Business Law Prof Blog

Nocera: The Champion of Feel Good-Regulation

Whenever I pick up the New York Times and see a column by Joseph Nocera I know that I will get a traditional dose of the need for "feel-good regulation."  The column will contain a fuzzy, well-intended discussion of the the need for expanded federal regulation of the business and investment community, a community that is habitually misbehaving.  "Feel-good regulation" makes proponents feel better because they believe they are addressing a social problem;  the effectiveness of the regulation is secondary to the warm feeling proponents have when regulation is aimed at the rich and powerful.  Fuzzy thinking on effects is tolerated;  critics are dismissed as pawns of the powerful.  Today's column , "Offering Up an  Even Dozen of Odds and Ends," is more of the same.

Take one example:  Nocera again defends the need for hedge fund regulation because they are, horrors, "secret."  "Secrecy is the Achilles heel of the hedge fund industry. It's scary that nobody knows what hedge funds are doing..."  He is incorrect on several levels.  First, hedge fund investors know what hedge funds are doing;  they are sophisticated investors and keep track of their money.  Hedge fund managers must communicate with hedge fund investors and hedge fund investors money is "hot"-- investors can and do withdraw funds at the drop of a hat.  Some managers lie of course but their investors watch, discover and pull their money out.  Second, some secrecy by hedge funds makes imminent business sense:  hedge fund trading strategies -- researched, designed and market tested -- are valuable and the value disappears once they become public knowledge.  Other traders will free ride off the success of the strategy until the strategy no longer works.  Why spent capital to develop a strategy if you have to tell everyone else what it is once it makes money?  Unless hedge fund managers inherently lie to their own investors there is no need to force them to publicly file or declare their trading strategies.  Forcing them to reveal their strategies will mean that hedge fund managers underinvest in developing strategies unless they can avoid the regulation (move to the Canary Islands or require a two year lock in of investments).  In short, secrecy is sometimes bad and sometimes not.  It is bad when, for example, CEOs use techniques to obscure the true nature of their salary from their shareholders.  Old tricks include options and perks; the new trick (in yesterday's WSJ) is the tax "gross-up", the company pays an executives tax bill.  This is bad; CEOs are hiding their total pay package from their investors.  If CEOs believe that the deserve such salary payments then why do they hide them?  They should be able to justify them on the merits.   

The fuzzy thinking is in not discriminating the CEO pay package problem (too much secrecy) and the hedge fund problem (some secrecy is necessary to the business).

 

NYSE Decision on Sovereign: Technical Evasion Works

The NYSE decision  that Sovereign Bancorp's decision to issue 19.9% of its shares to Banco Santander Central does not trigger the NYSE's voting requirements is a victory for technical evasion of the NYSE rules.  The NYSE Listing Company rules, unlike the Nasdaq rules, require a shareholder vote whenever a company issues 20% or more of its securities to a purchaser.  The key word is "issue."  Some states, including Delaware, have an old method of recording repurchased stock as treasury shares;  treasury shares are still "issued" but not "outstanding" and can be resold without being "reissued."  Treasury shares can be held by the company or canceled.  When canceled the treasury shares are no longer issued.  Most states, following the Model Business Corporation Act (MBCA), deem repurchased shares to be automatically canceled -- the sensible modern system.  So under NYSE rules a company can issue 19.9% new shares to a purchaser and also sell to the same purchaser another 5% of its treasury shares and not trigger the voting requirements.  The key is that Delaware has the old rule on treasury shares. For corporations incorporated in MBCA states this is not possible because treasury shares are canceled and must be reissued;  hence the trick is unavailable.  The so called "treasury exemption" at the NYSE comes from the misreading of another rule on how to count outstanding shares for the purpose of calculating the 20% (it is 20% of outstanding shares, excluding treasury shares).  The treasury exemption is sensible here (in the calculation of outstanding shares) but not sensible in its extension to the term "issue" in the calculation of the shares sold to the purchaser.  This is sophistry at its best and the NYSE should be ashamed of itself.  The hope the SEC gets involved and comes down hard on such decisions.

