ProfessorBainbridge.com

My upcoming course "The Law of Elon Musk" featured in New York Magazine's Intelligencer Column

Here.

 

Corporate Law and the Utopian Fallacy

New paper by Beate Sjåfjell, Re-embedding the Corporation in Society and on Our Planet: Company Law as a Vehicle for Change (January 13, 2022). Chapter 12 in Beate Sjåfjell, Carol Liao and Aikaterini Argyrou (eds), Innovating Business for Sustainability: Regulatory Approaches in the Anthropocene (Edward Elgar Publishing). Available at SSRN: https://ssrn.com/abstract=4008062

The corporation needs to be ‘re-embedded’ in society and on our planet. Business is an integral element of the disembedding from society, through the way the corporation, a dominant legal form for undertaking business, has been conceptualised in the dominant legal-economic theories. This has formed the basis for and has been exacerbated through the social norm of shareholder primacy. Re-embedding the corporation requires a reconceptualisation of corporation’s role in society and the environment, and challenging a deeply gendered approach not only within business but also within sustainability science. Employing an interdisciplinarity feminist sustainability perspective, I make the case for using company law as a lever to re-embed the corporation through the embedding into the core of company law, key societal concepts of sustainability, drawing on sustainability research. The reform proposals concentrate on EU law but the reform ideas and the basis for them are of global relevance.

Sorry, but I don't buy it. Compare and contrast with D. Gordon Smith, The Dystopian Potential of Corporate Law (March 2007). Univ. of Wisconsin Legal Studies Research Paper No. 1040, Available at SSRN: https://ssrn.com/abstract=976742.

The community of corporate law scholars in the United States is fragmented. One group, heavily influenced by economic analysis of corporations, is exploring the merits of increasing shareholder power vis-a-vis directors. Another group, animated by concern for social justice, is challenging the traditional, shareholder-centric view of corporate law, arguing instead for a model of stakeholder governance. The current disagreement within corporate law is as fundamental as in any area of law, and the debate is more heated than at any time since the New Deal.

This paper is part of a debate on the audacious question, Can Corporate Law Save the World? In the first part of the debate, Professor Kent Greenfield builds on his book, THE FAILURE OF CORPORATE LAW: FUNDAMENTAL FLAWS AND PROGRESSIVE POSSIBILITIES, offering a provocative critique of the status quo and arguing that corporate law matters to issues like the environment, human rights, and the labor question.

In response, Professor Smith contends that corporate law does not matter in the way Professor Greenfield claims. Corporate law is the set of rules that defines the decision making structure of corporations, and reformers like Professor Greenfield have only two options for changing corporate decision making: changing the decision maker or changing the decision rule. More specifically, he focuses on board composition and shareholder primacy. Professor Smith argues that changes in corporate law cannot eradicate poverty or materially change existing distributions of wealth, except by impairing the creation of wealth. Changes in corporate law will not clean the environment. And changes in corporate law will not solve the labor question. Indeed, the only changes in corporate law that will have a substantial effect on such issues are changes that make the world worse, not better.

I stand with Gordon.

Conservative activists are finally discovering SEC Rule 14a-8 and using it to make shareholder proposals: Will the SEC apply neutral principles?

I have long wondered why conservative activists don't make use of the shareholder proposal rule to the extent liberal activists do. In 2004, for example, I asked:

Every time I teach the shareholder proposal rule (Securities Exchange Act Rule 14a-8) in Business Associations, I always wonder the same thing: Why don't conservative activists use the rule more often?

An informed reader responded:

t seems that conservatives have attempted to push a limited agenda through the 14a-8 process. In almost all of these cases, these types of proposals were excluded under 14a-8(i)(7) [as an ordinary business matter]. Which brings me to your point. I think that most proposals pushing a conservative agenda would deal with ordinary business matters.

He had a point. But the SEC under Gary Gensler seems to have liberalized the ordinary business exception to allow a slew of social and environmental proposals from progressives to be included on company proxy statements. Which raised the question: Would he apply neutral principles and allow conservative proposals?

Accordingly, last fall, I took to Twitter to propose that "What I need are some really rich conservatives to finance a Rule 14a-8 shareholder proposal campaign."

