April 21, 2018 By ehansen

Sidestepping the Rat Holes: Investment Risk and Securities Law

This Article presents a novel understanding of the purpose of federal securities laws as the management of investment risk. Those laws should be treated as a whole. When two rules, even under different statutes, address the same risk, they should be applied concomitantly. For example, broker-dealer regulation under the Securities Exchange Act of 1934 might justify relaxation of prospectus delivery requirements in the Securities Act of 1933.

“The [Securities Act] bill is not foolproof. It will not prevent anybody from putting his money into rat holes…” — Congressman Carl E. Mapes¹

Unsated Curiosity

Mr. Loni Almoni is the ever-punctilious Chief Compliance Officer for Figurative Wealth Management. On October 3, 2016, Almoni reviewed several accounts for Figurative, a registered broker-dealer.² Straightening his bowtie,³ he observed:

A broker had recommended that customers purchase shares of a registered investment company and shares of an operating company in its initial public offering.
- Almoni confirmed that the broker had conducted a reasonable inquiry into the securities and his recommendations were suitable.
- He also confirmed that the prospectus for the registered investment company and the preliminary prospectus for the initial public offering were delivered as required to the customers.
Some of these customers were accredited investors who had purchased private placements without having received private placement memoranda.
- Upon consultation with the firm’s legal staff, Almoni confirmed that delivery of private placement memoranda was not required by law.
The broker also had recommended a private placement to customers who were not accredited investors.
- Almoni confirmed that a private placement memorandum had been provided to those customers as required, and that the recommendations were suitable.

Almoni believed that he was an expert in the federal securities laws, but he always brought his questions to the legal department.

Of what benefit is the private placement memorandum to an unsophisticated customer who purchases through a licensed broker?
Why must Figurative Wealth Management deliver prospectuses about registered investment companies that are comprehensively regulated to customers who are represented by licensed brokers?
Why must the firm deliver prospectuses to customers who are qualified to buy privately-placed securities without having received any disclosure?

The legal department could not explain the policy behind these requirements but dutifully cited the applicable rules.

A measure applied in one circumstance, such as prospectus delivery to unsophisticated investors, seems unnecessary in another, such as prospectus delivery to accredited investors. Two conditions with seemingly identical purposes, such as prospectus delivery and investor accreditation, are imposed simultaneously without obvious regard for one another.

This Article proposes a new way to understand the securities laws. In Part II, this Article considers their legislative purpose. For the sake of simplicity, this Article gives particular attention to one set of laws that regulate the formation and sale of securities, the “Product and Sales” Provisions.⁴ They are administered by the Securities and Exchange Commission (SEC), the self-regulatory organizations, and the only national securities association, the Financial Industry Regulatory Authority (FINRA).

In Part II, this Article explains that the legislative purpose of the Product and Sales Provisions is investor protection. Investor protection is the confrontation of investment risk. In Part III, Product and Sales Provisions are distinguished as those that prohibit bad conduct like fraud and manipulation from “Prescriptive Provisions” that require certain behavior. In Part IV, this Article explains how the Prescriptive Provisions confront investment risk, such as the risks related to an issuer’s business and the markets in which its securities trade. In Part V, this Article argues for a more cohesive understanding of securities law, framed according to investment risk. The Prescriptive Provisions are viewed as a body of law. By considering together measures under different statutes that address the same type of risk, we produce a coherent understanding of the law. Inefficiencies can be reduced, burdens minimized, and gaps exposed. This Article presents two case studies that demonstrate this.

Legislative Purpose of Securities Law

Even a cursory review of the federal securities laws and their legislative history will reveal that protection of investors is their principal purpose. A typical, perhaps formulaic description of the SEC’s rulemaking power occurs repeatedly in the federal securities laws: The SEC is to adopt rules that are “necessary or appropriate in the public interest and for the protection of investors.”⁵ Sometimes the phrase appears in the disjunctive (“in the public interest or for the protection of investors”) and sometimes in conjunction with other requirements (“in furtherance of this title”).⁶ Nevertheless, the frequency with which it appears confirms that the SEC’s central mission is to protect investors.

Stated most generally, the Securities Act of 1933 (Securities Act) advances investor protection through disclosure, the Securities Exchange Act of 1934 (Securities Exchange Act) and the Investment Advisers Act of 1940 (Investment Advisers Act) through the regulation of financial intermediaries, and the Investment Company Act of 1940 (Investment Company Act) through the oversight of investment companies.⁷

One might ask, “From what harm is the investor to be protected?” The statutes hint at one answer: fraud, and inequitable and unfair practices. Some provisions prohibit behavior that is morally or ethically reprehensible, such as fraud, market manipulation, churning of brokerage accounts, and excessive markups on principal transactions. These Product and Sales Provisions are intended, quite simply, to protect investors by eliminating these practices.

Other Product and Sales Provisions prescribe behavior that isn’t morally or ethically laudable but is to be encouraged. One who commits fraud is morally reprehensible; one who fails to make line item disclosures required by Regulation S-K may not be, but there may be a public good in requiring him to do so. The Product and Sales Provisions can be divided between those prohibiting nefarious conduct and others prescribing salutary behavior. The former protect investors from the morally reprehensible conduct. The latter prescribe behaviors whose connection to investor protection is more attenuated. We will call the latter requirements the “Prescriptive Provisions.”

The Prescriptive Provisions

The Prescriptive Provisions protect investors from conditions that might cause them harm even in the absence of malevolent conduct. These harmful conditions are implied by the objectives of each statute.

Disclosure by issuers militates against the potential loss that comes from investing in the dark, from ignorance about the proposed investment. Public disclosure also allows the capital markets to reflect this information in the price of widely-traded securities and to price the “risk premium” associated with the security.⁸ Exemptions from the prospectus delivery requirements are provided when investors are deemed qualified to participate without disclosure. The qualification of investors helps to ensure that they have the financial acumen or resources to obtain necessary information about the offering, to evaluate the offering, and to bear the investment risks.
The regulation of financial intermediaries reduces the possibility that an intermediary will engage in practices that might cause its customers harm. These practices might constitute abject abuse, like fraud and manipulation, or they might devolve from the conflicts of interest that distract the financial intermediary from its responsibilities to the customer.
The oversight of investment companies addresses the concern that conflicts of interest in their operation or the complexity of their structure might encourage behavior that causes shareholders harm.

In short, the Prescriptive Provisions address risks associated with securities investments.⁹ These risks include the possibility of investing in the dark, retaining the services of a financial intermediary with conflicts of interest, and investing in an investment company whose liquid assets might be pilfered or whose shareholder equity might be dissipated. The legislative purpose of “investor protection” may be understood as a response to the risks of buying securities, hiring broker-dealers or investment advisers, and purchasing investment company securities.

How the Prescriptive Provisions Address Investment Risk

The Prescriptive Provisions essentially address two categories of risk, those associated with a financial intermediary and those associated with a security.

Broker-dealers and investment advisers present agency risk, counterparty risk, and competency risk. The Prescriptive Provisions address these risks in varying degrees, agency risk being the most extensive subject of regulation. Agency risk refers to the possibility that financial intermediaries, in performing their financial service, will benefit themselves at their customers’ expense. As discussed more below, FINRA comprehensively regulates the business of a broker-dealer and the Investment Advisers Act imposes a fiduciary duty on investment advisers that requires the investment adviser to act with a duty of care and a duty of loyalty to the customer.¹⁰

The Prescriptive Provisions also address the risks associated with a security. These are business and market risks, agency risk, and competency risk. Business and market risks include the risks associated with the investment’s business prospects and its operations, those associated with the terms of the security, the risk that those terms will not be enforceable, the risks associated with the conditions under which the security trades, and those associated with economic or political influences on the expected total return. Agency risk concerns the probability that agencies of the issuer will act in their own interest in a manner inconsistent with the interests of shareholders. Competency risk concerns the probability that the managers of the issuer are not competent.

For ease of discussion, we will elaborate only on the business and market risks associated with a security.¹¹ The Prescriptive Provisions mitigate business and market risks associated with a security through disclosure and the regulation of financial intermediaries.

Disclosure

Under Section 10 of the Securities Act, an issuer must register its publicly-offered securities;¹² Section 5 generally requires that a prospectus be provided to investors.¹³ The Securities Exchange Act requires that public issuers provide periodic reports concerning their financial condition and material events. Also, the issuer’s financial statements must be audited by an independent public accountant registered with the Public Company Auditing Oversight Board.¹⁴ The periodic reports are “integrated” into the issuer’s registration statements for its follow-on offerings.¹⁵

This integrated reporting system ensures that the investing public is informed about the condition of the public issuer and its business and market risks. The Prescriptive Provisions respond to the business and market risks through disclosure about matters such as the operation of the issuer’s business, associated risks, the terms of the security, the primary market upon which it will be traded, and economic and political risks.¹⁶

Disclosure is required in certain private placements too. For example, Rule 506 of Regulation D exempts a private placement from the registration requirements of Section 10 if it will be offered to no more than 35 unaccredited investors or to an unlimited number of accredited investors,¹⁷ provided that unaccredited investors receive disclosure concerning the terms of the offering, risk factors, potential dilution, the plan of distribution, and the issuer’s business.

The Prescriptive Provisions provide exceptions to disclosure requirements for investors who are deemed “qualified.” For example, under Rule 506, accredited investors are presumed to have the financial acumen or resources to obtain necessary information about the security, to evaluate it, and to bear the investment risks.¹⁸ For these investors, disclosure is not required.

Regulation of Financial Intermediaries

The regulation of financial intermediaries also addresses business and market risk. The Securities Exchange Act regulates broker-dealers and requires most of them to belong to a regulated national securities association, the only one of which is FINRA.¹⁹ FINRA comprehensively regulates virtually all aspects of a broker-dealer’s operations and requires that a broker-dealer’s recommendations be suitable.²⁰ The suitability rule requires the broker-dealer to conduct reasonable diligence into the features of the recommended security, including the types of risks enumerated above as “business and market risks.”²¹

Section 11 of the Securities Act imposes strict liability on broker-dealers who participate in the distribution of publicly-offered securities with respect to untrue statements or omissions of material fact in the registration statement. The underwriter may have a defense if it can demonstrate that the underwriter had “after reasonable investigation, reasonable ground to believe and did believe . . . that the statements . . . were true and that there was no [material] omission.”²² As a practical matter, this defense imposes a due diligence obligation on underwriters. Broker-dealers who serve as underwriters help to address business and market risks by conducting due diligence about the accuracy of the registration statement that discloses information about the issuer.

The Investment Advisers Act imposes a fiduciary duty on registered investment advisers, including a duty of loyalty and a duty of care. According to the SEC, embedded in this fiduciary duty is a suitability obligation similar to the one that FINRA imposes on broker-dealers.²³

Investment Company Regulation

The Investment Company Act mitigates business and market risks associated with investment company issuers. The Act comprehensively regulates all aspects of registered investment companies, including their capital structure and organization, the terms of their securities, and the liquidity of their held assets.

To summarize, the Prescriptive Provisions address the business and market risks associated with a security through:

Disclosure and investor qualification;
Financial intermediary regulation; and
Investment company regulation (in the case of investment company issuers).

A New Way to Appreciate Securities Law

Securities law can be understood as a response to specific types of investment risk. Provisions in different statutes often address the same type of risk. For example, prospectus delivery and broker-dealer regulation both address the business and market risks associated with a security. Prospectus disclosures bring to light the salient facts about the issuer and security; FINRA’s suitability rule imposes a diligence requirement on broker-dealers when they recommend publicly-issued securities.

These provisions should be considered together. Redundant confrontation of the same risk can be eliminated and gaps in the confrontation of investment risk exposed. Efficiencies in the law’s application would be obtained and burdens on capital formation and financial services minimized.

In short, the Product and Sales Provisions and other identifiable subsets of the securities law should be viewed organically, without regard to the statute in which they happen to appear. A Securities Act provision for prospectus delivery should be considered alongside the Investment Company Act’s regulation of investment companies and FINRA’s suitability rule. The various ways in which they address business and market risk should be contemplated in unison. This understanding of the securities law as an organic body of law would better ensure that they are coherently understood and consistently applied.

To illustrate our proposed method of understanding we will apply it to two examples.

The business and market risks associated with privately-placed securities recommended by a financial intermediary.
The business and market risks associated with publicly-offered securities recommended by a broker-dealer.

These examples are concomitant with the conundra of Loni Almoni in Part I.

The Purchase of Securities in a Recommended Transaction under Rule 506

Loni Almoni asked, “Of what benefit is the private placement memorandum to an unsophisticated customer who purchases through a licensed broker?” After all, the broker must conduct a reasonable inquiry about a private placement and recommend only suitable investments to the customer.

Rule 506 permits the sale of privately-placed securities to no more than thirty-five unaccredited investors and an unlimited number of accredited investors.²⁴ Unaccredited investors must receive disclosure concerning the terms of the offering, risk factors, potential dilution, the plan of distribution, and the issuer’s business, including financial information.²⁵ Each unaccredited investor “either alone or with his purchaser representative(s)” also must have: “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.²⁶

“Purchaser representative” is similarly defined to include any person who “[h]as such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives, or together with the purchaser, the merits and risks of the prospective investment.”²⁷ Purchaser representatives may be broker-dealers and investment advisers.²⁸

Accredited investors need not receive disclosure nor representation from a purchaser representative.²⁹ The rule relies on the notion common in the federal securities laws that some investors possess the financial acumen or resources to evaluate the offering and bear the associated investment risks.

Our proposed method of rulemaking requires an integrated analysis of the Prescriptive Provisions. If a provision in one statute mitigates an investment risk, then another rule might defer to it to mitigate the same risk in a different situation. Rule 506 illustrates this integrated understanding of the Prescriptive Provisions. If an unaccredited investor is unsophisticated, then the broker-dealer or investment adviser who recommends the private placement should possess the requisite knowledge and experience. Rule 506 relies on the knowledge and experience of a broker-dealer or investment adviser to evaluate business and market risks of privately-placed securities on behalf of unaccredited investors.

Nevertheless, Rule 506 does not rely on the performance by an intermediary of its suitability and fiduciary obligations. Indeed, Rule 506 does not require a purchaser representative to be a regulated broker-dealer or investment adviser.³⁰ Regardless, the cohesive assimilation of the broker-dealer and investment adviser into the rule, even limited to considerations of knowledge and experience, is consistent with the method of rulemaking that this Article recommends.³¹

However, this method does present one question. As Loni Almoni inquired, will unsophisticated investors who are represented by a broker-dealer or investment adviser value the private placement memorandum that the rule requires? If broker-dealers and investment advisers are subject to adequate regulation concerning the diligence and suitability of recommendations, why must Rule 506 require delivery of a private placement memorandum to unaccredited investors?³² At most, perhaps, investors should have the ability to obtain a private placement memorandum upon request.

The Purchase of Publicly-Offered Securities in a Recommended Transaction

Loni Almoni asked:

Why must Figurative Wealth Management deliver prospectuses about registered investment companies that are comprehensively regulated to customers who are represented by licensed brokers?
Why must the firm deliver prospectuses to customers who are qualified to buy privately-placed securities without having received any disclosure?

The requirement that an investor will receive, or at least have access to a prospectus, is fundamental to the Securities Act.³³ Nevertheless, one might inquire whether prospectus delivery should be required when an investor is represented by a registered broker-dealer.³⁴ Do the Prescriptive Provisions governing the broker-dealer’s due diligence and suitability responsibilities adequately address the business and market risks associated with the recommended purchase? If they do, then what is the added value of prospectus delivery to a retail investor who is represented by a broker-dealer? Are there other purposes served by prospectus delivery to such an investor?³⁵ If the due diligence and suitability requirements do not adequately address the business and market risks, then what level of regulation of the broker-dealer’s distribution of publicly-offered securities would ensure that the business and market risks are addressed?³⁶

Moreover, the requirement that a retail investor receive or at least have access to a prospectus before the purchase of publicly-offered securities exists regardless of its sophistication or financial resources. Under Rule 506, an accredited investor is not required to receive disclosure concerning a private placement in which it invests.

Why should prospectuses be delivered to accredited investors who purchase publicly-offered securities? If these investors are deemed to have the financial acumen or capacity to analyze the business and market risks associated with privately-placed securities, why can they not analyze the business and market risks associated with registered and publicly-distributed securities?³⁷

The public offering of investment company securities leads to more questions. The federal securities laws and FINRA rules impose a suitability obligation upon a broker-dealer that recommends registered investment company securities, as they do upon the recommendation of any other security. Investment advisers must comply with their fiduciary duty when they recommend investment company securities. The fiduciary duty embraces a suitability obligation and a requirement to conduct reasonable diligence about the security.³⁸

Under what circumstances must a broker-dealer or investment adviser conduct reasonable diligence about the operation, organization, or structure of an investment company, which the Investment Company Act comprehensively regulates?

To summarize our answers to Loni Almoni:

Delivery of a private placement memorandum to unaccredited investors represented by a broker-dealer could be duplicative of the protections afforded by the regulation of their broker-dealer.
Delivery of investment company prospectuses to investors who purchase as a result of their broker-dealer’s recommendation also appears to be redundant.
Delivery of prospectuses to accredited investors may be unnecessary.

The organic understanding of securities law as a response to investment risk thus could allow a more efficient tailoring of investor protections. The Prescriptive Provisions would operate in a more coherent framework, investors would be better served, and undue burdens on the industry would be removed.

January 28, 2018 By ehansen

How Do I Sell My Crowdfunded Shares? Developing Exchanges and Markets to Trade Securities Issued by Start-ups and Small Companies

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Governments worldwide are increasingly recognizing that assisting the development of start-ups and small to medium enterprises may be critical to fostering job creation and economic growth. As such, there is a concerted effort to rework securities regulation to encourage the funding of these businesses through innovative approaches such as crowdfunding. However, one major problem with investing in securities issued through crowdfunding is that investors typically have limited-to-no ability to sell the securities. There are a number of over-the-counter, venture and small company markets trying to bridge that gap and proposals in some countries to develop new markets for these types of securities. However, such markets present significant regulatory challenges, as they have historically been plagued by fraud and “pump and dump” manipulation schemes. This Article considers these regulatory challenges and explores how regulators can work to improve the integrity of these markets as a way of encouraging their development.

I. Introduction

Traditionally, start-ups and small to medium enterprises (SMEs) have had to turn to bank financing to fund both their establishment and expansion. However, obtaining debt financing can be challenging. Many entrepreneurs, particularly those in the tech industry, do not have the available assets required as collateral for a loan. Furthermore, paying interest means that a reliance on bank financing reduces cash flow, which can impact the ability of the business to grow while at the same time hinder its capacity to withstand economic downturns.

