I recently ran across a very short article by my friend and UCLAW colleague on "The Lost Maxims of Equity," 52 J. Legal Educ. 619 (2002):
Equity abhors a nudnik.
I recently ran across a very short article by my friend and UCLAW colleague on "The Lost Maxims of Equity," 52 J. Legal Educ. 619 (2002):
Equity abhors a nudnik.
Alison Frankel recently reported on a major new court decision on using clawbacks to punish executives under whose watch firms made financial misstatements:
The SEC is demanding that the Arthrocare officials, former CEO Michael Baker and former CFO Michael Gluk, return to the company the unspecified bonuses, stock options and stock-sale profits they received in 2006 and 2007 — even though Baker and Gluk were not involved in the accounting misconduct that forced Arthrocare to restate its financials in those years.
In upholding the SEC's claims, U.S. District Judge Sam Sparks of Austin, Texas, "all of the challenges, including constitutional arguments, that the former top officials of ... Arthrocare raised in the SEC’s so-called clawback suit under [Sarbanes-Oxley] Section 304."
As Kevin LaCroix noted:
... there have been prior rulings upholding the SEC”s right to pursue clawback actions under Section 304 even in the absence of allegations that the corporate executives from whom compensation clawback is sought were involved in or even aware of the misconduct that led to the restatement. However, Spark’s opinion provides a broad theoretical justification for the SEC’s use of the provision and may represent something of an encouragement to the agency to use its authority under the statute ...
Although I support 304, I'm not unsympathetic to LaCroix's concern that "that Section 304 represents part of a dangerous legal trend that tends to want to try to impose liability without culpability (as [he] discussed at length here)." Even so, Section 304 is on the book and whether the trend as a whole is a good idea, there are good policy reasons to impose liability without moral culpability in this context. As Frankel explains:
By demanding that they return bonuses and other incentive compensation to the company, the provision “creates an incentive for (officials) to be diligent in carrying out those (certification) duties,” the judge wrote, noting that Congress deliberately drafted the law to apply to officials who weren’t involved directly in cooking the books. “The absence of any requirement of personal misconduct is in furtherance of that purpose: It ensures corporate officers cannot simply keep their own hands clean, but must instead be vigilant in ensuring there are adequate controls to prevent misdeeds by underlings.”
Moreover, as LaCroix notes:
Section 304’s requirements are “crystal clear”; the Act “tells executives precisely what they must do to avoid reimbursement liability.” They must, Sparks noted, “ensure the issuer files accurate financial statements.” They are to do so by establishing and maintaining internal controls. Judge Sparks went further to find that there is a “reasonable relationship” between the conduct and the penalty; “where, as here …corporate officers are asleep on their watch,” they are liable for a penalty that is limited to the amounts of their bonus compensation.
Obviously, Section 304 applies only to corporate executives (and only to performance pay), but outgoing Securities and Exchange Commission Chair Mary Schapiro's announcement that she is stepping down raises the question of why she gets a free ride on precisely the same sort of conduct for which corporate executives are subject to having their pay clawed back.
During Schapiro's tenure, the Government Accountability Office has consistently found that the SEC's internal controls are seriously flawed. In a 2012 letter to Schapiro, for example, the GAO explained that:
In our audit of SEC’s fiscal years 2011 and 2010 financial statements, we identified four significant deficiencies in internal control as of September 30, 2011. These significant internal control deficiencies represent continuing deficiencies concerning controls over (1) information systems, (2) financial reporting and accounting processes, (3) budgetary resources, and (4) registrant deposits and filing fees. These significant control deficiencies may adversely affect the accuracy and completeness of information used and reported by SEC’s management.
Some of these deficiencies "resulted in misstatements in SEC’s liability balances."
And then there are the appalling "allegations of serious misconduct, failure of internal controls, and whistle blower retaliation" advanced by SEC whistleblower David Weber:
Weber’s titillating testimony turns its focus on other executives within the Commission, including the COO and chair Mary Schapiro. Weber’s charges of nepotism and a lack of meaningful internal controls expose the risks that the Commission presented in its daily management of operations and beyond that as well. One does not need to read very hard to understand Weber’s belief that the SEC’s COO utilized a “pay to play” practice. Additionally, in a scene fit for the classic movie Dumb and Dumber, Weber asserts that SEC representatives brought highly sensitive computer code and encryption data to monitor activity on our equity exchanges to a hacker’s conference in Las Vegas. You cannot make this stuff up, folks.
