Nakkhumpun v. Taylor: Former Delta Petroleum Executives Dodge Class Action Suit

In Nakkhumpun v. Taylor, Civil Action No. 12-cv-01038-CMA-CBS, the United States District Court for the District of Colorado denied the motion to amend a dismissed class action suit against former executives of Delta Petroleum Corporation, a now bankrupt oil and gas company (“Delta”) (“Defendants”), by Patipan Nakkhumpun, an individual investor, on behalf of all persons similarly situated (“Plaintiffs”).

Plaintiffs' claims focused on a number of allegedly inaccurate statements. They included allegations that Delta had misstated the reasons negotiations ended with Opon International (“Opon”) over the sale of $400 million in assets. In addition, Defendants allegedly misrepresented Delta’s financial condition by stating that Delta’s liquidity had “improved materially" and that the company was in "a far better liquidity and financial situation" than a year earlier. In dismissing the former, the court found an absence of causation. With respect to the latter, the court found that Plaintiffs had not shown the statements to have been false.  

In their amended complaint, Plaintiffs alleged that the misrepresentations concerning the negotiations with Opon “caused” their losses as a result of the “materialization of the concealed risk.” This theory requires a plaintiff to allege that the risk which caused the loss was within the zone of risk concealed by the misrepresentation and that the share price dropped because of the risk.

Plaintiffs asserted that Delta had concealed three risks that caused the drop in share prices: the assets were not worth $400 million; the assets were not marketable at $400 million; and Delta’s inability to sell the assets at a high price would force it to file for bankruptcy.

The first alleged risk failed because Defendants do not owe a legal duty to disclose the value Opon assigned to Delta’s assets. The third alleged risk also failed because there were too many intervening events that could have led to Delta’s bankruptcy. Only the second alleged risk was found to be within the zone of risk concealed by the misrepresentations.

Nonetheless, the amended complaint could not survive because Plaintiffs failed to allege a strong inference that the July 2010 statement was made with scienter. The court ruled that the general motives for executives to further the interests of the corporation, such as signaling to potential partners that assets are marketable at a certain price, fail to raise an inference of scienter.

With respect to the statements about Delta’s liquidity, the court found that the allegations and clarifications added to the amended complaint were not sufficient to allege that the statements were false.   

In considering each of the proposed amendments, the court concluded that the amended complaint could not survive a motion to dismiss.

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


Class Action Over $106 Million Merger Dismissed 

In Kugelman v. PVF Capital Corp., CASE NO. 1:13 CV 1606, 2013 BL 241456 (N.D. Ohio Sept. 9, 2013), the United States District Court for the Northern District of Ohio, Eastern Division, affirmed the dismissal of a class action suit brought against PVF Capital Corporation (“PVFC”), PVFC’s board of directors (“Directors”), and F.N.B. Corporation (“FNB”) (collectively, the “Defendants”) by an individual investor, Sylvia Kugelman (“Plaintiff”).

This securities fraud class action arose out of the proposed merger between PVFC and FNB. After several rounds of negotiations, FNB submitted an indication of interest to acquire the outstanding shares of PVFC in an all-stock transaction worth approximately $106 million. Plaintiff filed this lawsuit to prevent the merger.

Plaintiff alleged multiple claims for relief. First, Plaintiff asserted violations of Sections 14(a) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”) arising from alleged misrepresentations and omissions in the proxy statement. Second, Plaintiff alleged that the Directors breached their fiduciary duties through materially inadequate disclosures and omissions in the proxy statement. Last, Plaintiff alleged the Directors breached their fiduciary duties of loyalty, good faith, and independence owed to the shareholders. 

Under the Private Securities Litigation Reform Act (“PSLRA”), a complaint must specify each statement alleged to have been misleading and the reasons why the statement is misleading. Further, an omission violates Section 14(a) of the Exchange Act only if an SEC regulation requires disclosure of the information or the omission makes other statements materially false or misleading. Here, Plaintiff’s complaint made no argument that the omitted material was required by the SEC. Rather, the complaint alleged the omitted material rendered other statements in the proxy statement misleading.

The court faulted the complaint for failing to “identify any specific statement” rendered misleading as a result of the omissions. Moreover, even with respect to broader sections of the Proxy, the court viewed the complaint as alleging that the omissions “are necessary to allow the shareholders . . . to assess the quality of the information provided in the Proxy Statement.” While recognizing that shareholders “might want more information,” shareholders were only entitled to information required by Rule 14a-9. The court found that Plaintiff failed to plead sufficient facts to show a plausible violation of Section 14(a).

Section 20(a) of the Exchange Act imposes joint and several liability on directors who control any person liable for securities fraud. Therefore, to violate Section 20(a), there must be a primary violation of federal securities laws. Given that Plaintiff’s Section 14(a) claim was dismissed, there was no primary violation on which a Section 20(a) claim could be premised.

The court declined to exercise jurisdiction over Plaintiff’s state law claims of fiduciary duty because the federal claims failed. 

The court granted Defendants’ motion to dismiss because Plaintiff failed to state a plausible claim for relief under the Exchange Act, and the court declined to exercise supplemental judgment over Plaintiff’s remaining state law claim. 

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


Class Action Suit Against UGG Maker Over Security Fraud Dismissed

In Percoco v. Deckers Outdoor Corp., Civ. No. 12-1001-SLR. 2013 BL 180341 (D. Del. July 8, 2013), the United States District Court for the District of Delaware dismissed a class action lawsuit brought against UGG-maker Deckers Outdoor Corporation (“Deckers”); Deckers’ CEO, Angel Martinez (“Martinez”); and Deckers’ CFO, Thomas A. George (“George”) by an individual investor, Michael Percoco. 

Deckers, a Delaware corporation based in California, allegedly deceived investors about its financial outlook by failing to disclose adverse facts regarding its UGG brand. Despite a cost increase in the key component of UGG products, sheepskin, Deckers reported record results from October 2011 through April 2012. George was alleged to have stated that, through selective price increases and the addition of other footwear brands, Deckers would fully offset the negative impact on the bottom line. However, following an April 2012 press release announcing Deckers’ decreased gross margin of 46% and diluted earnings per share, Deckers stock dropped approximately 25% in one day. Percoco claimed violations of § 10(b) and § 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”).

