After releasing the executive summary earlier this week, the Commission released the full report of the Inspector General on the Madoff debacle.  The report can be found here.   The report is full of nuggets.  We mention one of them.

Officials in OCIE's investment management group received credible information on Madoff from a hedge fund manager.  Madoff was not a registered advisor but was a registered broker-dealer.  Although much of the ponzi scheme had apparently been run out of the advisory business, registration as a broker dealer gave the staff the authority to search all of his records.  As the report noted: 

• According to the FTI Engagement Team, Madoff’s books and records were subject to examination whether or not he was registered as an investment adviser. As a registered broker-dealer, the Madoff firm’s books and records (including e-mails) related to that business are subject to compliance examinations and review by the SEC staff under Section 17 of the Exchange Act. If the firm had been registered as an investment adviser at that time, the firm’s books and records related to that business would have been subject to compliance examinations and review by the SEC staff under Section 204 of the Advisers Act. However, since Madoff was running the investment advisory business out of discretionary brokerage accounts at BMIS and it was a registered broker-dealer, those records were also subject to compliance examinations and review by the SEC staff under Section 17 of the Exchange Act.   

The problem, therefore, was not access but expertise.   In part because of the silo structure of the office, the broker-dealer group apparently lacked advisor experience (and the advisor group no doubt lacked broker dealer expertise).  While the examiners had access, they didn't have the expertise to take full advantage of the access.   

It took six months but examiners from OCIE scheduled an examination of Madoff.  According to the report, Lori Richards, head of the office, called Madoff.  As the report noted:  "Richards "recall[ed] telephoning him in advance of an exam that we were going to perform to tell him that we expected full cooperation of the firm."  In short, whatever, the reason, Madoff was told in advance of the examination. 

Finally, the examination ended unexpectedly with matters unfinished.  "Work on the Madoff examination came to a halt as OCIE shifted its focus to other priorities. Walker and Wood were directed by their supervisors to focus on a mutual fund revenue sharing sweep being conducted by OCIE."  In other words, shifting priorities within the Agency, may have resulted in the inability to uncover the ponzi scheme.  

Last week or so, the SEC and Bank of America filed with Judge Rakoff their views of the case.  In some respects, the two documents represented irreconcilable versions of the same case.  For Bank of America, it had done nothing wrong.  The disclosure was entirely accurate.  The $33 million settlement was only agreed upon to avoid the distraction of litigation.

From the SEC's perspective, Bank of America engaged in inaccurate disclosure.  But the agency couldn't pin the blame on anyone in specific because of reliance on outside counsel and the presence of the privilege. 

A day after the filings were in, Judge Rakoff gave his opinion and, frankly, he wasn't impressed with the submission of either side.  The submissions, he opined, "raises a few additional issues" that need to be addressed by September 9.  Specifically, the fine had been assessed against the Bank, which meant that shareholders and "arguably indirectly" taxpayers, would foot the bill.  Had the fine been imposed against individuals, it would not "come out of the shareholders' pockets." 

As for the argument that individuals could not be charged because the Bank had not waived privilege but relied on advice of counsel, Judge Rakoff rightfully noted the inconsistency of the argument.  

• This is puzzling.  If the responsible officers of the Bank of America, in sworn testimony to the SEC, all stated that "they relied entirely on counsel," this would seem to be either a flat waiver of privilege or, if privilege is maintained, then entitled to no weight whatever, since the statement cannot be tested.  . . .  If the SEC is right in this assertion, it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel, and, if the company does not waive the privilege, the assertion will never be tested, and the culpability of both the corporate officer and the company counsel will remain beyond scrutiny.  This seems so at war with common sense that the Court will need to be shown more than a single, distinguishable case to be convinced that it is, indeed, the law.  It also leaves open the question of whether, if it was actually the lawyers who made the decisions that resulted in a false proxy statement, they should be held legally responsible. 

As for Bank of America's strenuous argument that it was not guilty of any wrongdoing, Judge Rakoff wasn't moved by that either.  The distraction argument brought this response:  "Whatever this chain of expressions may mean, if it is intended to suggest that Bank of America settled this case to curry favor with the SEC or to avoid retaliation by the SEC, the Court needs to know the specifics."

Both sides employed questionable strategy.  Advice of counsel is a common defense used in SEC enforcement actions but it by definition means that the privilege has to be waived at least to the extent the "advice" needs to be explored.  Advice of counsel and privilege are, therefore, mutually incompatible, a matter, as Judge Rakoff notes, of common sense.  As for Bank of America, its assertion of complete innocence, as we have noted, makes the payment of a $33 million fine seem a complete waste of corporate funds, particularly for a financial institution benefiting from TARP.  In short, it made the Bank look wasteful, something Judge Rakoff will no doubt explore in greater detail.   

We have posted the Judge's order and other primary documents on the DU Corporate Governance web site.

