James River Management v. Kehoe: Advancement of Fees and Expenses

In James River Management v. Kehoe, No. 09-387, 2009 WL 4730715 (E.D. Va. Dec. 8, 2009), the District Court of the Eastern District of Virginia granted a motion for advancement of fees and expenses to defendant from a Delaware-chartered company and denied the same motion to defendants from the company’s Ohio-incorporated subsidiary. 

Plaintiff James River Group, Inc. (“JRG”) was a Delaware corporation and defendant Michael Kehoe was its sole director.  Plaintiff James River Insurance Company (“JRIC”) was incorporated in Ohio.  All defendants, Kinsale Management, Inc. and Kinsale Capital Group (“Kinsale”), William Kenney, Brian Haney, Ann Marie Marson, Edward Desch (“James River Individual Defendants”), Greg Share, and Michael Kehoe, were on JRIC’s board of directors, and all defendants sought advancement from JRIC.

Plaintiffs JRG and JRIC filed suit against defendants alleging misappropriation of trade secrets, breach of contract, and breach of fiduciary duty.  Plaintiffs claimed that defendants used their positions to form the knowledge and expertise to start a competing company. Defendants subsequently moved for an order requiring JRG and JRIC to advance all fees and expenses, including attorneys’ fees, incurred by defendants in connection with this litigation.

A corporation can make the right to advancement of expenses mandatory through either its certificate of incorporation or through its bylaws.  When this is the case, the recipient’s right is enforced as a contract.  A director’s right to advancement is not dependent upon the likelihood that he will ultimately be entitled to indemnification.  The two notions are distinct.  The right to advancement also does not depend on the likelihood of repayment if the litigant loses.

Section 145 of the Delaware Code provides that indemnification is available for actions brought against officers and directors, even if the defendant does not ultimately prevail.  Additionally, the statute provides that a corporation may "advance" fees and expenses in advance upon receipt of an undertaking by such director or officer to repay the corporation if the director or officer is ultimately not entitled to indemnification.  Advancement and indemnification rights, however, may only extend to legal proceedings incurred “by reason of the fact” of the director’s position as a director, and not resulting from activities that a director pursues in his personal capacity.  There needs to be a nexus or causal connection between the underlying proceedings and one’s official corporate capacity in order for those proceedings to be “by reason of the fact.”

 The JRG bylaws include mandatory advancement and indemnification provisions that state

[E]xpenses incurred by a present or former director, officer, employee, or agent… shall be paid by the corporation in advance of the final disposition of such action… upon receipt of an undertaking by or on behalf of the director or officer to repay the amount if it shall ultimately be determined that [the director or officer] is not entitled to be indemnified by the corporation.

The court found that nexus existed between the claims against Kehoe and his corporate capacity, thereby entitling him to the advancement of expenses.  The claim asserted that he used his “entrusted corporate powers” to misappropriate JRG’s trade secrets and form a competing company.  If Kehoe had any liability, it would rise directly out of his former position as a director of JRG, and thus would satisfy the requisite nexus between the proceedings and his official corporate capacity. 

With respect to advancement from JRIC, the issue turned on Ohio law.  Section 1701.13 of the Ohio Code contained language slightly different from Delaware.  Like the Delaware Code, the Ohio Code provides that a corporation may indemnify its management.  The Ohio Statute also states that “expenses incurred by a director in defending an action or proceeding shall be paid by the corporation as they are incurred, in advance of the final disposition of the action.”  As the court noted:

  • One could interpret it, as the Defendants urge, to command a result that corporations must always advance fees and expenses any time a corporate officer or director is sued for acts with a nexus to his official capacity. Alternatively, one could view the right to advancement . . . as devolving from a decision . . . to indemnify, as the Plaintiffs argue. It is undisputed that JRIC did not provide advancement or indemnification rights to its officers in its bylaws.

The District Court held that the latter view was correct.  Reading the statute as a whole, the court concluded that the plain meaning of the statute indicated that the advancement provision devolved from the decision made under the indemnification provision.  Ohio corporations were not, therefore, always required to advance fees to its director-litigants, but rather only when the corporation had chosen to make indemnification available. 

Because JRIC did not opt in to the indemnification and advancement provisions under the Ohio Code, the defendants were not entitled to advancement for fees and expenses incurred while litigating the claims brought by JRIC.

The court held JRG must advance Kehoe’s expenses for its claims against him under the Delaware Code, but JRIC was not required to advance expenses to the defendants under the Ohio Code.

The primary materials in this case can be found at the DU Corporate Governance Web Site.


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Need for Federal Intervention)(Part 2) 

As discussed in the last paragraph, shareholder approval of campaign expenditures is not an adequate solution to the issue, at least from a corporate governance perspective.

Another possibility would be to place the authority to approve expenditures on the board of directors.  One might think that it is already there, but that is unlikely.  Most expenditure decisions are made by the CEO, not the board.  Moreover, Delaware, in interpreting fiduciary obligations, has not been willing to specify when a board must be informed of developments within the corporation.  Thus, the CEO likely has no duty to inform the board when the expenditures are made.

To the extent that federal law requires board approval, the state law fiduciary duty standards would make any such decision a formality.  The board has an obligation to act in the best interest of shareholdres, which ordinarily translates into profit maximization.  Expenditures during election cycles, while perhaps bad for the country, would often be good for profit maximization. 

More importantly, board decisions that come under the duty of loyalty are analyzed under a process standard.  In other words, if they do it right from a process perspective, they will not be overturned or result in liability (with waiver of liability provisions the belt and suspenders when it comes to liability).  In short, directors may actually be acting in the best interest of the CEO but the substance of the decision will not be subject to review.  In short, any approval of campaign expenditures, if accompanied by sufficient process, will be unreviewable under state law. 

Imposing on boards an obligation to approve campaign expenditures, therefore, must be accompanied by a change in the standard of review.  This would be straightforward. Federal law should provide that:

  • boards of public companies (those registered under Section 12(g) of the Exchange Act and subject to periodic reporting requirements) must approve any campaign expenditures in advance and disclose the decision, the terms approved, and the basis for the decision;
  • boards have the burden of showing the fairness of the decision, with fairness including a finding that the expenditures will not unnecessarily cause public harm to the election process; and
  • shareholders can bring a derivative suit for a violation of this provision without first making demand on the board.

In short, the board would have a much higher standard for approving the campaign expenditures and would be more easily sued when they don't meet those standards.  This would likely have a salutary effect on the expenses. 


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Need for Federal Intervention)(Part 1)

We are discussing Citizens United v. Federal Election Commission,  No. 08–205,  Jan. 21, 2010the Supreme Court's recent decision on campaign finance.

So what is Congress to do?  We don't have any conclusions with respect to a specific federal regulatory regime, although presumably it would include substantial disclosure of the expenses and at least the type of disclaimers upheld by the majority.

