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Thursday
May172012

The SEC Fights Back

The SEC makes mistakes.  The Madoff fiasco is one of them; the lease on the building in DC that was never used is another.

But on the whole, the SEC is a highly professional, hard working place that has been a unfairly and relentless attacked for any number of things.  And, in the aftermath of Madoff, the Agency has often simply accepted its role as a pin cushion.

So it is nice to see the Commission becoming a bit more assertive and fight back against these sort of challenges.  The appeal of Judge Rakoff's decision to reject the Citigroup settlement, and more broadly reject the use of the neither "admit nor deny" approach was a case in point.  It is risky appealing bad rulings by the district court.  Bad district court cases can become bad appellate court cases.  But this time, the SEC decided that it could not let the matter rest.  Even judges need to know that the SEC will fight back.

With that in mind, we note a small but important series of examples of the growing verve at the SEC.  Top officials have been responding to editorials and stories that contained criticism of the Commission.  An editorial on DealBook, Taking On the Little Guy, but Missing the Bigger Ones, criticized the SEC's enforcement record.  The editorial conceded that the SEC had done "a much better job of investigating financial crisis wrongdoing than the Justice Department. And it’s true.  But it’s like being proud that you’re the 'Dumb' of 'Dumb and Dumber.'”  Robert Khuzami, the Director of the Division of Enforcement, wrote a letter taking on the editorial and noting that the "assertion that the S.E.C. somehow 'missed the big guys' misses the mark."

Then there was the response by George Canellos, then the head of the NY regional office, now the deputy director of the Division of Enforcement, to the claim that the SEC exposed a whistleblower.  For a short time there was a raft of articles accusing the SEC of mishandling the situation.  After the Canellos letter was published, the issue quickly died down. 

These are small steps but they are necessary and overdue.    

Wednesday
May162012

Glass Steagall, The Capital Markets and the Volker Rule

Glass Steagall was adopted during the Great Depression.  The effect of the legislation was to keep commercial banking (deposits and loans) separate from investment banking (underwriting and M&A activity).  One consequence was that commercial banks were mostly kept out of the equity markets, reducing the amount of risk they could undertake.  This was not to say that commercial banking was risk free.  There were plenty of examples of banks failing because they found themselves over committed to a particular market segment, say energy, and collapsed with the market.

But Glass Steagall had another affect. As set out in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act, Glass Steagall allowed for the rise of a world class, powerful set of investment banks.  In effect, the law prevented commercial banks from absorbing and taking over the investment banking industry. 

The takeover was inevitable because over time commercial banks have inherent advantages, including access to low cost funds (deposits) and access to the Federal Reserve window.  Moreover, as the article pointed out, just before Glass Steagall was adopted, the commercial banks were in the process of taking over the industry.  Indeed, Glass Steagall required some banks to separate their commercial and investment banking parts (JP Morgan & Morgan Stanley as one example). 

The consequence of separating the two areas meant that investment banks focused not on lending relationships but on relationships that centered around the capital markets.  They had an incentive to understand the capital markets and they had an incentive to encourage companies to rely on the capital markets.  In short, they were a class of intermediaries that promoted active capital markets.

With the end of Glass Steagall, commercial banks have, for the most part, taken over the investment banking business, just as they were seeking to do in the 1930s, before Congress acted.  Before the most recent financial crisis there were five world class investment banks:  Goldman, Morgan Stanley, Merrill, Bear Sterns, and Lehman.  Bear is part of JP Morgan; Merrill is part of BofA.  Lehman, of course, is gone.  Only Morgan Stanley and Goldman remain (afer both converted to commercial banks). 

Does it make a difference?  First, as one can see from the latest problems at JP Morgan, commercial banks engaging in market activities take on enormous risk.  But there is a deeper problem.  First, commercial banks can offer companies both lending and underwriting services.  In other words, they are not completely dedicated to the capital markets.  Second, at least historically, commercial banks, because of more extensive regulatory oversight, were more conservative.  They could be counted on not to push the capital markets envelope as hard as a traditional investment bank.  Both are bad for the capital markets.

The Dodd-Frank Act added the Volker Rule, a provision that prohibits banks from engaging in proprietary trading and from sponsoring a hedge fund.  This is not Glass Steagall.  Banks can still engage in market activities with their client's money.  Moreover, it does not guarantee a source of business for investment banks that do not want to engage in commercial banking activity.  Those subject to the Volker Rule can farm out their proprietary trading activity to another commercial bank. 

But this Blog will over time discuss the impact of the Volker Rule on the investment banking industry and the US capital markets.  

Tuesday
May152012

In re BP p.l.c. Securities Litigation: Some 10(b) Claims Spawned by Deepwater Horizon Disaster Survive Motion to Dismiss

In In re BP p.l.c. Securities Litigation, No. 4:10-md-2185 (S.D. Tex. Feb. 13, 2012), defendant BP p.l.c. (“BP”) moved to dismiss, under Rule 12(b)(6), securities claims brought by purchasers of BP ordinary shares and American Depository Shares (“ADS”).  The district court, following Morrison v. National Australia Bank, granted dismissal of all the claims of the holders of the ordinary shares; it also dismissed some claims of the purchasers of the ADS, while allowing others to go forward.

The suit arose in the aftermath of the well-known 2010 explosion of the Deepwater Horizon rig and the ensuing “blowout” of BP’s Macondo well, which caused a disastrous oil spill in the Gulf of Mexico. Plaintiffs, acquirers of BP ordinary shares and ADS between January 16, 2007 and May 28, 2010, asserted that BP violated Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission by issuing false or misleading statements before and after the incident.

According to the court, to adequately plead a 10(b) claim for misrepresentation under the heightened pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”), a plaintiff must “(1) specify each statement alleged to have been misleading; (2) identify the speaker; (3) state when and where the statement was made; (4) plead with particularity the contents of the false representation; (5) plead with particularity what the person making the misrepresentation obtained thereby; and (6) explain the reasons why the statement is misleading, i.e., why the statement is fraudulent.”

The court held that Plaintiffs pled with sufficient particularity that BP made false or misleading statements regarding the following: BP’s implementation of specific recommendations from an independent safety panel (the “Safety Panel”), BP’s Initial Exploration Plan (“IEP”), BP’s Oil Spill Response Plan (“OSRP”), BP’s ability to respond to a Gulf oil spill (including definite amounts of recoverable barrels per day), post-blowout estimates of spill size, and the Deepwater Horizon rig’s safety record. In contrast, the court held that Plaintiffs did not plead with sufficient particularity that general statements about BP’s “commitment to safety” and “safety culture” were false or misleading.