Foreign Companies List in London over the NYSE

After yesterday's post on the new SEC rules on deregistration for foreign companies the WSJ today has a column on the issue.  The stark fact is that since Sarbanes-Oxlely the listing of new foreign companies has gone to London.  In 2000, the United States claimed 89% of the new foreign listings; last year London claimed 88% of the new foreign listings.  SOX has been cheered in the hallways of the professional offices of the City of London.  Feel-good regulation has costs, folks.

Attack of the Hedge Funds

Posted by Bill Sjostrom

Click here for a short 12/21/05 memo from Wachtell, Lipton, Rosen & Katz titled “Be Prepared for Attacks by Hedge Funds.”  This is my favorite piece of advice from the memo:

Companies need to:   . . . Not allow attackers to achieve the moral high ground by wrapping themselves in the cloak of good governance.  Expose the attackers for what they are, self-seeking, short term speculators looking for a quick profit at the expense of the company and its long term value.

I assume the firm does not have any hedge fund clients or at least none that are self-seeking, short term speculators (is there such a hedge fund?).

Top Story of 2006: For Profit Securities Exchanges

The top story of 2006 for the securities markets will be the impact of the new for profit securities exchanges.  The New York Stock Exchange will soon go pubic in its merger with Archipelago, the Chicago Board of Trade and the Chicago Mercantile Exchange have gone public, and the Nasdaq is also publicly traded.  The SEC has focused on the SRO functions of the markets and requested that the SRO functions be separated from the for-profit companies.  The details are under negotiation.  This is small potatoes however.  The real impact will be in how the exchanges are run (will the squeeze fees out of traders because they have market pricing power) and whether the exchanges will consolidate.  The Charmian of the NYSE has continually noted that the primarily advantage of a for profit company is that it can use its stock as consideration for purchasing other markets.  The NYSE will be on an acquisition binge.  Both developments, pricing power and consolidations, will sorely test the economic market principles of the SEC.  I hope the SEC will rely on tried and true antitrust doctrine to guide it through the thicket, something it has not done in the past when it has relied instead on the abstract notion of trading markets as regulated quasi-public utilities.  Trading markets are not inherently natural monopolies (unless government rules make them so) and should not be regulated as such.   The SEC approach to for profit exchanges will be the story of 2006    

SEC Eases Foreign Exit Rules

The SEC has voted to propose rules that will ease exit from United States filing requirements by foreign companies.  Foreign companies after the passage of Sarbanes-Oxley in 2002 have been reluctant to list their shares on United States exchanges.  Foreign companies are uncomfortable with the enhanced filing requirements and with the prospect of Congress or the SEC continuing to increase those requirements in the future.  Once a foreign company lists in the United States under the current rules, it is very difficult to leave.  A company can leave only under current rules only if it reduces its United States shareholders to less than 300.  So the SEC, in attempt to encourage foreign companies to list in the United States has proposed rules that make it easier to leave. Rules Under the proposed rules a foreign company can deregister if 1) United States investors owns less than 5% of the company's world wide public float or 2) if United States investors own less than 10% of the company's world wide public float and the average United States daily trading volume is less than 5% of the average daily trading volume in the company's home market.  The company must have filed in the United States for two years and not have sold stock in a public or private offering in the United States of one year.  The SEC estimates that 26% of the foreign companies currently registered in the United States could chose to deregister under the proposed rules.

The most interesting part of the proposal perhaps is the added condition that a company may exit only on the condition that it maintain a web site that has, in English, the information specified in Rule 12g3-2(b)(primarily information filed, disclosed or distributed to shareholders in its home country).  This is yet another example of the SEC's backdoor, grudging use of the Internet.  Someday all United States companies as well will meet their disclosure requirements primarily through Internet sites rather than through paper filings and mailings.         

Strine on Shareholder Voting

Vice Chancellor Strine of the Delaware Chancery Court has authored an article on shareholder voting in the Harvard Law Review.  The some to be published piece suggests, but does not endorse, that state laws be changed to allow contested elections for boards of directors every three years.  Insurgents would appear on the management proxy card and get their expenses reimbursed if they receive over 35% of the shareholder votes.  Companies that choose to use the system would be exempt from including Rule 14a-8 shareholder resolutions in their proxy materials.  Strine's proposal is another in a long line of suggestions made to invigorate shareholder voting.  The high water mark of the many suggestions was the 2003 rule proposal by the SEC, now languishing and apparently withdrawn, that would allow institutional investors to put a short slate of candidates on a company's proxy card if management candidates in the previous election had received a high percentage of "abstain" votes.  Rather than mandate a given voting system, I would favor state rules that facilitated firm experimentation with voting procedures as long as the details of any system proposed by management were disclosed to shareholders.  A state law that required shareholder to periodically (every five years?) reconsider voting system options would get my endorsement (not just be my suggestion).

