Business Law Prof Blog

Can The Next Generation of Lawyers Save the World?

An ambitious question, yes, but it was the title of the presentation I gave at the Society for Socio-Economists Annual Meeting, which closed yesterday. Thanks to Stefan Padfield for inviting me.

In addition to teaching Business Associations to 1Ls this semester and running our Transactional Skills program, I'm also teaching Business and Human Rights. I had originally planned the class for 25 students, but now have 60 students enrolled, which is a testament to the interest in the topic. My pre-course surveys show that the students fall into two distinct camps. Most are interested in corporate law but didn't know even know there was a connection to human rights. The minority are human rights die hards who haven't even taken business associations (and may only learn about it for bar prep), but are curious about the combination of the two topics. I fell in love with this relatively new legal  field twelve years ago and it's my mission to ensure that future transactional lawyers have some exposure to it.

It's not just a feel-good way of looking at the world. Whether you love or hate ESG, business and human rights shows up in every factor and many firms have built practice areas around it. Just last week, the EU Corporate Sustainability Reporting Directive came into force. Like it or not, business lawyers must know something about human rights if they deal with any company that has or is part of a supply or value chain or has disclosure requirements. 

At the beginning of the semester, we discuss the role of the corporation in society. In many classes, we conduct simulations where students serve as board members, government officials, institutional investors, NGO leaders, consumers, and others who may or may not believe that the role of business is business. Every year, I also require the class to examine the top 10 business and human rights topics as determined by the Institute of Human Rights and Business (IHRB). In 2022, the top issues focused on climate change:

1. State Leadership-Placing people at the center of government strategies in confronting the climate crisis
2. Accountable Finance- Scaling up efforts to hold financial actors to their human rights and environmental responsibilities
3. Dissenting Voices- Ensuring developmental and environmental priorities do not silence land rights defenders and other critical voices
4. Critical Commodities- Addressing human rights risks in mining to meet clean energy needs
5. Purchasing Power- Using the leverage of renewable energy buyers to accelerate a just transition
6. Responsible Exits- Constructing rights-based approaches to buildings and infrastructure mitigation and resilience
7. Green Building- Building and construction industries must mitigate impacts while avoiding corruption, reducing inequality, preventing harm to communities, and providing economic opportunities
8. Agricultural Transitions- Decarbonising the agriculture sector is critical to maintaining a path toward limiting global warming to 1.5 degrees
9. Transforming Transport- The transport sector, including passenger and freight activity, remains largely carbon-based and currently accounts for approximately 23% total energy-related CO2 global greenhouse gas emissions
10. Circular Economy- Ensure “green economy” is creating sustainable jobs and protecting workers

The 2023 list departs from the traditional type of list and looks at the people who influence the decisionmakers in business. That's the basis of the title of this post and yesterday's presentation. The 2023 Top Ten are:

1. Strategic Enablers- Scrutinizing the role of management consultants in business decisions that harm communities and wider society. Many of our students work outside of the law as consultants or will work alongside consultants. With economic headwinds and recessionary fears dominating the headlines, companies and law firms are in full layoff season. What factors should advisors consider beyond financial ones, especially if the work force consists of primarily lower-paid, low-skilled labor, who may not be able to find new employment quickly? Or should financial considerations prevail?
2. Capital Providers- Holding investors to account for adverse impacts on people- More than 220 investors collectively representing US$30 trillion in assets under management  have signed a public statement acknowledging the importance of human rights impacts in investment and global prosperity. Many financial firms also abide by the Equator Principles, a benchmark that helps those involved in project finance to determine environmental and social impacts from financing. Our students will serve as counsel to banks,  financial firms, private equity, and venture capitalists. Many financial institutions traditionally focus on shareholder maximization but this could be an important step in changing that narrative. 
3. Legal Advisors- Establishing norms and responsible performance standards for lawyers and others who advise companies. ABA Model Rule 2.1 guides lawyers to have candid conversations that "may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client's situation." Business and human rights falls squarely in that category. Additionally, the ABA endorsed the United Nations Guiding Principles on Business and Human Rights ten years ago and released model supply chain contractual clauses related to human rights in 2021. Last Fall, the International Bar Association's Annual Meeting had a whole track directed to business and human rights issues. Our students advise on sanctions, bribery, money laundering, labor relations, and a host of other issues that directly impact human rights. I'm glad to see this item on the Top 10 list. 
4. Risk Evaluators- Reforming the role of credit rating agencies and those who determine investment worthiness of states and companies. Our students may have heard of S&P, Moody's, & Fitch but may not know of the role those entities played in the 2008 financial crisis and the role they play now when looking at sovereign debt.  If the analysis from those entities  are flawed or laden with conflicts of interest or lack of accountability, those ratings can indirectly impact the government's ability to provide goods and services for the most vulnerable citizens.
5. Systems Builders- Embedding human rights considerations in all stages of computer technology. If our students work in house or for governments, how can they advise tech companies working with AI, surveillance, social media, search engines and the spread of (mis)nformation? What ethical responsibilities do tech companies have and how can lawyers help them wrestle with these difficult issues?
6. City Shapers-  Strengthening accountability and transformation in real estate finance and construction. Real estate constitutes 60% of global assets. Our students need to learn about green finance, infrastructure spending, and affordable housing and to speak up when there could be human rights impacts in the projects they are advising on. 
7. Public Persuaders- Upholding standards so that advertising and PR companies do not undermine human rights. There are several legal issues related to advertising and marketing. Our students can also play a role in advising companies, in accordance with ethical rule 2.1, about persuaders presenting human rights issues and portraying controversial topics related to gender, race, indigenous peoples, climate change in a respectful and honest manner. 
8. Corporate Givers- Aligning philanthropic priorities with international standards and the realities of the most vulnerable. Many large philanthropists look at charitable giving as investments (which they are) and as a way to tackle intractable social problems. Our students can add a human rights perspective as advisors, counsel, and board members to ensure that organizations give to lesser known organizations that help some of the forgotten members of society. Additionally, Michael Porter and Mark Kramer note that a shared-value approach, "generat[es] economic value in a way that also produces value for society by addressing its challenges. A shared value approach reconnects company success with social progress. Firms can do this in three distinct ways: by reconceiving products and markets, redefining productivity in the value chain, and building supportive industry clusters at the company's locations." Lawyers can and should play a role in this. 
9. Business Educators- Mainstreaming human rights due diligence into management, legal, and other areas of academic training. Our readers teaching in business and law schools and focusing on ESG can discuss business and human rights under any of the ESG factors. If you don't know where to start, the ILO has begun signing MOUs with business schools around the world to increase the inclusion of labor rights in business school curricula. If you're worried that it's too touchy feely to discuss or that these topics put you in the middle of the ESG/anti-woke debate, remember that many of these issues relate directly to enterprise risk management- a more palatable topic for most business and legal leaders. 
10. Information Disseminators- Ensuring that journalists, media, and social media uphold truth and public interest. A couple of years ago, "fake news" was on the Top 10 and with all that's going on in the world with lack of trust in the media and political institutions, lawyers can play a role in representing reporters and media outlets. Similarly, lawyers can explain the news objectively and help serve as fact checkers when appearing in news outlets.

