January 07, 2012
Slightly Delayed "Live-Blogging" From the AALS
Over at the Glom, Gordon Smith recounts some of the discussion from the recent Business Associations Section meeting at the AALS Annual Meeting this past Thursday. Like Gordon, I was particularly struck by the remarks of Delaware Chancery Court Vice Chancellor J. Travis Laster on the issue of Say-on-Pay. Here is some of Gordon's summary (you can find his entire post here):
[I]s there room for a Delaware claim on executive compensation in the wake of Say on Pay? Teasing the assembled law professors, Vice Chancellor Laster suggested that the Delaware courts could decide to review pay decisions with a form of enhanced scrutiny (because that standard of review applies to situations involving structural bias), but he rightly observed that such a move would be comparable to Smith v. Van Gorkom in 1985…. The more likely path to a claim is one already being pursued by a number of plaintiffs lawyers, namely, going after a board of directors for waste of the corporate assets…. If you couple such a claim with a bad vote on Say on Pay, you might have something.
One of the other things that struck me from Vice Chancellor Laster's remarks was his statement (according to my notes) that the Delaware judiciary is very aware of the "Zeitgeist." This means that while subjecting compensation decisions to enhanced scrutiny may constitute a "thermonuclear explosion" in corporate law, Delaware may nonetheless get there if the threat of further federalization of corporate law in this area becomes great enough.
For those of you not familiar with Vice Chancellor Laster, here is a short video wherein he mentions that his preferred theory of the corporation is "utilitarian":
January 03, 2012
A Ribstein Legacy: Politics, Scholarship, and the Value of Discourse
Last month, there was something of a squabble with Professors Ribstein, Romano, and Bainbridge on one side and Professor Coffee on the other. The squabble highlighted some differences in views among some of the truly elite business law scholars -- mostly about the value of securities regulation and how Professor Coffee characterized the views of the others -- which I found interesting because I agree with all of them about some significant portion of business law. The squabble had scholarly, as well as political, overtones. A summary of the difference of opinion is here and the conclusion is here and here.
The passing of Larry Ribstein has caused me to reflect on what his scholarship meant to me as a developing business law professor. I agree with most of Ribstein's writing about LLCs and corporate obligations, and this agreement represents an evolution in my way of thinking about entity governance and operations. What is particularly appealing to me about this is that, from his blog posts, I get that sense that Professor Ribstein and I were not necessarily on the same page politically. Nonetheless, even when I disagreed with what seemed to be the motivations for his thinking, I usually thought his analysis was right.
His writing on LLCs and "uncorporations" had a particularly profound impact on how I view business entities because he helped (and perhaps caused) me to think about the value in multiple options among enitities. He explained how the LLCs and corporations are different in their respective histories and how those histories should inform the law's view of each entity. In his book, Rise of the Uncorporation he explains, at page 6:
Uncorporations are characterized by their reliance on contracts. This is an aspect of uncorporations’ partnership heritage, as partnerships are contracts among the owners. . . . In contrast, corporate law is mainly couched in mandatory terms. . . . [T]he corporation’s special regulatory nature emerged from its historical roots. The corporation initially was a vehicle for government enterprises, monopolies, or franchises.
See more of his thoughts on this here. It was, in part, Professor Ribstein's writings that spurred me to write the short piece, LLCs and Corporations: A Fork in the Road in Delaware? (Harvard Business Law Review Online).
As I think about it, through their books, articles, and blogging, Professors Ribstein and Bainbridge have probably had more of an influence on my views of corporations and LLCs than anyone, even though I tend to disagree on any number of political issues. I suspect part of it is that I like to be engaged by people with different views, and I want them to have the chance to change my view. If I'm not questioning my rationale, I'm not learning. Changing my mind doesn't happen that often, but it does happen. In turn, I hope to be given the same opportunity to influence others from time to time.
This is just one more small reason, among many large ones, why Larry Ribstein will be missed.
January 01, 2012
Happy New Year!
If you want to spend a little time looking back at 2011, you might try going over to The Race to the Bottom and checking out Jay Brown's overview of Delaware's worst shareholder decisions for 2011.
December 31, 2011
The "Shell Company" Controversy: Energy Version
Earlier this week, I was quoted in a Reuters story about a large energy company's use of smaller a "shell company" in making leases for a potential shale play in Northern Michigan. (MSNBC picked it up here, with the title: "Oil giant's shell game nets elderly farmers: Promises made, but not kept, and it's all legal."
The article explains:
Legal scholars say the operation serves as an intriguing test case of the use of shell companies.
The tactics "raise moral and ethical questions about how entities can be used," says Joshua Fershee, a contract law professor at the University of North Dakota.
Others, including Chesapeake, defend the need to use shell companies and front companies - contractors with local ties who do business on behalf of a larger corporation. John Lowe, a professor of energy law at Southern Methodist University, calls it "business as usual."
(Side note: I'm really a business and energy law professor, not a contracts professor.) From the quote, it may appear that John Lowe and I disagree, but I don't suspect we do. I stand by my quotes -- I do think the apparent use of a smaller shell company in this case raises some moral and ethical questions, as well as legal ones. But I, too, believe that larger corporations can and should be able to use smaller companies for a variety of ends, including creating local ties and managing the larger entity's risk. Still, there are boundaries.
The MSNBC article title notes that promises weren't kept, but "it's all legal." I'm not sure that's true in this case, but it's true it is legal to use smaller entities to manage risk. That shouldn't be a problem. That doesn't mean it's legal to commit fraud. So, for example, if the large entity created a small entity to take out leases and speculate on the land, it's probably legal. The entity can create a company to try new ventures like any of the rest of us. If, on the other hand (and as an example), the entity created a small LLC, instructed the LLC to draft leases with specific flaws or otherwise use deceptive practices so that the entity would only need to pay if the shale play was viable, that could certainly be a problem.
