October 31, 2007
According to the Washington Post, one car industry expert maintained that while the car sharing industry, in which both Flexcar and Zipcar are engaged, may not supplant the more traditional car rental market, it has developed a "little cult of users." Both Flexcar and Zipcar, the nation’s two largest car-sharing firms, rent cars by the hour to people who are able to satisfy their environmental consciousness, while avoiding the expense of car ownership. I must admit I never really thought this idea would take off. It could be because I grew up in LA and cannot image getting around without owning a car. Or maybe it is because the car sharing industry relies significantly on students, and hence I wonder about the wear and tear on the cars being shared. Yet now that I think about it further, it seems that the car sharing industry is just a further extension of the leasing business model, whereby people are able to use cars without the expense and hassles of car ownership. Indeed, the car sharing companies take care of gas and insurance. And because relying on car sharing means you do not have to worry about where to park your car, it certainly makes sense for people who live in cities like DC where parking is scarce. Of course neither of the two car sharing companies has managed to achieve profitability. However, the two companies hope profitability is just around the corner, and hence plan to merge in order to establish one identifiable brand that offers a larger fleet of cars to share. Experts predict that a larger fleet of cars will allow the company to achieve economies of scale and hence make more money. I can imagine that offering a larger fleet of cars also provides certainty for customers regarding the availability of cars, thereby ensuring their commitment to the car sharing arrangement. Since I am not personally aware of anyone I know actually participating in car sharing, it could be that this trend has simply passed by me. Yet I can imagine that if the new company is successful in getting students to believe that car sharing is a viable and environmentally friendly alternative to car ownership, then there could be a core set of people committed to this industry and its business model.
Permalink | Businesses of Note | Comments (1) | TrackBack (0)
October 30, 2007
Earlier today, I discovered Lawrence Friedman's Contract Law in America: A Social and Economic Case Study, written while Friedman was at Wisconsin. It is a study of over 500 contract cases decided by the Wisconsin Supreme Court. This is a portion of the Preface:
Probably nothing has so crippled historical study of American law as the traumatic effect of some fifty jurisdictions. Nothing, that is, unless it is the devastating obsoleteness of legal education, which (except for some meager palliatives in upper-class seminars) tends to develop notions and habits of thought inimical to the study of law either as a branch of human behavior or as a chapter in the book of human ideas. Legal education, in general, seeks to teach students 'how to think and act like lawyers' and turns its back on imparting 'mere facts.' 'Mere facts' (if this means rote learning) should of course not be the prime goal of education; but overemphasis on skills training has severe drawbacks of its own. It substitutes manipulation of data for understanding of data. In general, the law schools fail to teach the legal system as a whole, let alone the legal system as part of society; they teach disjointed fragments of a fragment.
The publication date of the book is 1965, and the breadth of Friedman's indictment (touching all of legal education except a few upper-class seminars) suggests that "skills training" had a broader meaning for him than it has today.
What I really love about this passage, however, is Friedman's vision of the study of law "as a branch of human behavior or as a chapter in the book of human ideas." In an attempt to convey this idea to my first-year Contracts students, I placed the following aspirational statement at the front of my Contracts syllabus (some of the following is taken from the casebook for the course, Stewart Macaulay et al., Contracts: Law in Action):
This is an introductory course on the law of contracts. Note the italics. Despite the unqualified title of the course – "Contracts" – we are not much interested in the structure or content of contracts. This is not a course on contract negotiation or drafting, and we rarely read more than a short excerpt from any contract documents. We study the law of contracts, which encompasses the technical legal rules found in statutes, regulations, and judicial opinions that, among other things, prescribe the requirements of contract formation, provide certain bases for avoiding performance of contracts, and describe various legal and equitable remedies for breach of contract.
But there is more to our study than the mastery of legal rules. We are interested in the law in action. Knowing legal rules is like learning to play scales on a musical instrument. While playing scales may be an essential step in becoming a musician, mastering the scales is not the end goal. Similarly, while knowing legal rules is essential in becoming a lawyer, mastering those rules is not the end goal. We must become experts in understanding how legal rules express themselves in the lives of real people. This requires us to treat the study of law as more than a series of logical puzzles. In the final analysis, our goal is to develop a better understanding of human behavior.