Hedge Funds and Poison Pills

Phyllis Plitch, who writes the "Tracking the Numbers/Street Sleuth"  column for the Wall Street Journal, wrote a piece in Tuesday's Journal (12/20/05 at C3) entitled "Hedge Funds Find Cure for Poison Pill: Teamwork."  Her point?  Hedge funds buy 9.9% each so as to not trigger a firm's poison pill plan and then work together (in "wolf packs") to influence target firm behavior.  She cites Lipton claim that the SEC could stop all this by enforcing a group definition under Section 13(d) of the 34 Act.  This is old news and incomplete.  First, Section 13(d), forcing disclosure of stock positions when a bidder buys over 5% of the voting stock of a publicly traded company, aids hedge funds' wolf pack behavior.  A single fund buys 5%, triggers the disclosure requirement that includes a description of its plans for the target and thereby implicitly invites other funds to join.  Expanding a "group" definition in the section will cause technical filing difficulties perhaps but it does not solve any problems.  Second, when two or three hedge funds each hold 9% stakes, the company itself does not want to trigger its own poison pill plan.  A triggered poison pill plan causes numerous difficulties, affecting firm planning (through severe stock dilution) and negotiation and rewarding those hedge funds that have purchased stock but are not in any group that triggers the pill.  A firm may group two hedge funds to hurt them by triggering the pill only to find that the firm has given windfall profits to three or four others.  [You take out one wolf only to enable the rest of the pack to attack.]  So an expanded group definition for a poison pill plan trigger is a problem not a solution.  Hedge funds have thus, in a sense, used poison pill plans against the firms that have them.      

The General Solicitation Prohibition in Private Offerings

There is scattered evidence that the Securities and Exchange Commission has relaxed the prohibition on general solicitations in private offerings under Regulation D.  Bartlett Essay.  Hedge Funds have stretched the limits of the doctrine as they publicly advertise their activities and then raise money in private offerings.  The argument is now reduced to the length of the "cooling off" period from the public ads and the private solicitations; it is thirty days and shortening.  The SEC relaxation is in practice and not in law however and represents another example of the SEC failure to come to grips with the effect of the Internet on capital formation in the United States.  These are difficult questions but they need to be revisited directly, not by inaction.

Kerkorian's Tracinda Sells 12M Shares of GM

Posted by Jason R. Job

Late yesterday, when General Motors (NYSE: GM) closed trading at a 23-year low, Tracinda, the investment vehicle for Kirk Kerkorian, filed with the SEC that it has sold 12 million shares of General Motors, reducing its stake to 44 million shares.  The SEC filing can be found here.  According to the filing, the following describes the purpose of the sale:

On December 15, 2005, and December 19, 2005, Tracinda sold 5,000,000 shares and 7,000,000 shares, respectively, of General Motors common stock in private transactions. Tracinda sold these shares

because it is eligible for substantial federal and California corporate income tax savings if it incurs a capital loss prior to the end of its current fiscal year, January 31, 2006. The capital loss will offset certain capital gains realized by Tracinda in an unrelated transaction. The Filing Persons may determine, based on market and general economic conditions, the business affairs and financial condition of General Motors, the market price of its shares and other factors deemed relevant by the Filing Persons, to acquire or dispose of additional shares. In this regard, the Filing Persons may consider acquiring additional shares when they are able to do so without jeopardizing the tax benefits realized as a result of the sales described herein.

Kerkorian's Tracinda sold the shares of general motors for $251 million.  A far cry from the $372 million he would have paid for those shares from his $31 per share May 2005 tender offer.

Even though Kerkorian's reason for selling the stock, I feel is somewhat legit.  I do question whether his true motivation is to lessen his stake in a company that is having some major problems, allowing him to sleep better.

