ProfessorBainbridge.com

Howard Stern Sued

CBS is suing Howard Stern for breach of contract and misappropriation:

Howard Stern repeatedly and willfully breached his written contract with CBS Radio over the last 22 months of that contract, misappropriated millions of dollars worth of CBS Radio airtime for his own financial benefit, and fraudulently concealed his interest in hundreds of millions of dollars of Sirius stock while promoting it on the air.

That on or about January 9, 2006, Sirius paid over 34 million shares of stock, valued at approximately $220 million, to Stern and his agent because Sirius exceeded by the end of 2005 certain subscriber targets that were set in the Sirius-Stern contract. The complaint alleges that the Sirius-Stern contract provided that Stern was to receive this stock payment in 2010, but it had an acceleration provision that allowed Stern to receive the compensation as early as January 2006 if these subscriber targets were met. All of Stern's actions for which he received this expedited compensation occurred during the time that Stern was under exclusive contract with CBS Radio, when the Sirius payment terms to Stern were kept secret.

This contract thus provided a compelling incentive for Stern to do all that he could to help Sirius reach the subscriber targets by the end of 2005 so that he could receive his Sirius stock payment as soon as possible while Sirius's stock was extremely valuable. Without the accelerated payment, Stern would risk the decline of the Sirius stock value. By taking action on CBS Radio's airtime in 2004 and 2005, Stern assured himself of immediate access to $200 million in assets that could be readily converted to cash.

By engaging in continuous promotion of Sirius on CBS Radio airtime without any payment by Sirius to CBS for these advertisements and by pocketing over $200 million dollars for his personal benefit, Stern misappropriated millions of dollars worth of CBS Radio airtime for his own financial benefit and the financial benefit of Don Buchwald, his agent, and Sirius in contravention of repeated directives by CBS Radio.

Without having seen Stern's contract, I can't speak to the breach of contract claims. But the misappropriation and fraud claims go to basic issues of an agent's fiduciary duties and I have argued that Stern was in breach of those duties.

In fact, my TCS column today is an analysis of the legal claims being made by CBS against Howard Stern.

Majella Sparkling Shiraz (Coonawarra) 2003

A very fine example of a category on which I came to dote when we visited Australia last summer. IMHO, sparkling Shiraz is often the perfect wine for foods that do not necessarily lend themselves to wine. As in tonight's case, BBQ pork sandwiches with coleslaw, baked beans, and pickles. The big fruit flavors can stand up to the acidity of the meal, while the scrubbing bubbles and cold temperature provide a textural counterpoint to the unctuous meat.

Big blast of blackberry and plum aromas, plus a lot of black pepper and an earthy note. The palate follows. Grade: B++

Chateau Ste. Michelle Syrah (Columbia Valley) 2002

Quaffable and approachable. At about $12, you can probably do better with a Shiraz from downunder, but this is a perfectly fine wine. A little jammy with a medium finish. Cherry and plum fruit dominates. Grade: B

Duckhorn Merlot (Napa Valley) 1997

<p>I bought this wine in June 2002 for about $45. Frankly, I had sort of lost track of it (hey, you try keeping track of several dozen cases scattered across 4 storage locations!), and when two bottles turned up recently I was a little doubtful as to whether they'd still be good. At nearly nine years of age, a point at which most California Merlots have long since given up the ghost, however, this wine is still going strong. </p>

 

<p>Although there might be a <em>very </em>slight hint of volatile acidity, this bottle was still quite agreeable. It is an elegant wine with a lot of finesse. An aromatic and still quite fruity bouquet is followed by a medium bodied palate impression with a long finish. Plums, prunes, and black cherries, plus a touch of mocha java. Grade: A--</p>

 

<p>Update (3/2007): Now on the downhill side, the last bottle nevertheless gave considerable pleasure. The wood is now much more dominant, with a lot of vanilla oak influence. Yet, there was still plenty of dried fruit flavors. Still, drink up.</p>

Did Sarbanes and Oxley Rush to Judgment?

