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Thursday
Aug302012

Rosenthal v. New York University: No Legal Obligation to Award MBA after Student Pled Guilty to Insider Trading

In Rosenthal v. New York University, No. 10-4168-cv., 2012 WL 1700843 (2nd Cir. May 16, 2012), the Second Circuit Court of Appeals affirmed the district court’s dismissal of Ayal Rosenthal’s claims for relief. The court also held that New York University (“NYU”) did not have a “legal obligation” to confer a Master of Business Administration (“MBA”) to Rosenthal after he pled guilty to insider trading while attending NYU.

According to the Complaint, Rosenthal was a certified public accountant at Pricewaterhouse Coopers (“PwC”) while attending NYU’s Stern School of Business (“Stern”) as an MBA candidate. Through his employment at PwC, Rosenthal learned of “material non-public information” concerning a transaction between two publicly traded companies; he provided this information to his brother, who subsequently traded on this tip. Rosenthal completed the academic requirements for an MBA in December 2006; he pled guilty to insider trading in February 2007. He never disclosed to Stern that he was the subject of a criminal securities investigation, but somehow Stern discovered Rosenthal’s guilty plea in February 2007 and commenced a disciplinary review. In October 2007, Stern informed Rosenthal that he would not be awarded the MBA.

Rosenthal asserted that his implied contract with Stern prohibited the university “from punishing him for off-campus conduct, however egregious the conduct or connected it may be to his academic pursuits.” However, the court reasoned that Stern’s Code of Conduct provided notice to students that they must act with “personal honesty, integrity, and respect for others,” and Stern informed students that the faculty’s disciplinary jurisdiction includes “[v]iolation of federal, state and local laws.”

Rosenthal also argued that Stern’s policies contradicted  “general [NYU] policy” which prohibited disciplinary action for violations outside the academic context; therefore, according to Rosenthal, Stern’s policies that were “inconsistent with that [NYU] policy are themselves without force.” After noting that NYU’s policies were confusing, the court held that under New York law, courts give great deference to a university’s decision, and courts “will disturb [universities’] decisions only if their actions are arbitrary, irrational, or in bad faith.” The court reasoned that, “[w]ithout question, a business school faculty could reasonably believe such [criminal] conduct is not befitting of a member of the academic business community . . . .” Accordingly, the conflicting interpretations were left to the university to reconcile, and neither NYU nor Stern was found to have “acted arbitrarily, irrationally, or in bad faith.”

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

Wednesday
Aug292012

Law Faculty Blogs and Disruptive Innovation: A Conclusion

Where does this leave blogging by law faculty?

First, law blogging is a disruptive innovation that has the capacity to affect faculty reputation, law school rankings, and the continuum of legal scholarship.

Second, a class of widely recognized and widely cited faculty law blogs has emerged.  These blogs reflect some level of intermediation and have become a trusted source of legal authority.

Third, faculty law blogs, at least those that are widely recognized and widely cited, represent a form of scholarship.  They address a gap left in the scholarship continuum left over by traditional law reviews.  Moreover, the effort to reduce this role through the implementation of online supplements has so far failed. 

Fourth, as a disruptive technology, faculty law blogging represents a mechanism for challenging the status quo with respect to faculty reputation.  The evidence indicates that blogging can lead to an increase in faculty reputation (evidenced by a correlation with SSRN rankings).  Moreover, other evidence of faculty reputation comes from surveys of the number of citations in legal periodicals by faculty.  Blog posts written by faculty that are cited in legal publications are counted as citations in these surveys.  Thus, blogging may elevate a faculty member's ranking in this metric as well.  

Fifth, as a disruptive innovation, faculty law blogs provide a mechanism that can be used by non-elite law schools to improve their reputation and their rankings.  With few barriers to entry, faculty law blogs can increase the awareness of a law school.  Moreover, the very top schools have not targeted faculty law blogging.  As a result, it provides a unique opportunity for faculty at less elite law schools.  The evidence suggests that in fact these schools are taking advantage of this opportunity.   

Sixth, the most significant barrier to blogging is time.  Law schools using blogging as a means of increasing awareness would rationally want to create an internal system of rewards designed to promote the practice.  In addition to rewarding the practice in the context of salary determinations (not to mention tenure and promotion), law schools presumably could encourage blogging at the expense of other activities. 

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Tuesday
Aug282012

Law Faculty Blogs and Disruptive Innovation: The Impact on Law School Reputation

Law faculty blogs also have the capacity to disrupt law school rankings. 

US News uses a variety of factors to rank law schools.  The single largest component is reputation, with 25% from other academics and 15% from practitioners and judges.  These scores are generally thought to depend upon the scholarly reputation of a law school’s faculty.  Scholarly reputation in turn depends upon the quality and placement of scholarship, something evidenced through publication in elite journals. Reputational rank is notoriously hard to change and for the most part remains constant over time.   

Assessing a faculty, whatever the basis, is not easy.  With approximately 200 law schools, many schools and their faculty are not particularly well known.  In those circumstances, reputation can depend upon incomplete information, often unrelated to the actual quality of the law school.   In other instances, law schools (and their faculty) are well known but they nonetheless seek to improve their relative rank.   In both cases, law schools engage in marketing campaigns designed to promote a school’s reputation.  Expensive, the approach favors those schools with the resources necessary to embark on an effective campaign.

