ProfessorBainbridge.com

What Left and Right Both Miss About the Wal-Mart Debate

Once again, Wal-Mart is being used as a political football. On the left, politicians and pundits use Wal-Mart as the poster child for living wages and mandatory health care benefits. On the right, Wal-Mart is held up as a paragon of corporate efficiency.

Interestingly, however, both the left and right implicitly cast Wal-Mart in the role of free market capitalist. What's missing from the debate is the extent to which the Wal-Mart story really is the antithesis of laissez-faire capitalism. When you look under the rug, it turns out that Wal-Mart is a beneficiary of corporate welfare.

When Wal-Mart plans a new store, it typically asks local and county governments for an array of benefits, principally in the form of various economic development subsidies:

• Infrastructure assistance in the form of new or expanded roads and utilities servicing the store location.
• Sales tax abatements.
• Property tax abatements.
• Income tax credits.
• Enterprise zone treatment for the store location.
• Eligibility for job training programs.
• Eligibility for tax exempt industrial revenue bond financing.
• Economic development loans and grants.

In some cases, Wal-Mart benefits directly from such subsidies. In others, the benefits initially go to the real estate developer who owns the land on which the store is built, but are then passed on to Wal-Mart in the form of reduced rents or a lower land sale price. In 2005, for example, the Dallas City Council approved a plan "to grant the developer half of the sales tax revenue that the Lake Highlands Wal-Mart produces specifically for the city of Dallas, up to $1 million."

It's hard to find reliable numbers on the total value to Wal-Mart of such subsidies. The leading report is Shopping for Subsidies: How Wal-Mart Uses Taxpayer Money to Finance Its Never-Ending Growth by Philip Mattera and Anna Purinton was published by a left-leaning advocacy group and funded in part by one of the very unions trying to unionize Wal-Mart's work force, which will suggest to some a need for caution. Yet, even if one applies a substantial discount to Mattera and Purinton's results, Wal-Mart is still doing quite well at the public trough:

• In a sample of subsidy deals for individual stores, they found subsidies ranging from "$1 million to about $12 million, with an average of about $2.8 million."
• In a survey of Wal-Mart regional distribution centers, they found that "84 of the 91 centers have received subsidies totaling at least $624 million. The deals, most of which involved a variety of subsidies, ranged as high as $48 million, with an average of about $7.4 million."

In a very real sense, Wal-Mart thus is in part a creature of big government. From this perspective, Wal-Mart's recent hiring of long-time Democratic operative Leslie Datch and significant increase in contributions to Democratic politicians comes as no surprise. (Of course, as Timothy Carney has argued, it may also be that Wal-Mart is now using big government not just to boost its own growth but as a tool to squash competition.)

Wal-Mart's defenders likely will argue that the long-run benefits to local communities outweigh the costs of the subsidies. On this question, reliable data is almost impossible to find. Yet, there are a couple of arguments against giving this defense too much weight.

First, it's clear that Wal-Mart plays off one community against another. When it comes to locating a new store, one city can be played off against another (or against unincorporated areas). As with any auction, the resulting inter-jurisdictional competition may lead cities to "over-pay" by giving Wal-Mart excessively large subsidies.

The problem is not just that competing cities bid up the price. Rather, if there are enough competing jurisdictions, one may see the so-called "winner's curse" come into play. In any auction, the winner will be the party with the highest reservation price. By definition, the winner thus is not only the party that puts the highest value on the item being auctioned, but also is the party most likely to over-value the item. After all, if the universe of bidders looks like a bell curve, is the bidder further to the right likely to be the one with the best estimate of the item's worth?

Second, we know that cities often over-estimate the economic benefits to be gained in return for such subsidies. A leading analysis of convention center feasibility studies, for example, found "consistent over-estimates of convention and tradeshow growth." As a result, "the competitive situations of new or expanded centers may be more difficult than predicted" by their boosters. There's no reason to think city or county analyses of the economic benefits of a Wal-Mart store or distribution center are any more reliable.

In sum, informed debate requires one to view Wal-Mart not as a rugged free market capitalist, but as a leading recipient of corporate welfare. If one is on the left, one thus might insist that Wal-Mart provide a so-called living wage in return for its subsidies. If one is on the right, one might call for abolishing such subsidies. In either case, however, we at last will be debating the real issues.

The nonexecutive chairperson

As detailed in a McKinsey survey , most US corporations have an executive chairman of the board of directors; typically, the CEO serves as chairperson. The US is relatively unique among major economies in this regard; in most, companies generally separate the CEO and board chair roles by law or practice.

