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When do transactional business lawyers add value to projects?  The literature tells us that transactional business lawyers can help correct information asymmetries and facilitate regulatory arbitrage through their knowledge and skills.  That all seems right.  But how can that message and other conceptions of value be conveyed to first-year law students in less than two hours in a mandatory, S/NC course (i.e., a course in which some–maybe many–of the students do not really want to be there and believe they have better uses for their time)?  Welcome to my world, for today . . . .

Steve Bainbridge has a nice blog post relating to transactional business lawyers that our students are required to read before class.  (Thanks, Steve!)  We will discuss the absence of transactional business lawyers in popular culture, elucidate the value propositions they represent in real life, and work through some business transactional scenarios that illustrate the value (or lack thereof) of involving lawyers in the matter.  I have worked out the class plan with my co-instructor (who cannot be there for this class meeting).  But I am looking for more.

What, in your view, must I ensure that I cover–and how?  Are there videos or charts that you recommend I “check out” for potential presentation to the class?  I teach the main session on this topic tomorrow afternoon (and I had hoped to post this yesterday . . .), but I can always come back to this topic in a future class meeting, if I play my cards right.  Let me know if you have ideas or views.

These days, it often seems like technology is eradicating the difference between our public and private selves, and apparently, the SEC is going down the same path with respect to companies.

Matt Levine at Bloomberg is fond of saying that private markets are the new public markets, by which he means that companies no longer seek to raise capital by tapping the public markets; instead, they do that in private offerings, and turn to public markets when early investors want to cash out.  This is made possible by the fact that Congress and the SEC have, over the years, loosened many of the rules that required companies seeking large capital infusions to register their shares publicly.  Today, due to Rule 506 and other exemptions, companies can grow to enormous sizes solely based on the investment of accredited investors.  These investors are usually institutions, like venture capital funds, but also the stray mutual fund or sovereign wealth fund.  Other rule amendments have made it easier for private companies to pay their employees in stock and stock options, which allows them to free up capital.

But now the SEC is working to make it easier for new classes of individuals to invest in these private companies.  First, it has proposed changes to the definition of “accredited investor,” to allow people to qualify based on their expertise.  The expansion is relatively narrow now, but I assume it’s a foot in the door for further rule changes that will open the door for more “expert” individuals to invest in private companies.  And apparently, the Commission is also considering a program to allow platform workers for private companies – like Airbnb hosts, and so forth – to receive equity as part of their compensation.

Now, I posted before about the risks to private company workers when they receive equity compensation.  The current rules were enacted on the theory that company employees are likely to have intimate knowledge of the business and therefore don’t need the protections of mandatory disclosure, but that’s not likely to be true of the enormous private companies that exist today.  Plus, employees are unlikely to understand how the preferences granted venture capital investors dilute the value of their common stock holdings.  That’s why, for example, Yifat Aran has proposed amendments to the rules that would recognize employees’ informational disadvantage in larger companies.

Given that – not to mention the spectacular recent failures of large startups, like WeWork, and the obvious fact that even “hot” private companies like Uber and Lyft have struggled in the public markets – it seems particularly incongruous that the SEC is considering allowing gig workers (who are likely to have even less insight into corporate operations than ordinary employees) to invest. 

But the implications go further.

The SEC and Delaware are in a peculiar sort of dance; federal changes to the relationships between investors and managers necessarily shape Delaware law.  I’ve mentioned before that Delaware has reformed a lot of its corporate law around the expectation that most investors are large institutions trading in public markets, who are less in need of judicial protection.  Thus, as I’ve written about and discussed in this space, the rise of large private companies is one factor that has strained Delaware’s definition of a controlling shareholder.  Meanwhile, newly proposed federal regulatory moves to limit shareholder power may have the perverse effect of causing Delaware to engage in more muscular oversight of management.  And that’s equally true when federal regulation works at the retail investor end, by encouraging more ordinary persons to invest in private companies.  As Elizabeth Pollman has documented, these companies may have exceedingly complex capital structures that are fraught with different kinds of conflicts, which, of course, is likely to give rise to more litigation. 

