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

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!)

Comparing Tyco’s Kozlowski and Deutsche Bank’s Ackermann

There is an interesting parallel set of prosecutions going on in the US and Germany. In the latter, the WSJ (sub. req'd) is reporting that Deutsche Bank CEO Josef Ackermann (and some other supervisory board members of Mannesmann AG) have been charged with approving bonuses for Mannesmann executives following approval of Mannesmann's acquisition by Vodafone. In the US, as CNNfn is reporting, the trial of former Tyco CEO Kozlowski began today.

The two cases illustrate a striking difference between US and German law. In US law, executive compensation typically is an issue for private litigation, typically involving shareholder derivative litigation charging waste of corporate assets. Kozlowski's case is a very rare exception to that rule, in which prosecutors are charging that Kozlowski stole from the corporation. The key charge in the indictment is that Kozlowski borrowed money from Tyco and then stole it by causing the "loans to be forgiven without the board's knowledge." If Kozlowski can prove that the board knew and approved the loan forgiveness, I don't see how the charges can stick. Indeed, I'm not convinced the charges will stick even if all Kozlowski can prove is that the loans were properly processed by corporate subordinates (specifically the firm's accounting department).

In contrast, under German law, criminal prosecutions over allegedly excessive executive compensation are a lot easier. The Economist explains that "Paragraph 87 of Germany's securities law says that [bonuses] to board members should bear a 'reasonable relationship to their duties'." I gather that such prosecutions are pretty rare in Germany and that this prosecution is especially controversial.

Personally, I think criminalizing the issue of excessive executive compensation is just nuts. But prosecuting not just the executives who got paid too much but also the board members who approve the payments is really crazy. Public corporations are finding it increasingly difficult to recruit and retain qualified independent directors. Relatively low pay, compensation in stock rather than cash, and increased time demands and liability exposure have all combined to render board service far less attractive than it once was. Criminalizing their executive compensation decisions, which are among the most controversial decisions a board makes, however, would make an bad situation almost impossible. What sane person would be willing to sit on a corporate board?

Yes, the insiders are selling. But should you?

The headline of a NY Times article poses the titular question. Heavy insider selling is usually thought to be a bearish signal. The Times, however, relies on work by Nejat Seyhun, a finance professor at the University of Michigan to suggest that the current wave of selling is not necessarily pro-bear.

[Seyhun explains that] the new wave of insider selling has occurred while the stock market has been rallying. His research has found that such selling carries far less bearish significance than selling during a market decline.

To document this difference, Professor Seyhun looked at each publicly traded company on the New York and American stock exchanges and the Nasdaq market from the beginning of 1975 to the end of 2000, identifying all months when the company's insiders were net sellers.

Professor Seyhun found that when insiders sold during a decline, the stocks they sold lagged behind the overall market by an average of 5 percent over the next 12 months. ... In contrast, Professor Seyhun found no discernible pattern in the subsequent performance of stocks sold by insiders while the market was rallying.

As a result, he concludes, the current high level of insider selling provides no signal for the market's direction. He advises investors who base their equity exposure on the behavior of insiders to "sit tight and watch both stock prices and insider trading" in the coming months.

Sounds like good advice to me. (But I have my money, such as it is, parked in no-load low-fee passively managed index funds. Why? Because Malkiel told me to!) Anyway, while I have never met Prof. Seyhun, I have read much of his scholarly output. He is a very close and able student of insider selling patterns, who has done a lot of high quality empirical research on the subject. Seyhun's book Investment Intelligence from Insider Trading pulls that research together in a very effective way.

Reed to cut NYSE board

The WSJ (sub. req'd) is reporting that interim chief John Reed "favors much smaller boards [that the NYSE's current 27 members] as being more effective." He's right that a smaller board will be more effective, for reasons I have blogged previously. Apparently Reed also favors effecting the change by moving some or all of the Wall Street CEOs on the current board into a new advisory board that would lack any oversight of or involvement with the NYSE's regulatory function. IMHO, this is also the right call, as it made no sense for Grasso to be monitored by the very people he regulated. Long term, however, as I have argued before, the best solution is separation of the regulatory and trading functions followed by privitization of the latter.

