So what is the solution to the executive compensation problem?

One solution is a vigorous system of access.  If shareholders can elect their own representatives to the board, they will be able to break up the cozy system for approving CEO compensation.  Matters are moving forward on that front.

In addition, Section 13 of the Exchange Act should be amended by adding a new Section 13(m).  The provision could read:

(m)   It shall be unlawful for the board of directors of any issuer reporting under section 13(a) or 15(d) to pay compensation to any executive officer deemed excessive.

1.   Excessive shall include any compensation that is significantly greater than what is ordinary for companies in the same peer group (taking into account, among other factors, the published industry or line-of-business index of the company and companies whose equity securities are traded on the same exchange or are of comparable market capitalization) and where the board of directors does not provide a substantial justification for the compensation. 

2. Safe Harbor. Executive compensation shall be presumed not excessive where:

a. The board of directors has a compensation committee. The compensation committee, in its capacity as a committee of the board of directors, shall be directly responsible for the determination of the compensation paid to executive officers of the company.

i. Independence

1. In general

Each member of the compensation committee of the issuer shall be a member of the board of directors of the issuer, and shall otherwise be independent.

2. Criteria

In order to be considered to be independent for purposes of this paragraph, a member of an compensation committee of an issuer may not, other than in his or her capacity as a member of the compensation committee, the board of directors, or any other board committee—

i. accept any consulting, advisory, or other compensatory fee from the issuer;

ii. agrees in writing to serve on the board of directors for a period of not longer than six years;

iii. has no preexisting and significant personal relationship with any executive officer of the issuer or controlling shareholder at the time the director becomes a member of the compensation committee;

iv. receive directors fees that are material to the director unless the director agrees in writing to serve not more than six years as a director of the issuer; or

v. be an affiliated person of the issuer or any subsidiary thereof.

3.  Safe Harbor:   Any director who is nominated by a shareholder or shareholders owning not less than 2% of the voting shares of the issuer and is unaffiliated with the issuer shall be considered independent for purposes of this provision.

4.  In the case of a director who has served on the compensation committee and thereafter ceases to serve on the compensation committee for any reason, the Commission shall by rule require disclosure of the reasons for the cessation. 

b. Advisers

i. Each compensation committee shall have the authority to engage independent counsel and other advisers or consultants, as it determines necessary to carry out its duties.

ii. Any advisor or consultant engaged to provide advise on or otherwise opine on the fairness of the form or amount of executive compensation shall be independent. Independent shall mean any advisor or consultant, or any affiliate of the advisor or consultant, shall have no material financial relationship with the issuer beyond the relationship with the compensation committee of the board of directors.

iii. Each issuer shall provide for appropriate funding, as determined by the compensation committee, in its capacity as a committee of the board of directors, for the proper functioning of the committee, including the payment of compensation to any person hired under this section.

c.  Rulemaking and Exemptive Authority

The Commission may prescribe rules and regulations and define terms contained in this subsection as necessary or appropriate in the public interest or for the protection of investors. 

We will discuss the provisions in a subsequent post.  By amending Section 13, the provision would be limited to reporting companies and there would be no private right of action for violations.  It would be left to the Commission to enforce the provision.  This would add an additional layer of enforcement, beyond exclusive reliance on derivative suits, which is controlled by the Delaware courts.  At the same time, it does not go so far as to create a private right of action.

There is a serious executive compensation problem, something obvious from the daily reportage in the business press.  The problem as we have noted often, arises from the standards (or lack of standards) adopted by the Delaware courts in connection with the approval of executive compensation.  The process used by the Delaware courts effectively allows directors to ignore the interests of shareholders and encourages directors to act in the best interest of management.  The system replaces substantive review of compensation with meaningless process.  This is discussed at length in Returning Fairness to Executive Compensation.

So what is the solution?  The only practical solution is preemption.  Delaware cannot be counted on to implement meaningful governance requirements.  It is a small state that has an economic incentive to adodpt a pro-management approach to corporate governance.  Nowhere is this more clear than in connection with executive compensation.  In effect, the system in Delaware is compensation without limits.  This is what management wants; this is what would encourage companies to incorporate in Delaware. 

The compensation process needs to be federalized and the standards set by federal law and regulation.  Moreover, the requirements need to be applied to all public companies, not just those receiving bailout money.  With that in mind, the next post will propose a solution.

The Wall Street Journal reported the Obama administration has forced the resignation of General Motors CEO Rick Wagoner. Wagoner served as CEO since 2000, but has been with the company for 31 years. Although he has overseen GM during some of the company’s most turbulent times, GM’s stock price has fallen from $70 per share at his appointment in 2000 to $2.88 earlier today. Below is a table detailing the compensation Wagoner has received over his time as CEO. GM has yet to file its proxy statement for 2008.

The big news on Sunday was that the Obama Administration insisted on the removal of Rick Wagoner, the CEO at General Motors as a precondition for any additional bailout money.  As the article summarized:

• Mr. Wagoner has been CEO since 2000 and has managed the company through some of its most difficult moments. The company has not logged a profit since 2004, reporting losses since then of $82 billion, and it nearly ran out of money at the end of 2008 before the Treasury Department provided emergency loans. GM's stock was trading above $70 when Mr. Wagoner took over as CEO in June of 2000. Shares closed last week trading at $3.62, placing the company's market capitalization at $2.21 billion.

The degree to which these circumstances can be blamed on Wagoner is not clear (turning a huge barge like General Motors is not a simple matter).  But it seemed clear that as General Motors tottered on the edge of bankruptcy and the Company asked for additional government money, a change in management was in order.  As usual, the salient question is where was the board of directors? 

