The Unreviewability of Compensation Decisions in Delaware (Part 2)

We are discussing Freedman v. Adams, C.A. No. 4199 (Del. Jan. 14, 2013), the Delaware Supreme Court's most recent pronouncement in the area of executive compensation.

The facts are straightforward.  According to the allegations made by the plaintiff, XTO Energy paid to executive officers bonsues totalling more that $130 million from 2004 to 2007.  The board had not approved a plan under Section 162(m) that was submitted to shareholders for approval.  As a result, the compensation was not deductible, resulting in the company paying "approximately $40 million" in additional taxes.  As the opinion stated, "The XTO board was aware that, under a qualified Section 162(m) plan, bonuses could be tax deductible, but it did not think its compensation decisions should be 'constrained' by such a plan."

Plaintiff brought a derivative suit alleging that the board committed waste.  Plaintiff alleged, according to the Chancery Court, that "by failing to structure the cash bonuses as tax-deductible compensation, the Board Defendants had breached their fiduciary duties and committed waste."  After the complaint was filed, the XTO board approved a plan under Section 162(m) that was approved by shareholders.  XTO, however, merged with a subsidiary of Exxon Mobile and, as a result, the plan was never actually utilized. 

The shareholder agreed to dismiss her complaint as moot but sought attorneys fees.  The Chancery Court denied the fees, concluding that the complaint did "not adequately allege that demand on the board would have been futile."  The court found that Plaintiff had not stated a claim for waste.  

The Supreme Court affirmed the reasoning, using extraordinarily broad language.  Waste required a showing that:

the exchange was so one sided that no business person of ordinary, sound judgment would conclude that the corporation has received adequate consideration. A claim of waste will arise only in the rare, unconscionable case where directors irrationally squander or give away corporate assets. This onerous standard for waste is a corollary of the proposition that where business judgment presumptions are applicable, the board’s decision will be upheld unless it cannot be attributed to any rational purpose.

The company explained the failure to rely on Section 162(m) in its company in its proxy statement:

While the compensation committee monitors compensation paid to our named executive officers in light of the provisions of Section 162(m), the committee does not believe that compensation decisions should be constrained necessarily by how much compensation is deductible for federal tax purposes, and the committee is not limited to paying compensation under plans that are qualified under Section 162(m).

The Court found that this expanation was sufficient:

the XTO board was aware of the tax law at issue, but intentionally chose not to implement a Section 162(m) plan. The board believed that a Section 162(m) plan would constrain the compensation committee in its determination of appropriate bonuses. The decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment. Even if the decision was a poor one for the reasons alleged by Freedman, it was notunconscionable or irrational.

In other words, it was enough for the Court that a board wanted to be free of constraints in making compensation decisions.  There was no need to explain why the particular constraints (performance based compensation and shareholder approval) were necessary.

The decision makes clear that the courts in Delaware will not require that boards have a link between the amount of compensation and performance.  To the extent such a link is necessary, it will require federal intervention.    

The Unreviewability of Compensation Decisions in Delaware (Part 1)

Congress dabbles in the area of substantive limits on executive compensation only once.  In the 1990s, Congress adopted Section 162(m) of the Internal Revenue Code.  The provision applies to public companies and limits the deducatability of remuneration by top officers to $1 million.  The provision, however, contains a significant exception. 

The limits on deductability do not apply to compensation paid on the basis of "performance goals" that are determined by a compensation committee consisting of two or more "outside directors" and the material terms are approved by shareholders.  The compensation committee must then certify that the performance goals have been met before any actual payment occurs.

The sole operative, substantive requirement, therefore, is that compensation be based upon performance goals.  The two procedural requirements are the need for approval by shareholders and by an independent compensation committee. 

All of this brings us to Freedman v. Adams, C.A. No. 4199, Jan. 14, 2013, the Delaware Supreme Court's most recent pronouncement in the realm of executive compensation.  The case demonstrates the impossibility of challenging compensation decisions in Delaware and the need for further federal intrusion in to this area. 

The JOBS Act, the On Ramp Provisions, and the Impact on the Public Offering Process

Congress adopted the JOBS Act ostensibly in an effort to increase jobs by facilitating capital raising.  The Act, however, cobbled together provisions that were introduced separately and were never intended to be part of a comprehensive law.  As a result, some of the provisions work against each other.

One set of provisions, the On Ramp provisions, were designed to make the public offering process easier.  The JOBS Act exempted emerging growth companies from a host of requirements, some reasonable, some less so.  Thus, these companies were required only to produce two rather than three years of financial statements in an IPO.  At the same time, however, the companies were exempted from any PCAOB Rule that required mandatory rotation of independent auditors, despite the fact that no such rule exists.

As a press release concerning a new study put out by BDO:  

less than one-third (29%) of capital markets executives at leading investment banks believe the JOBS Act has been effective in increasing the number of IPOs on U.S. exchanges. This is a considerable drop since last summer when a majority (55%) of I-bankers believed the JOBS Act would be successful in increasing the number of businesses going public. Today, forty-two percent of the bankers see no evidence that the new law is positively impacting IPOs, while more than a quarter (28%) believe that it is too early to evaluate the law's impact.

The study is here.

Nor were some of the other provisions particularly popular.  This was true, according to the study, of the "testing the waters" provision and the ability to file registration statements on a confidential basis.  As the study described:

According to the SEC, in 2012, more than 100 companies utilized the JOBS Act’s confidential filing process to “test the waters” for a possible IPO. More than three-quarters (80%) of I-bankers indicate that this lack of transparency has had a negative impact on their ability to advise clients on their offerings due to a lack of information on potential competitors for investment dollars. Although only 9 percent of the bankers describe this difficulty as “substantial”

Some of the opposition has come from investors.  See id.  ("Almost half (48%) of capital markets
executives report that investor groups are reluctant to meet with emerging businesses that are confidentially testing the waters for an IPO under the JOBS Act, as they prefer to wait until the company has made a public commitment to the offering."). 

Investor resistance can also be seen from the fact that some emerging growth companies have opted out of the provisions while others have opted out of the exemption for new or revised accounting standards.  Moreover, it is common for companies that opt for emerging growth company status to include a risk factor indicating that this may generate investor resitance and impact the liquidity of the trading market. 

But there is another factor that will push down the potential value of the On Ramp provisions.  The JOBS Act also allowed for the use of general solicitations in connection with offerings under Rule 506 (although the SEC is currently in the process of implementing rules in this area).  Amendments to Section 3(b) of the Securities Act altered the small offering exemptions and essentially permitted offerings under Regulation A of up to $50 million. 

Companies that had considered a public offering may instead rely on private placements (marketed through a general solicitation) or a small offering under Regulation A+.  The small offering may require an offering circular (one is currently required for Regulation A).  Unlike a registration statement, however, an offering circular is not subject to Section 11 liability and does not trigger the reporting requirements in Section 15(d) of the Exchange Act.  So even with the reduced requirements contained in the On Ramp provisions, the JOBS Act may negatively impact the number of public offerings by providing a number of alternatives that will be, in some cases, more attractive method of raising capital than an IPO. 

The Consequences of the Delaware Guidance Function

There recently was a bit of an unexpected exchange between the Delaware Supreme Court and the Chancery Court over the use of dictum in an opinion.  The Delaware Surpreme Court chastized the trial court for using dicta in Gatz v. Auriga.  