In In re Trados Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013), VC Laster fired a shot across that bow by warning venture capitalists that they have fiduciary obligations to prioritize the common stockholders in their management of the company.  A survey by Abe Cable found that Trados’s impact on venture capital practices has been modest, though boards may express more concern for the common when in sale mode.  But I’m betting there’s going to be more where that came from, because as the SEC encourages unsophisticated investors to leap into private markets – where the protections of disclosure, common trading, and federal board independence requirements are lacking – Delaware will be drawn into the fray, and will no longer be able to comfortably rely on simple maxims that a shareholder vote ratifies all.

We even have a preview of coming attractions in a current dispute involving Juul.  Juul apparently required its employee-shareholders to waive their inspection rights under Section 220, and the enforceability of that waiver is currently being litigated.  If Delaware finds waivers are permissible, the next step will be for companies to insert such waivers in their charters or bylaws – and apart from the effect on public companies, these moves will leave private company investors, specifically, without access to information unless they bargain for it.  And that’s going to mean employees, gig workers, and similar investors will be at an extraordinary informational disadvantage.  (You can read more about on issues of waiver and inspection rights in George Geis’s paper, Information Litigation in Corporate Law)

Of course, it may turn out that all of these companies simply contract for individualized arbitration of shareholder disputes and leave Delaware out of it entirely, which will be much easier to do if they remain private, and thus maintain contractual privity with their investors.  And even if “private” secondary market platforms expand and companies no longer directly contract with purchasing shareholders – so that there is no obvious contract in which to insert the arbitration clause – companies may simply adopt charter and bylaw provisions that require individualized arbitration.  Yes, of course, Delaware law currently prohibits that, but if the Delaware Supreme Court decides that charters and bylaws are just ordinary contractual terms that can include limits on securities claims, and if we then move to the obvious next step of putting securities arbitration provisions in corporate bylaws and charters, Delaware will have a harder time maintaining that its current arbitration prohibition passes muster under the Federal Arbitration Act.  So maybe it is the death of corporate law, after all.

In any event, what we’re seeing in broad strokes is the erosion of the public/private distinction in securities law, in favor of something that looks more like a continuum.  (We may even see limits on the ability of retail investors to buy public company shares that are deemed too risky).  And that, of course, not only threatens to rob the market of the valuable externalities provided by generalized public trading subject to standardized comprehensive disclosures (see Elisabeth DeFontenay, The Deregulation of Private Capital and the Decline of the Public Company; see also Jesse Fried and Jeffrey Gordon on bubbles in private markets and, ahem, me on the implications of the WeWork debacle), but also places enormous weight on regulators’ judgment as to who, precisely, has the exact level of sophistication and risk tolerance to invest in what kind of company.

California Western’s Catherine Hardee, recently posted her paper Schrodinger’s Corporation: The Paradox of Religious Sincerity in Heterogeneous Corporations to SSRN.  It’s a fascinating piece and has already been featured on Ipse Dixit if you’re curious about a podcast version.

Her abstract sets the key problem out well:

Consider a corporation where one group of shareholders holds sincere religious beliefs and another group of shareholders does not share those beliefs but, for a price, will allow the religious shareholders to request a religious exemption to a neutrally applicable law on behalf of the corporation.  The corporation is potentially both religiously sincere and insincere at the same time. A claim by the corporation for a religious accommodation requires the court to solve the paradox created by this duality and declare the corporation, as a whole, either sincere or insincere in its beliefs. While the Supreme Court and scholars have noted some of the particular issues raised when determining the religious sincerity of shareholders’ claims, to date no one has engaged systematically with the question of whose religious sincerity should be attributed to the corporation when shareholders hold heterogeneous, or diverse, religious beliefs.

One possible solution to the problem might be to allow ordinary private ordering to address the issue.  The board could designate one share class with the right to control the corporation’s religious beliefs about birth control.  So long as the holder of those shares sincerely held the belief, it could settle the question of what religious view to attribute to the corporation.

Hardee takes a hard look at this commodification of religious sincerity and explores how it could harm religious freedom generally.  She creates a framework for considering how to resolve these questions and cautions against using contracts to barter for religious exemptions.

I promised to check back in after negotiating The House on Elm Street (here).  I’m checking in!  We negotiated this exercise – which contains both legal and ethical issues – in my MBA Business Ethics/Legal course this evening.  It proved to be a great learning experience.  My previous post mentioned that Professor Siedel had made its use easy by creating thorough teaching notes.  And as I suspected, while it might be ideal to have students read a negotiation text or have a full 75 minutes to debrief the exercise, neither proved essential to a valuable learning experience.  It also provided a great segue into agency law, another of tonight’s topics.

