ProfessorBainbridge.com

"Conflict Minerals and Pay Ratio: SEC Rules of Unintended Consequences"

Glen Lammi argues that the titular SEC rules have had important and deleterious unintended consequences.

The case against proxy access for shareholders

An important new paper argues that:

The prerogative of boards of directors to nominate the members of the board for election by the shareholders is now challenged by institutional investors determined to acquire the right, under certain conditions, to nominate their own candidates. This challenge to a board prerogative is called proxy access by shareholders to the director nomination process.

As a result of amendments to the existing regulations in the United States, there has been a flood of proposals from shareholders to institute rules granting them access to the nominating process. In Canada, a form of access is already provided for by the Canadian Business Corporations Act (CBCA), but the conditions of this access are not perceived – by institutional investors, in particular – as sufficiently congenial because, among other factors, of the differential treatment for candidates put forward by shareholders.

Several plausible arguments may be marshalled in support of access to the nominating process by shareholders, such as the enhanced legitimacy of the directors sitting on the board. However, this proposal also raises a host of issues related to the logistics of its application and the potential adverse effects on governance and board dynamics. After an in depth analysis of the arguments for and against proxy access, IGOPP concludes that any process that would grant shareholders the right to put forward candidates for election to the board, whether such a process arises from new regulations or spontaneous proposals from shareholders, is unwise and likely to create serious dysfunctions in corporate governance.

We do recommend however that the nomination committee of the board implement a robust consultation process with the corporation’s significant shareholders and report in the annual Management Information Circular on the process and criteria adopted for nominating any new director.

Given the popularity of proxy access proposals among institutional shareholders, this policy position includes an appendix outlining the typical features, conditions and mechanics proposed for this shareholder access to the director nominating process. All these aspects of the proxy access initiative raise difficult questions to which we unfortunately find few satisfactory answers.

Allaire, Yvan and Dauphin, Francois, Who Should Pick Board Members? Proxy Access by Shareholders to the Director Nomination Process (October 30, 2015). Available at SSRN: http://ssrn.com/abstract=2685790

Francis Levien of Sinclair Oil v. Levien was the lawyer who won Guth v Loft

In preparing to teach one of my favorite cases, Sinclair Oil v. Levien, I came across an obituary of plaintiff Francis S. Levien from the NY Times:

Francis S. Levien, a New York lawyer-industrialist who specialized in the creation of corporate conglomerates, died on Thursday at Mount Sinai Hospital. A resident of Palm Beach, Fla., he was 90 and had lived in Manhattan and Stamford, Conn. 

Mr. Levien (pronounced leh-vee-EN) struck it rich in the late 1930's, when he and a partner won a Delaware case that resulted in the forming of what is now Pepsico.

He went on to become a wealthy industrialist. But the interesting thing is that his firm Levien, Singer & Neuburger was counsel for the plaintiff in Guth v. Loft, Inc., the classic corporate opportunity case.

 

The Last Word on Sanchez

I'm going to let the estimable and admirable Usha Rodrigues have the last word on Sanchez.

SEC v. Texas Gulf Sulphur and Soviet spies

Keith Paul Bishop discusses the "tenuous link between the case and the recently released movie Bridge of Spies directed by Steven Spielberg."

Ridge Geyserville (Sonoma County) 2010 w/ barbecued pork tenderloin

Deep purple despite having thrown a substantial amount of light sediment (decanting required). Nice berry bouquet although not terribly complex. On the palate, lots of intense berry flavor associations--raspberry, blackberry, blueberry, as well as star anise and a dash of pepper. Well balanced with smooth tannins. Likely will improve for a few more years. Sadly, however, this was my last bottle. Grade: 88

I marinated/brined a pork tenderloin for 8 hours in a mixture of 1 cup Wild Turkey bourbon, 2 tablespoons sherry vinegar, 2 tablespoons Stubbs original BBQ sauce, 1 ½ tablespoons kosher salt, ¼ cup olive oil, 1 tablespoon Lea & Perrins Worcestershire sauce, ½ tablespoon smoked paprika, ½ tablespoon Cajun spice, and 1 teaspoon @ garlic and onion powder. I roasted the tenderloin at 425° for 15 minutes, turning once, and then basted it with Stubbs BBQ sauce several times, while turning it several times for 10 more minutes. Once it hit an internal temperature of 140°, I pulled it from the oven, basted it one last time, and let it rest for 10 minutes. I served it with Zatarain's Dirty Rice to which I had added tomatoes, finely diced carrots, and green onions.

