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

Stock ownership guidelines for corporate directors - Revised and reposted

A growing number of US public corporations require that directors own stock in the corporation in order to serve on the board. In theory, such requirements align director incentives with those of shareholders. In practice, however, some of these plans may have an exclusionary effect by limiting the pool of potential candidates to those with the means to acquire the requisite amount of stock. Consider, for example, the plan adopted by Praxair:

The board has adopted a policy whereby directors must acquire and hold during their service as a Praxair board member shares of the company's stock equal in value to at least five times the base cash retainer for directors. Directors have five years from their initial election to meet this guideline (or, for incumbent directors, until October 2007). As shown in the stock ownership table, all directors have met this guideline or are within the compliance period; and most substantially exceed the guideline. In addition, any new director elected after October 2002 must, no later than the date of his/her election, acquire, using his/her own personal resources, shares of the company's stock equal in value to the base cash retainer. [Emphasis supplied -- ed.]

In order to join Praxair's board, you'd thus have to pony up $55,000 (the amount of the annual retainer) before joining the board and out of your own personal resources. Requiring such a substantial investment would discourage a lot of capable folks (guess who?). Granted, one could probably borrow against receipt of the retainer, but persons with a modest portfolio still might be reluctant to make such a sizeable investment if doing so left their portfolio substantially less diversified. As we strive to get rid of crony and ceremonial directors, the question must be asked whether it makes sense to limit the pool of plausible candidates to the very wealthy. [Update: Thanks to an alert reader who caught an error in the first version of this post.]

Getting rid of crony and ceremonial directors

The WSJ has a major report today on Dick Grasso's tenure as NYSE CEO. It reminds us that one of the key problems with Grasso was his ability to stack the NYSE board with nominally independent directors who were in fact Grasso cronies and/or ceremonial figureheads who knew nothing but had a lustrous resume. Eliminating crony and ceremonial directors would be a major step towards undoing the imperial CEO of the management-captured corporation and restoring the primacy of the board of directors. But how?

Requiring that the corporation have a majority of independent directors, as the NYSE listing standards now do, is not enough. The Grasso story confirms that a CEO can still stack the board while complying with a director independence requirement.

Instead, the key is control of the nominating process. As boards become stronger and more independent of top management, the process builds momentum. For example, Westphal and Zajac have demonstrated that in CEO-dominated boards, newly appointed board members tend to demographically resemble the CEO. In contrast, as board power increases relative to the CEO - measured by such factors as the percentage of insiders and whether the CEO also served as chairman - newly appointed directors demographically resemble the board rather than the CEO. The NYSE and NASDAQ listing standards now require that the corporation have a separate nominating committee comprised solely of independent directors, which is a major step in the right direction. Additional transparency, so that the markets can verify that the nominating committee itself is not stacked with cronies or figureheads would help too (although I still share Mike O'Sullivan's skepticism of the SEC's new rules, even though some of the concerns he raised were resolved in the final rule). Only when boards truly wrest control of the levers of nominating power from the CEO will director primacy triumph over managerialism.

Charles Elson on Related Party Transactions in the Boardroom

My friend and law school classmate Charles Elson is a leading expert on corporate governance. Although we have much in common, including membership in the Federalist Society, we often do not see eye-to-eye on corporate governance issues. A case in point is offered by today's major WSJ article on related party transactions between directors or officers and the corporations they serve. Elson favors banning such transactions:

All these deals present the risk of conflicts between a company official's two roles: representative of the shareholder and individual seeking to get the best deal for himself. Some argue that the risks outweigh any potential benefits of such arrangements. "I think we should just have a blanket prohibition on any significant related-party transactions," says Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. Only minor deals would escape Mr. Elson's ban, such as the director of a bank having a checking account at the institution.

In contrast, I think a complete ban would be overkill. At an abstract level, prohibiting conflicted interest transactions fails to give due deference to the principles of party autonomy and freedom of contract, which are important values both in themselves and because they promote efficient transactions. At a practical level, many transactions between the corporation and a director prove beneficial to both sides. If a director owns a valuable piece of property, which would be useful to the corporation, should not the director be allowed to sell it to the firm? As the WSJ observed, I think correctly:

[M]any public companies began as family enterprises and employment and business relationships involving family members arose as a natural part of the company's growth. Likewise, a company might want the head of a key supplier as a director in order to get that person's business insights. As more and more women have been employed at all levels of corporations, the workplace has become a much more common place to meet one's spouse.

