Category: Corporate Law

4

Legal Diversification

I’ve just posted my latest paper, Legal Diversification, on SSRN. The paper starts from the premise that investors derive significant protection from the risks of capital investment by diversifying their holdings. By the same token, it seems to me that investors may be able to realize benefits from the broad diversity of corporate and securities laws governing investment opportunities.

The Essay introduces a new dimension of diversification for investors: legal diversification. Legal diversification of investment means building a portfolio of securities that are governed by a variety of legal rules. Legal diversification protects investors from the risk that a particular method of minimizing agency costs will prove ineffective and allows investors to own securities in a variety of firms, with each security governed by the most efficient set of legal rules given the circumstances of the investment. Diversification of investment by legal rules is possible because of the varied menu of legal rules firms can choose from when organizing and raising capital. The most recent addition to the securities laws, the JOBS Act, may compromise the diversity of legal rules that protects investors by pushing even more firms toward organizing as public corporations, thereby threatening to curtail or eliminate the variety that allows effective diversification.

The Essay makes several contributions to the literature. By introducing legal diversification, it reveals a new understanding of how investors, issuers, and society can benefit from maintaining a variety of legal rules to govern investment in businesses. The corporate law scholarship has long advocated preserving a variety of rules under which firms can organize, but it has yet to consider how investors can take advantage of that variety to protect themselves before market competition has revealed the “best” rules. Legal diversification also complements recent literature emphasizing the importance of diversity in financial regulation by highlighting another reason diversity of legal rules is important to healthy capital markets. Legal diversification fills gaps in the literature advocating regulatory diversity by offering an explanation for why that diversity is a valuable protection for investors and an indispensable mechanism for allowing firms to choose the most efficient legal rules to govern their organization and operation.

I’m still working on editing the draft, so would greatly appreciate any thoughts or comments you may have on the project.

 

5

Wachtell Lipton’s Errors on Shareholder-Paid Director Bonuses

Amid debate over shareholders offering contingent payments to directors, Wachtell Lipton recommends an option that may be tempting for incumbent boards: unilaterally adopting a bylaw banning the arrangements.  Boards should be wary of this advice.

True, Wachtell’s position concurs with my view that such payments are lawful, contrary to the position urged by my esteemed fellow corporate law Prof., Stephen Bainbridge.  But that’s where Wachtell and I part company, first because Wachtell’s proposal is myopically universal and second because it errs on a basic legal point about board and shareholder power.

In my view, not only are the arrangements lawful, but shareholder bodies ought to have the choice to embrace or reject them.  My guess is that they are desirable for some corporations in some settings and not so for others.  Therefore, the use or rejection of these ought to be determined, as with much else in corporate life and law, in context by business people participating in particular governance situations. Read More

0

The Reality of Short Termism Per Mark Roe

Short-termism in stock markets preoccupies many policy makers and analysts of late but Mark Roe wonders about the validity of some of the conventional talk.   He has posted a series of three short articles on the topic excerpted from a larger project, all worth a look: (1) about whether the cause of any new corporate short-termism may not be stock markets but the speed of change in business pressures;  (2) Are Stock Markets Really Becoming More Short-Term?, and (3) Apple’s Cash Flow Problem, using that case to question the assumption of short-termism.   Business Lawyer will publish the longer version of the inquiry this summer in Mark’s piece, Corporate Short-termism — In the Boardroom and in the Courtroom.  All worth reading.

