Professor Bainbridge...on law, politics, religion, culture & food

SOX and Going Private

Robert Bartlett’s article Going Private But Staying Public: Reexamining the Effect of Sarbanes-Oxley on Firms’ Going-Private Decisions validates a lot of the recommendations in the chapter on going dark in my SOX text.

This article examines whether the cost of complying with the Sarbanes-Oxley Act of 2002 (SOX) contributed to the rise in going-private transactions after its enactment. Prior studies of this issue generally suffer from a mistaken assumption that by going private, a publicly-traded firm necessarily immunizes itself from SOX. In actuality, the need to finance a going-private transaction often requires firms to issue high-yield debt securities that subject the surviving firm to SEC-reporting obligations and, as a consequence, most of the substantive provisions of SOX. This paper thus explores a previously unexamined natural experiment: To the extent SOX contributed to the rise in going-private transactions, one should observe after 2002 a transition away from high-yield debt in the financing of going-private transactions towards other forms of SOX-free finance.

Using a unique dataset of going-private transactions, this paper examines the financing decisions of 453 going-private transactions occurring in the eight year period surrounding the enactment of SOX. Although SOX-free forms of subordinated debt-financing were widely available during this period, I find no significant change in the overall rate at which firms used high-yield debt in structuring going-private transactions after SOX was enacted. Cross-sectional analysis, however, reveals that the use of high-yield financing marginally declined after 2002 for small- and medium-sized transactions, while significantly increasing for large-sized transactions. These findings are consistent with the hypothesis that the costs of SOX have disproportionately burdened small firms. They also strongly suggest that non-SOX factors were the primary impetus for the name brand buyouts commonly evoked as evidence that SOX has harmed the competitiveness of U.S. capital markets.

Shareholder- versus Director-Centric Governance

John Olson:

I’ve been giving some thought to the dust up last year between Marty Lipton and other governance experts as to whether Pfizer’s initiative of having several of its independent directors meet with its largest institutional investors represented a landmark in the decline of director-centric corporate governance, and have also been thinking about what we mean when we talk about director-centric vs. shareholder-centric governance. The working text of a talk I gave on the subject last week at the Corporate Governance Center at the University of Tennessee in Knoxville, at the invitation of Joe Carcello and Joan Heminway, is available here. I plan to do some more work on this and turn it into an article later this year. In the meantime, I’d greatly appreciate comments.

Here at PB.com, of course, we are well-stocked with thoughts on that subject and have no qualms about sharing them. Selected samples:

First, why do we have boards instead of a unitary executive? Why a Board? Group Decision Making in Corporate Governance, 55 Vanderbilt Law Review 1 (2002). Abstract:

The default statutory model of corporate governance contemplates not a single hierarch but rather a multi-member body that acts collegially. Why? This article reviews evidence that group decisionmaking is often preferable to that of individuals, focusing on evidence that groups are particularly likely to be more effective decisionmakers in settings analogous to those in which boards operate. Most of this evidence comes not from neo-classical economics, but from the behavioral sciences. In particular, cognitive psychology has a long-standing tradition of studying individual versus group decisionmaking. This article contends that behavioral research, taken together with various strands of new institutional economics, sheds considerable light on the role of the board of directors. In addition, the analysis has implications for several sub-regimes within corporate law. Are those sub-regimes well-designed to encourage optimal board behavior? Two such sub-regimes are surveyed here: First, the seemingly formalistic rules governing board decisionmaking processes turn out to make considerable sense in light of the experimental data on group decisionmaking. Second, the adverse consequences of judicial review for effective team functioning turns out to be a partial explanation for the business judgment rule.

Next, why director-centric governance? Director Primacy: The Means and Ends of Corporate Governance, 97 Northwestern University Law Review 547 (2003), which was selected as one of the 10 best corporate and securities law articles published in 2003. Abstract:

Any model of corporate governance must answer two basic sets of questions: (1) Who decides? In other words, when push comes to shove, who has ultimate control? (2) Whose interests prevail? When the ultimate decisionmaker is presented with a zero sum game, in which it must prefer the interests of one constituency class over those of all others, whose interests prevail?