Instead, we consider reforms that would address the problem through shifts in corporate governance.  Some have suggested that the expenditures ought to require shareholder approval.  Mark Tushnet at Harvard had this to say:

  • Requiring shareholders to approve a general power in the corporation to spend money on campaigns probably wouldn't accomplish much. Requiring them to approve specific expenditures—in advance—would, probably to the point of making such expenditures impossible for large general-purpose corporations. (It probably wouldn't affect small corporations or ideological ones like Citizens United much, which is an attractive feature of the proposal.)  Or, you could require that some supermajority of shareholders approve a general power to spend money on campaigns -- say, two-thirds or three-quarters -- and treat spending in the absence of such approval as ultra vires the corporation.

Shareholder approval, in advance, is very rare.  In the corporate codes of most states, only four matters typically require pre-approval of shareholders (dissolution, merger, sale of all/substantially all of the assets, and amendments to the charter).  To the extent pre-approval was required, it would make these types of expenditures relatively rare. 

Nonetheless, that would change.  At least for companies that regularly see their business tied up with campaign support, they could easily place the matter on the agenda of the annual shareholder meeting.  Moreover, it would likely pass in most instances.  First, shareholders opposing the effort confront the usual collective action problems (for a discussion of these problems, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom).  Second, many shareholders would likely support the expenditures.  While they may negatively affect the public interest, the expenditures are likley good for business.  In short, they will help companies profit maximize, which is something supported by most shareholders.

In short, shareholder approval is a road block to the expenditures and would prevent companies without sufficient foresight to make them.  On the other hand, there is no reason to believe that it will correct the problems raised by Citizens United.  Large expenditures by large companies may still be common.


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Politics of Judicial Activism, Part 2) 

There is a second example of judicial activism in the majority opinion.

In interpreting the statute at issue, the majority characterized the prohibition on electioneering communications as a "complete ban."  In doing so, the majority addressed other avenues potentially open to corporations to influence elections, including political action committees, or PACs.  It was presumably enough to dispense with this alternative by noting that PACs could only be funded by shareholders and employees and not by the corporation itself.  2 U. S. C. §441b(b)(4)(A)

Had the majority done so, it would have left open the possibility that Congress could have amended the relevant law and, rather than prohibit electioneering communications, allow them but only through the creation and operation of PACs funded by corporations.  This would have allowed corporations to expend funds on elections but only if they met the strict requirements imposed on PACs, including detailed reporting obligations.  Instead, the majority went on to presumptively foreclose this approach.  As Justice Kennedy wrote:

  • Even if a PAC could somehow allow a corporation to speak—and it does not—the option to form PACs does not alleviate the First Amendment problems with §441b. PACs are burdensome alternatives; they are expensive to administer and subject to extensive regulations. For example, every PAC must appoint a treasurer, forward donations to the treasurer promptly, keep detailed records of the identities of the persons making donations, preserve receipts for three years, and file an organization statement and report changes to this information within 10 days.  See id., at 330–332 (quoting MCFL, 479 U. S., at 253– 254).  And that is just the beginning. PACs must file detailed monthly reports with the FEC, which are due at different times depending on the type of election that is about to occur . . . Given the onerous restrictions, a corporation may not be able to establish a PAC in time to make its views known regarding candidates and issues in a current campaign.

This was an entirely unnecessary holding, an obvious example of dictum.  Justice Kennedy himself notes at the beginning of the quote that PACs do not allow corporations to speak, making everything that followed unnecessary to the opinion. 

Moreover, the conclusion is suspect.  While it is true that PACs must adhere to many requirements, there is no affirmative evidence that the expenses impose any kind of meaningful restriction on speech.  The only evidence provided by the Court is the number of PACs.

  • PACs have to comply with these regulations just to speak. This might explain why fewer than 2,000 of the millions of corporations in this country have PACs. See Brief for Seven Former Chairmen of FEC et al. as Amici Curiae 11 (citing FEC, Summary of PAC Activity1990–2006, online at 20071009pac/sumhistory.pdf); IRS, Statistics of Income: 2006, Corporation Income Tax Returns 2 (2009) (hereinafter Statistics of Income) (5.8 million for-profit corporations filed 2006 tax returns).

Yet this sort of statistic is meaningless.  Most corporations are very small and would not have PACs even if the cost of forming them were insignificant.  Indeed, 2000 corporate PACs is arguably a large number.   As the dissent noted:

  • A significant and growing number of corporations availthemselves of this option; during the most recent election cycle, corporate and union PACs raised nearly a billion dollars. Administering a PAC entails some administrative burden, but so does complying with the disclaimer,disclosure, and reporting requirements that the Court today upholds, see ante, at 51, and no one has suggested that the burden is severe for a sophisticated for-profit corporation.

It is clear that in an entirely unnecessary fashion the majority is precluding, in advance, an attempt by Congress to simply insert corporations into the pre-existing regulatory structure for PACs.   This is an approach that can only be described as legal activism.


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Politics of Judicial Activism, Part 1)

Whatever the merits of Citizens United, it was a fairly clear example of judicial activism.  There was at least one obvious way to avoid the constitutional question through statutory analysis.

The specifics of the case involved a movie created by Citizens United about Hillary Clinton.  Because Citizens United received some corporate funding for the movie, it potentially fell within the definition of electioneering communication.  But the phrase did not include every communication that mentioned a candidate, only those that were "publicly distributed."  Publicly distributed in turn meant that the communication “[c]an be received by 50,000 or more persons in a State where a primary election . . . is being held within 30 days.”  11 CFR §100.29(b)(3)(ii).

Citizens United wanted to make the movie available to cable subscribers.  Rather than broadcast the movie, however, subscribers would access the movie through on demand transmission.  In other words, the movie had to be requested and then would be seen by viewers within the household.  Citizens United asserted that "a single video-on-demand transmission is sent only to a requesting cable converter box and each separate transmission, in most instances, will be seen by just one household—not 50,000 or more persons." 

The Court rightfully disagreed with the argument.  The regulation went to the total number of possible viewers for the relevant communication. As the relevant regulation noted:

  • (G) In the case of a communication appearing exclusively on a cable or satellite television system, but not on a broadcast station or network, that the viewership of the cable system or satellite system lying within a Congressional district or State is 50,000 or more;

11 CFR §100.29(b)(7)(i)(G).  Because the cable system that would provide the video-on-demand system had 34.5 million subscribers nationwide, the numerical test in the regulation would have been met. 

Yet a review of the entire regulation reveals a detailed definition that entirely deals with materials that are involuntarily disseminated to the public.  Thus, subsection (7)(i)(A) - (D) addresses communications broadcast over AM and FM radio.  Subsection (F) deals with television broadcasts.  These subsections rely on population counts, which reflect the number of people who could have heard the relevant communication.

