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SOX and Board Size

I haven't been blogging much lately, mainly because I've been working away on meeting the looming 9/15 deadline for submitting my forthcoming book, The Complete Guide to Sarbanes-Oxley, to the publisher. In working on the book, I've learned a lot about SOX. One tidbit, which I found interesting because it relates to work I've done on group decision makning by boards of directors, is the impact SOX and related stock exchange listing standards is having on the size of boards of directors.

There’s a very famous 1913 industrial psychology study that confirms the old adage “too many cooks spoil the broth.” The researcher measured how hard subjects pulled on a rope. Members of two-person teams pulled to 93% of their individual capacity, members of trios pulled to only 85%, and members of groups of eight pulled to only 49% of capacity. The researcher named the phenomenon “social loafing.” It’s attributable partially to the difficulty of coordinating group effort as group size increases. Social loafing is also attributable, however, to the difficulty of motivating members of a group where identification and/or measurement of individual productivity is difficult —i.e., where the group functions as a team.

While board decision making differs rather dramatically from tug-of-war, members of a multi-member board nevertheless likely engage in a certain amount of social loafing. To be sure, unlike a team in a tug-of-war game, board members probably do not get into each other’s way. Accordingly, it is unlikely that there will be physical coordination problems. Yet, because social loafing is also attributable to the difficulty of motivating members of a team with non-separable outputs and non-observable inputs, it nevertheless also can be expected with respect to the workings of a relational team like the board.

Although the social loafing phenomenon suggests that smaller boards probably are more effective, there are considerations cutting in the other direction. For example, larger boards may facilitate the board’s resource-gathering function. Having more directors usually translates into more interlocking relationships with other organizations that may be useful in providing resources, such as customers, clients, credit, and supplies. Board interlocks may be especially helpful with respect to formation of strategic alliances. Firms considering a joint venture need access to credible information about the competencies and reliability of prospective partners. Almost by definition, however, this information is asymmetrically held and subject to strategic behavior. Interlocks between prospective partners provide both access to such information and, by analogy to hostage taking, a credible bond of the information’s accuracy.

Larger boards with diverse interlocks are also likely to include a greater number of specialists—such as investment bankers or attorneys. This is relevant not only to the board’s resource gathering function, but also to its monitoring and service functions. Complex business decisions require knowledge in such areas as accounting, finance, management, and law. Providing access to such knowledge can be seen as part of the board’s resource gathering function. Board members may either possess such knowledge themselves or have access to credible external sources who do. Larger, more diverse boards likely contain more specialists, and therefore should get the benefit of specialization.

So is there an optimal board size? This is yet another situation in which one size likely does not fit all, but corporate governance experts generally agree that seven to nine members is the right size for most boards.

Advice for 1Ls

Paul Caron has rounded up a massive collection of links with advice for first year law students.

One size does not fit all businesses

American securities regulation tends to adopt a one size fits all model. Under Sarbanes-Oxley, for example, all companies are required to have an audit committee. Under NYSE and NASDAQ listing standards, all companies (except those with controlling shareholders) must have a majority of independent directors. It has been a fundamental thesis of my scholarship that one size does not fit all (see, e.g., my critique of the NYSE director rules). Now I have evidence. One Size Does Not Fit All, After All: Evidence from Corporate Governance by SRIDHAR R. ARCOT and VALENTINA GIULIA BRUNO of the London School of Economics (LSE):

We identify well-governed companies by accounting for heterogeneity in their governance choices by using a unique dataset. We find that companies that depart from governance best practice because of genuine circumstances outperform all others and cannot be considered badly-governed. On the contrary, we find that mechanical adherence to best practice does not always lead to superior performance. We thus argue that flexibility in corporate governance regulation plays a crucial role, because companies are not homogenous entities.

In the Mail: The Geek Gap

The Geek Gap is sub-titled "Why Business and Technology Professionals Don't Understand Each Other and Why They Need Each Other to Survive." After spending my summer writing a guide to Sarbanes-Oxley for businesspeople (forthcoming late fall), one of the things I've learned is the essential and growing role IT plays in law compliance. At WorldCom, for example, it was an antiquated and only partially computerized system of internal controls that allowed top management to cook the books. In contrast, post-SOX, most businesses have adopted comprehensive software platforms to manage their section 302 and 404 compliance obligations. Unfortunately, as The Geek Gap demonstrates in detail, IT and management are rarely on the same page. It's a fast read with lots of anecdotes. Recommended.

