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Do Lawyers Matter?

Yes! We Need Damn Good Business Lawyers Now, More Than Ever

Over the last 20 years or so, it has become quite fashionable, particularly among corporate law scholars, to claim that the corporation is nothing more than a nexus of contracts. Under this law and economics view of the corporation, no legal rules are mandatory. Instead, everything is negotiable, including the fiduciary duties of corporate managers. Increasingly, this academic perspective has troubled me, especially as I reflected on the events of our world since the fall of 2001.

Ironically enough, as the events of last fall unfolded -- most significantly the bombings of September 11th, then later the financial scandal surrounding the collapse of Enron -- I was busy finishing an article in which I maintained that fiduciary law matters. Moreover, my article claimed that damn good business lawyers have always appreciated the truth of this assertion, notwithstanding considerable academic commentary to the contrary.

To demonstrate the truth of this assertion -- that Law Matters -- my article focused on a real world problem that has received -- and continues to receive -- significant attention in the financial press following the recent meltdown of the IPO market: that is, the Wall Street practice known as “spinning.” In this essay, I will draw on my analysis of the practice of spinning to show why fiduciary duty law principles must continue to be mandatory in nature -- that is, non-waiveable -- notwithstanding the outpouring of academic commentary to the contrary. Once I establish that Law Matters, then I will argue that this conclusion must, in turn, inform us as to the proper role for lawyers in advising their corporate clients. In other words, Lawyers Matter; that is, damn good business lawyers do, in fact, add more to the decision-making process of corporate managers than just their technical knowledge of relevant legal rules. Lest I leave the reader with the misimpression that this conclusion holds true only when dealing with Wall Street selling practices such as spinning, I will conclude this essay by offering some observations, related particularly to the events of last fall, including the Enron debacle, that further underscore the essential truth of my premise: Law Matters... and Lawyers Matter.

A disclaimer is in order before I set forth my analysis of the fiduciary duty issues inherent in the practice of spinning. Nothing in my analysis is particularly novel. In this essay, I am not positing any type of new or radical legal theory. In fact, I would go so far as to say that any damn good business lawyer that I know will readily recognize the fiduciary duty implications presented by the recent Wall Street (IPO allocation) practice known as spinning. Rather, I write this essay to underscore the modern importance of certain enduring principles of law, such as principles of fiduciary duty in the corporate law context. In the context of today’s business environment, it is often easy to lose sight of the importance of the rule of law. But, as I will show, recent events, including the tragedy of September 11th followed closely by the financial scandal that engulfed Enron, further underscore the importance of ethical lawyering, which forms the very foundation of the legal education program we offer at Loyola Law School. So, in tribute to the countless number of damn good business lawyers that we have had the privilege to educate, I dedicate this essay to the alumni of Loyola Law School.

What is Spinning?

Spinning refers to the practice that was reportedly used by Wall Street investment banking firms to allocate shares in the hot IPO (initial public offering) market that prevailed in the late 1990s. In reality, though, the story of spinning is essentially another version of what has recently become a now all-too-familiar story of corporate managers exploiting their position, in this case to seize for themselves certain business opportunities that rightfully belong to the corporation.

The story of spinning takes us back to the incredibly hot IPO market that prevailed for a brief period in the late 1990s. It was in this market that we saw the IPO of VA Linux Systems, Inc. go effective at $30 a share and, by the close of its first day of trading, surge a whopping 698%, to close at $239.25, for the then-biggest ever first-day gain. In this market, the competition to get an allocation of shares in a hot IPO was fierce, owing in no small part to the widely held perception that IPOs -- especially of Internet-related issuers -- would yield tremendous profits to any buyer who was lucky enough to get the opportunity to purchase these shares from the underwriters.

In the midst of this frenzied IPO activity, at least one individual investor made a substantial profit flipping shares allocated to him as part of a hot IPO. According to a November 12, 1997 article in the Wall Street Journal, Joseph Cayre, CEO of GT Interactive Software, a privately held computer software firm, was lucky enough to receive a sizeable allocation of shares of Pixar’s hot IPO from the company’s lead underwriter, Robertson Stephens. As was usually the case with these widely oversubscribed hot IPOs of the late 1990s, Pixar’s IPO shares soared by 77% over the fixed offering price by the close of its first day of trading. Mr. Cayre was then heard to brag about the $2 million profit he made when he “flipped” (sold) his Pixar shares in the aftermarket. According to the Wall Street Journal, the allocation of Pixar shares to Mr. Cayre’s personal trading account at Robertson Stephens was apparently made in anticipation that Mr. Cayre would direct his company’s future investment banking business to Robertson Stephens. In fact, when GT Interactive Software went public a month later, Robertson Stephens served as the lead underwriter of the company’s IPO.

Does the Underwriter’s Practice of Spinning Violate the Federal Securities Laws?

