(Editor’s Note: This post comes from Ning Chiu and Michael Kaplan of Davis Polk & Wardwell.)

The Securities and Exchange Commission has issued an interpretive release on the use of corporate websites by public companies. The release provides a means of complying with Regulation FD through posting information on websites in certain circumstances, and also gives additional clarification as to the use of websites for providing other information to investors. While we do not expect the release to lead to significant changes in practice for most companies, it presents a valuable opportunity for companies to revisit their website-related practices.

Our memorandum, available here, explains the circumstances under which information posted on a company’s website will be considered “public” for purposes of Regulation FD and factors companies should consider in determining whether to alter their practices for disseminating information in view of the SEC’s new guidance. The interpretative release may be accessed here.

The SEC is soliciting comments on issues concerning corporate use of technology in providing information to investors. Comments are due on or before November 5, 2008.

In a recent working paper co-written with Rick Mergenthaler and Shiva Rajgopal entitled CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks, we investigate whether missing quarterly earnings benchmarks is associated with career consequences in the form of lower compensation (bonus, equity grants) and the dismissal of the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO).

Prior research has found that a disproportionately large number of firms appear to meet or just beat quarterly earnings benchmarks relative to firms that just miss these benchmarks. Why do managers work this hard to meet or beat these quarterly earnings benchmarks? We propose that the CEO and CFO suffer negative career consequences if they repeatedly miss quarterly earnings benchmarks. We examine three earnings benchmarks - analyst consensus forecast, seasonally lagged quarterly earnings, and zero earnings. We evaluate a comprehensive set of career consequences such as the impact on compensation (bonus and equity grants) and dismissal from office for both CEOs and CFOs, conditioned on failure to meet quarterly earnings benchmarks.

Our sample includes CEOs and CFOs for the S&P 1500 firms covered in the ExecuComp database. We examine over 11,000 firm-year observations during the years 1993-2004 and investigate whether bonus changes and equity grants are associated with the failure to meet or beat quarterly earnings benchmarks after controlling for the known determinants of such compensation and for measures of firm performance such as stock returns, return on assets, and the magnitude of the earnings surprise. We use news articles to determine the circumstances surrounding each CEO and CFO’s departure to classify such turnover as forced dismissals. Our analysis seeks to predict CEO and CFO forced turnover as a function of the failure to meet earnings benchmarks. We find evidence that the failure to meet quarterly earnings benchmarks, especially the analyst consensus estimates, is associated with lower bonus and equity grants, and a higher probability of forced dismissal for both the CEO and the CFO, after controlling for several proxies for performance.

In economic terms, failing to meet two quarterly analyst consensus forecasts in a year is associated with a lower bonus equivalent to 14% (8%) of the CEOs (CFOs) salary, a lower equity grant of 24% relative to an equity grant with no misses for both the CEO and the CFO, and a 0.61% (0.62%) higher probability of being dismissed for the CEO (CFO). If the firm fails to meet all four consensus quarterly earnings forecasts in a year, the penalties jump to a lower bonus equivalent to 28% (16%) of the CEOs (CFOs) salary, a lower equity grant of 48% relative to an equity grant with no misses for both the CEO and the CFO, and a 1.51% (1.53%) higher probability of being dismissed for the CEO (CFO). Compared to the unconditional probability of forced dismissal (which is 3% for CEOs and 5% for CFOs), the dismissal penalty appears to be significant in an economic sense. We also find systematic cross-sectional and inter-temporal variation in the nature of these career consequences. In particular, career consequences for both the CEO and CFO are worse if they miss quarterly earnings benchmarks and their firms provide earnings guidance. Bonus cuts on missing quarterly benchmarks are greater if the firm has a history of consistently meeting or beating quarterly benchmarks in the past. In addition, career penalties to missing quarterly earnings benchmarks have increased in the post-Sarbanes-Oxley Act time period.

The full paper is available for download here.

Having now become explicitly government-backed entities, Fannie Mae and Freddie Mac (and their supporters in Congress) can no longer argue that they do not pose a risk to taxpayers. It is not politically feasible for the government to back private companies when their shareholders and managements keep the profits but the taxpayers cover the losses. Thus, even if they escape their current precarious financial straits, Fannie and Freddie are now operating in a kind of twilight before they will eventually have to be nationalized, privatized, or liquidated. In addition, the recent attention to covered bonds as a way to finance mortgages suggests that, in the future, Fannie and Freddie’s traditional business–buying and holding or securitizing mortgages–will no longer be essential to U.S. housing finance. An analysis of the available options for policymakers suggests that the best course–from the standpoint of taxpayers–is not to keep Fannie and Freddie alive through the injection of government funds but to allow them to go into receivership. A receiver can continue their operations in the secondary mortgage market and–using the Treasury line of credit recently authorized by Congress–meet their senior debt and guarantee obligations as they come due. A decision to nationalize, privatize, or liquidate them can be made at a later time and can be implemented more simply and efficiently through a receivership than if the companies are helped to survive through government recapitalization.

It took a hair-raising crisis in the housing and international capital markets, but for Fannie and Freddie, the wondrously generous world of Washington–the world they have dominated for so many years with threats, intimidation, and sheer financial and political muscle–is at last coming to an end. Both companies are hovering near insolvency. Whether they can avoid eventual receivership will depend on how much further housing values fall. But even if they are lucky enough to survive this current crisis, their halcyon days will never return. This is not because Congress has learned any kind of lesson. Without question, the preferred position in Congress, especially on the Democratic side of the aisle, will be to reconstitute Fannie and Freddie as newly recapitalized government-sponsored enterprises (GSEs).

But this will not fly politically. The world was irretrievably changed by the Housing and Economic Recovery Act of 2008 (HERA) signed by President Bush on July 30, 2008. The act, in effect, authorized the bailout of the companies by giving the secretary of the treasury the authority to make unlimited loans to, and equity investments in, both GSEs. Thus, HERA resolved once and for all whether Fannie and Freddie were actually backed by the U.S. government; it provided the explicit backing that investors always believed would ultimately be there and that the enterprises themselves vigorously denied. But now that they are explicitly backed by the U.S. government, the GSEs can no longer claim that they represent no risk to taxpayers. As explicitly government-backed entities, they cannot deny the obvious: that their profits will go to their managements and shareholders while their losses will be picked up by taxpayers. This fact is crucial to their future.

The privatization of profit and the socialization of risk inherent in this new arrangement is politically untenable, even though it may take some time for Congress to see the substantial difference between their former status as merely government-sponsored and their new status as explicitly government-backed. Inevitably, however, the light will dawn and their form will have to be changed. The question, then, comes down to whether Fannie and Freddie will, in the future, become government agencies, private companies, or just unpleasant memories.

