Last Monday, the Financial Stability Board (FSB) released the consultative document, Guidance on financial resources to support CCP resolution and on the treatment of CCP equity in resolution (here).  As readers know, I’ve written several times about clearinghouses, the central feature of the G20’s reforms to the over-the-counter derivative markets following the 2007-08 crises, implemented in the US in Dodd-Frank’s Title VII (for example, here and here).    

The Guidance’s title is a succinct encapsulation of its two-part focus.  In the first part, it uses a five-step process to evaluate the adequacy of a CPP’s resources and available tools to support its resolution (were that to prove necessary).  These steps include:

Step 1: identifying hypothetical default and non-default loss scenarios (and a combination of them) that may lead to resolution;

Step 2: conducting a qualitative and quantitative evaluation of existing resources and tools available in resolution;

Step 3: assessing potential resolution costs;

Step 4: comparing existing resources and tools to resolution costs and identifying any gaps; and

Step 5: evaluating the availability, costs and benefits of potential means of addressing any identified gaps.     

In the second part, the Guidance focuses on how to treat CCP equity in resolution.  A resolution of a CCP would be distinct from a “wind down” of the CCP.  Readers might ask why one would have to think about such a thing – equity will likely get wiped out, right?  Not necessarily.  Today, most CCPs are shareholder-owned, but the CCP users/customers (clearing members) are mostly on the hook for any losses resulting from a user’s default.  As I’ve written about in Incomplete Clearinghouse Mandates (here), this creates a foundational incentive problem because the shareholders benefit from the CCP’s profits, but the users are primarily responsible for any default losses. 

As the Guidance notes, in theory, CCPs could experience losses due to user defaults, non-default issues, or a combination of both.  How CCPs owned by shareholders will allocate losses between themselves and users in a “combination” scenario is completely unclear (allocation of non-default losses is also unclear in many cases) and should be addressed as I’ve noted before (here).  Should the combination scenario arise, I think loss allocation will prove to be an intractable problem. 

In reading the second part of the Guidance, one realizes how complicated and legally fraught the question of CCP equity could be in a resolution given the status quo.  Towards the end of the second part, the Guidance states that:

Based on the analysis undertaken in accordance with the previous sections, the relevant home authorities should address the challenges relating to CCP equity fully bearing losses in resolution. This may include, where possible, that home authorities having the relevant powers and authority require that CCPs modify their capital structures, rules or other governance documents in a manner that subordinates shareholders to other creditors or sets out the point at which equity absorbs losses in legally enforceable terms. This may also include identifying or proposing potential changes to laws, regulations or powers of the relevant supervisory, oversight or resolution authorities that would enable achieving the resolution objectives or limit the potential for NCWOL claims.

In the short term, the last sentence of this quote likely offers a more feasible approach to handling CCP equity than what I think would be a more sensible approach: addressing the ownership structure of these institutions.  This would almost certainly be much more difficult to implement in practice, but it’s ultimately a simpler, more sensible long-term solution for addressing CCP equity in resolution and for addressing loss allocation under a combination scenario.  Until we fix this foundational issue of ownership, we shouldn’t be surprised if the path of a distressed, systemically significant clearinghouse ultimately resembles that of the government‐backed mortgage lenders whose fate more than 11.5 years after entering government conservatorship still remains uncertain. Let’s not repeat this history!   

I’ve blogged a lot about the complexities of Delaware’s controlling-stockholder jurisprudence (here, here, here, here, here, and here), and written an essay on the subject.  The latest Chancery opinion on this issue, Gilbert v. Perlman, represents another, unusual, addition to the genre.

In Gilbert, Francisco Partners was the controlling stockholder of Connecture with a 56% stake.  During its tenure, however, it worked closely with Chrysalis Ventures, a firm that it had coordinated with in prior ventures, and who was the next largest Connecture blockholder with an 11% interest.  A Chrysalis partner, Jones, also served as Connecture’s Chair.  Eventually, Francisco proposed to buy out the minority Connecture shareholders in a deal that was neither conditioned on the approval of an independent director committee nor a majority of the minority shareholder vote.

