It’s been a minute since I took some time to look at whether courts are still treating LLCs as corporations.  Spoiler alert: They are.  Last week, the Southern District of Florida gave a shining example:

Defendants argue that Vista, a limited liability corporation, is a citizen of any state of which a member of the company is a citizen for diversity purposes. Because the January 26, 2018 written agreement (“Agreement”) granted the PJM Defendants a 10% ownership interest in Vista, Defendants maintain that Vista is a Florida citizen by virtue of the PJM Defendants’ Florida citizenship, thereby destroying complete diversity. . . .

Plaintiffs contend that Vista is a California corporation and complete diversity exists. In support, Plaintiffs proffer Vista’s California LLC records which show that Armen Temurian is the entity’s only member. Defendants argue that these records are self-serving, and that the plain language of the Agreement contradicts these records and establishes the PJM Defendants’ ownership in Vista.  . . .

The Agreement expressly recognizes that the PJM Defendants have obtained a 10% ownership of all Vista current and future direct and indirect entities, which contradicts Plaintiffs’ proffered California LLC records on their face. . . . Because Vista is a citizen of every state that any member is a citizen of, Vista is a citizen of Florida, which destroys diversity. The Court therefore does not have diversity jurisdiction over this matter.

ARMEN A. TEMURIAN, et al, Plaintiffs, v. PHILLIP A. PICCOLO, JR., et al, Defendants. Additional Party Names: George Foerst, Joseph Reid, K.F.I. Software, Kevin Dalton Johnson, Paul Morris, Travelada, LLC, Vista Techs. LLC, No. 18-CV-62737, 2019 WL 5963831, at *3-*4 (S.D. Fla. Nov. 13, 2019) (emphasis added).

The court seems to arrive at the correct conclusion, though without clearly and properly identifying the entities involved, it’s hard to be sure.  Note that here, according to the court, the defendants claim Vista is an LLC ( a limited liability company.) The Plaintiffs replied, the court says, that the company is a “California corporation.” If Vista is an LLC, as it seems to be, and it had members who were also Florida citizens, the court would be correct to find a lack of diversity jurisdiction. Still, it would be a big help if the court would help lay out the facts in an accurate way so that the facts more clearly lead to the legal outcome.

I’ve frequently been asked to express a view on the spectacular decline of WeWork.  Is there a broader lesson here?  Or is this just a bizarre one-off?

I actually think there are a few lessons, and for this week’s post, I’ll start with the one about securities regulation and capital allocation.

One of the primary purposes of securities regulation is to ensure the efficient allocation of capital. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System,  70 Va. L. Rev. 717 (1984); see also Benjamin Edwards, Conflicts and Capital Allocation, 78 Ohio St. L. J. 181 (2017).  SEC Chair Jay Clayton recently gave a speech in which he emphasized that the SEC is “not in the business of dictating a company’s strategic capital allocation decisions,” which is true – the SEC’s job is not to tell market actors where or how to invest – but the SEC is responsible for creating a disclosure regime that facilitates efficient capital allocation via investors’ choices.  And by that measure, the securities laws are failing.

As we all know, the securities laws – both through statutory revisions (JOBS Act) and regulatory interpretation – have made it easier for companies to raise capital without public disclosure.  The theory is that wealthy, institutional investors can bargain for the information they need to make an intelligent investment decision.  But – as others have pointed out – when capital is raised privately, optimistic sentiment can be expressed but negative sentiment cannot.  I’ll go further: Because private-market investors are a small group, they have strong incentives to keep their negative opinions to themselves lest they be shut out of future deals.  Meanwhile, mutual funds have made a deep dive into the private markets, and agency costs infect those decisions: active managers, hoping to improve their market relative to competitors, may well think it would be worse to miss out on a great deal than to make a bad bet that puts their fund on par with everyone else’s.

The result is a bubble of private company valuations that meets reality only when it comes time to go public, as recent experience has demonstrated.  But the injuries are not experienced by these sophisticated investors alone; they’re experienced by all of the other actors whose lives are affected by the allocation of capital to doomed business models.

The New York Times just published an expose on the havoc SoftBank has wreaked internationally by dumping cash into unprofitable startups, which have then gone on to persuade small business owners and independent contractors around the world to upend their plans in hopes of opportunities that never materialize.  Violent and/or fire-laden protests have resulted in Indonesia, India, and Colombia.  Obviously, many of these investments were outside of the scope of American securities regulation, but not all of them, and they serve as a cautionary tale of the consequences when capital is allocated to poorly-designed businesses.  In this, SoftBank is not alone; American venture capital firms have been pouring money into U.S. startups, well beyond amounts that the companies themselves have requested; some founders  apparently feel that if they don’t accept venture capital money they don’t need, the VCs will simply invest in a competitor and drive them out of business. See also Sheelah Kolhatkar, WeWork’s Downfall and a Reckoning for SoftBank (“The fact that the Vision Fund flooded its companies with capital made it difficult for other startups or traditional companies with even a modicum of fiscal discipline to compete.”)