As the announcement was being made that the US government had to step in and do the board's job by insisting on regime change, the board of Peugeot Citroën did its job and removed its CEO.

In addition to demonstrating continued weakness in the system of corporate governance in the United States, the act demonstrates the unfortunate ad hoc practice still taking place in the federal government with respect to these corporate governance problems.  Congress wants to take away the bonuses paid by AIG, the Obama Administration wants to replace management.  These are tasks that rest with the board.  It is not useful to interfere with board duties on a case by case basis.  This entire problem screams for systemic solutions, none of which are apparently under serious consideration.

Later in the week we will propose a legislative solution, at least with respect to the executive compensation problem.  It is time to move beyond an ad hoc approach and beyond temporary reform that is limited only to companies taking public funds.

On February 10, 2009, Vice Chancellor Leo E. Strine denied motions to dismiss filed by Maurice Greenberg, AIG’s CEO and Chairman since the late 1960s, and members of his “Inner Circle.” The claims against the AIG executives assert breach of the duty of loyalty and breach of other fiduciary duties. AIG itself asserted breach of fiduciary duty and indemnification claims against Greenberg and Howard I. Smith, former AIG director and CFO. American International Group, Inc., Consolidated Derivative Litigation; AIG, Inc. v. Greenberg, et al., 2009 Del. Ch. LEXIS 15 (Feb. 10, 2009).

In addition, AIG stockholders filed derivative claims against Edward E. Matthews, long-time board member and former Vice Chairman of Investments and Financial Services; and Thomas R. Tizzio, former director, Senior Vice Chairman of General Insurance, and member of AIG’s reinsurance security committee.

The First Amended Combined Complaint, which includes both AIG and stockholder claims, alleges that Maurice Greenberg and members of his Inner Circle deceived investors through a series of deliberate actions that included:

• Carrying out a fraudulent $500 million reinsurance transaction with Gen Re Corporation to overstate loss reserves.
• Using secret offshore subsidiaries to hide AIG losses.
• Blatantly misstating accounts, including making “topside adjustments” to AIG’s consolidated financial statements.
• Failing to correct well-documented accounting problems in AIG’s Domestic Brokerage Group.
• Hiding AIG’s controversial “life settlement” investments; namely, the bulk purchase of insurance policies owned by the sick and elderly in the hope that the original policy holders will die sooner rather than later and result in a profit for AIG.
• Avoiding taxes by claiming that workers’ compensation policies were other types of insurance.
• Engaging in “covered calls” to recognize investment gains without paying capital gains taxes.
• Conspiring with other companies to rig municipal derivative and general insurance markets- among those companies was the insurance brokerage Marsh & McLennan run by Greenberg’s son.
• Using their own “expertise” in balance sheet manipulation and special purpose entities to help other companies overstate their own financial results, for a substantial fee.

These misdeeds resulted in the restatement of years of financials and a $3.5 billion reduction in stockholder equity. AIG has also paid over $1.6 billion in fines, while litigation and regulatory proceedings will hobble the company into the foreseeable future.

V.C. Strine determined that each of the inner circle defendants was directly responsible for business units involved in the pervasive misconduct alleged in the Complaint and that the pled facts supported the assertion that each had personal knowledge of the wrongdoing. Moreover, the court found that misconduct was not isolated to certain areas of the company, but instead permeated the corporation's way of doing business.

Further supporting the denial of the motion to dismiss were the equity-heavy compensation packages that each defendant received and the world-class financial sophistication that each possessed. Thus, the defendants were motivated to ensure a high trading price for AIG stock and to use their own expertise to generate illicit profits.

AIG’s auditors, PricewaterhouseCooper LLP (“PWC”), were also defendants. The court, however, applied New York law, the location of AIG’s headquarters and were PWC’s allegedly wrongful conduct occurred. New York law immunizes an auditor’s breach of a professional duty of care where it fails to discover a fraud committed by a corporation’s top insiders. V.C. Strine stressed the outcome would have been different under Delaware law.

In a separate action, Bloomberg reports that Greenberg filed his own suit against AIG on March 2, 2009, alleging that the company’s “material misrepresentations and omissions” caused him to acquire AIG shares in his deferred compensation profit participation plan at an inflated valued.

The primary materials discussed here can be found on the DU Corporate Governance website.

The US Government owns 80% of the equity of AIG but if standard rules apply, it cannot successfully sue to get back the hundreds of millions of bonuses paid out to employees.  This is the point made by Carl Icahn in a recent editorial in the Sunday NYT.  He rightfully makes the point that any effort by shareholders to change the board of directors will ultimately founder on the shoals of cost and time.  The editorial mostly argues for shareholder access to the proxy statement for nominees, something that will reduce the costs associated with a proxy solicitation. 

Mentioned but less discussed are the limits on bringing a law suit against the board.  As the editorial notes: 

• Sadly, though, under American corporate law share ownership does not count for much. Mr. Frank might be surprised to learn that a lawsuit would have almost no chance of success in court, even for a majority shareholder like the government. A.I.G. would most likely argue that the oft-cited “business judgment” rule gives management wide latitude to set compensation without shareholder interference.

True enough but the problem is far deeper and more invidious.  AIG is incorprated in Delaware.  Actually what management would argue is that shareholders did not make demand and that there was no basis for demand excusal.  Demand excusal merely requires management only to show a board with a majority of "independent" directors. 

Delaware uses a definition of independent that in fact does not ensure that the board is independent at all (for more on this take a look at Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).  In most instances, director independence will only be lost if the directors have an economic interest in the decision they are making.  So long as the bonuses were paid to others, the directors will be treated as independent. 

