ProfessorBainbridge.com

Insider Trading: Miller v. Verstein

Two of my favorite corporate law scholars are jousting over insider trading. I like them both too much to try to referee, but both articles are well worth reading:

Verstein, Andrew, Mixed Motives Insider Trading (March 21, 2020). Iowa Law Review, Vol. 106, 2020, UCLA School of Law, Law-Econ Research Paper No. 20-05, Available at SSRN: https://ssrn.com/abstract=3558540 or http://dx.doi.org/10.2139/ssrn.3558540

If you trade securities on the basis of careful research, then you are a brilliant and shrewd investor. If you trade on the basis of a hot tip from your brother-in-law, an investment banker, then you are a criminal. What if you trade for both reasons?

There is no single answer, thanks to a three-way circuit split. Some courts would forgive you according to your lawful trading motives, some would convict you in keeping with your bad motives, and some would hand the issue to the jury. Sometimes called the “awareness/use” debate or the “possession/use” debate, the proper treatment of mixed motive traders has occupied dozens of law review articles over the last thirty years.

This Article demonstrates that courts and scholars have so far followed the wrong reasons to the wrong answers. Instead, this Article takes trader motives seriously, drawing on insights and solutions from the broader jurisprudence of mixed motive. This analysis generates a new legal test and demonstrates the test’s superiority.

Miller, Robert T., Market Practices and the Awareness/Use Problem in Insider Trading Law: A Response to Professor Verstein’s Mixed Motives Insider Trading (November 15, 2022). Iowa Law Review, Vol. 107, No. 162, 2022, U Iowa Legal Studies Research Paper No. 2022-41, Available at SSRN: https://ssrn.com/abstract=4277164

Professor Verstein suggests that we approach the awareness/use problem in insider-trading law by analyzing the mixed-motives of insider traders, and he argues that insider trading should be illegal only when the trader’s primary reason for trading involves proscribed material non-public information (MNPI). To reach this conclusion, he assumes what he calls the “Equal Profits Principle,” which holds that two traders alike in all respects except for their knowledge of MNPI should enjoy the same expected profits from trading. This Response argues that the Equal Profits Principle can be analyzed into the “No Greater Profits Principle” (traders with MNPI should not make more than other traders) and the “No Lesser Profits Principle” (traders with MNPI should not make less than other traders), and that while the No Greater Profits Principle is intuitively plausible, the No Lesser Profits Principle is not. In particular, both classical insiders and potential misappropriators are in contractual relationships with the sources of their MNPI, and the standard market practice is for such persons to agree with the source, in exchange for compensation, to refrain from trading while in possession of MNPI (not merely to refrain from using MNPI to trade). In fact, public companies and other firms regularly in possession of large amounts of MNPI typically adopt insider trading policies that not only prohibit their employees from trading when in possession of MNPI, but also go considerably further, imposing blackout periods (when all trading is prohibited) and pre-clearance rules (which require certain senior employees to pre-clear all their trades with a compliance officer, regardless of whether they are in possession of MNPI). Such policies are efficient in the sense that they produce benefits in excess of their costs, and since they are manifestly incompatible with the Equal Profits Principle (because they violate the No Lesser Profits Principle), that principle is inefficient and very likely untenable. A better way to deal with the awareness/use problem is to follow the market consensus, which strongly favors the awareness rule.

Although not taking sides, as a point of personal privilege, I must note that only Professor Verstein cites the work of yours truly. Tsk.

Keith Bishop on the Recent McDonald's Decision re Officers' Fiduciary Duties: Why is Delaware Involved?

I blogged my take on VC Laster's recent McDonald's decision and that of Kevin LaCroix. Now comes Keith Bishop:

Today's post does not question the ruling, but does question why the case is in Delaware and why Delaware law is being applied.

Although McDonald's Corporation was incorporated in Delaware, its principal executive office is in Chicago and I assume that Mr. Fairhurst was employed in Illinois and not in Delaware.  So why is Mr. Fairhurst subject to the personal jurisdiction of the Court of Chancery?  Vice Chancellor Laster provides the explanation:

The absence of an earlier decision holding that officers owe oversight duties likely has a more practical explanation. Before January 1, 2004, Delaware’s jurisdiction-by-consent statute did not extend to officers.  See Del. S.B. 126, 149th Gen. Assem., 81 Del. Laws ch. 83 (2003).  After that date, stockholder plaintiffs moved slowly to name officers as defendants. Only recently has naming officers as defendants become more frequent, prompting the General Assembly to authorize exculpation for officers for stockholder claims, albeit not for claims by or in the name of the corporation, effective August 1, 2022.  Del. S.B. 273, 151st Gen. Assem., 83 Del. Laws ch. 377 (2022).

The fly in the ointment ( Ecclesiastes 10:1) is that the Delaware's jurisdiction-by-consent statute is constitutionally suspect.  See Will Mallory Doom Delaware's Officer Exculpation Statute And Its Corporate Hegemony?

