We've noted before the often short sighted approach taken by opponents to shareholder access.  The Cox Commission proposed a wholly ineffective form of access (requiring an access bylaw to pass first) yet it was opposed with enormous vehemence.  The consequence has been a change in administration and an even more invasive form of access (one that is much better and promises to be more effective).  Anti-access groups are grousing about possible litigation. 

The likely effect of litigation?  Either a judicial decision that clarifies the broad nature of SEC authority (leading to the prospect of even more intrusive corporate governance regulation) or congressional intervention, largely to the same effect.

With that in mind, we note the study Institutional Monitoring Through Shareholder Litigation, by professors Cheng, Huang, Li and Lobo.  The study examines the impact of institutional investors as lead plaintiffs.  Before we give some of the conclusions, recall that the lead plaintiff provisions in place today were included in the PSLRA.  The PSLRA was an attempt to cut back and restrict securities litigation.  Specifically, the lead plaintiff provisions were designed to stop the race to the courthouse and end or at least limit lawyer driven litigation.  In other words, the provisions were inspired by those who opposed the plaintiffs' bar and the existing method of determining lead plaintiffs. 

What has been the consequence of this requirement?  First, the number of insitutional lead plaintiffs is increasing.  "The percentage of lawsuits with institutional lead plaintiffs has more than doubled from less than 15% in 1996 to more than 30% in 2004."  And the consequence?  As the study concludes:

• After controlling for these determinants of having an institutional lead plaintiff in our multivariate regression analysis, we find that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements. Further analysis indicates that all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount. We also find that within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than those with individual lead plaintiffs.

In other words, the reform in fact encouraged greater participation by institutions.  And their participation has resulted in a lower likelihood of dismissals and greater payouts. 

Opposition to access will also likely generate these types of unintended consequences.  Comparing the last access proposal to the current one shows that this has already occurred. 

Access is inevitable.  As we have written (The SEC, Corporate Governance, and Shareholder Access to the Board Room), the denial of access only occurred because, in the early days of the proxy rules, issuers opposed it and, frankly, so did shareholders.  With no constituency of consequence supporting the right (to the extent there was a consistent support of access, it was the staff of the Commission), access languished.

But it remained an anomaly.  For an agency that ostensibly was on a mission to protect shareholders and investors, it was a provision that largely allowed federal law to eviscerate the right of shareholders under state law to nominate directors.  As shareholders began to lobby for access, the incongruity of the restriction became harder and harder to justify.  

Putting aside the merits of the proposal, the blunt truth is that the proxy rules are being used to mask what ought to be done under state law.  To the extent that restrictions on shareholder nominations exist, they should be imposed under state law.  Yet state law (read Delaware) has not really had to address this since the restrictions in the proxy rules did it for them.  

When access is adopted, the remarkably responsible Delaware legislature (not to mention the courts) has an out.  They can effectively give to corporations the right to prohibit nominations by shareholders, perhaps based on the size of the holdings or the tenure of ownership.  Access does not allow the submission of nominees from those shareholders who cannot nominate.  

The effect of this, however, would be to force Delaware to affirmatively restrict the right of shareholders to nominate directors.  As a result of their pro-management bias, the legislature and the courts would, almost certainly have no problem with the approach.  Nonetheless, it would be an overt example of anti-shareholder bias that would make the role of this state and its courts much clearer (and facilitate the arguments by those who seek federal preemption in the area). 

Access is about overturning federal restrictions on shareholder rights.  It does not displace the role of states but forces states to more clearly define their restrictions. 

We are the first to note that access upsets the current state of the law.  Delaware allows any shareholders to nominate directors, the proxy rules effectively take that right away.  Many of the letters, therefore, contained pleas to leave things as they were, as if this supported the state law role in the governance process.

At least one commentator, however, noted that any access rule should "[p]reserve the nominating committee's vital role in maintaining the quality and diversity of the board as a whole."  See  O'Melveny letter.   We appreciate that this is a comment calling for the preservation of the committee's authority to preserve board quality.  But the reference to preserving the board's role in maintaining diversity?  Come on.  That's a role that, given the dismal performance to date, ought not to be maintained but changed outright, with access likely to play a role in that process.

For a history of access, go here.

One of the much repeated arguments against access has been that corporate governance has so improved over the last few years (since SOX), that this additional right is not needed.  The letters usually refer to the same developments:  The adoption of majority vote provisions (which we address in a separate post), the increase in the number of independent directors on the board, and the use of independent chairmen/lead directors.

We will address this issue in much greater terms when we put up some posts on an ABA Report on Governance.  Suffice it to say that there is not much credit to be given for these reforms.  The existence of more independent directors (again, something likely limited to the largest companies) while at the same time allowing the CEO to remain chair of the board (collapsing lead director and independent chair stats masks the fact that almost no large companies rely on the latter model) simply facilitates CEO control and capture of the board (the chair largely controls the information flow to these directors and is far less likely to circulate materials critical of his/her performance).  We have likewise noted over and over that "independent" directors are not, in many cases, actually independent. 

Maybe a much stricter definition of independence coupled with an independent chair of the board would make access far less urgent.  In those circumstances, the board might well be in a position to look out for shareholder interests.  But that is not the system that is currently in place and until it is, access is an imperative. 

For the complete letter filed by this Blog with the SEC on the access proposal, go here.  For a history of access, go here.

One of the main arguments made in opposition to access has been the widespread adoption of majority vote provisions.  Somehow, the evidence implies, access will undergo something similar and, in the corporate governance realm, a thousand access flowers will bloom.  In fact, this is almost certainly wrong and misstates the reasons why majority vote provisions have become "widespread" in their adoption.

The use of majority voting as evidence is misguided for a number of reasons.  Almost everyone using the evidence overstate their popularity.  They typically refer to the percentage of companies in the S&P 500 or Fortune 500 that have adopted these provisions.  While it may be true that they have been broadly implemented among the largest companies, they are far less common among smaller public companies. According to Directorship, for example, around 75% of the companies in the Russell 3000 still use straight plurality voting.

