Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recenlty published a book titled Corporate Governance, Promises Kept, Promises Broken.  We are discussing the book in a series of posts.

In addition to the dual functions expected of boards, he emphasizes in Chapter 4 that diretors are inherently subject to capture by management.  Capture applies not only to the inside directors, but those considered independent under the relevant definitions.  As he describes:

• The problem with boards is their unique susceptibility to capture by the managers they are supposed to monitor. The problem of capture is so pervasive and acute that no board, not even those that appear highly qualified, independent, and professional, should be relied upon entirely.

Id. at 57.  What are some of the foundations for the capture phenomena? He relies primarily on the cognitive bias that arises out of constant interaction between directors and officers and the control of management over the flow of information to the board.

• Boards select top management and "become committed to and responsible for theirs managers. For this reason, as board tenure lengthens, it becomes increasingly less likely that boards will remain independent of the managers they are charged with monitoring."

The phenomena is enhanced by the advisory function expected of directors.  This leads to constant interaction, presumably in a trusting enviornment, that contributes to caputre.  Likewise, capture is exacerbated by an organizational structure that invariably combines the positions of CEO and chairman of the board.  The CEO, therefore, controls the flow of information to the board.  At the same time, the CEO has an incentive to paint himself/herself in the most favorable light possible.  in other words, the board by definition gets a skewed body of information.  

This analysis recognizes that "capture" occurs not necessarily before a director joins the board (say through friendship with the CEO0 but afterwards.  Moreover, as Macey emphasized, the current structure makes capture inevitable.  Interestingly, the courts in Delaware courts have all but excluded structural bias from consideration when examining director independence.  It is another example of the pro-management bias of these courts.  They provide legal advantages to "independent" boards but then systematically ignore evidence that suggests the boards are not in fact independent.

Unlike the Delaware courts, governance systems overseas have recognized the capture phenomena.  A numbe of them specify that after a certain number of years on the board, a director will no longer be considered independent.  Thus, in Great Britain, the period is set at nine years.  The approach is blunt and does nothing to address capture prior to the expiration of the relevant time period.  Nonetheless, it recognizes that directors and CEOs serving together for long periods cannot approach decisions in a neutral manner.

The positions on this Blog are consistent with the capture analysis set out by Macey.  Recognizing that boards are captured begs the question of what to do about it.  On this point, Macey and The Race to the Bottom diverge.

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale.

Singularly the most provocative portion of the book is the discussion of the board of directors in Chapter 4.  He does two things.  First, he notes the almost schizophrenic purposes given to directors.  They are expected not only to monitor but also to advise, tasks that are in many ways irreconcilable.  Moreover, the relative weight given to each function has normative implications.

• [A] board structure that emphasizes independent directors reflects a corporate governance policy of favoring monitoring over managing because the independent directors inevitably will have less information and therefore will be less able to contribute to managerial decision-making than will inside directors. On the other hand, a board structure designed to maximize the efficacy of board participation in strategic planning and other managerial functions will have relatively few outside independent directors.

In other words, increased independence weakens the advisory function; reduced independence weakens the monitoring function.  For Macey, the impossibility of this dual function raises concern about whether the board, as currently configured, can ever fulfill its role in the corporate governance process.

The discussion of these responsibilities highlights one of many weaknesses in the current approach to corporate governance.  The emphasis is on independent directors, with exchange traded companies required to have a majority of such directors on their boards.  Moreover, many companies rely on a super majority of independent directors, with the CEO often the only non-independent director on the board.  As data by Sherman and Sterling on the top 100 largest publicly traded companies notes, independent directors constitute 75% or more of the boards of 89 of the Top 100 Companies surveyed this year, with the CEO the only non-independent director in 44 of the top 100 companies. 

Moreover, while the NYSE definition of independent has many problems (excluding consideration of fees for one), it clearly encourages the use of directors who have no existing business relationships with the company.  In other words, these boards really have no one on them except the CEO who really knows about the business of the corporation.  This highlights the consequence of allowing CEOs in the US to also serve as chairman of the board.  The position gives them almost complete control over the information about the company that is communicated to directors.

They are, therefore, expected to monitor management but then are subject to extensive controls over the information that they need to accomplish the task.  At a minimum, the two positions (chairman and CEO) must be separated (a position Macey takes in his book).  Provisions in SOX governing audit committees and internal control seek to address this imbalance by essentially requiring companies to report certain kinds of information to the board, taking it away from the CEO's discretion and monopoly.  But even if the information is given to the board, they have to understand it.  The provision in SOX that all but requires boards to have directors with financial expertise edges in this direction.

We are looking at the corporate governance commitments made by the automobile companies should they receive federal funds. 