Shareholders filing a securities fraud lawsuit under § 10(b) of the Exchange Act are subject to heightened pleading standards. The Private Securities Litigation Reform Act (“PSLRA”) requires the plaintiff plead "with particularity": (1) each allegedly misleading statement and the reasons why the statement is misleading ("falsity"); and (2) the facts giving rise to a strong inference that the defendant acted with the required state of mind ("scienter"). In addition to those requirements, the PSLRA’s Safe Harbor Provision immunizes any forward-looking statement if it is accompanied by meaningful cautionary language.

The court determined that the allegations, if assumed true, met the falsity requirement. No program had been implemented to offset negative impact on the bottom-line. Further, Percoco had alleged that Deckers reported false numbers in its press releases.

However, the court found that Percoco’s pleadings failed to meet the scienter requirement. The close proximity of the allegedly false statements to the corrective disclosure was not enough. “Simply noting that only a short period of time existed between defendants' statements or omissions and the reporting of the apparent inconsistency is insufficient to find an inference of scienter.”

The court also declined to apply the “core operations” doctrine. The court found that at the time the statements were made it was conceivable that Deckers’ top executives would not have been able to accurately predict the price of sheepskin and how that would impact Deckers’ cost of goods sold. Further, a compelling scienter inference was not raised since the evidence showed that Martinez and George purchased shares of Deckers stock during the class period between October 2011 and April 2012.

Deckers provided numerous cautionary statements; however, Percoco alleged that Deckers knew its statements were false and that its forecasts were unattainable. The court concluded that Deckers was optimistic, but not unrealistic, and that the forward-looking statements were protected under the Safe Harbor Provision.

Section 20(a) of the Exchange Act imposes liability on contemporaneous traders for insider trading. Because this violation cannot be met without a § 10(b) violation, Percoco’s § 20(a) claim was dismissed.

The court granted Deckers’ motion to dismiss. Additionally, the court denied Percoco leave to further amend because Percoco did not offer any facts that could alter another court’s decision.

The primary materials for this case can be fount on the DU Corporate Governance website.


In re Longwei Petroleum: Red Flags Save 10(b) and 20(a) Claims from Dismissal

The United States District Court for the Southern District of New York partially granted a motion to dismiss claims under sections 10(b) and 20(a) of the Securities Exchange Act against Longwei Petroleum Investment Holding Ltd.’s (“Longwei”) directors and auditors. In re Longwei Petroleum Investment Holding Ltd., 13 CV 214 (HB), 2014 BL 20751 (S.D.N.Y. Jan. 27, 2013).

Shareholder plaintiffs (“Plaintiffs”) brought a class action against Longwei Petroleum and its directors and auditors (“Defendants”) for securities fraud. Plaintiffs alleged that Longwei’s directors—Michael Toups, Douglas Cole, and Gerald DeCiccio (“Directors”)— were liable for misrepresentations on Longwei’s financial filings and for false statements made in a 2011 press release. Plaintiffs alleged that Longwei’s auditors, Child VanWagoner & Bradshaw, PLLC and Anderson Bradshaw, issued unqualified audit reports about Longwei’s financial position and its conformity with generally accepted accounting principles.

Defendants filed a motion to dismiss for failure to state a claim challenging the elements of misrepresentation, scienter, and loss causation in Plaintiffs’ section 10(b) claim.

With respect to the claims of misrepresentation, Directors asserted that any misstatements were either not attributable to them or constituted puffery. The misstatements in question were company financial filings signed by defendant Directors and filed with the SEC. The filings allegedly showed revenues totaling hundreds of millions of dollars while financial reports issued to Chinese authorities showed revenues in only the hundreds of thousands. Plaintiffs presented additional evidence including interviews, photos of abandoned rail tracks connecting to Longwei’s facilities, and a failed safety inspection, to demonstrate that Longwei could not have generated the revenues reported in the SEC filings and had most likely not operated the plants in question for quite some time. The court deemed these allegations sufficient to show misrepresentation.

Defendants also challenged whether the Plaintiffs had adequately pleaded scienter. Plaintiffs alleged scienter through conscious misbehavior or recklessness. The court found that the pleadings sufficiently alleged that CFO Michael Toups had regular access to Longwei’s financial information and should have been aware of the alleged fraud, which would have been “obvious to even a casual observer.” It also found that, as alleged in the complaint, Directors Cole and DeCiccio, members of Longwei’s audit committee, failed to take any action with respect to admitted financial reporting failures. Additional red flags, such as Longwei’s inadequate reporting and remarkable revenues compared to its competitors, the court reasoned, should have put the Directors on notice to the strong possibility of fraud.

The court further found sufficient allegations of scienter to survive a motion to dismiss with respect to Longwei’s Auditors. The allegations were sufficient to show that the auditors should have been aware of the red flags but that they were disregarded. Additionally, the pleadings sufficiently demonstrated loss causation by alleging that the disparity in Longwei’s actual revenues versus its reported revenues caused Plaintiffs’ losses.

Regarding the 20(a) claim, the court found that through adequately pleading scienter, Plaintiffs also sufficiently alleged culpability for directors Toups, Cole, and DeCiccio. The complaint asserted that the directors each had responsibility for overseeing Longwei’s financial and audit reports and each signed the company’s Form 10-K statements. Conversely, the court found that Plaintiffs did not allege sufficient facts to demonstrate that Longwei’s auditors knew of or consciously participated in the fraud.

Therefore, the court granted the motion to dismiss the section 20(a) claim against the auditors and denied all other motions to dismiss.

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


City of Brockton Ret. Sys. v. CVS Caremark Corp: Court Finds Adequate Pleadings by Brockton Upon Remand

Upon remand from the First Circuit Court of Appeals, the District Court of Rhode Island in City of Brockton Ret. Sys. v. CVS Caremark Corp., 09-cv-554-JL, 2013 WL 6841927 (D.R.I. Dec. 31, 2013), denied CVS Caremark Corporation’s (“CVS”) motions to dismiss the claims submitted by a class of CVS shareholders (“Plaintiffs”). With all of the judges in the District Court of Rhode Island recused, the matter was set before Judge Joseph N. Laplante of the District Court of New Hampshire.

