As we watch those companies subject to the bailout get rid of their corporate jets (this was required as part of the bailout of the auto companies), we have noted that other companies not obtaining government largess are still operating the planes.  Exxon-Mobile recently reported that it had a record year of profits (setting a record for a US company).  In the 2007 proxy statement (this year's hasn't been filed yet), the company disclosed that it had private aircraft and that the CEO, Rex Tillerson, had used it for personal travel (costing the company $41,000, not including capital costs). 

The proxy statement disclosed that its use for personal travel was necessary for "security reasons."  As the proxy statement explained:  "the Board requires the Chairman and CEO to use Company aircraft for both business and personal travel." 

Really?  What was the basis for the board's determination?  Was there any actual evidence of threats?  With only Tillerson making personal use of the corporate aircraft, why did the board not think other officers would be equally at risk? 

While we are not privy to the factors that actually went into the decision, we have written often on this Blog about how directors have an incentive to give the CEO what he/she wants in order to keep their lucrative sinecure on the board.  Thus, while there may have been a genuine concern about security, it's also possible that the board simply gave another perq to the CEO because he wanted it. 

To the extent Exxon continues to maintain the corporate aircraft and continues to allow its use by the CEO for personal travel (we shall find out when the proxy statement for 2008 is filed), it illustrates the fact that while companies accepting bailout funds are under pressure to eliminate this type of largess, other companies can quietly do what they've always done.  What needs to happen is a more permanent and substantive reform of the standards for determining executive compensation.  Preemption of Delaware law in short.

In other words, while financial institutions and companies taking bailout money are selling the corporate aircraft, there's no guarantee that the practice has actually become widespread in other areas of business.

9:06 a.m.

As public anger grows, Obama calls for a ceiling on executive pay

Minnesota Public Radio

For the audio of the show, go here.

President Obama proposes to overhaul executive compensation, not just for the companies accepting federal bailout funds, but all public companies.

Guests

J. Robert Brown: Professor of business law at the Sturm College of Law at the University of Denver. Michael Mandel: Chief economist for BusinessWeek magazine. His latest book is "Economics: The Basics." James Reda: Founder and managing director of James F. Reda & Associates, an executive compensation consulting firm.

The WSJ reported that, as predicted on this Blog, the Obama Administration would quickly come down with tougher rules on executive compensation in the aftermath of President Obama describing bonuses by companies participating in the bailout as "shameful."  The most severe restrictions will apply only to companies receiving "exceptional assistance." As the article reports:

• Under the new rules, companies that receive "exceptional assistance" from taxpayers may not pay any top executive more than $500,000 a year, an administration official said. Any additional compensation would have to be in restricted stock that will not vest until taxpayers have been repaid, the official said.

Treasury's description of the restrictions is here.  The provision walks a delicate line.  On the one hand, the public needs to be appeased by restricting the compensation practices of companies taking public money.  On the other hand, harsh limits will discourage financial institutions from participating in TARP and slow down the financial recovery.  At least 50 banks have declined to participate and some financial institutions are talking about paying back their TARP funds as quickly as possible in order to get out from underneath the tougher government scrutiny.  

In walking this line, Treasury is adopting harsh restrictions but applying them in a sparse manner.  The restrictions limit corporate officials (including the CEO) to $500,000 a year, although they permit some extra compensation in the form of restricted stock (apparently without limit).  They apply only to companies accepting "exceptional assistance."  The term is currently undefined.  The WSJ suggests that the term will apply to bailouts of the magnitude of AIG.  That one involved somewhere around $85 billion.  In other words, the restrictions will only apply to the most massive of the buyouts.  When all is said and done, the number of financial institutions subject to the severe restrictions will probably amount to no more than the fingers on a single hand.

Most interestingly, the Administration will also require that companies accepting exceptional assistance institute "say on pay," an advisory vote for shareholders on compensation practices.  Similarly, other financial institutions taking bailout funds may avoid the $500,000 cap on executive compensation if they provide the same advisory vote.  As Treasury has indicated:  "Companies that participate in generally available capital access programs may waive the $500,000 plus restricted stock rule only by disclosure of their compensation and, if requested, a non-binding “say on pay” shareholder resolution."

First, President Obama is on record favoring legislation that would mandate say on pay for all public companies, not just those participating in the bailout.  Thus, it is at least possible that this effort represents a retreat.  After all, it will apply say on pay to only a limited class of companies and the restrictions will expire once the bailout money is paid back.

Second, though, it will provide many companies with experience with say on pay.  In truth, say on pay gives little authority to shareholders but it does require management to make its case for compensation in a very public way.  Say on pay may prove less painful to companies and may benefit them by taking away some of the shareholder animosity towards compensation practices.  The experience may weaken the issuer opposition to implementation of say on pay in a broader way.

All of these reforms are stop gaps.  They do not address the systemic problems that cut across all industries, not just those in the financial markets.  The White House and Treasury have announced a Conference on Long-Term Executive Pay Reform that will seek guidance on "model executive pay initiatives in the cause of establishing best practices and guidelines on executive compensation arrangements for financial institutions."  In the end, it is this conference that holds out the prospect of something more systematic and more permanent.