The pleadings sufficiently alleged a “strong inference” of scienter for only two of the individual defendants: Tony Hayward, the CEO, and Douglas Suttles, the COO for Exploration and Production. According to the complaint, Hayward admitted he was responsible for BP’s “process safety” and spoke publicly about measurable safety improvements that addressed the Safety Panel’s findings. Thus, the inference that Hayward was highly involved in, and thus aware of, operational safety was stronger than the opposing inference that he was only pretending to be involved but was unaware of operational safety problems. Similarly, the inference that Suttles — who was in charge of BP’s spill response team — knowingly provided public spill estimates lower than BP’s internal estimates was stronger than the opposing inference that he was unaware of the internal estimates.

With respect to corporate scienter, the claims involving the IEP and OSRP met the Tellabs II bar: misleading announcements “so dramatic” as to have been approved by officials who knew they were false. Indeed, the court noted that the numbers in the plans “appeared to have been invented out of thin air” and were so egregiously erroneous that a finding of corporate scienter was appropriate.

Ultimately, although many of the ADS holders’ claims failed to meet the heightened pleading standard of the PSLRA, a number of claims established and pled with particularity the requisite elements of securities fraud, and thus survived the motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.

Monday
May142012

The Board and "Reliable" Directors 

Boards are sometimes described as institutions designed to provide the CEO with advice.  To the extent they filled with knowledgeable people from different backgrounds, boards stand ready to counsel and assist CEOs in what can often be very challenging environments.

There may be some boards that play this role.  But boards that give advice can also fire the CEO.  CEOs wanting to retain their post have a rational incentive to "neutralize" the board.  This entails a preference not for directors who provide the best advice, but for those who will be the least likely to intervene in corporate affairs.  In short, directors are often picked not for their diverse perspective but for their "reliability."  This is discussed at some length in Essay: Neutralizing the Board of Directors and the Impact on Diversity

Picking reliable directors, however, is not without limits.  Most boards of public companies consist of independent directors.  Thus, to the extent the CEO prefers reliable directors, these individuals must be both reliable and independent.

What are some categories that meet both tests?  Friends of the CEO.  As we have noted, the definitions of director independence used by the stock exchanges do not require boards to screen for friendship.  To the extent boards contain directors who are friends of the CEO, they will presumably be less likely to intervene in the affairs of the company (something that can include firing the CEO).

Another category, however, are executive officers of other companies, particularly other CEOs.  A CEO of another company is likely to be less interested in intervention.  For one thing, he (and rarely she) does not want his/her own board to intervene.  The CEO as director probably takes that same philosophy to other boards where he/she sits as a director.  

These directors may be common but pressure is growing to make them a little less common.  According to an article in the WSJ, 118 "top officers of Fortune 1000 companies sit on at least three boards," including their own.  The actual analysis is here.  Some institutional investors think that this is too much and are pressuring some of them to reduce their commitments.  As the article noted:

Some investors are actively objecting to executives' multiple directorships. Calpers and the UAW Retiree Medical Benefits Trust, which manages about $53 billion in assets for retired auto workers, say they likely will oppose board re-elections at 2012 annual shareholder meetings of several dozen CEOs with more than one outside board seat.

Top executives may take these positions "to broaden their business perspective."  But they are also well paid.  "Among companies in the Standard & Poor's 500-stock index, average annual compensation for directors exceeded $232,000 in 2010, up 8% from $215,000 the year before, according to a 2011 study by recruiting firm Spencer Stuart."

The pressure is to prevent executive officers from taking too much time away from the primary company that they manage.  At the same time, however, the approach also makes it a little bit harder to ensure the reliability of the board. 

Saturday
May122012

Does JP Morgan's $2 Billion Loss Implicate Board Oversight?

JP Morgan recently reported a surprising $2 billion loss that it attributed to "egregious" mistakes in its derivatives-based hedging strategy.  A news report (here) notes that CEO Jamie Dimon acknowledged that part of the problem was poor monitoring.  This made me think about Delaware's Caremark duty of oversight, which requires boards to implement information gathering and reporting systems designed to alert them to problems in the business.  As Stephen Bainbridge has noted (here), while the duty has typically been understood to cover violations of the law, there is a good argument to be made for including oversight of risk management.

The financial crisis of 2008 revealed serious and widespread risk management failures throughout the business community. Shareholder losses attributable to absent or poorly implemented risk management programs are enormous. Efforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremark claims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation. Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes. Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremark is the most difficult theory of liability in corporate law, risk management is the most difficult variant of Caremark claims.

While I agree that it should be difficult to hold a board liable for failing to properly oversee a corporation's financial risk management, at some point the critical "utter failure" threshold is crossed and imposing liability is appropriate.  The critical questions are: (1) How do we define the risk exposure, such that an information gathering and reporting system's failure to bring it to the attention of the board constitutes an utter failure? (2) How well do the directors have to understand the risk, such that they have not utterly failed to exercise judgment in responding to the relevant reports?  Applying this analysis to JP Morgan's recent loss, I actually think an argument could be made that in light of JP Morgan's overall size a failure to bring the strategy to the board's attention might not constitute an utter failure of the reporting system.  Of course, that's assuming $2 billion is at the upper end of the range of potential losses implicated by the hedging strategy.  And that's assuming further that the masters of the universe implementing the strategy can actually accurately calculate their exposure.  All of which raises a final interesting question (at least for purposes of this post):  Should an inability to fully understand the risk exposure of a particular strategy or financial instrument constitute a per se violation of Caremark?  My current inclination is to answer that question in the affirmative.

Friday
May112012

Delaware Courts and the "Protection" of Investors

Martin Marietta Materials v. Vulcan Materials Co., 2012 Del. Ch. LEXIS 93 (Del. Ch. May 4, 2012) is a 138 page tome ultimately holding that Martin Marietta violated a confidentiality agreement with Vulcan.  As a result, the Chancery Court enjoined Martin Marietta's hostile offer for Vulcan.  The interesting thing in the case concerns the court's treatment of the argument that an injunction would harm shareholders. 

When the court finds a violation of the law, they must consider an appropriate remedy.  In some cases, the parties argue that a particular remedy would be harmful to shareholders.  That issue came up in El Paso Energy.  There the Chancery Court first found that shareholders had sufficiently alleged a violation of the duty of loyalty.  When addressing the injunction sought by shareholders, however, the court  demurred.  Doing so would harm shareholders.  As the court reasoned, an injunction would potentially cause "more harm than good" to shareholders by allowing the purchaser to walk away from the offer.

The court made no mention of the broader benefits to the market that could have flowed from an injunction.  While shareholders of El Paso could have been injured by the remedy (any delay could have caused the bidder to withdraw the offer and move on), the market arguably would have benefited in the aggregate from strong measures against alleged breaches of fiduciary obligations.  The broader benefit, however, was not addressed. 

