The Legal Infrastructure of Business

GGP, Good Faith, and the Limits of Bankruptcy Remoteness

Chicago's own General Growth Properties, an over levered shopping mall Real Estate Investment Trust, filed for bankruptcy protection last spring, marking one of the biggest commercial mortgage casualties of the credit crisis. Not only did GGP the corporate parent file for bankruptcy, however, twenty of their Special Purpose Entities ("SPE"), which are used to make individual investments in properties across the country, did as well. This was despite the fact that most of these SPEs were not actually insolvent; rather, GGP's problems stemmed primarily from two bad shopping mall loans in Las Vegas.

This unprecedented action gave the appearance that GGP was trying to hide behind the bankruptcy code, which would allow the workout/restructuring of all of their investments, whether performing or non-performing. Overshadowing this was the fact that all of GGP's SPEs have unique, independent Boards of Directors, meaning they should not be slaves to the corporate parent. Therefore, the fact that they all simultaneously agreed to file for bankruptcy protection, whether or not there was true financial insolvency, led to the claim that the Directors had acted in "bad faith," a breach of their fiduciary duty.

In August, the United States Bankruptcy Court of the Southern District of New York was forced to confront this question. In an unprecedented decision written by Judge Allan Gropper that has sent shock waves through the commercial mortgage lending industry, the court held that in order to dismiss a bankruptcy petition for bad faith, the court must find both objective futility of the reorganization process and subjective bad faith in filing the petition. In this case, the court found none, because, the SPE Directors could consider the financial condition of their corporate parent in deciding whether or not to file for bankruptcy. This is despite the fact that the SPE is independent and bankruptcy-remote from the parent. Further, the court held that an SPE is not required to postpone filing for bankruptcy until it is actually insolvent, and found that the Directors were justified in their respective Chapter 11 filings. On this basis, the court held that the Directors had exercised subjective and objective good faith, thus not violating their fiduciary duties.

The court was also not sympathetic to arguments that the integrity of the bankruptcy-remote SPE structure would be compromised as a result of their affirmation of the filings, despite potentially adverse legal implications for all commercial mortgage lenders (and the greater securitization industry as a whole--if there is such an industry going forward). The court also didn't give much heed to GGP's behavior post-filing, where all of the Independent Directors were summarily dismissed and replaced with insiders without the lenders' knowledge (as was permitted under the SPE governing documents). This would appear to be the elevation of form over substance, as GGP appears to have had a self-serving strategy in trying to regain control of the SPEs: unify interest and ownership, restructure them by liquidating under (not necessarily non-)performing assets, and reemerge from bankruptcy with a cream-skimmed portfolio of what the corporate parent feels is its best assets.

In the weeks since the decision came out, it has been highly scrutinized (and criticized) by commercial lenders, as it suggests that the bankruptcy of a corporate parent alters some of the rights that they negotiated and relied upon when the loan was initially made. In other words, SPEs are not completely bankruptcy-remote, in the eyes of the law. But then what the eyes of the accountants, for whom bankruptcy remoteness is required to ensure non-consolidation of the asset on the company's balance sheet? The court anticipated this concern and made it very clear that they did not intend to alter the accounting (or tax treatment) of the SPEs, by forcing corporate parents to collapse or consolidate them on their balance sheet.

 

Yet despite this dicta, the jury is still out as to whether SPEs are still viable legal structures for securitizations (e.g. CMBS, RMBS, etc.), where bankruptcy-remoteness and the true sale of assets from the originator is an absolute requirement. If they are not, this will be yet another legal impediment to resuscitating the structured finance market post-credit crisis. As a live controversy, it will continue to be discussed as lawyers, accountants, and trade groups sort out the implications. While some have claimed the impact of the holding is limited by the unique circumstances of GGP's bankruptcy, others are not as confident.

 

The ruling in question is available http://www.nysb.uscourts.gov/opinions/alg/178734_1284_opinion.pdf.

 

A piece about the legal implications of the ruling is available http://www.lexology.com/library/detail.aspx?g=43ecc0b8-0f67-4f1e-969a-1890f90caa6e.

