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The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 3)

I’m continuing my online article workshop on my latest project, “The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases” (abstract and draft available here). Certainly, this continues to be timely as Citizens United is once again in the news—this week being cited by one commentator (here) as part of a line of cases—soon to be extended (at least in the author’s view) by the Court’s ruling on “Obamacare”—that demonstrate that the current Supreme Court “sees no limits on its power [and] no need to defer to those elected to make our laws.”

The aspect of my paper that I want to discuss this week is my assertion that the director primacy theory of the corporation is better aligned with real entity theory rather than the aggregate theory of the corporation—at least for the purposes of my paper.  For the uninitiated, the aggregate theory of the corporation posits that the corporation is best understood as primarily an association of individuals.  This is to be contrasted with artificial entity theory, which views the corporation as much more than simply an association of individuals—and traces that “much more” to advantages flowing from the state.  Real entity theory, meanwhile, argues that the corporation should be understood as something independent of both the individuals that make it up and the state that created it.  The relevant consequences of all of this is that artificial entity theory tends to be quite deferential to state regulation, while aggregate and real entity theory tend to favor private ordering.  Aggregate theory is then distinguishable from real entity theory on the basis of what the private ordering in each case is primarily understood to serve: in the case of aggregate theory it is the shareholder, while in the case of real entity theory there is more discretion to serve a variety of stakeholder interests.  (It should go without saying that scholars are not universally united on these formulations.)  Finally, because corporate law theorists tend to use different terminology, it is necessary to correlate those terms with the foregoing.  Thus, corporate law’s concession theory is typically aligned with artificial entity theory, while contractarianism (the nexus-of-contract theory of the corporation) is typically aligned with aggregate theory.  But what about director primacy, which posits that “the corporation is a vehicle by which the board of directors hires various factors of production. Hence, the board of directors is not a mere agent of the shareholders … but rather is a sui generis body—a sort of Platonic guardian” (Stephen Bainbridge, “The Board of Directors as Nexus of Contracts”)?

My greatest obstacle in aligning director primacy theory with real entity theory is likely that Stephen Bainbridge, the leading proponent of the theory whom I quote above, disagrees. However, even Bainbridge has arguably acknowledged that there may be some limited role for viewing director primacy as an expression of real entity theory: “[T]o the limited extent to which the corporation is properly understood as a real entity, it is the board of directors that personifies the corporate entity” (quote from here).

One reason why it may be correct for me to align director primacy theory with real entity theory for the limited purposes of my paper, is that director primacy theory may properly be understood to be a version of contractarianism.  For example, I note in my paper that J.W. Verret has written that: “The contractarian model is in many ways a precursor to … the director primacy model” (quote from here). If that is correct, and if it is further correct to align contractarianism with aggregate theory, then I should arguably either ignore director primacy or locate it elsewhere.  Because director primacy theory at the very least has a lot in common with some versions of real entity theory, it seems better to locate it there than ignore it.  For example, real entity theory has been described by Reuven Avi-Yonah as the theory which “represents the most congenial view to corporate management, because it shields management from undue interference from both shareholders and the state” (quote from here). That seems quite consistent with director primacy. 

There’s obviously much more to say on this, but I think I’ll stop there for the time being.  Before I close, however, I want to note the reason I believe all of this matters.  I am arguing in my paper that the conclusions of the justices in Citizens United (and the main cases leading up to Citizens United) were driven in large part by what theory of the corporation they aligned themselves with.  Yet they either ignored or expressly disavowed any role for corporate theory.  I believe that this is an omission and inconsistency that negatively implicates the transparency and legitimacy of the Court, and my paper is intended to advance the ball on getting the justices to directly address the issue of corporate theory in these types of cases.  Thus, for the time being it may not matter as much how we align the various theories, so long as we are talking about them. 


The "JOBS" Act and the Capital Raising Process (Crowdfunding and the Costs of the Exemption)

Issuers seeking to use the crowdfunding exemption will discover that it is cumbersome and expensive.  As a result, many legitimate companies will likely shy away from it.  Less legitimate companies will have no such qualms. 

First, the idea is that issuers will need to use a portal (or broker) to effectively advertise the offerings.  Presumably, issuers will need to pay portals for the service.  Perhaps the fee will be up front; perhaps it will be a percentage of the amount of capital raised.  To the extent the former, issuers will have to take the risk that they will raise sufficient capital to compensate for the costs.

Second, success for issuers will often depend on the ability to promote their offering.  Yet the provision prohibits general solicitations by issuers (except to the extent they merely refer investors to the relevant portal).  See Section 4A(b) (issuers may "not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker"). 

On the other hand, third parties can promote the offering and will be allowed to charge for this service (although they must use communication channels provided by the portal), subject only to the limitation that the financial arrangement be disclosed.  See Section 4A(b) (issuers may "not compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking such steps as the Commission shall, by rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication").  All of this will add expense. 

Third, issuers seeking to raise the maximum amount permitted under the exemption will find that they need an independent accountant.  Those with a capital raising target of more than $500,000 must have audited financial statements. 

Fourth, companies will incur costs arising out of the shareholder configuration resulting from the crowdfunding exemption.  All companies must have an annual meeting of shareholders.  Shareholder with voting rights need to be notified of the meeting.  Companies will, therefore, have to provide a notice every year to these shareholders. 

Fifth, the crowdfunding exemption imposes a requirement that companies keep investors informed even after they purchase the shares.  The provision requires companies to file reports with the Commission at least annually and provide the reports to investors.  The reports must contain "the results of operations and financial statements of the issuer, as the Commission shall, by rule, determine appropriate, subject to such exceptions and termination dates as the Commission may establish, by rule". 

Sixth, because investors purchasing pursuant to the exemption do not count as shareholders "of record" for purposes of Section 12(g), the company will need to maintain more intricate shareholder ownership records.  They will need to know which shares were acquired through the crowdfunding exemption (and therefore not "of record") and which ones were not. 

Seventh, while these shares will be difficult to sell (in many cases there will be no meaningful secondary market), the company is likely to incur increased expenses associated with the transfer of shares.  Companies must maintain a list of record owners.  In many cases, this entails the issuance of a stock certificate.  When a sale occurs, the certificate must be canceled and a new one issued.  Companies using the crowdfunding exemption will likely see an increase in transfers.  Either the company must do the paperwork (and pay an employee to do it) or hire a transfer agent (or perhaps increase the fees to the transfer agent).  Either way, the companies will incur increased costs associated with servicing the additional shareholders.

Finally, in addition to costs, issuers, their directors and executive officers will need to go through a background check.  It may not add expense but it is intrusive.  

Given these costs and restrictions, one has to wonder why an issuer wouldn't just rely on Rule 506 of Regulation D, particularly now that general solicitations are permitted in offerings limited to accredited investors.  Moreover, the issuer itself can conduct the general solicitation, without having to pay a portal for the same service.


