Among the failure of the the inspections of investment banking firms, the Report of the Inspector General identified one problem area with respect to the board of directors.  As the report noted:   

• TM [Trading and Markets] took no actions to assess Bear Steams' Board of Directors' and senior officials' (e.g., the Chief Executive Officer) tolerance for risk although we found that this is a prudent and necessary oversight procedure;

In effect the report concluded that the staff should have used discussions of  "risk management practices" and "risk tolerance" to bring to the attention of the board: 

• "evidence that the staff [of Bear Stearns] kept increasing the firm's exposure to mortgage securities. TM [Trading and Markets] staff could also assess whether firms are inappropriately increasing leverage to help meet a revenue level that is tied to compensation that is provided to the CSEs' senior·officers.
  

The issue illustrates a continuing problem with allowing board obligations to be determined under state law and the race to the bottom.  In effect, the conclusion of the report is that federal regulators should have forced the board to focus on risk related practices, including the increasing amounts of debt. 

But the better question is why the board wasn't already fully engaged in the issue.  Under Delaware law, there is little obligation on the part of the board to ask for information or become informed about what is going on inside the company.  The only requirement is that the board have some process for receiving information in order to fulfill its obligations under Caremark and the duty to monitor.  But in fact the Delaware courts have never made the requirements meaningful.  It is, therefore, possible to meet fiduciary obligations without having an actual obligation to supervise or assess internal risks.

Without state law obligations, it falls to federal regulators to ensure that the board remains involved.  In this context, inspectors at the SEC apparently failed. 

There has been considerable discussion over the role played by the SEC in the current turmoil.  Some, including presidential candidate John McCain, have tried to pin blame on the Chairman but have had a hard time specifying exactly how the agency could have prevented the current problems.  Much of the criticism has focused on a reduced emphasis on enforcement (particularly the decision to tie the staff's hands with respect to penalties imposed on companies), which has been a problem but is hard to relate back to the current market turmoil.

Evidence of a Commission role, however, has come from an unexpected source.  The SEC Office of the Inspector General has published a report on the consolidated supervised entity program.  This was the "voluntary program" designed to increase the inspection of investment banks ("was" because, since there are no more independent investment banks, the program has been terminated).  As the report described:

• The CSE program is a voluntary program that was created in 2004 by the Commission pursuant to rule amendments under the Securities Exchange Act of 1934.  This program allows the Commission to supervise these broker-dealer holding companies on a consolidated basis. In this capacity, Commission supervision extends beyond the registered broker-dealer to the unregulated affiliates of the broker-dealer to the holding company itself. The CSE program was designed to allow the·Commission to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place United States regulated broker-dealers and other regulated entities at risk.  A broker-dealer becomes a CSE by applying to the Commission for an exemption from computing capital using the Commission's standard net capital rule, and the broker-dealer's ultimate holding company consenting to group-wide Commission supervision (if it does not already have a principal regulator). By obtaining an exemption from the standard net capital rule, the CSE firms' broker-dealers are permitted to compute net capital using an alternative method. The Commission designed the CSE program to be broadly consistent with the Federal Reserve's oversight of bank holding companies.
  

So, the Commission put itself in a position to inspect investment banks and specifically to try to duplicate the oversight of the Federal Reserve Board.  Things didn't work out, however, and the report is fairly damning in its conclusions about Commission oversight.   Much of the criticism was aimed at the staff's approach to inspections.  Standards were inadequate.  See Report ("Overall, we found that there are significant questions about the adequacy of a number of CSE program requirements, as Bear Steams was compliant with several of these requirements, but nonetheless collapsed."). 

In other instances, the staff failed to follow their own procedures. See Report, at ix ("In addition, the audit found that procedures and processes were not strictly adhered to, as for example, the Commission issued an order approving Bear Stearns to become a CSE prior to the completion of the inspection process.").   

Finally, even when the staff uncovered problems it didn't always take steps to correct them.

• In addition, the audit found that TM [Trading and Markets] became aware of numerous potential red flags prior to Bear Stearns' collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors.
  

Perhaps worst of all, with respect to Bear Stearns, the staff became aware of the excessive concentration of mortgage securities but took no steps to correct the problem.

• Although TM [Trading and Markets] was aware, prior to Bear Stearns becoming a CSE firm, that Bear Stearns' concentration of mortgage securities was increasing for several years and was beyond its internal limits, and that a portion of Bear Stearns' mortgage securities (e.g., adjustable rate mortgages) represented a significant concentration of market risk, TM did not make any efforts to limit Bear Stearns' mortgage securities concentration;
  

It is possible that these problems, even had they not occurred, would not have prevented the current crisis.  The discovery that Bear Stearns had engaged in excessive risk taking with respect to mortgage securities may have come too late.  Nonetheless one cannot help but wonder whether, had the staff done a better job at inspection, there still might be independent investment banks today. 