Today, GM shares have traded as low as $19.30, but currently are trading for $20.15.

New York City transit workers and CEOs

New York City transit workers have an average salary of $63,000 a year, can retire with full benefits at 55 (if they have 25 years of service), make no contributions for health care, and put away only 2% of their salary for pension benefits.  It is not enough, apparently, and they was gone on strike, illegally, hamstringing New York City during the holiday shopping and tourist season.  The workers are striking for guaranteed raises at about three times the inflation rate for the next three years.  They have also demanded that they be able to retire at 50 and that disciplinary proceedings for poor driving be reduced by 25%.  The workers ability to extract sure wages and benefits is, of course, not related to their skill and uniqueness as bus drivers, it is related to their ability to hold up others creating value.  It reminds me of CEOs who claim that they are worth $30 million a year when the run a company.  The CEOs are in a position to claim value, value not necessarily related to the value that they add.  It is easy to confuse the arguments.

Poison Pill Promises Enforceable

Chancellor William B. Chandler III of the Delaware Court of Chancery denied a defendant's (News Corp.'s) motion to dismiss on a claim that the defendant's board of directors had broken a promise to rescind a poison pill plan.  The case can now proceed to trial.  Institutional shareholders claim that the board made the promise in order to secure their votes for reincorporating the company in Delaware (from Australia).  The judge did dismiss claims based on fraud, misrepresentation and breach of fiduciary duty however.  The judge's ruling reinforces the common view that the Delaware Supreme Court's Omnicare decision, in which a board's decision to bind itself without a "fiduciary out" provision was set aside,  will not be widely applied outside its facts -- which is a relief. 

SEC Advisory Committee Reports on Internal Controls for Small Companies

On December 17, 2005 the Internal Controls Subcommittee to the Advisory Committee on Small Public Companies issued a Preliminary Report.  Report  The Subcommittee recommended that Microcap Companies (with a market capitalization of under $100 million) be totally exempted from Section 404 of Sarbanes-Oxley requiring both a CEO certification and an audit of the effectiveness of a company's internal control systems.  It also recommended that Smaller Companies 9with a market capitalization of $100 million to $700 million) be exempted from the audit requirements of Section 404 (the CEO will still have to certify the effectiveness of the company's internal controls).  It is unknown whether the SEC will adopt the recommendation.  The Report found that the costs of Section 404 were much higher than expected and were disproportionally higher for smaller companies, that internal controls were not as necessary in smaller companies and did not provide the same benefits as those in larger companies, that there is no clear SEC guidance on how to apply the SOX requirements to smaller companies, that investors know that smaller companies pose a greater risk of management fraud, and that there are other more effective methods of stopping management fraud in small companies.  Finally, in its most important finding, the Subcommittee found that applying Section 404 to smaller companies would hurt the United States economy by chilling the capital formation in small publicly traded companies.  This is a welcome note of sanity in the Sarbanes Oxley discussion.  Whether the SEC will do anything with the report is anyone's guess.

Tender Offer Best-Price Rule Amendments Proposed

Sections 14d-10(a)(2) (for third party offers) and Rule 13e-4(F)(8)(ii)(for self tender offers) require bidders making public tender offers to offer the same price to all target shareholders in the targeted class.  Several target shareholders had successfully challenged employment agreements, severance agreements and non-compete contracts for target senior executives under the rule as a violation of the rule.  The plaintiff shareholders argued that the agreements were disguised compensation for the senior executive's stock that enabled the executives to sell their shares at prices in excess of those paid the ordinary shareholders.  The claim, as reported here, significantly chilled the use of negotiated tender offers in acquisitions;  parties used the more expensive (and longer) statutory merger form instead.  Lawyers did not want special provisions for senior executives to fail in the deals.  The SEC has proposed rules that will  stop the uncertainty.  Basically, the employment agreements are exempt for the best price rules as long as they are based on past or future services and not on the executives number of shares.  A safe harbor is available if an independent compensation committee makes the appropriate finding.  The rule leaves problems with the size of the employment agreements to the state doctrines of fiduciary duty:  If a target board negotiates arrangements that pay too much (as a disguised bribe), it remains a violation of the board of directors fiduciary duty to the firm and its shareholders.