If you've made it to the end of this post, you're either nodding in agreement or shaking your head violently in disagreement. I expect many of my students will feel the same, and I encourage that disagreement. But it's my job to expose students to these issues. As they learn about ESG from me and the press, it's critical that they disagree armed with information from all sides.

So can the next generation of lawyers save the world? Absolutely yes, if they choose to. 

Teaching Race & Entrepreneurship: A Guest Post from Prof. Priya Baskaran

Given anti-democratic events at the nation’s Capitol which were made possible by continued structural injustice in the U.S. – I feel obligated as a lawyer and professor to emphasize our responsibilities to address the interlocking systems of subordination that impact every area of the law – with entrepreneurship being no exception. These systems divide us into “haves” and “have nots” based on race, gender, class, and even geography.

We have a moral obligation as lawyers and professors to address these structural barriers in the classroom. Entrepreneurship is often touted as a means for greater economic participation and a vehicle for innovation. Yet many entrepreneurs and small businesses are hobbled by barriers rooted in structural injustice. These obstacles prevent them from raising necessary capital, accessing legal resources, obtaining other technical assistance, and numerous impediments related to operations such as insurance and talent retention. A full accounting of existing barriers, though important, is insufficient. We must examine the legal roots of modern structural barriers to entrepreneurship - interlocking systems of subordination based on race, class, and gender. Sadly, U.S. laws and policies have actively devalued certain populations and entire communities, elevating certain communities while relegating others to the economic margins. For example, redlining influenced decades of public and private investment, decimating both the inner-city as well as rural areas.

Law professors must equip our students to be thoughtful, diligent, competent, compassionate, and ethical lawyers. As part of this education, students must confront, and unpack legal regimes and reckon with their practical impacts. At a minimum, our students will engage with state and local policy as private attorneys, regulators, and even elected officials. Grounding them in a thorough understanding of the impacts of structural barriers and empowering them to create change by demanding legal reforms is a task we must embrace.

This blog post expands on my presentation at the AALS 2021 Annual Meeting, where I outlined methods for introducing this vital and complex topic into the business law classroom. Below, I detail my learning goals, lesson plans, and provide some additional materials that may prove helpful for other business law professors. This class was first designed and implemented during my time as an Associate Professor at West Virginia University’s College of Law. I mention this to emphasize that the demographics of a law school student body or fellow faculty should not deter academics from engaging in these topics. I have also modified this class successfully for my current students at American University’s Washington College of Law. I can attest that the class has resulted in important and rich dialogue in both law school classrooms. (Please click below for more.)

 

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Do Black Entrepreneurs Matter?

Yesterday, I had the pleasure of moderating a panel of Black entrepreneurs sponsored by the Miami Finance Forum, a group of finance, investment management, banking, capital markets, private equity, venture capital, legal, accounting and related professionals. When every company and law firm was posting about Black Lives Matter and donating to various causes, my colleague Richard Montes de Oca, an MFF board member, decided that he wanted to do more than post a generic message. He and the MFF board decided to launch a series of webinars on Black entrepreneurship. The first panel featured Jamarlin Martin, who runs a digital media company and has a podcast; Brian Brackeen, GP of Lightship Capital and founder of Kairos, a facial recognition tech company;  and Raoul Thomas, CEO of CGI Merchant Group, a real estate private equity group.

