We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

The Report also mentions that the lawsuits "pointlessly transfer money from one innocent investor to another."  This has been a popular argument of late.  Essentially, so this argument goes, settlements entail the payment from the company (and the current owners), who had no role in any fraud, to the past owners (although there is of course some overlap in the two groups).  So one group of innocent shareholders (those in the present) are paying another group of innocent shareholders (those injured in the past). 

The first problem with this argument is that it would justify a system where the present owners would never pay for the bad behavior of the past managers.  In other words, based upon this rational, there should never be recovery for fraud in a private action.  But the argument goes much further.  The same argument has been used to oppose the system of fines imposed on companies for fraud by the SEC (see the views of former Commissioner Atkins).  After all, fines are paid by innocent shareholders in the present for bad behavior in the past.   Yet the Chamber Report explicitly favors government enforcement, nowhere reconciling why transfers in the private sector are somehow pointless while transfers in the public sector are apparently not.   

In any event, the main problem with the argument is that most payments made to settle these cases come not directly from the company but from the insurance carriers under D&O policies, something one would never know reading the Chamber Report (some of the mega suits exceeded insurance amounts but this is not the norm).  Insurance involves shared risk among all of the companies in the same pool.  In other words, the settlement comes from the pool of funds maintained by the carrier.  It does not reduce the net value of the company settling and does not involve a transfer from present to past shareholders.  Moreover, the recovering shareholders paid for the protection in the form of D&O premiums back in the year when the fraud occurred.   

Of course, future shareholders may suffer from an increase in the cost of D&O insurance as a result of a settlement.  But that is highly problematic and not easily quantified.  Moreover, the amount of the increase may be small relative to the amount paid to the past shareholders.  Did the Chamber Study address this issue?  It had only this to say: 

• Even when a company's insurance covers the settlement and litigation costs, the company ultimately ends up footing much of the bill because insurance premiums inevitably increase to reflect the higher risk of liability.  These spiraling expenditures in part explain why insurance costs for a Fortune 500 company are over six times higher in the United States than in Europe.
  

Perhaps but this is a noticeably unsupported proposition.  To the extent there is a settlement, the quote suggests that premiums will increase.  It offers no actual authority for the proposition and is, in fact, wrong.  As Kevin  LaCroix (of D&O Diary fame), explained:  

• I agree with your criticism of the Chamber report’s statement that “insurance premiums inevitably increase to reflect the higher risk of liability.” This statement is simply not true. If it were true, insurance rates now would be much higher than five years ago, because of dramatically higher average claims severity. Instead, rates now are less than half of what they were in 2003. The largest determinant of insurance pricing is the availability of capital and related competition. Capital is abundant and competition is fierce, as a result of which buyers enjoy much lower rates than five years ago, despite much higher average claims severity. The mechanism that establishes insurance prices is much more complex and multifaceted than the Report’s statement suggests. Obviously there is a connection but it is neither as direct nor as “inevitable” as the Report suggests.
  

In other words, the report largely ignores the single most important issue in the entire securities litigation area -- the role of insurance and when it does mention the subject, it gets the facts wrong.

The Report has little to say about insurance because the topic represents an "inconvenient truth." First, focusing only on the cost of insurance is not very sexy and may not be excessive relative to other types of commercial insurance.  Thus, for companies with market capitalization over $10 billion, a recent report put their D&O costs at an average of $3 million, hardly the crisis levels claimed by the report.  

Second, those companies that pay the D&O premiums and are never sued may well, as a matter of economics, be the losers in the system.  They pay the insurance proceeds year after year, with no amount ever returned to shareholders (past or present).  A settlement in a securities suit at least returns some of the amount paid in insurance premiums back to shareholders.   

Finally, the focus on insurance gives rise to possible reforms not at all in line with what the Chamber is seeking.  By paying settlement amounts from insurance, the argument is strong that companies do not have sufficient incentive to reduce instances of fraud.  One way to solve the problem would be to eliminate insurance and severely restrict indemnification, making the responsible parties pay for any fraud.  These types of reforms, however, are absent from the Chamber's report. 

We have noted from time to time the difference in the regulatory approach between the US and the UK.  The UK relies on a "regulation lite" approach, with the Financial Services Authority (the British SEC equivalent) taking a less aggressive hand in the area of enforcement.  It is one of the reasons that explains the success of Alternative Investment Market or AIM. 

It is with interest, therefore, that we note the continued movement away from "regulation lite."  The WSJ reported that the FSA is becoming more aggressive in policing insider trading and will seek stiffer penalties, including jail time.   In a speech by the FSA's head of enforcement, Margaret Cole, she noted that "U.S. style punishment like jail time is a more powerful deterrent."  So is an increased level of enforcement.

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

Perhaps the greatest irony in the report is the shots it takes at institutional investors.  Recall that Congress, with the support of the Chamber, adopted the PSLRA in an attempt to cut back on securities litigation.  One of the central pieces to the litigation was the effort to diminish the role of professional plaintiffs.  The PLSRA did so by replacing the race to the courthouse with a presumption that the shareholder (or shareholders) with the largest loss would serve as plaintiff.  It was expected that this would transfer control of the litigation to institutional investors who could exercise greater control over the case and over counsel. 

In other words, the Chamber got what it wanted.  But it doesn't seem to want this anymore.  The Chamber complains that the reliance on institutions has resulted in a "pay-to-play" mentality.

• As institutional investors like public pension funds play an increasingly important role as lead plaintiffs in securities class actions, a "pay-to-play" culture has emerged in which plaintiffs' law firms contribute to the political campaigns of officials who control the decisions of those funds.  

The evidence mostly comes from a single article in USA Today.  But even assuming this type of culture exists, it is ironic (and unmentioned) that it is a dynamic that the Chamber helped cause. 

