Thomson Reuters recently published an accounting & compliance alert (here) noting the following.

• Representative Bill Huizenga of Michigan signaled a new working group “will lean heavily into the Supreme Court’s 2022 ruling in West Virginia v. EPA to argue that the SEC has gone beyond its statutory authority with the proposed [climate] rules, set to be finalized this spring…. The working group will examine how to ‘rein in the SEC’s regulatory overreach’ and reinforce the materiality standard in the disclosure regime, as well as ‘hold to account market participants who misuse the proxy process or their outsized influence to impose ideological preferences in ways that circumvent democratic lawmaking,’ according to a news release.” 

• “Senator Marco Rubio on Feb. 2 announced his ‘anti-woke agenda’ for the 118th Congress, including the Mind Your Own Business Act that would enable shareholders to more easily sue public companies over socially-driven actions, such as refusing to do business in states that crack down on abortion or restrict voting rights.” [FWIW, I suspect that Sen. Rubio might replace “refusing to do business in states that crack down on abortion or restrict voting rights” with “refusing to do business in states that protect the lives of the unborn or defend the integrity of our voting system.”]

• “Senator Mike Braun of Indiana on Feb. 1 announced plans to launch a Congressional Review Act (CRA) resolution seeking to nullify the Department of Labor’s recent rules clearing barriers to ESG investing and proxy voting for retirement plan fiduciaries, alongside 49 other senators, with Representative Andy Barr of Kentucky introducing the resolution in the House.”

As I’ve mentioned repeatedly in this space, I recently posted a new paper to SSRN: Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine, forthcoming in the Wake Forest Law Review.  The paper is about the uncertain boundary between matters subject to the internal affairs doctrine, and matters subject to ordinary choice of law analysis, and one of the issues I tackle concerns LLC agreements.  Specifically, LLCs have increasingly included employment provisions in their operating agreements, leaving Delaware courts in somewhat of a quandary as to whether the operating agreement is subject to the internal affairs doctrine – and thus Delaware law – or whether instead it should be treated as an employment contract, subject to ordinary choice of law analysis. (I also blogged about one such case here; as longtime readers are aware, stuff I muse on in blog posts often ends up in papers).

Anyhoo, this is why VC Will’s new opinion in Hightower Holding LLC v. Gibson is so striking.  There, partners in a financial advisory firm sold their interests to Hightower, and were made LLC members and principals in Hightower.  The LLC agreement contained a noncompete clause and selected Delaware law; so did a separate “protective agreement” signed by the partners.  You can guess what happened next.  One partner quit and started a competing firm, and Hightower sued to stop him.  VC Will’s opinion refusing to enjoin the partner is striking for what it does not do, namely, even so much as mention the internal affairs doctrine.  Instead, the opinion treats the entire dispute as an ordinary contractual matter, concludes that Alabama has the greater interest in the dispute notwithstanding the selection of Delaware law, and ultimately holds that the noncompetes are likely invalid. 

I don’t disagree with that decision, of course, but the failure even to consider the role of the internal affairs doctrine sits uneasily alongside some of Delaware’s other caselaw – and the meta issue is just how far we can go in treating LLCs like ordinary contracts for choice of law purposes.  If LLCs are not subject to the internal affairs doctrine and still manage to sail along just fine, how necessary is the internal affairs doctrine itself (often justified on the grounds that absolute chaos would result if it were abandoned)?

As reported by America First Legal (here), Texas Governor Greg Abbott’s office recently issued a memo reminding state agencies and universities that “federal and state law forbid discrimination against a current or prospective employee because of that person’s race, color, religion, sex, national origin, age, disability or military service.” As stated in the letter (here): “Rebranding this employment discrimination as ‘DEI’ doesn’t make the practice any less illegal.” Of course, the extent to which diversity may be deemed a compelling interest justifying at least some forms of racial discrimination is an issue currently before the Supreme Court (see here).

