ProfessorBainbridge.com

The problem with "fairness"

Marc Hodak:

The overwhelming rationale for socializing health care is the sense of fairness it’s supposed to satisfy in our society.  Yet anyone who has experienced socialized anything knows that the system reinforces the notion that we are all playing in a zero-sum game, that what you get must come at my expense, which it does, of course, when we’re paying for each other’s stuff, and there is no way to economize except by rationing.

Clarkson's Offenses

The Times collects Jeremy Clarkson's top ten most controversial Top Gear moments. What a man!

Veganism Poll

Brian Leiter's taking a poll of his readers on veganism. For lack of a better option, I chose "Veganism is neither morally commendable nor morally wrong, but is a reasonable personal choice for some individuals to make" as my answer. I'd qualify that statement, however, by noting that the attitude of moral superiority on the part of many vegans gets old real fast. Plus, the efforts by some vegans to turn the issue into a political one, using the state to regulate food choices (see, e.g., foie gras bans), needs to be resisted at every opportunity.

Oddly enough, I had a shipment of live crabs Fed Ex'd from Maryland today, which I'm going to steam up for dinner. Think of it as a coincidental blow for food freedom.

An Ironic August

David Hyman:

August is proving to be rich in ironies. The Administration of a former teacher of constitutional law is unhappy that individuals are exercising their Constitutional right to petition the government for redress of grievances. The Administration of a former community organizer is complaining about community organizing. Congressional Democrats have long relied on community organizing (and union members), and are suddenly appalled at organized communities.

PCAOB Briefs

I was pleased to sign onto an amicus brief filed with the Supreme Court in the case challenging the constitutionality of the Public Company Accounting Oversight Board. The brief argues that:

Amici support Congress’s decision in the Sarbanes-Oxley Act to establish a new regulator to oversee the auditors of public companies. But amici express concern that the particular design chosen by Congress accords the PCAOB substantial discretion and autonomy without imposing constitutionally sufficient accountability. Specifically, the brief argues that the PCAOB's structure is unconstitutional because it violates the Appointments Clause and the doctrine of separation of powers. With a focus on statutory analysis, legislative history, and the securities industry’s self-regulatory organization (SRO) model on which the PCAOB was patterned, the brief challenges the D.C. Circuit’s conclusion that the PCAOB is merely 'a heavily controlled component' of the SEC. The brief argues instead that the PCAOB is an independent regulatory entity subject to oversight and enforcement by the SEC, another independent regulatory entity, and that this double-decker independence stretches the Constitution’s text and precedents too far.
Amici curiae: Stephen Bainbridge, Robert Bartlett, William Birdthistle, Timothy Canova, Lawrence Cunningham, James Fanto, Theresa Gabaldon, Lyman Johnson, Roberta Karmel, Donna Nagy, Lydie Pierre-Louis, Adam Pritchard, Margaret Sachs, Gordon Smith, Kellye Testy.

Regular readers may recall that I wrote an op-ed for TCS Daily a while back, summarizing the constitutional problems with the PCAOB:

The Fund claims that the PCAOB thus violates a number of constitutional provisions, most notably the appointments clause of the US Constitution. The potential constitutional problem is that members of the PCAOB are appointed not by the President but by the SEC.
The Appointments Clause of Article II section 2 of the US Constitution provides that:

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

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

I concluded that the Fund has a strong case, which I still believe even though the DC Ciorcuit disagreed.

Update: Larry Ribstein and Henry Butler also filed an amicus brief along with Cato.

Specter leading charge to reverse Stoneridge

Stoneridge Investment Partners v. Scientific-Atlanta was one of the most consequential securities cases to come before the Supreme Court in recent years.

The claim was that Charter engaged in a scheme involving sham transactions designed to inflate Charter's cash flow by $17 million in one quarter in order to meet the expectations of Wall Street analysts. The alleged scheme was to pay equipment vendors additional moneys in exchange for the vendors returning the moneys to Charter in the form of advertising fees. The vendors named in the case were Scientific-Atlanta, Inc. and Motorola, Inc. 

The vendors' position was that they could not be held liable because they were alleged to be only aiding and abetting. The 8th Circuit agreed, holding that one who does not make a fraudulent misstatement or omission, and does not directly engage in manipulative securities practices cannot be guilty of anything more than aiding and abetting - and thus cannot be held liable under Securities and Exchange Act Section 10(b) or SEC Rule 10b-5. (Source)

These facts raised an important issue about the scope of liability under SEC Rule 10b-5. As I explain in the section on 10b-5 in my Corporation Law and Economics text, the Supreme Court held Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. Central Bank thus substantially limited the scope of secondary liability under the rule, at least insofar as private party causes of action are concerned.

