Business Law Prof Blog

The Little Investor As Sucker

  Jim Kramer's new hit show "Mad Money" is the newest in a long line of shows designed to cater to the individual investor who is hoping to make it rich in the stock market.  Kramer does, to his credit, trumpts diversification and tells views not to speculate with their retirement money.  But he knows, and the industry knows, that the game is rigged against the individual investor.  Many more will lose money than will make money (at at minimum make less than they should in even bull markets).  A new book by David F. Swenson, Unconventional Success: A Fundamental Approach to Personal Investment, is an honest assessment of the individual investors, situation.  Only the very best pros make money in this market pricking stocks.  His recommendation?  Invest in low management fee index funds, diversify using the funds, and periodically rebalance your portolio to reflect your ability to bear risk.  This kind of advice does not help Kramer or the many other personal investment shows sell air time, nor does it make money for stock broker/dealers or securities exchanges or the banks that lend money to market players.  We have a well-hyped securities market designed to encourage suckers (individual investors) to play.  It's elemental alllure to small investors and its techniques are no different than the three card monte players on the streets of New York city.  Kramer, if he really wanted to teach investors, would have a three card monte player on his show and have the fellow discuss how he makes his money.

An Example of The New Strategy of Hedge Funds: Wendy's

    Several months ago a hedge fund announced that it had taken a position in Wendy's stock.  The company's performance and stock price had been flat for some time.  The fund had scoured Wendy's operations and decided that it could increase the value of the stock by spinning off a part of its operations (Tim Hortons).  Immediately, other hedge funds piggybacked on the initial funds research and took similar positions.  With the hedge funds holding a substantial majority of the stock, they approached Wendy's management and argued for the spin off.  Management, although initially reluctant, responded by announcing a restructuring and the stock price jumped.  The hedge funds cashed out and so did Wendy's senior managers, exercising millions in options.

This is the new form of takeover, the non-takeover takeover.  Hedge funds do not have to buy legal control to get there recommendations tested in practice.  They buy temporary, effective control by combining resources with each other.   Aggressive hedge funds accumulate powerful minority stakes in the stock and announce publicly their recommendations for increasing a company's stock price.  Management resistance melts as other investors support the idea and as executives, flush with options, decided that they too can cash in if the idea has merit. 

One should note that Wendy's management did not come up with the restructuring on its own -- it came from the outside.  It is further support for the now well known management tendency to favor holding assets or favor growth when retrenchment would increase shareholder value.   

Ichan to Shape Up Time Warner?

Carl Ichan has purchased a minority stake in Time Warner in an attempt to change its management practices.  He efforts to reform poorly managed companies are not new.  In the 80s he led takeovers, purchasing control of companies to oust managers.  He now has a new and more efficient technique.  He purchases a minority stake and attracts other hedge funds to join him.  Hedge funds now hunt in packs.  The incumbants managers cannot ignore the new shareholders, together they are too large.  As the size of the packs of hedge funds grows, no American corporation is too large to be affected.  The effect is a revitalization of shareholder power and pressure.  We may finally be seeing inroads on the Berle and Means' complaint that managers of our largest companies do not run them in the best interests of the shareholders.   This is huge folks.  Lets hope that lawmakers do not disable the hedge funds the way they disabled takeover artists in the 90s.

Krispy Kreme's Board of Directors

   A special sub-committee of the Kripsy Kreme board of directors has issued a report asking a judge to dismiss shareholder litigation against the board for management actions taken to hide the company's failing business operations over the past year and a half or so. http://www.krispykreme.com  The board oversaw a management that, in dealings with failing franchisees, bailed out insiders who owned franchises and sugar coated the company's financials.  The committee did however not recommend dismissal of the shareholder's suit against three officers who have now left the company, the ex-CEO, COO, and CFO.  The committee also said that the company would not get involved in the suits.  The committie has also passed on a fuller report to the Securities and Exchange Commission.

  The sub-committee's report should remind us that the modern function of a company's board of directors is as much to insulate the company from litigation (minimize ligation exposure) as it is to help manage the company's operations.  Indeed, with new case law the former role now, in my view, has superseded the latter.  This is the unintended consequence of the new doctrine designed to force boards to be more "independent."  He has given lawyers a blueprint to create procedures that do not aid in the management of the company but that aid in the reduction of the company's exposure to shareholder lawsuits.  The boards are now primarily useful as litigation barriers.