Furthermore, if the smaller entity was created to act as agent for the large entity, there may be liability for the larger entity as principal. And if the smaller entity were an alter ego of the larger entity, there may be a veil piercing opportunity if the smaller entity doesn't have the funding necessary to cover its debts. (Whether veil piercing is proper here is different than whether it's possible.)
One of the complaints here is that the large entity used a small "local" company to entice landowners to do business with the local entity over other companies. Of course, if it were so important that the landowner work with a local person solely, the landowner could contract for that protection by limiting transferability or adding some other change in control provision. That would reduce the value of the lease, but if it matters that much, ask for it. If you take the local person at his or her word, then you have signed up for the risk that your ability to judge character wasn't that good.
Ultimately, I can't tell whether this is a case of lessors wanting more than they bargained for or if it's a case of a large entity using a subsidiary lessee to speculate without taking on any concomitant risk. Frankly, it sounds like a little of both, but the facts available are limited.
Last July, when Reuters published another of story in a series on the use of shell companies, I said this:
[Another] thing worth mentioning is that corporations and LLCs are not inherently evil. Sure they can be used to help facilitate some bad things, but it doesn't take a corporation or an LLC to do evil. Individuals, sole proprietorships, and partnerships can all be pretty scummy, too. It has to do with the people running them, not an entity form.
I'm all for a little monitoring of bad behavior, but a some self policing can help, too. Among the reasons people claim to want to form a company is to make it look like their operation is bigger or more established. Before doing business with anyone, we all need to do our due diligence. Check financials and get personal guarantees if that's necessary. And if we don't care to check, then caveat emptor is still usually an appropriate rule. And if we do check, and it's a well-played scam, well, it's not the entity that is the problem. It's criminal behavior, that happened because of the criminal, not the corporate code.
I'd add to that that even if it's not criminal behavior, it may be traditional civil fraud, and that creates liability for the perpetrator, too. I am not naive -- I have noticed that corporations and LLCs can do bad things, and because they are often larger and have more resources than individuals, the harm can be broader. But people are not incapable of gathering information. At least some of the complaints about the "evil entity" are really complaints that we can't always get what we want. Unfortunately that's true, but if we get what we bargained for, we don't have a lot of room to complain about the legality of entities, even if we did deal with a scummy person.
December 29, 2011
15% Contingency Fee Award Spurs Discussion
The Wall Street Journal Law Blog discusses the $300 million plaintiffs’ attorneys’ fees awarded by a Delaware court in the Southern Peru Copper Corporation Shareholder Derivative Litigation here. (Our own Josh Fershee previously commented on the merits of this case here.) Stephen Bainbridge noted a few days ago that “there are a lot of folks in Delaware who are happily expecting this decision to encourage plaintiffs to come back to Delaware.” He quotes Jonathan Macey and Geoffrey Miller as explaining that “in Delaware well-intentioned judges can be expected to devise legal rules requiring that Delaware lawyers be consulted when important decisions are to be made. Moreover, if Delaware judges believe that the state judicial system well serves Delaware corporations, they will be more likely to approve rules that stimulate litigation in the Delaware courts.” But the Macey and Miller quote that caught my attention was this one: “The members of the Delaware Supreme Court are drawn predominantly from firms that represent corporations registered in Delaware.” Just for the fun of it I decided to search for this quote in other law reviews on Westlaw. Here’s what I found:
1. The inability of any province to fashion a provincial jurisprudence is also a function of the manner in which judges are appointed. In Delaware, as in other states, judges are state appointees. This ensures that the state can choose judges who will be sympathetic to corporate managers. As Macey & Miller (1986, p. 502) observe, “[t]he members of the Delaware Supreme Court are drawn predominantly from firms that represent corporations registered in Delaware. The bar and the judiciary are tied together through an intricate web of personal and professional contacts.” As a result, Delaware “judges are specialized in resolving corporate law disputes and as a consequence, the state can offer firms access to a system of corporate law rules that is stable, predictable and sophisticated relative to that of other states” (Macey & Miller, 1986, p. 500). Moreover, because judicial appointments are a state matter, the state can decline to renew the appointment of a judge who does not decide cases in a manner suitably sympathetic to corporate concerns. Douglas J. Cumming & Jeffrey G. MacIntosh, The Role of Interjurisdictional Competition in Shaping Canadian Corporate Law, 20 Int'l Rev. L. & Econ. 141, 157 (2000).
2. Although judges obviously are more isolated from interest group influences than legislators, Delaware's justices are likely to reflect the interests of the corporate bar. The most obvious source of sympathy is the judicial selection process. As described earlier, the Delaware bar plays a central role in selecting justices, and it can be expected to recommend individuals who have a natural affinity to the corporate bar. This natural inclination is amply borne out by even a cursory look at who is ordinarily selected to sit on the supreme court. Nearly all of the justices, both currently and as a historical matter, were members of the Delaware bar before donning judicial robes. David A. Skeel, Jr., The Unanimity Norm in Delaware Corporate Law, 83 Va. L. Rev. 127, 158 (1997) (quoting Macey & Miller in accompanying footnote).
Not exactly ringing endorsements of objectivity.
December 28, 2011
"Shareholder Primacy" in Delaware Still Only Matters When Buyers Benefit
Steven Davidoff notes, For Wall Street Deal Makers, Sometimes It Pays to Be Bad. He focuses on J.Crew’s $3 billion buyout management buyout and Del Monte Foods’ $5.3 billion acquisition by KKR, Vestar Capital Partners and Centerview Capital. Davidoff notes that a Delaware court found J Crew management's behavior to be “icky” and another Delaware court heavily criticized the Del Monte deal. Nonetheless, the deals went forward.
Davidoff says that the current state of the law makes it hard to come up with a penalty to to deal with bad behavior. He explains:
[T]he problem is what to do about the penalty. Depriving shareholders of a buyout, even at a bad price, would punish them.
