Bernie Sharfman’s paper, A Private Ordering Defense of a Company’s Right to Use Dual Class Share Structures in IPOs, was just published, and I think he has a point. In fact, as I read his argument, I think it is consistent with arguments I have made about the difference between restrictions or unconventional terms or practices that exist at purchase versus such changes that are added after one becomes a member or shareholder.  Here’s the abstract: 

The shareholder empowerment movement (movement) has renewed its effort to eliminate, restrict or at the very least discourage the use of dual class share structures in initial public offerings (IPOs). This renewed effort was triggered by the recent Snap Inc. IPO that utilized non-voting stock. Such advocacy, if successful, would not be trivial, as many of our most valuable and dynamic companies, including Alphabet (Google) and Facebook, have gone public by offering shares with unequal voting rights.

Unless there are significant sunset provisions, a dual class share structure allows insiders to maintain voting control over a company even when, over time, there is both an ebbing of superior leadership skills and a significant decline in the insiders’ ownership of the company’s common stock. Yet, investors are willing to take that risk even to the point of investing in dual class shares where the shares have no voting rights and barely any sunset provisions, such as in the recent Snap Inc. IPO. Why they are willing to do so is a result of the wealth maximizing efficiency that results from the private ordering of corporate governance arrangements and the understanding that agency costs are not the only costs of governance that need to be minimized.

In this essay, Zohar Goshen and Richard Squire’s newly proposed “principal-cost theory,” “each firm’s optimal governance structure minimizes the sum of principal costs, produced when investors exercise control, and agent costs, produced when managers exercise control,” is used to argue that the use of dual class shares in IPOs is a value enhancing result of private ordering, making the movement’s renewed advocacy unwarranted.

The recommended citation is Bernard S. Sharfman, A Private Ordering Defense of a Company’s Right to Use Dual Class Share Structures in IPOs, 63 Vill. L. Rev. 1 (2018).

I find his argument compelling, as I lean toward allowing contracting parties to enter into agreements as they so choose. I find this especially compelling at start-up or the IPO stage.  I might take a more skeptical view of changes made after start-up. That is, if dual-class shares are voted created after an IPO by the majority insiders, there is a stronger bait-and-switch argument. Even in that case, if the ability to create dual-class shares by majority vote was allowed by the charter/bylaws, it might be reasonable to allow such a change, but I also see a self-dealing argument to do such a thing post-IPO. At the outset, though, if insiders make clear that, to the extent that a dual-class share structure is self-dealing, the offer to potential purchasers is, essentially, “if you want in on this company, these are our terms.” I can work with that. 

This is consistent with my view of other types of disclosure. For example, in my post: Embracing Freedom of Contract in the LLC: Linking the Lack of Duty of Loyalty to a Duty of Disclosure, I discussed the ability to waive the duty of loyalty in Delaware LLCs:

At formation . . . those creating an LLC would be allowed to do whatever they want to set their fiduciary duties, up to and including eliminating the consequences for breaches of the duty of loyalty.  This is part of the bargain, and any member who does not agree to the terms need not become a member.  Any member who joins the LLC after formation is then on notice (perhaps even with an affirmative disclosure requirement) that the duty of loyalty has been modified or eliminated.

It was my view, and remains my view, that there some concerns about such changes after one becomes a member that warrant either restrictions or at least some level of clear disclosures of the possibility of such a change after the fact, though even in that case, perhaps self-dealing protections in the form of the obligations of good faith and fair dealing would be sufficient. 

Similarly, in my 2010 post, Philanthropy as a Business Model: Comparing Ford to craigslist, I explained: 

I see the problem for Henry Ford to say, in essence, that his shareholders should be happy with what they get and that workers and others are more his important to him than the shareholders. However, it would have been quite another thing for Ford to say, “I, along with my board, run this company the way I always have: with an eye toward long-term growth and stability. That means we reinvest many of our profits and take a cautious approach to dividends because the health of the company comes first. It is our belief that is in the best interest of Ford and of Ford’s shareholders.”

For Ford, there seemed to be something of a change in the business model (and how the business was operated with regard to dividends) once the Dodge Brothers started thinking about competing. All of a sudden, Ford became concerned about community first. For craigslist, at least with regard to the concept of serving the community, the company changed nothing. And, in fact, it seems apparent that craiglist’s view of community is one reason, if not the reason, it still has its “perch atop the pile.”

