Business Law Prof Blog

The New Spin-Off Scheme?

In the 80s and 90s lawyers devised a series of disguised spin-offs in an attempt to isolate growing asbestos liabilities from a firm's other valuable assets.  Most failed.  The new spin-off scam may be designed to limit employee health benefits.  A class action against Abbott Laboratories makes just such a claim. Article

SEC on Financial Penalites

The Securities and Exchange Commission has issued a statement on financial penalties for corporations.  Release  Critics of financial penalties on corporations, a relatively recent SEC practice, claim that shareholders suffer twice -- once when managers fraudulent practices are revealed and again when the firm is assessed a fine that is a charge on the firm's equity.   The SEC states that it will seek penalties only "when the violation results in an improper benefit to shareholders."  If shareholders are the primary victims, the SEC "will seek penalties from the individual offenders."  The SEC also expects "shareholder turnover" be a factor in the decision.  Illustrating the distinction the SEC announced a $50 million penalty against McAfee Inc.  The company had used fraudulent disclosures to make acquisitions using overpriced shares.  In a second case, the commission refused to assess a corporate fine against Applix Inc..  Applix shareholders had not benefited from the accounting fraud. 

The cases of "improper benefit to shareholders should be rare.  In the garden variety disclosure fraud case, managers lie to keep stock prices high so they can cash in compensation options and/or sell their stock.  Shareholders in general do not profit in such cases;  only managers do (and those shareholders who are lucky enough to sell before the fraud is revealed).  Those shareholders that hold stock (choose not to sell because of artificial expectations) or those that purchase when prices are artificially high are big losers. Whether or not they are victims depends on one's view of whether they should be held responsible for choosing the firm's managers.  On the other hand, when managers take overpriced stock and exchange it for valuable, permanent assets (either directly, as in McAfee, or indirectly) shareholders do, as a whole, benefit.    

The controversial part of the release is an assessment of shareholder benefit after the SEC begins to investigate the fraud.  The release seems to imply that shareholders who are victims of their manager's fraud may turn into fraud "beneficiaries" if the firm does not cooperate with the investigation.  This makes little sense; the managers are the one's not cooperating, not the shareholders.  Shareholders should not be held responsible for their manager's refusal to cooperate.  The cooperation mitigation principle should only kick in the those cases in which the firm exhibits a permanent benefit from the fraud (the McAffee type case).   This need to be cleared up.

Golden Parachutes Are Excessive

Merger and acquisition activity for 2005 was hot, touching $1 trillion. Gurus predict even more deals for 2006, particularity in the finance, technology and energy sectors. 

            The headline story in 2005 was the fat payouts to acquired company CEOs.

            Gillette’s CEO, James M. Kilts, will pocket an astounding $188 million in cash and stock options for selling his company to Procter & Gamble.  He earns another $6.5 million for agreeing to stay on board for one year as a vice-chairman after the deal.

            The payout was too much even for insiders.  The retiring Gillette vice-chairman, Joseph E. Mullaney described the package as “obscene.”  Kilts, speaking up after shareholders had approved the acquisition, was indignant, complaining that we had become “a piñata” and had earned his pay by creating billions in shareholder value.

He was not alone.  The CEO of Georgia-Pacific, A.D. Correll, will receive a $92 million severance package when the company is sold to Koch Industries.  MBNA CEO  Bruce L. Hammonds will similarly receive $102 million, Toys are Us Inc. CEO John H. Eyler will receive $63 million; David Dorman of AT&T will take home $55 million; and Michael D. Capellas of MCI will pocket $39 million.

            These are astounding numbers and are the tip of the iceberg.  Many other CEOs have negotiated similar promises.  On a sale of his company William W. McGuire of United Health will make $162 million, Robert L. Nardelli $114 million, J.J. Mulva of ConcoPhillips $92 million, Gary D. Forsee of Sprint Nextel $80 million, and   Kenneth I. Chenault of American Express $73 million.  The average parachute payment for CEOs of our largest one hundred corporations is a whopping $28 million.  

            In the 1980s we worried that CEOs were too reluctant to sell their companies, even when buyers offered above market prices for the stock.  We argued that incumbent CEOs were retaining the perks of office at the expense of their own shareholders.  Corporate boards fashioned “golden parachutes”, special severance payments if a company changed hands, to prevent executives from resisting reasonable deal offers. 

            Some boards have overcorrected and we now have the reverse incentive problem.  Now there is a serious question of whether CEOs are doing deals more for their own benefit than from their shareholders.  Indeed, a CEO who has mismanaged a company, attracting bidders who see an opportunity to correct a weakness, may benefit the most. 

            At minimum, CEOs may come to specialize in dressing up a company for a deal rather than manager the company long term. Capellas’s $39 million payout from MCI, for example, comes just three years after he collected $14 million for selling Compaq Computer to Hewlett-Packard.

            The stunning number of colossal parachute payments in 2005 has generated a reaction from shareholder advocates and attracted the attention of the Securities and Exchange Commission. 