Conventional wisdom says that the Sarbanes-Oxley Act was rushed into law without very much meaningful consideration. Lynn Turner and Broc Romanek are arguing that the conventional wisdom is wrong:

The intial "roots" of Sarbanes-Oxley go back to the '72-'73 Bear market and scandals such as Penn Central, Equity Funding, National Student Marketing - as well as the corporate corrupt payments and bribes that came to light during the Watergate investigations and other such shenanagins. During that time, Congress held many hearings into corporate governance practices and the accounting profession in general. The Congressional Staff also undertook an investigation and created a Staff Report on the accounting profession.

As a result of these deliberations, legislation was introduced in 1978 on these problems and further hearings were held. However, after the death of one key Congressional backer and another backer decided not to stand for re-election, this legislation stalled. This legislation would have created an oversight body for the accounting profession - similar to today's PCAOB - and would have strengthened audit committees.

Similar legislation was considered once again by members of Congress, regulators and the profession during the debate over the '95 tort reform legislation known as PSLRA. However, no legislation was enacted.

In 2002, after 42 further witnesses presented during 10 days of public hearings, the Senate passed a precursor to Sarbanes-Oxley. Then, the House conducted numerous hearings and heard from many witnesses. After the WorldCom scandal came to light, both the Senate and House overwhelmingly adopted Sarbanes-Oxley - which included many similarities to the '78 legislation (in some places, it is nearly word for word). Not exactly what one might call a 'rush to judgment.'"

One problem with this theory is that you'd have to show Congress has a functional institutional memory, such that the 1978 and 1995 legislative efforts were actually pertinent to the deliberations in 2002, which seems implausible. Second, 10 days and 42 witnesses really isn't all that much. President Bush called SOX the most far-reaching change to the securities laws since the New Deal. Jack Ellenberger's collection of the legislative history of the 1933 and 1934 laws fills 11 volumes! Finally, there were key provisions (such as section 307 on legal ethics) that were adopted on the floor with almost no debate.

Larry Ribstein makes the point quite well:

The idea that SOX is anything other than a misguided rush to judgment is refuted absolutely by Roberta Romano in her dissection of the Act and its legislative history, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance. Nothing more clearly shows the haste and lack of care in the act that the lawsuit against the PCAOB threatens the entire Act because Congress forgot to add a severability clause.

The fact that SOX finally adopted the oversight board idea that refused to die for 30 years is hardly an argument for the Act. If anything, it’s a demonstration that SOX sprouted from pro-regulatory soil so fertile it would let anything grow, even an idea that had been squashed for 30 years. The idea that Elvis lives has been around as long as the accounting oversight board idea, and wouldn’t become less idiotic if Congress finally enacted it into law.

Finally, as Steve Bainbridge points out in response to Romanek, none of this has anything to do with the lawsuit. If the Act is unconstitutional, it doesn’t matter whether it’s good or bad.

Sometimes conventional wisdom achieves conventionality by virtue of being true.

The Mayo Family Winery The Libertine (Sonoma County) 2003

At about $15 (if memory serves), this is a very attractive mid-week wine. A blend of Merlot, Cabernet Sauvignon, Syrah, and Zinfandel, the flavor associations remind this drinker mainly of the latter two. Medium to full-bodied on the palate, the wine is a little bitter, with notes of pepper, camphor, menthol, and red and black berry fruits. Agreeable and quaffable, if not especially distinguished or sophisticated. Grade: B+

The Little-Known SEC Exemption to the Constitution

It frequently seems as though the SEC and its partisans believe there is some sort of securities law exemption from the constitution. What is proxy regulation other than regulation of speech, after all? What is the shareholder proposal rule other than compelled speech? And so on. We see this again in a recent post by Broc Romanek seemingly characterizing the lawsuit challenging the constitutionality of the PCAOB and, implicitly, SOX itself a "mistake."