We've been talking about Treasury's efforts in the area of executive compensation.  The use of private aircraft illustrate the problems in this area.  Starbucks and Citigroup both opted to do without a corporate aircraft.  Needless to say, the interesting thing is not the decision itself but the lateness in the day for opting to do something seemingly obvious.

Starbucks is closing more stores (300) and reducing the number employees (6700).  Buried in the WSJ article was a mention that the company was also planning to sell its private aircraft.

• Starbucks also said it put its Gulfstream 550 aircraft up for sale last week, just after the plane was delivered last month. The company had been criticized for buying the plane, in light of all the store closings and worker layoffs.

Buying the plane in the first instance is worse than John Thain spending $1.2 million on his office suite.  At least Thain did so back in January 2008, before the bottom fell out.  Starbucks can't say the same thing.  As it struggles with downsizing and lower earnings, it chose this time to buy a private aircraft.  It's not far from the auto companies flying to Washington in their private jets to ask for bailout money. 

As usual, the unanswered question is the oversight of the board.  And this is not the only company where the question needs to be asked.  Citigroup has announced that it won't take delivery of a $42 million jet.  The question is why, in this climate, it thought to buy the plane in the first place. 

Surely the board of Starbucks (and Citigroup) ought to be more involved in the trials and tribulations of the company and ought to be sending a message that this is not the time for profligate spending.  Apparently not. 

Stock exchanges like Nasdaq and the NYSE are for profit companies that have a fiduciary obligation to maximize earnings.  Sometimes enforcing the rules of the exchange is inconsistent with this.  In some cases, non-enforcement requires permission of the SEC.  This is the case, for example, in connection with the post below where Nasdaq asked to put in suspension the rule that requires companies to trade at a minimum price ($1).  But in the case of individual exemptions, SEC review is not required.  Thus, when the NYSE opted to not require shareholder approval of the shares issued by Wachovia to Wells Fargo the decision was unilateral and non-transparent.  There was no double check by a government regulator.  Perhaps it is time to extend mandatory Commission review to more decisions by for-profit stock exchanges.

Last October Nasdaq requested that the SEC allow it to suspend the listing requirement that requires companies to have a minimum bid price of $1. Nasdaq rules classify a security as “deficient” if it has a closing bid price of less than $1 for thirty consecutive business days. Once deficient, issuers have an automatic180 day period to regain compliance by having a closing bid price of at least $1 for ten consecutive business days, and can receive an additional 180 days if all other listing requirements are met. According to the Nasdaq proposal to the SEC, by October 9, 2008 there were 344 securities trading below $1, and another 300 securities trading between $1 and $2, up from 64 securities below $1 at the end of September.

The SEC agreed with Nasdaq’s assessment that this drop in bid price was not a result of a “fundamental change in the underlying business model or prospects” for these companies, but was a result of “decline in general investor confidence,” and that these companies remain “suitable for continued listing.” Since the proposed rule change would not endanger investors or burden competition and was in the best public interest, the SEC waived the 30-day operative delay between receipt of the proposal and its implementation. The rule suspension became immediately effective on October 16, 2008 and was to expire January 16, 2009.

The effect of the rule suspension is not only to ignore share bid price in determining whether a listing deficiency exists, but also to suspend calculating the 180-day recovery period for any security that was deficient before October 16. If a company’s security was 150 days into its initial deficiency period at October 16, the company would have 30 days after January 16^th to recover or seek an additional 180-day extension.

On Dec 18, 2008, Nasdaq requested an extension of the rule suspension to April 19, 2009, noting that “extraordinary” market conditions continue. (As of January 30, 2009, there were 430 shares listed on Nasdaq for $1 or less.) Unlike the first proposal, for which the SEC waived the 30-day operative delay, there is time for the SEC to publish this rule for notice and comment. The initial proposal was published post-approval, and received one supportive comment.  One blogger suggests that the rule be permanently eliminated as a way to discourage companies from doing a reverse stock split merely to meet the listing requirement.  Comments must be submitted to the SEC referencing File Number SR-NASDAQ-2008-009 on or before February 5, 2009.

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This post discusses whether Delaware courts would uphold the $4.5 billion, 6.6% reverse termination fee in Pfizer's proposed acquisition of Wyeth if shareholders were to challenge the fee. The WSJ reported that Pfizer will pay Wyeth the break-up fee if “Pfizer’s ratings are cut and the banks don’t lend.” According to a Pfizer press release it must, “maintain credit ratings of A2/A long-term stable/stable and A1/P1 short term affirmed,” or the banks financing the deal can walk away, triggering the reverse termination fee.

Unlike a normal termination fee, the acquirer pays a reverse termination fee to the target if the deal is not completed for specified reasons. Such reasons can include failure to obtain regulatory clearance for antitrust concerns, failure to obtain financing, or any other breach by the acquirer indentified in the agreement. Delaware courts have addressed the reasonableness of termination fees, but not reverse termination fees. In re Topps Co. S'holders Litig., 926 A.2d 58, 86 (Del. Ch. 2007).