He's right, but if you go back to poison pill cases, see, e.g., the Airgas decision, you can see that Delaware courts are willing to deprive shareholders of a buyout, as long as management wants to keep the deal from shareholders, even for an all-cash deal. As I have noted before, "I can't see a good justification for not presenting an all-cash offer to shareholders once . . . ample time has been given to entice other potential bidders into the game."
Anyway, I share Professor Davidoff's view that we need a good penalty, but I happen to think the big issue is that there is a lack of willingness, not ability. I mean, Delaware courts are really, really good at this corporate governance thing.
Maybe the answer to create a sort of shareholder's business judgment rule for all-cash deals. That is, after adequate time for gathering other offers has passed, we add a blanket rule that all, all-cash deals that offer a premium over the current trading price will be presented to shareholders (along with management's explanantions and recommendations). This would operate like a sort of all-cash Revlon trigger. I can imagine a scenario where shareholders might choose the wrong option in such a case, but I think part of shareholder primacy includes, from time to time, respecting possible shareholder stupidity.
December 24, 2011
Davidoff on "how globalization increasingly allows companies to avoid United States taxes and regulation."
Over at DealBook, Steven Davidoff has posted "The Benefits of Incorporating Abroad in an Age of Globalization." Davidoff uses Michael Kors Holdings as a case study demonstrating how companies are incentized to incorporate abroad in order to take advantage of tax savings, decreased regulatory burdens, and a decreased threat of shareholder litigation. He notes further that this is not an isolated case, as "[p]rivate equity firms have been buying American companies with significant foreign operations and reorganizing them as foreign corporations." To the extent that this creates problems for the U.S., he suggests that "[p]erhaps it is time for the United States to adopt a tax system more in line with the rest of the world." What I found more interesting, however, was his suggestion that "American investors may be investing in Kors and other companies incorporated outside the United States without appreciating that they are not subject to the same United States laws that other publicly traded companies are." This seems to me to be the crux of the debate about whether corporate regulation generally follows a race to the bottom or the top. The greater the likelihood that signifcant portions of the investing community do not properly value the jurisdiction of incorporation, the greater the likelihood that the race is to the bottom rather than the top.
December 24, 2011 in Corporate Governance, Current Affairs, Government and Business, International Business, Investing, Mergers & Acquisitions, Musings, Politics, Securities Markets, Securities Regulation | Permalink | Comments (0)
December 16, 2011
A Note to the SEC: Don't Just Take Some Case and Hope
On Dec. 14, 2011, a reporter for ProPublica, Jesse Eisenger, wrote the following article for New York Times Dealbook: In Hunt for Securities Fraud, a Timid S.E.C. Misses the Big Game. In it, he argues:
Does the Securities and Exchange Commission suffer from trialphobia?
Ever since Judge Jed S. Rakoff rejected the S.E.C.’s settlement with Citigroup over a malignant mortgage securities deal, the agency has been defending its policy to settle securities fraud cases. But the public wants a “Law & Order” moment, and who can blame them?
. . . .
But so far, there’s been no civil trial in a major case directly related to the biggest economic fiasco of our time: the financial crisis.
Two days later, the Dealbook, from authors Azam Ahmed and Ben Protess, provides this: S.E.C. Sues 6 Former Top Fannie and Freddie Executives, which reports that the SEC seems to have answered Mr. Eisenger's call:
The Securities and Exchange Commission has brought civil actions against six former top executives at the mortgage giants Fannie Mae and Freddie Mac, saying that the executives did not adequately disclose their firms’ exposure to risky mortgages in the run-up to the financial crisis.
The case is one of the most significant federal actions taken against top executives at the center of the housing bust and ensuing financial crisis.
Obviously, this case would have been in works long before last Wednesday, so the timing is something of a coincidence, and it's not as though Mr. Eisenger is the first person to question where the SEC is on this. But I sure hope that this case is proceeding because the SEC thinks it's proper to move forward, and not because they think they need to bring a case, any case, forward.
I bristle at the idea that an agency, law enforcement or regulatory, would purse a case simply because "the public wants a 'Law & Order' moment." I know, of course, that many prosecutors seek cases primarily to raise their profile and send a message, but that doesn't mean it's right. I undertand what he's saying, but I don't care for Mr. Eisenger's recommended use of authority. He explains:
To overcome its greatest fear, the S.E.C needs to realize that it can win even if it loses. A trial against a big bank could be helpful regardless of the outcome. It would generate public interest. It would put a face on complex transactions that often are known only by abbreviations or acronyms. Litigation would cost the bank money, too. And it could cast the way Wall Street does business in such an unflattering light that even if the bank won, it might bring about better behavior.
A trial would show boldness. And when the S.E.C. found itself at the negotiating table again, it would feel a new respect.
You don't earn respect by being a bully, by making people jump through hoops, or by making them expend resources just because you can. You may earn fear and you will almost certainly earn disdain, but that's not the same thing.
I agree that the SEC shouldn't seek only cases it can win or settle. In fact, I think a lot of relatively "little guys" are getting forced into SEC fines and settlements right now, not because they necessarily did something wrong, but because they can't afford the fight. The SEC gets to report the settlements, which go down as wins over "corruption and fraud."
And I think there may be value in pursuing some of the big guys for fraud because some of them probably committed fraud. But you need to facts before you go hauling people into court. I'm all for pursuing fraud vigorously, but I'm not willing to let any regulator decide to mess with people's lives just because the public thinks someone needs to pay. Law enforcement and regulation only work if the right people pay for the wrongs they committed. So, SEC, don't just take some case and hope for it. Put together the right case, and then go for it.
December 13, 2011
One More Thought -- Does Anyone Own the Packers?
