Eight days ago, Scottsdale Capital Advisors and Alpine Securities Corp. filed a Complaint in the Middle District of Florida arguing that FINRA’s structure and operation violate the U.S. Constitution.  The firms argue that FINRA is unconstitutional under the Appointments Clause, separation of powers principles, and the nondelegation doctrine.  The case has attracted some coverage already.

The suit makes many of the arguments I previewed in Supreme Risk, which was recently published by the Florida Law Review.  When I foresaw this risk, I highlighted four doctrinal areas where the Supreme Court might invalidate or significantly limit SROs, including: (i) nondelegation doctrine; (ii) separation of powers doctrine; (iii) state action; and (iv) appointments clause issues.

While it’s still very early, this type of challenge now presents a colorable risk to self-regulatory organizations.  If these arguments succeed against FINRA, it’s likely to cause significant market disruption.  It also lowers the barrier to press the same arguments against any SRO with a similar structure.

I would expect a case like this to make its way through the courts and toward the Supreme Court eventually.  It would not surprise me if groups like the Pacific Legal Foundation seek to get involved as well.  As FINRA has not yet filed its answer, it’ll be interesting to watch this matter develop.

A lot of people are talking about this complaint against Meta, filed by James McRitchie, alleging that the Board violates its fiduciary duties to diversified shareholders because it seeks to maximize profits at Meta individually while externalizing costs that impact shareholders’ other investments.   The complaint further argues that the Board, whose personal holdings in Meta are undiversified, labors under a conflict with respect to diversified investors (seeking, apparently, to avoid the business judgment rule and obtain higher scrutiny of the Board’s actions).

The “universal ownership” theory of corporate shareholding has got a lot of traction recently; as I previously blogged, it’s appealing because it suggests that corporations can be forces for social good without actually changing anything about the structure of corporate law.

That said, academic champions of the theory do not necessarily argue in terms of fiduciary duty – that is, they aren’t claiming that either as a normative or descriptive matter, corporate boards are legally obligated to maximize wealth for shareholders at the portfolio level – instead, they tend to elide those kinds of claims and simply argue that as a matter of power, diversified investors have sufficient stakes and influence to control board behavior in this regard.

The problem with making the argument from the legal perspective, as Marcel Kahan and Ed Rock point out, is that it is not terribly compatible with corporate law as it is currently structured.

That comes through very clearly in the McRitchie complaint, which is brought both directly and, in the alternative, derivatively.

As a direct claim, the plaintiffs are only arguing that they are injured in their nonshareholder capacities – that is, with respect to the aspects of their existence other than their investment in Meta, namely, their existence as shareholders in other companies.  The Board of Meta obviously has no duty to maximize the wealth of these shareholders in their nonshareholder capacities, any more than it has a duty to maximize the wealth of corporate employees by paying them larger salaries, simply because the employees might also be shareholders.

As a derivative claim, it fails because derivative claims by definition allege harm to the corporate entity, and the complaint is very explicit that the Board’s actions do not harm Meta, but instead maximize its value (at the expense of others).

That said, the complaint highlights the underlying tension in corporate law, namely, the question whether directors’ fiduciary duty is to advance the interests of a kind of abstract notion of a shareholder (in which case, directors’ duties are a matter of government policy rather than private ordering), or instead, whether the duty is – or should be – to advance the interests of the actual shareholders who actually make investment and voting decisions.

It is worth noting, by the way, that these tensions are also playing out in the context of federal disclosure requirements.  The SEC’s proposed climate change disclosure rule does, to some extent, take into account the preferences of diversified investors who want a portfolio-eye view:

Investors have noted that climate-related inputs have many uses in the capital allocation decision-making process including, but not limited to, insight into governance and risks management practices, integration into various valuation models, and credit research and assessments.  Further, we understand investors often employ diversified strategies, and therefore do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across registrants.

Commissioner Peirce, however, objects:

The Commission justifies its disclosure mandates in part as a response to the needs of investors with diversified portfolios, who “do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across registrants.”  Not only does this justification depart from the Commission’s traditional company-specific approach to disclosure, but it suggests that it is appropriate for shareholders of the disclosing company to subsidize other investors’ portfolio analysis.  How could a company’s management possibly be expected to prepare disclosure to satisfy the informational demands of all the company’s investors, each with her own idiosyncratic portfolio?  The limiting principle of such an approach is unclear. 

Edit: After this post was published, the plaintiffs suing the Meta board amended their complaint to eliminate the derivative claims.

