Like Lisa, I participated in this excellent discussion group at the SEALS conference co-organized by Joan Heminway. As I told co-organizer and friend-of-Glom Mike Guttentag, for a week I had a Word document open with the titular question at the top. Participants were supposed to submit a 2-3 page paper before the meeting. I totally lamed out. I kept trying to write, but couldn't come up with anything coherent.
I do have an answer to the question, though: Yes, the public/private divide does make sense. But it's gone, daddy, gone.
As I said at the conference, I think I'm essentially a conservative person: I'm resistant to change. And when I learned the world of securities, it seemed to me that there was this Grand Bargain. If you wanted to go public, you got many benefits, most notably a high degree of liquidity and access to public capital markets. But you had to take the bitter with the sweet: mandatory disclosure and increased liability risks. If you stayed private, your equity was far less liquid, and you couldn't make use of general solicitation. Your capital raising was much more circumscribed. But within those limitations you were free to order the firm more or less as you saw fit. Other substantive areas of law of course constrained private firms--environmental law, labor law, etc.--but in terms of corporate and securities law, they were relatively free. I realize this is a simplification, but in broadstrokes I think it's true.
No more. The Grand Bargain is gone. General solicitation for private firms. Conflict minerals rules. Emerging growth companies. Disclosure of executive pay ratios. Private secondary markets. Dodd-Frank, the JOBS Act, and technology have made a hash out of it. Or at least, the line between public and private is blurred.
This blurring makes me uneasy. I feel like there's a disruption in the natural order of things. But I can't tell if that's my innate conservatism talking, or if there really was something we lost with the Grand Bargain.
Two recent developments in the law and practice of business include: (1) the advent of benefit corporations (and kindred organizational forms) and (2) the application of crowdfunding practices to capital-raising for start-ups. My thesis here is that these two innovations will become disruptive legal technologies. In other words, benefit corporations and capital crowdfunding will change the landscape of business organization substantially.
A disruptive technology is one that changes the foundational context of business. Think of the internet and the rise of Amazon, Google, etc. Or consider the invention of laptops and the rise of Microsoft and the fall of the old IBM. Automobiles displace horses, and telephones make the telegraph obsolete. The Harvard economist Joseph Schumpeter coined a phrase for the phenomenon: “creative destruction.”
Technologies can be further divided into two types: physical technologies (e.g., new scientific inventions or mechanical innovations) and social technologies (such as law and accounting). See Business Persons, p. 1 (citing Richard R. Nelson, Technology, Institutions, and Economic Growth (2005), pp. 153–65, 195–209). The legal innovations of benefit corporations and capital crowdfunding count as major changes in social technologies. (Perhaps the biggest legal technological invention remains the corporation itself.)
1. Benefit corporations began as a nonprofit idea, hatched in my hometown of Philadelphia (actually Berwyn, Pennsylvania, but I’ll claim it as close enough). A nonprofit organization called B Lab began to offer an independent brand to business firms (somewhat confusingly not limited to corporations) that agree to adopt a “social purpose” as well as the usual self-seeking goal of profit-making. In addition, a “Certified B Corporation” must meet a transparency requirement of regular reporting on its “social” as well as financial progress. Other similar efforts include the advent of “low-profit” limited liability companies or L3Cs, which attempt to combine nonprofit/social and profit objectives. In my theory of business, I label these kind of firms “hybrid social enterprises.” Business Persons, pp. 206-15.
A significant change occurred in the last few years with the passage of legislation that gave teeth to the benefit corporation idea. Previously, the nonprofit label for a B Corp required a firm to declare adherence to a corporate constituency statute or to adopt a similar constituency by-law or other governing provision which signaled that a firm’s sense of its business objective extended beyond shareholders or other equity-owners alone. (One of my first academic articles addressed the topic at an earlier stage. See “Beyond Shareholders: Interpreting Corporate Constituency Statutes.” I also gave a recent video interview on the topic here.) Beginning in 2010, a number of U.S. states passed formal statutes authorizing benefit corporations. One recent count finds that twenty-seven states have now passed similar statutes. California has allowed for an option of all corporations to “opt in” to a “flexible purpose corporation” statute which combines features of benefit corporations and constituency statutes. Most notably, Delaware – the center of gravity of U.S. incorporations – adopted a benefit corporation statute in the summer of 2013. According to Alicia Plerhoples, fifty-five corporations opted in to the Delaware benefit corporation form within six months. Better known companies that have chosen to operate as benefit corporations include Method Products in Delaware and Patagonia in California.
