ProfessorBainbridge.com

Proxy Monitor "Findings"

James Copland:

On Wednesday, the Manhattan Institute released a new "finding," looking at executive-compensation shareholder proposals, as part of the Proxy Monitor project. Key findings include:

• Labor unions are playing a big role here. "The two most frequent shareholder sponsors of proposals related to executive compensation have been the American Federation of State, County and Municipal Employees (AFSCME), with twenty-three proposals, and the AFL-CIO, with twelve. Overall, labor unions and their pension funds introduced 70 proposals related to executive compensation to Fortune 100 companies since 2008, constituting over 38 percent of all identified proposals coming to a vote."
• Shareholders are electing to hold annual say-on-pay votes. "Under Dodd-Frank's Section 951, executive-compensation advisory votes are now mandatory for public companies. In 2011, companies with annual meetings scheduled after January 21 must hold a vote to determine the frequency of such votes, which under the statute can be every one to three years. Of the four companies in the Fortune 100 to have voted on the issue thus far--Johnson Controls (JCI), Costco (COST), Emerson Electric (EMR), and Tyson Foods (TSN)--shareholders have supported annual advisory votes on executive compensation at each company save Tyson, which has a dual-share structure giving insiders effective voting control."

I discuss the new finding in a podcast here. Read the whole thing here.

Proxy Monitor is going to be a useful tool.

How Wall Street "reforms" broke the capital markets

Marc Hodak:

Today, our IPO market is broken.  That avenue of exit has been crushed by the weight of governance regulations, especially Sarbanes-Oxley.  These rules were intended to restore confidence in our public markets.  They have, instead, prevented ordinary people from investing in maturing companies like Facebook, Twitter, or LinkedIn, and hampered the ability of companies like that to attract the talent they need to get going.  Such companies are now forced to go to private markets for liquidity, markets that are far less accessible to smaller firms than IPOs used to be.

We will never know how many Microsofts or Apples have not been able to get off the ground since 2002–the year SOX was passed–or may not in the future, because of the higher cost of securing needed talent.  Unfortunately, the people who proliferate these rules like Topsy are not accountable for what doesn’t get created.

He's right. See my Corporate Governance and U.S. Capital Market Competitiveness, which argues that:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Brady on Airgas

Delaware lawyer Kevin Brady has a lengthy, detailed, and very useful analysis of the recent Delaware Chancery Court's decision in Airgas on poison pills.

"Stephen Bainbridge disdains the trend" towards empirical legal scholarship

An article from the National Law Journal (reg. req'd) captures the debate over the merits of empirical legal scholarship. I was in a particularly bad mood the day the reporter called and took it out on ELS, so my remarks are a bit more frank than they might have been had I been feeling more diplomatic, but I must confess that it does capture the gist of my views:

Proponents of this movement — dubbed empirical legal studies — view it as a major trend in legal academia. Harnessing data to answer legal questions gives their work credibility, and empirical research tends to reach a wider audience than traditional legal scholarship, they say. ...

"One of the concerns I have is on the pedagogical side," said University of Chicago Law School professor Brian Leiter. "There are some very smart and talented people doing this, but what does it add in the classroom, and how does it help teach analytical reasoning?"

A damned fine question.

The University of California at Los Angeles School of Law, Washington University in St. Louis School of Law, the University of California, Berkeley School of Law and Northwestern University School of Law are among the institutions that have established centers for empirical legal studies.

Yeah. This article's not going to win me any friends at the office.

Stephen Bainbridge disdains the trend. "A lot of the people I see who are empiricists, often with doctorates in the social sciences, aren't very good lawyers," he said. "I've read numerous papers that just got the law wrong. The problem is that we're hiring people with Ph.D.s in other fields, but their law credentials are middling at best. Someone who is a brilliant economist wants to be in a economics department, so we get second-rate lawyers who are second-rate in their academic field." ...

Empirical scholars have been knocked for conducting research simply because a data set is available, not because they have an important subject to explore. "They can only answer questions when they can get numbers," Bainbridge said. "If they can't count something, it doesn't exist for their purposes." ...