Plaintiffs asserted a claim under Section 10(b) of the Securities Exchange Act of 1934, alleging that they purchased CVS securities after relying on purportedly fraudulent statements made by CVS following its merger with Caremark Rx, Inc. (“Caremark”) in 2007. According to Plaintiffs, the company misrepresented the success of the integration of the two companies. When the market learned of the turth, share prices allegedly declined by 20%.    

Defendants sought dismissal alleging that Plaintiffs had not sufficiently asserted actionable misstatements or omissions or adequately plead scienter.   

To establish a claim under Section 10(b), the complaint must specify the statement that was misleading, the reasons why it was misleading, and if relied upon, it must state with particularity facts that would support reliance on such statements. However, Plaintiffs were not required to plead evidence, but “only to put ‘a significant amount of meat . . . on the bones of the complaint.’ ”  In order to satisfy the scienter requirement, the complaint must show either “conscious intent to defraud or a high degree of recklessness.” Under corresponding Rule 10b-5 “a complaint must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’ to sustain the claim.”

The court found that plaintiffs sufficiently alleged misrepresenations. The court focused on allegations that CVS had denied that it "had lowered prices for some of its PBM customers 'because of a lack of service' ." The Plaintiffs, however, asserted that CVS had in fact “unilaterally reduced prices on over 50 percent of its existing PBM contracts in order to retain customers that were dissatisfied with [its] inferior service [and] integration-related issues.” Reiterating that Plaintiffs did not have to plead evidence but only to put some "meat . . . on the bones of the complaint," the court found that the failure to allege any specific contract that had been re-priced in response to a perceived lack of service was not "fatal" to the claim.   

The court also rejected allegations that the statements alleged to be false constituted “inactionable puffery.” The court agreed that defendants were “probably right” that a number of the alleged misstatements qualifed. Nonetheless, for purposes of the motion, dismissal would not be warranted where at least one statement did not meet the definition. The court declined to find as puffery the statement alleging that the repricing of the prescription benefit manager business was not a result of a “lack of service.”

With respect to scienter, the court noted that CVS’s CEO was directly confronted with a question about whether the price cuts had any connection to concerns about service. In response, according to plaintiffs, the CEO denied that it did and instead stated that the repricing was done on "accounts that we kind of wanted to lock down." 

The court found the allegations sufficient to allege scienter.

  • Asked point-blank, then, whether “a concern about service” among the company's PBM customers had caused it to lower its prices, [the CEO] unequivocally denied that, and proffered an alternative explanation that cast no aspersions on any aspect of the CVS–Caremark integration. If, as the plaintiffs allege, that statement was indeed untrue—and, again, taking a cue from the Court of Appeals, this court rules that the plaintiffs have sufficiently alleged as much—then the statement, by its very nature, supports a “cogent and compelling” inference that the CEO was acting either with the intent to deceive or with a high degree of recklessness as to whether he was doing so.

The court found that Plaintiffs “adequately pled at least one actionable misstatement,” and that scienter had been adequately pled for that statement. The Court of Appeals had also initially found loss causation to be adequately pled. Consequently, CVS’s motion to dismiss was denied.

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


Wagner v. Royal Bank of Scotland: Court Denies Motion to Dismiss Claim for Alleged 16(b) Violations

In Wagner v. Royal Bank of Scotland Grp. PLC, the United States District Court for the Southern District of New York denied a motion to dismiss Jeff Wagner's (the "Plaintiff") claim to recover short-swing profits generated by defendants, Royal Bank of Scotland Group PLC and its conglomerates (collectively, “Defendants”), through swap agreements that led to transactions in LyondellBasell Industries, N.V. (“LBI”) securities, of which Plaintiff was a shareholder. No. 12 Civ. 8726 (PAC), 2013 BL 239950 (S.D.N.Y. Sept. 5, 2013). In denying the Defendants’ motion to dismiss, the court recognized the Plaintiff’s complaint pursuant to Section 16(b) of the Securities Exchange Act of 1934 (“Section 16(b)”).    

Since its formation in 2009, LBI maintained two classes of ordinary outstanding shares that were structured to automatically convert to a single class of ordinary outstanding shares upon a triggering event. On December 6, 2010, LBI’s Class B shares were converted into Class A shares according to this provision.

During October 2010, the Defendants and various counterparties entered swap agreements that related to specified baskets of equities. LBI’s Class B shares were the primary focus of several of these swap agreements. Between October 2010 and December 2010, the Defendants maintained beneficial ownership of more than 10% of LBI’s outstanding Class A shares.   

Plaintiff alleged that because the Defendants controlled the equity baskets subject to the swap agreements, the addition of approximately 358,000 LBI Class B shares to the equity baskets between October and November 2010 was equivalent to purchasing the same quantity of Class B shares, which, in turn, was equivalent to purchasing Class A shares, a potential Section 16(b) violation. 

The legislative intent of Section 16(b) was to prevent inside parties from “engaging in speculative transactions on the basis of information not available to others.” Section 16(b) imposes a strict-liability standard on insiders who procure short-swing profits on transactions made within a six-month period of time. Under Section 16(b), a plaintiff must prove that an issuer’s officers, directors, or principal shareholders purchased and sold its securities within a six-month period.

To support their motion to dismiss, Defendants first argued that the swap transactions at issue were exempt from Section 16(b) because the Defendants’ pecuniary interest in LBI securities was never affected by the swap transactions. Defendants emphasized that the swap transactions merely altered the nature of their beneficial ownership in the underlying securities. The court declined to address this issue because, in considering a motion to dismiss, a court must only assess the plausibility of facts alleged in the complaint and is not required to assess the factual validity.

Defendants also argued that the transactions were not based on any type of inside information that would trigger liability under Section 16(b). The court denied the validity of this argument based on precedent reemphasizing the strict liability standard imposed by Section 16(b), indicating that “such a blunt instrument was the only way to control insider trading.”

Finally, Defendants pointed to certain administrative decisions that ostensibly precluded similar transactions from Section 16(b) liability due to a lack of pecuniary interest in subject securities. The court, however, emphasized that the administrative decisions referenced were narrowly construed and expressly stated that “any different facts or conditions might require a different conclusion.” More importantly, the court pointed out that Defendants explicitly admitted to having a pecuniary interest in the LBI securities.

For the foregoing reasons, the court denied the Defendants’ motion to dismiss.

