Archives For corporate governance

UCLA’s Milken gift

Larry Ribstein —  23 August 2011

The NYT discusses a controversy at UCLA (mainly, it seems, involving objections by Lynn Stout) to the $10 million gift it just announced from Lowell Milken, Michael’s brother.  Lowell was accused many years ago in connection with his brother’s securities violations and escaped prosecution because of his brother’s plea deal. Steve Bainbridge comments in response to the NYT story, discussing this ancient history:

Some of us who were active in the field at the time–as I was–remember the story a bit differently. In our view, the government used threats to go after Lowell as one of the ways on which they coerced Michael into taking a plea deal.

I have more perspective in my paper, Imagining Wall Street.  There I note that Oliver Stone’s film Wall Street

may have helped create an environment that became increasingly unfriendly to takeovers.  In the year following the film’s release, Drexel and Milken were prosecuted, eventually culminating in the fining and jailing of Milken along with many others in the takeover game, and the demise of Drexel Burnham. Milken pleaded guilty and was sentenced to ten years in jail.68 [United States v. Milken, No. (S) 89Cr.41(KMW), 1990 WL 264699 (S.D.N.Y. Nov. 21, 1990)]  * * * It is hard to say how much of that attitude was based on actual events reported in the media, and how much on the fiction Wall Street helped create. Milken was prosecuted not for insider trading, but rather for technical violations of the Williams Act—that is, using Boesky to accumulate non-disclosed positions in target shares.69 [Id. at 4]

In short, there is a big question whether Lowell’s history is such as to taint UCLA by his gift.

But I am not unsympathetic with the idea that law schools are supposed to be teaching their students that ethics trumps money, and so should be careful about whom they take money from, and more generally the company they keep. Indeed, for that reason I wrote critically last year about Bill Lerach’s foray into law teaching.

The real question here is where you draw the line and who decides.  Is the decision to turn down a gift based on ethics or politics?  More to the point, would the same people who oppose the Milken gift also object to an association with Lerach?

And how do you balance those considerations against the institution’s needs?  Interestingly, Professor Stout has written extensively about the need to take the interests of all constituencies into account in corporate decision-making.  Where would UCLA’s students stand in the decision Professor Stout favors to reject the Milken gift?

The Shareholder Protection Act been reintroduced in Congress, and Lucian Bebchuk still likes it. He and Robert Jackson wrote an article defending the basic idea, which Bebchuk describes as to “establish special corporate-governance rules for deciding when corporate resources may be spent on politics.”  He admits “the bill is unlikely to be adopted during this Congress.” However, since it seems no more likely to go away than Freddie Krueger or Michael Myers, it’s worth discussing why, like these characters, it’s a scary idea.

Bebchuk’s post is timely (for me) because it coincides with the publication of my article, The First Amendment and Corporate Governance.  This article argues generally (per the abstract)

that regulation of the corporate governance process that produces speech faces significant obstacles under the First Amendment. These include the limited efficacy of regulation of corporate governance, regulation’s potential for protecting the expressive rights of some shareholders by suppressing others, and the uncertain implications of this rationale for types of speech other than that involved in Citizens United. These problems with the corporate governance rationale for regulating corporate speech suggest that protection of shareholders’ expressive rights may be trumped by society’s interest in hearing corporate speech and the First Amendment’s central goal of preventing government censorship.

Here’s what the paper has to say about the SPA and Bebchuk & Jackson (footnotes omitted):

This Act would, among other things, require extensive quarterly and annual disclosures of corporate speech expenditures and majority shareholder authorization of “specific” expenditures a year in advance and impose damages for unauthorized expenditures.

The SPA makes clear that its purpose goes beyond merely protecting shareholders. As the bill’s “purpose and summary” notes in its opening sentences, “The [Citizens United] ruling invalidated longstanding provisions in U.S. election laws and raised fresh concerns about corporate influence in our political process. To address those concerns, the Shareholder Protection Act gives shareholders of public companies the right to vote on the company’s annual budget for political expenditures.” In other words, the proposed Act is concerned with “corporate influence.” This illustrates the tension discussed above between the concern for shareholder expression and that for corporate distortion of the political process. 