More on behavioral economics

The new Law and Economics Blog criticizes my post Behavioral Economic Analysis of Law:

An uninformed reader would be greatly mislead in reading Professor Bainbridge's broad based criticism of legal decision theory, backed by what is simply a critique of one of its applications. Moreover, he largely ignores the descriptive power of legal decision theory by mentioning only one of its potential normative implications. To be fair, the blogosphere does not lend itself to comprehensive critiques. Professor Bainbridge may have good reasons in support of his seemingly over-broad introductory criticism. That the blogosphere is so situated, though, only speaks to why we should be careful when engaging in such a critique.

As to the complaint that I did not provide a "comprehensive critique," it would have been nice if the blogger had acknowledged that I included the following at the end of my post:

You can read an even more extended version of my argument, with application to the longstanding debate over mandatory disclosure in securities regulation, in my article Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000).

If we're going to "be careful when engaging in ... a critique," let's include all the relevant facts.

Anyway, as for the complaint that I mention "only one of its [i.e., behavioral economics'] potential normative implications," the policymaking normative implications of behavioral economics strike me, at least, as the key question. In my article, I provide an example of one scholar who used generic behavioral economics claims to justify a prohibition of investor waivers of their rights under the securities laws, without showing that the various cognitive errors cited actually affect investor behavior in the context at hand. Behavioral economics, of course, can be relevant to legal issues other than policymaking. It might, for example, help lawyers and academics get a better handle on negotiations. Nothing in my post denies that. But my post was intended principally to suggest a limitation on the use of behavioral economics as a normative policymaking tool. If that wasn't clear enough, my bad; but, personally, I think it was clear enough.

UPDATE: Greg Goelzhauser of the Law and Economics blog responds here. Admittedly, I got a little testy in responding to his initial post. (In my defense, I hadn't had my morning coffee yet, although that's not much of an excuse, I admit.) But I stand by my substantive point that people are already using behavioral economics to make normative policy recommendations and that I am skeptical of doing so for the reasons developed in both the post and the article.

BusinessPundit on business ethics

The BusinessPundit has an interesting post on business ethics:

If the only way you can stay in business is by lying, cheating, and manipulating your books, then you are a lousy capitalist and you will eventually get what is coming to you. Business schools need to step up and teach students more business philosophy. They need to know that they should play fair even when government regulators aren't looking, because otherwise earnings, stock price increases, or contract wins are meaningless. How can anyone be proud of their business accomplishments if they cheated?

Its not clear to me that ethics education at the post-graduate level can help all that much. Values and ethics education needs to start a lot earlier than that to take, I suspect: "Raise up a child in the way he should go. And when he is old he will not depart from it." On the other hand, it can't hurt.

One virtue of values and ethics education is suggested by the distinction between virtue and principle ethics. Principle ethics are most attractive to those who are tempted to propose a rule as a solution to a problem. In a principle-dominated ethical system, the moral life consists mainly of complying with society’s mandated code of conduct. In contrast, virtue ethics reject codes of conduct in favor of context-based judgment. In a virtues-based ethical system, the moral life consists mainly of the habitual private exercise of truthfulness, courage, justice, mercy, and the other virtues. Ideally, values-based education becomes one of those intermediating institutions that build what George Weigel calls “a citizenry regulating itself from within according to a shared public ‘language of good and evil.’”

In the wake of the Enron scandal, Congress and the SEC opted for a principle ethics-based approach. They mandated a host of new legal ethics rules. I supported these rules, but for reasons I’ve outlined in two recent law review articles (here and here) I doubt whether they’ll work in the absence of the sort of business and legal professionals who are capable of regulating themselves because they have internalized norms of honesty and justice.

