ProfessorBainbridge.com

Guidance for the 2010 Proxy Season

The Washington Legal Foundation now has a video channel of legal briefs on Youtube. The latest may be of interest to readers of this blog, as K&L Gates LLP partner Phillip J. Kardis details the changes SEC has imposed for the 2010 proxy season, including expanded information on executive compensation, director qualifications, and leadership structure. Candidly, however, Kardis is pretty dry and speaks in a monotone. Somebody needs to pep him up:

The Divided SEC

Jay Brown observes:

Anyone who studies the history of the SEC knows that most decisions are made by consensus.  Those days are over.

Several thoughts:

Mandatory Disclosure and Securities Regulation: A Behavioral Analysis

The recent blogosphere debate over the SEC's guidance on climate change disclosure really ought to be a debate about mandatory disclosure generally or, at least, mandatory disclosure of future trends and uncertainties as required by Regulation S-K Item 303. Which prompts me to repost my October 4, 2004 TCS Daily column:

Mandatory disclosure is a -- maybe the -- defining characteristic of U.S. securities regulation. Issuers selling securities in a public offering must file a registration statement with the SEC containing detailed disclosures, and thereafter comply with the periodic disclosure regime. Although the New Deal-era Congresses that adopted the securities laws thought mandated disclosure was an essential element of securities reform, the mandatory disclosure regime has proven highly controversial among legal academics -- especially among law and economics-minded scholars. Some scholars argue market forces will produce optimal levels of disclosure in a regime of voluntary disclosure, while others argue that various market failures necessitate mandatory disclosure.

Both sides in this longstanding debate assume that market actors rationally pursue wealth maximization goals. In contrast, my work in this area draws on the emergent behavioral economics literature to ask whether systematic departures from rationality might result in a capital market failure necessitating government regulation. I conclude that behavioral economics is a very useful tool, but that it in this instance it cannot fairly be used to justify the system of mandatory disclosure.

Disclosing Known Uncertainties

In criticizing the SEC's new guidance on climate change-related disclosures, about which I blogged earlier, Megan McArdle argues that:

SEC just voted, 3-2, to offer "interpretive guidance" to companies on making public the threats posed to their business by climate change. ...

... in conditions of radical uncertainty, such disclosures could as easily be misleading as useful.

There's two problems with Megan's critique.

The SEC's New Climate Control Disclosure Guidance: "Nonsense on Stilts"?

The Securities and Exchange Commission yesterday promulgated (by a 3-2 party line vote) interpretative guidance for disclosure of business or legal developments relating to climate change:

The interpretive release approved today provides guidance on certain existing disclosure rules that may require a company to disclose the impact that business or legal developments related to climate change may have on its business. The relevant rules cover a company's risk factors, business description, legal proceedings, and management discussion and analysis. ...

Specifically, the SEC's interpretative guidance highlights the following areas as examples of where climate change may trigger disclosure requirements:

• Impact of Legislation and Regulation: When assessing potential disclosure obligations, a company should consider whether the impact of certain existing laws and regulations regarding climate change is material. In certain circumstances, a company should also evaluate the potential impact of pending legislation and regulation related to this topic.

• Impact of International Accords: A company should consider, and disclose when material, the risks or effects on its business of international accords and treaties relating to climate change.

• Indirect Consequences of Regulation or Business Trends: Legal, technological, political and scientific developments regarding climate change may create new opportunities or risks for companies. For instance, a company may face decreased demand for goods that produce significant greenhouse gas emissions or increased demand for goods that result in lower emissions than competing products. As such, a company should consider, for disclosure purposes, the actual or potential indirect consequences it may face due to climate change related regulatory or business trends.

• Physical Impacts of Climate Change: Companies should also evaluate for disclosure purposes the actual and potential material impacts of environmental matters on their business.

The case for shareholder choice re proxy access

Stanley Keller et al. opine on shareholder choice with respect to proxy access:

The debate at the Commission’s open meeting in May 2009, preceding its divided vote to propose proxy access rules, centered on issues of shareholder choice and private ordering. As proposed, the proxy access rules would give shareholders only a right to liberalize proxy access, but no right to make the terms of proxy access more restrictive or to opt-out completely. Many commentators have criticized the asymmetrical, “one way street” aspect of this version of shareholder choice and argued for a broader version that would allow greater freedom to shareholders to vary the SEC prescribed access regime in either direction.

Shareholder choice has a number of possible meanings in the context of proxy access. For purposes of our analysis, we define shareholder choice as a right of shareholders of a company, through bylaw adoption or ratification of a board adopted bylaw, to implement or vary the terms and conditions of proxy access for that company or to choose not to apply a proxy access regime, possibly but not necessarily in favor of an alternative approach, such as a proxy contest reimbursement policy.

They start from the following premise:

We believe there is ... a widespread consensus that the purpose of proxy access is to facilitate through use of a company’s proxy materials the ability of long-term shareholders who have a meaningful ownership stake in the company and no-control purpose to seek election of a limited number of persons they nominate for election as directors in a manner that has no control effect.

I agree that that ought to be the purpose of proxy access. I fear that the intent is to empower state and local and union pension funds, as well as hedge funds, to use proxy access to pursue private rents. (See my essay Shareholder Activism in the Obama Era.)

In any case, they continue with nice, concise summaries of both the pros and cons, before concluding that paternalistic restrictions on shareholder choice are conceptually unsustainable:

... not all shareholders agree on the appropriate structure for proxy access. This is illustrated by, but hardly limited to, the more than 500 hundred comment letters the Commission received in response to its proxy access rule proposal. These comment letters contained a wide diversity of views even on the most fundamental questions, such as size of ownership threshold, minimum holding period, maximum number of access directors and provisions to obviate access from being used as a vehicle for a change of control.

More fundamentally, of course, is whether and why there should be access at every public company. Some shareholders might well prefer an alternative to access in the form of a proxy expense reimbursement policy. Indeed, it is far from implausible that a majority of shareholders of some companies might conclude that access will be too costly, distracting and divisive and therefore vote not to have any access regime. Similarly, some shareholders might view proxy access as undermining the efficacy of majority voting for directors because it promotes election contests to which majority voting typically would not apply. Put another way, what is so compelling about the creation of a proxy access right that should lead the Commission to create a regime which affirmatively excludes the judgment of shareholders as to its structure and application to the companies in which they have invested?

A damn fine question.

Keller's argument finds support in a recent study of shareholder access concluding "that empowering shareholders is not necessarily perceived as a good thing by most shareholders."

Cited re SCOTUS Case Free Enterprise Fund v. PCAOB

Hans Bader opines in the Examiner:

Is it constitutional to vest the appointment of an independent agency, not in the President, but in the members of another independent agency?  That is a question presented by a case argued in the Supreme Court on December 7, Free Enterprise Fund v. Public Company Accounting Oversight Board.

I have argued in court briefs and elsewhere that it violates the Constitution's appointments clause, which requires that federal officers be picked by the President and confirmed by the Senate, unless they are inferior officers, who can be picked either by the President, or by the head of a department, or by a court.  So have leading law professors like Stephen Bainbridge and Donna Nagy.

