The Uncomfortable Implications of Morrison: City of Pontiac v. UBS (Part 2)

We are discussing CITY OF PONTIAC POLICEMEN’S AND FIREMEN’S RETIREMENT SYSTEM v. UBS, a decision holding that Rule 10b-5 does not apply to transactions involving securities listed on a domestic stock exchange that are co-listed on a foreign exchange, at least where the transactions occurred outside the United States.  

The reasoning conflicts with the analysis in Morrison. Morrsion, for better or worse, set out two circumstances where investors could state a claim using Rule 10b-5. The first was based upon the type of security. Investors could bring actions involving securities listed on a domestic stock exchange. The second was a transactional test. Investors could bring actions where the transaction occurred in the U.S.   

In City of Pontiac, the court made the transactional test the exclusive method of stating a claim under Rule 10b-5. In effect, sales invovling listed shares could only give rise to an action under Rule 10b-5 if they in fact occurred in the United States. See Id. (finding that Rule 10b-5 did not apply to "claims by a foreign purchaser of foreign‐issued shares on a foreign exchange simply because those shares are also listed on a domestic exchange."). 

The court got there by asserting that the "listing theory" was simply a "proxy for a domestic transaction." Perhaps. But because the Supreme Court explicitly held that Rule 10b-5 applied to "domestic transactions in other securities," the "proxy" could only have meaning if it did something additional. The "proxy" was effectively an over-inclusive test that allowed for actions involving shares of listed companies no matter where the transactions occurred. Moreover, it was a "proxy" explicitly imposed by Congress and included in the language of Section 10(b). See 15 USC 78j(b) (provision applies to deceptive conduct “in connection with the purchase or sale of any security regis­tered on a national securities exchange or any security not so registered.”).  

The court tried to divine some additional support for its position mostly from silence on the part of the majority in Morrison. The shares at issue in Morrison were listed in Australia and listed in the U.S. in the form of ADRs and this, according to the court, "did not affect the Court’s  analysis  of  the  shares  that  were purchased on foreign exchanges." True, but this was because Morrison involved two different securities: shares in the bank and ADRs. The ADRs were listed in the U.S. But as note 1 in Morrison points out, none of the remaining plaintiffs in the case had alleged that they purchased ADRs (Ironically it was Morrison himself who had purchased ADRs but his claims were dismissed and not part of the case). Thus, Morrison did not involve the overseas purchase of a security listed on a domestic exchange.       

Finally, the court in the City of Pontiac emphasized that Morrison had "rejected our prior holding that 'the Exchange Act [applies] to transactions regarding stocks traded in the United  States  which  are  effected outside the United States . . . .’ ” But Morrison did so in a context where the Second Circuit relied not on the type of security involved but on the possible effects of the transaction. Morrison merely rejected the test. The decision did not address or even remotely speak to whether a case decided under the effects test could nonetheless support the use of Rule 10b-5 under a different theory.  

So what is going on here? The Second Circuit is uncomfortable with a test that allows the use of Rule 10b-5 in cases that have limited nexus to the U.S. Most of the plaintiffs in City of Pontiac were foreign. All of the transactions apparently occurred outside the United States. And the securities were listed on foreign exchanges.  

But this was a direct consequence of the reasoning in MorrisonMorrison rendered irrelevant the location of the harm, the foreign nature of the security, or the identity of the investors. Instead, the Court substituted a bright line test that looked only to whether the security was listed on a domestic exchange or the transaction closed in the U.S. The shares in City of Pontiac were, in fact, listed on the NYSE.  

As we have noted before, the type of analysis used in City of Pontiac is really a reverse effects test. Courts are apparently willing to follow the Supreme Court and reject cases that have great effect in the U.S. but otherwise do not involve listed securities or trades that occurred in the U.S. At the same time, however, the courts appear to want to reinstate the effects test where the cases brought under the Morrison standard appear to have little effect in the U.S. But that is not a determination for the lower courts to make. The Supreme Court has decreed that the effects don't matter. In this case, the shares at issue were listed on a domestic exchange. That fact alone is sufficient to permit the use of Rule 10b-5.  


The Uncomfortable Implications of Morrison: City of Pontiac v. UBS (Part 1)

Morrison v. National Australia Bank is properly understood as another case by the Supreme Court that reflects a desire to cut back on litigation under Rule 10b-5. Janusand Stoneridge are two other examples. The Court in Morrison opted to conclude that Congress did not intend to give Section 10(b) extraterritorial effect. The Court rejected the "effects" test, an approach that allowed actions under the anti-fraud provisions where the transaction had "some effect on American securities markets or investors."  

The effects test admittedly could be uncertain in application. It had the advantage, however, of limiting fraud actions to transactions that had "substantial effect in the United States or upon United States citizens.” In other words, the test limited actions to those involving harm within the United States.   

In rejecting this approach, the Supreme Court focused on a test that made the location of the harm irrelevant. As the Court determined: "we think that the focus of the Exchange Act is not upon the place where the deception originated, but upon purchases and sales of securities in the United States." This meant that the provision applied only to "the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States."  

The decision left the analysis in a very uncomfortable place. Transactions that had an enormous effect in the U.S. were not necessarily subject to Rule 10b-5. Transactions that had no discernible effect in the U.S. but had the fortune or misfortune of closing in the U.S. were suddenly subject to Rule 10b-5. It was, frankly, an outcome that took no account of the need for or purpose of the anti-fraud provisions.   

The Second Circuit confronted these consequences in CITY OF PONTIAC POLICEMEN’S AND FIREMEN’S RETIREMENT SYSTEM v. UBS, No. 12‐4355‐cv (2nd Cir. May 6, 2014). In the case, a  group  of  foreign and domestic institutional investors bought shares in UBS outside the U.S., apparently on a foreign exchange. The UBS shares, however, also traded on the NYSE. Using what the court described as the "listing theory," the plaintiffs asserted that it was enough under Morrison that the securities at issue were listed on a stock exchange in the U.S.

Morrison explicitly allowed actions to be brought in connection with securities that were listed on a domestic exchange. The Second Circuit panel, therefore, acknowledged that the language in the decision "taken in isolation, supports  plaintiffs’  view."  Nonetheless, the court found that the “listing theory” was "irreconcilable with Morrison read as a whole." 

