Legal Services for Startups: Toward a Web-Based Form System Business

Tuesday, November 25th, 2014

In a 2013 article, Forbes identified 10 Big Legal Mistakes Made By Startups. These include breakdowns in documentation, ignorance of tax consequences, and choice-of-entity issues. Significantly, the article concludes by naming “not having the right legal counsel” as a serious problem for startup companies. Strapped for cash, startups often hire discounted and inexperienced legal counsel from among friends and relatives. Instead, Forbes advises conscientious startups to research and vet potential counsel, retaining attorneys or law firms that have experience in “some, if not many” of the following areas: contract law, employment law, IP law, real estate law, tax law, franchise law, and corporation, commercial and securities law. Perhaps not surprisingly, Forbes does not suggest that startups hire in-house legal counsel.

In his article How Do Startups Obtain Their Legal Services, Darian Ibrahim explores the reasons why many startups choose outside counsel – like the sophisticated full-service firms recommended by Forbes – instead of bringing legal services in-house. Ibrahim’s empirical survey identifies two reasons why startups favor outside counsel: a) early-stage startups cannot justify the expense of an in-house attorney, and b) outside counsel can offer “more coverage” (i.e. more relevant expertise) than in-house. However, Ibrahim’s study also reveals that a minority of startups do choose to hire in-house counsel, for two main reasons: (a) in-house counsel is perceived to have lower information asymmetries about their business, and (b) in-house counsel often demonstrates greater responsiveness and increased monitoring capabilities.

Beyond the Binary of In-house and Outside Counsel 

Ibrahim’s study was one of the first to examine issues of in-house legal representation in the context of startups. However, framing a startup’s legal options as a binary choice between in-house counsel and outside representation ignores several other options for a startup’s legal support. As Ibrahim notes, most companies that use in-house counsel also retain outside counsel, including full-service firms. Furthermore, the choice between hiring in-house and retaining experienced representation may be inapplicable to the youngest and most vulnerable startups; Ibrahim’s study only examines startups that are backed by at least 5 million dollars in venture capital, a sensible limitation that nonetheless excludes alternatively funded companies and nonprofits. These other entitiesmay be financially unable to retain quality counsel, to say nothing of a salaried in-house attorney. (Although Ibrahim explores the possibility of compensating in-house attorneys with stock options, only 6.3 percent of participating startups used this method of compensation, a method that nonprofit startups lack entirely.)

Furthermore, the most socially conscious among for-profit startupsmay be hit hardest by this binary thinking; while not-for-profits are well positioned to obtain grants and pro bono legal services, social enterprises and other for-profits with social or charitable aims may have less access to these resources. For these reasons, the startup community may benefit greatly from the development of cheaper, more direct access to legal services in the early stages of their organizations.

Alternatives for Legal Service: the Form System   

To this end, the startup community should further explore the use of a kind of legal self-help called the form system. In his article The Legal Spark, 78 UMKC L. Rev. 455 (2009), Jeff Thomas references the proprietary form systems used by Silicon valley law firms to counsel young startups and help them develop into sophisticated organizations. While these form systems are currently proprietary to law firms, Thomas proposes that a hypothetical Foundation acquire and develop one such form system and make it available online. The Foundation would also provide “starting point documents,” teach legal and economic strategies, and provide annotations with background and explanatory content to accompany both the documents other counseling content. Thomas emphasizes that this system would be tailored to a specific kind of organization undergoing a particular series of developments, rather than a “collection of random legal information and forms.” Although Thomas’s proposed system focuses on venture capital-backed startups, it is not difficult to imagine form systems developed for other kinds of startups, such as nonprofits, social enterprises, and sole proprietorships. These systems might be housed by the same hypothetical Foundation or perhaps by separate foundations.

A Web-Based Form System Business 

The vehicle that Thomas proposes to make form systems accessible to startups is his Foundation – presumably a charitable foundation functioning as part of the not-for-profit community. However, it may be easier and more efficient to provide startups with a well-maintained form system through the use of a form system business. A business–perhaps charging a monthly access fee or a fee-per-service –  may be particularly well positioned to efficiently compile, manage and distribute form systems. Since, as Thomas imagines, this information could be made available online, a form system business could provide access to legal advice with low overhead, passing its savings on to struggling startups.

Furthermore, as a web-based service provider, a form system business could be national in scope. This is particularly significant in light of concerns about startup attorneys engaging in rent-seeking. In his article Startup Lawyers at the Outskirts, Abraham J.B. Cable describes a growing perception of startup attorneys as engaged in a distinctive practice that combines legal services with civic engagement and support of local economic development. Although he sees the role of specialized startup lawyers as a positive one, Cable expresses concerns about such lawyers developing rent-seeking cottage industries by trying to recreate the conditions that made them successful in early startup communities like Boston and Sillicon Valley. A national, web-based, form system business could ameliorate this concern by shifting focus from communities of specialized lawyers and relocating it to startups, regardless of location. In addition to providing legal services at lower fees, such a company could employ lawyers for legal support and complex issues, but prevent the enterprise from creating a cottage industry for them.

In sum, a web-based form system business could fill a niche in the legal market for low-cost counseling to startups. Furthermore, it could provide this counseling without incentivizing rent-seeking by attorneys or creating a false dichotomy between in-house and outside counsel.

Occupational Licensing: Protecting the Public or Enriching the Entrenched?

Tuesday, November 25th, 2014

Are you at risk from a rogue interior designer? If requirements to be known as a “Certified Interior Designer” are anything to go by, the State of New York believes you might be. To use that title, New York requires applicants to pay a fee of $377, accrue “at least seven years of acceptable education and experience credits,” and pass a three section test known as the National Council for Interior Design Qualification Examination. Fees for this exam can approach $1000, without factoring in any costs for prep materials.