The JOBS Act and the Capital Raising Process (Crowdfunding and Concerns with the After Market)

A central problem with crowdfunding is the absence of any meaningful exit strategy once the shares are purchased.  Shares must be restricted.  Investors will need to wait a year before selling unless they sell to accredited investors, back to the company, in a registered offering, or to a family member. Presumably after a year, shareholders can get the restriction removed and sell them to anyone.  But if investors think that at the end of a year they will be able to sell, they will need to think again. 

A number of factors suggest that, in fact, it will be very difficult to sell shares purchased through the crowdfunding exemption. 

First, the exemption cannot be used by companies already public.  As a result, there will be no preexisting public market for the shares. 

Second, the large private companies intending to do a public offering will not use the exemption.  The amount that can be raised is too small.  Besides, companies thinking of going public probably have already obtained some venture capital financing.  For the most part, venture capitalists do not like the crowdfunding exemption, particularly the complex ownership structure that will result.  So crowdfunding investors will not have a public offering to look forward to as an exit strategy. 

Third, the most likely candidates for crowdfunding are those companies that intend to stay small and private.  Some may be listed in the pink sheets, but this will only occur if brokers can obtain the information required by Rule 15c2-11.  It is highly possible that many crowdfunding companies will not even be listed in the pink sheets. 

This will leave investors without the benefit of a trading market of any kind.  In those circumstances, it is possible that the investors may have to hold onto the shares indefinitely.  Nothing in the crowdfunding exemption addresses these problems except for the requirement that investors answer questions demonstrating that they have "(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers; [and] (ii) an understanding of the risk of illiquidity".  

It is not clear that these "questions" will ensure that investors understand the problems of illiquidity in any meaningful way.  They may only realize the consequences when the time comes to write a tuition payment or pay off a car loan and discover that no one will buy their shares.   

What is the consequence of an indefinite holding period?

In addition to the possibility that shareholders may never be able to liquidate the investment (until the company liquidates, at which time there may or may note be funds around for distribution to shareholders), shareholders will be at risk as minority investors. Minority investors can see their interests diluted through the issuance of additional shares or the value of the company dissipated through the sale of assets. 

The crowdfunding exemption merely requires companies to provide a description "of the risks associated with minority ownership, corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties." This is likely to result in boiler plate disclosure that will in some cases not be understood, in others ignored and, invariably, forgotten when the corporate action actually occurs. 

In some cases, these transactions may even be a result of deliberate design.  In other words, companies (and their controlling persons) may intend to raise the capital then engage in transactions designed to eliminate shareholder value.  Because these transactions will occur after the sale of shares, perhaps long after, it will be much harder for regulators or private parties to bring actions under the securities laws based upon false disclosure or registration violations. 

Some of the referenced transactions may require shareholder approval.  But it is not clear that shareholders will even receive voting shares.  In any event, as minority investors, they will have little actual say in the outcome. 

Investors relying on the crowdfunding exemption may be subjected to fraudulent transactions.  Even investors purchasing from legitimate companies, however, will incur the risk that they will have to hold the investment indefinitely.  They likewise will incur the risk that the company may engage in subsequent transactions that dilute the ownership interest and the value of the shares purchased. 

In short, for many investors, this will prove not to be a good use for any available funds. 


The "JOBS" Act and the Capital Raising Process (Crowdfunding and the Consequence of Gambling)

Crowdfunding embraces the notion that unaccredited investors with modest means should be allowed to invest in unregistered offerings.  The exemption, however, provides investors with little information about the company, often leaving them uninformed when they make the investment.  Some have likened the approach to gambling.  The saving grace was supposed to be that these investors could only invest a small amount of money and therefore wouldn't see their financial condition impaired in the event that the investment turned out to be fraudulent or quickly failed. 

But in fact, the crowdfunding exemption included in the JOBS Act is not limited to amounts that investors can afford to lose.  The provision allows those with an income or net worth of less than $100,000 to invest up to 5% of that amount or $5000 every year.  For those with a net worth or annual income above $100,000, they can invest up to 10% of that amount or up to $100,000 during any 12 month period.  The amounts will go up since the SEC is required to adjust them at least every 5 years in accordance with the Consumer Price Index.  See Section 4A(h) ("Dollar amounts in section 4(6) and subsection (b) of this section shall be adjusted by the Commission not less frequently than once every 5 years, by notice published in the Federal Register to reflect any change in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics.").  In other words, investors over time will be allowed to invest annually more than $100,000.

Moreover, in computing income and net worth, the exemption contains no definition of the terms.  Instead, the exemption references the approach taken with respect to accredited investors.  Neither term is defined in Rule 501 of Regulation D.  Moreover, the SEC took a flexible approach with both terms, using high dollar thresholds for accredited investors as the primary mechanism for preventing abuse.  The same approach, however, does not work in the context of crowdfunding.   

While the term income is not defined, it was intended to apply to gross, rather than net, income.  As a result, the amount need not be reduced by the taxes paid or deductions taken.  See Securities Act Release No.  6389 (March 8, 1982) ("The test [for income] is no longer keyed to the federal income tax return. . . . Also, the term 'adjusted gross income' has been changed to 'income'. Use of the term 'income' will permit the inclusion of certain deductions and additional items of income which, as noted above, were excluded in the proposed concept of adjusted gross income.").  The term does not include for the most part unrealized capital appreciation but otherwise includes most if not all sources of income.  See Securities Act Release No. 6455 (March 3, 1983) (unrealized capital appreciation generally cannot be used in calculating income for purposes of the accredited investor standard). 

In other words, someone with $100,000 in gross income will be allowed to invest $10,000.  Yet the possibility that someone with a gross income of $100,000 can afford to lose $10,000 is small.  Moreover, the amounts used by investors of modest means to invest in crowdfunding ventures will probably result in other expenditures foregone.  Since rent, taxes, food, etc. cannot be eliminated, one has to wonder whether the amount invested in crowdfunding will result in a reduction in contributions to retirement plans.  Given the risks involved in crowdfunding (remember the analogy to gambling), swapping funds in this way will probably not be beneficial for investors of modest means in the long run.

But even those with income of far less than $100,000 will be eligible to invest $10,000 or more in crowdfunding ventures because the test turns not only on income but also on net worth.  Again, net worth is to be computed consistently with the approach used for accredited investors and again the term is not defined.  See Securities Act Release No. 9177 (Jan. 25, 2011) ("Neither the Securities Act nor our rules promulgated under the Securities Act define the term 'net worth.' The conventional or commonly understood meaning of the term is the difference between the value of a person's assets and the value of the person's liabilities.").  In adopting the net worth standard for accredited investors, the SEC allowed all assets to be included.  See Securities Act Release No. 6455 (March 3, 1983) ("Rule 501(a)(6) does not exclude any of the purchaser's assets from the net worth needed to qualify as an accredited investor."). 

