An editorial in the NYTimes from Sunday asks the intriguing question whether Congress should regulate executive compensation.  The answer that it provides, however, is disappointing and reflects a misunderstanding of many aspects of corporate governance.

The editorial, written by Robert Frank, an economist at Cornell, concedes that a problem exists.  As he notes, "executive pay in the United States is vastly higher than necessary. Executives in other countries, whose pay is often less than one-fifth that of their American counterparts, seem to work just as hard and perform just as well.  The same was true of American executives in the 1980s."

Despite recognizing the problem, the editorial goes on to reject any solution.  It does so by providing a single, untenable solution, then criticizing the solution.  The editorial notes that one possibility is a cap on salary equal to 20 times its average worker’s salary.  Doing so will reduce the pool of talented executives.

• The problem is that although every company wants a talented chief executive, there are only so many to go around. Relative salaries guide job choices. If salaries were capped at, say, $2 million annually, the most talented candidates would have less reason to seek the positions that make best use of their talents.

Moreover, they may go elsewhere.  If "C.E.O. pay were capped and pay for other jobs was not, the most talented potential managers would be more likely to become lawyers or hedge fund operators."  

It is, of course, highly doubtful that those wishing to run a business would collectively opt to become lawyers.  But even if true, the argument is unrefined and not a basis for entirely rejecting a cap.  Compensation needs to be high enough to attract a sufficient pool of talent.  If 20 times the average worker is not enough, then the multiplier should be increased.  After all, there is a lot of room here.  In 2006, the average salary for CEOs was 364 times the amount of the average US worker.  Presumably some multiple less than 364 would be sufficient to attract the necessary pool.

The editorial apparently prefers to allow compensation to be determined by the market.  It answers criticism that these markets are not competitive because the board is packed with the CEOs friends because "C.E.O.’s have always appointed friends, so that can’t explain recent trends."

This is of course not an answer at all.  First, board compensation has changed dramatically in recent decades.  There is a higher percentage of independent directors who are paid lucrative amounts and have every incentive, whether friends or not, to avoid disappointing a CEO.  In other words, they have every economic incentive to provide the CEO what he or she wants. 

More importantly, the editorial ignores the shift in the law arising out of Delaware.  Courts in that state, which determine the law for most public companies, have gradually weakened the standard of review for executive compensation decisions.  Thus, directors can pay top officers excessive amounts and have little fear of liability.  This has effectively resulted in a legal standard that imposes no meaningful limits on executive compensation.  These are discussed in greater detail in the paper, Returning Fairness to Executive Compensation.

What should be done?  The simple solution would be to leave compensation in the hands of directors but impose greater obligations on the board in determining compensation.  In short, the ideal solution is not a cap but overturning the standards imposed by the Delaware courts on directors.  It would be sufficient to provide that in determining the compensation for executive officers, the board had the burden of establishing that the terms of the compensation were fair to the corporation and that directors would be personally liable for any compensation found to be unfair.  A definition of fairness might include a standard that provides that compensation will be reasonable if equal to or less than what a third party would obtain through arms lengh negotiations.

This standard would be broad and allow compensation to vary with the circumstances.  But by making directors personally liable for any excess, it will induce boards to only pay an amount that directors can objectively justify.  This would be a massive improvement over the current system, with directors able to pay any amount without having to show that it was fair.

As the CSX case illustrates, it is time to reform the disclosure requirements under Section 13(d) to address some of the more exotic methods of acquiring shares, particularly in connection with derivative transactions.

There is an increasing recognition that derivatives securities play a role in determining the influence of shareholders.  TCI v. CSX involved allegations that shares acquired by counterparties as part of equity swaps should be attributed to the hedge funds creating the swaps. The case involved understandable consternation among swap parties, concerned that they might become members of a group for purposes of the beneficial ownership requirements and Section 13(d).

At the same time, however, the case demonstrated the potential impact of derivatives on a change of control.  The hedge funds in CSX entered into equity swap positions that were hedged by the counterparties (large investment/commercial banks).  To hedge the transactions, the banks acquired the same number of shares subject to the swap.  As a result, the banks ultimately owned approximately 10% of the shares of CSX.  The hedge funds were, therefore, in a place to pick up the block of shares (adding to the approximately 8.7% of the shares already owned) or, given the business incentive, receive the voting support of the banks without any explicit agreement. 

Whatever the precise parameters of Section 13(d), ordinary investors would likely find the availability of these shares as material.  Without necessarily attributing ownership to the funds or lumping the banks into a group, the rules should clarify instances when these types of ownership blocks are subject to disclosure.  The matter should not be left to a case by case determination of the courts.

The need for rules is made more critical by the involvement of the Division of Corporation Finance in the matter.  The trial judge in CSX asked for the views of the Division.  The position is not particularly helpful manner and does not necessarily reflect the views of the entire Commission (leaving the weight to be given to the pronouncement unsettled).

The Commission needs to instruct the Division of Corporation Finance to begin developing amendments to the beneficial ownership reporting requirements under Section 13(d) to capture in an objective manner derivative ownership that can facilitate changes in control.

We have noted that the Delaware courts often use the word "prolix" (or some variation thereof) to describe submissions by plaintiffs but never defendants.  Indeed, the reference in Wood v. Baum earned the case the award for the most anti-shareholder decision of 2008.   While our preference would be to have the courts cease using pejorative characterizations, particularly when aimed only at one side of a legal conflict, we have an alternative suggestion.

In Stark Trading v. Falconbridge, a recent case written by Judge Posner, he described plaintiff's complaint not as prolix but as brobdingnagian (a reference to the 289 paragraphs and 85 or so pages in the document).  The term is derived from the giants in Gulliver's Travels and means something of tremendous size.  It is not a term used often, appearing in only 57 cases (including Stark) in the Lexis-Nexis data base for all state and federal cases (with the first appearance coming in 1928).  The term has only been used once by a Delaware court and not to criticize plaintiffs.  See David B. Shaev Profit Sharing Account v. Armstrong, 2006 Del. Ch. LEXIS 33 (Del. Ch. Feb. 13, 2006)("These transactions were, in the words of plaintiff's counsel, proverbial 'elephants in the room,' frauds of such 'brobdingnagian' enormity that only reckless indifference to fiduciary duty could explain the defendants' now conceded lack of knowledge.").  

