Given that this is the final part of this 10 part series, it is appropriate to summarize the key take-aways from the visits with Senate Banking Committee members and staff.  They are organized by the encouraging observations, causes for concern, and the open questions.

Encouraging Observations: The Good Guys and Gals
The most encouraging observation is that there appear to be several Senators, House Members, and a President who are concerned about repeating the mistakes of the past. 

1. Senate: There are some very engaged Senators and staffers on the Banking Committee who want to prevent future financial crises. The one who stands out is Senator Jeff Merkley (and his fabulous staffer, Andy Green) from Oregon. A close second is Senator Kohl from Wisconsin, due to his stellar staffer, Harry Stein.
2. House Legislation: I am encouraged that the House did pass by a vote of 223- 202, H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009. Quite simply, there are at least 223 people looking out for the taxpaying middle class. The general topics this bill covers were identified earlier in this series.  You might want to see who supported this bill. Here’s the roll call for the vote. It is worth noting that there was not a single Republican “aye” vote and there were 27 Democrats who voted “no.” There were nine who did not vote at all. If you want to know the name of your Representative in the House, check here. 
3. House Hearings on Executive Pay: Moreover, at the House Financial Services Committee hearing on “Compensation in the Financial Industry,” many in attendance (at least one Republican and at least a half dozen Democrats) were very concerned about the way Wall Street is using the bailouts and back-door subsidies to the record of $140 billion in bonuses for 2009. One expert witness noted that some banks that received bailout funding (TARP) returned the money even though it lead to a decline in stock value. The implication is that the CEOs of those banks did this so that they would be able to make more money personally at the expense of their own shareholders.
4. Obama “Volcker Rule”: It was encouraging that the President heard the message that the public is frustrated with the slow progress on financial regulatory restoration, and though not as expansive as one would hope, the proposal does require action to be taken to help prevent the gambling and speculation at too-big-to-fail banks to avoid another massive economic crisis.

Causes for Concern

1. Taxpayers to Fund the Next Bailouts: I am not kidding you. It is true. The Senate plan is for taxpayers to fund the next bailout. In some Orwellian double speak, we heard from both Warner's and Corker's staff that no one wants another bailout, but that the funding to resolve a failing giant bank will come from the Treasury, capped to some degree, but open for Congress to increase the funding.
2. The Warner- Corker Bankruptcy Approach: As noted in detail in an earlier part in this series, bankruptcy instead of pre-funded receivership-type resolution is (1) not new; (2) not a resolution; and (3) not the free market approach, but just another taxpayer funded bailout.
3. Lack of Preventative Measures:  It was alarming to hear the staffer for Tennessee Senator Bob Corker (R) inform us that no preventative regulation was needed other than some transparency, and that she doubted that we would ever again have a situation where another large financial institution became insolvent. This was stated in the context of questions we raised about funding a resolution. In other words, this reflects a view, perhaps of her boss, Senator Corker, that transparency and the presence of more regulators with oversight (such as the Fed’s current oversight of investment banks that are now bank holding companies) would be enough to prevent a future debt-fueled asset bubble.
4. Power of the Big Banking Lobby: It was extremely distressing to find out that the lead Democratic Senator on the systemic risk/too-big-to-fail legislation appears more committed to satisfying the big banks than taxpayers, consumers, or the 5,000 community banks. This was evident, as noted above, when his lead legislative aid chose to meet with the President of the American Bankers Association instead of keeping the appointment with us. Indeed, the  banks may be okay with the ban on proprietary trading because they can easily get around the ban, according to former Goldman Managing Director, Nomi Prins.
5. The Obama proposal freezes firms as they are, but does not address their existing scope, scale, concentration or interconnectedness. Finally, many of the important measures for improving corporate governance (including shareholder empowerment), enhancing consumer protection, ending predatory lending, reforming credit rating agencies, creating transparency in the asset-backed securities markets, requiring registration of advisers of hedge funds, and other private pools, are not being addressed in the Senate. They are outside of the Warner-Corker team's scope or the President’s proposal. And, many excellent suggestions such as those by SAFER, Shareowners.org, and AFR are relevant and not yet being considered.

Open Questions

The Volcker Rule: The president declared that “Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.” There seems to be uncertainty as to what qualifies as “proprietary trading for their own profit, unrelated to serving their customers.” That might appropriately include all trading activities other those under which the bank has a “fiduciary duty." Expect this definitional space to be where the lobbying begins.

Meeting with Staff for Tennessee Senator Bob Corker (R)

Defensive Posture: Darlene Rosenkoetter was mostly answering our questions, not inquisitive, not engaged in thinking through the issues. Obviously a smart person, it appeared she was only behaving this way because she was in defensive mode.

Don’t Re-Invent the Wheel – Use the House Bill Model for Too Big to Fail Banks: Dana mentioned Kanjorski's approach in the House bill and said that it made sure the burden didn't fall on the taxpayer.

Prevention: Dana asked what the Corker-Warner team was doing about leverage, capital requirements and other preventative measures. Shockingly, Darlene said that the prevention plan was to have better disclosure and more people watching. She also indicated that they would never need to use the resolution authority due to this type of prevention sans any operational changes. This seemed uncanny.

Volcker Rule: She said that she had read about Volker/Obama, but indicated we'd have to see how it all fit in, in light of Massachusetts. However, she agreed that the discount window should not be open for those who engage in proprietary trading.

Warner-Corker Plan:  Darlene described the current state of the Warner-Corker legislative plan. The focus is on how to deal with too big to fail firms that start to fail. The concept would be to put them into bankruptcy first and possibly as a last resort resolution (i.e. receivership) by the government – similar to how the FDIC takes care of insolvent depository institutions. She explained that the decision whether a financial holding company would be sent the resolution pathway would be made within 24 hours after filing for bankruptcy. The deciders would be a panel from treasury, the President, and 2/3 of some other entity.  All firms would as a first step file, then the deciders would determine if the entity was systemically important. If so, it would go into resolution and out of bankruptcy. I had heard a different version of this elsewhere, that the criterion would be whether the firm was truly insolvent. This other source indicated that the “systemically important” test would happen upon bankruptcy filing – ie. If systemically important, then the special panel convenes to determine whether it’s insolvent. I’d also heard that it would not be a special panel, but instead a special court.

Community Banks: Rene of the ICBA made clear that they want a pre-funded receivership type resolution managed by the FDIC rather than bankruptcy for too-big-to-fail firms.

Who Pays?  Darlene did not know what the funding mechanism would be in a Chapter 11 scenario but did know a lot about funding for the receivership type solution. She said it would be ex-post by Treasury and that the US would get senior priority. We had a focused discussion about pre-funding. She explained the concern was moral hazard, but we pointed out that post-funding also creates an equal hazard.  She claimed there was bipartisan support for post funding. We pointed out that the American people don't want it another bailout even if there’s bipartisan support for it.

Meeting with Oregon Senator Jeff Merkley (D) and Andy Green:

Proprietary Trading: As Senator Merkley had only 15 minutes (before leaving for a press conference), we addressed what interested him. This was proprietary trading. He wanted to understand how this was central to the financial crisis. Merkley commented that the banks were having a good quarter due to their prop trading desks, but "what goes up, comes down." Clearly this was on his mind given the President’s emphasis in his “Volcker Rule” announcement that morning on ending proprietary trading at commercial banks. Andy had a very thoughtful perspective on how to categorize prop trading. In our discussion we added that it went beyond asset classes to also be risk due to the amount of leverage used and the liquidity problems -- using short term borrowing to finance long term assets. Andy also asked about the fire walls between the businesses wondering how that would work.