Nonexecutive board chairs (and/or so-called lead independent directors) have been one of the major corporate governance "reform" proposals in recent years. Curiously, however, I can't find much evidence that separating the two roles improves corporate performance and/or has a positive stock price effect. Holmstrom and Kaplan's major survey of the corporate governance literature, for example, cites but a single study, which looked at the impact of various UK corporate governance rules on CEO turnover. The study found that the beneficial results "appear to have been driven by the increase in the fraction of outsiders on the board rather than the separation of the chairperson and CEO."

All of this is called to mind by the HP Leakgate. HP became one of the leading US companies to separate the CEO and chair roles after the board fired Carly Fiorina. Reportedly, however, if current board chairwoman Patricia Dunn steps down, CEO Mark Hurd may "emerge as chairman." Will it matter? In the absence of compelling evidence, count me as a skeptic. My intuition is that this sort of thing is mostly window dressing.

Can HP's Board of Directors Fire Dunn?

Reportedly, Patricia Dunn has said that she will step down if asked by the HP board of directors (unlike leaker George Keyworth who remains on the board, having refused requests that he resign). As I detailed in a 2003 post on Hollinger's Conrad Black, Delaware law pretty clearly empowers a company's board of directors to remove the chairman of the board from his/her position as chairman, but does not allow the board to remove that person from his/her position as a director. Only the shareholders (or, in rare cases, a court) can remove a sitting director from the board. This is why Keyworth is still hanging onto his board seat. On the other hand, of course, the board can refuse to nominate someone for reelection to the board when his/her term expires (as HP's board has said it will do with respect to Keyworth).

Incorporating Prediction Markets into Rule 14a-8

Todd Henderson has the interesting idea of incorporating prediction markets into (or in place of) the SEC's shareholder proposal rule:

The problem, as we see it, is two fold. First, many of these proposals are absolutely frivolous—like requesting that the board to study proposals for government-run healthcare—and yet firms spend many millions of dollars in an elaborate kabuki dance with the SEC and plaintiffs’ lawyers arguing about whether a proposal can be included. Second, even for legitimate proposals, shareholders are under-informed and lack incentives to become informed. Shareholder apathy is predicted, not only by the standard voting models, but also by standard corporate law models, which show that shareholders sensibly prefer liquidity to control (the “Wall Street rule”). The problem is, in essence, that the questions presented to shareholders are rarely, if ever, couched in terms of economic impact. What is the expected impact on shareholder value from adopting a majority voting rule? No one says, and the average shareholder has no idea.

A solution to the first problem would be to use conditional prediction markets to anticipate the proportion of shareholders who would vote for a proposal if it were placed on the ballot. If the threshold were set at, say, 25 percent, the corporation could easily avoid proposals with little chance of passage, but managers would not be able to exclude relatively serious ones. The SEC might consider requiring firms or shareholders to set up these markets as a pre-condition of including or excluding a proposal.

A more ambitious use of prediction markets would be as a substitute for or alternative to shareholder proposals themselves. Prediction markets provide a neutral, objective estimate of the impact of the proposed strategy or action on firm value. In other words, a well-crafted market would give shareholders a simple but powerful fact on which to base their votes: the likely impact on the firm’s stock price. The market is able to do this because it solves the problem of rational ignorance and is superior to all other existing methods for collecting and aggregating information. Even if only a small number of people participate in the markets, those people will have strong incentives to conduct research and to become informed about the issues, and their opinions will manifest themselves in a price they are willing to pay instead of unsupported, often political, arguments.

Are we sufficiently confident in prediction markets to entrust them with such gatekeeping powers? Are there real life examples of analogous regimes? Or is this one of the kind of ideas about which Dan Farber wrote in The Case Against Brilliance, 70 Minn. L. Rev. 917 (1986)?

Regulation FD and HP's Leakgate

The NYT reports that HP chairman Patricia Dunn may yet be asked by her board of directors to step down in response to Leakgate. Ironically, the report relies in part on a leak from an anonymous source "with knowledge of some portions of yesterday’s board meeting." Another boardroom leaker, perhaps? Keyworth himself, perhaps?

As we assess the ongoing corporate governance issues this fascinating story, it might be worth exploring the extent to which Reg FD played a minor role in the story.

Michael Lewis observed that Reg FD dramtically changed the role of business journalism:

Regulation Fair Disclosure, rammed through by former Securities and Exchange Commission Chairman Arthur Levitt (now a director of Bloomberg LP, parent of Bloomberg News) in 2000 over Wall Street's objections, accelerated the trend. The rule made it illegal for companies to whisper one thing to Wall Street analysts and something else to the rest of the world, thus ending Wall Street analysts' superior access to financial news. ...

