As we continue to cogitate over the 50% tax announced by the British Government (and supported by the French Government) on bonuses paid by banks, we understand even better the wisdom of the decision.

It will be during the next two months that boards throughout the financial system will meet to approve bonuses for officers and other employees.  As the criticism rained down on Goldman illustrates, some financial institutions can be counted upon to pay bonuses that reflect a certain tone deafness to the current financial crisis and economic difficulty.  In other words, they will pay bonuses that look excessive given current circumstances.  These amounts will be disclosed as part of the proxy process or leaked to the press. 

Thus, without any serious change, the public is likely to be treated to a series of stories, one after another, about excessive pay packages and bonuses.  As foreclosures rise and unemployment remains in double digits, these announcements will likely stoke considerable voter anger, particularly at incumbent politicians. 

By imposing a 50% tax, the British Government significantly raised the costs of bonuses above L 25,000.  As a result, the amounts announced over the next few months in Great Britain are likely to be lower than they would have.  There will be fewer instances of outrageous bonuses and fewer instances of voter anger at incumbent politicians.

In the United States, however, where there is no increased cost associated with the bonuses, excessive payments are likely to occur.  The only thing in those circumstances that can be done to reduce the predictable anger is to have a solution ready.  In other words, the Administration even more needs a long term fix.  The British Government, through the imposition of a tax, has more time. 

As BofA pays off its TARP money, allowing it to avoid the oversight of the Pay Czar and to pay compensation essentially without limits, and Goldman opts to pay compensation that, on the present course, will equal more than $700,000 for every employee, it is clear that the US has done nothing to fix the problem of executive compensation.  It is also clear that public pressure carries little weight in determining these amounts. 

The British (with support from the French) have taken steps to fix the problem in the short term.  The British Government announced that it would impose on bonuses above L 25,000 (somewhere around $42,000) paid by banks a tax of 50%.  The tax comes just at the time boards are gathering to decide on bonuses for top officials.  It essentially forces the board to step back and reconsider the amounts that will be paid. 

Paying lavish bonuses unconnected to the merits will result in a substantial additional cost (the 50% tax) that essentially comes out of the remainder of a company's earnings that ordinarily would inure to the benefit of shareholders.  In other words, paying lavish bonuses without a strong justification will bring howls from shareholders and result in substantial criticism on the board.

If the bonuses are truly deserved, they should still be paid, even with the additional charge.  If they are truly deserved, the board will be able to make the case to shareholders about the need for the payments, irrespective of the tax.  

Bonuses should only be paid if truly justified.  This tax will help ensure that this happens.

This post represents the final post of a three part series focused on NASDAQ's exemption rule for foreign private issuers.

Israel has the second largest number of foreign issued securities listed on the NASDAQ.  The rules Israeli companies most commonly deviate from are:

• Rule 5605(b) and (e) – Nomination and Composition of Board of Directors
• Rule 5605-6 – Executive Compensation
• Rule 5620(c) – Quorum Requirements

Under Israeli law, public companies are not required to have the majority of their boards be independent nor are companies required to have a nominating committee.  Israeli law states that the board of directors must include at least two external directors, nominated and elected by the board, to serve a term of three years.  External directors and their family members cannot at any time preceding the two years prior to their appointment have had any affiliation with the issuing company.  Additionally, external directors’ current jobs cannot interfere with service on the board otherwise the external director may be terminated.  In comparison, an independent director or family member by NASDAQ standards, cannot have had any affiliation with the issuing company for the last three years prior to being appointed. 

Israeli law allows for a company to choose its own method of nominating its board of directors as opposed to a nominating committee comprised of independent directors established by NASDAQ.   ITRN, for example, has its shareholders owning 1% or more of common stock nominate members for the board of directors in the general meeting, as is custom in Israel.  A majority of shareholders must approve the nominations. 

The NASDAQ independent director rule and the Israeli external director rule are similar in many fashions.  Both rules operate to ensure there is no conflict of interest between the director and issuing company.  Where the rules differ is in the composition of the board.  While NASDAQ requires the majority of the board be independent, the Israeli law only provides that at least two directors be external.  While Israeli law does present a strict set of rules for their external directors, the two required external directors may not be enough to veto company initiatives that could be deemed unjust.

Nasdaq Rule 5605-6 requires independent directors to oversee executive compensation plans.  Under Israeli law, compensation packages for employees who are not directors must be approved by the board of directors.  Compensation packages for directors must be approved by the audit committee, board of directors and at least one third of shareholders.  Under NASDAQ rules, a compensation committee made up of independent directors reviews executive compensation plans.  Israeli law dictates a more stringent requirement having not only the board approve compensation plans but also the shareholders. 

In comparison to NASDAQ’s rule, Israeli law has additional checks in place to determine executive compensation.  This process could be more costly to Israeli companies in time and expenses to have shareholders approve compensation packages however allows for shareholders to have a check on compensation packages. 

Like Canada, Israel has also moved away from NASDAQ’s quorum rule requiring 33 1/3% of shareholders present to conduct a meeting.   Unlike Canada, however, Israel’s Companies Law requires a higher quorum requirement.  Israel’s Companies Law requires a minimum of two shareholders holding at least 25% of the outstanding stock present at a meeting. Most companies in the sample, such as ROSG and GILT, set their quorum requirements to the minimum required by law while EZCH set its quorum requirement to 50%, much higher than the NASDAQ requirement.  

