ProfessorBainbridge.com

Ribstein versus Yours Truly

From Delaware Vice Chancellor Stephen Lamb's opinion in Big Lots Stores, Inc. v. Bain Capital Fund VII, LLC, 2006 WL 846121 (Del.Ch. 2006):

As numerous commentators have observed, creditors are usually better able to protect themselves than dispersed shareholders.⁵⁰

⁵⁰ See, e.g., Stephen M. Bainbridge, Much Ado About Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, J. BUS. & TECH. L. (forthcoming) at 28 (noting, for example, that "relative to many nonshareholder constituencies, shareholders are poorly positioned to extract contractual protections. Unlike bondholders, for example, whose term-limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations"); But see Larry E. Ribstein & Kelli A. Alces, Directors' Duties in Failing Firms, J. BUS. & TECH. L. (forthcoming) at 8 (arguing that the greater protection generally due to debt-holders over shareholders is not an inherent characteristic of either instrument, because such distinctions may not apply to closely held corporations, or public corporations held substantially by institutional shareholders who can act collectively or through intermediaries).

The Milberg Weiss Indictment

Famed plaintiffs' law firm Milberg Weiss and two senior partners, David J. Bershad and Steven G. Schulman, have been indicted for conspiracy to obstruct justice, and commit perjury, bribery and fraud. They are accused of "a scheme in which several individuals were paid millions of dollars in secret kickbacks in exchange for serving as named plaintiffs in more than 150 class-action and shareholder derivative-action lawsuits. The indictment alleges that the firm received well over $200 million in attorneys’ fees from these lawsuits over the past 20 years." From the NYT:

The indictment is the first instance of a law firm with national reach facing criminal charges, and it could prove to be a fatal blow for the firm. ...  The prosecutors are asking for the return of the fees earned by the firm and those named in the indictment. In addition, there is the possibility of prison for the two partners — up to 20 years for racketeering conspiracy, for example.

To disguise some of the secret payments to plaintiffs, which prosecutors referred to as kickbacks, the law firm moved cash through casinos and kept money in a credenza in Mr. Bershad's office, the indictment said. ...

Feared and loathed inside boardrooms across the country, Milberg Weiss made hay out of the numerous accounting and management scandals that caused stocks to collapse in recent years. Sometimes bullying, sometimes screaming, sometimes speaking very softly, the firm's lawyers coaxed and cajoled what it has estimated to be $45 billion in recoveries from companies.

Those who recall how being indicted put Arthur Andersen out of business should note that the indictment of Milberg Weiss will not prove immediately fatal. Clients were unwilling to have an indicted firm audit their books, even though the SEC adopted temporary rules offering AA clients ways of continuing to use AA's services in auditing their financials. Milberg Weiss doesn't face that prospect. Nor am I aware of any mechanism for disbarring an entire law firm. (Anybody know anything to the contrary?) The potential for huge fines and even a class action against MW, coupled with the possible loss of major institutional investors as potential clients, however, may do serious damage to the firm over time. (On the other hand, as discussed below the fold, the latter factor may bear fruit very quickly.)

Is that a bad thing? I repeat what I wrote back when news of a possible indictment first broke:

I've been skeptical of the government's power to destroy firms by indicting them. (Although less so; I still think reasonable people could believe that it was Arthur Andersen's time to go.)

Yet, at the same time, it strikes me that there are sound policy reasons to prohibit lawyers from making kickbacks to the named plaintiffs in class actions. Since a named plaintiff is essential to bringing a class action, paying kickbacks to someone willing to serve as the requisite plaintiff may tend to make it easier for lawyers to bring nuisance claims. Because a named plaintiff who has received a kickback is even less likely to monitor the activities of the lawyer (who is the real party in interest in a lot of these suits) than is a typical class action plaintiff, it increases the probability of a settlement that benefits the lawyer but not the class (such as the notorious practice of coupon settlements).

One gathers that this practice is fairly widespread. Certainly, the testimony back when the PSLRA was adopted suggested it was common in the securities class action field. If the probability of detection and punishment is low, the economics of deterrence tells us we need a high nominal sanction to deter. As a result, we may well need criminal sanctions. Hence, I believe that an indictment of any individual lawyers who engaged in this practice would be perfectly appropriate.

