Business Law Prof Blog

GE Starts its Bust Up

GE, a company that should go through a classic series of spin-offs to focus on its core business, has started the process of divesting some of its units.  The problem? It is divesting its appliance unit, its best known consumer brand.  Many, many shareholders associate GE with appliances, even though the unit is a small part of its overall business.  This could get interesting folks.

Exxon Not Well Managed?

Exxon, a company that had over 12 billion dollars in profits last year (perhaps the highest in real dollars in modern history for any private company), raising howls of protest from Congress and the left, is apparently not well managed.  By the way, Exxon paid 30 billion in federal taxes, more that the aggregate paid by close to forty percent of the country's entire population.  Shareholders are sponsoring resolutions to separate the positions of chairman and chief executive officer (CEO) and to give them a vote on executive compensation.  Apparently the company is --- not making enough in profits?? Who'd a thought it.

Shell and BP "Retention Bonuses"

Shell and BP roiled their investors by announcing plans to pay huge, one-time ("one-off") "retention bonuses" to senior executives.  They make no sense.  A "one-off" retention bonus, once made, will not retain anybody once the bonus is paid.  The bonus, to work, has to be paid over time and conditioned on someone staying over time.  The Shell bonus is conditioned on staying until 2011, for example, but needs to be paid over time not "up-front."  Even in a proper form (in pieces over time), the bonuses should be tied to performance and not unconditional once time in office is clocked in.  They are an invitation to grant boondoggles.     

"Say on Pay" a Bust?

Pundits have spent years, years, trying to get a shareholder vote on executive pay packages.  Be careful what you wish for.  First, shareholders have voted for some time on parts of executive pay packages (most option programs) and overwhelmingly supported them.  Second, a no vote on a complex pay package carries much noise -- it is on performance, the details of the package?  Third, as is in evidence in the Aflac vote on Monday in which 93 percent of the shareholders voted to ratify a $12 million pay package, shareholder routinely will vote yes.  Yes votes make shareholder derivative suits harder to win.

The Fed

New evidence suggests that the substantial drops in interest rates by the Federal Reserve have 1) not aided substantially the stock or debt markets and 2) have enhanced fears of inflation.  The Fed can have four interrelated goals:  help the securities markets, control inflation, keep unemployment rates low, or boast gross domestic product.  The first, third and fourth have substantial political overtones, the second-- controlling inflation, does not.  Our Fed, seemingly heavily influenced by savage criticism from the financial sector (who have called for Bernanke's head) and by a pending national election, appears too focused on the securities markets.  The European Central Bank, isolated from State political influences by top level of multiple state administration, has shown much less sensitivity to political trade winds and is focused more on controlling inflation.  Have we taught the financial markets that over-the-top criticism of the Fed will have an impact on Fed actions?  If so, we are in for some tough times. 

Stoneridge v Scientific Atlanta Decided

The Supreme Court, very predictably to anyone who read the arguments, decided 5-3 in favor of the defendants in Stoneridge.  Justice Kennedy, the author of the earlier Central Bank of Denver opinion, wrote the majority opinion affirming the logical extension of the earlier opinion.  Pity.  The big winners are lawyers and investment bankers.  The largest of our financial frauds are now so complex that they must involve lawyers who write and file the paper and investment bankers who fund and underwrite the deals.  These professionals, if they participate with intent but do not attach their names to any of the fraudulent statements known to the public markets are free from liability in private suits.  The SEC can still sue them and seek substantial civil penalties but the SEC has traditionally focused on the CEOs and CFOs who are the primary violators.  There is an unimportant sense in which lawyers are losers however.  It is less likely that they will have a BarChris style opinion to hand out to young associates and clients as a defense to the pressures from clients to go along with clients' questionable activities.  The pressure to generate billable hours plus the strategy of documented plausible denial ("I only filed X based on assurances and did not know of the fraud") and the full plate of the SEC enforcement office may mean that lawyers will continue to be too willing to not ask questions when a lucrative fee is available. The claim that such an action would generate more "strike suits" has some merit but it is limited given the need to pled specifically and prove scienter, which would be signficantly harder in aiding and abetting cases than it is now in primary violator cases.

Smart People Seeking Dumb Money

There was a great headline in the NYT "Smart People Seeking Dumb Money" referring to the IPO's of private equity groups in the past year (all have lost money since their initial day price run-ups).  The headline is broader than the story.  This is an old, old Wall Street game.  It has some very familiar and repeatable themes; only the names of the securities sold change.  First, smart people sell something novel, new trendy -- with a promise of high returns-- and take fees [Goldman underwriting SIVs].  The fees go into solid investments (treasuries).  The recent new, new thing was CDOs and/or ABSs.  Second, some smart people get caught in the returns and themselves take equity, hoping to sell to greater fools (the greater fool theory) [Merrill Lynch; not Goldman].  If they get out fast enough they win; if they get in too late or hold too long they lose.  And third, the really smart people sell short the very thing they are pushing [Goldman].  The whole thing explodes and those who still hold the equity in the security lose big.  Government investigates, castigates and over-regulates.  It is a very old game. For our government, perched on a capitalist economy,  the issue has always been how much to protect the dumb money.  Too much protection and we get too little financial risk-taking and innovation.  Too little protection and we get too little investment capital.  The tendency of government is to overprotect -- with each crisis comes more federalism, more promises to protect, more efforts to appear concerned and empathetic.  Only the threat of new competitive economies elsewhere keeps government honest and even then we often get unhelpful subsidies and other forms of protection rather than structural reform than makes us more competitive.  What always amazes me is that we find enough common sense in this repetitive process to stay competitive at all.

