As the hit counter on the right hand side of this blog indicates, our Harvard Law School Corporate Governance Blog has just reached the 2-million-hits mark. Our blog, which was founded in December 2006, has been enjoying robust growth in traffic. The cumulative number of hits on the Blog has doubled in the past six months. A chart depicting the monthly traffic on our blog since its inception is displayed below:

The Blog has also experienced substantial growth in the number and range of guest contributors. In addition to the Harvard Law School faculty and fellows, and the members of the Program’s advisory board listed on the left hand side, more than sixty other academics and practitioners have contributed to our blog. Posts on the Blog have been referred to and relied on by prominent media publications such as the Economist and the Wall Street Journal. The Editors and Staff at the Blog would like to express our appreciation to all contributors and to our readers for our continued success.

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(Editor’s Note: This post comes to us from Jeff Stein and Bill Baxley at King & Spalding.)

Following the corporate scandals in the early part of this decade, there were calls to fundamentally change the way U.S. public company boards were structured — with some advocating for the “European model” of boards being led by independent chairmen rather than by a combined chairman-CEO. Many U.S. board members and business groups questioned whether the separation of the CEO and chairman roles actually adds value, so rather than implementing this profound change, the stock exchanges adopted what many consider to be a relatively weak compromise position. Under the approach adopted by the stock exchanges, the board is required only to appoint a director to preside over executive sessions of the independent directors and to receive shareholder communications.

Despite its humble beginnings, the appointment of “lead directors” has become a prevailing practice for U.S. public companies and lead directors have assumed increasing responsibilities within their companies. Still, there is little consensus at this point about which responsibilities lead directors should undertake and how they can act to improve both the governance and the performance of their companies. (In this posting, we refer to the director serving as “presiding” director, “lead” director, or independent non-executive chairman as a “lead director”.)

In order to consider these issues and respond to questions from our clients on these issues, King & Spalding and Tapestry Networks have created The Lead Director Network (LDN). The LDN brings together a select group of lead directors, presiding directors, and non-executive chairmen from many of America’s leading companies for private discussions about how to improve the performance of their corporations and earn the trust of their shareholders through more effective board leadership. The LDN currently includes 16 members (who serve as lead directors of 21 companies) and plans to meet three times per year. The group comprises lead directors from companies like Caterpillar, The Coca-Cola Company, Constellation Energy, Delta Air Lines, The Home Depot, Microsoft, Morgan Stanley, and others.

The inaugural meeting of the Lead Director Network was held on July 8, 2008, and the members present at the meeting considered the role and value of lead directors, how the role has evolved over recent years, and some of the key issues that lead directors are confronting. Following this meeting, King & Spalding and Tapestry Networks have published ViewPoints, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of these important topics.

Highlights of the July 8, 2008 meeting, as summarized in the ViewPoints document, include the following:

• The Origins of the Lead Director Role. While there were external factors that led to the establishment of the lead director position (including stock exchange listing requirements and pressure from various stakeholders to separate the CEO and chairman roles), internal factors have played an important role in the evolution of the position. Among the factors that may cause the expansion of the lead director role for a company are changes in the leadership of the company, a significant event (such as a government investigation or a potential change of control transaction) and directors’ own efforts to ensure board independence and improve board performance.

• Value of the Lead Director Role. Despite its modest beginnings, the lead director position has become increasingly important for many U.S. companies. Lead directors are contributing to improved corporate performance in at least four key areas: (1) taking responsibility for improving board performance, (2) building a productive relationship with the CEO, (3) supporting effective communications with shareholders, and (4) providing leadership in crisis situations. Ironically, these areas where lead directors are making the most valuable contributions are not among those officially described for the position by the NYSE.

• How the Title Affects the Role. Members analyzed the different meanings that lie behind the different titles — “lead director”, “presiding director” and “non-executive chairman” — and how these titles relate to the responsibilities of the role. While the title may signal differences in how the lead director position is perceived by other directors, members concluded that, in practice, the terms “lead” and “presiding” do not say much about the actual portfolio of responsibilities delivered by the director. By contrast, the term “non-executive chairman” typically does describe something different, often a larger role in both company and board leadership.

• Current Issues for Lead Directors. Members of the LDN identified five topics that they feel are important for lead directors and that they will discuss in more depth in future meetings: (1) how the board should be engaged in the development of corporate strategy, (2) the lead director’s role in crisis turbulent times, including preparing for a crisis situation, (3) the lead director’s role in succession planning for the CEO, the board, committee chairs and the top tier of management, (4) improving director and CEO evaluation processes and how individual director performance should be evaluated, and (5) alternative governance models (for example, the European model and models used by private equity firms).

• The Future of the Lead Director Position. The lead director position was created as a compromise between having a board with no leader of its independent directors and mandating that every company have a non-executive chairman. Six years after the creation of the position, the most important contributions of lead directors have come not from the duties mandated by stock exchange requirements, but from the responsibilities that lead directors in fact have undertaken for their companies. As some activist shareholders renew their call for the “European model” of board leadership, it will be interesting to see whether the lead director position will continue to evolve as a viable and preferred alternative for corporations and their stakeholders.

We welcome comments on the subject of lead directors and suggestions for future topics to be considered by the LDN members, and plan to make other postings based on the discussions and reports of the LDN.

Additional information regarding the LDN may be found on the websites of Tapestry Networks and King & Spalding.

A copy of the Lead Director Network ViewPoints report is available here.

Last month I discussed the emerging importance of what I call “uncorporate” governance – that is governance characteristic of partnership-type firms – for large, publicly held firms. As elaborated in my Uncorporating the Large Firm, a critical aspect of these firms is that they substitute distributions, liquidation rights and high-powered managerial incentives for traditional corporate monitoring devices, particularly including fiduciary duties.

The Delaware legislature does effectuate this “substitution” by explicitly letting LLCs eliminate all duties except for “the implied contractual covenant of good faith and fair dealing” (6 Del. Code §18-1101; there are similar provisions for other unincorporated firms). By contrast, the Delaware provision on fiduciary duty modification in corporations (DGCL §102(b)(7)) prohibits waivers of the duty of loyalty and “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” And as I discussed in Uncorporation and Corporate Indeterminacy, Delaware courts have enforced waivers consistent with the statutes.

But will Delaware courts apply corporate restrictions on waivers to publicly held uncorporations. In particular, might they interpret the “good faith” qualifier in the uncorporation statutory waiver provisions as similar to corporate-type good faith, which has been interpreted as part of the fiduciary duty of loyalty (see Stone v. Ritter, 911 A.2d 362 (Del. 2006))? Until very recently, the Delaware Supreme Court had never held that fiduciary duties could be waived in any publicly held firm.

That has now changed thanks to the Delaware Supreme Court’s recent opinion in Wood v. Baum. The case involved Municipal Mortgage & Equity, LLC (“MME”), at the time of the case a NYSE-listed Delaware LLC with 2500 record holders (see MME 2006 10K). The question in the case was whether the plaintiff had adequately alleged facts justifying excusing demand in a derivative suit as futile. Under the controlling Aronson standard in Delaware, in a case like this one involving an independent board the plaintiff had to show that the directors had an incentive to protect themselves from a substantial risk of personal liability. The court noted that:

under the Operating Agreement and the [Delaware Limited Liability Company Act] the MME directors’ exposure to liability is limited to claims of “fraudulent or illegal conduct,” or “bad faith violation[s] of the implied contractual covenant of good faith and fair dealing.”

Where directors are contractually or otherwise exculpated from liability for certain conduct, “then a serious threat of liability may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on particularized facts.” Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. Therefore, the issue before us is whether the Complaint alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.

With respect to bad faith, the complaint alleged, among other things, that the defendants had “breached their Caremark duties by “fail[ing] properly to institute, administer and maintain adequate accounting and reporting controls, practices and procedures,” which resulted in a “massive restatement process, an SEC investigation, and loss of substantial access to financial markets.” (footnotes omitted). These allegations may have raised a good faith issue under Stone. Nevertheless, the court said:

the Complaint does not purport to allege a “bad faith violation of the implied contractual covenant of good faith and fair dealing.”The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here. The implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements. Here, the Complaint does not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in “bad faith”). (footnotes omitted)

The court concludes: “Given the broad exculpating provision contained in MME’s Operating Agreement, the plaintiff’s factual allegations are insufficient to establish demand futility. (emphasis added)”

In short, the directors had no fiduciary duties under the agreement, and no incentive to protect themselves from liability for breach of any such duties. Although this case did not involve particularized allegations of self-dealing, there is no apparent reason why the court’s reasoning should not cover such allegations as well.