According to the proxy statement, the Connecture board, in the course of its internal deliberations, considered it important that Chrysalis support any proposed transaction.  Chrysalis suggested that it be permitted to roll over its shares in the new entity, which would, it believed, allow Francisco to bump up the price for the remaining minority shareholders.  A few days later, Jones asked for the same participation rights personally.  A deal on these terms was struck.  The unaffiliated shareholders, however, were unimpressed by the arrangement, voting only 9.9% in favor of the deal.  But their votes were unnecessary and the merger closed.

Two minority shareholders of Connecture filed suit alleging that Francisco, as controller, breached its fiduciary obligations.  Because Francisco had negotiated the deal with essentially no procedural protections for the minority, it was plain this was a transaction that would receive entire fairness review, and Francisco did not even bother moving to dismiss; instead, it simply answered the complaint.  The more complex allegations concerned Chrysalis and Jones: plaintiffs alleged that they had formed a control group with Francisco and thereby shared its fiduciary obligations, and it was that question that Vice Chancellor Glasscock addressed on Chrysalis’s and Jones’s 12(b)(6) motion.

First, Glasscock articulated the basic landscape.  As he put it:

Under Delaware law, “controlling stockholders are fiduciaries of their corporations’ minority stockholders.” That is, where a stockholder may control the corporate machinery to benefit itself, as by exercising voting control, it is a potential fiduciary. Where in fact it exerts such control, a controlling stockholder is bound by Delaware’s common law fiduciary duties of loyalty and care.  Conversely, stockholders who control only their own shares, and cannot exert corporate control, are owed fiduciary duties; they themselves are not obligated to act in the corporate interest….

It is also possible under Delaware law for several minority stockholders to band together to form a “control group.” In this situation, though none are individually controllers, because they act in consort to exercise collective control, the stockholders in the group owe fiduciary duties. To demonstrate the existence of a control group, it is insufficient to identify a group of stockholders that merely shares parallel interests. To form a control group, the stockholders must be “connected in some legally significant way—e.g., by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” By pooling resources in a plan by which they control the corporation, they become fiduciaries.

So, what if we have a controller who joins with minority shareholders?  Do those minority shareholders inherit the same fiduciary obligations of a controller merely by virtue of their agreement, or is more required?  Per Glasscock, we need more:

To create a control group, a controller must go beyond merely permitting participation by other stockholders in the transaction. Instead, the minority-holder’s participation must be material to the controller’s scheme to exercise control of the entity, leading to the controller ceding some of its control power to the minority-holders. In this way, the minority stockholders involved wield their own levers of power as part of the group; this control of the corporate machinery makes them fiduciaries. … [O]nly if the controlling stockholder shares or materially limits its own control power through an arrangement (such as a voting agreement) could a control group potentially be found….

In my view, where a controlling stockholder takes an action joined by minority stockholders, the latter can be deemed members of a control group, and thus fiduciaries, where two conditions exist. There must be an arrangement between the controller and the minority stockholders to act in consort to accomplish the corporate action, and the controller must perceive a need to include the minority holders to accomplish the goal, so that it has ceded some material attribute of its control to achieve their assistance. In order to survive a motion to dismiss, a plaintiff advancing this unusual theory must plead facts that permit a reasonable inference that these conditions exist.

Alas for the plaintiffs, they were unable to make such a showing.  They definitely demonstrated the existence of an arrangement to act in concert – indeed, the parties disclosed in the proxy statement that they had entered into a voting agreement – and Chrysalis and Jones even received a nonratable benefit, namely, the right to rollover their stock.  But the plaintiffs did not show that Francisco needed them in any way, or ceded its power, such that they shared fiduciary obligations with Francisco.  As Glasscock put it:

if the Plaintiffs could have pled that Francisco Partners needed something material in way of its take-private scheme, and was accordingly willing to give up some material part of its control attributes to Chrysalis and Jones to get it, they may have adequately made the allegation that a control group existed here. The Complaint, however, points to neither quid nor quo—it describes nothing Francisco Partners needed or ceded to the Moving Defendants, other than the bare right to roll over shares.

