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Attractive Nuisances in Finance
Sung Eun (Summer) Kim1
Abstract
Private equity – or the business of pooling funds for investment in other businesses – is one of the largest, fastest-growing and crisis-resilient asset classes in finance. Much of this strength comes from private equity firms’ ability to operate efficiently by eliminating standard investor protections, such as the fiduciary duty of loyalty to investors and investors’ monitoring and voting rights. While this structure is a radical departure from the public company norm, no was harm done as these were private entities marketed exclusively to sophisticated investors and retail investors had little to no opportunity to invest in private equity—until recently. In the last few years, however, a number of private equity firms have gone public, opening the door to less sophisticated retail investors, who are drawn to these publicly-listed private equity firms because of the promise of high returns, despite their high risk. If private equity firms have thrived on their private nature, how will the public version of private equity maintain their competitiveness? In this paper, I review a sample of 46 publicly-listed private equity firms (with a total market capitalization of US$ 106.4 billion) that are traded on the United States stock exchanges to reveal how these publicly-listed private equity, or PLPE, firms have succeeded at “going public” while “staying private.” Incumbent owners of PLPE firms have used complex contracts and availed themselves of various legal and regulatory exceptions to retain most of the private benefits of private equity while spreading the risks and losses to new owners by taking their firms public. This conferral of a significant benefit to a few by spreading the risk of small harms to the many directly offends the core principles of public company and securities regulations. I analogize the PLPE investment to an “attractive nuisance” that is given special treatment under tort laws, and propose a new mode of regulation for investments like PLPE that are attractive to less sophisticated investors specifically because of their elevated risks. Unlike the current regulatory system, which relies predominantly on disclosures of risks, the proposed Attractive Nuisance regulatory model would require PLPE to mitigate avoidable risks to less sophisticated investors. This model more appropriately mediates risks between PLPEs and retail investors by accounting for the imbalances of information and power between the incumbent and new investors as well as the heightened yet attractive hazards of PLPE investments.
1 Assistant Professor, University of California, Irvine, School of Law; (617) 455-9053; [email protected]. 1
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Introduction Private equity refers to the business of pooling funds from multiple investors and investing such funds in other businesses for a profit.2 Private equity touches virtually every aspect of everyday life, from the clothes we wear,3 the food we eat,4 to the books that are used in law school classrooms.5 According to a 2015 industry report, more than 11,000 companies headquartered in the United States are supported by private equity investments.6 The most frequently noted features of private equity firms in the legal and finance literature are the innovative legal and financial strategies that private equity has been able to develop to reduce agency costs.7 Notably, Professor Michael Jensen has praised the private equity model for its ability to reduce agency costs by using centralized control structures, high leverage and managerial incentives.8 Relying on this advantage, private equity has developed into a high- powered financial engine that has generated impressive returns for its investors.9 This elaborate yet durable model of private equity was initially developed with sophisticated investors (such as institutional investors and wealthy individuals) in mind.10 Even though the private equity model has been stripped of standard investor protections such as fiduciary duties11, monitoring rights12 and voting rights13, these sophisticated investors were satisfied with this arrangement because they received high returns and limited liability in exchange, and could rely on extralegal mechanisms such as reputation and market power14 to ensure that their investments
2 JOSH LERNER ET AL., VENTURE CAPITAL AND PRIVATE EQUITY: A CASEBOOK 1-11 (5th Edition, 2012). 3 See e.g., Press Release, TPG Capital, TPG Capital and Leonard Green & Partners to Acquire J. Crew Group, Inc. for $43.50 Per Share in Cash (Nov. 23, 2010) https://tpg.com/images/news/101123_JCG.pdf (press release announcing private equity firm TPG’s buyout of J. Crew). 4 See, e.g., PRESS RELEASE, 3G CAPITAL, BURGER KING HOLDINGS (Sept. 2, 2010) http://www.3g- capital.com/bkw.html (press release announcing private equity firm 3G Capital’s buyout of Burger King). 5 See e.g., PRESS RELEASE, EUREKA GROWTH CAPITAL, EUREKA GROWTH CAPITAL ACQUIRES LAW SCHOOL PUBLISHING BUSINESS FROM THOMSON REUTERS (Feb. 6, 2014) http://www.eurekagrowth.com/news/eureka-growth- capital-acquires-law-school-publishing-business-from-thomson-reuters/ (press release announcing private equity firm Eureka Growth Capital’s buyout of West Academic). 6 Quick Facts, PEGCC, http://www.pegcc.org/education/pe-by-the-numbers. 7 Firms with multiple owners must coordinate the management of the firm through a centralized decision making body (or agent), and agency costs refer to the costs of monitoring and binding the agent to ensure that it acts in the best interests of the owners. FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 10 (1991). 8 See Michael C. Jensen, Eclipse of the Public Corporation, HARV. BUS. REV. 326 (Sept. 1989) available at http://hbr.org/1989/09/eclipse-of-the-public-corporation/ar/1. Cf. Steven M. Davidoff, Black Market Capital, 2008 Colum. Bus. L. Rev. 268 (2008) (criticizing private equity for “their exorbitant fees and the spectacular profits of some of their managers, their involvement in a number of high-profile, controversial transactions and investment scandals, and the systemic and idiosyncratic risks these investments pose.”) 9 See JOSH LERNER, VENTURE CAPITAL AND PRIVATE EQUITY: A COURSE OVERVIEW 1 (2001) (“Private equity’s recent growth has outstripped that of almost every class of financial product.”). 10 For a description of the prototypical private equity investor and the minimum investment requirements that have limited the pool of eligible investors to high net worth individuals and institutional investors see, e.g., Private equity, INVESTOPEDIA, http://www.investopedia.com/articles/mutualfund/07/private_equity.asp. 11 See infra [ ] (discussing contractual waivers of fiduciary duties in the private equity contract). 12 See infra [ ] (discussing removal of investors’ monitoring rights such as access to books and records in the private equity contract). 13 See infra [ ] (discussing removal of investors’ voting rights such as the power to elect/remove the board in the private equity contract). 14 Usha Rodrigues & Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of SPACs, 37 DEL. J. CORP. L. 928 (2012–2013) (“[R]eputational constraints hold the richly dynamic tension between traditional private equity investors and managers largely in equilibrium.”) (citing Matthew D. Cain, Steven M. Davidoff & Antonio J. Macias, 2
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were protected even beyond the levels that would have been provided under the standard protections that had been given away.15 However, the recent decision of several prominent private equity firms to go public has provided ordinary retail investors the opportunity to directly invest in private equity firms, even if they only have a small amount of money to invest. This is a relatively recent phenomenon that peaked during the boom years immediately prior to the 2007-2009 financial crises and has continued into the post-crisis period.16 The starting point of the paper is the question: why did these private equity firms choose to go public? The classic story of a young company coming to the capital markets as a rite of passage to seek a broader pool of investments for its next phase of operations does not fit with the private equity firms. In fact, the private equity firms that have chosen to go public were those among the most successful among their peers.17 The voluntary conversion into a public company by what is
Broken Promises: Private Equity Bidding Behavior and the Value of Reputation, AFA 2012 Chi. Meetings 1, 11 (Sept. 2012); Lloyd L. Drury, III, Publicly-Held Private Equity Firms and the Rejection of Law As A Governance Device, 16 U. PA. J. BUS. L. 57 (2013). Cf. Lee Harris, Critical Theory of Private Equity, A, 35 DEL. J. CORP. L. 259, 264 (2010) (“However, recent empirical evidence by Kate Litvak suggests that a fund manager's performance does not necessarily predict her future success in terms of raising the next fund. This creates reason to believe that reputation may not work as a constraint as well as previous commentators have suggested.”). 15 The descriptor “sophisticated” in this context is used as shorthand to indicate whether investors have the capacity to appreciate the complexities and risks of investing in the capital markets, or possess the opportunity and resources to either directly or indirectly bargain for protections when entering into these investments. 16 While much has been written about the ways in which increased congressional scrutiny following the 2007-2009 Financial Crises has forced more light on the shadow of private equity, this Article focuses on private equity’s own emergence from the shadows into the public domain. Of the 46 firms reviewed in this study, there were three firms that were already public before the year 2000. Since the year 2001, there has been a steady stream of private equity firms that have made the decision to go public in every year (with the exception of 2002), including the years leading up to and out of the 2007-2009 Global Financial Crisis. In the last year alone, 4 private equity firms (Macquarie Infrastructure Corp, CSW Industrials Inc., PJT Partners Inc. Class A and Gores Holdings Inc.) have made the decision to go public.
17 For a sampling of reports on the respective successes of Blackstone, KKR, and Apollo, see Trevor M. Gomberg, After the Storm: Unmasking Publicly-Traded Private Equity Firms to Create Value Through Shareholder Democracy, 73 ALB. L. REV. 575 (2010) (“With a stellar reputation and analyst praise, [Blackstone’s] IPO may have a far-reaching impact on an industry thrust in the spotlight.”); KKR Joins Other Private Equity Firms on the Stock Market, Sunday 3
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arguably one of the most oversubscribed and opaque variety of all private companies presents a rare public display and articulation of the private equity firms’ view of (and the markets’ response to) the tradeoffs between the costs and benefits between private and public forms of corporate financing. The goal of this work is to first, review what motivates these firms to convert to a public company in the first place, and then to examine how that decision impacts the boundaries between public and private companies and their regulation, with a specific focus on ordinary investors who are the primary intended beneficiaries of such regulations. In this article, I review the going public decision of 46 publicly-listed private equity firms, which have a total market capitalization of more than $100 billion.18 I review the company reports, regulatory filings and organizational documents of these firms to study the motivations and mechanics of how these private equity firms have converted to a public company. What I find is that while these firms have “gone public” in the sense that their shares have been made available for trading on the national stock exchanges, they have “stayed private” in terms of how they are managed.19 Essentially, incumbent owners have relied on complex organizational structures and contract design to retain many of the private benefits of a private company while spreading the risk of loss across the new owners (i.e., retail investors). In other words, they have succeeded at creating a one-sided bet that allows them to maximize their gains while creating an exit strategy that leaves the retail investors to bear the brunt of losses in the event of loss.20 This result has been achieved through three channels: (1) first, by limiting investors’ monitoring rights which prevent them from receiving early warning signs, (2) second, by limiting investors’ voting rights which prevent them from intervening (or threatening intervention), and (3) third, by eliminating the agency relationship and fiduciary duties which would otherwise hold incumbents liable for any actions which place their interests ahead of their investors’. These channels have been constructed by relying on market hype, exotic organizational structures, and complex contract design, in each case, utilizing the full extent of carveouts and exceptions permitted under existing securities regulations, listing rules, state corporate law and principles of agency. The main premise of the paper is that capital markets regulators must also, in the same way publicly-listed private equity (or PLPE) has prepared for the best and worst case, do the same on behalf of the prospective owners (i.e. the investing public) that they seek to protect. I argue that the current regulatory regime fails at this task and make suggestions for how capital markets regulation can better achieve their intended purpose when it comes to regulating high-risk-high- return investments like PLPE.