It’s not just the investors or even the founders who suffer; the effects are felt throughout the economy.  SoftBank’s ill-considered bet on WeWork has upended real estate markets on two continents and that doesn’t even get into the effects on employees; even WeWork’s janitorial staff was paid in stock.

Now, I’ve argued that the securities disclosure regime should not be broadly interpreted to encompass the interests of all actors in society; securities disclosure is, at its core, for investors, and if we’re worried about other corporate constituencies – and we should be – we should design a disclosure system for their needs.  But even within the confines of securities disclosure, efficient allocation of capital should be one of the central goals.  And the overwhelming evidence is that, wherever the appropriate line between privatization and “publicization,” the American system has gone too far in the direction of the private.

Recent news reports claim that T-Mobile CEO John Legere may be in discussions with WeWork for him to leave T-Moble to take over as CEO at WeWork.  Legere came to my attention because of social media ads featuring videos of him bedecked in T-Mobile gear and hawking its services.   You’ve probably seen the ads as well. By all accounts, T-Mobile has grown dramatically under his leadership.  Legere’s name recognition and public visibility has also grown with the CEO becoming the ubiquitous face of the company.  In contrast, I cannot readily name or picture the CEOs of Verizon, Sprint, or AT&T.

T-Mobile may have spent millions to promote itself and also generate Legere’s visibility and name recognition.  It’s difficult to recall a T-Mobile advertisement without him in it. He now has about 6.5 million followers on Twitter.  In contrast, T-Mobile itself only has 1.2 million followers.  If he goes to WeWork, will his Twitter account go with him?  What does this mean for T-Mobile’s brand?  Is using corporate resources to secure additional social media followers for yourself ever a breach of the duty of loyalty to the corporation?

This strikes me as a corporate governance issue that boards should be thinking about.  The celebrity CEO strategy comes with its own risks and rewards.  Recall George Zimmer, the former CEO of Mens Wearhouse.  When the Mens Wearhouse board ousted him as the CEO, the Mens Wearhouse also lost their key brand pitchman.

The possible loss of John Legere might be even bigger for T-Mobile.  Legere’s Twitter account even made it into a T-Mobile 10-K.  It’s referenced this way:

Investors and others should note that we announce material financial and operational information to our investors using our investor relations website, press releases, SEC filings and public conference calls and webcasts. We intend to also use the @TMobileIR Twitter account (https://twitter.com/TMobileIR) and the @JohnLegere Twitter (https://twitter.com/JohnLegere), Facebook and Periscope accounts, which Mr. Legere also uses as means for personal communications and observations, as means of disclosing information about us and our services and for complying with our disclosure obligations under Regulation FD. The information we post through these social media channels may be deemed material. Accordingly, investors should monitor these social media channels in addition to following our press releases, SEC filings and public conference calls and webcasts. The social media channels that we intend to use as a means of disclosing the information described above may be updated from time to time as listed on our investor relations website.

 

As a professor, I love it when academic research is front-page news!  So, I was delighted yesterday to see a piece there in the Financial Times, Academics accuse Morningstar of misclassifying bond funds (here – subscription required), on Huaizhi Chen, Lauren Cohen, and Umit G. Gurun’s recently posted SSRN article: Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds (here). 

The gist of the article is that in deriving its risk classifications/ratings for bond funds, Morningstar’s rating system relies upon self-reported, summary data – often misreported – from bond mutual fund managers about the percentages of funds’ assets in different risk categories (AAA, AAA, B, etc.) rather than using it to supplement the data that those same funds file quarterly with the SEC.  The authors explain that assets in equity funds are generally of the same security type (for example, common stock), but that this isn’t true in the case of bond funds, which are “more bespoke and unique” with differences “in yield, duration, covenants, etc. – even across issues of the same underlying firm.” (p.2)  And while equity might have about 100 positions, bond funds generally have more than 600 issues. (p.2)  So, in the case of fixed income funds, the role of information intermediaries such as Morningstar is incredibly important.   

