Business Law Prof Blog

SEC Loses In Court on the Mutual Fund Rules

Everyone in the securities business has to get a chuckle out of the latest SEC loss in the D.C. Circuit Court in Chamber of Commerce v SEC (3-0!).  The federal appeals court held that the SEC had not complied with procedural rules for adopting valid agency rules when it adopted two very controversial mutual fund regulations -- 75 percent of a mutual fund board must be independent and the chair of the board cannot come from the funds investment adviser.  The Court held that the SEC should have given a better explanation for the cost basis of its rules and should have given groups opposing the rules time to comment on the cost calculations.  Why the chuckle??  The SEC had for over seventy years regulated the technical, procedural side of the securities industry -- from public and private offerings, to securities markets, and brokerage operations.  The agency is a stickler for procedural rules;  taking the position that better procedure means better results.  Time and time again the SEC has held market participants to have violated procedural rules and turned a deaf ear to results based defenses.   Now the agency is getting a dose of its own medicine -- it failed procedural rules even though the agency was convinced the outcome was justified.

We have over-proceduralized market regulations for decades and the SEC is now discovering the sting of excessive over-proceduralization in our administrative procedure rules.

Hedge Funds Change the Minority Shareholder Buyout Game

Academics and the courts have long been very wary of majority shareholder buyouts of minority residual shares (known as "squeeze-outs" or "freeze-outs").  The courts have erected a variety of special tests and some courts, notably Massachusetts, have given minority shareholders special buyout rights.  Hedge funds have seized the opportunity presented by the rules to buy the minority shares in proposed buyouts and, armed with their knowledge of law and emboldened by bargaining toughness and savvy, have been holding out for higher buyout premiums.  The hedge funds assess the type of the acquisition (tender offer or statutory merger), the size of the minority stake, the character of the independent directors, and the state of incorporation (which sets the minority buyout standards).  If the funds guess correctly, they make money, buying shares at the buyout offering price (or higher if demand drives up price), holding out, and selling shares at an increased offering price.  Great business:  Helps minority shareholders; tests court decisions at the margin (do they really help minority shareholders on average?? --i.e. yet another reason not to incorporate in Massachussetts).

My Quote in the Economist Magazine

I was quoted in the Economist Magazine of April 6th on GM's sale of GMAC.  The quote was a tongue- in- cheek response to GM's situation.  As I have noted here, GM is bleeding cash and, unless something is done, will bleed it huge cash reserves until it becomes insolvent in 2007.  In Chapter 11 the company can reorganize and attempt to make itself viable.  The sale of GMAC gives the company more cash and a bigger cash cushion and delays bankruptcy a bit longer.  This is not then a positive.  Unless GM makes radical changes, the sale simply delays the inevitable.  Yet the changes GM needs to make may only be possible in Chapter 11;  GM may not be able to restructure its legal obligations to workers in any other way.  GM needs to cut workers salaries significantly to make automobiles that are price competitive and this does not appear possible outside of Chapter 11. 

This is an awful position - the firm seems locked into a strategy that requires it to burn up all its cash before it can heal itself.   I suggested to the reporter, with tongue-in-cheek irony, that we would be better off if GM could give its extra cash to shareholders (rather than burning through it) and then reorganize in bankruptcy sooner rather than later. He published the quote; some may take it more seriously than I intended.  I recognize that an extraordinary dividend or a share buyback program could be set aside in bankruptcy as a fraudulent conveyance (or preference) if the payment itself makes the firm insolvent (and directors could be personally liable under state corporate codes).   Any extraordinary dividend would have to not cause insolvency (nor cause GM not to be able to pay debts as they become due).  I can see the extraordinary dividend strategy as a possible scenario (and a very risky one at that) only if the dividend were to be coupled with massive cost cutting (layoffs), breaking the causal tie of the dividends to insolvency.

The Thompson Memo

The WSJ reports that a federal district court judge in New York City, Judge Lewis A. Kaplan, questioned the Justice Departments use of the now infamous "Thompson Memo" in criminal prosecutions.  The Memo lays out guidelines for firms that want to avoid criminal indictment.  The guidelines include, among other things, turning over information on employees to prosecutors for prosecution and cutting off support for employees legal defense.  It is questionable policy.  Judge Kaplan ha suggested that it is unconstitutional!  Good grief. So the Sixth Amendment, intended to protect those without means to pay for counsel (requiring government paid lawyers), now protects executive deals with firms to pay for counsel?.  The Judge suggested that the memo violated the Sixth Amendment Right to Counsel;  this is a stretch to put it mildly -- the Constitution does not (can not and should not) redress all that is unfair.  Next we will hear Due Process arguments.  Congress needs to fix this, not the Courts using Constitutional sleight-of-hand.      