Regular readers know that I'm no fan of judicial imperialism, but the idea that courts should refrain from striking down an unconstitutional law because some reformers think it would be a "mistake" is a bit of a stretch even for me. If Congress violated the appointments clause in creating the PCAOB, as it did, and Congress messed up by failing to include a severability provision in Sarbanes-Oxley, as it did (and so much, by the way, for Broc's theory that SOX was well thought out), on what possible basis would a court refrain from striking down said law? We are not dealing here with the penumbras and emanations that judges rely on for their most controversial rulings. We are dealing with the express text of the Constitution. To which there is, after all, no SEC exemption.

The cat peed on my evaluations

We've all heard that old excuse - the dog ate my homework. Well, just in case you don't own a dog, but need such an excuse, I offer you the following true story told me by my friend and co-author Mark Ramseyer of the Harvard law school:

The inquiry: The course evaluations for Professor Ramseyer's Governance and Finance of Japanese Firms Reading Group last semester appear to have been misplaced.  Do any of you remember who collected the evaluations and took them to the BSA?

The answer from the student who collected the evals and was to deliver them to the BSA: I took the evaluations. I was going to take them directly to the BSA office, but then I found out that it had moved, so I ended up taking them home. I planned on taking them to the BSA office the next day, which I learned was moved to Pound. I left them in my backpack, however, and my cat urinated on my  backpack (strange I know) and really ruined the papers inside, which, actually only consisted of the evaluations that were completely wet with urine, leaking through the  entire envelope. In my judgment, I did not feel that they were sanitary  to be handled after that, so I threw them away. Perhaps I should  have saved them... but I didn't think anyone would want to handle them after that.  I am really sorry about that...

Hmmm.... I wonder how I could get an incontinent cat access to my evaluations?

The Economics of Summer Blockbusters

Interesting article in Variety:

... consider the outlook for studio chiefs in summer '06: The most expensive sequels and franchise movies in history are colliding on successive weekends from May through July.

Hence, though everyone (including the studio chiefs) acknowledges that the business model is broken, the movies of summer '06 have to produce record numbers or heads will roll. Last summer the insiders could complain that movie attendance was sagging. No excuses this year. ...

... the clashes on several weekends will be downright Darwinian. "Mission: Impossible 3" gets little breathing room before "Poseidon" floats by, to be imminently followed by "The Da Vinci Code," "Over the Hedge" from DreamWorks and then Fox's "X-Men 3." The July 4 melee begins with "Superman Returns" and ends with "Pirates of the Caribbean II." And so it goes all summer. ...

... Some high-profile casualties inevitably will result from this combat -- the production chiefs fully understand this. Given the extraordinary costs ($150 million and up) of summer blockbusters, they know that a major flameout will impinge on the bottom line of their parent companies. ... So here's the paradox of summer '06: While the studios fully acknowledge they're making too many films -- and too many expensive films -- the number of these movies going head-to-head this summer will reach record proportions. Though everyone concedes costs have gone through the roof, the roof will be raised once again.

Are the studio heads behaving like rational economic actors? As I pondered that question, I was reminded of a famous economics experiment in which a $20 bill is auctioned:

Suppose that anyone who bids at the auction of our $20 bill must pay the amount of the bid whether he wins or not. Someone will open the bidding low at $.50 in hopes of getting a real bargain. Someone else will top the bid with a $1 bid. Bidding will usually proceed up to about $10 and then pause. The second bidder must now decide whether to lose his $8 or $9 bid, or continue. If he continues, the bidding will usually advance up to $20 and then pause again. The second high bidder now realizes that he is not going to gain anything on this auction, but has the potential for a substantial loss, so he has a strong temptation to up his bid beyond $20. Here is how Frank and Cook describe this game:

"One might be tempted to think that any intelligent, well-informed person would know better than to become involved in an auction whose incentives so strongly favor costly escalation. But many of the subjects in these auctions have been experienced business professionals; many others have had formal training in the theory of games and strategic interaction. For example, psychologist Max Bazerman reports that during the past ten years he has earned more than $17,000 by auctioning $20 bills to his MBA students at Northwestern University.... In the course of almost two hundred of his actions, the top two bids never totaled less than $39, and in one instance totaled $407."