Continuing ongoing coverage of the case challenging FINRA’s constitutional status, we have some new developments.  The plaintiffs have filed an Amended Complaint.  The United States has also intervened in the case to defend the constitutionality of the securities laws.

Lamentably, the Amended Complaint does not cite to Supreme Risk.   I can understand why they would not want to cite me.  Although the article discusses the possibility of their types of claims at length and characterizes them as a colorable risk with the current Supreme Court, it also points out that they might trigger a financial crisis if they win.  That being said, they cite many of the same people I cited in my article.  

Although I haven’t spent much time sitting with the Amended Complaint, I saw a few things that struck me as just plain wrong immediately. 

Let’s take one of their jurisdictional allegations.  To deal with the earlier motion to dismiss, the amended complaint tries to detail much more of FINRA’s connection to Florida.  It alleges that “FINRA also funds, operates, and conducts business in Florida through its Investors Rights Clinic that is located in this state.”  This struck me as completely untrue.  The Clinic is run by Miami’s Law School.  One of the major challenges for securities clinics has been the total absence of any FINRA funding.  It’s why Senator Cortez Masto introduced legislation last year to create a federal funding mechanism.

It includes questionable allegations about the power of the President to remove SEC Commissioners, stating “the SEC commissioners cannot be removed by the President except for in limited circumstances. . . Thus, because the President cannot remove SEC commissioners without
cause, and because the SEC cannot remove FINRA Board members without cause, the Board and its appointed executives and officers are unconstitutionally insulated from Presidential control and oversight.”  This remains uncertain and unsupported by the statute, despite the Supreme Court’s prior comments to this effect.  

Ultimately, I think FINRA and the United States are right to take this challenge seriously and show up.  The current Supreme Court has put the ball in play for these sorts of challenges and they have to be addressed.

Many BLPB readers are likely aware that Stephen Bainbridge recently published a new book, The Profit Motive: Defending Shareholder Value Maximization. I must admit that I’m a fan of the Introduction:

There are a lot of books on the market praising stakeholder capitalism. They proclaim a new age in which big corporations should embrace—and, in fact, are embracing—environmental, social, and governance (ESG) goals. Whether putatively objective academic tomes filled with statistics or mass market books filled with bullet points, the bottom line is the same; namely, that stakeholder capitalism is the right thing to do both morally and financially. This is not one of those books.

For those of you on the fence, there is an hour-long overview on YouTube (here), but if that’s too long you might consider a recent guest post by Prof. Bainbridge on the Corporate Finance Lab discussing the book (here). Below is a brief excerpt from that post.

Three major themes animate the project. First, any conception of corporate purpose that embraces goals other than creating value for shareholders is inconsistent with the mainstream of U.S. corporate law. Second, directors do—and should—have wide and substantially unfettered discretion as to how they go about generating shareholder value. Although many commentators claim that those statements are inconsistent, in fact they both reflect fundamental normative principles deeply embedded in U.S. corporate law. Third, a shareholder-centric conception of corporate purpose is preferable to stakeholder capitalism….

 

Pursuit of shareholder value maximization leads to more efficient resource allocation, creates new social wealth, and promotes economic and political liberty. To be sure, there will always be externalities. Just as pursuing profit is baked into the corporation’s DNA, so is externalizing costs. There is no such thing as a free lunch. The theory and evidence recounted in The Profit Motive, however, suggests that the balance comes down strongly in favor of shareholder value maximization.

The following excerpt is from the introduction to a recent publication that may be of interest to BLPB readers. The publication is: Emilie Kao, 303 Creative v. Elenis: Can Stand-Alone Dignitary Harm Create A Right to Endorsement and Duty to Endorse?, 2023 Harv. J.L. & Pub. Pol’y Per Curiam 5, 2–5 (2023). Emilie Kao is Senior Counsel and Vice-President for Advocacy Strategy at Alliance Defending Freedom (ADF), which represents Lorie Smith.

