April 12, 2010
Corporate and Securities Anomalies, Fictions and Inconvenient Truths
Posted by Mae Kuykendall

A good way to get ideas for a corporate law blog is to talk with a knowledgeable corporate lawyer.  I stay in touch with Cy Moscow, a Detroit lawyer who has counseled corporations and instructed generations of law students in legal doctrine and practical realities.  He brought three observations to my attention that have a common thread.  They concern the formal rules in class and derivative litigation barring payments to plaintiffs from law firms, the demand for "undivided loyalty" by corporate directors chosen to represent specific constituencies, and the rule under Exchange Act Section 12(g) basing registration (and deregistration) under the Exchange Act on record ownership.

First, as is widely known, the practice by
Milberg Weiss of compensating named plaintiffs in shareholder suits was exposed and prosecuted. The courts and defense bar were aware that the same plaintiffs appeared repeatedly.  Simple logic said they could not have all been participating in litigation as repeat players out of a spirit of public service.  Nonetheless, for many years, Milberg Wiss conducted business unchecked by any consequence of this widespread knowledge.  The Milberg Weiss method was to pay referral fees to a nominal co-counsel, who would pass on the benefit to the plaintiffs.  Although the Milberg Weiss lawyers claimed that others were doing the same thing, there have not been other prosecutions.  No facts about others are public (and here is an empirical examination of Milberg’s fees compared with other plaintiff’s lawyers that seems to set Milberg apart).  Despite a bit of pay-to-play criticism, legal observers have mustered little enthusiasm for further expose of the practices of the plaintiff’s bar, perhaps because of the unprovable assumption that the public benefits of shareholder suits brought by entrepreneurial lawyers outweigh the distortion of the system. 

1995 Private Securities Litigation Reform Act converted the system into a race by law firms for institutional lead plaintiffs.  A leading plaintiff’s lawyer advised Cy that the greatest beneficiaries of the Reform Act were the local law firms that represented various government or union pension plans.  These firms either receive referral fees, or appear as co-counsel with the specialized plaintiff’s bar, after encouraging their clients to act as lead plaintiff.  Assuming reasonably normal behavior, one might expect that some compensation finds its way back to the officials of the lead plaintiffs in political contributions or other benefits.  Publicity also carries a benefit to some lead plaintiffs.  Judges and defense lawyers shake their heads, knowing that neither a firefighters municipal pension fund in Mississippi nor a pipefitters union fund in Alaska should really care whether they are named the lead plaintiff in a securities class action filed in Manhattan.  In these instances, the real plaintiffs remain the lawyers.  A lot of, perhaps most, litigation energy is spent in competition to get the prize of being lead counsel and in later justifying fees.  A law anthropologist would locate the primary field work in the communications between lawyers and potential plaintiffs rather than in the law firm library with the associates.

The world continues to spin, while economic and policy driven distortions in class and derivative litigation sustain anomalies in law and practice.  Such a known unknown may not qualify as a "legal fiction" in traditional usage.  So Cy raises a good question. What should we call this form of legal knowing and not knowing?

Second, it is reasonably common to name representative (a/k/a constituent or nominee) directors to corporate boards.  Even though directors have been chosen to represent special shareholder interests, Delaware cases and commentators speak of "undivided loyalty."  For example, parent corporations place officers on the boards of majority owned subsidiaries, venture capitalists have seats, hedge funds wage proxy contests to get nominees elected, and the government appoints representatives to boards when it deals with troubled companies.  Despite the necessary and understood loyalty of these nominees to their sponsors, corporate rhetoric goes so far as referring to the biblical admonition against serving two masters (Cy comments, "New Testament 'God and Mammon' - hardly an apt parallel").  The conventional statement in the
Corporate Directors Guidebook is that a director should keep all nonpublic corporate information confidential, overlooking materiality and the common expressed or implied consent in sharing information with the sponsor in the representative situation.  Cy has written about this in a useful Insights article. It seems fair to call the conceptual divide between what is known and approved regarding representative directors, and the absence of doctrinal revision to acknowledge the role differences implicated by the practice, a corporate law anomaly.

Third, Exchange Act Section 12(g) bases registration (and deregistration) under the Exchange Act on record ownership.  Most shareholders, though, hold their shares in street name and only the number of beneficial owners matters.  The mechanism for imposing public company status on companies is a mismatch for the statutory purpose.  In another context, the law imposes obligations on the brokerage industry to transmit proxy forms to the real holders.  But for 12(g), record holding is treated as a sufficient touchstone for counting owners.  Here, the law knows one thing, and it knows another thing, but not at the same time.

These are the odd corners of corporate and securities law, the fictions and inconvenient truths.  The broad outlines of law, ethics, and regulation can remain intact even where the mismatch with a detail, small or large, is there to see.

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