ProfessorBainbridge.com

Best week ever at CodeCracker. No brag. Just fact.

Verstein on "Improving Corporate Governance with D&O Insurer Rotations"

My friend and UCLA colleague Andrew Verstein has had a busy summer. Over at CLS, he has posted a summary of his new article “Changing Guards: Improving Corporate Governance with D&O Insurer Rotations,” available here.

I explain that a pernicious mixture of agency costs and relational contracting is largely responsible. When corporations buy D&O insurance, it is the directors and officers who decide what to buy. These managers prefer policies without extensive loss-mitigating interventions that would constrain their freedom and expose them to criticism. Insurers would hesitate to offer such risky policies, but managers implicitly promise to cover any extra losses with lucrative future business. Renewal rates approach 100 percent.[2] These renewals occur despite increasing premiums. Global D&O premiums may be around $15 billion,[3] with U.S. premiums expected to perhaps double in the upcoming year.[4]Dependable renewals at higher rates allow insurers to recoup any losses and thus make them comfortable tolerating, rather than preventing, losses today; shareholders and society bear the cost of ever rising governance risk.

A solution is implicit in the diagnosis: Force corporations to rotate D&O insurers every few years.  Mandatory rotation would impose a final round on an otherwise indefinite insurance relationship. Theory predicts that it would stir both participants to action. If insurers know that they are going to lose a client soon, they will realize that there is no chance to recoup losses in the future and will seek to control their risks now. If executives know that insurers are going to demand and enforce risk-mitigation, they will know there is no benefit to paying extra for insurance from passive insurers and will seek to control their costs now. Both sides will seek benefits over a shorter period. That will help control governance risks that could harm shareholders and other stakeholders.

Do read the whole thing.

SEC Commissioner Hester Peirce on stakeholder capitalism

SEC Commissioner Pierce:

Companies add value to society by seeking to be profitable for their shareholders.  To do so, they make things people need.  In the process, they enrich their workers, business partners, and communities.

By shifting their focus to stakeholders rather than investors, CEOs may be attempting to distance themselves from their fiduciary duties to shareholders—fiduciary duties that are underpinned by moral principles.  Former Chief Justice of the Delaware Supreme Court Myron Steele argues that the morality imbued in Delaware corporate law’s fiduciary duties “holds corporate actors to a higher standard, discourages distasteful or unsavory conduct in blind pursuit of individual interests, and reflects the manner in which those same actors might interact in other, similar, but non-business contexts.”[46]  No such higher standard of conduct applies to the relationships between stakeholders and corporate officers and directors, so it is not surprising that those relationships are being used to justify certain business decisions.

Shibusawa [Eiichi, who is known as “the father of Japanese capitalism,"] again serves as an example of a better way.  He devoted his own time and resources to philanthropy.  He was an early supporter of one of Japan’s first institutions dedicated to the care of orphans, the elderly, and the disabled.[47]  He helped found the Japanese Red Cross, several of Japan’s leading educational institutions (including at least two institutions of higher education for women), and hospitals.[48]  He was known for never turning down a request for a meeting from an entrepreneur or a younger corporate manager and mentored hundreds of younger businessmen.[49]  It is wonderful when people earn money and spend it for good causes, but shareholders and corporate executives should earn the money first and only then give it away.  True, this is the harder road, as it requires each of us as individuals to give of our own time and resources and to give sacrificially, rather than letting shareholders foot the bill, but none of our great moral teachers ever said the path to virtue was an easy one.

SEC Commissioner Hester Peirce on Shibusawa Eiichi, “the father of Japanese capitalism”

Fascinating stuff. Japan just put his image on the 10,000 yes note. 

Shibusawa concluded that Japan’s economic development would require a transformation of values: disdain for commerce would need to give way to a respect for commercial enterprise.  This transformation would be impossible without convincing his fellow countrymen that commerce was itself a moral endeavor. ...

Shibusawa’s insight is one that is often overlooked, but it is important.  Voluntary commercial activity both requires and cultivates a heightened moral sensitivity in those who engage in commerce, and according value to those who engage in this activity helps build healthy societies.  Others have made the same point.  The most famous, of course, is Adam Smith, but consider economist Deirdre McCloskey, who argues that “[t]he growth of the market . . . promotes virtue, not vice.”  She repeatedly directs our attention to the ways that commercial activity forces us to attend to each other, to understand what each other wants or needs, and to find ways to satisfy those wants and needs.