If publicly held firms can waive fiduciary duties in the LLC form, why should they not be able to do so in the corporate form? Should the Delaware legislature take the next seemingly logical step and carry the complete exculpation approach over to corporations from uncorporations? Seventeen years ago, in the wake of Delaware’s initial adoption of broad fiduciary opt-out provisions for limited partnerships, I predicted that would happen, in my Unlimited Contracting in the Delaware Limited Partnership and its Implications for Corporate Law, 17 J. Corp. L. 299 (1991). I argued that the absence of other corporate-type protections made fiduciary duties even more important in unincorporated firms, so that if the latter could opt out, a fortiori corporations should be able to do so. Also, if publicly held corporations could opt out by simply disincorporating, why force them to take this procedural step? Perhaps, as discussed in Uncorporating the Large Firm, corporations should be distinguished from uncorporations on the basis that the latter offer disciplinary and incentive devices that make fiduciary duties less necessary in this context. There is also an argument for letting firms and investors choose between two distinct approaches to opting out of fiduciary duties.

In any event, it now seems clear that publicly held unincorporated firms can opt out of fiduciary duties in Delaware. It remains to be seen whether my initial prediction that this permission will extend to publicly held corporations ultimately will prove to be correct.

(Editor’s note: This post comes to use from Feng Gao, Joanna Shuang Wu, and Jerold Zimmerman at the Simon School of Business Administration at the University of Rochester. This paper was presented by Professor Wu at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.)

In our paper Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation: Evidence from the Sarbanes-Oxley Act, we investigate whether the enactment of SOX created incentives for certain firms to stay small – in particular to keep their public float below $75 million, the threshold in the SEC’s definition of “non-accelerated” filers. Since 2003, the SEC has on several occasions deferred the implementation deadline for non-accelerated filers regarding Section 404 of SOX, considered by many commentators as one of the most onerous parts of SOX, particularly for smaller firms.

At least two non-mutually exclusive reasons can motivate managers to retain their firm’s non-accelerated filer status: (i) they believe that complying with Section 404 reduces shareholder value, and/or (ii) they believe that Section 404 reduces their private control benefits. Our paper does not differentiate between these two motives. Rather, it documents that regulatory size thresholds in fact induce some firms to remain below the threshold and identifies the various methods used to accomplish this objective. Our sample consists of non-accelerated filers and a control sample of accelerated filers with market capitalizations below $150 million. Our event period spans June 1, 2003 (following the first SEC deferment of Section 404 compliance deadline for non-accelerated filers) to December 31, 2005 (soon after the SEC issued the new exit rule for accelerated filers).

We document several actions that non-accelerated filers appear to employ to keep their public float below the $75 million threshold post-SOX. We find that they take actions to reduce net investment in property, plant, and equipment, intangibles, and acquisitions, that they pay out more cash to shareholders via ordinary and special dividends and share repurchases, and that they take actions to decrease the number of shares held by non-affiliates. Because the testing date of a firm’s filing status occurs only once each fiscal year (the last trading day of its second fiscal quarter), we find that non-accelerated filers disclose more bad news and report lower accounting earnings in the second fiscal quarter in an effort to exert temporary downward pressure on share prices before testing their filing status. Furthermore, we find evidence that the non-accelerated filers’ incentives to undertake the above actions are weaker when they are further away from the $75 million threshold. Finally, we document that the various actions undertaken by the non-accelerated filers post-SOX appear to be effective in that these firms are more likely to remain below the $75 million threshold in the following year.

The full paper is available for download here.

(Editor’s note: A related development was the 2007 establishment in London of the Hedge Fund Standards Board in response to concerns about financial stability and systemic risks associated with the hedge fund industry. The Board monitors conformity by hedge funds with best practice standards, which are available here).

Ted Mirvis, Bill Savitt, David Shapiro and I have written a memo entitled “De-Coupling of Ownership, Economic and Voting Power in Public Companies - The UK’s Financial Services Authority (FSA) Moves Decisively to Close the Gap.” The memo considers the decision of the Financial Services Authority - the UK’s financial and securities markets regulatory authority - to require disclosure of cash-settled and other derivative contracts, on an aggregated basis with ownership of actual common stock, at the 3% level. The FSA’s new policy is aimed squarely at the now-popular technique of making undisclosed accumulations of significant stakes in publicly traded companies through derivative instruments (including cash-settled derivative instruments) and in other non-traditional ways.

The memo also discusses the urgent need for reform of section 13(d) of the Exchange Act to expand required disclosure to include within the definition of “beneficial ownership” all derivative instruments which provide the opportunity to profit or share in any profit derived from any increase in the value of public equity securities, as well as to require disclosure of large short positions. We note that unless and until lawmakers and securities regulators in the U.S. adopt disclosure requirements in accord with what is now the overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques – which must and should be done promptly – U.S. corporations are well advised to adopt such self-help measures as may be available, including appropriate provisions in by-laws, rights plans and other arrangements with change-in-control protections.

The FSA’s statements on this topic are available here and here. Our memo is available here.

Given their leadership positions and compensation, CEOs likely have a significant impact on their companies’ success. And, of course, there is a great deal of anecdotal evidence about what CEOs do and how they matter, particularly in the popular press. Surprisingly, economic theorists provide little guidance, and there is very little systematic, large sample, empirical evidence in the economics, finance and management literatures on how and why CEOs matter.

In “Which CEO Characteristics and Abilities Matter?” Mark Klebanov, Morten Sorensen and I provide new evidence on CEO characteristics and abilities, and their relations to hiring, investment decisions, and firm performance. The problem, historically, is finding information on CEO abilities or characteristics at the time the CEO is hired. We were able to obtain detailed assessments of 316 CEO candidates for positions in firms funded by private equity (PE) investors – both buyout (LBO) and venture capital (VC) investors. The candidates were assessed on more than 30 characteristics, including efficiency, teamwork, and analytical abilities. The assessments were performed from 2000 to 2006 by ghSMART, a firm that specializes in assessing top management candidates.

We find that abilities are generally positively correlated. The abilities can be organized along two important dimensions: (1) general talent and (2) team player and interpersonal talents versus fast, aggressive, and persistent behavior.

We then relate abilities to hiring, investment decisions, and outcomes. CEOs are hired based on general talent and incumbency (firm specific knowledge and skill). Many individual abilities, both team-related and execution-related, are significant, particularly for outsider hires.

Success is also related to general talent, particularly for LBOs. However, when considering team versus execution-related skills, success seems to be more strongly related to execution skills, particularly for LBOs, and not related or negatively related to the interpersonal, team-related skills. And success is not related to incumbency.

The results suggest that CEO talent can be measured and those talents are important for hiring, investment and success. General talent matters for success. However, on the margin, execution-related attributes, not team-related attributes seem to drive success. This suggests that team-related attributes may be overweighted in CEO hiring decisions.

The full paper is available for download here.

(Editor’s note: This post is by Amy L. Goodman of Gibson, Dunn & Crutcher LLP.)

My colleagues and I recently published our thoughts on issues to be considered by boards of directors in deciding whether, and how, to implement provisions addressing the “clawback” of executive compensation. Clawback provisions have become increasingly common in the past few years, and we expect that they will remain a focal point for boards of directors, both because of the ongoing spotlight on executive compensation and because of the attention that institutional shareholders and governance activists have focused on clawbacks as a significant corporate governance and executive compensation issue.

Clawback provisions vary by company, but they share a common goal of enabling companies to recover performance-based compensation to the extent they later determine that performance goals were not actually achieved, whether due to a restatement of financial results or for other reasons.

For boards of directors, the threshold question to consider is whether to address clawbacks in the first place. Doing so sends a message to shareholders that the board is committed to sound executive compensation practices and effective corporate governance, and voluntary implementation of clawback provisions will reduce the likelihood that a company will receive a shareholder proposal. On the other hand, companies need to consider whether the adoption of a clawback will adversely affect their ability to attract and retain executives.

Once a board decides to adopt a clawback provision, there are a number of issues to be addressed in formulating the provision. The memo below goes into more detail about these issues, but they include the following:

1. the individuals to whom the clawback provision should apply (the CEO and CFO, all executive officers or all employees)

2. the types of awards to which the clawback provision should apply (short-term or long-term, or both)

3. the circumstances that should trigger the clawback provision (a material restatement, restatements generally, or any error in financial information)

4. the type of conduct that triggers application of the clawback provision (misconduct by the particular individual from whom the company seeks to claw back compensation, misconduct by any employee, or any conduct that results in incorrect financial information)

5. whether the clawback provision should grant discretion to the board in determining whether misconduct occurred and whether to claw back compensation

6. the extent to which the clawback provision should modify existing employment agreements, compensation plans and award agreements

7. how far back the clawback provision should reach

We welcome comments on this subject, including views of readers as to which approaches make the most sense in various situations. Also, we would be glad to have any examples of cases where a board of directors has actually enforced a clawback policy or contractual provision. The memo is available here.

(Editor’s Note: This post comes from Tracie Woidtke, a member of the Finance faculty at the University of Tennessee College of Business Administration, and a Research Fellow at the Corporate Governance Center at the University of Tennessee.)