In (G) and (H), the focus is on cable and satellite and, with equal logic, the focus is on the number of subscribers.  This is the number of persons who, at any one time, might have heard/viewed a communication sent out over these mediums.  Indeed, an exception contained in subsection (7)(iii) provides that the definition is not met where the evidence shows that the cable or satellite systems "did not carry the network on which the communication was publicly distributed." 

In other words, the regulation is keyed to an affirmative distribution by the relevant station, network, or cable/satellite system, and uses as a metric the number of people who were able to actually hear the communication when it was distributed.  The regulation does not in any way contemplate circumstances where the relevant system only released a communication upon request.  The counting rules of potential listeners would presumably need to be different since a single distribution of the communication to a single household could not possibly meet the test.  In other words, the activities conducted by Citizens United were not contemplated by the regulation.  This is consistent with the administrative history to the provision which makes no mention of these types of communications.  See Interim final rules with requests for comments, FEC Notice 2002-21, Oct, 23, 2002.

Said another way, the majority could have ducked the whole constitutional issue by concluding that a movie distributed through an "on demand" process did not fall within the definition of "Can be received by 50,000" as defined in 11 CFR §100.29(b)(7).  Instead, the Court simply referred to the number of cable subscribers as if this was an acceptable method of determining the number of persons who could receive an on demand movie. 

The fact that it could have ducked the constitutional issue through an interpretation of the regulation suggests a judicially active approach to the issue, with the majority wanting to reach the constitutional question.


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Role of the SEC)

We are discussing Citizens United v. Federal Election Commission, No. 08–205,  Jan. 21, 2010the Supreme Court's recent decision on campaign finance.

The first thing that needs to happen in this area is to require complete disclosure of campaign expenditures by public companies.  The Supreme Court foreclosed the application of the standards for political action committees.  Excessive pleading standards prevent access through state law inspection rights.  Congress may eventually intervene, with the majority all but inviting some kind of regulatory regime based upon disclosure.

In the short term, however, the Securities and Exchange Commission should act.  The SEC could put in place a new disclosure item as part of the quarterly disclosure system.  Companies would be required to disclose any expenditures made by the company in connection with elections that surpass a specified threshold.  An appropriate threshold would be the $120,000 standard used in Item 404 for related party transactions.  As for defining the types of expenditures, the Commission can borrow the definition of expenditures from the Federal Election Commission. See, e.g. 2 USC § 431. 

This type of disclosure will be useful but it will be after the fact.  The disclosure obligation should also require that companies reveal any plans to make such expenditures, including the nature of the campaigns that will be supported and the amount expected to be expended. 

Finally, as is increasingly the case, the disclosure obligations should place pressure on the board to supervise the expenditure process (which in turn increases their legal exposure if matters are mismanaged).  The disclosure obligations should, therefore, require disclosure of the role of the board in the approval of the expenditures, including the particular committee with responsibility.  To the extent the expenditures were not approved by the board, the provision should require an explanation as to why the board did not feel it was necessary to make the decision.

The approach will put pressure on the board to be more involved.  Moreover, it creates the risk of liability under Rule 10b-5 to the extent that the role of the board and the reasons for the decision are misstated.

The SEC cannot substantively regulate the expenditures but it can require their disclosure.  This should be done immediately.


Corporate Governance and Campaign Finance: Citizens United v. FEC (The Role [or Non-Role] of Delaware)

We are discussing Citizens United v. Federal Election Commission,  No. 08–205,  Jan. 21, 2010the Supreme Court's recent decision on campaign finance.

While Congress cannot abridge the right of corporations to expend funds on electioneering communications, states apparently can.  As the majority opined:

  • Shareholder objections raised through the procedures of corporate democracy, see Bellotti, supra, at 794, and n. 34, can be more effective today because modern technology makes disclosures rapid and informative. A campaign finance system that pairs corporate independent expenditures with effective disclosure has not existed before today. . . .  With the advent of the Internet, prompt disclosure of expenditures can provide shareholders and citizens with the information needed to hold corporations and elected officials accountable for their positions and supporters.  Shareholders can determine whether their corporation’s political speech advances the corporation’s interest in making profits, and citizens can see whether elected officials are “‘in the pocket’ of so-called moneyed interests.” 540 U. S., at 259 (opinion of SCALIA, J.); see MCFL, supra, at 261.

It is, in the end, a misguided proposition.  It assumes that with some kind of public disclosure of the payments, shareholders can put a stop to them.  There are several problems with this. 

First, there is no state law requirement that these expenses be disclosed.  Shareholders can only find out about the expenses if they exercise their inspection rights.  Yet inspection rights can only be exercised if shareholders present credible evidence of wrongdoing (something at least one court has all but transformed into a summary judgment standard). 

Shareholders cannot, therefore, simply ask to see the documents pertaining to campaign contributions.  The only way for shareholders to get the relevant information is for the imposition of a federal standard.  In effect, therefore, the Supreme Court is calling for further federal government intrusion into, and preemption of, the corporate governance process. 

Second, there is little evidence (or common sense judgment) that disclosure would in any way result in some kind of correction at the corporate level.  As we have noted often on this Blog, Delaware in particular does not require that boards know anything in particular about the business of the corporation.  As a result, directors do not need to know that the expenses have even been made.   

As for shareholders, they have no power to prevent the expenditures.  Suits for breach of fiduciary duties will likely fail (particularly if brought under the duty of care and are therefore subject to the ubiquitous waiver of liability provisions, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom).  Directors will not be voted out of office unless there is a contest, something that is rare and expensive.  (Even directors who lose under majority vote provisions will not generally lose their positions on the board).

Finally, were shareholders likely to incur the costs and try to overcome the problem of collective action by proposing a bylaw that would ban the payments, it would probably be struck down as interfering with the day to day business of the corporation.

In short, there is nothing shareholders can do about the expenditures.  While it is possible that states could change the standards (passing a law, for example, that required all companies to get shareholder approval for these types of expenditures), it won't happen.  Unless Delaware passes such a statute, other states won't.  And, the Race to the Bottom predicts that Delaware will not.  Federal preemption is the only way to make this a true matter of governance.


Corporate Governance and Campaign Finance: Citizens United v. FEC (A Bit of History)

We are discussing Citizens United v. Federal Election Commission, No. 08–205,  Jan. 21, 2010the Supreme Court's recent decision on campaign finance. 

It is a rare case that examines the corporate form with an exegesis that begins with the founding of the United States (or at least the adoption of the First Amendment).  Yet there is considerable history on this opinion, instigated by Justice Stevens and, to some degree, answered by Justice Scalia.  Whatever merits of the discussion for purposes of the case at hand, the discussion does show the significant evolution of corporations over the last 200 years.  

