I have been doing some research on the impact of shareholder activism on board composition—and in fact was generously given data on shareholder activism from the folks at SharkRepellent.net.  I am in the very early stages of analyzing the data, but thus far have observed a couple of interesting things about the impact of shareholder activism on boards.

1.  It is often the case that when managers and shareholders agree to alter board composition, they expand the board.  This means that instead of replacing directors up for re-election with dissident directors, one or two shareholder-supported directors get added to the existing group.  This raises an issue about whether and to what extent this kind of management/shareholder agreement really has an impact on the board since they only serve to add one or two dissident voices to the “status quo.”  Of course, perhaps the most important thing for shareholders is to obtain a seat, even a lone one, at the table.

2.  Thus far the data suggest that shareholder-supported directors tend to be younger than their management-nominated counterparts.  Indeed, in one proxy contest management specifically emphasized the fact that shareholders had nominated a 28 year old to serve on the board.  To be sure, most nominees are not as young as 28, but they do tend to be younger than members of the existing board or those being nominated by management.  This may be because boards tend to draw from an “older” pool—that is former CEOs, etc—while shareholders (though not all) tend to draw from managers and partners in various funds, who tend to be younger as a group.  Regardless, this “youth” factor leaves shareholders open to criticism regarding the experience of their nominees. 

3.  The data suggest that shareholder activist groups tend to nominate founders/partners/managers of their own group.  To be sure, it is not surprising that shareholders would nominate candidates inside their group—and perhaps it is the same as managements’ decision to nominate members of their management team to serve on boards.  Nevertheless, this practice leads to criticism concerning whether shareholder nominees represent the entire shareholder class or just a few shareholders.

4.  Finally, the data I have reviewed to date suggest that nominees do not tend to be diverse in terms of gender, race or ethnicity.  To be sure, sometimes it is difficult to determine if a board candidate is diverse.  Moreover, sometimes the boards on which shareholder nominees seek to serve are not necessarily diverse either.  And yet, while boards that are the subject of activism tend to have at least one diverse member, this is not usually the case with the slate of shareholder nominees.  This appears to confirm the notion that shareholder activism may be detrimental to the interests of other constituents by suggesting that while corporations are more likely to pay heed to the interests of a variety of different groups (including those that view board diversity as important), shareholders are likely to have a narrower perspective.

Again, I am in the beginning phases of my research and hence these observations could change, but they nevertheless are indicative of some interesting issues that may provide insight into how shareholder activism impacts the board and its composition.

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So, we wake up to find (unless you watch ESPN all night long) that Brett Favre has been traded to the New York Jets.  But for all you corporate lawyers out there, the most interesting factoid is that the trade agreement has an earnout provision!  Because the future profitability of Favre is somewhat unknown, the agreement provides as the baseline that the Packers receive a fourth-round draft pick from the Jets.  However, if Favre does really well, that draft pick may become a first-round draft pick.  (Talk about some strange incentives for Favre!)

The agreement also has an interesting football version of a "noncompete."  The Packers, a team in the NFC, traded Favre to the Jets, a team in the AFC.  However, if the Jets trade Favre to the Minnesota Vikings, another NFC team and rival of the Packers, then the Jets have to give the Packers three first-round draft picks.  Cool.

OK, enough football blogging for awhile!

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A Texas friend of ours emailed today, wishing we still lived in Wisconsin.  He said that getting Brett Favre updates every 5 minutes wasn't enough for him -- perhaps if we still lived in Wisconsin, we would have minute-by-minute updates.  Well, according to the Milwaukee local news, Favre has left town -- probably for the foreseeable future.

I have to say that I was a cheesehead before we went to Wisconsin (I loved that thing where they jumped into the fans' seats when they scored a touchdown), and was even more of a fan while living there.  My kids first encountered the Packers and St. Patrick's Day the first year there, so they still think there's something called St. Packer's Day where everyone wears their green Packers shirt to school so they don't get pinched.  But, here's my prediction about Favre's revived career.

It will be bad.  The Packers will trade him to a stinky team.  This team will have a stinky offensive line.  Favre will give the team one or two more wins and sell some tickets, but he won't have a great season.  He'll have a stinky season.  And he might get hurt because (you guessed it) his offensive line is stinky.  I predict he will retire after one season, maybe two if he doesn't get hurt.  (I hope the team recruits a star left tackle for their star quarterback.)  Recall how stinky pro teams do when they draft Heisman trophy-winning quarterbacks and put them with their stinky team and their stinky offensive lines.  It's bad.  And everyone says, "I thought that quarterback was supposed to be good?"  This is what happens.

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In my last post, I discussed how proposed revisions to the basic “accounting for lawyers” course could improve the transactional curriculum.  In this post, I suggest that we add a new course to the curriculum: B-school for Law School. 

Many students enter law school with little or no business background.  They come directly to law school from college, having taken a broad range of liberal arts courses with perhaps a course or two in economics.  While a sophisticated grounding in economics is essential to understanding the business world, economics and business are not synonymous.  As transactional lawyers do business deals, knowing about business is essential.  Indeed, to be a good transactional lawyer, the lawyer must understand business, the client’s business, and the business deal.

To give students the background they need, we must begin by giving them a primer in the most basic aspects of business.  “B-school for Law School” would start with students learning about the business world in general.  They would learn, among other things, about interest rates, currency exchange rates, insurance, credit-rating agencies, commercial banks, investment banking, and how stock exchanges function.  (While students may study how securities are issued, most do not know the pragmatics of how they are bought and sold once issued.)

Students also need an understanding of how companies function – not the legal issues relating to shareholders, directors, and officers - but how companies function as businesses.  As part of this course, students would learn about corporate organization – cost v. profit centers and the various reporting structures.  In addition, they would learn about strategic planning, quality control, risk management, and human resource management.  With this background, students will gain insight into the business issues with which their clients grapple and how those issues affect their legal needs. 

Finally, as today’s deal market is the progeny of the LBO market of the 80’s, the course should include a history of deals over the last 25 years, providing students a much needed perspective on what is happening today.  Among other things, students need to know about Drexel and Michael Milken.  They need to know not only legal ethics, but also business ethics. 

To give all of this context and some fun, students could play two computer games.  The first is a business simulation game companies use to teach management skills to their employees.  Each student runs a company, making such decisions as to whether to invest in inventory or research and development.  Bad things happen along the way and students have to decide what to do.  The winner is the student whose company makes the most money.

The second game is known as the Stock Market Game.  In it, each student invests $100,000 in a hypothetical portfolio.  As the Dow Jones Average goes up and down, so too does the value of a student’s portfolio.  The winner, of course, is the person with the largest portfolio when the game ends. 

If we are to give students a solid foundation for the practice of transactional law, B-school for Law School is not an elective; it is an indispensable, core course. 

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Welcome back to the fourth day of the Fourth Annual Conglomerate Junior Scholars Workshop.  Today's author is James Park, an assistant professor at Brooklyn Law School, where he teaches securities regulation, corporations, corporate finance and civil procedure.  His research so far has focused on securities law, including this paper, which has been accepted by the Journal of Corporation Law, Assessing Materiality of Financial Misstatements:

While markets rely on accurate financial reports in valuing companies, it can be difficult to interpret vague accounting rules. Federal securities law thus makes liability for financial misstatements contingent on a showing of materiality. There are two competing approaches to assessing the materiality of a financial misstatement. First, there is a quantitative approach, where a misstatement can only be material if it is above a bright-line threshold - often 5 percent of net income. Second, there is a qualitative approach, where a misstatement under the 5 percent threshold can still be material if it allows a company to meet its earnings forecasts or results in management bonuses.

Today we have a nonembarassment of riches with a star-studded lineup of commentators and past workshop participants: Adam Pritchard, Larry Cunningham, Joan Heminway, Elizabeth Nowicki, Dave Hoffman and Michael Guttentag. Our own Fred Tung is also waiting in the wings with some thoughts.

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I have long thought that the doctrine relating to materiality suffered from a fundamental contradiction.  On the one hand, Basic set materiality on a path toward an empirical approach to the question.  By adopting TSC’s “reasonable investor” standard for Rule 10b-5 in the same opinion in which the Court endorsed the efficient capital market hypothesis in adopting the fraud-on-the-market presumption of reliance, the Court set the stage for a market test for materiality.  Did the stock of the company experience an abnormal return when the misstatement was made, or subsequently, when the omitted information was revealed?  The presumption is that the market consists of reasonable investors (or at least that the reasonable investors are the one that drive price discovery.  It follows that the consensus of those investors, as reflected in changes in that market price, is the best evidence with respect to whether reasonable investors considered the information relevant to their buying and selling decisions.  This version of materiality has a nice, objective appeal.  On the other hand, the SEC has long insisted that managerial integrity is material to reasonable investors, most notably in the Franchard decision.  This view would also seem to be supported by the legislative history of the securities laws, born as they were of the scandal mongering of the Pecora hearings and FDR’s polemics against the moneyed classes.  To put the matter more generously, “sunlight is the best disinfectant,” that is, disclosure is likely to have a therapeutic effect on agency costs.

