August 22, 2014
icon The Con Law Conundrum
Posted by Usha Rodrigues

The question: to con law or not to con law?

The context: Steve Bainbridge responding to Anne Tucker's post on including a Citizens' United/Hobby Lobby discussion in a BA course (see Anne's reply to Steve here).  The question is a timely one for me:  Georgia Law started classes this week, and I (the rare bird who rotates casebooks because she is easily bored) am happily back teaching from Steve's casebook, co-authored with Klein & Ramseyer, which I highly recommend.  I never hand out a syllabus with assigned readings because invariably we move quicker or slower than I anticipate.  I have to cut or add material, and I find that students find such midstream changes unsettling.  So I don't tell them where we're going til we get there.

But I do have a "working syllabus" I hash out for myself at the semester's opening and tweak as the classes unfold.  As Anne and Steve point out, the semester is ridiculously crowded.  In 3 credits I cover partnership, corporations, and LLCs, and I cover the MBCA and Delaware corporate code.  It's way too much material (as I told my class Wednesday as part of my "drop this class" introductory speech).  My working syllabus has material for each of the 42 50-minute classes I'm allotted, and I agonize over the choices I make in filling each one.  This year, for the first time ever, my roughed-out working syllabus includes a day for Citizens United/Hobby Lobby.

Why?  Steve makes a terrific case for private law, and I am with him.  I love teaching BA for BA's sake.   Explaining to students the basic puzzle of ownership versus control, the different ways to run the railroad in terms of choice of entity and the tradeoffs among them?  Throw in the importance of private ordering and the ability to read a statute, and I'm in heaven.  I'm no public law scholar in sheep's clothing.  I'm a true believer, proselytizing for the beauty of business law in what sometimes does feel like a con law desert.

But I have got more doctrinal material than I can possibly cover.  Throw in a class where I invite in a practitioner, a class for Bill Chandler to talk about whatever the heck it is he wants to, and a review session, and we're talking precious few classes to cover a lot of material.


So why cede a precious class to public law jibber-jabber?  I'm still not sure I will.  But the reason came to me on a playground, chatting with an English professor mom.  We were commiserating over our lack of preparation for the start of the semester (secret: professors procrastinate, too), and she said, "well, it must be nice to teach a subject so interesting to students.  Hobby Lobby, Citizens United."  She nodded knowingly. 

The comment brought me up short.  Nobody things corporations are interestng.  At least, no one used to.  But now they do.  And sure it's for the "wrong" reasons--not for coprorate law reasons, but for reasons that deal with corporations' role in society.   And I think that might be enough to devote one class out of my 42.  Not for Anne's reason,  "to “hook” students who didn’t come to my class with an interest in corporate law."  I'm confident I can hook them on the merits.  But because, as she also says, "Corporate law also matters to general members of society because corporations wield tremendous power in elections, in lobbying (regulatory capture anyone?), in shaping retirement savings, in religious and reproductive rights debates and setting other cultural norms around issues like corruption, sustainability, living wage, etc."  It struck me on the playground that the "legal literacy" reason I give for taking Corporations--it's just something that every lawyer should know--may apply here as well.  With Hobby Lobby we might have reached the point where corporate law literacy demands a passing understanding of these two cases.  

Maybe not.  The CU/Hobby Lobby class may well end up on the cutting room floor.  But one last thing: as I get older, it is increasingly less clear to me that my students retain much past the exam.  What I want them to get out of the class, ultimately, is a basic knowledge of the relevant codes, of the importance of codes, an ability to read statutes, an understanding of the importance of default rules versus mandatory ones, agency costs, the trade-offs in choice of entity, the business judgment rule, and fiduciary duty.  Looked at that way, perhaps one public law class out of 42 isn't too much of a sacrifice in terms of coverage.

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August 21, 2014
icon Outsourcing the Board: A Good Idea?
Posted by Sung Hui Kim

This week’s Economist has a column praising my UCLAW colleague Stephen Bainbridge’s and University of Chicago law professor Todd Henderson’s creative proposal, published in the Stanford Law Review, to replace individual directors with professional-services firms acting as Board Service Providers (BSPs).  (That article can be accessed here.)  The column nicely summarizes the possible impact of such a change:

“Messrs Bainbridge and Henderson argue that this would require only a simple legal change but could revolutionise the stick-in-the-mud world of boards. It would replace today’s nod-and-a-wink arrangements with a market in which rival BSPs compete. It would create a new category of professional director. And it would allow BSPs to exploit economies of scale to recruit the best board members, introduce more rigorous training programmes and develop the best proprietary knowledge. Now, even the most diligent board member can only draw on his or her experience. BSPs would be able to draw on the expertise of hundreds. This would increase the chances that corporate incompetence will be corrected, corporate malfeasance found out and corporate self-dealing, in the form of inflated pay, countermanded.”

The BSP idea is very creative. (Frankly, I am always puzzled by the extent to which academics have trouble appreciating creativity. Perhaps—and I’m speculating here—traits such as creativity are weakly correlated with succeeding in the academic tournament—getting high LSAT scores, writing good law school exams, getting judicial clerkships, and placing law review articles?)  I also agree that introducing market competition by enabling firms to compete on performance will likely benefit consumers and shareholders, as well as increase the leverage of the board vis-à-vis executive officers.