Bishop goes on to point out that conflicts of law rules may lead to a result other than applying Delaware law. He raises some great points.

A New ProfessorBainbridge.com Video: The Profit Motive: Defending Shareholder Value Maximization

Professor Bainbridge's recent writing on corporate purpose, ESG, corporate social responsibility, and stakeholder theory

I gave a talk today to the American Bar Association's Business Law Section's Mergers and Acquisitions Committee. The talk was mostly about my new book, but I promised to post links to all of my recent work in this area:

My forthcoming book (February 9 but available for preorder now):  The Profit Motive: Defending Shareholder Value Maximization.

What responsibility, if any, does a corporation have to society? How should corporations balance environmental, social, and governance factors? The Profit Motive addresses these questions of corporate purpose using historical, legal, and economic perspectives. Stephen M. Bainbridge enters the debate around corporate social responsibility to mount an unabashed defense of shareholder capitalism and maximizing shareholder value. The book offers context for the current questions about corporate purpose, and provides a reference going forward. Direct and corrective, The Profit Motive argues that shareholder value maximization is not only required by law, but what the law ought to require.

Why We Should Keep Teaching Dodge v. Ford Motor Co.,  48 Journal of Corporation Law 77 (2022)

What is the purpose of the public business corporation? Is it to maximize shareholder value? Or is it to simultaneously enhance the welfare of shareholders, stakeholders, and the larger society? These are perennial questions, of course, but they also have been much in the news in recent years. Whether tagged as stakeholder capitalism, stakeholder theory, corporate social responsibility, or ESG (i.e., environmental, social, and governance), much attention is being paid.

The time has thus seemed propitious to many legal scholars to revisit the law of corporate purpose. Many of these scholars have been influenced by the late Lynn Stout’s work on the topic. Ten years ago, Stout published her book, The Shareholder Value Myth, which built on her earlier article, Why We Should Stop Teaching Dodge v. Ford. As the latter title suggests, Stout’s principal foil was the Dodge case.

Stout’s focus on Dodge was well chosen, as the case is included in almost all law school corporation law and business association casebooks and has been widely discussed in the academic literature. The influence of Stout’s critique of Dodge work was confirmed by a March 31, 2022, search of the Westlaw Law Reviews and Journals database, which identified 98 articles published in the last three years that cited her book and 43 during the same period that cited her article.

Given the renewed attention to the corporate purpose question and the continuing influence of Stout’s work on that debate, it seems appropriate to revisit her arguments to determine whether she was correct that law professors should stop teaching Dodge. I conclude that law professors ought to keep teaching Dodge. It was good law when handed down in 1919 and remains good law today.

Don’t Compound the Caremark Mistake by Extending It to ESG Oversight, 77 The Business Lawyer 651 (2022)

The question addressed in this article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with environmental, social, and governance (ESG) issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to ensure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational. The article concludes that Caremark should not be so extended.

Christianity and Corporate Purpose, in Christianity and Market Regulation: An Introduction 101 (Cambridge University Press; Daniel A. Crane & Samuel Gregg eds. 2021)

This essay compares and contrasts the law governing corporate purpose with the pertinent Christian teachings from Scripture and Tradition, with a special focus on Catholic social thought.

Making Sense of the Business Roundtable’s Reversal on Corporate Purpose, 46 Journal of Corporation Law 285 (2021)

In August 2019, the Business Roundtable (BRT) issued a statement on the purpose of the corporation in which it reversed a longstanding position. Since 1978, the BRT has periodically issued statements on Principles of Corporate Governance, which purport to summarize law and best practice in this area. Since 1997, all versions of those statements had embraced the view that corporations exist primarily to serve their shareholders. In contrast, the 2019 version contains a much broader conception of corporate purpose, which posits that corporations should “commit to deliver[ing] value to all of” the corporation’s stakeholders.

Obviously, the BRT cannot unilaterally change the law. As this article explains, the law of corporate purpose remains that directors have an obligation to put shareholder interests ahead of those of other stakeholders and maximize profits for those shareholders.

What people do matters more than what they say. To date, the evidence is most BRT members remain committed to shareholder value maximization, despite their recent rhetoric to the contrary. This should not be surprising. The incentive structure faced by directors and managers still skews in favor of shareholders.

Why then did the BRT shift position? This article suggests two possibilities. First, the members may be engaged in puffery intended to attract certain stakeholders for the long-term benefit of the shareholders. Specifically, they may be looking to lower the company’s cost of labor by responding to perceived shifts in labor, lower the cost of capital by attracting certain investors, and increase sales by responding to perceived shifts in consumer market sentiment. They may also be trying to fend off regulation by progressive politicians. Second, some BRT members may crave a return to the days of imperial CEOS.