In Martin Marietta, the same issue came up. Martin Marietta argued that even had it violated the confidentiality agreement, any injunction prohibiting its hostile acquisition attempt would be harmful to shareholders.   As the court described:

In some of its arguments, Martin Marietta has tried to assert that this case has large implications for the ability of American investors to receive premium-generating offers for their shares. Martin Marietta implies that, if it is enjoined from pursuing its Exchange Offer and Proxy Contest because it violated the Confidentiality Agreements, a chill on M&A activity will result, harming stockholders and lowering share values. In its starkest form, Martin Marietta's argument is that a loss for Martin Marietta in this litigation will turn every confidentiality agreement into a standstill, even though standstills are a common contractual provision.

That contention, however, received short shrift.

But to the extent that Martin Marietta suggests that courts should not enforce confidentiality agreements as they do other contracts on the ground that to do so is necessary to protect stockholders, I see no warrant in our law for such adventurism and no empirical basis to move our common law of contracts in that direction.

In other words, harm or not to shareholders, the court intended to enforce the contract.  The court went on, however, to explain how shareholders in the aggregate benefited from the enforcement of the confidentiality agreement.  

The American M&A markets are extremely vibrant and generate a high volume of premium-generating transactions, even in comparison to the U.K. system beloved by certain of my favorite academics in corporate law. One of the reasons for this vibrancy is the freedom given to corporations to use contracts to limit the very real business risks attendant to exploring M&A transactions. By respecting contract rights, our courts give parties in commerce the confidence that they can rely upon the contracts they execute to reduce risks and transaction costs. . . . If the message is sent that the confidentiality and other agreements that control the downside risks of such engagement will not be respected, then one can rationally expect such competitors not to be as prone to considering such transactions. 

In other words, whatever the impact in this particular situation, investors and the market would benefit from knowing that contracts will be vigorously enforced. 

Perhaps.  Only the same thing can be said about enforcing fiduciary obligations.  Yet in the Delaware courts, that does not seem to be the case.

Thursday
May102012

Disclosure of the Personal Use of Aircraft by Officers and Directors: The SEC and Fiduciary Obligations

In reporting personal use of the aircraft, top officers and directors must disclose the value of the services as part of their executive compensation.  In computing the value, however, they are required to rely on the "variable" costs to the company.  These numbers can be eye popping in amount. 

If the same amount were actually treated as income for IRS purposes, the tax liability would probably result in reduced use of the corporate aircraft.  But in fact the IRS does not require this number to be taken into taxable income.  Taxable income is typically a much smaller amount.  For a post discussing the approach to valuation by the SEC and IRS, go here.  The high level of comfort and the low level of tax consequences makes this a hard benefit to give up even if it often generates public criticism. 

Now it turns out that even the eye popping numbers under the variable cost approach may be an under statement.  The WSJ reported that Chesapeake Energy has been sued for allegedly understating the costs of personal travel on the corporate aircraft for "top executives and outside directors by as much as $10 million per year."  Apparently the suit alleges that the personal use of the aircraft was so great that computation of the value should have included fixed as well as variable costs. 

There may need to be an SEC fix to this issue.  The SEC may have to amend Item 402 (an already excessively long provision) to provide that fixed costs must be included once personal use climbs above a specified percentage.  But in truth this is asking the SEC to fix a problem that really ought to be handled under state law.  Fiduciary duties ought to prohibit this from occurring with any real frequency.  But they do not.  This is because state law requires deference to decisions by "independent" directors. 

Yet at Chesapeake Energy, those same "independent" directors are authorized to use the corporate aircraft for 40 hours of personal use.  See Preliminary Proxy Statement, at 10 ("each non-employee director is entitled to personal use of fractionally owned Company aircraft for up to 40 hours of flight time per calendar year.").  It is this same group that state law says is supposed to oversee personal use by the CEO and other executive officers. 

How are they doing?  Let the preliminary proxy statement speak for itself.  Id.  ("Feedback from the named executive officers indicates that limited access to fractionally owned Company aircraft for personal use greatly enhances productivity and work-life balance, which we believe provides performance and retention incentives far in excess of the cost of the perquisite to the Company."). 

Wednesday
May092012

Personal Use of the Aircraft by Corporate Officials: An Update and a Call for Access

Some companies allow officers and directors to use the corporate aircraft for personal travel.  For a post in Dealbook on this, go here.  Companies report the amount of personal use as part of the "total" compensation paid to executives in the proxy statement.

As a matter of corporate law, directors must act in the best interests of shareholders.  How does allowing for personal use of the aircraft (and the accompanying expense to the company) support the interests of shareholders?  As the DealBook article points out (and we have mentioned on this Blog), boards justify the position by asserting that its necessary to protect the security of the CEO.  Presumably this means the desire to protect the CEO from terrorist attacks or other types of physical assaults.

This is not without some justification.  A vacation spent in some dangerous location may require companies to take unusual steps to protect the CEO.  Of course, boards could, in those circumstances, prohibit the trip, much the way athletes are prohibited from engaging in dangerous activities, rather than have the company absorb the travel expenses.

But, in fact, corporate use of the aircraft ensure security of the CEO on trips to Hawaii or anywhere else in the United States.   As Steve Davidoff pointed out on the DealBook, the board at Ford requires the CEO to "fly on a private jet whether he is going to Washington for business or Hawaii for vacation."  He notes that in contrast, "Justice Ginsburg flies commercial with all its attendant hassles."  As he asks and answers:  "Are corporate chieftains really in that much danger?  The answer has to be no in most cases."

So what's going on? Delaware allows boards, for the most part, to do anything they want in the executive compensation area as long as they employ proper process.  So legally, directors can easily allow the practice. 

Just because they can, however, does not mean they must and, in fact, most public companies do not provide the benefit.  Why then do some boards (and their independent directors) approve the practice in circumstances where security of the CEO does not seem to be a real issue? 

It may be that the board is full of the friends of the CEO (this is discussed in  Essay: Neutralizing the Board of Directors and the Impact on Diversity) or it may be that the board has been captured by the CEO.  Jon Macey discusses capture in his book on Corporate Governance.  But even more directly, directors who antagonize the CEO risk the possibility of not being renominated and, as a result, losing a well paid sinecure on the board.  Total compensation for independent directors can exceed $1 million.  In other words, even where some directors have qualms about the practice, they are loathe to stick their neck out and object to a practice by the CEO.

Is there a solution?  If the board had a couple of directors nominated by shareholders (and therefore not screened by management), these directors could be the ones to "stick their neck out" since they would not be worried about the threat of no renomination by the CEO.  If some directors did this, others would likely go along.  In short, the process for approving CEO use of the corporate aircraft for personal reasons would suddenly become more rigorous.  

How do we get shareholder nominees on the board?  Shareholder access.  Dodd-Frank allowed for it, the DC Circuit did not, but eventually there will be the appropriate rules in place.  Until then, the approval process for personal use of the corporate aircraft will be less rigorous and, as a result, provide less confidence that the decision was appropriate.  

