Jon Macey on Corporate Governance (Part 7)

Jon Macey, Deputy Dean and Sam Harris Professor, of Corporate Law, Corporate Finance, and Securities Law at Yale, has recently published a book titled Corporate Governance, Promises Kept, Promises Broken.

According to Macey, the board of directors cannot be counted on to keep the promises made to shareholders because of the problem of capture.  Instead, the best method of ensuring that promises are kept is a robust market for corporate control.

In an era when financial markets are in turmoil and reliance on the markets has fallen out of favor as a solution, this is a tough argument.  Essentially, he is contending that it should be left to the markets to protect shareholders. 

There can be no argument that a market for corporate control is an important component for any system of governance.  But Macey's argument goes further.  He more or less sees it as the only significant source of discipline on corporate management.

There are many problems with that approach.  First, he must assume that there are no alternatives to ensuring proper governance.  As we will discuss in the next post, he discounts derivative suits and dissident directors as a source of improved governance, but his arguments are not very convincing.

Second, he views hostile acquisitions as inherently beneficial, noting that target shareholders receive abnormal returns.  The analysis in this area, however, requires greater nuance.  It is true that target shareholders earn a premium in hostile acquisitions.  But that ignores what happens once the acquisition occurs.  It is quite common, in fact, probably the majority rule, for bidders to poorly manage acquisitions.  This is an actual, not a theoretical, cost to the economy.  Disney was the subject of takeover efforts in the 1980s, mostly to break up the company and sell off the land around the theme parks.  Disney fended off the overtures and brought in Michael Eisner as CEO.  It is highly unlikely that the acquisition of Disney would have produced a more efficient use of Disney assets.  In the Hobbsian universe of a robust market for corporate control, the inefficient bidder will eventually be acquired, but not before substantial damage has been done.

Third, no matter how much one improves the robust nature of the market for corporate control, there are substantial costs associated with finding targets and completing an acquisition, not the least of which is the need to pay a large premium (50% in case of hostile takeovers, as Macey notes).  That means that companies must obtain a certain degree of inefficiency before they will become a target.  The market for corporate control cannot, therefore, police most self serving decisions by management.  This is particularly true with respect to executive compensation.  Managers can significantly overpay themselves and, as long as the amount isn't so great that it would trigger a takeover, can do so without concern about the consequences.

We will do one more post that examines the alternatives to hostile takeovers as a means of effectuating a system of corporate governance that protects the interests of shareholders.

Jon Macey on Corporate Governance (Part 6)

Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recenlty published a book titled Corporate Governance, Promises Kept, Promises Broken.

Macey forcefully shows that boards of directors are "captured" by management.  As such, they cannot adequately protect the interests of shareholders.  His solution to the problem, as any good proponent of the nexus of contracts theory must argue, is to let the market resolve matters.  The best way to ensure the protection of shareholders is to ensure an active and robust market for corporate control.

The market penalizes inefficiency.  "Because running a firm below its firm potential would make it more likely that the company's incumbent management would be replaced in a hostile acquisition, a robust market for corporate control is vitally important as a corporate mechanism for monitoring and disciplining managers."  He notes that the "scientific evidence" on the importance of these markets is "so overwhelming as to be incontrovertible" (he does note, in his footnote, that some notable scholars disagree with the overwhelming and incontrovertible evidence).  The evidence?  That there are "significant positive abnormal returns on the investments of shareholders in companies that receive takeover bids." 

It is a theoretical argument in today's market.  As he notes, "the poison pill has effectively destroyed the hostile takeover market."  He places the blame on the Delaware courts, where they have "by judicial fiat . . . removed from the marketplace the hostile tender offer, which is the most powerful corporate governance device in the shareholders' corporate governance arsenal."

The observation is quite accurate.  The explanation? 

• The shareholders who would benefit from the high premiums and more rigorous scrutiny of management associated with a robust market for corporate control from more intense monitoring and are widely disbursed and disorganized.  On the other hand, the managers who want to be free of the intense market discipline associated with a robust market are a small, discrete, well-organized group that constitutes an effective political coalition.  This coalition, aided by management lawyers and investment bankers who benefit from a sclerotic market for corporate control that is run by lawyers and bankers rather than entrepreneur, can be credited for the regulations we observe. 

It is a powerful observation but one that entirely undercuts the entire nexus of contracts analysis.  It suggests that contracts are not a product of bargaining, but the result of self serving behavior by management, aided by key advisors.  In other words, with this dynamic in place, all contracts are better explained by self serving behavior than by efficiency.  It is the point that we make in Opting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom.

It is also not enough to emphasize the wide dispersion and disorganization of shareholders.  They are also subject to substantial legal limitations, whether the lack of the authority to initiate amendments to the articles or to adopt shareholder proposals that provide for mandatory repayment of expenses in proxy contests. 

In addition, the criticism of lawyers and investment bankers leaves entirely unmentioned the role of the Delaware courts.  It is the Delaware courts that resolutely refuse to impose meaningful duties on directors that would otherwise result in increased protections for shareholders. 

The irony in all of this is that those in the law and economics movement generally and those favoring the nexus of contracts approach specifically typically approve of the role of the Delaware courts.  The courts have resolutely removed categorical protections of shareholders in favor of broader discretion for the board.  Thus, directors can discriminate against shareholders of the same class of stock or buy votes, so long as consistent with fiduciary duties.  It is an approach that theoretically favors private ordering. 

But of course the Delaware courts are motivated not by efficiency but by pro-management outcomes.  Any overlap of the two approaches is entirely accidental.  Thus, one of the reforms not really addressed in the book is a mechanism that would seek to reduce the pro-management bias of the courts.

