October 2013 - That's Not Market

SEC Files Fraud Charges Against Wing Chau, One of the CDO Managers Profiled in Michael Lewis’ “The Big Short”

This won’t be good for the Wing chau defamation suit against Michael Lewis.

Some readers may be familiar with “The Big Short: Inside the Doomsday Machine,” Michael Lewis’ chronicle of the run up to the financial meltdown. I strongly recommend it. It is a great read.

In the book, there was a discussion of Wing Chau, who helped create and, in theory, manage some disastrous CDOs. He was not portrayed like the brilliant hedge fund managers who cashed in on the crash of real estate-backed securities. He was portrayed like a fool. For this, he sued Lewis for defamation.

I’m not sure if that case is ongoing or not, but the SEC has weighed in. Verdict: fraud charges against Chau for misleading investors in a CDO and for breach of fiduciary duties.

The SEC’s claims that Chau and his firm, Harding Advisory LLC, compromised their independent judgment as collateral manager to a CDO in favor of a hedge fund firm. The hedge fund, the awesomely named Magnetar Capital LLC, had invested in the equity of the CDO. Merrill Lynch structured and marketed the CDO. Harding was collateral manager for the CDO.

Specifically, the SEC claims that Harding agreed to let the hedge fund help select the subprime mortgage-backed assets underlying the CDO. This was not disclosed to investors.

The SEC claims that the influence of the hedge fund led Harding to select assets that its own credit analysts disfavored. In the tradition of criminal geniuses everywhere, in accepting the bonds, Chau wrote in an e-mail to the head of CDO syndication at Merrill Lynch:

“I never forget my true friends.”

The SEC claims that Chau understood that Magnetar was interested in investing as the equity buyer in CDO transactions, and that Magnetar’s strategy included “hedging” its equity positions in CDOs by betting against the debt issued by the CDOs. Because Magnetar stood to profit if the CDOs failed to perform, Magnetar’s interests were not necessarily aligned with investors in the CDO debt, which depended solely on the CDO performing well.

Internet Sales Tax Law Struck Down In Illinois

Statute providing for Internet sales tax on out of state sales and sales through affiliates struck down in Illinois.

Link: Performance Marketing Association, Inc. v. Hamer (Illinois Supreme Court)

Amazon.com is typically the primary target for state Internet sales tax laws.

Like many states, Illinois desperately wants to collect an Internet sales tax when its citizens buy stuff over the Internet. Generally, a state cannot impose duties to collect taxes on out of state retailers and must rely on people to report their own purchases and pay the sales taxes directly to the state. Good luck with that.

In order to get to the Internet sales, Illinois changed its sales tax law to change the definition of “maintaining a place of business in this state” to include:

“a retailer having a contract with a person located in this State under which the person, for a commission or other consideration based upon the sale of tangible personal property by the retailer, directly or indirectly refers potential customers to the retailer by a link of the person’s Internet website.”

In other words, Illinois can get to Amazon and its sales if someone in Illinois signs up for their affiliate program and includes an Amazon ad on their website.

The performance marketing industry has been fighting these laws across the United States and made it to the Illinois Supreme Court.

The court noted that the statute does not require tax collection by out-of-state retailers who enter into performance marketing contracts with offline and over-the-air broadcasters. As a result, the amended statute is targeted solely at “online” performance marketing.

The plaintiffs argued that the federal Internet Tax Freedom Act (the “ITFA”) preempts the Illinois statute and that the Illinois statute violates the commerce clause of the U.S. Constitution. The ITFA prohibits a state from imposing discriminating taxes on e-commerce. This includes revenue raising measures and the imposition of obligations to collect sales taxes.

The court concluded that the statute uses performance marketing over the Internet as the basis for imposing a use tax collection obligation on an out-of-state retailer. However, national, or international, performance marketing by an out-of-state retailer which appears in print or on over-the-air broadcasting in Illinois will not trigger an Illinois use tax collection obligation. As a result, the statute imposes a discriminatory tax on electronic commerce within the meaning of the ITFA. Accordingly, it is expressly preempted by the ITFA and is therefore void and unenforceable.

Because the court made its decision based on preemption, it did not make a decision based on the alternative argument that the statute violates the commerce clause of the Constitution.

Contracts and the Law – Beer Contracts in Mergers & Acquisitions

Labatt distributor shows why contracts must work with the law and can’t just change it.

Link: Esber Beverage Company v. Labatt USA Operating Company (Ohio Supreme Court)

Every now and then I get a request to draw up an agreement that does not jive with the law. I’ll get suggestions such as, “Just call it something else, like “Consulting Agreement.’” I have to say, “It doesn’t work that way. The contract has to work within the framework of the law. Sorry.”

