Archives For fiduciary duty

Last year I wrote here about Roni LLC v Arfa, which I cited as an example of the “troubling lawlessness of NY LLC law.”

As discussed in my blog post, the court in that case, after holding that the parties’ arms-length pre-formation business relationship did not support a fiduciary relationship, nevertheless denied defendants’ motion to dismiss based on “plaintiffs’ allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them.” The court applied old corporate cases holding that “both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.”

I criticized the court’s holding as misapplying NY LLC law, concluding:

[T]he court’s reasoning using hoary old corporate promoter cases to create a pre-formation fiduciary duty to disclose in LLC cases promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.

It seems the only way NY business people involved in business formation can avoid this problem is simply to avoid New York.

My blog post ended up being cited in the appellants’ brief on appeal, which prompted a response in the respondents’ brief (see n. 25).

I was then moved to write an amicus brief in connection with the appeal, which the NY Court of Appeals has now accepted for filing. To complete the picture, here’s the appellants’ reply.

I understand the case will be heard in November and decided a couple of months thereafter.  It will be interesting to see what the Court of Appeals makes of all this.

On Friday the Delaware Supreme Court decided the important case of CML V, LLC v. Bax (see Francis Pileggi’s helpful summary).

The court, per CJ Steele, held that a creditor lacks standing to sue an insolvent LLC derivatively.  The court reasoned that when the Delaware LLC Act says in §18-1002 that a plaintiff in an LLC derivative suit “must be a member or an assignee of a limited liability company,” it really and unambiguously means that he “must be a member or an assignee of a limited liability company.” Not a creditor.

Plaintiff argued that the Delaware statute refers only to member/assignee suits authorized by §18-1001 and does not preclude all creditor derivative suits.  This argument, draws force from N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007), which said that creditors of an insolvent corporation could sue derivatively under similarly phrased §327 of the DGCL. Plaintiff also insisted that it would be absurd to distinguish between LLCs and corporations.

CJ Steele responded that while the DGCL is limited to a shareholder-instituted derivative suit, Delaware §18-1002 refers to “a derivative suit.”  Also, while §18-1001 says that a a member or assignee “may” bring a derivative suit, §18-1001 says the plaintiff “must” be a member or an assignee, thereby calling attention to mandatory nature of §18-1002.

As to the plaintiff’s absurdity argument, here’s the opinion gets interesting (footnotes omitted):

[T]he General Assembly is free to elect a statutory limitation on derivative standing for LLCs that is different than that for corporations, and thereby preclude creditors from attaining standing. The General Assembly is well suited to make that policy choice and we must honor that choice. In this respect, it is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity. Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.

Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore, logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests. because there’s no difference in this respect between LLCs and corporations.

So this opinion reinforces developing Delaware law highlighting the LLC’s nature as a contractual entity, in contrast to the regulatory nature of the corporation.  Indeed, as I point out in my Rise of the Uncorporation (p. 6):

Uncorporations are characterized by their reliance on contracts. This is an aspect of uncorporations’ partnership heritage, as partnerships are contracts among the owners. * * * In contrast, corporate law is mainly couched in mandatory terms. * * * [T]he corporation’s special regulatory nature emerged from its historical roots. The corporation initially was a vehicle for government enterprises, monopolies, or franchises.

The CML opinion also carefully responded to plaintiff’s argument that this holding strips the Chancery Court of equitable jurisdiction to deal with injustice, in violation of the Delaware constitution. The court reasoned that the constitution freezes equity’s jurisdiction as of 1792, a time when LLCs didn’t exist.  The court went on to explain (footnotes omitted):

[T]he General Assembly passed the LLC Act as a broad enactment in derogation of the common law, and it acknowledged as much. Consequently, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is only the statute that creates those rights, remedies, and obligations.

Although the LLC statute provides that equity supplements its express provision, this refers only to rights and remedies the statute doesn’t address. On the other hand,

if the General Assembly has defined a right, remedy, or obligation with respect to an LLC, courts cannot interpret the common law to override the express provisions the General Assembly adopted.

