Yearly Archives: 2015

Appraisal Arbitrage

Nov 25, 2015 Bill BrattonAdd a Comment

Developments in corporate law center on two topics these days—shareholder voting and merger litigation.  One of the more surprising of the many twists and turns in the latter area is the appearance of appraisal arbitrage. The arbitrage characterization applies because the petitioner under section 262 of the Delaware corporate code takes advantage of the section’s standing rule to buy the transferor’s stock after the record date for the vote on the merger, based on a financial analysis that signals a good chance to prove a valuation in excess of the merger price. A number of special-purpose hedge funds have cropped up as players—Merion Capital, now a frequent appraisal plaintiff, raised $1 billion for a fund dedicated to appraisal claims in 2013. The volume of petitions has spiked up.

Volume has increased substantially despite the fact that appraisal is supposed to be brutally unfriendly to plaintiffs, partly because class actions are prohibited and partly because the plaintiff bears the burden to prove every dollar of damages through a ground up valuation of the company. The surge casts a negative light on the permissive the standing rule, which, in contrast to the blocks erected in representative litigation, facilitates buy-ins. The surge in filings also bids reconsideration of the open-ended approach to valuation techniques followed in the Delaware courts. Finally, it calls into question the fed funds plus 5% interest rate applied to appraisal recoveries under section 262. It is alleged that at a time when interest rates have fallen to little more than zero, a petitioner with a substantial stake can turn a profit on a return of the merger price alone, given an assured 5% yield during the litigation period. Critics are pressuring Delaware to amend the statute to turn back the plaintiffs.

In Appraisal Arbitrage and the Future of Public Company M&A, Myers and Korsmo turn back the critics.

This is a model law review article. It succinctly lays out the framework, and then reports on what has been going on lately, reporting an empirical study of Delaware appraisal litigation over the past ten years. The authors produce a series of crisp, telling descriptive statistics. (There is also a regression but it does not really add anything.) They persuade the reader that the appraisal surge, while certainly dependent on the loose standing rule as a door-opener, is not a function of hold up tactics and does not depend on the 5% interest add-on. The petitioners are selective and target low-premium mergers. Appraisal rights thus are being deployed in accordance with their purpose. Indeed, the authors suggest that Delaware expand section 262 to make appraisal available whatever the form of merger consideration.

This is one of those rare cases where there arises a strong inference that an article influenced the development of the law. Everyone in Delaware with whom I have raised the appraisal arbitrage question makes reference to Myers and Korsmo. The Council of the Corporation Law Section of the Delaware Bar Association cited the article when it took the matter up earlier this year. Significantly, the Council left the standing door open and proposed only a tweak of the statute, suggesting (1) a de minimis dismissal opening for petitions including 1% or less of the shares outstanding or involving a merger consideration of $1 million or less, and (2) an interest cutoff option in the company keyed to a payment of all or part of the merger consideration. As it happened, the legislature left the Committee’s suggestions on the table.

Delaware’s adjustment for appraisal arbitrage instead shows up in the caselaw. Vice-Chancellor Sam Glasscock recently has been using the merger price to trump the petitioner’s showing, reasoning that a well-conducted sale process lends confidence in the dollar result. See, e.g., Huff Fund Investment Partnership v. CKx, Inc., 2013 WL 5878807 (Del. Ch.), affirmed 2015 WL 631586 (Del.).  Process concerns have been known to spill over into appraisal cases before, but never to this extent. Even so, the process move makes sense in the present context. Myers and Korsmo pick up on it, mooting a section 262 safe harbor constructed on Revlon principles. This is an intriguing suggestion, but then safe harbors are not the style in Delaware corporate jurisprudence.