As I noted in an earlier commentary, the members of the Public Company Accounting Oversight Board, an agency being challenged in the Supreme Court on December 7, aren't appointed by the President, nor can he remove them.   The General Accounting Office describes the PCAOB as "an independent board with sweeping powers and authority"; its rules and red tape cost the economy billions of dollars every year (with a long-term cost of perhaps a trillion dollars).   

Yet the Government suggests in its brief that the President has “fully effective control” over the PCAOB (see pg. 46 of that brief).  That’s not the only peculiar claim made in the PCAOB’s defense.

The case raises the issue of whether members of an agency (the PCAOB) picked by the members of yet another independent agency (the five SEC Commissioners acting as a group) are, in light of their broad policymaking role, actually “principal officers” who thus should have been picked instead by the President under the Constitution’s Appointments Clause.  Alternatively, assuming the PCAOB members are mere “inferior” officers, the case raises the issue of whether they should, as the Appointments Clause requires for inferior officers, have been picked by the "Head" of a "Department," rather than the SEC Commissioners acting collectively

via www.examiner.com

Bader's article goes on to blow the government argument out of the water. For my take on the PCAOB case, read Peekaboo, the Constitution Doesn't See You.

New NYSE Corporate Governance Standards

The SEC has approved new NYSE corporate governance listing standards. The new rules, John Olson reports, are principally intended "to update the NYSE’s corporate governance listing standards in light of the SEC’s 2006 adoption of Item 407 of Regulation S-K, which requires disclosure about director independence and certain other aspects of a company’s corporate governance practices." Olson provides a detailed analysis of the new rules, which will be helpful for corporate counsel, securities lawyers, and those few odd law professors who inflict listing standards on their suffering students (like me).

PCAOB Before Supreme Court

The Supreme Court today is hearing oral argument in a lawsuit challenging the constitutionality of the Public Company Accounting Oversight Board. Because the Sarbanes-Oxley Act, which created the PCAOB, contains no severance clause, the case creates a possibility that the entire Act may be invalidated.

For my op-ed on the case go here. For the amicus brief I co-signed, go here

SCOTUSblog has links to lots of key documents and backgrounders, and also offers up a podcast debate beween supporters and opponents of the suit.

James Freeman uses the occasion to advance an argument that "the costs of this legislation far outweigh its benefits to the investing public." The difficulty I have with this argument is that the benefits of the legislation are so hard to quantify. At the end of the day, however, my educated guess is that Freeman's right.

See also:

• Larry Ribstein, Sarbox on Trial
• Hans Bader, False claims by Government to Supreme Court: PCAOB agency more powerful and independent than alleged
• A collection of links from Point of Law

Update: Bloomberg reports on the oral argument:

Hearing arguments today in Washington, several justices suggested that the Public Company Accounting Oversight Board lacks the presidential oversight required under the Constitution for executive branch agencies.

“As a practical matter, does the president have any ability to control what the board does?” Justice Samuel Alito asked. ...

Justice Anthony Kennedy, potentially the swing vote in the case, questioned whether the SEC is in a position to oversee the PCAOB’s investigations. He said the “history and tradition of boards like this” is that they have independence in their investigations.

FWIW, I tried my hand at Yale Law Professor Ian Ayres' online tool Supreme Court Forecasting (Predict Justice Kennedy's Vote). My inputs predict that Kennedy will vote to overturn the lower court and strike down the PCAOB:

 

AEI on PCAOB

The American Enterprise Institute's Henry Olsen sent along the following email:

*****

Dear Professor Bainbridge,

 

In June, National Journal’s Jonathan Rauch devoted a column to the case challenging the constitutionality of the Public Company Accounting Oversight Board (known as “Peekaboo”) created by Congress in 2002 in a frantic response to the Enron scandal. “A little over three years later, in fall 2005,” Rauch wrote, “a handful of free market activists and litigators met in a windowless 11th floor conference room at the American Enterprise Institute. . . . They included . . . Michael Greve . . . who brought the group together. They shared a conviction that Congress’s 2002 creation was a constitutional monster.” The lawyers and scholars gathered together filed suit in February 2006, asking the Supreme Court to strike down Peekaboo. In May, the Court agreed to hear the case. Today, the arguments begin. In a post on the Enterprise blog, Greve writes that “the case presents a direct, dramatic confrontation between the political institutions’ government by free form improvisation and the Supreme Court’s responsibility to protect the constitutional structure and order.” In a column in the Wall Street Journal this morning, James Freeman writes that “new research suggests that the costs of [Sarbanes-Oxley] far outweigh its benefits to the investing public.” AEI scholars agree.

 

“What’s at Stake in the Sarbanes-Oxley Case,” by Michael S. Greve

Blog post on the Enterprise Blog

Full Text: http://blog.american.com/867

 

“Public Company Accounting Oversight Board: A Preview”

AEI event with Paul S. Atkins, Michael S. Greve, and others

More Information: www.aei.org/event/100177

 

“The Sarbanes-Oxley Debacle,” by Henry N. Butler and Larry E. Ribstein

AEI Press book

More Information: www.aei.org/book/855

 

“Sarbanes-Oxley in the Light of the Financial Crisis,” by Alex J. Pollock

AEI Regulation Outlook

Full Text: www.aei.org/outlook/100090

 

“Sarbanes-Oxley and the Ebbers Conviction,” by Peter J. Wallison

AEI Financial Services Outlook

Full Text: www.aei.org/outlook/22648

Dodd's Restoring American Financial Stability Act of 2009

Margaret Tahyar offers a concise analysis of key provisions of Senator Dodd's Restoring American Financial Stability Act of 2009.

The project of federalizing major elements of our corporate governance and executive compensation processes continues apace. The 1,136-page Restoring American Financial Stability Act of 2009, introduced last week by Senate Banking Committee Chairman Christopher Dodd, has principally attracted attention for its proposed radical overhaul of the regulation of financial institutions. But the Dodd bill also contains corporate governance and executive compensation provisions that would be applicable to all US public companies. The governance elements function as a somewhat more modest Version 2.0 of the universal governance mandates that had earlier been proposed in Senator Charles Schumer’s Shareholder Bill of Rights. The compensation elements are to a great extent lifted from legislation already passed by the House of Representatives this summer under the Corporate and Financial Institution Compensation Fairness Act of 2009. ...

The passage of the Dodd bill is highly uncertain, particularly in light of the sweeping impact of the balance of the bill. But the chances appear to be increasing that, in one form or another, Congress will act to strengthen the hand of the SEC and to convert a number of recent governance and compensation trends into permanent features of the landscape.

Jay Brown thinks the bill's regulatory provisions on executive compensation should be extended from financial institutions to all public corporations.

Nothing I've seen to date changes my mind that the creeping federalization of corporate governance is a very bad idea.

Delaware's Competition

I'm at the Federalist Society to participate in a panel on federalism in corporate governance. My thoughts on this subject have been heavily influenced by Mark Roe's article Delaware's Competition, from which I borrowed some fo the following remarks (if it's okay for Joe Biden, why not me?):

For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states. To be sure, over the years, there have been countless proposals to federalize corporate law. Until quite recently, however, none were successful.