The court arrived at the conclusion by concluding that the focus of the decision was on "domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction." The court also noted that the shares at issue in Morrisonwere listed in Australia and also listed in the U.S. in the form of ADRs and that this "did not affect the Court’s analysis of the shares that were purchased on foreign exchanges."  

Most telling to the court, however, was the rejection of the effects test by the Supreme Court. 

  • Perhaps most tellingly, in rejecting this Circuit’s “conduct and effects” test in favor of a bright‐line rule, Morrison rejected our prior holding that “‘the Exchange Act [applies] to transactions regarding stocks traded in the United  States  which  are  effected  outside the United States . . . ."

As we will discuss in the next post, the Second Circuit misread Morrison. The court did so because it was uncomfortable with the consequences of the analysis in Morrison.   


Legal Challenges to the Conflict Minerals Regulation

On November 21, 2012, the National Association of Manufacturers, together with the Chamber of Commerce of the United States and Business Roundtable (“Challengers”) filed in the U.S. District Court for the District of Columbia a preliminary statement of issues as part of its suit seeking to bar implementation of conflict minerals regulation (the “Rule”). Those regulations, adopted by a 3-2 vote of the SEC require public companies to disclose annually whether any "conflict minerals" that are "necessary to the functionality or production of a product" manufactured by the company originated in the DRC or an adjoining country (referred to as the "covered countries"). "Conflict minerals" refers to gold, tin, tungsten and tantalum – which are used in a wide variety of products.  For a more in-depth discussion of these regulations, go here.  

The preliminary statement identified the following issues:

  • Whether the SEC's economic analysis of Rule 13p-1 and Form SD is inadequate;
  • Whether the SEC's refusal to adopt a de minimus exception to Rule 13p-1 is erroneous, arbitrary and capricious, or an abuse of discretion;
  • Whether the SEC's interpretation of Exchange Act §13(p) as including non-manufacturers who "contract to manufacture" products is erroneous, arbitrary and capricious, or an abuse of discretion;
  • Whether the SEC's interpretation of "did originate" in Exchange Act §13(p) as "reason to believe . . . may have originated" is erroneous, arbitrary and capricious, or an abuse of discretion;
  • Whether the standard and requirements imposed by Rule 13p-1 's "reasonable country of origin inquiry" are erroneous, arbitrary and capricious, or an abuse of discretion;
  • Whether the structure of the transition period established by the rule is erroneous, arbitrary and capricious, or an abuse of discretion;
  • Whether Exchange Act §13(p) compels speech in violation of the First Amendment;
  • Whether the SEC otherwise acted in a manner that was arbitrary and capricious, an abuse of discretion, unlawful, or contrary to a constitutional right within the meaning of the Administrative Procedure Act or other applicable law in adopting Rule 13p-1 and Form SD.

Challengers also moved for and were granted expedited consideration of their petition, claiming that “the delay will cause irreparable injury and…the decision under review is subject to substantial challenge....”  USCA Case #12-1422, Document #1406293 Filed:  11/21/2012.  Challengers identify irreparable injury stemming from the “extraordinary costs” implementation of the Rule will impose upon them given the difficulty of determining country of origin and other matters relevant to compliance.  This claim has anecdotal support in statements given at a general session panel of controllers at the Financial Executive International annual Current Financial Reporting Issues Conference.  For instance, Stephen Cosgrove, the Controller of Johnson & Johnson said that his firm had been trying to gather the information required by the Rule for months but has had difficulty.  “[I]t’s clear to me that the kind of process they were getting would get you approximate data, but not up to the standard of what you would need to be able to certify to the SEC.” (BNA Corporate Counsel Weekly, http://news.bna.comccln/display/batch_print_display.adp )

Challengers acknowledge that companies will have to incur some portion of the Rule’s costs while the litigation is being heard because the first compliance period begins earlier than the litigation could be completed.  However, they assert that under their proposed expedited review schedule, briefing would conclude in March of 2013, greatly increasing the possibility that the case can be decided before the end of 2013.  Challengers claim that this would enable the "challenge to the Rule [to] be resolved well before the first disclosures and reports under the Rule would be due, in May of 2014, and preferably before the start of the Rule's second compliance period, in January of 2014. If Petitioners' challenge is successful, expedited consideration would help Petitioners avoid the astronomical costs of finalizing compliance infrastructure, preparing disclosures, preparing and obtaining private sector audits of reports, and beginning a second year of compliance."

Clearly hoping to replicate the success Business Roundtable had with their challenge to proxy access,) Business Roundtable and Chamber of Commerce of the United States of America v. SEC. --- F.3d ----, 2011 WL 2936808 (C.A.D.C.)) Challengers focus in their motion for expedited consideration on errors in the SEC’s economic analysis of the Rule, claiming that  that the SEC "never estimated the benefits of the Rule and even acknowledged that there might be no benefits at all.” In addition, they claim that the SEC misinterpreted Section 1502 (the section of Dodd-Frank pursuant to which the Rule was promulgated) by wrongly concluding, among other things, that the statutory text left it no authority to create a de minimus exception despite its general exemptive authority and wrongly interpreting the term ‘manufacture' as including those who ‘contract to manufacture.’  Finally, Challengers assert that the Act compels speech in violation of the First Amendment by forcing companies to state that certain of their products are not ‘DRC conflict free.'"

It is of course impossible to predict the final outcome of the challenge to the Rule. The enormous costs imposed by the Rule –initially estimated by SEC staffers at $71 million and later revised upward to $3 billion to $4 billion for initial compliance and $206 to $609 million for annual compliance, the fact that the Rule passed on a 3-2 vote and the fact the challenge is being heard in the DC Circuit Court and involves Business Roundtable as a petitioner suggest it has some chance of success.  That must be balanced however with the recent increase in violence in and corresponding international attention being paid to the DRC.  If advocates of the Rule can make the case that the disclosure sought by the Rule would truly help to mitigate the dire conditions in the DRC they may make the case for the Rule to be upheld.


Say on Pay and the International Trend: Lessons for the US? 