Moreover, there are strong indications that a far more efficient and sensible mechanism for financing home mortgages in the United States is about to be born. In mid-July, the Federal Deposit Insurance Corporation (FDIC) issued a final policy statement on how it would treat covered bonds in the event of a bank’s failure,[1] and at the end of July, the Treasury issued a long statement on best practices for covered bonds.[2] In a covered bond transaction, mortgages remain on the books of the bank or other depository institution but serve as collateral for bonds issued to finance the acquisition of the mortgages. If the mortgages in the covered bond pool default, the bank that established the pool has an obligation to replace the assets with performing mortgages that will continue to serve as collateral for the outstanding bonds.

In other words, this structure requires lending banks to retain an interest in the quality of the mortgages they make and addresses the problem that no one in the securitization process has a continuing interest in sound underwriting after the mortgages are sold to Fannie and Freddie. Trillions of dollars in covered bonds have been issued in Europe over many years without any substantial losses. There are, of course, issues associated with the widespread use of covered bonds in the United States–mostly in balancing the interests of the FDIC and bank depositors in gaining access to the assets of a failed bank–but if these can be balanced with the need for a strong residential finance system, covered bonds could, over time, make the Fannie and Freddie business model obsolete. This is one more indication that Fannie and Freddie, both as GSEs and as essential elements of the U.S. residential finance market, are on their way out.

The Gathering Storm

It is axiomatic that Congress only acts in a crisis, and this crisis was so serious that Congress was compelled to do three important things that under ordinary circumstances it would never have done: it adopted legislation, HERA, that significantly strengthened the regulation of Fannie Mae and Freddie Mac; it authorized the appointment of a receiver to take over either company if it becomes “critically undercapitalized”; and it gave the Treasury Department a blank check, limited only in time and by the U.S. debt limit, to make loans or equity investments in both companies. With its new powers, the regulator should be able to reduce the size of the GSEs and prepare them for one of the three fates: liquidation, privatization, or nationalization.

It need not have been this way. Congress was warned over two decades, by both Democratic and Republican administrations, about the dangers presented by Fannie and Freddie. But Congress, under both Democratic and Republican control, did nothing. The same process is now unfolding with respect to Social Security, Medicare, energy, securities class actions, and probably a dozen other long-term problems that Congress is seemingly unable to address. It makes you wonder why 98 percent of them are reelected.

Not that this and previous administrations are blameless. Although at their higher reaches–usually in the Treasury–they recognized the dangers, their bank regulatory arms continued to allow banks to invest in Fannie and Freddie securities without the percentage limitations normally applied to investments in privately owned business corporations. The regulators obviously believed that the government would eventually stand behind Fannie and Freddie and thus permitted U.S. banks to load up on Fannie and Freddie debt in preference to U.S. government securities. Now, thousands of banks hold more than their total Tier 1 capital in the form of Fannie and Freddie debt. A 2004 FDIC report showed that the holdings of GSE-related securities by commercial banks and savings associations aggregated more than 11 percent of the total assets of these institutions and more than 150 percent of their combined Tier 1 capital.[3] Holding Fannie and Freddie debt gave the banks some extra earnings over what they would receive from Treasuries, but it also sent signals to the capital markets that the government saw Fannie and Freddie as virtually risk-free. And when the prospect arose a few weeks ago that Fannie and Freddie debt might decline in value, Uncle Sam had to step in to prevent thousands of U.S. banks from becoming insolvent because of their GSE investments.

In any event, the Fannie and Freddie crisis has now arrived, and, in order to avert a disaster in the housing and financial markets, the United States government has been forced to put its credit behind these two ill-conceived and badly managed institutions. During the past month, as the dimensions of the problem have become clear, sensible people have actually wondered whether the credit of the United States might actually be impaired by the obligations it might be required to assume on Fannie and Freddie’s behalf. That idea, previously unthinkable, is still highly unlikely, but what is clear is that the size of the taxpayers’ losses will grow as housing prices continue to decline. There is no telling how deep into insolvency Fannie and Freddie might sink, and the further down they go, the more potential losses they will impose on the government and ultimately the taxpayers.

This, of course, is all water over the dam. The damage–allowing two privately owned companies to grow so large that they become both wards of the government and threats to the financial system–has been done. Now the only relevant question is how we get out of this mess with minimal cost to taxpayers. In the end, the options available to the Treasury Department and the new GSE regulator, the Federal Housing Finance Agency (FHFA), are both unpleasant and few. They are outlined below.

…continue reading: Fannie and Freddie by Twilight

I have recently completed a paper titled Securities Laws, Disclosure, and National Capital Markets in the Age of Financial Globalization. The paper examines the following question: If capital can move freely between countries to take advantage of the best investment opportunities, are national capital markets still relevant?

With complete capital market integration across countries, there would be no national interest at stake for a country in having well-functioning capital markets. If capital can flow freely among countries, firms raise capital where it is cheapest. In a fully integrated world, we would therefore expect national capital markets to be irrelevant. If a country’s capital markets functioned poorly in such a world, firms would simply ignore these capital markets as sources of capital. The welfare consequences from having poorly functioning national capital markets would be extremely limited because firms and investors could bypass these markets freely.

As far as the trading of securities is concerned, the role of location has decreased dramatically because of the replacement of pit trading with electronic trading. With electronic trading, the location of the trader is operationally irrelevant and so is the location of the exchange.

The fact that portfolios of investors are still heavily biased towards securities issued and traded in their own country, a phenomenon described as the home bias, shows that, despite the free flow of capital, we are far from a fully integrated world in which countries are irrelevant for the issuance and trading of securities. A major reason for why countries are not irrelevant is that they have different laws and enforce them differently. The laws that apply uniquely to publicly traded securities are securities laws.

I construct a model where I show that securities laws can reduce agency costs and therefore increase share prices. I model a firm led by an entrepreneur who decides whether to take the firm public or not. I show that the entrepreneur wants to commit ex ante to a level of disclosure that is not optimal for her ex post. By committing to disclosure, the entrepreneur increases the cost of consuming private benefits and of taking decisions that are not optimal for shareholders. After the IPO, the entrepreneur would like to consume private benefits and would like to take decisions that are optimal for her but not for shareholders. It is therefore optimal for the entrepreneur to renege on disclosure commitments after the IPO. I examine private solutions to this problem and show that under some circumstances strong securities laws dominate private solutions. Strikingly, securities laws help entrepreneurs in the model rather than shareholders. Shareholders buy the shares for what they are worth, so that poor securities laws do not hurt them. Poor securities laws hurt entrepreneurs because they reduce the value of the firms that they take public.

