ProfessorBainbridge.com

Lawyers Behaving Badly

Lawyer David Boies has made a career going after corporate abuses of power (see, e.g., his service as a special counsel for the Justice Department's suit against Microsoft and his role in the Tyco litigation). Tom Kirkendall has the scoop on some apparent questionable conflicts of interest on Boies' part. The Law Blog also has some additional details.

Securities lawyer Mel Lifshitz is under investigation for, essentially, owning his own plaintiff:

Since 2003, a charitable trust funded and administered by Lifshitz's family has donated money to various causes, most of them orthodox Jewish organizations. Another recipient of the charity's money, however, has been a limited partnership that was a plaintiff in more than a dozen class-action lawsuits filed by Lifshitz's firm over the past four years, a review of documents shows. ... Moreover, in five filings with the Securities and Exchange Commission, Lifshitz is listed as a "beneficial owner" of the Colbart Birnet partnership -- a circumstance Lifshitz says is plain wrong and attributes to "human error."

If true, Lifshitz would seem to have discovered that you don't need to chase ambulances if you own the ambulance company.

Challenging SOX

The Free Enterprise Fund has filed a law suit claiming that the Public Company Accounting Oversight Board created by the Sarbanes-Oxley Act is unconstitutional. (Read the complaint.) The gist of the complaint is that the PCAOB is vested with extensive governmental functions and powers, including a quasi-law enforcement investigatory power and a quasi-judicial power to impose substantial fines for violations of its rules.

The Fund claims that the PCAOB thus violates a number of constitutional provisions, most notably the appointments clause of the US Constitution. The potential constitutional problem is that members of the PCAOB are appointed not by the President but by the SEC.

The Appointments Clause of Article II section 2 of the US Constitution provides that:

[The President] shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

Three questions are thus presented. First, are the members of the PCAOB "Officers of the United States" and thus subject to the appointments clause? Second, if so, are the members of the PCAOB "inferior Officers" whose appointment Congress "may by Law vest" in one of the specified alternative mechanisms other than the advice and consent process? Third, if so, do the SEC Commsissioners collectively qualify as a Head of Department for this purpose?

There seems to be surprisingly little guidance on these questions. But I still think there is a strong argument to be made in favor of the Fund's position. As the Fund points out, the PCAOB wields extensive governmental powers, but limited accountability:

[The PCAOB] has enormous powers to levy taxes on public companies and to regulate the accounting business. The board, a regulatory agency in all but name, is composed of five directors, no more than two of whom may have any experience as accountants or auditors.

The PCAOB, ostensibly a self-regulating organization for the auditing industry, is supported by a general power of taxation over all publicly-held companies. As Senator Phil Gramm, R-Texas, explained on the Senate Floor, ?The board is going to have massive, unchecked power, by design.? There are early indications that the PCAOB?s independence and ability to raise its own revenue through taxation is supporting a dramatic expansion in its size and scope. Its 2004 budget was $103 million, and its staff started the year at 126 employees and ended the year with 262 employees. The PCAOB?s 2005 budget is another 30 percent higher, at $136 million, and it expects to end the year with 450 employees.

PCAOB has an enormously broad Congressional mandate to create rules and enforce them under Sarbanes-Oxley. Most regulatory agencies are limited in their reach by the amount of money appropriated to them by Congress?with its independent power to tax and raise funds as needed, there is hardly any institutional control on the power of the PCAOB.

All of which seems highly problematic under the relevant precedents. In Edmond v. United States, 520 U.S. 651 (1997), for example, the Court (per Scalia) wrote:

By vesting the President with the exclusive power to select the principal (noninferior) officers of the United States, the Appointments Clause prevents congressional encroachment upon the Executive and Judicial Branches. . . . This disposition was also designed to assure a higher quality of appointments: The Framers anticipated that the President would be less vulnerable to interest-group pressure and personal favoritism than would a collective body. . . . The President's power to select principal officers of the United States was not left unguarded, however, as Article II further requires the "Advice and Consent of the Senate." This serves both to curb Executive abuses of the appointment power, . . . and "to promote a judicious choice of [persons] for filling the offices of the union," The Federalist No. 76, at 386-387 [(M. Beloff ed. 1987) (A. Hamilton)]. By requiring the joint participation of the President and the Senate, the Appointments Clause was designed to ensure public accountability for both the making of a bad appointment and the rejection of a good one. . . .