NASDAQ’s Rule 5615(a)(3), by allowing foreign companies to follow home country corporate governance standards, has encouraged foreign issuers to list on a U.S. exchange.  While some home country practices may be more favorable to the foreign issuer, some standards have also increased the level of corporate governance as required by NASDAQ. 

Founded in 1971, the NASDAQ stock exchange currently lists approximately 3,200 domestic and foreign companies.  Domestic issuers must comply with the corporate governance standards set forth in the NASDAQ 5600 rule series.  Foreign issuers may deviate from NASDAQ’s corporate governance standards under Rule 5615(a)(3).  Rule 5615(a)(3) provides:

A Foreign Private Issuer may follow its home country practice in lieu of the requirements of the Rule 5600 Series, the requirement to distribute annual and interim reports set forth in Rule 5250(d), and the Direct Registration Program requirement set forth in Rules 5210(c) and 5255, provided, however, that such a Company shall: comply with the Notification of Material Noncompliance requirement ( Rule 5625), the Voting Rights requirement ( Rule 5640), have an audit committee that satisfies Rule 5605(c)(3), and ensure that such audit committee's members meet the independence requirement in Rule 5605(c)(2)(A)(ii). Except as provided in this paragraph, a Foreign Private Issuer must comply with the requirements of the Rule 5000 Series, including the going concern disclosure requirement in Rule 5250(b)(2), and the listing agreement requirement in Rule 5205(a).

Although foreign issuers can elect to follow home country corporate governance standards, NASDAQ has to grant the exemption.  For NASDAQ to grant the exception under Rule 5615(a)(3), a foreign issuer has to provide a letter from an attorney in its home country stating the practice is legal and an accepted business practice. 

Based on a sampling of equities traded on NASDAQ, we will post a three part series that explores the corporate governance standards of the three largest countries that utilize Rule 5615(a)(3):  Canada, China, & Israel.

This post is the second part of a three part series exploring NASDAQ's rules regarding foreign private issuer exemptions.  In this post, we look at China.

The country with the largest amount of foreign securities listed on NASDAQ is China.  Please note of the securities used for sampling, all were incorporated in the Cayman Islands or British Virgin Islands and followed home country practices of the incorporating country.  An increasing number of Chinese companies are choosing to incorporate in the Caribbean due to more favorable tax considerations and faster incorporation times. The most common rules that Chinese companies elect to follow home country practices for are:

• 5620(a) – Annual Shareholder Meetings
• 5605 Series – Board Composition
• 5635(c) – Shareholder approval for equity incentive plans

NASDAQ Rule 5620(a) requires issuers of stock to hold an annual shareholder meeting no later than one year after the company’s fiscal year end. The laws in the Cayman Islands and the British Virgin Islands do not require companies to hold annual shareholder meetings.  Looking specifically at AMCN, the company did not hold a shareholder meeting in 2008 but may hold annual meetings in the event that shareholder approval is required. APWR and LTON followed suit and did not hold annual meetings for their prior fiscal year ends.

By opting out of the required NASDAQ annual shareholder meeting under Cayman Island law, these companies save on expenses associated with hosting a shareholder meeting.  On the contrary, forgoing an annual meeting could result in less shareholder involvement and awareness. 

The NASDAQ Rule Series 5605 sets the standard for board and committee composition.  Rule 5605(b)(1) calls for the majority of an issuer’s board of directors to be independent.  Independent directors, as defined in Rule 5605(a)(2) do not have a relationship with the company that would create a conflict of interest.  The Cayman Islands does not have a rule governing composition of boards and committees.  For example, only three of the seven directors sitting on CEDU’s board are considered independent. 

Under 5605(c) the audit committee should include at least three independent members.  LTON’s auditing committee was only comprised of two members for 2008 and is currently one independent director. 

NASDAQ Rule 5605(e)(1)(A-B) states that nominees for a director position within the board must be selected by either a vote of independent directors only or by a nomination committee made up of independent directors.  Since there is no applicable law in the Cayman Islands, several companies have deviated from this rule.  For instance, LTON’s nomination committee currently has two non-independent members.  While non-independent directors may have better knowledge of the company and its operations, this exemption could create a conflict of interest.  Under Cayman Island law, it is possible to have a non-independent director serve on both the auditing and nomination committees. 

According to Rule 5635(c), shareholder approval is required for new issuances or amendments to equity compensation plans.  Under Cayman Island law, issuing companies do not have to seek shareholder approval for amendments to equity compensation plans. For example, AMCN followed home country practice with regards to Rule 5635(c) and allowed its board to re-price stock options without seeking shareholder approval. 

Since shareholder approval is not required, companies following home country practice can approve and implement equity based incentive plans more efficiently.  Conversely, the shareholders do not have a voice presenting the opportunity for the board to approve and implement questionable incentive packages.  The reasoning behind the NASDAQ rule is to provide checks and balances for equity incentive packages.  Getting rid of shareholder approval for equity incentive plans, although more efficient, does not follow that rationale. 

This post represents the first of a three part series that examines NASDAQ's rules for foreign private issuer exemptions.