Professor Bainbridge reasonably asked what I actually thought about whether the Green Bay Packers stock is a security. I said it's not under federal securities law, but that I think it should be. Then I had one other thought -- who really "owns" the Packers? Professor Bainbridge noted in his post Owning the Green Bay Packers, that his first weekend went well. Of course, as he has said, he really is the "proud owner of 1 share of stock in Green Bay Packers, Inc." By his own standards, anyway, the good professor is not actually an owner of the Packers.
Back in March of 2010, Professor Bainbridge let me know: Once more with feeling: Shareholders Don't Own the Corporation. As he explained:
There is no entity or thing capable of being owned. Granted, because the shareholders hold the residual claim on the corporation's assets, their deal with the corporation has certain ownership-like rights. But they have only those rights specified by their contract, as that contract is embodied in state corporate law and the firm's organic documents.
So, to recap, the Packers sale of stock provides neither a security nor ownership of the Packers. So what is it? The stock grants the right to attend an annual meeting and vote on a few things, but provides very few "ownership-like rights." Is it really just an expensive piece of paper? It must be a little more than that, because even though people feel good about a donation to Goodwill and other such groups, they don't frame the receipt. (Maybe some people do, I guess, but I'm assuming not.)
Ultimately, then, it is this simple: Packers "stock" is a contract that provides the right to vote for the members of the Board of Directors, amendments to the Article of Incorporation, certain mergers or sales, and dissolution, at a price of $250 per vote.
With that settled, on to the next issue: With the Delaware Chancery Court having filled Chancellor Chandler's seat, when does Professor Bainbridge join the Packers board, as permitted under the bylaws? Assuming he'd accept such a nomination, consider that campaign launched. Their quarterback is a West Coast guy. Why not add a similarly situated director?
December 12, 2011
A Reason People Hate Corporate Lawyers or Why the Packers Should Be an LLC
On Friday, I asked whether the sale of Green Bay Packers stock should be considered a security. A few people asked whether I really think the Packers stock could be a security. The answer, under Wisconsin law, is almost certainly no, especially given that that Green Bay Packers, Inc., "is organized as a Wisconsin nonprofit stock corporation." And that's probably the case for almost any other state, too, and under federal law.
But just because the outcome is pretty clear, it doesn't mean that there aren't policy implications that are worth thinking about. I think the biggest one is this: lawyers and business people should say what they mean. Mixing marketing and corporate law is not always a good idea. I find it more than a little silly that the cover of the Packers offering documents says:
Green Bay Packers, Inc.
Common Stock Offering Document
COMMON STOCK DOES NOT CONSTITUTE AN INVESTMENT IN “STOCK” IN THE COMMON SENSE OF THE TERM. PURCHASERS SHOULD NOT PURCHASE COMMON STOCK WITH THE PURPOSE OF MAKING A PROFIT.
So, you see, the word stock without quotes is different than stock with quotes. In my view, you shouldn't call something stock if it's not stock, even if you can under securities laws. There's no doubt that the Landreth court, interpreting Forman, said that stock is not a security just because the company said it issued stock:
[I]n Forman we eschewed a "literal" approach that would invoke the [Securities] Acts' coverage simply because the instrument carried the label "stock." Forman does not, however, eliminate the Court's ability to hold that an instrument is covered when its characteristics bear out the label.
Now, before these cases, one could argue that something labeled "stock" is always a security, as per § 2(1) of the 1933 Act:
"The term `security' means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . . investment contract, voting-trust certificate,. . . or, in general, any interest or instrument commonly known as a `security.' " 15 U. S. C. § 77b(1).
In Landreth, the court cited Louis Loss, Fundamentals of Securities Regulation 211-212 (1983), providing the following excerpt:
It is one thing to say that the typical cooperative apartment dweller has bought a home, not a security; or that not every installment purchase `note' is a security; or that a person who charges a restaurant meal by signing his credit card slip is not selling a security even though his signature is an `evidence of indebtedness.' But stock (except for the residential wrinkle) is so quintessentially a security as to foreclose further analysis."
And, in fact, before Landreth, SEC v. C. M. Joiner Leasing Corp., 320 U. S. 344 (1943) indicated that notes or bonds could possibly be deemed securities "by proving [only] the document itself." The Forman court said that interpretation was dictum as to stock, and the Landreth confirmed that was not true for stock (leaving that question as to notes and bonds "until another day"). Thus, the Supreme Court said, we must look to the economic realities to determine whether stock is a security.
Which bring me back to this: If the Packers are really just selling a $250 (plus handling) certificate (suitable for framing), they shouldn't call it stock. And they shouldn't start their offering letter: "Dear Future Owner of the World Champion Green Bay Packers." It should say: "Dear Future Owner of a Certificate saying 'World Champion Green Bay Packers.'"
In my view, the Packers are using the sense of ownership to secure investors and people who have a connection with the team. I think that's fine; I actually rather like the idea. But I don't like the idea that they can use the term stock, the sense of ownership, provide voting rights and the opportunity to attend Annual Meetings, restrict gifting or sales, and then disclaim that what they are selling is a security simply because the primary upside is that past purchases helped "ensure the team survived and remained in Green Bay" and the new purchases will fund an "expansion [that] has been designed to keep the crowd noise in the stadium and maximize our home-field advantage."
So, I admit my argument is largely academic (a luxury I have), but I do think there is value in not allowing people to muddy the waters. Suppose, for the sake of argument, the Packers committed a massive fraud and used the money to invest in Greek debt. The debt tanks, the Packers can't have a stadium upgrade, and the home field advantage begins to fade. The team suffers, and shareholders sue under 10b-5. The court says, nope, you didn't buy a security because you only had voting rights, without ecomomic rights. The court would probably be right under Landreth (notice my continuing, apparently unavoidable, hedge). And it would be reasonable under the actual terms of the offering document, if you read it. But it would still make a bunch of lawyers and judges look like jerks.