In those early days, corporations were not a creature of state statute but of state legislature.  As Justice Stevens noted: 

  • Those few corporations that existed at the founding were authorized by grant of a special legislative charter. Corporate sponsors would petition the legislature, and the legislature, if amenable, would issue a charter that specified the corporation’s powers and purposes and “authoritatively fixed the scope and content of corporate organization,” including “the internal structure of the Corporation in the Law of the United States 1780–1970,pp. 15–16 (1970) (reprint 2004). Corporations were created, supervised, and conceptualized as quasi-public entities, “designed to serve a social function for the state.” Handlin & Handlin, Origin of the American BusinessCorporation, 5 J. Econ. Hist. 1, 22 (1945). It was “assumed that [they] were legally privileged organizations that had to be closely scrutinized by the legislature because their purposes had to be made consistent with public welfare.”

Of course, reliance on charters passed by the legislature also left open the possibility that the decision (including the terms in the charter) were determined by political rather than economic considerations.

He likewise notes that corporations were viewed with some suspicion.  After all, they could have an indeterminate life.  Again as Justice Stevens describes:

  • The individualized charter mode of incorporation reflected the “cloud of disfavor under which corporations labored” in the early years of this Nation. 1 W. Fletcher, Cyclopedia of the Law of Corporations §2, p. 8 (rev. ed. 2006); see also Louis K. Liggett Co. v. Lee, 288 U. S. 517, 548–549 (1933) (Brandeis, J., dissenting) (discussing fears of the “evils” of business corporations); L. Friedman, A History of American Law 194 (2d ed. 1985) (“The word ‘soulless’ constantly recurs in debates over corporations. . . . Corporations, it was feared, could concentrate the worst urges of whole groups of men”). Thomas Jefferson famously fretted that corporations would subvert the Republic. General incorporation statutes, and widespread acceptance of business corporations as socially useful actors, did not emerge until the 1800’s.

Justice Scalia doesn't agree ("Despite the corporation-hating quotations the dissent has dredged up, it is far from clear that by the end of the 18th century corporations were despised.").  He notes properly that early suspicion may have arisen through "resentment towards corporations was directed at the state-granted monopoly privileges that individually chartered corporations enjoyed."  Yet these were the types of businesses that sought and received the corporate form.  It is not so easy, therefore, to separate opposition to the corporate form from opposition to the type of business they conducted. 

Finally, he notes that the corporate form in those early days was rare.

  • Scholars have found that only a handful of business corporations were issued charters during the colonial period, and only a few hundred during all of the 18th century. See E. Dodd, American Business Corporations Until 1860, p. 197 (1954); L. Friedman, A History of AmericanLaw 188–189 (2d ed. 1985); Baldwin, American Business Corporations Before 1789, 8 Am. Hist. Rev. 449, 450–459 (1903). . . .  More than half of the century’s total business charters were issued between 1796 and 1800. Friedman, History of American Law, at 189. 

In short, the corporate form lacked anything close to widespread acceptance and dominant position held today.  Moreover, as discussion arises over increased legislative intervention into corporate affairs (mostly in the form of federal preemption of governance standards), it is important to remember that corporations began as creatures of the legislature.


Corporate Governance and Campaign Finance: Citizens United v. FEC (Introduction)

We don’t ordinarily delve into campaign finance issues but  the Supreme Court’s recent decision in Citizens United v. Federal Election Commission,  No. 08–205,  Jan. 21, 2010, merits some unique attention.  As everyone who has not lived under a rock for the last several weeks knows, the Supreme Court largely threw out a provision of McCain-Feingold that restricted the right of corporations to expend funds on political campaigns, concluding that the restrictions interfered with the first amendment rights of corporations.

The particular provision at issue did not involve restrictions on corporate contributions to political campaigns or prohibitions on expenditures that expressly advocated the election or defeat of a candidate.  Instead, the case inolved language added in 2002 that prohibited expenses for anything deemed to be an  “electioneering communication."  The term encompassed communications that referred "to a clearly identified candidate for Federal office” and was made 30 days before a primary or 60 days before a general election. See 2 U. S. C. §441b; see also 2 U. S. C. §434(f)(3)(A).  In short, corporations (and unions) could not pay for communications that referred by name to candidates just before an election. 

There are a number of topics that warrant examination.  First, there is an interesting discussion of the history of the corporate form in the United States.  Second, there is a suggestion that the best place to solve the corporate expenditure process is through resort to corporate governance.  We will discuss assertion.  Third, there is room for some regulatory intervention both by the Securities and Exchange Commission and Congress.  Finally, we will examine two places where the majority evidenced an activist approach in deciding the case.


The Don Quixote of Anti-Delaware Scholarship

The Race to the Bottom and my posts are criticized often enough (including by the Delaware courts) but I have to say I have never been disparaged through reference to a fictional literary character.  That honor has now been bestowed upon me.  JW Verret, an assistant professor at George Mason recently referred to me as "the Don Quixote of anti-Delaware scholarship".

Now it might be that this was intended as a compliment.  After all, Don Quixote has been labeled one of the greatest works of fiction in history.  Or perhaps it was meant as a criticism of Delaware and the Delaware courts, characterizing them as windmills.  Alas, neither is likely correct.  The reference was apparently to what Verret considers, shall we say, quixotic attacks on the Delaware model.  Dictionary .com kindly labels quixotic as "extravagantly chivalrous or romantic; visionary, impractical, or impracticable".  We suspect that Verret means the alternative definition, "impulsive and often rashly unpredictable". 

His defense of the Delaware model is an appropriate topic to debate, although with additional federal preemption coming, there will be less of it to debate.  Moreover, with executive compensation as an indication of the consequences of the model, it is not an easy case to make.

Yet his analysis is, in the end, weakened by gratuitous and overbroad slaps at those in academia who have cause to criticize Delaware's approach to corporate governance ("I’m proud to say that Lucian has forgotten more about corporate governance than most of the anti-Delaware critics who have followed in his footsteps."), not to mention excessive praise for himself ("I will, however, offer that my viewpoint is far more informed than most of Delaware’s critics."). 

It is reminiscent of the days when law and economics controlled legal analysis in the corporate area and shouted down anyone who did not agree with their reasoning.  In the end, personal attacks, much like saying it again louder, do not advance the debate.  Verret would have been more convincing had he stuck to the legal issues and avoided the personalities.  Otherwise, as Don Quixote said, "[b]y a small sample we may judge of the whole piece."  


Deloitte LLP v. Flanagan: Big Four Partner Breaches Fiduciary Duty 

In Deloitte LLP v. Flanagan, No. 4125-VCN, 2009 WL 5200657 (Del. Ch. Dec. 29, 2009), plaintiffs Deloitte LLP and Deloitte & Touche LLP (collectively “Deloitte” or the “Partnerships”) accused defendant Thomas P. Flanagan (“Flanagan”), a partner in the international accounting firm partnership Deloitte, of trading in the securities of some of the firm’s clients in breach of his partnership agreement and the general fiduciary duties he owed his partners.  The plaintiffs also accused Flanagan of misrepresenting this trading activity in annual representations to the firm.  Deloitte sued to recover damages caused to the firm and sought partial summary judgment on the question of liability.  The court granted the plaintiffs' motion for partial summary judgment as to liability.  Vice Chancellor John Noble left the determination of damages for a later hearing.