Other blogosphere reaction: Ed Morrissey:

The explosion of Milberg Weiss may portend darker days for the ambulance chasers. Milberg Weiss conducted its lawsuits by knowingly filing fraudulent claims using plaintiffs that they kept on retainer in order to get suits filed quickly enough to occupy the primary position in the case. It's unlikely that other firms kept their hands entirely clean when they had to compete with Milberg Weiss for the big-money business of class-action suits. When prosecutors find the first and most egregious violators, the others usually follow as defendants attempt to trade information for leniency.

Christine Hurt:

The law firm, a limited liability partnership, was given the opportunity to avoid an indictment against the entity if the firm waived attorney-client privilege and turned over otherwise privileged documents.  Apparently the firm said no. ... In any event, the people making the decision to "cooperate" are not only managers but undiversified investors with both a monetary and reputational stake in the outcome of the individual indictments.  What is at stake here is the future of the MW model and class-action lawyering in general.  MW cannot afford to cut and run.

Tom Kirkendall:

... the indictment alleges that Bershad used cash from a safe in his credenza to pay kickbacks to plaintiffs. Gee, I thought that only big-time college football and basketball coaches engaged in that sort of thing with their star players. ;^)

Larry Ribstein thinks an indictment could prove fatal because:

An indictment may put Milberg effectively out of business because courts and lead plaintiffs would be leery of supporting lead counsel status for firm facing this much trouble.

Law Blog notes a case in which that chicken is already coming home to roost:

The ripple effects of yesterday’s criminal indictment of Milberg Weiss Bershad & Schulman are starting to be felt. Today the Ohio attorney general, acting on behalf of its client the Ohio Tuition Trust Authority, fired Milberg Weiss. The class-action firm was representing Ohio’s public college savings fund in class-action litigation against Putnam American Government Income Fund for its alleged involvement in improper mutual-fund trading.

The 1965 Immigration Act

Steven Taylor reviews the US immigration laws that lead up to the critical Immigration and Naturalization Act of 1965. Personally, I've always thought the 1965 Act was one of the most beneficial pieces of legislation in our nation's history. Why? I'll let Calvin Trillin explain:

I think in some ways there is a lot more good food in the country than there ever was, and I always say that it’s because of the Immigration Act of 1965, which replaced a policy that actually let in more people from Great Britain who wanted to come at the expense of the Chinese. That’s a suicidal policy when it comes to food, a national quota system based on favoring England and northern Europe, basically on the theory that people who eat bland food make better citizens than other people. It took a few years for the effect to be felt, but now you might go to a town in Iowa and find a Laotian restaurant or something, you know, because there are clumps of people all over the place.

Indeed, as Trillin observed elsewhere, the pre-1965 laws "reflected not simply bigotry but the sort of bigotry that seemed to equate desirable stock with blandness in cooking." Like Trillin, "although I am perfectly aware that only a person lacking in sensitivity would compare the problem of living in a place that offered a narrow range of truly interesting restaurants with the problem of involuntary servitude, I have to say that some serious eaters think of the Immigration Act of 1965 as their very own Emancipation Proclamation."

SOX: No Relief in Sight

Despite clear evidence that Sarbanes-Oxley has a disproportionate impact on smaller public corporations, and the recommendations of its own advisory committee for significant regulatory relief for such corporations, the Securities and Exchange Commission has offered up an incredibly lame proposal whose centerpiece is a Concept Release in which the SEC will ask for advice as to the types and forms of guidance it should provide to corporations on how to complete their assessment of internal controls over financial reporting. In other words, the SEC wants advice from corporations as to what advice the SEC should give corporations. Really. How incredibly lame.

For background on the problem, see my Sarban es-Oxley: Legislating in Haste, Repenting in Leisure. For additional (negative) commentary on the SEC's decision, see Larry Ribstein's Ideoblog and the W$J's Law Blog. If I get my druthers, a blast at the SEC's fecklessness will be the subject of next week's TCS Daily column.

UCLA Entertainment Law Program

National Law Journal reports:

Students who graduated last week from the University of California at Los Angeles School of Law were among the first at the school to earn law degrees with an area of concentration in entertainment law.