The Delaware Chancery Court’s silence leads some to speculate that there is no limit on the size of reverse termination fees. Darren Tucker and Kevin Yingling made exactly this point in their article Keeping the Engagement Ring: Apportioning Antitrust Risk with Reverse Breakup Fees by stating:

• "Unlike breakup fees, there are no fiduciary duty-related legal restrictions on the size of reverse breakup fees. Courts have not limited the size of reverse breakup fees because they do not  affect the bidding process to the detriment of shareholders."

Consistent with this point of view, there appears to be no case law invalidating reverse termination fees or even indicating that there is a permissible limit to such a fee. It follows then that Pfizer’s shareholders would have little ground to challenge the $4.5 billion, 6.6% reverse termination fee.

The Race to the Bottom has recently added a Donate link. The Blog is advertisement free and plans to remain that way. If you have an interest and enjoy the content, consider a contribution.

As we have discussed on this Blog, the bailout bill contained provisions that regulated executive compensation.  Treasury drafted regulations that implemented these provisions.  The Treasury regulations are, however, noticeable in their vagueness.  They merely require the compensation committee to make sure that the TARP requirements are met.  In other words, the regulations contain no metrics, no standards, and no meaningful guidance.

Part of the problem is that the appropriate amount of executive compensation is, in the end, company specific.  There are companies that undergo huge share price increases (which increase the compensation of CEOs with stock and options) through no significant acumen or contribution of the CEO (natural resource companies that increase in value because of a spike in natural resource prices, for example).  On the other hand, a CEO might be the most effective and work the hardest when share prices are tumbling.  In truth, as I have discussed in Returning Fairness to Executive Compensation, the answer is to leave the decision in the hands of the board but with modifications to the applicable standards. 

Right now, compensation is approved by "independent directors" on the compensation committee.  The directors are often not really independent, whether under the definition used by the NYSE or by the Delaware courts.  Nor is the process designed to ensure fairness.  The process is rife with invovlement by the CEO and with the use of consultants who often have ties to the CEO, working in his/her interest rather than that of the board and the company. 

Two things need to happen.  First, the board needs to have the obligation of showing that the process was independent.  This means truly independent directors and truly independent advisors, with little involvement of the CEO.  Second, it means imposing on the board the obligation, even if approved by independent directors, to show that the compensation was "fair."

Truly independent directors means directors not nominated by management.  This problem, therefore, screams for shareholder access to the company's proxy statement, an act that would facilitate the election of shareholder nominated directors.  But as we await Mary Schapiro and the SEC's action in this area, there is a more immediate place to show the affect of truly independent directors. 

Treasury recently agreed to bailout GMAC.  GMAC is an LLC.  Under the agreement with the government (which is attached to a current report), there are to be seven managers (aka directors).  One will be the CEO of GMAC.  Three of the remaining directors will be selected by investors, with one by Cerberus and two by a trustee of a trust holding interests in GMAC and appointed by Treasury.  The remaining three are to be approved by a majority vote of the board and must, according to the agreement, be "independent."  Moreover, one of the "independent" managers must serve as chairman. General Motors has no right to representation on the board but can designate a "board observer" to attend the meetings.

It is, therefore, Treasury (or Treasury's designated trustee) that has the right to determine the independent managers.  Treasury is in a position to ensure that the directors not only meet some technical definition of independence used by the NYSE or the emasculated definition used by the Delaware courts, but are also genuinely independent and genuinely interested in setting the compensation package that will benefit investors in GMAC (who are, in reality, the public). Moreover, the directors should receive a multi year term but agree not to stand for reelection.  In those circumstances, they will have no incentive to act in a manner that is designed to curry favor with one interest group or another.  In short, they can be truly neutral. 

There is also the issue of the applicable legal standard.  The agreement with Treasury specifically incorporates Delaware law (and GMAC is a Delaware LLC).   As a result, the anemic standards employed in Delaware apply.  Perhaps in the future this could be changed by agreement.  Rather than allow process to eliminate fairness, some burden of fairness should remain on the board even if properly approved.

Nonetheless, Treasury is in a position to ensure that the process for determining executive compensation has the the highest level of integrity, something not the case currently.  In those circumstances, it would seem appropriate for Treasury to defer to the decision of these directors, without requiring government approval of any performance based compensation decision, as the term sheet with GMAC currently requires.  See Term Sheet ("GMAC shall not pay or accrue any bonus or incentive compensation to the Senior Employees unless otherwise approved by the President’s Designee (as defined in H.R.7321)).

The Treasury rules implementing the executive compensation provisions of TARP essentially impose on the compensation committee the obligation to consider the arrangements and to determine whether they cause excessive risk taking.  Nonetheless, the rules go further and essentially impose on the CEO the obligation of certifying that the compensation committee has performed its prescribed task.  In other words, the rules give oversight of the board's obligations to the CEO.

This of course stands the usual state of things on its head.  It is the board that is supposed to oversee the CEO, not the CEO overseeing the board.  But, of course, as we have noted often on this Blog, CEOs exercise considerable influence over the board.  They are invariably on the board and usually the chairman.  Boards, as Jon Macey at Yale has written, are susceptible to capture by top officers.  In other words, the idea that the board supervises the CEO is largely a fiction.  It is the CEO that controls what happens at the board level.