It seems others have stepped up to the plate. Bloomberg reports:

More conservative proposals were filed this proxy season by activists looking to bend the ears of CEOs on social issues, aligning with a political crusade to skewer “woke capitalism.”

Conservative or anti-ESG proposals have doubled this proxy season, according to consulting firm Georgeson Inc., which counted 52 such resolutions filed this year—double the 26 filed 2021. ...

The resolutions, most of which target major companies including Walmart Inc.and Comcast Corp., received very few shareholder votes on corporate ballots, regularly securing less than 3% support. But the number of proposals won’t be letting up, said Scott Shephard, a fellow at the National Center for Public Policy Research, one of the main organizations driving conservative shareholder activism.

“I wouldn’t expect the numbers to sink,” said Shephard, explaining that one of his aims is to put CEOs on notice for allegedly violating their fiduciary duties when they project personal preferences.

My new paper: Sarbanes-Oxley § 404 at Twenty

Bainbridge, Stephen Mark, Sarbanes-Oxley § 404 at Twenty (August 26, 2022). UCLA School of Law, Law-Econ Research Paper No. 08, 2022, Available at SSRN: https://ssrn.com/abstract=4201778

Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) was intended to improve public company internal controls over financial reporting (ICFR). Faulty internal controls were believed to have contributed to many corporate scandals during the dot-com era. Empirical research of the pre-SOX era suggested that reporting companies with poor internal controls tended to have more frequent earnings restatements, more SEC enforcement proceedings, and poorer performance than comparable firms with strong internal controls. When SOX was adopted § 404 was not among the most controversial provisions. Instead, it was the attorney conduct rules, CEO and CFO certification requirements, and the ban on loans to officers and directors—plus the larger question of federalizing corporate governance—that generated most of the early criticism aimed at the statute. Once companies began implementing § 404’s mandate for assessments of their internal controls over financial reporting, however, it became apparent that compliance costs were considerably greater than anticipated. In short order, § 404 became—and remains—SOX’s most controversial provision. SOX’s twentieth anniversary seems an opportune time to reassess the controversy over § 404. There is a considerable body of empirical evidence on the costs and benefits of § 404, which this article reviews. As it turns out, however, there are so many potential confounding factors that all of the evidence must be viewed with a degree of skepticism. Nonetheless, a few conclusions can be drawn. With the benefit of hindsight, it seems clear that Congress in 2002 had no idea what it would cost companies to comply § 404. The SEC had an estimate of what § 404(a) compliance would cost but had no idea what § 404(b) compliance would cost. Sticker shock seems the right description of the reaction once those costs became clear. Section 404 compliance costs were substantial from the outset. Those costs were disproportionately borne by smaller firms from the outset. Section 404 compliance costs remain high and show no signs of dropping over time. It remains the case that those costs are disproportionately borne by smaller firms. As far as achieving its main goal of reducing material weaknesses in ICFR, § 404 cannot be deemed a success. Both adverse managerial reports and auditor attestations actually rose prior to 2014 and have dropped only slightly in the subsequent period. Problems with firms failing to remediate persistent material weaknesses remain a source of concern.

"The Rise of Anti-Activist Poison Pills"

Very interesting new paper:

We create a novel dataset of the terms of poison pill plans to examine their prevalence over time. Consistent with the hypothesis that poison pills have responded to the increase in hedge fund activism, recent adoptions have characteristics and provisions that appear to target hedge funds, such as low trigger thresholds. Moreover, using unique data on activist hedge fund views of SEC filings as a proxy for the mere threat of an activist intervention, we show that hedge fund interest strongly predicts pill adoption. Finally, the likelihood of a 13D filing declines after firms adopt “antiactivist” pills. Our analysis has implications for understanding the modern dynamics of market discipline of managers in public corporations, and evaluating policies that regulate defensive tactics.

Eldar, Ofer and Kirmse, Tanja and Wittry, Michael D., The Rise of Anti-Activist Poison Pills (August 22, 2022). Fisher College of Business Working Paper No. 2022-03-007, Charles A. Dice Center Working Paper No. 2022-07, Available at SSRN: https://ssrn.com/abstract=4198367 or http://dx.doi.org/10.2139/ssrn.4198367

Footnotes are legal in California

Apropos my post the other day about Alan Palimter's smackdown of footnotes, Keith Paul Bishop passed along a link to a 2018 post of his, in which he observes:

My question for today is whether it is legal to use footnotes.  It turns out that this is a question that the California legislature has actually addressed in statute.   For example, Section 1363(c) of the California Health & Safety Code provides:

"Nothing in this section shall prevent a plan from using appropriate footnotes or disclaimers to reasonably and fairly describe coverage arrangements in order to clarify any part of the matrix that may be unclear." 