Scott Sullivan, WorldCom ex-CFO gets Five Years

  Judge Barbara S. Jones, a United State District Court Judge for the Southern District of New York, sentenced Scott Sullivan, the ex-CFO of WorldCom to five years in jail.  He was the brains behind the scandal.  Sullivan cooperated with federal prosecutor David Anders, testifying against the CEO Bernard Ebbers.  Ebbers recieved a 25 year sentence.  The Judge told Sullivan that his cooperation had substantially reduced his sentence.  It is a powerful message to white collar criminals, once revealed -- cooperate with the prosecution of take the risk of a very heavy sentence.  Sullivan's sentence is one-half what prosecutors agreed to in the Enron trial for ex-Enron CFO Andrew Fastow in exchange of his cooperation.   Anders is to be commended for the pace of the WorldCom trials, which are far ahead of the Enron prosecution.  Neither of the two Enron CEOs that have been indicted have been brought to trial.  Anders has tried Ebbers twice, the first trial ending in a mistrial and the second trial ending in a verdict. 

News Corp. Extends Poison Pill

According to Reuters, Rupert Murdoch's News Corp. (NYSE: NWS) extended its poison pill for another two years in order to defend itself from John Malone's Liberty Media Corp. amassing nearly an 18 percent stake in News Corp.  After unsuccessful talks to dilute Liberty Media's stake, News Corp decided to extend the poison pill in order to make a hostile takeover by Liberty Media prohibitively expensive.  Murdoch believes that the extension of the poison pill, which will severely dilute Liberty's holding if a hostile bid is made, will put to rest any hostile takeover by Liberty Media and will allow News Corp to put the issue firmly in the past.  Allowing the company to focus on new ventures.

Two Former Bayer Execs Indicted for Price Fixing

The Associated Press is reporting that a federal grand jury indicted Jurgen Ick and Gunter Monn, both former executives at German chemical maker Bayer AG, for allegedly taking part in a international price fixing scheme.  According to the report, Ick and Monn were charged with conspiring with other industry executives to suppress competition to fix rubber and chemical prices in the United States and elsewhere.  This indictment is the latest from a long-running antitrust investigation into an international price fixing ring created by some of the world's largest rubber chemical producers.  If convicted, Ick and Monn could face up to three years in prison and be fined as much as $350,000 each.

Whirlpool Raises Offer For Maytag

The Associated Press reported today that Whirlpool Corp. raised its offer to buy Maytag Corp. for a third time to $1.79 billion or $21 a share.  According to the terms of the deal, Whirlpool will assume $977 million of Maytag debt.  The new offer, which is $1 more than an offer Whirlpool proposed on Monday, also includes a "reverse breakup" fee of $120 million payable to Maytag if regulators do not approve the combination, which might be a problem since Whirlpool is the number 1 and Maytag is the number 3 appliance maker in the nation.  Triton Acquisition Holding Co. is the private investment group which has a $14 a share bid already in place which was accepted by the Maytag board.  The shareholders will vote on the Triton bid on August 19th.  With a 50% higher offer in place by Whirlpool, Triton is expected to come with a higher offer, but an offer that is no where near the offer of Whirlpool.  However, the Triton offer has no regulatory hurdles to cross and that is their bargaining chip for their takeover of Maytag.