4

Prof. Bainbridge on Hess: Critics Still Not There Yet

Prof. Steve Bainbridge replied to my post about shareholders paying bonuses to director nominees elected in contested elections, highlighted by the pending proxy battle at Hess.  Steve clarifies his objection to Elliott Associates, the activist shareholder hedge fund, promising to pay its director nominees bonuses if Hess’s stock price outperforms a group of industry peers over the next 3 years:

When I described these transactions as involving a conflict of interest, what I had in mind was the general conflict of interest ban contained in Restatement (Second) of Agency sec 388:  “Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal.”  Surely the hedge fund payments here qualify as, for example, the sort of gratuties picked up by comment b to sec 388:

“An agent can properly retain gratuities received on account of the principal’s business if, because of custom or otherwise, an agreement to this effect is found. Except in such a case, the receipt and retention of a gratuity by an agent from a party with interests adverse to those of the principal is evidence that the agent is committing a breach of duty to the principal by not acting in his interests.  Illustration 4.   A, the purchasing agent for the P railroad, purchases honestly and for a fair price fifty trucks from T, who is going out of business. In gratitude for A’s favorable action and without ulterior motive or agreement, T makes A a gift of a car. A holds the automobile as a constructive trustee for P, although A is not otherwise liable to P.”

How is the hedge fund’s gratitude for good service by the Hess director any different than T gift to A?  To be sure, directors are not agent of the corporation, but “The relationship between a corporation and its directors is similar to that of agency, and directors possess the same rights and are subject to the same duties as other agents.” . . . Thus, I believe, even if the hedge fund nominee/tippees are scrupulously honest in not sharing confidential information with the funds, put the interests of all shareholders ahead of those of just the hedge funds, and so on, there would still be a serious conflict of interest here.

I can offer 4 replies to Steve’s fine legal points, which I’ll first summarize and then elaborate:

1.  While Steve acknowledges that agency law doesn’t apply, he stresses similarities between agency and corporate law when justifying reference to the American Law Institute’s Restatement (Second) of Agency, but then omits the differences that warrant treating directors differently than agents.

2. Even accepting arguendo Steve’s proposal to rely on the Restatement (Second) of Agency,  he chose to present Illustration 4 as governing the Elliott-Hess arrangement, but the next one, Illustration 5 (excerpted below), is more on point and comes out the other way because the agent and principal are free to agree otherwise.

3.  Even if agency law applied, the Restatement (Second) of Agency, initially adopted in 1958, was superseded in 2006 by the Restatement (Third) of Agency, whose provisions support the Elliott-Hess arrangements.

4.  But agency law doesn’t apply.  The ALI’s applicable standard from corporate law is stated in its Principles of Corporate Governance, expressly referenced in the Restatement (Third) of Agency.  This standard puts the burden on those challenging such arrangements to prove defects such as unfairness or secretiveness, which opponents have not done.  Read More

17

Debating “The Shareholder Value Myth”

Many thanks to Larry and the Concurring Opinions folks for inviting me to blog this month. This is my first time blogging and I’m glad to finally try it out.

On Wednesday, I attended an event promoting Lynn Stout’s book The Shareholder Value Myth, sponsored by the Federalist Society and the American Enterprise Institute. The event was structured as a debate of Stout’s thesis with Jonathan Macey (who wrote this review of the book) taking the opposing position. In her book, Stout argued that the widely accepted norm that corporations are owned by shareholders and exist to maximize shareholder wealth is a destructive myth. Instead, Stout claimed, corporations own themselves and in running corporations, managers can and should pursue any lawful purpose.

It is a real credit to Lynn that there was such a lively, thought-provoking debate about the topic. That corporate managers have an obligation to work on behalf of shareholders to maximize shareholder wealth may be the most basic tenet of corporate law and policy. Options theory aside, many think of shareholders as the “owners” of the corporation and even those who question whether shareholders technically own the corporation do not doubt that the corporation should be operated in such a way as to maximize shareholder value. This unwritten “norm” has dominated corporate law, policy, scholarship, and, indeed, management for a long time (for precisely how long, Stout and Macey disagreed).  It is extremely impressive that Stout has been able to provoke a debate about the viability of this fundamental norm.

