Volume 11
Volume 11.1
A Statutory and Precedential Approach to Corporate Scienter in Section 10(b) of the Securities Exchange Act
Travis S. Andrews
Every year, hundreds of private lawsuits alleging violations of Section 10(b)’s antifraud provision of the Securities Exchange Act are filed in federal courts. These lawsuits have a substantial impact on the national economy, with millions of dollars at stake in most cases. While the Supreme Court has clarified many questions of ambiguity within the Private Securities Litigation Reform Act of 1995 (“PSLRA”), the court has not opined on the scienter requirement for claims involving a corporate defendant. A circuit split has thus developed surrounding “corporate scienter.” When permitted, this doctrine allows a plaintiff to meet the PSLRA’s pleading requirement by alleging one person had the requisite state of mind when another person committed the fraudulent act. The corporate scienter doctrine therefore allows the plaintiff to more easily bring a lawsuit against a corporate defendant, leading to the potential for forum shopping and inequitable results among defendants. I examine the current circuit split, which was fractured even more after the Sixth Circuit’s recent creation of a new pleading standard. After examining the current approaches to corporate scienter, I study the text and structure of the PSLRA to argue for a new approach to corporate scienter. My suggested approach would require plaintiffs to demonstrate (1) that an executive officer made or approved a fraudulent statement and (2) that the officer had actual knowledge of the statement’s falsity. Such an approach comports with prior, related case law and the structure of the statute.
Do Mutual Fund Investors Get What They Pay for: Securities Law and Closest Index Funds
KJ. Martijn Cremers & Quinn Curtis
Actively managed mutual funds sell the potential to beat the market by picking stocks that are expected to outperform passive benchmarks like the S&P 500. Funds that are marketed as active vary substantially in the degree to which their portfolio holdings actually differ from the holdings of passive index funds. A purportedly active fund with a portfolio that substantially overlaps with the market or any indexed market segment is known as a closet index fund. Since closet index funds charge considerably higher fees than true index funds but provide a substantially similar portfolio, they tend to be poor investment choices. This Article presents empirical evidence on closet index funds, showing that more than 10% of U.S. mutual fund assets currently could be categorized as closet index funds and that high-cost closet index funds substantially underperform their benchmarks. We argue that persistent closet indexing implicates a number of legal issues, including possible liability for fund advisors under the Securities Act and the Investment Company Act. We conclude by discussing potential adjustments to mutual fund disclosures that could help investors identify closet index funds.
Rethinking Self-Dealing and the Fairness Standard: A Law and Economics Framework for Internal Transactions in Corporate Groups
Sang Yop Kang
In the controlling shareholder ownership, tunneling (i.e., wealth transfer from a corporation to a controlling shareholder) is a prevailing business practice. In corporate groups—which are main business associations in many emerging markets—it is reported that tunneling often takes place in the form of internal transactions among affiliated companies. Regarding a controlling shareholder’s incentive to attain private benefits, this Article analyzes three components of a controller’s internal-transaction tunneling: ownership gap, price gap, and the quantity of goods or services. In addition, based on two leading U.S. cases on conflicted transactions, Sinclair Oil Corp. v. Levien and Weinberger v. UOP, Inc., this Article develops an analytical tool to reinterpret the fairness standard in the context of internal-transaction tunneling in corporate groups. Specifically three conditions of the Sinclair standard—a controller’s domination on both sides of a transaction, exclusion of non-controlling shareholders from benefits available to a controller, and detriment of non-controlling shareholders—are rigorously reviewed. This Article also provides courts with law and economics logic for a fair range of price gap, and reinterprets Weinberger to examine a special issue of substantially large internal transactions without abnormal profits (i.e., with normal profits). In addition, this Article explains market-based mechanisms to mitigate tunneling such as non-controlling shareholders’ discounted purchase of stocks and diversified portfolios. In sum, this Article suggests a new, more sophisticated law and economics-based analysis of tunneling/self-dealing. In doing so, this Article will shed light on corporate governance scholarship on tunneling in corporate group settings.
