On August 27^th, 2008, in a long anticipated move, the U.S. Securities and Exchange Commission voted unanimously to issue a proposed roadmap for the potential transition by U.S. issuers from U.S. Generally Accepted Accounting Principles (“ GAAP ”) to International Financial Reporting Standards (“ IFRS ”).  The proposed multi-tiered plan sets out several milestones that, if achieved, could lead to the use of IFRS by U.S. issuers in their filings with the Commission.

Under the SEC’s current rules, U.S. issuers are required to prepare financial statements in accordance with accounting principles that are generally accepted in the United States. The increasing integration of the world’s capital markets has, however, resulted in roughly two-thirds of U.S. investors owning foreign issued securities that report their financial information using IFRS. Increasing integration has made the establishment of uniform global accounting standards a matter of growing importance. Currently, over 100 countries have adopted IFRS, a common accounting language aimed at giving investors greater comparability and transparency of financial reporting worldwide(a complete, detailed explanation of the differences between GAAP and IFRS can be found here ).

The proposed roadmap lays out a timeframe for use of IFRS by all registrants, anticipating mandatory reporting under IFRS beginning in 2014, 2015, or 2016 depending on the size of the issuer. The roadmap also articulates a number of milestones that must be met by 2011 to allow the proposal to proceed. Some of the milestones include requiring independent funding and greater accountability from the International Accounting Standards Board, which is responsible for the integrity of IFRS. Domestically, the roadmap requires satisfactory integration of interactive data technology to allow for IFRS reporting, as well as adequate training and education of professionals and investors regarding IFRS.

IFRS may not be welcomed by some companies initially, as its conversion is much more than a technical accounting issue. According to the international accounting firm PricewaterhouseCoopers, IFRS may significantly affect any number of a company’s day-to-day operations and may even impact the reported profitability of the business itself. The Conversion experience in Europe, as well as Asia and Australia has been more time consuming than expected, causing some companies to rush and risk mistakes or outsource more work than necessary, driving up costs and hindering the embedding of IFRS knowledge within the company.

The Commission will make a determination in 2011 on whether adoption of IFRS is in the public interest and would benefit investors. A roundtable to discuss potential accounting changes was held on October 29, 2008. More information can be found here.

The SEC’s press release can be found here.

We have already noted that Barak Obama is a strong supporter of say on pay.  Pundits are, however, already calling for more with respect to executive compensation.  Calling the current state of affairs an "ethical embarrassment to our country," an editorial in Business Week by Leo Hindery Jr. calls for the following:

• First, Congress should immediately grant public shareholders the rights, on their own, to call a shareholders' meeting to vote out the current board and to render an advisory vote on executive compensation — rights that they don't currently have. Much better than any other similar measures contemplated or previously adopted, these three rights, which are already in place and working well in Britain, would align shareholder and management interests as to both governance and executive compensation.

• Second, Congress should establish a ceiling for individual executive compensation as a reasonable multiple of average employee compensation, and penalize through the corporate income tax code and/or otherwise those companies that elect to pay in excess of that multiple.

• Third, Congress should close the loopholes that currently allow the wealthiest Americans to use offshore tax schemes that cost our Treasury $70 billion in taxes each year, and it should aggressively step up tax enforcement to capture the 30 percent or so of earnings from selling investments that currently goes unreported each year.

The ceiling would be hard to implement and not always equitable.  Moreover, tax penalties don't work.  The CEO will still want the compensation and the board will approve them, the tax effects merely increasing the costs to the company. 

Nonetheless, the proposal demonstrates continued outrage and anger at executive compensation levels and indicates continued pressure for some type of greater federal involvement.  Preemption in short.

With impending regime change in the White House, we take a moment to reminisce.  The one significant corporate governance accomplishment of the Bush administration was the adoption of Sarbanes Oxley.

Its almost hard to remember the vehement outpouring of criticism that swirled around Sarbanes-Oxley for the first three or four years after its adoption.  Everything was criticized, whether the hurried process employed in adopting the Act to greater reliance on independent directors.  For more on these views, see The Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.

Any piece of data that could be used to challenge SOX was trotted out, the need for rigor usually a casualty of the process.  The decline in IPOs, the drop in foreign listings, the number of companies "going dark" were all trotted out as "proof."   But probably none was trumpeted louder than the rise of private equity and the likely disappearance of public companies from the market place.  No longer willing to put up with aggressive shareholders and the costs of SOX, companies would simply sell out to private equity firms.  Take a look at Lynn Stout's position on the subject.

To the extent companies sold out to private equity, it had little to do with the costs of SOX or whiny shareholders.  Instead, it took place because of self interest.  Private equity funds were able to raise large amounts of capital and borrow at low rates.  With these funds available, they could afford to pay exorbitant amounts to buy out public companies. 

Those days, however, are gone.  The debt markets are largely frozen.  Now we learn that the capital side of things is likewise winding down.  According to the WSJ, private equity has been drawing a "cold shoulder" from large institutional investors.  As the WSJ has noted:

• Public pension funds and endowments are turning down invitations to make private-equity investments. The nation's largest public pension fund, the California Public Employees' Retirement System, or Calpers, is asking private-equity firms to ease off on requests for additional capital it had previously committed to deliver. . . . Harvard University, with an endowment of $36.9 billion under Jane Mendillo, is seeking to offload about $1.5 billion in investments with private-equity firms such as Bain Capital LLC, according to people familiar with the situation.

The article also noted that the two publicly traded private equity funds had seen their shares fall by 70%. 

