Empirical Studies and the Shareholder Activism Debate

Wednesday, July 16th, 2014

In the recent Sotheby’s case, the Delaware Court of Chancery permitted the creation of a two-tier defensive poison pill that provided for different treatment of activist and passive acquirers of stock in the art auction house.  At about the same time, Valeant Pharmaceuticals and hedge fund Pershing Square Capital Management made headlines when they teamed up to bid on Allergan Inc., a smaller pharmaceutical company.  Allergan’s board of directors defended against the joint bid by instituting a one-year poison pill.  Pershing Square, run by activist investor Bill Ackman, then filed a lawsuit in Delaware, claiming that the structure of the poison pill may limit the ability of shareholders to call a special meeting.  The lawsuit quickly settled, but the broader story has now been front-page business news for nearly two months.

These two recent corporate dramas have led to many discussions about corporate governance in mainstream news outlets and in the legal blogosphere.  Importantly, these cases come in the midst of a heated stretch in the long-standing debate over corporate governance as it relates to activist shareholders.  These cases have thus provided new fuel for the fire.

The debate over activist shareholders has focused on Williams Act disclosures, short term-ism, poison pills, and other related issues in corporate governance.  Many academics have tended to argue for more shareholder influence over corporate affairs.  As Delaware Chief Justice Leo Strine highlights in a 2014 essay in the Columbia Law Review, however, a fervent reliance on empirical studies to “prove” any position neglects the complexity of the issues at hand.

Empirical studies are extremely valuable to academics, practitioners, and judges, as they ground our thinking and can inspire action.  But the underlying assumptions of any work can threaten its prescience, and the drawbacks of certain empirical studies tend to get lost in the noise of a clamorous debate.  This blog post highlights three fundamental concerns with empiric-based legal storytelling on both sides of the activist debates:

(1) Averages are simplifications;

(2) Outliers require careful treatment; and

(3) “Long” and “short” are relative, malleable terms.

(1)  Averages are simplifications.  By definition, averages are not descriptive with respect to variation across data points (e.g. range, standard deviation, etc.).  Information is lost when experts rely on the “average” impact of any given cause.

A business school professor provided one of my classes with a simple example: A beverage company performs market research to drive the launch of a new tea product.  If 50% of customers ask for hot tea, and the other 50% ask for cold tea, the company should not develop lukewarm tea.  We would expect those sales to be tepid, at best.

The clearest examples of the potential misuse of averages in governance debates are the articles that seek to demonstrate the impact of different governance events on firm value.  For example, a study might find that shareholder value grows on average when activists make proposals.  But such a sample could include several firms with marginal gains in value, and one firm whose reputation – and with it, shareholder value – was destroyed by an activist campaign.

In fact, this problem is demonstrated crisply by one frequently cited study related to the share price impact of 13D filings.  In this study, there was a 14.3% average abnormal return for target firms 12 months after a hedge fund’s 13D filing for an accumulation of 5% or more of a firm’s shares.  But the median firm saw no material gains, and many firms had steeply negative abnormal returns.  As Professor John C. Coffee Jr. describes it, “the target firm stalked by the activist fund faces an outcome that may either be a feast or a famine.”  Such a scenario warrants a nuanced weighing of outsized returns against corporate instability.  Unfortunately, the current debate doesn’t seem to strike that tone.

(2)  Outliers require careful treatment.  Just as means and medians can gloss over nuance, the way research examines (or fails to examine) outliers can also lead to relatively superficial analysis.  Basic statistical methods – and the desire to easily articulate results – often dismiss or otherwise ignore extreme cases as anomalous.

We can define outliers, here, both quantitatively (as in the “feast or famine” example, above) and qualitatively (the Valient-Allergan example represents an outlier in the sense that the activist behaviors are pushing up against legal boundaries).  But when it comes to our legal system, the unusual cases tend to be precisely the ones at the heart of a debate.  People instinctively respond differently to corporate transactions that generate outsized returns for certain shareholders, change the culture and trajectory of family-owned or iconic brands, transform innovative companies into cash cows, or otherwise impact the social and economic landscape in a way that run-of-the-mill M&A deals simple don’t.

Outliers, here, are thus not a mere statistical challenge.  Rather, they may represent the battleground itself.  Most empirical studies do not – or cannot – properly incorporate such quantitatively and qualitatively extreme cases.

(3)  “Long” and “short” are relative, malleable terms.  Short-termism – the concept that some shareholders take a myopic view of company performance – is ever-present as a talking point on all sides of the activist debate.  Harvard Law Professor Lucian Bebchuk has implied that long term can mean anything from two-and-a-half (FN 40) to five years (see generally this 2013 study).  Harvard Business School Professor Robert Pozen recently argued that the “war” on corporate short-termism is misdirected, pointing to oft-cited studies that hedge funds on average hold stocks for one or two years.  Presumably, Pozen thinks that a one- or two-year period is not short-term.  On the other side of the debate, Martin Lipton of Wachtell, Lipton, Rosen, & Katz has also referenced numerous studies with time horizons between two and five years.  But how long is long for securities analysis?

One could argue that the debate is anchored downward because of the presence of high-frequency traders acting on the order of milliseconds.  Compared to holding a stock for fractions of a second, holding an asset for multiple quarters or years appears quite long-term.  At the other extreme, Joe Tsai, co-founder of the Chinese e-commerce giant Alibaba, wrote in a blog post related to Alibaba’s IPO that the firm required a consolidated ownership structure because their goal was to thrive for over one hundred years.

The answer probably lies somewhere between those poles.  Then-Vice Chancellor, now-Delaware Chief Justice, Leo Strine has criticized Lucian Bebchuk’s view of the “long-term” as “myopic” and as “sitcom-length rather than motion-picture-length“ (see FN 40).  It seems intuitive that great firms, which have survived decades of competition, seek strategies that will be accretive over a longer timeframe than one or two or three years.  A pharmaceutical CEO, for example, regularly makes decisions that will not impact customers for upwards of 10 years (i.e. the time it takes for a drug to go from discovery to FDA approval).

Academics might respond, in turn, that for practical purposes it is too difficult to develop airtight quantitative studies over a horizon beyond a few years; there are simply too many variables, too much “noise,” or too many disparate data sets to piece together.  This may be true, but methodological challenges should mean that we treat these studies with a grain of salt, not that we change our normative expectations.

