Saturday, March 21, 2020
(All right, in my heart, I still believe I was right in my account of existing law, and Salzberg v. Sciabacucchi actually changed the law. But, if law is just a prediction of what judges will do, then okay, fine, yes, I was wrong.)
As you all know by now, I’ve been blogging about this case, and the issue of litigation-limiting bylaw and charter provisions, for a while, and I’ve written an article, and a book chapter, on the subject. In this post, I’ll assume the reader’s familiarity with the issue and my prior argument.
Anyway, the basic logic of the decision is illustrated by this figure from the opinion:
In other words, in the Delaware Supreme Court’s view, there are matters of internal affairs that are governed by the state of incorporation, and then there is a slightly larger category of matters that are still “intra-corporate” but not “internal affairs,” and can be governed by a corporation’s charter, and then there are truly external claims that cannot be the subject of a charter provision. Federal forum provisions for Section 11 claims, at least facially, count as intra-corporate claims because “FFPs involve a type of securities claim related to the management of litigation arising out of the Board’s disclosures to current and prospective stockholders in connection with an IPO or secondary offering. The drafting, reviewing, and filing of registration statements by a corporation and its directors is an important aspect of a corporation’s management of its business and affairs and of its relationship with its stockholders.” Op. at 11.
I’d love to do a full analysis of the decision but to be terribly honest, I’m just a wee bit distracted right now and also I found the opinion itself kind of … elliptical in its reasoning. Point being, I’ll give it a more thorough read at a later date but for now I’ve only got a series of quick points:
As I understand it, those matters that are sufficiently intracorporate to be the subject of a charter provisions, but not within the category of internal affairs, are to be determined case by case. But, per the Court’s earlier decision in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), even provisions related to antitrust lawsuits are at least facially permissible, so it’s going to be really interesting to find out what the court does, and does not, believe can be governed by corporate charters – and even more interesting to see if any other states (hello, California) push back. I’ll note that simply as a matter of terminology, I find the logic puzzling because the court quotes its own decision in McDermott v. Lewis, 531 A.2d 206 (Del. 1987), where the phrase “intracorporate” is treated as coextensive with “internal affairs.” Op. at 37. Moreover, apparently because the court couldn’t find better precedent, in explaining how external matters would be distinguished from intracorporate-but-not-internal-affairs matters, the court cited – well, Mohsen Manesh on the definition of the internal affairs doctrine. Op. at 47-48. Suffice to say, for those of us trying to figure out what falls into this middle category of “intracorporate” matters, a definition that distinguishes only between internal affairs and external affairs is not helpful.
As Larry Hamermesh says of the decision, “I thought we were in a predictable room, but the door has opened up into very uncertain challenges and positions.”
The case largely focuses on charter provisions, even going so far as to mention charter provisions specifically in its discussion of why forum selection clauses do not violate federal policy. Op. at 45. But occasionally, the decision cites to DGCL 109, regarding the bylaw power. I … do not know how to interpret this. And this is not a minor issue: Part of the reason I have been arguing that corporate constitutive documents cannot govern “external” claims is precisely because there’s no vocabulary outside the corporate law context to discuss whether a waiver, say, of a jury right, or an agreement to pay litigation expenses, should be in bylaws, charters, or both, or subject to supermajority voting provisions, or what happens if someone has dual-class stock or is a controller, etc. We know how to answer those questions when they concern matters of corporate law; we don’t when we step outside that realm.
The opinion very much hangs the NJAG out to dry. As I previously blogged here, here, and here, Professor Hal Scott has been pushing for bylaw at J&J which would mandate arbitration of all federal securities claims, including ones brought under Section 10(b)/10b-5. J&J is chartered in New Jersey. As part of the dispute over whether the proposal could be included on J&J’s proxy under Rule 14a-8, NJ’s Attorney General argued that such provisions violate NJ law, relying on Chancery’s Sciabacucchi decision. Now, that decision has been reversed. Professor Scott’s lawsuit will go forward and New Jersey will … I don’t know.
I think? there’s a basis for distinguishing Section 11 and 10b-5 in the opinion. The court emphasizes that Section 11 necessarily involves directors (“Section 11 claims are ‘internal’ in the sense that they arise from internal corporate conduct on the part of the Board and, therefore, fall within Section 102(b)(1)”), but 10b-5 does not. The court also says that tort claims are “external,” and 10b-5 is akin to common law fraud. But, umm … then there’s the antitrust thing so I really don’t know.
Further to this, the decision opens with a description of how both Section 11 and Section 12 claims operate. Section 12, like 10(b), also does not necessarily involve directors. But the opinion doesn’t discuss whether such claims count as intracorporate, even though the forum provisions at issue in the case cover both types of claims.
So, yeah. I got nothing.
I note that since the decision permits charters to govern securities claims, there is now apparently no barrier to inserting a loser-pays provision in corporate constitutive documents for federal securities claims. After all, the DGCL only bars loser-pays for internal claims. So, Professor Bainbridge’s preferred policy may yet (mostly) prevail. Which again highlights why I think this is a problem. If a corporation adopts such a provision, Delaware will have to decide if it’s permissible, if it violates public policy, whether the provision must be in the charter or the bylaws, what to do if there are nonvoting shares, etc, and that’s just way outside of its area of expertise. What happens when a director invokes a loser-pays provision and a shareholder argues that, under the circumstances, doing so was a breach of the director’s fiduciary duty? How will Delaware make the call? The Supreme Court has not, umm, demonstrated much savvy with respect to the difference between Section 11 and Section 12 claims (or, if you read some decisions, even the difference between a Schedule 14D-9 filing and a Schedule 14A), so I’m not confident of its ability make these judgments.
The Delaware Supreme Court should maybe start boning up on PSLRA pleading standards now, is what I’m saying.
Which brings us to arbitration. At the very end of the opinion, in Footnote 169, the court mentions that even though this case only involved forum selection provisions, many commenters – and I’d fall into this category, naturally – are concerned about using charters and bylaws to force individualized arbitration of shareholder claims. The court dismisses this concern on the grounds that DGCL 115 would prohibit mandatory arbitration for internal affairs claims. The problem here is twofold: First, the court opens the door to corporations adopting arbitration provisions for federal securities claims – precisely as Prof. Scott is currently arguing – but secondly, there looms the possibility that DGCL 115 is invalid under the Federal Arbitration Act.
Now, I wrote a whole long paper explaining why I believe the Federal Arbitration Act does not apply to corporate constitutive documents, but the basis for that article is that corporations are not ordinary contracts within the meaning of the FAA. Every decision – like this one – that expands the boundaries of the corporate “contract” and applies ordinary contract law principles to define its scope not only, ahem, renders my article less relevant, but also undermines the basis for excluding corporations from FAA’s purview. This is not an abstract issue; Professor Scott’s lawsuit, for example, argues that the FAA renders arbitration bylaws valid, regardless of any New Jersey law to the contrary. Again, his lawsuit only deals with a bylaw mandating arbitration of federal claims, but there is no reason the logic would not extend to bylaws purporting to mandate arbitration of internal affairs claims.
In other words, this decision hands corporations the keys to challenging the viability of DGCL 115, and in that respect, I have a sinking fear that it signs Delaware’s death warrant.
But people have made that prediction before, so who knows.
My final observation is this: I think the contrast between the Supreme Court and Chancery decisions as a matter of corporate theory are quite striking. The Chancery decision is a fairly stark example of the concession theory of the corporation: Laster makes very clear that Delaware, as sovereign, is intimately involved in establishing corporations, designing their operations, and articulating their limits. The Supreme Court, by contrast, is a model of contracts theory; it treats the corporation as simply a private arrangement among its constituents, with few prohibitions on what that arrangement may entail. I have been thinking about designing a corporate theory seminar; if it comes to fruition, I’ll likely include excerpts of both opinions.
Saturday, March 14, 2020
For the last several weeks, Xerox has been pursuing a takeover over HP. At first, its overtures were friendly, and more recently it turned hostile (well, sort of hostile). It has put the campaign on hold in light of the pandemic – it says, because it is unsafe to travel and conduct meetings with shareholders – but before that, it filed a Schedule TO and an S-4 with the details of the offer. As relevant here, the S-4 explains that Xerox is proposing a tender offer followed by a second-step merger under DGCL 251(h). Shareholders who do not tender their shares, and thus are merged out, will receive the same consideration as shareholders who tender. Which is:
That said, Xerox plans to pay a total of $27,326,000,706 in cash. Therefore, if shareholders’ elections would result in a different figure, these elections are capped:
In other words, shareholders have a choice of whether they receive stock, cash, or a combination of both, but only up to a point; if too many shareholders select one or the other, Xerox will rebalance.
Which brings us to the right of appraisal. According to the S-4:
So, what’s the law on this? Delaware provides that public company shareholders who lose their shares in the second-step of a 251(h) merger are entitled to appraisal if they are “required by the terms of an agreement of merger or consolidation… to accept for such stock anything except” public company shares. See DGCL 262. In other words, cash consideration gets you appraisal; public company stock consideration does not. And, per Delaware caselaw, a combination of the two entitles shareholders to appraisal. See Louisiana Municipal Police Employees’ Retirement System v. Crawford, 918 A.2d 1172 (Del. Ch. 2007).
Where does Xerox’s offer fit?
On first glance, it doesn’t require anyone to accept anything; HP shareholders can choose stock, cash, or a combination of the two. Thus, according to at least once Delaware decision, appraisal should be unavailable. See Krieger v. Wesco Financial Corp., 30 A.3d 54 (Del. Ch. 2011).
But wait! Xerox contemplates that some shareholders might be required to accept cash, if it turns out that too many elect stock. We don’t know yet whether that will happen, and so Xerox is assuming that there will be appraisal rights. Which could mean that even if everyone makes the exact right election, no one is forced to accept any particular combination of cash or stock, second-step shareholders could still seek appraisal no matter what they elected, simply because of the ex ante possibility that some shareholders might have been required to accept cash. Cf. Krieger (appraisal is unavailable where “[t]he merger agreement did not contemplate proration or impose any cap on the number of shares available for individual stockholders or the class as a whole.”)