The “Public Company Accounting Reform and Investor Protection Act” of 2002—popularly known as the Sarbanes-Oxley Act—marked a major shift in the allocation of power between the states and the federal government. (The stock exchanges are important players in this dynamic, as well, due their ability to impose corporate governance requirements via their listing standards. The formal and informal powers of Congress and the SEC to influence exchange action in this area, however, justifies treating the exchanges as a de facto branch of the federal government in this area.)

The Obama administration’s various responses to the financial crisis of 2008 and the concomitant recession have included a number of specific new federal corporate governance rules. Collectively, they mark the largest shift in power from the states to the federal government since the New Deal securities regulation statutes.

So far, most of these changes have been restricted to financial institutions and beneficiaries of federal bailouts. Many of them, moreover, are temporary impositions that will disappear when the various bailout regimes come to an end.

Others, however, are likely to become permanent features of the federal regulatory regime for all public corporations. The Securities and Exchange Commission, for example, is moving ahead with a regulatory proposal designed to empower shareholders to nominate directors.

The so-called “Shareholder Bill of Rights” proposed by Senator Charles Schumer contains many provisions that would federalize core corporate governance issues. Schumer’s press release identifies the following specific areas affected by the bill:

“1. It requires that all public companies hold an advisory shareholder vote on executive compensation. By allowing shareholders to have a “say on pay,” companies are far less likely to award compensation packages that are excessively lavish or tied to risk-taking that is not good for the long-term health of the firm.

“2. It instructs the SEC to issue rules allowing shareholders to have access to the proxy form if they want to nominate directors to the board. In order to make a nomination, shareholders will have to have owned at least 1% of a public company’s shares for at least two years. Schumer and Cantwell said it is essential that long-term shareholders have a real voice in selecting the men and women who sit on the boards of the companies they own.

“3. It requires board directors to receive at least 50% of the vote in uncontested elections in order remain on the board. It makes no sense for board members to be re-elected if a majority of shareholders cast their ballots against them.

“4. It requires all board directors to face re-election annually. Schumer and Cantwell said there is no reason that directors at a well-run company should fear facing their shareholders every year. So-called “staggered boards” just serve to insulate board members from the consequences of their decisions.

“5. It requires public companies to split the jobs of CEO and Chairman of the Board, and requires the Chairman to be an independent director. It is vital that the Chairman of the Board, who sets the board’s agenda, should be someone who works closely with the CEO, but also brings a different perspective to the table.

“6. It requires that public companies create a board risk committee. Today, the oversight of how companies manage their risks is most often a responsibility of the audit committee, which has enough responsibilities already without also having to focus on risk. By creating separate risk committees, boards will never again be able to say they did not understand the risks that the firms they oversee were taking.”

Congressman Barney Frank reportedly is likewise considering legislation including many of these ideas. Senator Dodd's financial regulation bill also includes a number of these provisions.

Virtually all U.S. corporations are formed (“incorporated”) under the laws of a single state by filing articles of incorporation with the appropriate state official. (A very few exceptions are formed under federal law.) The state in which the articles of incorporation are filed is known as the “state of incorporation.” Selecting a state of incorporation has important consequences, because of the so-called “internal affairs doctrine”—a conflicts of law rule holding that corporate governance matters are controlled by the law of the state of incorporation. Virtually all U.S. jurisdictions follow the internal affairs doctrine, even if the corporation in question has virtually no ties to the state of incorporation other than the mere fact of incorporation.

The internal affairs doctrine takes on particular transactional significance when considered in conjunction with the constitutional restrictions on a state’s ability to exclude foreign corporations. With rare exceptions, states have always allowed foreign and pseudo-foreign corporations to do business within their borders. As early as 1839, for example, the U.S. Supreme Court held that federal courts should presume a state would recognize foreign corporations in the absence of an express statement to the contrary by the legislature. A subsequent Supreme Court decision implied that states could not exclude foreign corporations from doing business within the state provided that the business constituted interstate commerce under the Commerce Clause of the U.S. Constitution. These decisions effectively created a common market for corporate charters. If Illinois, for example, adopts a restrictive corporation law, its businesses are free to incorporate in a less restrictive state, such as Delaware, while continuing to conduct business within Illinois.

Throughout the nineteenth century state corporation laws gradually moved in the direction of increased liberality, making the incorporation process simpler on the one hand, while at the same time abandoning any effort to regulate the substantive conduct of corporations through the chartering process. In later years, this process became known as the “race to the bottom.” Corporate and social reformers believed that the states competed in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. According to this view, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

Many legal scholars reject the race to the bottom hypothesis. According to a standard account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro-management statutes. The empirical research appears to bear out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Whether state competition is a race to the bottom or the top, there is no question that Delaware is the runaway winner in this competition. More than half of the corporations listed for trading on the New York Stock Exchange and nearly 60% of the Fortune 500 corporations are incorporated in Delaware.

The passage of the Sarbanes-Oxley Act, along with various other developments, suggests that Delaware has new competition. The new competitor is not, however, another state. Instead, it is the federal government.

When a corporate governance issue has national ramifications, the federal government is increasingly willing to nationalize the relevant legal regime or, at least, to threaten to do so in the expectation that Delaware will do the “right thing.” Our job today is to discuss whether this is a good thing.

(BTW, for those of you who are following along at home, I settled on leaving the tie home.)

The Constitutionality of the Delaware Takeover Statute

Guhan Subramanian has posted an interesting study of the Delaware takeover statute (§ 203), in which he and his co-authors find that “no bidder in the past nineteen years has been able to achieve 85% in a hostile tender offer against a Delaware target.” Because the federal courts that upheld the Delaware statute as constitutional did so because they believed the statute gave bidders “meaningful opportunity for success,” Subramanian argues that the constitutionality of the Delaware statute is now in play.

I don’t think so. As Subramanian admits, it’s “possible that the federal courts would uphold the constitutionality of Section 203 on different grounds.” In fact, based on my research on state takeover statutes (presented in my book Mergers & Acquisitions), I believe it is highly probable that they would do so. In my view, the constitutionality of the Delaware statute simply is not an open question.

Background: MITE

Simultaneously with Congress’ adoption of the Williams Act, the states began adopting what are now known as first generation state takeover laws.[1] Like the Williams Act, the first generation state laws were mainly disclosure statutes. Unlike the Williams Act, the first generation statutes also imposed certain procedural and substantive requirements creating substantial obstacles for takeover bidders.

The Illinois Business Takeover Act (IBTA), which the Supreme Court invalidated in Edgar v. MITE Corp.,[2] was typical of the first generation statutes. It differed from the Williams Act in three critical ways. First, the IBTA required bidders to notify the target and the Illinois Secretary of State twenty days before the offer’s effective date. Second, the IBTA permitted the Secretary of State to delay a tender offer by holding a hearing on the offer’s fairness. Moreover, the Secretary was required to hold such a hearing if one was requested by shareholders owning ten percent of the class of securities subject to the offer. Finally, the Secretary of State could enjoin a tender offer on a variety of bases, including substantive unfairness.

On January 19, 1979, MITE Corporation filed a Schedule 14D-1 with the SEC, indicating its intent to make a $28 per share cash tender offer for Chicago Rivet & Machine Company. On February 1, 1980, Illinois officials notified MITE that the proposed offer violated the IBTA and issued a cease and desist order and a notice of an administrative hearing. Chicago Rivet then notified MITE that it would file suit under the IBTA to restrain the tender offer. MITE thereupon sued in federal court, seeking to have the IBTA declared unconstitutional on both preemption and commerce clause grounds. The district court struck down the statute on both grounds and the Seventh Circuit affirmed.