Plaintiff Deloitte LLP is a Delaware limited liability partnership that provides audit, consulting, financial advisory, risk management, and tax services to clients.  Plaintiff Deloitte & Touche LLP is a Delaware limited liability partnership that provides audit and risk management services to clients.  Defendant Flanagan, a Certified Public Accountant, was a partner of one or both of the Partnerships for 30 years until his resignation on September 5, 2008.  As a partner of Deloitte, Flanagan was required to sign a Memorandum of Agreement with each of the Partnerships (“MOAs”) setting forth his rights and obligations as a fiduciary.  The MOAs require that partners not engage in any activities inconsistent with Deloitte’s rules and policies, one of which prohibits partners and employees of Deloitte from owning any securities in the firm’s “Attest Clients.”  Deloitte defines Attest Clients as clients for whom Deloitte performs audits, reviews of financial statements, or other “agreed upon procedures or engagements.”  The policies also require partners to disclose all information regarding investments held by them so that Deloitte can track any unauthorized holdings.  The policies further require that partners make annual representations to the Partnerships that they complied with these policies.   

Flanagan consistently made annual representations that he was familiar with the policies, that he had accurately and completely disclosed all investments he held, and that at no time did he have a financial interest in a restricted entity.  Deloitte’s Complaint asserted that, notwithstanding Flanagan’s representations, he did in fact trade in the shares of Deloitte clients in more than 300 instances over several years.  Deloitte requested partial summary judgment as to the question of liability on its claims for breach of fiduciary duty, breach of contract, common law fraud, and equitable fraud. 

The court focused on a subset of trades for which Flanagan did not offer a defense and which appeared to violate Deloitte’s policies.  According to the complaint, Flanagan received an 85% gain from trading call options of Allstate Corporation shortly after he reviewed a draft of the insurer's upcoming earnings release.  Flanagan then purchased and sold call options of Best Buy Company for a 31% return, after he directly provided audit services and learned of the company’s earnings prior to their public announcement.  Lastly, Flanagan received a 1,400% return by improperly trading in options of Motorola Corporation, another of Deloitte’s clients with whom he had worked, not long after receiving an e-mail that included a statement from the company's CEO about the Corporation’s recent performance. 

The court held that Flanagan’s misrepresentations with respect to his holdings constituted a breach of his duty to be “just and faithful to the Partnership,” therefore the court granted Deloitte’s motion for summary judgment on its breach of fiduciary duty claim.  For the breach of contract claim, the court stated that Flanagan was on actual notice that these three entities were clients of Deloitte since he personally provided them audit services.  As a result, his trading in these entities and his failure to report his trades to Deloitte constituted a breach of the MOAs.   The court also granted summary judgment for the equitable fraud claim because the court stated that Flanagan had an obligation to accurately report his trading on the Annual Representation form and to maintain an accurate and complete list of his holdings in Deloitte’s Tracking and Trading system.  Flanagan failed to fulfill either of these obligations.

Lastly, the court granted Deloitte’s motion for summary judgment on liability with respect to the common law fraud claim.  The standard for scienter in common law fraud requires committing the misstatement recklessly or with intent.  The court found that the magnitude of Flanagan’s unauthorized trades, the discerning trading in those clients for which Flanagan had material nonpublic information, and his misuse of the Tracking and Trading system established that Flanagan acted with requisite scienter. 

In summary, the court granted Deloitte’s motion for partial summary judgment as to liability.  Vice Chancellor John Noble left the determination of damages for a later hearing.

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


Doug Branson Contributes

We are happy to have a post today from Douglas Branson, W. Edward Sell Chair in Business Law, University of Pittsburgh. 

Doug received his B.A. from the University of Notre Dame and his J.D. from Northwestern University. He has also earned an LL.M. from the University of Virginia, specializing in corporate law and securities regulation. Before joining the faculty at the University of Pittsburgh, Professor Branson taught for more than 20 years at Seattle University. He holds a permanent faculty appointment at the University of Melbourne, Australia, in its Masters of Law Program.  As an elected member since 1981, he had an influential role in framing the American Law Institute’s recommendations for corporate governance.  Most recently, he has been a USAID consultant to the Ministries of Justice in Indonesia, Ukraine, and Slovakia advising on corporate law, capital markets law, corporate governance, and securitization issues.  Currently, he is the Condon-Falknor Distinguished Visiting Professor at the University of Washington in Seattle.

We welcome him to The Race to the Bottom.


The Depreciating Law Degree: A Story In Search of Facts

What a disappointment. 

On Sunday, the NYT carried a story titled "No Longer Their Golden Ticket" with a smaller heading that described young associates as "stuck with depreciating law degrees." Depreciating law degree suggests some type of permanent decline in the value of the JD.  Yet the article does little to support this apparent contention.  The article simply contains a list of horrors that have arisen as a result of the current recession.  

There is no question that the job market for legal degrees is horrible.  Large firms have deferred and sometimes canceled offers.  A higher proportion of graduates are likely confronting the end of their third year with no offers in hand.  Anxiety is up as is, apparently, the number of lawyers seeking counseling has risen. 

Yet these are the consequences of a bad recession, the worst since the Great Depression as pundits are fond of saying.  In the fourth quarter of 2008, the same article could probably have been written about pampered investment bankers.  Their financial institutions were failing and the market for corporate finance was drying up.  Now the market has recovered and these same financial institutions (at least the survivors) are looking at record bonuses.  Will the same be true for those with law degrees?  The article doesn't answer that question. 

The one insight, though, was that associates should be aware that they can no longer automatically count on partnership.  As the article described: 

  • Smart, talented people will still find advancement within firms, he said. But “speaking candidly,” [a partner from Willkie Farr] added, “in the past, associates were a little oblivious” in presuming that if they “simply showed up every day and didn’t offend anyone, they were there indefinitely. They have had a wake-up call.”

But for associates at most large firms, this is not news and it is not a change in circumstances.  Even in the best of times, most large law firms promote to partnership only a tiny handful of the associates who start each year. 

Its a tough year to be sure.  But prosperity is just around the corner. 


The Financial Crisis and Helping the Homeless

On Christmas afternoon, we repeat the following post:

We talk often about executive compensation, particularly as financial institutions are in the process of calculating bonuses for the prior year.  President Obama has taken the "fat cats" in the financial sector to task.  As he noted on 60 Minutes:

  • "They're still puzzled why is it that people are mad at the banks. Well, let's see," he said. "You guys are drawing down $10, $20 million bonuses after America went through the worst economic year that it's gone through in -- in decades, and you guys caused the problem. And we've got 10% unemployment."

