Let’s return to Attorney Donovan’s suggestion during oral argument, that the Supreme Court  “consign 8,000 mutual funds to trial.”  Given that Donovan spoke as counsel for Harris Associates, L.P. (the fund manager), this is a startling recommendation. Yet, his invitation to litigation was merely a rhetorical flourish. It was used to demonstrate a presumptively horrible result that would materialize should the Supreme Court side with the mutual fund investors who brought the case. Context reveals his meaning:

“If you take the plaintiffs' point of view and say that a comparison to institutional accounts is always required and may be dispositive and is always a fraction of what mutual fund charges and that judges are the, in the first instance, the ones to decide who is fair and reasonable or what is fair and reasonable, as opposed to directors, I suggest you consign 8,000 mutual funds to a trial.”

Let the Lawsuits Begin

Donovan does not actually support increased investor lawsuits. Nevertheless, the Court should take him up on his “suggestion.” Access to courts to bring excessive fee litigation would help to exert downward pressure on mutual fund fees. Historically and currently, neither market forces nor mutual fund director oversight has managed to do so. Indeed, the conditions that prompted Congress to enact Section 36(b) still prevail. These include mutual fund shell entities that are captive to the firms that created and manage them (the “Advisers”). In turn, members of boards are captive to the Advisers that initially selected them and continue to nominate them to the occasional (not annual) uncontested elections. As put in the Brief of Robert Litan, Joseph Mason, and Ian Ayers Supporting Petitioners,

• “Allowing courts to use a reasonable competitive benchmark like the fees advisers charge to pension fund clients in evaluating excessive fee cases will encourage the mutual fund industry to price more efficiently and increase consumer welfare.”
  

Background on the Fiduciary Duty under Section 36(b) of the 1940 Act

In 1970, Congress enacted Section 36(b)  to impose “a fiduciary duty with respect to the receipt of compensation for services” upon fund managers.  It also created a right for investors to sue for breach of that duty. While the right to sue for has existed for nearly 40 years, very few cases have been brought. After the 1984 Gartenbert decision, “no plaintiff has ever prevailed under any litigation

purporting to interpret these standards” according the Brief of the Amici Curiae Law Professors in Support of Petitioners.  The need for Section 36(b), the lack of arms-length bargaining between boards and managers still exist. Jack Bogle, founder and former CEO of the Vanguard Group of mutual funds in his Amicus Brief contends that:

• “concerns that led Congress to enact Seciton 36(b) are still present today. Certainly, the structural problems in the industry have remained: Mutual fund boards remain completely dependent on their investment advisers . . and even greater fees have been reaped by advisers as mutual fund assets have ballooned.”
  

New Test Expected for Determining If Management Fees Result in a Breach of Fiduciary Duty

Given the direction of oral argument, it’s quite possible that Jones, Jones and Winerman will never get their day in court, let alone prevail. If the Court affirms the decision, it will still need to grapple with the problem of the 7^th Circuit opinion. Neither petitioner nor respondent support Easterbrook’s reasoning. A new standard (or reaffirmation of Gaternberg) for interpreting the fiduciary duty under 36(b) is expected. Whatever legal standard prevails, the factual outcome is important. U.S. mutual funds managed nearly $10 trillion in assets and earn annually an estimated $100 billion in management fees. With over 90 million U.S. investors in mutual funds, the potential savings to captive investors is substantial.

(For additional background on mutual fund fees see, Jennifer S. Taub, “It’s a Wonderful Lie: Mutual Fund Advocacy for Shareholders’ Rights,” Part 2,  The Race to the Bottom.org., Aug. 17, 2009 )

“I suggest you consign 8,000 mutual funds to a trial,” declared Attorney John Donovan during oral argument at the U.S. Supreme Court on Monday. Before the Court was Jones v. Harris Associates on appeal from the 7^th Circuit. Plaintiffs Jerry N. Jones, Mary F. Jones and Arline Winerman were investors in three Oakmark mutual funds managed by Harris Associates L.P. (“Harris Associates”).

Lawsuit Filed in August 2004

In August 2004, the trio sued in federal court in Illinois, claiming that Harris Associates violated its fiduciary duty to the funds under Section 36(b) of the Investment Company Act of 1940 (the “1940 Act”) by charging excessive fees. Plaintiffs contended that Harris Associates charged outside institutional clients half as much as captive mutual funds for the same services. As one example:

• “Harris charged the Oakmark Fund an effective rate of 0.88% on assets of $6.3billion, and it charged an independent client with a comparable investment objective . .  0.45% on assets of $160 million. . .  Thus, the Oakmark Fund paid approximately $55 million in fees, while the independent client paid only $720,000 for essentially the same services.” Petitioner’s brief

Case Dismissed by District Court in February 2007

In February 2007, the district court granted Harris Associate’s motion for summary judgment, dismissing the case, reasoning that since there was nothing preventing the board of directors from negotiating a fee at arm’s length, and because the fee was comparable to what other fund advisers charged mutual funds, there was no breach of fiduciary duty. It was irrelevant to the court that independent institutional clients paid half as much.

