Archives For disclosure regulation

The WSJ reports that the SEC is considering raising the 500-shareholder limit on the number of holders of a class of securities a company can have before having to register that security with the Commission under Section 12(g) of the 1934 Act. The SEC reportedly is also considering relaxing the “general solicitation” restriction on private offerings.

At first blush this seems like a pro-market liberalization.  The story notes that “the agency has a responsibility to encourage companies to raise capital as well as to protect investors.”

But look again.  The SEC move clearly results from market arbitrage moves by hot firms like Facebook, Twitter and Zynga to open an end-run around the 500 shareholder rule.  I noted last January that Facebook got around the limit by selling all the stock to one person, a special purpose vehicle, which only wealthy investors can trade privately under an exemption to the 1933 Act.  (And maybe only non-US rich people.  Shortly after the story reported above, I noted that Goldman had moved its Facebook market exclusively offshore.) The SEC was also worried about insider trading in this new private market.

In other words, the market created this exemption, not the SEC.  Faced with inexorable market demand and arbitrage the SEC is considering making the escape route official. This resembles the “check the box” tax rule a decade ago which opened the door for LLCs after numerous unincorporated vehicles had challenged the government’s ability to put a lid on exempting unincorporated firms from the partnership tax. 

The SEC’s other option was reducing the various regulatory taxes on IPOs and public companies under the 1933 Act, SOX and Dodd-Frank which created the pressure on the 500 share limit.   In my earlier post I noted that VC partner Ben Horowitz had told the WSJ that

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

By expanding the private market for new firms, the SEC would release some of the political and market pressure building against over-regulation of going public.  Rather than liberalizing regulation, it would help protect existing regulation. 

The costs of this choice are significant.  Consider that in 2004, Google went public when it ran up against the 500 shareholder requirement.  Now, instead of IPOs, we have a market reserved for rich people. As I said last January:

[T]he increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted

The emerging market for rich people is especially ironic in view of the SEC’s increased push against insider trading. While the SEC is going all out in its Quixotic task to “level the playing field,” it is emptying that playing field of the people for whom it’s supposedly unlevel.

This move from public to private has broad ramifications.  The US traditionally has the broadest and deepest public securities markets in the world.  Indeed, the securities laws were enacted in the 30s to encourage participation by ordinary investors, and the securities laws have been interpreted consistent with that goal.  The problem is that Congress and the SEC have taken this goal too far, overburdening the US markets with regulation.  Coupling the shrinkage of the public market with an expanded option for rich people hastens this evolution away from strong US capital markets. 

At the same time, the US faces increased global competition.  As I discussed last week, evidence on IPOs suggests that public markets elsewhere in the world are catching up with the US.

The privatization of US markets could have important indirect effects.  Broad public participation helps democratize capitalism.  A move in the opposite direction could deepen Americans’ suspicion of capitalism as the playground of the wealthy.  Also, the securities markets are the primary source of data about large companies.  Closing these markets reduces transparency for everybody and not just investors.

The better move is to reverse the regulation that prompted this trend toward closing the public markets. The SEC is opting instead for short-term political expediency.

Steve Davidoff discusses materiality issues in the GS Abacus transaction, Gupta/Galleon, Apple and Jobs’ health and Sokol. He questions “quirky” American securities laws that don’t require continuous disclosure of material information, and a materiality standard which “allows lawyers and others to argue that something is not material because they didn’t think it was certain or important enough to affect the stock price of the company significantly.” 

Davidoff also says that “efforts to find distinctions between material and nonmaterial can seem baffling” to non-lawyers, and that “the current disclosure scheme and its definition of materiality* * * is increasingly disconnected from the desires of investors and the marketplace.” He adds that “a failure to act here may lead to increasing distrust of the markets by an already wary public.”

Davidoff may be right that investors want more information, but fails to identify a key reason why the legal standard can’t and shouldn’t be tighter:  litigation.  A looser materiality standard could expose every statement or non-statement to judicial second-guessing. 

This also answers Davidoff’s question of why companies don’t just disclose on their own “what investors will find important,” and why companies don’t seem to “understand that information disclosure is not just a legal game.”:  Every disclosure is a potential securities fraud claim.

More disclosure may be a good idea.  But the way to get it is to fix securities litigation.