Is that the law? Maybe. Or maybe appraisal is only available if Xerox pulls the trigger and actually does force some shareholders to accept cash. Or maybe appraisal is only available to those particular shareholders who elected stock and were forced to accept cash, but not to shareholders who elected cash and received it. But cf. Krieger (“The General Corporation Law in fact makes appraisal rights available on a transactional and class-wide (or series-wide) basis. Stockholders can choose individually whether to perfect and pursue their appraisal rights, but the underlying statutory availability of appraisal rights is not a function of individual choice.”)
We don’t know!
Now, that in itself is not shocking; lots of times you have a statute and it covers some scenarios but not others and caselaw fills in the gaps. And when there’s a question of first impression, lawyers step in and use a combination of arguments based on statutory language, precedent, and policy to persuade the court to go their way.
But here’s where Delaware law fails us. As I’ve previously argued, there is no policy. The appraisal statute is a mess; there is no clear reason why Delaware permits appraisal in the first place, let alone why it distinguishes between public company stock and cash. To quote, ahem, me:
[Appraisal] can’t just be about liquidity because it applies to publicly-traded stock, it can’t just be about conflict transactions because it’s available in nonconflict transactions – even if it’s more available in 90% controller squeezeouts – and the distinction Delaware draws between receipt of cash versus receipt of publicly traded stock is incoherent. See Charles Korsmo & Minor Myers, Reforming Modern Appraisal Litigation, 41 Del. J. Corp. L. 279 (2017). It’s a Frankenstein’s monster of different impulses that act at cross-purposes.
That’s why we’ll never see agreement on how to reform the current system, and it’s also why it’s unclear how the Xerox/HP merger should be treated under existing law. One of the critical tools we use to make these kinds of predictions – a functional analysis of the purposes behind the statutory scheme – is entirely absent; it’s a crap shoot.
My point is, this is no way to run a railroad. I know Delaware has contemplated reforms to its appraisal statute and methodology but before we can see movement on that score, Delaware needs to answer the fundamental question of why we have appraisal in the first place. From that, everything else will (mostly) follow.
Saturday, March 7, 2020
On Thursday and Friday, Tulane hosted its 32nd Annual Corporate Law Institute. The CLI is a major conference focused on the latest developments in M&A and related topics, and features a variety of speakers drawn from the bench, the bar, and the SEC.
Now, obviously, it’s a tough time to host a large conference – the big question was whether we’d see cancelations – and I’m not in charge of administration so I can’t say what the final numbers were, but from what I could see, attendance looked just fine.
That said, I personally was not able to attend the whole event, but I did go to a few of the panels, and below are my notes from Hot Topics in M&A Practice and Chancellor William T. Allen and His Impact on Delaware Jurisprudence.
Saturday, February 29, 2020
I often skim through recent opinions issued in private securities class actions, just to see what the latest issues are and how courts are addressing them. So this week, I’ll talk about a few that caught my eye. As the subject line indicates, most of this discussion concerns materiality, but there are some extra issues tossed in.
And yes, this is a very long one, so behind a cut it goes:
Friday, February 21, 2020
Sean Griffith recently wrote a book chapter explaining how plaintiffs’ merger-related challenges developed over time. Plaintiffs began by seeking disclosure-only settlements, but after Trulia stamped out the practice in Delaware, plaintiffs began bringing claims in federal court challenging corporate proxies under Rule 14a-9. And once they got there, they realized they did not have to limit themselves to merger litigation, and began bringing other kinds of proxy-related claims, and eventually these morphed into individual, rather than class, actions.
That’s what I thought of when I read the new books and records complaint filed against Facebook in Employees’ Ret. Sys. Of Rhode Island v. Facebook, No. 2020-0085-JRS.
In it, Rhode Island’s pension fund is seeking privileged documents related to Facebook’s $5 billion settlement with the FTC over allegations that it violated a previous FTC settlement regarding its data practices. Much of the complaint is redacted – the plaintiff received some documents already, just not the privileged ones it is seeking now – but the basic allegation is that, according to news reports, the FTC wanted to charge Mark Zuckerberg personally, but the company refused, and accepted a larger fine to protect him. The plaintiff now claims that this was the equivalent of giving a “non-ratable” benefit to a controlling shareholder. I.e., the company could, theoretically, rationally conclude that keeping its CEO out of legal crosshairs was the best course of action for the company as a whole, but when that CEO is also a controlling shareholder, those decisions must either be made using the procedural protections of Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) (negotiation by independent directors and conditioned on independent stockholder approval), or reviewed for entire fairness by a court ex post. Therefore, argues the Rhode Island fund, it is entitled to books and records to evaluate potential claims, and under Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), even attorney-client privileged documents should be made available.
This case is just getting started – all that’s happened is that the complaint was filed – but it reminded me of the 14a-9 situation because we’re seeing a similar kind of evolution with respect to controlling shareholder arguments.
(I am not – let’s be clear! – suggesting that the Facebook complaint is frivolous in the way that a lot of 14a-9 litigation has been accused of being. This is just about how claims shift over time.)
It began, as I’ve frequently argued (in this essay, plus numerous blog posts, most recently last week), when Delaware tightened the screws on merger-related challenges with Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), MFW, and also C&J Energy Services v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, 107 A.3d 1049 (Del. 2014). Those cases made it very difficult for plaintiffs to challenge a merger unless they were able to demonstrate that the merger involved a controlling stockholder. Suddenly, everything turned on demonstrating that even minority blockholders had effective control of the company, which put enormous pressure on courts to find the presence of a controller when transactions appeared to be conflicted or suspicious in some way.
But there was more. This sharp divide between transactions that could be cleansed with a shareholder vote, and those that could not, led courts to question whether the MFW/Corwin divide should be extended to nonmerger transactions – which they decided to do, in cases like IRA Trust FBO Bobbie Ahmed v. Crane, 2017 WL 7053964 (Del. Ch. Dec. 11, 2017), In re Ezcorp Inc. Consulting Agreement Derivative Litig., 2016 WL 301245 (Del. Ch. Jan. 25, 2016), and Tornetta v. Musk, 2019 WL 4566943 (Del. Ch. Sept. 20, 2019) (the latter of which I blogged about here).
Now, suddenly, new rule: Any transaction with a controller gets entire fairness review absent MFW protection.
And that rule was even extended into the books-and-records space, where the failure to use MFW protections in a given transaction was deemed suspicious enough to weigh in favor of granting plaintiffs access to internal documents. We saw that happen in CBS, which I blogged about here. At the time, I said:
Slights determined that the mere fact that CBS made no attempt to adhere to MFW cleansing was itself evidence of wrongdoing for Section 220 purposes. That interests me [because] it extends MFW into a novel space: previously, its purpose was to trigger business judgment review for controlling shareholder transactions, but now it will also be used to “cleanse” for the purpose of avoiding a 220 demand.
Leading us to where we are now: An argument that even a legal settlement is subject to the MFW/Corwin divide, and therefore can be bootstrapped to justify plaintiffs’ access to internal (privileged) documents.
I wouldn’t begin to guess how this case will play out – to be honest, I am sympathetic to the argument but I worry about implications (i.e., starting with Tesla’s and Musk’s settlement with the SEC, which may have become worse for the company because of Musk’s initial recalcitrance) – but it strikes me that this is a rulification problem.
In the earliest days, Delaware didn’t sharply distinguish between controlling shareholder transactions and other kinds of interested transactions. And the development of the law was messy, in its common-law way. Sometimes Delaware suggested independent-director cleansing was enough, sometimes not, the types of transactions that received extra scrutiny were sometimes limited to “transformative” transactions, sometimes not; it was as much an issue of how the court felt about a given scenario than anything else. It was only recently that courts began to set down a bright-line rule that all controlling shareholder transactions would receive entire fairness scrutiny absent MFW protections, and to some extent, that rule was hastened by MFW itself, as courts struggled to identify the cases to which it applied. And we’re now seeing the implications of that, because it turns out, when a controlling shareholder is involved in corporate governance, lots of otherwise-mundane business decisions could implicate their interests. Throw back in the issue of whether someone’s a controlling shareholder in the first place, and you’ve just invited bedlam. One rule (MFW) begets another (all controlling shareholder transactions, except the demand requirement) which presumably will beget another (except for some set of cases) and possibly more (except these factors do/do not contribute to the inquiry whether someone is a controller in the first place).
Not sure I have any great conclusions to draw here, but if Delaware doesn’t watch out, it’s going to become the MBCA.
Saturday, February 15, 2020
Back to a subject near and dear to my heart: The increased pressure on the definition of “controlling stockholder” occasioned by Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015) and Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”). I’ve posted about this on several prior occasions, and written an essay on the subject, so I would be remiss if I didn’t discuss VC Laster’s new ruling in Voigt v. Metcalf. The facts, as taken from the opinion, are these:
CD&R was a 34.7% blockholder of a publicly-traded corporation called NCI. In earlier years, CD&R had held as much as 68%. CD&R had a stockholder agreement that, among other things, guaranteed it a certain number of board seats – but also guaranteed a certain number of seats for the unaffiliated stockholders – guaranteed that its nominees would have seats on key committees, and gave it blocking/consent rights for various board actions, though none were triggered in this case.
In early 2018, three things happened nearly simultaneously: Metcalf, one of the independent/unaffiliated directors of NCI, was elevated to Chair; CD&R acquired a majority stake in a company called New Ply Gem; and Metcalf proposed that NCI acquire New Ply Gem. To negotiate the deal, Metcalf met with certain NCI directors who were also CD&R representatives/designees.