Faced with stagnant employment rates, governments are increasingly asking their regulatory agencies to look at novel ways to encourage the funding of start-ups and SMEs.¹ Because statistics show that these businesses are significant employers, their development can be pivotal to both the growth of an economy and the creation of new jobs.² For example, in the United States, in the wake of the global financial crisis, there were calls from politicians from both political parties to change the structure of securities regulation to encourage the funding of small businesses to stimulate growth and employment.³ This ultimately led Congress to pass the Jumpstart Our Business Startups Act (JOBS Act), signed into law in 2012.⁴ The JOBS Act directed the U.S. Securities and Exchange Commission (SEC) to make a number of important changes that were designed to increase sources of funding for small businesses. One significant change was that it asked the SEC to develop rules allowing equity crowdfunding.[mfnId. at 20. Another important change is commonly known as a Regulation A+ reform. This increased the amount that could be raised using a mini registration statement, rather than a full prospectus, from $5 million in a 12-month period to $50 million. See id. at 401–02.[/mfn] Many other countries have also recently introduced rules to allow equity crowdfunding for small enterprises.⁵

However, despite this current enthusiasm for equity crowdfunding, one factor which may significantly hinder equity crowdfunding development is the lack of an exit strategy for investors. Investors purchasing securities via an equity crowdfunding issue are usually locked into their investment and almost invariably cannot quickly sell such securities through a secondary market or exchange if their investment preferences change.⁶ Over time, this inflexibility may temper the willingness of investors to participate in such ventures. The lack of a secondary market may also limit the attractiveness of equity crowdfunding for entrepreneurs as a funding strategy given that they will not be able to readily unlock some of the value in the firm by selling their own securities.

A solution is to enable securities issued through an equity crowdfunding campaign to be sold via a secondary market such as an exchange or market specifically designed to trade securities issued by smaller companies. However, compared to the large stock exchanges, such secondary markets face a number of significant challenges. One is that there is generally less trading in the securities of a small company often simply because of the limited number of securities on issue. This can lead to a significant spread between the price at which a seller is willing to sell those securities and the price at which a buyer is willing to purchase them.⁷

This lack of liquidity can also make those securities vulnerable to manipulation, as a lack of supply makes it easier to artificially drive up the price dramatically with relatively few low-value trades. This kind of manipulation frequently takes the form of what is colloquially called a “pump and dump” manipulation scheme. In such a scheme, the manipulator gradually acquires a large number of securities in a particular company. Positive false or misleading information is then disseminated about the company. This may be accompanied by a flurry of matched purchases and sales between associates to give the appearance of heightened interest in the securities, which in turn has a tendency to further artificially inflate the price. When the price of the securities has become inflated, the manipulator sells, that is “dumps,” the securities before the price falls back to a more realistic level.

Because securities traded on secondary markets created for smaller companies are susceptible to manipulation, these markets can be prone to developing a poor reputation that can result in unpopularity among brokers and investors. In addition, regulators responsible for maintaining the integrity of such markets have been forced to devote significant resources to detecting, investigating, and prosecuting such schemes in order to clamp down on abuse in these markets.⁸ The task of tackling such abuse has become even more challenging in recent years because the growth of worldwide electronic trading has meant that in many instances, the manipulators are situated outside of the jurisdiction. Rampant abuse has even led to the closing of such markets, which occurred in the case of the First Board of the Open Market in Germany.⁹

This Article considers the challenges for markets designed for the trading of securities of smaller companies and, in particular, their vulnerability to fraud and market manipulation. It argues that safeguarding the integrity of such markets by eliminating, or at least minimizing, such abuse is a necessary part of ensuring the success of new innovations in the financing of smaller companies such as equity crowdfunding. To this end, this Article also suggests ways in which the integrity, and hence the reputation, of those markets can be enhanced. Part II briefly outlines the recent shift in securities regulation to facilitate the funding of start-ups and SMEs, as well as the growing recognition that secondary markets are needed to enable the trading of the anticipated “tsunami” of securities to be unleashed by these changes.¹⁰ Part III considers venues which currently exist to trade such securities as well as proposals for the creation of new markets. Part IV describes how historically, markets for secondary trading of securities issued by smaller companies have frequently suffered from an unenviable reputation and as a direct consequence, have struggled to attract investors. Nevertheless, this kind of negative reputation is not inevitable. As such, Part V proposes possible ways in which the credibility of those markets can be enhanced by way of the structure of the market, obligations on market participants, and enforcement mechanisms calculated to deter those tempted to engage in fraud and abuse.

II. Facilitating Equity Funding for Small Companies

The early 21^st century is shaping up to be one characterized by rapid technological advances which can disrupt traditional industries. The demise of such industries can, in turn, result in significant job losses which may impact the social cohesion of society, resulting in political upheaval with governments finding themselves under pressure to generate solutions to tackle unemployment and underemployment.

Rather than resort to protection of traditional industries, one response has been to encourage the development of start-ups and SMEs which are known to be significant job creators. As such and as discussed below, an idea that has gained significant traction in recent years is that of loosening securities regulations to enable smaller companies to more readily raise equity capital rather than having to rely on debt finance. One approach which is becoming increasingly popular throughout the world is for regulations to be relaxed so smaller companies can raise capital through equity crowdfunding.

Equity crowdfunding allows a company to obtain funds from a large body of investors whereby each investor provides only a small amount of the funds required in exchange for securities in the company. A key feature of this approach is the use of the Internet to gather investors, with a licensed Internet platform typically being used to match investors with ventures seeking finance. Use of the Internet platform technology reduces search costs associated with finding appropriate investors.¹¹ Another advantage of equity crowdfunding for entrepreneurs is that they are able to maintain management control because ownership of the issued securities is dispersed across many investors. In contrast, raising funds by way of venture capital or private equity typically means that the entity or entities providing the finance will tend to have significant sway over the management and direction of the company. Equity crowdfunding may also enhance the profile of a company as investors become customers whose positive experiences may inspire them to invest in the business and who, in turn, may disseminate information about the company and its products through social media.¹²

It is also possible that equity crowdfunding may address another issue that has arisen in recent years—in many countries, there has been a marked fall in the number of initial public offerings (IPOs) and, in particular, smaller IPOs.¹³ This has resulted in retail investors being effectively locked out of investing in innovative start-ups during what may be their most rapid-growth phase. Presently, well-developed private equity and venture capital markets supply most of the funding for new high-tech enterprises, with such start-ups only going public after they are well-established.¹⁴ Equity crowdfunding may allow smaller investors to “get in on the ground floor” of what might be the next Apple or Facebook and thereby experience a substantial return on their investment if these companies rapidly expand.¹⁵

In the United States, the JOBS Act directs the SEC to develop rules to allow equity crowdfunding. The SEC released the final rules in 2015 which went into effect in 2016.¹⁶ Many other countries have recently altered their securities regulation to allow equity crowdfunding, including the UK,¹⁷ France¹⁸ and New Zealand in 2014,¹⁹ Germany in 2015,²⁰ Canada in 2016,²¹ and Australia in 2017.²² At the same time, while the equity crowdfunding industry is arguably still in its infancy, the number of Internet platforms offering equity crowdfunding is growing, and it is anticipated that it will continue to expand.²³ Similarly, the funds raised by equity crowdfunding are expected to grow exponentially over the coming years.²⁴

However, the development of the equity crowdfunding industry is likely to be hindered unless the investors who subscribe to equity crowdfunding issues are able to onsell their securities. At present, unlike investors who obtain securities by subscribing to a registered prospectus, investors who subscribe for securities in a crowdfunding issue usually cannot onsell their securities to the public. As such, crowdfunding investors are generally locked in and must wait until the company either has an IPO or is taken over before the funds invested are returned to them. Unless this issue is addressed, over time, crowdfunding may be relegated to the position of a niche industry with most investors avoiding equity crowdfunding issues due to the inability to sell their securities quickly.

III. Venues for Secondary Trading

To address this issue of investors being unable to sell their securities, there appears to be a renewed focus on establishing markets or exchanges for the secondary trading of securities issued by smaller companies. For example, in 2013, the SEC Advisory Committee on Small and Emerging Companies recommended the creation of a separate U.S. equity market for smaller companies and start-ups.²⁵ Following this recommendation, a number of SEC Commissioners suggested that the SEC consider approving one or more venture or regional exchanges with relaxed disclosure and other rules specifically designed for smaller companies.²⁶

In other parts of the world, new venues for trading smaller companies are already emerging.²⁷ For example, in 2015, the New Zealand Stock Exchange launched a new market known as the NXT Market.²⁸ The NXT Market replaced the NZX Alternative Market, which was established in 2003 but struggled with low trading volumes.²⁹ The NXT Market is aimed at small- to mid-sized businesses with a market capitalization of $10–100 million. These companies are required to have at least fifty members of the public as shareholders who cumulatively hold at least a quarter of the shares. There is a simplified disclosure regime with a focus on key operating milestones by which investors can measure and monitor the performance of the company. Each company must also use an NXT-registered adviser for the first three years. ³⁰

Another New Zealand market is also gearing up to deal with securities issued through crowdfunding. A market called “Unlisted” operates under an exemption to the Financial Markets Conduct Act 2013 (FMC Act). As such, investors trading in securities quoted on this market do not receive the kind of protections provided by the FMC Act.³¹ In 2016, Armillary Private Capital, the company that manages the Unlisted market, launched a licensed equity crowdfunding platform called Crowdsphere. As such, Armillary Private Capital can now offer equity crowdfunding services as well as the capacity to trade securities issued through equity crowdfunding via the Unlisted market.³²

The Korea Exchange, the sole securities exchange operator in South Korea, has opened a market to trade crowdfunded securities called the “KRX Startup Market” and is geared to attract companies by offering equity crowdfunding combined with the capacity to trade such securities.³³ As these companies grow, the Korea Exchange can enable them to progress to KONEX (Korea New Exchange) and finally to the Korea Exchange’s principal exchange, the KOSDAQ.³⁴

In Taiwan, although the Taipei Exchange is not directly engaged in crowdfunding, it has set up a platform to link businesses and crowdfunding providers.³⁵ Undoubtedly, this was implemented with the hope that as those companies grow they will eventually look to list on its exchange.

Although there is this renewed enthusiasm for establishing new exchanges or markets for the secondary trading of securities issued by smaller companies, globally there already exists a number of markets and exchanges with differentiated admission and disclosure standards to cater to the trading in the securities of SMEs. These have had varied degrees of success.

For example, the U.K. is home to what may be one of the most successful markets for SMEs, namely the Alternative Investment Market (AIM), owned by the London Stock Exchange and created in 1995. Since its inception, over 3,600 companies have listed on it, although the number of companies seeking a listing has fallen to just 47 new listings in 2015 from a high of 399 new listings in 2005.³⁶ To list on AIM, each company must appoint and retain a Nominated Advisor, referred to as a NOMAD, at all times. A NOMAD is a firm of experienced corporate finance professionals who are approved by the London Stock Exchange. There are no minimum criteria in relation to listing in terms of the company size, track record, country of origin or set number of shares to be allocated to the public. Rather, the determination for whether the company is appropriate for the market is decided by the NOMAD.³⁷

In the United States, securities not listed on the major exchanges can be traded over-the-counter (OTC), principally by services provided by the OTC Markets Group and through the OTC Bulletin Board (OTCBB) operated by the Financial Industry Regulatory Authority (FINRA). The OTCBB is an inter-dealer quotation system that is used by subscribing FINRA members to reflect market-making interest in OTCBB-eligible securities.³⁸ The OTC Markets Group operates three financial marketplaces: (i) the OTCQX, the top tier marketplace with the most stringent eligibility and disclosure standards; (ii) the OTCQB, the venture stage marketplace for medium-sized or early-stage companies; and (iii) the OTC Pink, which comprises the lowest tier of the three marketplaces and features no reporting requirements.³⁹ These marketplaces require less disclosure and impose much lower fees than other U.S. exchanges and markets.⁴⁰

In Canada, the Canadian Securities Exchange (CSE) provides a venue for the trading of microcap and emerging companies and has relatively few reporting and listing requirements.⁴¹ It has over 300 listed companies and has recently grown due to the listing of a number of start-ups in the cannabis industry.⁴² Canada is also home to the TSX Venture Exchange, which is designed for smaller cap companies, particularly those in the mining as well as oil and gas industries.⁴³

Other significant markets and exchanges for smaller companies include the Euronext Growth market in Europe,⁴⁴ the Shenzhen Stock Exchange SME Board in China,⁴⁵ the BSE SME platform in India,⁴⁶ the AIM Italia in Italy,⁴⁷ and the Tokyo PRO market in Japan.⁴⁸

IV. Regulatory Challenges in Relation to Secondary Markets for Smaller Companies

Despite the call for new exchanges and markets to trade securities issued by smaller companies, historically such markets have faced a number of significant challenges. These include the fact that some markets, particularly those which are more junior markets of the larger exchanges, gradually become populated by what could be seen as unsuccessful companies. This is because over time, successful firms graduate to larger exchanges, and companies in the larger exchanges that decline in value, sometimes referred to as “fallen angels,” may be relegated to the junior market.⁴⁹ In some cases this poor reputation, coupled with high levels of fraud, has led to the closing of such markets, as occurred with the Emerging Company Marketplace, the junior board of the American Stock Exchange, which opened in 1992 and closed in 1995, after only three years of operation.⁵⁰

Another significant problem is a lack of liquidity for markets designed to trade the securities of smaller companies. Having fewer securities on issue means that it becomes more difficult for those securities to be bought or sold, as a buyer may find that there is just no one willing to sell securities at the price the buyer is willing to pay and vice versa. This illiquidity can also make securities sold on those markets particularly susceptible to pump and dump manipulation schemes.⁵¹

A plague of pump and dump schemes led to the closing of the First Board of the Open Market in Germany in 2012. The Open Market is a multilateral trading facility run by Deutsche Börse that used to be divided into First and Second Quotation Boards. The First Quotation Board, which was designed for smaller companies, had few listing and post-admission requirements. Admission was granted on application by an entity authorized for trading, normally a securities trading bank, and it was considered sufficient if an auditor confirmed the entity had equity of at least €500,000 with each share of at least €0.10 par value.⁵² Over time, it became clear to Germany’s securities regulator, Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), that the majority of the cases of market manipulation that it investigated each year were pump and dump schemes occurring in this market.⁵³ These cases were frequently complex and difficult to investigate, had the potential to inflict substantial damage to investors and often involved extensive cross-border activity, as many of the companies whose shares were used in this way came from abroad, particularly Switzerland and the UK.⁵⁴

Because of the level of manipulation in the First Board of the Open Market, BaFin gradually became critical of the listing requirements.⁵⁵ Initially, Deutsche Börse’s response was to tighten listing standards and to suspend trading in the shares of entities that did not meet those standards.⁵⁶ However, prompted by an onslaught of new incidents of suspected market manipulation, in December 2011, Deutsche Börse decided not to admit any new entities to the First Quotation Board and closed it down in 2012.⁵⁷

In the United States, most of the market manipulations prosecuted by the SEC each year are pump and dump schemes in the OTC markets. While the details of these schemes vary, they typically follow the same pattern of a person taking a large stake in the target company. The person then “pumps” the securities by way of igniting interest via matched orders between associates and promoting the securities in false or misleading emails, Internet postings or social media postings.⁵⁸

The approach of U.S. authorities in tackling the relatively high volume of such schemes in the OTC markets has been to utilize a specialized unit within the SEC to identify and suspend trading in the securities of dormant companies before they can be hijacked and used for pump and dump schemes.⁵⁹ Second, the Federal Bureau of Investigation (FBI) has engaged in sting operations, whereby an undercover FBI agent offers bribes to fund managers in exchange for those fund managers using investors’ funds to purchase penny stocks.⁶⁰ Third, the SEC has worked with the U.S. Department of Justice to criminally prosecute recidivist pump and dump scheme promotors with a view to those promotors being convicted and sentenced to lengthy prison terms.⁶¹ Finally, FINRA has been active in taking action against brokers who have facilitated manipulative trading in these markets in an effort to deter brokers from acting for clients engaging in this type of illegal conduct.⁶²

Nevertheless, despite these efforts, pump and dump manipulation schemes still appear to be a problem for U.S. OTC markets. In 2015, the SEC took action in relation to nineteen cases of manipulation that were primarily pump and dump schemes.⁶³ Like BaFin, the SEC has found that these schemes are often complex and frequently involve accounts or corporations located in foreign jurisdictions such as the British Virgin Islands, Anguilla, the Bahamas, and Turks and Caicos, presumably in an attempt to avoid detection by U.S. regulators.⁶⁴

This prevalence of manipulation in markets for trading securities issued by smaller companies presents a festering problem going forward if these same markets are to be utilized to trade the expected significant increase in securities generated by equity crowdfunding. A recent survey by the World Federation of Exchanges found that a solid regulatory framework designed to enhance the integrity of the market, coupled with strong supervision and enforcement, is a very important requirement for both investors and companies if they are to participate in markets for SMEs.⁶⁵ As such, it appears that unless action is taken to deter fraud and manipulation in these markets, they are likely to be avoided by investors. Therefore, it is critical to their success, and ultimately the success of equity crowdfunding, that there is an unwavering focus on minimizing fraud and manipulation in regulations governing both the design and ongoing supervision of these markets.

V. How to Enhance the Integrity of Markets for Smaller Companies

Eliminating unfair trading practices such as fraud and market manipulation is pivotal in achieving two of the main objectives of securities regulation—to protect investors and to ensure markets are fair, efficient and transparent.⁶⁶One of the most important ways in which regulators endeavor to meet these objectives is by imposing comprehensive listing requirements and thereafter continuous disclosure requirements on companies listed on the large exchanges. This is backed up by the threat of criminal and civil liabilities for failing to provide such information or for providing false or misleading information.

However, for small companies the cost of these kinds of comprehensive listing and disclosure requirements is prohibitive. The real challenge then is for securities regulators to protect investors and preserve the integrity of markets for the trading of securities issued by smaller companies in the absence of a full disclosure regime. While there appears to be no one solution to this problem, there are some mechanisms that could be employed, which may go some way to enhancing the integrity of these types of markets and protecting the investors who use them.

A. Vetting of Companies

In the absence of comprehensive disclosure requirements, some degree of vetting needs to be imposed on companies to reduce the potential for outright fraud. The cheapest and perhaps most effective way for this to occur may be to make a market intermediary responsible for conducting due diligence to determine the bona fides of the company and its management team. This model has been used by some of the existing markets for small companies, including the AIM, which requires companies to use a NOMAD.⁶⁷ The advantage of requiring a market intermediary to vet companies is that most companies utilizing equity crowdfunding will already have a relationship with a licensed financial service intermediary, namely the licensed crowdfunding platform it used for the issue of its securities. Some of these crowdfunding platforms already undertake due diligence on projects listed on their portals. This can include background checks, site visits, credit checks, account monitoring, and proof of transactions obtained from third parties.⁶⁸ As such, it seems like a logical step that such a firm could also serve to vet the company for listing.

