“Mergers frequently force target CEOs to retire early, and CEOs’ private merger costs are the forgone benefits of staying employed until the planned retirement date. Using retirement age as an instrument for CEOs’ private merger costs, we find strong evidence that target CEO preferences affect merger patterns. [...]]]> As Joan Hemingway nicely illustrated, firms ought to disclose facts about their managers which are likely to influence stock purchasing decisions, even if those facts are otherwise private and personal.  Now, from a different direction, comes further evidence of the point that managers’ self-interested goals can influence their firm’s disposition.  In CEO Preferences & Acquisitions, Jenter and Lewellen take a look at the relationship between CEO retirement and “the incidence, the pricing, and the outcomes of takeover bids.”

“Mergers frequently force target CEOs to retire early, and CEOs’ private merger costs are the forgone benefits of staying employed until the planned retirement date. Using retirement age as an instrument for CEOs’ private merger costs, we find strong evidence that target CEO preferences affect merger patterns. The likelihood of receiving a takeover bid increases sharply when target CEOs reach age 65. The probability of a bid is close to 4% per year for target CEOs below age 65 but increases to 6% for the retirement-age group, a 50% increase in the odds of receiving a bid. This increase in takeover activity appears discretely at the age-65 threshold, with no gradual increase as CEOs approach retirement age. Moreover, observed takeover premiums and target announcement returns are significantly lower when target CEOs are older than 65, reinforcing the conclusion that retirement-age CEOs are more willing to accept takeover offers. These results suggest that the preferences of target CEOs have first-order effects on both bidder and target behavior.”

A few thoughts.

1.  As Brian Quinn noted, this is exactly what seemed to be going on in Smith v. Van Gorkom.

2.  The paper includes a nice set of confounding controls, but it’d be useful to have compared founding- with non-founding-CEOS.  At least anecdotally, one hears often of the founding CEO seeking cash out his sweat in a swan-song merger – and that kind of behavior seems less pernicious than a caretaker selling the company to pad her nest.  In the authors’ defense, I’d imagine thatin this fortune 500 dataset there weren’t many such originating great leaders.

3.  It’d be surprising if this common-sense result wasn’t already priced into the acquiring company’s shares, which might make it difficult to truly control for a recent rise in company performance against the market basket.

4.  But if #3 isn’t right, I have a strong sense that I know what my new investment strategy would like.  Someone want to start a corporate-executive retirement watch list with me?  There are models available.

Below is a description of the panel, which will occur (as perhaps a [...]]]> I am glad to announce that the AALS Committee on Special Programs selected my proposal as a “Hot Topics” panel for the 2012 AALS Annual Meeting in Washington D.C. next month.  The program is called: “The Dictatorship of Law: The Khodorkovsky Case, Human Rights, and the Rule of Law in Russia.”  William Pomeranz, Deputy Director of the Kennan Institute for Advanced Russian Studies at the Woodrow Wilson International Center for Scholars, will chair a panel that includes Kim Lane Scheppele (the University of Pennsylvania and Princeton), Bruce Bean (Michigan State University), Christopher Bruner (Washington and Lee University), Alexei Trochev (Nazarbayev University) and me.  The program will begin at 10:30 on Friday morning, January 6. 

Below is a description of the panel, which will occur (as perhaps a “hot topic” should) between two central events on the Russian calendar: the surprising results of yesterday’s parliamentary elections in Russia and presidential elections scheduled for March 4 that (at least until yesterday) everyone was saying would be certain to return now Prime Minister Vladimir Putin to the presidency currently held by his protégé, Dmitrii Medvedev.

During his first campaign for President of Russia in February 2000, Vladimir Putin defined democracy as a “dictatorship of law.”  This was meant to signal a shift away from the perceived lawlessness of his immediate predecessor’s governance, and to feed the nostalgia for Soviet-era stability.  As Putin starts his gambit to return to the Russian presidency, this panel examines which half of that slogan will dominate the other.  Recent developments in the most well-known case in the courts of both Russia and the Council of Europe present an opportunity to do so at a pivotal moment not only in that case but for the future of the rule of law in Russia.

Mikhail Khodorkovsky was the CEO of the Yukos Oil Company and the richest man in Russia when in 2003 he and his business partner, Platon Lebedev, were arrested and charged with crimes connected to Yukos, Russia’s most profitable and well-known private corporation.  They were convicted of fraud, causing property damage by deceit or breach of trust, and tax evasion and sentenced to eight years in prison.  Yukos was seized and sold to state-controlled companies.  In December 2010, as their sentences drew to a close, Khodorkovsky and Lebedev were convicted by another court of embezzlement and money-laundering, charges arising out of the same time period and concerning the same corporate activities that were the basis for the first conviction.  On the eve of that verdict, Prime Minister Vladimir Putin informed a nationwide television audience that “a thief should sit in jail,” a reference to a well-known Soviet mini-series that would have been quite familiar to viewers (the quote continues: “… and people don’t care how I put him away.”).  In midsummer 2011, a Russian court upheld the verdict, extending the defendants’ sentences until 2016. 

A bit more on the tension this case embodies for Russian law and human rights after the break …

While Russian courts have repeatedly found against Yukos, Khodorkovsky, and his associates, the European Court of Human Rights has consistently found that their detention and trials worked numerous violations of the European Convention on Human Rights.  Four judgments have been handed down by the Strasbourg Court, all against Russia.  More are pending.  The most recent decision, handed down in late September 2011, held that some of Russia’s actions to seize control of Yukos violated the Convention.  The Court reserved the determination of damages to a later date, thus setting the stage for a confrontation that has the potential to sunder the already tense relationship between Russia and the Council of Europe.

In the shadow of the Russian presidential election scheduled for March, the panel will examine this tension and the mirror this case holds up to reflect the state of the rule of law in Russia.  Russian membership in the Council of Europe has often been a catalyst for legal reform.  European judgments concerning this most political of cases have unsettled an already rocky relationship.  Russian President Dmitrii Medvedev will shortly receive a report on this case from his Council on Civil Society and Human Rights.  The Russian Constitution grants him a pardon power.  What can, what should, what will he do?

In the same remarks in which he vowed to create a “dictatorship of law,” Putin asked “what then should be the relationship with the so-called oligarchs?  The same as with anyone else.  The same as with the owner of a small bakery or a shoe-repair shop.”  This panel will reflect on the impact of Khodorkovsky’s case on the rights of “anyone else” in Russia.

We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured [...]]]> I’ve never taught Secured Transactions, so I’ll start by saying that the following is purely speculative and subject to correction.

We had a job candidate come through at some point this Fall who generally is interested in the field of commercial law.  That person mentioned in passing that although they were more than willing to teach the traditional secured transactions course, in their opinion it wasn’t well structured.  Why? Not, as the navel-gazer might imagine, because the field of commercial law is supposedly intellectually dead.  Rather because the traditional secured transaction course is too narrowly conceived — it usually is limited in coverage to personal property security interests under Article 9.  But many security interests that matter to lawyers aren’t held on movable property.  Since secured is ordinarily the foundational course for the commercial curriculum, students are left starting on too narrow a footing in understanding bankruptcy and bank regulation.  It’s even worse than having a corporations course that excludes LLCs.  Because of its technicality, ST is traditionally so difficult to teach that many students are turned off to the idea of commercial law practice at all.

Again, I don’t know much about this area of law.  I never took ST in law school, I haven’t taught it, and (worse) I haven’t even read a ST syllabus at my current institution.  But it struck me as an interesting thought, at least worth airing.  It’s related to concerns I have about the general corporate curriculum — is “corporations” really a subject that ought to be taught in a single course, or is it really a merger of too many (or too few) legal principles that have glommed together over time.  It’s also related to concerns that one might have about continuing to use the increasingly outdated, purportedly uniform, UCC to teach when States’ adopted versions are moving ever-further-away from that ideal.

“If the big bond insurers like MBIA and Ambac get downgraded because of the subprime mess, there could be a big ripple effect throughout the markets. A lot of investment-grade securities get their rating [...]]]> The last question in tonight’s Republican debate was, essentially, “what important threat to national security aren’t we talking about enough.”  This was a useful question — and it produced surprisingly illuminating answers.  (I’m with Newt– EMP!)   It reminded me of an occasional tradition here at Co-Op, the Gorilla Award.  As I explained in 2005, the award is named for this famous video demonstrating the phenomenon of “inattentional blindness.”  The gist was to recognize corporate law crises on the horizon.  2007′s lone entrant, Ben Barros, won by default and by retrospective acclimation:

“If the big bond insurers like MBIA and Ambac get downgraded because of the subprime mess, there could be a big ripple effect throughout the markets. A lot of investment-grade securities get their rating from the insurance policy (or “wrap”) that the bond insurers place on the issue. If the insurers get downgraded, a lot of debt instruments might also get downgraded. Among other things, entities that can only hold investment-grade instruments might be forced to sell lots of this stuff at the same time.”

The floor is open for nominations.  The criterion: what stuff is happening now that is likely to cause an important set of problems for corporate/financial regulatory law in the next 12-18 months, and which is not being talked about enough.  So, in my view, that excludes the European debt crisis, corporate political contributions, anything to do with credit swaps or mortgages, and (of course) the continued regulatory overhang from Dodd-Frank.  Basically, anything that comes to first to mind.  You can see why the Award is so prestigious — it requires out-of-the-box thinking!

What do you think?