Debt, Detroit, Democracy

Oct 28, 2015 Anna GelpernAdd a Comment

I feel only a bit sheepish for snatching Melissa Jacoby‘s Federalism Form and Function in the Detroit Bankruptcy (Yale J. on Reg. forthcoming) from all the other sections that could claim it, notably Constitutional Law and Courts Law. Although it is the richest law review article I have read in a while—sweeter for being the first in a cycle—I worry that it might fall through the interdisciplinary cracks. Debt rarely takes center stage in constitutional theater these days, ditto bankruptcy procedure in procedure. Even by bankruptcy standards, the project might seem exotic—a deep dive into audio recordings and other primary sources from Chapter 9 (municipal) bankruptcy hearings. Whatever your discipline, you would be mad to miss it. The subject is the biggest-ever public debt restructuring under a statutory scheme. The article is packed with doctrinal, theoretical, and methodological insights. The treatment is sophisticated and empathetic. The policy salience is obvious, as Detroit taps the markets, Chicago totters, Puerto Rico defaults, and the United Nations and the Pope endorse bankruptcy for states.

Chapter 9 of the U.S. Bankruptcy Code is one of the few statutory regimes in the world for public debt restructuring. Its effort to balance federalism and democratic deference against the need to put an over-indebted (likely mismanaged) political unit on a sound financial footing has inspired imitation and criticism. Chapter 9 combines a high barrier to filing with extraordinary deference to the debtor’s policy decisions once it files. There is no bankruptcy estate, no equity, and no liquidation. In theory, states retain sovereignty over municipalities, while federal bankruptcy courts must keep their noses out of municipal affairs. Some commentators have argued that such reticence fuels debtor moral hazard; others have used it to highlight the limitations of Chapter 9 as a framework for bigger, more complex political units.

Until recently, the debate was mostly academic because real political units never restructured under Chapter 9; most of the filing activity involved special tax districts and the like. Detroit’s bankruptcy, coming on the heels of Vallejo and Stockton, CA, Central Falls, RI, and Jefferson County, AL, among others, is arguably a game changer. Having shed over $7 billion of debt in 17 months, Detroit comes closest to testing the proposition that statutory bankruptcy could deliver durable debt relief without compromising people power.

Federalism Form and Function gets at the heart of the question in a novel way. Taking a cue from complex litigation, Jacoby sifts through months of courtroom recordings in real time to draw a framework for managerial intervention by the bankruptcy judge. Those who know the procedure scholarship would not be surprised to discover that courts can exercise tremendous power over the debtor municipality and its creditors through seemingly mundane channels, such as fixing the calendar, appointing mediators and experts, monitoring costs, and conditioning motion rulings. Yet this insight upends the bankruptcy consensus about how Chapter 9 actually works, and poses uncomfortable questions for those who would extend the model to states and countries on the assumption that statutory bankruptcy and third-party adjudication are easily compatible with debtor democracy.

Judge Steven Rhodes used process leverage to force a stream of information out of city officials, then used the information to force the officials to reckon with tort claims, pensions, water services, and other big challenges in a systematic fashion. The all-star team of outsiders assembled under the judge’s direction did exactly what outsiders are meant to do. Unburdened by local political and financial ties, often out of public view, they made practically irreversible decisions with an eye to long-term viability. The outsiders seemed to be people of good will and reasonable priorities: restoring city services, preserving irreplaceable cultural assets, protecting the vulnerable. The end was impressive—a record-fast restructuring, oodles of new money for the city, a renewed sense of possibility—but was it impressive enough to justify the means?

The author comes across as unsettled about the implications of judicial power she documents in Detroit. I was unsettled by my own reaction—I came away from the article in awe of the “Detroit Blueprint.” Intense collaboration among circuit, district and bankruptcy judges, state and local officials left little room for deviation in Detroit. It is as if every part of the process were meticulously rigged to permit a particular range of expressions and outcomes. Thinking outside the box is encouraged; wandering into the woods is unthinkable. No Syriza-Schauble clash-of-democracies circus here. Detroit stayed on the path; now the future looks bright and the all-star team moves on.

Where I live, it is not hard to imagine a city becoming a political football for outsiders whose good will and good judgment are suspect. For all the problems one might have with the Detroit outcome, the Detroit Blueprint could be used in much scarier ways. Federalism Form and Function and its sequels are well-placed to illuminate the possibilities and design the safeguards. No time to waste.