Chrysler is not a public company, but is mostly owned by Cerberus Capital Management, a private equity firm.  The company has agreed to "comply with all conditions relating to executive compensation established under the Emergency Economic Stabilization Act of 2008 ("EESA") and such other conditions as the Government may require."  The company committed to doing so for "the term of the loans."  Presumably that means clawbacks and limits on golden parachutes.

Ford, which is a public company, and not as desperate as the other two, has committed to, among other things, the elimination of all merit increases and bonuses to be paid in 2009.  The company vaguely indicated a willingness to abide by the compensation limits in the bailout legislations.

• Ford recognizes that transforming our industry will require the shared sacrifice of many stakeholders and we will be asking our employees, dealers, and others to make changes to help save their jobs and our company. To underscore our commitment, Ford’s senior executives will not receive any salary increases or bonuses in 2009, and we will extend that restriction if business conditions continue to warrant it. We believe that the executive compensation limits imposed under TARP (to which we may be availing ourselves even without bridge loans if the TALF program is implemented so that our credit operations can participate and benefit from this program) are equally appropriate for the automobile industry.

The language stops short of an actual commitment (the company merely thinks they are appropriate) perhaps because Ford may not even use funds under the bailout.  Nor does the commitment contain a time period for adherence.

Both CEOs (Alan Mulally at Ford and Robert Nardelli at Chrysler), like Rick Wagoner at GM, have agreed to reduce their annual pay to $1.  To the extent this involves only a reduction in salary, the impact is minimal.  Thus, for example, Mulally received in 2007 a salary of $2 million and a bonus of about twice that amount.  But his total compensation (including deferred comp, options, stock awards, perqs, etc.) was $21.6 million.  Ultimately, the salary/bonus component of his salary was a modest portion.

In other words, neither company has committed to any permanent, lasting corporate governance reform.  Chrysler has less reason to make the commitments since its corporate governance structure presumably reflects the interests of its controlling shareholder.  But Ford, a public company, needs improved confidence in its future direction.  Leaving in place a system of governance that has resulted in near disaster does not provide confidence.

We are taking a short break from the discussion of the book by Jon Macey on corporate governance to discuss the recent proposals submitted by the automobile companies in connection with their renewed request for federal funds.

General Motors, Ford and Chrysler have presented Congress with plans on what would happen if they receive a bailout.  We have provided links to each report.  It is the type of plan that should have been presented the first time the CEOs of the three auto makers traveled to Washington.  In the proposals are some concessions with respect to corporate governance.  General Motors, for examples, provides the following:

• The Chairman and CEO will reduce his salary to $1 for 2009. He will not receive an annual bonus for 2008 and 2009.
• Consistent with this action, members of the GM Board of Directors will reduce their annual retainer to $1 for 2009.
• The next four most senior officers (Executive Vice Presidents and above) will reduce their total cash compensation by approximately 50% in 2009, which includes no bonus paid for 2008 and 2009 and a 30% salary reduction for the President and COO, and 20% salary reductions for the remaining three.

In addition, the company made some vague concessions on executive compensation. 

• GM agrees to maintain the strictest oversight on Executive compensation including annual bonuses and golden parachutes. The top 5 most senior officers do not have any employment or severance agreements. Post-2009 compensation will be determined in conjunction with the Oversight Board, and would be dependent upon the achievement of the benchmarks in the Plan.

As for corporate aircraft, the company "is immediately ceasing all corporate aircraft operations" and is "exploring options for transferring the aircraft." 

In other words, there is no real change in governance.  The reduction of salary and retainer to $1 does not address performance based compensation such as stock options.  To the extent, for example, that the reference to "salary" simply means the annual cash component of Wagoner's compensation, it isn't much of a sacrifice.  Thus, in the 2007 proxy statement, he received $1,558,333 in "salary" but his total compensation (including stock awards, options, and deferred compensation) was $14,415,914.

What else ought to be done?  A truly independent board, with the removal of any director who has overseen the steep decline of General Motors.  Wagoner should be required to step down as chairman of the board, replaced by an independent director.  Finally, shareholders should be given slots on the board to ensure that shareholder interests are actively protected in the decision making process.

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale. 

As we have noted, Macey views corporations as a nexus of contracts.  This is a theoretical framework that allows managers and shareholders to agree to the terms of their relationship.  In other words, it elevates private ordering over mandatory corporate law provisions. 

While the approach has interesting theoretical implications and arguably results in an approach to governance that favors activist shareholders (at least those who want to change the "contract" by limiting compensation or requiring reimbursement of expenses for proxy contests), the approach breaks down in practice.  In Opting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom, we studied the waiver of liability provisions in the top 100 companes to see if there was any evidence of private ordering. After all, theory behind them was that, as amendments to the articles, both directors and shareholdes had to approve them. This would, therefore, result in some negotiations between the two groups.