As generally described in the numerous (reportedly now over 200) lawsuits pending in federal court, the term “spinning” is used to refer to the decision of a lead underwriter (such as Robertson Stephens) to allocate shares of a hot new issue (such as shares of Pixar’s hot IPO) to the personal brokerage account of certain clients (most often corporate executives, such as Mr. Cayre, or venture capitalists). As generally alleged in these lawsuits, these hot IPO allocations were made in an apparent effort to recruit future investment banking business from the executive’s firm (such as GT Interactive, where Mr. Cayre was CEO). On receiving these hot IPO shares, the executive (such as Mr. Cayre) would immediately “flip” -- that is, sell -- these shares at a substantial profit and pocket the profit (in Mr. Cayre’s case, reportedly a $2 million profit) in the executive’s own personal trading account.

The litigation now pending centers primarily on alleged violations of the federal securities laws on the part of those managing underwriters who made these hot IPO allocations. These allegations generally charge that the IPO prospectus contained misleading statements about the underwriters’ information practices in violation of the disclosure obligations of the Securities Act of 1933 and the Securities Exchange Act of 1934. In addition, these lawsuits usually include a claim that the underwriters’ hot IPO allocation practices, such as spinning, violate the NASD’s rules prohibiting free-riding and withholding (all of which I have analyzed in detail in my article, “Spinning in a Hot IPO: Breach of Fiduciary Duty or Business As Usual?” 43 William And Mary L. Rev. (forthcoming 2002).

To the extent that the conduct of the investment banker acting as the underwriter in a hot IPO is found to be wanting, some legal commentators have suggested that the regulators -- particularly the SEC or the NASD, or both -- should undertake rulemaking activity to specifically proscribe the practice of spinning. This approach, however, suffers from the fundamental drawback in that it emphasizes the conduct of the investment banker, a member of a regulated industry, as the gatekeeper to the IPO process and virtually ignores the culpability of those corporate executives who flip the spun shares for personal profit. By focusing attention on the underwriter’s role (as apparently is the case in much of the pending litigation challenging the validity of spinning activity), the culpability of the manager’s role in the spinning activity is largely ignored. However, by including fiduciary duty principles as a mandatory rule of law that is part of the analysis of liability for spinning activity, we bring the conduct of these corporate executives into proper focus -- without the need to rely on any further rule-making initiatives. Accordingly, any disclosures or other regulatory reform measures that may be added at the federal level should not dilute the courts’ willingness to vigorously enforce the manager’s fiduciary duties, including the duty of candor and the duty of loyalty that is reflected in the common law doctrine of corporate opportunity.

Spinning as a Breach of Fiduciary Duty -- The Corporate Opportunity Doctrine

What has not received as much attention in the financial press accounts of spinning activity -- and what is most relevant as we watch the Enron debacle continue to unfold -- is the culpability of those corporate executives who received allocations of these hot IPO shares. What the financial press has failed to appreciate is that spinning activity indicts both the investment banker and the corporate CEO. Specifically, the corporate manager’s receipt of an allocation of hot IPO shares from the managing (or lead) underwriter gives rise to potential liability for breach of fiduciary duty on the grounds, among other things, that it involves the manager’s usurpation of a corporate opportunity. The lessons to be learned from the story of spinning, particularly in analyzing the scope of fiduciary duty that corporate executives, such as Mr. Cayre, owe to their corporations, such as GT Interactive, are particularly relevant in light of the events of last fall.

Briefly summarized, the corporate opportunity analysis of spinning activity starts out by focusing on the manner in which allocations of hot IPO shares came to be deposited into the personal trading accounts of company managers. Thus, in the case of Mr. Cayre, the analysis starts out by focusing on the manner in which the allocation of Pixar’s hot IPO shares came to be deposited by Robertson Stephens, Pixar’s lead underwriter, into the personal discretionary trading account of Mr. Cayre. This allocation seemingly was made to Mr. Cayre because he served as the CEO of a company, GT Interactive, that was itself about to launch an IPO of its own shares. Under traditional common law formulation of the corporate opportunity doctrine, since this opportunity to invest in Pixar shares apparently came to Mr. Cayre as the direct result of his position within the company, this is powerful evidence that this investment opportunity constituted a corporate opportunity. Even more compelling evidence of the corporate opportunity taint to this allocation of Pixar shares is the underwriter’s apparent assumption that Mr. Cayre would direct his company’s future underwriting business to Robertson Stephens. If this allocation were made to Mr. Cayre in order to obtain the underwriting business of his company, it would seem that this investment opportunity properly belongs to the company and, hence, should be treated as a corporate opportunity. Since the executive took advantage of this investment opportunity without any disclosure to his company, the executive is liable for usurping a corporate opportunity in breach of his fiduciary duty. As such, the traditional remedy for this type of breach of fiduciary duty is to impose a constructive trust. Under this common law remedy, the approximately $2 million profit that was reportedly made by flipping the Pixar shares properly belongs to the corporation, GT Interactive, and not to the company’s CEO, Mr. Cayre.