Blogging has the capacity to improve a law school’s reputation in two ways.  For less well known schools, blogging can increase name recognition.  These law schools can benefit both from blogs that contain substantive posts and blogs that emphasize description over analysis.  This might occur, for example, on blogs that focus on timely disclosure of legal developments, something that can attract attention from practitioners, academics, and others seeking to remain substantively current.  While these blogs may duplicate functions already performed by non-academics such as law firms, they provide a useful service that will help elevate awareness of the relevant law school. 

Law schools already well known will benefit primarily from blogs that emphasize substantive analysis.  Particularly when writing for a widely read law blog, faculty can become better known among academics, judges, and practitioners, all of whom fill out the reputational survey circulated by US News.  With a significant Internet footprint, they can be located through the use of search engines, something commonly used by the press.

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Monday
Aug272012

Law Faculty Blogs and Disruptive Innovation: Routing Around Reputational Metrics

Law blogging represents a method for routing around traditional means of determining reputation.  Faculty can increase awareness of their expertise and scholarship without having to obtain “prestige slots” in elite journals.  Moreover, with blogs increasingly used for authority in law review articles, posts represent a mechanism for increasing the number of faculty citations.

Evidence of improved reputation can be seen from the correlation between blogging and SSRN downloads.  Blogging can increase downloads in two ways.  First, articles can be marketed directly through references and links in posts.  These references will have a lingering effect.  Even after blog posts have disappeared from the main page, they will be subject to subsequent discovery by those searching the Internet.     

Second, a sustained presence on the Internet can enhance name recognition.  Substantive, high quality analytical posts will associate increased awareness of particular faculty with expertise.  That in turn can stimulate interest the faculty member’s scholarship, even if the articles are not specifically mentioned in posts.  The result will be an increase in SSRN downloads.   

This can be seen from the apparent correlation between law blogging and SSRN rankings. An analysis of the top 200 law faculty by downloads (on May 1, 2012) over the prior year revealed 140 US law faculty scholars (“Download Rankings”).  The elite schools (arbitrarily determined to be the top ten schools in the US News rankings) produce 33% (46) of the US Faculty in the Download Rankings.  That increases to 58% (81 out of 140) when considering the top 25 law schools, and 72% (101 out of 140) when examining the top 50.  Law schools outside the top quartile contributed only 39 or 28% of the US Law Faculty on the Download Rankings.

There is at least some correlation between the Download Rankings and blogging.  Of the 39 faculty outside the top 50, a significant number (11) were affiliated with blogs.  The relationship, however, is even more pronounced when comparing faculty at elite law schools (the top 10 in the US News Rankings) with those just outside.   Faculty from elite schools who appear in the Download Rankings do not blog.  Yale has seven faculty in the top 200; only one blogs.  Harvard has 12; only one blogs.  At Stanford, Columbia, NYU, Berkeley, Penn, Virginia and Michigan, none of the faculty in the Download Rankings blogs on a regular basis. 

For law schools ranked immediately outside the top 10, however, the situation is markedly different.  Georgetown (ranked 13th), has four faculty in the Download Rankings, three of whom blog.  Of the three faculty members in the rankings from UCLA (ranked 15th), two blog.  GW (ranked 20th) has six faculty in the Download Rankings, four of whom blog.  The two faculty from Washington University (ranked 23rd) in the Download Rankings also blog. 

The data is suggestive.  For faculty teaching at an elite law school, reputation is most likely based upon the status quo.  Because they benefit from the existing set of biases, these professor have little incentive to route around the traditional criteria for determining reputation.  For faculty outside this group, however, they benefit less from the status quo and have greater incentive to embrace mechanisms such as blogging that permit them to route around the status quo.    

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Saturday
Aug252012

Bratton and Levitin on the Role of Special Purpose Entities in Financial Scandals

Of all the papers posted on SSRN in the last 60 days, the most downloaded in the category of "Corporate Governance U.S." was "A Transactional Genealogy of Scandal: From Michael Milken to Enron to Goldman Sachs."  Here is the abstract:

Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit. The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality. When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership. The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.

Friday
Aug242012

Law Faculty Blogs and Disruptive Innovation: Law School Reputation and the Facts on the Ground

So blog posts can constitute scholarship.  They also fill a gap in the scholarship continuum left over by traditional law reviews. 

Characterizing blog posts as scholarship has other consequences. Blogging can elevate a faculty member's reputation, routing around some of the biases that apply to the law review submission process.  Blogging can also elevate a law school's reputation, something that can affect rankings. 

To the extent this is true, one would suspect that blogging is dominated by persons outside of the schools that benefit from the current status quo.  In fact, faculty at law schools outside the highest ranked schools dominate faculty law blogging. 

On June 1, 2012, there were approximately 302 law school faculty who actively blogged, a number that has been relatively stable over much of the last six or so years.  Only 8% of the law faculty who blogged came from the top 10 schools and only 38% came from the top 50.  The remaining 62% came from lower ranked schools. 

In at least some cases, blogging represents a zero-sum game with respect to other types of scholarship. Protracted output on the Internet can reduce the time available for law review articles or papers posted on SSRN (although for some, the two can complement each other).  To the extent true, the data suggests that faculty from non-elite schools see blogging as an important mechanism for participating in the legal debate that, in some cases, is more important than other forms of scholarship. 

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Thursday
Aug232012

Law Faculty Blogs and Disruptive Technology: Law Blogs and a Permanent Place in the Scholarship Continuum

This suggests that faculty law blogs have become a permanent part of the scholarship continuum.  Moreover, this has both relieved law reviews of a significant role but also consigned law reviews to a smaller niche in the scholarship continuum. 