And, in fact, it would have been OK if the directors authorized bonuses for some of the directors.  Delaware merely requires a majority of independent directors.  Thus, even if the board authorized hundreds of millions of dollars in bonuses and paid some of those millions to directors on the board, the Delaware courts would dismiss the case, acting as if the board was a neutral decision making body.

The effect of this approach is to have matters turn on the status of the directors, not on the underlying behavior.  It involves the fiction that boards with a majority of interested directors are nonetheless neutral decision makers.  As a result, the Delaware courts use these procedural mechanisms from ever letting shareholders uncover the true facts of what happened.

There are many many problems with the Delaware model of corporate governance.  We have noted that Delaware applies the business judgment rule to duty of loyalty decisions (read executive compensation) when the board consists of a majority of independent directors.  The approach entirely ignores the fact that this allows the interested influence to remain in the decision making process.  Moreover, as we have noted time and time again, the Delaware courts use a number of devices to pre-terminate the exploration of director independence, often not letting the allegations get past a motion to dismiss.  For a more complete discussion of these issues, read Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  The result is that independent boards are often not independent at all.

We have likewise noted that directors have an economic incentive to do what the CEO wants.  Sitting on the board of a public company can be an incredibly lucrative proposition.  In 2007, the directors of Goldman Sachs received around $700,000 in total compensation.  The Delaware courts, however, have an almost categorical rule that fees are not taken into account in determining whether directors are independent.  Because fees can clearly be material, the only analytically defensible basis for the approach is that the CEO has no ability to terminate the material income stream.  (The Delaware Courts use less definsible justifications including the argument that applying the materiality analysis would result in the elimination of "regular folk" from the board). 

While legally true (only shareholders can fire directors), in fact it is practically incorrect.  The best way to lose the comfortable sinecure of a board seat is to not be renominated.  The best way to not be renominated is to irritate the CEO.

With that in mind, we turn to In re: Affiliated Computer Services, Inc. Shareholder Litigation, 2009 Del. Ch. LEXIS 35 (Del. Ch. Feb. 6, 2009).   The case is a relatively straightforward demand excusal case where, as usual, shareholders had their case dismissed for failing to make demand.  The Chancery Court concluded that the board in fact contained a majority of independent directors.

The more interesting thing is the facts.  It seems that the outside directors irritated the CEO.  The consequence?  He insisted that they all resign.  As the opinion noted:  "That same day, Deason (by letter from a New York lawyer purporting to act as counsel to ACS, but delivered through Deason's personal counsel) demanded the immediate resignation of all of the outside directors of ACS, whom the letter accused of various breaches of fiduciary duty, and named four candidates to replace them."  Two days later, the board held a special meeting.  What did the directors do?  Resign, conditioned upon reviewing the candidates proposed by the CEO.

On November 1, 2007, at another special meeting of the Board of Directors, the independent directors informed Deason and the management directors that, because of Deason's and management's conduct, they felt compelled to resign from the Board and not to stand for re-election. However, to ensure that their successors were truly independent and to protect the Company's minority shareholders, the independent directors also stated during the November 1 special meeting that they were prepared, prior to their resignation, to immediately begin the process of reviewing Deason's suggested nominees and any additional nominees proposed by the Company's shareholders. 

Whatever the significance of the assorted allegations of misconduct and breach of fiduciary duty, one thing was clear.  The CEO wanted the directors out and they left.  It is a rare public example of what happens to independent directors when they no longer have the confidence of the CEO. 

While the public nature of this fracas is unusual, the takeaway is widely understood.  The CEO can effectively terminate a director, albeit at the next meeting when he or she is not reelected.  As a result, the CEO can terminate the fees.  Fees, therefore, ought to be tested under the same materiality test as any other income stream received from the company.  But this being Delaware,  fees are simply ignored in the determination of independence.  

Predicting what will happen to a cert petition is not always easy.  This case has a couple of things going for it.  Maureen Mahoney is well known to the justices and anything she authors will likely get a serious examination.  Likewise, the advocacy of Judge McConnell on the Tenth Circuit, a smart and conservative judge, will likewise cause some on the Court to pause over the case.  The closeness of the en banc (it was, after all, a 5-4 decision) also helps.  Finally, the case involves Rule 10b-5 and the Supreme Court expressed a willingness in Stoneridge to put an end to any more expansion of the antifraud provision.  The Court could decide that this case presents another opportunity to implement that agenda.

Weighing in against the granting of certiorari is that the case really doesn't raise particularly important legal issues.  It mostly turns on the facts.  The real question is not about the standard of materialty for internal projections but whether Nacchio had in his possession facts that indicated his projections to the market no longer had a reasonable basis.   A jury found that he did.  While it is possible to argue the facts either way (that the information was too uncertain, that the percentage of the shortfall was not enough to cross the materiality threshold), the jury found otherwise.  For the Supreme Court to come out in Nacchio's favor, it will have to find that the information known to Nacchio was immaterial as a matter of law.  This is unlikely.

Our prediction:  Cert denied.

Judge Nottingham continues to be the additional judge in the decision making process.  After laying out a series of legal arguments about the reasons for reversal, Nacchio's cert petition takes direct aim at the trial judge.  As the brief notes:

• As the en banc dissenters explained in detail, the majority mischaracterized the district court’s decision, ignored settled law, and ducked meritorious issues to gloss over obviously prejudicial errors by a district judge whose “sense of fairness toward this defendant” was very much in doubt, App.92a (McConnell, J., dissenting), and who openly displayed ethnic bias against the defendant and his counsel and recently resigned in disgrace in a lurid prostitution and obstruction of justice scandal.