Too Big To Fail: Andy also asked questions about the benefits of a breaking up the banks (separating commercial banking from investment banking and restoring Glass-Steagall) as compared to the crisis management of  bankruptcy for insolvent financial holding companies. We made the same points about bankruptcy as compared to an FDIC-type resolution authority as we did above: It’s not new, it’s not a resolution and it’s really a bailout (if it’s not prefunded by the firms).

Bankruptcy vs. Receivership – the Warner-Corker Approach: We responded to the Warner-Corker plan of a presumption that too-big-to-fail insolvent firms would go through bankruptcy. The plan has been pitched as “not a bailout”. We disagreed with this positioning. We expressed concerns about the bankruptcy option along the following lines:

1. Not new: We already have Chapter 11 (restructuring). That's what Lehman did. Didn't work out so well and in fact create more market instability, asset prices collapsing and credit freezing. This is not a solution, it's a smokescreen. The time consuming aspects and the complexity make it a poor solution for handling failing systemically important institutions.
2. Not a resolution -- Resolution implies finality and a smooth, successful transition of a firm so that it does not damage the broader system and economy. In fact, 1 in 8 bankruptcies that start as restructurings do not result in a rehabilitated firm.
3. Not a free market solution -- In order for a chapter 11 to happen at all (as opposed to converting to a liquidation), bridge financing -- called DIP (debtor-in-possession) financing is needed. Firms that don't get it, fail. In good market conditions, there are lenders willing to do this in order to get priority. In a situation like Lehman (or GM), this did not exist. So, under this plan, would the US government provide the bridge financing? Isn't that a bailout?
4. Moral Hazard: CEOs get to stay in control and delay for another 180 days (at least) while they figure out a reorganization plan -- they get an exclusive.  With resolution by the FDIC, they  are pushed aside and not in control. This creates an incentive to not face reality when things look bad. Consider Dick Fuld in Sorkins’ Too Big to Fail. That is a case study in moral hazard and denial.
5. Creates more consolidation and more too big to fail institutions. Consider (as documented in Sorkin's TBTF) all of the mergers and deals that came about as the investment banks bargained in the shadow of bankruptcy. No one is going to do any kind of helpful lending to a firm in a death spiral unless they get something -- often a big piece of ownership or a full merger and control. So, it's either taxpayer funded financing or  private funding and more consolidation.
6. Forum Shopping: Bankruptcy courts are not uniform in their treatment.

Other Issues/Securitization: Jane discussed the erosion of capital due to the mark-to-market accounting applied to traditional banking (as opposed to trading where it is appropriate).  She also discussed the Bank Holding Company Act of 1956, the One Bank Holding Company Act of 1970. This came up because Andy voiced concerns (that others had raised) re the failure of the S&Ls after the monetary control act eliminated Reg Q.

International Competition:  He was very interested in the problem of international competition. Will the UBS of the world crush the US banks if the Volcker rule becomes law? 

Meeting with Michelle Maiwurm, Staff for Virginia Senator Mark Warner (D):

Less Engagement: Unlike the first two meetings where the staff proactively began the discussion with pointed questions and were very prepared to engage in this issues, Michele made clear that she was either not authorized to say much or that she was not knowledgeable of the details. The person who was supposed to meet with us, as noted above, decided to instead meet with the president of the American Bankers Association, the lobbying group for big banks.

Draft Language Expected by end of February: When asked how far along they were and whether Warner was open for input she quoted Warner’s Republican counterpart, Corker as saying in the Congressional Quarterly: "We don’t have a deal until we have a deal." That said, she indicated that Corker-Warner were pretty far along in the process and would have a draft by the end of February and a mark-up in March. She also made clear that the go-it-alone approach Dodd initially attempted was a non-starter.

Bankruptcy vs. Receivership: We discussed the bankruptcy default/resolution plan. She said that any financing of the failing firm would be capped and then Congress would have to authorize the additional funding. She said Warner does not want another bailout, but Jerry pointed out this looks like a "backdoor bailout" if it is funded ex post. We also made the points identified above from the Merkley meeting.

Community Banks: Rene (from the community bankers association) made clear that ICBA wants an FDIC type resolution process that is clear and wants authority consolidated at the FDIC.

Prevention: Jerry also discussed the need for preventative measures -- i..e there is concern that all they've focused on is the resolution/TBTF issues and not the leverage restrictions etc. that are part of the Volcker Rule.

Don’t Re-Invent the Wheel – Use the House Bill Model for Too Big to Fail Banks: AFR (Dana) mentioned the Kanjorski amendment and the wisdom in benefiting from the other chamber. See previous part of the series for more details.

What follows is a more detailed synopsis of the content of our discussions during our January 21^st meetings with members of the Senate Banking Committee:

Meeting with Harry Stein, Staff for Wisconsin Senator Herb Kohl (D)

Massachusetts Senate Election: The meeting began with Harry describing the financial reform legislation as being in a "weird holding pattern due to Massachusetts"- meaning Tuesday's special election of Scott Brown. However, he added that Senator Dodd had already been committed to a non-partisan bill.
 
The “Volcker Rule”: We next discussed what we knew of the "Volcker Rule". Harry had not read the full news story yet, though knew generally about it. He was interested in details. AFR briefed him on the key points: reducing size and complexity, ending proprietary trading (and hedge fund ownership) at commercial banks, leverage limits, limiting growth through new cap on liabilities.  He remarked that this was not a Glass-Steagall separation. We also noted that it seemed that non-depository institutions would not have access to the discount window.

Derivatives: Harry suggested there was consensus on exchange-trading and central clearing of standard derivatives. But, he was also very interested in opposing points of view. He had heard that end-users preferred over-the-counter (OTC) because they would not need to post collateral/margin. AFR mentioned that some end users were actually in favor of the exchange/clearing plan.  I raised the possibility of an outright ban on naked credit default swaps (where the buyer does not own the underlying debt instrument – or reference credit – that is insured). I  also mentioned the Henry Hu/Bernard Black article about the problems in bankruptcy when a creditor owns both CDS (betting/hoping the entity will default) and is also on the creditors' committee and has an incentive to run the firm into the ground instead of rehabilitation.

Don’t Re-Invent the Wheel – Use the House Bill Model for Too Big to Fail Banks: AFR (Dana) mentioned the Kanjorski amendment and the wisdom in benefiting from the other chamber. This amendment, introduced by Paul Kanjorski (D, 11^th District of Pennsylvania), which passed the Committee on November 18^th   was part of the final bill approved by the house in December (HR 4173).  This would empower regulators to take precautionary measures concerning “too big to fail” financial institutions before they fail. This would include the power to preemptively break up big banks. This power to examine and break up such banks would rest with the Financial Services Oversight Council (instead of the Fed). Unlike the original house bill, this would consider not just size and scale to be critical factors, but also interconnectedness and concentration.