In a forthcoming Journal of Financial Economics article co-written with Diane Del Guercio and Laura Seery, entitled Do Boards Pay Attention when Institutional Investor Activists ‘Just Vote No’?, we examine whether the external pressure of a ‘just vote no’ campaign is sufficient to motivate directors to act in shareholders’ interests. ‘Just vote no’ campaigns are organized attempts by activists to convince their fellow shareholders via letters, press releases, and Internet communications, to withhold their vote from one or more directors in an effort to communicate a message of shareholder dissatisfaction to the board.

Our study utilizes a comprehensive sample of 112 publicly announced ‘just vote no’ campaigns during the period 1990 to 2003. We find that ‘just vote no’ campaigns have several characteristics in common with shareholder proposals in addition to their non-binding nature. Specifically, the typical campaign targets a large, poorly performing firm, and is sponsored by a public pension fund. Although other proponent types sponsor campaigns, we only observe institutional investor proponents, and not the small individual shareholders who commonly sponsor shareholder proposals. Proponents typically have broad campaign goals, commonly expressing overall dissatisfaction with firm performance and/or with management and board decisions on firm strategy. Some campaigns, however, are narrowly focused on corporate governance issues, such as removing an insider from the compensation committee. Campaign proponents are typically able to garner vote support from their fellow shareholders.

In contrast to the shareholder proposal literature, we find consistent evidence across a broad set of measures suggesting that on average campaigns are effective in spurring boards to act. The typical campaign target has significant post-campaign operating performance improvements. Moreover, we find a forced CEO turnover rate of 25% in target firms in the one year following a campaign, a rate more than three times higher than the 7.5% rate for a control sample matched on sales and performance, and over 12 times the annual 2% rate in the general population of firms. We find this result to be robust to controlling for a variety of firm performance and governance control variables, as well as for concurrent events, such as changes in the board of directors or external pressure from block-holders. Further analysis reveals that the improvements in operating performance are primarily driven by the campaigns motivated by firm performance and strategy reasons, and not by the campaigns focused on general corporate governance practices. In fact, within these campaigns motivated by firm performance and strategy reasons, we find that boards take a variety of value-enhancing actions; 31% of these targets experience disciplinary CEO turnover and 50% of the remaining targets that do not dismiss the CEO make other strategic changes. Consistent with these board actions being value enhancing, post-campaign operating performance improvements are economically and statistically significantly higher in these sub-samples of target firms. Overall, our evidence suggests that activists can be successful at disciplining managers and directors despite the non-binding nature of withholding votes.

The full paper is available for download here.

Earlier this year, the SEC submitted to the DE Supreme Court two questions pertaining to a bylaw proposal – requiring CA to reimburse the reasonable expenses of a successful “short-slate” board candidate nominated by a stockholder (unaffiliated with management) – that had been submitted by a shareholder for inclusion in the forthcoming CA proxy materials. In its recently issued AFSCME/CA opinion, the Court concluded “yes” to the first question (i.e., whether the bylaw proposal would be a proper subject for shareholder action) … AND … concluded “yes” to the second question (i.e., whether if adopted, it would cause CA to violate any DE law to which it is subject).

The core rationale for the second “yes” was that the bylaw would preempt the Board’s fiduciary duty to exercise its discretion (vis-à-vis any such request) by mandating the payment. The Court concluded that “the Bylaw, as drafted, would violate the prohibition[s] … against contractual arrangements that commit the board of directors to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders”. [emphasis added, footnote omitted]

There has been considerable professional commentary about the Court’s decision. In some cases, writers have taken a short-cut by stating that the problem with the proposed bylaw was that it would interfere with the directors’ role vis-à-vis “management” of the enterprise (e.g., the decision “reaffirms the bedrock principle that the directors of the corporation, not the shareholders, manage the business and affairs of the corporation”). That characterization of the board’s “management” role calls for the recollection of a bit of corporate-law history.

In the early 1970s a prominent outside director – noting that (then-current) DE law “required” him and his fellow directors (serving on the board of a major publicly-owned DE corporation) to manage the business and affairs of that enterprise – demanded that the board be provided a separate staff to assist the board in performing that task. In fact, a literal reading of the relevant DE statutory provision in effect at the time so provided – as was similarly the case with the parallel provision in the Model Business Corporation Act! BUT that literal interpretation of the statute – calling for active involvement by the board with the day-to-day business affairs of the corporation – was clearly not what was intended for the board of a large corporation. AND it was clearly not intended for the board of a large publicly-held corporation!

In reaction, the ABA Committee on Corporate Laws (in its role providing ongoing editorial oversight for the Model Act) amended the Act in l974 to provide that “[a]ll corporate powers shall be exercised by or under the direction of the board of directors … and the business and affairs of the corporation shall be managed by or under the direction of [the board].” [emphasis supplied] Samuel Arsht (at the time a noted leader of the DE corporate bar and a member of the ABA Committee as well) spearheaded a comparable adjustment that was made in the DE statute.

The point here is a very simple one; that is, while the board of directors has authority to engage in the conduct of the corporation’s business and affairs at whatever level it chooses – subject to the directors’ fiduciary duty and, in the case of a DE corporation, subject to any limitation set forth in its certificate of incorporation (as provided by the DE statute) – the CA board of directors does not have obligatory involvement with day-to-day management of the business and affairs of the enterprise. To suggest that it does have a duty to manage the business and affairs of CA, Inc. – or even might – is mischievous!

In a recent working paper entitled Board of Directors’ Responsiveness to Shareholders: Evidence from Shareholder Proposals, Yonca Ertimur, Stephen Stubben and I investigate the frequency, determinants and consequences of boards’ responses to advisory shareholder proposals. Our sample consists of 620 non-binding, MV shareholder proposals between 1997 and 2004.

In recent years, there has been a significant increase in shareholder activism through shareholder proposals submitted for a vote at the annual meeting. Proposals pushing for the adoption or removal of certain governance features (e.g. classified boards, poison pills) are filed by activists in record numbers every year and, in spite of boards’ opposition, sometimes they win a majority vote. Boards face a tough decision. While shareholder votes on these proposals are advisory, ignoring them may have negative consequences, particularly if the proposal wins a majority vote. Directors failing to implement majority-vote (MV) proposals are often the target of “vote-no” campaigns and receive a “withhold vote” recommendation by ISS. Firms ignoring MV proposals end up on CalPERS’ “focus list”, receive lower ratings from governance services and attract negative press coverage. On the other hand, if boards truly believe the proposal is not in the interest of the company, they should not adopt it, in spite of the majority support by shareholders.

We find that, while proposals failing to achieve a majority vote are almost always ignored by the boards, about 30% of the MV proposals are implemented within a year from the vote. Strikingly, the frequency of implementation of MV proposals has almost doubled after 2002, from approximately 20% (1997-2002) to more than 40% (2003-2004), consistent with an increase in the cost of ignoring MV resolutions in the post-Enron environment. The likelihood of implementation seems to depend on the degree of shareholder pressure – in particular, the voting outcome and the influence of the proponent. For example, a MV proposal supported by 70% of the votes cast has a 10% higher chance of implementation than one supported by 55% of the votes cast. The behavior of peer firms and the type of proposals also have an effect, while traditional governance indicators do not seem to matter.

We then focus on the labor market for outside directors to evaluate the consequences of the implementation decision. We find that the implementation of a MV shareholder proposal is associated with approximately a one-fifth reduction in the probability of director turnover at the targeted firm. In addition, implementing a MV proposal is associated with approximately a one-fifth reduction in the probability of losing directorships held in other firms. These “rewards” for responding to MV proposals are higher when the proposal was supported by a higher percentage of votes. If the labor market for directors correctly reflects the quality of their performance, then the presence of reputation rewards (penalties) for responsive (unresponsive) directors may suggest that, on average at least, MV shareholder proposals are viewed as beneficial.

The full paper is available for download here.

(This post is based on a memorandum issued by Mr Olson’s firm, Gibson, Dunn & Crutcher LLP.)

The United States Bankruptcy Court for the District of Delaware recently issued a memorandum opinion in which it refused to dismiss breach of fiduciary duty claims against corporate directors who approved the sale of a financially distressed company’s assets on the eve of bankruptcy.[1] The Court’s opinion sheds light on directors’ duties, and what they can and should do to protect themselves from liability, in such situations.

In Bridgeport, a bankruptcy liquidating trust filed a complaint against the officers and directors of the debtor, traded as “Micro Warehouse,” alleging that they breached their duties to the company, its shareholders and its creditors in connection with a sale of the company’s assets. The complaint alleged that Micro Warehouse began experiencing financial difficulty in 2000. After several years of declining financial performance, in early August 2003, the company concluded that its best option was to execute a sell strategy. At that point, one of the directors called upon an acquaintance at another company, CDW Corporation (”CDW”), to talk about purchasing Micro Warehouse.

