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. Janus and 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.   


More Developments on Conflict Minerals

For those tracking the progress of the conflicts minerals rule and the challenges thereto comes word that oral arguments in the case have been scheduled for January 7, 2014.  The case will be heard by the DC Circuit Court of Appeals before Circuit Judge Srinivasan, and Senior Circuit Judges Sentelle and Randolph.

On a related matter, it is worth noting that the European Commission's legislative proposal on conflict minerals that was expected to be released shortly has instead been put on hold until next year.   The European legislation is meant to be compatible with the US legislation but is expected to differ in some respects.  The EU legislation may cover a wider geographical area (extending into Latin America) than the U.S. conflict minerals rule.  While the list of covered minerals remains the same (the 3G T) the EU legislation is expected to focus on smelters instead of targeting suppliers and end-users as the U.S. law does.

The delay in EU action comes after a speech in September by European Commissioner for Trade Karel De Gucht in which he indicated that a final version of the EU legislation would be issued by the end of this year.  No reason for the delay has been given, but it is known that the impact assessment report, which must be finalized before any legislative proposal can be brought, was rejected by the College of Commissioners. According to Judith Sargentini, Member of European Parliament (“MEP”), “the impact assessment was ready but was deemed not enough.” The Commissioners did not state a reason for their rejection of the report but speculation is rife that German mineral extraction firms lobbied hard against it—with apparent effect.

The Commission is now expected to present its impact assessment into the new conflict minerals law by the end of 2013, but no proposal is likely to be adopted until February or March 2014 at the earliest.

 “When the proposed rule does come out, it will be nearly final for all intents and purposes. The process will be unlike the U.S. process in which a proposed rule is often changed significantly after it is commented upon by interested parties. For the EU rule, the comment and lobbying is done at the front end,” said Dynda Thomas, a partner at law firm Squire Sanders.

The challenge to the US conflict minerals rule and the delay in enactment of EU legislation leave large question marks hanging over this whole topic.  Those question marks will not be helped if the M23 truly do lay down their arms and wind down the conflict the conflict minerals disclosure regimes are meant to be addressing.  That the rebels are “quitting” may or may not have a real impact on the conflict in the DRC—but if it does to what end is conflict mineral disclosure?  The problem with using disclosure to address political and social issues is that those issues are fluid and changeable in a way the legislation is not.


Update on the Iran Threat Reduction And Syria Human Rights Act

Earlier posts discussed the Iran Threat Reduction and Syria Human Rights Act  and Section 219 of the Act.  That section added a new subsection (r) to Section 13 to the Exchange Act imposing disclosure requirements on public companies with respect to compliance with the Act.   Section 219 went into effect on February 6, 2013 so there have now been two reporting periods covered by the Section and more than 400 instances of disclosure have been made and accompanying IRANNOTICEs filed.

As noted in earlier discussions, the disclosure requirements are both broad and vague.  The requirements attach to “the issuer or any affiliate of the issuer” on a world-wide basis.  The SEC defines affiliate broadly to include any entity controlled by the issuer as well as any person or entity that controls the issuer or is under common control with the issuer.  Reporting companies are required to disclose the “nature” of certain types of “transactions or dealings” neither of which term is defined.  In addition, reporting companies must disclose the gross revenues and net profits attributable to reportable activities but there is no specification as to how such disclosures should be made.  Nor is there any materiality qualifier or de minimis exception.

So what have we learned? The over-reporting discussed in earlier posts continues.  For example, Costco disclosed that it processed transactions for four cardholders from Iranian embassies. Gross revenue from these transactions was approximately US $5,178 from the Iranian embassy cardholders and profit of less than US $160. It also processed a transaction for a cardholder affiliated with Iran Air, but no revenue or profit was attributable to that transaction.

Credit Suisse Group AG (a Swiss Company) disclosed that during 2012, it processed a small number of de minimis payments related to the operation of Iranian diplomatic missions in Switzerland and to fees for ministerial government functions such as issuing passports and visas. Processing these payments is permitted under Swiss law and Credit Suisse intends to continue processing such payments.

Tata Communications Limited (an Indian company) disclosed that one of its affiliates received US $41 and US $65 from supplier of services agreements it had with Telecommunications Company of Iran, an instrumentality of the Iranian government.

Other examples are readily available.  The “value” of these disclosures can certainly be questioned.  What cannot be questioned and should not be forgotten is the burden these types of disclosures are putting on reporting companies.  They must step up their internal controls possibly by expanding sanctions compliance procedures and broadening the scope of parties screened so as to include any possible “affiliate.”  Pre-Act screens are not sufficient because Section 219 requires disclosure of activities that are not prohibited under US law and therefore probably not previously watched for.

