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Further Developments on the Benefit Corporation Front (Part 1)

Legislation to amend the General Corporation Law of the State of Delaware (the “DGCL”) and related sections of title 8 of the Delaware Code is currently before the Corporate Law Section of the Delaware State Bar Association for approval. If the amendments become effective, they would result in several significant changes to the DGCL, including adding a new subchapter to the DGCL authorizing benefit corporation status under Delaware law.

As discussed in earlier posts, benefit corporation legislation permits a corporation to state in its articles of incorporation that it intends to operate in furtherance of a specific public benefit (or benefits).   The Delaware statute includes among permissible “public benefits” having a positive effect (or causing a reduction in negative effect) on persons, entities, communities or interests, including those of an artistic, charitable, cultural, economic, educational, literary, medical, religious, scientific or technological nature.

The legislation states that directors of a benefit corporation must balance the pecuniary interests of stockholders, the interests of those materially affected by the corporation’s conduct, and the identified public benefits, and make it clear that benefit corporation directors shall not have any duty to any person solely on account of any interest in the public benefit and would provide that, where directors perform the balancing of interests required of them, they will be deemed to have satisfied their fiduciary duties to stockholders and the corporation if their decision is both informed and disinterested and one that a person of ordinary, sound judgment would approve.

Stockholders in a Delaware benefit corporation may bring a derivative suit asserting that the directors are not advancing the stated public benefits adequately if they own at 2% of the corporation’s outstanding shares (or, in the case of listed companies, the lesser 2% of the outstanding shares or shares having at least $2 million in market value).

Additionally, the legislation sets limits on the ability of benefit corporations to amend their certificates of incorporation or effect mergers or consolidations if the effect would be to abandon their public benefit purpose. These limitations would be imposed through a 66 2/3% vote of each class of the public benefit corporation’s outstanding stock.  It also restricts the ability of corporations that are not benefit corporations to amend their certificates of incorporation to become public benefit corporations or to effect mergers or consolidations that would result in their stockholders receiving shares in a public benefit corporation.  This would be done by requiring a 90% vote of each class of the corporation’s outstanding stock to effect such a change, and grants appraisal rights to any stockholder of a corporation that is not a public benefit corporation that, by virtue of an amendment to the corporation’s certificate of incorporation or any merger or consolidation becomes such a corporation.

Benefit corporations would be subject to all other applicable provisions of the DGCL, except as modified or supplanted by the new benefit corporation legislation. We may see a groundswell of benefit corporations in Delaware if benefit corporation status becomes available (The B Corporation website currently states that there are a total of 720 benefit corporations in existence.)  Opting into that status would overcome the general stance of Delaware corporate law, which while not mandating shareholder primacy certainly permits easy perpetuation of the myth that it is a legal mandate.


Dusting Off the Ultra Vires Doctrine to Rein in Corporate Violations of International Law

This past week, Kent Greenfield alerted me to a suit against Hershey seeking to get records about their alleged use of child labor.  (You can find a news item providing some background here.)  As Kent explained in his email: “The theory of the case -- that violations of international law are ultra vires -- is basically something I came up with 10 years ago, and this is the first case using the theory.”  (You can find an example of Kent’s relevant scholarship here.)  I reviewed the amicus brief that Kent and The Honorable Nancy Gertner, Professor of Practice at Harvard Law School, have filed with the Delaware Court of Chancery, and here is an excerpt I thought might be of interest to our readers:

The implication of the requirement that corporations not engage in illegalities in this case cannot be overstated. Shareholders have an interest in monitoring whether the corporation is acting unlawfully even if there is insufficient evidence to show that directors or other fiduciaries should be subject to personal liability for a failure to monitor under Caremark and Stone v Ritter…. In all fairness, however, there are two gaps in the argument that would hold Hershey and its directors responsible under Delaware corporate law for the illegalities alleged in the complaint. The first gap is informational, and the second is doctrinal…. [However, while t]he extent of knowledge or involvement of Hershey management and of The Hershey Corporation in these illegalities is yet murky…. gathering this kind of information is a very purpose of a § 220 inspection…. Meanwhile, the Delaware judiciary has not yet defined the contours of corporations’ responsibility for illegalities committed by suppliers, business partners, or other third parties. Certainly a company and its board cannot protect itself from legal accountability simply by hiding behind an assertion that an illegality was committed by a separate legal entity or middleman…. On one end [of the continuum of responsibility] will be situations in which there is de facto unity between a Delaware corporation and a subcontractor, supplier, or middleman acting illegally, or when a Delaware corporation is acting in partnership with entities acting illegally. The responsible end of the continuum would also capture situations in which a Delaware corporation and its fiduciaries were knowingly complicit in such illegalities, even if managerial unity or partnership did not exist. On the other end of the continuum, it would be unjust for corporations and their management to be held responsible for the behavior and decisions of independent actors committing illegalities without the complicity, benefit, or knowledge of the corporation.


Some Thoughts on the "Independent Review" of Barclays: More Time on the Job (Part 3)

The Report on Barclays (aka the Salz Review) examines the role of the Board at the universal bank.  For the most part, the analysis is not particularly insightful.  There are, however, a few interesting observations that warrant consideration. 

Most interestingly, the Report supports an increased role in the oversight process for independent directors.  It promotes this approach by asserting that these directors should devote significant time to board activities. 

Directors at Barclays already attend a significant number of meetings.  According to the Report:  "The Board met on 30 occasions in 2008, at times by conference call, and 27 times in 2009."  Report, at 106. 

Nonetheless, the Report suggests a substantial minimum time commitment that would transform service on the board, at least in times of crisis, to something approaching a full time position.  As the Report stated:  "In normal circumstances we see minimum time commitments for non-executive directors trending towards 45 to 50 days a year, and considerably more than this (probably in the region of 80 to 100 days) for key committee chairs. In times of crisis, this will inevitably increase."

With more time devoted to the bank and more meetings, directors presumably will need a staff.  They already, apparently, have a significant amount of support.  As the Report described: 

  • Barclays’ Board is supported by the Barclays Corporate Secretariat. This comprises a  total team of 27, of which 7 work primarily on agendas, papers, minutes and actions from the Board and committees and the writing of annual reports. The others deal primarily with the formalities of the many companies in the Barclays Group.

Full time boards with support staff are not a panacea.  More time does not automatically equal increased quality.  The Report hinted at this.

  • The Walker Review outlined how the “principal deficiencies in [bank] boards related much more to patterns of behaviour than to organisation”. It went on to explain that: “The pressure for conformity on boards can be strong, generating corresponding difficulty for an individual board member who wishes to challenge group thinking. Such challenge on substantive policy issues can be seen as disruptive, non-collegial and even as disloyal. Yet, without it, there can be an illusion of unanimity in a board, with silence assumed to be acquiescence (...) Critically relevant to success of the challenge process in any well - functioning board will be the demeanour and capability of the CEO, who is unlikely to be in the role without having displayed qualities of competence and toughness which are not dependably tolerant of challenge. Even a strong and established CEO may have a degree of concern, if not resentment, that challenge from the NEDs is unproductively time - consuming, adding little or no value, and might intrude on or constrain the ability of the executive team to implement the agreed strategy. Equally, however, the greater the entrenchment of the CEO, perhaps partly on the basis of excellent past performance and longevity in the role, the greater is likely to be the risk of CEO hubris or arrogance and, in consequence, the greater the importance (and, quite likely, difficulty) of NED challenge. Achieving an appropriate balance among potentially conflicting concerns is frequently the most difficult part of the overall functioning of the board.”