Say on pay has been around longer overseas than in the United States.  As a result, the evolving practices overseas provide a look into the future of what might happen in the US.  Because say on pay is an advisory vote, boards are not obligated to follow shareholder advice on the subject, although sometimes they do.  As a result, the use of an advisory vote can sometimes result in failed expectations.  Pressure then builds for reforms designed to increase shareholder authority.  At least that has been the practice overseas.

Britain put in place a requirement that shareholders have the right to approve company policies on compensation.  The vote is binding.  Moreover, as Wachtel Lipton recently wrote:

The Netherlands has since 2004 provided shareholders with a binding vote on key changes to executive pay policies.  Switzerland will be holding a referendum sometime around March 2013 that could give shareholders a binding vote on executive compensation.  The EU’s internal markets commissioner, Michel Barnier, reportedly has stated that he would like to see not only mandatory votes on executive pay, but also shareholders having the power to vote on the ratio between the lowest and highest paid employees in the company and the ratio between fixed and variable compensation.

Will the same thing happen here?  It could.  There will need to be a catalyst.  The pressure will likely come not from shareholders but from the public.  Can it be stopped?  Toughening up the fiduciary obligations of the board with respect to compensation might help.  So would shareholder access.  With shareholder directors part of the compensation determination process, the amounts approved would likely cause less controversy. 


Rogers v. Petroleo Brasileiro: Immunity Under the Foreign Sovereign Immunities Act

In Rogers v. Petroleo Brasileiro, S.A., 2012 WL 806812 (2d Cir. Mar. 13, 2012), two United States citizens, Dennis Rogers and Kevin Burlew (collectively, “Plaintiffs”), filed separate suits against Petroleo Brasileiro (“Petrobrás”) because the corporation declined to convert their bearer bonds into preferred shares. Combining the two actions, the Second Circuit Court of Appeals held that Petrobrás was immune under the Foreign Sovereign Immunities Act (“FSIA”).

In 1953, the Brazilian legislature enacted a law which incorporated Petrobrás, a Brazilian state-owned oil company, and required every motor vehicle owner in Brazil to pay an annual fee. Petrobrás subsequently issued four series of bearer bonds (the “bonds”) to evidence payment of the annual fee. Each bond stated that Petrobrás owed the bondholder one thousand cruzeiros, plus interest, to be paid during the relevant redemption period. Bondholders could also exchange the bonds for preferred shares. All of the redemption periods ended in 1980, and Petrobrás has denied requests for redemption or conversion since then. The Brazilian President’s Office issued a report in 1989 supporting Petrobrás’ denials. On June 22, 2009, Plaintiffs mailed letters to Petrobrás’ New York City office demanding Petrobrás convert their bonds to preferred shares.

Petrobrás asserted that the “commercial activity” exception under the FSIA was not satisfied and that the court therefore lacked subject matter jurisdiction. All parties agreed that Petrobrás was a “foreign state” under the FSIA. The FSIA grants immunity to foreign states, with three exemptions.

The first clause of the “commercial activity” exemption states that a foreign state will not receive immunity if “the action is based . . . upon an act performed in the United States in connection with a commercial activity of the foreign state elsewhere.” Although Plaintiffs contended that an email sent from Petrobrás’ New York office should constitute the act, the court held that this was “‘notice to [the Plaintiffs] of the alleged breach, rather than the actual mechanism of breach” (emphasis in original). Accordingly, the relevant act at issue was not performed in the United States.

The second clause of the “commercial activity” exemption states that a foreign state will not receive immunity if “the action is based . . . upon an act outside the territory of the United States in connection with a commercial activity of the foreign state elsewhere and that act causes a direct effect in the United States.”  The court reasoned that the bonds were issued in Portuguese and were evidence of a Brazilian motor vehicle fee. Therefore, the court held that there was no “direct effect” because the bonds did not include language “suggest[ing] a reasonable understanding that the United States could be a possible place of performance.”

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


Brummer on International Financial Regulation

I spent last Friday at Georgetown at a scholarly roundtable and book launch party celebrating the release of Soft Law and the Global Financial System by Chris Brummer.  I've followed Chris's work for a number of years because of our shared interest in transnational financial regulation, and I was pleased to be invited to participate in the event.  Here is the book's abstract:

The global financial crisis of 2008 has given way to a proliferation of international agreements aimed at strengthening the prudential oversight and supervision of financial market participants. Yet how these rules operate is not well understood. Because international financial rules are expressed through informal, non-binding accords, scholars tend to view them as either weak treaty substitutes, or by-products of national power. Rarely, if ever, are they cast as independent variables that can inform the behavior of regulators and market participants alike.

This book explains how international financial law "works" - and presents an alternative theory for understanding its purpose, operation, and limitations. Drawing on a close institutional analysis of the post-crisis financial architecture, it argues that international financial law is often bolstered by a range of reputational, market, and institutional mechanisms that make it more coercive than classical theories of international law predict. As such, it is a powerful, though at times imperfect tool of financial diplomacy, and poses novel opportunities and challenges for the evolving global economic order.

Having spent time digesting the book, I can say it is worth reading.  The book is a welcome addition to Chris's other articles on transnational financial regulation, which can be found on his ssrn page.


Koehler on the Foreign Corrupt Practices Act 

Mike Koehler (Butler University College of Business) has posted Revisiting a Foreign Corrupt Practices Act Compliance Defense on SSRN with the following abstract:

This article asserts that the current FCPA enforcement environment does not adequately recognize a company’s good faith commitment to FCPA compliance and does not provide good corporate citizens a sufficient return on their compliance investments. This article argues in favor of an FCPA compliance defense meaning that a company’s pre-existing compliance policies and procedures, and its good faith efforts to comply with the FCPA, should be relevant as a matter of law when a non-executive employee or agent acts contrary to those policies and procedures and in violation of the FCPA. This article further argues that a compliance defense is best incorporated into the FCPA as an element of a bribery offense, the absence of which the DOJ must establish to charge a substantive bribery offense. 

Mike currently edits the FCPA Blog, and his expertise on the FCPA is extensive.  For FCPA fans or foes, the article is worth the read.


SOX and FCPA Enforcement

Sarbanes Oxley was once the center of aggressive criticism.  See Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.  Today, though, SOX doesn't get as much attention.   Occasional criticism surfaces but for the most part opponents have moved on to other targets such as Dodd-Frank.

