calculations like discounted cash flow, in part because there are many different types of “inefficient” markets and some will process the most important information about the company and produce a reasonably accurate price – perhaps with the judge adjusting for any information that was not assimilated. The test for market efficiency in an appraisal action is, in their view, too demanding.
Part of the reason I find this argument so interesting is that it mirrors the same kind of arguments we’ve been having in the fraud on the market space for over a decade, namely, how efficiently must the stock trade before plaintiffs are entitled to the fraud on the market presumption? In that context, just like Mitts and Macey, Donald Langevoort (among others) has argued that courts have demanded too high a standard of efficiency when a lesser one would do for the purposes of the inquiry – a point that the Supreme Court seems to have found persuasive. Of course, in the Section 10(b) context, we’re talking about informational efficiency; Mitts and Macey's argument depends on markets being efficient for fundamental value, or at least more accurate than other types of analysis.
The second argument that Macey and Mitts make is that the stock price reaction of the acquirer may indicate whether the deal price was too high, in which case, any appraised value should be lower. I.e., if the acquirer’s stock price drops in response to announcement of the deal, that would suggest that the market believes the target was overvalued. That’s a really clever suggestion, though I do wonder about their argument that the analysis holds even for private targets – we might legitimately ask whether the market knows enough about private targets to make an informed assessment of the appropriateness of the deal price and the target’s effect on the acquirer’s value.
Of course, overall, their argument would push Delaware’s law even further toward eliminating appraisal for all but the most egregious cases; in recent years, many scholars have argued that appraisal can be used as a kind of substitute for a broken system of fiduciary duty litigation. Macey and Mitts believe that if fiduciary litigation is broken, it should be fixed, rather than substituting in a different cause of action to do that work.
Saturday, November 3, 2018
Yesterday, I had the pleasure of participating in Case Western Reserve Law Review Conference and Leet Symposium, Fiduciary Duty, Corporate Goals, and Shareholder Activism. It was a fun and lively set of discussions with some interesting themes that hit right in my sweet spot of interests, so I had a wonderful time. I’ll give a brief synopsis of the topics under the cut, but the entire thing will soon be available as a webcast online at the above link, and next year the law review will publish a special symposium issue.
Also, I just apologize in advance if I misdescribe anyone’s remarks – if you see this post and want to correct me, feel free to send an email.
[More under the jump]
Friday, October 26, 2018
Daniel Greenwood coined the term “fictional shareholders” to refer to courts’ tendency to base corporate law decisions on the preferences of a set of hypothetical investors, untethered to the real-world priorities of the actual shareholders who hold a company’s stock. See Daniel J.H. Greenwood, Fictional Shareholders: “For Whom Are Corporate Managers Trustees,” Revisited, 69 S. Cal. L. Rev. 1021 (1996). If ever there were an illustration of Greenwood’s point, it comes in VC Laster’s recent post-trial decision in In re PLX Stockholders Litigation.
And hey, this got really long, so more under the jump
Friday, October 19, 2018
If you follow this blog regularly, you’ve probably seen me rant about the myriad errors courts make when evaluating market and investor behavior in the context of securities litigation. I finally did what I’d been threatening to do and compiled my complaints into a single Essay on the subject, which I presented at the Connecting the Threads symposim hosted by the University of Tennessee at Knoxville in September. (The symposium featured all of the Business Law Prof bloggers, and Marcia posted a description of the full program here)
My Essay, along with pieces by my co-bloggers, will be published in Transactions: The Tennessee Journal of Business Law. I’ve just posted a draft to SSRN, and – anyway, here’s Wonderwall:
Abstract: Courts entertaining class actions brought under Section 10(b) of the Securities Exchange Act are required to make numerous factual judgments about the economic effects of the alleged misconduct. For example, they must determine whether and for how long publicly-available information has exerted an influence on security prices, and whether an alleged fraud caused economic harm to investors. Judgments on these matters dictate whether cases will proceed to summary judgment and trial, whether classes will be certified and the scope of such classes, and the damages that investors are entitled to collect.
Over the years, courts have developed a variety of common law doctrines to guide these inquiries. As this Essay will demonstrate, collectively, these doctrines operate in such an artificial manner that they no longer shed light on the underlying factual inquiry, namely, the actual effect of the alleged fraud on investors. The result is that determinations of market impact and investor loss have become, in a real sense, fictional: the size and effects of the fraud are determined based on abstract doctrine rather than any empirical assessment of market behavior. Ultimately, these stylized approaches to assessing market evidence interfere with the ability of the Section 10(b) cause of action to fulfill its modern function as a mechanism for deterring fraud.
This Essay therefore recommends that, to the extent possible, these inquiries should be replaced with alternative schemes that award damages based on some combination of statutory formulas and evidence of investors’ reliance on the fraud. These alternatives would be easier for courts to administer, and would re-align the fraud-on-the-market action with its fundamental goals.
Saturday, October 13, 2018
This week, the Delaware Supreme Court decided Flood v. Synutra, and began to clear up some of the questions left open after its earlier decision in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”). Flood itself is relatively straightforward but, for me, it inevitably calls to mind some larger issues regarding the relationship between independent directors and controlling shareholders under Delaware law.
For many years, the regime in Delaware was that a controlling shareholder squeeze-out transaction would be reviewed for entire fairness, but the burden to prove lack of fairness would be placed on plaintiffs if the deal was approved by either a majority of the minority shareholders, or by a committee of independent directors who acted freely, without coercion, had the power to say no, etc. See Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).
In MFW, the Delaware Supreme Court held that if a controlling shareholder employs both protections, and makes clear from the outset that any deal will be conditioned on their satisfaction, and there is no reason to think the protections were circumvented (i.e., the committee acted with care, was fully empowered, and so forth), the resulting deal will get business judgment review. But a lot was still left open.
For one thing, MFW had this odd footnote that suggested that an independent committee’s lack of care/bargaining power might be demonstrated, for pleading purposes, by a showing that the deal price was insufficient. The footnote was odd because normally a lack of care is not pled by challenging a substantive outcome; allowing it in this instance suggested the Court was not entirely confident that MFW’s dual protections truly substituted for an arm’s-length deal. And for another thing, MFW did not specify how early in the process the controller would have to disable itself to be entitled to business judgment protection.
So in Flood, per Chief Justice Strine, the Court began to close the holes.
First, it basically did away with MFW’s baffling footnote, which to be honest is more housekeeping than anything else.
And second, the Court held that “so long as the controller conditions its offer on the key protections at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”
In other words, a controlling shareholder may still take advantage of the MFW framework if it proposes the deal without the protections, and adds them later, so long as no “substantive economic negotiations” (and possibly other steps) have taken place in between.
Justice Valihura, in dissent, argued that the majority’s rule would inevitably draw courts into factual disputes as to what constitutes “substantive economic negotiations.” (And I admit, even I’m unclear what happens if the deal is proposed, and the special committee hires advisors and conducts due diligence without any negotiations, but before the conditions are added). Valihura would have preferred that the MFW rule kick in only if the conditions appear in the first formal written proposal (with, it must be said, exceptions if plaintiffs can show there was intentional evasion via oral negotiations before that point – so factual disputes are always possible).
Which brings me to the issue of independent directors.
In Flood, the controlling shareholder submitted a letter proposing a deal without either of MFW’s protections. Over the next two weeks, a new independent director – one previously proposed by the controller – was added to the Board, a special committee was formed to consider the proposal, and the newly-added director was placed on that committee. Also (and this was the focus of the Valihura dissent) there were other arrangements involving each side hiring counsel, and the directors being briefed on their fiduciary duties. After that, the controller submitted a revised letter conditioning the deal on the MFW protections. Despite the intervening events between the first proposal and the revised letter, the majority held that the MFW framework would apply. The majority was untroubled by the new addition to the Board, or his presence on the special committee. In other words, the Court was confident that, even under these circumstances, he could perform his duties fairly.
So here’s why this all strikes me as odd.
It has never been entirely clear whether the Delaware Supreme Court believes that independent directors can be trusted to stand up to controlling shareholders.
In Kahn v. Lynch, the Court held that squeeze out mergers would get entire fairness review even if approved by independent directors who acted diligently, fairly, etc. But it did not justify its holding on the ground that independent directors are likely to be coerced by a controller; rather, it only explicitly said that minority shareholders might feel coerced. Standing alone, then, Kahn might be interpreted to mean that since mergers ordinarily have dual protections (disinterested director plus disinterested shareholder approval), then if only one is present (disinterested director approval), there must be heightened scrutiny, with no suggestion that independent directors are likely to bow to a controller’s wishes.