Ridge Lytton Springs (Dry Creek Valley) 2000

I wouldn't say this wine has evolved since it was last noted in February 2005, but it certainly continues to mellow. This bottle exhibited a lot of black pepper, with a definite impression of sour cherries and wild berries on the mid-palate. It is fully integrated and drinking nicely, but should hold for several more years. With three bottles left in my cellar (albeit one of which has gone MIA), I plan to drink them up by 2008. Grade: B++

Ribstein on Strine on Bainbridge

Larry blogs:

In Trenwick America Litigation Trust v. Ernst & Young, L.L.P., C.A. No. 1571-N, August 10, 2006 (I don’t yet have an online cite), in a typically insightful opinion, Delaware’s VC Strine held, among other things, that the directors of a subsidiary did not breach a fiduciary duty to its creditors for taking on debt for the benefit of its parent corporation, which owned 100% of its stock, although the parent and the sub eventually became insolvent. ...

Of particular interest (to me, anyway) is Footnote 75 to the opinion, in which VC Strine responds to Steve Bainbridge’s idea in Much Ado about Little that directors cannot owe duties to the corporate entity, because the entity doesn't really exist:

The judicial decisions indicating that directors owe fiduciary duties to the firm when it is insolvent are not, in my view, at odds with Bainbridge’s fundamental perspective; indeed, they seem to me more a judicial method of attempting to reinforce the idea that the business judgment rule protects the directors of solvent, barely solvent, and insolvent corporations, and that the creditors of an insolvent firm have no greater right to challenge a disinterested, good faith business decision than the stockholders of a solvent firm. ....

I will have more to say about this opinion soon, of course.

In Trenwick America Litigation Trust v. Ernst & Young, L.L.P., C.A. No. 1571-N, August 10, 2006 (I don’t yet have an online cite), in a typically insightful opinion, Delaware’s VC Strine held, among other things, that the directors of a subsidiary did not breach a fiduciary duty to its creditors for taking on debt for the benefit of its parent corporation, which owned 100% of its stock, although the parent and the sub eventually became insolvent. ...

Of particular interest (to me, anyway) is Footnote 75 to the opinion, in which VC Strine responds to Steve Bainbridge’s idea in Much Ado about Little that directors cannot owe duties to the corporate entity, because the entity doesn't really exist:

The judicial decisions indicating that directors owe fiduciary duties to the firm when it is insolvent are not, in my view, at odds with Bainbridge’s fundamental perspective; indeed, they seem to me more a judicial method of attempting to reinforce the idea that the business judgment rule protects the directors of solvent, barely solvent, and insolvent corporations, and that the creditors of an insolvent firm have no greater right to challenge a disinterested, good faith business decision than the stockholders of a solvent firm. ....

The War Myopia

Austin Bay proposes a McCain-Lieberman ticket in 2008 (which An drew Su llivan also floated it a couple of months ago), which is just about the worst political idea I've heard in ages. It's premised on the myopic idea that the war on terror is the only thing that matters:

A McCain-Lieberman presidential ticket would be the closest thing a national unity government the American system can produce. It would make an international political statement of enormous significance. The McCain-Lieberman statement: ?We?re fighting, we?ll continue to fight, and we will finish it.?

Campaigns against modern terrorism tend to be interminable. Look how long the Troubles in Northern Ireland, the Basque separatist movement in Spain, the various forms of Palestinian terror, the first Israeli occupation of Lebanon, the Kashmir separatists and other terror movements lasted. Decades. In each of these cases, the countries involved had to manage terror while also going forward with domestic policy. And so do we. Bush's myopic focus on the war has already pissed away the conservative moment, as I've documented before.

A McCain-Lieberman "national unity" ticket would be a disaster for those of us who prefer conservative policies. My problems with McCain's record are well documente d on this blog. As for Lieberman, I admire him personally, but with few exceptions this is a man of the left. As Ilya Shapiro observes:

Lieberman's supposed moderation rests mostly in his even-tempered disposition. This is a man, after all, who received an 80 percent approval rating Americans for Democratic Action and only 8 percent from the American Conservative Union (less than Hillary Clinton and Barbara Boxer and equal to Chuck Schumer and John Kerry).

A McCain-Lieberman ticket would be a disaster for conservative principles and policies. It could be justified only if you think (a) the war is the only thing that matters (which wasn't true even in WW II) and (b) you think military solutions are the way to win the "war."