New York’s law was passed in 1990. At the time, supporters warned that without the law, interior designers would continue to suffer from a “lack of credibility” and the public would be vulnerable to “anyone [who] could go hang a shingle and call themselves an interior designer . . .” New York is not alone. 26 states, plus Puerto Rico and Washington, D.C., have interior design laws, with more legislation introduced each year. New York’s law is a “title act,” governing who is permitted to use the phrase “certified interior designer,” but not preventing those without the title from practicing. Other jurisdictions, including Nevada and Washington, D.C., have gone further still by enacting “practice acts” which require anyone wishing to practice interior design to obtain a license first.

It is not just interior designers. The number of professions requiring licenses has exploded from 5% in 1950 to around 30% today.  Discussion of this surge in occupational licensing can often be fodder for light-hearted pieces, with seemingly obligatory references to retail florists (Louisiana requires a $50 fee and passage of a written exam before one can “arrange and sell floral designs, cut flowers and ornamental plants”) or shampoo specialists (Texas requires 100 hours of study on the “theory and practice” of shampooing), and of course a good bit of that 30%  may be desirable licensing of health care workers and the like.

However, as Sophie Quinton points out in National Journal, other occupational licensing requirements make less sense, and can have serious consequences, particularly when they end up “targeting mostly minority women and their businesses.”

Quinton writes about Salamata Sylla, an African hair braider originally from Senegal who now lives in Kent, Washington. State regulators informed Sylla that in Washington, like in many other states, one seeking to operate an African hair braiding business must obtain a cosmetologist’s license. To get this license, Sylla would have to accrue 1600 hours of education at a community college or trade school and pass an exam.

As the Institute for Justice points out, in many instances these mandatory education requirements for hair braiders can devote little or no time at all to actual hair braiding.  For example, Wyoming requires 1000 hours of education to become a licensed hairstylist but dedicates just 1 percent of that educational time to teaching how to braid hair. Missouri requires 1500 hours of education to become a cosmetologist and defines how 1030 of these hours are to be spent. Not one of the 1030 is devoted to braiding hair. This education, unhelpful as it may be to an aspiring hair braider, does not come cheap. The same IJ report found that cosmetology courses meeting state licensing requirements routinely charge between $10,000 and $20,000. Though the Washington Department of Licensing now cites a miscommunication in Sylla’s case and no longer intends to force her to obtain a license, Sylla intends to maintain her lawsuit challenging the restrictions. Plaintiffs have won similar challenges in seven other states.

Regulations like these, which lock some out of the labor market are not harmful to everyone. Indeed, those already in the club can benefit immensely. A study by Morris M. Kleiner and Alan B. Krueger found that occupational licensing can raise wages by around 15%. This is not necessarily reason to cheer. Kleiner warns that this could actually exacerbate inequality, with the well-off having their choice of higher-cost services, while lower income individuals, some of them immigrants like Sylla, are left with fewer options and higher barriers to entry to break into their chosen fields. Krueger, the former head of President Obama’s Council of Economic Advisers, points out that this is only a small part of the overall problems facing the country, but agrees that occupational licensing is “a bit run amuck”, and that there are “too many restrictions for entry.”

The International Interior Design Association asserts that “[i]t’s easy to see why such regulation is necessary both for public safety and the enrichment of the interior design profession.” Perhaps so, and we ought to be more worried about the wellbeing of the residents of the 24 states currently without interior design laws. Perhaps, however, we should focus more on the second half of that statement, and question just who is being enriched by occupational licensing requirements, and at what cost.

In My Mind and In My Car: How the Alliance of Artists and Recording Companies suit against Ford is using old copyright law to solve new industry problems

Sunday, November 16th, 2014

You cannot teach an old dog new tricks – but you might be able to use old laws to solve new problems. The music industry consistently complains about the lack of profits from new technologies, just look at Taylor Swift’s record label, Big Machine Records recent decision to pull their music off of Spotify for the lack of royalties. Set against this background one organization is using a law from 1992 aimed at a niche area of technology to sue car companies who are earning money off of the American public’s love for music. In July, the Alliance of Artists and Recording Companies (AARC) sued Ford and General Motors in a Washington D.C. District Court for the failure to register devices installed in several models of their cars and pay subsequent royalties under the Audio Home Recording Act of 1992 (AHRA). AARC is represents “featured recording artists and sound recording copyright owners […] in the areas of hometaping [sic]/private copy royalties and rental royalties.AARC was formed specifically to collect and distribute AHRA royalties to featured recording artists and owners of the copyright to sound recordings (mostly record companies).

What is AHRA?

AHRA was reached as a compromise to a two-decade long controversy in Congress over home recording that began in the early 1970s. In 1989 the Congressional Office of Technology Assessment (OTA) explained that, “[t]oday’s consumer electronics allow the average citizen to make very good copies of recorded music. […] home copying is becoming much more common.” John H. Gibbons, Director of the OTA explained that, “Copyright owners are concerned, and claim that home copying displaces sales and undermines the economic viability of their industries.” Furthermore, the OTA study found that 4 in 10 Americans over the age of 10 had tape recorded music in 1988 alone and that, “much of this home audiotaping was for the purpose of copying music from records or compact discs to audiocassettes to be played in the car or in portable cassette players.”

In 1992, AHRA was passed as a way to place financial liability directly on the manufacturers of the devices which are used to do this kind of home recording since it would have been too difficult and cumbersome to try and hold individuals liable for their copyright violations. AHRA “does not broadly prohibit digital serial copying of copyright protected audio recordings. Instead, the Act places restrictions only upon a specific type of recording device,” and how the act defines what devices it applies to is the issue at question in the AARC’s lawsuit.

What is the AARC Lawsuit About?