 

Another perspective on the case, which sees limited fallout, due to its unique circumstances, is available http://retailtrafficmag.com/mag/retail_isolated_occurrence/.

Investment Research versus Insider Trading: Will Galleon be the First of Many?

The story of the Galleon Group and the unprecedented insider trading scheme allegedly perpetuated by its founder, Raj Rajaratnam, is old news, as the fund has already been liquidated. However, with each passing day, more details have come to light about the conduct which federal prosecutors believe makes for a damaging insider trading case with far-reaching implications for the broader hedge fund industry.

The prima facie insider trading case is the simple exchange of cash for (misappropriated) information.

 

Yet rarely in the current day is insider trading so straightforward, or easy to prove. In fact, insider trading cases are among the most challenging for prosecutors, as evidence is usually circumstantial. There often is no smoking gun, which directly implicates someone in an insider trading network, nor is there direct evidence that, even if the person had the sensitive information, that they were able to trade on it for a profit. More recently, as information has become increasingly commoditized, hedge funds have relied on everyone from doctors and meteorologists to corporate executives to give them an informational edge. This has only created more ambiguity as to where engaging in legitimate, shoe leather research and trading rumors ends and illegally paying for market-moving information begins.

 

In the case of Galleon, the Justice Department and the Securities and Exchange Commission allege that Mr. Rajaratnam went too far for a trading edge. They describe a tangled web of hedge fund managers, analysts, C-level executives, and consultants who all traded tips with one another (a graphical representation of the alleged network is available http://s.wsj.net/public/resources/images/P1-AS079_GALLEO_NS_20091016203329.gif). The quid pro quo often involved money, sensitive information, or sometimes even the promise of future favors. While trading on these trips is alleged to have yielded around $20 million in profits for Galleon, many of the tips did not lead to profitable trades. In fact, according to the Justice Department’s complaint, the fund lost millions of dollars trading in Advanced Micro Devices, even though they were getting stock tips from a high-ranking executive.

 

In other instances, Mr. Rajaratnam received information from someone who is now a cooperating witness, but it is not clear whether he knew the source of the information, nor, does it appear as if the witness was compensated. Corroborating the witness’ claims is evidence from a wiretap, which the government believes will help demonstrate that Mr. Rajaratnam knew the information was valuable and thus, should not have been trading on it.

 

With respect to criminal law, the two essential elements that must be satisfied in order to prosecute are mens rea and actus reus. While the second (a person must commit a voluntary act) is not problematic, the first may be, in a case such as this. Mens rea captures the intent necessary for criminal liability. In an insider trading case, this intent surrounds the source of the information and its potential value. If one can prove that the trader knew the source and value of the information, yet traded on it anyway, they can be said to possess the requisite mens rea.

 

Yet in many of Mr. Rajaratnam’s trades, it does not appear as if the mens rea was always satisfied. There was no compensation being paid to many of the sources, while much of the other information was gleaned from independent research. Moreover, trading on nonpublic information that could move the markets is usually not enough to prosecute someone for insider trading (see shoe leather research, supra).

 

Despite the difficulty such nuances might make in convicting Mr. Raharatnam, they are indicative of a more far-reaching issue, namely hedge funds’ camouflaging the use of non-public data as legal research. Hedge funds often seek to compile data from a variety of sources, piece it together, and execute trades based on it. Because the sources are so disparate, if any of them is an illegal source, they can find refuge in what has been termed the mosaic-defense, whereby they are operating in a gray area, but avoid criminal liability by claiming there was no intent to commit a crime. For example, a hedge fund manager could claim that he spoke to hundreds of sources on the day during which it is alleged s/he engaged in insider trading, implying that s/he did not know which source’s information was privileged and notwithstanding, used it in conjunction with numerous other sources in formulating the ultimate investment decision. In light of such complexities, it becomes apparent why it is ordinarily so difficult to prove beyond a reasonable doubt that a fund manager engaged in insider trading.