Moreover, if anyone is harmed by this approach, it is shareholders.  But the fact that the Chamber of Commerce, an organization that represents the entities sued for securities fraud, is promoting the reforms suggests the contrary.  The fact that the Chamber doesn't like the system suggests that it is because institutional investors are too hard on public companies, perhaps seeking even higher settlements (a conclusion consistent with the data they rely on in the report).  In other words, hidden by the pejorative use of the words "pay to play" is an implicit criticism that institutional investors are, as a result, promoting the interests of shareholders, something the Chamber doesn't appreciate.   

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce. 

The report is a collection of arguments, not all consistent.  Some of them, if they became the basis for reform, would probably be opposed by the Chamber.  An example?  The report rightfully notes that "even if a [securities fraud] claim is legitimate, the "guilty individuals rarely make a significant contribution." 

In other words, the company pays (or more accurately the insurance carrier pays) but the persons responsible for the fraudulent disclosure do not.  In that case, isn't the solution obvious?  It's not to reduce litigation but to change the regulatory system to provide for increased likelihood that the responsible individuals will have to dig into their own pockets and pay a portion of any settlement. 

Yet in the list of reforms proposed by the Chamber, that particular one is noticeably absent.  In other words, there is nothing in the proposal designed to reduce fraud or bring to judgment the guilty individuals.  There are only proposals designed to make companies more litigation proof, irrespective of the merits.

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

The Report emphasizes the increase in the number of class action suits that have been filed in the first half of 2008.  During the six month period, according to the report, the number of filings increased by 60% from the same period in 2007.  Moreover, the number of suits filed in 2007 was 58% higher than in 2006. 

True enough but what the report mentions nowhere is the cause for much of the uptick.  The implication is that matters have returned to the pre-PSLRA days when litigation was out of control.  But the reasons for the increase have a more specific explanation entirely omitted from the report. 

The Chamber report never uses the words "subprime," which says a considerable amount about the report's neutrality (or lack thereof).  According to NERA, 51% of the filings made in 2008 since June 30 have been "related to the subprime collapse."   In other words, the Chamber study pretends that the increase is a capital markets wide phenomena without making any attempt to isolate the impact of the current subprime problem. 

Similarly, the report contends that settlements have "skyrocketed."  It points in particular to the data from 2007. "The total value of securities class action settlements in 2007 was nearly 15 times the total in 1998."  The report likewise noted that 2007 "featured the highest median settlement amount ever."  NERA, however, has a different take.  "Even as filings were increasing in 2007 and 2008, average settlement values remained around $30 million.  Removing settlements over $1 billion from the calculation, the 2008 average settlement actually fell to $10 million, well below the level of recent prior years, and much closer to the 2008 median of $6 million."  

In other words, the data is not as bad as the Chamber makes it out to be.  Moreover, none of the reforms suggested by the Chamber address any of the problems associated with the subprime crisis.  Indeed, the reforms would make all securities suits more difficult to bring,  essentially making it harder for shareholders injured in the subprime fiasco to vindicate their rights.  In other words, the reforms are not about preserving the integrity of the capital markets in the US but simply cutting of causes of action that arise even out of meritorious facts.   

Now that SOX has faded as the whipping post for everything wrong with regulation and the US capital markets, the problem of excessive litigation has become the replacement.  These were addressed in my piece, Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.  

Excessive litigation interferes with competitiveness and causes foreign companies to take their business elsewhere.  These arguments were made, for example, in Stoneridge and the Supreme Court repeated them back.  But in fact, there's not any real evidence supporting the position, irrespective of the number of tendentious studies churned out on the topic.  This is not to say that there isn't room for reform.  But the level of criticism and blame placed on litigation as an explanation for concerns about US competitiveness is unproven. 

In that regard, we'll spend a couple of days examining the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” put out by the Institute for Legal Reform, a subdivision of the Chamber of Commerce.  The report mischaracterizes data (or is at least highly selective), cites as authority almost nothing except other, comparably reasoned reports, and contains arguments that are internally inconsistent.  Moreover, in analyzing the report, we have the benefit of an equally recent study, 2008 Trends, put out by the National Economic Research Associates.  The NERA report demonstrates some of the biases inherent in the Chamber report. 

The conclusions of the Chamber Report are predictable.  Securities litigation is ruining the US economic system. 

• "The costs of securities litigation are enormous, but the benefits are minuscule.  The culture of abusive class actions drive by a multibillion dollar plaintiffs' lawyer industry, is eroding the competitiveness of the U.S. capital markets at a time when they face perhaps their greatest threat from foreign competition."

In other words, the sky is falling and something needs to be done right away.  The urgency is in fact real but not for the reasons stated in the report.  Whatever happens at the presidential level, the November 2008 elections will almost certainly bring larger Democratic majorities in both chambers.  The urgency is that the days of favorable consideration of these types of arguments (which reached their apogee in the 1990s with the adoption of the PSLRA) are coming to a close.  If something isn't done now, it will only get harder in the next few years.  With that in mind, let us examine the report.  We start in the next post. 

The Race to the Bottom previously discussed the board of directors' role in Bear Stearns demise.  Bear Stearns' troubles began in 2007 when two of its hedge funds failed.  They culminated in an acquisition of the investment bank by JP Morgan Chase.  August's "Vanity Fair" article covered the reaction of the board of directors during J.P. Morgan Chase's first offer. 

J.P. Morgan’s initial offer came in at two dollars a share, and Bear Sterns President Alan Schwartz gave a half hour presentation to the board on its choices: a J.P. Morgan merger or bankruptcy.  Bankruptcy would have resulted in the seizure of the investment bank's assets by creditors and allowed federal regulators to take over customer accounts.  It would also mean the loss of fourteen thousand employees and likely wiped out the equity interests of shareholders. Shareholders, however, complained about the two-dollar share price (the price had been $27 on the Friday before the offer).  The parties renegotiated, and J.P. Morgan raised its offer to ten dollars a share.  Bear Stearns' board approved the merger. 