On the other hand, the CEO may try to avoid liability by showing that this investment opportunity is not a corporate opportunity. So, if in fact a CEO, such as Mr. Cayre, has an ongoing personal relationship with a particular investment banking firm, such as Robertson Stephens, that includes the specific investment strategy of getting as many hot IPO allocations as he can for his personal account, then the CEO may be able to eliminate the corporate opportunity taint from this hot IPO investment. However, the fiduciary obligations of this CEO may require that he voluntarily disclose of his prior transactions with a prospective underwriter for his company’s IPO. This disclosure should, at a minimum, explain why receiving hot IPO allocations does not involve the usurpation of a corporate opportunity. This disclosure obligation would seem to be all the more compelling if the company is considering using the services of this same underwriter in connection with the company’s proposed IPO.

Spinning and the Corporate Manager’s Fiduciary Duty of Candor

On another level, the story of spinning offers valuable lessons that further refine our understanding of the scope of the corporate manager’s disclosure obligation. This analysis starts from the premise that the manager’s fiduciary duty to the corporation includes a duty of candor, which triggers affirmative disclosure obligations at two distinct points in time within the context of the corporate manager’s participation in spinning activity.

The first time period to consider is the time at which the manager receives an allocation of hot IPO shares. Looking at this issue in the context of Mr. Cayre’s situation as reported in the Wall Street Journal, the question is whether, at the time that Mr. Cayre received the allocation of Pixar shares, he incurred any duty to disclose to the corporation his receipt of these shares. I am of the view that the most obvious source of a disclosure obligation at this time is the manager’s fiduciary duties under state law, including the corporate manager’s duty of loyalty. Under a duty of loyalty analysis, the scope of the disclosure obligation imposed on the corporate manager at the time the hot IPO allocation is made to his/her personal account will presumably turn, at least in part, on whether the manager’s receipt of these hot IPO shares constitutes the usurpation of a business opportunity in potential breach of the CEO’s fiduciary duty to his/her corporation.

The second time interval to consider is the time at which the company selects the investment banking firm who will serve as the lead underwriter for the company’s IPO. At this later date, there arises the separate issue of whether the CEO (Mr. Cayre) has any fiduciary obligation to come forward and disclose to the company’s (GT Interactive’s) Board of Directors the nature of his prior involvement with the investment banking firm (Robertson Stephens) now being considered for the position of lead underwriter of the company’s (GT Interactive’s) IPO. At a minimum, it would seem that the existence of this type of relationship should affect the credibility and weight to be given by the Board to any recommendation made by the company’s CEO as to the selection of lead underwriter. It would seem to go without saying that no Board member wants to be embarrassed by this type of disclosure -- of the CEO’s prior spinning activity with the investment banking firm who is ultimately chosen by the Board to serve as the company’s lead underwriter -- after the Board has decided to hire this particular investment banking firm to serve as the company’s lead underwriter.

So precisely which rule or legal doctrine serves as the source of the corporate manager’s duty to disclose this information to the Board -- before the Board makes its decision as to the selection of the lead underwriter? My own view is that, at the very minimum, the CEO’s fiduciary duty obligates him to disclose his prior spinning activity to the Board before it finalizes its selection of the lead underwriter for the company’s IPO. If managers know that the courts will rigorously enforce fiduciary duty standards, then the rule of law creates powerful incentives for managers (such as Mr. Cayre) to come forward and volunteer disclosure of unforeseen contingencies (such as the opportunity to purchase shares in Pixar’s hot IPO) and then to bargain for an appropriate allocation of rights and responsibilities (as between Mr. Cayre and his corporation) in light of these unforeseen developments. As we watch the events surrounding the collapse of Enron continue to unfold, we see powerful evidence in support of the law and economics view that suggests we rely on the reputation market and other market forces to promote adequate disclosure and to otherwise curb unethical business practices, such as spinning activity. But the lesson to be learned from spinning -- that is further supported by the events that led to the collapse of Enron -- is that the reputation market and other market forces are simply not enough in and of themselves. Without the firm foundation of fiduciary duty law, the scope of the disclosure obligation on the corporate manager is uncertain at best, and nonexistent at worst.

The Reaction of the Venture Capitalist Community to Publicity Surrounding Spinning

In further support of the view that spinning implicates the fiduciary obligations of corporate managers such as Mr. Cayre, it is instructive at this point to consider the reaction of the investment community, including the venture capitalist industry, on learning that corporate managers and venture capital investors used their executive positions to influence the underwriters in order obtain shares of a hot IPO for their personal accounts.