Corporate Purpose in A Populist Era, 98 Nebraska Law Review 543 (2020)

In the wake of the 2016 U.S. presidential election and similar devel- opments in parts of Europe, commentators widely acknowledged the rise of populist movements on both the right and left of the political spectrum that were deeply suspicious of big business. This development potentially has important implications for the law and practice of corporate purpose.

Left-of-center corporate social responsibility campaigners have long advocated the use of “boycotts, shareholder activism, negative publicity, and so on” to pressure corporate managers to act in ways those campaigners deem socially responsible. Right-of-center populists could use the same tactics to induce corporate directors to make decisions they favor. The question thus is whether they are likely to do so based on their historical track record.

Assuming for the sake of argument that right-of-center populists be- gin focusing on corporate purpose, the question arises whether modify- ing the shareholder wealth maximization norms to give managers more discretion to take the social effects of their decisions into account would lead to outcomes populists consider desirable. Populists histori- cally have viewed corporate directors and managers as elites opposed to the best interests of the people. Today, right-of-center populists find themselves increasingly at odds with an emergent class of social justice warrior CEOs, whose views on a variety of critical issues are increas- ingly closer to those of blue state elites than those of red state populists.

Kevin LaCroix on VC Laster's "explosive" McDonald's decision

Apropos my post yesterday, Kevin LaCroix of the invaluable D&O Diary blog has weighed in on VC Travis Laster's opinion n In re McDonald's Corp. Stockholder Deriv. Litig., in which the VC held that Caremark's over sight duty applies to officers as well as directors.

As is his wont, Kevin provides extensive factual background. In delving into the opinion's analysis of the legal issues, he points out that:

While recognizing that corporate officers have a duty of oversight, “its context-driven application will differ.” Some company officers – for example, the CEO – will have company-wide oversight responsibilities, while other officers oversight responsibilities will generally pertain to their “particular areas of responsibility.” However, officers can be liable for violations of the duty of oversight only “if a plaintiff can prove that they acted in bad faith and hence disloyally.”

As developed by the Delaware Courts, a breach of the duty of oversight claim can be either an “Information-Systems Claim” (that is, failing to have systems in place to facilitate necessary oversight) and a “Red-Flags Claim.” Vice Chancellor Laster determined that the plaintiffs’ claims against Fairhurst were of the red flags variety. In order for a red flags claim to survive a dismissal motion, Vice Chancellor Laster said, a plaintiff must plead facts sufficient to support an inference that the fiduciary knew of evidence of corporate misconduct; that the fiduciary consciously failed to take action; and that the failure was sufficiently sustained, systematic, or striking to constitute action in bad faith.

Kevin shares my concern that "the Delaware courts are going too far in sustaining breach of the duty of oversight claims," noting the telling point that:

Vice Chancellor Laster’s opinion omits this ritualistic restatement of how difficult it is for plaintiffs to sustain a breach of the duty of oversight claim.

And he shares my concern that Fairhurst's misconduct, while doubtless egregious, did not go to the sort of existential, "mission critical" failures that drove the recent Marchand and Boeing decisions:

My concern here is that in light of this decision, it may be easier for plaintiffs to sustain claims that both officers and directors have breached their duty of oversight. In that regard, I note that academic commentators had already raised the alarm that oversight duty breach claims are not in fact the most difficult kind of claim to sustain, and in fact they increasingly are being sustained with alarming frequency.

(By the way, he kindly links to me in that passage.)

Critically, however, Kevin also points out that:

In a short but nonetheless important final section of his opinion that could be overlooked given his other holdings on the duty of oversight issue, Vice Chancellor Laster addressed the plaintiffs’ further and analytically distinct allegation that Fairhurst had also violated his fiduciary duties by engaging personally in acts of sexual harassment.

In concluding that the plaintiffs had sufficiently stated a claim on this basis, Vice Chancellor Laster noted that “When Fairhurst engaged in sexual harassment, he was not acting subjectively to further the best interests of the Company. He was therefore acting in bad faith.” Laster added further that “It is not reasonable to infer that Fairhurst acted in good faith and remained loyal to the Company while committing acts of sexual harassment, violating company policy, violating positive law, and subjecting the Company to liability. It is reasonable to infer that Fairhurst acted disloyally and for an improper purpose, unrelated to the best interests of the Company.”

This may in fact be a more important aspect of the opinion than that dealing with the Caremark issue on which I focused. Kevin aptly calls it "explosive."

Vice Chancellor Laster’s conclusion about breach of fiduciary duty claims based on alleged sexual misconduct is most unfortunate. I could be proven wrong – and I hope I am – but there is a very real risk that the court’s recognition of the validity of this type of claim could indeed open the floodgates to these kinds of shareholder claims.

As regular readers know, I am a great admirer of Kevin's work in this area. He is one of the most well informed and erudite commentators on the broad set of corporate law and governance issues loosely group as D&O questions. His post is one that everyone in the corporate law area needs to read and study.