In late August 2003, the company formally retained a restructuring advisor and appointed him to the position of Chief Operating Officer. Within 72 hours of commencing work, the restructuring advisor determined to sell the company’s assets. However, instead of hiring an investment bank and commencing a competitive bidding process, the complaint alleged that the restructuring advisor immediately continued the sale process with CDW and reached a handshake deal with CDW on September 2, 2003. During this time, the restructuring advisor made contact with only one other potential acquiror, but provided it with limited due diligence materials. On September 9, 2003, Micro Warehouse sold to CDW a substantial portion of its North American assets. The next day, Micro Warehouse filed for chapter 11 bankruptcy protection.

The liquidating trust sought to recover damages from the officer and director defendants for breaches of the fiduciary duties of loyalty, care and good faith as a result of: (1) failing to put the assets up for sale earlier, (2) failing to hire a restructuring professional earlier in 2003, (3) abdicating all responsibility to the restructuring professional after he was hired, and (4) acquiescing in the decision to sell the assets quickly, immediately before filing a chapter 11 petition, rather than in a court-supervised sale under the Bankruptcy Code.

The complaint made no allegations of self-dealing. As a result, the defendants argued that the breach of duty of loyalty claim must fail. The Court disagreed, pointing out that the Delaware Supreme Court had recently clarified that a claim for breach of loyalty may be premised on a failure to act in good faith. The Court concluded that the liquidating trust had alleged sufficient facts to support a claim that the officer and director defendants breached the duty of loyalty and acted in bad faith by consciously disregarding, or abdicating, their duties to the company. Specifically, the Court said, “the allegations support the claim that the D&O Defendants breached their fiduciary duty of loyalty and failed to act in good faith by abdicating crucial decision-making to [the restructuring advisor], and then failing adequately to monitor his execution of the ’sell strategy,’ resulting in an abbreviated and uninformed sale process; and approving the sale to CDW for grossly inadequate consideration.”[2]

The defendants argued that the breach of duty of care claim must fail because of the exculpation provision in Micro Warehouse’s certificate of incorporation and the business judgment rule. The Court again disagreed, noting that “‘[w]hen a duty of care breach is not the exclusive claim, a court may not dismiss [the duty of care claim] based upon an exculpatory provision.’”[3] Therefore, because the liquidating trust had alleged facts supporting a claim for breach of the duty of loyalty as well as lack of good faith, the exculpatory provision was not cause to dismiss the duty of care claim.

With respect to the business judgment rule, the Court said that to invoke its protections “‘directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them.’”[4] If directors fail to do so, then a court will scrutinize the challenged transaction under the “entire fairness” standard of review. The complaint had alleged that the director and officer defendants had approved an uninformed fire sale of the company’s assets because they had not hired an investment banker to shop the deal or value the assets, they had not obtained a fairness opinion, and they failed to seek offers from other purchasers. As a result, the defendants lost the protection of the business judgment rule.

Plaintiffs will certainly seize upon the Bridgeport decision to press their claims against the directors and officers of financially distressed companies. In particular, plaintiffs will be sure to allege any facts they can to support the inference that officers and directors abdicated their responsibilities and failed to inform themselves of material facts before making decisions. By doing so, under Bridgeport, plaintiffs will hope to make out claims for breach of the duty of loyalty even in the absence of any self-dealing. In turn, by making out such claims, plaintiffs will argue that exculpatory provisions and the business judgment rule will not act to defeat claims for breach of the duty of care.

To limit such claims, directors and officers of financially distressed companies should:

• assume all actions will be scrutinized and second guessed;

• avoid actions that could cause loss of protection of business judgment rule (e.g., conflicts of interest or conflicting loyalties; insider issues; preferential treatment of certain stakeholders, failing to keep informed);

• act with care after obtaining all necessary information (directors, members and managers can rely in good faith on reports prepared by officers or outside experts);

• obtain adequate professional and expert advice on a timely basis;

• in consultation with the company’s advisors, establish and follow a deliberate decision-making process;

• document the decision-making process;

• disclose all material facts;

• in connection with potential transactions, hire investment bankers, obtain fairness opinions and/or seek offers from potential purchasers;

• do not freeze up–no decision is a decision and will likely lead to an argument that duties were abdicated.

[1] See Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 2008 WL 2235330 (Bankr. D. Del. May 30, 2008).

My article entitled “Delaware’s Compensation,” which was published in the Virginia Law Review, focuses on the compensation that Delaware­ – the state in which most public companies are incorporated – is getting from the firms it attracts. For its corporate law – and related services it offers­ – firms pay Delaware an annual franchise tax. The aggregate collections from this tax amount to approximately 20% of Delaware’s annual revenue. It has long been argued that this compensation provides Delaware with incentives to provide corporate law that maximizes shareholder value.

This article points out that the structure of the tax is not optimally designed to provide Delaware with incentives to maximize shareholder value. Delaware’s franchise tax is not based on firm income, market value, or any other measure of performance, but rather functions much like a lump-sum tax. Nearly half of Delaware’s revenue comes from firms who pay the maximum tax rate. For most of the rest of the firms, Delaware’s franchise tax is based primarily on the number of authorized shares. For a small group of firms, the tax is based on, among other things, their assets. Yet, if the tax increases as a result of an increase in assets, Delaware law allows firms to switch to the authorized shares method.

The current tax does not provide Delaware with incentives to improve corporate governance terms that correlate significantly with firm value – such as staggered boards or liability protection for directors and officers – even if improving them could result in an increase of several percentage points, or hundreds of billions of dollars, to the value of Delaware’s firms. Because its tax is not tied to firm performance, even those corporate law amendments that could increase firm value significantly would not increase the amount of tax per firm that Delaware would generate. And since they may antagonize some managers, resulting in some firms reincorporating outside the state, Delaware could even lose revenue from adopting them.

The paper argues that adding a tax component based on changes to corporate value or income on top of the current tax would improve the current system. It would align Delaware’s incentives with those of shareholders and induce it to offer corporate law that maximizes shareholder value. It could have this effect even if Delaware faces no competition from other states over incorporations and even if shareholders are passive.

The paper also argues that Delaware does not have sufficient incentives to change its franchise tax to a more incentive based compensation for several reasons. First, risk aversion and lack of information make Delaware officials reluctant to make any changes to the structure of its franchise tax. Second, the current tax, even though suboptimal, serves Delaware’s interests by creating a commitment that the state will cater to managers’ needs on an ongoing basis, inducing managers to incorporate in Delaware.

For the longstanding debate over the market for corporate law the analysis suggests that it should not result in a race to the bottom or to the top. While the tax that it charges restrains Delaware from racing to the bottom, it does not push it to the top either, but rather to the middle–to produce corporate law that is superior to that of other states, but that falls short of being optimal.

The full paper is available for download here.

In our forthcoming Journal of Financial Economics paper, Managerial Ownership Dynamics and Firm Value, Rüdiger Fahlenbrach and I examine the dynamics of managerial ownership for American firms from 1988 through 2003 and their relation to changes in firm value. We find that the average and median annual change in managerial ownership during that period is negative. Further, we show that a firm that experiences a large change in ownership is substantially more likely to experience a decline in ownership than an increase. High past and concurrent stock returns make it more likely that a firm will experience a large decrease in managerial ownership. In contrast, there is little evidence that low past and concurrent stock returns increase the probability of large increases in managerial ownership. Strikingly, firm characteristics other than stock returns and stock liquidity, such as proxies for information asymmetry, are mostly unrelated to large decreases in managerial ownership driven by sales of shares by insiders.

The widely held view that higher managerial ownership is valuable for shareholders because it aligns the interests of managers better with those of shareholders would make one concerned about the implications of our finding of decreasing ownership for firm value. However, controlling for the determinants of ownership changes, we find no evidence that large decreases in managerial ownership reduce Tobin’s q. In contrast, we show that large increases in managerial ownership can be interpreted, in our experimental design, to cause increases in q. Using insider trading data and a decomposition of changes in managerial ownership, we show further that the positive relation between large increases in managerial ownership and changes in q is driven by increases in shares owned by officers rather than increases in shares owned by directors or changes in the number of shares outstanding.

Our findings suggest the following interpretation. Managers own shares to maximize their welfare subject to constraints and firms start their life with highly concentrated ownership. The highly concentrated ownership of young firms is partly explained by the fact that early in the life of the firm managerial ownership is a cheap form of financing for financially constrained firms. Later in the life of the firm, when the firm is doing well and their reputation has increased, managers start to reduce their stake to diversify. They do so in a way that does not endanger their position or reduce the value of their remaining shares. As a result, sales have little impact on firm value. By buying shares, managers bond themselves to pursuing policies that benefit minority shareholders more – at least as long as their ownership does not become so high that they become safe from removal. Managers buy shares when this bonding effect is valuable to them because it enables the firm to raise funds on better terms and reduces threats to their position. Managers also increase their holdings when the firm is financially constrained and they prevent the firm from becoming more constrained by receiving shares instead of cash.