As AIG’s controlling shareholder, FRBNY thereby breached its fiduciary duties to AIG and its other shareholders, charges a complaint filed in Federal court in Manhattan.  The complaint, filed by AIG’s largest private shareholder, Starr International and its CEO Maurice (“Hank”) Greenberg, was drafted by David Boies (Boies, Schiller & Flexner) and John Gardiner (Skadden Arps). It accompanies the commencement [...]]]> In September 2008, at the depth of the financial crisis, the U.S. Government arranged for control of the American International Group to be lodged in the Federal Reserve Bank of New York.  With that power, FRBNY for two years caused AIG and its board and top managers to engage in a series of deals that, to AIG shareholders, were designed more to benefit the financial system and other financial institutions than AIG. 

As AIG’s controlling shareholder, FRBNY thereby breached its fiduciary duties to AIG and its other shareholders, charges a complaint filed in Federal court in Manhattan.  The complaint, filed by AIG’s largest private shareholder, Starr International and its CEO Maurice (“Hank”) Greenberg, was drafted by David Boies (Boies, Schiller & Flexner) and John Gardiner (Skadden Arps). It accompanies the commencement of a parallel case filed in the Federal Court of Claims against the United States under the takings clause of the Fifth Amendment. Following are some excerpts from the complaint against the FRBNY.

6.  FRBNY [caused] AIG to pay AIG’s credit default swap counterparties 100 cents on the dollar . . . which at the time could have been compromised for substantially less than 100 cents on the dollar.

7. FRBNY was ostensibly motivated in these transactions by a desire to help the counterparties weather the financial crisis without confronting the public and political opposition that the FRBNY feared would arise if it aided the coutnerparties openly and directly. Regardless of whether the FRBNY’s support of the counterparties was good or bad public policy, in using AIG and AIG’s assets to accomplish a secret “backdoor bailout” of AIG’s counterparties, FRBNY breached the duties it, and those acting in concert with FRBNY, owed to AIG.

8. FRBNY then concealed both the identityof the counterparties receivving payments as well as the fact that those counterparties were paid in full. . . .

11. FRBNY [caused the evasion] of AIG’s existing Common Stock shareholders’ right to approve the massive issuance of the new Common Stock shares required to complete the Government’s taking of a nearly 80% interest in the Common Stock of AIG [in violation of Delaware corporate law].

14. [I]n a series of self-dealing transactions, FRBNY used its control over AIG to divert the rights and assets of AIG and its shareholders to itself and favored third parties . . .

by Ciara Torres-Spelliscy

As I told my law students in a recent class, when I was in law school, no one cared a fig about corporate political spending.  I did not hear about it in Constitutional Law, Corporate Law or Fed. Tax.  It was a non-issue because for the most part, it was banned.  It made sense that back then, the SEC would not have a corporate political spending reporting requirement.  That would have been tantamount to the agency’s asking, “have you committed any federal election [...]]]> Ciara Torres-Spelliscy is an Assistant Professor at Stetson University College of Law and the co-author along with economist Dr. Kathy Fogel of Shareholder-Authorized Corporate Political Spending in the United Kingdom.  I am posting her views on American corporate political transparency below [FP]: 

by Ciara Torres-Spelliscy

As I told my law students in a recent class, when I was in law school, no one cared a fig about corporate political spending.  I did not hear about it in Constitutional Law, Corporate Law or Fed. Tax.  It was a non-issue because for the most part, it was banned.  It made sense that back then, the SEC would not have a corporate political spending reporting requirement.  That would have been tantamount to the agency’s asking, “have you committed any federal election crimes?”  Now that such political spending is legal, the SEC should respond to the growing calls for a new disclosure rule.

Much has changed in the years since I was on the business end of a Con Law exam.  In particular, in 2010, the Supreme Court did away with corporate source limits on election ads altogether in the infamous Citizens United case.  The upshot of this case changed not just federal law going back to 1947, but also state laws, some of which dated back to the turn of the twentieth century.

The new normal is corporations can spend an unlimited amount of their treasury funds on independent political expenditures in local, state and federal elections.  This brings us back to the SEC and its utter lack of political disclosure rules.  Because of this gap, publicly-traded corporations can spend in elections without ‘fessing up.  This seems odd given how passionate shareholders are about transparency.

In the summer of 2011, ten corporate law professors petitioned the SEC for a new disclosure rule to rectify this situation.  These professors are both conservative and progressive, yet they all agree transparency of corporate political spending is a must.

Economists have already written in support of the professors’ petition.  Economist Dr. Michael Hadani of Long Island University noted that one of the reasons why shareholders should want more reporting on corporate political spending is that it can backfire.  His regression analysis of over 1,100 companies over an 11 year period found political spending had a negative impact of firms’ market value.

Economist Dr. Susan Holmberg, Program Director at the Center for Popular Economics, also argued that transparency would bring more efficiency to the market by reducing monitoring costs for investors of managers’ spending corporate resources in politics.

Shareholders have also weighed in loudly in support of more transparency of corporate political spending.  Over the past few years, shareholders have been calling for transparency company by company in shareholder resolutions.  And shareholders are asking the SEC for a new rule as well:  on November 1, organizations managing $690 billion on behalf of individual and institutional clients filed a comment urging the SEC to act.

As I pointed out in my comment to the SEC, the US is embarrassingly over four decades behind the UK which has required disclosure of corporate political spending since 1967 under the Companies Act.  The UK can offer some pointers on how a rule might work here.  In the UK, political expenditures over £2,000 are included in the directors’ report to shareholders.  The company must say where the money was spent and the law covers not just political spending in the UK, but also in all EU member nations.

The SEC, of course, has a lot on their plate, including finishing the Dodd-Frank rules.  But this is important to the integrity of our markets as well.  And the Commissioners don’t have to look very far for model language.  They could copy some from the Shareholder Protection Act pending in Congress or they could lift some language from our friends in jolly old England.  The ball is now in the SEC’s court.  As an investor, I hope they step up and do the right thing.

1) Alan Hyde, The Idea of the Idea of Labour Law: A Parable.

2) Yves Smith, The Decline of Manufacturing in America: A Case Study.

3) Mark E. Anderson, $500 a Month Less.

4) John Bowe, Nobodies: Modern American Slave Labor and the Dark Side of the New Global Economy.

5) Liza Featherstone, Selling Women Short: The Landmark Battle for Worker’s Rights at Wal-Mart.

6) Robert Reich on the great regression.

7) Kyle Leighton, Less Fruits Of More Labor.

8. Andrew Leonard, The Big Squeeze on Labor.

9) Washington Post, Breakaway Wealth.

10) But don’t worry, CEOs are doing something to stanch the flow of such disheartening news:

Here’s one financial figure some big U.S. companies would rather keep secret: how much more their chief [...]]]> Just a few points of interest on Labor Day:

1) Alan Hyde, The Idea of the Idea of Labour Law: A Parable.

2) Yves Smith, The Decline of Manufacturing in America: A Case Study.

3) Mark E. Anderson, $500 a Month Less.

4) John Bowe, Nobodies: Modern American Slave Labor and the Dark Side of the New Global Economy.

5) Liza Featherstone, Selling Women Short: The Landmark Battle for Worker’s Rights at Wal-Mart.

6) Robert Reich on the great regression.

7) Kyle Leighton, Less Fruits Of More Labor.

8. Andrew Leonard, The Big Squeeze on Labor.

9) Washington Post, Breakaway Wealth.

10) But don’t worry, CEOs are doing something to stanch the flow of such disheartening news:

Here’s one financial figure some big U.S. companies would rather keep secret: how much more their chief executive makes than the typical worker. Now a group backed by 81 major companies — including McDonald’s, Lowe’s, General Dynamics, American Airlines, IBM and General Mills — is lobbying against new rules that would force disclosure of that comparison.

The lobbying effort began more than a year ago. It involved some of the biggest names in corporate America and meetings with members of both parties on the House Financial Services Committee and Senate banking committee. The companies and their Republican allies in Congress call comparisons between the chief and everyone else in the company “useless.”

But some Democrats and investors say the information should be issued to highlight the growing income disparity in the United States. They add that opponents of disclosure merely want to hide the outrageous scale of executive pay packages.

Opaque pay is a big problem in the UK, too. In pay-without-performance world of corporate titans, expect a lasting war against disclosure.

The findings reflect sharp differences between law on the books in most countries, where directors command plenary authority over a corporation and are accountable to shareholders, and business in practice, where they delegate power to managers, who really call all the shots. They also reflect no change in practice in the three years since the financial crisis, which many blame, in part, on weak boards.

Some highlights from the report:

* 44% of respondents say their boards simply review and approve management’s proposed strategies;

* only 1/4 characterize their boards’ overall performance as [...]]]> A new McKinsey study of corporate directors of international companies shows that today’s boards remain exemplars of the modern era’s so-called monitoring board, swinging into action occasionally when needed, rather than the old-fashioned managerial board, actually overseeing and directing the corporation.  

The findings reflect sharp differences between law on the books in most countries, where directors command plenary authority over a corporation and are accountable to shareholders, and business in practice, where they delegate power to managers, who really call all the shots. They also reflect no change in practice in the three years since the financial crisis, which many blame, in part, on weak boards.

Some highlights from the report:

* 44% of respondents say their boards simply review and approve management’s proposed strategies;

* only 1/4 characterize their boards’ overall performance as excellent or very good;

* directors report that their boards have not increased the time spent on company strategy since the previous survey of February 2008—seven months before the collapse of Lehman Brothers;

* the share of boards that formally evaluate their directors has dropped over the past three years;

* only 21% of directors claim a complete understanding of their companies’ current strategy;

* boards in the financial sector indicate that directors’ knowledge is below average on industry dynamics (just 6% claim complete understanding);

* directors on average spend 28 days’ worth of work annually, but think they should ideally spend 38 to do the job well.

The gap between the model and the reality is unsurprising given powerful political trends over the past 40 years. These have stressed that directors should be independent of the corporations they serve, rather than have any particular expertise to do the job well. 