The Disney Case

  Last week  Chancellor William B. Chandler III of the Delaware Chancery Court released a 174 page opinion on the shareholder derivative suit against the Walt Disney Company and its board of directors over the hiring and firing of ex-President Michael S. Ovitz in 1995 and 1996. 
Michael D. Eisner, the CEO, led the both the hiring and firing of Ovitz, who received a severance package of around $140 million for his fourteen months on the job.  Shareholders sued the company and the board in 1997, alleging that the excessive payments to Ovitz constituted a breach of the board's fiduciary duty to the company.  Now, ten years after the payment, the Chancery Court has ruled, after a full trial, that the board did not breach its fiduciary duty in making the payments.  The ruling was front page news in the New York Times and the Wall Street Journal.
It would be wrong to assume that Disney in particular and corporate boards in general have once again escaped judicial oversight.  The Disney board won this case only technically (and perhaps only temporarily), the board and its members have been big losers for months, years really. 
Eisner and the other members of the Disney board lost irrevocably when Chancellor Chandler decided two years ago that the case deserved to be tried (he denied motions to dismiss and for summary judgment).  This was the big change in the law; under earlier doctrine, cases such as this were easily dismissed and trail avoided -- the board was protected by the "business judgment rule" and the plaintiff's usually, absent conflicts of interest on the board could not pled enough facts to show that they could win on the merits at trial.  Now, plaintiffs can force these cases to trial if the alleged facts smell enough.
Once Eisner lost the on the preliminary motions, he knew and the board knew that they would be embarrassed and humiliated in public.  During the trial earlier this year, skillful lawyers, in a room full of press, bought out the dirty laundry of the management practices of Disney.  The testimony was painful. Eisner was shown to be imperialistic, arrogant, and wrong-headed and his board members were shown to be toadies.  The management team at Disney was revealed as petty back-stabbers; it was a new form of a TV reality show.  We listened as office decorating became a huge company issue, as a funeral procession became an issue -- it was awful. 
The Chancellor's opinion in many ways was anti-climactic, only confirming the obvious, bashing Eisner and the board for "less than best practice."  Furthermore, the Chancellor Chandler's opinion will not be the last word on the case; the Delaware Supreme Court will get the case on appeal and will, no doubt, offer its own opinion, adding further language of ignominy.  I doubt the Supreme Court will reverse the holding; it will just add its own language on condemnation.
The board members will not pay cash to reimburse the company for Ovitz payments (even these would have been indemnified probably by the company or a insurance company) but they have paid and will pay more.  Their reputations have been permanently and publicly sullied.  The corporate bar and all current managers will learn through the case (no-one wants to be embarrassed like this) and successive generations of law students and business students will read the final version of the case and be similarly told of this reality show.  No, this was not a  victory for the defendants.

Disney prevails on Ovitz suit.

The Wall Street Journal reports this morning that Chancellor William B. Chandler III of the Delaware Chancery Court has found in favor of Disney's board of directors in the shareholder suit arising out of Michael Ovitz $140 million severance payment. According to the Journal, Chancellor Chandler's decision rested on the importance of directors being able to assume risk in making their business decisions in an attempt to maximize shareholder value. A link can be found in the Journal article to the entire opinion, which will likely be available on the Chancery Court's website shortly.

Is Chevron's Victory a Mixed Blessing?

The Wall Steet Journal reported this morning that Chevron's bid for Unocal may be both a defensive strategy to mask declining discoveries of oil and natural gas (Chevron's replacement rate is just 18%), and a gamble that oil prices will remain high for the foreseeable future. Unocal shareholders are not convinced that the acquisition of their company will enhance Chevron's position, as a majority of Unocal shareholders appear to want cash on the barrel rather than Chevron stock (see article here).

Koizumi's Defeat: A Lesson in the Difficulties of Reducing Government Investment Funds

  Yesterday the Prime Minister of Japan, Junichiro Koizumi suffered a defeat in the Upper House of the Japanese Parliament.  He lost a vote, 125 to 108, on his efforts to privatize Japan's $3 trillion postal system.   Over twenty members of his own party, the LDP, voted against the measure. After the vote, Koizumi declared the result a vote of no confidence and called for new elections for the Lower House.  He hopes to oust the rebels from the LDP party in the new election.   

The postal system is misnamed, it is in reality a huge government run investment trust.  The postal system manages a quarter of Japan's total household financial assets!  The problem -- the government managed the assets not to maximize returns but to serve political interests -- porkbarrel projects favored by politicians.  The effect of the mismanaged fund is to add to Japan's fiancial doldrums.  Japan's economy stalled in the 90s and is now growing only very slowly, at about 2%.  There is a near consensus in the economic community on the need to eliminate this pool of government-managed money.  The IMF has, for example, condemned the trust for some time.

There are two sobering lessons:  First, despite good intentions, government managed investments can become dominated by political, not financial goals.  Second,  once created government-managed investment pools can be very difficult to eliminate, as vested interests lobby hard to save them. 

