Yesterday, I had the pleasure of participating in Case Western Reserve Law Review Conference and Leet Symposium, Fiduciary Duty, Corporate Goals, and Shareholder Activism.  It was a fun and lively set of discussions with some interesting themes that hit right in my sweet spot of interests, so I had a wonderful time.  I’ll give a brief synopsis of the topics under the cut, but the entire thing will soon be available as a webcast online at the above link, and next year the law review will publish a special symposium issue.

Also, I just apologize in advance if I misdescribe anyone’s remarks – if you see this post and want to correct me, feel free to send an email.

[More under the jump]

Continue Reading What I Did on My Friday in Cleveland

The SEC’s influential Investor Advisory Committee has just released new recommendations for the SEC as it continues to move forward with its effort to raise the standard for investment advice given to retail customers.  Although the entire recommendation is worth reading, it highlights the special importance of making sure that account-type recommendations fall within the rule.  As it currently stands, the proposed regulation does not apply to initial recommendations about what kind of account a customer should select.

The Committee described the issue’s critical importance:

Some of the most important decisions investors make arise at the outset of the relationship, before they receive recommendations regarding specific transactions. These include decisions about whether to roll money out of a retirement account and into an IRA, what type of account to open (where the firm has more than one account type available), and the scope of services to be provided. Those central decisions, generally made at the beginning of a brokerage or advisory relationship, set up the contours of the relationship. They will often have a far greater impact on the investor than subsequent recommendations regarding which specific securities to invest in.

Rollover recommendations, for example, are frequently provided at a critical juncture in an investor’s life – retirement – and are often irrevocable decisions. Similarly, while some investors (including those who trade frequently) may be best served by paying an asset-based fee, others (including buy-and-hold investors who rarely trade) may be better served by paying transaction fees. Decisions about which type of account to open have the potential to greatly affect their costs. Moreover, both rollover and account type recommendations are recommendations of an “investment strategy involving securities” that can have substantial potential long-term impacts on investors. And both types of recommendations inherently involve potential conflicts of interest, making it critical that advisers and brokers put their clients’ interests ahead of their own in making such recommendations.

Early account-type decisions will likely have significant impacts on the range of options available later.  The risk is that advisers eager to gather assets to manage will cause investors to pay higher fees and experience lower returns by drawing them into the wrong account type for their situation.  Consider a choice facing a retiree with a buyout offer for a defined-benefit pension.  If the retiree asks a financial adviser for advice, the advice should be in the best interest of the retiree–not the financial adviser.  The right advice might be for the retiree to keep the pension and not move assets to the financial adviser.  It’s hardly acting in a person’s best interest to draw them into a decision that isn’t in their best interest and then act in their best interest once bad advice has caused them to surrender a stable pension.   

 

Tom Rutledge, at Kentucky Business Entity Law Blog, writes about a curious recent decision in which the Kentucky Court of Appeals overrule a trial court, holding that the law of piercing the veil required the LLC veil to be pierced. Tavadia v. Mitchell, No. 2017-CA-001358-MR, 2018 WL 5091048 (Ky. App. Oct. 19, 2018).

Here are the basics (Tom provides an even more detailed description):

Sheri Mitchell formed One Sustainable Method Recycling, LLC (OSM) in 2013. Mitchell initially a 99% owner and the acting CEO with one other member holding 1%. Mitchell soon asked Behram Tavadia to invest in the company, which he did.

He loaned OSM $40K at 6% interest from his business Tavadia Enterprises, Inc. (to be repaid $1,000 per month, plus 5% of annual OSM profits).  There was no personal guarantee from Mitchell.  OSM then received a $150,000 a business development from METCO, which Tavadia personally guaranteed and pledged certain bonds as security.

Two years (and no loan payments) later under the original $40,000 loan, Tavadia agreed to delay repayment. OSM and Tavadia the created a second loan for $250,000, refinancing the original $40,000 and a subsequent Tavadia $12,000 loan.  This loan provided Tavadia a 25% ownership interest in OSM, but there was still no personal guarantee on the loan. Mitchell claimed this loan was needed to purchase essential equipment (no equipment was purchased). OSM then received a $20,000 loan from Fundworks, LLC, which was secured by Mitchell, who signed Tavadia’s name for OSM and she signed a personal guarantee in Tavadia’s name (both without permission).

Not surprisingly, in October 2015, OSM stopped operations, the equipment was sold, and more than half of the sale proceeds were deposited in Mitchell’s personal bank account, with the rest going to OSM’s account. OSM (naturally) defaulted on the Fundworks’ loan, which Tavadia learned about when Fundworks demanded repayment. The METCO loan also defaulted, and Tavadia was asked to provide funds from the bonds he provided as collateral.