Law reviews will represent a repository for lengthy analysis on legal topics that are typically written in dense prose and heavily footnoted.  To the extent that a legal topic requires detailed and extensive consideration in a non-time sensitive fashion, traditional articles meet these needs.  Particularly in common law systems that accede to courts broad policy discretion, there will always be a need for thoroughly researched pieces that analyze and bring order to areas of law or that suggest alternative approaches. 

Blog commentary has become the place of choice for rapid analysis of current developments.   Quality is to some degree enforced by the intermediation provided by well known, often cited law blogs that have an incentive to maintain their reputation by ensuring high quality posts.  Yet even if weak scholarship occasionally emerges onto the blogosphere, it is not without value.  Bad ideas are still ideas and they can spur a debate that may result in a better end result.   

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is post here.

Thursday
Aug232012

Law Faculty Blogs and Disruptive Innovation: Law Reviews Fight Back (The Fading Promise of Online Companions)

Part of the evidence of the influence of faculty law blogs comes from the response of law reviews.  They have sought to address the concerns with timliness and relevancy by developing online companions. 

The contents of online law reviews range from full length articles to op ed pieces and blog style commentary.  Most online supplements seek “intermediate” scholarship that discusses current issues or responds to articles in the hard copy journal.  The pieces are expected to be “lightly footnoted” and shorter than traditional articles. Some specifically seek “op ed” or blog length pieces written in a “highly readable style.”  

Online companions have a number of advantages.  They are published more quickly than traditional reviews and offer some intermediation, including cite checking and editing by students, albeit at a reduced level.  Online publication can also benefit from the “good name” of the law school and the inclusion in legal data bases. 

They have not, however, succeeded in stemming the influence of faculty law blogs.  With respect to shorter, op ed or blog style pieces, the advantages of online companions in comparison to widely cited faculty law blogs is unclear.  The “good name” of the law school has some value, but for online publications, the value is subject to a significant discount.  Moreover, the value of the “good name” arises at least in part from the rigorous selection, editing and cite checking process that precedes publication.  For shorter, op ed and blog like pieces, these services will be less important.  

Moreover, the online companions have struggled to find sufficient current and topical issues.  Many online companions have largely abandoned this approach and mostly published responses to hard copy articles.  These are less time sensitive and often can be arranged with the assistance of the author of the hard copy piece.  In addition, attracting and publishing intermediate scholarship on a regular basis will tax the resources of many law reviews.   

For all of these reasons, online companions have not succeeded in replacing faculty law blogs as a source of timely scholarship on current developments. 

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Wednesday
Aug222012

Law Faculty Blogs and Disruptive Innovation: Replacing Law Reviews

The law blogosphere is no longer a state of nature lacking in intermediation.  A cluster of faculty law blogs have emerged that are often cited by courts and legal publications.  A list of these blogs can be found here.

The reasons are not hard to see.  They fill a gap in the scholarship continuum largely left unaddressed by traditional law reviews. 

There has been plenty of criticism of law reviews.  They have been criticized for their length and questionable relevancy.  One of the most significant is that they take significant time to write and significant time to publish.  When they are out in hard copy, many legal debates are already over.  Many metrics show a decline in the influence of law reviews, whether Supreme Court citations or paid subscriptions.

Faculty law blogs, in contrast, represent a superior method for disseminating legal analysis in some cases.  Law blogs are often the first (and sometimes the only) source of analysis on current developments, whether new cases, proposed legislation, or pending rules.  They can quickly introduce ideas into an ongoing debate or apply existing ones to new developments.  Nor do these posts consist only of unsupported opinion.  They frequently refer to legal authority, although in a less dense, more flexible narrative.  As a result, the analysis is more accessible to those outside the academic community, including judges, practitioners, and regulators. 

In other words, blog posts not only can qualify as scholarship but they can qualify as better scholarship than law reviews, at least in some cases. 

Law reviews have tried to stem this influence through online companions.  We will address the success of this approach in the next post. 

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Tuesday
Aug212012

Law Faculty Blogs and Disruptive Innovation: Blog Posts and Introduction of Intermediation on the Blogosphere

Faculty law blogs represent an almost classic case of disruptive innovation.  Disruptive innovation usually connotes the introduction of a new technology that eventually destabilizes an existing market.  Often, the technology, when introduced, is inferior and not perceived as a threat.  Over time, however, the technology improves and migrates from a market niche and becomes the reigning standard.

In legal education, faculty law blogs arose in a state of nature and were often perceived as inferior technology used by faculty to convey random, often personal, views.  Early criticism was that blogging allowed second rate scholars to elucidate second rate opinions to a mass audience.  The criticism was always overbroad.  The fact that there was second rate analysis ignored the fact that there was also first rate analysis.  Moreover, other forms of scholarship, whether law review articles or papers posted on SSRN, suffered from similar problems.

Nonetheless, the criticism did reflect one unquestionable reality.  Blogging by law faculty began in an undifferentiated state.  There was no structural method of separating the good from bad.  Anyone could start a blog and post.  The blogosphere lacked a system of content intermediation, a function provided by students on law reviews.    

That, however, has changed.  A class of widely recognized and often cited law faculty blogs has emerged.  They are regularly cited in court opinions and law review articles. At least nine have been cited by courts more than once (with one having been cited 45 times).  There are 18 faculty law blogs that have been cited by legal periodicals more than 100 times.  The full data is here.