Second, and more importantly, the popularity of these bylaws is no doubt due in large part to the lack of any meaningful authority extended to shareholders. The most common models of majority voting merely require that nominees not receiving a majority of votes submit a letter of resignation. Boards may reject the letter and, in fact, have done so on a number of occasions, effectively overturning the decision of shareholders.  Our posts on the Axcelis litigation illustrate the point and the difficulty incurred by shareholders in trying to learn all of the facts surrounding the decision.

Even if a bylaw were to require resignation, with no residual discretion given to the board, shareholders still have no real authority. Any vacancy that results from the defeat of a director will be filled by the board. The board can, if it wants, fill the position with the very director who did not receive a majority of the votes cast.  See Commentary to Section 10.22 of the Model Business Corporation Act ("In the exercise of its power under Section 10.22(a)(2), a board can select as a director any qualified person, which could include a director who received more against than for votes.").

Because of this lack of real authority for shareholders, majority vote provisions have been labeled on this Blog as a “myth.”[15] Other commentators have described them as “smoke and mirrors.” William K. Sjostrom, Jr. & Young Sang Kim, Majority Voting for the Election of Directors, 40 Conn. L. Rev. 459, 487 (2007).

Access proposals, in contrast, are not illusory. They provide shareholders with meaningful and substantive rights. They allow shareholders to insert nominees in the company’s proxy statement, increasing the likelihood that the candidates will be elected. Management has no discretion to ignore the results or otherwise fill the board position. Boards can, therefore, be expected to vigorously oppose these bylaws, as has been the case so far.

For the complete letter filed by this Blog with the SEC on the access proposal, go here. For a history of access, go here.

The Atlantic Monthly has an article about the pressure put on BofA and its CEO, Ken Lewis, to close the deal to purchase Merrill Lynch.  See The Final Days of Merrill Lynch.  Treasury Secretary Henry Paulson apparently threatened Lewis with removal if he tried to use the material adverse condition clause to get out of the merger.  To the extent that the story is accurate (the three main principals, Paulson, Lewis and Bernanke declined to be interviewed for the article), it suggests that Paulson was overbearing and Lewis weak.  As the article states:

• On one level, the merger between Bank of America and Merrill Lynch is a simple story of executive hubris and cowardice. Leaving aside the question of whether Lewis’s failure to publicly disclose new information—about Merrill’s losses, about his deal with Paulson and Bernanke—was legal, his passivity throughout the process was, in the eyes of some financial-industry insiders, contemptible.

On this Blog, we are often critical of managerial practices, particularly when involving executive compensation.  But we feel compelled to note that there is an entirely different way of looking at the same facts.

As the economy seems to be crawling out of the recession, it is perhaps easy to forget the desperation that prevailed in the financial markets during the September - December time period.  With the collapse of Lehman, lending markets froze.  The inter-bank market was paralyzed.  It has taken $700 billion in TARP funds (although not all of it has been invested) and over $1 trillion in stimulus to unfreeze the markets.  The failure of Merrill, which almost certainly would have occurred if BofA had walked away from the deal, would have jolted the financial markets and exacerbated the desperate economic conditions.  The recession would likely have lasted longer, greatly increasing the costs.  

Paulson was right to want the deal to go through and Lewis did the right thing.  The acquisition may not have been the best thing for shareholders although they will recover some of the loss in the law suits that have been filed.  But for the United States and the economy, it was very much the right thing.

Lewis in particular wasn't weak.  Quite the reverse.  In the long run, his actions ought to be viewed as heroic.  In many ways, the easy path would have been to walk away from the merger.  Nor did it mean Lewis would actually lose his job.  As one commentator noted in the article: “There is no question what I would have done if I were in his shoes,” he told me. “I would have told [Bernanke and Paulson] I was calling the MAC, was releasing the decision publicly, and dared them to fire me and the board—and that never would have happened, trust me.”

It is frankly a good thing for the United States that Lewis chose the more difficult path and avoided the potential shock to the financial system.  With housing sales improving and the stock market up, Lewis deserves some of the credit.

Many have taken the position that the SEC is taking a "one size fits all" approach that should be eschewed in favor of private ordering.  Private ordering is a concept that suggests companies ought to put in place provisions that uniquely fit their own needs and circumstances and, that, presumably, includes the views of management and owners.

In fact, the whole concept of private ordering in the corporate law environment is flawed.  It presupposes that directors and shareholders will somehow negotiate and adopt the most efficient set of provisions. The theory does not coincide with the practice. Evidence suggests that management’s control over the drafting process and its ability to rely on the corporate treasury eliminate any real prospect of private ordering. Instead, when matters are made discretionary, they result in a categorical rule that favors management. This has been the case with respect to waiver of liability provisions and likely to be the case with respect to access proposals.  This has been chronicled in Brown & Gopalan, Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, 42 Indiana L. Rev. (2009).

The evidence points to a categorical rule against access.  Until the SEC's proposal, there has been no history of boards adopting access bylaw.  Since the new milenium, only three companies have done so (Comverse, Aprial Healthcare, and Riskmetrics).  In three other instances, proposals were submitted to shareholders and vigorously resisted.  Two failed (HP and United Health), one passed (Cryo Cell).  The empirical evidence to date (supported by the comment letters filed in connection with the access proposal) shows almost implacable opposition by issuers.

There is no evidence that in the absence of an SEC rule in this area, that shareholders will obtain meaningful access in an appreciable number of cases.  Indeed, the evidence is entirely to the contrary.  Those calling for private ordering are really proposing a system that will result in a categorical rule denying shareholders access.  It is, in fact, the system that is currently in place.

For the complete letter filed by this Blog with the SEC on the access proposal, go here.  For a history of access, go here. 

Attached to the BofA memorandum filed yesterday was an affidavit from Morton Pierce, the chairman of the Mergers and Acquisitions Group at Dewey & LeBoeuf LLP.  He was asked "to analyze how compensation disclosures of the type that are the subject of the Complaint are customarily made in transaction documents of this nature."  The affidavit is in fact an interesting exegesis into some of the customary practice that surrounds compensation disclosure.