Though you may be tempted to think that such auctions never happen, they may in fact describe a common phenomenon in situations where there is only one winner, which happens frequently in rent-seeking situations. For example, consider the competition for an Olympic gold medal in figure skating. The winner (and perhaps the runner-up) will earn considerable money in endorsements, whereas the rewards to those finishing out of the medals will be much less. One bids for this medal by investing time and money for practice, and that time is lost both for winners and losers. It can easily happen that the total value of the money and time for all those who compete, including all those who never make it onto an Olympic team, far exceed the value of winning.

The ex ante rational thing to do, of course, would be not to participate in such an auction. Of course, studio heads are gambling with other people's money, but, as Variety explains, "heads will roll" among those who lose, so they still ought to have an incentive to behave rationally.

So why don't studio heads just admit that their business model is busted and try some other approach? My guess is herd behavior. Here's what I wrote about herd behavior in my article Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000):

Why do lemmings leap off that cliff in Norway? What explains fads like Beanie Babies and Pokémon? …

Herd behavior occurs when a decision maker imitates the actions of others, while ignoring his own information and judgment with regard to the merits of the underlying decision. Various explanations for herd behavior have been offered, some of which are more easily squared with rational choice theory than others. For example, following the crowd may have a reputational pay-off even if the chosen course of action fails. Because even a good agent can make decisions resulting in a bad outcome, the market evaluates the agent by looking at both the outcome and the action before forming a judgment about the agent. If a bad outcome occurs, but the action was consistent with approved conventional wisdom, the hit to the manager’s reputation from an adverse outcome is reduced. As Keynes famously remarked, “it is better to fail conventionally than to succeed unconventionally.” …

There is lots of evidence that smart, seemingly rational decisionmakers are prone to herd behavior. I have shown elsewhere, for example, that the popularity of participatory management among corporate managers owes much to herd behavior. My conclusion is confirmed by various studies, including one by Lawler and Mohrman that reported: “In a number of cases we studied, the CEO of the company had seen a TV program or read a magazine article praising [quality] circles and decided to give them a try.”

There is also evidence of herding behavior in capital markets. Several studies have found evidence of herding among institutional investors. Chevalier and Ellison, for example, found that young mutual fund managers tend to herd into popular market sectors and conventionally weighted portfolios. Other recent work shows that globalization of securities markets increases the volatility of cross-border capital flows by strengthening the incentives of institutional investors to herd. Klausner and Kahan contend that herding by lawyers explains the persistence of suboptimal provisions in bond indentures.

Presumably the studio heads are following Keynes advice: They know they'll likely lose their jobs if their summer blockbuster flops, but they also figure that failing conventionally will result in a softer landing.

Penfolds Bin 389 Cabernet Shiraz (South Australia) 1997

From a magnum. A big, firm wine. Very deep ruby, to the point of being almost black. Still needs some time. Pungent and strong nose of currant, black olives, tobacco, cedar, and cloves. The palate follows the bouquet, but the steel core of tannins and acid is the dominant impression. Give it a couple of hours in a decanter or wait 5 more years to see if it softens. Having picked this 1.5-liter bottle up at auction for just $35, however, I'd say it was a great bargain. Grade: B++

Several emails from readers:

1. Penfolds Bin 389 has often been called "baby Grange". It has a reputation for being long lived and a 1990 I had a couple of years ago was in superb condition and the wine of a night that included a 1951 Barolo. 1997 is a lesser vintage and if you could find 1996 or 1998 (or 2002) you would be well rewarded in years to come. I tried the 1997 recently and it is earlier maturing than the great vintages and drinking well now but with plenty of life left in it. The quality is excellent for the vintage. 1990 and 1986 are great older vintages that should still be drinking beautifully.
2. I've found more and more my purchasing for both the big reds and Chardonnay is from the Southern Hemosphere these days.  It's reasonably priced and especially the chardonnay has a more crisp, clean taste than any California wines in the same bracket. I really enjoy both Rosemount and Penfolds for Shiraz (or big red blends) and they always are my recommended wines for people looking for a decent, inexpensive table red.
3. I have to agree on the review, phenominal wine for the price, especially when its $23 at World Market.  That may bump the score to B+++ wouldn't you say? 