While it seems fair game to argue that in a close case on the evidentiary issue, there was some evidence of unfairness towards the Defendant, the brief goes well beyond that.  It suggests that the Court ought to take a close look at the matter because of the moral turpitude of the trial judge. 

It is an interesting approach and one that ordinarily would be high risk.  Judges do not take kindly to aspersions cast on other judges.  Nonetheless, with someone as experienced in Supreme Court behavior as Maureen Mahoney, she must be thinking that in this case, the reference to the trial judge's out of the courtroom peccadilloes will attract the eye of some justices, perhaps those with an accentuated sense of morality and self righteousness.  One can only guess who that would be.

Alerted by Steve Bainbridge, we have become aware that the Delaware Supreme Court has issued the much awaited decision in Lyondell Chemical.  The Chancery Court caused a ruckus by denying a motion for summary judgment on whether the board acted in bad faith (and thereby leaving the board unprotected by the waiver of liability provision)  by failing to fulfill its duties under Revlon. 

The case caused an outcry, particularly by those who view waiver of liability provisions as sacrosanct.  Suddenly they looked a little bit less sacrosanct.  These provisions are ubiquitous and have all but rendered the duty of care meaningless.  Those who view the provisions favorably often claim that they are a product of the market, a product of negotiations between management and shareholders.  They are anything but.  They are more like a contract of adhesion than an agreed upon term between owners and managers.  This is discussed at length in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom. 

In this particular case, it hardly mattered that the Chancery Court denied the motion for summary judgment.  The court all but invited the defendants to file another motion for summary judgment and all but admitted that he would grant it.  Indeed, the tone of the Vice Chancellor's opinion was one of pique, viewing the outcome as forced on him by the failings of the defendants.  In other words, the plaintiff was going to lose when the defendants refiled.

As a result, the Supreme Court's decision to reverse the denial of summary judgment merely finished the case a little bit earlier.  Indeed, by ending it now, the Court has avoided forcing the plaintiff to engage in more discovery and respond to more briefs and then lose the case.  This was a good result for plaintiff.

The weakness in the analysis was never the application of the waiver of liability provision.  It was the treatment of the allegation that the board lacked independence.  Plaintiffs alleged that the board was interested in the transaction because of huge payouts received by directors as a result of the merger and that the transaction ought to be tested under the duty of loyalty.  The lower court's decision?  Ignore the conflict and apply the duty of care.  That is the travesty of the decision.  It illustrates the meaningless of the duty of loyalty in Delaware.  At least the Supreme Court had the sensitivity to write in a gender neutral manner.

As usual, some of the operative documents (from the Chancery Court proceeding) are on file at the DU Corporate Governance web site.

The cert petition takes the position that, based upon the 10th Circuit's holding, insiders "cannot buy or sell company shares ever."

This is another example of hyperbole masquerading as analysis. The sentence is only potentially correct if in fact an insider always knows inside information and cannot disclose the inside information to the public.

Nacchio was convicted of having inside information. The information was internal data suggesting that the forecasts he had issued to the public were no longer valid. Had Nacchio wanted to trade, he merely needed to tell this to the market. Had he disclosed that there was doubt about the validity of the external forecasts, he likely would have been able to trade (assuming there was nothing else going on that qualified as material).

Moreover, once disclosure occurred, Nacchio would have been able to sell shares with impunity. While insiders often come into contact with inside information that interferes with the ability to trade, the Commission has addressed this by allowing insiders to put in place non-discretionary trading plans under Rule 10b5-1. Had Nacchio disclosed that there was internal information suggesting the forecasts were no longer valid and then put in place a 10b5-1 plan, he would have been able to sell as many shares as the plan permitted.

The brief for certiorari also trots out the position that the 10th Circuit decision will result in less disclosure, discouraging the use of projections.

• It will also seriously discourage companies from issuing projections at all. Nacchio’s inside information was supposedly “material” here only because Qwest had first made public projections. Supra 13, 20-21. If making a projection can render internal forecasts and interim results “material,” and subject executives to criminal liability, without reasonable safeguards like those applied in Shaw and Wielgos, companies will not do it.

There are several responses to this. 

First, as most securities lawyers already know, the issuance of projections is already fraught with risk.  Projections must have a reasonable basis and, when proven wrong, are open to allegations of fraud.  Once issued, most securities lawyers likewise know that projections may require updating if ultimately they cease to be accurate.  That there may be liability for issuing projections and then trading on information that suggests the projections are no longer valid is already widely known and unlikely to be altered by anything in the Nacchio decision.

Second, the argument that companies may restrict disclosure is an old one, soundly rejected by the Supreme Court in Basic.  As the Court noted in that case:

• The final justification offered in support of the agreement-in-principle test seems to be directed solely at the comfort of corporate managers. A bright-line rule indeed is easier to follow than a standard that requires the exercise of judgment in the light of all the circumstances. But ease of application alone is not an excuse for ignoring the purposes of the securities acts and Congress' policy decisions.

Basic, 485 US at 236.

Finally, it is a strange argument to suggest that it was the internal forecasts that subjected Nacchio to criminal liability.  It was his trading that did that.  Had he not traded or traded after the information was disclosed, there would have been no criminal liability.

The main substantive argument is presented in a confusing fashion.  According to the brief:

• The Tenth Circuit’s materiality analysis conflicts with several other circuits, which have held that internal predictions and interim operating results are immaterial as a matter of law unless they establish a very strong likelihood that the company’s eventual reported performance will be substantially below what the market is expecting.