Resolution Authority (Bankruptcy vs. Receivership): We turned to the topic of resolution authority and the questions: who does resolution and how is it done. This led to a discussion of the Warner-Corker plan. We challenged the idea that bankruptcy was really (1) new; (2) a resolution and (3) a free-market solution as opposed to a back door bailout. (More on this below).

Credit Rating Agencies: Next, we discussed credit rating agencies and mentioned the "public option" plan endorsed by shareowners.org.

Leverage Restrictions: We talked about leverage restrictions only being meaningful if the accounting is honest, including getting short-term borrowing (commercial paper, repurchase agreements etc.) on balance sheets.

Fluency in non-verbal cues is a prerequisite for comprehending Washington politics.  Late on Thursday evening, as I looked back on the day, I realized there seemed to be a direct correlation between physical proximity to a Senator and how our views (and those of Americans for Financial Reform and the Independent Community Bankers Association) were valued.  The most productive meetings were those where either the Senator showed up or the meeting was in his office conference room. One of the least promising was the one where we were down the hall and ultimately kicked out of the room by a senior staffer who was supposed to meet with us but instead was meeting with Edward L. Yingling, President of the American Bankers Association, an extremely influential big bank lobbyist. For more on his role in dismantling our regulatory structure, you might read, Dan Geldon's Why Is Anyone Listening to Ed Yingling? And, the most memorable, but hopeless was the one where we were consigned to a dimly lit basement cafeteria, enveloped in the sweet, stale smell of buttered popcorn.

Thursday, January 21^st meetings:

(1)   Senator Kohl: We met with Harry Stein, senior legislative staff for Wisconsin Senator Herb Kohl (D). The meeting was held in one of the Senator’s conference rooms at 11:00 a.m. We moved mid-meeting into another one of the Senators’ conference rooms so that we could watch President Obama’s press conference on the Volcker Rule. Harry was extremely knowledgeable and engaged and inquisitive. He took notes, asked questions. We had a real conversation with him.

(2)   Senator Merkley: We met with Oregon Senator Jeff Merkley (D) and his legislative counsel, Andy Green. The meeting took place in the Senator’s own office at 2:00 p.m.. Senator Merkley stayed with us for about 15 minutes, and then left for a press conference. The Senator and Andy were smart, engaged, challenging. He asked tough questions, had great ideas and clearly valued our visit.

(3)   Senator Warner: We met with Michelle Maiwurm, senior legislative correspondent for Virginia Senator Mark Warner (D). The meeting was held in a conference room down the hall from the Senator’s office at 3:00 p.m. We were supposed to meet with a different staffer who was the lead person on this topic. However, he decided instead to meet with the President of the American Bankers Association. Some might see this as a slight, demonstrating where the priorities are in that office. Big banks ranked higher over both community banks and American consumers. Michelle started the meeting by admitting she was not the key person on the issue and was not sure what she was at liberty to share. She was very smart and polite, but in a defensive posture the whole meeting. She took very few notes.

(4)   Senator Tester: I did not attend this meeting with the Montana Senator Jon Tester (D), though Jane D’Arista did. Jerry Epstein and I were at the meeting with Warner’s staff.

(5)   Senator Corker We met with Darlene Rosenkoetter, legislative staff for Tennessee Senator Bob Corker (D). There was no available space in the Senators’ conference rooms or down the hall. So, we had to journey to the basement to a dimly lit cafeteria known as the Senate Chef for our 4:00 p.m. meeting. She was authorized to speak, however she was also in a defensive posture and took very few notes. When it came down to details, she had them, but when it came down to responding to questions about faulty logic, she chose to respond “we have bipartisan support” instead of thinking through a solution with us.

Early in the morning of January 21, news appeared that President Obama was prepared to announce a plan to get tough on the banks. At a press conference in the late morning, the President announced his plan, known as the "Volcker Rule."

Battle in the White House:
According to my around-the-Capitol sources, the President named his approach after economic adviser and former Federal Reserve Chair, Paul Volcker after a fierce debate in the White House. The winners included Paul Volcker and Vice President Joe Biden. The losers included Lawrence Summers (former Treasury Secretary and current Director of President Obama’s National Economic Council) and Tim Geithner (current Treasury Secretary). As per many news sources leading up to the announcement, Paul Volcker has been advocating that we break up the too-big-to-fail banks. Many on both ends of the political spectrum agree with Volcker. Consider the ultra-conservative Wall Street Journal editorial page’s endorsement of breaking up the banks, as well as progressive thinkers.

Causes of the Economic Crisis and the Bailout Remembered
 Frustrated that Wall Street was “still operating under the same rules that led to its near collapse,” President Obama remembered the causes of the crisis.

“This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses.  When the dust settled, and this binge of irresponsibility was over, several of the world's oldest and largest financial institutions had collapsed, or were on the verge of doing so.  Markets plummeted, credit dried up, and jobs were vanishing by the hundreds of thousands each month. We were on the precipice of a second Great Depression. "

"To avoid this calamity, the American people -- who were already struggling in their own right -- were forced to rescue financial firms facing crises largely of their own creation.  And that rescue, undertaken by the previous administration, was deeply offensive but it was a necessary thing to do, and it succeeded in stabilizing the financial system and helping to avert that depression.”

The Volcker Rule itself (as explained in his speech):

“Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that's something they're free to do.  Indeed, doing so –- responsibly –- is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people."

"In addition, as part of our efforts to protect against future crises, I'm also proposing that we prevent the further consolidation of our financial system.  There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank.  The same principle should apply to wider forms of funding employed by large financial institutions in today's economy.  The American people will not be served by a financial system that comprises just a few massive firms.  That's not good for consumers; it's not good for the economy.” (emphasis added)

Limiting Access to Cheap Money Through the Federal Reserve Discount Window

The President also addressed blocking non-depository institutions from access to cheap money through the Federal Reserve:  “Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks.  We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression. 

"But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage.  When banks benefit from the safety net that taxpayers provide –- which includes lower-cost capital –- it is not appropriate for them to turn around and use that cheap money to trade for profit.  And that is especially true when this kind of trading often puts banks in direct conflict with their customers' interests."

"The fact is, these kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong.  We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.  And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.”

Prior to our visit, financial regulatory reform had progressed in the House, but stalled in the Senate.

House Reform Bill Passed in December
In December of 2009, the full House of Representatives passed by a vote of 223- 202, H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009. The bill, if ultimately enacted, would among other things: (1) create the Consumer Financial Protection Agency, (2) establish an inter-agency financial stability oversight council, (3) authorize a dissolution (receivership) authority and process for shutting down “too big to fail institutions” before they cause harm – and this would be prefunded through fees assessed on financial firms, (4) give shareholders an advisory vote on pay (“say on pay”), access to the proxy, a vote on merger related golden parachutes, requirements for certain institutional investors to disclose how they voted on these matters and allows regulators to ban risky compensation practices, (5) strengthen SEC powers to protect investors in light of the Madoff scandal, (6) regulate derivatives by requiring standard swaps (between dealers and major swap participants) to be traded and cleared on an exchange or electronic platform, (7) prohibit predatory lending and reform mortgages, (8) reform credit rating agencies, (9) require advisers to hedge funds and other “private” pools of capital to register as advisers, and (10) create an office of insurance.