To me, this would all be better done as an LLC, with a granting of an owership unit clearly defining the terms. Then it's plainly (or should be) contractual, and it's not stock, and we have very little problem with confusion with traditional stock or other securities. Frankly, isn't that confusion the main reason the Packers are calling it stock? I think so. This is just one more reason we should start respecting and using the LLC for creative entities, and leave the off-the-rack stuff for corporations.
[Update: Professor Bainbridge wanted an answer to the real question of whether Packers stock is a security. My answer is that I don't think a federal court would find this to be a security, especially with the appropriate disclaimers that have been made. But I reserve my right to think they should. In the interest of full disclosure, I am a life-long Lions fan.]
December 11, 2011
Beneish, Marshall & Yang on Collusive Directors
Messod Daniel Beneish, Cassandra D. Marshall, and Jun Yang have posted "Why Do CEOs Survive Corporate Storms? Collusive Directors, Costly Replacement, and Legal Jeopardy" on SSRN. Here is the abstract:
We use an observable action (non-executive directors’ insider trading) and an observable outcome (the market assessment of a board-ratified merger) to infer collusion between a firm’s executive and non-executive directors. We show that CEOs are more likely to be retained when both directors and CEOs sell abnormal amounts of equity before the delinquent accounting is revealed, and when directors ratify one or more value-destroying mergers. We also show that a good track record, higher innate managerial ability, and the absence of a succession plan make replacement more costly. We find retention is less likely when the misreporting is severe and directors fear greater litigation penalties from owners, lenders, and the SEC. Our results are robust to controlling for traditional explanations based on performance, founder status, corporate governance, and CFOs as scapegoats. Overall, our analyses increase our understanding of the retention decision by about a third; they suggest that financial economists consider collusive trading and merger ratification as additional means of assessing the monitoring effectiveness of non-executive directors.
December 08, 2011
De Angelis on the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX
David De Angelis has posted "On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX" on SSRN. Here is the abstract:
I examine the effect of information frictions across corporate hierarchies on internal capital allocation decisions, using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment. SOX requires firms to enhance their internal control procedures in order to improve the reliability of financial reporting across corporate hierarchies. I find that after SOX, the capital allocation decision in conglomerate firms is more sensitive to performance as reported by the business segments. The effects are most pronounced in conglomerates that are prone to information problems within the organization, such as conglomerates with more segments and conglomerates that restated their earnings in the past, and least pronounced in conglomerates that still suffer from material weaknesses in their internal controls after SOX. In addition, I find that conglomerates’ productivity and market value relative to stand-alone firms increase after SOX. My results support the argument that inefficiencies in the capital allocation process are partly due to information frictions across corporate hierarchies. My findings also shed light on the importance of SOX on the efficiency of capital allocation decisions in large firms.
December 07, 2011
Veil Piercing the Rule Even When It's Not
I just stumbled across the United States Supreme Court decision from June of this year: Goodyear Dunlop Tires Operations, S.A. v. Brown, 131 S.Ct. 2846 (2011). The case was essentially a personal jurisdiction case, in which the plaintiffs sought to sue European affiliates of Goodyear in North Carolina courts. The plaintiffs' child was killed in a bus accident in France and European-manufactured tires were allegedly the culprit.
So what does this have to do with business law? Well, a unanimous Supreme Court explained, in denying jurisdiction:
Respondents belatedly assert a “single enterprise” theory, asking us to consolidate petitioners' ties to North Carolina with those of Goodyear USA and other Goodyear entities. See Brief for Respondents 44–50. In effect, respondents would have us pierce Goodyear corporate veils, at least for jurisdictional purposes. See Brilmayer & Paisley, Personal Jurisdiction and Substantive Legal Relations: Corporations, Conspiracies, and Agency, 74 Cal. L.Rev. 1, 14, 29–30 (1986) (merging parent and subsidiary for jurisdictional purposes requires an inquiry “comparable to the corporate law question of piercing the corporate veil”). But see 199 N.C.App., at 64, 681 S.E.2d, at 392 (North Carolina Court of Appeals understood that petitioners are “separate corporate entities ... not directly responsible for the presence in North Carolina of tires that they had manufactured”). Neither below nor in their brief in opposition to the petition for certiorari did respondents urge disregard of petitioners' discrete status as subsidiaries and treatment of all Goodyear entities as a “unitary business,” so that jurisdiction over the parent would draw in the subsidiaries as well. Brief for Respondents 44. Respondents have therefore forfeited this contention, and we do not address it. This Court's Rule 15.2; Granite Rock Co. v. Teamsters, 561 U.S. ––––, ––––, 130 S.Ct. 2847, 2861, 177 L.Ed.2d 567 (2010).
December 06, 2011
From Street Activism to Shareholder Activism
The Occupy protests over the last few months have gotten me thinking about methodology lately. Suppose someone has a criticism, legitimate or not, against a corporation. (At this point, I don’t mean to challenge the rationales behind the protests.) Certainly, there are some practical advantages to drawing up a sign and simply camping. Anyone can do it: it imposes minimal effort costs on the participant and minimal political costs in that two participants can agree to disagree while together contributing to and benefitting from the overall effect of a mass movement (e.g., public visibility, occupying enough physical space to impede infrastructure). And acting in a cohesive group provides morale benefits in the form of camaraderie and social reinforcement. But what is puzzling is not so much the strategies in the arsenal as much as the one strategy palpably missing from it. Why haven’t more protesters turned to shareholder activism?
Take, for example, the use of SEC Rule 14a-8 (shareholder proposals). Though limited to 500 words and one submission per year, these proposals enable relatively small-time investors to campaign in annual meetings and distribute literature to all the stakeholders, on the company’s dime, about issues “significantly related” to a company’s business. And members of the 99% can participate even if they do not have the investment capital of a pension plan or a social-responsibility fund: at the relatively low price of $2,000.
