Today is the rare day where I feel like a professor.  Dressed in jeans and drinking coffee in my office, I have been reading Colin Mayer‘s book Firm Commitment in advance of the Berle VIII Symposium in Seattle next week (you can also see Haskell’s post & Joan’s post about Berle).  That’s not a typo, my agenda for the day is reading.  And not for a paper or to prep for class, I am just reading a book–cover to cover. I can hardly contain my joy at this.

I have been struck by the elegantly simple idea that corporations’ true benefit is to advance (and therefore) balance commitment and control.  I have long viewed the corporate binary as between accountability and control.  Under my framework the two are necessary to balance and contribute to the checks and balances within the corporate power puzzle of making the managers, who control the corporation, accountable to the shareholders.  Colin Mayer posits that the one directional accountability of the corporation to shareholders without reciprocity of commitment from the shareholders to the corporation is a corrosive element in corporate design.  

“The most significant source of failure is the therefore that we have created a system of shareholder value driven companies who detrimental effects regulation is supposed to but fails to correct, and in response we week greater regulation as the only instrument that we believe can address the problem.  We are therefore entering a cycle of the pursuit of ever-narrower shareholder interests moderated by steadily more intrusive but ineffective regulation.”

In developing the notions of commitment and control, I have found the following passages particularly thought-provoking:

“The financial structure of the corporation is of critical importance…The commitment of owners derives from the capital that is employed in the corporation. What is held within it is fundamentally different from what remains outside as the private property of its owners. What is distributed to owners as dividends is no longer available as protection against adverse financial conditions and what is provided in the form of debt from banks and bondholders as against equity form shareholders is secure only as long as the corporation has the means with which to service it.”

“While incentives and control are centre stage in conventional economics, commitment is not. Enhancing choice, competition, and liquidity is the economist’s prescription for improving social welfare, and legal contracts, competition policy and regulation are their basic toolkit for achieving it. Eliminate restrictions on consumers’ freedom to choose, firms’ ability to compete, and financial markets’ provision of liquidity and we can all move closer to economic nirvana. Of course, economics recognizes the problems of time inconsistency in us doing today what yesterday we promised we would not conceive of doing today; of reputations in us continuing to do today what we promised to do yesterday for fear of not being able to do it tomorrow, and of capital and collateral in making it expensive for us to deviate from what we said yesterday we would do today and tomorrow. But these are anomalies. Economics does not recognize the fundamental role of commitment in all aspects of our commercial as well as our social lives and the way in which institutions contribute to the creation and preservation of commitment. It does not appreciate the full manner in which choice, competition and liquidity undermine commitment or the fact that institutions are not simply mechanisms for reducing costs of transaction, but on the contrary means to establish and enhance commitment at the expense of choice, competition, and liquidity. Commitment is the subject of soft sentimental sociologists, not of realistic rational economists. The sociologists’ are the words of Shakespeare’s ‘Love all, trust few. Do wrong to none’, the economists’ those of Lenin:  ‘Trust is good, control is better.'” 

-Anne Tucker

Last week, a federal court determined that an insurance disclosure that asked about an “applicant’s” criminal history did not apply to an LLC member’s individual criminal past.  In Jeb Stuart Auction Servs., LLC v. W. Am. Ins. Co., No. 4:14-CV-00047, 2016 WL 3365495, at *1 (W.D. Va. June 16, 2016), the court explained: 

“Question Eight” on the [insurance] application asked, “DURING THE LAST FIVE YEARS (TEN IN RI), HAS ANY APPLICANT BEEN INDICTED FOR OR CONVICTED OF ANY DEGREE OF THE CRIME OF FRAUD, BRIBERY, ARSON OR ANY OTHER ARSON-RELATED CRIME IN CONNECTION WITH THIS OR ANY OTHER PROPERTY?” Hiatt, on behalf of Jeb Stuart (who [sic] was the sole [LLC] applicant for the insurance policy), answered, “No.” Hiatt signed the application and left.

As you might imagine, Hiatt had been convicted of “hiring individuals to wreck cars so that he could receive the proceeds from the applicable insurance policies,” and, yep, about a month later, the building burned down.  Id. at *2.