Several empirical scholars said that some doctrinal scholars simply don't understand their work. Bainbridge insisted that the skepticism is justified. "I think ELS is pretty much getting a free ride," he said. "There are a lot of people who have decided, for whatever reason, that this is the coming thing. We need to have a much more vigorous debate about the place of empirical legal studies in the legal academy."

Update: A friend and colleague emailed me as follows:

In the most recent postings to PB, I noticed, you slam ELS but elsewhere you propound:
 
"During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme." Emphasis supplied.
 
Is the principle that it's good for lawyer-scholars to be consumers of empirical studies but that they should not be producers? That is not illogical or even entirely implausible, but neither is it self-evident.
 
To be sure, we may (I await evidence)  give too much weight to PhDs in the hiring process (and I have long pointed out that we tend to get the second-rate PhDs). But some of our colleagues who are adept at legal analysis and do not have PhDs are doing some good empirical work. Maybe we need some empirical study of the performance of legal scholars who do empirical work.

I have no objection to legal scholarship that relies on real social science being done by real social scientists. Having said that, I'm always skeptical of data mining and causation issues. See, e.g., this "study":

Here's a deeply strange 2010 study in which college undergrads were asked to imagine a female instructor with various tattoos:

"128 undergraduates' perceptions of tattoos on a model described as a college instructor were assessed. They viewed one of four photographs of a tattooed or nontattooed female model. Students rated her on nine teaching-related characteristics. Analyses indicated that the presence of tattoos was associated with some positive changes in ratings: students' motivation, being imaginative about assignments, and how likely students were to recommend her as an instructor."

So tattooed teachers make students more motivated and more creative, not to mention stand a better chance of getting a positive recommendation from her pupils?

What I object to is (1) pseudo-social science being done by legal academics untrained in the relevant discipline, (2) hiring people to teach law with because they ran enough linear regressions to get to the point of being ABD in some social science but not to the point of actually being able to get hired in their home discipline, and/or (3) hiring people who are really good at their home social discipline but have mediocre legal credentials/skills. Both of the latter categories tend to produce lousy legal scholarship and make awful classroom teachers.

Off to Valcon to talk about executive compensation

I am off to Las Vegas to attend Valcon 2011, which is a conference for deal makers, fund investors, and financial or legal advisers in the distressed debt, restructuring and valuation business.

I'll be giving the Regulatory Keynote Address on "Will Dodd-Frank Reduce Systemic Risk?" To narrow that sweeping topic a bit, I've focused my presentation on "Executive Compensation and Risk in the Post-Dodd Frank Environment."

The talk is loosely based on my article Dodd-Frank: Quack Federal Corporate Governance Round II (September 7, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-12. Available at SSRN: http://ssrn.com/abstract=1673575.

Blogging will be light until I get back next week.

Fleebagging: Today's Word of the day

Fleebagging: Used to describe Democratic lawmakers cowardly absconding from their state so as to avoid having to vote on some controversial bill. It is a pejorative adapted by right of center bloggers from pejorative "teabagging," which had been adopted by left-liberal bloggers to equate activities of the Tea Party movement with a form of oral sodomy.

Possibly coined by Ed Morrissey.

Chait's bullshit

Jonathan Chait purports to respond to my post on the case against public sector unionism by claiming that my analysis "does not reflect actual reality at all." He elaborates:

If public sector unions were merely bargaining with themselves, wouldn't they be winning unbelievably fat contracts that paid their workers considerably more than they could get in the private sector? (They aren't.) For that matter, would they be facing contract rollbacks in states across the country? It seems obvious that there's a very powerful adversary at the bargaining table -- namely, the desire by elected officials to minimize taxes on their constituents.

Since TNR apparently doesn't allow one to comment on his posts without taking out a 20-issue subscription, I'll respond here.

In attacking my argument, Chait engages in a very selective editing of my post. Specifically, he edits out my discussion of Terry Moe's research, which shows that "there is ample evidence" that unions behave in precisely the way I described in that post.