We are coming up on the need for the Commission to renew its ban on short selling. Under Section 12(k)(2),emergency orders cannot last more than ten days unless renewed, although they can be renewed at least twice. So, we consider the consequences of the ban. The WSJ reported that the ban on short selling has "effectively shut down much of the convertible-bond market, a crucial area of financing for struggling companies." The significance?

• Convertible securities are essentially bonds that can be exchanged for stock in the future. It's a relatively small market with less than $400 billion in securities outstanding, according to market participants, a fraction of the total for investment-grade bonds. But in times of stress, struggling companies turn to convertibles in order to raise capital when a share price has fallen.
  

The NYTimes ran an article on Sunday noting that short selling may not be so bad after all. The article pointed out the possibility of inefficient pricing as a result of the ban. Shareholders may, therefore, avoid the stocks because, once the ban has been listed, there may be a correction to the price. As the article notes:

That means investors should think twice before buying shares of any companies for which short-selling is now banned, Professor Reed said. In his research, he said, he has found that ‘stocks without short-selling not infrequently trade at prices that deviate widely from their true value.

Moreover, despite claims of abusive short selling in the form of “bear raids,” one academic noted that: “when academic researchers have looked for bear raids – even in those areas in which investors suspected that they existed – they haven’t found them.”

So, harm from the ban and doubt about its benefit, at least for such a broad based ban for so many companies.  What will the Commission do? Renew the ban to appear involved in the efforts to end the turmoil. Instead, it may well contribute to the problem.

We have a nice post below from Scott James, one of the Blog student editors.  He discusses In re Ceridian, a case from the 8th Circuit that upholds the dismissal of a securities fraud case despite the company having undertaken five restatements over a fourteen or so month period.  The case applied the elevated standards for pleading scienter that were included in the PSLRA.  Since a motion to dismiss stops discovery, the high pleading standards shield wrongdoing in some cases since shareholders cannot examine what actually happened but are limited in their information to public sources.  These pleading standards, along with the new limits imposed by the Supreme Court in Stoneridge, limit the ability of shareholders to reach culpable defendants.  This will become increasingly apparent as the litigation relating the the subprime crisis winds its way through the courts.  Assuming regime change in November, it may well be time for Congress to revisit these restrictions and consider overturning them.  

This post examines how the 8th Circuit applied the heightened pleading standard under the Private Securities Litigation Reform Act (“PSLRA”) in the case of In re Ceridian Corp. Sec. Litig. , 2008 WL 416782 (8th Cir. Sept 11, 2008). Plaintiff, Shareholders, sued Ceridian Corp. claiming violations of §10(b) and §20(a) of the 1934 Act. The Minnesota District Court dismissed the case because the plaintiffs failed to prove scienter. The 8th Circuit affirmed.

Between February of 2004, and April of 2005, Ceridian Corporation restated its financial statement five times due to numerous GAAP violations. These violations included flawed methods of revenue-recognition, capitalization of expenditures, and amortization of trademarks.

On August 6, 2004, Plaintiffs sued Ceridian Corporation and former CEO and President, Ronald Turner, former CFO, John Eickhoff, and former accounting officer, Loren Gross in Minnesota District Court for alleged violations of § 10(b) and 20(a) of the 1934 Act. The Plaintiffs claimed that Ceridian used accounting methods that violated GAAP in preparing its financial statements for the purpose of inflating the value of Ceridian stock. Allegedly , Turner and Eickoff unloaded substantial amounts of Ceridian stock in September of 2003, when they were “in the money” because the stock price was overstated by 35%. Plaintiffs argued that the GAAP violations, along with the timing of insider trades by Ceridian executives showed scienter.

To state a claim under the PSLRA, “Plaintiffs must specifically allege such matters as the time, place, and contents of false representations, as well as who made each misrepresentation.” To avoid summary judgment, plaintiffs must state with particularity “ facts giving rise to a strong inference that the defendant acted with the required state of mind.” The required state of mind in this case was scienter. To prove scienter, a plaintiff must show that the defendant had the intent to deceive, manipulate, or defraud. Ferris, Baker Watts, Inc. v. Ernst & Young, LLP , 395 F.3d 851, 854 (8th Cir.2005).

The district court found “the sheer number of violations, and the magnitude of the restatements, give rise to an inference that the defendants were at least severely reckless,” but did not show scienter. GAAP violations alone, without proof of fraudulent intent, do not state a claim for securities fraud. Kushner v. Beverly Enters., Inc. , 317 F.3d 820, 831 (8th Cir. 2003).

The court reasoned that because the accounting errors involved “dozens of employees committing hundreds of unrelated accounting errors of many different types over many different years-it seems almost inconceivable that there could have been any unifying intent behind the errors, much less an intent to defraud.”

