I’m continuing to read my way through Hilary Allen‘s Driverless Finance.  The second chapter examines how fintech now alters how the financial system manages risk.

She begins by breaking down different kinds of risks.  Systemic risk, of course, is the biggest risk of them all.  It’s really about risks to the entire financial system, not just winners and losers within it.  For example, it doesn’t matter how well-diversified your portfolio is if nuclear war breaks out.  That’s systemic risk. Managing systemic risk is primarily a job for regulators and government.

Investors often need to manage other kinds or risks.  Market risk is about what might happen in the marketplace.  When we think about interest rate risk for bonds, it’s a market risk. Credit risk refers to the risk that a counterparty might not pay you.  There are all kinds of risks and substantial research has been done to look at how to build a portfolio to manage risk.  Financial firms now construct complex models to game out these risks.  There’s even model risk; the risk that your model doesn’t accurately capture the risks!

Allen brings our attention to machine learning and risk management.  We now have rapidly developing artificial intelligence technology working to identify and learn from patterns in data.  This technology has begun to play a role in risk management as well.

Machine learning now happens in a variety of different ways.  Firms using machine learning in risk management still make choices about what type of machine learning technology to deploy.  Firms also have to make choices about the data they feed into the machine.  How do they acquire it?  How much do they spend?  How do they even test to see if the data they used to train the machine worked?  How do we even know if the data used to train the machine was good or garbage?  These are all choices that people make.  And they may make these choices in ways that increase their ability to make money in the short term.

We should not be too confident that machine learning can solve risk management.  Machine learning may particularly struggle with low-probability events and unusual circumstances.  There simply may not be enough data available or datasets may exclude unusual circumstances.  How do we manage risk in unusual circumstances? Do we keep deferring to the algorithms? We shouldn’t simply trust an algorithmic answer when we can’t understand it. Allen warns us about the risks that automation bias may play and the risk that regulated firms will automate decisions with inscrutable black box algorithms to ward off regulators.

Allen also warns about the possibility of algorithmic decisions leading to asset bubbles.  If everyone uses the same algorithm and bids up the price of the same kinds of assets, enormous and widespread harm could result when the music stops.  This has already happened with credit ratings for mortgage-backed securities.

She also highlights the possibility that widespread deployment of machine learning technology may lead to both increased complexity and more coordinated behavior.  If most market participants are running the same algorithm, they may all behave in the same way, increasing risks overall.  We can see this beginning to happen with roboadvice firms, insurers, and risk managers all beginning to lean more and more on these tools.

Dear BLPB Readers:

“The American Business Law Journal invites ALSB members who are interested in serving on the Editorial Board of the American Business Law Journal to apply for the position of Articles Editor. The incoming Articles Editor will begin to serve on the Board in August 2022. Board members commit to serve for four years: three years as Articles Editor and one year as Senior Articles Editor. After that, the option is to continue to serve two more years—one as Managing Editor and another as Editor-in-Chief. The ABLJ is widely regarded, nationally and internationally, as a premier peer-reviewed journal and the position provides the opportunity to serve the Academy of Legal Studies in Business and broader academic discipline at the highest levels of service. 

Articles Editors supervise the review of articles that have been submitted to the ABLJ to determine which manuscripts to recommend for publication. In the case of manuscripts that are accepted, the Articles Editor is responsible for working with the author to oversee changes in both style and substance. In the case of manuscripts that are believed to be publishable but in need of further work, the Articles Editor outlines specific revisions and further lines of research that should be pursued. The Articles Editor’s recommendations for works-in-process are perhaps the most important and creative aspect of the job because they provide the guidance necessary for works to blossom into publishable manuscripts.  

An applicant for the position of Articles Editor should have an established track record of publications and should have published at least one article with the ABLJ. Experience serving as a Reviewer for the ABLJ or as a Staff Editor is helpful. Please send a resume and letter of interest to Susan Park, ABLJ Managing Editor, at spark@boisestate.edu by May 31, 2022, for full consideration.”