I attended the BLPB “Connecting the Threads” symposium last week at the University of Tennessee and, as per usual, had an excellent time with the students, staff, and faculty associated with the Transactions journal.  Upon asking the regular bloggers in this space, I was assured that it was acceptable to “toot my own horn” about publications.  To that end, please allow me to mention that my article on Contracting Out of Partnership has (finally) come out in the most recent issue of the Journal of Corporation Law.  If interested, the abstract is as follows:

Can parties contract out of the general partnership form of business organization, even if their conduct would otherwise establish a partnership? Although a recent judicial decision suggests that they can, treating contractual disclaimers of partnership as dispositive is inconsistent with modern statutes. More importantly, permitting parties to contract out of partnership imposes substantial costs by undermining the protections of fiduciary duty, creating uncertainty about the operating rules for the business, and threatening to deny the rights of third parties. These costs outweigh the benefits of promoting freedom of contract and providing certainty on the partnership formation question, particularly because such benefits can largely be captured within existing partnership and LLC law.

At our wonderful BLPB conference a week ago (details here), I presented “An Introduction to Anti-ESG Legislation.” Thus, news that Louisiana Treasurer John Schroder plans to liquidate all BlackRock investments within three months over Blackrock’s ESG policies caught my eye. Here are some notable excerpts from the FOXBusiness article (here) on the news:

Louisiana Treasurer John Schroder penned a letter to BlackRock CEO Larry Fink, explaining the state would liquidate all BlackRock investments within three months and, over a period of time, divest nearly $800 million from the bank’s money market funds, mutual funds or exchange-traded funds. The state treasurer blasted Fink’s pursuit of so-called environmental, social and governance (ESG) standards that promote green energy over traditional fossil fuels. “Your blatantly anti-fossil fuel policies would destroy Louisiana’s economy,” Schroder wrote to Fink in the letter …. “Consumers’ Research applauds Treasurer Schroder’s commendable decision to withdraw the state’s assets from BlackRock’s misuse,” Will Hild, the executive director of Consumer’s Research, told FOX Business in a statement. “As noted in his letter, BlackRock is using the people of Louisiana’s money to advance a destructive agenda that raises costs for consumers in the state and across the country. The seeds of today’s energy crisis were planted by BlackRock and others in their reckless abandonment of their fiduciary duty [in order] to cozy up to radical, woke politicians,” he continued. “We are glad to see the Treasurer working to put an end to their economic vandalism.”

You can find the full letter to BlackRock here. Here is a notable excerpt:

[A]ccording to my legal counsel, Environmental, Social and Governance (ESG) investing is contrary to Louisiana law on fiduciary duties, which requires a sole focus on financial returns for the beneficiaries of state funds. Focusing on ESG’s political and social goals or placing those goals above the duty to enhance investors’ returns is unacceptable under Louisiana law. A letter signed by 19 state attorneys general sent to you recently emphasized this same point…. You have admitted that your ESG agenda of forcing behaviors will not increase investor returns. Your 2022 letter to CEOs stated plainly that “We need to be honest about the fact that green products often come at a higher cost.” High cost/low return environmental policies will reduce a company’s profits … and investors’ returns…. Recently Blackrock set a record for “the largest amount of money lost by a single firm over a six-month period” having “lost $1.7 trillion of clients’ money,” associated with ESG accounts, according to a July 20, 2022 Bloomberg article titled “BlackRock Is Breaking the Wrong Kind of Records.” Such huge losses would seem to indicate that BlackRock is either not focused on investor returns or that its ESG investment strategy is flawed. Neither bodes well for investors…. I’m convinced that ESG investing is more than bad business; it’s a threat to our founding principles: democracy, economic freedom, and individual liberty. It threatens our democracy, bypasses the ballot box and allows large investment firms to push political agendas. It threatens our economic freedom because these firms use their massive shareholdings to compel CEOs to put political motivations above a company’s profits and investors’ returns. Finally, it threatens our personal liberty because these firms are using our money to push their agendas contrary to the best interests of the people whose money they are using!

Last week, the Second Circuit issued an interesting decision on the scope of Section 10(b) standing in Menora Mivtachem Insurance v. Furtarom, 2022 WL 4587488 (2d Cir. Sept. 30, 2022).  IFF is a U.S. publicly traded company that purchased Frutarom, which also traded publicly but outside the U.S..  Frutarom lied about its business, and these lies were incorporated into IFF’s S-4 issued in connection with the merger.  The truth came out, and IFF’s stock price fell.  Stockholders of IFF tried to sue Frutarom, now a wholly-owned IFF subsidiary, for making false statements in connection with IFF’s stock.  The Second Circuit held that under Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the plaintiffs had no standing because they did not buy stock in the precise company being lied about.  As the Second Circuit put it:

Under Plaintiffs’ “direct relationship” test, standing would be a “shifting and highly fact-oriented” inquiry, requiring courts to determine whether there was a sufficiently direct link…Section 10(b) standing does not depend on the significance or directness of the relationship between two companies.

Rather, the question is whether the plaintiff bought or sold shares of the company about which the misstatements were made…The fact that this case involved a merger instead of the sale of a business unit and that IFF incorporated some of Frutarom’s misstatements in its SEC filings and investor presentations does not change the analysis here.  Plaintiffs did not purchase securities of the issuer about which misstatements were made….