Apart from the uncertainty of the Act’s intended goal, its means of implementing this goal probably cannot survive First Amendment scrutiny under Citizens United. First, the Court suggested that, while a corporate governance regulation might pass, a remedy “based on speech, contravenes the First Amendment.” The SPA, like the restrictions at issue in Citizens United, is “based on speech.” This raises the question whether the proposed Act’s restrictions can be sustained on shareholder-protection grounds * * *.

Second, the SPA favors the expression of some stakeholders to the detriment of more passive shareholders. The provisions requiring authorization of expenditures may, depending on the applicable voting rules, empower activist shareholders, such as public pension funds, while submerging the preferences of many, perhaps a majority, of others.  

Third, the Act’s requirement that corporations get advance shareholder approval for corporate political activity sharply constrains all such speech by essentially requiring firms to lock in their political activity for a year from the close of a fiscal year. This prevents firms from dealing effectively with a dynamic political landscape. Managers’ treble damage “fiduciary” liability for unauthorized speech reinforces this inflexibility. Imposing these burdens on speech would be inconsistent with Citizens United’s emphasis on the social value of corporate speech.

Bebchuk and Jackson’s governance proposals may fare better under the First Amendment because they are more squarely aimed at corporate governance and the internal distortion problem. The authors suggest requiring the shareholders approve the firm’s overall spending budget, allowing shareholders to submit binding resolutions on corporate speech for shareholder vote, requiring that independent directors make decisions on corporate speech, and mandating more disclosure concerning corporate speech decisions. These provisions are probably less onerous than those in the SPA, depending on their specific implementation, including how they interact with the rules for shareholder voting under federal and state law. Bebchuk and Jackson also would enable shareholders to opt out of the regulation, which further mitigates the impact on corporate speech. 

The main problem with the Bebchuk-Jackson proposal is that it allows for possible super-majority shareholder authorization of corporate speech in order to protect the expressive rights of minority shareholders. * * * [P]rotecting the expressive rights of some shareholders may infringe the expression of other stakeholders and unacceptably restrict corporate speech under the Citizens United listeners’ rights rationale. These concerns increase with the level of protection for minority shareholders. Bebchuk and Jackson even suggest any level of shareholder approval is acceptable that enables “a practically meaningful opportunity to obtain the required approval.” The authors draw this standard from cases on whether state antitakeover law preempts federal law protecting shareholders’ rights. The preemption standard is based on the intent underlying federal takeover law and has little to do with determining corporations’ and corporate stakeholders’ rights regarding corporate speech.

The full article provides support for the positions underlying these criticisms, and cites to my earlier writing on these issues containing deeper background.

In a recent Dealbook post, Steven M. Davidoff complains that Delaware’s business judgment rule is too lenient.  Davidoff contends that “[a] Delaware court is not going to find [directors] liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.”  He then asserts that a commonly heard justification for this lenient approach — that it is required in order to induce qualified individuals to serve as directors — is “laughable.”

Prof. Davidoff’s pithy summary of the Delaware business judgment rule seems accurate, and I share his skepticism toward the argument that the rule is justified as a means of inducing highly qualified directors to serve.  I disagree, though, with his insinuation that the Delaware approach is unjustified.  The rule makes a great deal of sense as a means of aligning the incentives of directors (and officers) with those of shareholders.

Under Delaware’s business judgment rule, courts will abstain from second-guessing the merits of a business decision — even one that appears, in retrospect, to have been substantively unreasonable — as long as the directors acted honestly, in good faith, without any conflict of interest, and on a reasonably informed basis (i.e., they weren’t “grossly negligent” in informing themselves prior to making the decision at issue).  Courts treat the rule as quasi-jurisdictional, insisting that they simply will not hear complaints about the substantive reasonableness of a decision as long as the prerequisites to BJR protection are satisfied. 

One frequently hears two justifications for this deferential approach.  First, courts sometimes seek to justify it on grounds that they are not business experts.  Second, as Prof. Davidoff observes, directors and officers often defend it on grounds that it’s needed to prevent qualified directors from being scared off by the prospect of huge liability for good faith business decisions that turn out poorly.  

Neither justification works very well.  Courts routinely second-guess the substance of decisions in areas where they lack expertise and might, by imposing liability, dissuade qualified individuals from offering their services.  Consider, for example, medical malpractice.  Courts aren’t medical experts, yet they routinely second-guess the substance of good faith, reasonably informed treatment decisions.  And they do this with full knowledge that malpractice judgments dissuade qualified doctors from providing their services.  (Remember President Bush’s concern that malpractice verdicts were dissuading gynecologists from “practic[ing] their love with women all across this country”?)  There must be something more to the story.

