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

Gordon Smith on “The Attraction of Delaware”

At his new Venturpreneur site, Gordon Smith chimes in on the Delaware v. California discussion Mike O'Sullivan of Corp Law Blog and I have been having. (HERE for Smith; Here for O'Sullivan; Here for me):

Steve Bainbridge offers another content-driven explanation for Delaware. His purpose is not so much to explain Delaware as to explain why not California (as if the recent recall election isn't reason enough!), but his argument rests on assumptions about the importance of content. He writes provacatively: "California can indulge the luxury of allowing its corporation laws to reflect the overall anti-business/anti-capitalist leanings of the state's dominant left-liberal political elites. In other words, California doesn't retain so few incorporations because it has no antitakeover statute; California has no antitakeover statute because it retains so few incorporations ... and doesn't care." One problem with this argument is that takeover laws do not seem to be an important determinant in the incorporation decision. (See Rob Daines' recent work on this.) Another, more serious, problem is that it does not explain the relative lack of success of all 48 other states in the hunt for corporate charters. Most of those states have anti-takeover statutes -- indeed, most have statutes much more protective of managers than Delaware's -- and still they fail to attract firms from outside their state.

I don't agree with Gordon's assessment of the empirical evidence. The most recent empirical study is Bebchuk and Cohen's paper Firms' Decisions Where to Incorporate. Bebchuk and Cohen find that "the fraction of local firms that each state retains is correlated with the number of antitakeover statutes that the state has." (21). A finding even more pertinent to Smith's argument is Bebchuk and Cohen's result "that offering a stronger antitakeover protection is also helpful in attracting out-of-state incorporations." States that do so do not do as well as Delaware, but they do better at attracting out-of-state firms than states with no antitakeover law. I will have some critical things to say about Bebchuk and Cohen's paper when I post my comments from the Vanderbilt conference (probably on Saturday), but these findings strike me as persuasive evidence that content matters a lot. Content is not all that matters -- other factors were suggested by the Coors reincorporation proxy blawgged a while back and there is a trumping factor I'll identify in my post this weekend -- but it does matter.

Today’s shareholder access question: Does state law permit corporations to forbid shareholders from

By Corp Law Blog's count, the SEC's shareholder access rule proposal poses over 320 questions for commenters. I will not be answering all of them. As I work up my comment letter to submit to the SEC, however, I will post my answers to those I find interesting. In honor of this new process, I've launched a new index category: SEC Rule Proposals: Shareholder Access.

Today's question:

[A]s proposed, a company would become subject to the security holder nomination procedure in Exchange Act Rule 14a-11 only where the company's security holders have an existing, applicable state law right to nominate a candidate or candidates for election as a director. To eliminate any uncertainties in this regard, the proposed rule would state that the security holder nomination procedure would be available unless applicable state law prohibits the company's security holders from nominating a candidate or candidates for election as a director. If state law permits companies incorporated in that state to prohibit security holder nominations through provisions in companies' articles of incorporation or bylaws, the proposed procedure would not be available to security holders of a company that had included validly such a provision in its governing instruments.

Does state law permit this? A recent Delaware decision suggests an affirmative answer, albeit with qualifications. In Harrah's Entertainment, Inc. v. JCC Holding Co., 802 A.2d 294 (Del.Ch. 2002), the Honorable (and estimable) Leo Strine noted that:

Because of the obvious importance of the nomination right in our system of corporate governance, Delaware courts have been reluctant to approve measures that impede the ability of stockholders to nominate candidates. Put simply, Delaware law recognizes that the "right of shareholders to participate in the voting process includes the right to nominate an opposing slate." And, "the unadorned right to cast a ballot in a contest for [corporate] office ... is meaningless without the right to participate in selecting the contestants. As the nominating process circumscribes the range of choice to be made, it is a fundamental and outcome-determinative step in the election of officeholders. To allow for voting while maintaining a closed selection process thus renders the former an empty exercise." (310-11)

On the other hand, Delaware law also has a fairly strong streak of freedom of contract. A corporation thus may opt out of the default voting -- and nominating -- rules, provided it does so clearly and unambiguously:

When a corporate charter is alleged to contain a restriction on the fundamental electoral rights of stockholders under default provisions of law - such as the right of a majority of the shares to elect new directors or enact a charter amendment - it has been said that the restriction must be "clear and unambiguous" to be enforceable. (310)

Because restrictions on shareholder voting rights, such as a departure from the one share-one vote norm, must be in the articles of incorporation (DGCL § 212), it would be advisable to include a restriction on shareholder nominations in the articles rather than the bylaws. Not only would a bylaw provision be of dubious enforceability, under DGCL § 109(a) the shareholders always retain the right to initiate amendments to the bylaws. For existing companies, getting the shareholders to approve a charter amendment banning stockholder nominations likely will be tough -- probably few would even try to buck the inevitable bad press and institutional investor complaints. Assuming the rule goes through in present form, however, it will be interesting to see how many IPOs include such a provision.