Eventually, NCI created a Special Committee to evaluate the transaction, and hired Evercore. Well, actually Metcalf hired Evercore before the committee was even formed, and the Committee was told that Evercore had no conflicts – which was untrue, because Evercore was currently working for another CD&R portfolio company. The Committee decided to keep NCI’s counsel, Wachtell.
Evercore recommended that New Ply Gem be acquired with NCI stock valued, post-deal, at roughly 1/3 of NCI’s total equity. This valuation was based on CD&R’s own valuation when it acquired New Ply Gem. CD&R – via the NCI board members – insisted on closer to a 50/50 split. The Committee agreed. The Committee asked for a majority-of-minority voting condition; CD&R refused. When the deal was announced, NCI’s stock price fell, and of the unaffiliated stockholders, only 55% voted in favor.
After the transaction closed, an NCI stockholder brought a derivative lawsuit and, for our purposes, the critical question was whether CD&R was a controlling shareholder. If not, the deal was likely cleansed by the shareholder vote – and even if there were disclosure deficiencies (spoiler: there were), plaintiff would have to establish that the Special Committee was interested/dependent on CD&R to succeed on his claim. But if CD&R was a controlling shareholder, the deal was subject to entire fairness review.
VC Laster concluded that CD&R was a controlling shareholder, and refused to dismiss.
So, what’s notable here?
[More under the jump]
Saturday, February 8, 2020
The following post comes to us from Prof. Ilya Beylin of Seton Hall:
On Monday, I read Ann Lipton's thoughtful and informative post, on "The Eroding Public/Private Distinction". One of the luxuries being a business law professor offers is the space, and perhaps even community encouragement, to feel strongly about and delve deeply into esoteric albeit perhaps consequential matters such as the boundary between public and private securities markets. Well, the feeling came, and I wrote Ann to see if I could riff on her piece in a response. So here we are, although the more I mull over the strands in the original piece, the more I recognize the completeness of Prof. Lipton's work and the keenness of the insights there.
A definitional question is predicate to evaluating the growth of exceptions to the traditional public/private divide. Public and private under the ’33 and ’34 Acts have two drastically different implications. Under the ’33 Act, private typically refers to being able to conduct a securities offering outside of the SEC mediated registration process under Section 5. Under the ’34 Act, however, private means not having to provide ongoing public disclosure on the state of the company (e.g., quarterly and annual filings, current reports). While the ’33 Act principally governs the manner in which a primary market transaction may be conducted, the ’34 Act principally governs how secondary trading may be conducted. Expansions of Regulation D to permit public offers to accredited investors under 506(c), relaxation of Rule 701 to enable greater distribution to employees and other service providers, Crowdfunding under Reg CF, expansion of Reg A into Reg A+, and some of the other incursions we’ve seen since 2005 into the protective sphere of Section 5 do not generally implicate the continued significance of the private/public distinction in secondary markets.
As background, the Exchange Act’s ongoing public disclosure requirements apply to three prototypical issuers: those that engaged in a public offering under the ’33 Act, those that have enough equity holders (raised, significantly, to up to 2,000 accredited investors from a prior cap of 500 as Prof. Lipton and others have keenly pointed out), and those listed on an exchange. The realities, however, of secondary market trading mean that substantial liquidity remains largely conditional on becoming exchange listed and thus public for purposes of ongoing disclosure under the ’34 Act.
[More under the cut]
As most readers of this blog are likely aware, the SEC recently proposed some rather dramatic changes to the rules governing shareholder proposals under Rule 14a-8. Among other things, the revisions would raise ownership and holding period requirements, raise the thresholds for resubmission, and bar representatives from submitting proposals on behalf of more than one shareholder per meeting.
The changes have at least the potential to fundamentally reshape the corporate governance ecosystem, and part of the reason for that is highlighted in a new paper by Yaron Nili and Kobi Kastiel, The Giant Shadow of Corporate Gadflies. As they document, forty percent of all shareholder proposals are submitted by just five individuals, who have made the practice something of a combined life’s mission and personal hobby. The proposals submitted by these individuals tend to focus on corporate governance, and they also tend follow the stated governance preferences of large institutional investors. As a result, these proposals frequently win substantial, if not majority, support, and have a real impact on target companies – which means, over time, they dramatically alter the norms of what is considered good corporate governance.
Now, there’s no legal reason why we have to depend on a handful of quirky individuals to reshape corporate governance – institutional investors have far greater holdings and could submit proposals far more widely – but, for whatever reason, institutions mainly prefer instead to wait for someone else to propose something and then vote in favor of it. Some pension funds may be active in submitting proposals, but large mutual funds never submit any, even though they have far greater resources to do so. As a result, if the revisions to 14a-8 take effect, they could dramatically inhibit the activity of these “gadflies” and thus shareholder proposal activity across the board (of course, some of these gadflies have been at it for decades – Evelyn Davis, one prominent gadfly, died in 2018 – so the reality is, the passage of time might limit their activity anyway).
Nili and Kastiel offer a few policy proposals to relieve the system’s reliance on gadflies. They suggest we create a nonprofit organization whose job it is to submit proposals, or create a rotating system whereby popular governance reforms are automatically included on corporate ballots.
All of that, of course, assumes that institutional investors want these reforms. That may not be an unreasonable conclusion – they vote for them, after all – but that just begs the question why the largest institutions aren’t submitting proposals in the first place.
Nili and Kastiel have a couple of theories. One possibility is that large mutual funds believe that taking the lead on a proposal would anger managers at their portfolio companies. Funds may depend on these companies for other business, or simply depend on cordial relationships with managers in order to engage with them about various governance-related issues. Being the face of a proposal – rather than quietly voting in favor of one – could create frictions in these relationships. Alternatively, the big mutual fund companies may feel that obtrusive activism will make them political targets. There are already rumblings about the need for greater fund regulation, which is why BlackRock is now busy trying to pretend that it doesn’t have the influence it obviously has. Open agitation for governance changes might spur a more aggressive regulatory response.
But if that’s right, we might expect large asset managers to at least oppose any changes to Rule 14a-8, because the managers rely on their retail shareholder-avatars to advance the mutual funds’ own agendas. Yet that’s not what seems to be happening.
There are some asset managers – especially, though not exclusively, ones who focus on corporate social responsibility issues – who have objected to the SEC’s proposed revisions. But the largest have not. BlackRock submitted a letter that says – well, honestly, nothing at all; it takes no position. Meanwhile, Reuters reports that Vanguard submitted a letter that supports restricting the use of 14a-8, though the details are not clear, and nothing’s up at the SEC website as of this posting.*
So, what gives?
Well, an alternative explanation – championed by some commenters, including Sean Griffith and Dorothy Lund – is that large asset managers do not want to be stewards, and do not like voting on governance changes; they do it because the regulatory system requires or at least encourages them to do so. If that’s the case, these asset managers would be delighted by the prospect of fewer 14a-8 proposals for them to worry about.
But there’s another possibility. As it turns out, BlackRock may not have taken a position, but the Investment Company Institute, which is a trade association of mutual fund companies, did. In its letter, the ICI generally supports the 14a-8 changes, and even recommends further limits on proposals that are submitted by investors in mutual funds.
And that, it seems, may part of the issue here. Mutual fund companies are, well, companies. Even if they do appreciate the power that Rule 14a-8 gives them over their portfolio investments, they don’t like receiving 14a-8 proposals themselves, either from shareholders in their mutual funds, or at the corporate level. (BlackRock, for example, often receives proposals submitted under Rule 14a-8.)
*It’s hard to draw any conclusions without seeing Vanguard’s letter, but I do note that Wellington Management’s sustainability arm signed on to a letter submitted by Principles for Responsible Investment, which generally urged the SEC to keep the current framework and avoid changes that would disrupt the proposal process. This is significant because Wellington is one of the managers Vanguard uses for its external/active funds, though Vanguard recently gave its external managers freedom to vote separately from Vanguard’s indexed funds. So, that’s an interesting dynamic.
Saturday, February 1, 2020
These days, it often seems like technology is eradicating the difference between our public and private selves, and apparently, the SEC is going down the same path with respect to companies.
Matt Levine at Bloomberg is fond of saying that private markets are the new public markets, by which he means that companies no longer seek to raise capital by tapping the public markets; instead, they do that in private offerings, and turn to public markets when early investors want to cash out. This is made possible by the fact that Congress and the SEC have, over the years, loosened many of the rules that required companies seeking large capital infusions to register their shares publicly. Today, due to Rule 506 and other exemptions, companies can grow to enormous sizes solely based on the investment of accredited investors. These investors are usually institutions, like venture capital funds, but also the stray mutual fund or sovereign wealth fund. Other rule amendments have made it easier for private companies to pay their employees in stock and stock options, which allows them to free up capital.
But now the SEC is working to make it easier for new classes of individuals to invest in these private companies. First, it has proposed changes to the definition of “accredited investor,” to allow people to qualify based on their expertise. The expansion is relatively narrow now, but I assume it’s a foot in the door for further rule changes that will open the door for more “expert” individuals to invest in private companies. And apparently, the Commission is also considering a program to allow platform workers for private companies – like Airbnb hosts, and so forth – to receive equity as part of their compensation.
Now, I posted before about the risks to private company workers when they receive equity compensation. The current rules were enacted on the theory that company employees are likely to have intimate knowledge of the business and therefore don’t need the protections of mandatory disclosure, but that’s not likely to be true of the enormous private companies that exist today. Plus, employees are unlikely to understand how the preferences granted venture capital investors dilute the value of their common stock holdings. That’s why, for example, Yifat Aran has proposed amendments to the rules that would recognize employees’ informational disadvantage in larger companies.
Given that – not to mention the spectacular recent failures of large startups, like WeWork, and the obvious fact that even “hot” private companies like Uber and Lyft have struggled in the public markets – it seems particularly incongruous that the SEC is considering allowing gig workers (who are likely to have even less insight into corporate operations than ordinary employees) to invest.
But the implications go further.