That said, I worry about uncontrolled expenditures as BSPs find yet another reason to bill the corporation another $250,000 for yet another “critical project.” My prior experience as general counsel of a corporation (plus my six years of practicing law in a law firm) make me skeptical of the incentives of partners within firms (“Bill, bill, bill!”). I worry about the ratio of the value of services to cost. While we may see a decrease in executive compensation as a result of increased board leverage, are we going to see an increase in the effective compensation (i.e., including billings) of the board? My guess is yes.

I also worry about the audit/gatekeeping function of the Board.  After all, we have plenty of experience with auditors being firms, rather than individuals. And the record there doesn’t look so hot. Remember Enron and Arthur Andersen? And remember Ted Eisenberg’s and Jonathan Macey’s empirical study suggesting that Andersen was not an outlier but typical?  While gatekeeping theory provides that market gatekeepers, such as investment banks and accounting firms, are incentivized to work hard to prevent malfeasance out of fear that their longstanding reputations will be damaged, the reality is that the reputational informational markets are noisy and manipulable. Moreover, the incentives of the firm’s agent – the functional gatekeeper – may diverge from the incentives of the firm.  In other words, large firms may suffer from principal-agent problems, as has often been alleged with David Duncan, the lead audit partner responsible for the Enron account at Andersen. (In prior work, I wrote about the incentives of firms vs. individuals for the audit/gatekeeping function.)

But I suppose Henderson and Bainbridge would respond that still, those reputation markets would work better with firms competing with one another than the status quo—little to no competition with respect to individual directors (for various reasons).

Perhaps there’s room for compromise. If you’ve been following the accounting profession, you know that the PCAOB (the body that regulates the accounting of public companies) in an effort to improve the transparency of audits has proposed to require the disclosure of the name of the engagement partner for the most recent period’s audit. Also, it has been suggested that the engagement partner individually sign the audit report. It should not be surprising that accounting firms uniformly dislike these suggestions. This indicates that they are probably good ideas. Perhaps, then, as a means of dealing with the principal-agent problem within BSPs themselves and to ensure that the incentives of the firm’s agents (the persons who actually sit in board meetings) are more properly aligned, similar measures should be taken.  

Permalink | Accounting, Business Ethics, Corporate Governance | Comments (View) | TrackBack (0) | Bookmark

August 20, 2014
icon Trying To Understand New York State's Regulation Of Business
Posted by David Zaring

You'd think that the state that's home to the center of American business would take a Delaware-style light touch approach to overseeing it.  But instead, the New York paradigm is to take ambitious politiicans, blend with broadly worded supervisory or anti-fraud statutes like the Martin Act, and come up with stuff that, to my ears, sounds almost every time like it is off-base, at least in the details.  So:

  • Eliot Spitzer pursued research analysts for the sin of sending cynical emails even though they issued buy recommendations, despite that fact that analysts never issue negative recommendations, and if cynical emails are a crime, law professors are the most guilty people in the world.
  • I still don't understand what Maurice Greenberg, risk worrier par excellence, did wrong when he was running AIG.  I do know that after he was forced out by Spitzer, the firm went credit default swap crazy.
  • Maybe there's something to the "you didn't tell your investors that you changed the way you did risk management for your mortgage program" prosecutions, but you'll note that it is not exactly the same thing as "you misrepresented the price and/or quality of the mortgage products you sold" prosecutions, which the state has not pursued.
  • Eric Schneiderman's idea that high frequency trading is "insider trading 2.0" is almost self-evidently false, as it is trading done by outsiders.
  • Federal regulators wouldn't touch Ben Lawsky's mighty serious claims that HSBC or BNP Paribas were basically enabling terrorist financing.
  • And now Lawsky is going after consultants for having the temerity to share a report criticizing the bank that hired them to review its own anti-money laundering practices with the bank, who pushed back on some, but not all of the conclusions.

The easiest way to understand this is to assume that AGs don't get to be governor (and bank supervisors don't get to be AGs) unless people wear handcuffs, and this is all a Rudy Giuliani approach to white collar wrongdoing by a few people who would like to have Rudy Giuliani's career arc.

But another way to look at it is through the dictum that the life of the law is experience, not logic.  The details are awfully unconvincing.  But these New York officials have also been arguing:

  • Having analysts recommending IPO purchases working for the banks structuring the IPO is dodgy.
  • HFT is front-running, and that's dodgy.
  • This new vogue for bank consulting is dodgy, particularly if it's just supposed to be a way for former bank regulators to pitch current bank regulators on leniency.
  • If we can't understand securitization gobbledegook, we can at least force you to employ a burdensome risk management process to have some faith that you, yourself, understand it.
  • And I'm not saying I understand the obsession with terrorism financing or what the head of AIG did wrong.

Their approach is the kind of approach that would put a top banker in jail, or at least on the docket, for the fact that banks presided over a securitization bubble in the run-up to the crisis.  It's the "we don't like it, it's fishy, don't overthink it, you're going to pay for it, and you'll do so publicly" approach.  It's kind of reminiscent of the saints and sinners theory of Delaware corporate governance.  And it's my pet theory defending, a little, what otherwise looks like a lot of posturing.