Global Executive Compensation

I just finished reading Jennifer Hill's article Regula ting Executive Remuneration: International Developments in the Post- Scandal Era, which makes the interesting point that national laws governing executive compensation seem to be diverging even as commercial practices re executive compensation are converging. It's an interesting comparative overview of the various ways of regulating executive compensation. One quibble, however:

Hill says that the recent Disney litigation "demonstrated a surprising gap between acceptable and legally enforceable conduct by directors." I'm not sure why Hill finds this surprising. A basic premise of US corporate law is that much conduct that falls short of best practice is insulated from judicial review by the business judgment rule. One way of thinking about the issue is to conceptualize the duty of care as a standard of conduct, which specifies how directors should conduct themselves. In contrast, the business judgment rule is a standard of review, which sets forth the test courts will use in determining whether the directors? conduct gives rise to liability. Unlike typical negligence tort cases, in which the standard of review and the standard of conduct are identical, in corporate law they purportedly diverge. The function of the business judgment rule thus is to create a less demanding standard of review than the (largely aspirational) standard of conduct created by the duty of care. For more on this point, see the discussion of the Business Judgment Rule in my Corporation Law and Economics.

Unions and Corporatism

Michael Wachter's new paper Labor Unions: A Corporatist Institution in a Competitive World makes a very interesting read. In it, he argues that the long decline in private sector union membership is best understood as resulting not only from market forces and labor law changes, but also from changes in antitrust and corporate law. During the New Deal era, reformers configured those laws to create a corporatist state:

In a corporatist economy, labor unions, and in particular the federation of unions, are a central player. The union federation, as a peak association, counts separately from its members and has a seat at the highest level of policymaking. The union federation’s primary goal – achieving a fair wage rather than a competitive wage – fits the corporatist goal of stabilizing business. Unions serve as a public good; the critical countervailing force to corporate power.

The United States’ experiment with corporatism offered a coherent theory. Labor, antitrust and corporate laws were all to pull in the same direction. Fair wages were to be paid and those wages were to be above competitive wages. Fair wages were to be paid out of fair prices, and the fair prices were to be above the prices that would exist in a competitive product market. Directors of corporation would be asked consider the interest of stakeholders such as workers, in addition to shareholders.

That coherent story, where unions had a clear and consistent public-supporting role, was not replaced when today’s highly competitive economy crystallized. Unions no longer count directly in the public welfare calculus; only individuals count. Unions still bargain for a fair wage, but antitrust or industrial regulation no longer provides for above-competitive prices to pay those above-market wages. In corporate law, the directors are asked to manage the corporation so as to maximize the value of the shareholders’ interest. High wages that reduce corporate profits are arguably inconsistent with the fiduciary duties of faithful corporate directors.

The unraveling of the coherent corporatist theory leaves unions alone. Unions are a corporatist institution; they do not prosper when the forces of the competitive economy are unleashed.

Given that state corporatism is generally regarded as one of the components of Italian fascism, this is a very provocative argument. Given that the equation of New Deal corporatism and fascism also is a particularly common complaint of paleoconservatives/libertarians like Von Mises and Lew Rockwell (see, e.g., here), Wachter finds himself in some odd company here. Having said all that, however, it's still an interesting read.

Who killed the electric car?

My Examiner column:

As a work of entertainment, Chris Paine’s "Who Killed the Electric Car?" is a pretty decent thriller. As a historical document, however, it is sorely lacking.

Paine traces the history of General Motor’s EV1. Unlike Ken Burns’ Civil War documentary, which brought us distinguished historians as commentators (wasn’t Shelby Foote especially wonderful?), Paine relies mainly on Hollywood liberals whose stunning lack of understanding of engineering and economics becomes obvious the moment they open their mouth.

GM didn’t want to build the EV1, but did so to comply with the California Air Resources Board’s mandate that car companies doing business in the Golden State had to produce a zero-emissions vehicle.

Once the CARB modified the mandate to allow car companies to meet emissions targets in other ways, GM stopped producing the EV1 and recalled all existing cars. In Paine’s version of the story, the EV1 was a potential environmental savior murdered by evil car and oil companies and corrupt politicians.

In fact, except for a few Hollywood tree-huggers such as Ed Begley Jr. and Alexandra Paul, there really wasn’t much of a market demand for the EV1. And the reason is obvious: The original version with lead-acid batteries had a claimed range of 55 to 95 miles; the nickel-metal-hydride battery version had a claimed range of 75 to 130 miles. Both required an eight-hour charge.