Thus, one consequence of the financial crisis is pressure on Barclays (and perhaps other similarly situated financial institutions) to increase the hours of directors devoted to the oversight process.  This could be the first steps in turning the position into a full time job. 

In the end, however, its not about the number of meetings but the quality of the meetings that occur.  Challenging the CEO is not for the most part encouraged behavior on boards.  Until it is, more meetings is unlikely to significantly increase governance quality.


Some Thoughts on the "Independent Review" of Barclays: Compensation and an Absence of "Humility" (Part 2)

The Report on Barclays (aka the Salz Review) also discussed some of the tension that arose in the bank over executive compensat ion. 

  • Barclays has struggled to deal with pay in a way that reflects a reasonable balance between the interests of shareholders on one hand, and those of executives and employees on the other. The structuring of pay was typically focused on revenues and not on other aspects of performance. Encouraging the maximisation of short-term revenues carried risks of unsatisfactory behaviour, with significant and adverse reputational consequences for the bank. The principal issues we have identified include high bonus awards in the investment bank which were incapable of justification to many stakeholders –especially since the beginning of the crisis; actions that maximised current year bonuses rather than consideration of sustainable profitability; and, in the retail bank and Barclaycard, sales incentives that risked products being sold to customers whether or not suitable for them. Overall, the pay structures gave the message to staff that the bank valued revenue over customer service.

Report, at 9.  At the same time, according to the Report, the problem was not a bank wide one.  It arose mostly in the investment banking side of the business.

  • Most but not all of the pay issues concern the investment bank. To some extent, they reflect the inevitable consequences of determinedly building that business –by hiring the best talent in a highly competitive international market (and during a bubble period) – into one of the leading investment banks in the world. The levels of pay (except at the most senior levels) were generally a response to the market. Nevertheless, based on our interviews, we could not avoid concluding that pay contributed significantly to a sense among a few that they were somehow unaffected by the ordinary rules. A few investment bankers seemed to lose a sense of proportion and humility.

The Report diplomatically pointed out that any true reform of the approach to compensation had to start at the top.

  • Barclays has responded to the public, political and regulatory concerns by trying to manage down total employee compensation as a proportion of adjusted profit before tax and adjusted net operating income, by deferring certain bonus payments and by applying claw - back or malus. If Barclays is to achieve a material improvement in its reputation, it will need to continue to make changes to its top levels of pay so as to reflect talent and contribution more realistically, and in ways that mean something to the general public. Barclays’ success depends on hiring and keeping good people – and this requires that it pays them fairly. Its ability to lead change in compensation practices materially ahead of its competitors will necessarily be constrained if it is to avoid risking damage to its businesses. But we also feel that there is more that it can do over time to emphasise forms of recognition for performance other than pay.

The Report, therefore, noted bonuses "incapable of justification" to stakeholders, an emphasis on short term returns that carried reputational harm, employees "unaffected by the ordinary rules," and the need to more realistically reflect "talent and contribution." 

Some of this is a problem of culture.  Those operating in the securities markets are paid differently than those operating in the commercial banking universe.  Commercial banks expanding into the securities area, therefore, have to address this often very different culture. 

Nonetheless, the cultural problem is presumably foreseeable.  The Report raises fundamental concerns with board oversight of compensation and the content of the board's fiduciary obligations.  The government's choice (other than to do nothing) is to tighten fiduciary standards or impose direct regulation of compensation (Britain is already moving beyond advisory votes for shareholders).  Thus, without reform of the fiduciary obligations of directors (say by imposing on directors an obligation to show the fairness of a compensation scheme), increased government regulation is likely.  


Some Thoughts on the "Independent Review" of Barclays (Part 1)

Barclays just published the Salz Review, a lengthy self study of the business practices at Barclays.  Barclays is of course a British Bank but the Report contains some insight that is equally applicable to the evolution of the banking system in the US. 

Of the commercial banks in the US, the Big Four (JP Morgan, BofA, Citigroup, Wells Fargo) came out of the financial crisis with a larger share of financial assets than before the crisis.  Sheila Bair in a recent editorial in the WSJ suggested that growth since the crisis came from increased activity in the securities markets "while loans, which are subject to tougher capital rules, have remained nearly flat." 

Barclays looks to have done something similar.  Ten years ago, Barclays was a commercial bank.  By 2012, it was more of an investment bank.  As the Report notes:

  • About ten years ago, its ambition wasto become a top-five global bank, with one third of Group profits coming from investment banking and two thirds from global retail and commercial banking (including Barclaycard). The strategy also envisaged the bank  having more international scale. The investment bank planned to double in size in four years and it exceeded these plans. In addition, the retail and commercial bank expanded rapidly in Spain, India, Russia and elsewhere. By 2008 the bank’s growth had resulted in leverage (ratio of assets to equity) of 43, higher than the other UK banks. With the acquisition of parts of Lehman Brothers in September 2008, the investment bank grew to represent rather more than half of Barclays’ profits and three-quarters of its assets.

As the JP Morgan London Whale incident shows, involvement in the securities markets can be a high risk affair.  But the Barclays Report illustrates the Siren song of the securities markets to large banks.  The Report noted that the profits produced by Barclays Capital increased from 15% in 2000 to 75% in the period from 2009 to 2012.  Report, at 33. 

But deeper involvement in the securities markets came at a cost.  One of them was an increase in government oversight.  The Reported noted that "there has been an explosion in new regulation and in the intrusiveness of regulators."  Report, at 6.  Moreover, staffing by Barclays has had to keep pace.  According to the Report, the Compliance Office at Barclays went from 600 employees in 2008 to 1500 in 2012.  Report, at 24. 

In other words, as commercial banks get larger (in part from expansion in the securities markets), regulators often seek to tighten oversight.  At least some of the oversight is to ensure that banks do not take excessive risk. At the time of the JP Morgan London Whale incident, the OCC already had more than 60 examiners on staff at JP Morgan.  Notwithstanding the presence of these examiners, the OCC did not focus on the London Whale transaction until after the fact.  One possible response might be to increase the number of examiners and subject more JP Morgan transactions to even more intense review, perhaps examining transactions on a real time basis.

Tightened oversight may not work.  Whether the London Whale or Lehman, government regulators did not react to the risk taking until after the fact.  Thus, there may be tightened oversight without any guarantee that the oversight will work.  On the other hand, increased oversight will probably result in less risk taking by the commercial banks.  While this may be good for the safety and soundness of the banking system, it may not be good for the securities markets. 