The insurance company cancelled the policy because it claimed Hiatt had lied on the application, and Hiatt sued for the improper cancellation of the policy because he did not lie (he prevailed) and for attorneys fees claiming “the insurer, not acting in good faith, has either denied coverage or failed or refused to make payment to the insured under the policy.” Id. at *3.  Judge Kiser determined that not attorneys’ fees were warranted: 

Neither party was able to rely on a case on point regarding the issue of whether questions on an LLC’s insurance application asking about criminal history applied to the members of the LLC, to the corporate entity, or to both. Although I believe the answer to that question is clear, I am not aware of any other court being called upon to answer it. Therefore, although it was unsuccessful in asserting its defense to Jeb Stuart’s claim, West American’s position did present a novel legal question. As such, the final Norman factor weighs in favor of a finding of good faith.
Id. at *5.  I’ll buy that, though I think it’s a stretch. Would the court have thought this was a close call if an employee signed Amazon or IBM instead of Jeb Stuart? I doubt it.  Maybe the court meant that a small business or single-member LLC makes it a closer call?  Should it?  I don’t think so. Suppose Jeb Stuart was the claimant, but the property was under water, so all of the recovery was supposed to go to a bank.  Would this tactic be appropriate then?  I would think not, and it would seem “less close,” I suspect. Hopefully, this case answering the question will put this to rest, but I don’t love it.  Still, I concede it is a plausible interpretation, but wrong, when put in context. 
 
The Judge explains his thinking, stating that “[p]rimarily, as West American argued, the question of whether an LLC has a prior criminal history is, admittedly, confusing.” Id. at *4.  As I just noted, I don’t think that’s remotely true if it’s a large entity.  We care about who gets the payment, not who signs, I think. That is, the question is designed to track incentives, not applicants.  Maybe — maybe — this is a harder case if the question were about the “beneficiary” or “real party in interest” and not the “applicant.” 
 
The Judge notes, “Criminal laws typically target and punish individuals, and the types of crimes addressed by Question Eight overwhelmingly ensnare individuals, not corporate entities.” Id.  I’ll buy that.  He continues: “Therefore, although the question, by its terms, applied to the applicant (the LLC), a reasonable person reading Question Eight might interpret it to apply to the individuals that make up the LLC.” Id.  Perhaps, but not always. Again, now I worry about the size of the entity.  And who the applicant is.  
 
Judge Kiser finished: “Undoubtedly, that is what West American envisioned when it drafted the application, and Question Eight in particular. This factor weighs in favor of West American.”  But we construe ambiguity against the drafter for a reason, right?  Is it clear that’s what they meant?  I don’t know that it is, especially because this appears to be their standard form, not something applying to just this application. 
 
What’s clearly wrong is the discussion of Jeb Stuart as “a single-member limited liability corporation (‘LLC’).” Id. at *1.  (It’s a limited liability company.) As are the statements above (did you think I missed them?) calling LLCs “corporate” entities  at Id. **4-5.  
 
On the facts here, this seems like a reasonable outcome, but I don’t like the path this is headed down.  That is, this case suggests that it might be reasonable for a sophisticated entity to argue that because “some people” think something.   Even if they knew (or should have known) better.  Even worse, by conflating LLCs and corporations, this case helps reinforce inaccuracies in what “some people” think.

Having helped a few Tennessee bar applicants get straight on their knowledge of agency, unincorporated business associations, and personal property law last Friday at my BARBRI lecture (such a nice group present at the taping to keep me company!), it’s now time for me to wrap up my June Scholarship and Teaching Tour with a twofer–a week of travel to two of my favorite U.S. cities: Chicago, for the National Business Law Scholars Conference and Seattle for Berle VIII.  At both events, I will present my draft paper (still in process today, unfortunately) on publicly held benefit corporations, Corporate Purpose and Litigation Risk in Publicly Held U.S. Benefit Corporations.  Here’s the bird’s-eye view from the introduction:

Benefit corporations—corporations organized for the express purpose of realizing both financial wealth for shareholders and articulated social or environmental benefits—have taken the United States by storm. With Maryland passing the first benefit corporation statute in 2010, legislative growth of the form has been rapid. Currently, 31 states have passed benefit corporation statutes.