To the extent the Delaware courts are moved to label the complaints filed by shareholders as prolix, this Blog recommends the substitution of the word "brobdingnagian."  The change will perhaps eliminate some of the sting from the usually gratuitous criticism and will also contribute to the literary bona fides of the Delaware courts.

As expected, plaintiffs have filed a cert petition in the PCAOB case.  Reading it over, one would think this the single most important case of constitutional magnitude in a lifetime.  In fact, it largely turns on whether Congress can limit the removal authority of persons within independent agencies.  The practice is relatively common.  As the PCAOB noted in its brief opposing rehearing en banc:

• The Inspector General of the Postal Service is an inferior officer. See 5 U.S.C. App. 3 § 8G(f );About the USPS OIG, at http://www.uspsoig.gov/about.htm. But he is removable only for cause by the Governors of the Postal Service, who in turn are removable only for cause. 39 U.S.C. § 202(a)(1), (e)(3). Likewise, the Chief Actuary of the Social Security Administration is an inferior officer. See 42 U.S.C. § 902(c)(1); Office of the Chief Actuary, at http://www.ssa.gov/ OACT/actuaries/organization.html. He too is removable only for cause, and the Commissioner to whom he reports is removable only for cause. 42 U.S.C. § 902(a)(3), (c)(1). Finally, many independent agencies have administrative law judges (ALJs) who are subject to for-cause removal protections. Although some are mere employees, others are clearly inferior officers. ALJs in the Federal Mine Safety and Health Review Commission, for example, are inferior officers because their decisions are final rather than recommendatory and are subject only to limited review. See 30 U.S.C. § 823(d)(1), (2)(A)(ii)(I); Landry, 204 F.3d at 1133-34. All of those ALJs, however, are removable only for cause by officers who in turn are removable only for cause. 30 U.S.C. § 823(b)(1), (2) (incorporating 5 U.S.C. § 7521); 5 U.S.C. § 1202(d). (ALJs cannot be distinguished on the grounds that agencies can choose whether to use them, and that their decisions are subject to agency review. See 537 F.3d at 699 n.8 (Kavanaugh, J., dissenting). 

Plaintiffs' brief is once again written in an unfortunately non-gender neutral manner.  Mary Schapiro, the incoming chair of the SEC, would no doubt be surprised to learn on page 17 that "he serves as Chairman 'at the pleasure of the President.'"  She would likewise be surprised to hear that, in creating the PCAOB,  Congress denied the Chairman "his traditional statutory authority to 'appoint and supervise'" members of the body.  And this is not the only example.  On this basis alone the petition deserves to be denied.

We will wait for the government's response before venturing a prediction on the merits.

The petition is posted on the DU Corporate Governance web site.

Let's face it.  The SEC regulates corporate governance but has a limited repertoire of weapons.  With some exceptions, the Agency can do little more than require disclosure.  But at least with disclosure, shareholders have the information necessary to bring pressure on management for reform. 

It is time for the SEC to define standards in connection with the disclosure of information related to corporate social responsibility.  Social responsibility typically takes into account activities designed to have an impact on stakeholders, including customers/suppliers, employees, the community, and the environment.  Disclosure today is voluntary and non-uniform.  This is both the type of information increasingly important to investors and therefore worthy of standardized disclosure requirements and, frankly, a place where disclosure requirements might affect substantive behavior.

In this regard, the US is already behind Great Britain.  Section 417(5) of the Companies Act of 2006 requires disclosure and provides:

• In the case of a quoted company the business review must, to the extent necessary for an understanding of the development, performance or position of the company’s business, include— (a) the main trends and factors likely to affect the future development, performance and position of the company’s business; and (b) information about— (i) environmental matters (including the impact of the company’s business on the environment), (ii) the company’s employees, and (iii) social and community issues, including information about any policies of the company in relation to those matters and the effectiveness of those policies; and (c) subject to subsection (11), information about persons with whom the company has contractual or other arrangements which are essential to the business of the company.

Rule proposals would need to develop a definition and standards.  This wouldn't be particularly easy and like any number of innovative disclosure areas, an effort that would need to be revisited periodically.  Nonetheless, in the realm of information important to investors, this qualifies. 

The Division of Corporation Finance should be instructed to develop a rule proposal providing for mandatory corporate social responsibility disclosure.

Hearings were held on Monday before the House Committee on Financial Services concerning the failure of the SEC to uncover the Madoff Ponzi scheme sooner. It was a relatively staid affair, including testimony from academics, government officials, and at least one investor.

The hearing involved testimony from the agency's Solicitor General, David Kotz, who has been charged by the chairman to look into the matter.  In addition to the specifics surrounding Madoff, Kotz indicated that he will look into a variety of structural issues, including:

1. The complaint handling procedures of the Division of Enforcement, including a review of how complaints are processed, internal incentives that may affect the decision whether to take action with respect to a complaint, an analysis of which complaints are brought to the Commissioners' and Chairman's attention, and whether tangible and specific complaints are being reviewed and followed-up on appropriately;

2. The OCIE examination and inspection procedures, including an analysis of what policies and procedures were then and are currently in place, whether these policies and procedures are being followed and/or whether there are gaps in these policies and procedures relating to operations involving voluntary private investment pools, such as hedge funds, because they are subject to limited oversight by the SEC, and whether any such gaps may lead to fraudulent activities not being detected; and

3. The relationships between different divisions and offices within the Commission and whether there is sufficient intra-agency collaboration and communication between the Agency components to ensure comprehensive oversight of regulated entities.

Consistent with this approach, Tamar Frankel, a professor at Boston University, testified on the need to strengthen the gate keeping function of examiners, including more frequent inspections and reliance on examiners who are "top notch experts." 

