The Puffery Defense As Theatre of the Absurd

This past week the Wall Street Journal reported that:

Standard & Poor's Ratings Services has long declared that its letter-grade ratings are independent and objective, part of a bid to allay concerns over its business model [because] Standard & Poor's, like all major credit-rating firms, is paid by issuers to rate the securities that they sell…. Now, lawyers defending the company against the Justice Department's recent civil lawsuit say that statements about independence and objectivity are "puffery" and were never meant to be taken at face value by investors…. In its formal defense filed Monday, S&P pointed to two earlier court decisions where judges ruled that such statements by the firm were puffery and therefore can't form the basis for a fraud claim…. One of the decisions highlighted by S&P's lawyers is a March 2012 ruling by U.S. District Judge Sidney H. Stein. The judge dismissed a securities-fraud lawsuit filed by McGraw-Hill shareholders, who maintained that they bought shares in the company believing that S&P's ratings were independent and objective. "These statements were mere commercial puffery," and therefore can't form the basis for a fraud claim, Judge Stein wrote. That decision was upheld in December 2012 by the U.S. Second Circuit Court of Appeals, which S&P also highlighted in its Monday filing. "No reasonable purchaser of McGraw-Hill common stock would view statements such as these as meaningfully altering the mix of available information about the company," the three-judge panel wrote.

I have previously criticized judicial reliance on puffery as a safety valve to dismiss securities fraud claims.  In “Is Puffery Material to Investors? Maybe We Should Ask Them” I noted that:

Federal securities laws make it illegal to make a material misstatement in connection with a securities transaction. Materiality is generally deemed to be a fact-intensive issue only to be resolved on the basis of pretrial motions when no reasonable shareholder could find the challenged statement material. Nonetheless, and despite assertions to the contrary, materiality is often resolved pretrial. One of the doctrines relied upon by courts to dismiss securities claims on the basis of immateriality is the puffery defense. “Puffery” has been defined as ambiguous, promotional, or hyperbolic speech commonly known as “sales talk.” While the puffery doctrine has been the subject of a great deal of criticism, it continues to be relied upon by courts--in fact, its use may be increasing…. This Article seeks to fill some of the void of empirical research in this area by reporting the results of an investor survey (the “Puffery Survey”), focusing on materiality determinations in the puffery context, and comparing these responses to judicial predictions that no reasonable investor could find the surveyed statements material. What the survey results show is that while the judges in the four surveyed cases concluded that no reasonable investor could find the statements challenged therein to be material because they constituted non-actionable puffery, between 33% and 84% of reasonable investors surveyed deemed the statements material. These results have implications for both our confidence in the accuracy of judicial determinations in this area, as well as the potential utility of survey evidence for bringing judicial conclusions more in line with actual investor behavior.

In “Immaterial Lies: Condoning Deceit in the Name of Securities Regulation” I noted that:

There are a number of problems … with overdependence on materiality safety valves. First, courts' repeated declarations that management is free to lie, so long as that lie is immaterial, arguably sends the message to executives that it is often okay to embellish the truth--and sends the message to investors that they should adopt an attitude of caveat emptor (“buyer beware”) when it comes to the statements of corporate executives. One might argue that it is overly pejorative to characterize these disclosures as lies. However, when a court grounds dismissal on a finding of immateriality, it is effectively saying that there is no basis for liability even if it were proven that an executive misstated the facts with intent to deceive (i.e., there was a lie). Second, the safety valves themselves twist the definition of materiality to the point that they seemingly make a mockery of the Supreme Court's declarations on the issue. Finally, courts' excessive reliance on these safety valves creates a conflict with the disclosure rules, which often turn on determinations of materiality. Fortunately, there is a better way: focusing on the other elements of Rule 10b-5 [like scienter].

I have not yet read the opinions cited in Journal article in their entirety, but at least my initial impression is that these opinions continue a pattern of improper over-reliance on puffery as a basis for dismissing fraud claims.  In fact, to hear S&P characterize its own declarations of independence and objectivity as being nothing more than mere puffery conjures up images of the Theatre of the Absurd.

The Problem of Zombie Directors (Part 2)

We noted in the last post that majority vote provisions do not, for the most, part allow shareholders to actually defeat or remove directors.  Instead, they force the directors to submit a letter of resignation to the board.  We noted, however, that boards have a number of reasons why they are unlikely to accept these letters of resignation.

Directors who do not receive a majority of the votes cast but remain on the board are sometimes termed "Zombie Directors."  A recent analysis by the Council on Institutional Investors indicated that, in 2012, there were 41 Zombie Directors. 

Zombie Directors fall into two categories:  Those not receiving a majority of the votes cast at companies with a majority vote provision and those not receiving a majority of the votes cast at companies without majority vote provisions. 

The difference is significant.  In the latter case, there is no required letter of resignation (although the Zombie Director could voluntarily submit one).  Thus, the Zombie Directors have been elected under the plurality system.  Without a letter of resignation, the board is left with the default rule that it cannot remove incumbent directors. 

The board is not, however, powerless.  The board can decide not to renominate the Zombie Director the following year.  This authority notwithstanding, companies without majority vote provisions confront the same structural concerns that militate against a decision declining to renominate.  It is, therefore, likely that in most cases Zombie Directors will be renominated. 

With majority vote provisions themselves providing no real authority and state law unlikely to impose meaningful standards of review on the retention of Zombie Directors, the board, at this stage, has little incentive to replace Zombie Directors.  That may, however, change.  The CII has compiled data in this area.  Calpers has begun to look into the issue.  Pressure continues on large public companies to implement majority vote provisions and at least force boards to take a position on Zombie Directors (in the post-Jobs era, Apple adopted a majority vote provision), although greater attention may need to be given to the implementation of these provisions at smaller public companies. 

Pressure from investors may make it harder for boards to keep Zombie Directors in office.  Nonetheless, it illustrates a profound weakness in the governance structure.  Shareholders can successfully vote against directors but the act has little independent value.  Only with a second, post-election campaign against the Zombie Director will shareholders likely see the decision at the ballot box implemented.

The Problem of Zombie Directors (Part 1)

Majority vote provisions are a relatively recent innovation.  Under the laws of most states, directors are elected by a plurality of the votes cast.  See DCGL 216(c).  That means that the candidates who receive the most number of votes are elected, irrespective of the number of no votes (designated as "withheld" on the proxy card).  To the extent that the number of candidates equals the number of vacancies on the board, the nominees in a plurality system always win. 

Pressure has been brought on public companies to change this dynamic.  Shareholders have sought the implementation of "majority vote" provisions.  The pressure has, for the most part, worked for the largest public companies.  Of the 100 largest US companies in 2012, according to a study by Shearman & Sterling,  91 had these provisions.  The number, however, drops off signifcantly for smaller public companies.  According to another study, only 43% of the S&P 1500 have majority vote provisions in place. 

Although these provisions create the appearance that shareholders have a say in board membership, that perspective is for the most part a myth.  These provisions generally require directors not receiving a majority of the votes cast to submit a letter of resignation (they must resign because, even without majority support, they were, under the plurality standard, elected).  The board (without the presence of the "defeated" candidate) then must decide whether to accept the resignation. 