Although the circuit court recognized that the federal scheme of regulating tender offers is not so pervasive that an implicit congressional intent to preempt parallel state legislation could be inferred from the Williams Act, it found that the IBTA empowered the Illinois Secretary of State to pass upon the substantive fairness of a tender offer and to prohibit it from going forward, if the Secretary judged the offer inequitable. Thus, the circuit court stated, “Illinois’ substitution of the judgment of its Secretary of State for an investor’s own assessment of the equitability of a tender offer is patently inconsistent with the Williams Act, . . . which contemplates unfettered choice by well-informed investors.” Consequently, the IBTA was preempted by the Williams Act. The circuit court also found that the IBTA unconstitutionally burdened interstate commerce. The circuit court relied on the balancing standard set forth by the Supreme Court in Pike v. Bruce Church: “Where the statute regulates evenhandedly to effectuate a legitimate local public interest, and its effects on interstate commerce are only incidental, it will be upheld unless the burden imposed on such commerce is clearly excessive in relation to the putative local benefits.”[3] Illinois asserted two interests: protection of resident shareholders and regulation of the internal affairs of Illinois corporations. The circuit court rejected both arguments. It found that the IBTA provided shareholders “marginal” benefits and that Illinois’ “tenuous interest” was counterbalanced by the statute’s “global impact” and its “significant potential to cause commercial disruption” by blocking an offer “even if it received the enthusiastic endorsement of all other States.” Consequently, because the IBTA substantially obstructed interstate commerce, without significant countervailing local benefits, it violated the dormant commerce clause.

The Supreme Court affirmed in a badly divided opinion.[4] Rejecting an argument that the preliminary injunction rendered the case moot, the plurality reached the constitutional issues. Among the substantive portions of Justice White’s opinion, only the Pike commerce clause analysis commanded a majority. On that issue, the Court found that Illinois had “no legitimate interest in protecting non-resident shareholders,” and offered only “speculative” protection for resident shareholders. The Court agreed with the circuit court “that the possible benefits of the potential delays as required by the Act may be outweighed by the increased risk that the tender offer will fail due to defensive tactics employed by incumbent management.” The Court also rejected Illinois’ “internal affairs” argument, noting that: “[t]ender offers contemplate transfers of stock by stockholders to a third party and do not themselves implicate the internal affairs of the target company. Furthermore, . . . Illinois has no interest in regulating the internal affairs of foreign corporations.” The Court therefore concluded that the IBTA was unconstitutional under the dormant commerce clause because it imposed a substantial burden on interstate commerce that outweighed the putative local benefits.

Writing for a plurality of the court, Justice White also argued that the Williams Act preempted IBTA. According to White, the Williams Act adopted a policy of neutrality as between bidders and targets. In an oft-used metaphor, Congress supposedly intended to create a level playing field for takeover contests. The IBTA’s prenotification and hearing requirements imposed significant delays before a bid could commence, during which management could erect defenses and take other measures designed to prevent the offer from going forward, and thus frustrated Congressional purpose by tipping the playing field in target management’s favor. Drawing on the Williams Act’s legislative history, White noted that Congress had rejected an advance filing requirement precisely because “Congress itself ‘recognized that delay can seriously impede a tender offer’ and sought to avoid it.” In addition, White concluded that found that the administrative veto granted the Secretary of State conflicted with a Congressional intent that shareholders be allowed make the final decision as to whether to accept a tender offer.

The MITE decision’s immediate impact was unclear. Only those statutes with similarly “global” ability to block tender offers were directly rendered unconstitutional by the opinion of the Court. Because Justice White’s preemption analysis commanded the votes of only two other Justices, it seemed possible that state statutes with a more narrow jurisdictional basis but still having a pro-target bias could pass constitutional muster. Indeed, in refusing to join the preemption analysis, Justice Stevens expressly stated that he was “not persuaded . . . that Congress’ decision to follow a policy of neutrality in its own legislation is tantamount to a federal prohibition against state legislation designed to provide special protection for incumbent management.” Similarly, Justice Powell declined to join the preemption analysis, observing that the Court’s “Commerce Clause reasoning leaves some room for state regulation” and that “the Williams Act’s neutrality policy does not necessarily imply a congressional intent to prohibit state legislation [protecting] interests that include but are often broader than those of incumbent management.” Surprisingly, however, subsequent lower court decisions almost uniformly adopted the plurality’s preemption analysis.

 Background: CTS

Justice White’s MITE opinion left open a narrow window of opportunity for states to regulate takeovers: the internal affairs doctrine, pursuant to which the state of incorporation’s law governs questions of corporate governance. The second generation of state takeover statutes was carefully crafted to fit within that loophole by being, for the most part, cautiously tailored to avoid direct regulation of tender offers. Instead, the second generation statutes addressed issues purporting to fall within the sphere of corporate governance concerns traditionally subject to state law. In the years between 1983 and 1987, many of these statutes were challenged and almost uniformly were struck down by the lower courts as unconstitutional. That trend was reversed following the Supreme Court’s decision in CTS Corp. v. Dynamics Corp.,[5]  however.

There are two important variants of “second generation” statutes: Control share acquisition statutes rely on the states’ traditional power to define corporate voting rights as a justification for regulating the bidder’s right to vote shares acquired in a control transaction. A “control share acquisition” is typically defined as the acquisition of a sufficient number of target company shares to give the acquirer control over more than a specified percentage of the voting power of the target. The triggering level of share ownership is usually defined as an acquisition which would bring the bidder within one of three ranges of voting power: 20 to 33 1/3%, 33 1/3 to 50% and more than 50%. Most control share acquisition laws provide that shares acquired in a control share acquisition shall not have voting rights unless the shareholders approve a resolution granting voting rights to the acquirer’s shares.[6] The shares owned by the acquirer, officers of the target and directors who are also employees of the target may not be counted in the vote on the resolution.

The stated purpose of control share statutes is providing shareholders with an opportunity to vote on a proposed acquisition of large share blocks which may result in or lead to a change in control of the target. These statutes are premised on the assumption that individual shareholders are often at a disadvantage when faced with a proposed change in control. If the target’s shareholders believe that a successful tender offer will be followed by a purchase by the offeror of non-tendered shares at a price lower than that offered in the initial bid, for example, individual shareholders may tender their shares to protect themselves from such an eventuality, even if they do not believe the offer to be in their best interests.

By requiring certain disclosures from the prospective purchaser and by allowing the target’s shareholders to vote on the acquisition as a group, control share acquisition statutes supposedly provide the shareholders a collective opportunity to reject an inadequate or otherwise undesirable offer. For example, since control share acquisition statutes generally require the offeror to disclose plans for transactions involving the target that would be initiated after the control shares are acquired, shareholders presumably would be unlikely to approve a creeping tender offer or street sweep which would be followed by a squeezeout back-end merger at a price less than or in a consideration different than that paid by the acquirer in purchasing the initial share block.