Linking the reputation of the market intermediary to the companies it authorizes for listing should help ensure the quality of the companies traded on the exchanges and minimize the prospect of outright fraud. Of course, the effectiveness of the vetting process is arguably compromised, to some extent, in that the market intermediary is in a fundamental conflict of interest because the company to be vetted engages it and pays for its services. In fact, some argue that conflicts of interest and poor monitoring of NOMADs have led to the failure of many companies listed on the AIM.⁶⁹ Accordingly, for such a regime to be effective, it is critical that market intermediaries be coherently regulated and supervised by regulators. Subjecting market intermediaries to harsh penalties for failure to properly conduct their due diligence responsibilities would also further reduce the prospects of fraud by the company to be listed or its management team.⁷⁰

B. Disclosure of Substantial Shareholders

There is a strong argument in support of strict regulations to ensure that changes to substantial shareholders are rapidly and clearly disclosed, coupled with significant penalties for a failure to do so. This is because pump and dump schemes are usually characterized by a person and his or her associates gradually accumulating a significant holding in a stock. Disclosure of changes to holdings by substantial shareholders should alert market participants and the authorities to potential schemes and, as such, strict requirements to disclose substantial shareholdings may tend to deter those contemplating this type of manipulation.

C. Liquidity and Market Surveillance

Improving the liquidity of markets for the trading of securities issued by smaller companies should significantly reduce the ability of perpetrators of pump and dump schemes to radically increase the price by virtue of there being a lack of supply of securities. Some suggestions that have been made for improving liquidity of such markets include:

changing trading so that it is not continuous but only takes place in batch auctions at various intervals;⁷¹
altering the tick size of trades to encourage market makers who traditionally have provided liquidity in the markets in which they operate;⁷² and
ensuring all of the trading of a particular company’s securities is concentrated in one venue and not fragmented over a number of markets or by off-exchange, internal order matching by brokers.⁷³

Concentrating the trading of a company’s securities in one market also has a significant advantage for the authority responsible for detecting manipulation and other abusive practices. This is because currently, the main method by which market manipulation and insider trading is detected is via surveillance software used by the authorities. This software monitors trading on the markets and is designed to identify anomalous trading patterns. If the trading takes place in only one venue, this substantially simplifies the surveillance software systems needed for such detection. By way of comparison, if trading is fragmented over a number of different venues, to effectively conduct such surveillance, trading and order information from each of those markets needs to be collected and assembled before it can be analyzed. This significantly adds to the cost and complexity of the surveillance systems required, not to mention delays the entire analysis process.⁷⁴

Of course, concentrating all trading within one trading venue creates a monopoly and could potentially result in that venue extracting excess profits from brokers and listed companies. However, the benefits of concentrating all trading in one venue for thinly-traded stocks seem to outweigh this possible disadvantage. Furthermore, given the fact that there are many venues for smaller companies to list their securities around the world, competition between venues should keep in check the possibility of extracting monopoly profits.

D. Enforcement

If the probability of wrongdoing being detected is high and the penalties are substantial, potential perpetrators will tend to be deterred from engaging in such conduct. Accordingly, it is essential that there be robust laws prohibiting fraud and manipulation coupled with significant penalties for violations, including the possibility of lengthy prison terms. However, this is not enough by itself. It is also necessary for there to be a high probability of both detection and prosecution, rather than just a theoretical risk.⁷⁵

In addition to detection via market surveillance systems, another important detection method can be reports made by market intermediaries. In particular, regulations need to require that compliance systems be maintained by market intermediaries. These regulations should also impose on market intermediaries an obligation to immediately report suspicious transactions directly to the authorities. Ideally these reports should be made directly to the securities regulator responsible for taking action against market manipulation. In Europe, for example, market intermediaries are required to report directly to the regulator any suspicious transactions, including suspicious unexecuted orders. Failure to do so attracts a penalty of up to €1 million for a natural person and €2.5 million, or 2% of turnover, for other legal persons.⁷⁶ European securities regulators are also required to forward a copy of any suspicious transaction report to all other supervisory authorities of organized securities markets within the EU who may be affected by the report. Over time, such reports are proving to be an important way in which European securities regulators detect market manipulation.⁷⁷

Another increasingly important detection mechanism for fraud and manipulation is voluntary reports from the public to securities regulators in the form of complaints, tip-offs, or whistleblowers. Such reporting appears to be significantly enhanced when the regulator offers monetary awards to whistleblowers, as is the case with the SEC and the Ontario Securities Commission.⁷⁸ These awards are most commonly made to individuals who have inside knowledge of the fraud, but can also be made to anyone who provides the regulator with original information derived from independent information or independent analysis.⁷⁹

After initial detection, it is necessary that securities regulators be in a position to rapidly take action against the perpetrators of the abuse, even if those persons are outside of the jurisdiction. Currently, when a perpetrator is outside of the jurisdiction, most securities regulators can obtain access to the information they require to undertake an investigation relatively quickly via a memorandum of understanding established by the International Organization of Securities Commissions (IOSCO), which almost all the securities regulators in the world have signed.⁸⁰ However, a perpetrator can only be brought before the courts if an extradition arrangement is in place or the regulator where the perpetrator is situated is itself prepared to bring a prosecution. If neither occurs, apart from perhaps having assets frozen within the jurisdiction, the perpetrator will escape jail and perhaps even be emboldened to offend in the future. Given the risk to the integrity of the markets that fraud and manipulation pose, securities regulators should consider restricting access to the market from all persons who reside in countries where there is no extradition treaty or where the authorities in that country will not bring their own proceedings against the perpetrators.

VI. Conclusion

For equity crowdfunding to continue to grow, it will be necessary for secondary markets to be developed for smaller companies and for such markets to succeed and thrive. A critical aspect of the success of such markets will be ensuring that investors have the confidence to trade in those markets without an unreasonable risk of becoming the victim of fraud or manipulation.

It is possible to have successful markets for the trading of securities issued by smaller companies, but there must be a clear focus on ensuring the integrity of those markets. This can be achieved by careful design of regulations and the structure of the market with a view to preventing fraud and manipulation schemes. Furthermore, the authorities need to demonstrate to market participants, including those contemplating engaging in manipulation, that any fraud or manipulation in the market will be rapidly detected and effectively prosecuted.

† Associate Professor, University of New Brunswick, Canada.

[1] See, e.g., Communication from the Commission to the European Parliament, The Council, The European Economic and Social Committee and the Committee of the Regions’ Entrepreneurship 2020 Action Plan: Reigniting the Entrepreneurial Spirit in Europe, COM (2012) 795 final (Sept. 1, 2013).

[2] For example, in the EU, it is estimated that SMEs employ two out of every three people and produce 58 cents in every euro of value-added. Patrice Muller et al., A Partial and Fragile Economy: Annual Report on European SMEs 2013/2014 6 (2014). In the US, it is estimated that small businesses have provided 55% of all jobs and 66% of all net new jobs since the 1970s. Manage Your Finances, U.S. Small Bus. Admin. (2017), https://www.sba.gov/managing-business/running-business/energy-efficiency/sustainable-business-practices/small-business-trends.

[3] Andrew Fink, Protecting the Crowd and Raising Capital Through the CROWDFUND Act, 90 Univ. Detroit Mercy L. Rev. 1, 2 (2012).

[4] See Jumpstart Our Business Startups Act of 2012, Pub. L. No. 112–106, 126 Stat. 306 (2012).

[5] Id. at 20. Another important change is commonly known as a Regulation A+ reform. This increased the amount that could be raised using a mini registration statement, rather than a full prospectus, from $5 million in a 12-month period to $50 million. See id. at 401–02.

[6] See infra Part III.

[7] For example, in Canada, investors who purchase crowdfunding securities can usually only sell those securities through utilizing an exemption from the requirement to issue a prospectus. See Prospectus and Registration Exemptions, Nat’l Instrument 45-106 (Can.). In relation to restrictions on selling crowdfunded securities in the United States, see U.S. Secs. and Exch. Comm’n, Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers (2016), https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051316.htm.

[8] Luis A. Aguilar, Comm’r, U.S. Secs. and Exch. Comm’n, The Need for Greater Secondary Market Liquidity for Small Businesses, Public Statement to the Advisory Committee on Small and Emerging Companies (Mar. 4, 2015), https://www.sec.gov/news/statement/need-for-greater-secondary-market-liquidity-for-small-businesses.html.

[9] See infra Part IV.

[10] Id.

[11] See Kay Koplovitz, One Year After Title II and Equity Crowdfunding, Huffington Post (Oct. 10, 2014), http://www.huffingtonpost.com/kay-koplovitz/one-year-after-title-ii-a_b_5965466.html.

[12] World Fed’n of Exchs., SME Financing and Equity Markets 36 (2017), https://www.world-exchanges.org/focus/index.php/features/research/111-wfe-publishes-report-into-sme-financing-equity-markets.

[13] See Alma Pekmezovic & Gordon Walker, The Global Significance of Crowdfunding: Solving the SME Funding Problem and Democratizing Access to Capital, 7 William & Mary Bus. L. Rev. 347, 384 (2016).

[14] See U.S. Sec. Exch. Comm’n, Rebuilding the IPO On-Ramp: Putting Emerging Companies and the Job Market Back on the Road to Growth 1 (Oct. 20, 2011), https://www.sec.gov/info/smallbus/acsec
/rebuilding_the_ipo_on-ramp.pdf.

[15] Chris Brummer has analyzed the reasons why this has occurred. In brief, it seems that reduced regulatory requirements and technological innovations have led to the growth of the private placement market. At the same time, listed public companies have been subject to additional layers of reporting and corporate governance requirements, decreasing the attractiveness of going public. See Chris Brummer, Disruptive Technology and Securities Regulation, 84 Fordham L. Rev. 977 (2015).

[16] For a discussion on the benefits of crowdfunding for small investors, see Andrew Schwartz, Inclusive Crowdfunding, 4 Utah L. Rev. 661 (2016).

[17] Crowdfunding, 17 C.F.R. §§ 200, 227, 232, 239, 240, 249, 269, 274 (2015).

[18] See generally Fin. Conduct Auth., The FCA’s Regulatory Approach to Crowdfunding Over the Internet, and the Promotion of Non-Readily Realisable Securities by Other Media Feedback to CP13/13 and Final Rules (2014), https://www.fca.org.uk/publication/policy/ps14-04.pdf.

[19] See Loi 2014-559 du 30 mai 2014 relative au financement participatif [Law 2014-559 of May 30, 2014 relating to the crowdfunding], Journal Officiel De La République Française [J.O.] [Official Gazette of France], May 31, 2014, p. 9075.

[20] See Financial Markets Conduct Act 2013, subs 7 (N.Z.); Financial Markets Conduct Regulations 2014, reg 184 (N.Z.).

[21] Kleinanlegerschutzgesetz [Retail Investor Protection Act], July 9, 2015, BGBl I at 1115 (Ger.).

[22] See Multilateral Instrument Crowdfunding, O. Reg. 45/108 (Can.); Start-Up Crowdfunding Registration and Prospectus Exemptions, N.B. Reg. 45/506 (Can.).

[23] See Corporations Amendment (Crowd-Sourced Funding) Act 2017 (Cth) sch 1 (Austl.).

[24] See OECD, Financing SMEs and Entrepreneurs 2016: An OECD Scoreboard 65 (2017), http://www.keepeek.com/Digital-Asset-Management/oecd/industry-and-services/financing-smes-and-entrepreneurs-2017_fin_sme_ent-2017-en#.WgJhG1ynET8.

[25] See Robert Wardrop et al., Breaking New Ground: The Americas Alternative Finance Benchmarking Report 19 (2016).

[26] See U.S. Sec. Exch. Comm’n, Recommendation Regarding Separate U.S. Equity Market for Securities of Small and Emerging Companies (Feb. 1, 2013), https://www.sec.gov/info/smallbus/acsec/acsec-recommendation-032113-emerg-co-ltr.pdf. However, the SEC only recommended that accredited investors be allowed to trade on this market or markets. Id.

[27] See Daniel M. Gallagher, Comm’r, U.S. Sec. Exch. Comm’n, Remarks at FIA Futures and Options Expo (Nov. 6, 2013), https://www.sec.gov/news/speech/2013-spch110613dmg; Kara M. Stein, Comm’r, U.S. Sec. Exch. Comm’n, Supporting Innovation through the Commission’s Mission to Facilitate Capital Formation (Mar. 5, 2015), https://www.sec.gov/news/speech/innovation-through-facilitating-capital-formation.html. For an example of such a proposed regional exchange, see, e.g., Haw. Dep’t Com. & Consumer Aff., Hawaii Exchange for Local Investment: Report to the Twenty-Sixth Legislature (Feb. 2012), http://files.hawaii.gov/dcca/dfi/reports
/Final-Report-Hawaii-Exchange-for-Local-Investment-Pursuant-to-SCR-134-SD1.pdf.

[28] For example, in Australia, the legislation introducing crowdfunding anticipated that secondary markets for crowdfunding would be established and provides the Minister with great flexibility for granting exemptions for such markets. See Corporations Amendment (Crowd-sourced Funding) Act 2017 (Cth) sch 3 (Austl.).

[29] Calida Smylie, NXT market launches today, Nat’l Bus. Rev. (June 18, 2015), https://www.nbr.co.nz/
article/nxt-market-launches-today-cs-174300.

[30] NZX’s Alternative Market Trading Dwindles, Scoop Bus. (Oct. 5, 2010), http://www.scoop.co.nz/
stories/BU1010/S00095/nzxs-alternative-market-trading-dwindles.htm.

[31] See Smylie, supra note 29.

[32] Important Information – Please Read Before Proceeding, Unlisted, http://www.unlisted.co.nz:80/
uPublic/unlisted.mt_public.home (last visited Nov. 6, 2017).

[33] Market Places, Armillary Private Capital, https://www.armillary.co.nz/Market-Places (last visited Nov. 6, 2017); see also James Murray, Equity Crowdfunding and Peer-to-Peer Lending in New Zealand: The First Year, JASSA Finsia J. Applied Fin. 2 (2015), http://www.finsia.com/docs/default-source/jassa-new/jassa-2015/jassa-2015-issue-3/equity-crowdfunding-and-p2p-lending-in-new-zealand-the-first-year.pdf?sfvrsn=8fcd9793_4.

14199-private-market-startups-krx-establish-private-market-support-startups%E2%80%99-stock.

[35] Id.

[36] See Introduction, Taipei Exchange, Gofunding Zone, http://gofunding.tpex.org.tw/introduction.php?l=en-us&t=0 (last visited Nov. 6, 2017).

[37]AIM 20 – The World’s Most Successful Growth Market, London Stock Exchange, http://www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm (last visited Nov. 6, 2017); Richard Wheat, The Death of Aim: Can Equity Crowdfunding Eclipse the LSE’s Junior Market? (Apr. 28, 2016, 4:42 AM), http://www.cityam.com/239865/the-death-of-aim-can-equity-crowdfunding-eclipse-the-lses-junior-market; see also Susanne Espenlaub & Arif Khurshed, Is AIM A Casino? A Study of the Survival of New Listings on the UK Alternative Investment Market (AIM), Research Gate 4 (Dec. 2010), https://www.researchgate.net/publication/
228380249_Is_AIM_A_Casino_A_study_of_the_survival_of_new_listings_on_the_UK_Alternative_Investment_Market_AIM.

[38] Darryl Levitt & Andrew Derksen, The AIM listing Process: Steps to a Successful AIM Listing, Fasken Martineau, http://www.fasken.com/files/Publication/84c66c81-421b-47cd-bbfe-74eccafa86d5/Presentation/Public
ationAttachment/5b5d87c4-07fe-44e0-b03e-9bf76acd6073/AIM_LISTING_PROCESS.PDF (last visited Nov. 6, 2017).

[39] OTC Bulletin Board (OTCBB), FINRA, http://www.finra.org/industry/otcbb/otc-bulletin-board-otcbb (last visited Nov. 6, 2017).

[40] OTCQX, Investopedia, http://www.investopedia.com/terms/o/otcqx.asp (last visited Oct. 31, 2017). See generally Ulf Brüggemann et al., The Twilight Zone: OTC Regulatory Regimes and Market Quality, Rev. Fin. Studies (2017).

[41] John Mackie, Delisting Deluge: Stocks Under Pressure And What To Do About It, SECNWS – Securities Law Newsletters (2009).

[42] Canada Securities Exchange, http://thecse.com/en/about (last visited Oct. 31, 2017).

[43] Christina Pellegrini, TMX Considers Change that Could Hamper Marijuana Industry, The Globe and Mail (Aug. 11, 2011), http://archive.li/m4YII#selection-6997.191-6997.199.

[44] David Johnston, Kathleen Rockwell & Cristie Ford, Canadian Securities Regulation 565–66 (5th ed., 2014).

[45] Eurogrowth, Euronext, https://www.euronext.com/en/listings/euronext-growth (last visited Oct. 31, 2017).

[46] Listing Q&A, Shenzhen Stock Exch., http://www.szse.cn/main/en/ListingatSZSE/ListingQA/ (last visited Oct. 31, 2017).

[47] Introduction, BSE, http://www.bseindia.com/static/about/introduction.aspx?expandable=0 (last visited Oct. 31, 2017).

[48] AIM Italia, London Stock Exch., http://www.lseg.com/areas-expertise/our-markets/borsa-italiana/equities-markets/raising-finance/aim-italia-mac (last visited Oct. 31, 2017).

[49] Overview, Japan Exch. Grp., http://www.jpx.co.jp/english/equities/products/tpm/outline/ (last updated Jan. 16, 2017)

[50] See e.g., Reena Aggarwal & James Angel, The Rise and Fall of the Amex Emerging Company Marketplace, 52 J. Fin. Econ., 257, 259–265 (1999) (describing the history of the failed Amex Emerging Company Marketplace).

[51] Id. at 264.

[52] For the profitability of pump and dump schemes, see Taoufik Bouraoui, Does ‘Pump and Dump’ Affect Stock Markets?, Int’l. J. Trade, Econ. & Fin., 45, 48 (2015).

[53] BaFin, Annual Report 2011, 195 (2012) .

[54] In 2005, BaFin reported that 55% of manipulation investigations were related to sham trading. See BaFin, Annual Report 2005, 158 (2006). These were transactions which are referred to as “matched orders,” prearranged transactions between two entities, or were “wash sales,” trades without changes in the beneficial ownership of the securities. Id. Another quarter of manipulation investigations were related to informational offenses, that is, misleading or incorrect information or the concealing of information. Id. It also reported that the transactions mainly impacted “illiquid equities or ‘penny stocks’ traded on the OTC market.”Id. In 2006, BaFin reported that reports by investors in relation to market manipulation doubled and “related primarily to low-liquidity financial markets traded in the OTC market.” See BaFin, Annual Report 2006 163 (2007). In 2007, it recognized the involvement of foreign companies in such schemes, noting that this “occurs when shares, mostly of foreign companies in the commodity sector, are included in . . . OTC trade[s] [on] German stock exchanges.” BaFin, Annual Report 2007, 173–74 (2008). By 2008, BaFin reported that “the significance of OTC trading for market manipulation remained consistently high” and that it was identifying “increasing levels of cross border manipulation in the German market.” BaFin, Annual Report 2008, 156, 162 (2009). In 2009, BaFin reported that “there has been a marked shift in the focus of BaFin’s report analysis activities towards market manipulation. Sham actions, such as matched trades, were the focal point of these activities in 2009 . . . . The shift from insider trading to more market manipulation analyses is likely to be due to the fact that the current market environment makes it more difficult for potential insiders to exploit their insider information to their advantage.” See BaFin, Annual Report 2009, 171 (2010) (citation omitted).