UCLA's law school launched the entertainment program last fall. "The new dean, Dean Michael Schill, felt that with Los Angeles being the center of the entertainment practice, it was desirable that the law school have a form of specialty in that area," said Kenneth Ziffren, an entertainment lawyer and partner at Los Angeles- based Ziffren, Brittenham, Branca, Fischer, Gilbert-Lurie, Stiffelman & Cook.  "We sat down over a six-month period and came up with a program we think is unique. We checked out other law schools and found nothing of this nature."

... The program requires students to take a total of seven courses and write a research paper. The required courses involve a basic background in entertainment law, plus classes taken from UCLA's School of Theater, Film and Television and Anderson School of Management.

Once again, first in the nation.

Pay with Performance

A core claim of the "CEOs get paid too much" school of thought is summarized by the title of Lucian Bebchuk and Jesse Fried's book Pay Without Performance; i.e., CEO salaries aren't correlated with firm performance. Tyler Cower begs to differ:

But in a new paper, "Why Has C.E.O. Pay Increased So Much?" (http://ssrn.com/abstract=901826), the economists Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Stern School of Business at New York University offer a contrarian view. They suggest that the higher salaries for chief executives can largely be explained by increases in the value of the stock market. Viewed as a whole, these salaries are a result of competitive pressures rather than the exploitation of shareholders.

Their core argument is simple. If we look at recent history, compensation for executives has risen with the market capitalization of the largest companies. For instance, from 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional sixfold matching increase (the correlation coefficients are 0.93 and 0.97, respectively; 1.0 would be a perfect match).

So how does this argument work? Better executive decisions create more economic value. If the number of big companies is greater than the number of good chief executives, competitive bidding will push up pay to reflect the value of the talent.

As Professors Gabaix and Landier predict, chief executives' salaries in different sectors are higher when the capitalization of that sector is higher. A stronger sector means more bidders for a chief executive of a particular kind; an executive who has run one car company can go run another. Chief executives in large industries, therefore, receive more, even after adjusting for the size of their current companies. Business services, computers and banking turn up as exceptions for this comparison; their top executives are overpaid relative to what market capitalization alone would imply. Perhaps chief executives can add more value in more dynamic sectors.

... Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. The critics contend that chief executives cheat public shareholders. But private equity typically pays its top executives very well, even though public shareholders are not a factor. Furthermore, the rate of productivity growth in the United States has been the envy of the world. Chief executives must be doing something right.

For my take, see Executive Compensation: Who Decides?

Impact of SOX on Corporate Boards

A new paper finds that Sarbanes-Oxley has a significant impact on corporate boards of directors:

Director workload and risk increased: audit committees meet more than twice as often post SOX as they did pre SOX, and Director and Officer (D&O) insurance premiums more than doubled. SOX also had a dramatic affect on the makeup of the corporate director pool: more post-SOX directors are lawyers/consultants, financial experts and retired executives, and fewer are current executives.

Whether these changes are providing significant corporate governance benefits is debatable; what is not subject to debate is that they are proving quite costly and, worse yet, those costs are being felt disproportionately by smaller public corporations.

These changes drove a large increase in the cost of the board, particularly for small firms. For example, small firms paid $3.19 in director fees per $1,000 of net sales in 2004, which is $0.84 more than they paid in 2001 and $1.21 more than in 1998. In contrast, large firms paid $0.32 in director fees per $1,000 of net sales in 2004, seven cents more than they paid in 2001 and ten cents more than in 1998.

I find it more than a tad ironic that I should receive this paper on the same day the SEC announced its pathetically lame regulatory relief (or, should I say, "non-relief") for small public companies.

Predicting Enron

Back in January, Gordon Smith said he "would not be surprised to see both Ken Lay and Jeff Skilling acquitted, but perhaps the government's case is stronger than I expect."

Now Gordon says: "The government's case was pretty much what I expected, but Lay and Skilling were much worse than I expected. ... Predicting juries is highly uncertain, but this one looks like it's headed for a guilty verdict." Gordon also notes that the betting at Tradesports is leaning heavily towards convictions for both.

Based on what I've seen of the trial, I think Gordon's current prediction is correct: My guess is that both will be convicted. In any event, we should now soon. The jury is expected to begin deliberations today.

Meetings and Dominance Rituals: Implications for Corporate

Because I fancy myself something of a student of how groups make decisions, during meetings I devote much of my time not to the agenda but to observing how the group is behaving. As the owner of two dogs, I'm also necessarily something of a student of pack behavior and dominance rituals. Lately, I've been thinking about how the two lines of inquiry overlap. After all, effective boards of director meetings presumably promote effective corporate governance.