We get mail: SOX and business ethics

A reader writes:

Given that the 33 and 34 acts were designed to separate from participation in the securities market, those who act unethically, and that President Bush and the Congress stressed a desire to return the market to a higher ethical plane; it might be useful to reflect upon whether Sarbox accomplishes this goal.

I'm pessimistic, but grateful for the opportunity to pull together some of the arguments I've made in this space over the last weeks.

The ethics provisions of Sarbanes-Oxley strike me as likely to have positive effects, but only at the margins. First, for reasons explained here, I am very skeptical of the utility of principles-based ethical systems (as opposed to those based on virtue). Second, as I argued here, I am doubtful that SOX section 307 (the legal ethics provision) will be all that effective (see also here).^* Third, the mandated ethics codes are a joke, as one of my readers pointed out a while back.

The disclosure provisions are the best hope for improved ethical standards following from SOX. Louis Brandeis famously observed: "Sunlight is said to be the best of disinfectants; electric light the most efficient policeman." To the extent SOX leads to greater transparency, that will discourage unethical practices. The problem is that we may be drowning investors in disclosure. A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs (see here for more). To the extent we drown investors in information, the benefits of enhanced transparency are lost, because the opportunity costs of processing those disclosures rises without apparent benefit to the individual investor (note that monitoring of management is a public good).

The basic reason I'm pessimistic, however, is that CEOs are pessimistic. A Foley & Lardner survey found that only 46% of CEOs thought Sarbanes-Oxley has "made investors more confident in the integrity of your financial and other public reporting." Sixty percent thought corporate governance reform had gone too far, while 93% (!) thought compliance costs would continue to rise. Not encouraging numbers.

^* Ed.: I continue to work on 307 issues in preparation for a conference in the spring, and will be continuing to post on it periodically.

UCLA Faculty Colloquium: Chander’s Minorities--Shareholders and Otherwise

Yesterday's faculty collquium speaker was Anupam Chander, of the UC Davis School of Law (visiting Cornell), who presented his paper "Minorities, Shareholder and Otherwise," which is forthcoming in the Yale Law Journal. You can download a copy of this very interesting paper here; the abstract follows:

Corporate law understands what constitutional law does not. Being a minority matters to law. While constitutional law moves towards colorblindness, shunning knowledge of minority status, corporate law places minorities at the heart of its endeavor. This Essay seeks to reconcile the "minorities" in corporate and constitutional law, developing a larger theory of minority status and its relevance to legal decision. I begin by rereading the corporate canon. I show that body's concern not just for wealth maximization, but also its distribution. I reveal corporate law's deep commitment to protecting minority shareholders, operationalized through an elaborate common law and statutory framework. Ironically, it is corporate law, not constitutional law, that is obsessed with issues such as fairness, oppression, and power. My Essay highlights this and then applies corporate law's theory of minority/majority relations to three hot button debates in the constitutional law realm: affirmative action (currently before the Supreme Court), California's Racial Privacy Initiative (on the ballot for 2004), and the demographic shift to a majority minority polity (already a reality in California).

Chander is very smart and interesting, and so is his paper. It's a very clever idea, which is quite well-executed. Most important, it's quite novel, which is what really counts in the academic reward system. Yet, as explained below, I think I must respectfully dissent.

Corporate law permits discrimination among shareholders. Probably the best known examples are the discriminatory self-tender offer Unocal used to fend off Boone Pickens and the poison pill. Instructively, however, those devices involve discrimination directed against someone who is trying to become a majority shareholder. As Chander correctly observes, corporate law has many doctrines intended to protect minority shareholders and to ensure fair treatment of such shareholders. Chander then claims that constitutional law is much less concerned with protecting racial minorities. Obviously, this will strike many as a controversial claim, especially after last term's Supreme Court decisions in Grutter and Lawrence. Indeed, Chander's analysis seems far more persuasive as a critique of Scalia's color blindess-based dissent in Grutter than of the majority opinion.