 

However, in the case of Galleon, it would appear as if the government might have their smoking gun in the wiretapped telephone conversations, which are truly unprecedented for an insider trading case, as it marks the first time court approved wiretaps were used. As such, this case may be only the tip of the iceberg. In a hyper-competitive industry such as hedge funds, where mere ticks or basis points can make or break a trade (or business), every marginal data point has non-marginal value. Further, because the industry benchmarks hedge funds according to how much alpha they generate, relative to the market’s beta, anything that can help them eliminate beta is extremely lucrative. Therefore, we may see more such cases going forward, especially as the SEC expands its use of sophisticated data-mining systems to track suspicious trading patterns. Ironically, the activities at Galleon were discovered by old-fashioned wiretapping, proving that sometimes, the best way to spot crime, especially the white collar variety, is to catch someone in the act.

 

The Justice Department’s press release on the Galleon insider trading network is available http://www.justice.gov/usao/nys/pressreleases/October09/hedgefundinsidertradingpr.pdf.

The SEC’s complaint against Galleon is available http://www.sec.gov/litigation/complaints/2009/comp21255.pdf.

An interesting New York Times article on the gray area between insider trading and research is available http://www.nytimes.com/2009/10/20/business/20insider.html. Fox News’ take is available http://www.foxbusiness.com/story/markets/industries/finance/fine-line-insider-trading-shoe-leather-research/.

A Fortune Magazine article about the moasic defense is available http://money.cnn.com/2009/10/22/magazines/fortune/raj_rajaratnam_case.fortune/?postversion=2009102309.

Finally, a DailyFinance blog post about the impact the Galleon investigation could have on the broader hedge fund industry is available http://www.dailyfinance.com/2009/10/30/galleon-insider-trading-probes-could-slam-hedge-funds-and-stock/.

Hemi Group vs New York City. Cheap Cigarettes or NYC Public Schools?

On May 4^th 2009, the Supreme Court agreed to review the case of Hemi Group vs. New York City to answer the question of:

“Whether city government meets the Racketeer Influenced and Corrupt Organizations Act standing requirement that a plaintiff be directly injured in its "business or property" by alleging non commercial injury resulting from nonpayment of taxes by non litigant third parties.” Docket

 

The case was dismissed by the federal district courts of the fourth and third circuit and the Ninth and Sixth Circuits Court of Appeals and it was reinstated by the Second and Seventh Circuit Court of Appeals.

The city alleges that Hemi Group, an online cigarette vendor, benefited from selling cigarettes over the internet and neither reporting nor paying state and city taxes on those sales. The “scheme”, as the city calls it, or business model consists of advertising the cigarette through the internet to New York city residents, shipping the product from low-tax jurisdictions (in this case tribal lands in New Mexico) using any of the common carriers, and not reporting the sales to the costumers’ high-tax jurisdictions (in this case New York State and City taxes) which is a clear violation of the requirement of the Jenkins Act, Chapter 10A.

As general background information, taxes on cigarettes are collected at the point-of-sale by the states’ revenue departments and, in the past, when interstates sales occurred (i.e. retailers shipping their product across states’ lines) buyers were responsible for reporting the purchase and paying the taxes themselves. Because of the obvious difficulties in this reporting method, congress passed in 1949 the Jenkins Act, which establishes the reporting requirements for any distributor that ships cigarettes across states’ lines to the buyer’s state tax administrator to facilitate tax collection.

Jenkins Act, Chapter 10A: Jenkins Act

The key aspect of this case is that the city claimed that failing to submit the required reports in accordance with Jenkins Act have caused them millions of dollars in losses in the form of uncollected tax revenues. However, in an unprecedented move the city claimed that such losses shall be considered “property losses” which entitles them to file a civil law suit against the defendants under the Racketeer Influenced and Corrupt Organizations Act (RICO).

RICO act confers standing to “any person injured in his business or property by reason of a violation of” prohibited activities. In this case, the city filed the suit for acts of mail and wire frauds (covered by RICO’s sections 1341 and 1344 respectively), which they said were committed by falsely advertising that cigarettes were “tax-free” and that retailers were not required to report the sale to the consumers’ state authorities.

Chapter 96 – Racketeer Influenced and Corrupt Organizations: RICO Act

The defendant, on the other hand, presents two main arguments against the suit. First, Hemi says that “the sovereign interest in collecting taxes” cannot be “owned or possessed” and therefore is not something that can be considered as part of the city’s “business or property”. Second, they mention that even if the damages exist they would have been “indirect injury at best” since it is the consumers and not the company who owes the taxes.