Ranking law blogs is notoriously hard to do.  Do you rank by traffic, an approach used by Paul Caron when he does a quarterly list?  If you rank by traffic, do you go with individual IP addresses or page views?  Do you rely on the number of links to your blog, a method used for example by Google?  (Ranking of blogs, including the influence of blogs on US News rankings, is examined in greater detail in Of Empires, Independents, and Captives: Law Blogging, Law Scholarship, and Law School Rankings). 

And, of course, whatever the metric, how does one assess influence?  Particularly in the realm of modestly trafficked blogs (as most law blogs can be characterized), the goal is influence quality rather than quantity (although some law bloggers are paid and this does often depend upon traffic). 

So, we were very pleased, here at The Race to the Bottom, to see that we had achieved a mark of influence.  Law Week Colorado, a legal newspaper, put out an issue titled "The Best of the Best," a paean to "the very best things about living and working in the legal world of Colorado."  The issue included a number of categories and ranked the best based on the consensus of the 400 or so readers who submitted ballots, labeled the People's Court, and the staff of Law Week, labeled Barrister's Best.  

Included among the many categories was the best law blog (see page 16).  The People's Court weighed in on Above the Law, a blog that unabashadly describes itself as a "legal tabloid"  (http://www.abovethelaw.com/).  

The Barrister's Best?  Our very own Race to the Bottom.  As the paper explained:

• Race to the Bottom is a blog written by University of Denver Sturm College of Law students and profs, and it gives you something more substantial to read after you've gotten your daily schadenfreude fix at Above the Law.  Though Race to the Bottom's main focus is corporate governance, few blogs or newspapers have explored the Nacchio and Churchill trials from as many angles.

We don't aspire for these sorts of things but when they happen, we appreciate them.  The students worked particularly hard covering the two trials mentioned above.  Its nice to know that some arbiters of quality and influence noticed.   The University of Denver has posted a short story on the accomplishment. 

We are discussing the executive summary of the report ("Investigation of Failure of the SEC To Uncover Bernard Madoff's Ponzi Scheme") by the Inspector General on the failure of the SEC to uncover the Madoff ponzi scheme sooner.  The Enforcement Division conducted two investigations (and probably should have conducted a third).  We discussed these in an earlier post.   

In addition, however, there were three "examinations" of Madoff's business.  The first examination was conducted by the Office of Compliance Inspections and Examinations (OCIE)   (a broker-dealer team) in 2003.  The summary described the team as "inexperienced," including limited knowledge of the securities laws.  Moreover, the complaint that triggered the examination involved issues "typically" handled by investment adviser personnel.   The examination focused only on front running because, as one official described, it was "the area of expertise of my crew."  In other words, they examined what they knew.  Ultimately, the team was pulled off the matter to shift focus to "mutual funds."

A second examination occurred in 2004.  This team operated out of the Northeast Regional Office (NERO) (aka the New York office).  Once again, the examiners came out of the broker-dealer program, not investment management.  Why?  "An examiner stated that each of the examination programs in NERO was a 'silo' and they almost never worked together."  The examiners often apparently asked perfunctory questions and accepted Madoff's responses. 

The report chronicled intimidation by Madoff designed to throw off the examination.  As the summary noted:  

• Madoff made efforts during the examination to impress and even intimidate the junior examiners from the SEC. Madoff emphasized his role in the securities industry during the examination. One of the NERO examiners characterized Madoff as "a wonderful storyteller" and "very captivating speaker" and noted that he had "an incredible background of knowledge in the industry." The examiner said he found it "interesting" but also "distracting" because they were there "to conduct business." 
• The other NERO examiner noted that "[a]ll throughout the examination, Bernard Madoff would drop the names of high-up people in the SEC." Madoff told them that Christopher Cox was going to be the next Chairman ofthe SEC a few weeks prior to Cox being officially named. He also told them that Madoff himself "was on the short list" to be the next Chairman of the SEC. When the NERO examiners would seek documents Madoff did not wish to provide, Madoff became very angry, with an examiner recalling that Madoffs "veins were popping out of his neck" and he was repeatedly saying, "What are you looking for? .... Front running. Aren't you looking for front running," and "his voice level got increasingly loud.

Ultimately, the examiners concluded that there was no front running and the examination was concluded.  A simultaneous investigation undertaken by OCIE examiners was likewise terminated, with the workpapers sent to the NERO examiners.   

In short, the examinations involved a silo mentality, a lack of coordination among offices, and a lack of sufficient expertise.  In addition, the browbeating suggests a lack of support from higher ranked officials within the Commission.  If there are structural changes that need to take place in the SEC as a result of the Maddoff fiasco, these are what need to be addressed. 

We discussed yesterday, briefly, the Summary of the Report of the Inspector General on its "Investigation of Failure of the SEC To Uncover Bernard Madoff's Ponzi Scheme."  As we noted, the SEC received a number of credible reports and complaints over the years and conducted three examinations (run by OCIE and/or examiners from regional offices) and two investigations (conducted by the Division of Enforcement) of Madoff between 1992 and 2008 when the scheme finally collapsed. 