How is this relevant to anything? Well, because when a manufacturer sell its rights relating to a particular brand of alcohol to a successor, the new owner can terminate any distributor’s franchise without cause. At that point, the new owner’s obligations are notice and compensation.

We learn this because Esber Beverage Company was a long-time distributor of Labatt for InBev. InBev went on to merge with Anheuser-Busch. Because easy is cheap, the U.S. Department of Justice would not allow this merger to proceed without some sort of obstacle. With no consideration at all of the good folks who distribute Labatt, the Justice Department forced the merged company to divest itself of all assets relating to Labatt. A new company backed by private equity firm KPS Capital Partners, L.P. purchased the rights to Labatt and terminated Esber.

Esber sued claiming that the statute only applied when there was no written agreement.

The court didn’t buy it.

Pursuant to the statute, every manufacturer of alcoholic beverages must offer its distributors a written franchise agreement specifying the rights and duties of each party. If the parties do not enter a written franchise agreement, a franchise relationship will arise as a matter of law when a distributor distributes products for 90 days or more. So far so good.

The statute also sets forth how to cancel or terminate a franchise. There are three situations:

With prior consent and 60 days’ notice
With “just cause,” and the statutes explains what this means.

In addition, in either case, the manufacturer must repurchase all of the terminated distributor’s unsold inventory and sales aids.

However, the statute also provides for terminating a franchise when the manufacturer sells a particular brand or product of alcoholic beverage to a successor manufacturer. If a successor manufacturer acquires all or substantially all of the stock or assets of another manufacturer, the successor manufacturer may give written notice of termination, nonrenewal, or renewal of the franchise to a distributor of the acquired product or brand. On termination of the franchise, the successor manufacturer must repurchase the distributor’s inventory and must compensate the distributor for the diminished value of the distributor’s business that is directly related to the sale of the terminated product, including the appraised market value of the distributor’s assets devoted to the sale of the terminated product and the goodwill associated with that product.

This was not enough for Esber, which asserts that the statute does not permit a successor manufacturer to terminate when the successor manufacturer has itself entered into or assumed a written contract with the distributor. The court disagreed and quoted another case for the proposition:

“When a statute’s language is clear and unambiguous, a court must apply it as written.”

It continued:

“The plain language of the statute allows the successor manufacturer to terminate a franchise. The definition of “franchise” includes both written franchise agreements and franchise agreements that have arisen by operation of law.”

As a result, the new owner can terminate Esber and Esber is entitled to compensation. However, the contract does not trump the statute.

SEC Rolls Out Market Structure Website

It is actually a part of their sec.gov website, but it is a new part.

MIDAS Website here.
SEC Press Release here.

The SEC released its new MIDAS site to “promote better understanding of our equity markets and equity market structure through the use of data and analytics.” This is a fancy way of saying that you can make charts of market info that you usually don’t see in traditional stock tickers rolling across your t.v. screen.

I am still combing through it to see what it does and how it can be useful. It seems to provide some very detailed information relating to trading activity. We are not talking about mere buy-sell-bid-ask information for stocks, but information that generates pretty charts purporting to show how the market functions.

It seems aimed at understanding (or providing the premise for going after) the high frequency trading (HFT) crowd and flash crashes.

The SEC believes it will help it to monitor and understand mini-flash crashes, reconstruct market events, and develop a better understanding of long-term trends. To this end, MIDAS collects:

posted orders and quotes on national exchanges;
modifications/cancellations of those orders;
trade executions against those orders; and
off-exchange trade executions.

The SEC’s new website will be making available broadly:

ratios related to the number and volume of orders that are canceled instead of traded;
percentage of on-exchange trades and volume that are not disseminated on the public tape (odd-lot trades);
percentage of on-exchange trades and volume that are the result of hidden orders; and
quarterly distributions analyzing the lifetime of quotes ranging from one millionth of a second to one day.

The website can be used to:

compare and contrast data series according to the type of security, market capitalization, volatility, price, and turnover; and
explore detailed quote-life distributions, and download data series and quote-life distributions.

It is not immediately clear to me how this will be used as a policy-making tool, but you can expect charts generated from MIDAS to be displayed in some very exciting Congressional hearings.

Can Open Market Stock Purchases Resulting In Majority Control Constitute A Breach Of Fiduciary Duty?

How about the board’s granting of the right to engage in those purchases?

Answer: No.