The basic allegation made by AARC in the complaint they submitted to the court is that General Motors and Ford included devices known variously as the Ford “Jukebox” and the GM “Hard Drive Device (HDD)” in over half a million vehicles, and that these devices fit the definition of a Digital Audio Recording Device (“DARD”) and are therefore subject to AHRA.

The applicability of AHRA is based on a series of nested definitions in the first section of the Act that outlines what kinds of devices are covered by it. AHRA requires royalty payments and registration for all Digital Audio Recording Devices. The act defines a DARD as “any machine or device of a type commonly distributed to individuals for use by individuals, whether or not included with or as part of some other machine or device, the digital recording function of which is designed or marketed for the primary purpose of, and that is capable of, making a digital audio copied recording for private use.” Basically, a device is a DARD if it is marketed or designed for the primary purpose of (and is capable of) making a digital audio copied recording, which is a reproduction of a digital music recording, which is a material object with fixed sounds that are not only spoken words, and in which no computer programs are fixed.  The aim of AHRA was to limit serial, ongoing at home copying. If that capability exists, it strengthens the plaintiffs claim for relief, and if not the connection becomes more tenuous.

Why Should I Care?

Technology entrepreneur Mike Masnick in his blog Techdirt claimed that the effort by the AARC to obtain royalties from car companies is simply an effort by the music industry to avoid, “searching for new business models to make money, but rather … default[ing] to new ways to squeeze money out of others through legal changes or lawsuits.” Masnick is not wrong on all accounts—the AARC lawsuit is indeed an effort to squeeze money out of the car industry and these device manufacturers—but what he ignores is the fact that the money may very well belong to the music industry in the first place. The fact remains that devices like the Ford Jukebox and the GM Hard Drive Device are inherently an effort by car companies to capitalize on their customers’ love of music. By installing these devices in their vehicles, they are acknowledging that car buyers are interested in having music at their fingertips as they drive, while still avoiding the need to keep CDs and other media constantly on hand. Ford and GM include these devices in their cars because they believe consumers want them there and they will pay to have them. However, in 1992 Congress decided that companies making money from exactly these kinds of devices could only do so if they shared some of the wealth with the music industry. Ford and GM are profiting from car owners’ love of music, and if they want to do so they have to pay the required royalties to the artists who create that music.

Where Does This Leave Us?

If Americans value the continued production of music it is vital that our laws protect musicians and their representatives. The AARC’s lawsuit, while not a slam dunk—is grounded in sound legal reasoning. AHRA was an obsolete law almost as soon as it was passed. Copyright law has a hard time keeping up with technological change, and it is often artists who lose out the most. If the AARC lawsuit can use an old law—whose target technology no longer exists—to solve a modern problem, they can and they should.

Ebola: The Legal Implications of an Epidemic

Friday, November 14th, 2014

The outbreak of Ebola has created a tremendous humanitarian crisis with nearly 14,000 confirmed cases and 5,000 deaths, primarily in the West African countries of Guinea, Liberia, and Sierra Leone. With the appearance of cases in the United States, including two healthcare workers who contracted the disease while they were caring for a patient in Dallas, media coverage and public alarm has greatly magnified. While health and humanitarian concerns predominate, the Ebola epidemic has also created significant legal issues—most prominently the legitimacy of enforced quarantine of aid workers who came into contact with the disease and the imposition of travel bans on the most afflicted countries. Although less visible, the outbreak similarly poses crucial legal concerns for businesses in an eclectic array of industries ranging from hospitals to shipping companies.

While businesses have most immediately felt the impact of the Ebola epidemic through swings in stock prices and the risk of social and political unrest in West Africa, industries likely to come into contact with Ebola also must address their potential liability should their employees or consumers contract the disease. According to Reed Smith’s Global Managing Partner, Sandy Thomas, threats like Ebola often spawn complex legal problems. In particular, Ebola may impact several realms in the near future such as employer responsibilities to their employees, employer liability to consumers, and contractual obligations.

For example, given the exposure of two healthcare workers to Ebola while treating a patient at Texas Health Presbyterian Hospital Dallas, there are numerous questions about whether the hospital could face liability if the training, procedures, or equipment utilized were inadequate. Increasing the difficulty of solving these issues, there is no specific mandate requiring employers to protect their employees from Ebola and dictating the consequences employers might face by failing to adequately do so. However, while Ebola-specific legislation is lacking, there is substantial federal regulation of employers and the work environment that may be implicated by the current epidemic. In particular, the Occupational Safety and Health Act (“OSHA”), Family and Medical Leave Act (“FMLA”), and Americans with Disabilities Act (ADA) likely apply to employees contracting the disease in the course of their employment.

Under OSHA, employers are required to furnish their employees with a safe and healthy workplace. While there is no Ebola-specific provision, the Act’s General Duty Clause, codified at 29 U.S.C. §654, requires worksites to be free from hazards likely to cause death or serious physical harm. Accordingly, under OSHA, the Occupational Safety and Health Administration can require employers to develop procedures to protect employees reasonably likely to be exposed to Ebola (i.e. healthcare workers, transportation employees servicing afflicted countries). Employers failing to comply would face fines. Employees are further protected under the Family and Medical Leave Act and Americans with Disabilities Act. Under the FMLA, employers who have more than fifty employees are required to provide up to twelve weeks of unpaid leave to qualified employees who have a serious health condition. Given its high mortality rate, Ebola seems certain to qualify. Similarly, the ADA would provide protections for employees facing lasting disabilities from exposure to the disease.

In addition to responsibilities to employees, businesses must also consider traditional tort liability should a customer contract Ebola through the company’s negligence. The risk is especially significant for airlines, which face a heightened duty to passengers as a common carrier. Accordingly, airlines servicing regions heavily afflicted with Ebola must exercise particular care in implementing precautions to prevent transmission of the disease on their planes. Similarly, manufacturers of protective equipment designed for healthcare workers treating Ebola patients face the even higher standard of strict liability should the gear prove defective.