Canadian private issuers listed on the NASDAQ most widely utilize home country practices for quorum requirements. The quorum requirement, found in NASDAQ Rule 5620(c), provides: “Each Company . . . shall provide for a quorum as specified in its by-laws for any meeting of the holders of common stock; provided, however, that in no case shall such quorum be less than 33 1/3% of the outstanding shares of the Company’s common voting stock.” 

Canada’s corporate governance standards allow for the company’s by-laws to set the quorum requirements.  For dually listed companies (VSGN, PAAS), the Toronto Stock Exchange does not list any specific quorum requirements.  As Canadian corporate governance standards do not set a specific percentage for quorum requirements, the companies that take advantage of Rule 5615(a)(3) have a lower quorum requirement than NASDAQ’s 33 1/3%.  Companies such as Descartes Systems Group (NASDAQ:  DSGX) and Research in Motion (RIMM) have set the quorum requirement to 20% while others such as FMTI, BLDP, and ONCY have all set the quorum requirement as low as 5%. 

By electing to follow home country practices, Canadian companies are benefitting by creating a more efficient meeting environment. Less required shareholder presence offers a higher level of discussion and a more liberal initiative approval process for the board.  Lower quorum requirements can be unfavorable to private foreign issuers.  Fewer required to be in attendance could result in a minority proposing and passing initiatives that affect the majority.  Lower quorum requirements could also result in less shareholder involvement impairing equality among the shareholders.

We are commenting on the efforts of Norges Bank Investment Management, a branch of the Norwegian central bank which, among other things, manages the Norwegian Government Pension Fund to influence governance practices in the United States.  NBIM has submitted four shareholder proposals calling for the separation of chairman and CEO.  The targeted companies?  Harris Corporation, Clorox, Cardinal Health, and Parker Hannifin.

In the United States, the position of chair and CEO are ordinarily combined.   We've written on this topic before, pointing out the anomalous position of the US in global financial markets.  The Economist has likewise indicated the unusual nature of the US approach.  As the article notes:

• America is unusual in the power that it awards to chief executives. Splitting the two jobs is commonplace in Canada, Australia and much of continental Europe (though France is a notable exception: even AXA, one of the few French firms to separate the roles, now wants to fuse them). In Britain 95% of companies in the FTSE 350 list have an outside chairman. But in America 53% of Standard & Poor’s top 1,500 companies combine the two jobs.

The only thing wrong with the quote is that it understates the issue in the United States.  For the largest companies, the percentage combining the positions is closer to 70%.  As the article further notes, the premise for separating the two positions is basic and goes to the heart of the board's function.

• The case for separation is based on the simple principle of the separation of powers. How can boards discharge their basic duty—monitoring the boss—if the boss is chairing its meetings and setting its agenda? How can a board act as a safeguard against corruption or incompetence when the possible source of that corruption and incompetence is sitting at the head of the table?

Other reasons to do it? 

• Dual-purpose bosses make it more difficult for the board to manage the succession from one chief executive to another. . . . Two-timers also reinforce popular doubts about the legitimacy of the system as a whole, conjuring up images of bosses writing their own performance reviews and setting their own salaries.

Yet the opposition in the United States to a separation continues.  Moreover, even the Economist can't quite give up on something approaching a market solution.

• But these objections nevertheless suggest some important caveats to the case for driving bosses out of the boardroom. There is no one-size-fits-all solution. Smaller companies, particularly start-ups, may benefit from the simplicity and clarity provided by bosses with two hats. Separating the two jobs is only one element of better corporate governance, as the many disasters presided over by independent chairmen demonstrate. Companies need to devote as much thought to the chemistry between the boss and chairman as they do to getting the structure right.

As a result:  "The best solution to the corporate problem is evolutionary, rather than revolutionary: pressure from activists and investors rather than sweeping legislation from Congress."  

Of course, the paean to the market is knee jerk and not well reasoned.  The only real criticism is that the requirement may not be best for small companies.  But the current proposal in Congress to separate the two positions would only apply to companies traded on the stock exchange (the Schumer Shareholder Bill of Rights), not all public companies, particularly not the smaller ones. 

It is true, though, that a separation is not a silver bullet and is only one aspect of good corporate governance.  But it is an obvious and necessary one.

This is the final post regarding the Financial Services Authority’s (FSA) adoption of a new “Remuneration Code” to regulate, for the first time, executive compensation in the UK’s financial sector.  Without question, the FSA understands its actions have international consequences.  So too will the action - or inaction - of other major international financial centers in addressing this issue affecting the FSA:

“The effectiveness of our approach in achieving real change will depend on our ability to gain international agreement to enforce similar principles in all major financial markets. In deciding whether to implement our plans we will therefore take into account whether we consider there is satisfactory alignment of implementation plans by the authorities in the major financial centres.” (See, Policy Statement, ¶2.16).

It is thus important to note – as does the FSA – that the race to the bottom can take on an international scope.  Traditionally, history, costs, culture, and proximity to entities’ capital supplies and target marketplaces limited the choices of corporate and financial giants about where to base their operations.  As globalization continues to press forward, firms’ desires to locate or relocate within favorable regulatory environments has also drawn considerable concern. 

The overwhelming tendency of corporations to locate in Delaware, due to that state’s industry-friendly courts, is the American example of the race to the bottom.  Now, aided by advances in internet and communication technologies, corporations and financial firms can now conduct significant businesses from distant locations with relative ease, perhaps opening the door to a era of a speedier international race to the bottom.  