This is a difficult aspiration to fulfill, and I know that I have not always done so. But it is a worthy goal. And it makes for more interesting classes, too.
I’ve been feeling a bit guilty since July, when I speculated that the Delaware Chancery Court might only devote 15% of its docket to corporate law issues. Better versed Delawareans than I wrote in that the number seemed to them more like 60-70%. And that’s why we love the internet. But still, I have to think about my honor. While the majority number must be the right one in all the important ways (maybe those are the cases up in Wilmington, that get a lot of court time, and so on), I’ll note that – according to a footnote in a paper recently consumed hereabouts (it’s not out yet, or I’d name authors) - in 2002, the Chancery Court disposed of 3,525 cases, 2,183 of which involved estates, 440 guardianships, 38 “other matters” and 52 trusts. That leaves 902 cases that might be assumed to be corporate. Which is, I’ll have you know, 26% of the cases.
Professor Bainbridge has commented on my earlier post, Why Do We Trust Directors? He begins by turning the question around ("Why should we trust judges?") and providing what is essentially a defense of the business judgment rule. I am whole-heartedly in agreement with that doctrine (although not necessarily his defense of it). He then goes on to get to the real issue, structural bias:
Although most academics focus on structural bias solely in the context of special litigation committees in derivative litigation, it is a much wider problem. If purportedly independent directors are likely to favor their fellow directors when the latter are sued, they are equally likely to do so in any conflict of interest situation. As somebody once said, the structural bias argument thus has no logical terminus. It would swallow up most of corporate law if we let it out of the bag.
I've heard this argument before, but I am entirely unconvinced. There is a logical terminus: at most, structural bias only covers "any conflict of interest situation"; it does not cover most situations, which do not involve conflicts of interest. In fact, in my article on structural bias, I note the three main situations in which structural bias is an issue: derivative litigation, hostile takeovers, and executive compensation. (There is a fourth: proxy contests not involving a hostile takeover.) This is not a particularly large universe. Derivative litigation and control contests are relatively rare. Only executive compensation poses a real problem, because of its ubiquity.
(In my article, I suggest a review for substantive reasonableness which is not quite as deferential as the business judgment rule's rationality standard, but still deferential enough to be decided as a question of law as a threshold matter. This would not involve too much judicial interference, but would allow courts to reach a case such as Brehm v. Eisner (2000), which the court itself described as "a close case" which "pushes the envelope of judicial respect for the business judgment of directors ....")
The business judment rule counsels that directors, being experts, generally are better at making business decisions than judges. However, the entire fairness test counsels that conflicted experts are not be better than unconflicted judges. Bainbridge admits as much:
To be sure, this argument has no traction where a majority of the board is disabled by conflicting interests. The shareholders’ preference for abstention, however, extends only to board decisions motivated by a desire to maximize shareholder wealth. Where the directors’ decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted. The affirmative case for disregarding honest errors simply does not apply to intentional misconduct.
The problem with Bainbridge's argument is that it assumes that judicial review is limited to cases involving intentional misconduct. That is simply not true. The entire fairness test is invoked not by intentional misconduct, but rather by the mere existence of self-dealing (i.e., a situation where the directors stand on both sides of a transaction, or receive something from the company to the exclusion of, and detriment to, the shareholders). Because of the conflict, we switch the burden of proof: rather than requiring the shareholder plaintiffs to prove misconduct, we require the directors to prove that the transaction was entirely fair. The protection of the business judgment rule is lost not by intentional misconduct, but by a conflict of interest.
The claim regarding structural bias is that it presents a similar conflict of interest and deserves similar treatment. Of course, the claim can be rejected -- and it is, by some. But Bainbridge doesn't seem to be in that camp. Rather, he seems to suggest that practical considerations outweigh the theoretical ones. One such consideration has already been discussed above. Another is as follows:
To be sure, some cases in which the board majority’s decision was swayed by actual or structural bias thus escape judicial review. But so what? Such cases will not escape market review.
Of course, the same could be said of self-dealing. And my response would be the same: it is not clear that "such cases will not escape market review"; and, even if so, the inefficiency in the market review process allows management to do quite a bit of damage (and/or become quite enriched) before they are replaced. To me, that is significant enough to merit attention.
