ProfessorBainbridge.com

Using the financial crisis to justify regulating Main Street

Lucian Bebchuk is still trying to use the financial crisis of 2007-2008 to justify his sweeping regulations of executive compensation:

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

The trouble with this rhetorical move should be obvious. Unfortunately, Bebchuk's not the only one peddling it. So I was forced to spell out the problem in my book Corporate Governance after the Financial Crisis:

Scholars are divided as to whether this incentive structure causally contributed to either the housing or credit crunch. Grant Kirkpatrick contends that incentive pay encouraged high levels of risk taking.  Richard Posner argues that the structure of executive compensation practices encouraged management to cling to the housing bubble and “hope for the best.”  In contrast, Peter Mulbert contends that the empirical evidence does not support treating compensation as a major causal factor.  What seems clear, however, is that the problem was localized to the financial sector. Whether or not financial institution executive compensation practices contributed to the crisis, there is no evidence that executive compensation at Main Street corporations did so.

Accordingly, using the financial crisis as a legitimate rationale for regulating Main Street executive compensation practices is a bogus argument.

Macey talks to the Economist about Dodd-Frank

Jonathan Macey of Yale Law School explains why the Dodd-Frank bill may not have prevented the financial crisis, but will create jobs for regulators and lawyers, plus I like his tie.

Truer words: "It takes courage not to regulate ...."

Winter, Jaap W., The Financial Crisis: Does Good Corporate Governance Matter and How to Achieve it? (December 14, 2011). DSF Policy Paper No. 14. Available at SSRN: http://ssrn.com/abstract=1972057

After the governance crisis of 2001-2003 and the regulatory response through the Sarbanes-Oxley Act and the European corporate governance codes, the financial crisis has revealed persistent governance problems in financial institutions relating to executives, non-executives and shareholders. For executives these problems lie in the areas of risk and remuneration. Non-executives may have been insufficiently involved in key decisions and underlying direction of the institutions, despite the strong push to increased monitoring by non-executives through Sarbanes-Oxley and European governance codes. Institutional investors have shown a general lack of engagement with investee companies. The paper continues to critically review the governance provisions for financial institutions set forth in the recent proposals for a European Capital Requirements Directive IV and related Regulation. It concludes that regulation often is not the best way to deal with the persistent governance problems, either because it cannot deal with the intricacies of corporate and human reality, as is the case of board and non-executive director performance, or because it will be ineffective as long as underlying generally held beliefs, world views, assumptions and paradigms remain unaffected, for example in the case of risk culture, remuneration and institutional investor lack of engagement. Regulation may actually worsen the situation in some cases, like remuneration and board performance. It takes courage not to regulate and seek alternative avenues to address such problems.

A recommended read.

What would happen if the NCAA adopted Dodd-Frank?

Stanford business law professors David Larcker and Brian Tayan have conducted an interesting thought experitment:

In recent years, NCAA football has been rocked by a string of high-profile violations, including those at USC, Ohio State, the University of Miami, and Auburn. In many ways, these violations were similar to the governance breakdowns at financial and other corporations leading up to the financial crisis of 2008 and 2009.

In the corporate world, Congress responded to the financial crisis by enacting the Dodd-Frank Wall Street Reform Act, which among other things imposed various governance requirements on all publicly traded companies.

What would happen were the NCAA to adopt these same provisions and require them of all universities and their football programs?

In this fictitious tale, we explore what such a set of rules would look like. We ask:

* If these requirements would not work in an athletic setting, should we expect them to work in business?
* Why are the governance provisions of Dodd-Frank legally required, rather than voluntarily adopted by individual companies?
* Why does Dodd-Frank place such emphasis on executive compensation and disclosure? Will its compensation requirements reduce governance failures?

The NCAA Adopts 'Dodd-Frank': A Fable (September 14, 2011). Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-20. Available at SSRN: http://ssrn.com/abstract=1927108

I think I know the answer to their last question, which I address in my forthcoming book Corporate Governance After the Financial Crisis (You can pre-order the book from Oxford or Amazon.)

There is an odd disconnect between the internal logic of Dodd-Frank’s governance provisions and the back story of the financial crisis.