Having excised real social science by a real social scientist, Chait substitutes rhetorical questions for data. He does provide a link whose phrasing would lead one to assume that public employees don't get paid more than private sector employees.When you follow the link, however, you learn the author (journalist Jonathan Cohn of TNR) finds the evidence inconclusive:

Having spent some time reporting on public and private sector compensation before, I can tell you that there is a lot of disagreement over the proper way to adjust the raw compensation figures to account for variables like age, education, and so on. (The debate is as much philosophical as methodological: Some conservatives argue that public employers put an artificial premium on graduate education, effectively paying more for degrees that don’t make workers better qualified.) I haven’t seen a specific refutation of Keefe’s report on Wisconsin, but if you want to read an analysis that suggests public workers, in general, are over-compensated, Andrew Biggs of the American Enterprise Institute has done work along those lines--and has a new article in the Weekly Standard summarizing his views.

Finally, Chait completely ignores the alternative argument I offered based on the Wellington and Winter analysis, which expressly does not require that unions be on both sides of the bargaining table.

If you'll pardon me for using a variant of one of the infamous seven words, I call bullshit.

Fiduciary duties of employees

Robert Goddard reports on a pair of interesting cases from Scotland:

An employee does not owe the employer fiduciary duties by virtue of being an employee (see, e.g., Nottingham University v Fishel [2000] EWHC 221 (QB), [2000] ICR 1462). However, it has been recognised that the circumstances of the relationship may be such to give rise to a fiduciary relationship. In an opinion given last week - Samsung Semiconductor Europe Ltd. v Docherty [2011] CSOH 32 - Lord Glennie found that such circumstances were present in the case before him.

This strikes me as most curious. Under US law, employees typically will be deemed agents of their employer. Hence, Restatement (Third) of Agency § 7.07 provides that “an employee is an agent whose principal controls or has the right to control the manner and means of the agent's performance of work.” The Restatement elsewhere (§ 1.01) provides that all employees are agents, and that “[a]s agents, all employees owe a duty of loyalty to their employers.” Hence, although “employers do not generally owe fiduciary duties to employees,” “an employee normally owes fiduciary duties to his employer.” Combs v. PricewaterhouseCoopers, 382 F.3d 1196, 1200 n. 2 (10th Cir.2004)."

Having said that, Justice Felix Frankfurter famously observed that "[t]o say that a man is a fiduciary only begins analysis; it gives direction to further inquiry." We would then go on to ask whether the employee had breached his duties by engaging in the specified conduct. Whether that would lead to the same of a different result as the Scottish cases would be highly fact specific.

Corporate Veil Piercing and Corporate Formalities

Steve Bradford:

My Business Associations class has been discussing piercing the corporate veil.  Every time I return to this material, I’m struck by how intellectually vacuous the doctrine in this area is.

    Some of the factors courts consider in piercing have an obvious policy tie to the question at issue: whether the corporation’s creditors should be able to recover from one or more of the shareholders.  Undercapitalization, for instance, can have an obvious effect on the corporation’s ability to pay creditors.  There’s an argument that consensual creditors should protect themselves from any undercapitalization that exists at the time the debt is incurred, but at least there’s a tie between undercapitalization and harm to the creditors.  The same thing can be said for transfers of funds from the corporation to the shareholder after the obligation is incurred.  The harm to the creditors is obvious and, in the case of post-obligation transfers, the self-protection argument is more difficult.

    The factor that doesn’t seem to make sense is failure to follow corporate formalities.  In most cases, you cannot establish a causal link between the failure to follow corporate formalities and the creditor’s loss.  The creditor’s position is no worse because, for instance, the corporation didn’t hold regular board meetings or keep minutes of those meetings. 

    I understand the penalty argument—if you want a corporation, you have to comply with the rules for operating one, or we will penalize you.  But it’s a very uneven penalty.  Successful corporations are never penalized, no matter how blatantly they fail to follow corporate formalities.  They are able to pay their bills, so veil-piercing isn’t usually an issue.  Only corporations that fail to follow corporate formalities and are not successful are penalized.

This is why I advocate Abolishing Veil Piercing:

The corporate law doctrine of limited liability has been much written about, but veil piercing as such has gotten far less academic scrutiny. This article addresses that lacuna, offering a doctrinal and economic analysis of veil piercing. It concludes that veil piercing cannot be justified and, accordingly, advocates abolishing the doctrine. The standards by which veil piercing is effected are vague, leaving judges great discretion. The result has been uncertainty and lack of predictability, increasing transaction costs for small businesses. At the same time, however, there is no evidence that veil piercing has been rigorously applied to effect socially beneficial policy outcomes. Judges typically seem to be concerned more with the facts and equities of the specific case at bar than with the implications of personal shareholder liability for society at large. Veil piercing thus has costs, but no social pay-off.