Blankfein Pockets $69 Million for the Year

The CEO of Goldman Sachs made $69 million in salary for the year.  His base salary was $600,000 (plus a charitable gift of 200,000) and the rest was in bonuses tied to the performance of Goldman this year.  Cayne, the CEO of Bear Stearns, had a base of $250,000; the disastrous year for Bear Stearns meant he had few bonuses.   At least for investment banks, the incentive system put in by the tax code (limiting base salary deductions to $1m thereby encouraging salary in excess of the base to be incentive driven) seems to have worked.

When is There A Fiduciary Duty to Liquidate? Chrysler?

Nardelli, the new chief of Chrysler, is reported to have been asked "Are we bankrupt?"  His answer -- "Technically no, operationally yes. The only thing that keeps us from going into bankruptcy is the $10 billion our investors entrusted us with."  In other words, the company may well run on its cash reserves until there are none left and then go into bankruptcy.  Chrysler is privately held so I am not worried about investor input.  But suppose it was in public hands.  When should the CEO voluntarily initiate liquidation of the company (ratified by the shareholders) in the best interest of the shareholders?  Or better, when could shareholders sue the CEO for not initiating a vote on liquidation and win?  Never, the CEO is protected by the Business Judgment Rule that protects all but grossly negligent management decisions.  But wait, the Unocal test establishes a threshold for the business judgment rule in takeover defenses because of inherent conflicts of loyalties and perhaps we need a similar threshold for liquidation decisions, which put management positions on the line.  In other words, the inherent conflict in non-liquidation decisions should make them easier to attack in shareholder suits -- they must be "reasonable" give operational losses that survive two years, for example.  In other words, the prospect of future operational gains must be real and not fanciful.  Would change things quite a bit.   

Outside Attorney Charged in Refco Collapse

Federal prosecutors in the Southern District of New York had charged the outside lawyer for Refco, a partner with the law firm of Mayer Brown LLP, will aiding Refco financial fraud.  He is charged with documenting a series of fraudulent "round trip" loans between related entities designed to keep debt off Refco's books.  Lawyers are rarely charged in financial fraud cases and charges against outside lawyers are even rarer still.  Yet anyone in business well knows that most modern financial fraud require the preparation and use of fraudulent legal documents that are almost always prepared by always prepared by lawyers.  I welcome these prosecutions both as a warning to lawyers and as useful to lawyers in refusing requests from clients that want them to prepare such documents.  Reputational and professional accountability has apparently not been enough.

CFIUS Outdate: Sovereign Wealth Funds

The new Foreign Investment and National Security Act of 2007 is already out of date and the regulations under the act have yet to be written.  The threat posed by sovereign wealth funds is not just to "critical infrastructure" or "critical technologies" it is also to our financial markets.  1) If sovereign wealth funds turn from focusing on investor returns to using their funds as a mechanism for implementing a foreign country's foreign policy decisions, then our financial markets will be affected adversely.  2) The injection of reports to individual members of Congress in which districts American companies are located can only be fuel for protectionist behavior by those members.  We need and want foreign capital if the sovereign wealth funds are acting as investors and individual members of Congress ought not be encouraged to get in the way.   

Small Companies and SOX

The SEC seems to be delaying yet another year the application of Section 404 of Sarbanes Oxley (enacted in 2002) to small publicly traded companies.  Companies with market capitalization of less than $75 million, a small percentage of the total market value of United States publicly traded companies but a majority in number of such companies, do not have to comply with the Section.  The small companies will not have to comply until 2009.  Currently they must comply by Dec. 15, 2008.  This is getting ridiculous.  It reminds me of State Attorneys General not enforcing "horseless carriage" laws (it is illegal to spook a horse...) still on the books.  The Section should not apply to small companies at all and they should be permanently exempted. 

Senator Dodd Gives Us A Giggle

Senator Dodd is going to fix the sub-prime mortgage mess.  He has a bill that outlaws the loaning of money to people who cannot pay it back.  So banks can no longer loan money if they know, on the distribution of the loan proceeds, that they will not get repaid.  This is good; the jails will be full.  What next?  A bill outlawing selling cars to the lowest bidder? or outlawing selling long-term life insurance to those near death?  New data from the Treasury's Financial Crimes Enforcement Network shows that over 60% of all Subprime mortgages involved fraud by the borrowers, not the lenders.  Borrowers lied about their ability to repay.

IPO Flight

New evidence from the Committee on Capital Markets Regulation chronicles the flight of IPOs from American to foreign markets.  More United States companies are going abroad and more foreign companies are not coming here.  Moreover, foreign companies listed in the United States are de-listing at higher rates and those foreign companies that list here are choosing a semi-private market, Rule 144a offerings, rather than public offerings.  Our legal system is much too blame.  At issue is which part -- is it private class action and derivative litigation or is it SOX 2002 auditing and certification requirements?  It is probably elements of both -- I suspect that our private class action system is the primary culprit.   