The logic has a certain surface-level appeal.  With great power comes great responsibility, and absent power, the responsibility does not follow.  Therefore, gratuitous receipt of a controller’s largesse is not sufficient for the beneficiary to take on the controller’s responsibilities.

But beneath that simple maxim lies a raft of complexity.

First, as a practical matter, we may have trouble identifying which test applies.  Recall, the rule is, in order to show that shareholders were working together – such that minority blockholders become controllers in the first instance – plaintiffs only need show the existence of an agreement.  The enhanced test, requiring that the controller actually engage in a quid pro quo with someone else, only comes into play once the existence of a controlling shareholder is established.  So imagine you have a large minority blockholder working with another, smaller blockholder.  If the larger minority blockholder is incapable of exercising control on its own, the two together will owe fiduciary obligations if they reach an agreement; if, however, the larger blockholder does exercise control on its own, an agreement is not sufficient; the plaintiff will need to show that some of that power was ceded to the smaller in order to bring a claim against the two together.  Given the inherent uncertainty associated with determining whether a minority blockholder exerts control in the first instance (see, ahem, my essay), you can already imagine the bizarre and conflicting set of incentives under which both plaintiffs and defendants will labor in order to make their cases at different stages of litigation.

Or, imagine you have three minority shareholders, any two of which are sufficient to control the entity.  If the three shareholders combine, is only the third subject to the enhanced test?  What if it’s not clear which are the “two” and which is the “third” – especially if the original two are alleged to have control from a minority (under 50%) position?

Maybe this is an angels-on-pinheads concern – after all, this scenario doesn’t come up much in general, and it probably doesn’t come up much with triad combinations – but we might further delve into what counts as a “benefit” to the controller that justifies a finding of a quid pro quo.

Here, there was not simply an agreement to act in concert: the minority shareholders received a unique benefit in the transaction, namely, Chrysalis and Jones were given the opportunity to roll over their shares, which was significant for a merger that, by hypothesis, undervalued the minority stake. (The fact that Jones immediately jumped on the deal personally is further evidence that this opportunity had real value, to the detriment of the minority shareholders being squeezed out).

But that was not enough for Glasscock: He required that Francisco have received something of value in exchange.  What possibilities exist?

Here are some ideas.  Apparently, because it was buying fewer minority shares, Francisco was willing to pay more for them (though the financial logic of that is not clear) – which would place it in a stronger legal position both in the (inevitable) fiduciary lawsuit or in an appraisal action.  Plus, by maintaining good relations with Chrysalis, it avoided a lawsuit by Chrysalis itself – a significant threat, given that Jones was Chair of the Board and presumably knew where all the Francisco bodies were buried.

Also, Connecture was an unusual controlled company in that, as far as I can tell, Francisco had only put 2 nominees on a 7 member board (though plaintiffs alleged it had close ties to the remaining members).  Chrysalis, of course, had the Chair.  If Francisco wanted to force a merger through over board/Chrysalis objections, it would have had to go through the process of replacing the existing board members, including Jones.  Could it have done so?  Surely, but it would have taken time and placed it in an even more precarious legal position later.  This is especially so given that, under federal law, Connecture was required to discuss the fairness of the proposed transaction in its proxy statement.  Imagine the difficulty of doing so if the Chair of the board did not agree, or had been forced out in some kind of prolonged dispute.

The point is, even a cursory review of the facts reveals how Francisco benefitted by keeping matters amicable with Chrysalis.  All of these possibilities suggest Chrysalis therefore had some control over the deal’s final shape; after all, the proxy statement itself stated that Chrysalis proposed higher minority shareholder consideration in exchange for its own participation.

So why aren’t these facts enough to meet Glasscock’s test?

One possibility is that this is simply a pleading matter.  If plaintiffs had framed the case with these benefits made explicit, perhaps they’d have survived a motion to dismiss, with further factual development to come after discovery.