If the purpose of protest is to bring the message to a forum where it will be heard by the decisionmakers, this method potentially generates a lot of bang for one’s buck. If the purpose is to gain bargaining power, a lawsuit after a no-action letter will create more headaches for a company than physical occupation of property. If the purpose is to gain media attention for one’s demands, this method provides an additional means of attracting such attention and specifically using it to apply public relations pressure against a targeted corporation, when coupled with a visible movement.
Granted, requests to circulate shareholder proposals in proxy statements often, in themselves, entail a legal battle, and proposals are rarely successful when put to a vote. Although Rule 14a-8 no longer expressly prohibits social or political proposals, it would take some careful thought to frame the proposal in such a way to convince the SEC that the proposal isn’t about a pet cause and that it has some relevance to the business of the company, without crossing the line into becoming a management function. And some topics would be more suitable as proposal subject matter than others. (For example, resolutions calling for corporate transparency, investigations into the benefits of certain compensation structures, or recommendations on the desirability of certain company policies might have greater success than standalone proposals exhorting the corporation to embrace certain moral principles.) But even if a proposal loses at the lawsuit stage or garners only a small percentage of the votes, the point, for protestors, isn’t necessarily to win, but to acquire a loudspeaker and a bargaining chip. Cf. D.A. Jeremy Telman, Is the Quest for Corporate Responsibility a Wild Goose Chase? The Story of Lovenheim v. Iroquois Brands, Ltd., 44 Akron L. Rev. 479 (2011), http://www.uakron.edu/dotAsset/1849639.pdf. That article gives an interesting account of aftereffects that favor the activist shareholder, even if the proposal never reaches a vote or the vote fails, including the fact that, often, proposals are withdrawn as moot because the company adopts them sans vote. (Another interesting example of well-organized shareholder activism: http://www.csjsl.org/news/nuns-who-wont-stop-nudging-shareholder-activism.php.)
To be clear, I am not saying that shareholder meetings are hotbeds of democratic process and dialogue. Most shareholders are passive, most professionally managed funds won’t poll their constituents about their preferences, and most institutional investors have a fiduciary duty to their members to focus narrowly on profit maximization, even if incidentally a majority of their members, if asked, would rather not invest in certain weapon production or oil exploration in a politically unstable country. But at least some differences of opinion between management and an activist investor may come from information asymmetry: some suggestions are desirable to both, but the management does not know to pursue it until someone speaks up. Or, even if the management is only thinking of cold hard profit, the undesirability of a highly publicized campaign airing out the company’s dirty laundry may persuade it to make concessions and to correctly value the reputational risk of not compromising with some of the more reasonable, socially favored demands.
And though a proposal loses, it may confer other benefits too. For example, if uniform demands are made to several major companies in an industry regarding executive compensation, it may create a norm (if enough companies pledge to meet the demands) or articulate a standard (even if the demands are not met). Just as marketers use product differentiation to educate consumers about the differences between Company A and B, communicating expectations has inherent value in creating a tangible point of differentiation. (For example, I might not know to buy a car with a certain airbag configuration as opposed to another, but if someone simplifies the analysis and tells me that expensive Car A meets 2012 safety standards while cheap Car B does not, I will buy Car A over B.) Reputational risk increases when norms are clearly communicated.
Certainly, such a world would come with costs. A well-executed campaign and lawsuit would require a company to respond by redirecting profits into counterattacking, and critics may observe that a relatively small but active stakeholder may exercise undue influence over a company, at the expense of the passive majority of stakeholders that have no agenda other than profit. It’s possible that an ill-advised but popular idea might pressure a board into following a bad course of action. Decisionmakers will still have to weigh the costs, benefits, and risks of alternatives, even though a successful campaign may cause it to rethink the weight it gives to principles it undervalued before, or the company’s long-term relationships with employees, consumers, and communities. A protestor, similarly, may have to come to terms with the fact that many investors, even those not part of the 1%, do not share his views. But protestor participation as shareholders may create a better forum for dialogue between the two sides.
And there are obstacles. The average protestor knows more about political activism than shareholder activism, whether navigating Rule 14a-8 or engaging a proxy services firm. And some protestors may find participation in the capital market, itself, distasteful. (After all, one is contributing to the demand for a particular company’s stock, not because the company is worthy of approval, but simply because the company is influential.) In order to have any impact, this brand of activism may require some like-minded protestors to agree on certain modest priorities, to pool resources, and to coordinate closely with a larger campaign designed to amplify the private dialogue between shareholder and management into a public one.
But whether because of distrust in the market system itself or lack of leadership, expertise, and consensus, it does not appear that protestors are supplementing their methods with any serious attempts at shareholder activism. Using the power of numbers, Occupy protestors have garnered media attention, sparked public dialogue, and even shut down facilities. But, despite symbolically occupying ground near financial institutions and centers of commerce, there does not appear to be much dialogue with (or pressure against) the perceived adversary---the corporations themselves, and the people who run or own them.
December 04, 2011
Campbell on Normative Justifications for Lax (or No) Corporate Fiduciary Duties
Rutheford B. Campbell Jr. has posted "Normative Justifications for Lax (or No) Corporate Fiduciary Duties: A Tale of Problematic Principles, Imagined Facts and Inefficient Outcomes" on SSRN. Here is the abstract:
Corporate fiduciary duty standards are at an all time low.
Normative justifications offered to support lax corporate fiduciary duty standards, however, are weak. The justifications fail adequately to provide a persuasive reason for abandoning the economic principle widely applied in society, which is to hold actors accountable for the economic loss caused by their actions. Such accountability is thought to provide an incentive for efficient conduct.
This paper offers a critical analysis of two arguments for allowing corporate managers to act without accountability for the full economic loss caused by their mismanagement. The two arguments have been largely unchallenged and today garner broad support from influential quarters.