Wednesday’s debate was the second time I’d seen Stout present at a Federalist Society event. Both times, she began her presentation by arguing that hers was the truly conservative position. It seems an unlikely claim that surprises the audience given what her conclusions are, but I think it highlights what Stout does so well – she reaches her audience with their priors in mind in order to really draw them into her ideas where they might be tempted to dismiss her arguments out of hand. Her presentation was not about good corporate behavior or environmentalism, themes she touched upon in the book, but rather about how debunking the shareholder value myth would allow corporate law to favor state law over federal regulation, to prefer common law rules to statutory regulation, to enhance private ordering, and to honor the lessons of history.

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0

Director Bonuses for Performance, Prawf Debate and the Bigger Picture for Hess

A hot debate rages among corporate law professors amid one of the largest proxy battles in a decade: Hess Corp., the $20 billion oil giant, is the focus of a contest between its longstanding incumbent management and the activist shareholder Elliott Associates.   Ahead of Hess’s annual meeting on May 16, where 1/3 of the seats on Hess’s staggered board are up, antagonists offer dueling business visions.  They battle bitterly over such fundamentals as sectors to pursue, degrees of integration to have and cash dividend policy.

The professorial debate, more civil, is about a novel pay plan Elliott proposes for its director nominees, which Hess’s incumbents condemn and Elliott defends as suited to shareholders. On one side, all quoted in Elliott’s investor materials circulated April 16, are meLarry Hammermesh (Widener), Todd Henderson (Chicago), Yair Listoken (Yale) and Randall Thomas (Vanderbilt); on the other  Steve Bainbridge (UCLA), Jack Coffee (Columbia) and Usha Rodriques (Georgia), all of whom have blogged since the matter was first reported by Steven Davidoff (Ohio State) in the New York Times April 2 (for which he connected with me for comment).

As in all such cases, Elliott proposes to pay nominees a flat fee of $50,000 each for their troubles and to indemnify them for legal liability.  The novelty is that Elliott will provide incentive compensation to the group: if any Elliott nominee is elected as a result of this year’s  contest, all nominees receive a bonus at the end of three years if Hess’s stock performs better than a group of industry peers. Elliott, not Hess, pays all bonuses.

Hess incumbents portray the bonuses as objectionable (and Steve, Jack and Usha agree). Incumbents say they give nominees incentives to maximize short-term shareholder value rather than serve as long-term stewards.   They say the pay somehow makes the directors beholden only to Elliott, preventing the exercise of business judgment for the benefit of the corporation and its shareholders as a whole.

I have taken a different view, set out in Elliott’s materials last month (p. 148):  The bonuses seem surgically tailored to tie the payoff to Hess’s stock price performance compared to competitors. That is intended to align the interests of those directors with those of the company’s shareholders.  Elliott makes the promise at the outset and then has no role to play afterwards, other than to pay up if milestones are met.  No one is beholden to Elliott and the independence of those directors is not compromised.  There is no incentive to liquidate the company or concentrate on the short term but every incentive to manage to outperform peer company stock price performance over three years.

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5

The Supreme Court’s Theory of Corporate Political Activity

In an earlier post, I outlined an argument that – despite having attracted a fair amount of criticism – the Supreme Court’s vision of corporate political activity may have substantial normative merit from a corporate governance perspective.  In this post, I’ll describe that vision in two related parts.  First, whose expressive rights are being vindicated when corporations engage in political activity?  And second, what internal governance structures should regulate how and when corporations speak?

The first question raises a tricky issue at the intersection of constitutional law and corporate theory.  Corporations are legal fictions, albeit exceedingly useful ones.  They are not self-aware, they have no conscience, and they cannot act or speak except through human beings. Yet, the law has long treated corporations as legal “persons” for most purposes, including eligibility for many (though not all) constitutional protections. This treatment poses a metaphysical question: just what sort of “person” is a corporation?  To answer this question, the Supreme Court has historically relied on several theories of the corporation: the grant (or concession) theory, the aggregation theory, and the real entity theory.  Briefly, the grant theory views the corporation as purely a creature of the state, having only the rights and protections provided by statute, and thus broadly vulnerable to government regulation. The aggregation theory looks past the corporate form to the individual members or shareholders exercising their freedom of associating for some legitimate business, and concludes that corporations must thus have whatever powers and privileges necessary to vindicate the rights of those underlying constituents. The real entity theory posits that corporations exist independently of their constituents or the statutes authorizing them, and are thus a distinct entity entitled to all (or at least most) of the rights of natural persons. The Supreme Court’s corporate jurisprudence has, infamously, cycled repeatedly and inconsistently through each of these theories, often employing multiple theories in the same case.