The gap is also due to a certain hypocrisy in corporate law, where rhetoric about directorial fiduciary duties is stronger than the bite, especially in Delaware, the leading producer of U.S. corporate law.

But many still will be disappointed in these results. They will wonder why no change appears in director modus operandi, over the past 3 to 10 years, given how national policymakers prescribed changes in the formal model in law reform (in the United States, in such legislation as the Sarbanes-Oxley Act or the Dodd-Frank Act).

To some, the ever hopeful, such studies confirm the soundness of the most recent reforms. They would endorse again reforms such as giving shareholders power to nominate directors rather than leaving that power to managers or rules requiring directors to win a majority of shareholder votes rather than letting those earning a mere plurality serve.

To others, more practically-minded, the results may suggest abandoning both hope and pretense in the prevailing model. These might endorse bold suggestions, such as that of Florida State’s Kelli Alces, to abolish the board altogether.

The fashion, raging for some 40 years, has been to make boards the solution to all corporate problems, stressing that members be independent of management. There is no evidence that this works. 

I continue to believe we’d all be better off giving up the illusion and electing directors who know what they are doing, rather than those who look good on paper. Then results of surveys like this may be more heartening.

Financial Institutions and Consumer Financial Services Section

AALS Annual Meeting – January 2012

Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue

This program will take place one and a half years after the Dodd-Frank Act was signed into law. The law left many of the details of financial reform to be filled in by regulators, raising the risk of capture. Some of the most important rule makings have begun in earnest; others have stalled as reform fatigue sets in. Meanwhile, reform efforts in Europe and international regulatory initiatives remain works-in-progress.

What lessons can we draw from the implementation of Dodd-Frank so far? What have been the greatest achievements and the greatest disappointments as the legislative process has given way to the administrative? What devils have lain hidden [...]]]> Call for Papers:

Financial Institutions and Consumer Financial Services Section

AALS Annual Meeting – January 2012

Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue

This program will take place one and a half years after the Dodd-Frank Act was signed into law. The law left many of the details of financial reform to be filled in by regulators, raising the risk of capture. Some of the most important rule makings have begun in earnest; others have stalled as reform fatigue sets in. Meanwhile, reform efforts in Europe and international regulatory initiatives remain works-in-progress.

What lessons can we draw from the implementation of Dodd-Frank so far? What have been the greatest achievements and the greatest disappointments as the legislative process has given way to the administrative? What devils have lain hidden in the details of the Federal Register? What aspects of reform have been largely forgotten? What does the path of financial reform say about legislative and regulatory process? What lessons can be drawn from the reform efforts in Europe and elsewhere? Does the focus on regulating institutions detract from a focus on regulating financial instruments, markets or economic functions and risks?

More ominously, is the crisis truly over? Are we at grave risk of fighting the last war? Has reform missed the mark altogether? This meeting is part of a project to engage the legal academy in sustained theoretical and policy contributions to financial regulation. It also presents an opportunity to look at specific rulemakings in detail, as well as to address larger questions about the course of reform after laws are made.

Call for papers:

Law teachers and other scholars are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Junior faculty members are particularly encouraged to submit manuscripts or abstracts. A review committee consisting of Section officers will select one or more papers or proposals and will invite the author(s) of each selected submission to present their work at the program session in Washington, D.C. in January 2012.

Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose. Please send manuscripts or abstracts to the Program Chair (Erik Gerding, University of Colorado) at profgerding@gmail.com no later than August 30, 2010. Please place the name and contact information of authors only on the cover page of submissions.

Please forward this Call for Papers to anyone who might be interested.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex [...]]]> Secretive practices and institutions are common in contemporary finance. For those who’ve ceased the search for long-term value creation, temporary information advantage is key. Even commonplace practices can be reinterpreted as havens of hiddenness. My colleague Michael Simkovic’s article “Secret Liens and the Financial Crisis of 2008” exposes the role of derivatives and securitization as secretive borrowing strategies, designed to keep the naive or trusting from discovering the fragility of the institutions they loan funds to. His work has been presented to the World Bank Task Force on the Bankruptcy Treatment of Financial Contracts, and is relevant to both private and sovereign debt risks.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex and opaque financial products received the highest priority in bankruptcy.” Products like swaps and over-the-counter derivatives were not adequately disclosed (either by banks in their consolidated financial statements or by their counterparties in publicly accessible transaction registries). By concealing those debts, these already overleveraged financial institutions were able to attract ever more credit and investment, at better rates than those who reported their overall financial health more accurately. (All other things being equal, it’s safer to lend to an entity that owes 10 billion rather than 100 billion dollars.) The genius of Simkovic’s article is to show how “fundamental causes of the financial crisis are relatively old and simple,” even as an alphabet soup of instrument acronyms (CDO, CDS, MBS, ad nauseam) and government programs (TARP, TALF, PPIP, et al.) makes our time seem unique.

As Simkovic explains:

Losses act as a spark; widespread leverage is the powder keg. Leverage can be “regulated” privately by creditors or regulated by government, but only if the extent of leverage is known [emphasis added]. Hidden leverage is a perennial problem because debtors rationally wish to borrow at the lowest price possible. Debtors can borrow at more attractive rates by hiding their existing debts and creating an exaggerated appearance of creditworthiness. [emphasis added]

Debtors who wish to hide their debts can exploit competition between potential creditors to gain active cooperation from some creditors. These cooperative creditors will work with debtors to hide loans either through simple non-disclosure or through complex structures. Debtors may compensate these cooperative creditors for their assistance with higher fees, a deeper business relationship with the creditors, or liens on the debtors’ property. The result of this subterfuge is lower financing costs for the debtor and lower profits—or steeper losses—for unsophisticated unsecured creditors.

Note that Simkovic’s work is more incrementalist than that of Stephen Lubben (another colleague of mine) or Mark Roe, who question the wisdom of safe harbors for derivatives in bankruptcy. Whatever you feel about that position—and however you feel about the relative advantages of regulation or market forces in deterring systemic risk—Simkovic’s work points to a fundamental problem that all sides in these debates must grapple with. Neither market forces nor regulators can deter systemic risk if there’s not fair warning that an interaction between secrecy and priority in bankruptcy can suddenly create disastrous runs on financial institutions. It’s one thing to create priorities (or supersecured creditors) that everyone knows about. It’s quite another to allow sophisticated debtors to promise the moon and stars to entities that have no idea what rival claimants are going to demand.

Pushing for Priority

For “financial innovators” in the years leading up to 2008, the game was straightforward: sophisticated lenders wanted to obtain first priority in bankruptcy (and/or the right to make collateral calls quickly), while borrowers wanted to hide how much they’d borrowed (and how encumbered their assets were). Like the fraudulent subprime broker who added a few zero’s to the end of his client’s W-2 form, leading bankers exaggerated the well-being of the desks and divisions they fronted for by obscuring certain obligations on their books.

How did they do it? Simkovic explains how the bankruptcy code now favors “securitized” over “secured” debt. The code forces secured creditors to try to keep their bankrupt debtor afloat during reorganization. For example, an “automatic stay[] prevents a secured creditor from seizing and liquidating the underlying collateral to recoup its investment.” A securitization can stave off such obligations by “distancing” certain obligations from bankruptcy. Simkovic explains these steps:

In an asset securitization, the debtor (or “Originator,” the term typically used in documentation) transfers financial assets such as credit card receivables or mortgage receivables to a special purpose entity, or SPE, typically a wholly-owned subsidiary of the debtor. The SPE (or another transferee) issues debt to investors. Investors pay the SPE which then pays the debtor.

For the securitization to isolate the underlying assets from the debtor’s bankruptcy, the transfer of assets from the debtor to the SPE must qualify as a “true sale.” Most securitizations do not economically resemble “true sales” because the debtor retains the risk of default or non-performance of the underlying assets. The debtor retains risk because the debtor owns the equity (or “first loss tranche”) in the SPE, and because the debtor may be required to repurchase assets from the SPE if losses reach a level exceeding . . . [a] pre-set trigger.

However, just as clever legislators let AIGFP characterize its disastrous CDS business as “protection-selling” (rather than insurance), Delaware’s Asset-Backed Securities Facilitation Act let securitizers safely call the SPE fancy footwork a “true sale” to avoid the responsibilities associated with secured debt. The debtor’s obligation to its SPE’s is kept “off balance sheet,” hidden from many creditors. Limited disclosure of asset securitizations (and their terms) means that “even professionals can underestimate the extent of debtors’ exposure to losses from securitized assets.”

Rating agencies have given very high ratings to securitized debt, reasoning that the originating “‘companies retain the subordinated interest in the transaction known as the equity tranche or ‘first-loss’ piece.’” But they ignored the underlying economic motivations behind the transaction: those who brokered the deals would walk away with huge fees regardless of how well it did overall. Aside from sacrificial wolf Fabrice Tourre, virtually everyone involved in the securitization machine has done fine financially. And as the WSJ noted in 2008, the SEC failed to require rating agencies to “disclose to the public all underlying information about any debt they are rating.”

Financial Innovation as Epiphenomen of Legislation: The Case of Credit Default Swaps and BAPCPA

Simkovic also highlights how another aspect of the CDO doomsday machine thrived on secrecy. Just as a firm could both stand behind a securitization (to assure buyers of the securitized assets) and not stand behind it (for accounting purposes, so it looked like it had less exposure than it actually did), so too could the buyers of securitized assets have their cake and eat it too. The securitized asset promised a steady income stream, and a transaction called a “credit default swap” allowed its beneficiary to offload the risk that the income would not materialize onto another entity, in exchange for steady payments of its own. So even when outside observers might bridle at the amount of leverage an entity took on to buy securitized assets (often from another entity that was heavily leveraged to create and support the same assets), the buyer could outwardly appear to be placing one bet with its publicly disclosed balance sheet, while secretly hedging its bets by buying a credit default swap from a well-capitalized firm that promised to pay in case the SPE and originator could not. Its purchase of the assets, a “vote of confidence” in public, might even be swamped by skepticism about the viability of the assets, if the CDS paid off far more than the expected value of the CDO it insured.