The Fed: In A Hopeless Mess

The credit trading markets predict a large fed rate cut to help ease credit in a sticky market.  They will probably get their wish.  We all know that consumers are finding mortgage loans tougher to get and that, as a result, housing prices (new and used) are falling in most all markets.  Falling housing prices affect consumer demand at some level and we worry that the falling prices will leak into the boarder economy.  In other words, corporate profits may fall next year.  This threat, we has many labeling a "coming rescission," has spooked the Fed.  No Federal Reserve Chairman wants a recession on his or her watch (the criticism from those who lose money will be merciless) and Bernanke is no different -- he will cut rates.  The probable is, of course, that housing prices were too high and need to adjust lower. They were too high because the federal government subsidizes them with 1) the deductibility of mortgage payments and 2) with cheap credit.  We are treating the solution like an alcoholic that has the shakes because he is off the bottle -- our solution is to give him another drink.  Our treatment just delays the inevitable market correction and has side problems too boot -- like inflation and poor allocation of resources.  The Fed needs to impose tough love here but will not have the political or personnel will to do it.  Appeasement is not always the best treatment nor is it always even evidence of compassion.         

Executive Pay Consulting Conflicts

It took a formal series of hearings before a House committee, the House Committee on Oversight and Government Reform, to gather data on what most already knew to be true:  Executive pay consultants are often giving advice on appropriate levels of executive pay when also acting under severe conflicts of interest.  The consultants often also provide often services to the same corporation. Such a conflict for auditors was explicitly outlawed by SOX in 2002.  At issue is why did this not come up in the several court cases that handled complaints on executive pay.  Where are our courts on this? 

United Health Ex-CEO Settles Backdating Charges

In a settlement of record proportions the ex-CEO of United Health, McGuire, has agreed to surrender 9.2 million compensatory stock options, a retirement plan, and an executive savings account.  He allegedly acquired the options in a program that used back dating to maximize option value on grant dates.  The total estimated value -- about $420 million.  He also agreed to pay $7 million as a civil penalty to the SEC and will be barred from serving as an officer of a publicly trading company for 10 years.  He had already voluntarily given back $200 million of options when he was fired.  The total value lost -- $627 million.  Yet, do not cry for Mr. McGuire; he retains 24 million in compensatory stock options in United Health valued at roughly $800 million.  The former United Health general counsel has also settled, agreeing to repay $20 million in option gains and to surrender another $3 million in unexercised options.  Where was the board of directors?? The entire board at the time of the option grants (from 1999 to 2006) should be fired.  Their best excuse, they did not know, is not acceptable.  The board approved these staggering payments and should have taken the time to make sure they were justified in their details.  What a colossal abandonment of oversight. 

Apple Wins Again

Judge Fogel, after dismissing the securities class action against Apple for back dating options and telling plaintiffs that their remedy was a derivative action, has dismissed the derivation action against Apple for violating the statute of limitations.  So, one of the most high profile cases of compensatory stock option back dating will go unaddressed by federal courts in private actions.

Poison Pills: Who is Right?

Shareholder activists are continuing to attack poison pill plans as shareholder unfriendly (20 percent of the Fortune 500 companies still have them in place).  We are told by academics, however, that it should not matter.  All companies can put them in on a moments notice so all companies have "shadow pills."  Are management and shareholder activists wasting their time battling over actual pills or are the academics right?  I vote with those in the trenches; actual pills do matter.  They signal management intentions and it is easier for the board to refuse to waive a pill than put one in when the board is under threat.

The Stoneridge Case

Since everyone, and I mean everyone (including an ex-Chancellor of the Exchequer writing an op-ed in the Wall Street Journal), has weighed in on the merits of the Stoneridge Investments v Scientific-Atlanta case  (to be argued in the Supreme Court on October 9th), these comments may be pointlessly futile.  Never stops other bloggers, so here is my two cents.  The case is the most important private securities litigation case in two decades.  At stake is the number of potential defendants in such cases.  The case pits the SEC against the Department of Justice and the Treasury Department.  The SEC voted 3-2 to support the plaintiffs (Chairman Cox voted with the two Democratic seat holders against the two Republican seat holders).  Sec. Paulson of the Dept. of Treasury came out in favor of the defendants and the Dept. of Justice brief supports his position. 

In the case a cable company, Charter Communications, cooked its books, inflating revenues.  The scheme involved contracts with two suppliers of set-top boxes, who may or may not have known of the alleged fraudulent disclosures by Charter.  The plaintiffs sued Charter and the two suppliers, arguing "scheme liability."  The business community recognized immediately that at stake is not only supplier liability but liability of professional advisers (lawyers, accountants, underwriters and financial consultants) and of lenders.  These groups do not want to be caught in private suits.  In short, Goldman Sachs and the corporate law firms of New York do not want to be sued (have I mentioned that the present Sec. of the Treasury is an ex-Goldman Sachs CEO?).  They have riled up foreign companies as well with arguments that foreign corporations, supplying United States companies, will be sued in United States courts.  This caught the attention of the ex-Chancellor of the Exchequer in England who made a veiled threat that English companies would not longer do business with United States companies if the case went against the defendants.