Link: In re Sirius XM Shareholder Litigation

Background

In 2009, Sirius was hurting. Liberty Media was nice enough to provide $530 million for a 40% interest, some board seats and some consent rights. The agreement included a standstill provision preventing Liberty from gaining majority control for three years. Following the standstill period, the agreement prevented Sirius from using a poison pill or charter or bylaw amendment to interfere with additional purchases of Sirius stock by Liberty. The investment and agreement were disclosed publicly.

At the end of the standstill period, Liberty announced it would obtain a controlling position through open market purchases. Sirius opposed it, and even opposed the FCC approval that Liberty would need in order to obtain majority control. However, Liberty was able to get its majority stake.

Plaintiffs sued claiming breach of fiduciary duty on the part of Liberty and the Sirius board of directors.

Fiduciary Duty Claims Against Sirius Board

The court initially noted that the time period for fiduciary duty claims ran from the time of the agreement in 2009, and thus their claims were time barred. The plaintiffs also argued that the board should have instituted a poison pill to prevent Liberty’s additional purchases, the court said this was not the wrongful act. The plaintiff’s complaints arise out of the initial agreement in 2009, and the plaintiffs did not have a good reason for waiting to file a lawsuit. The terms of the deal were fully disclosed in 2009, and the board’s inability to stop Liberty’s purchases were based on the 2009 deal.

Anything the board did that is subject of the plaintiffs’ complaint was based upon 2009 activity and, therefore, the statute of limitations ran from 2009. As the court said, “[u]nder Delaware law, a plaintiff’s cause of action accrues at the moment of the wrongful act – not when the harmful effects of the act are felt – even if the plaintiff is unaware of the wrong.”

Fiduciary Duty Claims Against Liberty

The Plaintiffs also argued that Liberty had a fiduciary duty even if it was a non-controlling shareholder when it initially invested in 2009. This duty of fairness would preclude Liberty from buying additional shares in the open market unless the Sirius board approved the terms.

The court disposed of this claim as well. First, they are time-barred because they were still the product of the arms-length negotiations and deal in 2009 when Liberty was not even a stockholder, much less a controlling stockholder. Second, open market purchases after disclosing the intent to make such purchases do not involve any control over Sirius’ board or misuse of Sirius’ resources by Liberty. There was no allegation of insider trading or an attempt to effect a going private transaction. To the contrary, even the plaintiffs conceded that Liberty’s purchase announcement would result in the market price for the Sirius shares to increase prior to purchase. As a result, what the plaintiffs are really claiming is a repackaging of their opposition to the 2009 deal.

The only real complaint of the plaintiffs is that the board did not institute a poison pill, which was not only prohibited by contract but is not actionable under Delaware law without additional bad acts (recall the Landry’s case, Louisiana Municipal Police Employees’ Retirement System v. Fertitta, 2009 WL 2263406 (Del Ch. July 28, 2009)).

The court finished with its adherence to basic corporation law and contracts:

“There are many situations when corporations enter into contractual arrangements that have important implications for corporate control in conceivable future situations; for example, debt instruments commonly give creditors rights that, if used, may result in their assuming control. The use of such rights to obtain control in the situations specifically contemplated by those contracts does not constitute a fiduciary breach. As this court has explained, even “[a] controlling shareholder is not required to give up legal rights that it clearly possesses; this is certainly so when those legal rights arise in a non-stockholder capacity.””

Domain Misdirected – Now Fixed

I learned yesterday that the domain for this blog was misdirected and attempts to reach it ended up on some random landing page with popup ads.

I contacted HostGator, which hosts this blog as well as the Underdisclosed.com blog and my law firm site, DougBermanLaw.com. The domain was directed to the wrong HostGator server. There is no indication of why, how or when this happened since the site was working fine through last week.

In addition, the DougBermanLaw.com site was down due to a glitch on the HostGator side involving the site builder tools.

Anyway, its fixed now. HostGator customer service did a great job in getting them back up and running.

In the Freelance Economy, you never know what kind of problems you’ll face day-to-day, including IT issues. Get a good service provider.

I Was Quoted In An Article

. . . on the MyCorporation blog regarding LLCs vs. Corporations. I was one of the experts weighing in on this issue.

While it may seem pedestrian to practitioners, considering the amount of ink spilled over this issue, it is an ongoing item of concern for entrepreneurs.

Here is my excellent contribution:

“7. “The short answer is “it depends.” However, I have found that an LLC will often provide more flexibility in terms of division of rights and responsibilities from the default rules in many business entity statutes. There is more flexibility in terms of pass-through tax treatment with LLCs vs. corporations, even with a Subchapter S election.”

– Doug Berman, Corporate Attorney, Law Office of Douglas M. Berman“

Sage advice, indeed.