Because of the merger, shareholders filed a number of lawsuits, including class action lawsuits under the federal securities laws.  The suits generally focus on the disclosure made by Bear Stearns during the period prior to the merger.  Eastside Holding, Inc. alleged that Bear Stearns' officers and directors violated §10(b) and 10b-5.  The wrongful conduct occurred between December 14, 2006 to March 14, 2008, when the defendants allegedly issued false or misleading statements regarding Bear Stearns' business and financial health. 

The complaint alleged that Bear Stearns knowingly allowed its subsidiaries and high yield fund managers to avoid fully disclosing the risks involved in its underlying hedge fund investments.  In addition, the complaint asserted that the firm failed to "inform the market of the ticking time bomb in the Company’s hedge funds due to the deteriorating subprime mortgage market, which would cause Bear Stearns to have to rescue the funds, cause the Company and its officers possible criminal liability and hurt the Company’s reputation."  The plaintiff alleged it would not have bought Bear Stearns' common stock if it had known defendants’ misleading statements had falsely inflated the stock’s market price.  Plaintiff claimed it suffered damages by paying artificially inflated prices for the common stock.  Plaintiff asked for class action certification, damages, and equitable, injunctive, or other relief.  

J.P. Morgan’s S-4 filing stated it would hold harmless and indemnify present and former directors.  This covers "matters" occurring before or at the time of the merger's completion.  The indemnification remains in effect for six years after the merger, with JP Morgan Chase paying for directors' liability insurance coverage during that time.

Subsequent posts will examine the derivative suits against the directors of Bear Stearns. 

The primary materials for this post are available on the DU Corporate Governance web site.

BNA reports that the SEC has approved a rule change by the NYSE in connection with corporate governance requirements. The changes would eliminate the need for an opinion of counsel in connection with any application to list securities. The opinion mainly attested to the legality of the shares and the qualification to do business. The requirement would be replaced with the submission of legal opinions filed in connection with recent stock offerings or, if none where available, a certificate of good standing from the state of incorporation.

More importantly for purposes of this blog, the Exchange proposed eliminating the opinion that effectively attested to the company's compliance with the corporate governance requirements of the Exchange. The reasons for the change? A race to the bottom. As the Exchange described: " No other major exchange requires as a condition to listing an opinion with respect to the issuer’s compliance with the exchange’s corporate governance requirements."

The Exchange took the position that there were two other "sources of assurance that, at the time of initial listing, a company is in compliance with the Exchange’s corporate governance requirements." The first was that an authorized officer had to execute a listing application attesting to the fact that he/she had “read and understood the Exchange’s Listings Rule, and fully believes itself to be in compliance with, and, if approved for listing, intends to continue to be in compliance with, the Exchange’s listing and corporate governance rules and requirements, . . .”

In addition, the company must provide at the time of listing a written affirmation that it is in compliance with the director independence requirement. The NYSE promised to amend the written affirmation to have it include "compliance with the Exchange’s nominating and compensation committee independence requirements and thereby comprehensively covers the Exchange’s corporate governance requirements."

There are several problems with these substitutes. First, the requirements are legal in nature.  While a board could in good faith attest to compliance, nothing about the process ensures legal involvement.  Thus, for example, in determining whether directors are independent, they may not have a "material relationship" with the company.  Legal advise on the meaning of the phrase is necessary for appropriate application.  Yet the NYSE rule proposal is essentially eliminating a required role for counsel.

Second, the whole approach of SOX was to recognize that boards function better when there are gatekeepers looking over the shoulders of management.  Thus, Section 404 required management to assess the company's internal controls but further mandated that the outside auditor attest to the findings.  In other words, the auditors had to review management's opinion.  The rule change by the NYSE is eliminating a gatekeeper role in the process.   It is doing so despite the existing problems of enforcement.

The NYSE has an incentive to propose the change.  The other exchanges don't do it and it adds a cost to the listing process.  This is a tough thing to require in a competitive environment.  But that is no excuse for the SEC to improve what is an obvious weakening in corporate governance standards administered by the SROs.

We are reviewing Exchange Release No. 58367 (August 15, 2008), where the SEC approved changes to the NYSE definition of director independence.  The changes weaken the definition.  The first change was to raise the amount of "direct compensation" a director could earn and still remain independent.  The second concerned relationships with the outside auditor. 

Section 303A provided that a director lost his/her independence if an immediate family member was a current employee of the accounting firm and worked in the audit practice.  As the release noted: 

• "NYSE's current test has required a listed company's board to conclude that a director may no longer be deemed independent when the director's child took an entry-level job in the audit practice of the listed company's external auditor upon graduation from college, notwithstanding the fact that the child was a low-level employee in a different region and had no involvement with the listed company's audit."  

The solution?  Disqualification occurs only when the family member is a partner of the auditor or works on the lited company's audit.  What does this exclude?  Employees who are not partners but work in the same office where the audit takes place; employees who work on the company's account but are not actually working on the audit (providing, for example, assurances or tax compliance advise); and employees who are not partners but otherwise participate in the setting of standards that could affect the company's audit.

The NYSE identified a problem, albeit one likely to arise rarely.  Nonetheless, in solving the problem, it would have been easy enough to exclude employees who are not partners, not in policy making positions, and conduct no work for the company subject to the audit.  Instead, the change permits a far broader category of relationships than the specific problem identified by the NYSE.

That the NYSE would come up with these changes is no surprise.  The organization is, after all, a for profit business that benefits by making listing standards easier.  It is the SEC that is the gatekeeper and should ensure that investors are protected.  There is no indication with that change that the SEC played this role. 