We address the issue of hostile takeovers and the market for corporate control in the next post.

Jon Macey on Corporate Governance (Part 5)

Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recenlty published a book titled Corporate Governance, Promises Kept, Promises Broken.  We are discussing the book in a series of posts.

In addition to the dual functions expected of boards, he emphasizes in Chapter 4 that diretors are inherently subject to capture by management.  Capture applies not only to the inside directors, but those considered independent under the relevant definitions.  As he describes:

• The problem with boards is their unique susceptibility to capture by the managers they are supposed to monitor. The problem of capture is so pervasive and acute that no board, not even those that appear highly qualified, independent, and professional, should be relied upon entirely.

Id. at 57.  What are some of the foundations for the capture phenomena? He relies primarily on the cognitive bias that arises out of constant interaction between directors and officers and the control of management over the flow of information to the board.

• Boards select top management and "become committed to and responsible for theirs managers. For this reason, as board tenure lengthens, it becomes increasingly less likely that boards will remain independent of the managers they are charged with monitoring."

The phenomena is enhanced by the advisory function expected of directors.  This leads to constant interaction, presumably in a trusting enviornment, that contributes to caputre.  Likewise, capture is exacerbated by an organizational structure that invariably combines the positions of CEO and chairman of the board.  The CEO, therefore, controls the flow of information to the board.  At the same time, the CEO has an incentive to paint himself/herself in the most favorable light possible.  In other words, the board by definition gets a skewed body of information.  

This analysis recognizes that "capture" occurs not necessarily before a director joins the board (say through friendship with the CEO), but afterwards.  Moreover, as Macey emphasized, the current structure makes capture inevitable.  Interestingly, the courts in Delaware courts have all but excluded structural bias from consideration when examining director independence.  It is another example of the pro-management bias of these courts.  They provide legal advantages to "independent" boards but then systematically ignore evidence that suggests the boards are not in fact independent.

Unlike the Delaware courts, governance systems overseas have recognized the capture phenomena.  A number of them specify that after a certain number of years on the board, a director will no longer be considered independent.  Thus, in Great Britain, the period is set at nine years.  The approach is blunt and does nothing to address capture prior to the expiration of the relevant time period.  Nonetheless, it recognizes that directors and CEOs serving together for long periods cannot approach decisions in a neutral manner.

The positions on this Blog are consistent with the capture analysis set out by Macey.  Recognizing that boards are captured begs the question of what to do about it.  On this point, Macey and The Race to the Bottom diverge.

Jon Macey on Corporate Governance (Part 4)

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale.

Singularly the most provocative portion of the book is the discussion of the board of directors in Chapter 4.  He does two things.  First, he notes the almost schizophrenic purposes given to directors.  They are expected not only to monitor but also to advise, tasks that are in many ways irreconcilable.  Moreover, the relative weight given to each function has normative implications.

• [A] board structure that emphasizes independent directors reflects a corporate governance policy of favoring monitoring over managing because the independent directors inevitably will have less information and therefore will be less able to contribute to managerial decision-making than will inside directors. On the other hand, a board structure designed to maximize the efficacy of board participation in strategic planning and other managerial functions will have relatively few outside independent directors.

In other words, increased independence weakens the advisory function; reduced independence weakens the monitoring function.  For Macey, the impossibility of this dual function raises concern about whether the board, as currently configured, can ever fulfill its role in the corporate governance process.

The discussion of these responsibilities highlights one of many weaknesses in the current approach to corporate governance.  The emphasis is on independent directors, with exchange traded companies required to have a majority of such directors on their boards.  Moreover, many companies rely on a super majority of independent directors, with the CEO often the only non-independent director on the board.  As data by Sherman and Sterling on the top 100 largest publicly traded companies notes, independent directors constitute 75% or more of the boards of 89 of the Top 100 Companies surveyed this year, with the CEO the only non-independent director in 44 of the top 100 companies. 

Moreover, while the NYSE definition of independent has many problems (excluding consideration of fees for one), it clearly encourages the use of directors who have no existing business relationships with the company.  In other words, these boards really have no one on them except the CEO who really knows about the business of the corporation.  This highlights the consequence of allowing CEOs in the US to also serve as chairman of the board.  The position gives them almost complete control over the information about the company that is communicated to directors.

They are, therefore, expected to monitor management but then are subject to extensive controls over the information that they need to accomplish the task.  At a minimum, the two positions (chairman and CEO) must be separated (a position Macey takes in his book).  Provisions in SOX governing audit committees and internal control seek to address this imbalance by essentially requiring companies to report certain kinds of information to the board, taking it away from the CEO's discretion and monopoly.  But even if the information is given to the board, they have to understand it.  The provision in SOX that all but requires boards to have directors with financial expertise edges in this direction.

Jon Macey on Corporate Governance (Part 3)

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale. 

As we have noted, Macey views corporations as a nexus of contracts.  This is a theoretical framework that allows managers and shareholders to agree to the terms of their relationship.  In other words, it elevates private ordering over mandatory corporate law provisions. 

While the approach has interesting theoretical implications and arguably results in an approach to governance that favors activist shareholders (at least those who want to change the "contract" by limiting compensation or requiring reimbursement of expenses for proxy contests), the approach breaks down in practice.  In Opting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom, we studied the waiver of liability provisions in the top 100 companes to see if there was any evidence of private ordering. After all, theory behind them was that, as amendments to the articles, both directors and shareholdes had to approve them. This would, therefore, result in some negotiations between the two groups.