Stoneridge required the SCOTUS to delineate what causes of action arise out of secondary violations of Rule 10b-5 from those that arise from primary violations. I signed onto an amici curiae brief, which argued that:

Both the text of Section 10(b) and the structure of the Exchange Act preclude judicial implication of a private right of action against a non-trading, non-speaking entity that merely “enables” the commission of an alleged fraud by a public company on its shareholders.

Petitioner’s “scheme liability” theory is simply a semantic ploy designed to recast secondary conduct as a primary violation. The conduct at issue in Central Bank fits squarely within petitioner’s definition of “scheme liability,” but this Court has already held such conduct to be secondary to a primary violation and, thus, not actionable under Section 10(b). Mere knowing participation in another’s alleged fraud is not sufficient for liability to attach under that provision, as Central Bank makes clear, and petitioner has not alleged that respondents did anything more than that.

I also did a podcast on the case before it was argued before the Court.

The SCOTUS took an unexpected turn in its decision: In Central Bank of Denver v. First Interstate Bank of Denver, the Court held that there was no implied private right of action against those who aid and abet violations of Rule 10b-5. Some read Central Bank broadly to hold that liability under Rule 10b-5 was limited to primary rather than secondary actors. In Stoneridge, however, the Court stepped back from that broad reading of the case, holding that secondary actors can be held liable in cases in which all the elements of Rule 10b-5 are satisfied.

Reliance proved to be the critical element of the 10b-5 cause of action in Stoneridge. Reliance ensures that the “requisite causal connection” between a defendant’s misrepresentation or omission, or deceptive or manipulative conduct, and the plaintiff’s injury is present.  The Court held that, on the facts of this case, reliance could not be proven.

 

Plaintiffs in the case were shareholders of Charter Communications—one of the nation’s largest cable television providers. They alleged that Charter engaged in a “pervasive and continuous fraudulent scheme intended to artificially boost the Company’s reported financial results” by, among other things, entering into sham transactions with two equipment vendors that improperly inflated Charter’s reported operating revenues and cash flow. In addition to various other parties, including Charter, plaintiffs sued Scientific-Atlanta and Motorola (collectively, “the Vendors”).

 

At the time in question, Charter delivered cable services through set-top boxes. Charter purchased the boxes from third-parties, including the Vendors. In August 2000, although Charter had firm contracts with the Vendors to purchase set-top boxes at a set price, Charter agreed to pay the Vendors an additional $20 per set-top box in exchange for the Vendors returning the additional payments to Charter in the form of advertising fees.

 

Plaintiffs alleged that these were sham or wash transactions with no economic substance, contrived to inflate Charter’s operating cash flow by some $17,000,000 in the fourth quarter of 2000.

 

Plaintiffs alleged that the Vendors entered into these sham transactions knowing that Charter intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations.

 

The Court held that there need not “be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." Instead, "[c]onduct itself can be deceptive" and provide the basis for liability. At least in theory, the Vendors conduct thus could constitute fraud in connection with a purchase or sale of a security.

 

Even so, however, the Court concluded that the plaintiffs could not satisfy the reliance element, The Vendors did not – and had no duty to – disclose their conduct to Charter's investors. Accordingly, plaintiffs could not prove that they relied “upon any of respondents’ actions except in an indirect chain that we find too remote for liability.”

 

Plaintiffs argued that they need not prove reliance, because reliance should be presumed under the fraud on the market theory. The Court rejected that argument because the Vendor’s conduct was “not communicated to the public.”

According to the WSJ, Senators Arlen Specter (D-PA), Jack Reed (D-R.I.) and Edward Kaufman (D-DE) have introduced legislation that would reverse Stoneridge. This is a terrible idea. Stoneridge rests on important public policy concerns:

There is growing concern that American capital markets are becoming less competitive in the global economy. Indeed, as both the Paulson Committee and the Schumer-Bloomberg reports documented, New York financial markets, stifled by stringent regulations and high litigation risks are in danger of losing business and highly skilled workers to overseas competitors, adversely impacting not only New York, but the entire US economy.