Meanwhile, the legislation continues to produce salutary effects.  The number of securities fraud suits remain modest.  While there are no doubt a number of explanations, the prophylactic measures put in place by SOX are likely some of them. 

What other benefits might flow from SOX?  One of the most criticized provisions was the requirement that the CEO and CFO certify the financial statements.  A recent article in the WSJ noted one of the consequences of this requirement.  The article examined the current waive of enforcement by the SEC and Justice under the Foreign Corrupt Practices Act.  In explaining the increased enforcement activity, the article gave credit to SOX.

  • Congress passed the [FCPA] in 1977, after the Watergate scandal revealed the use of corporate slush funds to bribe foreign government officials, but it was sporadically enforced until recent years. Justice Department officials have attributed the recent enforcement push, in part, to the 2002 Sarbanes-Oxley Act, which requires corporate officers to certify the accuracy of their financial statements. That has led to more companies discovering potentially illicit payments on their books and disclosing them to the Securities and Exchange Commission and the Justice Department, they say.

In other words, by requiring executives to take responsibility for their own financial statements, they have greater incentive to uncover and stamp out illegal behavior.  This can be seen with respect to the FCPA.  One suspects that the same effect is likely taking place in a less public manner with respect to financial fraud and other inaccuracies. 


The Palestinian Stock Exchange

The WSJ noted that a broker (Auerbach Grayson & Co.) has begun to make shares on the Palestinian Stock Exchange available to large investors.  The web site for the PSE is here.  The float of the exchange is tiny and, as the article in the WSJ noted, an "obvious deterrent is the constant threat of war and political upheaval". 

Of course, there's also the fact that the West Bank has no currency (the PSE trades in Jordanian Dinars and dollars) and is in Nablus, a place Wikepedia said "was a central flashpoint of violence between the Isreal Defense Forces (IDF) and Palestinian militant groups."

In addition, there is the problem of the applicable legal regime.  For a list of some of the laws that apply in the West Bank, go here.  While the West Bank has in place a company law (it uses the 1964 version of the Jordanian company law, the version that was in effect when Israel took control of the West Bank in 1967), it is sorely in need of updating.  Gaza, by the way, uses a version of the British Company Law from the 1920s, the version that was in effect at the time Gaza fell under the oversight of Egypt following the creation of Israel in the 1940s.


Tourre Seeks Reconsideration

Fabrice Tourre, the lone defendant from the SEC's case that originally included Goldman Sachs, lost a motion to dismiss mostly because the trial court found that the SEC had sufficiently alleged claims under Section 17(a).  With the Supreme Court's holding in Morrison in the background, the court focused on the language in Section 17(a) and held that the SEC had alleged sufficient facts to show that an offer had occurred in the US. 

Tourre argues that the analysis is inconsistent with Morrison, that the interpretation of the term "offer" was incorrect and that the offer/sale division in Section 17 is inconsistent with congressional intent.  The most interesting part of the motion is the argument that the lower court's analysis will influence private actions under Section 11 and 12 of the 1933 Act.  As the brief notes:

  • Employing language that is materially similar to the “offer or sale” language of Section 17, Section 12 provides investors a private right of action against a defendant who “[o]ffers or sells” securities by means of a materially misleading prospectus or oral statement. See 15 U.S.C. § 77l(a)(2). Under the logic of the June 10 Order, a foreign investor in a foreign securities transaction has a claim under Section 12 if there is some minimal amount of pretransactional conduct in the United States that satisfies the statute’s very broad definition of “offer”—conduct that would never have been sufficient even to satisfy the pre-Morrison conduct test, under which the defendant’s U.S.-based conduct had to be “more than merely preparatory” to a securities fraud.

The SEC's brief pointed out, however, that there are differences between actions brought under the two Sections.  See SEC Response, at 14. 

The SEC's case against interlocutory appeal seems the stronger of the two.  The court should, therefore, decline to hear the appeal.  A decision to do otherwise may portend the outcome.  A decision to take the case may reflect a view of some on the panel that the decision should be reversed. 

For primary materials on SEC v. Tourre, go to the DU Corporate Governance web site.  For primary materials in Morrison v. NAB, including the many amicus briefs filed in the case, go to the DU Corporate Governance web site.


The Matter of Terminology: HP, Goldman Sachs, and "Activist Investors"

The WSJ has an article about HP hiring Goldman to "help the company defend itself against possible activist investors who could push for change at H-P".  Said another way, the company is, apparently, "an attractive target for investor activism." 

The term activist, of course, has a certain pejorative connotation.  These are shareholders that want to interfere with management's prerogative and force change on the business.  The implication of the article is that now that HP has hit a low point, sharks are swarming around and the board may need to defend itself.

But in fact, given the instability at the top of the company, the dramatic drop in share prices (by about 50% in the last year), and the questionable corporate strategies bantered around (getting out of the computer business), aren't all shareholders activists in the way its being used in the article?  Don't all shareholders want stability, better management, and improved profitability?  Yet somehow shareholders who want this are viewed negatively and branded with a pejorative term. 

The article notes that a common response to "activist" shareholders is the adoption of a poison pill, which effectively insulates the company from a hostile takeover.  Hopefully in this case, the tactic adopted by the board (upon the advice of Goldman Sachs) will not be a poison pill but a strategy designed to improve profitability and stability to HP.  That strategy, more than any other, will likely deactivate those pesky activist shareholders.   


Corporate Governance and Say on Pay: The Problem of an Advisory Vote and the Australian Response 

Certain types of corporate governance reforms are slow to come to the United States.  Shareholder access has been in place in Britain for years.  Say on Pay was implemented in the UK in the early part of the new millenium and in Australia in 2005.  It took the US until 2010 to require the same practice. 

Say on pay provides shareholders with an advisory vote on the compensation of top officers.  In the US, it is the CEO, CFO and top three highest paid officers.  An advisory vote, however, is exactly what it says.  Boards are free to ignore any advice provided by shareholders, even if the compensation package submitted to shareholders is voted down. 