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


Retail Investors on Life Support (Part 3)

We are discussing the outflow of retail investors from the markets.

What can be done to help retail investors overcome their distrust for the market? As one market participant stated, "[i]t is not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges, or the regulators either." 

Trust in the regulator. Let's focus on the primary regulator: The Securities and Exchange Commission. The SEC has the right focus.  As the Chair of the SEC recently stated in a speech: "The retail investor must be a constant focus of the SEC – if we fail to serve and safeguard the retail investor, we have not fulfilled our mission."  

With respect to market structure issues, there are avenues that could be undertaken to increase the appearance of fairness.  This is not necessarily the high frequency trading practices discussed in Flash Boys.  High frequency traders benefit in part from technology.  They have relied on speed and high quality algorithms to make money.  One suspects that this is a variation on a theme: Those with informational advantages can figure out ways to exploit them, whether through arbitrage or otherwise. Moreover, Flash Boys suggests that there are responses to this dynamic (the discussion of the approach taken by IEX). The reports that Goldman may shut down its dark pool also suggests that there may be a reduction in fragmentation as a result of market forces.   

What certainly does not have the appearance of fairness, however, are traders that profit from information not otherwise available to the public.  Published reports have indicated that high frequency traders have received "advance peaks" at information (they paid for it of course) from assorted news services. The practices came to a stop after Eric Schneiderman, the Attorney General in New York, intervened. Schneiderman gave a speech on the subject titled "Frequency Trading & Insider Trading 2.0." The video is here.  Other reports indicate investigations by the FBI, the CFTC, and the SEC. So the problem has captured the attention of regulators.

But in some cases, the "advance peak" is legal and institutionalized. The stock exchanges provide their data feeds to brokers at the same time they send the information to the Securities Information Processor ("SIP") for inclusion in the consolidated tape. Because of the short delay in consolidating the information (expressed in milliseconds), those buying the data feed know how the direction of the market a few milliseconds before everyone else. 

The practice is permitted under Regulation NMS.  The SEC did sanction the NYSE for providing information in the data feed to brokers before it was given to the SIP. See In the Matter of New York Stock Exchange LLC, and NYSE Euronext, Admin. Proceeding File No. 3-15023 (Sept. 14, 2012). Yet as long as the information does not go out to purchasers before it goes to the SIP, the practices is allowed. It is, however, difficult to understand the value to the market of allowing these advance purchases of information. 

So what should be done? At a minimum, the SEC needs to step into the space created by the issue.  Right now New York Attorney General has been far more active.  As the primary financial regulator with the requisite expertise, the SEC needs to be at the forefront of any reforms in the area.  Reexamination of the right to provide access to the data feed before the information is distributed over the consolidated tape is in order.  

It may be the case, as some at the Commission have suggested, that the "[m]arkets are not broken."  But from the perspective of retail investors, they may still be unfair.



Retail Investors on Life Support (Part 2)

What should be done about retail investors leaving the markets?

In part the answer depends upon why they are departing. Some attribute the decline to the market collapse in 2008. But the trend began before that (net outflows from stock funds occurred in 2007). Moreover, the market has been up consistently since then, yet retail investors have continued--for the most part--to pull funds out of stock funds (the "trickle" of inflows in 2013 was the exception).  

Instead, there seems to be something more systematic going on.

Michael Lewis recently called the markets "rigged." While the hyperbole made for a good soundbite, it was nothing new. The markets have often been labeled a "casino." In 2012, the title of an article in the WSJ was "When will Retail Investors Call it Quits?"

There is a declining level of trust by retail investors in the market. And, as Commissioner Stein noted recently:  "If investors don’t trust the markets, they won’t invest their capital."

Lack of trust can come from a number of places. With the collapse in 2008 and the disclosure of some of the unsavory practices that occurred, investors likely lost trust. Certainly corporate America hasn't faired well, with investor trust down last year even as equity markets were up.  Operational difficulties of the markets (the flash crash, the Facebook IPO disaster, the market shutdown in August 2013) can't help.  

What this suggests is that the renewal of trust requires some changes. But many of the structural issues with the market (dark pools, fragmentation, even high frequency trading) are not issues that most retail investors likely follow or that implicate trust. It is not to say that these matters shouldn't be considered but addressing them is not likely to return retail investors to the market.

So what will? 


Retail Investors on Life Support (Part 1)

I had an opportunity to speak at the NASAA Public Policy Conference in Washington on April 8. The title of the topic was "Restoring Main Street Investors to the Capital Markets." The topic was an interesting one under any set of circumstances but became particularly topical in the aftermath of the publication of Flash Boys, the book by Michael Lewis. Lewis famously described the stock markets as "rigged."   

As a result the conference provided an opportunity to stand back and offer some observations on the state of the market from the perspective of the retail investor. For some, retail investors have never had it better. The spreads on the largest shares are greatly reduced from 10 years ago and commissions are down.  

Yet the evidence suggests that retail investors are leaving the market.  And if they are, the "never having had it better" approach is not particularly consoling.  

The participation rate of retail investors is a surprisingly difficult matter to empirically ascertain.  "Retail" investors have no single definition. Finding data in the market that can be used as a proxy for retail investor activity is also not easy. No single statistic precisely captures the category. Moreover, to the extent evidence indicates one investment avenue is down, the possibility exists that investors simply moved their money to another category of equity. Thus, any decline in direct purchases by investors could be overcome by increased purchases of mutual funds or ETFs. In other words, the net to the market could be "0."

In addressing the issue, most point to the annual Gallup poll, last released in April 2013, that showed a precipitous decline in the number of households that own equities, whether directly or through mutual funds and retirement accounts (placing the percentage at 52%).  Or, as Gallup put it: “US Stock Ownership Stays at a Record Low.” For most of the life of the poll, the numbers have been above 60%. The latest iteration will be out in May so we will see if the percentage changes. One suspects that, after a run up of 26.5% in the Dow Jones last year, there will be an increase but that the number will remain low (below 60%).

But polls are polls. Are there any other indicators that retail investors are leaving the market? Equity stock funds are another place to look. These are typically associated with retail investors. Through 2012, ICI reported that "domestic equity mutual funds have had outflows for seven consecutive years." Understand that this took place despite the fact that the market has been up significantly since the collapse in 2008.  