All people have inherent dignity and should be treated with respect. However, whether and how courts should address legal claims surrounding dignity are notoriously complicated. Does the government have an interest in protecting citizens from “dignitary harm”–subjective feelings of emotional distress or stigma? If so, does the government’s interest require it to compel or silence the expression of certain views? If so, does the dignity of the person compelled to speak or remain silent matter? Dignitary harm has played important roles in conflicts between religious freedom and anti-discrimination laws in Masterpiece Cakeshop v. Colorado Civil Rights Commission and Fulton v. Philadelphia. And they are at issue again in 303 Creative v. Elenis, a free-speech case that was recently argued at the U.S. Supreme Court.

 

In 303 Creative, Colorado’s public accommodation law–the Colorado Anti-Discrimination Act (CADA)–requires graphic artist, Lorie Smith, to create websites celebrating same-sex marriage that violate her religious belief that marriage is between one man and one woman. Colorado stipulated that Ms. Smith serves all people, regardless of sexual orientation and that her websites are unique, custom, and expressive; in other words, that she is engaging in pure speech. Like many artists, Ms. Smith chooses each word, visual design, and artistic element to tell a unique story that is consistent with her beliefs, whether about animal rescue, homelessness, or marriage. She wants to design websites to “promote God’s design for marriage.” Therefore, she cannot create websites that celebrate marriages contrary to God’s design for any of her clients, regardless of sexual orientation. Her decisions are always based on the message, not the person.

 

Colorado claims that it has a compelling interest in ensuring that members of protected classes are shielded from “dignitary harm.” That dignitary harm, though, consists merely in a creative professional declining to endorse their desired message. The Tenth Circuit agreed with Colorado. But in his dissent, Chief Judge Tymkovich warned that, “[l]ike Nineteen Eighty-Four’s Winston Smith, CADA wants Lorie Smith to not only accept government approved speech but also to endorse it.” The Supreme Court should refuse Colorado’s attempt to create a right to endorsement and a corresponding duty to endorse that would compel Ms. Smith to speak messages that violate her conscience. A government interest in protecting citizens from the emotional and moral distress of disagreement is intrinsically distinct from the material and dignitary harms created by status-based denials. Therefore, courts should treat the claims arising from these distinct interests differently.

Section 12 of the Securities Act gives a right of rescission to purchasers of illegally unregistered securities, and purchasers of securities sold by means of a false prospectus. See 15 U.S.C. § 77l.  Although the right of action has existed since 1933, its exact contours have always been somewhat hazy.  But now, in the age of social media – with the potential for widespread promotion of unregistered and/or fraudulent investments (lately, cryptocurrencies) – interpretations of Section 12 are getting a work out, and the legal ground may be shifting.

So, the background.  Section 12 provides:

(a)In general

Any person who—

(1) offers or sells a security [without meeting registration requirements]

(2) offers or sells a security (… by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

shall be liable… to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

In Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court addressed what it means to be a “seller” under Section 12, such that one can be held liable.  First, one is a seller if one actually passes title to the subject security in a transaction with the plaintiff.  Remote sellers, i.e., persons who passed title back in a chain of sales that led to the sale to the plaintiff, are not liable.

Second, one is a seller if one “solicits” the sale to the plaintiff, even if the soliciting person did not actually pass title.  The Court explained that brokers, for example, or agents of the seller, can be held liable under Section 12, and the critical question is whether the soliciting person acted for his own financial gain, or the financial gain of the seller.  If the soliciting person was merely offering gratuitous advice to the buyer, however, he would not come within the scope of Section 12.  The Court rejected a test that would make liability turn on whether the defendant’s “participation in the buy-sell transaction is a substantial factor in causing the transaction to take place.”  As the Court put it, “§ 12’s failure to impose express liability for mere participation in unlawful sales transactions suggests that Congress did not intend that the section impose liability on participants’ collateral to the offer or sale.”  The Court further elaborated, “The ‘purchase from’ requirement of § 12 focuses on the defendant’s relationship with the plaintiff-purchaser. The substantial-factor test, on the other hand, focuses on the defendant’s degree of involvement in the securities transaction and its surrounding circumstances.”