We found more intriguing, in a tough economy, the statement of Mr. Pierce's billing rate.  As he notes:  "I am being compensated at my normal hourly rate of $1,090 per hour for my time on this matter."  As for additional work done by the firm, the affidavit notes:  "From time to time, Dewey & LeBoeuf and its predecessor firms have provided legal services to Bank of America Corp. ("Bank of America") and Merrill
Lynch & Co. ("Merrill Lynch"). During the period from January 1, 2007 through the present, we have billed Bank of America $7,706,153.03 and Merrill Lynch $3,862,390.68."

In short, the $33 million paid as a penalty to the SEC (assuming approval of the settlement) is likely to be a fraction of the total cost associated with this matter.

There are once again hundreds of letters submitted to the SEC on its access proposal.  A number of letters are unusual, including one by the Delaware Bar Association, another by 80 law professors (including this one), and one by seven major law firms (with Wachtell agreeing to the group approach rather than file its own letter).  Nonetheless, the positions are unchanged.  Issuers and those who work for issuers oppose access; shareholder groups support it.

When we examined this subject under the prior administration, we noted that the Commission proposed a weak form of access.  It would allow shareholders to submit bylaws that, if they passed, would permit access to the proxy statement at the next meeting.  In other words, access would be limited to the small cadre of companies that saw shareholders adopt (no doubt over vigorous management opposition) the requisite bylaw.   The same groups (issuers and their supporters) adamantly opposed this mild, indeed ineffective, effort to give shareholders access. We noted on this Blog that the consequence would be a more intrusive access proposal.  In fact, at the time, we wrote that no access was better than this form of pseudo access, anticipating that better proposals were on the horizon. It was, to say the least, short sighted.

So now we confront a more intrusive but frankly far superior access proposal.  This one gives shareholders the right to insert nominees directly into the company's proxy statement.  The company and not the shareholder will carry the costs of distributing the basic background information on the nominee and the proxy card that will allow shareholders to vote for the individual. Shareholders will incur any additional costs associated with a campaign for the candidate.

In looking over the opposition letters, we detected two themes that ought to be discussed.  These are themes that go to access in its entirety, rather than particular aspects of the rule.  These include the fact that governance has so improved over the last few years that access is not necessary and that private ordering ought to be the approach, with letters sometimes pointing to the adoption of Section 112 in Delaware and to the widespread use of majority vote provisions.  We have addressed some of this in our comment letter filed on August 17.  We will address them in the next few posts.

For the complete letter filed by this Blog with the SEC on the access proposal, go here.  For a history of access, go here.

BofA has filed its "MEMORANDUM OF LAW ON BEHALF OF BANK OF AMERICA CORPORATION", a document filed at the court's direction in connection with the proposed settlement between the SEC and BofA over the disclosure of the bonuses paid by Merrill Lynch just before the merger closed.  The memorandum sets out BofA's side in the case.

The document emits a bit of a tone of indignation.  Why not?  BofA settled a case on questionable materiality grounds (something we asserted on this Blog) while agreeing to pay a not insubstantial penalty of $33 million.  For all of its troubles, the financial institution was treated to a raft of bad publicity and a judge demanding to know more.

Yet having said that, the memorandum is curious.  It is a document that argues for complete exhoneration.  As the memorandum notes:

• First: There was no false or misleading statement or omission in the Proxy Statement. The Proxy Statement accurately described the terms of the pertinent forbearance or "negative covenant" in the Merger Agreement. That provision was not – as the SEC alleges, see Compl. ¶ 3 – a "representation that Merrill was prohibited from making [year-end] bonus payments."

• Second: The intention of Merrill Lynch & Co., Inc. ("Merrill Lynch") to pay incentive compensation for 2008 was disclosed and was part of the "total mix" of information available to shareholders. In each of the quarterly reports publicly filed by Merrill Lynch in 2008 – which were part of the Proxy Statement, as incorporated by reference under the SEC rules – Merrill Lynch disclosed in both its financial statements and the accompanying discussion and analysis that it was accruing compensation and benefits expenses of roughly $3.5 billion each quarter. 

• Third: It was widely understood from Merrill Lynch’s public disclosures that Merrill Lynch intended to pay multi-billions of dollars in year-end incentive compensation. In the seven weeks from the signing of the Merger Agreement to the December 5 shareholder vote, both before and after the Proxy Statement was sent to shareholders, there was an extensive amount of media coverage in major newspapers, on television, and over the internet concerning Merrill Lynch’s year-end incentive compensation. Those media – ranging from The New York Times to Bloomberg News to NBC’s Today Show to Fox News – all uniformly reported that Merrill Lynch was expected to pay multi-billions of dollars in year-end incentive compensation. There were no media or analyst reports to the contrary. In fact, the incentive compensation that Merrill Lynch actually paid for 2008 was precisely in line with its quarterly accruals and with this widespread and uniform market expectation.

In other words, the SEC has mischaracterized the facts in the complaint, the BofA has done nothing wrong, and the Bank ought to be entirely exonerated under the facts of the case.

Then why agree to pay $33 million?  The memorandum describes it as a "constructive conclusion to this matter."  Doing so prevents the Bank from suffering through "the unnecessary distraction of a protracted dispute with one of its principal regulators at a time of uncertain and difficult market conditions."  In other words, the Bank is willing to give away $33 million (of shareholder's money or taxpayer's money, you decide), to avoid a "distraction." 

Joe Grundfest, in his affidavit, puts a more complete spin on things.  He provides the following explanation for accepting the settlement:  

• First, Bank of America is a highly regulated entity. It can be imprudent for regulated entities to engage in protracted litigation with their regulators. Second, Bank of America is active in the retail market and relies on access to financial markets for capital funding. Reputational capital is valuable in these markets. Quickly resolving disputes that have the potential to impair brand value can be a rational strategy. Third, Congress and the Administration have an ongoing interest in financial services regulatory reform. There can be value in resolving disputes that can influence the course of this public policy debate. Fourth, as is the case in every major potential lawsuit that presents a risk of significant litigation costs or material management distraction, it can be prudent to resolve the matter so as to minimize these cost and allow management to focus on forward-looking concerns likely to generate greater shareholder value.