Accordingly, the incentive for the world’s financial and corporate giants to engage in international forum shopping for regulatory safe havens has increased.  A recent report by the BBC highlights calls by G20 members and the broader international community for a coordinated international effort in the reforming of executive compensation regulations.  The report further states that the FSA has already suggested it will back down on enforcing its new code if other countries do not follow suit, another adverse effect of an international race to the bottom.  Without a coordinated effort, critics fear that companies may easily avoid efforts to regulate executive compensation and could see punishment as corporations and financial firms relocate to more jurisdictions with less aggressive regulatory landscapes.   

These are the primary fears of the Code’s critics who worry that increased regulation may adversely affect London’s status as a major center for international finance.  (See, Policy Statement, ¶1.13).  Generally, commentators have criticized the FSA for its seemingly ambiguous “principle-based” regulatory system that created an industry-friendly, race-to-the-bottom atmosphere due to a definite lack of concrete rules. (See, SEC v. FSA: Rules v. Principles).  However, now that the FSA has responded to the market crises by creating relatively bright-lined regulations for executive compensation, leaders of London’s financial industry fear that larger international firms may be compelled to move overseas to jurisdictions with softer regulations. (¶3.8).

The FSA cites these concerns in and responds by laying out a strategy for achieving “international alignment and implementation of remuneration principles” via lobbying the G20 member-states, the European Union, and the Basel Committee on Banking Supervision in Switzerland to adopt regulations that are either similar to or exactly the same as the FSA’s new Remuneration Code.  (See, Policy Statement §5).  However, even with an atmosphere of  relative consensus regarding the need for a coordinated international effort to regulate unchecked executive compensation, it remains to be seen if the political will exists within the legislative bodies of important G20 members and the broader international community to enact regulations similar to the UK’s new Remuneration Code.    

This blog recently addressed “Reforming remuneration practices in financial services,” a Policy Statement (PS) issued by the United Kingdom’s Financial Services Authority. 

Primarily, the new regulation is the FSA’s response to the perceived role that the immediate payment of large cash bonuses played in incentivizing bank executives to pursue the extreme risks that eventually led to the recent market crisis.  That said, “[t]he fundamental objective of the FSA’s remuneration policy is to sustain market confidence and promote financial stability through removing the incentives for inappropriate risk taking by firms, and thereby to protect consumers.” (¶1.17) Under the Code, SYSC 19.2, “A firm must establish, implement and maintain remuneration policies and practices that are consistent with and promote effective risk management.” 

Specifically, the Code lays out eight “remuneration principles” to be adopted by firms that fall within its scope of enforcement (SYSC 19.3).  The principles below address specific language from the Remuneration Code itself. 

1.  Role of bodies responsible for remuneration policies and their members: 

Under this principle the remuneration committee should be independent and should consider a reasonable assessment of the firm’s financial situation and future prospects.  Additionally, the committee should “have the skills and experience to reach an independent judgment on the suitability of the policy, including its implications for risk and risk management.”  Non-executive directors must make up the majority of the committee, and one or more of the directors should have practical skills and experience in risk management.  Lastly, “it is good practice for a firm’s governing body or the remuneration committee to issue a separate public document to inform its shareholders and other stakeholders about its remuneration policy and its implications for the firm’s risk profile and for employee behavior.”

2.  Procedures and risk and compliance function input:

“Procedures for setting remuneration within a firm should be clear and documented, and should include appropriate measures to manage conflicts of interest.”  Furthermore, “a firm’s risk  management and compliance functions should have appropriate input into setting the remuneration policy for other business areas.”

3.  Remuneration of employees in risk and compliance functions:

“Remuneration for employees in risk management and compliance functions should be determined independently of other business areas.  Risk and compliance functions should have performance metrics based principally on the achievement of the objectives of those functions.”

4.  Profit-based measurement and risk-adjustment:

“Assessments of financial performance used to calculate bonus pools should be based principally on profits. A bonus pool calculation should include an adjustment for curren and future risk, and take into account the cost of capital employed and liquidity required.”  

5.  Long-term performance measurement:

“Where the performance-related component of an employee’s remuneration is a significant part of his total remuneration, the assessment process should be designed to ensure assessment is based on longer-term performance.”

6.  Non-financial performance metrics:

“Non-financial performance metrics should form a significant part of the performance assessment process.  Non-financial performance metrics should include adherence to  effective risk management and compliance with the regulatory system and with relevant overseas regulatory requirements . . .  Poor performance in non-financial metrics such as poor risk management or other behaviors contrary to firm values can pose significant risks for a firm and should, as appropriate, override metrics of financial performance.”

7.  Measurement of performance for long-term incentive plans:

“The measurement of performance for long-term incentive plans, including those based on the performance of shares, should take account of future risks . . .  Many common measures of performance for long-term incentive plans, such as earnings per share (EPS), are not adjusted for longer-term risk factors.  Total shareholder return (TSR), another common measure, includes in its measurement dividend distributions, which can also be based on unadjusted earnings data. If incentive plans mature within a two to four year period and are based on EPS or TSR, strategies can be devised to boost EPS or TSR during the life of the plan, to the detriment of the true longer-term health of a firm. For example, increasing leverage is a technique which can be used to boost EPS and TSR. Firms should take account of these factors when developing risk-adjustment methods.”

