One final post on the SEC’s proposed changes to Rule 147 and I promise I’m finished—for now. Today’s topic is the effect the proposed changes will have on state crowdfunding exemptions. If the SEC adopts the proposed changes to Rule 147, many state legislatures will have to (or at least want to) amend their state crowdfunding legislation.

As I explained in my earlier posts here and here, the SEC has proposed amendments to Rule 147, currently a safe harbor for the intrastate offering exemption in section 3(a)(11) of the Securities Act. If the proposed amendments are adopted, Rule 147 would become a stand-alone exemption rather than a safe harbor for section 3(a)(11). There would no longer be a safe harbor for intrastate offerings.

That creates some issues for the states. Many states have adopted state registration exemptions for crowdfunded securities offerings that piggyback on the federal intrastate offering exemption. That makes sense, because, if the offering isn’t also exempted at the federal level, the state crowdfunding exemption is practically worthless. (An offering pursuant to the federal crowdfunding exemption is automatically exempted from state registration requirements, but these state crowdfunding exemptions provide an alternative way to sell securities through crowdfunding.)

The SEC’s proposed amendments would actually make it easier for a crowdfunded offering to fit within Rule 147. (In fact, the SEC release says that’s one of the purposes of the amendments.) Most importantly, the SEC proposes to eliminate the requirement that all offerees be residents of the state. That change would facilitate publicly accessible crowdfunding sites which, almost by definition, are making offers to everyone everywhere. The securities would still have to be sold only to state residents, but it’s much easier to screen purchasers than to limit offerees.

Problem No. 1: Dual Compliance Requirements

Unfortunately, many state crowdfunding exemptions require that the crowdfunded offering comply with both section 3(a)(11) and Rule 147 in order to be eligible for the state exemption. Here, for example, is the relevant language in the Nebraska state crowdfunding exemption: “The transaction . . . [must meet] . . . the requirements of the federal exemption for intrastate offerings in section 3(a)(11) of the Securities Act of 1933 . . . and Rule 147 under the Securities Act of 1933.” (emphasis added).

Currently, that double requirement doesn’t matter. An offering that complies with the Rule 147 safe harbor by definition complies with section 3(a)(11). That would no longer true if the SEC adopts the proposed changes. Since Rule 147 would no longer be a safe harbor, an issuer that complied with Rule 147 would still have to independently determine if its offering complied with section 3(a)(11). Because of the uncertainty in the case law under 3(a)(11), that determination would be risky. (But see my argument here.) The leniency the SEC proposes to grant in the amendments to Rule 147 would not be helpful unless state legislators amended their crowdfunding exemptions to eliminate the requirement that offerings also comply with section 3(a)(11).

Problem No. 2: State-of-Incorporation/Organization Requirements

There’s another potential issue. Many state crowdfunding exemptions include an independent requirement that the issuer be incorporated or organized in that particular state. That’s inconvenient, and reduces the value of the state crowdfunding exemption, because corporations and LLCs are often incorporated or organized outside their home states. But, until now, that state requirement hasn’t mattered because both section 3(a)(11) and Rule 147 also impose such a requirement.

The SEC proposes to eliminate that requirement from Rule 147, so it now matters whether the state crowdfunding exemption independently imposes such a requirement. Issuers won’t be able to take full advantage of the proposed changes to Rule 147 unless states eliminate the state-of-incorporation/organization requirements from their state crowdfunding exemptions as well.

On to More Important Things

That’s the end of my Rule 147 discussion for now. I promise! Now, we can turn to more important questions, such as why your favorite team belongs in the college football playoff. (I know for sure that my college football team won’t be there. I would be happy just to have my college football team in a bowl game.)

Guest post by Jeffrey Lipshaw:

I’m honored to be asked to participate in this micro-symposium, and will (sort of) address the first two questions as I have restated them here.

  1. Does contract play a greater role in “uncorporate” structures than in otherwise comparable corporations and, more importantly, do I care?