The full paper is available for download here.

(Editor’s note: The author of this post, Robert Giuffra, argued on behalf of CA in the Delaware Supreme Court.)

My firm has recently issued a memorandum on the Delaware Supreme Court’s decision in CA, Inc. v. AFSCME Employees Pension Plan. The Supreme Court’s decision addressed a proposed stockholder bylaw that would have required the Board of Directors of CA, Inc. to reimburse the reasonable expenses incurred by stockholders in conducting successful “short-slate” proxy contests. The Court held that, while the proposed bylaw related to director elections and, thus, was a proper subject for stockholder action under Delaware law, the proposed bylaw “mandates reimbursement of election expenses in circumstances that a proper application of fiduciary principles could preclude” and, thus, if adopted, could cause CA to violate Delaware law.

The Delaware Supreme Court’s decision has numerous implications. It reaffirms the bedrock principle of Delaware corporate law that the directors of a corporation, not the shareholders, manage the business and affairs of the corporation. The decision confirms that shareholder bylaws may not prevent the directors from fulfilling their fiduciary duties. To attempt to address the concerns articulated by the Court with the proposed bylaw, stockholders may attempt to modify their proposed bylaws in ways that leave boards with discretion to discharge their fiduciary duties. In addition, the decision makes clear that bylaws may not “mandate how the board should decide specific substantive business decisions,” but may “define the process and procedures by which those decisions are made.” Where the line will be drawn between those bylaws that mandate substantive decisions and bylaws that are procedural likely will be decided by the Delaware courts on a case-by-case basis in the future. Finally, under the Court’s reasoning, a binding shareholder bylaw proposal to prohibit a board of directors from adopting or implementing a “poison pill” likely would be deemed improper under Delaware law.

Our memorandum is available here.

(Editor’s note: SEC Release No. 34-55970 (2007), under which the SEC abolished the “Uptick” rule, is available here. In making its decision, the SEC considered its own economic analysis, available here, and four academic studies, three of which are available here, here and here.)

In response to the SEC’s emergency rule, issued Tuesday evening, barring short sales of stock in Fannie Mae, Freddy Mac and seventeen primary dealers, my colleagues Theodore A. Levine, Caitlin S. Hall and I have issued a memorandum entitled “SEC Bars Naked Short Sales of Major Financial Firms; More is Needed.” The emergency rule, which takes force July 21 and will be in effect for thirty days, comes on the heels of a week in which Fannie Mae and Freddie Mac stocks were battered by unsubstantiated rumors. In the memorandum, available here, we urge the SEC to take immediate strong action, including expanding the temporary rule beyond its initial thirty-day period and extending its coverage to all publicly traded securities.

The emergency rule follows the unusual statement on Sunday evening by the SEC that it, FINRA and NYSE Regulation would immediately begin examinations of broker-dealer and investment adviser supervisory and compliance controls, with the goal of stemming the spread of false rumors intended to manipulate security prices. Our memorandum on this development, entitled “SEC Takes First Step to Address Manipulative Rumor-Mongering; More Aggressive Action Still Needed,” is available here.

Although these regulatory developments are commendable, we believe that the SEC should immediately re-impose the “Uptick” Rule, a 70-year-old regulation that constrained short selling in declining markets by requiring that listed securities be sold short only at a price above their last different sale price. In a memorandum on July 1, available here, we discussed the rationale for the Uptick Rule, the Commission’s reasons for abolishing it, and the limitations of the pilot program undertaken by the Commission prior to its decision to abandon the rule. On an urgent basis, we urged the SEC to consider re-imposing the Uptick Rule, or to take alternative measures, in these extraordinary times to dampen volatility and address abusive and manipulative short selling.

The Delaware Supreme Court has issued its opinion in the AFSCME/CA matter. The opinion is available here. We have earlier posted on this important case here, here, and here.

We have received communications from several of our guest contributors.

Ted Mirvis of Wachtell, Lipton, Rosen & Katz writes:

The Delaware Supreme Court much-awaited decision on the AFSCME stockholder bylaw proposal did not disappoint. It is a thoughtful and important treatment of the intersection of stockholder and director authority. The director-centric view won. Here is our memo on the decision.

John F. Olson of Gibson, Dunn & Crutcher LLP offered a different perspective:

While the Delaware Supreme Court’s unanimous opinion, responding to the SEC’s two certified questions, is a clear victory for CA, Inc., and the SEC has already issued the requested no action release, the opinion of the Court provides a road map for different mandatory by-laws dealing with the election of directors that can be adopted by shareholders without offending Delaware law, even if some corporate expense is involved. The key is to leave room for director fiduciary discretion to prevent abuses. Thus, there is something for both sides to cheer about and, in Delaware, the fun has just begun.

J.W. Verret of George Mason University School of Law, who posted with us on the case here, offered the following comments:

For more analysis on this issue, see my essay on SEC Certification to the Delaware Supreme Court here. The verdict is in. First, let’s review the issues. The SEC certified two questions to the Delaware Supreme Court:

1) Is the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?

2) Would the AFSCME Proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

The Court’s ruling is an affirmative answer to both questions. Shareholder proposals like the one at issue in this case are a proper subject of shareholder action, and are not invalid encroachments on Board authority merely because they mandate a payment of money. Yet, as the Court could conceive of a way in which mandated payment could cause the Board to violate its fiduciary duty to the shareholders, the bylaw is illegal under Delaware Corporate Law for lack of a “fiduciary-out” exception.

My prior post, and an analysis from Professor Bainbridge here, describes the recursive loop between DGCL 141 and DGCL 109(a). More commentary from Larry Ribstein, and his compilation of links to other commentators, can be
found here. Rather than avoiding the question, as both counsel invited them to do, the Court faced this paradox head on. Boards and shareholders are both granted the right to amend the bylaws in the DGCL. Shareholder authority to amend bylaws is limited by 141, but the extent of that limitation has been mired in uncertainty. The Court also rejected CA’s argument that any limitations on Board’s authority must be contained in the Certificate of Incorporation.

The Court has given us its first look into the contours of 141’s limit on 109(a). The Court rested in a process/substance distinction outlined in previous Court of Chancery opinions. Bylaws mandating substantive business decisions are impermissible, but bylaws altering the process whereby Boards make decisions are permitted. In analyzing this bylaw, the Court announced “We conclude that the Bylaw, even though infelicitously couched as a substantive-sounding mandate to expend corporate funds, has both the intent and the effect of regulating the process for electing directors of CA.”

As to the second question, the Court held that, because of conceivable circumstances in which the bylaw could require the Board to reimburse insurgents running solely for personal reasons, there are conceivable situations in which the bylaw would require the Board to violate its fiduciary duty. This relied on similar holdings in Quickturn and Paramount v. QVC. The Court was unconvinced that the fact that limitation was shareholder adopted reduced the impact on the board’s ability to discharge its fiduciary duties. (Though including this mandate in the Certificate of Incorporation would be permissible.) The Court relied on its prior holding in Hibbert v. Hollywood Park for the proposition that only reimbursement for contests involving substantive differences about corporation policy are permitted.

Technically this is a loss for AFSCME, but the opinion should be considered a measured victory for the shareholder activist community. A reimbursement bylaw with a fiduciary duty out exception does not eliminate all of the risk associated with funding a proxy campaign. Only proxy access to the corporate ballot can do that. But such a bylaw would significantly reduce the risk associated with funding a proxy campaign. There is a good chance that a Board’s decision to withhold reimbursement through claims that its fiduciary duty requires it would be subject to heightened review under Blasius, since the Court has accepted that this bylaw is intimately connected with the election process and candidate’s incentives to run for election.

FedEx Corporation became the fourth major company this proxy season to reach an agreement with me under which it adopted a pill-limiting bylaw. Under the new bylaw, any poison pill plan adopted by the board without prior stockholder approval shall expire no later than one year following its adoption if not ratified by a stockholder vote.

The agreement followed my submission of a shareholder proposal to amend FedEx’s bylaws. Following the agreement, the board of FedEx adopted the new bylaw and I withdrew the shareholder proposal. While the bylaw’s limitation on poison pills not approved by stockholders is consistent with Fed Ex’s preexisting policy statement on poison pills, the board’s action incorporates this limitation in the company’s legally binding bylaws.

In addition to Fed Ex, other companies that, following my shareholder proposals, agreed to amend their bylaws to incorporate pill-limiting provisions are JCPenney, Safeway, CVS Caremark, Disney, and Bristol-Myers Squibb. I hope that other public companies will follow the example set by these six companies.