All of this is to say that the use of private equity as a source of cricisim for SOX was misplaced.  But then, so was most of the criticism of SOX.  Instead, what seems clear now is that SOX did not go far enough.  Perhaps that will be a topic addressed by the new administration.

In a case that may become increasingly important as the market crisis continues, the Southern District of New York in In re: American Express Co. Sec. Litig., 02 cv 5533 (S.D. N.Y. Sept. 26, 2008) dismissed a shareholder complaint that alleged Amex fraudulently misrepresented its high risk - high yield investments. Plaintiffs, who bought common stock between July 1999 and July 2001, brought a securities class action lawsuit against American Express (“Amex”) and seven of its officers claiming securities fraud under section 10(b).

In their complaint, Plaintiffs alleged three categories of fraud: (1) false and misleading statements regarding adoption of risk managements procedures; (2) failure to comply with Generally Accepted Accounting Procedures (“GAAP”) concerning losses from the High Yield Debt investments; and (3) mischaracterizations regarding 2001 investment developments.           

Securities fraud requires proving statements or omissions of material fact made with scienter. In securities fraud statutes, scienter is a mental state that requires the intent to deceive, manipulate, or defraud or at least knowing misconduct. Allegations that someone “ought to know” is not enough to plead scienter. A court must take into account all the facts alleged collectively and find a strong inference of scienter and not infer scienter solely from an individual event. Plaintiffs may establish scienter by proving the defendants intentionally acted fraudulently to benefit personally, deliberately participated in illegal behavior, knowingly did not disclose inaccuracies in company financial statements, or recklessly failed their duty to monitor.           

Plaintiffs claimed the incentive to increase compensation motivated Defendants and that Defendants should have known of the fraud based on their positions within the company. The court reasoned that a desire to increase executive compensation is insufficient to plead scienter because that desire can be imputed to all corporate officers and pleading one “should have known” is a “boilerplate” allegation. Therefore, the court dismissed these claims because under well established law an allegation that defendants were motivated by compensation or alleging defendants should have known of fraud based on their positions within a company are insufficient claims to plead scienter.

Furthermore, the Plaintiffs claimed that if Defendants did not know of the status of the High Yield Debt, they were reckless in not being aware. Under 10(b) a reckless claim requires completely unreasonable conduct that is an extreme departure from ordinary care such as a defendant “shut[s] their eyes to the facts.” The court dismisses Plaintiffs’ allegations of recklessness as being purely “conclusory” because Plaintiffs failed to plead specific acts constituting recklessness.            

The complaint also relied on allegations made by confidential sources. A complaint may rely on confidential sources if the sources provide a foundation for believing the defendants made false statements and the sources are in a position to properly posses the information. Plaintiffs’ complaint did not meet this standard because the confidential sources did not state that any particular Defendant had information or access to information regarding valuation, inadequate risk control, GAAP violations, or information that contradicted the 2001 reports. Plaintiffs showed that Defendants were aware of risks associated with high yield investments but not that they failed to monitor the risks or were incorrectly valuing the portfolio. In addition, Plaintiffs provided no proof that the confidential sources had any contact with Defendants or possessed knowledge of what Defendants knew at that time.          

Plaintiffs claimed two directors received information that should have alerted them that the public statements were false or misleading. The directors received an email regarding the deterioration of the High Yield Debt portfolio but the court found that knowledge of the deteriorating portfolio does not demonstrate that either Amex’s 2001 filings or the director’s previous statements regarding unexpected losses were false or misleading. The court noted the fact that Defendants put together a team to analyze the High Yield Debt and reported the results was evidence that Defendants were not attempting to deceive but rather trying to quantify the problem. In addition, because Defendants did put together this analyst team, the court determined Defendants upheld their duty to monitor and that this precluded any inference of recklessness.           

Since the Plaintiffs failed to plead scienter by showing Defendants mental state consisted of the intent to deceive, manipulate, or defraud, the court granted Defendants motion to dismiss the § 10(b) claim.

The primary materials for this are available on the DU Corporate Governance website.

United States v. Stockman, 07-0220 (S.D.N.Y. filed Mar. 21, 2007), is moving forward.  Recently, Judge Barbara set the trial date for May 4, 2009.  On September 4, the United States Attorney's office for the Southern District of New York filed a Notice of Appearance and Request for Electronic Notification.   Assistant United States Attorney Anjan Sahni joined the complex prosecution against Stockman and his co-conspirators.

Sahni studied at Emory University as an undergraduate. Sahni also received the McMullan Award, an award given to a graduating senior who demonstrated outstanding citizenship, exceptional leadership, and great potential to improve their local and global community. Sahni attended Yale law school. As a United States Attorney Sahni has lead prosecutions against gunrunners, drug dealers, and investment fraud linked to terrorists. These cases have yet to go to trial to provide practical experience. However, Sahni's apparent talent for prosecuting conspiracies could prove a useful supplement to the other United States Attorneys.

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

Regime change has arrived.  The Democrats have taken the White House and increased their margins in the House and Senate.  What impact will it have for the corporate governance debate? 

It's unlikely to be a high priority in the short term (although economic reform and reform of the financial markets might be).  Nonetheless, the change in administration is likely to have a profound impact on the debate.

First, Barak Obama has indicated sympathy with some of the issues promoted by shareholders.  He has introduced a bill on Say on Pay in the Senate.  (Shareholder Vote on Executive Compensation Act - S. 1181).  The election will presumably provide new impetus for the legislation.  It has already passed in the House.