In another realm of possible concern, businesses are uncertain about the potential effects of Ebola on contractual obligations. Depending on the jurisdiction, it may be possible for a party to claim his contractual duties are vitiated because the epidemic has rendered performance impossible or impracticable. Such a determination would largely hinge on whether the Ebola outbreak was a foreseeable risk that was allocated by the parties. This issue is particularly interesting for the shipping industry, where several companies have suspended shore leave for crews, and nations have begun imposing restrictions on vessels originating from West Africa. Who, if anyone, is liable if a ship cannot fulfill its contractual obligations because a port is declared unsafe or its crew must be quarantined? While such contingencies may be covered under some contracts through force majeure clauses, courts may be required to adjudicate in other instances.

In sum, the Ebola outbreak poses difficult legal issues for businesses regarding their responsibility to employees, potential tort liability to consumers, and contractual relationships. Recognizing these concerns, law firms have responded to the crisis in a number of ways. First, some firms have responded by issuing alerts to clients in affected industries. Waller Lansden Dortch & Davis, LLP went a step further, launching an Ebola-specific website to serve as a comprehensive resource for health care organizations preparing for the disease. On the other hand, in response to increasing client inquiries, Reed Smith announced its formation of a global Ebola task force. Headed by an aviation and products liability expert, the team consists of over twenty professionals with experience in diverse practices, including labor and employment, life sciences, shipping, and the firm’s Africa Business Team. Accordingly, law firms have provided ample resources for clients to best position themselves against future liability. Hopefully, businesses will take the Ebola threat seriously and use the available information to take the necessary precautions and develop effective response plans.

CBLR Seeking Papers for 2015 Survey Issue

Thursday, November 13th, 2014

In keeping with its tradition of publishing leading business law scholarship, the Columbia Business Law Review (CBLR) is pleased to announce that it is soliciting papers for its 2015 Survey Issue (Volume 2015, Issue No. 2), which will be focused exclusively on the topic “Business & Technology.” This is a time of exciting changes, and CBLR would like to publish your contributions to the legal literature.

There is no shortage of topics to explore, from cyber-security and net neutrality to high-frequency trading and e-discovery rules.

Interested scholars and/or practitioners should submit their Articles through ExpressO or though the CBLR website at submissions must be received by January 1, 2015.

Click here for more information.

RMBS Fraud: The Search for Accountability Continues

Tuesday, November 11th, 2014

In remarks before the Senate Judiciary Committee in March 2013, Attorney General Eric Holder famously professed his concerns about pursuing criminal charges against financial institutions: “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute – if we do bring a criminal charge – it will have a negative impact on the national economy, perhaps even the world economy.” While Holder was quick to backtrack from the idea that some banks are “too big to jail,” the Justice Department has brought criminal indictments against neither financial institutions nor high-level financial executives for wrongdoing related to the financial crisis.

On the other hand, DOJ has moved aggressively in securing monetary settlements. At the behest of President Obama, the Residential Mortgage-Backed Securities (RMBS) Working Group was formed in early 2012 “to investigate those responsible for misconduct contributing to the financial crisis through the pooling and sale of residential mortgage-backed securities.” Comprised of federal prosecutors and investigators from a variety of government agencies, the Working Group has sought to not only hold institutions accountable for their wrongdoing, but also provide relief to victims and homeowners struggling in the aftermath of the financial crisis.

Indeed, the Justice Department has reached a string of recent high-profile settlements with three banks: a $13 billion settlement with JPMorgan Chase in November 2013, a $7 billion settlement with Citigroup in July 2014, and most recently, a $16.65 billion deal with Bank of America in August 2014. The settlements have faced some criticism—they been accompanied with Statements of Fact that outline the banks’ actions, yet the statements have not disclosed figures for bank profits or investor losses from the securities, or how the settlement figures have been computed. The statement for the Citigroup settlement was all of nine pages long. A recent New York Times article pointed out that despite the nearly $17 billion figure, Bank of America may actually only incur costs of $12 billion. While BoA can modify the terms of mortgages in order to help homeowners, costs of such changes would be borne by investors that own the loans through bonds rather than the bank. Nonetheless, the resolution includes a record nearly $10 billion to settle federal and state claims and is expected to provide more consumer relief than the prior settlements.

Yet there have been no such high-profile efforts at prosecutions of top financial executives. The Justice Department is not afraid of going after the big fish; one need only look at numerous recent insider-trading convictions, from Raj Rajaratnam to Mathew Martoma. So why has the government been either unable or unwilling to do the same with RMBS fraud? According to Holder, “[T]he buck still stops nowhere” because “responsibility remains so defuse, and top executives so insulated, that any misconduct could again be considered more a symptom of the institution’s culture than a result of the willful actions of any single individual.” And insider-trading cases have often been built on wiretapped phone conversations and real-time investigating, neither of which is available in potential RMBS cases.

Without knowing what information DOJ has uncovered in its civil investigations, it’s fruitless to armchair quarterback the government’s decision to not seek indictments of high-level executives. Although incidentally, a key JPMorgan Chase whistleblower recently asserted that such a case could be made. Let’s assume, as Holder says, that it is difficult to prove criminal intent because those at the top are too far removed. This does not preclude DOJ from seeking—if no bank truly is too big to jail—criminal indictments of the financial institutions themselves. Of course, the value in charging the bank is no substitute for the deterrence benefits of holding actual individuals responsible. And there are real risks. Criminal charges against a financial institution can trigger subsequent action by its regulators, including loss of the institution’s charter, and can spark larger consequences for the market. But prosecutors need not play economist as long as they proceed with caution: “The potential for such severe consequences simply means that federal prosecutors conducting these investigations must go the extra mile to coordinate with the regulators that oversee these institutions’ day-to-day operations.”