These blogs have an incentive to maintain their reputation by ensuring quality.  Blogs in Empires (Law Prof Blog and Jurisdynamics) and Captives (those supported by a law school), quality can be promoted through uniform standards imposed as a condition of participation. 

With respect to Independent Blogs (those neither supported by a specific law school or part of an Empire), posts are mostly derived from a group of regular, although often shifting, commentators.  The members of the group have an incentive to ensure that their reputation is not harmed by substandard posts.   This can be most readily accomplished by avoiding contributions from faculty who do not meet minimum standards of quality.  Indeed, blogs often provide contributors with the right to post as a guest, giving permanent members an opportunity to assess quality. 

All of this suggests that law faculty blogs are no longer undifferentiated or devoid of intermediation.  While anyone can start a blog and post, not all law faculty can access the most widely recognized and cited law faculty blogs.  Moreover, content has evolved.  The most widely read for the most part eschew personal information in favor of substantive legal analysis, typically in a specific area of law. 

The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Monday
Aug202012

Law Faculty Blogs and Disruptive Innovation:  Introduction

We posted on this Blog a data set that provides the number of law faculty who are currently blogging (as of June 2012).  There were slightly more than 300 active bloggers on that date (a number that has been remarkably consistent over the last five or six years).  We also broke down the faculty by law school and showed that law blogging is dominated by faculty at schools outside the top 50.

The data set included a list of the top blogs by citations in court opinions and citations in legal publications.  The lists demonstrates that there are a cluster of law blogs that are widely cited as authority.  With respect to legal opinions, one faculty law blog has been cited 45 times.  For legal publications, one faculty law blog has been cited over 700 times, with another 17 blogs having more than 100 citations in legal publications.  

At one level, the data shows that the number of law faculty who blog has remained relatively consistent over the last five years (although the particular faculty and the list of active law faculty blogs has evolved considerably).  The increase in citations shows that faculty have become increasingly comfortable citing law blogs as authority.  Moreover, in rankings of faculty based upon law review citations, citations to posts count.  Thus, faculty who blog may obtain an increased citation count in these rankings.

But in fact, the raw data tells a much larger story, one that requires an additional set of data points.  The raw data also looks at the full time law faculty in the top 200 of SSRN downloads for the 12 month ending May 1, 2012 and identifies the faculty in the list who also blog and where they teach.  All of this data provides a basis for some intriguing conclusions.  

While we will explore the meaning of this data over the next two weeks, lets start with a conclusion.  Faculty law blogs have become a permanent part of the scholarship continuum.  They are, in certain circumstances, a better mechanism for articulating ideas and participating in legal debates than traditional law reviews.  Moreover, efforts by law reviews to fight back through online companions have largely failed. 

So let’s talk about what all of this data means.  The full paper, Essay:  Law Faculty Blogs and Disruptive Innovation is here; the underlying data is posted here.

Saturday
Aug182012

Can you be against corporate social responsibility but in favor of unbridled corporate political speech?

The “corporate social responsibility” (CSR) movement can be explained by contrasting it with Milton Friedman’s proposition (here) that:

[I]n a free society … there is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.

This exclusive focus on profits makes adherents of CSR uncomfortable because it seemingly urges individuals to ignore issues like environmental impact and working conditions when dealing with corporations.   Fans of Friedman respond that if there are environmental and labor conditions that need to be dealt with, then they should be addressed via generally applicable laws that corporations will be subject to—but beyond that corporations should be judged solely on the basis of the wealth they create.  CSR proponents reply that modern corporations are too powerful to be dealt with solely via generally-applicable laws.  And so it goes.

The debate took center-stage in the blogosphere this week, spurred on by a post by Will Wilkinson (here), which noted that the uproar created by Chik-fill-A’s CEO’s anti-gay marriage comments raised some difficult questions for proponents of CSR.  As Erik Gerding noted in introducing a Masters Forum on the topic over at The Glom (here):

Is CSR viewpoint neutral?  When covering CSR in a Corporations course, I ask students whether social activists who are lobbying a corporation to change what they see as immoral employment practices, should be able to put their views to a shareholder vote?  Then I ask whether the answer would or should change based on whether the activists are looking to end racial or gender discrimination or whether they are lobbying a company to stop offering benefits to partners in same sex couples.

(Stephen Bainbridge also chimed in here.)

Wilkinson ultimately argues that:

CSR, when married to norms of ethical consumption, will inevitably incite bouts of culture-war strife. CSR with honest moral content, as opposed to anodyne public-relations campaigns about "values", is a recipe for the politicisation of production and sales…. I'd suggest the best arena for moral disagreement is not the marketplace, but our intellectual and democratic institutions.

In other words, if the sine qua non of capitalism is the free flow of capital to the actors who will use it most effectively, then CSR hurts us all by diverting the flow of capital from the best producers to those who simply share our views on particular social issues (at least in those instances where the two don’t overlap).

I won’t rehash all the interesting arguments made in the posts linked to above (they are all well worth reading--you can find all the Glom Masters' posts here), but I will note that it seems to me a similar objection can be raised to the post-Citizens United freedom of corporations to spend seemingly unlimited sums on political elections.  As just one recent possible example, I note that it seems at least some of the flow of capital to banks has been diverted on the basis of political leanings rather than banking efficiency (story here).  So, should opponents of CSR also oppose unbridled corporate political speech rights?