These panelists aren't the typical Black entrepreneurs. Here are some sobering statistics:

• Black-owned business get their initial financing through 44% cash; 15% family and friends; 9% line of credit; 7% unsecured loans; and 3% SBA loans;
• Between February and April 2020, 41% of Black-owned businesses, 33% of Latinx businesses, and 26% of Asian-owned businesses closed while 17% of White-owned business closed;
• As of 2019, the overwhelming majority of businesses in majority Black and Hispanic neighborhoods did not have enough cash on hand to pay for two weeks worth of bills;
• The Center for Responsible Lending noted that in April, 95% of Black-owned businesses were tiny companies with slim change of achieving loans in the initial rounds of the Paycheck Protection Program;
• Only 12% of Black and Hispanic business owners polled between April 30-May 12 had received the funding they requested from the stimulus program. In contrast half of all small business had received PPP funds in the same poll.

Because we only had an hour for the panel, we didn't cover as much as I would have liked on those statistics. Here's what we did discuss:

• the failure of boards of directors and companies to do meaningful work around diversity and inclusion- note next week,  I will post about the spate of shareholder derivative actions filed against companies for false statements about diversity commitments;
• the perceptions of tokenism and "shallow, ambiguous" diversity initiatives;
• how to get business allies of all backgrounds;
• the need for more than trickle down initiatives where the people at the bottom of the corporation/society don't reap benefits;
• the fact that investing in Black venture capitalists does not mean that those Black VCs will invest in Black entrepreneurs and the need for more transparency and accountability; 
• whether the Black middle class still exists and the responsibility of wealthier Black professionals to provide mentorship and resources;
• why it's easier for entrepreneurs to get investments for products vs. services, and a hack to convince VCs to invest in the service;
• whether a great team can make up for a so-so product when a VC hears a pitch; 
• why there are so many obstacles to being a Black LGBTQ entrepreneur and how to turn it to an advantage when pitching; and
• whether reparations will actually help Black entrepreneurs and communities.

If you want to hear the answers to these questions, click here for access to the webinar. Stay safe and wear your masks!

Unicorns Built by and for Women

We hear a lot about unicorns in technology, finance, and the sharing economy.   But many of us do not realize that a number of unicorns are owned by women and a number of those focus on make-up and skin care--products geared to a female audience.  Female-owned beauty unicorns are all around us . . . .

Why should we care?  Well for one thing, female-owned businesses have historically been somewhat rare.  (In 1972, women-owned businesses accounted for only 4.6% of all firms, e.g.)  And for another, it has been noted that women often have a tough time financing their businesses. (See this 2014 U.S. Senate Committee report and other sources cited below for some details.) Also, it may be interesting to some (it is to me) that a business in such a traditional space can succeed so well in private capital markets given the competitive dominance of major conglomerates (most of which are publicly traded). Also, as I note in closing below (for those teaching in the business law area), the facts and trends in this space may be fodder for great exercises and exam questions.

Women-owned businesses are beginning to catch up in the race for space in commercial and capital markets.  The National Association of Women Business Owners (NAWBO) represents on its website (based on data from an American Express report, updated here) that "[w]omen-owned firms (51% or more) account for 39% of all privately held firms and contribute 8% of employment and 4.2% of revenues."  The Women's Business Enterprise National Council (WBENC) notes that "From 2007 – 2018, total employment by women-owned businesses rose 21%, while employment for all businesses declined by 0.8%."  Women Owned, a WBENC initiative and WEConnect International, asserts that "[o]ver the past 20 years, the number of Women Owned businesses has grown 114 percent compared to the overall national growth rate of 44 percent for all businesses."  More relevant to the matter of female-led unicorns, however, the NAWBO reports that "[o]ne in five firms with revenue of $1 million or more is woman-owned" and that "4.2% of all women-owned firms have revenues of 1 million or more."

Yet, unicorns owned by women are the exception rather than the rule in women-owned businesses.  Overall, according to the WBENC, the revenues generated by businesses owned by women contribute only 4.3% of the total revenues of private sector firms, despite the fact that they constitute almost 4 of every 10 privately held businesses. WBENC also reports that "88% of women-owned businesses generate less than $100,000 in revenue," noting that "[t]his group is growing at a rate that is faster than the growth rate for larger women-owned companies." So, women still have some work to do in producing gender equity through the creation of large, independent, private firms--whether in the beauty industry or another sector.

Why would an investor fund a female-owned beauty unicorn?  Here's an answer from one who did--Glossier, well-known by me for its lip glosses, founded by Emily Weiss:

“A category that is mostly acceptable price points with high margins and consumable products—that’s a pretty good business setup,” says Green, who was the first person to back Glossier. Green points out that the momentum women like Weiss and Soare [Anastasia Soare, founder of Anastasia Beverly Hills, a leader in eyebrow products, including its famously popular Brow Wiz^®] have created has forced investors to reevaluate what has historically been considered a niche women’s space but is on track to grow to $750 billion by 2024. It has also unleashed a harras of unicorn foals—entrepreneurial hopefuls working to emulate this kind of megawatt success in the cosmetics industry and beyond. “Beauty companies have never been considered companies that are changing the world,” says Weiss. But they are changing the dynamics of who’s in the boardroom.