As we noted, the criticism came despite an article written by the Chief Justice encouraging judges to do exactly that as part of what he characterized as the Delaware guidance function.  See Myron Steele & J.W. Verret, "Delaware's Guidance:  Ensuring Equity for the Modern Witenagemot," 2 Virginia Law & Business Review 189 (2007) ("The Delaware courts recognize the need to wait for a live controversy to resolve an issue definitively, but fortunately they also recognize that this does not mean that they cannot, or should not, use the attention paid to a published opinion to offer guidance on uncertain but vital areas of corporate law."). 

In Gatz, the Supreme Court instructed the lower court to stay away from dicta.  The Court did not, however, back away from the guidance function.  Instead, the trial court was encouraged to use other avenues such as speeches and law review articles.  See Gatz v. Auriga ("To the extent Delaware judges wish to stray beyond those issues and, without making any definitive pronouncements, ruminate on what the proper direction of Delaware law should be, there are appropriate platforms, such as law review articles, the classroom, continuing legal education presentations, and keynote speeches."). 

The latest salvo in the debate was fired by another jurist in the Chancery Court.  In Feeley v. Nhaocg LLC, the Vice Chancellor considered the disavowed dicta from Gatz.  The trial court noted that the language was "dictum without any precedential value."  Nonetheless, he opted to give the language "the same weight as a law review article, a form of authority the Delaware Supreme Court often cites." 

The approach suggests several things.  First, to the extent dicta is used in an opinion in a manner the Supreme Court finds inappropriate, trial courts may nonetheless cite it and use it in their analysis.  They will not give it precedential weight, but it will be a source that can assist in determining the analysis. In other words, there are no real limits on the use of dicta by the Delaware courts. 

Second, the Supreme Court's concern was not over the right of Chancellors or Vice Chancellors to speak on an issue that might come up in their courts but, apparently, over the precedential value attached to a decision.  See Gatz ("It is axiomatic, and we recognize, that once a trial judge decides an issue, other trial judges on that court are entitled to rely on that decision as stare decisis.").  Thus, a jurist can say the same thing but only in a law review article that has no precedential value. The Vice Chancellor in Feely handled the concern by disavowing the precedential value of the dicta in Gatz.  

Third, Feeley gave the dicta "the same weight" as a law review article.  It showed that law review articles written by other jurists on the Delaware bench can be a source of persuasive reasoning.  See Feeley (the "explanation of the rationale for imposing default fiduciary duties remains persuasive"). 

Mary Jo White and the SEC

Mary Jo White went from being under consideration as Chair of the SEC to the likely choice, to officially nominated in little more than a week.  The nomination still leaves one opening (Chairman Walter's term has expired).  Commissioner Paredes' term apparently ends in June. 

The process of Senate confirmation could go quickly.  Mary Jo White is not, by trade, a securities lawyer (at least beyond the securities laws involved in the litigation context).  What she is is a prosecutor who has a history of strong enforcement (with the added benefit of managerial experience having overseen the US Attorneys Office in the Southern District).  In the post-Madoff world, this is the safest type of appointment for purposes of confirmation. 

At the same time, however, positions on the Commission have increasingly been paired at the time of confirmation, with nominees representing each political party being confirmed at the same time.  This was the case most recently with respect to Commissioners Aguilar (for a second term) and Gallagher.  Back in 2008, Commissioners Aguilar, Walter and Paredes were confirmed on the same day. 

It does not always happen this way, at least with respect to the chair of the Commission.  Mary Schapiro was confirmed without having been paired.  Of course, when she was confirmed, there were no other opening on the Commission.  Chris Cox, however, was paired with Commissioners Campos and Nazareth when they were confirmed back in 2005. 

All of this suggests that confirmations will be easier when there are persons from both parties up for nomination.  With Commissioner Paredes seat open in June, that suggests that confirmation will not occur until the early summer.   

Is there enough empiricism in corporate law?

Today’s Wall Street Journal contains an essay by Bill Gates that starts with the proposition that:

From the fight against polio to fixing education, what's missing is often good measurement and a commitment to follow the data. We can do better. We have the tools at hand.

The essay caught my attention in part because I’ve been pondering the extent to which corporate law is justified by data as opposed to more generalized notions of, e.g., fairness, efficiency, freedom of contract, or power (i.e., the race to the bottom).  My impression is that at least in the cases we use to teach our students, there is a dearth of supporting data.  I’ve taken a stab at this issue before in my article, “Is Puffery Material to Investors? Maybe We Should Ask Them,” wherein I presented investors with statements deemed to be immaterial puffery as a matter of law by judges ruling on pre-trial motions.  I asked the investors to make their own materiality determinations and my results showed that “anywhere from 33% to 84% of them found the statements to be material” (as compared to what were in essence judicial predictions of 0%).  Based on this data, I argued that “surveys should play a role in materiality determinations in securities litigation similar to the role they already play in Lanham Act cases.”

Of course, relying on empirical data is not without its own shortcomings.  As Stephen Bainbridge recently noted: “Empirical analysis all too often is flawed by GIGO, design errors, selection bias, and a host of other problems.”  Furthermore, one can arguably become so enamored with empirical proof that progress grinds to a halt as there is always one more study to be done to make sure the results are accurate.  At least some have read the D.C. Circuit’s Business Roundtable decision, and the renewed calls for enhanced cost-benefit analysis in SEC rule-making, as nothing more than a backdoor means to tie the SEC’s hands as a regulator.  Nonetheless, I think I’m going to start trying to add the question, “How would you prove that?” to my in-class discussions concerning policy rationales.

Finally, a couple of random related points:

One of my favorite examples of empirical legal research:  Andrew Torrance, The Patent Game: Experiments in the Cathedral of Law.

A good place to go if you’re interested in learning more about empirical legal scholarship: Conducting Empirical Legal Scholarship Workshop.

Implications of the OECD Report on Conflict Minerals Due Diligence Guidance for Issuers Subject to Dodd-Frank Reporting Requirements

While we wait for a decision in the suit filed by the National Association of Manufacturers challenging the SEC’s final rule implementing Section 1502 of Dodd-Frank (the “conflict minerals provision), it is worth reviewing the findings of the Final Downstream Report on One-Year Pilot Implementation of the Supplement on Tin, Tantalum, and Tungsten issued by the OECD (the “Report”).  

The Report discusses the pilot program implementation of the OECD’s Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas (“Guidance”).  The Guidance has particular relevance for issuers subject to SEC reporting requirements because it is intended to help companies put in place a due diligence process to help them meet disclosure requirements under Section 1502. The Securities Exchange Commission has stated that the Guidance “satisfies our criteria and may be used as a framework for purposes of satisfying the final rule’s requirement that an issuer exercise due diligence in determining the source and chain of custody of its conflict minerals.”  Currently, the Guidance is the only internationally recognized due diligence framework which issuers can use to develop the due diligence process for satisfying the reporting requirements under Dodd-Frank.

Participants in the pilot program include large multi-billion multinationals from the information and communications technology sector and also aerospace and defense, automotive, medical devices and consumer products among others. The majority of participants are subject to US disclosure requirements and are under pressure to adopt systems and processes that will comply with the US law.

The Report highlights the difficulties issuers have in determining the source of minerals used, a piece of information critical to the disclosure regime established under Dodd-Frank. While the Guidance provides tools to better enable companies to trace minerals through their supply chains it remains impossible to be fully informed of where each mineral used is sourced from.  Therefore, at present, the SEC final rule implementing Section 1502 “creates a disincentive to source materials from the DRC and its nine neighboring countries, because [companies then] must conduct due diligence, write a conflict minerals report and get an independent audit,” stipulating the precise sourcing of all covered minerals.  None of these steps are if minerals come from other “conflict-free” regions.  This observation supports the finding that production of minerals in certain regions of the DRC was down by 80% in 2011 as compared to production in 2008 and that only five provincial mineral trading houses remain in operation in 2011, as compared to 29 in 2010.   http://digital.olivesoftware.com./ODE/FTUS.