Most agree that we have too much private securities class action litigation in the United States. Over the past fifteen years the Supreme Court and Congress have be chipping away at the cause of action. That is the problem -- the chipping away-- there has been no systematic definition of the cause of action.  The Court has required scienter, actual trading by the plaintiff, and limited secondary liability.  Congress has enhanced pleading requirements (recently affirmed by the Court) and recast the priority of named plaintiffs.  I agree that "scheme liability" may be too broad, but only if it does not require that the secondarily liable parties have intent to aid the fraud.  In short I like the old aiding and abetting (and conspiracy) standards for secondary liability and believer the Court made a mistake in the old Central Bank of Denver case (the Court disabled private litigants from making an aiding and abetting claim). Those who intentionally aid someone else make a fraudulent disclosure should be liable under a centuries old notion of secondary liability for aiding and abetting or conspiracy.  At present only the SEC can sue under an aiding and abetting allegation (this is want some academics favor, power in the SEC, a public agency, and less power in the hands of private litigants).  This case is about protecting Goldman Sachs, Price Waterhouse and Cleary, from private suits not about English suppliers.  I do not see why they should be protected from damage claims if they intentionally aided and abetted a fraud, espectially if the primary wrongdoer is involvent.

Shareholder Activism and the SEC

There has been a lively debate in the editorial pages of our financial newspapers on whether the shareholder activism practiced by modern private equity funds, hedge funds, and public pension plans is healthy for American business.  On one side are the traditional republicans (with a small "r") that believe shareholders should delegate management details to their boards of directors and then let them do their work.  Shareholders who are displeased should replace the poorly performing managers or sell their shares.  On the other side are investors that believe the board should listen to their specific strategies to increase stock value. Many of the strategies include leverage (stock buy-backs or extraordinary dividends) or unbundling the business (spin-offs or bust-up buyouts).  The debate is complicated by a side-bar debate (the activism debate does not inherently depend on the side-bar debate) on the shareholder primacy principle.  Those who are not comfortable with shareholder value as the primary concern of a board of directors are new-found republicans; a board with maximum discretion can favor non-shareholder constituencies. 

The SEC in a very unusual move, promulgated two mutually contradictory rules on shareholder voting (one re-affirming the traditional view and one giving major shareholders access to the firm's board nomination procedure), to see what public comment it would generate.  I doubt either side is correct or, if one side is correct, that it will be correct for very long.  Firms should be able to choose their internal structure (a division of power between shareholders and firms included), publicize it to the markets, and suffer or enjoy the consequences of their choices.  Those firms that choose well will lower their costs of capital and have a competitive advantage.  In other words, the danger is for the SEC to attempt to try and pick a winner in the debate.  The best position for the SEC is an enabling position:  the proxy machinery regulated by the SEC should act in furtherance of whatever state law allows.  Far-sighted states (and/or exchanges) should enable firms to opt into various internal control systems, no one system is mandatory.  Let the investment market, not the political (or academic) market, decide on optimal firm governance procedure.   

CEO's Personality Cult Promotions Bite Back

CEO's, in justification of their very generous salary and severance packages, have trumpeted their unique importance to the success of any company -- "We make or break companies."  Personality cult promotion by companies of their CEOs is now a common marketing tool.  It may have backfired.  Researchers are running correlations on CEOs' personal life to their performance.  We have studies on CEOs buying large houses and CEOs frequency on the front page of business magazines (there are negative correlations to performance on both).  The latest is a study on family deaths.  CEOs that have suffered the death of a child (or spouse) belong to companies that underperform the market (the death of an in-law correlates to market overperformance).  Trading on CEO family loses is profitable but unsavory.  CEOs do not welcome this kind of introspection (as none of us would) but it may be inevitable due to the larger than life role of the CEO in the profitability of a company -- something the CEOs have themselves told us to true. 

Ratings Firms and Auditors

Ratings firms, hired and paid by those they rate, and accounting firms, hired and paid by those they audit, will have inherent conflicts of interest.  We attempt to ameliorate the conflicts with independent regulatory authorities, professional standards, anti-fraud rules, and Chinese wall procedures, but the conflicts remain.  Ratings firms and auditors want to keep clients happy (and they personnel often want the option of working for clients on job transfers).  Periodically we are reminded of the conflicts when bad news breaks and firms that may even be transparent scams have clean audits and their bonds have high rankings.  In some of our worst cases, the audit and ratings stay until the eve of some company's bankruptcy declarations.  The ratings firms and auditors protest any questions on their work:  "We are proud professionals careful to protect our reputations for integrity and honesty.  We have multiple protections in place...."  A better system would be one that mirrored the one we use for testing automobile crash worthiness or hiring referees for football games.  Independently funded groups (there are two) buy cars and test them.  The league hires and pays the referees (can you imagine referees paid by, for example, the home team based on calls during the game?? That's what we do with auditors and ranking agencies.)  Firms can hire whoever they want for advertising purposes in an attempt to convince ("see A-Rod likes our bonds"), but the SEC (and the exchanges) do not rely unequivocally on the hired services for filings or categorization.  At some point, the inherent conflict of client/checker cannot be "fixed" enough by structured relief to justify our current practice.