A number of contributing factors are cited by the proponents of this view, such as the Sarbanes-Oxley legislation, the inconsistencies between US GAAP and IFRS, and so on. The liability exposure created by US securities laws, however, has come under especially close scrutiny. Indeed, Treasury Secretary Henry Paulson has called securities litigation the "Achilles heel" of the US economy. Likewise, the Schumer-Bloomberg report argued that "the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair."

Despite the active debate, there has been little legislative or regulatory progress in addressing these concerns. 

In Stoneridge, however, the Supreme Court stepped into the debate, coming down hard on the side of promoting American competitiveness. The majority opined:

The practical consequences of an expansion [of the Rule 10b-5 cause of action], which the Court has considered appropriate to examine in circumstances like these, provide a further reason to reject petitioner's approach. In Blue Chip, the Court noted that extensive discovery and the potential for uncertainty and disruption in a lawsuit allow plaintiffs with weak claims to extort settlements from innocent companies. Adoption of petitioner's approach would expose a new class of defendants to these risks. As noted in Central Bank, contracting parties might find it necessary to protect against these threats, raising the costs of doing business. Overseas firms with no other exposure to our securities laws could be deterred from doing business here. This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.

I defended the SCOTUS reliance on these policy concerns from those who attacked the court's use of policy-based analysis and/or the policies themselves in this space when the decision came down (here).

The key issue today, however, is that Stoneridge got the policy right. Specter's bill would once again throw American business to the trial lawyer wolves, weakening our competitive position, at a time when our economy needs all the help it can get.

Update: Jonathan Adler has put up a post with links to lots of Stoneridge resources.

Should the CEO also be the Chairman of the Board?

There's once again some talk around the corporate governance blogosphere of proposals to prohibit a corporation's CEO from serving as the chairman of the corporation's board of directors. Jay Brown is all for it:

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.
One of the most obvious areas of abuse concerns the resolute insistence by most public companies to have the CEO serve as chairman of the board.  (Some stats are here).  With the board responsible for supervising the CEO, the the combination of the two positions materially weakens the function. Moreover, the chairman has the authority to call meetings and exercise control over the issues placed on the agenda.
Nor is this the norm overseas.  Most other countries, including the United Kingdom, call for a separation.  Pressure is growing for this to occur in the United States.  Shareholders are agitating for a separation; a provision of the Shareholder Bill of Rights would require it for exchange traded companies.  This Blog called on the SEC to address the separation as part of its corporate governance agenda.  The call seems to have been answered.
The SEC's corporate governance proposals call for increased disclosure about a company's "leadership structure" and an explanation as to why "the company believes it is the best structure for it at the time of the filing."  In other words, those companies that combine the two positions will have to explain why this is in the best interests of shareholders.  As the release noted:

• Under the proposed amendments, companies also would be required to disclose whether and why they have chosen to combine or separate the principal executive officer and board chair positions. In some companies, the role of principal executive officer and board chairman are combined, and a lead independent director is designated to chair meetings of the independent directors. Those companies would also be required to disclose whether and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company.

The Commission has disavowed any attempt to influence the choice of management structure.  Yet in explaining why the disclosure was necessary, the release could only offer the thin justification that it would "increase the transparency for investors into how boards function."  In fact, for companies that separate the two positions, the disclosure will largely be meaningless.  For those that do not, however, they will find themselves having to justify the explanation, either to institutional investors, the Commission, or, perhaps, to a judge should they be sued for securities fraud under a theory that the justification was misstated.

The SEC's claim that it's proposal is not intended to have substantive effect is, of course, a material misrepresentation. The proposal is a classic example of so-called therapeutic disclosure.

As I explain in Corporation Law and Economics:

Therapeutic disclosure requirements undoubtedly affect corporate behavior. Therapeutic disclosure, however, is troubling on at least two levels. First, seeking to effect substantive goals through disclosure requirements violates the Congressional intent behind the federal securities laws. When the New Deal era Congresses adopted the Securities Act and the Securities Exchange Act, there were three possible statutory approaches under consideration: (1) the fraud model, which would simply prohibit fraud in the sale of secu¬rities; (2) the disclosure model, which would allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision; and (3) the blue sky model, pursuant to which the SEC would engage in merit review of a security and its issuer. The federal securities laws adopted a mixture of the first two approaches, but explicitly rejected federal merit review. As such, the substantive behavior of corporate issuers is not within the SEC’s purview. Second, and even more disturbing, in this case the SEC’s rules overstep the boundaries between the federal and state regulatory spheres.