In fact, nothing of the kind occurred. All of the publicly traded companies in the top 100 (there were a few mutual companies) had waiver of liability provisions, excepting only Pepsi. (Some companies did not have them because of statutory provisions that effectively waived liability. In those cases, none of the companies "opted out."). In other words, they were universal. Even more revealing, every one of them waived liability to the furthest extent permitted.

There are only two explanations for this data. Either waiver of liability provisions that waive liability to the maximum extent permitted are inherently efficient in all circumstances or there is no actual bargaining between the two groups and the corporate contract merely reflects the interests of management. It is, of course, the latter that makes the strongest case (as the article goes on to show).  In fact, management dominates the contracting process.  To have anything even resembling a negotiation process, existing state law would require dramatic revision, including acceding to shareholders the authority to initiate amendments to the articles of incorporation.

In fairness to Macey's view, he would likely recognize this reality.  Instead, he relies on the market for corporate control to police inefficient arrangements.  If management relentlessly enters into unfair arrangements with shareholders, it will suffer at the capital markets and eventually be taken over by someone with a more efficient approach.  We will deal with this later.  For now, it is enough to note that reliance on the market still leaves the choice in the hands of management, which is not real bargaining, and would only penalize management to the extent the "inefficiency" was great enough to justify the high costs of a hostile acquisition.  In other words, reliance on hostile takeovers does not ensure a meaningful role for shareholders in the bargaining process.

Jon Macey on Corporate Governance (Part 2)

We are discussing Corporate Governance, Promises Kept, Promises Broken, the provocative book by Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale.

Macey defines corporate governance in terms of promises.

• The purpose of corporate governance is to persuade, induce, compel, and otherwise motivate corporate managers to keep the promises they make to investors.  Another way to say this is that corporate governance is about reducing deviance by corporations where deviance is defined as any action by management or directors that are odds with the legitimate, investment-backed expectations of investors.  Good corporate governance, then, is simply about keeping promises.  Bad governance (corporate deviance) is defined as promise-breaking behavior.

The metaphor allows Macey to immediately disarm critics who see corporate governance as not limited to the interests of shareholders and profit maximization.  In Macey's view, there is nothing wrong with promoting other interests as long as it is part of the promise made between owners and managers.  As he notes:

• The purpose of corporate governance is to safeguard the integrity of the promises made by corporations to investors, but investors and companies are left to their own devices (i.e., the contracting process) to define the content of the promises themselves.  Generally, the baseline goal is profit maximization.  Corporations are almost universally conceived as economic entities that strive to maximize value for shareholders.  But the goal of maximizing wealth for shareholders is, or should be, a matter of choice.  Investors should be free to choose to invest in ventures that purse others goals besides profit maximization.  

He concludes that there is "no legitimate theoretical or moral objection to those who assert that the goals of the modern corporation should be to serve the broad interests of all stakeholders rather than to serve the narrow interests of just the shareholders . . . "  The only real limitation is that the company state in advance that this is the goal before investors invest.  In other words, the corporation is a "nexus of contracts" and the parties are free to order their relationships in any way that they deem best (within all legal parameters, of course).

In addition to providing a mechanism for expanding board considerations, Macey's approach also runs head long into the interpretive approach used by the Delaware courts.  Presumably, he would disagree with the determination in CA v. AFSCME, where the Court struck down a proposed bylaw that would require a board to reimburse expenses to insurgents who engage in a proxy contest and successfully elect a candidate to the board.  Private ordering presumably means that managers and shareholdes can effectively enter into these types of agreements.

We will continue this thread in the next post.

Jon Macey on Corporate Governance (Part 1)

Jon Macey, Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale, has recently published a book titled Corporate Governance, Promises Kept, Promises Broken.  The book is, as expected, thorough, thoughtful, and provocative.  It contains a number of conclusions that fully support the positions typically taken on this Blog, as well as a number that do not.  We will take a couple of days to examine the text and highlight the portions that raise some of the most interesting issues.

GM, the Bailout and the Role of the Board

It seems that after the disastrous appearance of Rick Wagoner, the CEO of General Motors, in Washington to ask for a bailout without any real plan and flying back to Detroit on a private jet, has had one potential benefit.  The "mirror image" board at GM seems to have woken up.   According to the WSJ:  "Following Mr. Wagoner's poor performance in Washington last month, the board began meeting more and taking more seriously its obligation to investigate other options." 

But of course, GM was in deep trouble before Wagoner went to Washington.  The more interesting question is why the board wasn't more involved before he took the trip.  Had Wagoner gotten a grilling from directors about what was expected, he might have been better prepared once in Washington.  Of course, it would have required a board prepared to offer the CEO tough advise, a quality not obvious in this apparently "captured" board. 

In any event, there is one possible answer to the delay in becoming involved.  The anemic duties imposed on boards by the Delaware courts did not require any higher level of involvement.  Said another way, the lack of involvement met their fiduciary obligations.  This fact alone says something about the need to change these obligations.

As for lessons learned the last time around, the CEO of Ford won't be taking a private jet to the next meeting in Washington.  He'll be going by autombile, presumably a Ford.

Director Resignations and Board Diversity

The WSJ reports that the number of directors resigning from public company boards has increased, highlighting particularly the resignation of CEOs who are otherwise too busy to sit on board of companies in trouble.  The numbers in the article are actually quite small.  Only 46 outside directors who also served as CEOs and CFOs have departed in what the article describes as "three struggling industries -- financial services, retail and residential construction."  That compares with 31 the year before.