The counterintuitive trend caused the ICI to opine that there was something different going on in the market. As the ICI observed:   

  • Generally, demand for equity mutual funds is strongly related to performance in the stock markets. Net flows to equity funds tend to rise with stock prices and the opposite tends to occur when stock prices fall. This historical relationship, however, appears to have weakened in the past several years, particularly for domestic equity mutual funds. In 2012, U.S. stocks returned a total of about 16 percent (including dividend payments) and investors withdrew, on net, $156 billion from domestic equity funds. 

There are two immediate responses to this data. First, what about 2013? The market was in fact up and so were inflows into stock funds.  But the numbers were low, variously described as a "trickle" or a "drop in the bucket." In other words, retail investors largely stayed out despite the 26.5% increase in the Dow Jones for the year.

The other is the role of ETFs. In fact, some of the withdrawal from stock funds has been redirected into ETFs, but it is unlikely to have been dollar for dollar. Moreover, the ETF numbers do not negate the trend of the departing retail investors.  Thus, for example, in 2012, stock funds had an outflow of somewhere around $150 billion; equity ETFs had an inflow of around $70 billion. So even if they are viewed as a dollar for dollar replacement (which they shouldn't), there was still a substantial net outflow of equity in 2012 despite a positive market (ICI indicated in 2012 that U.S. stocks, measured by the Wilshire 5000 Total Market Index, returned a total of about 16 percent, including dividend payments). 

Finally, there is the study done by the Economic Policy Institute, the State of Working America. The data shows that stock ownership by household has declined from 51.9% in 2000 to 46.9 in 2010. Most interestingly, however, the fall off has mostly with respect to non-retirement ownership. During the same period, shares not held in retirement accounts declined from 31.5% to 21.7%.

So the numbers for retail investors are down, but in the end this may be the wrong question to be asking. ICI shows that in 2013 "47.1 percent of U.S. households owned shares of mutual funds or other U.S.-registered investment companies—including exchange-traded funds, closedend funds, and unit investment trusts." A smaller percentage of these families are invested in equity funds.

The low percentage of U.S. households in the market carries enormous consequences. For one thing, the Fed reported (and the chair of the SEC quoted) that in 2013, household net worth went up by 14%, with most of that gain coming from increases in the value of corporate equity ($5.6 trillion). So for the half of households in the market, 2013 was a very good year. For those not in the market, however, 2013 was a year where wealth inequality got worse at their expense.  

For another (and really a variation on a theme) if households are not in the market, they are not maximizing their returns for retirement. Baby boomers are retiring. The first batch hit 65 in 2011 and there will be 10,000 hitting that age every day until 2030. One study showed that the investment return of funds invested in 10 year T-Bills from 2004 to 2013 was almost 5%. The same money in the S&P 500 returned 9%. Equity investments can, therefore, advance retirement goals in a way that other investments likely cannot.

So retail investors are leaving the market and/or are underrepresented in the markets. The question now is what should be done?


Shareholder Proposals and the Merits of the UK Model

The shareholder proposal rule has come under assault.  The rule permits shareholders owning $2000 of a company's stock to submit a proposal that must be included in the proxy statement (unless a ground for exclusion is available).  A recent editorialin the WSJ called for changes that would reduce the number of proposals.  The letter from CII and also published in the WSJ was a through rebuttal of the  arguments made in the editorial.  As the letter noted:

  • More than 85% of the companies in the Russell 3000 didn't receive a single shareholder proposal in 2013. What's more, the costs to companies that Mr. Knight cites are largely self-inflicted. Too many companies choose to spend tens of thousands of dollars—shareholders' money—in legal fees in an effort to keep these proposals from coming to vote. Some companies even up the ante by going straight to court to block shareholder proposals, bypassing the Securities and Exchange Commission's well-established, less costly process for reviewing these submissions.

We want to take issue with one additional argument in the editorial.  The editorial noted that other countries had higher threshholds for shareholder access to the proxy statement.

  • Shareholders of U.K.-registered companies face a more reasonable test: They must be supported by at least 5% of eligible voting shareholders to submit a proposal, or represent a group of at least 100 shareholders whose collective stake is valued at a minimum of £10,000, or approximately $16,660.

The statement is true but it omits more than it includes.  First, Section 338 of the Companies Act in the UK allows 100 members owning at least £100 to submit a proposal as long as they "have a right to vote on the resolution at the general meeting."  In other words, there is no one year holding period.  See Rule 14a-8(b) ("In order to be eligible to submit a proposal, you must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal.").

Second, Section 338 does not limit shareholders to 500 words.

Third and most important, Section 338 specifies the grounds for omission of a proposal.  There are exactly three.  As the statute provides, a resolution may properly be moved at an annual general meeting unless:

  • (a) it would, if passed, be ineffective (whether by reason of inconsistency with any enactment or the company’s constitution or otherwise), (b) it is defamatory of any person, or (c) it is frivolous or vexatious.

Thats it.  Compare this to Rule 14a-8 and the 13 vague and unpredictable grounds for exclusion. 

Moreover, these grounds are used routinely by the staff of the Commission to exclude the vast majority of proposals that are submitted for consideration.  Thus, in 2012 the staff agreed to allow for the exclusion of 75% of the proposals challenged (196 excluded of the 263 considered), a number that did not include the 47 that were withdrawn. In 2013, the percentage was 66% (173 excluded of the 263 considered), with 68 withdrawn. 

Lest one think this is because shareholders are poor drafters.  Think again.  At least some of them are from what can be characterized as debatable interpretations of the exclusions in the Rule.  For example, in 2013, the staff reiterated that a proposal was vague and therefore subject to exclusion because it referred to the NYSE definition of director independence.  See Chevron (March 2013). The staff considered it "vague" to use a definition that it or something close to it is employed by all listed companies (Nasdaq has a substantially identical definition) and easily accessible. 

Or how about the exclusion of a letter that was designed to specifically meet the standards set out in an earlier staff letter?  The new resolution was close but, apparently, just missed the mark.  See Bank of America, Feb. 19, 2014 ("In this regard, as we have previously stated, we believe that the incentive compensation paid by a major financial institution to its personnel who are in a position to cause the institution to take inappropriate risks that could lead to a material financial loss to the institution is a significant policy issue. However, the proposal relates to the compensation paid to any employee who has the ability to expose Bank ofAmerica to possible material losses without regard to whether the employee receives incentive compensation and therefore does not, in our view, focus on the significant policy issue.").