In other words, the SEC uses therapeutic disclosure to effect corporate governance changes it has no authority to regulate directly. It's an abuse of the constraints on the scope of the SEC's authority and a violation of basic federalism principles. (I'd direct the same complaint against a possible SEC proposal to mandate disclosure of board of director diversity, another item Brown supports.)

Anyway, back to the issue of non-executive chairmen. 

John Coates also recently addressed it:

... the evidence on the proposal to mandate the separation of the chair and the CEO of public companies is more extensive and considerably more mixed [than evidence on say on pay]. At least 34 separate studies of the differences in the performance of companies with split vs. unified chair/CEO positions have been conducted over the last 20 years, including two “meta-studies.” Dalton et al. (1998) (reviewing 31 studies of board leadership structure and finding “little evidence of systematic governance structure/financial performance relationships”) and Rhoades et al. (2001) (meta-analysis of 22 independent samples across 5,271 companies indicates that independent leadership structure has a significant impact on performance, but this impact varies with context). The only clear lesson from these studies is that there has been no long-term trend or convergence on a split chair/CEO structure, and that variation in board leadership structure has persisted for decades, even in the UK, where a split chair/CEO structure is the norm.
One study provides evidence consistent with one explanation of the overall lack of strong findings: optimal board structures may vary by firm size, with smaller firms benefiting from a unified chair/CEO position, with the clarity of leadership that structure provides, and larger firms benefiting from the extra monitoring that an independent chair may provide given the greater risk of “agency costs” at large companies. Palmon et al. (2002) (finding positive stock price reactions for small firms that switch from split to unified chair/CEO structure, and negative reactions for large firms). If valid, this explanation would suggest that it would be a good idea for any legislation on board leadership to (a) limit any mandate to the largest firms and (b) permit even those firms to “opt out” of the requirement through periodic shareholder votes (e.g., once every five years).

Coates concludes:

... while mandating a split between the chair and the CEO is not clearly a good idea for all public companies, it may well be a good idea for larger companies. Because shareholders of those same companies may find it difficult to initiate such a change, given the difficulties of collective action, a legislative change requiring a split leadership structure but permitting shareholder-approved opt outs may improve governance for many companies while imposing relatively minor costs on companies generally. Requiring that companies give shareholders a vote on such a choice episodically (e.g., every five years) would also be a way to help solve shareholders’ inevitable collective action problems without forcing a one-size-fits-all solution on companies generally.

I am not a fan of these proposals. I addressed them in a blog post back in May. In a more recent op-ed, I again argued against mandating a non-executive chairman: 

A substantial number of corporate governance reforms advocates want to separate the positions of Chairman of the Board and Chief Executive Officer. When one person holds both posts, they argue, that person wields too much power to be supervised effectively by the board of directors. The result, they claim, is CEO entrenchment, excess CEO compensation, and other corporate ills.

The empirical evidence from studies of firm performance is, at best, mixed. There simply is no unambiguous evidence that splitting the CEO and Chairman positions between two persons has a statistically significant positive impact on firm performance. Although the absence of conclusive evidence--one way or the other—may seem surprising, on close examination it makes sense. Proponents of a mandatory non-executive Chairman of the Board have overstated the benefits of splitting the positions, while understating or even ignoring the costs of doing so. The reality of such costs is confirmed, at least anecdotally, when one recalls that both Enron and WorldCom--the poster children of bad corporate governance in the last decade--had separated the CEO and Chairman positions. The board of directors has three basic functions; selecting, monitoring, and compensating the top management team; advising top management; providing access to external resources (such as where a company's banker sits on the board). Only as to the former does it seem likely that there will be benefits to appointing a non-executive Chairman.

Famed economist Michael Jensen identified the potential benefits in his 1993 Presidential Address to the American Finance Association, arguing that: "The function of the chairman is to run the board meetings and oversee the process of hiring, firing, evaluation, and compensating the CEO. … Therefore, for the board to be effective, it is important to separate the CEO and Chairman positions."

In fact, however, "oversee[ing] the process of hiring, firing, evaluation, and compensating the CEO," is the job of the board of directors as a whole, not just the Chairman of the Board. Indeed, oversight of that process increasingly is designated to a Compensation Committee composed of independent directors.

To be sure, in many corporations, the Chairman of the Board is given unique powers to call special meetings of the board, set the board agenda, and the like. In such companies, a dual CEO-Chairman does wield powers that may impede board oversight of his or her performance. Yet, in such companies, the problem is not that one person holds both posts; the problem is that the independent members of the board of directors have delegated to much power to the Chairman. The solution, obviously, is to adopt bylaws that allow the independent board members to call special meetings, require them to meet periodically outside the presence of managers, and the like.