As a Vanguard investor, I do not want Vanguard index funds becoming activists

WTF is Vanguard thinking?

Vanguard, the largest fund family, is beginning to wield that power more aggressively. It has adopted a new approach to push for improvements to compensation practices, board construction, and other corporate issues, says Glenn Booraem, head of its corporate governance efforts.

Vanguard is now sifting through data, looking for companies that don't adhere to mainstream good-governance principles and then pressing the companies about its concerns.

My message to Glenn is: Stop it. Set aside the fact that shareholder activism is bad for corporate governance, the economy, and world peace. I buy index funds precisely because they are PASSIVE! I don't want index funds spending one dime more than necessary. I want my funds to keep costs as low as possible, because the evidence is clear that over time that's the best way to build wealth. So I don't want Vanguard paying multiple analysts 6-figure salaries to look for activism opportunities. If we must have shareholder activism, I want Vanguard to free ride on the efforts of others.

And if this nonsense keeps up, I will vote with my feet.

Why hasn't civil procedure caught up with advancements in partnership and LLC law?

A friend sent along this email comment:

Grynberg v. Kinder Morgan Energy Partners, L.P. concludes that a Master Limited Partnership, which is a publicly traded type of firm used in the oil and gas business, should be treated for purposes of federal diversity jurisdiction as a collection of individual investors (and "aggregate") rather than as an entity. That may be consistent with legal doctrine in your field but it defies common sense. The court offers the following argument:

"Second, even if we consider the MLP’s characteristics, they do not support treating an MLP like a corporation for diversity jurisdiction. MLPs and corporations are publicly traded, centrally managed, and have freely transferable interests. But the similarities end there. MLPs are formed as unincorporated entities under state law, and Carden reaffirmed the dichotomy between corporations and unincorporated entities."

This certainly deserves the famous observation, "I understand everything but the therefore."

To which I responded: It may be that the common law is an ass, but until UPA (1997) changed the law in this area, partnerships were regarded by PARTNERSHIP LAW itself as an aggregate not an entity. Hence, partnerships have long been viewed as a collection of the partners for purposes of diversity. The rule has been extended to LLCs, by the way:

Notwithstanding LLCs' corporate traits, however, every circuit that has addressed the question treats them like partnerships for the purposes of diversity jurisdiction. See Gen. Tech. Applications, Inc. v. Exro Ltda, 388 F.3d 114, 120 (4th Cir.2004); GMAC Commercial Credit LLC v. Dillard Dep't Stores, Inc., 357 F.3d 827, 828–29 (8th Cir.2004); Rolling Greens MHP, L.P. v. Comcast SCH Holdings LLC, 374 F.3d 1020, 1022 (11th Cir.2004); Handelsman v. Bedford Village Assocs. Ltd. P'ship, 213 F.3d 48, 51 (2d Cir.2000); Cosgrove v. Bartolotta, 150 F.3d 729, 731 (7th Cir.1998). This treatment accords with the Supreme Court's consistent refusal to extend the corporate citizenship rule to non-corporate entities, including those that share some of the characteristics of corporations. Carden, 494 U.S. at 189, 110 S.Ct. 1015 (treating a limited partnership as having the citizenship of all its members); Great S. Fire Proof Hotel Co. v. Jones, 177 U.S. 449, 456–57, 20 S.Ct. 690, 44 L.Ed. 842 (1900) (refusing to extend the corporate citizenship rule to a “limited partnership association” although it possessed “some of the characteristics of a corporation”). 