Over the course of the pilot program, more companies have implemented policies, undertaken efforts to gain a better understanding of their supply chain and engaged with their suppliers, but challenges persist in obtaining information about upstream and smelter due diligence.  Participants’ attempts to obtain information from their suppliers provided new insights into the depth and complexity of their supply chains.  As companies attempted to implement the various steps of the Guidance the process revealed a lack of control and insight beyond their immediate suppliers.  This suggests that it will be extremely difficult for issuers to state with certainty whether their products contain "conflict minerals" that are "necessary to the functionality or production of a product"—the key disclosure item required under Section 1502 of Dodd-Frank.

The Report also noted that companies subject to the Dodd-Frank requirements face a compliance cost deterrent.  For companies in the upstream part of the supply chain, the cost of implementing in-region due diligence programs that can provide assurance of the conflict-free nature of minerals used in production may be problematic.  Costs associated with conducting the requisite diligence will have to be absorbed elsewhere in the supply chain or other mineral sources (where diligence is not required) will always be less expensive.

There are certainly many positive findings in the Report, including, among others, that more participants have defined and established clear policies on sourcing materials from conflict regions and are increasingly willing to participate in industry programs (including the Conflict Free Smelter program). It is clear from the Report however, that the process will take time and that the additional burdens imposed by Dodd-Frank may hinder progress in the very areas it was intended to help.  The U.S. District Court for the District of Columbia which is hearing the challenge to the SEC final rule may likely ignore the Report’s findings, but the Report does lend some credence to the challengers’ claim that the final rule is inappropriate in that it imposes “extraordinary costs upon them given the difficulty of determining country of origin and other matters relevant to compliance." 

The SEC, Social Benefit Rules, and the Inapplicability of Cost-Benefit Analysis: The Legal Challenge to Rule 13q-1 (Part 4)

The conceptual problem is that the SEC is charged with analyzing rules for the impact on efficiency, competition, and capital formation.  This for the most part means the costs imposed on, and the benefits received by, the market.  In the resource extraction context, this type of cost-benefit analysis will lead to useless results. 

The benefits of the rule have little to do with capital markets.  Even if the benefits could be quantified, which the SEC says they cannot, there is no logical reason why these benefits should be offset against only the costs imposed on the capital markets.  In other words the “cost-benefit” analysis for Rule 13q-1 is mixing apples (benefits to the citizens of countries with resource extraction industries) with oranges (the costs to the US capital markets).  One possibility would be to analyze the rule solely for its impact on the capital markets.  Yet doing so ignores the purpose of the provision and the intent of Congress. 

The reality is that the use of a cost-benefit analysis in this case is inappropriate.  This can be seen from the provision that requires a cost-benefit analysis.  Section 3(f) of the Exchange Act does instruct the Commission to consider the impact of rules on efficiency, competition and capital formation.  But this ignores the prefatory language in the provision.  The Commission only must do so for rulemaking when “required to consider or determine whether an action is necessary or appropriate in the public interest.”  In other words, the public is benefited from a consideration of the impact of a rule on “efficiency, competition and capital formation.”

Section 13(q) requires rulemaking but does not require the Commission to act in the public interest.  The provision for the most part provides no discretion.  As Section 13(q)(2) states: 

Not later than 270 days after the date of enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commission shall issue final rules that require each resource extraction issuer to include in an annual report of the resource extraction issuer information relating to any payment made by the resource extraction issuer, a subsidiary of the resource extraction issuer, or an entity under the control of the resource extraction issuer to a foreign government or the Federal Government for the purpose of the commercial development of oil, natural gas, or minerals.

Moreover, in setting out the requirements for the rule, Congress was specific and imposed no obligation to factor in the public interest.  The absence can also be seen from the one instance where Congress, in fact, required consideration of the public interest.  Section 13(q)(2)(D)(ii)(VII) instructed the Commission to consider the public interest when determining other information to be tagged electronically.  In other words, had the rule more broadly been subject to review under a public interest standard, Congress would have said so.  Having failed to do so, the mandatory cost-benefit analysis in Section 3(f) is not triggered.

So the SEC was not required to engage in a cost-benefit analysis when adopting the mineral extraction rule.  Said another way, it was not required to consider the impact on efficiency, competition and capital formation.  And, in fact, this is what the Commission really did.  It did not compute benefits but merely sought to assess the costs.  Was this an appropriate approach?  Case law suggests that it was. 

In Entergy Corp. v. Riverkeeper, Inc., 556 US 208 (2009), the Court had to address a decision by the EPA to apply a cost-benefit analysis in the context of certain rules addressing the discharge of effluents into the country’s waters under the Clean Water Act.  In providing rulemaking authority, Congress did not mandate cost benefit analysis or insist on the consideration of the public interest.  Instead, Congress instructed the EPA to adopt rules that resulted in the application of the “best technology.” 

The lower court (in a decision written by then Judge Sotomayor) found that the language precluded a cost-benefit analysis.  See Riverkeeper, Inc. v. United States EPA, 475 F.3d 83 (2d Cir. 2007) ("We conclude in any event that the language of section 316(b) itself plainly indicates that facilities must adopt the best technology available and that cost-benefit analysis cannot be justified in light of Congress's directive.").  The majority at the Supreme Court, however, concluded that the language did “not unambiguously preclude cost-benefit analysis.”  Under Chevron, therefore, the Court had to defer to any interpretation by the agency that was reasonable.

The approach in Entergy suggests that courts should take a deferential approach toward agency interpretations.  One possibility, therefore, is that Congress precluded the application of the standard in Section 3(f) by declining to tie the rule specifically to the public interest.  Another possibility, however, is that the appropriate approach on the most appropriate method of implementation is a matter to be left to the discretion of the Commission.  Accepting that a rule must be adopted that is consistent with congressional intent but assessing costs in order to minimize the impact on the capital markets is a reasonable interpretation of the requirement of Section 13(q). 

So where does this leave things?  In Dodd-Frank, Congress mandated disclosure requirements that did not have to have a nexus to the capital markets.  Without such a nexus, a cost-benefit analysis that looks to the impact of disclosure on the capital markets has no application.  It would, therefore, be inappropriate to strike this rule down because of an analysis that the SEC is not required to apply.

Primary materials on the case including the briefs filed by the Petition and the SEC can be found on the DU Corporate Governance web site.

The SEC, Social Benefit Rules, and the Inapplicability of Cost-Benefit Analysis: The Legal Challenge to Rule 13q-1 (Part 3)

The most intriguing issue in the litigation over Rule 13q-1, the mineral extraction rule, however, relates not to the costs of the rule but to the benefits.  Petitioners challenged the SEC’s decision by noting that “the Commission made no determination that the Rule would benefit investors or anyone else.”  Moreover, some of the purported benefits raised by commentators (that the Rule could “’materially and substantially improve investment decision making,’”) were, according to Petitioners, “preposterous” or were little more than “passing, indeterminate observations.” 

Thus, “the Commission relied on no empirical studies in support of the Rule, and did not even conclude that the Rule would actually produce the benefits commenters claimed.”  This was, Petitioners asserted, “an even flimsier consideration of benefits and effects on efficiency, competition, and capital formation than the rules struck down in the Chamber of Commerce cases, American Equity, and Business Roundtable.”