According to a November 17, 1997 article published in the Wall Street Journal, the venture capitalist community moved quickly to lobby its members to avoid the practice of “spinning” and the attendant appearance of impropriety that such activity created. On one level, the informal lobbying of its members can be seen as a shrewd move on the part of the venture capital industry who presumably feared that continued publicity of Wall Street’s spinning practices -- at least insofar as they involved allocations to venture capitalists -- might invite more scrutiny, which ultimately might lead to greater regulation of the venture capital industry, either by the NASD or the SEC, or both. Seen in its best light, the swift reaction of the venture capital industry may reflect promisingly on the general proposition that corporate executives conform their behavior to a particular ethical standard because they have internalized this standard as part of their character. On the other hand, a more dim view is that the industry’s reaction simply reflects that some folks in the business community determined their response to this potentially negative publicity regarding spinning activity by examining the costs and benefits of adhering to a particular standard of behavior, without regard to any ethical or fairness considerations.

However, no matter what reasoning ultimately motivated the venture capital industry to lobby its members to avoid participating in spinning activity, what is important for purposes of this discussion is that the industry’s response reflects on the essential truth of my premise that fiduciary duty law matters. In other words, the concerns that motivated the venture capital industry to respond in the manner it did to reports of spinning activity are clearly grounded in concerns over potential conflict of interest problems that they fear might ultimately result in claims of breach of fiduciary duty. As such, the venture capital industry’s warning to its members reflects how fiduciary duty law continues its traditional role of monitoring standards of ethical conduct that we as a society can legitimately expect of our modern corporate managers.

The Continuing Importance of the Damn Good Business Lawyer

Seen from this perspective, the story of spinning provides a compelling reason for the law to continue to enforce a rigorous standard of fiduciary duty. In framing the default rule for corporate opportunity to include the CEO’s receipt of an allocation of shares in a hot IPO, the law continues its traditional role in shaping the standards of what investors and other members of the business community can reasonably expect as “fair commercial practice.” The recent developments surrounding the practice of spinning provide a concrete illustration of the continuing importance of the role of fiduciary law as the default rule. Rigorous judicial enforcement of fiduciary duty standards as the default rule -- a rule which cannot be completely waived by the parties -- provides the courts with the basis for intervening to protect the legitimate expectations of investors and others as to what constitutes fair and ethical business practices.

The reaction of the venture capital industry further reflects on the continuing importance of ethical lawyering. In formulating its warning to its members, the venture capital industry clearly turned to their lawyers for advice as to the legitimacy of spinning activity. In giving advice to the venture capital industry, the lawyer, at least implicitly, relied on the foundational premise that fiduciary duties are mandatory. Moreover, if the damn good business lawyer is not confident that fiduciary duty law is mandatory, and therefore, confident of vigorous judicial enforcement of fiduciary obligations, then the lawyer is handicapped (substantially, if not completely) in his or her effort to counsel the client as to the timing and scope of disclosure required. Without that guiding principle, the ability of lawyers to give advice to move behavior of corporate managers to conform to standards of fair and ethical business practices is mooted. By emphasizing the mandatory nature of fiduciary duty obligations, the rule of law facilitates the lawyer’s ability to give advice that will move the behavior of modern corporate managers into line with standards of fair and ethical business practices to be expected of such persons.

Conclusion: Law Matters and Lawyers Matter

By focusing attention on these fiduciary duty issues, this essay seeks first to clarify the scope of a manager’s fiduciary duty, in order to show that Law Matters. The lessons learned from the story of spinning certainly must resonate strongly in our post-Enron world. The implications seem clear: if the courts fail to reinforce this duty of candor as part of the manager’s fiduciary obligations, then the transparency of managerial conduct is considerably clouded, thereby creating considerable disincentives in the future for managers to be forthcoming with information that bears directly on their trustworthiness and credibility. In the case of spinning activity, this lesson is most clearly reflected in the reaction of the venture capital industry and the resulting warning it issued to its members following widespread publicity in the financial press of Wall Street’s spinning practices. All of which just goes to show you what I think any damn good business lawyer will tell you...Without the support of a mandatory rule of law rigorously enforcing managers’ fiduciary duty obligations, we undermine the ability of lawyers to give advice that will move the behavior of corporate managers into line with standards of fairness and ethical conduct that investors and others in our modern business world are entitled to expect of their corporate managers. So, in the end, the lesson to be learned is a time-honored one: Law matters...and we need damn good business lawyers now more than ever.

Professor Therese H. Maynard teaches corporate and securities law at Loyola Law School, Los Angeles. Her description of the damn good business lawyer can be found in her article, “Teaching Professionalism: The Lawyer as a Professional,” 34 U. of Ga. L. Rev. 895 (2000). This essay is adapted from her forthcoming article, “Law Matters. lawyers Matter,” 76 Tulane L. Rev. Spring/Summer 2002.