In real-word driving, the EV1’s range frequently proved to be substantially less than the claims. There was more than one story of a commuter running out of charge on the freeway. On top of the limited range, the EV1 lacked luggage capacity. Not only couldn’t you haul the proverbial 4-by-8 sheet of drywall, you couldn’t even haul the equally proverbial two bags of golf clubs.

Limited range and cargo capacity don’t matter much if you’re a wealthy movie star who can afford two or more cars. You just supplement your EV1 with an SUV. However, most Americans don’t have that option.

Most Americans want a car that can handle occasional weekend jaunts. In my case, from my base in Los Angeles, I’d like to be able to reach places like Las Vegas (about 275 miles) or San Francisco (383 miles) in a single day’s driving. The EV1 simply couldn’t do it.

It thus was the market that killed the electric car. Even though it could have handled most day-to-day work-to-home commuting, it simply didn’t reflect the options most Americans want their car to provide.

The much-ballyhooed new generation of electric cars aren’t likely to have any more success than the EV1. The new Tesla electric sports car has a claimed maximum range of 250 miles, which would leave me stranded in the middle of the desert on a Vegas run, even if the maximum claimed range proved accurate (which it rarely did for the EV1). Plus, of course, the Tesla carries a movie-star price tag north of $100,000.

Meanwhile, the market continues to work its magic. Toyota recently announced plans to introduce a new version of its very popular line of hybrids in which the electric motor can be charged from a household outlet. Most estimates suggest a plug-in hybrid should achieve 100-plus mpg fuel efficiency.

So who killed the electric car? The Hollywood liberals who believe you can legislate taste. Who created a superior replacement? The market. Somewhere, Adam Smith is smiling.

Harvard Law Profs on SEC Rule 14a-8

Most of the corporate law professors on the Harvard Law School faculty jointly filed an amicus brief in American Federation of State, County & Municipal Employees Pension Plan v. American International Group, which is now on appeal before the Second Circuit Court of Appeals. They explain:

In this case, a shareholder submitted a proposal to amend the company's bylaws to require the company in certain circumstances to place candidates nominated by shareholders on the company's ballot, and the company sought to exclude this proposal from the ballot. We suggest in our amicus curiae brief that companies should not be allowed to exclude form the company ballot bylaw amendments concerning corporate elections. Prohibiting companies from doing so, we argue, is required by a reasonable interpretation of the proxy rules and necessary to advance the policy goals underlying the rules.

Wrong.

With respect to the policy argument, they contend that:

Allowing companies would to [sic] exclude a given type of proposal would all but eliminate voting on such proposals. Expanding the ability of companies to exclude a given class of corporate governance proposals whose exclusion is not permitted by the Rule would thus have potentially severe consequences, making it practically very difficult if not impossible for shareholders to adopt such proposals.

The problems with this argument are at least three-fold: (1) The Rule already allows companies to exclude shareholder proposals on a variety of substantive grounds. As such, the fact that "Allowing companies ... to exclude a given type of proposal would all but eliminate voting on such proposals" is irrelevant. By definition, the rule already allows companies to "eliminate voting" on a host of proposals. As such, this argument has zero force.

(2) Likewise, by definition, anytime the Rule permits exclusion of a proposal it becomes "practically very difficult if not impossible for shareholders to adopt such proposals." Hence, since the Rule does so with respect to a host of proposals, this argument is another red herring.

(3) Rule 14a-8(i)(8) allows exclusion of a proposal "If the proposal relates to an election for membership on the company's board of directors or analogous governing body." Hence, it is false to assert that exclusion of the proposals at issue "is not permitted by the Rule." Contrary to the argument made by Harvard law professors, the plain text of the Rule thus is to the contrary, requiring exclusion of the AFSCME proposal.

Finally, the Harvard law professor's interpretation of Rule 14a-8 is inconsistent with the basic policies of the securities laws. As I detail in The Short Life and Resurrection of SEC Rule 19c-4, the DC Circuit's seminal decision in Business Roundtable v SEC, the federal proxy rules were not intended to deal with the substantive aspects of shareholder voting rights. The federal proxy rules are properly concerned only with the need for full disclosure and fair solicitation procedures. While SEC Rule 14a-8 arguably is allowable as a control on management's ability to set the agenda, the Harvard law professors suggest an expansive interpretation of the rule that would gut the dividing line between state corporation law and federal proxy regulation.