The tone may not be to the SEC’s liking, but the analysis from a descriptive perspective has some merit.  The SEC did not quantify the benefit provided by the rule, a usual requirement in conducting a cost-benefit analysis.  Nor did the SEC claim otherwise.  Instead, the SEC asserted that it did not quantify the benefit because it could not. 

As the adopting release indicated, the provision was intended by Congress to provide a “social benefit [that] differ[ed] from the investor protection benefits” that SEC rules typically sought to achieve.  While some commentators in the rulemaking process did assert that the disclosure would “help investors model project cash flows and assess political risk, acquisition costs, and management effectiveness,” the Commission reasoned that these “social benefits that [could not] be readily quantified with any precision” and the objectives of the rule did not “appear to be ones that [would] necessarily generate measurable, direct economic benefits to investors or issuers.” 

In defending the benefit analysis, the SEC on brief made similar observations. “Empirical evidence regarding the social benefits that may result from the transparency and ‘enhanced government accountability’ that Congress intended when it enacted Section 13(q) . . . was not obtainable” and could not be quantified “’with any precision.’”   

So what should one make of this argument?  What role, in a cost-benefit analysis, does "social benefit" play?  We will pick up the analysis in the next post. 

Primary materials on the case including the briefs filed by the Petition and the SEC can be found on the DU Corporate Governance web site.

The SEC, Social Benefit Rules, and the Inapplicability of Cost-Benefit Analysis: The Legal Challenge to Rule 13q-1 (Part 2)

The issue of disclosure largely unmoored from the capital markets is a central issue in the litigation over the validity of Rule 13q-1, the resource extraction rule. 

The Petroleum Institute and the Chamber of Commerce have challenged the rule on a number of grounds.  The challenge includes a First Amendment claim that we do not address.  Mostly they seek to invalidate the rule on administrative law grounds, primarily arguing that the Commission acted in an arbitrary and capricious fashion.  

Petitioners allege flaws in the cost-benefit analysis.  Many of them center upon an alleged failure to accurately assess the costs of the rule.  Petitioners assert that the Agency “vastly underestimated the Rule’s costs and used flawed methodologies to extrapolate industry-wide estimates from a miniscule subset of companies.”  They also contend that “the Commission relied on a cost-benefit analysis that was completely different from the analysis accompanying the proposed rule” and therefore, should have reproposed the rule to permit additional comment. 

Finally, the Petitioners argue that the Commission “had the ability to write the Rule in a manner that would have substantially reduced these costs. By failing to do so, did the Commission act in a manner that was arbitrary and capricious and violated its statutory duty not to place burdens on competition that are unnecessary to furthering the purposes of the Exchange Act.”

In many ways, these arguments pick up on comments made by the DC Circuit in the three earlier cases that struck down SEC Rules.  The inadequacy of cost assessment was a theme in Business Roundtable v. SEC, 647 F.3d 1144 (DC Cir. 2011). 

The need to repropose a rule came up in Chamber II.  See Chamber of Commerce v. SEC, 443 F.3d 890 (D.C. Cir. 2006) (“When, after an agency explains the basis for its preliminary conclusions by reference to the information on which it has relied and requests data regarding its conclusions, and the agency concludes no such data (or no data the agency concludes is reliable) has been produced during the comment period, the agency may develop data along the lines it has proposed to fulfill its statutory obligations without further public comment.”). 

The requirement to consider alternatives was an issue in Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005) (Chamber I).  See Id.  (“We conclude the Commission's failure to consider the disclosure alternative violated the APA.”).  For the most part, these types of arguments ought to gain little traction with the courts.  Given the high level of deference necessary to agency decisions, the threshold for invalidating agency rules on these grounds should be very high.

But having said that, the outcome may well depend upon the approach of the panel that shows up for oral argument.  Two of the panels that have struck down SEC were for the most part tough but fair on the SEC.  While reasonable minds might differ in connection with Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005) (Chamber I) and American Equity Investment Life Insurance Co. v. SEC, 613 F.3d 166 (D.C. Cir. 2010), the decisions were tightly reasoned and eminently defensible. 

In Chamber I, for example, the court overturned the SEC’s rule because of the failure to make any determination of cost.  See Id. (“That particular difficulty may mean the Commission can determine only the range within which a fund's cost of compliance will fall, depending upon how it responds to the condition but, as the Chamber contends, it does not excuse the Commission from its statutory obligation to determine as best it can the economic implications of the rule it has proposed.”).  Similarly, in American Equity Investment Life Insurance Co. v. SEC, 613 F.3d 166 (D.C. Cir. 2010), the court found that, with respect to the competition analysis, the SEC “did not make any finding on the existing level of competition in the marketplace under the state law regime.”   

In other words, these decisions did not micro-manage the rulemaking process.  They did not turn on an imprecise calculation, the failure to consider a tangential cost, or the use of one study over another.  They instead found a complete absence of a necessary analysis. 

The panel in Business Roundtable, however, took a very different approach to the analysis.  The court did not find a complete absence of analysis.  In striking down the shareholder access rule, it found that the analysis had not been adequately conducted.  In doing so, however, the court evidenced very little deference toward the agency, micro-managed the approach employed by the SEC (by, for example, specifying the studies that the SEC should or should not have used), and required consideration of tangential factors including the costs associated with the hypothetical non-use of shareholder access as a means of obtaining benefits in other forums. 

The reception by the panel to the issues raised by Petitioners about the cost analysis instituted by the SEC and about the obligation to repropose the rule will depend in large part upon the panel that shows up to hear the case.  If the panel is a panel similar in disposition to those from Chamber I and American Equity, the Petitioners will have a tough time with these arguments.  If it is a panel more in the nature of the one that decided Business Roundtable, the SEC will receive less deference and have much greater likelihood of being reversed.

Primary materials on the case including the briefs filed by the Petition and the SEC can be found on the DU Corporate Governance web site.

The SEC, Social Benefit Rules, and the Inapplicability of Cost-Benefit Analysis: The Legal Challenge to Rule 13q-1 (Part 1)

There was a time when corporate governance was neatly divided between the substance, which was a matter for the states, and disclosure, which was left to the Securities and Exchange Commission.  An attempt by the SEC to regulate substance through the vehicle of listing standards was struck down by the DC Circuit in Business Roundtable v. SEC, 905 F.2d 406 (2^nd Cir. 1989). 

The division of authority was never really that clear.  The SEC, for example, had (and still has) a practice of trying to use disclosure to influence substantive behavior.  See Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  

More importantly, however, Congress officially obliterated the distinction with the adoption of SOX, and then Dodd-Frank.  SOX gave the SEC authority over audit committees of listed companies (see Rule 10A-3) and provided a mechanism for clawing back excessive compensation, among other things.  Dodd-Frank went further and gave the Commission authority over compensation committees (see Rule 10c-1), over say-on-pay, and over the factors to be used by the board in determining director independence.  All of these inserted the SEC directly into the substance of corporate governance. 

So the SEC is no longer limited to disclosure.  This is a new task for the Commission but one that is at least something investors and others participating in the market consider important.  Dodd-Frank, however, did something even more radical to the traditional authority of the Commission.  It fundamentally altered the disclosure role of the Commission.   