Turning from the benefit side to the cost side of the equation, let's consider the impact of separation on the board's monitoring role. Even if splitting the posts makes it easier for the board to monitor the CEO, the board now has the new problem of monitoring a powerful non-executive Chairman. The board now must expend effort to ensure that such a Chairman doesn't use the position to extract rents from the company and, moreover, that the Chairman expends the effort necessary to carry out the post's duties effectively. The board also must ensure that a dysfunctional rivalry does not arise between the Chairman and the CEO, both of whom presumably will be ambitious and highly capable individuals. In other words, if the problem is "who watches the watchers?," splitting the two posts simply creates a second watcher who also must be watched. A non-executive Chairman inevitably will be less well informed than a CEO. Such a Chairman therefore will be less able to lead the board in performing its advisory and networking roles. Likewise, such a Chairman will be less effective in leading the board's in monitoring top managers below the CEO, because the Chairman will not know those managers as intimately as the CEO.

In sum, corporate governance is not an arena in which one size fits all. Different firms have different governance needs. Boards of directors should be free to select the governance structures optimal for their unique firm without having corporate governance activists putting them in a straight jacket.

Political Theater Works Both Ways

I can't help but wonder how many left-liberal bloggers who are now outraged by the town hall protests being encountered by Congressmen thought it was great theater when ACORN sent protestors to the homes of AIG corporate executives?

Gantler: Officers, Agents, and Directors

Francis Pileggi reports on what sounds like a very interesting panel at the ABA annual meeting, in which there was discussion of the Delaware Supreme Court's decision in Gantler v. Stephens, 965 A.2d 695 (Del. 2009), which held that:

The Court of Chancery has held, and the parties do not dispute, that corporate officers owe fiduciary duties that are identical to those owed by corporate directors.FN34 That issue-whether or not officers owe fiduciary duties identical to those of directors-has been characterized as a matter of first impression for this Court.FN35 In the past, we have implied that officers of Delaware corporations, like directors,*709 owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors.FN36 We now explicitly so hold.FN37

FN34. See, e.g., Ryan v. Gifford, 935 A.2d 258, 266 (Del.Ch.2007).

FN35. See, e.g., In re Walt Disney Co., Deriv. Litig., 2004 WL 2050138, at *3 (Del.Ch. September 10, 2004) (“To date, the fiduciary duties of officers have been assumed to be identical to those of directors.”) (citations omitted).

FN36. That officers and directors of Delaware corporations have identical fiduciary duties has long been an articulated principle of Delaware law. See, e.g., Guth v. Loft, Inc., 5 A.2d 503, 510 (Del.1939) (discussing the duty of loyalty applicable to officers and directors); Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del.1993) (same).

FN37. That does not mean, however, that the consequences of a fiduciary breach by directors or officers, respectively, would necessarily be the same. Under 8 Del. C. § 102(b)(7), a corporation may adopt a provision in its certificate of incorporation exculpating its directors from monetary liability for an adjudicated breach of their duty of care. Although legislatively possible, there currently is no statutory provision authorizing comparable exculpation of corporate officers.

I have long found this aspect of Delaware corporate law quite puzzling. In the first place, as Pileggi notes, Delaware law has no good definition of the operative term "officer."

The DGCL does not define “officer”, but Section 142(a) does allow for a corporation to have such officers as are provided for in the bylaws. Moreover, in the long-arm statute, the Delaware Code imposes personal jurisdiction over officers who hold such titles as President, CFO, etc., or one who is identified as such in SEC filings.

That's a rather large lacuna in my book.

Second, all employees of a corporation--including the top management team, among whom the officers of the corporation presumably will be found, at least in part--are agents of the corporation. Restatement (Second) of Agency § 14 C cmt. a. In turn, agents have both fiduciary duties of care and loyalty to their employer/principal. 

The correct analogy for an officer's fiduciary duty thus is not that of a director, but rather that of an agent. (This is, of course, in the absence of a statutory provision like MBCA sec. 8.42 setting out the duties of an officer expressly. The DGCL has no such provision.)