During our discussion of ethical issues, I mentioned Professor Clayton M. Christensen’s How Will You Measure Your Life?  This past week, this question became particularly poignant.  Christensen, one of Harvard Business School’s leading lights, passed away at the age of 67.  Several years ago, BYU Law School Dean Professor Gordon Smith and I started “The Business Ethics Book Club for Law Professors.”  The wonders of technology enabled several of us business law professors from all over the country to gather virtually about once a semester for a few years to read books on ethics, including Christensen’s book, which were generally written by business school professors.  It’s a short, but powerful read.  I highly recommend it to all BLPB readers.  My recollection is that it was a popular book club selection too!

In this book, Christensen (and coauthors) seek to answer three simple questions:  “How can I be sure that”: 1) “I will be successful and happy in my career?”, 2) “My relationships with my spouse, my children, and my extended family and close friends become an enduring source of happiness?,” and 3) “I live a life of integrity – and stay out of jail?” (p.6) Christensen wasn’t a business ethics professor.  Rather, the book’s prologue explains that one of Christensen’s courses was Building and Sustaining a Successful Enterprise, in which “we study theories regarding the various dimensions of the job of general managers.  These theories are statements of what cause things to happen – and why.” (5)  On the last day of the course, instead of using these theories to examine organizations, the class used these theories to study themselves: “We are there to explore not what we hope will happen to us but rather what the theories predict will happen to us, as a result of different decisions and actions…Year after year I have been stunned at how the theories of the course illuminate issues in our personal lives as they do in the companies we’ve studied” (p.6)  According to Amazon, this is “the only business book that Apple’s Steve Jobs said “deeply influenced” him.”  And it’s not the only time Christensen’s work has been widely praised.  His breakout work, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, was heralded by some as “one of the six most important business books ever written.”  Without doubt, both books are great, worthwhile reads.

(revised 1/29/20)

Although I had to miss the American Bar Association’s LLC Institute this past year, it looks like I can still get the benefit of some of the wisdom shared there in written form.  FSU Law Dean Emeritus and Alumni Centennial Professor Don Weidner has posted an article, LLC Default Rules Are Hazardous to Member Liquidity, based on the thoughts he shared as the keynote speaker at that annual event.  The SSRN abstract follows:

This article is based on the author’s Keynote Address at the 2019 LLC Institute sponsored by the American Bar Association’s Business Law Section. It traces and critiques the shift in the default rules in LLC law away from partnership law and toward corporate law, using the Uniform LLC Acts of 1996 and 2006 as exemplars of the national trend. It focuses on two key issues: the removal of liquidity rights, both the right to dissolve and the right to be bought out, and the removal of easy access to member remedies. It argues that, on both key issues, the default rules have moved away from enforcing the presumed intent of small groups of entrepreneurs who form businesses without the benefit of counsel. By forming LLCs, entrepreneurs across the country are now unwittingly locking themselves in to perpetual entities that offer them no liquidity and present them with costly procedural obstacles to enforcing both their rights under the operating agreement and their statutory rights.

I look forward to reading this.  SSRN: it’s the next best thing to being there–at least in this case.  I am grateful to Don for writing up his thoughts on the migration of limited liability company default rules (away from partnership norms and toward corporate norms) and for mentioning this work to me in a recent conversation and email message.

As a new dean in a new city, I have had the opportunity to meet hundreds of impressive lawyers in Omaha.  I have been incredibly impressed by the sophisticated practices at the very law firms I have visited. For “midsized” firms, there are lawyers doing incredible work here that is the same work being done on the coasts, including some amazing M & A work. 

But here in Omaha, just like every city around the country, law firms have “corporate” practices.  But really, those are business law practices or transactional practices.  Almost every corporation of significant size also owns some LLCs (limited liability companies) and perhaps other entities. And certainly these firms, especially those working with real estate companies, will work with LLCs and other pass through entities.  

So, consistent with my prior posts on this subject, I urge lawyers and firms to acknowledge the full scope of what we do.  It’s not just corporate.  It’s so much more. And that’s a good thing. I just ask that we embrace business practice or transactional practice to try to include all we do.   

 

 

 

One of the things I’ve talked about before is how courts adjudicating securities claims must perennially police the line between “fraud” and “mismanagement.”  The issue goes back to the Supreme Court’s decision in Santa Fe Indus. v. Green, 430 U.S. 462 (1977), which held that “the language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.”  Thus, Section 10(b) claims cannot be based on mismanagement or breach of fiduciary duty alone.