In addition, the district court ruled that the timing of the insider trades did not raise suspicions of scienter, since the GAAP violations continued to occur months after Turner and Eickoff sold their stock. On June 5, 2007, the court granted Ceridian’s motion to dismiss for failure to state a claim.

Less than three weeks after the district court opinion, the United States Supreme Court in Tellabs clarified the standard for sufficiently pleading scienter in securities fraud cases. The Supreme Court reinforced the heightened pleading requirement under the PSLRA:

"The inference of scienter must be more than merely “reasonable” or “permissible," it must be cogent and compelling, thus strong in light of other explanations. A complaint will survive, we hold, only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

After Tellabs, the Plaintiffs appealed to the Court of Appeals for the 8th Circuit. The 8th Circuit agreed with the lower court that Turner and Eickoff’s stock sales were not suspicious, because they occurred before the publication of the allegedly inflated earnings report. On September 11, 2008.  The 8th Circuit affirmed the dismissal because the plaintiffs failed to show strong evidence of scienter.

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

When Enron collapsed, many on the continent viewed it as evidence of fundamental flaws in the Anglo-American model of corporate governance.  The collapse of Parmalat confirmed that common law jurisdictions had no monopoly on fraud and serious governance problems.

Parmalat also represented an opportunity to use the US court system to vindicate the rights of shareholders worldwide.  Outside of the US, derivative and class action law suits are difficult to bring.  A major import business, shareholders in international markets sometimes try to take advantage of the more open litigation model in the US.  Alas, in the case of Parmalat, shareholders (both in the US and overseas) didn't have much luck.  The remaining defendants were recently dismissed on Stoneridge grounds, as the post by Charlene Hunter below illustrates.   

After three years and seven opinions, the U.S. District Court for the Southern District of New York has issued a final order regarding motions to dismiss claims against firms and individuals associated with Parmalat. Parmalat is the Italian-based international dairy conglomerate that perpetrated massive shareholder fraud for ten years. The company collapsed at the end of 2003 with a deficit of over $16 billion. Shareholders brought 10(b) fraud and 20(b) control person claims against Parmalat’s auditors, lawyers, banks, and related individuals. The claims asserted the defendants helped to market Parmalat securities that were based on fraudulent transactions. Allegations included securitizing duplicate invoices, restructuring loans through shell companies to appear as asset sales, and using outdated audits to overvalue the private placement of securities.

Court decisions issued over three years were generally grouped according to categories of defendants: auditors, banks, law firms, and one shareholder on Parmalat’s board. The auditing companies are the U.S. parent companies and certain international subsidiaries of Deloitte & Touche and Grant Thornton. The bank defendants are local and parent companies of Citigroup, Bank of America (“BoA”), Banca Nazionale del Lavoro (“BNL”) and Credit Suisse First Boston (“CSFB”). The defendant law firm is Pavia e Ansaldo (“Pavia”). Maria Martellini is the defendant minority shareholder representative on Parmalat’s Board of Statutory Auditors. Defendants’ motions to dismiss predictably included arguments against jurisdiction, lack of control over subsidiaries, lack of specificity in pleadings, failure to plead the necessary elements of a 10(b) claim, including committing a deceptive or manipulative act, scienter, affecting a market, and causation.

In In re Parmalat Securities Litigation, 375 F.Supp.2d 278 (S.D.N.Y. 2005) (“Parmalat I”), the court dismissed claims against auditors Deloitte, Grant Thornton and Deloitte Director James Copeland. It held that plaintiffs failed to show that the auditors committed a 10(b) violation as primary actors, therefore the 20(b) control person claims also fail. The court, however, gave plaintiffs leave to amend the complaint.

In the second memorandum opinion, issued July 12, 2005 (“Parmalat II”), the court dismissed the claim against Ms. Martellini. The plaintiffs failed to plead with particularity and the court lacked jurisdiction over nine of eleven plaintiffs who are not U.S. citizens and did not purchase securities in the U.S. Plaintiffs chose not to amend this complaint.

The court used the July 13, 2005 decision (“Parmalat III”) to issue an extensive and scholarly analysis of the elements of a Rule 10b-5 claim, noting the difference between claims based on the (a), (b) or (c) subsections. The 10b-5(a) and (c) claims do not require allegations of misrepresentation or omission, but rather allegations describing what “manipulative acts” were performed, by whom and when, and how those manipulative acts or schemes affected the securities at issue. The court pointed out that the case Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) made it clear that “there is no private civil liability for aiding and abetting a violation of Section 10(b) and Rule 10b-5.” Therefore, the issue in this case was whether the claims indicate the banks “directly or indirectly used or employed any device or contrivance with the capacity or tendency to deceive.” The court held that securitizing worthless invoices and overstating the value of a conversion right, if proven, would qualify as deceptive, whereas merely handling transactions would not.

In the fourth memorandum opinion, issued August 17, 2005, the court dismissed claims against law firm Pavia as it made no misleading statements. The court, however, upheld claims for participating in a deceptive scheme to use shell companies to defraud investors.