Nonetheless, it is interesting to see the spin placed on these modest changes.  Mostly, they suggested that CEO/directors were too busy to sit on other boards. 

• When DuPont Co. directors named Ellen J. Kullman the company's chief executive starting Jan. 1, she agreed to resign her board seat at General Motors Corp. next June, according to a person familiar with the situation. Now, Ms. Kullman faces pressure from some DuPont directors to quit the GM board sooner because she "lacks time to breathe," the informed person said.

The article did not mention reputation.  Having a CEO sit on the board of an ailing company might not be the best thing for a CEO's reputation in the market.

As the article notes, this is not a new trend. CEOs of S&P companies held, on average, one outside directorship in 2003, a number that had declined to 0.7.  In other words, the decline of CEOs on boards has been ongoing and likely reflects the increased demand of CEO positions and director position.  It also explains why there has been an uptick in the number of retired CEOs who sit on boards. 

The most important thing in the evolution of boards is to understand that, with the change in traditional configuration, comes opportunity.  There is greater opportunity to reach out to more diverse constituencies for replacements, constituencies that can give the CEO advice that is useful and not likely to be meted out internally.

Exxon-Mobile, Mirror-Image Boards, and Comeuppance in the Market

Exxon-Mobile is an oil company, as it likes to say.  As such, it has had a history of resisting pressure to do more in the area of alternative energy sources and the reduction of green house gasses.  In 2008, the company confronted a shareholder revolt over the issue, led by the Rockefellers.  A series of shareholder proposals in the area failed, although they garnered considerable support. 

Like a war time president, many shareholders at the last meeting no doubt were willing to leave well enough alone as the profits poured in.  Management could fend off pressure to change mostly because it operated the company as a huge money making machine, setting a record for profits last quarter of almost $15 billion (breaking its own record from the quarter before). 

But the high profitability couldn't last.  As a result, despite the victory at the shareholder meeting, common sense suggested that the company had some serious work to do in repairing its image and in considering the profitability of green technology and energy.  Apparently the opportunity was wasted. Despite some shift in tone, the company remains committed to its hydrocarbon strategy.

• But while Exxon is slowly unshackling itself from Mr. Raymond’s stance on global warming, it remains faithful to his legacy by dismissing most green alternatives and sticking with hydrocarbons. Although the company’s tone has changed, its strategy has not. Despite growing pressures on oil companies to invest in alternative energy, Exxon’s long-term view remains unapologetically tied to fossil fuels

With oil prices plummeting  back to the $50 a barrell range, the massive oil company is not the same darling of the marketplace.   As the NY Time described (See Green Is for Sissies):  "Exxon’s shares are on track for their worst performance since the early 1980s, a result of the market sell-off and the drop in oil prices recently."  Moreover, its strategy looks increasingly out of date and out of sync with the interests of investors and the new administration.

• The question for Exxon, which Mr. Obama repeatedly singled out as an exemplar of corporate greed during the presidential campaign, is whether the model that has served the company so well for so long will keep it competitive — or whether it will still be producing hydrocarbons long after the world has moved away from dirty fuels.

The question, as always, in these circumstances, is where was the board during this reprieve period? The company has a mirror image board.  This is defined to mean a board that is not diverse and looks remarkably like the CEO. In addition to a noticeable lack of diversity (according to the proxy statement, two women, one person of color, only two younger than 60). 

It is clear that Rex Tillerson, the CEO, is steeped in the internal culture of Exxon, having joined the company in 1975.  He could use a little hard advice from people with a different background about the perception of Exxon in the real world and about the need to move in a new, pro-environmental direction, both for the public relations value and for the future profitability of the company. 

But, from all appearance, this mirror image board is unlikely to deliver that message.  In addition to looking a lot like Tillerson and therefore likely having many of the same views, the directors earned last year somewhere around $400,000 in total compensation for 11 meetings.  It is a nice sinecure that could be lost by questioning the CEO.  It is a board unlikely to take control over the flow of information it receives (a task left to the chairman, who happens to be the CEO) or to provide the brutal advise that management ought to be hearing about the company's reputation in the community.

This is a classic example of a board that might benefit from shareholder access to the proxy statement and the threat of a proxy contest.  Perhaps that would cause the board to nominate a more diverse set of directors and focus more closely on the interests of shareholders.

The Demise of Merrill Lynch and the Need for Corporate Governance Reform

The New York Times had a piece in the weekend edition on the fall of Merrill Lynch.  The piece is not very insightful, doing little more than noting that Merrill piled into the mortgage business and took on too much risk.

The piece notes, for example, that "it was never clear how well Merrill’s management understood the risks in the mortgage business."  Similarly, as the debt markets began to implode, Merrill found itself holding too many mortgage backed securities.  Again, according to the NYT:  "Unlike the C.D.O. pioneers at J. P. Morgan who saw themselves as financial designers and intermediaries wary of the dangers of holding on to their products too long, Merrill seemed unafraid to stockpile C.D.O.’s to reap more fees."  Moreover, the investment banking firm apparently found itself without hedges or guarantees for the inventory.

• For years, Merrill had paid A.I.G. to insure its C.D.O. stakes to limit potential damage from defaults. But at the end of 2005, A.I.G. suddenly said it had had enough, citing concerns about overly aggressive home lending. Merrill couldn’t find an adequate replacement to insure itself. Rather than slow down, however, Merrill’s C.D.O. factory continued to hum and the firm’s unhedged mortgage bets grew, its filings show.