Court of Appeals Affirms in May 2008

In May 2008, the 7^th Circuit affirmed the district court’s decision, but  employed a new legal standard. In the opinion, Judge Easterbrook rejected the long-followed approach articulated in 1982 by the 2^nd Circuit in Gartenberg v. Merrill Lynch Asset Mgmt. Under Gartenberg, an Adviser violates 36(b) by charging the mutual fund a fee that exceeds “the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances.”

Instead, Easterbrook supported a market-based, director-centric model of corporate governance. He determined that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Short of “pulling the wool over the eyes” of the fund board members, the board’s approval of the fee “is conclusive.” Easterbrook did admit that  it was “possible to imagine compensation so unusual that a court will infer that deceit must have occurred, or that the persons responsible for decision have abdicated.” Nevertheless, this could not, as a matter of law, be inferred if  fees were similar to what other Advisers charged  mutual funds. In other words, evidence of lower fees paid to institutional clients was not considered.

Denial of En Banc Rehearing in August 2008

Displeased with Easterbrook’s opinion, Judge Posner and four others on the 7^th Circuit supported a rehearing en banc, however, the decision was split 5-5 and rehearing was thus denied in August 2008. However, Posner wrote a dissent to the denial of rehearing. In this dissent, he challenged Easterbrook’s departure from the Gartenberg standard and also questioned the effectiveness of boards and market forces. He referred to “Growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation.” Regarding the Jones v. Harris litigation specifically, he insisted that “there is no doubt that the captive funds are indeed captive . . . [and noted that Harris had a practice of “charging its captive funds . . . more than twice what it charges independent” clients.

We are discussing the recent interview with Myron Steele, the Chief Justice of the Delaware Supreme Court.  The interview be found here.

Chief Justice Steele was asked about the plans to increase the powers of the SEC, an extraordinarily vague question.  Presumably it referred mostly to the shareholder bill of rights, something that would indirectly allow the Commission to regulate governance practices through the use of listing standards. 

His response was excoriating.

• Chief Justice Steele: The federal government is supposed to police disclosure and fraud on the market through the SEC. . . .The federal government's answer today is to give the SEC, which failed miserably in those respects, more power to intrude into corporate governance and that balance between directors' accountability and shareholders' authority. It is the wrong answer and it is not the right time. The right answer is to let it play out until we at least have the empirical data to understand what ought to be done.

The Chief Justice mostly seems to be calling for delay pending the development of empirical evidence.  The point has no obvious connection to the SEC's miserable failure.

Moreover, the precise miserable failure is unclear.  Certainly its not the intrusion into the corporate governance process since the prior Commission largely left the field alone.  Its not shareholder access since the Commission hasn't acted beyond proposing a rule.  Presumably, he's talking about the Madoff scandal which may be a miserable failure but is not a miserable failure in the realm of corporate governance.

The sharp tone is coming from the same court system that has its own issues with the appropriate role in the corporate governance process.  This is, after all, a court system that has routinely authored opinions that included unflattering descriptions of the written work of counsel for shareholders, as well as other criticisms.  

Finally, whatever one thinks of the answer, it likely reflects the views of the Delaware courts in general towards the Securities and Exchange Commission.  With Delaware courts locked into a pro-management position, it is perhaps unsurprising that they would view the Commission, which has a more investor/shareholder protection orientation, with some hostility.  In other words, they are not comrades trying to achieve the same mission.  They are competitors, arguably hostile ones at that.

The message here is one that ought to be heard by the Commission.  After all, the Agency only recently opted to refer a question under Rule 14a-8 of the proxy rules to the Delaware Supreme Court.   The response in CA v. AFSCME was predictable.  Shareholders lost and the Delaware Supreme Court used highly questionable reasoning, ignoring potentially dispositive points raised at oral argument, and may have heard the case in violation of its own rule.

The use of the referral authority was as a mistake of monumental proportion, something we said at the time.  It entailed a decision to delegate federal authority over shareholder rights to a jurisdiction that had a far different philosophy.  Chief Justice Steele's comments provide yet another reason why the referral authority should not be used again and, if not affirmatively disavowed, allowed to permanently atrophy. 

We are discussing the recent interview with Myron Steele, the Chief Justice of the Delaware Supreme Court.  The interview be found here.

The Chief Justice was asked about the "executive compensation scandals."  We know that there have been excessive amounts of compensation paid over the years, with most outrage in recent years aimed at the practices of extraordinary bonuses paid at financial institutions.  Governments overseas are talking about restrictions on bonuses and limits were imposed under TARP.  Justice Steele's response?

• Chief Justice Steele: I understand the public's outrage over outrageous bonuses. It's very difficult to explain to any rational person how the outgoing CEO of Merrill Lynch can redecorate his office to tune of $1-million. There is a state remedy, a waste claim, that can be litigated and that way you can build case law over time that gives you direction.