Both approaches are more appealing in theory than in practice.  A market test for materiality has objective appeal until one gets down to the messy business of measuring it.  Objective is not the same thing as accurate.  Relying on abnormal market movements as the measure of materiality invites manipulation by fraudulent corporations, who will have every incentive to bury the revelation of a prior misstatement in amongst positive news, daring the plaintiffs’ expert to untangle the resulting mess.   Also complicating measurement are the various components that are reflected in the stock market’s response to the revelation of the bad news.  Part of the response is a revaluation of the company’s prospects in light of new information about its earnings prospects, but part of the response reflects the market’s assessment that the company will face a class action lawsuit or an SEC enforcement action.    These costs could lead to an abnormal return, even if the original misstatement was not material.  The market surely understands that materiality judgments are a murky area for courts, and therefore prone to error.  A sufficiently high probability of error means that the company will bear heavy distraction and settlement costs, even for a trivial misstatement.  Finally, the market test for materiality can only be applied ex post, which is not very useful for lawyers trying to make materiality assessments when they are crafting disclosures.

The weakness of the integrity approach is that is likely to be taken hostage by the SEC’s nanny-state paternalism.  The agency has a low threshold for outrage, triggered by anything likely to provoke embarrassing headlines if revealed.  Reasonable investors know that firm specific risks can be managed through diversification, so they are likely to have a higher threshold for outrage at management.  Earnings management of the income smoothing variety is unlikely to provoke much outrage among hedge fund managers, who likely expect a certain amount of such behavior, but from the SEC’s perspective, it raises fundamental questions about the senior management team’s capacity to lead.  The SEC’s delicate sensitivities would be tolerable if its views only played out in enforcement actions, but they are also likely to influence class actions.

Park does not have the silver bullet that would resolve the existing tensions in materiality doctrine.    Instead, he wants to further complicate the matter, bringing the question of damages reform into the mix.  Specifically, he proposes to use materiality doctrine to limit vicarious corporate liability to cases in which there has been a sustained misstatement in a company’s financial statements.  Such misstatements make it difficult for market participants to value a company’s future earnings, in Park’s view.   By contrast, liability for minor misstatements would be measured by whether a defendant gained from the fraud.  So, stock options that were bumped into the money by shifting revenues up a quarter would be subject to disgorgement.  The result is some shifting of the liability burden from corporations to executives.

Damages reform is near and dear to my heart, but I am not persuaded that materiality is the best doctrinal hook for addressing the issue.  A number of issues highlighted by Park as relevant to the question of materiality are already part of the Rule 10b-5 inquiry, in particular, the scienter element.  Was a misrepresentation isolated or persistent?  That’s probative evidence on recklessness.  Was an officer enriched by the misstatement?  That’s motive and opportunity.  The strength of evidence showing scienter is a key factor for settlement negotiations, so practically speaking, these questions are already incorporated into the penalty calculus of Rule 10b-5 actions.  And they are clearly already factors that the SEC considers in assessing penalties in its enforcement actions.   

A broader objection to Park’s proposal is that if damages should be reformed, they should be reformed across the board, and not just with respect to financial misstatements.  Other misstatements, both historical and forward-looking, also give rise to liability.  Why single out financial misstatements for lower penalties against the corporation?  Given the importance of financial information, why should companies enjoy a lower antifraud standard for that set of misstatements?

Park’s standard would appear to make the greatest difference in § 11 cases.  But couldn’t we achieve much the same result by giving the issuer a due diligence defense?  And all of this assumes that we should relax issuer liability standards in public offering cases.  Given the institutional incentive to inflate the company’s prospects when it is raising capital, relaxing standards in the context is not obviously a good idea.

One minor nit.  Park suggests that misstatements might lead a corporation into insolvency because it might induce the corporation to take on an excessive debt load (MS. p. 38).  This seems implausible to me.  I have no doubt that misstatements are positively correlated with insolvency, but it seems a stretch to suggest causation.  If managers are misrepresenting the financials, they presumably know this, and they are basing their financing decisions on the true picture, not the one that they are presenting to investors.  Insolvency is unpleasant for corporate managers; it seems doubtful that they are actively courting it through their misrepresentations.  More likely that they are seeking to avoid it by papering over the weaknesses in the business.

Overall, I enjoyed the paper, which I think canvasses the existing problems with materiality doctrine quite ably.  I’m not sure that I agree with the proposal that comes out of those problems, but thinking about it in these terms is certainly a step in the right direction.

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            Professor James Park’s paper makes at least two excellent contributions to the literature on materiality in financial reporting: (1) the relevant viewpoint for testing materiality is the reasonable investor, as under current law, here taken to mean the investor engaged in fundamental valuation analysis, not necessarily proxied by aggregate market reaction models and (2) an important basis for assessing materiality, using current law’s “total mix of information” conception, is whether a misstatement is persistent as opposed to isolated.   The paper also offers valuable implications of these insights for preferring vicarious or individual liability arising from material financial misstatements. 

            The paper thus addresses the pervasively important issue of assessing materiality in financial reporting. This subject is particularly topical amid high levels of financial restatements in the past five years.  The subject also is receiving formal policy attention.  For example, the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR) http://www.sec.gov/about/offices/oca/acifr.shtml, in its Final Report  http://www.sec.gov/about/offices/oca/acifr/acifr-finalreport.pdf, released last Friday, addresses this territory.   The paper admirably enriches the field of law and accounting.  I had the pleasure previously to comment to Professor Park on his paper and here can register just a few additional modest observations. 

            First, Part II of the paper explores how to enhance analytical understanding of the prevailing legal notion of a reasonable investor. It notes the prevalent invocation of market reaction models to assess materiality from the reasonable investor’s viewpoint.  It explores how materiality should be conceived if one instead locates the reasonable investor in traditional fundamental valuation analysis. As a devotee of value investing practiced by luminaries such as Warren Buffett, I particularly appreciate this orientation shift.

            The most powerful implication of Professor Park’s insightful analysis “reveals a basic flaw in the current tests for assessing materiality.” Those tests concentrate too heavily on size (quantitative materiality, often using a 5% of net income rule of thumb) and certain specific notions of qualitative materiality, especially managerial motivations.  Professor Park concludes this illuminating discussion by observing that this prevailing result obscures a vital aspect of materiality assessments: the relative persistence or isolation of a misstatement.

            Excellent as the discussion is, a modest addition could note inherent, methodological, limitations on market reaction studies.  For financial misstatements, these studies are conducted in relation to subsequent restatements of previously misstated financials.  Problems include measurement difficulties arising from the time lag between market knowledge of a forthcoming restatement and its ultimate resolution;  the bearing on market price of matters other than the misstatement and restatement; and disclosure accompanying a restatement that may provide offsetting pricing effects.

            Second, Part III of the paper proposes explicitly to examine persistence versus isolation as a central factor in materiality evaluations.  The paper wisely puts this proposal in terms of legal presumptions.  This shows the proposal’s distinctiveness and adds flexibility to promote its utility.  Persistence yields a presumption of materiality, even if less than 5%; isolation yields a presumption of immateriality, even if greater than 5%.    Both are rebuttable.  If it is unclear whether a misstatement is persistent or isolated, then law continues to resort to examine the totality of circumstances (under the “total mix” conception). 

            Thus Professor Park rightly acknowledges that the notion of persistence-isolation will not always be dispositive. The main point is that it can help in a wide range of contexts where it affects the total mix of information available to reasonable (fundamental valuation) investors.  Notably, in my view, this contribution makes explicit a component of qualitative materiality analysis that has been obscured but deserves a prominent place.  Professor Park’s prescription to take explicit account of persistence versus isolation is thus valuable.

            Professor Park’s proposals are also consistent with CIFR’s recommendations and provide an intellectual basis to accept those recommendations.  CIFR recommends retaining the reasonable investor standard, while placing more emphasis on actual investor valuation analytics as opposed to the prevailing heavy reliance upon market reaction studies.  It recommends giving explicit attention to the persistence or isolation of a misstatement (at least so long as an isolated item “does not alter investors’ perceptions of key trends affecting the company”).

            Given the nature of high-quality legal scholarship compared to advisory committee reports, Professor Park’s analysis is richer and more complete than the briefer CIFR recommendations.  Accordingly, when the SEC and others study CIFR’s Final Report, they would benefit from reading Professor Park’s elaboration of these two important propositions.

            That said, worth appreciating is how CIFR’s Final Report does not propose to eliminate market reaction studies from analysis nor to elevate the persistence-isolation inquiry above other ways to assess materiality.   After all, there are many different types of misstatements, some important to investors and some not.  The persistence-isolation spectrum is one useful ground for gleaning that distinction.  But it may not be the only one. 

            Other ways to probe materiality in financial reporting concern the measure or classification at stake.  For example, revenue recognition is generally a more important category than non-core expenses.  Even isolated revenue recognition errors may be important in ways that persistent misstatements in non-core expenses are not.  Similarly, misstatements concerning recurring operating expenses often are more important than those concerning many reclassifications.  More broadly, of potential importance, especially when adopting a reasonable investor’s fundamental valuation viewpoint, some misstatements, even if persistent or large, may not drive investor models, metrics or conclusions.  In these contexts, the notions of persistence or isolation may be less useful.   