Thus, while it is true craigslist never needed to accept eBay’s money, eBay also knew exactly how craigslist was operated when they invested. If they wanted to ensure they could change that, it seems to me they should have made sure they bought a majority share.  

I understand some of the concern about dual-class shares and other mechanisms that facilitate insider control, but as long as the structure of the company is clear when the buyer is making the purchase decision, I’m okay with letting the market decide whether the structure is acceptable.  

This week, I plug my new article, Shareholder Divorce Court, available here on SSRN and forthcoming in the Journal of Corporation Law.  Here is the abstract:

Historically, shareholder power within the corporate form has been tightly constrained on the assumption that dispersed shareholders are too inexpert, and insufficiently invested in the business, to contribute positively to governance.  In recent years, however, the nature of shareholding has changed.  Whereas in the mid-twentieth century, most stock was held by individuals, today, most publicly traded stock is held by large institutions with significant stakes.  Corporate law has responded to the increasing sophistication of the shareholder base by expanding shareholder power, but doing so has created a new problem: shareholders have heterogeneous preferences, and when they conflict, the majority may exploit the minority.

The problems are particularly acute when it comes to mergers and acquisitions.  Large shareholders may have a variety of investments, and thus be conflicted in their preferences when it comes to merger terms.  Their greater influence within the corporate form may influence directors.  In this scenario, minority shareholders are left without an effective advocate for their interests, and therefore may be coerced into suboptimal transactions.

This Article proposes that if corporate law is retooled to grant shareholders more power, it should also facilitate “divorce,” namely, provide a mechanism for price discrimination among shareholders with different interests.  In particular, states can look to an old solution: the right of appraisal.  Appraisal permits a shareholder to petition a court for a judicial evaluation of the fair value of her shares.  Before falling into disuse, appraisal was one of the earliest remedies for addressing conflicting shareholder preferences.  In recent years, it has enjoyed a renaissance as a mechanism for deterring conflicted or unfavorable transactions.  This Article argues that with some modification, appraisal could also be used to satisfy the divergent preferences of a heterogeneous shareholder base.

The project was inspired by the increasing concentration of ownership among a handful of institutional investors, as well as numerous examples of mergers that depended on the votes of shareholders who held stakes in both target and acquirer.  I addressed the issue from the shareholder side in an earlier essay, Family Loyalty: Mutual Fund Voting and Fiduciary Obligation.  The new paper is a more in-depth examination of the implications on the corporate governance side.

Earlier this week, Keith Paul Bishop observed on his blog, “Professor Joshua Fershee has been fighting the good fight on limited liability company nomenclature, but I fear that he is losing.”   I am not willing to concede that I am losing (yet), but I have to concede that I am winning less often than I’d hoped.  

Bishop noted my “helpful checklist” from last week for those writing about LLCs, but he argues, “it may be time to give up the fight and bestow an entirely new name on LLCs that is less likely to be confused with corporations. I am still not ready to give up the fight, but it is an interesting thought, and there are some options.

One path I have proposed before that I think would help: Let Corps Be Corps: Follow-Up on Entity Tax Status.  In that post, I suggested that the IRS should just stop using state-law entity designations, and thus stop having “corporate” tax treatment. I explained:

My proposal is not abolishing corporate tax . . . .  Instead, the proposal is to have entities choose from options that are linked the Internal Revenue Code, and not to a particular entity. Thus, we would have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax. 

Federal requirements to be eligible for the various tax status options would remain, but the entity type itself would cease to be a consideration. And we’d have to change our language to reflect that. 

But maybe LLCs could be something else. A current problem is that “company” is a synonym for “corporation” in common usage. Thus, it is easy to see why a layperson would think a “limited liability company” is the same thing as a “limited liability corporation.”  Of course, there are lots of words that have a broad meaning in common parlance, but a narrower meaning in the legal sense, so it is not inherently problematic to expect lawyers to be able to draw such a distinction. (For example, as a 1L, we learn that assault does not include physical contact, but in general usage, there would be the assumption of contact.) 