But if that’s the case, we might ask why this kind of pleading and proof are even necessary.  If a controller grants a boon to a minority shareholder as part of a conflict transaction, why can’t we assume the controller is getting some kind of “soft” benefit in exchange?  Why else would it ever agree to such an arrangement?  Why can’t we view the specter of this kind of quid pro quo as sufficiently omnipresent to forego the necessity of proof?  After all, we do that with controlling shareholder transactions generally; we assume that they are coercive to the minority even absent specific evidence that minority shareholders actually were coerced.  We could similarly assume that if a controller confers a valuable benefit on a specific minority shareholder in connection with an self-interested deal, it’s not acting out of graciousness.

So the alternative possibility is that these soft benefits – which facilitated the transaction but were not, perhaps, legally necessary to complete it – were not, in Glasscock’s view, significant enough to rate.  But if not, why not?  Does Glasscock require actual proof of the control ceded by the controller (beyond, apparently, Chrysalis’s actual involvement in setting the price for the minority shares)?  Or does Glasscock require different benefits to the controller?  What would those benefits be?

I guess my thinking is, the whole reason we subject controlling shareholder transactions to heightened scrutiny is because we cannot trust the ordinary market mechanisms for disciplining predatory behavior.  But that doesn’t mean controlling shareholders wield unconstrained power; as with anything else, their paths can be made rougher or smoother, and a smooth path may have value to the controller.  As a result, even minority blockholders may wield influence.  They can use that influence to ally themselves with the remaining minority, and thus make transactions more fair, or to ally themselves with controllers, in order to receive private benefits.  To the extent Delaware law is designed to encourage “good” behavior that minimizes the need for judicial intervention, shouldn’t the rules in this area incentivize those blockholders to either maintain an alignment of interests with the minority shareholders, or bear legal responsibility for them?

Glasscock’s framing of the inquiry suggests some skepticism toward the notion that a controller would ever cede power to a minority blockholder, so that a plaintiff must allege an unusually explicit arrangement before the scenario will be contemplated.  But, as I’ve repeatedly discussed in this space, control is not a simple on/off switch.  Even a 56% stockholder may encounter obstacles in a take-private deal despite its legal ability to force it through. Delaware’s repeated insistence on viewing control through a black/white lens glosses over the practical realities of how control is often exercised, putting its doctrine at odds with the underlying reality.

After finishing Aldous Huxley’s Brave New World, I devoured Neil Postman’s Amusing Ourselves to Death. Published in 1985, Postman’s thesis is that Huxley in Brave New World, not George Orwell in his dystopian novel 1984, more accurately predicted life in the modern United States. In the forward to his book, Postman writes:

Contrary to common belief even among the educated, Huxley and Orwell did not prophesy the same thing. Orwell warns that we will be overcome by an externally imposed oppression. But in Huxley’s vision, no Big Brother is required to deprive people of their autonomy, maturity and history, As he saw it, people will come to love their oppression, to adore the technologies that undo their capacities to think.

 

What Orwell feared were those who would ban books. What Huxley feared was that there would be no reason to ban a book for there would be no one who wanted to read one. Orwell feared those who would deprive us of information. Huxley feared those who would give us so much that we would be reduced to passivity and egoism. Orwell feared that the truth would be concealed from us. Huxley feared the truth would be drowned in a sea of irrelevance. Orwell feared we would become a captive culture. Huxley feared we would become a trivial culture. (xix).

Postman argues that we have moved from an Age of Exposition–where print-based works encouraged logic, order, relevant criticism, and deep learning–to an Age of Show Business, dominated by “the language of headlines–sensational, fragmented, impersonal.” (55-70). This shift, according to Postman, has led to a focus on applause over reflection, a focus on image instead of ideas. He compares a 7-hour Lincoln-Douglas debate in the Age of Exposition (44-45) to the 1984 Age of Show Business presidential debates with 5-minute addresses and 1-minute rebuttals (97).  Given the biases of the medium of television influencing the 1984 “debates,” Postman argues that:

in such circumstances, complexity, documentation, and logic can play no role, and, indeed, on several occasions syntax itself was abandoned entirely. It is no matter. The men were less concerned with giving arguments than with “giving off” impressions, which is what television does best. Post-debate commentary largely avoided any evaluation of the candidates’ ideas, since there were none to evaluate. Instead, the debates were conceived as boxing matches, the relevant question being, Who KO’d whom? The answer determined by the “style” of the men–how they looked, fixed their gaze, smiled, and delivered one-liners. (97)