            Finally, neither Professor Park nor CIFR are offering particularly radical or revolutionary suggestions.  Indeed, CIFR explains that its diagnosis and recommendation arise less from problems in the legal or regulatory standard than in applications in practice.  Current law’s reasonable investor and total mix tests of materiality are coherent and prevailing SEC are appropriate.  But CIFR says too many materiality judgments do not adopt those standards in practice.  CIFR says its suggestions are a “modest clarification of the existing guidance to conform practice to the standard” and “not a major revision to the concepts and principles embodied in existing SEC staff guidance.”  Practical and sensible,

Professor Park’s paper is an important contribution to the law and accounting literature and a good source of analytical support for CIFR’s recommendations. 

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[Professor Heminway has written on this topic before here -- eds.]

Professor James Park’s Assessing the Materiality of Financial Misstatements is a gutsy piece of scholarship that arrived on my desk at the right time.  “Gutsy,” in that he takes on a hugely complicated area; and timely in that I am finishing off a paper relating to the conceptualization of the reasonable investor in materiality analysis then plan to extend my earlier work on materiality in a paper that I am writing during the fall and winter.  Professor Park’s article focuses generally on rationalizing the assessment of the materiality of financial misstatements and specifically on making sense of the use of quantitative and qualitative measures in those materiality determinations.  It is an insightful piece, although I do disagree with some of the underlying observations and characterizations.  As has become my habit, I am affording my more detailed comments to Professor Park individually, offline.  A summary of key points follows.

Park hits the nail squarely on the head when he states that “[t]he current debate myopically focuses on the practicalities of the standard – whether it is easy to apply (favoring the quantitative standard) or allows prevention of earnings manipulation (favoring the qualitative standard).”  In this piece, Professor Park attempts to widen the debate by looking at the overall significance of financial reporting to the securities regulation scheme.  He is largely successful in that effort.

In a new tweak on the “short-term vs. long-term investor” debate and in contravention of those arguing for a definition of materiality that relies on price effects, Professor Park first argues for the inclusion of persistence in financial misstatement materiality assessments.   Ultimately, I like this argument, although I will not, with my limited finance expertise, validate or challenge the simple valuation analyses he uses to support his position.  (I know from 15 years of hard labor with investment bankers and valuation experts that there’s more than one way to value a company . . . .)  There’s plenty more there in the paper for nonquants like me to grasp onto and rely on, in any event.  If I had one wish about this part of the paper, it would be that Professor Park should tie his observations back to the policy underpinnings of the securities laws more directly and clearly.  Why does his approach, e.g., better assure market integrity?  And how does his approach better protect investors, especially short-term investors?  Are these two policy underpinnings put into conflict or do they coexist symbiotically or synchronistically in this environment?

Professor Park then goes on to suggest that corporations and their agents be treated differently for purposes of liability in fraud-on-the-market cases (although I think he means to reference securities fraud actions—at least private enforcement actions—more broadly).  I find this part of  Professor Park’s article less persuasive, largely because he builds it off a narrow view of the purpose of qualitative materiality assessments.  He asserts that qualitative materiality exists to prevent self-dealing/conflicts of interest.  Certainly, concern about management conflicts drives the consideration of matters other than bright-line financial tests in determining materiality.  But there is more than that in qualitative materiality.  Said another way, earnings management is only a part of the overall picture of what materiality addresses in the financial statement area.  As Professor Park himself notes: “[n]ot all accounting frauds are alike.”

Professor Park would be on safer ground if he narrowed his claim in this part of the article to the role of qualitative materiality in addressing earnings management.  Also, in this part of the paper, he refers to the “vicarious” liability of a corporation for material financial misstatements.  In spite of these references, I do believe that he realizes that the liability of an issuer/registrant for material misrepresentations in its financial statements is primary, statutory liability, not merely the common law liability of a principal for the actions of its agent.  He does offer one express statement in that regard (noting that “[i]ndeed, liability for financial misstatements may be an issue of direct rather than vicarious liability”), and he also admits as much in his discussion of securities fraud under Section 11 of the 1933 Act and Section 10(b)/Rule 10b-5 under the 1934 Act and in his discussion of proposals to exempt issuers from that liability.

I do have a few lesser substantive quarrels with statements Professor Park makes in his article.  For example, he indicates without citational support that the concept of the reasonable investor may differ based on the type of statement at issue:  “While the term ‘reasonable investor’ can encompass both irrational and rational investors, the case for focusing on the perspective of the rational investor is strongest with respect to financial misstatements.”  I am not confident, based on my own research, that this is correct as a positive or normative matter.  Moreover, the narrow focus on rational vs. irrational investors (without taking into account other conceptions of the reasonable investor) did not satisfy me.  I would like to see more on this in the paper—or at least an acknowledgement of the academic debate—if he intends to rely on contextual differences in the reasonable investor to any significant extent.  He does mention the existence of a debate briefly in passing, so I know he’s aware of it . . . .

Also, at the outset and throughout the article, Professor Park draws a distinction between quantitative and qualitative materiality in evaluating the significance of financial statement misstatements.  He narrowly defines quantitative materiality to include principally the debunked “5% test” (but also other bright-line financial tests).  He then states that SAB No. 99 adopts qualitative materiality as the exclusive test.  I disagree with that characterization.  SAB No. 99 adopts the TSC/Basic formulation of materiality, which includes both quantitative and qualitative components; “[e]valuation of materiality requires a registrant and its auditor to consider all the relevant circumstances” and the “interaction of quantitative and qualitative considerations.”  Nevertheless, his overall views on the vagueries of the existing materiality standard are dead-on right.

All in all, this is a valuable piece of work that contributes new insights to the literature on materiality.  I am grateful for the opportunity to contribute to the dialog.  Thanks, again, to Christine, Gordon, and the whole Glom gang for inviting me to participate.

more ...

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The nettlesome issue of how to implement the materiality standard is one of the crucial open questions in securities regulation.  It’s good to see Professor Park make a solid effort to advance our understanding of this issue.  Park is clearly correct that leaving judges and juries with the task of interpreting a vague “reasonable investor” standard is a cop out, and the SEC is struggling to come up with a better solution.  But I would want a more precise connection to theoretical rationales for securities regulation and more research on the types of information sophisticated investors actually use to value stocks before endorsing Park's many recommendations.

To review, the Supreme Court has borrowed the reasonable person standard from other areas of law and adopted a "reasonable investor" standard to evaluate when information disclosed by public companies is material.  But, as Park correctly points out, there are many questions that come about in implementing a reasonable investor standard.  Should only rational investors be considered?  Is a quantitative test an efficient way to reduce the transaction costs associated with determining when information is material?

I will address two areas in which I think more careful consideration could improve Park’s article.  First, Park could be more thorough in identifying the larger theoretical issues that any discussion about how to implement the materiality standard should build upon.  Second, looking more carefully at the types of information that sophisticated investors actually use to value companies would help to better elucidate how to apply a “reasonable investor” standard.

On the theoretical front, Park is not sufficiently thorough in considering why public securities are regulated.  He does mention the importance of share price accuracy, noting the work of Professor Fox.  But he does not acknowledge the problems with these claims identified by Roberta Romano (and myself).  He also fails to mention Paul Mahoney’s excellent work distinguishing between the accuracy enhancing and agency cost reducing benefits of requiring disclosure.

These theoretical debates about securities regulation have direct implications for how to implement the materiality standard.  For example, if agency cost reduction is an important aspect of disclosure regulation, then it is the transactions between the agent and the firm that may be more important to monitor, regardless of scale.  The analysis gets more complicated if, as I have argued, there are certain types of information that simultaneously increase accuracy enhancement and reduce agency costs (for example, by reducing opportunities for agents to capture for themselves the value of information asymmetries).  Park’s discussion alludes to these issues, but a more explicit discussion of theoretical issues is needed. Such considerations would be helpful, for example, in clarifying Park’s effort to distinguish large scale fraud from other kinds of misleading statements.  Working with a broader theoretical palette, in part by acknowledging the potential relevance of the work of Romano and Mahoney among others, would lead to a more satisfying answer to the puzzle of materiality.

On the practical front, Park chooses to focus on the perspective of the rational investor, which I think is the correct approach.  But then he goes on to rely on what I find to be an overly simplistic description of how the rational investor would rely on earnings in carrying out a Discounted Cash Flow (DCF) analysis to value securities.  Park needs to make more of an effort to research the types of information that sophisticated investors actually use to value firms.  In supporting an argument that the appropriate standard for materiality should use as a template the disclosures required by sophisticated investors in private transactions I did such research (Florida State, 2004).  Park cites textbooks and a few academic studies.  (His footnote 107 is a little better, but later in the article he does not incorporate this complexity).  Even if DCF analysis and earnings estimates are important tools in valuing firms, the inputs into sophisticated financial analysis tend to be more diverse than Park acknowledges.   

It is primarily by relying on a relatively simple DCF valuation technique to model the rational investor that Park is able to justify one of his main claims, that separating misstatements into two categories, temporary misstatements and ongoing misstatements, would be a helpful addition to the law.  Once we move away from a simple DCF valuation technique, such distinctions become more problematic.  It does not work to equate one-time write-downs with one-time misstatements.  As but one example, of which I'm sure Park is aware, a one-time change in income has on ongoing effect on the balance sheet.

Materiality is an important issue in securities regulation and enforcement.  I hope these comments help to make a good article better.

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Assessing the Materiality of Financial Misstatements usefully highlights the intersection of accounting law and securities law.  As Larry Cunningham wrote in a comment to this post a while back, this field presents an "amazingly rich field with many current and continuing opportunities" and one that should interest junior scholars.  Because I've been somewhat absent in appreciating of accounting's relationship to securities doctrine, I was happy to get a chance to read Prof. Park's work and learned a lot from the paper.  In no particular order, here are some (hopefully helpful) comments.

