ProfessorBainbridge.com

The Dodd Wall Street Reform Bill: A Nevada Perspective

John Berlau:

Tucked into the 1,336-page "Restoring American Financial Stability Act of 2010," which was sent out of committee on a party-line vote in March, are provisions that would shackle Nevada and the entrepreneurs who set up corporations in the state. A small section of the bill with the stated aim of "strengthening corporate governance" would put states like Nevada at a competitive disadvantage by federalizing state rules for incorporation. ...

The businesses that incorporate in Nevada range from tiny firms to publicly held companies that trade on stock exchanges and the Nasdaq Stock Market. On WhyNevada.com, the Web site created by Democratic Secretary of State Ross Miller, the state government advertises the advantages of incorporating here, including the fact that "Nevada grants directors more flexibility."

But the Dodd bill would take much of this flexibility from states like Nevada and those public firms that incorporate there. ...

If this federal takeover of corporate law goes into effect, there will be fewer reasons for out-of-state firms to incorporate in Nevada. Why should they, when they would still have live with the federal government's new rigid rules regarding director elections?

But the bill wouldn't just hurt states like Nevada and the firms that incorporate here. The bill would harm the very shareholder interests it is claiming to protect.

Buying a stock is a choice, and shareholders benefit from having a variety of corporate structures to choose from. If they wanted to, they could choose a firm that requires majority votes for a board of directors. But they might also want go with a firm that uses the plurality standard, which is younger and more entrepreneurial.

The "proxy access" provisions are especially detrimental, as they would give leverage to activist shareholders who pursue special interest political agendas at the expense of ordinary investors.

Union pension funds, for instance, could use the threat of a director nomination to get concessions from a firm such as a "card check" election that would end secret ballot in unionization votes. And the radical animal rights group People for the Ethical Treatment of Animals buys stock at many firms for the sole purpose of introducing shareholder resolutions to stop animal research.

In the end, these provisions would hurt not just Nevada but the United States by imposing a one-size-fits-all mandate for director elections that would reduce options for entrepreneurs and investors. This could hurt the country's international competitiveness.

One can only hope Harry Reid pays attention.

The Corporate Governance Provisions of the Dodd Wall Street Reform Bill: What Others Are Saying

James Gattuso:

Allows activist groups to use the corporate governance process for issues unrelated to the corporation or its shareholders. Section 972 of the bill authorizes the SEC to require firms to allow shareholders to nominate directors in proxy statement. Such proxy access turns corporate board elections from a process designed to ensure that each board has a good mix of skills and experience into a popularity contest where the long-term interests of the stockholders become secondary to political agendas or corporate raiders. The process can also be used by labor unions, politicians who manage public pension funds, and others to force corporations to respond to pet social or political causes.

Duncan Currie:

There are also legitimate concerns that Dodd’s corporate-governance provisions would boost the clout of labor unions and other politically active interest groups while doing very little to help smaller shareholders.

Ira Stoll quoting Obama's recent speech on financiaL reform:

"These Wall Street reforms will give shareholders new power in the financial system. They will get what we call a say on pay, a voice with respect to the salaries and bonuses awarded to top executives." Britain's shareholders had a say on pay. It didn't prevent the failure of Northen Rock or Royal Bank of Scotland.

"And the SEC will have the authority to give shareholders more say in corporate elections, so that investors and pension holders have a stronger role in determining who manages the company in which they've placed their savings." Another handoff to unelected bureaucrats, this time at the SEC rather than at the Federal Reserve. They did so well with Madoff, why not give them the additional job of rewriting Amerian corporate governance? The "investors and pension holders" that Mr. Obama really has in mind are things like the New York and California state pension funds that have already been troubled by scandals and politicization. Shareholders have a role in corporations, as even good capitalists like Carl Icahn recognize. But using the proxy power to take control of companies away from management and directors and into the hands of radicals is straight out of the Saul Alinsky playbook.

Corporate Governance, the Dodd Bill, and Private Ordering

I've been arguing that the corporate governance provisions of the Dodd Wall Street reform bill are seriously flawed both individually and collectively. One problem with all the provisions under consideration is that they impose one size fits all mandates that have no scope for private ordering.

The trouble, of course, is that 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 Senator Dodd putting them in a straight jacket.

Remove the CEO/Chairman of the Board Provision of the Dodd Bill

Section 973 of the Dodd Wall Street reform bill mandates new disclosures from all firms -- Main Street as well as Wall Street -- explaining "the reasons why the issuer has chosen— (1) the same person to serve as chairman of the board of directors and chief executive officer (or in equivalent positions); or (2) different individuals to serve as chairman of the board of directors and chief executive officer (or in equivalent positions of the issuer)."