Subsequent Chancery cases – including one authored by Chief Justice Strine when he was Vice Chancellor – interpreted Kahn to mean that independent directors might be cowed by the presence of a controller, and therefore their decisions are suspect. See, e.g., In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002) (where then-VC Strine characterized controllers as 800-pound gorillas). As a result, a series of Chancery cases have subjected controlling shareholder transactions to entire fairness review, even if approved by the independent directors, and even if the transaction wouldn’t ordinarily require shareholder approval. See discussion in In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016).
Then came MFW. In response, some Chancery cases clarified that controllers can get the benefit of business judgment review if they employ the MFW framework, including transactions that ordinarily wouldn’t require shareholder approval at all. See In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016); IRA Trust FBO Bobbie Ahmed v. Crane,(Del. Ch. Dec. 11, 2017) (endorsing Ezcorp).
In other words, Chancery courts seem (?) to have coalesced around the view that controlling shareholders are likely to overwhelm both stockholders and independent directors, and therefore we can only trust the fairness of an interested-controller transaction if both approve, without any additional evidence of coercion.
If I’m not mistaken, the Delaware Supreme Court did eventually explicitly endorse the idea that directors can never be truly independent of a controller, but only twice. In Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997), the Court held:
Entire fairness remains applicable even when an independent committee is utilized because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny….The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder. Consequently, even when the transaction is negotiated by a special committee of independent directors, no court could be certain whether the transaction fully approximated what truly independent parties would have achieved in an arm's length negotiation.
(quotations and alterations omitted). Later, the Court said the same thing in Ams. Mining Corp. v. Theriault, 51 A.3d 1213 (Del.2012), quoting Tremont. But these cases are the only ones that I know of where the Delaware Supreme Court explicitly said that we cannot fully trust even independent directors when they stand opposite controlling shareholders. And I note that earlier cases held in dicta that independent directors could cleanse transactions involving controlling shareholders. See, e.g., Summa v. Trans World Airlines, Inc., 540 A.2d 403 (Del. 1988); Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993).
(Am I wrong? Is there another case where the Delaware Supreme Court was explicit about the fact that independent directors should be distrusted as a matter of law – even absent a showing of some specific dysfunction – when across the table from a controlling shareholder?)
But if that’s right, there’s an odd incongruity, which Vice Chancellor Laster explored in detail in In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016), and that then-Vice Chancellor Strine flagged in In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002). Namely, it is well-established that independent directors are presumed to be unbiased for the purposes of the demand requirement in a derivative lawsuit, even if the defendant is a controlling shareholder. In other words, we always trust that independent directors can make a fair determination as to whether it is in the corporation’s interest to file a lawsuit against the controller. That much goes back to Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
The Aronson rule does not seem to have changed – mostly. I’ve previously blogged about how in Delaware Cty. Emps. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015) and Sandys v. Pincus, 152 A.3d 124 (Del. 2016), the Delaware Supreme Court addressed demand futility in cases against controlling shareholders, and employed a much more nuanced inquiry than it had performed in the past. Specifically, the Court was willing to hold that nebulous social and business ties could, collectively, compromise a director’s independence. Neither case, however, limited its holding to the controlling shareholder context (and Chancery has not interpreted the cases to be so limited). So Sanchez and Sandys, as far as we know, are not cases about controlling shareholders generally; they are cases about what constitutes independence.
So now here we are, back in the context of a controlling shareholder squeeze-out, and we have a prima facie reason to distrust the decisionmaking of the independent directors: A whole new one was added to the board, at the controller’s behest, and added to the special committee, after the controller had proposed the deal.
But does the Court suspect wrongdoing? No! To the contrary, it cites Aronson – the original case to hold that independent directors are unlikely to be cowed by controllers – to justify its faith in the directors’ fortitude. See Flood, slip op. at 8 n.37. The Court does not invoke Tremont, with its explicit doubts whether independent directors can resist controllers.
Point being, which is it? Do we trust independent directors to protect minority shareholders when their interests diverge from the controller, or don’t we? If we do, then MFW should only apply in the context of transactions that legally cannot be consummated without both director and shareholder approval; if the transaction does not require both, approval by independent directors should be sufficient. And if we don’t trust independent directors to stand up to controllers, then MFW should apply to all situations where a controlling shareholder has interests that diverge from the minority, including determinations of whether demand is futile. And if we don’t fully trust independent directors to defy controlling shareholders, we should be much more suspicious of squeeze-outs that are initiated without the MFW protections, even if the directors only engage in minimal preparations before those protections are added. Or perhaps the demand requirement is its own separate world - which is what VC Laster seemed to think in Ezcorp - in which case, Aronson should not be used to support an inference of director independence in other contexts.
Anyhoo, these incongruities have persisted for many years; it’s quite possible they’ll continue for many years more, and I guess we’ll have to live with the uncertainty for now.
Monday, October 8, 2018
BLPB reader Tom N. sent me a link to this article last week by email. The article covers Elon Musk's taunting of the U.S Securities and Exchange Commission (SEC) in a post on Twitter. The post followed on the SEC's settlement with Musk and Tesla, Inc. of a legal action relating to a prior Twitter post. The title of Tom N.'s message? "Musk Pokes the Bear in the Eye." Exactly what I was thinking (and I told him so) when I had read the same article earlier that day! This post is dedicated to Tom N. (and the rest of you who have been following the Musk affair).
Last week, I wrote about scienter issues in the securities fraud allegations against Elon Musk, following on Ann Lipton's earlier post on materiality in the same context. This week, I want to focus on state corporate law--specifically, fiduciary duty law. The idea for this post arises from a quotation in the article Tom N. and I read last week. The quotation relates to an order from the judge in the SEC's action against Musk and Tesla, Alison Nathan, that the parties jointly explain and justify the fairness and reasonableness of their settlement and why the settlement would not hurt the public interest. Friend and Michigan Law colleague Adam Pritchard offered (as quoted in the article): “She may want to know why Tesla is paying a fine because the CEO doesn’t know when to shut up.” Yes, Adam. I agree.
What about that? According to the article, the SEC settlement with Musk and Tesla "prevents Musk from denying wrongdoing or suggesting that the regulator’s allegations were untrue." The taunting tweet does not exactly deny wrongdoing or suggest that the SEC's allegations against him were untrue. Yet, it comes close by mocking the SEC's enforcement activities against Musk and Tesla. Musk's action in tweeting negatively about the SEC is seemingly--in the eyes of a reasonable observer--an intentional action that may have the propensity to damage Tesla.
At the very least, the tweet appears to be contrary to the best interests of the firm. But is it a manifestation of bad faith that constitutes a breach of the duty of loyalty under Delaware law? As most of us well know,
[b]ad faith has been defined as authorizing a transaction "for some purpose other than a genuine attempt to advance corporate welfare or [when the transaction] is known to constitute a violation of applicable positive law." In other words, an action taken with the intent to harm the corporation is a disloyal act in bad faith. . . . [B]ad faith (or lack of good faith) is when a director acts in a manner "unrelated to a pursuit of the corporation's best interests." It makes no difference the reason why the director intentionally fails to pursue the best interests of the corporation.
Bad faith can be the result of "any emotion [that] may cause a director to [intentionally] place his own interests, preferences or appetites before the welfare of the corporation," including greed, "hatred, lust, envy, revenge, . . . shame or pride."
In Re Walt Disney Co. Derivative Litigation, 907 A.2d 693, 753-54 (Del. Ch. 2005). Of course, Musk was not authorizing a transaction--or even clearly acting for or on behalf of Tesla--in making his taunting tweet. But he is identified strongly with Tesla, and his tweet was intentional and inconsistent with the best interests of the firm. Did he intend to harm Tesla in posting his tweet? Perhaps not. Did he act in a manner "unrelated to a pursuit of the corporation's best interests?" Perhaps. The tweet is certainly an imprudent (and likely grossly negligent or reckless) action that appears to result from Musk intentionally placing his own hatred or revenge ahead of the interests of Tesla.
"To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation." Id. at 755. Yet, it is unclear how far that goes in a Twitter-happy world in which the personal blends into the professional. Musk was (in all likelihood) not taking action as a director or officer of Tesla when he tweeted his taunt. Yet, he was undoubtedly cognizant that he occupied those roles and that his actions likely had an effect on the firm. Should his fiduciary duties extend to this type of conduct?