In contrast to this general indecisiveness, though, the Court’s corporate political speech cases fairly clearly adopt a version of the aggregate view.  I treat the language from the cases in more detail in this paper, but the core idea – which flows from the early cases concerning corporations’ right to lobby, through Bellotti and more recently Citizens United – is that First Amendment speech rights inure to human beings.  Thus, when corporations speak they do so on behalf of the human constituents acting collectively through the corporate form.  As Justice Scalia explains in his Citizens United concurrence: “[t]he authorized spokesman of a corporation is a human being, who speaks on behalf of the human beings who have formed that association.”

As to the second question, the Court gives a firm but vague response: shareholders, acting through the procedures of corporate democracy, decide whether and how their corporations should engage in public debate.  Yet, it’s not exactly clear what the Court means by “corporate democracy.”  As a matter of corporate law, that concept is not self-defining; the proper allocation of decision-making power between managers and shareholders is one of the central, unresolved debates in modern corporate law.  One can, however, glean three key principles from the Court’s decisions.  First, the decision-making process is necessarily majoritarian. Some shareholders may dissent from the decision, but their remedy (if any) lays elsewhere.  Second, the process must actually vindicate shareholders’ concerns.  The Court concluded that shareholders need no legal protections external to corporate law because any “abuse[s]” – referring to managerial decisions that do not accord with the majority’s desires – can be “corrected by shareholders” through this process.  Finally, the Court seems to contemplate something broader than merely the representative democracy of electing the board.  As Justice Powell notes in Bellotti, shareholders should be able to privately order their preferences as to corporate political activity by “insist[ing] on protective provisions” in the corporation’s constitutional documents, which would bind managerial authority ex ante.

Some claim that the combination of these criteria simply illustrates the Court’s misunderstanding of modern corporate law.  Shareholder control rights within public firms are largely illusory.  Even a majority of shareholders cannot insist on corporate action outside of certain limited circumstances, and the directorial election process usually leaves much to be desired in terms of disciplining management.

I argue, though, that there is a ready-made governance structure that conforms with this framework: allow shareholders to enact intra-corporate bylaws regulating corporate political activity, which (in most jurisdictions) they can do unilaterally by majority vote.  In the next post, I’ll explain the mechanics of this approach, describe potential limitations arising from current jurisprudence concerning the scope of the shareholder bylaw power, and discuss pragmatic benefits to this form of private ordering.

1

Call for Papers: National Business Law Scholars Conference

I am delighted to pass along the following notice from the organizers of the National Business Law Scholars Conference.  I’m also honored to report that they have asked me to deliver the keynote at this year’s conference, and I look forward to doing so.  

Deadline Extended to May 31

We have received an enthusiastic response to the Call for Papers for the National Business Law Scholars Conference, scheduled for June 12-13, at The Ohio State University School of Law.  We will have additional openings for anyone who would like to make a presentation but has not yet responded.  Thus, we have extended the deadline to MAY 31st.  See the Call for Papers, re-posted below with the extended deadline date, for details on how to submit:

National Business Law Scholars Conference: Call-for-Papers

The National Business Law Scholars Conference (NBLSC)  will be held on Wednesday, June 12th and Thursday, June 13th at The Ohio State University Michael E. Moritz College of Law in Columbus, Ohio.  This is the fourth annual meeting of the NBLSC, a conference which annually draws together dozens of legal scholars from across the United States and around the world.  We welcome all on-topic submissions and will attempt to provide the opportunity for everyone to actively participate.  Junior scholars and those considering entering the legal academy are especially encouraged to participate.