I use the model to show that differences in securities laws across countries explain differences in share values and in the distribution of share ownership. In the model, some firms from countries with poor securities laws will choose to subject themselves to stronger securities laws. Some have argued that U.S. laws protecting shareholders have become too costly and inefficient. I model this argument by considering the case where strong securities laws have deadweight costs. I show that, to the extent that firms can choose the securities laws they are subject to, firms with poor growth opportunities choose weak securities laws with no deadweight costs while firms with strong growth opportunities choose strong securities laws even if they have some deadweight costs.

A key conclusion of my paper is that securities laws are more beneficial if they are not at risk of being watered down over time through lobbying by incumbents. However, incumbents have strong motivations to reduce the strength of securities laws since doing so increases their ability of consuming private benefits.

(Editor’s Note: This post comes from Paul E. Fischer and Henock Louis from the Smeal College of Business at Pennsylvania State University)

In our forthcoming Management Science paper, Financial reporting and conflicting managerial incentives: The case of management buyouts, we analyze the effect of external financing considerations on manager’s financial reporting behavior prior to management buyouts (MBOs). Our main motivation for choosing the MBO setting is the potential conflicting financial reporting incentive associated with external financing considerations. Managers planning to undertake an MBO want to purchase their firms‚ equity at as low a price as possible. Consequently, previous studies hypothesize that managers have an incentive to release less favorable earnings reports to equity market participants prior to an MBO in an attempt to reduce the MBO purchase price. We consider the possibility that managers have a conflicting earnings management incentive prior to MBOs that is attributable to external financing concerns, which are thought to be substantial.

In the framework we employ for our analysis, the financing related reporting incentive is driven by management’s concerns regarding their ability to obtain MBO financing from external parties and their desire to obtain that financing at a favorable cost. The financing incentive conflicts with the equity market incentive because the financing incentive suggests that managers should manage earnings upward. Consequently, to the extent that an external financing incentive exists, we expect it to temper the equity market incentive. Based upon our framework, we hypothesize that financing related earnings management incentives are more pronounced when the funds needed to execute the buyout must be raised to a greater extent from external parties. In addition, we hypothesize that the increase in financing related incentives arising from increased external financing is greater when there are fewer fixed assets available to secure loans.

Using a sample of 138 MBOs that occurred between 1985 and 2005, we find evidence consistent with both hypotheses. We find that firms that use more external funds to finance their MBO report less negative abnormal accruals. We also find that the positive effect of external financing on earnings management decrease as the amount of fixed assets increases, which is consistent with the conjecture that the effect of external financing on the marginal cost of managing earnings down prior to MBOs increases as the firm has fewer physical assets that it can use as collateral.

The full paper is available here.

(Editor’s Note: This article appeared in the New York law Journal this week.)

Courts do not like being arbiters of disputes over what is reasonable compensation. The recent, abrupt conclusion of the state of New York’s lawsuit against Richard A. Grasso is a case in point.

The lawsuit began on May 24, 2004 at the initiative of then-Attorney General Eliot L. Spitzer, claiming that the payment of a lump-sum amount of $139.5 million to Mr. Grasso was unreasonable compensation.(1) The action was brought under the New York Not-For-Profit Corporation Law (N-PCL).

Earmarks of Dubious Behavior

This case appeared to offer an ideal opportunity for New York courts to address the issue of what is reasonable compensation. It had all the earmarks of an egregious case of overpayment of compensation to an executive together with evidence of dubious corporate behavior in the setting of that compensation. Earmarks included:

• The payment of $139.5 million, in a lump sum, to the CEO of a relatively small not-for-profit trade organization and regulator (albeit a well-known and very powerful one).

• According to the complaint (and there is substantial publicly available data to support this) the compensation and benefits for Mr. Grasso expensed over the period of 2000-2002 equaled slightly less than 100 percent of the New York Stock Exchange’s (NYSE) net income over this same period. Complaint, para. 34. Over these three years, this represented $130.3 million of compensation and benefits to Mr. Grasso compared to $132.8 million of net income. Id.

• Many of the directors of the NYSE (including members of the Compensation Committee) were subject to regulation by Mr. Grasso himself, as chairman and CEO of the NYSE. During the periods relevant to the litigation, Mr. Grasso was authorized to appoint the members of the Compensation Committee (subject to board approval) and to select one of the members as the chairperson of the committee (the selection of the committee chairperson did not require board approval). See, for example, Charter: Human Resources and Compensation Committee, adopted June 7, 2001; see also Complaint, paras. 5, 6 and 25.

• For the Aug. 7, 2003 meeting of the board that approved Mr. Grasso’s 2003 compensation arrangements, including the lump-sum payment of $139.5 million, no advance notice (or virtually none) was given to board members. Statement by the Director of Human Resources of the NYSE (HRD Statement), Exhibit A to Exhibit 1 to Complaint, paras. 37-38. Apparently due to this lack of notice neither of the outside consultants who had been working on the matter was available to attend the meeting. HRD Statement, Id. at para. 41. It would appear that, at the Aug. 7, 2003 meeting, the board had very little time (and very little information) before voting to approve Mr. Grasso’s compensation package including the lump-sum payment of $139.5 million.

• The NYSE Compensation Committees that approved Mr. Grasso’s compensation arrangements over several years, including 2003, apparently were not given accurate and complete information on Mr. Grasso’s compensation. HRD Statement, Id. at para. 50; see also Assurance of Discontinuance Agreement with Consultant, Exhibit 2 to Complaint at pp. 1-2.(2)

Attorney General’s Standing

Apart from the facts and alleged facts in this case, the attorney general appeared to have standing to bring this action. The bases for this conclusion were as follows:

…continue reading: New York Courts Dismiss ‘Grasso’ Compensation Case

Recently, the German legislature adopted the Risk Limitation Act (Risikobegrenzungsgesetz, the “Act”) aimed at the limitation of perceived risks deriving from financial investors. Following the notorious “locust debate” in Germany, the new law is the result of the still ongoing discussions about the impact of foreign hedge funds and private equity investors. It provides for a number of amendments to securities law and corporate law applicable to domestic and international investors in public companies. The Act is scheduled to be formally announced later this summer or fall.

Acting in Concert

The Act will modify the existing rules on “acting in concert”, i.e., the rules under which the shareholdings of investors forming a “group” must be aggregated. This is relevant in two areas, namely (i) the reporting thresholds for shareholdings in German listed companies and (ii) the rules on public offers:

• Regarding the former, an investor reaching, exceeding or falling short of 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% or 75% of the voting rights attached to shares must notify the company and the German financial supervisory authority within four trading days at the latest. Otherwise the shareholder’s rights are suspended and it can be fined. The company is required to publish such notification within three trading days.