Johnson v. Columbia Properties Anchorage, LP, 437 F.3d 894, 899 (9th Cir. 2006).

 

Of course, the UPA (1997) has now adopted the entity theory: 

RUPA adopts the “entity” theory of partnership as opposed to the “aggregate” theory that the UPA espouse[d]. Under the aggregate theory, a partnership is characterized by the collection of its individual members, with the result being that if one of the partners dies or withdraws, the partnership ceases to exist. On the other hand, RUPA's entity theory allows for the partnership to continue even with the departure of a member because it views the partnership as “an entity distinct from its partners.”

Republic Properties Corp. v. Mission W. Properties, LP, 391 Md. 732, 744, 895 A.2d 1006, 1013 (2006). See UPA (1997) Section 201. Partnership as entity: "(a) A partnership is an entity distinct from its partners."

The same is true of LLCs. See ULLCA (1997) Section 108.  Nature, purpose, and duration of limited liability company: "(a) A limited liability company is an entity distinct from its member or members.”

 

The curious question is why civil procedure has not caught up to these advancements in the law of unincorporated entities.

The case against divesting from fossil fuel companies

Here at PB.com we oppose divestment campaigns (even in those rare cases when we agree with the proponents about the issue at hand), so we were glad to see our friend Todd Henderson take on the issue in the Chicago student newspaper:

No matter what your views are on the climate change debate, no rational person should support divestment. There is no evidence to demonstrate it will do anything to help the climate, and it will ultimately cost the University hundreds of millions of dollars—Swarthmore estimates it would cost their endowment $200 million over 10 years to divest. This is money that could be spent on research, scholarships, or perhaps best of all for the cause, reducing the University’s carbon footprint.

Here is why divestment won’t work: A central tenet of corporate finance is that demand curves for individual stocks are approximately horizontal. For most things we buy, demand curves slope downward. This means if we demand less, less will be supplied and at lower prices, but stocks are not like other products. The stock price is merely an estimate of the cash flows that ownership of the stock will produce in the future, and therefore is not determined by a “demand” for the stock. Unless the sale of stock conveys information to the market about the future cash flows, no individual sale can move the price.

If the Office of Investments, which manages the University’s nearly $9 billion endowment, sells all of the shares it owns in ExxonMobil, the stock price of ExxonMobil should not change. Others will stand ready to buy the shares at the current market price, meaning supply and demand aren’t helpful ways to think about stock prices. Unless the money that ExxonMobil is expected to earn in the future goes down, the stock price will stay the same. And nothing about the decision of a few university endowments to sell the shares provides the market information about how much oil or coal will be sold at what prices tomorrow. Undervalued shares in the near term will be bought up until their price more or less reflects the expected gain from holding those shares. In an extreme case, ExxonMobil could simply go private, removing any need to rely on public markets for funding or valuation.

The fact that the stock price of divested companies will not fall means that these firms will not experience a higher cost of capital, and therefore nothing about their capital raising activities, project choice, or other decisions will be affected by divestment. Managers with stock-based compensation won’t be affected either nor will other shareholders of these firms. In short, the economic impact of the SJSF demands on the targets of their ire would be nearly zero.

Making matters worse, universities—or rather their employees and students—would bear large costs to achieve no benefits. The endowments already have to spend money defending their investment decisions, and, if it comes to it, will spend more selling shares and accepting lower returns than would otherwise be available. Taking profitable investments off the table also means lower returns for endowments. This means taking money out of the universities’ pockets and putting it into the hands of other people, all without actually imposing any cost on the alleged bad actors.

Indeed.

Related articles

"The Feel-Good Folly of Fossil-Fuel Divestment"

Divestment mania expanding massively on college campuses, despite moral and financial flaws

Presbyterian Church Votes for Anti-Israeli Divestment: Bad Economics, Bad Politics, Bad Religion

"Big Oil Is Not Big Tobacco: Why The Witch Hunt Against Exxon Is Absurd"

Forbes:

The attorney general of New York, Eric Schneiderman has commenced an investigation of Exxon MobilXOM +0.00%. He seeks to find out what the oil giant knew about the possible risks of carbon-induced climate change and when. Schneiderman’s office on Thursday served a subpoena to Exxon, demanding years of internal documents on global warming issues. The impetus for Schneiderman’s investigation appears to be recent revelations that Exxon, as far back as the 1970s, had funded studies concluding that global warming could result from carbon emissions — but that Exxon had failed to publicly disclose those risks to shareholders.