Reform at the SEC has been in the air for awhile.  Much of it has centered around a bureaucratic consolidation of the SEC and the CFTC.  The legacy of the Madoff scandal may be a shift in focus, with increased emphasis on internal reform, particularly to the Office of Compliance Inspections and Examinations.  It is a proactive office that can provide early warning of scandals and frauds.  That it requires greater resources and expertise is apparent.  That it will receive this support will likely be the result of the convincing case made by Bernard Madoff.   

As he did last year, Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog has responded to my list of the five most anti-shareholder decisions by the Delaware courts in 2008 (a five part series beginning with this post).  He has offered a list of cases designed to "counterbalance" those in my list.  Two of the cases, Julian v. Eastern States and Ryan v. Lyondell have been the subject of considerable commentary on this Blog (with Julian playing a prominent role in the paper, Returning Fairness to Executive Compensation).

We leave it to readers to resolve the debate and look forward to any commentary on the subject.  Until next year, when, as in 2008, there will no doubt be more than enough material for yet another set of competing lists.

There are few more pressing areas of regulatory concern these days than executive compensation.  The SEC systematically amended the disclosure requirements in Item 402 back in 2006.  The result has been far greater emphasis on the process for determining compensation and greater sunlight cast on assorted perqs including club memberships and personal use of corporate aircraft.

The one area where the disclosure requirements fall short, however, is with respect to compensation consultants.  The consultants are commonly used to meet state law fiduciary duty requirements by allowing the board (or the compensation committee) to claim it was informed.  Yet the consultants may not always meet these requirements.  Shareholders, however, have no way of knowing given the weak disclosure regime for compensation consultants.  

The SEC requires only minimal disclosure about compensation consultants. Under Item 407(e), companies must disclose the role of the compensation consultant:

• in determining or recommending the amount or form of executive and director compensation,
• identify such consultants and state whether such consultants are engaged directly by the compensation committee or any other person; and
• describe the nature and scope of their assignment, and the material elements of the instructions or directions given to the consultants with respect to the performance of their duties under the engagement.

The provision, however, does not address conflict of interests. There is no obligation to disclose other services provided by the consultants. There is no requirement to disclose the method used to select the consultant, including the CEO's role in the process. Indeed, in adopting the requirement, the SEC deleted a requirement that would have required companies to identify "the executive officers of the company that the compensation consultants contacted in carrying out their assignment." Exchange Act Release No. 54302A (August 29, 2006). This requirement would have at least put into the public domain information about the CEO's contacts with the consultant.

This is not an academic concern. Shearman and Sterling conducts periodic surveys of corporate governance practices among the 100 largest companies that have shares traded on an exchange.  One of the surveys tracks director and executive compensation trends.  The report noted concern with the independence of compensation consultants. 

• The concern arises from the fact that many compensation consultants work for diversified human resources consulting firms that have developed strong ties to management by providing other non-compensation-related services to their corporate clients, including actuarial services, information technology services, risk management and insurance underwriting, health and welfare services, tax and legal advice and outsourcing.  The fees earned for these service are often significantly higher than the fees earned for executive compensation consulting services provided to the compensation committee.

The issue has been examined by the Congressional Oversight Committee.  The report published in December 2007 concluded the following:

• Compensation consultant conflicts of interest are pervasive. In 2006, at least 113 of the Fortune 250 companies received executive pay advice from consultants that were providing other services to the company.
• The fees earned by compensation consultants for providing other services often far exceed those earned for advising on executive compensation.
• Some compensation consultants received over $10 million in 2006 to provide other services. One Fortune 250 company paid a compensation consultant over $11 million for other services in 2006, over 70 times more than the company paid the consultant for executive compensation services.
• Many Fortune 250 companies do not disclose their compensation consultants’ conflicts of interest. In 2006, over two-thirds of the Fortune 250 companies that hired compensation consultants with conflicts of interest did not disclose the conflicts in their SEC filings. 
• There appears to be a correlation between the extent of a consultant’s conflict of interest and the level of CEO pay. In 2006, the median CEO salary of the Fortune 250 companies that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use conflicted consultants. Over the period between 2002 and 2006, the Fortune 250 companies that hired compensation consultants with the largest conflicts increased CEO pay over twice as fast as the companies that did not use conflicted consultants.

The Sherman and Sterling report noted that only a small number of companies have adopted a policy requiring compensation consultant independence, including Wachovia Corporation, The Procter & Gamble Company, Pfizer Inc., Sprint Nextel Corporation, The Home Depot, Inc. and Verizon Communications Inc.

In other instances, the compensation consultants appear to act more as agents for executive officers than the board and shareholders.  For posts on the subject, go here and here.  Yet the existing disclosure requirements do not pick up the interaction between the consultants and the CEO.

The Division of Corporation Finance should be instructed to begin working on rule proposals that would amend Item 407(e) and expand the disclosure surrounding the use of compensation consultants, including conflicts of interest that might exist.

We are discussing the editorial in the NYT ("The End of the Financial World As We Know It") that contends that the SEC is partly to blame for the current turmoil because it has excessively close relations with Wall Street.

So what is the solution? 

• Close the revolving door between the S.E.C. and Wall Street. At every turn we keep coming back to an enormous barrier to reform: Wall Street’s political influence. Its influence over the S.E.C. is further compromised by its ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.

• But keep the door open the other way. If the S.E.C. is to restore its credibility as an investor protection agency, it should have some experienced, respected investors (which is not the same thing as investment bankers) as commissioners. President-elect Barack Obama should nominate at least one with a notable career investing capital, and another with experience uncovering corporate misconduct. As it happens, the most critical job, chief of enforcement, now has a perfect candidate, a civic-minded former investor with firsthand experience of the S.E.C.’s ineptitude: Harry Markopolos.