Treasury and TARP recognize this.  Rather than entirely leave matters to the board, they impose on the CEO the obligation to certify that board has done its job.  Of course, this will likely ensure that the CEO is always on the board (no great change) and that the CEO is involved in the compensation process to ensure that the standards in the rules are met.  This also confirms what anyone who watches this area knows.  CEOs of exchange traded companies cannot sit on the compensation committee (they must be independent directors) but can still participate in the process and exercise considerable influence over compensation decisions.  Neither the exchanges nor the Delaware courts prohibit this.  And Treasury and TARP confirm it.   

Treasury is considering new limits on executive compensation for certain companies participating under TARP.  Treasury is considering limits on bonuses and severance paid at companies that receive "exceptional" aid under TARP.  The problem is not the limitations but the companies subject to the limitations.  While we don't know yet what exceptional means, it probably applies to companies receiving, based on a yet to be determined metric, large payments.  These are likely to be the financial institutions in the most trouble and having the most difficulty returning to financial health.

Yet these will be the same companies subject to limits on executive compensation, particularly with respect to the CEO.  A CEO would, therefore, know that if he or she joined one of these financial institutions, companies in deep trouble, the CEO could be dismissed by the board without severence.  It would be like a law professor giving up his/her tenure.  Either the CEO will insist, as a result, on much higher compensation to pay for the risk or will simply not take the job.  Either way, the result is a bad one.

The problem is trying to fix a systemic problem by applying standards to only a small number of companies, probably the companies that need the most flexibility in determining executive compensation.  Treasury needs to work on a broader solution.

Treasury (before Geithner's arrival) recently issued an updated "interim final rule" updating a similar provision that had been issued in October.  The rule contains technical amendments and imposes specific time periods on certain certification obligations.  It presents an opportunity to comment on the broader approach used by Treasury.

TARP applied the limits on compensation to any financial institutions selling troubled assets to Treasury.  See section 111(b) of the Emergency Economic Stabilization Act of 2008, Div. A of Pub. Law No. 110-343.  Of course, the idea of acquiring troubled assets was quickly abandoned, displaced by a strategy of making capital contributions to healthy financial institutions through the purchase of preferred stock.  The October interium rule (as does this one) extended the compensation limitations to these companies as well, going beyond the language in the statute.

Section 111(b)(2)(A) of EESA requires:

• “limits on compensation that exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution.”

EESA also provided for clawbacks and limits on golden parachutes. 

The responsibility for execution falls on the compensation committee.  The October Rule imposed on the compensation committee the obligation to identify compensation arrangements that could result in exessive risk taking.  The committee also must review the incentive compensation arrangements with top officers. Finally, the committee must meet at least annually with senior risk officers to review the relationship between risk management policies and the incentive compensation arrangements.The entire set of rules adopted by Treasurey are here.

Nonetheless, Treasury has essentially imposed on the CEO the obligation to see that these compliance steps are taken.  Within 120 days of a capital infusion under TARP, the CEO must certify that the compensation committee has reviewed the incentive compensation arrangements with the senior risk officers to ensure that there are no arrangements that encourage unnecessary and excessive risk taking.  Within 135 days of the completion of each fiscal year while the company is participating in the bailout, the CEO must certify:

• that the compensation committee has met at least once during the prior fiscal year with the senior risk officers of the financial institution to discuss and review the relationship between the risk management policies and practices of the financial institution and the SEO incentive compensation arrangements; the compensation committee has certified to this review; the financial institution has required that SEO bonus and incentive compensation be subject to recovery or “clawback” by the financial institution if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria; the financial institution has prohibited any golden parachute payment to a SEO; the financial institution has instituted procedures to limit the deduction for remuneration for federal income tax purposes to $500,000 for each SEO for the most recently ended fiscal year as if section 162(m)(5) of the Internal Revenue Code applied to the financial institution; and certain named individuals are the SEOs for the current fiscal year based on the compensation of such individuals during the prior fiscal year.

Finally, within 135 days of the completion of the the fiscal year, the CEO must certify that the company limited the deduction for compensation to the $500,000 limits set out in 162(m)(5) of the Internal Revenue Code.  

There are two issues that arise from these requirements.  First, why did it take TARP and participation in the bailout to make consideration by the compensation committee of the possibility of excessive risk taking mandatory? It reflects the fact that under Delaware law (mostly interpretations by the Delaware courts) there is almost no affirmative obligation by directors to take any specific steps or perform any specific analysis with respect to executive compensation. 

The Disney case illustrates how little the Delaware courts require.  In that case, the compensation committee received an incomplete term sheet, had no outside advisors present, and met for a short period of time, and ultimately approved a contract that resulted in the payment of somewhere around $160 million to an officer who worked at the company for slightly more than one year.  The Delaware Supreme Court held that this behavior was consistent with the directorys' fiduciary obligations to the company.  In other words, Delaware imposes no meaningful standards when considering compensation issues.  Could any case better illustrate why standards for determining executive compensation need to be federalized (the appropriate standards are discussed in my paper here)?

We will consider the other issues in the next post.

Barack Obama labeled the bonuses paid to officials at financial institutions taking funds under TARP as "shameful."  Senator McCaskill introduced a bill to cap compensation at the amount paid to the President ($400,000).  On Saturday, he described the payments this way:

• “we learned this week that even as they petitioned for taxpayer assistance, Wall Street firms shamefully paid out nearly $20 billion in bonuses for 2008.” The American people will not tolerate “such arrogance and greed,” the president said.