2. Crowdfunding firms. Crowdfunding along the lines of Kickstarter and Indiegogo campaigns for the creation of new products have become commonplace. And the amounts of capital raised have sometimes been eye-popping. An article in Forbes relates the recent case of a robotics company raising $1.4 million in three weeks for a new project. Nonprofit funding for the microfinance of small business ventures in developing countries seems also to be successful. Kiva is probably the best known example. (Disclosure: my family has been an investor in various Kiva projects, and I’ve been surprised and encouraged by the fact that no loans have so far defaulted!)
However, a truly disruptive change in the capital funding of enterprises – perhaps including hybrid social enterprises – may be signaled by the Jumpstart Our Business Start-ups (JOBS) Act passed in 2012. Although it is limited at the moment in terms of the range of investors that may be tapped for crowdfunding (including a $1 million capital limit and sophisticated/wealthy investors requirement), a successful initial run may result in amendments that may begin to change the face of capital fundraising for firms. Judging from some recent books at least, crowdfunding for new ventures seems to have arrived. See Kevin Lawton and Dan Marom’s The Crowdfunding Revolution (2012) and Gary Spirer’s Crowdfunding: The Next Big Thing (2013).
What if easier capital crowdfunding combined with benefit corporation structures? Is it possible to imagine the construction of new securities markets that would raise capital for benefit corporations -- outside of traditional Wall Street markets where the norm of “shareholder value maximization” rules? There are some reasons for doubt: securities regulations change slowly (with the financial status quo more than willing to lobby against disruptive changes) and hopes for “do-good” business models may run into trouble if consumer markets don’t support them strongly. But it’s at least possible to imagine a different world of business emerging with the energy and commitment of a generation of entrepreneurs who might care about more in their lives than making themselves rich. Benefit corporations fueled by capital crowdfunding might lead a revolution: or, less provocatively, may at least challenge traditional business models that for too long have assumed a narrow economic model of profit-maximizing self-interest. James Surowiecki, in his recent column in The New Yorker, captures a more modest possibility: “The rise of B corps is a reminder that the idea that corporations should be only lean, mean, profit-maximizing machines isn’t dictated by the inherent nature of capitalism, let alone by human nature. As individuals, we try to make our work not just profitable but also meaningful. It may be time for more companies to do the same.”
So a combination of hybrid social enterprises and capital crowdfunding doesn’t need to displace all of the traditional modes of doing business to change the world. If a significant number of entrepreneurs, employees, investors, and customers lock-in to these new social technologies, then they will indeed become “disruptive.”
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Corporate disclosure, especially in securities regulation, has been a standard regulatory strategy since the New Deal. Brandeisian “sunlight” has been endorsed widely as a cure for nefarious inside dealings. An impressive apparatus of regulatory disclosure has emerged, including annual and quarterly reports enshrined in Forms 10K and 10Q. Other less comprehensive disclosures are also required: for initial public offerings and various debt issuances, as well as for unexpected events that require an update of available information in the market (Form 8K).
For the most part, corporate disclosure has focused on financial information: for the good and sufficient reason that it is designed to protect investors – especially investors who are relatively small players in large public trading markets. Some doubts have been raised about the effectiveness of this kind of disclosure and, indeed, the effectiveness of mandatory disclosure in general. A recent book by Omri Ben-Shahar and Carl Scheider, More Than You Wanted to Know: The Failure of Mandated Disclosure, advances a wide-ranging attack on all mandatory disclosure. (I think that their attack goes too far: I’ll be coming out with a short review of the book for Penn Law’s RegBlog called “Defending Disclosure”). Assuming, though, that much financial disclosure makes sense, what about expanding it to include other activities of business firms?
Consider three types of nonfinancial information that might usefully be disclosed: information about a business firm’s activities with respect to politics, the natural environment, and religion.
1. Politics. One good candidate for enhanced corporate disclosure concerns business activities in politics. Lobbying laws require various disclosures, and various campaign finance laws do too. It is possible to obscure actual political spending through the complexity of corporate organization. (For a nice graphic of the Koch brothers’ labyrinth assembled by the Center for Responsive Politics, see here.) Good reporters can ferret out this information – but they need to get access to it in the first place. My colleague Bill Laufer has been an academic leader in an effort to encourage public corporations to disclose political spending voluntarily, with Wharton’s Zicklin Center for Business Ethics Research teaming up with the nonpartisan Center for Political Accountability to rank companies with respect to their transparency about corporate political spending. The rankings have been done for three years now, and there are indications of increased business participation. Recently, even this voluntary effort has been attacked by business groups such as the U.S. Chamber of Commerce for being “anti-business.” See letter from U.S. Chamber of Commerce quoted here. Jonathan Macey of Yale Law School has also objected to the rankings in an article in the Wall Street Journal, arguing that the purpose of political disclosure is somehow part of “a continuing war against corporate America.” These objections, however, seem overblown and misplaced. What is so wrong about asking for disclosure about the political spending of business firms? One can Google individuals to see their record of supporting Presidential and Congressional candidates via the Federal Election Commission’s website, yet large businesses should be exempt? Political spending by corporations and other business should be disclosed in virtue of democratic ideals of transparency in the political process. Media, non-profit groups, political parties, and other citizens may then use the resulting information in political debates and election campaigns. Also, it seems reasonable for shareholders to expect to have access to this kind of information.