Are the burdens worth it?  If the goal of the Act is to decrease transactions with Iran, the answer is maybe.  US sanctions in place before ITRA already effectively prevent US companies from doing business in or with Iran or Iranian companies.  To date, no issuers have been the subject of the investigatory process permitted under ITRA.  Are issuers pulling out of activities that would have to be reported to avoid the need to disclose?  Perhaps.  It is impossible to know.  Some commentators point to the level of detail provided by reporting companies and their care to disclose even de minimis transactions as evidence that issuers are worried about the “name and shame” impact of the Act.  “The fact that companies are going to such lengths to distance themselves from potentially prohibited Iran-related activities indicates that the public disclosure of this in sensitive SEC filings is having the desired effect of making doing business in Iran toxic,” said Gary Emmanuel, a securities attorney at the law firm Sichenzia Ross Friedman Ference LLP.

However, even if the disclosure regime is having some impact it cannot be separated from larger political trends that drive company behavior.  Political relations with Iran have been the focus of media attention lately and that may also be contributing to company choices.  The impossibility of proving causal effect highlights another difficulty with tasking the SEC with disclosures concerning social and political concerns rather than matters that fall more naturally within the agency’s mandate.

Another, as yet undiscussed, problem with the ITRA and Section 219 (and a concern that is also relevant to the conflict minerals rule) is what happens when the political impetus for the disclosure requirement changes?  The US and other world powers are currently in talks with Iran that could lead to the lessening of sanctions.  If that does occur, what will happen to the disclosure of Iran related activity?  It certainly could still be reported but to what end?  When the SEC is tasked with drafting disclosure regulations that are concerned with matters outside their core mission (as is becoming increasingly common) unforeseen problems such as these are bound to continue to arise.


Tragedy in Bangladesh: What Role For Corporate Law?

On June 6th the Senate Foreign Relations Committee held a hearing to consider labor rights and worker safety issues in Bangladesh in response to the spate of horrific factory accidents that have occurred recently in that country.   Among the topics discussed was a consideration of whether Bangladesh meets the statutory worker rights criteria of the Generalized System of Preferences (GSP), which requires that beneficiary countries be taking steps to afford workers internationally recognized worker rights, including the right of association and the right to organize and bargain collectively.

Assistant U.S. Trade Representative for Labor Lewis Karesh testified that the Administration is conducting a review and will announce next steps by the end of June.  Among the options under consideration is possible withdrawal, suspension, or limitation of Bangladesh’s trade benefits under the GSP program.

This is not the first time that global attention has been drawn to Bangladeshi working conditions. Incidents of fire and collapses and appalling working conditions are commonplace. In November 2012, a fire in the Tazreen Fashions factory on the outskirts of the Bangladeshi capital, Dhaka, killed 112 people. In Chittagong in 23 February 2006, fire killed 83 garment workers – including girls aged between 12 and 14 years – at the KTS Textile Industries factory. 

In response to Tazreen fire, Wal-Mart instituted policy (that became effective  April 15th ) requiring  companies that make products for it to tell Wal-Mart exactly which factories they work with. The requirement is intended to ensure that Wal-Mart never again has to admit, as it did in the Tazreen fire situation, that it didn’t know where its products were made.

What does any of this have to do with corporate law?  Maybe nothing.  We see in the responses to the Bangladeshi problems governmental and voluntary corporate action.  (Wal-Mart also made a $1.6 million donation to the Institute of Sustainable Communities (ISC), a U.S. based NGO, to establish the Environment, Health and Safety (EHS) Academy in Bangladesh.)  However, there have been few signs that safety issues and other questionable labor conditions are sending shockwaves through the major Western retailers, their shareholders or the people who buy the clothes in the United States, Europe and elsewhere. Dozens of major retailers and apparel makers continue to operate in Bangladesh.  Can changes in corporate law stir more outrage and action?

Corporate Social Responsibility (CSR) proponents would likely say yes, arguing for mandatory disclosure of factory safety conditions.  I remain unconvinced.  In 2011 Wal-Mart shareholders soundly defeated (by a nearly 50-to-1 margin) a proposal to require suppliers to report annually on safety issues at their factories. In arguing against the proposal, Wal-Mart's management made its reasoning clear: Having suppliers compile such reports "could ultimately lead to higher costs for Wal-Mart and higher prices for our customers. This would not be in the best interests of Wal-Mart’s shareholders and customers and would place Wal-Mart at a competitive disadvantage," the company said in proxy materials. 