And what about the Tesla board's duty to monitor? Does it extend to monitoring Musk's personal tweeting? E.g., the argument made in the Chancery Court's opinion in Beam Ex Rel. Martha Stewart Living Omnimedia, Inc. v. Stewart. Even of not mandated by fiduciary duty law, the SEC clearly wants the board to have that monitoring responsibility. The settlement with the SEC reportedly provides for "Tesla’s board to implement procedures for reviewing Musk’s communications with investors, which include tweets." More for us all to think about when we think about Elon Musk and Tesla . . . . It's always best not to poke the bear.
Saturday, October 6, 2018
All I’ve got this week is a drive-by of interesting things (which is necessary because of how the news was so. exceptionally. boring)
1) You’ve probably at least heard about the New York Times’s massive expose on Donald Trump’s inherited wealth and the tax fraud that enabled it. If you’re not a tax person, the length may be a little intimidating, but trust me it’s very accessible and worth the read. Among other highlights are some specific descriptions of the use of a shell company called All County Building Supply & Maintenance that served a dastardly dual purpose: to spin cash gifts from Fred Trump to his children into ordinary income (thus avoiding gift tax liability), and to justify rent increases for rent-stabilized apartments. Fred Trump accomplished this by making his children owners of All County, and then using All County as a purchasing agent for his buildings. For every purchase, All County added a large markup – pure profit for All County (and thus the kids), paid by Fred Trump. Then, Fred Trump used the inflated bills as proof of property improvements to justify his rent increases. The scheme was sheer elegance in its simplicity.
For the securities aficionados, the article also has a soupcon of market manipulation: Fred Trump would buy stock in companies just before Donald Trump leaked an intention to take them over, causing a quick boost in the stock price.
2) Another expose, this one from the Washington Post, on the fate of small investors in Trump hotels. These investors bought individual units as condominiums, in the expectation that the Trump organization would rent them out and, after deducting maintenance fees, pay them the income. Problem is, after 2016, business has plummeted in New York and Chicago, leaving these investors with large losses. An interesting tale of corporate governance and, if you like, a timely hypothetical regarding application of the Howey test to condo sales. (Also, for those interested in reporting process, here is a Tweet thread explaining how WaPo developed the story.)
3) Finally, I previously posted about a pending oral argument in Delaware Chancery on the question whether corporate charters and bylaws can impose litigation limits (forum selection clauses, etc) on federal securities claims, in addition to placing limits on Delaware internal affairs claims. That argument, in the case of Sciabacucchi v. Salzberg, 2017-0931, took place on September 27, and the transcript is available from the Chancery court reporters. Attorneys did most of the talking, but towards the end of the hearing, VC Laster honed in on the critical question: if charters and bylaws can extend to cover claims not governed by Delaware law or the internal affairs doctrine, how much further can they go? William Chandler – yes, that William Chandler, former Delaware Vice Chancellor, now with Wilson Sonsini – argued that they extend to any claim that deals with the stockholder’s rights as a stockholder; VC Laster expressed concern about defining the appropriate relationship between the claim and the plaintiff’s stockholder status. At the same time, he acknowledged that ultimately the issue will probably be resolved not by him, but by the Delaware Supreme Court.
That’s all – here’s looking forward to another deadly dull week.
Monday, October 1, 2018
I have been so grateful for Ann Lipton's blog posts (see here and here) and tweets about Elon Musk's going-private-funding-is-secure tweet affair. Her post on materiality on Saturday--just before the SEC settlement was announced--was especially interesting (but, of course, that's one of my favorite areas to work in . . .). She tweeted about the settlement here:
[Note: this is a screenshot.] Ann may have more to say about that in another post; she did add a postscript to her Saturday post reporting the settlement . . . .
But I also find myself wondering about another of the contentious issues in Section 10(b)/Rule 10b-5 litigation: scienter. This New York Times article made me think a bit on the point. It tells a tale--apparently relayed to the U.S. Securities and Exchange Commission (SEC) in connection with its inquiry into the tweet incident--of fairly typical back-room discussions between/among business principals. This part of the article especially stuck with me in that regard:
On an evening in March 2017, . . . Mr. Musk and Tesla’s chief financial officer dined at the Tesla factory in Fremont, Calif., with Larry Ellison, the chairman of Oracle, and Yasir Al Rumayyan, the managing director of the Saudi Public Investment Fund. During the meal, . . . Mr. Rumayyan raised the idea of taking Tesla private and increasing the Saudi fund’s stake in it.
More than a year later, . . . Mr. Musk and Mr. Rumayyan met at the Tesla factory on July 31. When Mr. Rumayyan spoke again of taking the company private, Mr. Musk asked him whether anyone else at the fund needed to approve of such a significant deal. Mr. Rumayyan said no . . . .
Could Musk have actually believed that a handshake was all that was needed here? We all know a handshake can be significant. (See here and here for the key facts relating to the now infamous Texaco/Getty/Pennzoil case.) But should Musk have taken (or at least should he have known that he should take) more care to verify before tweeting? In other words, can Musk and his legal counsel actually believe they can prove that Musk (1) had no knowledge that his tweet was false and (2) was merely negligent--not reckless--in relying on the oral assurance of a business principal to commit to a $70+ billion transaction?
Don Langevoort has written cogently and passionately about the law governing scienter. One of my favorite articles he has written on scienter is republished in my Martha Stewart book. What he urges in that piece is that the motive and purpose of a potentially fraudulent disclosure are not the relevant considerations in determining the existence of scienter. Rather, the key question is whether the disclosing party (here, Musk) knew or recklessly disregarded the fact that what he was saying was false. Join this, Don notes, with the securities fraud requirement that manipulation or deception be in connection with the purchase or sale of a security, and the test becomes not merely whether Musk misrepresented material fact or misleadingly omitted to state material fact, but also whether he could reasonably foresee the likely impact of his misrepresentation on the market for Tesla's securities.
On the one hand, as Ann points out in her post on Saturday, a number of investors in the market thought the tweet was a joke. Given that, might we assume that Musk--a person perhaps similarly experienced in finance--knew or should have known that his tweet was false? On the other hand, as Ann notes in her post, the SEC's complaint states that "market analysts - sophisticated people - privately contacted Tesla’s head of investor relations for more information and were assured that the tweet was legit. So that’s evidence the market took it seriously." Yet, Musk might just be presumptuous enough to believe he could reasonably rely on an oral promise by a person who is in control of executing on that promise--thinking it represented a deal (although, of course, not one that experienced legal counsel would understand to be legally, or even morally, binding or enforceable). Too wealthy men jawing about a deal . . . .Puffery, or the way business actually is done in this crowd?
Based on what I know today (which is not terribly much), my sense is that a court should find that Musk acted in reckless disregard of the falsity of his words and understood the likely impact those words would have on the trading of his firm's stock. To find otherwise based on the specific facts alleged to have occurred here would inject too much subjectivity into the (admittedly subjective) determination of scienter. But we shall see. As Ann noted in Saturday's post, a private class action also has been brought against Musk and Tesla based on the tweet affair. So, we may yet see the materiality and scienter issues play themselves out in court (although I somehow doubt it).
Saturday, September 29, 2018
By now, I’m sure everyone’s seen the eyebrow-raising SEC complaint filed against Elon Musk for his fateful tweet announcing “funding secured” for his plan to take Tesla private at $420/share – while keeping all the old shareholders. There are a lot of juicy details here, including an allegation that the $420 price was – as many suspected – a reference to marijuana; he ballparked a 20% premium, which would bring the price to $419, and then rounded up to impress his girlfriend.
Well, as we all know by now, funding was not secure, there was no plan, and – as I previously posted – there was no way the plan was ever going to work in the first place, because you can’t go private while keeping a massive retail shareholder base.
That said, the thing I keep wondering is, if anyone but the SEC had brought this case, would there be a serious question of materiality?
For starters, there has been a private complaint. A short-seller, apparently injured when Tesla’s price shot up in the wake of Musk’s initial tweet, filed a class action complaint alleging securities fraud. Now, this case is in the early stages so there’s no way to tell exactly where it will go, but I first note that even though a short-seller filed the complaint, the class appears to consist of people who went long – who bought in on the tweet, and lost money when it became clear that no take-private deal would be forthcoming.