Parsing through the assorted allegations, one of the two investigations, which occurred in 1992, failed because the staff investigated one matter (an advisor feeding funds to Madoff) but did not expand the investigation to include Madoff.  In 2000-2001, the Boston District Office and the Northeast Regional Office (NERO) received complaints from Harry Markopolos but declined to investigate them.  Markopolos submitted another complaint in 2005.  The resulting investigation focused on whether Madoff was an unregistered investment advisor, in part because examiners who had examined Madoff's operations were critical of Markopolos and indicated that the complaint raised issues that were "basically some of the same issues we investigated. . . "

In short, the explanations for the failure to spot Madoff were unfortunate but not unreasonable.  The investigations may have been narrow, but the Commission has often been (and still is) excessively driven by statistics.  Enforcement attorneys who want to spend time examining every possible lead would end up conducting lengthy investigations with little to show for it, hurting the stats.  

Moreover, the fact that Madoff sometimes provided inaccurate or evasive answers sounds bad but is unfortunately common enough.  The staff was investigating Madoff for violating the securities laws (operating an unregistered investment advisor).  One way or another, he was going to try to provide answers that obscured or evaded the effort in an attempt to avoid charges.  This is not an uncommon strategy.

In other words, the staff wanted to examine the case before it then move to the next one.  There was no real desire to "look around the corner" and determine whether other violations were taking place.  In other words, the Division is generally reactive, not proactive.  A proactive response would require a change in approach and culture and one that would require the Division to move away from statistics as the measure of success and productivity.

A summary of the Report by the Inspector General of the SEC has been posted on the Commission's web site, a long with a comment by Chairman Mary Schapiro.   The full 450 page missive will eventually follow.

The study concludes that there was no impropriety by anyone working on the case, including the SEC official who had a relationship with Madoff's niece.  The study does conclude, however, that the Commission staff failed in its task of ferreting out the fraud when it had ample notice.  As the Summary described:

• The OIG investigation did find, however, that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed. The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoffs hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff's investment operations that appeared in reputable publications in 2001 and questioned Madoff's unusually consistent returns.

In short, the explanation was mostly a story of lost opportunities.  The Agency was hindered by poor coordination, inexperienced attorneys and examiners, and a failure to follow up, particularly when requesting documents by third parties that would have demonstrated Madoff's deceit.  The summary contains examples of browbeating by Madoff and evidence of personal dislike by Commission staff that may have affected the investigation.  In short, there is no single smoking gun but a series of lost opportunities, with each of the three examinations and two investigations failing for somewhat different reasons.     

Of interest, one of the tips about Madoff's activites went to the Office of the Chairman.  According to the Summary:

• In March 2008, the SEC Chairman's office received a second copy of the previous complaint, with additional information from the same source regarding Madoff's involvement with the investor's money, as follows:  "It may be of interest to you to that Mr. Bernard Madoff keeps two (2) sets of records. The most interesting of which is on his computer which is always on his person."

The matter was forwarded to the staff in the Division of Enforcement who had conducted an investigation of Madoff.  The only response was that "we will not be pursing the allegations on it."  Another opportunity lost.   

Institutional investors (including union pension plans) achieve fewer dismissals and greater settlement amounts.  What else?  According to Institutional Monitoring Through Shareholder Litigation, they also generate improvements in governance.  As the study notes: 

• The changes in audit committee independence exhibit similar patterns. Firms with institutional lead plaintiffs experience a significantly higher increase in audit committee independence than firms with individual lead plaintiffs. We also find that, after lawsuit filings, defendant firms with institutional lead plaintiffs are more likely to establish a lead director position than defendant firms with individual lead plaintiffs.

In short, companies that confront pension plans as lead plaintiffs are going to have to pay more and institute better governance.   The data suggests the need for more not less institutional involvement in the shareholder litigation process. 

Remember in the prior administration the complaints that surfaced because of shareholder activism by pension plans, particularly ones sponsored by unions?  We recall, in particular, the editorial written by  Justice Scalia's son (Eugene) criticizing union shareholder activism and calling on the Department of Labor to do something about it, a position that engendered a reply from this Blog. 

With that in mind, we note the study Institutional Monitoring Through Shareholder Litigation, by professors Cheng, Huang, Li and Lobo.  The study concludes that institutional lead plaintiffs produce better outcomes for shareholders, with fewer of their cases dismissed and the settlement amount higher.  In addition, however, they had this to say:  "we find our results are not driven solely by public pension fund lead plaintiffs; the impact on immediate litigation outcomes is also significant for union pension fund, mutual fund and other institutional lead plaintiffs." 

In short, when union pension plans become active in litigation and serve as lead plaintiffs, the outcome is better for shareholders.  This study doesn't validate shareholder activism in all spheres (that is mostly left to common sense) but does validate it in one of them.  As we noted back in the day, if there was any investigation that ought to be conducted it would be why more pension plans do not take an active role in the governance process. 

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.