Tuesday
May082012

SEC v. SIPC: The SEC Exerts its Authority over SIPC in a Case of First Impression

In SEC v. SIPC, 2012 WL 403602 (D.D.C. Cir. Feb. 9, 2012), the court granted the Securities and Exchange Commission’s (“SEC”) Ex Parte Motion to Show Cause and denied the Securities Investor Protection Corporation’s (“SIPC”) Motion to Strike the SEC’s motion.  The SEC requested that the court order the SIPC to file an application in Texas federal court to start liquidation proceedings for the Stanford Group Company (“SGC”). 

Congress passed the Securities Investor Protection Act (“SIPA”) with the goal of protecting “customers of failed broker dealers who f[ind] their cash and securities on deposit either dissipated or tied up in lengthy bankruptcy proceedings.”  Congress then created SIPC, a non-profit private corporation, to carry out SIPA’s goal.  Members are broker-dealers registered with the SEC, and they are required to join SIPC.  When a member firm has financial problems, SIPC has the authority to initiate a liquidation proceeding and facilitate in returning customers’ funds.

Robert Stanford (“Stanford”) owned SGC, a broker-dealer registered with the SEC and SIPC member, and the Stanford International Bank, Ltd., (“SIBL”) located in Antigua.  In 2009, Stanford’s companies failed after selling more than $7 billion worth of CDs issued by SIBL and sold by SGC.  According to the SEC, Stanford was operating a fraudulent Ponzi scheme.  Stanford is also facing criminal charges brought by federal prosecutors in Texas. 

SIPC declined to file an application for a protective decree which, if approved by the court, would appoint a trustee to liquidate SGC’s assets in bankruptcy court and allow SGC’s customers to file claims against SGC’s estate in an attempt to recoup their losses.  SIPC contended that SGC’s customers were not covered because “SGC did not perform a custody function for the customers who purchased the SIBL CDs.”  The SEC advised SIPC that “SGC’s customers were in need of the protections of the SIPA and that SIPC should seek to commence a liquidation proceeding.”  SIPC maintained its original position that SGC’s customers were not entitled to protection under SIPA and refused to file an application to commence liquidation proceedings. 

Under SIPA, “[i]n the event of the refusal of SIPC to commit its funds or otherwise to act for the protection of customers of any member of SIPC, the Commission may apply to the district court…for an order requiring SIPC to discharge it obligations…and for such other relief as the court may deem appropriate.”  The court noted this is the first time since SIPA was created 42 years ago that the SEC has sought to exert this authority over SIPC.

The SEC argued that, under SIPA, the term “apply to the district court” meant the SEC need only file an application with the court and a formal complaint and summons were not required.  The SEC also argued that summary proceedings were permitted and the discovery process was not necessary.  SIPC took the position that, under SIPA, plenary proceedings were required, the SEC should file a formal complaint, and the court should allow discovery.  

The court looked to the plain meaning of the statute and held that a formal complaint and summons were not appropriate and summary proceedings were allowed.  The court granted the SEC’s Motion to Show Cause and allowed the parties to determine how to proceed in the case. 

The primary materials for this case may be found on the DU Corporate Governance website

Saturday
May052012

Corporate Gender Inequality, the Meritocracy Fiction, and Other Related Points

The Wall Street Journal ran an article this past week (here) about a recent discussion Jack Welch had with a group of women executives.  While the article pointed out that only 3% of Fortune 500 companies have a female CEO, and female board membership is “similarly spare,” Mr. Welch apparently attributed this inequality to a lack of adequate production by women.  I say this because the article described him as being both dismissive of programs designed to increase workplace diversity, and confident that performance is rewarded:

Programs promoting diversity, mentorships and affinity groups may or may not be good, but they are not how women get ahead. "Over deliver," Mr. Welch advised. "Performance is it!"

The responses of some of the attendees reflected a different view:

"He showed no recognition that the culture shapes the performance metrics, and the culture is that of white men."

"While he seemed to acknowledge the value of a diverse workforce, he didn't seem to think it was necessary to develop strategies for getting there—and especially for taking a cold, hard look at some of the subtle barriers to women's advancement that still exist. If objective performance measures were enough, more than a handful of Fortune 500 senior executives would already be women. "

"This meritocracy fiction may be the single biggest obstacle to women's advancement."

While the issue of gender inequality in corporate board rooms and executive suites is obviously complex, one particular item I was reminded of while reading this was the suggestion that having a few more women in positions of power in the financial industry might have actually allowed us to avoid the recent financial crisis.  As one news item put it (here):

There is a dramatic difference in the data between female and male risk-taking types…. Evolutionary speaking, the species has survived because of the balance of the genders. One would suggest that in investment banking, which is very male dominated, you need a balance of risk types if you want to survive. If you’re not recruiting people of all risk types, you’re missing out on a fundamental self-controlling mechanism. It’s a bloody good formula for survival.

For another perspective you might want to review Julie Nelson’s essay, “Would Women Leaders Have Prevented the Global Financial Crisis? Implications for Teaching About Gender and Economics,” which is available via SSRN (here).  Here is the abstract:

Would having more women in leadership have prevented the financial crisis? This question challenges feminist economists to once again address questions of "difference" versus "sameness" that have engaged — and often divided — academic feminists for decades. The first part of this essay argues that while some behavioral research seems to support an exaggerated "difference" view, non-simplistic behavioral research can serve feminist libratory purposes by debunking this view and revealing the immense unconscious power of stereotyping, as well as the possibility of non-dualist understandings of gender. The second part of this essay argues that the more urgently needed gender analysis of the financial industry is not concerned with (presumed) "differences" by sex, but rather with the role of gender biases in the social construction of markets. An Appendix discusses specific examples and tools that can be used when teaching about difference and similarity.

Wednesday
May022012

The JOBS Act and the Capital Raising Process (What Was the Problem Again?)

The JOBS Act sought to make capital raising for small businesses easier.  We have criticized the efforts both from the lack of sufficient protections for investors but, equally fundamentally, from the perspective that they will not do much to facilitate capital raising.

But based upon a study just issued by the Commission, there is a more fundamental issue:  Was there a problem to begin with? The data in the study allowed for a number of interesting observations.  First, no great surprise, but in the time period studied (2010), "Reg D offerings surpassed debt offerings as the dominant offering method in terms of aggregate amount of capital raised." Moreover, an analysis of the use of the exemption in the first quarter of 2011 showed that the use of Regulation D offerings was growing exponentially.  As the study noted:

Our analysis of information extracted from all electronic Form D filings in calendar years 2009 and 2010 reveals that unregistered offerings were $587 and $905 billion, respectively (Table 1). The pace of capital formation in the first quarter of 2011—already $322 billion—corresponds to an annualized rate of $1.3 trillion, far in excess of capital acquired through offerings reported in either of the previous two years, suggesting a significant increase in use of private market capital.

Nor did the exemption need to raise large amounts of capital to be cost effective.  Indeed, the median offering was approximately $1 million.  Likewise most of the companies that use the exemptions appear to be small. 