So, first thing to note is why this matters.  Normally, if plaintiffs bought stock in the parent, they’d sue the parent.  But here, at least some of the false statements issued before the merger, when the parent is not responsible for the subsidiary’s misconduct.  Post-merger, through a combination of agency and scienter theories, it’s tough to show that the parent company is liable for the false statements of a subsidiary.  See my blog post about Plumbers & Steamfitters Local v. Danske Bank; see also Pugh v. Tribune Co., 521 F.3d 686 (7th Cir. 2008), and in fact, those kinds of allegations were dismissed in this very case.  And despite the Second Circuit’s reservation that state law may permit claims here, the only likely remedy under state law would be a derivative action by parent company stockholders – which of course wouldn’t benefit anyone who had sold their shares since the truth was revealed, and, again, would not work without a showing of scienter at the parent level, to excuse demand.

Which leaves the subsidiary as the only viable defendant.  But, as above, the Second Circuit narrowly construed the subsidiary’s statements to be about the subsidiary, and not about the parent – even when the subsidiary’s statements (presumably with the subsidiary’s permission) were included in merger documents associated with the parent.

So, first, let’s just point out the incongruence of treating statements in a prospectus for the sale of the acquirer’s stock as not being about the acquirer.

Leaving that aside, though, this issue comes up repeatedly.  In Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Inc., 369 F.3d 27 (2d Cir. 2004), for example, Nortel was JDS Uniphase’s largest customer, and issued stock to JDS in exchange for a business unit.  When Nortel collapsed in fraud, JDS shareholders tried to sue Nortel on the grounds that the false statements had affected JDS Uniphase’s price.  They were rebuffed because Nortel’s statements were about Nortel, not JDS Uniphase.  Not long ago, though, a district court held that Juul might be liable to Altria’s shareholders for misstatements about its own business, seeing as how Altria was a 35% shareholder of Juul at the time. See Klein v Altria Group, 2021 WL 955992 (E.D. Va. Mar. 12, 2021).  And in Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000), the Third Circuit held that shareholders of a target company in a proposed, but unconsummated, stock-for-stock merger might be able to sue the acquirer and its auditor for a fraud discovered before the deal closed, on the ground that the acquiring company’s inflated performance affected the stock price of the target.

The Second Circuit’s decision here may – or may not – be at odds with Semerenko.  Formally, the Third Circuit’s decision was not based on “standing” but on construction of Section 10(b)’s language prohibiting fraud “in connection with” the purchase or sale of a security, which the Second Circuit here took as permission to disregard its holding: “Nortel rejected Cendant as persuasive authority, so Plaintiffs’ attempt to invoke Cendant to argue that other courts have allowed plaintiffs in their circumstances to sue is unavailing. In any event, as we noted in Nortel, Cendant did not discuss standing.”  That’s a little weird, because the standing requirement of Blue Chip is rooted in 10(b)’s “in connection with” language.  More generally, Semerenko has often been understood as representing the general principle that if two companies are closely related, a false statement about one is actionable by shareholders of the other.

I’ve previously written about the artificiality of how the fraud on the market doctrine is applied in modern cases, because there are so many judicially-created rules that limit what is supposed to be a court’s empirical inquiry into how frauds affect securities trading, and this is (sort of) another addition to the pile.  Leaving aside the fear that this allows, say, public companies to wink-wink-nudge-nudge induce related private companies to make false statements about their businesses, knowing that shareholders of the public company will be blocked from suing anyone at all, it’s fairly obvious that false statements by a target company about its business will affect the trading price of its acquirer.  That’s why the statements go in the acquiring company’s SEC filings in the first place.  Of course, when it comes to securities trading, everything affects everything else and certainly it’s reasonable to place limits on the connections one draws from one company to another – a point I made when discussing this issue in connection with “shadow” insider trading – but there’s a difference between requiring a close nexus, and creating a bright line rule that bars lawsuits of this kind.  Let alone a bright line rule that somehow excludes statements made in a prospectus for the sale of stock purchased by the plaintiff.  

That said, even a “nexus” rule may be applied strangely; in this case, Judge Pérez in concurrence would have applied a nexus rule, but she still found a nexus was lacking because the plaintiffs had not shown a direct relationship between the false statements of Furtarom and IFF’s stock price.  If required disclosures in an SEC registration statement are not enough to show that kind of relationship on a motion to dismiss, I’m really confused about what we’re all doing here. 

It’s also worth pointing out some sparring between the majority opinion and the concurrence that does not bear on the direct holding.  The majority justified its refusal to permit standing here on the grounds that judicially created private rights of action, such as the right under Section 10(b), should be narrowly construed.  The concurrence, however, appeared to be concerned that the majority’s broad language could be taken to apply outside the 10(b) context, and warned that the opinion should not be taken to mean that all implied private rights of action should be read narrowly.