The following comes to us from Professor Mike Guttentag in response to my recent post on his excellent and thought-provoking new article, Avoiding Wasteful Competition: Why Trading on Inside Information Should be Illegal. This is a worhy discussion I look forward to continuing–and I hope others will engage in the comments below. Now, here is Professor Guttentag’s response:

As always, I am honored and impressed by the seriousness and respect with which Professor Anderson approaches my work.  I would, however, take exception to the reasons he offers for rejecting my conclusions.

The debate about insider trading over the past five decades has suffered from limited evidence of either benefits or harms. Those who have objected to a strict insider trading prohibition have reasonably asked: what evidence is there that the harms of insider trading justify a broad prohibition?

In my article I believe I have answered that challenge.  First, I explain why there is a significant mismatch between private gains and social gains when trading on inside information. This mismatch arises both because of how inside information is produced (largely as a byproduct of other activities) and how trading on this information generates profits (at the expense of others). I next show how this mismatch between private gains and social gains (perhaps the defining economic feature of insider trading) leads to an unusual problem: the problem of too much or wasteful competition. This is not just a theoretical concern. I offer concrete estimates of the magnitude of the costs of this wasteful competition problem. One very conservative estimate puts the costs of wasteful competition in United States equity markets in the range of tens of billions of dollars a year. The logic is compelling, and the amounts involved substantial: insider trading is a socially wasteful activity that should be outlawed. 

The time has now come for those who would do less than outlaw all trading when in possession of inside information to provide either equally compelling evidence of the benefits of an alternative regime or an explanation as to why my calculations are flawed. I do not believe that Anderson’s critiques meet either of these challenges.  

I will go through Anderson’s critiques one by one. The first concern Anderson raises is that he believes my argument hinges on the claim that all inside information is produced as a byproduct of other activities. Anderson has read my argument as relying on a stronger claim than I think it needs to rely on. I do not aim to refute the vast body of work by the likes of Henry Manne and many, many others on the various costs and benefits of insider trading. These lists of the potential costs and benefits established over the past decades are largely correct. However, there are two problems with these lists. First, these lists have consistently failed to realize the magnitude and importance of the wasteful competition problem created by insider trading (I have addressed the reasons for this oversight elsewhere, Law and Surplus: Opportunities Missed). Second, once the costs of wasteful competition are included in the calculus the appropriate starting point shifts. Given how significant the wasteful competition problem is, we need more than just a list of plausible but hard-to-quantify costs and benefits to rebut the presumption that all trading when in possession of inside information should be outlawed. That is the extent of my claim.

The second point that Anderson raises in his comments is that he does not think I have carried out an adequate “comparative institutional approach to market failure.” In fact, I think I do a fair job in the article of addressing this question, and show, for example, why private ordering is not an effective alternative to legal intervention as a way to address the wasteful competition problem created by insider trading. Moreover, the correct comparison should be between the cost of our muddled and confused current regime and the simple proposal I offer, a proposal, by the way, that is similar to the insider trading prohibition already in place in Europe (albeit with less enforcement capability in Europe). I do not see what institution Anderson thinks could do a better job addressing the problem I have identified than the federal government. As a side note, if we want to minimize the kind of rent-seeking by government officials that Anderson also mentions, then a bright-line such as the one I propose might well be preferable to the murky waters that now surround the insider trading prohibition.

The third point Anderson raises is that he finds my consideration of internal compliance costs lacking.  My response to this observation is: internal compliance costs as compared to what baseline? The current system is a quagmire, whereas the one I propose would be more straightforward to implement. It seems to me that when it comes to minimizing internal compliance costs my proposal is preferable to the status quo.  But even if I am incorrect about the relative costs of internal compliance under different regulatory regimes the larger point remains: discussions of these kinds of second order, difficult-to-quantify cost simply do not offer enough evidence to justify accepting the costs of wasteful competition that a very conservative estimate puts in the range of tens of billions of dollars a year in only one marketplace.

The fourth point Anderson raises is yet another potential cost of my proposal as compared to the status quo. Anderson correctly points out that my rule may be over-inclusive and prevent some individuals from gathering and trading on information for which social gains are equal to or greater than private gains. This is true. However, again, where is the concrete evidence that these costs of over-inclusivity are anything near the magnitude of the quantifiable costs that result from wasteful competition. The evidence in support of a sweeping prohibition remains.