The effect of a majority vote provision, therefore, is to give to the board the authority to remove an incumbent director.  This flies in the fact of the general rule that directors cannot remove other directors.  A few states permit directors to remove other directors in limited circumstances but Delaware for the most part does not.  A majority vote provision, therefore, augments the authority of the board, not the authority of shareholders. 

Moreover, there are structural reasons to believe that most of the time the board will decline to accept the resignation.  First, directors may be defeated because of the perceived mismanagement of the company.  To accept the resignation would amount to a vote of no confidence on the CEO, something directors will mostly want to avoid.  Moreover, this may be particularly since the the CEO will be on the board and, potentially, part of the deliberative process.

Second, accepting the resignations will potentially empower shareholders to seek a repeat performance in future years.  The directors who agreed to accept the letter may find themselves submitting letters following subsequent elections.  

Third, those on the board may disagree with the reasons shareholders were unhappy enough to vote against the directors.  If, for example, shareholders are unhappy with the board refusing to accept a merger offer and, as a result, cast a majority against directors deemed responsible, the remainder of the board may think the judgment unfair.  They may believe that the merger is not in the best interests of shareholders.  In these circumstances, they may also decline to accept the letter of resignation.

Moreover, as a matter of state fiduciary obligations, Delaware courts have already signaled that they will give the board broad discretion to decline to accept a letter of resignation.  It may be enough to find that the directors have "knowledge and experience" valuable to the board.  Since the defeated directors were nominees of the board, it is highly likely that the board believes these directors have "knowledge and experience" valuable to the board.  

This has given rise to the phenomena of the "Zombie" Director.  Defeated but still serving.  We will look at this phenomena in the next post. 

Reporting Under the Iran Threat Reduction and Syria Human Rights Act: Be Careful What You Wish For

As discussed in earlier posts, on August 10, 2012 President Obama signed into law the  Iran Threat Reduction and Syria Human Rights Act of 2012 (Act).  The Act added new disclosure requirements for reporting companies, including, among others, a requirement to disclose in annual or quarterly reports whether during the period covered by the report the issuer or any of its affiliates knowingly engaged in certain Iran-related activities.  

Following enactment of the Act, the SEC issued Compliance and Disclosure Interpretations which provide, among other things, that: "the disclosure requirements apply to all quarterly and annual reports filed after February 6, 2013."  Moreover, "'affiliate' will be broadly interpreted to mean any 'person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with the person specified.'"

Importantly, the SEC did not include a materiality limitation—all transactions must be disclosed in the company’s periodic reporting and concurrently on a notice filed through EDGAR with the SEC (an IRANNOTICE) that identifies the issuer and indicates that disclosure of the activity was included in its periodic report.

We now have over a month’s worth of reports filed under the Act and some interesting observations can be made.  First, the broad definition of affiliate is leading to attenuated and repetitive disclosures. Companies are casting a broad net when considering what activities must be disclosed.  A prime example is the reporting done by Fidelity National Information Services, Inc. that disclosed activities conducted by Bausch & Lomb.  Why?  Because “[d]uring 2012, Warburg Pincus LLC, a private equity firm, was potentially an upstream affiliate of ours as so defined, as a result of the share ownership of WPM, LP (which owned 14.2% of our outstanding stock as of February 27, 2012, but only owns 6.5% as of the date of this report) and its right to designate a single director to our eight person board…”  Although Fidelity had no involvement, Bausch & Lomb had conducted business in Iran and therefore Fidelity felt obligated to report.

Even more attenuated is reporting done by British Petroleum, stating that ”BP has become aware that a Canadian university had been using graduate students, some of whom were nationals of Iran, on research programme funded in part by BP. BP has suspended such programme and made an initial voluntary disclosure to the US Treasury Department’s Office of Foreign Asset Control (‘OFAC’), and is currently reviewing these activities to determine to what extent if any the activities may have violated OFAC Regulations.”

In addition to these tenuous connections that trigger disclosures, the breadth of the definition of affiliate means that one company’s activities in Iran can trigger multiple reports-- as happened with the Blackstone Group, among others.  Blackstone has investments in TRTRW Automotive and Travelport, which both reported potential activities related to Iran. This triggered disclosure by Cheniere Energy, Freescale Semiconductor, Nielsen, Orbitz Worldwide, Pinnacle Foods Finance and Sabine Pass LNG, LP due to their affiliation with Blackstone.

As much as expansive reporting is being engaged in due to the broad definition of affiliate, the absence of a materiality qualifier is leading to the same result, with issuers reporting activities involving relatively little or no value.  Among the many examples of this type of disclosure is reporting by Citigroup Inc. (a US company)who disclosed, that Citibank Venezuela had participated in a clearing and settlement exchange network in Venezuela for transactions involving the clearing and settlement of domestic checks.  As part of this legal, government-run network, the bank, processed four domestic check transactions (approximately $1,000 in the aggregate) involving Bank Internacional de Desarollo, a bank on the OFAC Specially Designated Nationals (SDN) list. The transactions resulted in no revenues or net income to Citigroup. 

Another example of reporting of de minimus amounts involves Dell Inc. who disclosed that an affiliate of Qwest Software, Inc. ,  which Dell  acquired in September of  2012, performed certain transactions with  Melli Bank PLC, a wholly-owned subsidiary of Bank Melli, an Iranian bank and a SDN.  Although the services were valued at only approximately $170.00 and involved nothing other than software maintenance license renewals, and although the software maintenance activity under the licenses was terminated upon discovery of the relationship, Dell felt obligated to report.

And so what?  Perhaps this is all for the best as it is clear that companies are bending backwards to disclose any possible connection with activities in Iran.  However, there are some real downsides to this outcome.  The level of disclosure indicates that companies are incurring significant time and expense to uncover potential reportable activity, adding to an already increasing disclosure cost burden (recall that many of companies will also be subject to conflict mineral reporting).  Some advice given to companies gets at the burdens the new disclosure requirements impose:

Issuers should consider designing and implementing standing measures that will simplify compliance with Section 219 in future reporting periods and position issuers to swiftly and persuasively respond to any SEC comment letters. Some possible measures include broadening sanctions compliance procedures to screen for and escalate activities involving customers, vendors, and other business partners on the lists of entities and individuals covered by Section 219. Existing sanctions screens used across global operations might not be broad enough to capture this information, especially because all transactions and dealings involving Iran and certain SDNs that might need to be disclosed under Section 219 are not necessarily prohibited under current U.S. law. Early identification of covered activities also enables an issuer’s leadership to contemplate whether discloseable activities should be terminated for reputational or legal reasons, a topic which Section 219 requires issuers to address as part of their disclosure.

As well as being burdensome, to what end is this disclosure?  Does the reasonable investor really care that a distant “affiliate” of Citigroup engaged in a transaction with connections to Iran that yielded no economic return?  Does the government care?  Consider the burden being placed on the US government as a result of these broad reaching disclosures.   Section 219 requires that upon receipt of notice, the SEC promptly submit a report to, among others, the President. The President (i.e., OFAC or the State Department via delegation) is then required to initiate an investigation and within 180 days make a determination whether the activity is sanctionable. It is highly doubtful that Congress intended that the limited resources of either OFAC or the State Department be expended to investigate many of the transactions currently being disclosed (in addition to those described above, others include $81 of sales in the UAE to an Iranian Hospital, $170 of software maintenance services or $9,000 worth of hotel stays in Germany by employees of a designated bank.   By encouraging overly-broad disclosure, the current process may cause the US government to lose sight of clearly sanctionable transactions that the Act sought to target.