[55] See BaFin, Annual Report 2010, 187–89 (2011).

[56] Id. at 188 (“The regulated unofficial market is run by the stock exchanges, but does not count as exchange trading. It is used primarily to trade small and in some cases highly illiquid stocks that are frequently of foreign origin. The conditions to be met for companies to be included are extremely lax compared with the regulated market. There is no serious examination of the issuers, nor must the companies comply with any reporting obligations. Even companies in respect of which it is completely unclear whether they have, or are planning, operational business activities can be included in trading extremely easily and used for manipulative purposes. Although Deutsche Börse AG introduced stricter inclusion requirements in 2009, this has yet to have any noticeable effect.”).

[57] See Bafin Annual Report 2011, 195 (2012).

[58] Id. at 168, 195.

[59] See U.S. Sec. Exch. Comm’n, Annual Report 2010, 2011 SEC 160; see also U.S. Sec. Exch. Comm’n, Litigation Release Archive 2010 (2010), https://www.sec.gov/litigation/litreleases/litrelarchive/litarchive2010.shtml (reporting, in 2010, that the SEC took action in relation to seventeen cases of manipulation primarily involving pump and dump schemes in the OTC market).

[60] The SEC does this through its Microcap Fraud Working Group established in 2012. This group scrutinizes microcap stocks to identify dormant shell companies that could be used for potential fraud. U.S. Sec. Exch. Comm’n, Annual Report 2012, 2013 SEC 136; U.S. Sec. Exch. Comm’n, Annual Report 2013, 2014 SEC 137.

[61] U.S. Sec. Exch. Comm’n, Litigation Release No. 22389 (JunefFffbi 4, 2012), https://www.sec.gov/litigation/litreleases/2012/lr22389.htm.

[62] See, e.g., United States v. Harold Bailey Gallison II, No. 1:15-CR-00178-AJT (E.D. Va. filed June 24, 2015).

[63] See, e.g., Sarah O’Brien, Brokers, Firms Land on FINRA’s ‘Bad Guys’ List, CNBC (May 11, 2016), http://www.cnbc.com/2016/05/10/brokers-firms-land-on-finras-bad-guys-list.html.

[64] Litigation Release Archives 2015, U.S. Sec. Exch. Comm’n (last visited Nov. 6, 2017), https://www.sec.gov/litigation/litreleases/litrelarchive/litarchive2015.shtml.

[65] See, e.g., U.S. Sec. Exch. Comm’n, Litigation Release No. 19481 (Dec. 2, 2012), http://www.sec.gov/litigation/litreleases/lr19481.htm; Rockies Fund, Inc. v. SEC, 428 F.3d 1088 (2005); U.S. Sec. Exch. Comm’n, Litigation Release No. 22326 (Apr. 11, 2012), http://www.sec.gov/litigation/litreleases/
2012/lr22326.htm.

[66] A 2017 survey conducted by the World Federation of Exchanges in relation to SME Financing and Equity markets found that for companies “a well-established regulatory and supervisory framework” was the most critical factor to the success of a market for SMEs. For retail and institutional investors, this was the second most important factor, the first being a mechanism to support SMEs to prepare disclosure documents. These factors were more important than liquidity, research analysis, tax incentives and simplified disclosure documents. See World Fed’n of Exchs., supra note 12.

[67] See Int’l Org. of Sec. Comm’ns, Objectives and Principles of Securities Regulation (June 2010), http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf.

[68] Supra Part III.

[69] Douglas Cumming & Yelin Zhang, Are Crowdfunding Platforms Active and Effective Intermediaries? 4–5 (Dec. 9, 2016) (unpublished manuscript) (on file with author) (finding that due diligence by crowdfunding platforms is associated with a higher percentage of successful campaigns and larger amount of capital raised on platforms).

[70] Ben Turney, Does the London Stock Exchange Deserve its Licence to Regulate AIM, UK Investor Magazine 26–27 (July 2015).

[71] See Joseph Gerakos, Mark Lang & Mark Maffett, Post-Listing Performance and Private Sector Regulation: The Experience of London’s Alternative Investment Market, J. Acct. & Econ. 189, 212 (2013) (finding that companies listed on the AIM underperformed similar firms listed on the NASDAQ, the OTC Bulletin Board, and the LSE Main Market but that firms subject to high quality auditors and NOMADs performed better although still not as well as the firms listed on the other markets—one reason may be that there were only few disciplinary actions taken against AIM firms and NOMADs and, even in those cases, the penalties were low).

[72] See Jeff Schwartz, Venture Exchange Regulation: Listing Standards, Market Microstructure and Investor Protection 15–16 (Sep. 8, 2016) (unpublished manuscript) (on file with author).

[73] See id.; Press Release, U.S. Sec. Exch. Comm’n, SEC Approves Pilot to Assess Tick Size Impact for Smaller Companies (May 6, 2015), https://www.sec.gov/news/pressrelease/2015-82.html (stating that the SEC is currently conducting a tick size pilot program).

[74] See Gallagher, supra note 27.

[75] See generally Janet Austin, Unusual Trade or Market Manipulation? How Market Abuse is Detected by Securities Regulators, Trading Venues and Self-Regulatory Organizations, 1 J. Fin. Reg. 263 (2015) (explaining how insider trading and market manipulation are detected by securities regulators).

[76] See generally Utpal Bhattacharya & Hazem Daouk, The World Price of Insider Trading, 57 J. Fin. 75 (2002) (explaining the impact of enforcement); Laura Beny, Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence, 7 Am. L. & Econ. Rev. 144 (2005).

[77] 2014 O.J. (L 173) 179; Regulation 596/2014 (EU).

[78] Austin, supra note 75.

[79] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, § 922(a), 121 Stat. 1841–49 (2010) (inserting a new § 21F into the Securities Exchange Act of 1934); OSC Policy 15-601 Whistleblower Program (Policy 15 – 601/2016) (Can.), http://www.osc.gov.on.ca/documents/en/Securities-Category1/20160714_15-601_policy-whistleblower-program.pdf.

[80] Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, 17 C.F.R. §§ 240, 249 (2011).

[81] See generally Janet Austin, IOSCO’s Multilateral Memorandum of Understanding Concerning Consultation, Cooperation and the Exchange of Information – A Model for International Regulatory Convergence, 23 Crim. L.F. 393 (2012).

January 3, 2018 By ehansen

Bullish on Blockchain: Examining Delaware’s Approach to Distributed Ledger Technology in Corporate Governance Law and Beyond

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I. Introduction

The buzz around blockchain is getting ever louder. Mergers & Acquisitions (M&A) activity in the blockchain technology sector rose 33.3% between Q2 2016 and Q2 2017,¹ and approximately 80% of respondents to Bain & Company’s 2017 survey of financial institution executives expect their organizations to begin using the technology by the time current first-year law students graduate.² Nasdaq continues its investment in Nasdaq Linq, its blockchain-based platform for the private market, as stock exchanges around the world, such as the Australian Stock Exchange, Korea Exchange, and the London Stock Exchange, begin testing blockchain-based services in their respective markets.³

Increased legislative response is perhaps the clearest signal yet that blockchain technology may be more than a passing fad. As of September 2017, several jurisdictions in the United States have amended their state laws to explicitly legitimize the use of blockchain technology in both commerce and corporate governance.⁴ Most notably, Delaware amended the Delaware General Corporation Law (DGCL) to expressly allow Delaware corporations to use “distributed electronic networks or databases”—blockchains—to create and maintain corporate records.⁵ Just a few months after the new Delaware statutes were signed into law, the 2017 Business Law Section Meeting of the American Bar Association (ABA) featured a panel session entitled “Blockchain: How the Technology Behind Distributed Ledgers will Impact Corporate Law and M&A Practice.”⁶ The panel featured high-profile speakers such as Vice Chancellor Travis Laster of the Delaware Court of Chancery and Andrea Tinianow, Director of Corporate and International Development at the Delaware Department of State. Ms. Tinianow also serves as Director of the Delaware Blockchain Initiative.

With a focus on Delaware’s embrace of blockchain technology, this Article examines the potential role of distributed ledgers in corporate governance and capital market transactions. The Article then considers the solutions such technology offers, as well as some barriers its advocates might face in pursuing its wide-scale adoption.

II. What is a Blockchain?

A blockchain is a digital ledger.⁷ Blockchain technology is also known as “distributed ledger technology” (DLT), because copies of a single, shared ledger are distributed across a decentralized network of multiple “nodes,” or users.⁸

In a blockchain, all transactions that occur within a network are validated and recorded in the ledger by consensus.⁹ When a transaction is proposed, all nodes verify that the sell-side account has the promised inventory and that the buy-side account has the promised currency to purchase it.¹⁰ If all nodes validate the transaction, the transaction is executed and cryptographically recorded in the shared ledger.¹¹ Thus, rather than having an intermediary institution reconcile the sell-side and buy-side’s respective ledgers in order to settle the transaction, the transaction is authenticated and executed in real time by automated network consensus.¹²

In addition to circumventing the inefficiencies of relying on an intermediary, blockchain’s automated consensus technology promises accuracy and security.¹³ First, by consolidating data into a shared database, the technology minimizes the chance of accounting discrepancies—and any subsequent disputes—among the parties involved.¹⁴ The technology has been likened to the functionality of Google Docs, in which all permissioned parties have access to a single document at the same time and only a single version of the document exists at any one time.¹⁵ Further, all transactions are recorded sequentially and irreversibly, thus creating an immutable and indisputable audit trail.¹⁶ Finally, since copies of the ledger are cross-authenticated and updated in real time, enormous computing power would be required to corrupt any portion of the data encrypted in the network.¹⁷

III. Delaware’s Approach

A. Examples of Corporate Governance Disputes in Recent Delaware Jurisprudence

With roughly two-thirds of Fortune 500 companies incorporated in Delaware, a vast portion of U.S. corporate litigation occurs in the state, and the Delaware Court of Chancery’s docket provides a reliable snapshot of current trends in corporate governance disputes.¹⁸ A March 2017 article co-authored by Andrea Tinianow, the state’s Director of Corporate and International Development, pointed to two disputes in particular that were characteristic examples of transactional litigation that arises out of administrative error—In re Appraisal of Dell, Inc. and In re Dole Food Co., Inc.¹⁹ Dell gives a dramatic example of how beneficial shareholders lost appraisal rights in a merger proposal due to a botched proxy vote. Dole, on the other hand, showcases the accounting discrepancies than can arise as a consequence of using a corporate record-keeping system that is unable to keep up with the volume and nature of today’s capital market transactions. Though it should be noted that Tinianow’s article explicitly advocates for the adoption of blockchain technology and that her co-author is Caitlin Long, Chairman and President of a start-up that offers a proprietary, blockchain-based issuance and securities trading platform, the cases the article cites do shed light on the systemic shortcomings of today’s corporate infrastructure

1. Proxy Voting Errors in Dell

Dell Inc. completed a go-private merger in February 2013, and in July 2013, certain of Dell’s beneficial shareholders petitioned for appraisal.²⁰ In May 2016, Vice Chancellor Laster of the Delaware Court of Chancery denied the shareholders’ petition and entered judgment against them by holding that they had lost standing to claim shareholder appraisal rights.²¹

Vice Chancellor Laster has publicly stated that the outcome of this case, while consistent with Delaware case law, is “absurd”: the shareholders lost standing because of nothing more than a proxy voting error.^{²²Vice Chancellor J. Travis Laster, Keynote Speech at the Fall 2016 Meeting of the Council of Institutional Investors: The Block Chain Plunger: Using Technology to Clean Up Proxy Plumbing and Take Back the Vote (Sept. 29, 2016).}

Under § 262(a) of the DGCL, shareholders can request appraisal of the fair value of their shares only if they meet certain conditions. One such condition is the “Dissenter Requirement”—the shareholder must have neither voted in favor of the merger, nor consented thereto in writing.²³ Ultimately, the petitioning shareholders in Dell were deemed to have waived their appraisal rights because they voted in favor of the merger and thus did not meet the Dissenter Requirement.²⁴ However, the shareholders were so deemed only due to an almost laughable clerical error.

The shareholders—mutual funds sponsored by T. Rowe Price & Associates, Inc. (T. Rowe)—intended to vote against the merger. However, because they were beneficial shareholders and not holders of record, the shareholders voted by proxy.²⁵ As a result of an error in the voting instructions sent to their proxy voter, the shareholders’ votes were inadvertently recorded for the merger.²⁶

i. Stock Ownership and Voting Right Structure

The petitioning shareholders’ votes were recorded through something akin to a protracted game of “telephone.” Under Delaware law, voting authority for the shares beneficially owned by the petitioners lay with a company named Cede & Co. (Cede)—the holder of record whose name was represented on Dell’s corporate stock ledger.²⁷ However, Cede did not have a direct relationship with the petitioners. Cede merely held Dell shares in “fungible bulk” for a number of custodial banks, including a certain State Street Bank & Trust Co. (State Street), which, in turn, held the Dell petitioners’ shares in smaller fungible bulk.²⁸ Accordingly, when the Dell merger was announced, Cede had to seek shareholder approval through a long chain of intermediaries.

First, Cede transferred its voting authority to the relevant custodial banks, including, in the Dell petitioners’ case, State Street.²⁹ State Street then outsourced the task of collecting and implementing voting instructions from the petitioners, as well its other account holders with claim to the fungible pool of Dell shares, by giving power of attorney to a third-party company named Broadridge Financial Solutions, Inc. (Broadridge).³⁰ On the other side of the chain, T. Rowe involved another third-party, called Institutional Shareholder Services, Inc. (ISS).³¹ ISS was to collect T. Rowe’s voting instructions and convey them to Broadridge.³²

Thus, in order for the Dell petitioners to oppose the Dell merger, their voting instructions needed to flow through ISS, then Broadridge, whose authority was delegated from State Street, which, in turn, had received proxy authority through Cede.

ii. Mistaken Voting Instructions

The critical error occurred in the process of ISS collecting T. Rowe’s voting instructions. T. Rowe informed ISS that it wanted to vote against the merger in the vote to be held at Dell’s July 2013 shareholder meeting.³³ T. Rowe’s Corporate Governance Specialist explicitly asked ISS to override T. Rowe’s default for vote, which would otherwise automatically populate the ISS voting system.³⁴ ISS confirmed accordingly; the entry in ISS’s system for the July 2013 Dell shareholder meeting showed T. Rowe’s voting instruction against the merger.³⁵

However, the July meeting was postponed three times.³⁶ Each time a new date was announced, ISS confirmed that T. Rowe’s vote against the merger was recorded in ISS’s system.³⁷ But when the vote was eventually pushed back to September 2013, the ISS system generated a new entry.³⁸ Unbeknownst to either ISS or T. Rowe, the new entry fatally replaced the July meeting entry. The new entry was automatically populated with T. Rowe’s default for vote and thus, ISS submitted voting instructions to Broadridge indicating that the T. Rowe shareholders were in favor of the merger.³⁹ At just the second link of the proxy voting “telephone” chain, the petitioners’ instructions were garbled; the petitioners had ostensibly approved the merger and effectively waived their appraisal rights.

Figure 1: Chain of ownership between issuer, record holders, and beneficial owners.

Dell, 143 A.3d at 25.

Figure 2: Chain of voting authority between issuer, record holders, and beneficial owners.

Dell, 143 A.3d at 31.

2. Ledger Discrepancies in Dole

i. Inconsistent Ledgers

The cause of conflict in Dole could similarly be likened to a “telephone” game. As in Dell, the record owner of the relevant shares was Cede.⁴⁰ Cede again held shares in fungible bulk, and its stock ledger recorded the accounts of custodial institutions, which, in turn, held shares in fungible bulk for their clients—the actual beneficial owners.⁴¹ But this time, Cede, the beneficial shareholders, and the layers of intermediaries between them muddled a much more routine communication—the routine trading of shares.⁴² This muddled communication led to an inaccurate stock ledger, which came to the Dole court’s attention in a case regarding a class action settlement.⁴³

In the wake of the go-private merger of Dole Food Company, Inc. (Dole), which closed on November 1, 2013, shareholders brought a class action against Dole’s fiduciaries.⁴⁴ The parties settled the case for $2.74 per share plus interest.⁴⁵ When the settlement administrator instructed class members to submit claims for the settlement consideration, it received facially valid claims for 49,164,415 shares.⁴⁶ Unfortunately, this far outnumbered the number of shares actually outstanding according to Cede’s centralized stock ledger, which showed only 36,793,758 shares outstanding.⁴⁷ Asserting that it would require “a forensic audit of herculean proportions” to retrace every trade and to rectify the ledger, the Dole court held that the settlement consideration should be distributed by the same mechanism as the merger consideration—Cede’s stock ledger would govern, even though this would mean that some beneficial owners, who admittedly fell within the class definition, would not be able to collect on their settlement claims.⁴⁸

ii. Delayed Settlement and Unrecorded Transfers

Upon investigation, there were two main causes of the stock ledger discrepancy. First, in anticipation of needing to distribute merger consideration pro rata among the custodial institutions’ claims, Cede had frozen its centralized ledger on the effective date of Dole’s merger.⁴⁹ Freezing a ledger restricts securities from being deposited or withdrawn,⁵⁰ which would theoretically have given Cede an accurate snapshot of account balances on the merger’s effective date. Unfortunately, however, this does not mesh with the current process for clearing trades; the clearing process has a lag time of three days, meaning that any trades placed in the two days prior to, or on the day of, the Dole merger’s closing were not captured in Cede’s ledger.⁵¹ And in the three-day period prior to the merger becoming effective, more than thirty-two million shares of Dole common stock were traded.⁵²

Second, this discrepancy was further exacerbated because, as of October 31, 2013, 2.9 million shares of Dole common stock had been shorted.⁵³ Current share-lending laws allow brokers and the custodial institutions that hold beneficial owners’ shares in fungible bulk to lend shares for short sale without the beneficial owners’ knowledge.⁵⁴ In Dole, this facilitated double counting. It created more beneficial owners who could facially claim settlement consideration, while the unknowing lenders of a shorted stock could simultaneously submit claims based on the same underlying shares.⁵⁵

Declaring that it was “functionally impossible to resolve the share discrepancy in a practical or cost-effective manner,” the Dole court held that the settlement consideration should be distributed according to Cede’s ledger and shifted the burden to the custodial institutions to allocate the consideration among its clients.⁵⁶