Conclusion

In sum, fresh eyes reveal that high-level debates can overlook basic methodological questions.  Far from a novel concept, we must remember that numbers don’t tell the whole story: quantitative rigor does not obviate human judgment, nor does it capture the ephemeral ways that market events impact society.  The academy, the regulators, and the courts all embrace empirical, quantitative studies because they provide useful evidence.  And yet, there is still an important place for qualitative analysis that affixes values alongside value.

What is the question we are trying to answer?  How does a particular study’s methodology contribute to answering that question?  How does a study’s assumptions strengthen or weaken its explanatory power?   By asking basic questions such as these, we are reminded that transparency is invaluable not only for functioning capital markets, but for constructive scholarship and debate.

Legalized Pot and Banking

Wednesday, April 23rd, 2014

Legalized marijuana sales have turned out to be a boon for the state of Colorado, which now expects to collect $98 million in tax revenue from recreational pot, 40% more than initially expected. Although business is by all accounts booming, cannabis growers and dispensaries are now facing a new challenge: where to put their money when banks won’t take it. Financial institutions are spooked by the possibility of facing federal money laundering charges for taking cash from marijuana related businesses and while the Department of Justice has attempted to reassure them that they won’t be prosecuted for banking legal pot, the banks don’t appear to be budging.

The Obama Administration first outlined its approach to legal, recreational marijuana in an August 2013 memo by Deputy Attorney General James Cole (“the Cole Memo”). The Cole Memo laid out eight points of priority for the DOJ in enforcing marijuana prohibition including preventing sales to minors, preventing marijuana trafficking between states that have legalized the drug and those that have not, and preventing driving under the influence. Noticeably absent from the list of priorities is the prevention of regulated sales in states where marijuana is legal under state law. Furthermore, the memo emphasizes that low-level and localized activity has been and will continue to be left to the states. States that have legalized marijuana under state law are told that the implementation of strong regulatory and enforcement regimes are less likely to draw the interest of federal prosecutors. Although the memo is couched in equivocal language—necessarily, as marijuana remains a Schedule I controlled substance under the Controlled Substances Act—the message is quite clear: if you regulate then you won’t be hassled by the feds.

While the Cole Memo may have given some assurances to cannabis enterprises, it apparently was not enough to convince banks to take deposits or provide other services to legal pot. This inability to access financial services is a critical problem for those in the business of legal marijuana. Some businesses have been forced to shut down entirely. Others have been forced to do business on a cash-only basis and consequently they have to store massive amounts of cash on premises and arm their employees to protect it. This in turn could lead to further problems as one of the Cole Memo’s eight points of priority is “preventing violence and the use of firearms in the cultivation and distribution of marijuana.” It has also led to cries of hypocrisy as the state of Colorado can take its pot money to the bank, while the people paying those taxes are left to do the equivalent of stashing cash under their mattresses.

On February 14th,the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) released guidance in an effort to assuage the concerns of banks about taking money from marijuana-related businesses. Specifically, the memo outlines how financial institutions can provide services to cannabis enterprises while still meeting the requirements of the Bank Secrecy Act. Under the process outlined by FinCEN, banks must do due diligence to determine whether a marijuana-related business is appropriately licensed by the state and that there are no red flags from its operations.

Institutions that provide financial services to a marijuana business are required to file one of three different suspicious activity reports (SARs), because marijuana is illegal under federal law. If the bank believes that the marijuana business does not implicate one of the Cole Memo priorities or violate state law, the bank should file a “Marijuana Limited” SAR as well as periodic continuing activity reports. The SAR contains limited information on the business and indicates that the bank is only filing the SAR because the client is in the marijuana business.

However, if the bank finds, either during initial or continuing due diligence, that a Cole Memo priority is implicated or a violation of state law is taking place, the bank must file a more detailed “Marijuana Priority” SAR. Finally, if the bank feels it needs to terminate the relationship to maintain compliance with anti-money laundering laws, it must file a “Marijuana Termination” SAR. The FinCEN memo lays out a number of “red flags” for banks to distinguish priority SARs.

Read together with the Cole Memo, FinCEN’s guidance can be seen as an assurance to banks that providing services to compliant cannabis enterprises in states where the substance is legal will not result in prosecution. A business that does not implicate the Cole Memo priorities and thus requires only a Marijuana Limited SAR would not, if the DOJ is to be believed, attract the attention of a prosecutor. Therefore, it is understandable why some media outlets reported the FinCEN guidance as the Obama Administration giving banks the go-ahead to accept deposits from marijuana-related businesses. However, as other commenters note, banks remain reluctant to offer services to marijuana-related businesses. The Colorado Bankers Association has stated that, “an act of Congress is the only way to solve this problem,” and that the FinCEN guidance is just a modified reporting system imposing a heavy burden with which “[n]o bank can comply.” The American Bankers Association has similarly stated that banks still face the risk of prosecution.

From a legal standpoint, the bankers are right to be unconvinced about the efficacy of these memos. They are not laws or even regulation and do not carry the same force. By relying on them, banks are placing themselves in the hands of the Department of Justice and trusting in prosecutorial discretion. Furthermore, the DOJ’s priorities may change under the next administration—or even under the current one—once again exposing banks to risk of money laundering charges. Legal marijuana generates about $2.6 billion in sales per year, meaning the market may not be large enough for banks to take a risk by providing services in an uncertain environment.

For those who follow the interplay between global finance and the drug trade, this new reluctance to accept deposits from legal marijuana businesses is a head scratcher. After all, the history of banks taking deposits from drug cartels is well documented. Perhaps banks are on edge due to the record $1.9 billion fine assessed to HSBC for its acceptance of deposits from Mexico’s Sinaloa cartel among other blacklisted organizations. However, this explanation is unpersuasive considering that the fine was a drop in the bucket for a bank with $2.6 trillion in assets. In fact, the relative softness of the fine, contrasted with the harsh penalties that some face for carrying or selling small amounts of drugs, lead at least one commenter to deem it proof that the “Drug War is a Joke.”

