The JOBS Act requires the SEC to create an exemption for small, crowdfunded offerings of securities. That exemption, if the SEC ever enacts it, will allow issuers to raise up to $1 million a year in sales of securities to the general public. (Don’t confuse this exemption with Rule 506(c) sales to accredited investors, which is sometimes called crowdfunding, but really isn’t.)

The crowdfunding exemption restricts resales of the crowdfunded securities. Crowdfunding purchasers may not, with limited exceptions, resell the securities they purchase for a year. Securities Act sec. 4A(e); Proposed Rule 501, in SEC, Crowdfunding, Securities Act Release No. 9470 (Oct. 23, 2013). Unlike the resale restrictions in some of the other federal registration exemptions, the crowdfunding resale restriction serves no useful purpose. All it does is to increase the risk of what is already a very risky investment by reducing the liquidity of that investment.

Enforcing the “Come to Rest” Idea

Some of the resale restrictions in other exemptions are designed to enforce the requirement that the securities sold “come to rest” in the hands of purchasers who qualify for the exemption.

Rule 147, the safe harbor for the intrastate offering exemption in section 3(a)(11) of the Securities Act, is a good example. To qualify for the intrastate offering exemption, the securities must be offered and sold only to purchasers who reside in the same state as the issuer. Securities Act sec. 3(a)(11); Rule 147(d). This requirement would be totally illusory if an issuer could sell to a resident of its state and that resident could immediately resell outside the state. Therefore, Rule 147(e) prohibits resales outside the state for nine months.

The resale restrictions applicable to the Rule 505 and 506 exemptions have a similar effect. Rule 506 only allows sales to accredited investors or, in the case of Rule 506(b), non-accredited, sophisticated investors. Rules 506(b)(2)(ii), 506(c)(2)(i). These requirements would be eviscerated if an accredited or sophisticated purchaser could immediately resell to someone who does not qualify.

Rule 505 does not limit who may purchase but, like Rule 506, it does limit the number of non-accredited investors to 35. Rules 505(b)(2)(ii), 501(e)(1)(iv). If an issuer could sell to a single purchaser who immediately resold to dozens of others, the 35-purchaser limitation would be meaningless.

To enforce the requirements of the Rule 505 and 506 exemptions, Rule 502(d) restricts resales in both types of offering.

Preventing an Information-less Resale Market

Rule 504 also includes a resale restriction, Rule 502(d), even though it does not impose any restrictions on the nature or number of purchasers. A resale would not, therefore, be inconsistent with any restrictions imposed on the issuer’s offering.

However, Rule 504 does not impose any disclosure requirements on issuers. See Rule 502(b)(1). Because of that, people purchasing in a resale market would not have ready access to information about the issuer. But the Rule 504 resale restriction does not apply if the offering is registered in states that require the public filing and delivery to investors of a disclosure document. Rules 502(d), 504(b)(1). In that case, information about the issuer is publicly available and there’s no need to restrict resales. People purchasing in the resale market would have access to information to inform their purchases.

The resale restrictions in Rule 505 and 506 offerings could also be justified in part on this basis. If issuers sell only to accredited investors in those offerings, there is no disclosure requirement. If they sell to non-accredited investors, disclosure is mandated, but even then there’s no obligation to make that disclosure public. See Rule 502(b). People purchasing in the resale market therefore would not have ready access to public information about the issuer.

This lack-of-information justification is consistent with the lack of resale restrictions in Regulation A. To use the Regulation A exemption, an issuer must file with the SEC and furnish to investors a detailed disclosure document. Rules 251(d), 252. Because of that, information about the issuer and the security will be publicly available to purchasers in the resale market.

The Crowdfunding Exemption

Neither of these justifications for resale restrictions applies to offerings pursuant to the forthcoming (some day?) crowdfunding exemption.

The come-to-rest rationale does not apply. The crowdfunding exemption does not limit the type or number of purchasers. An issuer may offer and sell to anyone, anywhere, so no resale restriction is necessary to avoid circumvention of the requirements of the exemption.

The information argument also does not apply. A crowdfunding issuer is required to provide a great deal of disclosure about the company and the offering—as I have argued elsewhere, probably too much to make the exemption viable. See Securities Act sec. 4A(b)(1); Proposed Rule 201 and Form C. The issuer is also obligated to file annual reports with updated information. Securities Act sec. 4A(b)(4); Proposed Rule 202. All of that information will be publicly available. Even if one contends that the information required to be disclosed is inadequate, it will be no more adequate a year after the offering, when crowdfunding purchasers are free to resell. Securities Act sec. 4A(e); Proposed Rule 501.