For countries that have adopted say on pay provisions before the US, there is some evidence that second generation statutes are emerging.  These statutes are designed to erode the advisory nature of the vote by providing management with incentives to respond to the concerns evidenced by shareholders opposing the compensation package. 

The most overt example of this is underway in Australia.  Legislation there to modify the say on pay process has undergone its third reading.  A history of the legislation as well as some commentary can be found here.  The legislation provides for a "two strike" policy with respect to say on pay votes.  To the extent the remuneration report is opposed by 25% or more of the voting shares in two successive meetings, shareholders have the right to vote on a "spill resolution." 

If the resolution passes, the company must hold another meeting within 90 days and shareholders have the right to replace certain non-management directors.   As one sponsor of the legislation described: 

  • Once the second strike is triggered, shareholders are given the opportunity to vote on a resolution to spill the board and subject the directors to re-election. If this spill resolution is passed by more than 50 per cent of eligible votes cast, then a spill meeting is to be held within 90 days, at which shareholders will be given the opportunity to vote on the re-election of the directors, one by one. 

The legislation was introduced in order to penalize companies that routinely ignored the "advice" of shareholders on compensation for two consecutive meetings.  As the sponsor described: 

  • This proposal targets the small number of boards that have not adequately addressed shareholder concerns over two consecutive years. The government believes that it is appropriate that these boards be subject to this  additional scrutiny and accountability.

In most cases, the spill resolution will probably not pass.  In particular, those say on pay resolutions that are opposed by more than 25% but less than a majority will likely not result in the spill resolution passing.  Moreover, even when say on pay resolutions fail by larger majorities, shareholders displeased with compensation may not want to force the company to go through the uncertainty and expense of a second meeting that could result in replacement of much of the board.

Nonetheless, the provision, to the extent it becomes law, does provide management with greater incentive to communicate with shareholders and develop compensation packages that are more reflective of the interests of shareholders. 


Morrison, Tourre, and the Misguided Interpretation of Rule 10b-5 (The Non-Transactional Transactional Test) (Part 2)

We are discussing Morrison v. National Australia Bank, 130 S. Ct. 2869 (June 24, 2010), the Supreme Court case that held Rule 10b-5 does not have extraterritorial effect and the misreading of the decision by the lower courts.

The test employed by the Court, however, was confusing, not the least because it was described as transactional when, at best, that was only partially true.  Much like the registration provisions of the securities laws which exempt not only transactions (Section 4) but also types of securities (Section 3), Morrison had elements of both.  The reference to domestic sales was transactional.  Only the location of the transaction mattered.  But the reference to securities listed on a US stock exchange was not.  That reference sought to apply Rule 10b-5 to a type of security, those traded on a US exchange.

This suggests that any transaction in a security traded on the NYSE would result in application of Rule 10b-5.  If all that mattered was the type of security (US exchange traded), the antifraud provisions would apply even if the transaction took place entirely outside the United States and involved foreign investors.  This interpretation is compelled by the plain language of the opinion.  To the extent securities traded on a US exchange was somehow meant to apply only to exchange transactions in the United States, the analysis would have been swallowed by the portion of the test that captured all domestic transactions, irrespective of the type of security.    

The two tests together require a straightforward analysis.  First, is the security involved listed on a US stock exchange?  If so, nothing else matters.  It makes no difference that the security is also listed on a foreign stock exchange or that the investors were located outside the US or that the fraud occurred in another country.  Moreover, the test would presumably extend to shares sold overseas in a private placement.  While those shares would not be immediately tradable on a US exchange, they would nonetheless constitute transactions in securities listed on domestic exchanges.  Moreover, they would also likely be traded over the exchange once any limitations on transferability expired.

The second test looks only to the location of the transaction.  The test turns not on the nature of the security (whether a  domestically issued security, a security listed on a foreign exchange, or an ADR) but on the place where the sale occurred.  Determining where first requires proof of when.  Here there is a relatively developed body of law.  Section 3 of the Exchange Act defines a purchase includes “any contract to buy, purchase or otherwise acquire.”  15 USC 78c(a)(13); see also Blue Chip Stamps v. Manor Drug Stores, 421 US 723, 751 (1975) (noting that under statute purchase includes “contractual rights or duties to purchase”).  The terms "purchase" and "sale" are defined in the Exchange Act.  See 15 USC 78c(13) & (14).

Assuming a purchase or sale, the analysis would shift to the location.  Presumably a sale would seem to occur if the irrevocable commitment to purchase or sell occurred in the US.  As a practical matter, these transactions would most often involve US investors.  As a legal matter, however, the identity of the investor would not matter (except as a factor in determining where the transaction occurred). 

The test had some uncomfortable aspects.  While fraud committed in the US was not sufficient to establish jurisdiction, a trade entirely conducted outside the US could trigger jurisdiction under the antifraud provisions if the stock happened to be traded on Nasdaq or the NYSE.  Indeed, one can imagine that Justice Scalia would have preferred a test that limited jurisdiction exclusively to domestic transactions.  But the language referring to transactions in shares traded on a domestic stock exchange came directly from Section 10(b), the source of his test, so there was little he could do about it.  

For primary materials on SEC v. Tourre, go to the DU Corporate Governance web site.  For primary materials on Morrison v. NAB, including the many amicus briefs filed in the case, go to the DU Corporate Governance web site.


Compensation and National Culture (Part 3)

We have been discussing the differing approaches used by Europe and the United States in addressing the problem of excessive compensation. 

In Europe, the approach has been not to rely on the market but to instead impose caps.  The caps apply to the amount of the bonus and the percentage that can be paid in cash.  The approach arises from the belief that the market does not work and there needs to be affirmative, substantive regulation.  It also reflects a view that there is a role for the government in setting compensation levels. 

In the United States, the approach is entirely different.  Caps are seen as excessive interference in the market.  CEOs (and anyone else with unique skills) should be allowed to bargain for their services and obtain any price that they can obtain from the market.  Regulators here would no sooner limit the compensation of a CEO than they would restrict the total compensation that could be paid to an athlete like Michael Jordan.  Moreover, even for those who concede that executive compensation is out of kilter, there is a strong opposition to direct government involvement in the determination of compensation.  The Obama Administration found this out when it had to back off salary caps for executives at TARP companies (limitied to $500,000) almost as soon as the proposal was floated.   