On the means question, prior scholarship has almost uniformly favored either shareholder primacy or managerialism. This article argues that control - the power and right to exercise decisionmaking fiat - is vested neither in the shareholders nor the managers, but in the board of directors. According to this “director primacy” model, the corporation is a vehicle by which the board of directors hires various factors of production. The board of directors thus is not a mere agent of the shareholders, but rather is a sui generis body - a sort of Platonic guardian - serving as the nexus of the various contracts making up the corporation. As a positive theory of corporate governance, director primacy thus claims that fiat - centralized decisionmaking - is the essential attribute of efficient corporate governance. As a normative theory of corporate governance, director primacy claims that resolving the resulting tension between authority and accountability is the central problem of corporate law.

On the ends question, prior scholarship has tended to favor either shareholder primacy or various forms of stakeholderism. Again, director primacy rejects both approaches. Although shareholder primacy and the shareholder wealth maximization norm are often conflated, one can have the latter without necessarily endorsing the former. Hence, this article argues that director decisionmaking primacy can be reconciled with a contractual obligation on the board’s part to maximize the value of the shareholders’ residual claim.

Then a specific reply to a leading theory of shareholder-centric governance: Director Primacy and Shareholder Disempowerment, 119 Harvard Law Review 1735 (2006), selected as one of the 10 best corporate and securities law articles published in 2006. Abstract:

This essay is a response to Lucian Bebchuk’s recent article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow shareholders to initiate and vote to adopt changes in the company’s basic corporate governance arrangements.

In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm’s organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights.

Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk’s account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule.

Finally, I suggest a number of reasons to be skeptical of Bebchuk’s claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.

Last, but perhaps not least, a more expansive treatment of the arguments against shareholder-centric governance: The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601 (2006). Abstract:

Recent years have seen a number of efforts to extend the shareholder franchise. These efforts implicate two fundamental issues for corporation law. First, why do shareholders - and only shareholders - have voting rights? Second, why are the voting rights of shareholders so limited? This essay proposes answers for those questions.

As for efforts to expand the limited shareholder voting rights currently provided by corporation law, the essay argues that the director primacy-based system of U.S. corporate governance has served investors and society well. This record of success occurred not in spite of the separation of ownership and control, but because of that separation. Before changing making further changes to the system of corporate law that has worked well for generations, it would be appropriate to give those changes already made time to work their way through the system. To the extent additional change or reform is thought desirable at this point, surely it should be in the nature of minor modifications to the newly adopted rules designed to enhance their performance, or rather than radical and unprecedented shifts in the system of corporate governance that has existed for decades.

Green CSR Harms Shareholders

Voluntary Corporate Environmental Initiatives and Shareholder Wealth by Karen Fisher-Vanden and Karin Thorburn:

Researchers debate whether environmental investments reduce firm value or can actually improve financial performance. We provide some first evidence on shareholder wealth effects of voluntary corporate environmental initiatives. Companies announcing membership in Climate Leaders and Ceres - two voluntary environmental programs related to climate change - experience significantly negative abnormal stock returns. The price decline is smaller in carbon-intensive industries, where regulatory actions are more likely, and for high book-to-market firms, suggesting that “green” expenditures crowd out growth-related investments. We also document insignificant announcement returns for portfolios of industry rivals. Overall, the environmental investments appear to conflict with shareholder value-maximization. This has far reaching implications since the U.S. government relies on voluntary initiatives to reduce the emissions of greenhouse gases.

Student Evaluations: A Debate

They’re debating student evaluations at Phi Beta Cons. Excerpts follow, but it’d be worth going over and reading the whole thing.

‘Subjecting the Wise to the Scrutiny of the Unwise’

Studies have shown, I say solemnly, that the young faculty, particularly, who are subjected to course evaluations, tend to raise the grades of their courses to avoid untoward comment,” Mansfield said.