Indeed, there is.  By insulating directors from liability for good faith, informed business decisions that turn out poorly, the business judgment rule encourages directors to take greater business risks.  This is a good thing, because directors and officers tend to be more risk averse than their principals, the shareholders.  I previously explained that point in criticizing Mark Cuban’s claim that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.”  I wrote:

… Stockholders would normally prefer corporate managers to take more, not less, business risk.

When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). …

Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.

The need to reconcile risk preferences among corporate managers (directors and officers) and their principals (the shareholders) provides a compelling justification for Delaware’s business judgment rule.  Chancellor Allen clearly articulated this point in footnote 18 of the 1996 Caremark opinion:

Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical “reasonable person”, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what persons of ordinary or average judgment and average risk assessment talent regard as “prudent” “sensible” or even “rational”, such persons will have a strong incentive at the margin to authorize less risky investment projects.

As Geoff has often reminded us, the optimal level of business risk is not zero.

Did you know that shareholders in US corporations are like oppressed citizens of corrupt governments?  Or that “say on pay” is their Arab Spring?

If not, you haven’t been reading Gretchen Morgenson.  Better that you read Christine Hurt’s excellent critique of Morgenson’s latest screed.

Jason Zweig wrote Saturday in the WSJ about how companies are hoarding their cash. Microsoft, Cisco, Google, Apple and J & J “added $15 billion in cash and marketable securities to their balance sheets. Microsoft alone packed away roughly $9 billion, or $100 million a day. All told, the companies in the Standard & Poor’s 500-stock index are sitting on more than $960 billion in cash, a record.” The proportion of earnings paid as dividends is at the lowest level since 1936.

What are they planning to do with the money?  Well, MS paid almost precisely all of its additional cash, $8.5 billion, for Skype.  Zweig asks, “[w]as that torrent of cash burning a hole in Microsoft’s pocket?” 

The hoarding may be because firms don’t see opportunities in an uncertain, highly taxed and increasingly regulated economy.  But whatever the reason, Zweig is right in saying, following Benjamin Graham, that if they don’t have good uses for the cash they should give it back to the shareholders. Zweig notes that Graham proposed that investors insist on payouts of inappropriately hoarded cash and set formal dividend policies, with leading companies paying out two-thirds of their earnings.

But managers generally have the final say over dividend policies.  So what to do?  Well, as Henry Manne proposed long ago, takeovers can solve this problem.  More specifically, the kind of takeovers that turn publicly held corporations into private-equity managed uncorporations.  As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with. 

The uncorporation is not for all firms.  But, alas, it may be for an increasing number of firms, even former growth firms, this economy has beached. 

Meanwhile it would be nice to find away to create the kinds of growing firms that do have opportunities and might actually be able to use the corporate form.

I’m just catching up with this Board Member article about Delaware’s new competitor, Nevada. It notes that Nevada’s share of the out-of-state incorporation market rose from 4.6% in 2000 to 6% in 2007.  Part of this may be due to lower fees than Delaware. But that can’t be the full explanation because all states are cheaper than Delaware.  More interestingly, the article suggests Nevada may be succeeding by offering a haven for shady operators with low fiduciary standards and high barriers to takeovers. 

The article features a discussion of Michal Barzuza’s article with David Smith, What Happens in Nevada? Self-Selecting into a Lax Law, which as the title indicates supports the competition-for-laxity position.  This paper, as the Board Member article notes, shows that “Nevada corporations posted accounting restatements twice as often as the national average from 2000-2008.”  Barzuza tells Board Member:  “It should be a cause for concern if the companies that need regulation most are allowed to choose a lax legal regime.”

I get a chance to respond in the Board Member article.  Here’s my quote:  “The data show that riskier firms are going to Nevada, but risky firms need capital, too. What Delaware has to offer is its legal infrastructure. But it’s reasonable to ask what that is worth to me as a business.” This is along the lines of my comment on Barzuza-Smith at last year’s Conference on Empirical Legal Studies. 

Barzuza also has a sole-authored paper that focuses on the normative aspects of the Barzuza-Smith empirical study.  That paper doesn’t yet have a public link, but I’ve read it and saw it presented at ALEA last week. 

