A few weeks ago, the faculty here gave a lunchtime discussion of various SCOTUS cases in the 2013OT. As a corporate law professor, there's never a lot to choose from, and this year's skimpy offering was no different. I chose the consolidated cases of Chadbourne & Parke LLP v. Troice; Proskauer Rose LLP v. Troice and Willis of Colorado Inc. v. Troice. (Documents courtesy of Scotusblog.) Though the names do not suggest it, these are the private securities lawsuits stemming from Allen Stanford's Ponzi Scheme. Mr. Stanford is serving 100 years in prison right now and probably doesn't have a lot of extra cash lying around, so investors have chosen to sue these other entities. Because federal securities law is not very amenable to securities fraud lawsuits against aiders and abetters (like these defendants would be), these cases were brought under state law.
Unfortunately, federal securities law, and the Private Securities Litigation Reform Act, is not that easy to bypass. Defendants wanted the case dismissed under the Securities Litigation Uniform Standards Act, which pre-empts class actions in which plaintiffs allege a misrepresentation in connection with the purchase or sale of a "covered security." As you can tell from my quotation marks and boldface, plaintiffs counter that the fraud was not in connection with a "covered security."
What was the fraud? Stanford touted certificates of deposit (CD) accounts that paid 10% (what?) at Stanford International Bank, based in Antigua. Now, CDs at U.S. banks aren't considered securities at all, but the SEC and the DOJ argued that Stanford committed securities fraud in the purchase and sale of a security anyway. However, these charges were dropped in favor of wire fraud, obstruction and money laundering, and he was convicted on those counts.
That being said, no one is arguing that the CDs aren't a "security." But, plaintiffs argue that the CDs aren't a "covered security." A covered security is one that is listed on a regulated national exchange and traded nationally. The CDs are definitely not covered securities. But, SIB represented that the accounts were backed by "safe, liquid investments" and that monies were "invested in a well-diversified portfolio of highly marketable securities issued by stable governments, strong multinational companies and major international banks." Defendants argue that this is enough to meet the "in connection with" standard -- the monies were supposed to be used to purchase covered securities at some point. (The money was never used to purchase anything, but no one is taking the "phantom securities aren't securities" angle in this post-Madoff era!) In addition, defendants make the argument, and the SEC was using this argument in the Stanford case, that at least one plaintiff sold covered securities to invest in the CDs. If the defendants are right, then the case is dismissed under SLUSA and cannot continue in any court as a class action.
Here is the transcript of the oral arguments on the first day of the term. Other commentators seem to think it was split and that defendants may win. I wasn't there, but the transcript seems to suggest that the justices were very skeptical of the reach of the defendants arguments. Both the "in connection with" argument and the "selling covered securities to purchase the fraud" arguments seem to bring up spectres of ordinary purchases becoming securities fraud fodder. I.e., if I sell stock to buy a house, the seller better not say anything misleading or its securities fraud for you! I hope the plaintiffs win for this and other reasons.
It's unlikely, but not impossible. Twitter was a big lobbying force for the JOBS Act provision that changed the Section 12(g) of the Exchange Act's threshold from 500 to 2000 investors. And we know from this prospectus that it went public with 755 shareholders (p. 155) of record. But 12(g) has a second threshold: you have to register under the Exchange Act if you have 500 or more unaccredited shareholders. I was curious whether Twitter would break out the number of unaccredited shareholders in its prospectus, but it doesn't. To be fair, I don't suggest it has to: the regulations don't require it, at least as far as I know.
We know Twitter was approaching that magic 500 number when JOBS was passed, but JOBS changed the rules regarding counting: employee stockholders who gain their shares via vesting of stock options don't count in the tally. Presumably once Twitter excluded these stockholders it was well under the 500 unaccredited threshold. But it would be interesting to know.
Tuesday's WSJ had an article on changes in the private secondary market. Long time readers know that I've been interested in this space for quite some time. Here are some nuggets, plus my take:
- Auction volumes are way down, and the number of companies whose shares are available for purchase is, too.
- Post-Facebook IPO, SecondMarket has laid off 40% of its staff
- The other major player, SharesPost, has created a joint venture with Nasdaq OM and will launch Nasdaq Private Market later this year.
- Companies are looking for mutual fund and hedge fund investors that can aggregate individual investors (think Goldman's failed pre-Facebook investment vehicle)
None of this surprises me. (Indeed, here's a little prescience for you) The puzzling thing in the wild west that was the pre-Facebook IPO secondary market was that companies allowed so much trading of their shares--trading that inmost cases required their explicit permission. According to the WSJ, after Facebook's IPO debacle, companies woke up to the risks: "Firms feared online trading could bring in too many investors, lead to speculative swings in share price affecting companies' stock-based incentives for employees, and spread information about privately held companies too widely."