In fact, nothing of the kind occurred. All of the publicly traded companies in the top 100 (there were a few mutual companies) had waiver of liability provisions, excepting only Pepsi. (Some companies did not have them because of statutory provisions that effectively waived liability. In those cases, none of the companies "opted out."). In other words, they were universal. Even more revealing, every one of them waived liability to the furthest extent permitted.

There are only two explanations for this data. Either waiver of liability provisions that waive liability to the maximum extent permitted are inherently efficient in all circumstances or there is no actual bargaining between the two groups and the corporate contract merely reflects the interests of management. It is, of course, the latter that makes the strongest case (as the article goes on to show).  In fact, management dominates the contracting process.  To have anything even resembling a negotiation process, existing state law would require dramatic revision, including acceding to shareholders the authority to initiate amendments to the articles of incorporation.

In fairness to Macey's view, he would likely recognize this reality.  Instead, he relies on the market for corporate control to police inefficient arrangements.  If management relentlessly enters into unfair arrangements with shareholders, it will suffer at the capital markets and eventually be taken over by someone with a more efficient approach.  We will deal with this later.  For now, it is enough to note that reliance on the market still leaves the choice in the hands of management, which is not real bargaining, and would only penalize management to the extent the "inefficiency" was great enough to justify the high costs of a hostile acquisition.  In other words, reliance on hostile takeovers does not ensure a meaningful role for shareholders in the bargaining process.

DONALD M. HOERL NAMED REGIONAL DIRECTOR OF SEC’S DENVER REGIONAL OFFICE

Washington, D.C., Dec. 2, 2008 – Securities and Exchange Commission Chairman Christopher Cox today named Donald M. Hoerl as the Regional Director of the SEC’s Denver Regional Office. The Denver office conducts examination and enforcement activities in Colorado, North Dakota, Kansas, South Dakota, Wyoming and New Mexico.

Currently serving as Acting Regional Director, Mr. Hoerl is also the Associate Regional Director for Enforcement in the Denver Regional Office, a post he has held since 1997. Mr. Hoerl succeeds George Curtis, the previous head of the Denver office, who was appointed to a Deputy Director position in the SEC’s Division of Enforcement in Washington, D.C.

Chairman Cox said, “Don has been a champion of investors throughout his distinguished career with the Commission. In his previous role in charge of the SEC’s enforcement program in the Denver Regional Office, and more recently as Acting Director of that office, Don has initiated a number of important cases that have made our markets safer for investors. America’s investors are fortunate to have a person of such high caliber and talent in this position of leadership at the SEC.”

SEC Director of Enforcement Linda Chatman Thomsen stated, “Don brings to this job a long record of accomplishment. Since his first days at the Commission, he has carried out his responsibilities with care, intelligence and effectiveness. Don is a very talented attorney who has played a critical role in the Commission’s investigation and litigation of numerous complex enforcement matters. I am sure that the Denver Regional Office will continue to flourish with Don at the helm.”

Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, added, “Don has demonstrated an appreciation for the importance of the regional office’s examination staff and the contribution they make to the overall effectiveness of the Denver office. I know he will be an asset to the Commission’s oversight of securities firms in the region.”

Mr. Hoerl said, “I am honored that Chairman Cox has named me as Regional Director of the Denver Regional Office. I am privileged to have the opportunity to lead its dedicated and talented staff in meeting the many challenges facing the Commission and the investing public in these difficult times.”

Mr. Hoerl began his career with the Commission in 1982 as a Trial Counsel in the Denver Regional Office. He has also served as the head of the SEC’s Philadelphia office for four years, and as the District Administrator of the Commission’s Salt Lake office for six years. Before joining the SEC, Mr. Hoerl was an Assistant United States Attorney in Denver for more than five years. He received his B.A. degree from the University of California, Los Angeles and his J.D. degree from the University of Colorado School of Law.

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale.

Macey defines corporate governance in terms of promises.

• The purpose of corporate governance is to persuade, induce, compel, and otherwise motivate corporate managers to keep the promises they make to investors.  Another way to say this is that corporate governance is about reducing deviance by corporations where deviance is defined as any action by management or directors that are odds with the legitimate, investment-backed expectations of investors.  Good corporate governance, then, is simply about keeping promises.  Bad governance (corporate deviance) is defined as promise-breaking behavior.