Second, Obama will get to appoint a new chairman of the SEC.  Currently, the position is held by Chris Cox, a former Republican congressman.  The president gets to appoint the chairman.  Cox has a seat on the Commission until June 2009 but has indicated that he will step down when the Bush administration expires.  According to one post, Andrew Cuomo and Elisse Walters are names currently being discussed.  Harvey J. Goldschmid is another possibility and has strong support among the unions.  In any event, the choice will likely result in a more pro active, pro shareholder stance for the Commission.  Access will likely return to the top of the agenda.

Third, Obama will appoint a new Secretary of the Treasury.  Some have been bantering around the name of Lawrence Summers, the former Secretary under President Clinton, and Jon Corzine from New Jersey.  Whomever is appointed, he or she will likely take a firmer stance on the enforcement of the executive compensation provisions in the Bailout Bill and will be less likely to take positions designed to damage the interests of shareholders.  It was, after all, Treasury that led the fight to narrow the scope of Rule 10b-5 in Stoneridge and ultimately succeeded in prevailing upon the Solicitor General to file a brief opposing the extension of the antifraud provision to vendors.

We will have further thoughts as the days progress but the interests of shareholders are likely to receive a higher priority with the new administration.

So what did the Inspector General conclude about these communications between Morgan Stanley and the top echelons at the SEC? 

The Report concluded that "relevant information was imparted to representatives of Morgan Stanley by both Berger and Thomsen regarding the nature of the evidence that the Enforcement Division had aagainst Mack in connection with the Pequot investigation."  With respect to Thomsen's representation that the disclosure was appropriate "given the potentially disruptive effects on the markets of information concerning the potential CEO of a large institution like Morgan Stanley," the Report observed:

• the information she and Berger imparted (i.e. the lack of evidence against Mack) only served the interests of John Mack personally and Morgan Stanley.  This was not a situation where Morgan Stanley and the larger financial markets would have been adversely affected by Enforcement not advising Morgan Stanley that they were poised to bring an Enforcement action against the person chosen to be their new CEO.  In fact, the only danger in Enforcement not sharing with Morgan Stanley that Enforcement did not have substantial evidence against Mack while Morgan Stanley was considering Mack for the CEO position was that Mack may not have not obtained the position, and Morgan Stanley would have to find another candidate.

Finally, the Report recommended that appropriate "disciplinary and/or performance-based action" be taken against Linda Thomsen, the clarification of the Commission's policies on the disclosure of nonpublic information, and a reassessment and clarification of the practice of allowing outside counsel the opportunity to communicate with counsel above the staff attorney level when they have disagreements or issues.  

On this point we take strong objection to the Inspector General's conclusions.  First, it is true that the information involved the hiring of John Mack as CEO of Morgan Stanley.  But to imply that it was about an ordinary personnel matter at Morgan Stanley understates the importance of the decision.  Mack had been with Morgan Stanley before losing out in a battle for CEO.  In replacing Phillip Purcell, Mack stepped into a business that to some degree was in turmoil.  His return had a quick effect. 

• "Morale has already improved in anticipation of his return," Byron Wien, a senior investment strategist at the firm, said before the announcement. "He has proven that he can bring harmony to disparate factions."

In other words, the entire firm and, to some degree, the market, had an interest in the decision. 

Second, as we have noted, there is some discretion to release non-public information to the public.  Linda Thomsen essentially informed Mary Jo White that, at that particular stage of the investigation, Mack was not a target.  At the same time, however, she made it abundantly clear that the circumstances could change and that his testimony would likely be necessary.  To reveal facts about an investigation that implicate others is one thing.  To reveal facts about an investigation that suggest that the SEC is not targeting someone is to prevent the existence of an investigation from unnecessarily impugn reputation.

The decision was Thomsen's to make.  She made the right one.

A redacted version of the Report is posted.

The Inspector General's Report contained a section that discussed Morgan Stanley's access to the top levels of the Division of Enforcement. 

Some officials noted that "this practice is not actually that uncommon."  Indeed, Mary Jo White noted that it was "known to the securities bar" that "if you've got an issue and you do not think you are getting a fair hearing on something . . . pick up the phone, you know, we have an open-door policy."  Others in the Division raised concern about the practice, according to the Report, labeling it as something that would "undercut" the staff attorney on the case and that it was a "cheap trick" that irked the investigators on the case.

The Inspector General's Report questioned the practice.

• In addition, there are some questions about the appropriateness of the current common practice in Enforcement that allow (and even encourage) outside counsel the opportunity to contact those above the line attorney level on behalf of their clients when they have issues or disagreements with the line attorneys. . . . This practice could also result in greater access by former Commission lawyers who had established relationships with high-level Enforcement officials prior to going into private practice. Greater access could lead to better results, or at least the appearance thereof.

On this one, the Inspector General is wrong.  First, the issue is not truly raised by the discussion in the Report.  Most of the communication above the "line attorney" level were not designed to influence the direction of the investigation but were mostly attempting to elicit information about the possible status of one individual involved. 

Second, while the cases are mostly run by staff attorneys (with tight supervision by branch chiefs), cases can sometimes run amuck.  Lawyers know that they can go over the staff attorney's head to complain but they do so at great peril.  For one thing, the staff attorney won't like it and he or she still has the authority to make thousands of small decisions that can make a potential defendant's life miserable.  For another, the culture within the Division is to back up the line attorneys almost always in the case of an appeal, even when they are wrong.  Any other practice would undercut the role of the staff attorney and encourage a constant stream of appeals to supervisors.  In other words, aside from the inexperienced lawyer, most attorneys representing persons subject to investigation would not take the risk of going over the staff attorney's head. 

