In my undergraduate course, The Law of Business Organization, we’re studying material on “Investor Protection, Insider Trading, and Corporate Governance.”  During our last class, we examined the registration statement for last year’s Dropbox IPO.  Before this exercise, however, we reviewed a highly-generalized funding life cycle for businesses in the U.S. that eventually went public.  In doing this, I shared with students that an important caveat to this presentation was the increasing role of private capital in U.S. debt and equity markets.  I mentioned that the cost not only of going public, but also of the related and continuing reporting and compliance requirements could be a potential explanation for this shift.  As it turns out, I’m planning to supplement my explanation of the role of regulation in this shift during tomorrow’s class.     

Several weeks ago, I mentioned in a post the increasing role of private capital in U.S. capital markets.  Shortly thereafter, I was chatting with my Finance Division colleague, Bill Megginson, about this trend and other financial market developments.  It proved to be good timing as Megginson (along with coauthors Gabriele Lattanzio and Ali Sanati) had recently posted a new article, Listing Gaps, Merger Waves, and the New American Model of Equity Finance to SSRN.  I’ve finally had a chance to review it this weekend.

Megginson and coauthors argue that a “new model of equity finance has emerged in the United States,” which “is characterized by four inter-related features: (1) a dramatic decline in the number of publicly listed corporations…(2) a surge in U.S. merger and acquisition (M&A) activity…(3) an ‘aggregate capitalization premium’ assigned to U.S. listed stocks that emerged in the early 1990s…(4) the ‘privatization of U.S. equity finance’ reflected in the massive increase in private equity funding for U.S. entrepreneurial growth companies…Today more than five times as much external equity is provided to American businesses through private markets as through the public markets…”  They econometrically examine each of these features both individually, and in connection to each another. 

The authors’ intriguing findings include that “the massive and sustained increase in mergers after 1993 explains virtually completely both the magnitude and the timing of the decline in the number of U.S. public corporations;” that “the U.S. public stock market has become populated exclusively by behemoths,” suggesting that public companies are “the shining pinnacle of the modern U.S. financial economy, rather than its core building block;” and, that though belatedly, other economically developed countries seem to be following the U.S. model of equity finance.  Hence, one of the many important takeaways of this article is that the U.S. listing gap (the decrease in the incidence of public companies) largely predates a wave of regulation in the early 2000s, which is often held responsible for this decrease.  At the same time, the National Securities Market Improvement Act of 1996, “might have played a significant role in widening the U.S. listing gap” (hence the need to supplement my regulation comments!). 

What exciting research to incorporate into tomorrow’s class!  We’ll also be discussing Lorenzo v Securities Exchange Commission, a recent U.S. Supreme Court decision covered in a post by my co-blogger Ann Lipton – definitely also a must read!     

Where we last left off in our saga, Professor Hal Scott of Harvard Law School, as trustee for the Doris Behr 2012 Irrevocable Trust, sought to introduce a shareholder proposal at Johnson & Johnson to amend the corporation’s bylaws to require arbitration of federal securities claims by any J&J stockholder, on an individual basis.  (You can read a full accounting of all of this, with links, here)

J&J sought to exclude the proposal on two grounds.  First, that the proposal would cause the company to violate federal law because an arbitration bylaw of this sort would act as a prohibited waiver of rights under the Exchange Act, and second, that the proposal would violate state law because – as Delaware Chancery’s decision in Sciabacucci v. Salzberg made clear – corporate bylaws and charters only govern claims pertaining to corporate internal affairs, and cannot impose limits on non-internal affairs claims, like federal securities claims.  J&J was boosted in this latter effort by an opinion letter from the NJ Attorney General agreeing that NJ law would be in accordance with Delaware on this issue.  In light of the NJ AG letter, the SEC granted J&J’s request for no-action relief.

Undaunted, the Trust has now filed a complaint in the District of New Jersey, alleging that J&J violated the federal securities laws by excluding the proposal, and seeking an injunction requiring that J&J circulate supplemental proxy materials before the April 25 shareholder meeting.  J&J’s argument in response has mainly focused on what it claims is the Trust’s unreasonable delay in bringing the matter to court, which belies any claim of irreparable harm.

Without wading into that dispute, I want to talk a little about the Trust’s complaint and supporting briefing.