In adopting a broad notion of net worth, the Commission deliberately decided not to take into account complicated issues surrounding the concept.  The Commission knew that this would allow investors to effectively overstate their real net worth but chose to address the concern through a high net worth amount.  See Securities Act Release No.  6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions.").  

For persons with more modest means, however, this ability to "overstate" their net worth allows them to invest amounts that in fact they cannot genuinely afford to lose.  Thus, if they make $25,000 a year in gross income but have a net worth of $100,000, investors will be allowed to invest $10,000 in a crowdfunding venture.

How might someone with such modest income meet the $100,000 net worth standard?  They cannot use the appreciation in their principle residence.  Congress in Dodd Frank commanded that this amount be excluded from the calculation of net worth for accredited investors.  See Rule 501(a)(5) of Regulation D.  But as long as they borrow the equity appreciation (in the form of a second mortgage) more than 60 days before the purchase, they can count the loans as an asset.  Moreover, net worth can include their 401(k)/IRA, their car, their furniture, appreciation in property that is not a primary residence, and any other asset.  As a result, it will likely not be difficult for people with very modest means to have the ability to invest large amounts that they cannot afford to lose. 

In short, the dollar thresholds contained in the crowdfunding provision allow investors of very modest means to invest amounts that are beyond what they can afford to lose.  Moreover, the amounts invested may well result in a reduction in contributions to retirement plans, something that may have long term harmful consequences. 


The "JOBS" Act and the Capital Raising Process

As the House adopts the Senate version of the euphemistically titled "JOBS" Act (which is actually the House version, HR 3606, plus one significant Senate amendment on crowdfunding), the legislation continued the fast track to becoming law.  Pieces of the legislation have significant flaws.  Many investor groups have challenged all or portions of the law because of the lack of sufficient investor protections.  We will discuss some of those criticisms. 

In addition, however, the legislation does not do a particularly good job at encouraging capital formation.  We will discuss some of the capital raising weaknesses in the legislation in subsequent posts.  Thus, the law will weaken investor protections without necessarily delivering on the promised benefits of increased capital formation and job creation. 


Lawson v. FMR LLC: SOX Whistleblower Protection Does Not Extend to Employees of Private Contractors to Public Companies

In Lawson v. FMR LLC, No. 10-2240 (1st Cir., Feb. 3, 2012), a divided First Circuit reversed the district court’s denial of a motion to dismiss, holding that the whistleblower protection provision of the Sarbanes-Oxley Act of 2002 (“SOX”) does not cover employees of certain contractors or subcontractors retained by public companies.

Jackie Hosang Lawson and Jonathan M. Zang (“Plaintiffs”) were employees of FMR LLC and of other related private companies that served as investment advisers to the Fidelity family of mutual funds.  In 2005 and 2006, Plaintiffs filed SOX whistleblowing complaints.  See 18 U.S.C. § 1514A(b)(1)(A).  Zang alleged that he was discharged for reporting inaccuracies in a draft registration statement and Lawson alleged that she was discharged for raising concerns related to cost accounting methodologies.

SOX’s whistleblower protection provision states that no public company or “officer, employee, contractor, subcontractor, or agent…of such company” may “discriminate against an employee” for engaging in a protected activity.  18 U.S.C. § 1514A(a).  Plaintiffs argued that this protection extended to employees of any of the listed agents of that company, including contractors and subcontractors.  Defendants argued that the list of agents merely identified those who may not retaliate and was not intended to define the boundaries of those who were protected under the statute.

In interpreting the statute, the court found no evidence that Congress intended the list of agents barred from discriminating to also define those protected from discrimination. In contrast, both the title of SOX § 806 and the caption of § 1514A(a) provided guidance: both referred to “employees of publicly traded companies.” The court also examined similar statutory provisions in SOX and other acts, and found that Congress was explicit when extending broader whistleblower protection.  Finally, the legislative history of SOX specifically showed that the protection of § 1514A(a) was intended for employees of publicly traded companies.  

Finding that the protections of § 1514A(a) only extend to employees of publicly traded companies, and not to employees of private contractors or subcontractors to those companies, the court reversed and remanded to the district court with instructions to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.

A previous post on the district court decision may be found here.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Broader Significance of the Decision)(Part 6)

There are many things to like about this case. 

Plaintiffs alleged conflicts of interest. Defendants provided a rational for a finding that, at the pleading stage, these allegations did not raise any real concerns about the merger process.  The interest of the CEO of El Paso in buying the E&P business from Kinder Morgan could have been viewed as insignificant, a passing fancy.  The Chinese wall designed to keep Goldman from influencing the merger could have been viewed as adequate. Had the court agreed with these views, the case would have been addressed under the duty of care and quickly dismissed. The court, however, applied a mix of legal analysis and common sense to acknowledge that the allegations brought by plaintiffs in fact raised real concerns. 

The court also used a mix of legal analysis and common sense to conclude that an action for damages would not be sufficient.  Claims against directors would, at a minimum, flounder on the waiver of liability provision.  Claims against the CEO may have had a stronger legal foundation, but the court, in a common sense fashion, recognized that such an action would not provide an adequate amount of recovery even if plaintiffs were able to succeed.  

The court also recognized that, despite the payment of an adequate price for El Paso, shareholders may nonetheless have been harmed by this type of conflict. 

The kind of troubling behavior exemplified here can result in substantial wealth shifts from stockholders to insiders that are hard for the litigation system to police if stockholders continue to display a reluctance to ever turn down a premium-generating deal when that is presented. The negotiation process and deal dance present ample opportunities for insiders to forge deals that, while “good” for stockholders, are not “as good” as they could have been, and then to put the stockholders to a Hobson’s choice.

There are also some lessons from the case that in fact may improve the integrity of the process, providing greater assurance that the outcome will in fact be in the best interests of shareholders.  Certainly this case and others have sent a message to financial advisors that the Delaware courts will take a close look at their role in any merger, particularly those involving the possibility of a conflict of interest.  At a minimum, they will need to provide greater certainty that potential conflicts of interest play no role in the merger process. 

But in the end, there were no consequences for the potential problems identified by plaintiffs.  In other words, alleged conflicts of interest could be identified and harm shown but the courts would do nothing about them.

What about the argument that the injunction would have been harmful to shareholders?  There is, of course, the possibility that an injunction would have benefited shareholders by allowing the company to be sold at a higher price.  Likewise, the injunction could have caused Kinder Morgan to walk and take with it the highest possible price available to shareholders.  

The opinion, however, hinted at interest by both Kinder Morgan and other companies in acquiring the pipeline business.  Moreover, while the court was correct that there was no competing offer, El Paso was considering an alternative: spinning off the E&P business and allowing the pipeline to become a free standing business that was apparently of considerable interest to other companies.  It is possible that shareholders would have benefited from the alternative. 