Hemi’s first argument is supported on interpretation of the Clayton Antitrust Act, which they mentioned was used by congress when writing RICO Act in 1970 and has the same standing requirements.  In their brief it is mentioned that the city fails to recognize the divided opinion of the circuit courts in regard to the interpretation of “business or property” under the Clayton Act. This brief also asks the Supreme Court to address this issue between circuit courts by saying: “Not only is it proper for this Court to resolve the split in the circuits and in doing so clarify this important RICO issue, it is important to do so now as resolution is likely to terminate; the proceedings below. There is nothing to be gained by postponing review of the court of appeal’s decision on RICO standing until the district court addresses factual issues that do not impact the pure issue of law sought to be reviewed. To the contrary, postponing review would only exacerbate the adverse consequences of the decision both within the circuits and for the parties in this case.”

Their second argument is based on the difference between what the city defines as a direct damage and what they consider, if it exists, an indirect one. If damages are considered indirect, the city will have failed to meet a valid cause for a civil law suit under the RICO Act. Their Brief states “The City cannot allege a direct injury because petitioners owed no duty to the City upon which a direct injury could be based. Br. In Opp. at 3 ("information provided by out-of-state cigarette sellers to state taxing authorities under the Jenkins Act provides states the information necessary to collect the payment of cigarette taxes  directly from the purchasers" (emphasis added)).2 The only injury the City has alleged (Br. In Opp. at 2) is that it "is unable to collect use taxes owed" by its citizens; an indirect injury at best.”  

Petition of Writ of Certiorari by Hemi Group: Hemi's petition for Writ of Certiorari

In response to Hemi’s first argument the city starts by defining the difference between “sovereign interest” and “property interest”.  They say “While the power to tax may be a sovereign one, the tax revenue itself and the right to collect such tax revenue is a proprietary interest of the government. See Pasquantino, 544 U.S. at 357 and cases cited ante, pp. 21-24; see also Wyoming v. Oklahoma, 502 U.S. 437, 448-49 (1992) (in original jurisdiction case between states, this Court distinguished between parens patriae sovereign actions and those which involve proprietary direct injuries such as the loss of specific tax revenues).” The city also argues that interpretations of Clayton’s Act are inappropriate in this case since it encompasses a much narrower set of market activities, whereas the scope of RICO’s act is broader and includes a larger number of injuries.

In response to Hemi’s second argument the city states that “contrary to Hemi’s and the dissent’s misapprehension, the predicate racketeering acts in this case are not the Jenkins Act violations, but rather the mail and wire fraud” and also that “The fact that defendants have no statutory duty to the City under the Jenkins Act does not make the City’s alleged harm from the mail and wire fraud violations derivative, unforeseeable, or any less direct” (Pet. App. 31a).

New York City Brief: New York City Brief

The Supreme Court has schedule the oral argument hearing on Nov. 3^rd and it is needless to say that local and state governments will be following this case closely.

Scotuswiki: Hemi Group LLC et al. v. City of New_York

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Eat at your own risk: Cargill on the hot seat

Growing up, I fondly remember the last minute family meals at McDonald’s,  Wendy’s or another fast food chain. If we were lucky, my mom would substitute the Happy Meal for a home-cooked hamburger. When I read the front-page story about Stephanie Smith, those fond memories were overshadowed by my serious contemplation in joining the vegan movement. Smith, a 22-year-old female dance instructor, suffered serious injuries and eventually paralysis after she ate a hamburger contaminated by a virulent strain of E-coli.

The facts: Smith ate an “American Chef’s Selection Angus Beef Patties” hamburger (packaged by Cargill) after her mother grilled the frozen patty for a Sunday dinner. Soon after, Smith’s stomachaches turned into seizures, a coma and eventually paralysis. 