There is, therefore, adequate checks on the practice.  At the same time, the ability to sometimes appeal upwards in the hierarchy is a necessary safety valve.  Not only does it provide an opportunity to correct something egregious, all staff attorneys know that if they exceed SEC imposed boundaries in the investigatory process (say through excessively broad and expensive subpoenas), the mistake may well come to the attention of their supervisors.  

The Division of Enforcement is right to let the bar know the avenue is available and the Inspector General has raised nothing in his report that suggests the practice ought to be curtailed.

A redacted version of the Report is posted.

Berger's comments (whatever they were) were, apparently, not comforting enough.  Mary Jo White opted to reach out to the Director of the Division of Enforcement, Linda Thomsen. The call came after Berger and Dinallo had spoken. According to White:

• I told [Thomsen] that what my assignment was [and] who I was representing. I also told her that I had the consent of both Morgan Stanley and Mr. Mack and his counsel to be making this call, and I told her that the board was on the verge of -- was certainly considering appointing him as the chairman and the CEO. The subpoenas had come in, and needless to say, the board didn't want to step into this if he had a problem. And that I was calling to see what, if anything, the SEC could say about whether indeed the judgment was that he had exposure in the insider trading investigation.

White asked if it was possible to accelerate the production of the emails that "we had identified as potentially of interest" and, according to the Report, Thomsen said to send them down. White arranged to have the emails delivered within 24 hours.  The delivery included a fax to Thomsen that contained 26 pages of emails.

Here is what the report had to say about Thomsen's reaction:

• Thomsen said that what was running through her mind was "how am I going to handle this if we have something negative on Mr. Mack."  Thomsen said she had a concern that "a corporation who's trying very hard to do the right thing, hire somebody pristine to run their corporation," and if "I was sitting on information that we were confident that we had, whether there was any way to communicate that to them so they didn't do something that they would be sorry about it later."  Thomsen said she was concerned that "the effect on the markets could be quite dramatic particularly for an institution like Morgan Stanley," if the SEC was confident that they had a case against Mack and could not find some way to communicate it.  Thomsen explained that "if Morgan Stanley were to hire as its CEO someone who engaged in insider trading shortly after he became CEO that could be potentially quite disruptive" to the capital markets.  She said "it could have  ripple effects that makes the markets go haywire."  Thomsen added that since Morgan Stanley is a financial institution, the Commission's failure to provide information about Mack's exposure, could be disruptive and she was worried about the SEC "contribut[int] to that in some way that could have been avoided."  Thomsen said the disruption could affect, in addition to Morgan Stanley, "other companies' ability to raise capital," noting that Morgan Stanley's previous CEO had just left, she thought their General Counsel may have just left or was about to leave, and they had several lawsuits with the SEC.  Thomsen said "on the other side, I similarly worried that the fact that we had an investigation that [Morgan Stanley] obviously knew about . . . might cause the Board to act so cautiously that "[Morgan Stanley] would not hire a candidate they deemed to be qualified because somehow, by our communication, we had signaled that he was in violation of the federal securities laws."

The next day, June 28, White talked again with Thomsen.  According to the presentation prepared by White for the Morgan Stanley board:

• Thomsen called me late on Tuesday after she and her staff had reviewed those emails and confirmed that the emails did not change their view of Mr. Mack, it was still "too early" in the investigation to tell her whether Mr. Mack had any issues.  She added that there is "smoke there" -- but that there was "surely not fire."  She said they are weeks away from knowing more and could give us no more comfort.  She commented that the "Board will have to trust him." 

White's notes went further.  In them she noted that based on the conversation, "it does seem clear that the SEC will continue to pursue the Pequot investigation aggressively, including making sure that there is no misconduct by Mr. Mack."  Further, her notes opined that "it also seems likely that Mr. Mack will be asked to testify in the SEC's investigation at some point." 

Thomsen more or less confirmed the smoke/fire comment.  According to the Report:

• Thomsen acknowledged that the section in White's notes about her saying "there is smoke there but that there was surely not fire," was "accurate," although she could not recall if that was exactly what she said, but stated that she "was trying to convey to Ms. White the notion that we have information that puts Mr. Mack as an actor in the events we're looking at, but we don't have anything at this point that says we're going to sue him tomorrow.  She also said White got the point she was trying to convey that they did not know one way or the other, and there was noting she could provide to help her weigh the balance.

We'll have more comments on this interaction later.  For now, it is enough to note that Linda Thomsen has some discretion in revealing non-public information. She did so in a carefully calibrated way.  Moreover, she did not disclose the existence of an investigation (White already knew about it) or the identity of possible defendants.  Instead, she essentially sought to prevent the existence of an SEC investigation from causing collateral damage to someone who, at the time of the conversation, was not a serious target.

A redacted version of the Report is posted. 

We have been slow in digesting the reports issued by the Inspector General at the SEC.  Today we look at the report on Gary Aguirre, the staff attorney who was working on an insider trading investigation centering around purchases of shares by Pequot Capital Management, a hedge fund.  The fund bought shares of Heller Financial just before its acquisition by General Electric.  The investigation included the role played by John Mack, who, in 2005, became the Chairman and CEO of Morgan Stanley. 

The Inspector General examined whether John Mack received preferential treatment and whether Aguirre was fired in retaliation for his complaints about the preferential treatment.  In addition, however, the Inspector General also examined whether the senior enforcement officials "improperly" provided Morgan Stanley with nonpublic information about the Pequot investigation.  This is the portion of the report that we will examine in a number of posts.