Friday
Aug172012

The Volcker Rule and the Curse of the Second Best Solution (Part 2)

The premise of the last post was that the Volcker Rule is a second best solution designed to reduce the risk that a bank too big to fail will in fact fail.  The alternative approach would be to make the banks smaller so that they were not too big to fail.  One way to do this would be to strengthen the Volcker Rule into something that more closely resembled the barriers imposed by Glass Steagall.  The effect would be to downsize the large banks through additional limitations on their activities.  In effect, it would result in smaller financial institutions without imposing specific size limitations.  

At the same time, the division would allow the development of a group of investment banks that could provide additional competition in the financial markets.  Recall that before the recent financial crisis, there were five large investment banks (Goldman, Morgan Stanley, Merrill, Bear Sterns, and Lehman).  They competed with commercial banks by offering capital raising expertise.  Two of the five were acquired (Bear and Merrill), one failed (Lehman) and two converted to commercial banks.  The large free standing investment banks have been eliminated. 

The idea of a reinstatement of Glass Steagall has been mentioned often but has generated little serious effort.  So it was quite interesting to hear an unexpected source call for the reinstatement of Glass Steagall, Sandy Weill.  Weill, probably more than any single industry titan, was responsible for the elimination of Glass Steagall.  He presided over the financial conglomerate that consisted of a combined Travelers and Citigroup. 

According to the WSJ, he was reported as saying: 

  • What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail

The statement is not unlike the about face taken by Alan Greenspan during the financial crisis.  It is a recognition that prudential limitations (Glass Steagall) may sometimes be better than piecemeal and complicated regulatory structures (the Volcker Rule).

For an article on the benefits to the capital markets of having a Glass Steagall type restriction in place, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

Thursday
Aug162012

The Volcker Rule and the Curse of the Second Best Solution (Part 1)

One of the key components to Dodd Frank was the so called Volcker Rule.  Sometimes characterized as a mini-Glass Steagall, this provision prohibited banks from engaging in short term proprietary trading or from operating hedge funds.  The Report issued by the Financial Stability Oversight Council in January 2011 about the requirement is here.  The final rule is here.

The Rule, consisting of hundreds of pages, has been criticized as excessively complex and full of potential loopholes.  Banks can still engage in certain hedging transactions, market making activities, transactions in government securities and transactions on behalf of clients. 

Putting aside the legitimate concerns over implementation of the Volcker Rule, the real problem is more central.  The Volcker Rule represents a second best solution to a problem that is well known but intractable.  The central problem is that the largest financial institutions, no matter what regulators and politicians say, are too big to fail.  

With the four largest commercial banks in the US each having consolidated assets of over $1 trillion, the failure of any one of them would have profound effects on the economy.  The economic catastrophe that followed in the collapse of the much smaller Lehman set off (or greatly contributed to) a damaging recession that may have altered the outcome of a presidential race.  Given that risk, no politician, Democrat or Republican, will likely allow that to happen under his or her watch.

The obvious solution would be to make the financial institutions smaller and allow them greater freedom to operate.  If they took excessive risk and failed, they would suffer the consequences.  Breaking up the commercial banks, however, is not a viable solution.  There is no will.  Nor is there agreement on the method of doing so nor the ultimate size of a bank that would not be too big to fail.

The second best solution then is to reduce the risk that one of these behemoths will fail.  One way to do that is to have government regulators camp out at the various banks and prevent excessive risk taking.  They already do that.  See Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("The primary focus of examiners is to determine whether banks have sound risk control processes commensurate with the nature of their risk-taking activities, capital, reserves, and liquidity. Given the millions of transactions that large banks conduct daily across varied product lines and businesses, examiners do not review every transaction in a bank."). 

Indeed, the FDIC maintains a permanent staff at some or all of these large financial institutions.  So does the Office of the Comptroller of the Currency.  See Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("The foundation of the OCC’s supervisory efforts is our continuous, onsite presence of examiners at each of the 19 largest banking companies.").  

The losses at JP Morgan forced on regulators a reexamination of their oversight role, see   Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("We are also undertaking a two-pronged review of our supervisory activities and response. . . . The second component evaluates the lessons learned from this episode that could enhance risk control and risk management processes at this and other banks and improve OCC supervisory approaches."), and may result in more effective oversight. 

Nonetheless, the potential for excessive risk taking cannot be eliminated by government oversight.   Developments happen quickly.  In some circumstances, they are brought about by a single person (remember the collapse of Barings?).  They may also be covered up by the perpetrators.   

As a result, the Volcker Rule gets at the concern over excessive risk taking in a blunderbuss way.  It simply bans certain kinds of transactions. Doing so will take away profit making opportunities for the banks.  It will not necessarily result in greater stability for the entire financial system since other, less regulated investors, may engage in the transactions previously undertaken by banks.  But what it will do is reduce the likelihood that a bank will take a bet in the capital markets that threatens its solvency and triggers the problem of too big to fail.

For an article on the consequences of repealing Glass Steagall, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

Wednesday
Aug152012

The Jobs Act and the Interference with Capital Raising

The JOBS Act ostensibly had as a central purpose the elimination of restrictions on capital raising in order to facilitate job creation.  The Act raised a number of concerns about investor protection.  These concerns, in turn, threatened to generate less, not more, capital raising.   

An example may be the so called "On Ramp" provisions.  These were provisions designed to reduce the regulatory requirements for "emerging growth" companies.  For the most part, these are companies worth less than $1 billion that have been public for no more than five years.  They avoid certain disclosure obligations (fewer years of audited financial statements and a dispensation from new or revised accounting standards) and a pack of other requirements such as the need to submit executive compensation to shareholders ("say on pay"). 