Venture firms go where the money is, and it appears the beauty market is not yet saturated.  One needs only note the soaring popularity of Korean beauty products in the United States to understand that this is a big market.  Women are credible business leaders in this industry as key, long-term consumers of beauty products.

There is much more data out there on various aspects of women-owned businesses and unicorns.  I plan to poke at these topics more from time to time in this space.  Information about these types of firms--as part of a growth economy--may be useful to both law academics and legal practitioners--especially those working with, or engaged with issues relating to, entrepreneurs, start-ups, or small businesses.  

The mainstream business news media already has taken note.  Witness this article on Glossier in Forbes and this one in Business Insider on Anastasia Beverly Hills, the two firms mentioned above.  And, of course, the fashion retail media and blogosphere are awash with information on these firms. That's where I learned about these beauty unicorns in the first place.  Some super exercises and exams questions may come out of this space.  I already base an experiential exercise on Urban Decay, which once was a privately held female-owned beauty business.  See this case for details.  Other ideas for how to use the information and trends presented here are, of course, invited.  Leave a comment to share yours.

Quick Take on Polsky's Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups

Gregg D. Polsky, University of  Georgia Law, recently posted his paper, Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups. It is an interesting read and worth a look. H/T Tax Prof Blog.  Following the abstract, I have a few initial thoughts:

Perhaps the most fundamental role of a business lawyer is to recommend the optimal entity choice for nascent business enterprises. Nevertheless, even in 2018, the choice-of-entity analysis remains highly muddled. Most business lawyers across the United States consistently recommend flow-through entities, such as limited liability companies and S corporations, to their clients. In contrast, a discrete group of highly sophisticated business lawyers, those who advise start-ups in Silicon Valley and other hotbeds of start-up activity, prefer C corporations.

Prior commentary has described and tried to explain this paradox without finding an adequate explanation. These commentators have noted a host of superficially plausible explanations, all of which they ultimately conclude are not wholly persuasive. The puzzle therefore remains.

This Article attempts to finally solve the puzzle by examining two factors that have been either vastly underappreciated or completely ignored in the existing literature. First, while previous commentators have briefly noted that flow-through structures are more complex and administratively burdensome, they did not fully appreciate the source, nature, and extent of these problems. In the unique start-up context, the complications of flow-through structures are exponentially more problematic, to the point where widespread adoption of flow-through entities is completely impractical. Second, the literature has not appreciated the effect of perplexing, yet pervasive, tax asset valuation problems in the public company context. The conventional wisdom is that tax assets are ignored or severely undervalued in public company stock valuations. In theory, the most significant benefit of flow-through status for start-ups is that it can result in the creation of valuable tax assets upon exit. However, the conventional wisdom makes this moot when the exit is through an initial public offering or sale to a public company, which are the desired types of exits for start-ups. The result is that the most significant benefit of using a flow- through is eliminated because of the tax asset pricing problem. Accordingly, while the costs of flow-through structures are far higher than have been appreciated, the benefits of these structures are much smaller than they appear.

Before commenting, let me be clear: I am not an expert in tax or in start-up entities, so my take on this falls much more from the perspective of what Polsky calls "main street businesses." I am merely an interested reader, and this is my first take on his interesting paper. 

To start, Polsky distinguishes "tax partnerships" from "C Corporations."  I know this is the conventional wisdom, but I still dislike the entity dissonance this creates.  Polsky explains: 

Tax partnerships generally include all state law entities other than corporations. Thus, general and limited partnerships, LLCs, LLPs, and LLLPs are all partnerships for tax purposes. C corporations include state law corporations and other business entities that affirmatively elect corporate status. Typically, a new business will often need to choose between being a state-law LLC taxed as a partnership or a state-law corporation taxed as a C corporation. The state law consequences of each are nearly identical, but the tax distinctions are vast.

 As I have written previously, I'd much rather see the state-level entity decoupled from the tax code, such that we would 

have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax. 

As Dinky Bosetti once said, "It's good to want things." 

Anyway, as one who focuses on entity choice from (mostly) the non-tax side, I dispute the idea that "[t]he state law consequences of each [entity] are nearly identical, but the tax distinctions are vast."  From governance to fiduciary duties to creditor relationships to basic operations, I think there are significant differences (and potential consequences) to entity choice beyond tax implications. 

 I will also quibble with Polsky's statement that "public companies are taxed as C corporations."  He is right, of course, that the default rule is that "a publicly traded partnership shall be treated as a corporation." I.R.C. § 7704(a). But, in addition to Business Organizations, I teach Energy Law, where we encounter Master Limited Partnerships (MLPs), which are publicly traded pass-through entities. See id. § 7704(c)-(d).