The SEC could temper the over-inclusive nature of current reporting under the Act by issuing additional guidance to address some of the identified concerns, but unless and until it does it seems to be a case of be careful what you wish for.

NetRoadshow, Inc. Request to SEC for No-Action Relief: SEC Concludes Netroadshow, Inc.’s “Electronic Roadshows” Not Official Statements

In NetRoadshow, Inc., SEC No-Action Letter, 2013 WL 368363 (Jan. 29, 2013), the Securities and Exchange Commission’s Office of Municipal Securities responded to a “no-action request” by NetRoadshow, Inc. (“Net”). The Office of Municipal Securities stated that it would not recommend enforcement action to the SEC against Net or its client underwriters under Rule 15c2-12 of the Securities Exchange Act of 1934 for failing to treat “electronic road shows” (“ERS”), which provide retail investors with offerings of municipal securities, as official statements.

Net is a private company that provides ERS as a service to securities issuers that seek to expand their investment base. The ERS are online audiovisual presentations, “coordinated by [an issuer’s] underwriters,” that disseminate information about an issuer’s securities to potential investors. Net provides ERS for varying types of securities, including municipal security offerings that target institutional investors. Net sought to ensure that it could provide ERS that target retail investors for municipal security offerings without any requirement that the ERS be disseminated to potential customers or filed with the Municipal Securities Rulemaking Board (“MSRB”) as an official statement under Rule 15c2-12.

Rule 15c2-12 provides that “underwriters of primary offerings of municipal securities . . . must receive, review and disseminate [o]fficial [s]tatements prepared by issuers.” 17 CFR 240.15c2-12.  Official statements are “documents prepared by an issuer of municipal securities or its representatives that [are] complete as of the date delivered to the Participating Underwriter(s) and that set[] forth information concerning the terms of the proposed issue of securities . . . .”

Net argues that the ERS are not official statements because Net’s client underwriters do not treat the ERS as official statements. Net claims that in Securities Act Release 7586 (May 4, 2000), the SEC asserted that an issuer of a municipal securities offering “can use writings outside of the [o]fficial [s]tatements and can designate which documents or set of documents constitute the [o]fficial [s]tatements.” Net further argues that Release 7586 states that other documents “displayed alongside the official statement” will not be treated as part of the official statement so long as the official statement does not include a hyperlink to these other documents. Therefore, because Net’s client underwriters do not treat the ERS as official statements or provide a hyperlink to the ERS in the official statement, the ERS should not be subject to the restrictions of Rule 15c2-12.

With respect to the facts provided by Net, the Office of Municipal Securities stated that it would not treat ERS as official statements, and in so doing, would “not recommend enforcement action to the [SEC] against [Net]” under the current regulatory scheme.

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

SEC v. Gowrish: Vinayak Gowrish’s Ninth Circuit Appeal Fails to Warrant Reversal

In SEC v. Gowrish, No. 11–16956, 2013 WL 681053 (9th Cir. Feb. 26, 2013), the Ninth Circuit Court of Appeals affirmed a civil judgment against former TPG Capital, LP associate, Vinayak Gowrish, for violations of Section 10(b) of the Securities and Exchange Act and Rule 10b–5.

The Securities and Exchange Commission’s (“SEC”) case against Vinayak Gowrish (“Defendant”) revolved around the Defendant’s connection with three parties: Adnan Zaman, former vice president at Lazard Freres & Co.; Pascal Vaghar; and Sameer Khoury.

The SEC alleged that the Defendant tipped inside information to Zaman concerning three likely acquisitions. Zaman allegedly relayed that information to both Vaghar and Khoury, who traded on the tip. The SEC initiated a civil prosecution against the Defendant for violations of Section 10(b) of the Securities and Exchange Act and Rule 10b–5.   

A jury returned a verdict against the Defendant on three counts of insider trading. The district court ordered: (i) the permanent enjoinment by the Defendant from further violation of Section 10(b) of the Securities and Exchange Act and Rule 10b–5; (ii) the disgorgement of $12,000, plus prejudgment interest; and (iii) the imposition of a $100,000 civil penalty. The Defendant appealed to the Ninth Circuit.

First, the Defendant averred that due process demanded a new trial because “(1) he was denied access to the medical file of an SEC witness, Pascal Vaghar; (2) the SEC elicited impermissible testimony from another witness, Adnan Zaman; and (3) the SEC vouched for Vaghar during closing arguments.”

The Defendant sought access to Vaghar’s medical file in order to challenge Vaghar’s testimony at trial, alleging that he suffered from memory loss due to a traumatic brain injury. The district court denied the discovery request, noting that it was untimely. The Ninth Circuit, reviewing the denial for an abuse of discretion, held that the Defendant provided no excuse for failing to meet the discovery deadline, and therefore, no abuse of discretion existed. As for the Defendants remaining two due process assertions, the Ninth Circuit held that the Defendant failed to establish any showing of plain error.

Second, the Defendant argued that the district court erroneously instructed the jury that a showing of “recklessness” was sufficient for finding scienter. The Ninth Circuit in dismissing the argument noted that the law was well settled that recklessness was sufficient for Section 10(b) violations. Moreover, the result did not change just because this case involved Rule 10b–5(a) and (c), rather than Rule 10b–5(b).      

Third, the Defendant claimed that the district court’s remedy was improper on two fronts. The district court improperly enjoined future violations of Section 10(b) and violated Defendant’s Seventh Amendment rights by looking at facts beyond those found by the jury in imposing the $100,000 civil penalty.

As for enjoining future violations, the Ninth Circuit explained that the district court property looked to the Fehn five-factor test. To overcome application of the test, the Defendant was required to show that application of the test was “illogical, implausible, or without support in inferences that may be drawn from facts in the record.” The Ninth Circuit concluded that the Defendant had not met this standard. 

Addressing the Defendant’s Seventh Amendment argument, the Ninth Circuit characterized the argument as consistent with the position that fines could only be imposed based upon facts found by the jury. Existing precedent, however, had held that the “Seventh Amendment right to a jury trial does not extend to the determination of facts necessary to support a civil fine in a government enforcement action.” The court noted that the decision, while having “potential vulnerability . . . remains the law and controls in this case.” In any event, the Ninth Circuit found that any error was “harmless.”

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

3 Interesting SSRN Papers From the Past Month

I came across 3 papers on SSRN recently that I thought might be of interest to our readers:

Amnon Lehavi, “The Corporation as a Nexus of Property”:

Whereas corporate law theory is increasingly looking beyond the “nexus of contracts” model to illuminate the firm’s proprietary foundations, property theory has yet to fit the business corporation into its newly integrative framework.  The Article argues that this deficiency is not merely a coincidence. In many ways, the business corporation undermines the paradigms of current property theory. To start with, the underlying notion of divorce of ownership from control in the business corporation seems antagonistic to the owner’s right to exclude in property. In addition, while property theory recognizes the need to pool together resources and overcome collective action problems, conventional models of property governance, such as residential community associations, seem alienated from the power relations and vertical authority within the business firm. Specifically, the setting of a majority shareholder enjoying a control premium alongside owing fiduciary duties to dispersed minority shareholders is allegedly at odds with the horizontal governance assumption in contemporary property paradigms.