The PCAOB, by way of contrast, seems almost designed to avoid public accountability. As the W$J opined:

... under Sarbox, the President can neither appoint nor remove Peekaboo members. Sarbox requires that the appointed Securities and Exchange Commissioners themselves appoint the oversight Board. Similarly, only the SEC can remove Board members, and then only if they can be shown to have willfully violated federal laws. Nowhere in any of this is there a role for the elected executive.

There is also little oversight. The only way the SEC can undo any of the accounting Board's regulations is by proving that the rules are obviously inconsistent with the Sarbanes-Oxley statute -- a nearly impossible task given its vague wording. The PCAOB is even largely independent of Congressional oversight because its budget is financed from the fees it levies on the companies it regulates. The Justice Department may well argue in response that the Board simply doesn't rise to the level of a "real" agency. But that will surprise corporate America, given that the Peekaboo can fine accounting firms up to $2 million and individual accountants up to $100,000 for violations.

And, of course, familiar principles of agency capture by the industries it regulates suggest that interest group pressures and favoritism are potentially serious problems.

Likewise, the Fund can draw support from Freytag v. CIR, 501 U.S. 868, 884 -885 (1991), in which the Court opined that:

''The Framers understood . . . that by limiting the appointment power, they could ensure that those who wielded it were accountable to political force and the will of the people. . . . The Appointments Clause prevents Congress from distributing power too widely by limiting the actors in whom Congress may vest the power to appoint. The Clause reflects our Framers' conclusion that widely distributed appointment power subverts democratic government. given the inexorable presence of the administrative state, a holding that every organ in the executive Branch is a department would multiply the number of actors eligible to appoint.''

Holding that the SEC is a Department empowered to appoint the PCAOB would threaten precisely these democratic values the Appointments Clause was designed to protect.

In Edmond, the court also held that:

Generally speaking, the term "inferior officer" connotes a relationship with some higher ranking officer or officers below the President: Whether one is an "inferior" officer depends on whether he has a superior. It is not enough that other officers may be identified who formally maintain a higher rank, or possess responsibilities of a greater magnitude. If that were the intention, the Constitution might have used the phrase "lesser officer." Rather, in the context of a Clause designed to preserve political accountability relative to important Government assignments, we think it evident that "inferior officers" are officers whose work is directed and supervised at some level by others who were appointed by Presidential nomination with the advice and consent of the Senate.

Because the members of the PCAOB are not subject to such oversight except to the very limited extent they are overseen by the SEC, it would seem that the members of the PCAOB likely are not inferior officers.

The Importance of the Shareholder Wealth Maximization Standard

My latest TCS column:

There has been a fair bit of ruminating about corporate cowardice lately. Several technology firms have been criticized lately for agreeing to cooperate with authorities in China. Google's decision to censor its Chinese search engine, for example, elicited widespread criticism in the blogosphere (although it also prompted some to speak out in its defense; see here for example). Blogger Mark Kleiman has spotted what he thinks is another example and invites me to reply:

"The weekend Financial Times (behind a paywall; just below the fold on page two of the December 4/5 edition) reports that Nestlé has been swift to advise the Islamic bigots boycotting Danish products that Nestlé is Swiss, not Danish. A rumor had spread in Saudi Arabia that some Nestlé products were of Danish origin. 'We took the trouble to rectify the situation — to give the correct information to consumers,' said a Nestlé spokescoward.

"The implication, of course, is that Danish origin is something to be ashamed of. And the result is to help focus the boycott on the Danes, and thus to increase the pressure on the Danish government to back off from its support of a free press.

"No doubt, if this had been the 1930s, Nestlé would have been equally swift to assure the Nazis that its products were of strictly Aryan origin.

"I'm still waiting for Professor Bainbridge to tell us whether he's prepared to stand behind his theory that the sole duty of corporate managers is to make money for the shareholders when it comes to cases such as this one. Assume, for the moment, what is probably correct: that Nestlé had good reason to think that selling out the Danes would help its bottom line. Is that really any excuse?"

First, the duty of directors is not solely to make money for the shareholders, but rather to do so within the bounds of law. Second, it should be apparent that the duty of directors is not so much to make money as it is to maximize share value. The two are different, because the value of a share of stock is the present discounted value of the stream of dividends the stock will pay in the future. Hence, directorial actions that are inconsistent with short term profit maximization but are consistent with increasing the present discounted value of the future stream of dividends are perfectly appropriate. Suppose, for example, that Nestle management thought confusion over the national origin of its products might endanger employees working in predominately Muslim countries. If so, it would seem both ethical (preservation of life) and profitable (enhanced employee morale) to safeguard the lives and property of those employees through statements such as the ones about which Mark complains.