The court points out that the creditor plaintiff’s exclusive redress in this situation is to contract for protection, and notes a variety of contractual terms that could have addressed the problem in this case.

This is a significant opinion because of its bluntness.  The basic point is that the legislature has decreed that LLCs are about contracts, so LLCs, unlike corporations, are freed from the sort of mandatory interference by Chancery that the constitution provides for corporations. In short, LLCs can opt out of litigation; corporations can’t.

This is wholly consistent with the central point of my Uncorporation and Delaware Indeterminacy, which surveys in detail Delaware uncorporation law and contrasts it with Delaware corporate law.

It’s also consistent with CJ Steele’s 2007 article, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies.  There he criticized his predecessor’s opinion in the Gotham case, which suggested that fiduciary duties are unwaivable, noting:

The supreme court apparently found it difficult to abandon the view that judicial oversight of disputes within the governance structure of limited liability unincorporated entities must invariably be from the perspective of a set of freestanding non-waivable equitable principles, drawn from the common law of corporate governance.

The Delaware legislature later fixed the Gotham court’s mistake, and CJ Steele has made clear ever since that the legislature meant what it said.  In this case he settles the potential constitutional impediment.

Interestingly, the Supreme Court’s reasoning in this case eschewed the more elaborate reasoning of VC Laster in this case, analyzed here. Although the Vice Chancellor reached the same result, he included an extensive analysis of how the LLC act differs from the corporate act in protecting creditors, thereby making the creditor derivative suit unnecessary. CJ Steele implies that it doesn’t matter whether the LLC Act includes effective substitute remedies.  It’s enough that the legislature has spoken and left creditors to their contracts.

Finally, it’s worth concluding the same way I did in my earlier post on this case by contrasting the clear and predictable approach in the Delaware courts with the

chaotic and unprincipled case law on LLCs in the supposedly commercially sophisticated New York, which I’ve discussed in several posts, as noted here. Among other sins, New York courts constructed an LLC derivative remedy out of nothing, and then had to make up the rest of LLC derivative suit law out of a whole cloth. In CML, VC Laster combined scholarly analysis and business sophistication in an opinion that gives contracting parties and later courts plenty of guidance.”

CJ Steele makes it even clearer:  There is no derivative remedy for LLCs in Delaware other than that provided for in the statute. Moreover, the parties to LLCs must look to their contracts.  If they want a court to fill in the blanks for them, they should have been a corporation, or an LLC in some other state.

Yaniv Grinstein and and Stefano Rossi have an interesting paper, Good Monitoring, Bad Monitoring, on the effect of corporate law, and specifically of the famous Delaware case Smith v. Van Gorkom and the Delaware legislature’s subsequent “fix” of that result.  Here’s the abstract:

We estimate the value of monitoring in publicly traded corporations by exploiting a natural experiment. A Delaware Supreme Court decision unexpectedly held directors liable for monetary damages for breach of fiduciary duties. The ruling signaled a sharp and exogenous increase in Delaware Courts’ scrutiny over board decisions. We analyze the impact of the ruling on stock returns using matching and differences-in-differences techniques. We find that, compared with appropriately matched non-Delaware firms, Delaware-incorporated firms in high-growth industries lost (CARs of -2.10%) and firms in low-growth industries gained (CARs of 1.40%) in the [0,10] window around the announcement of the Supreme Court decision. A later regulatory reform to the Delaware Code that reversed the effects of the Supreme Court decision had opposite results: firms in high-growth industries gained and firms in low-growth industries lost significantly. Our results shed light on the complex interplay of courts and regulation and on its implications for shareholder value.

In the conclusion the authors state:  “We interpret these results as implying that “one-size-fits-all” models represent inadequate solutions to the corporate governance problem.” In other words, a strict duty of care is good for some companies but not others.

This suggests that firms should be allowed to contract to tailor regulation to their needs. But the Delaware code revision did just that — allow firms to contract.  Yet returns for low-growth firms dropped, despite the fact that the statute allowed these firms to remain subject to the strict care standard.

Does this suggest that corporate contracting is flawed?  Or what?