Yet Another Special Purpose Entity Scam??

Special Purpose Entities (or Vehicles, SPVs, for short) used for off-balance sheet financing were the focus of the Enron scandal and are back in the news again.  Enron "transferred" debt to SPVs and took the debt off its balance sheet.  The transfer is legit only if the SPVs are independently owned (not a sub of Enron).  Enron officials concealed the identity of Enron as a true majority owner of its SPVs, hence the scandal.  The new game is with "conduits" and SIVs (Structured Investment Vehicles).  These "independent" investment vehicles, created by investment banks (most notably Citigroup), hold assets and sell asset backed commercial paper (among other forms of debt).  Banks use the vehicles to issue commercial paper and use the proceeds to purchase long-term, often illiquid assets (receivables, auto loans, and home loans), all off the balance sheet and, therefore, not a problem with bank minimum capital requirements.  They learned from Enron -- ownership is independent -- but the new game is in the bank's guarantees of default.  Entitled "liquidity backstops" the banks in essence guarantee the vehicles against losses but technically skirt the definition of a legal "straight guarantee" (which would make them owners). These non-guarantee, guarantees have now put the true exposure of Citigroup to vehicle insolvencies on the table and investors are not sure they like what they do not know. 

Compensation Disclosures

The Securities and Exchange Commission (SEC) has startled the CEOs of over 300 companies with letters asking for more detail in their compensation disclosures on the SEC's new rules.  The CEOs are startled because they did little to prepare the disclosures; their attorneys did.  We again have an example of corporate attorneys reading the SEC rules as closely and conservatively as is possible (or beyond what is possible) in order to disclose the barest minimum.  The SEC is apparently not happy with the practice and may have itself over-reacted in demanding more detailed information.  It will take some time for this ping-pong match to play itself out.  It is yet another illustation of the extreme sensitivity of the country's CEOs to executive compensation disclosure requirements.

State Courts and Options Backdating

Early this year the Delaware Chancery  Court, in two opinions,, In re Tyson Foods and Ryan v Gifford, allowed shareholder derivative suits to proceed that were based on dating compensatory stock options.  In one suit the allegation was that spring loaded options (options given before the announcement of favorable news) could be deceptive if they were disclosed only as "at the market" grants.  In a second suit, backdated options could be a breach of fiduciary duty.  Both opinions were a clear declaration that options dating practices were potential violations of state law as well as federal law.  At issue is whether plaintiffs attorneys have taken full advantage of the opening.

Topps Delays Shareholder Meeting

The management of Topps Co. has delayed a shareholder vote because it fears it will lose.  The management is pushing a buyout with a favored bidder, Tornante Co., at $9.75 or so a share.  Topps management had previously rejected a bid, valued at $10.75 a share, from Upper Deck.  The Delaware Chancery Court has a long history of not supporting tampering with shareholder meeting dates and one wonders whether this move can past muster.

Nardelli Takes the Reins at Chrysler

There has been universal surprise at the selection, by Cerberus Capital Management, of Robert Nardelli to run Chrysler.  Recent management history has taught us 1) that the identity of the CEO is very, very significant to a company's success and 2) that, for a CEO, character matters.  Given Nardelli's poor performance as CEO of Home Depot and as the chair of the compensation subcommittee of the board of directors for the NYSE, it seems that Cerberus has made a very unfortunate choice.  As CEO of Home Depot he hurt the company, arrogantly abused its shareholders and investors, and then took excessive executive compensation for his troubles; on the NYSE board he facilitated the excessive compensation of its controversial CEO, Grasso (who single-handedly blocked technological innovation), which Nardelli later vocally defended.   The new CEO of Chrysler will have to boost the public confidence in Chrysler's products (to buyers), in its financial position (to lenders), and in its labor relations (to the union) while reorganization the company's operations.  He will have to be part diplomat; Nardelli is not diplomat.      

Midwest Air Group Takeover

The refusal of the board of Midwest Air Group to sell to AirTran Holdings for $400 million, despite the overwhelming support of Midwest shareholders, is a classic illustration of the power of constituency statutes.  Midwest is incorporated in Wisconsin, a state that by legislation empowers corporate boards to look after constituencies other that shareholders (read employees).  The Midwest board used the statute to justify the rejection of the bid.  Midwest shareholders are now voting the board out, one election at a time (it will take two years; the shareholders elect only one-third of the board a year).  The CEO of Midwest, with a healthy yearly salary, has only a modest golden parachute in place.  Look for a bigger payout (a "consulting contract") and a deal.  Constituency statutes do not help non-shareholder groups, other than senior excutives of course.