Whatever merit exists with an attempt to limit the revolving door phenomena, the editorial gave little evidence that this is a concern.  Only one division director (Walker) joined a bank right after leaving Enforcement.  Cutler waited 18 months, Lynch waited more than a decade.  McLucas has remained with a private law firm.  The solution, however, does not fix a problem supported by the editorial.

As for the composition of the Commission, it's a make weight point.  For one thing, the nomination of Mary Schapiro, the executive director of FINRA, presumably meets the category of commissioners "with experience uncovering corporate misconduct."  As for someone with a notable career "investing capital," there is no reason to believe that this quality, standing alone, will generate any of the needed reforms.  Having said that, it is true that the Commission could use some members who have strong shareholder/investor leanings, the area left most unaddressed by the current regime at the SEC.

We are discussing the editorial in the NYT ("The End of the Financial World As We Know It") that contends that the SEC is partly to blame for the current turmoil because it has excessively close relations with Wall Street.

In addition to contending that those in Enforcement were excessively close to Wall Street in order to parlay their position into a high paying job, the editorial also noted that the staff at the SEC was afraid to bring cases that might "roil the markets" by driving down share prices.   To do so would somehow roil "the careers of the people who run the S.E.C." 

This is a different allegation than the desire by enforcement attorneys to "position" themselves for a good job on Wall Street after they leave the SEC.  This one contends that careers within the SEC could be harmed by taking positions that affect not Wall Street but issuers.  Somehow, aggressive enforcement against public companies will wreck a career within the SEC.

We took a few minutes to look at some of the cases that were brought by the Commission in 2008.  These included a raft of backdating cases involving officials at UnitedHealth, Monster Worldwide, Mercury Interactive, Broadcom, Sycamore Networks, and Apple Computer.  There was the bribery scandal at Siemans AG and the auction rate securities cases against Citigroup and UBS,  Wachovia and Merrill Lynch.  Lazard Capital was sued for improperly entertaining traders at Fidelity Investments, Executives at Duane Reade, the drugstore company, for a multi-million dollar accounting scheme, a final judgment obtained against the former CEO of Waste Management, and actions were brought against a former executive at Kellogg, Brown & Root, for violating the anti-bribery provisions of the Foreign Corrupt Practices Act.  

This is by no means a complete list.  Moreover, the earlier post on the former Directors of the Division of Enforcement listed a number of other high profile cases from the past.  While this is all anecdotal, it at least suggest that the allegation about concern over roiling the market is in fact incorrect.  To the extent there is a problem with a lite touch with public companies, it comes from commissioners like Atkins who strongly objected to some of the staff's enforcement policies, particularly with respect to the imposition of penalties on public companies.  It is a problem that will be easily fixed as the new president appoints officials to the Commission who do not share these views.

We are discussing the editorial in the NYT ("The End of the Financial World As We Know It") that contends that the SEC is partly to blame for the current turmoil because it has excessively close relations with Wall Street. 

The article claims that those in the Enforcement Division want to "maintain good relations with Wall Street" in order to "be paid huge sums of money to be employed by it."  The evidence?  That the most recent director of enforcement is the general counsel of JPMorgan and the one before him is general counsel at Deutsche Bank.  Finally, "one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley."  As a result, a "casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street."

The statements about the employment history of the former directors is true enough but decidedly incomplete.  Additional facts demonstrate exactly the reverse.  If anything, the former directors to a person had a reputation for being hard on Wall Street.  Let's assign some names to these anonymous descriptions and take a look at a more complete version of the facts.

The current director of the Division of Enforcement is Linda Thomsen, who was appointed in 2005. 

Her predecessor, Stephen Cutler, served as Director from 2001 to 2005.  The article is correct that Cutler is currently the general counsel of JP Morgan.  But the implication that he left the SEC to go to Wall Street ignores the fact that Cutler was in Wilmer Cutler before joining the SEC and went back to WilmerHale after leaving the SEC.  This hardly smacks of positioning. 

Moreover, the notion that he "positioned" himself for Wall Street presumably means he was not a rigerous Director of Enforcement.  During his four year tenure, however, Cutler oversaw:

• enforcement actions totaling more than $6 billion in penalties and disgorgement, more than $4.5 billion of which is being returned to harmed investors. Among them were WorldCom's $750 million penalty (the largest against a public company in Commission history) and the more recent $300 million penalty against AOL-Time Warner. Of the 12 largest penalties in Commission history, ten were obtained in cases brought under Mr. Cutler's leadership.
• led the Commission's groundbreaking efforts against banks, insurance companies and other financial intermediaries for their roles in a number of public company financial reporting failures, including the Commission's cases against Merrill Lynch, Citigroup, J.P. Morgan and CIBC in connection with Enron's collapse; and the cases against AIG for its transactions with two different public companies;
• helped bring some of the agency's significant financial reporting cases involving foreign companies, including Parmalat, Royal Ahold, Royal Dutch Shell, Hollinger, TV Azteca and Vivendi;
• oversaw the agency's investigations that led to historic cases against the New York Stock Exchange, its specialist firms and a number of individual specialists for inter-positioning and trading ahead violations;
• spearheaded the agency's crackdown against illegal IPO allocation practices on Wall Street, leading to significant cases against Credit Suisse First Boston, J.P. Morgan, Goldman Sachs and Morgan Stanley;
• led the agency's enforcement efforts against mutual fund abuses, including the agency's revenue sharing (or "shelf space") cases against Morgan Stanley, Pimco, Franklin Templeton, Putnam, MFS, Edward D. Jones and others, as well as the agency's cases involving market timing and late trading against Bank of America, Strong Capital Management, Janus, Pilgrim Baxter, Alliance Capital, Invesco and others;
• played a key role in the historic "global settlement" with Wall Street brokerage firms over research analyst conflicts of interest, which called for payments totaling nearly $1.5 billion, as well as significant reforms;and
• stepped up the Commission's efforts to hold audit firms (as well as their personnel) accountable for misconduct, including significant cases against, among others, KPMG for its audits of Xerox and Gemstar, and Ernst & Young and PriceWaterhouseCoopers for their violations of the auditor independence rule.