While the statute of limitations for a federal securities fraud case is five years, the Financial Institutions, Reform, Recovery and Enforcement Act of 1989 (FIRREA) extended the statute of limitations to ten years for mail and wire fraud if the “offense affects a financial institution.” With Holder set to leave as soon as his successor is confirmed, it is important to look back upon his record in holding accountable those responsible for contributing to the financial crisis. That record is currently mixed. But through the use of FIRREA, there is still time to bring criminal charges for RMBS fraud, be they against individual or institution.

Rebutting Reliance: Keeping up with Halliburton and Defendants’ Efforts to Block Class Certification

Saturday, November 8th, 2014

In Halliburton v. Erica P. John Fund, handed down last June, the Supreme Court held that investor-plaintiffs in securities fraud actions could continue to invoke a presumption of reliance for purposes of class certification but that defendants would be permitted to rebut the presumption at the certification stage. The decision was conservative in that it upheld the controversial presumption of reliance, which effectively allows plaintiffs to bypass one of the usual certification requirements. It did, however, provide defendants, usually businesses, with a new defensive tool – if they could show that their alleged fraud had no “price impact,” they would effectively disprove reliance and thereby raise a nearly insurmountable barrier to class certification. The challenge now is for defendants to figure out how to successfully disprove price impact – the signs indicate that this will be an uphill battle but it will be well worth the effort if it means escape from the threat of hefty adverse damage awards that comes with class certification.

In this post, I describe the reliance requirement in private securities fraud class actions before and after Halliburton. I then highlight some recent attempts to rebut the presumption of reliance before class certification and analyze which arguments might work.


In order to bring a securities fraud action under § 10(b) of the Securities Exchange Act of 1934 (hereafter “1934 Act”), private plaintiffs must allege, among other things, that defendants made a materially misleading statement upon which plaintiffs relied in deciding to buy or sell a security. In the securities fraud context, this “reliance” requirement represents factual causation – but-for defendants’ misrepresentation, plaintiffs would not have entered into the transaction that ultimately caused them harm. Federal Rule of Civil Procedure 23(b)(3) requires that in order for a class seeking damages to be certified, “questions of law or fact common to class members predominate over any questions affecting individual members.” The need to show that each individual investor relied on the alleged misrepresentations threatened to frustrate plaintiffs’ ability to fulfill this “predominance” requirement.

It was in the context of this “unnecessarily unrealistic evidentiary burden” that the Supreme Court, in a 1988 case called Basic v. Levinson, created the rebuttable presumption of reliance. The Court held that it would presume reliance if plaintiffs in private securities fraud class actions showed that (1) the alleged misrepresentations were publicly known, (2) they were material, (3) the stock traded in an efficient market, and (4) the plaintiff traded the stock between the time the misrepresentations were made and when the truth was revealed. The Court based this decision on the “fraud on the market” theory (hereafter “FOTM”), which finds the requisite causal link by suggesting that stock prices in an open and developed securities market reflect all material, publicly-available information and that investors rely on the integrity of these stock prices in deciding to buy or sell. The Basic decision was always controversial – it changed the dynamics of private securities fraud class actions by essentially neutralizing a once insurmountable obstacle to class certification.

Halliburton and the “Price Impact” Rebuttal

Relying on the force of precedent and the dearth of new arguments not considered in Basic, the Halliburton Court unanimously elected to retain the rebuttable presumption of reliance. The Court embraced the FOTM theory, as a method of proving reliance, for the “fairly modest premise” that market professionals do consider publicly available information and that such information must therefore have some effect on prices. The Court did, however, hold that rather than having to wait until the merits stage, defendants would be permitted to rebut the presumption of reliance at the class certification stage. There was never a dispute that defendants could indirectly challenge reliance at the certification stage by challenging one of the four showings plaintiffs would have to make in order to invoke the presumption. Halliburton held that rather than arbitrarily limiting defendants to making such indirect arguments to rebut the presumption of reliance, it would only be logical for defendants to also be able to make direct arguments to challenge actual reliance. Specifically, rather than having to show that plaintiffs couldn’t have relied on misrepresentations because a market wasn’t generally efficient, defendants could argue that plaintiffs in a certain case didn’t rely because the alleged misrepresentations had no impact on the price of the security in question.

Arguments on Price Impact: What have businesses tried after Halliburton?

The key question now is how a defendant might successfully show a lack of price impact. Justice Roberts suggests in Halliburton that the presumption wouldn’t apply, for instance, if a defendant could show that (1) “the alleged misrepresentation did not, for whatever reason, actually affect the market price,” or (2) “that a plaintiff would have bought or sold the stock even had he been aware that the stock’s price was tainted by fraud.” The following paragraphs highlight some arguments that were considered in courts this past summer.

In an August case, the 11th Circuit re-emphasized the existing idea that it would not be enough for defendants to merely show that the stock price did not change in the period immediately following an alleged misrepresentation. Local 703 v. Regions Financial Corp.. Quoting precedent, the court noted that “a corollary of the efficient market hypothesis is that disclosure of confirmatory information – or information already known by the market – will not cause a change in the stock price…because the market has already digested that information and incorporated it into the price.” FindWhat Investor Group v. In that case, the market knew that the defendant financial institution had artificially low loan reserve figures and inflated goodwill but not that these numbers were intentionally false and misleading. Defendants argued that the market price already incorporated an expected change in these numbers since the market knew they were false (regardless of intent.) Defendants also argued that the market viewed goodwill as “immaterial,” and that a change in goodwill would therefore have no price impact. The case has been remanded for a full consideration of these arguments after Halliburton. The district court’s initial consideration of the issues indicates that at least the first argument may have some traction.