Clayton Christensen comes to Wall Street

Sep 21, 2015 Cristie FordAdd a Comment

In the early 2000s, I spent some time as a fly on the wall of the floor of the New York Stock Exchange. I talked to specialists—those whose job it was to personally manage trading and make a market for particular high volume stocks—including one who had just earned a coveted specialist’s “seat” (price: $3 million). Once upon a time, a seat was practically a license to make money. As market-makers, specialists bought low and sold high on their own accounts. The NYSE specialists I spoke to talked about decimalization, new at the time—the fact that securities were now quoted in pennies instead of in eighths or sixteenths of a dollar. They agreed that it had cut into their profitability. They were already using an electronic system to pair off small customer orders, and they agreed that it actually handled more order volume than they did. None of them seemed to have given much thought to electronic trading, alternative trading platforms, or the derivatives market. Certainly none of them seemed to think these were existential issues that would undermine their 130-year-old business model.

Securities markets are utterly transformed today. Specialists, as they were then, are gone. Electronic trading networks reign, as does algorithmic trading. The NYSE handles less than 20% of US stock trades (it was 80% just a decade ago). Chris Brummer’s new article, Disruptive Innovation and Securities Regulation, is a gorgeous account of how this happened, how law intersected with innovation, and what the implications might be.

We know already that derivatives and financial engineering have profoundly challenged the assumptions underlying corporate law: think of Bernie Black and Henry Hu’s work on empty voting,¹ Ron Gilson’s and Chuck Whitehead’s work on risk-slicing beyond the corporate share,² or Tamar Frankel’s ruminations on how profoundly new technology affects Adolf Berle’s classic analysis of the separation between ownership and control.³ Bill Bratton and Adam Levitin have pointed out how innovations like the synthetic CDO involving a special purpose entity have redrawn the conceptual boundaries of a firm, and done through contract what formerly would have been done through equity ownership.⁴ For a broader audience, Michael Lewis’s influential book Flash Boys gave many a sense of the complex ecosystem in which high frequency traders operate (along with a sense of outrage about the disadvantage at which retail investors and even their pension and mutual funds are put in those ecosystems).

Chris Brummer’s important contribution here is at least four-fold: first, he illuminates the historical dance, from the New Deal era onward, between securities regulation and financial sector innovation. The history he provides is engaging and precise, and he consolidates in one place information about how particular regulatory moves, like the SEC’s Rule 144A (in 1994) or Regulation NMS (in 2007), unexpectedly rearranged markets and altered the business models of the very intermediaries—exchanges, broker-dealers and the like—they were intending to regulate. Among other unexpected relationships, he points out how greater clarity around the standards for private placements produced greater innovation around private placements. The relationship between clarity or standardization, and innovation, is an important one that does not always make it into conversations about finance or the financial crisis.

Second, Brummer identifies the ways in which new technology (particularly automated financial services and private capital markets, including dark pools and crowd-funding) has disrupted regulatory practice. For example, the SEC promulgated Regulation NMS in order to deal with the market fragmentation problem that electronic trading networks had created. It promulgated Rule 144A to help investors gain access to young, innovative, capital-intensive firms. The combined result, though, was to spur high frequency trading and to move trading off public markets, to the detriment of price discovery and fair treatment for retail investors (not to mention the specialists I once spoke to).

The other thing that comes out is how vast and tricky remains the challenge of consumer protection in this space. Consumer protection regulators like the SEC, and the law-based nature of their expertise, did not come out well during the financial crisis. In the wake of the crisis, policy-making momentum and credibility has shifted toward prudential regulation, and more technical financial expertise. Among the contributions in Brummer’s article is a reminder that someone needs to be thinking hard about consumer protection, and priorities such as creating an equal playing field for “real economy” and retail players, in the midst of all this disruptive innovation.