Who was the Greatest US Supreme Justice? A Corporate/Securities Law Perspective

I was recently given a copy of Bernard Schwartz's entertaining book, A Book of Legal Lists, which includes lists of both the 10 greatest and 10 worst US supreme court justices. Those chapters reminded me of an article I wrote with my friend (and, regretably, former colleague) Mitu Gulati a few years ago, in which we had occasion to make an objective empirical evaluation of greatness on the part of modern supreme court justices.

As a proxy for the importance of cases decided by the Supreme Court, we looked at opinions that found their way into the casebooks. Specifically, we looked at thirty-eight currently used case books on Corporations, Business Associations, Securities Regulation, and Corporate Finance. For each casebook, we counted the number of securities and corporate opinions by the various Supreme Court justices. If the same case appeared in two casebooks, it was counted twice, and so on. We assumed more important cases would appear in more casebooks and that greatness would translate into a justice being assigned the most important (and most often reproduced) cases.

The table reveals a dramatic dominance effect for the late Justice Lewis Powell, both in terms of his overall number of securities and corporate cases in casebooks and his per year entry rate. In terms of total cases, Powell has sixty-one and only two other justices have more than 20 (White (22) and Blackmun (21); Marshall comes next closest with 19). A similar skew is present in the per year entry rates. Powell has an average of four securities or corporate cases entering the casebooks per year. The next closest number is 1.25. Finally, note that these are only comparisons for only those justices who have securities or corporate cases in the casebooks. Most have none. So, for our purposes, Lewis Powell ranks as the Greatest Supreme Court Justice. Your mileage, of course, may vary.

An alternate to the expertise/greatness hypothesis might be that Powell was simply a superior casebook opinion writer. While we did not test this alternate hypothesis, anecdotal evidence suggests that Powell did not having anything close to the same level of influence in other areas. He was an excellent opinion writer and among the more influential justices of his time. But his clear dominance was limited to the business areas. See Richard A. Posner, Cardozo: A Study in Reputation (1990) (commenting on Powell’s skill at opinion writing and comparing the influence levels of a set of different justices); Montgomery N. Koma, Measuring the Influence of Supreme Court Justices, 27 J. Legal Stud. 333 (1998) (ranking the justices according to influence levels as measured by citations).

Guttman v. Huang: Del VC Strine on audit committee due care standards

In recent years, increasing regulatory attention has been devoted to the role of the audit committee. In 1999, the major stock exchanges adopted new listing standards (after being prodded by then-SEC Chairman Arthur Levitt in a classic example of how the SEC uses (arguably, abuses) its �raised eyebrow� power) toughening the rules on audit committees. See generally 64 Fed. Reg. 71, 529 (Dec. 21,1999). Likewise, the SEC adopted new disclosure requirements, most notably requiring an annual Audit Committee Report in the proxy statement. Regulation S-K item 306; Schedule 14-A item 7(d)(3). Sarbanes-Oxley and the accompanying stock exchange listing standard amendments further ratcheted up the burdens on audit committees.

A (relatively) new Delaware chancery court opinion by Vice Chancellor Leo Strine sheds light on the state corporation law fallout from these developments. Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003). Strine is a very smart fellow, with a strong academic bent, who has written a number of important decisions of late. His opinion in Guttman is the best recent summary of the rules of audit committee liability. Because this is a very long post, I have dumped the legal analysis in the Extended Post below. (One of the main reasons for starting this blog was to provide an outlet for scholarly analysis of problems to which I don't want to devote an entire law review article. This is a very good example of just what I had in mind.)