Yet calls for government managed money persist.  Here in Ohio the Governor is sponsoring a voter initiative, called the Jobs Initiative, to create a huge pool of cash ($500 million by selling bonds) controlled by the state and invested in the state's interest.  If the measure passes, how will the cash be allocated?  In a state full of "pay-to-play" political exchanges?  It will be allocated according by political power.   We are attempting to create our own version of the Japanese postal system.      

Corporate Social Responsibility

   The August 15, 2005 Business Week has an fine article by Brian Grow (with Steve Hamm and Louise Lee) on corporate social responsibility.  It makes the point that new information age technology has enabled investors, customers and employees to get information on what a company is doing anywhere in the world and, in many cases, to read the complaints of critics.  Since employees want to work for "good companies" and customers want to buy products from and support "good" companies, companies are developing taking pains to develop reputations for social responsibility.  This is all to the good, as long as the government does not decide to mandate it (as some academics would have them do).  This is difficult stuff:  companies can spin their efforts (mislead),  companies can get carried away (deverting too much time away from making a competitive product), and companies can get too imperialistic (dragging staff into controversial issues that are favored by the managerment).  Look at DaimlerChrysler -- a company that built a "Smart" car, that has employee representatives ("co-determination") in its management structure, that resists private equity ("locusts") control in favor of control by "long-term" investors (banks)(among other good deeds) -- and yet forgot to build a good quality Mercedes automobile.  The company is a mess (its stock is down over 50% from its high) and employee jobs are at risk all over the world. 

Lerach's Troubles

   There is much glee in corporate boardrooms as a federal prosecutor is after the country's premier securities class action plaintiffs' lawyer, Learch and his old law firm, Milberg Weiss.  The investigation is over kickbacks to the plaintiffs in the class actions.  Whatever one's views on the practices of Learch, he often took the lead in the private litigation over securities violations.  His problems should not obscure a more basic problem -- private securities litigation is a valuable enforcement tool that has been corrupted by both plaintiff and defense attorney (with the complicity of judges) into a settlement dance.  Suits that should not have been bought get rewarded with greenmail money and suits that should be pursued get eliminated early (in confidence) with buyout money.  The class action procedure ought to work better.  We do not need new rules, however.  The courts are the weak link;  judges must approve settlement amounts and attorneys' fees and the lawyers will do what the judges permit.  Delaware Chancery Court Judge Strine has recently been looking more carefully at  attorney fee requests in shareholder derivative litigation and if all trial judges start spending more time on class action settlements, the procedure will work better. 

Hedge Fund Regulation

Hedge funds are all in the financial news.  Last Sunday's New York Times has an article on how hedge funds are cutting in on the business of the private equity funds.  The Securities and Exchange Commission has passed a very controversial rule requiring hedge funds to register.  New Chair Cox has suggested that he will leave the rule alone.  Phillip Goldstein has sued the SEC in federal court challenging the rule.  Academics, late to the party of course, are now holding conferences on the SEC's legal power.  Ironically, the cash flows into hedge funds have slowed down, peaking in 2002.  Why?  Hedge fund returns have been lower than publicly trumpeted in the press for some time.  Investors are smart and starting to recognize that hedge funds returns can be -- shall we say -- spun and are demanding a more accurate accounting.  Here is where the SEC should be -- if a hedge fund has "spun" its returns to its investors, those investors (or the SEC) can sue for a material misrepresentation -- regardless of confidentiality agreement.  The SEC does not need to register hedge funds (the Treasury should force banks to disclose exposure to such funds, however), it needs to do what it does best, enforce rules against basic investor fraud.

Responses to Rule 10b-5-1 plans

  There have been some excellent responses to my post on Rule 10b-5-1 plans.  Here is one:

Prof. Oesterle:

I have a few observations on your post concerning the potential for abuse under 10b5-1 plans. 