Well, short-sellers occupy a kind of weird position in Section 10(b) cases, especially for a scenario like this. They borrow shares, sell them, and lose money if they have to return the borrowed shares by repurchasing at a higher price. If the allegation is that the company’s lies forced them to cover at a higher price than they otherwise would have – i.e., if the lies happened after the initial sale – there may not be any reliance in the traditional sense. That is, the seller may not have necessarily believed the lie, but might have been forced to cover anyway. Courts have been a bit inconsistent in how these claims are treated, see Rocker Management, LLC v. Lernout & Hauspie Speech Products N.V., 2007 WL 2814653 (D.N.J. 2007) (discussing cases), and Basic v. Levinson, 485 U.S. 224 (1988) suggests that forced transactions made while knowing the truth are not in reliance on the fraud – so it is not clear that under existing doctrine, a short-seller who saw through the lie almost immediately, but was injured because other people didn’t, has a Section 10(b) claim. (It’s not impossible that Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398 (2014) will change how courts think about these things; in that case, the Supreme Court was explicit that reliance exists for traders who disbelieve the market price but expect it to eventually correct; the Court was not talking about short-sellers, but the logic might extend that far).
But anyway! Leaving aside the short-seller bit for a moment, the problem from a materiality standpoint is that the market saw through the lie almost immediately.
We start with the definition of materiality: a fact is material if there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” Basic, 485 U.S. at 231-32. Well, would a reasonable shareholder have taken Musk’s statement seriously? Musk has a history of bizarre tweets, so on the day the fatal tweet issued, people were speculating it was a joke. For example:
FUNDING SECURED pic.twitter.com/svlPG4ifNa— The_Real_Fly (@The_Real_Fly) August 7, 2018
From now on signing off every tweet “funding secured.”— Downtown Josh Brown (@ReformedBroker) August 7, 2018
Am considering taking a sandwich private at 12:15. Funding secured.— Jim Prosser 🖖 (@jimprosser) August 7, 2018
Am considering taking the wife to dinner tonight. Funding secured.— Matthew Argersinger (@MArgersinger) August 7, 2018
I think “funding secured” may become this generations “mission accomplished “ #tsla— Guy Adami (@GuyAdami) August 7, 2018
To be sure, with respect to this argument, one of the best points in the class’s favor is a nugget in the SEC complaint that market analysts - sophisticated people - privately contacted Tesla’s head of investor relations for more information and were assured that the tweet was legit. So that’s evidence the market took it seriously.
That said, as I explained in my prior post, the structure Musk proposed was legally impossible – indeed, his failure even to investigate the legality is a central factor in the SEC’s complaint. But those legal standards are publicly known, and thus are part of the “total mix of information made available.” See, e.g., Wielgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989) (“Issuers needn’t print the Code of Federal Regulations…”). So, one might argue – especially in the fraud-on-the-market context, where truths might have an offsetting impact on market price – that the truth about the impossibility of Musk’s plan was necessarily known to investors and could not have impacted the stock’s price.
Aha, you might say – but the tweet did impact the stock’s price – it closed up nearly 11%! Market reaction was so volatile that the NASDAQ had to temporarily suspend trading! Isn’t that proof of materiality?
Well, you would think, but it turns out courts aren’t really eager to relinquish their authority over materiality determinations to market evidence, and frequently reject stock price reaction as proof of materiality. See, e.g, Police Ret. Sys. v. Intuitive Surgical, Inc., 759 F.3d 1051, 1060 (9th Cir. 2014); Greenhouse v. MCG Capital Corp., 392 F.3d 650 (4th Cir. 2004).
That said, whatever challenges these issues might pose for private plaintiffs, it’s not clear they’ll get much traction in the context of a governmental action, where, rightly or wrongly, courts often treat materiality differently than they do in the private-litigation context. Cf. Margaret V. Sachs, Materiality and Social Change: The Case for Replacing “the Reasonable Investor” with “the Least Sophisticated Investor” in Inefficient Markets, 81 Tul. L. Rev. 473 (2006) (describing some cases). However, Musk reportedly already rejected an SEC settlement and – Musk being Musk – might be determined to fight this thing all through trial, so I’m curious to see how it plays out.
Edit: Well, doesn’t look like we'll get a chance to find out, because Musk backed down and agreed to settle with the SEC after all. We might see these arguments play out in the private action, though - and while I don’t actually expect a court to dismiss on materiality grounds (the market furor was just too great to ignore), the fact that these arguments are even available in the doctrine highlights, to me, a point I’ve emphasized in this space before: concepts of materiality, loss causation, market efficiency and so forth have become stylized to the point of fiction.
Saturday, September 22, 2018
Back when the CBS Board first decided to revolt against its controlling shareholder, Shari Redstone, I posted a collection of immediate thoughts. My final one was:
[T]here’s a subtext in all of this, and it’s that Shari Redstone in particular is an untutored interloper, interfering in a business that she knows little about having finally managed to wrest control from her ailing – and often-estranged – father….It’s hard not to wonder about something of a gendered undercurrent in this kind of commentary, and that, in turn, taints CBS’s general depiction of Shari Redstone as a gossipy – and they don’t use that word but that is the implication when they allege that Redstone basically is saying mean things about people – busybody in corporate affairs.
In light of what transpired and came to light since then, I’m going to emphasize that point again. Because there’s even more evidence today that the Board’s hostility to Redstone – and its support of Moonves – was tainted by (what I assume was unconscious) bias. And now, after an expensive and pointless legal battle, terrible publicity, and a general waste of corporate resources, we have a cautionary tale about how sexism distorts and inhibits business judgment.
[More under the jump]
Saturday, September 15, 2018
Corporate managers have long complained about proxy advisory services, such as ISS, Egan-Jones, and Glass Lewis. They argue that proxy advisors provide governance advice to companies – for a fee – and then make influential voting recommendations to client shareholders, functionally creating a kind of shakedown service (“Pay us and we’ll be able to recommend that shareholders vote in your favor; don’t, and who knows what we’ll do?”). Corporations argue that shareholders don’t conduct their own analysis of issues anymore, and blindly vote with however proxy services recommend – giving them far too much power.
There is plenty of reason to be skeptical of their complaints. At least one study shows that most institutional investors take recommendations into account but ultimately make their own decisions. And as John Coates recently testified before Congress on the issue, there is no evidence of a market failure necessitating congressional regulation, and regulation might make the industry more concentrated and less competitive, which is the exact opposite of what we should strive for.
I won’t deny that to the extent proxy advisory services potentially have conflicts, these should be known and their policies for cleansing should be clear. But one cannot help but suspect that companies’ reasons for objecting to proxy advisors is the same as their objection to unions – it’s not conflicts or corruption, it’s that they overcome transactions costs of a disaggregated constituency and facilitate coordination so as to create a countervailing power center. Managers, in other words, just don’t want to be challenged – by anyone.
That said, corporate complaints have found a sympathetic ear among Republicans in Congress and now, apparently, in Jay Clayton at the SEC. The SEC just announced that it was withdrawing two no-action letters from 2004 that have become the bete noire of corporate managers, in preparation for an upcoming Roundtable on the Proxy Process. Clayton even went out of his way to issue a separate statement clarifying that staff guidance is non-binding, if we hadn’t gotten the message that anything done under previous administrations is now suspect.
You can’t read the letters online, because apparently withdrawing them means making them inaccessible unless you have access to a legal database – and that, by the way, is just terrible practice from a transparency point of view; I’d rather they just be clearly marked as withdrawn.
That said, I will summarize (and embed the letters in this post, if I can get the tech to cooperate). But first, some background – and this is going to get long, so I’m putting the rest behind a cut.
[More under the jump]
Saturday, September 8, 2018
I’ve been absolutely riveted by Nike’s decision to make Colin Kaepernick the face of its new ad campaign. (I assume most readers are aware of the basics but here’s an article to catch you up if you need it.) It’s a daring move, not just because of the controversy over Kaepernick himself, but also because of Nike’s relationship with the NFL: Nike is the official supplier of uniforms and sideline gear (a deal that was just extended through 2028), and presumably, in that capacity, Nike wants to keep the NFL popular and football fans happy.
So, there’s so much to chew over here.
We start with the ongoing tension between the fact that it is good marketing for companies to look like they care about various social causes – whatever those causes may be – and their fiduciary duty not to actually care about those things. (Assuming you buy into a shareholder primacy model, etc etc).
My favorite example for my students is, well, this FT Alphaville blog post in reaction to Jamie Dimon’s ostentatious announcement that he was giving his employees a raise. And then there’s Tax Exempt Lobbying, a new paper by Marianne Bertrand, Matilde Bombardini, Raymond J. Fisman, and Francesco Trebbi, finding that companies strategically direct charitable giving so as to please politicians that have control over their fates.
So on the one hand, it may be good business to promote Kaepernick, but Nike has to absolutely pretend that’s not really its motivation.