Donald Langevoort has an article entitled 'On Leaving Corporate Executives Naked, Homeless and Without Wheels": Corporate Fraud, Equitable Remedies, and the Debate Over Entity Versus Individual Liability'. The quote is from former SEC Chairman Richard Breedan who once threatened that his agency would pursue corporate executives so as to leave them “naked, homeless and without wheels.” If the title does not grab you, the article itself is a very interesting and important read on the extent to which our current regime enables us to effectively go after individual executives involved in corporate malfeasance, particularly in order to recoup monetary rewards received in the context of such malfeasance.
To be sure, Breedan’s words were uttered in the context of insider trading scandals. Yet many in law enforcement expressed a similar sentiment on the heels of the more recent corporate scandals, suggesting that corporate executives should and would be held accountable for their misdeeds. And that they would be stripped of their ill-gotten gains. Yet as Langevoort points out, too often law enforcement efforts appear to miss the mark as it relates to individuals. Certainly several high-profile criminal prosecutions reveal that since 2002, there has been some increased focus on corporate executive liability. However, even when executives go to jail, some of them retain their incentive compensation. Moreover, criminal enforcement efforts increasingly have included a focus on entity liability. A similar phenomenon occurs on the civil side. Thus, Langevoort notes that reports reveal that settlements in fraud on the market lawsuits tend to be paid by companies or D&O insurers, while fines extracted from SEC enforcement actions tend to be paid by companies—and not executives. In fact, while some people feared that the personal settlements crafted pursuant to WorldCom and Enron would prompt a trend towards greater personal liability in civil settlements, they instead appear to stand as the exception to a system that generally relies on corporate payouts.
Of course the recent focus on entity liability, particularly in the criminal context, not only has sparked debate, but also has generated some degree of consensus that the justifications for such corporate payouts are not clear. Langevoort’s article uses the debate regarding entity versus individual liability as a springboard to examine the available tools for going after executives complicit in corporate fraud. As he notes, entity liability emerged as a solution for the difficulties with holding individual executives liable. Thus, while individual liability may be preferable to entity liability, it is appropriate to ask, if we pull back on entity liability, will individual liability will take its place? In particular, Langevoort focuses on the equitable remedies of rescission and restitution as applied to corporate executives. Langevoort concludes that while there are some remedies available in this area at both the state and federal level, they are underutilized because of legal and practical impediments.
Langevoort’s article pinpoints an important issue that merits further attention. In fact, many appear frustrated by the fact that current law enforcement efforts appear to leave executives’ monetary rewards intact. Certainly one oft-cited complaint regarding the ousting of underperforming CEOs is that, despite their underperformance, they manage to leave with very lucrative severance packages. So while we may not be interested in leaving executives “naked, homeless and without wheels,” there is an interest in ensuring that they do not reap the monetary benefits of corporate misconduct. And it appears that our current regime does not effectively respond to that interest.
Permalink | Corporate Governance | Comments (0) | TrackBack (0)
October 29, 2007
- The D C Circuit still is pretty quiet, but today it turned away a union challenge to a smoking ban in the workplace. The agency defendant handled the arbitration where the union grieved the smoking ban, but didn't mention said ban in its arbitral decision. The court concluded that because the agency hadn't treated the ban like an unfair labor practice, the court didn't have jurisdiction to assess whether it was one, which was the only grounds it had for review. David Tatel dissented from this somewhat odd conclusion - that the agency essentially, can define its own jurisdiction by limiting what it says in its adjudications - with a lengthy post that really gets into the labor law weeds. The case, Association of Civilian Technicians v. FLRA, is here.
- Richard Lazarus and Orin Kerr are considering what to make of the shrinking size, and increasing quality, of the Supreme Court bar. Both appear to suppose that the quality of the advocacy before that Court matters, in anything other than an aesthetic sense. I'll look forward to reading more about why.
I realize that a post on Stoneridge isn't exactly timely, but I'm not a regular blogger. Anyway, it seems that the Supreme Court is likely to affirm the judgment of the Eighth Circuit in the Stoneridge case. I think that would be the right outcome. However, the reasoning of the opinion may be more important than the outcome. I would like the Supreme Court to use this case to take up the meaning of either "in connection with a purchase or sale of securities," or the scienter requirement.