            The nutty severance payments are a reminder that corporate governance in the United States has serious problems.  Boards of directors are struggling to get appropriate compensation incentive packages in place for their shareholders. In the end it is the boards of directors who must shoulder the responsibility for agreeing to such awards.

            The responsibility of boards of directors for the compensation package of CEOs is evaluated under the legal rubric of "fiduciary duty."  The Supreme Court of the State of Delaware, home to one-half of our major corporations, is considering, in the Disney case, whether to give more scrutiny than it has in the past to such board compensation decisions.  The Disney decision will affect golden parachute packages.

             The SEC, on the other hand, is likely to propose rules that force publicly traded companies to be more candid about the value of golden parachute agreements.  Much of the public shock at such payouts comes after they are made and not when the board agrees to do them because the corporations, under current rules, negotiate a pay package with a CEO and then disclose the value of the package's  future promises only obscurely and obliquely.  It is only when the money comes due after an acquisition that financial commentators are able to add up the bill.

Roberts on the High Court

Business Week, Dec. 19, 2005, had an intriguing article on Roberts' nine recusals in his short service on the Supreme Court.  ("Business' High Court Handicap:  Stock Holdings of Justice Can Keep Corporate Cases Off the Docket"All the recusals are related to his diverse investment portfolio.  The recusals not only involve cases that the court decides but also decisions on which cases the court should take.  So business savvy Justices may not take an active role in fashioning the Supreme Court's agenda.  The business community gets a Justice on the high court that understands and respects the business community and he has to recuse himself from important business cases because of his investment portfolio.  The cases are thus left to members of the court with limited investments.  Some Justices have limited personal assets; others hold their money exclusively in money market funds.  So Justices that have had success in business investments must either stay off business cases and the decision to take business cases or dump their portfolios and be content to hold money market funds.    

Chamelion Bonds: The New Tax Dodge

The federal tax code creates operating incentives for business that do not match business operating efficiencies.  Clever planners spend time attempting to narrow the gap.  The newest trick is "chameleon bonds."  The investment instruments are taxed like bonds (payments are deductible) but act like equity (on which dividends are not deductible).  Like debt the chameleon bond promises routine interest payments and have finite maturities for principal repayments but, like dividends, the interest payments can be deferred by the issuing company in times of financial distress.  Principal repayments may also be made by issuing new bonds; the bonds can be rolled over at the discretion of the issuing company.  Congress should stop such nonsense by treating both interest and dividends as a cost of capital and taxing them the same at both the issuing company and investor level.

Regular Religious Worship Correlates with Higher Personal Income

Jonathan Gruber, an economist at MIT (Massachusetts Institute of Technology), has an new paper finding that doubling religious attendance raises one's income by almost 10%. Religious participation is also correlated with lower rates of crime and drug use and higher rates of school attendance.  "Religious Market Structure, Religious Participation and Outcomes: Is Religion Good for You? NER Working Paper 11377 (May 2005).  Gruber offers several possible explanations:  Going to religious worship raises "social capital" (networking); enhances mutual emotional and financial insurance; or provide emotional balance for life's inherent travails.

New York Times Obit Page

Check out today's obituaries in the New York Times.  There are obituaries of Candy Barr, a stripper, and Frank Wilkinson, one of the last two jailed by the House UN-American Activities Committee for refusing to testify. Both life stories are fascinating and well done. The NYT obit page, no longer just for dignitaries and wealthy industrialists, has turned into some good reading.

SEC Charges that Skilling Attempted to Deceive the Agency

The SEC has charged Jeffrey Skilling, ex-Enron CEO, with multiple crimes but a new charge is worth noting -- deception of the SEC in civil depositions.  The SEC had targeted Skilling in a 2001 civil proceeding for insider trading and asked him to explain, on Dec. 6th, his September 2001 trades in Enron stock in a deposition.  Skilling failed to disclose an aborted Sept 6th sale of Enron stock and stated that his sales in Sept. 17 were solely due to Sept. 11th concerns.  The SEC says the Dec. 6th statement was false in light of the Sept. 6th aborted sale.  Skilling's lawyers argue that the government cannot use Skilling's statements in a civil proceeding as evidence in a criminal proceeding when Skilling had not been informed that he was a target of a criminal investigation.  The tension between civil and criminal proceedings in securities violations has always been problematic and a court's decision on this charge may help clarify the interrelationship.   

Securities Lawyers' Need to Keep Info from Lovers

The SEC has brought civil and criminal insider trading charges against a 34 year old New York securities trader, Lee David Edelman, who allegedly bought shares of an acquisition target.  The SEC charges that he acquired the information from his live-in girlfriend, a lawyer at a prominent New York law firm who was working on the acquisition.  The SEC did not charge the ex-girlfriend, who told the SEC that she told Edelman about the deal in confidence and expected him to keep the information confidential.  If the allegations are true, is she technically liable for insider trading as well as a tipper?  It depends on whether one views the "scienter" requirement of Rule 10b-5 to apply to the tip iself (Tipper knew she should not tell) or to the tippee's trading ("Tipper knew the tippee would trade"). Views?