 

The NYSE has proposed and the Commisson has approved amendments to the listing standards governing the definition of director independence.  Before the amendment, Section 303A.02(b)(ii) of the NYSE contained a categorical rule providing that directors lose their independence if they receive more than $100,000 in direct compensation.  The rule was adopted in the post-SOX reform era and was little more than a sop to those critical of the existing state of corporate governance. 

Thus, the amount does not include directors fees, something that can result in payments to directors in the vicinity of $700,000.  In other words, a director making $700,000 in fees is independent under the rules of the NYSE while a director making $100,000 in fees and $100,001 in "direct" income is not.  Go figure but this is the system that the Commission has allowed.  

Add in that there is anenforcement problem with the independence requirements at the NYSE.  Rather than exercise increased supervision over the NYSE, the Commission has chosen to bring its own enforcement proceedings in connection with director independence.  

With that in mind, we note that the Commission recently approved amendments to the rules of the NYSE that weaken, albeit modestly, the definition of  independence.  The amendments raise the amount of "direct compensation" that can be earned from $100,000 to $120,000.  The reason?  Absolutely nothing related to the notion of independence.  Instead, it was done to bring the rules into better harmony with the SEC requirements for related party transactions in Item 404 of Regulation S-K.  The Commission had previously raised the threshold for conflict of interest transactions that must be reported from $60,000 to $120,000.  According to the NYSE: "Using a consistent standard would enahance the NYSE's abilty to assess compliance with the independent director requirements because companies are required to disclose compensation in excess of $120,000 but are not necessarily required to disclose compensation between $100,000 and $120,000."

It's a curious way to deal with an assessment problem not by doing anything designed to faciliate assessment but by simply eliminating the enforcement obligation.  Moreover, the carefully worded explanation noted that companies were "not necessarily" required to disclose the compensation.  In fact, Item 402 provides that the director compensation table must include "[c]onsulting fees earned," irrespective of the amount.  In other words, the NYSE often had available information about payments made to directors for amounts between $100,000 and $120,000.  In other words, the NYSE was using Item 404 (self interested transactions) as the excuse to raise the threshold when the issue was one primarily of exeuctive compensation and should have been resolved with reference to Item 402. 

There is one more change that we will discuss. 

We have written a series of posts on the proposed change by US News to the system of rankings for law schools (go here, here, here, here and here).  The proposal would rank law schools on their median LSAT and GPA calculated based on a combination of the full time and part time division (it's currently ranked based only on full time). 

The WSJ this week had an article on the subject, Law School Rankings Reviewed to Deter 'Gaming'. It doesn't add much that we haven't already said except that it profiles a few additional schools deemed to be at risk.  The article includes a table that lists law schools that "could have been affected if the change had been made for this year's rankings." Its not exactly going out on a limb to make that statement and our posts point out the schools most likely at risk in greater detail.  Nonetheless, the schools listed by US News:  Fordham, George Mason, Maryland, SMU, Connecticut, Seton Hall, Chicago Kent, Loyola (Chicago), St. John's, Depaul, University of Denver, St. Louis, University of the Pacific (McGeorge), Hofstra, and Stetson.  

The most significant thing about the article is to essentially confirm that US News will make the change.  The director noted that U.S. News was "seriously" considering the change.  Moreover, as for the timing:  "Mr. Morse of U.S. News says the magazine will run tests of how the change would play out in rankings, and then decide in January. How colleges adjust their programs in response isn't the magazine's responsibility, he said. The ranking is published in the spring."

Surely with the issue having been discussed on the front page of the WSJ and with the issue having been framed as a reform designed to stop schools from gaming the system, US News has the cover (and pressure) it needed to make the change (it will be criticized for a change that will make it harder for students with alternative criteria to get in).  Besides the change will help sell additional magazines.  If I were a school with a night/part time division, I would start considering the impact it will have on this year's rankings.

We noted yesterday about the role of Say on Pay in the current election cycle, the matter having become part of the Democratic Platform.  A small matter in the greater scheme of things perhaps, but nonetheless interesting that the matter has become part of the national campaign.  Moreover, as corporate behavior in response to proposals shows, there is a need for mandatory federal legislation in the area. 

In that regard, Risk Metrics has a nice post on the latest in the "say on pay" and noted that a proposal at Valero Energy passed with 53.7% of the vote.  It was the tenth say on pay proposal to pass, with the proposals averaging 42%, roughly the same as last year.  In other words, there has not, as some have suggested, been a significant decline in support for the proposals. 

The Valero vote, however, demonstrates clearly the need for federal legislation.  It is the second year in a row that the proposal has passed and so far there is no indication that the company will implement the proposal.  This is the case even though any vote would be advisory.  Thus, shareholders have to go through the logistical process of obtaining approval by shareholders.  Even then, because many such proposals are advisory (a result encouraged by the Delaware Court's decision in the CA case), board are legally free to ignore them, and they do.  With federal legislation, however, the proposals will become mandatory.

This Blog operates out of Denver, the current location of the Democratic National Convention, which began yesterday.  It is the convention that will, on Thursday, nominate Barak Obama.  We have mentioned Obama a number of times on this Blog, including his endorsement by some former SEC chairmen, his support for "say on pay," and the inclusion of "say on pay" in the Democratic Platform.   Denver is, as a result, overflowing the election talk and Obama paraphanalia.  This is particularly true given that Colorado is a purple state and one of the places targeted by both parties.

For those of us who live in Denver, there is some opportunity to observe the convention in action.  Getting inside requires a pass and getting a pass requires knowing someone.  Some are contributors (or fundraisers) who go through their political connections.  Some are lending out their house to those attending the convention and receive passes as a return favor.  Still others come from places outside of Colorado and know members of the Democratic hierarchy, whether politicians or fundraisers and are bestowed with entry opportunities.  Then there are the rest of us who know someone who knows someone in these three categories and manages to tag along.