That worst economic crisis has caused pain to any number of segments of the US population.  One that I know first hand is the homeless population.  

The Denver Metropolitan area does a count of the homeless every year.  The Point in Time Survey provides a comparison for changes in the homeless population in the area.  The last survey showed that the area had 11,061 homeless, with 53.5% single homeless, 26.8% children under the age of 18,  41.8% women, 13% veterans.

By all accounts, things have only gotten worse since the Point in Time Survey.  It shouldn't come as a surprise.  This recession, with its source in subprime lending and mortgages, has been uniquely connected to housing.  A percentage of those losing their housing end up in the homeless population.

There are plenty of ways to help, but I suggest three:

Colorado Coalition for the Homeless:  I sit on the board of the Coalition for the Homeless, which provides housing, child care and health.  It runs the only clinic in Denver for those who are medicaid/medicare ineligible (read homeless).  The numbers served at the clinic are increasing but the resources/funding are not.  The web address is here:  Some contributions are eligible for state tax credits. 

Catholic Workers Soup Kitchen:  I also sit on the board of the Catholic Workers Soup Kitchen which is a group of people who serve food at the St. Francis Center on Wednesdays and Fridays.  The food is always home made soup and fresh green and fruit salad.  There are no paid staff and 100% of the funds benefit the homeless. 
Numbers at the soup kitchen are way up.  The web address is here:

St. Francis Center:  The St. Francis Center is a day shelter.   It is a place for the homeless to go during the day to get out of the miserable cold or the miserable heat.  The  Center provides health care (in conjunction with the Coalition) and counseling; it has a used clothing store.  The St. Francis center is a mail drop and a place for the homeless to make/receive phone calls.  I don't know their ratio of administrative costs to services but I have no doubt that they put most of the money directly to work.  My recollection is that they also provide a Colorado state tax credit since they are considered part of an enterprise zone.  They are here:


Operating Agreements and Advancement of Legal Fees: The Need for Careful Drafting (Ficus Investment v. Private Capital Management)

LLCs are relatively new entities.  They rely largely on principles of contract, with the rights and responsibilities of the participants usually reflected in an operating agreement.  State law allows operating agreements wide discretion in setting out the respective rights of the participants.  This can be the case, for example, in connection with advances for attorneys fees to a member, even when he or she is sued by another member. 

In Ficus Investment, Inc. v. Private Capital Management, LLC, the New York Supreme Court’s appellate division upheld a decision that the provision to advance expenses in the Operating Agreement applied when one member of an LLC initiates litigation against another.  As a result, the defendant was entitled to an advance of his litigation expenses.

Thomas Donovan and Ficus Investment, Inc were members of Private Capital Management, LLC.  Ficus brought a claim against Donovan alleging that he misappropriated funds and assets worth $9.872 million from the LLC.  Donovan argued that under the terms of Private Capital Management’s Operating Agreement, he was entitled to an advance of his legal expenses.    

In reaching its decision, the court relied heavily upon the terms of the Operating Agreement.  The Operating Agreement described Donovan as CEO.  The Operating Agreement also provided for advancement of expenses and indemnification for members, managers and officers of the company when certain criteria are satisfied.  “Officers” include the CEO.  

The court observed that the Operating Agreement distinguished between the relief available  at the end of proceedings (i.e. indemnification) and payments while the proceedings were still ongoing (i.e. advancement of legal expenses).  The court noted that the Operating Agreement provided for advances “before final disposition of a proceeding” but that the officer must repay the advanced funds if upon a determination he or she is not entitled to indemnification.  Thus, advancement does not depend on whether the officer is ultimately indemnified; the officer is entitled to the funds even though they might ultimately need to be paid back.  After reaching this conclusion, the court upheld the lower court’s decision to require Private Capital Management to advance Donovan his litigation expenses in accordance with the Operating Agreement. 


Corporate Profits and Corporate Political Spending: Why Companies Care and Corporate Legal Academics Should Too

First, I applaud the Harvard Corporate Governance blog for posting the Cooper, Gulen & Ovtchinnikov paper on Corporate Political Contributions and Stock Returns. Documenting the ways that companies influence federal Congressional campaigns -- and hence shape the broader political and legal system to maximize corporate profit --  is a crucial endeavor if we are going to have a meaningful discussion of what we mean by "free markets." 

The professors' new paper, based on a sophisticated new data set of FEC-documented PAC contributions to Congressional campaigns (from 1979 to 2004) reveals positive abnormal stock returns correlating with these contributions by public companies. Obviously, the results attest to companies' powerful interest in shaping the national political environment in their favor: whether that influence is exerted in the area of financial (de)regulation, limits on shareholder lawsuits, the scope and shape of healthcare reform, climate change regulation or new standards for food and product safety.

But even as this new paper (soon to be published in the Journal of Finance) documents the ways that public companies' donations to Congressional elections positively influence corporate profits, it only captures a tiny part of the picture. Part of what makes corporate political spending so tough to understand and talk about convincingly is that there are so many forms of it, and in each case, fine distinctions between what is and is not legal.

Finally, there is a lot of corporate political spending which remains almostly entirely invisible. (I heard that Obama resisted allowing grand corporate expenditures at his Inaugural, no?) 

In addition to campaign contributions, we need to analyze corporate lobbying expenses and gifts to legislators, issue advocacy, issue-based litigation advocacy (e.g. the filing of amicus briefs in pro-business lawsuits, especially in Supreme Court cases), and gifts companies make to candidates' and sitting legislators' favorite charities - a practice which (though noted in a midJune USA Today article) is only barely recognized or studied, and is often legal. Witness the force that the U.S. Chamber of Commerce has become in shaping federal law.

Furthermore, as I've noted in my UCLA paper ("Pandora's Box: Managerial Discretion and the Problem of Corporate Philanthropy"), much corporate politicking can be effectuated via corporate contributions to nonprofits. In many cases, the nonprofits are even 501(c)(3) "charities" (especially educational organizations aka think tanks). Such corporate donations/payments max out at 5% of a public company's total profits -- consider what a ceiling that establishes! And there is no public disclosure requirement: neither at the company or the recipient's (fund's) side. Late Congressman Paul E. Gillmor (R- Ohio) had pressed for new disclosure of such corporate donations, but there wasn't much political support. Imagine that.

Faith Stevelman/Director, Center on Business Law & Policy/Professor of Law/New York Law School/57 Worth Street/New York, NY 10013/212.431.2197


Jennifer Taub Posts on The Race To the Bottom

For the second time in two weeks, we are please to announce another contribututor to The Race To the Bottom.  Jennifer Taub is a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst.  

Her area of exptertise?  Mutual funds and their role in the governance process.  Before joining academia, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.  At Fidelity, she advised senior management within the Fidelity transfer agents, broker-dealers, investment advisers and other mutual fund administrators on compliance with the federal securities laws. 