I objected to a previous SEC proposal to impose similar disclosure obligations in an August 2009 post, in which I explained that:

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 also explained why the underlying substance of the argument against one person serving as both CEO and Chairman of the Board is flawed:

The Dodd Bill's Unnecessary Majority Vote Provision

Section 971 of Senator Chris Dodd's draft Restoring American Financial Stability Act of 2010 (the Wall Street Reform bill) imposes a federally-mandated majority vote in the election of directors of all corporations.

The provision ought to be removed from the final draft of the bill for three reasons:

1. Federal law historically has been concerned solely with disclosures made in connection with shareholder voting and, to a much lesser extent, the processes by which proxy voting takes place. State law traditionally governed substantive issues like the vote required for electing directors. As documented in an earlier post, the dominance of state law in this area has served us well. In contrast, federal law imposes a one size fits all model that will impede innovation in corporate governance.
2. A federal majority vote mandate is unnecessary. Both the Delaware General Corporation Law and the Model Business Corporation Act have been amended to authorize majority voting. Unlike Section 971, however, state law does not adopt a one size fits all rule. Instead, both statutes have significant scope for private ordering so that firms can adapt majority voting rules to their unique circumstances.
3. The evidence suggests that shareholders do not value majority voting. An event study of "stock price movements of firms around announcements that they have or will adopt some form of majority voting ... found no statistically significant market reaction.

In sum, there is no justification -- none, nada, zilch -- for section 971 to be included in a bill that supposed to be about Wall Street reform.

No Wonder the SEC Didn't Catch Madoff

They were too busy spanking the monkey:

Republicans are stepping up their criticism of the Securities and Exchange Commission following reports that senior agency staffers spent hours surfing pornographic websites on government-issued computers while they were supposed to be policing the nation's financial system.

• A senior attorney at the SEC's Washington headquarters spent up to eight hours a day looking at and downloading pornography. When he ran out of hard drive space, he burned the files to CDs or DVDs, which he kept in boxes around his office. He agreed   to resign, an earlier watchdog report said.
• An accountant was blocked more than 16,000 times in a month from visiting websites classified as "Sex" or "Pornography." Yet he still managed to amass a collection of "very graphic" material on his hard drive by using Google images to bypass the SEC's internal filter, according to an earlier report from the inspector general. The accountant refused to testify in his defense, and received a 14-day suspension.
• Seventeen of the employees were "at a senior level," earning salaries of up to $222,418.
• The number of cases jumped from two in 2007 to 16 in 2008. The cracks in the financial system emerged in mid-2007 and spread into full-blown panic by the fall of 2008.

Maybe the SEC should have spent less time looking for clues with Fred and Daphne and more time poking around under the rocks of Wall Street.

Will the Unaccountable Power of RiskMetrics Put Teeth in the Dodd Bill's Say on Pay Provision?

The say on pay provision in the Dodd financial reform bill purports to create a purely advisory shareholder vote on executive compensation. (See prior post.) In fact, however, the legislation could turn out to have real teeth that will shift power over compensation from boards of directors to Risk Metrics (formerly ISS).

Eric Hilfers explains:

Those who have followed the NYSE Rule 452 changes will be familiar with the issues. Here is a quick summary for those who haven’t. Retail investors generally hold their investments through brokers. The broker is typically the “legal” owner of the stock, and the client is the “beneficial” owner. As a result, the issuer’s shareholder registry will reflect the ownership position of the broker, but not the individuals who hold through that broker (the issuer might not even know (or be able to find out) the true owners’ identities). Under state corporate law, only legal owners of shares may vote which means that brokers (rather than their clients) are the ones that in form vote retail shares. Brokers, however, are generally required to ask their clients for voting instructions. ... However, as it turns out, very few retail investors actually go to the trouble of instructing their broker how to vote. This leaves the shares “uninstructed”. NYSE rules permit brokers to vote uninstructed shares as the broker sees fit, but only in the case of “routine” matters. As it turns out, brokers tend to vote in favor of the positions recommended by management and the retail float of a typical public company can be anywhere from a few percentage points to 20+%. In other words, the retail shares are in practice a significant and reliable pro-management voting block.

The action in this area revolves around what is or isn’t a “routine” matter. If something is routine, then brokers can vote uninstructed shares; if it is not routine, then brokers can’t vote them, and the shares effectively don’t exist (quorum is a different discussion). ...

The latest addition to the Dodd bill takes the recent NYSE rule change a step farther. It essentially deems all votes regarding executive compensation to be non-routine. ...

An important related consequence of this is that it puts relatively greater voting power in the hands of institutional investors and that leads us to consider ISS.