Permalink | Administrative Law, Finance, Financial Crisis, Financial Institutions, White Collar Crime | Comments (View) | TrackBack (0) | Bookmark

August 19, 2014
icon In Praise of Maritza Munich
Posted by Sung Hui Kim

The blogosphere is filled with chatter about the recent decision Wal-Mart Stores, Inc. v. Indiana Electrical Workers Pension Trust Fund IBEW, Del. Supr., No. 614, 2013 (July 23, 2014), in which the Delaware Supreme Court en banc explicitly endorsed the Garner exception to the attorney-client privilege in a Section 220 books-and-records proceeding. But there been less attention showered on Maritza Munich, the general counsel of Walmart International, who resigned. As the court opinion tells us, Munich tried to stop the bribery scandal that was unfolding at the world’s largest retailer. As summed up nicely by Michael Scher of the FCPA Blog (HT to Stephen Bainbridge):

“As head of international compliance, Munich insisted on an investigation of a ‘campaign of bribery’ in Mexico and the top manager who led it. According to ongoing media reports, the top executives of Wal-Mart blocked the investigation. She then ‘resigned,’ while other executives were promoted.

Munich’s career at Wal-Mart was stolen from her. Instead of incentive pay, a bonus, and a stellar career, she lost out on the recognition, respect and financial security she deserved for doing a [compliance officer’s] job when it mattered most.”

I think it is important to circulate stories of lawyers who take ethical stands against those who hold power over them. Although martyrs and whistleblowers are common subjects of films and books, as I’ve argued in prior work and based on a plethora of research in sociology departments and management schools, such acts of courage and integrity are rare. But they do happen and, when we encounter such an instance, we should take a moment and celebrate that person's courage.

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icon Does the Public/Private Divide in Federal Securities Regulation Make Sense?
Posted by Usha Rodrigues

Like Lisa, I participated in this excellent discussion group at the SEALS conference co-organized by Joan Heminway.  As I told co-organizer and friend-of-Glom Mike Guttentag, for a week I had a Word document open with the titular question at the top.  Participants were supposed to submit a 2-3 page paper before the meeting.  I totally lamed out.  I kept trying to write, but couldn't come up with anything coherent. 

I do have an answer to the question, though: Yes, the public/private divide does make sense.  But it's gone, daddy, gone. 

As I said at the conference, I think I'm essentially a conservative person: I'm resistant to change.  And when I learned the world of securities, it seemed to me that there was this Grand Bargain.  If you wanted to go public, you got many benefits, most notably a high degree of liquidity and access to public capital markets.  But you had to take the bitter with the sweet: mandatory disclosure and increased liability risks.  If you stayed private, your equity was far less liquid, and you couldn't make use of general solicitation.  Your capital raising was much more circumscribed.  But within those limitations you were free to order the firm more or less as you saw fit.  Other substantive areas of law of course constrained private firms--environmental law, labor law, etc.--but in terms of corporate and securities law, they were relatively free.  I realize this is a simplification, but in broadstrokes I think it's true.

No more.  The Grand Bargain is gone. General solicitation for private firms.  Conflict minerals rules.  Emerging growth companies.  Disclosure of executive pay ratios. Private secondary markets.  Dodd-Frank, the JOBS Act, and technology have made a hash out of it.  Or at least, the line between public and private is blurred.

This blurring makes me uneasy.  I feel like there's a disruption in the natural order of things. But I can't tell if that's my innate conservatism talking, or if there really was something we lost with the Grand Bargain. 

Permalink | Rants, Securities | Comments (View) | TrackBack (0) | Bookmark

August 18, 2014
icon Family Film Blogging: Guardians of the Galaxy
Posted by Christine Hurt

Man, the deadweight loss of moving cannot be underestimated!  We are finishing the busiest yet least productive summer in history, but we did find time to go to the movies!

So, I'll start with the fact that when we saw the trailer for Guardians of the Galaxy, I looked over at our youngest and said, "You will have to make Dad take you to that one."  A racoon?  I don't think so.  I have taken the kids to a lot of really dumb movies (top of that list:  Dougal, Space Chimps, Ice Age 24), but I have standards.  A superhero raccoon is where I draw the line.  Can you see Iron Man fighting side by side with a raccoon?  No.  But then, when the movie came out a few weeks ago, the reviews were pretty universally great.  And, there was a lot of construction and confusion at my house.  So, off to Guardians of the Galaxy we went.

My take:  Guardians is the Fletch of the Marvel universe.  That is a compliment.  The movie has a lot of action, violence, etc., but it's also really funny.  And not funny every half hour like the Avengers or even the Iron Man series, but funny throughout.  The big four Avengers are serious.  Captain America is super-serious, and Thor couldn't even get the timing right on the funniest line in the Avengers ("He's adopted.")  Tony Stark is usually funny, but had serious mental illness in his last movie that dampened the mood.  Peter Quill (aka Star Lord or Star-Lord) is mostly funny.  Action comedies are a hard combination to get right, but Guardians seems to get it right.  We started quoting the movie as we were walking out of the theater, and are still quoting it today.

For Marvel junkies out there, the Peter Quill backstory does not follow any of the various Marvel narratives.  In the movie, his mother dies, apparently from cancer, when Peter is small.  She speaks lovingly of his father, who she believes will return to them.  Minutes later, a spaceship arrives at the hospital and takes Peter away.  The next time we see him, he is a grown man flying around the galaxy retrieving artifacts for shadowy clients.  (The second scene is reminiscent of Indiana Jones, but Peter Quill is no archaelogical genius.)  Unfortunately, he unwittingly becomes involved in a high-stakes grab for a valuable object, the importance of which ties this movie into other Marvel movies.

