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

SOX Resource

The Weil, Gotschal & Manges law firm has been publishing a series of backgrounders and alerts on Sarbanes-Oxley developments, which are collected here. It's a great resource for anyone doing SOX-related research.

Kirk Kerkorian’s Suit

A couple of days ago, I blogged my disagreement with Holman Jenkin's analysis of Krik Kerkorian's suit against DaimlerChrylser. If you want to see a really good analysis of that suit, check out my friend Gordon Smith's exellent post at his Venturpreneur site. He does a great job of tracing the history of Kerkorian's Chrysler investment.

Regulation by Litigation: Spitzer’s Attack on Mutual Fund Fees

NY attorney general Elliot Spitzer has no power - none, nada, zilch - to regulate mutual funds fees. Yet, the WSJ reports that Spitzer plans to require fee reductions as part of any settlements he reaches with fund companies in late trading and market timing cases. This is even worse than the private party Regulation through Litigation about which I have opined in this space before. This is a gross abuse of prosecutorial power - leveraging what I regard as perfectly legitimate charges to accomplish unrelated goals the regulator has no constitutional right, statutory authorization, or common law power to regulate directly. (In contrast, the SEC gets it.) Early on in my blogging career I gave an affirmative answer to the question Can you be a Competitive Federalist and still want Spitzer to shut the #@!% up?. The case I made there for preempting Spitzer via federal legislation becomes stronger with every passing day.

Use and Abuse of Sarbanes-Oxley § 307

I've blogged on the problems with SOX § 307 and I've written law review articles on them. Yet, now we have a new thing to worry about; namely, overeager application by the SEC. The NY Times is reporting that SEC Commissioner Harvey "I never saw a problem that didn't need a new law" Goldschmid is threatening to use § 307 against mutual fund lawyers (link via Mike O'Sullivan):

"An attorney who is aware of credible evidence of a material violation of the securities laws, or a material breach of fiduciary duty, must report this evidence up the chain of command," if necessary to independent members of the fund's board, said Harvey J. Goldschmid, the S.E.C. commissioner, in a speech before the Investment Company Institute, the mutual fund trade group, in Washington.

What's wrong with that? Well, number one, there is no evidence any fund lawyers knew anything about the problematic trades:

No one has yet asserted that specific lawyers representing particular funds knew of possibly unethical behavior by managers, said Paul Schott Stevens, a partner in the Washington office of Dechert. What is more, Mr. Stevens said, no one has charged that a lawyer knew that fund managers permitted after-hours trading by certain favored investors or that the managers allowed some investors to buy and sell fund shares rapidly.

In my work on § 307 I have repeatedly argued that:

Managers who intentionally commit fraud or breaches of fiduciary duty will only rarely consult their legal counsel, of course. Instead, counsel will be consulted by a manager who is pursuing an aggressive course of conduct or one who has inadvertently strayed over the line into illegality. Unfortunately, SOX 307 likely will discourage even those contacts. Even corporate managers not engaged in actual misconduct will not welcome the investigation that an attorney’s “reporting up” would engender, especially where there is a possibility that counsel will go over their heads. Managers therefore may withhold information from counsel, so as to withhold it from the board, especially when the managers are knowingly pursuing an aggressive course of conduct. Indeed, in many of the recent corporate scandals, the misconduct was committed by a small group of senior managers who took considerable pains to conceal their actions from outside advisors such as legal counsel.

Bringing the sort of marginal cases Commissioner Goldschmid is proposing will only strengthen those incentives. Hence, it becomes even less likely that managers will consult lawyers. At the same time, juries and regulators acting with the benefit of hindsight may infer the lawyers must have known what was going on, imposing liability. Being a corporate practitioner is likely to get a lot more stressful, which means being a corporate client is likely to get a lot more expensive.

9900 MarkDow Crosses 9900 Mark

I don't know, obviously, but I wouldn't count on it. Why? Check out my post, Dow 10000, Psychology, and the ECMH.

Was Martha Stewart’s Denial Material? The Problem with Count 9

Over at Slate, Henry Blodgett's continuing coverage of the Martha Stewart trial remains must-reading for anyone remotely interested in domestic divas in distress. In entry # 2 he correctly explains that the criminal indictment against Stewart does not allege insider trading. He also correctly explains that:

[T]he securities fraud charge is not based on Stewart's denial that she committed insider trading. It is based on her having gone beyond a denial to offer what the prosecution regards as a false explanation for the trade. Still, as Judge Miriam Cedarbaum observed in the Nov. 18 hearing, the charge is, at the very least, a "novel" application of securities law. Typical securities fraud cases are based on false statements about a company's business, financial performance, or products. In this case, Stewart's statements were not about her company but about her personal sale of stock in another company.

I agree with the Judge that the securities fraud charge is a bit of a stretch. Here's why.

As I explain in my book, Securities Fraud: Insider Trading, one can only be held liable for securities fraud if one has made a material misrepresentation or omitted to state a material fact that one had a duty to disclose.