Apparently Treasury will rush out new rules or standards early in the week to deal with these payments.  The project approach appears to be a significant mistake. 

Treasury is only targeting payments/bonuses for companies taking funds under TARP.  Moreover, the proposals under discussion differentiate among companies receiving bailout funds.  According to the WSJ, only those companies receiving "exceptional" aid will "be banned from receiving any severance payments and they, along with the top 50 executives, will see their bonus pools shrink by about 40% from 2007 levels." 

If the Government treats companies differently with respect to executive compensation practices, it will trigger the rule of unintended consequences.  Those who are more mobile will go the companies and banks not participating in TARP (the WSJ reported that so far at least 50 financial institutions have already rejected TARP funds), or to the companies in TARP subject to the least restrictions.  As a result, the very class of financial institutions that need the Government's help the most will see an outflow of talented management, potentially undoing the Government's goal of strengthening the financial markets, thereby lengthening the period of economic instability.

This is not a TARP problem.  It is a systematic problem.  Excessive compensation is harmful, whether or not paid to a CEO of a company participating in TARP.  Treasury needs to come up with a solution that makes reasonable all executive compensation, not just for those companies taking federal funds. 

The Speculative Debauche has a nice post on the source of possible opposition to an SEC/CFTC merger.  There is some potential opposition from agricultural interests in the US Senate.  Mary Schapiro has her work cut out for her.

The fallout from President Obama's reference to the payment of bonsues as "shameful" is already being felt.  Claire McCaskill, Senator from Missouri, has already introduced legislation that would limit salaries of all company officials to no more than the salary of the President of the United States (which is $400,000 by the way).  And if you didn't get the message, the bill is titled "The Cap Executive Officer Pay Act of 2009").  As noted in the WSJ:  "In 2007, Goldman Sachs Group Inc. Chief Executive Lloyd Blankfein earned that much in about two days." (This is also less than the directors of Goldman received in total compensation in 2007).   The bill likely has no chance of passing but it is a reflection of the growing frustration being felt with executive compensation issues in Washington.

The anger, however, is focused on companies receiving TARP funds.  The problem is broader than that.  Apparently excessive compensation is not tolerable when the money is from the public but is tolerable when the funds are from shareholders.  This approach will result in no lasting impact.  Once the current turmoil passes and the TARP funds are repaid (or preferred shares repurchased), the same practices will return with a vengeance.  Indeed, even among financial institutions, many are rejecting TARP funds and, therefore, will be free to pay whatever comensation they want.

This is an opportunity to continue a systematic reform that will have permanent impact on executive compensation, not just those receive TARP funds.  The answer is not a cap but process reform.  It means overturning the system of determining compensation that has been put in place by the Delaware courts. 

The solution can be found in the article, Returning Fairness to Executive Compensation.  The most immediate thing that can be done?  Access.  With shareholder representatives on the board of directors (or the threat of shareholder representatives), "independent" directors may be inclined to take a more realistic view towards executive compensation.

When would one imagine a president of the United States describing executive compensation using the word "shameful"?  President Obama did so on Thursday.

It came after a study was issued by Tomas P. DiNapoli, the NY State Comptroller, indicating that $18.4 billion was paid in bonuses to financial executives during a time when the economy was plummeting downward.  The bonuses were apparently the same size as those paid in 2004 when matters in the financial markets were substantially better off.  President Obama had this to say:

• “That is the height of irresponsibility,” Mr. Obama said angrily. “It is shameful, and part of what we’re going to need is for folks on Wall Street who are asking for help to show some restraint and show some discipline and show some sense of responsibility.

• “The American people understand that we’ve got a big hole that we’ve got to dig ourselves out of, but they don’t like the idea that people are digging a bigger hole even as they’re being asked to fill it up,” Mr. Obama said, adding that “there will be time for them to make profits and there will be time for them to make bonuses. Now is not that time.”

The Executive Branch is in the eye of the executive compensation storm.  It is Treasury that has adopted rules designed to implement the compensation provisions in TARP.  We will, over the next couple of days (Friday and Monday), look at the federalization of compensation decisions.  There are a few observations, however, that can be set out right now.

First, the anger and frustration is over a system governed by Delaware law.  The courts have interpreted fidicuary duties in a way that puts no real limits on executive compensation.  We see the results of the Delaware system daily.

Second, it goes well beyond ordinary compensation.  Compensation raises concerns over money or assets that ultimately benefit the CEO (and other top officers) personally.  They include such things as country club dues and personal use of the company's private aircraft (for officers and family members).  But even where it's for business use, management has become profligate.  Ownership of private jets for business use, expensive remodeling of offices, highly paid private drivers, are all expenses ostensibly designed to benefit shareholders.  Yet one cannot help but think that in fact the decisions are based less on the interests of shareholders and more on the interests of management.  

Third, Treasury's efforts so far are weak.  TARP only applies to companies that accept bailout funds.  In other words, whatever abuses Treasury seeks to stop, they are still allowed to remain in place in other, non-bailout companies.  Moreover, Treasury had done little except to adopt vague admonitions that call for compensation committees to pay attention.  These requirements are not enough.