The WSJ discusses yesterday’s testimony by SEC chair Mary Schapiro.  Former SEC GC David Becker, you’ll recall, had a family interest in a Madoff account but nevertheless was allowed to work on Madoff issues, including recommending Madoff victim payouts that directly affected the Becker family.

Ms. Schapiro said the incident had taught her to be more thoughtful about ethics matters.

“I have to be looking around the next corner, looking beyond the horizon and thinking above and beyond what may be appropriate advice from ethics counsel to make sure nothing occurs that raises questions about the commission’s mission or process,” she said.

Ms. Schapiro has directed the SEC’s internal watchdog to conduct an investigation of the matter and has ordered a review of the agency’s conflict-of-interest policies. She said the SEC had made significant strides since she took over an agency reeling from enforcement breakdowns.

Many companies will sympathize with Schapiro about “looking around the next corner, looking beyond the horizon” etc. 

Suppose a company or executive civilly or criminally charged with disclosure or internal control violations after a sudden market decline magnifies risks the company ignored tells the SEC or Justice: “we’re making significant strides on disclosure and we’ll do a better job the next time.”  The SEC or Justice will tell the company:  “We understand.  You have to be looking around the next corner or beyond the next horizon, and that’s very hard.  Just do the best you can.” Something like that.

Maybe it’s time to renew my suggestion, triggered by a previous report of SEC internal controls breakdowns , that Congress “shut down the SEC and turn its work over to the private sector, which is subject to SOX.”

Last December Abercrombie filed a preliminary proxy statement announcing a plan to reincorporate from Delaware to Ohio.  Steve Davidoff and I commented on the move. Steve noted that, while Abercrombie had highlighted various reasons for the move, the shareholders had to dig through the disclosures to learn that it was, as I said in December, “essentially a takeover defense.”  I added that “[t]his situation illustrates how jurisdictional choice makes contractual what would otherwise seem to be mandatory takeover rules.”

With respect to the disclosure issue, I asked:

Does it matter if there were enough sophisticated or well-advised institutional shareholders to help ensure an informed vote?

In January, Davidoff commented on Abercrombie’s definitive proxy statement, which he said “was virtually unchanged from the preliminary one”:

This proxy may be technically correct in its disclosure, but a reader can easily fail to put it all together. Moreover, you are left wondering whether the proxy statement truly discloses Abercrombie’s real reason for the reincorporation. * * *The Abercrombie shareholder meeting will be Feb. 28. It will be interesting to see if shareholders have the same questions that I do.

On February 21 Abercrombie told its shareholders:

Although we believe that the definitive proxy statement fully explains the reasons why the reincorporation proposal is in the best interests of our stockholders, there have been a series of articles posted by a “Deal Professor” on The New York Times’ website that question the Company’s reasons for proposing the reincorporation, question the timing of the proposal and imply that the Company has some ulterior motive in proposing the reincorporation. In effect, the articles, which we believe contain a number of factual errors in addition to mischaracterizations of Ohio law and our motivations, appear to demonize not just us and our proposal but Ohio corporate law itself. As a public company, we do not have the same ability to wage a campaign of unsubstantiated words in the public media. However, we would welcome an opportunity to discuss our proposal with you and address the factual errors and mischaracterizations in the blogs. * * *

But yesterday DJ wrote that Abercrombie

facing resistance to its plan to reincorporate in its home state of Ohio, delayed a special meeting of shareholders it had scheduled for Monday, in order to drum up enough investor support for the move.

The teen retailer said in a proxy filing on Monday that it was “convinced” it had strong support for the move after “a succession of positive communications with a number of significant stockholders.” But, general counsel Ronald Robins said, it has “been unable to obtain a strong consensus in favor of reincorporation at this point.” * * *

The company has faced criticism for its plan including from former lawyer and current law professor Steven Davidoff, who writes for the New York Times’s Dealbook Web site under the moniker Deal Professor. He cites provisions in Ohio law that could either make it easier for management to buy the company or make it harder for suitors to acquire the company, both to the potential detriment of stockholders.

Proxy advisory firm ISS had similar criticisms of the move’s effect on shareholder rights. * * *

Robins said that, whether as a result of press criticism or other reasons, some holders that had once supported the reincorporation now oppose it, including one hedge fund he declined to name.