In other cases, however, the legislature discourages, but doesn't prohibit, footnotes.  See, for example, Insurance Code Section 10509.950 that provides:

"Insurers should, as far as possible, eliminate the use of footnotes and caveats and define terms used in the illustration in language that is understandable by a typical person within the segment of the public to which the illustration is directed."

The SEC's Regulation S-K includes numerous references to footnotes and in some cases actually requires footnote disclosure.   See, e.g., Instruction 1 to Item 402(c)(2)(v) and (vi) 

In short, California never met anything it didn't think was worth regulating. Including footnotes.

Keith goes on to discuss Gibbon's use of footnotes, which (I must confess) was news to me.

Alan Palmiter tees off on footnotes, law review editors, law & economics, and law professors

The good professor:

I detest footnotes. Except for this one, this letter has none. Does anyone use footnotes when they write a friend? Are there footnotes in Walt Whitman’s Leaves of Grass? Or the US Constitution, for that matter? Why does the law academy insist on footnotes? For one, they are archaic. A hyperlink sends you to the relevant text ...

For another, footnotes are pedantic. Academics cite to other academics in footnotes, to pretend that they’ve read the drivel written by others – in the hope that others will read their drivel. Footnotes are mostly drivel-reinforcement – no? And then, some footnotes are where authors (law professors are not “writers”) put their clever insights, hoping not to interrupt the flow of the drivel in the text of their writings. Sometimes these asides are more interesting than the main show, but usually they’re just pedantic.

Finally, footnotes are an impediment to following and understanding the text. Maybe that’s their purpose. The reader is asked after almost each sentence to look at the bottom of the page, read something that’s mostly useless, and then return to the body of the text. By the time the reader finds where they were, their train of thought is derailed. ...

But what I really detest is the Blue Book. It’s put out by Chicago in order to keep law academics from thinking. That’s right. Law students are so concerned about whether a comma gets italicized or not in the citation of a law review article that they don’t notice that the law review article is drivel. Or, worse, that it advocates something that is both logically untenable and morally unacceptable. I’m convinced that this is why Chicago put out the Blue Book, so that law students and law scholars would not notice that Law & Economics is ... dangerous. More on this later.

Actually, I believe you'll find that Chicago put out the Maroonbook.

Purchase versus pooling accounting

A student in my Mergers and Acquisitions class asked a question that took me back two decades:

I had a question about how pre 2001 consolidation was preferred due to accounting rules allowing pooling rather than purchase. I was taught last year and working this past summer that the form of an M&A deal was heavily influenced by tax considerations. I intuitively assumed purchase was the far superior option; doesn’t purchase accounting create an massive taxation benefit by allowing the surviving corporation deductions for goodwill even though I am ignorant as to the marked up value of assets on other considerations such as basis? I get that there are appearances to consider, but is that the only reason pooling was the preferable method of accounting?

Let's start with basics.

Acme Co., Inc., buys Omega, Inc., with Acme as the surviving entity. If pooling accounting was used, Acme's financial statements would be combined—“pooled”—with those of Omega, so that both companies’ assets and liabilities would be included on Acme’s balance sheet at their existing book value.[1]

If the deal is structured so as to use purchase accounting, however, the transaction is treated for accounting purposes as a purchase by Acme of Omega. In that case, Omega's assets would be marked up or down, as the case might be, to their fair market value on Acme's post-acquisition financial statements.

In addition, in purchase accounting, any control premium—defined for this purpose as the difference between the fair market value of Omega's assets and the price Acme paid to acquire Omega—would be included on Acme’s balance sheet as “goodwill.” In pooling accounting, there is no goodwill, because both companies' items are simply combined—the control premium is ignored.

Goodwill is amortized over time, which during the amortization period generates an annual expense on the company’s income statement. This reduces the company’s earnings and, as such, earnings per share.