                  Yes, as I’ll get to in #2, but indeed I probably don’t care. My friend and casebook co-author, the late great Larry Ribstein, was more than a scholar-analyst of the non- or “un-” corporate form; he was an enthusiastic advocate. It’s pretty clear that had to do with his faith in the long-term rationality of markets and their constituent actors and a concomitant distrust of regulatory intervention. Indeed, he argued the uncorporate form, based in contract, was more amenable than the regulatory-based corporate form to the creation of that most decidedly immeasurable quality, trust, and therefore the reduction of transaction costs. I confess I never quite understood the argument and tried to explain why, but only after Larry passed away, so I never got an answer. 

                  Unlike Larry (and a number of my fellow AALS Agency, Partnership, & LLC section members), I was never able to generate a lot of normative fervor about the ultimate superiority of the non-corporate form. I view all organizational and transactional structures, including corporations, LLCs, and contracts, as models or maps.  The contractual, corporate, and uncorporate models are always reductions in the bits and bytes of information from the complex reality, and that’s what makes them useful, just as a map of Cambridge, Massachusetts that was as complex as the real Cambridge would be useless.  

                  The difference between city maps and word maps is that the latter are artifacts we lawyers create to chart or control a reality that, in all its damnable uncooperativeness, insists upon moving forward through time and not necessarily respecting all that hard work we did trying to map its possible twists and turns. City maps may also become obsolete over time, but streets and buildings tend not to evolve and adapt quite as quickly or fluidly as human desires and relationships. So we have fewer issues with the gaps between physical maps and physical reality (notwithstanding the desire of my car’s GPS to sell me annual updates) than with the gaps between what we want now and what we wrote down some time ago (whether by way of bylaws, operating agreement, or supply contract) to see that we got it.  

                  Hence, if uncorporations differ from corporations, it’s more a matter of degree than of any real difference.  Both are textual artifacts.  We have created or assumed obligations pursuant to the text at certain points in time, and we use the artifacts and their associated legal baggage opportunistically when we can.  I am not convinced that organizing in the form or corporations or uncorporations makes much difference on that score.

  1. Is the unfettered ordering in LLCs and limited partnerships – like being able to eliminate wholly all fiduciary duties among the members or partners, as Delaware permits – a good thing?  Or should there be some standardized (and I presume therefore mandatory) fiduciary obligations for uncorporations, as Chief Justice Strine and Vice-Chancellor Laster suggest?

                  Having now gotten my general curmudgeonly-ness out of the way about the whole subject, and believing that a foolish consistency is the hobgoblin of little minds, I want to point out an area where the corporate model and its baggage indeed don’t match up to what normal human beings would expect as reasonable.  I confess it’s something that has been a bug up my backside for a number of years, in that I personally had to counsel on the dilemma, and would have loved it if we had organized this particular company as a Delaware limited partnership with only limited and specified fiduciary obligations.

                  Here’s the circumstance.  ABC Corporation spins off one of its businesses into a majority-owned subsidiary, DEF Corporation, possibly as the first step in a complete divestiture.  (There’s possibly a tax benefit doing it this way, but let’s not go there right now.)  DEF is now publicly traded, with a substantial minority, but ABC controls it both as to ownership (a majority share percentage) and management (posit that ABC appoints a majority of the board of the subsidiary).  Assume that DEF’s common stock is now trading at, say, $15 per share on the NASDAQ.  A third party, XYZ Corporation, contacts ABC’s CEO, and says the following: “We are prepared to pay $32 per share for all of DEF, both yours and the public minority, but we view this as pre-emptive, and if you shop the bid, we will walk away.”  ABC’s CEO’s visceral reaction is to tell XYZ that if it will send over the check, she will deliver the share certificate this afternoon.  Indeed, were DEF still wholly owned, that’s probably what would happen soon, if not that afternoon. 

                  But Delaware corporate law doesn’t like that at all when there’s a public minority.  See McMullin v. Beran, 765 A.2d 910 (Del. 2000) and Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (Del. 2009).  DEF’s board is going to have to create a special committee of the independent (i.e. public) directors to undertake diligence satisfying the duty of care obligation.  That committee will feel obliged to hire independent counsel and its own investment banker.  It may believe that its duty requires a shopping of the bid, which could cause the pre-emptive offer to go away.  But how do we know that there isn’t a $35 per share offer just waiting out there?  (I commented on this in connection with Lyondell back in 2008.)  As any transactional lawyer knows, time means deal risk.