Barzuza and I agree that Delaware and Nevada appeal to different segments of the incorporation market.  We disagree on whether this is a problem.  In a nutshell:

  • Barzuza thinks the relatively high level of accounting restatements by Nevada corporations indicates Nevada offers an escape from regulation for firms that most need to be regulated.  As Barzuza-Smith say in their abstract:  “Our findings indicate that firms may self-select a legal system that matches their desirable level of private-benefit consumption, and that Nevada competes to attract firms with higher agency costs.”
  • But I see an efficient contracting story, with Nevada offering smaller firms an opportunity to economize on monitoring and litigation costs. (Note: the more recent unposted Barzuza paper also discusses the efficient contracting story.)

The implications of this debate are important because it carries the threat of more federal regulation of corporate governance.

Here’s some support for my efficient contracting hypothesis:

  • Nevada isn’t, in fact, a haven for defrauders.  Its law provides for liability for fraud as well as intentional misconduct or a knowing violation of law. It couldn’t if it wanted to offer escape from federal securities law liability. Although B-S (Table 4) show a higher fraud percentage in Nevada restatements, the total percentage is tiny in Nevada as elsewhere.  More importantly, B-S found no evidence that increased restatements followed incorporation under Nevada’s lax (post-2000) provisions.  In other words, although Nevada may attract dishonest managers, there’s no indication these firms were reincorporating in Nevada in order to commit fraud.
  • The value of Nevada corporations doesn’t suffer from any evident “fraud discount” as measured by Tobin’s q (B-S Table 5) (although it’s not clear how these values might be affected by pre- or post-restatement accounting). 
  • There are benign explanations for the larger number of Nevada accounting restatements.  Nevada public firms are smaller than those in Delaware, increasing the per capitalization cost of setting up controls that could catch accounting errors.  Small size is one of the factors associated with weaker controls (see Doyle, Ge and McVay).  B-S show that Nevada has a relatively high percentage of mining firms, and Barzuza’s ALEA paper shows that Nevada has a relatively high percentage of family firms.  Both of these characteristics relate to the amount and type of monitoring required, and therefore to the efficient contracting story.

In short, the article’s data is consistent with the hypothesis that firms choose Nevada for its better balance of costs and benefits of monitoring than they could get in Delaware. Its strict default standards for suing managers may tolerate some managerial misconduct, but they also reduce firms’ exposure to opportunistic strike litigation.  Nevada removes from its statute the sources of legal indeterminacy that Delaware has been criticized for.  This enables Nevada to offer a legal package that is attractive to some firms without the costly legal infrastructure required to apply Delaware’s open-ended good-faith and loyalty standards.

In other words, in contrast to the B-S claim that Nevada “competes to attract firms with higher agency costs,” in fact Nevada may be attracting firms seeking lower agency costs defined by Jensen & Meckling to include monitoring and bonding costs as well as agent misconduct (Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).  This recognizes that the costs of hiring an agent, and thereby separating ownership and control, are never zero.  Attempting to reduce agent misconduct to zero could actually increase total agency costs as compared with cheaper monitoring that tolerates a reasonable level of agent misconduct.

None of this is to say that Nevada law offers an optimal set of terms.  We could probably benefit from additional standard forms to match firms’ diverse governance needs.  (Watch for my forthcoming paper with Kobayashi on the production of private law.)   But Nevada law doesn’t have to be optimal to be welfare-increasing. The question is whether the Nevada package of terms offers a better match for some firms than a Nevada-less market for corporations in which only Delaware competes for out-of-state incorporations.

Aside from substantively evaluating Nevada law, it is worth asking whether the Nevada story suggests market failure in the corporate law market.  B-S show that Nevada is not pretending to be something it isn’t.  It clearly advertises its “laxity,” so both shareholders and managers know what they’re getting.  Moreover, the Board Member article indicates there’s inherent resistance to any state that departs from the Delaware standard.  Investors may over-discount Nevada corporate shares out of distrust or fear of the unknown so Nevada laxity is, if anything, over-reflected, in the price of Nevada IPOs.  If Nevada shareholders don’t get an adequate voice on Nevada reincorporations (as where an existing firm merges with a Nevada shell) this is a problem with the law of the non-Nevada states where the firms originate.