I would like to express my appreciation again to Michael Barry and Ananda Chaudhuri from the law firm of Grant & Eisenhofer for their valuable legal advice and legal representation in connection with my shareholder proposals in general and the pill bylaw proposals in particular. I also wish to thank again Greg Taxin and Julie Gresham of Spotlight Capital Management for advising me on engagement with companies.

The amended bylaws of FedEx, filed yesterday with the SEC, and containing the new Section 13 of Article III, are available here.

(Editor’s Note: The post below comes to us from Jennifer G. Hill of the University of Sydney, Australia, who has a continuing position as Visiting Professor at Vanderbilt Law School.)

In Unocal Corp v Mesa Petroleum Co (493 A. 2d 946, 957 (Del SC, 1985), the Delaware Supreme Court stated that “our corporate law is not static. It must grow and develop in response to, indeed in anticipation of, evolving concepts and needs”. Historically, however, this evolution and growth has occurred with only limited and sporadic attention to international corporate governance regimes.

In my recent paper, Regulatory Show and Tell: Lessons from International Statutory Regimes, which was recently presented at a recent Symposium at Widener University to mark the 40th anniversary of major revisions to the Delaware General Corporation Law, I examine reasons for the relative lack of attention in the US to international corporate regimes. One possible reason is the influence of competition for corporate charter theory in the US. Another is the fact that it is often assumed that a standardized Anglo-US model of corporate governance exists, and that US corporate law reflects the law in other common law jurisdictions.

The paper challenges the assumption that there is a harmonized common law model of corporate law, by reference to differences between the approach of the US and some other common law jurisdictions in the topical area of shareholder rights. The paper argues that, at a time when there is growing skepticism about the influence today of the competition for corporate charters, it makes sense for the US to examine and test how international jurisdictions address common problems in corporate regulation. One recent event reflecting growing interest in this regard was the announcement by the SEC in March 2008 that it had entered into a pilot mutual recognition program with Australia in relation to securities market regulation.

The paper is available here.

Writings by three Harvard Law School professors — Lucian Bebchuk, Mark Roe, and Guhan Subramanian – were selected to be among the 10 Best Corporate and Securities Articles of 2007 in the annual poll of corporate and securities law faculty around the country. This is a repeat appearance on the top ten list for each of these authors.

Bebchuk’s articles appeared on the top-ten list of the year’s best corporate and securities articles in each of the last six years. The 2007 top ten list included his article The Myth of the Shareholder Franchise. In addition, he had seven articles in the top-ten lists of the preceding five years:

• Letting Shareholders Set the Rules in the 2006 top-ten list;

• The Case for Increasing Shareholder Power in the 2005 top-ten list;

• Firms’ Decisions Where to Incorporate (with Alma Cohen) in the 2004 list;

• Does The Evidence Favor State Competition In Corporate Law? (with Alma Cohen and Allen Ferrell) and The Powerful Antitakeover Force of Staggered Boards: Further Findings and a Reply to Symposium Participants (with John Coates and Guhan Subramanian) in the 2003 list; and

• Managerial Power and Rent Extraction in the Design of Executive Compensation (with Jesse Fried and David Walker) and Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy (with John Coates and Guhan Subramanian) in the 2002 list.

Roe’s article in the 2007 top-ten list is Legal Origins, Politics, and Modern Stock Markets. He has three other articles in the top-ten lists of the preceding five years:

• Delaware’s Politics in the 2005 list;

• Delaware’s Competition in the 2003 list; and

• Corporate Law’s Limits in the 2002 list.

Subramanian’s article selected for the 2007 top-ten list is Post-Siliconix Freeze-outs: Theory and Evidence. His prior contributions to the top-ten lists are:

• Fixing Freezeouts in the 2005 list;

• Bargaining in the Shadows of Takeover Defenses and The Disappearing Delaware Effect in the 2004 list;

• The Powerful Antitakeover Force of Staggered Boards: Further Findings and a Reply to Symposium Participants (with Lucian Bebchuk and John Coates) in the 2003 list; and

• The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy (with Lucian Bebchuk and John Coates) in the 2002 list.

The full list of the best corporate and securities law articles of 2007 is available here.

My partners Craig M. Wasserman, Richard K. Kim, Lawrence S. Makow, Nicholas G. Demmo and Matthew M. Guest and I have recently issued a memorandum entitled “Acquisition of Troubled Financial Institutions and Assisted Transactions.” The memorandum discusses the credit-related losses suffered by some financial institutions, their efforts to raise capital, and the increasingly prominent role played by federal and state regulators in monitoring and shoring up the capital and liquidity situations of struggling institutions. Against this backdrop, the memorandum discusses the FDIC’s historical approach to addressing failures of insured depository institutions. In this context, the FDIC is required by law to guarantee insured deposits and dispose of the failed institution’s assets in the manner least costly to the FDIC’s deposit insured fund. We also discuss the FDIC’s formal resolution process, which may include a managed auction to dispose of failed bank franchises, and explain the options open to the FDIC after a bank has been declared insolvent. In view of distinguishing features of the current economic downturn, we expect a more receptive regulatory climate for private investments into banks and thrifts.

The memorandum is available here.

(Editor’s note: Posts by Brian Cadman and Tatiana Sandino, available here and here also analyzed the role of compensation consultants in setting pay.)

In a recent working paper, Christopher Armstrong, Christopher Ittner and I investigate the relation between the use of compensation consultants and CEO pay levels. We conduct an analysis using proxy disclosures by a diverse sample of 2,116 companies. Consistent with claims that executive pay levels in clients of compensation consultants are higher than justified by economic characteristics, ordinary least squares (OLS) regressions that control for a wide variety of economic determinants of compensation indicate that total pay is higher for clients of most (but not all) of the consulting firms relative to companies without consultants. The OLS results also suggest that pay levels of clients of the larger, most frequently used compensation consultants are higher than those of firms using other consulting firms (most of which are smaller, boutique compensation consultants) in some model specifications. However, when more sophisticated propensity score matched pair analyses are used to relax the stringent functional form assumptions imposed by OLS models and to assess correlated omitted variables problems, most differences between the individual consulting firms disappear, though the statistically higher levels of total pay at companies using compensation consultants persist.

When we add governance variables, we continue to find higher pay in clients of most consulting firms in OLS regressions. In contrast, we find no significant differences in total pay levels between users and non-users of consultants or among the various consulting firms when propensity score matched pair analyses are used. This evidence indicates that once companies with similar economic and governance characteristics are compared and OLS’s strict functional form is relaxed, pay levels are not significantly different, suggesting that governance differences account for much of the unexplained pay differences between consultant users and non-users.

Further analysis indicates that these results are due (at least partially) to pay levels for clients of individual consulting firms varying with governance strength, with weaker governance within clients of a given consultant associated with higher total pay. These results suggest that the higher pay found in consulting clients is at least partially explained by the link between weaker governance and higher pay in companies using consultants. This is consistent with the rent extraction view of the association between compensation consultant use and CEO pay. Finally, we find no support for claims that CEO pay is higher for clients of potentially “conflicted” consultants that offer a broad range of advisory services relative to clients of specialized, “non-conflicted” compensation consulting firms.

The full paper is available for download here.

(Editor’s Note: This post is by John F. Olson and Amy L. Goodman, partners at Gibson, Dunn & Crutcher LLP in Washington, DC)

In a post to this blog on June 25th, Marty Lipton presented a paper entitled “Shareholder Activism and the Eclipse of the Public Corporation: Is the Current Wave of Activism Causing Another Tectonic Shift in the Public Corporation?,” in which he expressed concern about the eroding centrality of the board and its vulnerability to pressure to seize short-term value at the expense of long-term value creation. Marty is one of our most experienced and thoughtful observers of corporate governance trends, based in large part from his front row seat as an advisor to many corporate boards and managements. However, while his points of caution are well worth bearing in mind, we think that directors and those who advise them must do more than decry what to many are troublesome trends that erode the ability of the board to take decisive action on behalf of the corporate enterprise.

The new world of inexpensive and constant communication is not limited to the corporation and its constituents; it is part of everyday life in every realm. Shareholder and other interest groups are going to make themselves heard; proxy contests are going to be cheaper and more accessible to those who may have short term goals; regulation will continue to be hard pressed to adapt quickly to these changes. In response to this environment, which we argue is inescapable, we submit that it’s time to move beyond the us (corporate board/managers) versus them (shareholder) mindset and recognize the commonality of interest that exists between boards and most shareholders in creating long-term value. We are preparing a paper that will develop these ideas in more detail but wanted to encourage more dialogue surrounding these important issues now.

Given the increasingly complex and global world facing corporations today, we need to get away from focusing on the corporate governance issue du jour or per annum to assisting the Board in addressing its complex role. In recent years, there has been an annual “hot” corporate governance issue–from declassifying boards, to shareholder approval of poison pills, to majority voting for directors, to an advisory vote on pay. While companies have embraced many of these proposals, boards of directors are becoming increasingly concerned about the amount of time and attention they, management and the company’s advisors must spend on responding to the corporate governance issue du jour. It may be time to step back and consider whether other issues should take priority, especially given the state of the economy and the many challenges facing corporate America.