• The rules on public offers also refer to an important threshold: An investor holding less than 30% of the voting rights must launch a public takeover offer once it decides to acquire (additional) shares aimed at reaching or exceeding the 30% threshold. An investor who reaches the 30% threshold other than in the course of a takeover offer must launch a mandatory public offer to acquire all outstanding shares in the target.

When several shareholders are found to be “acting in concert”, their shareholdings are mutually attributed; therefore, each of them is subject to notification and offer duties if the aggregate of their shareholdings reaches, exceeds or falls short of one of the above thresholds. Until now, the Federal Supreme Court held that only investors who coordinate their voting within the general meetings of the company were acting in concert.

The Act will broaden the scope of the rules on acting in concert. The new rules will also apply to cooperating in a way that aims at a steady and substantial change of the strategic orientation (unternehmerische Ausrichtung) of the company. Thus, the scope of application will no longer be limited to coordination with regard to the exercise of voting rights, but will also include cooperation on the level of the supervisory board or even outside any corporate bodies, provided that the investors concerned intend to steadily and substantially change the business of the company. Fortunately, the German legislature abstained from further extensions of the rules: Pursuant to initial draft bills of the Act, the mere cooperation of investors with respect to the acquisition of shares would have been considered acting in concert, too. What is more, it would have been sufficient if the coordination referred to an individual case or had an either steady or substantial influence on the business of the company. The German legislature changed its opinion after harsh criticism from legal scholars and international investors.

As a result, the impact of the changes will be limited. For example, investors will generally still be able to initiate public takeovers by agreeing on standstill agreements with shareholders or accepting irrevocable undertakings from them. Until German courts begin to interpret the new rules, however, there will be legal uncertainty for some time about what shareholders may agree on regarding the business and strategy of the company without triggering a mutual attribution of voting rights.

Aggregation of Voting Shares and other Securities giving the Right to Acquire Shares

Holders of marketable securities giving the right to acquire voting shares (e.g., marketable call options) have similar notification duties if their securities refer to a shareholding which reaches, exceeds or falls short of the above thresholds (except for the 3% threshold). Under the current rules, the positions in voting shares and other financial instruments are not aggregated. Presently, an investor who acquires (i) up to 2.99% of voting shares of the company and (ii) other securities giving the right to acquire up to 4.99% of the voting shares does not need to make any notification.

The Act provides for the aggregation of these two positions with the effect that in the above example, the investor will be obligated to report the excess of the 3% and the 5% threshold. Nonetheless, the 3% threshold will still be irrelevant for an investor who only holds marketable securities other than voting shares.

Extension of Sanctions in Case of Violation of Notification Duties

In the past, non-compliance with the aforementioned notification requirements, apart from the risk of administrative fines, has only led to a suspension of the shareholder rights (in particular, voting rights and rights to dividends) until the missing or wrongful notification was made or corrected. Hence, verifying compliance with the notification duties immediately prior to a general meeting was sufficient to avoid any impact on these rights. Under the Act, the suspension of shareholder rights would only be lifted six months after the late or corrected notification, provided the violation (i) was due to gross negligence or intent and (ii) reached a certain degree of non-compliance: If the investor did not completely fail to make a required notification and the deviation of the notified shareholding from the actual shareholding was less than 10% of the actual shareholding, the six months period will not apply.

New Disclosure Duties Relating to Significant Shareholdings

Further, the Act will implement new disclosure duties for investors holding at least 10% of the voting rights in a German listed company. Such significant shareholders will be required to disclose to the company their intentions with respect to the shares and the origin of the funds used to purchase the shares. These duties (as well as the existing notification duties) will not only apply to direct shareholders but also to investors to which the shares of third parties are attributed due to certain circumstances. Examples of such attribution are: (i) controlling influence over the direct shareholder, (ii) holding shares of a third party in trust without further instructions of the third party with regard to the exercise of voting rights, and (iii) acting in concert (see above). The new disclosure duties also apply to investors who already hold 10% or more of the voting rights in a German listed company once they reach or exceed another threshold.

These significant shareholders will be required to disclose their intentions with respect to the shares and the origin of the funds within 20 trading days unless the articles of association of the company waive such duty. Significant shareholders must also disclose all changes to their intentions.

With regard to its intentions each requested investor will be required to disclose whether:

• the investment aims to attain strategic goals or to achieve trading profits,

• it plans to obtain further voting rights within the next 12 months by way of purchase or otherwise,

• it strives for representation in corporate bodies of the company, and

• it strives for substantial changes of the capital structure of the company, in particular with regard to the ratio of equity financing and debt financing as well as to the dividend policy.

When disclosing the origin of the funds, the investor will be obliged to indicate whether and to what extent it has used equity or debt.

The company will be required to publish (i) the information received from the investor or (ii), if applicable, non-compliance of the investor with the disclosure duties. The Act does not provide for any additional consequences in case of non-compliance and the above mentioned suspension of shareholder rights will not apply. Please note, however, that non-compliance with these duties may, under certain circumstances, violate the prohibitions on market manipulation and insider trading.

…continue reading: New Rules for Investors in German Listed Companies

If a firm insider has private information and intends to trade on the basis of this information, the conventional wisdom is that the insider garners no strategic advantage from disclosing in advance of the trade the information or the intention to trade. This account, however, ignores the potential litigation benefit from pre-trade disclosure of trading plans. If an insider discloses many months in advance the intent to trade at certain times, this can be expected to reduce the likelihood of a lawsuit (either alleging insider trading alone or as an element of a securities fraud suit), since disclosure may rebut any allegation that the insider was acting with the requisite scienter when the trade executed. The insider who pre-discloses may be turning Brandeis’s aphorism that “sunlight is the best disinfectant” on its head – the insider is using transparency for strategic advantage, what we might call “hiding in plain sight.”

In a new paper, entitled Scienter Disclosure, Alan D. Jagolinzer, Karl A. Muller and I show the existence of the strategic advantage from disclosure – what we call “scienter disclosure” – in a study of insider voluntary disclosure under Rule 10b5-1 trading plans. The SEC promulgated Rule 10b5-1 in 2000 to provide an affirmative defense for insiders who pre-commit to trades in the future at times when they do not possess inside information, even if they do possess such information when the trades ultimately execute. There is evidence, however, that Rule 10b5-1 may provide insiders with strategic trade opportunities that generate abnormal trade returns. Insiders may, for example, pre-plan trade based on longer-term nonpublic information because of perceived lower legal risk. Insiders may also strategically modify the content or timing of disclosure to increase profitability of previously planned trades. Finally, insiders may also terminate Rule 10b5-1 plans when they possess material nonpublic information that indicates a hold strategy would be more profitable than allowing pre-planned sales to continue. We show insiders use these features of the Rule to earn abnormal returns.