Although a significant number of issuers decline to disclose their sizes (50%), for those that do, most have revenue less than $1 million. Only 1.8% of all new offerings are by issuers that report more than $100 million in revenues.

In other words, Regulation D, prior to the amendments in the JOBS Act, was available to small companies to raise small amounts of capital.  While these numbers do not resolve whether reforms would permit even more small companies to raise capital, one possible conclusion from the data is that there was no need to "reform" Rule 506 or to add the crowdfunding provision since the companies that would use either may have already had cost effective access to the capital markets.

Tuesday
May012012

Delaware, Equitable Authority, and the Removal of Directors

Can the board remove directors?  On the whole, the law says no, although the authority in Delaware is a particularly weak reed.  A discussion of the issue is here.  For the most part, this is the right answer.  Directors are elected by shareholders.  It should be up to shareholders, not other board members, to determine the continued tenure of a director.  Of course, there is one inroad into this limit.  Majority vote provisions mostly require losing directors to resign.  This effectively leaves in the hands of the board the authority to remove an elected director.  

But what about the courts?  Can a court remove a director?  This raises a different issue.  Sometimes directors engage in harmful behavior and their continued tenure will result in harm to the company.  Sometimes the offending director owns a controlling block of stock and cannot be removed.  Appealing to a court does not raise the same inherent concerns that arise with directors removing directors. 

Delaware has a statute that permits judicial removal of directors but only in exceedingly narrow circumstances.  According to 8 Del. C. § 225(c): 

If 1 or more directors has been convicted of a felony in connection with the duties of such director or directors to the corporation, or if there has been a prior judgment on the merits by a court of competent jurisdiction that 1 or more directors has committed a breach of the duty of loyalty in connection with the duties of such director or directors to that corporation, then, upon application by the corporation, . . . in a subsequent action brought for such purpose, the Court of Chancery may remove from office such director or directors if the Court determines that the director or directors did not act in good faith in performing the acts resulting in the prior conviction or judgment and judicial removal is necessary to avoid irreparable harm to the corporation.

Anything short of a felony or an adjudicated violation of the duty of loyalty will be insufficient for purposes of removal under the statute. 

But the Chancery Court in Delaware is a court of equity, a source of authority typically read in a broad fashion.  See Whittington v. Dragon Group, LLC, 2011 Del. Ch. LEXIS 63 (Del. Ch. April 15, 2011) ("This Court, as a court of equity, has broad discretion to form an appropriate remedy for a particular wrong."). Does equity, therefore, allow the Chancery Court to remove directors in cases other than those prescribed by statute? 

That was the issue in Shocking Technologies, Inc. v. Michael, C.A. No. 7164-VCN (Del. Ch. March 26, 2012).  In that case, the company sought the removal of a director.  Not bringing the action under Section 225, the company appealed to the Chancery Court's equitable authority.  The company claimed that the director had improperly "interfered with [the company's] efforts to raise additional capital."  Moreover, the company alleged that the "actions, if they happened and are likely to happen again because it must raise funds to survive."  The court found that the company "pled a colorable claim and the likelihood of irreparable harm." 

The only issue was whether the court had the equitable authority to remove the director.  While the court left the issue unanswered, it indicated that the factual circumstances at issue were not sufficient to trigger the court's "inherent equitable powers" even if the authority existed. 

Without resolving the question of whether or not the Court has the power to remove a particular director outside of a § 225(c) action, the Court notes that the General Assembly set forth in § 225(c) the circumstances in which the Court is expressly empowered to remove a director. The Court concludes that this action is not so unusual and does not involve such pressing issues that the Court would be moved to exercise any inherent equitable powers (if, indeed, it has such powers) it might have to remove a director outside of a § 225(c) action.

But tucked in the opinion was a footnote indicating that there was "significant authority for the proposition that the Court does not have the power, other than as granted by statute, to remove a duly selected director who has breached the duty of loyalty."  The one case cited by the court (in addition to secondary and legislative sources), was Ross Sys. Corp. v. Ross, 1993 WL 49778, at *17-18 (Del. Ch. Feb. 22, 1993)  ("But the plaintiffs here do not ask the Court to appoint a receiver or trustee, and they are unable to point to any statute or other source of law that would empower this Court to remove a particular member of the corporation's board of directors."). 

Thus while the issue is not entirely foreclosed, the courts in Delaware seem unwilling to apply equity in the case of director removal.  Those on the board, therefore, do not generally have to worry that their term will be cut short when they act in an inequitable fashion.   

Monday
Apr302012

Corporate Governance, the Role of Disclosure and the Myth of Majority Vote Provisions

A director at NYSE Euronext, Ricardo Salgado, failed to obtain a majority of the votes cast. The reason, apparently, was that he failed to attend 75% of the meetings of the Board. 

How do we know about his attendance?  The SEC requires disclosure in the proxy statement of any director that does not meet this standard. See Item 407 of Regulation S-K ("State the total number of meetings of the board of directors (including regularly scheduled and special meetings) which were held during the last full fiscal year. Name each incumbent director who during the last full fiscal year attended fewer than 75 percent of the aggregate of: The total number of meetings of the board of directors (held during the period for which he has been a director); and the total number of meetings held by all committees of the board on which he served (during the periods that he served)."). 

This is one of those interesting requirements that is less about material information and more about altering substantive behavior.  The provision was put in place back in 1978.  See Exchange Act Release No. 15384 (Dec. 6, 1978).  For a discussion of the requirement go here.  The provision was less about informing shareholders and more about encouraging directors to attend board meetings in order to avoid embarassing disclosure.  The SEC has often used this approach under the securities laws.  See Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure

In an era of both majority vote provisions and "just say no," attendance has become a flashpoint with shareholders.  The NYSE Euronext apparently recognized this and provided a spirited defense of Mr. Salgado. As the Company explained in its proxy statement:

Each of our directors attended at least 75% of the total number of meetings of the Board and committees on which the director served that were held while the director was a member, except for Mr. Salgado. Mr. Salgado has been a member of the Board since 2007, and this is the first year that Mr. Salgado did not attend at least 75% of meetings of the Board and the committees on which he served. Mr. Salgado holds a key position as vice-chairman and president of the executive committee of Banco Espirito Santo, Portugal’s largest bank, which in 2011 required him to focus on managing the bank’s navigation of the European debt crisis. He also actively participated in high-level European regulatory and political discussions about how best to resolve the crisis. Mr. Salgado attended a number of joint meetings of the European Commission, the European Central Bank and the International Monetary Fund, as well as meetings of the Bank of Portugal and the Portuguese Banking Association, to implement the new requirements imposed on Portugal and its banking sector. Mr. Salgado’s intensive efforts to address the crisis restricted his ability to attend certain of the significant number of special meetings held in connection with the proposed business combination with Deutsche Börse, which were not part of the regular meeting schedule and were often called with little advance notice. Mr. Salgado participated in major decisions of the Board concerning the proposed business combination, kept apprised of developments regarding the transaction through communications with his fellow directors, and attended all but one of the regularly scheduled meetings of the Board and the committee on which he served.