Shareholders tried to have a similar proposal concerning workplace safety put before Wal-Mart shareholders at the 2013 meeting but were rebuffed by the Wal-Mart board. According to documents filed with the U.S. Securities and Exchange Commission, a shareholder presented a proposal to require the company to report on its progress for assessing risks to human rights in its operations and supply chain. Wal-Mart said the proposal was so similar to the one that failed in 2011, and that it already addresses the request through its standards for suppliers, that it did not merit reconsideration. The SEC approved its decision to reject the request for a shareholder vote.

An alternative to requiring disclosure of workplace safety conditions would be to require disclosure of supply chains, as was recently done with conflict minerals, an approach advocated by certain major investors.  This approach also has problems however.  For companies such as Wal-Mart, who use thousands of suppliers, keeping an eye on the supply pipeline is proving difficult. After the Rana Plaza building collapsed Wednesday, it took Wal-Mart more than a day to confirm that its goods were not being made at the building that collapsed. And in the Tazreen Fashions fire, Wal-Mart learned after the fact that a supplier was having garments made there without Wal-Mart's approval.  This is not to say that companies have no responsibility to monitor their supply chains.  Rather it is to urge caution.  If supply chain reporting is made mandatory without attention to structural reform with Bangladesh itself it is likely that we will see a repeat of what happened in the DRC when conflict mineral supply chain disclosure became mandatory.  In that case a de facto trade embargo took effect as companies could not ensure their supply chains within the relevant time frame of the disclosure requirements.

Rather than piling more disclosure requirements on companies we could let the issue be handled at the governmental level through the trade processes mentioned above.  This has the advantage of putting some pressure on the Bangladeshi government and may force the issue of the intractable corruption present in that country to the forefront.  If a corporate law response is required, a better route may be to refocus attention on companies’ already existing disclosure obligations under Reg S-K.  Factory safety clearly could be discussed in several areas, including but not limited to description of business and risk factors. 

As corporate lawyers we are often quick to default to the idea that disclosure will solve problems.  The problems in Bangladeshi factories (problems that are replicated elsewhere in the world) offer an opportunity to think more carefully about how to best effect meaningful change.


The Myth of Majority Vote Provisions: Occidental Petroleum and the WSJ

The Journal had an article on Friday noting that, based upon a regulatory filing,"Chairman Ray Irani, one of the most highly paid executives of the last decade, appears to have lost his longtime seat on the oil-and-gas company's board".   The filing in question is a current report on Form 8-K that disclosed a list of directors who received majority support at the Occidental annual meeting.  Mr. Irani's name was  not among the directors listed ("Directors Spencer Abraham, Howard I. Atkins, Stephen I. Chazen, Edward P. Djerejian, John E. Feick, Margaret M. Foran, Carlos M. Gutierrez and Avedick B. Poladian have received a majority of votes cast in favor."). 

The filing does in fact suggest that Mr. Irani did not receive majority support from shareholders.  But it is not correct to suggest at this stage that Mr. Irani has "lost his longtime seat".  In Delaware, a director who receives a plurality but not a majority in fact is elected to the board.  So, despite the absence of majority support, Mr. Irani was, under Delaware law, reelected.

Occidental does have a majority vote policy in place.  This requires directors who do not receive majority support to submit a letter of resignation.  As the policy provides:

  • Pursuant to Occidental’s by-laws, directors are elected by the majority of votes cast with respect to such director, meaning that the number of votes cast “for” a director must exceed the number of votes cast “against” that director. Any director who receives a greater number of votes “against” his or her election than votes “for” in an uncontested election (a “Majority Against Vote”) must tender his or her resignation. Unless accepted earlier by the Board of Directors, such resignation shall become effective on October 31st of the year of the election.

As a result, Mr. Irani will be required to submit a letter of resignation.  It will then be up to the board to determine whether or not to accept the resignation.  For the most part, boards decline to accept these letters of resignation. Directors who do not receive majority support but remain on the board are known as "Zombie Directors." 

So, the WSJ appears to have assumed, as most Americans likely assume, that the failure to obtain a majority of the votes cast results in the defeat of a director.  That would, however, be management unfriendly and, in Delaware, the law does not tack in a management unfriendly direction. 


SEC Compliance and Disclosure Interpretations Regarding the Iran Threat Reduction and Syria Human Rights Act of 2012 

Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012 amended the Securities Exchange Act of 1934 (Exchange Act) to require disclosure of certain activities relating to Iran.    