In the past, a conservative approach to risk taking by commercial banks likely didn't have much impact on the securities markets.  A world class group of investment banks (Goldman, Morgan, Merrill, Lehman and Bear) stood ready to take on and profit from the risk in the securities markets.  But the financial crisis has decimated the population of independent investment banks.  Lehman is bankrupt; Bear and Merrill have been absorbed by commercial banks; Goldman and Morgan hang on but have converted to commercial banks. 

Reinstating some elements of Glass Steagall would presumably allow for the resurrection of independent investment banks.  For more of this, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  With independent investment banks, risk can be transferred away from commercial banks without taking the risk out of the capital markets. 


Too Big to Fail and the Consequences

There was a sharp story about draft legislation circulating in Washington designed to address some of the concerns over "too big to fail." According to the article:

  • The draft bill would require all U.S. banks to hold 10% equity capital and subject banks with more than $400 billion in total assets to additional capital surcharges based on the size of the institution. . . . It would also restrict banks from structuring themselves or their activities to avoid the new capital rules, and would prohibit government assistance for non-banks.

Too big to fail is the moniker used to describe the four largest commercial banks.  These are the banks that are so large no government regulator would let them fail.  Certainly, the economic consequences of the failure of Lehman, a financial institution much smaller than the Big Four (JP Morgan, BofA, Wells Fargo and Citigroup), demonstrates the potential harm to the economy (and political careers) that can occur when a large financial institution is allowed to fail.

Solutions to the "too big to fail" problem (assuming anyone is seeking a solution) fall into two broad camps:  Making banks capable of failing (downsizing is the most obvious method of doing so) or making them less likely to fail.  Despite occasional voices about downsizing the largest banks, there is no real effort underway to make the banks smaller.  Instead, most of the focus is on heightened regulation.  This means greater separation between securities and banking, increased capital, increased liquidity, and reduced risk.  All of this collectively means greater government oversight of commercial banks. 

It is the growing price that large commercial banks will pay for being too big to fail. 


IPOs and the JOBS Act: A Complicated Analysis

The JOBS Act sought to increase the number of public offerings in part by providing some regulatory relief for "emerging growth companies."  The JOBS Act also provided a mechanism for non-public review of registration statements. 

According to the WSJ, the JOBS Act has not delivered, at least with respect to an increase in the number of IPOs. 

  • The one-year-old law, officially the Jumpstart Our Business Startups Act, was aimed at helping companies with less than $1 billion in sales go public. But IPOs of such companies in the year since the law was enacted are on track to fall 21%, to 63 from 80 in the year prior, according to Jay Ritter, a University of Florida professor who tracks IPOs

Its never particularly easy to draw conclusions from one year of data.  Its possible that, while the number of public offerings were down, they fell less sharply because of the JOBS Act. 

Morover importantly, however, the provisions in the JOBS Act were not significant enough to produce a large boost in the number of public offerings.  The most significant change was probably the right of emerging growth companies to go public with two rather than three years of audited financial statements.  Yet this is a modest change that would not so significantly change the cost structure of a public offering that it would induce a raft of companies to go public.

Moreover, this does not take into account the fact that the JOBS Act actually made it easier to avoid the public offering process.  As crowdfunding offerings come on line, private placements are allowed to be sold through general solicitations, and the provisions raising Regulation A Offerings to $50 million are implemented, companies will have a number of additional non-public alternatives to raising capital.  The overall impact of the JOBS Act may well be, therefore, a reduction rather than increase in the total number of IPOs. 



Regulation FD, Social Media, and the Non-Clarification Clarification (Part 2) 

The issue in the Netflix Report involved allegations of disclosure of material non-public information over social media.  To complicate (or really uncomplicate) matters, the alleged disclosure occurred not over the company's Twitter account or Facebook page, but over the Facebook page belonging to the CEO. 

In describing the findings in the Section 21(a) Report (and keep in mind that its only a report, its not even a settled case, so the facts are entirely the SEC's rendition and not the result of a contested proceeding), the SEC's Press Release said this about the incident. 

  • The SEC’s report of investigation stems from an inquiry the Division of Enforcement launched into a post by Netflix CEO Reed Hastings on his personal Facebook page stating that Netflix’s monthly online viewing had exceeded one billion hours for the first time. Netflix did not report this information to investors through a press release or Form 8-K filing, and a subsequent company press release later that day did not include this information. Neither Hastings nor Netflix had previously used his Facebook page to announce company metrics, and they had never before taken steps to alert investors that Hastings’ personal Facebook page might be used as a medium for communicating information about Netflix. Netflix’s stock price had begun rising before the posting, and increased from $70.45 at the time of the Facebook post to $81.72 at the close of the following trading day.

The Release (rather than the press release) noted that Mr. Hastings had over 200,000 subscribers to his Facebook page.  They included analysts, shareholders, reporters, and bloggers. 

The Release went on to "amplify" two points.  First, "issuer communications through social media channels require careful Regulation FD analysis comparable to communications through more traditional channels."  In addition, the "concept that the investing public should be alerted to the channels of distribution a company will used to disseminate material information" apply to "disclosures made through social media channels." 

Finally, the Commission had this to say about the use of personal social media sites to disseminate material information:

  • Although every case must be evaluated on its own facts, disclosure of material nonpublic information on the personal social media site of an indvidual corporate officer, without advance notice to investors that the site may be used for this purposes, is unlikely to qualify as a method "reasonably designed to provide broad, non-exclusionary distribution of the information to the public" within the meaning of Regulaiton FD. 

Moreover, this was true even if "the individual in question has a large number of subscribers, friends, or other social media contacts, such that the information is likely to reach a broader audience over time." 

The Release adds nothing new to the existing analysis.  The insight provided in the release is the same thing that any reasonable securities lawyer would have provided to a client asking about social media.  Regulation FD is conditioned around disclosure to the market.  There are some avenues that are treated as tantamount to market disclosure.  Electronic filing of an 8-K is an example.  It is instantly available to everyone in the market and, anyone following a company, knows to keep an eye open on this source of information. 

Anything less traditional (The side of a rocket, the Good Year Blimp, Twitter, or a notation in the New York Review of Books), all have the possibility of meeting the market disclosure requirement but all are contingent upon the market knowing that the approach will be used.  This means advanced notice and consistent use.

Grey areas still exist.  Companies that don't alert the market to the use of social media (one has to wonder why any company would do that) but have a wide following will violate the spirit of Regulation FD but probably not be charged by the SEC.  Analysts by now know to follow all communications emanating from a company and, at least for a widely followed company, would likely know about anyting put out over Twitter or on Facebook. 

Personal Twitter accounts and Facebook pages are an entirely different matter.  It will be a long time before the market is aware, in the ordinary course, that material information will be routinely disclosed over an officer or director's personal page (or spouse/child of an officer director).  The Section 21(a) Report makes this clear and serves as a warning to any company that uses this method of communicating without advance notice.  Whatever pass Netflix got in this case won't apply to the next company/officer that does the same thing. 


