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

Martha Stewart Living Omnimedia suit dismissed

Delaware Chancellor William Chandler has dismissed a shareholder lawsuit against top executives and directors of Martha Stewart Living Omnimedia (MSO), using surprisingly harsh language. Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 2003 WL 22271421 (Del.Ch. 2003). (I've only found the opinion on Westlaw, which requires a subscription.) The suit alleged that MSO's disclosure documents routinely stressed the importance of Martha Stewart to the company's success. After the controversy over Stewart's trading in ImClone stock broke, MSO's stock price dropped precipitously, ultimately bottoming out at a 65% loss. The suit alleges Caremark violations by MSO directors and execs (click here for a discussion of Caremark), who allegedly failed to "ensure that Stewart would not conduct her personal, financial, and legal affairs in a manner that would harm the Company, its intellectual property, or its business." The suit also raised allegations as to Stewart's trading in MSO stock and compensation. (the stock trading part of the opinion is also interesting, as it raises some unique corporate opportunity questions. I may post about that part of the opinion later.)

Chandler hammered the plaintiff's lawyers for racing to the courthouse with little justification:

It is troubling to this Court that, notwithstanding repeated suggestions, encouragement, and downright admonitions over the years both by this Court and by the Delaware Supreme Court, litigants continue to bring derivative complaints pleading demand futility on the basis of precious little investigation beyond perusal of the morning newspapers.

Ouch.

As a substantive matter, one of the particularly interesting things about this opinion is Chandler's apparent resuscitation of Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125, 130 (Del. 1963). Chandler wrote that in Graham:

[T]he Delaware Supreme Court held that "absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists." Despite this statement's implication that a duty to monitor may arise when the board has reason to suspect wrongdoing, it does not burden MSO's Board with a duty to monitor Stewart's personal affairs.

Chandler explained that: (1) plaintiff had failed to allege facts that would have put the board on notice of potential wrongdoing; and (2) Graham speaks to wrongdoing in a corporate capacity, not in an exec's personal life.

Chandler's reliance on Graham is surprising because that decision is routinely criticized these days. The Delaware supreme court itself described Graham as �quite confusing and unhelpful.� Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 364 n.31 (Del. 1993). Graham held that corporations have no obligation to create programs of internal control designed to ensure law compliance by the corporation unless the board is on notice of facts suggesting that legal violations are likely. Some commentators have suggested that firms should be required to maintain law compliance programs without regard to whether the board is on notice of potential problems. My impression was that the law was clearly moving in that direction, prompted by Caremark. At the same time, however, I still think Graham was right. (I explain why in the extended post below.) If Chandler had relied solely on the proposition that boards have no duty to monitor an exec's personal life, the citation to Graham would not have done much to resuscitate the case. And, in fairness, his focus is on what he called plaintiff's "quite novel" argument that "the Board has a duty to monitor the personal affairs of an officer or director." Yet, I am still struck by the fact that he also relied on the absence of any reason for the board to be on notice. It is that part of the opinion that might resuscitate Graham.

Why do I think Graham deserves to be resuscitated? Consider the old saying: �every dog gets one bite.� This saying was based on the common law principle that a dog�s master was only liable for bites if the master knew or had reason to know the dog had a propensity to bite. Such knowledge could be based either on the breed�s inherently violent propensities or a prior bite. The economic rationale for such a rule is simple�monitoring costs. Keeping an eye on your dog requires costly precautions, such as leashes, fences, and the like. Why require such expenditures if Fido is as gentle as a lamb?

The analogy to Graham should be self-evident, but let�s beat the dead horse anyway. Just as a dog owner does not have liability unless the owner knows the dog has a propensity to bite, directors are liable only if they are on notice that their employees have a propensity for crime. Just as a dog owner is put on such notice by a prior bite, prior criminal violations can put directors on notice. Just as owners have an affirmative duty to control dogs of an inherently vicious breed, directors may not recklessly fail to monitor an obviously untrustworthy employee.

As with the dog bite rule, Graham implicitly rests on a cost-benefit analysis. Law compliance programs are not free. At the very least, a law compliance program requires preparation of a company manual telling employees not to fix prices. It probably also requires training of employees. Beyond that, the firm probably should send lawyers out to do compliance audits from time to time. Programs with real teeth require substantial high-level commitment and review, frequent and meaningful communication to employees, serious monitoring and auditing, and appropriate discipline where violations are discovered. By analogy to the dog bite cases, one reasonably would expect a firm to go through all this only when on notice of a past violation.