Last night, I was able to tag a long with a faculty member from the Law School (Roberto Corrada) who scored two passes as an "Honored Guest" (as opposed to Guest and Special Guest) to the first night of the convention.  It was from the nose bleed vantage point in the capacious Pepsi Center in Denver that we were able to watch a number of speakers, including Michelle Obama (we were still searching for seats when Edward Kennedy spoke).

We can report definitively that Michelle Obama said nothing about corporate governance or say on pay (the theme was something like middle class America).  But she did note that her speech and her husband's would be given during the same week when, 45 years ago, Martin Luther King gave his "I have a dream" speech.  In other words, however one comes out politically, it was an historic occasion and one that, 45 years ago, was only a dream.  It was a honor to be there for the event. 

We have on this Blog occasionally dealt with Delaware cases that seemed to give inordinate discretion to management to manipulate the voting process.  Thus, Delaware courts have upheld the right of management to delay a meeting more or less because they know from the proxy tabulator that they are going to lose the vote. 

The discretion, however, apparently has limits.  In Steel Partners v. Point Blank Solutions, the Delaware Chancery Court dealt with a company that had not held an annual meeting for three years.  The complaint alleged that six of the seven directors had never been elected by shareholders but had been appointed by the board.  The Company scheduled a meeting for April 22 but after Steel Partners, a shareholder holding more than 8% of the shares, filed proxy materials in order to elect five directors, the Company opted to delay the meeting until August. 19.  Steel Partners filed suit under Section 211 (chancery court has jurisdiction to "summarily order a meeting" whenever a period of 13 months has elapsed since the last meeting) and requested an order requiring the Company to "promptly hold its annual meeting" and "designating a time and place" for the meeting. 

The parties came to agreement and the court issued an order providing that:  "Unless otherwise approved by this Court, for good cause shown and on notice to plaintiff, defendant Point Blank . . . shall hold its annual meeting of stockholders no later than August 19, 2008."   The stipulation, therefore, removed all discretion from the board and conditioned any change upon court approval.  Point Blank moved to delay the meeting for 60 days, arguing that it needed more time.  According to the court, it based the request on the following:

• the Company points to its concern that Steel Partners and the former CEO of the Company, David H. Brooks ("Brooks"), together control approximately 40% of the vote. Their combined vote, Point Blank contends, is enough to warrant the requested postponement. First, as to Steel Partners, a potential buyer of the Company that has nominated a slate of directors, Point Blank argues that, if elected, these directors will be conflicted and will seek to purchase the Company for Steel Partners' own investors for the lowest possible price. Second, the Company insists, Brooks has a personal interest adverse to the majority of the Company's stockholders because Brooks is currently litigating his claim to advancement fees against the Company, which has asserted the defense of unclean hands, and is also defending a breach of contract action that the Company filed against him in federal court in New York. In addition, Point Blank notes that Brooks has voting control over 22% of the 29% of the Company's stock he owns with his former wife. Though his former wife has beneficial economic ownership of these shares, Brooks has voting control, highlighting the disparity of Brook's interests as compared to those of other stockholders.

In resolving the matter, the Chancery Court did not determine whether the appropriate standard was "good cause" or "extraordinary circumstances" since neither was met. 

• Though I do not fail to recognize the influence that Steel Partners and Brooks may have on the outcome of a shareholder vote, the Company's proper recourse under the circumstances is to communicate its concerns directly to its shareholders. Should the Company wish to communicate its concerns with the shareholders to inform them, for example, of the perceived hazards that may befall the Company if the Steel Partners' slate of directors is elected or, for another example, of the report of the findings of the Institutional Shareholder Services, Inc., then the Company certainly may make any and all communications it determines are necessary and appropriate (and in fact appears to already be doing so). After evaluating all the information made available to them, the stockholders will then decide to stay the course with the Company's current management or else elect a new slate of directors.

The case is a difficult one to characterize.  It suggests some limit on a board's ability to reschedule a meeting.  The Chancery Court rejected the board's argument that it needed more time to consider "strategic options."  As such, the opinion arguably conflicted with the decision in Inter-Tel that a meeting could be postponed where the board argued that a particular acquisition was in the best interests of shareholders. 

But this is Delaware.  More likely, the case will have limited impact, standing merely for the proposition that when you don't hold an annual meeting for three years and then condition any postponement on judicial approval, you have less discretion to change the meeting date.

Oh, and by the way, the outcome of the vote?  As the Company predicted, all of the plaintiffs candidates won, receiving approximately 65% of the vote. 

Primary materials (although not the opinion, unfortunately) are posted on the DU Corporate Governance web site. 

On this Blog, we often criticize the Delaware courts, whether for an anti-shareholder bias (go here and here for examples) or what we sometimes perceive as a lack of appropriate judicial disposition.  Mostly, though, these issues are symptomatic of a larger problem, the failure to impose meaningful standards of behavior on directors.  The courts have turned the duty of loyalty into a shill, relying on procedural mechanisms, particularly approval by independent directors, to obviate any need to examine fairness.  They have done so, however, without making meaningful the very processes they have put in place.   For example, the approach to independence does not ensure at all that directors are in fact independent.  As a result, the courts have, in most instances, effectively repealed the duty of loyalty.  I have addressed this issue in greater length in the article, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  

But just for a moment, let's imagine a different Delaware, a Delaware that in fact made the requisite process meaningful.  It would be a state that deferred only to boards or, more likely, board committees, that ensured membership was truly independent.  The individuals could not be close friends of the CEO, receive fees disproportionate to their other sources of income (like the principal in Disney), or head nonprofits that receive significant contributions from the company (or its CEO).  Nor could the person with the conflict participate in the deliberations.  In this Panglossian universe, the standards would be difficult to meet and, as a result, boards would often be left with the burden of establishing why a particular transaction was fair.  Thus, executive compensation would not be a matter of process but a matter of fairness. 