Fair price statutes are modeled on the approach taken in company charters that include fair price provisions. These statutes provide that certain specified transactions, sometimes called “Business Combinations,” involving an “interested shareholder” must be approved by a specified supermajority shareholder vote unless certain minimum price and other conditions are met. The term “interested shareholder” is typically defined by statute as a shareholder owning more than some specified percentage, often 10%, of the outstanding shares of the target. Business combination statutes are an extension of the fair price statute concept, providing substantially greater teeth. The typical statute prohibits a target from engaging in any business combination with an interested shareholder of the target corporation for a set period of time, often five years, following the date on which the interested shareholder achieved such status. Following the initial freeze period, a business combination with an interested shareholder is still prohibited unless the business combination is approved by a specified vote of the outstanding shares not beneficially owned by the interested shareholder or the business combination meets specified fair price and other criteria.[7] The definition of interested shareholder typically is comparable to that used in fair price statutes. As with fair price statutes, the term “business combination” typically is defined to include a broader variety of transactions than just a statutory merger.

In CTS Corp. v. Dynamics Corp.,[8] the Supreme Court upheld an Indiana control share acquisition statute. Justice Powell’s majority opinion began by noting that the MITE plurality’s preemption analysis was not binding on the Court, but he declined to explicitly overrule it. Instead, Powell claimed that the Indiana Act passed muster even under White’s interpretation of the Williams Act’s purposes. It is perhaps instructive, however, that Justice White was the lone dissenter from Powell’s preemption holding.

In fact, CTS’ preemption analysis differed from MITE’s in at least two key respects. Where Justice White emphasized Congress’ neutrality policy, Justice Powell emphasized Congress’ desire to protect shareholders.[9] Where Justice White would preempt any state statute favoring management, Justice Powell upheld the Indiana Act even though he recognized that it would deter some takeover bids. Justice Powell did so because he believed that, despite the Indiana statute’s deterrent effect,[10] Justice Powell believed that it protected shareholders by permitting them collectively to evaluate an offer’s fairness. He laid particular emphasis on a bidder’s ability to coerce shareholders into tendering, such as by making a two-tier tender offer. By allowing shareholders collectively to reject such offers, the Indiana statute defuses their coercive effect. That the statute also deters takeovers and thereby protects incumbent managers is merely incidental to its primary function of protecting shareholders. The Indiana act therefore did not conflict with the Williams Act; to the contrary, Justice Powell concluded that it furthered Congress’ goal of protecting shareholders.

Although Justice Powell acknowledged the Indiana act imposed a substantial delay on bidders, he reinterpreted MITE to only bar states from injecting unreasonable delay into the tender offer process. He then concluded that a potential 50 day waiting period was not unreasonable. Justice Powell noted that a variety of state corporate laws, such as classified board and cumulative voting statutes, limit or delay the transfer of control following a successful tender offer: “[T]he Williams Act would pre-empt a variety of state corporate laws of hitherto unquestioned validity if it were construed to pre-empt any state statute that may limit or delay the free exercise of power after a successful tender offer. . . . The longstanding prevalence of state regulation in this area suggests that, if Congress had intended to pre-empt all state laws that delay the acquisition of voting control following a tender offer, it would have said so explicitly.”

Justice White’s analysis implied that the Williams Act’s neutrality policy meant that any state laws which derogated from the level playing field established by the Williams Act were to be preempted. However, there was another, perhaps equally plausible, interpretation of the Act; namely, that Congress wanted to assure that the Act itself not affect the balance of power between bidders and targets but did not intend to prohibit all state laws that affected that balance. Powell’s opinion implicitly embraced the latter view.

Turning to the commerce clause issues, Powell held that the Indiana statute also passed muster under the dormant commerce clause. The statute did not discriminate against out of state entities. It did not bar tender offers, leaving a meaningful opportunity for the offeror to succeed. Because the statute was limited to Indiana corporations, the statute did not have significant extraterritorial effects. As to the local benefits aspect of the balancing test, Justice Powell held that the state had a legitimate interest in defining the attributes of its corporations and protecting shareholders of its corporations. He opined, for example, that “[n]o principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations, including the authority to define the voting rights of shareholders.”[11] Accordingly, it “is an accepted part of the business landscape in this country for States to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.”[12]

Interpreting CTS

Clearly CTS contemplated a greater degree of state regulation than did MITE, but how much greater remained uncertain. Because Justice Powell so narrowly focused on the specific provisions of the Indiana Act, he failed to provide a generally applicable analysis. Indeed, both proponents and opponents of state takeover legislation can mine CTS for support for their arguments. Faced with this uncertainty, two distinct lower court readings of CTS’s preemption analysis developed.

A meaningful opportunity for success

The more restrictive interpretation of CTS requires states to preserve a meaningful opportunity for successful hostile bids. This standard is most fully developed in a trilogy of cases involving the Delaware takeover statute’s constitutionality.[13] DGCL § 203 is a variant on the older business combination statutes. Section 203 prohibits a Delaware corporation from entering into a business combination for a period of three years after an offeror becomes an interested stockholder. Business combination is defined to include freezeout mergers and other common post-acquisition transactions.[14] Interested shareholder is defined, subject to various exceptions, as the owner of 15% or more of the target’s outstanding shares.

Unlike the older business combination statutes, the Delaware statute does not impose either a supermajority approval or a fair price requirement in connection with business combinations after the freeze period expires. Thus, once the three-year period expires, the interested stockholder may complete a second-step business combination on whatever terms and conditions would be lawful under applicable corporate and securities law provisions. In addition, the three-year freeze period is waived if any of four conditions are satisfied: (1) prior to the date on which the bidder crosses the 15% threshold, the business combination or the triggering acquisition is approved by the target’s board of directors; (2) the bidder, in a single transaction, goes from a stock ownership level of less than 15% to more than 85% of the target’s voting stock (not counting shares owned by inside directors or by employee stock plans in which the employees do not have the right to determine confidentially whether shares held by the plan will be tendered); (3) during the three year freeze period, the transaction is approved by the board of directors and by two-thirds of the outstanding shares not owned by the bidder; or (4) the target’s board of directors approves a white knight transaction. Section 203(b) also sets forth various other conditions under which the statute will not apply, most prominently an opt-out provision pursuant to which a corporation may exempt itself from the statute through appropriate charter or bylaw provisions.

In the leading case of the trilogy, BNS Inc. v. Koppers Co.,[15] Chief District Judge Schwartz began by interpreting CTS as meaning that neutrality between bidders and targets was no longer regarded as a purpose of the Williams Act in itself, but rather merely as a means towards the true congressional end of shareholder protection. State statutes having a substantial deterrent effect are now permissible, as are statutes favoring management, so long as these effects are merely incidental to protecting shareholders.[16] This proviso, however, is critical. As Chief Judge Schwartz saw it, CTS does not permit states to eliminate hostile takeovers. Rather, states must preserve a “meaningful opportunity” for hostile offers that are beneficial to target shareholders to succeed. Chief Judge Schwartz offered a four part test to decide whether a state law did so: (1) does the state law protect independent shareholders from coercion; (2) does it give either side an advantage in consummating or defeating an offer; (3) does it impose an unreasonable delay; and (4) does it permit a state official to substitute his views for those of the shareholders. Concluding that Section 203 probably satisfied these standards, Chief Judge Schwartz declined to enjoin its enforcement.