Having watched a number of political “debates,” I must say Postman nails it here, though 5-minute addresses may have shrunk to 2-minutes by 2020! In contrast, on October 16, 1854, Douglas received 180 uninterrupted minutes before Lincoln was given a chance to respond. In a shorter debate on August 21 1858, Douglas received 60 minutes to speak, followed by a 90 minute reply from Lincoln, and concluding with a 30 minute rebuttal by Douglas. Unfortunately, in the modern United States, Postman convincingly argues that “the fundamental metaphor for political discourse is the television commercial….on television commercials, propositions are as scarce as unattractive people…the commercial disdains exposition, for that takes time and invites argument.” (126-31)

Postman claims: 

Those who run television do not limit our access to information, but in fact widen it. Our Ministry of Culture is Huxleyan, not Orwellian. It does everything possible to encourage us to watch continuously. But what we watch is a medium which presents information in a form that renders it simplistic, nonsubstantive, nonhistorical, and noncontextual: that is to say, information packaged as entertainment. In America, we are never denied the opportunity to amuse ourselves. (141)

According to Postman, the Age of Show Business influences everything from how modern books are written to how our education is shaped. His tenth chapter is entitled “Teaching as an Amusing Activity” and starts with intense criticism of Sesame Street. Postman claims, “[w]e now know that ‘Sesame Street’ encourages children to love school only if school is like ‘Sesame Street.’ Which is to say, we now know that ‘Sesame Street’ undermines what the traditional idea of schooling represents.” (143). Postman cites no evidence to support this claim and the research on Sesame Street’s impact seems varied. Nevertheless, Postman argues that the material in the Sesame Street shows is not nearly as important as the way it is taught. Postman writes “the most important thing one learns is always something about how one learns,” not the content of the lesson. (144). In responding to television’s increasing influence, Postman argues that teachers are increasing visual stimulation in the classroom and “are reducing the amount of exposition their students must cope with; are relying less on reading and writing assignments; and are reluctantly concluding that the principal means by which student interest may be engaged is entertainment.” (148-49). 

Postman admits that he doesn’t have strong solutions for the shriveling cultural spirit that he observes (155-63). He is not optimistic about Americans abandoning television nor about attempts to improve the programming. The only hope he sees is education, though he admits that even education may be powerless. Interestingly, Postman (in 1985) claims that he “believe[s] the computer to be a vastly overrated technology.” (161). More accurately he predicted:

[Americans will give computers] their customary mindless inattention, which means they will use it as they are told, without a whimper. Thus a central thesis of computer technology–that the principal difficulty we have in solving problems stems from insufficient data–will go unexamined. Until, years from now, when it will be noticed that the massive collection and speed-of-light retrieval of data have been of great value to large-scale organizations but have solved very little of importance to most people and have created at least as many problems for them as they may have solved. (161) 

I need to do a lot more thinking about this book. Postman makes a compelling case for the shallowness of the Age of Show Business, but I am more hopeful than Postman that students, with the help of professors, can see this shallowness and work in more meaningful directions. While many of us have been immersed in the Age of Show Business for our entire lives, we professors should aspire to much more than mere amusement in education. There is great value in working through dense, difficult material over long periods of time. This difficult work may not be enjoyable in the short-term for students, but it is indispensable for deep work and growth to maturity. Sadly, the pull of the Age of Show Business is quite strong, and maybe the amusing Matt Damon will be cast for the role of professor in future classes. For all our sake, let’s hope not.      

The AALS Section on Professional Responsibility invites papers for its program “Professional Responsibility 2021Works In Progress Workshop” at the AALS Annual Meeting in San Francisco. Two papers will be selected from those submitted.