Because the amortization period does not depend on the amount of goodwill in question, the more goodwill created in the acquisition, the greater the amount the company will recognize each year as an expense and, hence, the greater the reduction in the company’s annual earnings. Purchase accounting thus typically resulted in lower reported earnings.

Why would a company care? After all, we’re talking about a technical accounting treatment. The company’s actual cash flows are not affected. Yet, because reported earnings get so much attention from analysts and investors, falling accounting earnings are generally disfavored.

In addition, as we’ll see below, the purchase method makes it easier to assess the total purchase price paid to acquire the target, which in turn allows for more meaningful evaluation of the subsequent performance of that investment than is the case with the pooling method. Managers who would prefer that their shareholders not be able to accurately assess their performance might opt for pooling.

Given the option between purchase and pooling, companies thus would often pick pooling because management believed it made their earnings look better.

The SEC and the FASB thus worried that companies would choose between pooling and purchase based purely on how they wanted their accounting earnings to look rather than their actual financial condition.

Did the choice between purchase and pooling actually affect the stock price of the surviving entity? The answer appears to be no. Empirical studies found no statistically significant abnormal returns from one choice versus the other. Analysts and investors appear to have focused on cash earnings rather than accounting earnings. Perhaps as a result, the corporate preference for pooling was marginal. Most years, the split between purchase and pooling leaned only slightly to the latter. Still, there was a perception that companies wasted a lot of money trying to structure deals so that their preferred accounting treatment could be available and that some deals didn’t happen simply because they couldn’t get the preferred treatment.

Turning to the tax consequences, it is true that purchase accounting generates significant tax benefits. The goodwill accrued generates amortization tax deductions. The stepped-up basis means that if the surviving company sells some of the acquired assets, the company will recognize less gain and, accordingly, pay less tax.

In 2001, the FASB ruled that all acquisitions should be taxed as purchases:

The single-method approach … reflects the conclusion that virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for-based on the values exchanged.

The FASB argued that the change would aid investors by ensuring that financial statements would:

Better reflect the investment made in an acquired entity—the purchase method records a business combination based on the values exchanged, thus users are provided information about the total purchase price paid to acquire another entity, which allows for more meaningful evaluation of the subsequent performance of that investment. Similar information is not provided when the pooling method is used.

Improve the comparability of reported financial information—all business combinations are accounted for using a single method, thus, users are able to compare the financial results of entities that engage in business combinations on an apples-to-apples basis. That is because the assets acquired and liabilities assumed in all business combinations are recognized and measured in the same way regardless of the nature of the consideration exchanged for them.

Provide more complete financial information—the explicit criteria for recognition of intangible assets apart from goodwill and the expanded disclosure requirements of this Statement provide more information about the assets acquired and liabilities assumed in business combinations. That additional information should, among other things, provide users with a better understanding of the resources acquired and improve their ability to assess future profitability and cash flows.

In addition, the FASB argued it would lower transaction costs:

Requiring one method of accounting reduces the costs of accounting for business combinations. For example, it eliminates the costs incurred by entities in positioning themselves to meet the criteria for using the pooling method, such as the monetary and nonmonetary costs of taking actions they might not otherwise have taken or refraining from actions they might otherwise have taken.

In sum, both forms had perceived advantages—but only if you assumed analysts and investors focused solely on headline earnings rather than digging into the income statement and balance sheet.

SOX Section 404 Compliance Costs are Still Rising Twenty Years Later

Sarbanes-Oxley section 404 average compliance costs have not fallen significantly over the last two decades. According to Protiviti, for example, large accelerated filers had average internal § 404 compliance costs of $1,335,000 in 2016 and $1,338,000 in 2018.[1] Firms with more than two years of compliance experience had average internal compliance costs of $1,183,000 in 2016 and $1,105,300 in 2018.[2] Fifty percent of large accelerated filers reported that their external audit fees went up in 2017 relative to 2016.[3] In 2019, Protiviti reported that the hours and effort level committed to SOX compliance had not decreased significantly in the preceding decade.[4]