Consider, for example, the question of executive compensation. Regulators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a contributing factor almost from the outset of the financial crisis. As was the case with almost all public U.S. corporations, banks and other financial institutions shifted in the 1990s to a much greater reliance on equity-based pay for performance compensation schemes. The rationale for such schemes is that they align the risk preferences of managers and shareholders. Because managers typically hold less well-diversified portfolios than shareholders, having significant investments of both human and financial capital in their employers, they tend to be much more averse to firm specific risk than diversified investors would prefer. Pay for performance compensation schemes that link managerial compensation to shareholder returns are designed to counteract that inherent bias against risk and thus align managerial risk preferences with those of shareholders.

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, for the reasons just discussed. 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.”

In sum, the shareholder empowerment measures adopted before the crisis did nothing to prevent it and may well have contributed to it. The new provisions included in Dodd-Frank thus are unlikely to prevent another such crisis and may even increase the odds of some similar crisis induced by excessive risk taking.

Skeel's "faith and finance" approach to Dodd-Frank

David Skeel's posted an interesting new paper, Making Sense of the New Financial Deal:

In this Essay, I assess the enactment and implications of the Dodd-Frank Act, Congress’s response to the 2008 financial crisis. To set the stage, I begin by very briefly reviewing the causes of the crisis. I then argue that the legislation has two very clear objectives. The first is to limit the risk of the shadow banking system by more carefully regulating the key instruments and institutions of contemporary finance. The second objective is to limit the damage in the event one of these giant institutions fails. While the new regulation of the instruments of contemporary finance - including clearing and exchange trading requirements for derivatives - is promising, its treatment of systemically important financial institutions is likely to create a troublesome partnership between these institutions and the government. I also argue that our financial world is just as prone to bailouts after Dodd-Frank as it was before, and that it would have made a lot more sense to focus on bankruptcy as the solution of choice for troubled financial institutions.

After this initial assessment, I discuss the CEO compensation issues that have gotten so much attention in the press. I conclude by considering the legislation from a distinctively Christian perspective.

It's the conclusion that is the most provocative part of the paper. Skeel makes 5 points about "faith and finance":

The first is that we always need to be careful about how much we expect from secular law. Law is essential in a fallen world, but it cannot save us and can be used to oppress. It is important to be modest about our aspirations for law. This is true with social issues like abortion and gambling, and it is true with economic issues like credit and banking.

I would invoke the Fall for a somewhat different purpose; specifically, to suggest that economics may be more relevant to legal analysis than theology. In my view, the assumptions about human behavior made by economists are largely congruent with the fallen state of man. If Economic Man is a fair description of Adam after the Fall, the rational choice model used in economics is not a bad model for predicting the behavior of fallen men.

To be sure, Christians are called to a higher standard of behavior than that of fallen man. If the purpose of economic analysis is to predict how people will respond to changes in legal rules, however, can we assume Christian behavior by the masses of a secular and God-less society? As Michael Novak observed somewhere or another, no realistic social order can assume “heroic or even consistently virtuous behavior” by its citizens. A realistic social order therefore must be designed around principles that fall short of Christian ideals. In particular, the rules must not be defined in ways that effectively require every citizen to be a practicing Christian. Christian visions of Justice therefore cannot determine the rules of economic order. Instead, legal rules and predictions about human behavior must assume the fallen state of Man, which is precisely what economic analysis does.

Back to Skeel:

Second, with this caveat in mind, the most useful contribution that legal reform can make is often to fix rules that have the unintended consequence of encouraging people to misbehave.

The trouble, of course, is that determining what constitutes "misbehavior" can be quite difficult. Skeel posits, for example, that:

The implicit governmental subsidy enjoyed by banks that are “too big to fail” has this kind of effect, since it invites risk-taking, as does the tax treatment of executive compensation ...

As the Parable of the Talent teaches, however, we want servants to take risks on behalf of their masters when it comes to investing the master's assets. This is so because risk and return are positively correlated. As such, or so I assume, the real problem is "excess" risk taking and the moral hazard inherent in government subsidies. If so, however, does the faith Skeel and I share (even though he's on the wrong side of the Tiber), tell us very much about how to identify what constitutes "excess" risk taking? To answer that question, I revert to the fallen nature of humankind. Because regulators are fallen people, we cannot trust them to adopt optimal rules. In an incisive essay Catholic Social Teaching, Free Enterprise and Poverty, Paul Atkins argues that:

It is a blunt instrument at best, and subject to the frailties of the human regulators. If the regulator does not use an effective cost/benefit screen to analyse its proposed rules properly, or does not listen to public comments, or tries to regulate through enforcement, the consequences can be inconsistent, distortive, and not easily corrected. We must remember that investors ultimately pay for regulation. If regulations impose costs without commensurate benefits, investors suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. That ultimately hurts them in their investment performance, because it means less opportunity for diversification. ...