Looking at a few other price impact cases, it seems that evidentiary concerns will represent one of defendants’ largest hurdles to rebutting the presumption of reliance. For instance, a district court in Minnesota held that it would be insufficient for defendants to argue that misleading statements were made concurrent with non-actionable material statements that were likely to have caused the stock price change in question. IBEW Local 98 Pension Fund v. Best Buy. Additionally, although defendants must prove that an alleged misrepresentation did not affect market price, arguments that generally attempt to provide alternative explanations for a certain change in stock price will not be considered – such arguments will be deemed as going to loss causation, which is a different part of the § 10(b) action and a merits stage consideration.


The purpose of the Halliburton decision seems to have been to eliminate frivolous cases without affecting the Basic decision to facilitate plaintiffs’ suits. Indeed Justice Ginsburg wrote a 4-sentence concurrence simply to highlight that the decision “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” The case also seems to value protecting defendants with strong merits arguments from the risky reality of having a class certified against them. Time will tell whether the Court’s current standard gets this balance right. As of now, the few post-Halliburton cases seem to suggest that the presumption of reliance is still strong and that defendants seeking to disprove reliance at the class certification stage still have the odds stacked against them.

Opinion Apparently a Matter of Opinion in Omnicare

Wednesday, November 5th, 2014

Corporate mens rea is back in the spotlight as Omnicare, Inc. (NYSE: OCR), a defendant familiar to Corporations students countrywide, is once again pitted against investors in a private action lawsuit. After having granted certiorari in March 2014, the Supreme Court will consider this term whether a statement of opinion in a Form S-1 (“Registration Statement”) must be both objectively and subjectively false to be actionable under Section 11 of the Securities Act of 1933 – that is, whether a plaintiff asserting a claim under Section 11 must plead that the allegedly false statement was both factually incorrect and disbelieved when made. In so doing, the High Court is expected to resolve the Sixth Circuit court’s split from the Second, Third, Ninth, and – as of this past August – Tenth Circuits in Indiana State District Council of Laborers v. Omnicare Inc.

Backdrop of Omnicare

In connection with a December 2005 offering of 12.8mm shares, the Cincinnati-based provider of pharmaceutical services to long term care facilities issued a registration statement that asserted that the company was in compliance with all laws and regulations. As it turns out, certain Omnicare practices may have been less than kosher; government raids on Omnicare’s facilities sparked by an investigation into the alleged submission of false claims to Medicare and Medicaid and kickback arrangements with pharmaceutical manufacturers resulted in substantial settlements.

A number of large shareholders, led by lead plaintiffs Laborers District Council Construction Industry Pension Fund and Cement Masons Local 526 Combined Funds, brought suit in the Eastern District of Kentucky against Omnicare and certain managers and directors, alleging that Omnicare’s statement concerning its legal compliance was misleading.

Section 11 of the Securities Act of 1933

Section 11 provides for strict liability for directors, officers, underwriters, experts, and issuers who intentionally make a material misstatement or omission in a registration statement for publicly offered securities. In effect, it establishes fiduciary requirements in the context of any securities offering registered with the SEC and provides the buyer of an infected security with an express right of action if the registration statement “contained an untrue statement of a material fact or omitted to state a material fact” (15 U.S.C. § 77k(a)).

Section 11 claims tend to arise when corporations make plainly inaccurate statements – consider, for example, the cases of Section-11-Standouts WorldCom and Enron. Less clear, and at issue in Omnicare, is how to treat “soft” information or statements of opinion. Is an opinion “untrue” at the time it was made because the opinion proved wrong with the benefit of hindsight (as the Sixth Circuit holds) or is it untrue only if the opinion maker did not subjectively believe it (as the majority holds)? Does strict liability render a defendant’s mindset irrelevant in cases where soft information is implicated?

Sixth Circuit Refuses to Extend Virginia Bankshares

In holding that Section 11 creates a strict liability regime under which liability can attach to inaccurate statements of opinion in the absence of the statement maker’s knowledge of the inaccuracy, the Sixth Circuit distinguished Section 11 claims from those brought under Section 10(b) and Section 14(a). In so doing, the Court refused to apply the “subjective falsity” requirement established in Virginia Bankshares v. Samberg, which has provided guidance to circuit courts on the other side of the split. Parting with the majority, the Sixth Circuit held: “No matter the framing, once a false statement has been made, a defendant’s knowledge is not relevant to a strict liability claim.”

The Legal Community Goes Wild

The Sixth Circuit’s opinion was greeted with fervent reception by the legal community. Over the June-September period, twelve amicus briefs were filed, expressing opinions of the circuit’s core holding ranging from praiseworthy (“Prefacing a statement with the phrase ‘we believe’ neither adds nor detracts from the truth or falsity of a statement . . .”) to highly critical (“The [] decision cannot be squared with precedent, statutory text, or logic.”). Big law got in on the action, offering harder hitting commentary.

For a few goods reads, see

  • Important Conflict Being Overlooked In Omnicare Case: King & Spalding’s Drew Dropkin discusses the Sixth Circuit’s split with particular emphasis on Virginia Bankshares, ultimately noting that the Sixth Circuit’s deviation is no less controversial because of its “wholesale failure to follow its own circuit’s prior interpretation of [relevant law]”

Consequences of the Supreme Court’s Decision

The Supreme Court’s decision is expected to have a pronounced impact on the securities markets. Affirmation of the Sixth Circuit’s decision will result in plaintiff-friendly pleading standards expected to lead to an increase in Section 11 filings, which could drive settlement value up. Furthermore, there are concerns that such a ruling would cause issuers to become tighter-lipped in their disclosure practices, leading to higher costs of capital and depressing capital markets activity.