Shareholders have fewer rights.  They will receive less disclosure.  In a rational environment, this could result in investors shunning the companies.  In fact, that is exactly the concern confronting companies eligible to be treated as an "emerging growth company."  According to CFO.com:

  • During one week last month, at least 13 companies, including HomeTrust Bancshares, Plesk, and LegalZoom.com, warned investors in their Securities and Exchange Commission prospectuses that the regulatory relief provided by the JOBS Act could actually be a turnoff.

What is an example of this disclosure?  As one company decribed in its risk factors

  • We are an "emerging growth company," as defined in the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not "emerging growth companies" including, but not limited to, not being required to comply with the auditor attestation requirements of section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We cannot predict if potential investors will find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile or decrease.

Emerging growth companies may suffer harm through investor resistance.  Moreover, the harm may not be limited to them.  Section 107 of the JOBS Act allows companies to opt out of the On Ramp exemptions.  Yet investors without the time or inclination to figure out which is which may well have an incentive to simply avoid investing in any company that has recently gone public.

Tuesday
Aug142012

Finn v. Smith Barney: 10(b) Market Manipulation Suit Dismissed for Lack of Reliance

In Finn v. Smith Barney,  No. 11-1270-cv, 2012 WL 1003656 (2d Cir. Mar. 27, 2012), the Second Circuit affirmed the Southern District of New York’s dismissal of market manipulation claims brought under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The plaintiffs were investors who purchased auction rate securities (“ARS”), securities whose interest rates were reset periodically via a Dutch auction, from the defendants, various Citigroup, Inc. subsidiaries (collectively, “Citigroup”). The investors alleged that Citigroup’s frequent intervention in the ARS market was manipulative, and that the parent company, Citigroup Inc., was a 20(a) controlling person.

Section 10(b) forbids the use of a “manipulative or deceptive device” in contravention of the Security and Exchange Commission’s (“SEC”) rules and regulations. SEC Rule 10b-5 forbids any fraudulent practice in connection with the purchase or sale of securities. Manipulation occurs when a party intentionally or willfully controls or artificially affects security prices for fraudulent or deceptive purposes. Further, “[m]arket manipulation requires a plaintiff to allege (1) manipulative acts; (2) damage (3) caused by reliance on an assumption of an efficient market free of manipulation; (4) scienter; (5) in connection with the purchase or sale of securities; (6) furthered by the defendant’s use of the mails or any facility of a national securities exchange.”

The plaintiffs alleged that they purchased the ARS under the belief that the auction markets were driven solely by investor supply and demand, and that Citigroup’s increasing interventions, by placing bids for its own accounts, distorted that market. However, various documents--including prospectuses, confirmations, website disclosures, and media reports--had disclosed that Citigroup could, to prevent auction failure, “routinely place . . . bids . . . for its own account” that were “likely to affect” auction rates and allocations. In light of these disclosures, the court held that the plaintiffs could not plausibly claim reasonable reliance on the assumption of an efficient free market.

The plaintiffs further argued that the sheer frequency of Citigroup’s market interventions rendered any disclosures misleading. However, the court reasoned that at least one of Citigroup’s disclosures specifically included the word “routinely,” indicating the potential for such a high frequency of intervention.

The plaintiffs also argued that the district court had taken improper judicial notice of the disclosure documents in question. Under Federal Rule of Evidence 201(b)(2), such notice may be taken when a document can be readily and accurately determined “from sources whose accuracy cannot reasonably be questioned.” Because the district court took judicial notice for the sole purpose of establishing the public availability of the disclosure documents, and the documents were in fact publicly available before and during the class period, the judicial notice was not an abuse of discretion.

Because Citigroup’s disclosure negated the reliance element of the alleged 10(b) violations, there was no primary manipulation; without primary manipulation, there could be no 20(a) liability for the parent company, Citigroup, Inc. Therefore, the court affirmed the dismissal of all claims.

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

Monday
Aug132012

In re Optimal U.S. Litigation: Presumption against Extraterritoriality of Exchange Act Trumps Plaintiffs’ Claims in Madoff Feeder Case

In In re Optimal U.S. Litigation, 10-cv-04095-SAS, 2012 WL 1988713 (S.D.N.Y. June 4, 2012), the district court dismissed the plaintiffs’ securities claims, holding that, under Morrison, the Securities Exchange Act of 1934 (“Exchange Act”) did not reach those claims.

The plaintiffs were investors in Optimal U.S., an investment fund owned by Banco Santander, S.A., and managed by Optimal Investment Management Services, S.A. (collectively, “the defendants”). Optimal U.S. invested all of its assets in the infamous Bernard L. Madoff Investment Securities LLC. The plaintiffs alleged that the defendants violated Section 10(b) of the Exchange Act by “fail[ing] to conduct adequate due diligence, ignor[ing] red flags, and ma[king] misstatements and omissions in connection with the sale of Optimal U.S. shares . . . .” Although they conceded that the purchase and sale of the shares took place outside the United States, the plaintiffs alleged that the Exchange Act still reached their claims under two theories: 1) the purchase was “in connection with” trades made in the United States; and 2) the defendants’ investments constituted an “economic reality” of trades made in the United States.

The court rejected the first theory, noting that the presumption against extraterritorial application of the Exchange Act foreclosed a broad interpretation of the phrase “in connection with” in the context of extraterritoriality. In addition, although SEC v. Compania Internacional Financiera, S.A. established that certain foreign securities that were “functional equivalents” of United States securities could be considered “in connection with” those securities, the Optimal U.S. shares and the domestic shares subject to Madoff’s trades were not “functionally equivalent” because the relationship between the two was “much more attenuated.”  See SEC v. Compania Internacional Financiera, S.A., No. 11 Civ. 4904, 2011 WL 3251813 (S.D.N.Y. July 29, 2011).