Reform is Currently Stalled in the Senate
The reform effort has stalled  in the Senate. In November, Senator Dodd introduced the Restoring American Financial Stability Act of 2009. Dodd received tremendous push back within 48 hours. He then was forced to start over completely with a fully bi-partisan process. He established four different teams. Each team had a Democratic and Republican Senator. Each team was given a different topic to address. Some topics were preventative, others crisis management. The only team that had made meaningful progress is being lead by Virginia Senator Warner (D) and Tennessee Senator Corker (R). The Corker-Warner team owns the topic “too big to fail/systemic risk.”  The Corker-Warner plan appears to have no preventative measures. This (and the Brown victory-kick-in-the-pants) undoubtedly motivated President Obama to speak up on Thursday.

This Corker-Warner approach is described in the Wall Street Journal: “It would create a ‘presumption’  that large, failing financial companies would have to go through a new bankruptcy process. This is different than what the White House proposed, which would give the government immediate control to put large, failing firms through a government-controlled resolution. The Warner/Corker deal would give the government the option to still put failing firms through a government-structured resolution, but they would have to clear hurdles first and it would be a bit more complicated.”

Based upon our discussions (detailed later in the series), this seems to be the Emperor's New Clothes approach as it authorizes another taxpayer funded bailout.

Ten Steps for Restoring Financial Stability:
Beyond the action in the House, Senate and White House, there are other reforms being discussed, including on the SAFER and AFR websites. A useful top 10 list can be found with the shareowners.org recommendations. Shareowners’ ten steps are: (1) “Break up financial institutions that are too big to fail"; (2) “Split commercial and investment banking"; (3) “Create a public-option rating agency"; (4) “Restrict investment banks’ and hedge funds’ access to pension and retirement assets without investors’ approval"; (5) “Restrict Wall Street firms from listing as public companies"; (6) “Bring transparency to the dark corners of the financial markets"; (7) “Strengthen corporate governance and regulatory oversight"; (8) “Clarify and enforce the duties and responsibilities of financial intermediaries"; (9) Protect consumers of financial products; and (10) “Simplify financial market structure.” This is a terrific list. I would also add some concepts I identified in a recent paper entitled Enablers of Exuberance: The Legal Acts and Omissions that Facilitated the Global Financial Crisis. That was a preliminary paper with a limited scope and I have more ideas that will find their way into a book I’m writing on this subject. For full disclosure, in addition to being a participant in SAFER, I am also a member of shareowners.org.

The Need for Financial Regulatory Reform
Boom and bust cycles are not necessary attributes of a healthy, stable economy. After the New Deal legislation was enacted following the Great Crash of 1929, the United States managed to exist for nearly 50 years without a major panic or crash. By the 1980s, the regulatory structure needed some updating. Cracks in the foundation appeared with the S&L Crisis of the 1980s and then later in the accounting fraud (Enron) meltdowns of the late 1990s and 2000s and the 1998 crash of giant hedge fund Long Term Capital Management. Each of these events should have served as warning signs that we needed to strengthen our regulatory supports so the whole edifice did not collapse. Instead, zealous advocates of unbridled free markets and unchecked managerial control (at the expense of good corporate governance, shareholder rights and systemic stability) influenced policy decisions and instead of repairing the vulnerable points, we weakened the supports. Don’t just take my word for it. Read Alan Greenspan’s testimony on this – he certainly had a turn-around after the 2008 meltdown. In addition, another good source on this is the Congressional Oversight Panel special report on regulatory reform or a draft paper of mine on this topic.

Additionally, after the massive up front and back door bailouts of the banking system (see Nomi Prins chart detailing the bailouts and subsidies), there is now what’s known as an “implicit guarantee” of giant banks. Because there is an expectation that the government will bailout these giant banks in the future due to their interconnectedness, their sheer size and the bad consequences of letting Lehman fail, these big banks can borrow money from private counterparties more cheaply than they should. This fuels growth and makes them even bigger. Thus one goal of the legislative reform is that “too big to fail” should mean “too big to exist.”  And, those who want to restore financial stability have also targeted the role of compensation systems in creating perverse incentives for short term, debt-fueled speculation and illusory short-term gains at the expensive of both long-term shareholder value and the stability of the entire financial system. This is but a very general overview, not a comprehensive list.

On Thursday January 21^st, we met with members of the Senate Committee on Banking, Housing and Urban Affairs (referred to herein as the “Senate Banking Committee.”)  The purpose was to gather information on the status of financial reform legislation and to provide expertise and analysis where asked. Given my professional experience (formerly an Associate General Counsel at Fidelity Investments) and my current research agenda, SAFER co-founders Gerald Epstein (U-Mass) and Jane D’Arista (PERI) invited me to join them.

Perfect Timing
The visit was planned the prior week and was not a result of: (a) Scott Brown’s stunning victory in the Tuesday Massachusetts Senate election, (b) President Obama’s announcement on Thursday of a plan to get tough on the banks, the “Volcker Rule” ; (c) the Supreme Court’s 5-4 decision Thursday in Citizens United, to strike down the limits on corporate political spending; or (d) Friday’s House Financial Services Committee Hearings on “Compensation in the Financial Industry,” where witnesses included two corporate governance gurus and one Nobel Laureate  (Nell Minow, Lucian Bebchuk and Joseph Stiglitz.)  However, it was an astonishingly intense two days to be in Washington as a result of all four events.

Senate Meetings Arranged by Americans for Financial Reform
The meetings were arranged by the leadership at Washington-based Americans for Financial Reform (AFR), a coalition of over 200 organizations, including AARP, NAACP, Center for Responsible Lending, AFL-CIO and many others. Dana Chasin of AFR joined us in our meetings. Rene Rappaport of the Independent Community Bankers Association (ICBA), representing 5,000 community banks attended two of our meetings. Ellen Taverna of NACAA attended one.

SAFER
SAFER stands for Economists’ Committee for Stable, Accountable, Fair and Efficient Financial Reform. SAFER was founded in September of 2009 and “is a focal point, clearinghouse and coordinating mechanism for progressive economists and analysts to gather and present their views on financial re-regulation and reform.” SAFER participants and contributors are identified here . You might recognize SAFER participant Rob Johnson as the co-author with Arianna Huffington of the “Move Your Money” project. In addition to publishing a variety of policy notes and policy briefs, SAFER participants’ views have appeared widely in venues including the New York Times, the Huffington Post, the Nation and the Real News Network. SAFER members have also testified before Congress.

We return to Judge Posner's conversion.  Adhering to Mark Twain's observation in Connecticut Yankee (p. 58), the jurist allowed the facts to modify his views. 

The same ought to be true of Delaware.  What are the facts?  Financial institutions engaged in excessive risk taking, resulting in the current economic carnage.  Financial institutions paid excessive compensation, with formulas often promoting a short term, high risk approach to management.  Boards were largely absent from the process, acting as little or no check on these practices

As we have noted, the lack of board involvement isn't irrational.  Directors have every incentive to do what is in management's best interest.  Given the often lucrative compensation paid to directors, they rationally would like to keep the positions.  They would, therefore, be aware of the types of behavior that can result in removal.  