The SEC and Delaware are in a peculiar sort of dance; federal changes to the relationships between investors and managers necessarily shape Delaware law. I’ve mentioned before that Delaware has reformed a lot of its corporate law around the expectation that most investors are large institutions trading in public markets, who are less in need of judicial protection. Thus, as I’ve written about and discussed in this space, the rise of large private companies is one factor that has strained Delaware's definition of a controlling shareholder. Meanwhile, newly proposed federal regulatory moves to limit shareholder power may have the perverse effect of causing Delaware to engage in more muscular oversight of management. And that’s equally true when federal regulation works at the retail investor end, by encouraging more ordinary persons to invest in private companies. As Elizabeth Pollman has documented, these companies may have exceedingly complex capital structures that are fraught with different kinds of conflicts, which, of course, is likely to give rise to more litigation.
In In re Trados Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013), VC Laster fired a shot across that bow by warning venture capitalists that they have fiduciary obligations to prioritize the common stockholders in their management of the company. A survey by Abe Cable found that Trados’s impact on venture capital practices has been modest, though boards may express more concern for the common when in sale mode. But I’m betting there’s going to be more where that came from, because as the SEC encourages unsophisticated investors to leap into private markets – where the protections of disclosure, common trading, and federal board independence requirements are lacking – Delaware will be drawn into the fray, and will no longer be able to comfortably rely on simple maxims that a shareholder vote ratifies all.
We even have a preview of coming attractions in a current dispute involving Juul. Juul apparently required its employee-shareholders to waive their inspection rights under Section 220, and the enforceability of that waiver is currently being litigated. If Delaware finds waivers are permissible, the next step will be for companies to insert such waivers in their charters or bylaws – and apart from the effect on public companies, these moves will leave private company investors, specifically, without access to information unless they bargain for it. And that’s going to mean employees, gig workers, and similar investors will be at an extraordinary informational disadvantage. (You can read more about on issues of waiver and inspection rights in George Geis’s paper, Information Litigation in Corporate Law)
Of course, it may turn out that all of these companies simply contract for individualized arbitration of shareholder disputes and leave Delaware out of it entirely, which will be much easier to do if they remain private, and thus maintain contractual privity with their investors. And even if “private” secondary market platforms expand and companies no longer directly contract with purchasing shareholders - so that there is no obvious contract in which to insert the arbitration clause - companies may simply adopt charter and bylaw provisions that require individualized arbitration. Yes, of course, Delaware law currently prohibits that, but if the Delaware Supreme Court decides that charters and bylaws are just ordinary contractual terms that can include limits on securities claims, and if we then move to the obvious next step of putting securities arbitration provisions in corporate bylaws and charters, Delaware will have a harder time maintaining that its current arbitration prohibition passes muster under the Federal Arbitration Act. So maybe it is the death of corporate law, after all.
In any event, what we’re seeing in broad strokes is the erosion of the public/private distinction in securities law, in favor of something that looks more like a continuum. (We may even see limits on the ability of retail investors to buy public company shares that are deemed too risky). And that, of course, not only threatens to rob the market of the valuable externalities provided by generalized public trading subject to standardized comprehensive disclosures (see Elisabeth DeFontenay, The Deregulation of Private Capital and the Decline of the Public Company; see also Jesse Fried and Jeffrey Gordon on bubbles in private markets and, ahem, me on the implications of the WeWork debacle), but also places enormous weight on regulators’ judgment as to who, precisely, has the exact level of sophistication and risk tolerance to invest in what kind of company.
Saturday, January 25, 2020
One of the things I’ve talked about before is how courts adjudicating securities claims must perennially police the line between “fraud” and “mismanagement.” The issue goes back to the Supreme Court’s decision in Santa Fe Indus. v. Green, 430 U.S. 462 (1977), which held that “the language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.” Thus, Section 10(b) claims cannot be based on mismanagement or breach of fiduciary duty alone.
That said, as federal securities regulation increasingly enters into the governance space, the distinction between fraud and mismanagement is harder and harder to identify. In general, courts hold that if there’s been a false statement, then the claim is properly stated as securities fraud; if not, not. The problem is, as the SEC imposes more and more disclosure requirements, many of which concern core aspects of governance (ethics codes, risk taking, and whatnot), the “deception” test does not seem to emotionally do the work of distinguishing a claim based on poor governance from a claim based on fraud.
As I’ve repeatedly blogged about – and written articles about, most extensively in Reviving Reliance– given this problem, courts have deployed a number of doctrines to dismiss claims that feel more governance-y than fraud-y, the most prominent of which is puffery. Puffery, ostensibly, refers to statements that are so vague or hyperbolic that they are essentially without content, but it’s often used to toss claims that courts feel just don’t belong in the securities space.
Anyhoo, I lay out the theory in more detail in the links above, but for today, I want to highlight a recent example of the phenomenon, In re Liberty Tax Securities Litigation, 2020 WL 265016 (E.D.N.Y. Jan. 17, 2020).
In this case, the CEO, who was also the controlling shareholder, was accused of using the company to “advance his romantic and personal interests.” Which basically means he conducted romantic relationships in the office, including dating employees and bringing them along on business trips. The false statements that formed the basis of the claim included representations that the company’s internal controls were “effective,” and risk warnings that the CEO’s interests as a controlling stockholder might differ from those of the other stockholders.
This is, to be sure, weak sauce. And speaking as a former plaintiffs’ attorney, I read this and the first thing I think is, why was this case even brought? There wasn’t a stock price drop upon revelation of the misconduct, so whose bright idea was it to file a complaint?
Well, it turns out, after the CEO’s unprofessional conduct was revealed, he was actually fired (which itself is remarkable, given his voting control), the company’s auditor resigned, and there was some board turnover. That’s the kind of thing that catches the attention of a plaintiff’s attorney, and my guess is that we’re seeing the results of some of the perverse incentives created by the Private Securities Litigation Reform Act (PSLRA).
Once upon a time, the first plaintiff to file a complaint got to control a securities fraud class action – which incentivized attorneys to file poorly-researched complaints the moment there was any hint of fraud. In 1995, the PSLRA changed the system: Now, the court considers multiple applicants for the “lead plaintiff” slot, selects the one most appropriate – usually the one who has the largest loss – and that lead plaintiff selects lead counsel. The theory here is that because there’s no advantage to filing early, counsel will seriously research a case before filing a complaint. And the kind of large, institutional clients who have large losses, and thus are viable contenders for a lead plaintiff appointment, will expect such research, and refuse to sign on until they see the work.
I actually think the PSLRA’s lead plaintiff provisions are the best things about the PSLRA, but in this respect, they didn’t play out as expected. Specifically, there is little incentive for counsel to expend the resources to research a case – which can include hiring an investigator, hiring an accountant, and spending multiple attorney hours combing through news reports and SEC filings – before they’re sure they will be appointed lead. Instead, what tends to happen is that counsel identifies cases that look promising, pitches the idea to a potential institutional client who experienced a large loss, the client hires them, and then counsel and client seek a lead plaintiff appointment. After the court appoints lead plaintiff and counsel, the serious research begins. But at this point, counsel is committed. The last thing they want to do is discover there’s no fraud, and go back to the valuable client – who they hope will hire them for future cases – and admit error. So counsel will continue to pursue the case even if there’s no there there.
If I had to wager - and I am just drawing inferences based on the opinion - I’d say this is what happened in Liberty Tax. KPMG resigned and the controlling shareholder was fired by his own board: HUGE red flags! Plaintiffs’ counsel jumped, assuming accounting shenanigans would eventually turn up. But none did, either because there were none to be had, or because they were buried deep enough that without discovery (which the PSLRA blocks before resolution of the motion to dismiss), nothing could be established.
And rather than drop the case and confess error to the client, counsel made the best of a bad situation, arguing that the CEO’s boorishness and self-dealing amounted to fraud because the company claimed it had effective internal controls.
The court, clearly, sensed all of this: We’re looking at something like classic controller breach of duty, tunneling, misuse of corporate resources for personal gain, what-have-you. But none of that counts as fraud under Section 10(b) without a clear misrepresentation, and “internal control deficiencies” doesn’t capture what’s going on here. Internal controls concern appropriate recordkeeping, ensuring that material information is communicated to management, ensuring that unauthorized persons cannot alter records, and so forth. For all the CEO’s sins, there’s no allegation that expenses were misrecorded in the company books, or that – if they were – the errors were ever disclosed to the public or caused plaintiffs any losses.
Rather than say that, however, the court held that representations as to the effectiveness of internal controls are “puffery,” namely, that they were “too general to cause a reasonable investor to rely upon” them.
But that really misunderstands and distorts the concept of internal controls. Internal controls are a critical aspect of corporate governance, and they have a fairly defined meaning with respect to accounting and information flow within the firm. Saying they are effective is not, in other words, the equivalent of saying “world’s best coffee!”
Moreover, ever since Sarbanes Oxley, corporate officers are required to disclose whether internal controls are effective. It is perverse to suggest that these mandated disclosures – which the SEC, and Congress, clearly think are critically important to investors – are immaterial as a matter of law. (That’s also how I feel about codes of ethics, by the way, which have also been held to be puffery – most recently in the case concerning undisclosed sexual harassment at CBS, Construction Laborers Pension Trust for Southern California v. CBS Corporation, 2020 WL 248729 (S.D.N.Y. Jan. 15, 2020) – but that’s an argument for another post.) I mean, imagine we had an actual, for real case of accounting fraud, where the internal controls did not in fact prevent unauthorized entries and expenditures, and the CEO knew it and lied about it. Would we seriously say that was puffery? Well, after this opinion, that’s certainly what defendants are going to argue.
So I come back to where I started, which is, courts are grasping for some basis to distinguish poor governance from fraud. Given today’s disclosure requirements, not to mention new demands for investors to act as stewards, that may be a fruitless exercise, but in the meantime, courts seem to be treating just about any statement about internal governance and corporate procedure as “puffery.” Which means that the concept of “puffery” has drifted from its original meaning – vague and unfalsifiable self-praise – to become synonymous with, “I know fraud when I see it, and this isn’t really fraud, exactly.”