Brummer’s most significant contribution, though, is to pursue a conversation about how we might respond to the challenges that innovation presents for regulation. Back in 2009, Mitu Gulati and Bob Scott asked why law firms don’t have R&D departments.⁵ This is a good question (and they provide a fascinating answer) but the question goes beyond just firms. The reality is that law is not terribly good at tracking, let alone engaging in, innovation. This is true even for securities regulation, the area of law perhaps most directly concerned with allocating capital to its best (which often means its most innovative) uses. Brummer’s article has done us a real service by setting out a thorough, insightful description of how far reality has strayed from the static, institution-oriented market structure that New Deal-era regulation assumes. His helpful proposals are to expand the regulatory perimeter, to consider the benefits and limits of objectives-based regulation, and to consider “adaptive financial regulation.” We could perhaps even go further, to consider the ways in which financial regulation needs to be reframed to allow us to think about innovation as a first order regulatory challenge. How might our perspective change, if we started from the point to which Brummer brings us: from a sense of the historical dance between regulation and innovation, and a recognition of the ways in which regulation itself must anticipate and respond to the disruptive and undermining effects of private sector innovation?

Private Ordering in Corporate Litigation

Aug 10, 2015 D. Gordon SmithAdd a Comment

The debate over litigation bylaws has been percolating in Delaware for several years, but it shifted into high gear last year, when the Delaware Supreme Court held unexpectedly that a fee-shifting bylaw was “facially valid.” ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 558 (Del. 2014). This decision prompted discussion of a corporate litigation crisis, which seems to have abated with action this summer by the Delaware General Assembly, passing legislation prohibiting fee-shifting bylaws and charter provisions for Delaware stock corporations. This legislation also addresses forum selection clauses, authorizing bylaws, or charter provisions designating Delaware as the exclusive forum for claims relating to “internal affairs” and prohibiting provisions designating courts outside of Delaware as the exclusive forum for such claims. Although the immediate threat of crisis has been abated, important issues remain regarding bylaw- and charter-provision-regulating corporate litigation. In Shareholder Litigation by Contract Verity Winship offers a useful framework for thinking about these issues.

Winship begins with a sensible premise: “procedural law should not be used to waive mandatory provisions of substantive law.” (P. 6.) Of course, she recognizes that the number of mandatory provisions in state corporate law is few, but she includes among those provisions “the core duty of loyalty claim within the umbrella of state-law fiduciary suits.” (P. 45.) This is a controversial claim, but one that seems to be shared by the Delaware General Assembly, as the implicit motivation for prohibiting fee-shifting is the desire to preserve fiduciary duty litigation.

It is probably worth noting that the legislation prohibiting fee-shifting was not drafted by members of the Delaware General Assembly, but rather by the Council of the Corporation Law Section of the Delaware State Bar Association, an organization comprising top Delaware corporate lawyers, who have a strong pecuniary interest in a vibrant litigation environment. That said, anyone who believes that fiduciary duty litigation is an important part of the corporate governance system should also endorse Winship’s aspiration to “prevent procedural provisions from being used to kill shareholder litigation altogether” and to “also avoid throwing the baby out with the bathwater.” (P. 6.)

Winship’s approach depends on a contracting framework, which also is not uncontroversial, even though the ATP used this framework in approving the fee-shifting bylaw in that case. The Court in that case reasoned:

Delaware follows the American Rule, under which parties to litigation generally must pay their own attorneys’ fees and costs. But it is settled that contracting parties may agree to modify the American Rule and obligate the losing party to pay the prevailing party’s fees. Because corporate bylaws are “contracts among a corporation’s shareholders,” a fee-shifting provision contained in a nonstock corporation’s validly-enacted bylaw would fall within the contractual exception to the American Rule. Therefore, a fee-shifting bylaw would not be prohibited under Delaware common law. (Pp. 9-10.)

In Private Ordering with Shareholder Bylaws, my co-authors and I suggested that shareholders in public corporations perform not only the conventional functions of selling, voting, and suing, but they also engage in contracting through bylaw amendments. One limitation on our proposal is embedded in the term “shareholder bylaws.” The fee-shifting bylaw in ATP was a “director bylaw,” which seems unlike “contracts among a corporation’s shareholders.” We criticized the Delaware Supreme Court’s opinion in CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227, 238 (Del. 2008) for placing too much bylaw power in the corporate directors, and ATP suffers from this same shortcoming.