Whatever the reason for banks’ reluctance to offer services to cannabis enterprises, it appears that Congressional action will be necessary for legal pot to be a viable business. To that end, in 2013, Colorado representatives Jared Polis and Ed Perlmutter introduced legislation aimed at legitimizing recreational marijuana sales. Polis’ Ending Federal Marijuana Prohibition Act of 2013 is the more ambitious of the two bills. It aims to amend the Controlled Substances Act to eliminate marijuana as a controlled substance and to set up a regulatory framework for marijuana similar to that in place for alcohol. Perlmutter’s Marijuana Businesses Access to Banking Act of 2013 sets a more modest goal of removing criminal liability for banks who provide services to legitimate marijuana-related businesses. Unfortunately for those in the marijuana business, neither bill is likely to pass in the near future.

Legal pot has proven to be a financial boon to the state of Colorado, and given the state’s success in extracting tax revenue from legalization it appears that other states will soon follow suit. For existing marijuana businesses, increasing legalization by states may be the best hope for spurring Congressional action to make financial services accessible to the industry. Without the ability to bank, the legal marijuana experiment may die in its infancy.

CBLR Cited in The Economist!

Friday, April 11th, 2014

Stephen Crimmins’ 2013 CBLR article Insider Trading: Where is the Line? was cited by The Economist this week in an article concerning enforcement agencies’ successes in prosecuting insider trading.  Crimmins’ piece concerns potential enhancements to the SEC and DOJ’s enforcement programs in the face of uncertain standards for liability.  The Economist‘s piece can be accessed here.

Antitrust Implications of the Comcast-Time Warner Cable Merger

Friday, April 11th, 2014

On February 14, Comcast and Time Warner Cable (TWC) announced that they had reached a merger agreement that would allow Comcast to acquire Time Warner Cable for $45.2 billion.  The deal came largely as a surprise, since Time Warner Cable had been the target of a highly public hostile takeover effort by Charter Communications Inc.  The deal between Comcast and Time Warner Cable would bring together the two largest cable providers in the country and form a combined company with approximately 30 million subscribers, nearly 30% of the national market, and a presence in 19 of the 20 largest domestic markets.  As a result, the merger is likely to face careful public interest reviews by the Federal Communications Commission (FCC) and antitrust reviews by either the Department of Justice (DOJ) or the Federal Trade Commission (FTC) as well as by several states.

Critics of the deal cite the potential for a horizontal merger between the top two competitors in the cable industry to ultimately increase the price paid by consumers and to stamp out the innovation that is fostered by a competitive environment.  For example, Senator Al Franken has been one of the most outspoken opponents of the deal, stating that the merger would result in increased prices, decreased competition, and diminished service and innovation.  Similarly, The Economist denounced the deal as creating a fearsome “Goliath” in the cable industry and advocated that the deal should be struck down on antitrust grounds.

In response to these criticisms, Comcast and TWC executives have emphasized that the merger will actually foster increased innovation and better service.  For example, Robert D. Marcus, the CEO of TWC, stated in a letter to his customers that the combined company would be able to innovate faster and create, among other things, “a superior video guide, faster Broadband Internet speeds and even more WiFi access points.”  In addition, David Cohen, Comcast’s Executive Vice President, emphasized that Comcast and Time Warner Cable do not currently overlap in any market, meaning that there will not actually be decreased competition in any specific markets.  Comcast also has stated that it will divest (i.e. stop providing services to) 3 million customers in an attempt to limit the anticompetitive effects of the merger.  The divestment would keep the combined company below 30% of the total market, an amount that regulators used to have as a strict cap until the DC Circuit Court struck down that cap as “arbitrary and capricious” in response to a challenge by Comcast.  Even without the cap, regulators may still see the 30% number as an important benchmark, so this concession could be significant for Comcast.

This merger also raises an additional concern related to the retransmission fees that cable companies must pay to channel programmers in order to distribute their content.  There have been many disputes between cable distributors and programmers over the amount of the retransmission fees; for example, Time Warner Cable recently had a very public debate with CBS over how much to pay as fees.  It stopped airing CBS for a month for 3 million of its customers; the dispute ultimately ended with TWC paying an additional amount per subscriber.  These retransmission fees are often extremely expensive because of the high value of programming, exceeding $3 billion total for pay-TV operators last year.  As a result, the cable companies have a large degree of control over what channels their consumers are able to watch.

These fee disputes could become even more pronounced after the merger because of the increased leverage that a merged Comcast would have with the programmers.  Comcast would then be in the position of being a “monopsony,” i.e., Comcast would be a buyer with disproportionate power.  As a result, consumers may lose out on programming that they desire because of hostile negotiations between Comcast and the programmers.  On the other hand, the larger Comcast may be able to use its increased bargaining power to negotiate for reduced retransmission fees that could be passed down to its consumers.

Perhaps more importantly, there is also a concern about what the merger will mean for Internet services.  A merger would provide the company with more control over broadband networks (approximately 40 percent) and thus provide the company with more power to ask for money from websites and control what content gets through to its customers.  Particularly in conjunction with the DC Circuit striking down the FCC’s Net Neutrality rules, this merger could provide Comcast with the ability to act as a gatekeeper for the Internet and greatly reduce the openness of the Internet.  However, Comcast has stated that it plans to continue its commitment to a policy of treating Internet traffic the same.

Both Comcast and Time Warner Cable believe that the merger will pass the scrutiny from the US regulatory agencies and that the deal will close in late 2014.  In addition, Comcast has employed a large number of well-connected lobbyists to go to Capitol Hill and fight for the deal.  Nonetheless, the many factors that are involved in this merger leave a wide range of perspectives that the regulators may use which will affect whether the merger is successful.  If they view the national market as the relevant analytical point, they may see the company’s nearly 30% market share as detrimental and strike down the deal based on the likely price increases or diminished innovation.  However, they may agree with Comcast’s position that the lack of market overlap is enough to assuage that concern or that the divestment of 3 million customers will leave the company with an acceptable level of national market power.  In addition, the regulators will have to decide whether Comcast’s role as a monopsony is something to fear because of the potential for channels to be withheld or rather something that is beneficial to consumers by preventing excessive network transmission fees.  Lastly, they will have to evaluate whether the increased broadband market share would too negatively impact the openness of the Internet.  Regardless of what happens, the regulators’ decision will have dramatic ramifications for the cable and Internet industries and will surely be hotly debated.