On the other hand, affirmation of the Sixth Circuit’s decision could increase the quality of information disclosed, in particular, the quality of soft information.

Oral argument took place on Monday, November 3… SCOTUSblog’s analysis forecasts vindication for the Sixth Circuit.

Stay tuned!

Implications of Blackstone’s Purported Elimination of Accelerated Monitoring Fees

Tuesday, November 4th, 2014

Recent changes in fee policies at private equity firms have given rise to largely optimistic responses from the press and the SEC alike, and some have lauded the change as an indication of the efficacy of the investor protection provisions in the Dodd-Frank Act Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). However, it is important to view the policy change in light of the problems inherent in the complex private equity business model, and doing so sheds light on its less-optimistic practical implications.

Among Dodd-Frank’s amendments to the Investment Advisers Act of 1940 is Title IV, Section 403’s elimination of the “private investor exemption,” which effectively requires private equity fund managers (previously relatively unregulated) to register with the SEC, subject to a few new exemptions. These exemptions are set out under Section 403 itself (for “foreign private advisers” as defined in Section 402(a)), as well as under Sections 407 (for venture capital fund advisers) and 408 (for fund advisers with less than $150 million in assets under management). Many of the larger private equity fund managers in the country do not qualify for these exemptions. Section 404 requires the SEC to “conduct periodic inspections of the records of private funds maintained by an investment adviser registered under [Title IV] . . . .” The Office of Compliance Inspections and Examinations (“OCIE”) of the SEC has carried out these inspections, as well as a review of roughly 150 private equity firms which concluded in early 2014, and found several deficiencies in private equity industry practices.

One such deficiency, noted by Andrew J. Bowden, director of the OCIE, is the routine charging of accelerated monitoring fees to portfolio companies upon advanced termination of a monitoring agreement. For example, in the sale of Biomet, Inc. to Zimmer Holdings, Inc., expected to close in early 2015 pending approval by European Union antitrust regulators, the current PE owners are to receive up to $30 million in accelerated monitoring fees upon closing. When private equity firms including Blackstone Group acquired Biomet in 2007, the monitoring-fee agreement detailed fees to be paid up until 2017 and, consistent with industry practice, called for the present value of remaining fees to be paid lump sum if the agreement were to be terminated through a sale prior to 2017. Ultimately, this practice decreases return for investors in PE funds (i.e. the funds’ limited partners), since the mandated payment of accelerated monitoring fees will lower the selling price of the portfolio company, and general partners (i.e. fund managers) historically do not share the proceeds with limited partners.

Blackstone has recently received a great deal of media attention for a purported change in its policy on accelerated monitoring fees: for companies acquired going forward it will not charge these accelerated fees, and for companies already held by one of its funds it will share 100% of any accelerated monitoring fees charged with the fund’s limited partners. Because this information is allegedly contained in Blackstone’s private correspondence with one of its investors and the firm has not subsequently issued any comment on the matter, it is unclear when this policy change took/will take effect.

Most mainstream news outlets that have reported on this change, including the Wall Street Journal and the New York Times, have taken a fairly optimistic view on its effect—they claim that the change by Blackstone signals a revolution in industry practice that will benefit investors and cost private equity firms, indicating that Dodd-Frank may finally be taking effect. A senior official in the SEC’s private funds unit also recently praised the change, urging other firms to follow suit and claiming that this would result in “billions of dollars back to investors that would have gone to fund managers.” However, it remains to be seen whether this will truly be the case. It is difficult to imagine PE firms willingly forgoing significant profits in response to SEC investigation without a means of recuperating this cost. Indeed, industry experts including analysts from Citigroup, Inc. have predicted that the change will have a negligible economic impact on Blackstone and the private equity industry as a whole.

PE firms maintain that the practice of charging accelerated monitoring fees is not a violation of any law and that their policy changes are motivated more by a desire to build goodwill with clients. The argument in favor of PE firms charging these fees is that their investors are sophisticated institutions and the fee structures in question are disclosed up front in the monitoring-fee agreement. This is essentially an autonomy theory of contract argument, which relies on the normative principal that contracting parties should be able to allocate the benefits and risks of a contract as they choose. It is possible, though perhaps a stretch, to construe the accelerated fees as part of the bargained-for consideration in purchase agreements between PE firms and portfolio companies, simply an allocation of the risk of early termination from general partners to limited partners, instead of as payment for future work that will not be performed. From Mr. Bowden’s comments in his May 2014 speech on the matter, however, it seems that the underlying issue is really the lack of transparency in the private equity industry due to insufficient disclosures and poor oversight, particularly after closing.

Viewed in this light, it seems that the policy change by Blackstone, even if followed by an industry-wide elimination of accelerated monitoring fees, may not be effective as it does not address the sector’s problems with transparency. While it may garner goodwill for PE firms to abolish questionable fees without explicitly being asked to do so, the move may serve merely to placate fund investors and direct scrutiny away from the underlying issues that remain: the faulty disclosures and other deficiencies that result from “temptations and conflicts” inherent to the private equity business model. For example, it is unclear whether a similar elimination of so-called “evergreen monitoring fees” (also charged following the early termination of a monitoring agreement, but not lumped) will occur, or whether any reform will occur in the allocation of expenses to PE fund managers’ consultants. Thus, while Blackstone’s elimination of accelerated monitoring fees appears on the surface to be a definitive step in the direction of investor protection, it is much less certain whether it will lead to a significant improvement in practice.