In some cases, of course, long-term corporate viability may require the entity to take controversial political positions. In particular, as I argued in my paper Catholic Social Teaching and the Corporation, good corporate managers have a very strong stake in supporting democratic capitalism:

"The corporation has proven to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihood depends on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. Because tyranny is far more likely to come from the public sector than the private, those who for selfish reasons strive to maintain both a democratic capitalist society and, of particular relevance to the present argument, a substantial sphere of economic liberty therein serve the public interest."

Both society and their shareholders would have been well-served if German corporate managers had nipped Hitler's rise in the bud instead of facilitating it, for example.

But does all of this mean that corporate fiduciary duty law should require -- or, at least, allow -- corporate directors and officers to behave in ways Kleiman deems brave or responsible when doing so would be inconsistent with shareholder wealth maximization? I think not.

In the first place, requiring directors to maximize shareholder wealth provides the board of directors with a determinate metric for making business decisions. I often use the following example to explain what I mean by that: Suppose Acme's board of directors is considering closing an obsolete plant. The board is advised that closing the plant will cost many long-time workers their job and be devastating for the local community. On the other hand, the board's advisors confirm that closing the existing plant will benefit Acme's shareholders, new employees hired to work at a more modern plant to which the work previously performed at the old plant will be transferred, and the local communities around the modern plant. Assume that the latter groups cannot gain except at the former groups' expense. By what standard should the board make the decision?

Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards. Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.

Worse yet, absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.

In the plant closing example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if the board of directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.

In sum, if you don't like corporate cowardice, the answer is to work for changes that make corporate courage profitable. If you thought Nestle's decision was deplorable, buy American-made Scharfenberger. But don't try changing the basic rules of corporate governance.

The author is Professor at the UCLA School of Law.

Board Representation

Gordon Smith correctly notes that:

Board representation has become the corporate governance issue of our time. The SEC's director nomination proposal is dead, but shareholders have taken the battle to the streets. Majority voting provisions recently have been adopted by Dell, Intel, and other firms, and shareholders will vote on such provisions at additional firms in the coming proxy season. AIG is currently battling a proposal that would allow shareholders to adopt a director nomination bylaw. And tomorrow GM's board of directors will meet to consider granting a board seat to Jerome York as Kirk Kerkorian's representative. ...

If recent events have taught us anything, they have taught us that shareholders want more influence over board composition ... and not only the sort of influence that shifts outright control. In my view, this is a positive development in manager-shareholder relations, even though I expect the transition to be bumpy. The most common objection that I have heard from directors is that shareholder nominees  have the potential to destabilize the board. If you can get past your initial incredulity at this claim -- "Doh! That's why we want them!" -- you will recognize an important assertion about the nature of boards. The assertion is that board's work as teams, and shareholder nominees are the corporate equivalent of Terrell Owens.

I don't share Gordon's view that this is a positive development, although I'm coming around to the view that it has a certain inevitability.

I would direct you in the first instance to my TCS columns Does the SEC Know When Enough Is Enough? and The SEC: From Bad to Worse?, which discuss some of the many objections to tis trend. In particular, building on my law review article Why a Board? Group Decisionmaking in Corporate Law, which emphasizes the board's role as a team, I advanced precisely the argument that the board's ability to function as a team production unit would be compromised:

The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the boards decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes.

it's not the only argument in favor of the status quo, but I think it's an especially good one.

The Business Judgment Rule

I used my latest TCS column to explain it:

Last week, the Delaware Supreme Court heard arguments in an appeal by Walt Disney Co. shareholders who unsuccessfully sued Disney's board of directors over the $140+ million severance package Disney paid Michael Ovitz when he stepped down (under pressure) as Disney's President. In reporting on the appeal, the New York Times observed that: "The pivotal legal issue in the appeal is the esoteric 'business judgment rule.'"

As it is usually phrased, the business judgment rule is "a presumption" that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. If the Times is right that the rule is understood only by a particular group, that's unfortunate, because the rule deserves to be known to not just business lawyers, but also every corporate director, executive, and shareholder.