WORKSHOP DESCRIPTION:

This workshop will be an opportunity to test ideas, work out issues in drafts and interrogate a paper prior to submission. It will pair each work in progress scholar with a more senior scholar in the field who will lead a discussion of the piece and provide feedback. Successful papers should engage with scholarly literature and make a meaningful original contribution to the field or professional responsibility or legal ethics.

ELIGIBILITY:

Full-time faculty members of AALS member law schools are eligible to submit papers. Preference will be given to junior scholars focusing their work in the area of professional responsibility and legal ethics. Pursuant to AALS rules, faculty at fee-paid law schools, foreign faculty, adjunct and visiting faculty (without a full-time position at an AALS member law school), graduate students, fellows, and non-law school faculty are not eligible to submit. Please note that all faculty members presenting at the program are responsible for paying their own annual meeting registration fee and travel expenses.

PAPER SUBMISSION PROCEDURE:

Two papers will be selected by the Section’s Executive Committee for presentation at the AALS annual meeting.

There is no formal requirement as to the form or length of proposals. However, the presenter is expected to have a draft for commentators one month prior to the beginning of the AALS conference.

The paper MUST be a work in progress and cannot be published at the time of presentation. It may, however have been accepted for publication and be forthcoming.

DEADLINE:

Please email submissions to Ben Edwards, Associate Professor of Law, William S. Boyd School of Law, University of Nevada, Las Vegas at Benjamin.Edwards@unlv.edu  on or before September 30, 2020 The title of the email submission should read: “Submission – 2021 AALS Section on Professional Responsibility”

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It’s been eight weeks since the WHO declared the coronavirus outbreak a pandemic, and the NBA cancelled games. As of this writing, the NY Post reports: Total cases globally = 3,662,691; Deaths = 257,239.

In two earlier posts (here and here), I addressed a number of issues and tips related to the emergency remote online teaching that became the norm for most of us in the law academy back in March.  I finished my “classroom teaching” for the semester two weeks ago.  My online timed exam was given last week.  My take-home project in another class is due this week.  I survived; the students survived.  That may be the best I can say for all that. 

However, a larger, long-term issue looms in the background relating to the online teaching we did–and may continue to do–as a result of COVID-19.  That issue?  Whether our current remote teaching will catalyze a movement in higher education, including legal education, to teach more classes online.  If university and law school budgets continue to contract, administrators may see cost-savings in moving more courses online.

This issue has engendered much debate among educators generally.  I bring it to the fore here for consideration in the business law teaching context.  I have mixed feelings about moving clinical, simulation, and standard doctrinal business law courses online. The reasons vary from course to course.  And there is no doubt much that I likely do not see or anticipate that I would want to take into account.  

As a result, I have started reading up on online teaching and online course design, and I have been thinking through my personal experience with remote teaching this semester.  Among the articles I read this past week is this one, which calls on us to push back against central administrative demands to move teaching online.  In fact, I am not opposed to moving some of my teaching online.  But I would want to be able to choose what to move online, when, and how based on quality information and my own assessment of the benefits to and challenges for our learners.

Have you thought about teaching all of your courses online?  If so, I would be interested to know your views . . .  Please share them below, or send me a message.

As I write about derivatives, I’m always excited to see new articles in this area such as Professor Sue Guan’s Benchmark Competition (here; forthcoming, Maryland Law Review).  And I was also delighted to learn that we’d overlapped at Wharton (Guan earning a B.S. in 2009 and, me, a PhD in 2010).  I’ve had a chance to read about Guan’s intriguing article on Columbia Law School’s Blue Sky Blog (here) and look forward to reading the article soon.  Here’s the abstract:

Over-the-counter (OTC) markets—those for currencies, derivatives, swaps, bonds, commodities—make up an immense and critical component of global financial markets. Certain benchmarks, such as the London Interbank Offered Rate (LIBOR), are hardwired throughout these markets and play crucial roles in pricing and valuation. For example, interest payments on instruments ranging from student loans and mortgages to synthetic derivatives are tied to the value of LIBOR. In 2016, estimates of notional exposure to U.S. dollar LIBOR totaled about $200 trillion—ten times U.S. GDP that year. Correspondingly, minuscule variations in a benchmark’s value will impact vast numbers of assets and transactions for hundreds of millions of people.

