Friday, October 20, 2006
Yesterday in my Business Enterprises I class, we moved into the fiduciary duties of corporate directors, a subject close to my heart, having counseled a public company board from 1999 to 2005, a period that spanned the burst of the Internet bubble, the Enron fiasco and its ilk, the passage of Sarbanes-Oxley, and the New York Stock Exchange's adoption of the governance standards in it revised listing requirements. During that period, we did an partial IPO of an wholly-owned subsidiary, resulting in a controlled public company listed on NASDAQ, and later acted on behalf of all of the shareholders of the subsidiary to sell it in a cash-out merger. We also pondered significant strategic redirection, saw the resignation of a CEO, and then merged the company out of existence.
So, as I observed to my class, I have perhaps a harder time seeing corporate directors as "them," and prefer to think not of directors as demons, or even as Richard Posner's faceless and automatonic "rational frogs," but as real human beings faced with difficult choices, and without the benefit of the hindsight that either litigators or law professors bring to the table. Perhaps that is why I was taken with the even-handed approach of Professors Rasmussen and Baird in the article I highlighted several days ago. I also suggested to the class, whether someday they are in the position of counseling, defending, or suing directors, they would be well served to appreciate the complexity of the ex ante decisions (whether or not it is a calculation) facing corporate directors. Indeed, my pedagogical point is that this is at least some basis for the deference that courts give to directors, absent breach of the duties of care and loyalty, for actions taken in good faith under the business judgment rule.
Should we look at corporate directors with the glass half full or half empty? I confess, having watched a white male conservative Republican director (one of our curmudgeons) argue that our non-discrimination policy should include a ban on discrimination on account of sexual orientation, and similar displays of independent-mindedness against type on a fairly regular occasion, I incline toward the former. But I cannot deny the reality of what seems to me good judgment gone awry in what viscerally seems to be a non de minimis number of backdating cases. (I have already expressed my view on that issue: I would have criticized a general counsel who did not go beyond the strictly legal in pointing out the issues of truth-telling - or its opposite - in undertaking the practice.)
More below the fold.
So, as I was thinking about this before class yesterday, I got onto the SEC website in a frenzy to see if I could find out quickly the number of public companies in the United States, defined as those required to make annual and quarterly filings on Forms 10-K and 10-Q under the Securities and Exchange Act of 1934. (By the way, that would include companies without public shareholders, but with public debt, for example, under Rule 144A.) I couldn't find the number, but I did find out that Yahoo reports on over 9,000 companies trading on the NYSE, AMEX, NASDAQ and OTC exchanges.
The question is to what extent the scholarship in this area is affected by the availability heuristic. (I don't care for behavior economics when presented as the way to a unified theory of human behavior, but I do think its tools provide tremendous insight into aspects of that behavior.) As Jolls, Sunstein, and Thaler observed in their seminal Stanford Law Review article on law and behavioral economics:
A major source of differences between actual judgments and unbiased forecasts is the use of rules of thumb. As stressed in the pathbreaking work of Daniel Kahneman and Amos Tversky, rules of thumb such as the availability heuristic--in which the frequency of some event is estimated by judging how easy it is to recall other instances of this type (how "available" such instances are)--lead us to erroneous conclusions. People tend to conclude, for example, that the probability of an event (such as a car accident) is greater if they have recently witnessed an occurrence of that event than if they have not.
(50 Stan. L. Rev. 1471, 1477 (1998).)
It's not a stretch to say that Congress was overwhelmed by the availability heuristic in enacting Sarbanes-Oxley. That's certainly a conclusion we may draw from Roberta Romano's canon The Making of Quack Corporate Governance (114 Yale L. J. 1521 (2005).) As she observed, "the corporate governance provisions were not a focus of careful deliberation by Congress. SOX was emergency legislation, enacted under conditions of limited legislative debate, during a media frenzy involving several high-profile corporate fraud and insolvency cases. These occurred in conjunction with an economic downturn, what appeared to be a free-falling stock market [NB: as I quote this on October 20, 2006, the DJIA has just closed above 12,000 for the first time ever], and a looming election campaign in which corporate scandals would be an issue."
So, as I mentioned a couple days ago, I was intrigued when I flipped through Professor Elizabeth Nowicki's The Unimportance of Being Earnest, recently posted on SSRN, which I interpret to advocate the gutting of the business judgment rule as it presently exists - i.e., that the judgment of the directors, taken in good faith, is presumed to have been taken in the best interests of the corporation and its shareholders, in the absence of fraud, illegality, or breaches of the duties of care or loyalty. The particular manner of the gutting would be to recast the duty of good faith essentially as a duty of due care, the net result of which would something more akin to an ordinary negligence standard for director conduct than what is generally accepted as a gross negligence or egregious conduct standard under the BJR.
What caught my eye was not so much the proposed solution, but the statement of the problem:
The corporate landscape of the recent past is littered with corporate governance failures, corporate scandals, significant valuation depression, and disgruntled stockholders. Enron went completely bankrupt – from shares of stock trading at $90 on August 23, 2000, to shares of stock trading at 22 cents on March 22, 2002. And the Enron investors were not alone in their woes. WorldCom investors suffered a similar fate as mismanagement and financial tomfoolery were revealed. As did the investors in Tyco, Adelphia, and numerous other corporations. This corporate upheaval did not only manifest itself in bankruptcies or financial ruin. Rather, investors bore witness to sex scandals, executive gluttony, corporate lethargy, and outright crimes. Hundreds of thousands of investors not only lost the stock they were counting on as their “savings,” to fund a new car or a child’s schooling, but they also lost the stock that was intended to fund their retirement (right around the corner for some investors).
If the denominator of the fraction for corporate scandal is, at a minimum, 9,000, I am also willing to concede that the numerator is larger than the three companies that Professor Nowicki cites. I don't know how many companies have reported backdating issues (I don't count merely having disgruntled shareholders as putting a company in the numerator - most shareholders I ever met tended to fall on the dis- end of the gruntlement spectrum, even when things were going good.)
Here is a call for empiricists! Yea and verily, wade into the data and help us discover the truth! Is my casual empiricism misguided, and should I conclude that I counseled, for all their human flaws, one of the few honorable boards left? Or is the availability heuristic at work, albeit in the extended time that is appropriate to scholarly reflection (as opposed to frenzied and half-baked corporate legislation)?