It is well-established that persons of higher stature within the group tend to talk more than persons of lower stature. Where the group is a new one, and status relations are undefined, however, the competition for speaking time becomes a critical part of the larger competition for dominance within the group. In turn, this leads to filibustering, cross-talk, and other dysfunctional behaviors that may prevent the meeting from accomplishing anything substantive.

You can usually identify the would-be alpha dogs pretty easily. They will start talking and simply not stop. Typically both their volume and speaking speed will be high. They will not meet anyone in the eye for an extended period and will ignore "I want to talk" body language. Anything said by anyone else will be immediately woven back into the filibustering speaker's line of argument, including express disagreement or even non sequiturs.

There are several ways of managing this sort of competition. One is to define a group hierarchy pre-meeting, perhaps by establishing a chairman as a presiding officer, who becomes the alpha dog by definition. An effective chairman can keep control of the agenda and keep the meeting on course. Unfortunately, just as a weak-minded owner invites his/her dog to compete for dominance, an ineffectual chairman can actually make the situation worse by inviting nominal subordinates to compete for control.

Alternatively, you can believe that people are not pack animals and hope to set up an egalitarian, non-hierarchical, consensus-building atmosphere. Personally, I don't believe it is possible to do so. Humans are pack animals. We are hard-wired by evolution to establish dominance relationships, which is probably one reason we were able to so successfully domesticate dogs. Stud ies of chimpanzees, for example, find that "high-ranking females were shown to have significantly higher infant survival, faster maturing daughters, and more rapid production of young." Our ancestors thus got a significant reproductive and genetic reward for successfully competing for dominance.

Competition for dominance, moreover, is arguably socially beneficial. Once a clear dominance hierarchy (pecking order) is established, aggression within the group becomes less likely, because less dominant individuals will not incur the high costs of challenging more dominant individuals. The resulting social stability facilitates subsequent cooperation between group members.

Hence, for effective meetings, it likely will be best if the group has a dominance hierarchy imposed on it from the outside at the outset or collectively establishes one at the earliest opportunity, so as to minimize the amount of time spent on non-constructive dominance rituals. (The benefits of such competition, after all, follow mainly from the establishment of the hierarchy rather than the competition itself.)

(Or, you can do what I often do, which is to slip out the back door and go for a drive.)

If I'm right about the way dominance rituals affect group decision making in meetings, it suggests that one function of the board of directors is providing a set of status equals for top managers. We know, for example, that higher status group members are more inclined to propound initiatives and exercise greater influence over the group?s ultimate decision. As such, corporate law?s insistence on the superiority of the board to management begins to make sense. To the extent law shapes social norms, admittedly a contested proposition, corporate law may empower the board to constrain top management more effectively by creating a de jure status relationship favoring the board.

A US MI5?

Judge Richard Posner thinks it would be a good idea:

The U.K.'s domestic intelligence agency, MI5, works closely with Scotland Yard, Britain's counterpart to the FBI. But it is not part of Scotland Yard.

The British understand that a criminal-investigation culture and an intelligence culture don't mix. A crime occurs at a definite time and place, enabling a focused investigation likely to culminate in an arrest and conviction. Intelligence seeks to identify enemies and their plans before any crime occurs. It searches for terrorist sleeper cells in the U.S. with no assurance of finding any. Hunting needles in a haystack is uncongenial work for FBI special agents. And so at the same time that the attorney general was testifying before Congress that the National Security Agency's intercepting some communications of U.S. citizens is essential to national security, leaks from inside the FBI revealed that special agents are disgruntled at having to chase down the leads furnished to them by NSA. FBI special agents--the bureau's only operations officers--want to make arrests, and so they zero in on animal-rights terrorists and ecoterrorists--people known to be committing crimes and therefore relatively easy to nail. These people are criminals and should be prosecuted, but as they do not endanger national security, prosecuting them should not be an intelligence priority.

One advantage of such an agency would be the fresh start - it would, presumably, be unencumbered by the predelictions and biases of the FBI and CIA.