Disclosure is triggered when companies knowingly engage in the activities specified in the statute.  These include, assistance in the development of petroleum and refined petroleum production resources in Iran; assistance in the development, research, or financing of any stage of production of weapons of mass destruction; financing that benefits Iran’s Revolutionary Guard Corps; and participation any transaction or dealing relating to persons who commit, threaten to commit, or support terrorism. Additionally, unless a United States federal department or agency authorized the specific activities, any transaction or dealing with a person or entity within the definition of the Government of Iran triggers the mandatory disclosure requirements.

In general, any issuer or its affiliate must disclose any of the activities enumerated in section 13(r)(1) in its quarterly or annual reports due after February 6, 2013, regardless of the actual date of filing. An “affiliate,” as defined by Rule 12b-2 of the Exchange Act, is “any person that directly, or indirectly, through one or more intermediaries, controls, or is controlled by, or is under common control with” the issuer. Any enumerated activity engaged in during the time-period covered by the reports due after February 6, 2013 triggers mandatory disclosure requirements, regardless of whether the activity occurred before the promulgation of the amendment.

Under Section 13(r)(2) and (3), the issuer or its affiliate must include a detailed description of each activity in its annual or quarterly report, including the nature and extent of the activity, the gross revenues and net profits attributable to the activity, and whether the issuer or the affiliate intends to continue the activity. The issuer or its affiliate must also provide a notice to the SEC identifying itself as a party that made disclosures of one or more enumerated activity within its report.  

The SEC will make the report public and also transmit it to the President of the United States , the Committee on Foreign Affairs and Financial Services of the House of Representatives, and the Committee on Banking, Housing, and Urban Affairs of the Senate under Section 13(r)(4).     

Section 13(r)(5) requires the President, on reception of a report that includes a disclosure of an enumerated activity (excluding activities authorized by a federal department or agency), to initiate an investigation into the possible imposable sanctions on Iran pursuant to various applicable pieces of legislation. The President will also make a determination with respect to whether or not imposable sanctions are necessary for the issuer or its affiliate.


The Compliance and Disclosure Interpretations may be found on the SEC website.


Dari-Mattiacci, Gelderblom, Jonker & Perotti on “The Emergence of the Corporate Form”

Giuseppe Dari-Mattiacci, Oscar Gelderblom, Joost Jonker, and Enrico C. Perotti have posted “The Emergence of the Corporate Form” on SSRN.  Here is the abstract:

The Dutch East India Company (VOC) is generally viewed as the first modern corporation, yet its 1602 charter did not introduce all features of legal personality. A detailed historical analysis reveals how its statute proved inadequate to sustain the massive military investment needed to secure a strong trade position in Asia. In response, legal innovations were introduced in the subsequent twenty years. In 1612, state intervention overruled shareholder rights and created capital lock-in. The associated loss of control by shareholders was ultimately compensated by long-term profits, as the escalated commitment to Asia allowed the VOC to outperform its competitors. Once capital became permanent, VOC directors needed and gained the final corporate feature of general limited liability in 1623. We argue that this transition could be achieved while preserving private interests because the Dutch Republic’s limited form of government protected long term private capital, while autocratic colonial powers maintained a royal monopoly on colonial trade. The English East India Company adopted the much-admired Dutch model only half a century later, as the crown became subject to parliamentary control. By then the Dutch grip on South-East Asia had become entrenched, leading its competitors to focus elsewhere.


Swiss Vote in Tough Executive Compensation Rules

On March 3rd, over the fierce opposition of business executives and others, Switzerland passed some of the world's strictest controls on executive pay.   In outrage over compensation plans including the later dropped plan to provide the outgoing board chairman of Swiss drug maker Novartis AG, Daniel Vasella 72 million Swiss francs ($77 million) over five years as part of a deal to prevent him from going to a rival firm, aapproximately 68% of Swiss voters approved a proposal championed by Thomas Minder who claims the restrictions are aimed at ending a culture of short-termism and rewards for managers of badly-run companies rather than just capping salaries. 

To achieve this, the proposal gives shareholders a binding say-on-pay and requires pension funds holding company shares to participate in compensation package votes.   It also ban “golden hellos” and “golden goodbyes” — one-time bonuses that senior managers often receive when joining or leaving a company which can run into millions of dollars. Finally, the proposal pushes greater corporate transparency, for example by requiring that all loans to executives be declared to shareholders. Breaching the rules could lead to a fine of up to six annual salaries and up to three years in prison.

Attempts to give shareholders some measure of voice on executive compensation are nothing new.  In the US Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 gives shareholders of public companies a non-binding say-on-pay right.   Other countries including the United Kingdom, Norway, and the Netherland also have some form of say-on-pay regulation.