                  I’m not suggesting that the duty of care obligations imposed by the corporate law are wrong in change of control cases, but their imposition in Smith v. Van Gorkom (where the essence of the decision was that, regardless of the attractiveness of the offer, the board went too fast and wasn’t careful enough) provoked the adoption of §102(b)(7), exculpating the directors from monetary liability on account of any breach of the duty of care largely because they were held liable in a “devil if you do – devil if you don’t” circumstance.  That is to say, §102(b)(7) is an implicit acknowledgment that broad and standardized fiduciary obligations are sometimes overbroad.  But there’s really no way, at least logically, to tell a board when a bid is sufficiently pre-emptive as to trump the ordinary procedural precautions.

                  The great benefit of Delaware LLC and LP law, in providing that the usual fiduciary duties apply as a default matter, but permitting the parties to eliminate or modify them, as one cannot under the corporate law, is precisely the customization that would have been useful here.  Assuming no penalty in the market for having organized as a public limited partnership or LLC (see Blackstone Group LP), that form would have allowed the governing organizational document to waive any fiduciary obligation of the board or the majority owner in connection with the consideration of a seemingly pre-emptive offer, and avoided delay and the associated risk to the deal.

                  With all due respect to Chief Justice Strine and Chancellor Laster, I still don’t believe this has anything to do with the magic of private ordering in contract.  As I’ve written extensively, I think there’s significant illusion among lawyers and law professors about the extent to which any text capable of colorable competing interpretations actually reflects any mutual intention even if it was the subject of arm’s-length negotiation. That’s because I tend to believe that even sophisticated parties to sophisticated contracts put in a lot of boilerplate they hope maps accurately the twists and turns of future events or, more importantly, clearly favors them if there’s ever a dispute.  And when there is a later dispute, they turn to the text and hope to hell there’s something helpful in it.  So I’ve never been under the misapprehension that the operating agreement or partnership agreement of a publicly held LLC or LP reflects real intentions about the resolution of later disputes any more than corporate bylaws or the rights and preferences of a class of stock.

                  The LLC or LP form is just an alternative map or model, with alternative rights and obligations.  In the case that bugged me, it would have been a way to avoid a problem the corporate model really couldn’t quite get right.  Whether that’s “contract” or something else, reinstating standardized or mandatory fiduciary obligations strikes me as eliminating the very choice the different forms were meant to offer.

-Jeff Lipshaw

Well, it turns out Halliburton is going – you guessed it – back to the Fifth Circuit on 23(f) review.

If you recall, the Fifth Circuit overturned the district court’s class certification order in the first go-round – a decision that was vacated by the Supreme Court in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011).  The district court recertified the class; the Fifth Circuit granted 23(f) review, and the Supreme Court vacated – again!  And then the district court certified the class for a third time, and the defendants petitioned for 23(f) review, and the Fifth Circuit has – again! – granted the petition. 

The thing that’s so amazing, of course, is that this case has hit the Supreme Court twice, the district court three times, and now the Fifth Circuit three times, and it’s the exact same argument, over and over and over, on the same evidence – just using slightly different words.  Namely, the defendants’ position that if there is no price increase at the time of an initial false statement, and no price drop in reaction specifically to news that later reveals the earlier statements to have been false at the time they were made, therefore it must be concluded that the false statements never impacted prices in the first place. 

This time, however, the 23(f) grant comes with a concurrence.  I’ve actually never heard of a 23(f) concurrence before – are there others?   They can’t be common, and in this case, the concurrence is by Judge Dennis – who has long been hostile to the Fifth Circuit’s strict approach to class certification in Section 10(b) cases.  See Erica P. John Fund, Inc. v. Halliburton Co., 2015 U.S. App. LEXIS 19519 (5th Cir. Nov. 4, 2015).

In his concurrence, Judge Dennis expresses open skepticism of the defendants’ argument that they can rebut Basic’s presumption of price impact by demonstrating that any alleged corrective disclosures were not, in fact, corrective.  He chides the defendants for rehashing points that the Supreme Court rejected in the first Halliburton case, namely, that if the “truth” was never disclosed in a fraud on the market case, the class cannot be certified.  But, given the issue’s importance, he “reluctantly” concurs in the panel’s decision to grant the 23(f) petition, in order to allow the Circuit to clarify the law.