Bausch & Lomb: A Sorry Tale

Bausch & Lomb, a 154 year old company, is selling to a private equity firm, Warburg Pincus for $65 a share.  The company is struggling and its stock price is well down from highs of $80 a share two years ago.  The CEO responsible for the company's recent setbacks is Ronald L. Zarella.  Zarella will receive a golden parachute payout of $40 million and have an equity stake in the privatized company.  If the company turns around, he will rake it more millions.  There are three things seriously wrong with this story:  First, Zarella is profiting from his own weak managing record (there were accounting problems while he led the company).  Second, Zarella is conflicted in the buyout both by the overly generous golden parachute and by his participation in the purchaser. And third, the purchaser will undoubtedly do the cookie cutter "Peltz thing" to print money -- sell under-producing assets, sell undervalued assets, leverage and distribute money to shareholders (an extraordinary dividend or buyback).   This is not rocket science; it is pathetically simple. If this is a viable strategy for the private company it is surely a viable strategy for a public company; Zarella should have done the Peltz thing as CEO of the public company.  The entire deal smells.  At some point, we are going to have to come to grip with the fact them many of the private buyouts are a huge reward for those who should not be rewarded and this reward may itself be a primary reason for the buyout.  Buyout groups look for companies with poor managers and fat golden parachute agreements; convince the manager to sell, cash the agreement, and come abroad the buyout team which can use his knowledge and contacts (and inside information) and tell him how to behave. We need a decent judicial opinion on one of these deals that lays out more protections for shareholders.    

The Blackstone IPO

The Blackstone IPO is way oversubscribed.  The underpricing tomorrow will be horrific.  Priced at 29 to 31, watch the run by the end of the day to double that.  Others have noted the ironies in this IPO:  1) a company that takes others private is going public, 2) small investors can buy stock in a firm that puts investments together for only the sophisticated and wealthy, 3) knowledgeable insiders are exiting, in part, a mature market in buyouts and inviting the noise traders, who know nothing of the state of the buyout market, to get in.  I focus on the nature of the offering itself.  It reminds me of Google.  A company worth $32 billion is selling a small fraction of itself, $4.8 billion, and over half, $2.6,  is going directly into the pockets of the founders not into the company.  Moreover, the new shareholders will have no management power at all.  In other words the company does not need the money and is not conceding any manager rights to the new shareholders (other than the right to sue for breach of fiduciary duties perhaps).  This is a pure liquidity play for the exclusive benefit of existing insiders; the insiders want to be able to sell shares in a public market and the markets are content to play along, assuming a speculative gain in a roller coaster stock.   

Tellabs: Not a Victory for Defendants

The Tellabs opinion is out and the court reversed the Seventh Circuit in a 8-1 decision.  The majority opinion held that the Seventh Circuit had used the wrong standard to assess the pleadings under a motion to dismiss stage.  The majority opted for a "at least as likely" standard for assessing pleadings of scienter (an inference of scienter must be at least as likely as competing plausible inferences); the plaintiffs get the benefit of all reasonable factual inferences and the standard applies to the complaint as a whole, not each factual pleading or each fact pled with "particularity."  Two concurring judges favored a "more likely than not" standard (an inference of scienter must be more likely than any competing plausible inference of no scienter) and a dissenting judge favored a "probable cause" standard (competing inferences could b, but do not necessarily have to be considered).  The majority standard is not what the defense bar wanted; they wanted the standard of the concurring judges, which the court rejected.  This is not a defense bar victory; it is a draw at best.  Reporters will fail to get this correct and rack with up as another victory for corporate American; it is not. The majority held, importantly, that the pleading standard was not higher that the standard of proof required at trial; the defense bar argued that Congress so intended it to be higher.  This is a big difference.  Reporters, do not overstate the true meaning of this case.

Another Academic Study That Has Caught the Attention of the SEC

A new study by professors Andrea Frazzini of Chicago Christopher Malloy on London and Laurne Cohen of Yale found that mutual fund managers do significantly better when they invest in companies rule by their old college or graduate school classmates.  The study, another in a long line of academic studies that find abnormal correlations in stock trading (remember the study that started the options back dating scandal by finding abnormalities in executive option grants??).  At issue is the inference -- are the results due to legitimate or illegitimate trading.  Some say it is evidence of insider trading; other say it is evidence that fund managers use superior information on their old buddies to pick the good managers.  The study confirms in data what the elite business and law schools have known for decades; you go to these schools for the contacts as much as for the teaching.   

The Management Style of the CEO of GE, Jeffrey R. Immelt

Joe Nocera published a column in the New York Times on Saturday, June 9th, entitled "Running G.E., Comfortable in His Skin."  The column detailed and lauded the management style of the CEO of GE, Jeffrey R. Immelt.  Nocera wrote that Immelt is the "prototype of the modern chief executive.. unflappable...a good listener, consensus builder, ambassador to the larger world... comfortable in his own skin..."  Trouble is, GE stock price has been stagnant during the entire time of his tenure while the major stock market indexes had all shown increases.  The column comes out in a time when "soft skills" are emphasized in hiring and in business school curriculum.  We may be overdoing it.  Judgment and perspicacity are not "soft skills."  Immelt's risky bet on environmental technology will matter more to the stock price over time than whether or not he has -- and this is the new buzz word -- "authenticity."  Business leaders in firms that are becoming or staying private are noting the management advantages in not playing the ambassador role to the world -- A CEO that deals with a few focused shareholders can focus more on operations than interviews, deliver better results, and have fewer headaches.