So more work needs to be done to flesh out the Nevada story.  This might include

  • More specific comparisons of the firms that are and aren’t choosing Nevada to get a clearer picture of the effect of Nevada incorporation. 
  • As somebody suggested at ALEA, perhaps California-based firms incorporating in Nevada may not really be choosing Nevada governance law because of California’s “quasi-foreign” provisions. 
  • Is there an “out of Nevada” effect analogous to the “out of Delaware” effect documented by Armour, Black and Cheffins, in which Nevada corporate cases, particularly those involving fraud, are being litigated in, say, California or federal court?  This would negate any effort by Nevada to attract managers seeking to escape fraud liability.
  • Is Nevada using a similar strategy to compete in the market for LLCs?  Kobayashi and my data on the market for LLCs suggest not, and that the overall market for LLCs differs from that for corporations.  So why don’t firms opt out of Delaware corporate law by opting into uncorporate law?  I show that this strategy could produce a Nevada-like reduction of indeterminacy.

In short, Barzuza & Smith are right and clever to focus on this evidence of segmentation in the incorporation market.  This contradicts those who contend that the so-called market for out-of-state incorporations is really a Delaware monopoly. 

But it’s a mistake without much more data to jump to the conclusion that this is a “cause for concern.” This sort of argument could feed building pressures to federalize corporate law.  So far the Nevada story shows that there’s a significant demand for rules that reduce governance costs even in the face of strong pressures toward Delaware standardization. This cuts against rather than for increasing federalization, particularly as we are learning that even federal law competes in a global market for corporate law.

Acharya, Gabarro and Volpin’s Competition for Managers, Corporate Governance and Incentive Compensation has interesting insights and data on both corporate governance and executive compensation debates.  In the final analysis, I think it’s most interesting for what it says about the uncorporation.  Here’s the abstract: 

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm’s incentives to invest in corporate governance because managerial rents are determined by the manager’s reservation value when employed elsewhere and thus by other firms’ governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm’s executive compensation is not chosen in isolation but also depends on other firms’ governance and that better managers are matched to firms with weaker corporate governance.

Some particularly interesting points in the paper:

  • Pay-for-performance compensation is greater in firms with weaker governance, thus indicating that these are substitutes.  Another reminder of the dangers of putting on blinders when evaluating and regulating corporate governance.
  • Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
  • Managerial quality also depends on firm governance. When a firm gets a better CEO, the quality of its governance decreases, and vice versa,

This paper shows that corporate governance and executive compensation are much more complicated not only than regulators’ simplistic assumptions, but even than some leading theories, such as Gabaix & Landier on the effect of firm capitalization (Why Has CEO Pay Increased So Much?, 123 QJE 49 (2008)) and Hermalin & Weisbach on CEO power (Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 American Economic Review 96 (1998)).  The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”

Of particular interest for my work is this final observation in the paper:

A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders that concentrated private equity investors can “arbitrage” through their investments in active governance.

This is another testament to the governance implications of the uncorporation.  For explanations of these implications, see my Rise of the Uncorporation, Chapter 8, and Partnership Governance of Large Firms.

Much significant regulation has been inflicted on the financial markets over the last decade with little regard for evidence of whether the regulation is likely to accomplish its intended purpose.  A couple of recent studies on SOX and Dodd-Frank suggest that at least some of this regulation has made things worse.

Kim and Lu, Unintended Consequences of the Independent Board Requirement on Executive Suites investigates the effect of SOX independent director requirements.  They find that the executives react to the regulation by filling executive suites with their friends, with worse results for their firms. According to the abstract:

Following enactment [of SOX], affected firms fill their executive suites with significantly higher abnormal fractions of top-executives appointed (AFTA) during the current CEO’s tenure, replacing predecessors’ appointees. * * * [T]he newly appointed executives are more connected to their CEOs through past employment. * * * Higher AFTA is associated with lower firm valuation and less profitable acquisition bids. Moreover, the regulation’s overall effect on shareholder value is negative and significant, implying that the benefits of more independent directors are overwhelmed by harmful effects of the unintended consequences.

The good news is that markets to some extent ride to the rescue:

Importantly, affected firms facing strong product market competition do not increase AFTA. Strong external pressure for good governance from the product market seems to preclude the unintended consequence, demonstrating the merits of market-based solutions for better governance.

This suggests that the market would have done a better job on governance if the regulators had simply left them alone, at least in terms of independent director regulation. 