This is hardly the record of someone trying to curry favor with Wall Street.

Cutler's predecessor was Richard Walker.  Walker served from 1998 until 2001.   Again, the article is correct that he is the general counsel to Deutsche Bank.   It is a large financial institution to say the least (ranked the 26th largest global company in the 2008 Fortune 500 list).  But it is hard to equate Deutsche Bank with Wall Street.  The universal bank has a strong position in Europe but has traditionally not been in the upper leagues within the United States. 

In any event, Walker served under Chairman Levitt who most view as very pro-shareholder and pro-enforcement.  During his tenure, the Division brought actions against a host of well known issuers, including W.R. Grace, Livent, Cendant, McKesson HBOC, Microstrategy, Sunbeam, and Arthur Andersen.

Of the two division directors before Walker, one was Bill Mclucas, the longest serving director of the Division and currently a partner at WilmerHale.  Presumably he wasn't using his reign as Division Director to position himself for Wall Street. 

The other was Gary Lynch.  Lynch is the Division Director who the editorial notes was at CSFB before traveling to Morgan Stanley.  What the editorial omitted was that Lynch left the SEC in 1989 and went to the law firm, Davis Polk, only joining CSFB in 2001.  In other words, his stint as head of Enforcement "positioned" him for private practice, not the investment banking firms that came later.

More importantly, both Lynch and McLucas were known, not for a lite touch when it came to Wall Street, but the exact opposite.  They were the top SEC officials probably most responsible for bringing down Michael Miliken and Drexel Burnham, the investment banking firm on Wall Street.  (Lynch in a subsequent interview indicated that he spent approximately 30% of his time on those cases).  In other words, the only positioning they did with respect to Wall Street was to bring down the hammer. 

As we noted, there are issues at the SEC.  But one of them is not excessive kowtowing to Wall Street.  Top enforcement officials get high paying jobs in the private sector because they are talented lawyers who have credibility within the SEC (among other things).  Credibility comes from ethical and hard nosed attitudes about enforcement, something that would be lost if they were viewed either inside or outside the agency as little more than sieves for industry.

On this issue, the editorial in the NYTimes got it wrong.

We are examining the top ten corporate governance agenda items for the SEC under the Obama Administration.  We will continue this tomorrow (with #5) but today have a slightly different mission.

The NYT contains an editorial titled "The End of the Financial World As We Know It."  The editorial discusses a number of the causes of the current financial turmoil and places some of the blame on the SEC.  The blame, however, is not a result of bureaucratic ossification or lack of resources.  Instead, the article claims that the SEC, specifically the Division of Enforcement, has an excessively cosy relationship with Wall Street.  As the editorial describes:

• Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)

The basis for this extraordinary assertion?  The editorial contends that the SEC has an incentive not to "roil the markets" by bringing cases that might affect the "share price of any given company."  To do so would roil "the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined."

The other reason?  A desire to curry favor with Wall Street in order to obtain high paying jobs.

• It's not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

And the evidence for this assertion?

• The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.

As we will explore in the next several posts, these are cheap shots taken at the Commission.  They are also unsupported by the available evidence.  There are unquestionably problems at the Commission and reforms that are necessary.  There are also reasons to believe that the problems rest not with the staff but with ideological commissioners like Paul Atkins, who fought the imposition of penalties on corporate wrongdoers.

#1     Wood v. Baum, 953 A.2d 136 (Del 2008):  Supreme Court encouragement of intemperate behavior towards shareholders.

#2     Portnoy v. Cryo-Cell Int'l, Inc., 940 A.2d 43 (Del. Ch. 2008):  Discouraging shareholders from vindicating their rights.

#3     In re Transkaryotic Therapies, Inc., 954 A.2d 346 (Del. Ch. 2008):  Exonerating false disclosure to shareholders.

#4     McPadden v. Sidhu, 2008 Del. Ch. LEXIS 123 (Del. Ch. June 17, 2008):  Rendering good faith a meaningless protection for shareholders.

#5     CA, Inc. v. AFSCME Emples. Pension Plan, 953 A.2d 227 (Del. 2008):  Marginalizing the ability of shareholders to elect their own nominees to the board of directors.

Wood v. Baum, 953 A.2d 136 (Del 2008)

We chose this case not because of its legal reasoning, which was bad enough, but because of the tone set by the state Supreme Court with respect to the treatment of parties who appear in the Delaware courts.  In that case, the Court, in a completely gratuitous fashion, chose to include in the opinion a disparaging reference by the Chancery Court to plaintiff's complaint.

• The Court of Chancery noted that "though the complaint is 80-some pages long and is a model of prolixity, it fails to state any basis on which the Court could reasonably conclude that the demand futility standard is met."

As we noted, the use of the word prolix is not meant as a complement.  Moreover, the term has been used in numerous cases to describe something submitted by plaintiffs.  The courts have never used the word to describe a submission by management.  The attitude also ignores the excessive pleading standards imposed on plaintiffs by the courts. 

But the use of the term sets a tone.  It is the Supreme Court condoning harsh language in describing plaintiffs and shareholders.  Perhaps it explains why so many lower court cases do the same thing.  Thus, in In re Lear Corp., 2008 Del. Ch. Lexis 121 (Del. Ch. June 2, 2008), VC Strine described the claims brought by plaintiffs as "inflammatory and conclusory charges of wrongdoing." But the most egregious slap concerned the complaint. He didn't like that either and had this to say about the efforts of plaintiffs' counsel:

• The amended complaint in this case is an unwieldy document comprised of 208 paragraphs. As the case evolved, the complaint simply grew, with the plaintiffs adding on to their original complaint without any attempt at editing.

The statement was unnecessary even if true (which it wasn't).  But in any event, the language was intemperate and adding nothing to the legal reasoning in the case.  Lear is not unusual.  When one wonders why these outbursts are allowed to take place, they need only look to the tone set by the Delaware Supreme Court.