Sanford Pinot Noir Sanford & Benedict Vineyard (Santa Rita Hills) 2001

This is a very fine Pinot, but its firm acidity and potent - albeit well-integrated - tannic backbone mandate some additional cellar time for it to fully develop. This is already a sophisticated and harmonious wine but it should improve as it continues to soften with age. Black cherries and green tea, plus a stemmy note on the nose. Perhaps a tad pricey at $50, but I still recommend it. I've got one bottle left and I think I'll give it 18 months or so in the cellar to see what happens. Grade: A--

The effect of reputational sanctions

It is common for those who prefer markets to regulation to argue that reputational sanctions are an effective constraint on behavior. (I've made this argument more than once myself.) This is generally referred to as "shaming" in the literature. In response to a paper Hillary Sale recently presented at my seminar, however, one of my students made an interesting observation:

Sale argues that the SEC’s remedial powers, such as a bar order, can act as an incentive by shaming or dishonoring the director. She presumes that the corporate director community is small enough for a shaming sanction to work. A little research tends to undermine this argument. Sale tells of the rare private suit that led independent director Bert Roberts to owe $4.5 million as part of the Worldcom settlement. While this is in the context of a private suit, we should still expect to see the same shaming or dishonoring incentive at work. Given this result is rare, while we may not see it promote good behavior among other directors, we should at least see an impact on the corporate community’s treatment of Roberts personally. So what happened to Roberts? A Google search reveals that currently he sits on the boards of Valence Technology (traded on Nasdaq), John Hopkins University, and CaPCURE. The Valence website brags that, “he served as chairman and chief executive officer of MCI, having previously held the positions of president and chief operating officer” (hmmm, doesn’t sound like full disclosure). After Worldcom, we would not expect to see him serving on the board of another publicly traded company, though there he is. Perhaps this illustrates the lack of SEC action. Perhaps the SEC should have barred Roberts from serving as an officer and director anywhere. Perhaps Roberts has learned his lesson and is now the model independent director (I doubt it). As far as shame and dishonor, this shows that the director world maybe looks out for their own. Perhaps, the director community comprises a heard that sticks together rather than a close-knit community quick to shame those who fail in their director duties. My point is not that Sale is wrong in lobbying for more SEC action, but that relying on peer pressure will probably be insufficient. Certainly, a more comprehensive study showing the impacts of SEC and private action on directors and the corporate world’s response and later treatment of those directors could further prove me right or wrong.

Indeed, it would be instructive to collect the 10Ks for Enron, WorldCom, Adelphia, and some of the other prominent scandal firms to see what happened to their outside directors. Did their outside directors lose seats on other boards? Lose their day jobs? And so on. Of course, since post-SOX, the average number of boards on which a director sits has gone down, so you'd need to compare the scandal firm results to a control group. But this still would make an interesting law review article or student note for somebody with more patience for wading through a stack of 10Ks than I have.

Update: The Unknown Professor emails: 

I had actually started on this project, but found out it's been done - Suraj Srinivasan has a Journal of Accounting Piece titled "Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members" (May, 2005).  
He finds that "directors experience significant labor market penalties. In the three years after the restatement, director turnover is 48% for firms that restate earnings downward, 33% for a performance-matched sample, 28% for firms that restate upward, and only 18% for technical restatement firms. For firms that overstate earnings, the likelihood of director departure increases in restatement severity, particularly for audit committee directors. In addition, directors of these firms are no longer present in 25% of their positions on other boards. This loss is greater for audit committee members and for more severe restatements." 
So it appears that these directors at least get disciplined by the labor market for directors' seats.