Finally, Anderson raises the specter of criminal punishment. I did not hope, as Anderson suggests, to fully “detach my model from the debate over the morality of insider trading.” I only rejected current efforts to base an insider trading prohibition on fairness concerns. In terms of advancing my own arguments, I felt that as a practical matter the topic of links between solutions to a wasteful competition problem and criminality was too vast to fit in an already long article. For those who are interested, I have begun to further explore these connections elsewhere in work on the relationships between evolutionary psychology and the use of law as a tool to share resources.

The one point I did make in the article relevant to the question of criminal liability for insider trading was to observe that engaging wasteful competition can trigger moral outrage in some circumstances. Such feelings can be observed, for example, when others react to people cutting in line. We have normative reactions to people who pursue their naked self-interest in situations where payoffs through cooperation are greater than those that can be realized through competition by, for example, refusing to honor a queue.  Anderson investigates this analogy by asking about someone who has permission to cut in line.  Presumably, he means to draw a parallel to issuer-sanctioned insider trading wherein firms allow employees to trade on material nonpublic information. The question of whether or how permission to cut in line might be granted is quite complex and is a topic for another day. I only hoped in this article to suggest why there might be a link between my conclusion that avoiding wasteful competition justifies an insider trading prohibition and the choice to criminalize insider trading.

Again, I truly appreciate Anderson’s honest engagement with my work. However, I think he fails to provide a compelling rebuttal. What we need now in the United States is a prohibition on all trading when in possession of inside information.

Description

THE UNIVERSITY OF TENNESSEE COLLEGE OF LAW invites applications for a 9-month visiting faculty position to commence in the fall semester of 2022 to teach Business Associations, Bankruptcy, Law & Technology/Privacy Law, and other business law courses through the Clayton Center for Entrepreneurial Law. 

Qualifications

Successful applicants must have a strong academic background and substantial, relevant practice experience.  Preference may be given to those applicants who are seeking to enter the academy from private practice or those seeking to contribute to the academy or the College of Law community through teaching and scholarship before returning to the private practice of law.  Candidates must have a strong commitment to excellence in teaching, scholarship and service.

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Applications should include a letter of intent, resume, and the names and addresses of three references in hard copy or electronic format.  Applications will be accepted at http://apply.interfolio.com/103638 until the position is filled.  Questions may be addressed to:

Professor George W. Kuney
Director of the Clayton Center for Entrepreneurial Law
The University of Tennessee
College of Law
1505 W. Cumberland Avenue
Knoxville, TN  37996-1810
gkuney@utk.edu

I’ve previously posted about problems in how courts determine whether a complaint pleads scienter under the standards of the PSLRA; last summer, I talked about courts’ unduly narrow use of evidence of insider trading, namely, to consider it only as a pecuniary motive for fraud, rather than as evidence of knowledge of a problem.  Which is why I was very pleased to see the decision in Gelt Trading Ltd. v. Co-Diagnostics Inc., 2022 WL 716653 (D. Utah Mar. 9, 2022).

The claim is that Co-Diagnostics overstated the accuracy of its covid-19 tests, and its stock price fell when the truth was revealed.  The complaint only alleged two false statements; the court dismissed claims based on one, but permitted claims based on a false press release – which was mostly attributed to the company, but also quoted Dr. Satterfield, the company founder/chief science officer – to proceed.

In evaluating the allegations of scienter, the court considered, among other things, that although Dr. Satterfield had not sold stock, others had.  As the court put it:

multiple board members sold significant amounts of stock just as news outlets began to question the accuracy of Co-Diagnostics’ test. This suggests that at least some individuals within the company knew that the statements were misleading that the artificially propped up stock could soon crash. If other corporate officials knew this fact, presumably Satterfield—the company’s Chief Science Officer—would have known the same.