The first observation about the question is that it conflates several issues.  Internal predictions and interim operating results are entirely different types of information.  One is soft (predictions) and the other is hard (actual operating results).  The tests for each are different and cannot be conflated.  Moreover, the issue with interim operating results ordinarily centers not on materiality but on the duty do disclose.  When must companies, in between quarterly reports, disclose changes in interim financial results.  Finally, while the issue is pitched as the materiality of internal forecasts, the government will likely argue that what Nacchio knew was hard information that alerted existing, public forecasts.  In other words, the government will argue that this is not about internal forecasts at all.

Nonetheless, the brief argues that the standards for assessing the materiality of "predictive information" is murky and unclear and requires clarification.  The brief seeks clarity.  At the same time, the standard adopted by the Court ought to be high, with the brief contending that the "extreme departure" standard in the First Circuit is the appropriate one.

The case relies mostly on language from Shaw v. Digitial, 82 F.3d 1194, 1201-02 (1st Cir. 1996), a somewhat dated First Circuit case.  According to the brief, "[t]he First Circuit held that “soft” information like internal predictions is always immaterial."  Soft information is generally a category of information that encompasses projections and appraisals. 

It is a relatively extraordinary statement since most would recongize that in fact projections are extraordinarily material to those trading in the market.  Indeed, the very importance of the information is what makes the category of information such a difficult and sensitive disclose issue.  Given that, we povide the language from footnote 21, which does not say that soft information is always immaterial.

• 21 It bears reemphasizing that the plaintiffs' claim is sustainable only to the extent it relates to the nondisclosure of "hard" material information, as opposed to "soft" information in the nature of projections. See In re Verifone Sec. Litig., 784 F. Supp. 1471, 1482 (N.D. Cal. 1992), aff'd, 11 F.3d 865 (9th Cir. 1993); see generally 2 Loss & Seligman, supra, at 622 n.66. Although DEC had no obligation to disclose a forecast of results for the quarter in progress at the time of the offering, it was permitted to do so. If it had chosen to disclose such a forward-looking projection, and if the projection was made with reasonable basis and in good faith, it would have been protected by the SEC's safe harbor provision. See SEC Rule 175, 17 C.F.R. § 230.175; see also Arazie v. Mullane, 2 F.3d 1456, 1468 (7th Cir. 1993); Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995);  cf. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, § 102, 109 Stat. 737, 749-55 (creating expanded statutory protection for forward-looking statements). Furthermore, had DEC chosen to disclose projected results, such a disclosure (if reasonable) could very well have rendered the "hard" interim information underlying the projection immaterial as a matter of fact or of law, unless the market would have had some reason to discredit the projection, thereby creating a substantial likelihood that a reasonable investor might still have found the underlying information important to the total mix of information available.

The footnote arose in the context of whether a company was required to disclose projections in a shelf registration statement and amounts to nothing more than the general view that, in general, there is no obligation to disclose internal projections in the first instance.  It does not deal with a situation where the company discloses a projection then obtains internal information suggesting that the projection is incorrect. 

Moreover, the remainder of the discussion of Shaw in the brief, oddly, does not involve projections at all but, as the brief notes, the standard for the disclosure of “'hard' intra-quarterly operating results the company."  In other words, it addresses when changes in earnings must be disclosed in between quarterly reports, not the standard for soft information. 

There is a split in the circuit.  Some courts have applied a "substantial certainty" standard in determining the materiality of projections, a standard reminiscent of the "agreement in principle standard" for merger negotiations that was done away with in Basic. But this case is not about when projections are material enough that non-disclosure would make another statement inaccurate or incomplete under the anti-fraud rules.  This case involves the standard for information known to an insider that suggests an existing, already disclosed projection is now inaccurate.  As a result, these cases do not help Defendant.

The oddest position taken in the brief is that had Nacchio disclosed internal projections, he might have been liable.

• Finally, in at least the Seventh and Ninth Circuits an internal projection cannot be released unless it is “reasonably certain,” a standard plainly not met here.  The Tenth Circuit is sending Nacchio to prison for selling stock without disclosing conflicting predictions (worries, really) by his employees that other circuits would regard as misleading and punish him for disclosing. This is terribly unfair, particularly when criminal conviction requires proof that the defendant knew the information was material, App.147a, and vividly illustrates the depth of confusion in the lower courts.

There are so many things to say about this statement.  The brief cites two cases, one from 1980 and one from 1981.  That alone should suggest that the proposition warrants careful examination.  Both, for example, predate Basic, the Supreme Court's most relevant exposition of materiality.  In that case, the Supreme Court expressly rejected this rational.  See Basic, 485 U.S. at 234 ("Disclosure, and not paternalistic withholding of accurate information, is the policy chosen and expressed by Congress.").

Second, the cases hardly provide meaningful support for the proposition.  The primary case, Panter v. Marshall Field & Co., 646 F.2d 271, 292 (7th Cir. 1981), contained one critical sentence in what would have to be described as dicta.  See Id.  ("However, projections, estimates, and other information must be reasonably certain before management may release them to the public.").  The case was not dealing with liability for disclosure but liability for non-disclosure.  In other words, the sentence was at best an imprecisely drafted phrase indicating that internal projections did not have to be disclosed unless reasonably certain, not a sentence imposing on a company liability for disclosing such information. 

Third, and most importantly, the proposition conflicts with basic principles of securities laws.  The federal securities laws are built around the notion of accurate and complete disclosure, not merit review.  The cert petition suggests that there are some categories of information that are absolutely prohibited from disclosure.  This is simply wrong.  Companies can disclose information, even if highly tentative and speculative (they do it all the time) if accurately characterized.  Thus, if projections were disclosed that were not "substantially certain," a company could disclose the information but make very clear the tentative and preliminary nature of the information.