Perhaps the only lasting legacy of Paul Atkins, a commissioner relentlessly hostile to shareholder interests (he opposed access) and strong enforcement (particulary his antagonism towards the imposition of penalites on companies), was to induce the Commission to refer the legality of a shareholder proposal to the Delaware Supreme Court.  It occurred in CA v. AFSCME.

The decision, involving a shareholder proposal under Rule 14a-8, was predictably disastrous for two reasons.  First, it allowed state courts to have some say in the SEC's interpretation of its own rules.  Second, and more importantly, it was all but designed to reduce the rights of shareholders.  The outcome was predictable (the Delaware Court would rule in favor of management).  The result was that an agency ostensibly charged with the responsibility of looking out for the interests of shareholders did the opposite. 

The issue involved the use of authority set out in Delaware law.  Supreme Court Rule 41 provides that the Securities and Exchange Commission "may, on motion or sua sponte, certify to this Court for decision a question or questions of law arising in any matter before it prior to the entry of final judgment or decision if there is an important and urgent reason for an immediate determination of such question or questions by this Court and the certifying court or entity has not decided the question or questions in the matter."

The certification invovled a shareholder proposal submitted by AFSCME.  The proposal would have required the payment of reimbursement expenses in a proxy contest but only where the insurgent nominated a short slate of directors and one or more members of the slate actually won.  The staff in the past refused to allow such proposals to be excluded.  This time, however, the Commission asked the Delaware Supreme Court whether the proposal violated state law.

The outcome was predictable.  This could be seen first by the fact that the Court violated its own rule in accepting the certified question.  Second, the reasoning used by the Court was likely to be pro-management, even if the conclusion required legal legerdemain.  In fact, the Supreme Court did exactly that, writing an opinion that deliberately ignored outcome determinative issues that favored shareholders. 

The Court ultimately held that the proposal violated state law because it did not have a "fiduciary out."  The board needed to have the authority to deny the payment of expenses "where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation."

In so holding, the Court completely ignored the argument that the motive for the contest was rendered irrelevant by the actual election of the director, a precondition for reimbursement under the AFSCME proposal.  The Court also ignored the board's existing authority to repeal the bylaw if it would have resulted in a violation of fiduciary obligations.  Counsel for AFSCME conceded that the reimbursement bylaw could be repealed by the board if repeal was consistent with the board's fiduciary duties.  Finally, the proposal provided for reimbursement of "reasonable" expenses.  The Court completely ignored the argument that payments in violation of fiduciary obligations were not reasonable.   These were all arguments raised in briefs or at the oral argument.  Yet the Court did not address any of them in its opinion.

The decision provides companies with additional ammunition in efforts to omit shareholder proposals under Rule 14a-8.  While it will have the clearest impact on proposals concerning the reimbursement of proxy expenses, it is likely to extend into other areas such as the mandatory removal of poison pills.

With regime change, the Commission should make it clear that the days of referring questions to the Delaware Supreme Court for anti-shareholder opinions on the legality of proposals are over.

Portnoy v. Cryo-Cell Int'l, Inc., 940 A.2d 43 (Del. Ch. 2008).

This was a case where plaintiff challenged management's efforts to manipulate the process for electing directors. With a proxy contest underway and management apparently about to lose, the court descirbed the CEO of Cryo-Cell as "desperate" and tried to get the FBI to intervene. In addition, she obtained votes through "a combination of threats . . . and inducements." The court agreed that the elections were "tainted by inequitable behavior by [the CEO] and her allies and must be set aside." So, having proved these facts, the shareholder won, right?

Not in Delaware. The plaintiff, Portnoy, incurred the costs of the tainted proxy contest and the litigation expenses associated with vindicating his rights. The remedy of a new election meant that he had to again incur the costs of a proxy contest and, had there been a repeat of the behavior, any litigation expenses.

Having overturned an "inequitable" election, he reasonably asked that his costs be reimbursed but VC Strine declined. He did so as punishment because Portnoy had talked with a former corporate official who was subject to a confidentiality agreement. Denial of reimbursement would be "a fitting consequence for Portnoy's alliance with Archibald, a course of conduct that I do not believe disentitles him to a remedy but that ought to have some consequence."

This was true even though the court recognized that:

• Archibald, the employee, revealed to Portnoy her view that misconduct and misuse of corporate assets was occurring at Cryo-Cell. Portnoy attempted to communicate that information to the four outside directors on Cryo-Cell's board.
• Nor did he publicly disclose any information that he received from Archibald other than to note the board's failure to investigate "unsubstantiated, troubling information from a purported former Cryo-Cell employee."
• Defendants did not "identify any confidential information of Cryo-Cell possessed by Archibald that was truly of a sensitive nature, much less that it was misused by Portnoy or even communicated to him."
• Morover, the court conceded that there "is at least as much reason to believe that the defendants were wielding the confidentiality agreement against Archibald, not to keep her from revealing trade secrets or business strategies in a way that could aid Cryo-Cell's competitors, but to keep her from discussing improper conduct she observed while at Cryo-Cell."
• Finally, Portnoy did not "believe that Archibald was violating her confidentiality agreement" because she "was looking to, I believe, protect the assets of the company by providing me with that information."

In other words, Portnoy talked with an employee who had possible information about corporate wrongdoing that was not particularly sensitive, he conveyed the information to the board, which did not act, and never revealed the information to the public. Moreover, the confidentiality agreement signed by the employee may have been designed to prevent disclosure for corporate wrongdoing.

The consequence of this conversation was to have Portnoy denied any reimbursement of expenses. The clear message in the case was that in VC Strine's court, shareholders would be subjected to a heavy financial penalty even when they vindicated their rights. Whether by design or accident, the consequence was to discourage shareholders from vindicating their rights in the Delaware Chancery Court even when there was proof of "inequitable behavior by management." As for impact of the decision, it could be seen from Portnoy's behavior. He declined to incur the costs of a new proxy contest (and the possible litigation expenses) when the required election was held. Management's slate ran unopposed and, as an anonoymous post to the Blog noted, was likely to recover its costs from insurance carriers.