Business Post (July 8, 2007), available at: http://search.proquest.com/docview/817626427?accountid=14509 (noting that “KKR, whose funds own 40 companies that have 560,000 employees, led $200 billion of leveraged buyouts in the past 12months.”); and Henry Sender, Private Equity: Apollo’s Charge to the Top, FT.com (March 10, 2014), available at: http://search.proquest.com/docview/1514047396?accountid=14509 (referring to Apollo as “the most powerful player in the industry” with “the single biggest fund in the private equity world with its new $18.4bn Fund VIII, which it raised in only 10 months.”) 18 See infra [ ] (explaining the dataset). 19 The phrase “going public but staying private” is inspired by Robert Bartlett’s 2009 article “Going Private but Staying Public” which describes the reverse phenomenon in private equity – i.e., the ways in which private companies that have been the target of private equity investments still remain subject to reporting requirements even after delisting. Robert P. Bartlett, Going Private but Staying Public: Reexamining the Effect of Sarbanes-Oxley on Firms' Going- Private Decisions, 76 U. CHI. L. REV. 7 (2009). 20 See infra [ ] (discussing limited call rights and expiration of lock-up period which creates pathway for exit). 4
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The current securities regulatory regime which relies on disclosure does not adequately serve its function when it comes to regulating PLPE. Moreover, this is not a shortcoming of regulations that applies only to PLPE. As evidenced by the recent financial crises, disclosure-based evaluations of risk have proven to be blunt and ineffective, and in some cases, a direct contributor to investor losses.21 This paper is a critique of this unitary approach to securities regulation as applied to high- risk investments like PLPE, and instead suggests that capital markets regulation should consider a new and expanded perspective of issuer’s duty of care that moves beyond disclosure.22 Specifically, I analogize PLPE investments to an “attractive nuisance” that is given special treatment in tort doctrine. Also referred to as the ‘attractive nuisance doctrine,’ this long line of landowner duties cases subject landowners to a heightened duty to eliminate avoidable risks on land when the victim is a child and the premises contain hazards that are particularly attractive to children.23 Based on this analogy, I introduce a new model of securities regulation called the Attractive Nuisance Model. Unlike the current regulatory system, which attempts to protect investors by mandating disclosure of risks, the Attractive Nuisance regulatory model would require PLPEs to mitigate avoidable risks to investors. I argue that this mode of regulation more appropriately mediates risks between PLPEs and retail investors by accounting for the imbalances of information and power between the PLPE issuer and retail investor as well as the type and level of hazards involved in investing in high-risk-high-return investments like PLPEs. Part I provides an overview of private equity and examines why and how private equity firms have chosen to go public. By showing how private equity’s conversion from a private to public
21 Existing categorizations and boundary lines at times fail to accurately represent the reality of capital markets, and in the worst case, mislabeling has misled investors. At heart of problem is the attempt to regulate complex, dynamic and multi-faceted products with blunt boundaries. ‘Private’ companies act like public companies and ‘public’ companies act like private companies. Shadow banks take traditional bank roles of intermediation and banks act in the shadows. Triple A (investment grade) securities have higher levels of default than ‘junk’ bonds (speculative grade). Here I am using PLPE as one example of mislabeling in securities regulation: Private equity firm goes public. Gets public investors interested in investment opportunity using lure of strong track record of high returns. But even after IPO, continues to operate much like a private company. Able to do so via complex legal and financial engineering and availing themselves of legal and regulatory carveouts. So in reality these are really private companies that are in the business of pooling and investing funds but they are categorized as public operating company for regulatory purposes. This mislabeling is problematic in securities regulation in several key respects: 1) investor expectations about baseline protections that come with ‘public’ companies, 2) the label determines your peer group – i.e. the reference against which your conduct will be judged (e.g., how reasonableness of care taken is assessed, and what constitutes unreasonably great risk), 3) results in reduced accountability. Steven L. Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, 2008 UTAH L. REV. 1109 (2008) and Ross Levine, The Governance of Financial Regulation: Reform Lessons from the Recent Crisis, 12 INT’L REV. FIN. 39 (2012). 22 This work complements the recent discussions within the SEC to move “beyond disclosure” (recent remarks from SEC Chair Mary Jo White on the Commission’s recent efforts to go beyond disclosure are available at the following link: https://corpgov.law.harvard.edu/2016/02/23/beyond-disclosure-at-the-sec-in-2016/). Applying the duty of care under the general heading of negligence to corporate/securities context is not new. See e.g., Melvin A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. PITT. L. REV. 945, 972 (1989) (referring to the duty of care as serving “a critical component of the corporate system” that has “flourished in part because it has included mechanisms that combine accountability with minimal government intervention.”). The basic premise is that issuer has introduced a new risk of injury to investors and is therefore under a legal obligation to perform such role with due care. This paper is a critique of capital markets regulations’ reliance on disclosure as a stand in for due care, and its novel contribution is the suggestion that we should use a status-based approach in setting the appropriate duty of care to extend beyond a duty to disclose in exceptional cases like PLPE. 23 It is duly noted that modern torts doctrine has since moved away from status-based approaches to a more unitary standard of reasonable care even in landowner cases, but for reasons that do not undermine its usefulness for capital markets regulation. 5
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company deviates substantially from the traditional public offering, I argue that traditional modes of public company regulation do not fit well with private equity’s conversion to a public company. Notably, a regulatory approach that relies exclusively on disclosure is not effective at protecting retail investors from the heightened risks of investing in publicly-listed private equity firms, when it is such elevated risks (and the heightened returns they could potentially produce) that are especially alluring to retail investors. Part II supplies the empirical support for the arguments advanced in Part I. Part III answers the question: if disclosure doesn’t work well here, what is the alternative? Here, I set up the basic model of the Attractive Nuisance Model, which is the main innovation of this Article. I suggest imposing an affirmative duty that goes beyond disclosure on PLPE issuers to mitigate or eliminate avoidable risks to retail investors. The proposal is to take a status-based approach to defining the duty of care which is tailored to the identity of the parties and natures of risks involved. I build and rely on an analogy between PLPE regulation and the attractive nuisance doctrine in tort law. Part III also provides a summary of the strengths and weaknesses of the proposal and explores possible alternative solutions as well as extensions of the proposal to other “attractive nuisances” in finance.
I. Publicly-Listed Private Equity (PLPE) This Part provides an overview of (a) private equity, (b) why and how private equity firms have chosen to go public, (c) the features that make publicly-listed private equity (PLPE) firms, in their current form, unsuitable for public investment, and (d) why disclosure of such features does not adequately protect retail investors from the risks of PLPE investments.
a. Private equity Coming off of record performances in realized investments and cash distributions in 2013 and 2014, more than 2,000 private equity funds are estimated to be seeking more than $700 billion of capital commitments from investors in 2015.24 What is private equity, who are the investors in private equity, and what does private equity do with these capital commitments? Private equity refers to the business of pooling funds from multiple sources and investing it in other businesses. 25 The managers of private equity funds collect a fee, and also receive a percentage of the returns from investments.26 Private equity, as its name suggests, has many private qualities. Quintessential private equity pools funds from a small number of wealthy investors or institutional investors like pension funds and university endowment funds.27 The usual targets of private equity investments include firms whose value has not yet materialized or that are struggling; and once a private equity fund identifies a target where it would like to invest such funds, the standard course of action is to take the target
24 Antoine Drean, Ten Predictions for Private Equity in 2015, FORBES (Jan. 12, 2015), http://www.forbes.com/sites/antoinedrean/2015/01/12/ten-predictions-for-private-equity-in-2015/. For scale, the $700 billion that is estimated to be invested into private equity this year is equivalent to the total amount that the entire arts and culture sector contributed to the U.S. gross domestic product (GDP) in 2014. Javier Panzar, Arts and culture accounted for nearly $700 billion in U.S. GDP, LA TIMES (Jan. 12, 2015), http://www.latimes.com/business/la-fi- arts-culture-gdp-20150112-story.html. 25 Josh Lerner et al., Venture Capital and Private Equity: A Casebook 1-11 (5th Edition, 2012). 26 Josh Lerner et al., Venture Capital and Private Equity: A Casebook 1-11 (5th Edition, 2012). 27 See Josh Lerner, Venture Capital and Private Equity: A Course Overview (2001). 6
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company, which is often a public company, private.28 The identity of owners and investors, investment strategies and how much is made and lost, are not typically known to outsiders.29 There are some discrete moments in the private equity cycle when some glimpses into the innerworkings of private equity are provided, such as at formation, re-up after dissolution, private equity’s exit from its investment, and litigation.30 Other than these momentary resurfacings (most of which, with the exception of litigation31, are at the private equity fund’s discretion and control with respect to the timing and extent of what gets disclosed), private equity largely operates privately. And relying on this veil of privacy, private equity firms have been a black box not only to public investors but also to regulators.32 Because the private equity investor base consisted of large, wealthy and sophisticated investors who are not the primary intended beneficiaries of securities regulations, private equity has generally avoided or has only been lightly touched by securities regulation.33 This outcome was largely by design and the work of financiers and lawyers who created an elaborate structure that creatively combined organizational features and contract design to allow private funds to operate in regulation’s shadows.34 A look into the early history and origins of private equity show that private equity, from its inception, was premised on filling gaps left open by regulation. Private equity firms were introduced in the 1930s specifically to fill the gap created by bank regulations after the Great Depression. 35 Chiefly, the Glass-Steagall Act prevented merchant banks from being both a
28 JOSH LERNER, VENTURE CAPITAL AND PRIVATE EQUITY: A COURSE OVERVIEW, 12 (describing the standard features of private equity firms) and 16 (“Private equity investors are almost invariably attracted to firms that find traditional financing difficult to arrange”). 29 Comment, Steven E. Hurdle, Jr., A Blow to Public Investing: Reforming the System of Private Equity Fund Disclosures, 53 UCLA L. Rev. 239, 243-44 (2005) (“Most private equity funds and investors appear to agree that keeping investment details confidential benefits all parties because ‘[limited partners] want to earn the best return possible and [general partners] want to safeguard sensitive information about the private companies in which they invest.’”). 30 For example, in November 2002, a California Superior Court mandated California Public Employees’ Retirement System to disclose “all reports of showing the performance of private equity investments made under CalPERS Alternative Investment [] Program cases,” under the authority of California’s Public Records Act. 53 UCLA L. Rev. at 255-257. Similarly, the University of California was compelled to reveal “all documents showing the internal rate of return of any private equity investment which have been made by [it].” Id. 31 And even with respect to litigation, confidentiality and waivers have been carefully negotiated to set bounds on the extent of the content and timing of what will need to get disclosed. 32 Private equity firms fit under the private placement exemption which relieves them from the disclosure obligations related to a public offering.” James C. Spindler, How Private Is Private Equity, and at What Cost?, 76 U. Chi. L. Rev. 311, 321 (2009). 33Id. (“[I]f offers and sales are restricted to accredited investors, no disclosures are necessary.”). 34 JOSH LERNER, VENTURE CAPITAL AND PRIVATE EQUITY: A COURSE OVERVIEW, 9 (“Private equity partnership agreements are complex documents, often extending for hundreds of pages.”). For a discussion of the role of lawyers as transaction cost engineers, see Ronald J. Gilson, Value Creation by Business Lawyers: Legal Skills and Asset Pricing, 94 Yale L.J. 239 (1984). See also Victor Fleischer, Regulatory Arbitrage, 89 TEX. L. REV. 227, 230 (2010) (defining regulatory arbitrage as “the manipulation of the structure of a deal to take advantage of a gap between the economic substance of a transaction and its regulatory treatment.”); Chris Flood, SEC Issues Fresh Warning to Private Equity; REGULATION, Financial Times (London, England), Jun. 1, 2015, FT REPORT - FUND MANAGEMENT, at 11 (“Jay Baris, chairman of the investment management practice at Morrison & Foerster, a law firm, said private equity managers had been accustomed to flying below the radar of regulators.”). 35 John Steele Gordon, A Short (Sometimes Profitable) History of Private Equity, Wall Street Journal (Jan. 17, 2012) (“Merchant banks such as Morgan were largely forced out of such deals by the strictures of the Glass-Steagall Act, passed in 1933, which required these institutions to choose between being a depository bank and an investment bank, limiting the funds they had available. After World War II, private-equity firms began to fill the void.”). 7