That’s exactly the analysis I’d hoped courts would undertake.  As I mentioned in my prior post, a desire to sell stock at inflated prices might be a cause of fraud, but it is also result of it, as insiders scramble to cash out before their wealth is destroyed.  Even a non-defendant’s trades can tell us something about the kind of information that was available within the company, and thus can shed light on what the actual defendants knew when they spoke.  

For some time now, the insider trading enforcement regime in the United States has been criticized by market participants, scholars, and jurists alike as lacking clarity, theoretical integrity, and a coherent rationale. One problem is that Congress has never enacted a statute that specifically defines “insider trading.” Instead, the current regime has been cobbled together on an ad hoc basis through the common law and administrative proceedings. As the recent Report of the Bharara Task Force on Insider Trading puts it, the absence of an insider trading statute “has left market participants without sufficient guidance on how to comport themselves, prosecutors and regulators with undue challenges in holding wrongful actors accountable, those accused of misconduct with burdens in defending themselves, and the public with reason to question the fairness and integrity of our securities markets.”

Congress appears to be responding, and a number of bills that would define insider trading and otherwise reform the enforcement regime are receiving bipartisan support. But it would be a mistake to pass new legislation without first taking the time to get clear on the economic and ethical reasons for regulating insider trading. This is particularly true in light of the fact that the general public is clearly ambivalent about whether and why insider trading should be regulated.

Mike Guttentag’s new article, Avoiding Wasteful Competition: Why Trading on Inside Information Should Be Illegal, offers an important new (or at least heretofore underappreciated) lens through which the potential costs of insider trading may be identified. For Guttentag, inside information is generally created as a mere byproduct of otherwise productive economic activity. But though it takes no additional effort to create, it has significant economic value for those who can trade on it. The rush to capture this surplus results in “wasteful competition because competition for surplus (or rent-seeking in the terminology economists prefer) is both hard to prevent and inherently wasteful.” Absent comprehensive regulation of insider trading, vast resources would be wasted in efforts by market participants to capture what Guttentag estimates may amount to tens of billions of dollars in potential insider trading profits each year.

Since the problem of wasteful competition arises whenever trading with material nonpublic information is permitted, Guttentag recommends “(1) that federal insider trading legislation should be enacted that prohibits all trading on inside information regardless of whether the information is wrongfully acquired, (2) courts should not require proof that a tipper received a personal benefit to find tippers and tippees culpable, and (3) the mere possession of inside information should be sufficient to trigger a trading prohibition.”

Guttentag’s arguments are original and compelling, but I am not convinced they justify the reforms he proposes. Here are some of my reasons:

  • First, Guttentag’s wasteful competition argument turns on the claim that all inside information is a mere byproduct of otherwise productive activity. But this seems to beg the question against Henry Manne and others who have argued that insider trading as compensation can be an effective incentive for entrepreneurship and innovation at firms. And this incentive can come at a savings to shareholders by reducing the need for other forms of compensation. If the production of inside information is part of the motivation behind innovation, it is not a surplus. Guttentag does address some (though not all) of Manne’s arguments concerning insider trading as compensation, but I would like to see a more complete treatment.
  • Second, even if we are convinced that insider trading drives wasteful rent-seeking, I’m not sure Guttentag has shown that the broad enforcement regime he recommends is the appropriate response. Under the comparative institutional approach to market failure, the proponent of regulation needs to show the regulation would improve matters. Rent-seekers come in all shapes and sizes, and government agencies such as the SEC are by no means immune to the temptation to engage in rent-seeking and rent-selling. Expanded authority would no doubt increase the opportunities and incentives for such wasteful action on the part of the regulators. Guttentag fails to address this concern.
  • Third, Guttentag fails to acknowledge the internal compliance costs his proposed expansion of liability will impose on issuers. I address the significant costs of insider trading compliance in my article, Solving the Paradox of Insider Trading Compliance. I suspect these already significant costs (and incentives to rent-seek from regulators) would only increase under Guttentag’s proposed regime. This concern should be considered as part of a comparative institutional analysis.
  • Fourth, Guttentag’s proposed reform would impose liability for trading while in possession of inside information even if that information played no part in the trading. But trading for reasons unrelated to inside information does not evidence wasteful competition for that information. Guttentag’s rationale cannot therefore justify this rule. He suggests that this mere possession rule can be justified as a prophylactic measure—simplifying enforcement of insider trading that does derive from wasteful competition. Guttentag fails, however, to consider the significant costs (e.g., in terms of [a] liquidity for those who are compensated with equity and [b] the preclusion of otherwise innocent, value-enhancing trades) the broad restriction would impose on the insiders, the issuers, and the market more broadly.
  • Finally, Guttentag considers it a virtue of his wasteful competition model that it does not rely on any controversial claims regarding the ethics of insider trading to justify its regulation. His model imposes liability on those who trade while possessing inside information because it is wasteful—not because it is wrongful. But insider trading liability in the United States has historically carried stiff criminal penalties. Guttentag is comfortable with the idea that these penalties be imposed under his proposed regime as well. This makes me wonder what other criminal sanctions for morally innocent but wasteful behavior this logic might justify. Guttentag seems to anticipate this concern and hedges a bit by suggesting that wasteful behavior may not be morally innocent after all. He notes that, for example, those who engage in wasteful behavior like cutting in line typically elicit “strong feelings of moral disapproval.” First, this may be true, but what about those who ask permission to cut (for some good reason)—and receive that permission? Such persons’ behavior would be just as wasteful, but would probably not receive the same moral disapproval. Second, to the extent Guttentag considers detaching his model from the debate over the morality of insider trading, this line-cutting example pulls him right back in.