Instead, in the US, the response is increased disclosure and improved process.  It is a recognition that in fact the market for executive compensation doesn't work but that the best approach is to fix the process rather than substantively limit compensation.

The two approaches reflect a significant cultural difference.  The US elevates the market and devalues the role of the government.  The Europeans do the reverse.  Of course, the Europeans will discover that the caps can be manipulated (for bonuses limited to a percentage of salary, the amount can be manipulated upward by increasing the base) and the US will discover that improved process is no panacea.


Compensation and National Culture (Part 2)

As noted, the Europeans have taken an approach to executive compensation that focuses mostly on caps.  The policies rely on caps on the size of the bonus relative to total compensation, caps on the amount of the bonus that can be paid in cash, and limits on the availability of the bonus.

What is the approach taken in the United States?  Process, process, process. 

The Dodd-Frank Wall Street Reform Act (DFA) contained several provisions related to executive compensation. 

First, was say on pay.  Shareholders received the right to an advisory vote at least every three years (we will review this provision in more detail in a subsequent post). See Section 951. 

Second, the Compensation Committee was strengthened, mostly by giving the SEC the authority to define "independent" for purposes of the Committee (by setting out "relevant factors" that the exchanges must consider) and by allowing the committee to act on its own in selecting compensation consultants, without the approval of the full board.  See Section 952.

The Act stops short of requiring independent compensation consultants.  It only requires that the committee consider the factors set out by the Commission (some of which are in the statute).  The provision is, therefore, far weaker than the independence requirements for auditors contained in SOX.  See Sections 201 & 202 of SOX.  In theory, committees could consider the factors and ignore them.  As a practical matter, however, this is likely to result in the widespread use of independent compensation consultants. 

Finally, the Act heightened to disclosure required for compensation.  While several provisions touched on the issue, the most interesting is the one that requires the company to disclose the ratio between the CEO's compensation and the compensation of the average worker employed by the company.  Ratios have often been used to demonstrate the escalating nature of executive compensation. 

As this provision is implemented, it will likely vary widely among companies, particularly given the anticipated variation in the median of total annual compensation of all employees (minus the CEO).  Nonetheless, it will provide another metric for judging the fairness of the compensation. 

In short, the DFA provides no caps and no substantive limitations.  The only possible exception is Section 956 of the DFA provides that federal regulators must adopt regulations or guidelines that prohibit incentive-based compensation arrangements from resulting in “excessive compensation” or lead to “material financial loss."  Covered financial institutions include broker-dealers and investment advisors but do not include any financial institution with assets of less than $1 billion.  The provision does not, therefore, impose caps but it does provide some authority to ban certain types of compensation practices or arrangements.


Compensation and National Culture (Part 1)

The EU just approved compensation requirements for financial institutions (although they will need to be enforced at the national level).  The US has likewise adopted new regulations designed to reign in executive compensation.  The two approaches, however, are widely different.  They reflect large cultural differences on how to approach the problem of excessive compensation.

With respect to the EU, the European Parliament focused less on process and more on firm caps. The legislation adopted on Wednesday, July 7, favored caps on the proportion of a bonus paid in cash, required vesting schedules, and provided for recapture of bonus amounts in the event that performance suffered.  In addition, the legislation called for over all caps in proportion to salary. 

More specifically, as the New York Times reports, the cash component of bonuses must be limited to 30% in most cases, 20% where the bonuses are particularly large (a standard to be determined at the national level, although based on EU guidelines).  In addition, as the European Parliament describes, a significant portion of the non-cash component would need to be deferred for up to three years and would be subject to recapture in the event the performance of the financial institution suffers.  Specifically, between 40-60% of the bonus must be deferred for at least three years and can be recaptured "if investments do not perform as expected."  At least half of the bonus must be paid in "contingent capital" and shares.  Contingent capital is described as "funds to be called upon first in case of bank difficulties) and shares."

Finally, bonuses must be limited in size as a proportion of salary.  The limit, however, was left to each financial institution to set, although they must be consistent with EU guidelines.  The limits on bonuses  will apply to "senior management, risk takers, controller functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers."  The provisions apply to the subsidiaries of foreign banks (read US banks) operating in the EU.  The provisions will go into affect in January 2011.


Corporate Governance, Executive Compensation and the Japanese Approach (Part 3)

So what impact will these disclosure requirements have on executive compensation?  The best case scenario is none.  The worst case scenario is a full blown escalation of executive compensation.  At least in the short term, however, cultural norms and, importantly, arm twisting by the Financial Services Agency will likely keep the worst case scenario from taking place. 

CEOs in Japan are already poorly paid by international standards.  As the WSJ noted:

  • U.S. chief executives of companies with revenue of over one trillion yen, or $10.9 billion, received a total compensation package nine times greater than their Japanese counterparts, according to data compiled from 2004 to 2006 by New York-based human-resources-services firm Towers Watson. European compensation was 4.4 times greater.

Why?  Culture and history.

  • Masato Shirai, a director in the human-resources-consultancy group at PwC, said the lower levels of executive compensation are a historical and cultural legacy of Japanese corporations where salary increases are largely set by fixed formulas, and not by performance or negotiation by individual executives. The lower pay, Mr. Shirai said, is also a trade-off for job security.

Yet there is already pressure on this system.  Foremost, disclosure will reveal disparity among companies in Japan.  For example, the aggregate pay to the top 20 officers showed that companies like Nissan and Sony paid much higher averages.  Second, the disclosure will reveal higher compensation paid to non-Japanese officers, a consequence of having to compete with compensation standards in other countries.  In short, disclosure will help build pressure for increases in executive compensation.

Culture will keep the numbers down to some degree but so will the strong arm of the government.  This can be seen with the recent treatment of compensation at Shinsei Bank. 

Shinsei is the successor to the the Long Term Credit Bank, a financial institution created in the aftermath of WWII to provide long term capital to Japanese corporations (long term credit banks had debenture issuing authority, ordinary commercial banks did not; see Brown,  Japanese Banking Reform and the Occupation Legacy:  Decompartmentalization, Deregulation, and Decentralization, 21 Denver J. Int'l Law 361 (1993)). 