With this Panglossian universe in mind, we turn to Julian v. Eastern States Development, a recent Chancery Court decision.  The case was essentially a dispute among three brothers.  As part of the case, three directors (and two of the brothers) voted to award bonuses to themselves. They asserted that the payments were a reward for "a good year" and to "reduce retained earnings."  The meeting lasted "less than half an hour and no legal or financial advisors attended." 

As the court noted, self interested transactions not accompanied by "independent protections" are subject to the entire fairness analysis.  In other words, the board can pay the bonuses but has the burden of establishing that they are fair.  In this case, the board was unable to meet that burden.  The court indicated concern with the timing of the bonuses but  was mostly concerned about the substantive fairness of the payments.  As the opinion observed: 

• Before the December 20, 2005 meeting, the [Company] board had not approved bonuses near the magnitude of $1.3 million. While the record is imperfect, it suggests [Company] paid no bonuses from 1996 through 1998. From 1999 through 2004, [Company's] bonuses as a percentage of adjusted income hovered between 3.30% and 3.36%. In contrast, the challenged 2005 bonuses constituted 22.28% of adjusted income. Additionally, 2005 marked the first time [the non-brother director] received a bonus beyond the performance-based compensation set forth in his Employment Agreement.
  

Even an unusually large bonus, however, wasn't automatically unfair. But in those circumstances, there needed to be a credible explanation.  This, the Vice Chancellor, did not find.  "I do not find credible Defendants’ argument that the board approved the Benchmark Bonuses as a reward for a good year in 2005 or to reduce retained earnings in the event of a lawsuit. Regarding the reward for a good year, Benchmark had a better year in 2004 than 2005, and the bonuses in 2004 were still only 3.36% of adjusted income."  The court, therefore, found that the directors had not met their burden of showing fairness. 

This case illustrates the type of analysis that applies when the court does not hide behind poorly developed process and forces the board to establish fairness.  The board in Julian merely needed to show that the bonus was typical or was based on some objective criteria.  Shouldn't this standard always be the case?  Shouldn't conflict of interest transactions always have to be typical or, if unusual in timing or amount, be accompanied by an explanation for the unusual terms?  But in fact its the exception not the rule.  Instead, the Delaware courts use process as a mechanism to sidestep all analysis of fairness.  Said another way, process is a mechanism by which courts uphold unfair transactions. 

Imagine if this weren't the case (our Panglossian universe again) and, in fact, boards were required to establish the fairness of their transactions.  Take the Disney case.  It was a board that lacked independence (and one found by Business Week two years running to be the worst in corporate America based on corporate governance criteria).  Nonetheless, in an astounding opinion, the Chancery Court decided otherwise.  Had the court found an absence of independence (in other words, had the court applied a meaningful definition of independence), it would have shifted the burden to the board to demonstrate that the Ovitz contract was "fair."  In other words, the board would have had to justify why it was necessary to execute a contract that resulted in the payment of $160 million after a little over one year of service.  Maybe it was, but in any event shareholders would have been owed the explanation.  Instead, the court treated the matter under the duty of care/good faith, with the case turning entirely on process.  The fairness of the agreement (and the payment) was never determined.

Imposing an obligation to establish fairness in conflict of interest situations would protect shareholders and not result in severe burdens on boards.  At the same time, aware that the transaction would be subject to review for fairness, boards would presumably be less likely to approve transactions that were not substantively fair.  Were this to be the standard, it would solve the executive compensation problem.  The board would be able to pay any amount it wanted (short of waste) but would have to justify the fairness of the payment.  This alone would temper the amounts paid.  But this is the kind of approach that, given the current race to the bottom, could only be suggested an incurable optimist like Pangloss (or this Blog).     

 

As stock markets switch to for profit enterprises, a process of consolidation is taking place.  The NYSE merged with Euronext and Nasdaq acquired the Nordic Exchange.  There are some redoubts, however, and one of them is in Spain.  Currently, the Bolsas & Mercados Espanoles SA has managed to remain unacquired while doing, apparently, a booming business.  According to the WSJ, BME was the eighth largest exchange by value of shares.  The article described the exchange as efficient, with "tight cost controls" and profitable.  It sounds like a recipe for success. 

But in fact not all is well at BME.  The share prices of the exchange have declined by 60% over the last nine months.  Part of this is a result of reliance on equities for a good chunk of the exchange's profits at a time when sales are down.  What has kept the BME independent?  Most likely the government's ability to veto any acquistion of 1% or more of the company's stock.  Likewise the entity has only five directors who are independent out of a 15 person board.  

BEM will remain independent as long as the government desires.  But were the market to decide, BME would become part of a larger trading network that allows for economies of scale and offers easier accessibility to a larger number of buyers. 

We offer a final note.

There is no doubt at this Blog that the litigation has not yet ended. We fully expect the plaintiffs to file a petition for ceriorari and see if they can attract the attention of the high court. Certainly, the dissent has written one of those opinions designed to attract the attention of those on the Supreme Court most concerned with limits on executive authority. But having said that, we'll be surprised if Justice Scalia is able to convince three others (cert requires four justices to assent) to join him. Why?

First, Judge Kavanaugh is caught in a conundrum. On the one hand, he wants to make the case one of critical importance, a direct threat to the Republic. On the other hand, he knows that he must delicately walk around the independent agency issue. He cannot issue a decision that provides ammunition to those wanting the challenge the constitutionality of independent agencies. That ship has sailed and there is no going back. Consequently, he starts by opining on the importance of the decision but ends with an explanation of the unimportance of the decision. He points out that the decision does not impact the independent agencies and, in fact, only impact the PCAOB. He's not quite right on that, as we have noted, but it sure reduces the power of any argument that the case, if left standing, will disrupt our system of government.

