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

Why institutional investors are not the saviors of corporate governance

At the CorporateCounsel.Net Blog, Broc writes:

As Pat McGurn of ISS noted in our recent "Wildest Proxy Season" webcast, mutual funds often are the "swing" vote in a close vote. In addition, the SEC's recent proposal on shareholder access will undoubtably make the votes cast by mutual funds even more important. That's one reason why the governance failures at funds are so scary. The reforms that companies have undergone over the past two years pale next to the ones necessary to fix governance in the mutual fund industry.

If I may be allowed to toot my own horn, I saw this one coming. In my article, The Politics of Corporate Governance, 18 Harvard Journal of Law & Public Policy 671 (1995), I wrote:

Dr. Seuss tells a marvelous tale about the town of Hawtch-Hawtch, whose principal industry is a bee. The Bee-Watcher’s job is to watch the bee, because “[a] bee that is watched will work harder, you see.” Unfortunately, the bee didn’t work very hard. The townspeople concluded that this was the fault of the Bee Watcher, so they decided to hire a Bee-Watcher-Watcher. But the latter also failed. So a Watch-Watcher-Watcher was hired. Things progressed as one might expect, with the upshot being that soon all of Hawtch-Hawtch was out in the field watching one another. ...

[The] problem with reforms designed to enhance institutional investor monitoring of public corporation management should now be readily apparent: it amounts to hiring a Bee-Watcher-Watcher. The vast majority of large institutional investors manage the pooled savings of small individual investors. From a governance perspective, there is little to distinguish such institutions from corporations. The holders of investment company shares, for example, have no more control over the election of company trustees than they do over the election of corporate directors. Nor do the holders of such shares have any greater access to information about their holdings, or ability to monitor those who manage their holdings, than do corporate shareholders. Indeed, until quite recently, most investment companies would not even disclose the name and background of the individual who managed the fund. Worse yet, although an individual investor can always abide by the Wall Street Rule with respect to corporate stock, he cannot do so with respect to such investments as an involuntary, contributory pension plan. In sum, if separation of ownership and control is a problem in search of a solution, encouraging large financial intermediaries to evolve and to take an active corporate governance role simply moves the problem back a step: it does not solve it.

SEC may support NYSE split

Back during the Grasso pay flap, I posted an argument that the NYSE's market and self-regulatory functions should be separated, with the former being spun off and privatized (see also here for criticism of NYSE interim chief Reed's decision to oppose such a split). At the time, I explained that there widely held suspicions that front running and trading ahead were serious problems among exchange specialists.

Yesterday's Wall Street Journal (sub. req'd) reported on an internal SEC report finding that such suspicions were well-taken:

It paints a picture of a floor-trading system riddled with abuses, with firms routinely placing their own trades ahead of those by customers -- and an in-house regulator either ill-equipped or too worried about increasing its workload to care. And it concludes that when the NYSE does act on investor abuses, the exchange often does little more than admonish the specialists in a letter or slap them on the wrist with a light fine. The SEC staff "is concerned that the NYSE's disciplinary program is viewed by specialists and specialist firms as a minor cost of doing business, and that it does not adequately discipline or deter violative conduct," the report says.

The report is quite damning both as to the Exchange and the specialists. It seems clear that abuses are indeed rampant, while the Exchange has systematically overlooked them. The conflict of interest inherent in the current scheme, in which the Exchange is owned by the very people it is supposed to regulate, has affected enforcement. The case for privatization of the market and incorporation of its regulatory function into a new body, as NASDAQ did some time ago, is now compelling. Interestingly, the WSJ's website is now reporting that SEC Chariman William Donaldson has reached the same conclusion:

Mr. Donaldson was "horrified" by the regulatory breakdown at the exchange, according to a person familiar with his thinking, and is convinced that the NYSE's regulatory arm needs to be separate from its market operations. ... But even considering a complete split of the NYSE's regulatory function represents a turnabout from his recent public comments.

Omnicare v. NCS Healthcare: What did the majority expect the NCS board to do?

In two prior posts, I discussed the Delaware supreme court's decision in Omnicare v. NCS Healthcare, 818 A.2d 914 (Del. 2003), focusing on the court's strange hostility to corporate precommitment strategies and the majority's evisceration of § 251.