The authors explain why, in theory, we should expect exactly what occurred:

Board independence is but one of many facets of a firm’s governance structure. When regulation imposes a quota on one area of governance, it may have spillover effects on other less regulated areas of governance. The purpose of this paper is to identify spillover effects of the independent board requirement and ask: What are the effects of the regulation on shareholder value and what circumstances allow the spillover effects to take place?* * *

We explain these results with the Hermalin and Weisbach (1998) model, which shows in the absence of regulation, board independence is endogenously determined by a bargaining process between CEOs and boards, leading to an outcome where CEOs with greater bargaining power (due to their perceived superior managerial talent) have less independent boards. The quota on the percentage of independent directors nullifies the bargaining outcome for firms without independent boards, reducing their CEO influence over the board below what they bargained for. To recoup the loss of influence, these CEOs may attempt to increase their influence in their executive suites by replacing top-executives appointed by their predecessors with more of their own men–“circling the wagons” against more independent directors by assembling a more closely aligned and loyal team of top-executives. CEOs affected by the regulation will be more effective in making these personnel decisions and meet less resistance from the board because of their relatively strong bargaining positions, which according to the Hermalin and Weisbach model, is witnessed by the greater proportion of dependent directors prior to the regulation.

Martin, Trends in Financial Reporting: Shareholder Rights as a Poor Solution to Financial Reporting Abuses, studies the effect of shareholder rights provisions of Dodd-Frank. According to the abstract, it finds  

a general positive relation between stronger shareholder rights and accruals-based earnings management. Even when coupled with other reforms such as the Sarbanes-Oxley Act of 2002, this general positive relation may persist. These results provide evidence consistent with the inability of stronger shareholder rights to reduce earnings manipulation and actually provide evidence to the contrary. For those who propose shareholder rights as a solution to reduce irregularities in financial reporting, this paper should at a minimum cause pause and hopefully redirect regulatory and legislative efforts to more effective tools.

Martin theorizes that where shareholders are stronger managers have stronger incentives to manipulate earnings to keep them happy.

From the conclusion:

At a minimum, this paper provides additional evidence that manager discretion in financial reporting is complex, with many confounding incentives simultaneously in operation, with some in competition with one another. Therefore it is important for researchers to continue to explore better ways to identify and empirically document the factors that affect financial reporting decisions.

The lesson from both these papers is that corporate governance is a more complex mechanisms than the regulators thought. 

Of course even more conscientious regulators than the ones who enacted SOX and Dodd-Frank in a regulatory panic (see Romano on SOX) can’t predict all the potential effects of their laws.  That’s why they need to be more modest and recognize the need for regulatory competition (like the state competition that used to prevail in corporate governance) or at least sunset and opt-out provisions for federal regulation.  See Butler and Ribstein and Ribstein.

So you thought unconscionability was for furniture stores?  Larry Cunningham has news for you:

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

The article, among other things, would take the executive pay issue out of the internal affairs doctrine and put it into the morass of general choice of law rules for contracts (footnotes omitted):

[B]ecause they are not matters of internal affairs, they would be governed by the law of the state having the greatest interest.  Managers could name Delaware as the choice of law by contract and maintain Delaware’s quasi-monopoly that insulates the devices from judicial scrutiny. Yet contractual choice-of-law clauses are but one factor relevant to determining what law governs a contract.

To be sure, says Cunningham,

investors may recoil at the prospect of gadfly fellow shareholders challenging corporate pay contracts.

But he sees this as

a way to restore a modicum of external pressure on the State of Delaware, the leading promulgator of corporate law for national use. * * * [T]he practical reality is that the competition has ended, and Delaware faces no such pressure today.

There is, of course, a substantial literature questioning the Bebchuk-Fried-Walker conclusion on which this proposal is based that executive pay is out of whack.  And another substantial literature on whether or not the market for corporate law is out of whack.  But let’s put those questions aside and play along with the premises of the proposal.  Consider the consequences: 

  • Under this proposal, an executive, having negotiated her pay with a corporate board, would have no way of knowing whether, at some point, the pay might be challenged under standards to be named later in some state (her residence state, the corporation’s main place of doing business, somewhere else?) at the instigation of a lawyer seeking to extort a payment from the company. 
  • Executives would retain whatever power they supposedly had over the corporation in negotiating their contract to negotiate protection from or payment for this litigation risk.  Shareholders, of course, would pay.
  • Firms would surely find some way to deal with this new rule.  Would the result be better than the system we have now of entrusting the decision to directors?