Hierarchy and Markets

Blogger Ronny Max emails:

I'm an avid reader of your blog, and although I don't agree with all of your opinions and sometimes I don't understand what you say, I cherish your posts as a personal litmus test.

I read your article Happy Hierarchy? on TCS, and I agree happiness is not a good argument in support of activist shareholders. I think a better way to approach this topic by presenting a case for 'efficiencies of hierarchy versus market Transactions.' Any thoughts?

He's right, of course. See my Privately Ordered Participatory Management: An Organizational Failures Analysis:

Abstract: American industrial enterprises long organized their production processes in rigid hierarchies in which production-level employees had little discretion or decision making authority. Recently, however, many firms have adopted participatory management programs purporting to give workers a substantially greater degree of input into corporate decisions.

Quality circles, self-directed work teams, and employee representation on the board of directors are probably the best-known examples of this phenomenon.These forms of workplace organization have garnered considerable attention from labor lawyers and economists, but relatively little from corporate law academics. This is unfortunate, both because the tools routinely used by corporate law academics have considerable application to the problem and because employee participation is ultimately a question of corporate governance.

According to conventional academic wisdom, perceptions of procedural justice are important to corporate efficiency. Employee voice promotes a sense of justice, increasing trust and commitment within the enterprise and thus productivity. Workers having a voice in decisions view their tasks as being part of a collaborative effort, rather than as just a job. In turn, this leads to enhanced job satisfaction, which, along with the more flexible work rules often associated with work teams, results in a greater intensity of effort from the firms workers and thus leads to a more efficient firm.

Although this view of participatory management has become nearly hegemonic, the academic literature nevertheless remains somewhat vague when it comes to explaining just why employee involvement should have these beneficial results. In contrast, my article presents a clear explanation of why some firms find employee involvement enhances productivity and, perhaps even more important, why it fails to do so in some firms. Despite the democratic rhetoric of employee involvement, participatory management in fact has done little to disturb the basic hierarchial structure of large corporations. Instead, it is simply an adaptive response to three significant problems created by the tendency in large firms towards excessive levels of hierarchy. First, large branching hierarchies themselves create informational inefficiencies. Second, informational asymmetries persist even under efficient hierarchial structures. Finally, excessive hierarchy impedes effective monitoring of employees. Participatory management facilitates the flow of information from the production level to senior management by creating a mechanism for by-passing mid-level managers, while also bringing to bear a variety of new pressures designed to deter shirking.

JEL Classifications: G31, G32, J53

Happy Shareholders?

In his recent book, Shareholder Participation and the Corporation: A New Perspective, Australian corporate law scholar James McConvill draws on "recent empirical studies into human happiness" to argue that "shareholders, particularly individuals, should be included in the internal governance framework of public corporations, and enjoy a direct participatory role in the corporation if they so choose."

McConvill relies on behavioral research claiming that active participation in the organizations of which one is a part are one of the key lifestyle factors positively correlated with personal happiness.

This is the first time happiness has been advanced to justify shareholder participation in corporate decision-making. The happiness research usually is deployed so as to justify participation by non-shareholder corporate constituencies in corporate governance, especially corporate employees.

One immediate problem with McConvill's argument is that it is difficult to cabin participation rights granted on the basis of promoting happiness to a single constituency. Indeed, if this is the basis on which participation rights are to be assigned, other corporate constituencies would have a far stronger claim than diversified investors who own stock in many companies and often are active traders. In particular, if this is the basis on which we allow participation, employees, who generally work for a single firm and often find community and solidarity at work, would have the strongest case for participation.

A second problem is that the literature on happiness and participation simply isn't very persuasive. The bulk of the research focuses on claims relating to employee happiness, attempting to link participation rights to productivity. As I detailed in Corporate Decisionmaking and the Moral Rights of Employees: Participatory Management and Natural Law, the literature's claims simply don't hold up on close examination.

As John Witte contended in his important case study of self-directed work teams, "there is little reason to suspect that most workers would either endorse participation or become actively involved if the opportunity arose." To the contrary, Witte posits that workers generally accept hierarchical authority and perceive obedience to authority as an integral part of their job: "for the majority, disobedience is unthinkable."