In re McDonald's Corp. Stockholder Litig.: Caremark is the Chicken Heart

Arch Oboler was an American entertainer perhaps best known for running the 1930s radio drama Lights Out. One of his most famous stories was The Chicken Heart. In brief, a mad scientist keeps a disembodied chicken heart alive and beating. Until one day the apparatus is overturned and smashed. And disaster followed:

That apparatus - robot-heart or whatever you want to call it - was accidentally smashed and over the week-end, in some miraculous manner, that little chicken heart no larger than my thumb-nail grew into a mass of pulsing flesh a thousand times its original size! ...

When those women knocked over the apparatus - it fell against that rack of chemicals! Is it not possible that some unknown combination of those reagents acting upon the tissue resulted in what you choose to call a "miracle" - the super-growth of this heart, this independent existence of an organ outside its own bodily environment?

And the chicken heart kept growing. And started moving:

With my own eyes I saw it! It moved out until it reached that case of white mice there and then it - it wrapped itself around one of the mice! ... Then - then the tentacle retracted itself and the mass of flesh engulfed the mouse!

And still it grew:

That little piece of flesh has grown until now it's jamming that building with flesh! All inside the space of an hour!

Until:

The end has come for humanity - not in the glory of interstellar combustion - not in the peace of white cold silence - but (IN DISGUST) with that - creeping, grasping flesh below us! It is a joke, eh, Lewis? A great joke! The joke of the Cosmos! The end of mankind - because of a chicken's heart!

That tale of horror came to mind when I read Delaware Vice Chancellor Travis Laster's opinion in In re McDonald's Corp. Stockholder Deriv. Litig., in which the VC held that Caremark's over sight duty applies to officers as well as directors.

At this point, I pause to ask readers unfamiliar with Caremark to skip over to my earlier post: After Boeing, Caremark is no longer "the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment". It will provide necessary background on Caremark's growth. For those wishing still more on why Caremark was wrong from the outset and has grown into a massive mistake, I refer you to my article Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 2021).

First, Caremark was wrong from the outset. In the original Caremark decision, the unique procedural posture of the case, which was such that it would not be appealed, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors' oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.

Second, Caremark was further mangled by subsequent decisions. The underlying fiduciary duty was changed from that of care to loyalty, with multiple adverse effects. In recent years, moreover, there has been a steady expansion of Caremark liability. Even though the risk of actual liability probably remains low, there is substantial risk that changing perceptions of that risk induces directors to take excessive precautions.

In brief, the allegations are that McDonald's chief Human Resources executive (Fairhurst) ignored red flags about a culture of sexual harassment in certain McDonald's locations and that Fairhurst himself committed sexual harassment.

The plaintiffs have sued Fairhurst for breach of the duty of oversight, and they also have sued Fairhurst for breaching his duty of loyalty by engaging personally in acts of sexual harassment.

The opinion is long with an exhaustive history of Caremark's evolution. But three paragraphs capture the gist:

This decision clarifies that corporate officers owe a duty of oversight. The same policies that motivated Chancellor Allen to recognize the duty of oversight for directors [in In re Caremark International Inc. Derivative Litigation] apply equally, if not to a greater degree, to officers. The Delaware Supreme Court has held that under Delaware law, corporate officers owe the same fiduciary duties as corporate directors, which logically includes a duty of oversight. Academic authorities and federal decisions have concluded that officers have a duty of oversight."
 
The fact that corporate directors owe a duty of oversight does not foreclose officers from owing a similar duty. Just as a junior manager with supervisory duties can report to a senior manager with supervisory duties, so too can an officer with a duty of oversight report to a board of directors with a duty of oversight. And just as a senior manager with supervisory duties can hold a junior manager accountable for failing to fulfill the junior manager’s supervisory duties, so too can a board with a duty of oversight hold an officer accountable for failing to fulfill the officer-level duty."
 
Although the duty of oversight applies equally to officers, its context-driven application will differ. Some officers, like the CEO, have a company-wide remit. Other officers have particular areas of responsibility, and the officer’s duty to make a good faith effort to establish an information system only applies within that area. An officer’s duty to address and report upward about red flags also generally applies within the officer’s area, although a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain. As with the director’s duty of oversight, establishing a breach of the officer’s duty of oversight requires pleading and later proving disloyal conduct that takes the form of bad faith.

VC Laster seemingly was determined to make that arguably unprecedented jump (he devotes a lot of the opinion to the question of whether it had precedents), as he rewrote the plaintiff's complaint for them. Plaintiff's had alleged Fairhurst breached his duty of care, which Laster acknowledged was "insufficient." Because Delaware has adopted notice pleading, the question "is whether the complaint contained a short, plain statement of facts sufficient to support a claim against Fairhurst for breach of the duty of oversight," which VA Laster concluded they had done.