·        Park starts with the assumption that ideally "the materiality standard would serve as a significant gatekeeper in screening out trivial from substantial misstatements," and criticizes courts for instead substituting a "nebulous" standard that has resulted in substantial uncertainty by reporting entities.  Here, I think Park significantly understates the current screening effects of materiality doctrine.  As I've shown, judges considering materiality find that about half of considered disclosures are immaterial as a matter of law, and doctrines like puffery and bespeaks caution (which are bright-line rules) have increased in importance over time.  See also Bainbridge & Gulati, How to Judges Maximize, at 116 n.94 (most securities cases decided on MTD, and most determinations involved materiality).  These case-counting findings suggest doubt as to the need to reform materiality.  Indeed, over the last several years, I've seen an emerging consensus that the current state of securities law – from pleadings standards, to materiality, to scienter – has combined to create an such anti-plaintiff environment that the risk of fraud being screened out of court is higher than the likelihood of weak cases finding strike settlements.  Even were this not true, I think Park could do more to develop his thesis that materiality is the appropriate gatekeeping vehicle for in securities cases.  Why not the pleadings/scienter nexus?  Or to put it a different way, why would common-law courts be effective at determining when securities litigation is good for financial markets and investors? Bainbridge & Gulati and most other observers think that judges are looking for any scheme to move these cases off of their dockets, not be thoughtful gatekeepers.

·        Park's discussion of the difference between fundamental and market valuation (pps. 23-5) is lucid and informative, except that I think it comes to the wrong conclusion.  As Park recognizes, fundamental valuation doesn't necessarily track harm to investors (resulting from stock price effects) but instead hypothetical "rational investor[]s".  In my view, Park needs to do more to justify privileging such investors (who will usually be institutional) over ordinary traders.  There could be some unexpected gender effects here, given studies finding that women and men process financial information distinctly. See, e.g., Odean. 

·        In arguing against market materiality measures, Park suggests that event studies may be flawed instruments, and that price movements provide little ex ante guidance.  But, as I'll discuss in just a minute, his proposed solution doesn't much help with the ex ante problem.  As for event studies, I think we'd all agree that they are somewhat of an art form, and that judges evaluating them on SJ are unlikely to be particularly discerning critics.  But I wonder (again) about the missing competing competence argument: why should we conclude that judges would be any better at evaluating competing claims from experts about the fundamentals of accounting?

·        Park argues that materiality findings ought to be based, in part, on the difference between persistent and isolated misstatements.  Recognizing that this distinction is subject to abuse – both by managers and by securities-averse judges - Park urges that we should be wary of attempts to short-circuit the decision making process, potentially resolving it at summary judgment or at trial.  This would a pretty radical (pro-plaintiff) change in securities litigation practice, and not one I think courts are likely to embrace.  It's also somewhat in tension with Park's envisioned early gatekeeper role for materiality doctrine. Moreover, the fact that the definition is something that requires adjudication, and isn't self-evident, makes it harder for me to see why fundamental analysis provides better ex ante guidance for disclosing entities and their agents.  I imagine that executives will be overly self-confident about the likelihood that a misstatement is of the "harmless" short-term variety (as Park argues, they may even believe that they are smoothing earnings to reduce "irrational" market distortions)

·        The paper would be aided by more talk throughout about settlement.  The current system seems designed (especially after recent pleadings decisions from the Supreme Court) to knock out cases at the dismissal stage, and to leave all further cases to settlement in the early stages of discovery.  Park's system, by contrast, appears designed to require extensive discovery about corporate financials before the parties can realistically assess their odds of succeeding on summary judgment. (Securities cases are even less likely than the ordinary civil case to go to trial; I doubt that much securities practice is shaped by the shadow of the too-few jury verdicts.) Park should consider expanding his analysis to consider how and when in litigation lawyers would be able to distinguish between persistent and isolated financial misstatements, and thus what effects, both static and dynamic, it would have on settlement.

·        Park's vicarious liability proposal is intriguing and I agree with much of it.  It is, of course, part of a larger trend to focus on ways to target securities law on agents.  That literature, in turn, is premised on the idea that securities law does a bad job deterring corporate misconduct because the "real wrongdoers" don't feel the sting of sanctions. This literature is terrific, though it strikes me that policymakers would be aided by more empirical (experimental) work that examines the relationship between organization liability and individual psychology.  As always, individual liability proposals must be clear to address about the effects of insurance and indemnification.  Park argues that individual managers will internalize sanctions (notwithstanding D&O) when they are adjudicated to be liable.  This may be correct, although I think that the instances of D&O insurers successfully disclaiming coverage, notwithstanding the language of their policies, are pretty rare.  And of course, an adjudication-contingent D&O liability policy will result in the settlement of more non-meritorious claims.   That is, the more we focus on individual liability, the less likely we are to see adjudication, which will potentially result in more uncertainty for disclosing entities.  Don Langevoort's suggestion that we should instead focus on equitable remedies seems like it could use more discussion here.

That's it!  I hope that Prof. Park finds these comments helpful, and that he continues to focus on this important aspect of securities law doctrine.  The paper is relatively short, quite well-written, and certainly worth readers' time.

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Assessing the Materiality of Financial Misstatements:  Two Articles for the Price of One.

Many thanks to Christine Hurt and the folks here at the ‘Glom for including me in Junior Scholars Forum.  This is my third year participating, and the papers I have been asked to read are always stellar.

This year, I had the good fortune to read Professor James Park’s article, Assessing the Materiality of Financial Misstatements.  What I found was that I was actually reading two articles, one on materiality in the context of financial misstatements and one on vicarious liability for securities fraud related to financial misstatements.  While I favor Professor Park’s latter article more than his former, I applaud Professor Park for taking on two major topics and boldly addressing the vexing factual issues implicated in accounting fraud.

Regarding materiality, Professor Park takes the position that the two methods normally bandied about for assessing the materiality of financial misstatements – the qualitative and the quantitative methods – are unacceptable.  He maintains that courts should instead assess the persistence of a financial misstatement (whether the misstatement inflates earnings or hides significant declines in earnings over multiple reporting periods as opposed to simply changing a company’s financial picture at one moment) in assessing its materiality.  Regarding vicarious liability, Park maintains that vicarious liability for securities fraud in the context of financial misstatements merits revisiting, and vicarious liability should only be imposed in the context of quantitatively large misstatements .

In a nutshell, Professor Park does a wonderful job of explaining and unpacking the factual aspects of accounting fraud.  His detailed examination of financial statements and various ways to manipulate financial statements is worth reading in and of itself.  His subsequent materiality discussion and proposals to revise the way materiality assessments are make in the context of accounting fraud, however, raises a few questions for me, as discussed in detail below.  The vicarious liability section of his paper is a solid exposition of a minimally examined issue, and I imagine the more he develops this section of his paper (perhaps even making it its own paper), the further he will help advance the debate on how to address vicarious liability.  The reality is that courts rarely examine the propriety  of imposing liability vicariously in securities fraud cases.  Most courts simply impose vicarious liability on issuers without comment.  Park raises enough concerns about this issue, in the vein opened by Professors Carney and Arlen more than 15 years ago in their article titled Vicarious Liability for Fraud on Securities Markets:  Theory and Evidence, that he has the potential to inspire courts to re-examine the sensibility of imposing vicarious liability without analysis.  While I am not sure I necessarily agree with his ultimate conclusion that vicarious liability should only be imposed in the case of quantitatively large financial misstatements while individuals should be liable for both quantitatively small and large financial misstatements “especially if they cause stock price fluctuations,” I think his discussion of the issues is thought-provoking and likely to inspire further debate.  In this environment where some say law review articles are irrelevant to courts, I think more examination of the propriety of, fairness of, policy concerns implicated by, and deterrent effects of vicarious liability in securities fraud cases involving financial misstatements is much needed.  I look forward to Professor Park leading that charge.

Where I want to focus my specific comments, then, is on his materiality proposal.  As above stated, Professor Park maintains in his paper that the law regarding materiality in the context of financial misstatements merits revision.  While traditionally the debate about materiality has focused on whether it is appropriate to measure materiality against a qualitative or a quantitative standard, Park argues that this is myopic as neither standard is ideal.  Parks suggests that courts should add to their calculus a “persistence” analysis, which examines whether an allegedly material misstatement inflates earnings or hides significant declines in earnings over multiple reporting periods.  “Persistent misstatements,” he says” should be presumed to be material while isolated misstatements should be presumed to be immaterial.”

In reaching this conclusion, he reviews expertly the methodology by which investors value firms.  “A deeper analysis of what misstatements are most likely to affect the market’s assessment o f a company’s value,” he instructs, is necessary in developing a new materiality standard.  When looking at the market price method of valuation, he maintains that using this as a gauge for materiality is inappropriate in part because market price fluctuations can be arbitrary.  Information that impacts a firm’s short term stock price cannot be presumed to be material by virtue of simply having impacted stock price.  When looking at a fundamental analysis of valuation, however, he notes that persistent misstatements are more likely to impact valuation, such that it seems more appropriate to target these misstatements as presumptively material.