8.  Remuneration structures:

Principle 8 states to whom the new Remuneration Code applies: “(1) a person who performs a significant influence function for a firm; and (2) an employee whose activities have, or could have, a material impact on the firm’s risk profile.”  Furthermore: “[a] firm should ensure that the structure of remuneration for a person to whom this evidential provision applies is consistent with and promotes effective risk management.”

Slated to take effect on January 1, 2010, the new Code does not purport to change the “bonus culture” in the UK “overnight.”  For one, the Code grants transitional periods to firms that need to amend or terminate employment agreements in order to become complicit with the code.  Ultimately, the FSA recognizes that fine tuning of the Code and its enforcement will take time and will require the participation of many players from senior executives to shareholders and UK regulators to authorities in other major international financial centers.

We are discussing the recent decision by the the Financial Services Authority (FSA) in the United Kingdom to regulate executive compensation in the wake of the current financial crisis.  In its August Policy Statement, the FSA identified that reforming the current system of unchecked executive compensation was a necessary step in establishing and maintaining economic stability.  Despite its clear purpose, it remains uncertain how the FSA will enforce its recently proposed regulations.      

The FSA has mostly relied on principal-based regulations that stops far short of any defined or formulaic limits on executive compensation.  In the introduction of Section 2 of the Policy Statement, “Remuneration policies and risk,” the FSA further explained the purpose of its decision:

• If remuneration consists predominantly of cash bonuses that are paid out immediately without any deferral or claw back mechanism, and are based on a formula that links bonuses to current year revenues rather than risk-adjusted profit, there are strong incentives for managers to shy away from conservative valuation policies, strong incentives to ignore concentration risks, strong incentives to rig the internal transfer pricing system in their favour and strong incentives to ignore risk factors, such as liquidity risk and concentration risk, that could place the institution under stress at some point in the future. These strong incentives could undermine effective risk management. (¶2.1)

The Policy Statement also concluded that the compensation schemes implemented in the banking and financial services industries had “allowed management to introduce compensation policies that in effect subordinate the interests of shareholders to those of employees.” (¶2.2). 

The presence of the new code, however, leaves several important questions unresolved. First, to what extent will the FSA pursue an agenda of aggressive enforcement?  Given the FSA’s laissez-faire track record and ambiguous principle-based philosophy, how prepared will the agency be to take the steps necessary to curb the defined dangers of excessive executive compensation?  Secondly, what will enforcement look like?  As enforcement of the new regulations begins, the FSA will be applying principles with which it has little experience and for which no precedential authority exists to provide guidance.  

On this blog, we track issues regarding executive compensation practices and regulations.  We take some time to examine the recent actions of the United Kingdom’s Financial Services Authority (FSA).  In this four post series, we will analyze the FSA’s August Policy Statement (PS) which revealed the adoption of a new “Remuneration Code” for executive compensation in the UK’s financial sector.

Compensation practices have been targeted because of their perceived role in the current financial crisis.  Nonetheless, British regulators have been slow to tackle the problem.  The reason isn't hard to see.  London depends on revenues from the financial sector. See The devil's punchbowl, The Economist  July 9, 2009 (“[T]he earnings from the United Kingdom’s financial services in a good year add over £25 billion (US $41 billion) to government revenues, and the financial sector employs over 1 million people across the country.”).  Additional regulation, particularly with respect to compensation, could threaten this source of revenue by damaging London's role as an international financial center.   Perhaps unsurprisingly, the Economist reported in July that “[i]ndeed, the pay culture that rewards bank bosses for short-term risk-taking has barely been touched.  Bonus pools, which in some firms scoop up as much as 50% of trading revenues, are a hangover from the days of private finance houses, when partners shared losses as well as gains.”  

The FSA, the UK’s equivalent of the American Securities and Exchange Commission, has now begun to address the matter, having issued a Policy Statement, “Reforming remuneration practices in financial services." 

The FSA Statement noted: “Inappropriate remuneration policies, practices and procedures were a contributory factor rather than a dominant factor behind the market crisis.  Nevertheless fundamental changes in the approach of many financial firms to remuneration will be needed if we are to be confident that we have laid a solid foundation to avoid future crises.” (¶1.18).  The Policy Statement contains the final rules on remuneration practices incorporated into the FSA Handbook in the form of a Code of practice on remuneration policies. 

Essentially, the new rules will require 26 of the largest banks and financial institutions operating in the UK to establish compensation committees.  Non-UK firms will be exempt from the Code unless they have total regulatory capital exceeding £1 billion (US $1.64 bn).  The Code will require the compensation committees to comply with the new rules for determining compensation packages for senior level executives and employees.  Notions of director “independence” and “expertise” already familiar to firms operating in the United States are prominent features in the new code. 

Furthermore, the Code provisions require a marked change away from bonus packages that rely mostly upon the immediate payment of cash bonuses.  The new code requires that future remuneration agreements must take into account the firm’s current and future risk analysis, principles of risk management, and must integrate more deferred-payment bonus schemes such as stock option plans that only vest after 3 or 5 year periods. 

We will discuss the contents of this code in the next several posts.

This post is the first of a series looking into the certiorari, merit, and amicus briefs filed in Morrison v. Nat'l Austl. Bank Ltd., No. 07-0583-cv, 2008 U.S. App. LEXIS 21986, (2d Cir. 2008).  As mentioned in my introduction, the blog covered the decision of the Second Circuit.  This discussion focuses on the petition for certiorari following the Second Circuit’s decision.