During the course of the investigation, Mack was under consideration to become the CEO of Morgan Stanley (he was then the CEO of CSFB).  As part of the investigation, a subpoena had been issued that requested emails from Mack, suggesting that his behavior was under scrutiny.  This apparently caused concern at Morgan Stanley and resulted in calls to the Commission to try to uncover the status of the investigation with respect to Mack.

In late June 2005, Aguirre received a call from Eric Dinallo, the managing director for regulatory affairs at Morgan Stanley.  With Mack under consideration as CEO, Dinallo was trying to find out whether Mack was a target and if so, the seriousness of the claims.  Aguirre told Dinallo nothing about the investigation and informed his superiors about the call. Discussions occurred among Aguirre's branch chief, assistant director, and associate director.  According to some of the testimony set out in the Report, Paul Berger, the associate director, "was adamant in saying absolutely not [to say anything to Dinallo] and instructed [the assistant director] not to do that."  Report, at 73.

Despite the apparent instructions, Dinallo in fact received a call from the SEC, with the call coming from Paul Berger.  According to the Report, Berger denied informing Dinallo about the investigation.  "Berger was asked if he implied that the SEC did not presently have evidence of any wrongdoing by Mack, and replied 'no,' and that he 'was specifically trying to stay away from conveying anything that would suggest that they take from the conversation that they can make a business decision based on what the SEC is doing." 

The Report, however, also quoted a presentation prepared by Mary Jo White, the former US Attorney from the Southern District of New York and a partner at Debevoise, for the Morgan Stanley Board, apparently based upon conversations with Dinallo.  "The response [from Paul Berger] was that the SEC was looking at Mr. Mack, among others, as part of their investigation, primarily based on what they had seen in e-mail traffic, but implied that they did not presently have evidence of any wrongdoing by Mr. Mack."  When reading the language in the presentation, Dinello stated:  "I think that's exactly what my conversation with Paul Berger was about."

The exchange contains a number of issues.  There is obviously a dispute about what was transmitted during the conversation.  The disagreement is understandable.  Clearly Berger didn't come out and say that Mack wasn't a target.  The issue seems to be one of tone, something that can easily be misread.

The more serious concern are the hints at a possible conflict of interest.  The communications between Morgan Stanley and the Commission took place in June 2005.  The Morgan Stanley Board had retained Debevoise to engage in due diligence on the hiring of John Mack.  See Report, at 75.  The Report noted that in September 2005, Berger "authorized the friend to mention his interest in a job with Debevoise," Report at p. 3, and lists Berger as a partner at Debevoise. See Report at p. 8. 

The Report does not, however, address these circumstances.  As the Report notes:  "allegations regarding former Associate Director Paul Berger's improper contacts with the law firm of Debevoise & Plimpton and the failure to recuse himself from the Pequot investigation were not addressed because Berger no longer works for the Commission." 

We are always interested in the online universe and so read with interest the analysis by the Pew Research Center on the source of campaign information.  Turns out that the percentage of those describing the Internet as the "principal source" of campaign news has grown from 10% in 2004 to 33% in 2008, second only to television.  There is a clear generational divide in the data.

• Not surprisingly, the internet is a considerably more popular source for campaign news among younger Americans than among older ones. Nearly three times as many people ages 18 to 29 mention the internet as mention newspapers as a main source of election news (49% vs. 17%). Nearly the opposite is true among those over age 50: some 22% rely on the internet for election news while 39% look to newspapers. Compared with 2004, use of the internet for election news has increased across all age groups. Among the youngest cohort (age 18-29), TV has lost significant ground to the internet.

As we have noted, the Internet is a paradigm shift and is gradually affecting the staid world of law scholarship.  This is discussed in Of Empires, Independents, and Captives: Law Blogging, Law Scholarship, and Law School Rankings.

This post is part of an ongoing series that examines the way stock exchange independence rules influence director compensation. We are including companies from 2007’s Fortune 100 and using information found in their 2008 proxy statements. In addition to state standards and the requirements of SOX, the stock exchanges each have their own standards for independence. While substantially the same, there are some minor differences between NYSE and NASDAQ rules that are worth noting.

Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards. Directors are not independent if they received over $100,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii). (The NYSE recently increased this amount to $120,000).  This is a looser restriction than the equivalent NASDAQ Rule, 4200(a)(15), which includes all compensation. Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also know as SOX 301.

One can see some of the effects of these rules when looking at the director compensation table from Wells Fargo (WFC-NYSE) 2008 proxy statement. According to the proxy statement, the company paid the directors the following amounts:

Director Compensation. Wells Fargo’s board met seven times in 2007 and board members averaged 97% attendance. Each director attended at least 75% of all meetings, including general board meetings and each director’s committee meetings. Only two of the fourteen directors’ base salaries exceeded $129,000. On average, total compensation equaled $220,534. Approximately 34% of director compensation comprised of stock awards, which are considered director’s fees for purposes of complying with exchange rules.

Director Tenure. Almost two-thirds of the non-employee directors have served on the board for at least nine years, and six have served for at least fourteen years. Richard McCormick has the longest tenure at twenty-five years. Several directors also sit on other boards. Enrique Hernandez, a director of Wells Fargo since 2003, is also a director at both the McDonald’s Corporation and Nordstrom, Inc. Donald Rice, a director since 1993, is also a director at Chevron Corporation and Vulcan Minerals Company.