Starting with the proposal itself, it states that “The shareholders of Johnson & Johnson request the Board of Directors take all practicable steps to adopt a mandatory arbitration bylaw” governing disputes between shareholders and the company arising under the federal securities laws, and prohibits class claims or joinder.  It then contains a supporting statement: “The United States is the only developed country in which stockholders of public companies can form a class and sue their own company for violations of securities laws. As a result, U.S. public companies are exposed to litigation risk that, in aggregate, can cost billions of dollars annually…”

I realize this isn’t the main issue, but I have to pause to observe that while I enjoy the United States/Canada rivalry as much as anyone, I’m not sure I’d go so far as to deny that Canada is a developed country.  As a result, the proposal may run afoul of Rule 14a-8(i)(3), which prohibits proposals that contain false information.  That strikes me as an alternative ground for exclusion.  (I believe Japan and Australia also permit securities class actions, and the list could probably be broadened depending on how “class action” is defined).

Leaving that point aside, I have to engage in another bit of nitpicking.  The complaint’s introductory statement says:  “The Trust is seeking shareholder approval for a proposal that would amend Johnson & Johnson’s bylaws and require the company’s shareholders to resolve their federal securities law claims through arbitration rather than costly class-action litigation”  This, of course, is inaccurate; the proposal does not amend the bylaws, but rather requests that the directors amend the bylaws.  Even if it passed, the directors would be free to ignore it.

But moving on to the heart of the matter, the preliminary injunction brief has a few main arguments:

First, the Trust argues that under the Federal Arbitration Act, agreements to arbitrate federal securities claims must be enforced according to their terms.  That statute provides that “[a] written provision in any … contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2.  Thus, it claims, it is impermissible to single out agreements to arbitrate federal securities claims and declare them unenforceable.

On this latter point, I’m inclined to agree; though there once was an argument that the securities laws themselves treat arbitration agreements and bars on class claims as an impermissible waiver of substantive rights, after American Express v. Italian Colors Restaurant, that argument has far less force.

That said, the unspoken assumption of the Trust’s argument is that a corporate bylaw constitutes an contract to arbitrate for FAA purposes, and that federal securities claims “aris[e] out of” state law corporate constitutive documents.  These are both points that are very much in dispute, as I discuss in my Manufactured Consent paper. 

Second, the Trust argues that a state law rule that would limit the enforceability of an arbitration bylaw is similarly preempted by the FAA. 

In this case, the state law rule at issue is simply one that holds that corporate bylaws can only govern internal affairs claims – not a rule that singles out arbitration specifically.  For that reason, it would seem that the FAA has little role to play, for that statute only “preempts any state rule discriminating on its face against arbitration…[and] also displaces any rule that covertly accomplishes the same objective by disfavoring contracts that (oh so coincidentally) have the defining features of arbitration agreements.” Kindred Nursing Centers v. Clark, 137 S.Ct. 1421 (2017).

The Trust has an answer to that, however: it claims that limiting the rule only to corporate bylaws and charters is itself an impermissible act of discrimination against arbitration agreements.  The rule at issue here does not apply to all contracts, but only some contracts – namely, the corporate contract – and for that reason, it runs afoul of the FAA’s command that arbitration agreements may only be invalidated on the same grounds as would exist for “any contract.”

I admit, there’s some superficial textual appeal to that argument – one of the maddening aspects of this area of law is that it is impossible to tell what counts as “discrimination” against arbitration without a baseline for comparison, and that baseline can be elusive – but as I understand it, in the Trust’s reading, states have a choice: Either they can allow corporations to include arbitration agreements in their bylaws – which can then govern disputes that have nothing to do with the corporate form or the corporate constitutive documents themselves, or the laws that ordinarily govern them – or states can create a rule that all contracts formed under state law must pertain only to corporate internal affairs.  That seems to me to go well-beyond a nondiscrimination principle for contracts to arbitrate, and would also seem to be in some tension with the Supreme Court’s recognition of the particular need for a choice-of-law principle unique to the corporate form, namely, the internal affairs doctrine.  See CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69 (1987).

Which just illustrates one of the problems with applying the FAA to corporations.  The entire corporate form is structured by state law rules, from distinctions between what goes in the bylaws versus matters that must be in the charter, to how charters are amended versus how bylaws are amended, to what counts as a quorum, to who has the power to call meetings and under what circumstances, to when written consent can substitute for a shareholder vote, and so forth.  If you say that rules specific to the corporate form cannot be applied to arbitration provisions, you undermine states’ ability to dictate corporate structure. 

Third, the Trust argues that Sciabacucci was wrongly decided and does not in fact represent the law of Delaware – which, well, again, eventually it will be appealed and we’ll know one way or the other.