In that regard, they need not worry about shareholders.  Shareholders have no real authority to remove directors.  Proxy contests almost never occur.  Majority vote provisions leave the board with the discretion to retain the defeated directors.  Indeed, in a study by Riskmetrics, none of the 93 directors in the Russell 3000 who did not receive majority support in 2009 left office because of this shareholder vote.  See Riskmetrics Risk & Governance Blog ("Despite this surge in majority withhold votes, it does not appear that any of the 93 directors have stepped down as a result of investor dissent."). 

The only way directors of public companies can be effectively removed from the board is not to be renominated by the board.  Since the CEO has disproportionate influence on the nominating process (not withstanding SEC efforts to limit this through the use of disclosure, see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure), directors have every incentive to keep managers happy, not shareholders.  As a likely result, there is less oversight of management than what shareholders would like and less restraint imposed on executive compensation.

Yet despite this obvious dynamic and despite the facts, Delaware has not "modified" its view.  The legislation and decisions coming out of Delaware continue to espouse the pre-crisis philosophy that resolutely favors management.  The current evidence of excess has not changed this view. 

Perhaps the failure to evolve is merely myopic.  Perhaps it is supported by a logic that is not readily apparent.  The solution is likely to be a creeping federalization, with Congress stepping in to rectify what the state will not, perhaps there is an alternative solution. 

In truth, Delaware's best chance of warding off federal intervention and retaining its preeminent position it the corporate governance debate is to concede past mistakes (ala Judge Posner) and accept that the facts of the current financial crisis have shown the need to abandon or modify old approaches.  A somewhat tougher approach to compensation and a somewhat more rigorous approach to board oversight would not significantly change the balance of authority.  Indeed, in many cases, directors would likely welcome the judicial tools necessary to restrain compensation practices.  Yet these modest reforms would remove much of the pressure for reform. 

But they require change and, as the New Yorker article indicates, some have evolved (Judge Posner) while others have not.  Delaware apparently falls into the latter camp. 

So, with the Chicago School in retreat and Judge Posner undergoing conversion, we turn to the Delaware model of corporate law. 

Despite Chief Justice Steele's protestations to the contrary ("It’s important to let people know about Delaware law and to correct the inaccurate view that some have that Delaware is pro-management."), the Delaware approach to corporate governance is pro-management both in its philosophy and its result. 

With respect to philosophy, the Chief Justice acknowledged in the same interview that he adheres to a “'contractarian' view of the law" and one where he expects "to continue writing more about the principles of freedom of contract."  Yet to the extent this contractarian approach suggests some type of negotiating between shareholders and managers (private ordering, in other words), the Chief Justice is adhering to a decidedly pro-management position.  As a matter of empirical evidence, shareholders, at least in public companies, have little ability to "bargain."  Thus, the output from "bargaining" reflects not a give and take of contract negotiations but positions of managment who entirely dominate the process.  This was discussed at length in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  In other words, the contractarian approach often means the right of management to impose. 

The pro-management bias can be seen in the actual ouput of the state courts and legislature.  Over the last quarter of a century, there has been considerable erosion of shareholder rights.  The duty of care is gone, killed both by judicial interpretation (Disney is the poster child) and the adoption of Section 102(b)(7), where "private ordering" and a contract approach to corporate governance resulted not in give and take negotiations but in a categorical rule eliminating damages for breach of the duty of care.  See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  With respect to the duty of loyalty, particularly executive compensation, requirements of fairness have been all but eliminated, with the result that companies can pay compensation without effective limits.  See Returning Fairness to Executive Compensation. 

Despite total compensation that can climb to around $700,000, directors are legally allowed to maintain an ostrich approach to governance (Citigroup is the best recent example) and need not be informed about contractual provisions that limit the franchise of shareholders.  Derivative suits mostly turn on the independence of the board yet the courts have adopted standards (particularly excessive pleading standards) that prevent any meaningful exploration of the concept of director independence.  The result is that non-independent boards are treated as independent and derivative suits routinely dismissed.  See Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

Inspection rights have been emasculated through the use of the credible evidence standard.  Owners can't exercise their inspection rights to look at materials that were used by the board in paying what was arguably excessive compensation or in refusing to accept the resignation of directors who did not receive majority support from shareholders.  The requirement that shareholders must prove bad faith to recover attorneys' fees in inspection rights cases effectively means that litigation has become a routine expense associated with the exercise of inspection rights and one that effectively limits exercise of the rights. 

The Blasius standard is under assault.  The court declined to apply it in Axcelsis.  VC Strine in Mercier has suggested that it be scrapped and transformed into the far more malliable and pro-management standard.  Equal treatment of shareholders of the same class was eliminated in Unocal. 

With law and economics no longer sustaining this pro-management philosophy, what justifies the approach?  We will address that in one final post on the subject. 

The New Yorker has an article (Chicago School Betrayal) that highlights the conversion of Judge Posner away from the Chicago School of economic theory, particularly its disproportionate reliance on the market (rather than more invasive approaches such as increased regulation) as the solution for all problems. 

For anyone marginally familiar with the current financial crisis and Judge Posner's opinion in Jones v. Harris, the conversion is widely known.  Whatever one may think of Judge Posner's opinions in general, it is clear that he has allowed the present circumstances to modify his views.  In other words, he did not stick to a theoretical approach once the facts demonstrated otherwise.  Or, as Mark Twain observed in Connecticut Yankee (p. 58):  "This was the report; but probably the facts would have modified it."  Judge Posner allowed the facts to modify the report. 

One can quibble on the timing.  It was an overdue revelation.  The law and economics approach to corporate law had been on life support even before the current crisis. The Chicago School both relied on the Delaware approach to corporate law (an enabling approach for management) and placed disproportionate reliance on the market for corporate control as the mechanism to discipline inefficient management (thereby eschewing the need for regulation). 

The very enabling approach supported by these adherents ultimately undercut their entire theory.  The Delaware courts "enabled" mangement to use defensive measures (mostly poison pills) to all but shut down hostile tender offers.  With the hostile market for corporate control eviscerated, there was no meaningful market disciplining mechanism that could be used to support reliance by the Chicago School on the corrective ability of the market.  All of this is discussed in greater detail in The Irrelevance of State Corporate Law in the Governance of Public Companies.  Without a market disciplining method, adherents to the Chicago School in the corporate area have had a tough time justifying how the market can ensure efficient systems of management and corporate governance. 

Nonetheless, while it may have taken a financial crisis to alter his views, Judge Posner has done so.  The same can't be said for a number of other prominant adherents to the approach. We have yet to hear a mea culpa from Daniel Fischel and, from the tone of Judge Easterbrook's opinion in Jones v. Harris, he has moved little in his views despite the "facts" produced in the current crisis.  Jon Macey at Yale and I had a mild go round on the merits of the market v. regulation on CNBC (Bonuses, Do They Get It?  Street Signs, CNBC, Thurs. Dec. 10 2009).  Macey's recent and thoughtful book on Corporate Governance acknowledges the well known problems with the board of directors (particularly capture by the CEO) but continues to rely on the market as the best method for ensuring proper governance (read efficiency). 

And, while the phrase "law and economics" has fallen into disuse, many of the ideas have been repackaged in the form of "private ordering."  In effect, private ordering has become to law and economics what "intelligent design" became for creationism.  And, the drum of private ordering has been particularly loud with respect to the SEC's efforts with shareholder access (see Majority Voting, Delaware Statutory Reform, and Shareholder Access to the Proxy Statement: A Comment to the Securities and Exchange Commission ), it suffers from the fundamental flaw of the Chicago School:  There is no market.  See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.