The petition for certiorari presents three main questions.  First, whether the anti-fraud provisions of the U.S. securities laws extend to transnational cases where (1) the corporation conducted a substantial amount of business in the U.S.; (2) the company’s stock trades on the New York Stock Exchange (“NYSE”); (3) the parent company files financial statements with the Securities and Exchange Commission (“SEC”); and (4) whether the accounting fraud originated from a Florida based subsidiary.  The second question presented is whether the Supreme Court should set out a policy to resolve the split among the circuits.  The third question is whether the Second Circuit erred by not adopting the SEC’s proposed test for determining subject matter jurisdiction in foreign cubed fraud cases.

The text of the Exchange Act of 1934 says nothing with regard to the applicability of the statute to transnational cases.  However, since the enactment of the Exchange Act, the courts have extended subject matter jurisdiction to international securities fraud cases.  See SEC v. Berger, 322 F.3d 187, 192 (2d Cir. 2003).  Despite widespread recognition by lower courts, the Supreme Court has not taken up this issue.  This brings our analysis to the second, and most prevalent issue, the need for the Supreme Court to address the split among the circuits on this issue of jurisdiction.

This petition centers on the lack of consensus among the circuits with regard to finding subject matter jurisdiction in transnational fraud cases.  All jurisdictions interpret the “conduct” test differently.  The Second Circuit’s interpretation of the test focuses “on the nature of the conduct within the United States as it relates to carrying out the alleged fraudulent scheme.”  More restrictively, the D.C. Circuit requires that the domestic conduct itself constitute a securities violation.  Some circuits have imposed a lower burden, requiring the domestic action to be more than mere preparation and a direct cause of the loss in question.  Furthermore, other circuits have been entirely less restrictive in finding subject matter jurisdiction, requiring only a fraction of the overall activity to further a fraudulent scheme to took place domestically.  In light of this confusion, the Second Circuit in Morrison asked the SEC to submit an amicus brief with a suggested approach to the issue.

The SEC rejected both the most and least restrictive approaches followed by the circuit courts.  The proposed standard would apply the antifraud provisions of securities laws to transnational fraud cases only if (1) it results exclusively or principally in overseas losses; (2) if the domestic conduct is material to the success of the fraud; and (3) forms a substantial part of the scheme.  The SEC also noted that the increased prevalence of transnational fraud cases and crimes such as the Madoff ponzi scheme require a more common standard.  Unfortunately, after requesting this suggestion, the Second Circuit did not follow or investigate it further. 

In their petition for certiorari, Petitioners have asked the Court to consider this proposition by the SEC.  The petition concludes by emphasizing the need for a clear-cut procedure for transnational fraud cases.  The petitioners acknowledge that a Supreme Court decision is the only way to make such a standard clear and binding, and this case provides an opportunity for that decision.  They also argue that the need for a clear procedure is evident through the divided opinions of the circuits.  The opinion of the SEC agrees there is a need for a clear-cut approach to subject matter jurisdiction in international securities fraud cases and that this case offers an opportunity for that change.  The next post will detail the brief filed by the SEC pursuant to this petition for certiorari. 

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

In the coming weeks and months, The Race to the Bottom will feature a series of posts that will discuss the petition for certiorari, merit, and amicus briefs filed to the Supreme Court in Morrison v. Nat'l Austl. Bank Ltd., No. 07-0583-cv, 2008 U.S. App. LEXIS 21986.  Morrison is an example of a “foreign cubed” securities case where the plaintiffs, defendants, and securities transactions were all foreign in nature.  The case tests the reach of U.S. securities laws in transnational cases.  We will also post on the decision of the U.S. Supreme Court when it is decided.

In a post by Gregg Emmel, this blog covered the Second Circuit’s decision in Morrision.  The court dismissed the claims brought by Australian investors against National Australia Bank for lack of subject matter jurisdiction.  The ruling held that the majority of the fraud took place in Australia rather than the United States; and therefore, they did not have jurisdiction to hear the merits of the case.  The Second Circuit declined to outline a bright line test for similar cases; rather it continued the case-by-case analysis that has split the circuits on this issue in the past.

The first post in the series will focus on the petition for certiorari to the United States Supreme Court.

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

Those who allege that access will cause substantial disruption in the corporate governance process have a serious weakness:  the facts.

Access has been in place in Great Britain for years with no apparent harm.  Indeed, we note that in a letter submitted by the Association of British Insurers, Peter Montagnon, Director of Investment Affairs, had this to say:

• Experiences in the UK and other markets have shown that the ability to nominate directors does not lead to frivolous nominations. Indeed, a lack of access to the proxy and an inability to vote in a meaningful way (i.e. majority voting) on directors' elections, may have encouraged shareholder requisitioned resolutions on corporate affairs, which are significantly more prevalent in the US than other markets. In our experience, an ability to nominate and majority-vote on directors has created an environment of engagement and consultation between boards and investors, not confrontation through the proxy ballot. However, we do support sensible ownership thresholds to prevent the possibility of frivolous nominations. The current thresholds therefore proposed are in our view set at reasonable levels.