In my view, Judge Dennis is absolutely correct that the defendants’ argument rehashes territory that the Supreme Court has already rejected, but, to be fair, at least some of the problem can be laid at the feet of the plaintiffs – who appear to have accepted defendants’ premise, namely, that there must be some affirmative evidence of price impact – either an upward movement when the statement is first made, or downward movement upon its correction – before a class can be certified.  That, of course, is contrary to the notion of a presumption; it is the defendants’ burden, not the plaintiffs’, to show not only that any price movements were not due to the fraud, but also that even price stability means that the fraud had no effect (i.e., that the fraud did not, say, operate to keep prices level instead of falling).  Or to put it another way, even if defendants are entirely right that the corrective statements did not reveal any truths, that still does not answer the question whether the initial false statements had an impact on price.

Anyway, in light of Judge Dennis’s concurrence, the defendants must be grateful that 23(f) petitions are usually transferred to a merits panel after being granted.  But see Margaret V. Sachs, Superstar Judges as Entrepreneurs: The Untold Story of Fraud-on-the-Market, 48 U.C. Davis L. Rev. 1207 (2015) (arguing that Judges Easterbrook and Posner of the Seventh Circuit have chosen to assign Rule 23(f) petitions to themselves for merits review in Section 10(b) cases).

Meanwhile, we can at least look forward to seeing these issues  explored in a novel setting.  The Eighth Circuit recently heard oral arguments on a 23(f) appeal from the certification decision in IBEW Local 98 Pension Fund v. Best Buy Co., 2014 U.S. Dist. LEXIS 108409 (D. Minn. Aug. 6, 2014), where – again – the defendants contend that they can rebut price impact by showing that the market did not react to the false statements initially, nor were any later statements corrective of the earlier ones.  The case has attracted a degree of industry attention; defense-side amicus briefs have been filed by the Chamber of Commerce and the Securities Industry and Financial Markets Association.  

It’s a race to see which circuit produces an opinion first; the Eighth Circuit has a large head start but then, it’s not like the Fifth Circuit needs any extra time to familiarize itself with the facts.

 

Just a few days ago, San Franciscans voted against Proposition F, a referendum that would have placed restrictions on AirBnBs and other short-term housing rentals. This type of legislation is far from unique. Fueled by arguably the United States’ most prominent housing crisis, San Francisco has enacted layers of housing laws intended to protect tenants from skyrocketing rents, arbitrary evictions, and diminished rental supplies. Notable examples include laws governing rent controls (landlords have little ability to raise rents), market exoduses (the Ellis Act often incentives landlords to withdraw from the San Francisco rental market for five years), and buyout restrictions (landlords face numerous obstacles in buying out a tenant’s lease). Although the motives behind these statutes is admirable—considering affordable housing’s position as a social justice issue—many housing laws intended to benefit tenants are misguided, harming both tenants and landlords.

The folly of housing laws is neatly described by an economics term known as the “cobra effect,” which refers to solutions that exacerbate an original problem. The term was coined after cobras overran Delhi, prompting city officials to issue bounties for each killed cobra. Upon learning that local residents had begun farming cobras to generate additional bounties, city officials terminated the program. Left with no use for their farm-raised cobras, residents released their snakes back into the city, creating a far greater cobra crisis. It seems that a similar cobra effect is attributable to urban housing statutes, which—despite their remedial intent—are actually causing rents to rise.

The problem is this: many remedial laws ignore the economics of human behavior. In response to new incentives, rational actors typically adjust their behaviors as opposed to remaining passive. Landlords are no different. Take rent controls for example, which prevent landlords from raising a unit’s rental price. While ostensibly protecting tenants, they also produce unintended consequences by raising rents on future tenants. This is because, knowing that rental rates generally increase over time, landlords tend to charge more upfront to compensate for future years of below-market rent income. For instance, if a unit’s current price is $800, but may rise to $1,200 in five years, a landlord is likely charge $1,000 upfront to mitigate the lost profits occurring in years four and five of the lease (assuming that tenants typically remain for five years). This is why rent control laws can generate rate increases that exceed what the market would have otherwise rendered.