The proliferation of benefit corporation statutes and B Corp certifications can largely be attributed to the active promotional work of B Lab Company, a nonprofit corporation organized in 2006 under Pennsylvania law that supports social enterprise (“B Lab”). B Lab works with individuals and interest groups to generate attention to social enterprise generally and awareness of and support for the benefit corporation form and B Corp certification (a social enterprise seal of approval, of sorts) specifically. B Lab also supplies model benefit corporation legislation, social enterprise standards that may meet the requirements of benefit corporation statutes in various states, and other services to social enterprises.

Benefit corporation statutes have not, by and large, been the entity law Field of Dreams. Despite the legislative popularity of the benefit corporation form, there have not been as many benefit corporation incorporations as one might expect. In the first four years of benefit corporation authority, for example, Maryland reported the existence of fewer than 40 benefit corporations in total. Tennessee’s benefit corporation statute came into effect in January 2016, and as of May 2, 2016, Secretary of State filings evidence the organization of 26 for-profit benefit corporations. However, a review of these filings suggests that well more than half were erroneously organized as benefit corporations. Colorado, another recent adopter of the benefit corporation, does appear to have a large number of filings (90 in total as of June 12, 2016 based on the list of Colorado benefit corporations on the B Lab website). However, as with Tennessee, a number of these listed corporations appear to be erroneously classified. These anecdotal offerings indicate that published lists of benefit corporations—even those constructed from state filings—over-count the number of benefit corporations significantly.

Research for this article identified no publicly held U.S. benefit corporations. For these purposes (and as referenced throughout this article), the term “publicly held” in reference to a corporation is defined to mean a corporation (a) with a class of equity securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (“1934 Act”), or (b) otherwise required to file periodic reports with the Securities and Exchange Commission under Section 13 of the 1934 Act. Yet, benefit corporations may be subsidiaries of publicly held corporations (as Ben & Jerry’s Homemade Inc., New Chapter Inc., and Plum, PBC have demonstrated), and corporations certified as B Corps have begun to enter the ranks of publicly held corporations (perhaps Etsy, Inc. being the most well known to date). It likely is only a matter of time before we will see the advent of publicly held U.S. benefit corporations.

With the likely prospect of publicly held U.S. benefit corporations in mind, this article engages in a thought experiment. Specifically, this article views the publicly held U.S. benefit corporation from the perspective of litigation risk. It first situates, in Part I, the U.S. benefit corporation in its structural and governance context as an incorporated business association. Corporate purpose and the attendant managerial authority and fiduciary duties are the key points of reference. Then, in Part II, the article seeks to identify the unique litigation risks associated with publicly held corporations with the structural and governance attributes of a benefit corporation. These include both state and federal causes of action. The reflections in Part III draw conclusions from the synthesis of the observations made in Parts I and II. The closing thoughts in Part III are intended to be of use to policy makers, academic observers, and advisers of corporations, among others.

As Haskell mentioned in an earlier post, he and Anne and I will be together at the Berle VIII event.  What a great way to end my June tour–with my friends and colleagues from the Business Law Prof Blog!  I look forward to it.

As Rodney Tonkovic discusses in more detail, the plaintiff in Fried v. Stiefel Labs, 814 F.3d 1288 (11th Cir. 2016), has petitioned the Supreme Court to delineate disclosure duties in the context of trading by private companies.

Richard Fried was the former CFO of Stiefel Labs, which was privately held.  As an employee, he received stock as part of a pension plan.  When he retired, he sold the stock back to Stiefel (I don’t know much about the market for Stiefel stock, but I’m guessing that, since it was privately held, Fried didn’t think he had many alternative options).  Sadly for Fried, shortly after his sale, it was announced that Stiefel was being acquired by GlaxoSmithKline, and that negotiations had been in the works at the time of his sale.  By selling to Steifel instead of waiting for GSK’s acquisition, he missed out on, roughly, an additional $1.62 million.  He sued Stiefel, alleging that Stiefel had been obligated to disclose the negotiations to him at the time of his sale.