While Joe's explanation is better than the "distraction" explanation offered in the memorandum, it is still a generic statement that would apply to any hilgh profile piece of litigation with almost any government agency.  In short, its not a particularly specific explanation as to why a company receiving TARP funds is giving away $33 million.

The trial judge in general must determine the fairness of the settlement.  Paying $33 million by a bank receiving funds under TARP that is entirely innocent may not be fair. 

Moreover, the SEC needs to reexamine the settlement.  BofA has apparently thrown down the gauntlet and all but said that the SEC is wrong on the merits.  It is not unlike those defendants who disavow a settlement after it is executed and made public.  There is little the SEC can do about it except drop the settlement.  Surely that will need to be considered in this case. 

We are discussing Wayne County Employees' Retirement System v. Corti, a recent Delaware case that concluded that directors simultaneously negotiating over the sale of the company and subsequent employment arrangements did not have a conflict of interest.  The court gave a myriad of disjointed reasons for dismissing the existence of the conflict. 

For one thing, it apparently mattered that there was no current move afoot to dismiss either of the two officials. 

• Significantly, the factual allegations in the Complaint do not suggest that Kotick and Kelly’s jobs were ever in danger. There is no allegation that there was a bidder threatening to take over Activision and replace management.  There is no allegation that Kotick and Kelly would be removed as managers if Activision did not pursue a transaction with Vivendi. Moreover, plaintiff alleges that from the start of negotiations Vivendi assumed Kotick and Kelly’s roles in the combined company.  That Kotick and Kelly did not have to pursue the transaction with Vivendi in order to retain their positions as managers significantly alleviates the concern that Kotick and Kelly were acting out of an impermissible "entrenchment" motive. When Vivendi’s assumption regarding Kotick and Kelly’s roles is added to the analysis, plaintiff’s "entrenchment" theory fails completely. 

But of course, entrenchment wasn't the only possible conflict.  The conflict was the opportunity to obtain a more lucrative employment agreement (one where the two officials received "substantial benefits" as the Chancery Court obliquely described), an issue almost completely glossed over by the court.

Another was that the contract was ultimately approved by two committees of the Activision board that consisted of independent directors.  Id.  ("Moreover, before approving the Combination, Activision’s compensation committee and the NCGC met in a joint session to approve employment agreements for Kotick and Kelly, that replaced agreements scheduled to expire on March 31, 2008.").  Approval established, according to the court, that the agreements were not "kept secret" from the board. 

True enough but irrelevant.  At this stage of the proceedings, the issue was whether the two officials negotiating the deal had a conflict of interest.  A conflict of interest doesn't necessarily mean a violation of fiduciary duties but it does suggest the need to analyze the transaction under stricter standards such as entire fairness.  The fact that the board committees approved the agreement does not eliminate the presence of a conflict of interest in the transaction.

Perhaps aware that these arguments entirely sidestepped the conflict issue, the court added two almost conflicting points.  The first was that in fact the two officials "waived some benefits" by agreeing to the new contract.  The reference perhaps was meant to suggest that in fact the new agreement was not as good as the old.  In addition, the court added that the two officials owned 7.5% of Activision's stock, which gave them "an incentive to obtain a higher price for Activision shares."  In other words, the new employment contract was better than the old but the ownership of shares overcame any conflict of interest.

The weakness of the analysis was made even more suspect by the omission of the benefits actually received under the new employment contracts.  The complaint, however, did set them out and from all appearances, they look lucrative.  With respect to Kotick, for example, he would receive:

• 1.25 million performance shares that vested in 20% increments, para. 101
• 363,637 "restricted stock units and two cash payments of $5 million each on the date of the signing of the replacement bonus agreements"  para. 102
• a salary of $950,000, with the possibility of a bonus up to 200% of his salary and options to buy up to 1.85 million shares of Activision, para. 103; and
• "substantial severence and change of control compensation"

The omission was not just an oversight.  By noting that the two officials waived some benefits (certain undefined "change of control benefits" according to para. 102 of the complaint), the court suggested that the two officials actually made sacrifices during the negotiation process.  Yet a more complete discussion of the facts would have at least raised the possibility that the benefits sacrificed were insignificant compared to the additional benefits received.  Yet the court did one without the other.

Similarly, the Delaware courts have, in the past, sometimes asserted that conflicts of interest were largely eliminated where directors were also large shareholders.  Presumably the high level of equity eliminates any incentive to engage in transactions that are otherwise harmful to the corporation.  In this case, the court noted that the two officials owned 7.5% of the shares of Activision, suggesting that something like this had taken place.  Yet this would not be true economically where the benefits received from the employment agreements were greater than any harm to the value of the equity position.  To make that assessment required an analysis of the benefits obtained in the employment agreement.  The court, however, chose not to provide the information.  Nor was there any mention of the increase in equity position that resulted from the units, shares and options provided in the new agreement.

This was a case resolved on a motion to dismiss.  Two officials negotiated an acquisition that could be argued was very favorable to the acquirer (one in which "no control premium was paid" to shareholders of Activision, para. 3) while obtaining what appeared to be highly favorable employment benefits.  In other words, there was a potential conflict of interest that deserved additional examination. 

But not, apparently, in Delaware. 

For the opinion and assorted filings in this case, go the the DU Corporate Governance web site.

In the compensation area, we have often talked about how the Delaware courts took a traditional duty of loyalty claim (compensation paid to another director, the CEO) and transformed it into a duty of care case.  The effect was to eliminate any examination of the substantive fairness of the payments.  This has been discussed in Returning Fairness to Executive Compensation. 

In Wayne County Employees' Retirement System v. Corti, the court came up with yet another way to avoid a duty of loyalty analysis:  Ignore that a conflict exists.  The case arose out of the acquisition by Vivendi, a French corporation and owner of the World of Warcraft, of majority control of Activision (maker of Guitar Hero and Tony Hawk).  The majority stake was sold to Vivendi directly from Activision.  Shareholders of Activision were allowed, however, to participate in a tender offer for up to 50% of the remaining  shares.  The result of the transaction was that Activision shareholders were reduced to minority investors with no premium in the process. 