Regulation FD, Social Media, and the Non-Clarification Clarification (Part 1)

The SEC issued a rare Section 21(a) Report explaining the use of social media as a mechanism for public disclosure under Regulaiton FD.  See  Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Netflix, Inc., and Reed Hastings, Exchange Act Release No. 69279 (April 2, 2013).  Section 21(a) Reports are just Reports.  They are not litigated or settled cases but instances where the SEC chooses not to bring an action but nonetheless wants to issue something along the lines of an advisory opinion.  See Section 21(a) of the Exchange Act, 15 USC 78u(a) ("The Commission is authorized in its discretion, to publish information concerning any such violations, and to investigate any facts, conditions, practices, or matters which it may deem necessary or proper to aid in the enforcement of such provisions, in the prescribing of rules and regulations under this title, or in securing information to serve as a basis for recommending further legislation concerning the matters to which this title relates.").  

In this case, the Section 21(a) Report dealt with the use of social media to disseminate information to the market under Regulation FD.  There are two things interesting about the Report.  First, the Report was issued because of the "market uncertainty about the application of Regulation FD to social media".  Second, the decision has been heralded as an example of the SEC approving the use of social media for purposes of disseminating material non-public information to the market.  We will consider both of these points at the end of the post.

Regulation FD is the regulation adopted by the SEC in the aftermath of SEC v. Dirks, the famous insider trading case.  Dirks held that the tipping of information by an insider (Secrist) to an analyst (Dirks) did not constitute insider trading.  The case effectively exonerated corporate insiders for selective disssemination of inside information, at least in circumstances where they did not perosnally benefit.

Regulation FD was the SEC's response, although it took until the 1990s to implement.  Relying on rulemaking authority under Section 13(a) (not Section 10(b), the antifraud provision), the Commission required companies that are intentionally disseminating material non-public information to the market to make simultaneous disclosure to the market.  The requirement does not apply to information already public.

The issue of social media comes up under Regulation FD in two ways.  First, is information disclosed over social media "public."  Second, does it qualify as disclosure to the market?  Social media clearly represented a form of dissemination that would eventually qualify as disclosure to the market.  But like all developing technologies, there is a grey area when it is widely used but not necessarily a means of disclosing to the market.  Social media is currently in that place.

While millions (billions?) use twitter and facebook, that would seem to suggest social media is tantatamoun to public disclosure.  On the other hand, the practice has not yet arisen whereby most companies use social media to disseminate material non-public information.  Thus, it is not a source that most analysts or institutional investors will consider.  This is exacerbated where the disclosure occurs over a social media source belonging to an officer or director rather than the company. 

It probably been the case for a long time that social media was acceptable as long as the company provided plenty of advance notice that it would be a mechanism for disseminating material non-puplic information.  Alerting the public (including analysts and institutional investors) puts them on notice and allows them to be aware that such information might be disclosed in that manner.

The problem of using social media, therefore, arises not from using social media but from using social media without telling anyone in advance.  In doing so, only those fortunate enough to be relying on social media get the information.  It can, therefore, be a form of selective disclosure, albeit one that goes selectively to millions of people.  With that in mind, we turn to the SEC's Section 21(a) Report in Netflix.

BofA, the Securities Settlement and the Financial Crisis

The WSJ reported that on Friday the court accepted the settlement between investors and BofA in connection with the company's alleged disclosure violations relating to the acquisition of Merrill Lynch.  (Note that the article indicated that the settlement was approved by the "U.S. District Court for the Southern District of Manhattan").   The case settled for a reported $2.43 billion. 

While BofA's disclosure may have been problematic (a settlement is no admission), we take this opportunity to repeat what we've said on this Blog before.  In truth, had BofA walked away from the acquisition of Merrill which, with the burgeoning losses, it had an economic basis for doing so, Merrill would likely have failed.  Following on the footsteps of the failure of Lehman, one suspects that the body blow to the financial system that would have resulted from any such failure would have added to the paralysis in the financial markets and significantly lengthened the recession.

Whatever the merits of the securities fraud suit, BofA did this country a big favor in going through with the Merrill acquisition.  That should not be lost in any article that revisits the period of the Merrill acquisition.


Wells on “the Puzzle of Corporation Law at the Height of the American Century”

Harwell Wells has published “’Corporation Law is Dead’: Heroic Managerialism, the Cold War, and the Puzzle of Corporation Law at the Height of the American Century” in the University of Pennsylvania Journal of Business Law.  Here is the abstract:

In 1962, the corporation law scholar Bayless Manning famously wrote that “[C]orporation law, as a field of intellectual effort, is dead in the United States.” Looking back, most scholars have agreed, concluding that corporation law from the 1940s to the 1970s was stagnant, only rescued from its doldrums by the triumph of modern finance and the theory of the firm in the 1980s. What a strange time, though, for corporation law to be “dead” — the same decades that the American corporation had seized the commanding heights of the world economy, and gripped the imagination of social and political theorists. This paper takes a new look at mid-century corporation law, situating it within larger economic and political developments, in order to explain the distinctive features of corporate law in the “long 1950s,” why the field appeared vibrant at the time, and how later changes in the American political economy led most to eventually agree with Manning’s diagnosis. In the process, it aims not merely to restore a lost episode to the history of American law but to tell readers something about the nature of corporate law and how it changes from era to era.


SEC Settlements and Court Approval: Judicial Reallocation of Agency Resources

The Second Circuit ought to rule shortly on the appeal by the SEC of Judge Rakoff's refusal to approve an SEC's settlement with Citigroup.  Judge Rakoff objected to the settlement in part because he did not approve of the portion of the settlement that allowed Citigroup to settle but, at the same time, neither admit nor deny the allegations in the complaint.

The approach taken by Judge Rakoff has not swept the nation but it also not be undertaken in isolation.  A federal district court in Colorado indicated that he would not accept an SEC settlement in the face of the defendant "standing mute" in response to the SEC allegations.  As the one operative paragraph stated:

  • I refuse to approve penalties against a defendant who remains defiantly mute as to the veracity of the allegations against him. A defendant’s options in this regard are binary: he may admit the allegation or he may go to trial. I also object to the language in the consents and the proposed final judgments whereby the defendants waive their rights to the entry of findings of fact and conclusions of law pursuant to FRCP 52 and their rights to appeal. These findings are important to inform the public and the appellate courts. I will not endorse any final judgments including such provisions.

SEC v. BRIDGE PREMIUM FINANCE, LLC, 1:12-cv-02131-JLK-BNB (D. Colo. Jan. 17, 2013). 

A second trial judge in the 2nd Circuit, however, has indicated concern with the neither admit nor deny language in a settlement.  This one arose in connection with court approval of the $616 million settlement with SAC (the case was actually brought against CR Intrinsic, an affiliate of S.A.C. Capital Advisors and a number of "relief defendants" that included a number of other SAC related entities).  The complaint with all of the parties is here.  The settlement entailed a payment of $274,972,541 in disgorgement, $51,802,381.22 in prejudgment interest, and a $274,972,541 penalty.