CEO Compensation. Until June 2007 Richard Kovacevich served as CEO and Chairman of Wells Fargo. For his services, Mr. Kovacevich received $22,874,952 in total compensation. Option awards comprised approximately fifty percent of his total compensation, while he received $995,000 in base salary. In June 2007 Mr. Kovacevich resigned as CEO but continued as Chairman. After June 2007, John G. Sumpf moved from COO to CEO of Wells Fargo. In 2007, Mr. Sumpf received $12,568,917 in total compensation. Based the company’s 2007 performance, Mr. Kovacevich received 33% less in incentive compensation compared with his 2006 award, while Mr. Sumpf received 24% less. “Other compensation” comprised less than 3.4% of both Mr. Kovacevich and Mr. Sumpf’s total compensation.

We are pleased to note the entry of the Shareholder Communications Coalition to the blogosphere.  The Coalition is an advocacy organization "dedicated to improving the ability of individual investors to vote their shares and communicate with the publicly traded companies in which they invest."  The Coalition is seeking, among other things, reform of the Shareholder Communication Rules and supports the petition submitted by the Business Roundtable on the topic. 

This aspect of the Coalition's task is wholly supported by The Race to the Bottom.  The Shareholder Communication Rules, particularly those that deal with communications between issuers and beneficial owners, are unnecessarily complex and do more to impede rather than improve the communication process.  For more, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The article is listed on the Coalition's web site.  We are sure to follow the Coalition's efforts in this area.

We don’t disagree with the determination about independence in Loral.  The evidence, even if conclusory, suggested at least the possibility that the directors were too closely connected to MHR to be considered independent.  There were preexisting personal relationships and some (albeit conclusory) evidence of outside business relationships.  The two directors at issue even solicited business from MHR.  Indeed, as we have argued, the standard used in Loral ought to be the standard applicable in all cases challenging independence.

But, based upon past decisions, it has not.  Perhaps VC Strine is changing the law and adopting a more reasonable standard for showing a lack of independence.   Perhaps "structural bias" and preexisting friendships will play a larger role in the analysis of independence in the future.  The next case or two on the independence issue will demonstrate whether or not this is the case. 

Our prediction?  The standard in this case will be limited to activist shareholders.  Conclusory allegations, reliance on structural bias, and overlapping board positions will not be enough to challenge the independence of directors tied to the company and the CEO but will be enough to show a lack of independence for directors tied to an activist shareholder.

One thing is for certain.  The conclusion that the standard in the case arose in part because of the type of shareholder involved would have been much tougher to reach but for the external writings and musings of the Vice Chancellor writing the opinion.  The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

We are discussing In re Loral and examining the trial judge's search for a fifth director who failed to meet the independence standard and therefore resulted in a board with a majority of non-independent directors.

The court found a fifth director, John Harkey, to be too connected to MHR to be independent.  Harkey served on the Special Committee considering the financing proposal from MHR.  He lost his independence mostly because of a host of personal connections, perhaps the toughest ground in Delaware for doing so.

The personal relationship?  He was a business school classmate of Rachesky, the founder of MHR.  But of course, that is an example of structural bias, the very type of evidence rejected in Beam.

The court also, however, noted that Harkey had a “long-time friendship” with Rachesky, the founder of MHR.  The long time friendship conclusion was supported by no evidence in the opinion except an isolated citation to someone named Simon, apparently the other director on the Special Committee.  It was not supported by statements from Rachesky or Harkey, the two involved in the relationship. Moreover, there was no surrounding evidence to sustain the conclusion, no examples of interaction between the two directors.  This was the very sort of evidence emphatically rejected in Beam.  As the Court noted in Beam:  "Mere allegations that they move in the same business and social circles, or a characterization that they are close friends, is not  enough to negate independence for demand excusal purposes."  845 A.2d 1040, 1052-53. 

The opinion noted that the two men served as “business resources and references for each other.”  Again, the opinion provided no example or instance where the references had actually been used.  The Chancery Court rejected the argument that the use of a director as a reference resulted in a loss of independence in In re Transkaryotic Therapies, 954 A.2d 346 (Del. Ch. 2008).  In that case, the court did so even though one director used another as a reference during the period when the challenged transaction occurred.  As the court in that case described:

• Second, plaintiffs' attempt to show Yetter's dependence on Emmens for employment is unavailing. Plaintiffs allege that Yetter "was relying on Emmens's reference for a job at the time of Emmens's October 2004 approach."  The actual record evidence, however, shows that Yetter merely included Emmens's name on a list of references submitted in connection with an application for a position with Odyssey Pharmaceuticals. There is no evidence that Emmens was actually contacted by Odyssey or any affiliate. In fact, there is no evidence whatsoever that Emmens  even knew he was listed as a reference.  Moreover, the suggestion that Yetter would sell his vote for a positive job reference is belied by the fact that Yetter--unlike Leff and Moorhead--voted affirmatively to reject the initial Shire offer of $ 31 per share. At the time of that vote, February 26, 2005, Yetter had already listed and was, according to plaintiffs, already relying on Emmens's reference. If indeed Yetter had sold his vote, it would have presumably been sold by then.

We criticized that holding.  But in any event it contained much stronger evidence of a potentially disqualifying relationship that the conclusory references in Loral. 