In short, those alleging that the practice will disrupt carry the burden of demonstrating why practices in Great Britain will not be replicated here.  It is a burden they have not yet met.

How things have evolved.  Two years ago, the corporate governance debate was about the competitive harm of Sarbanes-Oxley (see Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance) and the need to restrict shareholder litigation in order to return the US to the pinnacle in global markets.  Pension plans, particularly union owned ones, were under attack, as were investment advisory services, those companies that could help guide institutional investors to vote their shares in a manner that was not automatically pro-management. 

One of the pieces of "evidence" used to support the declining importance of the US markets (due to SOX, excessive litigation, surly institutions, take your pick) was the decline in foreign listings.  This encompassed those companies formed in another country that chose to list on a foreign market.  Companies were, some claimed, moving to London instead of New York because of over-regulation.  It was a weak argument from the beginning but the study, Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices over Time, pretty much put paid to the argument.  There was in fact no real decline, although the AIM Market in London gained a large number of listings that would never qualify to list in the US.  The premium that foreign companies got for listing in the US remained in place, evidence that companies came to the US specifically for its tougher corporate governance regulation.  London showed no similar premium.

We write not to reminisce about an overturned debate, although that would surely be a worthy exercise.  Instead, we note that the Journal has reported on Asian companies flocking to list in the US.  So far, five of the 15 IPOs in the U.S. this year have been from Asia and, while only one Asian public offering remains, "there is a pipeline of Asian companies preparing IPO paperwork behind the scenes with the U.S. Securities and Exchange Commission, according to bankers and lawyers."  Moreover, the types of companies that are deciding to list in the US include "newer, growth-oriented companies" such as those in the "health-care, clean-tech, or tech" industries. 

For profit stock exchanges like the NYSE and Nasdaq would no doubt like to reduce the regulatory barriers to listing in the United States.  Ironically, however, it is probably those very requirements that cause companies to come here.  If the NYSE/Nasdaq offered regulatory lite, there would be little difference between New York and London.  Companies that come to the US to obtain that badge of good governance and the resulting cross premium listing could just as easily go to the LSE.  All of which shows that a race to the top can be good for business. 

Great Britain has sometimes been labeled a shareholder's paradise.  Unlike the United States, large shareholders have access to the company's proxy statement for their nominees.  They also get a say on pay and directors must be elected by a majority of the votes cast. 

But there is at least one place where protections between the two countries differ.  As the WSJ reports, in an article about growing shareholder activism in Europe:  "The U.K. government has so far shied away from requiring fund managers to disclose their votes, though several fund managers do so voluntarily."  The SEC required disclosure by mutual funds back in 2003.  See Rule 30b1-4, adopted in Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, Investment Company Act Release No. 25922 (Sept. 23, 2003)(requiring open end mutual funds to disclose how they voted proxies of portfolio securities).  As a result, their patterns can be examined and investors unhappy with the approach can vote with their feet and exit the fund. 

On this one issue, the shareholder's paradise could learn a thing or two. 

Those fighting governance reform must confront the fact that many of the proposed changes are already in use overseas.  This is particularly true in Great Britain, a country sometimes derisively called a "shareholder's paradise."  Great Britain allows access and provides say on pay.

The country is reexamining governance matters in light of the recent financial meltdown.  Interesting ideas in that regard were floated by Paul Myners, the British Treasury minister.  He has suggested that shareholders have the authority to buy and sell their voting rights.  As he stated:

• "Some shareholders who never vote could sell their voting rights to others who do want to vote," he said in an interview last week. "That would introduce some market discipline into voting. It would have to be limited -- voting could not go beyond two votes per share, say. It is quite complicated, but it's got merit."

He likewise called for timed voting, with voting rights increased the longer shareholders held their shares. 

These rights already mostly exist in the US.  Empty voting, the practice of a shareholder having the right to vote without any of the economic risks, already takes place.  Moreover, most shareholders do not have fiduciary obligations and are, therefore, free to sell their votes.   As for timed voting, Delaware has upheld the practice, at least when in the articles of incorporation.

While there is nothing wrong with thinking broadly and spurring debate, both of these ideas, as the article notes, are antagonistic with good corporate governance.  A-B recapitalizations are a form of timed voting, leaving supervoting stock in the hands of long term investors.  Nonetheless, the practical effect is to allow certain shareholders to exercise control while owning a diminished share of the equity.  Moreover, as some critics of Myner's proposal noted, the approach has the wrong focus.

• Liz Murrall, senior adviser on corporate governance at the Investment Management Association, says differential voting in practice doesn't have the effect Lord Myners intends and in fact can be used as a tool by management to reward shareholders who support their strategy. "But long-term holders need to be enabled to exercise their proper responsibilities and there is certainly room for debate about the framework which will give them the incentives to do so most effectively," she said.

As for buying and selling votes, there are innumerable problems with the approach, not the least of which is the prospect of the company using the corporate treasury to buy enough votes to ensure the outcome of proposals it supports or opposes. 

Shareholder paticipation will increase when voting rights have meaning.  Right now with the Soviet style of elections at the board level, voting rights hardly matter.  Even with majority voting in the US, shareholders have marginal ability to influence board composition.  Boards can, as they have, refuse to accept the resignation of shareholders who do not receive the requisite majority. 

The better way to improve shareholder participation is to make voting rights more meaningful and allow for increased participation in the voting process. 