Polsky notes that "while an initial choice of entity decision can in theory be changed, it is generally too costly from a tax perspective to convert from a corporation to a partnership after a start-up begins to show promise."  This is why those of us not advising VC start-ups generally would choose the LLC, if it's a close call. If the entity needs to be taxed a C corp, we can convert.  If it is better served as an LLC, and the entity has appreciated in value, converting from a C corp to an LLC is costly.  Nonetheless, Polsky explains for companies planning to go public or be sold to a public entity, the LLC will convert before sale so that the LLC and  C Corp end up in roughly the same place:  

The differences are (1) the LLC’s pre-IPO losses flowed through to its owners while the corporation’s losses were trapped, but as discussed above this benefit is much smaller than it appears due to the presence of tax-indifferent ownership and the passive activity rules, (2) the LLC resulted in additional administrative, transactional, and compliance complexity (including the utilization of a blocker corporation in the ownership structure), and (3) the LLC required a restructuring on the eve of the IPO. All things considered, it is not surprising that corporate classification was the preferred approach for start-ups.

This is an interesting insight. My understanding is that the ability pass-through pre-IPO losses were significant to at least a notable portion of investors. Polsky's paper suggests this is not as significant as it seems, as many of the benefits are eroded for a variety of reasons in these start ups.  In addition, he notes a variety of LLC complexities for the start-up world that are not as prevalent for main street businesses. As a general matter, for traditional businesses, the corporate form comes with more mandatory obligations and rules that make the LLC the less-intensive choice.  Not so, it appears, for VC start-ups.  

 I need to spend some more time with it, and maybe I'll have some more thoughts after I do.  If you're interested in this sort of thing, I recommend taking a look.

My Favorite Business Law Cases, Round 1: Sinclair Oil Corp. v. Levien (Del. 1971)

I am such a fan of Sinclair Oil Corp. v. Levien,  280 A.2d 717 (Del. 1971), that I use the case in both Business Organizations and in Energy Law. The case does a great job of giving a basic overview of parent-subsidiary relationships, some of the basic fiduciary duties owed in such contexts, and it sets up the discussion of why companies use subsidiaries in the first place. 

On fiduciary duties and when the intrinsic (entire) fairness test applies: 

A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, this alone will not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealing — the situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary

On what test to apply to parent-subsidiary dividends: 

We do not accept the argument that the intrinsic fairness test can never be applied to a dividend declaration by a dominated board, although a dividend declaration by a dominated board will not inevitably demand the application of the intrinsic fairness standard. Moskowitz v. Bantrell, 41 Del.Ch. 177, 190 A.2d 749 (Del.Supr. 1963). If such a dividend is in essence self-dealing by the parent, then the intrinsic fairness standard is the proper standard. For example, suppose a parent dominates a subsidiary and its board of directors. The subsidiary has outstanding two classes of stock, X and Y. Class X is owned by the parent and Class Y is owned by minority stockholders of the subsidiary. If the subsidiary, at the direction of the parent, declares a dividend on its Class X stock only, this might well be self-dealing by the parent. It would be receiving something from the subsidiary to the exclusion of and detrimental to its minority stockholders. This self-dealing, coupled with the parent's fiduciary duty, would make intrinsic fairness the proper standard by which to evaluate the dividend payments.

. . . . The dividends resulted in great sums of money being transferred from Sinven to Sinclair. However, a proportionate share of this money was received by the minority shareholders of Sinven. Sinclair received nothing from Sinven to the exclusion of its [722] minority stockholders. As such, these dividends were not self-dealing. We hold therefore that the Chancellor erred in applying the intrinsic fairness test as to these dividend payments. The business judgment standard should have been applied. 

On whether shareholder of one subsidiary should be allowed to participate in ventures pursued by other subsidiaries: 

The plaintiff proved no business opportunities which came to Sinven independently and which Sinclair either took to itself or denied to Sinven. As a matter of fact, with two minor exceptions which resulted in losses, all of Sinven's operations have been conducted in Venezuela, and Sinclair had a policy of exploiting its oil properties located in different countries by subsidiaries located in the particular countries.

It makes sense for companies, often, to use subsidiaries to keep certain businesses well organized and to protect assets for shareholder.  That is, I might only want to invest in a subsidiary doing business in Mexico because I trust that the assets there are secure.  I may not want to participate in work in Venezuela, which I might deemed riskier.  And it's not just shareholders who might feel that way.  Creditors, too, may view such investments very differently and may only be willing to participate in ventures where the risks can be more easily assessed. 

Volcker Rule Data Collection Under Congressional Scrutiny

House Representative Carolyn B. Maloney, Democrat of New York, sent a formal request to a slew of federal agencies to share trading data collected in connection with the Volcker Rule. The Volcker Rule prohibits U.S. banks from engaging in proprietary trading (effective July 21, 2015), while permitting legitimate market-making and hedging activities.  The Volcker Rule restricts commercial banks (and affiliates) from investing investing in certain hedge funds and private equity, and imposes enhanced prudential requirements on systemically identified non-bank institutions engaged in such activities.

Representative Maloney requested  the Federal Reserve, Federal Deposit Insurance Corporation, Commodity Futures Trading Commission, Office of the Comptroller of the Currency, and the Securities and Exchange Commission to analyze seven quantitative trading metrics that regulators have been collecting since 2014 including: (1) risk and position limits and usage; (2) risk factor sensitivities; (3) value-at-risk (VaR) and stress VaR; (4) comprehensive profit and loss attribution; (5) inventory turnover; (6) inventory aging; and (7) customer facing trade ratios.