Amanda Acquisition

The 1980s takeover wars took many a surprising turn. Perhaps none was more surprising, however, than Judge Frank Easterbrook’s decision in Amanda Acquisition Corp. v. Universal Foods Corp.[17] Judge Easterbrook is an unabashed proponent of hostile takeovers, of course; indeed, Amanda Acquisition itself sings their praises. Yet in upholding the Wisconsin business combination statute, Judge Easterbrook authored the most permissive preemption analysis of state takeover legislation to date.[18]

Like most post-MITE state takeover statutes, the Wisconsin law deters tender offers by regulating freezeout mergers and other post-acquisition transactions. Like most business combination statutes, it imposes a statutory freeze period, here three years, following the acquisition during which business combinations are prohibited. The sole viable exception to the freeze period is prior approval by the incumbent directors: “In Wisconsin it is management’s approval in advance, or wait three years.”

Judge Easterbrook began with the Williams Act’s neutrality policy. Congress unquestionably expected the federal tender offers rules to be neutral as between bidders and targets. In MITE, Justice White read that expectation as forbidding state statutes from tipping the balance between them. Both Justices Powell and Stevens rejected that reading in their concurrences. And, of course, CTS implicitly backpedals from the spirit of Justice White’s analysis. Judge Easterbrook recognized that all of this might open the door for nonneutral state laws, but he claimed to “stop short of th[at] precipice.” At a minimum, however, Amanda Acquisition implicitly treats neutrality as a means rather than an end in itself. Easterbrook’s decision to uphold the Wisconsin statute in the face of its admitted deterrent effects only makes sense if he has rejected Justice White’s analysis in MITE of the neutrality policy’s preemptive power.

In any case, Judge Easterbrook thereafter essentially ignored the Williams Act’s neutrality policy. Instead, he asserted that Congress intended the Williams Act to regulate the process by which tender offers take place and the disclosures to which shareholders are entitled. He then used this reading of congressional purpose to distinguish MITE from CTS. The IBTA threatened to preclude a bidder from purchasing target shares even if the bidder complied with federal law. In contrast, the Indiana control share acquisition statute did not interfere with the federally mandated tender offer process; indeed, it did not even come into play until that process was completed and the shares acquired.

The Wisconsin business combination statute, like the Indiana Act, left the tender offer process alone. According to Judge Easterbrook, the Wisconsin statute therefore could be preempted only if the Williams Act gives investors a federal right to receive tender offers. He determined, however, that no such federal right exists: “Investors have no right to receive tender offers. More to the point—since Amanda sues as bidder rather than as investor seeking to sell—the Williams Act does not create a right to profit from the business of making tender offers. It is not attractive to put bids on the table for Wisconsin corporations, but because Wisconsin leaves the process alone once a bidder appears, its law may coexist with the Williams Act.” The state statute need not even leave the bidder an opportunity—meaningful or otherwise—for success. Accordingly, the issue is not whether the statute deters tender offers. The issue is whether the state law directly interferes with an undeterred bidder’s ability to go forward on schedule and in compliance with federal law.

Choosing a standard

Selection of the standard of review is often determinative. Plausible arguments can be made for both the meaningful opportunity for success standard and Amanda Acquisition. On balance, however, Amanda Acquisition seems preferable. The meaningful opportunity for success standard inherently poses difficult interpretative problems for legislators attempting to remain within constitutional bounds and for judges reviewing new statutes. More important, Amanda Acquisition is a logical extension of the Supreme Court’s recent trend in drawing the dividing line between state corporate law and federal securities law.

As for ease of application, what does “meaningful opportunity for success” mean? Against what potential injuries may the state guard shareholders? Which proxy contests are “beneficial to shareholders”? How much deterrence is too much? How open must the window of opportunity be to be meaningful? Admittedly, stringing together rhetorical questions is not the most powerful of argumentative devices, but each of these is critical to application of the standard. Yet, each also has no readily apparent answer.[19] Amanda Acquisition thus offers courts a standard posing much simpler questions.

As for consistency with CTS, there are perhaps as many theories about what the Supreme Court did in CTS, why it did it, and whether it should have done it as there are corporate law professors. While disputes as to the latter two questions were unavoidable in light of the hot debate over corporate takeovers, disagreement as to the former was avoidable. The disparate readings offered by BNS and Amanda Acquisition were only possible because Justice Powell failed to face and resolve the tensions inherent in his analysis.

On the one hand, recall that Justice Powell argued that the Indiana statute actually furthered the Williams Act’s purpose. While the MITE plurality had emphasized Congress’ neutrality policy, Justice Powell emphasized Congress’ desire to protect shareholders. Because he believed that the Indiana act protected shareholders by giving them a collective opportunity to pass on a tender offer, he concluded that the state statute was consistent with congressional intent. Chief Judge Schwartz used this aspect of CTS as the intellectual underpinnings of the meaningful opportunity for success standard.

On the other hand, however, there is Justice Powell’s broad language about the traditional primacy of state regulatory authority in the corporate governance field. Recall that Justice Powell limited his preemption analysis by noting the “long-standing prevalence of state regulation.”[20] Accordingly, absent express congressional direction, he declined to interpret the Williams Act in a manner that might permit it to preempt any state law that interfered with tender offers. Justice Powell’s commerce clause analysis even more strongly endorsed the primacy of the states in corporate governance regulation. Proponents of state takeover regulation seize on that language to argue for a broad reading of CTS. Correspondingly, opponents of an active state role feared that subsequent decisions might make this aspect of CTS the basis for preemption analysis in this area. In Amanda Acquisition, that chicken came home to roost.

The case for Amanda Acquisition begins with the burden of proof in preemption litigation. When a state takeover law is challenged, the challenger bears the burden of proof. This is not an easy burden to carry. The Supreme Court is generally reluctant to infer preemption.[21] This is especially true in areas traditionally regulated by the states.[22] That corporate law is such an area goes a long way towards explaining CTS.

States have been in the business of regulating corporate governance since before the United States was founded. Throughout that same time span, many have argued for federalizing corporate law. Yet, the federal government did not enter the picture until the New Deal securities legislation of the 1930s and 1940s. Moreover, when Congress finally did get involved, it did so in a fairly limited way. Congress was mainly concerned with disclosure and with providing procedural safeguards to make the disclosure requirements more effective.

In a long line of cases, the Supreme Court has respected the balance created by Congress by holding that the federal securities laws merely place a limited gloss on state corporate law.[23] Unless federal law expressly governs some corporate law question, the court will treat state law as controlling.[24] The corporation thus is recognized as a creature of the state, “whose very existence and attributes are a product of state law.”[25] The court therefore acknowledges that states have legitimate interests in overseeing the firms they create and in protecting the shareholders of their corporations. Finally, the CTS court further accepted a state’s “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.” If so, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.[26]

The country as a whole benefits from state regulation in this area, as well. The markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation.[27]

This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.”[28] So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion. In contrast, a uniform federal standard would preclude experimentation with differing modes of regulation.