Wholesaling Best Execution: How Entangled are Off-Exchange Market Makers?
Stanislav Dolgopolov
This Article examines the reach of the duty of best execution to and potential breaches of this duty by off-exchange market markers in the context of the evolving business model of these market participants and the current market structure crisis. Several key areas, such as routing practices, order handling functionalities, and the usage of private data feeds, are analyzed.
Volume 11.2
Laxity at the Gates: The SEC’s Neglect to Enforce Control Person Liability
Marc. I. Steinberg & Forrest C. Roberts
The U.S. Securities and Exchange Commission (SEC) emphasizes the importance of holding gatekeepers accountable in order to help effectuate law compliance and sound corporate governance practices. This Article shows that the SEC’s assertions, with respect to individuals at the large enterprises, is mere “jawboning.” This inaction is puzzling as the SEC, from a civil enforcement perspective, has greater statutory authority than does even the U.S. Department of Justice in promoting compliance with the rule of law.
This Article examines the SEC’s refusal to pursue enforcement actions premised on control person and failure to supervise liability against allegedly culpable executives, directors, and other subject persons. This failure is seen most recently by the Commission’s refusal to institute enforcement actions against corporate insiders in the aftermath of the financial collapse of 2008. Instead, allegedly blameworthy publicly-traded companies have paid huge monetary penalties—a punishment which directly harms innocent shareholders—while allegedly culpable insiders largely have avoided government scrutiny.
In this Article, we will explain that by invoking the control person and failure to supervise provisions, the SEC would incentivize subject individuals to fulfill their statutory obligations. In undertaking this task, the Article: (1) discusses the legal authority granting the Commission the authority to utilize these statutory provisions; (2) explains the advantages that these provisions provide over those normally employed by the SEC; (3) addresses recent alleged misconduct resulting in huge monetary settlements with several major financial institutions; (4) sets forth possible rationales explaining why the SEC has declined to invoke these provisions against individuals at the “big player” enterprises; and (5) proposes an enforcement framework that would promote sound corporate governance practices and compliance with the rule of law.
Preferential Treatment and the Rise of Individualized Investing in Private Equity
William Clayton
Preferential treatment is more common than ever in the $4 trillion private equity industry, thanks in part to new structures that make it easier to grant different terms to different investors. Traditionally, private equity managers raised almost all of their capital through “pooled” funds whereby the capital of many investors was aggregated into a single vehicle, but recent years have seen a dramatic increase in what I call “individualized investing”—private equity investing by individual investors through “separate accounts” and “co-investments” outside of pooled funds. Many of the largest and most influential investors have used these individualized approaches to obtain significant advantages that are often unavailable to pooled fund investors.
This raises a question that is both economic and philosophical: Can preferential treatment be a good thing for private equity? The idea of preferential treatment runs counter to many people’s intuitive sense of fairness, but in this Article I make the case that these trends are efficiency-enhancing developments for the industry when managers fully abide by their disclosure duties and keep their contractual commitments. Some forms of preferential treatment made possible by individualized investing create new value for preferred investors without harming non-preferred investors. Others generate what I call “zero-sum” benefits because they are accompanied by offsetting losses to non-preferred investors, but when disclosure is robust and the market for capital is competitive, there are limits on the amount of zero-sum preferential treatment that we should expect. Even zero-sum preferential treatment can increase the efficiency of private equity contracting to the extent that pre-commitment disclosure gives investors a clear understanding of the quality of the investment product that are buying and the true price at which they are buying it.
Policy should seek to blend three elements. First, to support the efficiency gains made possible by individualized investing, it should support individualized contracting between managers and investors and not presume that preferential treatment is an inherently bad thing. Second, to minimize harms to non-preferred investors, it should promote conflicts disclosure, consistent compliance by managers with their contractual commitments, and clear performance and fee/expense disclosure. Lastly, policymakers should seek to promote these goals at low cost, as non-preferred investors will likely bear much of the cost of policies designed to help them, and high costs could have an anti-competitive effect.