Will explore some of these matters in upcoming posts.

The latest on Merrill Lynch is that Andrew Cuomo is barrelling ahead in his investigation of the unexpectedly large losses in December and the payment of employee bonuses.  As part of the investigation, he has already sent a subpoena to John Thain, the former CEO.  As Cuomo has stated:

• Today, as part of our ongoing inquiry into executive compensation issues at institutions who have received TARP funds, my Office issued subpoenas seeking the testimony of former Merrill Lynch CEO John Thain, as well as the testimony of Bank of America Chief Administrative Officer J. Steele Alphin. These subpoenas are part of an ongoing inquiry into billions of dollars in bonuses paid by Merrill Lynch late last year just days before Merrill was taken over by Bank of America. The fact that Merrill Lynch appears to have moved up the timetable to pay bonuses before its merger with Bank of America is troubling to say the least and warrants further investigation.

His focus is on the bonuses and, according to the WSJ, Cuomo is looking into what Thain told the directors at Merrill about the losses.  As the article noted:

• According to the person familiar with the situation, Mr. Cuomo also wants to know if Merrill's board knew about the deepening losses last month, which resulted in a net loss of $15.31 billion in the fourth quarter. That information may have led Merrill's compensation committee to readjust the bonus payouts, the person familiar with the probe said.

He is also, apparently, looking into whether shareholders were mislead by the disclosures. 

There are several observations that need to be made this investigation.  First, to the extent that there is some concern about false disclosure, it seems that the State of New York (as happened many times under Eliot Spitzer) is doing the job for the Securities and Exchange Commission (albeit that there could be an investigation that has not yet leaked to the public).  Perhaps the resources devoted to the health problems of Steve Jobs would be better spent on looking into this issue.

Second, and more profoundly, there is a fundamental issue about the role of the board in this escapade.  Did the board know of the losses when it approved the compensation?  What exactly did the board know?  Even if Thain did not provide all of the necessary information, was there a system of controls in place that should have required it? 

All of these issues are state law issues that turn on the application of fiduciary duties.  Fiduciary duties in turn depend upon the interpretation of the Delaware courts.  And the courts have largely eliminated any avenue for exploring these issues.  The Attorney General of Delaware has and will remain silent on these issues.  Private plaintiffs can bring a law suit but will confront the excessive limitations on the suits imposed by the Delaware courts. 

In other words, the issue between Thain and the Merrill board by and large raise issues of fiduciary obligations.  But rather than have the state that sets the standards determine whether a violation has occurred, shareholders and the market have to rely on the aggressive stance of the attorney general of New York.  And while Spitzer and Cuomo have been willing to take on this responsibility on a case by case basis, the approach is not systematic and depends upon the personality of the NY attorney general.  Were Cuomo not involved in this case, the issues between Thain and the board would likely never be exposed and shareholders would likely never know whether the board or Thain is responsible for the bonus decisions.

A governance system that relies on the attorney general of a different state to explore fiduciary duties is inefficient, incomplete, and demonstrates the weakness in having the standards determined by Delaware.

In the class action suit In re Crocs, Inc. Securities Litigation, No. 07-cv-02351-REB-KLM, 2008 U.S. Dist. LEXIS 87524 (Colo. Dist. Ct. Sept. 17, 2008), the United States District Court of Colorado held the presumptive lead plaintiff adequate to represent the class because its “contracts for difference” (“CFD) were “securities” under the Securities Exchange Act.

Plaintiffs filed a complaint against defendants Crocs Inc. (“Crocs”), along with its CEO and CFO, for violations of sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5. Plaintiffs alleged that Crocs issued inaccurate financial statements and forecasts for the second and third quarters of 2007 resulting in a stock price increase from $55.42 to $74 per share. When Crocs corrected the disclsoure, its shares fell to $47.74.

The Sanchez Group sought appointment as lead plaintiff.  The Group had the largest loss but owned CFDs rather than shares.  CFDs are contracts between a buyer and seller, requiring one party to pay the other the difference between the current value of an asset and its value at the contracted time.  They do not require actual ownership of the shares.  As the court described: 

• CFD purchasers acquire the future price movement of the underlying company's common stock (positive or negative) without taking formal ownership of the underlying shares. Unlike calls and puts, which trade in tandem with, but not at the same price as, the underlying publicly traded common stock, the purchase and sale prices of CFDs are alleged to be identical to the prices quoted for shares of the underlying company's common stock on the public securities exchange. In advance of pricing the CFDs, actual matching shares of the underlying common stock are purchased or sold by the broker on the public securities exchange on which the common stock normally trades. The prices paid or received by the broker for those corresponding shares of common stock are the prices set for the CFDs representing those shares and charged to, or paid by, the customer. Because identical matched transactions occur in shares of the actual common stock immediately before the purchase or sale of the CFDs, any influence on the public market price of the underlying securities is also reflected in the price of the CFDs. CFDs [*13]have no fixed expiration date, CFD holders receive the benefit of any dividends paid on the underlying shares, and the CFD may include voting rights on the underlying shares. 