This is not something that comes up very often, but the case law that does exist tends to hold that insider trading principles apply both to private and public companies and, in particular, that when a company buys its own stock back from an employee, it has a duty to disclose material inside information.  See, e.g., Castellano v. Young & Rubicam, Inc., 257 F.3d 171 (2d Cir. 2001); Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987).

The issue is a bit of a theoretical muddle, though, not least because it is the company – not a particular employee – who is doing the trading, and thus the precise fiduciary duty at issue is harder to nail down.  The employee knows the price is not being set by the market generally, and the employee’s expectations regarding the company’s superior information depend – well – on the existing background legal regime of required disclosures.   (The SEC filed a brief in a related case, where it argued that “where a company trades in its own stock it does have a duty to disclose material information or abstain from trading.” SEC Brief, Finnerty v. Stiefel Labs, 2013 WL 2903651, at *9-*10.  This was an odd statement because that’s a hard case to make if the company is selling its stock, at least to the extent it’s relying on a Section 5 exemption.)  So what the employee might reasonably expect, or rely upon – and thus be deceived by – is something of a moving target.

I’m not going to hazard a guess as to whether the Supreme Court is likely to grant cert in the Fried case– my track record on these sorts of predictions is embarrassingly terrible – but I will say that there are some uphill battles Fried may have to climb.  First and most importantly, the Eleventh Circuit never actually decided the issue of whether a private corporation counts as an “insider” for insider trading purposes, because it rejected the claim on essentially technical grounds – i.e., that Fried should have requested jury instructions under 10b-5(a) or 10b-5(c), not 10b-5(b).  The Circuit’s failure to address the substantive issues detract from its utility as a vehicle for addressing the duties of a private corporation.  Indeed, the “questions presented” in Fried’s petition do not even mention the Eleventh Circuit’s focus on the distinctions between 10b-5(a), (b), and (c) – which, as we know, are really important distinctions to the Supreme Court, see Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011).

Even leaving that point aside, because of the dearth of caselaw, the Court might reasonably say these issues need more development in the lower courts.  And though Fried argues that this case involves the question whether 10b-5 prohibits trading in possession of material inside information, or only trading on the basis of inside information, that point was only mentioned by the Eleventh Circuit in passing, and it certainly has nothing to do with the far more interesting question of the duties owed by private companies repurchasing their stock.

But, as I said, I’m not going to try to predict what the Court is likely to do here.  I’ll simply say that assuming the Supreme Court rejects Fried’s petition, it almost certainly will have other chances to get at these problems, because of the increasing tendency of companies to stay private for prolonged periods of time, and to go through multiple rounds of financing.  As Bloomberg reports:

[T]he more money you have, the more information you get in private markets. Sven Weber launched the SharesPost 100 index fund in 2012 to let unaccredited investors (with a net worth below $1 million) own shares in late-stage startups, including DocuSign Inc., Spotify AB and Social Finance Inc., with a minimum investment of $2,500. He could only write $500,000 checks at first and it was hard to get information to gauge if he was getting a fair price. As the SharesPost 100 grew to 34 startup positions and $71 million under management, he got more access.

Weber said one Silicon Valley unicorn provided virtually no information when he was trying to purchase shares last year. Based on historical statements and publicly available documents like articles of incorporation, he invested anyway. During the past year, he increased his stake, got to know company executives and eventually convinced them to share quarterly revenue updates and forward-looking statements.

The differential access to information has attracted not only SEC attention, but also other lawsuits like Fried’s – and I’m assuming there will be more to follow.   So the really interesting question is, when you invest in a private company, to what extent are you assuming the risk of this kind of informational asymmetry?

By now, I am sure all readers are aware of the horrific, hateful mass shooting that occurred in Orlando earlier this week.