Oscar Couwenberg & Stephen J. Lubben, “Essential Corporate Bankruptcy Law”:

In this paper our goal is to identify the core of corporate bankruptcy law that parties cannot achieve on their own, no matter how robust their contract law. Our approach takes organizational law as starting point and we posit that bankruptcy law is a necessary addition to organizational law. Necessary in that two essential elements of corporate bankruptcy law cannot be achieved by contract: asset stabilization and asset separation.

Thomas E. Rutledge, “The Man Who Tells You He Understands Series Will Lie to You About Other Things as Well”:

My good friend Scott Ludwig, a font of southern aphorisms, is known to have observed “A man who tells you he is in charge of his household will lie to you about other things as well.” While it is beyond my skill set to assess the universality of this obvious generalization, I am confident that anyone representing that they truly understand the “series” as utilized in certain LLC, limited partnership and business/statutory trust acts is at a minimum overestimating their capabilities. Simply put, consequent to the disparate elements of series between the various acts and the many unresolved questions, understanding is simply at this time not possible.

Goldman and the Consequences of Converting to a Bank

Goldman announced that it is setting up a fund to raise capital that will then be used to make loans to middle market companies (companies with earnings between $5 million and $75 million). The registration statement is here. 

According to Goldman, this is a market that is currently under serviced by banks. Id.  ("We invest primarily in U.S. middle-market companies, which GSAM believes have been underserved in recent years by banks and have difficulty accessing the public debt markets."). 

Were Goldman simply an investment bank, it could do whatever it wanted with respect to this fund.  But Goldman, as a result of the financial crisis of 2008, converted to a commercial bank and came under the watchful eyes of bank regulators.  Goldman also became subject to the Volcker Rule (that is, will become subject to it whenever it goes into effect).  One of the requirements of the Volcker rule is that commercial banks cannot establish hedge funds. 

Goldman plans to structure the fund to avoid the definition of hedge fund.  As the prospectus notes:

• Section 13 of the BHCA, often referred to as the “Volcker Rule,” is expected to impose significant restrictions on Goldman Sachs’ ability to sponsor or invest in hedge funds, private equity funds or commodity pools (“covered funds”).  We expect and intend that we will not be a covered fund under the Volcker Rule once such rule is fully effective. As a result, we may refrain from engaging in certain activities, including entering into derivative transactions such as interest rate and currency hedging. The proposed rules are highly complex, and many aspects of the Volcker Rule remain unclear.  The full impact on us will not be known with certainty until the rules are finalized.  Compliance with the Volcker Rule may have a material adverse effect on our operations and share price.

In other words, Goldman will potentially have to limit the activities of the fund in order to avoid falling within the definition of hedge fund.  While Congress presumably wanted to decrease the amount of short term securities speculation by banks, the impact on the Goldman fund may be to prevent some types of hedging that would benefit investors in the fund.

With the demise of free standing investment banks, the securities business is increasingly dominated by the large commercial banks.  Large commercial banks, however, are subject to significant limitations on risk taking (with the Volcker Rule representing one manifestation of this). 

Were there a class of free standing investment banks not subject to severe limitations on risk, they could pick up and assume the risk denied the commercial banks.  They could, for example, set up a fund to lend to the middle market without significant limitation on hedging activity.  Thus, risk averse behavior by banks would not necessarily result in a net reduction in risk in the capital markets.

But those intermediaries no longer exist.  Thus, a reduction in risk by banks may not be assumed by other intermediaries.  This results in a net reduction in risk taking.  This type of reduction in risk taking may be good for the safety and soundness of the banking system but not necessarily good for liquid securities markets. 

For a discussion of the role of the repeal of Glass Steagall on the demise of independent investment banking firms, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

Consents and "A Great Potential for Mischief"

On this Blog, we don't hesitate to criticize what can often be described as management friendly decisions by the Delaware courts.  But sometimes its not always easy to tell if a decision falls into that vocabulary, particularly when the Delaware courts use an investor friendly vocabulary.    

Such is the case with Carsanaro v. Bloodhound Technologies, C.A. No. 7301-VCL, 2013 Del. Ch. Lexis 69 (Del. Ch. March 15, 2013).  In that case, the court discussed the information that had to accompany a consent solicitation.  Unlike the MBCA, consents in Delaware do not require unanimity.  As a result, they can represent an important tool for shareholders.

Under Delaware law, a notice of a shareholder meeting that will address an amendment to the articles must include the text of the amendment or "a brief summary of the changes to be effected thereby."  8 Del. 242(b)(1).  Consents, on the other hand, must "set[] forth the action so taken." 8 Del. 228(a). 

The language is different but could have been interpreted as imposing identical requirements.  After all, whatever shareholders need to approve an amendment at a meeting is presumably what they would need to approve an amendment in a consent proceeding.  The court, however, chose not to read the requirements as identical.  The court did so because of what it described as the "'great potential for mischief'" that arose out of a consent solicitation.  As a result, the requirements must be "'strictly complied with if any semblance of corporate order is to be maintained.'"

The court concluded that there were heightened disclosure obligations in the context of consent solicitations.  See Id.  ("When a consent specifically refers to exhibits and incorporates their terms, the plain language of Section 228(a) requires that a stockholder have the exhibits to execute a valid consent").  

The decision is, of course, a mixed blessing for shareholders.  Its hard to argue with a need for increased disclosure to shareholders.  Yet the decision is very clear.  Shareholders undertaking consent solicitations have higher disclosure burdens than those imposed on management in connection with shareholder meetings.  Management does not, apparently, have to provide shareholders with the same information when using the vehicle of a shareholder meeting.  Shareholders using consents have a potential to engage in mischief, management seeking action at meetings of shareholders apparently does not. 

That may come as a surprise to some investors.  Put this one into the category of management friendly. 

Executive Compensation and the Highest Paid CEOs

The NYT has commissioned a study of the 100 highest paid CEOs.  The study was done by Equilar and is here.  The range was $10.2 million for #100 (John Brock of Coca-Cola) and $96.1 for #1 (Larry Ellison at Oracle). 

The NYT provided some intereting observations about the data.  Total compensation was up modestly but the perks exploded.  As the NYT described:

• For the 100 highest-paid C.E.O.’s among American companies with revenue of more than $5 billion, the typical 2012 perks package was worth $320,635, up 18.7 percent from 2011, according to an analysis by Equilar for The Times. By contrast, median total pay among the 100 C.E.O.’s rose just 2.8 percent, to more than $14 million.

The article in DealBook focused on the personal use of the corporate aircraft.  See DealBook, April 8, 2013 ("Steve Wynn of Wynn Resorts, for instance, enjoyed more than a million dollars’ worth of personal travel on his company’s private jet. The chief executive of Hertz, Mark Frissora, logged nearly a half-million dollars’ worth of personal travel on the corporate jet."). 

The compensation median for the top 100 was more than $14 million.  With that kind of compensation, the need for significant perks is not intuitively obvious.  These numbers are presumably approved by an "independent" compensation committee of the board.  Yet the reality is that directors have little incentive to oppose $300,000 in perks since it saves the company very little and potentially alienates the CEO. 