The Dodd Financial Reform Bill Say on Pay Provision

Section 951 of the Dodd Financial Reform bill imposes a so-called say on pay rule on not just Wall Street but also Main Street firms, creating a new Securities Exchange Act section 14A:

Any proxy or consent or authorization for an annual or other meeting of the shareholders occurring after the end of the 6-month period beginning on the date of enactment of this section, for which the proxy solicitation rules of the Commission require compensation disclosure, shall include a separate resolution subject to shareholder vote to approve the compensation of executives ....

It could be worse. The bill makes clear that the vote is advisory and does not create new fiduciary duties. (But see the following post.)

Even so, say on pay is a bad idea. Imposing it at the federal level compounds the problem.

My essay Is Say on Pay Justified? examines three premises fundamental to the 'Say on Pay' movement: that current executive compensation is unjustifiably high, that federal legislation is required to address that high compensation, and that federal legislation would be effective in this aim. The paper finds that all three claims are problematic.

Instead of quoting extensively therefrom (just go read it), let's go to the videotape:

 

The Pernicious Corporate Governance Provisions of the Dodd Bill

The WaPo reports that:

Key members of both parties said Wednesday that they are close to agreeing on the main elements of a bill to overhaul the nation's financial regulations, raising the prospect that the Senate could begin formal discussion of the landmark legislation early next week.

I accept that Wall Street "reform" is a political necessity. What I don't understand is why the legislation includes one-size fits all corporate governance rules that will apply to every Main Street firm. Even if there's justification in the financial crisis for reforming Wall Street, there's no reason to drag Main Street into the morass.

Four provisions are especially pernicious:

• Say on Pay (sec. 951)
• Majority vote for election of directors (sec. 971)
• Proxy Access (sec. 972)
• Separation of Chairman of the Board and CEO (sec. 972)

Each of these is a very bad idea. Each will make corporate governance less effective. Subsequent posts will address each provision in turn.

Collectively, however, they have the hugely pernicious effect of substantially expanding the federal role in corporate governance. So in this post I want to focus on the federalism implications of the Dodd Bill.

My analysis here is a capsule summary of the detailed argument made in my essay The Creeping Federalization of Corporate Governance, to which I refer you for the definitive explanation (if I may say so myself) of why these sort of issues should be left to state law.

Goldman Sachs Skepticism

David Zarig ticks off 5 reasons he is skeptical of the SEC suit against Goldman Sachs.

Who is a Record Shareholder? Kurz Reversed

In February, the Delaware Chancery Court issued a much discussed opinion in Kurz v. Holbrook, in which the Court gave the corporate law concept of record shareholder an expansive definition. As a Sullivan and Cromwell client memo explained: "the court ruled that banks and brokers that hold shares in street name through the DTC depositary system are the stockholders of record under Delaware law."

A couple of days ago, the Delaware Supreme Court reversed, stating that the Chancery Court's view was “obiter dictum and without precedential effect.” A Richards Layton client memo explains that:

The Supreme Court therefore expressly declined to review the Court of Chancery’s holding that the Cede breakdown constituted part of the stock ledger for purposes of 8 Del. C. § 219(c). The Supreme Court wrote that a “gratuitous statutory interpretation resolving this difficult issue” would not be “prudent,” and indicated that a legislative cure by the Delaware General Assembly to resolve the question was preferable.

You can download the Delaware Supreme Court decision here. 

Francis Pileggi has a nice bullet point analysis of the key issues.

The Timing of the SEC's Goldman suit

There's been some commentary that the timing of the SEC's suit against Goldman Sachs seems suspicious. For example, Politico reports that:

Rep. Darrell Issa, the top Republican on the House Oversight committee, is demanding a slew of documents from the Securities and Exchange Commission, asserting that the timing of civil charges against Goldman Sachs raises “serious questions about the commission’s independence and impartiality.” ... Issa implied that the timing was a bit too convenient, saying President Barack Obama’s push on Wall Street reform “neatly coincided with the commission’s announcement of the suit.”

I agree that there's reason to be concerned about the timing of the suit, but I suspect the suit's not about helping Obama's Wall Street legislation. Instead, I suspect the WSJ got it right:

Last Friday, the same day that the government unexpectedly announced its Goldman lawsuit, the SEC's inspector general released his exhaustive, 151-page report on the agency's failure to investigate alleged fraudster R. Allen Stanford. Mr. Stanford was indicted last June for operating a Ponzi scheme that bilked investors out of $8 billion. He has pleaded not guilty.

Guess which of these two stories was pushed to the back pages? The SEC did its part by publishing the Stanford report so deep in its Web site that more than a few of our readers had trouble finding it. Yesterday, the SEC management's response to the report was available on the agency's homepage, yet it provided no links to the report itself.