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depository bank and investment bank, and limited the kinds of investments that traditional banks could pursue.36 Another set of laws that motivated the growth of private equity were tax laws.37 A 1981 cut in capital gains tax rate to 20% made private equity much more lucrative since its primary source of income is capital gains.38 Yet, it would be a misunderstanding to view private equity’s only strength as its ability to exploit regulatory loopholes. Private equity has also originated many financial and legal innovations which have generated efficiencies at both the fund level and the portfolio company level in which the funds invest.39 These innovations include matching investments, executive compensation, and corporate governance advantages.40 Because private equity managers have invested some of their own money into the fund, they have ‘skin in the game,’ which provides a strong incentive alignment mechanism.41 Further, clawback provisions and agreements not to compete further ensure the loyalty and dedication of private equity management to the fund.42 What has been most frequently noted about private equity in the law and finance literature is its ability to generate impressive returns while reducing agency costs that are endemic to the corporate form. Firms with multiple owners must coordinate the management of the firm through a centralized decision making body (or agent), and agency costs refer to the costs of monitoring and binding the agent to ensure that it acts in the best interests of the owners.43 Notably, Professor Michael Jensen has praised the private equity model for its ability to reduce agency costs by using high leverage and managerial incentives.44
36 The Glass-Steagall Wall, as it is referred to, eventually came down in 1999. Several politicians notably Elizabeth Warren have called for re-erection following the events of the 2007-2009 Financial Crisis. For an account of the Glass- Steagall Act and the resulting separation between investment and commercial banking, see Edward J. Markey, Why Congress Must Amend Glass-Steagall: Recent Trends in Breaching the Wall Separating Commercial and Investment Banking, 25 New Eng. L. Rev. 457 (1990). To this day we are debating what is the proper relationship between PE and banking. Allen N. Berger & Gregory F. Udell, The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle, 22 J. Banking & Fin. 613 (1998). 37 Sridhar Gogineni & William L. Megginson, IPOs and Other Nontraditional Fund-Raising Methods of Private Equity Firms, in PRIVATE EQUITY: FUND TYPES, RISKS AND RETURNS, AND REGULATION 31, 31 (Douglas Cumming ed., 2010). 38 Gogineni & Megginson, p.1. To this day, private equity firms avail themselves of favorable treatment under the tax code. See, e.g., Victor Fleischer, Taxing Blackstone, 61 TAX L. REV. 89 (2008); Gregg D. Polsky, Private Equity Management Fee Conversions, 122 TAX NOTES 743 (2009). 39 Elisabeth De Fontenay, Private Equity Firms as Gatekeepers, 33 REV. BANKING & FIN. L. 115, 169 (2013–2014) (noting the “frequent innovations in debt terms that originate with private equity-related financings”) and Id. at 134 n.84 (“One of the skills developed by private equity firms is the ability to recognize and act on “mispricings” between the debt and equity markets.”). 40 See, e.g., Ronald W. Masulis & Randall S. Thomas, Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance, 76 U. CHI. L. REV. 219 (2009) (describing the corporate governance advantages of private equity, which include financial sophistication of directors and close supervision of management). 41 See Lloyd L. Drury, III, Publicly-Held Private Equity Firms and the Rejection of Law As A Governance Device, 16 U. Pa. J. Bus. L. 57, 84-86 (2013). 42 Clawbacks ensure general partners will repay any amount they gain in excess of what was specified in a limited partnership agreement. JOSH LERNER ET AL., VENTURE CAPITAL, PRIVATE EQUITY, AND THE FINANCING OF ENTREPRENEURSHIP, 42-43 (2012). 43 Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 10 (1991). 44 See Michael C. Jensen, Eclipse of the Public Corporation, HARV. BUS. REV. 326 (Sept. 1989) available at http://hbr.org/1989/09/eclipse-of-the-public-corporation/ar/1. 8
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Relying on this advantage, private equity has developed into a high-powered financial engine that has generated impressive returns.45 While this lean and opaque model of private equity is a stark departure from the public company norm, calibrations were not needed or prompted as public investors had little to no opportunity to invest in private equity - until recently. In the last few years, however, a number of prominent private equity firms (such as Apollo, Ares, Blackstone, Carlyle, Fortress and KKR) have decided to go public, which has created a direct pathway for public investors to invest in private equity firms. Yet, these publicly-listed private equity firms (or PLPE) have not done much to accommodate this change in their investor base; nor have they been required to do so, either by market forces or the law. Instead, PLPEs have been able to retain many of their private features even following their conversions to public firms. The remainder of this Article reviews how PLPEs have been operating in the gray area between public and private companies, and unpacks the theoretical implications and regulatory challenges of this hybridity.
b. Motivations and mechanics of publicly-listed private equity (PLPE) Within the last decade, the private nature of private equity has been eroded in a transformational way by the initial public offerings (IPOs) of private equity firms. Ordinary retail investors can today buy and sell a share of several private equity firms on the national or foreign stock exchanges. Upon purchase, the common unitholder immediately becomes a limited partner of the private equity firm, if it is organized as a partnership. A quick search of any of these private equity firms on the SEC database gives anyone access to these firms’ disclosures regarding their financial performance, securities ownership, and extraordinary events, among other information required to be disclosed by publicly-traded firms.46 The going public transaction of private equity firms, notorious for being private entities, offers an interesting case study that can be used to answer a variety of questions: What kinds of private equity firms have decided to go public? 2007 was the year that we saw the first private equity IPOs of Fortress, Blackstone Group and KKR, three of the largest and most prominent private equity firms at that time and to this day.47 The primary explanation for these early IPOs of private equity firms was that the industry desired to diversify the sources of capital. 48 Generally speaking, as will be discussed later in Part II, private firms suffer from liquidity constraints because they are limited as to the number and type of
45 See JOSH LERNER, VENTURE CAPITAL AND PRIVATE EQUITY: A COURSE OVERVIEW 1 (2001) (“Private equity’s recent growth has outstripped that of almost every class of financial product.”). 46 Wulf A. Kaal, Hedge Fund Manager Registration Under the Dodd-Frank Act, 50 San Diego L. Rev. 243, 316 (2013) (“As part of the new rules [under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010], the SEC introduced controversial reporting obligations that require [private equity managers to disclose] strategies and products used by the investment adviser and its funds, performance and changes in performance, financing information, risks metrics, counterparties and credit exposure, positions held by the investment adviser, percentage of assets traded using algorithms, and the percentage of equity and debt, among others.”); see Dodd-Frank Act, Pub. L. No. 111-203, §§402-408, 124 Stat. 1376, 1570 (2010). 47 These three issuers are still traded on markets today. We now have the benefit of 5-8 years of progression and hindsight to evaluate a new development which has shown that it is not just a fad or failed experiment. When search Companies for SIC 6282 - INVESTMENT ADVICE in SEC Edgar, there are 133 companies. Of these [___] are PE firms. 48 Mohsen Manesh, Legal Asymmetry and the End of Corporate Law, 34 Del. J. Corp. L. 465, 499 (2009) (“Rather than ensuring distributions to the owners and thereby forcing the managers to return to the capital markets in pursuit of cash, [private noncorporations] . . . go public partly in order to get “permanent” capital.”) (citing Larry E. Ribstein, Uncorporating the Large Firm 14 (Univ. of Ill., Law & Econ. Research Paper Series, Paper No. LE08-016, 2008), available at http://ssrn.com/abstract=1138092.) 9
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investors they can accept investments from, while public firms suffer from the agency problem that arise from the dispersed ownership and the separation of such owners from those who control the firm. However, these private equity firms that had chosen to go public were not firms that suffered from liquidity constraints. They were the most successful among their peers and were oversubscribed. The classic story of a young company coming to the capital markets to seek a broader pool of investments for its next phase of operations does not fit with the private equity firms that launched IPOs. Instead, a more accurate statement of private equity motivations for going public is that the firms that decided to make the switch had come to the conclusion that the private benefits (including liquidity benefits) of going public were enough to exceed the agency benefits of remaining private.49 Turning to the mechanics of how, Fortress Investment Group was the first private equity firm to launch its initial public offering (IPO) in 2007, with Blackstone and KKR soon following suit later that year.50 Index funds based on a composite of publicly-listed private equity (or PLPE) firms are also actively traded on the stock exchanges.51 Notably, the S&P Listed Private Equity Index (Ticker: SPLPEQTY) which is comprised of the leading PLPE firms, was launched in March 12, 2007 and on August 1, 2015, had 60 constituent firms and a constituent total market cap of almost $35 billion. To unpack the specific mechanics of a private equity firm’s conversion from a private to public company, I will rely on the example of the IPO of Blackstone Group L.P. (Blackstone), which was one of the first of the large private equity firms to go public.52 The timing of Blackstone’s IPO was at the peak of market, and Blackstone filed its S-1 (Securities Registration Statement) with the Securities and Exchange Commission (SEC) on March 22, 2007.53 Blackstone raised $4.13 billion (an offering of 133,333,334 common units representing limited partner interests at $31/share) for 12.3% control of the fund,54 and was soon thereafter listed and traded on the New York Stock Exchange (ticker symbol: BX).55 The IPO of Blackstone was at the fund level, Blackstone Group L.P.56 Also referred to as a holding partnership, Blackstone Group L.P. is a Delaware limited partnership (L.P.) that is also the parent of several Blackstone Holdings partnerships. Upon purchase, the common unitholder immediately becomes a limited partner of the private equity firm, if it is organized as a partnership. Section 2.1 (Formation) of Blackstone’s Limited Partnership Agreement (LPA) states that except as expressly provided to the contrary in the LPA, the rights, duties, liabilities, obligations, administration, dissolution, and termination of the partnership shall be governed by the Delaware Limited Partnership Act. Above the fund sits the Blackstone Group Management L.L.C., which is
49 See Id. at 468-469 (“Investments in private equity were lucrative but relatively illiquid, transferable in only limited circumstances, and often requiring the consent of the private equity fund's manager.”); Id. at 472 (“Shareholders of public corporations tend to be dispersed and fragmented, each holding only a small stake in the corporation. As a result, like all large groups, shareholders suffer from problems of collective action, making it difficult for shareholders to organize in large blocs to challenge their corporate managers.”). 50 David P. Stowell, Investment Banks, Hedge Funds, and Private Equity 418 (2013). 51 For an argument that such PLPE composites are too volatile for public investment, see see Conrad de Aenlle, Private-Equity ETFs Aren’t Fit for the Public, MARKETWATCH (May 6, 2013, 8:31 AM), http://www.marketwatch.com/story/private-equity-etfs-arent-fit-for-the-public-2013-05-06. 52 As of March 1, 2007, Blackstone had $78.7 billion assets under management. Blackstone S-1, p.1 53 Blackstone S-1, cover page. 54 Blackstone final prospectus 55 Blackstone CERTNYS, June 19, 2007. Blackstone received certification by the New York Stock Exchange (NYSE) that its securities had been approved for listing on the NYSE on June 19, 2007. 56 As of March 1, 2007, Blackstone had $78.7 billion assets under management. Blackstone S-1, p.1 10
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the general partner and is wholly-owned and controlled by the senior managing directors and founders of Blackstone. 57 While the investor base of PLPE has undergone this significant shift, there has not been a corresponding change in the organizational structure and contractual design of private equity to reflect this change in the ownership and investor base.58 In fact, private equity firms that have gone public tout that their edge lies in their ability to conduct their business as usual as though they were still a private company even following their IPOs.59 The most problematic aspects of this hybridity and the inadequacy of the current securities regulatory regime in remedying the problem are discussed in the following sub-parts c and d, respectively.
c. PLPE Hybridity: Going public while staying private The central argument advanced in this Article is that the legal and financial engineering that has made private equity firms successful has eroded the core rights of public investors, making PLPE unsuitable for public investment in its current form.60 PLPE have been able to achieve this result by availing themselves of both the full extent of contractual waivers permitted under state law, and the full extent of regulatory exemptions and carveouts under securities regulations and exchange listing rules.
Public (open) Private (closed) PLPE (hybrid) Fiduciary duties Yes Limited Limited Investor voting Yes Limited Limited Investor monitoring Yes Limited Limited Liquidity benefits Yes Limited Yes Mandated disclosures Yes None Yes
While PLPE does not offer the full suite of investor protections typically offered by public companies, the current regulatory regime tolerates this outcome so long as disclosure of limited fiduciary, voting and monitoring rights are provided. The balance of this sub-part explains the problematic aspects of PLPE hybridity, and the following sub-part d. explains why disclosure alone is ineffective for investments like PLPE that are attractive to investor particularly due to their high levels of risk (and the presumed high returns that investors expect they will receive in return).