Dodd-Frank required the SEC to put in place disclosure requirements that were mostly unmoored from market-related disclosure.  In other words, the SEC was ordered to adopt disclosure requirements that were foremost designed to benefit interest groups other than those operating in the market.  Resource extraction disclosure was one of them.  Section 13(q) of the Exchange Act was not primarily intended to make the securities markets more efficient, investors more informed, or shareholders more involved.  Instead, the provision, as the adopting release explained, was intended “to increase the accountability of governments to their citizens in resource-rich countries for the wealth generated by those resources.” 

To be sure, the SEC has often been subjected to requests to implement disclosure requirements that involve issues important to interest groups not participating in the market.  Just glance through the rulemaking petitions filed with the Commission.  Climate change and political contributions are issues that transcend the markets.  But they also are of interest to investors and shareholders. 

With respect to resource extraction disclosure, however, the connection between the disclosure requirement and the market is far more attenuated.  Moreover this type of disclosure is not something where the Commission has any significant expertise. 

The validity of the rule has been challenged in the DC Circuit.  The unusual nature of the disclosure requirement and the attenuated nexus to the markets may well play a role in the outcome of the case.  We will discuss these issue in this four part series of posts. 

Primary materials on the case including the briefs filed by the Petition and the SEC can be found on the DU Corporate Governance web site.

Lipton on Boards of Directors in 2013

Having just completed my first week of teaching Corporations, I thought it might be a good idea to briefly review Martin Lipton’s “Some Thoughts for Boards of Directors in 2013,” which was posted over at The Harvard Law School Forum on Corporate Governance and Financial Regulation on December 31, 2012.  By way of background for anyone not familiar with Lipton, you can find his official profile here, and Wikipedia notes (here):

In 1979 Lipton authored “Takeover Bids in the Target’s Boardroom”, the seminal article advocating the right of a board of directors to take into account the interests of all the constituencies of the corporation, a position adopted by the Delaware Supreme Court in 1985, and in more than thirty other states by statute or judicial decision and in the Companies Act 2006 of Great Britain…. In 1982 Lipton created the Shareholders Rights Plan or poison pill, which has been described by Ronald Gilson of the Columbia and Stanford Law Schools as "the most important innovation in corporate law since Samuel Calvin Tate Dodd invented the trust for John D. Rockefeller and Standard Oil in 1879." 

Lipton starts his post by bemoaning that: “The assault on the director-centric model of corporate governance continues in the shareholder activist and political arenas ….”  He then goes on to note 8 key issues facing boards in 2013:

1. Short-Termism;
2. Shareholder Activism;
3. Balancing the Roles of Business Partner and Monitor;
4. CEO Succession Planning;
5. Board Composition;
6. Special Investigations;
7. Say on Pay; and,
8. Corporate Governance “Best Practices”

While the entire post is clearly worth reading, what caught my attention was the following:

The workload and time commitment required for board service continues to escalate; the 2012 Public Company Governance Survey of the National Association of Corporate Directors reported that public company directors spent on average over 218 hours performing board-related activities, compared to the 155 hours reported in 2003.

First of all, anyone following our Director Compensation Project, wherein we noted that, “More than a dozen public company boards had directors whose compensation averaged more than $500,000 in 2011,” will realize that this equals a very nice hourly rate for at least some directors.  Second, I believe one seriously has to question whether directors, no matter how much expertise and brilliance they bring to the job, can carry out all their monitoring duties by devoting what amounts to roughly 4 hours per week to the job.  Lipton notes that there has been a rise of presumably full-time corporate governance board secretaries, and this may be a step in the right direction, but I continue to wonder whether the complexities of overseeing at least the largest of corporate enterprises might not require us to reconsider the entire part-time director model.  Obviously, this is not a new idea.  For example, Ronald J. Gilson & Reinier Kraakman wrote, in “Reinventing the Outside Director: An Agenda for Institutional Investors,” 43 STAN. L. REV. 863, 885 (1991):

We propose to create a novel position, that of the professional outside director, that would exist prior to, and apart from, the election of other directors to the boards of portfolio companies…. the new position would require a full-time commitment, and would obligate each expert to serve on the boards of perhaps six portfolio companies.

Gun Sales and the Capital Markets

Columbine.  Virginia Tech.  Aurora.  Sandy Hook.  These are only some of the most recognized mass killings that have occurred in the US since 1999.  For a longer list, go here.  The Obama Administration has indicated that it intends to propose some type of legislation in this area, including a possible closing of the gun show loophole and restrictions/prohibitions on high-capacity clips and magazines. 

Whatever happens along these lines, there is the potential for another source of regulation, the capital markets.  Freedom Group, the alleged maker of the semi-automatic rifle used by Adam Lanza at Sandy Hook is owned by Cerberus, a private equity firm.  Shortly after the shooting, Cerebrus apparently fielded a call from at least one influential investor.  As DealBook described:

An official at the California teachers’ pension fund, which has $750 million invested with the private equity firm, Cerberus Capital Management, was on the line, raising questions about the firm’s ownership of the Freedom Group, the gun maker that made the rifle used in the Connecticut school shootings.

Cerberus has since announced that it is putting Freedom Group on the market. The Firm issued a statement acknowledging the seriousness of the matter and the ongoing debate. 

It is apparent that the Sandy Hook tragedy was a watershed event that has raised the national debate on gun control to an unprecedented level. The debate essentially focuses on the balance between public safety and the scope of the Constitutional rights under the Second Amendment. As a Firm, we are investors, not statesmen or policy makers. Our role is to make investments on behalf of our clients who are comprised of the pension plans of firemen, teachers, policemen and other municipal workers and unions, endowments, and other institutions and individuals. It is not our role to take positions, or attempt to shape or influence the gun control policy debate. That is the job of our federal and state legislators.

Although professing a mostly agnostic position in the debate, Cerberus noted that "[t]here are, however, actions that we as a firm can take."  Their interest in Freedom Group would be put on the market.

we have determined to immediately engage in a formal process to sell our investment in Freedom Group. We will retain a financial advisor to design and execute a process to sell our interests in Freedom Group, and we will then return that capital to our investors. We believe that this decision allows us to meet our obligations to the investors whose interests we are entrusted to protect without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so.

The decision to sell right after Sandy Hook probably amounts to the worst time to put Freedom Group on the market.  As DealBook noted:  "It is not clear whether Mr. Feinberg [at Cerebrus] will find a ready buyer for the Freedom Group."  Nonetheless, the Firm has decided that any hit in the sale price is preferable to retaining ownership.

DealBook suggested that the difficulty in finding a buyer wasn't based on reputation and publicity but the increased possibility of gun control legislation.   As the Article noted, "Over the last two days, shares of the publicly traded American gunmakers, Sturm, Ruger & Company and Smith & Wesson, have dropped precipitously on fears of increased gun regulation." 

But, in fact, there may well be a much broader dynamic taking place.  The market is not necessarily reacting to the preceived decline in profits.  After all, some modest gun control legislation is not likely to significantly impact sales or profits.  

What may well be driving down value is the reaction of shareholders.  The profits of owning Freedom Group are outweighed by the publicity.  Certainly, this is suggested by the concerns expressed to Cerberus by CalSTRS.  Any other private equity fund with significant investments from CalSTRS or other similarly opinionated pension plans would likely be hesitant to buy Freedom Group.  Other gun companies may see downward pressure on shares as other pensin plans consider disinvestment. 

Clearly, this is an area of concern for at least some public pension plans.  Adam Kanzer at Domini Funds, in an editorial, Let’s stop investing our retirement funds in lethal weapons, suggests that mutual funds may also need to be concerned with ownership interests in gun manufacturers.  