I guess you could say I’m not convinced. I prefer to take this article as an interesting thought-experiment on why regulation of corporate pay is misguided.

The ramifications of the Supreme Court’s decision in Citizens United promise to play out for quite awhile, particularly including its effect on corporate governance. For example, will corporate decision-making that produces corporate speech be exempt from the First Amendment?  And how does the First Amendment apply to securities law limitations on what corporations can say to their shareholders and the markets?   I discuss these issues in my recently posted The First Amendment and Corporate Governance.

An important battleground for these issues is the challenge by the Chamber of Commerce and the Business Roundtable of the SEC’s Rule 14a-11, which forces corporations to give certain large shareholders access to the corporate proxy materials for purpose of nominating directors.  I discussed the COC/BRT brief a few weeks ago. Now we have the SEC brief.

The SEC argues that the rule survives a First Amendment challenge because it affects only the firm’s “internal communications,” and that strict First Amendment scrutiny does not apply because this is securities disclosure regulation and commercial speech.

My paper linked above suggests, among other things, that Citizens United may have obliterated the commercial speech doctrine.  For what it’s worth, I’m skeptical that 14a-11 would even meet the lower scrutiny standard for commercial speech. 

In general, my article discusses two possible theories the Court might apply.  Some would argue that the Court will permit government to protect the expressive rights of shareholders from abuse by corporate agents and majority shareholders.  For reasons discussed at length in the article, I think that’s unlikely. It think it’s more likely the Court will stress listeners’ rights to hear what corporations have to say. Here’s an excerpt from the article relating to the 14a-11 issue[footnotes omitted]:

An important pre-Citizens United case on corporate governance speech is Pacific Gas & Electric Co. v. Public Utilities Commission, where the Court struck down under the First Amendment a law compelling speech by a corporation in the form of mandatory inserts in its power bills. Justice Stevens, the Citizens United dissenter, also dissented in PGE, comparing the regulation at issue to the SEC’s shareholder proposal rule, which also requires corporations to distribute statements to its shareholders in connection with corporate elections.  The majority rejected the analogy because the shareholder proposal rule does “not limit the range of information that the corporation may contribute to the public debate” and because proxy regulation governs managers’ use of corporate property. 

The PGE distinction makes some sense in terms of Citizens United’s shareholder expression rationale.  Under that reasoning it is arguably acceptable to regulate speech within the corporation in order to protect shareholders’ control of corporate resources.  This would seem to be an even more important consideration post-Citizens United, given corporations’ new freedom to spend their resources on political speech.  On the other hand, PGE‘s fine distinction between proxy and other types of corporate speech would not square with Citizens United‘s broad listener-based rationale.  Thus, corporate governance, and specifically proxy regulation, may be a significant battleground for Citizens United’s shareholder protection rationale for regulating corporate speech.

This reasoning is particularly relevant to the SEC’s new Rule 14a-11 providing that large, long-term shareholders (i.e., those who have held a three percent interest for three years) may use the corporation’s proxy materials to nominate directors. It has been argued that the PGE distinction between billing inserts and shareholder proposals would not apply to this rule because it affects the speech of shareholders such as hedge funds and not just corporate officials.[citing the COC/BRT brief].

The shareholder expression argument seems to support PGE’s internal-external speech distinction.  In order to ensure that corporate speech reflects shareholders’ views — that is, to protect against internal distortion — the First Amendment arguably authorizes not only direct regulation of authorization of corporate speech, such as via the proposed Shareholder Protection Act, but regulation of corporate governance processes that might affect control over corporate speech, such as Rule 14a-11. 

On the other hand, the analysis comes out differently under Citizens United’s listeners’ right rationale.  As corporate activities are more regulated and therefore seek to play an increasing role in public discourse, their internal governance debates increasingly relate to political debates occurring outside the corporation.  This suggests a direct conflict between the shareholder protection rationale, which seeks to regulate internal governance because of its effect on public debate, and the special need for First Amendment protection of speech related to that debate. 