In this light, MITE can be seen as an aberration that CTS corrected. If read broadly, MITE threatened to preempt any state corporate law that affected control contests. As Justice Powell recognized, much of state corporate law was potentially vulnerable to challenges based on such a reading of MITE. By limiting the Williams Act’s preemptive force, Justice Powell prevented this scenario. The tensions and contradictions in Justice Powell’s preemption arguments resulted from his failure to face the full implications of his own analysis. In contrast, Judge Easterbrook saw and accepted those implications. Judge Easterbrook was unable to find a firebreak between preemption of the Wisconsin business combination statute and preemption of the host of state corporate laws that affect tender offers. If the Williams Act preempted the Wisconsin statute, there was no principled basis upon which to preserve classified boards, cumulative voting, supermajority voting requirements, dual class voting rights, and takeover defenses. While BNS essentially ignores this risk, Amanda Acquisition drew the logical conclusion from Justice Powell’s refusal to preempt that body of state law.

Accordingly, I believe courts today would follow Amanda Acquisition rather than BNS. Which is why I don’t think Subramanian’s study changes the constitutional landscape.

---

[1] Indeed, Virginia’s first generation statute was adopted several months prior to the William Act’s passage. Stephen M. Bainbridge, State Takeover and Tender Offer Regulations Post-MITE: The Maryland, Ohio and Pennsylvania Attempts, 90 Dickinson L. Rev. 731, 736 (1986).

[2] Edgar v. MITE Corp., 457 U.S. 624 (1982).

[3] Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970) (citation omitted). The commerce clause of the U.S. constitution is both a grant of power to Congress and a limitation on state power. Under the supremacy clause a valid congressional exercise of the commerce power will preempt conflicting state regulation. However, even in the absence of congressional legislation, the “dormant” commerce clause bars direct state regulation of commerce. Edgar v. MITE Corp., 457 U.S. 624, 640 (1982) (White, J.).

[4] Edgar v. MITE Corp., 457 U.S. 624 (1982). In his lead opinion, Justice White determined that the IBTA was preempted by the Williams Act and also invalid under the commerce clause because (1) the IBTA directly regulated interstate commerce and (2) the IBTA’s legitimate local benefits did not outweigh its indirect burden on interstate commerce. Only the latter holding, however, commanded a majority of the Court.

[5] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987).

[6] E.g., Ind. Code Ann. § 23-1-42. A few states took a slightly different approach, under which the shareholders determine whether or not the proposed acquisition may be made. E.g., Ohio Rev. Code Ann. § 1701.831. This is a slightly more aggressive position than the more usual approach, which simply requires shareholder approval for voting rights to be accorded to the acquirer’s shares.

[7] See, e.g., N.Y. Bus. Corp. Law § 912(c). Delaware § 203 is similar to the original business combination statutes in a number of respects, but there is no requirement of shareholder approval after the freeze period expires. Shareholder voting may still occur, however, because the freeze period will be waived if at any time during it a proposed transaction is approved by the board of directors and by the two-thirds of the outstanding shares not owned by the bidder. DGCL § 203.

[8] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987).

[9] In dissent, Justice White argued that the Williams Act was primarily intended to protect individual investors. CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 98-99 (1987) (White, J., dissenting). In contrast, Justice Powell believed that the Williams Act was intended to protect shareholders. Id. at 82. The difference between investors and shareholders is more than just semantic. Under Justice White’s view, a statute will be preempted if it interferes with an individual investor’s ability to freely make his own decision. In contrast, Justice Powell would uphold state takeover statutes that make shareholders as a group better off, even if the wishes of some individual investors are thereby frustrated.

[10] Arguably, the control shareholder acquisition statutes are an ineffective takeover deterrent. The bidder’s ability to request a special shareholder meeting to consider its proposed acquisition provides corporate raiders with an opportunity to cheaply advertise a target’s takeover vulnerability. Likewise, a bidder can reduce the impact of a control share acquisition statute by simply delaying consummation of a purchase until a shareholder vote has been held and requiring a favorable vote as a condition to its tender offer. Most control share statutes prohibit both bidders and target insiders from voting on the resolution, but do not impose any minimum holding period on the “disinterested” shareholders in order for them to be eligible to vote. As a result, the outcome of the vote likely will depend in large part on the views of takeover arbitragers and other speculators who can be expected to favor the bidder over target management.

[11] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89 (1987).

[12] Some ten years after the Supreme Court’s decision, CTS Corporation (the target) agreed to acquire Dynamics Corporation of America (the bidder) for $210 million in cash and stock. Dynamics still owned a 44 percent stake in CTS, which dated back to the contested control share acquisition. Ironically, the CTS acquisition was intended to thwart WHX Corporation’s hostile takeover bid for Dynamics. CTS’ chairman described the acquisition as a major benefit to “our shareholders.” He also observed that the two companies’ product families were complementary. The deal was structured as a cash tender for part of the Dynamics shares, to be followed by a stock swap for the rest of the shares, which gave Dynamics shareholders an opportunity to reject the cash end and take CTS shares, thereby avoiding tax on unrealized gain. Wall St. J., May 12, 1997, at B9.

[13] City Capital Assoc. Ltd. v. Interco, Inc., 696 F. Supp. 1551 (D. Del. 1988), aff’d on other grounds, 860 F.2d 60 (3d Cir. 1988); RP Acquisition Corp. v. Staley Cont’l, Inc., 686 F. Supp. 476 (D. Del. 1988); BNS Inc. v. Koppers Co., Inc., 683 F. Supp. 458 (D. Del. 1988).

[14] Section 203 puts fewer restrictions on the raider’s use of target assets to finance an acquisition than do the older business combination statutes. For example, it permits the raider to sell off target assets to third parties (subject to the usual fiduciary duty and voting rules).

[15] BNS Inc. v. Koppers Co., Inc., 683 F. Supp. 458 (D. Del. 1988).

[16] Accord Hyde Park Partners, L.P. v. Connolly, 839 F.2d 837, 850 (1st Cir. 1988) (“protection of management that is incidental to protection of investors does not per se conflict with the purpose or purposes of the Williams Act.”).

[17] Amanda Acquisition Corp. v. Universal Foods Corp., 877 F.2d 496 (7th Cir. 1989).

[18] Some observers posit that Judge Easterbrook did not mean what he said, but said it only to goad the Supreme Court or Congress into preempting state takeover legislation. Perhaps so, but then why did he not simply say so, instead of creating an elaborate justification for state takeover regulations? It is not uncommon for lower court judges to follow Supreme Court precedents they disagree with, while expressly urging the Supreme Court to reconsider its prior holdings. No one doubts the appropriateness of such behavior. At the very least, however, there would be something unseemly about a judge deliberately misrepresenting his position in an attempt to force the Supreme Court to reverse him. Accordingly, it seems better to take Judge Easterbrook at his word, as several subsequent cases have done. E.g., Hoylake Investments Ltd. v. Washburn, 723 F. Supp. 42, 48 (N.D. Ill. 1989); Glass, Molders, Pottery, Plastics, and Allied Workers Int’l Union v. Wickes Co. Inc., 578 A.2d 402, 406 (N.J. Super. 1990).