Veil piercing tries to do too much. Allocating liability within a corporate group controlled by a publicly held corporation involves far different policy considerations than does holding liable the individual shareholders of a closely held corporation. These tasks should be unbundled. Intra-corporate group liability issues should be dealt with as a species of enterprise liability, while the liability of individual shareholders is the proper subject of veil piercing law.

So defined and delimited, the survival of veil piercing is difficult-if not impossible-to defend. A standard academic move treats veil piercing as a safety valve allowing courts to address cases in which the externalities associated with limited liability seem excessive. In doing so, veil piercing is called upon to achieve such lofty goals as leading shareholders to optimally internalize risk, while not deterring capital formation and economic growth, while promoting populist notions of economic democracy. The task is untenable. Veil piercing is rare, unprincipled, and arbitrary. Abolishing veil piercing would refocus judicial analysis on the appropriate question-did the defendant-shareholder do anything for which he or she should be held directly liable. Did the shareholder commit fraud, which led a creditor to forego contractual protections? Did the shareholder use fraudulent transfers or insider preferences to siphon funds out of the corporation?

How do we teach them to think like lawyers when we're only hiring PHDs?

Steve Bradford:

My former colleague Michelle Harner has written an interesting paper entitled The Value of “Thinking Like a Lawyer.”  Michelle recognizes that the market for legal services is changing, but argues for the preservation of that unique set of analytical skills that those in the legal profession call thinking like a lawyer.

Here’s the abstract:
“The legal profession was hit particularly hard by the recent recession. Law firms laid off lawyers in record numbers, and law school graduates found few if any employment opportunities. Clients also started rethinking the terms of the lawyer-client relationship, at least in the larger law firm context. Some commentators suggest that these changes are indicative of things to come; that the legal profession is undergoing a long-overdue paradigm shift that will permanently change the nature of the legal profession. This Essay examines these developments through the lens of Larry Ribstein’s The Death of Big Law and Richard Susskind’s The End of Lawyers?: Rethinking the Nature of Legal Services. It compares and contrasts Ribstein’s and Susskind’s analyses of the profession and assesses potential lessons for lawyers, clients, and legal educators. This Essay concludes by encouraging professionals to remain open to changes that improve efficiency and client service. It also stresses the value of preserving and promoting the hallmark of being a lawyer - that is, thinking like a lawyer.”

I agree, but how do we make sure law schools can teach people to think like lawyers when our hiring criteria increasingly privilege people who do interdisciplinary and empirical rather than traditional legal scholarship? When we hire people with mediocre law credentials just because they're good at running regressions or have a PhD? Or when the PhDs we hire went the law route either because law schools pay more or because they didn't have the chops to get a top job in their home discipline.

If we were still trying to hire folks because they were EIC of a top law review, head of their law school class, had a good clerkship, and some experience in a top law firm doing real law, I'd be more confident of our ability to teach people to think like lawyers instead of teaching them to think like mediocre statisticians, sociologists, philosophers, economists, or what have you.

Why Don't the Wisconsin Senate Republicans Just Pass the Collective Bargaining Section?

As I understand it, the Wisconsin Senate has 19 GOP and 14 Democrat members. (When the Democrat senators decide to respect the principle that elections have consequences and come back to their jobs, I'll let them have back their "ic." But not when they're behaving so undemocratically.)

The flight of the 14 Democrats out of state deprived the Senate of the 3/5 quorum necessary to conduct business relating to fiscal matters. As to non-fiscal matters, however, the quorum is a simple majority. The GOP members thus constitute a quorum for conducting such items of business.

As I understand the bill that triggered the Democrats mass exodus, it includes the controversial provisions cutting back on collective bargaining by public employees and various fiscal matters relating to public employee pensions and benefits and so on.