Cross-Listing Premiums

A new study by Karolyi, Stulz & Doidge, which Professor Stulz has hinted was coming for some time, documents that the Sarbanes-Oxley Act of 2002 does not adversely affect the appeal of United States stock markets to foreign company seeking to list shares.  United States listings still offer substantial cross-listing premiums on stock prices (due, in theory, to superior regulation) and London listings do not.  The decline in the number of listings in the United States after 2002 is due to the fewer number of companies that are eligible to be listed, not the Act they argue.  There is some contrary evidence; the explosion of our Rule 144A market in foreign stocks (an exempted offering) and the success of the Toronto and London AIM small offering markets as compared to our own small offering markets.  There is also an alternative theory: We have established a very high standard of reporting that only very large, well run companies can use as a "seal of approval."  It makes sense for them to do so; smaller and medium companies with more average business practices no longer find is sensible to incur the high costs of using the "seal."  At issue is whether we should apply a top "seal of approval" system to all our companies.  Is the growth of small and medium companies too hindered by such a requirement?         

Attacks on Private Equity Funds

Unions, long suspicious of private equity fund buyouts (leverage buyouts or LBOs), have a sympathetic ear in Congress.  Barney Frank, chair of the House Financial Services Committee, is rustling about attempting to find ways of regulating LBOs.  His basic complaint is that the LBOs do not help and often hurt rank and file employees (in particular unionized employees).  He seems to want to limit buy-out funds access to debt to finance the deals.  He will have trouble.  Buyout funds are taking advantage of a broader market phenomenon -- debt is cheap because it is subsidized and control by the government.  The federal government favors debt in the tax code and the fed keeps debt at below free market rates.  Buyout funds are using subsidized debt (interest rates are too low).  Too many across the financial markets (both main street and wall street) are invested in low interest rates to change this. Disabling one actor, private equity funds, from using debt, will merely embolden and empower others (who are probably less efficient but just as willing).

Take-Two Proxy Fight

The success of the dissident shareholders in the annual meeting of Take-Two Interactive Software, Inc., is stunning (five new directors and the firing of the CEO) and may be a harbinger of a new day for corporate governance.  Institutional investors held large stakes in the company, got together when problems surfaced, and in a no-nonsense show of steady strength, put a turnaround artist in control of the company. The ousted CEO tried to sell the company and delay the annual meeting but in the end, he lost.  The meeting will have long run effects -- it will encourage institutional investors to be active and, most important perhaps, it will encourage outside directors (two of whom survived by aligning themselves with the dissidents) to switch sides when it is obvious that there are internal problems. 

Lawyers Accountable?

Several recent new items suggest that lawyers are being held accountable for their roles in the recent financial scandals.  Several of Enron's house counsel have been indicted and Jenkins & Gilchrist has dissolved, due to the involvement of attorneys in an acquired Chicago law firm in the marketing of tax evasion schemes.  Modern financial scams, due to filing requirements imposed by both state and federal authorities, necessarily involve the participation of lawyers and often involve lawyers in the planning.  High profile prosecution of lawyers who have misbehaved should help to sober up the practice and give some cover to lawyers who want to resist pressure from clients.   

The Summit: To Whom Should We Listen??

The March 13 "Summit" at Georgetown with some of the biggest names in the country in finance, organized by the current Secretary of the Treasury Paulson, is a continuation of his efforts to create a political consensus for reducing business regulation.  He primary targets are parts of Sarbanes Oxley (Section 404) and class action (and derivative) litigation.  We have had two non-partisan reports (Hal Scott's and Senator Schumers' committees) and a US Chamber of Commerce report and now the "Summit."  The problem for observes is who to believe; many in the game have vested interests in spinning the facts to their advantage and they are good at it (they are pros).  Rubin and Paulson are carrying the water for concerned CEOs.  Are the CEOs just seeking another business advantage or are they speaking for something in the national interest?? It's hard to say.  But there is one man who is candid to a fault and who know what he is talking about -- Warren Buffet -- he is a national treasure.  His opinion??? "If something's wrong with he system, it hasn't seeped through to the operating results of business."  Translated -- the CEOs have not made their case.  Business performance, operating profits, are healthy; business to make there case must show that profits could be even better with less regulation -- something they have failed to do.  An answer to Buffett cannot come in general caterwauling about how tough it is to do business in the United States, it must come in a careful analysis of the details of the rules themselves -- what are Section 404 costs versus Section 404's benefits.

President's Work Group Hedge Fund Report

The President's Working Group on Financial Markets (the heads of the Treasury, Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission) issued it report on whether to regulate hedge funds.  The answer -- to the dismay of the New York Times, Democrats, and many law school academics -- is no.  The Working Group discusses the advantages of hedge funds and the risk (investor fraud; excessive risk-taking) and concluded that counter parties could and should monitor and control their risks in dealing with hedge funds and that wealthy investors could look out for themselves.  Even the milder forms of regulation, more forced disclosure, were rejected as unnecessary.  The report is sensible and, I believe, correct. Many will disagree.  With Democratic in control of the executive, this report would have been very, very different.  Much, out of the news, is at stake in the next election.   