By September, 2008, AIG had sold $440 billion of CDS protection. It had no way of paying out anywhere near that amount, and had not reinsured itself, or offloaded some of the risk onto someone with deeper pockets. Where were the regulators? Stupefyingly uninformed, as the FCIC Report shows:

The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. . . . [S]upervisors failed to recognize the extent of liquidity risk of the Financial Products subsidiary’s credit default swap portfolio. John Reich, a former OTS director, told the FCIC that as late as September 2008, he had “no clue—no idea—what [AIG’s] CDS liability was.” [emphasis added].

According to Mike Finn, the director for the OTS’s northeast region, the OTS’s authority to regulate holding companies was intended to ensure the safety and soundness of the FDIC-insured subsidiary of AIG and not to focus on the potential impact on AIG of an uninsured subsidiary like AIG Financial Products. Finn ignored the OTS’s responsibilities under the European Union’s Financial Conglomerates Directive (FCD)—responsibilities the OTS had actively sought. (350) [emphasis added]

Throughout late 2007 and 2008, the company’s accountant tried repeatedly to discover the true amount of risk involved in its transactions. As Simkovic shows, this was exceedingly difficult to do:

Credit default swaps, like most OTC derivatives, are an ideal vehicle for hidden leverage and secret liens because of their inherent complexity, limited disclosure, and superior treatment in bankruptcy. . . .Unlike exchange traded derivatives, which are standardized, simplified, and priced by the market through frequent trading, OTC derivatives are custom, bilaterally negotiated, relatively illiquid contracts and therefore difficult to price. The value of the derivative depends on three things: (i) the value of the underlying asset; (ii) the contractually negotiated formula that determines the counterparties’ obligations to each other based on that value; and (iii) the creditworthiness of the counterparty to the derivative, which determines the likelihood that the obligation will actually be paid. . . .

In the case of credit default swaps written on CDO tranches held by financial institutions: (i) the value of the underlying assets is difficult to determine because of the mathematically complex structuring that governs loss allocation among tranches and because of limited information about the credit quality of the underlying loans; (ii) the extent of counterparties’ obligations to each other is difficult to determine because of the subjective nature of determining when a “credit event” has occurred and the risk that disagreement will result in litigation; and (iii) the creditworthiness of counterparties is difficult to determine because they too have extensive and hard-to-measure exposures to derivatives such as credit default swaps.

Simkovic discusses how it may be impossible, even in principle, for large players to figure out the true extent of their exposure. CDS counterparties thought they were safe once they bought protection from AIG, and didn’t realize that AIG might go under. The banks didn’t accurately gauge the risk posed by AIG.

Willful Blindness

Simkovic’s position has been amply confirmed by other critics’ work. Consider, for instance, the cutting analysis from Eric Banks’s prescient The Failure of Wall Street (2004), which describes “financial controllers and auditors who don’t understand the nature of the business they are meant to be ‘independently monitoring,’” and trading desks which have little sense of “what kind of credit risks they are exposed to.” Combine these internal weaknesses with the regulatory arbitrage that allowed institutions to seek the most pliant “watchdogs,” and disaster was inevitable.

Of course, there were some forward-thinking participants in the financial markets who saw the risks, and ran away from them. As one report noted about Warren Buffett:

When Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” [Buffett] said to [a] government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.”

As one commentator observed, this type of complexity leads to a number of other problems:

Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties – “a spiral that can lead to a corporate meltdown,” [Buffett] wrote. They create a “daisy chain” of risk as the troubles of one company infect another.

That “daisy chain” of risk echoes the diagnoses of Yale economist John Geanakoplos (whose work has indicated the instability caused by high leverage and “tight chains of financial interdependence”), Rick Bookstaber (who chronicles the instability inherent in “tightly coupled” systems), and Lawrence Baxter (who brings attention to recent network science on the “cascading failure” that is “common to many complex systems”). An interdependent system as complex as the OTC derivatives market can crumble at any moment. If key participants are too highly leveraged and one or more of them experience a shock, disaster is inevitable. The problem is not a “black swan;” it’s the black box dealmaking that make it impossible for markets or regulators to grasp how leveraged and fragile institutions really are.

Secrecy vs. Resilience

So how resilient should these systems be? That is a matter due much more political and regulatory attention than it is currently getting. Regardless of one’s views on leverage, one thing is clear: the types of opacity described in Simkovic’s article prevent us from getting any handle on the scope and severity of the problem. As he notes,

[E]ven basic information about OTC derivatives transactions can be extremely hard to come by. Market participants themselves are often unaware of the extent of their net exposures or the identity of counterparties to their transactions. Mandatory disclosures to third parties are even more limited, and the industry group, the International Swaps and Derivatives Association, has resisted voluntary disclosure.

Why the lack of clarity? There’s a fundamental contradiction in finance. Financial managers need to compete by keeping what they know secret so they can place big bets at “wrong” prices and make money when the prices eventually correct. At the same time, the policy justification for financial markets is that markets get the pricing right. As Simkovic has argued, “Allowing greater secrecy is essentially a decision to allow financiers greater private profits and to reduce the public benefit from quick ‘price discovery’ by markets.”

Accounting rules compound the difficulties, allowing certain deals to be quarantined from the rest of the bank’s financial status. For example, since a “simple fixed/ floating interest-rate swap contract . . . has zero value at the start,” it “is considered neither an asset nor a liability, but is an ‘off-balance-sheet’ item.” Lehman Brothers had $738bn in derivative contracts labeled as “off balance sheet arrangements” in its 2007 accounts, it’s now hard to accept uncritically its estimate of their ultimate “netted” value at the time. Carol Loomis did a post-mortem on the situation:

Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not-so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful – the last reported number was 18,000 – are still open.

Each of these contracts has a “fair value” – an amount that one side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility. In fact, we have a weird tale, gleaned from court documents, supporting that suspicion. It involves Lehman, Bank of America, and J.P. Morgan, and suggests how far some of those “terminated” contracts are from being truly settled.

That last point—that both parties could “simultaneously claim a gain” on what had to be zero-sum arrangements—is critical to understanding the risks posed by black box finance. It explains why deal complexity is often pursued for its own sake, and not for a genuine economic or investment purpose. Webs of debt become a smokescreen for what is really going on: institutions are rendered more and more vulnerable (both individually and collectively) so that privileged parties within them can reap enormous incomes from fees and bonuses. Formalities didn’t matter: as Stephen Lubben notes, “many credit default swaps were assigned to new protection buyers without the prior consent of the seller,” even though the ISDA Master Agreement governing such deals forbids this. Murky accounting kept Chuck Prince’s famous “music” playing ever longer, as a mountain of leverage and misallocated capital accumulated.

It Gets Worse: BAPCA’s Ugly Legacy

According to Simkovic, 2005 amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) have exacerbated the problem. This law assured that “derivatives counterparties effectively bear no risk of loss to the extent that the debtor posts collateral to cover its obligations.” Simkovic describes the rush of creditors to take advantage of its provisions, a stampede that made it “harder for those creditors to communicate with one another and monitor debtors’ leverage.” AIG was the poster child for overleveraged indebtedness, selling $440 billion in “protection” on CDOs. According to Lynn Turner, “In one year, the disclosures from the company had gone from not losing a dollar to over $26 billion in valuation losses and counter parties that to this day have not been disclosed demanding over $16 billion in collateral.” Since the Treasury Department believed that “the global economy was on the brink of collapse” when the the magnitude of the problem became clear, the government stepped in to bail out AIG (and, thus, its counterparties).

(Turner, former chief SEC accountant, describes how opaque AIG’s procedures were. The recent book Fatal Risk gives the “tick tock” details, chronicling the deepening unease of AIG’s auditors as the mark-to-fantasy approach of its subsidiary AIGFP became clear.)

From 2000-2008, AIG made $66 billion in profit, but in 2008, it had a $99.3 billion loss. The employees and execs who benefited in the boom years have kept nearly all their cashed out compensation. By January, 2011, according to the FCIC report, AIG had cost US taxpayers $152 billion (FCIC Report, 350). It’s an incredible sum for a process whose only social contribution, so far as I can see, was a marginal (and likely temporary) bump upwards in the rate of homeownership.

Simkovic describes financial sector creditors consumed by a desire for positional advantage, ignoring the slow erosion of the viability of the system as a whole. It’s an “I’ll be gone, you’ll be gone” culture, where accountability has largely vanished. If we really want to understand the recent investor rush to gold and commodities, it’s better to look beyond the central banks’ “printing money” and to think hard about why they’ve had to do so. Do you really want to park much money—be it in stocks, bonds, or some other instrument—at institutions staffed and run by people who bear virtually no pain in case of their collapse?

Picking Up Pennies in Front of a Bulldozer

Asymmetric compensation schemes are common in finance: managers enjoy substantial upside (perhaps even a life of leisure) if things go well; there is very limited downside if things go badly. Simkovic analyzes how opacity, corporate law, and bankruptcy code provisions help preserve this lack of accountability at the core of finance. The usual Wall Street metaphor for behavior like AIG’s is “picking up pennies in front of a bulldozer.” But the agency problems (and amounts involved) flesh out the metaphor: financial institutions are like wheezing couch potatoes, suddenly running to pick up suitcases of cash in front of a bulldozer of risk, and delivering most of the proceeds to high-flying managers lounging on settees by the side of the road. When the financial institution finally ends up getting a hand or arm caught under the bulldozer, it faces the horror of an impromptu amputation or annihilation. The managers will surely rue the untimely death or disability of their “runner,” but they’ll walk away with cash they’ve “earned,” and almost certainly find some other institutional form to renew the game another day. Even if some don’t, they may have made enough while the getting was good to fund an early retirement to the Caribbean.