Despite these concerns, I am convinced that Guttentag’s new article advances the discussion about why insider trading is (or can be) harmful to markets and society. I recommend it to anyone who wishes to be educated on the subject. Here’s the abstract to Mike’s article:

This article offers a new and compelling reason to make all trading based on inside information illegal.

The value realized by trading on inside information is unusual in two respects. First, inside information is produced at little or no incremental cost and is nevertheless quite valuable. Second, profits made from trading on inside information come largely at the expense of others. When the value of something exceeds the cost to produce it, a wasteful race to be the first to capture the resulting surplus is likely to ensue. Similarly, resources expended solely to take something of value from others are wasted from an overall social welfare perspective. Thus, both at its source and in its use inside information invites wasteful competition. A law prohibiting insider trading is the best way to avoid this wasteful competition.

Previous scholarship misses this obvious conclusion because of its reliance on one of three assumptions. First, wasteful competition is assumed to be a problem that markets can rectify. Second, private ordering solutions are assumed to be available even when market mechanisms fail to address this problem. Third, a wasteful race to acquire and use inside information is viewed as otherwise unavoidable. None of these assumptions is correct.

The findings here have immediate policy implications. First, insider trading legislation should be enacted that bans all insider trading and not just trading based on wrongfully acquired information. Second, there is no reason to require proof that a tipper received a personal benefit to prosecute someone for tipping inside information. Third, the possession and not the use of inside information should be enough to trigger a trading prohibition.

Dear BLPB Readers:

“The Department of Insurance, Legal Studies and Real Estate in the Terry College of Business at The University of Georgia invites applications for a full-time non-tenure-track faculty position in Legal Studies at the lecturer level, beginning Fall 2022. The position is renewable based on performance and promotion to Senior Lecturer is possible after six years of service. Participation in service activities appropriate to the rank is expected. Salary is competitive and commensurate with qualifications.“

The full job posting is here.

A recent opinion of the Court of Appeals of Tennessee at Nashville, Buckley v. Carlock, is chock full of great issues from the standard Business Associations course.  Specifically, the case involves allegations of controlling shareholder oppression under Tenn. Code Ann. § 48-24-301.  The plaintiff requested, and was grated, a buy-out of his shares in lieu of dissolution.

As noted in the opinion, the plaintiff raises a variety of issues on appeal, arguing:

that the trial court’s valuation of his interest in TLC was “erroneous as a matter of law, or at least contrary to the weight of the evidence.” He also claims that the court abused its discretion in denying him prejudgment interest. And he contends that he was entitled to attorney’s fees as the prevailing party for the whole case. Lastly, he argues that the trial court erred in dismissing his claim for unjust enrichment as moot.