Turning to the corporate law analogy, an initial question is whether the appropriate analogy is to the close or public corporation. It�s an important question because fairness is much more of a concern in the law of close corporations than in that of public firms. Close corporations are like the body politic because exit is costly in both, while secondary capital markets make exit from public corporations quite easy. Yet, it is very doubtful one would want to export the law of close corporations to the constitutional context.^{1 Close corporations are often described as �incorporated partnerships,� which explains why fairness is such a big issue in the close corporation context. Query, however, whether partnership is a useful way of thinking about the body politic. Partnerships make decisions by consensus, which they can do because partners typically have comparable interests (profit maximization) and equal access to information. In a pluralistic body politic, those conditions do not hold, and decisionmaking must be effected through the exercise of authority. As such, the body politic most closely resembles the public corporation, where fairness concerns � while still present � are more attenuated.}

Consider, for example, former Delaware Chancellor William Allen�s opinion in Mendel v. Carroll. The Carroll family collectively controlled Katy Industries, Inc., owning at various times 48 to 52% of the stock. Even when they did not have an outright majority, their status as the largest shareholder ensured that they had effective control. The Carroll family had proposed a freeze-out merger that would have involved cashing out the minority shareholders at about $26 per share. A competing offer was made by a group organized by a fellow named Sanford Pensler at about $28 per share. The Carroll Family withdrew their merger proposal, but also announced that they had no interest in selling their shares. Their opposition to the Pensler proposal effectively precluded it from going forward. Minority shareholders sued, alleging that the Carroll Family violated its fiduciary duties and that the board of directors violated its fiduciary duties. Specifically, the minority wanted the board to issue more stock to dilute the Carroll family�s holdings to the point at which they no longer have control. Chancellor Allen held: �The board's fiduciary obligation to the corporation and its shareholders, in this setting, requires it to be a protective guardian of the rightful interest of the public shareholders. But while that obligation may authorize the board to take extraordinary steps to protect the minority from plain overreaching, it does not authorize the board to deploy corporate power against the majority stockholders, in the absence of a threatened serious breach of fiduciary duty by the controlling stock.� [651 A.2d 297, 306 (Del. Ch. 1994).] Mendel thus illustrates the extent to which corporate law is far more tolerant of hegemony than constitutional law.^{2 As the Massachusetts court observed in Wilkes v. Springside Nursing Home, 353 N.E.2d 657 (Mass. 1976), there must be a balance between the fiduciary duty of the majority and its right to selfish ownership, which gives the controlling group �some room to maneuver� in setting policy. Hence, it is not clear to me that corporate law provides a useful lens through which to view constitutional law problems like affirmative action. Nothing I saw in Grutter suggests that racial majorities are entitled to �selfish ownership� of the body politic.}

Another way of getting at my problem with the paper might be to examine the corporate law doctrine that permits a controlling shareholder to freeze-out the minority, so long as the controlling shareholder pays a fair price. If we export both corporate law's solicitude for minority shareholders and corporate law's tolerance of hegemony to the constitutional context, Plessey was correct and Brown was not. The racial majority would be permitted to freeze-out the minority from their schools, for example, so long as they gave the minorities fair treatment, which leads directly to separate but equal schools. For a while post-Plessey the Supreme Court actually tried to enforce separate but equal by monitoring whether the separate schools really were equal. The Court gave that project up in Brown, however; and rightly so, because it never worked. Separate but equal was inherently unequal and properly was struck down. Accordingly, I am left unpersuaded that exporting corporate law principles to the constitutional context does very much to advance the analysis in the latter, unless one is prepared to be very selective about which corporate law principles one is prepared to export and which one intends to leave behind. But that seems to defeat the purpose of the exercise.

In sum, it is a very interesting paper that is well-worth reading. The idea is clever and the execution is impressive. In my view, however, it would have been even more impressive if Chander had been willing to make the move of advocating that con law adopt corporate law�s more tolerant view of hegemony. That would have been a really radical and daring step. But go download the paper and decide for yourself.

^{1 Chander denies any agenda of exporting the fairness technologies, which tends to make the normative payoff kind of anticlimactic.}

^{2 Chander forthrightly acknowledges this difference between corporate and constitutional law; indeed, the differing ways in which the two bodies of law view power is a motivation for the paper.}

Coase redux

Will Baude of Crescat Sententia criticizes the all too common ways in which the Coase theorem is misused (and misexplained):

Very roughly speaking, this Coase Theorem says that if property rights are fully defined and enforceable, and if transaction costs are zero, then the initial distribution of property or rights makes no difference to how they will finally be allocated. ... My pet peeve is seeing Coase cited in support of the optimistic version of this theorem. Last Spring he gave a lecture at The University of Chicago, and said that the point he had always been trying to make was that the assumption of zero transaction costs was a critical one, and often not realized. ... So it's annoying to have one's professor going on and on about asymmetric bargaining games (involving the exploitation of the tragedy of the commons) and then cite the simplified version of the Coase Theorem, as if no game theoretic problems existed there. This is all the more annoying when the class is a large lecture where you aren't supposed to talk back to the professor.

This space has gone around the block a few times with the Coase theorem, most notably here. Suffice it to say that I share Baude's annoyance, but also must confess that as a professor I have done exactly the sort of thing of which he complains. The optimistic Coase theorem is just so seductively beguiling.