I’ll stick to my original assessment that the market for state corporate law, at least for widely traded public companies, is working efficiently in a rich information environment that includes SEC disclosures, proxy advisor firms and, last but not least, Steve Davidoff.

A couple of weeks ago I noted regarding the “Sachsbook” deal:

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it. 

I guess I was a bit optimistic.  Now you have to be a foreign investor to invest in Facebook

I love it:  the US securities laws excluding US investors from investing in a US company in the US. What will they think of next?

What happened to IPOs?

Larry Ribstein —  4 January 2011

So Facebook finally had its public offering.  But it didn’t look like your father’s IPO.  Instead, Facebook sold $500 million in stock to one person. The stock will be held by a single special purpose vehicle so Facebook avoids going over the 500-investor-limit for avoiding the disclosure obligations of a public company.  Wealthy investors get to trade interests in that interest.  Facebook gets that cash (plus an expectation of another $1.5 billion in stock sales) for growth, a $50 billion market valuation (of which 14 billion belongs to Zuckerberg), stock it can use for acquisitions and hiring — many of the goodies post-IPO companies get. 

According to Steve Davidoff, this won’t work if Facebook is deliberately circumventing the securities laws, and “Goldman’s planned special purpose vehicle and any other vehicles formed certainly appear to be cutting it close.” Facebook therefore may have to start reporting anyway, but not until May 2012, by which time it may be ready to go public, which it may want to do anyway.  The tactic at least enables Facebook to delay an IPO for as long as possible.

Per the VC partner Ben Horowitz, quoted in the WSJ,

the incentive for going public has lowered and the penalty for going public has increased. . . [T]he regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash. In general, we recommend that our companies be very careful about going public.

Meanwhile, Dealbook reports the establishment of another trading system for private firms.

Another Dealbook story adds that “[l]ots of people would stand in line to buy shares in Facebook, but for now, only an exclusive few — wealthy clients of Goldman Sachs — will be able to.”

 “This is a topsy-turvy world,” said Scott Dettmer, a founding partner of Gunderson Dettmer, a law firm that has advised venture capitalists, start-ups and entrepreneurs since the 1980s. He added that even a few years ago, “there were all sorts of business reasons to go public, but for entrepreneurs it was also a badge of honor.”

But now, private market alternatives

have become more attractive for companies, in part because of the increased regulations imposed on public companies but also because of the rise in short-term trading, which leaves some executives feeling they have lost control of their companies. * * *

Ben Horowitz, a partner with Andreessen Horowitz, a venture capital firm, said the cost of being a public company had risen to about $5 million a year, from about $1 million a year. Mr. Horowitz, an early employee of Netscape, said that such costs would have eaten into the meager profits of the pioneering Internet company when it went public in 1995. Additionally, accounting and legal requirements have become distractions for many start-ups, said Mr. Horowitz, whose firm is an investor in Facebook.

So it seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.  Back in the 1980s, you could just call your broker and get rich off of the Microsoft IPO.  Now you have to be a wealthy Goldman client to do it.  Of course you also got to get poor off of a company that turned out to be a dog.  Now both options are reserved for wealthy people in the name of increasingly onerous disclosure regulation and federal governance requirements such as board structure, proxy access, and whistleblowing rules.

Each of these rules was thought to have some benefit at the time they were enacted.  Nobody really considered how private markets would react (e.g., by establishing alternatives to public markets) or the long-run effects of substituting quasi-private for public markets.  So rules designed to make the markets safe for ordinary investors have ended by excluding them.

Maybe it’s time to start considering whether we got what we wanted.

I have been writing for some time about the First Amendment and the securities laws.  In a nutshell, the formerly inviolate notion that the securities laws are a First-Amendment-free zone has always been constitutionally questionable.  The questions multiply with the expansion of the securities laws.  The Supreme Court’s recent broad endorsement of the application of the First Amendment to corporate speech in Citizens United signals that we may finally get some answers. 

The bottom line is that securities regulation that burdens the publication of truthful speech is subject to the First Amendment.

For a little history:  I first wrote on this issue 16 years ago in my article with Henry Butler, Corporate Governance Speech and the First Amendment, 43 U. Kans. L. Rev. 163 (1994).  This was the basis of a chapter in Butler & Ribstein, The Corporation and the Constitution,  excerpted here.