This test for “seller” status under Section 12 is now known as the “statutory seller” requirement, and in the aftermath of Pinter, all courts agree that whether a plaintiff proceeds under Section 12(a)(1) – for unregistered securities – or 12(a)(2) – for false prospectuses, the seller requirement remains the same.

So, two routes to liability under Section 12.  Transfer of title – which is usually easy to spot – or solicitation.  But what is a solicitation?  In a bunch of cases interpreting Pinter, courts latched on to the “defendant’s relationship with the plaintiff-purchaser” language to hold that statutory sellers must have direct contact with the plaintiff, or at least some kind of active relationship with the plaintiff, to become liable.  See, e.g., Holsworth v. BProtocol Foundation, 2021 WL 706549 (Feb. 22, 2021). This often came up in the context of registered offerings, where plaintiffs suing for false prospectuses were informed that participation in the preparation of offering materials is not “solicitation” for Section 12 purposes, unless there was some kind of direct relationship between the preparer and a particular purchaser.  Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996); Mass. Mut. Life Ins. Co. v. Residential Funding Co., LLC, 843 F. Supp. 2d 191 (D. Mass. 2012); Braun v. Ontrak, 2022 WL 5265052 (Cal. Super. Oct. 4, 2022); Citiline Holdings v. iStar Fin., 701 F. Supp. 2d 506 (S.D.N.Y. 2010); Rosenzweig v. Azurix Corp., 332 F.3d 854, 871 (5th Cir. 2003); Baker v. SeaWorld Entertainment, 2016 WL 2993481 (S.D. Cal. Mar. 31, 2016); In re Westinghouse Sec. Litig., 90 F.3d 696 (3d Cir. 1996); Freeland v. Iridium World Comms., 2006 WL 8427320 (D.D.C. Sept. 15, 2006); In re Deutsche Telekom AG Sec. Litig., 2002 WL 244597 (S.D.N.Y. Feb. 20, 2002).

But now we have social media!  And more and more investment opportunities are being advertised through mass communications (sometimes, in Regulation A offerings, which are subject to Section 12 liability for false communications).  A bunch of these are, of course, cryptocurrencies, where the issue isn’t just false prospectus communications, but unregistered sales.  All of which makes a flat rule of personal communication somewhat unsatisfying.

Recently, the Ninth and Eleventh Circuit reversed district court rulings that direct communication was necessary.  Both Circuits held that mass social media communications that urge particular investments can trigger Section 12 liability to all affected purchasers.  See Wildes v. Bitconnect, 25 F.4th 1341 (11th Cir. 2022); Pino v. Cardone Capital, 55 F.4th 1253 (9th Cir. 2022); see also Owen v. Elastos Foundation, 2021 WL 5868171 (S.D.N.Y. Dec. 9, 2021); Balestra v. ATBCoin LLC, 380 F. Supp. 3d 340 (S.D.N.Y. 2019).

Notice the shift, then.  For some courts, preparing a prospectus for a registered offering was not deemed to involve sufficient solicitation to trigger Section 12 liability – but now other courts are saying that urging purchases on social media is sufficient.  Someone’s got to give.

And even on the internet, what kind of communications qualify?  That part’s still not entirely clear.  In the social media cases, the defendants created and sold particular investments and hawked them relentlessly, and that was found to be a solicitation.  Which brings us to Underwood v. Coinbase Global, Inc., 2023 U.S. Dist. LEXIS 17201 (S.D.N.Y. Feb. 1, 2023).

There, a class of plaintiffs alleged that many of the cryptotokens available for sale on the Coinbase exchange were, in fact, unregistered securities, and brought a battery of claims against Coinbase, including claims under Section 12 for unregistered sales.  The plaintiffs actually tried to establish liability under both of Pinter’s definitions of seller – they sued Coinbase for transferring title, and for soliciting sales.