Can regulators do the jobs of industry better than industry can? In his last book, The Fatal Conceit: The Errors of Socialism, Friedrich Hayek, the Austrian-born economist, wrote in 1989 about the dangers of a paternalist attitude toward regulating the economy. He labels as the “fatal conceit” the idea that “man is able to shape the world around him according to his wishes.” Hayek argues: “To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.”

As Hayek teaches, at some point, we must recognize that businesses are better than governments at business. To suggest that regulators somehow know more than a company about its own business and the risks its faces is both egotistical and naïve. In addition, by removing risk management from firms and placing it in the hands of government, there is a danger that firms will become careless and take on additional risk, believing regulators are protecting them. This is the moral hazard that we all try to avoid. Simply put, the risk management function must remain in the hands of the firms that face the risk.

Back to Skeel:

Third, I believe that the income inequality that we hear so much about— the enormous gap between the income at the highest level and income at lower levels—is a genuine issue with obvious Christian implications. The real estate bubble disguised the gap between those in the executive suites and ordinary Americans by encouraging Americans to buy and live beyond their means.

As a Catholic, I accept that social policy ought to reflect what the Church calls the preferential option for the poor. Once we move beyond basic wealth redistribution questions, however, turning the preferential option into policy becomes difficult. many people truly thought that promoting home ownership would reduce wealth inequality, help the poor to build assets, and, of course, provide shelter. As Skeel's excerpt suggests, however, the pre-2008 policies that drove home ownership ever higher may actually have been detrimental to the poor.

That point is affirmed in Atkin's essay:

The fundamental problem was that mortgage loans were made to borrowers who, if they had had tighter underwriting standards, might not have been able to get those loans. They put little money down, in general, so the amount of money lent on the house was pretty close to what the house was worth. That means not much room for error if the house price declined.

The  policies pursued by the government thus increased the vulnerability of the poor.

Skeel's fourth point is that "Congress would have done far more to make the biggest banks and their executives more accountable—and more responsible—if it had taken serious steps to downsize them, and had looked to bankruptcy as the strategy of choice if they fail." Which strikes me as a true point, but not one especially driven by faith-based insights.

The same seems to be true of Skeel's fifth point, which is that there is a "cultural cost of the recent bailouts" in that they "may have made homeowners less hesitant to default on their own home loans." Again, it's not clear to me that this insight is uniquely faith-derived.

In sum, I liked this piece a lot, but I came away once again wondering if faith-based reasoning really leads to unique scholarly insights when it comes to issues like corporate governance or finance.

The late William Stuntz was a friend of both Skeel and I. At a conference many years ago, I heard Stuntz observe that, before His public ministry, Jesus made tables and whatever else it was that ancient Middle Eastern carpenters made. Bill went on to ask whether there was anything uniquely Christian about those tables. Bill's insight suggests that we need to ponder what, if anything, makes Christian perspectives on law distinctive.

In doing so, we need to differentiate between several different types of "law and religion" scholarship:

1. Studies of how the law impacts religion. This probably is the dominant form of law and religion scholarship, but it's really mostly Constitutional law dealing with the free exercise and establishment clauses of the First Amendment. Not really distinctively Christian.
2. Critiques of policy recommendations made by religious figures. This is what I mostly do in the law and religion field. Where US Catholic Bishops have made legal and regulatory proposals grounded in Catholic social thought, for example, there is a space for distinctively Christian legal scholarship that engages those proposals not only from secular grounds like economics but also from theological perspectives. 
3. Christian critiques of laws like Dodd-Frank. This is the area where I think it is hardest to do something that is both rigorous and distinctively Christian. As far as I can tell, for example, there's very little in either the Bible or the Magisterium that would help me answer the question of whether executive compensation at TARP recipient firms should be capped.

For more on these issues, see Skeel's excellent article The Unbearable Lightness of Christian Legal Scholarship.