But let’s get real. See this for what it is — a witch hunt against a big company with deep pockets that the anti-carbon lobby wants to fleece to support their pet renewable energy projects.

Go read the whole thing.

Updated: Still thinking about how you prove a sufficiently close friendship under Sanchez

A while back, Usha Rodrigues suggested that case book authors (pointing directly at Klein, Ramseyer & yours truly) include Del. County Emples. Ret. Fund v. Sanchez in the section on derivative litigation:

So it's nice to see Chief Justice Strine doing what he does best--writing a clear, accessible opinion acknowledging that independence is complicated and contextual. ... True, Chief Justice Strine acknowledges ... the economic dependence that the director in question also allegedly had to the defendant.  But it is his eloquent defense of friendship that resonates for me. Just last week I paraphrased the Beam court as holding that "friendship alone is not enough."  But I asked students if they would feel unbiased if they were a director and the defendant and fellow boardmember was their college roommate. Their answer was an emphatic no.  I hazard that Chief Justice Strine might agree.

I ran Sanchez up the flag pole, but our little triumvirate rejected it for reasons I explained in an earlier post:

First, it is almost devoid of facts--especially interesting ones. ... 

Which leads me to a question that really does puzzle me: How the [expletive deleted] are trial courts supposed to distinguish between mere social friendships and enduring close relationships? Especially because the issue will often be decided on the pleadings before discovery.

In the case at bar, the issue was easy because there was both an enduring friendship and close economic ties (at least according to Strine's version of the facts as opposed to that of the Chancery Court). But what if all you have are ties of friendship?

To which Usha has now responded:

But, although Steve is a very, very smart guy that knows him some Delaware law, I disagree with the plaint at his post's end: "How the [expletive deleted] are trial courts supposed to distinguish between mere social friendships and enduring close relationships? Especially because the issue will often be decided on the pleadings before discovery."

Aronson's first prong and Zapata both, in different contexts, try to get at this question: should we trust the board that recommends dismissing a derivative suit? or are the directors too biased?  Answering that question gives us a chance to play that perennial law school game, "Rules or Standards?"

Rules approach: Has the director been paid by the defendant in question?  Are they related?  If yes, they are biased. If not, they're fine.  This beauty of this definitional approach, as with all rules, is that it's simply, blessedly clear. But it also may be over- and under-inclusive.

Standards approach: Let's look at the situation.  What is the director's tie to the defendant?  Does the director depend on the defendant financially?  Are they related?  How closely?  Are they friends?  Are they in the same social circle?  How close?  The beauty of this situational approach is that it's granular.  The cost is that it is a whole lot harder to apply, and harder to plan around. 

I favor standards over rules for this particular question.  The derivative suit is at core a sorting mechanism, and it would be too easy to game a rule and stack the board with manager-friendly-but-not-financially-dependent directors, rendering the whole derivative suit mechanism a farce.   

Bringing us back to the classroom, I also like that Delaware has opted for standards here because I can use it to make the weird animal that is the derivative suit come alive for the students.  Most of our students came straight through from undergrad. When I ask them: "Would you be unbiased in deciding whether the board should sue the defendant, if the defendant was your college roommate?", I get a visceral reaction, one that gets them to engage with the complexities of the derivative suit. 

I agree with all of that (especially the first part!), but the problem is that Usha doesn't deal with the procedural posture. As the Delaware Supreme Court explained in Grimes v. Donald (1996):

A stockholder filing a derivative suit must allege either that the board rejected his pre-suit demand that the board assert the corporation's claim or allege with particularity why the stockholder was justified in not having made the effort to obtain board action.