(More under the jump)
Monday, September 3, 2018
Like many in the law academy, I find three-day holiday weekends a great time to catch my breath and catch up on work items that need to be addressed. This Labor Day weekend--including today, Labor Day itself--is no exception to the rule. I am working today, honoring workers through my own work. My husband and daughter are doing the same.
This blog post and the announcement it carries are among my more joyful tasks for the day. I have been remiss in not earlier announcing and promoting our second annual Business Law Prof Blog symposium, which will be held at The University of Tennessee College of Law on September 14. The symposium again focuses on the work of many of your favorite Business Law Prof Blog editors, with commentary from my UT Law faculty colleagues and students. This year, topics range from the human rights and other compliance implications of blockchain technology to designing impactful corporate law, with a sprinkling of other entity and securities law related topics. I am focusing my time in the spotlight (!) on professional challenges in the representation of social enterprise firms. More information about the symposium is available here. For those of you who have law licenses in Tennessee, CLE credits are available.
I am looking forward to again hosting some of my favorite law scholars at this symposium. I am sure some will blog about their presentations here (Marcia already has previewed her talk and summarized all of our presentations, and I plan to later blog about mine), Transactions (our business law journal) will publish the symposium proceedings, and videos will be processed and posted on UT Law's CLE website later in the year. But if you are in the neighborhood, stop by and hear us all in person! We would love to see you.
Saturday, September 1, 2018
Did I lose you with the title to this post? Do you have no idea what a DAO is? In its simplest terms, a DAO is a decentralized autonomous organization, whose decisions are made electronically by a written computer code or through the vote of its members. In theory, it eliminates the need for traditional documentation and people for governance. This post won't explain any more about DAOs or the infamous hack of the Slock.it DAO in 2016. I chose this provocative title to inspire you to read an article entitled Legal Education in the Blockchain Revolution.
The authors Mark Fenwick, Wulf A. Kaal, and Erik P. M. Vermeulen discuss how technological innovations, including artificial intelligence and blockchain will change how we teach and practice law related to real property, IP, privacy, contracts, and employment law. If you're a practicing lawyer, you have a duty of competence. You need to know what you don't know so that you avoid advising on areas outside of your level of expertise. It may be exciting to advise a company on tax, IP, securities law or other legal issues related to cryptocurrency or blockchain, but you could subject yourself to discipline for doing so without the requisite background. If you teach law, you will have students clamoring for information on innovative technology and how the law applies. Cornell University now offers 28 courses on blockchain, and a professor at NYU's Stern School of Business has 235 people in his class. Other schools are scrambling to find professors qualified to teach on the subject.
To understand the hype, read the article on the future of legal education. The abstract is below:
The legal profession is one of the most disrupted sectors of the consulting industry today. The rise of Legal Tech, artificial intelligence, big data, machine learning, and, most importantly, blockchain technology is changing the practice of law. The sharing economy and platform companies challenge many of the traditional assumptions, doctrines, and concepts of law and governance, requiring litigators, judges, and regulators to adapt. Lawyers need to be equipped with the necessary skillsets to operate effectively in the new world of disruptive innovation in law. A more creative and innovative approach to educating lawyers for the 21st century is needed.
For more on how blockchain is changing business and corporate governance, come by my talk at the University of Tennessee on September 14th where you will also hear from my co-bloggers. In case you have no interest in my topic, it's worth the drive/flight to hear from the others. The descriptions of the sessions are below:
Session 1: Breach of Fiduciary Duty and the Defense of Reliance on Experts
Many corporate statutes expressly provide that directors in discharging their duties may rely in good faith upon information, opinions, reports, or statements from officers, board committees, employees, or other experts (such as accountants or lawyers). Such statutes often come into play when directors have been charged with breaching their procedural duty of care by making an inadequately informed decision, but they can be applicable in other contexts as well. In effect, the statutes provide a defense to directors charged with breach of fiduciary duty when their allegedly uninformed or wrongful decisions were based on credible information provided by others with appropriate expertise. Professor Douglas Moll will examine these “reliance on experts” statutes and explore a number of questions associated with them.
Session 2: Fact or Fiction: Flawed Approaches to Evaluating Market Behavior in Securities Litigation
Private fraud actions brought under Section 10(b) of the Securities Exchange Act require courts to make a variety of determinations regarding market functioning and the economic effects of the alleged misconduct. Over the years, courts have developed a variety of doctrines to guide how these inquiries are to be conducted. For example, courts look to a series of specific, pre-defined factors to determine whether a market is “efficient” and thus responsive to new information. Courts also rely on a variety of doctrines to determine whether and for how long publicly-available information has exerted an influence on security prices. Courts’ judgments on these matters dictate whether cases will proceed to summary judgment and trial, whether classes will be certified and the scope of such classes, and the damages that investors are entitled to collect. Professor Ann M. Lipton will discuss how these doctrines operate in such an artificial manner that they no longer shed light on the underlying factual inquiry, namely, the actual effect of the alleged fraud on investors.
Session 3: Lawyering for Social Enterprise
Professor Joan Heminway will focus on salient components of professional responsibility operative in delivering advisory legal services to social enterprises. Social enterprises—businesses that exist to generate financial and social or environmental benefits—have received significant positive public attention in recent years. However, social enterprise and the related concepts of social entrepreneurship and impact investing are neither well defined nor well understood. As a result, entrepreneurs, investors, intermediaries, and agents, as well as their respective advisors, may be operating under different impressions or assumptions about what social enterprise is and have different ideas about how to best build and manage a sustainable social enterprise business. Professor Heminway will discuss how these legal uncertainties have the capacity to generate transaction costs around entity formation and management decision making and the pertinent professional responsibilities implicated in an attorney’s representation of such social enterprises.
Session 4: Beyond Bitcoin: Leveraging Blockchain for Corporate Governance, Corporate Social Responsibility, and Enterprise Risk Management
Although many people equate blockchain with bitcoin, cryptocurrency, and smart contracts, Professor Marcia Narine Weldon will discuss how the technology also has the potential to transform the way companies look at governance and enterprise risk management. Companies and stock exchanges are using blockchain for shareholder communications, managing supply chains, internal audit, and cybersecurity. Professor Weldon will focus on eliminating barriers to transparency in the human rights arena. Professor Weldon’s discussion will provide an overview of blockchain technology and how state and nonstate actors use the technology outside of the realm of cryptocurrency.
Session 5: Crafting State Corporate Law for Research and Review
Professor Benjamin Edwards will discuss how states can implement changes in state corporate law with an eye toward putting in place provisions and measures to make it easier for policymakers to retrospectively review changes to state law to discern whether legislation accomplished its stated goals. State legislatures often enact and amend their business corporation laws without considering how to review and evaluate their effectiveness and impact. This inattention means that state legislatures quickly lose sight of whether the changes actually generate the benefits desired at the time off passage. It also means that state legislatures may not observe stock price reactions or other market reactions to legislation. Our federal system allows states to serve as the laboratories of democracy. The controversy over fee-shifting bylaws and corporate charter provisions offers an opportunity for state legislatures to intelligently design changes in corporate law to achieve multiple state and regulatory objectives. Professor Edwards will discuss how well-crafted legislation would: (i) allow states to compete effectively in the market for corporate charters; and (ii) generate useful information for evaluating whether particular bylaws or charter provisions enhance shareholder wealth.
Session 6: An Overt Disclosure Requirement for Eliminating the Duty of Loyalty
When Delaware law allowed parties to eliminate the duty of loyalty for LLCs, more than a few people were appalled. Concerns about eliminating the duty of loyalty are not surprising given traditional business law fiduciary duty doctrine. However, as business agreements evolved, and became more sophisticated, freedom of contract has become more common, and attractive. How to reconcile this tradition with the emerging trend? Professor Joshua Fershée will discuss why we need to bring a partnership principle to LLCs to help. In partnerships, the default rule is that changes to the partnership agreement or acts outside the ordinary course of business require a unanimous vote. See UPA § 18(h) & RUPA § 401(j). As such, the duty of loyalty should have the same requirement, and perhaps that even the rule should be mandatory, not just default. The duty of loyalty norm is sufficiently ingrained that more active notice (and more explicit consent) is necessary, and eliminating the duty of loyalty is sufficiently unique that it warrants unique treatment if it is to be eliminated.