Saving some venom for Ms. Schapiro as well, Weber paints her as a “LIAR” for perjuring herself during a presentation before the House and Senate Oversight Committee regarding the SEC’s bungled attempt to move to new office quarters. Weber would not be the first to label Ms. Schapiro with the big L. Recall that Attorney Richard Greenfield did just the same in the case brought on behalf of Standard Chartered v FINRA, Mary Schapiro et al.
In sum, as Hester Pierce observes, under Schapiro's tenure there has been "a continuing embarrassment for the SEC" when the GAO annually identifies "new and continuing significant deficiencies in the SEC's internal controls over financial reporting."
At the very least, Mary Shapiro has been asleep at the switch while the SEC has continually failed to remediate serious internal control deficincies that the SEC would never tolerate in a private company. As the late Larry Ribstein once quipped:
Suppose a company or executive civilly or criminally charged with disclosure or internal control violations after a sudden market decline magnifies risks the company ignored tells the SEC or Justice: “we’re making significant strides on disclosure and we’ll do a better job the next time.” The SEC or Justice will tell the company: “We understand. You have to be looking around the next corner or beyond the next horizon, and that’s very hard. Just do the best you can.” Something like that.
If clawing back executive pay is necessary to give corporate executives "an incentive for (officials) to be diligent in carrying out" their duties over corporate internal controls, maybe clawing back government official pay when they "are asleep on their watch,” would give future SEC chairs the necessary incentive to avoid Schapiro's manifold failures to fix the SEC's internal problems.
The Volokh Conspiracy has been named to the ABA Law Blog Hall of Fame:
The Volokh Conspiracy: The layout, lineup of writers and libertarian leanings have stayed the same, as well as the blog’s focus on constitutional law issues in the news (although there is a little more about legal education in the past year). Which is to say, it’s still a great blog, and there’s no other one with contributors so engaged with each other that they’ll spontaneously post dueling updates on a topic within the same day—or maybe within the same hour.
In connection with the growing controversy over Hewlett-Packard's acquisition of Autonomy, the WSJ is reporting that HP is accusing Autonomy of having "made 'outright misrepresentations' to inflate its financial results" prior to the acquisition:
Last week, the company wrote down the value of Autonomy by $8.8 billion, blaming more than half the charge on what it said was Autonomy's misleading accounting. ... Autonomy used aggressive accounting practices to make sure revenue from software licensing kept growing—thereby boosting the British company's valuation. The firm recognized revenue upfront that under U.S. accounting rules would have been deferred, and struck "round-trip transactions"—deals where Autonomy agreed to buy a client's products or services while at the same time the client purchased Autonomy software, according to these people. ...
A person familiar with H-P's investigation said the company is confident the deals are improper even under the international accounting standards Mr. Lynch cites. "We've looked at this very closely," this person said.
In a statement issued Saturday, H-P said its "ongoing investigation into the activities of certain former Autonomy employees has uncovered numerous transactions clearly designed to inflate the underlying financial metrics of the company before its acquisition" ....
As a corporate governance teacher/scholar, my immediate thought was to ask "where was HP's board" and then "what's their liability exposure."
I can imagine two claims on the facts as we know them. First. H-P shareholders might sue the H-P board of directors for having made an uninformed decision to approve the merger. The key precedent here is Smith v. Van Gorkom, about which I have written here. In brief, that case held that directors who make an uninformed decision are not entitled to the protections of the business judgment rule. Instead, they face liability for damages caused by their breach of the duty of care. Instructively, Van Gorkom also involved a merger (although it was the target board being sued rather than the acquirer, as would be the case here).
Second, the shareholders might sue the H-P directors for having failed to exercise adequate oversight of the merger process. The key precedent here would be in re Caremark, about which I have written here. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate “information and reporting systems” are in place to provide the board and top management with “timely and accurate information.” The claim here would be that the H-P board failed to ensure that such systems were in place to supervise both the pre-merger negotiations and the post-merger integration process.
In either case, a key question will be whether the board ignored red flags that should have alerted it to problems with Autonomy's books.
Because liability generally requires a sustained or systematic failure on the board’s part, rather than just a few instances of inattention, red flags need to be "numerous, serious, directly in front of the directors, and indicative of a corporate-wide problem." Regina F. Burch, Director Oversight and Monitoring: The Standard of Care and the Standard of Liability Post-Enron, 6 Wyo. L. Rev. 481, 498 (2006).