The trial judge, however, has not approved the settlement.  According to the WSJ, the trial judge indicated that he needed "more time" to consider the settlement.  Reports suggested that he was troubled by the neither admit nor deny language and that he might want to wait for, or condition the settlement on the outcome on, the Citigroup decision.  According to one report, the Judge stated that “There is something counterintuitive and incongruous about settling for six hundred million dollars if it truly did nothing wrong". 

Holding up the settlement is not a good use of judicial resources.  This may effectively end the SEC's efforts with respect to the entity.  It does not end the ongoing investigation of individuals.  Indeed, last week, criminal charges were brought against another SAC official were announced.  Moreover, the any amount paid in settlement does not take into account the loss of business that has likely occurred as a result of the swirl of investigations.  

Federal district court judges are not substitute regulators.  They should leave it to the government to engage in the complicated balancing of resources and litigation risk that goes into any settlement. Any more resources spent in defending this case in front of the Southern District amounts to a reallocation of resource that is dictated by a judge rather than the regulators charged with the responsibility.  


Director Compensation and Director Independence: Average Compensation at the Big Banks

The stock exchanges recently implemented Rule 10C-1.  Rule 10C-1 in turn implemented the requirements of Dodd-Frank with respect to compensation committees of listed companies.  Among other requirements, Congress mandated that the board consider "relevant factors" in determining whether the directors sitting on the compensation committee were independent.  One of those factors that Congress explicitly required to be considered was compensation.  Thus, boards had to consider the compensation paid to directors in determining director independence.

During the debate over the listing standards, commentators argued that compensation included consideration of the fees paid to directors.  See my comment Letter here.  Consideration was in part based upon the fact that fees were a "relevant factor" standing alone.  Consideration was also arguably required by the language in the statute.  Nonetheless, the stock exchanges refused to add an explicit requirement that directors consider fees. 

The NYSE noted that, were fees to be material, boards were required to consider all material relationships.  Thus, to the extent fees were relevant, they were captured by the general language of the listing standard and did not need to be explicitly referenced. 

With that background in mind, we turn to the recent artilc in DealBook on fees paid to directors of bank.  (The Table is below).  The article examined, over a three year period, the director compensation of the Too Big to Fail Banks (JP Morgan, BofA, Citi and Wells Fargo) and the two holdovers from the days when the US had independent investment banks (Goldman & Morgan Stanley).  The data did not include the 2012 compensation numbers for Goldman since they had not yet been filed.

The thrust of the article was that director compensation continued to escalate even during the financial crisis.  As the article reported:

  • Since the financial crisis, compensation for the directors of the nation’s biggest banks has continued to rise even as the banks themselves, facing difficult markets and regulatory pressures, are reining in bonuses and pay.

The article also stated that the "nation’s biggest banks paid their directors over $95,000 a year more on average in 2011 than what other large corporations paid."  The extra compensation was necessary because of the premium needed "to entice and keep qualified directors."  Moreover, Goldman prohibits a director from selling stock paid as part of compensation until they've left the board. 

In truth, the numbers for the large financial institutions do not look particularly out of whack (with the total compensation paid by Goldman an exception in a couple of the years).  Perhaps as DealBook says, they are paying more than average.  But for the most part directors are receiving around $300,000.  This is not an unusual amount of compensation to pay to directors of large public companies. 

The broader issue, which transcends the issue of banks, is whether the amount of compensation ought to be considered in determining whether directors are independent, at least when making compensation decisions.  Moreover, board compensation can vary among directors depending upon their role (chairs of committees might be paid more; the lead director might receive an extra dollop of compensation).  As the numbers get larger and larger, directors have an increased incentive to want to stay on the board.

It is a consideration that the board ought to take into account when determining director independence. 


Investment Bank Director Pay

2007 2008 2011 2012
Source: Equilar
Goldman Sachs $670,292 $310,324 $488,709 -
Morgan Stanley $346,875 $343,500 $357,708 $351,080
Wells Fargo $217,634 $253,502 $294,628 $299,429
Citigroup $227,282 $192,087 $281,136 $315,000
Bank of America $248,571 $248,571 $275,000 $275,000
JPMorgan Chase $256,296 $255,500 $274,750 $278,194
Average $327,825 $267,247 $328,655  

The Costs of Omitting Women from the Board of Directors

Women make up half the population (slightly more actually).  They are also, increasingly, the better educated gender.  As one study stated:

  • From 1999–2000 to 2009–10, the percentage of degrees earned by females remained between approximately 60 and 62 percent for associate's degrees and between 57 and 58 percent for bachelor's degrees. In contrast, the percentages of both master's and doctor's degrees earned by females increased from 1999–2000 to 2009–10 (from 58 to 60 percent and from 45 to 52 percent, respectively).

Yet they hardly appear in the list of CEOs in the Fortune 500 (4%) and barely register on corporate boards (15%). 

It is true that evidence has not conclusively tied improvements in performance to an increase in the number of women on the board of directors.  But likewise the number of women does not harm corporations (although there is some data suggesting that they are tougher monitors of executive behavior).  

So even without the conclusive tie to performance, the dearth of women seems anomalous.  This is particularly true since there are some obvious benefits to including more women on the board.  More women on the board sends a positive message to employees and customers.  There is some data suggesting that with more women on the board, board attendance by male directors improves.

In addition, women may approach the decision making process differently, something that may sometimes be beneficial.  This latter notion gained some support from conclusions drawn from a recent survey of directors.  

As reported in the LA Times, a recent study determined that women make "better corporate leaders than men because they are more likely to make fair decisions when competing interests are at stake". The conclusion was drawn from a study to be published in the International Journal of Business Governance and Ethics and resulted from a survey of 600 board directors.  According to the LA Times:

  • Male directors, who made up 75% of the survey sample, prefer making decisions using rules, regulations and tradition, the survey found. Female directors, by contrast, are less constrained by rules and more prepared to “rock the boat,” the researchers found. They are also more likely “to use cooperation, collaboration and consensus-building.”

Women directors were also described as "more inquisitive than men" and tended "to see more than one solution to a problem." 

This type of research provides support for the goal of increasing the number of women on the board.  There ought not to be a need to develop this type of support.  Any board that contains a dozen or so directors selected in order to provide substantive skills and viewpoints needed by the company ought to have a reasonable number of women and people of color as an ordinary part of this process.  Perhaps the best way to increase gender and racial diversity on the board, therefore, is to encourage companies to devise a more flexible director selection process that puts greater emphasis on substantive skills and viewpoints useful to the company.  


The Resource Extraction Rules: SEC as Poverty Alleviator and Tax Disclosure Agency?

Earlier post s have discussed the “conflict minerals” provision of Dodd-Frank—a little known provision mandating disclosure by issuers of the use in their products of certain minerals mined in the Democratic Republic of Congo and surrounding states.  Another “miscellaneous” provision of Dodd-Frank is also worthy of discussion as it too uses the SEC disclosure process to achieve goals far removed from stated mission of the SEC “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Section 1504 of Dodd-Frank, the Cardin-Lugar Amendment and the rules promulgated thereunder require publicly traded resource extractive industry issuers—those involved in oil, gas and mining-- to make project-level disclosures on a new Form S-D (separate from the annual report) of payments in excess of $100,000 made to governments around the world for the purpose of commercial development of natural resources.  Importantly, the rules require disclosure of all payments, thereby imposing far more disclosure requirements than those demanded by the Foreign Corrupt Practices Act.  Although the rules implementing Section 1504 are currently under challenge , they are currently scheduled to go into effect on September 30th of this year, meaning that the first reports would be due February 28, 2014, if any affected firms have a fiscal year ending September 30th.