All of this is, of course, speculation.  The truth is that any injunction would have posed the risk that shareholders would have lost out on the highest possible price.  Even if true, however, such an injunction would have produced benefits that went beyond the specific deal.  An injunction would have sent a warning in future mergers that the process mattered. 

Instead, the effect of this decision is to conclude that sometimes process matters and sometimes it does not, hardly a basis for shareholders placing their faith in process as a means of protecting their interest.   

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 2)

Last week I posted the abstract of my latest paper, The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (you can find the abstract and download the paper here).  I mentioned that I might engage in some “open source article writing,” since the paper is still subject to further revision and there are parts of it that I think would be of interest to our readers and that I’d love to get additional feedback on.  This week I’d like to focus on my argument that understanding Citizens United to be about the rights of listeners does not preclude finding an important role for corporate theory in the decision.  The following is from my introduction:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court ruled that corporate political speech could not be regulated on the basis of corporate status alone.   Given that there is a great deal of debate about what corporations are (they have to date eluded capture), one would think that the Court would have needed to answer that question first before reaching its conclusion.  However, the majority was silent on this issue and the dissent went so far as to expressly disavow any role for corporate theory at all.   Instead, the opinion appeared to rest on a “listeners’ rights” analysis.   It remains unclear, however, how focusing on listeners’ rights could eliminate all need to examine the nature of corporations.  For example, how would one know whether corporations fit within the well-established line of identity-based exception cases under the First Amendment without addressing the unique aspects of corporate identity?

The majority in Citizens United (at page 899 of the opinion) referenced the status-based exception cases as follows:

The Court has upheld a narrow class of speech restrictions that operate to the disadvantage of certain persons, but these rulings were based on an interest in allowing governmental entities to perform their functions. See, e.g., … Civil Service Comm'n v. Letter Carriers, 413 U.S. 548 (1973) …. The corporate independent expenditures at issue in this case, however, would not interfere with governmental functions, so these cases are inapposite.

The citation of the Letter Carriers case is of particular interest because after Citizens United it is apparently permissible under the First Amendment for the government to prohibit live human beings who happen to be federal employees “from taking ‘an active part in political management or in political campaigns,’” 413 U.S. at 595, 597 (Douglas, J., dissenting) (“We deal here with a First Amendment right to speak, to propose, to publish, to petition Government, to assemble.”), but the government may not similarly restrict the First Amendment rights of state-created artificial entities that have been granted unique attributes greatly amplifying their ability to concentrate wealth and thereby influence elections.

Justice Stevens’s response in dissent captures quite nicely why the question of what corporations are (and what sorts of threats they pose) remains relevant.  Justice Stevens notes (at 946, n.46) that:

The majority states that the [status-based exception cases] are “inapposite” because they “stand only for the proposition that there are certain governmental functions that cannot operate without some restrictions on particular kinds of speech.” The majority's creative suggestion that these cases stand only for that one proposition is quite implausible. In any event, the proposition lies at the heart of this case, as Congress and half the state legislatures have concluded, over many decades, that their core functions of administering elections and passing legislation cannot operate effectively without some narrow restrictions on corporate electioneering paid for by general treasury funds.

Thus, even putting aside for the moment the fact that listeners’ rights are not absolute as a general matter, the nature of the speaker remains relevant in any case because of the possibility that the speech of the particular class at issue implicates the protectable “interest in allowing governmental entities to perform their functions.”


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (Injunctive Relief)(Part 5)

With a finding that plaintiffs had sufficiently alleged "a reasonable likelihood of success in proving that the Merger was tainted by disloyalty" and a finding that an action for damages would be inadequate, the court considered whether an injunction was in order.   

Plaintiffs for the most part sought to enjoin not the merger agreement (although at oral argument they agreed they would accept this remedy), but sought what the court described as:

an odd mixture of mandatory injunctive relief whereby I affirmatively permit El Paso to shop itself in parts or in whole during the period between now and June 30, 2012, in contravention of the no-shop provision of the Merger Agreement, and allow El Paso to terminate the Merger Agreement on grounds not permitted by the Merger Agreement and without paying the termination fee. 

In other words, plaintiffs wanted the court to correct the faulty process.  Given the alleged conflicts of interest, shareholders wanted the court to allow for a process that would ensure that the company was sold for the highest possible price.

This, the court suggested, "would pose serious inequity to Kinder Morgan, which did not agree to be bound by such a bargain."  More importantly, the injunction would potentially cause "more harm than good" to shareholders by allowing Kinder Morgan to walk away from the offer.  "The injunction the plaintiffs posit would be one that would sanction El Paso in breaching many covenants in the Merger Agreement and that would bring about facts that would mean that El Paso could not satisfy the conditions required for Kinder Morgan to have an obligation to close."

The court also hinted that the efforts to shop the company were unlikely to succeed.

Although it is true that the absence of a pre-signing market check and the presence of strong deal protections may explain the absence of a competing bid, the reality is that this is a highprofile transaction, litigation has been pending since early autumn 2011, and no bidder has emerged indicating that it would bid for any part of El Paso absent the deal protections.

At the same time, by refusing to issue the injunction, shareholders would have an opportunity to collectively express their judgment on the transaction when they voted on the merger.  

Putting aside the expectations of Kinder Morgan, which is arguably stuck with the risk of having dealt with potentially faithless fiduciaries, the real question is whether the court should intervene when the El Paso stockholders have a chance to turn down the Merger at the ballot box.

As a result, as the court reasoned, "the record does not instill in me the confidence to deny, by grant of an injunction, El Paso’s stockholders from accepting a transaction that they may find desirable in current market conditions, despite the disturbing behavior that led to its final terms." So, there would be no relief for the alleged conflicts of interest.  As the court noted: "We all wish we could have it all ways. But that is not real life, nor is it equitable." 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Damage Alternative) (Part 4)

Having found sufficient allegations of a conflict of interest, the court had to consider the remedy.  Plaintiffs sought an injunction. 

In a refreshing discussion, the court considered the alternative of a cause of action for damages but concluded that the claim was unlikely to succeed. 

Some claims were likely to fail because of legal impediments.  A claim for damages for breach of the duty of care against directors would fail both on the merits, see id. ("the independent directors’ reliance upon [the CEO] seems to have been made in good faith."), and because of the waiver of liability provision.  

Some claims might be inadequate for practical reasons.  The court suggested that any action against the CEO would not result in an adequate recovery. See id.  (wealth of CEO was unlikely to be sufficient to pay "a verdict of more than half a billion dollars."). 

An action against Goldman for aiding and abetting would also have little chance of success.  See id. ("And although Goldman has been named as an aider and abettor and it has substantial, some might say even government-insured, financial resources, it is difficult to prove an aiding and abetting claim."). 