Remedying Skilling

Larry Ribstein —  15 August 2011

The WSJ comments on bills in Congress to “remedy” the Supreme Court’s decision in U.S. v. Skilling by explicitly criminalizing agent conduct that doesn’t involve bribery or kickbacks:

The biggest objection to such laws is their injustice, but they also harm the economy by introducing legal uncertainty that deters or delays business investment. A Congress that claims to care about job creation would drop these attempts to undermine a wise and unanimous Supreme Court decision.

I would also call attention to the significant prosecutorial misconduct that has been associated with these bringing these cases. As discussed in my Agents Prosecuting Agents, it is difficult to effectively discipline this misconduct.  We should therefore consider another option: being more careful about what gets criminalized.  Our politicians should balance the significant costs imposed by the public’s agents (i.e., prosecutors) against the benefits of adding criminal sanctions to the many other ways of disciplining breach of fiduciary duty by corporate agents.

Congress clearly has better things to “remedy” than Skilling.

The WSJ comments on a dumb proposal by the Employee Benefits Security Administration to broaden the definition of “fiduciary” to cover brokerage services with respect to retirement accounts.

As the WSJ notes,

For decades the finance industry has provided investors roughly two kinds of services: the “advisory” model, in which an investment professional makes trading decisions, provides specialized advice and charges savers an annual fee; and the “brokerage” model, in which the saver makes the decisions and pays a fee for each trade and occasional advice. The latter model can be cheaper because the broker is often compensated by the company whose products he’s offering.* * *

The rule would have huge consequences for the retirement savings industry. Brokers would have to weigh the cost of higher regulatory compliance against staying in the business. Investors would pay more for trades and advice and have fewer investment choices. Investment educational seminars would likely halt in many cases, lest organizers think they’ll be held liable as a fiduciary for giving general investment advice.

Many firms would raise minimum investment amounts to cover their higher costs, cutting off access to lower-income savers. Consultancy Oliver Wyman surveyed about 40% of the investment retirement account market and estimated the proposed rule could “eliminate access to meaningful investment services for over seven million IRAs.” Investors could see “direct costs” rise between 75% and 195%. * * *

Moreover, the SEC is still studying the broker-dealer fiduciary issue pursuant to Dodd-Frank.  Despite its failings, the SEC is the more appropriate agency to consider this sort of move.

The big problem here is that the proposal seeks to apply a fiduciary duty to a relationship that is simply not fiduciary, resulting in massive confusion.  As I said in my recently published Fencing Fiduciary Duties concerning moves to make brokers fiduciaries:

Customers generally do not delegate fiduciary-type open-ended power that would justify fiduciary-type selflessness consistent with this article’s analysis.  Brokers, dealers, and advisers usually lack authority to commit the customer’s property without further instructions.  Nor should customers expect unselfish conduct from people who are selling securities for a commission or profit.  Thus, application of fiduciary duties to brokers, dealers, and advisers would not be consistent with customers’ expectations and would create a potential for confusion.

The Supreme Court’s recent Jones v. Harris provides a good example of the “potential for confusion” in the context of fiduciary duties for mutual fund advisors under Section 36(b) of the Investment Company Act of 1940.  I recently discussed this case and the misbegotten history of this regulation.

Another day, another industry targeted for crippling regulation — in this case smothering investor choice with a wet fiduciary blanket.  The haphazard expansion of fiduciary duties is a senseless move by a regulator that seems to have no idea what it’s doing.

Bob Monks has a lot to say about Business Roundtable v. SEC.  Some notable quotes:

“The DC Circuit now has really made a reputation over four or five years of throwing out SEC regulations.  Their reason for doing it is that the SEC has failed to generate cost-benefit information that conforms with their interpretation of what the APA requires for the validity of new regulation.  Obviously this is a judgment that court can make, but if they’re making that judgement four times running it tells you a little more about the court perhaps than about the specific issue or the SEC….What Douglas Ginsburg adduces is a failure of the SEC to produce information about the costs of having independent nominations on the company ballot.  And he speaks of the cost of the directors exercising their fiduciary duty, whether or not to place the name of a nominee on the ballot….You begin to wonder whether there’s any substance to what Douglas Ginsburg is saying.  I mean if he’s scraping up something like the fiduciary duty of the board to consider the nominee you know this is a matter of a de minimis amount of money.  Any why, how can one accord credibility to this opinion?  …It is simply the ranting of the DC Circuit Court that says they haven’t satisfied the gravamen of proof necessary to demonstrate cost-benefit.”