A related problem concerns the propensity of landlords to completely abandon rental markets due to the burdens of inflexible rental laws. An alternative landlord strategy which avoids a complete marketplace withdrawal is to reject yearlong leases in favor of short-term rentals such as AirBnBs. Since squatter rights take effect only after 30 days of occupancy, opting for short-term rentals sidesteps certain landlord/tenant laws. This later trend was the impetus behind the now-defeated Proposition F. And as economics tells us, when a good’s supply decreases (e.g., standard yearlong leases) while demand stays constant, prices rise.

I’m not suggesting that all remedial housing laws are entirely bad and that unfettered free markets are always preferable. For instance, I would argue that a law vesting tenants with the right to sublease their apartment’s unused bedrooms would be a great law (i.e., a singular renter living in a three bedroom apartment could co-lease to two additional individuals). It would increase the number of rental leases on a market without overly burdening landlords; and when supply goes up, prices go down. The lesson to be learned is that remedial (housing) laws must consider the manner in which rational actors respond to incentives (i.e., laws) or else suffer the likelihood of making a crisis worse.

Last week I shared my thoughts on REI’s #OptOutside campaign and concluded that the campaign appeared, in my opinion, to be more of a marketing ploy than anything truly socially responsible. 

I promised to discuss what I think it takes to build a respected socially responsible brand.

In my opinion, respected socially responsible brands are: (1) Authentic; (2) Humble; and (3) Consistent. 

These three work together. Authenticity comes, at least in part, from not over-claiming (also seen in humility) and from showing social responsibility in many areas over time (consistency). Authenticity with regard to social responsibility requires some serious sacrifice, at least in the short term. Humble companies admit their imperfections, work to right wrongs, and seek to improve. Building a socially responsible brand takes time, often decades.  As Warren Buffett supposedly said, “It takes 20 years to build a reputation and 5 minutes to ruin it.”

Patagonia’s “Don’t Buy This Jacket” campaign was probably one of the best socially responsible advertising campaigns I have seen. This campaign seemed authentic because of Patagonia’s consistent history of social responsibility and because it seemed clear that Patagonia was going to take a serious financial hit from this campaign. Patagonia’s add was also humble in admitting the social costs of the goods it produces. Patagonia is not a perfect company, and their executives often admit that, and Patagonia may experience mission drift, but they continue to be one of the most socially responsible companies I know.  

Just a quick report from the 2015 ABA LLC Institute, an annual event held in the fall in Washington, DC that attracts anally compulsive (and I do mean that in the most positive way possible) business lawyers (academics and practitioners) interested in limited liability companies (LLCs) and other alternative business entities.  The agenda for this year’s program is full of nifty stuff and great presenters (present company excepted).  Co-blogger Josh Fershee would love the LLC Institute.  No one here confuses the LLC with the corporation!  (I will just link to one of Josh’s fabulous posts on that topic as a reference point.)

For this year’s institute, I chaired a panel on dissolution in the LLC and also participated in a panel that explored just what an LLC operating agreement really is.  I was wowed in each case by my co-paneleists.  Because the norm at this conference is to interrupt the panelists and comment on their presentations as they speak, the discourse was engaged and lively.

I will save my comments on the operating agreement panel for next week’s micro-symposium.  Today, I want to briefly cover highlights from  the dissolution panel.  Specifically, we focused a lot of attention on the evolution of dissolution events under the uniform and prototype LLC acts and various state LLC statutes since the adoption of the federal income tax “check the box” rules.  There’s more in and related to that topic than you might think . . . .

Continue Reading ABA LLC Institute: A Great Bunch of LLC Nerds–I Mean Wonks!

I have spent the past week immersed in whistleblower discussions. On Saturday, I served on a panel with plaintiffs and defense counsel at the ABA Labor and Employment Law Mid-Year meeting using a hypothetical involving both a nursing home employee and a compliance officer as potential whistleblowers under the False Claims Act, Dodd-Frank, and Sarbanes-Oxley. My co-panelist Jason Zuckerman represents plaintiffs and he reminded the audience both through a recent article and his presentation that Dodd-Frank has not replaced SOX, at least for his clients, as a remedy. Others in the audience echoed his sentiment that whistleblower claims are on the rise.