Other putative plaintiffs challenged the appointment of the Sanchez Group as lead plaintiff, alleging that the CFDs were not “securities” but futures contracts.  Additionally, they argued CFDs made the lead plaintiff an atypical plaintiff with special defenses.

The court disagreed with the challengers’ assertions that CFDs were not “securities,” because the term, as envisioned by Securities Exchange Act, is “very broad, encompassing a wide range of financial instruments.”   The opinion contained little direct reasoning, relying mostly on Freudenberg v. E*Trade Financial Corp., 2008 US Dist. Lexis 62767 (SD NY July 16, 2008) which likewise found the instruments to be securities.  The court also dismissed the argument that the Sanchez Group was an atypical plaintiff.  Because the CFDs were classified as securities, the court concluded that there were no unique defenses that precluded the group from serving as lead plaintiff.

Finding all of the challengers’ arguments unpersuasive, the court approved the Sanchez Group and their counsel as lead plaintiff.  The primary materials for this post are available on the DU Corporate Governance web site.

As we have discussed at length on this Blog (and in this Paper: The SEC, Corporate Governance, and Shareholder Access to the Board Room), the Commission's decision to not provide shareholders with  access to the proxy statement was an incorrect interpretation of the law, inconsistent with the Agency's pro-investor, shareholder mission and, in the end, short sighted. 

Access as proposed by the Commission was really not very beneficial to shareholders.  Under the proposal, shareholders would only have the right to insert a nominee in the company's proxy statement if they first adopted the requisite bylaw.  Even this two step, minimal process drew vociferous criticism from issuers, their supporters (Wachtell Lipton for one) and the opposition from the three Republican Commissioners (Casey, Atkins & Cox).  Chairman Cox worried that if access were left in place, there would be a "law of the jungle." 

We noted that the decision would result in unintended consequences and would ultimately result in increased pressure for access.  Moreover, with regime change, pressure would build for shareholder access directly, without having to go through the two step process proposed by the prior Commission.  

With that in mind, we were pleased to see answers to questions posed by Senator Carl Levin given by the incoming Chairwoman, Mary Schapiro, on her opinion of access and say on pay.  According to her answers, access is coming, at least for large, long term shareholders. 

Here is what she had to say about access:

19. Former SEC Chair William Donaldson proposed establishing a mechanism to allow certain shareholders of publicly traded corporations to nominate a candidate to the board of directors. If confirmed, would you support a rule to allow shareholder nominations of some board members?

Response: Yes. A central tenet of our market system is that shareholders are the owners of the company in which they hold shares, and they should have a way to hold their representatives –- members of the board of directors -- accountable for their actions.  Access to the proxy has been debated for many years, and I believe it is time for a thoughtful approach to proxy access for significant, long term shareholders.

As for say on pay, the matter is not in the hands of the Commission but Congress.  Nonetheless, she supports the idea.  As she answered:

20. What is your view of the compensation paid to executives and market traders at financial institutions? If confirmed, would you support a rule to allow shareholders to express an advisory opinion on executive compensation?

Response: Yes. Like you and millions of Americans, executive compensation has been a concern of mine for some time now, and I believe that it’s an appropriate measure to give shareholders an advisory vote on these matters.

Had the prior Commission adopted the two step approach to access, the pressure likely would have abated.  It will now resume and the results will be far better for shareholders.

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This post concludes and summarizes our coverage of the case United States v. Stockman. The government filed the Indictment in March of 2007 in the Southern District of New York. The named Defendants were David Stockman, Paul Barnaba, David Cosgrove, and J. Michael Stepp. Stockman was the CEO and Chairman of the Board of global auto parts manufacturer Collins & Aikman, Inc (C&A). Barnaba was the Director of Financial Analysis for the Purchasing Department, and later the Vice President and Director of Purchasing for the Plastics Department. Cosgrove served as Group Controller for the Plastics Group. Stepp was Vice Chairman of the C&A board.

According to the Indictment:

·          under Stockman’s control, C&A availed itself to a variety of sources of debt financing including: notes, revolving credit lines, and securitizing accounts receivables. C&A’s debt financing was subject to financial covenants. Failure to comply with these covenants would constitute a default by C&A and warrant demand for immediate payment. The covenants required C&A to maintain a performance ratio measured by C&A’s net debt divided by EBITDA. Discussed here.

The indictment alleged that Stockman and the other defendants joined in a scheme to defraud C&A’s investors, banks, and creditors by manipulating C&A’s reported revenue and earnings because of the operational pressures and covenants to keep C&A’s financial performance at certain levels.

C&A provided Defendants with Director & Officer Insurance (D&O Insurance) to help with the cost of defending against the indictment. The burn rate of the D&O policies quickly became another issue as the policy depleted by an estimated $1.67 million per month for Defendant Paul Barnaba. Total coverage under the policy was $50 million. For discussion of the adequacy of $50 million D&O insurance for a company the size of C&A see Stockman and the Limits of D&O Insurance and US v. Stockman and the Burn Rate on the D&O Policy.

As the D&O policy diminished, the number of documents increased to 12 million. On April 8, 2008 Barnaba filed a motion to dismiss, alleging violation of his constitutional right to a speedy trial. Discussed here. The government argued that the number of documents in discovery justified the trial delay. Judge Barbara Jones agreed with the government, and denied Barnaba’s motion to dismiss in the July 24, 2008 status conference.