[...] Mansfield added that he thought the evaluations “subjected the wise to the judgment and scrutiny of the unwise.”

... Student evaluation of their teachers really is, for the most part, a counterproductive enterprise. Not only does it have the flaws Mansfield notes, it also allows students to breeze through the Q Guide and pick gut courses by the assessment of its “difficulty” — on a 1 to 5 scale — made by its former students. And, yes, a sad number of Harvard students pick their “Core” (i.e. general education) courses this way. That, and student evaluation only gives weight to the flawed notion that somehow teaching a course is primarily a “learning experience” or, as another professor’s recent exhortation to students has it — *cringe* — a “dialogue.”

Re: ‘Subjecting the Wise . . . ‘

They certainly have flaws, but I have to disagree that student course evaluations are “counterproductive.” It’s sad that some professors give higher grades to get higher ratings in return, and even sadder that some students will go out of their way to take easy classes (because of the wide range of difficulty, college GPAs are as much a measure of course selection as of work quality) — but my college had evaluations, and I often found them quite valuable.

Students comment, for example, on lecturing ability, fairness in grading, reasonableness of workload (I don’t think it’s wrong to avoid professors who intentionally assign more reading than can plausibly take place, just to test your ability to “find the important parts"), usefulness of reading assignments, political indoctrination, etc. And while it’s absurd to put a professor’s learning on the same level as that of his students, I do think student suggestions can improve teaching.

Re: ‘Subjecting the Wise’

A reader, Vivek Rao, writes in: 

I think that student evaluations of faculty should be made available, but we should be wary of their shortcomings. There was a study finding that student evaluations of professor depend in part on the professor’s looks and whether he is an easy grader.

The study is here.

There are a number of methods that have much the same utility as student-review of their professors, but are absent the pitfalls. A number of schools have introduced a peer-review structure for professors; doubtless this is equally or more unpopular with professors, territorial as they are, but the reviews carry the weight of non-specialists who nonetheless understand the expectations of the field. Their criticisms, I imagine, are far more likely to be taken seriously as well, rather than simply appeased by inflating grades.

One Last Thing on Faculty Evals...

Another correspondent, Jeannine McDevitt, writes in with some anecdotal evidence on the grade-inflation-in-the-face-of-student-evaluation (hey, that rhymes!) issue:

I am a tenured faculty member at a small community college. My own institution is very reasonable in interpreting student evaluations.

However, last summer I attended a conference for faculty who had recently received tenure or were soon eligible, and I met a woman who was eligible for tenure at one of my state’s universities. Her student evaluations after her first semester of teaching were very negative, and she was called in before the tenure and promotion committee to warn her that her performance was unacceptable. Her faculty mentor spoke to her privately afterward and asked her about her grading. His advice to her was to give more A’s and B’s so that the students would like her. She was angry, but she decided to try that approach as an experiment the next semester. The result? Much more positive student evaluations, and a commendation from the committee on her “progress” as a teacher.

Milberg Weiss

The Washington Examiner posts a page entitled Lawyers Gone Wild, which claims to shine “light on a revealing back story from the saga of the Milberg Weiss securities class-action lawsuit kickback scheme.”

Whence Goeth Say on Pay?

Lisa Fairfax provides an update.

Director Standing qua Director to Sue Derivatively

Francis Pileggi alerts us to a new Delaware supreme court decision, Schoon v. Smith, which Pileggi explains held that “a director qua director may not sue fellow directors of a corporation derivatively.”

Plieggi links to a commentary by Steven Haas, who opines that:

Does a Director Qua Director Have Standing to Sue Derivatively? No, so said the Delaware Supreme Court yesterday in Schoon v. Smith. The Supreme Court affirmed the Court of Chancery’s little-noticed ruling last year that dismissed a derivative claim brought by a director against the company’s other directors, including its controlling stockholder. The plaintiff-director, who was not a stockholder of the company, charged his fellow directors with, among other things, breach of fiduciary duty and unjust enrichment. The court held that, notwithstanding the equitable origins of derivative suits, the issue of director standing today is best left to the legislature. “Although the Delaware General Assembly has the prerogative to confer standing upon directors by statute,” the court wrote, “it has not chosen to do so.” Rejecting the American Law Institute Principles that give individual directors standing to sue on behalf of their corporations, the court continued that, “because a stockholder derivative action is available to redress any breach of fiduciary duty, we decline to extend the doctrine of equitable standing to allow a director to bring a similar action.” The court concluded, however, by leaving itself a little room to permit directors to bring derivative suits, but only where the failure to do so would result in a “complete failure of justice”—a seemingly high standard.