All in all, some argue, a ban on related-party dealings could deprive a company of talented employees or beneficial business arrangements.

In sum, it's worth remembering that a conflict of interest is just a state of affairs, not a crime to which we should ascribe moral blameworthiness. Corporate law has a long tradition of policing rather than prohibiting conflicts of interest, including related party transactions. Because of the potential conflict of interest, such transactions indeed should be policed quite closely, being subjected to exacting scrutiny under the duty of loyalty's entire fairness standard, but not banned.

Parmalat as a Corporate Governance Scandal

The Parmalat situation started out as a fairly standard - if stunningly large - accounting fraud. Managers allegedly used various accounting tricks to avoid disclosing sizeable losses, possibly with the collusion of at least some auditors and lawyers. According to this morning's WSJ, however:

As the probe advances, one of the chief questions remains: Where did the money go? Much of the alleged fakery appears to have been aimed at hiding losses, according to a person familiar with the matter. But prosecutors also say they now suspect that individuals were siphoning off some cash for themselves, this person said. ...

Prosecutors looking into Parmalat are alleging Mr. Tanzi, who stepped down this month, misappropriated at least $600 million from the business over the years, according to a person familiar with the widening probe at the Italian dairy conglomerate.

In other words, the Parmalat problem has expanded from "mere" accounting fraud into a classic example of the corporate governance problems associated with large publicly held corporations. I thought it might be useful to spend a few minutes explaining how the corporate governance problem at Parmalat differs from that at, say, Enron.

My professional career has been devoted to the study of large publicly held corporations. The key governance problem in such firms, of course, is the separation of ownership and control. The firm’s nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically owned only a small portion of the firm’s shares.

Separation of ownership and control occurs in its purest form in the truly public corporation in which stock ownership is dispersed amongst many shareholders, no one of whom owns enough shares to materially affect the corporation’s management. As Professors Berle and Means famously explained: “The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge ....” Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property 6 (1932). Preventing such divergences, or at least minimizing their effects, has been the primary concern of scholars and regulators. Enron stands as a classic example that, despite all our work, unscrupulous managers can still - and always will - use their control over such corporations to benefit themselves at the expense of their shareholders (not to mention creditors, employees, and other stakeholders).

Yet, not all publicly held corporations exhibit a complete separation of ownership and control. Some public corporations have a single shareholder (or a small cohesive group of shareholders acting together) who own a majority of the voting stock of the corporation. Many more have a single shareholder or group who owns less than a majority but nevertheless ows a sufficiently large block to give it effective voting control. (The classic example is John D. Rockefeller, Jr.’s struggle to oust the chairman of the board of Standard Oil of Indiana. Rockefeller controlled only 14.9% of Standard Oil’s stock. After an admittedly long and difficult contest, however, Rockefeller ultimately prevailed in attracting enough support from other shareholders to ust the chairman.)

The presence of a controlling shareholder solves the classic separation of ownership and control agency problem. Managers who pursue their own self-interest will be displaced by the controlling shareholder.

Yet, the presence of a controlling shareholder introduces a new divergence of interest; namely, that between the majority shareholder and the minority shareholders. Precisely because of the power exercised by a controlling shareholder over management, it is very easy for the controlling shareholder to extract non-pro rata benefits for itself at the expense of the minority. At Hollinger, for example, Lord Conrad Black allegedly not only caused the corporation to pay large management fees to companies controlled by hom or his cronies, but also caused the company to spend $8 million of its own money to buy FDR historical papers Black then used in writing his FDR biography. If the prosecutors are right, Parmalat controlling shareholder and CEO Tanzi joined that club sometime ago.

Because of the potshots some European comentators took at Anglo-Saxon capitalism after Enron, it is tempting to make much of the Parmalat scandal (even for me). Yet, in truth, there is no room for jingoism in this context. The problem of majority shareholder abuses is no respecter of national boundaries. In juxtaposition to Parmalat, for example, one could cite the Anglo-US example of Hollinger, or the domestic US example of Adelphia.

There are no easy solutions to the problem of dealing with a controlling shareholder. Forcing a majority shareholder to give up control is no answer, both because of the enfringement on contract and property rights and because it solves one governance problem by restoring the agency problem associated with dispersed ownership. Transparent accounting rules is key, but enforcement is a problem. Accounting fraud will be with us as long as there are unscrupulous businessmen and dishonest or incompetent lawyers and auditors. Attempts to drive out every last residue of fraud are more likely to burden honest corporations with undue regulations than to prevent bad actors from acting badly. Instead, what we should strive for is a cost-effect system of better accounting rules and responsible enforcement that strives only to reduce the problem to manageable proportions.