B. Delaware’s Response

1. Vice Chancellor Laster’s Criticism of the Current System

Vice Chancellor Laster summarized the history of the current stock ownership system and its incompatibility with the realities of modern-day securities trading in a different decision from the Dole case. In In re Appraisal of Dell, Inc., he explained why most U.S. equity securities are currently registered in the name of Cede, rather than in the names of their beneficial owners.⁵⁷ In the 1970s, as trading volumes rose to an unprecedented level, the U.S. Securities and Exchange Commission (SEC) implemented a national “share immobilization” initiative.⁵⁸ The initiative halted the physical exchange of share certificates with every trade.⁵⁹ Instead, custodians such as banks and brokers—State Street in the case of Dell—placed “jumbo certificates” representing masses of shares into one of three depositories.⁶⁰ The jumbo certificates were issued in the name of each depository’s nominee.⁶¹ The depositories then served as central accountants—the depositories tracked any trades among the various custodians’ accounts—but as discussed earlier, held the custodians’ shares in fungible bulk.⁶² The structure was then repeated at a smaller level within each custodian’s account.⁶³ The custodians tracked any trades among their clients, who were the true beneficial shareholders, but actually held all their clients’ shares in fungible bulk. ⁶⁴

This system is still in place, but today, the only surviving depository is the Depository Trust Company (DTC).⁶⁵ Now, almost all U.S. stock is issued in the name of DTC’s nominee—Cede.⁶⁶

Given that much of Delaware’s corporate governance law exclusively grants shareholders’ executory power to owners of record, rather than beneficial owners, this multilayered system requires all the parties involved to participate in a new game of “telephone” each time shareholder action is required.⁶⁷ Although the share immobilization system was designed to accommodate the increased trading volumes of the 1960s and 1970s, it has ironically become an enormous encumbrance on the exponentially higher trading volumes of the twenty-first century. Vice Chancellor Laster asserts that the current system’s inability to accurately and timely track trading activity and shareholder voting is a “systemic failure[] [that] undermine[s] the legitimacy of our corporate governance system.”⁶⁸ In Dole, he warned that the circumstances that led to the dispute were not uncommon and that “[t]he only difference [that made Dole unique] was the magnitude of the [stock ledger] discrepancy, which made the issues visible.”⁶⁹ He noted that such discrepancies appeared “endemic to the depository system.”⁷⁰

2. The Beginnings of Blockchain-Based Governance Mechanisms in Delaware

Vice Chancellor Laster’s warnings did not fall on deaf ears. Both the Delaware legislature and executive branch seemed to agree with his assessment of the state’s corporate governance requirements. To much fanfare, Delaware Governor John Carney signed the “Blockchain Bill” into law in July 2017. The bill amends the DGCL to expressly allow the inclusion of blockchain technology in the infrastructure of corporate governance.⁷¹ For example, § 151(f) of the DGCL now explicitly allows the delivery of certain shareholder communications by distributed ledger platforms, and, crucially, § 224 now grants statutory authority to use distributed ledgers in the creation and maintenance of corporate records.⁷² The latter provision even enumerates minimum requirements of such records.⁷³

These legislative changes come in the midst of a broader push from the Delaware executive branch to embrace blockchain technology. In 2016, then-Governor Jack Markell announced the launch of the Delaware Blockchain Initiative.⁷⁴ A press release from the Governor’s Office stated that the initiative is a “comprehensive program to provide an enabling regulatory and legal environment for the development of blockchain technology and to welcome blockchain companies to locate in the state.”⁷⁵ Governor Markell announced that Delaware, in demonstration of its commitment to the technology, would also invest in its own use cases for blockchain and smart contract technology.⁷⁶ For example, Delaware partnered with Symbiont, a DLT start-up, to store state archival records on a distributed ledger.⁷⁷

Further, Tinianow, who also serves as the Director of the Delaware Blockchain Initiative, used her March 2017 article to publicly contemplate the benefits of distributed stock ledgers and advocate unequivocally for Delaware’s bullish position on the technology:

If shares are registered on a distributed ledger, investors and issuers would be able to interact directly. Property rights would be crystal clear. Capitalization table management would become easy. Proxy voting would be transparent and always accurate. Dividends and other corporate actions (such as stock splits) would be automated and always accurate. Certificates of good standing would never again require a prerequisite forensic audit. Securities lending records would always be accurate, so accidental over-issue of securities would never happen.⁷⁸

IV. Challenges to Wide-Scale Adoption

Tinianow and Long’s piece certainly raises valid points about the advantages of adopting blockchain-based platforms. Features such as (1) direct issuer-investor relations; (2) transparent, unified, and real-time transaction data; and (3) automated processes for dividend distribution and investor communications all would seem likely to bring us closer to Vice Chancellor Laster’s “utopian vision of share ownership system where there is only one type of owner: record owners.”⁷⁹ Further, there seems to be consensus among capital markets experts that, by replacing the manual, redundant, and error-prone processes of secondary markets with an automated system for execution, clearing, and settlement, blockchain technology could not only minimize liquidity and credit risks, but allow companies to harness richer—but cheaper—market reference data.⁸⁰

But both corporations and the capital markets still seem tepid towards wide-scale blockchain adoption.⁸¹ Certainly, there are still technological limitations. Although the technology has been tested in smaller use cases, such as Nasdaq’s previously mentioned private market platform,⁸² and could have substantial near-term impacts on smaller domestically focused markets such as the Australian Stock Exchange,⁸³ there are still questions regarding DLT’s scalability and capacity to handle high-volume, high-frequency trading.⁸⁴

Further, implementation requires some degree of consensus from all market participants, in terms of both policy and actual system design. Technology that distributes ledgers inherently requires group participation because there must be a network of nodes to which ledgers can be distributed, and all nodes in the network must agree to the protocols the network will use.⁸⁵ Naturally, such coordination will be harder to achieve in larger markets. Moreover, there needs to be a critical mass in the number of participants willing to invest in blockchain technology for it to become useful and an attractive investment.⁸⁶ As such, Bain & Co. predicts that many market actors will face “game-theory-type decisions.”⁸⁷ Being the first to adopt a technology that may never achieve critical mass and widespread usage may result in a losing investment, but being too slow may result in being left behind as the market evolves.⁸⁸

Relatedly, although Delaware has adapted the DGCL to welcome the advent of blockchain technology, for most market participants, changes to Delaware law alone may not be sufficient to justify migrating to blockchain-based platforms. Although the Blockchain Bill’s changes to the DGCL seem to promise a path to Vice Chancellor Laster’s utopia, they are hardly a panacea to the convoluted system currently in place. First, Delaware’s new rules address only record ownership, and while this could be revolutionary for companies incorporating in Delaware moving forward, existing corporations will be largely unaffected. Existing entities, who see very little day-to-day change in their stock ledgers and whose shares are currently traded almost exclusively in the secondary market, will only feel the simplifying benefits of a blockchain-based platform when secondary market actors buy into the technology too.⁸⁹

Second, as the DGCL stands now, a Delaware corporation may only use uncertificated shares—and shares issued or recorded exclusively by DLT would necessarily be uncertificated—if certificates that previously represented those shares are surrendered to the corporation.⁹⁰ This requirement renews precisely the logistical challenge that the SEC’s 1970s share immobilization initiative sought to defeat—the physical movement of stock certificates. For Delaware corporations with stock certificates outstanding, which encompasses the vast majority of publicly traded corporations, this is an additional labor and cost intensive obstacle to transitioning to blockchain-based stock ledgers.⁹¹

Perhaps most crucially, widespread adoption may be slowed because the benefits of migrating to blockchain-based trading will not be distributed evenly.⁹² Recent estimates from an Oliver Wyman study put global annual expenditure on post-trade and securities servicing in the region of $100 billion, with an additional $100 to $150 billion in general information technology and operations expenses in capital markets.⁹³ Although Bain & Co.’s research suggests that issuers and end-investors may see between fifteen and thirty-five billion dollars in savings by transitioning secondary markets to blockchain technology, those savings will likely come at the expense of clearinghouses and custodians, whose utility would be replaced by DLT.⁹⁴ As such, those intermediary actors, who currently hold vast power in the ecosystem,⁹⁵ have little incentive to make or facilitate the transition. Though many intermediaries are actively exploring the potential of blockchain technology lest the market leave them behind,⁹⁶ the risk of disrupting their own business models and competitive offerings looms large.⁹⁷

V. Conclusion

In light of the issues “endemic to the depository system,”⁹⁸ DLT undeniably has potential to improve the current infrastructures of corporate governance and capital market transactions. The Delaware Blockchain Initiative and subsequent Blockchain Bill certainly mark significant steps toward wider implementation of the technology. However, blockchain proponents face a conundrum: to unlock its full potential, the technology must become scalable, and a critical mass of market participants must take the leap. To be successful, advocates must stimulate enough market interest in the technology to keep driving product innovation and to persuade all actors that the upside is worth the investment.

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January 2, 2018 By ehansen

The High Cost of Fewer Appraisal Claims in 2017: Premia Down, Agency Costs Up

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^{Matthew Schoenfeld^†}

This Article considers the preliminary results of an ongoing effort to discourage appraisal litigation. Since the August 2016 reforms to the Delaware appraisal statute, Chancery has issued a slew of at-or-below merger price appraisal opinions in cases such as Clearwire and PetSmart, while simultaneously pinioning fiduciary litigation by reiterating the principles of Corwin. The result—as one would expect when costs are raised and benefits are reduced—has been that fewer deals are being challenged via appraisal: In 1H 2017, the number of deals challenged fell by 33%. Those who successfully advocated for curbs on the practice had argued that appraisal claims lowered deal premia by incenting buyers to withhold top dollar, thereby hurting non-appraising shareholders. On their view, curtailment of appraisal should have sent premia upwards. But year-to-date the average U.S. target premium of 22.4% is the lowest of any year in recent history. The average target premium in 2Q 2017 of 19.3% was the single-lowest of the fifty prior quarterly observations; thus far, 3Q 2017, at 19.6%, is tracking as the second-lowest. Amid the pronounced decline in merger premia, change-in-control payouts have expanded as a percentage of transaction value. When analyzed in concert with other measures indicative of agent rent-seeking—such as target premium to 52-week high over varying periods—the evidence points to a substantial transfer of value from target shareholders to selling chief executive officers (CEOs), who have adapted to an environment rendered more permissive by the weakening of the shareholder litigation “check” that had formerly restrained such behavior.

I. As Shareholder Litigation Weakens, M&A Premiums Fall

It has been a year since the August 2016 reforms to the Delaware appraisal statute—intended to make appraisal less economically attractive^[1]—took effect. Over that period, Chancery has further clamped down on shareholder litigation using a two-pronged approach. It has issued a slew of at-or-below merger price appraisal opinions in cases such as Clearwire^[2] and PetSmart,^[3] while simultaneously pinioning fiduciary litigation by reiterating the principles of Corwin^[4]—a 2015 decision that limited the number of transactions subject to enhanced scrutiny under Revlon, Inc. v. Macandrews & Forbes Holdings, Inc.^[5]—in cases such as Singh v. Attenborough^[6] (May 2016), In re OM Group, Inc. Stockholders Litig.^[7] (October 2016), and In re Volcano Corp. Stockholders Litig.^[8] (June 2016).^[9]

The result—as one would expect when costs are raised and benefits are reduced—has been that fewer deals are being challenged via appraisal. During the first half of 2017, eighteen deals were challenged, one-third fewer than the twenty-seven challenged during the same period in 2016.^[10] One might argue that a year-over-year decline in M&A is responsible for the fall—but this seems a bit beside the point given that the 33% year-over-year contraction in such claims (from twenty-seven to eighteen) during the first half of 2017 compares to a more than 20% annual growth rate from 2013 to 2016.^[11] To be sure, M&A volume is down in 1H 2017. But declines in M&A volume had not tempered appraisal claims in recent years. Namely, in 1H 2016, M&A was also down,^[12] but the number of deals challenged grew by 42%.

So what has happened to deal premia? Those seeking curtailment of the appraisal remedy in Delaware argued that the presence of appraisal-seeking holdouts induces buyers to withhold top dollar, thereby harming non-appraising shareholders. That is, acquirers would maintain dry powder ex ante for payments to purported rent-seekers in the form of appraisal arbitrageurs ex post. In the words of one highly respected deal lawyer: “This [appraisal] risk is one that troubles buyers of Delaware companies (especially private equity firms), preventing them from paying the highest prices they can pay . . . .”^[13] On their view, curtailment of appraisal should have sent premia upwards as buyers used more of their powder for bids.

But year-to-date the average U.S. target premium of 22.4% is the lowest of any year since at least 2005.^[14] In fact, the target premium in 2Q 2017 of 19.3% was the single lowest of the fifty quarterly observations dating to 1Q 2005.^[15] What is more, if the quarter to date average premium for 3Q 2017 holds, it will be the second-lowest quarterly observation since at least 2005 at 19.6%.^[16]

The devil’s advocate might say that flagging premia for target shareholders in 2017 can be attributed to the late-cycle nature of the current expansion and already-inflated equity valuations. That may be correct, although 2015 and 2016 could have been described similarly, and even 2007—the archetypal late-cycle sample—yielded an average premium of 26%, about 360bps better for target shareholders.^[17]

II. Parachutes Trump Paranoia

CEOs typically have substantially lower personal reservation prices in sell-side M&A than do their respective disinterested minority shareholders. This reservation price disparity stems not only from CEOs’ ability to internalize 100% of their change-in-control package (CIC) while externalizing most “costs” of a lower transaction price, but also from any additional rents they are able to extract—via transaction-related bonuses or ex post parachute augmentations—at the expense of disinterested shareholders. The threat of appraisal, and resultant discovery, can serve as a check on such rent-seeking value transfers.^[18]

Amid the recent enfeeblement of germane shareholder litigation, it is perhaps not surprising then that as premia have fallen, parachutes and related bonuses have burgeoned. In 1H 2017, the average named executive officer’s (NEO) CIC, or “golden parachute,” in deals substantial enough to warrant an Institutional Shareholder Services (ISS) recommendation, was 2.1% of transaction equity value, up 52% from its 2012-2016 average of 1.36%.^[19] And it does not appear that a handful of outlier transactions are responsible for the surge—the median 1H 2017 parachute was 1.83% of transaction value, nearly triple the 2012 to 2016 median of 0.69%.^[20]

Perhaps the best way to measure the impact of this rent-seeking, from shareholders’ perspective, is via target M&A premium to trailing 52-week high. This measure is better suited to gauge the value siphoned off by rent-seeking—versus simple pre-announcement, T-1, premium—because it tends to eliminate noise engendered by CEOs “talking-down” share prices, or “sandbagging,” ahead of deal announcement to “create space” for an acceptable T-1 premium, and thus avail themselves of CIC payouts.

Per the figure below, from 2010 to 2015, the average and median premium to 52-week high were 13.4% and 12.5%, respectively^[21]—but since 2016, as shareholders’ ability to challenge transactions waned, the average and median premium to 52-week high have dropped to 6.0% and 6.4%, respectively^[22]:

The notion that CEOs—when afforded the opportunity—will sacrifice merger premia to secure parachute payouts is not a novel one. A study of 851 acquisitions from 1999 to 2007 found that:

A 1-standard-deviation increase in parachute importance [relative size] raises the probability of merger completion by 6.9 percentage points but lowers the takeover premium by 2.6 percentage points. . . . Our results are consistent with the following interpretation: As the importance of the parachute to target CEOs increases, they negotiate an offer up to their own reservation premium . . . .^[23]

The fact that this underlying tendency has recently shifted into overdrive—and adopted a more value-destructive form^[24]—isn’t probative of unique avarice among today’s CEOs. They are simply rational actors adapting to an environment rendered more permissive by the weakening of the shareholder litigation “check” that had formerly restrained such behavior.

III. A Billion Here, a Billion There, and Pretty Soon You’re Talking Real Money

Had the average premium to 52-week high remained at historical norms since 2016, target shareholders would have received an additional $116.1 billion in cumulative merger consideration, or an additional $77.4 billion per year on an annualized basis^[25]:

It is important to note that CEO rent-seeking need not necessarily involve an explicit “bribe” or quid pro quo via transaction bonus or continuing employment. For CEOs with relatively substantial CICs, this prospective payout may not require additional “sweeteners” to incentivize the pursuit of a value-destructive sale, at least from the perspective of the disinterested shareholder.

Granted, this temptation to “cash-in” by consummating even a below-fair-value sale might be tempered by the monitoring capabilities of independent members of a respective firm’s board of directors. Unfortunately, there is compelling evidence that even this restraint has been substantially eroded.^[26]

IV. (Re)Defining the “Self-Interested” Transaction: Reasonable Person Test

Considering the accelerating imbalances delineated above, it may be worth re-evaluating the definitional lens of the “self-interested” transaction.

Private equity firm Lone Star’s acquisition of DFC Global could be considered an archetype of the pristine sales process.^[27] In its ruling on the appraisal action which followed the DFC Global sale, the Chancery Court noted, “The deal did not involve the potential conflicts of interest inherent in a management buyout or negotiations to retain existing management—indeed, Lone Star took the opposite approach, replacing most key executives.”^[28] On appeal, the Delaware Supreme Court remarked that “[t]here was no hint of self-interest that compromised the market check.”^[29]

Now, for a moment, consider the lens of DFC Global’s then-CEO—who stood to receive a $17.1 million golden parachute payout,^[30] more than 1,200% his trailing-twelve-month cash compensation,^[31] but only if a sale of the company was consummated. The size of his payout varied little based on the price at which the company was sold—just 21% of the parachute was equity-derived and thus sensitive to transaction price; the remaining 79%, or $13.5 million, consisted of direct cash severance^[32]—but it disappeared entirely if he failed to consummate a sale. He presumably had a prominent role in deciding upon an implicitly evolving reservation price during the pendency of the sales process—which lasted two years^[33] and which could continue only based on the prospect of exceeding that very reservation price.

Would a reasonable person believe this process to have been devoid of self-interest?

Amid weakened shareholder litigation, dipping premia, and ever-larger parachutes, this question should no longer be confined to management buyouts and controlling-shareholder squeeze-outs. Indeed, even the “pristine” might be fair game.

† Portfolio Manager, Burford Capital. Previously, Mr. Schoenfeld was a Portfolio Manager at Driehaus Capital Management, an $8 billion investment firm, where he ran the firm’s appraisal rights strategy, as well as other event-driven investments, including merger arbitrage and shareholder activism. He is a graduate of Columbia University (B.A. 2008) and Harvard Law School (J.D. 2012), where he was a John M. Olin Law & Economics Fellow and Program on Corporate Governance Fellow. Special thanks to Jesse Fried, Dane Professor of Law, Harvard Law School, for many helpful comments and discussions throughout. Please direct additional comments to the author at mschoenfeld@burfordcapital.com. This Article was prepared in Mr. Schoenfeld’s personal capacity and does not represent the views of Burford Capital.

[1] Guhan Subramanian, Using the Deal Price for Determining “Fair Value” in Appraisal Proceedings (February 6, 2017 draft), in The Corporate Contract in Changing Times: Is the Law Keeping Up? (U. Chi. Press 2017).