"In connection with" has been interpreted extremely broadly over the years, and that probably is for the best. But its limits should be better defined than they are. Even assuming a "sham" transaction is fraudulent, that fraud is not necessarily in connection with a purchase or sale of securities. Perhaps it is with respect to the company that intends to account for it improperly (although I would argue that it is the improper accounting, rather than the transaction itself, that satisfies the requirement). But it is quite a stretch to say that a third party vendor engaging in a sham transaction is doing so "in connection with a purchase or sale of securities." From the respondents' perspective, any fraud would have been in connection with the purchase and sale of set-top boxes and advertising, not securities.
Alternatively, the court could focus on scienter. Scienter has been defined by the Supreme Court as an "intent to deceive," although most (all?) lower courts have held that recklessness will suffice. I doubt that the respondents truly had an intent to deceive the securities markets. At most, you could say that they were reckless with respect to the truth: they didn't care whether their actions would deceive the markets. I would like the Supreme Court to hold that while recklessness may suffice with respect to participants in securities transactions (and their fiduciaries, including insiders), actual intent to deceive is necessary with respect to third parties. If a person who is not involved in a securities transaction nevertheless intends to deceive others who are, then it may be reasonable to hold that person liable; but not if they're simply doing their own thing in disregard of securities markets.
Both of these analyses get at the same point: a person who has nothing to do with a securities transaction should not easily be held liable as a primary actor in securities fraud. Liability, if any, should be based on aiding and abetting. And Stoneridge seems a particularly good example of the difference between the two. The respondents were not themselves engaging in securities fraud, but their actions may have aided and abetted securities fraud.
One of the worst possible outcomes would be for Supreme Court to limit itself to the question presented and decide that respondents cannot be held liable solely because they "made no public statements concerning those transactions." A statement is expressly required by neither Rule 10b-5 nor § 10(b). Section 10(b) speaks of "any deceptive device or contrivance," which is clearly broader than only statements; Rule 10b-5 is broader still (but limited by the statutory language, of course). This issue is really about reliance, and since reliance is a separate requirement, you don't need to demand a statement. With the availability of other statutory (and common law) bases for limiting Rule 10b-5, it would be imprudent for the Court to disregard the plain meaning of the statute.
I've often been intrigued by the question of whether, if an entire industry can be negligent, can an entire industry be criminal? Many of the so-called corporate scandals seem to involve practices that were engaged in widely throughout a certain sector or industry, and the unlucky few lose the "corporate crime lottery" by becoming targets of prosecutorial discretion. In a scenario not unlike Shirley Jackson's The Lottery, these unfortunate targets are punished for the purported crimes of many in hopes of deterring the larger population. The defense that everyone backdated or engaged in wash trades or practiced aggressive earnings management is not even worth advancing.
However, at least in the NBA, widespread rule-breaking seems to have exonerated each individual. The NBA commissioner David Stern, in reacting to a report that all of the NBA's 56 referees broke the league's anti-gambling rule in some way, criticized the rules instead of the rule-breakers. Evidence that none of the referees live by the rules, with half gambling in casinos and the group hosting a poker tournament at its annual meeting, seemed only to convince Stern that the rules were "harsh" and "outdated in regards to changing attitudes toward gambling in the United States." As a consequence, the rules will now be rewritten to include various non-sports gambling in the off season.
According to commentators last week on Pardon the Interruption, Stern (who apparently has claimed in the past to be tied to the letter of the law of other Draconian NBA rules) was put in a difficult situation because he could not practically fire all or even half of the NBA referees. Being unable to prosecute all offenders has never stopped the DOJ, however. Apparently Stern is new to the art of prosecutorial discretion.
Permalink | White Collar Crime | Comments (1) | TrackBack (0)
October 28, 2007
Over the weekend, Larry Ribstein posted two entries at Ideoblog that are well worth reading: first, he uses my "moral responsibility" post as a springboard to discuss corporate social responsibility, and second, he expands significantly on an older post of mine on Facebook, discussing "shelf LLCs," federal diversity jurisdiction, and choice of form. Over the past week, I have been updating my Business Organizations casebook, and in the process, I have had the chance to read several of Larry's articles on these latter subjects relating to LLCs. No one writes more meaningfully in the field, and if you don't have time to read the articles, at least do yourself the favor of reading the post.