Nonetheless, shareholders disagreed and declined to give him majority support.  That in turn triggered an obligation to resign.  The NYSE has a bylaw that provides for majority voting.  See Bylaw 2.7 ("each director shall be elected by the vote of the majority of the votes cast with respect to that director’s election at any meeting for the election of directors at which a quorum is present"). 

As is typical of these provisions, the director did not actually lose, but instead was required to submit a letter of resignation.  Id.  ("In the event an incumbent director fails to receive a majority of the votes cast in an election that is not a Contested Election, such director shall tender his or her resignation to the Nominating and Governance Committee of the Board of Directors").  Mr. Salgado submitted the requisite letter.

In the past, resignation letters have not been accepted by the board.  They were rejected at Pulte and Axcelis.  The NYSE Euronext, however, accepted the letter of resignation.  So does this mean that these majority provisions have teeth after all?  It does not.

These majority vote provisions do not give meaningful authority to shareholders.  They merely trigger a resignation that places in the hands of the board the authority to remove an incumbent director, something ordinarily not permitted under state law.  In other words, the resignation enhances the board's authority.  This case shows that when confronted with a letter that does not implicate the behavior of management, boards will at least sometimes accept the resignation.  Where, however, a defeat by shareholders is at least partially a commentary on incumbent management, boards have little incentive to accept the resignation.  Nothing about the NYSE Euronext situation altered that dynamic. 

Saturday
Apr282012

Federal Securities Regulation: Are We Moving Toward Merit Review? (Part 2)

Last week I blogged (here) about the possibility that the Supreme Court’s apparent increasing willingness to strike down regulation of corporate speech as contrary to the First Amendment could lead to a reconsideration of merit review as a part of our federal securities regulation regime (it is already a part of many states’ blue sky laws).  The next day, Stephen Bainbridge responded: "No thanks!" (here).

Bainbridge noted the following criticisms of merit review (I provide some additional considerations):

Criticism: “[Merit review thus is] premised on the debatable notion that a security has an ascertainable fair price.” (Quoting Wendy Gerwick Couture, Price Fraud, 63 Baylor L. Rev. 1 (2011).)

Comment: “[While t]he fundamental value of a security cannot be reduced to a specific number … security analysis is used to identify a range of values that are supported by the fundamentals and reasonable assumptions…. factfinders are often asked to determine the fundamental value of securities in other contexts that are equally as complicated ….” Couture, Price Fraud, 63 Baylor L. Rev. at 61-62.

Criticism: “In addition, by lowering offering prices below what the market will bear, [it will] divert money away from the issuer to be scooped up by speculators in the secondary market.”  Id.

Comment: We already have money being diverted from issuers when they offer their securities.  It’s called underpricing, and it has so far not killed the market.

Criticism: “[M]erit review is widely criticized as unduly paternalistic…. in essence, merit review protects investors from themselves.” Id.

Comment:  Actually, I think that what merit review should be about first and foremost is protecting the market from collapse.  When we can figure out how to keep the health of the overall market from being implicated when individual investors burn their life savings up in bubble feeding frenzies, I might be more open to equating the old saw “a fool and his/her money are soon parted” with good policy.  Relatedly, I recently watched the first Frontline episode of “Money, Power & Wall Street” wherein Frank Partnoy commented on the on-going industry debate about whether risk tends to end up in the smartest or the dumbest hands.  Partnoy concluded that the latter appeared to be the case when we allowed credit default swaps to trade freely in unregulated markets.

Criticism: “[M]erit regulation has also provided a fertile breeding ground for rent seeking and corruption by regulators.”  (Quoting Robin Hui Huang, 41 Hong Kong L. J. 261, 270.)

Comment:  There is no such thing as a free lunch.  If the SEC’s ability to protect markets by mandating certain types of disclosures is excessively constrained, merit review may be considered as a way to fill the regulatory void.  The question of whether the cost of rent-seeking outweighs the cost of leaving markets vulnerable to another financial crisis is a complicated one.  But the mere fact that we can expect to see some rent-seeking does not necessarily doom merit regulation as an effective regulatory choice.

Criticism: “Therese Maynard notes that merit review also has been blamed for impeding capital formation. ‘Small issuers in particular complained bitterly that the cost of complying with California's merit review standard in order to register their securities offerings for sale in this state substantially raised their capital formation costs.’” (Quoting 30 Loy. L.A. L. Rev. 1573, 1586.)

Comment: Recent events suggest we have the ability to address concerns related to small business capital formation directly.

Criticism: “What would I do if the Supreme Court struck down the current mandatory disclosure regime? … I'd rely on voluntary disclosure.”

Comment: Again, are we talking about the type of voluntary disclosure that kept the credit default swap market in check in the period leading up to our most recent financial crisis?

I certainly don’t claim to know whether the increasing protection of corporate speech will implicate securities regulation in such a way as to spur the SEC or Congress to look for regulatory alternatives.  Nor am I certain that merit review would be a good choice if that were to be the case--it may be that the sum of Bainbridge's well-grounded criticisms above are too much to overcome even if there are adequate responses to them taken individually.  I do, however, think both contentions are interesting and should not be dismissed prematurely.

Friday
Apr272012

Facebook, Instagram and the Non-Role for the Board of Directors

According to the WSJ, the Facebook Board of Directors was presented with a proposal to buy Instagram with little notice and little involvement.  According to the article, the board was made aware of the acquistion when "the deal was all but done."  As one person put it, the board "[w]as told, not consulted."  The deal was negotiated by Mark Zuckerberg, the CEO and owner of 28% of the company's stock, 57% of the voting power. 

The article noted some possible advantages.  Mr. Zuckerberg was concerned that the CEO of Instagram might have reacted "negatively had he approached him through lawyers."  Moreover, the talks proceeded quickly. 

But the article also raises concerns about the role of the board.  There is nothing wrong with the CEO negotiating an acquisition.  There is nothing wrong with a plan to avoid inundating a CEO of a high tech company with lawyers.  But that is not an explanation for the failure to keep at least some directors informed or otherwise seek their advice.  It suggests that the role of the board is not to provide advice but to ensure legal sufficiency. 

This is not unusual.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity.  But this may well result in an under utilization of the board.  It effectively deprives CEOs of advice that boards are in a unique position to provide. 

Thursday
Apr262012

The SEC and Whitleblowers

The SEC has been accused of outing a whistleblower.  But as Mark Twain observed in Connecticut Yankee (p. 58):  "This was the report; but probably the facts would have modified it." Some of the facts come from George Canellos, head of the New York Regional Office of the SEC in a letter to the WSJ. 