The court’s fifth memorandum opinion, issued in February 2006, addressed the Second Amended Complaint. The court dismissed claims that BoA used a Cayman Islands “special purpose vehicle” to deceptively restructure an asset sale on the basis that the transactions themselves were not deceptive. The court upheld claims that BoA knowingly used an outdated audit to overstate the value of securities and redirected the payee on a political risk insurance policy to disguise increased risk.

The court waited until the fifth opinion to comment extensively on the length of the 389-page complaint. The court in Parmalat I did not dismiss under FRCP Rule 8 (“short and plain statement of the claim”) even though it noted that “the requirement of pleading fraud with particularity does not justify a complaint longer than some of the greatest works of literature.” The fifth opinion noted that “this brontosaurus of a pleading” did not “serve the interests of the alleged class” because it delayed resolution of the action. The court further opined that “[s]hould there ever be a fee application in this case, the efficiency and dispatch with which counsel have handled the case are likely to be prominent considerations.”

The sixth memorandum opinion of July 24, 2007 dismissed claims brought by foreign purchasers for lack of jurisdiction. There was no evidence of U.S. purchases or sufficient activity in the U.S.

After the Supreme Court’s decision in Stoneridge, on August 7, 2008, the U.S. District Court for the Southern District of New York issued its final memorandum opinion. Under the Court’s holding from Stoneridge “[r]eliance by the plaintiff upon the defendant’s deceptive acts is an essential element of the § 10(b) private cause of action.” The Court may presume reliance where “(1) a party omits a material fact in breach of a duty to disclose or (2) a party’s deceptive acts are communicated to the public.”

Applying the Stoneridge factors to the present case, the court ruled that BoA did not have a duty of disclosure because none of the plaintiffs were BoA private placement purchasers. Nor did Pavia owe a duty to any plaintiff. The claims, therefore, did not prove the first element of reliance. The court in Stoneridge held that the second element, deceptive acts, requires that plaintiffs show reliance on the deceptive conduct of the defendant companies. Reliance on deceptive acts of the primary fraudulent perpetrator—in this case Parmalat—is not enough. The court found that the Third Amended Complaint did not include evidence that defendants themselves made deceptive disclosures.

Plaintiffs, therefore, failed to establish the necessary reliance element of their 10(b) claims against BoA, Citigroup, and Pavia. The court’s final decision granted the outstanding motions to dismiss against banks and the law firm. Since the claims against auditors were dismissed in an earlier decision, and BNL and CSFB settled, all remaining claims against auditors, banks, and law firms associated with Parmalat have now been dismissed.

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

J. Bruce Boister & David J. Grais to speak at BVR Legal/Mealey's Conference on Structured Finance & Derivatives Litigation on October 15-16, 2008 in New York City.

For more information & to register please visit Grais & Ellsworth LLP.

In a relatively frank statement, the Chairman of the SEC, Christopher Cox, confessed that deregulation was at least in part responsible for the current financial crisis.  In a press release issued by Chairman Cox, he noted:

• The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

It was a frank admission.  According to the NYT: "The retreat on investment bank supervision is a heavy blow to a once-proud agency that has seen its influence over Wall Street steadily erode as the financial crisis has exploded over the last year."  While Cox was addressing the voluntary program for overseeing large investment banking firms, there are other areas where the regulatory structure is not adequately enforced.

Stock exchanges impose meaningful corporate governance standards but there are substantial concerns with enforcement, something we have noted on this Blog. Congress tried to address this concern in the creation of the PCAOB by providing that the SEC can remove board members for cause and defining cause as the failure to enforce their own rules. In other words, it gives the SEC a sanction where the SRO like organization doesn't enforce its rules.

In December 2007, the Race to the Bottom reported on the case In re UnitedHealth Group Inc. S'holder Derivative Litig., 2007 U.S. Dist. LEXIS 94616 (D. Minn., Dec. 26, 2007 ). At that time, UnitedHealth’s Special Litigation Committee (“SLC”) approved a settlement with William McGuire, its CEO and chairman of the board. The settlement came in response to several lawsuits alleging that McGuire benefited from backdating stock options and required him to pay the company approximately $600 million.

The trial judge expressed some reservations about the settlement, though, and declined to approve it. Instead, the trial judge certified to the Minnesota Supreme Court the question of whether the court was limited to a review of the SLC process or whether it could review the SLC's business judgment with respect to the settlement.

The Minnesota Supreme Court responded that the business judgment rule requires courts to defer to an SLC’s decision to settle suits if the decision meets two criteria: (1) the members of the SLC were independent; and (2) the SCL’s “investigative procedures and methodologies were adequate, appropriate, and pursued in good faith.” In re United Health Group Inc. S'holder Derivative Litig., In re United Health Group Inc. S'holder Derivative Litig., 754 N.W.2d 544 ( Minn. 2008).