The negotiations on the Activision side were conducted by Robert Kotick, the chairman and CEO, and Brian Kelly, the co-Chairman.  The two men entered what the court described as "exclusive, nonpublic discussions" with Vivendi.  After four months, the two men informed the board of the discussions.  The board eventually authorized the nominating and corporate governance committee to review, evaluate or respond to any proposed transaction.  The committee, however, never retained "its own legal or financial advisors." 

Plaintiff alleged that the two negotiators breached their duty of loyalty because, while negotiating over the sale of the majority stake in the company, they were simultaneously negotiating employment benefits that would apply to the combined company.  Despite this apparent conflict, the court granted the motion to dismiss, refusing to even allow discovery on the issue.  We will have more to say about this in the next post.

For the opinion and assorted filings in this case, go the the DU Corporate Governance web site.

We have followed the financial crisis in part because of the relationship to executive compensation and current efforts at reform.  We have also followed it because of the structural shift that has occurred in the securities markets, particularly the elimination of independent investment banks as financial intermediaries, an inevitable byproduct of the repeal of Glass-Steagall.  See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act. 

The third reason for following the crisis has been the role of regulatory agencies in the process, particularly the SEC.  The Commission supervised the investment banks under the voluntary Consolidated Supervised Entity program, a system of supervision operated by the Division of Trading and Markets (then Market Regulation). 

Which brings us to a Bear Stearns.  Bear Stearns gets less attention these days.  The current financial crisis truly became inflamed with the collapse of Lehman Brothers in September 2008, a transaction that put markets on notice that everyone, even the largest financial institutions, were at risk.  Inter bank rates skyrocked and lending dried up.  

But Lehman had been only the most immediate crisis.  Months before, in March, Bear Stearns had disappeared into the acquiring arms of JP Morgan Chase, brought down at least in part by the deterioration in the market for mortgaged backed securities.  Because the consequences were not as immediately dire, the transaction has tended to be overlooked, subsumbed by Lehman, AIG and Citigroup.   But in many respects, it was the real beginning of the collapse. 

The collapse of Bear Stearns was the first of the major transactions that required considerable involvement from both the Fed and Treasury.  As part of the transaction, the Fed agreed to purchase $30 billion in hard-to-trade securities, reducing the risk absorbed by JP Morgan.  In effect, it was the first government bailout of the crisis.  When Paulson confronted the crisis at Lehman six months later, his response may have been bailout fatique, unwilling to save yet another ailing financial institution.   

Bear Stearns was under the supervision of the Securities and Exchange Commission.  A recent GAO Report explained the collapse, and the views of the staff, this way:

• In particular, Bear Stearns, formerly a CSE [Consolidated Supervised Entity], reported that it was in compliance with applicable rules with respect to capital and liquidity pools shortly before its failure, but SEC and Bear Stearns did not anticipate that certain sources of liquidity could rapidly disappear. According to SEC officials, Bear Stearns’ failure was due to a run on liquidity, not capital. Shortly after Bear Stearns’ failure, the then SEC Chairman noted that Bear Stearns failed in part when many lenders, concerned that the firm would suffer greater losses in the future, stopped providing funding to the firm, even on a fully-secured basis with high quality assets provided as collateral. SEC officials told us that neither they nor the broader regulatory community anticipated this development and that SEC had not directed CSEs to plan for the unavailability of secured funding in their contingent funding plans. SEC officials stated that no financial institution could survive without secured funding. Rumors about clients moving cash and security balances elsewhere and, more importantly, counterparties not transacting with Bear Stearns also placed strains on the firm’s ability to obtain secured financing. Prior to these liquidity pressures, Bear Stearns reported that it held a pool of liquid assets well in excess of the SEC’s required liquidity buffer, but this buffer quickly eroded as a growing number of lenders refused to rollover short-term funding. Bear Stearns faced the prospect of bankruptcy as it could not continue to meet its funding obligations. Although SEC officials have attributed Bear Stearns’ failure to a liquidity crisis rather than capital inadequacy, these officials and market observers also stated that concerns about the strength of Bear Stearns’ capital position—particularly given uncertainty about the potential for additional losses on its mortgage-backed securities—may have contributed to a crisis of confidence among its lenders, counterparties, and customers.

The explanation is not really an explanation.  It is true that collapses of the magnitude of Lehaman are often directly preciptated by a liquidity crises.  Lenders see the looming failure and stop lending.  Enron failed when lenders stopped lending.  It is not news to attribute failure to such a consequence. 

But the liquidity crisis merely begs the question.  What happened that caused the crisis and how did the inspection staff miss the warning signs? 

As part of the Race to the Bottom’s continuing coverage of Joseph Nacchio’s legal saga, Professor O’Brien posted on the 10^th Circuit’s decision on Nacchio’s sentence. A three-judge panel remanded the calculation of Nacchio’s sentence to U.S. District Court for being excessive. The panel ruled the initial sentence improperly calculated Nacchio’s gains from insider trading. The amount gained from insider trading dictates the sentence length. If the U.S. District Court finds the gain was overstated, Nacchio’s sentence will likely shrink from its current six years.

As reported in the Denver Post, the Department of Justice will not to appeal the decision to remand the sentence. The Department of Justice had the options of asking the panel to review the decision, requesting an en banc review, or appealing the decision to the Supreme Court.

We have done a series of posts on San Antonio Fire & Policy v. Amylin Pharmaceuticals, a Delaware court that upheld the use of coercive contractual terms that effectively denied shareholders their voting rights.  It occurred to us that this was an issue that ought to be addressed through federal regulation.

The Shareholder Bill of Rights will make many changes to the governance process, some of which are designed to enhance the ability of insurgents to nominate and elect their own candidates.  Thus, the provision will eliminate staggered boards and guarantee shareholder access to the company's proxy statement. 

As we have already noted, the legislature has adopted provisions designed to allow Delaware corporations to restrict shareholder access to the company's proxy statement.  Similarly, this case points to a method that can be used by management to ensure that the insurgent directors are not elected.  They can use contracts with third parties as a means of putting coercive pressure on shareholders to not side with insurgents.  Thus, while the Shareholder Bill of Rights provides additional authority to include shareholder nominees in the company's proxy statement, management can take it away by having the election of these directors trigger a default on material contracts.