In Omnicare, by a 3-2 vote, the Delaware supreme court struck down the NCS-Genesis merger agreement. The majority acknowledged that “[a]ny board has authority to give [a bidder] reasonable structural and economic defenses, incentives, and fair compensation if the transaction is not completed.” In addition, the majority acknowledged that the controlling shareholders “had an absolute right to sell or exchange their shares with a third party at any price.” Yet, the majority nevertheless concluded that NCS’ board “was required to contract for an effective fiduciary out to exercise its continuing fiduciary responsibilities to the minority stockholders.” The majority also stated that “[e]ffective representation of the financial interests of the minority shareholders imposed upon the [NCS board] an affirmative responsibility to protect those minority shareholders’ interests.” What could the NCS board have done, however, if Outcalt and Shaw -- the controlling shareholders -- insisted on supporting Omnicare?

Omnicare v. NCS Healthcare: The § 251 issue

In an earlier post, I discussed the Delaware supreme court's puzzling decision in Omnicare v. NCS Healthcare, 818 A.2d 914 (Del. 2003). We noted therein that the NCS-Genesis merger agreement required NCS’ board to submit the Genesis deal to a shareholder vote even if the board withdrew its recommendation that the shareholders approve the deal. This is known as a § 251 clause. As with so much else in the Omnicare decision, the majority's treatment of § 251 is quite troubling.

New paper on Catholic social teaching and the corporation

My essay Catholic Social Thought and the Corporation can now be downloaded from SSRN. Here's the abstract:

This brief essay explores Catholic social thought on corporate governance. Human dignity and freedom are central principles of Catholic social thought. This essay argues that preserving the economic freedom of corporations to pursue wealth is an essential part of effective means for achieving human freedom. To the extent prudential judgments about corporate regulation are required, the Church and civil society should strive towards a nuanced balancing of freedom and virtue.

Henry Manne on academic corporate law

Law and economics superstar Henry Manne has a fabulous essay in the latest issue of the Emory Law Journal, A Free Market Model of a Large Corporation System, in which he makes a telling observation about recent corporate law scholarship:

Scholars have for too long been led by events into accepting the status quo and building on it. As the total picture gets more and more complicated and messier and messier, it is much easier to do limited "event studies" or other partial equilibrium analyses. This necessarily results in a loss of a sense of history and a lack of a proper cynicism about the beneficence or legitimacy of previous government regulation.

Academic careers can be ruined by too much departure from the conventions of the moment, even though the cumulative effect of this is to limit any chance for large-scale rethinking of a whole field. What is needed now is a larger debate on the real costs and benefits of market and regulatory alternatives to corporate governance. This could in time result in a very different accepted wisdom about large corporations.

52 Emory L.J. 1381, 1400 (sub. req'd). [Ed.: Thunderous applause in the hall.]

Omnicare v. NCS Healthcare: The precommitment issues

In class yesterday, we tackled the Delaware supreme court's decision in Omnicare v. NCS Healthcare, 818 A.2d 914 (Del. 2003), in which the Delaware supreme court held that an exclusive merger agreement -- such as a no shop or best efforts clause -- must include a fiduciary out, at least where the agreement presents target shareholders with a “fait accompli.” No Delaware court has yet offered a persuasive reason for their hostility to no shop clauses and the like. Instead, the invalidity of such strategies has been asserted by mere fiat. If Omnicare proves anything, it proves that the Delaware supreme court's fiat is not infallible.

SOX Costs

From Financial Executives Int'l (link via Broc), here's an analysis of what it is costing corporation to comply with just one provision of Sarbanes Oxley (§ 404):

In looking at initial one-time expenses for a "typical" $3 billion company, The Johnsson Group estimates incremental unanticipated expenditures totaling $1.1 to $3.5 million, itemized as follows:

Section 404-Related Activity- Initial one-time costs estimates:
Independent audit scope changes/fee increases	$500,000 - $2 million
Internal audit expansion	$200,000 - $500,000
Outside consulting services	$400,000 - $1 million
SubTotal	$1.1 - 3.5 million in one-time Section 404-related costs

And that's just the beginning. Given the heightened new requirements, companies can reasonably expect to incur ongoing incremental costs in the range of $800,000 to $2.8 million:

Section 404-Related Activity- Ongoing annual costs estimates:
Independent audit scope changes/fee increases	$500,000 - $2 million
Internal audit expansion	$200,000 - $500,000
Outside consulting services	$100,000 - $300,000
SubTotal	$800,000 - $2.8 million in ongoing Section 404-related costs