Quill eventually bands together with four others -- Rocket (the raccoon), Drax (who looks like a body builder, but seems to lose most fights for some reason), Groot (a tree-man), and Gamora (the requisite female).  The movie is very self-aware, and people don't just casually join up with a talking raccoon.  There is quite a bit of condescension there, which gets dispelled, thereby dispelling my own skepticism.  Groot is the fan favorite, and Gamora is sufficiently complex and interesting to be more than just the token girl.  Most of the buzz about the movie is how awesome Chris Pratt (Parks & Rec, Lego Movie) is as Quill/Star-Lord.  He is very enjoyable.  Indiana Jones Harrison Ford enjoyable, I'm not sure.  We'll (anxiously) wait for the sequel.

One caveat:  The Marvel/Avengers movies are fairly family-friendly.  (Our 6 year-old is still a little too freaked out by the more graphic and dark Iron Man movies, though.)  Guardians is definitely more on the 13-level of PG-13 for language than it needs to be, but your mileage may vary.

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August 17, 2014
icon After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, by Davidoff Solomon and Zaring
Posted by David Zaring

Steve Davidoff Solomon and I have put together a paper on the litigation between the government and the preferred shareholders of Fannie Mae and Freddie Mac.  Do give it a look and let us know what you think.  Here's the abstract:

The dramatic events of the financial crisis led the government to respond with a new form of regulation. Regulation by deal bent the rule of law to rescue financial institutions through transactions and forced investments; it may have helped to save the economy, but it failed to observe a laundry list of basic principles of corporate and administrative law. We examine the aftermath of this kind of regulation through the lens of the current litigation between shareholders and the government over the future of Fannie Mae and Freddie Mac. We conclude that while regulation by deal has a place in the government’s financial crisis toolkit, there must come a time when the law again takes firm hold. The shareholders of Fannie Mae and Freddie Mac, who have sought damages from the government because its decision to eliminate dividends paid by the institutions, should be entitled to review of their claims for entire fairness under the Administrative Procedure Act – a solution that blends corporate law and administrative law. Our approach will discipline the government’s use of regulation by deal in future economic crises, and provide some ground rules for its exercise at the end of this one – without providing activist investors, whom we contend are becoming increasingly important players in regulation, with an unwarranted windfall.

Permalink | Administrative Law, Corporate Law, Financial Crisis, Financial Institutions | Comments (View) | TrackBack (0) | Bookmark

August 16, 2014
icon Ownership and Control in Startups
Posted by Gordon Smith

Since reading Barbarians at the Gate in the early 1990s, I have been a huge fan of business histories. Although I have read scores (perhaps hundreds) of business histories, my list of "must reads" is still long. Recently, I decided to read one of the books on that list, The Soul of a New Machine, Tracy Kidder's account of Data General's efforts to build a minicomputer in the 1970s. This book was published in 1981, and it deals with events during my high school years, so it is a great trip down memory lane.

Here is an observation about the founders of Data General early in the book:

Some notion of how shrewd they could be is perhaps revealed in the fact that they never tried to hoard a majority of the stock, but used it instead as a tool for growth. Many young entrepreneurs, confusing ownership with control, can't bring themselves to do this.

Hmm. The distinction between ownership and control is a familiar one in corporate law circles, but this Berle-Means concept is typically applied to large corporations. What does it mean in the startup context?

Chuck O'Kelley examines the connection between entrepreneurship and the Berle-Means corporation in his 2006 article, The Entrepreneur and the Theory of the Modern Corporation, 31 J. Corp. L. 753, but I am curious about viewing this from the other direction. As noted by O'Kelley, the separation of ownership and control is used by Berle and Means to describe firms after the decline of the classical entrepeneur, so it seems somewhat surprising to see Kidder use those terms to describe a startup.

Founders often exert a tremendous influence on a company, even when shares are held by other employees and investors. This control may emanate from their formal positions within the company (CEO, CTO) or perhaps from the respect they are paid from other employees. But I think it is fair to say that ownership matters a great deal in the startup context because it is more concentrated than in the public company context. Thus, to a large extent, ownership is control in a startup.

Permalink | Books, Corporate Governance, Corporate Law, Entrepreneurs, Entrepreneurship | Comments (View) | TrackBack (0) | Bookmark

August 15, 2014
icon Paul MacMahon on Good Faith and Fair Dealing
Posted by Gordon Smith

In Good Faith and Fair Dealing as an Underenforced Legal Norm, Paul MacMahon of the London School of Economics explores the divide between "the rhetoric of good faith and fair dealing and the reality of judicial enforcement." MacMahon relies in part on Meir Dan-Cohen’s distinction between conduct rules and decision rules, which corporate law scholars should recognize from discussions of the business judgment rule by Mel Eisenberg, Julian Velasco, and others. MacMahon also references the substantial literature on underenforcement in constitutional law. And, of course, the vast discussion of the duty of good faith and faith dealing, which contract scholars know well. The thesis is elegant: "the underenforcement idea allows courts to lend their expressive support to the broader norm while avoiding the negative side effects that attempted full enforcement would entail."