Market in the Remaking: Over-the-Counter Derivatives in a New Age
Norman Menachem Feder
In the aftermath of the financial crisis of 2007-08, governments in leading jurisdictions deluged the traditionally free-wheeling over-the-counter derivatives market with legislation and regulation. Political leaders, lawmakers, and regulators not only imposed oversight but also sought to rework the way OTC derivatives trade. They cited reduction in the risk of financial system collapse as justification. This Article reviews key aspects of the new rules, fundamental workings of the OTC derivatives market, and significant issues that OTC derivatives documentation specialists must face. It also shows how the new rules might sometimes fail to advance the intended systemic safety. Regardless, whatever transformation the new rules force the OTC derivatives market to undergo, they layer complexity over already complex documentation norms and increase documentation density. The new rules thus amplify documentation risk, which market participants must manage. Familiarity with the new rules, the traditional documents, and the now additionally needed documents is essential to controlling the intricacy that, more than ever, characterizes the legal structures of OTC derivatives transactions.
The OPEC of Potatoes: Should Collusive Agricultural Production Restrictions Be Immune from Antitrust Law Enforcement
Michael A. Williams, Wei Zhao, & Melanie Stallings Williams
The Capper-Volstead Act, a pre-Depression era statute that allows farmers to cooperate in marketing goods, has been interpreted to permit farming cartels to avoid the application of antitrust law. Such cooperatives set production limits designed to reduce quantities so that prices rise. Normally, horizontal output restrictions would constitute per se violations of antitrust law. Does the Act permit collusion so that production is restricted? An unclear legislative history and a lack of adjudicated cases have left agricultural producers uncertain about the legality of coordinated production limitations under the Capper-Volstead Act. While the practice remains extant—at significant cost to buyers—there are not judicial decisions determining whether the practice is legal. Four class action cases have been filed in recent years involving supply control under the Act (in the milk, egg, mushroom, and potato industries). However, because of the expense, uncertainty, and high stakes of such cases, they are likely to settle (as have two of the four cases in whole or in part).
Because such cases rarely go to trial, there is a lack not only of judicial opinions on the legality of horizontal production restraints among agricultural producers, but also of publicly available economic analysis on the cost of such collusion. We examine the potato industry and conclude that coordinated production caps significantly increased the cost to buyers, with an average nationwide overcharge of 30.0% for fresh potatoes and 48.7% for Russet potatoes at the point of shipping, and 24.4% for fresh potatoes and 36.5% for Russet potatoes at the wholesale level. The social welfare costs are thus substantial.
This costly collusion has gone almost unexamined and unregulated. An analysis of the Capper-Volstead Act shows that it should be interpreted to encourage—not thwart—competition, and therefore, should not provide antitrust immunity to farmers who collude to restrict output.
Volume 11.3
Bankruptcy Beyond Status Maintenance
Govind Persad
This Article examines the tendency of current American bankruptcy law to maintain the social and economic status of middle- and upper-class debtors while doing much less to assist poorer debtors and non-debtors. In doing so, it examines and categorizes various aspects of statutory and case law that allow debtors to preserve their prior economic status. After reconstructing and rebutting the normative arguments offered in defense of these provisions, it suggests a proposal for reforming bankruptcy law to emphasize goals other than the maintenance of economic status.
Part I of the Article begins by describing ways in which current bankruptcy law serves to help debtors retain their pre-bankruptcy social and economic status, with a focus on exemptions from the bankruptcy estate. Part II then critically evaluates two types of arguments that defend the goal of helping debtors retain their prior social and economic status: one appeals to debtors’ claims, while the other appeals to societal interests. Part III proposes reorienting bankruptcy law away from the preservation of debtors’ part status and toward three interlocking goals: economic adequacy for debtors, economic freedom for debtors, and equal treatment for debtors and non-debtors. It also proposes some ways that this reorientation might be achieved.