No mention of the tens of millions of dollars in bonuses and instead a single reference to an act that did not even involve executive compensation.  John Thain presumably left the commode on legs behind when he left Merrill Lynch.   In short, Justice Steele's reaction to the current problem is to not acknowledge that it exists.  

Moreover, as anyone who watches the development of the law in Delaware, the idea that there could be a waste claim in these circumstances is simply untenable.   Waste arises as a fail safe where the board otherwise meets the requirements of the duty of care.  But in a jurisdiction that never finds a breach of the duty of care, waste claims are viewed with equal disfavor.  As then Chancellor Steele described:

• The standard for a waste claim is high and the test is "extreme…very rarely satisfied by a shareholder plaintiff." To state a claim for waste the plaintiff must allege facts to establish that the Delaware directors "authorize[d] an exchange that [was] so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration". The transfer must either serve no corporate purpose or be so completely bereft of consideration that "such transfer is in effect a gift." 

In re 3COM Corp. Shareholders Litig., 1999 Del. Ch. LEXIS 215  (Del. Ch. Oct. 25, 1999).  This standard hardly ever applies to extreme amounts of compensation.  The idea that it would apply to paltry amounts for something with a clear business purpose -- a $1 million plus office redecoration -- is the type of claim that would likely be dismissed by the Chancery Court quickly and likely draw a chastising lecture from the trial judge (after all, far more serious claims based on a failure to supervise risk in In re Citigroup drew a lecturing response).

In short, the Chief Judge did not propose fixing the duty of care or the duty of loyalty.  Moreover, he proposed reliance on a standard that would not work in his own courts. 

Elisse Walter is one of the three democrats on the SEC and a certain supporter of shareholder/investor rights.   Elisse was also my boss at the SEC (although there were several layers between me and her).  US Today did a nice and well deserved article on her. 

We are discussing the recent interview with Myron Steele, the Chief Justice of the Delaware Supreme Court.  The interview be found here.

One of the questions was about the proposals to federalize aspects of the corporate governance process, including "such powers as voting on executive pay, more freedom to launch proxy battles [presumably this is a reference to shareholder access] and the power to separate the roles of a chairman and chief executive officers."   The Chief Justice does not care for the reforms.

• Chief Justice Steele: They all trouble me. As a matter of principle, it is not the business of the government to regulate governance... what is dangerous in today's environment is that someone thinks they have an absolute answer with a list of corporate governance rules when we don't have sufficient evidence about what went wrong. . . .The whole purpose of our federalism is to allow the states to be federal laboratories. Let the states experiment and see what works. The problem is that Congress has to be seen to be taking corrective measures without a good idea of where they are going and why they are going there.

We have provided the complete answer.  Any deletions from the answer are in the orginal contained in the article. 

There are at least two things wrong with this answer.  First, concern with the solution requires some sensitivity to the role played by the Delaware courts in creating the existing problems.  They are the ones that developed the standards for determining executive compensation; they are the ones that developed the standards for board responsibility in risk oversight.  It is the lack of sufficient standards that is generating much of the call for federal reform.  While it is easy to trumpet the benefits of 50 laboratories, it is also inherent in a federal system that sometimes there is the need for national standards.  Delaware has had over a century to do the job and, as this crisis shows, has not done well.  Federal standards, therefore, would be designed to compensate for failings of state law. 

Second, as set out in greater detail in The Irrelevance of State Corporate Law in the Governance of Public Companies, the competition provided by the 50 states has a certain value.  Delaware became the first state to permit virtual shareholder meetings and other states have done the same (eliminating some of the most overtly pro-management components of the Delaware approach, particularly the provison that only allowed management to allow for the use of virtual meetings).  But in the area of fiduciary duties, there is no experimentation.  There is only Delaware (with corporate opportunity a slight exception).  Indeed, even the North Dakota experiment did not tamper with fiduciary obligations. 

Justice Steele may be correct when there are 50 laboratories.  In the case of fiduciary duties for public companies, however, there is only one functioning laboratory and the results have not been good. 

We have been discussing some of the recent cases arising out of Delaware that take a predictably harsh view towards shareholder rights. 

Sometimes in trying to explain these things, we are unable to do so with the same clarity and erudition of others, particularly those in the middle of this debate.  So for the next four or five posts, we turn to an interview by Myron Steele, the Chief Justice of the Delaware Supreme Court.  He has given his views on a number of issues in the corporate governance debates, something that comes as no surprise.  We will devote a couple of posts to the interview, which can be found here. 

Amylin potentially raised important issues about what the board needed to know when it made important decisions.  In particular, the case turned upon whether the board had to know about anti-takeover provisions in indentures that potentially eliminated the ability of shareholders to replace the board.

The complexity of the issues notwithstanding, the Court came to a speedy decision.  Oral argument was held on Sept. 30, 2009.  Five days later, an order was issued.  It stated in its entirety: 

• This 5th day of October 2009, upon consideration of the briefs of the parties, and their contentions in oral argument, it appears to the Court that the order and judgment of the Court of Chancery should be affirmed on the basis of and for the reasons set forth in its decision dated May 12, 2009.