My biggest concern with this analysis and conclusion is that it reworks the true nature of a materiality assessment.  A materiality assessment, in the context of disclosure and financial misstatements, is intended to separate the wheat from the chaff.  Some things investors want to know about and are likely to care about when buying or selling a stock, and some things are not so important.  If I am the CEO of Disney, and I lie on Squawkbox about whether I like the Disney President’s necktie, that is an insignificant lie.  That is immaterial.  No investor is likely to care about that lie.  If I am the CEO of Disney, and I lie on Squawkbox about whether I think the Disney President is an incompetent sociopath, that is not an insignificant lie.  (I am making reference to the time years ago when Ovitz and Eisner were on some business news show together and professed to adore each other, very shortly before Disney announced that Ovitz was being forced out.) 

The Supreme Court has said that, in the context of financial misstatements, a fact is material if there is a substantial likelihood a reasonable investor would consider it important, in the context of the total mix of information available, in making her investment decision.  What Park does is wholly take us away from that Supreme Court standard as a normative matter, yet nowhere does not acknowledge this point and justify it.  If we move to his standard, where we use “persistence” as a more controlling factor for assessing materiality, we leave behind the focus on what an investor is likely to consider important in making her investment decision in favor of what is important in a longer-term objective valuation.  This fundamentally changes what the Supreme Court has said we should do in assessing materiality.

Looking at persistence deprives the investor who is making an investment decision today of the right to have information that is accurate today, regardless of whether that information will “persist” in its effect on a company’s longer timer value.  By using a persistence analysis, or incorporating persistence into the materiality analysis as a defining factor, we would be obliterating a category of material misstatements that are overt lies with only a short term impact.  That does not strike me as such a good thing, particularly for the poor investor who bought the stock based on those financial misstatements.  Moreover, it reworks the fundamental nature of the Supreme Court’s construct – “a substantial likelihood that a reasonable investor would consider the information important in making their investment decision.”  In a related vein, nowhere does Park account for the shareholder decision-making perspective which is, by nature, a time-limited perspective in some sense (either a shareholder will buy stock today or not; either a shareholder will sell stock today or not).

It speaks well of Park’s boldness and the magnitude of the issues Park addresses in his paper that I had to stop several times while it to simply chew on his analysis and his suggestions.  When reading law review articles, I usually do not have to completely stop reading to just let the wheels turn in silence.  That I had to do so in this case speaks well of Park’s willingness (as a junior scholar!) to take on big, complex, vexing topics.

Part of what kept stopping me was a lurking wonder if Park’s valuation and persistence concerns had more to do with damages than with materiality.  I have twice published about securities fraud and materiality, and, both times, I have observed that courts and scholars often mix materiality, damages, and reliance analysis together.  While reading Park’s bold paper, I could not help but ask “doesn’t the assessment of the impact a misstatement has on the long-term valuation of the company have more to do with damages than materiality?  By focusing on persistence, aren’t we conflating (even worse than we currently do) the damages and materiality assessments?  As a matter of common law fraud, on which Section 10(b) was based, isn’t this objectionable?”

I leave Professor Park with these questions, recognizing again that I am glad he has written a paper strong enough to inspire me to ask such questions.  Although I respectfully disagree with his conclusion that materiality should be reworked to focus on persistence, I commend his intellectual curiosity and willingness to take on such a major topic.  I applaud his boldness in making a radical proposal, and I am sure he will inspire debate in the future on incredibly important securities fraud topics.  I thank him in advance, and I look forward to reading his future work.

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A recent Investment Company Institute report revealed that sponsorship of shareholder proposals was relatively concentrated in the hands of a few individuals and groups.  Thus, the report revealed that in 2007, just five individuals accounted for about half of the proposals submitted by individuals, while only three unions accounted for about half of the proposals submitted by unions.  So, what do these figures mean?

In what he called his last formal speech, SEC Commissioner Paul Atkins specifically pointed out these figures and suggested that there were both troubling and indicative of some shareholders’ abusive use of the proposal process.  Similarly, while the ICI report indicated that many people submitted proposals in order to benefit the corporation, it also suggested that the figures confirmed research revealing that some shareholders used the proposal process to advance their own personal agenda.  Indeed, at first, and even second, glance, these figures seem to confirm the notion that shareholder activism reflects agitation by a narrow segment of the shareholder population, and that such activism may be antithetical to the interests of the broader shareholder class and the corporation.  In this regard, the figures appear to raise questions about the legitimacy of the recent increase in shareholder activism.

Of course, the figures can be viewed in another, and perhaps less troubling, light.  First, to the extent that shareholder activism represents a kind of activist movement, isn’t it the case that all movements need their leaders?  Moreover, given the natural apathy of shareholders, shouldn’t we expect shareholders to rely on a select few within their group to put forth shareholder proposals?  From this perspective, we should have expected that a small group of shareholders would bear the responsibility of submitting most of the shareholder proposals, and hence we should not be overly alarmed by the fact that they do.  Second, why should sponsorship matter when measuring the legitimacy of shareholder proposals and activism more generally?  Instead, shouldn’t the focus be on the percentage of shareholders who approve shareholder proposals?  In this regard, the fact that many shareholder proposals in the recent past were actually approved by a majority of shareholders seems to reveal that such proposals have a broad cross-section of support.  So who cares that they were submitted by the same few individuals or group of individuals?  Moreover, even if shareholders’ approval only reflects their dissatisfaction with the status quo, as opposed to their support of the issue embedded in the specific shareholder proposal, broad shareholder support of the proposal nevertheless appears to be an important signal to managers—and a signal being conveyed by a significant percentage of the shareholder base. These observations suggest that the fact that a relatively few shareholders sponsor shareholder proposals should not be seen as problematic.

Alas, of course, the troubling aspect of the sponsorship figures has little to do with the issue of shareholder approval of a given proposal. Instead, as Atkins points out, sometimes shareholders are able to wield significant influence over corporate affairs even when a proposal is not approved—and in fact some sponsors have no desire for a proposal to appear on the proxy statement for a vote. Thus, Atkins noted that some shareholders acknowledged that they sponsor proposals as a tactic to gain leverage to achieve their objectives “behind closed doors and out of the public eye.” He called such a tactic “appalling.”  This ability of shareholders to use the proposal process as an indirect means to influence corporate decision-making does cast a more sinister light on the sponsorship figures.

Ultimately, of course, it is difficult to know to what extent shareholders use the proposal process to negotiate behind closed doors (the doors are closed after all!), and thus it is difficult to know the extent of the problem. However, the possibility of such a phenomenon makes the sponsorship figures much more troubling than they otherwise would be, suggesting that at least some aspect of the recent increase in shareholder activism reflects increased power of a small and potentially unrepresentative sample of the shareholder class.

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Our friends at orgtheory are hosting a Book Forum on Steve Teles' Rise of the Conservative Legal Movement. I haven't read the book, but it seems to focus on just what you might expect: law and economics, the Federalist Society, and conservative public interest firms (e.g., Institute for Justice). Teles traces the movement to the late 1970s, and it certainly was in full swing by the time I attended law school at Chicago in the late 1980s.

My first direct contact with CLM was in 1985, when I visited Clint Bullock at the Institute for Justice in Washington DC. I was an undergraduate in the DC Circuit Executive's office, and I was incredibly impressed with his work. And I thought the humble offices were cool.

The secretaries at my internship were encouraging me to go to Chicago for law school, rather than any number of other top law schools. Chicago had the right values, they said. Well, I didn't just take their word for it -- and it certainly made a difference that Chicago happened to be close to Wisconsin -- but that's where I ended up two years later. Once at Chicago, I was initially drawn to the Federalist Society because they had the best speakers and food (most money) ... and because I have always had a libertarian leaning.

I ultimately became an officer in the law school chapter of the Federalist Society, then founded a lawyer's division in Delaware. I have been the adviser to student chapters at Lewis & Clark and Wisconsin, but they don't need me here at BYU. Anyway, I don't spend much time with the Federalist Society anymore, but Teles' book sounds like a nice trip down memory lane.

In addition to a stroll down memory lane for me, the book seems to have some very interesting stories to tell law professors. This is from Teles' first post at orgtheory:

L&E was successful in law schools in part because of the pre-existing weakness of the fields it was attacking. Doug Baird, who went on to become Dean of the Chicago Law School, told me that in the 1970s, "it was clear that…doing great work was easy…I used to say that this was just like knocking over Coke bottles with a baseball bat…I remember writing articles where the time between getting the idea and getting it accepted from a major law review was four days." (p.100) That suggests that to account for the success of L&E, we need an approach that looks both at the pre-existing regime in the law schools (especially in private law), and not just on what the agents trying to bring it down were doing. That is, there was an opportunity that, in the 1970s, meet a set of mobilized agents. I think that you can’t explain what happened with the explosion of law and economics without dealing with the structural vulnerability in the legal academy that agents were able to exploit (along with the fact that the immune system of the legal academy was much lower in areas like bankruptcy that had lost much of the ideological interest that they once had).

Doug Baird's comment will seem shocking to those outside of the legal academy. It brings to mind a conversation I once had with a colleague that getting something published in a law review was no great accomplishment: "I could start a brand new article right now and have something publishable -- somewhere, maybe even somewhere respectable -- by the end of the weekend." That's merely a function of having way more outlets for publication than we have good product to fill those outlets. Still, I think there is no question we have come a long distance in the past 30 years.