In any case, if we are to equate the fiduciary duties of directors and officers, we ought also consider whether officers should get the same sort of liability protections as directors. In my treatise, Corporation Law and Economics, for example, I argued that officers should get the benefit of the BJR:

It is reasonably well-settled that officers owe a duty of care to the corporation. It is less well-settled that officers get the benefit of the business judgment rule. Under the ALI PRINCIPLES, the rule applies to both directors and officers. [ALI Principles § 4.01.]

Judicial precedents are divided, however. [Compare Galef v. Alexander, 615 F.2d 51, 57 n.13 (2d Cir. 1980) (holding that the business judgment rule “generally applies to decisions of executive officers as well as those of directors”); FDIC v. Stahl, 854 F. Supp. 1565, 1570 n.8 (S.D. Fla. 1994) (holding that the rule “applies equally to both officers and directors”) with Platt v. Richardson, 1989 WL 159584 at *2 (M.D. Pa. 1989) (holding that the rule “applies only to directors of a corporation and not to officers.”). At least one court claims that the former view is the majority position, rejecting an argument that “the business judgment rule applies only to the conduct of corporate directors and not to the conduct of corporate officers” on grounds that it was “clearly contrary to the substantial body of corporate case law which has developed on this issue.” Selcke v. Bove, 629 N.E.2d 747, 750 (Ill. App. 1994).]
Most of the theoretical justifications for the business judgment rule extend from the boardroom to corporate officers. Many corporate decisions are made by officers, for example, who are likely to be even more risk averse than directors. Accordingly, insulation from liability may be necessary to encourage optimal levels of risk-taking by officers. Just as the board of directors is properly regarded as a production team, so is the so-called top management team. Accordingly, internal team governance may be preferable to external review. In sum, the better view is that officers are eligible for the protections of the business judgment rule.

Pileggi's post goes on (I think paraphrasing Delaware lawyer Kurt Heyman) to opine that:

The exculpation protection of DGCL Section 102(b)(7) does not apply to officers. That section allows protection for directors for claims against them for monetary liability for breaches of the duty of care (but does not cover breaches of the duty or loyalty or suits for injunctive relief). Also, DGCL Section 141(e) only protects directors from liability for “good faith reliance" on reports of managers….” However, 10 Del. C. Section 3114 (b) imposes personal jurisdiction on both directors and (since 2004) officers of Delaware corporations via implied consent.
One possible legislative change in response to Gantler is to include officers within the protection of both Sections 102(b)(7) and 141(e), although at least one school of thought argues that such a change is not necessary.

I'm pretty sure I agree with that suggestion.

102(b)(7) Procedure

Francis Pileggi offers up a very informative post on a panel discussion at the ABA Annual meeting, in which he mentions in passing that prominent Delaware lawyer "Kurt Heyman added that in the Rule 12(b)(6) context, the court will take judicial notice of a Section 102(b)(7) provision in the corporation's charter to the effect that the directors are protected from claims for a breach of the duty of care."

This reminds me of a rather curious problem I've been wondering about for a while.

As I explained in my Corporation Law treatise:

... the Delaware supreme court held in Emerald Partners that a sec. 102(b)(7) provision is an affirmative defense. [Emerald Partners v. Berlin, 726 A.2d 1215, 1223n24 (Del.1999). See also McMullin v. Beran, 765 A.2d 910, 926 (Del.2000).] Defendant directors thus have the burden of proving that they are entitled to exculpation under the statute. If aggressively applied, Emerald Partners could mean that a sec. 102(b)(7) provision rarely will entitle directors to a dismissal on grounds that plaintiff's complaint fails to state a cause of action. Consequently, plaintiffs will be entitled to discovery, which some might call a fishing expedition, and the settlement value of such claims will go up. Thus far, however, the chancery court has continued to hold a sec. 102(b)(7) based motion to dismiss is appropriate pre discovery where plaintiff solely alleged violations of the duty of care. [See, e.g., McMillan v. Intercargo Corp., 768 A.2d 492 (Del.Ch.2000); In re Lukens Inc. Shareholders Litig., 757 A.2d 720 (Del.Ch.1999). A subsequent Delaware supreme court decision in the Emerald Partners litigation confirmed this approach, while emphasizing that limited discovery is available where plaintiff has adequately alleged a violation of the duty of loyalty or of good faith. Emerald Partners v. Berlin, 787 A.2d 85 (Del.2001).]

Am I thus correct in inferring that judicial notice of a 102(b)(7) exculpation provision is how the Chancery Court is getting around Emerald Partners' identification of such a provision as an affirmative defense? And, if so, does Emerald Partners have any teeth on that score?