Fourth, the Trust claims that there is no reason to believe that NJ law follows Delaware law on this point.  On this, I take no position, other than to note that in addition to the NJ AG’s opinion, Professor Jacob Hale Russell wrote an analysis of NJ law which is now available on SSRN.

Finally, the Trust argues that even if the proposed bylaw would be unenforceable, it still would not violate either state or federal law for J&J simply to enact it, recognizing that, if J&J chose to enforce it against a stockholder in court, the bylaw would be declared ineffective and nonbinding.  Therefore, the proposal is not excludable on the grounds that it would cause J&J to violate the law.

This is also an intriguing point, which gives rise to the general question whether it would be a violation of a Board’s fiduciary duties to enact a bylaw that purported to bind stockholders, but that it knew would be unenforceable in a court of law.  Would that be a misuse of the corporate machinery?  Impermissibly deceptive?  It would certainly seem to be beyond the scope of the Board’s powers to enact – that’s the whole basis of the Sciabacucci decision – which itself would be a violation of state law. 

Anyhoo, that’s as far as my thinking takes me – but, as I said, the most immediate argument before the court right now is whether the Trust waited too long to seek a preliminary injunction, so we’ll see what happens from here.

Financial Planning’s Ann Marsh recently published an article detailing how a registered investment adviser’s chief operating officer allegedly stole $6 million from the firm and clients.  As often happens, the alleged thefts started small and gradually escalated over time, becoming more and more daring.  The COO allegedly first began by meddling with the firm’s payroll to increase his own pay.  When a client later raised questions about charges to his account with the CEO, the SEC’s complaint alleges that the CEO took the concern to the COO who “confessed to overbilling clients in order to personally profit himself.”

Although nothing in the report indicates that the CEO had any idea any of this was going on, there are some lessons.  Despite managing nearly half a billion dollars, the CEO held three different roles simultaneously:  CEO, Chief Compliance Officer, and Chief Investment Officer. When the same person occupies all three roles, it necessarily means that they cannot devote themselves entirely to any one role.  Although there is no guarantee that a full-time chief compliance officer or CEO would have caught this earlier, it’s hard to imagine that they would have stood a worse chance than someone overburdened with three simultaneous roles.

The precise moment where a growing firm should hire additional personnel will be a business decision.  I don’t know the right threshold for this.  But it does seem that the SEC might want to devote more examination and oversight resources to firms with concentrated roles and significant assets under management.

At the 2018 Annual Conference of the Academy of Legal Studies in Business, I spoke on a panel, New Developments in Corporate Governance, with Vincent S.J. Buccola, Gideon Mark, Josephine Sandler Nelson, and David Zaring, the organizer (thanks again, David!). 

Buccola discussed governance aspects of corporate bankruptcy law in the modern economy.  I was particularly intrigued by his argument that “Bankruptcy law is potentially valuable…insofar as it can toggle from property to liability rule in domains where legal or practical impediments prevent investors from arranging their own, “tailored” toggles.” 

I’ve taught Corporate Bankruptcy, and in my research at the time, I was analogizing bargaining processes in the context of the recovery and resolution of clearinghouses to bargaining processes in private restructurings and formal bankruptcy filings.  I wondered about the potential application of Buccola’s work within the clearinghouse context, and have been eagerly awaiting his article.  I’m excited to share with readers that the wait is over!  Bankruptcy’s Cathedral: Property Rules, Liability Rules, and Distress, an impressive and significant new work, is forthcoming in the Northwestern University Law Review, and also now available on SSRN.  Here’s its abstract:            

What justifies corporate bankruptcy law in the modern economy? For forty years, economically oriented theorists have rationalized bankruptcy as an antidote to potential coordination failures associated with a company’s financial distress. But the sophistication of financial contracting and the depth of capital markets today threaten the practical plausibility, if not the theoretical soundness, of the conventional model. This article sets out a framework for assessing bankruptcy law that accounts dynamically for changes in the technology of corporate finance. It then applies the framework to three of the most important artifacts of contemporary American bankruptcy practice and, on that basis, points toward a radically streamlined vision of the field. I contend that bankruptcy’s virtue lies in its capacity to replace “property rules” that may protect investors efficiently when a company is financially healthy with “liability rules” more appropriate for distress, in domains where investors are unable to arrange state-contingent toggling rules on their own. This agenda plausibly justifies two important uses of Chapter 11—to effect prepackaged plans of reorganization and conclude going-concern sales—but casts doubt on what many suppose to be the sine qua non of bankruptcy, the automatic stay. More broadly, the analysis suggests that an “essential” bankruptcy law would look very different, and do much less, than the law we know.