The paper has two primary findings based on insiders’ voluntary disclosure choices. First, we show Rule 10b5-1 disclosure increases with firm litigation risk and insider strategic trade potential. Firms with higher expected litigation risk and greater opportunities for insiders to earn profits from private information are much more likely to disclose, meaning insiders see disclosure as a litigation prophylactic.

Second, we show Rule 10b5-1 disclosure is associated with greater abnormal returns to insiders’ trades, especially for firms disclosing specific plan details. The SEC intended Rule 10b5-1 to provide insiders greater opportunities (than the normal blackout windows allow) for uninformed, diversification trades, but we present data showing that insiders who use the Rule earn large abnormal returns compared with those not using the Rule, and that these returns are increasing in the amount of disclosure. (The returns are about 12 percent in six months for insiders making specific disclosures.) The intuition here is that disclosure is not just a litigation risk reducer, but also has costs. Making specific disclosures, say about the dates and amounts of trades, provides the most litigation protection but it also raises the costs for insiders who may terminate their plans if it turns out a hold strategy is superior. Therefore, only the most bearish insiders will adopt a specific disclosure strategy, since the termination option is less valuable to them. Insiders making limited disclosures get less litigation protection, but they preserve the termination option. These insiders are less confident of negative private information, so their expected abnormal returns are lower than the specific disclosure group.

The paper also presents findings about the interaction of disclosure choice and firm governance, and makes some preliminary policy recommendations for regulators, firms, and other corporate stakeholders. Most obviously, a disclosure requirement is unlikely to provide much benefit, since it is the insiders not disclosing who are acting the way the SEC intended.

The paper is available here.

Facing the prospect of Congressional legislation that would forbid federal prosecutors and civil enforcement lawyers from requesting any communications protected by the attorney-client privilege or work product doctrine, the Department of Justice has indicated that it will, yet again, revise its Principles of Federal Prosecution of Business Organizations (“Principles”). The current version of the Principles, known as the “McNulty Memo,” has been the subject of criticism since its issuance in December 2006 for not going far enough to guard against encroachments on the attorney-client privilege and work product doctrine.

On June 26, 2008, Senator Arlen Specter re-introduced the Attorney-Client Privilege Protection Act of 2008, which is a modified version of legislation that he had previously introduced. (See Year End Review: Current Regulatory and Enforcement Climate, January 2, 2007). Apparently in response to this legislation and the continuing criticism of the Principles, on July 9, 2008, the Deputy Attorney General, Mark Filip, wrote a letter to Senators Specter and Patrick Leahy, indicating that DOJ intended to make certain changes to the Principles in the coming weeks.

The Deputy Attorney General identified the following changes:

• Cooperation will be measured by the extent to which a corporation discloses
relevant facts and evidence, not its waiver of attorney-client privilege or work product;

• Federal prosecutors will not demand the disclosure of non-factual attorney work
product or core attorney-client communications as a condition for cooperation credit;

• Federal prosecutors will not take into consideration in evaluating cooperation whether a corporation has (i) advanced attorneys’ fees to its employees; (ii) entered into a joint defense or common-interest agreement; or (iii) retained or sanctioned employees involved in alleged wrongdoing.

There are at least two significant limitations to addressing the problem of government interference with the attorney-client privilege or work product doctrine through a revision of DOJ’s Principles. First, unlike the proposed Attorney-Client Privilege Protection Act, the Principles do not apply to the SEC or other federal regulators. Second, the Principles do not have the force of law, but would require corporations to rely on self-policing by DOJ.

If implemented, the new Principles will have a significant impact on how corporations respond to federal criminal investigations. But what must not be lost in considering these proposed changes is the continuing fundamental requirement that, under the Principles, corporations must cooperate with government investigations to help avoid indictment. Corporations will still need to be forthcoming with detailed and relevant factual information to be perceived as cooperative.

(Editor’s Note: This post comes from Simi Kedia at Rutgers Business School and Shivaram Rajgopal at the University of Washington Michael G. Foster School of Business)

Our forthcoming paper in the Journal of Financial Economics, Neighborhood Matters: The Impact of Location on Broad Based Stock Option Plans, provides the first evidence on the importance of geographic effects on broad based stock option plans. The question of why broad based option plans are so prevalent in the real world remains a puzzle for standard economic theory. Broad based options are a costly form of compensation relative to other alternatives, such as cash, because: (i) employees can expect to only garner trivial personal gains from their contribution to firm value or profits; and (ii) holding stock options in their employer exposes employees to stock price risk which is highly correlated with the risk in their human capital. Yet, broad based equity plans are commonly observed in corporate America. We show that the geographically segmented labor markets for rank and file talent is a hitherto unexplored explanation for why we observe broad-based option plans.

Using data on rank and file option grants from over 9,000 firm-years from Execucomp over the years 1992-2004 intersected with geographical data gathered from several sources such as the U.S. Census Bureau, we find that firms grant more options to rank and file workers when a higher fraction of firms in the local community (firms located within a 100 or a 250 km of its headquarters) grant more broad based options. This result holds regardless of whether we analyze aggregate state-level, or county-level, or individual firm-level patterns in broad-based option usage. We recognize that firms of certain industries cluster in certain geographical areas. However, the effect of the local community’s option usage on an individual firm’s holds even after controlling for industry membership and other traditional variables known to account for broad based option usage such as firm size, investment opportunity, leverage, cash constraints of the firm, its tax status and its stock return performance.

The neighborhood’s option granting practices can affect an individual firm’s option usage for two reasons: (i) influence through the labor market circumscribed by firm’s geographical neighborhood; and (ii) influence of other exemplary peer firms in the neighborhood. Our empirical results find consistent and strong support for the role of tight labor markets in an individual firm’s option granting decisions. In particular, we find that the neighborhood’s option granting affects an individual firm’s option grants when (i) the neighborhood has more rather than fewer firms, a proxy for the demand of rank and file labor; and (ii) the firm has a higher local beta. Further, the effect of a firm’s local beta on its broad based options usage is statistically significant only when the firm faces a tight labor market in its neighborhood. There is some empirical support for the peer-influence story in that the neighborhood’s option granting practices matter to an individual firm’s option granting when exemplar firms are present in its neighborhood. However, this result is not robust to the introduction of proxies for tight labor markets, suggesting, in effect, that tight labor markets, in general, and Oyer’s (2004) wage indexation explanation in the presence of tight labor markets, in particular, are the key reasons why the community’s broad based option grants explain option usage for individual firms.

The full paper is available for download here.