In short, Merrill Lynch took on too much risk by holding onto large inventories of unhedged debt instruments, a bad position to be in when the mortgage market collapsed.  While the names of the instruments are complicated (derivatives, synthetic CDOs), the mishap wasn't.  Somehow the company did not have in place sufficient oversight to prevent what now appears to be a completely inappropriate level of risk taking.

As we have noted often on this Blog, the board of directors apparently did nothing to prevent this from occurring.  While it is possible that the board was aware of the looming crisis, it is more likely that the  board was unaware.  In other words, under Delaware law, boards do not have to be informed of such a high level of risk taking.  The failure, therefore, was in the negligible obligations imposed on boards to monitor the activities of the company.  In other words, the collapse was likely a consequence of the failure of the Delaware model of governance.

Connolly v. Gasmire and Director Independence

The Race to the Bottom presupposes that while Delaware controls in its anti-shareholder decision making, other jurisdictions will follow suit in order to hold onto the modest number of companies who have opted to remain incorporated in the jurisdiction.

Justin Loyola has a nice post today on a case out of Texas that illustrates the point.  The court relied on Delaware law since, under the internal affairs doctrine, the issue was controlled by the law of the state of incorporation.  The court found that plaintiffs had not met their burden of establishing that the board lacked sufficient independence to excuse demand.  In other words, the Texas Court faithfully applied the Delaware approach:  Impose high pleading standards and dismiss potentially meritorious suits by avoiding the merits entirely and focusing instead on the independence of the board.   

Connolly v. Gasmire: “Independent and Disinterested” Under the Aronson Test

In Connolly v. Gasmire, 2008 Tex. App. LEXIS 4930 (July 2, 2008) shareholders John Connolly and Anne Molinari filed a derivative suit against several current and former Odyssey Healthcare, Inc. board members.  The 14th District Court in Dallas County dismissed the suit because plaintiffs failed to show that demand was futile.  Plaintiffs appealed to the 5th District Court of Appeals of Texas.  The Court of Appeals affirmed and dismissed the case.  Odyssey Healthcare is one of the largest hospice providers in the United States and allegedly participated in billing fraud that resulted in a $13 million settlement with the U.S. Department of Justice.

On appeal to 5th Circuit, the shareholders sought to show that demand was futile under the Aronson test.  The Aronson test excuses a demand when there is reasonable doubt that (1) the majority of the directors are independent and disinterested; or (2) the transaction was the product of a valid exercise of business judgment.

Under the first factor of the Aronson test, the majority of directors must be independent and disinterested.  The court rejected the shareholders’ first claim that a director lacks independence if he or she is a member on the compliance committee, audit committee, or compensation committee.  The Membership alone does not render a director too interested to consider a shareholder’s demand. 

The shareholders also claimed that a director is not independent if he or she gains a substantial return from insider trading transactions.  The court rejected this contention and held that a substantial return does not support the conclusion that the directors were interested or that they face a substantial likelihood of liability for those sales.
The court also reaffirmed that mere personal friendship among directors did not create a reasonable doubt about a director’s independence.  See, e.g., Beam v. Stewart.  The shareholders argued that many of the directors had prior relationships that prevented them from being independent.  For example, director Burnham co-founded Odyssey with directors Gasmire, Cross, and Steffy.  Directors Rash, Feldstein and Steffy are all members of the board for Providence Healthcare Company.  Directors Cross and Steffy co-founded Intensiva Healthcare Corporation; and director Feldstein is a director and Rash is the chairman of Pre-Veinor Resources, Inc.  The court refused to find that these relationships defeated independence.

Finally, the shareholders claimed that the board of directors’ high level of experience and expertise elevated their duty, and by not complying with the rules and regulations of the healthcare industry, they breached that duty, causing demand to be futile.  The court rejected that assertion and held that heightened experience and expertise did not result in lack of director independence.  Since the court found no grounds to support the shareholders’ allegations, it found the directors were independent and disinterested.

The court then applied the second factor of the Aronson test that excuses a demand if the transaction was the product of a valid exercise of business judgment.  The shareholders alleged the board did not act honestly in their business decisions because they knew about the defects in their internal controls.  They further allege that the board would have known about the Medicare and Medicaid violations but did not act.  The court held that the board is not required to be aware of every fact; it need only be reasonably informed.  Therefore, the court concluded the shareholders failed to raise a reasonable doubt as to the second factor of the Aronson test.

Since the shareholders’ failed to prove demand futility under the Aronson test, the Court of Appeals affirmed the trial court’s dismissal without prejudice.

The primary materials for this post are available on the DU Corporate Governance web site.

In search of corporate boards with chutzpah

As I think about the recent bailout and the discussions about curbing CEO compensation (see here, for example)--and as I think about AIG's recent corporate retreat (here)--I have to wonder exactly why corporate boards (and C-level officers) are so darn concerned about making sure that (1) their CEOs get paid the "going rate" for top executives and (2) rats don't abandon sinking ships (i.e., paying all sorts of retention bonuses and perks to people who might not stay on if their pampering suddenly ended). 

Is it really true that good companies won't attract and retain talented people unless they provide obscenely fat paychecks?  Is it also true that no one working at a company that's going under will stay unless he or she is bribed with retention pay?  Or are corporate boards just afraid to test the waters by paying normal amounts (OK, high amounts, but within some bounds of reason) to C-level officers, and by letting some of their employees abandon ship?

I know at least one CEO who scoffs at the behavior of some public companies.  He actually asked his board to reduce his annual salary so that he could work slightly fewer hours and spend more time with his family.  As he explained, he didn't think it was fair to reduce his hours and still earn the same amount as before.  After considering his request, the board acquiesced, and everyone involved was happy with the result.

