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Tuesday
Jan312012

NYSE Rule 452 and the Problems of Uninstructed Shares (Part 1)

NYSE Rule 452 has always been a bit of an anomaly.  With the rise of street name accounts, most shareholders no longer hold record title to their shares.  Instead, they are held in the account of a broker (or bank).  The broker or bank typically transfers the shares to a depository, typically DTC.  So it is DTC that had record title to the shares.  

Under state law, voting rights belong to record owners.  DTC, however, does not want the voting rights.  Instead, the depository routinely (but not always) transfers voting rights to the brokers and banks that have deposited the shares.  At the time of a meeting, therefore, it is the broker that for the most part has the legal right to vote shares.

A complicated set of rules requires that brokers pass voting rights to street name owners.  They typically do so by distributing voting instructions to the account holders.  These instructions are executed then returned to the broker.  The broker will total up the votes and send the company a proxy card that reflects the views of street name owners.  For a discussion of this system, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The system gives street name ownes a guaranteed opportunity to vote at shareholder meetings even though they are not record owners for state law purposes.  Many street name owners, however, do not return their voting instructions.  Without some kind of regulatory or contractual intervention, brokers can vote the shares.  This gives them a potentially significant role in shareholder decisions even though they have no economic interest in the shares. 

The easiest thing to do would be a rule that bans brokers from voting uninstructed shares.  Opposition to this usually centers around the perceived concern that without voting the shares, they will not be deemed present at the meeting for quorum purposes.  To the extent a company lacks a quorum, it will have to reschedule and hold another meeting, causing additional delay and cost.

As a result, brokers are allowed to vote uninstructed shares.  Rule 452 delineates the circumstances where they are not allowed to do so.  Thus, if something is not listed in the Rule, brokers can vote the uninstructed shares.  Rule 452 in turn contains a complicated list of 21 items, including such matters as those relating to "executive compensation," something that, according to the notes, encompasses say on pay. 

The Rule has undergone considerable revision over the years.  An Information Memorandum issued by the NYSE effectively continues this process.  It prohibits brokers from voting uninstructed shares for certain corporate governance provisions even when supported by management.  We will discuss this interpretation in the next post.  

Friday
Jan272012

Sterling v. NestlĂ©: Defendant Lacked Injury and Therefore, Lacked Standing

In Sterling Merch., Inc. v. Nestlé, S.A., 656 F.3d 112 (1st Cir. 2011), the First Circuit Court of Appeals upheld summary judgment in favor of Nestlé, S.A. (“Nestlé”) for lack of standing. Sterling Merchandising Inc. (“Sterling”) sued Nestlé and its subsidiaries for violating the Clayton Act, 15 U.S.C. §§ 12-27, the Sherman Act, 15 U.S.C. §§ 1-7, antitrust laws, and various Puerto Rican laws.  On June 23, 2010, the United States District Court of Puerto Rico granted summary judgment in favor of Nestlé. Sterling subsequently filed this appeal.

In the complaint, Sterling alleged that Nestlé engaged in anti-competitive conduct from June 2003 through October 2009. Sterling contested the Nestlé merger with Payco Foods Corporation (“Payco”) in 2003 that made Nestlé the largest ice cream distributor in Puerto Rico and making Sterling the second largest distributor.  The Puerto Rico Office of Monopolistic Affairs approved the merger upon stipulated conditions. Sterling did not allege breach of any of those conditions.  Instead, Sterling presented a two-part injury and damages theory.  First, Sterling alleged that but-for Nestlé’s exclusivity agreements with a multitude of grocery stores, Sterling missed out on an additional $21-29 million in gross sales.  Second, Sterling alleged that Nestlé’s merger limited Sterling’s market share and caused a decrease in efficient operations.

The district court found that the Puerto Rico ice cream distribution market expanded during the relevant time period, the merger did not restrict output, consumer prices did not increase, and on certain products consumer prices actually decreased. The record also showed that before the merger, Payco and Nestlé had a combined 85% market share, and by 2007, the combined market share fell to 70%.  Sterling’s market share on the other hand, increased from 14.7% in 2003 to 22% in 2008.  Sterling’s sales, which declined $1.06 million from 2001 to 2003, increased after the merger at an average of 11% a year.  