Decline in Securities Class Actions

The debate over the cause in the recent decline in securities class actions in federal court continues to rage.  Some say managers are behaving better (due to SOX??); I have argued that the troubles of Milberg Weiss have an underestimated effect.  My argument to date has focused on the high percentage of cases bought by Milberg Weiss (and its two successors) over the years.  I may have missed the boat.  Milberg Weiss is in trouble because of allegations that it paid individuals to be plaintiffs.  The major effect of the case may be on the ability of all firms, not just the successors of Milberg Weiss, to find individual shareholders to be lead plaintiffs.  Once a suit has begun, some institutional investors will step up but the institutional investors are only rarely the initiating plaintiffs.  Plaintiff's firms need that one shareholder who will step up and lend her name to the initial filing.  How does one find such shareholders that do not expect some compensation for their time (other than costs and expenses)??  The old, under the table payment system used by some has been exposed and is now way too risky.  The problem of attracting shareholders as plaintiffs may be part of the reason for the decline. 

Professor Subramanian on Staggered Boards

Professor Subramanian notes in a recent editorial to the Wall Street Journal that staggered boards are slowly being eliminated under pressure by shareholder advocacy groups.  He recommends that staggered boards be moved to the bylaws from the articles of incorporation as a "best of both worlds" solution.  The board can be staggered to minimize elections but shareholders can amend the bylaws to eliminate and replace a staggered board in a single year in takeover situations.  Of interest to his claim, however, is the new popularity of two-tier voting stock in IPOs however.  Google and now Fortress are two of many, many examples.  One does not need a staggered board to defend against takeovers when the votes are concentrated in a Class B stock held solely by the founders. 

Professor Grunfest on Securities Class Actions

Professor Grunfest of Stanford has an editorial in the Wall Street Journal noting the surprising falloff in securities class actions filings since 2005.  He argues that the best explanation for the decline in filings is that, in response to Sarbanes-Oxley perhaps, managers are behaving better.  He dismisses as not "holding water" my view, expressed in an earlier blog, that the difficulties of the country's two largest plaintiff law firms, once joined, are to blame.  Milberg Weiss & Bershad split with Lerach, Coughlin et al. a few years ago. When joined the firms filed over 60 percent of the country's class action suits and apart the two firms combined continued to dominate the market with similar numbers.  Cooperman, a named plaintiff in over 70 lawsuits by the firms, pled guilty to accepting kickbacks of over $6.4 million.  Two lawyers in Milberg have been indicted and there is speculation on whether Milberg and Lerach, the two founders are under investigation.  The charges have caused both firms to lose clients and to lose partners and associates.  Professor Grunfest argues that there are many more plaintiff's firms out there ready to take over whatever cases could be brought.  I think he overlooks the barriers to entry in the business.  Plaintiff firms have to be very-well financed and very-well staffed;  they take substantial risks on a portfolio of cases, carrying the costs of each, and hoping that some will come in and pay for those that do not.  This is not for the faint of heart.  The firms also must have reputations for success that attract shareholders who are willing to named plaintiffs.  Bankrolling the very largest cases, against multiple determined and well represented opponents, is not something any small plaintiff's firm can do.  I think he underestimates the difficulty of starting and maintaining a successfully law firm that does the very largest cases.  New firms will emerge but it will take time, and we will see the class actions come back.  As evidence for my position, I note that the earnings restatements are down only slightly but that the percentage of earnings restatements that have immediately stimulated securities class actions seems to have declined (my data is anecdotal however)

Delaware Chancery Court on BackDated and Spring Loaded Stock Options

The Delaware Chancery Court, in two opinions, In re Tyson Foods and Ryan v Gifford, ruled against motions to dismiss in derivative actions based on improperly granted compensatory stock options.  In Tyson Foods the claims was based on spring-loaded options (options granted on the eve of known good news);  in Ryan v Gifford the claim was based on back-dated stock options (options back-dated to an earlier grant date so as to fix a lower exercise price equal to a lower stock market price).  In both the Court held the a demand on the board excused and in both the Court noted that the claims stated an allegation of board "bad faith" and breaches of the duty of loyalty.  The decision on the spring-loaded options is particularly notable because the SEC, although uncomfortable with the practice, has apparently decided that the options are not a version of illegal insider trading under Rule 10b-5.  The use of "bad faith" as the defining doctrine is notable as well; the Court may be giving life and shape to the Disney ruling that identified the lack of bad faith as a separate duty of the board of directors (although the Court did freely use duty of loyalty language as well).  The Chancery Court held that spring loading was potentially deceptive to shareholders and needed express shareholder approval. Both rulings should encourage shareholders to bring derivative actions against the 200 or so companies accursed of improperly granting compensatory options.

There are only twenty or so pending class action lawsuits in federal court arguing that back dating options is a violation of federal securities laws.  The federal suits are limited by the need of shareholders to show damage to the value of their shares; when the illegal practice is disclosed the stock prices of many firms have not declined significantly.  The state derivative actions are not so limited and may simply demand that executives cancel the options and otherwise pay damages suffered by the firm itself.  These two rulings should stimulate a wave of private derivative litigation.   Even litigants worried about statute of limitations issues (most of the practices happened form 1998 to 2002) should take solace in the Tyson ruling, which held the statute tolled by "fraudulent concealment."