In this case, the government is trying to prove that Martha's public defense of her transaction was a material misrepresentation. First, the government must prove that she lied when she claimed the transaction was executed pursuant to a pre-established trading plan. This going to be a battle of credibility, unless they have smoking gun physical evidence. UPDATE: On the physical evidence issue, compare the Media Cynic and Tung Yin. I don't find any of the items Prof. Yin cites to be "smoking guns," which is why I still think it will end up being a credibility contest. He may be right that the government is likely to win that contest, but after the Quattrone trial, I'm not so sure about that. (All of which tends to confirm my argument below that jury selection will matter a lot.)

Second, even if the government can prove Stewart lied, the government still must prove that her lie was material. In order for a misrepresentation to be material, the government will have to prove that there was a substantial likelihood that the reasonable investor would have considered it important in deciding whether to buy or sell Martha Stewart Omnimedia stock. This is the real stretch.

Would the reasonable investor be effected in his/her decision by Martha's explanation? I don't see how. The government is making a big deal about how critical Martha is to the company. But that's not the right question.

The right question is whether the reasonable investor would factor Martha's explanation for the trade into the investor's calculus of whether Martha will get off, which in turn would have to then be factored into the investor's calculus of whether to buy or sell MSO stock. In other words, they're either going to have to prove (1) a reasonable investor would have thought Martha was guilty of insider trading, would have changed his/her mind because of Martha's explanation for the trade, and therefore would have bought MSO stock or (2) a reasonable investor would have thought Martha was innocent of insider trading, would have had that belief confirmed by the explanation, and therefore would have bought MSO stock. Or maybe sold. Or maybe .... Well, you get the point.

I find the government's case implausible. My guess is most people either figure she didn't commit insider trading, in which case her allegedly false explanation for the trade is irrelevant, or (probably more likely) they figure she did do it but would give her a pass on the denial. Nobody would expect Martha to admit guilt. To the contrary, reasonable people would expect her to deny it, even if they think she did it. So I have a very hard time seeing how the government is going to prove that Martha's denial (even if false) would have been considered important by the reasonable investor in deciding whether to buy or sell MSO stock. (Whether they can get her on any of the other 8 counts is beyond the scope of this post!)

The government's best shot - maybe its only shot - on Count 9 is to get a jury that's really mad at rich corporate fatcats, but I assume Martha can afford a really good jury consultant.

Holman Jenkins on Control Premia

In a WSJ op-ed criticizing Kirk Kerkorian's securities fraud suit against DaimlerChrysler (among other current corporate governance disputes), Holman Jenkins says some very sensible things, such as:

Amid all the bellyaching about corporate governance, it's good to recall that the purpose of corporations is to create wealth. We ought to be careful before giving up too much vitality and risktaking in return for the false security of lawyers and prosecutors crawling all over management night and day.

Yet, he also makes a fundamental economic error in describing Kerkorian's suit. When Daimler and Chrysler merged, the deal was structured as a merger of equals. Unlike most corporate acquisitions, in most mergers of equals shareholders of neither constituent corporation receive a control permium for their shares (instead they just end up owning an equivalent amount of shares in the newly combined entity). In his suit, Kerkorian claims that the deal ended up being a de facto acquisition of Chrysler by Daimler, that Daimler planned it that way all along, and that Daimler's failure to disclose its alleged true intentions constituted securities fraud. Kerkorian's claim strikes me as being a bit of a stretch, but Jenkins' cavalier dismissal of it is clearly erroneous. Jenkins claims:

A "control premium" is a mythical concept: The large premium sometimes paid above market value in takeovers is purely a function of the presence or likely emergence of other bidders. Bidders weren't exactly lining up for Chrysler.

Wrong. The likelihood of competitive bidding may affect the size of the control premium offered by the initial bidder, and the emergence of competing bids definitely drives up the control premium that is ultimately paid, but a control premium is not dependent on either the existence of nor the prospect of competitive bids. I identified one source of control premia at page 213 of my text Mergers and Acquisitions:

Stock consists of two rights: economic and voting. A single share of stock gives the owner little control over the company. The market price of a share of stock thus reflects nothing more than the estimated present value of the future stream of dividends payable on that share. Someone buying a control block of stock, however, obtains significant control through the ability to elect the board of directors. Such control might be valuable if the purchaser believes it can use its position to extract nonpro rata special benefits from the corporation, such as generous salaries, perquisites, and the like. Note that such a sale does not necessarily leave the minority shareholders any worse off. The selling shareholder may well have been doing the same thing. Alternatively, the purchaser may believe that the shares will be worth more in its hands than in those of the incumbent. Perhaps the incumbent is a poor manager. If the stock price is depressed due to poor management, replacing the incumbents with more competent managers should raise the stock price and enable the purchaser to profit.

An alternative explanation for why control premia are paid in acquisitions has to do with the hypothesis that the demand curves for stock slope downward. I discuss that explanation at pages 55-56. But if you want the details on that one, you'll have to buy the book! (Heh.)

Corp Law Blog on Omnicare

Mike O'Sullivan has a great post today on the Delaware supreme court's decision in Omnicare v. NCS Healthcare. I especially liked his analyses of how the case can be distinguished and, even more so, how transaction planners can structure a deal to evade it. A must read for corporate and business law students and lawyers.