The metaphor allows Macey to immediately disarm critics who see corporate governance as not limited to the interests of shareholders and profit maximization.  In Macey's view, there is nothing wrong with promoting other interests as long as it is part of the promise made between owners and managers.  As he notes:

• The purpose of corporate governance is to safeguard the integrity of the promises made by corporations to investors, but investors and companies are left to their own devices (i.e., the contracting process) to define the content of the promises themselves.  Generally, the baseline goal is profit maximization.  Corporations are almost universally conceived as economic entities that strive to maximize value for shareholders.  But the goal of maximizing wealth for shareholders is, or should be, a matter of choice.  Investors should be free to choose to invest in ventures that purse others goals besides profit maximization.  

He concludes that there is "no legitimate theoretical or moral objection to those who assert that the goals of the modern corporation should be to serve the broad interests of all stakeholders rather than to serve the narrow interests of just the shareholders . . . "  The only real limitation is that the company state in advance that this is the goal before investors invest.  In other words, the corporation is a "nexus of contracts" and the parties are free to order their relationships in any way that they deem best (within all legal parameters, of course).

In addition to providing a mechanism for expanding board considerations, Macey's approach also runs head long into the interpretive approach used by the Delaware courts.  Presumably, he would disagree with the determination in CA v. AFSCME, where the Court struck down a proposed bylaw that would require a board to reimburse expenses to insurgents who engage in a proxy contest and successfully elect a candidate to the board.  Private ordering presumably means that managers and shareholdes can effectively enter into these types of agreements.

We will continue this thread in the next post.

Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recently published a book titled Corporate Governance, Promises Kept, Promises Broken.  The book is, as expected, thorough, thoughtful, and provocative.  It contains a number of conclusions that fully support the positions typically taken on this Blog, as well as a number that do not.  We will take a couple of days to examine the text and highlight the portions that raise some of the most interesting issues.

It seems that after the disastrous appearance of Rick Wagoner, the CEO of General Motors, in Washington to ask for a bailout without any real plan and flying back to Detroit on a private jet, has had one potential benefit.  The "mirror image" board at GM seems to have woken up.   According to the WSJ:  "Following Mr. Wagoner's poor performance in Washington last month, the board began meeting more and taking more seriously its obligation to investigate other options." 

But of course, GM was in deep trouble before Wagoner went to Washington.  The more interesting question is why the board wasn't more involved before he took the trip.  Had Wagoner gotten a grilling from directors about what was expected, he might have been better prepared once in Washington.  Of course, it would have required a board prepared to offer the CEO tough advise, a quality not obvious in this apparently "captured" board. 

In any event, there is one possible answer to the delay in becoming involved.  The anemic duties imposed on boards by the Delaware courts did not require any higher level of involvement.  Said another way, the lack of involvement met their fiduciary obligations.  This fact alone says something about the need to change these obligations.

As for lessons learned the last time around, the CEO of Ford won't be taking a private jet to the next meeting in Washington.  He'll be going by autombile, presumably a Ford.

We have noted that executive compensation is a matter of state law.  Delaware, a state that earns considerable income by attracting large corporations to form in the state, has an incentive to appeal to management to induce them to enter the jurisdiction.  For more on this topic, take a look at The Irrelevance of State Corporate Law in the Governance of Public Companies.

To induce management to incorporate in Delaware, there can be nothing more important than maximum latitude on setting executive compensation.  Managers will want to gravitate to jurisdictions that allow for the highest salaries.  In that respect, Delaware is a highly attractive jurisdiction.  It has largely put in place a system that makes compensation decision by the board unreviewable.  In other words, the fairness of the compensation and the terms are almost impossible to challenge.

The consequences of this approach is compensation without limits, something made clear by some of the  enormous payouts earned by top officials in companies that have failed or otherwise faired poorly during the current period of financial turmoil.  These payouts have focused public attention on the problem of excessive executive compensation.  But it is nothing new.

Prior to the current turmoil, reform efforts focused on "say on pay," an advisory vote by shareholders on executive compensation.  Say on pay was passed in the house and introduced by Senator now President Elect Obama in the Senate.  But while a useful devise (it exists in Great Britain and induces increased conversation between shareholders and managers), it contains no substantive limits on compensation.  Boards can still pay excessive amounts and can ignore any negative vote of shareholders.

Perhaps emboldened by the current turmoil, shareholders seem to be shifting their attention to more substantive limits on compensation.  Riskmetrics has announced that it will target an expanded category of executive compensation practices.  It will recommend that shareholder votes be withheld from directors that approve the payment of excise tax gross ups for management.  In other words, while say on pay is likely to retain strong support, shareholders want more than an advisory vote. This proxy season, expect to see even more shareholder proposals and withhold campaigns targeting lavish compensation practices.