The court rejected the second theory on two grounds. First, the concept of “economic reality” had been employed in a prior case to dismiss claims based on a United States swap agreement that was held to be “economically equivalent” to German shares; the same concept could not be used in the “reverse situation” in an attempt to expand the reach of the Exchange Act. See Elliott Associates v. Porsche Automobile Holding, 759 F. Supp. 2d 469 (S.D.N.Y. 2010). Second, Optimal U.S. shares were not economically equivalent to any U.S.-listed shares, because the former did not have a “direct, one-to-one relationship” with the latter.

Because the court held that the strong presumption against extraterritorial application of the Exchange Act was not overcome by the plaintiffs’ two legal theories, it dismissed the plaintiffs’ securities claims brought under the Exchange Act, leaving only claims of common law fraud, negligent misrepresentation, and aiding and abetting fraud.

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

 

Friday
Aug102012

When Does a Promissory Note Become a Security? Fletcher Int'l, Ltd. v. ION Geophysical Corp.

In Fletcher Int'l, Ltd. v. ION Geophysical Corp, Fletcher International Ltd (Fletcher), a preferred shareholder of ION Geophysical Corp. (ION), challenged the issuance of promissory notes by an ION subsidiary.  Fletcher asserted that the notes were securities and that under the rights and preferences of the preferred shares, it had a right to “consent” to the issuance of “any security.”  The Court of Chancery of Delaware granted in part and denied in part the parties’ cross-motions for partial summary judgment, concluding that one note ION issued was a security and its issuance violated Fletcher’s consent rights.  No. 5109-CS, 2012 WL 1883040 (Del. Ch. May 23, 2012).

The instant case concerned three promissory notes ION caused another subsidiary to issue in connection with ION’s acquisition of ARAM Systems Ltd. and its affiliate Canadian Seismic Rentals, Inc. (“ARAM”). The notes were issued to ARAM’s owner, Don Chamberlain and his family.  ION issued these notes as a condition of its agreement with ARAM to finance the purchase price through short-term bridge financing and to expedite the closing. This included a one-year, non-convertible $35 million “Escrow Note” and a one-year, $10 million “Tax Receivable Note.” After ION issued the first two notes, ION and ARAM amended the Senior Credit Facility of the purchase agreement that shortened the lives of both notes from one year to three months. 

The third note was issued as a result of Lehman Brothers’ collapse and the resulting credit market freeze.  Instead of going forward with its planned bond offering, ION issued the five-year, transferrable, $35 million “Final Note” with a quarterly interest rate of fifteen percent.  ION failed to consult with Fletcher before causing any of the three notes to be issued.  

The court had to determine whether the notes were securities under the Certificate of Rights and Preferences for the preferred shares.  As in an earlier decision involving the same parties, the court relied on the four-factor test set out in Reves v. Ernst & Young, 494 U.S. 56 (1990).  Reves set out a four-part “family resemblance” test for determining when, under the federal securities laws, a note constituted a security.  The test required consideration of: “(1) the motivations that would prompt a reasonable buyer and seller to enter into the transaction; (2) the plan of distribution of the note; (3) the reasonable expectations of the investing public; and (4) whether some factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering the application of the securities laws unnecessary.”

In applying the test, the court determined that two of the loans were not securities but short-term bridge loans. Factors that led the court to this conclusion were the notes’ short terms, the inherent difficulty in pricing or selling the notes, and their short-term nature, something that made the protection of the securities laws unnecessary. The court was not dissuaded by the fact that the notes contained securities act legends and contained references to securities laws.   

The court found that the third note was a security.  The note was issued to finance a substantial investment in lieu of the planned bond offering; it had a long, high-interest life, necessitating securities law protection; and it included a securities legend and securities law references.

As a result, the court granted Fletcher’s motion for summary judgment, finding that the issuance of the one note had violated the consent rights under the Certificates.  

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

Thursday
Aug092012

St. Clair Shores General Employees’ Retirement System v. Lender Processing Services: If at First You Don't Succeed…

In City of St. Clair Shores Gen. Emp. Ret. Sys. v. Lender Processing Serv., Inc., 3:10-CV-1073-J-32JBT, 2012 WL 1080953 (M.D. Fla. Mar. 30, 2012), the court granted Defendants' motion to dismiss, while also allowing Plaintiff leave to file another amended complaint.

According to the complaint, Defendant Lender Processing Services ("LPS") provides mortgage processing and settlement services and default and technology solutions to mortgage lenders; Defendant Lee A. Kennedy is an officer and chairman of LPS's board; and Defendants Jeffrey S. Carbiener, Francis K. Chan, and Michelle M. Kersch are officers of LPS (collectively, "Defendants"). Plaintiff City of St. Clair Shores General Employees' Retirement System, a municipal pension fund, and other possible class members, purchased or acquired LPS shares between August 2008 and October 2010. Plaintiff claimed that during that period, Defendants inflated LPS's revenue through the use of fraudulent business practices. Plaintiff alleged that as a direct result of this fraud, LPS shareholders lost millions of dollars.