 

SEC Did Not Blow Source's Cover

The Securities and Exchange Commission in no way exposed Peter Earle as a whistleblower, and our use of his notebooks in an investigative deposition was neither "inadvertent" nor a "breach" or "gaffe" ("Source's Cover Blown by SEC," Page One, April 25). It was a deliberate decision, which SEC lawyer Daniel Walfish discussed in advance with his supervisor, who was present for the deposition in which the notebooks were exhibited. Nor did the fully authorized use of the notebooks in any way compromise Mr. Earle or the integrity of the SEC's investigation of the Pipeline Trading Systems matter.

Although it was widely known among executives of Pipeline and Milstream Strategy Group that Mr. Earle had approached the SEC after he was terminated from Milstream—a fact volunteered by several witnesses and acknowledged by Mr. Earle long before any use of his notebooks—the SEC declined to confirm his identity and still treated his status as a cooperating witness as confidential. The SEC made sure to obtain all of the notes of the approximately six Milstream traders, and in the SEC's deposition of Gordon Henderson (the supervisor of Mr. Earle and the other traders), the SEC used other traders' notes along with those of Mr. Earle. The use of these traders' notes—highly relevant evidence prepared in the ordinary course of their work at Milstream—in no way revealed whether Mr. Earle or any other trader was or was not cooperating with the SEC.

George S. Canellos

Director

New York Regional Office

U.S. Securities and Exchange Commission

New York

Thursday
Apr262012

The SEC and the Non-Cost Benefit Analysis Analysis (Part 4)

For the time being, there is no question that the SEC will have to perform an even lengthier cost benefit analysis than is typically the case.  Recall that in the shareholder access rule, the staff included 80 pages of analysis.  This was not enough.  The irony is that while the court in Business Roundtable used its questionable analysis to strike down a rule included in Dodd-Frank, the immediate consequence at the SEC will be felt under the JOBS Act. 

Take crowdfunding. The provision is replete with rulemaking requirements.  For example, the law creates a Section 4A of the Securities Act and requires an intermediary (broker or funding portal) to register with the SEC.  The intermediary:

  • will have to provide certain disclosure to investors, including disclosures related to risks and other investor education materials, as the Commission shall, by rule, determine appropriate;
  • ensure that each investor reviews investor-education information, in accordance
    with standards established by the Commission, by rule;
  • require investors to answer questions demonstrating an understanding of "such other matters as the Commission determines appropriate, by rule."  
  • must take measures designed to reduce the risk of fraud "as established by the Commission, by rule."
  • ensure that investors have the right "to cancel their commitment to invest, as the Commission shall, by rule determine appropriate." 
  • ensure that the investors do not invest more than is permitted under the statute, in accordance with "efforts as the Commission determines appropriate, by rule."
  • take steps to ensure that information from investors is kept private "as the Commission shall by rule, determine appropriate." 
  • meet such other requirements as the Commission may, by rule, prescribe, for the protection of investors and in the public interest.

Issuers using crowdfunding will need to provide to investors certain types of financial information.  For some, they must use accounts that meet the "standards and procedures established by the Commission, by rule, for such purpose."  Offerings of $500,000 must provide audited financial statements, although the Commission may "by rule" specify other amounts subject to the requirement.  In addition, the Commission may "by rule" require companies to disclose information necessary "for the protection of investors and in the public interest." 

Investors cannot compensate anyone for promoting the offering through communication channels provided by the intermediary "without taking such steps as the Commission shall, by rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication." 

They must distribute a report to investors that includes "the results of operations and financial statements of the issuer, as the Commission shall, by rule, determine appropriate, subject to such exceptions and termination dates as the Commission may establish, by rule."  The Commission may also adopt by rule any other requirements for issuers for the protection of investors and in the public interest. 

The Commission must make available certain information to the states as the Commission "by rule" determines appropriate. There are restrictions on transferability of shares acquired by investors under the crowdfunding exemption, with the Commission having the authority "by rule" to establish other limitations.  The provision also exempts certain issuers from using the provision.  In addition to the categories listed, the Commission may "by rule or regulation" determine other exempt issuers. 

The provision imposes time limits.  The Commission must adopt rules "[n]ot later than 270 days after the date of enactment of the Act."  The provision does not, however, require that all of the rules in the section be adopted, only those that "the Commission determines may be necessary or appropriate for the protection of investors to carry out sections 4(6) and section 4A of the Securities Act of 1933."  

In other words, the crowdfunding provision cannot become operative until the SEC adopts rules.  Business Roundtable will require a lengthy and far more detailed cost benefit analysis.  Moreover, the SEC will likely be inundated with comments that the staff will be forced to address.  Business Roundtable more or less stands for the proposition that the Agency runs a serious risk if it fails to address any comment.  All of this will lengthen the rulemaking process even more.

Changes to the cost benefit analysis at the SEC will occur, the Chairman has already made that clear.  But for the most vociferous critics of the SEC's process, the outcome of the reforms may entail some consequences they did not intend.   

Wednesday
Apr252012

The SEC and the Non-Cost Benefit Analysis Analysis (Part 3)

On Tuesday of last week, a House Subcommittee held a hearing titled "The SEC’s Aversion to Cost-Benefit Analysis." The chairman of the SEC listed a number of reforms in her testimony designed to improve the cost benefit analysis conducted by the SEC.  For some witnesses, these steps were not enough. 

Two witnesses called for a significant increase in the number of economists at the SEC.  Dean Emeritus Manne had this to say:

There are presently 16 economists among the over-3000 employees of the SEC, and I believe that this is an all-time high number. Given the tasks of generating new rules under the Dodd-Frank law and that Act's additional requirement for cost-benefit studies of existing rules, the number of highly trained and competent economists necessary to complete this job in several years is more likely to be on the order of 100 to 150 if not more.

JW Verret from George Mason recommended that the SEC "freeze attorney hiring until it hires at least 200 more economists." 

Both witnesses also suggested that these hires should not be accompanied by any increase in the SEC's budget.  Dean Emeritus Manne suggested that there was no need for "additional funding" because the resources already existed "in the persons of what will soon be redundant lawyers and policy experts presently working on rule making in the 'old style.'"  JW Verrett had a similar view. "The fact that it has misallocated resources in the past should not justify added appropriations, but instead suggests a need for reallocation of present resources."

In other words, by reallocating funds away from other employees (lawyers for example) in favor of additional economists, they are essentially calling for a simultaneous cut in the SEC's budget for all other programs.  Yet for an already thinly stretched agency, the witnesses did not do any cost benefit analysis of their own proposal.  There was no real attempt to weigh the costs of the cuts to other programs against the purported benefits of having 200 more economists. 