At a recent event on the LSE report on the Future of Finance, panelists and audience members suggested that rent-seeking, as well as tax, accounting, legal, and agency distortions, are driving finance sector transactions more than the real economic substance of deals. Simkovic helps us understand the full extent of the problem. The bankruptcy code is becoming the tail that is wagging the dog of investment decisions. He argues that we need to “revive recordation,” as Hernando de Soto and other luminaries have urged. Perhaps real financial reform will ultimately depend on more radical approaches. But I see no way of significantly improving the situation without regulators taking seriously the problems Simkovic has described. In my next post on the issue, I will look at Michael Greenberger’s relatively optimistic take, and Arthur Wilmarth’s pessimistic view, on whether aspects of Dodd-Frank can address Simkovic’s concerns. Early developments have not been promising.

X-Posted: The Pareto Commons.

It’s not everyday that textbook law and economics concepts have a practical application. But a nice little object lesson came up recently in my practice. It’s a classic case of Pareto inefficiency, or suboptimality – arising entirely from the way lawyers chose to draft a contract. The true life case study is after the fold. Green Co., a Delaware corporation, had been spun out as a dividend from an older privately-held company based in New York City. So it began life with a couple of dozen shareholders on three continents. I represented one based in Japan, who held 200 shares, well under 0.5% of the outstanding; some people held even less. The new entity set up its offices in Toronto, Canada, and a law firm there [...]]]>

It’s not everyday that textbook law and economics concepts have a practical application. But a nice little object lesson came up recently in my practice. It’s a classic case of Pareto inefficiency, or suboptimality – arising entirely from the way lawyers chose to draft a contract. The true life case study is after the fold.

Green Co., a Delaware corporation, had been spun out as a dividend from an older privately-held company based in New York City. So it began life with a couple of dozen shareholders on three continents. I represented one based in Japan, who held 200 shares, well under 0.5% of the outstanding; some people held even less. The new entity set up its offices in Toronto, Canada, and a law firm there acted as main counsel. (The vast majority of the shareholders were not Canadian.) Recently Green had a round of venture financing. In addition to buying newly-issued shares, the investors offered to purchase up to US$10 million of shares from existing stockholders, who were invited to tender either at least 250 shares or, if they held fewer than that number, 100% of their holdings. If the offer was oversubscribed, all sellers would be reduced pro rata. In this case, the total tendered came out to roughly $15 million at the deal’s price per share, so each seller was cut back to roughly 2/3 of the number of shares tendered.

The timetable worked this way:

Friday, ___ 1st, 17:00 EST: Deadline to deliver notice of tender by email or fax, stating number of shares tendered;
Monday, ___ 4th, 17:00 EST: Email distribution of Stock Purchase Agreement (SPA) to selling stockholders, indicating the number of shares being sold by each Seller, reflecting oversubscription reduction;
Friday, ___ 8th, 17:00 EST: Deadline to submit signature page and “duly endorsed” share certificate (or affidavit of loss) by emailed scan/.pdf or by fax;
Friday, ____ 15th, 17:00 EST: Deadline for originals of sig page and endorsed certificate to be received by Escrow Agent (Green Co.’s outside law firm).

The SPA included this provision about the closing:

“2.6 At the Closing:
“(i) the funds received by the Escrow Agent from the Purchasers will thereupon be held in trust for the Sellers, each of whom instruct the Escrow Agent, subject to subsection 2.6 (iii), to remit such Seller’s portion of the purchase price solely upon receipt by the Escrow Agent of the original of the stock certificate duly endorsed by such Seller representing the Securities sold by such Seller or an affidavit of loss in respect thereof;
(“ii) subject to the terms and conditions hereof, the Escrow Agent shall hold in trust for each of the Purchasers duly executed stock certificates representing the Securities purchased by such Purchaser, registered in the name of such Purchaser, and, subject to subsection 2.6 (iii), shall expedite same by no later than [Monday, Week 4]; and
“(iii) In the event that, for any reason whatsoever, the Escrow Agent has not received, before 5:00 p.m. EST on [Friday, ___ 15th], any original stock certificates duly endorsed by Sellers in whose name such certificate is registered or original affidavit of loss in respect thereof, the purchase and sale of the Securities represented by such certificates shall thereupon be deemed to be null and void, and (a) the number of Securities purchased by the Purchasers as set forth on Schedule B hereto shall be reduced accordingly and proportionally between all Purchasers, and (b) the Sellers having failed to so deliver such originals irrevocably instruct the Escrow Agent to return to the Purchasers such Sellers’ portion of the purchase price held in trust.” (Emphasis added.)

So far, so good. The first hiccup came when tried to figure out what “duly endorsed” meant. We realized on the 7th Japan time (Thurs.) that the SPA was silent on that point. Clearly, it wouldn’t do for the stockholder to just sign and fill in the number of shares, and then send it in: not only does that mean that the next person who handles it could cause shares to be transferred to himself or herself, but most common carriers, including Fed Ex, won’t carry such “endorsed stock certificates” – and this puppy had to get to Canada. I emailed the lawyers, and got an apologetic reply and instructions on how to fill in the blanks for the recipients’ name and the name of an attorney-in-fact for transfer. We met the Friday deadline for electronic delivery. But it was too late to send the original certificate and sig page out by carrier until after the weekend (Japan being 14 hours ahead of EST).

A bigger hiccup came when my client went to Japan Post on Monday. Delivery of “documents” to Toronto took only three days, so there was an extra day’s margin. But he had to fill out a customs declaration – which agitated first him and then the JP staff he was talking to. I had to go there myself and explain in my broken Japanese why the certificate was less negotiable than a money order. But we could only pray that the way we described the contents on the airbill (“Stock certificate – NON-NEGOTIABLE”) would reassure Canadian customs officials. Needless to say, the Canadian lawyers hadn’t provided any guidance on how to finesse this description. And lots of selling stockholders would be in the same boat.

What would happen if the package were in Canada, but stuck in customs when the 5:00 PM Friday deadline passed? A look at the SPA wasn’t reassuring. Section 2.6(iii) said that if there was a delay “for any reason whatsoever,” the sale would be rescinded. There wasn’t any force majeure clause (while customs delay might not count as force majeure, we were lucky that there wasn’t another huge earthquake). And as for waiver, the SPA said this, in relevant part:

“6.4 Amendment and Waiver. Any provision of this Agreement may be amended and the observance thereof may be waived (either generally or in a particular instance and either retroactively or prospectively), only by the written consent of the Sellers, the Purchasers and the Company.”

In other words, just to cut my client, or some other unlucky stockholder, a break, all the sellers and all the purchasers, plus the Company, would have to sign something in writing. Fat chance. If a seller’s certificate was stuck in customs, then by the terms of the SPA the deal would almost certainly unravel as to his or her shares.

How did my client find himself in this predicament? My client steamed that it was all the lawyers’ fault. If they had included an adequate definition of “duly endorsed,” we wouldn’t have lost a day or more. And if they had given non-Canadian sellers a head’s-up about clearing Canadian customs, we wouldn’t be biting our nails. Maybe some readers will look at things differently: after all, it was incumbent on the stockholder to read the SPA immediately and identify any problems — then he could have gotten endorsal instructions a couple of days sooner. And he could have chosen a more expensive, but faster, method of shipment. (Though each of these measures might only have improved his odds as to timely customs clearance – for all anyone knew, that might take a week or more).

To see where Pareto comes in, let’s review some economic terminology. Given a couple of situations, X and Y, you can call X “Pareto superior” if at least one person is better off in X than in Y, and if no one is better off in Y than in X. If there isn’t any other available situation that’s Pareto superior to X, we can say X is “Pareto optimal” or “efficient.” And of course Y would be “suboptimal,” or “inefficient.”

Now consider this case: Each Seller wants to sell his or her shares — and the Purchasers want to buy them. Rescission of the sale means not only that the individual Seller doesn’t get to sell, but the remaining Sellers don’t pick up the slack – the amount each of them sells remains fixed at the amount specified in the SPA (and indicated in the endorsement on their respective stock certificates). So the rescission means the Purchasers can’t buy as many shares as they were hoping to do. That is, it’s a lose-lose. No one is better off, and some people on both sides of the deal are worse off. On the other hand, allowing some grace period so that the sale can go forward doesn’t make anybody worse off, and makes people on both sides of the deal better off. (I’m not saying the same would be necessarily true if the deadline for the closing were extended forever — I’m just talking about some wiggle room.) So giving the sale a chance to go forward is “Pareto superior” to the way things play out under the SPA, which is “inefficient” by comparison.

And the source of this inefficiency? The gratuitously hardball language in the contract — courtesy of the lawyers on the deal.

Gratuitous, because the drafters could have chosen language to make rescission less automatic, or easier to waive. For example, there could have been a provision that if a Seller sent in the certificate by traceable means and the package were determined to be in customs at the deadline, there would be a grace period of __ days. Or that the deadline provision in 2.6(iii) could be waived in a writing signed by the Purchasers only (much less difficult, since they weren’t so numerous).

Were the lawyers in this case incompetent? I don’t think so – more like very typical, in my experience. In the name of a different sort of “efficiency,” they simply redacted some earlier agreement, probably from an entirely domestic U.S. deal. The problems we encountered were subtle ones, and unlikely to have been very obvious to the lead sellers and purchasers who did negotiate the deal (assuming this SPA was even negotiated at all).