Still, what else could we use?  To start, if a change were in the works, I think the “c” needs to go. Otherwise, the assumption will remain that the “c” means “corporation.”   Here’s an initial list: 

  • LLA: Limited Liability Association
  • LLB: Limited Liability Business
  • LLE: Limited Liability Entity
  • LLG: Limited Liability Group
  • LLO: Limited Liability Operation
  • LLV: Limited Liability Vehicle

It would not need to be, necessarily, something that says “limited liability” as long as that is conveyed.  So perhaps:

  • EOA: Entity Assets Only
  • CLB: Capped Liability Business
  • NIL: No Individual Liability
  • LCI: Losses Capped (at) Investment 
  • ILL: Investment Limited Losses
  • WYSIWYG: What You See Is What You Get
  • AMY or TED:  Just a name. You can assign a name to anything. We could name our entity AMY or TED.  (I considered SUE, but that already has a legal meaning)

I remain committed to trying to educate people so we can keep the current regime and just get it right, but it is good to have options. I welcome alternative ideas or critiques of any of these.  

Long live the LLC! 

It was great to see co-blogger Marcia Narine Weldon (albeit briefly) at the Sixth Biennial Conference: To Teach is to Learn Twice: Fostering Excellence in Transactional Law and Skills Education hosted by Emory Law’s Center for Transactional Law and Practice.  I had the opportunity to present and attend some of the presentations on Friday.  I had to leave Saturday morning to teach Contract Law to ProMBA students in Knoxville Saturday afternoon, however, and missed hearing half the conference program as a result.  Even on Friday, due to the number of super concurrent sessions, I had to forego a lot of great presentations.  Consequently, I was delighted to read Marcia’s post on Tina Stark’s presentation.  Great stuff.

At the conference, I offered insights on my document “treasure hunt” teaching method in a “try this” session on Friday afternoon.  More specifically, I talked about and demonstrated a corporate finance treasure hunt.  After laying a substantive and practical foundation, I sent the audience, some of whom are not corporate finance folks, on a search for blank check preferred stock provisions in Delaware corporate charters.  Then, I called on them to share their search logic and make observations about what they found, relating their treasure to the example I had given them.  They did so well with this exercise!  Everyone found a blank check stock provision, and many in the audience were willing to talk about what they found.

I went to several other “try this” sessions on Friday (billed as forums “for individual presenters to demonstrate in-class activities”).  They included:

The Creative Aspect of Transactional Lawyering: Structuring the Transaction and Drafting the Agreement to Resolve a Legal Issue

John F. Hilson
UCLA School of Law

Stephen L. Sepinuck
Gonzaga University School of Law

Teaching Contract Law, Terms, and Practice Skills Through Problems

Nadelle Grossman
Marquette University Law School

Teach the Basics of Contract Drafting, Corporate Governance & Transactional Law in One Sentence

Neil J. Wertleib
UCLA School of Law

Each session offered much to think about, a hallmark of this conference.  I plan to consider over the course of the summer–and beyond–how I may use some of the demonstrated techniques in my teaching and writing.  The proceedings of the conference will be published in principal part in Transactions: The Tennessee Journal of Business Law, UT Law’s business law journal, during the 2018-19 academic year.  I will try to remember to let folks know when that volume of Transactions is available.

This week, I am off to New York and Toronto for two additional conferences (in New York, the Impact Investing Legal Working Group (IILWG)/Grunin Center for Law and Social Entrepreneurship’s 2018 Conference on “Legal Issues in Social Entrepreneurship and Impact Investing–in the US and Beyond,” and in Toronto, the Law and Society Association Annual Meeting on “Law at the Crossroads: Le Droit à la Croisée des Chemins”).  I am at the airport waiting for my first (delayed) flight as a type this.  I expect to be able to report out on both next week.

Institutional shareholders are increasingly using their “voice” in matters of corporate policy, and, in particular, are taking an interest in “environmental, social, governance” (ESG) performance measures at their portfolio companies.  Investments are selected, and shareholders engage with management, using a variety of ESG metrics, often concerning matters like climate change, gender and racial diversity, and similar issues.  Though it’s often argued that some ESG engagement reflects the investors’ personal policy preferences rather than a sincere attempt to improve corporate performance, it seems that at least some ESG factors are, in fact, wealth maximizing.  It’s also been argued that many institutional investors have already diversified away their vulnerability to idiosyncratic risks and, by engaging on ESG matters, are attempting to protect themselves against systemic risks.