Yet this same movement (the Chicago School) in fact provided the intellectual justification for Delaware's approach to corporate governance.  In effect, Delaware could claim that its pro-managment approach was the most efficient approach.  Yet, back to Mark Twain, the facts ought to conclusively modify this view.  We'll consider this in the next post.

The system of corporate governance in the United States has many positive aspects.  The degree of disclosure in this country likely exceeds all others.  But there is one place where the development of the law has bordered on the irrational.  In a country of 300 million people, the substance of most aspects of corporate governance are determined by the State of Delaware, a tiny place geographically (save Rhode Island, it is the smallest state in the country) and demographically (the 45th smallest state based upon the 2000 census). 

It is also a state with a financial incentive to skew the law in a manner that maximizes revenue.  Foreign corporations allow Delaware to avoid charging a sales tax.  As we quoted in an earlier post:

• The revenue that the legal industry generates for the State of Delaware is also of vital importance to the First State and its residents as well. Over $709 million or 21.6 percent of all of the state's general fund revenue in fiscal year 2007 came from the corporate franchise tax and related fees. Corporations generated another $15 million in special fund revenue and about $10 million for local governments.

This represents only a portion of the economic benefits gained by the state.   Yet this is the state that determines the standards for board behavior in the largest companies in the country (and the world). 

The results are predictable.  Incorporation in Delaware usually means reincorporation.  Reincorporation is ordinarily done through a merger.  Under the laws of all 50 states, a merger can only be initiated by the board of directors.  States that want to attract corporations (and their tax dollars) must appeal to management.  Delaware does that with a law that is extraordinarily pro-management in its orientation. 

This can be seen from the cases decided in 2009.  The cases selected as the worst have a decidedly pro-management flavor.  They reaffirmed the ostrich approach, permitting management to remain unaware of critical matters within the corporation, including those that affect the voting rights of shareholdes or the solvency of the company.  They continued to deny shareholders the right to information on matters of clear importance to owners.  Finally, they continued to diminish the role of the duty of loyalty, despite clear circumstances suggesting a conflict of interest. 

The cases explain why the process of creeping preemption of corporate governance continues.  Bills in the House and the Senate would once again preempt Delaware law in connection with compensation committees, compensation consultants, and, if the Senate Bill gets adopted, with respect to the test for excessive compensation.  A review of the worst five decisions for 2009 illustrates why this is occurring. 

There is a problem of diversity in the board room.  There are few women CEOs.  Only slightly more than 10% of the directors are women or people of color.  This compares with countries like Norway that have legislatively commanded companies to increase gender representation on their boards to at least 40% (a change that appears to be working). 

The lack of diversity is harmful.  It ensures that boards will be filled with persons coming from similar backgrounds with similar views.  It deprives CEOs of a wider range of views that could improve the effectiveness of decisionmaking.  

A similar lack of diversity exists within the Delaware courts.  The judges on the Supreme Court and Chancery Court have almost identical backgrounds.  There is only one woman.  There are no people of color.  Most come from defense oriented law firms.  In other words, when they address corporate governance legal issues, there is little that would suggest a diversity of views or considerations. 

Nor does there seem to be much impetus to change.  This year a Chancery Court judge resigned.  The pool of applicants seeking the position consisted mostly of lawyers with similar backgrounds.  There were no people of color and only one woman.  The prize, as it always does, went to a Caucasian male with a mostly defense oriented background.

Diversity on the court might well result in judges with a broader viewpoint.  Like diversity in the boardroom, diversity on the court might improve the decision making process.  This in turn would enhance the credibility of the court on matters of corporate governance and perhaps slow the rapid pace of federal preemption.

When asked about changes in the legal profession and the lawyers practicing before the Delaware courts, Chief Justice of the Delaware Supreme Court explained that:  "The Bar is much more diverse than it was in 1970 or even in 1990 and it is becoming increasingly so, which is a positive factor."  Perhaps that diverse bar will one day have a diverse court to consider its views. 

The Chancery Court in 2009 confronted the board's responsibility for the crisis plaguing the financial markets.  The crisis arose in part out of excessive risk taking by large financial institutions.  Few suffered more than Citigroup.  The financial conglomerate came close to failure and had to be rescued by a large capital infusion from the federal government.  In addition to purchasing non-voting preferred shares, the US government ultimately acquired around 34% of the voting shares of Citigroup.

Shareholders sued the board of Citigroup alleging that the board should have played a larger role in preventing the financial conglomerate from taking on so much risk.  The plaintiffs alleged that the board had plenty of "red flags" that alerted it to the problems in the subprime lending market yet took no steps to address the concerns. The board had staked out a role in assessing corporate risk having established an Audit and Risk Management Committee (ARM Commitee).  

The case involved two discrete issues.  The first was whether the board could be charged with awareness of the problems of excessive risk and, in the face of these concerns, had consciously disregarded the risks.  This issue turns on what the board knew and whether it had a duty to act.  The claim is grounded in bad faith.

The second was whether the board had a duty to know about the excessive risk taking.  It was more than a generic claim that boards had a duty to be informed about risk taking.  Plaintiffs claimed that the board failed to “make a good faith attempt to follow the procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup’s risk to the subprime mortgage market.” Specifically, the plaintiffs asserted, among other things, that the ARM Committee had responsibility to:

• Discuss with management Citigroup’s major credit, market, liquidity and operational risk exposures and the steps management has taken to monitor and control such exposures including Citigroup’s risk assessment and risk management policies;

In short, plaintiffs alleged that the board had responsibility for risk oversight and failed in that responsibility.  

The case presented the Chancery Court with an opportunity to discuss the oversight responsibilities of the board.  It also gave the court an opportunity to define the types of information that ought to be reported to the board in order for it to fulfill its oversight function.  Nothing of the kind occurred. 

The court turned the case into something that it was not.  Instead of focusing on inadequate process, as plaintiffs alleged, the court characterized the cause of action as simply a hindsight attempt to impose liabilty for a decision that turned out badly. 

• When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company.

In fact, it was nothing of the kind.  Indeed, the board never made a decision that could be reviewed under the business judgment rule.  Plaintiff's claim was one of faulty process, exactly what the court typically requires in these circumstances.  It was about whether the board should have considered the relative risks, having formed a board committee assigned the task of doing so.  Had the board considered the relative risks and made a decision to go forward, the decision almost certainly would have fallen under the business judgment rule and almost certainly would have been insulated from liability.

Even worse, the court actually limited Caremark to the oversight of fraudulent and criminal conduct by employees, specifically disclaiming any obligation of the board to participate in risk assessment. 

• There are significant differences between failing to oversee employee fraudulent or criminal conduct and failing to recognize the extent of a Company’s business risk. Directors should, indeed must under Delaware law, ensure that reasonable information and reporting systems exist that would put them on notice of fraudulent or criminal conduct within the company. Such oversight programs allow directors to intervene and prevent frauds or other wrongdoing that could expose the company to risk of loss as a result of such conduct. While it may be tempting to say that directors have the same duties to monitor and oversee business risk, imposing Caremark-type duties on directors to monitor business risk is fundamentally different. Citigroup was in the business of taking on and managing investment and other business risks. To impose oversight liability on directors for failure to monitor “excessive” risk would involve courts in conducting hindsight evaluations of decisions at the heart of the business judgment of directors. Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.