In other words, in this case, when Nacchio had repeatedly made forecasts to the market, the brief suggests that once he learned that the forecasts might not be achievable, the company might have been liable had it disclosed this negative information to the market.  Surely no serious securities lawyer would tell a client that it would be liable for revealing to the market that published forecasts no longer might be valid, even if the basis was tentative.

Finally, the approach entirely ignores the safe harbor for projections inserted into the PSLRA. Under the Act, there will not be liablility for inaccurate projections where the statement is:

• identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement, . . . or . . . the plaintiff fail to prove that the forward-looking statement . . . [if made on behalf of a business entity by or with the approval of an executive officer was] made . . . with actual knowledge by that officer that the statement was false or misleading.

15 USC 78u-5(c)(1).  In other words, the provision codifies the traditional approach by insulating the  disclosure of projections from liability (unless made with "actual knowledge" that they were false) so long as they are accompanied by meaningful cautionary language.

The brief raises some interesting issues involving the interpretation of the federal securities laws.  But this argument takes away from the entire credibility of the brief.

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

Joe Nacchio has filed a cert petition with the US Supreme Court.  In it, he raises three issues.  These include:

• 1. Whether the defendant is entitled to acquittal or a new trial because the Tenth Circuit, in conflict with the standards applied in other circuits, erred by upholding the jury instructions bearing on the materiality of the type of information at issue, and by holding that there was sufficient evidence that the defendant failed to disclose material information and knew it.

• 2. Whether the judgment must be reversed and remanded for a new trial because the Tenth Circuit approved the use of impermissible procedures for the exclusion of expert testimony under Rule 702 that conflict with decisions of other circuits.

• 3. Whether the Tenth Circuit’s decision should be summarily reversed because it misapplied decisions of this Court, mischaracterized the district court’s reasoning, failed to resolve all the issues presented, and held that Nacchio failed to address an issue that was a principal focus of his brief.

We will take a look at this petition, mostly by examining the first issue.  The other two have been examined in great detail in earlier posts in connection with the various 10th Circuit decisions.

We at this Blog are no experts on cert petitions and Maureen Mahoney is.  Nonetheless, we question some of the strategy.  The brief in a number of places makes dramatic predictions.  If the 10th Circuit decision is upheld, officers and directors will never be able to trade.  That Nacchio (or Qwest) would have been liable had they disclosed the internal data suggesting that the external forecasts were wrong. 

Both of these positions border on sophistry.  While there are technical arguments for the positions, it is hard to believe that many trained securities lawyers would agree with either.  They seem designed to promote a sense of Armageddon in an effort to attract attention to the brief and encourage the Court to take the case.  Fair enough.  But such positions also detract from credibility.  Having said that, Mahoney's strategy has caught us flat footed before (her one sentence in the appellate brief asking for a new judge, for example).  Perhaps it will happen again.  On with the posts.   

The cert petition, like all important documents in this case, is posted on the DU Corporate Governance web site.

In re Parmalat Sec. Litig. , 2009 WL 179920 (S.D.N.Y. Jan., 2009).

Paramalat SpA collapsed in 2003 after the discovery of immense understatements of debt and overstatements of assets. The international extent of the fraud has garnered a lot of attention from accounting firms worldwide, with the latest U.S. ruling causing particular concern.

Plaintiffs filed a derivative suit under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Deloitte Touche Tohmatsu (DTT) alleging vicarious liability for fraud committed by member firm Deloitte Italy. The District Court for the Southern District of New York denied plaintiff’s motion for summary judgment under both the respondeat superior claim and the joint and several liability claim.

The court first rejected defendant’s contention that Stoneridge foreclosed secondary liability for Exchange Act claims under common law. The court related that Stoneridge did not foreclose the principle of respondeat superior, and principals may be held expressly liable for violations of Section 10(b) by their agents.

The court then addressed whether DTT was in fact a principal of Deloitte Italy by analyzing the elements of control. The court found several factors that mitigated in favor of substantial control. Those factors included but are not limited to DTT requiring 1) adherence to policies, and protocol regarding professional standards and methodology; 2) specific methods and procedures for conducting audits; 3) member firms to sign a license agreement mandating compliance with quality standards; 4) use of the DTT name; and 5) authority to transfer employees from one member firm to another, without the transferring firm’s permission. Finally, there was evidence that DTT exercised authority specifically in the Paramalat engagement.

The court then denied the motion for summary judgment under both the theory of respondeat superior and the issue of control. The court stated that DTT’s “general structure”—encompassing its authority over member firms—accompanied by its specific use of authority in this particular engagement, presented genuine issues of material fact as to whether Deloitte Italy was an agent of DTT leaving the issue of respondeat superior for the fact-finder. Turning again to the issue of control, the court rejected the contention that DTT did not control Deloitte Italy under the language of the statute. The court rejected this argument stating that the Section 20(a) does not require control of a particular violating transaction, but only control of a person or entity liable under the chapter.

DTT then proffered good faith as an affirmative defense. The court recognized that while there may not be evidence that DTT had reason to know of the fraud, or recklessly disregarded it, this did not demonstrate good faith. The court noted that this assertion neglects to encompass the possibility that DTT was willfully blind to the violations. Additionally, while DTT argued that appropriate compliance review systems were in place, the court stated that this is only a factor in evaluating good faith, but is not dispositive. The court further held without evidence of how systems were implemented during the time in question, the court could not find good faith.