Interestingly, relatively recent amendments to the Model Business Corporation Act�s director liability provisions codify a standard closer to Graham than Caremark. Under MBCA � 8.31(a)(2)(iv), a director may be held liable for sustained inattention but only when �particular facts and circumstances materialize that� would put �a reasonably attentive director� on notice of the need for further inquiry. Under this provision, it would seem, proactive vigilance is not required.

Villanova Conference: Solidarity’s Debt to Burke

As I anticipated, the Villanova conference has been quite interesting. One of the best papers on the first day came from my friend Tom Kohler (Boston College law). Kohler’s paper traced the evolution of the concept of solidarity in Catholic social thought (CST). Interestingly, Kohler pointed out the influence that Edmund Burke had on that process. (I should note, of course, that I may well be reading a lot into the paper that Tom did not intend. Best to say that I'm using it as a jumping off point for my own ramblings.)

I liked this paper because Burkean thinking has always struck me as having close parallels to CST. Both Burke and CST acknowledge that reason is a useful guide, but caution that it can flirt with a grave danger–namely, the triumph of individual reason. Burke contended that individual reason could never fully comprehend the divine intent, although we grope towards it through history, myth, fable, custom, and tradition. Of these, tradition and custom are by far the most important. Likewise, while Catholicism obviously draws on revealed truth, it too draws on a long history of tradition and custom.

Do laws and lawyers matter?

Lawrence Solum (of the excellent Legal Theory Blog) notes a new paper by Bradley Wendel of the Washington and Lee law school, Civil Obedience. Money quote from the paper (or, at least, the one that caught my eye): "Citizens disagree through lawyers, seeking authoritative settlement of their disputes through the medium of law." No, they don't. Much (probably most) social intercourse is carried on with little regard to legal rules. Robert Ellickson famously studied the way in which residents of Shasta County, California resolved disputes over trespassing cattle. Robert C. Ellickson, Order Without Law: How Neighbors Settle Disputes (1991). Ellickson found that that “large segments of social life are located and shaped beyond the reach of law.” (4) Most disputes are resolved without resort to law. I couldn’t find a cite to Ellickson in the paper. Is this fatal to the paper's project? I doubt it, and I actually thought the paper was pretty interesting, but I start out being skeptical of any model that doesn't fully take into account the ways people resolve disputes without law or lawyers.

Counterpoint: "We live in a society of laws. Why do you think I took you to all those Police Academy movies? For fun? Well I didn't hear anybody laughing, did you?" -- Homer Simpson.

Professor Wendel sent me the following email:

I'm glad you liked the paper enough to read it and post a comment. Regarding Ellickson, I know his work well, and have discussed it extensively in some other stuff I've written about informal ordering, in particular an article in the Vanderbilt Law Review a few years ago. You're absolutely right that most disputes aren't resolved through law, and much social order doesn't depend on law. The argument in my civil obedience paper is not that law has authority because it is the way most people resolve disputes, most of the time. Rather, it is that to the extent law impinges on conduct in some way, its authority should be understood in terms of its capacity to facilitate coordinated action in the face of disagreement. It's not a totalizing argument, that law should regulate most domains of activity, but it's a much more modest point, that whatever authority law has should be understood in those terms.

Shareholder Access (Again): NYT Reports: “Big Pension Funds Object to Proposal on Proxy Rules”

NY Times (reg. req'd) reports that major pension funds are objecting to the SEC's soon to be proposed proxy amendments. As proposed:

The rules set up a two-year process for selecting new board members. In the first year, some triggering event must occur, like a vote by a majority of shareholders to open an election, or a sizable percentage of shareholders withholding votes for the board's own nominees. In the second year, there would be a contested election pitting the directors selected by the board against one to three directors chosen by the largest block of shareholders. The challengers would be able to propose one to three directors, depending on the size of the board, S.E.C. officials said. They said the directors up for election would need to certify that they had no conflicts of interest and no financial relationship with or special ties to the investors who had nominated them.