But there is an even larger issue.  In effect, the proposals call for a substantial increase in the resources devoted to cost benefit analysis.  This will essentially make rulemaking more expensive and discourage agencies from engaging in the process (another possible consequence of the court's decision in Business Roundtable).  This is a problem.  Rulemaking is a system whereby agencies seek notice and comment from the public and give all interest groups an opportunity to participate in the approach to be implemented by the agency.  In effect it is a more democratic form of policymaking. 

Discouraging rulemaking eliminates this form of participation.  Moreover, the effect will have broad effect.  While burdening rulemaking may kill some initiatives in Dodd-Frank, it may also kill initiatives in the JOBS Act. 

Moreover, in many cases, the agency will simply implement policies on a more informal, less inclusive basis, without resorting to notice and comment.  By striking down the shareholder access rule, the DC Circuit effectively eliminated rulemaking and replaced it with a system of staff discretion under Rule 14a-8.  The informal system imposes costs on companies, shareholders and the SEC.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors

Tuesday
Apr242012

The SEC and the Non-Cost Benefit Analysis Analysis (Part 2)

We are discussing the hearings last Tuesday on the cost benefit analysis conducted by the Commission.  Some have argued that the SEC's cost benefit analysis for the shareholder access rule was lacking and have pointed to the analysis of the DC Circuit in Business Roundtable as evidence on how it should be done. 

This opinion in Business Roundtable does not provide a guide post for an adequate cost benefit analysis.  The SEC discussed the costs and benefits in 80 pages.  The DC Circuit combed the 80 pages and either found a number of small mistakes or found errors when none really existed. On this basis, the court struck down the rule. 

This is not the appropriate role of a court.  Under our system of administrative law, the standard of arbitrary and capricious (the legal standard used by the DC Circuit to strike down the rule) requires a deferential approach to the agency.  See Nat'l Ass'n of Home Builders v. Defenders of Wildlife, 551 U.S. 644, 658 (2007) (noting that arbitrary and capricious standard is "deferential" to the agency).  There is no evidence in the opinion of a deferential approach (the court does not even mention this approach in the opinion).

Given this lack of deference, there is no reason to believe that the court's decision would have been altered had the SEC turned over the analysis to a raft of economists, as some have suggested.  Those economists presumably would have produced 80 pages of more quantitative analysis.  Yet any quantitative analysis would have had to be based on an assortment of variables, assumptions, and legal standards.  There is no reason to believe that the court would have been any more deferential to 80 pages of that type of analysis than the analysis actually presented in Business Roundtable

Monday
Apr232012

The SEC and the Non-Cost Benefit Analysis Analysis (Part 1)

On Tuesday of last week, a House Subcommittee held a hearing titled "The SEC’s Aversion to Cost-Benefit Analysis." The Committee received testimony from the Chairman of the SEC, Mary Schapiro.  The other witnesses included the former Inspector General of the SEC, David Kotz, Henry Manne, emeritus dean from George Mason, Jacqueline McCabe from the Committee on Capital Markets, JW Verret from George Mason, and Mercer Bullard from the University of Mississippi Law School.

Much of the testimony was highly critical of the SEC.  Often the testimony pointed to the decision of the DC Circuit in Business Roundtable as evidence of how it should be done.  For example, one witness described the opinion as "remarkable" and notes that the author "lays out a veritable catalog of components to an acceptable cost-benefit analysis." 

The approach suggests that the SEC conducted an extraordinarily weak cost benefit analysis and that the DC Circuit provided a guide post for how to properly conduct the analysis.  Both are not a particularly accurate perspective on what actually happened. 

First, it often overlooked in the debate that the SEC conducted an extraordinary amount of cost benefit analysis in adopting the shareholder access rule.  The adopting release for Rule 14a-11 the cost benefit analysis begins on page 305 and continues more or less until page 383.  In other words, there is almost 80 pages of analysis.  Of that analysis, 22 pages (beginning on page 343) assessed costs. In those 22 pages, the staff identified a number of costs, including "(1) potential adverse effects on company and board performance; (2) additional complexity in the proxy process; and (3) preparing the required disclosures, printing and mailing, and costs of additional solicitations."  In other words, the staff conducted a thorough analysis of costs that were entirley speculative since shareholder access has never existed in any meaningful sense. 

Second, whatever one thinks of the DC Circuit's opinion (for a criticism of the decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC), the decision does not really criticize the economic analysis used by the Commission.  Instead, the court bought off on a mish mash of criticism of the staff's approach, almost none of which would be corrected by a more rigorous cost benefit analysis. 

For example, according to the court, the staff did not adequately take into account the "costs" associated with an access challenge.  The staff noted that boards "may be motivated" to expend considerable resources to combat an access challenge.  The staff also noted, however, that the costs "may be limited . . . to the extent that the directors’ fiduciary duties prevent them from using corporate funds to resist shareholder director nominations for no good-faith corporate purpose."  The staff cited three comment letters for the proposition. 

In other words, the staff merely noted that the expenditure of considerable resources may not always occur.  Given that access has not been implemented, the degree to which management will resist is entirely speculative.  To conclude that, depending upon the circumstances, management may not always resist in a significant fashion, seems a reasonable observation.  Yet it was this very determination that gave the DC Circuit the basis for finding the SEC's determination arbitrary. 

In what was an entirely speculative endeavor, the court found only the conclusion that boards would not always expend significant resources as speculative.  The support?  A letter from the ABA Committee on Federal Regulation of Securities.  According to the letter: 

If the [shareholder] nominee is determined [by the board] not to be as appropriate a candidate as those to be nominated by the board's independent nominating committee..., then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests.

But the letter did not support the court's position.  The letter was conditioned upon a finding that the board had determined that shareholder nominees were "not . . . as appropriate" as those nominated by management.  In those cases, the board be compelled by its fiduciary duties to "make an appropriate effort" to resist.

First, boards might find that shareholder nominees are as qualified.  In those circumstances, there would be no fiduciary obligation to resist.  Second, boards might decide that the access candidates had no realistic chance of winning.  The "appropriate" response, therefore, could easily be a statement of opposition in the proxy statement and nothing else.  In short, the board might not expend "considerable resources" to resist a proxy challenge.  In other words, the ABA letter did not disprove the staff's reasonable conclusion that boards might not always expend "considerable resources" to resist. 

Indeed, had the Commission concluded the opposite, that boards would always expend considerable resources to resist, the court could easily have faulted the staff for having made that determination.  On this issue, the staff could not win. 

Most importantly, however, the court's analysis provides no support for a dramatic change in the SEC's approach to cost benefit analysis.  Had the SEC turned the matter over to a raft of economists, as some seem to suggest, the problem would have been the same.  In computing costs, those economists still must determine what costs are included.  Had those economists concluded (reasonably) that management would not always expend "considerable resources" to resist, they presumably would have discounted the total costs associated with tis resistance.  Under the DC Circuit's reasoning, this would have resulted in an arbitrary determination.

There is nothing in the analysis of this issue that provides any guidance on how to better conduct a cost benefit analysis in the future.