Session 7: Does Corporate Personhood Matter? A Review of We the Corporations
Professor Stefan Padfield will discuss a book written by UCLA Law Professor Adam Winkler, “We the Corporations: How American Businesses Won Their Civil Rights.” The highly-praised book “reveals the secret history of one of America’s most successful yet least-known ‘civil rights movements’ – the centuries-long struggle for equal rights for corporations.” However, the book is not without its controversial assertions, particularly when it comes to its characterizations of some of the key components of corporate personhood and corporate personality theory. This discussion will unpack some of these assertions, hopefully ensuring that advocates who rely on the book will be informed as to alternative approaches to key issues.
September 1, 2018 in Ann Lipton, Compliance, Conferences, Contracts, Corporate Governance, Corporate Personality, Corporations, Current Affairs, Employment Law, Human Rights, Intellectual Property, International Business, Joan Heminway, Joshua P. Fershee, Law School, Lawyering, LLCs, Marcia Narine Weldon, Real Property, Shareholders, Social Enterprise, Stefan J. Padfield, Teaching, Technology, Web/Tech | Permalink | Comments (0)
Friday, August 31, 2018
It's not that there isn't other news, it's just that this is swimming in warm water. A few days ago, SurveyMonkey filed an S-1 for its forthcoming IPO, and there are a few things that jumped out at me.
First, there's a survey!
(Okay, I'm feeling a little attacked right now.)
Second, there's a warning! I previously warned about warnings; poorly drafted ones can warn the registrant right out of a truth on the market/materiality defense if there's a subsequent securities fraud claim. SurveyMonkey seems to get it right, though:
So, unlike warnings that have gotten issuers into trouble in the past, this one doesn't explicitly tell anyone not to rely on external information. It's just warning you that external information isn't attributable to SurveyMonkey.
(Which, incidentally, highlights the artificiality of the entire exercise; does anyone seriously believe that from an investor/market perspective, there's any real difference between "you should only rely on us" language and "we have not authorized anyone else" language?)
And finally, as I promised in my subject line, there's the litigation limit:
Okay, so much to talk about here. First, if you've been following along, you know that I've repeatedly posted about - and written one article and one book chapter discussing - the question whether corporate governance documents can limit federal securities claims. My view is, they can't. But, as I previously mentioned, that issue is currently being tested in Delaware, with oral argument currently scheduled for September 27, so we may have a clear answer soon (umm, well, after the appeal that I assume will follow whatever the Chancery court decides).
And this matters a heckuva lot, because funneling Securities Act claims into federal courts may not seem like much of a deal, but that's just a stalking horse for the more explosive question, namely, whether corporations can use their governance documents to require that federal securities claims be arbitrated, and likely, arbitrated individually rather than on a class basis. That issue has seen a resurgence of interest, with SEC Commissioners current and former seeming to encourage the idea, and the Consumer Federation of America recently issuing a white paper arguing against it. If Delaware decides - as I think it should - that litigation limits in corporate governance documents can only be applied to state claims, then it's difficult to see what mechanism companies could use to dictate the arbitration of federal claims, no matter what the SEC says. (Though I suppose they'll come up with something, but there will then be the question whether that "something" is a contract subject to the Federal Arbitration Act, etc, etc.)
Finally, I note that SurveyMonkey put its forum selection clause in its bylaws. That's a change from other companies that recently went public, like Snap, Roku, Blue Apron, and Stitch Fix, all of which included the provisions in their charters where they would be much more difficult for shareholders to change (umm, also, some of those shareholders can't vote). In any event, SurveyMonkey is implicitly giving its shareholders the option of repealing the bylaw if they want to (assuming SurveyMonkey's directors don't, you know, change it right back).
So, that's the state of play, and as far as I'm concerned the ball's now in Delaware's - not the SEC's - court.
Saturday, August 25, 2018
If you’re like me, you’ve been riveted by the Tesla drama and Elon Musk’s off-the-cuff, possibly Ambien-high, tweet announcing that he planned to take the company private at $420 per share, only to finally admit yesterday that, no, Tesla would stay public after all.
In any event, back when the idea was first floated, and investors (and, I assume, Musk’s counsel) demanded more information about this take-private scheme, Musk vaguely announced that he expected most shareholders – perhaps as many as two-thirds – would stay with the company, and roll over their shares into a special purpose vehicle. He even invited shareholders to remain invested, writing, “I would like to structure this so that all shareholders have a choice. Either they can stay investors in a private Tesla or they can be bought out at $420 per share.”
Much has been written about this proposal, including all the reasons why it didn’t make financial sense, and the evidence that no, he never had funding or a plan, and now the SEC is investigating, and so forth, but there’s really one aspect I want to focus on, which is, the proposal never could have worked, because you can’t go private that way.
Companies incur the responsibility to periodically, and publicly, report on their financial status if they have a class of securities outstanding and traded by the public (with various definitions and trigger points for what that means). In this case, we’re talking about public reporting obligations Tesla incurred by making its stock available to the public. (A whole ’nother question might be whether the company would have maintained reporting obligations for its bonds, but let’s stick to stock for now.)
When that stock is no longer publicly held – which, under the Securities Exchange Act, means owned by fewer than 300 shareholders – the company has the option to “go dark” and cease reporting publicly. So for Tesla to do this, it would have had to somehow get itself down to under 300 shareholders – while, according to Musk, still keeping most of the shareholder base.
His thinking, apparently, was that if one giant fund was created, and that fund held Tesla stock, and then two-thirds of Tesla’s current shareholders bought shares of the fund, then Tesla would have one shareholder – the fund – and would no longer have reporting obligations.
One potential problem with this idea is that then the fund would be considered public and might have its own reporting obligations, but leaving that point aside, the idea still wouldn’t fly. Ordinarily, he’s right: if a fund or a vehicle or a trust holds shares in a company, it is considered a single holder for the purposes of a shareholder count. This, in fact, is exactly what’s happened with Uber, as I previously posted: a couple of funds sprung up that bought Uber stock and sold fund shares to investors, thus allowing investors to gain exposure to a “private” company whose stock wouldn’t ordinarily be available to them. But the SEC will only allow that if the funds are formed independently of the subject company. As the SEC explained, they’ll look through to the fund’s real investors if the fund is simply a sham to evade reporting requirements, which is exactly what Musk announced that he planned to do.
That said, it’s not impossible that Musk would have been able to get Tesla down to fewer than 300 shareholders while maintaining two-thirds of the old shareholder base, in a manner of speaking (if he had the funding, and a plan, etc), but almost certainly some shareholders would have to be forced out, i.e., there would be no choice available to them.
The SEC has an odd way of counting shareholders. If the shareholder keeps the shares titled in the name of his or her brokerage company, which most shareholders do, the brokerage company counts as the shareholder. Because lots of beneficial owners of Tesla stock use the same set of brokerage companies, that means that the official count of Tesla shareholders is much lower than the real number. In fact, Tesla’s latest 10-K says that Tesla has 168,919,941 shares of common stock outstanding, but only 1,156 shareholders of record. Obviously, the true number of shareholders is much higher, but the official number is 1,156, because of the practice of holding shares through brokerage companies.
So getting down to fewer than 300 shareholders is not so far-fetched. To use an extreme example, if Musk offered a buyout and one-third of the shareholders accepted, but the remaining two-thirds all happened to hold their shares through, say, JP Morgan, Tesla could get itself down to a single shareholder of record.
But here’s the rub: I’m assuming that large institutional investors use a lot of the same large brokerage companies. Which means, even though there are something like 886 institutional holders, the number for SEC purposes may in fact be much lower. At the same time, though, retail shareholders hold 23% of Tesla stock. I’m guessing that they also hold in a more far-flung set of brokerage companies, maybe even some hold in their own names, and of course, they each hold much smaller amounts of Tesla stock than do institutions. So it’s very likely that, to get down to fewer than 300 shareholders, these are the ones Tesla would have to buy out. And these are the shareholders who are unlikely to want to sell, because Tesla retail shareholders are a particularly devoted set of true believers. Given a choice, many would likely to want to stay with the company.
They could, however, be forced out. For example, a company can do a reverse stock split at a very high ratio – like, 1 to 1,000 – and thereby cash out anyone who holds less than 1,000 shares. After such a split, voila! The company has fewer than 300 shareholders. (Matt Levine discusses a recent example; and here’s a funny story from when Bacardi tried, and failed, the same trick). If Tesla wanted to go that route, it could sort of keep two-thirds of its shareholders – in the sense that, the original holders of two-thirds of those 168,919,941 shares might still be in place – while bringing the official shareholder count down below 300. But once again, the involuntary nature of that plan does not at all sound like what Musk was describing, and there’s no need to use a special purpose vehicle to accomplish it.