He goes on to call Judge Ginsburg “obdurate.”

I think its important to interpret the Monks rant in historical context.  Bob Monks ran the Office of Pension and Welfare Benefits at the Labor Department during the early Reagan years.  His work there culminated in a mandate issued by his successor that plan fiduciaries are required to actively vote their shares.  Almost immediately upon leaving his post, he founded Institutional Shareholder Services, a proxy advisory company that profited from the artificial demand for proxy advisory services created by the regulatory regime he helped to institute.  He has since been a leading profiteer of the corporate governance advisory industry.  It is an impressive example of rent-seeking in action.

I don’t the see the logic to Bob’s point that the SEC’s four losses before the DC Circuit in the last ten years demonstrate a problem with the Court.  Whether you agree with the NSMIA’s requirement that the SEC perform robust economic analysis of new rules or not, it is apparent that the SEC has ignored continued warnings from the Court.  In the interim, it has wasted agency resources in promulgating rules that are ultimately overturned.  For example, the SEC estimates that it wasted 2.5 million dollars on the failed proxy access rule.  I think that estimate is actually a lowball, as it includes 21,000 man hours of SEC staff time and does not account for opportunity costs.  Imagine what 21,000 hours of time devoted to a ponzi scheme task force could have done, or a top-to-bottom review of SEC rules to highlight inefficient rules for repeal (as President Obama’s recent executive order to the independent agencies actually requires) could have accomplished.

Others have similarly charged reactions to the proxy access case.  In a WaPo article today Harvey Goldschmid, the former SEC Commissioner who championed the first proxy access rule in 2003, responds to the Court scrutiny of the SEC’s economic analysis by urging “But how do you prove that empirically?  If the Court’s unrealistic requirements were applied across the board, the regulatory process would grind to a halt.”  J. Robert Brown is also quoted as saying “What the court is doing is second-guessing economic analysis that can always be second guessed.”

Harvey and Jay no doubt have an impressive knowledge of the securities laws.  I think they could profit from a course in policy analysis.  The legislative history of the securities laws makes clear that the objective is a purely economic one, to stabilize markets, prevent fraud, and maximize economic growth.  The 33′ and 34′ Acts were a response to the stock market crash of 1929 after all.  Cost-benefit analysis is a tough fit in areas where nebulous ideas like justice or equity are at issue (though it is still quite informative) but where as here the underlying objectives are purely economic it is the only legitimate mode of analysis.  It is hard to demonstrate net benefits from new rules, that’s true.  But does that mean we shouldn’t even ask the question?  I suspect their hostility to cost-benefit analysis is actually grounded in their belief that independent agencies are useful tools to accomplish a progressive agenda, including empowering labor unions, promoting climate change regulation, fair trade, affirmative action, and a variety of other liberal causes.  Putting these issues in the hands of independent agencies politicizes the SEC, undermining its credibility and hindering the SEC’s job of promoting the efficient function of American capital markets.

Well, well.  It looks like the heatwave hitting DC has encouraged the Judges on the panel reviewing the SEC’s proxy access rule to finish their opinion earlier than expected.  The rule has been struck down by the DC Circuit as arbitrary and capricious for failure to meet the SEC’s mandate to consider the effect of new rules on efficiency, competition and capital formation.  I suspect there will be a torrent of blogging about this one.