The stated reasons for inclusion of Section 1504 are that it:

“furthers the critical public policy goals of i) protecting United States interests in both national and energy security, ii) ensuring investor awareness and protection, and iii) promulgating American core principles of transparency, integrity and good governance worldwide. Members of Congress and the Executive Branch, on a bipartisan basis, have long supported transparency through comprehensive disclosure of payments made by resource companies to foreign governments on extraction projects undertaken abroad.” Statement filed by Sen. Cardin.

A key Senate sponsor of the provision stated that Section 1504 seeks to hold foreign governments accountable for payments received from foreign companies seeking to exploit resources, in an effort to reverse what has been commonly called the “resource curse.”  The provision is intended to ensure that taxpayers and shareholders will no longer unknowingly fund dictators or fuel conflict, and will be privy to how their investments are being spent.  According to Senator Patrick Leahy “Transparency is good for U.S. taxpayers, it encourages more accountable government, and a better business environment for foreign investors.” 

As with the conflict minerals rule, no one objects to the stated goal of the resource extractive industries rule—reducing the resource course and improving transparency are admirable objectives.  Closer consideration of the provision, however, raises some questions.  First, why is the SEC being tasked with the job of addressing the resource curse?  This delegation of responsibility for alleviating poverty through better resource management to an agency charged with the ordering of US financial markets seems odd. 

It also seems unnecessary given that at the same time as the SEC rules implementing Section 1504 come into effect, the U.S. Department of the Interior is working to bring the U.S. into compliance with the Extractive Industries Transparency Initiative (EITI), a nongovernmental organization dedicated to improving the economic returns for resource-rich countries through reporting of extractive industry company payments, including taxes, made to governments. Governments of countries wishing to be EITI compliant must publicly disclose payments received from the oil, gas, and mining sectors. Companies operating in those sectors of the country must similarly report all payments made to the government.

The US EITI effort was launched by President Obama who stated  "We're continuing our leadership of the global effort against corruption, by building on legislation that now requires oil, gas, and mining companies to disclose the payments that foreign governments demand of them. Today, I can announce that the United States will join the global initiative in which these industries, governments, and civil society, all work together for greater transparency so that taxpayers receive every dollar they're due from the extraction of natural resources.”   

The disclosure requirements of Section 1504 and EITI are not identical—Section 1504 requires disclosure of all payments made to governments  (US and foreign) by US listed issuers, while EITI requires disclosure of payments made to EITI-complaint governments  by firms operating in the country.   Payments to non-EITI compliant governments would not be covered.  To be EITI-compliant, governments must disclose payments received from companies operating in the oil, gas, and mining sectors. Companies operating in those sectors must similarly report to a third party all payments made to the government.  Importantly, EITI complaint reports must include payments made by state-owned firms, a requirement missing from the SEC resource extractive industry rules.

One wonders why the SEC is being made to police legal payments issuers make when the stated intent of the resource extractive industries rules closely tracks that of EITI and the disclosures required pursuant to Dodd-Frank were earlier rejected as free-standing legislation when the Congress refused to pass the  Energy Security through Transparency Act of 2009.  Inclusion of the Section 1504 was little noticed and seemed to catch the industry by surprise.  While covered industry participants state that they support EITI as a voluntary initiative, they object to the SEC rules because, among other reasons, the required disclosures would impact negatively their competitive advantage against state owned firms in China and Russia that have no interest in transparency and that the rules would violate issuers’ First Amendment rights.  If there are deficiencies in the EITI reporting requirements (and there are arguments to be made that Section 1504 does a better job at demanding relevant information), changes could be made there rather than layering on yet another disclosure regime.  It is not news that too much disclosure is every bit as bad as too little.  We should be seeking informational efficiency, not informational overload.

In addition to questioning whether the SEC is an appropriate agency to address the issue of resource curse, a second, less clearly articulated goal of Section 1504 also raises questions as to whether it should be under the purview of the SEC.

 US issuers involved in the resource extractive industries object strenuously to the new SEC disclosure requirements because they require disclosure of amounts paid by US companies in taxes to foreign governments on a country-by-country and project-by-project basis.   The need for greater disclosure of tax payments stemmed from a report issued years ago by an international resource-industry watchdog group identifying the global under-taxation of multinational companies in the extractive sector as a key component of corruption and development failure in resource-rich countries.

The detailed disclosures required by the SEC resource extractive industry rules was earlier covered by rules that protect the confidentiality of such information or are so complex that accurate assessment of a company’s financial situation is extremely difficult even when information is publicly available.  Multi-national companies take advantage of current piecemeal and limited disclosure regimes to employ complex financial strategies and multijurisdictional structures to locate profit in ways that are difficult to monitor or understand. Section 1504 will demand clearer accounting of tax revenues and as such is certainly unobjectionable in its goals—few other than the issuers involved would object to greater clarity in tax reporting. 

However, articulating a laudable goal does not mean that SEC disclosure requirements are the proper method for achieving that goal.  The tax disclosures sought under Section 1504 and its implementing rules could be just as easily be demanded by the IRS from US companies as part of their annual tax reporting requirements.  Tax matters are usually thought of as subject to IRS—not SEC jurisdiction.   As might be asked of the conflict minerals (and other  SEC rules), why does Congress continue to burden the SEC with crafting disclosure regulations that are outside the ordinary purview of the Commission when other, more suitable, avenues exist through which to achieve desired goals?


The Board of Directors and the A Rational Stragey for Remaining on the Board

We are in the middle of the annual meeting cycle.  Most public companies are sending around proxy materials and seeking the election of directors for another year (or three years in the case of those with a staggered board).  

Most shareholders are asked to vote on a single, unopposed slate of directors.  Although all shareholders have the legal authority to nominate directors, the candidates in the proxy statement have been nominated by the board of directors.  Shareholders do not typically run competing slates because of the costs associated with the proxy process.  Moreover, while the costs of the solicitation of management's nominees are borne by the company, the costs of the solicitation for shareholder nominees must be borne by the shareholder.

Running unopposed, the directors nominated by the board will always be elected.  The one slight variation is that a number of public companies have in place majority vote requirements.  If directors do not receive a majority of the votes cast, they must submit letters of resignation.  It is then up to the remaining directors to decide whether to accept the resignation.  The dynamics of board behavior suggest that in many cases the letters will not be accepted.

This suggests that, structurally, directors are not at risk of losing their position on the board through shareholder opposition.  Thus, directors approving practices opposed by shareholders (excessive compensation, for example), are not likely to lose their positions. 