[2] ACP Master, Ltd. v. Sprint Corp., Nos. 8508-VCL, 9042-VCL, 2017 Del. Ch. LEXIS 125 (Ch. July 21, 2017).

[3] In re PetSmart, Inc., No. 10782-VCS, 2017 Del. Ch. LEXIS 89 (Ch. May 26, 2017).

[4] Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015).

[5] 506 A.2d 173 (Del. 1986).

[6] 137 A.3d 151 (Del. 2016).

[7] 2016 Del. Ch. LEXIS 155 (Ch. Oct. 12, 2016).

[8] 143 A.3d 727 (Del. Ch. 2016).

[9] Steven M. Haas, The Corwin Effect: Stockholder Approval of M&A Transactions, Harv. L. Sch. F. on Corp. Governance and Fin. Reg. (Feb. 21, 2017), https://corpgov.law.harvard.edu/2017/02/21/the-corwin-effect-stockholder-approval-of-ma-transactions/.

[10] Berton Ashman Jr., Christopher Kelly & Mathew Golden, Appraisal Practice Tips 1 Year After Prepayment Amendment, Law360 (July 31, 2017, 10:44 AM), https://www.law360.com/articles/944765?utm_source=rss&utm_medium=rss&utm_campaign=articles_search.

[11] Id.

[12] Market Data, Bloomberg (Bloomberg Terminal, ‘MA’ Function, select 12-Year Trailing Quarterly U.S. M&A Transaction Data, narrow by Transactions >$1 billion USD), (last searched Aug. 9, 2017).

[13] Trevor Norwitz, A Debate: Is the Appraisal Rights Remedy in Need of Repair?, Remarks at the Delaware Business Law Forum (Nov. 2016) (transcript available at https://www.americanbar.org/publications/blt/2017/01/03_norwitz.html).

[14] Market Data, Bloomberg (Bloomberg Terminal, ‘MA’ Function, select 12-Year Trailing U.S. M&A Transaction Data, narrow by Transactions >$1 billion USD) (last searched Aug. 9, 2017).

[15] Id.

[16] Id.

[17] Id.

[18] See Albert H. Choi and Eric L. Talley, Appraising the “Merger Price” Appraisal Rule (Va. L. and Econ. Research Paper No. 2017-01, 2017), https://ssrn.com/abstract=2888420.

[19] ISS, Advisory Votes on Golden Parachutes (Aug. 9, 2017) (on file with author).

[20] Id.

[21] See Bloomberg, supra note 12.

[22] Id.

[23] Eliezer M. Fich, Anh L. Tran & Ralph A. Walkling, On the Importance of Golden Parachutes, 48 J. of Fin. and Quantitative Analysis 1717, 1719–20 (2013).

[24] Fich et al. found that the increased implied probability of completion engendered by increased relative parachute importance roughly offset the decline in premium, on a net basis, from the standpoint of target shareholders on an ex ante “unaffected” price basis. Id. Two key differences today, among others, are: 1) T-1 premiums have dipped substantially, decreasing the probability-adjusted expected value of completion, assuming T-1 to be “unaffected,” and 2) Premium to 52-week high data has dipped even more markedly, undermining the credibility of T-1 as a genuine proxy for “unaffected.” Id.

[25] See Bloomberg, supra note 12 (calculating the product of average premium differential of 2010 to 2015 vs. 2016 to 1H 2017, and volume of M&A subset during latter period).

[26] A recent study finds that boards’ monitoring capabilities may have been eroded by attempts to strengthen them in the aftermath of Sarbanes-Oxley. See Michelle L. Zorn, Christine Shropshire, John A. Martin, James G. Combs, & David J. Ketchen, Jr., Home Alone: The Effects of Lone-Insider Boards on CEO Pay, Financial Misconduct, and Firm Performance, Strategic Mgmt. J. (2017). To summarize some of the study’s key points: One of the tenets of post-Sarbanes effort was pressuring companies to jettison insiders from the boardroom and replace them with independent directors. As a result, most companies in the S&P 1500 are now overseen by “lone-insider” boards, in which the CEO is the only executive director. Lone-insider boards hamper the monitoring capabilities of independent board members by a) restricting their access to critical information given that the lone-insider CEO is generally their only well-informed source and such dissemination is implicitly tainted by self-interest, and b) limiting their ability to find viable internal CEO succession options. The result of this diminished oversight is rent-seeking and underperformance: Per the study, Lone-insider CEOs are paid 81% more than their non-lone-insider peers while “firms with lone-insider boards have net incomes approximately $54 million less, on average, than non-lone-insider firms, given the mean net income of $544 million in [the] sample.” Id. As it relates to the subject matter at hand, it seems quixotic to believe that the same rent-seeking and value destruction doesn’t extend itself to M&A when these same firms put themselves up for sale. Nearly three-quarters of the companies that sold themselves in 1H 2017 were overseen by “lone-insider” CEOs. In fact, a prospective sale is likely far more challenging from an oversight perspective. To check prospectively perverse incentives engendered by CICs, setting a reservation price ex ante is crucial. But any such ex ante valuation would stem directly from financial forecasts crafted by the “lone-insider” CEO. Given the CEO’s considerably deeper knowledge of the business, it is difficult for independent directors to credibly challenge such projections. Furthermore, the CEO maintains considerable optionality to revise such forecasts downward during the pendency of the sales process to justify a lower reservation price, ex post, if needed, given such revisions will be equally inscrutable.

[27] In re Appraisal of DFC Glob. Corp., 2016 WL 3753123, at *21 (Del. Ch. 2016).

[28] Id.

[29] DFC Glob. Corp. v. Muirfield Value Partners, L.P., 2017 WL 3261190, at *1 (Del. 2017).

[30] DFC Glob. Corp., Merger Proxy Statement (Form DEFM14A) (May 1, 2014).

[31] DFC Glob. Corp., Proxy Statement (Form DEF 14A) (Oct. 7, 2013).

[32] See Merger Proxy Statement, supra note 30.

[33] Id.

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June 3, 2017 By ehansen

When the IRS Prefers Not to: Why Disparate Regulatory Approaches to Similar Derivative Transactions Hurts Tax Law

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^{Leon Dalezman and Philip Lenertz†}

This Article examines decisions made by the Internal Revenue Service on whether to promulgate regulations pursuant to three different but related provisions of the Internal Revenue Code: sections 1259, 1260, and 871(m). This Article concludes that when there is a statutory imperative to regulate, the use of softer methods—methods other than issuing new regulations, such as creating listed transactions—has a negative effect on tax law, slowing its evolution. Further, this Article suggests that this detriment is not outweighed by the positive effect of issuing regulations—chilling aggressive transactions in the short term. While clear regulatory lines almost always invite new forms of tax planning, this Article argues that this is better than a regime where legitimate tax planners are unfairly faced with uncertainty and where enforcement against egregious abuse is often less than forthcoming.

I. Introduction

The evolution of tax law occurs in starts and fits. While Congress, the Internal Revenue Service (IRS), and the courts all play a role, the private tax bar is pivotal in pushing the boundaries and spurring legal change, even more so than in many other areas of law. When new transactions emerge, the law adapts to counter tax planning that it views as overly aggressive. Many have lamented the fact that the IRS is outgunned,^[1] and that the traditional methods of regulating have sometimes given way to using uncertainty as a weapon,^[2] enlisting third parties to validate and report information,^[3] relying on non-tax legal friction to chill private tax innovation,^[4] and even adopting pro-taxpayer “customary deviations” from statutory imperatives when the task of enforcement seems unattainable.^[5]

Another soft-regulation tactic used by the IRS is creating listed transactions. Listed transactions are expressly authorized by the Internal Revenue Code (Code).^[6] Once a transaction is listed, taxpayers and tax planners face penalties if they do not report the transactions promptly to the IRS.^[7] Through notices that announce new listed transactions, the IRS can create uncertainty by requiring information reporting, which slows aggressive behavior without running the risk of bringing an action and creating bad precedent if it lost in court. As long as the lines remain obfuscated and there are information reporting requirements, the full negative effects of a listed tax strategy on revenue never materialize since most taxpayers will not engage in the practice once it is listed. While there is merit to this IRS strategy, it does come with a downside. Having fewer regulations and fewer actions brought under these regulations slows the pace at which the courts interact with the tax law, which leads to an overall slowing of the tax law’s evolution.

Some of the most important and complicated statutory provisions of the modern Code were created in direct response to court decisions, often overturning decisions where the result led to a bad policy.^[8] In other cases, the Code and the regulations have incorporated court decisions.^[9] These clarifications and changes to the tax law are then cited later by courts, leading to a beneficial cycle where effort from all three branches of government contribute to a robust and meaningful tax law.

However, there are also disadvantages to regulating. The promulgation of regulations by the IRS is often met with aggressive tax planners’ attempts to get around the new regulation.^[10] In fact, it was this fear that caused the IRS in 1983 to withdraw regulations that were proposed under § 385^[11] that provided a much-needed distinction between debt and equity.^[12] Despite the fact that § 385 was enacted in 1969 and called for the U.S. Department of the Treasury (Treasury) to proscribe such regulations as may be necessary to determine whether an interest in a corporation is to be treated as stock or debt,^[13] the IRS subsequently withdrew them on the grounds that the proposed regulations were too vague and opened up the possibility of taxpayer manipulation.^[14] Instead, for nearly fifty years since its enactment, the debt-equity distinction was shaped through case law.^[15] It was not until 2016 that the Treasury finally issued final regulations under § 385 that were more narrowly tailored to target specific taxpayer behavior, notably inversions and earnings stripping.^[16] Given this background, it is no wonder that the IRS sometimes shies away from regulating in favor of a softer approach to stopping aggressive planning.

However, when regulation is expressly called for by statute, the failure of the IRS to provide regulation can lead to taxpayer confusion and abusive transactions.^[17] This happened with § 385, and more recently, with two statutory provisions dealing with derivatives. These two provisions provide even more apt examples. The constructive sale rules of § 1259 and the constructive ownership rules of § 1260 are among those containing a statutory demand for clarifying regulations.^[18] This is noteworthy because, despite these demands, regulations have not been issued for either provision even as taxpayer abuses have been ongoing. Conversely, the dividend equivalent amount statute, § 871(m), is also concerned with the use of derivatives to avoid taxation, but it contains no similar call for regulation.^[19] However, detailed regulations have been issued for § 871(m) in response to very similar taxpayer behavior as in the §§ 1259 and 1260 contexts.^[20]

This Article examines these three statutory provisions—§§ 871(m), 1259, and 1260—in detail, and concludes that additional regulation is more fair to legitimate tax planners, better at policing aggressive tax avoidance transactions, and more beneficial to the evolution of tax law.

II. The IRS’s Failure to Heed Section 1260’s Call to Regulate Led to Hedge Fund Abuses

The IRS’s response to “basket options” and the failure of § 1260 to evolve provide examples of how government inaction creates uncertainty, which, in the case of § 1260, directly led to the loss of over six billion dollars in tax revenue.^[21] Congress enacted § 1260 in the 1990s in response to investors’ attempts “to use derivatives, including options on hedge funds, to convert short-term trading profits into long-term capital gains subject to a lower tax rate.”^[22] Section 1260 attacked these derivative-trading transactions by considering the owner of the derivative to be the “constructive owner” of the underlying security.^[23] However, while this provision demonstrated congressional intent to stop the abusive use of derivatives,^[24] including options, its subprovisions were drawn narrowly to stop the problematic tax schemes then under scrutiny and have not since been expanded by regulation to capture similarly abusive structures despite being statutorily authorized to do so.^[25]

An example of such a transaction that failed to fall within the grasp of § 1260 is the “basket option” transaction. In a basic basket option structure, a hedge fund client enters into a contract with a bank to purchase an option on the performance of an unspecified basket of assets placed in a designated account.^[26] The referenced account and all the securities are held in the name of the bank. The hedge fund provides a small percentage of the funds (for example, ten percent) to purchase the securities in the form of a premium on the option, and the bank provides the rest of the funds, with the hedge fund paying the bank fees for that amount. Despite the bank controlling the designated account, in most cases the bank appoints someone related to the hedge fund as an investment advisor who makes all the trading decisions. As a way for the bank to protect its downside, most of these option contracts contain a “knockout” provision, whereby if the designated account loses more than the amount of the hedge fund’s premium, the option contract would terminate. In most cases after a year, assuming the option did not terminate, the hedge fund will exercise its option at a strike price of the initial value of the securities in the basket and in return receive a cash settlement equal to the greater of zero or the reimbursement of the premium plus basket gain or less basket loss. The result of these transactions is to turn what would be short-term capital gains, due to the frequent trades the designated account engaged in, into long-term capital gains in the form of the gain from the option contract.

Given that this transaction does not fall cleanly within § 1260, the Treasury tried to police this behavior through non-binding notices and memoranda. In 2010, the IRS issued a General Legal Advice Memoranda (GLAM) arguing that the hedge fund taxpayer should be considered to “constructively own” the underlying securities.^[27] In 2015, the IRS issued a notice stating that basket option transactions are to be considered listed transactions and thus subject to reporting requirements.^[28] However, this proved to be ineffective^[29] since GLAMs are non-binding and the notice as written seems to allow taxpayers to structure transactions in a manner that avoids the narrow confines of the listed transaction as described.^[30]

The government’s final method of dealing with this type of transaction was to initiate a Senate investigation that culminated with the U.S. Senate Permanent Subcommittee on Investigations and the Committee on Homeland Security and Governmental Affairs issuing a report recommending that the IRS collect additional taxes from two hedge funds that engaged in transactions involving basket option structures.^[31] In reaching its conclusion, the report relies on § 1260, judicial doctrines such as the substance over form doctrine and the step transaction doctrine, and the 2010 GLAM.^[32]

Despite the fact that the government has devoted substantial resources investigating the two hedge funds and creating the report, and despite the fact that the cited transactions alone cost the government over 6.8 billion dollars of potential tax revenue,^[33] the IRS has not initiated any action against either of these hedge funds. This is likely because the IRS believes it will lose in litigation, given the lack of any clear statutory authority disallowing these transactions, resulting in pro-taxpayer precedent.^[34]

None of the rationales provided in the subcommittee report make it likely that a court would rule in favor of the IRS. As mentioned above, and laid out in the report, § 1260, despite giving the IRS authority to issue regulations on the matter, does not directly cover the case of basket options.^[35] While the GLAM and subcommittee report recharacterize the transaction as one where the hedge fund option holder is bearing all the risk, the reality is that the bank does bear some downside risk if all the money put into the basket by the bank is lost before the bank has the chance to sell the securities in the basket.^[36]

The judicial doctrine of substance over form would also not likely provide the IRS with a winning argument against a hedge fund using basket options. Despite its seemingly straightforward application to basket options, courts often do not rely on substance over form if a transaction seems authorized and there are no regulations disallowing it.^[37]

The net result is that, despite the notices and reports, the government does not have an actual way, short of regulations, to stop aggressive tax planners that are trying to take advantage of the ambiguity. Those that are trying to follow the law are left confused by what is and is not allowed. For example, the confusion surrounding what exactly falls under the “listed transaction” described in the notices causes risk-averse tax planners to be overly cautious. On the other hand, tax planners that have a lot to gain through aggressive tax planning, for example hedge funds, are inclined to take risks knowing well that there is little that the government will do after the fact other than issue a non-binding GLAM or report. Even if it is clear that a particular transaction falls within the description in an IRS notice, a taxpayer can avoid penalties under the regulations if contrary authority creates uncertainty about the viability of the government’s position.^[38] The result is that the current method of inaction by the IRS hurts tax planners trying to follow the law and helps those seeking to avoid it.

III. The IRS’s Failure to Regulate under Section 1259 Left Holes in the Fight Against Constructive Sales and Set Confusing Precedent in the Courts

Section 1259 provides another example of how a law designed to halt the abusive use of derivatives to avoid taxation has suffered from the lack of government clarification after its enactment. Section 1259 requires a taxpayer who has a “constructive sale of an appreciated financial position” to “recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale.”^[39]

This statute was enacted in response to the Estee Lauder short sale against the box transaction where the founder of the company was able to get cash without paying tax by borrowing shares and shorting them while still holding a huge quantity of low basis shares from the founding of the company.^[40] As long as the short remained open, no tax could be levied since the extent of gain or loss on that transaction was uncertain; but what was certain was that however much the short gained or lost, the corresponding long position would cancel it out. This minimization of economic exposure to an asset without tax is now known as a constructive sale. Section 1259(c) describes what specifically qualifies as entering a constructive sale of an appreciated financial position and, like §1260, calls for regulations barring transactions with “substantially the same effect.”^[41] However, despite this, no regulations have yet been prescribed.

Even less guidance has been given for § 1259 than for § 1260. The only major preemptive guidance from the IRS has been revenue ruling 2003-7, which states that a transaction does not count as a constructive sale when, in exchange for payment, a taxpayer agrees to transfer at a fixed date 100 shares of stock if the price per share is under $20, a number of shares worth exactly $2,000 if the price per share is between $20 and $25, and 80 shares if the price per share is greater than $25.^[42] While this provides some guidance, it does not discuss the stock’s price volatility at all, instead relying on legislative history that merely states that “a forward contract that provides for the delivery of an amount of stock that is subject to ‘significant variation’ under the terms of the contract is not within the statutory definition of a forward contract.”^[43]

Both price volatility and the range of prices to which the counterparty has no economic exposure are important to a transaction like this. For example, if the price of the underlying stock in the revenue ruling had been fixed at, for instance, $22.50 for the last 10 years and had never fluctuated more than a dollar either up or down, then the transaction would look a lot more like a constructive sale for a fixed price of $2,000. Even though on paper there was “significant variation,” without examining price volatility such a forward is just as likely to be “for delivery of a substantially fixed amount of property [at] a substantially fixed price.”^[44]

The only other major development concerning how § 1259 is interpreted has been the single notable case where the IRS attempted to stop an end run around these rules, Anschutz v. Commissioner.^[45] In Anschutz, the taxpayer used a Prepaid Variable Forward Contract (PVFC) to receive money in exchange for a promise to deliver a variable number of shares of a corporation’s stock at some time in the future.^[46] By careful financial engineering, the product allowed the taxpayer to bear none of the downside risk below a set threshold while capping his upside exposure at a level only slightly higher.^[47] By limiting the exposure Anschutz had to such a narrow band, this arguably could have been caught by § 1259 had regulations been in effect. Without any, the court held that the transaction was not a constructive sale, relying on revenue ruling 2003-7’s statement that a forward for a variable number of shares between 80 and 100 was not a constructive sale.^[48]

Curiously, the court ruled in favor of the Commissioner overall on the basis of an actual sale theory under § 1001 due to a simultaneous pledge agreement where the counterparty to the PVFC got to control the stock immediately.^[49] While the facts of the case suggest that this was the right result under § 1001, it raises the question of how something could be an actual sale yet fall short of the constructive sale threshold, given that a constructive sale is supposed to be something less than an actual sale. The court may have struggled with this apparent inconsistency too, stating in its opinion that its decision on the constructive sale issue might have come out differently had regulations been issued outlining in more detail what counted as a constructive sale.^[50]

Of course, had the IRS issued regulations beforehand, then tax planners may have side-stepped them in a different way than was attempted in Anschutz. Any time a bright-line rule is advanced, it increases the ability of planners to create transactions that fall just barely on the right side of the line while still getting their desired tax advantages. But the court decision in Anschutz created the same result: now that there is precedent that a certain technique is not a constructive sale, it is more likely to be used by others going forward. Had regulations been in place, the court might have considered the Anschutz transaction a constructive sale. Even if it did not, having both the court opinion and the regulations would make it easier for the legislature to change the law going forward if Congress decides that the transaction should have counted as a constructive sale.