I’ve written on this subject from time to time since the 90s: 

  • On the unconstitutionality of Regulation FD (which requires firms that disclose material nonpublic information to securities market professionals to disclose the same information simultaneously or promptly to the public, thereby effectively restricting truthful statements to analysts)
  • On the SEC’s recent mandatory disclosures on global warming.
  • Most recently, on the SEC’s proxy access rule (14a-11), where I noted that “the ramifications of Citizens United may be even broader than were initially supposed.  Speech about capitalism finally may get the same protection as, say, pornography.  And one of the first casualties of this approach may be ill-considered and unnecessary SEC restrictions on truthful speech.”

And now:  Bulldog Investors’ challenge of Massachusetts securities laws forbidding it from disseminating truthful information about its investment products. Here’s the complaint against Bulldog and a lower court opinion from last summer on a suit filed by Leonard Bloness, a non-investor who is simply seeking information about Bulldog.

The trial court opinion notes that from about June 9, 2005, to January 5, 2007, Bulldog Investors maintained a website that made certain information about its products available to any visitor, subject to getting the visitor’s agreement to a disclaimer providing, in part, “[t]he information is available for information purposes only and does not constitute solicitation as to any investment service or product and is not an invitation to subscribe for shares or units in any fund herein.”  The visitor could get more information by registering with certain information. 

The Massachusetts regulatory action began when an employee of a law firm that was representing a client in litigation with Bulldog registered on the Bulldog website and received an email with additional information about Bulldog funds. The administrative complaint alleged that Bulldog had offered unregistered/nonexempt securities for sale in the Commonwealth through the website. Bulldog denied the allegations and raised a First Amendment defense.  While this action was pending, the Bloness complaint was filed seeking relief pursuant to 42 U.S.C. § 1983 from the alleged violation of their First amendment Rights.

The basic problem here is that Bulldog lost its exemption when it generally advertised its fund through its website and followup email.  As a result, it is broadly barred from distributing information about its funds, however truthful, including to people who are accredited investors like Bloness.  Nor does it matter, as with Bloness, whether the people seeking access to the site are even would-be investors, as distinguished from scholars and journalists who want information on the industry.

The administrative action concluded with a cease and desist order and fine of $25,000.  The court later denied plaintiffs’ mostion for preliminary injunction on the 1983 complaint.

At the July 31, 2009, trial of that case, the court received the expert testimony of Suffolk law professor Joseph Franco of Suffolk University Law School that, according to the court’s summary, ” the regulatory scheme directly serves the identified governmental interest, and that none of the alternatives would do so as effectively.”

The court denied relief, concluding:

Capital formation is, of course, an important goal, which is to some degree in tension with investor protection and market integrity. Regulatory constraints that protect market integrity impose burdens on issuers and sellers of securities. In that respect, they may tend to impede capital formation. It follows that relaxation of such regulatory restraints might ease capital formation. The state regulatory scheme in issue here, and the corresponding federal scheme, reflect a regulatory choice to emphasize market integrity over capital formation. This Court has no authority to second-guess that choice. Rather, once it has been established (as it has been here by stipulation), that the interest the regulator seeks to serve is a substantial one, the Court’s role is to determine whether the means the Secretary has chosen to effectuate that choice is proportional to that interest, as measured by the criteria articulated in Central Hudson. Neither the Advisory Committee’s report nor the New York City Bar’s letter purports to address that issue, and neither sheds any light on it.

The Court concludes, based on the stipulated facts and the evidence presented at trial, that the statute and regulations in issue, and the Secretary’s enforcement action against Bulldog Investors, meet the test of Central Hudson, and do not violate the First Amendment rights either of Bulldog or of Mr. Bloness. A declaration will enter to that effect.

The case is now on appeal.  Here’s a website with the briefs.  The court will hear oral argument  to be posted here, on January 6.  I understand via an email from Bulldog’s Phil Goldstein (also reported here) that Harvard Professor Laurence Tribe will argue the case for Bulldog.

Tribe’s participation suggests the constitutionality of the securities laws may finally get the attention the issue has long deserved.  And, as I noted above, Citizens United suggests this attention may not be favorable to those laws (I expect to have another post on that later this week).  The Massachusetts case threatens the entire scheme for new issues under the Securities Act of 1933, while the 14a-11 case threatens significant chunks of federal proxy regulation. The reasoning in these cases could affect some mandatory disclosure rules, particularly including Regulation FD.