Miranda Inc.: Corporations and the Right to Remain Silent
Robert E. Wagner
The right to remain silent is one of the most cherished and controversial rights that Americans have. The merits of this right have been debated for over two hundred years. Many supporters claim that it is the height of our civilization, and detractors claim that it only benefits the guilty and cannot be justified by a cost-benefit analysis. What has received little attention during this time is whether corporations should have the right to remain silent. An early Supreme Court case established that they do not. This Article asks why corporations do not have this right and whether that should remain true. The piece begins the discussion with an overview of corporate criminal liability, examining how the law treats a corporation that has engaged in illegal activity and what it means to say that a “corporation broke the law” in the first place. The Article then considers the constitutional standing of corporations and discusses the numerous constitutional rights that have been granted to them, followed by an analysis of the Fifth Amendment specifically and the arguments for and against the right to remain silent. The Article especially focuses on one of the more recent arguments in favor of a right to remain silent, namely that counter to the claim that the right only helps the guilty, it may in fact also prevent false convictions of the innocent. With this argument in mind, the piece turns to the ultimate question of whether corporations should have the right to remain silent. After showing that the original case law denying the right lacked substantive basis, the Article demonstrates that what little reasoning supported the denial of the right has been implicitly overruled in recent Supreme Court decisions. The Article concludes that given the unclear justifications for the modern right to remain silent and the applicability of some justifications to corporations, they should either receive the right to remain silent or it should be clearly established what goal the right is accomplishing and why that goal does not apply to corporations.
Crowdfunding Investment Contracts
Jack Wroldsen
This Article examines the first wave of crowdfunding investment contracts that were offered in the U.S. during the first month after crowdfunding investment became legal in May 2016. Assessing the earliest possible data sample of crowdfunding investment contracts is particularly important because crowdfunding investment platforms create influential path dependencies that drive start-up companies to use the standardized contract templates that the platforms promote. This paper provides a basis, grounding in actual crowdfunding investment contracts, for recommending improvements to the agreements that govern the emerging field of crowdfunding investments while also establishing a baseline from which to measure future evolution of crowdfunding investment contracting practices.
Initial crowdfunding investment offerings include contracts for six distinct types of investments: common stock, preferred stock, interest-bearing loans, revenue-sharing arrangements, convertible debt, and future equity. In addition, many of the initial crowdfunding investment offerings also include a rewards component, in the style of Kickstarter crowdfunding campaigns.
This Article’s analysis of each type of crowdfunding investment contract leads to four primary observations. First, crowdfunding investors may garner more practical protections from their collective leverage through social media than from formal contract rights. Second, crowdfunding investment intermediaries (i.e., websites known as funding portals) profoundly influence crowdfunding contracting practices by forging the standardized channels through which crowdfunding investments flow. Third, in the initial set of crowdfunding investment contracts, debt securities were significantly less likely to be offered than equity securities, and hybrid revenue-sharing securities were even less common, even though debt and revenue-sharing securities are well-suited for stable businesses with positive cash flows that seek investments from the crowd. Fourth, two new forms of simplified contracts—the “SAFE” and the “KISS,” which are specially tailored for crowdfunding investment offerings with high-growth potential—hold great promise, though not without drawbacks, for efficiently providing crowdfunding investors with the types of protections that venture capitalists typically demand when investing in seed-stage start-up companies.
Fool’s Gold? Equity Compensation & the Mature Startup
Abraham J.B. Cable
There are a record number of startups valued at $1 billion or more, but there are signs that these so-called unicorns (or “mature startups”) are faltering. Employees who are compensated with stock options may bear the brunt of these disappointments due to senior rights of managers and financial investors.
Private placement regulations are surprisingly lax when it comes to protecting employees as compared to other types of investors. While securities laws once followed other fields in considering employees to be vulnerable, the SEC has gradually relaxed regulation of equity grants to employees.
This Essay considers a fundamental question: are startup employees capable investors? The analysis reveals a counterintuitive possibility: startup employees may be relatively capable investors in a company’s early stages (when the risk of investment is sometimes perceived as highest), but poorly equipped to navigate the risks of a mature startup.