Daily Show's Dodd-Frank One Year Update

http://www.thecorporatecounsel.net/Blog/2011/07/canadas-continuous-disclosure-review-program.html

The Daily Show
Get More: Daily Show Full Episodes,Political Humor & Satire Blog,The Daily Show on Facebook

HT: Broc

Blogosphere reactions to proxy access decision

In addition to my very long post below, several other prominent law and business bloggers have commented on the decision striking down the SEC's proxy access rule (14a-11). The following are snatched from my newsreader in reverse chronological order:

Sean Hackbarth at the US Chamber's blog:

On Business Roundtable and Chamber of Commerce v. SEC, Mike Scarcella at The BLT reports:

The appeals court sided with the business groups’ lawyers, who argued that investors with special interests, including unions and state and local governments, would be likely to put the maximization of shareholder value second to other interests.

“By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily,” Judge Douglas Ginsburg said in the ruling, joined by Chief Judge David Sentelle and Judge Janice Rogers Brown.

The SEC, the appeals court said, “inconsistently and opportunistically framed the costs and benefits of the rule” and also failed “to respond to substantial problems raised by commenters.”

The Chamber's president and CEO Tom Donohue was pleased with the ruling:

We applaud the court’s decision to prevent special interest politics from being injected into the boardroom.  Companies and directors need to continue to focus on the important work of creating jobs and reviving our economy. Today’s decision also sends a strong message that regulators need to meet their statutory requirement to clearly prove that the benefits of regulation outweigh the costs.

Adam O. Emmerich of Wachtell Lipton:

The court did not reach plaintiffs’ claims that proxy access rules are fundamentally unconstitutional, theoretically leaving open the possibility that an access regime could be implemented in revised form in the future if the above defects are addressed.  It is unclear whether the SEC will continue to pursue proxy access in the face of this unqualified rejection of such a high-profile initiative which had been many years in the making. What is virtually certain, however, is that proxy access will not apply to the 2012 proxy season.

While shareholder activists are likely to be disappointed by this decision and seek to portray it as a setback for “shareholder democracy,” we believe this is a positive development for American corporations and their shareholders.  As we have always said, proxy access is not a necessary or even beneficial element of corporate governance.  Shareholders have many avenues to influence boards of directors, who are in general more independent, more engaged and more vigilant than ever before, and we do not expect this ruling to decrease the frequency of proxy contests.

Gordon Smith:

The most interesting part of the opinion is where the Court considered the possibility that union and state pension funds might use Rule 14a-11 for personal gain. The Court: "By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily." ...

... The opinion is a rather limited indictment of the proxy access proposal, relying on the lack of sufficient justification. The SEC is considering its options. While it might challenge the ruling, I suspect that the agency is more likely to produce a newly justified rule in the near future. 

JW Verret:

This decision brings to light a fundamental problem at the SEC.  Speaking against my own interest as a securities lawyer, I think it is an agency with too many lawyers and not enough economists.  The Federal Reserve and Federal Trade Commission are better regulators because they have teams of sharp economists to consider the effects of new rules.  As Senator Shelby noted in a recent hearing, the SEC on the other hand has over a thousand lawyers and less than 25 economists.  Today’s decision is one of the predictable results.  So were similar decisions striking down rules on the same basis in American Equity v. SEC and in Chamber of Commerce v. SEC.

The SEC has now proposed rules on proxy access in 2011, 2009, 2007 and 2003.  It still doesn’t have a rule in place.  That’s a lot of man hours to put into writing a rule that is never ultimately adopted.  I wonder if Chairman Schapiro will look to re-write the rule given all the deadlines she is facing under Dodd-Frank.  I don’t think we’ve seen the last of Rule 14a-11, but I think it may be awhile before it is resurrected.  What would a new SEC rule look like?  I doubt it would cover investment companies, as the opinion gave particular attention to the SEC’s decision to apply the rule to them.  I would also suspect it would allow for an opt-out procedure.  We’ll see.

Let’s not forget that the changes to Rule 14a-8 are still in place.  So shareholders can still adopt election bylaws which specify proxy access procedures at a particular company.  It’s never to early for boards to consider putting into place the proxy access defenses that I have developed.

Brett McDonnell:

... let me briefly lament the D.C. Circuit's vacating of the proxy access rule.  I have my own reservations about the rule, in particular the SEC's failure to allow shareholders to opt out in any way they choose.  Still, I think it's on balance a pretty sensible and defensible rule.  The SEC's documents proposing and finalizing the rule are about extensive as I have ever seen from that agency, and they had voluminous comments from all sides to help guide them.  The D.C. Circuit cherrypicks areas where it asserts the SEC didn't do enough.  It will almost always be possible to do that with any agency rulemaking.  Requiring that level of deliberation could well make the task of rule-writing for Dodd-Frank more daunting still.  This opinion is little more than the judges ignoring the proper judicial rule of deference to an agency involved in notice-and-comment rulemaking and asserting their own naked political preferences.  Talk about judicial activism.