Barnaba continued his effort to speed the trial along by filing a motion to sever on August 25, 2008. Discussed here. Barnaba argued that he:

·       has not been able to pay counsel for 2.5 months and his Motion for Appointment of Counsel under the Criminal Justice Act filed August 18, 2008 was still pending. Barnaba claimed that he was ready for trial and making him wait until May 2009 would “impair [his] ability to put on an effective defense due to his limited resources.

Judge Jones orally denied Barnaba’s Motion to Sever during the August 25, 2008 status conference. Barnaba filed a second Motion to Sever in October of 2008. Discussed here.

On January 9, 2009 the Government filed a Nolle Prosequi, dismissing the charges against Stockman, Barnaba, Cosgrove, and Stepp. The Government provided little reasoning for the dismissal by stating:

·          After a renewed assessment of the evidence, including evidence and information acquired after the filing of the Indictment, it has been concluded that further prosecution of David A. Stockman, J. Michael Stepp, David R. Cosgrove, and Paul C. Barnaba would not be in the interest of justice.

Professor Brown speculated as to what may have happened in his post The Stockman Dismissal: What Really Happened? He indicated that contributing factors to the dismissal may have included the amount of government resources exhausted by the 15 million documents in discovery, the vigorous defense put up by defense counsel, and the Southern District’s preparation for the Madoff case.

For documents filed in the Stockman case (including many of the status hearings before the trial judge), go to the DU Corporate Governance web site.

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This Blog tries, when the opportunity is presented, to shed light on corporate governance practices from other countries that vary from those in the United States. In part this illustrates the lack of uniformity in the area. In addition, however, it demonstrates that there may be ways the US can learn from the experience in other countries in reforming its own governance process.

In the Fall, students from my comparative corporate governance class produced some posts that raise interesting issues. Over the next week or so, we will publish some of them. The following post today is about the system of governance in South Africa and was written by Carrie Stanley, a third year student at the University of Denver Sturm College of Law.

The end of Apartheid in South Africa prompted major revisions to the common law country’s policies and practices, including corporate governance. International and domestic pressures called for the country to address human rights abuses of the previous regime, and the weak state of the economy caused the government to seek out policies that would lead to market stabilization in an effort to attract foreign investors.

This led to South Africa’s adoption of the King Report, a voluntary governance code of corporate practices and conduct. The Report, first published in 1994 and revised in 2002, solicits voluntary compliance with a multitude of corporate governance directives, including director duties and responsibilities, requirements for internal audits, a compensation committee, a code of ethics, and annual reporting.

What makes the King Report unique from other voluntary codes is that it goes beyond the traditional financial and regulatory aspects of corporate governance by advocating an integrated approach taking into account social, financial, and environmental interests. Coined “the triple bottom line,” or “people, profits, planet,” this approach calls for companies to move away from profit maximization when developing business strategies and focus on a broad range of stakeholders, such as customers, employees, suppliers, and the community.

The King Report made compliance with the triple bottom line voluntary. Most public companies, however, comply because external sources track and publish performance, providing a powerful incentive. For example, South Africa’s security exchange, the JSE, publishes a Social Responsibility Index that measures the triple bottom line performance of selected trading companies. Major South African companies, such as SABMiller, AngloGold Ashanti, and Mondi tout their social responsibility initiatives on their websites.

Legal developments, however, have created the possibility that the triple bottom line will become a legal mandate and a permanent part of the fiduciary duties of directors. Under the existing Companies Law, directors have a fiduciary duty to act in good faith for the “company as a whole.”

Historically, courts have interpreted “company as a whole” to mean acting in the best interests of the shareholders. There has, however, been a shift in public opinion towards the recognition of stakeholder interests, with academic commentators contending that director requirements to act in the interest of the company as a whole “cannot mean anything else nowadays, but a blend of all these [triple bottom line] interests.”

The shift has begun to affect the courts. In Minister of Water & Forestry v. Stilfontein Gold Mining Co., 2006 (5) SA 333 (W), four directors of a Gold Mining Company faced a contempt of court order. The Department of Water Affairs and Forestry directed the company to drain water from a mine to avert pollution and promote safe mining operations in the area. After a period of inaction, the Department filed a court order. The directors still did not comply, stating it was “financially impossible for the company to comply with the directives and remain financially viable.”

The Court held that the directors blatantly failed to comply with court orders and their conduct “flies in the face of everything recommended in the code of corporate practices and conduct recommended by the King Committee.” The Court further held, “the corporate community within South Africa has widely, and almost uniformly, accepted the findings and recommendations of the King Committee on Corporate Governance” and “[t]he King Committee, correctly . . . stressed that one of the characteristics of good corporate governance is social responsibility.”

The Court’s acknowledgement of the King Report and the triple bottom line shows potential for infusion into common law. It is too early to determine how this precedent will affect directors’ fiduciary duty, but it is clear that the Court believes the triple bottom line principles are relevant. Additionally, the legislature has recognized the importance of the principles and drafted some recommendations from the King Report into a forthcoming revised Companies Act. This Act is expected to be effective in 2010.