IV. Despite their Imperfections, Regulations Issued under Section 871(m) Provide a Framework that Could Benefit Sections 1260 and 1259

Derivatives have also been used to avoid § 871(m), which provides for a tax on U.S. source dividend equivalent amounts received by nonresidents.^[51] U.S. source dividends themselves are taxed as Fixed, Determinable, Annual, or Periodical (FDAP) income when nonresidents receive them from U.S. sources at a 30% withholding rate.^[52] Prior to § 871(m), however, a nonresident could get the exact same economic payout and avoid withholding on dividends by buying a derivative instead of the stock itself.^[53] Such a derivative would appreciate in line with the stock and give the holder gain equal to the amounts of dividends paid out as well. Then, when the derivative was sold outside the U.S., the gain from sale would be foreign source income, thus avoiding the dividend withholding tax completely.

As with §§ 1259 and 1260, § 871(m) is concerned with the use of derivatives to escape taxation.^[54] What is odd is that despite no statutory language inviting clarifying regulations, in the § 871(m) context the IRS has in fact regulated.^[55] Notably, for the first time in its history, the IRS has used the financial measurement of delta to write rules governing whether or not a transaction is in substance barred by the statute.^[56] However, the problem with these regulations is that they are sometimes unclear, and scholars have questioned the accuracy of the mathematics.^[57] The definition of delta in the regulations is correct, but an extra step appears to be added that could cause distortions in the result.^[58] Nevertheless, with these regulations in place, changes could be made to remedy these problems and improve the manner in which financial engineering of derivatives that too closely mirror the payout of stock ownership is restricted.

Issuing the § 871(m) regulations was sensible, but it raises the question of why the IRS would develop a regulatory tool only in this context and not employ it in others that involve essentially similar uses of derivatives like §§ 1259 and 1260. Here, perhaps the answer is that the IRS chose to regulate instead of creating listed transactions or relying on a revenue ruling because it is harder to get information reporting from nonresidents. Or it could be that § 1259 just addresses a less common situation, so the bottom line effect on revenue might be thought not to justify the time and effort of regulation. In Anschutz, that the taxpayer had just elected to become an S corporation was significant to its motivation, and the taxpayer would have had to pay corporate tax if it recognized any built-in gain on the corporate assets within 10 years after the S corporation election.^[59] But, the benefit of immediate money without taxation on an appreciated asset seems ripe for abuse in all manner of other situations too. And such an explanation does not hold at all for § 1260, which is all that stands in the way of huge tax savings by any hedge fund. It seems therefore that there is nothing special that makes § 871(m) more likely to be avoided by aggressive tax planning.

V. Conclusion

Issuing regulations to improve and clarify the Code wherever it is ambiguous would be a difficult task. There is, of course, an alternate approach: comprehensive tax reform. If many of the current distinctions between formally different but economically similar forms of income or expense were removed, much tax avoidance strategy would no longer be effective.^[60] A mark-to-market regime would also fix many of these problems; although, it would create others.^[61] These approaches, though, require unified action from Congress and a consensus on what the goals of the tax law should be. Unfortunately, such sweeping changes do not seem likely to come any time soon, especially not without intervening events that expose more clearly the weaknesses of the current system.

Thus, clear ex ante regulations are needed; implementing something less, like a general anti-abuse regulation, will have the same effect on taxpayers as any other soft mechanism for stopping abuse in that it will still create uncertainty and still not deter the most aggressive tax planners.^[62] It is possible to point to the problems in the § 871(m) regulations as evidence that when the IRS tries to use its regulatory authority, it is as likely to get things wrong as it is to get them right. But this overlooks the fact that the law can only develop when it is subjected to testing by private-party tax innovation. And even though bad regulations in full view of the legal community like the § 871(m) regulations invite tax planning, having a clear line is still better than the uncertainty prevalent in other areas of tax law such as §§ 1259 and 1260 where legitimate tax planners are potentially at risk of being caught up in an ill-defined net cast someday in the future should the IRS decide to change its approach and bring litigation.

Further, even short of comprehensive congressional tax reform, to amend an existing regulation is easier than to write one from scratch, and blatant mistakes that create loopholes are those most likely to be remedied. This is especially true when Congress has given clear statutory authority to regulate substantially similar transactions. To decline that invitation is counterproductive and leads to courts attempting to craft decisions in the face of terms without definitions, like the court in Anschutz. The IRS’s crutch of relying on other methods such as listed transactions, notices, revenue rulings, and reports hurts everyone due to the lack of guidance. While issuing regulations in response to particular transactions will result in some aggressive tax planners finding new ways to circumvent them, it would at least guarantee a stop to the particular action that caused its implementation, invite legitimate transactions to occur, and allow the legal landscape of tax law to evolve.

† Leon Dalezman and Philip Lenertz are J.D. Candidates at Harvard Law School (2017). The Authors would like to thank Professor Thomas J. Brennan, the Stanley S. Surrey Professor of Law at Harvard Law School, for helpful discussions and commentary while developing the article.

[1] See David M. Schizer, Enlisting the Tax Bar, 59 Tax L. Rev. 331, 334–36 (2006). See generally Alex Raskolnikov, Crime and Punishment in Taxation: Deceit, Deterrence, and the Self-Adjusting Penalty, 106 Colum. L. Rev. 569, 583–84 (2006).

[2] See Leigh Osofsky, The Case Against Strategic Tax Law Uncertainty, 64 Tax L. Rev. 489, 538 (2011).

[3] See Leandra Lederman, Statutory Speed Bumps: The Roles Third Parties Play in Tax Compliance, 60 Stan. L. Rev. 695, 742–43 (2007).

[4] David M. Schizer, Frictions as a Constraint on Tax Planning, 101 Colum. L. Rev. 1312, 1323–24 (2001).

[5] See generally Lawrence Zelenak, Custom and the Rule of Law in the Administration of the Income Tax, 62 Duke L.J. 829 (2012) (suggesting that the IRS’s treatment of frequent flyer miles earned by business travelers is an example of a “customary deviation”).

[6] I.R.C. § 6707A (2012) (prescribing penalties for failure to report listed transactions); Treas. Reg. § 1.6011-4 (2017) (“Requirement of statement disclosing participation in certain transactions by taxpayers”).

[7] I.R.C. § 6707A (2012).

[8] See, e.g., I.R.C. § 311 (2012) (supplanting the holding and subsequent codification of Gen. Utils. & Operating Co. v. Comm’r, 296 U.S. 200 (1935)); I.R.C. § 355(e) (2012) (penalizing specific kinds of spin-off transactions that had been allowed by the courts in Esmark, Inc. & Affiliated Cos. v. Comm’r, 90 T.C. 171 (1988)).

[9] See, e.g., Treas. Reg. § 1.338(h)(10)-1(d)(5) (2017) (incorporating the facts and holding of Kass v. Comm’r, 16 T.C.M. 1035 (1957), into an example of how the continuity of interest doctrine can apply unfavorably to minority shareholders in a reorganization).

[10] See George K. Yin, Getting Serious About Corporate Tax Shelters: Taking a Lesson from History, 54 SMU L. Rev. 209, 215–18 (2001) (referring to the incremental changes in law in response to tax shelters as the “tax avoidance game”).

[11] I.R.C. § 385 (2012).

[12] See 48 Fed. Reg. 50711 (Nov. 3, 1983); see also Jeffrey D. Eicher & Leo N. Hitt, Section 385: Debt by Any Other Name . . ., 65 Tax Notes 1033 (1994); Thomas A. Humphreys et al., Morrison & Foerster, LLP, Proposed IRS Debt-Equity Regulations: Aimed at Post-Inversion “Earnings Stripping,” But May Also Impact Ordinary Related-Party Debt 1–8 (2016), https://media2.mofo.com/documents/160412irsdebtequity
regulations.pdf.

[13] See I.R.C. § 385(b).

[14] See Humphreys et al., supra note 11, at 2.

[15] See Treatment of Certain Interests in Corporations as Stock or Indebtedness, 81 Fed. Reg. 20,912, 20,913–14 (Apr. 8, 2016) (to be codified at 26 C.F.R. pt. 1).

[16] See Trey Whitten et al., The Final and Temporary Section 385 Regulations: Scope and Recharacterization Rule, 44 J. Corp. Tax’n 18, 18–19, 22 (2017).

[17] Courts’ interactions with tax statutes in these circumstances has been quite varied. A test has arisen that distinguishes between when delegation of rulemaking to the IRS concerns “whether” a policy is to be effective for a certain class of taxpayers or if instead the delegation is merely to determine “how” a statutory policy is to be administered. In the former circumstance, judges treat the absence of regulations as a decision that the policy does not apply, since the absence of regulations could plausibly mean that the IRS does not wish the policy to apply. In the latter circumstance, judges generally have leeway to interpret statutes as though hypothetical “phantom” regulations had been issued, while still acknowledging that if the IRS ever issued actual regulations, they might differ from those of the judge. See generally Phillip Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 Tax L. 413 (2003).

[18] See I.R.C. §§ 1259, 1260 (2012).

[19] See I.R.C. § 871(m) (2012).

[20] See 26 C.F.R. § 1.871-15 (2017).

[21] See Majority and Minority Staff of U.S. S. Permanent Subcomm. on Investigations, Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits, at 5, 74 (2014), https://www.hsgac.senate.gov/subcommittees/investigations/hearings/abuse-of-structured-financial-products
_misusing-basket-options-to-avoid-taxes-and-leverage-limits [hereinafter Senate Report].

[22] Id. at 20.

[23] See I.R.C. § 1260(d) (2012).

[24] See H.R. Rep. No. 106-478, at 159–60 (1999) (Conf. Rep.).

[25] See I.R.C. § 1260(d)(1)(D). No regulations have been promulgated under I.R.C. § 1260(d)(1)(D).

[26] See I.R.S. Gen. Couns. Mem. AM2010-005, at 2–3 (Nov. 12, 2010); Senate Report, supra note 21, at 13–16.

[27] See I.R.S. Gen. Couns. Mem. AM2010-005, at 1–2, 10.

[28] See I.R.S. Notice 2015-73, 2015-46 I.R.B. 660; see also I.R.S. Notice 2015-74, 2015-46 I.R.B. 663.

[29] See Senate Report, supra note 21, at 5–6.

[30] See I.R.S. Notice 2015-73, 2015-46 I.R.B. 660; see also I.R.S. Notice 2015-74, 2015-46 I.R.B. 663. A taxpayer can specifically alter the structure of a transaction in order to get around the definition of “discretion” and “designee” by, for example, leasing the trading algorithm software to a separate joint venture created with the bank and hedge fund.

[31] See Senate Report, supra note 21, at 7.

[32] Id. at 20–25.

[33] Id. at 5.

[34] See, e.g., infra text accompanying notes 45–50 (discussing how the Anschutz case led to bad precedent being set).

[35] See Senate Report, supra note 21, at 22.

[36] See id. at 3–4, 42. “Gap risk” refers to the risk borne by the bank where market conditions deteriorate so rapidly that all the premiums paid by the hedge fund are lost and the bank is unable to sell the remaining assets quickly enough to cover losses in excess of the premium.

[37] See, e.g., Summa Holdings, Inc. v. Comm’r, 848 F.3d 779, 782 (6th Cir. 2017) (holding that the substance over form doctrine is inapplicable since “‘[f]orm’ is ‘substance’ when it comes to law”) (emphasis in original); Granite Trust Co. v. United States, 238 F.2d 670, 677–78 (1st Cir. 1956).

[38] See Treas. Reg. § 1.6662-3(b)(2) (2017); Osofsky, supra note 2, at 509.

[39] I.R.C. § 1259 (2012).

[40] Floyd Norris, New Tax Law Takes Aim at Estee Lauder, N.Y. Times (Aug. 6, 1997), http://www.nytimes.com/1997/08/06/business/new-tax-law-takes-aim-at-estee-lauder.html.

[41] See I.R.C. § 1259(c)(1) (“A taxpayer shall be treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person)–(A) enters into a short sale of the same or substantially identical property, (B) enters into an offsetting notional principal contract with respect to the same or substantially identical property, (C) enters into a futures or forward contract to deliver the same or substantially identical property, (D) in the case of an appreciated financial position that is a short sale or a contract described in subparagraph (B) or (C) with respect to any property, acquires the same or substantially identical property, or (E) to the extent prescribed by the Secretary in regulations, enters into 1 or more other transactions (or acquires 1 or more positions) that have substantially the same effect as a transaction described in any of the preceding subparagraphs.”).

[42] Rev. Rul. 2003-7, 2003-1 C.B. 363, 2003-5 I.R.B. 363.

[43] Id. (citing S. Rep. No. 33, at 125–26 (1997)).

[44] S. Rep. No. 105-33, at 125–26 (1997), as reprinted in 1997 U.S.C.C.A.N. 1067, 1205–06.

[45] Anschutz Co. v. Comm’r, 135 T.C. 78 (2010), aff’d, 664 F.3d 313 (10th Cir. 2011).

[46] Id. at 81–82.

[47] Id. at 87.

[48] Id. at 111–13.

[49] Id. at 104.

[50] Id. at 111–12 (“Section 1259 does not define the terms ‘substantially fixed amount of property’ or ‘substantially fixed price[.]’ Section 1259 gives the Secretary two sources of authority for issuing regulations to carry out Congress’ intent—section 1259(c)(1)(E) and (f)–but no regulations have been issued defining either phrase.”).

[51] See Report on Proposed Regulations under Section 871(m), 2014 N.Y. St. Bar Ass’n, Tax Sec. Rep. 1340.

[52] I.R.C. § 871(a)(1) (2012).

[53] See Report on Proposed Regulations under Section 871(m), 2014 N.Y. St. Bar Ass’n, Tax Sec. Rep. 1340.

[54] I.R.C. § 871(m).

[55] Treas. Reg. § 1.871-15 (2017).

[56] Delta measures the degree to which the rate of change in the price of a derivative mirrors the rate of change in the price of the underlying asset it refers to. A delta of 1 means that the price of the derivative and the asset move together in uniformity.

[57] Thomas J. Brennan & Robert L. McDonald, The Problematic Delta Test for Dividend Equivalents, 146 Tax Notes 525 (2015).

[58] Id.

[59] I.R.C. § 1374(a) (2012).

[60] See, e.g., Noel B. Cunningham & Deborah H. Schenk, The Case for a Capital Gains Preference, 48 Tax L. Rev. 319 (1993) (addressing the reasons for the long-term capital gains preference); Michael J. Graetz & Alvin C. Warren, Jr., Integration of Corporate and Shareholder Taxes, 69 Nat’l Tax J. 677 (2016) (proposing a system that would remove many of the distortions caused by the current double taxation of corporate earnings); Matthew T. Schippers, The Debt Versus Equity Debacle: A Proposal for Federal Tax Treatment of Corporate Cash Advances, 64 U. Kan. L. Rev. 527, 570–71 (2015) (discussing the treatment of debt versus equity prior to the 2017 § 385 regulations targeting inversions).

[61] See, e.g., David A. Weisbach, A Partial Mark-to-Market Tax System, 53 Tax L. Rev. 95, 135 (1999).

[62] See Yin, supra note 10, at 210, 230 (arguing that the uncertainty of an anti-abuse rule will likely undermine its ability to be an effective deterrent to corporate tax shelters).

May 16, 2017 By ehansen

Trading in Substitute Securities: Liability Under Rule 10b-5

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Cody Donald¹

I. Introduction

A trade in a substitute security occurs when a trader with inside information, typically an employee, trades—not in the securities of the company that is the subject and source of the information—but in the securities of another company whose stock would be affected if such inside information were to become public. The main piece of academic literature on this topic is Ian Ayres and Joe Bankman’s article, Substitutes for Insider Trading.² This Article builds on that work by providing a more in-depth analysis of liability for insider trading on substitute securities under Rule 10b-5 promulgated under the Securities Exchange Act of 1934.³ In contrast to Ayres and Bankman,⁴ this Article concludes that trading in substitute securities is presumptively illegal under the misappropriation theory pursuant to Rule 10b-5. While Ayres and Bankman argue that a possible-harm standard may apply to trades in substitute securities, such a standard is supported by neither background state law nor federal precedent. Instead, a fiduciary-sourced default rule should apply, which requires only the use of confidential information for private benefit to establish liability. Moreover, even if the possible-harm standard were to apply, most trades in substitute securities could result in a possible harm to the source of the information by way of reputational damage.

II. An Overview of Trading in Substitute Securities

In short, a trade in a substitute security occurs when an insider of one company (“A Corp.”) who has inside information about A Corp., beneficially trades not in the stock of A Corp., but in the stock of another company (“B Corp.”).⁵ This trade is advantaged because the inside information from A Corp. correlates to the performance of the stock of B Corp. There are four main types of companies that are likely to have stock prices that are correlated with any given company’s stock price: that company’s suppliers of goods or services, customers of goods or services, manufacturers or providers of competing goods or services (competitors), and manufacturers or providers of complimentary goods or services (complementors).⁶ Trading in substitute securities may be accomplished directly through the purchase or short sale of stock of a substitute company, indirectly by trading in derivatives of a substitute company, or in indexes of the industry generally.⁷

The direction of correlation between two linked companies is dependent on the type of information. For example, when Kodak entered the instant camera market, the shares of Polaroid, the only extant competitor, fell by 12.7%.⁸ This negative correlation is the expected result of a zero-sum game between substitute products.⁹ However, if Kodak subsequently beat analyst estimates as a result of an increase in general market demand for instant cameras, the share price of both Kodak and Polaroid would also likely increase. This information provided by Kodak would be incorporated into the share price of both companies.¹⁰ Thus, Kodak and Polaroid may also be positively correlated, depending on the nature of the information.