The opinion came with a three sentence footnote. 

• The Court of Chancery determined, inter alia, that Amylin Pharmaceuticals’ board of directors did not breach its duty of care in authorizing the corporation to enter into the Indenture Agreement, with its “proxy put” provision. That determination was correct, not only for the reasons made explicit in the Court’s opinion, but also for one that is implicit: no showing was made that approving the “proxy put” at that point in time would involve any reasonably foreseeable material risk to the corporation or its stockholders. That risk materialized only months later, and was aggravated by the unexpected, cataclysmic decline in the nation’s financial system and capital markets beginning in the Spring of 2008.

The footnote was a startling addition that was, in fact, inconsistent with everything that had happened in the case to date. 

First, the Chancery Court largely concluded that the board had no obligation even to be aware of the  poison put.  The decision did not turn on the risk of nonpayment of the debt obligation.  The decision's rationale was that the board had advisors and, not having been told, was not responsible.  In other words, the issue was not about what the board would have done or should have done had it been told of the poison puts but whether it even should have have been told. 

Second, the argument made to the Court was that the put amounted to an anti-takeover device that impaired the franchise.  The argument was that boards ought to be informed about provisions that could have this type of effect.  It was a focused argument about a narrow category of information where the board had clear responsibilities.  The argument was that the board ought to know about and consider these provisions whenever they are approved, irrespective of what might happen to the debt in the future.  The Court simply ignored the issue.  

Third, the contention that there had been no evidence of "any reasonably foreseeable material risk to the corporation or its stockholders" ignored entirely the nature of the instrument.  Whatever the Court meant by forseeable, financial risk was inherent.  The possibility always existed that the debt would trade at below par or that the company would lack the cash to repurchase the instruments.  Indeed, the only real example given by the Court of forseeability -- the "unexpected, cataclysmic decline" -- was, of course, inherently unforeseeable.  The board's obligation wasn't to be apprised of risk as much as it was to understand the puts, assess their role, and determine whether the benefits of obtaining them outweighed any harm to shareholders. 

Finally, the Court effectively acted in place of the board, an example of judicial speculation.  While the board may not have been apprised of certain risks, this may well have been because it wasn't told about the poision puts.  Had it been told about them, presumably the board also would have been told about their implication and perhaps something about the risks associated with their use.  In other words, the Court is suggesting that there was nothing to tell but that is pure conjecture. 

This is a case that could have helped define what it means to have a board that is informed.  It is clear from the rationale of this decision that the Court does not intend to go down that path.  The only way to ensure that boards are aware of poison puts and other anti-takeover devises is to impose the requirement at the federal level. 

What was the issue in the case?  Counsel for Plaintiffs, Joel Friedlander, summed it up this way:

• The problem is that the Vice Chancellor did not apply the standard that you need to have all material information to make a decision, and that's the standard laid down by this Court on numerous occasions. Instead, the court recognized what it called the particularly troubling reality that corporations and their counsel routinely negotiate contract terms that may in some circumstances impinge on the free exercise of the franchise. And in the face of  that troubling reality, the Court of Chancery was reduced to the empty exhortation to counsel to  tell their directors about change-of-control provisions, when really, under Delaware law, it's  the directors' obligation to know the material facts that counsel, under this opinion, if it allows to stand, counsel will know that despite  that exhortation, if they don't tell directors about these provisions, the directors get off scot-free, not just from monetary liability, but for purposes of any declaratory or injunctive relief because there is no underlying breach. And that's the fundamental flaw in the Court of Chancery's analysis, not imposing a fiduciary duty on the directors to obtain this information so that the counsel then knows they have to give it to them.  

In short, it was about having material information at a time when an important decision was about to be made.  This case provided an opportunity to provide some guidance on the type of information that directors needed to have when making important decisions.  The holding provided no such guidance.

Primary materials on this case are posted on the DU Corporate Governance web site.  The oral argument in this case is posted at the Delaware Supreme Court's web site.

There were a number of issues in the case.  The most critical from a governance perspective was the board's obligation with respect to the approval of the poison puts.  What is clear from the pleadings and the oral argument, is that the board was unaware of the poison put.

• JUSTICE: Am I correct that the officers and directors were given assurances by their legal advisors that there was nothing, there were no unusual provisions buried in this document?

• MR. FRIEDLANDER: The only -- that's correct.  There was evidence that an inquiry was made: Is there anything unusual or not customary in the agreement?

The only real question, then, was whether the board should have known about the provision and approved it consistent with its fiduciary obligations.  Counsel for Plaintiff asserted that it was an anti-takover device and that boards routinely ought to know about these matters.  

• This -- a proxy put was invented in 1986 as an anti-takeover device. The first generation of proxy puts and poison debt, 1986 to 1988, are generally recognized in the literature as to defend against proxy contests and hostile takeovers. This Court's jurisprudence is based on allocating responsibility to the board to make an informed judgment about whether a given defensive measure satisfies Unocal or satisfies Blasius if it reaches that above . . .