In our upcoming paper, we will address some of the issues that deserve focus from shareholders, directors, business executives and other interested stakeholders.

• First, and not necessarily in order of importance, we need to develop effective methods of board/shareholder communication that build on new electronic capabilities but are not burdensome and do not increase liability risks.

• Second, boards and business executives need to effectively and regularly communicate corporate strategy and the board’s oversight role to investors, the business press and analysts, once again without fear of increased liability.

• Third, companies need to make good investor relations, and “good listening” a day to day corporate priority, and shareholders need to take advantage of these opportunities to present their views to business executives and directors.

• Fourth, shareholders need to think for themselves and reduce their reliance on proxy advisory services and be more transparent in their proxy voting decision-making processes.

• Fifth, companies, boards and their advisors need to figure out a way for directors to spend more time addressing strategy and risk and less time on compliance.

• Finally, while efforts to better educate directors about corporate governance and their fiduciary responsibilities has been salutary, we now need to shift our efforts to better educating directors in understanding the businesses, including the risks, of their companies.

(Editor’s note: This post summarizes today’s oral argument in Delaware. For previous posts on the Blog about the case, and for the parties’ briefs, see here and here.)

AFSCME Employees Pension Plan submitted a shareholder proposal for inclusion in CA’s proxy materials for their annual meeting scheduled to be held on September 9, 2008. That proposal sought to amend CA’s bylaws to require the company to reimburse the reasonable expenses incurred by a dissident nominating a rival slate of directors, provided that at least one nominee from the dissident slate was victorious. CA sought no-action relief from the SEC permitting it to exclude that proposal under Rule 14a-8 as illegal under Delaware law, and the SEC certified the question to the Delaware Supreme Court. The Court’s opinion stands to re-define the nature of corporate federalism and ring in a new collaborative relationship between the Delaware Courts and the SEC. Indeed, it may encourage the SEC to include more state law carve-outs in future rule-making.

I wrote an essay (available here) on this issue in March predicting that the SEC would certify the bylaw question to Delaware soon. For more on the growing trend of shareholder democracy behind this challenge, see Pandora’s Ballot Box, or a Proxy with Moxie: Majority Voting, Corporate Ballot Access, and the Legend of Martin Lipton Re-Examined (available here). For more on bylaws, see Profs. Coates and Faris’s work (Second-Generation Shareholder Bylaws: Post-Quickturn Alternatives, 56 Bus. Law. 1323 (2001) (with B. Faris)) and Prof. Hamermesh’s article (available here). Anticipating that the opinion in this difficult case might make use of dicta guidance, see also my article with Chief Justice Steele on the Delaware Guidance Function (available here).

This post summarizes a very lively oral argument in Dover, Delaware this morning. The Justices and the parties displayed a rigorous command of this intricate subject, working in a very short timeframe. It was fascinating to watch these masters of the Delaware General Corporation Law at the height of their craft.

Arguing on behalf of Computer Associates was Robert Guiffra of Sullivan & Cromwell. His presentation focused on two key issues: first, he argued that this bylaw does not relate to an election of directors, but merely comes into play after the election, and thus is not protected by the principles in the Blasius line of cases. As a mandated payment of expenses it relates to control of the corporate treasury, part of the business and affairs of the corporation as defined in Rule 141(a). As such, limitations on the Board’s authority may only appear in its Certificate of Incorporation, not its bylaws. Second, he argued that the Board must be permitted to make a determination of whether a reimbursement was consistent with its fiduciary duty, where this bylaw mandated payment under all circumstances.

Arguing on behalf of AFSCME was Michael Barry of Grant & Eisenhofer. His presentation focused on two key issues: first, he argued that this bylaw relates to an election, implicates the shareholder franchise and Blasius review, and is not a part of the ordinary business affairs of the corporation. As such, it does not undermine the Board’s authority under section 141. He also argued that where directors are mandated to reimburse expenses, they cannot be doing so for the purposes of entrenchment, and thus cannot logically do so in violation of their fiduciary duties. He also cited Delaware’s approval of mandatory indemnification bylaws as binding precedent on this issue.

Both Counsel admitted that, though the bylaw was unclear, reimbursement of expenses for the full contest and not just for the successful nominee was anticipated. Both parties also skillfully argued that the Court need not permanently resolve any looming contradiction between section 109 and section 141(a) to rule in their favor. Section 109 of the DGCL grants shareholders the right to adopt bylaws, and section 141(a) reads that “the business and affairs of every corporation…shall be managed by…a board of directors.” Thus, the oft referenced “recursive loop” in which a bylaw adopted under section 109 might limit a board’s authority under 141(a). The Court nevertheless asked counsel’s opinion concerning the intent of the legislature in creating two conceivably conflicting sections of the code.

Questions from the Court during oral argument make any predictions difficult. The Justices pushed counsel for CA over whether the prospect of reimbursement was inextricably linked to the success of an election, and whether the bylaw would be legal if adopted by the Board. The Justices pushed counsel for AFSCME over whether there might be any circumstances under which a bylaw could force inequitable reimbursement and whether the Board’s authority to adopt bylaws was co-extensive with that of shareholders. Interestingly, Justice Berger, when she served as a Vice Chancellor, suggested in dicta that stockholders create a bylaw limiting the board’s power to amend a stockholder adopted bylaw in American Int’l Rent a Car, an opinion from 1984, which may indicate her view on whether the right to adopt bylaws is co-extensive. The Court also questioned whether the “reasonable” qualifier in this bylaw left enough room for board discretion not to reimburse wasteful expenses.

My own prediction is a substantive victory for AFSCME is possible, but the holding would be limited. If the Court allows election bylaws that mandate board action, it may require bylaws mandating board action have a “fiduciary out” clause similar to what we see in deal lock-in measures. This could be accomplished, I think, either by ruling that the bylaw is illegal only for lack of a fiduciary-out or ruling that the bylaw is legal but that a Board could ignore it if it’s fiduciary duty required it (board action which would then be critically reviewed under subsequent challenge, and the standard of that review for such a decision could be formulated in this opinion). The one thing I am most confident about is that the Court is likely to leave open the possibility to rule that other forms of bylaws, especially poison pill related bylaws, run afoul of 141(a).

In advance of the scheduled Delaware Supreme Court hearing tomorrow on the validity of the proposed shareholder-adopted election bylaw submitted for inclusion in the proxy materials of Delaware corporation CA, Inc, we are posting the briefs of the two sides, which were filed yesterday. As previously reported on the Blog, the case is before the Court on two questions certified by the Securities and Exchange Commission and accepted by the Court. Submitted by AFSCME Employees Pension Plan, the bylaw would require the company to reimburse reasonable stockholder expenses incurred in running a short slate of director nominees for election.

The brief of CA, Inc is here, and the brief of AFSCME Employees Pension Plan and its appendix are here and here. Oral argument is scheduled for tomorrow, July 9, at 10:00 a.m.

My paper “Liquidation Values and the Credibility of Financial Contract
Renegotiation: Evidence from U.S. Airlines” co-written with Nittai Bergman, which is forthcoming in the Quarterly Journal of Economics, documents empirically the conditions under which airlines renegotiate aircraft leases in the United States. The control rights that financial contracts provide over firms’ underlying assets play a fundamental role in the incomplete contracting literature since the threat of asset liquidation motivates debtors to avoid default. Thus, in the incomplete contracting literature, asset liquidation values play a key role in the ex-post determination of debt payments. To date, there is little empirical evidence analyzing the ability of firms to renegotiate their financial liabilities and the role asset values play in such renegotiations. This paper attempts to fill this gap.

We develop an incomplete-contracting model of financial contract renegotiation and estimate it using data on the airline industry in the United States. Our model has two testable implications. First, firms will be able to credibly renegotiate their financial commitments only when their financial situation is sufficiently poor. Second, when a firm’s financial position is sufficiently poor, and hence its renegotiation threat is credible, a reduction in the liquidation value of assets increases the concessions that the firm obtains in renegotiation.

Our empirical analysis examines renegotiation of leases amongst U.S. airlines. We collect data on all publicly traded, passenger-carriers and construct a dataset which includes information about contracted lease payments, actual lease payments, and fleet composition by aircraft type.

In addition, we construct four different measures of the ease of overall re-deployability of an airline’s leased aircraft. We find that publicly traded airlines often renegotiate their lease contracts. Furthermore, we show that aircraft lease renegotiations take place when liquidation values are low and airlines’ financial condition is poor. We supplement our analysis by studying lease renegotiation out of bankruptcy. We find that, even out of bankruptcy, airlines in poor financial condition can reduce their lease payments and that lower fleet re-deployability enables these airlines to extract greater concessions from their lessors.