San Antonio Fire & Policy v. Amylin Pharmaceuticals, however, demonstrates the lengths the courts in Delaware will go to to undercut these rights.  The poison put in the case effectively coerced shareholders into voting against the insurgent slate.  While the insurgent slate had been reduced to a minority (five directors for a twelve person board), even their election could result in the triggering of the acceleration provision for the debt.  If these five directors were elected and two of the other seven resigned or died, thereby making the insurgents a majority, the poison put likely would be triggered.  Moreover, evidence produced at the hearing on the matter indicated that the 2007 Notes were currently trading at less than 60 cents to the dollar.  Thus, all of the note holders would likely accelerate since doing so would allow them to be paid something closer to the face amount of the debt. 

The court exonerated the board from having any role in the adoption of the poison puts.  Likewise, the court declined to impose any obligation on the part of the board to be informed about contract provisions that materially weaken shareholder voting rights.  Finally, the court adopted a test for board "approval" of the directors that effectively gave shareholders no certainty even when the board approved the insurgent directors. 

The approach is part of a broad problem with the Delaware courts.  They resolutely refuse to impose meaningful obligations on the board.  Thus, the fundamental take away from the case is that the board doesn't even need to know about contract provisions that effectively strip away shareholder voting rights. 

The Shareholder Bill of Rights addresses this mildly by requiring a board committee to oversee risk.  It does not, however, specify the types of information that must be delivered to the committee or the committee's authority.  Without these steps, as In re Citigroup shows, the Delaware courts will not interpret board duties in a way that makes the committee assume a meaningful role in the governance process.  Specifying these obligations and adding to them (perhaps by requiring boards to be informed of contract provisions that substantially impair shareholder voting rights) would take the issue away from the Delaware courts and make board participation more meaningful. 

The opinion and assorted documents have been posted on the DU Corporate Governance web site.

First, I applaud the Harvard Corporate Governance blog for posting the Cooper, Gulen & Ovtchinnikov paper on Corporate Political Contributions and Stock Returns. Documenting the ways that companies influence federal Congressional campaigns -- and hence shape the broader political and legal system to maximize corporate profit --  is a crucial endeavor if we are going to have a meaningful discussion of what we mean by "free markets." 

The professors' new paper, based on a sophisticated new data set of FEC-documented PAC contributions to Congressional campaigns (from 1979 to 2004) reveals positive abnormal stock returns correlating with these contributions by public companies. Obviously, the results attest to companies' powerful interest in shaping the national political environment in their favor: whether that influence is exerted in the area of financial (de)regulation, limits on shareholder lawsuits, the scope and shape of healthcare reform, climate change regulation or new standards for food and product safety.

But even as this new paper (soon to be published in the Journal of Finance) documents the ways that public companies' donations to Congressional elections positively influence corporate profits, it only captures a tiny part of the picture. Part of what makes corporate political spending so tough to understand and talk about convincingly is that there are so many forms of it, and in each case, fine distinctions between what is and is not legal.

Finally, there is a lot of corporate political spending which remains almostly entirely invisible. (I heard that Obama resisted allowing grand corporate expenditures at his Inaugural, no?) 

In addition to campaign contributions, we need to analyze corporate lobbying expenses and gifts to legislators, issue advocacy, issue-based litigation advocacy (e.g. the filing of amicus briefs in pro-business lawsuits, especially in Supreme Court cases), and gifts companies make to candidates' and sitting legislators' favorite charities - a practice which (though noted in a midJune USA Today article) is only barely recognized or studied, and is often legal. Witness the force that the U.S. Chamber of Commerce has become in shaping federal law.

Furthermore, as I've noted in my UCLA paper ("Pandora's Box: Managerial Discretion and the Problem of Corporate Philanthropy"), much corporate politicking can be effectuated via corporate contributions to nonprofits. In many cases, the nonprofits are even 501(c)(3) "charities" (especially educational organizations aka think tanks). Such corporate donations/payments max out at 5% of a public company's total profits -- consider what a ceiling that establishes! And there is no public disclosure requirement: neither at the company or the recipient's (fund's) side. Late Congressman Paul E. Gillmor (R- Ohio) had pressed for new disclosure of such corporate donations, but there wasn't much political support. Imagine that.

Faith Stevelman/Director, Center on Business Law & Policy/Professor of Law/New York Law School/57 Worth Street/New York, NY 10013/212.431.2197

The Delaware State Bar Association has written a comment letter on the SEC's proposal to give shareholders access to the company's proxy statement for nominees to the board.  The letter was apparently unique ("To the best of our knowledge, this is the first time that the Delaware State Bar Association or any of its membership groups has ever submitted a formal written comment to the Commission.").  Yet the times are unique.

Predictably, the letter opposed the grant of access.  The main argument was opposition to the one size fits all approach.  ("Proposed Rule 14a-ll, however, would substantially limit the ability of stockholders and boards of directors to set the terms of a proxy access system, or to choose a system of proxy expense reimbursement in lieu of a proxy access regime.").  The letter noted efforts by the Delaware legislature to authorize bylaws in connection with access and reimbursement of proxy expenses.

• By setting forth a non-exclusive list of conditions that bylaws governing proxy access may contain, Section 112 clarifies the extent of stockholder choice in regard to proxy access, through their power (concurrent with that of the board of directors) to adopt bylaws governing the process by which directors are elected. Thus, the new provisions recognize that stockholders (or directors) may determine that a proxy access system may indeed be beneficial, and expressly authorize them to adopt such a system; at the same time, the statute gives stockholders the flexibility to determine that, with respect to any particular corporation, such a system would not be beneficial, or that a reimbursement system might provide a better alternative.

There are so many things to say about this approach.  If Delaware were to require that companies either allow access or require reimbursement and set thresholds at modest levels for those eligible, this would be a reasonable argument.  But in reality, the argument is simply to let companies do whatever they want, which hardly protects shareholders. 