Nonetheless, the trend has met with some criticism.  One set of concerns pertains to protection of retail investors to whom the institutional investors owe fiduciary duties – fear that their money is being used to advance social causes favored by the investment manager, rather than to benefit investors in the fund.

A parallel set of concerns has less to do with protecting fund beneficiaries than with protecting portfolio companies.  In the most charitable account, the fear is that inexpert fund managers will improperly meddle in corporate affairs, harming both their own beneficiaries and other shareholders.  In a less charitable account, corporate managers hope to avoid accountability to a powerful shareholder base by squelching institutional participation in governance (this is the account described in detail in David Webber’s new book, The Rise of the Working Class Shareholder, which Ben Edwards blogged about here).

The battle plays out to a large extent via federal securities regulation, in everything from the process for bringing shareholder proposals under Rule 14a-8 to new attempts to regulate proxy advisors.

And it also plays out in regulation of the funds themselves, many of which are retirement plans governed by ERISA.  Even those retirement plans that do not formally fall within ERISA’s ambit – local government plans, for example – may very well look to ERISA for guidance or best practices, making ERISA regulation a critical battlefield.  (Hence Anita Krug’s characterization of the Department of Labor as “the other securities regulator”).

Essentially, the critical question under ERISA has been, to what extent may fund administrators select investments based on ESG factors, and involve themselves in the corporate governance of portfolio companies?

Over the years, the DoL has issued a series of guidelines interpreting fiduciaries’ obligations under ERISA.  All emphasize that plan administrators must act to advance the economic interests of the beneficiaries, and may not subordinate those interests to “social” objectives.  That said, the Bush, Obama, and now Trump administrations have each put their own stamp their interpretation of an ERISA fiduciary’s obligations.  The Bush Administration’s 2008 interpretation emphasized, for example, that when voting proxies, “the responsible fiduciary shall consider only those factors that relate to the economic value of  the plan’s investment … If the responsible fiduciary reasonably determines that the cost of voting (including the cost of research, if necessary, to determine how to vote) is likely to exceed the expected economic benefits of voting, … the fiduciary has an obligation to refrain from voting.”  The Obama Administration, by contrast, stated that to the extent the Bush bulletin was interpreted to require a cost-benefit analysis for every vote or governance action, this was incorrect; instead, fiduciaries should generally vote unless there is a reason to believe costs exceed benefits, because – it would be assumed – most costs associated with a vote would be minimal.

The Obama Adminstration’s guidance was also more tolerant towards the plan involvement in corporate governance, and consideration of ESG factors in the administration of plan assets, than was the Bush Administration.  The Obama guidance stated that the Bush guidance might be “misinterpreted” to require specific cost-benefit analyses with respect to ESG factors, when in fact, fiduciaries may “recogniz[e] the long term financial benefits that, although difficult to quantify, can result from thoughtful shareholder engagement when voting proxies … or otherwise exercising rights as shareholders.”  The Obama bulletin went on to emphasize the growing recognition of the importance of ESG factors when making investment decisions, and the benefits of shareholder engagement.

But now the pendulum has swung back hard, via the Trump administration.  Trump’s bulletin warns, “Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits.”  The new bulletin further states that the Obama bulletin:

was not intended to signal that it is appropriate for an individual plan investor to routinely incur significant expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors. Similarly, the [Obama bulletin] was not meant to imply that plan fiduciaries, including appointed investment managers, should routinely incur significant plan expenses to, for example, fund advocacy, press, or mailing campaigns on shareholder resolutions, call special shareholder meetings, or initiate or actively sponsor proxy fights on environmental or social issues relating to such companies…. If a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager, that may well constitute the type of “special circumstances” that … warrant[] a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.

The new bulletin goes even further, by discouraging the inclusion of ESG funds within ERISA plans that permit plan beneficiaries themselves to choose among a menu of options.  Though the bulletin admits that fiduciaries may include ESG funds if plan participants request such an option, it also includes a footnote that contains a heck of a qualification:

in deciding whether and to what extent to make a particular fund available as a designated investment alternative, a fiduciary must ordinarily consider only factors relating to the interests of plan participants and beneficiaries in their retirement income. A decision to designate an investment alternative may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments

The bulletin also warns against making an ESG fund a “default” option based on “the fiduciary’s own policy preferences.”