An instructive Delaware precedent on this issue is Chancellor Chandler’s opinion in Ash v. McCall, in which plaintiff shareholders sued the board of directors of McKesson HBOC, Inc. for, inter alia, failure to exercise proper oversight of financial matters in connection with the merger that formed the corporation. Plaintiffs relied heavily on “red flags” supposedly thrown up by various news reports casting doubt on the quality of the target corporation’s financial statements. In contrast, the defendant relied on the “clean bill of health” given those financial statements by the acquiring corporation’s financial advisors. Chancellor Chandler concluded that the plaintiffs had failed to state a claim:
When plaintiffs’ “red flags” are juxtaposed with the clean bill of health given by DeLoitte and Bear Stearns after due diligence reviews, the complaint permits one conclusion: that the McKesson directors’ reliance on the views expressed by their advisors was in good faith. What would plaintiffs have the McKesson board do in the course of making an acquisition other than hire a national accounting firm and investment bank to examine the books and records of the target company?
In addition, the fact that HBOC’s management had responded to some of the media reports constituting plaintiffs’ red flags was not deemed to give the board of directors either constructive or imputed knowledge of the alleged accounting irregularities. Post-McCall decisions have further explained that alleged “red flags” must be “either waived in one’s face or displayed so that they are visible to the careful observer.”
So did the H-P board have sufficient such red flags to have been put on alert? The WSJ story recounts a certain amount of aggressive and unpleasant behavior on the part of senior Autonomy management, but that's not the sort of red flag in question. Instead, the issue is whether there were red flags that should have led the board to inquire into Autonomy's accounting practices.
Here the Journal's Heard on the Street column is suggestive:
Consider the multiple reports published about Autonomy by accounting research firm CFRA. Dating back to 2007, these raised questions about its lack of nonacquisition-driven revenue growth and unsustainable contributions to cash flow, among other issues. It would be surprising if no one at H-P doing due diligence on the Autonomy deal was aware of such concerns. And what of the back-office integration work once the deal closed? It isn't uncommon for small software companies to have funky revenue-recognition policies that need updating. Such issues are typically discovered immediately by acquiring companies. ...
Autonomy isn't the first problematic acquisition during [Chief Financial Officer Cathie Lesjak's] tenure as CFO. Others include H-P's purchases of EDS and Palm.
In light of Deloitte's giving the deal a clean bill of health, nothing in the Journal's reporting strikes this observer as rising to the level of serious and pervasive red flags that are required for liability, at least on sofar as the decision to merge with Autonomy.
As for board oversight of the merger integration, the main story reports that:
The company began seeing potential problems with Autonomy's business shortly after the deal closed earlier this year, say people familiar with the matter. The company clawed back some of the commissions paid to salespeople using questionable accounting methods, they said.
Autonomy tried to continue certain accounting practices that the new parent wouldn't allow, say people familiar with the matter. H-P fired Mr. Lynch in May, and soon afterward a member of his inner circle still at H-P told the company's general counsel about possible accounting problems.
Those look like pretty serious red flags. Having said that, however, what could an attentive board have done to prevent the loss? It's not at all clear that the board could have done anything sooner to reduce the damage suffered.
Warren Buffett is always bitching and moaning that the rich don't pay enough taxes. Greg Mankiw points out the numerous ways in which Buffett is avoiding massive amounts of taxes:
1. His company Berkshire Hathaway never pays a dividend but instead retains all earnings. So the return on this investment is entirely in the form of capital gains. By not paying dividends, he saves his investors (including himself) from having to immediately pay income tax on this income.
2. Mr Buffett is a long-term investor, so he rarely sells and realizes a capital gain. His unrealized capital gains are untaxed.
3. He is giving away much of his wealth to charity. He gets a deduction at the full market value of the stock he donates, most of which is unrealized (and therefore untaxed) capital gains.
4. When he dies, his heirs will get a stepped-up basis. The income tax will never collect any revenue from the substantial unrealized capital gains he has been accumulating.
You can make an economic case for # 1 and # 2. But, at a minimum, how about eliminating # 3 and 4 for people with estates worth > $1 billion.
For my many and manifold sins, I have been subjected to an administrative duty at the law school this semester that has entailed reading a great deal of second-rate, deeply biased, and one sided "scholarship" by so-called "progressive" scholars. As you can imagine, it is a universe in which George Bush is the epitome of evil and there is no imaginable defense for anything the Bush administration did to defend us after 9/11. Conversely, almost none of the so-called scholars have anything to say about the Obama administration's decision to keep Guantanamo open or to ramp up the use of unmanned drones to confuct essentially lawless targeted killings. Note that I very carefully chose the word "lawless." It may be that the killings are legal under the law of war, but there is no clear domestic US law governing their use.
My annoyance with the double standard I see in these articles--damning Bush while giving Obama a pass--came to a head today, when I saw the latest news account of how Obama planned to respond to the issue if Romney had won the election. I quote Althouse's summation:
Fearing election loss, the Obama administration rushed to "develop explicit rules for the targeted killing of terrorists by unmanned drones."