A fellow member on the Department of Labor Whistleblower Protection Advisory Committee, Greg Keating, represents defendants, and has noticed a significant increase in claims by in house counsel, as he told the Wall Street Journal recently. More alarmingly, a San Francisco federal judge found last month that board members can be held personally liable for retaliation under Sarbanes-Oxley and Dodd-Frank when they take part in the decision to terminate a whistleblower. This case of first impression involved the termination of a general counsel who complained of FCPA violations, but it is possible that other courts may follow the court’s reasoning, even though the judge acknowledged that it was a close call.

As the SEC continues to award whistleblower bounties to compliance officers and auditors, and as law firms continue to see in-house counsel raising concerns about their own companies, board members will have to walk the fine line between exercising appropriate oversight and not enmeshing themselves in the decisionmaking process.

Next week, the BLPB is hosting a micro-symposium organized by the AALS section on Agency, Partnership, LLCs, and Unincorporated Associations.  Confirmed participants include Joan MacLeod Heminway (BLPB editor), Dan Kleinberger, Jeff Lipshaw, Mohsen Manesh, and Sandra Miller.

The micro-symposium will explore the role of private ordering in LLCs and other alternative business entities, a broad topic that encompasses many interesting questions:

(1) To what extent, and in what ways, does contract play a greater role in LLCs and LPs than in otherwise comparable corporations? Is it helpful to conceptualize private ordering in this context as contractual?

(2) Does unfettered private ordering reliably advance the interests of even the most sophisticated parties? Does it waste judicial resources? In their book chapter, The Siren Song of Unlimited Contractual Freedom, two distinguished Delaware jurists, Chief Justice Leo Strine and Vice Chancellor J. Travis Laster, raise these concerns and argue in favor of more standardized fiduciary default rules. 

(3) Should the law impose fiduciary duties of loyalty and care as safeguards against abuse of the unobservable discretion managers enjoy because those duties reflect widely held social norms that most investors would expect to govern the conduct of managers?

(4) If the parties themselves would choose to waive their fiduciary obligations, is there nevertheless a continuing role for mandatory terms and judicial monitoring of the parties’ relationship?

(5) Does it matter whether an LLC or alternative business entity is closely held or publicly traded?

We look forward to an engaging discussion next week via blog, and we invite everyone who will be at AALS to attend our section meeting on January 7 at 1:30pm.  Joined by panelists Lyman Johnson and Mark Loewenstein, we will continue the conversation in person. 

-Anne Tucker

My recent article:  Locked In: The Competitive Disadvantage of Citizen Shareholders, appears in The Yale Law Journal’s Forum.  In this article I examine the exit remedy for unhappy indirect investors as articulated by Professors John Morley and Quinn Curtis in their 2010 article, Taking Exit Rights Seriously.  Their argument was that the rational apathy of indirect investors combined with a fundamental difference between ownership of stock in an operating company and a share of a mutual fund.  A mutual fund redeems an investor’s fund share by cashing that investor out at the current trading price of the fund, the net asset value (NAV). An investor in an operating company (a direct shareholder) exits her investment by selling her share certificate in the company to another buyer at the trading price of that stock, which theoretically takes into account the future value of the company. The difference between redemption with the fund and sale to a third party makes exit in a mutual fund the superior solution over litigation or proxy contests, they argue, in all circumstances. It is a compelling argument for many indirect investors, but not all.

In my short piece, I highlight how exit remedies are weakened for citizen shareholders—investors who enter the securities markets through defined contribution plans.  Constrained investment choice within retirement plans and penalties for withdrawals means that “doing nothing” is a more likely option for citizen shareholders.  That some shareholders are apathetic and passive is no surprise. The relative lack of mobility for citizen shareholders, however, comes at a cost.  Drawing upon recent scholarship by Professors Ian Ayres and Quinn Curtis (Beyond Diversification), I argue that citizen shareholders are more likely to be locked into higher fee funds, which erode investment savings.  Citizen shareholders may also be subsidizing the mobility of other investors.  These costs add up when one considers that defined contribution plans are the primary vehicle of individual retirement savings in this country aside from social security. If the self-help remedy of exit isn’t a strong protection for citizen shareholders, then it is time to examine alternative remedies for these crucial investors. 

-Anne Tucker