57 Blackstone S-1, p.11 58 Lloyd L. Drury, III, Publicly-Held Private Equity Firms and the Rejection of Law as a Governance Device, 16 U. PA. J. BUS. L. 57 (2013). 59 The Blackstone Group L.P., Form S-1 Registration Statement under the Securities Act of 1933, SEC, 7 (Mar. 22, 2007), available at http://www.sec.gov/Archives/edgar/data/1393818/000104746907002068/a2176832zs-1.htm (”We Intend to be a Different Kind of Public Company”). 60 In addition to the substantive erosions, another problematic aspect is the procedural deficiencies. Although the investors in the offering are not signatories to the LPA, the offering document makes clear that by purchasing common units, the common unitholders will become automatically bound to the provisions to the partnership agreement. The lack of any meaningful opportunity to renegotiate or amend such provisions as well as the restrictive nature of these provisions are discussed in greater detail in a companion paper. 11
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The absence of investor protections and rights was acceptable to initial investors of private equity so long as they were compensated by other means, primarily high returns 61 (or the possibility thereof) and limited liability,62 which were both attainable at elevated levels thanks to the lean structure and complex contractual design of private equity. And these investors were sophisticated investors who had the advice and counsel of financial and legal advisors in negotiating and documenting this bargain.63 Also, because private equity firms had to come back to market every few years to raise funds, there was a built-in mechanism to keep funds and their managers in check.64 In other words, what appear to be ‘absent’ governance mechanisms were supplemented by other informal and extra-legal measures which from the perspective of investors was net positive, and these investors possessed the capacity and resources to make such a determination. But retail investors do not enjoy the same capacity and resources as sophisticated investors. Notably, the concentration of ownership and control within the private equity structure means that key business decisions are being made unilaterally by the controlling group (usually the founders) at the exclusion of minority investor input. To obtain this outcome, the investors (or limited partners) of private equity have relinquished many basic investor rights and protections, such as the right to select the board or the general partner, and have agreed to waive basic fiduciary duties, such as the duty of loyalty.65
d. Why disclosure is not enough While the Limited Partnership Agreement (LPA) in its entirety is available to the common unitholders to review (it is appended as an index to the Registration Statement), and the offering document provides a summary of key provisions, the LP is a complex organizational structure with nonstandard features, and the LPA is a complex document that contains several hidden traps for the unwary. The risks involved with PLPE investments are particularly complex, and are described in ways that may not cause great alarm, particularly for an ordinary retail investor. In the next few paragraphs, I offer some comparisons of what is stated in the risk disclosures versus the unstated implications of that statement.
61 Paul A. Gompers et al., What Do Private Equity Firms (Say They) Do? (Harvard Bus. Sch., Working Paper No. 15- 081), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2447605 (Gompers et al.’s survey of 79 private equity firms show that private equity investors target a 22% internal rate of return on investments). 62 Lee Harris, A Critical Theory of Private Equity, 35 Del. J. Corp. L. 259, 273 (2010) (“Private equity investors traditionally are financial behemoths-insurance companies, pen-sion funds, and mutual funds-with substantial assets that they are likely loath to put at risk even if the probability of liability is a relatively low one.”). [Schwarcz has argued for removal of limited liability of PE owners][Morley separation of investment and management]. 63 Josh Lerner, Venture Capital and Private Equity: A Course Overview, 11 (“Investors [in private equity] – whether pension funds, individuals, or endowments – each have their own motivations and concerns. These investor frequently hire intermediaries.”) 64 Josh Lerner, Venture Capital and Private Equity: A Course Overview, 9-10 (“The need to terminate each fund imposes a healthy discipline, forcing private equity investors to take the necessary-but-painful step of terminating underperforming firms in their portfolios.”) 65 JOSH LERNER, VENTURE CAPITAL AND PRIVATE EQUITY: A COURSE OVERVIEW 10 (2001) (noting that “the structuring of private equity partnerships and their investments into portfolio firms provide insights into the parallels to and limitations of the approaches to corporate governance taken by investors in publicly traded firms”). See also Michael C. Jensen, The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, 48 J. FIN. 831 (1993); Andrei Schleifer & Robert W. Vishny, A Survey of Corporate Governance, 52 J. FIN. 737 (1997). 12
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As one example, PLPE has clearly stated that they will prioritize long-term vision over short- term returns.66 Taking the Blackstone offering document as an example, it explicitly states that Blackstone will not choose a course of action just because it maximizes short-term financial performance.67 Blackstone warns the common stockholder that returns will therefore vary from quarter to quarter and that they “do not plan to provide guidance regarding our expected quarterly and annual operating results.”68What this means is that business decisions that appear to be detrimental to short-term returns (which has a direct impact on the price at which public shareholders can sell) could be rationalized as having been made with long-term goals in mind.69 Further, the lack of guidance could lead to increased volatility in the stock price.70 Another example is a disclosure statement like the one below that appears on page 11 of the Blackstone registration statement: “it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm.” What the provision does not say is that Blackstone will maintain their success as privately-owned firm, but that they will continue to seek to optimize returns to the investors in their investment funds. While they “believe that optimizing returns for the investors in our funds will create the most value for our common unitholders over time”, what this really means is that if the two conflict the incumbent investor comes first, even at the expense of common unitholders. In addition, with high-risk-high-return investments like PLPE, high risk and the promise of high returns in exchange therefor, is what is appealing to investors. Therefore, disclosing that there are risks involved in PLPE is unlikely to dissuade retail investors from walking into such traps. Moreover, the fact that PLPE is listed on the national stock exchanges may presume that baseline protections are already there. The label of a “public” company triggers regulatory treatment and investor expectations premised on the availability of such core investor protections. This result leaves public investors vulnerable to opportunism, without any defense mechanism in the event of losses.71 To summarize, it is not liquidity constraints, but maximization of private gains to incumbent owners, that drive private equity firms to go public. A review of the organizational structure and contract design of PLPE that ensure that incumbents retain exclusive control over PLPE management and eliminates the monitoring and accountability to retail investors supports this explanation. In particular, the retail investor has inherited an investment product that has been stripped of core rights and protections without receiving anything in return. Furthermore, the bargaining process and standardized forms used to bind common investors to the pre-existing limited partnership contracts are adhesive.72 At the moment PLPE seek retail investment, it is the
66 and in fact private equity has often been criticized for its short-termism so we should applaud such long-term focused efforts. But worry that it is a way to deny shareholder the gains that they may expect in the capital markets. Balancing is important. 67 Blackstone S-1, cover 68 Blackstone S-1, p.8 (“We do not intend to permit our status as a public company to change our focus on seeking at all times to optimize returns to investors in our investment funds [cf. other investors]. Accordingly, we expect to take actions … to achieve this objective, even if these actions adversely affect our near-term results.”) 69 Blackstone S-1, p.8 70 Blackstone S-1, p.26 (Risk Factors)` 71 For an account of the unraveling of private equity investments during the recent financial crisis, see Steven M. Davidoff, The Failure of Private Equity, 82 S. CAL. L. REV. 481 (2009). 72 Adhesion contracts (or standardized contracts) generally refer to contracts based on a standardized form, where there is imbalance in the parties’ bargaining power, and little actual bargaining taking place (i.e., take-it-or-leave-it approach). Todd Rakoff, Contracts of Adhesion: An Essay in Reconstruction, 96 Harv. L. Rev. 1173, 1176-1177 (1983) (defining a model “contract of adhesion”). 13
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role of capital markets regulation to restore these lost rights and protections, or to bargain for concessions on behalf of the retail investor. As I explain, disclosures of such eliminations or erosions is not going to be an effective tool in reclaiming the rights of retail investors, and instead, I suggest looking to a well-established negligence rule – the attractive nuisance doctrine – as one template for managing the harms that result as a consequence of the hybridity of PLPE.
II. PLPE: Empirical Review This Part supplies the empirical basis of the arguments advanced in Part I. I reviewed the company reports, registration statement and organizational documents of a total of 46 publicly- listed private equity firms. I constructed the universe of publicly-listed private equity firms by running the below Company Search Criteria on Bloomberg which yielded a list of 11 private equity firms that are currently traded on either NASDAQ or the NYSE.
Type: Search (Company) Country: Matches any of the following: United States Industry: Matches any of the following: Private Equity Trading Status: Matches any of the following: Active
I then supplemented this list with the firms that are included in the five leading indexes of publicly- listed private equity firms, bringing the total number of firms to 46 firms. These indexes are:
1. S&P Listed Private Equity Index: The S&P Listed Private Equity Index comprises the leading listed private equity companies that meet specific size, liquidity, exposure, and activity requirements, available at http://us.spindices.com/indices/equity/sp-listed-private- equity-index 2. PowerShares - PSP Global Listed Private Equity Index: The PSP Index includes securities, American depository receipts and global depository receipts of 40 to 75 private equity companies, including business development companies (BDCs), master limited partnerships (MLPs) and other vehicles whose principal business is to invest in, lend capital to or provide services to privately held companies (collectively, listed private equity companies), available at https://www.invesco.com/portal/site/us/financial- professional/etfs/holdings/?ticker=PSP 3. ALPS | Red Rocks Listed Private Equity Fund: The ALPS | Red Rocks Listed Private Equity Fund is an open-end mutual fund that invests in publicly-traded private equity companies that trade on global exchanges. The Fund assembles approximately 30-50 holdings and is diversified by stage of investment, geography, industry, and capital structure, available at http://www.alpsfunds.com/holdings/alps-red-rocks-listed-private- equity-fund 4. iShares Listed Private Equity UCITS ETF: The iShares index tracks the performance of an index composed of publicly-listed companies active in the private equity space, available at https://www.ishares.com/uk/individual/en/products/251918/ishares-listed-private- equity-ucits-etf?siteEntryPassthrough=true 5. LPX Direct Listed Private Equity Index: The LPX Direct represents the most actively traded LPE companies covered by LPX Group that mainly pursue a direct private equity investment strategy. A listed private equity company is an eligible candidate for the Index if its direct private equity investments, as well as cash and cash equivalent positions and
14
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post-Initial Public Offering listed investments, represent more than 80% of the total assets of the company available at http://lpx-group.com/lpx/. I limited this review to domestically-organized and domestically-traded (i.e., NASDAQ and NYSE) firms. a. Organizational Structure Many publicly-traded private equity firms are organized as business development companies (BDCs). BDCs are subject to minimum dividend requirements and favorable tax rules which make them highly compatible with the private equity model. Others are organized as limited partnerships and limited liability companies.
Among the sample studied, 37 of the 46 firms are organized as a corporation, including BDCs. 5 are limited partnerships and 4 are limited liability companies. Whether the PLPE takes the form of a BDC, LP, or LLC, what the investor in that enterprise ultimately owns depends on whether the PLPE takes a direct or indirect investment approach. If the PLPE is a direct private capital investment company, the PLPE invests directly in the underlying companies, and what the investor owns is a portfolio of private companies.73 In the case of an indirect private capital investment company, the PLPE contributes to a limited partnership which in turn invests in the underlying companies. For example, a PLPE investor may own a share of a BDC which in turn commits the capital it has raised in the public capital markets into a traditional private equity limited partnership (LP). At the end of the day, what the investor owns is a portfolio of limited partnerships
73 For a description of the difference between the two investment strategies, see, e.g., Listed Direct Private Capital Investment Company, LPX and Listed Indirect Private Capital Investment Company, LPX. 15
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27 of the 46 firms are organized in Delaware, and 17 of the 46 firms are organized in Maryland. While Delaware is the most popular state of domicile for PLPEs, Maryland also is a popular choice. Since the 1975 recodification of the former Article 23 of the Annotated Code of Maryland into the Corporations and Associations Article, the basic corporation law of Maryland has been regarded as at least as favorable to corporations as (and in some respects considerably more favorable than) Delaware.74 1 firm is organized in Pennsylvania, 1 firm is organized in Texas.