Here's what i don't understand: Why can't the Wisconsin Senate Republicans simply cut the bill in half? Leave the fiscal reforms for another day when the Democrats come crawling back. In the meanwhile, however, put the collective bargaining provisions up for a vote. Is there some bizarre rule that sweeps collective bargaining rights into a broad definition of fiscal? If not, why not just do it. Or at least threaten to do it to put pressure on the Democrats?

At the end of the day, what matters in Wisconsin is not dollars and cents. What matters is limiting the power of public employee unions. As I discussed here a few days ago, I find the case against public sector unionism compelling. So I'd urge the Wisconsin Republicans to pull the trigger and pass the collective bargaining limits now.

The absurdity of the SEC's shareholder proposal policy and a proposed reform

SEC Rule 14a-8 permits qualifying shareholders to force the issuer to include a proposal and supporting statement in the company's proxy materials and thereby to force a vote on the issue at the annual shareholders' meeting.

Shareholder proposals traditionally were used mainly by social activists. Prior to the end of apartheid in South Africa, for example, many proposals favored divestment from South Africa. The rule is still widely used by social activists, but the rule also is increasingly being used by institutional investors to press matters more closely related to corporate governance. For example, proposals in recent years have included such topics as repealing takeover defenses, confidential proxy voting, regulating executive compensation, and the like.

Not all shareholder proposals must be included in the proxy statement. Rule 14a-8 lays out various eligibility requirements, which a shareholder must satisfy in order to be eligible to use the rule. The rule also lays out various procedural hurdles the shareholder must clear. Finally, the Rule identifies a number of substantive bases for excluding a proposal.

Rule 14a-8(i)(5) provides that a proposal relating to operations accounting for less than 5 percent of the firm’s assets, earnings or sales, and that is not otherwise significantly related to the firm’s business, may be omitted from the proxy statement. The principal problem here is deciding whether a proposal falling short of the various 5% thresholds is “otherwise significantly related to the firm’s business.” The classic case is Lovenheim v. Iroquois Brands, Ltd., 618 F. Supp. 554 (D.D.C. 1985). The defendant imported various food stuffs into the United States, including pâté de foie gras from France. Lovenheim suspected that Iroquois Brands’ French suppliers forced fed their geese, which produces larger livers, and which Lovenheim believed was a form of animal cruelty. Lovenheim proposed that Iroquois Brands form a committee to investigate the methods used by the firm’s suppliers in producing pâté and report its findings to the shareholders.

Iroquois Brands pâté operations clearly did not satisfy Rule 14a-8(i)(5)’s five percent threshold tests. Pâté sales constituted a mere $79,000 per year, on which Iroquois Brands lost money, relative to annual revenues of $141 million and profits of $6 million. The result therefore turned on whether the pâté operations were “otherwise significantly related” to its business. Iroquois Brands contended that the phrase related to economic significance. Lovenheim contended that noneconomic tests of a proposal’s significance were appropriate.

The court agreed with Lovenheim, holding that while the proposal related “to a matter of little economic significance,” the term “otherwise significantly related” is not limited to economic significance. Rather, matters of ethical and social significance also can be considered. The court articulated four rationales for its interpretation: (1) the rule itself was ambiguous; (2) the SEC previously had required inclusion of important social policy questions even where less than 1% of the firm’s assets or earnings were implicated by the question; (3) in adopting the present 5% threshold tests, the SEC said proposals falling short of the thresholds still must be included if their significance appeared on the face of the proposal; (4) the earlier Medical Committee decision implied that proposals involving general political and social concerns were acceptable.

As evidence that Lovenheim’s proposal “ethical or social” significance, the court observed that humane treatment of animals was one of the foundations of western civilization, citing various old and new statutes, ranging from the Seven Laws of Noah to the Massachusetts Bay Colony’s animal protection statute of 1641, to modern federal and state humane laws. Additional support came from the fact that “leading organizations in the field of animal care” supported measures aimed at eliminating force feeding.

Rule 14a-8(i)(7) allows the issuer to exclude so-called “ordinary business matters.” The question here is whether a proposal is an ordinary matter for the board or an extraordinary matter on which shareholder input is appropriate. The answer hinges on whether the proposal involves significant policy questions. As for deciding whether a policy question is significant, most courts assume that Lovenheim-style ethical or social significance suffices.