In its analysis, the court identified a second, broader interpretation of the business judgment rule that other jurisdictions have applied to SLC proposals. This interpretation permits a court to go beyond evaluating the SLC’s independence and good faith and apply its own independent business judgment to the proposal. This court rejected the more expansive interpretation and argued, among other things, that courts lack the business acumen to effectively evaluate an SLC’s business judgment and that such a rule would undermine the integrity of the SLC’s process.

In a concurring opinion, Justice Anderson criticized the majority for endorsing a rule that may give judicial deference to wholly irrational SLC recommendations. Justice Anderson identified a middle approach that permits a court to investigate the independence and good faith of the SLC and to “determine whether the SLC’s recommendation can be attributed to any rational purpose.” Justice Anderson argues that this approach has two advantages. First, it lessens the possibility that judicial deference would be given to irrational SLC recommendations. Second, it lacks the broad discretionary power that the more expansive interpretation of the business judgment rule entails. This approach would lessen the possibility that courts will give deference to irrational SLC recommendations while curbing the use of its own business judgment.

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

In many ways the corporate governance provisions of the Bailout Bill are a major step towards federal preemption of executive compensation. 

There are clawbacks applicable where the relevant criteria are "later proven to be materially inaccurate."  This will probably cause some increased care both in the determination of criteria and in the selection of criteria.  The provisions do not ban golden parachutes but prohibit payments during the relevant period.  Since golden parachutes apply in the context of changes of control, they will probably dampen enthusiasm for acquisitions.

The most notable provisions, however, are those that seek to exclude incentives that cause officers to "take unnecessary and excessive risks that threaten the value of the financial institution."  Treasury will have to adopt regulations implementing these provisions and presumably they will entail prohibitions on certain compensation practices. 

In the end, the extent of the intrustion into the compensation process will depend upon the standards adopted by Treasury.  It is likely that the restrictions will have limited impact.  Nonetheless, they will probably cause a more conservative approach to business and a more conservative approach to compensation, at least during the period of government investment.  To the extent that financial firms take a more restrained approach to compensation, it will demonstrate that the only way to restrain executive compensation is through federal preemption of the Delaware approach. 

Congressional negotiators apparently worked hard over the weekend to finish the bailout legislation.  A draft is posted on the House Financial Services Committee web site along with a section by section analysis.  The draft bill retains limits on executive compensation but no longer contains the provisions in the original House bill that would require access and a vote on say on pay.  

In the case of companies where Treasury makes a direct purchase of assets and, as a result, has a "meaningful" equity position,  the companies must meet  "appropriate standards for executive compensation and corporate governance."  Despite the mention of corporate governance, in fact the requirements all relate to executive compensation.  It requires the exclusion of incentives for taking excessive risks, a clawback provision for incentive compensation based on criteria "later proven to be materially inaccurate."  During the period when the government holds a debt or equity position, golden parachute payments are prohibited. 

Specifically, Section 111, titled "executive compensation and corporate governance," provides:

• (a) APPLICABILITY.—Any financial institution that sells troubled assets to the Secretary under this Act shall be subject to the executive compensation requirements of subsections (b) and (c) and the provisions under the Internal Revenue Code of 1986, as provided under the amendment by section 302, as applicable.

• (b) DIRECT PURCHASES.— 

• (1) IN GENERAL.—Where the Secretary determines that the purposes of this Act are best met through direct purchases of troubled assets from an individual financial institution where no bidding process or market prices are available, and the Secretary receives a meaningful equity or debt position in the financial institution as a result of the transaction, the Secretary shall require that the financial institution meet appropriate standards for executive compensation and corporate governance. The standards required under this subsection shall be effective for the duration of the period that the Secretary holds an equity or debt position in the financial institution.

• (2) CRITERIA.—The standards required under this subsection shall include— (A) limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution; (B) a provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; and (C) a prohibition on the financial institution making any golden parachute payment to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution.

• (3) DEFINITION.—For purposes of this section, the term ‘‘senior executive officer’’ means an individual who is one of the top 5 executives of a public company, whose compensated is required to be disclosed pursuant to the Securities Exchange Act of 1934, and any regulations issued thereunder, and non-public company counterparts.
  

• (c) AUCTION PURCHASES.—Where the Secretary determines that the purposes of this Act are best met through auction purchases of troubled assets, and only where such purchases per financial institution, in the aggregate exceed $300,000,000 (including direct purchases), the Secretary shall prohibit, for such financial institution, any new employment contract with a senior executive officer that provides a golden parachute in the event of an involuntary termination, bankruptcy filing, insolvency, or receivership. The Secretary shall issue guidance to carry out this paragraph not later than 2 months after the date of enactment of this Act, and such guidance shall be effective upon issuance.
  