Witte's pessimistic prediction is confirmed by a wealth of data. Only about half of the participants in Witte's own case study were willing to change jobs in order to get more participation and that rate declined rapidly if doing so would require longer hours or lower pay. A study of transportation firms found that long-term use of employee involvement initiatives increased stress and decreased employee fulfillment. [Anderson (1996).] A study of "empowered" employees versus a control group of unempowered employees within a single insurance company found no statistical difference between the two groups on such productivity-related issues as motivation or even on some job satisfaction measurements. [Thorlakson & Murray (1996).]

In unionized plants, rank and file workers have often resisted collective bargaining agreements that included employee involvement. In firms adopting self-directed work teams, ten to twenty percent of employees will resist the change because they prefer a mundane job to the greater responsibility and higher expectations associated with team membership. Other studies have found even higher rates of resistance: Participation rates in voluntary participatory management programs range from a low of 33 percent to a high of 68 percent of the eligible workforce. [Miller & Prichard (1992).] Conversely, nonparticipating employees in that study showed interest in volunteering for employee involvement programs at rates ranging from a low of 15 percent to a high of 63 percent.

Why does such a high percentage of workers appear to prefer hierarchy? Some are simply being economically rational. Behavioral patterns that are learned over many years, and reinforced by past rewards, are exceedingly difficult to change. As such, many firms will experience a path dependent resistance to participatory management. Introduction of participatory management within a firm typically entails substantial change, which will threaten vested interests in the workforce. Self-directed work teams threaten the seniority -- and even the jobs -- of foremen and other supervisory employees. Surviving supervisors are thrust into new positions as "team consultants" rather than bosses, with new and demanding responsibilities. Gain-sharing, pay for skills, and team-based compensation all threaten traditional seniority-based compensation. Training may be resisted by some workers: the old dogs who don't want to learn new tricks. The job rotation and stress on "continuous improvement" characteristic of self-directed work teams will threaten those workers who prefer a more mundane set of job responsibilities.

Studies of formalization -- the creation of written rules, procedures, and instructions -- provide an alternative explanation of the taste for hierarchy. Formalization reduces role conflicts and ambiguity, which increases work satisfaction and reduces feelings of alienation and stress. Employee involvement can trigger role stress because many employees lack the quasi-management skills -- agenda building, conflict management, and problem solving -- required for successful employee involvement. Alienation can result from the greater workload and negative changes in peer group relationships experienced by some participants in employee involvement.

Workers who respond well to formalization are poor candidates for participatory management, and vice-versa. This hypothesis is supported by findings that the success of a participatory management program largely depends on the personality of workers and managers. Workers with weak desires for independence are unaffected by employee involvement, while those with strong independence drives get increased job satisfaction from it. [Cotton (1993).] Based on the various studies recounted above, both types of workers appear to be present in the American workplace. Whether the taste for participation or for hierarchy is more common is hard to say from the evidence to date, but at the very least the history of participatory management has taught us that not everyone wants more autonomy, challenge, and responsibility.

Once the heterogeneity of worker tastes is conceded, government-mandated participatory management cannot be defended on Pareto superiority grounds. Those workers who have a taste for hierarchy would be worse off under such a mandate.

Most of these arguments would seem to apply with equal force to shareholder participation. Given the strong economic case against extensive shareholder participation, as I recently detailed in my UCLA Law Review article The Case for Limited Shareholder Voting Rights, I'm afraid I end up being rather skeptical of this new string in the shareholder empowerment bow.

References

Ronald D. Anderson et al., Relationships of Work Improvement Program Experience and Logistics Quality Management Factors, 36 Transportation J. 20 (1996).

John L. Cotton, Employee Involvement (1993).

Robert W. Miller and Frederick N. Prichard, Factors Associated with Workers' Inclination to Participate in an Employee Involvement Program, 17 Group & Org. Mgmt 414 (1992).

Alan J.H. Thorlakson & Robert P. Murray, An Empirical Study of Empowerment in the Workplace, 21 Group & Org. Mgmt 67 (1996).

John F. Witte, Democracy, Authority, and Alienation in Work: Workers' Participation in an American Corporation (1980).

The Bishops' Alter Ego

My latest law review article (co-authored with Aaron Cole, an outstanding recent UCLA graduate) is The Bishop’s Alter Ego: Enterprise Liability and the Catholic Priest Sex Abuse Scandal. The article is forthcoming in the Journal of Catholic Legal Studies, but a working version can be downloaded from SSRN by clicking the link above.