A real pitfall is that phrases like “for any reason whatsoever” have a certain grandiloquence that lawyers tolerate without hesitation. Most lawyers are proud that they have the patience to read, and the muscular fingers to write, pompous stuff that makes lesser mortals’ eyes glaze over. And such language shows that the contract “means business” (with the connotations of ‘tough’ and ‘serious’) or, to use a more contemporary idiom, that it “creates incentives for compliance.” The irony is that such provisions can be entirely contrary to the business of the parties. The usefulness – albeit very narrow, I suggest – of doing a Paretian reality check from time to time while drafting a contract is that it can help you to distinguish language that merely strikes you as pleasingly orotund or appropriately incentivizing from language that actually helps the parties to do the deal they want to do.

1) Campaign Finance Disclosures: Regardless of ideology, almost everyone used to agree that campaign funding sources and amounts should be disclosed. 92% of Americans had that position in 2010. Justice Scalia has eloquently insisted that such disclosure laws violate no one’s rights. But thought leaders in the Republican party are now vigorously resisting disclosure, as Norm Ornstein observes:

The 2010 mid-term elections showed clearly how legal loopholes involving non-profit groups called 501(c)4s, [...]]]> Three remarkable recent lobbying campaigns go beyond the normal bounds of partisan sniping over “markets vs. regulation.” They threaten our capacity to understand how society is ordered: whom it serves, for what purposes, and at what costs. Consider these attacks on basic disclosure norms in politics and business:

1) Campaign Finance Disclosures: Regardless of ideology, almost everyone used to agree that campaign funding sources and amounts should be disclosed. 92% of Americans had that position in 2010. Justice Scalia has eloquently insisted that such disclosure laws violate no one’s rights. But thought leaders in the Republican party are now vigorously resisting disclosure, as Norm Ornstein observes:

The 2010 mid-term elections showed clearly how legal loopholes involving non-profit groups called 501(c)4s, and the failure to adopt clear regulations surrounding campaigns, can result in hundreds of millions of dollars of spending to influence campaigns that masked the identity of huge donors. In response to these realities, the Federal Communications Commission is considering requiring robust disclosure by TV stations of the major donors of political ads; the Securities and Exchange Commission is considering requiring public corporations to disclose to stockholders their spending on politics, and the White House has drafted an executive order to require companies applying for federal contracts to disclose their spending on political campaigns. . . .

Last month, Mitch McConnell [said] he views disclosure as “a cynical effort to muzzle critics of this administration and its allies in Congress.” . . . The Wall Street Journal’s full-throated support for transparency has disappeared as well; it blasted the FCC recently for considering requiring TV stations to put donors of campaign spots on the Internet . . .

John Yoo has also joined the debate, arguing that presidential power stops just short of the prerogative to require federal contractors to disclose their political donations.

2) Conflict Mineral and Extractive Industry Disclosures: One of the surprising victories for decency in the Dodd-Frank Act last year was a provision requiring certain disclosures from mining and resource extraction companies, and companies using “conflict minerals” from in or around the Congo. If you’re a consumer with preferences for certain industrial processes (say, those that don’t create incentives for rape, murder, and starvation), you want to be able to see which companies are fueling conflict and corruption and which are not. But intense corporate pressure is now delaying the rulemaking process needed to implement the disclosure provisions. According to Gerry Fay, “it is estimated that going ‘conflict free’ would cost companies just one penny per product.” But apparently that is too high a price to end corporate complicity in one of Africa’s bloodiest wars.

3) CEO Pay Ratio: The Dodd-Frank Act also promises to shed some sunlight on ever-rising CEO pay levels. As Sam Pizzigatti explains, “corporations must now also report their overall wage ‘median’ and the ratio between this median and their top pay.” Seizing on some laughable comments on how “unduly burdensome” the law is, “the House Financial Services Committee’s Capital Markets Subcommittee [recently] approved, by a vote of 20 to 12 . . . legislation (H.R. 1062) to repeal the Dodd-Frank pay ratio mandate.” As one commenter put it on the Facebook page of the legislation’s sponsor, Nan Hayworth, “What is wrong with forcing [companies] to tell us how the executives are being compensated? It’s hardly a ‘burden.’”

It would be easy to give many more examples of recent efforts to gut funding for research and disclosure. This most minimal tool of regulation—a speck of hope at the bottom of a Pandora’s Box of laissez-faire—is under assault. What’s the rationale?

Benkler on the Distinction between Privacy and Nondisclosure

Perpetrators of injustice always want to hide it. Videophones may “offer[] a modicum of equity and justice to the ordinary man who can now hold his phone aloft to capture police brutality and send it to Youtube.” But structural violence is often done more secretly, and can be hidden for surprisingly long periods of time. For example, a large employer might forbid employees from even talking to each other about their salaries, so women can’t find out if they’ve been discriminated against. It can also delay public criticism of meager wages if it can avoid publishing its median compensation levels.

Manufactured doubt delays political action. Whole industries specialize in the cultural production of ignorance. Endless disputes about the nature of our social order tend to aid those in power. I have previously critiqued Wikileaks, but I found this item of social theory from Julian Assange clarifying:

There [is] not enough information available in our common intellectual record to explain how the world really works. . . . There are three types of history. Type one is knowledge. Its creation is subsidized, and its maintenance is subsidized by an industry or lobby: things like how to build a pump that pumps water, how to create steel and build other forms of alloys, how to cook, how to remove poisons from food, etc. But because this knowledge is part of everyday industrial processes, there is an economy that keeps such information around and makes use of it. So the work of preserving it is already done. . .

[A] second type of information no longer has an economy behind it. It has already found its way into the historical record through a state of affairs which no longer exists. So it’s just sitting there. It can be slowly rotting away, slowly vanishing. Books go out of print, and the number of copies available decreases. But it is a slow process, because no one is actively trying to destroy this type of information.

And then there is the type-three information that is the focus of my attention now. This is the information that people are actively working to prevent from entering into the record. Type-three information is suppressed before publication or after publication. If type-three information is spread around, there are active attempts to take it out of circulation. Because the[] first two pillars of our intellectual record either have an economy behind them, or there are no active attempts to destroy them, they do not call to me as loudly. But, this third pillar of information has been denied to all of us throughout the history of the world. So, if you understand that civilized life is built around understanding the world, understanding each other, understanding human institutions and so forth, then our understanding has a great hole in it, which is type-three history.

Of course, anyone who’s worked as an attorney knows that it’s important to respect rights to privacy, and so does Assange: Wikileaks itself operates according to a strict NDA. A growing movement urging a “right to be forgotten” is to be commended for expanding those rights in some contexts. These developments may confound those who insist on absolutely open or closed systems as hallmarks of consistency. But Assange’s sophisticated defenders, like Yochai Benkler, are working toward a balance of interests in the information environment:

[P]rivacy is at risk when there are powerful observers and vulnerable subjects. Transparency, by contrast, involves disclosure of information about powerful parties that weaker parties can use to check that power or its abuse. When we say that an act of information disclosure “threatens privacy” or “promises transparency,” we are making a judgment about who has power and who is susceptible to it and how that power ought to be limited. The demise of privacy is already built into the structure of the commercially owned and operated Net. We have already made that “choice,” at least in the sense of being socially and politically passive at crucial moments in the 1990s and early 2000s when key decisions were made. The technologies and practices epitomized by WikiLeaks serve as a compensating overlay on that privacy-denying platform.

Enormously powerful computing systems now aid corporations and law enforcement agencies in their quests for prediction and control. They could also accomplish the disclosure functions mentioned above. The question now is whether we, as a society, are as committed to the transparency project (“disclosure of information about powerful parties that weaker parties can use to check that power or its abuse”) as “we” have been to the privacy-destroying aspects of internet intermediaries that endlessly track and profile their users. It’s not surprising that resource extraction companies, big campaign donors, and CEOs are vigorously fighting disclosure. Occasionally inequality and abuse become so grotesque that they can’t be defended; they can only be hidden.

Photo Credit: Ninja M.

The Delaware Court of Chancery recently suggested one way for corporations to protect themselves from these practices. Last [...]]]> Corporate litigation has long followed a predictable pattern. When a corporation announces a restatement or similar bad news, shareholders race to the courtroom, filing nearly identical complaints in multiple courts. Congress sought to halt this practice in federal securities cases through the Private Securities Litigation Reform Act, but the practice continues unabated in state law cases. The Delaware Court of Chancery has been the clear loser of this filing strategy. Empirical evidence suggests that shareholder lawsuits are leaving Delaware in droves. Defense lawyers even claim that plaintiffs now use an “Anywhere but Chancery” approach when filing state law class actions and derivative suits.

The Delaware Court of Chancery recently suggested one way for corporations to protect themselves from these practices. Last summer, Vice Chancellor Laster stated in dicta that “if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution,” these corporations should adopt a charter provision selecting this forum as the exclusive venue for shareholder lawsuits.  This idea was not unprecedented—a small number of companies had already included such provisions in their governing documents—but it was the first time (to my knowledge) that the concept received judicial approval.  The defense bar quickly picked up the charge, with Wachtell, Lipton, Rosen & Katz recommending to its corporate clients that they adopt a charter amendment requiring that the Delaware Court of Chancery be the “sole and exclusive forum” for any breach of fiduciary duty suit filed against the company or its officers, directors, or shareholders. A recent memorandum by Latham & Watkins reports that more than 70 companies have included these provisions in their bylaws or charters.