The Court of Appeals affirms the trial court opinion after oral argument (a note on that below).  In the process, the court validates a dissenters’ rights (“fair value”) approach to calculating the value of the plaintiff’s shares.  It also confirms aspects of the valuation calculation.

All of these “real life” business divorce issues are illustrative of the way the statutes we teach get used in practice.  The related issues (e.g. as to attorneys’ fees, the admission of witness testimony, pre-judgment interest, and unjust enrichment) all add color to the standard Business Associations fare.  This case may make for interesting teaching material.

To that point, in writing up this post, I found some buried treasure relevant to teaching.  The oral arguments for the case were recorded on Zoom and are publicly available!  The two legal counsel arguing the case are professional and knowledgeable.  All of this may help to illustrate for students the relevance of the activities they engage in during law school.

Stanford Law School offers multiple specialized LLM programs to international students who have practiced law outside the U.S. The Corporate Governance and Practice LLM program admits approximately 20 students annually. Working under the supervision of Professor Michael Klausner, the Faculty Director of the program, the Teaching Fellow will assume significant academic, advising, and administrative responsibilities for these students.   Applicants for this fellowship are sought for a two-year commitment, starting in summer 2022.

The Teaching Fellow will be responsible for teaching two courses: one on corporate law from an economics perspective; and another on corporate law practice. The latter course will include outside speakers from practice. The fellow will also organize other academic and social events, and will be responsible for managing the Corporate Governance and Practice LLM program on a day-to-day basis, advising LLM students on academic and career issues, responding to inquiries from prospective LLM applicants, screening and admitting applicants, and interacting with faculty in support of the LLM program goals and needs. The fellow will have the support of and work with the Associate Dean for Advanced Degree Programs, the Associate Dean for Student Affairs, and the Associate Dean for Admissions. Although this is a full-time position, the fellow should be able to spend approximately half their time conducting their own research, and will have ready access to faculty for that purpose.

Qualifications:

  • Candidates for this position are expected to have strong academic records and references.
  • Professional experience in corporate practice is required, with two or more years of such experience preferred.  
  • JD from a US school is preferred but candidates with an LLM or JSD will also be considered.
  • In the past, people who have held this position have used it as a step toward a tenure track position at a law school. We have a preference for candidates with an academic career in mind but this is not a requirement.

How to Apply:

We invite you to submit your application online via the Stanford Careers website referencing job number: [93553].  Please include:

  • a cover letter addressed to Professor Klausner,
  • an official law school transcript,
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  • copies of any publications,
  • the names and contact information for at least three professional references (at least two law professors).

*Application deadline: Until position is filled

Additional Information:

This is a two-year fixed-term position starting in summer 2022 with the possibility of a third year by mutual consent and approval.

Stanford University is an Equal Opportunity Employer.

Stanford Law School seeks to hire the best talent and to promote a safe and secure environment for all members of the university community and its property. To that end, new staff hires must successfully pass a background check prior to starting work at Stanford University.

I call your attention this week to Chief Judge Marbley’s opinion in in re FirstEnergy Securities Litigation, 2022 U.S. Dist. LEXIS 39308 (S.D. Ohio Mar. 7, 2022), sustaining the securities fraud complaint against FirstEnergy and various additional defendants.  To some extent, the decision was unsurprising; Chief Judge Marbley sustained similar allegations in a parallel derivative 14(a) claim last year, but there are still some things here I want to highlight.

The basic claim is that FirstEnergy bribed Ohio politicians to secure a public bailout of failing nuclear plants, and lied about it to investors.  When the scandal came to light, the fallout was dramatic, resulting in, among other things, a criminal case against FirstEnergy and a plunge in its stock price.

I’m going to talk about two aspects of the decision.