Abstract: Since 1950, more than 11,500 sex abuse claims have been filed against priests and other agents of the Roman Catholic Church. The eventual direct costs to the Catholic Church of the priest abuse litigation are predicted to range from $2 to $3 billion.

The corporate structure of the Church under civil law can have a substantial impact on the ability of priest sex abuse claimants to recover on favorable judgments or settlements. In many U.S. dioceses, all Church assets are owned by a single corporation, typically a corporation sole, by virtue of which the local bishop becomes the legal titleholder of all Church-affiliated property in the diocese. The dominant view is that all assets of such dioceses, including those of individual parishes and other so-called juridic persons, are available to satisfy tort judgments against the diocese.

Some dioceses, however, long have separately incorporated at least some of their affiliated juridic persons. In response to the priest sex abuse liability crisis, there is a growing trend for diocesan assets to be divided among multiple incorporated entities. Although separate incorporation of diocesan assets implicates a number of legal doctrines, alter ego claims likely will play a central role in any litigation seeking to reach the assets of such corporations for the benefit of diocesan creditors.

There is no constitutional bar to a court using the alter ego doctrine to treat a diocese and its separately incorporated parishes as a single enterprise for liability purposes in the priest sex abuse scandal litigation (or any other dispute, for that matter). The analysis in this paper, however, suggests that appropriate cases for invoking the alter ego doctrine in this context will be few and far between.

Two entities will be treated as alter egos where (1) one entity exercises such a high degree of control that the other has effectively lost its separate existence and (2) the controlling entity has abused its power of control in an unjust or inequitable manner. As to the former prong, a diocesan bishop who comports himself in accordance with the requirements of canon law is unlikely to exercise the requisite degree of day to day control over a separately incorporated parish. As to the latter prong, the courts have discretion to consider the potentially severe deleterious impact of liability on the ability of innocent parties to exercise religious practices implicating constitutionally protected values. In other words, while the Free Exercise and Establishment clauses do not bar judicial application of the alter ego doctrine to churches, the values protected by those provisions appropriately may be weighed in the balance. Given the ready availability of alternative doctrines better suited to the problems at hand, particularly fraudulent transfer law, there case against invoking alter ego in this context thus becomes quite strong.

Grand Jury Leak = Insider Trading?

Via Law Blog comes news of the oddest insider trading allegation I've ever seen in 20-odd years of following the development of insider trading law (jeez, am I really that old?). Here's an excerpt from the SDNY US Attorney's press release:

MICHAEL J. GARCIA, the United States Attorney for the Southern District of New York, and MARK J. MERSHON, the Assistant Director-in-Charge of the New York Office of the Federal Bureau of Investigation, announced today the arrest of JASON SMITH and the unsealing of a Complaint in Manhattan federal court charging SMITH with insider trading. As alleged in the Complaint, SMITH, while serving as a juror on a federal Grand Jury in New Jersey, leaked confidential information concerning the grand jury's investigation of accounting fraud at Bristol-Myers Squibb Company. ...

SMITH, an employee of the U.S. Postal Service in New Jersey, is charged with leaking that information to Eugene Plotkin, an associate at Goldman Sachs & Co. and David Pajcin. Plotkin and Pajcin were previously charged with participating in a multi-million dollar international scheme to trade on inside information obtained from numerous sources. Pajcin and Plotkin, after receiving tips from SMITH concerning the progress of the Grand Jury's investigation, traded and tipped others to trade in Bristol-Meyers securities, betting that the stock price would decline once the outcome of the Grand Jury's investigation.

First, the chutzpah of Plotkin and Pajcin is almost unrivaled in my experience: Suborning a grand juror to tip them off about grand jury investigations? Not even Ivan Boesky went that far. Second, I just don't understand how what Smith did was insider trading.

Under SEC Rule 10b-5, there are two basic theories on which someone can be held liable for insider trading. (1) Classic disclose or abstain: An insider or other fiduciary trades in the stock of the company to whom he owes fiduciary duties. As a grand juror, Smith owed no duties to Bristol-Myers or the shareholders thereof. So no liability there.