The defendants next contended that DT-US did not control DTT and is therefore entitled to summary judgment. To this, plaintiffs argued that 1) many DT-US partners occupy important management positions at DTT; 2) that member firms, including DTT depend of DT-US for funding; and 3) there are specific instances where DT-US played a key role in DTT’s decision-making. The court held that each of these factors alone is not dispositive, but cumulatively show a genuine issue of fact as to DT-US’ control of DTT. The court also rejected DT-US’ assertion of good faith because the evidence does not sufficiently address willful blindness. Arguments that Copeland, CEO of DT-US and DTT were not in control or acted in good faith where quickly rejected based on his status in the company and a lack of evidence for the affirmative defense.

Finally, the defendants contend that they were not joint and severally liable because Section 21D(f)(2)(A) of the PSLRA limits joint and several liability to knowing violations of the securities laws, not merely reckless violations. The court rejected this argument based on legislative history.

The implication that accounting firms may be held liable for actions by their foreign affiliate may be welcome news to investors, but is sending shockwaves through the accounting world.

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

Much of the current criticism about executive compensation has focused on the bonuses paid by Merrill Lynch and AIG.  They are in the eye of the storm because they have accepted public money (Merrill indirectly when Bank of America received government money to facilitate the merger).  

But, as we have long argued, the problem of executive compensation goes way beyond companies receiving public money.  The central problem is that Delaware imposed no meaningful standards in connection with the approval of executive compensation.  The courts have all but eliminated fairness from the compensation analysis (see Returning Fairness to Executive Compensation).

An article in the WSJ supports this proposition.  As the Journal reports in the table below, there are plenty of CEOs who are well paid despite rapidly declining stock prices.  Stock prices are, of course, not the only measure of performance.  Nor are the amounts paid commensurate with many of the excesses witnessed in recent years.  Finally, the article contained some explanations for the amount paid that might truly mean the CEOs were paid in an amount commensurate with the services provided.

The problem is that we cannot be sure.  As Disney showed, directors making compensation decisions need not be particularly well informed when the standard is the duty of care.  Delaware courts apply the duty of care standard even to executive compensation paid to officers who sit on the board (and therefore are in a position to influence the compensation process).  In other words, under the Delaware approach, directors determining compensation for fellow directors are essentially insulated from liability for almost any amount paid.  This system produces what any system without standards would produce:  compensation in amounts unrelated to the services provided.

It is not a problem limited to companies receiving federal monies.  If the government does not provide a systemic solution, the problem of executive compensation will continued, with the current limits a mere hiccup, that will have no permanent affect on behavior in the long term.

We have assiduously kept the Churchill posts off the home page of the Race to the Bottom since they do not involve issues of corporate governance.  Nonetheless, we break our rule this once to note for anyone interested an interview for Colorado Matters on the coverage of the Churchill trial by the Race to the Bottom.  The interview can be found here.

We are discussing the loss causation analysis in In re Williams Securities Litigation.

This case invovles a spin off by The Williams Companies, Inc. (“WMB”) of its Communications Subsidiary (Subsidiary). Plaintiff essentially alleged that WMB had misrepresented the adequacy of the Subsidiary's capital at the time of the spin off.

Plaintiffs' expert provided other scenarios that attempted to show the necessary causation between the share prices and the fraud.  The court dismissed these as well.

This is a case where the courts accepted the presence of material mistatements about the adequacy of the Subsidiary's capital to meet its business needs.  While officers of the parent were speaking in glowing terms about the Subsidiary's prospects, the internal communciations told a bit of a different story. 

• Internally, however, there seems to have been much more pessimism about the continuing availability of enough capital to satisfy WCG’s appetite. Officers were warning that WCG was “still approximately $800 million under-funded through the end of 2001,” and that WCG did not have “any choice at this point other than going on a rigid, essential need only capital diet while [it] restore[d] capital capacity through operating performance and selling non core assets.”

It belies common sense that these types of statements wouldn't have influenced shareholders and share prices.  Thus, this is not a close call where the statement invovled a relatively insignificant part of the company's business and, in fact, the representations may not have affected share prices.

Given this situation, the burden of showing an impact on share prices shouldn't have been a particularly high bar.  Yet that is exactly what the 10th Circuit imposed.  Clearly the court has indicated a distaste for a leakage approach to showing causation.  The opinion made it more or less made clear that injured shareholders would have a tough time showing causation unless they could point to a specific disclosure (or materialization of a concealed risk) and a specific drop in share prices.  The idea that share prices could drop gradually as the market figures out the fraud will not find much favor in those courts that follow the reasoning in Williams.  

The impact of Williams is to make it harder to bring meritorious fraud suits.  It is an approach not required by the antifraud provisions and not required by Dura.  It is consistent with the position of this Blog that the new administration may discover that the biggest obstacle to reform lies not in Congress but in the courts.

We have some primary materials posted on the DU Corporate Governance web site.

We are discussing the loss causation analysis in In re Williams Securities Litigation.

This case involved a spin off by The Williams Companies, Inc. (“WMB”) of its Communications Subsidiary (Subsidiary).  Plaintiff essentially alleged that WMB had misrepresented the adequacy of the Subsidiary's capital at the time of the spin off. 

In a post-Dura era, loss causation is a relatively straight forward process.  In most cases, plaintiffs pinpoint the moment at which the market became aware of the fraud, usually when the company discloses the truth, and shows a resulting drop in share prices.  In some cases, the truth makes its way into the market over several days or through several announcements. Either way, the market learns about the fraud in a relatively identifiable fashion. Nothing in Dura prevents the use of this type of information in showing loss causation.