The current waive of turmoil in the financial markets has cast attention on the problem of executive compensation. Companies that have failed or disappeared in shot-gun mergers have nonetheless paid exorbitant sums to officers who arguably played a substantial role in their demise. In response, Congress for the first time established federal standards for determining compensation, including clawbacks and limits on golden parachutes.

The congressional efforts, although mild, represent a deep frustration with the system used by the Delaware courts in assessing executive compensation. With the CEO on the board, executive compensation has traditionally been examined under the duty of loyalty. Through legal legerdemain, the Delaware courts have accorded the decisions the all but insurmountable protection of the business judgment rule, requiring only that the board contain a majority of "independent directors." By largely reducing the test to a rote head count, the courts did little to ensure that compensation decisions were unaffected by the interested influence. At the same time, the courts did little to ensure that independent directors were in fact independent.

The paper, Returning Fairness to Executive Compensation, provides some suggested reforms. The efficacy of the process must be improved. Most importantly, however, fairness needs to be returned to the analysis. Only with some obligation to show the fairness of the compensation decision with the interests of shareholder be adequately protected.

The article is posted on SSRN.  We will post more on the contents of the paper later.

We have long pointed out that Starbucks needed to recast its strategy if it intended to fight back from the declining sales and the onslaught of competition, most noticeably McDonalds.  We have criticized the emphasis on gold cards (although we were rewarded with one during an experiment in Denver) and free flavors, noting that the approach did little more than treat lattes as commodities, a losing strategy.  The winning strategy was to make a Starbucks latte an experience, to give people a reason to seek out its product rather than go to one of the many other dispensers.

As part of that, consumers needed to know that a purchase at Starbucks would make a difference.  Social Responsibility in short.  Free coffee on election way provided some evidence that this was a winning strategy.  We have held up Chipotle (a chain begun here in Denver) as an example of the successful use of this strategy.  The burritos at Chipotle are not cheap but consumers are likely aware of the organic nature of the ingredients and the commitment to free range meat and poultry.

With that in mind, we note that Starbucks seems to be moving in that direction.  A Friday purchase at a Starbucks in Dummont, Colorado, right of Interstate 70, revealed, on the sleave of the chai, that the purchase of certain drinks would result in the contribution of 5 cents to the Global Fund, a highly respected organization combating a number of diseases including AIDs.  A subsequent email (the same day and inserted below) repeated the offer.  So does the Internet, where the location of participating Starbucks can be found.

The approach is a good beginning but very limited.  The contribution only occurs upon the purchase of three drinks, Espresso Truffle, Gingersnapp Latte, and Peppermint Mocha Twist.  The program also, apparently, expires on January 2.  It would be far better for Starbucks to create a culture of Social Responsibility that applied to all purchases in the stores.  In other words, customers would know that every purchase made some type of positive contribution.  But hopefully Starbucks will see some type of improvement in sales as a result of this promotion.  Maybe then the company will realize that it needs to by a much broader, systematic approach to the Starbucks experience.

And, maybe, Starbucks will finally realize that it needs to provide free Internet.

We received a memorandum drafted by Wachtell Lipton titled "Risk Management and the Board of Directors."  In the memorandum, the firm describes the oversight responsibilities of directors under Delaware law.  The memorandum has this to say about director oversight obligations:  "The cases that followed [Caremark] made clear that there would be no liability under a Caremark theory unless the directors intentionally failed entirely to implement any reporting or information system or controls or, having implemented such a system, intentionally refused to monitor the system or act on any warnings it provided."  

In other words, so long as a system is in place (with the Delaware courts essentially putting in place no standards designed to ensure that the system is thorough and meaningful), boards have few if any affirmative duties with respect to corporate oversight.  In other words, they merely must react to what is given to them.  They have no affirmative obligations to ask for information or require additional reports.  Moreover, much of the information flow is controlled by the chairman of the board (who traditionally sets the agenda for board meetings).  In the United States, the CEO and Chairman are typically one and the same, giving management a substantial amount of control over the information flow to the board.

Perhaps its time for a system of monitoring that has affirmative obligations attached.

Remember when one of the attacks on SOX was the loss of cross-listings by foreign companies?  The main evidence was the increase in cross listings in London.  Turned out that the growth in London came at Alternative Investment Market or AIM.  The market took small, often illiquid companies and was typified by regulation lite.  In other words, it attracted the type of company that US trading markets didn't want. 

Well, it turns out that this approach has largely run its course.  A recent article in the Financial Times suggests that the heyday of AIM is over.

• The number of new listings in the year to date has dropped to 99, compared with 284 in 2007, while the amount raised on the market has fallen to £1.1bn from £6.6bn ($9.9bn) in 2007. October was the first calendar month for 10 years when no new money was raised on AIM.