The same was true of any possible claim against Kinder Morgan.  Id. ("Nor do I find any basis to conclude that Kinder Morgan is likely to be found culpable as an aider and abettor.").  

Thus, the court agreed that, "[f]or present purposes," the plaintiffs had "shown that there is a likelihood of irreparable injury if the Merger is not enjoined." 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Alleged Conflicts) (Part 3)

Plaintiffs alleged two conflicts of interest.  One involved the role of Goldman Sachs, the other the role of the CEO of El Paso.

Goldman Sachs, the owner of 19% of shares of Kinder Morgan, had been been retained by El Paso in connection with the original plan to spin off the exploration and production (E&P) business.  With respect to the offer from Kinder Morgan, El Paso hired Morgan Stanley.  Goldman, however, remained the advisor on the proposed spin off and, allegedly, influenced the terms applicable to Morgan Stanley.  As the court found, Goldman:

continued to intervene and advise El Paso on strategic alternatives, and with its friends in El Paso management, was able to achieve a remarkable feat: giving the new investment bank an incentive to favor the Merger by making sure that this bank only got paid if El Paso adopted the strategic option of selling to Kinder Morgan. In other words, the conflict-cleansing bank only got paid if the option Goldman’s financial incentives gave it a reason to prefer was the one chosen.

Defendants argued that Goldman had been sufficiently walled off from the merger negotiation process. The court, however, disagreed, describing the Chinese wall as "not effective."  The role of Goldman in the strategic alternative was viewed as "important" because of the board's need to undertake a relative comparison of the proposed acquisition and the proposed spin off.  Moreover, the court noted "questionable aspects to Goldman’s valuation of the spin-off".  As the court reasoned:

At this stage, I am unwilling to view Goldman as exemplifying an Emersonian non-foolishly inconsistent approach to greed, one that involves seeking lucre in a conflicted situation while simultaneously putting the chance for greater lucre out of its “collective” mind. At this stage, I cannot readily accept the notion that Goldman would not seek to maximize the value of its multi-billion dollar investment in Kinder Morgan at the expense of El Paso, but, at the same time, be so keen on obtaining an investment banking fee in the tens of millions.

The shareholders also alleged that the CEO of El Paso had a conflict of interest.  The CEO was responsible for negotiating with Kinder Morgan.  He allegedly wanted to participate in the acquisition of the E&P business once Kinder had acquired El Paso.  The interest was not disclosed to the El Paso board.  As the opinion described:

[The CEO] kept that motive secret, negotiated the Merger, and then approached Kinder Morgan’s CEO on two occasions to try to interest him in the idea. In other words, when El Paso’s CEO was supposed to be getting the maximum price from Kinder Morgan, he actually had an interest in not doing that.

Once the merger price was set, the CEO allegedly approached Kinder about a possible management bid for the E&P business.  Thus, the CEO, while having a duty to "squeeze the last drop of the lemon out for El Paso’s stockholders," had an alleged desire to purchase the E&P business, something that provided "a motive to keep juice in the lemon that he could use to make a financial Collins for himself and his fellow managers interested in pursuing an MBO of the E&P business."

Efforts by defendants to minimize the CEO's potential conflict were not, at the pleading stage, convincing to the court.  While conceding that a trial may show that the CEO was " the type of person who entertains and then dismisses multi-billion dollar transactions at whim," the court suggested that the facts alleged left open the possibility that the CEO:

did not tell anyone but his management confreres that he was contemplating an MBO because he knew that would have posed all kinds of questions about the negotiations with Kinder Morgan and how they were to be conducted. Thus, he decided to keep quiet about it and approach his negotiating counterpart Rich Kinder late in the process – after the basic deal terms were set – to maximize the chance that Kinder would be receptive.

As a result, the court concluded that, at the pleading stage, shareholders had sufficiently alleged a conflict of interest.  

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Facts As Alleged) (Part 2)

So what happened?

El Paso, a pipeline operator, was considering a strategic plan to divide the company into two by spinning off the exploration and production business, retaining only the natural gas pipeline business.  While the plan was under consideration, Kinder Morgan approached El Paso about purchasing the entire company.  Kinder apparently really wanted just the pipeline but was willing to purchase the entire company to get it.  Goldman Sachs owned 19% of the shares of Kinder Morgan and had two representatives on the Kinder board. 

Goldman had been providing El Paso with advice on the plan to split the company into two pieces.   With respect to the interest from Kinder Morgan, however, El Paso retained Morgan Stanley to provide advice.  The CEO of El Paso was assigned the task of negotiating with Kinder Morgan.  The two sides agreed to a price of $27.55 in cash and stock.  Shortly afterwards, Kinder withdrew the bid.  As the court described:

Instead of telling Kinder where to put his drilling equipment, [the CEO of El Paso] backed down. In a downward spiral, El Paso ended up taking a package that was valued at $26.87 as of signing on October 16, 2011, comprised of $25.91 in cash and stock, and a warrant with a strike price of $40 – some $13 above Kinder Morgan’s then-current stock price of $26.89 per share – and no protection against ordinary dividends.

The deal involved a substantial premium over the market price for El Paso and Morgan Stanley advised that the deal was "more attractive in the immediate term than doing the spin-off and had less execution risk, because Kinder Morgan had agreed to a great deal of closing certainty."  The merger agreement contained a no shop provision and provided for a termination fee of $650 million or 3.1% of the equity value of the deal. 

Shareholders brought suit seeking to challenge the transaction, arguing that there were conflicts of interest in the negotiating process.  The court had to first consider whether plaintiffs have alleged sufficient facts to make out conflicts of interest. 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (Introduction) (Part 1)

It is traditional to attribute to the board of directors a duty of care and loyalty (with good faith a subcategory of loyalty).  Violations of the duty of care typically involve allegations of mismanagement (and resulting harm to shareholders) in circumstances that do not involve conflicts of interest. 

For all intents and purposes, the duty of care no longer exists in any meaningful way.  Back in the days of Van Gorkom, there was some notion that boards had to meet a minimum standard of behavior to fulfill their fiduciary obligations under the duty of care.  Van Gorkom is no longer good law, in fact or in practice, having effectively been reversed by Disney.  Moreover, the presence of waiver of liabilty provisions has eliminated any hope of damages whenever a breach does occur.  The ubiquitous nature of the provisions has been chronicled in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom

The approach is unfortunate but has a certain logic.  In cases without a conflict of interest, it can be assumed that the board for the most part acted in a way that it thought was in the best interests of shareholders.  In those circumstances, liability arises not because of a suspect motive but because of inadequate information or deliberation.  Imposing liability in those circumstances could cause boards to act in a slower, more bureacratic fashion or may encourage them to become risk averse. It is possible that these harms outweigh the benefits of elevating the board's standard of behavior. 