My colleague Laura A. McIntosh and I have written an article entitled “Delaware Decision Highlights Need for Director Protection,” which discusses the Delaware Chancery Court case of Schoon v. Troy Corp. The decision, which is on appeal, clarifies that in Delaware, unless otherwise provided in the bylaws or agreed by contract, a director’s right to advancement of expenses does not vest until the company’s obligation is triggered. This result is significant since the advancement of expenses in corporation-related lawsuits, along with broad indemnification, is an important feature of director protection. The decision may leave former directors, in particular, vulnerable to bylaw amendments affecting their right to advancement of expenses. In the article we address some of the many options available to consider to protect a director’s right to advancement of expenses, including the company revising its bylaws, directors entering into indemnification agreements and former directors purchasing D&O liability insurance specifically for themselves in some cases.

The article is available here.

(Editor’s note: This post comes from Harold Mulherin of the Terry College of Business at the University of Georgia, and William Brown and Marc Weidenmier of Claremont McKenna College)

For a significant part of its 213-year history, the New York Stock Exchange (NYSE) has reigned as the leading stock exchange both within the United States and across the world. Recently, ongoing changes in technology and the globalization of stock trading have given rise to a number of competitors that threaten the NYSE’s position as the preeminent stock exchange. These changes, as well as the NYSE’s proposed merger with Archipelago, raise many questions about the effects of direct stock market competition with the NYSE.

In a forthcoming article in the Quarterly Journal of Economics, Competing with the NYSE, we investigate whether the NYSE is susceptible to significant competition. We provide new evidence on both the viability and the nature of direct trading competition with the NYSE. We study the Consolidated Stock Exchange, a rival stock exchange that competed directly with the “Big Board” from 1885 to 1926. For almost 42 years, the Consolidated was an important competitor and garnered an average annual market share reaching as high as 60 percent of NYSE trading volume. This sustained incidence of competition with the NYSE came at a time of significant technological change in securities trading and thereby has direct relevance to the current competitive forces confronting the NYSE today.

Our analyses focuses on the effects of competition on the bid-ask spreads for NYSE stocks. We employ two complementary tests to identify the effects of stock market competition. We first study the impact of competition on bid-ask spreads when the Consolidated began to trade NYSE stocks in 1885. Then we analyze the effects of competition on bid-ask spreads for approximately 40 years of the stock exchange rivalry. Our results suggest that NYSE bid-ask spreads fell by more than 10 percent when the Consolidated began to trade NYSE stocks while bid-ask spreads for our control group of stocks trading on the regional exchanges remain unchanged. The effect persisted across the 42-year rivalry between the two exchanges. The finding is robust to a wide variety of changes in the empirical model and estimation technique. Overall, our results suggest that the NYSE has faced significant long-run competition and may be susceptible to a similar level of competition in the future.

The full paper is available for download here.

(Editor’s Note: The article below, just published in the Delaware Law Weekly, came to us from its author Elizabeth Bennett.)

The First State’s unique position as the corporate capital of the United States means that cutting-edge developments in corporate governance often come in the form of opinions from the Delaware Supreme Court and the Court of Chancery.

Of course, Delaware’s federal courts also decide giant cases in bankruptcy and intellectual property litigation, sometimes involving billions of dollars.

Given this, it’s no surprise that the number of blogs started by Delaware practitioners, or that address Delaware law, has grown since this publication first reported on the development in 2005.

Francis G.X. Pileggi, a partner in the Wilmington office of Fox Rothschild, was a pioneer. He started his ‘‘Delaware Corporate and Commercial Litigation Blog’’ in April 2005, and reports that traffic is seven or eight times more than when he started.

Wilmington firm Morris James now has three blogs: the “Delaware Business Litigation Report,’’ the “Delaware Patent Litigation Report’’ and the “Delaware Business Bankruptcy Report.’’

Edward M. McNally, a partner who edits the blogs, said they are up to about 4,000 hits per month.

Young Conaway Stargatt & Taylor also fields a blog called the “Delaware IP Law Blog.’’ Karen Keller, an associate with the firm, who writes some of the entries, reported that as of the end of 2007, the blog got an average of about 41 visitors per day from 69 different countries.

But the regent by far of all the blogs with a Delaware connection is the ‘‘Harvard Law School Corporate Governance Blog,’’ which has been hit nearly two million times in its roughly two years of existence. This is in part a testament to the importance of Delaware corporate law.

Lucian A. Bebchuk, Harvard Law School professor and director of the Program on Corporate Governance that runs the blog, said that a significant element of its entries “is following Delaware cases and presenting different normative viewpoints about them as well as thoughts about what they mean going forward.”

The blog was conceived about two years ago by Bebchuk and Vice Chancellor Leo E. Strine Jr. of the Court of Chancery, who has been teaching at Harvard Law for five years or so and is a fellow of the Program on Corporate Governance.

The vice chancellor “has been helping us a great deal in making the connection between academia and practice,” Bebchuk said.

The idea for the blog came when Strine and Bebchuk were brainstorming about making the scholarship produced by the academics of the program more available to practitioners.

Strine said he was also seeking ways to bring together the commentary of practitioners involved with the program, who write on corporate governance issues and who are scattered all over the country.

“We had some electronic newsletters that sent out the research products of the program,” Bebchuk said. “Leo [Strine] thought it would be good to have something that is more dynamic and something [that] would have some kind [of] back and forth and give and take of different ideas.”

Bebchuk said traffic on the blog has been growing exponentially. It is now visited by about 200,000 people per month.

“It’s a very open community,” Strine said “It’s not dominated by any one view. There are people who represent stockholder plaintiffs and people who represent managers, and professors from all kinds of law schools.”

“I don’t think anybody would have expected as much content or as much readership interest,” Strine said, adding that the Program on Corporate Governance has invited outside academics and practitioners to participate in order to create an open forum that can serve as a resource.

“As a result there is a lot of content people find provocative,” he said. There have been some pretty interesting dust ups among the contributors.”

Local contributors to the Harvard blog include an array of experienced Delaware practitioners such as A. Gilchrist Sparks III of Morris Nichols Arsht & Tunnell, Mark A. Morton of Potter Anderson & Corroon, Robert S. Saunders of Skadden Arps Slate Meagher & Flom, Jay Eisenhofer of Grant & Eisenhofer and Pileggi of Fox Rothschild, who also has his own blog, as noted above.

Lawrence A. Hamermesh, a professor at the Widener University School of Law and director of its Institute on Delaware Corporate and Business Law, is a frequent contributor and Andrea Unterberger has contributed as well.

Unterberger is assistant general counsel and director of CSC Media for the Corporation Service Company in Wilmington, which also sponsors the blog. She and the blog’s managing editor did a lot of hard work in the early days on the design and to build the community, Strine said.