The Court found that the SEC failed to consider the potential costs of empowering conflicted investors, like Union Pension funds.  It’s ironic that in an over 400 page rule, the SEC offered no discussion of this issue.  The Court found that the SEC failed to properly consider the frequency with which shareholders would bring proxy contests.  The Court also noted that a company’s fiduciary duties might compel a board to resist a proxy access nominee, and found that the SEC failed to adequately consider the effect of this problem.  The Court also found that the SEC failed to consider readily available empirical data which questioned the benefits of the rule, giving particular attention to the Buckberg/Macey Report.  It also questioned the persuasiveness of an empirical study on which the SEC relied (See J. Harold Mulherin & Annette B. Poulsen, Proxy Contests & Corporate Change: Implications for Shareholder Wealth, 47 J. Fin. Econ. 279 (1998)).

This decision brings to light a fundamental problem at the SEC.  Speaking against my own interest as a securities lawyer, I think it is an agency with too many lawyers and not enough economists.  The Federal Reserve and Federal Trade Commission are better regulators because they have teams of sharp economists to consider the effects of new rules.  As Senator Shelby noted in a recent hearing, the SEC on the other hand has over a thousand lawyers and less than 25 economists.  Today’s decision is one of the predictable results.  So were similar decisions striking down rules on the same basis in American Equity v. SEC and in Chamber of Commerce v. SEC.

The SEC has now proposed rules on proxy access in 2011, 2009, 2007 and 2003.  It still doesn’t have a rule in place.  That’s a lot of man hours to put into writing a rule that is never ultimately adopted.  I wonder if Chairman Schapiro will look to re-write the rule given all the deadlines she is facing under Dodd-Frank.  I don’t think we’ve seen the last of Rule 14a-11, but I think it may be awhile before it is resurrected.  What would a new SEC rule look like?  I doubt it would cover investment companies, as the opinion gave particular attention to the SEC’s decision to apply the rule to them.  I would also suspect it would allow for an opt-out procedure.  We’ll see.

Let’s not forget that the changes to Rule 14a-8 are still in place.  So shareholders can still adopt election bylaws which specify proxy access procedures at a particular company.  It’s never to early for boards to consider putting into place the proxy access defenses that I have developed.

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.

My article, Fencing Fiduciary Duties, has just appeared in a B.U. Law Review symposium.  Here’s the abstract:

This comment on the work of Professor Tamar Frankel builds on her encyclopedic discussion of the various types of duties that have been classified as “fiduciary.” I argue for a more precise definition and more limited application of fiduciary duties which recognizes that their usefulness depends on their being limited and separated from other duties that apply in other settings. The fiduciary duty is appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good faith and fair dealing, and to refrain from misappropriation. The fiduciary duty of unselfishness is appropriate only for a limited class of agency relationships in which the principal delegates open-ended power to the agent, and not for those who may exercise lesser power over the property of others, including co-investors, advisors, professionals, and those in confidential relationships. More broadly applying fiduciary duties could unnecessarily constrain parties from self-protection in contractual relationships, impose excessive litigation costs, provide an unsuitable basis for contracting, and impede developing fiduciary norms of behavior. This analysis of fiduciary duties helps address current issues, including those regarding the duties of brokers, dealers, and investment and mutual fund advisors. In short, fencing fiduciary duties protects both fiduciary and non-fiduciary relationships and enables parties to contract for the precise level of protection that is appropriate to the services they are purchasing. 

The paper develops, updates and applies ideas from my earlier paper, Are Partners Fiduciaries?  Email me if you’d like a free offprint.

It’s been over four years since the heyday of the last boom when I first discussed what I called “privlic equity” in an article about Blackstone’s proposed IPO.

So here we are post-bust, and according to the WSJ, they’re baack:

Apollo Global Management LLC became a public company in late March. Last year, KKR & Co. began trading on the New York Stock Exchange. * * * There is more to come. Oaktree Capital Group LLC is planning to sell $100 million of shares, while private-equity powerhouse Carlyle Group LLC is expected to come public in the next six months or so. Meanwhile, hedge-fund investor William Ackman is expected to sell public shares of a new hedge fund.

For those who were skeptical about this business form back in 2007, it’s worth noting that “skeptics acknowledge there is little evidence that being public crimps returns. Blackstone recently raised a $15 billion new fund despite the rough economic period.”