Professor Taub began her career in the Trade Practices and Regulatory Law Department at Weil, Gotshal & Manges in New York.  She graduated cum laude from Harvard Law School in 1993 and earned her undergraduate degree, cum laude, with distinction as an English major from Yale College in 1989.

Since joining academia in 2004, Professor Taub has been an invited guest at several industry and academic conferences. She presented a paper at a comparative corporate governance conference at Oxford University’s Said Business School. She was a discussant at the Sixth Annual "Capital Matters: Managing Labor's Capital Conference" sponsored by the Harvard Law School Pensions and Capital Stewardship Project, Labor and Worklife Program. In addition, she was invited to moderate a workshop at the Mutual Fund Directors Forum. Most recently, she has been selected to present a paper at the Elfenworks Center for the Study of Fiduciary Capitalism at St. Mary’s College of California.

 She begins on The Race to the Bottom with a five part series on the role (or non-role) of mutual funds in the governance process.  Enjoy! 

 Professor Taub has received research funding including a grant from the Millstein Center for Corporate Governance & Performance at the Yale School of Management. She was also awarded an honorarium in connection with a paper she is writing, entitled, “Enablers of Exuberance,” concerning the legal and corporate governance actions and inactions that led to the recent global financial meltdown. Her article “Able but Not Willing: The Failure of Mutual Fund Advisers to Advocate for Shareholders’ Rights,” was published in 2009 in the Journal of Corporation Law. It has been cited (in its working paper form) by leading academics and by the OECD in a paper regarding “Corporate Governance and the Financial Crisis.” In addition, she is coauthoring a book chapter for the Wiley Companion to Finance Ethics series entitled “Ethics in Commercial Bankruptcy.

The first post is below.  Enjoy.



Faith Stevelman Blogs on the Race to the Bottom

We are pleased to have Faith Stevelman begin a series of six posts today on Berger v. Pubco, a Delaware Supreme Court decision defining the remedies for minority shareholders in a short form merger when they have not received the information needed to decide whether to exercise appraisal rights.  It is an important case and, unexpectedly, favorable for shareholders.

Faith has a B.A. and M.Phil. (PhD.ABD) from Yale and a J.D. from NYU Law School. After four years of transactional work at Fried Frank's Wall Street office she joined the faculty at New York Law School in '93. She's also visited at Cornell Law and Georgetown, where she was a Sloan scholar.

In addition to teaching Corporations, Securities, and M&A, she's developed a case study on W.R. Grace & Co., entitled: "Regulation, Compliance and Litigation: Corporate Law in Perspective." She founded her law school's corporate honors program, "The Center on Business Law & Policy" in 2006. This year she's published Regulatory Competition, Choice of Forum, and Delaware's Stake in Corporate Law in the Delaware Journal of Corporate Law and Globalization and Corporate Social Responsibility in the New York Law School Law Review.

Enjoy the posts!


Interview with Eric Cohen, Co-Founder of Investors Against Genocide

Interview with Eric Cohen, Co-Founder and Chairperson of Investors Against Genocide on 3/7/09.


CH -- While the Congressional Act is titled the Sudan Accountability and Divestment Act, your organization, Investors Against Genocide, has not emphasized divestment but rather genocide-free investment. What is the difference, and why is it important to you?


EC -- The genocide in Darfur has been going on for six years now, and we’re still struggling with most of the major financial institutions making considerable investment in the very worst companies involved in the genocide. We need policies in place and ready to apply much earlier, policies that can have impact even before a genocide starts. The resolution we’ve written is an investment policy to be implemented by mutual funds requesting that the fund avoid holding stock in companies that substantially contribute to genocide. This policy applies to Sudan divestment, but it also calls for companies to avoid investment in the future PetroChinas of the world. We don’t want funds to connect their shareholders to genocide, the ultimate crime against humanity. When companies like PetroChina need capital they turn to the west and seek to raise money through public offerings. We want the response of the western world to be that companies involved in genocide are not supported, either in IPOs or in subsequent stock purchases.


CH -- While the forms required by the SEC to activate the SADA safe harbor for investment companies are publically available, it is difficult to sift through the thousands of filings to determine what companies—if any—have taken advantage of this safe harbor provision. Do you think the legislation has had any effect on fund investment?


EC -- We track the holdings of the major mutual fund holdings, for example Fidelity, Vanguard, Franklin Templeton, American Funds, and TIAA-CREF. We have not seen any major change in their holdings to suggest that they have decided to get out of stocks in these companies. If they sold, they could have taken advantage of the safe harbor in SADA, but they have not sold off their holdings. It may be that someone somewhere has filed for the safe harbor, but I haven’t heard of it yet, and have not found it from reading the filings.


What this exposes is that the reason that companies like Fidelity, Vanguard and American Funds are holding large positions in PetroChina is not because they are fearful of being sued over fiduciary responsibility, but because they are making a fund management decision that they want to hold those stocks. Further, anyone who is tracking the relative performance of oil stocks can see that while PetroChina generally follows the trend of other oil companies, it is much more volatile than its competitors. Volatility is something that professional money managers generally seek to avoid, so staying in that stock is proving to be not a good choice. Those funds that have maintained their shareholding in PetroChina are performing less well.


CH -- Do fund managers need shareholders to agree to a genocide-free investment policy or strategy?


EC -- Fund managers set policy for how their fund will invest. Every year they are required to update their prospectus so investors can see what the rules of the fund are. There is nothing preventing any fund manager from deciding to exclude companies that are substantially contributing to genocide and update their prospectus. What we’ve seen instead is that the major mutual fund companies are resisting setting any policy or taking action, which is where shareholder proposals come in. A shareholder vote forces management to engage in the question and take a position. If shareholders advocating the proposal win, we are confident that fund management will institute the policy.


CH -- To date, no shareholder votes have resulted in adopting a genocide-free investment policy; do you see this changing?


EC -- The campaign for genocide-free investing is still quite young. The first shareholder proposals were submitted just over a year ago at Fidelity, who happened to be having shareholder meetings. The proposal came to a vote at 21 different funds at Fidelity. We were surprised that in this initial go-round the proposals did as well as they did. The proposal got between 20 and 31% of the shareholder vote, even though Fidelity actively and aggressively opposed it. We know that half the Fidelity shareholders who could vote threw their materials away and recorded no vote. We think that if those ordinary investors had looked at the ballot and seen there was an issue regarding investing in genocide, they would have voted in very large numbers for the proposal. Even with Fidelity’s insiders and institutional investors voting with management against the proposal, Fidelity had as high as 31% voting against management, representing some two million shareholders of record. We think that’s a great start. It’s only a question of time before we win.


We are expecting another large batch of funds with votes coming up this proxy season. We already know that the CREF part of TIAA-CREF has a vote in July. CREF’s members focus in education, health care and cultural groups and are probably even more attuned than the population at large to the issue of genocide. Traditionally, voting at CREF only garners 15% of eligible voters, so a relatively few people have opportunity to have lots of influence. So we think that this year we are very likely to see the same or significantly better results as more people recognize the opportunity to vote their values.