I have a feeling that part of the problem is due to boards' tendency to want to replicate themselves when bringing on new board members.  Maybe it's sour grapes on my part, but I've interviewed with some headhunters for positions on the boards of a few public companies and, so far, I've had zero nibbles.  The headhunters tell me that the boards are looking for people with board experience, but they're not talking about my experiences on non-profit boards.  They want people who have served on public boards already, not people who only write about corporate governance and corporate ethics.  That rules me out. 

Admittedly, I haven't been on the board of any company that's hired an executive with a huge compensation package or a golden parachute worth millions of dollars, and I've not been on a board that rewards executives more for short-term performance than long-term vision.  Maybe if I had, I'd have gotten the experience that would get me a position on a public company's board.  But is that the kind of experience that boards should want?

Maybe it's time for boards to think outside the box.  There are a lot of academics who think about issues of board behavior, and it might behoove some public companies (especially now) to consider them, if not as board members, then as people who could prod the boards into thinking more creatively about compensation.  Based on today's ecoonomy, boards should be thinking seriously about making some changes.

The Delaware Courts and the Charade of Director Independence: Ryan v. Lyondell Chemical (Part 1)

The Delaware courts have relied on independent directors as a mechanism for insulating managerial behavior from judicial review. Conflicts of interest approved by independent directors are reviewed not under the duty of loyalty but the almost impossible to overcome business judgment rule. A board with a majority of independent directors will typically defeat a claim for demand excusal.

The approach might be appropriate, minimizing the role of courts in the governance process, were the Delaware courts to interpret the standards in any meaningful way. But, of course, the courts do not. Director independence is a charade. Courts largely ignore friendships, don't take into account fees, even where extraordinary, and impose excessively high pleading standards that prevent plaintiffs from exploring the issue even when they present evidence indicating a possible disqualifying relationship. All of this is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

All of this brings us to Ryan v. Lyondell Chemical Co., a Delaware decision issued on July 29 and one that has generated considerable controversy/commentary.  The opinion essentially found that, on a motion for summary judgment, sufficient evidence existed that the board violated its duties under Revlon in selling the company. It's an interesting opinion because, Van Gorkom-like, the acquirer agreed to pay a substantial premium over market and, non-Van Gorkom-like, the company obtained a fairness opinion to assist in justifying the opinion.

The case is wrongly decided but not for the standard reasons.  This is a case that clearly implicates duty of loyalty provisions with a board entirely interested in the outcome of the transaction.  The court disposed of the duty of loyalty arguments with weak analysis.  The court viewed the process as flawed but did not want to give additional life to conflict of interest challenges to the board. 

In challenging the approval of the merger, plaintiff alleged that the board had an interest in the outcome of the transaction and therefore the merger ought to be examined under the duty of loyalty. Mind you, a finding for the plaintiff would not automatically result in liability, only that the board have an obligation to show that the transaction was fair. In alleging a conflict of interest, plaintiff asserted that the transaction resulted in the acceleration of all options. Moreover, the complaint alleged that options could be surrendered, with the holder paid the spread on the difference between the option exercise price and the merger price. Finally, the complaint included a table that showed the cash payouts to the board as a result of the merger. How much of a payout? The amounts ranged from $233,000 to $3.75 million.

• In his brief opposing summary judgment, Ryan further asserted that the financial benefits accruing to the Lyondell directors were “much more beneficial than what the average shareholder [would] receive.” This contention apparently flows from the fact that the Independent Directors were entitled to have their stock options vested and cashed out in connection with the Merger as opposed to waiting for those benefits to accrue over a longer term if Lyondell remained independent.

The court called the contentions "bald allegations" and accused Ryan of presenting a "paucity of facts" to support the contention of improper interest. Why exactly was the approval of a transaction that resulted in huge payments to the board not an example of self interest?  As usual, the Delaware court engaged in simplistic reasoning that largely sidestepped the key issue.

The court first noted that the "vesting of stock options in connection with a merger does not create a per se impermissible interest in the transaction." But of course no one was making an argument that vesting was per se disqualifying. In order to constitute self interest sufficient to trigger the duty of loyalty, there had to be a material financial interest. Only if the accelerated vesting triggered this type of payment would the duty of loyalty be applicable. 

But try to find any discussion in the opinion of the materiality of the payment.  Its not there because had the court focused on that factor, it would have had to conclude that in fact a majority of the board was interested.  Instead, the court noted that if accelerated vesting would result in a conflict of interest, "directors would be faced with a proverbial Catch-22 requiring them either to forego the options (a rightfully earned component of their compensation) or to accept their rightfully earned compensation and risk a breach of their duty of loyalty. Such an irrational system would deprive the board of a strong incentive to maximize value."  In other words, the court suggested that all directors would be disqualified as a result of acceleration.

This simply isn't true. First, some directors may not have unvested options. Second, only those receiving a material payment would be disqualified. In other words, there are likely to be other directors on the board who can participate on a special committee and resolve the benefits of the merger offer. Thus, the directors are not subject to a Catch-22 that requires them to forgo the options or risk a violation of the duty of loyalty.  Third, even if the Catch-22 existed, it was a byproduct of a circumstance created by the board.  Supposedly, under Delaware law, directors must be able to make decisions in a neutral fashion, free of extraneous considerations. The fact that directors know they may receive payments of millions of dollars if they accelerated the options and approved the merger cannot, in any objective calculus, be viewed as an irrelevant factor when considering the merger. Yet the court entirely ignored the issue, much the same way courts ingore the issue of directors fees in determing conflict of interests.
 

