Business Law Prof Blog

Shareholder Power: The Case Study of CA Associates

Anyone interested in evaluating shareholder power in American corporations must study CA Associates.  The company, previously named Computer Associates, has had its executives (The CEO, CFO, and General Counsel) indicted for criminal fraud (they agreed to a Deferred Prosecution Agreement)in accounting manipulations, sued for civil fraud on the same grounds, seen its stock plummet, and is now unable to issue financial reports because of compensation shenanigans (the back-dating of options).  Shareholders want the directors who oversaw the firm during the time of the troubles to be kicked off the board.   The directors best and only defense ("I did not know") is not a defense to the charge that it was their job to know -- they failed as overseers and should be replaced. There are two directors still on the board who were on the board during all the trouble.  They are up for re-election and will probably be re-elected.  A large shareholder submitted a Rule 14a-8 shareholder resolution to have the two directors removed; the SEC staff supported the company's refusal to include the proposal on the company's proxy.  The shareholder has asked the full commission to review the staff no-action letter.  Technical matters aside, it is a case study on how directors, who should be embarrassed and run off the board, are protected by the the current system of shareholder voting.

Goldstein Opinion

A panel of the United States Court of Appeals for the District of Columbia recently decided the Goldstein v. SEC case.  In an opinion by Judge Randolph, the court held that the SEC rules requiring hedge funds to register under the Investment Advisors Act of 1940 were “completely arbitrary.”   The Court vacated the rules. 

The Court was troubled by the SEC’s argument that “client” meant one thing when determining to whom an adviser owed fiduciary duties (to the fund itself) and another when determining whether an investment adviser must register under the act (the investors and the fund are clients).  Moreover, the Court held that the SEC policy arguments for the rule, focusing on the national scope of hedge funds, did not justify registration based on number of clients:

The number of investors in a hedge fund … reveals nothing about the scale or scope of the fund’s activities. It is the volume of assets under management or the extent of indebtedness of a hedge fund or other such financial metrics that determine a fund’s importance to national markets.

SEC Chairman Christopher Cox, in response to the decision, asked the staff to prepare a “set of alternatives for our consideration.”   The SEC could appeal the decision, rewrite its rules to satisfy the Court’s concerns, or seek an amendment to the Investment Advisers Act from Congress.   The new rules or a new amendment may impose more searching regulations than those contained in the voided rules.  If so, the hedge fund industry may view this as a Pyrrhic victory.

I am surprised by the Court’s opinion because it does not accept the SEC argument for a bright-line test for hedge fund regulation.  Even though I do not favor the policy judgments behind the new rule I do not believe them to be “arbitrary.”  The SEC is using a client rule as a surrogate for catching most large hedge funds.  A test dependent on the size of hedge fund assets under management would have substantial measurement problems at the margin and necessarily be arbitrary at the margin as well.  The SEC chose a test that catches most of the funds it wanted to catch and the Court rejected the test.  A better test is possible, the Court noted.  This is, of course, most always the case for any given regulatory rule and this open-ended standard for Court rejection may let the Court be “arbitrary” in what rules it will vacate.  The Court showed very little deference to the SEC here.  It is a signal that the SEC is short on its political capital with the D.C. Circuit perhaps.

Grasso Pay

The article in the Sunday New York Times (June 25, 2006) on Grasso's pay is a great read.  Did NYSE board members understand what they were going to pay him when he his pay plans were approved?  Some board members say yes; others no.  The analogy to the Disney facts is obvious.  What does a compensation committee have to know to approve a pay package?  The Delaware courts say not much.  The attorney general of the State of New York (Sptizer) says "enough to know what it was doing."  I hope the latter view prevails.

The KPMG case

The federal district judge in the KPMG accounting fraud case has all but declared unconstitutional those parts of the Thompson memo.  The Thompson memo is a Justice Department document of guidelines on whether to indict a firm and well as its misbehaving executives.  The documents recommends that prosecutors take a corporation's willingness to pay legal fees of its indicted employees as evidence of lack of cooperation for an indictment of the company itself.  The judge found that this pressure on the firm is unconstitutional, a violation of an executive's the right to a fair trail and the right to an attorney.   I have written elsewhere criticizing the Thompson memo and think it is bad policy.  But unconstitutional??  We are fast developing a culture of protection based on a constitution that is "unfair."  My lay person friends believe that anything unfair is unconstitutional.  The document is some granddaddy protection against all that is unfair.  Opinion like this contribute to the fallacy. 

What to Do About Back Dated Options??

What should a board do once discovering that its executives have been awarded back dated options?  First, figure out who is responsible.  Second, if the executives back dated their own options knowing it was a violation, fire them and revoke the options.  The executives have participated in a dual tax and securities scam.  If the board back dated options to get more compensation to executives, knowing it was a violation, and the executive did not participate, fire the board members, fess up in public filings, pay the tax penalty.  If the executives or the board can honestly claim they thought it was legal based on consultants, fire the consultants, fess up in filings and pay the tax penalty.  Canceling the options is a compensation penalty and should be done  if the executives were complicit in any way or if the board just wants to remove the smell of the practice if the executive were not complicit. 

Supreme Court and Business

The case choices of the Supreme Court reflect the influence of the new Justices who obviously believe that the Court should decided more business related cases.  The Court has taken two antitrust cases and and patent law case, among others, on issues very important to the business community.  This move away from a preoccupation with constitutional law cases is very, very healthy.