In fact, until the amendments to the Delaware Code (adopted presumably in anticipation that the SEC would put forth a new access proposal), companies incorporated in Delaware had no history of adopting bylaws that allowed access.  Moreover, to the extent these provisions (particularly Section 112) clarfiy, they clarify the limits that can be imposed on access.  The instances of companies adopting access bylaws are chronicled in The SEC, Corporate Governance, and Shareholder Access to the Board Room and there is no evidence of any predilection by Delaware companies to provide shareholders with this authority. 

Similarly, when matters are left to the company's discretion, the result is not a varied approach that meets the needs of multiple constituencies.  The result is a categorical rule that favors management.  At least this has been the case with respect to waiver of liability provisions.  This was chronicled in:  Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  In other words, the proposal is really not about access, its about limiting access.

Indeed, the letter itself notes that if companies wanted to adopt access bylaws, it would be in an effort to restrict the use of access.  As the letter describes: 

• The "great deal of comment" on this issue when a mandatory proxy access rule was proposed by the Commission in 2003 (see Access Proposal at 44) suggests that stockholders may prefer utilizing their rights under Section 112 to establish a higher (e.g., 2% in the case of a large accelerated filer) minimum ownership requirement.

• In light of those comments, it is not unreasonable to expect that, if pennitted, stockholders of many corporations would choose a minimum holding period longer than the period that proposed Rule 14a-11 would establish.

• Under the proposed Rule, the corporation would be required to include in its proxy materials as many as three proxy access nominees -the maximum number that the public stockholders are entitled to elect. It is conceivable, however, that the stockholders (either the public stockholders or the stockholders as a whole) would prefer to limit the number of proxy access nominees to one or two, rather than all three ofthe board seats elected by the stockholders at large.

In other words, it is about wanting the preserve the right to restrict access.  What the letter doesn't say is that the most likely position of most companies is to entirely deny access (perhaps by imposing requirements that are so onerous that no one can realistically meet them). 

The letter essentially asserts that this is not the case by pointing to the widespread adoption of majority vote provisions.  The comparison is inapt.  First, it overstates their popularity.  While they have become common among the largest public companies, they are far less common among smaller public companies.  In other words, there is reason to believe that public companies could likewise benefit from a mandatory rule requiring majority approval of directors.

Second, majority vote provisions have been adopted because they in effect change little.  The typical model is to require shareholders without a majority to submit a letter of resignation.  Few directors failed to receive a majority (in part because of the votes they received by brokers engaging in discretionary voting, something eliminated recently by the SEC).  Moreover, when that happened, the board has had the discretion to refuse to accept the letter of resignation, something that has happened on a number of occasions.

Access is different.  It will in fact provide a mechanism for competition with management nominees.  There is no reason to believe that the bylaws will become common (as the last five years have indicated).  Moreover, the bylaws proposed by shareholders will likely meet more resistance than majority vote provisions, seldom passing. This is demonstrated by the empirical evidence.  In the brief period when access bylaw proposals were permitted by shareholders under Rule 14a-8, only three were submitted to shareholders, with one passing and two failing.   

In short, the position taken by the Delaware Bar is not really about additional corporate flexibility.  It is about minimizing or eliminating a right of shareholders to engage in a meaningful effort to nominate directors to the board.  It is a position entirely consistent with Delaware's role in the corporate governance process and a race to the bottom.

Reports percolating around indicate that Travis Laster has been designated as the replacement for Vice Chancellor Lamb on the Delaware Chancery Court.  While there is little dispute about his intellect or his disposition, there is also little dispute that he meets the traditional profile of those on the Delaware Chancery Court.  He is unlikely to bring much change to a court that is increasingly being marginalized through the imposition of federal standards. 

Seventy-five years after Berle and Means, we still examine corporate governance problems within their agency framework. Specifically, we see shareowners at the mercy of distant managers. Yet, the mutual fund example should show us at least one more layer. Presently, the real investors are no longer the corporate shareholders. The shareholders are now often middle class men and women. The true investors are now at the mercy of those intermediaries to advocate on their behalf. Given that mutual funds own nearly 25% of the U.S. equity markets, this is no small matter.

While this topic affects more than 77 million individuals, its impact is actually broader. For those with a shareholder-centric view of corporate governance, efforts to empower shareholders can not be effective when institutional shareholders have conflicts that inhibit their willingness to pressure management. As the research shows, Advisers do not exercise their existing rights in such a way that would empower shareholders at large.

As a result of this research, I suggest that corporate governance scholars and reformers use the mutual fund case to reexamine the prevailing framework. Specifically, we should shift our focus from empowerment of direct shareholders to the empowerment of the true equity investors. More than just a semantic distinction, this new framework would recognize that institutional shareholders cannot be expected to wrest power from, or demand accountability from, corporate managers. It also recognizes that after the “managerial” revolution, whereby ownership was separated from control, a further “intermediation” revolution has further divided ownership; separating risk-taking from legal title and pushing the risk-takers further away from the decisionmakers.

Taking an even broader perspective, what I find most useful about looking at the investor behind the institutional shareholders is that it ends the shell game that I often see played around issues of social responsibility. Proponents of various causes are often told that corporations cannot address social issues because corporate managers have a duty to maximize long-term shareholder value and may not consider other stakeholders. Then, when one looks to the legal shareholders, for example the mutual funds, their Advisers say, “We cannot address social issues, after all, we are beholden to our investors.” Then, when we look to these underlying investors, they say overwhelmingly (in their capacities as citizens, neighbors, people of faith, and so on) that they do not want to support genocide, or environmental damage, or poor labor standards. But they actually have no idea that their own money is furthering such causes.

Even if investors were informed, they have no real choices, no opportunities to make the corporations at the other end of this long intermediation chain accountable.  These underlying investors, as real owners, should have a voice. In the majority, they should have the right to instruct the corporate managers who work for them how to handle large compensation packages as well as large social issues. Like owners of a closely held company, the real owners of publicly traded institutions should have the right to forgo profit in the short or long term in the interest of other principles. Giving the true investors a voice on shareholder resolutions, governance, or otherwise is a step in that direction.

Excerpt from Jennifer S. Taub, “Able but Not Willing: The Failure of Mutual Fund Advisors to Advocate for Shareholders’ Rights,” Journal of Corporation Law, Vol. 34, Issue 3 (2009).