The analysis suggests that even if the board had red flags suggesting excessive risk taking, there was no duty or responsibility to act.  The suggestion contradicted longstanding and conventional wisdom that boards had a duty to act anytime they were put on notice of circumstances that could result in serious harm to the corporation.

The case was considered upon a motion to dismiss for the failure to make demand, a pre-discovery motion.  Thus, to escape dismissal, it was not enough to show the existence of a board risk oversight committee and an affirmative obligation to "monitor" risk exposure.  As a result, plaintiffs were never given the opportunity to explore what the board knew about the risks and what steps it had taken, if any, to address the concerns.  Ironically, this inabilty was in fact held against them.  As the court noted:  "Indeed, plaintiffs’ allegations do not even specify how the board’s oversight mechanisms were inadequate or how the director defendants knew of these inadequacies and consciously ignored them."  

In the end, the case may have a beneficial effect.  By essentially exonerating the board from any role in risk assessment, it provided considerable impetus for federal intrusion into the area.   The SEC has intervened, requiring companies to disclose “the extent of the board’s role in the risk oversight of the registrant, such as how the board administers its oversight function, and the effect that this has on the board’s leadership structure.”  Item 407(h), 17 CFR 229.407(h).  Senator Schumer's Shareholder Bill of Rights mandates a role for the board in risk assessment.  

With all of that in mind, on to In re Citigroup.  As usual, we have posted primary materials on the DU Corporate Governance web site.

In the discussion over shareholder access -- the right of shareholders to include their nominees in the company's proxy statement -- opponents have often pointed to majority vote provisions as if their existence somehow eliminated the need for access.  Majority vote provisions are, as we have noted, a myth.  They entail no additional authority for shareholders.  Instead, they augment the board's authority by allowing them to decide whether or not to retain a particular director. 

As much as we have tried on this Blog to demonstrate that, with respect to majority vote provisions, the emperor has no clothes, it was the Delaware Chancery Court that made the point in the most unequivocal language.  City of Westland v. Axcelis was an inspections right case.  Axcellis had in place a majority vote provision.  Shareholders successfully denied a majority to the three directors running for election.  The directors dutifully submitted their letters of resignation.  The board, however, rejected the resignations, allowing the directors to remain on the board.

Shareholders sought to inspect the records to better understand the basis for the board's decision.   They asked for minutes and agendas of meetings where the matter was discussed and any documents considered by the board in connection with its decision.  The request was hardly a fishing expedition.  It was narrowly tailored and, assuming the board acted in an informed manner, was not likely to produce anything that could be used in a subsequent derivative suit.

Nonetheless, the request ran head long into the Delaware court's use of excessive pleading standards to deny inspection rights.  It wasn't enough that the decision by the board directly implicated shareholder voting rights.  Shareholders had to present credible evidence of wrongdoing even to be able to inspect the minutes and examine the agendas. 

Needless to say, the Delaware Chancery Court found that shareholders had not met this burden.  The decision effectively meant that directors could be assured of complete secrecy in considering letters of resignation, effectively rendering their decisions unreviewable.  To the extent that directors declined to accept resignation letters for self serving reasons (they would expect the same treatment if they ever failed to receive majority approval),  they would know that shareholders would be denied any opportunity to explore these motives.  In effect, therefore, the board's authority with respect to resignation letters was not bounded by fiduciary obligations.  The analysis alone demonstrates the meaningless nature of majority vote provisions.

Yet if the point were not clear enough, Vice Chancellor Noble made it even more unequivocally. 

• The Three Directors were properly reelected to the Board under Delaware corporate law’s plurality voting provisions. With this fact the Plaintiffs do not, and cannot, disagree. However, because a certain number of shareholders withheld their votes, a Board-enacted governance policy was triggered requiring each of the Three Directors to submit their resignation to a Board designated committee, which would then recommend whether the Board should, it its sole discretion, accept the resignations. The Plaintiff argues that a sufficient number of shareholders withheld their votes in reliance on, and out of a desire to trigger, the Policy. If so, they were successful; these shareholders achieved their desired goal and the Policy was triggered.  The problem for the Plaintiff is that the Policy vested discretion whether to accept the resignations of the Three Directors in the Board. By refusing to accept these resignations, the Board effectuated the results of a valid shareholder election. There is no evidence that the Board identified, and then sought to thwart, the will of the shareholder franchise by refusing to accept the resignations of the Three Directors.

Of course, the conclusion that there was "no evidence" that the board sought to thwart the will of shareholders was wrong, both legally and practically.  Legally shareholders alleged that the company misstated the reasons for declining to accept the resignations.  Practically, the shareholders as a group voted to oust the directors from the board.  It smacks of a trip through the looking glass to then say that the rejection of this clear intent doesn't thwart the will of shareholders.

But in any event, none of this amounted to credible evidence, allowing the court to dismiss the request for minutes and agendas. 

• Merely pointing out the Board’s exercise of discretion under the Policy—an exercise which ultimately effectuated the shareholder franchise—is not credible evidence of wrongdoing on this record. The Three Directors took office, duly elected by a plurality of Axcelis shareholders. The ultimate result under the Policy was the result of the shareholder franchise, not an interference with it. Absent the Policy, the result of the May 2008 election would have been no different.

It was, in the end, the use of excessive pleading standards to deny shareholders a modest amount of information on a topic of unquestionable importance. 

The case is on appeal so there is some chance that the Delaware Supreme Court will fix the result.  Given the Court's reasoning in Seinfeld, however, that is unlikely.  Like so much in Delaware, the true fix will need to be federal.  With the SEC increasingly using disclosure to alter the corporate governance balance, it will need to adopt another amendment to the Form 8-K to require disclosure in this area. 

In short, rather than allow inspection rights to be an occasional source of additional information for motivated shareholders, the Delaware courts will cause the federal government to impose disclosure obligations on all public companies.  It is increasingly the consequence of the Delaware approach to decision making in the corporate governance area. 

Primary materials on this case can be found at the DU Corporate Governance web site.

Delaware courts assert that boards have a duty to be informed, something that often goes under the label of a duty to monitor.  The duty was first discussed in a meaningful way in Caremark, although it took the Delaware Supreme Court 15 years to acknowledge that in fact boards had a duty to monitor.  In Caremark, Chancellor Allen placed the duty squarely in the realm of good faith.  Directors had a good faith obligation to ensure an adequate system for reporting information to the board.

Recognizing the obvious harm to shareholders, the Chancery Court admonished outside counsel to make it a practice to report these types of matters to the board.

• Thus, I am of the view that a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.

In other words, there was no obligation of the board to require that counsel do so.  There was no fiduciary obligation to be informed of provisions in contracts that could have a materially detrimental effect on voting rights.  Instead, matters would be left to the professionalism of outside counsel.

The rationale was an example of the Ostrich approach to management. 

What did the reporting system have to include?

• But it is important that the board exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.

Caremark, therefore, required as a matter of good faith that boards put in place reporting systems designed to alert them to important developments inside the company.  The court also indicated that the system had to be sufficient to ensure timely revelation of appropriate information.