Friday, January 17, 2020
As part of what is apparently my continuing series on developments concerning the use of corporate bylaws and charter provisions to limit federal securities claims….
Earlier this month, the Delaware Supreme Court heard oral argument on whether corporations may include provisions in their charters and bylaws requiring that federal Section 11 claims be heard only in federal court (video of oral argument here; prior posts on this issue here and here and here and here… you get the idea)
Running parallel with that, Professor Hal Scott of Harvard Law School submitted a proposal under 14a-8 requesting that Johnson & Johnson adopt a bylaw requiring that all federal securities claims against the company be arbitrated on an individualized basis. As I blogged at the time, the SEC granted J&J’s request to exclude the proposal on the ground that it appeared that NJ, the state of incorporation – following what it believed to be Delaware law – did not permit federal claims to be governed by corporate charter/bylaw provisions. Scott filed a federal lawsuit over that, and the action was voluntarily stayed pending the Delaware Supreme Court’s ruling.
But Scott has not let the crusade rest. As I learned from Alison Frankel’s reporting, Intuit shareholders will vote on one of Scott’s securities arbitration proposals at their January 23 meeting. (I note that in this version of the proposal, Scott has corrected the text to acknowledge Canada’s existence – which he, ahem, previously overlooked)
Unlike J&J, Intuit did not seek to exclude the proposal from its ballot, but it does recommend that shareholders vote against. Intuit says:
we are not aware of any other U.S. public company that has adopted the bylaw sought by the proposal and the proponent’s pursuit of the adoption of an identical bylaw by another company is currently the subject of litigation. As a result, there is significant uncertainty as to whether the adoption of such a bylaw is prudent at this time. Given this continued uncertainty, we believe that the adoption of such a bylaw likely would expose Intuit to unnecessary litigation or other actions challenging the bylaw and its consequences. Such challenges would not only be economically costly, but also would divert management’s time and focus away from Intuit’s business.
So, several things.
First, another public company did have such a bylaw, sort of, as I discuss in my Manufactured Consent paper – that company was Commonwealth REIT. The bylaw did not bar class actions, though it did cover federal claims.
Second, Intuit’s objection is largely rooted in the uncertainty surrounding its legality. Which is probably why Scott recently filed a comment letter with the SEC regarding its proposed amendments to Rule 14a-8, in which he asks the Commission to permit resubmission of failed proposals “if legal or regulatory circumstances relevant to the proposal have materially changed since its last submission.” I assume he’s anticipating some losses, and wants to make sure he can resubmit these proposals if the Delaware Supreme Court - or anyone else (hint, hint) - rules his way.
Third, this is not the first time shareholders have had the opportunity to vote on arbitration bylaws. Back in 2012, Professor Adam Pritchard at Michigan assisted shareholders at Gannett, Pfizer, Google, and Frontier Communications in filing their own proposed arbitration bylaws. Pfizer and Gannett sought and received no-action relief to exclude the proposals, but Frontier and Google included them in their proxy statements (see here and here, respectively), though in both cases the companies recommended that shareholders vote against. And in both cases, the bylaws were defeated (see here and here, respectively – I mean, Google has controlling shareholders, it was sort of fait accompli, but even the A shares voted against, so.)
All of which is to say – I’m betting the bylaw fails at Intuit, but (1) I’m terrible at predictions and (2) that will not be the end. But for now, I guess, all eyes on January 23.
Edit: The proposal was defeated, on the following vote:
Saturday, January 11, 2020
Hey, everyone. Two very quick hits today. First, as any follower of this blog knows, I have been avidly following the Salzberg v. Sciabacucchi litigation (see prior posts here and here and here, etc), not because I care very much about whether corporations can select a federal forum for Section 11 claims, but because I think if corporations can use their charters and bylaws to select a federal forum for Section 11 claims, the next step is using charters and bylaws to adopt provisions requiring individualized arbitration of federal securities claims, and that opens up a whole new can of worms. (For newcomers, my article on the subject of arbitration clauses in corporate charters and bylaws is here).
In any event, on Wednesday, the Delaware Supreme Court heard oral argument on federal forum provision issue. I don't really have any insights about it - although the justices asked several questions at the beginning of each advocate's presentation, they were, for the most part, quiet - but if you want to see for yourself, the video is here.
Additionally, last week I had the opportunity to speak on a panel with Sean Griffith and Adriana Robertson, moderated by Jeremy Kidd, about the role of mutual funds in corporate governance. I'll straight up admit that I don't think I personally said anything you haven't already heard from me in this space - either in a post or a plugged article (like, ahem, my Family Loyalty essay on conflicts among mutual funds within a single complex) - but the video is worth watching if only to hear the views of my co-panelists. Sean describes his theory of when mutual funds should vote, and when they should abstain, or pass through their votes to retail shareholders (articulated in more detail in his paper, here), while Adriana discusses her research about how indexes don't really differ all that much from active management. It's definitely a treat to hear them describe their work (and to hear Adriana talk about her upcoming project at the very end.)
Saturday, January 4, 2020
Most readers are probably familiar with the case of Morrison v. Berry. There, Fresh Market was taken private by Apollo in a two-step tender offer. After the deal closed, a shareholder filed a lawsuit alleging that the directors had breached their duties and failed to obtain the best price for shareholders because Ray Berry, founder of Fresh Market and Chair of the Board, along with his son, colluded with Apollo to roll over their shares in the new company and rig the sales process in Apollo’s favor. Defendants contended that shareholders’ acceptance of Apollo’s offer cleansed any breaches under Corwin; therefore, the critical question was whether the shareholders were fully informed. VC Glasscock held that any omissions were immaterial as a matter of law, and the Delaware Supreme Court reversed, holding that omissions regarding the Berrys’ level of precommitment to Apollo were material.
After remand, the plaintiff filed a new complaint and the defendants renewed their motions to dismiss. And on December 31, VC Glasscock granted in part and denied in part those motions. In particular, he held:
(1) The directors other than Ray Berry were independent and disinterested, and neither the sales process nor the omissions evinced bad faith. In particular, enough was disclosed about Berry’s mendacity and the pressures facing the Board that any additional omissions could not have been intended to fool anyone, since, reading between the lines, shareholders could have sussed out the truth. (“If the Director Defendants’ intent was to ensure that the 14D-9 would entice stockholders to vote for the merger in the mistaken belief that the directors were unaware of activist pressure, or to hide that Berry’s weight was behind the Apollo bid, they did a poor job, indeed. So poor, I find, that a reasonable inference of bad faith in the omissions cannot be drawn.”). This, of course, is Glasscock’s way of reaffirming his original conclusion that the omissions were not material; the first time around, he held that enough was disclosed that shareholders did not require more details, and the second time around, he held that since so much was disclosed, the remaining omissions must not have been intentional deceptions.
(2) The plaintiff plausibly alleged that Ray Berry acted in bad faith and out of self-interest by misleading the Board about his relationship with Apollo.
(3) Two officer defendants (one of whom was also a director) were not protected by Fresh Market’s 102(b)(7) provision. Though the plaintiff did not plausibly allege they acted disloyally/in bad faith, the plaintiff did plausibly allege at least negligence with respect to the omissions. Again, however, Glasscock alluded to his earlier ruling: “another reasonable interpretation is that the 14D-9 represents a good faith but failed effort to make reasonable disclosures... As [one defendant] points out, I initially and erroneously determined that the omissions in the 14D-9 were not material.” But, since inferences on a motion to dismiss are drawn in favor of the plaintiff, these claims would survive – for now.
(4) Finally, the court reserved judgment on the plaintiff’s aiding and abetting claims. The plaintiff alleged that JP Morgan, Cravath, Apollo, and Ray Berry’s son Brett Berry all aided and abetted breaches by concealing Ray Berry’s discussions with Apollo, contributing to the omissions in the 14D-9, and by concealing from the Board that JP Morgan secretly fed Apollo information.
So, the things that stand out for me:
First, the case is being maintained, in part, due to the inability of corporate officers to exculpate negligence violations under 102(b)(7). Megan Shaner has written a lot about how officer duties are underdeveloped in Delaware law (see, e.g., Officer Accountability, 32 Ga. St. U.L. Rev. 355 (2016)); this case may become one of the few that permits an exploration of the subject.
Second, I am discomfited by the suggestion that the court’s initial mistake in concluding that the omissions were immaterial might be relevant to a determination of defendants’ scienter. The logic, apparently, is that if a court innocently believed these facts to be immaterial, corporate officers and directors may have operated under the same good faith misapprehension.
Leaving aside the difference in context – corporate insiders know far more about the business, the shareholders’ priorities, and the details of any omissions than a judge does (especially on a motion to dismiss) – I wonder how far the logic could extend. After all, in securities cases under Section 10(b), it’s not uncommon to see dismissals on materiality grounds that are reversed on appeal. Does the initial dismissal suggest that an inference of scienter is defeated, especially given the higher pleading standards for a 10(b) case? Couldn’t you draw exactly the opposite inference, i.e., if corporate insiders actually know a fact, and intentionally leave it out of a narrative but do hint at its existence (making “partial and elliptical disclosures,” in the Delaware Supreme Court’s phrasing), doesn’t that suggest they were strategically playing coy about the facts?
(I am also reminded of In re Ceridian Corp. Securities Litigation, 542 F.3d 240 (8th Cir. 2008), where the errors in the defendant company’s financial statements were so overwhelming that the court figured the mistakes must have been inadvertent; no intelligence could have designed them.)