In Business Persons, I’ve gone further to argue (in chapter 7) that both majority and dissenting opinions in Citizens United appear to support mandatory disclosure as a good compromise strategy for regulation. One can still debate the merits of closer control of corporate spending in politics (and I believe that though business corporations indeed have “rights” to political speech these rights do not necessarily extend to unlimited spending directed toward political campaigns). It seems to me hard to dispute that principles of political democracy – and the transparency of the process – support a law of mandatory disclosure of corporate spending in politics.
2. Natural environment. Increasingly, many large companies are also issuing voluntary reports regarding their environmental performance (and often adding in other “social impact” elements). Annual reports issued under the International Standards Organization (the ISO 14000 series), the Global Reporting Initiative, and the Carbon Disclosure Project are examples. The Environmental Protection Agency (EPA) has also established a mandatory program for greenhouse gas emissions reporting, which is tailored to different industrial sectors. One can argue about whether these kinds of disclosures are sufficiently useful to justify their expense, but my own view is that they help to encourage business firms to take environmental concerns seriously. Many firms use this reporting to enhance their internal efficiency (often leading to financial bottom-line gains). As important, however, is the engagement of firms to consider environmental issues – and encouraging them to act as “part of the solution” rather than simply as a generating part of the problem.
One caveat that is relevant to all nonfinancial disclosure regimes: The scope of firms required to disclose should be considered. I do not believe that the case is convincing that only public reporting companies under the securities laws should be included. (For one influential argument to the contrary, see Cynthia A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency,” 112 Harvard Law Review 1197 (1999)). Instead, it makes to sense for different agencies appropriate to the particular issue at hand to regulate: the Federal Election Commission for political disclosures and the EPA for environmental disclosures.
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Daniel Gitner got a splashy profile in the Times today in celebration of his recent trial acquiting Rengen Rajnaratnam, and congratulations to him. My theory of white collar/defense lawyer eminence is that often, you don't have to win to be able to market yourself. You were "picked by Martha Stewart," or "represented General Motors during the financial crisis," or "handle pro bono representations for five detainees in Guantanamo." See? It sounds like you're important. You're so good you drew the assignment.
Still, you probably won't get a Times profile when you lose those cases. Gitner won, and drew a reporter who didn't appear to like him much. He forbade his staff to get haircuts during the trial for some uninteresting lucky rabbit foot related reasons, and generally came across as intense but yet very platitudinous.
That right there isn't bad marketing either, though. My lawyer is a pain but leaves no stone unturned; it's practically in the job description. And now Gitner gets to add that he's the only person to win an insider trading case in the Bharara era; he did two things right there. First, he persuaded the jury to absolve his client of the one marginal count the judge didn't dismiss, and second, he got the judge to dismiss the two serious counts. It could be his briefwriting, rather than his bedside manner, that did the trick here - that, at least is what Matt Levine thinks.
Usually thought of as unusually receptive, for a financial regulator, at least, to legislative pressure, the SEC, perhaps in a testament to its recent obsession with insider trading, has done the opposite and filed suit against Congress, subpeonaing a congressman and his aide to see whether the aide disclosed news to a lobby/law firm about health funding that caused a bunch of stock prices to spike ahead of the announcement of the new policy. DOJ is in on the game as well.
Congress is, it appears, displeased:
“What the SEC has done is embark on a remarkable fishing expedition for congressional records -- core legislative records,” [congressional lawyer] Kircher said in a court filing. “The SEC invites the federal judiciary to enforce those administrative subpoenas as against the Legislative Branch of the federal government. This court should decline that invitation.”
The so-called speech and debate clause in the Constitution protects members of Congress and staff from any outside inquiry into legislative business.
It is pretty juicy, and we'll outsource why to corp counsel. I'm just ballparking here, but a conversion between an aide and a lobbyist would seem to be deeply, deeply covered by the speech and debate clause, as unappetizing as it might seem. Here's a note on the clause, and here's the Heritage Foundation, which does these recaps pretty well.