Somehow, however, the importance of the provision got lost on the Court.  The next question back made this clear.

• JUSTICE: Okay, but what I'm trying to get to is the argument you're making, in essence, is that directors must read every page of every document that they have to pass upon.

In other words, the Court converted a discussion over whether the board should know about an anti-takover device in a loan document into whether a board had to review every page of every document.  It was not an argument that plaintiffs were suggesting and not an argument that anyone has likely ever made to the Delaware Supreme Court.  Yet it is how at least one Justice potentially heard things.  

Indeed, reframing the question in these terms is misguided.  Even if directors read every page of every agreement, they would not understand them.  The issue is whether directors understand the contents of the material presented to the board.  This is usually done by having experts attend, make presentations and answer questions.  Actually reading the documents is probably the least efficient way to be "informed," particularly for non-lawyers.

So this wasn't what this case was about.  It is whether the decision makers (the directors) have an obligation to be informed about certain types of provisions in agreements.  Presumably when the presentation was made about the debt agreement, the directors were told the amount of the loan and the interest rate, as well as other terms.  It would not have been unreasonable to expect them to be informed about anti-takeover provisions as well. 

The question nonetheless provided insight into the Court's perspective.  They likely saw this case as the potential beginning of the obligation to read every page of every agreement.  If directors needed to know about anti-takeover devices, what would be next?  Before it was over, they would need to know about choice of law provisions and severability clauses.  The Court was determined not to go down this path.

In fact, it was a false path.  To adopt reasonable standards about what directors need to know when they approve important agreements would provide some certainty, protect shareholders and, frankly, help directors ask the questions that require answers.  The standards would never extend to every provision of every agreement.  It would also incidentally put the directors on alert about provisions that in fact they might want excluded.

But that is not what the Court did in this case.  Better to not be told at all than to walk down the path of having to read every page of every agreement. 

Primary materials can be found at the DU Corporate Governance web site.  The oral argument in this case is posted at the Delaware Supreme Court's web site.

The publicity swirling around the Pay Czar's apparent decision to drastically cut the compensation at seven companies receiving the most bailout money needs to be put into perspective.  First, it is the Pay Czar, not the board of directors, who is ensuring that the compensation is fair.  In other words, the need for a Pay Czar reflects an awareness that the system of relying on the board to determine compensation doesn't work, at least if setting compensation at a fair amount is the goal.

But this solution relies on one person, the Pay Czar, with his almost unlimited authority, to oversee a mere seven companies.  There are, however, over 10,000 public companies.  The pay issue cannot be so easily constrained.

Is there a permanent role for government review of executive compensation?  Proposals suggesting that the Federal Reserve Board was going to issue rules/guidelines to regulate some practices suggest that at least some think there is.  It looks like from published reports, that Fed guidelines on compensation will become part of the inspection process.  But if the experience at AIG is any indication, this won't be a particularly successful effort.

The Report issued on October 14 by the Office of the Special Inspector General for the TARP Program, SIGTARP-10-002, illustrates how confusing compensation has become and how woefully unprepared the government is to actually oversee it.  The study was essentially driven by the need to examine the role of the government (in this case the New York Fed and Treasury) in the decision, announced in March 2009, that AIG would pay out $168 million in retention bonuses.  The report concludes that the payments were legal and recommends a few mild policy changes, particularly the need to require advance notice to Treasury of these types of decisions.  

The more interesting aspect of the report is the daunting task confronted by the government in trying to oversee the compensation process.  The study describes the situation confronting the NY Fed (FRBNY) in the fall of 2009.  At that time, AIG had a:

• "staggeringly complex, decentralized system consisting of hundreds of separate compensation and bonus plans.  Over time, they identified 650 AIG bonus programs totalling approximately $455 million for 51,500 employees, 13 retetnion plans allocating about $1 billion to almost 5,200 personnel, and deferred compensation of approximately $311 million for about 5,400 employees."

The confusion wasn't limited to the government.  As the report also pointed out:  "Both [the NY Fed] and AIG corporate officials have struggled over time to fully understand and document the details of the varied compensation plans within AIG." 

The confused and staggering nature of the task didn't suffer from lack of resources.  As the report further notes: 

• "Within fifteen days of singing its September 22, 2008, credit agreement with AIG, a team of FRBNY officers, including Senior Vice Preidents, Vice Presidents, and supervision staff, moved on-site at AIG to assess the magnitude of the company's funding and liquidity needs, to understand its financial condition, and to assess borader risk managment issues at the company."

The FRBNY hired consultants, including Ernst & Young, which ultmately was used in connection with the examination of compensation issues.

It was an extraordinary commitment of resources.  Yet even with the examination, the report notes that while the FRBNY knew of the size of the retention bonuses, "it is unclear whether FRBNY officials knew that thousands of dollars in payments would go to non-essential AIGFPO support employees, such as kitchen and mailroom assistants."

With the 10,000 or so public companies, the government lacks the resources, the expertise or the incentive to become this involved in the compensation process.  Indeed, the report demonstrates why the focus should be on fixing the process inside the board of directors and avoiding government oversight as the solution.