It is state corporation law that decides the rule of the game by which directors are elected. It is precisely for this reason that the exclusion of matters relating to election of directors created by Rule 14a-8(i)(8) needs to get an expansive interpretation. The interpretation advanced by the Harvard law professors would intrude federal regulation into a core matter of corporate governance left to the states. The Harvard law professors may claim that the federal intrusion is minimal, since it goes only to whether shareholders get to vote on a proposal, but the logic of the Business Roundtable case is that deciding what issues are the proper subject of shareholder action is a matter of state law (which is also the logical interpretation of SEC Rule 14a-8(i)(1)'s exclusion of matters that are not a proper subject of shareholder action).

Even if the Harvard law professors' interpretation of the Rule was correct, it would still be awful public policy. Cf my TCS column on the Bally bylaws.

Stewart Settles

The SEC has announced a settlement of the insider trading charges against Martha Stewart, pursuant to which Stewart agreed to the following:

• Disgorgement of $45,673, representing losses avoided from her insider trading, plus prejudgment interest of $12,389, for a total of $58,062;
   
• A maximum civil penalty of $137,019, representing three times the amount of losses avoided;
   
• A five year bar from serving as a director of a public company; and
   
• A five year limitation on her service as an officer or employee of a public company. During that period, she will be prohibited from participating in certain activities, including financial reporting, financial disclosure, internal controls, audits, SEC filings, and monitoring compliance with the federal securities laws.

Wow! First, she's paying the maximum possible dollar penalties. Second, she's agreed to significant limitations on her abilities to function at her eponymous company Martha Stewart Living Omnimedia. She won't be able to go back on the board of directors or resume her position as CEO. So this is a very big win for the SEC - they couldn't have gotten much more by going to trial and winning. Query whether it's a big enough loss on Stewart's part as to amount to an implied admission of guilt?

The Best Book I Read this Summer ...

... was Charles Stross' Glasshouse. A brilliant blend of science fiction and horror, which is a fast-paced, brilliantly plotted, and fully realized post- singularity story. In a world where Stargate-like warp T-gates allow people to leap across light years and Star Trek replicator A-gates allow them to produce anything they like, including cloned versions of themselves, a gaggle of (we eventually learn) war criminals and espionage agents are trapped on a multi-generation starship for nefarious purposes by the side that lost the war. A bit heavy on computer jargon and the ending arguably is a little too pat/anti- climactic. Yet, even so, this book is further proof that Charles Stross is the best new talent in science fiction (with all due apologies to John Scalzi, who is also in the running for that title IMHO).

Mandle on Conason on Spitzer

At CT, Joe Mandle praises Joe Conason's review of Brooke Master's new bio of NY AG Eliot Spitzer:

[Spitzer] exposed widespread corruption, cronyism and immorality at the commanding heights of the American economy, exploding the myth of the self-regulating market.

Piffle. His attack on the mutual fund industry was "a gross abuse of prosecutorial power." "Just a quick overview of Spitzer's tactics over the past couple of years exposes the widespread abuse of authority and the rule of law in pursuing his popular agenda." He has consistently exhibited "egomania and serial disregard for due process." All in all, Spitzer has an impressive record of losing the Wall Street cases he actually takes to trial, conflicts of interest, abusing his prosecutorial powers for personal political gain, pushing his nose into areas that belong to the feds, higher mutual fund fees, using "the criminal law as an in terrorem weapon to force acceptance of industry-wide regulations," using litigation to regulate in ways that neither the state nor federal legislature chose to do, ignoring misconduct by political allies, and abusing the bizzare Martin Act.

King Pleads for Harry

Stephen King and John Irving both told JK Rowling they hope she won't kill off Harry Potter at the end of book 7:

"I don't want him to go over the Reichenbach Falls," King said in a reference to Arthur Conan Doyle's effort to kill off fictional detective Sherlock Holmes. Pressure from fans eventually led Conan Doyle to resurrect Holmes, who was found in a later story to have survived.

I still think Harry's done for. In reponse to King and Irving, Rowling made two very revealing comments:

"I feel quite liberated," she said. ...

Rowling said she didn't enjoy killing the major character who died in book six -- for the sake of those who haven't read it yet she avoided naming the victim -- but she said the conventions of the genre demanded the hero go on alone.

Rowling will only be truly liberated from the temptation to turn out sequels if Harry died. More important, as I've arg ued before, the "conventions of the genre" require that Harry die - or, at least, disappear. Joseph Campbell's Cosmogonic Cycle does a better job of defining those conventions than just about anything and it ends with the hero dying or otherwise leaving this plane of existence. Think King Arthur, Frodo, Anakin Skywalker, etc....