Representative Maloney requested the agencies analyze the data and respond to the following questions:

• The extent to which the data showed significant changes in banks’ trading activities leading up to the July 21, 2015 effective date for the prohibition on proprietary trading. To the extent that the data did not show a significant change in the banks’ trading activities leading up to the July 21, 2015 effective date, whether the agencies believe this is attributable to the banks having ceased their proprietary trading activities prior to the start of the metrics reporting in July 2014.

• Whether there are any meaningful differences in either overall risk levels or risk tolerances — as indicated by risk and position limits and usage, VaR and stress VaR, and risk factor sensitivities — for trading activities at different banks.

• Whether the risk levels or risk tolerances of similar trading desks are comparable across banks reporting quantitative metrics. Similarly, whether the data show any particular types of trading desks (e.g., high-yield corporate bonds, asset-backed securities) that have exhibited unusually high levels of risk.

• How examiners at the agencies have used the quantitative metrics to date.

• How often the agencies review the quantitative metrics to determine compliance with the Volcker Rule, and what form the agencies’ reviews of the quantitative metrics take.

• Whether the quantitative metrics have triggered further reviews by any of the agencies of a bank’s trading activities, and if so, the outcome of those reviews

• Any changes to the quantitative metrics that the agencies have made, or are considering making, as a result of the agencies’ review of the data received as of September 30, 2015.

The agencies' response to the request may provide insight into Dodd-Frank/Volcker Rule, the role of big data in the rule-making process (and re-evaluation), and bigger issues such as whether systemic financial risk is definable by regulation and quantifiable in data collection.  I will post regulatory responses, requested by October 30th, here on the BLPB.

-Anne Tucker

AALS Call for Papers: LLCs, New Charitable Forms, and the Rise of Philanthrocapitalism

At the 2017 AALS annual meeting, January 3-7 in San Francisco, the AALS Sections on Agency, Partnerships LLCs, and Unincorporated Associations & Nonprofit and Philanthropy Law will hold a joint session on LLCs, New Charitable Forms, and the Rise of Philanthrocapitalism.

In December 2015, Facebook founder Mark Zuckerberg and his wife, Dr. Priscilla Chan, pledged their personal fortune—then valued at $45 billion—to the Chan-Zuckerberg Initiative (CZI), a philanthropic effort aimed at “advancing human potential and promoting equality.” But instead of organizing CZI using a traditional charitable structure, the couple organized CZI as a for-profit Delaware LLC. CZI is perhaps the most notable example, but not the only example, of Silicon Valley billionaires exploiting the LLC form to advance philanthropic efforts. But are LLCs and other for-profit business structures compatible with philanthropy? What are the tax, governance, and other policy implications of this new tool of philanthrocapitalism? What happens when LLCs, rather than traditional charitable forms, are used for “philanthropic” purposes?

From the heart of Silicon Valley, the AALS Section on Agency, Partnerships LLCs, and Unincorporated Associations and Section on Nonprofit and Philanthropy Law will host a joint program tackling these timely issues. In addition to featuring invited speakers, we seek speakers (and papers) selected from this call.
Any full-time faculty of an AALS member or fee-paid school who has written an unpublished paper, is working on a paper, or who is interested in writing a paper in this area is invited to submit a 1- or 2-page proposal by June 1, 2016. The Executive Committees of the Sections will review all submissions and select two papers by July 1, 2016. If selected, a very polished draft must be submitted by November 30, 2016. All submissions and inquiries should be directed to the Chairs of the Sections at the email addresses below:

Mohsen Manesh
Associate Professor
University of Oregon School of Law
[email protected]

Garry W. Jenkins
Associate Dean for Academic Affairs
John C. Elam/Vorys Sater Professor of Law
Moritz College of Law,State University
[email protected] 

Walch on Bitcoin Blockchain as Financial Market Infrastructure

I was fortunate to hear Angela Walch (St. Mary's) present on this paper at SEALS last summer. Her article, The Bitcoin Blockchain as Financial Market Infrastructure: A Consideration of Operational Risk, has now been published in the NYU Journal of Legislation and Public Policy and is available on SSRN. The abstract is reproduced below:

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“Blockchain” is the word on the street these days, with every significant financial institution, from Goldman Sachs to Nasdaq, experimenting with this new technology. Many say that this remarkable innovation could radically transform our financial system, eliminating the costs and inefficiencies that plague our existing financial infrastructures, such as payment, settlement, and clearing systems. Venture capital investments are pouring into blockchain startups, which are scrambling to disrupt the “quadrillion” dollar markets represented by existing financial market infrastructures. A debate rages over whether public, “permissionless” blockchains (like Bitcoin’s) or private, “permissioned” blockchains (like those being designed at many large banks) are more desirable.

Amidst this flurry of innovation and investment, this paper enquires into the suitability of the Bitcoin blockchain to serve as the backbone of financial market infrastructure, and evaluates whether it is robust enough to serve as the foundation of major payment, settlement, clearing, or trading systems.