• (d) SUNSET.—The provisions of subsection (c) shall apply only to arrangements entered into during the period1 during which the authorities under section 101(a) are in effect, as determined under section 120.
  

As the summary to the draft legislation explains:

• No Windfalls for Executives. Executives who made bad decisions should not be allowed to dump their bad assets on the government, and then walk away with millions of dollars in bonuses. In order to participate in this program, companies will lose certain tax benefits and, in some cases, must limit executive pay. In addition, the bill limits “golden parachutes” and requires that unearned bonuses be returned.
  

As for the Section by Section analysis, the draft legislation explains:

• Section 111. Executive Compensation and Corporate Governance.  Provides that Treasury will promulgate executive compensation rules governing financial institutions that sell it troubled assets. Where Treasury buys assets directly, the institution must observe standards limiting incentives, allowing clawback and prohibiting golden parachutes. When Treasury buys assets at auction, an institution that has sold more than $300 million in assets is subject to additional taxes, including a 20% excise tax on golden parachute payments triggered by events other than retirement, and tax deduction limits for compensation limits above $500,000.
  

We have written on this Blog a number of times about the role of consultants in the executive compensation process, with their role often less than satisfactory.  Delaware law, in its emphasis on process, largely requires little more than some type of report from a consultant to justify any amount of executive compensation, irrespective of the nature or amount.  Yet consultants often end up serving as advocates for the CEO rather than the company.  

The student post below from Michelle Larson-Krieg examines some recent research in this area.  The key conclusion?  Compensation is higher in those companies employing the consultants. 

A new study from Kevin Murphy and Tatiana Sandino is the first to analyze the compensation consultant data from publicly traded corporations.  Kevin J. Murphy & Tatiana Sandino, Executive Pay and "Independent’" Compensation Consultants (2008). Since 2006, the Securities and Exchange Commission has required that public companies report any role that compensation consultants play in determining or recommending the amount of exeuctive or director compensation. 

Based on their analysis of 938 proxy statements, Murphy and Sandino present several interesting findings:

• Executive and director pay is higher at companies where consultants provide pay advice. CEO pay is 20.5% higher. Median CEO compensation is $1.5 million in companies not using consultants, $3.0 million in companies that purchase surveys but do not directly retain consultants, and $4.2 million in companies that retain consultants.

• Incentive-based pay is a larger component of the executive pay packages in companies that use consultants. Equity-based pay accounted for less than a quarter of CEO pay for companies without consultants, but nearly half of CEO pay for companies with consultants.

• Surprisingly, there is no evidence that pay is higher when the compensation consultant provides additional services or is positioned to provide additional services in the future. Murphy and Sandino speculate that this may be because consultants are wary of the reputational and legal hazards of blatant attempts to curry favor.

• Compensation is about 9% higher in companies where the consultant works exclusively for the compensation committee versus where the consultant works directly for and with the CEO and/or his direct reports. A possible explanation is that the compensation committee may retain their own consultant to provide legitimacy in cases where CEO pay appears to be excessive.

• Companies may use multiple pay consultants from different firms to justify or legitimize pay packages that are unusually generous. A company using three or more consultants pays almost 25% more to its CEO than a company using only one consultant. The authors observed that companies can mix and match recommendations from multiple consultants to create a single generous package or ignore recommendations that do not fit with expectations.

In sum, although conflicts of interest do not appear to explain why companies using compensation consultants pay more, the study suggests that the company, directors, and executives may be using compensation consultants to justify higher levels of pay.

The Race to the Bottom has covered executive compensation extensively. Please visit our Executive Compensation page for additional posts on this topic.

As you know, students who contribute to The Race to the Bottom frequently follow ongoing litigation. The Nacchio trial is one such example. Today, two students, Trevor Crow and myself attended en banc hearing for the Nacchio appeal. For the two of us, the federal courthouse was an uncomfortable environment and a far cry from the comforts of law school.

My first observation was that Maureen Mahoney was under fire. Mahoney began her argument by stating the government’s theory. It claims the defendant forfeited his right because the defense failed to say, “I want a hearing.” Immediately Judge Briscoe interrupted Mahoney and stated, “Isn’t that a pretty good theory?” Before Mahoney could finish her answer, Judge Holmes interrupted and asked about whether the district court could properly exclude the witness without giving the defendant a hearing? Mahoney responded that the exclusion was a “surprise” and that it was the court's obligation to hold a Daubert hearing. Briscoe, who was noticeably antagonistic, further questioned Mahoney about why the court should have the obligation when Nacchio is the one who wants the expert to testify. At one point, Judge Lucero said he was “perplexed” by the defense's argument.

On the light rail ride back to school, several things became apparent. We were both surprised how nine judges engaged two of the country’s best appellate attorneys. To be sure, Mahoney took the more difficult questions. But even with mostly softballs, at one point Judge Holmes saw fit to rescue Edwin Kneedler from Judge McConnell ’s inquisition. As a student observer, I left feeling that no experience in law school has prepared me to handle such an examination. The Socratic Method leaves much to be learned. Even the best had trouble persuading the court. As both Trevor Crow and Professor Brown note, it seems the court will vacate the panel’s decision and reinstate the conviction.