Top Execs Face Criminal and Civil Charges Related to the Collapse of Dewey

Tuesday, April 8th, 2014

Dewey and LeBoeuf, the former prominent New York law firm, has found its name plastered across multiple news outlets once again.  The firm’s former chairman, executive director, chief financial officer, and client relations manager have all been charged by Manhattan District Attorney, Cyrus Vance Jr., in a 106-count indictment alleging, among other things, that each was engaged in a pattern of grand larceny, securities fraud, and falsifying business records. The SEC has also filed its own separate civil suit connected to fraudulent acts surrounding a 2010 $150 million bond offering. Perhaps the most shocking part of the story is that these allegations are all underpinned by a series of emails exchanged among the “higher-ups” at Dewey, among other circumstantial evidence.

Background: The Collapse of Dewey

In 2007, under the direction of former Chairman, Steven Davis, LeBoeuf, Lamb, Greene & MacRae—a profitable midsized firm— was merged with Dewey Ballantine—a less profitable but much better-known firm— in order to create the largest merger of New York law firms in history. Thus, Dewey and LeBoeuf became one of New York’s preeminent law firms with high profile clients across a broad range of industries including Lloyd’s, A.I.G., JPMorgan Chase, Barclays, Dell, and eBay.

However, even with such a broad client base and over 1,100 lawyers around the world, Dewey collapsed and filed for Chapter Eleven Bankruptcy in May 2012. In the face of “The Great Recession,” the firm continued to take on massive debt obligations, including a bond placement of $125 million in 2010, while also accelerating the hiring of high-priced lateral partners in an attempt to bail itself out. Further, Dewey insisted on providing “lavish contracts,” in the face of its declining revenues and mounting debt obligations. Departing from the traditional “Cravath Model” of compensation, Dewey paid exceeding costs for “star” attorneys, such as Ralph Ferrara, who made more than $10 million in 2011, and Morton Pierce, who claimed in 2012 that the firm still owed him $61 million. These unwise attempts at rapid expansion depleted the firm and caused its collapse in 2012.

The Fraudulent Scheme 

In connection to Dewey’s collapse and seemingly reckless financial activity, Manhattan D.A. Cyrus Vance launched an investigation culminating in a 106-count indictment against “Steven Davis, Dewey’s former chairman; Stephen DiCarmine, the firm’s former executive director; Joel Sanders, the former chief financial officer; and Zachary Warren, a former client relations manager.” Specifically, the indictment, prepared after extensive investigation by the FBI and the District Attorney’s office, alleges that the above-mentioned individuals “engaged in a scheme to defraud the firm’s lenders, and later investors, by, among other things, falsely reporting compliance with the cash flow covenants” in 2008 and in future years to avoid credit issues that might harm Dewey’s credit-backed expansion. In attempts to conceal and advance their fraudulent scheme, “the defendants, directly and through others, lied to, withheld information from, and otherwise misled the firm’s auditors and partners, including members of the firm’s Executive Committee.” The massive cover-up involved fraudulent accounting entries, misrepresentations connected to financial statements, and the reclassification of expense and capital on financial statements all in an attempt to hide the truth and deceive creditors and lenders. Additionally, in 2010, Dewey refinanced its debt with a $150 million private placement of securities with insurance companies. To obtain this financing, individuals at the firm, including Davis, DiCarmine, Sanders, among others, misrepresented Dewey’s financial condition to potential investors and lenders. These practices culminated in the theft of around $200 million from 13 insurance companies and 2 financial institutions.

While it has been reported that seven people, whose names have not been publicly disclosed, have already pleaded guilty in the case, according to District Attorney Vance, the lawyers representing Davis, DiCarmine, Sanders, and Warren have either declined to comment on the circumstances surrounding their particular clients or have stated that their clients’ actions “were taken in good faith in an effort to make the firm a success,” and that the charges “reflect a bid by prosecutors to find a ‘scapegoat’ for the law firm’s collapse.” Thus, for the moment, the four “orchestrators” of the alleged scheme are poised to fight the charges.

Email Issue: Ignoring the Cardinal Rule

Perhaps the most interesting aspect of the case is the fact that after a lengthy investigation, some of the most incriminating evidence, and perhaps the basis of most of the allegations, arises from a series of emails sent among Davis, DiCarmine, Sanders, and Warren, among others. It is almost inconceivable that such a prominent law firm could have forgotten one of the most important maxims in today’s corporate legal environment—don’t put anything incriminating into an email. Even new SEC chair Mary Jo White commented on the “shocking” emails sent among the lawyers in the firm, saying that “writing this down, you do not expect it from lawyers.” For the executives of such a renowned law firm to subject their email communications to potential judicial scrutiny following an era in which emails exposed large corporations such as Enron, Hewlett-Packard, and Wal-Mart to millions of dollars in costs related to fines, investigations, and in some cases criminal liability, seems almost unimaginable.

In particular, the investigation into Dewey has turned up emails suggesting that while the firm’s finance executive did not want to “cook the books anymore,” he had still managed to “[come] up with a big one,” in reference to a representation that Dewey had to make to a lender. The District Attorney has also scrutinized another set of emails relating to an auditor of the firm who was recently fired. In the email exchange, Mr. DiCarmine expressly asks “[c]an you find another clueless auditor for next year?” to which another Dewey employee responds “That’s the plan. Worked perfect this year.” However, the defense attorneys continue to insist that the District Attorney’s office is simply looking for a scapegoat and just spinning “inartful emails into crimes.”

However the case turns out, the attorneys and executives at Dewey, a once-prominent law firm, ignored one of the cardinal rules that lawyers often prescribe to their clients: If it may be potentially incriminating, do not put it in writing. This is especially true in the email context where emails often do not exist in one form or even in a single isolated place since they are sent and saved to many different servers, in many different formats, and forwarded through many different recipients. Additionally, communication via email generally tends to be more candid and open and such communications are usually backed up to hard drives. These factors make emails a potentially enduring source of incriminating and candid information, especially when there is no potential attorney client privilege involved to shield a portion of the communications.