There is a certain logic to Laster's conclusion. After all, in general, Delaware law holds that officers have the same fiduciary duties as directors. As Spock's mother Amanda once said, however, "Logic! I'm sick to death of logic!"

Every step along the way there has been a certain logic to the expansion of Caremark, but at some point we have to wonder if we want Caremark to swallow the whole of corporate law.

Caremark started out as a logical consequence of Smith v. Van Gorkom. Directors must make informed decisions, which means they must ensure there are systems in place to provide them with the information necessary to making a fully informed decision. 

Most of what directors do, however, consists of supervision and oversight not discrete decision making. So it was logical to say that directors needed to ensure the corporation had information and reporting systems sufficient to ensure their monitoring efforts would detect wrongdoing at lower levels of the corporation.

But what sort of wrongdoing? Caremark started out as dealing with law and accounting compliance. In an important decision that the Delaware courts seem to have forgotten, former Chancellor William Chandler explained that it was essential to keep Caremark within those boundaries:

To the extent the Court allows shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor business risk, the Court risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions.

In re Citigroup Inc. Shareholder Derivative Litig., 964 A.2d 106, 126 (Del. Ch. 2009). As a result, Delaware courts long “routinely dismissed Caremark claims at the motion to dismiss stage, even in the face of substantial ‘corporate traumas.’”

Granted, as I have acknowledged, there was a certain logic to expanding Caremark to business risks. In general, however, even the recent cases most aggressively pushing the boundaries between legal and business risk-- such as Marchand and Boeing, both of which have been criticized here--have involved failures of board oversight of mission critical risks in areas that posed significant risk of harm to the public, such as food and drug safety.

I do not wish to minimize the toxic nature of the culture allegedly created at McDonalds during Fairhurst's tenure. Nor do I wish to minimize the trauma suffered by its victims.

But there are significant differences between this case and even cases like Marchand and Boeing:

• It involves an officer rather than the board.
  
  • At least by 2018, the Board was aware of the problems and was dealing with them.
• There is no allegation of pervasive criminal conduct (one of Fairhurst's own acts of misconduct is described as "technically" constituting an assault), especially by the people that Fairhurst was charged with supervising. (Presumably, Fairhurst has no Caremark duty to supervise himself).
• The problem is not a lack of supervision or oversight, but rather one of inaction in the face of a known problem. The decision of how to handle sexual harassment is a business decision. Fairhurst and the McDonald's C-suite handled the decision poorly but that's not what Caremark is supposed to be about.
• As appalling as Fairhurst and CEO's conduct undoubtedly was, it never posed the sort of existential threat that were involved in Marchand and Boeing. 
• In Marchand, the regulatory violations were not just important. "Food safety was the 'most central safety and legal compliance issue facing the company.'” In re Boeing Co. Derivative Litig., CV 2019-0907-MTZ, 2021 WL 4059934, at *26 (Del. Ch. Sept. 7, 2021).
  • The Marchand court observed that Blue Bell (an ice cream manufacturer) was a mono-line business for which "food safety was essential and mission critical. Marchand v. Barnhill, 212 A.3d 805, 824 (Del. 2019).
  • The Marchand board's oversight failures allowed listeria to "engulf" the company.
  • As a result, "to recall all of its products, shut down production at all of its plants, and lay off over a third of its workforce. ... Less consequentially, but nonetheless important for this litigation, stockholders also suffered losses because, after the operational shutdown, Blue Bell suffered a liquidity crisis that forced it to accept a dilutive private equity investment."
  • There is simply no suggestion anywhere in the McDonald's opinion that the problems posed an existential problem of comparable magnitude as the problems Blue Bell faced.
• "Like food safety in Marchand, airplane safety “was essential and mission critical” to Boeing's business, and externally regulated." In re Boeing Co. Derivative Litig., CV 2019-0907-MTZ, 2021 WL 4059934, at *26 (Del. Ch. Sept. 7, 2021).
  • "The crashes caused the Company and its investors to lose billions of dollars in value."
  • "The 737 MAX fleet was grounded for twenty months ...."
  • "In 2020, Boeing estimated that it had incurred non-litigation costs of $20 billion, and litigation-related costs in excess of $2.5 billion."
  • "And in January 2021, Boeing consented to the filing of a criminal information charging the Company with conspiracy to defraud the United States and thereby incurring billions of dollars in penalties."

Maybe there was a certain logic to dealing with such existential trauma under Caremark. But the McDonald's misconduct simply doesn't rise to the same level.

In sum, Caremark has now grown to encompass what amounts to Human Resources mismanagement. What should have been a matter of employment law (and punished severely thereunder) has become a matter of the most controversial doctrine in corporate law.

To be sure, VC Laster anticipated just such a complaint:

Some might ask whether the Court of Chancery should be hearing sexual harassment claims and worry that recognizing such a claim will open the floodgates to employment-style litigation. ...