To submit a presentation, email Professor Eric C. Chaffee at echaffee1@udayton.edu with an abstract or paper by MAY 31, 2013.  Please title the email “NBLSC Submission – {Name}”.  If you would like to attend, but not present, email Professor Chaffee with an email entitled “NBLSC Attendance”.  Please specify in your email whether you are willing to serve as a commentator or moderator.  A conference schedule will be circulated in late May.

Conference Organizers:

Barbara Black (University of Cincinnati)
Eric C. Chaffee (University of Dayton)
Steven M. Davidoff (The Ohio State University)

0

Publicity and Illegality in Organizations

“Corporations do not commit crimes, people do,” would be a good thing for everyone to remember but those who like to vilify the corporation too readily forget.  A valuable new research paper canvasses much of the literature about wrongdoing by people in corporations. Rosa Abrantes-Metz and Danny Sokol focus on cartels that violate antitrust laws, shifting the lens from the firm level to those within a corporation and offering a broader review of screens useful to combat illegality.  It’s a great contribution to and synthesis of the literature.  

I will draw on its lessons as I revise the current edition of my accounting textbook written for use in law schools, as well as to reflect on the corporate governance aspects of this problem, addressed in several important passages of my collection of Warren Buffett’s letters to constituents of Berkshire Hathaway.

Buffett’s writings address the tone at the top and promoting a culture of compliance. As CEO, he sends a biannual letter to his managers emphasizing that the most important job of every one of Berkshire Hathaway’s 300,000 employees is preserving Berkshire’s reputation.  For 25 years, that memo has included some version of this sentence:  “We can afford to lose money, even a lot of money, but we can’t afford to lose reputation, even a shred of reputation.”

Another point he repeats will be of special interest to lawyers among our readership.  He says it is not enough to comply with the law or letter of law. Berkshire must apply a stricter test, called the New York Times test: we would be happy to have all our activities written up on the front page of a national newspaper in an article written by an unfriendly reporter.  It is a much more poignant test than whether you comply with a particular antitrust law or accounting principle.

I call the toughest battle to fight concerning compliance the disease of the crowd. A common defense of sketchy behavior is that everyone else is doing it.  In that letter, Buffett explains that such a  response is usually an excuse rather than a reason. If so, the action probably should be avoided.  To implement such a policy, Buffett offers  senior managers a hotline to him directly if they detect even a whiff of dubious behavior. Those managers pass that message down the ranks and establish parallel hotlines from their troops to them.

Above all, once wrongdoing is detected, swift and public action is required. The worst thing managers can do when they discover illegalities by their employees is try to hide it.  In America, people are very forgiving of substantive errors or even wrongs. They are relentlessly unforgiving of attempts at evasion, duplicity, or hiding things.  (“It’s the cover up, stupid.”) Although Jonathan Macey has recently released an interesting book lamenting the decline of reputation as the constraint portrayed in economic models, it remains a powerful force.  Read More

0

Board Composition—Old Wine in New(er) Bottles

It’s a pleasure to join Concurring Opinions this month. The internet can be a little touch-and-go in China—I was in central China last week, with only limited access—but I hope to contribute some thoughts as the “Beijing correspondent” over the next few weeks.

For those who have not yet been to Beijing, let me commend it to you. Beyond the tourist attractions (and there are many), there is much going on in China as the country begins to lower the cost of central government, enhance domestic consump¬tion (and inward investment), and promote a deeper capital market. Every day brings something new.

Perhaps as surprising is the ubiquity of U.S. corporate governance—in particular, the director-monitor model—as a standard against which domestic alternatives are measured, notwithstanding some fundamental differences in corporate structure and financial markets.

As some may be aware, my co-authors and I recently addressed the role of directors beyond monitoring in a working paper, entitled Lawyers and Fools: Lawyer-Directors in Public Corporations (available here; forthcoming, The Georgetown Law Journal). Read More