The NYT reported the other day. Its sources say they wanted "a new president [to] inherit clear standards and procedures."
That means that the President was fine with the lack of rules/standards/procedures to confine his own power.
Mr. Obama and his advisers are still debating whether remote-control killing should be a measure of last resort against imminent threats to the United States, or a more flexible tool, available to help allied governments attack their enemies or to prevent militants from controlling territory.
Why are they still working on it? I imagine that every attempt to put the rules in writing and to cover everything they've already done (and want to keep doing) ends up with something they can't justify explicitly saying.
Like any thoughtful person, I have serious qualms about the Bush policy on issues like detention and interrogation. (Check the archives as far back as at least 2004.) I just wish that my fellow legal academics on the other side of the aisle were as eager to condemn Obama's policies as they were those of Bush 43. After all, the moral distance between Bush and Obama has gotten quite narrow.
The indispensable Alison Frankel reports on an 89-page opinion by U.S. District Judge Paul Engelmayer dismissing claims againt the Fed by a former major AIG shareholder:
Starr’s lawyers at Boies, Schiller & Flexner and Skadden, Arps, Slate, Meagher & Flom offered a different (and singular) view of recent financial history, in which the U.S. government pushed AIG to the brink of bankruptcy by refusing it access to capital; seized control of the company via an offer AIG’s board had no choice but to accept; plundered the company’s assets while paying off AIG’s credit-default swap counterparties in full; and then illegally engineered a reverse stock split to dilute the interests of AIG’s pre-bailout shareholders. “Starr’s amended complaint paints a portrait of government treachery worthy of an Oliver Stone movie,” Engelmayer wrote.
What's striking about Engelmayer's opinion is that he decided the case as a matter of law. In other words, assuming all of Starr's claims to be true, what the Fed did was okay as a matter of law because of dire economic necessity:
The judge, in a gracefully written decision, concluded that, indeed, Delaware fiduciary law is pre-empted by the Fed’s mission. “(The Fed’s) challenged actions with regard to AIG during the financial crisis were integrally bound up in the rescue loan packages it furnished AIG in fall 2008, made with the goal of stabilizing the American economy,” he wrote. “And, where imposing state-law duties upon a federal instrumentality would squarely conflict with its federal responsibilities, as would subjecting (the Fed) to Delaware fiduciary duty law in connection with the terms of its serial rescues of AIG, such state law is pre-empted.”
One wonders what if any limits will remain on the Fed's power to screw creditors and shareholders if Engelmayer's analysis is upheld. If the government can "treachery worthy of an Oliver Stone movie,” could the Fed use unmanned drones to conduct targeted assassinations? And, if not, where's the damned line?
Fortunately, as Ms Frankel reports:
Judge Thomas Wheeler of the U.S. Court of Federal Claims kept alive Starr’s parallel claim that the Fed’s takeover of AIG, including the company’s common shares, was unconstitutional under the takings clause. Wheeler said that the takings claim rests on whether AIG’s board was forced to accept the terms of the government bailout or did so voluntarily; he split with Engelmayer and said that Starr had presented sufficient facts to support the theory that AIG had no choice.
Starr counsel at Boies Schiller sent an email statement, pointing out that Monday’s ruling by Engelmayer will have no impact on the Court of Federal Claims case, which also seeks $25 billion.
Unfortunately, since Kelo, I've completely lost faith in the court's willingeness to use the takings clause to defend private property from government theft.
People are so used to air travel meaning delays and invasions of basic privacy that we’re willing to travel in less convenient, more dangerous ways to avoid the hassle. From Bloomberg Businessweek:
There is lethal collateral damage associated with all this spending on airline security—namely, the inconvenience of air travel is pushing more people onto the roads. Compare the dangers of air travel to those of driving. To make flying as dangerous as using a car, a four-plane disaster on the scale of 9/11 would have to occur every month, according to analysis published in the American Scientist. Researchers at Cornell University suggest that people switching from air to road transportation in the aftermath of the 9/11 attacks led to an increase of 242 driving fatalities per month—which means that a lot more people died on the roads as an indirect result of 9/11 than died from being on the planes that terrible day. They also suggest that enhanced domestic baggage screening alone reduced passenger volume by about 5 percent in the five years after 9/11, and the substitution of driving for flying by those seeking to avoid security hassles over that period resulted in more than 100 road fatalities.