Verstein on "The Problem with Insider Giving"

My friend and UCLA colleague Andrew Verstein has a post up at CLS on whether an insider can be held liable for insider trading when he donates stock to a charity while in possession of inside information.

Recommended.

Spicy fish and shrimp stew with Tablas Creek Vineyards Vermentino (Paso Robles) 2019

This recipe started out life as a Moqueca—the spicy Brazilian fish and shrimp stew—but swerved into a Thai lane somewhere along the way. 

• 1 6-ounce filet of mahi-mahi, cut into roughly 1 inch cubes
• 8 ounces medium shrimp, peeled and deveined (reserve shells)
• 1 cup milk
• pinch kosher salt
• 1 cup white wine
• 1 14.5-ounce can of diced tomatoes (I prefer Muir), strained (reserve juice)
• canola oil as needed
• ½ poblano Chile, minced
• white parts of 6 green onions, sliced thin
• 3 cloves garlic, crushed
• ½ tablespoon grated ginger
• 1 14.5-ounce can unsweetened coconut milk (not low fat)
• ½ tablespoon Gourmet Garden Thai seasoning mix
• 1 tablespoon fish sauce (I strongly recommend Red Boat, it’s so good you can drink it straight if you want, but why would you?)
• hot sauce to taste (I had a packet of Nando’s peri-peri sauce in the fridge, which I used)
• ¼ cup cilantro, chopped fine, loosely packed
• ⅓ cup green parts of the green onions, sliced thin, loosely packed

Place the shrimp and fish in a small bowl. Add the salt and the milk. Add water, if necessary, to cover. (This gets rid of any off odors.)

I heated a 1-quart sauce pan over medium-high heat for a couple of minutes. Next I added the reserved shrimp shells and cooked them, stirring constantly, for a minute or two. I add the wine, raised the heat to high, and brought the liquid to a boil. I let it boil for a minute or two and then added the reserved tomato juice. When the liquid returned to a boil, I reduce the neat to low and let it simmer to reduce slightly.

I heated my All-Clad 3-quart sauté pan for a couple of minutes over medium heat (6 out of 10) and then added enough canola oil to just lightly coat the bottom of the pan. In went the poblano chiles. They cooked for about 5 minutes. Then the onion whites went into the pan and the onions and chiles cooked for a couple of minutes. Then the garlic and ginger joined the party and sautéed for about 45 seconds. Finally, I added the strained and drained tomatoes and cooked the mixture for an outer couple of minutes. 

I strained the wine/tomato juice mixture into the sauté pan. I added the coconut milk, the fish sauce, the hoist sauce, and the Thai seasoning to the pan. I raised the heat to high and brought the sauce to a boil. I then added the seafood, covered the pan, and moved it off the heat to poach for about 10 minutes. I checked it every few minutes to make sure the shrimp were not overcooking. On the second check, I added the cilantro and green onions.

As it turned out, 8 minutes poaching time probably would have been enough, but the shrimp were still okay. 

I served it with some saffron rice, which further confused the origins of the dish, but tasted great. 

Put some Sriracha and fish sauce on the table to allow your guests to add as they see fit. (I like more spice and more fish sauce than Helen.)

The Tablas Creek Vermentino made a truly inspired match for the dish. Bright, fresh, tangy. Lots of citrus flavors: grapefruit, lemon, lime. A flinty note on the finish. Grade: B++

I have become a big fan of Tablas Creek wines and recommend them highly. I’ve yet to have a wine from them that wasn’t at least very good and most have been exceptional. 

What's Salesforce CEO Marc Benioff up to? Stakeholder capitalism or woke washing?

You will recall that we have been blogging a lot lately about the Business Roundtable statement on corporate purpose. You will also recall that I have argued that the statement is mostly about woke washing rather than a serious commitment to stakeholder capitalism:

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? ... 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.

Apropos of which, the WSJ reported today that:

A day after Salesforce.comInc. CRM -1.89% posted record quarterly sales, the business-software company notified its 54,000-person workforce that 1,000 would lose their jobs later this year.

I don't think even Scrooge would have told his employees that in a few months down the road 2% of them would be fired, leaving them to twist slowly in the wind for months while worrying whether they'll be among those who get fired.

What makes all of this especially pertinent is that Saleforce CEO Marc Benioff is one of the leading social justice warrior CEOs, constantly bragging about what a great human being he is.

As John Stoll opined in yesterday's WSJ:

Shareholders, the Business Roundtable pledged, would be just one of the stakeholder groups that a company would be judged on pleasing. Despite the trying times, boosters say that the ballyhooed effort is flourishing.