The business judgment rule is corporate law's central doctrine. It pervades every aspect of the state law of corporate governance; from negligence by directors, to self-dealing transactions, to termination of shareholder litigation and so on. Of particular relevance, it is the governing standard when shareholders complain that about allegedly excessive executive pay.

Corporate directors are subject to a fiduciary duty of care, which requires them to the sort of care that ordinarily careful and prudent people would use in similar circumstances. Because the corporate duty of care thus resembles the tort law concept of reasonable care, one might assume the duty of care is violated when directors act negligently. Yet, the one thing about the business judgment rule on which everyone agrees is that it insulates directors from liability for negligence.

The rule doesn't completely insulate directors from liability, of course. As the Delaware Supreme Court explained in an earlier appeal in the Disney litigation, the rule simply means that:

"...directors' decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.[1]

Yet, even with those qualifications, the rule provides directors with considerably greater protection from liability than most economic actors enjoy.

The business judgment rule's traditional justification is that courts are not business experts.[2] It is probably true that most judges do not have much expertise in business law matters, although that's hardly the case for Delaware's judiciary, which more-or-less specializes in corporation law. Moreover, business law is not the only context in which judges are called upon to review complex issues arising under conditions of uncertainty. Reviewing a board of directors' decision to pay Michael Ovitz $140 million for 14 months work, for example, seems no more technically demanding than reviewing medical or product design decisions. Yet, no "medical judgment" or "design judgment" rule precludes judicial review of malpractice or product liability cases.

Why then do directors of corporations get this special protection?

Justice Jackson famously observed of the U.S. Supreme Court: "We are not final because we are infallible, but we are infallible only because we are final." Neither courts nor boards of directors are infallible, but someone must be final. Otherwise we end up with a never-ending process of appellate review. The question then is a simple one: Who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?

Judges necessarily have less information about the needs of a particular firm than do that firm's directors. A fortiori, judges will make poorer decisions than the firm's board. As one court decision put it:

"[C]ourts recognize that after-the-fact litigation is a most imperfect device to evaluate corporate business decisions. The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur's function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge."[3]

Put another way, judges are no less subject to bounded rationality than any other decision makers. Just as the limits on cognitive competence impede the ability of market actors to write complete contracts, those same limits necessarily impede judicial review. Only with the benefit of hindsight will judges be able to make better decisions than boards, but we have already seen that hindsight review is problematic. While market forces work a sort of Darwinian selection on corporate decision makers, moreover, no such forces constrain erring judges. As such, rational shareholders will prefer the risk of managerial error to that of judicial error.

The posited preference for managerial error, however, only extends to decisions motivated by a desire to maximize shareholder wealth. Given that market forces encourage directors to make such decisions carefully, such a preference makes sense. Where the directors' decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted. As Delaware Chief Justice Veasey observes, "investors do not want self-dealing directors or those bent on entrenchment in office. ... Trust of directors is the key because of the self-governing nature of corporate law. Yet the law is strong enough to rein in directors who would flirt with an abuse of that trust."[4] The affirmative case for disregarding honest errors thus simply does not apply to intentional misconduct. To the contrary, given the heightened potential for self-dealing in an organization characterized by a separation of ownership and control, the risk of legal liability may be a necessary deterrent against such misconduct.

The function of the business judgment rule thus is to act as a filter for self-dealing and fraud. As long as the board made an informed decision untainted by conflicts of interest, the court will defer to the board's judgment. Directors are thus allowed to take business risks without fear that an error in judgment or even an act of God might result in liability being imposed on them. Conversely, however, the rule will not allow directors to cheat and self-deal.

Giving Michael Ovitz $140 million to go away after a mere 14 months on the job might not have been the smartest decision a board of directors made, but absent evidence that the board acted from conflicted interests, it is precisely the sort of decision that courts leave to the discretion of directors.

---

[1] Brehm v. Eisner, 746 A.2d 244 (Del. 2000).

[2] See, e.g., Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919).

[3] Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983).

[4] E. Norman Veasey, An Economic Rationale for Judicial Decisionmaking in Corporate Law, 53 Bus. Law. 681, 694 (1998).

Class Action for Stupid People

Some lawyer's filed a class action against Apple:

Apple Computer’s popular iPod music player was facing a new legal threat after an aggrieved customer filed a class action complaint claiming the company did not adequately warn customers about the potential for damaging hearing loss from playing its popular music player at full volume. A complaint filed with a California court this week alleged that Apple’s music players were “inherently defective in design” and “not adorned with adequate warnings regarding the likelihood of hearing loss”.