... Like an oversight claim, a claim for breach of duty based on the officer’s own acts of sexual harassment is derivative, so all of the protections associated with derivative claims apply.

But so what? Is Laster saying that if Fairhurst had moved to dismiss for failure to make demand that Fairhurst would have won? If so, why rewrite plaintiff's complaint but not defendant's motion? (Presumably some aspect of civil procedure that escapes me.) And how is sexual harassment different than all the other forms of managerial misconduct that until now lay outside the scope of Caremark.

I do not see a firebreak between Laster's decision and "employment-style litigation." But I do see a slippery slope.

Twitter Pushed Stakeholders Under the Bus: Just as my new book would have predicted

Lucian Bebchuk et al.:

We just posted on SSRN a new discussion paper, How Twitter Pushed Stakeholders under the Bus.(An earlier post noting our work on this project and our take on the subject is available here.)

This paper provides a case study of the acquisition of Twitter by Elon Musk. Our analysis indicates that when negotiating the sale of their company to Musk, Twitter’s leaders chose to disregard the interests of the company’s stakeholders and to focus exclusively on the interests of shareholders and the corporate leaders themselves. In particular, Twitter’s corporate leaders elected to push under the bus the interests of company employees, as well as the mission statements and core values to which Twitter had pledged allegiance for years.

Our analysis supports the view that the stakeholder rhetoric of corporate leaders, including in corporate mission and purpose statements, is mostly for show and is not matched by their actual decisions and conduct (Bebchuk and Tallarita (2020)). Our findings also suggest that corporate leaders selling their company should not be relied upon to safeguard the interests of stakeholders, contrary to the predictions of the implicit promises and team production theories of Coffee (1986), Shleifer-Summers(1988) and Blair-Stout (1999).

A basic point of my new book is that ESG is a means to an end and not an end in and of itself. Twitter is just the latest example.

;

ChatGPT flunks an essay question on shareholder primacy versus director primacy

In an earlier post, I mused on whether ChatGPT and coming AI systems will spell the end of traditional law school exams. Which got me to wondering how ChatGPT would do on an essay question near and dear to my heart.

I asked:

Explain the differences between the shareholder primacy and director primacy theories of corporate governance

ChatGPT answered:

Shareholder primacy theory holds that the primary goal of a corporation is to maximize shareholder wealth. Under this theory, the board of directors is primarily accountable to the shareholders and should make decisions that will increase the value of their investments.

Director primacy theory, on the other hand, holds that the primary goal of a corporation is to serve the best interests of the company as a whole, not just the shareholders. Under this theory, the board of directors has a fiduciary duty to act in the best interests of the company and all of its stakeholders, including employees, customers, and the community.

In summary, Shareholder primacy theory focuses on maximizing shareholder wealth, Director primacy theory focuses on serving the best interests of the company as a whole, This means that the board of directors has a fiduciary duty to act in the best interests of the company and all of its stakeholders, not just the shareholders.

The definition of shareholder primacy is only half right (shareholder primacy also speaks to who has ultimate control of the corporation). The definition of director primacy is completely wrong. Indeed, egregiously so. See my list of director primacy bullet points.

ChatGPT: The End of Law School Essay Exams?

From The NY Times:

While grading essays for his world religions course last month, Antony Aumann, a professor of philosophy at Northern Michigan University, read what he said was easily “the best paper in the class.” It explored the morality of burqa bans with clean paragraphs, fitting examples and rigorous arguments.

A red flag instantly went up.

Mr. Aumann confronted his student over whether he had written the essay himself. The student confessed to using ChatGPT, a chatbot that delivers information, explains concepts and generates ideas in simple sentences — and, in this case, had written the paper.

This is going to require law schools to rethink the traditional essay exam format. 

Especially because ChatGPT is just the opening wedge:

OpenAI is expected to soon release another tool, GPT-4, which is better at generating text than previous versions.

Personally, I switched to multiple choice some years ago when I had a semester in which I had to teach 2 sections of Business Associations, each of which had 100+ students. Worryingly, although ChatGPT reportedly failed to pass a multistage multiple choice bar exam, it did pass the evidence and torts sections.

Yours truly interviewed re Nelson Peltz's run at Disney

From Yahoo news:

Trian, which Peltz cofounded in 2005, oversees about $8 billion in assets under management. “That has enabled them to take on some big game,” said Stephen Bainbridge, a professor at the UCLA School of Law who has extensively researched corporate governance.

“I would say that on the spectrum of hedge fund activists, that Peltz is definitely at the aggressive end,” Bainbridge continued, though he noted that in many cases, Trian has made “changes that were regarded as helpful.”

The trouble is getting executives to listen without a protracted battle, he said, since CEOs are known for “big egos” and “nobody wants what they would regard as a sort of professional rabble-rouser coming in and telling them to change their plans.”

...