Peekaboo, the Constitution Doesn't See You

My latest TCS column

The Free Enterprise Fund, an activist think tank, has filed a law suit claiming that the Public Company Accounting Oversight Board (PCAOB, nicknamed "Peekaboo") created by the Sarbanes-Oxley Act is unconstitutional. (Read the complaint.) The gist of the complaint is that the PCAOB is vested with extensive governmental functions and powers, including a quasi-law enforcement investigatory power and a quasi-judicial power to impose substantial fines for violations of its rules.

The Fund claims that the PCAOB thus violates a number of constitutional provisions, most notably the appointments clause of the US Constitution. The potential constitutional problem is that members of the PCAOB are appointed not by the President but by the SEC.

The Appointments Clause of Article II section 2 of the US Constitution provides that:

[The President] shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Three questions are thus presented. First, are the members of the PCAOB "Officers of the United States" and thus subject to the appointments clause? Second, if so, are the members of the PCAOB "inferior Officers" whose appointment Congress "may by Law vest" in one of the specified alternative mechanisms other than the advice and consent process? Third, if so, do the SEC Commissioners collectively qualify as a Head of Department for this purpose?

There seems to be surprisingly little guidance on these questions. But I still think there is a strong argument to be made in favor of the Fund's position. As the Fund points out, the PCAOB wields extensive governmental powers, but limited accountability:

[The PCAOB] has enormous powers to levy taxes on public companies and to regulate the accounting business. The board, a regulatory agency in all but name, is composed of five directors, no more than two of whom may have any experience as accountants or auditors.

The PCAOB, ostensibly a self-regulating organization for the auditing industry, is supported by a general power of taxation over all publicly-held companies. There are early indications that the PCAOB's independence and ability to raise its own revenue through taxation is supporting a dramatic expansion in its size and scope. Its 2004 budget was $103 million, and its staff started the year at 126 employees and ended the year with 262 employees. The PCAOB's 2005 budget is another 30 percent higher, at $136 million, and it expects to end the year with 450 employees.

PCAOB has an enormously broad Congressional mandate to create rules and enforce them under Sarbanes-Oxley. Most regulatory agencies are limited in their reach by the amount of money appropriated to them by Congress -- with its independent power to tax and raise funds as needed, there is hardly any institutional control on the power of the PCAOB.

All of which seems highly problematic under the relevant precedents. In Edmond v. United States, 520 U.S. 651 (1997), for example, the Court (per Scalia) wrote:

By vesting the President with the exclusive power to select the principal (noninferior) officers of the United States, the Appointments Clause prevents congressional encroachment upon the Executive and Judicial Branches. ... This disposition was also designed to assure a higher quality of appointments: The Framers anticipated that the President would be less vulnerable to interest-group pressure and personal favoritism than would a collective body. ... The President's power to select principal officers of the United States was not left unguarded, however, as Article II further requires the "Advice and Consent of the Senate." This serves both to curb Executive abuses of the appointment power ... and "to promote a judicious choice of [persons] for filling the offices of the union," The Federalist No. 76, at 386-387 [(M. Beloff ed. 1987) (A. Hamilton)]. By requiring the joint participation of the President and the Senate, the Appointments Clause was designed to ensure public accountability for both the making of a bad appointment and the rejection of a good one. ...

The PCAOB, by way of contrast, seems almost designed to avoid public accountability. As the W$J recently opined:

... under Sarbox, the President can neither appoint nor remove Peekaboo members. Sarbox requires that the appointed Securities and Exchange Commissioners themselves appoint the oversight Board. Similarly, only the SEC can remove Board members, and then only if they can be shown to have willfully violated federal laws. Nowhere in any of this is there a role for the elected executive.