BNA has issued a report (apologies that the link requires a password) on some remarks given at the conference of the National Association of Corporate Directors.  It includes remarks by Kenneth Feinberg, the Pay Czar who, as rumors would have it, plans to cut the compensation for the top executives at the seven largest recipients of bailout funds by 50-90%. According to BNA, he noted the “incredible chasm between Wall Street perceptions and Main Street perceptions.”

The conference also received remarks from David Swinford, president and chief executive officer, Pearl Meyer & Partners.  Swinford indicated that boards must have integrity, candor, and courage.  He is of course correct and, with these three qualities (along with adequate information), boards might be able to adopt appropriate pay packages.  But, while directors no doubt try to do their best, these three qualities are not encouraged by the existing system of regulation.

As we have noted often on this Blog, the only significant way a director can lose his/her sinecure on the board is not to be renominated by management.  Shareholders almost never run a competing slate of directors (too expensive) and majority vote provisions are a myth that merely heighten the board's, rather than shareholders', discretion.  With pay for directors sometimes climbing to the vicinity of $700,000, there are many directors who do not want to lose the position.

The best way to not be renominated (short of committing a felony or engaging in other adverse public behavior) is to irritate the CEO.  Thus, those directors who demonstrate integrity and courage may irritate the CEO (denying him/her the right to use the corporate aircraft for personal travel, for example) and not be renominated.

What directors need is an assist on the courage front from the legal regime.  They need to be able to say to the CEO that, nothing personal, but the compensation sought might violate legal requirements.  This won't come from the Delaware courts.  They resolutely decide cases that uphold even the most poorly informed compensation decisions (see Disney).  But a federal prohibition on excessive compensation would provide the necessary ammunition and allow these directors, who have integrity and candor, to invoke the courage that is needed to say no.

In the earlier post, we discussed how the Delaware Chancery Court made the case, convincingly, for shareholder access.  The court discounted majority vote provisions, essentially making clear that they enhanced the board's authority not shareholders.

The second case made for access occurred in an interview with Steven Rattner, the Car Czar.  He described the board of directors at General Motors this way:

• if ever a board of directors needed shuffling, it was GM's, which had been utterly docile in the face of mounting evidence of looming disaster. We decided to recommend to Tim, Larry, and ultimately the President a package that would include replacing Rick with Fritz as interim CEO, changing at least half of the board, and making an outside director chairman (which should be universal).

Docile?  In other words, uninvolved.  Why?  Because there is no serious competition for the board.  Shareholders cannot vote them out of office, even if there is a majority vote provision (see above).  It's too expensive to run a competing slate of directors (although shareholder access will provide some savings once the SEC gets around to adopting it).  Our comment letter, including a criticism of majority vote provisions, is here.

But in fact, what explains the docile behavior is Delaware law.  Delaware courts encourage an ostrich approach to governance.  In the Citigroup case, the Chancellor lectured shareholders for trying to require boards to participate in risk review, all but concluding that they had no obligation to know about or participate in review of risk, irrespective of its enormity.  In Amylin, the Chancery Court first, then the Supreme Court in affirming, held that boards have no obligation to know about anti-takeover provisions that seriously undermine the shareholder franchise. 

In short, the courts in Delaware encourage indeed reward boards for not knowing.  In this legal climate, is it really any great surprise when a board acts in a "docile" fashion?  Why should it do otherwise?        

As we have noted, shareholders in this case merely sought board minutes/agendas and materials considered by the board in deciding whether to accept the letters of resignation by the three directors.  Shareholders presumably wanted to ensure that the letters were accepted in a manner that conformed with the board's fiduciary obligations.  The Chancery Court, however, refused to allow them to see the rquirested material, concluding that they had failed to present a "credible basis" for any wrongdoing.  The court did so despite an arguable inconsitency in the statements by the company and the statements by the potential acquirer of the company.

Shareholders nonetheless asserted that, given the majority vote provision, the board's behavior warranted "heightend scrutiny and a suspicion of wrongdoing."  The court rejected the argument, concluding that the "Plaintiff’s logic is not sufficiently credible to support such suspicion." 

• The Plaintiff’s position would require this Court to accept the theory that mere shareholder reliance upon a board-enacted governance policy could effectively rewrite the voting provisions contained in a corporation’s by-laws. The Axcelis By-laws provide for director election by plurality vote, and the interposition of the Board’s discretionary review required by the Policy cannot change that fact simply because the shareholders who chose to withhold their votes wish it to be so. Perhaps certain shareholders withheld their votes for the purpose of symbolically demonstrating their lack of confidence in the Board.

By referring to bylaws, the opinion made it sound like shareholders were asking for something inconsistent with the company's foundational documents.  In fact, the plurality requirement is in the Delaware statute and on this matter shareholders had no choice. 

Likewise, the court made it sound as if shareholders were asking for something that actually contradicted the franchise. 