The Aereo Case

Friday, April 4th, 2014

Broadcasters have just won their first major victory in their ongoing copyright infringement litigation against online TV provider Aereo. On February 19, Utah District Court Judge Dale Kimball issued a preliminary injunction against Aereo applicable throughout the 10th Circuit’s six-state jurisdiction. The 10th Circuit subsequently declined to stay the injunction, and Aereo shut down in the Denver and Salt Lake City markets on March 8th. This decision is the latest skirmish in a nationwide legal battle that will culminate when the Supreme Court hears Broadcasting Companies v. Aereo on April 22. The injunction disrupts Aereo’s business in the Denver and Salt Lake City markets and halts its plans for expansion until the Supreme Court ruling. Such a clear victory for broadcasters also bears implications for the upcoming Supreme Court case.

Aereo was first launched in New York in 2012 and has since rapidly expanded. Its business model is innovative and flaunts industry norms. Aereo has arrays of thousands of tiny dime-sized antennas in a central location, which pick up publically broadcast television channels. Aereo effectively leases each customer an individual antenna and puts the infrastructure in place for the individual to access it through an online stream. Aereo’s service also includes a cloud-based DVR. When a customer leaves the range that they would normally be able to pick up the signal, Aereo cuts off the stream. The service is currently available in 11 U.S. cities and counting.

Aereo argues that the way its service is set up allows it to operate without paying the broadcast companies that own the copyrighted content the retransmission fees that cable and satellite providers must pay. The nation’s major broadcasters have been trying to shut Aereo down in federal courts since it began streaming, arguing copyright infringement. At the heart of the debate is whether or not Aereo’s service constitutes a “public performance” under the Copyright Act. The issue is one of statutory construction. The Copyright Act defines a public performance as transmitting a performance to the public by any device or process. Aereo argues that all it does is facilitate private performances by enabling each customer to access his or her individual antenna. Broadcast companies argue that transmitting their programs to thousands of paid subscribers over the internet indeed constitutes a public performance.

So far, Aereo has won several major legal battles, but the issue has been relitigated by broadcasters as Aereo expands into new markets. Before this ruling, every court to review Aereo’s case has found it to be non-infringing, including the Second Circuit.  However, competitors offering similar services such as Film On and BarryDriller have faced setbacks in district courts.

The impact of the injunction on Aereo is significant, but not catastrophic. Service to customers in Denver and Salt Lake City is halted for now, and Aereo is losing momentum and revenues until a Supreme Court ruling later this year. Operations in markets outside the 10th Circuit are not impacted. Perhaps the most significant consequence of this decision for Aereo is the ammunition it gives broadcasters going into the Supreme Court. A finding of infringement from the Supreme Court would be disastrous for Aereo as its major competitive advantage lies in not paying fees for the content that its subscribers consume. Strip this advantage away, and Aereo’s set up starts looking like a Rube-Goldberg machine. Furthermore, retransmission fees are determined through private negotiations. Aereo would have very little leverage in these negotiations compared to behemoth cable and satellite television providers. Its price advantage would evaporate and cord-cutters would be stuck choosing between an old-school antenna or paying fees.

The effect of this litigation on broadcasters is a little more unclear. The injunction merely stems the flow of customers to Aereo in six states until the Supreme Court ruling. Perhaps some customers will switch back to cable and start indirectly paying retransmission fees and generating ad revenues. However, Aereo will keep eating away at the fees broadcasters receive from cable and satellite providers as its subscriber base keeps growing in other markets.

Aereo gaining clear victory in the Supreme Court is the most interesting scenario. Aereo has been growing rapidly, not only spreading to new markets but growth in existing markets has been strong enough that it recently ran out of capacity in its New York and Atlanta markets. Presumably, this growth would continue and broadcasters would face a decline in revenue. However, Aereo’s continued existence alone only is only a limited threat to broadcasters. Presumably many people would be unwilling to abandon their cable subscriptions for the benefit of cheaper broadcast television.

The potential doomsday scenario for broadcast networks is that cable and satellite providers will develop their own Aereo-like systems to avoid paying retransmission fees. This has led broadcasters to warn that if Aereo wins this battle, they could be forced to consider reducing the amount of free broadcast television they offer and move more of their programming to cable. In fact, News Corp. has threatened to move Fox to pay-TV if Aereo is allowed to keep operating unchecked by courts.

On the other hand, CBS CEO Leslie Moonves recently told analysts he believes that a victory for Aereo in the Supreme Court would not hurt their profits. All this points to uncertainty regarding the impact a victory for Aereo would have on broadcasters. Any major harm is speculative and would require major cable and satellite TV providers to be permitted to design Aereo-like workarounds for their broadcast channels. So far it seems as if Aereo really is just making it vastly easier for individuals to access and record free over-the-air television for personal use. An Aereo subscriber can tune into their leased mini-antenna through the internet or walk around with rabbit ears attached to their tablet to achieve a similar result. Given the consumer interest in accessing TV in an efficient manner, it seems plausible that the Supreme Court will follow the Second Circuit find in favor of Aereo.

The SEC Goes to Hollywood: The Implications of Securities Regulations for Equity Crowdfunding of Creative Projects

Friday, April 4th, 2014

On March 14, 2014, Warner Bros. will release the Veronica Mars movie for both theater and home viewing.  The film is based on the eponymous television series that the CW cancelled in 2007 after only three seasons, and Kristen Bell returns in the title role as a former teenage detective who has since graduated from our very own Columbia Law School.  Despite its short run, the series had developed a cultlike following, and fans (known as “Marshmallows”) were devastated by its cancelation, especially given the series’ particularly unsatisfying ending.  Six years later, these fans were still so dedicated that more than 87,000 of them pledged a total of $5.7 million to finance the film, shattering Kickstarter records.  This figure is particularly impressive given that producer Rob Thomas set the initial funding goal at $2 million, and this milestone took just ten hours to reach.

Although this enthusiasm indicates Veronica Mars’ potential for box office success, these investors will not see any of the resulting profits.  This is because those backing the project via Kickstarter are not truly “investors”––their payments are really more akin to operating revenue than traditional debt or equity capital.  Rather than investing capital in exchange for a promise of interest payments or a share of profits, those who fund a project through a crowdfunding site like Kickstarter or Indiegogo receive rewards in exchange for their donations.  Project creators like Thomas can harness the varying abilities of the “crowd” of potential backers by offering rewards for a wide range of specified price points.  Donation levels for The Veronica Mars Movie Project ranged from one dollar to $10,000, in exchange for rewards ranging from “eternal gratitude” to a speaking role in the movie.