Saturday, August 18, 2018
I try to explain to people that the motion to dismiss in a securities case is a unique animal; the complaints, and the briefing, are not like motions to dismiss in any other area of law. When it comes to securities cases – especially class actions – the motion to dismiss is really a mini motion for summary judgment. This week, in a case called Khoja v. Orexigen Therapeutics, No. 16-56069, the Ninth Circuit tried to draw a line in the sand, but as far as I’m concerned, did not go nearly far enough.
It all begins with the Private Securities Litigation Reform Act, which heightens the pleading requirements in securities cases. Among other things, the Act requires that plaintiffs “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” Additionally, plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted” intentionally or recklessly. 15 U.S.C. §78u-4.
As Hillary Sale has documented in the context of scienter pleading, and as I myself experienced over the course of my 1o-ish year-long career as a plaintiff-side securities litigator, over time, courts have incrementally raised the bar for what kinds of evidence they will accept as meeting these standards. To some extent, there’s a kind of one-way ratchet effect: plaintiffs hit upon the idea of using confidential witnesses to bolster the complaint’s allegations, and pretty soon they became de rigueur, to the point where the lack of such sources is viewed as a weakness, and so forth. Moreover, as Nancy Gertner pointed out in another context, the judicial habit of writing long opinions explaining the reasoning for dismissing a case – and often (though not always) writing shorter, brief orders when refusing to dismiss – creates a body of caselaw stacked against plaintiffs. Point being, securities complaints are subject to an extraordinary degree of scrutiny not present for many other kinds of actions.
One aspect of securities pleading that has grown worse over time is courts’ willingness to consider materials beyond the four corners of the complaint. Though the general rule is that on a motion to dismiss, courts can only consider the complaint itself, there are two significant exceptions. First, courts may consider “matters of which a court may take judicial notice,” and second, courts may consider “documents incorporated into the complaint by reference.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007). The principles behind these rules are relatively uncontroversial. Judicial notice is supposed to be a relatively narrow category: Rule 201 permits notice of facts “not subject to reasonable dispute” because they “can be accurately and readily determined from sources whose accuracy cannot reasonably be questioned.” Meanwhile, the “incorporated by reference” doctrine was intended to prevent plaintiffs from cherry-picking from documents – like, selecting part of a quote and leaving out the qualifier so as to create a false impression of what the defendant said.
But these narrow exceptions to the general rule against looking beyond the complaint have been stretched to the breaking point in securities litigation. Today, it is common for defendants to submit hundreds of pages of supplemental material on a motion to dismiss. Using one or both of these exceptions, courts consider SEC filings, court filings, press releases, federal agency reports, news articles, analyst reports, stock prices, accounting standards, patent applications, complaints and briefs in other cases, to name a few examples (See, e.g., Wolfe v. Aspenbio Pharma, 2012 WL 4040344 (D. Colo. Sept. 13, 2012); Carlucci v. Han, 2012 WL 3242618 (E.D. Va. Aug. 7, 2012); In re XenoPort, Inc. Sec. Litig., 2011 WL 6153134 (N.D. Cal. Dec. 12, 2011); In re MBIA, Inc. Sec. Litig., 700 F. Supp. 2d 566 (S.D.N.Y. 2010); Wilamowsky v. Take-Two Interactive Software, Inc., 818 F. Supp. 2d 744 (S.D.N.Y. 2011); In re American Apparel, Inc. S’holder Litig., 2012 WL 1131684 (C.D. Cal. Jan. 13, 2012); In re Seracare Life Sciences, Inc., 2007 WL 935583 (S.D. Cal. Mar. 19, 2007); In re White Elec. Designs Corp. Sec. Litig., 416 F. Supp. 2d 754 (D. Ariz. 2006)). Honestly, the supply of extraneous material is endless.
Partly, this is because plaintiffs cite and identify many sources to satisfy the particularity standards (thus opening the door for defendants to introduce documents “referenced”), and partly, this is because the fraud on the market context – with its vague articulation of what counts as publicly available information – invites introduction of any document that might, in any sense, be deemed publicly available. And partly, this is because so much of these disputes play out in SEC filings - which are at least noticeable as publicly-filed regulatory documents - it’s easy for defendants to drop a Tolstoy novel’s worth of them into an appendix.
From my perspective, the problem, really, is less that these documents are introduced at all than the matters for which they are introduced, namely, what they purport to establish. And that’s where the Khoja case comes in.
First –and perhaps most usefully – in Khoja, the Ninth Circuit simply made clear that it is important for district courts to think carefully about why they are considering a document and what its relevance is. In my experience, when faced with hundreds of exhibits produced by defendants (and often little pushback from plaintiffs, because of page limitations and because fighting too hard about authentic documents appears too defensive), district courts often simply say they are generally noticing the documents, without explaining what, precisely, they are considering and why. The Khoja decision demonstrates that this is insufficient: If the district court is relying on a document submitted by the defendants to dismiss a complaint, it should explain its reasoning.
Next, Khoja makes clear that when it comes to judicial notice, courts should articulate what, exactly, they are noticing. Identifying the document is not sufficient: That a document was filed with a public agency may be noticeable; that the document demonstrated the agency had knowledge of a particular fact by a particular date may also be noticeable. But the truth of facts asserted within those documents, or the implications of those documents, are not judicially noticeable facts. Courts need to make the appropriate distinctions.
Here’s where I think the Ninth Circuit did not go far enough. Usually for these kinds of documents – even ones never cited by plaintiffs – courts notice them for the purpose of making assumptions about what “the market” knew and when it was known, or how the stock price reacted. This is the nub of the problem. Some nominally “public” documents – like obscure court filings – may or may not have had an impact on the market, depending on whether they came to traders’ attention: courts cannot make assumptions without further evidence. Further, a document purporting to “reveal the truth” to the market may seem straightforward, but it’s difficult to say how the market interpreted the document without resort to even further evidence of analyst reports, news articles, and so forth, all of which may not be before the court. And price impact? Without expert analysis, what counts as impact (or what may have been confounded by other news) is impossible to tell. The motion to dismiss is not the appropriate stage at which to resolve these disputes.
There is also often a danger that courts will accept the facts in these documents as truthful. SEC reports of insider stock sales, for example; yes, they were filed, but they cannot be assumed (on a motion to dismiss) to represent a complete and accurate portrait of the defendants’ trading history. (The story is different if the plaintiffs themselves cite the document for that purpose - discussed below).
Okay, that’s judicial notice. A separate and distinct basis for a court to consider an extraneous document is when the plaintiffs themselves incorporated the document by reference. In this scenario, the Ninth Circuit set different ground rules. First, the complaint must “referextensively to the document or the document forms the basis of the plaintiff’s claim” to be considered at all. Second, according to the Ninth Circuit, unlike in judicial notice, the contents of an incorporated document may be assumed to be truthful, but “it is improper to assume the truth of an incorporated document if such assumptions only serve to dispute facts stated in a well-pleaded complaint.”
I don’t think the court is wrong here, exactly, but the standard should be articulated more precisely. Certainly, not every document relied on by plaintiffs can be assumed to be truthful (what if the plaintiffs alleged the document was a false press release?) What the court is grappling with is the scenario where plaintiffs use a document as the basis for an allegation, so that the plaintiffs themselves implicitly accept it as truthful. For example, the plaintiffs may rely on a news article, or a government report, that purports to describe the “true facts” at the company at the time the defendants made the allegedly fraudulent statements. A tempting rule of thumb is that the plaintiffs should accept the bitter with the sweet: if they themselves are alleging the document has accurately described the facts, then defendants should also be able to rely on it for that purpose.
But some of these documents may be long, or complex, or contain different anecdotes and explanations for different time periods. It is overinclusive to say that if plaintiffs rely on one specific description in one part of a document, then all other parts of the document should also be treated as truthful for 12(b)(6) purposes, including for the purpose of injecting entirely new facts into the motion to dismiss.
My experience with this comes from the mortgage-crisis era cases that dominated the latter part of my career. We would sometimes rely on something like the FCIC Report – which is 662 pages long – or even Michael Lewis’s The Big Short, which is only a few hundred pages long. We might cite a total of 10 pages, but we were occasionally met with an argument that the entire document should be considered by the court, and assumed to be truthful in all respects – even though we, as plaintiffs, were only basing our allegations on limited excerpts.
In my view, this is difficult balancing act for courts: Cherry picking may be unfair – if plaintiffs rely on a story, necessary parts of the story should not be ignored. But at the same time, unrelated sections of the document should not be assumed to be true for 12(b)(6) purposes merely because the plaintiffs relied on a few, separate portions.