Protiviti’s 2022 report found that § 404 compliance costs continued to rise, as did the number of personnel hours expended on compliance.[5] It also reported that external auditors were requesting greater amounts of SOX-related information in connection with § 404(b) evaluations.[6] The average cost for companies in their first year of § 404(a) and 404(b) compliance was $1,477,500.[7] Large accelerated filers had average internal compliance costs of $1,450,800 in 2022.[8]  Firms with more than two years of compliance experience had average internal compliance costs of $1,468,300.[9] The percentage of large accelerated filers paying more than $2 million per year rose from 24 to 26 percent, while the percentage paying less than $500,000 fell from 24 to 16 percent.[10] At least some of the increase was due to pandemic-related factors, such as labor shortage and employees working remotely,[11] but it remains striking that 20 years after § 404 was adopted costs continue to rise.

Still more on the requirement that board of director decisions be informed

Mark Twain and the Hale & Norcross Mining Case which is one of the ur-precedents on the requirement that board of director decisions be informed. https://t.co/NoL4pivbqk

— Steve Bainbridge (@PrawfBainbridge) August 23, 2022

Keith Paul Bishop on the origins of the requirement that board decision be informed

He writes:

In  Fox v. Hale & Norcross Silver Mining Co.,  108 Cal. 369, 41 P. 308 (1895), the trial court held directors liable for a diversion of funds by the president of the corporation to himself. The court said: “None of the directors, however, had any substantial interest in the corporation.…Being chosen in this way [i.e., by the president and substantial shareholders] and receiving no compensation for their services, except $5 for each meeting of the board at which they attended, they gave to the affairs of the company the amount of attention that might have been expected. Several of them seemed to have known next to nothing about the operations at the mine. While others took a little more trouble to keep themselves informed in a general way about the mining of ores and the price paid for reduction, they seem one and all to have entrusted the management of the entire business to the president, Levy, and to the superintendent of the mines; and, if these officers, by abuse of their trust, caused the loss and damage to the mining company which the court has found, the evidence warrants the conclusion that the directors were at least guilty of gross negligence.”  Despite this statement, the Supreme Court reversed the judgment against the directors on the technical pleading point that the complaint had alleged only that they were guilty of fraud, and not of negligence.

Ed Steiner sends along more information about the origins of the requirement that board decisions be informed

He writes:

The citation to the trial court opinion in Youngstown Sheet & Tube prompted this.  As you know I am on a solitary mission to pull Ohio corporation law out of obscurity. I came across a surprising manuscript in which Dodd and Berle were on the same side (nominally) in  arguing against an early 1931 proposed amendment to the appraisal section of the  Ohio corporation code. The amendment was  sponsored by Cyrus Eaton in connection with the Youngstown Sheet & Tube/Bethlehem Steel transaction that was the subject of the trial court opinion.  

That said, the  trial court opinion was reversed on every substantive issue on appeal.  (As to being informed, the Board members were all steel industry players and Y S & T had been in merger discussions on and off since 1927, including with Eaton companies).  As to Berle and Dodd, volume 44 of the Harvard Law Review had some interesting content.  Berle’s powers in trust piece was sandwiched between  Pound’s attack on the legal realists and Llewellyn’s response. Point 10 of Pound’s attack was on the legal realists’ so-called entrepreneur theory of the law,  that business functions were the proper concern of the law and not broader social matters. Llewellyn rebutted that, noting that 7 of the 10 commercial lawyers in his sample (Berle was not in  the sample group) were not guilty of that charge.  Given that Pound was Dodd’s mentor (Pound got Dodd his first real academic job at Nebraska, where Pound had been dean and where he was shaping the faculty in the early 1920s), Harvard colleague  and friend, it seems conceivable that Dodd’s response to powers in trust (coming out of Columbia, the hotbed of legal realism)  was another version of Pound’s point 10.  In his response to Dodd, Berle (like Llewellyn had) rebutted the notion that he didn’t take social concerns seriously.  The piece Berle wrote in the Ohio appraisal statute context could also have been cited by Berle in rebuttal.  More of this later (I still have a day job). Finally, I wonder whether Berle’s reaction to Eaton (who espoused a local control of industry philosophy but who was in fact a fairly cut-throat empire builder) added fuel to Berle’s response to Dodd about industrial princes feeling no obligation and not being accountable.  That too awaits further development.     Thanks for your provocative  blog post. Best.