This project is a prime example of how, where the investment is not made for primarily financial purposes, the rewards-based crowdfunding model can meet the needs of the interested parties.  First, Veronica Mars fans were already emotionally invested, and will ultimately get what they really want––the completed film––while still allowing Warner Bros. to avoid the risk of financing the movie.  Second, obtaining small amounts of funding from a large number of backers allowed Thomas to retain creative control over the project, which fans also wanted.   Third, donors placed a high value on rewards that were comparatively inexpensive to provide.  For example, these Marshmallows donated $3,000 in exchange for appearing as extras in the movie.

From a legal standpoint, the major advantage of the rewards-based model is that investors’ lack of profit expectation means that federal securities laws are not implicated.  But if The Veronica Mars Movie Project and similar undertakings result in commercial success, fans might not be so willing to provide funding without the opportunity to receive a piece of the earnings.  Recently, Zack Braff was criticized for using Kickstarter to fund his film Wish I Was Here even though the film later obtained additional gap financing from Worldview Entertainment and a $2.75 million acquisition fee from Focus Features in exchange for the North American distribution rights.  During the funding period, Thomas mentioned that similar concerns have been raised based on his project’s connection with Warner Bros., which still owns the rights to Veronica Mars and is handling the film’s distribution.

Should backers of future projects demand profit-sharing, their investments would qualify as “securities” under the Securities Act of 1933, meaning that they must either register with the SEC or qualify for an exemption from the registration requirements.  High fixed costs and difficulty in obtaining underwriting services would typically inhibit the ability of entrepreneurs like Braff or Thomas to undertake SEC registration, but Title III of the JOBS Act recently created a registration exemption for certain issuances of crowdfunded investments.  The Act charged the SEC with rulemaking and implementation, and on October 23, 2013, the SEC released nearly 600 pages of proposed rules in Regulation Crowdfunding.  The proposal addressed various issues, including annual restrictions on each individual’s total crowdfunding investment, limits on how much an individual company can raise through crowdfunding, required disclosures in issuers’ offering documents, and rules for crowdfunding intermediaries, which must facilitate each crowdfunding investment.

The comment period ended on February 3, and it is unclear which of these rules will remain in place, and if equity crowdfunding will even be feasible in light of these restrictions.  Under the proposed rules, however, it appears that using equity crowdfunding for a creative project will be largely impractical.  The associated regulatory burden and significant expense seem to defeat the very purpose of an exemption.  Not everyone sees these barriers in a negative light, however.  Critics of the crowdfunding exemption note the high failure rate of venture capital investments and the potential for fraud in crowdfunding (criticisms which, despite its claims of accountability, also currently apply to Kickstarter projects).

Only after the SEC finalizes and enacts these provisions will there be a true test of whether investors and creators of future projects will gravitate toward this new model.  Due to the costs and regulatory requirements that would be involved in transitioning from rewards-based to equity-based transactions, existing sites will likely remain unchanged, and Kickstarter has already announced that it plans to stay out of equity-based crowdfunding.  It may be possible, however, for new crowdfunding participants might develop a cost-effective method for making equity-based crowdfunding.  True to its spirit, the choice of the preferred crowdfunding model will remain in the hands of the crowd.

Despite Groans from Subscribers, Comcast – Time Warner Merger Will Go Through

Friday, April 4th, 2014

Terms of the Deal

For years, Comcast and Time Warner Cable subscribers competed in a game of “Who has it worse?” swapping tales of exorbitant prices, dropped services, missed appointments, and hours spent on the phone to remedy a full spectrum of cable and internet plights. Now, subscribers can truly commiserate together: last month, the two largest television providers in the country (and, incidentally, the two lowest ranked in terms of consumer satisfaction) agreed to Comcast’s mammoth $45.2 billion acquisition of Time Warner Cable.

Under the terms of the deal, Comcast will acquire 100 percent of Time Warner’s 284.9 million shares, with each Time Warner share exchanged for 2.875 shares of Comcast, resulting in a value of approximately $158.82 per share to Time Warner shareholders. After months of pursuit for Time Warner by smaller rival Charter Communications (recently turned hostile after it nominated an entirely new board of directors), Comcast unexpectedly stepped in with terms far superior to Charter’s rejected offer last month of $132.50 per share in a cash and stock deal.

Viewed solely in economic terms, clearly this is a good deal for Comcast, which effectively stands to control nearly 30% of television service across the country, as well as for Time Warner shareholders, who very nearly hit their target share price of $160 per share. But, is it a good deal for the public?

FCC & Justice Dept. Approval

Comcast must receive approval from the Federal Communications Commission (FCC), the U.S. Justice Department, and the Federal Trade Commission (FTC) before the merger can go forward. The FCC may only approve a merger if the public interest is served; if it finds the public interest is harmed, moreover, it may choose to issue narrowly tailored conditions to its approval of the merger. The Justice Department and FTC look at the merger in purely antitrust terms, namely whether a particular merger would “substantially lessen competition.” Though their duties appear to overlap somewhat, the FCC can and has come to different conclusions than the economic analysis conducted by the antitrust agencies.

Yet Comcast does not appear to be worried about its ability to sail through the FCC reviews, particularly due to the relatively painless approval it received for its merger with NBC Universal in 2011. As a condition to the deal, the FCC elicited a commitment by Comcast to provide broader deployment of broadband in low-income communities. Comcast also had to adhere to net neutrality rules, whereby it agreed not to play favorites among websites through manipulation of internet speed, as it did by discriminatorily slowing traffic for BitTorrent in 2007.

Comcast’s Empty Assurances

Anticipating similar requirements in this round of FCC approval, Comcast has touted its Internet Essentials program as the fulfillment of its former NBC merger promise. And despite the fact that the Court of Appeals for the D.C. Circuit recently struck down the FCC’s net neutrality requirements, Comcast is still required to abide by the net neutrality pre-conditions until 2018.

Comcast C.E.O. Brian Roberts has also announced he is prepared to divest 3 million subscribers in order to keep the merged company’s assets just slightly below 30 percent of the U.S.’s total pay-TV market shares. This voluntary divestment serves as another appeasement to the FCC, whose rule proposal to limit market share to no more than 30 percent of the Pay-TV market was struck down by the U.S. Court of Appeals for the D.C. Circuit back in 2009.