A further quandary in applying the shareholder protection rationale of regulating corporate speech concerns the question of which shareholders.  This is raised directly by Rule 14a-11, which as noted above favors certain large long-term shareholders.  Larger shareholders may favor rent-seeking actions that inflict deadweight losses on shareholders by seeking to transfer wealth among the firms in their broadly diversified portfolios. On the other hand, smaller, diversified shareholders, who own substantial amounts of large corporations’ shares, would favor actions that benefit their whole portfolios and not costly wealth transfers between individual firms in those portfolios. 

Citizens United’s listeners’ rights rationale raises additional questions concerning the constitutionality of other securities law provisions constraining truthful speech, particularly including prohibition of speech in unregistered public offerings under the Securities Act of 1933 and Regulation FD which penalizes selective disclosure of material information to securities analysts. These examples suggest that securities regulation may come under broad constitutional scrutiny following Citizens United.

The bottom line, as the ACLU’s Joel Gora said today in a WSJ op-ed celebrating the first anniversary of CU, comes down to this:  “Either the politicians and the government get to decide how much political speech there will be and what form it will take, or the people and the groups they organize get to make that call. But hasn’t the First Amendment already made that choice?” Yes.

Here’s  an earlier post on the constitutionality of Regulation FD. With respect to 1933 Act disclosures, see my post on the Bulldog Investors case. And for a general analysis of all these issues, see my article with Butler, Corporate Governance Speech and the First Amendment, 43 U. Kan. L. Rev. 163 (1994).

Agents Prosecuting Agents

Larry Ribstein —  12 January 2011

I’ve been blogging over the years quite a bit about a problem I call “criminalizing agency costs,” which is a piece of the general problem of over-criminalization.  In fact, this problem was a big reason for my getting started in blogging almost seven years ago.

As I mentioned a couple of months ago, I presented a paper on this at George Mason’s “Over-criminalization 2.0” conference. Now the paper’s on SSRNAgents Prosecuting Agents. Here’s the abstract:

Significant questions have been raised concerning the efficiency of criminalizing agency costs and the problems of excessive prosecution of crimes committed by corporate agents. This paper provides a new perspective on these questions by analyzing them from the perspective of agency cost theory. It shows that there are close analogies between the agency costs associated with prosecutors in corporate crime cases and those of the agents being prosecuted. The important difference between the two contexts is that prosecutors are not subject to many of the standard mechanisms for dealing with corporate agency costs. An implication of this analysis is that society must decide if prosecuting corporate agents is worth incurring the agency costs of prosecutors.

It’s a simple concept:  If agency costs are a big enough deal to criminalize, we should worry about the agency costs on the prosecutors’ side as well.

Read it while it’s hot.

I have spent some time over the last year discussing the Supreme Court’s big corporate speech case, Citizens United — at Stanford and Georgia State, and in an archive full of Ideoblog posts.

Now my paper on the case, The First Amendment and Corporate Governance, is finally available on SSRN.  Here’s the abstract:

The Supreme Court’s decision in Citizens United did not end the controversy over regulating corporate speech. Although the Court broadly subjected regulation of corporate speech to the First Amendment, it did not wholly preclude regulation of corporate governance processes that produce corporate speech. The Court’s opinion therefore shifted debate concerning corporate speech from corporations’ “external” distortion of the political process to their “internal” distortion of shareholders’ self-expression. This paper shows that regulation of the corporate governance process that produces speech faces significant obstacles under the First Amendment. These include the limited efficacy of regulation of corporate governance, regulation’s potential for protecting the expressive rights of some shareholders by suppressing others, and the uncertain implications of this rationale for types of speech other than that involved in Citizens United. These problems with the corporate governance rationale for regulating corporate speech suggest that protection of shareholders’ expressive rights may be trumped by society’s interest in hearing corporate speech and the First Amendment’s central goal of preventing government censorship.

As you can see from the abstract, I have moved on from debating whether the case is rightly decided to thinking about what will happen in the post-Citizens United era, particularly regarding corporate governance regulation and commercial speech. 

I think my paper is an important addition to the discussion of Citizens United.  It struck me at the AALS Business Associations/Con Law session on Citizens United last week that a lot of law professors do not seem to have fully internalized the fact that the Supreme Court has decided to protect corporate speech.  And the law professors who are thinking about the corporate governance implications of Citizens United haven’t fully internalized the fact that the First Amendment applies to this issue.  Thus, Bebchuk & Jackson’s recent paper devotes just a few paragraphs to the constitutionality of their proposals.

So if you want the lowdown on how the constitution now applies to corporate governance, read my paper.