There is also little oversight. The only way the SEC can undo any of the accounting Board's regulations is by proving that the rules are obviously inconsistent with the Sarbanes-Oxley statute -- a nearly impossible task given its vague wording. The PCAOB is even largely independent of Congressional oversight because its budget is financed from the fees it levies on the companies it regulates. The Justice Department may well argue in response that the Board simply doesn't rise to the level of a "real" agency. But that will surprise corporate America, given that the Peekaboo can fine accounting firms up to $2 million and individual accountants up to $100,000 for violations.

And, of course, familiar principles of agency capture by the industries it regulates suggest that interest group pressures and favoritism are potentially serious problems.

Likewise, the Fund can draw support from Freytag v. CIR, 501 U.S. 868, 884 -885 (1991), in which the Court opined that:

''The Framers understood . . . that by limiting the appointment power, they could ensure that those who wielded it were accountable to political force and the will of the people. . . . The Appointments Clause prevents Congress from distributing power too widely by limiting the actors in whom Congress may vest the power to appoint. The Clause reflects our Framers' conclusion that widely distributed appointment power subverts democratic government. given the inexorable presence of the administrative state, a holding that every organ in the executive Branch is a department would multiply the number of actors eligible to appoint.''

Holding that the SEC is a Department empowered to appoint the PCAOB would threaten precisely these democratic values the Appointments Clause was designed to protect.

In Edmond, the court also held that:

Generally speaking, the term "inferior officer" connotes a relationship with some higher ranking officer or officers below the President: Whether one is an "inferior" officer depends on whether he has a superior. It is not enough that other officers may be identified who formally maintain a higher rank, or possess responsibilities of a greater magnitude. If that were the intention, the Constitution might have used the phrase "lesser officer." Rather, in the context of a Clause designed to p reserve political accountability relative to important Government assignments, we think it evident that "inferior officers" are officers whose work is directed and supervised at some level by others who were appointed by Presidential nomination with the advice and consent of the Senate.

Because the members of the PCAOB are not subject to such oversight except to the very limited extent they are overseen by the SEC, it would seem that the members of the PCAOB likely are not inferior officers.

The Fund thus has a very strong case that the provisions of Sarbanes-Oxley creating the PCAOB are unconstitutional. Because Congress in its rush to adopt SOX failed to include a clear severability provision, moreover, the Fund may well be able to persuade a reviewing court that the entire Sarbanes-Oxley law must be thrown out. Since both Congressman Oxley and Senator Sarbanes are set to retire this year, wouldn't that make a lovely going away present for them?

The author is Professor at the UCLA School of Law.

The Many Functions of a Corporate Board

A recent presentation at my corporate governance colloquium raised the perrenial question of whether a corporation's board of director's function of monitoring management is merely primus inter pares or is the paramount function before which all other roles must give way.

In my article, Why a Board? Group Decisionmaking in Corporate Governance, I argued for the former understanding of the board:

What then does the board produce and how does it produce it? First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital.

This understanding of the board's role is critical to evaluating the debate over independent directors. Since Sarbanes-Oxley and the concurrent changes in the stock exchange listing standards, which I discussed in my article A Critique of the NYSE's Director Independence Listing Standards, most public corporations have been obliged to have a majority of board members who are independent of management. In addition, audit, nominating, and compensation committees staffed by outsiders are effectively required. One concern is that this trend will lead to more adversarial relations between boards and top managers. This concern is particularly pronounced when proposals are made to further incent independent directors to monitor management, as was recommended by our colloquium speaker, who encouraged greater SEC enforcement of rules designed to force independent directors to monitor corporate disclosures.

It is doubtful whether adversarial relations between the board and management help the former with their monitoring role (it may simply encourage management to treat outside directors like mushrooms). It seems clear, however, that encouraging an adversarial relationship between activist independent directors and outsiders is counter-productive.