When USDA (United States Department of Agriculture) officials tried to trace the source of the contamination, they were stumped. Though all of the ingredients and parts were eventually ‘ground’ at a Cargill facility in Wisconsin, the ingredients came from numerous slaughterhouses (Nebraska, Texas and Uruguay). Using multiple sources for procuring low-grade ingredients allows Cargill (and other large meat manufactures) to spend 25% less than they would have for a single cut of meat.  Unfortunately, these low-grade ingredients are more likely to be contaminated with virulent strains of Ecoli because of likely contact with feces.

But don’t these slaughterhouses, or even Cargill test for contamination? Yes, but the problem is when tests are actually performed. Cargill does not require its suppliers to test their ingredients before shipment—and then only tests the compiled ingredients after it has been ground together at a Cargill facility. So even if a ground patty came up positive for a dangerous strain of ecoli, the responsible supplier could not be identified. The NY Times article contends that most major slaughterhouses will not sell their ingredients to major meat grinders if they know that Cargill or other grinders will test before grinding.

Trade Secrets

The sole ingredient listed on the American Chef’s Selection Angus Beef Patties was “Ground Beef.” Yet, as mentioned, this ground beef is composed of multiple types of beef trimmings and fat from numerous sources. Cargill and other meat manufacturers contend that revealing more information about how their products are made involved giving up protected trade secrets. The USDA agrees with this trade secret application and has “blacked out details of Cargill’s grinding operation” from public documents.

Without sounding like a zealot consumer advocate, I’d like to know specifically which beef ingredients make up my hamburger. Allowing more transparency in the labeling process, without revealing the specifics of Cargill grinding, should at least be considered in the future. 

Liability

Is Cargill responsible for Stephanie Smith’s paralysis? Furthermore, are any of Cargill’s suppliers at fault?

Professor Picker briefly discussed “joint and several liability” in class a few weeks ago, and I suspect that it may apply in this instance. Since it is difficult to trace the source of an outbreak after grinding, meat ingredient suppliers are essentially being given a slap on the wrist.

Is Smith’s mother (who cooked the hamburger) at fault for not cooking the hamburger properly?

If hamburgers are cooked to at least 160 degrees, E.coli cannot live and will be killed. Warning labels urge consumers to use a thermometer to check the temperature of the meat. In the aftermath of Smith’s illness, Smith’s mother worried that the meat was perhaps not properly cooked. But recent tests performed by NY times suggest that E.coli can very easily be spread by sponges, countertops and other areas/utensils involved in the preparation of meat. Simply following the directions on the package of meat is not enough to prevent dangerous E.coli from spreading. (My family uses the “if its pink when you cut, put it back on the grill” inspection test when grilling. I know most average American families do the same.)

Does the USDA bear some liability since the agency oversees the seemingly inadequate labeling warnings on meat packaging? Has the USDA turned a blind eye to supplier loopholes?

Would consumers pay attention even if there were more stringent warnings on meat packaging (i.e. pay attention to sponges, cleaning services, anything that comes into contact with meat)? While I appreciate transparency and oversight, I have a hard time believing that additional labeling will dramatically change consumer cooking behavior.

The USDA is planning on creating more advanced spot testing at slaughterhouses, but unless the big meat grinder also get in line with required testing before grinding, I believe that it is unlikely that food safety issues will subside. Though on a hopeful note, Costco announced earlier this month that it plans to continue to test ingredients before grinding (Tyson refused to supply the wholesaler as Tyson refuses to test ingredients before grinding).

References: http://www.nytimes.com/2009/10/04/health/04meat.html?ref=heal

Pay-For-Delay

 

Right now major pharmaceutical companies are effectively keeping generic drugs off the market after the patent on the brand name has expired through “Pay-for-Delay” agreements.  These agreements are presumptively legal at this point, but should they be?  Testifying in front of Congress FTC Commissioner J. Thomas Rosch said that these Pay-for-Delay agreements pursued by the U.S. pharmaceutical industry “impose enormous costs on consumers and the health care system,” and that congressional action to prohibit these “pay-for-delay” settlements between brand manufacturers and their generic competitors is “both appropriate and timely.” 