And here's corp counsel:
the DOJ and SEC have sent subpoenas to Rep. David Camp, Chair of the House Ways & Means Committee, and Congressional Staffer Brian Sutter, regarding whether they tipped traders about a change in health care policy in the wake of a long-running investigation. And on Friday, as noted in this WSJ article, the SEC filed a lawsuit in the Southern District of New York seeking to compel the subpoenas. Possible grand jury to follow.
Here’s an excerpt from David Smyth’s blog about the case:
This is fascinating to me for so many reasons, among them: (1) the potential Constitutional cluster we’re about to witness; (2) the real test this poses for the recently passed STOCK Act’s effectiveness; and (3) another example of Mary Jo White’s severe distaste for those who defy Commission subpoenas.
And here’s an excerpt from the latest WSJ article:
“It’s not unheard of for an agency to serve a subpoena to Congress, but for an agency to sue is—if not unprecedented—at least very rare,” said Michael Stern, who was senior counsel to the U.S. House from 1996 to 2004. “It shows that there is a serious conflict; the SEC really wants the information and the House really wants it protected,” he said.
Call For Papers
AALS Section on Securities Regulation - 2015 AALS Annual Meeting
Saturday January 3, 2015, Washington, DC
The AALS Section on Securities Regulation invites papers for its program on "The Future of Rule 10b-5" for the AALS Annual Meeting in Washington, D.C. The AALS Section on Securities Regulation program will be held on Saturday January 3, 2015 from 3:30-5:15 PM.
TOPIC DESCRIPTION: This panel discussion will explore the current and future role of Rule 10b-5 in public and private offerings, public enforcement efforts, and private litigation. Participants also will discuss the manner in which Rule 10b-5 relates to expectations regarding public companies and their directors. Participants will explore these issues in light of recent court decisions (including, e.g., Halliburton), the Securities and Exchange Commission's enforcement priorities, and changing rules related to public disclosure obligations.
ELIGIBILITY: Full-time faculty members of AALS member law schools are eligible to submit papers. Pursuant to AALS rules, faculty at fee-paid law schools, foreign faculty, adjunct and visiting faculty (without a full-time position at an AALS member law school), graduate students, fellows, and non-law school faculty are not eligible to submit. Please note that all faculty members presenting at the program are responsible for paying their own annual meeting registration fee and travel expenses.
PAPER SUBMISSION PROCEDURE: Up to three papers will be selected from this call for papers. There is no formal requirement as to the form or length of proposals. Both shorter proposals and substantially complete papers will be considered.
Papers will be selected by the Section's Executive Committee in a double-blind review. Please submit only anonymous papers by redacting from the submission the author's name and any references to the identity of the author. The title of the email submission should read: "Submission - 2015 AALS Section on Securities Regulation."
Please email submissions to the Section Chair Lisa M. Fairfax at: email@example.com on or before August 21, 2014.
As David notes, the Second Circuit reversal of Judge Rakoff in the SEC v. Citigroup litigation fails to surprise. But that doesn’t mean the Second Circuit was correct. Indeed, I believe the Second Circuit, in an attempt to be pragmatic, allowed the emperor to continue strolling naked. The fact that the walk has going on for a while doesn’t mean the clothes are there.
If asking for facts makes a judge a maverick …
For all the media talk of Judge Rakoff as a “hero” or “maverick,” he carefully crafted his original opinion. The essence of his ruling: a court cannot approve a settlement and agree to an injunction when the SEC and the defendant give the court no facts. According to Judge Rakoff’s reasoning, without “any proven or admitted facts” the court cannot “exercise even a modest degree of independent judgment.”
Note that Judge Rakoff did not ask for an admission of liability. The Second Circuit panel recognized this and disposed of this quickly in Part II of its opinion.
Without facts, Judge Rakoff asked, how can district courts judge whether a settlement that includes substantial injunctive relief is reasonable, fair, adequate, and in the public interest? (The Second Circuit ruled that courts should not inquire into the adequacy of settlements.) Judge Rakoff rightly found that the SEC’s complaint does not itself establish facts.
Second Circuit ignores absence of elephant in room
The Second Circuit, as did Judge Rakoff, underscores the deference that trial courts must afford to SEC settlements. But the Second Circuit opinion chose to focus on dicta in Judge Rakoff’s order rather than the simple problem: how can a judge determine whether a settlement meets the legal standard – that it is fair, reasonable, and in the public interest – absent any facts about the defendant’s conduct. The Second Circuit held:
“Absent a substantial basis in the record for concluding that the proposed consent decree does not meet these requirements, the district court is required to enter the order.”
But what if there isn’t any real factual record? In the absence of any facts, wouldn’t district courts automatically have to approve a settlement? The Second Circuit may have created a strong incentive for the SEC and defendants to avoid creating any factual record.