Okay, so it sounds like Mitchell took advantage of Tavadia and engaged in some elements of fraud. What I can’t figure out from this case is why we’re talking about veil piercing.

First, the court states: “The evidence presented at trial demonstrated that Mitchell diverted OSM assets into her own account.” Tavadia v. Mitchell, No. 2017-CA-001358-MR, 2018 WL 5091048, at *5 (Ky. Ct. App. Oct. 19, 2018). So that money Mitchell owes to OSM, which owes money to Tavadia.  The court noted that at least half the funds from the sale of OSM equipment went into Mitchell’s personal account. That needs to go back to OSM, and if veil piercing has value, then a simple order of repayment should be, too. 

Second, the Fundworks loan, which Mitchell signed for, is really her loan, not Tavadia’s. He did not know about it until they sought payment, so it wasn’t ratified, and there is no other indication she has authority to enter into the contract. 

At a minimum, these funds are owed Tavadia (or OSM) and should be itemized as such.  Presumably, that is not enough money to make Tavadia whole. And I don’t know he should be. To the extent there were legitimate (if poorly executed) business attempts, he is on the hook for those losses. As such, I don’t see this as a veil-piercing case.

Instead, Tavadia should be able to sue Mitchell for her fraudulent actions that harmed him directly. And Tavadia should be able to make OSM sue Mitchell for improper transfers and fraud. 

Maybe there are other theories for recovery, too, but veil piercing should not be one. Mitchell did not use the entity to commit fraud. She committed fraud directly. Just because there is an entity, plus an unpaid loan, it does not make this a veil-piercing case. In fact, because Tavadia is a member of the LLC, I think there is a reasonable argument that (absent truly unique circumstances) veil piercing cannot apply. 

I am sympathetic that Tavadia was taken advantage of, and I think that Mitchell should have a significant repayment obligation to him, but I just don’t think this claim should be rooted in veil piercing.  At a minimum, like in administrative law, one should have to exhaust his or her remedies before proceeding to a veil-piercing theory. 

Last Friday, I had the honor of being the keynote speaker for the 64th annual conference of the Southeastern Academy of Legal Studies in Business (SEALSB).  The invitation for this appearance was extended to me months ago by BLPB contributing editor Haskell Murray.  It was a treat to have the opportunity to mingle and talk shop with the attendees (some of whom I already knew).

The participants in SEALSB are largely business law faculty members teaching at business schools.  Having never before attended one of their meetings and as a bit of a “foreigner” in their midst, I wondered for quite a bit about what I should talk about.  Should I take the conservative route and present some of my work, hoping to dazzle the group with my legal knowledge (lol), or should I take a riskier approach and tell them what was really on my heart when I accepted Haskell’s kind invitation?

I chose the latter.  I spoke for 15-20 minutes on “Valuing and Visioning Collaboration” between business law faculties in business and law schools and then took about 10 minutes of questions.  I started with the stories of two of my students–who could have been the students of anyone in the room.  Sarah took a business (accounting) major as an undergraduate and then came to law school; Ryan completed law school and went on to an MBA.  Both achieved lofty learning objectives and engaged in productive scholarship.  Both landed the jobs they wanted–ironically at the same firm (but years apart).  For me, the stories of these two students–what they did and how they became successful–illustrates both the power of business school law faculty and law school business law faculty working together and the high value in that relationship as to both teaching and scholarship.

I noted that, in these two (of the three principal) aspects of our common academic existence, teaching and scholarship, there are a number of ways that we can collaborate, offering examples of each:

  • conference organization and attendance;
  • work in interdisciplinary centers;
  • scholarship co-authorships;
  • co-teaching and teaching for each other;
  • co-currocular and extra-curricular programs (e.g., competitions and journals);
  • curriculum development; and
  • blogging.

I bet you can guess what blog I mentioned as an example in addressing that last collaborative method . . . .

I also noted, however, that there are barriers to these collaborations–or at least to some of them in certain contexts.  Those barriers may include: the fact that reaching across the aisle may be, for the relevant institutions and faculty members, new–that there is no history–and that it may therefore be more of a challenge to scope out and implement collaboration; differences in methodology, norms, and terminology; potential disagreements about institutional or personal credit allocation (including because of ego); questions about the necessary sources of funding and human capital; and overall, a lack of institutional or departmental incentives and rewards for collaboration (including credit in tenure and promotion deliberations at many schools).

Nevertheless, I offered that, even if institutions do not act to support collaborative efforts, we should strike out to overcome the barriers and engage with each other because the benefits are worth the costs.  To do so, however, we must both understand and truly appreciate the benefits of collaboration.  We also must be willing to take some attendant risk (or pick collaborative methods that avoid or limit risk).  I indicated that I plan to head down the collaborative path with increased focus.