These benchmarks have become so ubiquitous for an important reason: they have introduced substantial harmonization effects in otherwise decentralized, opaque dealer markets. These benefits fit within the prevailing view of financial regulation: because sophisticated market participants, through wealth-maximizing behavior, tend to select towards structures that maximize efficiency, in aggregate social welfare is maximized, meaning that observed equilibria are likely the most efficient equilibria. And thus, OTC markets have remained largely unregulated for decades.

This Article argues that this understanding is incomplete, and identifies a fundamental misalignment between what is privately optimal and what is socially optimal in OTC markets. By undertaking a novel structural analysis, the Article documents overreliance by market participants on benchmarks even when they are substantially suboptimal. Thus, in contrast to existing reform proposals, which overwhelmingly assume that a single benchmark will continue to dominate, this Article proposes an alternative competitive equilibrium—one where multiple benchmarks compete.

Much of the SEC’s disclosure regime is predicated on the idea of market efficiency: it’s not necessary that companies constantly repeat publicly available information, because that information is already known to, and absorbed by, market participants.  The problem is, even the SEC is never quite sure how far to run with this. 

Case in point: the SEC’s proposal to eliminate Item 303(a)(5), which requires that registrants provide a tabular disclosure of contractual obligations.  As the SEC explains, “We do not believe that eliminating the requirement would result in a loss of material information to investors given the overlap with information required in the financial statements and our proposed expansion of the capital resources requirement, discussed above in Section II.C.2.   As many commenters pointed out, much of the information presented in response to this requirement overlaps with U.S. GAAP and is therefore included in the notes to the financial statements…”

 Both the SEC’s Investor-As-Owner subcommittee, and the Council of Institutional Investors, have objected to the proposal.  For example, the Investor-As-Owner Subcommittee says:

Investors and analysts, however, have informed the subcommittee that the information in the current tabular format is useful and material.  While much of the information can be derived from other places in a Form 10K, it is more complete and substantially less costly and less time-consuming for analysts to gather and analyze, and for investors to use, in its current presentation.  It is not apparent to us that the cost savings from the company side from the proposed change would be greater than the increased costs that dispersed analysts and investors would have to bear from having to gather the information themselves. 

Its potential materiality can be illustrated with a recent analyst report on the cruise line industry, which has been hit particularly hard by the coronavirus.  The report relied on the tabular presentation of contract obligations to compare and contrast cruise lines’ exposures to a mismatch between revenue shortfalls and their near-term obligations.  While a similar analysis could have been done by relying on information in financial footnotes, the substitute analysis would have been less complete and taken longer to execute.  In the current environment, less timely disclosure of this analysis would have been less useful to investors. 

CII says:

Investors find these tabular presentations to be extremely useful, as they compile information that is often scattered throughout the filing into one central location.  For example, in periods in which a company’s liquidity becomes of concern to investors, such as at the present moment, it is useful for investors to be able to turn to a particular section of the filing and readily see what a company’s future contractual obligations are, without having to hunt for each piece of information throughout the filing…

This is also, by the way, an ongoing issue with respect to non-GAAP financial metrics – as long as the GAAP numbers are there, what does it matter if the company releases non-GAAP financials as well?  And yet it does matter, which is why Congress and the SEC regulate non-GAAP disclosures. 

 I’ll note that even as both Congress and the SEC demonstrate some ambivalence about market perfection – not only through non-GAAP regulation, by the way, but also via “crash” damages in the PSLRA context and proposed diversity disclosures – (some) courts continue to assume market perfection and make that the basis of their analysis of securities fraud lawsuits.