Generally, corporate directors and officers owe their firm and its shareholders three basic fiduciary duties: care, loyalty, and good faith. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). Of these, the duty of care is most relevant for present purposes. The duty of care requires corporate directors to exercise �that amount of care which ordinarily careful and prudent men would use in similar circumstances.� Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del.1963). Central to the duty of care is an obligation for directors and officers to avail themselves, �prior to making a business decision, of all material information reasonably available to them.� Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Where the directors have so informed themselves, however, judicial review of their decisions and actions is precluded by the duty of care�s chief corollary�the business judgment rule. [NB: In addition to an informed decision, there are a number of other preconditions that must be satisfied in order for the business judgment to insulate a board�s decisions or actions from judicial review. See generally Stephen M. Bainbridge, Corporation Law and Economics 270-83 (2002) (discussing preconditions).]

The business judgment rule, of course, is a presumption that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). �While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. . . . Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.� Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982). See also Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup.Ct.1976), aff�d, 387 N.Y.S.2d 993 (App. div.1976) (holding that the duty of care �does not mean that a director is chargeable with ordinary negligence for having made an improper decision, or having acted imprudently�); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (stating that �although the concept of �responsibility� is firmly fixed in the law, it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest�).

In the leading In re Caremark Int�l case, then-Delaware Chancellor William Allen opined that the directors� duty of care includes an affirmative obligation to ensure �that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.� In re Caremark Int�l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). Yet, it is critical to recognize the distinction drawn by Chancellor Allen between allegations involving lack of oversight by directors and mere inadequate oversight. The business judgment rule is relevant only where directors have actually exercised business judgment; in other words, there rule provides no protection where directors have made no decision at all. See, e.g., Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984) (stating that �the business judgment rule operates only in the context of director action�).

In Caremark, the corporation had no program whatsoever of internal controls to ensure that the corporation complied with key federal statutes governing its operations. When the corporation ran afoul of one of those statutes and was obliged to pay a substantial fine, a derivative suit was brought against the directors. In reviewing the merits of that claim for purposes of evaluating the settlement, Chancellor Allen noted that decisions made deep in the interior of an enterprise by relatively junior employees can have devastating consequences for the firm. Allen also noted two concurrent regulatory trends. On one hand, federal law increasingly uses criminal sanctions to ensure corporate compliance with various regulatory regimes. On the other, the federal criminal sentencing guidelines mitigate sanctions where the corporate defendant had law compliance programs in place. In light of these considerations, Allen rejected the defendants� argument that �a corporate board has no responsibility to assure that appropriate information and reporting systems are established by management . . . .� Caremark, 698 A.2d at 969-70. Instead, as we have seen, he imposed an affirmative obligation for management and the board to implement systems of internal control. Because the Caremark directors had failed to take any action, the business judgment rule did not insulate them from (potential) liability for this failure. Instead, the duty of care controlled.

Where the board and management have established systems of internal control, however, the business judgment rule becomes the relevant standard of review. [NB: Indeed, it may be plausibly argued that the business judgment rule would insulate directors from liability even if the board considered the issue and then affirmatively decided not to adopt a system of internal controls relevant to the issue at hand. In theory, after all, a decision not to act does not differ from a decision to take action. In Caremark, moreover, Chancellor Allen made clear that directors who act in good faith through proper procedures are not liable even if, in retrospect, they made the wrong decision. Caremark, 698 A.2d at 967-68. The business judgment rule, as typically formulated, would seem to protect directors who rationally adopt either a minimal compliance program or even no program at all after weighing the costs against the benefits. Bainbridge, supra, at 296.

Hence, when reviewing how the directors have exercised their oversight function through an extant system of internal controls�as opposed to entirely failing even to create such a system�the standard of review becomes one that a plaintiff-shareholder can satisfy only with great difficulty. Plaintiff must show the traditional grounds on which the business judgment rule is set aside: fraud, illegality, or self-dealing.

Vice Chancellor Strine�s decision in Guttman v. Huang seems to blur this important distinction. In that decision, Vice Chancellor Strine opined that:

[T]he Caremark opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith. Put otherwise, the decision premises liability on a showing that the directors were conscious of the fact that they were not doing their jobs.