Little wonder. The report is damning for an SEC that wants the public to believe it has turned the corner after the Bernie Madoff disaster. The commission has made young Fabrice Tourre of Goldman Sachs a household name for his debatable disclosures to institutional investors. But many individual investors will be more interested in learning the story of Spencer Barasch. He's the SEC enforcement official who sat on various referrals to investigate Allen Stanford and then, after leaving the SEC, performed legal work for . . . Allen Stanford.

In its own way, the Stanford calamity is arguably worse than the SEC's Madoff bungle. In the Madoff case, passionate outsider Harry Markopolos could find no one at the SEC who took the time to understand the scam, cared enough and had enough authority to shut down the fraud. In the Stanford case, we see numerous SEC insiders over many years urging—at times begging—the enforcement staff to take action, to no avail.

Either way, it ain't a pretty picture.

The SCOTUS Vacancy and Those Revolting Elites

My dear friend Tony Arend is prompted by recent complaints that you have to have gone to an elite law school to have a shot at being a SCOTUS appointee to observe that:

There is a very strange consensus developing relating to the next Supreme Court Justice nominee. [Namely, that President Obama should choose a judge without an Ivy League education to replace John Paul Stevens.]

What troubles me is that this would-be consensus seems to be part of a general tend in American politics to reject anything that has the appearance of being elite. And while I believe it is proper to reject leaders or judges that are snobs or disconnected from reality or condescending or patronizing, I think that in our leadership– both political and judicial– seeking the “elite” is not a bad thing. While the word “elite” has come to be associated with snobs, one of its core dictionary definitions is “the choice or best of anything considered collectively, as of a group or class of persons.” Using this definition, don’t we want an elite surgeon to perform our neurosurgery? Don’t we want an elite group of commandos to rescue a person held hostage? In other words, don’t we want to try to get the best for our most challenging tasks? I don’t really care where the next Supreme Court Justice when to undergrad or law school, but I do want to try to get a person that would be among the best– among the elite.

OTOH, Tony's clearly right if we're using elite to mean "the best." OTOH, there are lots of meanings we give to "elite" these days that are properly rejected.

Goldman Sachs: My Musings and Blogosphere Wanderings

I've been pondering the SEC complaint against Goldman Sachs. As the SEC litigation release explains, the complaint alleges that "one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events."

The SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.

According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.

If the SEC can prove those basic facts -- and that may be a very big IF -- this strikes me as pretty basic stuff. The fact that somebody who was going to take a short position against a security helped choose the instruments making up that security may involve high tech finance, but it's horse and buggy whip fraud. Goldman Sachs was on both sides of the deal, making money from both sides, and that's material information.

There is one red flag, however. SEC Commissioners Kathleen Casey and Troy Paredes reportedly voted against bringing the suit. Some partisans of the left will try to make political hay out of the fact that the Commission split on party lines. But I've interacted with Paredes many times over the years. He's not a blatantly partisan guy. He's one of the smartest and most knowledgeable securities law academics I know. Among other things, not everybody gets asked to take over maintenance of Louis Loss' famous multi-volume sec reg treatise. I respect his judgment and opinion. If he voted no, I'm inclined to think that he had good reason to do so. So I'm going to withhold judgment for now.

Let's take a spin around the blogosphere for more coverage:

Mac Heaven

About a year ago, I broke free of the evil Bill Gates at home, using an iMac as my main computer and a MacBook Pro as my road machine. At work, however, I was still obliged to muddle along with a Windows XP machine. Yet, while procrastinating one day by roaming the interwebs, I had discovered lots of articles about connecting Macs to a Windows network. 

This led to massive pleading on my part, which culminated today with the arrival and installation of my new Mac setup at work. 

 

That's a 27-inch iMac on the right and a 24-inch LCD display on the left. I'm using the latter as an extension of my desktop. I swapped the standard Apple keyboard for the extended one with numeric keypad (why Apple thinks most people would prefer a keyboard without the numeric keypad is beyond me). I also swapped out the Apple mouse for a 2-button mouse.

I revel in the massive amounts of desktop real estate. I love not having to remember two sets of shortcuts, menus, etc.... The clarity of the screen is amazing. 

I've added a couple of utilities that I've found useful at home. Sizeup is a shareware program that gives you features comparable to Windows 7's snap feature: 

SizeUp allows you to quickly position a window to fill exactly half the screen (splitscreen), a quarter of the screen (quadrant), full screen, or centered via the menu bar or configurable system-wide shortcuts (hotkeys). Similar to "tiled windows" functionality available on other operating systems. Additional features include moving windows from one monitor to another, from one Space to another, and restoring a window to its original size and position (SnapBack).

I use Chronosync to sync my network files to a USB drive and the USB drive to my home and road machines. It's very transparent and easy to automate.

So a big shout out to the good people in the UCLA law school IT department -- especially Albert, Scott, and Jason -- who made this possible.

Me so happy.