Conspicuously absent from the article is any indication that the loosening of Section 12(g) of the Exchange Act, which requires Exchange Act filings once a corporation reaches 2000 (pre-JOBS, 500) shareholders, has made any difference at all. Look for more on this from me. Eventually.
We've been following the debate between Lucian Bebchuk and Martin Lipton on the value of activist shareholders with interest, and it still seems as if the protagonists see the world very differently. The debate has been occasioned by a paper from Bebchuk and his co-authors arguing, essentially, that activist shareholders increase returns to investors:
We find no evidence that interventions are followed by declines in operating performance in the long term; to the contrary, activist interventions are followed by improved operating performance during the five-year period following these interventions. These improvements in long-term performance, we find, are present also when focusing on the two subsets of activist interventions that are most resisted and criticized – first, interventions that lower or constrain long-term investments by enhancing leverage, beefing up shareholder payouts, or reducing investments and, second, adversarial interventions employing hostile tactics.
We also find no evidence that the initial positive stock price spike accompanying activist interventions fails to appreciate their long-term costs and therefore tends to be followed by negative abnormal returns in the long term; the data is consistent with the initial spike reflecting correctly the intervention’s long-term consequences. Similarly, we find no evidence for pump-and-dump patterns in which the exit of an activist is followed by abnormal long-term negative returns. Finally, we find no evidence for concerns that activist interventions during the years preceding the financial crisis rendered companies more vulnerable and that the targeted companies therefore were more adversely affected by the crisis.
In this round, Lipton offers a literature review of the case for the other side, which is motivated by the plausible assumption that activist shareholders tend not to buy and hold:
numerous empirical studies over the years have produced results that conflict with those Prof. Bebchuk espouses. These other studies generally find that activism has a negative effect or no effect on long-term value, particularly when controlling for the skewing impact of a takeover of the target (which generally occurs at a premium regardless of whether the target is the subject of activism).
Some of the studies cited are quite old, and not all of the journals are top-drawer. But others seem quite on point. Perhaps the disputants will next be able to identify some empirical propositions with which they agree, and others with which they do not (other than, you know, sample selection).
This will be an outsource - first, to Steve Davidoff's column on the Company That Would End Fraud On The Market (it is Haliburton, with advice from Wachtell Lipton):
The company has petitioned the Supreme Court to overturn the decision in the Basic case, arguing that its standard should never have been adopted. A group of former commissioners at the Securities and Exchange Commission and law professors represented by the New York law firm Wachtell, Lipton, Rosen & Katz have also taken up the cause. In an amicus brief, the group argues that, in practice, the Basic case has effectively ended the reliance requirement intended by the statute, something that is not justified.
They rely on a forthcoming law review article by an influential professor, Joseph A. Grundfest of Stanford Law School. Professor Grundfest argues that the statute on which most securities fraud is based — Section 10(b) of the Exchange Act — was intended by Congress to mean actual reliance because the statute is similar to another one in the Exchange Act that does specifically state such reliance is required.
Professor Grundfest’s argument is a novel one and is likely to be disputed by the pro-securities litigation forces, but the question probably comes down to whether there are five justices who want to put a stake through the heart of securities fraud cases.
And then, to Jim Hamilton and Allen Ferrell, via Scotusblog, for a recap of the oral argument in Chadbourne and Park v. Troice. Here's Allen:
The specter of Bernie Madoff hovered over oral arguments Monday. This was appropriate to the occasion, as the Court was preoccupied with metaphysics: What does it mean for a misrepresentation to be “in connection with” a purchase or sale? The question that came up repeatedly was essentially, whether the lawyers arguing on both sides “agree that Madoff committed Rule 10b-5 securities fraud when he represented that he was purchasing securities on behalf of investors when in fact he purchased nothing.” According to at least one reading of the plaintiffs’ allegations, Stanford Investment Bank arguably acted like Madoff. The bank falsely represented to investors that they were buying an instrument (certificates of deposit) that were in some sense backed by securities — securities that did not exist (like Madoff’s securities purchases that never happened). The answer to this question is critical because if the answer is yes – Madoff did commit Rule 10b-5 securities fraud – and, yes – the alleged facts here are analogous to the Madoff situation – then it follows that the Securities Litigation Uniform Standards Act (SLUSA) precludes the state actions.