Leaving all of that aside, however, one of the more interesting observations is CII’s point that:

We would also note that the preparation of the contractual obligations table is a useful management exercise as it summarizes the obligations in one location and provides management with a picture of such obligations.  We know that what gets measured and disclosed is what gets monitored by management. This is another reason to include the table and enhance as we describe elsewhere herein.  

In other words, it’s not just about whether investors can glean and absorb types of information; the disclosure structure imposed by the SEC dictates board priorities and therefore indirectly polices corporate governance.  This is not a new idea – commenters have long made similar observations – but CII is right that to the extent the SEC is attempting to move to a principles-based disclosure system, it is perhaps not fully recognizing the real governance tradeoffs that accompany more exacting disclosure requirements.

A few securities industry groups hired Gibson Dunn to petition the SEC to abandon its share-class disclosure initiative.  The petition argues that the initiative should have been rolled out as a rule proposal through the notice and comment process instead of simply being announced by the Commission.

The share-class disclosure initiative explained that the SEC had “filed numerous actions in which an investment adviser failed to [disclose] its selection of mutual fund share classes that paid the adviser . . . [12b-1 fee] when a lower-cost share class for the same fund was available to clients.”   The SEC asked advisers to plainly disclose when they put client assets in higher-fee share classes when lower-fee share classes were available.

Let’s pause for a second here.  All the SEC has asked for is disclosure.  It has not asked firms to stop this practice.  It just wants fiduciaries to disclose when they do it.  

Many dually-registered investment advisers have operated this way for years, collecting enormous fees from investors who likely do not understand the conflict.  Nicole Boyson has a fascinating paper on how large, dual-registered investment advisers routinely operate with staggering conflicts.  We talked about an earlier draft of the paper in the Ipse Dixit Podcast here. She also spoke to the Wall Street Journal about the paper.

If you don’t follow the space, this may seem a bit confusing.   An example might help.  Imagine you hire a decorator to advise you and recommend tasteful furnishings for your home or office.  You pay the decorator $15,000 for the service.  The decorator recommends some furniture without telling you that many of the exact same recommended items are available through the decorator’s office at lower prices. The decorator is asking you to pay the higher prices because the furniture producer has a kickback deal where it pays the decorator more if the decorator can dupe you into overpaying.  This is, in essence, the issue with the 12b-1 fee disclosures.  Only it’s actually worse because you would only pay the decorator’s kickback once and you’d be paying the 12b-1 fee for as long as you hold a particular mutual fund.

The petition objects to the Commission’s decision to require clear disclosures.  In essence, it calls for the Commission to allow vaguer, more general disclosures to suffice or to go through a rulemaking process for every disclosure the Commission opts to enforce:

Although investment advisers have long disclosed that they receive 12b-1 fees and that receipt of those fees presents a conflict of interest, as per the Commission’s actual regulations, the Commission has recently claimed that investment advisers are (and were) also required to state specifically that some clients were placed in more expensive share classes where less expensive share classes were available. But, as discussed above, this type of broad disclosure has never been required by any of the Commission’s rules, or any litigated cases.

It’s one thing for a person to say that “I may receive some 12b-1 fees if you buy particular funds.”  It’s another thing for an adviser to disclose that “I recommend the higher-cost share classes to you even though lower cost ones in the same fund are readily available on my platform.  I make more money this way and profit off this conflict of interest even though you already pay me a fee for investment advice.  Under the law, that fee means I owe you a fiduciary duty to eliminate or disclose conflicts. I am not going to eliminate this conflict and have opted to disclose it to you instead.  This is that disclosure.”  

From an investor protection standpoint, it’s hard to see how investors benefit from hiding this information or making it less salient. If we expect the market to police disclosed conflicts, clarity will help investors make better choices.  The Commission should stand its ground to require clear disclosure at a time when assets increasingly shift from brokerage channels to investment adviser channels.  As this happens, the need for more enforcement and clarity in the space continues.

 

 

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It’s been seven weeks since the WHO declared the coronavirus outbreak a pandemic, and the NBA cancelled games. As of this writing, the NY Post reports: Total cases globally = 3,116,398; Deaths = 217,153.