To his critics, Peltz’s tactics prioritize short-term returns over long-term financial health. “They’re in it and then out of it,” Bainbridge said, summarizing the argument against many hedge fund investors. (Trian has said the firm invests in companies for an average length of six years when it receives a board seat, longer than some competitors.)

...

Despite his triumphs, in recent years Peltz’s name has more often been associated with his daughter, Nicola, who last spring married the son of soccer legend David Beckham and fashion designer Victoria Beckham. The event took place at Peltz’s Palm Beach estate.

“There’s a certain amount of irony here that a guy who’s a multi-billionaire, and in the corporate world is known and feared… is sort of in the back of a picture with a bunch of Beckhams in it,” said Bainbridge. “It’s kind of funny that way.”

Should we hold corporations liable or the officers and directors who run them? Specifically, social media companies?

A journalist recently posed the following question to me:

I'm looking at the U.K. Government's recent moves to add an amendment to its forthcoming Online Safety law, to create criminal sanctions for the executives of social media companies that are in breach of the law.

On the one hand, this suggests social media companies will work harder to comply with the British regulator that is enforcing the new guidelines, and this seems necessary given that so many of these firms have failed to prevent harm on their networks and have hitherto seen regulatory fines as a cost of doing business. On the other hand, this sort of move would also seem to do more to pierce the corporate veil, which could undermine efforts by corporations to mitigate risk for directors and employees.

The question of individual versus institutional liability is a very interesting one.

There is an argument for imposing civil liability on corporations and other institutions (i.e., legal persons) where their agents commit torts or breach contracts. A major function of civil liability, after all, is compensation of victims of malfeasance and misfeasance. The legal person will often have far deeper pockets than any of the natural persons amongst its stakeholders. Having one defendant rather than many, moreover, reduces tertiary costs for both parties and society.

Having said that, however, I'm not completely convinced. In the first place, most major corporate misconduct implicates senior corporate officials, such that a regime of personal--rather than corporate--liability would provide them with incentives to cause the corporate entity to insure against the risk of such losses, which satisfies the goal of compensation.

More important, however, the role of compensation as a justification for corporate liability is more complicated than one might think. In an important article, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. Ill. L. Rev. 691, Jennifer Arlen and William Carney tackled this question with regard to corporate liability for securities frauds committed by agents of the firm. As they demonstrate, when a corporation pays a large fine the resulting balance sheet effect is to reduce assets on the left side. On the right hand side, liabilities remain constant. To offset the decline in net assets, accordingly, shareholder equity must fall. As a result, the effect of civil monetary liability is to replace "one group of innocent victims with another: those who were shareholders when the fraud was revealed. Moreover, enterprise liability does not even effect a one-to-one transfer between innocent victims: a large percentage of the plaintiffs' recovery goes to their lawyers. Finally, enterprise liability may injure innocent people in addition to shareholders. For example, employees are injured if enterprise liability sends a firm into bankruptcy or causes it to lay off employees." Id. at 719.

The case for corporate criminal liability is even weaker. The principal functions of criminal liability are retribution and deterrence.

A corporation is not a moral actor. Edward, First Baron Thurlow, put it best: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?" The corporation is simply a nexus of contracts between factors of production. As such, there is no moral basis for applying retributive justice to a corporation - there is nothing there to be punished.

So who do we punish when we force the corporation to pay fines? Since the payment comes out of the corporation's treasury, it reduces the value of the residual claim on the corporation's assets and earnings. In other words, the shareholders pay. Not the directors and officers who actually committed the alleged wrongdoing. Retributive justice is legitimate only where the actor to be punished has committed acts to which moral blameworthiness can be assigned. Even if you assume the corporation is still benefiting from alleged wrongdoing, the shareholders are mere holders in due course. It is therefore difficult to see a moral basis punishing them. They have done nothing for which they are blameworthy.

As always in corporate accountability, both efficiency and morality require that punishment be directed solely at those who actually commit wrongdoing. In this context, it would be the directors, officers, or controlling shareholders who actually committed the wrong. 

My conclusion in this regard was influenced in part by the Arlen and Carney paper, which argues for imposing liability on the corporation's agents: “we find that there is little reason to believe that enterprise liability is the superior rule from the standpoint of deterrence, and there are many reasons to suspect the contrary. The deterrent effect of the available monetary sanctions under agent liability probably exceeds the deterrent effect of enterprise liability because a civil judgment against an agent hurts his reputation more than does a sanction imposed by the firm in private. Moreover, the threat that sanctions will be imposed appears to be greater under agent liability. Agent liability places the responsibility of sanctioning wrongful agents with the victims, who have no reason not to proceed against them and have every reason to proceed. Enterprise liability, by contrast, places the responsibility of proceeding against the wrongful agents with the firm, and thus with the very agents (and their close associates) most likely to have committed fraud. Moreover, agent liability in effect enlists insurance companies as corporate monitors and disciplinarians, thereby eliminating the agency costs associated with firm managers monitoring and disciplining each other. Furthermore, the judgment proof problem under agent liability can be completely eliminated if, in addition to civil liability, the government imposes sufficient nonmonetary criminal penalties on agents, such as imprisonment.”