One argument is that corporate managers should not be accountable for a lack of due care in their decisions, and the justification for this position is a claim that eliminating the duty of care obligation provides an incentive for managers to take value creating risks on behalf of the company and its shareholders. The second argument is that corporate managers should be free to allocate and re-allocate unlimited amounts of corporate wealth among various corporate stakeholders, and this position is justified by a claim that such a rule provides an incentive for the investment of efficient levels of firm specific capital by the corporate stakeholders who provide monetary and human capital to corporations.
The normative justifications offered in support of these arguments depend on multiple, essential factual assumptions that not only are unproven empirically but also are counterintuitive and seem to get only more factually improbable when unpacked and analyzed closely. In short, these factual assumptions – which heretofore appear largely to have been accepted without question or analysis – amount to a thin reed and do not meet the burden that should be required of those who propose abandoning or broadly limiting corporate managerial accountability.
A strong version of corporate fiduciary duties provides an economic incentive for efficient and fair outcomes.
December 01, 2011
Stanford Law Review Online: Summe on Misconceptions About Lehman Brothers’ Bankruptcy
Over at the Stanford Law Review Online, Kimberly Summe has posted "Misconceptions About Lehman Brothers’ Bankruptcy and the Role Derivatives Played." Here is an excerpt, but the entire piece is well worth a read:
Misconception #1: Derivatives Caused Lehman Brothers’ Failure ….
At the time of its bankruptcy, Lehman Brothers had an estimated $35 trillion notional derivatives portfolio. The 2,209 page autopsy report prepared by Lehman Brothers’ bankruptcy examiner, Anton Valukas, never mentions derivatives as a cause of the bank’s failure. Rather, poor management choices and a sharp lack of liquidity drove the narrative of Lehman Brothers’ bankruptcy…..
Misconception #2: Regulators Lacked Information About Lehman Brothers’ Financial Condition
The Valukas report was explicit that regulatory agencies sat on mountains of data but took no action to regulate Lehman Brothers’ conduct…..
Misconception #3: Derivatives Caused the Destruction of $75 Billion in Value ….
The allegation that derivatives destroyed value is flatly at odds with the fact that derivatives were the biggest contributor to boosting recoveries for Lehman’s creditors....
Misconception #4: Insufficient Collateralization
Policymakers focused on collateralization as a derivatives risk mitigation technique. Collateralization of derivatives, however, has existed for twenty years….
Misconception #5: The Bankruptcy Code Is Not Optimal for Systemically Important Bankruptcies ….
[U]nder the current settlement framework, Lehman Brothers’ bankruptcy will be resolved in just over three years—a remarkable timeframe given that Enron’s resolution took a decade.
Policymakers also focused on the wrong entities for failure. Banks, the most likely candidates for application of Dodd-Frank’s orderly resolution authority, have in fact been the least likely to experience failures due to derivatives losses, in part because of their efforts to hedge exposures. The largest derivatives failures to date involved non-bank entities such as Orange County, the hedge fund Long-Term Capital Management, and AIG Financial Products—entities with fewer risk management and legal resources than banks and which are less likely to hedge exposure. These types of entities are not covered by Dodd-Frank.
An alternative vision for policymakers in the aftermath of Lehman Brothers’ bankruptcy would have involved greater consideration of how liquidity can become constrained so quickly, as in the commercial paper and repo markets, and an effort to mandate the type and amount of collateral provided in these asset classes. In addition, a clarion call mentality among regulators with respect to critical issues such as the size and makeup of a bank’s liquidity pool and an insistence on adherence to banks’ self-established risk tolerances should be actionable. Instead, policymakers overlooked some of the principal causes of Lehman Brothers’ bankruptcy….
November 27, 2011
Occupy Climate Change
Democracy Now recently published transcribed portions of "Occupy Everywhere," a panel hosted by The Nation magazine, "On the New Politics and Possibilities of the Movement Against Corporate Power" (here). Naomi Klein was quoted as drawing a connection between the movement and the climate change debate, saying the following:
[T]here has been an ecological consciousness woven into these occupations from the start…. So, what I find exciting is the idea that the solutions to the ecological crisis can be the solutions to the economic crisis, and that we stop seeing these as two problems to be pitted against each other by savvy politicians, but that we see them as a ... single crisis, born of a single root, which is unrestrained corporate greed that can never have enough, and that ... trashes people and that trashes the planet, and that would shatter the bedrock of the continent to get out .. the last drops of fuel and natural gas. It’s the same mentality that would shatter the bedrock of societies to maximize profits. And that’s what’s being protested.... [T]he reason why the right is denying climate change now in record numbers— … 80 percent….. [is] because they have looked at what science demands, they’ve looked at the level of emissions cuts that science demands, 80 percent or more by 2050, and they have said, "You can’t do that within our current economic model. This is a socialist plot." [T]heir entire ideology, which is laissez-faire government, attacks on the public sphere, privatization, cuts to social spending, all of that, none of it can survive actually reckoning with the climate science, because once your reckon with the climate science, you obviously have to do something. You have to intervene strongly in the economy.
For more on this you can read her article "Capitalism vs. the Climate."
November 23, 2011
Jordan on Business Roundtable v. SEC
My colleague Bill Jordan has written a review of the Business Roundtable v. SEC decision (striking down the SEC's proxy access rule) for his "News from the Circuits" column in the forthcoming 37 Administrative and Regulatory Law News 1. Here's an excerpt:
The court criticized the agency’s rejection of studies favoring the management position in favor of “two relatively unpersuasive studies” purportedly showing the value of the inclusion of dissident directors on corporate boards.
The court’s dismissive treatment of the SEC’s response to these studies contrasts sharply with the longstanding principle of judicial, deference to agency assessment of complex technical and scientific studies.... Note that the court considered itself qualified to determine that the studies relied upon by the SEC were “relatively unpersuasive.” This is not the language of arbitrary and capricious review or even of hard look review. This is the language of substantive judgment, even political judgment.