Since the passage of Regulation FD, the journalist has enjoyed a tactical edge. Now he has, incredibly, a public relations advantage as well. The new perception that Wall Street research is inherently corrupt all but ensures the journalist soon will have his way with all chickadees.

Look around. Was there ever a time in the lifetime of anyone now working on Wall Street when journalists enjoyed more influence in the financial markets than now?

In turn, as we all know, leaks from anonymous sources are the bread and butter of modern MSM investigative reporting. In this sense, one might even say that Reg FD created the environmental conditions out of which Keyworth's misconduct grew.

Reg FD will only rarely apply to leaks by senior corporate executives and directors to reporters. For one thing, it would have to be shown that the leaker was acting on the company's behalf. For another, it would have to be shown that the reporter was someone who was likely to trade on the basis of the information before disclosing it (the other provisions of Rule 100(b)(1) being inapplicable on their face to most journalists). Yet, at least part of the logic behind FD would seem to apply to leaks.

One of the benefits of Reg FD's restrictions on selective disclosure is improving the quality of corporate disclosures. It discouraged executives and directors from providing information on the sly to analysts and encouraged the development of centralized disclosure processes. In other words, it encouraged corporations to speak publicly via a single voice, which reflects the collective understanding of the relevant stakeholders within the company.

Leakers like Keyworth undermine this process, by getting out potentially biased and/or incomplete information to the media.

Oddly, one of FD's unintended consequences thus would seem to be creating a dynamic that undercuts the Rule's best justification.

Smith versus Bainbridge

This week's Featured Discussion at PointofLaw.com offers a debate between my friend Gordon Smith and yours truly with respect to shareholder empowerment. Regular readers will be able to guess which side of the debate I come down on.

AFSCME v. AIG

Bill Sjostorm rounds up some links to blogosphere commentary on the Second Circuit's AFSCME v. AIG decision, which interpreted the SEC's shareholder proposal rule as allowing shareholders to use the rule to put forward proposed changes to the corporate bylaw that would allow shareholders to nominate director candidates and have those candidates included in the company's proxy material. (I blogged on the case here.) He also notes that the SEC is going to respond quickly:

As noted here, the SEC responded almost immediately in a press release stating it will formulate and recommend an amendment to Rule 14a-8 addressing issues raised by the decision. The proposed amendment is scheduled to be considered at an open meeting on October 18, 2006 (obviously they intend to get this sorted out prior to the next proxy season). It?s not clear how the SEC will respond. The SEC?s own efforts to allow shareholder nominations was highly controversial and died in 2003 with the resignation of Chairman Donaldson. I do not believe Chairman Cox has publicly taken a position on the issue. And the court?s opinion seems to afford the SEC the option of reaffirming its 1990 interpretation. Specifically the court notes that ?the SEC has substantial discretion to adopt new interpretations of its own regulations in light of, for example, changes in the capital markets or even simply because of a shift in the Commission?s regulatory approach? so long as it explains ?its departure from prior norms.? Hence, it seems to me that the SEC could simply put out a release explaining its departure from its pre-1990 position. It should be interesting.

Indeed.

The HP spying kerfuffle

The W$J reported yesterday that HP chairman Patricia Dunn "said she knew little about the tactics used by outside firms hired by H-P, and said she was "appalled" to learn in the past two months that investigators disguised their identities to obtain private telephone records of reporters and H-P directors. ... Ms. Dunn said her knowledge of the tactics used in the investigation was limited, because she was a potential subject of the probe. "As a subject of the investigation, I couldn't know everything," she said."

It shows the perils of outsourcing: loss of control. It also shows the perils of bending over too far backwards to appear even-handed. Dunn knew she wasn't the leak. She should have asked the board for power to identify the leaker and then played a very active supervisory role.  After all, she's investigating the board of directors - the people who run the corporation - you can't afford to let such an investigation be conducted slip-shoddily. Maybe Dunn wanted to have plausible deniability, but it would have been better to just suck it up and take charge to make sure the investigation was conducted properly.

At the same time, however, the media's focus on the possible technical illegality of the investigation is losing sight of the real villain. Dunn may have done something dumb, but leaker George Keyworth is the real bad guy in this story. Keyworth's the one who broke his contractual and fiduciary duties of confidentiality by leaking to the press. The MSM thrives on leakers, of course, so it's hardly surprising they're letting Keyworth slide, but that's precisely why those of us in the business law blogosphere need to keep the attention on him.