The pension funds are howling because it makes it harder for them to get a slate onto the company's proxy statement -- at the company's expense (of course, the funds could always run their own proxy contest, but then they would have to pay). Regular readers know that I am skeptical of shareholder access proposals. I shan't bore you with the details again (see index of prior posts below). Of particular interest in the present news account is the fact that almost all the complaining investors are political hacks like state treasurers. Do we really want to make it easier for some state treasurer to use a corporate proxy statement to raise his visibility for a gubernatorial run?

UPDATE: I blogged this report this am just before rushing from the hotel to the Villanova conference. In the interim, Corp Law Blog has blogged a much more detailed and typically thoughtful analysis. He seems to share my skepticism about the motives of the political hacks institutional investors:

It's all about politics, after all. A corporate board is just like the Knesset -- each member serves his own narrow interests and constituencies to the exclusion (and often the detriment) of the others. Forget that boards today have to be comprised largely of independent directors. Forget that state law requires directors to serve the interests of all stockholders and the corporation. It's not surprising that a political foot soldier views the corporate world as just another political battlefield. ... [Calif. treasurer Phil] Angelides also makes two dubious assumptions: every corporation is a WorldCom waiting to happen, and WorldCom wouldn't have happened if one or two directors nominated by a politically-appointed state treasurer sat on the board.

Exactly!

NYSE’s Reed plans to keep current structure

The WSJ (sub. req'd) is reporting that:

Interim New York Stock Exchange Chairman John Reed held his first board meeting since taking over for Richard Grasso, at which NYSE directors discussed reforms to the exchange's governance. One often suggested reform, however, appears to have lost some momentum. At a news conference following the board meeting, Mr. Reed told reporters that he isn't inclined to split the Big Board's regulatory and business units. "I don't intend to recommend it," Mr. Reed said. He said his instinct was to keep the regulatory and business sides "tightly coupled," though with a governance structure that doesn't compromise the integrity of the NYSE's regulatory duties.

I think Reed is making a very serious mistake. Regular readers know that I have been arguing that the Exchange should divide those functions and then privatize the market function. (E.g., HERE) Granted splitting such an old and we-established institution is a nontrivial task. Sorting out which functions go where (like corporate governance listing standards) would be difficult. But it seems increasingly clear that self-regulation does not work. At the NYSE, we have had the Grasso imbroglio for weeks and the continuing controversy over the specialists' alleged abuses of their affirmative obligation (see here) for months. Now we fiund out that "Grasso pressured a major Big Board floor firm to increase its purchases of shares of giant insurer American International Group Inc. after Mr. Grasso received written complaints from AIG Chairman Maurice "Hank" Greenberg, according to people familiar with the matter. ... Mr. Greenberg was on the NYSE's compensation committee when the controversial employment contract that ultimately led to Mr. Grasso's ouster was developed and approved." (WSJ) And so the problem ran in both directions -- inadequate supervision of firms of board members and improper use of board positions to affect specialist decisions.

The NASD and NASDAQ went their separate ways after repeated problems with the SEC over inadequate supervision of its member broker-dealers. It is time for the NYSE to follow their lead.

Review: Oliver Williamson’s Economic Institutions of Capitalism

Economic Institutions of Capitalism is a classic work of new institutional economics. In it, Williamson works out his theories of transaction cost economics across an array of interesting economic questions. Most of the covered topics will be of interest not only to economists, but also to lawyers and policymakers. Among other examples, Williamson tackles such subjects as vertical integration, corporate governance, and industrial organizations. Why review a book that was published almost a decade ago? because it's a classic that still rewards reading -- so much so that I've added to my corporate canon.

Why SOX 307 won’t work (again): Corporations waiving the privilege

Sometimes you do the right thing, even when you suspect it won't succeed. Or, at least, that's what I've come to thing about Sarbanes-Oxley section 307 (the legal ethics provision). It was the right thing to do, as I've argued before. Lawyers work for the corporation's board of directors, not its managers. The up-the-ladder reporting requirement thus is a blow against managerialism and a blow for director primacy. Yet, as I argue in my articles Managerialism, Legal Ethics, and Sarbanes-Oxley Section 307 and The Tournament at the Intersection of Business and Legal Ethics, the nature of legal practice, the largely unchanged relationship between lawyers and managers, and the problematic approach taken by the SEC to implementing Section 307 suggest that the new legal regime is unlikely to result in significantly better information flows within the corporate hierarchy.