So, let’s start with the title transfer allegations.  As we all know, in securities class actions, the original complaints are filed, consolidated, and then a notice is issued alerting other potential plaintiffs of the case.  Any plaintiffs (the original ones, or new ones) may then petition the court for “lead plaintiff” status.  The court appoints a lead, and (usually) appoints that lead’s chosen counsel as lead counsel, and a new, consolidated complaint is filed.  That consolidated complaint becomes the operative complaint for the case.  And, because the original plaintiffs may not be appointed lead, the early pleadings tend to be very sparse placeholders, in anticipation of a more detailed pleading to come after the leads are selected.

In Coinbase, however, there was no battle for lead status – after the original complaint was filed, one other plaintiff and one other law firm joined with the original plaintiffs/counsel, and they were all appointed lead together, after which they filed the amended complaint.

As is typical in these situations, the amended complaint was much longer and more detailed than the original complaint.  But, crucially, the original complaint had alleged that traders on the Coinbase exchange trade with each other, and Coinbase facilitates the exchange.  The amended complaint alleged that Coinbase acts as a market maker, buying directly from one user to sell to another, and vice versa – which would make it a statutory seller for Section 12 purposes under Pinter’s first prong.

Judge Engelmayer refused to accept the amended complaint’s allegations.  Citing circuit authority, he held that when an amended complaint contains factual allegations that contradict the facts alleged in earlier complaints, the new allegations may be rejected.  And he buttressed that holding by pointing out that the user agreement cited in the original complaint – but not the amended version – described Coinbase as merely facilitating transactions between users without trading itself.

I mean … I have no idea how Coinbase arranges its transactions, but, considering how securities class actions are organized, Judge Engelmayer’s holding is a little concerning, because the whole point is that early complaints are not drafted with the same kind of care as the consolidated complaint.  That’s not ideal, but it’s an inevitable byproduct of the lead plaintiff process, and the lead plaintiff process is – for its flaws – one of the best things to come out of the PSLRA.  And, in this case, a new plaintiff and new firm joined the action.  I don’t know the history there but it’s certainly possible neither had anything to do with the original complaint, and became part of the action because of the notice – precisely as the PSLRA intended.  It’s troubling that these new parties might be bound by mistakes – perhaps flat out errors – made by the original filers.

But let’s move on to the second prong of Pinter, concerning solicitation liability.  Plaintiffs alleged that Coinbase made money on trades – satisfying Pinter’s requirement that the solicitation be motivated by the defendant’s financial gain – and that Coinbase participated in “airdrops” of particular new token offerings, wrote news stories on price movements of particular tokens, and linked to news stories about them.

This, according to Judge Engelmayer, was not sufficient to qualify as solicitation under Pinter:

To hold a defendant liable under Section 12 as a seller, a purchaser such as plaintiffs must, therefore, demonstrate its direct and active participation in the solicitation of the immediate sale…. the AC’s allegations regarding Coinbase’s “solicitation” of the transactions involving the Tokens fail, because they do not describe conduct beyond the “collateral” participation that Pinter and its progeny exclude from Section 12 liability.  … These activities of an exchange are of a piece with the marketing efforts, “materials,” and “services” that courts, applying Pinter’s second prong, have held insufficient to establish active solicitation by a defendant.

I’m not even saying this decision is wrong, exactly, but the line between participating in promotional “airdrops” and linking to articles about price movements, and urging purchases through YouTube and Instagram (as occurred in some of the social media cases where plaintiffs were allowed to proceed), is a fuzzy one – and that’s exactly what the Supreme Court was trying to avoid in Pinter.  See 486 U.S. at 652 (“the substantial-factor test introduces an element of uncertainty into an area that demands certainty and predictability”).

Anyway, it’s an area where the law is rapidly developing so … stay tuned.