The same reasoning is not, however, applicable to the duty of loyalty.  Where a conflict of interest exists in the approval process, there is always a risk that the final terms will not be in the best interests of shareholders but in the best interests of the fiduciary with the conflict.  Heightened standards seek to reduce the risk that this will occur.  Moreover, loyalty transactions are only a small part of the board's activities.  Thus, while they may result in a slower process, they will not affect a significant number of board decisions. 

Despite these concerns, the courts in Delaware have gradually weakened the duty of loyalty.  It does not apply, for example, where the benefits are shared pro rata among shareholders.  This is the case despite the fact that even a shared transaction can be a result of a conflict of interest and be disadvantageous to the company or minority shareholders. 

Similarly, executive compensation involves a clear conflict of interest when paid to someone who also serves on the board.  Nonetheless, the courts have found that the duty of loyalty is rendered inapplicable if the compensation is approved by a board consisting of a majority of independent directors.  The approach ignores the presence of the conflict of interest in the decision making process and treats independent directors as if they were truly independent, an often questionable assumption.  See Returning Fairness to Executive Compensation

The latest blow to the duty of loyalty came in In re El Paso Securities Litigation.  The court found sufficient allegations to establish a number of conflicts of interest in the merger approval process.  Yet when it came time to impose sanctions, the court acknowledged that a suit for damages was unlikely to be an adequate remedy but declined to issue any injunction.  The result, as we will discuss in the upcoming posts, was a violation without remedy. 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 1?)

I've posted the latest draft of my current project, "The Silent Role of Corporate Theory in the Supreme Court's Campaign Finance Cases," on SSRN (here).  I've also just started sending the piece out to law reviews, so interested editors should feel free to contact me directly at spadfie@uakron.edu.  Finally, in future posts I may do some "open source article writing" and review some of the particular parts of the paper that might benefit from further feedback.  However, no one should feel like they need to wait till then to make comments.  Here is the abstract:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court held that corporate political speech could not be regulated on the basis of corporate status alone. In support of that conclusion, the majority characterized corporations as mere “associations of citizens.” The dissent, meanwhile, viewed corporations as state-created entities that “differ from natural persons in fundamental ways” and “have been ‘effectively delegated responsibility for ensuring society’s economic welfare.’” I have argued previously that these two competing conceptions of the corporation implicate corporate theory, with the majority adopting an aggregate / contractarian view, and the dissent an artificial entity / concession view. Even if one understands Citizens United to be primarily about listeners’ rights, this stark contrast of competing theories of the corporation is difficult to ignore. At the very least, what the majority and dissent thought about corporate speakers was relevant to the question of whether the campaign finance restrictions challenged in Citizens United should fall within that narrow class of speech restrictions justified on the basis of the speaker’s identity due to “an interest in allowing governmental entities to perform their functions.” Somewhat surprisingly, however, the majority was silent, and the dissent expressly disavowed, any role for corporate theory. I have previously offered some explanations for this apparent inconsistency, and concluded that an active “silent corporate theory debate” was indeed integral to the outcome of Citizens United—despite protestations to the contrary. In this project, I examine the key Supreme Court cases leading up to Citizens United to see whether a similar silent corporate theory debate is evident in those cases. I find that there is indeed such an on-going debate, and proceed to argue that in future cases involving the rights of corporations the justices should make their views regarding the proper theory of the corporation express. This will allow for a more meaningful discussion of the merits of those decisions, and impose an additional layer of intellectual accountability on the jurists.



Second Circuit Agrees to Stay Decision in SEC v. Citigroup

The Second Circuit issued a stay of trial court's decision in SEC v. Citigroup, the case that where the court rejected a $285 million settlement between the SEC and Citigroup.  The appellate court found that the SEC had "shown a likelihood of success", a finding that was not an express decision on the merits.  The opinion is here

Although disclaiming any view on the merits, it is clear from the analysis that Second Circuit will overturn the trial court's decision.  That is no surprise.  The trial court's decision was too broad to be left in tact. 

The surprising part is that in remanding the case (as the Second Circuit surely will do when it addresses the merits), the Second Circuit is likely to significantly constrain the trial court's ability to reject this or any settlement submitted by the SEC.  Thus, for example, in granting the stay, the court emphasized the need to give the SEC's decision to settle considerable deference.   

  • A still more significant problem is that the court does not appear to have given deference to the S.E.C.’s judgment on wholly discretionary matters of policy. The S.E.C.’s decision to settle with Citigroup was driven by considerations of governmental policy as to the public interest. The district court believed it was a bad policy, which disserved the public interest, for the S.E.C. to allow Citigroup to settle on terms that did not establish its liability. It is not, however, the proper function of federal courts to dictate policy to executive administrative agencies. . . . While we are not certain we would go so far as to hold that under no circumstances may courts review an agency decision to settle, the scope of a court’s authority to second-guess an agency’s discretionary and policy-based decision to settle is at best minimal.

The panel went on to note that "there is no indication in the record that the court in fact gave deference to the S.E.C.’s judgment on any of these questions."  As the court reasoned:

  • The S.E.C. believed, for example, that the public interest was served by the defendant’s disgorgement of $285 million, available for compensation of claimants against Citigroup, plus other concessions. The court simply disagreed. In concluding that the settlement was not in the public interest, the court took the view that Citigroup’s penalty was “pocket change” and the S.E.C. got nothing from the settlement but “a quick headline.” Id. at *5.3 In addition, the court does not appear to have considered the agency’s discretionary assessment of its prospects of doing better or worse, or of the optimal allocation of its limited resources. Instead, the district court imposed what it considered to be the best policy to enforce the securities laws. In short, we conclude it is doubtful whether the court gave the obligatory deference to the S.E.C.’s views in deciding that the settlement was not in the public interest.

Thus, courts will need to give considerable deference to the SEC's decision to settle.  While the court still has to rule on the merits, this case nonetheless sends a significant message to trial judges in the Second Circuit (and perhaps in other circuits), that their discretion to overturn SEC settlements is quite constrained.

For more primary materials on this case, go to the DU Corporate Governance web site. 


Facilitating IPOs

In passing the JOBS Act, the House sought to facilitate IPOs.  In fact, there is reason to believe that it does the opposite.  

The legislation seeks to do so by eliminating requirements for companies that have recently become public.  Many of the eliminated requirements (the vote on say on pay) will save little in costs but will remove important protections for shareholders.   

But it got us to thinking about costs.  When Groupon went public in an IPO, it listed the costs associated with the $700 million offering.  The costs included


The following table sets forth all expenses to be paid by the registrant, other than estimated underwriting discounts and commissions, in connection with this offering. All expenses will be borne by the registrant (except any underwriting discounts and commissions). All amounts shown are estimates except for the SEC registration fee, the FINRA filing fee and the NASDAQ Global Select Market listing fee.