Does the Swiss vote corrupt corporate governance?  The Wall Street Journal certainly thinks so, calling the action corporate governance reform run amok:                 

  • We know of no large company anywhere in the world, however, that is run along the lines Mr. Minder is seeking to impose on Switzerland‘s corporate sector—and to enforce with criminal sanctions and up to three years in prison. His is a grand experiment in imposing his own corporate-governance preferences on millions of other shareholders, their boards and their management, with the risks shared by the employees of many of these firms.

Mr. Minder says shareholders “should have the last word,” but his proposal accomplishes the opposite. It would give him the last word on how shareholders and their managers and board members organize their own affairs. If the Swiss can live with four languages, if they can withstand the diversity of a federal system that delegates many powers to the cantonal level, we dare say it can afford more than one corporate-governance model too.

Others, naturally, beg to differ, including some at Forbes

  • The Swiss idea is clearly to place more power in the hands of shareholders. To overcome some of what we call the principal agent problem. Management is supposed to work for shareholders and usually it does. But there’s always a certain amount of management doing what is good for management as well. The proposed law places more power in shareholder hands to determine what managers decide to pay themselves out of what is, after all, the shareholders’ company….
  • Rules on executive pay are, in so far as there are any, there to strengthen the discretion of owners on how much and how they pay their employees. Instead of how it must be done being directed down from on high, the power to decide is delegated downwards and the necessary legal ability placed in local and owners’ hands.  

It seems likely that each of these positions overstates reality.  When US shareholders were given say-on-pay rights they often, studies show that although not always, simply approved management action or failed to vote at all.  Similarly, 49 of the top 100 Swiss companies already give shareholders a non-binding vote on the pay of executives and a majority of investors have never voted down executive compensation plans. Reuters 

This is not to suggest that say-on-pay provisions have no impact.  Instead of waiting for a shareholder vote and responding reactively, companies fearful of negative votes may take proactive steps such as engaging in additional communication with shareholders or making changes to their pay practices – reflecting a shift in the management-shareholder dynamic.

The impact of the Swiss vote will only become clear over time and that time may be a long while coming.  Implementation of the restrictions awaits governmental action to draw up legislation and parliamentary posturing could delay the process until 2015 or later.  Further, even once implemented some predict that companies will simply seek ways around the new rules to reward executives, just as banks in Europe are looking to soften the impact of a cap on bonuses for top staff agreed by European politicians on Thursday.

"If a company wants to pay a top executive 25 million, then they will find a way to do so regardless of the initiative," Rolf Soiron, chairman of cement maker Holcim and drugs industry supplier Lonza, told the Reuters news agency before the vote.

Also unknown is the extent to which other countries may follow Switzerland’s approach.  The idea that shareholders should have a strong say in their company’s affairs is in keeping with Switzerland’s tradition of direct democracy--voters there who collect 100,000 signatures can force a binding referendum on any issue.  Other countries lack that foundation but may still be encouraged to consider mirroring Switzerland’s approach towards executive pay.   Political leaders in Germany and France have voiced support for compensation rules modeled on the new Swiss rules.

"The Swiss often show the way and personally I think we should take inspiration," French Prime Minister Jean-Marc Ayrault said on Monday, a day after Swiss citizens voted in a referendum to give shareholders veto rights on pay and ban big rewards for incoming and outgoing managers.

Rainer Bruederle, parliamentary floor leader for Germany's ruling Free Democrats (FDP), also backed the Swiss move, saying politicians in Berlin should "set an example" and enact similar rules before a Sept. 22 federal election.

Time will tell what overall impact the Swiss vote will have.  The only certainty is that it will keep the issue of say-on-pay in the public eye and will encourage further debate on the issue.


Virginia E. Harper Ho on Corporate Governance as Risk Regulation in China

Having just returned from the AALS Annual Meeting in New Orleans, I thought I’d pass on one of the papers that caught my attention at the conference: Corporate Governance as Risk Regulation in China: A Comparative View of Risk Oversight, Risk Management, and Accountability. Here is an excerpt of the abstract:

Risk management and oversight have long been recognized as core corporate governance issues and have gained renewed attention in the wake of the financial crisis. Following global trends, recent corporate governance reforms in China also focus on risk oversight and risk management…. This article observes that recent guidelines on enterprise risk management (ERM) and internal controls reflect international corporate governance standards, and that China adopts a broad perspective on risk oversight that extends to both financial and non-financial risks. China’s adoption of international models offers a new opportunity to reexamine long-standing debates on the potential for global corporate governance convergence…. Its conclusions support the literature on the path dependency of corporate governance systems and prior comparative studies of corporate governance in China that find convergence of form but divergence of function.


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.