• There has been a similar tail-off in international companies seeking to tap investors in London. There has been only 26 new listings this year from foreign companies, compared with 87 last year.

• For the first time in its history the number of companies quoted on the junior market is falling, dropping from 1,694 companies at the end of last year to 1,592 on Wednesday.

In other words, the panache of a foreign listing is no longer enough.  Unlike its counterparts in the United States, listing on AIM provides no cross premium advantage.  In other words, the home market gives the London listing no real value.  This decline may not last and may reflect the current global turmoil.  Nonetheless, it is an indication that in an era when local stock exchanges have climbed in quality, cross listings depend not on offering regulatory lite but on a higher standard.  In other words, the best competitive advantage arises out of a race to the top rather than a race to the bottom.

US News is considering changing the formula for computing rankings of law schools.  Right now, the magazine uses the median LSAT and GPA from the full time divison.  The magazine is considering using the median from the combined full time and part time divisions.  Because for most schools the part time division has lower LSAT medians, the impact of combining the two will be a drop in the median for at least some, if not many, of the schools with an part time division.  The change is, therefore, being watched with great interest.  The latest pronouncement?  Continued uncertainty.  As the US News Blog noted last month:

• Still undecided: In terms of the overall law school rankings, at this time, U.S. News is still studying the idea that was raised in my blog post "Changing the Law School Ranking Formula,” where we discussed the possibility of combining both full-time and part-time entering student data for median LSAT scores and median undergraduate grade-point averages in the calculation of the school's overall ranking. Our current law school ranking methodology counts only full-time student admissions data. Just to be clear, U.S. News is carefully contemplating the potential impact of such a methodology change: We will not make a decision until January 2009.

Wachovia Bank has been one of the casualties of the current financial crisis.  Trading in the $40s a year ago, the stock has plummeted to somewhere around $5. Perhaps the third quarter said it all.  According to the Washington Post, Wachovia:

• posted a $23.7 billion quarterly loss yesterday, the largest ever for a bank, as its portfolio of loans deteriorated and deposits fled. The report laid bare the serious financial straits the company was in before Wells Fargo announced earlier this month that it would buy Wachovia. On top of $10 billion in losses earlier this year, the quarter wipes out nearly all the profit Wachovia has earned since 2001, when it merged with First Union and became a much bigger, national bank. 

The Bank will, of course, disappear as an independent entity as it is swallowed by Wells Fargo. There is no realistic change of a higher, competing bid since the board voted to issue to Wells Fargo shares equal to about 40% of the bank's total voting power.  Ordinarily, this sort of action requires shareholder approval under the listing standards of the NYSE.  But the NYSE is a for profit company.  Tough enforcement of listing standards could hurt the bottom line.  The NYSE opted to allow Wachovia to proceed without shareholder approval.

While investors and employees watch the bulk of their investment evaporate, one group will apparently still make out reasonably well.  It turns out that ten executives at Wachovia have Golden Parachutes.  And what will they earn?  According to the Wachovia proxy statement:

• In addition, certain executives have employment agreements with Wachovia that provide for severance payments in connection with a qualifying termination of employment following a change in control. Assuming that the merger is completed on December 31, 2008 and all Wachovia executive officers who have employment agreements experience a qualifying termination of employment immediately thereafter, the 10 executive officers as a group would be entitled to receive an aggregate amount of up to approximately $98.1 million, as severance payments.

Not all of them will take the payments. Apparently one executive, David Carroll, was eligible for $19.1 million but because he is joining Wells Fargo will not accept the payments.  Nonetheless, most of the top executives (although not the current CEO, Robert Steel, who became CEO in July and apparently does not have a severance agreement) will do quite well from the Bank's demise.

The payments at Wachovia are symptomatic of a legal standard that largely allows executive compensation to escape judicial review.  The board gets to determine the circumstances that will trigger lavish payments and there is little or no review of these determinations.  It is further illustration that the matter cannot be left to determination by state courts.

The three auto makers came to Washington for a bailout.  They had no plan and arrived with no commitments that would ensure careful use of any funds received from Congress.

AIG gets a $65 billion bailout and throws a $400,000 party for sales people.  GM and the other car manufacturers come to Congress and ask for $25 billion, with no plan and no gurantee the money will be used in any effective manner then fly home in private jets, with Rick Wagoner making use of a $36 million luxury aircraft.  As ABC reported:

• All three CEOs - Rick Wagoner of GM, Alan Mulally of Ford, and Robert Nardelli of Chrysler - exercised their perks Tuesday by flying in corporate jets to DC. Wagoner flew in GM's $36 million luxury aircraft to tell members of Congress that the company is burning through cash, asking for $10-12 billion for GM alone. . . . While Wagoner testified, his G4 private jet was parked at Dulles airport. It is just one of a fleet of luxury jets owned by GM that continues to ferry executives around the world despite the company's dire financial straits.  . . .Wagoner's private jet trip to Washington cost his ailing company an estimated $20,000 roundtrip. In comparison, seats on Northwest Airlines flight 2364 from Detroit to Washington were going online for $288 coach and $837 first class.