Had these proposals been submitted in the UK, they almost  certainly would have been included. So the editorial does get one thing rights.  Adopting the British model would prevent the diversion of "substantial company resources and ultimately SEC resources."  This is because, unlike the model in the US, there would be almost no grounds for excluding a proposal.  Companies would presumably no longer challenge proposals and the SEC would largely be out of the review business.  This would save expenses for everyone including investors and taxpayers.    

Want to read more on the need to reduce the SEC's role in reviewing shareholder proposals, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.    


Raising the Standard of Behavior for Investment Banks in the Sale of the Company: In re Rural Metro Corporation Stockholders Litigation (Part 5) 

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).  

This is a very thoughtful, well reasoned and balanced opinion. It has the potential to elevate the role of the board in the oversight of the sale process, particularly the supervision of investment banks. It also has the potential to reduce the circumstances when conflicts of interests may arise during the process. The opinion could even alter the way investment banks are paid. Finally, the decision raises appropriate, fact specific questions about director independence.

Delaware has long marched down the path of replacing substantive duties for directors with process. As long as the process is adequate, the courts will defer to the decisions made by directors. In so doing, courts can avoid second guessing management and interfering in business decisions.  

Whatever the validity of the approach, it must be premised upon the requirement of rigorous process. The Delaware courts for the most part, however, have not ensured adequate procedural standards. This can be seen most clearly with the failure to ensure that "independent" directors are in fact independent. With respect to actual oversight, the cases have mostly left in place a "check the box" approach that elevates form over substance. None of this adequately protects shareholders or ensures fairness.

Rural is most significant in that it tries to make the process used in the transaction meaningful. A line cannot, however, be drawn from a single point. Whether this type of reasoning will become more common (and we hope that it does) remains to be seen. Indeed, whether the reasoning in this case survives any appeal to the Supreme Court in Delaware remains to be seen.   


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 5) 

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).

The case that went to trial only involved the alleged liability against the investment bank. The directors had already settled iwth plaintiffs. The court did analyze the underlying breach and, while purporting to avoid determining whether the behavior transgressed the duty of care or the duty of loyalty, mostly focused on the duty of care. See Id. ("Because this decision has not parsed whether the directors‘ conduct constituted a breach of the duty of loyalty, it assumes for purposes of the 'knowing participation' element that the directors breached only their duty of care."). In other words, the court deliberately declined to apply a duty of loyalty analysis to the board's behavior.

This was in part because the plaintiffs apparently did not ask the court to do so. Id. ("The plaintiffs do not contend that any director breached his duty of loyalty"). Nonetheless, there were facts that suggested a possible conflict of interest by some of the directors.  

One example was that one of the board members was a managing director of a hedge fund that owned shares of Rural. The Fund owned 12.43% of Rural, a holding that equaled 22% of the Fund’s entire portfolio (“twice the target size for a core position”). Moreover, Rural was embarking on an investment strategy that conflicted with the Fund’s goals.   

  • [Rural's] growth plan conflicted with [the Fund’s] investment strategy, which favored companies with predictable cash flows. The fund told its investors that it avoided companies whose valuations relied on exceptional growth, was reluctant to buy into sizable growth initiatives, preferred a margin for safety based on modest organic growth assumptions, and often penalized companies for acquisitions. 

Likewise, the Fund was in the process of raising capital. As the court noted: "A Rural transaction would be a coup for the young, activist hedge fund and could be used to market the fund to new investors.”   

The court did not find that the director was interested or lacking in independence but certainly raised concerns.  In general, independence in Delaware is not impaired even when directors represent large shareholders.  In Beam, Martha Stewart owned 94% of Omnimedia yet the factor was considered irrelevent in connection with the determination of independence.  See 845 A.2d. at 1051 ("Allegations that Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends,” even when coupled with Stewart's 94% voting power, are insufficient, without more, to rebut the presumption of independence.").   

This can be compared with the practice overseas.  In the Combined Code in Britain, for example, determination of independence requires consideration as to whether the director "represents a significant shareholder".  See Section A.3.1 of the Combined Code. In other words, the factor at least needs to be considered as a routine part of the independence analysis.  Perhaps after this case, it will be.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 4)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).

The court clearly viewed the investment bank as less than forthcoming with the board. "Most egregiously, [the investment bank] never disclosed to the Board its continued interest in buy-side financing and plans to engage in last minute lobbying of [the purchaser]."  

The idea that the seller's investment bank might be working in the interests of the buyer can be easily addressed through "meaningful restrictions." Boards should simply prohibit their investment banks from participating in the financing of the buyer's offer. This would put a dent into "staple financing" but would largely eliminate the conflict of interest. Alternatively, the board could require continuous disclosure of any approaches by the investment bank to the bidder and perhaps retain the right to veto any overtures. This likely reduces but does not eliminate the risk of a conflict.

The more interesting conflict put on the table by the court, however, is structural and arises out of the use of contingency fees to pay investment banks. As the court noted, the "contingently compensated agent has a greater incentive to get the deal done rather than push for the last quarter, particularly if pushing too hard might jeopardize the deal and if the terms offered are already defensible." Given this, the end of the transaction is where the "direct and active oversight by independent directors was needed most."

The analysis suggests that even an "independent" investment bank needs considerable oversight when providing advice on an offer and providing a fairness opinion. The board could, of course, address the concern by eliminating the contingency fee. One possibility would be to pay a flat amount. This would not, however, provide an incentive to obtain the highest possible price. Another possibility would be to pay a percentage of the highest offer actually generated, irrespective of whether the transaction was completed.  

In the absence of a change in the system of compensation, the structural conflict dictates that directors in all cases supervise the investment bank more closely. In other words, the conflict is structural and the board's response should be as well.  

Doing so, however, confronts the lack of financial expertise on the part of directors. Boards could hire another investment bank to review the work of the primary advisor, but that seems excessive. What the court suggests is that the board limit the role of the investment bank and ask for specific types of information in an effort to reduce the possibility that the conflict will have a role in the final outcome.