The article suggests that “[t]his misreporting has been persistent, widespread, and appears strategic – casting misreporting funds in a significantly more positive position than is in actuality.” (p.1)  This matters because such misclassified funds then appear to perform better than others with the same risk classification and, not surprisingly, both retail and institutional investors increase their investment in these funds. (p.3)  It also increases expense ratios. (p.5)   

Interestingly, the authors comment “[s]tepping back, what makes this even somewhat more surprising is that the funds actually do report holdings directly to Morningstar, and these holdings line up almost perfectly with the SEC-downloaded holdings.  Thus, it is literally that Morningstar uses the Summary Reports itself (and not the other data also delivered directly to it by funds) instead of taking the extra step of calculating riskiness itself that contributes to classification.” (p. 5-6).  So, did Morningstar allegedly not “tak[e] the extra step” for reasons of cost, an unfortunate oversight, or another possible explanation?  Note that the FT article quotes Morningstar as saying “We stand by the accuracy of our data and analytics, and we are reaching out to the authors with an offer to help understanding the data they used and to clarify the…methodologies we employ.”  Commentary on this article by Morningstar, Morningstar Stands Behind Its Fixed-Income Data and Fund Ratings, is here.  

If the article’s analysis is accurate, at least some funds must have been aware of the misclassifications.  If so, what (if any) related responsibility (legal or ethical) might they have in this systemic issue?  If the article’s analysis is correct, I would imagine that lawsuits won’t be far behind.  Stay tuned!  For now, here’s the abstract:

We provide evidence that mutual fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, we provide the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios. Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky. This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds– outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level.

Revised: 11/14/2019        

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The above photo honors my father’s U.S. Army service and my father-in-law’s U.S. Army service, in each case, in the Korean War.  I took a pause today to respect what they and so many others have done to serve our country.  I hope that all veterans and their families and friends have enjoyed a Happy Veteran’s Day.

With veteran legal service projects (some through student organizations, like our award-winning Vols for Vets organization at UT Law, a nonprofit supported by many in our community), including full-fledged law clinics (e.g., here and here and here and here and here), emerging across the country, I wondered whether there was any assistance outside the law school context, specifically for veterans who are entrepreneurs.  I did find, through a page on the U.S. Veterans Administration (VA) website, that the Office of Small & Disadvantaged Business Utilization has a program for Veteran-Owned Small Businesses.  Under the program, a veteran who owns a small business “may qualify for advantages when bidding on government contracts—along with access to other resources and support—through the Vets First Verification Program.”  A number of additional entrepreneurship programs exist under the auspices of the same VA office.  Many can be found on the website for the Office of Small & Disadvantaged Business Utilization (noted above).

In my web travels, I also found a nifty national veteran’s entrepreneurship program at the University of Florida Warrington School of Business.  And at one of our sister UT system schools, the The University of Tennessee at Chattanooga, the business school–the Gary W. Rollins College of Business–has a Veterans Entrepreneurship Program.  And it seems there is quite a bit more out there in the educational setting.

This all seems like a good start.  I am sure with more digging, I could find more.  I was admittedly gratified, however, to see that Forbes published a piece on free support programs for veteran entrepreneurs.  I was hoping to see a bunch more of that kind of thing . . . .  Maybe next year?

Again, I send abundant and heartfelt thanks to all of our veterans for their service.

I have a new(ish) essay that focuses on the concept of eliminating the fiduciary duty in an LLC, as permitted by Delaware law, and what that could mean for future parties. The paper can be found here (new link). When parties A and B get together to create an LLC, if they negotiate to eliminate their fiduciary agreements as to one another, I’m completely comfortable with that. They are negotiating for what they want; they are entering into that entity and operating agreement together of their own free will. So there may be differences in bargaining power—one may be wealthier than the other or have different kinds of power dynamics—but they are entering into this agreement fully aware of what the obligations are and what the options are for somebody in creating this entity.

My concern with eliminating fiduciary obligations comes down the road. That is, how do we make sure that if people are going to disclaim the fiduciary duty of loyalty, particularly, what happens if this change is made after formation? In such a case, I like to look at our traditional partnership law, which says there are certain kinds of decisions, at least absent an agreement to the contrary, that have to go to the entire group of entity participants. That is, a majority vote is not sufficient; there is essentially a minority veto.