As a practical matter, the decision is unlikely to have much significance because most directors are also stockholders. But the decision is still significant and may draw criticism with respect to its implications for corporate governance and director duties. In particular, the court noted that the concept of being an “independent director” does not mandate “a duty to sue on behalf of the corporation.”

In my Corporation Law and Economics treatise, I waffled:

Assume an injury to the corporation giving rise to a claim belonging to the corporation. Obviously, the board of directors, acting collectively, could authorize the corporation’s agents to bring the lawsuit in question. Suppose, however, the board has not acted. An individual director who is also a shareholder obviously could bring a derivative cause of action in the latter capacity. But does a director qua director have standing? The logical answer is no, although that answer is based on the implications of several distinct principles rather than a single statement of doctrine. First, both MBCA § 7.41 and Federal Rule 23.1 speak only of shareholders. As we have seen, other corporate constituents (such as creditors) lack standing. Second, under AGENCY RESTATEMENT § 14 C, an individual director is not an agent of the corporation. Indeed, comment b to that section states that the individual director “has no power of his own to act on the corporation’s behalf, but only as one of the body of directors acting as a board.” Taken together, these principles logically suggest that a director acting alone has no standing to sue qua director.

A few states, most notably New York, confer standing by statute on individual directors to bring derivative proceedings.  A director may not initiate a derivative action after leaving office, but neither removal nor expiration of the director’s term of office extinguishes the director’s standing to continue a previously filed suit.  ALI PRINCIPLES § 7.02(c) adopted the same rule.

Although director standing remains very much the minority position, it has a certain attraction. Recall the basic tenet of this text; namely, that shareholders do not own the corporation. Instead, they are merely one of many corporate constituencies bound together by a complex web of explicit and implicit contracts. To be sure, by virtue of their contractual status as residual claimants, shareholders ought to have standing to pursue suits that lower the value of that claim. If we view the directors as the corporation’s Platonic guardians, however, perhaps the directors ought to have prior standing to litigate injuries to the corporation. On the other hand, given the strong efficiency justifications for corporate law’s emphasis on the board as a collective, perhaps we ought to discourage directors from acting as lone rangers.

You’ll have to buy the book to get the benefit of the footnotes!

Another fun efficient capital markets anomaly

David Gaffen:

Regardless of how January turned out, the various indicators that involve some sort of luck and alchemy continue to line up well for U.S. equity markets. First, the Super Bowl indicator turned out better than anyone (save die-hard Giants fans [see Super Bowl anomaly]) expected. Then, the Chinese New Year came, ushering in the Year of the Rat, which has generally been a solid one for investors.

And MarketBeat’s exclusive Westminster Kennel Club Dog Show indicator also foresees reasonably good things for stocks. Last night, at the 132nd annual dog show, Uno, a 15-inch beagle, took home the blue ribbon, the first time that breed has won the competition.

The beagle belongs to the hound group, which has only mustered three previous winners since the show’s inception. In two of three years, the Dow performed quite well, with one negative performance.

The average return in those years is 7.4%, as the average gained 20.3% in 1983, the last time a hound was victorious (an Afghan hound). In 1964, when the whippet claimed the top prize, the Dow gained 14.6%. Only in 1957, when another Afghan took home the ribbon, was the Dow weak, losing 12.8%.

(HT: Dealbreaker.com) With Marisa Miller having appeared on the cover of Sports Illustrated’s swimsuit issue, it’s been a good week for ECMH anomalies.