Some may wonder why “private equity” wants to go public.  The WSJ story points to the “irony. . . that many private-equity firms tell potential acquisition targets that becoming private through a sale to these firms will allow their businesses to prosper.” The article ineptly responds by parroting the privlic equity hype that “operating privately works best for companies undergoing change, but their investment businesses already are strong and can thrive as public companies.” Yeah, whatever.

I have a more cogent explanation, which I’ve discussed in several places, including the University of Chicago Law Review and my book, Rise of the Uncorporation.  I argue that the important feature of what I call “uncorporations,” including private equity firms like the ones noted in the WSJ article, is not whether they’re public or private but their form of governance. In a nutshell, uncorporations substitute partnership-type incentives for corporate-type monitoring.  The elements of partnership-type governance include making managers true owners and giving the owners greater access to the cash.  This can make sense for both publicly and privately held firms.

Here, for example, is my description of Blackstone in the Chicago article (304-05, footnotes omitted):

[T]he owners of the managing general partner of the publicly traded Blackstone Group own equity shares in the funds and will continue to receive directly a share of the carry. The Group, in turn, owns controlling general partnership interests in the funds. As in other publicly traded partnerships, taxing earnings, whether or not distributed, to the owners should make them more averse than corporate shareholders to earnings retention. Managers who retain earnings on which the unitholders are taxed are likely to be judged harshly in the capital markets and thus face constraints on future capital-raising.

As a tradeoff for partnership discipline and incentives, “privlic” equity firms eliminate the monitoring mechanisms that characterize the corporate form. The Blackstone Group prospectus thus correctly calls itself “a different kind of public company.” Blackstone Group unitholders get almost no formal control rights. The LLC that manages the Group is controlled by a board elected by the LLC members, not by the Group or its unitholders. The prospectus makes clear that the unitholders “will have only limited voting rights on matters affecting our business and . . . will have little ability to remove our general partner.”

Privlic equity firms also sharply restrict managers’ fiduciary duties. For example, The Blackstone Group limited partnership agreement provides that the general partner may make decisions in its “sole discretion” considering any interests it desires, including its own. The general partner may resolve any conflict of interest between the Group and the general partner as long as its decision is “fair and reasonable.” A unitholder challenging the decision has the burden of proof on this issue, and a decision approved by independent directors is conclusively deemed to be fair and reasonable and not a breach of duty. In addition, since the Group is a Delaware limited partnership, courts are likely to enforce these limitations on fiduciary duties.

This uncorporate structure is not for all firms.  As discussed in Rise of the Uncorporation, the form makes a lot of sense for the standard publicly traded partnership, which manages “natural resources, real estate, and other properties as these firms can commit to making distributions without compromising long-term business plans.” It may make less sense for more entrepreneurial firms that have a lot of business opportunities and need to give their managers control of the cash.  Private equity is somewhere in between.

My discussion of privlic equity in this early-2010 book ended on a bleak note appropriate to the times, noting that “privlic equity shares have melted down with the rest of the market” and “the  possibility that the firms will repurchase their newly cheap shares and become private again. It is not clear whether the privlic model ultimately will be seen as a short-lived fad of the financial boom, will make a comeback when the market does, or be seen as a transitional structure that will give rise to the publicly held uncorporation of the future.”

I also suggested that privlic equity might be the harbinger of a “convergence of corporate and uncorporate forms or some sort of reconfiguration of the divisions among large firms.”

It’s not clear from the WSJ article exactly what is happening in this resurgence of privlic equity. Among other things, I don’t know whether the new IPOs will use Blackstone-type techniques to avoid restrictions on partnership taxation of publicly traded partnerships, or will be tax corporations.  If the former, it would seem the firms will face pressures to make distributions, since the owners will be taxed on the income whether distributed or not.  Yet the WSJ article suggest the firms will have corporate-type “capital lock-in” (to use Margaret Blair’s term): “Mr. Ackman’s IPO would give him capital for investments that can’t be yanked by investors if they sour on him or the market.” 