That said, as federal securities regulation increasingly enters into the governance space, the distinction between fraud and mismanagement is harder and harder to identify.  In general, courts hold that if there’s been a false statement, then the claim is properly stated as securities fraud; if not, not.  The problem is, as the SEC imposes more and more disclosure requirements, many of which concern core aspects of governance (ethics codes, risk taking, and whatnot), the “deception” test does not seem to emotionally do the work of distinguishing a claim based on poor governance from a claim based on fraud.

As I’ve repeatedly blogged about – and written articles about, most extensively in Reviving Reliance– given this problem, courts have deployed a number of doctrines to dismiss claims that feel more governance-y than fraud-y, the most prominent of which is puffery.  Puffery, ostensibly, refers to statements that are so vague or hyperbolic that they are essentially without content, but it’s often used to toss claims that courts feel just don’t belong in the securities space.

Anyhoo, I lay out the theory in more detail in the links above, but for today, I want to highlight a recent example of the phenomenon, In re Liberty Tax Securities Litigation, 2020 WL 265016 (E.D.N.Y. Jan. 17, 2020).

In this case, the CEO, who was also the controlling shareholder, was accused of using the company to “advance his romantic and personal interests.”  Which basically means he conducted romantic relationships in the office, including dating employees and bringing them along on business trips.  The false statements that formed the basis of the claim included representations that the company’s internal controls were “effective,” and risk warnings that the CEO’s interests as a controlling stockholder might differ from those of the other stockholders.

This is, to be sure, weak sauce.  And speaking as a former plaintiffs’ attorney, I read this and the first thing I think is, why was this case even brought?  There wasn’t a stock price drop upon revelation of the misconduct, so whose bright idea was it to file a complaint?

Well, it turns out, after the CEO’s unprofessional conduct was revealed, he was actually fired (which itself is remarkable, given his voting control), the company’s auditor resigned, and there was some board turnover.  That’s the kind of thing that catches the attention of a plaintiff’s attorney, and my guess is that we’re seeing the results of some of the perverse incentives created by the Private Securities Litigation Reform Act (PSLRA).

Once upon a time, the first plaintiff to file a complaint got to control a securities fraud class action – which incentivized attorneys to file poorly-researched complaints the moment there was any hint of fraud.  In 1995, the PSLRA changed the system: Now, the court considers multiple applicants for the “lead plaintiff” slot, selects the one most appropriate – usually the one who has the largest loss – and that lead plaintiff selects lead counsel.  The theory here is that because there’s no advantage to filing early, counsel will seriously research a case before filing a complaint.  And the kind of large, institutional clients who have large losses, and thus are viable contenders for a lead plaintiff appointment, will expect such research, and refuse to sign on until they see the work.

I actually think the PSLRA’s lead plaintiff provisions are the best things about the PSLRA, but in this respect, they didn’t play out as expected.  Specifically, there is little incentive for counsel to expend the resources to research a case – which can include hiring an investigator, hiring an accountant, and spending multiple attorney hours combing through news reports and SEC filings – before they’re sure they will be appointed lead.  Instead, what tends to happen is that counsel identifies cases that look promising, pitches the idea to a potential institutional client who experienced a large loss, the client hires them, and then counsel and client seek a lead plaintiff appointment.  After the court appoints lead plaintiff and counsel, the serious research begins.  But at this point, counsel is committed.  The last thing they want to do is discover there’s no fraud, and go back to the valuable client – who they hope will hire them for future cases – and admit error.  So counsel will continue to pursue the case even if there’s no there there.

If I had to wager – and I am just drawing inferences based on the opinion – I’d say this is what happened in Liberty Tax.  KPMG resigned and the controlling shareholder was fired by his own board: HUGE red flags!  Plaintiffs’ counsel jumped, assuming accounting shenanigans would eventually turn up.  But none did, either because there were none to be had, or because they were buried deep enough that without discovery (which the PSLRA blocks before resolution of the motion to dismiss), nothing could be established.

And rather than drop the case and confess error to the client, counsel made the best of a bad situation, arguing that the CEO’s boorishness and self-dealing amounted to fraud because the company claimed it had effective internal controls.