Third, the court rejected the plaintiff’s allegation that director and CEO Richard Anicetti was motivated to keep the buyout price low because if he stayed with the company, he’d be compensated based on whether Apollo earned particular multiples of invested capital (MOIC) – payments that would become increasingly lucrative the less that Apollo paid Fresh Market stockholders. Now, compensation tied to MOIC is a new tactic that Guhan Subramanian and Annie Zhao recently identified as having been adopted by private equity buyers to manipulate corporate management; here, however, Glasscock wasn’t buying the argument, in part because any such moves on Anicetti’s part would have cost him up front, to the extent he received a lower price for his own shares. Still, I expect we’ll continue to see litigation over the practice.
And ... yeah, I don’t have a pithy wrap-up here, but I do think the aiding-and-abetting determinations will be interesting.
Saturday, December 28, 2019
I’ve previously blogged about – and written an essay about – how one of the knock-on effects of Corwin and MFW is to increase the distance between the treatment of controlling shareholder transactions, and other transactions, under Delaware law. As a result, the outcome of many a motion to dismiss turns solely on the presence or absence of a controlling shareholder – which puts increasing pressure on the definition of control in the first place. In particular, I’ve argued, courts uncomfortable with Corwin’s Draconian effects may be tempted to expand the definition of control in order to avoid early dismissals of cases that smack of unfairness.
The latest example of the genre comes by way of Vice Chancellor McCormick’s ruling on the motion to dismiss in Garfield v. BlackRock Mortgage Ventures et al. There, an enterprise organized as an “Up-C” sought to transform itself into an ordinary corporation, largely for the benefit of the two founding investors, BlackRock and HC Partners, as well as several directors and corporate officers. The question was whether the transaction was fair to the public stockholders, who overwhelmingly voted in favor of the deal. If BlackRock and HC Partners were not deemed to be controllers, the stockholder vote would cleanse the deal under Corwin and the case would be dismissed; if they were, the court would be permitted to substantively examine the transaction’s fairness.
Together, BlackRock and HC Partners controlled 46.1% of the vote, had Board representation, and had blocking rights; thus, the court easily found that if they acted together, they had control. The critical question was whether they had, in fact, agreed to act in concert, or whether they simply had concurrent, but independent, interests in the transaction. For these sorts of inquiries, the standard on which Delaware courts have settled is that to constitute a group, the putative controllers must be “connected in some legally significant way—such as by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.”
To determine whether this standard was met, McCormick looked for both transaction-specific facts suggestive of an agreement, as well as historical facts indicting that the defendants had agreed to coordinate in the past. Here, BlackRock and HC Partners’s long history of coordinated involvement with the company, coupled with their critical roles in approving the reorganization, created an inference of concerted action. As a result, the plaintiff had plausibly alleged the presence of a controlling group, and Corwin did not apply. Motion to dismiss denied.
So, there are a couple of things that interest me here.
First, it’s another example of “controller-creep.” The cases on which McCormick relied, Sheldon v. Pinto, 2019 WL 4892348 (Del. Oct. 4, 2019) and In re Hansen Medical Shareholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018), also identified “historical” ties as a factor to consider when inferring the presence of an agreement among putative members of a control group, but in those cases, the courts demanded that plaintiffs identify multiple investments in multiple companies – and refused to infer an agreement without them. Here, by contrast, McCormick found a history just due to the defendants’ investment in this single company.
Second, there are many areas of law where the presence of an agreement among parties, rather than simply concurrent self-interest, is critical (13D filings, antitrust law, RICO), and courts therefore have to closely examine the defendants’ behavior to see if such an agreement can be inferred. There seems to be little cross-pollination in the caselaw, however (though in Hansen, one “historical” factor used to infer the existence of an agreement was a 13D filing from a previous venture), and to be honest, that’s how it should be – there are different policies at play in different areas of law, not to mention different legal standards on a motion to dismiss, and it makes sense courts would therefore approach the analyses differently. That said, in the Garfield briefing, I detect efforts by the BlackRock defendants in particular to import antitrust concepts into the controlling shareholder inquiry, via the suggestion that agreements can only be inferred if there’s evidence that the parties sacrificed their immediate self-interest in service of a larger goal. Correctly, I think, McCormick chose not to pursue that argument.
Third, though, I get back to my problem with this entire line of precedent, which is well-illustrated by this case. We’re talking about a transaction structured to benefit a small number of shareholders with outsized voting power and management control; BlackRock and HC Partners had veto rights and were intimately involved in the planning stage even before the presentation to the Board. If the goal is to protect the public stockholders, why on earth should it matter whether these two formally agreed to act together? Whether they did or they didn’t wouldn’t make the transaction any less favorable to them, or any less coercive to the public stockholders. And that’s because control exists on a spectrum, not as an on/off switch, and two large investors with concurrent interests, board representation, and 46.1% of the voting power are just as threatening to the public stockholders, and exert just as much influence, whether they’ve formally agreed to act together or not. Plus, recall that the whole (purported) reason controlling shareholder transactions cannot be cleansed by a shareholder vote is that we presume shareholders are afraid to buck a controller. Shareholders can’t be intimidated by a secret agreement they know nothing about; if we were truly serious about inquiring into shareholder coercion, we’d be asking about shareholder perceptions of an agreement, not whether there actually was one. So what we’re seeing, again, is how the “controlling shareholder” legal analysis imposed by Corwin/MFW is often divorced from the underlying business reality, which ultimately leads courts down a garden path of irrelevance.
Saturday, December 21, 2019
I have previously commented that many investments describe themselves as “sustainable” or “ESG” (environmental, social, governance) focused, without much standardization as to what those terms mean – and I’ve criticized the SEC for failing to step in to create a set of uniform definitions.
Many investment firms have been touting new products as socially responsible. Now, regulators are scrutinizing some funds in an attempt to determine whether those claims are at odds with reality.
The Securities and Exchange Commission has sent examination letters to firms as record amounts of money flow into ESG funds. These funds broadly market themselves as trying to invest in companies that pursue strategies to address environmental, social or governance challenges, such as climate change and corporate diversity.
But there have been critics of the growth in these funds. Some argue investment funds should focus solely on returns, and some firms have faced questions about how strictly they adhere to ESG principles….
One letter the SEC sent earlier this year to an investment manager with ESG offerings asked for a list of the stocks it had recommended to clients, its models for judging which companies are environmentally or socially responsible, and its best- and worst-performing ESG investments, ….
The SEC also homed in on proxy voting in the letter, which some investors say is a powerful tool that can be used to influence a company’s governance and might show how an investment fund is carrying out its ESG goals. The letter asked for proxy voting records and documents that related to how the adviser decided to vote on an ESG issue….
Senior SEC officials have sometimes expressed concern that focusing too narrowly on corporate morality could undermine a money manager’s duty to act in the best interest of clients. That could become a problem for pension funds pursuing ESG strategies if their retirees and beneficiaries aren’t as interested in sustainability but are nevertheless locked into funds’ investment choices, Republican SEC Commissioner Hester Peirce said last year.
Ms. Peirce has criticized ESG for having no enforceable or common meaning.
“While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled,” she said in a speech last year to California State University Fullerton’s Center for Corporate Reporting and Governance….
Notice there are two separate ideas here, and the article blurs them together. One idea is that retail investors can’t tell what they’re buying when a fund is labeled “ESG.” Another idea is that funds should not be permitted to elevate “sustainability” metrics over wealth maximization, even if investors would prefer they did. And that confusion goes to the heart of my problem with the ESG label as applied to funds. It can mean at least three things:
(1) I morally/ethically do not want to profit off of some kind of activities, and therefore, even if they would maximize my returns, I don’t want to invest in them;
(2) I am hoping to use my investment dollars to encourage certain kinds of socially responsible activities that might not otherwise get sufficient funding, and I am willing to accept sub-par returns to do that (“impact investing”); or
(3) I believe ESG metrics are one mechanism for maximizing returns because social responsibility is ultimately profitable.
Now, within these categories, there are lots of questions. Like, if you’re willing to accept below-market returns in order to make socially responsible investments – either for ethical reasons, or because you’re hoping to make an impact – what counts as an ethical investment, or an unethical one? What kinds of “impact” do you want to have – i.e., how will you define the kinds of beneficial projects that otherwise would not be funded but for your social responsibility considerations? And how far below market are you willing to go? Is there a point where you’ll give up and say hey, I’ll go all in on Exxon if it’ll put food on the table?
Additionally, before investors can make any kind of ESG-investment, they need metrics that describe the characteristics of a particular instrument, so that they understand what it means to say a particular project or instrument is “green” or environmentally-friendly or “sustainable.” That’s why Europe is working toward a taxonomy that would categorize different projects according to their environmental impact. Notably, Europe is explicit that these categorizations are based on the greenness of the project for the purpose of advancing environmental goals; they are not categorizations based on an idea that green projects are somehow long-run more profitable. That determination, and its relevance to a particular investor or asset manager, is left to the investor, who will now simply be informed as to whether a project that says it has certain environmental effects really in fact has those effects.
In the US, of course, we don’t have any kind of labeling system – you can call any project green or sustainable and no one will stop you, which is why market actors will pay actual cash money for a clear assessment of the environmental impact of specific projects. And because the SEC has apparently given up on developing standardized metrics in favor of, I dunno, preventing shareholders from communicating their priorities to portfolio companies, Europe’s going to be the market leader here.
(For the record, I’m not at all persuaded by Commissioner Peirce’s claim that the SEC’s hands are tied because financial reporting is more reliable than ESG reporting; as I previously argued, modern financial reporting standards are the product of a nearly century-old public-private partnership spurred by the federal securities laws. Regulation creates the standardization; it’s not necessarily the other way around.)
But even after an instrument is accurately described in terms of its environmental and social effects, investors can’t decide whether those effects add up to “buy” “hold” or “sell” without a clear sense of why they’re asking about those effects in the first place, namely, their higher order strategy: Are they asking so they can follow their morals, so they can make an impact, or because they think ESG is wealth-maximizing? Because until you know that, you don’t know what to do with a specific green, green-ish, or brown investment opportunity.