So what does all this mean?

Well, if you want law firm guidance, here’s some; there’s also a brief discussion in the Wall Street Journal.

As for me, I’ll start with the obvious: the back-and-forth makes clear that a larger debate about the proper role of shareholders in corporate governance is playing out across the stage of ERISA regulation, raising questions about the degree to which actual concern for plan beneficiaries is motivating the shifts (except, perhaps, in the very broadest sense that different administrations have different ideas about what balance of power will ultimately benefit shareholders generally).

Beyond that, the attempts to discourage the inclusion of ESG funds in ERISA plans strikes me as a peculiar elevation of legally constructed investor preferences over the, well, actual preferences of investors – what Daniel Greenwood dubbed “fictional shareholders.”

It’s all well and good to require that ERISA fiduciaries act solely in the economic interests of beneficiaries, on the assumption that this is what beneficiaries would likely want, and on the assumption that wealth maximization functions as “least common denominator” for beneficiaries’ otherwise conflicting interests.

But this reductionistic approach to defining beneficiary interests, adopted for the purpose of making them more manageable, should not stifle opportunities to accommodate the actual preferences of beneficiaries, especially when it is feasible to allow beneficiaries to sort themselves – like, say, when ESG-focused funds can be made available to those beneficiaries who are willing to sacrifice some degree of financial return to advance social goals.  Providing these opportunities to beneficiaries who choose them inflicts no damage on the interests of beneficiaries solely interested in financial return, and, in fact, the principle that investors should be able to control their own retirement planning is (supposedly) the reason these types of ERISA platforms are offered in the first place.

The new guidance, then, seems less about protecting beneficiaries from politically-motivated fiduciaries than it is about forcing beneficiaries to participate in the political goals of the Trump administration, namely, minimizing shareholder participation in corporate governance, particularly when those shareholders advance (what are usually) liberal policy priorities.

Greetings from Atlanta, Georgia, site of the Emory Transactional Law & Skills Conference. After only a few hours of presentations, I’m already inspired to make some changes in my new transactional lawyering class. I will write about some of the lessons learned next week. Today, I want to share some of Tina Stark’s remarks from the conference dinner that ended moments ago. Although she initially teased the audience by stating that she would make “subversive” statements, nothing that she said would scandalize most law students or surprise practicing lawyers.

Her “radical” proposal entailed having transactional skills education be a part of every law student’s curriculum. In support, she cited ABA Standard 301(a), which states:

OBJECTIVES OF PROGRAM OF LEGAL EDUCATION (a) A law school shall maintain a rigorous program of legal education that prepares its students, upon graduation, for admission to the bar and for effective, ethical, and responsible participation as members of the legal profession.

She argued that for the academy to meet this standard, schools must go beyond a narrow reading of ABA rules and provide every student with the foundation to practice transactional law, particularly because half of graduates will practice in that area even if they don’t know it while they are in law school. She also referenced ABA Standard 302, which states in part:

LEARNING OUTCOMES A law school shall establish learning outcomes that shall, at a minimum, include competency in the following: (a) Knowledge and understanding of substantive and procedural law; (b) Legal analysis and reasoning, legal research, problem-solving, and written and oral communication in the legal context.

Stark correctly observed that notwithstanding the litigation focus in law school, lawyers write more than predictive memos and briefs. She emphasized that competency in oral and communication skills is particularly important for deal lawyers.

If she came even close to being “radical,” (and I don’t think she did), it’s because she went beyond calling on more schools to offer, much less require drafting courses. Instead, she recommended that schools add at least one credit to the first year contracts course so that students can learn the structure of contracts and build a foundation for more advanced work. She likened law students failing to learn the parts of a contract to medical students studying anatomy without doing dissections. 

She anticipated the argument that schools do not have enough time to add an extra credit to the basic contracts course by countering that another first year course could be moved to the second year. This would allow professors to spend the first part of the semester teaching 1Ls to read and analyze a contract so that they can understand business drivers when reading cases in contracts and property class. 

Although some in the academy might resist the proposal, I believe that members of the bar and business community would applaud this move. If the long waiting list for my transactional lawyering course and similar ones around the country are any indication, law students would appreciate more balance in the curriculum as well.