The court, clearly, sensed all of this: We’re looking at something like classic controller breach of duty, tunneling, misuse of corporate resources for personal gain, what-have-you.  But none of that counts as fraud under Section 10(b) without a clear misrepresentation, and “internal control deficiencies” doesn’t capture what’s going on here.  Internal controls concern appropriate recordkeeping, ensuring that material information is communicated to management, ensuring that unauthorized persons cannot alter records, and so forth. For all the CEO’s sins, there’s no allegation that expenses were misrecorded in the company books, or that – if they were – the errors were ever disclosed to the public or caused plaintiffs any losses.

Rather than say that, however, the court held that representations as to the effectiveness of internal controls are “puffery,” namely, that they were “too general to cause a reasonable investor to rely upon” them.

But that really misunderstands and distorts the concept of internal controls.  Internal controls are a critical aspect of corporate governance, and they have a fairly defined meaning with respect to accounting and information flow within the firm.  Saying they are effective is not, in other words, the equivalent of saying “world’s best coffee!”

Moreover, ever since Sarbanes Oxley, corporate officers are required to disclose whether internal controls are effective.  It is perverse to suggest that these mandated disclosures – which the SEC, and Congress, clearly think are critically important to investors – are immaterial as a matter of law.  (That’s also how I feel about codes of ethics, by the way, which have also been held to be puffery – most recently in the case concerning undisclosed sexual harassment at CBS, Construction Laborers Pension Trust for Southern California v. CBS Corporation, 2020 WL 248729 (S.D.N.Y. Jan. 15, 2020) – but that’s an argument for another post.)  I mean, imagine we had an actual, for real case of accounting fraud, where the internal controls did not in fact prevent unauthorized entries and expenditures, and the CEO knew it and lied about it.  Would we seriously say that was puffery?  Well, after this opinion, that’s certainly what defendants are going to argue.

So I come back to where I started, which is, courts are grasping for some basis to distinguish poor governance from fraud.  Given today’s disclosure requirements, not to mention new demands for investors to act as stewards, that may be a fruitless exercise, but in the meantime, courts seem to be treating just about any statement about internal governance and corporate procedure as “puffery.”  Which means that the concept of “puffery” has drifted from its original meaning – vague and unfalsifiable self-praise – to become synonymous with, “I know fraud when I see it, and this isn’t really fraud, exactly.”

On January 17, I headed to the University of Florida’s Warrington College of Business to be a discussant at the Huber Hurst Seminar.  A great event!  On the same day, Randal K. Quarles, the Vice Chair for Supervision (a position created by Dodd-Frank) and Governor of the Federal Reserve System gave a speech, Spontaneity and Order: Transparency, Accountability, and Fairness in Bank Supervision, at the 2020 American Bar Association Banking Committee Meeting.  Legal scholars have focused scant attention on bank supervision in the past, but this is starting to change.  It can be a challenging area to work in as Wharton Assistant Professor Peter Conti-Brown explains in The curse of confidential supervisory information.  Indeed, confidential supervisory information is protected from disclosure with criminal penalties.     

Bank regulation (which has received a bit more attention) and bank supervision, though linked concepts, are distinct.  Supervision “implements the regulatory framework.”  An important tension exists in banking supervision.  In his speech, Quarles explains that “We have a public interest in a confidential, tailored, rapid-acting and closely informed system of bank supervision.  And we have a public interest in all governmental processes being fair, predictable, efficient, and accountable.  How do we square this circle?”  It’s an important question.  Quarles terms it “a complex and consequential issue that, for decades now, has received far too little attention from practitioners, academics, policymakers and the public.” 

Quarles’ speech makes several suggestions regarding “some obvious and immediate ways that supervision can become more transparent, efficient, and effective.”  To improve transparency, he makes three proposals: 1) “create a word-searchable database on the Board’s website with the historical interpretations by the Board and its staff of all significant rules,” 2) “putting significant supervisory guidance out for public comment,” and 3) “submitting significant supervisory guidance to Congress for purposes of the Congressional Review Act.”

All three proposals strike me as reasonable.  What would be the drawback of the Board making interpretations of significant rules transparent and easily accessible?  Regulatory guidance, as opposed to rules, is not legally binding.  Yet in reality, there may be no difference in practice.  I’d welcome both additional public comment on significant supervisory guidance and review by Congress.  However, it’s also critical that a variety of stakeholders, especially academics, policymakers, and the public, actively participate in these processes.