The contrast is particularly striking because this case essentially involved judgments about the value of democracy. In assessing electoral democracy, surely we assume that elections improve outcomes because they hold politicians accountable for their actions. It seems reasonable for the SEC to incorporate this fundamental principle of democratic institutions into the arena of shareholder democracy. At least a court should review such agency judgments – made by the politically accountable electoral branch of government rather than the unaccountable judiciary – with considerable deference. The D.C. Circuit’s review in this case was precisely the opposite. On one particular issue, the court characterized the agency’s explanation as “utterly mindless.”
It is difficult to determine the long-term significance of this decision. It suggests, among other things, that the D.C. Circuit (at least these three judges) consider themselves well qualified to second-guess agency decisions about issues of corporate structure and costs even if they should defer to agency decisions about scientific and technical issues.
November 19, 2011
The question that won't go away: Are boards simply not up to the task?
It often strikes me as somewhat of an emperor-has-no-clothes moment when I explain to my students that, in this era of too-big-to-fail, we continue to entrust oversight of institutions that have the potential to cripple the entire global economic system to folks who are doing so on very much of a part-time basis, and with some minor distractions to boot (like running their own TBTF enterprise as CEO). I was reminded of this when I read Steven Davidoff's post, A Board Complicit in MF Global’s Bets, and Its Demise. After pointing out that the failure of oversight in this case was not due to lack of expertise or knowledge, Davidoff suggests that perhaps "boards are inherently unable to do the job we want of them: to oversee the company and counteract the influence of its chief executive." As a possible solution, Davidoff suggests that "[i]f the board members were to be penalized for their failures through forfeiture of their own compensation, perhaps directors would [be more] focused on creating a stronger risk management culture." I have my doubts that we could ever implement any such system that wouldn't be left as anything other than a shell after Delaware got done with it. Perhaps the answer lies in part in doing more of what some have suggested we do in the area of Securities Regulation--that is, stop pretending we have more oversight than we actually do and let the capital market discounting begin.
New Report on the S&P 500's Corporate Governance of Political Expenditures
Back in August, ten law professors, as the "Committee on Disclosure of Corporate Political Spending," submitted a petition to the SEC asking “that the Commission develop rules to require public companies to disclose to shareholders the use of corporate resources for political activities.”
The group includes Lucian Bebchuk, Bernard Black, John Coffee Jr., James Cox, Jeffrey Gordon, Ronald Gilson, Henry Hansmann, Robert Jackson Jr., Donald Langevoort, and Hillary Sale. The petition explains: “We differ in our views on the extent to which corporate political spending is beneficial for, or detrimental to, shareholder interests. We all share, however, the view that information about corporate spending on politics is important to shareholders—and that the Commission’s rules should require this information to be disclosed.”
I’ve been following with interest the comments to this petition. They’ve included statements from scholars like Ciara Torres-Spelliscy who has written extensively about corporate political spending, and this week the IRRC Institute has submitted a report on the S&P 500's corporate governance of political expenditures. In its submission cover letter, the IRRC Institute explains: “The report is the first to examine the governance policies of the full S&P 500; the first to report on spending of the full S&P 500; and the first to be part of a benchmarking time series, enabling trends to be examined robustly.”
Earlier this month, I posted about a recent report on the governance practices of the S&P 100, which the Center for Political Accountability and Wharton’s Zicklin Center for Business Ethics released.
I’m still digesting the new IRRC Institute report and may post more soon, but note for those interested in this area that it is well worth reading as it takes a broad and detailed approach, including information on topics such as governance about lobbying and whether companies provide public justifications for why they spend money on politics.
A few tidbits from the fascinating report:
On companies with “no spending” policies: “The overall number of companies that assert they do not spend money in politics has grown to 57, up from 40 a year ago. But a comparison of spending records and policy prohibitions shows that only 23 companies with ‘no spending’ policies actually did not give any money to political committees, parties or candidates in 2010 (though they may still lobby). Only 17 of these firms avoided all forms of political spending, including lobbying. (Another 57 companies have no policies about spending but also do not seem to spend.)”
On transparency: “Voluntary company disclosure of political spending remains limited and only 20 percent of S&P 500 companies report on how they spent shareowners’ money. Two‐thirds of the companies that appear to spend from their treasuries do not report to investors on this spending. The least transparent are Telecommunications and Financials firms; by contrast over 40 percent of Health Care companies explain where the money goes.”
On independent expenditures: “There has been a significant increase in the number of companies that discuss independent expenditures, which following Citizens United are allowed at the federal level for the first time in 100 years. Comparing companies in the index in both years (468 firms) shows that 19 more companies now say they will not fund campaign advertisements for or against candidates, generally will not do so, or are reviewing their policies—up from 58 last year. But only five companies now acknowledge in their policies that they make independent expenditures, even though careful scrutiny of voluntary spending reports adds a few firms to this tally.”
On the increasing adoption of indirect spending policies: “The proportion of companies that have adopted policies on indirect political spending through their trade associations has grown from 14 percent in 2010 to 24 percent. Half of the 100 biggest companies now disclose their policies on indirect spending through trade groups and other politically active non‐profit groups, but this commitment evaporates at smaller companies.”
On big companies spending big: “The top two revenue quintile companies were responsible for the vast majority of both federal lobbying and treasury contributions to national political committees and state political entities, with $915 million (93 percent) of the S&P 500’s total.”
On board oversight: “The 151 companies with board oversight of their spending disburse on average 30 percent more than their peers that do not have such oversight, when the latter comparison is controlled for revenue size. This may give some comfort to investors and others concerned about accountability and transparency, but not to those who think that corporate governance could be used as a lever to reduce spending.”
The report is also terrifically direct about information that is unknown, such as how much companies give indirectly through trade associations and other non-profit groups that spend in elections and on lobbying.