“It sort of took off so they don’t need as much of our help as this point,” Unterberger said.

Rodman Ward Jr., of counsel in Skadden’s Wilmington office, sits on the board of CSC and is the grandson of its founder. He said Strine asked him if the company would consider sponsoring the blog. When he brought the idea to the leadership of the company, they went for it.

Ward said it is important that the blog not discriminate on the basis of ideology.

“We wanted the only criteria on which the posts would be chosen to be the academic quality,” Ward said. “They’ve been very good about it.”

While some core subjects for the blog are Delaware law and the Securities and Exchange Commission, Unterberger said, “there are opinions all over the country and all over the world that use Delaware law and that impact corporate governance and principles. There are academics now from all over the country that are posting. … It’s a must-read blog at this point.”

The range and breadth of the guest contributors has grown, Bebchuk said.

“We have the problems that come with success,” he said. “We have a lot of people who want to contribute but at the same time we don’t want to overwhelm readers.”

The goal is to try and maintain a balance to keep the site valuable for both academics and practitioners. Bebchuk said the success has been gratifying.

“We see how our materials are picked up by The Economist, The Wall Street Journal and by the mainstream media,” he said. “We feel there is a world out there that is paying attention to what we post on our blog.”

(Editor’s note: This post is by Yair Listokin of Yale Law School.)

Corporations have two primary means of aggregating dispersed information and making decisions—voting and price setting. When shareholders vote on a merger or in a contested director election (two examples of “proxy fights”), they aggregate diffuse opinions through voting; the corporation pursues the outcome favored by the holders of a majority of shares. Corporations also receive feedback from diffuse investors through stock prices. When price-setting shareholders support a company’s actions, the price of the company will rise. Indeed, the market’s ability to aggregate diffuse information into prices forms the basis for all event studies.

My paper entitled “Corporate Voting vs. Market Price Setting” evaluates these two information aggregation mechanisms from an empirical perspective. I estimate how the price-setting shareholder perceives the decisions of the median voter in a corporate election. I do this by examining stock market responses to the announcement of the outcomes of close votes. The stock market response to close votes has two desirable attributes for measuring the price setting market participant’s view of the median voter’s opinion. First, the outcome of close votes is uncertain, providing information to price setting shareholders.

Second, close votes suggest that the median shareholder/voter is nearly indifferent between the two voting options in a proxy contest. The median voter in a proxy contest is the shareholder in the exact middle of a ranking of voters along the dimension of preference for one side in a proxy contest. If shareholders vote for management so long as they prefer management and the vote is a perfect tie, then the median voter is exactly indifferent between management and “dissidents”. If the vote is not a perfect tie but closely favors existing management, then the median voter slightly prefers the winning option, but is relatively “close” to indifference.

The market response to close votes in proxy voting contests is striking. In close elections—when the median voter should be close to indifferent regarding either outcome– the price setting shareholder is far from indifferent. Stock price responds systematically to the announcement of vote outcomes. When management wins a close election, market value declines; when a dissident wins, the value goes up.

I conclude that the price-setting shareholder places lower value upon management control of companies than the median voter. If price-setting shareholders provide a reasonably accurate gauge of value (a proposition that underlies every event study) and value maximization is the goal of corporate law (as most assume)—then the results suggest a need for corporate voting reforms.

The full paper is available for download here.

(Editor’s Note: This post comes from Arturo Bris, a professor at IMD who is also affiliated with the Yale International Center for Finance)

I have recently completed a report Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order that analyzes the effect of the EO that was issued to “enhance investor protection against naked short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks”. The EO dealt primarily with the stocks of 19 financial institutions, which I denote as the G19. The study is conducted by comparing stock returns, firm fundamentals, measures of market quality, and pricing efficiency of the G19 to a matching sample of financial stocks from the U.S. and abroad, all listed on U.S. stock exchanges. The control sample of U.S. financial institutions includes 59 companies, and the control sample of non‐U.S. financial institutions includes 73 companies.

My preliminary findings are as follows:

• The performance of the G19 stocks is significantly worse in the period January 2008 through July 2008 than for comparable stocks.
• The short selling activities in the G19 stocks have not been significantly higher than for comparable stocks between 2006 and 2008.
• While short selling has increased overall, short selling activities in the G19 stocks have not increased significantly more than in comparable US Financial Stocks.
• After controlling for firm and market characteristics, all measures of shorting activity are indeed lower for G19 stocks than for comparable US Financial Stocks, but higher than for comparable non‐U.S. Financial Stocks.
• I find that the issuance of convertible bonds has been relatively more frequent for G19 stocks than for the sample of comparable firms, and that this activity fosters shorting activity.
• There is clear evidence that some firms outside the G19 group have been the subject of heavy shorting activity over the sample period.
• Although the performance of the G19 stocks has been significantly worse than for comparable firms, the negative returns of G19 stocks cannot be attributed to short selling activities.
• I find that the market quality of the G19 stocks is significantly worse on most measures of market quality than for comparable US financial stocks before July 15th 2008, and that this lower market quality is not caused by short‐selling activities.
• After July 21st, the G19 stocks have suffered a significant reduction in intra‐day return volatility and an increase in spreads, which suggests a deterioration of market quality.

The full report and a video of my interview on CNBC’s Squawk Box Europe about the report can be found here.

Per Stromberg and I have just completed Leveraged Buyouts and Private Equity. In the paper, we describe and present empirical evidence on the leveraged buyout and private equity industry, both firms and transactions.

We start the paper by describing how the private equity industry works. We describe private equity organizations such as Blackstone, Carlyle, and KKR, and the components of a typical leveraged buyout transaction, such as the buyout of RJR Nabisco or SunGard Data Systems. We present evidence on how private equity fundraising, activity and transaction characteristics have varied over time. The article then considers the effects of private equity. We look at evidence concerning how private equity affects capital structure, management incentives, and corporate governance. This evidence suggests that private equity activity creates economic value on average. At the same time, there is also evidence consistent with private equity investors taking advantage of market timing (and market mispricing) between debt and equity markets particularly in the public-to-private transactions of the last fifteen years.

We also review the empirical evidence on the economics and returns to private equity at the fund level. Private equity activity appears to experience recurring boom and bust cycles that are related to past returns and to the level of interest rates relative to earnings. Given that the unprecedented boom of 2005 to 2007 has just ended, it seems likely that there will be a decline in private equity investment and fundraising in the next several years. While the recent market boom may eventually lead to some defaults and investor losses, the magnitude is likely to be less severe than after the 1980s boom because capital structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a significant part of the growth in private equity activity and institutions is permanent.

The full paper is available for download here.