17 of the 46 firms are listed on NYSE. 29 of the 46 firms are listed on NASDAQ. While outside of the immediate scope of this paper, it is important to note that the universe of PLPE extends much beyond the NYSE and NASDAQ, including on the stock exchanges of Australia (ASX), Austria (VSX), Belgium (BSE), Brazil (Bovespa), Canada (TSX), Denmark (OMX Copenhagen), Finland (OMX Helsinki), France (Euronext Paris), Germany (Xetra, FWB), Great Britain AIM,
74 For a detailed study and comparison of the principal provisions of the Delaware and Maryland Corporation Statutes see James J. Hanks, Jr., Comparison of the Principal Provisions of the Delaware and Maryland Corporate Statutes (2015), available at https://www.venable.com/files/Publication/b6120455-7b9c-4fee-938a- 007d2accd17a/Presentation/PublicationAttachment/9ef7e472-37a8-40ff-b13c- 603c72fca450/Comparison_of_the_Principal_Provisions_of_the_Delaware_and_Maryland_Corporation_Statut.pdf 16
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LSE), Greece (ASE), Hong Kong (HKSE), Ireland (ISE), Italy (Borsa Italiana), Japan (JASDAQ, TSE), Netherlands (Euronext Amsterdam), Singapore (SGX), South Africa (JSE), Spain (Bolsade Madrid), Sweden (OMX Stockholm), and Switzerland (SWX). To demonstrate the one-sided nature of PLPE investment, I reviewed the organizational documents of the universe of 46 private equity firms (representing total market capitalization exceeding $106 billion), and report my findings in the next sub-Part.
b. Organizational Documents Limited Voting Rights.75 The original limited partners of private equity needed this limitation on voting in order to retain limited liability—it is a long-established principle of corporate law that with limited control comes limited responsibility. My empirical review confirms that this arrangement has continued even following the conversion of private equity into a public corm where limited liability is automatically conferred to shareholders as a result of the separation of ownership and control. For example, common unitholders of Blackstone do not have the right to elect or remove the general partner. GP removal (p.193) is decided by a supermajority standard – meaning it requires approval of holders of at least 66 2/3 % of outstanding voting units and the approval of a successor general partner, which in turn requires approval of holders of at least majority of outstanding voting units. The common unitholders hold less than 20% of outstanding units, so by design, the common unitholders have been stripped of the most basic power of owners to vote the managers who will run the company on their behalf. Founders fully retain the right to elect the general partner and the directors. 76 Limited call rights. Another feature that is frequently used in PLPE is the limited call right. One example is the mandatory call option used by Blackstone which is designed so that if at any point less than 10% of then issued and outstanding limited partner interests of any class (including the class of shares owned by a public investor) are held by persons other than the general partner (GP) or its affiliate, the GP has the right to acquire all (not less than all) of the remaining limited partnership interests. The purchase price is set according to a pre-set formula (greater of market price or price paid by GP for those interests within a 90 day window) and the only constraint is a simple procedural requirement of 90 days of advance notice. These partnership securities may represent interests with rights, powers, and duties that are not applicable to common units.77
75 A recent study of voting restrictions by Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption, 123 YALE L.J. 948 (2014) [hereinafter “H&P”], offers a survey of the various theories which explain restrictions on voting – one is a preference for democratic governance and another is to attract participation of small shareholders. H&P argue that neither theory explains why voting restrictions are approved only in certain industries and not in others and why voting restrictions disappear. Instead, they offer an alternative explanation and argue that voting restrictions serve as a consumer protection device. The premise of H&P’ work is the separation of ownership and consumption as fundamental turning point in the history of the business corporations. H&P describe 19th and 20th century developments in shareholder voting and find this understanding useful to understand patterns of corporate control. H&P notes the shift from restrictions on voting (rules favoring small over large shareholders) to pro rata rule to augmented voting (i.e. more votes per share allocated to the largest shareholders) (e.g. Facebook and Google’s dual class structure.) Id. at 956 (“there is no consensus on the reasons for the recent embrace of augmented voting”). 76 Blackstone S-1, 160. Explains that the election of the board of directors of the general partner will take place in accordance with the general partner’s LLC agreement. 77 LPA Section 5.6 (Issuance of Additional Partnership Securities) – Partnership may issue additional Partnership Securities and options, rights, warrants and appreciation rights related thereto for any partnership purpose at any time 17
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Limited ability to call meetings. Investors in PLPE are also limited in their ability to call meetings or acquire information about operations.78 In some extreme cases,79 if at any time any person or group acquires beneficial ownership of 20% or more of any class of the Fund’s common units then outstanding, “that person or group will lose voting rights on all of its common units and the common units may not be voted on any matter and will not be considered to be outstanding when sending notices of a meeting of common unitholders, calculating required votes, determining the presence of a quorum or for other similar purposes.” Such a ‘cliff’ effectively acts as a bar on shareholder activism. Limited monitoring rights. Lastly, PLPE’s investors right to inspect books and record is narrower than the investors of a typical company. Upon reasonable written demand and at own expense, any limited partner can, for purposes reasonably related to interest as limited partner, request a copy of Fund’s tax returns, and copies of partnership agreement, certificate of limited partnership, related amendments and powers of attorney. However, the scope of these disclosures are again subject to the general partner’s discretion regarding business interests and confidentiality.80
c. Agency Principles Limited Fiduciary Duties. Specific waivers of fiduciary duties vis-à-vis common unitholders have been effected by contract. 81 In addition, the general partner (GP) can make certain decisions in its sole discretion, which is defined to mean that the GP may consider any interests and factors, including its own interest (i.e., in its individual capacity). Any such decision made by the GP in its individual capacity and not in its capacity as GP will be “without any fiduciary obligation to [the limited partners] or the common unitholders whatsoever.”82 PLPE attempts to reconcile such tensions by stating their belief that “optimizing returns for the investors in our funds will create the most value for our common unitholders over time.” But to the extent the two interest groups are in tension, what economic incentives and legal mandates will direct PLPE’s course of action? As described above in the discussion of Part I.B., extra-legal for such consideration and on terms and conditions as general partner shall determine in its sole discretion, all without the approval of any limited partners. Section 6.3 (Requirement and Characterization of Distributions) (a) General Partner has sole discretion to authorize distributions by the partnership to the partners. 78 Blackstone S-1, p.45 79 Blackstone S-1, (pp. 194-195) 80 LPA Section 3.4(b) “The General Partner may keep confidential from the Limited Partners, for such period of time as the General Partner determines in its sole discretion, (i) any information that the General Partner reasonably believes to be in the nature of trade secrets or (ii) other information the disclosure of which the General Partner believes (A) is not in the best interests of the Partnership Group, (B) could damage the Partnership Group or its business or (C) that any Group Member is required by law or by agreement with any third party to keep confidential” 81 The decision and manner in which fiduciary duties are waived to the fullest extent in PLPE is consistent with the empirical findings of legal scholars that have studied publicly-traded limited partnerships and limited liability companies. See Mohsen Manesh, Contractual Freedom Under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs, 37 J. Corp. L. 555, (2012) (finding that majority of the 85 entities reviewed contain waiver/elimination of fiduciary duties without substitute mechanisms); Suren Gomtsian, The Governance of Publicly Traded Limited Liability Companies, 40 Del. J. Corp. L. 207 (2015) (finding that majority of the 20 entities reviewed contain limits on fiduciary duties of care and loyalty); Sandra K. Miller, A New Direction for LLC Research in a Contractarian Legal Environment, 76 S. Cal. L. Rev. 351 (2003) (observing few contractual protections of minority protections). Cf. Michelle M. Harner and Jamie Marincic, The Naked Fiduciary, 54 Ariz. L. Rev. 879 (finding non- uniformity across the 129 non-listed entities reviewed). 82 Blackstone S-1, 183. 18
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mechanisms such as reputation and fee structures favor the institutional investor and there are very few legal protections that are available to protect common unitholders. Professor Lloyd Drury has written previously about the dangers of individual investor oppression given the reality has two masters – institutional investors and non-institutional investors.83 This project sheds new light on this phenomenon by presenting the below data to confirm the overwhelming presence of institutional ownership in PLPE.
INSITITUTIONAL OUTSTANDING % COMPANY NAME HOLDINGS SHARES INSTITUTIONAL (million) (million) HOLDINGS Safeguard Scientifics Inc. 21.4 20 107.00%84 Macquarie Infrastructure Corp 80.3 80 100.38% Icahn Enterprises LP 127.9 131 97.63% Actua Corporation 38.0 40 95.00% American Capital Ltd. 218.1 239 91.26% Capital Southwest Corporation 11.0 15 73.33% Fortress Investment Group LLC 161.1 221 72.90% Solar Capital Ltd. 29.6 42 70.48% KKR and Co. Units 307.7 449 68.53% Apollo Global Management LLC 122.4 183 66.89% TCP Capital Corporation 31.4 48 65.42% Compass Group Diversified Holdings LLC 35.1 54 65.00% Oaktree Capital Group LLC 38.7 61 63.44% CSW Industrials Inc. 9.3 15 62.00% The Carlyle Group L.P. 49.6 81 61.23% PJT Partners Inc. Class A 9.5 17 55.88% Blackstone Group L.P./The 314.9 565 55.73% Ares Capital Corporation 173.4 314 55.22% Ares Management LP 44.1 80 55.13% Garrison Capital Inc. 8.6 16 53.75% Golub Capital BDC Inc. 27.0 51 52.94% MVC Capital Inc. 11.6 22 52.73% Fifth Street Asset Management, Inc. 77.6 150 51.73% Fifth Street Finance Corporation 77.6 150 51.73% THL Credit Inc. 17.0 33 51.52% New Mountain Finance Corporation 31.8 63 50.48% Apollo Investment Corporation 105.9 226 46.86% Hercules Technology Growth Capital 33.3 72 46.25% GSV Capital Corporation 8.3 19 43.68%
83 Lloyd L. Drury, III, Publicly-Held Private Equity Firms and the Rejection of Law As A Governance Device, 16 U. PA. J. BUS. L. 57 (2013). 84 There are two firms with more than 100% institutional ownership. This discrepancy in calculation can likely be explained by shorting transactions that could lead to double counting of certain institutional holdings. http://www.investopedia.com/ask/answers/07/institutional_holdings.asp 19
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Gores Holdings Inc. 14.9 37 40.27% Pennantpark Investment Corporation 28.3 71 39.86% Medley Capital Corporation 21.5 55 39.09% Main Street Capital Corporation 16.3 50 32.60% Capitala Finance Corporation 4.7 15 31.33% FS Investment Corporation 75.4 242 31.16% Pennantpark Floating Rate Capital 8.0 26 30.77% Solar Senior Capital Ltd. 3.3 11 30.00% Gladstone Investment Corporation 8.6 30 28.67% Triangle Capital Corporation 9.2 33 27.88% Blackrock Capital Investment Corporation 20.3 74 27.43% Oxford Lane Capital Corp. 4.6 17 27.06% TICC Capital Corporation 14.7 59 24.92% KCAP Financial Inc. 7.9 37 21.35% Fidus Investment Corporation 3.4 16 21.25% Prospect Capital Corporation 56.4 355 15.89% Gladstone Capital Corporation 3.5 23 15.22%
Institutional holdings data is collected from Bloomberg, which defines “institutions” as any of the following: 401(k) plans, banks, corporations, endowments, estates, foundations, governments, hedge fund managers, holding companies, insurance companies, investment advisers, pension funds, private equity funds and investment vehicles, stock ownership plans, trusts, and venture capital funds and their investment vehicles. The “% institutional ownership” calculates the institutional holdings as a percentage of total shares outstanding (listed in the above table in the order of largest to smallest). All of the firms studied have more than 15% institutional holdings, with more than half (26 of 46 total firms) of the firms studied having greater than 50% institutional holdings. This is evidence that the “average” investor targeted by PLPE is not the retail investor who is the intended beneficiary of securities regulations.