In order to state a claim under section 10(b) and Rule 10b–5, a plaintiff must allege a material misrepresentation or omission, scienter, a connection with the purchase or sale of a security, reliance, economic loss, and loss causation. To avoid dismissal, a Rule 10b–5 claim must satisfy the fraud pleading requirements under Federal Rule of Civil Procedure Rule 9(b), as well as the heightened pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”). The PSLRA requires plaintiffs to "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." Furthermore, the plaintiff must state with particularity the facts that demonstrate the defendant acted with scienter.

Defendants alleged that Plaintiff failed to plead the following: "(1) that the individual defendants ‘made’ any of the alleged misstatements; (2) that any of the alleged misstatements were materially false or misleading; (3) loss causation; and (4) a strong inference of scienter."

Defendants sought dismissal of the claims under the Supreme Court's decision in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, asserting that the individual defendants had not “made” the alleged misstatements.  The court, however, found that the allegations were sufficient to find that at least three defendants had “ultimate authority” over their statements.  This included statements made by the defendants in the press, statements made as agents for the company, and the execution by some of the defendants of the certification required for SEC fillings. 

The court also agreed that Plaintiff had sufficiently alleged the materiality of the misstatements.  This was the case "[e]ven if Defendants' statements were literally accurate, as argued by Defendants”.  Similarly, the allegations were sufficient to plead causation.  The court noted that

"loss causation is not subject to a heightened pleading requirement" and that "to sufficiently plead loss causation, a plaintiff must allege a disclosure or revelation of truth about a defendant's prior misstatement or omission that is in some way connected with a stock price drop.” Here, the court deemed that Plaintiff's Complaint establishes a connection between Defendant's misstatement and the drop in stock price and was therefore not subject to dismissal on a causation basis.

The court did find, however, that Plaintiff had not adequately allege  scienter. "Rule 9(b) does not allow a complaint to merely lump multiple defendants together, but requires plaintiffs to differentiate their allegations when suing more than one defendant and inform each defendant separately of the allegations surrounding his alleged participation in the fraud." Accordingly, the court dismissed Plaintiff's complaint without prejudice, but allowed Plaintiff to file a second amended complaint that would comply with the requirements of Rule 9(b).

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

Wednesday
Aug082012

The Director Compensation Project: Bank of America Corp.

This post is part of an ongoing series that examines the way stock exchange independence rules relate to director compensation.  We are for the most part including companies from 2011’s Fortune 500 and using information found in their 2011 proxy statements.

Nasdaq and the NYSE have similar rules with respect to director independence.  NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors.  A director does not qualify as “independent” if he or she has a “material relationship with the company.”  NYSE Rule 303A.02(a).  In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.  NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

Independent directors are compensated for their service on the board.  The amount of compensation can be seen from examining the director compensation table from the Bank of America (NYSE:BAC) 2011 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

  

Name

Fees Earned or Paid in Cash
($)

Stock Awards
($)

Option Awards
($)

All Other Compensation
($)

Total
($)

Mukesh D. Ambani *

92,282

184,534

0

0

276,816

Susan S. Bies

80,000

160,000

0

0

240,000

William P. Boardman (retired)

0

0

0

0

0

Frank P. Bramble, Sr.

100,000

160,000

0

0

260,000

Virgis W. Colbert

80,000

160,000

0

0

240,000

Charles K. Gifford **

100,000

160,000

0

257,190

517,190

Charles O. Holliday, Jr.

167,000

333,000

0

0

500,000

D. Paul Jones, Jr.

80,000

160,000

0

0

240,000

Monica C. Lozano

80,000

160,000

0

0

240,000

Thomas J. May

100,000

160,000

0

0

260,000

Donald E. Powell ***

80,000

160,000

0

75,000

315,000

Charles O. Rossotti

110,000

160,000

0

0

270,000

Robert W. Scully

100,000

160,000

0

0

260,000

* Mr. Ambani was appointed in March, 2011 and the amounts provided reflect pro-rated awards for service prior to the 2011 annual meeting

** Mr. Gifford receives office space and secretarial support

*** Mr. Powell is a non-management director with an annual cash retainer of $75,000

 

Director Compensation.  During fiscal year 2011, Bank of America held 18 Board meetings and each of the current directors attended at least 75% of the meetings of the Board and Board Committee meetings collectively.  The five active (non-emergency) Committees met at least 9 times each and one Committee as many as 16 times during 2011.  Bank of America grants an annual restricted stock award to Directors.  After a one-year vesting period, dividends are paid simultaneously as those on common stock stares.  The shares awarded to each Director equals the dollar value of the award divided by the closing price of common stock as of the grant date and rounded down plus a cash payment for fractional shares.  Non-management directors are given the opportunity to defer these awards to a stock account. 

Director Tenure.  The two most senior members of the Board of Directors include Mr. May and Mr. Gifford, each holding his position since April 2004.  All directors currently serving are slated for re-election except for one, Mr. Jones.  Most directors sit on other boards.  Mr. Colbert, for example, sits on the boards of both Sara Lee Corporation and Stanley Black & Decker, Inc.  Ms. Lozano serves on the board for The Walt Disney Company and ImpreMedia. 

CEO Compensation.  Thomas K. Montag, the Co-Chief Operating Officer, received the highest executive compensation during the 2011 fiscal year, totaling $14,298,604.  The Chief Financial Officer, Bruce R. Thomson, received the next highest compensation at $11,114,046.  Bank of America advocates a “pay for performance” policy that limits executive fringe benefits but does provide home security systems and secure parking.  Furthermore, use of corporate aircraft when conducting business on behalf of the Company is permitted and personal use is also allowed so long as the officer reimburses the Company for operating costs. 

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