My take? If you're too dumb to realize that playing really loud music through tiny buds stuck deep in your ear canal isn't a good idea, there's not a lot the legal system can or should do to help you. Except maybe require you to live in a bubble somewhere. BTW, if you fall into this category, you should also avoid holding cups of hot coffee between your thighs.

Stem Cell Debate

The latest UCLA magazine offers four perspectives on California Prop. 71, the voter referendum proposition that created state funding for stem cell research, including that of your's truly.

Class Action for Stupid People

Some lawyer's filed a class action against Apple:

Apple Computer?s popular iPod music player was facing a new legal threat after an aggrieved customer filed a class action complaint claiming the comany did not adequately warn customers about the potential for damaging hearing loss from playing its popular music player at full volume. A complaint filed with a California court this week alleged that Apple?s music players were ?inherently defective in design? and ?not adorned with adequate warnings regarding the likelihood of hearing loss?.

My take? If you're too dumb to realize that playing really loud music through tiny buds stuck deep in your ear canal isn't a good idea, there's not a lot the legal system can or should do to help you. Except maybe require you to live in a bubble somewhere. BTW, if you fall into this category, you should also avoid holding cups of hot coffee between your thighs.

Zywicki on LoPucki

Law professor and Volokh Conspiracy blogger Todd Zywicki has just posted a paper to SSRN reviewing my friend and colleague Lynn LoPucki's very important bankruptcy law reform book Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts. Zywicki writes:

Abstract: In his new book, "Courting Failure: How Competition for Big Cases is Corrupting the Bankruptcy Courts", Professor Lynn LoPucki's book argues that that current bankruptcy venue rules have spawned an improper competition for big cases that has corrupted America's bankruptcy courts. LoPucki argues that this competition has harmed the bankruptcy system and the economy, transferring wealth from creditors and employees to incumbent management and bankruptcy professionals. He also argues that the competition that has corrupted the American bankruptcy system is being replicated internationally, resulting in a similar competition and similar harm on the global stage.

This essay reviews LoPucki's book and its central theoretical and empirical arguments. LoPucki offers powerful empirical evidence that something is amiss with much of current American bankruptcy practice. This essay will try to flesh out in more detail the model and theoretical foundations that implicitly underlie LoPucki's indictment of bankruptcy forum-shopping (and other forms of forum-shopping as well). Empirical evidence standing alone is insufficient to draw conclusions about whether forum-shopping is in general good or bad without a clearly stated hypothesis to test. Instead, it is necessary to also have a theoretical model sufficient to generate testable hypotheses as a predicate both for determining whether forum-shopping is good or bad on net, as well as the likely effects of reform proposals. Although LoPucki identifies several problem areas in the current Chapter 11 reorganization process, it is not as clear that all of these problems can be clearly attributed to runaway forum-shopping. Instead, they may simply be good-faith errors or mistakes, for which continued competition may be beneficial, in that the competition may actually expedite the process of self-correction.

This review essay develops a model of the institutions and incentives governing the forum-shopping competition described by LoPucki in an effort to determine whether the empirical observations proffered by LoPucki can be best explained as the outcome of improper forum-shopping competition. The essay then closes with an analysis of provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, noting that many of the provisions in the legislation offer substantive responses to many of the problems identified by LoPucki.

Faith and Entrepreneurship

Interesting piece in Small Business about "the growing ranks of Christian business owners, who are banding together for mutual support while they seek to express their faith through their companies":

Entrepreneurship seems to appeal to many devout Christians for the same reason that it attracts environmentalists, devoted parents, feminists, and libertarians: They want a workplace that reflects their deepest values. Some doubtless use the gospels to rationalize business as usual.

But at a deeper level, sincere Christians have much in common with committed entrepreneurs. Both callings demand faith in things unseen and persistence in the face of dangers and doubts. They ask themselves: Is it right to lay off workers to boost profits, or only to save the company? How do you foster a Christian office culture without violating the rights of non-Christian employees? What if you can't get a city contract without bending the law? How fast must you run to beat a camel into paradise?

The questions posed have been addressed by my friend and colleague Eugene Volokh in a number of articles, including his piece Freedom of Speech, Religious Harassment Law, and Religious Accommodation Law, 33 Loyola University of Chicago Law Journal 57 (2001). His website Freedom of Speech vs. Workplace Harassment Law is an excellent resource for lawyers and businesspeople struggling with those questions, as well.