Second, although wanting to defend executive authority, the Supreme Court won't have the executive on its side. It has been the DOJ that has vigorously defended the constitutionality of the PCAOB. Judge Kavanaugh was clearly troubled by this. First, he tries to minimize the government's involvement.

• the Department of Justice representing the United States as intervenor has defended the constitutionality of this statute. To be sure, the defense has been rather tentative; at oral argument, the superb counsel from DOJ refused to say that the structure of the PCAOB would be permissible in any analogous situation, strongly implying that the Executive Branch’s position is a ticket good for this train and this day only. In any event, the Executive Branch has defended the statute as consistent with Article II. This is reason for respectful consideration.

The written transcript suggests a vigorous defense of the Act by the attorney for the DOJ, Mark Stern. 

Judge Kavanaugh then tries to make the case that the DOJ really didn't really believe its own position, that it was a matter of political expediency.

• History tells us that Executive Branch prerogatives have, in some instances, taken a backseat to the President’s other more immediate policy, legislative, or political priorities. The United States as intervenor has argued that the PCAOB is better from a Presidential control perspective than the private self-regulatory accounting organizations that previously existed to regulate the accounting industry. This is an odd argument as a matter of constitutional law. The fact that the President would have less control over a private organization than over an Executive Branch entity is both obvious and irrelevant. It certainly does not excuse compliance with Article II’s principles regarding Presidential appointment and removal of executive officers.

In the end, he is left with the only real response. He disagrees with the DOJ and, as a result, doesn't intend to follow the reasoning.    But added to this is the notion that it falls on Judge Kavanaugh to defend the Constitution, at least where the President won't. 

• But as the Supreme Court has stated when this situation has arisen before, the Judiciary cannot defer to the Executive Branch in justiciable cases affecting individual rights simply because the Executive Branch does not assert its Article II prerogatives. The primary reason, as the Court has explained time after time, is that the separation of powers protects not simply the office and the officeholders, but also individual rights. The point was captured well by Justice Blackmun in his opinion for the Court in Freytag: “In reaching this conclusion, we note that we are not persuaded by the Commissioner’s request that this Court defer to the Executive Branch’s decision that there has been no legislative encroachment on Presidential prerogatives . . . . The structural principles embodied in the Appointments Clause do not speak only, or even primarily, of Executive prerogatives simply because they are located in Article II. . . . The structural interests protected by the Appointments Clause are not those of any one branch of Government but of the entire Republic.” So too here.

The Justice Department is not always right but in this case, a potentially delicate issue dealing with separation of powers, the Supreme Court will get no help from the supposedly aggrieved branch of government.

Finally, even if the Supreme Court wanted to examine whether a somewhat more severe restriction on the president's removal authority was constitutional, this is not the right case, at least for those wanting to strengthen executive authority.  The case, after all, involves the regulation of independent auditors.  In other words, unless the Court was willing to issue a per se rule that these types of restrictions were always unconstitutional (like the way it struck down legislative veto in Chadha), this case simply doesn't intersect in any meaningful way with the president's constitutionally assigned duties.  

We have a limited track record in predicting decisions by the Supreme Court but so far are one for one, having anticiapted the outcome in Stoneridge.  We will therefore offer a prediction in this matter.  A petition for certiorari will be filed and it will be denied.

 We are discussing the decision, issued today, by the DC Circuit, upholding the constitutionality of the PCAOB.  It was a 2-1 decision. 

The dissent goes out of its way to minimize the impact of its reasoning.  Striking down the PCAOB (primarily because of the limitations on the president's removal authority) would, according to the dissent, have little effect and be easily corrected.  

• Third , to reiterate, the PCAOB is uniquely structured, and a judicial holding invalidating it would be uniquely limited to the PCAOB. And Congress could easily fix the constitutional flaws by, for example, making PCAOB members subject to Presidential appointment with the advice and consent of the Senate and therefore removable by the President. Cf. Housing and Economic Recovery Act of 2008, Pub. L. No. 110-289, 122 Stat. 2654 (2008) (creating new “independent” federal regulator of Fannie Mae and Freddie Mac appointed by President with advice and consent of Senate and removable for cause by President). Alternatively, Congress could fix the problem by making the PCAOB a truly subordinate part of the SEC – for example, by giving the SEC express authority to direct and supervise all Board actions and to fire Board members at will. In such a structure, the Board would not differ from any other inferior officers in the SEC. In the meantime, in my judgment, the Board’s structure violates the Constitution of the United States. 

We actually said the same thing on this Blog, at least with respect to the methods of fixing the board, but very much disagree with the efforts to minimize the potential impact of the decision.  First, the analysis is wrong to suggest that only the PCAOB will be impacted by the decision.  The existence of a double layer of for cause removal is more common than the dissent suggests. 

Second and more importantly, such a decision would essentially lock the government into a model of regulation that requires every regulatory body to be a full blown federal agency.  The PCAOB has an attempt to create a regulatory model with private sector sensibilities.  As a result, the PCAOB had strong ties to the private sector.  Were the PCAOB to be transformed into an independent agency, it would, as we wrote, "likely be less responsive to the private sector and would have the attendant problems associated with a traditional bureaucracy."  In other words, the implications of this case are not so much about the impact on other existing agencies but on the nature of regulation.  If the dissent becomes the law, a form of regulation that tries to more closely intersect with the private sector will be eliminated.  This would ultimately be detrimental and, frankly, not in the best interests of the private sector. 

The opinion (and the supporting documents) are here. 