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Every once in awhile I just have to blog about the folks who escaped having to go to law school and take securities regulation and now are unaware that their activities are governed by a whole host of rules that they could never imagine.  (See, e.g., minor league baseball guy.)  So, people have these great ideas of how to finance their careers the same way start-up companies finance their launches, but unfortunately, these creative plans move them from "borrowing money from grandma and I only have to pay her back when I hit big" to "violating securities law."

Sarah Lawsky (guest-blogging at Concurring Opinions) emailed me this snippet from the Freakonomics blog about Tao Lin, a struggling young novelist who thought that his second novel would be finished faster if he quit his day job and instead paid for life's necessities by selling six shares worth 10% each of his future royalties from the novel.  He makes the pitch on his blog here. 

Several commenters on the Freakonomics blog point out that this ingenious scheme involves securities, which must be registered unless they or the transaction fall under an exemption, and the public nature of the offering pretty much makes an exemption impossible now.  Interestingly, Tao Lin's response (because his novel is going so well he seems to spend a lot of time commenting on blogs) is "I don't understand how I have engaged in securities fraud. . . .I'm like an ant trading a mote of sand for a leaf or something.  I'm an ant, I go home to my room.  I sit there alone.  Sometimes I read a Joy Wiliams short story.  What do you want from me?"  I guess this is a persuasive argument for a new exemption:  the issuer and the project are so small and worthless that it's not worth anyone's time.  Intriguing, but the disclosure of this fact will probably also hamper sales of the securities.  I don't want to buy shares in an ant, Mr. Lin.

There are some interesting issues raised by Mr. Lin's post, however.  One is funny, but the other is real.  OK, I'll give you the funny one first.  I think a stock joke in commercials, stand up, etc. is someone saying "Eighty-five percent of statistics are made up.  See, I just made that up."  Well, Mr. Lin must really like that joke.  I guess he believes that his pitch for investors should have some numbers in it.  Instead of actually revealing data such as previous sales of his first novel and two books of poetry, he instead just spews out some probabilities and numbers about the future: 

Based on sales of my first novel I project sales of my second novel to be 13000 after 24 months (if there isn't more mainstream attention than with my first novel). If there is more mainstream attention, and I think there is a 80-90% chance there will be, sales will be "considerably higher" I think. . . . If I ever have a book published that sells a lot more copies than any of my other books there is a 60-70% chance it will be my second novel, I think. . . . Film, reprint, and serial royalties are included. If my second novel is published in hardcover (60-70% chance, I think) my publisher will most likely sell the softcover rights to another publisher, and I get 50% of that, and you would get 10% of my 50%, which if the softcover rights sold for $30,000 would be $1500. I think shareholders should, at worst (based on a low projection and no fil/reprint/etc. sales), expect to begin making a profit on their investment within 32-40 months, after which they will "make profits every 6 months for the rest of their lives without having to do anything."

That definitely makes for more interesting reading that a typical offering memorandum -- where are the quotes from? OK, so the interesting point is the feedback from commenters. Let's say that this is a security. Our securities regime is set up so that registration or other protection is necessary to provide proper disclosure. Through the comments on Lin's blog and the Freakonomics blog, I've discovered many things. Now, these things are unsubstantiated, but so are many things in an S-1, although it is subject to antifraud rules. I would think these comments are subject to defamation laws, bracketing aside the anonymity of the commenters. But here are some interesting tidbits informal disclosure by third parties has given us: some commenters believe that Lin's parents are serial securities fraudsters (with links, dates and details), commenters link to a publicity stunt Lin did before where he sold books on his blog then announced he was keeping the money and not sending the books, some commenters link to bad reviews of Lin's work, an astute commenter points out the moral hazard problem that Lin might just keep the money and not produce a second novel, another commenter corrects another that this scheme is not just like the "Bowie Bonds," and more. I think the commenters told us more about this offering than a vetting by the SEC would. All that aside, Lin says there is only one more share left at $2000. Maybe if you get order in the next thirty minutes, you'll get two shares for the price of one.

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For years, the teaching of transactional skills was in the real backwaters of legal education.  Not many courses were taught, and few if any full-time faculty made it through the brush and swamps to teach any of these courses.  But in the last three years, there has been a sea-change, and transactional education is hot.  Now we have two issues:  What are we supposed to teach and how should we do it?

Although the list of things that we should teach is long, one focus of our teaching must be business and the business world.  Business obviously does not have a long and storied history in the legal curriculum, but doing deals is fundamentally different from litigating and, therefore, what we teach and how we teach must also differ.

Business belongs in the curriculum because that is what transactional lawyers do.  “Transactional lawyers” is just a gussied up name for business lawyers and what business lawyers do is to help their clients do business deals, whether a multibillion dollar acquisition or the licensing of software.  It follows, therefore, that if lawyers are to represent their clients adequately, they must understand business and the client’s business.

For a deal lawyer, not knowing about business is akin to a litigator not knowing the evidence rules.  Business is discipline specific substantive knowledge that a deal lawyer must have to function effectively.

One way that law schools have tried to address the need for business education is through the “accounting for lawyer” course.  I believe that we need to rethink what this course should be. 

Traditionally, students learn the accounting concepts by learning debits and credits and reading cases.  But practicing lawyers don’t make book-keeping entries, and they read agreements, not cases, when doing deals.  The firms are not looking to their lawyers to make book-keeping entries.  Instead, they want lawyers who understand financial statement concepts and how to use those concepts to advance or protect their clients’ interests.  Indeed, when the firms bring in consultants to teach accounting, the only time they mention debits and credits is when they say they are not teaching them.  Instead, the consultants focus on the use of financial statement concepts in transactions and financial statement analysis.

Here are some specifics about how a revised accounting course could be taught.

First, the course would be three credits rather than two, so that students would have the time to cover a broader and more in depth curriculum.  Debits and credits would not be taught and students would not read cases – with a few exceptions.  Instead, source materials would be articles, financial statements, and agreements.  Pedagogically, the course would be divided into three parts – although they would often overlap.

In the beginning of the course, students would learn about the different financial statements and the line items on each statement.  When teaching the line items, we would provide context.  For example, when studying receivables, a factor could guest lecture, making very real to students the importance of collecting receivables. 

In the second part of the course, students would learn how to analyze and critically read both the financial statements and the notes.  Having this skill will give students the ability to gain a sophisticated understanding not only of a client’s financial position, but also the other side’s.  Ultimately, it would result in students being better able to counsel their clients.  It might even result in a student being able to spot something that was not “quite right.”

The course would conclude with the students applying the course material by learning how lawyers use the financial statement concepts in transactions.  Students would analyze and negotiate, among other provisions, purchase price adjustment provisions, earn-outs, royalty provisions, and complex financial loan covenants.

In my next post, I will discuss another course that I suggest be added to the business curriculum.

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Tina Stark is  a Professor in the Practice of Law and the Executive Director of Emory law School's Center for Transactional Law and Practice. Earlier this summer, I attended the Center's excellent "Conference on Teaching Drafting and Transactional Skills: The Basics and Beyond." That conference inspired me to recruit Tina as a guest blogger, and we look forward to reading her posts over the next two weeks.

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Welcome to the second week of the Fourth Annual Congloemrate Junior Scholars Workshop.  Today's featured scholar is Heather Field, an associate professor at Hastings College of Law, where she teaches corporate and partnership tax, federal income tax and tax policy.  Heather's paper today is of great interest not only to tax wonks, but also those of us lowly business law professors who talk about choice of entity, Checking in on Check-the-Box.  Think of it as our version of VH-1:  I Love the 90s.

Eleven years ago, new regulations dramatically changed the manner in which the federal income tax system determines how business entities are taxed. These new explicitly elective "check-the-box" regulations for entity classification replaced a multi-factored corporate resemblance test and drew wide praise for their potential to increase simplicity and certainty, reduce costs, and enhance efficiency and equity. Now, with the benefit of hindsight and with data regarding entity classification elections made since 1997, this Article revisits the "check-the-box" regulations. This Article analyzes the application of the "check-the-box" regulations over the last eleven years and concludes that, while the "check-the-box" regulations represent an improvement over the prior entity classification rules, they fall short of their promise. This Article also examines the scope of the explicit "check-the-box" election itself and argues that the election lacks a coherent set of limitations, which undermines the provision of the explicit entity classification election at all. Ultimately, this Article concludes that the policy weaknesses revealed by a close examination of the "check-the-box" regulations stem fundamentally from the existence of a multi-regime system for taxing businesses, and hence, the "check-the-box" regulations expose a problem with the choices themselves, thus adding to the literature in favor of reforming the federal income tax's treatment of businesses.

Today's expert commentary is provided by Leandra Lederman, Steven Dean, Gregg Polsky and past workshop participant David Gamage.  Each of our commentators' remarks will appear below this post.  Readers are invited and encouraged to give their thoughts in the comment section to this post.  Happy reading!

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I want to thank Christine and Vic for inviting me to participate in this Workshop.  I enjoyed having the opportunity to read Heather Field’s article, Checking In on “Check-the-Box.”  The article provides a useful survey of the practical consequences of the introduction of the elective entity classification scheme.  Field also insightfully places the election in a broader tax policy context. 