Critics of our contracting view note that bylaws are not really contracts, but are simply interpreted by the Delaware courts according to contract interpretation principles. You can see Kurt Heyman, a distinguished Delaware practitioner, making this argument in a recent panel discussion at Fordham Law School. This, of course, is merely a formal objection, which we assume that everyone who endorses the contracting framework recognizes. (Winship dedicates an entire section of her article to examining various caveats to treating bylaws and charters as contracts.) The issue is deciding the extent to which shareholders ought to be allowed to engage in private ordering. Or, in Winship’s words, “Should there be any limit to the procedural provisions to which the parties can contract?” (P. 6.)

Winship’s short answer is “yes.“ Bylaws should be limited by mandatory provisions in the statute, including the newly adopted fee-shifting prohibition. But if the underlying aspiration is to allow individual firms to act as “laboratories of corporate governance,” the number of mandatory provisions must remain rather small. Thus, bylaw provisions altering discovery rules, requiring the posting of a bond, implementing contemporaneous ownership requirements, identifying additional prerequisites to filing derivative lawsuits, and myriad other issues are candidates for private ordering under a robust contracting system.

This article is a full-throated defense of private ordering in corporate governance. It is well written, thoroughly researched, doctrinally sophisticated, and conceptually challenging. And, if it is not clear by now, I add that it is well worth reading.

Whistleblowers as Securities Fraud Detectors

Jul 7, 2015 Tom C.W. LinAdd a Comment

Securities fraud presents one of the more vexing challenges for financial regulators and policymakers. Each new financial crises and catastrophic fraud frequently begets new tools to fight securities fraud. In a thoughtful recent article, Better Bounty Hunting: How the SEC’s New Whistleblower Program Changes the Securities Fraud Class Action Debate, Professor Amanda Rose examines the SEC’s new whistleblower program as a tool for securities fraud detection, and explores its potential impact on the old fraud detecting tool of class action lawsuits.   The motivating argument of the article is that the SEC’s new Whistleblower Bounty Program (WBP) created by Dodd-Frank can serve as a superior alternative to the traditional fraud-on-the-market (FOTM) class action lawsuits as a tool for securities fraud detection and deterrence.

Professor Rose articulates this argument in a logical, measured fashion. She begins by providing background information on the origins of FOTM class actions and the WBP, which is designed to pay large sums to eligible individuals who provide valuable, original information about frauds that result in $1 million or more of penalties. Building on that background, Professor Rose then contends that the WBP could reduce the relative benefits associated with FOTM lawsuits while increasing their relative costs thereby making them a less desirable tool to combat securities fraud. With cautious optimism, she believes that the generous bounty of the WBP and the steep costs often associated class action lawsuits could ultimately lead tipsters who are aware of securities fraud to pursue redress through the whistleblower route rather than the class action route. However, to the extent that the WBP does not function as a feasible replacement for FOTM suits, Professor Rose introduces the innovative idea of adding a qui tam provision in the current whistleblower program as a modest improvement over FOTM suits.

The success and impact of the WBP remains to be seen as the program is still in its infancy. According to the SEC’s 2014 WBP report to Congress, a total of only fourteen awards have been granted since the creation of the program.   That said, the SEC has received thousands of tips annually since its inception, and those tips have been increasing year to year. The long term, sustainable success of the program will depend largely on the willingness of individuals with high-quality information about securities fraud to use the program, and the program’s vigilant administration by the SEC. While a more definitive verdict on the WBP remains forthcoming, Professor Rose has provided a promising, underappreciated preview of the program’s full potential.

Ultimately, perfect fraud detection and deterrence in the securities marketplace is a noble but elusive goal. Securities fraud is a persistent, diverse problem that requires a diverse toolkit to solve in a better way. Traditional tools like class action lawsuits are not always the best tools for tackling the diverse variations of securities fraud in the marketplace. In the end, traditional tools like class action lawsuits will have to be complemented, refined, and possibly supplanted by new and better tools such as smart whistleblower-based solutions, as Professor Rose has skillfully articulated in her article, in order to better detect and deter securities fraud in the marketplace.