The adoption of new listing standards for directors on the compensation committee may help modestly.  At least the SEC in the release approving the standards emphasized that, in determining director independent, boards had to take into account business and personal relationships between directors and executive officers.  As the Commission stated:

• Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.

Perhaps this will reduce the incidence of directors on the compensation who have personal and business relationships with the CEO.  That in turn may provide for a slightly more rigorous review of compensation, including perks. 

But in truth the problems with executive compensation are far more structural than personal and business relationships between directors and officers.  The SEC's pronouncement, therefore, is not likely to have significant impact. 

Further Developments on the Benefit Corporation Front (Part 2)

I continue to believe that special legal designation of benefit status is not necessary.  In time, empirical analysis may be able to establish whether the new legislation in Delaware and elsewhere makes any meaningful difference in corporate behavior or whether it simply provides another avenue for corporations to tout their ‘good’ behavior.  One example to consider on this point is Patagonia which became a benefit corporation in California in 2012 when enabling legislation went into effect. 

Patagonia has always held itself out as a corporation dedicated to environmental and other ‘socially responsible” causes.  Its mission statement reads: 

Our Reason for Being

Build the best product, cause no unnecessary harm, use business to inspire and implement solutions to the environmental crisis.

Company materials go on to state that “at Patagonia, a love of wild and beautiful places demands participation in the fight to save them, and to help reverse the steep decline in the overall environmental health of our planet. We donate our time, services and at least 1% of our sales to hundreds of grassroots environmental groups all over the world who work to help reverse the tide.”  The company also emphasizes its commitment to ensuring that its products are made under safe, fair, legal and humane working conditions throughout the supply chain.”

These principals have guided Patagonia since its creation in the 1950s as Chouinard Equipment and it seems likely that the switch to benefit corporation status from being a private, family-owned company will not change those core values.  So what is the impetus for Patagonia opting into the new corporate status?  According to Yvon Chouinard, the founder of Patagonia, “Benefit corporation legislation creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership, by institutionalizing the values, culture, processes, and high standards put in place by founding entrepreneurs.”   

Whether that statement is entirely accurate is unclear. No case has yet tested whether the election of benefit corporation status alters fiduciary obligation in the take-over context.   Proponents of benefit corporation legislation point to eBay v. Newmark as indicating that Delaware law mandates shareholder wealth maximization.  In ebay, the Delaware Chancery Court invalidated a poison pill under the Unocal test and seemed to endorse shareholder primacy

"[Newmark and Buckmaster—two minority shareholders acting in unison] did prove that they personally believe craigslist should not be about the business of stockholder wealth maximization, now or in the future. As an abstract matter, there is nothing inappropriate about an organization seeking to aid local, national, and global communities by providing a website for online classifieds that is largely devoid of monetized elements. Indeed, I personally appreciate and admire [Newmark's and Buckmaster's] desire to be of service to communities. The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment. Jim and Craig opted to form craigslist, Inc. as a for-profit Delaware corporation and voluntarily accepted millions of dollars from eBay as part of a transaction whereby eBay became a stockholder. Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders."

To some benefit corporation advocates this demonstrates that “the only game in town, if you are a U.S. corporation, is to maximize shareholder value. That makes it awfully hard to care about what you’re doing with your employees or what you’re doing with your community or what you are doing with the environment when that is the law of the land and if you don’t do that you can get sued.”  If true, benefit corporation status may make a difference.  However, it not likely that ebay really goes as far as that.  The case was unusual on its facts and can easily be understood as a minority oppression case rather than a shareholder primacy case—a fact many have noted in the past.  In general, Delaware law is quite deferential to directorial decision-making and if directors articulate a shareholder interest that would be protected by their actions (which was not accomplished in ebay) it is likely that those actions would be upheld.

I (and others before me) have questioned whether benefit corporation legislation is necessary when nothing in the law prevents corporations for acting to advance a public interest—other than the myth of shareholder primacy.  However, the fact that Delaware is willing to consider adopting this legislation is significant.  While it may not be the “seismic shift” in corporate law that B Lab (a leading proponent of benefit corporation legislation and also a leading third-party evaluator (for a fee) of whether such corporations are in compliance with their stated public benefit), it is worth note.  While benefit corporation legislation has been enacted in 12 states and is under consideration in 20 others, Delaware’s prominence in the corporate law arena means that any actions it takes carry particular weight.  It will be interesting to watch how many corporations choose to incorporate as benefit corporations in Delaware if the legislation passes. 

It is too early to make any definitive statement about the impact of benefit corporation legislation.  If Delaware does enact such legislation it will provide a rich opportunity to get fact based answers rather than the speculative assumptions that currently fuel the movement.

Further Developments on the Benefit Corporation Front (Part 1)

Legislation to amend the General Corporation Law of the State of Delaware (the “DGCL”) and related sections of title 8 of the Delaware Code is currently before the Corporate Law Section of the Delaware State Bar Association for approval. If the amendments become effective, they would result in several significant changes to the DGCL, including adding a new subchapter to the DGCL authorizing benefit corporation status under Delaware law.

As discussed in earlier posts, benefit corporation legislation permits a corporation to state in its articles of incorporation that it intends to operate in furtherance of a specific public benefit (or benefits).   The Delaware statute includes among permissible “public benefits” having a positive effect (or causing a reduction in negative effect) on persons, entities, communities or interests, including those of an artistic, charitable, cultural, economic, educational, literary, medical, religious, scientific or technological nature.

The legislation states that directors of a benefit corporation must balance the pecuniary interests of stockholders, the interests of those materially affected by the corporation’s conduct, and the identified public benefits, and make it clear that benefit corporation directors shall not have any duty to any person solely on account of any interest in the public benefit and would provide that, where directors perform the balancing of interests required of them, they will be deemed to have satisfied their fiduciary duties to stockholders and the corporation if their decision is both informed and disinterested and one that a person of ordinary, sound judgment would approve.

Stockholders in a Delaware benefit corporation may bring a derivative suit asserting that the directors are not advancing the stated public benefits adequately if they own at 2% of the corporation’s outstanding shares (or, in the case of listed companies, the lesser 2% of the outstanding shares or shares having at least $2 million in market value).

Additionally, the legislation sets limits on the ability of benefit corporations to amend their certificates of incorporation or effect mergers or consolidations if the effect would be to abandon their public benefit purpose. These limitations would be imposed through a 66 2/3% vote of each class of the public benefit corporation’s outstanding stock.  It also restricts the ability of corporations that are not benefit corporations to amend their certificates of incorporation to become public benefit corporations or to effect mergers or consolidations that would result in their stockholders receiving shares in a public benefit corporation.  This would be done by requiring a 90% vote of each class of the corporation’s outstanding stock to effect such a change, and grants appraisal rights to any stockholder of a corporation that is not a public benefit corporation that, by virtue of an amendment to the corporation’s certificate of incorporation or any merger or consolidation becomes such a corporation.