Some people, including Tom Hazen and my co-blogger Joan Heminway, have argued that resale restrictions may be necessary to avoid a repeat of the pump-and-dump frauds that occurred under Rule 504 when Rule 504 was not subject to any resale restrictions. As I have explained, Rule 504, which requires no public disclosure of information, fits within the information rationale. Such fraud is much less likely where detailed disclosure is required. There will undoubtedly be some fraud in the resale market no matter what the rules are, but public crowdfunding will be much less susceptible to such fraud than the private Rule 504 sales in which the pump-and-dump frauds occurred.

Conclusion

The resale restrictions are consistent with neither the come-to-rest rationale nor the information rationale for resale restrictions Forcing crowdfunding purchasers to wait a year before reselling therefore serves no real purpose. The only real effect of those resale restrictions is to make an already-risky investment even riskier by reducing liquidity.

The UAW Retiree Medical Benefits Trust recently won a battle with Gilead and Vertex to have those companies include on their proxy statements proposals to require them to explain to shareholders the risks of their drug pricing decisions.

Basically, both Gilead and Vertex have come under fire recently for charging extremely high prices for new drugs.  There’s an argument, of course, that this is simply a bad business decision – if your customers can’t afford your drugs, they won’t buy them.  And that’s the official basis for the Trust’s proposal.  The Trust describes, for example, how Sanofi was once forced to dramatically cut drug prices because the initial prices were set unrealistically high.

But I find it very hard to believe that the UAW Retiree Medical Benefits Trust is genuinely concerned about drug pricing in its capacity as a shareholder seeking maximum returns.  Instead, it seems far more likely that the Trust’s concern is, you know, drug prices.  That it has to pay.  For its beneficiaries.  And it’s using its status as shareholder of several pharmaceutical companies to try to influence policy in that regard.  The fact that the SEC is allowing the proposal to be included on the companies’ proxies suggests that the SEC is not terribly concerned about that possibility (unlike Delaware, which does not want shareholders to pursue their own idiosyncratic agendas).

It reminds me of the AFL-CIO’s earlier objection to Wall Street banks’ practice of paying deferred compensation to executives to leave to go to government.  From a wealth max perspective, you’d think this would be an awesome thing for shareholders – which means the AFL-CIO’s objections were not really rooted in concern about the banks’ financial performance, but in its broader political concerns about the practice.   But the SEC didn’t have a problem with that – it refused to allow Goldman to exclude the proposal.

So, I repeatedly threatened that I’d eventually post a summary of my paper on arbitration clauses in corporate governance documents – and well, now you’re all finally being subjected to it.

This post was originally published at CLS Blue Sky blog, but I’ve made some minor edits and added a new introduction.

For many years, commenters have argued that at least some shareholder disputes can and should be arbitrated, rather than litigated, and that this could be accomplished by amending the corporate “contract” – namely, its charter and/or its bylaws – to require arbitration.  The possibility was raised in articles by John Coffee and Richard Shell in the late 1980s,[1] and the idea has resurfaced many times since then, including this year by Adam Pritchard.[2]  For almost as long as the idea has been kicked around, there have been warnings that if arbitration clauses are “contractually” binding by virtue of their presence in corporate governance documents, then they may be subject to the Federal Arbitration Act (FAA), which would preempt state attempts to regulate/oversee their use.  Coffee discussed that possibility in his 1988 piece on the subject[3]; more recently, Barbara Black[4] and Brian Fitzpatrick[5] have sounded further alarms.

For foes of shareholder litigation, this is a feature, not a bug; though they rarely say so explicitly, whenever anyone relies upon FAA cases to justify the insertion of arbitration clauses in corporate charters and bylaws, they are implicitly advocating the idea that not only are charters and bylaws “contracts” for FAA purposes, but that federal law requires their enforcement, regardless of the preferences of the chartering state.  After the Supreme Court decided AT&T Mobility LLC v. Concepcion,[6] the notion was particularly powerful, because it meant that corporations would be free to use arbitration clauses to require that shareholder claims be brought on an individual, rather than class, basis.  Given the economics of shareholder litigation, this would almost certainly mean the death of most shareholder lawsuits.

And that’s where my paper comes in.   

[More under the cut]

Continue Reading Manufactured Consent

Last week, I wrote sports and the problems that could arise from a myopic focus on winning.

I promised to attempt to tie that post to business this week, but because I am running to a lunch meeting and then to the Belmont v. Virginia NCAA tournament basketball game viewing party, I am going to keep this short.

(Also, please indulge a little more bragging about my school. Before the game even begins, I am already incredibly proud of our basketball team. Belmont won the academic bracket for the NCAA tournament teams this year, which is based on academic measures like Academic Progress Rate (APR) and Graduation Success Rate (GSR)).

Anyway, I think there are a number of parallels between sports and business. Sports, done the right way, can teach many valuable lessons, such as the importance of teamwork, diligence, unselfishness, strategy, preparation, etc. In fact, team sport participation was one of the things I looked for when interviewing for law students when I was in practice and it is something I look for now when interviewing research assistants. 