Sloppy Martha Journalism by Reuters

Reuters is reporting that:

Home designing diva Martha Stewart, facing criminal charges in an insider-trading scandal, is feeling scared but doubts she will go to prison, she told ABC News in a recent interview set to air early next month.

Tsk, tsk. As regular readers of this space know, Martha is not being tried for insider trading. The criminal proceedings go solely to obstruction of justice (with one non-insider trading count of securities fraud). To the contrary, the Justice Department decided going after Stewart would be an “unprecedented” expansion of insider trading law. As for whether Martha is likely to be convicted on the obstruction charges, my most recent take on that issue is here (with links to earlier posts).

UPDATE: A reader writes that my post was:

Accurate in substance, but technically, she's being tried for (1) conspiracy to obstruct justice, make false statements, and commit perjury in violation of 18 U.S.C. s 371 (Count 1); (2) making false statements in violation of 18 U.S.C. s 1001 (Counts 3 and 4); (3) obstruction of justice in violation of 18 U.S.C. s 1505 (Count 8); and securities fraud (Count 9). The false statement counts, though perhaps overly technical in nature, represent the greatest threat to her.

I agree that counts 3 and 4 are the ones that are most likely to land Martha in Club Fed.

Is Delaware corporate law predictable or indeterminate: Corp Law Blog votes for predictability

The race to the top versus race to the bottom debate usually focuses on the quality of Delaware law. As part of their case, proponents of the race to the bottom thesis have embraced USC law professor Ehud Kamar's claim that Delaware law is indeterminate. I have never bought that argument. Granted, Delaware corporate law consists mainly of standards rather than rules, but it is still highly predictable.

The quantity -- and thus the predictability -- of Delaware corporate law is the subject of Mike O'Sullivan's response to my earlier post Why doesn't California retain incorporations:

Delaware's strength is its wealth of published judicial decisions applying its corporate law to real world factual situations. Even the clearest statute is of limited use to a practitioner, as the real world is infinitely more varied than any statute. It's only by applying a statute to the real world over time that the statute takes on a life, assumes certain habits, develops a personality and, in a word, becomes predictable.

Comparatively few corporate law issues ever make it to litigation, let alone to a published court decision. So often, when trying to figure out how a particular corporate statute works, we simply don't have any history showing how the statute worked in similar situations. Sometimes, we don't have any history of the statute operating in any situation. This void is the enemy of predictability.

Delaware, by dint of its efficient court system, its huge pool of corporations and its long record showing, through reported court decisions, how these issues have been applied and resolved, simply has the deepest well of corporate law experience out there. This deep well gives Delaware the most predictable corporate law. For example, Delaware's highly developed body of fiduciary duty case law is both unique and invaluable. When I get questions regarding fiduciary duties for directors of Delaware corporations, chances are very good that I'll find an very similar factual situation dealt with in a prior case. Even when I don't find a similar factual situation, I know enough about how Delaware courts have applied these principles in other situations to make a well-educated guess as to how they would apply it to my situation.

So much for the indeterminacy claim.

Auditing: A lousy idea from the PCAOB

The Financial Times is reporting that:

The Public Company Accounting Oversight Board (PCAOB), the US accountancy regulator created to oversee the audit profession, proposed last week that auditors check the effectiveness of board audit committees.

In its first big auditing standard, the board proposed that auditors, as part of their role in assessing a company's internal controls, "evaluate factors related to whether the audit committee is effective, including whether audit committee members act independently from management." [Ed.: Link via Cyberbug.]

A PCAOB briefing paper is available here (link via Broc).

This is a lousy idea. Sarbanes-Oxley contemplated a tiered system of top-down review: management creates internal controls, auditors evaluate the effectiveness of those controls, audit committees evaluate management and the auditors. Nothing in Sarbanes-Oxley compels a bottom-up review by the auditors of the audit committee. Under SOX and the NYSE/NASDAQ listing standards, moreover, the audit committee is charged with hiring the auditors. The PCAOB's proposals' create a huge conflict of interest for both auditors and audit committees. How likely is it that the auditors will bite the hand that feeds them? A recent Vanderbilt study "demonstrates that audit firms may lie to keep a profitable audit client if the expected benefits of keeping the client happy outweigh the expected costs of an audit failure if the firm gets caught." On the other hand, suppose the audit committee wants to fire the auditor and has good reasons to do so, won't the auditor be tempted to preempt that action by filing a negative report? Shouldn't we let companies get back to making widgets instead of filing yet more paperwork?

You can submit comments to the PCAOB by sending an email to comments@pcaobus.org or through the PCAOB's website. All comments should refer to "PCAOB Rulemaking Docket Matter No. 008" in the subject line and must be submitted no later than 5:00 p.m. (EST) on November 21, 2003.