• Merely pointing out the Board’s exercise of discretion under the Policy—an exercise which ultimately effectuated the shareholder franchise—is not credible evidence of wrongdoing on this record. The Three Directors took office, duly elected by a plurality of Axcelis shareholders. The ultimate result under the Policy was the result of the shareholder franchise, not an interference with it. Absent the Policy, the result of the May 2008 election would have been no different.

In other words, the majority vote requirement provided no enhancement of the franchise.  Indeed, the provision actually increased the authority of the board of directors. 

Boards ordinarily lack the authority to remove a director.  An unwanted director need not be renominated but can retain his/her seat until the next shareholder meeting.   The majority vote provision effectively circumvents this traditional restriction.  With directors duly elected under a plurality vote system but now required to resign because they failed to receive a majority, it was up to the board, not shareholders, who would get to decide whether "removal" was appropriate. 

In the end, as the court all but admits, majority vote provisions are little more than director enhancement provisions. 

The Chancery Court did make one point that we have stressed repeatedly.  Had shareholders wanted to have an actual voice in governance, they really had only one  choice.  "If the purpose was the removal of the Three Directors, then those shareholders would have been better served by supporting an alternative slate of directors in the May 2008 election."  Indeed, the court described this failure as a "poor strategic choice." 

In short, the Chancery Court made a persuasive case for the need for shareholders to possess the right to insert nominees in the company's proxy statement (shareholder access).  Only with enhanced authority to elect a competitive slate of directors can they affect the make-up of the board. 

On this point, we are in complete agreement. 

It was  an awfully stark week for news on the compensation front. 

On the one hand, the WSJ has reported that financial firms as a group are on course to pay a record amount of compensation.  While the data included a few companies subject to the restrictions imposed under TARP (Citigroup, for example), most of the companies in the study were subject to no regulatory restrictions on the amount of compensation they paid.  Some at one point had bailout money but have since paid it back. 

They are the "haves."  They can keep what they have and, more accurately, pay what they want, however they want, with no real restriction.  

The "have nots"are those subject to mandatory restrictions on compensation and oversight by the Pay Czar.  These are the seven companies that as penance for taking large amounts of bailout money have to give up independence over the determination of their compensation.  Instead, the pay is subject to the review of Kenneth Feinberg.  Feinberg apparently plans deep cuts, some reported to be as much as 90%, in the compensation of some of the top 25 officers in these companies. 

There will be two ways to look at these cuts.  Come will see the gesture as political, a demonstration that the Administration is tough on compensation.  There may be some of that but once the Pay Czar obtained oversight authority, cuts were eminently foreseeable.  No real surprise there.

More accurately, they continue to raise questions about the determination by boards of directors in setting compensation (the so called Delaware model).  First, how did the amount get set at a level that the Pay Czar needed to cut 90%?  Second, if these companies can be run on much smaller amounts of compensation, what's going on at the non-TARP companies that seem to know no limit in compensation?

Perhaps this is why, less widely reported, Feinberg wants the TARP companies to implement a series of corporate governance reforms, including separation of chairman and CEO, creation of a risk review committee of the board, and elimination of staggered boards.  Wise moves all.  But the changes are limited, applying apparently only to the biggest of the bailout companies.  In other words, the "reforms" are temporal.  Once the seven companies pay off the money, the restraints will be gone. 

Then these companies will go from the "have nots" to the "haves," with no more oversight by the government.  No more limits on compensation.  No more separation of CEO and chairman.  No more prohibitions on staggered boards.

If the Pay Czar really believes that this amount of compensation is too much and needs to be cut, if the Pay Czar really believes these corporate governance reforms are necessary, why isn't there some serious effort afoot to make the changes permanent and applicable to all companies?  Or, are we destined to go back to the pre-financial crisis situation where all the companies were "haves". 

Delaware courts are, in general, extraordinarily predictable, as we see in Westland Police & Fire Retirement System v. Axcelis. 

This case ought to have been a simple one.  Axcelis has in place a majority vote provision, one of those new requirements trumpeted by opponents of access as evidence of the benefits of private ordering between management and shareholders (for a rebuttal, go here).  As we have noted, the idea that majority vote provisions really give shareholders a meaingful say in board composition is a myth.  Most such provisions merely require directors who do not receive a majority to resign but leave with the board the authority to accept or decline the resignation. 

In plenty of instances, if not most of them, the board can be expected to decline to accept the letter of resignation.  This will particularly be likely where the reason for the "defeat" is that the directors were too deferential to the CEO.  The CEO will not want to send a message that excessive deference can result in the loss of the often lucrative sinecure.  Such a message might encourage a board to resist the CEO in other instances.

In Axcelis Technologies, three directors on a staggered board failed to receive a majority of the votes cast.  They dutifully submitted letters of resignation.  The board, however, declined to accept the resignations. In explaining the result, the company issued a press release that explained the decision this way: 

• In making their determination, the Board considered a number of factors relevant to the best interests of Axcelis. The Board noted that the three directors are experienced and knowledgeable about the Company, and that if their resignations were accepted, the Board would be left with only four remaining directors. One or more of the three directors serves on each of the key committees of the Company and Mr. Hardis serves as lead director. The Board believed that losing this experience and knowledge would harm the Company. The Board also noted that retention of these directors is particularly important if Axcelis is able to move forward on discussions with SHI following finalization of an appropriate non-disclosure agreement.