The Second Circuit said that in reviewing SEC consent decrees, courts should review at a minimum (1) the basic legality of the decree, (2) whether terms of the decree, including its enforcement mechanism are clear, (3) whether the consent decree reflects a resolution of the actual claims in the complaint, and (4) whether the decree is tainted by improper collusion or corruption.
That sets the bar incredibly low. Indeed, the Second Circuit limits Judge Rakoff to asking for “additional information sufficient to allay any concerns the district court may have regarding improper collusion between the parties.” Imagine the colloquial version of how this inquiry would proceed:
“Any colluders in there?”
“No – just us chickens.”
The potential absurdity of the Second Circuit’s position is underscored by its insistence that, of course, courts must develop a factual record.
“As part of its review, the district court will necessarily establish that a factual basis exists for the proposed decree. In many cases, setting out the colorable claims, supported by factual averments by the SEC, neither admitted nor denied by the wrongdoer, will suffice to allow the district court to conducts its review.”
Here is a fun exercise: find the facts in the preceding two sentences. “Factual averments by the SEC” are not facts (unless you want to get really cute: it is a fact that the SEC said A, B,and C were facts.)
Facts mean that judges can’t be mavericks
Perhaps this “just the facts” focus feels like wrestling with an epistemological dragnet. But Judge Rakoff’s insistence on a record of proven or admitted facts is crucial – not only to providing some check on the SEC, but, moreover, to restraining judicial powers.
Let’s focus on two pieces of the proposed consent decree between the SEC and Citi: the ongoing injunction not to violate federal securities laws and the injunction to enforce the internal compliance measures at Citigroup. A court cannot impose a broad and long-lasting injunction without having any factual basis to assess whether an injunction is appropriate and to guide the court in undertaking this responsibility.
In many ways, Judge Rakoff’s reasoning served to limit judicial power.
For the injunction on Citigroup’s internal behavior, the court needs some factual basis to grant this relief. The court needs admitted and proven facts for at least two related reasons. First, it needs to ascertain whether it can enforce this injunction. Second, it needs some factual basis to judge later requests by the agency to enforce the injunction. Injunctions are not computer codes, and courts require some factual basis to understand what it is that the parties are asking them to do.
For the injunction on violations of Section 17: an open-ended injunction invites courts to scrutinize all sorts of potential securities law behavior. A district court needs some factual basis in order to understand whether an injunction is an appropriate remedy, and if and how the court could prudently enforce the injunction. What types of conduct by the defendant should the court look to enjoin? The Second Circuit focuses on reviewing injunctions to make sure they are “legal” and “clear.” “I agree not to violate federal securities laws” is both legal and clear in one sense. But take a good read of Section 17 and see how less than specific this agreement is.
Open-ended injunctions sought by public agencies on the basis of no factual information run multiple risks. Among these risks, broad injunctions without a factual basis attempt to commandeer the judiciary in another branch’s responsibility to enforce the law. This creates real separation of powers problems.
Second, open-ended invite judges to take broad enforcement matters into their own hands. A factual basis helps to restrain judges from free-wheeling efforts to enforce injuctions.
Third, broad injunctions without facts run the risk of playing a running joke on the judiciary. If this injunction is a makeweight which the SEC will never seek to enforce (and there is quite a bit of evidence that the SEC does not follow-up on many injunctions), the agency should not be wasting the resources of the judicial branch. Nor should it be involving the judiciary in a charade in which it looks like the SEC is enforcing federal securities laws, but does little to follow through on injunctions it has already obtained.
As amicus briefs to the Second Circuit pointed out, the SEC was able to get admissions of facts in other consent decrees before the Citigroup case. And the SEC has other administrative remedies available to it: suing and then asking for a consent decree in the S.D.N.Y. was not the only game in town.
But the SEC chose to sue Citigroup in federal court and to ask a federal judge to approve a consent decree with a broad injunction. Judge Rakoff’s message to the SEC might have been paraphrased succinctly: “Don’t attempt to invoke the machinery of the judicial system, unless you are serious and you are willing to give a court the information necessary to perform its judicial role.”
The Second Circuit turns this on its head. Its message to trial judges seems to be: “unless the SEC hands you facts that this consent decree is illegal, unrelated to the complaint, or collusive/corrupt, you must approve.”
The only real hook for judges who are frustrated by settlement agreements without facts is the Second Circuit’s insistence that judges can review whether terms of a decree are “clear.”
How lasting a legacy?
Judge Rakoff’s opinion did leave an incredibly thorny question unanswered: what kinds of facts does a judge need to approve a settlement? His opinion simply said no facts cannot suffice. The Second Circuit answered the question in a very cramped way. The appellate court warns judges to take very limited role, which might be as little as comparing a consent decree to the SEC’s complaint.