With respect to Williams, however, the loss causation issue was more complex.  The issue was the inadequacy of the Subsidiary's capitalization.  There was not one day or one moment where the market learned of the misstatements.  Instead, the market would likely learn gradually (as evidence of a company's financial problems slowly surface) and would likely only learn the extent of the misstatement over time.  Moreover, to the extent the Subsidiary raised any capital during the relevant period, it would postpone the day of reckoning.

The court in Williams, however, made it clear that the plaintiffs could not just allege that share prices had fallen as a result of the fraud.  Instead, they had to identify the ways in which the truth was revealed.

• To satisfy the requirements of Dura, however, any theory--even a leakage theory that posits a gradual exposure of the fraud rather than a full and immediate disclosure--will have to show some mechanism for how the truth was revealed. A plaintiff cannot simply state that the market had learned the truth by a certain date and, because the learning was a gradual process, attribute all prior losses to the revelation of the fraud. The inability to point to a single corrective disclosure does not relieve the plaintiff of showing how the truth was revealed; he cannot say, "Well, the market must have known." (citation omitted)

Somehow, in other words, the truth had to get into the market.  To meet this burden, the expert selected by plaintiffs presented a series of scenarios that could explain the losses attributable to the disclosure of the fraud.  The strongest was labeled the "leakage" scenario.  The theory posited that no single disclosure resulted in the market learning about the fraud but instead it occurred as the market gradually became aware of the true financial condition and prospects of the Subsidiary during the Class Period.

As part of that scenario, the expert submitted 1300 pages of articles, reports, and filings that he used to show the gradual disclosure of the corrective information to the market.  Moreover, the expert testified that "tiny corrective disclosures occurred each and every day of the class period."

The court characterized most of the articles as news of general applicability to the entire industry or "an upbeat rather than negative statement about WCG."  Nonetheless, the court conceded that the reports contained negative information.  In a relatively dismissive fashion, the court concluded that the negative information was not enough to show that corrective disclosure had leaked into the market.

• As it would be difficult to characterize an announcement that contained no negative information about WCG as revelatory of the truth about WCG's grim prospects, we cannot say that the district court abused its discretion in rejecting the theory that these disclosures leaked the truth to the market.

The sentence is not analysis.  There are no examples of the negative information given in the opinion.  To the extent the negative information shows that the market is figuring out the inadequate capitalisation of the Subsidiary, it demonstrates the validity of the leakage approach.  Instead, the court simply ignored the information. 

The court tried to circumvent the approach by focusing on one sentence in the expert report stating that "Plaintiffs’ losses were caused by the materialization of the concealed risks, specifically that WCG’s assets were overstated, that WCG was in default of its debt covenants, and that there was significant uncertainty about WCG’s ability to continue as a going concern.”  To the court, this meant that the losses didn't result from leakage at all but from the actual materialization of the concealed risk (in the form of things like the default on debt covenants, and so on).  But in fact, this is a backdoor attempt by the court to require that the plaintiff identify a specific event and a specific drop in share prices.  As the court reasoned:

• While the truth could be revealed by the actual materialization of the concealed risk rather than by a public disclosure that the risk exists, see Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 173 (2d Cir. 2005) (loss can be caused by “materialization of the concealed risk”), any theory of loss causation would still have to identify when the materialization occurred and link it to a  corresponding loss.

But the notion of leakage is built around gradual disclosure, gradual revelation.  The market may know at some point that the earlier, optimistic statements were not entirely true, but for the truth to be fully reflected in share prices, the market must know the extent to which the false statements misrepresented the company's capital position.  Short of the company coming out with a blunt announcement about its deplorable financial condition, this is the type of information that the market will only gradually figure out and only gradually reflect in share prices.

Indeed, later in the opinion, the court all but admitted that the information had already leaked to the market.  In dismissing the claim that the corrective information made it into the market on specified days (an alternative scenario) such as the date the Subsidiary announced that it would delay filing its periodic reports.  As the court noted:

• While an announcement that WCG could be in default on its debt obligations might fall within the zone of risk obfuscated by the alleged misrepresentations, the district court questioned whether Dr. Nye had any basis for saying that the January 29 announcement revealed new information to the market such that the disclosure can be said to have caused that day’s loss. The fact that Milberg Weiss was able to assemble a complaint that very day and identify the very misrepresentations in question would suggest that the marketalready had at least some knowledge of the fraud.

In other words, the market knew.  Presumably, one way or another, the Subsidiary told it, through each statement that indicated a problem paying bills or raising capital.  In other words, that comment, in another part of the opinion, more or less confirmed the leakage scenario. 

In the end, the real objection to the expert appears to be his failure to factor out, to the satisfaction of the court, the other events that may have resulted in a drop in share prices. 

• WCG’s share price fell from $28.50 to $1.63 during that period, and while Dr. Nye could not explain how the market learned of the fraud over that year-and-a-half, he claimed that the decline must have resulted from its revelation and not from the “tangle of factors” that affect a company’s stock price—despite the fact that the same period witnessed the bankruptcies of WCG competitors, a decline in the telecommunications industry as a whole, and the overall market declines that followed the 9/11 terrorist attacks.

But this issue is dealt with through cross examination and rebuttal experts, not through dismissal.  Dura imposed a bar, requiring some pleading of evidence that the fraud caused a drop in share prices, but did not require, at the summary judgement stage, that the plaintiffs rule out the effects of other factors. 

We have some primary materials posted on the DU Corporate Governance web site. Oddly, the briefs are not available but are under seal.