Know Your (Terrorist) Customer: Terror-Financing Liability Under the Anti-Terrorism Act of 1990

Saturday, November 1st, 2014

The Anti-Terrorism Act of 1990 (ATA) allows private rights of action for a U.S. national “injured in his or her person, property, or business by reason of an act of international terrorism.” 18 U.S.C. § 2333(a). This encompasses penalties for those who knowingly provide material support, which is defined to include currency, financial services, lodging, and training, to a foreign terrorist organization. 18 U.S.C. § 2339A. But should “material support” extend to banking and processing financial transactions? And even so, how can banks “know” which customers are terrorists, beyond checking names against U.S. government blacklists?

Recently, an E.D.N.Y. jury found that the Arab Bank was liable to victims of Hamas terrorist attacks during the Second Intifada, the second Palestinian uprising against Israeli occupation from 2000 to 2005. It was the first time a bank has been liable for terror-financing in a U.S. civil suit. This post will discuss the verdict’s implications on interpretation of the ATA, and its consequences for international financial institutions.

Linde v. Arab Bank

The E.D.N.Y. suit, Linde v. Arab Bank (04-CV-2799), was brought by 297 victims of terrorist acts carried out by Hamas, the Palestinian militant group involved in 24 terrorist attacks launched between 2001 and 2004 in Israel, Gaza, and the West Bank. The plaintiffs accused Arab Bank of handling $73 million worth of transactions for Hamas and a charity called the Saudi Committee, which then sent payments to the families of Hamas suicide bombers.

Arab Bank noted that the Saudi Committee was never listed as a terrorist organization by the U.S., and that it properly checked its transactions against the required blacklists, using the same money-laundering-prevention processes as every other international financial institution. It argued that banks should not be expected to create their own terrorist blacklists; rather, that is the job of governments. In fact, at the time of the Second Intifada, only one of the accused Hamas leaders who had an account at Arab Bank was on the U.S. government’s blacklist. The bank claimed that any prohibited transactions that did go through were the result of errors, such as different renderings of names in Arabic and in English.

Plaintiffs’ lawyers responded that the Arab Bank officials were on the ground at the branches in the Palestinian territories during the relevant time period and knew who the recognized Hamas leaders were.

The bank was unable to convince the court that proximate cause should be shown between financial services and a terrorist act. The court ruled that plaintiffs needed to show “material support” and that the bank could have foreseen that its financial services would contribute to terrorist attacks.

The bank claims that sanctions before trial had prevented it from explaining several relevant transactions to jurors. Citing privacy laws of countries where it does business, the bank had refused to turn over a large number of requested documents, resulting in the sanctions. The bank appealed the sanctions in the Second Circuit and then turned to the Supreme Court, but was denied review.

The outcome in Linde ultimately construes the ATA too broadly, because in effect, it requires banks to conduct due diligence beyond what is currently required under international bank compliance procedures.

Implications for International Banks

In the short-term, the verdict could have a significant impact on similar suits against financial institutions. For example, following the verdict in Linde, a case filed by victims of terrorist attacks against the National Westminister Bank was reinstated by a federal appeals court. Other cases filed in U.S. courts include suits against Bank of China, Crédit Lyonnais, and a unit of Royal Bank of Scotland.

On a larger scale, creating liability for financial institutions under the ATA could deter banks from conducting business in areas of conflict. Undoubtedly, it will place greater pressure on banks to monitor their customers’ accounts and transactions. It may even discourage banks from opening accounts or processing transactions for certain “suspect” individuals or groups, but this kind of behavior might lead to accusations of discrimination. Crédit Lyonnais was sued in the U.S. for having maintained an account for a Muslim charity alleged to have links to terrorism, but is also being threatened with litigation in France for religious discrimination because the bank later closed those same accounts.

Critics have argued that the ATA suits against banks go against Congressional intent and the statutory language itself. Geoffrey Sant, special counsel to Dorsey & Whitney LLP, notes that the ATA was intended to be symbolic, because few terrorists have assets in the U.S. that could be used to pay damages.

Sant warns that such large potential liabilities may push banks out of areas of conflict, only to be replaced by financial institutions (which may be controlled by terrorist organizations) that circumvent international sanctions regimes. This has been a criticism of certain interpretations of the Alien Tort Claims Act.

The Linde case also raises a broader question of how much banks should be expected to do in fighting terrorism. Stephens argued during the trial that private institutions do not have the power to “strangle you financially.” The victims’ lawyers, by contrast, told the jury that the lawsuit would send a message to international banks to do more than check wire transfers against a terrorism blacklist. However, this latter argument overlooks the importance of having a uniform, standardized system for both international banking and the identification of terrorists. It is, at a minimum, inefficient to expect banks to obtain the kind of intelligence that would allow them to identify who is or is not a terrorist beyond government blacklists.

Holding that a bank “knowingly” provided services to terrorists, even after it followed the required compliance procedures, sends a confusing message and sets bank responsibility above what is currently required internationally. If current KYC and anti-money-laundering procedures are insufficient to prevent and deter financial institutions from providing resources to terrorist organizations, a change needs to be made on a systematic level. The judiciary is likely not best positioned to make this determination, and making changes on a case-by-case basis increases the possibility that both banks and customers will be treated unfairly.

In sum, the Linde interpretation of the ATA to require reasonable foreseeability in establishing “material support” to terrorists and to read “knowingly” to encompass knowledge beyond the required international banking compliance procedures is problematic for several policy reasons. The ATA could deter banks from operating in areas of conflict or to refuse to do business with suspect individuals, which could in turn lead to discrimination. Most importantly, banks may be pressured to go beyond government blacklists in trying to identify terrorists, a task which they are not practically or legally equipped to handle. While compensating the victims of terrorism is immensely important, the potential implications of the Linde outcome are also far-reaching, and could affect many individuals, organizations, and even charities in conflict zones. If it is determined as a matter of policy that banks can and do provide material support to terrorist organizations, then compliance standards should be revised internationally and banks’ responsibilities made clear in a systematic manner.