This development raises intriguing questions about how much control corporations should have when it comes to lawsuits filed by their shareholders. If corporations can choose the venue of these suits, can they also control other aspects of the litigation? As just one example, could a corporation adopt a charter provision limiting who can file a shareholder derivative suit on its behalf? Under current state law, any shareholder can file a shareholder derivative suit on behalf of a corporation. The law imposes minimal adequacy requirements, but otherwise a shareholder who owns as little as a single share of stock in a given corporation can file a multi-million dollar lawsuit on the corporation’s behalf. This power is unprecedented in the corporate world—shareholders generally do not have any individual power unless they own a majority of the corporation’s shares. The few exceptions to this rule, such as proxy access rules, require shareholders to own a certain percentage of shares (usually 5 percent). Given the problems in many shareholder lawsuits, I imagine that standing limitations might be appealing to many corporate boards.

Alternatively, could a corporation adopt a charter or bylaw provision requiring that shareholder claims be subject to arbitration? Part of the risk in a shareholder lawsuit is the uncertainty over how the claims will fare before a judge or jury. Corporations might try to alter the settlement dynamics by mandating that these claims be decided in arbitration.

I am not sure if provisions of this type would pass judicial muster, but I would not be surprised to see corporations test these limits over the next several years. The law does offer some general guideposts that might help corporate lawyers think about these questions. First, corporations should include these provisions in corporate charters, not bylaws. Charter amendments must be approved by the board and a majority of the shareholders; bylaw amendments, in contrast, can be approved by the board acting alone in most instances. It is one thing if the shareholders approve limitations on the board’s liability. It is obviously more problematic if the board limits its own liability. The Northern District of California recognized this point last year, invalidating a bylaw provision that purported to establish Delaware as the sole venue for certain corporate lawsuits (as discussed here).

Second, corporations likely cannot alter the substantive law at issue in the lawsuit. Some corporations might not be content tinkering with the procedural rules and might try to limit substantive fiduciary duties. Given recent judicial decisions, I cannot imagine that courts would allow such limitations. Nor do I think courts would allow procedural restrictions that have the substantive effect of eliminating shareholder lawsuits. For example, a corporation might adopt a provision stating that no shareholder can file a derivative suit on its behalf unless the shareholder owns at least twenty percent of the corporation’s stock. In most large public corporations, this restriction would have the practical effect of eliminating shareholder derivative suits, making it impossible to enforce the board’s fiduciary duties.

Third, any provision should only apply to conduct that occurs after the provision is adopted. A board should not be allowed to breach its duties and then adopt procedural protections that help shield it from liability.

Beyond these restrictions, my own view is that companies should be allowed to alter the procedural rules in shareholder litigation, at least in certain respects. But I would be interested in hearing the thoughts of others. Is there some obvious dividing line between venue provisions and standing rules, for example, that I am missing?

My sense is that many of us are interested in teaching these courses, but the practicalities are daunting.   Two years ago, I set out to create a course that would teach students how to be corporate litigators. I had visions of teaching my students an array of [...]]]> You would have to live under a rock not to know that law schools increasingly feel the pressure to teach practical skills. Law schools can no longer teach doctrine and count on law firms to teach new lawyers the skills they need.  As a result, many schools are starting to incorporate practicum-style courses into the curriculum. These courses allow students to learn litigation or transactional skills in the classroom by working on simulated cases or transactions.

My sense is that many of us are interested in teaching these courses, but the practicalities are daunting.   Two years ago, I set out to create a course that would teach students how to be corporate litigators. I had visions of teaching my students an array of practical skills, including how to untangle financial statements, read complex statutes, and draft various case materials. It looked so good in my head. Then I actually tried to put together the course. There was no textbook. There were no model exercises. There was no anything… I spent a crazy amount of time putting together a course packet, coming up with weekly drafting assignments, and thinking about how to teach the skills I thought my students would need. I hesitate to say exactly how much time out of fear of scaring away others, but I still have flashbacks of sitting at my kitchen table for days on end trying to come up with creative fact patterns and drafting exercises.

At the end of the day, I was able to put together the materials for a course called Corporate Fraud & Litigation. I have taught the course twice now, and I really love it. But the preparation continues. I still develop new graded exercises every year out of fear that last year’s students will pass on their answers to this year’s students. The end result is that I spend significantly more time preparing for this course than for my other two courses combined.  I am currently contemplating a complete overhaul of my course, but I have to admit that the massive work involved gives me pause.

I wonder whether the reality of having to prepare these materials—and then prepare many of the exercises anew every year—is holding back the development of these courses.  At some level, of course, this preparation is part of our job, and given how great the job is, we have no basis to complain. As someone who is obsessed with curricular issues, however, I have to think it is tough to roll out a new curricular model when preparing a class under the new model takes far longer than preparing to teach a traditional doctrinal course. If I went purely by my own self-interest, there is little doubt that I would opt to teach another doctrinal course rather than a practicum course. In fact, I might even opt to teach two doctrinal courses rather than a single practicum course!

The lack of materials for practicum courses also impacts what courses adjuncts teach. Many adjuncts are really well-suited to teach hands-on courses where students work through simulated cases or transactions. Adjuncts could also teach ethics courses grounded in specific doctrinal areas (corporate law ethics, family law ethics, etc.) that are taught using a problem-based approach. But it is hard to recruit good lawyers to teach these courses when they would have to spend significant amounts of time creating the materials and exercises from scratch.

As a corporate law professor, I am struck by the untapped market out there. In almost every curricular area, professors who want to teach practical skills have to reinvent the wheel. Many textbooks include some practice questions and exercises, but few books are based entirely around the practicum model. There are a few exceptions, including the new Business Planning book by Therese Maynard and Dana Warren and the Environmental Law Practice book by Jerry Anderson and Dennis Hirsch, but these books are few and far between. I would love to see the major casebook publishers devote more attention to this market niche. Ideally, I would even love to see the author/publisher offer new graded exercises every year, perhaps through a password-protected website. No matter how they are put together, however, it seems that there should be a market for practicum-style materials in a wide variety of curricular areas.

In the absence of a market solution, I am going black market. If anyone is interested in my course materials, just let me know. I am happy to share them. If you have developed materials for a similar course in another area and you are willing to share them, let me know. I am happy to serve as a clearinghouse for professors who want to chart a new path in other curricular areas.

I want to start with a topic that combines both of my passions. Over the last four years, I have taught many students who develop an interest in corporate law after spending their undergraduate years studying philosophy, political science, or other non-business subjects. These students all worry that they do not have the business knowledge to succeed as corporate lawyers. It is easy to tell them that they will learn on the job, and certainly that is true to some extent, but I wonder if law schools [...]]]> Thanks to Dave and the other folks at Concurring Opinions for inviting me to blog this month. I plan to write about two topics close to my heart: corporate law and the law school curriculum.

I want to start with a topic that combines both of my passions. Over the last four years, I have taught many students who develop an interest in corporate law after spending their undergraduate years studying philosophy, political science, or other non-business subjects. These students all worry that they do not have the business knowledge to succeed as corporate lawyers. It is easy to tell them that they will learn on the job, and certainly that is true to some extent, but I wonder if law schools should be doing more to introduce students to basic business and finance concepts.

I have often struggled with how to teach my students these concepts. On one hand, our job is to teach law. Teaching students about venture capital funding or accounting rules is arguably beyond this purview, at least unless a case deals directly with these concepts. On the other hand, I want to prepare my students to be lawyers, a task that requires teaching more than just the black letter law. I would hate to send my students out into the world with a strong understanding of Revlon and Unocal, but with no understanding of the business issues underlying basic M&A transactions.

The conventional approaches to teaching these skills have always seemed unsatisfying to me. Many professors require their students to read the Wall Street Journal every day. I think it is great to get future corporate lawyers into the habit of reading the business press, but I am also not sure that it really teaches them basic business skills. They may learn which hedge funds are making the most money (good information for client development, I suppose), but they still may not understand exactly what hedge funds do.

Other professors try to cover business basics in their traditional law courses. While discussing a case about venture capitalists, you can explain the concept of stage financing. In a case about accounting misstatements, you can discuss revenue recognition and reserve policies. But I am already hard-pressed to cover all of the relevant legal rules in my courses, and there is no way students leave my Corporations class with anything more than a scattershot sense of a few business concepts.

Finally, many schools offer students the opportunity to get a joint JD/MBA. I am not sure, however, that these programs target the business skills that law students most need to know. Full-semester courses on marketing and organizational management may be overkill for most law students.

I wonder about a simpler solution. What if law schools offered business courses geared directly to law students? In many ways, of course, law schools already do this. Most law schools offer corporate finance and accounting, two courses where students may not read a single case or statute, focusing instead on core business concepts. Yet for the political science major who hopes to be a transactional lawyer, these courses leave out crucial information about how the business world works. A course titled something like Introduction to Business Concepts could target this information directly. It could start by introducing the main players and then teach students about different facets of the business world. It could give students a concrete sense of what investment bankers, credit managers, and angel investors do and how different divisions operate in a typical business. It could also include guest speakers from various businesses to give students a real-life perspective on how businesses operate.

Does your school offer such a course? If so, how is it working?

Sitting this morning at Berkshire Hathaway’s annual meeting, I heard my great friend Warren Buffett report that it remains inexplicable to him why top Berkshire officer, David Sokol, violated corporate policy by buying shares in a company he was about to propose that Berkshire acquire. 

Here is my theory, pieced together based on all the available evidence: Sokol desperately wanted to resign from Berkshire and eschewed succeeding Buffett as CEO, but the board would not let him resign.  So Sokol, by calculation or subconscious action, did something egregious enough that his resignation would be accepted, but not criminal enough to land him in jail.