And here's Jim:
Mr. Clement said that the whole point of this fraud was to take a non-covered security and to imbue it with some of the positive qualities of a covered security, the most important of which being liquidity. And if you look at sort of the underlying brochures here that were used to market this, he continued, that is really what this fraud was all about. These CDs were offered as being better than normal CDs because we can get you your money whenever you need it.
My blogging has been a bit light lately, as I've been scrambling to finish working on a paper for what looks to be a great conference: The Securities Act of 1933 at 80: Does It Provide a Fair and Efficient Access to Capital? The paper is on post-JOBS IPOs, and I will try to post some data and observations after the conference.
I look forward to seeing some Masters (Joan Heminway, Don Langevoort) and friends of Glom (Bob Thompson) in beautiful Lexington, KY. And now, I'm going to see a man about a horse.
That's the rule that compares CEO pay to median worker pay - it is supposed to shame CEOs, but so was the rule requiring them to plain old disclose their own compensation, and look how that turned out.
Anyway, here's a nice overview from Matt Levine; I found it interesting how interested people are in this rule; the SEC said it would be regulating in this area (Dodd-Frank requires it), and:
In connection with rulemakings implementing the Dodd-Frank Act, we have sought comment from the public before the issuance of a proposing release. With respect to Section 953(b) of the Dodd-Frank Act, as of September 15, 2013, we have received approximately 22,860 comment letters and a petition with approximately 84,700 signatories.
If anything like those numbers comment on the agency's proposal, it will be pretty busy when it drafts the final rule's statement of basis and purpose. That statement must respond to "well-supposed arguments contained in public comments critical of the agency's proposed rule." A lot of comments means a long, long statement.
Earlier this week, we told you about the Klausner study on SEC enforcement actions. In that dataset, the SEC brought claims against individuals in 93% of actions. And the dataset included federal court cases: "A case, as we use the term, is a set of one or more enforcement actions against a company and/or its executives and/or third parties such as accountants or underwriters for the same misstatement that led to a violation."
As Mike Koehler observes, the story is rather different for that growth area of SEC work, the Foreign Corrupt Practices Act. "Of the 57 corporate SEC FCPA enforcement actions, 45 (or 79%) have not (at least yet) resulted in any SEC charges against company employees." That includes apparently hand collected data between 2005-12.
It is an interesting disparity.
Over at the Harvard Corporate Governance blog, Michael Klausner has some descriptive data on how often the SEC targets individual defendants in enforcement actions.
only 7 percent of cases involved no individual defendants. Focusing solely on cases involving at least one fraud count, only 4 percent of cases involved no individual defendants. In the remainder of cases, the SEC named either individual defendants only or it named both the corporation and individual defendants.... [T]he SEC names a wide range of individuals as defendants. It names CEOs in 56% of its cases, CFOs in 58% of cases, and lower level executives in 71% of cases. Regarding the scapegoat characterization, the SEC has targeted solely lower level executives in only 7% of its cases.
The charts alone are worth a look, so do check it out.
I'm not too surprised by this data, but it is nice to have it. There seems to be a feeling in the enforcement community that a fine paid by a corporation isn't much of a fine at all, and that individual sanctions must be included. The Klausner project certainly suggests that SEC practice is consistent with such a vision.
DealProfessor Steven Davidoff wrote a piece on SPACs yesterday that seemed unduly harsh to me. Admittedly I have a something of a soft spot for this odd duck entity, having written two papers about it (here and here).
Steven's main beef is that SPACs are good for their promoters and for hedge funds that invest in them, but maybe not for the average Joe. Let's examine those claims.
Silver Eagle Acquisition Corp.'s recent $325 million IPO is the launching point for the piece. Steven takes SPAC promoters to task for claiming, like their private equity cousins,
up to 20 percent of the equity mostly for finding the target company. The fee is similar to that of a private equity firm, as is the idea of picking a company, but a SPAC is not as safe or rewarding as private equity. SPAC investors take all of the risk in one company instead of a portfolio of companies held by a private equity firm.
As we show, however, the recent trend in SPACs has been to condition some of the 20% equity promoters receive on certain performance targets. In that respect Silver Eagle seems to be at the low end, with an "earnout" of 5% of the total equity contingent upon the stock reaching levels of $12.50 and $15.00. Many recent SPACs tie up considerably more (or all) of the promoter's equity.
Next Steven offers a little history: "In the 1980s, they were rife with fraud, and briefly disappeared from Wall Street in the wake of stricter federal regulation. But, like zombies, they reappeared in the mid-2000s. Before the credit crisis, these vehicles accounted for nearly 25 percent of all I.P.O.’s."