Coca-Cola Compensation for Directors

It is front page news today that Coca-Cola will tie directors compensation to earnings growth--less than 8% annual earnings growth, no directors fees.  Sounds good -- too good.  First, this company has some history of earnings manipulation (channel stuffing) and this will put pressure of firm accountants to use all the "gray areas" in the accounting rules to keep earnings up.   Second, the earnings growth should be indexed to the industry.  Coke did not use stock price because of industry-wide influences that can overwhelm company specific management choices.  Yet earnings growth has similar influences (interest rates for example).  The earnings growth needs to be indexed to the industry earnings growth.  Is earnings growth higher or lower than beverage companies earnings growth.  Third, and most important, it is not directors fees we should worry about.  These are peanuts -- it is executive officer salary that matters.  Any compensation program that leaves out the salary of the CEO and CFO, among others is a joke and a public-relations ploy.  If Coke is serious, give us a CEO all-or-nothing salary on earnings.

SOX News

The WSJ reports that the SEC is not likely to exempt small companies from Section 404, as was proposed by an advisory committee six months ago.  The likely outcome is a rule that lightens the 404 burden for smaller companies.  Meanwhile the main beneficiaries of Section 404 -- the auditing firms-- are mounting an effective campaign to keep the rule in place.  They cite data showing that costs for 404 compliance come down 16% after the first year.  Great, the firms already enjoy a 80% or so (and this is a very conservative calculation) total compliance cost increase from when firms began to prepare for the effective date of the rules, in 2003.  Large firms do not care much as long as all competitors pay the same charge and may even come to support the Section as long as smaller firms have a higher audit cost per dollar of revenue (due to dis-economies of small scale) -- the Section creates barriers to entry.  The SEC benefits too of course, as firms must turn to the agency and its partner PCAOP for minute details of instruction on internal compliance procedures.

Lipton's Solution (?)

I anticipate that Martin Lipton and his buddies will attack hedge fund activity by neutralizing their threat to vote their shares.  They will propose state legislation that lengthens the stagger of board elections by increasing terms from 3 years to 5 or 6 years, allows for board elections only once every three to five years (a proposal he has already made), sanctions poison pill plans triggered by hostile proxy contests for more than 2 seats or so, or sanction voting restrictions on stock held less than six months or so.  Can't wait -- these initiatives will fail.   

GM's Way Out??

GM is bleeding cash, $10 billion last year for Pete's sake, and still cannot declare bankruptcy (Chapter 11) to do the radical restructuring necessary to survive as an ongoing company.  Takeovers, the 80s method of workouts outside of Chapter 11, are blocked by state legislation and state courts.  Proxy contests take too long, are too expensive, and have only a very small chance of success.  What to do?   New accounting proposals, not yet in place, would require companies to report their pension deficits.  With the GMAC sale, the new accounting rules would leave GM with a negative shareholders' equity of $43 million (instead of the positive $14.6 billion under existing rules).  Eureka!  Declare a change to the proposed rules, declare bankruptcy, enter Chapter 11, form the creditors committees and fix the company.

GM and Constituency Statutes

Those fans of "constituency statutes" and other theories of board management style (team production) should note GM's problems.  There is a sizable group of academics that favor empowering boards of directors to favor constituencies other than shareholders (employees, suppliers, local citizens) in corporate decision making.  GM overpaid labor, buying peace for managers, at the expense of shareholder profit (and share price) for years.  Now GM's survivability is at stake; employees themselves would be better off it the GM board had been more careful of shareholder profits.  Railroads situation is similar to GM (they have special legislation that protects their unions). Compare GM's (or the railroad's) situation to that of Caterpillar's.  Caterpillar went through some tough strikes to hold the line on labor costs;  Caterpillar is now doing very well and is an international success story. The theory of shareholder primacy, rejected by many academics, is that in 9 cases out of 10, sustained shareholder profits are a surrogate for long-term gains for other constituencies -- when shareholders make money over-time, employees have good, stable jobs.  If we hold boards accountable for profits, all constituencies, over-time, also benefit.  In those rare cases in which interests are at conflict and do diverge, in takeovers for example, shareholder profits should be preferred.  A bidder should not, by law, have to make a payment to workers to buy a company (unless contractually stipulated).