Some commentators point out that Judge Rakoff’s now overturned opinion still prompted the SEC to change its enforcement policies with respect to “neither admit nor deny.” I agree. But there is nothing to say that the SEC’s policy cannot change. Certainly not this Second Circuit opinion.
After the SEC settled with Citigroup over misreprsentations made about a toxic security it sold during the financial crisis for a centimillion dollar fine among other things, Judge Rakoff rejected the settlement for failing to contain "cold, hard, solid facts established either by admissions or trials." I've been pretty critical of the decision, which was always headed for reversal. Not that Judge Rakoff cares: his familiarity with the agency (he once was in it), his generally respected status as a judge, and rumblings of discontent by other courts asked to approve other settlements once he fired his shot across the SEC's bow has led to a change in approach by the agency; I talked about the new policy here.
The problem with the decision was twofold, according to the Court of Appeals, at least as I interpret it.
Problem 1: Doctrinally, a settlement decision is an exercise of enforcement discretion, and enforcement discretion is basically unreviewable because the alternative - making it reviewable - would thrust the courts into the heart of what the executive branch does. Because the SEC wanted continuing court supervision of Citigroup as a consequence of the settlement, Rakoff did, indeed, have something to do. But if the SEC had simply dismissed its suit in exchange for the payment of a fine, which is less onerous than a fine plus continuing supervision by a court, Rakoff would have had, literally, no role to play in the resolution of the case. So requiring cold, hard facts to be established as a condition of signing off on a deal was a radical increase in the oversight of the SEC by a court.
No surprise, then, that the Second Circuit said that "there is no basis in the law for the district court to require an adminision of liability as a condition for approving a settlement between the parties. The decision to require an admission of liability before entering into a consent decree rests squarely with the SEC."
Problem 2: Settlements are not about right and wrong, while admissions of guilt are. Settlements are about moving on. We don't expect private parties to establish whether management caused the bankruptcy or someone else did, whether that product really was dangerous, or was misused by consumers, or whatever. And these can be matters of great public import. So it was never clear why the government, even though, yes, it is a state actor, should be treated very differently.
No shock, then, that the Second Circuit has said that "consent decrees are primarily about pragmatism" and "normally compromises in which the parties give up something they might have won in litigation and waive their rights to litigation."
According to the appellate court, the right way to review consent decrees is for procedural clarity and, as far as the public interest is concerned, with Chevron deference to reasonable decisions by the agency. It's not totally clear what that deference means - the court faulted Rakoff for figuring out whether the public interest in the truth was served by the deal when he should have been deciding "whether the public interest would be disserved by entry of the consent decree." But there you go.
Anyway, I think this stuff is interesting, because it's a tool in the regulatory arsenal, and indeed, my first baby law professor article was on just that.
While the very long and detailed SEC crowdfunding proposed rules continue to not be final, individual states have passed their own legislation exempting purely local crowdfunding efforts from state securities laws. Because purely intrastate offerings are exempt from federal legislation already under Section 3(a)(11) of the Securities Act. Of course, the trick is not to offer crowdfunded securities to residents of more than one state, even if only in-state residents purchase the securities. This is very tricky when you are using a website to attract investment.
So far, Michigan, Kansas, Georgia, Wisconsin, Washington, Indiana, and Alabama have passed crowdfunding exemptions from state securities laws. North Carolina's crowdfunding law has passed the House but not the Senate (yet). Other legislation is pending in Florida, Texas and California. These exemptions are not identical; crowdfunding portals hoping to serve more than one state will have to be aware of these differences in maximum amounts, disclosure, number of purchasers, and purchaser qualifications.
I took a look at two websites purport to engage in intrastate crowdfunding, Localstake and Groundfloor. These two sites take two different approaches to ensuring that no offers are made to out-of-state residents. On Localstake, a potential investor cannot see actual projects until the investor registers, which is a lengthy process that includes giving your driver license number and social security number. I did not finish the registration process, which also included linking my bank account. The portal would then know the investor's residence and then show only those intrastate projects suitable to that investor. (I think Localstake has projects in Michigan and Indiana only). Groundfloor allows you to see projects, but with the disclaimer "Information on this page is not an offer or a solicitation to sell or purchase securities." Registration was very quick, but I received an email immediately telling me I could "follow" projects for informational purposes, but I could not invest: "As soon as we're set up in your state, you'll be among the very first to know." The Localstake method seems to have a higher likelihood of success fitting the definition of "offer," but I hope that the Groundfloor method would satisfy federal securities laws as well. However, there could be an argument that letting nonresidents see the projects and "follow" them conditions the market, in securities law jargon.