Stay tuned.

Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

Stephen Bainbridge is the William D. Warren Professor of Law at UCLA School of Law.

Mandatory disclosure is a—maybe the—defining characteristic of U.S. securities regulation. Issuers selling securities in a public offering must file a registration statement with the SEC containing detailed disclosures, and thereafter comply with the periodic disclosure regime. Although the New Deal-era Congresses that adopted the securities laws thought mandated disclosure was an essential element of securities reform, the mandatory disclosure regime has proven highly controversial among legal academics—especially among law and economics-minded scholars. Some scholars argue market forces will produce optimal levels of disclosure in a regime of voluntary disclosure, while others argue that various market failures necessitate mandatory disclosure.

Both sides in this longstanding debate assume that market actors rationally pursue wealth maximization goals. In contrast, my work in this area draws on the emergent behavioral economics literature to ask whether systematic departures from rationality might result in a capital market failure necessitating government regulation. I conclude that behavioral economics is a very useful tool, but that it in this instance it cannot fairly be used to justify the system of mandatory disclosure.

Continue Reading…

Intel’s rebates are apparently given rise to a potentially whole new class of suits based on the notion recipients of the rebates at the center of the Commission’s antitrust action should have been disclosed.   The WSJ reports:

Dell said last week that it and Mr. Dell were in talks with the Securities and Exchange Commission to settle civil allegations that they violated securities laws in connection with Dell’s dealings with Intel, a longtime supplier of microprocessor chips. At issue, people familiar with the situation say, is whether Dell should have disclosed rebates it received from Intel to investors. …

The settlements also won’t affect Mr. Dell’s position as the company’s chairman and chief executive, the company said. But they may come with sizable monetary penalties—the company has set a $100 million reserve for its own potential liability. The settlements could also shed new light on what effect Intel’s subsidies had on Dell’s finances over the years.

The story mentions that competitively-sensitive information like prices and rebates are typically treated confidentially.  And for good reason.  Intel’s rebates are competitive activity.  Competition for distribution from Intel and AMD to secure business from OEMs like Dell are a normal part of the competitive process, and like other forms of competition, generate benefits for consumers.  Requiring disclosure of competitively-sensitive information to the public, and competitors, runs the same risks that one would presume present if one substituted the word “rebates” with “prices.”

The disclosure issue here brings to mind another example of a potentially misguided disclosure regime that was the subject of one of my first blog posts back from when TOTM was hanging out at Ideoblog.   Back in 2005, California was considering a bill that would require retailers to disclose shelf space payments (aka “slotting fees“) to rival manufacturers.  Senator Figeuroa introduced Senate Bill No. 582, which would have mandated that:

A retailer shall, upon the request of a qualified supplier or manufacturer, disclose the placement fees or arrangements that the retailer assesses other suppliers or manufacturers for placement of similar products.”

Violations would allow competing manufacturers to recover a $10,000 civil penalty and attorney’s fees from a retailer who fails to comply.  Luckily for California consumers, SB 582 went away.  SB 582 was embarassingly misguided policy, and obviously bad for California consumers, who are the ultimate beneficiary of payments to retailers for valuable shelf space.   Taking action to facilitate an agreement to collude on slotting fees would be obviously unwise policy with little or no offsetting benefits.

Disclosure regulation regimes are frequently given a pass when it comes to cost-benefit analysis.  Legal scholars and economists are often guilty presuming without analysis that disclosure presumptively satisfies the “do no harm” principle.  (Geoff Manne’s Hydraulic Theory paper offering a systematic analysis of the costs of disclosure in the securities context is a must read.)  While economists generally appear to agree with the notion that more information is better than less in many settings, and many disclosure proposals are offer some potential net benefits, policy proposals like SB 582 (and potentially required disclosure of rebates for OEMs) are grounded in a failure to understand the competitive process and specifically, the role of competitive payments for distribution in that process.   If the economics of these payments are not understood, an SEC settlement which requires Dell and recipients of these rebates to disclose them to rivals and the public may impose significant costs on consumers.   Regulators charged with protecting the public interest ought to be mindful of the competitive implications of these payments when thinking about disclosures.