Positing a scenario in which the Bitcoin blockchain does serve as the technology enabling significant financial market infrastructures, this paper highlights the vital importance of functioning financial market infrastructure to global financial stability, and describes relevant principles that global financial regulators have adopted to help maintain this stability, focusing particularly on governance, risk management, and operational risk.

The paper then moves to explicate the operational risks generated by the most fundamental features of Bitcoin: its status as decentralized, open-source software. Illuminating the inevitable operational risks of software, such as its vulnerability to bugs and hacking (as well as Bitcoin’s unique 51% Attack vulnerability), uneven adoption of new releases, and its opaque nature to all except coders, the paper argues that these technology risks are exacerbated by the governance risks generated by Bitcoin’s ambiguous governance structure. The paper then teases out the operational risks spawned by decentralized, open-source governance, including that no one is responsible for resolving a crisis with the software; no one can legitimately serve as “the voice” of the software; code maintenance and repair may be delayed or imperfect because not enough time is devoted to the code by volunteer software developers (or, if the coders are paid by private companies, the code development may be influenced by conflicts of interest); consensus on important changes to the code may be difficult or impossible to achieve, leading to splits in the blockchain; and the software developers who “run” the Bitcoin blockchain seem to have backgrounds in software coding rather than in policy-making or risk-management for financial market infrastructure.

The paper concludes that these operational risks, generated by Bitcoin’s most fundamental, presumably inalterable, structures, significantly undermine the Bitcoin blockchain’s suitability to serve as financial market infrastructure.

Blind Spots in Venture Capital and University Recruiting

Earlier this week, my co-blogger Josh Fershee authored an interesting post about the surprising crowdfunding success of the PicoBrew "Keurig for Beer.” After reading Josh’s post and the embedded links, I have to agree with him; I have no idea how they raised $1.4M for a product that I don’t see being that useful. The product appears to be both overly expensive and overly time-consuming.

I think many venture capitalists would join Josh and me in questioning the wisdom of PicoBrew, at least before it raised $1.4M. But as I wrote in an earlier post, crowdfunding may help overcome biases of venture capitalists. In the days since Josh’s posts, I have heard a few people talk about how excited they were about PicoBrew. These people were all at least 10 years younger than Josh, me, and most venture capitalists. While us “older folks” may not see a use for the product, judging from the crowdfunding results and a little anecdotal evidence here in Nashville, there appears to be significant market demand for PicoBrew. Similarly, on the show Shark Tank, the female “sharks” have accused their male counterparts of largely avoiding companies with products aimed at women; and while I have not run the numbers, it does seem like the sharks' investments skew toward products that they (or maybe their family members) would use. Very few venture capitalists are under 30 years old, so perhaps products aimed at younger people got passed on more often than they should have before online crowdfunding became popular. Of course, crowdfunding can have a dark side as well; crowdfunding may be used not only to uncover good products that were passed over, but could also be used to lure more gullible funders.

Somewhat related, the Chronicle of Higher Education recently ran an article entitled “When Recruiting Teenagers, Don't Forget to Question Your Assumptions.” The article is focused on undergraduate recruiting practices and challenges readers to question conventional wisdom. The article notes a disconnect between what universities think applicants want and what applicants say they want. For example, “[a]lthough 30 percent of admissions officials said social media was the most effective way for a college to engage students who had never heard of it, just 4 percent of students said the same. . . . And while 64 percent of admissions officials said a college’s official social-media accounts were important to prospective students after applying, only 18 percent of teenagers said the same.” The article’s main directive appears to be, don’t assume what prospective students want, ask them and use evidence to craft your recruitment programs. Using evidence rather than hunches to make decisions may be obvious to professors, but I wonder how many schools use sophisticated studies in designing their recruiting programs.

Like all of us, venture capitalists and university recruiting staff members have blind spots. Perhaps evidence, from crowdfunding and student surveys, can help these respective groups shrink those blind spots.

Do Sophisticated Parties Really Prefer the Freedom of Contract? (Contract Is King Micro-Symposium)

I would like to thank the Business Law Professor Blog for this very important symposium. My brief thoughts are filling in for Marcia Narine. I became well acquainted with LLCs when I practiced in the alternative entities group of a Delaware law firm. What most stood out during my time there was the freedom enjoyed by LLCs and LPs to abridge fiduciary duties and deviate from other corporate orthodoxies. I constantly thought about whether this freedom of contract was a good thing; after all, case law tells only the tragic stories.

As mentioned in other posts, contractual freedom is ideal when sophisticated parties of comparable strengths are allowed to define their relationships. And generally, few problems arise from the LLC form. Law firms typically provide those seeking to form an LLC one of their standard, boilerplate operating agreements, which includes fiduciary duties. In turn, business owners are able to enjoy limited liability while avoiding many of the formalities, transactions costs, and tax burdens associated with traditional corporations. However, there seems to be an increasing number of cases where operating agreements resemble adhesion contracts, creating opportunities for abuse. Is it wise that unsophisticated are more at risk for contractual related harms so that sophisticated parties can contract freely?