Steven paints with too broad brush. The 1980s were a time of bad hair, legwarmers, peerless teen movies, and blank check companies that indeed operated sketchily at best. But the SPAC was an invention of the 90s that strove to differentiate itself by offering two notable features: 1) it gave shareholders and up or down vote on any proposed acquisition, and 2) a trust account that kept shareholders' money safe. The promoters couldn't access the money unless and until the vote had occurred, and even if the acquisition was approved, they could elect to redeem their shares and get (most of) their cash back. Indeed, even if a majority of shareholders voted for the acquisition, if a lower threshold (say 25%) of the shareholders redeemed their shares, then the acquisition would fail. This supermajority veto set up unintended consequences that the form had to evolve to deal with, but the point is, SPACs have mechanisms in place to rein in the promoters.
SPACs only have 2-3 years to make an acquisition; otherwise they have to liquidate and return their cash to shareholders. Steven is absolutely right that this sets up the incentive for poor 11th hour acquisition choices. But SPACs' trust account offers unique downside protection that makes it hard to compare them with a typical stock. For example, Steven calls one SPAC's 6% return unspectacular, which is true. But that return was on a stock that promised to redeem the $10 shares for $9.97. A 6% return on a stock where the most you're guaranteed to lose is 3 cents might not be a bad deal, all things considered.
In sum, SPACs are good for promoters, but if shareholders don't like the acquisition the promoters propose, they can exit. And the trust account may offer a safe haven attractive enough to compensate for reduced return.
Over the years people have asked me what I think of SPACs as an investment, and I confess I'm still not sure. They fascinate me as in example of creative contract design that evolved quickly as the market changed. But I haven't invested any of my own money in SPACs. Then again, I'm a pretty boring, index fund investor, so you can't extrapolate too much from that!
This article in the Times on Wednesday provides more evidence that Oakland leads the nation in locavore cutlure and innovative financing for social entrepreneurs. The article spotlights the "direct public offering" of People's Community Market, a company that is bringing fresh produce to an un-served community in West Oakland. A key takeaway from the article: social entrepreneurs in California have been doing crowdfunding long before the JOBS Act. Another takeaway not in the article: many of these social enterprises in the Bay are connected by networks. For example, the CFO of People's Grocery, David Guendelman is also CFO or strategic advisor to a number of cutting edge social impact ventures, including Straus Family Creamery, Saveup, Lotus Foods and others.
What is a direct-public offering? It is a loose term covering securities offerings to a large group of investors sans underwriters and their commissions. For securities law mavens, the key is that firms rely on a transaction exemption under Regulation D/Rule 504, Regulation A, or the intrastate exemption (Section 3(a)(11)/Rule 147). The intrastate exemption might be a lot more workable in California than in smaller states given the need to impose resale restrictions on securities being sold and the demands of investors for some liquidity to their investment.
Correction: The direct public offering was conducted by People's Community Market, a forprofit C Corporation. People's Grocery is a non-profit sister corporation.
The SEC "failure to supervise" claim against Steven A. Cohen is an administrative one; it goes before an admnistrative law judge, insulated agency employees that preside over trial-type hearings (but can dispense with the rules of evidence, etc), appeal from which is made to the commission, and after that to the federal courts. Court review is likely to be most searching where the commission reverses the ALJ; and SEC ALJs in my view, have the most fun (or are tied for that honor with ITC ALJs who hear seriously big money disputes). Most ALJs work for the Social Security Administration, but a small number occupy specialized niches in other agencies (in the 90s, the SEC relied on all of three ALJs to do their administrative adjudications). These judges, because of a very strong veterans' preference, are very likely to have military backgrounds, which makes them in turn very likely to be men.
Will they rule in favor of the agency they work for? Here's John Carney on the early defense being put together by Cohen's lawyers:
First, they say Cohen didn't read the email. Like most of us, Cohen gets far too many emails to read them all. According to the paper, he gets roughly 1,000 emails each day. This is highly plausible for someone in Cohen's position. Let's call this the "Email is Broken" defense.
The second response is the "Hamptons Pool" defense. When the email was sent to Cohen, at 1:29 in the afternoon, Cohen was in the middle of a 19 minute telephone call with SAC's head of business development. A minute and a half after the conclusion of that phone call, at 1:37:46, Cohen got a call from a research trader, discussing something or other (no one is certain what). At 1:39:11, an order to sell shares of Dell in Cohen's personal account at SAC was placed.