In a televised interview this week, Salesforce. CRM -1.89% com Inc. Chief Executive Marc Benioff called the company’s strong earnings “a victory for stakeholder capitalism.” A signatory to the pledge, Mr. Benioff said, ”We did a great job for our shareholders this quarter, but we also did a great job for our stakeholders.” ...

... how does the billionaire founder justify this claim when shortly after that interview Salesforce notified staff of plans for around 1,000 layoffs? This despite Mr. Benioff’s no-layoff pledge in March on Twitter and the challenge to other CEOs to follow his lead. (Hint: the pledge was for 90 days.)

Told you so.

Can you explain the efficient capital markets paradox? No, but I know some folks who can

A student in my Mergers and Acquisitions class asked that question. What a great question!

The classic articulation of the efficiency paradox comes from Grossman and Stiglitz, who were demonstrating the circularity of the efficient capital markets hypothesis. Their insight was that the very assumption of efficiency meant that no one would have an incentive to look for arbitrage opportunities (because embedded in the efficiency assumption is a no-arbitrage assumption). But the market can only arrive at efficiency if market players look for arbitrages and eliminate them. See Sanford J. Grossman & Joseph E. Stiglitz, On the Impossibility of Informationally Efficient Markets, 70 Am. Econ. Rev. 393, 404 (1980).

Stephen J. Choi & G. Mitu Gulati, Contract As Statute, 104 Mich. L. Rev. 1129, 1173 (2006).

The relationship of information to an efficient market is not as simple as this description makes it seem, however. Information is not magically reflected in the market price of shares. Efficient markets are efficient because there is a large number of analysts and traders in constant competition with each other over the acquisition of information.Whenever new information is revealed, these competitors will trade on it until any possibility of making an arbitrage profit is exhausted. The greater the number of market participants following a company, the more quickly new information will be reflected in that company's share price. By the same token, the larger the number of participants, the less likely it is that any one of them will be able to systematically profit on trading when information becomes available.

There is a well known paradox inherent in the Efficient Capital Markets Hypothesis. If market participants could not systematically profit from their investments in gathering information, then they would have no incentive to acquire information and trade on it. However, if all market participants decided not to acquire information, then the markets would not be efficient and there would be room for participants to acquire information and use it to make arbitrage profits. This paradox occurs because market efficiency arises from the competition among analysts and traders to acquire information and trade on it. In other words, capital markets will immediately reflect all available information only when analysts and traders ferret out information and trade on it before others acquire the same information. As a result, in any efficient market there must be market participants who will undertake to acquire information and trade on it instead of merely relying on the current market price as a true indicator of the value of shares.

Not all market participants will have the same incentives to purchase information, however. Large investors, such as institutional investors, will be more likely to purchase information because, on a portfolio dollar basis, they bear lower costs in purchasing this information. In addition, for certain types of information there may be large threshold amounts that must be purchased to make the information useful.

The above discussion yields several conclusions. First, even if capital markets are efficient, there will be a large number of market participants competing with each other to acquire and use information to make arbitrage profits. Second, while some of these market participants will be engaged in the acquisition of information because the benefits of doing so exceed the costs, others will do so out of the misguided belief that they can still beat the market, i.e. , that the market is inefficient. Both types of market participants will compete actively in the market for information ....

Manuel A. Utset, Disciplining Managers: Shareholder Cooperation in the Shadow of Shareholder Competition, 44 Emory L.J. 71, 94–95 (1995)

Please welcome J.W. Verret to PofessorBainbridge.com as occasional guest poster

From time to time, the PB.com editorial board opens the blog to distinguished colleagues who offer guests posts on areas in which they are working that overlap with the interests of the blog. (If you're interested in guest posting, let us know. But remember many will apply but few will be chosen.)

We're delighted that GMU Law Professor J.W. Verret is our newest guest poster. Jay teaches Banking, Securities, Corporation Law, and Accounting for Lawyers.

He serves on the Investor Advisory Committee of the Securities and Exchange Commission, where he advises the Chairman of the SEC on legal and policy reform.  He is faculty liaison to the American College of Business Court Judges. He also serves as Independent Chairman of the Board of Directors of Egan-Jones Ratings, one of the eight domestic credit rating firms licensed by the SEC to provide credit ratings on the debt of public companies and provides recommendations on shareholder proxy votes.

He has served as Chief Economist and Senior Counsel to the U.S. House Committee on Financial Services.  He previously clerked on the Delaware Court of Chancery.  He received his JD from Harvard Law School, a Masters in Public Policy from the Harvard Kennedy School, and a BS in Financial Accounting from LSU.