For more on crowdfunding, see my latest paper, forthcoming in the Illinois Law Review.
Earlier in May, the Delaware Supreme Court decided a certified question from the District of Delaware as to whether a Delaware corporation could adopt a bylaw whereby any member in a nonstock corporation would pay legal fees of the corporation if it instituted litigation against it and was not wholly successful. As you might have guessed, the answer was yes, and this also applies to any Delaware corporation. Here are Kevin LaCroix at D&O Diary and the HLS Forum with the gory factual details. A few humble thoughts to add to the mix:
What sorts of companies will adopt these loser-pays bylaws? Presumably, shareholders could balk, particularly if the director-amended bylaws can be amended by shareholder consent. Companies might believe that this additional deterrent is unnecessary given 102(b)(7) carveouts and simply abstain. Or, companies might believe it to be a costless measure that adds an incremental deterrent factor, particularly in merger litigation. Considering the flood of 102(b)(7) charter amendment provisions, a tidal wave of fee-shifting bylaws might not be surprising.
Are these bylaws always permissible? the opinion said that the bylaws were facially valid, but might be impermissible given the circumstances. Which circumstances? I can imagine a Blasius-like circumstance in which a shareholder group is in the middle of a tender offer or a proxy fight and threatening to seek an injunction and the board adopts a fee-shifting amendment. Can the bylaw apply to litigation concerning subject matter that happened prior to the bylaw adoption? It also seems a bit unseemly that such a provision could be used to deter litigation over self-dealing or conflicts of interest.
What about multi-jurisdictional litigaton? Say a shareholder (ok, a plaintiff's lawyer) files a shareholder suit in jurisdiction 1 and attempts to stay identical litigation in jurisdiction 2. The case proceeds in jurisdiction 2, but is dismissed in jurisdiction 1. Does the shareholder have to pay costs of the defendant to dismiss in jurisdiction 1? That would be interesting and definitely change incentives.
It has been some time since we've done a download list, and it does seem that SSRN has gone off the boil a bit as a source of both downloads, and a source of good information about interesting new articles. Still, these below do look like they could deserve a look!
|1||316||The Equity Risk Premium in 2014
John R. Graham and Campbell R. Harvey
Duke University and Duke University - Fuqua School of Business
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|2||199||The Futility of Cost Benefit Analysis in Financial Disclosure Regulation
Omri Ben-Shahar and Carl E. Schneider
University of Chicago Law School and University of Michigan Law School
Date posted to database: 23 Mar 2014
Last Revised: 25 Mar 2014
|3||173||Do Hedge Funds Trade on Private Information? Evidence from Upcoming Changes in Analysts’ Stock Recommendations
April Klein, Anthony Saunders and Yu Ting Forester Wong
New York University (NYU) - Department of Accounting, Taxation & Business Law, New York University - Leonard N. Stern School of Business and Columbia Business School - Accounting, Business Law & Taxation
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|4||171||Do the Securities Laws Matter? The Rise of the Leveraged Loan Market
Elisabeth de Fontenay
Duke University - School of Law
Date posted to database: 4 Apr 2014
Last Revised: 10 Apr 2014
|5||147||Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law
Leo E. Strine
Government of the State of Delaware - Supreme Court of Delaware
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|6||137||CEOs and Presidents
Tom C. W. Lin
Temple University - James E. Beasley School of Law
Date posted to database: 25 Apr 2014
Last Revised: 7 May 2014
|7||121||Contractual Innovation in Venture Capital
John F. Coyle and Joseph M. Green
University of North Carolina School of Law and Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP
Date posted to database: 30 Mar 2014
Last Revised: 1 May 2014
|8||98||Evasive Shareholder Meetings
Yuanzhi Li and David Yermack
Temple University - Department of Finance and New York University (NYU) - Stern School of Business
Date posted to database: 17 Mar 2014
Last Revised: 21 Apr 2014
|9||97||Culpability and Modern Crime
Samuel W. Buell
Duke University School of Law
Date posted to database: 12 Apr 2014
Last Revised: 12 Apr 2014
|10||91||Proposed Crowdfunding Regulations Under the Jobs Act: Please, SEC, Revise Your Proposed Regulations in Order to Promote Small Business Capital Formation
Rutheford B. Campbell
University of Kentucky - College of Law
Date posted to database: 9 Mar 2014
Last Revised: 9 Mar 2014
Over at the DC Bar, SEC staffer James Lopez took a look at how the first IPO prospectus in the United States measured up to the requirements imposed by the commision today. That would have been in 1791, for the Society for Establishing Useful Manufactures (SUM), which was going to build a manufacturing district. A taste:
today’s IPO prospectus includes a discussion of the most significant factors that make the offering speculative or risky, pursuant to Item 503 of Reg. S–K. The SUM prospectus’ third paragraph consists of the following sentence: “The dearness of labour and the want of Capital are the two great objections to the success of manufactures in the United States.” Well, then, that’s clear and concise. In a few additional paragraphs the SUM prospectus focuses on each of these challenges in detail. For example, as for needing labor it states that “emigrants may be engaged on reasonable terms in countries where labour is cheap, and brought over to the United States,” and that “women and even children in the populous parts of the Country may be rendered auxiliary to undertakings of this nature.”