The above narrative suggests that sophisticated parties benefit and enjoy the organizational flexibilities provided by the LLC form. It goes unnoticed, though, that sophisticated parties often reject this freedom of contract. Without question the trend in Delaware is towards the formation of LLCs and LPs versus corporations (at seemingly a 3:1 rate). But that doesn’t mean alternative entities always choose to keep their form. I was discussing this issue with a friend and practicing lawyer who mentioned that, in his transactional practice, when Delaware LLCs become big, and attract big funds, a condition of investment almost always requires an LLC to convert into a Delaware corporation. It seems that the lack of predictability associated with the freedom of contract scares potential investors who prefer the comforts of fiduciary duties, among other corporate staples. Upon some reflection, this anecdotally lines up with my experience as best as I can remember. So the parties who ostensibly are best served by contractual freedoms—i.e., sophisticated parties—appear to be the ones most likely to demand the traditional corporate form. And on a related note, this helps to explain why such a paltry number of LLCs and LPs have become public companies.

Crowdfunding and Venture Capital - A Response

As Steve Bradford mentioned in his post on Monday (sharing his cool idea about mining crowdfunded offerings to find good firms in which to invest), our co-blogger Haskell Murray published a nice post last week on venture capital as a follow-on to capital raises done through crowdfunding.  He makes some super points there, and (although I was raised by an insurance brokerage executive, not a venture capitalist), my sense is that he's totally right that the type of crowdfunding matters for those firms seeking to follow crowdfunding with venture capital financing.  I also think that, of the types of crowdfunding he mentions, his assessment of venture capital market reactions makes a lot of sense.  Certainly, as securities crowdfunding emerges in the United States on a broader scale (which is anticipated by some to happen with the upcoming release of the final SEC rules under Title III of the JOBS Act), it makes sense to think more about what securities crowdfunding might look like and how it will fit into the cycle of small business finance.

Along those lines, what about debt crowdfunding as a precursor to venture capital funding?  Andrew Schwartz has written a bit about that.  Others also may have taken on this topic.  Professor Schwartz may be right that issuers will prefer to issue debt than equity--in part because it may prove to be less of an impediment to later equity financings.  But I don't necessarily have a warm feeling about that . . . .

And what about the crowdfunding of investment contracts (e.g., what I have previously called "unequity" in this article (and elsewhere, including in this further article) and perhaps even the newly popular SAFEs)?  There is no equity overhang with unequity and some other types of investment contract, but crowdfunded SAFEs, which are convertible paper, may be viewed negatively in later financing rounds--especially if the conversion rights are held by a wide group of investors.  While part of me is surprised that people are not taking the investment contract part of the potential securities crowdfunding market seriously (since folks were crowdfunding investment contracts before the JOBS Act came along--not knowing it was unlawful), the other part of me says that crowdfunded investment contracts would have a niche market at best.

So, thanks, Haskell, for the food for thought.  No doubt, more will be written about this issue as and if the market for crowdfunded securities develops.  Coming soon, says the SEC . . . .

Crowdfunding as a Strategy to Attract Venture Capital?

Recently, a number of the sports media outlets, including ESPN, the Pac-12 Network, and Fox Sports featured a company called Oculus that makes virtual reality headsets used by Stanford University quarterback Kevin Hogan, among other players, to prepare for games.

In 2012, Oculus raised about $2.4 million from roughly 9,500 people via crowdfunding website Kickstarter. Following this extremely successful crowdfunding campaign, Oculus attracted over $90 million in venture capital investment. In mid-2014, Facebook acquired Oculus for a cool $2 billion. 

Oculus is only one example, but it caused me to wonder how many companies are using crowdfunding to attract venture capital, and, if so, whether that strategy is working. This study claims that 9.5% of hardware companies with Kickstarter or Indigogo campaigns that raised over $100,000 went on to attract venture capital. Without a control group, however, it is a bit difficult to tell whether this is a significantly higher percentage than would have been able to attract venture capital money without the big crowdfunding raises. 

If I were a venture capitalist (and I was raised by one, so I have some insight), I would see a big crowdfunding raise as potentially useful evidence regarding public support for the company and/or product demand. Crowdfunding, in some cases, might also be a helpful check on venture capitalist groupthink and biases. 

As a venture capitalist, however, the type of crowdfunding used would matter to me. In most cases, I imagine I would see a large gift-based or rewards-based crowdfunding raise as a significant positive. Gift-based crowdfunding is essentially free money for the company, and reward-based crowdfunding usually comes with minimal costs or is simply pre-ordered product. Gift-based or rewards-based crowdfunders could create some negative press for the company when the company raises outside money, as the crowdfunders did in the Oculus case (see here and here), but that seems like a relatively small problem in most cases.

In contrast, the costs and risks associated with equity crowdfunding, in the states it is currently allowed, would raise at least a yellow flag for me. Equity crowdfunding comes with so many strings attached to various small shareholders that I could see it scaring off venture capitalists. The administrative headache, plus the risk of multiple lawsuits from uninformed investors seems significant. In addition, owners who have engaged in equity crowdfunding have a smaller percentage of equity in their hands and may have raised the crowdfunded money at an unattractive valuation.

At least two of my co-bloggers have written significant articles on crowdfunding (see, e.g., here and here), so perhaps they will weigh in on whether they have seen companies using crowdfunding as a strategy to attract venture capital, whether it is working, and whether the type of crowdfunding really matters.