Related post: Parmalat as an Accounting Scandal

Parmalat as an Accounting Scandal

Back when the Enron scandal broke, there was a lot of self-satisfied commentary in Europe about the evils of unregulated Anglo-Saxon capitalism (written in what Samizdata.net accurately calls a "smug tone"). The difficulty with the European line of reasoning, however, was that Enron was basically an accounting fraud (as have been most of the other major corporate scandals). Nobody who knew anything about European accounting standards was surprised when it turned out that Europe had its own share of Enrons just waiting to be discovered.

As I explained in my article Mandatory Disclosure: A Behavioral Analysis:

[M]any international issuers have voluntarily adopted U.S.-style accounting standards that promote transparency. One study of the German disclosure regime found, for example:

German managers have had difficulty explaining their (German GAAP) financial results to foreign investors and have claimed that a lack of international acceptance of German financial statements has led to disadvantages for firms seeking to raise capital abroad. In response to these problems and their financial needs, many German firms have increased their disclosure voluntarily and have adopted reporting strategies that bring them closer to international practice. [Christian Leuz and Robert E. Verrechchia, The Economic Consequences of Increased Disclosure (July 1999).]

Those chickens came home to first with Dutch retailer Ahold and now with a vengeance with Parmalat. As it turns out, neither the US nor Europe has any shortage of accounting loopholes or of businessmen eager to cease upon them to conceal losses or of lawyers and auditors prepared to assist.

Related post: Parmalat as a Corporate Governance Scandal

Mike O’Sullivan Compares the SEC and Spitzer

Over at Corp Law Blog, Mike observes:

Spitzer feels free to use New York's Martin Act to attack anything that strikes him as abusive, regardless of whether it's clearly illegal. The SEC has in its arsenal nothing as open-ended as the Martin Act, and that's a good thing for US markets. The Martin Act is, as one commentator called it (PDF), a "fierce sword" of uncertainty, permitting prosecutors to stretch the definition of crimes and then engage in extensive discovery to compel their targets to capitulate. This makes the Martin Act a very useful tool for a prosecutor looking to make his mark, and a nearly useless guide to a person looking to avoid becoming the target of a prosecutor looking to make his mark.

Beyond creating uncertainty, another interesting consequence of open-ended criminal statutes like the Martin Act is the freedom they give prosecutors the freedom to legislate on the fly. The SEC cannot adopt rules without first notifying the public of its intended rule, accepting and evaluating comments, publishing a final rule and waiting a certain period of time following publication before it can enforce the new rule. None of these protections apply to prosecutors like Spitzer. ...

Eliot Spitzer may measure his success by the number of perp walks he orchestrates. The SEC must measure its success first and foremost by the vitality and strength of the securities markets it regulates. Markets need clearly enunciated and consistently enforced standards. In order to achieve this, a responsible regulatory agency has to be somewhat legalistic, enforcing the four corners of the law and avoiding the desire to make it up as it goes along. Otherwise the regulator would be opportunistic, unbound by laws and, in a word, unpredictable -- the ultimate enemy of the markets it's supposed to protect.

I haven't bothered to replicate the many links in Mike's analysis, because you should go read the whole thing at the source.

Spitzer Claus

Sometimes I worry that I'm becoming a bit monomaniacal about Eliot Spitzer, but as somebody whose professional career has been devoted to the study of US capital markets it annoys me to no end to see him running amok in them. Every week seems to bring some new outrage to light. Here's the latest, hot off the WSJ's presses:

[T]o a host of Empire State charities and well-connected law-school deans, the crusading New York attorney general is acting a lot ... like Santa Claus.

Three civil settlements he struck in an unusual case against wealthy telecom executives and IPOs have allowed him to bestow more than $5 million in largess over the past several months to dozens of community groups across New York state. The recipients are intended as a sort of proxy for individual investors who allegedly suffered from the actions of the defendants, who were accused of profiting from undisclosed awards of sought-after initial public offerings from investment bankers seeking their business. ... But the groups receiving the windfall also represent voter constituencies that could be key to Mr. Spitzer's widely expected Democratic run for governor in 2006.

Once again, we see Spitzer abusing his prosecutorial powers for personal political gain. Once again, it is time for the feds to step in to keep Spitzer from getting elected governor on the backs of our capital markets.

Law Firm Humor

I like Fried Frank's annual holiday food fraud newsletter. This year it's Lobster Fraud.