Permalink | Corporate Law, Limited Liability | Comments (0) | TrackBack (0)
... of the carried interest bill. Rep. Rangel introduced a new version of the Levin Bill on carried interest (i.e. the broader House version) as part of his "mother of all tax reform" proposal. Of greater relevance is the possibility that the carried interest bill will be split off as part of an AMT patch.
$50 Billion. The Joint Committee on Taxation estimated the revenue from the carried interest legislation at $25 billion over 10 years. This is a bit lower than my back-of-the-envelope estimate, but still an impressive chunk of change. When you add in the proposal to end offshore deferral for hedge fund managers, you get about $50 billion, which is about what's needed to pay for the AMT patch.
The loan "workaround." One workaround to the original Levin bill would be to have the fund manager borrow money from the limited partners at a zero or below market rate of interest, followed by an investment of the loan proceeds in the fund. The net result would be a mix of ordinary income and capital gain. The new bill shuts down this strategy, treating a partnership interest purchased with proceeds of such a loan as an "Investment Management Services Partnership Interest," rather than a normal capital interest in the partnership. As such, any distributions to the service partner/fund manager would be treated as ordinary income. I would imagine that this amendment increased the revenue estimate by 20% or so. There is some additional language that shuts down similar avoidance strategies.
Offshore Deferral. I find it curious that hardly anyone is talking about the proposal to end offshore deferral for hedge fund managers. Under current law, hedge fund managers achieve deferral by organizing the fund in the Caymans and electing to be treated as a foreign corporation under U.S. law. (Because the Cayman Corp is engaged in securities trading, it's not treated as effectively connected with a US trade or business, even if the fund managers are working in Greenwich or elsewhere in the US.) In lieu of carried interest, the hedge fund managers structure their comp as an "incentive fee" from the Cayman Corp. They then set aside a large portion of their fee for deferral and reinvest the money (still using pretax dollars) offshore. The House legislation would end this strategy for corporations organized in certain tax haven jurisdictions.
The Senate. It's still not clear to me what's going on in the Senate. As I understand it, the Senate Finance Committee would rather waive the pay-go rules and provide an AMT patch without paying for it. It's not at all clear what's going on with carried interest--Schumer announced that he'd be introducing a new bill, but I haven't seen it introduced. At this point, I'd bet on the offshore deferral bill (introduced by Kerry) getting passed before carried interest. The Blackstone/PTP bill still seems to be alive as well.
After promulgation of the first Uniform Partnership Act in 1914, William Draper Lewis of the University of Pennsylvania Law School, one of the principal draftsman of the Act, described the debate over the legal personality of partnerships at a meeting of the UPA drafting committee and commentators:
"[T]hose with the largest practical experience present were opposed to regarding the partnership as a 'legal person' because of the effect of the theory in lessening the partner’s sense of moral responsibility for partnership acts."
William Draper Lewis, The Uniform Partnership Act — A Reply to Mr. Crane’s Criticism, 29 Harv. L. Rev. 158, 172-173 (1915).
Does this concern over the "moral responsibility" of partners seem odd to you? It is an argument that often has been raised with regard to limited liability, but in the partnership context, the supposed effect ("lessening the partner’s sense of moral responsibility for partnership acts") appears to emanate merely from a change in the nature of the partnership relationship, rather than any change in actual liability risk.
October 26, 2007
I am reading some old Karl Llewellyn articles, including one from the Harvard Law Review entitled "Across Sales on Horseback." Here is the first paragraph:
It is possible that there are fields of our law more fascinating than that of Sales, but I find the possibility difficult to credit. For packed into this small sector of the law is the course of our history over a century and a half, reflected with a range which the narrowness of the subject matter would seem offhand to make impossible, reflected with a precision which rivals even that of the constitutional law field. And because the work is the work of a multitude of courts, inexpert, busy chiefly on other things, average shrewd and more than average honest, but with no supreme authority over them, the picture yielded is a picture of the democratic process in law-making which the constitutional law field can never rival.
Does this resonate with you? Or do you read Llewellyn and think, "Surely he must be kidding!"? When I read the first sentence, I thought he was joking, but this passage resonates with me. I feel the same way about studying contracts and fiduciary law. During law school, I was a Con Law junkie, so I can see the attraction, but now I much prefer to read about private ordering.
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