Benefit corporations would be subject to all other applicable provisions of the DGCL, except as modified or supplanted by the new benefit corporation legislation. We may see a groundswell of benefit corporations in Delaware if benefit corporation status becomes available (The B Corporation website currently states that there are a total of 720 benefit corporations in existence.)  Opting into that status would overcome the general stance of Delaware corporate law, which while not mandating shareholder primacy certainly permits easy perpetuation of the myth that it is a legal mandate.

Dusting Off the Ultra Vires Doctrine to Rein in Corporate Violations of International Law

This past week, Kent Greenfield alerted me to a suit against Hershey seeking to get records about their alleged use of child labor.  (You can find a news item providing some background here.)  As Kent explained in his email: “The theory of the case -- that violations of international law are ultra vires -- is basically something I came up with 10 years ago, and this is the first case using the theory.”  (You can find an example of Kent’s relevant scholarship here.)  I reviewed the amicus brief that Kent and The Honorable Nancy Gertner, Professor of Practice at Harvard Law School, have filed with the Delaware Court of Chancery, and here is an excerpt I thought might be of interest to our readers:

The implication of the requirement that corporations not engage in illegalities in this case cannot be overstated. Shareholders have an interest in monitoring whether the corporation is acting unlawfully even if there is insufficient evidence to show that directors or other fiduciaries should be subject to personal liability for a failure to monitor under Caremark and Stone v Ritter…. In all fairness, however, there are two gaps in the argument that would hold Hershey and its directors responsible under Delaware corporate law for the illegalities alleged in the complaint. The first gap is informational, and the second is doctrinal…. [However, while t]he extent of knowledge or involvement of Hershey management and of The Hershey Corporation in these illegalities is yet murky…. gathering this kind of information is a very purpose of a § 220 inspection…. Meanwhile, the Delaware judiciary has not yet defined the contours of corporations’ responsibility for illegalities committed by suppliers, business partners, or other third parties. Certainly a company and its board cannot protect itself from legal accountability simply by hiding behind an assertion that an illegality was committed by a separate legal entity or middleman…. On one end [of the continuum of responsibility] will be situations in which there is de facto unity between a Delaware corporation and a subcontractor, supplier, or middleman acting illegally, or when a Delaware corporation is acting in partnership with entities acting illegally. The responsible end of the continuum would also capture situations in which a Delaware corporation and its fiduciaries were knowingly complicit in such illegalities, even if managerial unity or partnership did not exist. On the other end of the continuum, it would be unjust for corporations and their management to be held responsible for the behavior and decisions of independent actors committing illegalities without the complicity, benefit, or knowledge of the corporation.

Some Thoughts on the "Independent Review" of Barclays: More Time on the Job (Part 3)

The Report on Barclays (aka the Salz Review) examines the role of the Board at the universal bank.  For the most part, the analysis is not particularly insightful.  There are, however, a few interesting observations that warrant consideration. 

Most interestingly, the Report supports an increased role in the oversight process for independent directors.  It promotes this approach by asserting that these directors should devote significant time to board activities. 

Directors at Barclays already attend a significant number of meetings.  According to the Report:  "The Board met on 30 occasions in 2008, at times by conference call, and 27 times in 2009."  Report, at 106. 

Nonetheless, the Report suggests a substantial minimum time commitment that would transform service on the board, at least in times of crisis, to something approaching a full time position.  As the Report stated:  "In normal circumstances we see minimum time commitments for non-executive directors trending towards 45 to 50 days a year, and considerably more than this (probably in the region of 80 to 100 days) for key committee chairs. In times of crisis, this will inevitably increase."

With more time devoted to the bank and more meetings, directors presumably will need a staff.  They already, apparently, have a significant amount of support.  As the Report described: 

• Barclays’ Board is supported by the Barclays Corporate Secretariat. This comprises a  total team of 27, of which 7 work primarily on agendas, papers, minutes and actions from the Board and committees and the writing of annual reports. The others deal primarily with the formalities of the many companies in the Barclays Group.

Full time boards with support staff are not a panacea.  More time does not automatically equal increased quality.  The Report hinted at this.

• The Walker Review outlined how the “principal deficiencies in [bank] boards related much more to patterns of behaviour than to organisation”. It went on to explain that: “The pressure for conformity on boards can be strong, generating corresponding difficulty for an individual board member who wishes to challenge group thinking. Such challenge on substantive policy issues can be seen as disruptive, non-collegial and even as disloyal. Yet, without it, there can be an illusion of unanimity in a board, with silence assumed to be acquiescence (...) Critically relevant to success of the challenge process in any well - functioning board will be the demeanour and capability of the CEO, who is unlikely to be in the role without having displayed qualities of competence and toughness which are not dependably tolerant of challenge. Even a strong and established CEO may have a degree of concern, if not resentment, that challenge from the NEDs is unproductively time - consuming, adding little or no value, and might intrude on or constrain the ability of the executive team to implement the agreed strategy. Equally, however, the greater the entrenchment of the CEO, perhaps partly on the basis of excellent past performance and longevity in the role, the greater is likely to be the risk of CEO hubris or arrogance and, in consequence, the greater the importance (and, quite likely, difficulty) of NED challenge. Achieving an appropriate balance among potentially conflicting concerns is frequently the most difficult part of the overall functioning of the board.”

Thus, one consequence of the financial crisis is pressure on Barclays (and perhaps other similarly situated financial institutions) to increase the hours of directors devoted to the oversight process.  This could be the first steps in turning the position into a full time job. 

In the end, however, its not about the number of meetings but the quality of the meetings that occur.  Challenging the CEO is not for the most part encouraged behavior on boards.  Until it is, more meetings is unlikely to significantly increase governance quality.

Some Thoughts on the "Independent Review" of Barclays: Compensation and an Absence of "Humility" (Part 2)

The Report on Barclays (aka the Salz Review) also discussed some of the tension that arose in the bank over executive compensat ion. 

• Barclays has struggled to deal with pay in a way that reflects a reasonable balance between the interests of shareholders on one hand, and those of executives and employees on the other. The structuring of pay was typically focused on revenues and not on other aspects of performance. Encouraging the maximisation of short-term revenues carried risks of unsatisfactory behaviour, with significant and adverse reputational consequences for the bank. The principal issues we have identified include high bonus awards in the investment bank which were incapable of justification to many stakeholders –especially since the beginning of the crisis; actions that maximised current year bonuses rather than consideration of sustainable profitability; and, in the retail bank and Barclaycard, sales incentives that risked products being sold to customers whether or not suitable for them. Overall, the pay structures gave the message to staff that the bank valued revenue over customer service.

Report, at 9.  At the same time, according to the Report, the problem was not a bank wide one.  It arose mostly in the investment banking side of the business.

• Most but not all of the pay issues concern the investment bank. To some extent, they reflect the inevitable consequences of determinedly building that business –by hiring the best talent in a highly competitive international market (and during a bubble period) – into one of the leading investment banks in the world. The levels of pay (except at the most senior levels) were generally a response to the market. Nevertheless, based on our interviews, we could not avoid concluding that pay contributed significantly to a sense among a few that they were somehow unaffected by the ordinary rules. A few investment bankers seemed to lose a sense of proportion and humility.

The Report diplomatically pointed out that any true reform of the approach to compensation had to start at the top.