You realize that there is very little evidence that the TSA makes air travel safer. You get that, right? The shoes, the liquids, the random bag searches that uncover dildos and G.I. Joe weapons — none of that is actually helping. The TSA is one big rock that promises to prevent tiger attacks; you’re supposed to think it’s working just because a tiger doesn’t show up in your backyard to maul you.
Mystal then moves to the crux of the problem:
Maybe it’s the law school in me, but I think the problem is that there is no one particular interest group that TSA is picking on. There’s no “legal defense fund” that represents people who have been violated by the TSA. Hell, we don’t even have a Gloria Allred of TSA claims. We don’t have anybody whose job is to legally protect us from the TSA.
TSA’s greatest strategy has been to violate all of us. Not only Arabs or only poor people or only gun owners or only people who dislike watching their children molested. It turns out, there are no lawyers for “Americans.”
And so the TSA-ists win.
I'm delighted to once again have been named to the ABA's top 100 law and lawyer blogs. I'm especially gratified by Francis Pileggi's kind remarks, which the ABA quoted in the announcement:
“Professor Bainbridge is often cited by the Delaware courts in their opinions due to their recognition of his expertise in corporate law. In addition to citations to his books and articles, the court also has cited to his blog posts. [UCLA prof Stephen Bainbridge’s] blog is required reading for those who want the most current insights on corporate law developments from one of the foremost corporate law scholars in the country. His perceptive posts on culture and current events are also enjoyable.” —Francis Pileggi, Delaware Corporate & Commercial Litigation Blog
This is the 5th time in the 6-year history of the award that I've made the list.
The Des Moines Register ha an interesting article following up on the lawsuit against the University of Iowa law school alleging ideological discrimination in hiring. The judge declared a mistrial because the jury was deadlocked. According to interviews with jurors, however, there was genuine agreement that Teresa Wagner was denied a position because of her conservative views and political activism, but disagreement over whether the Dean could be held responsible. Given the nature of the claim, the Dean was the named defendant, rather than the university (or the faculty, who largely control academic hiring decisions).
jurors said they felt conflicted about holding a former dean personally responsible for the bias. They wanted to hold the school itself accountable, but federal law does not recognize political discrimination by institutions.
“I will say that everyone in that jury room believed that she had been discriminated against,” said Davenport resident Carol Tracy, the jury forewoman.
Meanwhile, attorneys for Teresa Wagner on Tuesday filed a motion for a new trial in the case that scholars agree could have national implications in what some argue is the liberally slanted world of academia.
The jury’s belief that Wagner was a victim of discrimination is significant as the case heads toward a retrial that will cost the state thousands of dollars to litigate and could cost the university hundreds of thousands of dollars should it lose or settle out of court, scholars following the case said.
Paul Caron has more here.
As I noted before, as a general matter I do not think faculty hiring decisions should be second guessed in courts. Ideological discrimination in faculty hiring is contrary to the principles of academic freedom and is incompatible with a genuine commitment to liberal education. But this does not mean such conduct should be illegal, particularly in private institutions. If the allegations are true the University of Iowa’s law faculty should be ashamed of themselves.
In Corporate Governance after the Financial Crisis, I explained that:
... regulators and some commentators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a causal factor in the financial crisis of 2007-2008. As we have also seen, shareholder activists long have complained that these schemes provide pay without performance. This was one of the corporate governance flaws Dodd-Frank was intended to address, most notably via say on pay.
The trouble, of course, is that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders. Accordingly, as Christopher Bruner aptly observed, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”
Now there's additional evidence that sharehjolder empowerment is dangerous, at least for banks. From Ferreira, Daniel, Kershaw, David, Kirchmaier, Tom and Schuster, Edmund-Philipp, Shareholder Empowerment and Bank Bailouts (November 2, 2012). Available at SSRN: http://ssrn.com/abstract=2170392:
We investigate the hypothesis that shareholder empowerment may have led to more bank bailouts during the recent financial crisis. To test this hypothesis, we propose a management insulation index based on banks’ charter and by-law provisions and on the provisions of the applicable state corporate law that make it difficult for shareholders to oust a firm’s management. Our index is both conceptually and practically different from the existing alternatives. In a sample of US commercial banks, we show that management insulation is a good predictor of bank bailouts: banks in which managers are fully insulated from shareholders are roughly 19 to 26 percentage points less likely to be bailed out. We also find that banks in which the management insulation index was reduced between 2003 and 2006 are more likely to be bailed out. We discuss alternative interpretations of the evidence. The evidence is mostly consistent with the hypothesis that banks in which shareholders were more empowered performed poorly during the crisis.
Somehow, however, I don't expect the apologists for shareholder empowerment to admit their error anymore than I expect the apologists for turning corporate governance over to the SEC to admit theirs.