The need for capital markets have become di rigueur everywhere, including in some unexpected emerging markets.

Apparently one legacy of the US presence in Iraq will be US style capital markets.  The WSJ reported back in April that the Iraq Stock Exchange (ISX) started electronic trading for five of the 91 exchange traded companies.  (A non-electronic system started in 2004).  Since then, the Exchange has been holding three sessions (including one electronic session) a week.  

The ISX is a non-profit that is owned by member-brokers.  Although not a governmental body, the Exchange is supervised by the Iraq Securities Commission.  For an indication of the trading volume, go here. 

The Exchange shows no signs that it has been subjected to requirements of Shariah.  A glance at the listed companies indicates that there are non-Islamic compliant companies trading on the ISX.  These include banks and insurance companies and, apparently, at least one brewery. 

Moreover, by having the Exchange be subject to oversight of the Iraq Securities Commission, the structure seems to duplicate the model in the US.  The ISX is owned by members (as was the NYSE before becoming public) and subject to government oversight.  Moreover, as in the US, the Iraq Securities Commission is an "independent" regulator. 

It will be interesting to see how much of this US style model survives the US departure from Iraq.

On Friday, I will give a talk on the financial crisis and the problem of executive compensation.  A link to the conference is here.

We will resume our discussion of Merck, the case pending before the Supreme Court on the standard for determining the onset of the statute of limitations under Rule 10b-5.

In the 20 or so years before the new millennium, the corporate law area was overrun by the law and economics movement.  Everything had to be tested based upon economic analysis.  There is nothing wrong with applying different disciplines to law.  It does, after all, provide useful insight and can point regulators in a more effective direction.  But the law and economics movement was really a guise for anti-regulation (it became strong during the Reagan Administration, when this was the preferred way to look at the regulatory universe) and for a pro-management approach to corporate law.  The adherents strongly supported the pro-management approach of the Delaware courts (and believers in the characterization of Delaware law as a race to the top). 

In the 1980s, adherents to this movement placed almost talismanic importance on the market for corporate control.  They believed that when management, with all of its discretion (gratis of the Delaware courts) abused the discretion, the inefficiencies would be exorcised by a takeover.  Another company would spot the inefficiencies, know they could do better, and take over the company. We don't hear much about this approach anymore because the Delaware courts, so praised by this movement, have given management the discretion (they get discretion on everything) to more or less stop hostile acquisitions.  That method of acquiring controls has largely been eliminated.

But even if we were to turn the clock back to the era of hostile takeovers, there were still many problems with the "solution" of redeployment to a higher use.  There are too many criticisms to discuss in a short post, but one comes to mind.  In proving that takeovers were beneficial, proponents pointed to studies that showed target shareholders on average received a significant premium for their shares.  Shareholders of the bidder, however, received nothing, on average.  The weight of the studies showed no movement on the part of the bidder.

This curious lack of movement (which actually masked the fact that some bidders saw a rise in value while others saw a decline) was nothing more than, at the time of a merger, the market's collective uncertainty about how to value a takeover.  It said nothing about what, in fact, happened after the takeover.  In other words, the stat said nothing about whether the company in fact mismanaged the assets of the target.  If this were the case, the costs of the takeover (less productive use of the target's assets) could easily outweigh the benefits (the premium paid to target shareholders).  Proponents of the law and economics movement professed indifference about this since the inefficient bidder would itself become a target because of its inefficient use of assets.

Put that aside for a moment (there were plenty of reasons to believe this was not true).  The professed indifference, in other words, ignored the costs associated with the inefficient use of the assets during the period before the bidder itself became a target.

Why bring up this ancient history?  For one thing, adherents to the law and economics movement still raise their head from time to time, although now using a different vocabulary (Commissioner Paredes use of the phrase "private ordering" in opposing access is a modern vestige of this movement and equally unsupported, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom). 

But we mention all of this because of a recent article in the London Review of Books, Its Finished, by John Lanchester, in the May 28 issue (it takes a long time to find the time to read these things).  It's a piece about the financial crisis.  (You have to be a subscriber to get an online version).  Of great interest is the story of the Royal Bank of Scotland (as well as others).  It turns out that the RBS wanted to grow (at all costs, it seems) and went on an acquisition splurge.  Ultimately, however, these acquisitions brought down the bank.  Apparently by acquiring pieces of ABN-Amro, the RBS found itself excessively exposed to the subprime market.  The bank should have failed but was instead rescued by a government bailout (with accompanying government ownership).

First, the story of RBS is unusual only in the scale (although there are other similar large failures).  More importantly this is the type of thing that the law and economics movement tended to ignore.  Presumably RBS got very big but apparently became very inefficient.  Yet in part because of its size and in part because of the market's inability to see clearly what was going on (the article talks about how balance sheets put together legally and honestly nonetheless can mask the true financial status of a business), the inefficiencies continued until the crisis and the bank's failure.  During this period when RBS owned the assets of the acquired companies, it looks like RBS put them to a less efficient use.

Its an old story but one made poignant by the current crisis.  The truth is that it suggests fallacies in an argument that's not made anymore.  The law and economics folks don't rely on hostile takeovers anymore to ensure efficiency.  I'd like to think its because my arguments in earlier pieces convinced them but in fact that's not the case.  Instead, these acquisitions have been done away with by Delaware, as part of the "race to the top."