On this issue, the federal district court decision in Austin v. Consolidated Edison Company of New York, Inc., 788 F. Supp. 192 (S.D.N.Y. 1992), is both instructive and troubling. The plaintiffs put forward a proposal that the issuer provide more generous pension benefits to its employees. The court authorized the issuer to exclude the proposal as impinging on an ordinary business matter. Acknowledging that shareholder proposals relating to senior executive compensation were not excludable, the court observed that the issue of “enhanced pension rights” for workers “has not yet captured public attention and concern as has the issue of senior executive compensation.” Does this mean that the significance of a proposal turns on whether its subject matter has become a routine story for CNBC or CNN?

Unfortunately, the answer appears to be yes:

... in this response to AT&T, the Corp Fin Staff explains how net neutrality "has recently attracted increasing levels of public attention" but that it hasn't emerged "as a consistent topic of widespread public debate such that it would be a significant policy issue." I imagine one could debate whether the Staff's statement foreshadows a possible change to the topic being deemed a significant policy issue - but my view is that the Staff is merely articulating a nuance on how to distinguish whether something is ordinary business.

I agree that that's what the staff is doing. But it is decidedly not what the staff should be doing.

The result in Austin—exclusion—doubtless was correct. The proposal was put forward by shareholders who were also officials of a union that represented company employees. The proposal mandated a specific change in company pension policy; namely, to allow employees to retire with full benefits after 30 years of service regardless of age. This was precisely the sort of (self-interested) micro-management that even the SEC agrees ought not be allowed. Yet, we need a better test.

Query whether we want federal bureaucrats or even federal judges deciding whether a politically-charged proposal has enough ethical or social significance to justify its inclusion in the proxy statement. Think about your least favorite political cause. Under Lovenheim, can the firm omit a shareholder proposal about that cause? If so, on what basis can you justify omitting that proposal and requiring inclusion of the Lovenheim proposal? The issue is particularly troubling because many proposals have less to do with a company’s economic performance than with providing a soap-box for the proponent’s pet political cause. In Lovenheim, for example, plaintiff knew that his proposal had little economic significance. Instead, he wanted to make a political statement about animal cruelty.

Here then is a plausible alternative to the Lovenheim approach: Courts should ask whether a reasonable shareholder of this issuer would regard the proposal as having material economic importance for the value of his shares. This standard is based on the well-established securities law principle of materiality. It is intended to exclude proposals made primarily for the purpose of promoting general social and political causes, while requiring inclusion of proposals a reasonable investor would believe are relevant to the value of his investment. Such a test seems desirable so as to ensure that an adopted proposal redounds to the benefit of all shareholders, not just those who share the political and social views of the proponent. Absent such a standard, the shareholder proposal rule becomes nothing less than a species of private eminent domain by which the federal government allows a small minority to appropriate someone else’s property—the company is a legal person, after all, and it is the company’s proxy statement at issue—for use as a soap-box to disseminate their views. Because the shareholders hold the residual claim, and all corporate expenditures thus come out of their pocket, it is not entirely clear why other shareholders should have to subsidize speech by a small minority.

Lipton on Airgas

Dean of takeover lawyers Martin Lipton weighs in on the recent Airgas poison pill decision:

The Chancellor could not have been clearer that “the power to defeat an inadequate hostile tender offer ultimately lies with the board of directors.”  And it is up to directors, not raiders or short-term speculators, to decide whether a company should be sold:  “a board cannot be forced into Revlon mode any time a hostile bidder makes a tender offer that is at a premium to market value.”  The Chancellor concluded:  “in order to have any effectiveness, pills do not—and can not—have a set expiration date.”  The poison pill lives.

Dude (Looks like a Lady)

The University of Dayton College of Law and its Project for Law & Business Ethics will host a symposium, Perspectives on Gender and Business Ethics: Women in Corporate Governance, on Friday, February 25, at which the keynote speaker is a male law professor. I can't decide whether that's stupid or enlightened.

The WSJ on independent directors

The WSJ's lead editorial today criticizes proposals to mandate that derivatives trading boards and clearinghouses have boards of directors with a majority of independent members:

We're still waiting for evidence that independent directors yield better financial results. Merrill Lynch's 2006 annual report proudly noted that 11 out of the 12 members of its corporate board were independent—people who had never worked at the firm and had little connection to it. Merrill was a model of trendy corporate governance, with a board of esteemed Americans who could offer an unbiased perspective.