The credit crisis provides an auspicious moment to read and reflect on Checking In. These days, it is easy to see echoes of that crisis throughout the American economy.  For a tax specialist, the broad impact of the check-the-box election that Professor Field describes presents the strongest parallel.  As Field persuasively argues, the introduction of the election has had both much-touted advantages and more obscure costs.  In a sense, the question Field’s article asks is whether today’s regulatory status quo gives private actors too much freedom or not enough—the same sort of question now being asked in the financial sector.

In recent years, financial innovation has made it possible for banks and other financial institutions to reallocate risk freely.  Likewise, the check-the-box election grants taxpayers the freedom to choose and even change the tax classification of entities.  Frictions that once constrained behavior have either simply fallen away (thanks to the increasing sophistication of our financial architecture) or been eliminated (through regulatory change). 

In many respects, the resulting autonomy has been a blessing. The concerns raised by Field’s article suggest that—in entity classification no less than financial markets— it may also be something of a curse.  Simply put, by liberating entities from the strictures of a mandatory classification regime, the check-the-box election leaves policymakers with the unenviable task of affirmatively deciding what, if any, limits to that freedom should be imposed. 

Obviously, as Professor Polsky has noted, some limits are imposed on, rather than by, the Treasury.  Beyond those basic, and often arbitrary, Congressional requirements (e.g., unless Congress declares otherwise, a state law corporation must be treated as either a “C” or an “S” corporation for tax purposes), the regulators at Treasury have a great deal of discretion.  The information on check-the-box usage that Field presents invites important questions about the ways that taxpayers are allowed to use—and perhaps misuse—check-the-box elections. 

Why, for example, should taxpayers be permitted to file 150,000 elections to treat non-corporate domestic entities as corporations for tax purposes?  With the possible exception of the Kintner doctors, no one has ever needed help securing corporate tax treatment for a domestic entity.  Field offers several plausible explanations to that particular puzzle (footnote 118), but the simple truth is that we have no comprehensive understanding of why and how taxpayers use check-the-box elections. 

As a result, the contours of the systemic impact of check-the-box remain largely unmapped.  Field’s article provides a tantalizing glimpse into how the election has affected taxpayer behavior.  Paired with a decade’s worth of worry about the effects of check-the-box, particularly on the international side, Field’s data is discouraging.  Even though the impact of the credit crisis has been surprisingly broad and deep, it still seems unlikely that we are headed toward a financial apocalypse.  If Field is right, the tax system may not be so lucky. 

Could the ultimate effect of the check-the-box election be, as Field suggests, the complete unraveling of our current “multi-regime system”?  If so, are there limitations—short of entirely eliminating the election—that could forestall such a collapse?  Would eliminating the possibility of elective classification changes (which, according to Field’s data, constitute a surprisingly high 30% of all check-the-box elections) and the virtual transactions they produce help to stanch the bleeding?  More generally, given the information about taxpayer behavior that Field has uncovered, what limitations on check-the-box elections would be appropriate?

Field invites such questions, but ultimately does not answer them.  It would be interesting to hear what Field would do, with the benefit of hindsight, if she were put in the shoes of the creators of the election.  Assuming she was forced to take the “multi-regime system” and the per se corporate treatment of corporations for granted, what would she have created to replace the Kintner regulations?  My guess is that the check-the-box regulations granted taxpayers far more autonomy than was necessary.  Knowing what we know now, could we create a classification regime that avoids the worst excesses of (in David Bradford’s terminology) (i) the rule and compliance complexity of the Kintner regulations on the one hand and (ii) the transactional complexity of check-the-box on the other?

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I greatly enjoyed Heather’s paper and found it to be an important contribution to the literature.  As is the nature of academic comments, most of what I say will be negative – or more politely phrased, “suggestions for improvement.”  But in truth, I think this is an excellent paper and I would strongly encourage Heather to submit the paper in the upcoming August cycle.

The body of Heather’s paper begins in Part II with an excellent discussion of the history leading up to the adoption of the check-the-box regulations and the circumstances behind their adoption.  From there, the paper proceeds in Part III to evaluate the CTB regs along a number of dimensions.  The discussion here is extremely thorough, balanced, and ultimately persuasive on its various points.  I found myself agreeing with most of Heather’s analysis and making a mental note to myself to return to this chapter whenever I have cause to think about the effectiveness of the CTB regs. 

If there is a flaw in this discussion, it is that the various points of analysis never really come together to make an overall thesis point.  Heather organizes Part III around a number of substantive issues on which she reaches different conclusions.  The advantage of this approach is that it makes it easy for someone interested in a specific issue surrounding the CTB regs to locate the relevant portions of Heather’s discussion.  The disadvantage is that the framework is not particularly memorable, and casual readers (such as law review editors) may lose interest.  If Part III could be reorganized so as to tell more of a cohesive story, I think this would ultimately improve the impact of Heather’s piece.

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Heather Field’s thoughtful paper, Checking In on "Check-the-Box," is a timely analysis of the check-the-box regulations, which have been in place for over a decade now. It compares the check-the-box rules to the corporate resemblance test of the former "Kintner" regulations; analyzes the pros and cons of the elective regime from a tax policy perspective; and considers the effects of the mechanics of the election itself. The paper explicitly sets aside the question of the rationality of retaining multiple regimes for taxing businesses, under which some entities are required to be taxed under Subchapter C—resulting, at least in theory, in taxation at both the entity and investor levels—while others have an explicit option to elect pass-through treatment and thus a single level of taxation. The paper concludes, however, that most of the weaknesses identified in the examination of the check-the-box regulations actually result from the existence of multiple regimes for taxing businesses. As discussed below, while the detailed analysis is very informative, this concluding insight might be expanded a bit to provide a broader context for the paper.

The paper starts with helpful background of the corporate resemblance test under the Kintner regulations" that the check-the-box regulations replaced. It traces the development of the LLC and the IRS’s tax treatment of it. A minor comment on this Part is that I think a bit more context could improve the discussion of the advent of the LLC—it might help to point out that the LLC was developed in light of the Kinter regs to be a vehicle that obtained pass-through treatment for tax purposes, while retaining limited liability. As the paper discusses, the advent of the LLC was a big part of the reason Treasury abandoned the corporate resemblance test in favor of a purely elective regime.

Part III of the paper analyzes the pros and cons of check-the-box. Some of the benefits and detriments have existed since the regulations were promulgated. However, the look back shows that the regulations have been amended more than ten times since they were promulgated in 1997, and the IRS has also issued numerous rulings related to entity classification issues. The paper argues that this is suggestive of complexity created by the regulations. This is an interesting argument that could be made stronger by including a baseline for comparison, such as how many times the Kintner regulations were amended in the eleven years before they were repealed and approximately how many rulings on entity classification were issued during that period. That is, how much complexity is due to check-the-box, and how much is endemic to having a regime that taxes different legal entities differently? Also, in the discussion of how the regulations apply to foreign entities, it might help to describe the abuses in a bit more detail, to clarify what tax benefits foreign entities obtain that they could not have gotten under the Kintner regs, for example.

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In her paper, Heather Field analyzes the effectiveness of the check-the-box (CTB) regulations.  She suggests that the CTB regime represents an improvement over the prior four-factor Kintner test in the domestic context while concluding that the costs of the elective regime outweighs its benefits in the international setting.  Field also argues that the limitations on “eligible entities” (i.e., those entities for which the election is available) “undermine the provision of the election itself.” 

I enjoyed this interesting piece and found myself agreeing with much of what the paper argues.  I will therefore focus my comments on the few areas where I believe the paper might be improved.

Despite her criticisms of the current regime, Field does not make any specific recommendations for reform.  Perhaps this is because she concludes that the whole U.S. unintegrated business tax system is itself completely unjustifiable as a policy matter.  But it’s unclear to me whether Field is arguing that the Treasury and the IRS should therefore just keep the current CTB regime (warts and all) based on the rationale that any entity classification regime will be substantially flawed in our substantially flawed classical system.  I think it would be helpful for Field to clarify at some point in the paper whether and how she believes the CTB regulations (as they currently exist) ought to be reformed, if at all. 

Instead of focusing on specific reforms, Field’s focus is on whether, with the benefit of a decade of hindsight, the CTB regulations represent an improvement over the previous Kintner regime.  Field ably describes the benefits and the detriments of the CTB regime.  Many of the significant detriments stem from one particular feature of the CTB regime.  As Field points out, the CTB regulations created the concept of disregarded entities (DE), which in turn stimulated state legislatures to allow for single-member LLCs (SMLLCs).  So now we have entities that are respected for state law purposes as separate and distinct with independent rights and duties, yet these entities are to be “disregarded” for federal tax purposes.  This was quite a new concept for the tax system to digest and it has resulted in complexities both in tax procedure (e.g., collection) and in the application of substantive tax law (which looks to state law consequences to determine the “substance” of transactions).  As just one example of a procedural ambiguity, is a SMLLC that is a DE really disregarded for purposes of determining liability for excise and employment taxes?  The IRS has litigated these cases (and won, though it should have lost) and the CTB regulations have recently been amended.  With respect to substantive ambiguities, the IRS has had to clarify when a DE owned by a corporation can participate in a merger that will qualify for tax-free reorganization status.  More significantly, DEs have often been used abusively in the international context, as Field notes. 