I think plan terminations are riskier to executives than you suggest.  Remember, a good faith requirement is baked into the rule, and the affirmative defense provided by 10b5-1(c) is available "only when the contract, instruction, or plan to purchase or sell securities was given or entered into in good faith and not as part of a plan or scheme to evade the prohibitions of [the rule]."  While the staff does interpret Blue Chip Stamps to mean there is not a 10b-5 violation where an executive terminates a plan while in possession of material non-public information, staff members have suggested (and lawyers often caution their clients) that such a termination could affect the status of pre-termination transactions, because termination under those circumstances could indicate that the plan was not entered into in good faith in the first place.    The classic example what The Corporate Counsel magazine referred to as the "heads I win, tails you lose" scenario:  an executive who sells under a 10b5-1 plan for several months, but upon learning that the company's earnings exceed expectations, decides to terminates the plan to avoid a sale just before an earnings announcement that will boost the stock.

I think the second abusive scenario that you point out also raises issues under 10b5-1(c)'s good faith requirement.  Timing the release of positive and negative news to pre-date purchases or sales scheduled in the plan could certainly involve, as you suggest, market manipulation.   I think a pattern of conduct like that could well attract attention from the SEC's enforcement division, and I don't think they'd hesitate to call into question reliance on a 10b5-1 plan under these circumstances.

As to the disclosure point, I think that a large number of issuers do, in fact, announce the adoption of a 10b5-1 plan by a corporate insider. (See for yourself-  http://news.google.com/news?hl=en&ned=us&q=10b5-1 ). One of the reasons for this is that when insiders do sell, it becomes public quite quickly, and companies get a lot of phone calls from investors inquiring about the reasons for the sale.  That puts the company in a reactive position when dealing with the market, which most companies would prefer to avoid. Also, because the adoption of a plan places you in somewhat murky waters in terms of materiality, I think many companies and lawyers view announcing these plans as a best practice.

Jagolinzer's conclusions about abnormal returns are interesting, but I don't think his conclusion is that his research establishes that those returns result from abusive conduct.  While he alludes to that possibility, the furthest that he appears willing to go on this front is to suggest that " exactly how insiders generate trade profits within their 10b5-1 plans is an interesting question for future research."

Your blog is interesting, informative and provocative.  I enjoy reading it.

Sincerely,

John Jenkins

My response to Mr. Jenkins:  Lawyers are asked to push the boundaries of these plans and will do so until the SEC warns someone that it will no longer accept the practice.  The "good faith" requirement is a very general but available limitation for the SEC but until the SEC actually uses the language to limit the plans, most lawyers will just use it as CYA language in opinion letters that otherwise give clients the green light on plan terminations. 

Nasdaq Efforts to Withdraw from ITS

   Hidden in the back pages of today's Wall Street Journal was a blockbuster news item.  The Nasdaq Stock Market announced plans to withdraw from the Intermarket Trading System, the ITS.  The ITS is the Securities and Exchange Commission's effort to link electronically the country's major securities markets.  The members of the ITS must send trades to each other when one members is posting better quotes than another (the "trade through rule"). 

I have written that it was beyond the SEC power under the 1974 national market system amendments to creat the organization and, additionally, that the ITS was bad public policy.  Recently the SEC expanding the coverage of the ITS under Regulation NMS to Nasdaq stocks, previously the ITS had been limited to stocks listed on national exchanges.  ECNs (electronic trading systems) had lobbied for the suspension of the trade through rule and the NYSE had lobbied for the extension (to protect its market position).  The NYSE won (with ex-President Donaldson at the helm of the SEC). 

The immediate effect was the announced mergers in the securities trading industry -- the NYSE bought ArcaEx and the Nasdaq bought Instinet.  The SEC rule will have a huge impact on the structure of the securities trading industry--- and the SEC should not play such a major role.  Consider for example the article on Glenn Hutchins in the Aug. 8, 2005 Business Week -- he is in the vanguard in doing financial deals in the trading markets.  The buyout of SunGard Data by buyout funds, itself a remarkable transaction in the private equity markets, is a part of the restructuring. 

Now Nasdaq is attempting to withdraw from the ITS so as to de-link itself from other markets and develop its own technology.  The technology of the ITS is slow and awkward -- imagine that, a government sponsored monopoly being slow and awkward.  Of course, the Nasdaq must get the permission of the SEC to do so.  Great.  The SEC will find a way to protect the trade through rule if it does so.  The Nasdaq is, in essence, asking the SEC to reconsider the adoption of the trade through rule.  If the SEC lets the Nasdaq out and also relaxes the trade through rule (tying it to the ITS) then much of the folly of Regulation NMS will be undone.  Do not bet on it.