Trust and Pretexting

Larry Ribstein blogs on the HP story:

I'm not saying that independent directors are more prone to illegality and foolishness, as some commenters misread. Rather, I'm saying that the essence of independence is to increase distrust among board members, which impedes the functioning of the board. Clearly a more collegial board would not have been sniping and leaking, which is what triggered the pretexting.

I think that's exactly right.

Ribstein on Backdating

Tom Kirkendall offers a link-filled post tracking the blogosphere debate on backdating options, noting that Larry Ribstein's latest is a winner. I agree. I especially like Larry's riposte to something my former colleague Vic Fleischer wrote:

Vic argues that backdating is a problem because "a company that is willing to violate one set of rules (however silly those rules may be) is more likely to violate other, not-so-silly rules." Yes, and marijuana smoking leads to heroin addiction. This seems to mean that we should come down hard on every technical violation because it might lead to something worse. In other words, it's an argument against balance and perspective in law enforcement.

In fact, Vic later concedes that "companies like Google and Apple have violated some technical rules (remember the Playboy interview by the Google founders?) without big skeletons lurking in the closet." So he asks, "what's going on?" What, indeed. Apparently marijuana doesn't always lead to heroin.

Of course, I can't comment from personal experience.

The HP Disclosure Issue

Broc Romanek nicely summarizes the disclosure issues relating to the spying "scandal" at HP:

Should what happens in a boardroom stay in the boardroom? Well, we know that answer is "no" if a director resigns due to a disagreement with management, as disclosure is required under Item 5.02(a) of Form 8-K. Item 5.02 requires that a Form 8-K be filed if "if a director has resigned or refuses to stand for re-election to the board of directors since the date of the last annual meeting of shareholders because of a disagreement with the company, known to an executive officer of the company, on any matter relating to the company's operations, policies or practices, or if a director has been removed for cause from the board of directors." The Form 8-K is required to include "a brief description of the circumstances representing the disagreement that management believes caused, in whole or in part, the director's resignation, refusal to stand for re-election or removal."

After Mr. Perkins resigned from the H-P board, a Form 8-K was filed on May 22nd that simply noted that Mr. Perkins had resigned and left it at that. Yesterday, Hewlett-Packard filed this Form 8-K describing the situation as it stands now. ...

As Broc explains, the "company decided to go the route of minimalist disclosure in the May 22nd Form 8-K" because the "board concluded Mr. Perkins had no disagreement with the "company," only with the non-executive chair." The company's decision strikes me as a very narrow reading of both the facts and the relevant legal rules.

Who's to Blame for the Options Backdating Scandal?

Answer: Bill Clinton and the U.S. Congress. SEC Chairman Chris Cox gets at least that much:

... no new SEC rules would be necessary to make executive pay transparent, if executives were all paid in the form of salary. But beyond the obvious fact that the income tax code discriminates in favor of non-salary compensation that can be taxed as capital gains, one of the most significant reasons that non-salary forms of compensation have ballooned since the early 1990s is the $1 million legislative cap on salaries for certain top public company executives that was added to the Internal Revenue Code in 1993.

As a Member of Congress at the time, I well remember that the stated purpose was to control the rate of growth in CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved. Indeed, this tax law change deserves pride of place in the Museum of Unintended Consequences.

In a burst of financial populism, President Bill Clinton and Congress in 1994 changed the tax laws to cap at $1 million the deduction corporations may take for executive compensation. Performance or incentive-based forms of compensation, most notably stock options, however, were exempt from this cap (as they still are).

The result was a dramatic shift in executive compensation away from cash and towards stock options. The result was not only a dramatic change in executive compensation, but also the creation of a set of incentives that led directly to Enron. In practice, stock options put tremendous pressure on managers to keep the stock price headed up no matter how the company actually was doing. CEOs insisted that the company beat—or, at least, make—the “number”; i.e., the consensus forecast by analysts of the company’s quarterly earnings. A company that failed to do so could see its stock price fall drastically as analysts complained and investors jumped off the bandwagon, with resulting catastrophic consequences for the value of the firm’s executives’ stock options. Under this compulsion to make the number, the temptation to resort to accounting trickery proved too much for many managers to bear.

One can only hope that Congress eventually learns that even it is not exempt from the law of unintended consequences.