Apparently aware of this, the court provided a second rational for ignoring the payments pursuant to the accelerated options.  There was no conflict of interest because the directors received the same benefits as the other shareholders. It is true that as shareholders, the directors were treated identically.  But the case wasn't about their treatment as shareholders, but as option holders.  And, as option holders, they received a unique benefit through acceleration.  The court tried to sidestep this by noting that "[w]here, as here, the options vesting in connection with a merger were awarded as part of an established compensation plan, the accelerated vesting does not confer a special benefit upon the directors."  The comment was disingenuous.  The case had nothing to do with the issuance of the options.  It was about the uniqure benefit that came with acceleration and that came, not at the time of issuance, but at the time of the approval of the merger. 

The case, therefore, managed to find a merger that allowed directors to accelerate their benefits and receive millions in payments did not result in a disqualifying financial relationship. Only in Delaware.

As usual, the opinion and some of the operative documents are on file at the DU Corporate Governance web site. A number of the pleadings are, however, under seal.

A Friday Editorial: Board Independence and the Separation of Chairman and CEO

We couldn't help but read with great interest the editorial in the Journal written by Gary Wilson called "How to Reign in the Imperial CEO."  He should know about the subject.  He was one of the directors on the Disney board  found to be "independent" by the Delaware court in the 1990s (the same board labeled by Business Week as the "worst" two years in a row, with the article noting that it was packed with "Eisner chums.").   

Wilson sits on the board of Yahoo and is a candidate for the board of CSX.  His editorial is not subtle.  The first two sentences say this:  

• America's most serious corporate governance problem is the Imperial CEO – a leader who is both chairman of the company's board of directors as well as its chief executive officer. Such a CEO can dominate his board and is accountable to no one.

What are the consequences of the imperial CEO?

• The result of this conflict of interest is excessive CEO compensation and undeserved job security. Entrenched management leads to empire-building, continued adherence to flawed business strategies, resistance to change, the stifling of healthy debate in the boardroom, and destruction of shareholder value. All too often, we also find an imperial air force of large private jets reserved for the CEO's trips to the Masters, the Super Bowl or that Paris "business" trip.

These are topics we have constantly discussed.  Excessive salaries, personal use of the aircraft, golden coffins (making a CEO sometimes worth more dead than alive, a curious type of incentive), they are all there.  They reflect boards that do not act independently.  Why?  Many have a comfortable sinecure (Goldman directors were paid last year around $700,000 for ten meetings) and don't want to rock the board.  In other words, they are not independent.  The CEO sits on the board and, while not on the compensation committee, has considerable ability to influence the process.  Compensation decisions are often justified by consultants who have every incentive to be an advocate for the CEO rather than provide neutral advise.  In other words, the Delaware courts impose procedural requirements for compensation (independence director approval and a requirement to be informed) but do not enforce either.  

What Wilson suggests is to separate the position of chairman and CEO.  For those who wonder about the power of the CEO, they need only realize that most CEOs of Fortune 500 companies insist on having it.  As he further notes, this is the norm here but not overseas.  Capitalism manages to function adequately in places like the UK despite a separation of chairman and CEO.  Indeed, the need for this can be seen by the growth in the use of a lead independent director.  In other words, some degree of independent director leadership is widely recognized but only in an emasculated fashion that does not, typically, come with the authority of the chairman such as the ability to call special meetings of the board. 

Sooner or later an imperial CEO will make an imperial mistake.  Countrywide?  Disney?  A board with an independent chairman provides a mild check on the CEO.  If the CEO wants to take a step that he or she cannot justify to an independent Chairman, perhaps the step ought not to be taken. 

The battle over access, the battle over a bylaw that would require companies to pay proxy contest expenses, the battle over separating these two positions, is a battle over an outdated model of governance, one that increasingly has the appearance of a dinosaur to the international community.  Most importantly it is a model that in long-term will harm business development in the US.  Or, as Gary Wilson puts it:

• The simple change I suggest to effect the separation of chairman and CEO – requiring that an independent director become chairman when a new CEO is named – would increase the rightful influence of ownership in the governance of American corporations, and lead to extinction of the Imperial CEO. This, in turn, would improve corporate performance and decrease the need for new, expensive and intrusive government regulations to control management excesses.

Boards and the Benefits of Diversity

A few Sundays ago, the NYT Magazine contained a story titled “Childless Europe.” At first, the story seemed to be another harbinger of doom about the declining birthrate in Europe. But in fact, the article was more sophisticated and more insightful. It in fact explained the huge disparity in birth rate among countries in Europe, with the countries of Scandinavia having a relatively healthy birth (as does the United States), while Southern Europe (Spain, Italy and Greece) do not. What explains the difference? Apparently in Italy, children live with their parents longer. As the piece noted, this may be the best contraceptive.

But a more significant explanation is the lack of flexibility when it comes to gender roles. In Italy, despite its reputation as a child friendly, family oriented community, the birthrate is among the lowest in Europe. There, women are expected to leave the work force when they have children. As a result, only about half of the women in Italy are in the workforce. Moreover, child bearing is associated with a fall in economic status as one of the parents leaves the job market.

Other countries, however, take a more flexible attitude. As the article noted, “many countries with greater gender equality have a greater social commitment to day care and other institutional support for working women, which gives these women the possibility of having a second or third child.” In Norway, for example, women receive 54 weeks of maternity leave and the state subsidizes the day care system. The attitude shows in the percentage of working women, with 75-80% of women in Scandinavia in the workforce.