 

http://www.ftc.gov/opa/2009/03/payfordelay.shtm

 

These pay-for-delay deals aren’t new but had slowed dramatically between 2000 and 2004 due to antitrust investigations.  Recently however, appellate decisions in favor of the Brand Name drug patent holders have led to a spike in the instances of these agreements.  Essentially patent holding companies pay their generic competitors to drop their patent challenges and delay entry into the market.  The FTC is of the opinion that this is harmful to consumers in that it results in less choice and artificially elevates healthcare costs.  They extend this argument in several directions even going so far as to imply that American Firms’ cannot compete as effectively on the world stage because they are incurring extra costs due to these generics not making it onto the market.

 

Makers of generics explain their participation in these deals in a couple of ways.  One generic maker testifying before Congress described a “delicate balance” and noted that in some cases generics actually make it to the market before the patent on the name brand drug has expired.  Another generic maker described a no-win scenario – either they participate in the pay-for-play deals or they compete with so called “authorized” generics launched by the patent holders themselves which are exempt from the 180 day exclusivity period.   This 180 day exclusivity period is what makes generics so lucrative in the first place.

 

However the makers of generics or the brand name patent holders explain the situation, it is a win-win situation for both parties.  Brand name patent holders get to extend their grip on lucrative drugs beyond the expiration date of their patents and the makers of generics are paid for doing nothing.  It certainly sounds like it could be anticompetitive but I have to wonder how much Congress and the FTC’s zeal has to do with stomping out an anticompetitive business practice and how much it has to do with pushing the Obama administration’s desired healthcare reforms.  J Thomas Rosch said in a speech to the Center for American Progress that stopping these deals could result in $3.5 billion dollars of savings to consumers and the Federal Government is one of the consumers paying for approximately one-third of prescription drugs.  It will be interesting to see how this plays out and how much consumers will really benefit.

Anonymous Blogging Isn't So Anonymous

Infuriated by some ugly and very personal commentary posted by an anonymous blogger model Liskula Cohen took Google to court and won.  After asking Google to reveal the name of the person who had defamed her and being stymied, the model filed a lawsuit to force Google to reveal the identity of the blogger.  In siding with Ms Cohen Justice Joan Madden of the New York State Supreme Court rejected the blogger's argument that "blogs serve as a modern day forum for conveying personal opinions, including invective and ranting, and that the statements in this action when considered in that context, cannot be reasonably understood as factual assertions."  The blogger’s lawyer in return said the ruling had "potentially damaging implications for free speech on the internet". 

Conversely in 2005 the Delaware Supreme Court overturned the ruling of a lower court forcing an ISP to divulge the identity of a blogger who had posted heavy criticism of a Delaware councilman.  The councilman who claimed he had been defamed by a number of angry posts which strayed beyond political commentary into speculation about the man’s sexual proclivities wanted the court to force the ISP to reveal the blogger’s identify so he could sue for damages.  In overturning the lower court’s ruling Chief Justice Myron Steele compared political blogs to political pamphleteering which the court felt should be protected from intimidation under the First Amendment.  He further cited a Supreme Court ruling from 1995 that stated that anonymous political speech is protected.

The defamation in question doesn’t seem that different to me in the two cases noted above.  In the first case the blogger referred to the plaintiff as a “skank” and a “ho”.  In the second case the councilman’s “sexual proclivities” were examined in an unflattering light.  The only difference seems to be that one victim of cyberbullying was a politician.   The 1995 case referenced in the Delaware ruling involved political pamphleteering and was a clear case of political speech. The court ruled that "Under our Constitution anonymous pamphleteering is not a pernicious, fraudulent practice, but an honorable tradition of advocacy and dissent. Anonymity is a shield from the tyranny of the majority." It also concluded that "the interest in having anonymous works enter the marketplace of ideas unquestionably outweighs any public interest in requiring disclosure as a condition of entry.”  Justice Scalia in writing his dissent and perhaps thinking of the internet wrote "it may take decades to work out the shape of this newly expanded right-to-speak-incognito, even in the elections field. And in other areas, of course, a whole new boutique of wonderful First Amendment litigation opens its doors." 

Here we are in 2009 and the boutique seems to be open for business.  Where is the line drawn?  Are we free to say whatever we want about politicians but not other members of society?  Are we free to say whatever we want just so long as we layer in our political views?  Is the harm somehow lessened by your chosen vocation?