The SEC has become increasingly involved in the governance process for public companies.  The agency has largely been limited to disclosure and has used this authority to try to affect substantive behavior of officers and directors.  For more on this subject, take a look at Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure. 

The governance requirements have largely been consolidated in Item 407 of Regulation S-K (fittingly titled "corporate governance").  This is the provision that requires disclosure of board independence, attendance at meetings, and assorted practices and policies implemented by the compensation, nominating and audit committees. 

Item 407 is more than just a disclosure provision, however.  To a large degree, it requires disclosure of the degree to which companies conform to the corporate governance provisions imposed by the stock exchanges.  The exchanges require that listed companies have boards with a majority of independent directors and nominating, governance and audit committees, with all members independent.  See Section 303A of the NYSE Manual.  Since no private right of action exists for violations of the stock exchange requirements, private enforcement of these provisions is nonexistent.  Similarly, as for profit companies, the stock exchanges have little incentive to engage in aggressive enforcement of the governance provisions.

The disclosure provisions ostensibly have teeth otherwise lacking in the enforcement process.  To the extent that companies misrepresent director independence, they could be sanctioned for violating the antifraud and/or proxy rules.  Not surprisingly, some companies have gone out of their way to note problems with the definition of independence arising out of the stock exchange rules apparently in the name of full disclosure.

The possible increase in enforcement, however, has been theoretical rather than actual.  The Commission has yet to bring a case under Item 407 (or, apparently, its predecessor provisions).  The Commission has brought a case concerning the failure of an "independent" director to disclose ties with the "independent" auditor.  But the case did not implicate Item 407 and so far is an isolated decision. This suggests that while the SEC has promoted disclosure of corporate governance provisions, it has not opted to devote resources to ensuring that in fact they are followed in any meaningful way.  As the Commission has learned, both in its MD&A project in the 1990s and the CD&A project in the new millennium, absent aggressive oversight, disclosure often suffers.

The Division of Enforcement should be made aware immediately that the Commission considers enforcement of Item 407 a priority.

In re Transkaryotic Therapies, Inc., 954 A.2d 346 (Del. Ch. 2008).

The case involved a merger. It turns out that during an appraisal action, plaintiffs discovered that in fact the votes for the merger may have been miscounted and the merger never approved. In other words, management potentially effectuated an unapproved merger. The court treated the claim with something akin to derision. As the court described:

• If one digs through enough of the rubble of a consummated merger, one will almost invariably find something questionable. A clever corporate archeologist can extrapolate from these suspicious artifacts and concoct a theory of malfeasance, disloyalty, and bad faith. Yet, theories alone cannot lead to liability.

But worse than attitude, the case contains very bad law and demonstrates once again that the Delaware courts have no interest in imposing meaningful standards on boards of directors. First, the Court, without authority, held that it could not grant injunctive or monetary relief for false disclosure in connection with a merger once the merger was consummated. This was apparently true even where the false disclosure was only discovered after the merger closed and the vote was "close" (the merger passed "by less than a million votes."). While this is only the opinion of one person on the Chancery Court, if it becomes controlling, it is tantamount to a holding that companies can issue false disclosure that affects the vote of shareholders and escape any consequence so long as the false disclosure remains undisclosed until after the merger closes.

Second, the Court arbitrarily lifted the standard of proof for Plaintiffs challenging the vote to approve a merger, requiring clear and convincing evidence. The opinion implied that this was necessary in cases of excessive delay between the date of the merger and the date of the law suit. In this case, the delay was about 19 months, hardly an excessive time period, and the Plaintiffs alleged that the delay occurred at least in part because of the actions of the Defendants. The Court ignored both and used the case as a vehicle to impose the higher standard.

Third, the opinion once again demonstrated the often impossible barrier thrown up by the Chancery Court with respect to the issue of independent directors. Plaintiff challenged the independence of a director, Wayne Yetter, on the Transkaryotic board becasue of his preexisting relationship with the CEO of the acquirer, Matthew Emmens. Emmens made the initial "expression of interest" through a "confidential call" to Yetters. In addition, as the court noted:

• Yetter and Emmens had a prior relationship. Emmens first worked for Yetter at Merck for about two years in the mid-1980s. Several years later, after Yetter had moved to a position with Astra Merck, he again hired Emmens. The two worked together at Astra from 1992 to 1997, when Yetter left to become CEO of Novartis Pharmaceuticals. They did not work for the same company again. Although he held positions on several boards, Yetter was looking for a new primary job when Shire first approached TKT, and his resume listed Emmens as one of his references.

Ultimately, Yetter stepped down from the board, the board having "expressed that its confidence had been shaken in Yetter, and Yetter believed that his relationship with the CEO was fractured." The court's treatment of the evidence? In a conclusory fashion, ignored it. The case demonstrates that allegations of disqualifying friendship with the CEO will largely be ignored. The courts treat these allegations entirely differently when they involve relationships with a controlling shareholder.  See In re Loral Space & Communs. Consol. Litig., 2008 Del. Ch. LEXIS 136 (Del. Ch. June 20, 2008).

Another area of necessary reform concerns NYSE Rule 452, the so called ten day rule. First adopted in 1937, the rule permits brokers to vote uninstructed shares, but not for controversial matters. Approximately 19% of votes cast at a shareholder meeting are from brokers. See Roundtable Discussion on Proxy Voting, Securities and Exchange Commission, Thursday, May 24, 2007 (statement by Rob O’Connor, managing director, Morgan Stanley).   Without the rule, companies would have a substantially more difficult time meeting quorum requirements and obtaining mandatory thresholds on uncontroversial matters if brokers could not vote the shares. See Licht v. Storage Technology, 2005 Del. Ch. Lexis 64, n. 8 (Del. Ch. May 6, 2005)(Broker non-votes "may be counted for purposes of establishing a quorum").