SEC registration fee

$ 87,075

FINRA filing fee

$ 75,500

NASDAQ Global Select Market listing fee

$ 250,000

Printing and engraving

$ 250,000

Legal fees and expenses

$ 2,500,000

Accounting fees and expenses

$ 1,500,000

Transfer agent and registrar fees

$ 10,000

Miscellaneous expenses

$ 1,032,428


$ 5,700,000


The amount is not insignificant but it is less than 1% of the amount raised in the offering.  Does this include all of the expenses?  Actually it does not.  The fourteen underwriters for the deal received $42 million, including $17.4 million paid to Morgan Stanley.

Want to adopt legislation designed to faclitate IPOs?   A focus on reducing the costs incurred in connection with the underwriting process might be a good place to start.  


The "JOBS" Act: Adding Cost and Confusion to the Capital Raising Process

Last week, the House adopted H.R. 3606, THE REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH COMPANIES ACT OF 2011. Despite the emphasis on raising capital, the short title for the legislation is the JOBS Act (‘‘Jumpstart Our Business Startups Act’’), suggesting that the purpose of the legislation is to spur jobs.

The legislation is really a series of laws that were not adequately integrated together.  There will be enormous uncertainty, harmful consequences and added expense that arise out of the inartful drafting.  Lets look at an example.

Section 12(g) of the Exchange Act provides that companies more than 500 shareholders of record and $10 million in assets (see rule 12g-1) must register with the SEC.  Once registered, the company is subject to the periodic reporting requirements, the proxy rules, the tender offer rules and the beneficial ownership reporting obligations (short swing profits) under Section 16. 

Counting the number of shareholders "of record" is, therefore, very important.  As currently used in the securities laws, the phrase essentially coincides with state law.  It counts as a shareholder anyone whose name appears on the list provided to the company by the transfer agent.  See Rule 12g-5 (shareholder of record includes "each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer").  For the most part, these are the shareholders who have an actual certificate. 

The approach taken by Congress (it was put in place in 1964) has the benefit of simplicity.  Get a list of shareholders from the transfer agent on the last day of your fiscal year, count the number, if its over 500 (and you have more than $10 million in assets) you are subject to Section 12(g).  If less, you are not. 

The "JOBS" Act is about to make a hash out of this simplicity.  The crowdfunding provision provides that anyone purchasing pursuant to the provision will not be treated as an owner "of  record."  See Section 302 ("For purposes of this subsection, securities held by persons who purchase such securities in transactions described under section 4(6) of the Securities Act of 1933 shall not be deemed to be ‘held of record’.’’).

Another provision proposes to increase the number of record ownes from 500 to 1000.  At the same time, however, Section 502 of that provision provides that record ownership does not include "securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration 10 requirements of section 5 of the Securities Act of 1933.’’.

So, if those provisions are adopted, a company must undertake a far more complicated and difficult calculation in determining whether it must register under Section 12(g).  First the company needs to obtain a list of record owners as of the last day of the fiscal year.  Then the company must count the number of record holders but deduct the number who bought under the crowdfunding exemption or pursuant to certain employee benefit plans.  Companies will either need to maintain these records or will need to recreate them, a likely expensive process that requires the company to figure out how the shares were obtained in the first instance.

Moreover, while employees and crowdfunding purchasers are not shareholders of record, the statute is silent about the status of the holders who buy from these persons.  So a company may not be public (500 shareholders of record) while the shares are held by employees/crowdfunding purchasers but may become public when these share are sold.  This may be true even though the actual number of shareholders has not changed.

By tinkering with the record ownership definition (a completely unnecessary thing to do), the legislation adds to the record keeping requirements of all companies, makes the requirements of Section 12(g) more fluid and harder to police, and potentially discourages companies from issuing shares to employees or using the crowdfunding exemption because the shares, once sold, may trigger an obligation to register under Section 12(g).  Shareholders will no longer have any certainty as to when companies will be required to register as a result of the 500 shareholders of record test.   

In other words, it has the potential to discourage capital raising, the opposite of its purpose. 


The JOBS Act and the IPO Off Ramp: Discouraging IPOs

One of the big developments of late has been the rush to pass legislation designed to reform the capital raising process.  The House adopted H.R. 3606, THE REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH COMPANIES ACT OF 2011.  Despite the emphasis on raising capital, the short title for the legislation is the JOBS Act (‘‘Jumpstart Our Business Startups Act’’), suggesting that the purpose of the legislation is to spur jobs.

There is much to be said about this legislation and much to be criticized (certainly of the version that made it through the House).  But we want to point out one thing right off the bat. 

Section 1 creates a class of companies (called emerging growth companies) then promptly exempts them from a grab bag of requirements that include the need for the advisory vote on compensation (say on pay) and certain financial disclosures.  This is the so called "IPO On-Ramp" legislation.  By imposing weaker standards on these companies, it is theoretically designed to encourage IPOs.  In fact, it is likely to have exactly the opposite effect.  

The statute defines emerging growth company as any company with less than $1 billion in gross revenues and allows companies to retain that status until the earliest of:  gross revenues exceeding $1 billion; qualification as a large accelerated filer (issuers with an aggregate worldwide market value of the voting and non-voting common equity held by its non-affiliates of $700 million or more), or the fifth anniversary of the "first sale of common equity securities of the issuer pursuant to an effective registration statement under the Securities Act of 1933." 

For companies that remain below the $1 billion mark, they can effectively retain their "emerging growth company" status simply by refusing to do an IPO.  Given the many exemptions from registration (some provided in the JOBS Act), they can continue to raise capital selling shares but not need to engage in a registered offering.  As long as they do not trigger the size/float requirements, they will remain an emerging growth company indefinitely. 

The legislation, therefore, creates a strong incentive for public companies under $1 billion not to engage in a public offering, exactly the opposite of what the legislation is trying to accomplish. 


Belmont v. MB Inv. Partners: Defendants not Liable for Employee’s Ponzi Scheme

In Belmont v. MB Inv. Partners, Inc., 2012 U.S. Dist. LEXIS 1656 (E.D. Pa. Jan. 5, 2012), investors swindled in a Ponzi scheme sought to recover against an assortment of defendants  associated with the money manager that employed the scheme’s perpetrator.  The court, however, granted summary judgment and dismissed the claims. 

This case arose out of a Ponzi scheme allegedly involving North Hills Partnership, L.P. (the “Partnership”), a privately offered investment vehicle controlled by Mark Bloom, (“Bloom”).  Bloom, according to the PPM for the Partnership, was the sole principal of the general partner.  During the period when the scheme occurred, Bloom also served as    a high-ranking money manager at MB Investment Partners (“MB”). 

Bloom ran this scheme independent of his work at MB.  According to plaintiffs, Bloom from July 2001 until February 2009 diverted more than $20 million from the Partnership for his own use.  Bloom also invested Partnership funds with the Philadelphia Alternative Asset Fund (“PAAF”), an entity with which Bloom had a referral agreement.