SOX 304 Claw-back

Section 304 of the Sarbanes-Oxley Act provides that:

(a) If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for

• any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and
• any profits realized from the sale of securities of the issuer during that 12-month period.

Did you notice the glaring ambiguity? As I explained in The Complete Guide To Sarbanes-Oxley:

A wag might call this the “Baldwin Brothers” provision—i.e., cute but dumb. Here are just some objections: It preempts the board’s power over executive compensation. It fails to define the kinds of misconduct that trigger the reimbursement obligation. It requires reimbursement even if others committed the misconduct, with no good faith defense. All of which will tend to encourage CEOs and CFOs to resist restating flawed financial statements and/or to game the timing of their compensation and stock transactions relative to any such restatements.

Did you notice how I expected the ambiguity to be resolved?

That's right. It wasn't clear from the plain text of the statute whether misconduct by persons other than the CEO or CFO could result in the claw-back being applied to CEO/CFO compensation. Yet, I expected that the SEC eventually would take the position that misconduct by others could trigger the claw-back provision.

Indeed, the SEC has now taken precisely that position in SEC v. Jenkins (complaint here). (HT: John F. Savarese) 

CSK Auto Corporation was obliged to restate its financials due to massive fraud by a number of senior officers. CEO Maynard Jenkins, however, has not been charged with any misconduct. Wachtell Lipton attorney John F. Savaresen argues that:

The SEC’s decision to depart from its prior reasonable restraint in using Section 304 is a regrettable policy choice. Clearly, the SEC believes fraud occurred at CSK, but apparently can find no basis to assert that the CEO was culpable in it. The SEC has not even pursued any of the lesser charges that would be available against a blameworthy executive in these circumstances, such as a negligence-based administrative case. In these circumstances, it is difficult to discern what conduct by similarly situated CEOs the SEC may think this case will deter or encourage. It also remains to be seen whether a federal agency may constitutionally deprive a person who is not alleged to have violated any law of compensation that was lawfully received, particularly where the statute’s intended reach is ambiguous.

In response, let me play devil's advocate for a minute. During the 1990s, restating financials became commonplace. Some firms were notorious for taking incredibly aggressive accounting positions. When they were called out for it, they simply restated their financials and claimed the SEC and/or private claim was moot.

As illustrated by other provisions of SOX, such as the CEO and CFO certification rules, Congress concluded that too many CEOs and CFOs had simply turned a blind eye to misconduct by subordinates. A claw-back rule that essentially imposes strict liability on CEOs and CFOs for subordinate misconduct arguably provides a powerful incentive for CEOs and CFOs to ensure that the company's internal controls work. 

A related argument is that much corporate financial statement shenanigans during the 1990s appears to have been motivated by efforts to maximize the value of top manager's stock options and other forms of equity and incentive compensation. Or, at least, so Congress concluded. It's precisely those forms of compensation that section 304 targets. The CEO and CFO, one might argue, should not be allowed to benefit from misconduct by subordinates, whether or not the CEO or CFO was aware of the misconduct. Any other rule would perpetuate the incentive to turn a blind eye.

Critics of my argument might argue that strict liability will result in over-deterrence. But over-deterrence of what? What valuable conduct are we concerned about overly deterring? If we assume that in this context, under-deterrence would be more costly than over-deterrence, strict liability is preferable to negligence.

How about fairness, however? I've never been a big fan of strict liability. Where someone acted in good faith, I have real problems with imposing legal liability and the shaming sanctions that accompany it. Put another way, strict liability bugs me because it ignores moral culpability. CEOs and CFOs are not insurers of stockholders, obliged to compensate them for any loss the stockholders may suffer, but that's what strict liability under 304 makes them with respect to misconduct no matter how far down the organization chart it occurs.