As a student contributor and managing editor of this blog I attended the en banc oral arguments in Joe Nacchio's appeal. Below, I provided my interpretation of the arguments by counsel from each side.

Maureen Mahoney, counsel for the defense, started by couching the issue as whether the defense forfeited its right to present Fischel’s testimony by failing to ask for a hearing. Mahoney argued that it was the court’s responsibility to require a separate hearing about the admissibility of Professor Fischel’s expert testimony. And that the en banc court should not permit the government to exclude Fischel’s testimony with a motion in limine on the day in which Fischel was supposed testify. Judges Briscoe, Holmes, and Lucero did not appear persuaded by this argument. Specifically, Judge Holmes noted that the party seeking admissibility has the burden to get its expert’s testimony admitted. When asked why the defense did not ask for hearing in response to the Rule 16 notice, Mahoney responded that the defense was not required to, she compared this to a court granting a motion for summary judgment because a party failed to attach all of its evidence to a reply.

Edwin Kneedler, counsel for the government, went straight into the standard of review by arguing that Judge Nottingham did not abuse his discretion by excluding Fischel's testimony without a separate hearing. Judge McConnell provided a majority of the tough questions directed at Kneedler. Judge McConnell seemed reluctant to accept that Fischel, a person who has testified in over 200 matters, could be denied as an expert witness. Whenever Judge McConnell would provide a good argument, however, Judges Holmes or Lucero seemed to throw out an easy question to get Kneedler back on track.

My prediction? The panel opinion will be vacated and the court will reinstate the conviction.

 

This post concerns a topic outside of the usual focus of this blog - namely, the regulation of finance.  This is a subject of intense interest over the past few weeks after the creation of a Fannie Mae and Freddie Mac government conservatorship and thecollapse of Lehman Brothers.

The current financial crisis illustrates how a national government’s regulation of commercial activity can impact the world’s economic health. Quoting Nouriel Roubini in the 2008 Financial Development Report by the World Economic Forum: "[i]n short, a systemic financial crisis is a sign of the failure of the financial system, the failure of appropriate risk management, and the failure of proper corporate governance."

The magnitude of the current crisis will, of course, not be limited to the U.S.  Other central banks have made major efforts to mitigate the impact of poisonous assets circulating throughout global financial markets. As an aside, the BRIC countries have been notably absent.  An editorial in last week's Financial Times by columnist Philip Stephens notes that national governments are “left with responsibility” for their failure to implement preventative regulation and are “without power” to do something about it. “Governments need to find ways to reclaim some of the sovereignty lost to globalisation. That means more global governance: credible international rules.”

To provide a specific example of how inadequate regulation enabled the current crisis, consider capital adequacy ratios. A capital adequacy ratio is the ratio of a bank’s capital to risk-weighted assets. The Basel Committee on Banking Regulation and Supervisory Practices, an international advisory body, provides standards that provide general guidelines on capital adequacy ratios. National governments are then encouraged to implement these guidelines. The Basel II Accord provides for a framework that gives banks various means to determine their risk exposure. Among them is the use of third-party credit rating agencies who determine the value of a bank’s risk-weighted assets.

Moreover, the Basel II regulatory world is the reliance on credit rating agencies to determine risk associated with leveraged assets with little in the way of regulation governing these agencies is a contributing factor to the current crisis. Alan Greenspan mentioned in an interview with a German paper in 2007 that these credit agencies mispriced credit risk and the market, unfortunately, believed their ratings. Moreover, national regulators failed to implement capital adequacy ratios on exchange-traded derivatives. As evidenced by Lehman Brothers’ collapse, the risk associated with these assets was never adequately priced and many other firms are and will be exposed to their unwinding. 

In Global Governance of Financial Systems: the International Regulation of Systemic Risk,  Kern Alexander, Rahul Dhumale, and John Eatwell present five specific guidelines for the international financial regulators dealing with the problem of systemic risk in globalized financial markets.  First, regulators must increase financial heterogeneity.  This may be done by creating a regulatory body “with the powers to develop [a] flexible structure of rules and rule making.”  Additionally, the Authors argue this body should have broad enforcement and monitoring powers.  Second, there should be an international lender of last resort.  However, the moral hazard associated with “liquidity without strings” must be tempered by “powerful rules on risk taking.”  Third, a “new financial architecture should encompass macroeconomic concerns.”  Fourth, the regulators’ rules “need to make greater use of the new work on extreme, rare events.”  Fifth, the scope of the regulators’ activity should be the international market itself.  I published a review of  this book last year. 

The case for stronger international financial regulation has never been more persuasive.