CH -- The premise that fund managers are assumed to have adopted is that restricting investments to genocide-free companies reduces the universe of investment opportunities in a way that gives their fund(s) a competitive disadvantage. Is there any data to support or refute this assumption?


EC -- If you read Fidelity’s statements very carefully, they do not say that they think that investing in PetroChina and the like are better investments. They couldn’t say that. Fidelity does not make the claim that if those few stocks are eliminated from their investment universe they would be at a competitive disadvantage. What they did say in their statement of opposition is that they are legally allowed to invest in PetroChina, but the resolution if adopted would require that they not invest in stocks they are otherwise legally allowed to purchase. That is a tautology, it is true, but it is devoid of meaning.


If they do fear they would be at a competitive disadvantage, they should check the data. The Sudan Divestment Task Force has looked at the two dozen companies they consider to be serious problems because of their involvement with the Sudan government’s genocide and did a study—posted on their website—to show the relative performance of those companies compared to their competitors. There is clear data that companies involved in Sudan did worse than their competitors. So the only data on the table argues for divestment. And if you think about it, that makes sense. The best companies with best management would be avoiding partnerships with regimes involved in genocide. If companies can’t avoid those problems, they are likely to have other serious problems affecting their performance.


CH -- That being the case, why are companies still holding these investments?


EC – All the major investment companies say the same thing: what they do is legal and they try their best to make money. We agree that those are good things. We are asking for one additional rule, which is to draw the line at genocide. For funds, adding that rule would be a change, and change is always a struggle. But funds need to come to grips with the fact that they operate in the real world, as we all do, and some moral judgments are appropriate, even for financial companies.


Now, companies may fear a slippery slope that if they care about genocide, what next would they have to care about? We are not campaigning for mutual funds to care about every social issue because there are lots of opinions about most of them. But genocide is a unique and terrible crime, universally decried as the worst crime against humanity, so we think it is appropriate to treat it as the singular rule to adopt and govern investment policy.


But let me give you a few examples of actions that companies have taken. Although Fidelity refused to establish policy for its company, one of their major fund managers, who had a very large position in PetroChina ($600 million) and Sinopec ($100million), sold all those shares during 2007. That divestment resulted in sales of nearly all the shares that Fidelity owned on the NYSE, though it continues to hold very large stakes in the same companies on the Hong Kong exchange. That fund manager is Will Danoff, the manager of Fidelity’s Contra fund, who went on to win an award from Morningstar as one of the fund managers of the year. What this demonstrates is that individual fund managers can make decisions about where they put their money. Will Danoff found plenty of good places to invest and didn’t need to invest in stocks that were connected to genocide. We applaud him for that action. He did not, however, make a statement about why he did it. So we didn’t get commitment to the policy, but we did see an excellent fund manager making the moral choice.


Another example later in 2007 is funds from Allianz Global who, after Fidelity, became the largest holder of PetroChina on the NYSE. Allianz’s NFJ Investments, a large US investment firm, during 3Q2007 sold every share they owned in PetroChina, amounting to $700 million. Again, Allianz did not make a statement about why they did it, but I suspect their action was related to the emails and private contacts that expressed concerns.


One other example of healthy decisions being made is T Rowe Price. It held shares in all four of the worst offenders – PetroChina, Sinopec, ONGC and Petronas. They made a decision to sell all their holdings in those companies, and over the course of a few quarters sold off a quarter-billion in holdings. At the same time they posted a statement on their website saying they thought it was appropriate to consider environmental, political and social factors and how those might affect financial values. That is a very high-level statement without much detail, but it is not a coincidence that it was made at the same time they completed divestment. They did not make a statement about genocide-free investing, but they did the hard part and got out of those stocks, so I congratulate them for taking that action.


What we are hoping to see over time is that T Rowe Price and Allianz—and even Fidelity—will make an explicit commitment to stay out of genocide-related stocks and satisfy their many millions of customers who want to support genocide-free investments.


The Hedge Fund Transparency Act 

In prior posts, The Race to the Bottom has discussed the growth, influence, and lack of regulation of hedge funds. Similar discourse occurred on the Harvard Corporate Governance Blog and the Wall Street Journal. On January 29, 2009, Senators Carl Levin (D-MI) and Chuck Grassley (R-IA) introduced The Hedge Fund Transparency Act. This post discusses how the bill is a reaction to previous hedge fund regulation.


Hedge funds are typically structured to avoid the strictures of the Investment Company Act of 1940As a result, hedge funds do not typically register with the SEC.  Unlike most mutual funds and other investment companies, there is little public information about hedge funds.  In 2004, the SEC, concerned over itslack of control, proposed The Hedge Fund Rule.


Rather than focus on the funds, the SEC instead opted to regulate hedge fund advisers.  Hedge fund advisers mostly avoided registration by relying on the exemption for advisers with fewer than 15 clients. Hedge funds only counted as one client.  Under the Hedge Fund Rule, however, an adviser of a "private fund" was required to count as clients all of the owners of the "private fund."  Private fund, in turn, applied to investment companies that would be subject to registration except for the exemption for funds with fewer than 100 owners, that allowed redemptions within the prior two years, and marketed the investment based on their skill.


By requiring registration of the adviser, the SEC's approach promised to provide hedge fund investors with the protections of the Investment Adviser's Act.  In addition, the registration requirement would have added a higher degree of transparency to the activities of hedge funds and their advisers.


The DC Circuit Court in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), however, struck down the Hedge Fund Rule, finding that it exceeded the SEC's rulemaking authority.  The court focused on how the Hedge Fund Rule expanded the term“client” to include the owners of the hedge funds.  Since the adviser's duties ran to the fund, not to the investors, the court viewed the interpretation as inconsistent with the statute and unreasonable.


As a result of the decision, hedge funds remained mostly unregulated.  With little SEC oversight, hedge funds became more influential on the market as their assets expanded.  Hedge funds in 2004, had 7.4 trillion dollars in assets, by 2007 they had amassed 10.7 trillion dollars in assets.


The Hedge Fund Transparency Act, if implemented, goes beyond the SEC's Hedge Fund Rule.  Funds with more than $50 million in assets, regardless of the number of clients, must file with the SEC.  Funds must disclose: the number of investors, the names and addresses of natural persons who are beneficial owners, the structure of ownership, and the current value of the fund.  The legislation focuses on the fund, instead of the advisers, avoiding the conflicts between an adviser, the fund, and its investors.  The legislation also requires the SEC to develop rules for an anti-money laundering program that hedge funds, regardless of asset value, will have to implement.


The bill is still working its way through the legislative process, subject to change and amendment.  In its current form, the legislation expands the SEC’s regulation of hedge funds.