Why newspapers are dying--with a Michael Vick note

There are a lot of reasons newspapers are dying, but surely a major factor must be the pace of the news. I was reminded of that fact by this excerpt from SI.com football columnist Peter King's latest MMQB column:

Tucker rides shotgun and fires up Twitter, profootballtalk.com and whatever other news ports he has on his BlackBerry. For a former player, he's a real sports junkie. He tells me someone's reporting that Mike Vick just worked out for the Patriots at 3 o'clock this afternoon in Foxboro. Immediately, I get a remember-where-you-heard-the-Vick-news-first text from Sal Paolantonio, who told the crowd at the Dr. Z benefit back in May that he thought the Patriots would be a major player for Vick. I'd been saying the Patriots were my best-guess landing spot for Vick too.
Five minutes pass. My phone rings, and it's Someone Who Knows, telling me absolutely, unequivocally the Patriots did not work out Vick, and there is no interest in signing him, and Bill Belichick likes Kevin O'Connell as Tom Brady's backup, and the team doesn't need the circus that Vick would engender.
It's a weird media world we're in right now. My allegiance, obviously, is to SI.com, but I know if I take 10 minutes right now to dictate the item to someone on the news desk, the story will get up in 20 minutes, and we'll probably be too late. So I decide to throw a couple of Tweets up, the first at 4:59 saying Vick wasn't in Foxboro, and the second that the Pats don't want Vick and like O'Connell. Sure enough, at 5:01 p.m., Adam Schefter Tweeted that Vick wasn't in New England either. It's a crazy media world. Forgive me, Time Warner.

If the news cycle (at least on some issues) is now so fast that King doesn't have time to get a story up on a news website, it's no wonder brick and mortar printed newspapers can't keep up.

On another note, even though its generally true that I like most dogs better than most people, I'm okay with Vick getting a job in the NFL. He paid his debt to society and, if Roger Godell concludes that he's remorseful and rehabilitated, I see no reason to continue punishing him. 

But I wonder who'll take a chance on him. Obviously, I have no inside info, so this is pure speculation, but here goes: I assume it will take a supremely self-confident, desperate to win, purportedly immune to criticism (but able to be tweaked about losing), and a little bit boorish owner to sign Vick. In no particular order, that tells me it will be one of: Al Davis, Jerry Jones, or Danny Snyder. I'm betting on Snyder, given his obvious unhappiness with Jason Campbell.

Kentucky Steak au Poivre et Frites for 1

With Helen out of town for a few days, tonight saw the revival of an old PB.com tradition; namely, bachelor night. Long time readers know what this means; namely, steak, potatoes, red wine, followed by a couple of Dunhill Peravias and either Port or Wild Turkey's American Honey Liqueur, depending on how hot it is, while watching a sci fi or fantasy DVD.

It was fairly warm tonight by So Calif standards, so it was a night for American Honey Liqueur and an old favorite: The Two Towers-The Extended Version, mainly because I felt like watching the Helm's Deep battle again.

The steak

• 1 10 oz. filet mignon, cut in half lengthwise to make 2 steaks approximately ½ to ¾ inch thick (or, if you're me on bachelor night when all bets are off, with neither spouse, personal physician, nor Obama's health cops around to supervise, 2 8 oz filets cut the same)
• sea salt 
• freshly ground black pepper 
• Pam® olive oil spray
• 1 tablespoon unsalted organic butter 
• 1 tablespoon finely chopped shallots 
• 1 teaspoon finely minced garlic 
• ½ cup Maker's Mark® bourbon
• ½ cup organic low sodium beef stock 
• ¾ cup organic heavy cream
• 1 teaspoon Dijon mustard 
• dash Lea & Perrins Worcestershire Sauce®

Season filet steaks with salt and lots of pepper, pressing salt and pepper into the meat with heel of your hand, spritz with olive oil spray, and allow to marinate briefly while heating a large nonstick skillet (I'm a big fan of Calphalon) over medium-high heat.

Add steaks to skillet and cook for 3 minutes. Turn and cook 3 minutes. Remove to a plate and tent loosely with aluminum foil.

Return skillet to heat, turning it down to medium. Do NOT clean skillet. You want the brown bits.

Melt butter in skillet. When butter stops foaming, add shallots and garlic. Sprinkle lightly with salt. Cook up to 1 minute, but do NOT let shallot/garlic mixture burn!

Add bourbon. Turn heat up to high. Use a lighter wand to ignite alcohol. Swirl pan until flames die out. Add stock and reduce to a glaze.

Reduce heat to medium and add cream. Reduce until sauce coats the back of a spoon.

Turn heat to low, add mustard and Worcestershire sauce, stir well.

Taste sauce and add salt and/or pepper as needed to taste.

Return steaks and any accumulated juices to pan. Coat steaks with sauce.

Plate steaks, topping with sauce.

I'll probably lose whatever standing I have as a foodie for admitting this, but I don't fuss with homemade frites. Instead, I use Ore-Ida® shoestring fries prepared as per package instructions.

Serve with a young Loire red or, as I did, a mature Napa Cabernet-based wine.