Overall, Comcast has preemptively concluded that competition will not be affected by the proposed merger. David L. Cohen, Comcast’s Executive Vice President, stated, “Importantly, the proposed transaction will not reduce competition in any relevant market.  Comcast and Time Warner Cable do not currently compete to serve customers in any zip code in America.” While that may be true, it gives short shrift to the reality of vertical bargaining power in the industry.

Despite all of its assurances, Comcast would reign coast to coast with the addition of Time Warner’s 11 million former New York City, Los Angeles and Dallas customers. And notwithstanding the fact that they “only” hold 29% of the video market share, the real problem is that Comcast would cover an estimated 66% of homes as a result of vertical integration. For example, Comcast (and other cable companies) frequently bundle together internet and television packages. And that presents a problem for maintaining real competition between Comcast and the emerging alternative for cable— subscription video-on-demand services like Netflix, Hulu Plus, and Amazon. When the very company controlling the speed at which Netflix streams its content is a competitor, kickbacks and shakedowns will be a huge issue (at least, in 2018 it will). Comcast’s increased power would also allow it to “make deals with Hollywood that starve its rivals of good or recent content,” according to Columbia Law Professor Tim Wu. If there were genuine competition among internet providers, and subscribers could simply take their business elsewhere if their ISP was deliberately slowing the connection for live streaming websites, this wouldn’t be as much of a problem. The majority of the time, however, the local cable provider is the only source of broadband. And, if this deal goes through, for almost one third of the U.S., that will be Comcast.

A Closer Look

At a superficial level, this deal will pass muster with the FCC, DOJ and FTC, though perhaps not without constraints, as in the NBC merger. Comcast has clearly had a team of lawyers anticipating their concerns regarding public interest and anti-trust issues, and chose to preemptively soothe those worries with a meaningless divestment and a sound-bite about the lack of overlapping zip codes. But if the regulatory agencies have any teeth at all, they would see through the smoke and mirrors Comcast has conjured up and recognize that this deal will severely impact the level of competition in the broadband sector.

Health Coverage of Contraceptives: Corporate America Stays on the Sidelines

Monday, March 10th, 2014

            Can a for-profit corporation deny employee health coverage of contraceptives, to which employees are otherwise entitled under federal law, due to religious objections by the corporation’s owners? On March 25, 2014, the Supreme Court will answer this question when it hears arguments from Hobby Lobby (an arts-and-crafts chain) and Conestoga Wood (a wood manufacturer). These two companies have challenged the Affordable Care Act (“ACA”) requirement that employer health plans cover the full range of Food and Drug Administration–approved contraceptives for employees, arguing that such a provision unconstitutionally violates their religious freedom.

Legal History:

The ACA’s contraception mandate requires companies with over fifty employees to provide insurance, including for contraception, as part of employees’ health care plans. The Obama administration amended the rules several times in an attempt to accommodate religious employers – the final law exempts religious institutions from the requirement and allows companies that self-insure to use a third-party insurance plan to pay for and provide contraceptives. Despite such revisions, though, religious employers across the country maintained that their constitutional rights were threatened.

Whether these employers can deny employees contraceptive coverage hinges on whether corporations can invoke the right of religious freedom guaranteed by the First Amendment and the Religious Freedom Restoration Act, an issue upon which the circuits are currently split. The law provides that the government “shall not substantially burden a person’s exercise of religion” unless that burden is the least restrictive means to further a compelling governmental interest.

The Third Circuit Court of Appeals upheld the contraception mandate in rejecting a challenge by Conestoga Wood, whose owner argued that he should not be required to provide contraceptive coverage to his 950 employees, in part because he views some of the contraception methods at issue as abortifacients. The Third Circuit, in a divided opinion, distinguished Citizens United, which held that corporations enjoy free-speech rights and that political spending is a form of protected speech. The majority explained that while there is “a long history of protecting corporations’ rights to free speech,” there is no analogous history for free exercise of religion. It also explained that finding such a right would “eviscerate the fundamental principle that a corporation is a legally distinct entity from its owners.”

Just weeks earlier, however, a divided Tenth Circuit Court of Appeals sided with Hobby Lobby regarding its constitutional challenge to the contraception mandate. The court held that corporations can be persons entitled to religious rights and upheld an injunction blocking the contraception requirement because it offended the owners’ religious beliefs.

Exploring Corporate America’s Silence

Given the importance of the Supreme Court’s upcoming ruling, one would assume that corporations would weigh in to protect their interests by filing amicus briefs. But despite the fact that over 80 briefs have been filed by parties ranging from members of Congress to women’s rights organizations to scholars and theologians, the response of the corporate world has been virtual silence. Of the 84 briefs filed thus far, there is not a single Fortune 500 company that has weighed in to voice an argument on whether or not corporations are persons that can independently exercise religion.

A brief filed by forty-four law professors – whose expertise is in corporate and securities law and criminal law as applied to corporations – sheds considerable light on this silence. The professors assert that attributing to a corporation the religious identity of its controlling shareholders – which is effectively what Hobby Lobby is urging the Supreme Court to do – contradicts the fundamental principle that a corporation is a legal entity that is separate and distinct from its shareholders. This basic concept forms the foundation of limited liability, a fundamental tenet of corporate law that protects shareholders from liability for corporate debts. Without this “corporate veil,” the very fabric of the U.S. business community would be destroyed (and with it would go entrepreneurialism, investment, and job generation).

The professors also argue that allowing Hobby Lobby and Conestoga Wood to disregard the corporate veil through reverse veil piercing would significantly complicate corporate governance and disrupt the market by allowing corporations to use their religious beliefs to avoid legal obligations and thereby gain distinct advantages over competitors. A ruling in Hobby Lobby’s favor would also breed confusion in corporate law and invite costly litigation.

Given the above arguments, it is not surprising that corporate America has not leapt to Hobby Lobby’s defense. But what is stopping corporations from filing amicus briefs for the other side? One can only speculate, but it appears that companies would be hesitant to come out against corporate personhood – in any form – for fear of laying the foundation for the court to overturn Citizens United, a ruling that has significantly buttressed corporations’ political influence and that corporations would not want to disturb. Additionally, corporations may be fearful of condoning a law that involves contraception because they run the risk of alienating religious customers who may boycott their products or services in response.