Finally, the opinion notes that “[b]ased on Rachesky’s recommendation, Harkey serves as a director on three boards – Loral, Leap Wireless International, Inc., and Emisphere Technologies, Inc. Unsurprisingly, MHR holds large blocks of stock in each of these companies.”   In other words, it was enough that Harkey served on boards where MHR owned shares.  No case in Delaware has ever found that this type of evidence has been sufficient to deprive a director of indpendence.  Indeed, on a number of occasions, the evidence has been specifically rejected.  See Khanna v. McMinn, 2006 Del. Ch. LEXIS 86 (Del. Ch. Nov. 7, 2005) ("Second, the Amended Complaint repeatedly alleges that McMinn (or another director) 'recruited' certain individuals to be Covad directors, that those individuals took their seats at McMinn's (or others') 'behest,' and that those individuals became directors with the other directors' 'consent and approval.' Again, conclusory allegations of this nature do not advance the Court's inquiry; they will not 'sterilize' a director's judgment with respect to demand."). 

Similarly, VC Strine has, in an earlier case, indicated that similar information was immaterial in the disclosure context. See In re Netsmart Techs., Inc. S'holders Litig., 924 A.2d 171 (Del. Ch. 2007) ("In view of the tightened definitions of independence that now prevail, I am chary about adding a judicially-imposed disclosure requirement that past interlocking board service involving a target's CEO and another independent director must always be disclosed.").

In other words, Harkey was found to lack independence using standards not typically applicable in prior cases.

The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

We are discussing the Chancery Court's opinion in In re Loral.

In Delaware, the standard of review doesn’t depend upon the conduct involved but on the approval mechanism. For plaintiffs to successfully challenge the board’s behavior, they have to show that the board was not independent. See Opinion, at 43 (“Because MHR had effective control of the Loral board, the plaintiffs argue that MHR has the burden of showing that the MHR Financing was fair to Loral.”). This is a notoriously difficult standard to meet in Delaware. The state courts impose excessive pleading standards at the motion to dismiss/demand excusal stage and apply an unrealistic definition of independence.

In this case, the Loral board contained nine directors. Three of the nine directors were appointed by MHR. Plaintiffs, therefore, needed to show that two additional directors were not independent because of their connections to MHR. The court found that plaintiffs met the standard in what can only be viewed as surprising analysis.

One of the directors was Michael B. Targoff, the CEO and vice chairman of the board. The evidence for a lack of independence? In a letter to its investors, MHR described Targoff as an advisor. He received free office space in MHR’s midtown offices rent free in return for providing advice on “potential transactions and business opportunities.”

That’s it. The opinion was devoid of any numbers that put a value on the services or the free office space. Only one other Delaware case has found allegations of free office space to be sufficient to result in a loss of independence.  See In re infoUSA, Inc. S'holders Litig., 953 A.2d 963 (Del Ch 2007).  In that case, however, the case was at a motion to dismiss and the court agreed to allow it to go forward only because an internal memorandum suggested that the space may have deprived the directors of independence and, as a result, the need for discovery.  But the opinion noted the kind of evidence it expected to see after discovery.  "Plaintiffs have not had the benefit of discovery, however, and it would be too much to expect for plaintiffs now to provide the Court with a detailed floor-plan of the Everest offices; an estimate of the cost of office space in Omaha, Nebraska; the square footage occupied by each defendant; an estimate of the personal net worth of Haddix and Walker; and any of the various other factors that would need to be presented to establish by a preponderance of the evidence that the two directors lack independence."

VC Strine needed none of that level of specificity.  The opinion contains no information on the amount of space, the net worth of Targoff, the square footage, or anything else that suggests the type of material impairment necessary to deprive a director of independence.

Similarly, with respect to the advisory role played by Targoff, there is nothing in the opinion that suggests Targoff was actually paid any money.  Nor is there any evidence of actual advice provided.  In other words, there is no evidence that a material business relationship of any kind existed.  It is the very kind of lack of information that ordinarily gets a plaintiff’s challenge to director independence dismissed.  But in the case of a relationship with an activist shareholder, the standard of proof is apparently lower.

Add in that the opinion provides data that suggests that in fact Targoff served in an independent role. First, he worked for a predecessor for Loral for 16 years. In other words, he knew the company and was experienced in the industry. Second, even the court couldn’t avoid noting his role in the negotiations with MHR. "Sadly, by the end of the negotiation process, it appears that Loral’s CEO, Targoff, was a more aggressive negotiator than the Special Committee itself or the Committee’s financial advisor, North Point"

The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

Perhaps we have an excessively jaundiced eye when it comes to Delaware decisions. In In re Loral Space and Communications, VC Strine produced a 91 page opinion essentially allowing shareholders to recover where the board allegedly entered into a sweetheart financing deal with the company's largest shareholder, MHR Fund Management.  But more closely read, the case very possibly demonstrates a hostility towards activist shareholders.

We are supported in the conclusion by the public pronouncements of the author of the opinion.  As VC Strine has more or less espoused in a law review article, activist investors are motivated by self interest and short term returns. They "can use the threat of a withhold campaign to bargain for concessions and the seating of some of their favorites by action of the incumbent slate." It is, as VC Strine believes, something that "smacks of green mail and a hidden form of cumulative voting, the benefits of which arguably flow largely to short-term activist investors."  The antagonism towards these types of shareholders has arguably shown instelf in at least one prior case.

In re Loral Space and Communications is consistent with this antipathy.  In that case, MHR owned 35.9% of Loral.  VC Strine described MHR as having a business model that "involved taking control of distressed companies and position itself to reap the benefits of control for itself and its investors."  Lest one have any doubt that the Vice Chancellor viewed the firm as a short term activist shareholder, he noted that MHR was the “eponymous creation of Mark H. Rachesky” and that Rachesky was "Carl Icahn's chief investment adviser."