Because brokers may not cast uninstructed shares on controversial matters, most issues of importance to shareholders remain uninfluenced by these votes.  There is, however, one significant exception.  The provision applies to any matter that is "the subject of a counter-solicitation, or is part of a proposal made by a stockholder which is being opposed by management (i.e., a contest)" but does not apply to the unopposed election of directors.

The latter omission has been the source of controversy. As public companies increasingly opt for majority vote provisions for the election of directors and shareholder activists push "just say no" campaigns, the ability of brokers to vote shares in uncontested elections for the board increasingly interjects them into a highly controversial environment. The NYSE formed the Proxy Working Group to consider the matter. The Group issued a report on June 5, 2006 with a series of recommendations. Most noticeably, as the report noted, Rule 452 should be amended to define as controversial the election of directors.

• The Working Group believes that the election of directors can no longer be considered a “routine” event in the life of a corporation. Directors have authority over the most fundamental issues of corporate governance today, while investors, regulators, courts, and others have all recognized the critical role directors play in the life of a corporation. Because shareholder voting for directors is a critical component of good corporate governance, the Working Group considered recommending the elimination of Rule 452 in its entirety. However, as described in more detail below, the Working Group concluded that Rule 452 continues to have an important role in the proxy process today, particularly with respect to allowing issuers to achieve a quorum for regular meetings. Accordingly, the Working Group recommends that even where an election of directors is not contested, Rule 452 should be amended so that the election of directors should not be considered “routine” and brokers should no longer be permitted to vote the shares of beneficial owners who do not give specific voting instructions.

The NYSE approved the recommendations, including the changes to Rule 452, and on October 24, 2006, sent them off to the Commission with the expectation that the amendments would be in place in time for the 2008 proxy season. The proposal conceded that the change could increase costs ("For example, it is likely to increase the costs of uncontested elections, as issuers will have to spend more money and effort to reach shareholders who previously did not vote.") but nonetheless noted that "the election of a director, even where the election is uncontested, is not a routine event in the life of a corporation."  In response to criticism from the Investment Company Institute, the NYSE amended the proposal to exempt companies registered under the Investment Company Act of 1940, allowing brokers to vote for uncontested elections to the board of mutual funds.

The response from the Commission has been deafening silence.  Given the growing importance of shareholder voting for directors, the reform is a necessary one. The Division of Corporation Finance should be instructed to issue the proposed change for notice and comment as soon as possible.

The reform should, however, be accompanied by reform of the Shareholder Communication Rules.  As brokers receive less voting rights, companies have an incentive to communicate with beneficial owners to encourage them to instruct the shares so that they will be voted at the meeting.

McPadden v. Sidhu, 2008 Del. Ch. LEXIS 123 (Del. Ch. June 17, 2008)

There has been much written about the Delaware Court's exploration of the board's duty of good faith. The doctrine has an accentuated importance. Because bad faith behavior is not covered by waiver of liability provisions, the doctrine has the potential to significantly increase the exposure for directors.

Given the pro-management bias of the Delaware courts, the race to the bottom would predict that the courts would craft innovative ways to limit the reach of the doctrine. This is exactly what they have done.

An absence of good faith generally requires a showing of something akin to conscious disregard. That is, the board knew about a problem and largely ignored it. As Disney has shown, almost any board response, no matter how anemic, will be sufficient to meet the good faith test.

Sidhu shows the lengths the courts will go to avoid characterizing board behavior as insufficient to meet the good faith requirement. This was a case where the board sold a subsidiary to a management group for $3 million. Six months after the sale, the management group received an offer for the subsidiary of $18.5 million, which it rejected. The group sold the subsidiary for $25 million two years after the purchase.

The evidence suggested that the subdsidiary had been sold at an artificially low price. Moreover, the board left to the officer who led the management team that bought the subsidiary the task of finding a purchaser. The court recognized the obvious conflict of interest. "The board's first step in the series of actions culminating in the sale of TSC to Dubreville was also its most egregious: tasking Dubreville with the sale process of TSC when the board knew that Dubreville was interested in purchasing TSC." Nor did the board exercise any significant oversight. As the opinion noted:

• Despite having tasked a potential purchaser of TSC with its sale, the board appears to have engaged in little to no oversight of that sale process, providing no check on Dubreville's half-hearted (or, worse, intentionally misdirected) efforts in soliciting bids for TSC. Dubreville's limited attempts to find a buyer for TSC did not include contacting the most obvious potential buyers: TSC's direct competitors, particularly a competitor that had previously offered as much as $ 25 million for TSC in 2003. Perhaps unsurprisingly, Dubreville's group emerged as the highest bidder for TSC from the sale process.

In addition, the board received a number of red flags that suggested problems with the sales efforts. The board knew that the potential buyers had been approached selectively and did not include any competitors. They also had evidence suggesting that the management price was not adequate. Finally, the offer of $3 million "was at the lowest end of the valuation range."

The sale of an asset potentially worth $25 millon for a bit over 10% of that amount, assigning a person with a conflict to run the sales efforts, and the complete lack of supervision notwithstanding red flags was not enough for the court to conclude that shareholders had alleged bad faith.

• Thus, for the reasons explained above, the Director Defendants' actions, beginning with placing Dubreville in charge of the sale process of TSC and continuing through their failure to act in any way so as to ensure that the sale process employed was thorough and complete, are properly characterized as either recklessly indifferent or unreasonable. Plaintiff has not, however, sufficiently alleged that the Director Defendants acted in bad faith through a conscious disregard for their duties. Instead, plaintiff has ably pleaded that the Director Defendants quite clearly were not careful enough in the discharge of their duties--that is, they acted with gross negligence or else reckless indifference. Because such conduct breaches the Director Defendants' duty of care, this violation is exculpated by the Section 102(b)(7) provision in the Company's charter and therefore the Director Defendants' motion to dismiss for failure to state a claim must be granted.

Said another way, the court refused to find that the directors had any meaningful obligations with respect to their supervisory functions.

Any notion that good faith would somehow develop to become a meaningful protection for the interests of shareholders was disabused with this case. But then, that is what the race to the bottom would have predicted.