Thus, many of the most significant detriments that Field identifies do not stem from the election feature of the CTB regime.  Nor do they stem from the CTB regime’s classification of entities as either corporations or partnership.  Rather, they stem from the regime’s creation of a brand new entity that now has to fit into a system that was never devised with it in mind.  The result has been administrative headaches and planning opportunities.   I would suggest that, given the fact that DEs have caused so many problems, Field devote a larger part of the paper to them.  A number of interesting issues come to mind.  Would the DE problem eventually have arisen under the Kintner regulations?  Would classifying all single-member entities with limited liability as corporations for tax purposes be a better approach?  Does Treasury have the statutory authority to treat only foreign DEs with limited liability as corporations, as recommended by the Joint Committee on Taxation? 

One issue that Field does not address is whether Treasury and the IRS had the authority to promulgate the CTB regulations.  Under administrative law principles, administrative agencies can fill statutory gaps and resolve statutory ambiguities, but they cannot contravene the clear intent of Congress as expressed in statutory text.  Some have argued (very persuasively, in my view) that sections 7701(a)(2) & (3) (which separately define “partnership” and “corporation” as mutually exclusive classifications) simply do not permit a result where two business entities that are wholly identical in every single substantive respect may nevertheless be classified differently.  These critics conclude that a statutory amendment would be necessary to implement an elective regime, which explicitly allows such a result.   While Treasury and the IRS apparently disagreed with this view (probably emboldened by the belief that the pro-taxpayer regulations would never be challenged because of strict taxpayer standing rules), they also appeared to recognize that they were not totally unconstrained by statutory text.  For example, the CTB regulations do not allow entities incorporated under state law (“state law corporations”) to elect their classification; instead they are always taxed as corporations.  Field criticizes this aspect of the CTB regulations (as discussed below), but the statute absolutely requires it.  Section 7701(a)(3) provides that “[t]he term ‘corporation’ includes associations, joint-stock companies…” and section 7701(c) provides that the term “include” should “not be deemed to exclude other things otherwise within the meaning of the term defined.”  Even Treasury and the IRS, which were extremely aggressive in promulgating the CTB regulations, must have concluded that allowing state law corporations to elect partnership (or DE) status would contravene the plain meaning of the governing tax statutes. 

Field argues that, under the principles of the CTB regulations (i.e., virtually indistinguishable entities ought to be treated alike), state law corporations ought to be able to elect their classification because they can be identical in all substantive respects as LLCs.  While this is hard to dispute, this is not a criticism of the CTB regulations, instead it is a criticism of the statutory regime which requires that state law corporations be taxed as corporations.  (The same can be said of Field’s criticism that the CTB regulations unjustifiably prohibit publicly traded partnerships from making the election.  This too is a mandate from Congress found in section 7704 and it cannot be undone without legislative action.) 

Field’s argument regarding per se corporations suggests an interesting criticism of the CTB regulations that Field might consider entertaining.  The Kintner regime was substantially flawed, and because of the emergence of LLC statutes everyone now knew it.  Besides the question of how it should be fixed, there was the question of who should do the fixing:  Congress or the Treasury.  When Treasury decided to fix it, it was constrained by the relevant statutes—i.e., it did not have unfettered discretion to create a comprehensive and fully coherent fix.  Treasury could only operate within the amount of arguable “space” given to it as a result of ambiguities and gaps in the statute.  If Treasury had decided that it simply lacked the statutory authority to implement the CTB regime (an extremely plausible view, to say the least) and instead invited Congress to fix the problem, perhaps a more positive policy outcome could have eventually resulted.  Maybe Congress would have taken the opportunity to address the fundamental problems in business taxation by fully integrating the system (stop laughing!).  More likely, Congress could have retained the corporate tax only for public firms (regardless of their state law entity classification), while providing for mandatory flow-through treatment for all other firms (regardless of their state law entity).  Perhaps Congress could have also at the same time gotten rid of the current dueling subchapter K and subchapter S flow-through regimes and created a single flow-through regime for nonpublicly traded businesses.  The point is that Treasury and the IRS let Congress off the hook by patching the roof.  Had they said to Congress “we’d like to fix the Kintner problem but our hands are tied by the statutes,” perhaps Congress would have built a new house or at the very least put on a new roof.  As it stands now, we have a patchwork entity classification system (as Field correctly argues) on top of a patchwork business tax system (as many have argued).  It is not unreasonable to suggest that, in light of the proliferation of LLCs, Congress (at Treasury’s invitation) might have fixed the former while at least making marginal improvements in the latter.  Perhaps the greatest cost of the CTB regulations is the cost of this lost opportunity.   

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My first Aleksandr Solzhenitsyn novel was A Day in the Life of Ivan Denisovich, but I soon assembled a collection of his books, though I can't claim to have read them all. The Gulag Archipelago was life altering for this kid from rural Wisconsin, even though by the time I read it, Solzhenitsyn was saying nasty things about my country from the safety of Vermont. As noted in the NYT, "Many in the West didn’t know what to make of the man," but it's hard to think of a writer with a more profound influence on the world than Solzhenitsyn.

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August is not the time of year when I normally think about student evaluations, but I have been re-designing my Business Associations course this summer, and in doing some background reading on teaching, I stumbled across an interesting article by Deborah J. Merritt called Bias, The Brain, and Student Evaluations, 82 St. John's L. Rev. 235 (2008). After describing several interesting studies exploring the importance of nonverbal behavior on student evaluations, Merritt offers this indictment of the present system:

The research on student evaluations is troubling. It confirms not some connection between a professor's style and student evaluations, but an overwhelming link between those two factors. Nonverbal behaviors appear to matter much more than anything else in student ratings. Enthusiastic gestures and vocal tones can mask gobbledygook, smiles count more than sample exam questions, and impressions formed in thirty seconds accurately foretell end-of-semester evaluations. The strong connection between mere nonverbal behaviors and student evaluations creates a very narrow definition of good teaching. By relying on the current student evaluation system, law schools implicitly endorse an inflexible, largely stylistic, and homogeneous description of good teaching. Rather than encouraging faculty to use nonverbal behaviors to complement excellent classroom content, organization, and explanations, the present evaluation system largely eliminates the "dog" of substance, leaving only the "tail" of style to designate good teaching. Neither law students nor faculty benefit from such a narrow definition of good teaching.

The psychology literature, moreover, identifies three further difficulties with the disproportionate role that nonverbal behaviors play in student evaluations. First, the behaviors that most influence these evaluations are rooted in physiology, culture, personality, and habit. Those behaviors are difficult for any faculty member to alter and they often reflect characteristics like race, gender, nationality, or socioeconomic class. Second, the current evaluation process allows social stereotypes to filter students' perceptions of instructor behaviors. Students see the nonverbal behaviors of some faculty differently than they view identical behaviors in other professors, potentially placing women and minority faculty at a greater disadvantage. Finally, the ratings that students award through the present evaluation system bear little relationship to objective measures of learning. The current system of student evaluations, in other words, rewards and penalizes faculty according to relatively trivial indicia, rather than what they accomplish in the classroom.

None of this seems new, exactly, but that's a nice synthesis of the perceived problems with the present system. Given my present interest in obtaining a better understanding of teaching and learning, I am most intrigued by the last complaint: that evaluations do not correlate with learning.

Can evaluations help us to become better teachers? Many law professors, particularly young law professors, use evaluations as an aid to improvement. After my first semester of teaching, for example, I went through the student evaluations and found five or six suggestions for improvement. In the next semester, I worked on those things. I did this every semester until the evaluations became too predictable to be useful. Now, I still read them, but usually rather quickly, unless I am looking for feedback on a specific part of the class (e.g., last semester I used teams for the first time, and I was curious to see how the students reacted in the evaluations).

But what if I wanted to know whether my teaching resulted in meaningful learning? Or whether certain changes in my teaching improved learning? Could evaluations guide me? The research summarized by Merritt suggests not: "The cumulative research suggests that there is little, if any, positive association between the ratings students give faculty and the amount they learn. The most recent study, in fact, suggests a negative correlation between evaluations and learning."

Hmm. Not so good. So, should we abandon our hope of improving our teaching -- rather than just improving our scores -- from student evaluations? Merritt says not so fast:

Students have essential feedback to offer faculty on teaching. They can tell professors what they learned from a course and how that compared to what they expected to learn. They can describe the educational techniques that worked for them and those that did not. They can provide suggestions for how a faculty member might teach differently. Law students can assess the quality of their educational experience in myriad ways.

The key to unlocking this information is in the evaluation technique. We need a technique that allows students to be reflective, not reflexive. Merritt suggests something along the lines of Gregory Munro's Small-Group Instructional Diagnosis. The idea is to have small groups of students provide feedback to a facilitator: "The students discuss their perspectives as a group, expanding the information available to each student, checking individual biases, establishing accountability, and implicitly noting the seriousness of the process and need for accuracy. These group discussions reduce cognitive overload by focusing attention and providing adequate time for thoughtful assessment."

In this part of her paper, Merritt cites to Eric Orts' short essay on the use of quality circles in the classroom. Eric W. Orts, Quality Circles in Law Teaching, 47 J. Legal Educ. 425 (1997). By using a quality circle, you can create your own system of reflective feedback. No need to wait for the law school administration to implement a whole new system of evaluations. I used a quality circle once, shortly after Eric's article was published, and it seemed to work well. I am not sure why I haven't gone back to it, but reading Merritt's article has inspired me to try it again.

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