Approximately 77.7 million individuals in the United States invest in equities through stock mutual funds. When these investors put their money to work and at risk, they depend upon strong corporate governance structures at corporations (portfolio companies) held by the mutual funds that they own. Unlike direct retail investors who can take action to influence corporate governance, these 77.7 million individuals depend upon mutual fund advisers (Advisers) to advocate for them. Yet, when it comes to pushing portfolio companies for shareholder governance reforms, mainstream fund families remain passive. Even in areas where Advisers have an affirmative duty to act on behalf of the funds they manage (and thus to benefit the underlying investors in those funds), they fall short. Subject to a fiduciary standard, Advisers owe a duty of care and loyalty with respect to all services performed on behalf of the mutual fund’s owners. This includes an obligation to monitor corporate events and to cast proxy votes in the best interests of funds. Yet data show that mainstream fund Advisers overwhelmingly cast votes in favor of management and against shareholder advisory resolutions on matters including corporate governance.

Many theories have been advanced for the reluctance of Advisers to take an active or even passively supportive role in matters of shareholder empowerment. Under one, the “conflict of interest theory,” Advisers favor corporate management (or disfavor corporate shareholders) because of existing or potential business ties with corporate managers. While many have argued that conflicts of interest influence Advisers to act in promanagement, antishareholder ways, very little empirical research has emerged thus far to support such claims.

Accordingly, I sought to explore whether shareholder empowerment behavior is associated with an Adviser’s economic interests. I linked the 2006 corporate proxy voting records (provided by the Corporate Library) on eleven key corporate governance topics for the ten largest fund families to the defined contribution (DC) assets under management (provided by Pension and Investments) of each family’s Adviser for the year that ended December 31, 2005. The result was a statistically meaningful negative correlation between DC assets and support for shareholder resolutions. Specifically, the analysis revealed that the greater the dependency of the Adviser upon the DC channel for asset management business, the less likely the fund family will be to support shareholder-sponsored governance resolutions.

Next, I considered possible explanations for this correlation, other than conflict of interest. I have grouped these into the following categories: (1) Wall Street Rule; (2) Alignment of Economic Interests; (3) Legal and Political Obstacles; (4) Cost-Benefit and the Free Rider Problem; (5) More Effective Behind the Scenes; (6) Fiduciary Duty; (7) Contract; (8) No Shareholder Demand; (9) Lack of Confidentiality; (10) Special-Interest Agenda; and (11) Lack of Expertise. While these defenses may work to explain passivity in some types of activism, none are solid explanations in the case of these corporate governance-related proxy votes.

In response to the results, this paper explores a range of reforms that would help make mutual fund Advisers less dependent upon corporate clients and more accountable to investors. These include: (a) Separation of Money Management from Retirement Plan Record Keeping; (b) Pass-Through Proxy Voting and Proxy Assignments; (c) Default Proxy Assignments; (d) Best Practices for Proxy Voting and “Comply or Explain”; (e) Uniform Disclosure “Product Label” for Proxy Policies and Procedures; (f) Choice at the Point-of-Sale; and (g) a Voting Suitability Requirement.

In its conclusion, this paper takes a broader perspective, suggesting that corporate governance scholars and reformers use the mutual fund case to reexamine the prevailing framework that is largely based upon the agency problem recognized in 1932 by Adolf Berle and Gardiner Means. Berle and Means saw a shift between the nineteenth- and twentieth-century business enterprises. “Persons other than those who [had] ventured their wealth” were directing industry. They recognized that the separation of ownership from control would lead to “directors or titular managers who can employ the proxy machinery to become a self-perpetuating body, even though as a group they own but a small fraction of the stock outstanding.” They identified the agency problem as a conflict between the interest of management and owners, whereby management “can serve their own pockets better by profiting at the expense of the company than by making profits for it.”

In response to the fruition of their observations, much of corporate governance work focuses on that power balance between management and owners, and seeks to find ways to enhance shareholders’ rights. Or, the work looks to the failure of the boards of directors to look out for shareholders. Leading corporate governance scholar John Coffee observed, “Academics tend to plough and re-plough the same furrow over and over. Nowhere is this truer than in the case of the scholars of corporate governance, who have studied the board of directors and shareholders endlessly.” In the world beyond academia, (according to Martin Lipton, the effort to “shift control of the company from the board to shareholders has been constant and increasing.”

For those who subscribe to a shareholder-centric vision of corporate governance, focusing just on direct shareholders ignores how much capitalism’s environment has changed. The concentration of ownership through pooled investment vehicles, such as mutual funds, and the growth of retirement savings plans, has led to a further revolution—an Intermediation Revolution. A staggering 69.4% of U.S. equities are owned by institutional investors. In fact, ownership is concentrated, with 100 institutions owning 52% of U.S. equities. Yet these institutional owners are often collective investment vehicles like state and union pension funds and mutual funds. In other words, they are legally constructed vehicles through which individual savers put their money at risk. Yet, those who make decisions as to the direction of those investments and those who exercise the legal rights of ownership are not the real investors, but managers or “registered investment advisers.” While “working people through their savings today hold the majority of stock in the most powerful enterprises in the world,” they are not even mere legal owners anymore. Thus, ownership is now separated again. Investment has been separated from legal title. Investors who are the risk-takers are now pushed further away from the decisionmakers, and the agency problem is amplified.

Accordingly, we should shift our focus from the empowerment of shareholders to the empowerment of the underlying equity investors. More than just a semantic distinction, this new framework would recognize that institutional shareholders (such as mutual fund advisers) cannot be expected to wrest power from or demand accountability from corporate managers. The intermediaries who stand between investors and corporate managers have their own interests, which are often at odds with the investors who trust them, and at times aligned with corporate management. This is seen in the arena of proxy voting. Accordingly, the first set of reforms to help not just investors in mutual funds, but also corporate shareholders at large, should start there.

Excerpt from “Able but Not Willing: The Failure of Mutual Fund Advisors to Advocate for Shareholders’ Rights,” Journal of Corporation Law, Vol. 34, Issue 3 (2009).