(Editor’s Note: This post comes from Glenn D. West and Sara G. Duran of Weil, Gotshal & Manges)

In our article, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, which was recently published in The Business Lawyer, we provide clarity on the issue of Consequential Damages. Even though consequential damage waivers are a frequent part of merger and acquisition agreements involving private company targets, we believe that few deal professionals understand the concept of consequential damages and, as a result, the inclusion of such waivers may have an unexpected impact on both buyers and sellers.

After tracing the historical derivation of the term, and its current use, we provide a number of basic guidelines for addressing consequential damage waivers in acquisition agreements, which include the following:

• At a minimum, buyers should avoid the “kitchen sink” approach to the consequential damage waiver.
• If possible, buyers should try to define “consequential damages” for the purpose of any waiver provision in such a manner that the term covers only those consequential damages for which the law already denies recovery for breaches of contract.
• Buyers should avoid including the broad term “lost profits” as a separate category of damages in the waiver provision.
• Sellers, on the other hand, should consider expressly limiting recoverable losses under their indemnification provisions to the “normal measure” of contract damages.
• Buyers should never include “incidental” damages in their waiver provisions under the assumption that they are a synonym for “consequential” damages. They are not.
• Instead of waiving “consequential” damages, buyers should seek waivers of “remote” or “speculative” damages. Even the term “indirect” damages is preferable to the term “consequential” damages for a buyer.
• Buyers should never agree to waivers of “diminution in value” or “multiples of earnings” damages.
• Sellers should not assume that contract law’s “rule of reasonableness” necessarily applies to broadly worded indemnification provisions that purport to indemnify buyers for any and all losses that arise from a breach of a seller’s representation and warranty.
• Buyers, on the other hand, should not assume that contract’s “rule of reasonableness” fails to apply to broadly worded indemnification provisions.

The full article can be found here.

(Editor’s Note: For earlier Blog posts on the CSX/ TCI decision, see here and here.)

I am posting the audio recording of the recent webcast in which a number of my colleagues analyzed the consequences of the court’s decision in the CSX case which held that two hedge fund investors had violated the provisions of Section 13(d) of the Securities Exchange Act of 1934, and Rule 13d-3(b) thereunder, by using cash settled swap transactions in a way that, in the circumstances, improperly evaded disclosure obligations related to the formation of a group “beneficial owner.” The discussants include Brian Lane, former Director of the SEC’s Division of Corporation Finance, Jim Moloney, former member of the SEC’s Office of Mergers and Acquisitions, Susan Grafton, former member of the Division of Trading and Markets staff and former compliance counsel at Goldman Sachs, and Adam Offenhartz, principal author of a brief filed in the case by a group of hedge funds. The panel is moderated by Gibson Dunn partner Ron Mueller. The discussion is particularly useful because it discusses the decision and its implications from a number of different perspectives, but does not “take sides” on resolution of the issues. This will be a subject of ongoing interest in the corporate governance community.

The recording is available here.

(Editor’s Note: This post comes to us from Craig Chapman at Northwestern’s Kellogg School of Management)

My recently updated working paper An Investigation of Earnings Management through Marketing Actions, co-written with Thomas J. Steenburgh provides a novel view on earnings management. Earnings management behavior may be divided into two categories: 1) the opportunistic exercise of accounting discretion; and 2) the opportunistic structuring of real transactions. This paper focuses on the latter by providing evidence that firms vary their use of retail-level marketing actions (price discounts, feature advertisements, and aisle displays) to influence the timing of consumers’ purchases in relation to the firms’ fiscal calendar and financial performance. The results are of interest to practitioners negotiating with suppliers as well as those responsible for setting price and promotion strategy in response to competitor actions, and practitioners responsible for designing incentive-based compensation as well as regulators monitoring reporting of fiscal period-ending promotions.

We find that:

• In contrast to prior literature that suggests firms reduce marketing expenditures in order to boost reported earnings, we find that soup manufacturers roughly double the frequency of all marketing promotions (price discounts, feature advertisements, and aisle displays) at the fiscal year-end and that they engage in similar behavior following periods of poor financial performance. In addition to offering promotions more frequently, we find that firms offer deeper price discounts to manage earnings during these periods.

• While these actions boost unit sales, revenue, and profits in the near term, the resulting gains come at the expense of long-term profit and may not be in the strategic interest of the firm. We estimate that marketing actions can be used to boost quarterly net income by up to 20% depending on the depth of promotion. But there is a price to pay, with the cost in the following period being 23.5% of quarterly net income.

• The results imply that firms make systematic decisions across their product lines to manage earnings and indicate the behavior is being driven by parties higher in the firm than the brand managers.

The full paper is available for download here.

In our paper, Institutional Investors and Proxy Voting: The Impact of the 2003 Mutual Fund Voting Disclosure Regulation, Martijn Cremers and I examine the impact of the mutual fund voting disclosure rule on corporate governance by examining its effect on proxy voting outcomes. We presented our paper at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.

In January 2003, the U.S. Securities and Exchange Commission (SEC) required mutual funds to disclose how they voted on proxy proposals presented at shareholder meetings. To assess the impact of this rule on voting behavior, we construct a sample of firms that experienced similar proposals, sponsored either by management or shareholders, both before and after the 2003 rule change using data gathered from the Investor Responsibility Research Center’s (IRRC) database of proxy voting.

We find that voting support for management has been declining for close to a decade and that mutual funds appear to support management less frequently than other investors. However, we find no evidence that the rule decreased mutual funds’ voting in support of management. Indeed, some of our results suggest that mutual funds’ support for management increased after the rule’s adoption, particularly for executive equity incentive compensation plan (EEIC) proposals. We further find that these results are not affected by other features of the voting environment, such as confidential voting and the elimination of the New York Stock Exchange (NYSE)’s rule permitting brokers to vote shares on certain compensation plans. Finally, taking into account mutual fund characteristics and the largest mutual fund families’ ownership does not change our results.

As the decision to put up an EEIC proposal is clearly a choice by management, we investigate to what extent selection issues could potentially explain our findings. We find some evidence that the firms sponsoring EEIC proposals both before and after the rule change are different from those that sponsored such a proposal before but not within two years after the rule change. In addition, we find that some takeover defenses decrease support for management, results independent of the rule change, but the results are so varied across defenses, and within and across proposals, that we cannot draw a conclusion regarding the relation between defenses and voting outcomes.

The full paper is available for download here.

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.

This post provides a good opportunity to remind readers that you can easily sign up for a free subscription to the Blog, which will allow you to receive automatic email announcements about our new posts. To sign up,

1) Go to our our signup page.
2) Enter your email address.
3) Click “Subscribe”.

(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).