On the other hand, a director will lose his or her position if not renominated by the board.  Conventional wisdom has it that directors who have an antagonistic relationship with the CEO are at risk for not being renominated.  The antagonistic relationship can presumably arise from personality differences.  They can also presumably arise from genuine differences in policy, including those involving executive compensation. 

The WSJ recently described efforts by Bank of America to alter the composition of the Board of Directors.   The Board had apparently been shaped by pressure from governent regulators during the post-financial crisis period. With the pressure off, BofA had greater flexibility to shape the board in a manner deemed best for its business.  

According to the article, BofA had replaced "financial experts" on the Board with executives from "heavily regulated, highly competitive industries often plagued by thin profit margins."  As the article observed:

  • In its search for new directors, the bank is looking for people who can help find ways to increase profit margins. Bank of America's return on assets in 2012 was 0.19%, compared with 0.97% for all U.S. banks, according to Federal Deposit Insurance Corp. data.

The article also noted, however, that some of the departed directors were described as those who "didn't click with" the CEO or had "tended to ask the 'tougher questions'" of the CEO.  See Id.  ("'People with knowledge and a deep understanding of the industry, they ask tougher questions than the people who don't know the industry and haven't been around for a while,' said the person.").

There is nothing in the article suggesting that the willingness to ask "tougher questions" was the reason for the removal of any director.  Nonetheless, as noted above, such behavior poses some potential risk for directors wishing to stay on the board.

Representative Markey Urges SEC Chairman Walter to use the Market Reform Act of 1990 to Fight High Frequency Trading

In a letter dated January 18, 2013, Representative Edward Markey (“Markey”) (D-Mass) encouraged the Securities and Exchange Commission (“SEC”) to curtail the use of high frequency trading (“HFT”) in equities markets.  HFT uses algorithms to buy and sell securities at incredibly fast speeds—up to one millionth (1/1,000,000) of a second—and it accounts for 70 percent of trading volume in the United States.  Markey noted that HFT use has exaggerated market volatility in recent years.

Markey described HFT as “a clear and present danger to the stability and safety of our markets” and advised the SEC to consider using the Market Reform Act of 1990 (the “Act”), which Markey himself coauthored, to combat such practices.  The Act provides the SEC with authority “to prohibit or limit practices which result in extraordinary levels of volatility.”

Initially used to curb automatic trading program abuses following the October 1987 Crash, the Act gives the SEC power to limit practices that affect market volatility and price level manipulation.  However, Markey pointed out that the Act may also be applied to HFT so long as the SEC finds that a period of “extraordinary market volatility” exists and that HFT is “reasonably certain to engender such levels of volatility.”  Moreover, Markey stated that such findings would be easy to make.

Markey requested that Chairman Walter respond to his letter by February 7, 2013.

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


Exchange Act Release No. 68640: SEC Approves Changes to NASDAQ Compensation Committee Rules

On September 25, 2012, NASDAQ filed a proposed rule change with the Securities and Exchange Commission (“SEC”) to amend Rules 5605 and 5615 to comply with the recently adopted Rule 10C-1.  17 CFR 240.10C-1.  Rule 10C-1  prohibits a national exchange from listing any equity security of an issuer (with certain exceptions), unless the issuer complies with the rules regarding compensation committees and compensation advisors.  On January 11, 2013, the SEC approved NASDAQ’s proposed changes, as amended.  See Notice of Filing of Amendments Nos. 1 and 2, and Order Granting Accelerated Approval of Proposed Rule Change, Exchange Act Release No. 68640 (Jan. 11, 2013).

Under the amended listing standards, Rule 5605(d) requires each listing company to have a compensation committee made up of independent directors and a committee charter detailing the committee’s responsibilities.  Issuers must comply with the new provisions by the earlier of either their first annual meeting after January 15, 2014, or October 31, 2014.  Issuers must also certify to NASDAQ that they have complied with Rule 5605(d) within 30 days of whichever deadline is applicable to that issuer.

Previously, NASDAQ had allowed listed companies the choice of having a formal compensation committee comprised of Independent Directors, or allowing the independent directors of the board to decide compensation decisions.  Under the amended rule, companies no longer have the choice.  A compensation committee with at least two members who are independent directors is now required.   

 Rule 5605(d), as amended, expands the factors that boards must consider in determining director independence.  Each member of a compensation committee is now prohibited from accepting, directly or indirectly, any consulting, advisory or other compensatory fee from the listed company or any of its subsidiaries.  In addition, the board must “consider whether the director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee.”

NASDAQ’s rule also includes an exception that allows a director who does not meet the definition of an independent director to serve on a compensation committee in “limited and exceptional” circumstances.  A director, however, cannot be an executive officer (or their family member) and cannot serve more than two years.   Any company using this exception must disclose on its website or in its proxy statement the nature of the relationship and the reasons for determining that the membership is required in order to serve the best interests of the company and its shareholders.  Additionally, the Rule provides a cure period if a company fails to comply with the Independent Director standards. 

Under amended Rule 5605(d), a compensation committee is required to have a written charter that must be reviewed on an annual basis.  The charter must contain the following: (1) the specific scope of the “committee’s responsibilities and how it carries out those responsibilities, including structure, processes, and membership requirements”; (2) a statement specifying the “committee’s responsibility for determining or recommending to the board for determination, the compensation of the CEO and all other executive[s]”; and (3) a statement that the “CEO may not be present during voting or deliberations on his or her compensation.”

NASDAQ also amended Rule 5605(d)(3).  The provision grants the compensation committee the sole authority to obtain the advice of a compensation consultant, legal counsel, or other adviser other than in-house legal counsel.  Such advisers may only be selected after the committee has taken into consideration the six independence factors.[1]  Although consideration of the factors is mandatory, the Rule does not actually require that the committee select an independent compensation advisor.  Companies are mandated to comply with the new provisions of 5605(d)(3) by July 1, 2013.

In addition, NASDAQ retained some existing exemptions.   This included “exemptions for asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies registered under the Investment Company Act of 1940 (“registered management investment companies”), and controlled companies.”  The SEC approved this continued exemption. 

Finally, NASDAQ addressed foreign private issuers.  A foreign issuer continues to be allowed to follow its home country practice in lieu of many of NASDAQ’s corporate governance listing standards, including the compensation-related listing rules.  Issuers adhering to their home country’s practices  must disclose in their annual report filed with the SEC each NASDAQ requirement not followed and describe the alternative home country practice.  In addition, foreign issuers must disclose the reasons why they do not have an independent compensation committee as required by NASDAQ’s standards in their annual report. The SEC also approved a phase-in schedule for initial public offerings, companies that lose their exemptions, companies transferring from other markets, and those deemed smaller reporting companies.

The SEC stated that it believes the rules being adopted “should benefit investors by helping listed companies make informed decisions regarding the amount and form of executive compensation.”  It also found these changes to be consistent with the requirements of Rule 10C-1. 

Therefore, the SEC issued an order granting the accelerated approval of the proposed changes.