Wagoner, who joined GM in 1977, is steeped in a culture that looks in, not out.  How else can one explain such an obvious gaffe?  And, where was the board?  Its true that the board cannot step in at every mistake but surely the board can set the tone. 

Of course, directors who want to discuss this at a special meeting have a problem.  The authority rests with the chairman and, like most large public companies, Wagoner is both the CEO and chairman.  He's unlikely to call a meeting that will have as its purpose a trip to the wood shed.  Of course, this is a mirror image board, one that Jon Macey at Yale would likely argue was captured by the CEO.  There would be no trip to the wood shed even if a meeting were somehow called.

Cases continue to arise involving efforts by foreign shareholders to seek recourse for fraud and mismanagement in US courts.  The efforts reflect the relative ease in suing in the US compared with other jurisdictions.

In Morrison v. Nat'l Austl. Bank Ltd. three Australian investors (“Plaintiffs”) sued National Australia Bank, and its wholly owned United States based subsidiary, HomeSide, alleging violations of Sections 10(b) and 20(a) and Rule 10b-5.  The case was an example of a"foreign-cubed” securities fraud action, a suit invovling foreign plaintiffs, foreign defendants, and invovling securities transactions taking place entirely in foreign jurisdictions.

The Second Circuit Court of Appeals dismissed the claim for lack of subject matter jurisdiction because the majority of the alleged fraud took place in Australia, not the United States.  Nonetheless, in dismissing the claim, the court did not articulate a categorical rule but reaffirmed the use of a case by case, fact dependant analysis to determine subject matter jurisdiction for "foreign-cubed” securities fraud actions. Morrison v. Nat'l Austl. Bank Ltd., No. 07-0583-cv, 2008 U.S. App. LEXIS 21986, (2d Cir. 2008).

National Australia Bank (“NAB”) is incorporated and headquartered in Australia.  In 1998, NAB acquired HomeSide Lending Inc., an American mortgage service provider headquartered in Florida.  In 2001, NAB announced write-downs to correct overstated corporate assets.  NAB’s stock price plummeted in response.  Plaintiffs alleged that NAB, HomeSide, and various directors and officers (“Defendants”) knowingly mislead investors by using unreasonably optimistic values for corporate assets in its reports to the SEC and general public. Plaintiffs also alleged that this misrepresentation occurred when HomeSide falsified the valuations in Florida and then sent the data to NAB in Australia, where NAB made the information public.

Defendants argued that the governing securities laws were applicable only for conduct within the United States, not the world at large, and therefore, the court was precluded from exercising jurisdiction over such cases. Defendants, and amicus curiae, argued for a simple bright-line test to determine subject matter jurisdiction in “foreign-cubed” cases. They argued that if the class action suit is predominately foreign, subject matter jurisdiction should not be extended. The court disagreed and instead applied the “binary inquiry” test, the traditional test applied whenever the court considers the application of the US securities laws to international transactions.

This “binary inquiry” test first looks to whether the wrongful conduct occurred in the United States and second to whether the conduct had a substantial effect in the United States or on United States citizens. For subject matter jurisdiction to exist under the first part, the alleged conduct has to be more than merely preparatory and directly cause losses.

HomeSide created and sent the allegedly fraudulent accounting data to NAB in Australia. Plaintiffs argued that because the defendants created the “numbers at issue” in Florida, the fraud occurred primarily in Florida. The Second Circuit disagreed.  Citing precedent, the court observed that liability under 10b-5 arose from making false and misleading statements, not from aiding and abetting such statements. The court found that while HomeSide used unreasonably optimistic assumptions, and thus inflated its book value, this was, at most, aiding and abetting the fraud that “culminated abroad.”

The court found that NAB, as the corporation that owned and controlled HomeSide, had the duty to oversee its subsidiaries and ensure the accuracy of reports it issued.  NAB, therefore, was directly responsible for the wrongful conduct. Since it was NAB in Australia that committed the wrongful conduct, and not HomeSide in the United States, the first prong of the “binary inquiry” test failed and the court found that is did not have subject matter jurisdiction.

The Defendants did not get the bright-line test they argued for, but they received the ruling they wanted. The courts, at least in the Second Circuit, will continue to use a case by case test. The onus for assuring accuracy is primarily on those responsible for issuing reports to shareholders and making SEC filings, not those who compile the repots.