If your social media feeds are anything like mine, it did not take long for politicians, pundits, and friends to politicize this tragedy. The tragedy was quickly used, by people all along the political spectrum, as evidence supporting their views on guns, religion, sexuality, and immigration. There is certainly a time and need for solutions, but there needs to be space to mourn. Orin Kerr (George Washington Law) summarized my thoughts well when he tweeted:

 

What could and should be done immediately after a tragedy? I am not entirely sure, but those who took steps to donate blood and financial resources should be commended.

Some local businesses also attempted to help. For example, it was reported that Chick-fil-A, which is famously closed on Sundays, cooked and gave away food to those waiting in line to donate blood. This is an admittedly small gesture, but at a time when our nation often seems hopelessly divided, I am thankful for the gesture. Chick-fil-A and its conservative Christian COO Dan Cathy were, of course, at the center of controversy regarding views on marriage. I have seen no indications that Dan Cathy has changed his views on marriage, though Chick-fil-A does appear to have made changes in its donations. In any event, I am so glad to see a business looking past differing views and caring for human beings in the aftermath of tragedy.

[Disclosure: While no company is perfect, my family and I are Chick-fil-A fans, and I have friends, including a former roommate, who work for the company.]

On Wednesday, the EU finally outlined its position on conflict minerals. The proposed rule will affect approximately 900,000 businesses. As I have discussed here, these “name and shame” disclosure rules are premised on the theories that: 1) companies have duty to respect human rights by conducting due diligence in their supply chains; 2) companies that source minerals from conflict zones contribute financially to rebels or others that perpetuate human rights abuses; and 3) if consumers and other stakeholders know that companies source certain minerals from conflict zones they will change their buying habits or pressure companies to source elsewhere.

As stated in earlier blog posts, the US Dodd- Frank rule has been entangled in court battles for years and the legal wranglings are not over yet. Dodd-Frank Form SD filings were due on May 31st and it is too soon to tell whether there has been improvement over last year’s disclosures in which many companies indicated that the due diligence process posed significant difficulties.

I am skeptical about most human rights disclosure rules in general because they are a misguided effort to solve the root problem of business’ complicity with human rights abuses and assume that consumers care more about ethical sourcing than they report in surveys. Further, there are conflicting views on the efficacy of Dodd-Frank in particular. Some, like me, argue that it has little effect on the Congolese people it was designed to help. Others such as the law’s main proponent Enough, assert that the law has had a measurable impact.

The EU’s position on conflict minerals is a compromise and many NGOs such as Amnesty International, an organization I greatly respect, are not satisfied. Like its US counterpart, the EU rule requires reporting on tin, tantalum, tungsten, and gold, which are used in everything from laptops, cameras, jewelry, light bulbs and component parts. Unlike Dodd-Frank, the rule only applies to large importers, smelters, and refiners but it does apply to a wider zone than the Democratic Republic of Congo and the adjoining countries. The EU rule applies to all “conflict zones” around the world.

Regular readers of my blog posts know that I teach and research on business and human rights, and I have focused on corporate accountability measures. I have spent time in both Democratic Republic of Congo and Guatemala looking at the effect of extractive industries on local communities through the lens of an academic and as a former supply chain executive for a Fortune 500 company. I continue to oppose these disclosure rules because they take governments off the hook for drafting tough, substantive legislation. Nonetheless, I  look forward to seeing what lessons if any that the EU has learned from the US when the member states finally implement and enforce the new rule. In coming weeks I will blog on recent Form SD disclosures and the progress of the drafting of the final EU rule.

Three Business Law Prof Blog editors (myself included) are presenting at the upcoming Berle Symposium on June 27-28 in Seattle.

Colin Mayer (Oxford) is the keynote speaker, and I look forward to hearing him present again. I blogged on his book Firm Commitment after I heard him speak at Vanderbilt a few of years ago. The presenters also include former Chancellor Bill Chandler of the Delaware Court of Chancery. Given that Chancellor Chandler’s eBay v. Newmark decision is heavily cited in the benefit corporation debates, it will be quite valuable to have him among the contributors. The author of the Model Benefit Corporation Legislation, Bill Clark, will also be presenting; I have been at a number of conferences with Bill Clark and always appreciate his thoughts from the front lines. Finally, the list is packed with professors I know and admire, or have read their work and am looking forward to meeting. 