In theory of course, independent board members could help the board fulfill all its roles. As to networking, for example, outside directors provide both their own expertise and interlocks with diverse contact networks. As to monitoring, at least according to conventional wisdom, board independence is an important device for constraining agency costs. A new paper from two European business scholars, however, suggest that board independence (at least insofar as it results in adversarial board-CEO relations) is undesirable because it intereferes with the board's non-monitoring functions:

Abstract: This paper analyzes the consequences of the board's dual role as an advisor as well as a monitor of management. As a result of this dual role, the CEO faces a trade-off in disclosing information to the board. On the one hand, if he reveals his information, he gets better advice. On the other hand, a more informed board will monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, our model shows that management-friendly boards can be optimal.

My bottom line is that that one size does not fit all. Firms have unique needs and should be free to develop unique accountability mechanisms carefully tailored for the firm’s special needs. Unfortunately, regulators (and a lot of academics) keep trying to squeeze firms into that one size fits all suit.

Who Owns the Corporation? Nobody

Phil Town responded a while back to one of my recent posts with this observation:

...the idea that the shareholders are not real owners is ridiculous.

Query: How do you own the a legal fiction? Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.

Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.

As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.

Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. For example, shareholders have no right to use or possess corporate property. Cf. W. Clay Jackson Enterprises, Inc. v. Greyhound Leasing and Financial Corp., 463 F. Supp. 666, 670 (D. P.R. 1979) (stating that “even a sole shareholder has no independent right which is violated by trespass upon or conversion of the corporation’s property”). Management rights, of course, are assigned by statute solely to the board of directors and those officers to whom the board properly delegates such authority. Indeed, to the extent that possessory and control rights are the indicia of a property right, the board is a better candidate for identification as the corporation’s owner than are the shareholders. As an early New York opinion put it, “the directors in the performance of their duty possess [the corporation’s property], and act in every way as if they owned it.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).

This remains true even if a single shareholder (or cohesive group) owns a majority of the corporation's voting stock. To be sure, ownership of such a control block gives shareholders substantial de facto control by virtue of their ability to elect and remove directors, yet this still does not confer either possessory or management rights on such shareholders. Indeed, an effort by such a shareholder to exercise such rights might well constitute a breach of fiduciary duty by the controlling shareholder. In appropriate instances of such misconduct by a controlling shareholder, the board may well have a fiduciary duty to the minority to take steps to dilute the majority shareholder's control (as by issuing more stock). See, e.g., Delaware Chancellor Allen's opinion in Mendell v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994), in which he suggested that the board of directors could "deploy corporate power against the majority stockholders" to prevent "a threatened serious breach of fiduciary duty by the controlling stock." Granted, as I have observed elsewhere on this blog, "corporate law is far more tolerant of hegemony than constitutional law," but Allen's dicta would make no sense if majority voting control equalled ownership.

Let me offer another illustration. As I discuss in my article Unocal at 20, if shareholders own the corporation, the board of directors of a target corporation would have no proper role in reponding to a tender offer. The shareholders' decision to tender their shares to the bidder would no more concern the institutional responsibilities or prerogatives of the board than would the shareholders' decision to sell their shares on the open market or, for that matter, to sell their homes. Both stock and a home would be treated as species of private property freely alienable by their owners. Yet, as we all know, corporate law confers an effective gatekeeping function on the target's board of directors by allowing them to deploy potent takeover defenses.

In discussing corporations, it is easy to lose sight of the overriding fact—that firms are nothing more than groups of people. We often find ourselves using jargon like owners, monitors, team members, agent, principal, partner, manager, employee, and shareholder. We also often find ourselves engaged in a form of reification—treating firms as though they were things having an existence separate from the people who comprise them—when we say things like “General Motors did so and so.” General Motors is a firm; it is pure fiction to say General Motors did anything. Reification is often useful, or even necessary, because it permits us to utilize a form of shorthand—it is easier to say General Motors did so and so than to attempt in conversation to describe the complex process which actually may have taken place. Indeed, it is very difficult to think about large firms without reifying them. Reification, however, can be dangerous. It becomes easy to lose sight of the fact that firms aren't things, they are simply a group of people for whom the law has provided an off-the-rack relationship we call the corporation. There simply is nothing there that can be owned.