As mentioned in last week’s post, sports can lead participants off-track if there is a myopic focus on winning that trumps certain overriding principles. Similarly, a myopic focus on profits in business, without adherence to certain legal rules and ethical principles, can lead individuals and companies astray. What the overriding principles should be, and the appropriate level of focus on profits, are two difficult questions that all businesses should attempt to address.   

Bernard Sharfman has posted a new article entitled “Activist Hedge Funds in a World of Board Independence: Long-Term Value Creators or Destroyers?” In the paper he makes the argument that hedge fund activism contributes to long-term value creation if it can be assumed that the typical board of a public company has an adequate amount of independence to act as an arbitrator between executive management and the activist hedge fund. He also discusses these funds’ focus on disinvestment and attempts to challenge those in the Marty Lipton camp, who view these funds less charitably. In fact, Lipton recently called 2014 “the year of the wolf pack.” The debate on the merits of activist hedge funds has been heating up. Last month Forbes magazine outlined “The Seven Deadly Sins of Activist Hedge Funds,” including their promotion of share buybacks, aka “corporate cocaine.” Forbes was responding to a more favorable view of these funds by The Economist in its February 7, 2015 cover story.

Whether you agree with Sharfman or Lipton, the article is clearly timely and worth a read. The abstract is below:

Numerous empirical studies have shown that hedge fund activism has led to enhanced returns to investors and increased firm performance. Nevertheless, leading figures in the corporate governance world have taken issue with these studies and have argued that hedge fund activism leads to long-term value destruction.

In this article, it is argued that an activist hedge fund creates long-term value by sending affirming signals to the board of directors (Board) that its executive management team may be making inefficient decisions and providing recommendations on how the company should proceed in light of these inefficiencies. These recommendations require the Board to review and question the direction executive management is taking the company and then choosing which path the company should take, the one recommended by executive management, the one recommended by the activist hedge fund or a combination of both. Critical to this argument is the existence of a Board that can act as an independent arbitrator in deciding whose recommendations should be followed.

In addition, an explanation is given for why activist hedge funds do not provide recommendations that involve long-term investment. There are two reasons for this. First, the cognitive limitations and skill sets of those individuals who participate as activist hedge funds. Second, and most importantly, the stock market signals provided by value investors voting with their feet are telling the rest of the stock market that a particular public company is poorly managed and that it either needs to be replaced or given less assets to manage. These are the kind of signals and information that activist hedge funds are responding to when buying significant amounts of company stock and then making their recommendations for change. Therefore, it is not surprising that the recommendations of activist hedge funds will focus on trying to reduce the amount of assets under current management.

 

 

 

 

 

Etsy

The biggest recent news in the social enterprise world is that certified B corporation Etsy is going public.

Despite confusing press releases, Etsy is not legally formed as a benefit corporation, they are only certified by B Lab. (In one of the coolest comments I have received blogging, an Etsy representative admitted that they confused the “benefit corporation” and “certified B corporation” terms and corrected their public statements). If you are new to social enterprise, the differences between a “certified B corporation” and a “benefit corporation” are explained here.  

Etsy, however, will face a dilemma as noted in this article sent to me by Alicia Plerhoples (Georgetown). The B Lab terms for certified B corporations require Etsy to convert to a public benefit corporation (Delaware’s version of the benefit corporation) within four years of the Delaware law becoming effective. Delaware’s public benefit corporation law went effective August 1, 2013.

So, unless B Lab changes its terms, Etsy will lose its certified B corporation status if it does not convert to a public benefit corporation on or before August 1, 2017.

Given that converting to a public benefit corporation while publicly-traded would be extremely difficult–obtaining the necessary vote (currently 90% in Delaware, with a proposal being considered to move it back to the more typical 2/3), paying dissenters’ rights, etc.–I imagine Etsy will need to make this decision before it goes public. Perhaps, Etsy will postpone the decision, and hope that they can just quietly lose their certification in 2017 or that B Lab will make an exception for them. Etsy’s CEO is on record promising social responsibility, but we will see whether that promise includes maintaining B Lab certification and making a legal entity change.  

Currently, I am not aware of any publicly-traded benefit corporations, though Delaware public benefit corporation Plum Organics is a subsidiary of publicly-traded Campbell Soup Company.

Many interesting issues would stem from a publicly-traded benefit corporation; I have added a number of items to my article ideas list this morning.

This Etsy story is one I hope to follow, so stay tuned.