And in the US, we don’t even have that higher order labeling system. Europe, again, is ahead of us: UK’s Investment Association recently put out a framework that tries to distinguish between these categories, and urged asset managers to label funds accordingly. But there’s no common language in the US.
And the reason there isn’t, I’d argue, is because there are a lot of different groups who have an interest in obscuring the distinctions. Just as individual companies like to claim they have a broader social purpose in order to free themselves from responsibility to one constituency (i.e., shareholders and regulators), asset managers, as well, want to earn the higher fees that come with the ESG label while avoiding any of the commitments associated with it. See, e.g., Dana Brakman Reiser & Anne M. Tucker, Buyer Beware: Variation and Opacity in ESG and ESG Index Funds (forthcoming Cardozo L. Rev.). Meanwhile, various advocacy and interest groups have their own (obvious) reasons to try to convince investors that it is entirely costless to insist on socially-responsible behavior from their portfolio companies.
All of which is to say, to the extent the SEC wants to make sure that ESG funds are clear on their strategy – THIS FUND IS FOR PEOPLE WHO WILL SACRIFICE WEALTH FOR MORALS, AT LEAST UP TO A POINT, AND HERE IS OUR PLAN versus THIS FUND IS FOR PEOPLE WHO BELIEVE THEY CAN DO WELL BY DOING GOOD, AND HERE IS OUR PLAN – I am all for it and believe it would be a great improvement in the marketplace.
But there’s a second issue that I’ve discussed in this space, namely, are funds even permitted to sacrifice wealth to achieve other goals? Normally, you’d think, if a retail investor understands what they’re doing, why shouldn’t they be able to choose a fund that prioritizes morals over money? But the latest suggestions from the Trump administration are that, at least to the extent the fund is regulated by ERISA, namely, it’s a private retirement fund, those choices are flat-out prohibited.
And if that’s what the SEC is after, well, I have to ask – what does the SEC have against markets?
Saturday, December 14, 2019
Alon Brav, Matthew Cain, and Jonathan Zytnick have a fascinating new paper analyzing the voting behavior of retail shareholders (and I linked to it once before but I'm pretty sure since then it's been updated with a lot of new data). Bottom line: They got access to the votes cast by retail shareholders from 2015 and 2017 and made a lot of interesting findings, including:
Retail votes matter. Collectively, they have as much influence on outcomes as the Big Three (Vanguard, BlackRock, and State Street).
Expressed as a proportion of the shareholder base, retail shareholders hold a higher percentage of small firms than large ones, and their participation in voting is higher in small firms.
Retail shareholders are more sensitive to management performance than the Big Three; they are more likely to turn out, and more likely to vote against management, when companies have underperformed. The Big Three, by contrast, are less sensitive to performance in terms of voting behavior.
Retail shareholder voting has an observable cost/benefit component. Retail shareholders vote more often when their economic stake is greater; when management has underperformed; in controversial votes; and when they live in a zip code less associated with labor income (suggesting more time to devote to their portfolio).
Retail shareholders with higher stakes in the subject firm are more likely to vote in favor of management proposals and against shareholder proposals as compared to institutions; by contrast, retail shareholders with lower stakes are less likely to vote at all, but when they do vote, they’re more likely support shareholder proposals – particularly for the largest firms.
So what are the implications of all of this?
Well, first, I’m struck by how everyone from the Progressives (Adolf Berle, William Riley) to modern thinkers like Einer Elhauge have assumed that the separation of ownership and control would lead shareholders to be less concerned about corporate social responsibility – the theory being that as shareholders feel less responsible for corporate behavior, they’ll shed morality in favor of wealth maximization. Yet, at least according to this data, smaller stakes and thus greater separation leads shareholders to greater support for social responsibility (i.e., shareholder proposals, many of which trend along these lines). Which makes its own sense: shareholders with smaller stakes may identify more as laborers, community members, etc than as shareholders, and feel less of an economic hit when companies sacrifice profits to benefit these other groups. Plus, these results may not mean the general principle is wrong, exactly; the argument was always that dispersed shareholders were absentee landlords, and Brav, Cain, and Zytnick find precisely that, in that lower stakes are correlated with lesser involvement in governance. Still, these findings are some counterweight to the assumption that dispersion breeds lack of social conscience.
Beyond that, we can ask what these findings suggest for those who would seek to enhance retail shareholder voice. For example, some have argued in favor of technological tweaks that would make it easier for retail shareholders to vote. What would the effects be? Well, it depends on who you think these nonvoters are. Perhaps, like the retail voters in the study, they’d turn out to be more attentive to corporate performance, less supportive of underperforming managers, and less supportive to shareholder proposals, than the current crop of voters – but again, as Brav, Cain, and Zytnick suggest, the infrequent voters are not the same as the frequent voters, and technological fixes may boost infrequent voters specifically. Thus, changes that enhance retail participation may in fact result in greater support for ESG initiatives.
And then there’s the question of requiring mutual funds to pass through votes to beneficial owners. That’s been proposed by a number of academics, including Caleb Griffin, Sean Griffith (for certain types of votes), Jennifer Taub, and Dorothy Lund, and has – as I understand it – even been suggested even by Bernie Sanders, who wants to ban asset managers from voting workers’ retirement fund shares unless they are following instructions (though it’s unclear to me whether he envisions straight pass through or more like a separate workers’ organization that sets voting policy). And here we have the same question: We might imagine the silent retail shareholders would become more like the retail shareholders who vote today, in which case they’d oppose ESG proposals and would be more hawkish on management performance as compared to institutional investors, or they might be more like the infrequent/lower stakes retail voters of today, who support ESG but barely bother to vote at all. Or they might be something entirely different: as Jill Fisch, Annamaria Lusardi, and Andrea Hasler note, investors whose only market exposure is a 401(k) plan are far less financially sophisticated than other investors. Presumably these are mutual fund investors whose voices would be promoted by a pass-through regime, and they might have particularly idiosyncratic preferences, if they have preferences at all.
We might also ask whether the retail voters from 2015 to 2017 are reflective of the retail voters of 2020, or 2021. As I previously pointed out, new technologies may encourage greater retail ownership, and these new traders may have entirely different preferences, especially if – as some data suggests – they treat stock trading as more of a leisure pastime than an investment opportunity.
But my big takeaway is this: I’ve previously argued that we should have more disclosure of the identity of voting shareholders, and, in particular, votes of high-vote shares and insiders should be distinguished from the votes of low-vote shares and unaffiliated investors. Brav, Cain, and Zytnick have convinced me that retail shareholders have a distinct point of view, as well, and – to the extent consistent with these voters’ privacy – their votes should be disclosed separately, as well.
Saturday, December 7, 2019
One of the biggest corporate law battles today concerns the appropriate role of institutional investors – and especially mutual funds – in corporate governance. There has been increasing concern expressed in the academy that mutual funds – especially index funds – don’t have sufficient incentives to oversee their portfolio companies, and/or that mutual fund complexes have become so huge that they dominate the economy. The concerns are rising to a level where the funds themselves are responding; witness, for example BlackRock’s attempted defenses here and here. And, of course, we have the SEC’s sneak attack on institutional power via proposed regulation of proxy advisors.
Which is why I found Fatima-Zahra Filali Adib’s new paper, Passive Aggressive: How Index Funds Vote on Corporate Governance Proposals, so interesting. She studies index fund voting behavior and contribution to corporate value by focusing on the “close call” votes, i.e., ones that narrowly pass or narrowly fail. She finds that index fund support is associated with value enhancement, and that these votes are not dictated by the proxy advisors (rebutting arguments that institutions blindly follow advisor recommendations). On the other hand, she also finds that ISS recommendations are not well correlated with value-enhancement, at least on the “close calls” – a point supporting the claim that proxy advisors do not know what they’re doing.
Also, fascinatingly – in direct response to those who claim that index funds do not have resources or incentives to devote to corporate governance – she concludes that funds allocate more resources to the “close call” proposals, apparently in anticipation that these are the ones where their votes will be pivotal. Her proxy for resource allocation is the fact that the fund voted against management (which suggests more attention to the issue). Bottom line is, funds are more likely to vote with management if they are “busy” – i.e., there are a lot of other proposals that require fund managers’ attention – but they are not more likely to vote with management, no matter how busy they are, if the vote is a close call. The voting behavior also suggests that index funds identify problem firms and continue to devote resources to them over time.
Anyway, that’s just a summary – there’s a lot here to dig into.
Saturday, November 30, 2019
I’m assuming most readers know the backstory here, but CBS and Viacom are both controlled by NAI, which in turn is controlled by Shari Redstone. NAI owns nearly 80% of the voting stock of each company; the rest of the voting shares are publicly traded but held by a small number of institutions. The bulk of each company’s capitalization, however, comes from no-vote shares, which are also publicly traded.
Redstone has long sought a merger of the two companies, which has been perceived as a boon to Viacom and a drag on CBS. That’s why, when she proposed a merger in 2018, the CBS Board revolted and tried to issue new stock that would dilute NAI’s voting control. That case resulted in a settlement whereby Redstone promised not to propose a merger for two years unless the CBS independent directors raised the issue first. By sheerest coincidence, as luck would have it, mere months after the settlement was reached and the CBS board restructured, CBS and Viacom announced that they had reached an agreement and would merge by the end of 2019.
Of course, the immediate question among academics was whether, if the merger did proceed, Redstone would shoot for MFW-cleansing, which would require conditioning the deal on the approval of the disinterested shares. And if Redstone did try to cleanse, would she give the no-vote shares the chance to vote? Or would she try to cleanse with only the voting shares that are not held by NAI? If the latter, would Delaware courts really permit a deal to be cleansed by the vote of unaffiliated shares representing such a small fraction of the total capitalization, especially when the no-vote shares have no say at all?