The WSJ article indicates there’s still confusion about what’s going on with these firms.  But since going privlic may be here to stay, it’s time to try to understand their financial significance.  I suggested in the conclusion of Rise of the Uncorporation that this could be the harbinger of a new type of hybrid firm:

For example, regulators may insist that firms adopt uncorporate discipline before they can waive such important corporate features as shareholder voting and fiduciary duties. Also, publicly traded uncorporations arguably have the same need for inflexible rules as publicly held corporations. Regulators therefore might mandate features such as limited terms or regular distributions for firms that seek to opt out of standard corporate features. In short, the publicly traded partnership could become a distinct type of firm that straddles the corporate-uncorporate boundary.

In other words, we might finally have to face the failure of standard corporate-type governance and the need to replace it with something that works better than shareholder democracy and the business judgment rule.

Steve Bainbridge responds to my post about insider trading as compensation with a suggestion that rules against insider trading are an example of a case “where mandatory rules are appropriate.”

I was about to sputter about laws against insider trading are really about property rights, and surely property should be alienable — right?  And about how this is really about fiduciary duties, and behind that agency costs, which is the heart of corporate law.  So how much of the rest of corporate law should be made mandatory and federal?

Then I realized Steve was really talking about lawyers trading on clients’ information.  Well, that’s different. Clients rarely authorize this, so it’s usually theft and therefore bad.  But I still wonder why clients shouldn’t be allowed to authorize it.  And who knows whether that might happen as lawyers’ roles evolve?  (You knew I was going to stick that one in again, didn’t you?)

But after calming down I got riled up by the last line: “If investors have a taste for prohibiting insider trading, it thus does no good to say that the world would be a more efficient place if insider trading were allowed.”

Um, well, where does that sort of reasoning stop?  People ought to be able to indulge a lot of seemingly goofy tastes.  But that’s a long way from a normative argument that these tastes should be imposed on society.

Gretchen Morgenson (with Louise Story), in today’s front-page NYT “newsatorial” reports on and complains about the fact that the SEC’s civil case against Goldman’s Fabrice Tourre (“Fabulous Fab”) in connection with the Abacus deal has not been accompanied by other civil and criminal prosecutions. 

The story notes that Tourre worked closely with others at Goldman and hints that Goldman is forcing Tourre to use its lawyers so that he alone and not one of his more prominent colleagues will take the fall. Morgenson/Story don’t explain why the SEC is collaborating with Goldman in this fall-guy strategy, and indeed provide a more innocent explanation:  that the SEC had incriminating emails on Tourre that it didn’t have for any others.  Nevertheless, Morgenson/Story imply that the fire of more prosecutions should in justice follow the smoke of the Tourre case. That, of course, assumes Tourre was doing something wrong, which is far from clear in the Morgenson/Story article.

I’m also disturbed by the Tourre case, but for entirely different reasons.  I discussed the suit’s weakness when it was filed and observed that its real motivation was to help push through Dodd-Frank’s regulation of derivatives trading.  I noted that “this could be the deal that saves financial regulation and brings down the derivatives business.”  I’ve also criticized here and here the use of these allegations to gin up a new broker-dealer fiduciary duty.

Oddly enough, Morgenson & Story end their article with a discussion of allegations that Goldman employees “tried to manipulate prices of securities used to bet against mortgages.”  This differs from the allegation against Tourre that he failed to disclose John Paulson’s involvement in constructing the reference portfolio of the security he was selling.  In other words, whether others should be sued or prosecuted for what Tourre did has nothing to do with whether somebody should be sued or prosecuted for different manipulation regarding other securities, or for any other financial misdealings in the last couple of years. 

By somehow gluing all this together into a big ball of wax, Morgenson is following her common practice of “leveraging” a story to make it look bigger than it is.  For more examples of these and other Morgensonian journalistic practices, see my extensive criticism of many of her weekly columns.

Cutting through Morgenson’s typical blustering and rhetorical flourishes, there’s a lot less to this story than meets the eye.  Fortunately for Morgenson and her co-author, there are no prosecutors or government agencies scrutinizing whether they are over-selling their product.