This is a particularly sensitive institution in Japan.  With the economic collapse in 1989 and the demise of the compartmentalized banking system in Japan, the LTCB couldn't make the transition.  It went bankrupt and was ultimately acquired by a consortium of foreign investors, making it the first Japanese bank to be acquired by foreign interests.  Moreover, the government still holds a large percentage of the shares. 

As the executive compensation disclosure deadline loomed, Shinsei looked likely to announce a structure that paid foreign executives substantially more than Japanese executives.  In response, the WSJ reported that the FSA pressured the Bank to force the high paid executives out.  According to the Journal

  • When the slate of board members was presented to the FSA, the regulator said the four executives with compensation of more than 100 million yen should leave so embarrassment could be minimized, according to the person. An FSA spokesman declined to comment on the discussion.

In other words, the FSA did not leave matters to culture or social pressure.  Those sources of restraint would likely have less impact on a financial institution with foreign ownership.  As a result, the government acted as the enforcement mechanism.

The approach -- to the extent true -- shows that the current system of "cultural" limits cannot be counted on to restrain executive compensation.  While banks can be pressured by the FSA, not all companies are subject to the same level of regulatory oversight.  Moreover, while the FSA may be in a good position to address outliers in the compensation area, it will not be in a good position to stop compensation from creeping upward.

So, with the new disclosure requirements, we can expect an increase in executive compensation in Japan, albeit slowly.  Onward and upward.  


Corporate Governance, Executive Compensation and the Japanese Approach (Part 2) 

Until recently, Japan required public companies to disclose the compensation paid to officers as a group.  It did not require the disclosure of specific individuals leaving, in most cases, the actual compensation of the CEO a mystery.  The aggregate data provided only a crude basis for examining the compensation of top officers.

This has changed.  Disclosure is now required of any officer making more than Y100 million or approximately $1.09 million.  The rule was promulgated by the Financial Services Agency, the successor to the old Banking Bureau within the Ministry of Finance and applied to all listed companies (approximately 3800 companies).  As the regulation provides:

  • (1) Disclose the total compensation etc. for each of four categories: directors other than external directors, audit officers other than external audit officers, executive officers, and external officers (external directors and external audit officers). Disclose the amounts by each compensation type (by basic compensation, stock options, bonuses, retirement benefits, etc.).
  • (2) For each officer, individually disclose the total amount and amount by each type of compensation etc. as an officer of the submitting company, and if simultaneously serving as officers of major consolidated subsidiaries then their compensation as officers of those consolidated subsidiaries. People subject to disclosure can be limited to people with total compensation etc. of 100 million yen or more as officers of the submitting corporation and its major subsidiaries. Also, if there are employees who simultaneously serve as officers, if the employee salary portion is important, then disclose its content.

The change applied to fiscal years ending on or after March 31, 2010.  In short, it applies now.  

The change unsurprisingly drew objections from business interest, particularly from the Keidanren, Japan's Business Roundtable.  In addition to learning the specifics of CEO pay, the disclosure promised to throw light on another aspect of executive compensation in Japan:  The payment of foreign officers more than Japanese officers. 

We will discuss the impact of these changes in the next post.


Corporate Governance, Executive Compensation and the Japanese Approach (Part 1)

Some aspects of corporate governance are converging in the global markets.  Countries have increasingly turned to the use of independent directors to protect the interests of shareholders (usually, outside the United States, minority shareholders).  Similarly, there is movement towards the use of specialized committees of the board, particularly compensation and audit, with membership consisting at least in part (if not entirely) of independent (or, in some cases, non-executive) directors.

Another place where converging seems to be occuring is in the area of compensation disclosure.  Since 1992, the US has had robust disclosure requirements for executive compensation.  After the 2006 reforms, the requirements apply to the CEO, CFO, and top three highest paid officers.  Moreover, the US has moved towards a system where all benefits (including perqs) must be included in "total compensation."  Total compensation does not necessarily reflect the amount actually paid to the officers but provides a basis for comparability. 

Disclosure seems like an inherently good thing but there is clearly a cultural component to the requirement.  In the United States, the expectation is that compensation will largely be determined and regulated by the market.  To the extent excessive, unhappy shareholders can sell, depressing share prices.  In order for this dynamic to work, shareholders must know the amount of compensation. 

Of course, the whole approach is flawed.  Shareholders do not react solely because of a single variable that makes them unhappy.  Moreover, even if they sell their shares and prices fall, the board is still in a position to award excessive amounts to top officers.  Indeed, most years when share prices have fallen, average executive compensation has risen.  

As a result, disclosure of executive compensation has not had downward pressure on the amounts paid.  Quite the reverse.  Executive compensation has likely gone up as a result of disclosure.  CEOs and CFOs in comparable companies can use the higher pay awarded by their competitors as a basis for arguing for a raise.  

Nevertheless, pressure has increased in other countries to follow the lead of the US and require robust disclosure of executive compensation.  One of the most recent converts has been Japan.  Yet as public reports indicate, the impact of disclosure is likely to be very different than what occurred in the US. 


BRIC Project -- China -- Regulatory Structures in China (Part 1)


Part one of the Race to the Bottom’s BRIC Project: China Series seeks to illuminate the regulatory structures, agencies, and institutions that make up the Chinese system of corporate governance (“gongsi zhili”).  While this discussion is not comprehensiave, it does provide sufficient detail to grasp the complexities and nuances of this blossoming market.  Specifically, this post will discuss (A) the historical evolution of corporate structures in China, and (B) the corporate statutory regulation in China.

 A. Historical Evolution of Corporate Structures in China

It is necessary to briefly summarize the development of Chinese corporations and the evolution of their structure in order to understand the nature of the current model for corporations, and the corporate governance and regulatory structures that evolved around them.  See Cindy A. Schipani & Junhai Liu, Corporate Governance in China: Then and Now, 2002 Colum. Bus. L. Rev. 1, 1-22 (2002) (summarizing the historical evolution of corporate models in China).

The State Owned Enterprise (“SOE”) traditionally dominated the Chinese market.  The SOE is the embodiment of the planned economy in China where the State exercises complete control and ownership of firms.  The SOE also held special social significance for individual Chinese citizens as the organizational unit of social welfare as well as economic sufficiency.   