In fact, as is often the case in Delaware, the potential of Caremark was quickly abandoned.  While the Delaware courts have often repeated the adage about the need for a reporting system, they have resolutely declined to give the reporting system any significant content.  Thus, as long as a reporting system is in place, boards have no obligation to ensure that the system actually provides them with the information needed to adequately oversee the activities of the corporation.

This unwillingness can be seen from the strained rational in San Antonio v. Amylin.  The case involved poison puts.  Amyln issued debt that contained default covenants triggered whenever the board no longer contained a majority of "continuing directors."  This could occur, for example, when shareholders elected a majority of non-management nominated directors.  In those circumstances, debt holders could put their notes back to the company at face value, a decided advantage since the Amylin debt was trading on a deeply discounted basis.

Shareholders challenged the puts, noting that they interfered with the corporate franchise by discouraging shareholders from voting for dissident directors.   The board's defense, however, was that it had been unaware of the put.  The case turned, therefore, on whether the board had a duty to be aware of contractual provisions in the change of control context that severely restricted the voting rights of shareholders.  It being Delaware, the resolution was predictable.

• The answer must be no. The board retained highly-qualified counsel. It sought advice from Amylin’s management and investment bankers as to the terms of the agreement. It asked its counsel if there was anything “unusual or not customary” in the terms of the Notes, and it was told there was not. Only then did the board approve the issuance of the Notes under the Indenture. This is not the sort of conduct generally imagined when considering the concept of gross negligence, typically defined as a substantial deviation from the standard of care.

In short, the corporation could implement contractual provisions that severely restricted the shareholder franchise and that provided the corporation with little apparent benefit.  As long as counsel and others kept the board in the dark, the decisions were unreviewable.  

• This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. . . . Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.

The last sentence was the most telling.  The board had no obligation to ask for the information.  The board's fiduciary duties and the obligation to act on an informed basis did not require them to insist on the information.  Instead, acting in a "fully informed" matter was something that depended upon the voluntary cooperation of outside counsel.   In other words, the duty of care and the business judgment rule requires nothing affirmative. 

As for the Supreme Court's view?  On appeal, the Court affirmed the lower court but in an entirely disingenous fashion.  The Court acted as if the board had considered the poison put and determined that it was appropriate.  

• The Court of Chancery determined, inter alia, that Amylin Pharmaceuticals’ board of directors did not breach its duty of care in authorizing the corporation to enter into the Indenture Agreement, with its “proxy put” provision. That determination was correct, not only for the reasons made explicit in the Court’s opinion, but also for one that is implicit: no showing was made that approving the “proxy put” at that point in time would involve any reasonably foreseeable material risk to the corporation or its stockholders. That risk materialized only months later, and was aggravated by the unexpected, cataclysmic decline in the nation’s financial system and capital markets beginning in the Spring of 2008.

It was, in the end, the best example of the ostrich approach to governance yet to come out of Delaware.  Companies can use contracts to substantially restrict shareholder governance as long as the board is told about it. 

It is the type of decision that justifies federal intervention and the requirement that reports be made to the board of directors.  SOX took that approach; so do other reform efforts.  If the Delaware courts will permit know nothing boards, federal legislation will need to insist otherwise.  

The primary materials in this case can be found at the DU Corporate Governance web site.  

The courts in Delaware claim that the duty of loyalty "demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty." It is the duty of loyalty that applies to transactions involving conflicts of interest, including executive compensation.  The duty is designed to protect shareholders from self dealing by imposing on the board the obligation to establish the fairness of any transaction subject to the standard. 

The language is from Guth v. Loft, 5 A. 2d 503 (Del. 1939), an early case but repeated in a legion of more recent decisions.  Yet the history of the duty of loyalty in Delaware has been one of circumvention.  The courts do so in two ways.  First, they provide that the duty of loyalty does not apply where the board contains a majority of independent directors. 

The other approach is to limit the application of the duty of loyalty through arbitrary standards.   An example occurred in Sinclair Oil Corp. v. Levien, 280 A.2d 717, 721-22 (Del. 1972).  The Court concluded that a dividend approved by the board of a subsidiary entirely dominated by the parent did not implicate the duty of loyalty since the parent did not receive a disproportionate benefit.  Why?  Because a dividend is paid proportionately to all shareholders.  As the Court noted:  "[A] proportionate share of this money was received by the minority shareholders of [the Subsidiary].  [The parent] received nothing from [the Subsidiary] to the exclusion of its minority stockholders. As such, these dividends were not self-dealing."  

In other words, a controlling shareholder can bleed off the cash and assets held by a subsidiary, do great damage to the subsidiary's business, and have as a primary motivation its own need for cash, without implicating the duty of loyalty.  The analysis ignored the Parent's control of the board, the impact on the Subsidiary, or the fact that most of the cash went to the controlling shareholder.  The Supreme Court, in reaching the legal conclusion, cited no authority for the proposition.

The weakness in the rational can be seen clearly in Pfeffer v. Redstone.  In that case, Viacom dominated Blockbuster, owning approximately 82.3% of the equity value and 95.9% of the voting power in Blockbuster.  Blockbuster approved a $5/share dividend that resulted in Viacom receiving over $738 million of the $905 million distributed to Blockbuster shareholders.  Blockbuster, which was already suffering, had to borrow the money needed to pay the dividend.  At the time, at least one analyst described Blockbuster's prospects as "grim."  In other words, the outflow of money was certainly good for Viacom but may have been very bad for Blockbuster.

Despite Viacom's degree of control and the possibility that the control influenced the decision to pay the dividend, the Court refused to apply the entire fairness test.  Why?  As the Court concluded: 

• Pfeffer complains that Redstone, through his company NAI, received an overwhelming majority of the Special Dividend. That may be true, but it does not establish a disqualifying self interest since NAI held a majority of Viacom’s stock. What is significant is that Director Redstone and NAI received nothing unique that was otherwise unavailable to the other stockholders.

In other words, the Court made no effort to require that the board approving the dividend show that it was fair.  As a result, the conflict of interest was simply ignored.  It is the law in Delaware but like so many other things, it is in conflict with common sense.

The Delaware courts have severely weakened the duty of loyalty.  The result is that unfair transactions involving a conflict of interest are subject only to the meaningless process requirements of the duty of care.  It allows management to treat shareholders unfairly without allowing them any recourse.

Primary materials can be found at the DU Corporate Governance web site.

Its that time of year when we go back over the last twelve months and point out the decisions rendered by the various Delaware courts that were the most disadvantagous to shareholders.  We did this for 2007 and 2008.  We do not look for decisions where shareholders simply lost.  We look for decisions where the courts applied suspect reasoning that reflected a judicial predilection against shareholders and in favor of management.

In 2009, the choice for the top 5 worst decisions was difficult to narrow.  This was a year where the courts all but eliminated any ability to review decisions by the board to reject resignation letters when directors failed to received sufficient support under a majority vote provision.  It was a year where directors were all but told that they had no affirmative role in examination of systematic risk undertaken by their business, even when they formed an express committee to conduct that function.  Finally, it was a year where the court approved poison puts and did so by concluding that directors had no obligation to be made aware of contractual provisions that erode shareholder voting rights.

So, on with the countdown.