And here's Matt Levine on the claim that Cohen should have realized he was being told to sell Dell stock based on inside information:
here’s the obvious paradox of “I was too busy not reading emails to not supervise.” ... [A] billionaire businessman who gets 1,000 emails a day can probably afford an employee to screen those emails and flag the most important ones for him. And Cohen did that. There was “a SAC employee whose duties included forwarding to Cohen trading-related information worthy of Cohen’s attention (the ‘Research Trader’).” And that employee forwarded the relevant Dell email to Cohen’s office and home email addresses. And then called to follow up. And talked to Cohen for 48 seconds. And then Cohen sold Dell. But: he never opened the email. Imagine the priority that he gave to emails that the Research Trader didn’t flag.
Over at Compliance Week, they've found a gap in the federal government's market surveillance, and they've gone and given it to the world:
This morning, the Daily Intelligencer reports, CNBC's Jim Cramer asked Preet Bharara, the U.S. Attorney for the SDNY, if Snapchat can be used to share insider trading tips without leaving a trail. Bharara's response: "I don't even know what you're talking about."
That's from the brilliantly titled Snapchat: The New Way to Tell Everyone that "Blue Horseshoe Loves Anacott Steel". You'll have to click on the link if you do not recall the reference.
When I teach Securities Regulation, after going through what is/is not a security, I begin with the topic of registration of securities, or the initial public offering. Then, I get to the exemptions, including Rule 506 of Regulation D and rules 144 and 144A. By this time, my students usually say, "So everything we learned about registration requirements is completely meaningless?" After the lifting of the ban on general solicitation for Rule 506, the answer seems to be unequivocally "yes."
If you are an issuer and want to raise a large amount of capital (over $5 million), your choices are basically a private placement of securities under Rule 506 or an IPO. Rule 506 has many fewer requirements, but historically it had to take place among the issuer, underwriter and institutional investors, funds, and high-worth individuals known to the underwriter. Now, "private placements" can be publicly advertised, even if the shares must only be "placed" in the hands of accredited investors. (See Usha's and Erik's posts from last week.) So, why would any issuer conduct an IPO?
In a registered offering, issuers and underwriters can't speak of the offering during the "quiet period" leading up to registration. Then, after registration, written communications must be through a statutory prospectus, or a "free writing prospectus" that meets certain requirements. Oral communications are allowed, but face-to-face and telephone conversations have practical limitations. The registration statement, with mandatory financials and disclosures, must be approved by the SEC, and prospectus delivery requirements continue once selling begins.
None of this applies to private placements! So, if Company A wants to raise $50 million in an IPO, it will cost more in legal and accounting fees, and Company A can't talk to the public about the offering until registration, then only with a detailed prospectus, and must wait for the SEC to declare the registration statement effective. Meanwhile, Company B can set up a website touting the offering, with no limitations on what it says or must say. Company B can purchase billboards, taxi signs, sandwich boards, Facebook ads, or even send an email to every person on earth. The catch is that it can accept offers to buy only from accredited investors.
Would that alone be enough for a company to forego the private placement and launch an IPO? So that the first-buyers of the shares can be retail (nonaccredited) investors? Exactly how many retail investors receive IPO shares? I'm going to say not many.
The only advantages of the IPO that I can see is first, that the secondary market starts immediately, as compared with the six-month or year waiting period with Rule 144 or the limited but immediate secondary market to qualified institutional buyers through Rule 144A. Second, the Facebook conundrum of mandatory registration under Section 12(g) if an issuer has over 2000 shareholders or 500 unaccredited investors. But I'm not sure that's enough to keep the struggling IPO market a strong alternative.
Unless you've been asleep, you've heard that the SEC Commissioners voted 4-1 on Wednesday to relax the general solicitation ban for Rule 506 and Rule 144A offerings. It was not a terribly surprising result given the language in the JOBS Act. Nor is the reaction from startup community boosters and hedge funds.
Now comes an analysis of unintended consequences. One: mutual funds are not happy with the relative advantage that hedge funds may enjoy in advertising.
Here is my own take. Much hay has been made that issuers relying on 506 still need to take steps to ensure that their investors are accredited investors. Ultimately, the securities laws are making the accredited investor definition do more and more work in protecting investors.
But how good is the definition at the task at hand? Net worth or income are not great proxies for measuring the financial sophistication of individuals. Perhaps they are better at measuring an individual's capacity to bear risk but a net worth of $1 million or annual income of $200K is not that much of a cushion against financial loss on sophisticated investments.
It may make some sense to have accredited investor definition play a role in multiple securities rules to ease compliance. But it also creates what engineers might call a single point of failure.
Consider how much of the architecture of financial regulations came to rest on rating agencies. That single point of engineering failure indeed failed. And we have yet to come up with other pillars on which to reconstruct the regulation of financial institution risk-taking.
It is high time to think about a more robust measure of investor sophistication and capacity for bearing risk than the current accredited investor standard.