[19] Recall that Chief Judge Schwartz offered a four part test in BNS to supplement the meaningful opportunity for success standard. BNS Inc. v. Koppers Co., Inc., 683 F. Supp. 458, 469 (D. Del. 1988). Unfortunately, there are several problems with that attempted clarification. First, several of the prongs are as unclear or as uncertain as the basic standard; so too is the question of how many prongs must be satisfied. Second, neither BNS nor its progeny solely operated within this framework. Finally, the second prong—whether the law gives one side an advantage—may be inconsistent with CTS. Justice Powell had asked whether the Indiana Act gave either side an advantage in communicating with shareholders; Chief Judge Schwartz recast that question to essentially ask whether the statute helped either side prevail. BNS thus “restated the question much more broadly and gave greater weight to the neutrality principle than the Court in CTS may have intended.” Evelyn Sroufe & Catherine Gelband, Business Combination Statutes: A “Meaningful Opportunity” for Success?, 45 Bus. Law. 891, 917 n.119 (1990).

[20] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 86 (1987).

[21] Exxon Corp. v. Governor of Md., 437 U.S. 117, 132 (1978).

[22] California v. ARC America Corp., 490 U.S. 93 (1989).

[23] E.g., Kamen v. Kemper Fin. Servs. Inc., 502 U.S. 974 (1991); Burks v. Lasker, 441 U.S. 471 (1979); Santa Fe Indus., Inc. v. Green, 430 U.S. 462 (1977); Piper v. Chris-Craft Indus., Inc., 430 U.S. 1 (1977); Cort v. Ash, 422 U.S. 66 (1975).

[24] Cort v. Ash, 422 U.S. 66, 84 (1975).

[25] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89 (1987). There is an on-going debate within academia as to “whether the modern corporation is essentially a matter of public or private concern.” Lawrence E. Mitchell, Private Law, Public Interest?: The ALI Principles of Corporate Governance, 61 Geo. Wash. L. Rev. 871, 876 (1993). For those who come down on the public side of the debate, the CTS arguments about the states’ interests in regulating the corporation should be conclusive. For them the corporation, and thus corporate law, is a matter of public concern that the state has a strong interest in regulating. For those on the private law side of the debate, however, the CTS arguments also should prove persuasive. They acknowledge that the state has an interest in ensuring that the gains of private transacting are maximized and further acknowledge that state regulation is more likely to maximize those gains than is national regulation.

[26] Some argue that the state also has an interest in corporations that make a substantial contribution to the state. Corporations provide employment, a crucial tax base, sell and purchase goods and services, and supply support for community activities. This interest in any corporation will vary from case to case, but it is a real interest, deriving from the corporation’s existence as a tangible economic entity created by state law. See Mark A. Sargent, Do the Second Generation State Takeover Statutes Violate the Commerce Clause?, 8 Corp. L. Rev. 3, 23 (1985).

[27] CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 90 (1987).

[28] New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).

Private Fund Investment Advisers Registration Act Approved by House Committee

Details here. It could have been worse. Much worse.

Jones v. Harris Argued

The Supreme Court heard argument today in Jones v. Harris, a case in which a mutual fund investor challenged allegedly excessive advisory fees.

Regulatory Background

• Congress enacted Investment Company Act of 1940 to mitigate conflicts of interest inherent in relationship between investment advisers and the mutual funds they create
• Section 36(b) imposes on investment advisers a fiduciary duty with respect to the receipt of compensation for services
• Authorizes fund shareholders to bring claims for breach of fiduciary duties
• Approval by the board of directors is not conclusive…shall be given consideration by the courts as deemed appropriate under all circumstances

The Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc. set prevailing standard for more than 25 years:

• Does the fee schedule represent a charge within the range of what would have been negotiated at arm's-length; or
• Are the fees so disportionately large that it bears no reasonable relationship to the services rendered
• Gartenberg found that fees paid to other fund advisers were not dispositive
• A court should rely on its own business judgment to determine whether the fee is inconsistent with the investment advisers fiduciary duty under Section 36(b)

Courts should consider six factors:

• Nature, extent and quality of services provided to fund shareholders
• The profitability of the fund’s fees to the adviser
• Fallout benefits to the adviser
• Whether fee levels reflect economies of scale as the fund grows
• Fee structure of comparative funds
• The independence and conscientiousness of the trustees

The Seventh Circuit Opinion in Jones v. Harris Associates

• Easterbrook's majority opinion held that Harris had not violated the Act because the fees were ordinary
• Rejects Gartenberg approach ("because it relies too little on markets")
• Disclosure plus fee-setting market will regulate itself
• Investors vote with their feet and dollars
• Market competition rather than a "just price" administered by the courts is appropriate
• Judge Posner issued dissent and chided the panel for rejecting Gartenberg

The SCOTUS

Prompted by the Circuit split and, one suspects, the split between Easterbrook and Posner--whom one normally thinks of as ideological soulmates--the SCOTUS took cert.

According to Bloomberg, which reported on the oral argument held today:

U.S. Supreme Court justices signaled they are split over the role judges should play in reviewing the compensation of mutual fund advisers in a case that might force reductions in the $90 billion in annual fees advisers collect.

Hearing arguments today in Washington, Chief Justice John Roberts and Justice Antonin Scalia emerged as the industry’s strongest defenders, questioning whether courts should second- guess the fund boards that approve the fees. The justices are considering the impact of the federal law that governs the mutual fund industry and its $10 trillion in assets.

An investor who objects to a fee “can go look at another fund,” Roberts said. “It takes 30 seconds.”

Other justices, including Stephen Breyer, suggested that judges should compare the fees paid by mutual fund shareholders to those the same investment advisers charge institutional clients that have similar investment objectives. Breyer said that, for fund directors, that would be a “normal question to ask.”

The WSJ opines that:

The U.S. Supreme Court seemed reluctant to intervene significantly in how mutual funds charge their customers, but indicated during arguments on Monday that it may request a more clearly defined standard for the fees.

The Journal also reports a rather curious comment by Justice Scalia:

And the justices noted that although the U.S. Securities and Exchange Commission backed the petitioners in the case, the agency has not filed any actions enforcing the relevant statute since 1980.

Assistant Solicitor General Curtis Gannon said the commission has focused instead on encouraging mutual funds to disclose more information.

Justice Antonin Scalia suggested the commission could more easily take on a larger role policing the industry than the courts. "It makes a lot more sense to have the SEC regulate rates than to have the courts do it, doesn't it?" he asked.

If Scalia's suggesting substantive fee regulation, that would be a really dramatic change. Certainly, it's true that courts should not be in the business of setting fees (as opposed to policing conflicts of interest).

As the Delaware Chancery Court has observed (In re Infousa, Inc.,2007 WL 3325920):

Sensational allegations may be grist for the mill of business journalists, but a Court cannot declare a grant of executive compensation to be excessive without immediately inviting the subsequent question: “How much is too much?” The answer to that question depends greatly upon context. The acumen of the business executive, the competitive environment in the industry, and the recruitment and retention challenges faced by the hiring corporation all bear heavily on an appropriate level of compensation. “How much is too much?” is a question far better suited to the boardroom than the courtroom.

That question is equally poorly suited for the administrative office rather than the board room. The SEC's track record from the days of regulating fixed broker-dealer commissions, for example, holds out little reason to think it could do a very good job of setting salaries.

Fionally, the Conglomerate Blog has a sort of mini-symposium of blog posts on the case for your edification.