Business Law Prof Blog

France

When I attempt to teach my students "Law for Business Associations", which is applied capitalism, I find that I have to explain what capitalism is and what it is not.  Part of my schtik is to mention that France has 12% unemployment; 23% unemployment in youth 18-14; and 55% unemployment in minority youth.  Ours is 5%; 12%; 25% (??) and we would riot -- be in the streets-- if we had France's numbers.   Have to change the schtik.

After the Shorts

I rarely agree with Joe Nocera of the New York Times, but today's column on "Selling Short the Virtues of Short-Sellers" is one I could have written.  Indeed, I am working on an article on the topic.  His thesis is that market participants, who are overwhelming long in stocks, dislike short sellers and that the press and the SEC seem to be piling on. (See the "60 Minutes" show on Gradient Analytics/Biovail or the SEC prosecution on Overstock.com). The impact is that short sellers do not talk to the press at all any more for fear of being sued.  Let's be clear:  A short seller cannot spread false negative rumors to cash in on a short position but a short seller, like anyone else, can express validly held opinions (held in good faith) and marshal actual facts on a company's negative outlook.  Yet if  short-seller does talk to the press there is a risk of litigation from disgruntled CEOs and the SEC if the opinions are not in perfect accord with how the future bears out.  So the incentive is to take a short position and not talk, adding to the pro-long bias already in the stock market.  The muzzling of short sellers, as Nocera points out, hurts the efficiency of the pricing of the markets.  It also contributes to bubbles -- the market runs up longer than it should -- pushed by CEOs and other investors with stakes in long positions -- and crashes only when the negative become painfully inevitable.  So we have sustained run-ups followed by cliffs and precipitous declines in stock prices.

Martin Lipton: Champion?

The August 2005 issue of the Business Lawyer, the American Bar Association, Section of Business Law publication, contained an article by Martin Lipton, of Wachtell, Lipton, Rosen & Katz, entitled “Twenty-Five Years after Takeover Bids in the Target’s Boardroom:  Old Battles, New Attacks and the Continuing War.” 

It was a self-congratulatory piece but worth attention nonetheless for its effort to set the stage for future policy initiatives from the board-dominance camp.  Martin Lipton is soon to meet his Waterloo.

In the opening of the piece, Lipton declares victory over hostile tender offers.  State anti-takeover legislation and state court sanction of poison pill plans, the most potent of which Lipton invented, gave target boards control over tender offers.  Hostile tender offers, tender offers that can close in the fact of target board disapproval, are dead.  Tender offers may still start hostile must close friendly; a hostile offer is now a mere bargaining tactic to convince the target board to assent.

“That battle was won. But there is little rest for the battle-weary…new, and perhaps more dangerous, battles await us”, laments Lipton.  At stake, he exhorts, is “American enterprise…the systematic risk-taker and risk-sharer of our economy -- the primary means through which wealth and prosperity are generated…”  He concludes with a call to arms: “We must do all we can to ensure that the train does not fly off the tracks.”  Whew.

What is this new awful threat?  Shareholders exercise of their voting rights. 

To understand the claim, we need some history.  In the 80s, shareholders in publicly traded corporations had, at minimum, two rights – the right to sell their shares and the right to vote their shares.  When hostile tender offers threatened incumbent managers, shareholders lost the right to sell their shares absent target board approval.  This loss of power to alienate shares came in most cases without a shareholder ratifying vote.

Courts that sanctioned the loss accepted Lipton’s claim that boards run corporations but with a reassuring caveat – shareholders could always vote out the board.  Lipton and his clients did not worry much because insurgent proxy contests were, at the time, expensive and very hard to win.   

But times have changed.  The Internet, a steady loosening of Securities and Exchange Commission rules, and coordinated hedge fund activity now mean that proxy contests are easier to wage and easier to win.  With the Internet, for example, an insurgent may eventually be able to file and distribute proxy materials and even collect votes on line.  Indeed, hedge funds that merely threaten proxy contests often have their requests for corporate action respected by sitting boards. 

Moreover, shareholders have successfully lobbied corporations for bylaw changes that affect board elections and structure.  The most popular shareholder resolution is a simple request that a corporation not seat a director who does not get a majority vote of the shareholders voting. It is hardly a radical request.  The shareholder proposals have Lipton seeing red (“dangerous…over-engineering”).   