HT: Corp Counsel.
The DC Circuit rather shockingly threw out the SEC's conflict minerals rule ONLY because it compelled publicly traded companies to speak about the issue in their securities filings, which it concluded violated the First Amendment. EDIT: This means that the parts of the rule that require reporting but not a statement that goods are "not DRC conflict free," might still be okay. Bainbridge has takes here and here, Jonathan Adler here, Matt Levine here.
But, you are thinking, the SEC compels companies to do a million things in their securities filings! Does the very existence of a disclosure regime violate the First Amendment? The court's novel theory was that it is okay to mandate disclosures that aim to prevent consumer deception (so the books of publicly traded companies could be opened to investors), but any other goal must have more than a rational basis to be sustainable.
It is a crazy theory. Warning labels, origin labels, nutrition labels, mandatory agricultural marketing schemes, they don't involve consumer deception, and they're okay. And maybe this reveals a lack of adoration for the First Amendment, but if Congress could prohibit companies from using conflict minerals, which it surely can, then requiring them instead to disclose the use is both less burdensome and possibly more efficient. Why would we want a legal system that does not permit disclosure regimes, thereby requiring command and control?
Some other observations:
- One judge wanted the court to wait for a ruling in a related case going en banc before the now democratically controlled circuit, and the two majority judges declined to do so because now the SEC and the petitioners could participate in the en banc. Unless the new Obama judges on the court cannot hear the en banc, this seems like a request for a quick reversal.
- Also interesting, the court didn't bullet proof the opinion. The SEC survived the adlaw challenges, and the very controversial cost-benefit analysis requirement the DC Circuit has started imposing, though that is likely to change very soon, on the agency. There is only one ground for reversal here: disclosure is unconstitutional.
- There is a difference between speech and conduct in the First Amendment, but the other big thing the SEC does in foreign policy is corrupt practices prosecutions (bribes paid to foreign government officials, that is). Could that be affected by the holding of this opinion, were it to stand? It sure isn't consumer protection.
- One of my many pet theories about why people care about constitutional law, though they often overdo it, is the sense that stare decisis is only sort of a good way to think about the subject. Conservative judges clearly love commercial speech, and have been using it to reverse some settled doctrines that have been in place for decades. I doubt a single securities lawyer thought that this was a plausible holding by the Court. Some smarter on the subject than I were clearly surprised. Let's see if it lasts.
Over at DealBook, I've got a look at the low-key rejection of Rajat Gupta's criminal appeal:
Judge Jed Rakoff, who presided over Mr. Gupta’s trial, demanded in another case that the government proffer “cold, hard, solid facts, established either by admissions or by trials” in enforcement proceedings against financial firms. He has called for more prosecutions over the crisis, and expressed a desire to see wrongdoing exposed in court. Other trial judges have also expressed some sympathy for public sanctions expressed through judicial orders.
But powerful and influential appellate judges have indicated less interest in sending this sort of a message. The Court of Appeals for the Second Circuit indicated in another case that it thought that Judge Rakoff had been too insistent on admissions of wrongdoing. And, as the opinion in Mr. Gupta’s appeal suggests, the court seems disinclined to make strong statements about appropriate business conduct when it could do so.
For more, head that way!
In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.
The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?
Coordination around uniform standards.
In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.
Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.
As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.
A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro or Lehman declaring bankruptcy.
For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:
Bloomberg. Click to enlarge.
Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.
To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.
Beyond the euro, what about the risks of boilerplate shock in general?
Boilerplate shock is probably an inherent and permanent risk in any securities market.
Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.
I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:
- The nature of the risk is that it is a byproduct, not the result of intentional choices about risk allocation. This is the reason for the information-forcing default rule I propose in the Eurozone.
- The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.
But banning or discouraging boilerplate is not the answer:
- The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
- A requirement to craft unique, artisanal terms—disclosures, subordination provisions ("flip clauses"), choice of governing law—for each individual securities transaction would be criminally inefficient.
- A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.
It's tricky to mitigate the risks of securities boilerplate.
Some options for places to start:
- Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
- Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
- Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
- Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.
In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.
Securities contracts as a source of systemic risk—what do you think?
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