His work as appeared in venues from the Stanford Law Review and the Journal of Law and Economics to the Wall Street Journal and New York Times.  He has appeared on most major television networks on financial regulatory issues and has testified before the U.S. House and Senate over a dozen times.

Be sure to check out his SSRN page.

We've cited his work many times here at PB.com, as far back as 2009. We're excited to have him contribute.

A perfect storm of the BRT, SEC, ESG, and GAAP

J.W. Verret here, honored to join for a few guest posts.  When I was young once and on the market, Prof. B blogged my work even when he didn't agree with it. You never forget that. I've been on weird scholarly hiatus the last couple of years to bulk up my accounting toolkit with the CPA exam (done!) and some time as Chief Economist at the House Fin. Services Committee. If you can forgive it, you will see some financial accounting policy and DC beltway stuff mixed in with corporate governance and securities law during my visit here.

 

Prof. B has posted about the Business Roundtable Statement on Business Purpose, and I agree with his assessment of their true purpose. Bebchuk recently pointed out some of the problems with stakeholder capitalism generally and the Business Roundtable statement specifically here.

 

I sit on the Securities and Exchange Commission's Investor Advisory Committee, where we have spent the year partly playing out a related debate regarding a series of recommendations that were approved by the IAC over substantial and vigorous dissent.

 

The question we faced there was somewhat different from the question of proper corporate purpose. Does ESG based disclosure, disclosure which is one tool to encourage stakeholder based governance, fit into the mandatory disclosure architecture of the federal securities laws and related GAAP accounting policy?

 

And yet it isn't really a different question. The entire goal behind ESG disclosure is to shame CEOs into supporting politically charged initiatives regarding environmental or social policy that are embraced by stakeholder governance theory. The question for that purpose is not whether it would be a good thing (and I don't concede it would), but instead does it fit within the federal securities laws and longstanding GAAP accounting policies?

 

Our first debate was over a recommendation that the SEC include more information about human capital metrics in the Management Discussion and Analysis section of the annual report, see here. There was a focus in the recommendation on variables like relative mix of part-time vs full-time worker. It was of the same vein as the pay ratio rules in Dodd-Frank, if a smidge less obvious in its pro-labor advocacy.

 

I argued vigorously against mandatory non-financial human capital disclosure in a dissent here.

 

What's wrong with more human capital disclosure, you ask? I don't believe the SEC has the legal authority to mandate it if it fails to meet the materiality definition in the federal securities laws. And these disclosures (while no doubt material to a subset of labor union pension funds for their own personal reasons) would not have a material impact on shareholder wealth. 

 

This was the same argument I've made previously against mandatory disclosure of corporate political spending, see here.  If a future SEC requires such disclosure a legal challenge would likely succeed because the disclosure is not material. A recent debate over a broader ESG mandate recommendation by the SEC IAC played out along similar lines, see here.

 

My other concern about mandatory ESG based disclosure rules is that they would muck up Generally Accepted Accounting Principles (GAAP) with items in the narrative of the annual report that are inconsistent with the financial accounting estimates. 

 

GAAP isn't perfect. The one way we are certain to make it worse is to allow politicians to infect financial accounting with political objectives. Mandatory ESG disclosure rules from the SEC is one way left leaning politicians have been pressuring the SEC to do just that.

 

There is no shortage of ESG disclosure guidance and standard setting bodies out there, including the Sustainability Accounting Standards Board. There are investment funds dedicated to ESG investing that can use those metrics. If investors want to support those initiatives with their own cash, then best wishes. 

 

Meanwhile, let's not allow the ESG crowd to overextend the SEC beyond the reach of its jurisdiction or muck up GAAP with socio-political and cultural objectives.

More indirect precedent for the proposition that California's Female Board Member Quota law is unconstitutional

Keith Paul Bishop has the details.

Keith Paul Bishop: "California Poised To Enact Wacky Successor Liability Statute"

Keith writes:

I have previously written about California Assembly Member Lorena Gonzalez's bill, AB 3075, that would would make successor employers liable for their predecessors' unpaid wage judgments.  Last week, Assembly Member Gonzalez amended the bill to provide that successorship is established when someone "[o]perates a business in the same industry and the business has an owner, partner, officer, or director who is an immediate family member of any owner, partner, officer, or director of the judgment debtor" (emphasis added).  

Family Ties That Bind?

The breadth of this provision is truly breathtaking.  ...