Ultimately, the Supreme Court’s ruling on the case – whichever side it supports – will significantly impact the business community. If the court rules against Hobby Lobby, and emphasizes in its opinion that corporations do not enjoy constitutional rights intended to protect individuals, it could reinvigorate attempts to narrow or even overturn the Citizens United holding. If the court sides with Hobby Lobby, it will open the door to other attempts to view the corporation and its owners as one and the same, a situation that taken to the extreme could alter the entire corporate landscape. If this latter scenario does indeed unfold, corporate America may regret its decision to stay on the sidelines.

Exchange-Based Philanthropy: Legal and Practical Implications of a “Non-Profit Nasdaq”

Saturday, March 8th, 2014

Not-for-profit corporations provide an array of beneficial social services in virtually every sector imaginable, but these valuable organizations perpetually face the danger of being underfunded.  In particular, non-profits struggle to convince donors to give sufficient amounts for the organization’s overhead expenses, as result-driven donors feel less passionate about funding an organization’s electricity bill than about helping support those activities that more directly affect a non-profit’s beneficiaries.  Moreover, these organizations have increasingly been the victims of government spending cuts, rendering what has previously been a consistent source of non-profit funding—i.e. support from the federal government—less reliable.  A compounding problem is that, because those who support non-profits are not necessarily informed on the entire landscape and because they want to see their donations succeed, an organization’s name-recognition has more to do with its fundraising prospects than its actual evaluation-based results.

The main avenue through which non-profits receive funding is the grant process.  While this basic process remains absolutely vital to the philanthropic sector, some have wondered whether non-profit fundraising could benefit from the forces of capital markets; as one person put it, “Could there be a Nasdaq for not-for-profits?”  A recent New York Times article by Andrew Ross Sorkin profiled a prominent philanthropist who is pursuing ways to create a stock market for non-profits.

At bottom, the idea is that exchange-based trading in shares of non-profits would produce increased transparency and, in turn, increased efficiency, as the best performing non-profits are rewarded by increased demand for share ownership, thus leaving more money with the best run organizations.  Thus, the argument goes, just as share price accuracy in capital markets leads to efficient (or near-efficient) allocation of resources in the private sector, the same forces would allow for efficient allocation among non-profits.  As Sorkin’s article points out, if just 1 percent of the portfolios of wealthy Americans were diverted to a non-profit market, these valuable organizations would enjoy an additional trillion dollars in funding.

However, several legal implications would pose significant obstacles to a non-profit stock exchange.  For starters, tax-exempt non-profits under 501(c)(3) of the tax code are subject to certain rules that would make the basic functions such an exchange problematic. Notably, the creation of a non-profit stock exchange would presumably require a change in current tax laws, which prohibit tax-exempt organizations from paying dividends to shareholders.  Rather, the organization can only use its profits to cover operating expenses and salaries.  Thus, without a way to pay dividends to its shareholders, non-profits would offer very little trading incentive to the would-be marketplace.

Another challenge would be the fundamental difference between the stakes attached to shares for non-profits, as compared to those of for-profit corporations.  Unlike for-profit corporations, which are charged with maximizing profits for shareholders, the primary goal of a non-profit organization is not to maximize its profit but to achieve some harder-to-quantify social good.  This fundamental difference raises several problems for exchange-based trading of non-profit shares.  First, the nature of social projects undertaken by non-profits makes it difficult to measure results with the same bottom-line precision of profit-based corporations.  This would mean that share prices, which are conventionally based on a company’s predicted future cash flows, would have to be based on some other, harder-to-measure metric, such as the efficiency with which a given organization achieves its stated goal.  Because share price accuracy is tied not only to market efficiency but also to bid/ask spreads, anything that makes it more difficult to price shares will only decrease the trading volume on a given exchange.  Second, if not done carefully, an exchange’s valuation metrics for non-profits could produce perverse incentives, as resources would be diverted to those activities that most directly affected the organization’s share price.  Both of these problems have possible solutions, but they demonstrate the factors at play in creating a market-based funding model for non-profits.

Finally, it is unclear how the SEC would react.  Under the Securities Exchange Act of 1934, the SEC’s purpose is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  However, regulatory efforts to protect investors would seem less important when the investors’ motivation was a charitable one.  On the other hand, just because an investor chooses to place part or all of her portfolio in non-profit shares cannot render protections from security fraud or insider trading meaningless.

Some of these issues—both regulatory and otherwise—might be avoided by learning from other recent efforts to fund socially beneficial projects by leveraging private-sector forces.  In particular, so-called “impact investing” has become a popular field for investment banks—including prominent players at Goldman Sachs.  These “social impact bonds” allow large banks to accomplish a three-fold objective: (1) provide funding to valuable social projects; (2) rebuild Wall Street’s tattered, post-recession image; and (3) maintain the opportunity for a financial return on the initial investment.  Indeed, recent examples have seen Goldman lend up to seven million dollars to several non-profits to fund early childhood education, whereby no public dollars are spent and the bank’s loan is tied to the success of the program.  Any additional savings realized because of the program’s success belong to the city.

If possible, certain aspects of impact investing could shed light on solutions to the problems discussed above with regard to a non-profit stock exchange.  First, valuation metrics would be easier to monitor if tied to discrete projects.  As with Goldman’s loan to education non-profits, shares of non-profit ownership could be project-based.  Such a system would make it easier to measure a program’s success and, in turn, the value of a given share.  For long-term projects, shares of the more successful projects would be traded, thus achieving the resource allocation goals discussed above.  Second, fewer problems would arise with regard to incentives for non-profit managers, as project-based shares would avoid some (admittedly, not all) of the ways to influence share price at the cost of the organization’s larger mission.

Non-profits play an important role in filling in the gaps where government fails to serve its constituents.  Organizations that face inadequate funding will necessarily provide inadequate results.  Any efforts to improve the fundraising landscape for these philanthropic organizations should be welcomed with open arms, especially if those efforts allow for donations to reach non-profits who consistently perform efficiently and effectively.  While a “Nasdaq for non-profits” faces legal and practical obstacles, outside-the-box thinking is exactly what might solve many of the financial problems that prevent these valuable organizations from achieving their goals.  If an exchange-based funding system allows them to do well while doing good, we should not get in the way.