James McRitchie:

 

As those of us committed to proxy access start over again, difficult but not impossible in the current political climate, we would do well to take Fisch’s advice on an alternative approach:

 

1. The SEC should amend Regulation 14a to require the issuer to disclose, in its proxy statement, all properly-nominated director candidates, regardless of whether the nomination is made by a nominating committee, a shareholder or some other mechanism. Provide for comparable disclosures, regardless of the source of the nomination.
2. Amend Rule 14a-4 to require the issuer’s proxy card to give shareholders the opportunity to vote for any of the candidates included in the proxy statement. The proxy card would thus constitute a universal ballot for all properly-nominated candidates.
3. Encourage firm-specific experiments by retaining the recently adopted amendments to the election exclusion under Rule 14a-8 authorizing the inclusion of shareholder proposals concerning the process by which directors are selected.

Jim Hamilton offers up a detailed summary of the opinion.

Proxy Access Invalidated on APA Grounds

The DC Circuit has struck down the SEC's proxy access rule. The opinion is here. Here is background from my essay The Corporate Governance Provisions of Dodd-Frank (October, 27 2010):

Dodd-Frank § 971 affirms that the SEC has authority to adopt a proxy access rule. At the same time, however, the legislative history makes clear that Congress intends that the SEC “should have wide latitude in setting the terms of such proxy access.” In particular, § 971 expressly authorizes the SEC to exempt “an issuer or class of issuers” from any proxy access rule and specifically requires the SEC to “take into account, among other considerations, whether” proxy access “ disproportionately burdens small issuers.”

Section 971 probably was unnecessary. An SEC rulemaking proceeding on proxy access was well advanced long before Dodd-Frank was adopted, so a shove from Congress was superfluous. Although the SEC lacks authority to regulate the substance of shareholder voting rights, moreover, proxy access almost certainly fell within the disclosure and process sphere over which the SEC has unquestioned authority. By adopting § 971, however, Congress did preempt an expected challenge to any forthcoming SEC regulation.

On August 25, 2010, just a few weeks after Dodd-Frank became law, the SEC adopted Rule 14a-11, which will require companies to include in their proxy materials, alongside the nominees of the incumbent board, the nominees of shareholders who own at least 3 percent of the company’s shares and have done so continuously for at least the prior three years. A shareholder may not use the rule to take over the company. Instead, the shareholder is limited to putting forward a short slate consisting of at least one nominee or up to 25% of the company’s board of directors, whichever is greater. Application of the rule to small companies will be deferred for three years, while the SEC studies its impact on them.

Proxy access has been highly controversial. As SEC Commissioner Troy Paredes pointed out in dissenting from adoption of new Rule 14a-11, proxy access marks a considerable displacement of state corporate law by federal securities regulation:

Rule 14a-11’s immutability conflicts with state law. Rule 14a-11 is not limited to facilitating the ability of shareholders to exercise their state law rights, but instead confers upon shareholders a new substantive federal right that in many respects runs counter to what state corporate law otherwise provides.

Commissioner Paredes further pointed out that:

The mixed empirical results do not support the Commission’s decision to impose a one-size-fits-all minimum right of access. Some studies have shown that certain means of enhancing corporate accountability, such as de-staggering boards, may increase firm value, but these studies do not test the impact of proxy access specifically. Accordingly, what the Commission properly can infer from these data is limited and, in any event, other studies show competing results. Recent economic work examining proxy access specifically is of particular interest in that the findings suggest that the costs of proxy access may outweigh the potential benefits, although the results are not uniform. The net effect of proxy access — be it for better or for worse — would seem to vary based on a company’s particular characteristics and circumstances.

To my mind, the adopting release’s treatment of the economic studies is not evenhanded. The release goes to some length in questioning studies that call the benefits of proxy access into doubt — critiquing the authors’ methodologies, noting that the studies’ results are open to interpretation, and cautioning against drawing “sharp inferences” from the data. By way of contrast, the release too readily embraces and extrapolates from the studies it characterizes as supporting the rulemaking, as if these studies were on point and above critique when in fact they are not.