This is a great paper, but the most intriguing comes near the end and I hope MacMahon plans to develop this idea in a future paper. The idea emanates from a fairly simple extension of the idea of underenforcement: if underenforcement of the legal norm of good faith and fair dealing is the right strategy, what is the optimal level of enforcement? To MacMahon's credit, he recognizes that the optimal level may vary by circumstance: 

There is no a priori reason why the choice of decision rule should be made at the wholesale level. In different contexts, the relative strengths of judicial enforcement and alternative mechanisms for inducing compliance with good faith and fair dealing will wax and wane. Accordingly, it probably makes sense for scholars and courts to develop differing levels of scrutiny for good faith and fair dealing claims. A single doctrinal test has the merit of simplicity, but a one-size-fits-all approach is unlikely to be optimal.

My sense is that Delaware courts are doing something like this with fiduciary law (indeed, I am writing a paper on this topic), and I suspect that other common law courts are calibrating the duty of good faith and fair dealing.

This is a well-researched, well-written, thought-provoking article, and I recommend it highly.

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August 14, 2014
icon The Argentinian Sovereign Bond Litigation, Part III
Posted by Sung Hui Kim

The saga of Argentina v. NML Capital, Ltd. (known by the anti-hedge fund camp as “Argentina v. Vulture Funds”) continues. And it’s getting pretty heated. Argentina published a two-page ad in the New York Times and The Wall Street Journal last Thursday, calling the judgment of the original U.S. court finding against Argentina (Judge Griesa of the federal district court of Manhattan) “erroneous and improper” and maintaining that Argentina had not defaulted on its debt obligations because the country deposited the money necessary for an interest payment due to the restructured bondholders on June 30. (Note: Every default has a 30 day grace period.) Argentina’s action is contemporaneous with its filing of a case against the U.S. in the International Court of Justice, contending that the U.S. court judgments violated its sovereignty. In response to the ad, Judge Griesa issued a summons to Argentina’s lawyers to appear in his court last Friday.  Judge Griesa told Argentina to cease making “false and misleading” statements about its debt obligations (i.e., that it did not default); also, if Argentina defies his orders, he would have to consider finding Argentina in contempt of court. Perhaps Griesa is annoyed with reports that Argentina is waging a social media campaign against the court rulings:

“Argentina recently sought to vilify not just the hedge funds [holding out from Argentina’s restructuring] but also Judge Griesa, resulting in a social media campaign under the name #GrieFault. In Argentina, posters have been mounted around the capital of Buenos Aires with images of Judge Griesa’s head imposed on the body of a vulture.” [NY Times]

The NY Times’ story can be found here. Parts I and II of this blogpost can be found here and here.

***

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icon Noted With Only A Little Comment
Posted by David Zaring

We're a family-friendly website, but your tastes may nonetheless run towards the SFW Billion-Dollar Corporate Malfeasance Erotic Fan Fiction.  (HT Matt Levine)

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August 13, 2014
icon The Argentinian Sovereign Bond Litigation, Part II
Posted by Sung Hui Kim

In a previous post (The Argentinian Sovereign Bond Litigation, Part I), I roughly described the factual background for the Argentinian bond litigation, culminating in the July 30th Argentine default of bonds.  Incidentally, Joseph Cotterill (Commentator, Financial Times’ FT Alphaville) tells us that on August 7, 2014, the Argentine Republic filed a case in the International Court of Justice in the Hague, claiming that “US court decisions . . . have violated its sovereign immunity in public international law.” That story can be found here.

In this post, I would like to focus on the particular clause which has served as the basis for the judicial decisions enjoining Argentina from paying its restructured creditors unless it also paid the holdout creditors in full. That clause is the pari passu clause – the contractual provision that promises that all (pari passu-designated) bondholders will be treated on an equal footing. A common variant of the clause reads: “The Notes will rank equally (or Pari Passu) in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the issuer.” Although the pari passu clause is ubiquitous in sovereign bonds, its meaning (or application) in the sovereign debt context is highly disputed. In fact, an empirical study, based on extensive interviews of sovereign debt lawyers, reveals at least five possible explanations, ranging from “the clause was simply the product of mindless copying from corporate bonds” to “the clause was intended to prohibit sovereigns from passing laws that would have the effect of involuntarily subordinating certain creditors.”

Why the confusion/disagreement over its meaning? In a corporate liquidation, the clause helps ensure that pari passu-ranking creditors receive equal shares of the proceeds. But in the sovereign debt context, no liquidation is possible.  Unlike private debtors, sovereigns cannot go bankrupt and their assets cannot be seized, pooled and distributed to a fixed group of claimants at a single moment of reckoning.

So what is the purpose of the pari passu clause in a sovereign bond? The federal district court in Manhattan and then the Second Circuit in NML Capital v. Argentina offered an interpretation of pari passu. They expressed the view that the pari passuclause required a debtor who was unable to pay all its creditors in full to pay each creditor proportionately or “ratably.” Hence, the sovereign debtor could not be permitted to stiff creditors who had refused to restructure their debts while paying the other creditors who had assented to the restructuring. To do so would violate the promise of equal treatment under the pari passu clause (according to these courts). And, by upholding an injunction against the third party financial intermediary responsible for transferring payments to the restructured creditors, the pari passu clause was given not only meaning but also teeth—a concrete remedy that could be used by the hold-out creditor to induce the sovereign debtor to pay its debt. These decisions disturbed many, because they threatened to make future sovereign debt restructurings more difficult—by encouraging, perhaps, more holdout strategies.