What it comes down to is, the complaint is a highly selective set of allegations – no doubt. But so are documents submitted by defendants in rebuttal. When the defendants’ documents add necessary context to the specific facts being alleged by plaintiffs, so that those facts are rebutted or recontextualized, it is appropriate to consider them on a motion to dismiss. Past that – that’s why we have summary judgment and, eventually, trial.
Saturday, August 11, 2018
As many readers are likely aware, the proposed acquisition of Tribune Media Company by Sinclair Broadcast Group fell through when the FCC referred the matter to an administrative hearing, thus creating a nearly-insurmountable roadblock to closing. On Thursday, Tribune filed a complaint against Sinclair in Delaware alleging that Sinclair breached the merger agreement by failing to use its best efforts to win regulatory approval. The complaint is an entertaining read and regardless of the outcome, I’m quite certain it will prove to be a vivid classroom example of best efforts clauses in the merger context.
The basic gist of the complaint is that Sinclair agreed to use its best efforts to win regulatory approval, and it was entirely foreseen by the parties that the relevant regulators – the Justice Department and the FCC – would want divestments in 10 specific markets. Nonetheless, Sinclair stonewalled the DOJ (at one point actually telling the Assistant Attorney General “sue me”), and submitted sham divestment plans to the FCC that involved, well:
selling WGN-TV in Chicago to Steven Fader, a close associate of [Sinclair Executive Chair David] Smith’s in a car dealership business who had no experience in broadcasting. Sinclair also proposed the sale of WPIX, a New York station, to Cunningham Broadcasting Corporation, a company that owns numerous television stations that are operated by Sinclair employees under joint sales and shared services agreements, has tens of millions of dollars in debt guaranteed by Sinclair, and had been controlled by the estate of Smith’s late mother until January 2018.
…When Sinclair’s applications were subject to public comment, opponents of the divestitures revealed facts that Sinclair had failed to disclose to the FCC …. For example, Sinclair had not told the FCC, in its applications, that Smith owned the controlling interest in Fader’s car dealership company, and that Cunningham’s controlling shares had been sold at a suspiciously low price only months earlier to a Sinclair associate with re-purchase options held by Smith’s family members.
All of which, predictably, submarined the merger and breached Sinclair’s obligations to Tribune.
Now, I have no idea what exactly happened, but I can imagine a cynical story. The cynical story goes something like, Sinclair is a conservative media organization and the merger was favored by Trump. The FCC’s Chair, Ajit Pai, up until now had bent over backwards to accommodate Sinclair, up to and including loosening regulations that allowed the merger to proceed. (Currently, Pai is under investigation by the FCC’s inspector general to determine if these regulatory maneuvers were impermissibly timed to benefit Sinclair). As a result – and knowing that the Trump administration is not renowned for its religious devotion to the minutiae of regulatory procedure – when Sinclair signed the merger agreement, it reasonably believed that its best efforts would not in fact, require it to divest anything (an expectation that may have gotten support from past practice), and was completely blindsided when matters went the other way (as was, apparently, Washington). Certainly, there have been reasonable grounds to believe that this administration occasionally intrudes upon agency decisionmaking.
Either way, if Sinclair were to make an argument along these lines – not that I expect it to, this is a thought experiment – how should the contract itself be interpreted?
Essentially, this is the conundrum that Delaware Chief Justice Leo Strine anticipated when he spoke earlier this year at the Tulane Corporate Law Institute. As I wrote at the time:
[R]eferencing the then-current dispute between Broadcom, Qualcomm, and CFIUS … he explained that judges often have to make difficult decisions about the interpretation of closing conditions that involve regulatory approvals. In the past, judges could at least be confident that, whether you agree with the regulator or not, regulation was not being done “sideways.” If, however, regulation is going to be used for other than its original purposes – such as for protectionist purposes – that will affect how courts address after-the-fact disputes about why deals fell through.
In other words, Delaware judges have to have faith in the legitimacy of the regulatory process in order to evaluate these kinds of disputes; without it, it becomes much harder to interpret “best efforts” clauses that involve entanglement with federal regulators.
Friday, August 3, 2018
As most readers of this blog are likely aware, the theory behind initial coin offerings and “smart” contracts is that the code itself is entirely transparent and self-executing; the terms of the contract are set in the programming, thus eliminating the need for enforcement mechanisms or for messy legal disputes over interpretation. The code dictates the agreement, and the code enforces it; investors curious about terms of an investment can simply read the code and have utter certainty as to the nature of the agreement.
As Matt Levine described it, “If you invest your Ether in a smart contract, you’d better be sure that the contract says (and does) what you think it says (and does). The contract is the thing itself, and the only thing that counts; explanations and expectations might be helpful but carry no weight.” Primavera De Felippi and Aaron Wright dubbed this system “lex cryptographica.”
But problems arise when the code diverges from the white paper summary typically distributed to potential purchasers. Famously, for example, in the case of one project known as the DAO, a “flaw” in the code allowed a “hacker” to steal Ether currency from investors. Or did it? Matt Levine explained, “The descriptions didn't matter; only the code did. The descriptions didn't allow for today's hack, but the code did. (By definition! If the code could be hacked, the code allowed for the hack.) Any vulnerabilities in the DAO's code were not flaws in the code; they were flaws in the descriptions -- which were purely for entertainment purposes.”
Which brings us to Coin-Operated Capitalism, a new paper by Shaanan Cohney, David Hoffman, Jeremy Sklaroff & David Wishnick. They compare the white paper descriptions to the actual code underlying the fifty top grossing ICOs in 2017, and conclude that the two regularly diverge on three critical aspects: whether there are any supply restrictions on the assets, whether there are transfer restrictions on assets distributed to insiders, and whether the code can be modified. Signifcantly, the authors also found no evidence that these misdescriptions in any way harmed the initial capital raise or affected trading prices thereafter, suggesting that – as the authors conclude – “no one reads smart contracts.”
These results present a challenge to crypto evangelists who hope smart contracts will eventually replace legal institutions, and lend further support for the notion that the demand for ICOs is based on a speculative frenzy rather than any true demand for the products or companies underlying the sales.
Saturday, July 28, 2018
Riffing off the well-documented phenomenon that people respond to telephone calls based on the perceived race of the caller, Sorry to Bother You tells the story of a young black man, Cassius Green – Cash is Green, get it? – who goes from rags to riches by using his “white voice” for telemarketing. As Cash climbs the corporate ladder, he is torn between his newfound prosperity and loyalty to his old friends.
But that bare description of the film’s premise is hardly preparation for the surreal dystopian fantasy that follows. The plot is nearly beyond description, but most of the action centers on WorryFree, a labor contracting company that offers its employees dormitory-style housing and cafeteria-tray meals in exchange for lifetime work commitments – an arrangement deemed not to be slavery after congressional investigation. A proto-anarchist movement struggles to disrupt WorryFree’s operations and unionize Cash’s workplace, but mass media and viral marketing allow even the protests to be commodified and sold as entertainment. As such, the film dramatizes the concept of narcotizing dysfunction, where knowledge of an issue is substituted for action to oppose it. Ultimately, the message is that in a capitalist society, all labor is slavery; some settings are simply more luxurious than others. Therefore, the only solution is a militant class solidarity.
The film is uneven and a bit slow to get going; some of the earlier scenes, especially, feel like filler. That said, most of it packs quite a wallop. Particularly standout moments include a party where, after “passing” as white to achieve professional advancement, Cash must perform a grotesque modern minstrel to curry favor with white society, as well as just about any scene in which Cash’s girlfriend, an avant-garde performance artist with an endless supply of sexually explicit and/or violent homemade apparel, makes an appearance.
As one review put it, “one of the secondary pleasures of watching ‘Sorry to Bother You’ is sifting through its possible influences.” Reviewers have compared it to a host of other satires of capitalism and race relations, but if you ask me, Sorry to Bother You is the spiritual descendant of Little Shop of Horrors.
Of course, Little Shop of Horrors is a lot less radical, and doesn’t have a racial message (unless that message is, “our Skid Row exists in a nearly all-white alternate universe”), but similarly tells the phantasmagoric story of a nebbishy guy who finds capitalist success via Faustian bargain. I’d also argue that they have a somewhat similar visual aesthetic in their depiction of slum life and the petite bourgeoisie.
In sum, it’s difficult to imagine a film capturing the current zeitgeist as well as Sorry to Bother You. So, if you’re not getting enough of that in your ordinary life – or you just want to see a version of it starring prettier people – it’s worth checking out.