His editorial focuses on the ownership interest by Vanguard in Smith & Wesson and Sturm, Ruger, "the largest publicly traded gun manufacturers."  Apparently Vanguard justified the interests both because the gun manufacturers were included in various indexes used by Vanguard funds and because the funds had a fiduciary obligation to maximize profits. These are, as he notes, explanations that could be given by an advisor to any mutual fund complex.  

The approach, he asserts, "should serve as a wake-up call for the millions of Americans invested in so-called ‘low cost’ index funds."  Said another way, individuals can play a role in the capital market response by considering the investments held by the mutual funds where they leave their IRA. To the extent that investors withdraw their holdings, investment advisors will react accordingly. 

Should gun manufactureres have trouble in the capital markets, they may have an incentive to adopt self-imposed limits.  They could, for example, opt to end the manufacture of certain weapons that, if used in a mass killing, would bring the most negative publicity.  The penalty exacted by the capital markets, to the extent there is one, may be reduced for companies that are seen as less likely to produce the sort of negative publicity engendered by what happened at Sandy Hook.

The Market for IPOs and the JOBS Act

For much of the last decade, there has been an attempt to explain the decline in IPOs in the US by referring to over regulation and excessive litigation.  The over regulation argument is often a mechanism used to criticize the provisions in Sarbanes Oxley.  

Often lost in the debate were a host of structural explanations (aside from the condition of the economy).  The elimination of Glass Steagall essentially spelled the demise of independent investment banking firms (they have mostly been absorbed by or converted into commercial banks), eliminating a class of freestanding intermediaries that profited from public offerings and active capital markets.  Public offerings in the US are more expensive than those conducted overseas. 

Concern over the strength of the IPO market resulted in legal changes in the JOBS Act.  The Act included the "on ramp" provisions designed to reduce the costs of going public.  The Act was also intended to reduce the costs associated with public company status for a five-year period. 

Some of the provisions of the Act may encourage public offerings on the margin.  The process of confidential review will allow companies to discuss issues with the Commission before deciding to go public.  The need for only two rather than three years of audited financial statements may reduce some costs associated with the offering process. 

Other provisions will likely have little or no impact on the decision, at least if the primary issue turns on costs.  The elimination of an advisory vote on compensation or the exemption from requirements that do not exist (i.e.  mandatory rotation of auditors) are not likely to reduce costs.  Instead, they seem to be more an effort to parry aside requirements (or potential requirements) strongly disliked by management.  Perhaps there may be a marginal offering that goes forward because management, having avoided an advisory vote on compensation, is more psychologically disposed toward the public offering process. 

Nonetheless, the data for 2012 suggests that the public offering process has less to do with marginal costs than with the underlying state of the economy.  Stats on IPOs for 2012 at first blush look dire. As the WSJ reported, 2012 saw a global decline in the number of IPOs. 

The drop in 2012 was driven by slowdowns in China and Europe, which offset a rise in the U.S. In 2011, 1,277 companies went public globally, raising $159.8 billion. In 2012, only 751 companies made initial offerings, raising $113.1 billion, a 29% decline in the amount of funds raised.

Despite the downturn, the US faired reasonably well.  In fact, the amount raised in IPOs in the US increased.  As the article noted: 

more money was raised in U.S. IPOs versus China and Hong Kong in 2012 for the first time since 2008, according to data provider Dealogic. The U.S. raised $38.9 billion, a jump of 15%, while China's markets raised $21.8 billion, a decline of 59%. Europe saw just $13.8 billion raised by IPOs in 2012, a decline of 62% from a year earlier.

The statistics suggest that the pace of public offerings is mostly a factor of underlying economic fundamentals.  Europe and China have been experiencing slower economic growth and, simultaneously, have seen a decline in the amount raised in IPOs.  The US has been gradually emerging from the recession of 2008 and has seen an upswing in the amount of capital raised in the initial public offering process.

Legal Scholarship and the Decline in Hard Copy Publications

In addition to all things corporate governance, we occasionally delve into a discussion about the impact of the Internet (and blogging) on legal scholarship.  As discussed in Essay: Law Faculty Blogs and Disruptive Innovation, faculty law blogs have established a niche in the legal scholarship continuum.  They outperform traditional law reviews by providing the legal market with commentary on legal developments in an accessibly written, quick format. 

They can comment on pending legislation, proposed rules, and cases on appeal.  Commentary on the same matters will be out of date by the time it is published in a traditional law review.  Evidence of the usefulness of blog posts can be seen in the growing number that have been cited by courts (one blog, Sentencing Law and Policy, has over 40 citations) and by law reviews (one blog, the Volokh Conspiracy, has over 700 law review citations).  The data for law review and court citations, current as of the summer of 2012, is here. 

At the same time blogs have grown in citations, law review subscriptions, as was noted in Essay: Law Faculty Blogs and Disruptive Innovation, have fallen off a cliff.  The data shows that in 2011 "no major law review had more than 2,000 paying subscribers. The Harvard Law Review remains the top journal, but its paid circulation has declined from more than 10,000 during much of the 1960s and ’70s to about 5,000 in the 1990s to 1,896 last year.” Law Review Circulation 2011: More Change, More Same, 1 JOURNAL OF LEGAL METRICS (2012). 

So what's the explanation for this?  One possibility is that lawyers read law reviews much the way they did before only electronically rather than in hard copy.  Reviews are easily available in the assorted legal data bases.  Moreover, some pieces are published on SSRN. They can, therefore, be easily obtained without the need for an actual subscription. 

At the same time, the data may suggest that hard copy law reviews are read less often and, as a result, less relevant in the legal debate.  In a different context, the WSJ suggests that the decline in hard copy subscriptions cannot be explained by a shift in reader preference to electronic versions. 

First, the demise of the hard copy publication has been overstated.  As the article noted:

Hardcover books are displaying surprising resiliency. The growth in e-book sales is slowing markedly. And purchases of e-readers are actually shrinking, as consumers opt instead for multipurpose tablets. It may be that e-books, rather than replacing printed books, will ultimately serve a role more like that of audio books—a complement to traditional reading, not a substitute.

Second, reader willingness to resort to electronic publication has become highly dependent upon the type of book involved.  Much of the ereading phenomena has been in fiction.  See Id.  ("Screen reading seems particularly well-suited to the kind of light entertainments that have traditionally been sold in supermarkets and airports as mass-market paperbacks.").  Other types of books are less likely to be read in that format.

Readers of weightier fare, including literary fiction and narrative nonfiction, have been less inclined to go digital. They seem to prefer the heft and durability, the tactile pleasures, of what we still call "real books"—the kind you can set on a shelf.

Of course, the comparison is not precise.  Lawyers may obtain an article through an electronic search and print it off.  In other words, they do not need a subscription to read the article in hard copy format. 

Nonetheless, the decline in subscriptions probably means that law reviews are read less often.  At a minimum, lawyers access articles through data base searches.  In those circumstances, the entirety of the issue will go unexamined.  The idea that a practitioner, law clerk or judge will receive a hard copy of a law review (or a copy of the table of contents of a hard copy law review) and read something out of curiosity is likely in decline.

With all of that said, law review articles still represent the coin of the realm in legal academia.  Hiring and tenure depend upon it.  Blogging receives little credit (it is not a good idea for an untenured faculty member to blog at the expense of publishing traditional law review articles). 