Bloom did not disclose his conflicts and made the investments in violation of the disclosed strategy for diversification.  When Bloom informed his investors that the PAAF’s funds had been frozen due to fraud, several investors asked for their money back; however, Bloom had already diverted the funds for his own private use.  In order to repay his investors, Bloom solicited additional investments into the Partnership.  Bloom was arrested on February 25, 2009, and pled guilty to numerous charges, including securities fraud, mail fraud, wire fraud, money laundering, and obstruction of tax laws.  MB fired Bloom the day of this arrest.

The plaintiffs sued defendants in an effort to recover some of the funds misappropriated by Bloom.  The defendants included investors in, and employees or directors of, MB.  Plaintiff asserted that they should be responsible for Bloom’s actions with the Partnership and that the defendants failed to adequately supervise Bloom.  The court, however, ultimately rejected these theories.

The plaintiffs’ control person liability claim under Section 20(a) of the Exchange Act of 1934 failed because the plaintiffs failed to show that the defendants culpably participated in Bloom’s fraud.  The plaintiffs argued that the defendants were reckless by failing to implement sufficient internal controls that would have detected Bloom’s fraud.  The court stated that this allegation – even if correct – proved nothing more than simple inaction on the defendants’ part.  Because the plaintiffs failed to offer any evidence showing the defendants actually participated in Bloom’s fraud, the court rejected the plaintiffs’ control person liability claim.

The court also rejected the plaintiffs’ Section 10(b) and Rule 10b-5 claims against MB.  Plaintiffs  argued that Bloom’s fraud, when combined with his high-ranking position at MB, was sufficient to render  MB liable for fraud.  After articulating the elements of claims under Section 10(b) and Rule 10b-5, the court noted that the alleged fraud was committed by the Partnership rather than MB.  Plaintiffs attempt to extend liability to MB rested on “Bloom's role at MB and without regard to whether he was acting in MB's interests or causing harm to MB.” The court found this to be insufficient to justify the claim against MB.  As the court reasoned:  “Plaintiffs have cited no decision extending liability under the federal securities laws to a corporation that had no involvement with the plaintiff harmed.”

The plaintiffs’ claims of negligent supervision, breach of fiduciary duty, and violations of Pennsylvania’s Unfair Trade Practice and Consumer Protection Law all failed because the plaintiffs consistently failed to establish a connection between the defendants and Bloom’s fraud.

The primary materials for this case are available on the DU Corporate Governance website.


A Test Case for Shaming As Sanction?

Commenting on Delaware Chancellor Strine’s El Paso opinion (here) seemed to be obligatory in the bizlaw blogosphere this week, so far be it for me not to follow marching orders.  In case you’ve missed out on the underlying facts, Alison Frankel provides an overview here (HT: Steve Bainbridge).  Among other things, she notes that:

Chancellor Leo Strine of Delaware Chancery Court is thoroughly sick of what he perceives as Goldman Sachs' disregard for the M&A rules everyone else plays by. His 34-page decision Wednesday in a shareholder challenge to Kinder Morgan's $21.1 billion acquisition of El Paso Corp is filled with scorn for Goldman's eagerness to remain an adviser to longtime client El Paso even though Goldman held a $4 billion stake and two board seats at Kinder Morgan. Writing four months after he took Goldman to task for manipulating valuations in the Southern Peru Copper case, Strine used works like "tainted," "furtive," and "troubling" to describe the investment bank's continuing influence on El Paso CEO Douglas Foshee, even after it was supposed to be walled off from the Kinder deal.

However, the Chancellor denied plaintiffs' request for an injunction and suggested it would be nearly impossible for shareholders to hold Goldman accountable.  It is also unlikely that anyone else will have to reach into their own pocket for their “sins.” Again, I quote Frankel from her post linked to above: “I should note that if the deal goes through as expected, Kinder Morgan will likely indemnify El Paso for any payments to shareholders; [El Paso CEO] Foshee is surely covered by D&O insurance, although he could meet resistance from his insurer if he's found to have breached his duty.”  (I reference “sins” as per Bainbridge (here): “Like the minor prophets of old, Delaware judges call out sinners among the rich and powerful and hold them up as examples of what not to do.”).

Thus, much of the focus of the discussion has been on the effectiveness of shaming, since that may well be the only “pain” the primary bad actors in this case experience.  Again, I quote Bainbridge:

[S]ingling out the sinners for opprobrium serves as a sanction and deterrent. This function invokes the controversial question of whether shaming is an appropriate sanction in corporate law. It is an issue on which I have frankly waffled over the years. There are good arguments on both sides and, at least for present purposes, I shall therefore take an agnostic position.

Personally, I think many of those at the top of the corporate food chain simply love the fact that so many of us apparently think that shaming, standing alone, serves any sort of an effective punishment/deterrent role.  As I have blogged previously (here):

I have been unimpressed by the idea of shaming as an effective form of deterrence or punishment ever since I heard the comments of a Big Corp board member effectively affirming what I had long believed to be true:  That at least for the top execs, they'll gladly take your shame all the way to the bank.  They don't live in the same circles as the rest of us and they are about as impacted by our scorn as I would be by the disapproval of my cat …. Ultimately, this is an empirical question.  And I am certainly willing to be convinced that shaming has an effective role to play in the punishment of corporate offenders (both as to the corporate entity and the individuals who run it).  But for now, if more punishment is actually warranted I'd prefer to see more jail time or fines.

I should amend the last part of that quote to read: “fines the wrongdoers have to pay out of their personal assets without any form of indemnification.”

Regardless, perhaps we will get some sort of empirical evidence as this case unfolds.  Frankel writes in a separate post (here):  

Thanks to those [shaming] opinions, plaintiffs' lawyers are much better situated in settlement negotiations than they would have been without expedited discovery and injunction hearings. For the purposes of eventually requesting fees, it's also a lot easier to quantify the benefit you've earned for shareholders through money damages than through an injunction, especially in a single-bidder scenario.

But again, I remain skeptical of shaming as sanction if no individual is reaching into their own pocket to pay for these wrongs. In fact, Robert Teitelman notes (here) that:

Perhaps by now we should begin to understand that reputation might not be what it used to be (particularly in a world where advisory has less clout at large Wall Street firms), or that the real rep Goldman would like to offer to its clients and competitors is that it's smart enough and tough enough to extract every bit of juice from a transaction, because it can.

However, Frankel notes that disgorgement remains a possibility, at least as per a related case ruled on by Vice Chancellor Sam Glasscock (opinion here): “Glasscock was even more explicit about monetary relief in the Delphi ruling than Strine was in El Paso; he said he could simply order Rosenkranz to disgorge the premium he's slated to receive, giving Class A and Class B shareholders the same price per share.”  We shall see.