Sadly for those of us in the nosebleed seats, those questions are not going to be answered, because Redstone refused to condition the deal on any kind of unaffiliated shareholder vote (one of the points of objection among the 2018 CBS Board) – which is important for where we are now.
Where we are now is that a holder of CBS’s no-vote shares is (inevitably) seeking books and records in order to determine if there was wrongdoing in connection with the proposed deal. (Spoiler: The shareholder thinks there was wrongdoing). CBS and Viacom refused to provide all of the documents sought, leading to a lawsuit, and ultimately VC Slights’s recent opinion in Bucks County Employees Ret. Fund v. CBS. Slights concluded that there was a “credible basis to suspect wrongdoing,” and granted the plaintiff access to a broad array of documents, if not everything identified in the initial requests.
There’s a lot that’s of interest here, including details that I didn’t see reported previously (they may have been, if so I missed it) suggesting Redstone influenced the transaction, by, among other things, pressuring what Slights describes as the “purportedly” unaffiliated CBS committee and offering increased compensation to CBS’s Chair and CEO in exchange for his support. So, interested readers should really review the entire opinion. That said, I’m going to highlight what I believe to be the most critical aspects:
(1) There is strong evidence that Redstone sought the merger as a mechanism of using CBS to bail out/shore up the failing Viacom. For example, after Redstone sought – and was refused – a merger in 2016, she complained that “the failure to get the deal done ha[s] caused Viacom to suffer,” admitted that she favored a deal because Viacom’s stock was “tanking,” and vowed to accomplish a merger by a “different process.” Slights seemed quite persuaded by this evidence, and, of course, it will bolster claims of CBS stockholders that the deal was unfair to them.
(2) Following VC McCormick’s opinion in Kosinski v. GGP, Slights determined that the mere fact that CBS made no attempt to adhere to MFW cleansing was itself evidence of wrongdoing for Section 220 purposes. That interests me for a few reasons. First, it extends MFW into a novel space: previously, its purpose was to trigger business judgment review for controlling shareholder transactions, but now it will also be used to “cleanse” for the purpose of avoiding a 220 demand. Moreover, as I’ve previously noted, the definition of a controlling shareholder transaction is itself malleable, and that malleability can be used to evade the strictures of Corwin. Going forward, though the CBS/Viacom merger is very clearly a controlling shareholder transaction, I can imagine that in future cases, uncertainty as to whether a controlling shareholder is present in the first instance will wind up weighing in plaintiffs’ favor as they attempt to gain access to corporate records.
(3) In 2018, when CBS first tried to use nuclear tactics to avoid the merger, I said: “the main purpose of these legal skirmishes may be less to actually limit NAI’s power than to create an extraordinarily persuasive record that any attempt Shari Redstone may make to combine CBS and Viacom will be accomplished over the objection of the independent directors, and in violation of her duties as a controller.” That prediction has proved accurate; Slights explicitly read CBS’s 2018 resistance to the deal as evidence that the new deal proposed in 2019 was unfair to the CBS minority shareholders. As he put it, “a straight line can be drawn between Redstone’s previous attempts to merge Viacom with CBS, which CBS maintained just one year ago ‘presents a significant threat of irreparable and irreversible harm to [CBS] and its stockholders[,]’ and the current attempt to combine these companies. This logical nexus is further evidence of wrongdoing…”
In short, the 2018 CBS Board – and Les Moonves – lost the battle, but may very well have won the war.
Saturday, November 23, 2019
Recently, these stories caught my eye:
Neptune Energy Group Ltd. said that preparing to go public, possibly within the next two years, means it has to explain to potential investors how its fossil fuel-based business model is sustainable.
The company is putting together an ESG strategy, a term encompassing environmental, social and governance issues, which it will publish along with its annual report in April. The move reflects growing concern about climate change among investors in the sector, many of whom are demanding a stronger response from oil producers amid a gradual shift toward cleaner energy….
John Browne [the former BP Plc chief] who helped create the largest privately held oil company in Europe -- Wintershall DEA --- has said an ESG strategy is now crucial to attracting investment.
Indeed, even oil behemoth Saudi Aramco has been touting its relatively low carbon intensity -- the level of emissions per unit of energy produced -- to woo investors to its initial public offering.
Credit rating companies are muscling their way into the burgeoning world of responsible investing, purchasing smaller outfits that provide environmental, social and governance (ESG) scores….
The 159-year-old ratings provider is also leaving the door open for more acquisitions in the future, as data is “enormously important” for companies that want to lead in the sector…
The explosion of investment products that are marketed as being environmentally and socially responsible is fueling the demand for ESG data and scores….
ESG ratings have been mostly used by investment-grade bond and loan issuers who tie their sustainability performance to transaction terms or pricing. This year, usage of ESG scores started to spread to leveraged loans, collateralized loan obligations,…
Global investor enthusiasm for saving the planet has helped spur record issuance of green bonds. It’s also driving a surge in third-party verification that proceeds from the debt sales are actually destined for environmentally friendly projects, as fears of “greenwashing” mount….
Sustainalytics issued 35% more second-party opinions for green bonds in the third-quarter of this year compared to the same period a year ago. That included a 20-page opinion on Verizon’s green bond framework before the phone giant sold $1 billion in green bonds in February.
The benefit of getting the second party opinion outweighed the cost, according to Kee Chan Sin, Verizon’s assistant treasurer….
Some borrowers are going a step further and asking auditors to review the use and management of proceeds, as well as reporting after the bond is issued. Assurance that funds raised are being allocated to the right projects could help the market grow, said Kristen Sullivan, sustainability and KPI services leader at Deloitte, which provides assurance to green bond issuers.
Some investors are also doing their own audits.
It is obvious that investors are clamoring for reliable ESG data – at the very least regarding climate change vulnerability – and they are desperate enough to be willing to pay for it. This is not some kind of social cause movement; these investors are seriously, financially concerned about the long-term viability of certain industries and industrial practices.
Still, due to coordination problems, there’s a lack of standardization of metrics, and a lack of comparability of data.
Which is why I stand in absolute amazement that (at least some) SEC Commissioners take all this as evidence that the SEC should not develop a disclosure framework, because the current metrics are too inconsistent. We would normally take that as a sign of the need for coordination by regulators. After all, when the federal securities laws were passed in 1933 and 1934, there wasn’t much in the way of accounting standards – it took a federally mandated disclosure regime coupled with decades of cooperation with the private sector to settle on a unified framework.
I mean, I suppose it’s great business for the private ratings industry, which gets to sell investors different analyses, but isn’t that kind of standardization the raison d’etre of the securities disclosure regime?
Saturday, November 16, 2019
I've frequently been asked to express a view on the spectacular decline of WeWork. Is there a broader lesson here? Or is this just a bizarre one-off?
I actually think there are a few lessons, and for this week’s post, I’ll start with the one about securities regulation and capital allocation.
One of the primary purposes of securities regulation is to ensure the efficient allocation of capital. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717 (1984); see also Benjamin Edwards, Conflicts and Capital Allocation, 78 Ohio St. L. J. 181 (2017). SEC Chair Jay Clayton recently gave a speech in which he emphasized that the SEC is “not in the business of dictating a company’s strategic capital allocation decisions,” which is true – the SEC’s job is not to tell market actors where or how to invest – but the SEC is responsible for creating a disclosure regime that facilitates efficient capital allocation via investors’ choices. And by that measure, the securities laws are failing.
As we all know, the securities laws – both through statutory revisions (JOBS Act) and regulatory interpretation – have made it easier for companies to raise capital without public disclosure. The theory is that wealthy, institutional investors can bargain for the information they need to make an intelligent investment decision. But – as others have pointed out – when capital is raised privately, optimistic sentiment can be expressed but negative sentiment cannot. I’ll go further: Because private-market investors are a small group, they have strong incentives to keep their negative opinions to themselves lest they be shut out of future deals. Meanwhile, mutual funds have made a deep dive into the private markets, and agency costs infect those decisions: active managers, hoping to improve their market relative to competitors, may well think it would be worse to miss out on a great deal than to make a bad bet that puts their fund on par with everyone else’s.
The result is a bubble of private company valuations that meets reality only when it comes time to go public, as recent experience has demonstrated. But the injuries are not experienced by these sophisticated investors alone; they’re experienced by all of the other actors whose lives are affected by the allocation of capital to doomed business models.
The New York Times just published an expose on the havoc SoftBank has wreaked internationally by dumping cash into unprofitable startups, which have then gone on to persuade small business owners and independent contractors around the world to upend their plans in hopes of opportunities that never materialize. Violent and/or fire-laden protests have resulted in Indonesia, India, and Colombia. Obviously, many of these investments were outside of the scope of American securities regulation, but not all of them, and they serve as a cautionary tale of the consequences when capital is allocated to poorly-designed businesses. In this, SoftBank is not alone; American venture capital firms have been pouring money into U.S. startups, well beyond amounts that the companies themselves have requested; some founders apparently feel that if they don’t accept venture capital money they don’t need, the VCs will simply invest in a competitor and drive them out of business. See also Sheelah Kolhatkar, WeWork’s Downfall and a Reckoning for SoftBank (“The fact that the Vision Fund flooded its companies with capital made it difficult for other startups or traditional companies with even a modicum of fiscal discipline to compete.”)
It’s not just the investors or even the founders who suffer; the effects are felt throughout the economy. SoftBank’s ill-considered bet on WeWork has upended real estate markets on two continents and that doesn’t even get into the effects on employees; even WeWork’s janitorial staff was paid in stock.
Now, I’ve argued that the securities disclosure regime should not be broadly interpreted to encompass the interests of all actors in society; securities disclosure is, at its core, for investors, and if we’re worried about other corporate constituencies – and we should be – we should design a disclosure system for their needs. But even within the confines of securities disclosure, efficient allocation of capital should be one of the central goals. And the overwhelming evidence is that, wherever the appropriate line between privatization and “publicization,” the American system has gone too far in the direction of the private.