AFSCME Wins Bylaw Suit

A couple of years ago, the SEC proposed adopting a rule pursuant to which certain shareholders would be allowed under certain circumstances to nominate directors and have those nominess included on the company's proxy statement and proxy card. (In the absence of that rule, a shareholder can go to the annual stockholders meeting and nominate someone from the floor, but the floor motion would be defeated because shareholders would have voted by proxy for the incumbent board's nominated slate. Hence, the only realistic chance the shareholders have is to conduct a proxy contest.) The rule was a very bad idea, as I documented both here and at TCS (I pulled all the arguments together in an essay entitled A Comment on the SEC Shareholder Access Proposal). Fortunately, the SEC quietly let the proposal drop.  Unfortunately, some self-appointed activist shareholders decided to use shareholder proposals under SEC Rule 14a-8 to amend company bylaws to impose a shareholder nomination process via shareholder vote. This is a bad idea, for precisely the same reasons the SEC proposal was unsound. Yet, it has gained some traction among institutional imvestor activists.

Initially, it looked like the SEC staff would let shareholders use Rule 14a-8 for this purpose. In the end, however, the SEC decided (correctly) that shareholder proposals to impose a director nomination bylaw were invalid and could be excluded from the company's proxy statement.  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."

In a lawsuit brought by labor union and activist shareholder AFSCME against AIG, the Second Circuit has just disagreed with the SEC. I quote from a copy of the opinion emailed me by a reader:

... we hold that a shareholder proposal that seeks to amend the corporate bylaws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot does not relate to an election within the meaning of the Rule and therefore cannot be excluded from corporate proxy materials under that regulation.

The court says the language of the Rule is ambiguous, Hogwash. What is so ambiguous as an exclusion of a proposal that "relates to an election for membership." The language is clearly sweeping, encompassing any proposal related to the process by which directors are elected.

The opinion was written by Judge Richard C. Wesley. This is the first time I've encountered one of his opinions. I must say, that I'm not impressed. The analysis sets aside key securities law policy issues (documented here) and the plain text of the rule in favor a meandering and not very convincing analysis of the history of various SEC glosses on the meaning of this and other proxy rules. It is an utterly unconvincing performance by Judge Wesley.

The court also wholly ignores the issue of whether the AFSCME proposal could have been excluded on other grounds. In particular, Rule 14a-8(i)(1) provides that a proposal may be excluded if it is not a proper subject of shareholder action under state law. The court only touches on this potential issue in passing, claiming without support that:

We believe Delaware corporate law, which governs AIG’s internal affairs, provides that shareholders have the power to amend bylaws by majority vote.

Which is true, but utterly beside the point. As I demonstrated in a TCS column, proposals like AFSCME's are fundamentally improper under Delaware law.

I don't know why AIG didn't press the 14a-8(i)(1) issue harder. It was at least as strong as the 14a-8(i)(8) defense. I do know this is a lousy decision, which is wrong on both the law and the policy.

We'll have to see how the decision pans out. Will AIG seek Supreme Court review? (I doubt whether the court would take cert on this issue, though.) En banc review? Will other companies fight the issue in other Circuits? Will the SEC change the rules?

One thing is for sure: If AFSCME gets this proposal on the ballot and it passes, that will be bad news for investors. See my article, Shareholder Activism and Institutional Investors, which argues that:

Recent years have seen a number of efforts to extend the shareholder franchise, principally so as to empower institutional investors. The logic of these proposals is that institutional investors will behave quite differently than dispersed individual investors. Because they own large blocks, and have an incentive to develop specialized expertise in making and monitoring investments, institutional investors could play a far more active role in corporate governance than dispersed individual investors traditionally have done. Institutional investors holding large blocks thus have more power to hold management accountable for actions that do not promote shareholder welfare. Their greater access to firm information, coupled with their concentrated voting power, might enable them to more actively monitor the firm's performance and to make changes in the board's composition when performance lagged.

In fact, however, institutional investor activism is rare and limited primarily to union and state or local public employee pensions. As a result, institutional investor activism has not - and cannot - prove a panacea for the pathologies of corporate governance. Activist investors pursue agendas not shared by and often in conflict with those of passive investors. Activism by investors undermines the role of the board of directors as a central decision-making body, thereby making corporate governance less effective. Finally, relying on activist institutional investors will not solve the principal-agent problem inherent in corporate governance but rather will merely shift the locus of that problem.

Biz/Econ Blog Ranks

Brian Gongol ranks business and economics blogs. PB.com ranks third by one count and fourth by another, making us the Washington Post (huh?) of biz/econ blogs.

Limousine liberals on the SCOTUS?

Today's factoid: Based on Supreme Court financial records, 4 members of the liberal bloc - Souter, Ginsburg, Stevens, and Breyer - are all in the top 5 court members ranked by wealth.