The July volume of the Capital Markets Law Journal  (CMLJ) happens to be devoted to the pari passu clause. (Links to all the CMLJ articles can be found here (subscription required), and links to the authors’ prior SSRN drafts are provided below where available.) (Apologies in advance to authors if I’ve mischaracterized some of their arguments or omitted them. I tried to be as judicious as possible.)

The centerpiece of the CMLJ volume is a fascinating work of history. Benjamin Remy Chabot (Federal Reserve Bank of Chicago) and G. Mitu Gulati (Duke) have discovered what appears to be the first use of pari passu principle in connection with a sovereign bond issue. In their article, "Santa Anna and His Black Eagle: The Origins of Pari Passu?" , they show that the spirit of the pari passu concept can be traced back to General Santa Anna’s 1843 decree promising that foreign holders of Mexican Black Eagle bonds would be treated with a “just equality among the creditors, as much as regards the rate of interest as the order of payment.” Similar language appeared in the preamble of the Black Eagle bonds, although not as a contractual provision per se. Chabot and Gulati show that the promise of equality was drafted in response to foreign outrage expressed against a former debt restructuring. This restructuring treated holders of identical claims differently based on their nationality or country of residence. Thus, the pari passu language in respect of the Black Eagle bonds appears to have been intended to prevent discrimination in payments among nationalities of the creditors in the context of a sovereign default.

Chabot and Gulati’s findings, of course, raise the question: why is the original (first) meaning of a clause relevant? Stated another way, what is the relevance of history as a guide to contract interpretation? Chabot and Gulati offer a response:

“Even if lawyers today are copying the clause by rote, surely the earliest drafters of the clause were not doing that. Someone had to have thought of this clause first. If we could find them, and figure out what they were thinking, that we potentially have a way of cutting the Gordian knot.”

W. Mark C. Weidemaier (UNC) addresses this question (“why is the original meaning of a clause relevant?”) in “Indiana Jones, Contracts Originalist”. With wit and humor, Weidemaier reminds us that, in the absence of contemporaneous evidence of the parties’ intentions, judges would ordinarily assign the clause’s historically-accepted meaning if one exists. But in a situation (such as this) where there is no historically-accepted meaning, Weidemaier asks, “ . . . why should the judge try to uncover the intentions of the first drafters?” He then answers, “Whatever the merits of originalism as an approach to constitutional interpretation, surely the originators of a contract term have only a modest claim to authority.” (But a modest claim is arguably still better than no claim, right?) Surveying the available historical evidence, including the Black Eagle bond story, Weidemaier concludes that there is no known precedent to support the Second Circuit’s interpretation that the pari passu clause grants each bondholder a unilateral right to block payments to restructured bondholders. Therefore, the million dollar question is the normative one: whether the pari passu clause, which has not traditionally served the purpose imbued it by the Second Circuit, should be repurposed to do so.

Sovereign debt guru, Lee C. Buchheit (Clearly Gottlieb), invites us to think more generally and deeply about the effort to excavate examples of contracts or clauses from a fragmentary historical record. In “A Note on Contract Paleontology,” Buchheit notes that while the Black Eagle bond story may not much clarify the substantive meaning of the modern version of the pari passu clause, it may explain “why some people have an emotional attachment to the notion of ratable payments in a distressed situation” and why modern litigants are prepared to stretch their interpretation of this boilerplate provision to assign it a meaning that neither the text nor the history of the clause can support.

My article, “Pari Passu: The Nazi Gambit” takes us through a pre-war instance of pari passu. In the paper, I present what might be the clearest historical evidence of what the clause was understood to mean in the pre-war period. I discovered this evidence while studying the protests lodged against the German government when Germany first defaulted on two international loans entered into by it during the aftermath of the First World War. When Germany, in response to its financial crisis, selectively defaulted on the American tranches of the Dawes and Young Loans, parties defending the interest of American bondholders invoked pari passu in their protests against Germany’s discriminatory practices. In claiming that Germany violated the pari passu clause, the protesters adopted the meaning that the clause promised parity in servicing across the various tranches of the Dawes and Young Loans. In other words, bondholders of the various tranches were entitled to be repaid in proportion to their holdings of debt. What’s more, based on the evidence, Germany seems to have acquiesced in this interpretation of pari passu. Perhaps more pertinent to the Argentinian bond litigation, I find no evidence to suggest that the pari passu clause was understood as entitling the aggrieved creditor to a unilateral right to block payments to bondholders who assented to a government’s restructuring proposal. In fact, neither the investors (in the Dawes and Young loans) nor the Bank for International Settlements (trustee) seemed to have interpreted the clause as a tool by which one investor could interfere with payments to another. That said, the failure to invoke an inter-creditor remedy may simply reflect the more mundane fact that legal redress of sovereign debt defaults was highly unlikely during this period.

John V. Orth (UNC) provides useful perspective in “A Gathering of Eagles.” Orth reminds us that the pari passu clause addresses a ubiquitous problem in the borrowing context: unequal payments to creditors of equal rank. Seen in this light, the story of the Mexican Black Eagle bonds is an instantiation of this ubiquitous problem. Accordingly, the meaning of the pari passu clause is clear: it promises equal treatment for all creditors of the same priority. The only problem is the application of the clause to the sovereign debt context, where it is difficult to enforce the terms against a sovereign debtor, which is the same problem with all other clauses of a sovereign bond. The implication of Orth’s piece (I think) is that the pari passu clause is not materially different from all other sovereign promises: they are all “ultimately unenforceable” and “will continue to multiply until there is an effective resolution regime for sovereign defaults.” So, in the end, Orth emphasizes the lack of a practical mechanism of resolving these types of disputes with sovereigns.