The critical issue, as we noted on this Blog, was the right of Congress to restrict the president's removal authority. The commissioners of the PCAOB were only subject to removal by the SEC for cause. The SEC, in turn, is an independent agency. Thus, removal by the president was subject to two layers of limitations. Unlike appointments, the Constitution is silent on removal. As a result, removal is addressed through application of separation of powers doctrine, an amorphous area to say the least. With respect to removal limitations, the Supreme Court is relatively clear that Congress can impose limitations on removal where it gets to participate in the removal decision. Thus, requiring advise and consent of the Senate before an executive branch employee can be removed is unconstitutional.

Second, assuming Congress stays out of it, limitations on removal are permissible if they do not prevent the president from performing his or her "constitutionally assigned duties." Morrison, 487 U.S. at 696. This is a highly underdeveloped area. But in Morrison, the Supreme Court essentially reaffirmed the holding in Humprhey's Executor. That was the case that upheld the restrictions imposed by Congress on the president's abilty to remove commissioners from the Federal Trade Commission. Congress allowed the president to remove them only "for cause." In other words, the Supreme Court held that Congress could limit removal authority by the president for officials that have wide ranging authority without it interfering with the president's "constitutionally assigned duties." Given this blessing of Humphrey's Executor, it is hard to make an argument that limitations on removal of commissioners of the PCAOB somehow interfere with the president's constitutionally assigned duties.

Nonetheless, the double layer of removal restrictions presents at least a unique set of circumstances. The majority addressed the issue in succinct fashion:

• The Fund does not assert that Congress or the judiciary have directly encroached on the Executive Branch’s appointment, removal, or decision making authority by aggrandizing their own powers. Instead, the Fund’s separation of powers challenge is premised on the contention that the Act constitutes an excessive attenuation of Presidential control over the Board. The crux of the Fund’s challenge – that the double for-cause limitation on removal makes it impossible for the President to perform his duties – is a question of first impression as neither the Supreme Court nor this court has considered a situation where a restriction on removal passes through two levels of control. But the Fund’s categorical, bright-line approach conflicts with the Supreme Court’s case specific reasoning in Morrison, which emphasized that there are “several means of supervising or controlling [Presidential] powers,” 487 U.S. at 696. The removal power thus does not operate in a vacuum; rather it is one of several criteria relevant to assessing limits on the President’s ability to exercise Executive power.

The dissent vociferously disagrees.  As the opinion notes:  "[T]he President is two levels of for-cause removal away from Board members, a previously unheard-of restriction on and attenuation of the President's authority over executive officers."  In other words, the dissent doesn't like this type of restriction on the president's removal authority.  Its true that the structure is unique.  But the broader question is whether increased restrictions on the president somehow interfere with constitutionally mandated duties.  It is a hard case, unless adopting a per se rule, to argue that increased interference with the president's ability to manage the accounting profession somehow interferes with constitutionally mandated duties. 

The opinion (and the supporting documents) are here. 

 The two main challenges were to the appointment of PCAOB members and the limits on their removal. In the former case, it was the SEC that appointed the members, not the President. Resolution of this issue came down to whether the limitation on presidential appointment violated the Appointments Clause. That in turn came down to whether members of the PCAOB were Principal (as opposed to inferior) officers. Resolution of that issue largely depended upon the issue of supervision. See Edmond v. United States, 520 U.S. 651, 662 (1997)("Generally speaking, the term 'inferior officer' connotes a relationship with some higher ranking officer or officers bleow the President: Whether one is an 'inferior' officer depends upon whether he has a superior.").

The PCAOB is subject to extensive supervision by the SEC, with all rules and sanctions subject to review by the agency. As such, the PCAOB was subject to the oversight of a superior. Plaintiff argued that there were places where the PCAOB could intitiate actions without supversion. Thus, for example, the PCAOB could intitiate an investigation without SEC approval although any sanctions ultimately were subject to SEC oversight. The majority rejected the argument.

• Consequently, the Board’s work is necessarily “directed and supervised at some level” by the Commission. Notably for purposes of this facial challenge, the Act subjects Board members to greater supervision than the Coast Guard judges in Edmond, whom the Supreme Court held were inferior officers even though supervision of the judges was fractured between two different bodies, id. at 664, and their decisions were not subject to de novo review, id. at 665. Contrary to the Fund’s suggestion, the fact that the Board is charged with exercising extensive authority on behalf of the United States does not mean that Board members must be appointed by the President, for principal as well as inferior officers, by definition, “‘exercis[e] significant authority pursuant to the laws of the United States.” Instead, what is key under the Edmond analysis is the fact that Board members “have no power to render a final decision on behalf of the United States unless permitted to do so by other Executive officers.” The Act vests a broad range of duties in the Board, 15 U.S.C. § 7211(c), but its exercise of those duties is subject to check by the Commission at every significant step.

The main argument, however, that took up most of the space in the majority and dissenting opinion, came back to one issue: The restriction on the president's ability to remove commissioners of the PCAOB. (It is the Commission that has this authority and may only remove for cause). Thus, the dissent essentially conflated appointments and removal authority. Limits on removal meant unconstitutional appointment. The majority rightfully noted the central weaknesses in the argument:

• The Supreme Court has expressly permitted legislatively imposed limitations on executive officers’ removal authority: We have no doubt that when congress, by law, vests the appointment of inferior officers in the heads of departments, it may limit and restrict the power of removal as it deems best for the public interest. The constitutional authority in congress to thus vest the appointment implies authority to limit, restrict, and regulate the removal by such laws as congress may enact in relation to the officers so appointed. The head of a department has no constitutional prerogative of appointment to offices independently of the legislation of congress, and by such legislation he must be governed, not only in making appointments, but in all that is incident thereto.

The critical issue was removal (as even the discussion of the appointments issue illustrates). We will discuss that issue next.

The opinion (and the supporting documents) are here.