• Barclays has responded to the public, political and regulatory concerns by trying to manage down total employee compensation as a proportion of adjusted profit before tax and adjusted net operating income, by deferring certain bonus payments and by applying claw - back or malus. If Barclays is to achieve a material improvement in its reputation, it will need to continue to make changes to its top levels of pay so as to reflect talent and contribution more realistically, and in ways that mean something to the general public. Barclays’ success depends on hiring and keeping good people – and this requires that it pays them fairly. Its ability to lead change in compensation practices materially ahead of its competitors will necessarily be constrained if it is to avoid risking damage to its businesses. But we also feel that there is more that it can do over time to emphasise forms of recognition for performance other than pay.

The Report, therefore, noted bonuses "incapable of justification" to stakeholders, an emphasis on short term returns that carried reputational harm, employees "unaffected by the ordinary rules," and the need to more realistically reflect "talent and contribution." 

Some of this is a problem of culture.  Those operating in the securities markets are paid differently than those operating in the commercial banking universe.  Commercial banks expanding into the securities area, therefore, have to address this often very different culture. 

Nonetheless, the cultural problem is presumably foreseeable.  The Report raises fundamental concerns with board oversight of compensation and the content of the board's fiduciary obligations.  The government's choice (other than to do nothing) is to tighten fiduciary standards or impose direct regulation of compensation (Britain is already moving beyond advisory votes for shareholders).  Thus, without reform of the fiduciary obligations of directors (say by imposing on directors an obligation to show the fairness of a compensation scheme), increased government regulation is likely.  

Some Thoughts on the "Independent Review" of Barclays (Part 1)

Barclays just published the Salz Review, a lengthy self study of the business practices at Barclays.  Barclays is of course a British Bank but the Report contains some insight that is equally applicable to the evolution of the banking system in the US. 

Of the commercial banks in the US, the Big Four (JP Morgan, BofA, Citigroup, Wells Fargo) came out of the financial crisis with a larger share of financial assets than before the crisis.  Sheila Bair in a recent editorial in the WSJ suggested that growth since the crisis came from increased activity in the securities markets "while loans, which are subject to tougher capital rules, have remained nearly flat." 

Barclays looks to have done something similar.  Ten years ago, Barclays was a commercial bank.  By 2012, it was more of an investment bank.  As the Report notes:

• About ten years ago, its ambition wasto become a top-five global bank, with one third of Group profits coming from investment banking and two thirds from global retail and commercial banking (including Barclaycard). The strategy also envisaged the bank  having more international scale. The investment bank planned to double in size in four years and it exceeded these plans. In addition, the retail and commercial bank expanded rapidly in Spain, India, Russia and elsewhere. By 2008 the bank’s growth had resulted in leverage (ratio of assets to equity) of 43, higher than the other UK banks. With the acquisition of parts of Lehman Brothers in September 2008, the investment bank grew to represent rather more than half of Barclays’ profits and three-quarters of its assets.

As the JP Morgan London Whale incident shows, involvement in the securities markets can be a high risk affair.  But the Barclays Report illustrates the Siren song of the securities markets to large banks.  The Report noted that the profits produced by Barclays Capital increased from 15% in 2000 to 75% in the period from 2009 to 2012.  Report, at 33. 

But deeper involvement in the securities markets came at a cost.  One of them was an increase in government oversight.  The Reported noted that "there has been an explosion in new regulation and in the intrusiveness of regulators."  Report, at 6.  Moreover, staffing by Barclays has had to keep pace.  According to the Report, the Compliance Office at Barclays went from 600 employees in 2008 to 1500 in 2012.  Report, at 24. 

In other words, as commercial banks get larger (in part from expansion in the securities markets), regulators often seek to tighten oversight.  At least some of the oversight is to ensure that banks do not take excessive risk. At the time of the JP Morgan London Whale incident, the OCC already had more than 60 examiners on staff at JP Morgan.  Notwithstanding the presence of these examiners, the OCC did not focus on the London Whale transaction until after the fact.  One possible response might be to increase the number of examiners and subject more JP Morgan transactions to even more intense review, perhaps examining transactions on a real time basis.

Tightened oversight may not work.  Whether the London Whale or Lehman, government regulators did not react to the risk taking until after the fact.  Thus, there may be tightened oversight without any guarantee that the oversight will work.  On the other hand, increased oversight will probably result in less risk taking by the commercial banks.  While this may be good for the safety and soundness of the banking system, it may not be good for the securities markets. 

In the past, a conservative approach to risk taking by commercial banks likely didn't have much impact on the securities markets.  A world class group of investment banks (Goldman, Morgan, Merrill, Lehman and Bear) stood ready to take on and profit from the risk in the securities markets.  But the financial crisis has decimated the population of independent investment banks.  Lehman is bankrupt; Bear and Merrill have been absorbed by commercial banks; Goldman and Morgan hang on but have converted to commercial banks. 

Reinstating some elements of Glass Steagall would presumably allow for the resurrection of independent investment banks.  For more of this, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  With independent investment banks, risk can be transferred away from commercial banks without taking the risk out of the capital markets. 

Too Big to Fail and the Consequences

There was a sharp story about draft legislation circulating in Washington designed to address some of the concerns over "too big to fail." According to the article:

• The draft bill would require all U.S. banks to hold 10% equity capital and subject banks with more than $400 billion in total assets to additional capital surcharges based on the size of the institution. . . . It would also restrict banks from structuring themselves or their activities to avoid the new capital rules, and would prohibit government assistance for non-banks.

Too big to fail is the moniker used to describe the four largest commercial banks.  These are the banks that are so large no government regulator would let them fail.  Certainly, the economic consequences of the failure of Lehman, a financial institution much smaller than the Big Four (JP Morgan, BofA, Wells Fargo and Citigroup), demonstrates the potential harm to the economy (and political careers) that can occur when a large financial institution is allowed to fail.

Solutions to the "too big to fail" problem (assuming anyone is seeking a solution) fall into two broad camps:  Making banks capable of failing (downsizing is the most obvious method of doing so) or making them less likely to fail.  Despite occasional voices about downsizing the largest banks, there is no real effort underway to make the banks smaller.  Instead, most of the focus is on heightened regulation.  This means greater separation between securities and banking, increased capital, increased liquidity, and reduced risk.  All of this collectively means greater government oversight of commercial banks. 

It is the growing price that large commercial banks will pay for being too big to fail. 

IPOs and the JOBS Act: A Complicated Analysis

The JOBS Act sought to increase the number of public offerings in part by providing some regulatory relief for "emerging growth companies."  The JOBS Act also provided a mechanism for non-public review of registration statements. 

According to the WSJ, the JOBS Act has not delivered, at least with respect to an increase in the number of IPOs. 

• The one-year-old law, officially the Jumpstart Our Business Startups Act, was aimed at helping companies with less than $1 billion in sales go public. But IPOs of such companies in the year since the law was enacted are on track to fall 21%, to 63 from 80 in the year prior, according to Jay Ritter, a University of Florida professor who tracks IPOs

Its never particularly easy to draw conclusions from one year of data.  Its possible that, while the number of public offerings were down, they fell less sharply because of the JOBS Act. 

Morover importantly, however, the provisions in the JOBS Act were not significant enough to produce a large boost in the number of public offerings.  The most significant change was probably the right of emerging growth companies to go public with two rather than three years of audited financial statements.  Yet this is a modest change that would not so significantly change the cost structure of a public offering that it would induce a raft of companies to go public.