The Decline in Securities Class Action Lawsuits

The statistics are in for the number of securities class actions filed in 2012.  As the Stanford Securities Class Action site reports, the number fell to 149. (Kevin LaCroix reports over at the D&O Diary puts the number at 156).  The decline was apparently a result of a dearth of claims filed in the 4th quarter.  As Kevin noted,  "There were 45, 45 and 41 filings during the first, second and third quarters, respectively. However, in the fourth quarter there were only 25 new securities class action lawsuit filings."

Using the data from the Stanford site, the total number of class action filings is the lowest since 2006 (when the number was reported at 120) and the second lowest in the last 10 years.  Since Stanford has been collecting data (beginning in 1996), only one other year had a lower number of filings than in 2012 when 1996 reported in at 111 filings.   

It would be premature to draw conclusions from a single year's data (indeed, apparently, from a single quarter's data).  As Kevin notes:

The decline in the number of new securities lawsuit filings during the fourth quarter of 2012 is interesting, but at this point it is hard to know what it might mean, and it is far too early to jump to any conclusions about possible permanent shifts in the level of securities suit filings. There have been periods before (for example, at the end of 2006 and the beginning of 2007) when there were lulls in the level of securities suit filings, but at least in the past, the lulls in filing levels have proven to be temporary and relatively short-lived. Indeed, the lull at the end of 2006 and the beginning of 2007 was followed by a surge of new securities filings during following periods, as securities suits related to the subprime meltdown and credit crisis came flooding in.

He lists as possible explanations the absence of any cyclical phenomenon to drive the filings.  In 2011, for example, there was a significant increase in filings against Chinese companies.  In 2001, the IPO Allocation lawsuits drove up the numbers. 

Other possibilities include an increase in the number of individual actions, the efforts by the plaintiffs bar to diversify by bringing other types of lawsuits, and coincidence.  Of course, it could also reflect a continued antagonism toward securities suits in the federal courts. 

The decline could, for example, be a result of the Supreme Court's decison in Morrison.  Thus, as Kevin notes, the number of suits against non-US companies declined from 68 in 2011 to 26 in 2012.  Some of the difference was attributed to a reduction in suits against Chinese companies.  At the same time, however, some of the explanation may be from the Court's decision that Rule 10b-5 lacks extraterritorial application.

Similarly, the Supreme Court's decision in Janus has made it more difficult to file fraud suits against accountants and other third parties with respect to false disclosure by issuers.  According to one report, for example, no accounting firm was named as a defendant in an accounting fraud suit as of November 2012. 

Whether the 4th Quarter of 2012 suggests a trend remains to be seen.  But to the extent the reduction in the number of lawsuits is structural, it could be permanent.  

The SEC, Rulemaking and the Disclosure of Political Contributions: The Impact of the Addition to the Unified Agenda

Considerable attention was paid last week to the SEC's decision to add a possible rule proposal on political contributions to its regulatory agenda.  The Commission indicated this possibility by notifying the public of an addition to the Unified Agenda. The Unified Agenda is published twice annually and contains the regulatory agendas for approximately 60 government agencies and commissions, including independent agencies.  The notice also resulted in the item being added to the Agency Rule List for the SEC.

The notice by the SEC stated that "[t]he Division [of Corporation Finance] is considering whether to recommend that the Commission issue a proposed rule to require that public companies provide disclosure to shareholders regarding the use of corporate resources for political activities."  The next step, according to the announcement, would be an NPRM (Notice of Proposed Rulemaking).  The notice gave April 2013 as a date for the NPRM.  The notice also assigned a Regulatory Identifier Number (RIN) (3235-AL36) to the matter.  The number that will stay with the matter until completed or withdrawn. 

Some described the Agency as "tak[ing] up a petition that asks the agency to craft a rule forcing publicly traded companies to list their political contributions on annual statements to shareholders."  Others noted that the impending rule "could require all publicly traded corporations to detail how much money they give for political activities, including to tax-exempt advocacy groups and trade associations such as the U.S. Chamber of Commerce."  

In fact, the information provided by the Commission was quite limited and tells little about what will actually happen in this area in the future.  The Unified Agenda is published twice a year online (with the exception that the Regulatory Flexibility Act requires publication in the Federal Register of rules that will have a significant economic impact on a substantial number of small entities). The Fall version also includes each agency's "regulatory plan."  See Executive Order 12866 (Sept. 30, 1993) (requiring agencies, including independent agencies to develop a regulatory plan that identified the "most important significant regulatory actions that the agency reasonably expects to issue in proposed or final form in that fiscal year or thereafter."). 

The Agenda is designed to alert the public about what the agency thinks it might accomplish during the next 12 months.  See Regulatory Information Service Center ("The activities included in the Agenda are, in general, those that will have a regulatory action within the next 12 months.").  Nonetheless, this is not a hard and fast requirement and matters that will take longer may also appear on the Agenda.  See id.  ("Agencies may choose to include activities that will have a longer timeframe than 12 months."). 

Publication in the Unified Agenda carries no firm obligations.  The matter need not be completed within the time period specified.  According to the Regulatory Information Center, agencies disclosing in the Unified Agenda:

have tried to predict their activities over the next 12 months as accurately as possible, but dates and schedules are subject to change. Agencies may withdraw some of the regulations now under development, and they may issue or propose other regulations not included in their agendas. Agency actions in the rulemaking process may occur before or after the dates they have listed. The Unified Agenda does not create a legal obligation on agencies to adhere to schedules in this publication or to confine their regulatory activities to those regulations that appear within it.

Moreover, agencies can change their mind and withdraw matters from the Unified Agenda. See 105 Nw. U.L. Rev. 471, 507 (2011) ("an Agency can change its mind and remove the proposal from the Agenda.  See most important significant regulatory actions that the agency reasonably expects to issue in proposed or final form in that fiscal year or thereafter.").

So what does all of this mean with respect to the proposal put forth by the SEC concerning political contributions?  The SEC is not issuing a firm commitment that there will be a rule proposal or that any action will be taken by a date certain.  The SEC is only stating that it cannot rule out that a proposal may surface sometime in the next 12 months.  The notice provides no meaningful information about the contents of any possible proposal. 

As an example, SEC has also disclosed on the Unified Agenda that it is considering pay ratio and other executive compensation disclosure rules, something mandated in Dodd-Frank.  See RIN: 3235-AL00 ("The Division is considering recommending that the Commission propose rules to implement sections 953 and 955 of the Dodd-Frank Act, which require disclosure of pay-for-performance, pay ratio, and employee and director hedging."). 

The proposed action was first added to the Unified Agenda in the Spring of 2011 with a date for the NPRM of August 2011. The proposal was republished in the Fall of 2011 with an NPRM of December 2011.  The SEC's current rule list still contains a reference to this proposal and provides an NPRM date of February 2013.  In other words, the proposal has been in the Unified Agenda for almost two years, with no public action haven yet been taken by the SEC.  

So publication of the notice concerning disclosure of campaign contributions in the Unified Agenda is a step forward.  By adding the matter to the Unified Agenda, the staff can make a recommendation and the Commission can propose a rule.  In effect the public has been alerted that this could occur.  But the decision comes with no meaningful legal obligations to move forward. 

Black on Behavioral Economics, Reasonable Investors & Efficient Markets

Barbara Black has posted "Behavioral Economics and Investor Protection: Reasonable Investors, Efficient Markets" on SSRN.  Here is the abstract:

The judicial view of a “reasonable investor” plays an important role in federal securities regulation, and courts express great confidence in the reasonable investor’s cognitive abilities. Behavioral economists, by contrast, do not observe real people investing in today’s markets behaving as the reasonable investors that federal securities law expects them to be. Similarly, the efficient market hypothesis (EMH) has exerted a powerful influence in securities regulation, although empirical evidence calls into question some of the basic assumptions underlying EMH. Unfortunately, to date, courts have only acknowledged the discrepancy between legal theory and behavioral economics in one situation, class certification of federal securities class actions. It is time for courts to address the gap between judicial expectations about the behavior of reasonable investors and behavioral economists’ views of investors’ cognitive shortcomings, consistent with the central purpose of federal securities regulation: protect investors from fraud.