In October 2004, the European Commission announced a non-binding Recommendation that encourages EU member states to adopt certain guidelines to halt excessive director compensation. The Recommendation asks member states to implement four measures (two involving disclosure and two involving shareholder rights). The disclosure guidelines require listed companies to (1) release a statement about their director compensation policy, including a breakdown of performance criteria; and (2) disclose how much individual directors earn and in what form. The shareholder rights guidelines seek to protect shareholders by allowing them to vote (1) on the company’s director compensation policy in a binding or advisory capacity; and (2) to approve company rules regarding stock option compensation.

Recently, Charlie McCreevy, the EU Single Market Commissioner,reiterated that the EU member states should move to adopt this Recommendation. According to McCreevy, less than half of the twenty-seven EU member states implemented the Commission’s Recommendation on director compensation. Allowing shareholders to vote on the payment of board members “would go a long way towards increasing or restoring shareholder confidence and it would force boards to do a whole lot more explaining than is done at present,” said McCreevy. In addition, McCreevy highlights that a vote permits shareholders to determine whether there is a link between executive pay and performance and to object to compensation packages.  

Currently, the EU Recommendation is not legally binding. Thus, unless the EU member states implement the Recommendation, shareholders likely are “unequipped” to constrain corporate excesses. We plan to follow whether additional EU member states voluntarily implement this Recommendation in the future. 

We are pleased to announce that Nancy Rapoport, founder of her own blog, Nancy Rapoport's Blogspot, and the Gordon & Silver, Ltd. Professor at the William S. Boyd School of Law, University of Nevada-Las Vegas, will be posting occasionally for The Race to the Bottom, with her first post today.  Her research interests include the intersection of ethics and bankruptcy, ethics in governance issues, the USNWR rankings, and lawyers in popular culture. When she's not obsessing over these issues or teaching her students, she competes, I have on good authority, in ballroom dancing on a pro-am basis (she's the "am").

Paul Caron's posting on the University of Michigan Law School's Wolverine Scholars program (see here) and Bill Henderson's follow-up (see here) demonstrate how the USNWR rankings are continuing to be the tail wagging the dog when it comes to a law school education.  

Do I think that Michigan's outreach to this particular group of students is wrong-headed?  Of course not (although Bill correctly points out that the rubric for finding the Wolverine Scholars is both over- and under-inclusive). 

Do I hope that Michigan is trying to find a way to reduce the over-reliance on the LSAT as a way of indicating student quality?  Sure, I do.

But this particular program has the same side-effect as does USNWR's proposed inclusion of the LSATs and UGPAs of part-time students (see here for Race to the Bottom's earlier post on USNWR's proposed change, and see here for my first take on the change).  It cedes control of a law school's educational program to a magazine in an attempt to game the system.  

Why do schools continue to play so hard to the rankings?  In part, it's a shared governance problem.  Deans and faculties are supposed to work together to develop their schools' policies.  (See here for my first-cut view about shared governance.)  Deans are pressured by every possible constituency--the university, the faculty, the students, the alumni, and the bar--to move their schools up the USNWR pecking order.  Law faculties are supposed to take the laboring oar when it comes to such faculty-centered issues as faculty hiring, the curriculum, and admissions policy.  Even though deans and faculties are supposed to take the long-term health of their schools into account when making or altering policies, there's a real short-term cost in not playing to the rankings.  A drop in the rankings can cost a school its best applicants, its movable faculty members, and its donations.  (Among other things.) 

And with every type of governance issue, the short-term costs of taking the hit on "measurables" can eclipse an organization's long-term stewardship.  Dropping in the rankings is akin to failing to meet quarterly earnings targets.  'Fessing up to the short-term hit for a good long-term reason is probably in an organization's best interest, but few organizations have the chutzpah to take the hit.

Shared governance makes the decision of whether to play to the rankings even more complicated.  Who makes the call on adopting a new program or policy that will improve the school's USNWR position?  The faculty is the body most likely to decide the broad picture in terms of admission, or to try to hire more USSC clerks to improve the reputation ranking, or to try the "move students to part-time" route.  But it's the dean who's going to be saddled with the ramifications if the new policy or program goes awry.  (Remember this article in the New York Times:  The $8.78 Million Maneuver?) 

It's a classic division of risk and responsibility.  At least when corporations make bad policy, we try to find the people who were charged with making that policy decision and bring them to task.  But in shared governance, deans make relatively few policy decisions on the "big three" of admissions, faculty appointments, and curriculum.  When the policy decisions are good, bravo for the faculty, which made them.  When they go bad, though, faculty heads don't roll.

When we sever responsibility from risk, we get Enron.  We get subprimes rolled into securities that fail.  We get the current financial crisis.  And we get law school decisions made in the hope of getting a slight short-term gain that lasts only until other schools catch on and mimic the idea or until USNWR figures it out.  That can't be good governance.