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

In the aftermath of Tellabs, the circuit courts continue to revisit the analysis of the pleading standards under the PSLRA for scienter.  A recent example emanated from the 9th Circuit.

In South Ferry LP v. Killinger, 542 F.3d 776 (9th Cir. 2008) Washington Mutual, Inc. (“WAMU”) shareholders filed a suit against several of the company’s officers alleging violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934.  The defendants included WAMU’s President and CEO, Vice-President and CFO, and consumer group President.  WAMU was a publicly traded financial services company that offered banking, mortgage lending and other services.  The complaint related to WAMU’s mortgage lending business of buying, selling, originating, and servicing home loans.  Specifically, the complaint concerned two types of risks presented by WAMU’s mortgage business – mortgage servicing rights (MSRs”) and mortgage “pipeline risks.”

Plaintiffs alleged that defendants made materially false or misleading statements regarding WAMU’s ability to manage its MSRs risks and mortgage “pipeline risks.”  Particularly, they alleged that defendants assured shareholders that WAMU’s information systems were updated to handle the market fluctuations in interest rates that created those risks.  Plaintiff, however, argued that the defendants knew otherwise, that WAMU "was unprepared for the interest rate volatility that occurred later because it failed to integrate its information systems to permit it to keep a close watch on the hedges that it maintains."  Plaintiff asserted that these concerns were "core operations" of the company and that the information could be attributed to the defendants because of their position with the company.

The district court denied defendants’ motion to dismiss because it concluded that plaintiffs’ pleadings of knowledge of core operations and defendant’s statements met the PSLRA’s pleading requirement of scienter.  The district court certified the issue for an interlocutory appeal.  As the district court noted: "the complaint does rely on circumstantial evidence and an inference of knowledge arising from the connection between defendants' job roles and the core operations of the business."

The Ninth Circuit analyzed its own precedents and the U.S. Supreme Court’s opinion in Tellabs.  Tellabs permitted the consideration of "a series of less precise allegations to be read together to meet the PSLRA requirement."  Moreover, this included "vague or ambiguous allegations" as part of the "holistic review when considering whether the complaint raises a strong inference of scienter."  The core-operations inference could, therefore, be properly considered.  Indeed, sometimes it would be enough, standing alone, to establish scienter.  

• A question remains, however, about reliance on the core-operations inference when it is the only basis for scienter in the complaint.  Where a complaint relies on allegations that management had an important role in the company but does not contain additional detailed allegations about the defendants' actual exposure to information, it will usually fall short of the PSLRA standard. In such cases the inference that defendants had knowledge of the relevant facts will not be much stronger, if at all, than the inference that defendants remained unaware. As a general matter, "corporate management's general awareness of the day-to-day workings of the company's business does not establish scienter--at least absent some additional allegation of specific information conveyed to management and related to the fraud" or other allegations supporting scienter. However, in some unusual circumstances, the core operations inference, without more, may raise the strong inference required by the PSLRA.  (citation omitted)(emphasis added). 

The court concluded that allegations regarding knowledge of "core operations" would be relevant and assist in satisfying the PSLRA’s scienter requirement in three circumstances: (1) if the allegations used when read together with other allegations, raise an inference of scienter that is cogent and compelling; (2) if the allegations are particular and suggest that defendants had actual access to the disputed information; and (3) allegations where the nature of the relevant fact is of such prominence that it would be absurd to suggest that management was without knowledge of the matter.

Despite the parties urging the court to resolve the entirety of the case in the interlocutory appeal, the court vacated and remanded the case because it concluded that the district court had detailed knowledge of the facts and should have the opportunity to review the defendants’ motion to dismiss under the appropriate standard.

The case has considerable significance.  In addition to squarely finding that a defendant's position can give rise to an inference of knowledge about "core operations," the reasoning of the case conflicts with and arguably overturns the 9th Circuit's decision in Silicon Valley.

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

Law schools live and die by rankings.  The mother of all rankings are those prepared and published by US News & World Report.    

The scourge of these rankings may, however, soon be over.  US News recently announced that it was shifting from publishing every other week (it had already ceased to be a weekly) to monthly.  Perhaps the next step will be a complete cessation of business.  As one columnist speculated:

• Just call it coincidence, but on Election Day, word spread that the once-weekly U.S. News was downsizing to a monthly — a step closer to the fate of Literary Digest, the weekly magazine that vanished two years after its straw poll predicated an Alf Landon landslide over Franklin Delano Roosevelt in 1936.

We shall see about the continued viability of US News.  For any change to benefit law school, it will have to happen by April.  That's when the next round of rankings come out.