Thus, boards should:

  • Not have the investment bank conduct final negotiations with the purchaser; 
  • Obtain valuation materials throughout the process but, at a minimum, before any offer is put on the table by a reputed purchaser; 
  • Obtain specific analysis of the alternatives, including whether the company should decline to engage in any transaction; and 
  • Query about any conflicts of interest, particularly involvement with the purchaser. 

Prudent lawyers should, therefore, add these requirements to the list of duties imposed on the special committee when using an investment banking firm that is only paid when a transaction is completed.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 3)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).   

The court was clearly concerned over the efforts by the seller's investment bank to simultaneously seek to participate in the financing of the purchaser. The investment bank, however, pointed out that this was expressly permitted in the engagement letter. The letter provided that the investment bank could "arrange and extend acquisition financing or other financing to . . . purchasers that may seek to acquire companies or businesses that offer products and services that may be substantially similar to those offered by the Company."  

The court, however, characterized the letter as a "generalized acknowledgement" that financing might be extended but "did not amount to a non-reliance disclaimer that would waive or preclude a claim against [the investment bank] for failing to inform the Board about specific conflicts of interest." So the general does not trump the specific when it comes to engagement letters.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 2)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).   

The waiver of liability provision in Section 102(b)(7) extends to directors. See 8 Del. C. § 102(b)(7) (allowing in the articles a provision that eliminates "personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director"). Courts in Delaware have, therefore, declined to extend the provision to officers. See Gantler v. Stephens, 965 A.2d 695, 709 n. 37 (Del. 2009) ("Although legislatively possible, there currently is no statutory provision authorizing comparable exculpation of corporate officers.").   

This case, however, involved allegations of aiding and abetting a breach of fiduciary duties by an investment bank. The court found that these claims were not covered by the provision in the company's articles. In addition to focusing on the plain language of the statute, the court emphasized the different roles played by directors and advisors. The latter had a gatekeeping function. See Id. ("Directors are not expected to have the expertise to determine a corporation‘s value for themselves, or to have the time or ability to design and carry out a sale process. Financial advisors provide these expert services. In doing so, they function as gatekeepers.").  

In those circumstances, advisors subject to a greater risk of liability would have an incentive to elevate their behavior. As the court reasoned: 

  • The threat of liability helps incentivize gatekeepers to provide sound advice, monitor clients, and deter client wrongs. Framed for present purposes, the prospect of aiding and abetting liability for investment banks who induce boards of directors to breach their duty of care creates a powerful financial reason for the banks to provide meaningful fairness opinions and to advise boards in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process, rather than in a manner that falls short of established fiduciary norms. It is not irrational for the General Assembly to have excluded aiders and abettors from the ambit of those receiving exculpation under Section 102(b)(7). The statutory language therefore controls.  

As a result, liability could attach for aiding and abetting a breach of fiduciary duty. Since the directors were no longer in the case, identifying the precise breach of fiduciary obligation was unnecessary. Id. ("From a doctrinal standpoint, this opinion need not proceed further and attempt to categorize the directors‘ conduct under the headings of loyalty or care, nor need it assess the individual directors' subjective motivations.").  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 1) 

Shareholders rarely win in Delaware but the decision in In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014), constitutes a qualified victory.   

The case involved a challenge by shareholders of the sale of a company. The company had, as usual, formed a special committee of “independent” directors. Shareholders, therefore, had to show that the process was inadequate. The directors and a financial advisor settled, but the primary investment bank did not and the matter went to trial. Ultimately, the trial judge found against the investment bank.  

There were several positive developments that came out of the case. First, the court found that waiver of liability provisions do not extend to third parties that have aided and abetted a board's breach of the duty of care. Second, the court elevated the standard of behavior for investment banks, most noticeably by raising concern over conflicts of interest. Third, the case essentially imposed on boards hieghtend obligations to oversee investment banks retained to assist directors in selling the company.  

Is it the best case for shareholders in Delaware of the New Millennium? It may well be.

We will analyze these issues in the next several posts.  


Inspection Rights and Unnecessary Burdens: The Race to the Bottom and the Delaware Corporate & Commercial Litigation Blog Agree (Finally)

Shareholders in Delaware can get access to corporate records by invoking their inspection rights under DGCL 220.  Court decisions in this area have been common fodder in this area.  The Delaware courts have created a system whereby corporations can almost with impunity refuse to provide requested documents (either because the purpose is not proper or the plaintiff has not presented "credible evidence" of the purpose). 

When that occurs, the burden falls to shareholders to incur the litigation expenses needed to vindicate their rights.  Moreover, unlike the MBCA, there is no presumption that the shareholder can recover attorneys fees if ultimately successful in getting the court to enforce inspection rights.  Instead, Delaware only permits recovery of fees when the denying company acts in bad faith, which is to say the courts almost never award fees.  So in Delaware, Section 220 is only the first procedural step.  Litigation is the second step, with the attendant costs and delays. 

This is nothing new.  Last year an inspection rights case made our top 5 worst Delaware decisions.  Nonetheless, this brings us to Caspian Select Credit Master Fund Ltd. v. Key Plastics Corp., C.A. No. 8624-vcn (Del. Ch. Feb. 24, 2014).  This case reminded us that there is yet a third way for companies to deny access to documents.  In that case, shareholders alleged two purposes that were well recognized as proper: investigating waste and valuation of shares.  Moreover, the presence of a credible basis was clear. 

The issuer, however, denied access in part by arguing that the purpose alleged by shareholders was not the "primary" purpose.  So even if you have a proper purpose and a credible basis to support the purpose, companies can deny access by arguing that it was not the really important purpose.  Moreover, with the possibility of litigation always looming when inspection rights occur, companies have a ready made argument that the primary "primary" purpose is seeking some kind of leverage, either in litigation or to force a repurchase of shares.  While the court in this case ultimately found for the shareholders, it was not until after the costs of a trial.  This is the system that the Delaware courts have constructed. 