The full paper is available for download here.

(Editor’s note: We have received other memoranda on the proposed amendments to Statement of Financial Accounting Standards No. 5 by Eric Roth of Wachtell, Lipton, Rosen & Katz and our guest contributor Holly Gregory of Weil, Gotshal & Manges LLP. The memoranda are available here and here.)

My colleagues and I have prepared a memorandum summarizing the serious concerns raised for public companies by proposed amendments to the Financial Accounting Standards Board’s Statement of Financial Accounting Standards Number 5, dealing with loss contingencies. Boards of directors, particularly audit committee members, and those who advise boards should become familiar with the proposed amendments and the potential consequences, which include earlier, more detailed public disclosure and, including liability estimates, for litigation and other claims, even in cases where the company expects to prevail or does not believe there will be a material cost to settle the matter. Comments in writing are due on this proposed amendment by August 8, 2008 and FASB will thereafter host an open forum on the issue at which those who have submitted comments may testify. We welcome reactions to the concerns we have expressed.

The memorandum is available here.

The Staff of the Securities and Exchange Commission has certified to the Delaware Supreme Court two questions of law regarding the permissibility of a bylaw amendment submitted as a shareholder proposal to a Delaware corporation, CA, Inc. The amendment would require the company to reimburse reasonable stockholder expenses incurred in running a short slate of director nominees for election. This is the first time that the SEC has used this certification procedure.

CA asserts that the shareholder proposal may be excluded from its 2008 proxy materials under Exchange Act Rule 14a-8 on the grounds that the proposal is an improper subject for shareholder action under Delaware law and that the proposal, if adopted, would cause CA to violate Delaware law. The Court has agreed to an immediate determination of the questions certified and ordered briefs to be filed on or before Monday, July 7. Oral argument is to be held on Wednesday, July 9.

The Supreme Court’s order accepting the questions certified by the SEC is available here. The SEC’s certification of questions of law, with the SEC General Counsel’s covering letter, are available here and here. The competing legal opinions are available here and here.

Together with my colleagues Adam Emmerich and Sabastian V. Niles, I have issued a memorandum entitled “Sovereign Wealth Fund Investment in the U.S. - Six Months Later,” which discusses the surprising slowdown in SWF Activity in the U.S. since the end of 2007 and into the opening weeks of 2008 when investment activity by these funds reached new heights. Our memorandum discusses some of the reasons for the slowdown, highlighting the possibility that the uncertain political receptivity to SWF investments and heightened regulatory activity has chilled SWF interest in the U.S. by increasing the costs and risks of investment. The memorandum concludes by calling for continued SWF activity in order to develop a track record of successful investments that will help cause political concerns to recede and by identifying the critical issues for those SWF transactions that get to the negotiation phase.

The memorandum is available here.

It is well known that firms contribute money to politicians. It is also widely held that such money, in the form of campaign contributions and lobbying expenditures, is used to buy access to and/or favors from politicians. Firms and politicians establish relationships with one another and the value to firms of such relationships likely increases over time. When a politician with a well-established relationship to a firm faces a tough election prospect, it is in the firm’s interest to secure that politician’s future. One obvious way to do so is to make further monetary contributions directly to the politician’s campaign. A priori, direct monetary contributions are not the only channel through which firms can deliver benefits to candidates during political campaigns. In a recent working paper, Sugata Roychowdhury of MIT and I investigate whether political contributions can take a non-cash form, specifically (accounting) information. In other words, we investigate whether (accounting) information can be used as political currency?

Our setting is the US congressional election of 2004, where outsourcing of US jobs was a campaign issue. Firms engaged in outsourcing activities had incentives to ensure that political candidates they were affiliated with did not suffer from negative media due to the outsourcing. These incentives were likely to be strongest when the candidates were in competitive races. We test whether outsourcing firms understated profits in the period leading up to the 2004 election, in circumstances where the firms’ affiliated candidates were in competitive races. Understating profits can help deflect attention away from the firms’ outsourcing activities, and thus spare the candidates considerable embarrassment. We find that outsourcing firms donating to congressional candidates in closely watched races managed their earnings downwards in the two quarters immediately preceding the 2004 election. We find no evidence of downward earnings management among outsourcing corporations donating to congressional candidates not in closely watched races.

Ceteris paribus, if donors’ downward earnings management is effective in deflecting attention away from outsourcing, thus sparing candidates from negative media, we expect such candidates to do better in the election (than the average candidate). In regression tests that control for likely determinants of election outcomes, we find vote shares for candidates are increasing in the extent of their corporate donors’ downward earnings management. Overall, our findings are consistent with firms managing accounting information in circumstances where this is likely to benefit allied politicians. The evidence is consistent the hypothesis that accounting information can be used as political currency.

You can read the entire paper here and an interview with me over the paper here.

As regulators increasingly embrace cooperative approaches to governance, voluntary public-private partnerships and self-regulation programs have proliferated. However, because few of these partnerships and programs have been subjected to robust evaluation, little is known about their effects. In my paper with Mike Toffel, “Coming Clean and Cleaning Up: Is Voluntary Disclosure a Signal of Effective Self-Policing?” we ask whether and in what ways self-regulatory practices at a subset of regulated facilities enhance the effectiveness of the regulatory scheme.

In the context of a program sponsored by the U.S. Environmental Protection Agency that encourages regulated entities to voluntarily self-police and self-disclose regulatory violations, we analyze whether such voluntary disclosures are a good signal of a facility’s effective self-policing practices. There are two components to this question. First, do facilities that send the self-regulation signal outperform those that do not? Second, what is the agency’s response to the signal? Are regulators effectively sorting the good facilities from the bad, and are they leveraging this information in a way that enhances the effectiveness of their enforcement efforts?

We find that, on average, self-policing facilities improved their environmental performance, as measured by a decline in the number and probability of abnormal events resulting in toxic pollution. However, upon closer examination, we find this effect to be significant only among “good apples,” or facilities with clean past compliance records. We find no evidence of improvement among facilities with more problematic compliance histories. In other words, it appears that voluntary disclosure is an effective signal for distinguishing the “great” apples from the merely “good” apples, but not for determining whether a “bad” apple has turned good.

With respect to the behavior of the regulatory agency, we find that regulators are interpreting these signals with a high degree of accuracy and responding accordingly. Our analysis shows that regulators significantly reduced their scrutiny of self-disclosers that were “good apples” (or those that improved their environmental performance) but continued to keep a watchful eye on the “bad apples” (who did not improve).

Taken together, these findings support the theoretical promise of meaningful self-policing practices and suggest that voluntary disclosure can serve as a reliable signal of future compliance under certain circumstances. But, at the same time, they highlight the way in which self-regulation outcomes are contingent on the organizational contexts into which self-regulatory practices are adopted. Our analysis also highlights the possibilities for gaming that self-regulation introduces into the regulatory system, but we demonstrate that, at least in this context, regulators do not appear to be fooled.

The full paper is available for download here.

My paper entitled “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors”, which I co-wrote with Emanuel Zur and which was recently accepted for publication in the Journal of Finance, examines recent aggressive campaigns by entrepreneurial shareholder activists, which we define as an investor who buys a large stake in a publicly held corporation with the intention to bring about change and thereby realize a profit on the investment.

We conduct our analyses on two samples of entrepreneurial activists. The first sample consists of 151 hedge fund activist campaigns conducted primarily between 2003 and 2005. The second sample contains 154 other entrepreneurial confrontational activist campaigns over the same time period. These activists are composed primarily of individuals, private equity funds, venture capital firms, and asset management groups for wealthy investors. The common feature of each group is that the investor is relatively free from the regulatory controls of the Securities Act of 1933, the Securities Exchange Act of 1934, and most notably the Investment Company Act of 1940.

We find similarities and disparities between our samples of hedge fund and other entrepreneurial activists.

The three main parallels are market reaction to the activism, a further significant increase in share price for the subsequent year, and the activist’s success in gaining its original objective. These findings suggest that the market, on average, believes activism creates shareholder value. Moreover, ex ante, the market is able to differentiate between overall successful and non-successful campaigns. For both groups of activists, the abnormal return surrounding the initial Schedule 13D filing is significantly higher for firms in which the activist gains its objective within one year, when compared to those firms in which the activist is unsuccessful.

The two main differences between the two categories of entrepreneurial shareholder activists are the types of companies each group targets and the activists’ post-13D filing strategies. Hedge fund activists target more profitable and financially healthy firms than other entrepreneurial activists. Hedge funds appear to address the free cash flow problem, since hedge fund activists frequently demand the target firm to buy back its own shares, cut the CEO’s salary, or initiate dividends, whereas other activists do not make these demands. In contrast, other entrepreneurial activists appear to redirect the investment strategies of their targeted firms.

The full paper is available for download here.