In the United States, where government support is far less prevalent, the economic system is more flexible, with mothers able to cycle out but then back into the work force more easily. In other words, the more that the economic system accommodates women in the workforce, the higher the birthrate.

Whatever flexibility exists with respect to gender roles in the United States, it does not apply to the board room of public companies. Employing “mirror image” boards, most companies have little gender representation among its directors. The percentage of women directors hovers slightly over 10%, a percentage that smacks of tokenism. The problem, among others, is that the boardroom becomes a place of stifling consensus, filled with individuals who look at matters in similar or identical terms. The board, therefore, becomes a place for rubber stamping executive decisions, depriving the CEO of a useful set of alternative views, particularly from a group representing over half of the worlds population.

Who knows how long it will take corporate America to realize the short sightedness of this approach. For at least two countries in Europe, the legislature has intervened and mandated a minimum percentage of women on the board. But over time, as the article in the NYT Magazine illustrates, those who see the advantage of gender flexibility will reap the advantages. Those that do not will suffer accordingly.

Bear Stearns and a Sleeping Board?

The WSJ ran a story about the waning days of Bear Stearns and the concerns expressed within the investment banking firm in the days and months leading to its ultimate demise.  At one point, buried in the piece, the WSJ described the board as "12 men largely handpicked by Mr. Cayne."  We have more or less made this point before.  The board was not diverse and contained a large number of individuals who had served with Bear Stearn's management for more than a decade.  And they were well paid. 

We don't know what happened inside the board room.  But serving for long periods of time with the same management can easily impair a director's independence.  Moreover, the lack of diversity on the board probably reduced the likelihood that management would hear alternative views.  What Bear Stearns (and the shareholders of Bear Stearns) needed was a board that could ask management tough questions.  The dynamics of this board suggest that this is not what they got.

Qwest and an Exemplary Legal Department

We are a corporate governance blog and do not typically comment on corporate legal departments.  Nonetheless we make an exception today to note the article by Amy Miller from Corporate Counsel on the Best Legal Department of 2008.  The award went to the legal department at the telecommunications giant, Qwest, headquartered right here in Denver. 

As the article rightfully points out (and anyone practicing in this community already knows), much of the accolades belong to Rich Baer, the general counsel.  Brought over from Sherman & Howard (one of the oldest firms in Denver) during the Nacchio years, he rose to the top when Drake Tempest (the general counsel appointed by Nacchio and whose name came up in Nacchio's trial for insider trading) stepped down.  Despite all of the turmoil during the waning years of Nacchio's tenure, the near bankruptcy of the company, and the raft of shareholder/investor law suits, Baer (with considerable help from another Sherman & Howard alum, Stefan Stein), managed to extricate the company from most of its legal problems and reinvigorate the legal department.  As the article noted:  

• The 51-year-old GC has brought virtually all commercial contract negotiations, disclosure and corporate governance, trademark and immigration work in-house. Baer created more supervisory roles and opportunities for advancement. He's willing to take chances, whether it's letting lawyers work part time or from home, or embracing new technology to streamline operations. And he's diversified his staff, too, and encouraged everyone to do more pro bono work. "He's energized the entire department," says deputy general counsel Andrew Crain, who joined the company in 1997.

The legal department has already been recognized for its pro bono activities, including work at the Colorado Coalition for the Homeless. 

The recognition from Corporate Counsel is a well deserved accolade for a top notch legal department and a top notch general counsel.  

Exxon and Mirror Image Boards

The corporate governance at Exxon has once again been in the news.  As the WSJ has reported, the company is engaged in a campaign to defeat a shareholder proposal calling for the separation of chairman and CEO.  As the article noted, Exxon "took the unusual step Monday [May 12] of sending an email to institutional investors asking them to reject a shareholder measure to shake up the company by pushing it to name an independent chairman." 

What did the email actually say?  "As discussed in more detail in the enclosed proxy responses, the ExxonMobile Board believes that the decision as to who should serve as Chairman and Chief Executive Officer is the proper responsibility of the Board."  The email also invited investors to contact the company for further discussions.

Exxon has reason to be concerned.  The same proposal received 40% of the vote during the prior year.  Moreover, at least three proxy advisory firms have recommended that shareholders support the proposal, with Proxy Governance the most recent. 

Why are shareholders up in arms?  The stock price has risen from the low $80s earlier in the year to over $90, so its probably not the stock price. According to the WSJ article:  "Shareholders backing the measure want the chairman free to focus on long-term planning, in part to provide a new perspective on the future of energy, including renewable fuels and the availability of crude oil." 

As we have noted in the past, ExxonMobile has been all but tone deaf on the issue of green house gases.  We have wondered on this Blog about the role of the board in allowing this attitude to be such a strong part of the company's public persona.  We have likewise noted that the board is not very diverse, not only in terms of race/gender (of the 11 directors in the proxy statement, there are two women and one person of color) but also in terms of age (two in their 50s, six their 60s, and three in their 70s) and background (most have backgrounds similar to the CEO).  In other words, the board looks much like the CEO, except that it is older.  One has to wonder whether it is the kind of board that can provide the CEO with important feedback on issues of growing importance to the world community such as green house gases.

In opting to support the separation, Proxy Governance noted that if ExxonMobile continues its "my way or the highway" approach, the company could find itself in the midst of a "shareholder revolt."  The management at ExxonMobile are in dire need of some good advice on how to deal with the public and with shareholders.  Boards need diversity so that they can provide top corporate officials with a wide range of advice.  Mirror image boards are less likely to do that.