I like the freedom of contract elimination of fiduciary duties provides, but I also am sensitive to the risks such eliminations can provide.  Thus, I argue that Delaware (and other states allowing reduction or elimination of the duty of loyalty) should require an express statement about the fiduciary duties (when modified from the default) and an express statement of how those duties can be modified, whether expanding, restricting, or eliminating the duties. To protect against the predatory modification of fiduciary duties, I believe that states should include a statutory requirement that changes to fiduciary duties must be express. Here’s my proposal:

Any limited liability company agreement that provides for a modification of the default rules for what constitutes a breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company, whether to expand, restrict, or eliminate those duties, must expressly state if the modifications are intended to expand, restrict, or eliminate the duties. Any limited liability company agreement that allows the modification of fiduciary duties must state expressly how those modifications can be made and by whom. Absent such any such statement, fiduciary duties may only be modified by agreement of all the members.

Supporting freedom of contract has value, but I also think we need to account for the fact that we did not traditionally allow for the elimination of fiduciary duties. As such, we should make sure that those participating in LLCs should know both what they signed up for initially, and also if the entity has provided the opportunity for a majority to make a fundamental change to traditional duties. This balance, I think, is essential to protecting investor expectations while still allowing for entities to develop the model that best serves the members’ goals.   

In recent years, there has been a lot of discussion over the problem of “common ownership,” namely, the fact that the giant institutional investors who dominate today’s markets tend to own stock in everything, and this may be a good thing but can also be bad if it encourages collusive behavior among competing firms linked by the same set of shareholders.

What has received less attention is the effect of common ownership on shareholder voting and corporate transactions.  When a handful of large shareholders own stock in two merging partners – say, Tesla and SolarCity (not a hypothetical, incidentally) – they may vote for less-than-optimal deals on one side in order to benefit their holdings on the other side. 

There are two implications to this:  First, these cross-holdings may incentivize corporate managers to pursue nonwealth maximizing transactions when cross-holders are a significant part of the shareholder base (and may call into question the disinterestedness of large shareholders for Corwin cleansing purposes).  And second, very often, these institutional shareholders are actually mutual funds, with cross-holdings not in a single fund, but in multiple funds across a fund family.  Yet their voting patterns (or the actions of their portfolio firms) suggest that their influence is geared towards maximizing wealth across the family as though the investments were all part of a single portfolio, which is a potential violation of their duties to each individual fund.

I’ve written about both of these issues: the former in Shareholder Divorce Court (where I describe the Tesla situation) and the latter in Family Loyalty: Mutual Fund Voting and Fiduciary Obligation, but at the time, I only had a limited set of empirical studies to draw upon.

All of which is a long way of saying that two new studies were recently posted to SSRN, and they reach conclusions similar to those of the earlier studies. 

First, there’s Dual-Ownership and Risk-Taking Incentives in Managerial Compensation, by Tao Chen, Li Zhang, and Qifei Zhu.  They find that institutional investors who own stock and bonds in the same firm are more likely to favor managerial compensation policies that minimize incentives for risk-taking, as compared to institutional investors who own stock alone.  Significantly, they find this effect at the mutual fund family level, suggesting that mutual funds are setting voting policy to maximize wealth at their funds collectively, without differentiating policies that might benefit some funds more than others.

Second, there’s Common Ownership and Competition in Mergers and Acquisitions, by Mohammad (Vahid) Irani, Wenhao Yang, and Feng Zhang.  Similar to those who find that firms with common owners compete less in their product markets, the authors find that firms with common owners compete less in the takeover market, so that common ownership across potential acquirers of a target firm reduces the likelihood that the target will receive a competing bid, and increases returns to acquirers upon announcement of a bid (though the cross-ownership does not seem to effect target bid premiums or target returns).  And, at least as I understand their methodology, these results are identified at the fund family level.

Anyhoo, this is a fascinating area and I very much hope we see more empirical work along these lines.

Tomorrow, we’ll host the first (and possibly annual) Corporate Governance Summit at the University of Nevada, Las Vegas William S. Boyd School of Law for public company directors and others involved in the corporate governance space.  Greenberg Traurig is co-hosting the event with us.  They, and some of the dedicated staff at UNLV, have done so much of the heavy lifting to get the event together.  I’m incredibly grateful for the work the team has put into this.  We’ve assembled a strong mix of panelists including directors, officers, law professors, and corporate lawyers.  

We’ve pulled together a series of panels focusing on hot topics this year.  We’ve got:

  • Basic Legal Duties
  • Cyber-security and Oversight
  • Shareholder Activism
  • Compensation
  • Social Media
  • Diversity 
  • Sexual Harassment

As I’m looking at the topics we’re hitting tomorrow, I’m also thinking ahead.  Many of these issues will probably still be significant next year.  What do we think the broader trends will be in the next five to ten years?  My early sense is that stakeholder governance will draw more and more attention. If we do decide to give non-shareholder stakeholders more voice in corporate governance, I’m not yet sure about the most efficient way to do that.