All of which reminded me of a quote from Ronald Coase (available here):

The rational utility maximizer of economic theory bears no resemblance to the man on the Clapham bus or, indeed, to any man (or woman) on any bus. There is no reason to suppose that most human beings are engaged in maximizing anything unless it be unhappiness, and even this with incomplete success.

The Promise and Peril of Crowdfunding: The Need for Legislative Reform (Part 4)

We have been discussing crowdfunding and have proposed that the JOBS Act be amended to give the SEC greater discretion over the computation of the income/net worth cap used to determine the amount that individuals can invest. There is at least one more thing, however, that must be done in order to allow for crowdfunding to achieve its potential as a source of capital for small start ups.

As we have noted, most start ups fail. This is an inherent part of the investment process. Start ups are risky.  Start ups in the crowdfunding context are likely to be particularly risky.  If they weren't, they would probably be able to raise funds from banks or venture capital funds.  Crowdfunding, therefore, is likely to be a source of last resort for capital, accessed only by those shut out of other sources.  As a result, investors buying shares in a crowdfunding investment will often lose their investment.

Nothing could or should eliminate this type of risk.  Trying to pick the businesses of the future, a form of prognostication, requires that creation of many start ups in an effort to find the most efficient survivors.  The economy benefits from this type of risk taking.

What it does not benefit from is the use of this type of offering to commit fraud.  Fraud can occur because the businesses are fraudulent ab initio and the amount invested may be immediately stolen.  In other cases, the amount from investors will be dissipated later.  The fraud will be disguised as business failure.  To the extent that crowdfunding becomes rife with fraud, it will gain an unsavory reputation.  Serious investors will stay away.  Companies using crowdfunding will be suspect.  It will not become a significant source of capital for legitimate start ups.

There will be problems with enforcement.  The amounts raised in crowdfunding are low (capped at $1 million).  The amount is not enough to spur many private actions.  The small amounts are also not likely to result in an extensive commitment of resources from the SEC.   Nor will the states play a significant role.  The JOBS Act preempted state registration requirements in connection with crowdfunding offerings. 

Portals must register with FINRA so it has some enforcement authority over the Internet sites advertising the offerings.  The authority, however, is limited and does not extend to the companies making the offerings. 

Yet enforcement and the prevention of fraud is critical to the success of crowdfunding.  The JOBS Act, therefore, needs to be amended in a manner designed to reduce the risk of fraud.  SOX took this approach by dramatically increasing the criminal penalties resulting from false certifications by CEOs and CFOs.  Certainly tough criminal sanctions for misbehavior in the crowdfunding context would help.

In addition, however, there needs to be a guaranteed increase in enforcement.  This can occur through dedicated appropriations for crowdfunding enforcement.  But this approach will be prone to changes over time.  A better solution would be to provide a dedicated source of funds for enforcement.  This could come from fees paid to the SEC in connection with offerings or an annual amount paid by portals.  This is nothing new.  The PCAOB is privately funded. 

Moreover, there is no reason that the crowdfunding industry should not fund stronger enforcement.  Ultimately, the industry will benefit from the increase in investor trust that comes from a reduction in fraud. 

And one additional change.  Allow the SEC to make criminal referrals and require that the US Attorneys Office receiving the referral to investigate and determine whether the referral requires criminal action.  The SEC can make referrals but the US Attorneys Office has no obligation to respond.  This should also change. 

The Promise and Peril of Crowdfunding: The Need for Legislative Reform (Part 3)

Crowdfunding is designed to allow unaccredited investors to invest in high-risk companies in a cost effective fashion.  Congress sought to accomplish this task primarily by reducing the amount of disclosure given to investors while limiting the amount that can be invested in any given year.  Thus, the primary protection for investors is a cap on investments. 

Yet the cap provides no meaningful protection for investors.  The cap does not ensure that investors can only invest what they can afford to lose.  To understand this, it is necessary to examine the mechanics of the cap.

The cap is computed based upon either the gross income of the investor or his/her net worth.  If either is less than $100,000, the individual can invest 5% each year (but not less than $2,000).  If more, the percentage doubles to 10%.  To get an idea of the amounts that these caps can yield, the statute imposed an outer limit on crowdfunding investments at $100,000 a year.  In other words, a cap designed to limit investors to an amount they can afford to lose can permit investments of up to  $100,000 a year.

Interestingly, the article in the NYT defines the cap in this fashion. "For example, legislators capped the amount that unaccredited investors can invest through crowdfunding in a given year to $2,000, or 5 percent of their income, whichever is greater."  In fact, investors can invest significantly greater amounts than the NYT suggests.   

The central problem, however, is in the definition of income and net worth.  The Act required the Commission to take the definition of net worth and income used in crowdfunding from the accredited investor standard.  Income in the accredited investor standard is really gross income.  It does not take into account deductions such as rent, food or tuition payments.  Net worth in the accredited investor standard includes all assets, whether liquid or illiquid (other than the primary residence).  Thus, net worth includes farmland, furniture, cars, and at least some assets in retirement plans. 

Stuck with this definition, the SEC cannot define net worth and income in the crowdfunding context in a manner that is designed to ensure that the the amount invested is an amount that investors can afford to lose.  Thus, for example, the SEC cannot exclude from the definition of net worth the assets held in retirement plans.  Likewise, the SEC cannot require that, in computing income for purposes of determining the income cap, investors deduct living expenses. 

The result is that many investors with modest income will have a net worth greater than $100,000 because of assets in retirement accounts.  They can, therefore, invest 10% of this amount.  It is unlikely that this is an amount they can afford to lose.  Moreover, these individuals may well have modest incomes and be cash poor.  Investments in crowdfunding offerings will need to come from a ready source of liquid funds, with early withdrawals from retirement plans an obvious source.

Thus the caps permit significant investments of amounts that unaccredited investors likely cannot afford to lose.  They also promote use of funds from retirement accounts, replacing what are probably conservative investments with high-risk purchases that will likely yield no significant return.  

To make crowdfunding really work, the JOBS Act should be amended.  The most significant amendment would be to give the SEC the authority to define net worth and income in a manner that is designed to ensure that investors can invest only what they can afford to lose.  This will in turn require that the SEC not use the definitions from the accredited investor standard.  In so doing, the SEC can define income as an amount net of living expense.  It can define net worth as an amount that does not include amounts in retirement and perhaps illiquid assets such as farmland.  

To the extent most unaccredited investors can only invest $500 or $1,000 a year, the amount would probably resemble what many spend in a year on lotto tickets.  Such a cap will allow for the millions of investors to participate in crowdfunding offerings and allow many small start ups to access this unique source of capital.  At the same time, it will prevent unaccredited investors in most cases from investing a sizeable chunk of their net worth or retirement assets in high risk ventures. 

In time, it may be possible to treat crowdfunding offerings on par with lotto tickets.  Eventually, the caps on investment can be increased or eliminated altogether.  But this is premised on the idea that investors have sufficient understanding of the risks that allow them to equate crowdfunding investments with lotto tickets.  That will require a significant level of investor education that has not yet taken place.