SEC Commissioner Kathleen Casey pointed out in her dissent that the new rule favors activist investors who may seek to use the new access rights to engage in private rent seeking:

The paradigm of a power struggle between directors and shareholders is one that activist, largely institutional, investors assiduously promote, and this rule illustrates a troubling trend in our recent and ongoing rulemaking in favor of empowering these shareholders through, among other things, increasingly federalized corporate governance requirements. Yet, these shareholders do not necessarily represent the interests of all shareholders, and the Commission betrays its mission when it treats these investors as a proxy for all shareholders.

The Chamber and Business Roundtable originally planned to challenge Rule 14a-11 on grounds that the SEC lacked authority to adopt it, per the earlier decision in Business Roundtable v. SEC, 905 F.2d 406. In my view, that claim would have failed, even if Congress had not adopted sec. 971. See my essay  The Scope of the SEC's Authority Over Shareholder Voting Rights (May 2007). Section 971 ensured that there was no doubt that the SEC had the requisite authority. (For discussion of the earlier BRT decision and the issues it raised, see my essay The Short Life and Resurrection of SEC Rule 19c-4.)

In this new case, however, the DC Circuit sided with the BRT and Chamber on administrative procedure grounds. candidly, while I am pleased, I'm also surprised. I had thought--and said publicly--that this suit was a long shot. In any event, the court--per an opinion by Douglas Ginsburg--held that:

We ... hold the Commission acted arbitrarily and capriciously for having failed once again — as it did most recently in American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167-68 (D.C. Cir. 2010), and before that in Chamber of Commerce, 412 F.3d at 136 —   adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.

That's a pretty serious smack down. "Once again failed," citing cases. "Opportunistically" assessed the evidence. "Contradicted itself." Ouch. The SEC definitely got a serious spanking from a court that was not amused.

Some interesting points. First, the court agreed with those of us who have argued that a board often will have not just the right--but the duty--to oppose shareholder nominees:

[T]he American Bar Association Committee on Federal Regulation of Securities commented: "If the [shareholder] nominee is determined [by the board] not to be as appropriate a candidate as those to be nominated by the board's independent nominating committee ..., then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests."

Second, the court slapped down the SEC's claim--which parroted the claims of shareholder power advocates--that shareholder activism is beneficial for corporate performance:

The petitioners also maintain, and we agree, the Commission relied upon insufficient empirical data when it concluded that Rule 14a-11 will improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees. ... The Commission acknowledged the numerous studies submitted by commenters that reached the opposite result. ... One commenter, for example, submitted an empirical study showing that "when dissident directors win board seats, those firms underperform peers by 19 to 40% over the two years following the proxy contest." Elaine Buckberg, NERA Econ. Consulting, & Jonathan Macey, Yale Law School, Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation 9 (2009), available at www.nera.com/upload/Buckberg_Macey_Report_FINAL.pdf. The Commission completely discounted those studies "because of questions raised by subsequent studies, limitations acknowledged by the studies' authors, or [its] own concerns about the studies' methodology or scope." 

The Commission instead relied exclusively and heavily upon two relatively unpersuasive studies, one concerning the effect of "hybrid boards" (which include some dissident directors) and the other concerning the effect of proxy contests in general, upon shareholder value. Id. at 56,762 & n.921 (citing Chris Cernich et al., IRRC Inst. for Corporate Responsibility, Effectiveness of Hybrid Boards (May 2009), available at www.irrcinstitute.org/pdf/IRRC_05_09_EffectiveHybridBoar ds.pdf, and J. Harold Mulherin & Annette B. Poulsen, Proxy Contests & Corporate Change: Implications for Shareholder Wealth, 47 J. Fin. Econ. 279 (1998)). Indeed, the Commission "recognize[d] the limitations of the Cernich (2009) study," and noted "its long-term findings on shareholder value creation are difficult to interpret." Id. at 56,760/3 n.911. In view of the admittedly (and at best) "mixed" empirical evidence, id. at 56,761/1, we think the Commission has not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders will result in improved board and company performance and shareholder value....

I have consistently argued that proxy access will not result in improved board performance, so I'm especially pleased by this aspect of the holding. See, e.g., Shareholder Activism in the Obama Era (July 22, 2009).