III. Proposal: Regulating PLPE and Other Hybrid Issuers
This Part reviews a host of solutions to the identified gap in PLPE regulation. One option is to force existing PLPE to become fully public by restoring basic governance mechanisms that are presently absent from the PLPE structure. A proposal in the same vein, but with prospective application would be to disqualify private equity firms that do not maintain a certain degree of ‘publicness’ from going public in the future.85 Both proposals presume that firms that raise capital
85 While both proposals are stated with reference to private equity issuers, the discussions in the part can be extended to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)’s “say-on-pay” provisions that apply to all public companies. “Say-on-pay” requires companies to provide their shareholders with an advisory vote on executive compensation matters such as pay, frequency and golden parachutes. This is not a new invention as it was first required in the U.K. more than a decade ago. Advisory means that the outcome of the vote is non-binding, but procedure requires disclosure of the compensation of named executive officers. See Jeffrey N. Gordon, “Say on Pay”: Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-In, 46 HARV. J. ON LEG. 323 (2009). 20
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from the public must meet certain baseline requirements, and that regulators (rather than investors, or the issuers, or any others) are in the best position to determine what those requirements should be. There are a number of ways to achieve this result. One way would be to amend the listing requirement that presently allows limited partnerships to opt out from governance requirements.86 Considering the incentives of the NYSE/NASDAQ and the origins of exceptions for limited partnerships, while this is the most straightforward approach, its feasibility is questionable.87 Another way would be to amend securities regulation to recognize a new category of issuer firms whose organizational and contractual complexities make them particularly hazardous to public investors and tailoring disclosure requirements accordingly. This idea is related to recent proposals suggested by Professors Langevoort and Thompson to create a sub-category of issuers subject to heightened disclosure requirements.88 Langevoort and Thompson have suggested that issuers with a larger “footprint” should sometimes be forced to take on public status.89 The specific firm that motivated their work was pre-IPO Facebook and how the then-private Facebook raised capital “privately” as a means of regulatory arbitrage.90 However, in this case, unlike theirs, the more fundamental problem for PLPE is not one of degree of regulation but type of regulation.91 A market-oriented approach could also be considered here. This is connected to Easterbrook and Fischel’s work which argues that the market may be imperfect but is the best-suited monitor
In the case of private equity, executive officers often do not take home a substantial salary, instead much of compensation tied to performance of investments. Executive compensation is used as an alignment mechanism – they have it down to a science. Combining stock options with contractual arrangements that restrict unloading. In many cases, CEOs set their own pay and there is no separate compensation committee. And there was been no reason for shareholders to object. Professor Robert Jackson studied the CEO pay at portfolio companies of private equity firms and finds that CEO pay at these firms are much more closely tied to performance via incentives. Jackson praises the executive compensation practices at these firms, and calls on other public companies to emulate it. I introduce the example of ‘say on pay’ regulation to show how treating private equity like a public company does not serve the intended purpose of public company regulation. The problems endemic to public companies generally do not apply to PLPE. And in some cases, like executive compensation, the misalignment between pay and performance that investors may be concerned about, is an area which PE has mastered. In fact, that is where their competitive advantage lies. What ‘say on pay’ intended to do – i.e., lower the level of executive pay and better align them with investor interests – that is what private equity already does best. So the proposed solutions and reforms attempt to solve a problem that is non-existent. PLPE will pass the “test” with flying colors but that’s not the area that needs improvement. 86 NYSE Listed Company Manual § 303A.00 (Corporate Governance Standards), NYSE, http://nysemanual.nyse.com/LCMTools/PlatformViewer.asp?selectednode=chp_1_4_3&manual=%2Flcm%2Fsectio ns%2Flcm-sections%2F (Aug. 20, 2015, 8:50 PM); NASDAQ Stock Market Rules § 5600 (Corporate Governance Requirements), NASDAQ, http://nasdaq.cchwallstreet.com/nasdaq/main/nasdaq- equityrules/chp_1_1/chp_1_1_4/chp_1_1_4_3/chp_1_1_4_3_8/default.asp (Aug. 20, 2015, 8:50 PM). 87 Chris Brummer, Stock Exchanges and the New Markets for Securities Laws, 75 U. CHI. L. REV. 1435 (2008). 88 Donald C. Langevoort and Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act, 101 Georgetown L. J. 337 (2013). 89 Donald C. Langevoort and Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act, 101 Georgetown L. J. 337 (2013). 90 Donald C. Langevoort and Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act, 101 Georgetown L. J. 337, 338 (2013) (analyzing Facebook’s capital-raising efforts to as “a legal artifice for avoiding a regulatory status to which the company should be subject”). 91 If not yet large enough (i.e., critical mass has not yet formed) to change the “one size” to fit all, or if there are too many layers such that tiering will no longer work, these are the areas where the competitive advantagee of courts is greatest. When tailoring by rules become impracticable, that creates a role for human intervention and the role of courts in striking a balance between competing interests. 21
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of governance mechanisms given the market’s ability to set the price.92 Professor Roberta Romano has also proposed a market-oriented approach of securities regulation that would expand role of states in securities regulation.93 Professor Romano’s motivating assumptions are three-fold: first, market participants know what regulations are in their interest (better than any government entity);94 second, that investors are informed of the liability rules of the governing legal regime; and third, based on this information, investors will choose the regime that best advances their interests.95 How well do each of these assumptions fit with PLPE? First, as to comparative informational advantages between market participants and regulators, there is a reason here why the government might know more than the investor about these issuers. There are multiple prongs of financial regulation beyond public securities and public company regulations – e.g., investment fund regulation, investment adviser regulation – which gather information about private equity and other funds. Such efforts are further bolstered by the coordinating roles of the Federal Financial Institutions Examination Council (FFIEC) and the Office of Financial Research (OFR) to bring all relevant information to the table to be shared across multiple regulatory platforms.96 Second, as to the sophistication of investors, the investor base of public companies today is changing. Hedge funds and pension funds are actively engaged in shareholder activism.97 And so the argument goes – public investors can rely on sophisticated investors (who are going to have significant voice and bargaining power) to be an advocate for the investor group’s collective interests. Institutional investors’ sophistication and their ability to bargain on equal footing with the issuer is not challenged here. These investors are just as well informed and have access to same quality of financial and legal advisers. But the presence of these investors could precisely be a reason for concern when it comes to PLPE. These institutional investors also invest in private equity privately. And in their capacity as private investors, these investors’ incentives are not aligned (and may at times be in competition) with the minority public investors. These sophisticated investors are often pre-existing limited partners whose interest PLPE has explicitly stated could at times be placed ahead of the minority public investors. It is important to recognize that what is being proposed above is a limit on potential entrants and the freedom of contract. Furthermore, to the extent the proposed solution involves undoing some of the solutions to agency problems that the private equity form has achieved, those costs will need to be factored into the consideration and comparison of possible solutions.
92 Easterbrook & Fishel 93 Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359 2361 (1998). 94 Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 Yale L.J. 2359, 2365 (1998) (“The motivation for the [market-based approach to securities regulation] proposal is that no government entity can know better than market participants what regulations are in their interest…”). 95 Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 Yale L.J. 2359, 2366 (1998) (“It is plausible to assume that investors are informed about liability rules given the sophistication of the institutional investors who comprise the majority of stock market investors and whose actions determine market prices on which uninformed investors can rely.”) 96 Edward Murphy, Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets. 97 2015 Annual Corporate Governance Review, available at https://corpgov.law.harvard.edu/2016/02/12/2015- annual-corporate-governance-review/ 22
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So how do we strike the balance between letting go of some agency protections in exchange for shareholder protections to yield net positive outcomes? The answer is that it depends on the type of firm and even among PLPE, it will be different for each issuer98 Recognizing that any revision of the structural characteristics of PLPE to accommodate public investors comes at the cost of reversing the agency benefits that are achieved by such features, one of the core strengths of the proposal outlined in the next sub-Part is that it would permit PLPE to operate in its current hybrid state while being attentive to the imbalance of power between PLPE and the investing public when allocating risks and loss.99
a. Attractive nuisance model of securities regulation The tailored approach of torts analysis which considers the specific structure of corporate defendants is useful for corporate matters, where structures are constantly evolving and labels can be misleading. 100 Another promise of torts is that it can tackle the most severe cases of opportunism.101 Several scholars have studied the intersection between tort and securities and company regulation.102 Notably, the work of Professors Hansmann & Kraakman (H&K) and Professor Thompson which probes the overlaps of tort law with shareholder liability and corporate governance, respectively, have most heavily influenced the analysis in this Part.103 Thompson’s work which reviews the interaction between state and federal rules, refers to intent-based tort as the preferred regulator of corporate managerial misbehaviors.104 Thompson explains that the extent of overlap between securities law and torts has deepened as federal regulation of the corporation matured from a gap filler of the state system to a standalone regime that finds its origins in the common law tort remedy of deceit.105 In the remainder of this Part, I build on the existing work of H&K and Thompson to consider the specific question of how tort analysis can be used to resolve tensions between PLPE and its investors and present a status-based approach which I call the Attractive Nuisance Model to determining the appropriate scope of duty owed by PLPE to the retail investor. I make the argument that the especially hazardous nature of the PLPE investment and the stark difference in sophistication between PLPE and retail investors justify the application of a heightened duty of care beyond a duty to disclose. In considering the process for determining the appropriate scope
98 Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 Yale L.J. 2360, 2367 (1997-1998) (Romano agrees: “Analytically, a demonstration that there are information externalities necessitating government intervention depends on the mix of informed and uninformed investors.” But her argument is that “a theoretical need for government regulation to prevent a market failure is not equivalent to a need for a monopolist regulator”). 99 For a discussion of the tradeoff between agency (governance) and liquidity benefits in the private equity context, see William W. Bratton, Private Equity’ Three Lessons for Agency Theory, 3 BROOK. J. CORP. FIN. & COM. L. 1 (2008). 100 See supra [ ]. 101 H&K 1918-1919 (acknowledging that while tort law is rough and has its own cost, it is useful in combatting “the most severe forms of opportunistic cost externalization”). 102 Henry Hansmann and Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J. 1879 (1991) [hereinafter “H&K”] 103 In particular, H&K make the point that the boundaries of the corporation used to enforce contractual rights need not be carried over to tort. 104 Robert B. Thompson, Federal Corporate Law: Torts and Fiduciary Duty, 31 J. Corp. L. 877, 887 (2006). 105 Id. 23
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of such duty, I look to a well-developed doctrine of torts law that subjects owners of hazardous premises to heightened duties toward children entrants.106 The attractive nuisance doctrine was developed to require landowners of hazardous premises to take reasonable care to protect against avoidable harms in cases involving children who lack the sophistication and capacity to appreciate the risks of the hazard. I argue that this novel approach can be used to set standards of conduct that are sensitive to the identity of the parties, nature of risks and potential harms involved could be useful in regulating PLPE. In particular, these characterizations of the plaintiff and the premises can be carried over into PLPE where there is a similar imbalance between the parties (a less experienced investor on the one side versus an issuer in complete control on the other) and a highly risky activity that has become even more riskier by contractual modifications put in place by the issuer. Much in the way that the attractive nuisance doctrine creates a special duty to owners of highly risky premises that are at the same time dangerous but known to attract unsophisticated victims, the regulation of PLPE involves similar dynamics and there are lessons to be learned from the refinements of the negligence tort in landowner cases. The doctrine was first developed in Sioux City & Pacific Railroad Co. v. Stout.107 To find the defendant railroad liable for a trespassing child’s injury on an unlocked turntable, the court considered five elements: (1) the nature of the condition, (2) the likelihood of the trespass, (3) the possibility of injury, (4) the utility of the condition to the landowner, and (5) the burden of removing it.108 This turntable theory of Sioux City was further extended to other hazards, most commonly, swimming pools and trampolines. The common feature of these cases was that they involved (i) conditions that were dangerous but also alluring and (ii) an unsophisticated victim who lacked the capacity to appreciate its risks.109 One of the conditions of negligence liability is that the defendant has an obligation to plaintiff and other persons in plaintiff’s position to act with reasonable care and avoid causing the injury suffered by the plaintiff. 110 The duty of the landowner is to take precautions to prevent unreasonable risks to children on premises that are expected to attract children because of the nature of the premises or their alluring qualities. The original Sioux City case relied on implied invitation theory to justify this heightened standard of care.111 Later cases focus more on the ability of child to understand and appreciate danger, or the lack thereof.112 The rule ultimately adopted in the Restatement of Torts articulates