 

Prof. Bainbridge yesterday posted about The Modern Corporation Statement on Company Law.  The statement has ten fundamental rules, of which number ten is:

Contrary to widespread belief, corporate directors generally are not under a legal obligation to maximise profits for their shareholders. This is reflected in the acceptance in nearly all jurisdictions of some version of the business judgment rule, under which disinterested and informed directors have the discretion to act in what they believe to be in the best long term interests of the company as a separate entity, even if this does not entail seeking to maximise short-term shareholder value. Where directors pursue the latter goal, it is usually a product not of legal obligation, but of the pressures imposed on them by financial markets, activist shareholders, the threat of a hostile takeover and/or stock-based compensation schemes.

Prof. Bainbridge is with Delaware Chief Justice Strine in that profit maximization is the only role (or at least only filter) for board members.  As he asserts, “The relationship between the shareholder wealth maximization norm and the business judgment rule, . . . explains why the business judgment rule is consistent with the director’s “legal obligation to maximise profits for their shareholders.” 

Chief Justice Strine has noted that the eBay decision, which I have written about a lot, says that “the corporate law requires directors, as a matter of their duty of loyalty, to pursue a good faith strategy to maximize profits for the stockholders.”  I think this is right, but I remain convinced that absent self-dealing or a “pet project,” directors get to decide that what is in the shareholders’ best interests.

I have been criticized in some sectors for being too pro-business for my views on corporate governance, veil piercing law, and energy policy.  In contrast, I have also been said to be a “leftist commentator,” in some contexts, and I have been cited by none other than Chief Justice Strine as supporting a “liberal” view of corporate norms for my views on the freedom of director choice. 

When it comes to the Business Judgment Rule, I think it might be just that I believe in a more hands-off view of director primacy more than many of both my “liberal” and “conservative” colleagues. Frankly, I don’t get too exercised by many of the corporate decisions that seem to agitate one side or the other.  I thought I’d try to reconcile my views on this in a short statement. I decided to use the model from This I Believe, based on the 1950s Edward R. Murrow radio show.  (Using the Crash Davis model I started with was a lot less family friendly.) Here’s what I came up with [Author’s note, I have since fixed a typo that was noted by Prof. Bainbridge]:   

I believe in the theory of Director Primacy.  I believe in the Business Judgment Rule as an abstention doctrine, and I believe that Corporate Social Responsibility is choice, not a mandate. I believe in long-term planning over short-term profits, but I believe that directors get to choose either one to be the focus of their companies.  I believe that directors can choose to pursue profit through corporate philanthropy and good works in the community or through mergers and acquisitions with a plan to slash worker benefits and sell-off a business in pieces. I believe that a corporation can make religious-based decisions—such as closing on Sundays—and that a corporation can make worker-based decisions—such as providing top-quality health care and parental leave—but I believe both such bases for decisions must be rooted in the directors’ judgment such decisions will maximize the value of the business for shareholders for the decision to get the benefit of business judgment rule protection. I believe that directors, and not shareholders or judges, should make decisions about how a company should pursue profit and stability.  I believe that public companies should be able to plan like private companies, and I believe the decision to expand or change a business model is the decision of the directors and only the directors. I believe that respect for directors’ business judgment allows for coexistence of companies of multiple views—from CVS Caremark and craigslist to Wal-Mart and Hobby Lobby—without necessarily violating any shareholder wealth maximization norms. Finally, I believe that the exercise of business judgment should not be run through a liberal or conservative filter because liberal and conservative business leaders have both been responsible for massive long-term wealth creation.  This, I believe.      

Greetings from Lyon, France, where I am presenting a work-in-process at an international conference on microfinance and crowdfunding organized by the Groupe ESC Dijon Borgogne (Burgundy School of Business) Chaire Banque Populaire en Microfinance.  As the only legal scholar, the only U.S. researcher, and the only presenter with an orange-casted arm (!), I stand out in the crowd.  So what is a one-armed U.S. law professor like me, with limited French language skills, doing in a place like this on my spring break?  Among other things, I am:

  • Broadening my academic and practical view of the world of business finance;
  • Making new connections, personally and substantively;
  • Getting different, pointed feedback on my ongoing crowdfunding work; 
  • Offering assistance and new perspectives (U.S.-centric, legal, regulatory, etc.) to scholars and industry participants from a spectrum of countries; and
  • Securing potential partners and resources for future projects.

Although most of the participants speak English, I am still living at the edge of my socio-lingual comfort zone.  It helps that I am an off-the-charts extrovert.  Regardless, however, the benefits of attendance have been immediate and meaningful.

Questions for our readers:

Do you participate in interdisciplinary research conferences?  

If not, why not?  

If so, what scholarly traditions were emphasized?  What did you find most beneficial . . . or most difficult?

Have you attended international research conferences?  

If not, is it because of cost, personal discomfort, or another reason?  

If so, how (if at all) have you benefitted from your attendance?  What insights can you offer those considering doing the same?