Lachlan Burn (Linklaters) is skeptical of the value of historical spelunking for interpreting the pari passu clause in sovereign debt issues governed by English law. In “History – ‘Bunk’ or a Useful Tool for Contractual Interpretation?”, Burn argues that English courts would interpret contracts in a “commercially sensible” way, which he believes “would prevent any due weight being given to the Black Eagle bonds.” After all, Burn notes, as these Mexican bonds have been sitting in a basement until their recent discovery, “[t]hey formed no part of the background information available to the sovereign issuer of bonds or the investors during the last hundred years or so.” Moreover, Burn cautions that “historical precedent will often be a dangerous tool for interpreting contracts.” Finally, Burn argues that enforcement, rather than the meaning of the pari passu clause, is the central issue underlying the Argentinian litigation. (This last point is similar to the one made by Orth.)

Tolek Petch (Slaughter and May) in “NML v. Argentina in an English Legal Setting” notes that under English law, the legal history of a clause is relevant but not determinative. Ordinarily, the court would find an interpretation that accords with business common sense as it would have been understood by both parties at the time that the bonds were issued. Therefore, English courts can and have overturned centuries of precedent on the basis that the proposed construction was not in conformity with the intentions of the parties. Petch discounts the significance of the fact that in the pre-war period Americans protestested against German discriminatory treatment because they are basically ex post facto arguments that will be seen as inherently self-serving and, more pertinently, not contemporaneous with the drafting/negotiation of the disputed provision. (Excellent point, but would Petch or English law accord any significance to the fact that Germans themselves apparently acquiesced in the Americans’ interpretation of pari passu?) Applying the “business common sense” principle of English courts, Petch in the end rejects the “rateable” interpretation of the clause, in part because “no sovereign borrower would agree to” it.  Argentina (and many sovereign debt experts) would agree with Petch’s last point!

In “Interpreting the Pari Passu Clause in Sovereign Bond Contracts: It’s All Hebrew (and Aramaic) to Me,” Mark L.J. Wright (Federal Reserve Bank of Chicago/NBER) argues that the Second Circuit “has, if not completely misinterpreted the meaning of the pari passu clause, then at least misapplied it.” He stresses the importance of interpreting the pari passu clause in the context of long-existing social norms among sovereign debt market participants. In short, it has been customary to treat holders of similar debts similarly, i.e., to repay them in proportion to their holdings of debt (measured at face value plus deferred interest). But custom also reveals a complementary “principle of differentiation,” under which certain claims (e.g., claims that had been reduced in value as a result of a prior default) were accorded preferential treatment precisely because they were meaningfully different. Applying the principle of differentiation and observing that Argentina’s restructured creditors hold bonds that have been reduced by almost 70% of their value, Wright argues that the NML decision got it all wrong and ignored the principle of differentiation.  

Side-stepping the debate over the relevance of historical origins, in “NML v. Argentina: The Borrower, the Banker, and the Lawyer – Contract Reform at a Snail’s Pace,” Leland Goss (Int’l Capital Markets Ass’n) looks to the present and the future and asks: Why have most of the foreign law governed sovereign bonds issued since the Second Circuit’s ruling failed to change their pari passu clauses? After surveying a number of explanations, e.g., network effects theory, blaming the lawyers’ risk aversion, he offers his own highly entertaining theory.

In “The injunction has landed: the ‘Black Eagle’, pari passu and sovereign debt enforcement,” Joseph Cotterill (Financial Times) recounts the Black Eagle bond history and key moments in the Argentine bond litigation to remind us that “the enforcement of sovereign debt can take many forms” and that “Pari passu is one strategy among many others,” including, e.g., discovery of assets, injunctions, and courts’ powers of equity. The Black Eagle Bond story is just as much about ad hoc enforcement of sovereign debts as it is about pari passu. And that ad hoc enforcement is what we see even today – 171 years after General Santa Anna’s decree.  

In “The origins and future of non-discrimination in sovereign bankruptcies: a comment,” Philip Wood (Allen & Overy) puts the pari passu clause into the context of the broader principle of non-discrimination and equality in payment between creditors. Wood speculates that the “concept of equality of payment by law was well established by the second century BC in Roman law.” This is evident from the laws against fraudulent conveyances, which developed around this time. Wood then provides a very helpful exposition of the byzantine devices used in sovereign debt contracts for restructurings in light of the non-discrimination principle.

In the same CMLJ volume, Jeffrey Golden (CMLJ, PRIME Fin. Found’n), Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.), and Joanna Benjamin (London School of Econ.) also have very interesting contributions (but not on the topic of the pari passu clause).

What’s the long-term impact of the judicial rulings? Anna Gelpern (Georgetown, Petersen Inst. for Int’l Econ.) has some interesting thoughts in her “Sovereign Damage Control.”

***  

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icon Rethinking Law School
Posted by Sung Hui Kim

Frank H. Wu, Chancellor & Dean of the UC Hastings College of the Law has written an interesting editorial, "It's Time to Rethink Law School," published on Monday, August 11, 2014 in the San Francisco Daily Journal (for which a subscription is required). A link to the article can be found here.