The Traditional Model, as it has come to be known, began in the 1950’s and lasted until the mid-1980’s.  After World War II, the SOE was the only legal entity available for large-scale commerce in China.  The Traditional Model’s method safeguarded the “People’s” property; whereby the State exercised complete ownership and authority in commercial activity.  This model, however, depressed growth, deprived SOEs of independence, and hindered productivity because all decision-making authority was concentrated in State agencies, not in the management personnel of the individual SOEs.  Within the planned economy, the State gave all production and distribution requirements to the SOEs in the form of a quota, instead of letting market demand set output levels.  The Party appointed all Executives, instead of the board of directors.  

The Transitional Model, lasting from 1984-1993, ushered in the beginning of privatization with the enactment of the “State-Owned Industrial Enterprises Law.”  Under this law, SOE reform encouraged firms to earn profits and expand production.  The goal was to make SOEs responsible for their own financial viability.  It marked a separation of the SOE and the State to a certain degree, but the State’s ultimate ownership remained.  This Model is also referred to as the “Contracting Model,” whereby the SOE and relevant government agencies contracted to lock in the minimum amount of profit the SOE was required to pay back to the State.  The SOE was allowed to keep any surplus profits, but was also required to pay back any shortfall.  

The Transitional Model succeeded in making the first steps towards a market based economy by diminishing government control, but is was unsustainable for several reasons.  First, accurate quota estimates and projected profits were difficult to achieve, leading to drastic under or over production.  Second, SOEs were simply unable to pay back the State for any shortfalls in profits sustained.  Third, SOE executive exploitation of State owned assets remained pervasive.  Finally, the firms were left with no retained earnings, making expansion and capital investment nearly impossible. 

In Response, the Modern Corporate Model was adopted with the passage of the “Chinese Corporate Law of 1993” (“Corporate Law”).  According to Deng Xiaoping, former Chinese Paramount leader, the goal was to modernize and “set up a modern corporate system in the majority of backbone industries.”  This model is still in place today.  Essentially, under the Corporate Law, SOEs should be fully “corporatized,” as functioning, public, companies.  A major caveat, however, remained in that the State itself persisted as the major shareholder.  

B. Corporate Statutory Regulation in China

The Chinese Government saw comprehensive corporate legislation as essential to fostering and implementing the State’s plan to modernize SOEs into globally competitive market actors, as discussed specifically in the Schipani & Liu article.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra at 1-22.  The Corporate Law, enacted by the National People’s Congress and its Standing Committee, is still in force today in an amended form.  The Act sets out the fundamental features of all available business entities in China.  This discussion, however, will focus solely on Publically Held Companies (“PHCs”) and SOEs.  It is helpful to bear in mind that the majority of all major companies in China are still to this day owned by the state.  

The Corporate Law recognizes both Closely Held (“Youxian Zeren Gonsi”) and Publically Held (“Gufen Youxian Gonsi”) Corporations.  Closely Held Corporations include both Wholly State Owned and Foreign Invested Corporations, both of which pre-date the Corporate Law but were incorporated into the Act.  However, as a condition of China’s inclusion into the World Trade Organization, foreign and domestic organizations are required to be governed by the same set of laws.  Therefore, the distinction between Wholly State Owned and Foreign Invested Corporations has become less important.  

Publically Held Corporations, on the other hand, consist of both Listed, and Non-Listed corporations defined as “corporation[s] in which the total capital shall be divided into equal shares, shareholders will assume liability towards the company to the extent of their respective shareholdings, and the corporation shall be liable for its debts to shareholders.” Corporate Law §§ 2-3.  A listed company is further defined as a “Joint Stock Limited Corporation which has its issued shares listed and traded on stock exchanges with the approval of the State Council or the Department of Securities Administration.”  Corporate Law § 151.  These listed corporations are typically corporatized SOEs, whose shareholders are entitled to rights in proportion to their ownership position.  

Salient features of Chinese listed corporations include: the company, not the state, retains full ownership of shareholder capital; the company owns all property and capital created in the course of business; the company is authorized to pay dividends to shareholders; and shareholders are entitled to net assets in the event of liquidation.  The Corporate Law defines eight legal relationships between: 1) the shareholder and corporation; 2) the shareholder and other shareholders; 3) the fiduciary relationship between the corporation and its governing bodies; 4) the corporation and its creditors; 5) the shareholders and the corporations creditors; 6) the corporation and its employees; 7) the corporation and its competitors; and 8) the corporation and consumers.  

In addition to the Corporate Law’s foundational and authorizing language, listed companies in China are also subject to “The Securities Law of 1998” (“Securities Law”).  The main function of the Securities Law is to regulate the shares of Chinese corporations available for sale.  It utilizes a quota system whereby the Planning Commission and various provincial leaders receive a listing quota for that particular region, which constitutes a certain amount of shares of government property that may be securitized and sold.  These bodies then assign their shares to Initial Public Offering (“IPO”) Candidates, which are usually SOEs.  See Qiao Liu, Corporate Governance in China: Current Practices, Economic Effects, and Institutional Determinants, CESinfo Economic Studies, Oxford Journals, Volume 52, Number 2, 415-453 (2005).  This system functions to mitigate the risk of bad information systemically related to IPOs in China.  It also incentivizes local leaders to choose only viable SOEs for an IPO.  This system has effectively regulated the emergence of the capital markets in China.  The main criticism of this system is that it has led to local leaders selecting only those firms that will provide them with the most benefits locally in the form of higher rents, highest potential employment rates, etc.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra at 1-22.

Additionally, this system has been blamed for stalling the corporatization of China in that a firm can only sell its initial quota given at its IPO, making it difficult to raise necessary capital.  Schipani & Liu, Corporate Governance in China: Then and Now,” supra.  Moreover, the quota system may represent a suboptimal structure chosen to promote indefinite state control. Schipani & Liu, Corporate Governance in China: Then and Now,” supra

A continuation of the BRIC Project’s China series is forthcoming, and discusses regulatory structures in China.  Specifically, the next post will be a discussion of the Chinese Stock markets, as well as the CRSC and other voluntary regulations imposed on Chinese Listed Companies.