First, many of the public lies were relatively generic statements to the effect that FirstEnergy’s political donations and lobbying activities complied with all laws, and that the company had a system of internal controls to ensure that this was the case.  (Sidebar: Speaking of generic statements, I assume everyone saw the news that the Second Circuit granted Goldman Sachs’s third 23(f) petition in the Arkansas Teachers case?  I guess the third time wasn’t the charm, for the plaintiffs, anyway).  Anyhoo, these are the kinds of statements that might under other circumstances be dismissed on puffery grounds, but the court focused here on how FirstEnergy’s shareholders cared enough about its lobbying to seek greater disclosure through a Rule 14a-8 proposal.  FirstEnergy, in opposing that proposal, made some of the challenged statements.  As the court put it, “Representations about the Company’s lobbying activities and legal compliance—which in other cases might be bland and innocuous—take on a different character when, as alleged, they were proffered in response to specific shareholder concerns and served to further the scheme through distraction and concealment.”  Later in the opinion, in response to defendants’ challenges to materiality, the court said: “several of these compliance statements were offered as reasons to vote against a shareholder proposal for increased oversight of lobbying policies and payments.  Context changes the meaning of those statements from aspiration to assurance; the speakers are claiming that increased oversight is not necessary because the Company is compliant and has effective controls.  That assurance—which, importantly, helped to shield the scheme from detection—was misleading and more than mere ‘puffery’ or ‘corporate cheerleading.’”

Similarly, the court held that, in this context, the corporate “Code of Conduct and Director Code of Conduct, espousing ‘high ethical standards,’ ‘fair dealing,’ and ‘compliance with the law’” constituted actionable misstatements.

I am fascinated by these holdings.  It’s a relatively novel use of the shareholder proposal mechanism (although I have to draw parallels to the Oracle court’s use of say-on-pay votes as evidence that a director who sat on the compensation committee, and ignored those votes, lacked independence Larry Ellison).  There are so many shareholder proposals on ESG topics; political activities are a fairly routine subset.  It would be fascinating if company opposition to these proposals was regularly treated as more material than ordinary company boilerplate, and thus became a backdoor way to strengthen Section 10(b) as a mechanism for policing ESG-like disclosures.  (I have previously written that under current doctrine, 10(b) does not do a very good job of this).

And frankly, I thought by this point, most courts were treating corporate codes of conduct as immaterial as a matter of law.  Usually, courts say something to the effect that codes of conduct are not promises, but merely “aspirational.”  Here, the court engaged in what I believe is the proper analysis – it held that you can’t call something aspirational if you weren’t even trying to behave in accordance with the code, i.e., as the court put it “The Company’s Code of Conduct and Director Code of Conduct false or misleading in that they were presented to shareholders in proxy statements but allegedly were being disregarded intentionally by the Company and its senior management. The Company later would admit to violations of these policies in a series of executive firings.”

That’s the first thing.

Second is the use of scheme liability to draw in nonspeaking defendants.  After Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), it seemed like nonspeaking defendants were free and clear of potential Section 10(b) liability, but then in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), the Supreme Court held that even nonspeakers might be liable for participation in a fraudulent scheme.  

At the time, it was not obvious if this holding would redound to the benefit of private plaintiffs (as opposed to the SEC) given the constraints imposed by Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008), but since then, some claims have gotten through, and FirstEnergy is the latest example.  The court held that certain officers who participated in the scheme by having discussions with the public officials who were bribed, overseeing media efforts, and coordinating political activities and lobbying, had potentially violated 10(b), and refused to dismiss claims against them.  Relying on West Virginia Pipe Trades Health & Welfare Fund v. Medtronic, 845 F.3d 384 (8th Cir. 2016), the court held that the scheme consisted of producing a “public-facing product” (the bailout and the misleading nature of FirstEnergy’s support), and these behind-the-scenes activities contributed to that product.  Notably, one of the defendants subject to this theory was the corporation’s general counsel and chief legal officer, who, quoting the court:

is alleged to have overseen “the Company’s fulfillment of its legal and ethical obligations, internal control policies and procedures and adherence to internal control, risk management and compliance guidelines,” and to have been terminated for “conduct” in support of the scheme as well as his failure to prevent it.

According to the plaintiffs, this defendant was eventually fired for ““inaction and conduct that the Board determined was influenced by the improper tone at the top.”

So. Let that be a lesson to you.