Elements of the theory: Sokol has sought to resign from Berkshire on several occasions the past two [...]]]> Live From Omaha: Berkshire Hathaway Shareholders’ Meeting:

Sitting this morning at Berkshire Hathaway’s annual meeting, I heard my great friend Warren Buffett report that it remains inexplicable to him why top Berkshire officer, David Sokol, violated corporate policy by buying shares in a company he was about to propose that Berkshire acquire. 

Here is my theory, pieced together based on all the available evidence: Sokol desperately wanted to resign from Berkshire and eschewed succeeding Buffett as CEO, but the board would not let him resign.  So Sokol, by calculation or subconscious action, did something egregious enough that his resignation would be accepted, but not criminal enough to land him in jail.

Elements of the theory: Sokol has sought to resign from Berkshire on several occasions the past two years.  Each time, the board urged him to stay, making it impossible to refuse.  There may be compelling reasons, as one of several rumored as potential successors to Buffett, to wish to resign.  The strongest?  Following Warren Buffett will not only be difficult, it may inevtiablly result in comparative failure. 

Further circumstantial evidence: when Dave reviewed for accuracy a press release announcing the objectionable trading that finally induced the board to accept his resignation, he told Warren to delete a sentence Warren had written that the resignation stemmed in part from a sense that Dave was no longer in the running to succeed him.  On the contrary, in this theory, he absolutely did not want to be in that running and was having a very hard time getting the board to understand that.

Without some theory such as this, it is difficult to explain why an executive who had enormous wealth and amazing stature, along with considerabe generosity to business partners that Buffett described this morning , would do something so dumb, obvious, and obviously wrong–but not obviously illegal.

As a student of Warren Buffett’s business and investment philosophy, a long-time shareholder of Berkshire Hathaway, and proud compliler of the book, The Essays of Warren Buffett: Lessons for Corporate America, I see potential explanations in this strange event, along with lessons from the lament. ]]> http://www.concurringopinions.com/archives/2011/04/why-david-sokol-traded.html/feed 7 http://www.concurringopinions.com/archives/2011/04/welcome-to-the-blogosphere-corporate-justice-blog.html http://www.concurringopinions.com/archives/2011/04/welcome-to-the-blogosphere-corporate-justice-blog.html#comments Wed, 27 Apr 2011 02:53:57 +0000 Frank Pasquale http://www.concurringopinions.com/?p=44160 There are a number of interesting posts up at the Corporate Justice Blog, which has discussed both the FCIC Report and the Levin-Coburn Report. It’s great to see this terrific group of scholars comment on economic justice issues in the blogosphere.

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and [...]]]> Cross-posted at Harvard Law School’s Corporate Governance blog, this summarizes in some detail my new paper on applying simple contract principles to police odioius executive pay contracts:

Executive pay has skyrocketed in recent decades, in absolute terms and compared to average wages. The area of largest growth has been in stock-based components, including stock options, often tending to focus on the short-term, with associated risks we’ve seen. A vigorous academic debate has run for more than a decade, becoming a popular political discussion amid the financial crisis exposing arcane debate to public scrutiny.

Growth could be laudable, explained as creating proper incentives to align manager interests with shareholder interests and to promote optimal risk taking. In this view, if there is a problem, it is narrow and limited. Critics are skeptical whether this story holds up. They worry that managerial power has strengthened to enable top executives to control setting their own compensation. In this view, the problem is pervasive and warrants a comprehensive response—and proposals abound.

I come down in the middle. There are problems in at least an important number of cases, and current proposals to redress them are unlikely to work. So I seek a new approach—contract unconscionability—to police extreme cases. The proposal must surmount some hurdles but isn’t as radical as it sounds.

A good way to summarize the debate highlights a three-pronged theory that promotes much of prevailing executive compensation, especially stock-based components, and contrasts it with limits on each prong.

First: in optimal contracting theory, boards design manager contracts to minimize agency costs. But when managers dominate the process, the managerial power thesis suggests this ideal may not be met.

Second: with efficient stock markets, stock price is a good proxy for the shareholder interest and a mirror of managerial performance. But stock price can differ from business value for sustained periods, fogging both.

Third: stock-based pay could align managerial incentives with shareholder interests if designed right and markets work well. But otherwise they create perverse effects.

From the viewpoint of critics, one problem with corporate pay is relatively little legal oversight. Even well-intended boards can fail, yet corporate law defers to them; federal securities and tax law encourage stock-based pay, without regard to perverse effects.

Reforms debate expanding shareholder power to motivate boards, led by Lucian Bebchuk and Jesse Fried. Others, like David Walker, prescribe tax changes or better disclosure. Still others, others, like Randall Thomas and Harwell Wells, look to enhanced corporate law oversight, invoking officer fiduciary duties, recently explicated in Gantler v. Stephens, to police renewals of employment contracts.

Throughout debate, and most of the reforms, there is much talk of redesigning pay contracts to focus managers on long term value, not short term price, by scholars as diverse as Bebchuk/Fried to Roberta Romano. Many of these are careful and useful. What’s still missing is a way to implement them, and I suggest using private litigation and contract law.

So I invent a new way to provide legal oversight to regulate associated risk: a contract law doctrine that has much in common with corporate waste, but is slightly more capacious. Pay has been evaluated under corporate law. But its business judgment rule and deference to independent committees and process means the only possible way to prevail is under corporate law’s waste doctrine. It bans only gifts, or dumping cash into the river, so massive salaries and stock-based pay with perverse incentives are outside it.

Unconscionability has some kinship to waste. It is used sparingly, reflecting freedom of contract. It looks at procedural aspects of a transaction. But unlike waste, which varies little with context, contract law’s propensity to use unconscionability intensifies according to a coherent logic. It becomes increasingly skeptical of lop-sided bargains as it goes beyond arm’s-length deals, into those plagued by procedural irregularities, heard by courts in equity, and involving fiduciaries.

So my basic theory is simple. These are contracts and when unconscionable should be rescinded—whether or not they amount to corporate waste, or are approved by boards or shareholders. Several hurdles appear, meaning few cases succeed, catching only the most odious.

First Hurdle: The first is the internal affairs doctrine that could make pay contracts governed by the corporate law of the state of incorporation, not the contract law of another. This doctrine protects corporate participants in relations with each other against inconsistent laws. Compared to the home state, others have weak interests in internal affairs, like shareholder voting, director elections, and mergers.

Employment agreements could be internal affairs. They are authorized by the board with officers as the counter-party. They regulate the corporation-officer relation. The internal affairs case is strengthened by seeing stock-based pay as a way to align manager-shareholder interests. But they are not inevitably internal affairs. That is clearest when formed with a newly-recruited manager—an outsider. Their primary function is to get labor in exchange for pay. They are increasingly justified as recruiting and retention tools, not alignment devices. From these viewpoints, they are merely contracts.

Second Hurdle.  Another hurdle could arise if managers put favorable choice of law clauses in their contracts. That’s a nice gambit but faces three limits.  First, choice-of-law clauses are not dispositive. Standard conflicts of law principles apply, asking what state has greatest interest. Second, an unconscionability claim can render the entire contract unenforceable, determined before applying any contract terms, including a choice of law. Third, even a Delaware choice of law clause would mean Delaware contract law not corporate law applies, which is a bit tougher.

Third Hurdle. The next hurdle involves whether a claim is direct or derivative. If derivative, shareholders face corporate law hurdles. Most seriously, shareholders must demand that boards act or show why that’s futile and special board committees can take control of the case and even decide to dismiss it. The line between the two can be blurry. The issue is whether a harm to be remedied is better conceived as individual to a shareholder or runs to the corporation as a whole.

The conceptual difficulty makes classification turn on factors, not bright line rules. These include the theory of liability and remedy. Cases tend to classify as derivative—claims for breach of duty and seeking money damages. Cases and statutes tend to classify as direct, claims asserting lack of corporate authority (called ultra vires), and/or seeking equitable relief.  Shareholder challenges to pay contracts will more likely be seen as direct by asserting that their unconscionable character puts them beyond the corporation’s authority, and the primary remedy is rescission.  

Fourth/Final Hurdle. Finally, judges may exercise comity and refuse to confront these hurdles or refrain because contracts may be so complex that judges hesitate to assume competency to evaluate them. Enforcement incentives are another practical issue. It is certainly beyond the SEC’s power and probably beyond that of many states or the interests of their attorney’s general. That leaves the private bar, whose incentives may be limited. A pure case of rescission would produce no payment and even a claim accompanied by a judgment in restitution may be comparatively small. But there may be sufficient incentives for the most high-profile case that could yield instrumental and reputational value.

Still, the hurdles are formidable, though incrementally lower than under corporate law. On balance, that is desirable. There is no risk of any floodgate effect. And a few egregious cases would be enough to deter excesses.

Turning to the merits, contract analysis is slightly broader than corporate law’s. Procedural aspects are not confined to corporate law’s focus on board independence or information. Courts consider the bargaining process, probing whether it was more consistent with optimal contracting or managerial power. Substantive unconscionability analysis is contextual, so stating broad principles difficult. But some tests can be suggested. One would compare the contract’s terms with academic models appearing in the literature (whether by Bebchuk/Fried or by Romano). Conforming contracts would be presumptively valid, but those wildly out of line suspect.

Another would compare dollar amounts, though that often will be difficult, and doubts resolved in favor of upholding the agreement. But when that ratio can be measured with reasonable certainty, and does shock the judicial conscience, the contract can be declared unconscionable and rescinded. 

In short, while not a slam dunk, this approach would be considerably stronger under contract law than corporate law. And that offers a new legal theory to test executive pay.  Not as radical as you thought, and not merely theoretical either, as readers who specialize in lawsuits targeting corporate abuses indicate that they are prepared to apply the proposal when the right factual case comes along.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, [...]]]> The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable.  Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell).  The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).