Holding individual corporate actors is not inconsistent with limited liability. As I explained in my book, Limited Liability: A Legal and Economic Analysis (Edward Elgar Publishing 2016), coauthored with M. Todd Henderson (Chicago Law), the purpose of limited liability is to encourage investment by shareholders. As the residual claimants on corporate assets and earnings, shareholders do not get a return on their investment until all other claims on the corporation have been satisfied. Because risk and return are positively correlated, shareholders prefer that the corporation take on risky, high return projects so that something will be left over after all other claimants have been paid. By insulating shareholders from the downside risk of firm investments, limited liability thus incentivizes shareholders to use their voting control of the corporation to elect directors who will opt for business activities consistent with the risk preferences of shareholders rather than those of the more risk averse fixed claimants.

Officers and directors are in a different position. To be sure, there may be arguments for limiting their liability exposure to shareholders through doctrines such as the business judgment rule, but those arguments do not apply to civil or criminal liability.

Can Corporate Governance Solve Social Ills?

No one can deny that we live in an era with many social issues and ills, not least of which is wealth inequality and the adverse social and economic problems that flow from it. But can those of us who toil in the corporate law and governance do much to solve those problems.

But first we have to identify the problem.

Is the Problem that Corporations are Fundamentally Undemocratic?

Some commentators contend that corporations and corporate wealth benefit a narrow slice at the top of society and that the benefits of the corporate form need to be more widely available?

But share ownership is already broadly distributed: Since 2009, an average of 55% of Americans annually reported owning stock. Although only about 15% directly hold stocks, mutual funds and ETFs have democratized investing. As a result, today, American families hold an average of $40,000 worth of stocks. His hypothetical financial intermediaries already exist in the form of ESOPs and 401(k)s.

Moreover, access to the corporate form is widely and easily available to impecunious entrepreneurs. In most states today, it is possible to form a corporation with no requirement for a minimum amount of capital, using low cost forms widely available from online vendors, and with payment of a modest franchise tax. The problem thus is not that we need to “extend to all people the competitive market opportunity to acquire an interest in corporate capital acquisition with the future earnings of that capital in amounts that are not limited in proportion to their (meager or negative) existing wealth.”

The inequality of which Professor Ashford writes exists not because of the corporate form and what he repeatedly refers to as its legislated advantages. In preparing its annual billionaires list, Forbes gives each member of the list a self-made score from 1 to 10, with scores of 6 and higher going to those who built their business on their own without inherited wealth.

Well over half (238) of the top 400 billionaires scored 8 or higher. The top three Americans on the most recent list—Jeff Bezos, Mark Zuckerberg, and Elon Musk—all scored 8. I would argue that part of what enabled these folks to start from more or less nothing and achieve great wealth was the ready availability of the corporate form.

Is the Problem that the Corporate Form is Unfit for Purpose?

Instructively, the corporate form historically has been embraced—albeit sometimes grudgingly—by populists.

During the early 1800s Massachusetts corporations did not get the benefit of limited liability but Maine and New Hampshire corporations did. In Massachusetts a public debate over limited liability broke out during the 1820s, in which “Jacksonian liberals” contended that capital was fleeing Massachusetts for those neighboring states.

Moving forward, populists of the late 1800s and early to mid-1900s tended to focus on abuses of the corporate form rather than the corporate form itself. To be sure, some populists were simply doubtful of the corporation’s fitness for purpose, disputing its utility as a way of organizing production.  In time, however, most populists came to recognize that the problem was not the corporate form as such because they recognized that even locally owned and operated business could advantageously use the corporate form.

What is the Problem of the Corporation?

If there is problem with “the corporation” today, it is not with that there is some intrinsic flaw with the form itself. It is not with the legal rules that require boards and officers to maximize shareholder value.

Instead, the populists correctly identified that problem: Size.

Size and the resulting potential for concentrated economic power are the chief recurring themes in the populist critique of the corporation. Late nineteenth century populists thought that the growing power of corporations was a significant threat to their economic and even political liberty.  The Southern Agrarians likewise believed, as Lyle Lanier observed, that “the corporate form of our economic system makes possible a scale of exploitation unheard of in history.” They argued that workers toiled under dehumanizing conditions. The Southern Agrarians further believed that the concentration of economic power in large corporations had created “a plutocratic corporate capitalist class” that effectively ruled the country and thus stood ready to fully exploit their power over farmers and workers.

Size is not something corporate governance can do much, if anything about. Neither shareholder nor stakeholder capitalism addresses size and power issues in any meaningful or useful sense; nor, it seems to me, does inclusive capitalism.