106 While this status-based approach has been gradually retired to be consistent with the modern trend toward uniform duty of reasonable care, there are lessons that company regulation can learn from its spirit. 107 Sioux City & Pac. R.R. Co. v. Stout, 84 U.S. 657 (1873). 108 For a helpful summary of the attractive nuisance doctrine, see Note, Attractive Nuisance: A More Flexible Approach, 1959 DUKE L.J. 137 (1959) [hereinafter AN Note]; Jeremiah Smith, Note, Liability of Landowners to Children Entering Without Permission, 11 HARV. L. REV. 349, 434 (1898) [hereinafter Smith Note]. AN Note focuses on the nature of premises and Smith Note on party characteristics. 109 AN Note, p.141-42. Alluring nature of premises is no longer a necessary element but relevant to determine whether presence of child was foreseeable by the landowner. 110 John C. P. Goldberg & Benjamin C. Zipursky, The Restatement (Third) and the Place of Duty in Negligence Law, 54 VAND. L. REV. 657, 664-87, 698-709 (2001) [hereinafter “G&Z”]. 111 Case Note, Torts—Attractive Nuisance—New Rationale for Refusing to Extend Liability for Injuries Caused by Natural Conditions—Loney v. McPhillips, 268 Or. 378, 521 P.2d 340 (1974), 1975 BYU L. REV. 561, 563 (1974). 112 Case Note, Torts—Attractive Nuisance—New Rationale for Refusing to Extend Liability for Injuries Caused by Natural Conditions—Loney v. McPhillips, 268 Or. 378, 521 P.2d 340 (1974), 1975 BYU L. REV. 561, 563-64, 563 n.21 (1974). 24
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that the rationale of the attractive nuisance doctrine is least cost harm avoidance.113 This modern version of the attractive nuisance doctrine is very helpful in filling the gap left open by the current PLPE regulatory framework. The formal proposal would be to require an affirmative duty to mitigate avoidable harms if the issuer satisfies a three factor test which considers: (1) the relative knowledge of the investor and issuer (sophistication), (2) the relative power of the investor and issuer (control), and (3) the hazardous nature of the activity (complexity). i. Sophistication The first dimension, investor versus issuer sophistication, requires a study of the kind of investors that PLPE draws capital from. Unlisted private equity firms tend to raise capital from a small number of wealthy investors whereas publicly-listed private equity raise capital from a large number of diverse investors. This distinction becomes important as a legal and regulatory matter as potential investors of PLPE span a broader segment of the population, many of whom lack investment expertise and sophistication. The descriptor ‘sophisticated’ when it comes to investors in this context is used as shorthand to indicate whether investors have the capacity to appreciate the complexities and risks of investing in the capital markets, or possess the opportunity and resources to either directly or indirectly bargain for protections when entering into these investments. As described in Part I, PLPE has used legal engineering through a combination of contracts, governance, and securities laws as a way to impose to limits on an already vulnerable investor. Common unitholders do not have the right to call meetings, acquire information about operations; and founders retain the exclusive rights to elect the general partner and the directors. Further, PLPE organized as limited partnerships have aggressively sought exemptions from corporate governance required by NYSE rules, such as the NYSE requirement regarding independent directors. In my prior work, I have written about how the private equity model of ownership of its portfolio companies does not fit well with how agency problems are viewed and resolved by corporate law and scholarship.114 The primary reason is due to the misfit of the private equity firms’ control structure with traditional agency analysis – while the agent works for the principal and for its benefit, the element of control is lacking. And while that work focused on the relationship between private equity owners and their portfolio companies, I show here how the same ideas can be extended to how the private equity firms run themselves and how the mismatch is even more pronounced in the public versions of private equity. When private equity becomes a public company, it becomes subject to regulations applicable to public companies whose key challenge is to reduce agency problems. But reducing agency problems is an area where private equity excels, but that excellence was gained precisely by forgoing governance mechanisms which other public companies are subject to. In each case, common unitholders have not delegated their power to elect to the founders, but had no such power from the outset. Because of the lack of an agency relationship, the common investor has no power to monitor the founders nor the GP. In turn, the absence of an agency relationship means there are no fiduciary duties of loyalty. More importantly, the general partner is agent of the founders and not to common unitholders, and to the extent the interests of founders on one hand and common unitholders on the other hand conflict, general partner is obligated to
113 Restatement (First) of Torts § 339 cmt. d (1934).. 114 Kim, Corporate Parenthood (2015). 25
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favor the interests of the former. Also, founders have sole authority to set the bounds of the GP fiduciary duties. And they have exercised this authority to its fullest extent.
As depicted by the above red-dotted line, PLPE has been set up to distance the common unitholders from the general partner to avoid the claim that the general partner is an agent of the common unitholders. By using initial owners’ position as (sole) principal of agents, and the policy of the Delaware Limited Partnership Act which favors principles of the freedom of contract and enforceability of partnership agreements to waive fiduciary duties to the extent legally permissible, and thus maximizing the extent of the information and power asymmetries between issuer and investor. ii. Control The second dimension, control, refers to the locus and pattern of control of PLPE. One well- developed and widely-discussed theory of this divide was advanced by Professors Fama and Jensen in their influential 1983 paper.115 Their method of distinction between public versus private companies (sometimes referred to as open versus closed companies) is determined by reference to the answer to the single question: Who is the decision agent and does it bear the major share of the wealth effects of the decisions made?116 Whether decision agents bear a major share of the wealth effects of their decisions is the key determinant of costs of what Fama and Jensen refer to as the separation between ‘decision management’ and ‘decision control’.117 When decisions agents do not bear a major share of the wealth effects of their decisions (i.e. decision and risk bearing functions are separate), as is the
115 Eugene F. Fama and Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 302-03 (1983) 116 Fama and Jensen (1983)’s analysis can be further broken down into two sub-steps: First, what are the residual claims? This step requires a review of how rights to net cash flows are defined and assigned. Second, what is the decision process? Fama and Jensen view the decision process as a four-part process: initiation, ratification, implementation and monitoring; the four parts are further organized into two groups of two: initiation and implementation are grouped under “decision management” and ratification and monitoring are grouped under “decision control”. Eugene F. Fama and Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 302-03 (1983). 117 Eugene F. Fama and Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 302-03 (1983). 26
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case for public companies, separation of decision management and decision control have the benefits of specialization as well as reducing implied agency problems. The benefit of framing the control analysis in this way is that it helps make the abstract concepts of “separation” and “control” more concrete. The important distinction between public (open) versus private (closed) companies is that the decision management and decision control structure is more streamlined in private companies. Common mechanisms used to separate decision management and decision control include hierarchy, mutual monitoring, and board of directors.118 I note here some instructions that can be drawn from the landowner duty cases on this second element of ‘control’. A possessor of land in that context is defined as (a) a person who occupies the land and controls it; (b) a person entitled to immediate occupation and control of the land, if no other person is a possessor of the land under Subsection (a); or (c) a person who had occupied the land and controlled it, if no other person subsequently became a possessor under Subsection (a) or (b).119 As described in comment a. to that section, the standard to be applied is ““intent to control” coupled with occupation”. Noting however that relying on fact of control is administratively easier than determining individual’s intent,120 courts and juries are instructed to look to written agreement as well as course of conduct to determine. 121What the law cares about is whether that person has the “authority and ability to take precautions to reduce the risk of harm to entrants on the land.” 122 That is the reason for imposing the duties on land possessors. When there are multiple possessors – look to what portion of land each possessor has control over and tailor the duty to the possessor depending on from each portion of land the harm arises from. 123 And in the case of PLPE, PLPE has exclusive control over the PLPE structure, and has taken every measure to retain exclusive control by limiting retail investors’ voting and election rights, call rights, rights to call a meeting, and rights to monitor. The PLPE structure also ensures that PLPE managers are not fiduciaries of retail investors, and therefore owe no fiduciary duty to the retail investors. In any case, retail investors have no relief for breach of fiduciary duties because their right to pursue remedies have also been written off by contract. This has made an already less sophisticated investor powerless and defenseless, reinforcing the vulnerabilities of the retail investors of PLPE. iii. Hazards The third dimension considers the hazards of the investment – what is the source of the hazard, the level of hazards, the benefits and the cost of avoidance? The kinds of risks we care about in PLPE context are those created artificially by PLPE issuer via complex organization structures and contract design. Private equity is a volatile investment. Private equity’s value is measured as a composite of the portfolio companies in which it invests, and often those investments are concentrated in specific markets or industries. As a result, private equity’s stock performance can suffer from unexpected downturns in specific markets or industries. Courts considering attractive nuisance doctrine cases have taken into consideration reasons why it may be important to maintain the premise notwithstanding its hazardous nature. Will
118 Eugene F. Fama and Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON. 301, 302-03 (1983). 119 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012) 120 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012), comment a. 121 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012, comment c. 122 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012, comment c. 123 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012), comment d. 27
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imposing liability on the landowner dis-incentivize landowners from keeping the hazardous but socially useful premises open to the public? This was the basis on which the court rejected the application of the doctrine in later cases that followed. 124 In one case, the court wanted to encourage landowners to keep private owned wild lands open for the public’s recreational use and declined to provide plaintiff relief. Likewise, recognizing PLPE is a financial innovation that can generate social gains, I am not advocating for a wholesale ban on PLPE but rather a way to fairly allocate gains and losses. This measure of fairness should be informed by the level of sophistication of PLPE’s public investors, the organizational and contractual features of the PLPE structure and the complexity of the PLPE investment, which together justify the imposition a special kind of obligation on the PLPE issuer. The application of the model requires a balancing of interests among plaintiff, defendant and third parties, which necessarily narrows its reach.125 Children in the attractive nuisance cases are given special treatment because their youth and inexperience adversely impact their capacity to recognize and understand hazards. The landowner, in contrast, has knowledge, awareness and is in a position to avert the harm. Whether they should have done something (or something more) to avert the harm depends on the cost of harm avoidance relative to the size of the avoided harm. This flexibility of tort doctrine to tailor the duty analysis to the status of the investor and nature of risks is useful not only for PLPE but to other complex areas of corporate finance. More importantly, such flexibility can also prevent the doctrine from morphing into a form of insurance for investors. The goal of this proposal is not to wedge law and finance into existing tort doctrine. Rather, the contribution of this paper is that it explores the applicable lessons of a well-understood doctrine in tort law which was developed to allocate risk between sophisticated and unsophisticated parties for especially hazardous activities, which is a persistent problem in corporate finance.