One thing of great interest is the view from our friends at the Delaware Corporate and Commercial Law Blog. The Blog is the best resource for current decisions in Delaware but it is very Delaware court friendly.  Nonetheless, the Blog had this to say about the decision in Caspian Select:

  • This Chancery opinion is one of many examples highlighted on these pages over the last 9 years or so, of the not infrequent inefficiency and unsatisfying nature of an action based on DGCL Section 220 in which a shareholder seeks books and records of a corporation. In this instance, the defendant company made the shareholder incur the substantial time and expense of going to trial based on what I would regard as a tactic by the company to make it as expensive and time-consuming as possible to obtain the books and records sought to value the shares of the company, notwithstanding the truism that valuation has been well-established as a proper purpose for a demand under Section 220.
  • The company’s defense, that only a lawyer could assert with a straight face, was that the stated proper purpose was merely a pretense for another unstated, improper purpose. It took the considerable expense of discovery and a trial for the court to conclude that the stated purpose of valuation was the “actual, real," primary purpose, and any secondary purposes would not defeat the Section 220 claim. In an instance of the “pot calling the kettle black," the defendant claimed, unsuccessfully, that the “real” purpose of the plaintiff was to use litigation as an expensive tactic to force a purchase of the plaintiff’s shares.

The analysis pins the blame on the companies and doesn't recognize that issuers are only doing what the Delaware courts permit.  Still, we couldn't agree more with the analysis and glad to be on the same side on this issue.  


Retail Investors and the Outflow from Capital Markets

Perhaps the single greatest strength of the U.S. capital markets is the presence of a significant number of retail investors.  If nothing else, these investors provide added liquidity to the markets.

However, evidence suggests that there has been a decline in retail investment in the US.  This straightforward point is unusually difficult to determine with any absolute certainty.  

Based upon Gallup polls, however, this is likely the case.  One Gallup poll found that "U.S. investors are generally wary about stocks as a way for Americans to build wealth."  Another found that only about half of U.S. households were invested in the stock market (whether directly or through mutual funds).  As the poll noted: 

  • Fifty-four percent of Americans now say they own stock, little changed from the 52% who said so last April--which was the lowest in Gallup's 16-year trend of asking this question in its current format. Stock ownership is far lower than it was during the dot-com boom of 2000, when 67% said they owned stock--a record high. While staying above 60% for much of the 2000s, the ownership percentage fell into the 50% range as the Great Recession took hold and has not yet rebounded. Despite economic booms and busts, however, a majority of Americans have maintained an investment in the markets in the past 15 years.   

Yet the numbers may not be entirely accurate.  Some individuals may not realize that their IRA or 401(k) is invested in mutual funds that in turn invest in the stock market.  But at a minimum, the data suggests a wariness about investing in the markets by individuals.  

The wariness could be a result of the weak economy and the financial collapse in 2008.  That would suggest that the problem will self correct with the passage of time.  Or there could be something more structural taking place.  With all of the assorted scandals that have rocked the financial markets, investors may lack trust in the markets.  Fixing that will require something more affirmative than the passage of time.  

With the President raising concerns about income inequality, one thing's for sure, those individuals who stayed out of the stock market in 2013 and sat on the sidelines lost out; while those in the market averaged an increase in wealth of 25%.  For those who sat out, the inequality only got worse.


Forum Selection Bylaws and the Federal "Out"

As we noted in our third worst shareholder case for 2013, the Delaware Chancery Court has upheld the use of forum selection bylaws that require shareholders to litigate fiduciary duty cases in Delaware.  See Boilermakers Local 154 v. Chevron.  As a result, shareholders are forced to bring actions to a court system with a management friendly approach.   

The Chevron bylaw upheld by the court, however, provided shareholders with a slight "out."  The bylaw required that the case be brought in a "a state or federal court located within the state of Delaware, in all cases subject to the court’s having personal jurisdiction over the indispensable parties named as defendants."  As a result, shareholders can, if they can obtain jurisdiction, file in federal court. 

This is likely to be a less management friendly forum.  The federal court in Delaware, for example, struck down a system that allowed members of the Chancery Court to act as arbitrators in business disputes but that excluded the press.  Moreover, appeal from this court is not to the management friendly state Supreme Court but to the US Court of Appeals for the Third Circuit.  Indeed, the decision striking down the arbitration system was eventually upheld by the Third Circuit.  See Del. Coalition for Open Gov't, Inc. v. Strine, 733 F.3d 510 (3rd Cir. 2013).  It is hard to imagine the case coming out the same way had it been litigated in the state court system in Delaware.

Other states may not treat forum selection bylaws with the same degree of deference as the Delaware courts.  As a result, they may not work in forcing shareholder litigation into the Chancery Court.  Nonetheless, to the extent that they do, the federal "out" may be an option worth considering.  


Finding Value in Shareholder Activism

We are happy to repost this from the CLS Blue Sky Blog.

The following comes to us from Bernard S. Sharfman, Visiting Assistant Professor of Law at Case Western Reserve University School of Law.


Finding Value in Shareholder Activism

In this era of shareholder activism, there are still many attorneys and academics who believe that the traditional authority model of corporate governance (the “traditional model”) leads to optimal corporate decision-making and shareholder wealth maximization for large organizations.  This model favors the views of management over those of outside shareholders like institutional investors.  In the words of Professor Stephen Bainbridge, it is an approach to corporate governance where the “preservation of managerial discretion should always be the null hypothesis.”

However, even a strong proponent of the traditional model does not believe that corporate boards and executive management should act without some outside accountability.  Therefore, it would be fruitless to ignore numerous and repeated empirical studies that create a strong inference that hedge funds, and other shareholder activists, help maximize wealth when they invest large amounts of money in the equity of a public company and then advocate for certain types of corporate changes.   Professors Brian Cheffins and John Armour refer to this activity as “offensive shareholder activism.”

This inference does not detract from the traditional model but enhances it by identifying a legitimate tool of accountability that helps to increase shareholder value in some cases. This is exactly how Professor Paul Rose and I interpreted the meaning of these empirical studies in our recent article, “Shareholder Activism as a Corrective Mechanism in Corporate Governance.”

According to renowned economist Kenneth Arrow, “others in the organization may have access to superior information on at least some matters.” Therefore, it is legitimate to criticize centralized authority from time to time and acknowledge and accept the value provided by the “corrective mechanism.” In this case, the value provided by offensive shareholder activism.

In sum, it may be more productive for those who believe in the traditional model to move away from attacking the value of offensive shareholder activism and instead focus on attacking those who opportunistically or inefficiently participate in other types of shareholder activism.

By  November 22, 2013

The full article is available here.