In short, the justification was little more than the directors are knowledgeable and valuable.  The press release did not explain why the board could not have functioned with the remaining four directors or why talented replacements would not work.  The effect was to allow the directors to serve an additional three year term despite the objection of shareholders. 

The matter didn't end there, however.  Shareholders invoked their inspection rights and sought documentation that explained the process used by the board in arriving at the decision.  We posted on this case while it was still at the pleading stage.  Our prediction?

• What will happen in this case? The Delaware courts and their pro-management bias will have a strong incentive to deny inspection rights.  If the inspection is allowed, it will open the door for shareholders to examine most decisions by the board to retain directors after they have been effectively voted out of office.  The courts will not want that to occur, preferring to render the decision unreviewable, thereby leaving the board with maximum discretion.

• There is, however, a glint of hope. With talk of preemption in the air, the Chancery Court will not want to look too unfriendly to shareholders, lest Congress decide to act.  In that case, Westland P&F better hope that the decision is made quickly, while the courts still have that concern.

The Chancery Court, as predicted, however, denied access.  In Westland Police v. Axcelis Technologies we will explore the rational in the next two posts.

Primary materials on this case can be found at the DU Corporate Governance web site.

The interplay between Delaware, particularly the courts, and the SEC, is becoming more pronounced and more complex.  We will examine over the next week or two some Delaware decisions that demonstrate the need for a federal response, particularly from the Securities and Exchange Commission. 

In particular, we will discuss the Chancery Court opinion in City of Westland v. Axcelis, the case where the board refused to accept the resignations of three directors who did not receive a majority of the votes cast under a majority vote provision.  Shareholders followed up the action with an attempt to use their inspection rights to examine the basis for the decision.  The Chancery Court, as we predicted, said no, effectively rendering these decisions unreviewable under any kind of fiduciary duty analysis.  The case demonstrates the largely meaningless nature of majority vote provisions.  It also shows why the SEC needs to step in and add disclosure in this area to the obligations that trigger a current report on Form 8-K.

We will also revisit Amylin Pharmaceuticals, a case where the Chancery Court approved poison puts, those claused in debt instruments that require repurchase of the debt at face value where there is a change of control at the board level, all but eliminating any possibility of a proxy contest for control, at least where it is uneconomical to repurchase the debt.  The case made its way to the Delaware Supreme Court and, five days after oral argument, the high court took a very important and difficult issue and affirmed with a one sentence order (although there was a three sentence footnote).  In so doing, the Court all but reaffirmed the now clear approach that the courts would refuse to require that  boards be informed of certain material developments such as provisions that would disenfranchise shareholders.  The effect of the opinion was to reaffirm the standard that its better for directors of companies incorporated in Delaware to be uninformed than informed. 

Finally, we will review an interview recently given by Chief Justice Steele on current developments.  His remarks are, as always, insightful, and relatively clearly lay out his philosophical approach in the current upheaval over corporate governance.

Enjoy.

LLCs are relatively new entities.  They rely largely on principles of contract, with the rights and responsibilities of the participants usually reflected in an operating agreement.  State law allows operating agreements wide discretion in setting out the respective rights of the participants.  This can be the case, for example, in connection with advances for attorneys fees to a member, even when he or she is sued by another member. 

In Ficus Investment, Inc. v. Private Capital Management, LLC, the New York Supreme Court’s appellate division upheld a decision that the provision to advance expenses in the Operating Agreement applied when one member of an LLC initiates litigation against another.  As a result, the defendant was entitled to an advance of his litigation expenses.

Thomas Donovan and Ficus Investment, Inc were members of Private Capital Management, LLC.  Ficus brought a claim against Donovan alleging that he misappropriated funds and assets worth $9.872 million from the LLC.  Donovan argued that under the terms of Private Capital Management’s Operating Agreement, he was entitled to an advance of his legal expenses.    

In reaching its decision, the court relied heavily upon the terms of the Operating Agreement.  The Operating Agreement described Donovan as CEO.  The Operating Agreement also provided for advancement of expenses and indemnification for members, managers and officers of the company when certain criteria are satisfied.  “Officers” include the CEO.  

The court observed that the Operating Agreement distinguished between the relief available  at the end of proceedings (i.e. indemnification) and payments while the proceedings were still ongoing (i.e. advancement of legal expenses).  The court noted that the Operating Agreement provided for advances “before final disposition of a proceeding” but that the officer must repay the advanced funds if upon a determination he or she is not entitled to indemnification.  Thus, advancement does not depend on whether the officer is ultimately indemnified; the officer is entitled to the funds even though they might ultimately need to be paid back.  After reaching this conclusion, the court upheld the lower court’s decision to require Private Capital Management to advance Donovan his litigation expenses in accordance with the Operating Agreement.