b. Strengths The main strength of the Attractive Nuisance Model of securities regulation is its fit with the particular issuer, investor, and product that is being regulated. The approach, taking a cue from landowner duties, looks not only at what parties say, but what they do. First, the model considers the locus of control. Possessor of land in the landowner duties case is defined as person who controls it. Control is important element of public company regulation.126 The basic premise is that securities regulation should recognize the shift in control dynamics which results from the conversion of a private equity firm into a public company and make adjustments to reflect such shifts.127 Second, most risks arising on land are result of land possessor’s conduct or artificial conditions. The kinds of risks we care about in PLPE context are those created artificially by PLPE issuer via complex organization structures and contract design.128 For these, their decision to go public is driven by the singular goal of maximizing the existing owners’ private gains from converting to a public company. These gains may be achieved by growing the firm so that both existing and new
124 Loney v. McPhillips, 268 Or. 378, 387, 521 P.2d 340, 344 (1974). See also Case Note, Torts—Attractive Nuisance—New Rationale for Refusing to Extend Liability for Injuries Caused by Natural Conditions—Loney v. McPhillips, 268 Or. 378, 521 P.2d 340 (1974), 1975 BYU L. REV. 561 (1974). 125 Cf. California led the charge of moving away from relying on status of victim to decide the applicable standard of duty. 126 Fama & Jensen (1983). 127 DAVID WESTBROOK, BETWEEN CITIZEN AND STATE (2007). 128 See supra Part I.c. 28
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owners profit (the “win-win scenario”). On the other hand, the size of the pie may remain the same (or may even shrink) but old owners may still profit by passing off some of the losses to the new owners (the “win-lose scenario”). Capital markets regulation has two main goals which are investor protection and maintaining a robust capital market. Stated another way, the goal of capital markets regulation is to protect the investors from the win-lose scenario, while building a market that facilitates win-win scenarios. One of the many challenges of capital markets regulators is distinguishing between win-win scenarios and win-lose scenarios and then designing regulations which invite the former but exclude the latter, and among losing scenarios, to sort between avoidable and unavoidable losses. Third, is the relationship between the first and second elements – tort laws impose duties on landowners to regulate risks that are within land possessor’s control. Land possessor has exclusive control over risks and therefore over the means to reduce it. To the extent PLPE has imposed one- sided risks on the retail investor that are avoidable at a cost lower than the private gains that flow therefrom, it is the role of capital markets regulation to restore that bargain to help the PLPE retail investor reclaim their absent seat at the initial negotiation table. There is much to be learned from status-based duties in torts which are based on relationships or specific activities.129 Status-based duties are based on relationships or specific activities, as evidenced for example by the special treatment of social hosts considering the toll that potential liability would take on social relations.130 While that approach has since been rejected in favor of a unitary duty of reasonable care, I return to the classical status-based approach to land-possessor duties, which is varied depending on the status of the entrant and the source of risk. The same logic that supports heightened duties on landowners in the attractive nuisance cases are instructive for the regulation of PLPE, which is that your actual (rather than your presumed or stated) role is what triggers your obligation. If you take on a role that creates risk of injury to others, you have both a moral and legal duty to perform that role with care, and you are subject to liability if you fail to perform such duty. The need for context in defining reasonable care in corporate context has been discussed in other contexts. For example Melvin Eisenberg suggests that the duty of care of directors and officers must be analyzed by reference to the specific function, knowledge, competence, and skill they are expected to have.131 And such expectations must reflect the business reality so that we can properly determine who actually manages, and thus has ability to alter conduct that reduces risks? 132 These approaches are not only consistent with but strengthened by the spirit of general tort law which is attentive to capacity to exercise care. For instance, on the issue of “control” tort law cares about not whose name it is under ‘owner’ on the legal title but about who actually occupies and is in control of the property. 133 If a contractor or tenant or even adverse possessor has control over the property, they are the person who has the duty, not the legal owner. Tort law cares about who
129 Chapter 9. Duty of Land Possessors, Restatement (Third) of Torts: Phys. & Emot. Harm 9 SC NT (2012) (“The duty of a land possessor has not traditionally been a uniform duty of reasonable care but instead has consisted of different duties imposed on the possessor, depending on the status of the person on the land.”). For an explanation of how modern tort law has evolved away from this system toward a unitary duty of reasonable care to entrants on the land see Chapter 9. Duty of Land Possessors, Restatement (Third) of Torts: Phys. & Emot. Harm 9 SC NT (2012). 130 Chapter 9. Duty of Land Possessors, Restatement (Third) of Torts: Phys. & Emot. Harm 9 SC NT (2012). 131 Melvin A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. Pitt. L. Rev. 945, 949-50 (1989) 132 Melvin A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. Pitt. L. Rev. 945, 949 (1989) 133 Restatement (Third) of Torts: Phys. & Emot. Harm § 49 (2012), comment c. 29
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is the person with authority and ability to reduce or eliminate the risk of harm, and with this north star as its guide stays loyal to the reason for imposing the duties in the first place. Under torts law, former possessors who have created risk of harm continues to be subject to ordinary duty of reasonable care for that risk, even after possession is relinquished to another. This approach recognizes that there are (at least) two layers to any duty. First is a disclosure duty – failure to disclose dangerous conditions (either created by former possessor or latent conditions of which former possessor has knowledge or should have knowledge) is misrepresentation by omission. By disclosing duty is shared since purchaser who takes control with knowledge of dangerous condition must now also exercise reasonable care with regard to that risk. Second, the former possessor may either make condition safe or could contract with purchaser to make necessary repairs.134 As such, former owners cannot escape liability via sale, exit or even contract in this case. This retroactive application of liability would be reserved for the extreme case where the manifestations that gave rise to the loss are traceable to the former owner. A final, and perhaps most important, benefit of the proposed regime is that it will provide PLPE with the opportunity to avoid regulatory treatment as an Attractive Nuisance by restoring the agency relationship and related fiduciary duties between the public investor and the insiders of the PLPE enterprise. Preserving this optionality returns to the PLPE issuer to use its superior knowledge and control to make the optimal decision which serves the collective interest of both issuers and investors.
c. Weaknesses and counterarguments Some of the reasons why the tort system has moved away from status-based duties toward an integrated and unitary duty of reasonable care is instructive in discussing potential weaknesses of the proposal.135 Among the stated reasons is that the ambiguity of boundaries that made the test difficult to administer and susceptible to different outcomes in similar cases is the most relevant to this discussion.136 Coupled with increased complexity, such boundary problems were seen to produce results that were felt to be unfair. 137 To be clear, this proposal is for a judicially created exception to ordinary liability rules to accommodate public investors of PLPE and other complex issues like it, by analogizing it to an “attractive nuisance” rather than a wholesale replacement and rewrite of the disclosure-based regime of securities regulation.
134 Reporter’s notes, comment k, §51 cites to string of cases, including Martinez. V. Chippewa Enters., Inc., 18 Cal. Rptr. 3d 152, 155 (Ct. App. 2004) (“The modern and controlling law on this subject is that ‘although the obviousness of a danger may obviate the duty to warn of its existence, if it is foreseeable that the danger may cause injury despite the fact that it is obvious…, there may be a duty to remedy the danger, and the breach of that duty may in turn form the basis for liability’”). Noting that analogous rules exist in products-liability area. Restatement, Third, Torts: Products Liability § 1, Comment l (“In general, when a safer design can reasonably be implemented and risks can reasonably be designed out of a product, adoption of the safer design is required over a warning that leaves a significant residuum of such risks…”). 135 The second of four stated reasons “Converging similarity with a unitary standard” is not applicable here as it is a harmonization point that does not carry over to this specific context. 136 comment c. to Section 51 of the Restatement. 137 comment c. to Section 51 of the Restatement. 30
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In addition, boundary problems are not new for securities regulators. There are already various duties of care imposed by current law in securities and companies regulation138, and the efforts to resolve those disputes can help navigate and narrow the application of the proposed Attractive Nuisance Model of securities regulation.139 For example, several landowners duty cases have embraced the argument that a guest in the home of another is not entitled to any more protection than host provides to herself and other residents.140 So to the extent limited partners ride the same boat and are subject to same fate as common unitholder, we can become comfortable with imposing no further duty on the issuer. That is the driving force of why the duty to regular social guests were often limited (e.g., such that a warning of hidden dangers was enough). Such context-dependent determinations of reasonable care standard can be accommodated with explanatory instruction to jury141 and the same strategies could be implemented in the securities litigation context. Another argument against the proposed model is that it reaches too far and too deep and may create distortive effects. 142 Professor Eisenberg has articulated one way to address this challenge by defining as express purpose rule as having to “distinguish between bad decisions and decisions that turn out badly.”143 By acknowledging that these are cases that involve complex judgments that are necessarily based on incomplete information, we can separate cases where there have been reasonable judgments made about shape of distribution and those errors in judgment which have skewed the shape of distribution altogether for which the law will assign liability. 144 What the Attractive Nuisance model aims to do is to situate the PLPE issuer in the latter bucket as have actually altered the shape of the probability distribution for its private benefit at the expense of the retail investor. And that is where the failure to exercise reasonable care has occurred. And for that reason, issuers’ actions have made it more likely that the outcome will fall on the unlucky tail, and that is morally and legally blameworthy conduct that could have been avoided, for which the parties could be made to pay for avoidable losses.145 Lastly, there are also upper limits on tort liability. For example land possessor is not subject to liability for risks that cannot reasonably be discovered and those that can be attributed to third party conduct.146 Likewise, securities regulation (notably Section 12147) distributes liability among issuer and also sellers (underwriters, brokers, dealers) of securities, emphasizing their role of policing issuers and insiders.148
138 ALI’s Federal Securities Code project (led by Harvard Law School’s Louis Loss) has pointed to various duties of care imposed by current law on various parties as a source of confusion. 139 E.g., Tom Lin, Reasonable Investor, 50 Wake Forest Law Review 643 (2015). 140 Restatement (Third) of Torts: Phys. & Emot. Harm § 51 (2012), comment i. 141 Gomtsian (2015) (“When reasonable minds could differ about the facts or about whether, given those facts, reasonable care was exercised, the issue is for the jury”). 142 See Stephen Bainbridge, Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303. 143 Melvin A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. Pitt. L. Rev. 945, 961 (1989) 144 Melvin A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. Pitt. L. Rev. 945, 962 (1989) 145 For argument that securities regulation should be structured directly around investors so as to reduce the impact of regulation on choices available to investors see Stephen Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 Cal. L. Rev. 279 (2000). 146 Restatement (Third) of Torts: Phys. & Emot. Harm § 51 (2012), comment e. 147 15 U.S. Code § 77l 148 Id. 31
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Conclusion Private equity is the overlapping section between contract and organizations. Full reliance on private ordering is premised on the idea that shares are freely tradable and that all parties at the table are willing participants. The introduction of the Attractive Nuisance Model as a new regulatory constraint reduces the scope of private equity that can raise capital from public equity markets, but enhances the protection of public investors who are otherwise marginalized by the organizational and contractual levers of private equity. While this Article focuses on the innerworkings of PLPE, PLPE is just one among multiple strands of issuers that raise capital from public investors in the capital markets. In a world that embraces diversity, firms have evolved in ways that have blurred the boundary lines between public and private companies. PLPE is just one example of such line-blurring, and other examples include government-sponsored but private organizations such as Fannie Mae and Freddie Mac, or federal insurers that are also corporations such as the FDIC and SIPC. More recent scholarship within the past decade has focused on the blurring of the boundaries between public and private companies. Professor Robert Bartlett’s study of VC finance was the first to bring attention to horizontal (i.e. inter-investor) agency problems in firms – which affects both public and private firms.149 Professors Todd Henderson and William Birdthistle have written about the inter-fund conflicts resulting from the diversification strategies of private equity investors. 150 Professor David Westbrook has explained the interaction between corporation (private) law and securities (public) law as mirrors and that they are organized across two dimensions: first, who is the owner of the institution and second, what is the relationship of the public (state). When owners dominate entities, the entity is associated with individual owners, which then are better understood in private terms, with the business corporation as at the boundary between individual owners and influence of government, where neither really dominates. The broader contribution of this paper is to show how the boundaries of private and public companies have been blurred by legal and financial innovations, using PLPE as a test case. The Article’s contribution on the narrowest end is that this study of PLPE offers a unique opportunity to study the conversion at the private-public border from the vantage point of private equity issuers, who otherwise have been a ‘black box’ to outsiders. On the broader end, this Article recognizes a trend in the interactions between law and finance and highlights the need for and makes suggestions for new laws and rules that can be used to regulate hybrid financing forms as they emerge. The heart of problem that this paper attacks is the repeated failed attempts of securities regulators to regulate with blunt labels and unitary regulatory tools. Relying on the case of PLPE, I show a modern example of how substantively, the label of a “public” company triggers regulatory treatment and investor expectations that rely on assumptions which the reality of PLPE is at odds with. As such, either the capital markets regulations which allow PLPE to operate in this hybrid state must be revised or the relationships between PLPE and its new owners must be reinterpreted in ways that are reflective of this hybridity of PLPE. I show here that the prevailing securities regulatory system which aims to protect investors by mandating disclosures of risk is an ineffective regulatory regime for high-risk high-return investments like PLPE that are attractive to investors precisely because of their high levels of risk.
149 Robert P. Bartlett, Venture Capital, Agency Costs, and the False Dichotomy of the Corporation, 54 UCLA L. Rev. 37 (2006). 150 William A. Birdthistle & M. Todd Henderson, One Hat Too Many? Investment Desegregation in Private Equity, 76 U. CHI. L. REV. 45 (2009). 32
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Securities regulation would better serve their intended purpose by imposing duties on issuers that are reflective of the sophistication of parties, locus of control, and nature of risks involved. The Attractive Nuisance Model of securities regulation proffered in this Article and its proposed redesign of rules that are sensitive to the unique structure of PLPE and investor realities will be useful for regulating not only PLPE but many other hybrid and complex companies that public investors come into contact with in the capital markets today.
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