823 A.2d at 506. Guttman thus seems to establish a single standard of liability for cases involving negligent oversight through an extant system of internal controls and for failures to exercise oversight by failing to create such a system. If so, in my view, Guttman blurs a doctrinal distinction I regard as critical to understanding Caremark. (The two standards perhaps can be reconciled by arguing that directors who are �conscious of the fact that they were not doing their jobs� have �abdicated their functions,� which is not protected by the business judgment rule. Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984).)

Fortunately, even if Guttman is correct, the standard remains one which a derivative suit shareholder-plaintiff can satisfy only with great difficulty. Vice Chancellor Strine approvingly quoted a key passage from Chancellor Allen�s Caremark opinion:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or systematic failure of the board to exercise oversight�such as an utter failure to attempt to assure a reasonable information and reporting system exists�will establish the lack of good faith that is a necessary condition to liability. Such a test of liability�lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight�is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

Caremark, 698 A.2d at 971 (emphasis supplied), quoted in Guttman v. Huang, 823 A.2d 492, 506 (Del. Ch. 2003). Hence, the Vice Chancellor indicated that a Caremark claim must plead facts showing that, inter alia, �that the company lacked an audit committee, that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.� Guttman, 823 A.2d at 507.

The bottom line thus seems to be that audit committees still receive substantial protection. Mere negligence still shpu;d not result in liability. Instead, a systemic breakdown in oversight or conscious disregard of clear problems is required. In my view, however, Vice Chancellor Strine would have done better to make clearer that the business judgment rule still applies in full force to an audit committee�s oversight functions. I have written a law review article entitled The Business Judgment Rule as Abstention Doctrine, forthcoming in the Vanderbilt Law Review, in which I explain in detail why courts generally should abstain from reviewing board decisions. In my view, those arguments carry over in full force to review of how an audit committee carries out its functions.

In brief, there is the problem of judging by hindsight. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471, 1523 (1998). If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective. Even where duty of care cases are tried without a jury, as in Delaware, judges who know with the benefit of hindsight that a business decision turned out badly likewise could be biased towards finding a breach of the duty of care. Cf. Chris Guthrie et al., Inside the Judicial Mind, 86 Cornell L. Rev. 777, 799-805 (2001) (discussing empirical evidence that judicial decisionmaking is tainted by the hindsight bias). Hence, there is a substantial risk that judges will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante.

Second, business decisions are frequently complex and made under conditions of uncertainty. Accordingly, bounded rationality and information asymmetries counsel judicial abstention from reviewing board decisions. Judges likely have less general business expertise than directors. They also have less information about the specifics of the particular firm in question. To be sure, the old adage that �judges are not business experts� cannot be a complete explanation for the business judgment rule. Yet, many old adages have more than a grain of truth. So too does this one. Justice Jackson famously observed of the Supreme Court: �We are not final because we are infallible, but we are infallible only because we are final.� Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final�directors or judges?

Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints are provided by a competition in a number of markets. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers. Granted, only the most na�ve would assume that these markets perfectly constrain director decisionmaking. It would be equally na�ve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges. As such, rational shareholders will prefer the risk of director error to that of judicial error.

Finally, judicial review could interfere with�or even destroy�the internal team governance structures that regulate board behavior. Research on relational teams �which are what boards and board committees are � shows that they are not only hard to monitor, but that they also are hard to discipline. Stephen M. Bainbridge, Why a Board? Group Decision Making in Corporate Governance, 55 Vand. L. Rev. 1, 49 (2002). Instead of external review, relational teams are best monitored by a combination of mutual motivation, peer pressure, and internal monitoring. As I have explained elsewhere in more detail, however, judicial review might well destroy the interpersonal relationships that foster these forms of internal board governance. Id. at 49-50.

In sum, Guttman is an interesting development, but one the Delaware courts should promptly clarify as incorporating the classic business judgment rule. The justifications for the business judgment rule apply in full force to the present setting.