More information about the conference is available here.

Starting 2 weeks ago at Law & Society, I began participating in a series of conversations that can be boiled down to this:  Artificial Intelligence and the Law. Even the ABA is on to this story, which means it has reached a peak saturation point.  Exciting, scary, confusing, skeptical and a variety of other reactions have been thrown into the conversations across the legal studies gamut from algorithms in parole & criminal sentencing  to its use to generate social credit scores (thank you Nizan Packin for opening my eyes to this application).  In another LSA shout out, I want to highlight to forthcoming scholarship of Ben Edwards at Barry College where he criticizes the conflicts of interest in investment advise channels. One possible work around he explores is relying on robo-advisors:    In the few years since I have looked at digital investment advise, the field has changed, matured, grown!   So much so that FINRA has issued a report on digital investment advise, and is unsurprisingly skeptical of the technology application that poses a significant threat to its members (new release synopsis available here).   For the uninitiated, check out this run down of popular robo-advisors and Forbes article.  Skepticism about the sustainability of low-fee model can be found here; and optimism about its ability to change the world can be found here.

A robo-advisor (robo-adviser) is an online wealth management service that provides automated, algorithm-based portfolio management advice without the use of human financial planners. Robo-advisors (or robo-advisers) use the same software as traditional advisors, but usually only offer portfolio management and do not get involved in more personal aspects of wealth management, such as taxes and retirement or estate planning.

-Investopedia

-Anne Tucker

 

    Thanks to the BLPB for inviting me to guest blog!  I’m excited to be here.  I’ll probably write a few substantive posts to start out and finish up with some musings on teaching.

    Here’s a head scratcher:  interested director provisions have long been a part of corporation statutes, and they are making appearances in LLC statutes as well.  The statutes generally address transactions between a corporation and one or more of its directors (or between the corporation and another entity to which the director is affiliated) and provide a mechanism for cleansing the “stink” of the conflict of interest. 

    The fundamental problem with interested director transactions is that we do not trust the interested director to put the entity’s interests before his own.  Correspondingly, in such transactions there is a need to find a “trustworthy decisionmaker” to review the transaction with the entity’s interests in mind.  See, e.g., Franklin Gevurtz, Corporation Law § 4.2.1, at 325 (2000); Douglas K. Moll & Robert A. Ragazzo, Closely Held Corporations § 6.03[B][2][b], at 6-59 (LexisNexis 2015).  Interested director statutes in corporate law can be viewed as providing three trustworthy decisionmaker options:  disinterested directors, disinterested shareholders, or a court.  Section 144 of the Delaware General Corporation Law is fairly typical of such statutes:

§ 144 Interested directors; quorum.

(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose, if:

(1) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or

(2) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the stockholders; or

(3) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the stockholders.

(b) Common or interested directors may be counted in determining the presence of a quorum at a meeting of the board of directors or of a committee which authorizes the contract or transaction.

    Although § 144(a)(2) does not explicitly indicate that a vote of disinterested shareholders is required, case law in Delaware has imposed a disinterested requirement.  See, e.g., Marciano v. Nakash, 535 A.2d 400, 405 n.3 (Del. 1987); In re Wheelabrator Technologies, Inc. S’holders Litig., 663 A.2d 1194, 1203 (Del. Ch. 1995).  If the purpose of the statute is to find a trustworthy decisionmaker—i.e., a decisionmaker lacking a conflict of interest in the transaction at issue—this disinterested requirement is eminently sensible.  Moreover, why require disinterested directors for director authorization, but permit interested shareholders for shareholder authorization?  After all, particularly in a closely held corporation, the interested directors are almost always significant shareholders.  If they are not to be trusted to bless the conflicted transaction at the director level, why trust them to bless the transaction at the shareholder level?  See also MBCA §§ 8.61(b)(2), 8.63(a) (requiring disinterested shares for shareholder authorization purposes).

 

Continue Reading The Logic (?) of Interested Director Statutes