Third, the Court agreed with those of us who have argued that certain institutional investors--most notably union pension funds and state and local government pension funds--would use proxy access as leverage to extract private gains at the expense of other shareholders (see my Obama Era article, cited above):

Notwithstanding the ownership and holding requirements, there is good reason to believe institutional investors with special interests will be able to use the rule and, as more than one commenter noted, "public and union pension funds" are the institutional investors "most likely to make use of proxy access." ... Nonetheless, the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause companies to incur costs even when their nominee is unlikely to be elected.

Note how Paredes and Casey are also vindicated here.

This is a big win for those of us who believe in the board-centric model of corporate governance and for the dominance of state law in regulating corporate governance.

But it is not the end of the story. Obviously, the SEC could appeal. The SEC could also go back to the rule-making process and try again. Neither would be surprising. Proxy access is a major goal of the union bosses and therefore has strong support from Democrats in Congress and the Democratic members of the Commission.

In addition, there is a private ordering solution. Shareholders who want proxy access can put forward proposals under Rule 14a-8 to amend the issuer's bylaws so as to permit shareholder nominees to be included on the proxy card.

But tonight let's celebrate a solid win for the good guys.

Proxy access struck down

I'm out and about w/o access to my computer. Just heard CNBC report that the SEC's proxy access was struck down by DC Circuit. Pleased but surprised. Will blog ASAP when back at computer.

Dodd-Frank at 1 blog symposium

Conglomerate is having a blog symposium on Dodd Frank Year One.

Dodd-Frank at 1: Say on Pay

Lisa Fairfax has a nice write up of the experience to date.

Derivatives and the Legal Origin of the 2008 Credit Crisis

My friend and UCLAW colleague Lynn Stout has posted an interesting paper to SSRN entitled Derivatives and the Legal Origin of the 2008 Credit Crisis:

Experts still debate what caused the credit crisis of 2008. This Article argues that dubious honor belongs, first and foremost, to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not primarily due to changes in the markets; it was due to changes in the law. In particular, the crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus, as an empirical matter, the social welfare consequences of derivatives trading depend on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the Commodity Exchange Act (CEA) largely replaced the common law. Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. For many decades, this regulatory system also kept derivatives speculation from posing significant problems for the larger economy.

These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in 2000 with the enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systemically important financial institutions (and the near-failures of several others) due to bad derivatives bets. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside of a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.

"It’s baaack: The Shareholder Protection Act"

Ribstein doesn't like it any better than I do.

Say on pay fizzles

Steve Bradford:

The latest results on “say on pay” voting are in. As readers of this blog probably know, the Dodd-Frank Act added a new section 14A requiring “say on pay,” shareholder votes on the compensation of senior executives. In February, the SEC adopted a new Rule 14a-21 providing for such votes.

The Wall Street Journal reports that shareholders at 39 of 2532 companies conducting such votes voted against executive pay plans. At 71% of the companies, the executive pay plans received at least 90% support.

The policy implication of these numbers is unclear. Is the 98.5% approval rate a strong argument against requiring companies to go through this exercise? Or should we focus on the small number of companies where shareholders voted against management? Even at the latter companies, the vote won’t necessarily have any effect. Under the SEC rules, these votes are purely advisory. A company has no obligation to eliminate a pay plan rejected by the shareholders.

In response to his question, "Is the 98.5% approval rate a strong argument against requiring companies to go through this exercise?," my answer would be a resounding YES.

"Why Proxy Access (Sec Rule 14a-11) is Harmful to Corporate Governance"

Bernard Sharfman has posted Why Proxy Access (Sec Rule 14a-11) is Harmful to Corporate Governance:

A key aspect of the current proxy access rules is that they are, for all intents and purposes, mandatory. There is no opportunity to opt-in or at least opt-out. This one-size-fits-all approach to corporate governance is wealth reducing because it does not allow for private-ordering. In addition, federally mandated proxy access eliminates the benefits of our federalist system from this area of corporate governance.

But there is something even more fundamentally wrong with proxy access. That is, it is a very inefficient means to promote good corporate governance in a public company. As argued here, it is expected that proxy access will lead to increased error in the nomination of directors as decision-making is moved from the board of directors to shareholders who will make their nominations based on significantly less information and a shifting of the potential for certain opportunistic behavior, such as the extracting of private benefits from the corporation, from an independent board and nominating committee to certain shareholders who, unlike directors, are not subject to fiduciary duties. Moreover, even if proxy access can be argued to be good for corporate governance, Rule 14a-11 is not designed to be the optimal default rule.

 I'm in substantial agreement with his analysis.