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

[1] The six factors the committee must take into account when selecting an advisor are the following: (1) the other services the advisor provides to the company, (2) the amount of fees the advisor receives from the company (as a percentage of the total revenue of the person employing the advisor), (3) the policies and procedures of the person that employs the advisor that are designed to prevent conflicts of interest,(4) any business or personal relationship of the advisor with a member of the compensation committee, (5) any company stock owned by the advisor, and (6) any business or personal relationship of the advisor or the person employing the advisor with an executive officer of the company.


SEC Files Its Initial Brief in Conflict Minerals Case

On March 1, 2013 the SEC filed its Initial Brief (available here) in the pending case challenging the Commission’s final conflict minerals rules.  (more detail about the case and the rule available in an earlier blog).

 In its brief the SEC responded to petitioners’ claims that enactment of the final rule was arbitrary and capricious because “the Commission has a unique obligation to consider the effect of the new rule upon 'efficiency, competition, and capital formation' ... and its failure to 'apprise itself –and hence the public and the Congress - of the economic consequences of a proposed regulation makes promulgation of the rule arbitrary and capricious and not in accordance with law.”

In response, the SEC stated that petitioners make a fatal error when they

  • “assume the Commission is authorized to second-guess and recalibrate policy judgments Congress made when it ordered the Commission to promulgate that rule. This novel and erroneous view animates their argument that the Commission was precluded from implementing Congress’s directive unless it independently confirmed Congress’s judgment that the statutorily mandated disclosure regime would produce the humanitarian benefits Congress intended. It also underlies their arguments that the Commission was required to use its interpretive and exemptive authority to adopt proposed alternatives that would reduce the statute’s costs even where the Commission concluded that doing so would undermine congressional intent. But neither the Administrative Procedure Act (“APA”) nor the Commission’s obligation to determine as best it can the economic implications of its rules gives the agency license to frustrate Congress’s purposes based on its own re-weighing of the benefits and burdens of Congress’s choices. “

In the view of the SEC, because Congress determined that the required disclosures will further the goals of the statute, the Commission’s job was to implement disclosure regulations, not to second-guessing Congress’s judgment by weighing whether the disclosures would promote the statute’s humanitarian goals.

The basic gist of the SEC’s argument is, not surprisingly, that it attempted to reduce the rule’s burdens while remaining faithful to Congress’s intent.   The brief states that

  • “Recognizing that the rule would “impose significant compliance costs on companies who use or supply conflict minerals,” the Commission incorporated changes from the proposal to “reduce the burden of compliance in areas in which [it had] discretion while remaining faithful to the language and intent of” Section 1502. Adopting Release, 77 FR 56,279/1-2. The Commission thus rejected several more costly alternative proposals and accepted numerous recommendations to reduce issuers’ compliance burdens. In some circumstances, however, such as those petitioners challenge, the Commission determined that recommended alternatives would undermine the scheme Congress envisioned.”

Further, the Commission:

  • “considered the costs and benefits of the rule as well as its effects on efficiency, competition, and capital formation…In conducting that analysis, the Commission thoroughly considered the economic consequences of the rule. It appropriately analyzed the empirical data commentators provided to produce a detailed estimate of the costs of the final rule. The Commission also provided a comprehensive qualitative analysis of its major discretionary choices. And the Commission’s choices themselves were reasonable in light of the correct reading of the statutory language, congressional intent, and the evidence in the extensive administrative record. “

Oral arguments in the case are scheduled for May 15, 2013.  The decision will be an important signal of the DC Circuit Court’s willingness to use the arbitrary and capricious standard to overturn SEC rulemaking.  The use of that standard is becoming more and more common given the success recent petitioners have had in cases involving proxy access as well as others.  A victory for petitioners here will only encourage more such actions in the future.

On another level, the conflict minerals case is important as an example of the overburdening of the SEC disclosure process, discussed in more detail in Conflict Minerals and SEC Disclosure Regulation .  Even if the process the SEC engaged in when adopting the final conflict minerals rules was not arbitrary and capricious it certainly was outside the normal bailiwick of SEC concerns.  While no one argues that stopping the atrocities in the DRC is not an admirable goal, it is far removed from the mission of SEC which it states is to “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  Commissioner Shapiro acknowledged as much when discussing the implementation process.  There are more appropriate venues and mechanisms to address the real concerns about violence in the DRC that are the purported motivation for the conflict minerals rules.  Congress should not rely on the SEC to take action that Congress has shied away from. 


Banyan Inv. Co. v. Evans: Court Allows Member of an LLC to Bring Direct Claims Against Other Members

In Banyan Inv. Co. v. Evans, 292 P.3d 698 (Utah Ct. App. 2012), the Utah Court of Appeals reversed the trial court’s dismissal of the plaintiff’s claims.  Banyan Investment Company, LLC (“Plaintiff”), one of six members of Aspen Press Company, LLC (“Aspen”), brought direct claims against the other five members (collectively, “Defendants”).  

Plaintiff alleged Defendants, in managing Aspen, engaged in self-serving conduct to the detriment of Plaintiff.  Defendants moved for dismissal on the grounds that the claims were derivative in nature and could not be brought directly.  The trial court granted the motion.  Plaintiff amended the complaint to include derivative claims but also appealed the dismissal. 

The court first analyzed whether Plaintiff waived the right to appeal the dismissal by filing an amended complaint.  An amended complaint supersedes the original and acts as a waiver of the right to appeal the original dismissed complaint.  However, an exception occurs when a court dismisses the original complaint on the merits, rather than for a technical defect.  Since the trial court dismissed the direct claims on the merits, Plaintiff did not waive the right to appeal. 

The court then looked at the substance of the original complaint.  Generally, shareholders must file claims that involve injury to the entity derivatively.  The closely-held corporation exception, however, allows “minority shareholder[s] in a closely held corporation to proceed directly against corporate officers” instead of bringing derivative claims.  The closely-held corporation exception applies “where a minority shareholder suffers uniquely as a result of majority shareholders engaging in the type of wrongdoing that would ordinarily give rise only to a derivative claim.”  In these circumstances, minority shareholders may bring a “classic” derivative claim directly so long as the claim does not “(i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons.” 

Defendants argued the exception was inapplicable to LLCs.  The exception was designed to allow actions involving actions that harmed minority shareholders but benefited majority shareholders.  The court, however, determined an LLC management structure was similar to that of a closely held corporation and that the exception extended to LLCs. 

Defendants also asserted that even if the exception did apply, Plaintiff failed to allege an injury distinct from that suffered by Aspen.  A distinct injury from the corporation was not a requirement of the closely held corporation exception.  The court reasoned that if a distinct injury were required, the exception would be unnecessary since a separate injury already gives rise to a direct cause of action.  Instead, Plaintiff must show an injury that is “distinct from that suffered by other shareholders.”  Since Plaintiff claimed a unique injury from Defendants, its claims were valid. 

Although it was within the discretion of the trial court to insist on a derivative action, the trial court had only dismissed the complaint based on its inaccurate application of the closely held corporation exception.  Therefore, the Utah Court of Appeals reversed the dismissal. 

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