Moreover, this does not take into account the fact that the JOBS Act actually made it easier to avoid the public offering process.  As crowdfunding offerings come on line, private placements are allowed to be sold through general solicitations, and the provisions raising Regulation A Offerings to $50 million are implemented, companies will have a number of additional non-public alternatives to raising capital.  The overall impact of the JOBS Act may well be, therefore, a reduction rather than increase in the total number of IPOs. 

Regulation FD, Social Media, and the Non-Clarification Clarification (Part 2)

The issue in the Netflix Report involved allegations of disclosure of material non-public information over social media.  To complicate (or really uncomplicate) matters, the alleged disclosure occurred not over the company's Twitter account or Facebook page, but over the Facebook page belonging to the CEO. 

In describing the findings in the Section 21(a) Report (and keep in mind that its only a report, its not even a settled case, so the facts are entirely the SEC's rendition and not the result of a contested proceeding), the SEC's Press Release said this about the incident. 

• The SEC’s report of investigation stems from an inquiry the Division of Enforcement launched into a post by Netflix CEO Reed Hastings on his personal Facebook page stating that Netflix’s monthly online viewing had exceeded one billion hours for the first time. Netflix did not report this information to investors through a press release or Form 8-K filing, and a subsequent company press release later that day did not include this information. Neither Hastings nor Netflix had previously used his Facebook page to announce company metrics, and they had never before taken steps to alert investors that Hastings’ personal Facebook page might be used as a medium for communicating information about Netflix. Netflix’s stock price had begun rising before the posting, and increased from $70.45 at the time of the Facebook post to $81.72 at the close of the following trading day.

The Release (rather than the press release) noted that Mr. Hastings had over 200,000 subscribers to his Facebook page.  They included analysts, shareholders, reporters, and bloggers. 

The Release went on to "amplify" two points.  First, "issuer communications through social media channels require careful Regulation FD analysis comparable to communications through more traditional channels."  In addition, the "concept that the investing public should be alerted to the channels of distribution a company will used to disseminate material information" apply to "disclosures made through social media channels." 

Finally, the Commission had this to say about the use of personal social media sites to disseminate material information:

• Although every case must be evaluated on its own facts, disclosure of material nonpublic information on the personal social media site of an indvidual corporate officer, without advance notice to investors that the site may be used for this purposes, is unlikely to qualify as a method "reasonably designed to provide broad, non-exclusionary distribution of the information to the public" within the meaning of Regulaiton FD. 

Moreover, this was true even if "the individual in question has a large number of subscribers, friends, or other social media contacts, such that the information is likely to reach a broader audience over time." 

The Release adds nothing new to the existing analysis.  The insight provided in the release is the same thing that any reasonable securities lawyer would have provided to a client asking about social media.  Regulation FD is conditioned around disclosure to the market.  There are some avenues that are treated as tantamount to market disclosure.  Electronic filing of an 8-K is an example.  It is instantly available to everyone in the market and, anyone following a company, knows to keep an eye open on this source of information. 

Anything less traditional (The side of a rocket, the Good Year Blimp, Twitter, or a notation in the New York Review of Books), all have the possibility of meeting the market disclosure requirement but all are contingent upon the market knowing that the approach will be used.  This means advanced notice and consistent use.

Grey areas still exist.  Companies that don't alert the market to the use of social media (one has to wonder why any company would do that) but have a wide following will violate the spirit of Regulation FD but probably not be charged by the SEC.  Analysts by now know to follow all communications emanating from a company and, at least for a widely followed company, would likely know about anyting put out over Twitter or on Facebook. 

Personal Twitter accounts and Facebook pages are an entirely different matter.  It will be a long time before the market is aware, in the ordinary course, that material information will be routinely disclosed over an officer or director's personal page (or spouse/child of an officer director).  The Section 21(a) Report makes this clear and serves as a warning to any company that uses this method of communicating without advance notice.  Whatever pass Netflix got in this case won't apply to the next company/officer that does the same thing. 

Regulation FD, Social Media, and the Non-Clarification Clarification (Part 1)

The SEC issued a rare Section 21(a) Report explaining the use of social media as a mechanism for public disclosure under Regulaiton FD.  See  Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Netflix, Inc., and Reed Hastings, Exchange Act Release No. 69279 (April 2, 2013).  Section 21(a) Reports are just Reports.  They are not litigated or settled cases but instances where the SEC chooses not to bring an action but nonetheless wants to issue something along the lines of an advisory opinion.  See Section 21(a) of the Exchange Act, 15 USC 78u(a) ("The Commission is authorized in its discretion, to publish information concerning any such violations, and to investigate any facts, conditions, practices, or matters which it may deem necessary or proper to aid in the enforcement of such provisions, in the prescribing of rules and regulations under this title, or in securing information to serve as a basis for recommending further legislation concerning the matters to which this title relates.").  

In this case, the Section 21(a) Report dealt with the use of social media to disseminate information to the market under Regulation FD.  There are two things interesting about the Report.  First, the Report was issued because of the "market uncertainty about the application of Regulation FD to social media".  Second, the decision has been heralded as an example of the SEC approving the use of social media for purposes of disseminating material non-public information to the market.  We will consider both of these points at the end of the post.

Regulation FD is the regulation adopted by the SEC in the aftermath of SEC v. Dirks, the famous insider trading case.  Dirks held that the tipping of information by an insider (Secrist) to an analyst (Dirks) did not constitute insider trading.  The case effectively exonerated corporate insiders for selective disssemination of inside information, at least in circumstances where they did not perosnally benefit.

Regulation FD was the SEC's response, although it took until the 1990s to implement.  Relying on rulemaking authority under Section 13(a) (not Section 10(b), the antifraud provision), the Commission required companies that are intentionally disseminating material non-public information to the market to make simultaneous disclosure to the market.  The requirement does not apply to information already public.

The issue of social media comes up under Regulation FD in two ways.  First, is information disclosed over social media "public."  Second, does it qualify as disclosure to the market?  Social media clearly represented a form of dissemination that would eventually qualify as disclosure to the market.  But like all developing technologies, there is a grey area when it is widely used but not necessarily a means of disclosing to the market.  Social media is currently in that place.

While millions (billions?) use twitter and facebook, that would seem to suggest social media is tantatamoun to public disclosure.  On the other hand, the practice has not yet arisen whereby most companies use social media to disseminate material non-public information.  Thus, it is not a source that most analysts or institutional investors will consider.  This is exacerbated where the disclosure occurs over a social media source belonging to an officer or director rather than the company. 

It probably been the case for a long time that social media was acceptable as long as the company provided plenty of advance notice that it would be a mechanism for disseminating material non-puplic information.  Alerting the public (including analysts and institutional investors) puts them on notice and allows them to be aware that such information might be disclosed in that manner.

The problem of using social media, therefore, arises not from using social media but from using social media without telling anyone in advance.  In doing so, only those fortunate enough to be relying on social media get the information.  It can, therefore, be a form of selective disclosure, albeit one that goes selectively to millions of people.  With that in mind, we turn to the SEC's Section 21(a) Report in Netflix.

http://www.sec.gov/litigation/investreport/34-69279.pdf