To determine whether Sterling had standing, the court considered “(1) the causal connection between the alleged antitrust violation and harm to the plaintiff; (2) an improper motive; (3) the nature of the plaintiff’s alleged injury and whether the injury was of a type that Congress sought to redress with the antitrust laws (‘antitrust injury’); (4) the directness with which the alleged market restraint caused the asserted injury; (5) the speculative nature of the damages; and (6) the risk of duplicative recovery or complex apportionment of damages.”

The First Circuit applied the Supreme Court’s six-factor standing test, and emphasized causation of the injury.  The court reinforced that, “absence of ‘antitrust injury’ will generally defeat standing” and measured injury by a decrease in output and an increase in prices in the relevant market.  Sterling’s expert failed to show evidence that output within the Puerto Rico ice cream market declined or that consumer prices increased after the merger.  In addition to the findings that the Puerto Rico ice cream market statistics did not support Sterling’s argument, Sterling could not attribute any injury directly caused by Nestlé.  Sterling argued that a “plaintiff’s post-violation successes do not necessarily preclude compensation.” However, the First Circuit disagreed with Sterling’s alternatives to the classic evidence of antitrust injuries.

Sterling also failed to show the requisite injury. Under §2 of the Sherman Act, Sterling must show that Nestlé’s monopoly power prevented competitors from entering the market.  However, new competitors entered the Puerto Rico ice cream market after the merger.  Without establishing any injury to itself or to the competiveness of the market, Sterling’s claims lacked standing.

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

Wednesday
Jan252012

The SEC, the Business Roundtable and an Appropriate Alliance

The Business Roundtable sought permission to file an amicus brief on the side of the SEC in the Citigroup case.  We have posted the brief on the DU Corporate Governance web site. 

At first glance, this may seem to be the case of strange bedfellows.  After all, it was the Business Roundtable that challenged the SEC’s shareholder access rule and essentially helped generate an opinion from the DC Circuit that will bedevil rulemaking endeavors for years to come. For an article criticizing that decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

But in fact the connection is a natural one.  To see the two as strange bedfellows is to see the role of the SEC as anti-business.  It is not.  The Commission’s goal of ensuring efficient capital markets benefits all participants.  It may be the case that in ensuring an appropriate regulatory regime the Commission sometimes tilts in favor of investors and shareholders.  But this is in large part a consequence of a shareholder unfriendly regulatory environment in Delaware.  It is a restoration of a necessary balance. 

Still, it seems as if the Business Roundtable and the SEC often find themselves on opposite sides.  Shareholder access is an obvious example.  What explains this?  It is not that one has a pro and the other an anti -business approach to regulation.  The difference is horizon. 

In the shareholder access case, those challenging access essentially sought to preserve the status quo.  The status quo is that directors are nominated by the board (often with considerable influence from the CEO, something chronicled in Essay: Neutralizing the Board of Directors and the Impact on Diversity) and elected by shareholders in a Soviet style contest (this is true even with majority vote provisions). 

As a result, directors often do not represent the interests of shareholders.  Under this electoral approach, there have been repeated breakdowns at the board level that have spurred calls for additional regulation, whether the failure to monitor for fraud that contributed to the pressure for Sarbanes Oxley or the failure to monitor for risk that contributed to the adoption of Dodd Frank. 

The status quo leaves in place a system that has resulted in a cycle of board failure followed by federal intervention and increased regulation.   Certainly this can be seen most clearly in the area of executive compensation, with the SEC now regulating compensation committees, overseeing say on pay, policing clawbacks, and banning practices that induce excessive risk taking.

Access alters the status quo but it also likely alters the cycle of board failure followed by increased federal regulation.  Access, under the model put forward by the SEC, limited the authority to long term investors and only permitted the election of a minority of directors on the board.  The presence of these directors in the boardroom would likely result in increased oversight of critical areas such as risk management and executive compensation.  Access challenges would also provide shareholders with an outlet for their frustration with management and reduce the need to seek a regulatory solution. 

Finally, the presence of shareholder nominated directors would probably stiffen the spine of the remaining directors and, at least in some cases, increasing the degree of oversight.  Under the current configuration, no one on the board wants a reputation as a trouble maker or someone who can be counted on to oppose the CEO.  This no doubt stifles genuine disagreement.  But if the disagreement is initiated by shareholder nominated directors, the others have more room to participate.

In other words, access holds the promise that by changing the status quo the inevitable dynamic of board failure followed by increased regulation will be allayed.  It is a long term benefit but one that trumps the short term consequences.  For now, however, the status quo remains in place and, as a result, so does the cycle of breakdown and regulation. 

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