The trading in substitute securities has the potential to achieve high, short-term returns. Ayres and Bankman analyzed a set of hypothetical substitute-security transactions, based on a 1998 Intel earnings announcement and the correlative effect on other companies and the Philadelphia Semiconductor Index.¹¹ A substitute-security trade directly on shares of the index would allow the hypothetical Intel insider (or Intel itself) to achieve a 6.0% to 7.3% two-week return (354.2% to 523.5% annualized).¹² In addition, a hypothetical set of option purchases in correlated companies would have produced a two-week return of 21.1% (14,277.5% annualized).¹³

III. Legality of Trading in Substitute Securities Under Rule 10b-5

A. Employees and Other Insiders

The first and most common¹⁴ form of trading in substitute securities is trading by an employee or other insider of the source of the information. A brief set of scenarios will help guide the analysis in this section:

Scenario 1: X is an employee of A Corp. and is in possession of information indicating that A Corp. is getting ready to manufacture Widget M that directly competes with Widget N manufactured by B Corp. Using that information, X short sells the stock of B Corp. Subsequently, A Corp. announces that it is selling Widget M. The share price of A Corp. climbs while the share price of B Corp. falls. X makes a sizeable profit.

Scenario 2: Same facts as Scenario 1, except X buys the shares of a supplier, C Corp., with which A Corp. currently has a contract and expects to order a significant number of critical components to manufacture Widget M. On announcement, the share price of C Corp. rises significantly.

Scenario 3: Same facts as Scenario 2, except X buys a controlling interest in C Corp.

1. Liability under the Traditional “Equal Access” Theory

Although explicitly overruled,¹⁵ the equal access theory derived from the Securities and Exchange Commission (SEC) administrative action Cady, Roberts & Co.¹⁶ is still useful to determine the theoretical and policy limitations of insider trading liability. While Cady, Roberts was narrowly considering the trading of the stock of the source company,¹⁷ it explicitly required only that there was a “relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose” and “the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing.”¹⁸ The resulting fundamental premise of the theory is that “anyone in possession of material inside information must either disclose it to the investing public, or . . . must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”¹⁹

Applying this theory to each of the scenarios above (and indeed the scenarios detailed below in Part III.B.3 as well), X could be found liable for trading in substitute securities. As a preliminary matter, the information on which the insider trades would be material under prevailing law²⁰: a reasonable investor in either the supplier or the competitor would likely consider information concerning A Corp.’s intention to enter the widgets industry as important in a potential transaction.²¹ Furthermore, X possesses the information only by virtue of his position as an insider and exploits that corporate information to the unfair disadvantage of the holders of the substitute security. Therefore, the failure to disclose the inside information to X’s counterparty would constitute a fraud under the equal access theory of Rule 10b-5.

Of course, the SEC would not be able to resort to this theory today.²² Nevertheless, it shows the potential outer limits of what the SEC may consider is, or should be, a violation of Rule 10b-5. Furthermore, it serves as a guidepost toward which the misappropriation theory appears to be headed.²³

2. Liability under a “Classical” Fiduciary Duty Theory

The fiduciary duty theory originates in Chiarella v. United States.²⁴ In that case, the defendant used information he gleaned from a hostile bidder to trade on the stock of the target firm. After overruling the equal access theory, the Court set a new standard for fraud under Rule 10b-5: “[w]hen an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”²⁵ This duty to disclose must arise “from a relationship of trust and confidence between parties to a transaction.”²⁶

In application to the facts of Scenario 1, it appears likely that X cannot be found liable under the theory announced in Chiarella. There is no relationship between X and B Corp. or between X and the counterparty to the short sale. As such, X has no duty to disclose. The existence of a relationship of trust and confidence between A Corp. and the supplier in Scenarios 2 and 3 appears to invoke the temporary insider doctrine.²⁷ However, in all scenarios, X obtained the confidential information through the fiduciary relationship with his employer, and not from any relationship with the supplier. Therefore, even if the corporate supply contract were to be attributed to X, it was not a breach of any relationship with the supplier to use the distinct corporate information for his own personal benefit.²⁸ Consequently, the doctrine does not provide any additional support for the liability of X in either scenario.

3. Liability under the Misappropriation Theory

In general, “[t]he ‘misappropriation theory’ hold[s] that a person commits fraud ‘in connection with’ a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”²⁹ In United States v. O’Hagan, the lawyer-defendant obtained information pertaining to that company’s tender offer and traded in the securities of the target firm.³⁰ This violated the duties of confidentiality he owed to both his law firm and to the client with whom he was working.³¹

In applying the misappropriation theory to trades in substitute securities, the primary question is whether X’s trading on a competitor’s stock, as in Scenario 1, is a breach of a duty owed by X to the source of the information, namely A Corp. Of course, if X’s employment contract were to explicitly allow or disallow trading in substitute securities, that would govern whether there was misappropriation.³² In the probable likelihood that there is no explicit contract provision,³³ Ayres and Bankman lay out two theories that could govern default law: the fiduciary-sourced default rule and the possible-harm standard.³⁴ In the fiduciary-sourced default rule, the insider can never trade without permission from the source of the information.³⁵ If this rule is applied to these three scenarios, X would be liable for insider trading because he would have a duty to disclose to his employer or to abstain from using the corporate information for private benefit. In contrast, in the possible-harm standard, the insider would be prohibited from trading in substitute securities only when such trades are likely to cause harm to the source of the information.³⁶

However, the possible-harm standard is not supported by background state law on the fiduciary duty of loyalty, whereas the fiduciary-sourced default rule is well supported by precedent.³⁷ Consequently, a fiduciary-sourced default rule should be applied to trading in substitute securities. Since trading in substitute securities necessarily involves the use of inside information for private benefit, it violates the insider’s duty of loyalty and runs afoul of Rule 10b-5. Moreover, even if the possible-harm standard did apply, many cases of trading in substitute securities may result in a possible harm because the corporation could possibly suffer reputational harm in current or future relationships.³⁸ Therefore, trading in substitute securities is presumptively illegal under Rule 10b-5.

i. The Fiduciary-Sourced Default Rule Should Apply

The content of the fiduciary duties under the misappropriation theory of Rule 10b-5 may be derived from three sources of background law: state agency law, state contract law, or federal common law. In each case, the possible-harm standard is not supported and the fiduciary-sourced default rule should be applied in its place.

The possible-harm standard is not supported by state law on the fiduciary duty of loyalty because state law does not require a harm to the principal in order for the agent to be liable. In general, “[a]n agent has a duty not to acquire a material benefit from a third party . . . through the agent’s use of the agent’s position.”³⁹ To recover from the agent, “it is not necessary that the principal show that the agent’s acquisition of a material benefit harmed the principal.”⁴⁰ The lack of a requirement for possible harm also draws support from early state law cases on insider trading: “[i]n equity, when the breach of a confidential relation by an employee is relied on and an accounting for any resulting profits is sought, loss to the corporation need not be charged in the complaint.”⁴¹ Thus, if the fiduciary duties under the misappropriation theory of Rule 10b-5 are derived from state law, there would be no requirement for a possible harm to the source of the confidential information.

Principally, Ayres and Bankman draw support for the possible-harm standard under a contract theory of implied terms: if the parties were to draft a contract, they would likely limit breaches of duty to situations in which the corporation was harmed.⁴² While this supposition may be generally supported from a business perspective, the employer’s and employee’s understanding of the relationship does not control the interpretation of rights and duties of the parties in that relationship.⁴³ Typically, state law fiduciary duties apply by default and the employer-principal must explicitly consent to waive the duty of loyalty of the employee-agent with respect to a specific transaction or class of transactions.⁴⁴ Thus, while employers might be able to waive the duty of loyalty conflict prospectively, where the employment contract is silent on the issue of trading in substitute securities, state law on fiduciary duties would apply. Since such state law does not require a possible harm to the principal, it seems probable that a court would not ordinarily imply consent to use or disclose information for personal benefit where no harm to the principal would result.

The final source of fiduciary duties under the misappropriation theory is from federal case law itself. Significantly, given that recent cases are generally silent on the source of the law governing such duties,⁴⁵ perhaps the duty on which all insider trading is now based is not derivative of any state law claim but exists as an independent duty under federal common law.⁴⁶ With respect to trading in substitute securities, it is notable that the primary cases involving misappropriation concern tender offers or other similar transactions.⁴⁷ In these cases, such a trade risks an increase in the market price of the target firm, which directly harms the attempted acquisition or damages an outside firm’s reputation by breaching confidentiality.⁴⁸

However, in O’Hagan, the Court implicitly suggested that the fraud was completed with the harm on the counter-party to the transaction, irrespective of the harm to the source of the information:

The securities transaction and the breach of duty thus coincide. This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. [See Barbara B. Aldave, Misappropriation: A General Theory of Liability for Trading on Nonpublic Information, 13 Hofstra L. Rev. 101, 120 (1984) (“A fraud or deceit can be practiced on one person, with resultant harm to another person or group of persons . . . .”).] A misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception; he deceives the source of the information and simultaneously harms members of the investing public.⁴⁹

This suggests that the misappropriation theory requires only a breach of the duty of confidentiality and that whether harm is done to the source of the information is irrelevant.⁵⁰ Therefore, the possible-harm standard is not applicable, and mere disclosure for a private benefit suffices—the fiduciary-sourced default.

Additionally, the case law regarding tippee liability supports the federal common law theory that does not require possible harm. In particular, the Supreme Court has defined an insider’s breach of duty as requiring only the disclosure of confidential corporate information for a personal benefit.⁵¹ It follows that if disclosing information for personal benefit would constitute an insider’s breach, then the insider directly using that inside information for a personal benefit would likewise constitute a breach of the insider’s duties.⁵² Such a duty does not, or at least does not explicitly, address the question of harm to the company and therefore would support the fiduciary-sourced default rule.

Overall, while the possible-harm standard may be a rational and justifiable private standard to limit the application of the misappropriation theory to trades in substitute securities, the standard appears to have weak justification in current case law on Rule 10b-5 as well as in agency law generally. Consequently, the fiduciary-sourced default rule is more likely to be applied to trading in substitute securities, and thus, under the misappropriation theory, an insider must always abstain from trading in substitute securities unless he discloses the matter to the source of the information. At least in this context, it appears that the conception of Rule 10b-5 liability has largely returned to the equal access theory—albeit that the target of the disclosure may not be a party to the transaction.

ii. Trading in Substitute Securities May Cause Possible Harm to the Source of the Information

While the possible-harm standard is not supported by state or federal law, if it did apply to trading in substitute securities, it is feasible that every trade in substitute securities could result in a possible harm to the source of the information. In application to the scenarios laid out above, it appears likely that the corporation suffered no immediate or direct harm in Scenario 1, because A Corp. has no direct relationship with the party harmed by the trading in substitute securities. On the other hand, if the possible harm were reputational damage from the breach of confidentiality as indicated by Ayers and Bankman,⁵³ then the similar breach of confidentiality by X in Scenario 1 would violate the possible-harm standard to the extent that it affected any future relationships with A Corp. It appears likely that at least in some circumstances, the mere private use of corporate information, even when trading in a completely unrelated company, may cause enough of a reputational damage that customers or suppliers would only be willing to engage with the source on less favorable terms. Essentially, A Corp. would be required to buy insurance against the possibility that its insiders would again use inside information to the detriment of shareholders. As much as a car accident will increase car insurance rates, incidences of trading in substitute securities will raise insider trading insurance rates. Since a literal reading of a possible-harm standard would include all possibilities, no matter how remote, and the trading in substitute securities could raise costs for the source of the information, the insider could be liable in Scenario 1 for trading in substitute securities.⁵⁴

In Scenario 2, there is a much higher risk that the transaction would affect the relationship between A Corp. and C Corp. There, the previous owners of C Corp. suffer a definitive harm, just as the previous owners of B Corp. suffered a definitive harm in Scenario 1. Unlike in Scenario 1, in Scenario 2, A Corp. and C Corp. have an ongoing relationship. Therefore, the possibility of reputational damage affecting relations, as discussed in application to Scenario 1, is likely to be less remote and hence has a higher risk of immediate harm. Moreover, there might be a retaliatory element as C Corp. may seek to directly recover or inflict harm on A Corp.

Scenario 3 presents a clearer example of a situation in which A Corp. is likely harmed by the trade in substitute securities, as the transaction more clearly seems to be a conversion of the corporate information, and the relationship between A Corp. and C Corp. is likely to be substantially altered, if not impaired. The reputational harms, as discussed in the application to Scenarios 1 and 2, are also possible in this case because X would not immediately control the board of C Corp., which might decide to alter relations with A Corp., possibly to A Corp.’s detriment. Moreover, X might subsequently use his inside knowledge to direct changes in the relationship between A Corp. and C Corp., which have at least the potential to harm A Corp. This is especially true where A Corp.’s information indicates reliance on C Corp. and C Corp.’s market power, or when, by virtue of X’s control, C Corp. waits to sign a long-term supply contract until after the product’s announcement. However, an issue with this directive theory is whether the fraud is “in connection with the purchase or sale of any security.” In Chadbourne & Parke LLP v. Troice, the Court stated, “[a] fraudulent misrepresentation or omission is not made ‘in connection with’ such a ‘purchase or sale of a covered security’ unless it is material to a decision by one or more individuals (other than the fraudster) to buy or to sell a ‘covered security.’”⁵⁵ Arguably, the harm in directing the company could be considered disconnected from the omission in the securities transaction. However, the prior owners would not have sold had they known the information that X possessed. At the time of sale there was at least a possibility that X would exploit the information on which the transaction was based to garner additional profits. Thus, by a possible-harm standard, it appears probable that X would breach his fiduciary duties to A Corp. by purchasing C Corp. stock when, at the time of sale, the exploited information could subsequently cause harm to A Corp.

Additionally, Scenario 3 may present a breach of duty under the doctrine of corporate opportunity.⁵⁶ However, the reach of corporate opportunity will likely be limited to situations in which companies have a practice of trading in stock substitutes.⁵⁷ Nevertheless, in such a case, the expropriation of a corporate opportunity could potentially serve as the basis of 10b-5 liability under the possible-harm standard, where the company is so engaged.

While the possible-harm standard likely would not govern trades in substitute securities, in each of the scenarios analyzed here, some possible harm is at least conceivable. Thus, even under the possible-harm standard, trading in substitute securities is presumptively illegal.

B. Tippees of Inside Information

Even in cases in which there is a transaction where the trader of securities is not an insider but received the inside information as a tippee, there still should be liability under the misappropriation theory. The formative case on tippee liability is Dirks v. SEC,⁵⁸ which held that a tippee is liable under 10b-5 when the tipper breaches his duty by disclosing information for personal benefit and the tippee knows or should know of the tipper’s breach.⁵⁹ Two scenarios will guide the analysis here:

Scenario 4: The same general facts as Scenario 1, but X sells to Outsider Y the information that A Corp. is going to manufacture Widget M. Y then short sells the stock of B Corp. and makes a tidy profit.

Scenario 5: Like Scenario 4, but X sells to Y his advice that Y should short sell the stock of B Corp. without giving any information about why he believes that is a profitable investment.

In Scenario 4, X breached a duty to his employer by directly disclosing confidential information for personal benefit.⁶⁰ It can be inferred that Y, in purchasing information, also directly knew that X was breaching his fiduciary duty. The major remaining question is whether Y can avoid liability by trading in substitute securities. While Dirks was decided under the classical theory provided by Chiarella, the Second Circuit has held that the doctrine applies equally under the misappropriation theory.⁶¹ Therefore, Y inherits X’s fiduciary duty to disclose and breaches that duty under the misappropriation theory by trading in substitute securities.

Scenario 5 raises another issue: whether X breached any duty by disclosing, not the insider information directly, but the correlative information itself. Arguably, this is a disclosure of information that is not per se confidential. However, X could be considered to have breached a duty to A Corp. because X misappropriated confidential information for his own personal, private benefit. In addition, while the case was focused on personal benefit, not trades in substitute securities, Salman v. United States⁶² suggests that a tipper cannot do by tipping what he could not do directly.⁶³ Therefore, so long as Y understands that X is still breaching a duty to A Corp. by disclosing the proposed substitute trade, Y would be liable.

C. Liability of the Corporation Itself

While the corporation itself may be liable for trading on inside information,⁶⁴ there appears to be no recognized theory on how the corporation, as an outsider, could be liable for trading in substitute securities.⁶⁵ Most importantly, except by contract⁶⁶ or control,⁶⁷ the misappropriation theory would not apply to corporate trading. Given the limited scope for liability and the significant availability of short-term profits, it is surprising that companies do not engage in the practice more frequently.⁶⁸

IV. Conclusion

Trading in substitute securities involves the holder of inside information trading in the securities of a firm that is not the source of the information. This Article concludes that such trading is illegal under Rule 10b-5. Under the misappropriation theory, a trader can violate Rule 10b-5 by breaching a duty to the source of the information. Employees or other insiders with a fiduciary relationship to the source breach their fiduciary duty when they use corporate information for personal gain. Therefore, an insider who uses corporate information to trade in substitute securities for personal gain breaches a duty to corporate source of that information and runs afoul of Rule 10b-5. Correspondingly, a tippee who receives that information from an insider with knowledge of the insider’s breach can inherit the breach and violate Rule 10b-5. However, as a corporation does not owe a duty to itself, it is not subject to enforcement under the misappropriation theory of Rule 10b-5—at least concerning its own information.

Like traditional insider trading, the debate over whether prohibiting trading in substitute securities is economically efficient is largely unresolved.⁶⁹ However, considering that trading in substitute securities is presumptively illegal, as well as the general lack of enforcement actions in this area, the overall costs of trading in substitute securities may not justify diverting scarce resources from the enforcement of other areas of the law. Even if enforcement itself may not be socially efficient, certain policy reforms, such as increased disclosure requirements, may be socially optimal because they generally deter inefficient trading.⁷⁰

Unsated Curiosity

Legislative Purpose of Securities Law

The Prescriptive Provisions

How the Prescriptive Provisions Address Investment Risk

Disclosure

Regulation of Financial Intermediaries

Investment Company Regulation

A New Way to Appreciate Securities Law

The Purchase of Securities in a Recommended Transaction under Rule 506

The Purchase of Publicly-Offered Securities in a Recommended Transaction

I. Introduction

II. Facilitating Equity Funding for Small Companies

III. Venues for Secondary Trading

IV. Regulatory Challenges in Relation to Secondary Markets for Smaller Companies

V. How to Enhance the Integrity of Markets for Smaller Companies

A. Vetting of Companies

B. Disclosure of Substantial Shareholders

C. Liquidity and Market Surveillance

D. Enforcement

VI. Conclusion

[35] Id.

I. Introduction

II. What is a Blockchain?

III. Delaware’s Approach

A. Examples of Corporate Governance Disputes in Recent Delaware Jurisprudence

1. Proxy Voting Errors in Dell

i. Stock Ownership and Voting Right Structure

ii. Mistaken Voting Instructions

2. Ledger Discrepancies in Dole

i. Inconsistent Ledgers

ii. Delayed Settlement and Unrecorded Transfers

B. Delaware’s Response

1. Vice Chancellor Laster’s Criticism of the Current System

2. The Beginnings of Blockchain-Based Governance Mechanisms in Delaware

IV. Challenges to Wide-Scale Adoption

V. Conclusion

I. Introduction

II. An Overview of Trading in Substitute Securities

III. Legality of Trading in Substitute Securities Under Rule 10b-5

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