In the article, Wu notes that there are two schools of thought about legal education. "One insists that law schools are fundamentally fine. . . . Another contends that the educational program leading into legal practice is fundamentally flawed."  Wu counts himself among those who embrace the latter view.

Most interesting to me was Wu's direct comparison with medical schools:

"A lawyer should be like a doctor. There isn't any medical school graduate who altogether lacks clinical experience. Every licensed physician has seen a live patient presenting actual symptoms before they charge anyone for a diagnosis."

Wu is not the first to make a comparison with medical schools. Professor John Flood in his article, "Doing Business: The Management of Uncertainty in Lawyers' Work" (25 Law & Soc'y Rev. 41 (1991)) contrasts law school education with medical schools.

In the end, Wu reminds us that we all need to do a better job in training future lawyers. While we should not abandon our substantive law courses, we should also provide many opportunities for students to obtain skills training. In my view, this last point should not be at all controversial.

 

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icon University of Alabama School of Law is looking for a business law scholar
Posted by Gordon Smith

Here is the information:

The University of Alabama School of Law anticipates making at least one tenure-track appointment to its faculty, to begin in the 2015-2016 academic year. The Faculty Appointments Committee seeks applications from entry-level candidates with excellent academic records and demonstrated potential for outstanding teaching and scholarly achievement. We also welcome applications from junior-lateral candidates who possess outstanding academic credentials, including demonstrated teaching ability and a record of distinguished scholarship. Although positions are not necessarily limited by subject matter, we are particularly interested in the following academic subject areas: business law (including enterprise, finance, and/or securities); administrative regulation (including the regulatory state and/or regulated industries or activities); intellectual property (specifically trademark and copyright); and criminal law (including substantive criminal law and/or criminal procedure). Most candidates will have a J.D. degree from an accredited law school. Exceptional candidates who possess an advanced degree, such as a Ph.D., and who have scholarly interests related to the law involving interdisciplinary, jurisprudential, empirical, or social scientific work may be considered even without holding a law degree. The University of Alabama embraces and welcomes diversity in its faculty, student body, and staff; accordingly, the School of Law actively welcomes applications from persons who would add to the diversity of our academic community.

 Salary, benefits, and research support will be nationally competitive. The School of Law will treat all nominations and applications as strictly confidential, subject only to the requirements of state and federal law. Interested candidates should apply online at facultyjobs.ua.edu. The positions will remain open until filled. Please refer any questions about the hiring process to Professor Julie A. Hill, Chair of the Faculty Appointments Committee for the 2014-2015 academic year (email: facappts@law.ua.edu).

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August 12, 2014
icon "Publicness" and Market Basket
Posted by Lisa Fairfax

As Joan Heminway has pointed out, I participated in a discussion group at the SEALS annual conference last week entitled "Does the Public/Private Divide in Securities Regulation Make Sense?"  It was an engaging discussion with a lot of interesting ideas and views shared.  Part of the discussion focused on the notion of "publicness" as that term was used by Hillary Sale, Don Langevoort and Bob Thompson.  That is, a public-driven demand for regulation of public corporations that accounts for more than just managers and their shareholders, but also for a corporation's "societal footprint" and its impact on non-shareholder constituents.  As Sale puts it, "the failure of officers and directors to govern in a sufficiently public manner has resulted not only in scandals, but also in more public scrutiny of their decisions, powers and duties." Sale suggests that because the definition of public corporation and the public's view of the corporation has evolved, directors' and officers' understandings of their obligations needs to evolve.  I was in Boston this past weeked at the ABA annual meeting, and it struck me that the ongoing back and forth at the grocery chain Market Basket raised some interesting issues surrounding publicness.

Market Basket is a private company with 25,000 employees and 71 stores in Massachusetts, New Hampshire and Maine caught in a battle for control.  In June 2014, then president Arthur T. Demoulas and two other executives were ousted by the board, controlled by Arthur T.'s cousin Arthur S. Demoulas. Since that time, the company has been plagued by rallies, strikes, and protest, one attracting crowds of over 5,000, seeking to reinstate Arthur T.  According to the Boston Globe, the turmoil apparently has "crippled" the company's operations, resulting in the company losing "millions of dollars a day," "stores with little food," and a "steep decline in business."  Apparently, the outpouring of support for Arthur T. stems from his support of employees, which includes not only ensuring that managers and other employees are well-compensated and receive regular bonuses and special benefits, but also his "personal touch"--remembering the names of low-level employees and their sick relatives.

Last Friday, Massachusetts Governor Deval Patrick entered the fray, which news outlets found remarkable because until that time the governor had insisted that he would not get involved in what he termed a "private" dispute between a company and its shareholders.  But it seems like the public impact of that dispute compelled him to act.  The governor wrote a letter to the Market Basket board offering to help resolve the dispute.  Although the governor insisted that he would not take sides, the letter noted that the dispute had gotten "out of hand." The letter went on to state, in part: "Your failure to resolve this matter is not only hurting the company's brand and business, but also many innocent and relatively powerless workers whose livelihoods depend on you."

The dispute is still ongoing and involves a lot of important issues both related to employees and the struggle for control of the company, but the dispute and the letter is an interesting commentary on publicness and the idea that even directors of private companies must be aware of the impact of public scrutiny and the manner in which that scrutiny may shape their decisions, powers, and duties.

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