These descriptions spell trouble for MHR, something that becomes clear from the decision.  In particular, the decision finds that a majority of the nine person board was beholden to MHR.  In doing so, however, it applied a standard for independence that, to say the least, conflicted with prior approaches by the Chancery Court.

We will examine the problems with the opinion in the next posts.  The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

The transcript of Greenspan's testimony before the House Committee on Oversight and Government Reform is posted.  Here is what he said on Thursday about the Delaware model:

• Mr. GREENSPAN. I made a mistake ín presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.

In other words, allowing top officers and directors to profit from the company (greed in short) was not the best way to protect shareholders.  It is, as we have noted, a frontal assault on the Delaware model of governance.  The Delaware model presumes that directors should have something approaching unlimited discretion and will use that authority to benefit shareholders.  The courts have done so by all but eliminating the duty of care and removing fairness from the analysis of the duty of loyalty.  The problem of excessive compensation demonstrates that the system works in the best interests of officers and directors.  The current financial turmoil demonstrates that the approach does not work in the best intersts of shareholders.  We have discussed this at length in the article, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

We welcome Alan Greenspan to the position, but note that it took the greatest financial crisis since the Depression to bring him along.

At the same hearing, Congressman Mark Souder had this to say:

• But one of the questions here is where are the corporate boards? Those of us who believe in the private sector believe that there was supposed to be some kind of corporate check on the stockholders. Do any of you have any suggestions of what we might be looking at here because clearly they were asleep at the wheel,

It is the great unaddressed issue.  With the bailout proceeding apace, one can wonder why there has not been an attempt at systemic reform that increases the responsibility of the board of directors to oversee the activities of the company, including examination of excessive risk taking.

When this Blog started almost two years ago, we listed ourselves as a Pro-SOX Blog.  In other words, one of our stated purposes was to defend Sarbanes Oxley against the withering criticism from much of the legal blogosphere.  The efforts generated an article:  Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance. 

What has become clear is that SOX, rather than going too far, did not go far enough.  For one thing, SOX largely relied on the stock exchanges to improve the governance process, making audit committees with independent directors a listing standard rather than a statutory requirement.  But what is clear is that SOX attempted to fix the problem of financial fraud and inaccurate financial disclosure.  SOX left undressed the broader issue of fiduciary duties.  This was accurately captured in an editorial in the WSJ :

• Today's financial crisis has shown what a real debacle looks like. And it has made clear that executives' duties to public companies have, if anything, been loosened, not reinforced. What is worse, the post-Enron crackdown appears not only to have failed to stop flagrant corporate risk-taking, but to have lulled Washington to sleep.

We can look at some of the specifics, such as the absence of any real obligation of the board to supervise unusual risk-taking by a company.  Thus, when Bear Stearns exceeded its own risk parameters in bulking up on debt obligations, it's safe to say that the board never reviewed or approved the practice.  Why not?  Because the board had no legal obligation to do so.

But the problems are far broader.  What about the fact that in the US, among the largest companies, most boards are chaired by the CEO?  Of the largest publicly traded companies, only 11 have chairmen who are independent directors.  In other words, the approach applied today in the US (not in most other countries) is to rely on the board to protect shareholders but to allow the CEO to control the board.  On its face that approach is inconsistent with the purpose of the board and its fiduciary obligations.  So is the process for approving self interested transactions (most noticeably executive compensation) or nominating directors.  All of these issues require reexamination.  In other words, as Gordon Smith notes, fiduciary duties are on the table.

By now, the saga of AIG is familiar to almost everyone.  The Company teetered on the edge of failure until the government had to agree to a bailout in return for an almost 80% interest in the company.  Despite the need for public assistance, AIG has been in the news constantly because of its policies with respect to executive compensation and other seemingly extravagant expenditures.  It all came to a head when New York Attorney General Andrew Cuomo sent a sharp letter to the board of directors more or less directing them to reexamine these policies.  

The letter got the board's attention.  According to the WSJ, AIG agreed:

• to freeze some $19 million in payments to its former chief executive, Martin Sullivan, while New York Attorney General Andrew Cuomo reviews executive compensation and other expenditures paid out as the company neared collapse earlier this year.  The insurance giant also has agreed not to distribute any funds from its $600 million deferred-compensation and bonus pools of its AIG Financial Products subsidiary, which Mr. Cuomo has said was largely responsible for the company's near collapse. .  . The company also agreed to establish a special governance committee to institute new expense-management controls and to immediately cancel all junkets or perks that aren't strictly justified by legitimate business needs. As a result, AIG will be canceling more than 160 conferences and events for a total savings of more than $8 million.

But the broader question is why it took the intervention of the attorney general of New York before these steps were taken.  The short answer is that Delaware is the state of incorporation for AIG.  As we have noted before, the courts in Delaware refuse to interpret fiduciary obligations in a way that would impose meaningful monitoring duties on directors.  In most instances, boards have no obligation to act except when confronted with a specific problem or issue.  In other words, the directors (who are, by the way, well paid) had no obligation to revisit compensation or lavish entertainment expenditures under the Delaware model.  Only when confronted with a threatening letter from the NY attorney general was the board confronted with a matter that required action.

It is helpful that Andrew Cuomo got the board at AIG to act responsibly.  But he can only write so many letters.  There needs to be broader reform.  This means replacing the Delaware model with federal legislation that imposes more pronounced obligations on the board.  In that way, boards will take the necessary steps before receiving the dunning letters from the attorney general.