To conclude my remarks, in the spirit of my invitation from Haskell to attend and speak at SEALSB, I encouraged the assembled crowd to join me on that collaborative journey, quoting from Patrick Lencioni’s book The Five Dysfunctions of a Team: A Leadership Fable.  In that book, he wrote: “Remember teamwork begins by building trust.  And the only way to do that is to overcome our need for invulnerability.” [p. 58; emphasis added]  Here, I invite all of you who teach business law in a business or law school setting to embrace vulnerability and reach across the aisle to work with your business law colleagues.  And if you already have done so, please leave a comment on the outcome–positive or negative.

Next Friday, the George Washington Law Review will host a symposium on Women and Corporate Governance. Co-sponsored by Lisa Fairfax, the symposium features an impressive lineup–three former SEC Commissioners, regulators, professors, partners at leading law firms, and the BLPB’s own Joan Heminway.  The panels include discussions about women and corporate boards, women as regulators, women in the C-Suite, and women as gatekeepers.  This is the quick overview:

The Symposium will explore the role of women in a changing corporate environment, particularly in light of the 2008 financial crisis and its aftermath. Recent social, political, and economic events have brought renewed attention to the ways in which the corporate environment is impacted by, and responsive to, women. It is especially vital to further this discussion today, as corporations grapple with the under-representation of women on their boards, in their C-suites, and in a host of other managerial positions.

In place of the traditional individual keynote, we have the privilege of hosting a fireside chat featuring the three women who have served as Chair of the U.S. Securities and Exchange Commission – Mary Schapiro, Elisse Walter, and Mary Jo White, moderated by Professor Lisa Fairfax.

Congratulations to Professor Fairfax and the George Washington Law Review for getting so many leading lights together on such an important topic.  

Some business school professors recently posted new research on FINRA arbitration and came away with interesting findings.  They looked at about 9,000 different arbitration cases and found significant differences between arbitrators.  Some were more industry-friendly, meaning they gave lower awards to claimants.  Others were more client/customer-friendly, giving more awards to customers.  Unsurprisingly, industry-friendly arbitrators were 40% more likely to be selected for panels.  The authors found that industry firms were, on the whole, better at picking arbitrators than customers.

The FINRA arbitration process allows parties to influence arbitrator selection.  FINRA generates lists with arbitrators for the parties and then allows the parties to strike a certain number of arbitrators before ranking the remaining arbitrators.  FINRA appoints the highest-ranking remaining arbitrators to decide the case.

The study provides some support for a longstanding fear about the FINRA arbitration process.  Customers with cases before arbitrators are usually not repeat players in arbitration.  Once burned in a stock swindle, customers tend to become more cautious about trusting brokers. Arbitrators and firms, on the other hand, are repeat players.  If the arbitrator tags the industry with a large award and rules in favor of the customer, other industry members will likely strike that arbitrator from future panels.  Fears of exclusion may bias arbitrators against sticking the industry with large awards. In contrast, giving industry-friendly awards significantly increases an arbitrator’s odds of picking up more cases.  Because arbitrators collect supplemental income from serving on cases, some may consider their personal financial incentives when deciding cases.  This financial incentive could tilt the scale against customers, making it more difficult for them to recover.

There are some customer-side repeat players involved in the process as well.  The Public Investors Arbitration Bar Association is a bar association for attorneys that represent claimants in FINRA arbitration.  The study found that customers represented by PIABA attorneys recovered four or five percent more on average of the amount sought.  Still, PIABA attorneys do not represent every customer claimant and the study provides strong evidence that arbitrators have an economic incentive to decide cases in favor of industry members.  (Quick Disclosure:  Although I am a member of PIABA’s board, I am not writing on behalf of PIABA.)

One possible solution to the problem–and suggested by the study’s authors–is to do away with the parties’ ability to influence arbitrator selection.  This would take away an arbitrator’s incentive to please the industry.  Of course, a shift away from parties selecting arbitrators from a list would put the arbitrator selection process entirely in FINRA’s hands.  Because FINRA isn’t subject to the Freedom of Information Act, the public would have little direct ability to verify how FINRA administered that process.  Of course, the SEC supervises FINRA’s operations.  If the process changes, the SEC should keep a close eye on how FINRA administers the selection process.

Daniel Greenwood coined the term “fictional shareholders” to refer to courts’ tendency to base corporate law decisions on the preferences of a set of hypothetical investors, untethered to the real-world priorities of the actual shareholders who hold a company’s stock.  See Daniel J.H. Greenwood, Fictional Shareholders: “For Whom Are Corporate Managers Trustees,” Revisited, 69 S. Cal. L. Rev. 1021 (1996).  If ever there were an illustration of Greenwood’s point, it comes in VC Laster’s recent post-trial decision in In re PLX Stockholders Litigation.

And hey, this got really long, so more under the jump

Continue Reading Talk About Fictional Shareholders