(2) Under the so-called misappropriation theory, liability arises where the trader breaches a fiduciary duty or other duty of trust and confidence owed to the source of the information. Suppose, for example, that Acme Corporation is planning a big contract with Ajax Corporation. When announced, the stock of both companies is expected to rise. I am a lawyer working for Acme. I owe fiduciary duties to Acme. I owe no duties to Ajax. If I trade in Acme stock, that is classic insider trading. If I trade in Ajax stock, that is misappropriation. But on what possible theory does a grand juror owe a fiduciary duty to the government? To be sure, he might have a legal obligation of confidentiality, so perhaps the SEC is relying on Rule 10b5-2(b)(1), which provides that "a 'duty of trust or confidence' exists in the following circumstances, among others: 1. Whenever a person agrees to maintain information in confidence ...." If so, this will raise several interesting questions. First, did the SEC have authority to adopt Rule 10b5-2 at all? Second, prior to the adoption of Rule 105-2, the Second Circuit in US v. Chestman held that, at least insofar as criminal cases are concerned, a duty of trust and confidence must rise to the level of a traditional fiduciary relationship. As such, a mere contractual (or statutory) obligation of confidentiality will not suffice. Does Chestman trump 10b5-2? Finally, does this case stretch the notion of insider trading too far? Or is the fact that there was a plan to trade on the basis of leaked information about securities fraud investigations suffice?

As Arte Johnson used to say, "Verrrrry interesting."

Is SOX Dragging Down the US Economy?

The world's capital markets are increasingly interconnected, but until recently the US remained the premier capital market. Most IPOs either took place wholly in the US or, at the very least, included a US component. Foreign firms aspired to public listing on a US capital market as validation of their governance and dissclosure practices.

Since Congress passed Sarbanes-Oxley, however, these trends are reversing, as pointed out by Senator Jim Demint and Congressman Tom Feeney:

America is no longer on the winning side when it comes to attracting capital. Nine of every 10 dollars raised by foreign companies in new stock offerings were raised in New York in 2000. Yet in just five years we have seen a complete reversal of fortunes. In 2005, nine of every 10 dollars raised by foreign companies in new stock offerings were raised abroad.

To be sure, the US economy is doing pretty well, but Demint and Feeney claim that that success is despite SOC rather than because of it:

America has had 18 consecutive quarters of economic growth and currently enjoys a low unemployment rate. Some may say this indicates that Sarbox is working well; but we believe this indicates the tax cuts in 2001 and 2003 are working well despite Section 404.

The data offered by a W$J editorial suggests that their analysis is correct:

House and Senate GOP conferees finally agreed yesterday on extending the 15% tax rate on dividends and capital gains for two more years through 2010. This means you can expect lots of media and liberal rhetoric about "the deficit" and "the rich," but the real news is how well these lower rates have been soaking the rich to fill government coffers.

The latest evidence is Treasury's monthly budget report for May that tax receipts were up by $137 billion, or a remarkable 11.2%, for the first seven months of Fiscal 2006 through April. That's more than triple the inflation rate. And it comes on top of the $274 billion, or 14.6%, increase in federal revenues for all of Fiscal 2005, which ended last September 30. ... this revenue tsunami is the direct result of the expansion that took off in earnest at about the time the 2003 tax cuts passed. Lower tax rates have since had precisely the result that supporters predicted, though don't look for that story on page one any time soon.

If that's right, we have a window of opportunity in which to fix SOX before the next downturn shows us just how badly SOX is affecting the US competitive position in the global capital markets. Towards that end, Demint and Feeney are sponsoring a Competitive and Open Markets Protecting and Enhancing Treatment of Entrepreneurs (Compete) Act::

The act would require the SEC to create alternative requirements for companies that wish to opt out of Section 404 and it would instruct the SEC and PCAOB to change the standard of what is a true material weakness. Auditors would be able to focus on substantial issues truly affecting the investor's bottom line rather than auditing every insignificant transaction. This will allow small- and medium-sized companies to invest in growth instead of unnecessary auditing costs. Also, our legislation would allow companies conducting an internal audit to receive technical advice from external auditors. While the PCAOB claims that guidance has been issued to address this problem, there is still significant confusion among auditors and companies on this issue.

It's a corny bill name designed (as so often is the case these days) to create a pleasing acronym, but the idea is sound. Despite the recommendations of its own Advisory Committee, the SEC seems disinterested in providing significant regulatory relief any time soon. The bill would give the SEC the necessary kick in the pants.