So now Lipton must attack the shareholder voting franchise in addition to the shareholder right to sell her stock.  And so he does.  Lipton declares that “special interest ‘gadflies’…[shareholders will] seek to conquer the corporate boardroom with their personalized agendas… without consideration, perspective or even interest in the long-term interest of the corporation and its shareholders as a whole.”

In other words, we are going to see an attack on proxy contests and shareholder resolutions by incumbent management (“main street”) and their lawyers.  They will attempt to roll back the clock to the days when proxy contests were expensive and difficult.  Several techniques will be tried and state courts, state legislatures and the Securities and Exchange Commission will be lobbying targets.

     The arguments in favor of restricting shareholder voting will take one or both of two forms.  First, some shareholders are better than others.  The fast money hedge fund types are inferior to those who hold shares for the “long-run.” Second, shareholders are only one constituency of several in a corporation (others are employees, customers, local communities) and the board should consider all constituencies when it makes a decision.

The first argument has to take the position that shareholders who vote a majority of the shares should be disregarded.  Hedge funds only win, like anyone else, with a majority.  The second argument sees the corporate board as a quasi-government entity with various constituencies.  The problem is that at present only shareholders vote; the other constituencies do not.  Pushed down its logical path the argument supports neutralizing the existing voting structure that favors shareholders -- either all  constituencies receive the right to vote in board elections or no-one votes at all and the board picks its own successors (the not-for-profit model).

Neither of these arguments is going to fly. Lipton, in attacking the shareholder voting franchise is on the road to his Waterloo.  He sold out to shareholder democracy to beat tender offers and the chickens are coming home to roost.
 
The simple truth is that investors should be able to choose where they put their money and folks soliciting their money should be able to offer various alternative business structures to attract it.  Government rules (be they corporate codes, securities acts and rules or tax laws) that favor unalterably one business model over others and limit investor choice should be minimized.      

Data on Mutual Fund Voting

The WSJ today, in a nice article by Jennifer Levitz, "Do Mutual Funds Back CEO Pay?", reported on the voting patterns of mutual funds on shareholder resolutions dealing with executive compensation issues.  The information not surprising -- mutual funds back executive pay proposals over shareholder limitation proposals -- but the fact that we have it is.  The SEC new rules on transparency in mutual fund voting are paying dividends.  We will enjoy much more of this information in the future.

Merilly Lynch's Legal Woes

You have got to wonder about how Merrill Lynch got into this legal box.  Merill Lynch paid $13.5 million in March of 2005 to state regulators for "failure to supervise" three brokers who participated in the after-market, mutual fund trading scandal.  Then Merrill gets hit for $15 million in a suit by the brokers for "defamation."  Good grief. 

KERPS in Bankrutpcy

Last year Congress revised federal bankruptcy law.  One of the targets was excessive key employee retention plans (KERPS).  CEOs who had driven companies into bankruptcy demanded and received huge pay packages inside bankruptcy so the would not leave.  The new act allows KERPS only if an executive has a competitive job offer elsewhere.  But there is an exception for "performance" incentives.  Performance incentives are regulated by judges. But judges have an incentive to give the high pay packages to CEOs and to their attorneys so they will win in the forum shopping contest for courts.  So crazy large performance packages are routinely advocated in bankruptcy proceedings under the new legislation.  [$1million for selling assets successfully in the Nobex Corp. bankruptcy, for example.]  Congress did not stop forum shopping in the legislation.  It is further evidence that the excessive executive pay problem is very difficult to regulate.   

Attack on the Shorts

The press has been preoccupied with the SEC subpoenas to journalists on the agency's investigation of Gradient Analytics but the real story is the attack on shorts.  Gradient is alleged to have participated in a "bear raid" on Overstock.com, an online discount retailer.  The CEO of Overstock has alleged that hedge funds shorted the stock and then pay analysts in the news media to published negative news about the company to drive the company's stock price down.  If true it is blatantly illegal.  The problem, however, is that these allegations against short traders are all to familiar by CEO's smarting under stock price declines (that they could not control with accounting massaging).  This prosecution is another bit of evidence that the SEC is suspicious of hedge-fund short-side activity.  SEC hostility to shorts seems over-cooked.