As it turned out, what Merrill really needed was a board that knew how to manage financial risk. And it would have helped immensely if directors had understood the mortgage-backed securities on which they had unwittingly bet the firm. The report was released in early 2007, and by that October the company was searching for a new CEO after an $8.4 billion quarterly loss.

In 2008, the firm again boasted of independent captains manning the board deck as Merrill sailed into the financial crisis. The company had 11 directors by then, and 10 of them were untainted by intimate knowledge of the business. Several months later, the securities that the board never did comprehend forced Merrill to sell itself to Bank of America.

Today the regulators are pushing aggressively for independent directors at both public and private companies, but there is even less of an argument for such changes than there was at Merrill.

I explore the evidence on the value of independent directors at some considerable length in my book The New Corporate Governance in Theory and Practice, which concludes that the econometric research on whether independent directors improve financial performance for the shareholders is, at best, inconclusive. Indeed, based on my review of the admittedly conflicting evidence, I come away doubting whether the percentage of independent directors on a board makes any difference at all to corporate performance.

Having said that, however, in The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, 59 Stan. L. Rev. 1465 (2007), Jeffrey Gordon has put forth a provocative argument that advances a plausible explanation for the ambiguous nature of the evidence:

The strongest explanation is the diminishing marginal returns hypothesis: most of the empirical evidence assesses incremental changes in board independence in firms where there is already substantial independence and after the cultural entrenchment of norms of independent director behavior. But … the most important effects of the move to independent directors, particularly over the long term, are systematic rather than firm specific and thus are unlikely to show up in cross-sectional studies. One systematic effect, the lock-in of shareholder value as virtually the exclusive corporate objective, could have benefits for early adopters, but other effects, such as the facilitation of accurate financial disclosure and corporate law compliance, have principally external effects.

In other words, studies of director independence are inherently flawed, because—to put it colloquially—a rising tide lifts all boats. The predominance of majority and now supermajority boards has had systemic effects, improving corporate governance across the board, while making identifying firm-specific effects difficult to identify.

Gordon argues that the last 50 years have seen the rise of “a new corporate governance paradigm that looks to the stock price as the measure of most things." This paradigm emerged because stock prices have become more informative. Companies must disclose vastly increased amounts of information per evolving SEC rules. Financial disclosures have become more transparent due to improvements in accounting standards. The resulting improvements in the quantity and quality of information made available to markets that themselves have become more liquid and efficient has made market prices an increasingly accurate metric by which to measure management performance.

Gordon argues this development radically simplified the task of independent directors. Outsiders no longer needed to struggle with the information asymmetry inherent in their relationship with management, because “the increasing informativeness and value of stock market signals” allow them to rely on “stock price maximization as the measure of managerial success."

Stock market performance, however, is an exclusively output-based metric. In at least some cases, input-based metrics may be more appropriate. This is so even if we think that monitoring is the board’s sole proper function.

The board’s supervisory function can be usefully subdivided into two broad categories. First, boards assess the abilities and effort of the top management team. Although this is a constant process, it is most salient in connection with hiring, promotion, and compensation decisions. In the later contexts, the board can focus mainly on monitoring outputs. Specifically, the board will focus on corporate performance metrics. A purely output based metric, however, is both inaccurate and unfair. Corporate performance may be skewed by temporary conditions beyond the abilities of even the most competent and dedicated management team. Unfortunately, monitoring managerial abilities and efforts using inputs is notoriously difficult. Much management work entails forms of non-separable team production in which the contributions of individual team members cannot be separately metered.

Second, boards engage in oversight of management conduct. Here boards examine individual management decisions and actions for misfeasance and malfeasance. This form of monitoring inevitably focuses on inputs. If all the board knows is that the corporation is hugely profitable, without knowing whether massive law breaking is the foundation on which that profitability rests, the board is failing to be an effective monitor.

Stock price-based metrics thus may have made life easier for independent directors. It is not clear that they have made independent directors better monitors.

So I continue to share the Journal's skepticism.