One of the reasons I advanced in support of that conclusion was my belief that managers will simply bypass their lawyers. 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.

In light of this report by the WSJ (sub. req'd), I am even more convinced that managers are going to bypass their lawyers to the maximum extent possible. The Journal reports that a key government wittness at the obstruction of justice trial of former investment banker Frank Quattrone will be David Brodsky who was Credit Suisse First Boston's general counsel when Quattrone allegedly ordered underlings to destroy documents relevant to a pending SEC investigation. Brodsky will testify as to legal advice he gave Quattrone. How can he do that? What about the attorney-client privilege? As the Journal correctly points out:

Attorneys aren't themselves permitted to waive privilege. That is something that only their clients can do. At companies such as CSFB, a general counsel's client is the company itself, rather than individual employees

(It can be a more complicated when counsel has an attorney-client relationship with both the corporation and the manager, but that is relatively rare.) CSFB waived its privilege, so as to allow Brodksy to testify against Quattrone. The Journal reports that this has become something of a trend:

Companies wishing to avoid onerous charges and fines are now quick to waive attorney-client privilege and force lawyers to cooperate with prosecutors. Tyco International Ltd., the former WorldCom Inc. (now MCI) and Adelphia Communications Corp. are among many companies that have waived privilege in a bid to avert fraud charges against them.

So all of this tends to confirm my views about SOX 307. On the one hand, lawyers are potentially valuable sources of information both for boards of directors and prosecutors. On the other hand, as it sinks in with managers that what they say to the lawyers may not only be used against them in the boardroom but also in the courtroom, managers will be even more reluctant to bring their lawyers into any deal that pushes the edge of the regulatory envelope.

UPDATE: Over at Scrivener's Error CE Petit has a very good critique and extension of my post. Well worth reading. Unfortunately, blogspot is being blogspot again (see here) and the archival link isn't working. At the moment, its the top post, so just hop over and, if need be, scroll down.

Shareholder access again—updated

Over at TheCorporateCounsel.net Blog, Broc blogs on the latest development in the shareholder access saga:

Readers of WSJ might have noticed a full-page advertisement on Thursday by a group of investors calling for the SEC to adopt a shareholder access rule. This ad followed a 9/23 press conference held by members of Calpers, AFSCME, CalSTERS, New York State Comptroller, New York City Comptroller and Connecticut State Treasurer on the same point. At the press conference, AFSCME released a survey showing that 84% of 1,030 individual investors stated that there should be a process to allow shareholders to nominate candidates for boards. The survey also showed that a majority of the respondents believed that management is not in the best position to determine who should be nominated. Many institutional investors have made clear that this rulemaking is their top priority right now.

My take? The SEC almost certainly has the authority to go forward with a shareholder access rulemaking (see here). But, on the merits, shareholder democracy is a very bad idea (see here and here). For those who want even more details, I discuss the scope of the SEC's reulmaking authority over the proxy statement at pp. 505-11 of my Corporation Law and Economics treatise, and provide an economic analysis of shareholder democracy at pages 512-17 thereof. (If you think that's a shamelessly self-serving plug, you're right.)

UPDATE: I'm reposting this discussion to move it up the scrolling order in light of this report from TheDeal.com:

The Securities and Exchange Commission is expected next month to issue draft rules that would allow a majority of shareholders to make a proxy proposal criticizing a public company's governance record and to seek investor approval to nominate their own board candidates. ... Under the SEC proposal, obtaining the right to nominate a board member by proxy would be a two-step process. First, a majority of investors must approve a shareholder measure nominating a board candidate. [Second, if] approved, that candidate would appear on the proxy ballot the following year. Only shareholders who own at least 3% to 5% of a company for a minimum of one year would qualify to nominate a candidate on the corporation's ballot. (Link via Corp Law Blog.)

My take remains as above. Corporations are not New England town meetings and shareholders are not owners (the corporation being a legal fiction representing a network of contracts incapable of being owned). If the links above do not persuade you, try my article Director v. Shareholder Primacy in the Convergence Debate. (Or, better yet, buy my book!)