The shareholder must include such allegations in the complaint when filed, without the benefit of having had any discovery:

If the stockholder cannot plead such assertions consistent with Chancery Rule 11, after using the “tools at hand” to obtain the necessary information before filing a derivative action, then the stockholder must make a pre-suit demand on the board.

In a footnote, the Court quotes its earlier decision in Rales to explain:

Although derivative plaintiffs may believe it is difficult to meet the particularization requirement of Aronson because they are not entitled to discovery to assist their compliance with Rule 23.1, ... they have many avenues available to obtain information bearing on the subject of their claims. For example, there is a variety of public sources from which the details of a corporate act may be discovered, including the media and governmental agencies such as the Securities and Exchange Commission. In addition, a stockholder who has met the procedural requirements and has shown a specific proper purpose may use the summary procedure embodied in 8 Del.C. § 220 to investigate the possibility of corporate wrongdoing. ... Surprisingly, little use has been made of section 220 as an information-gathering tool in the derivative context. Perhaps the problem arises in some cases out of an unseemly race to the court house, chiefly generated by the “first to file” custom seemingly permitting the winner of the race to be named lead counsel. The result has been a plethora of superficial complaints that could not be sustained. Nothing requires the Court of Chancery, or any other court having appropriate jurisdiction, to countenance this process by penalizing diligent counsel who has employed these methods, including section 220, in a deliberate and thorough manner in preparing a complaint that meets the demand excused test of Aronson.

My claim is that it will be much more difficult for plaintiffs use the "tools at hand" to develop sufficiently particularized facts relating to the nature of a friendship than an economic relationship. How often will a Section 220 books and records inspection produce evidence that the CEO and a director are life-long pals, for example. Or reading SEC filings, for that matter? Maybe plaintiffs will be able to find stories in the media about their lifelong friendship. A Google search turned up stories about Bill Gates being close friends at some point of his life with Paul Allen (still?), Water Buffett, Michael Larson, and Steve Ballmer (still?).

But what about less high profile CEOs with less high profile friends?

I await Usha's response eagerly.

Update: Of course, independence is an issue in many settings other than just demand excused cases. In many (most?) of those other situations, independence issues will be resolved at the summary judgment stage or even trial. Accordingly, in those cases, my objection is partially vitiated. Where to draw the line-something we must do even in a standards-based approach-remains a difficult question (IMHO).

What to do about dual class stock (if anything)?

Steven Davidoff Solomon discusses the split between firms with dual class stock and those without:

The haves are armed with dual-class structures that give voting control to their founding shareholders or the private equity firm that bought them. These are companies like CBS, Ford Motor, Facebook, Google, News Corporation and Viacom, where the shareholders often have one vote or none per share and the founders 10 votes (The New York Times Company also has dual-class voting). These companies are largely free from challenge by any of their other shareholders, and control is centered with the founders, who have largely unfettered authority to hire and fire the board and the executives.

The have-nots lack this dual class structure and instead have no controlling shareholder. Instead, these companies have one vote for each share. In these companies, institutional investors like mutual funds and pension funds wield great control and the ability to influence, if not outright direct, the company’s actions.

Is there any justification for dual class stock?

Many defend dual-class stock because it may insulate a company from pressure to take short-term actions at the behest of shareholders. It also allows the founders to take a long-term approach and invest in the company in a way that may not produce immediate results. And finally, defenders point out that institutional investors are often conflicted in their desires, and that dual-class stock allows more deliberate consideration of shareholder issues. ...

So how are shareholder activists reacting?

Calpers, the California pension fund, has taken the position that it will not invest in I.P.O.s with dual-class stock. And yet, this seems like a finger in the dike. Dual-class initial offerings keep coming as other shareholders keep buying. It’s an odd state of affairs. The same shareholders who repeatedly assert that they care about corporate governance and are for a shareholder voice do not seem to care about that voice at the initial offering stage.

Perhaps this says a lot about how much shareholders value their vote, and it may be very little. Certainly institutional investors talk a good game and are increasingly taking steps to influence companies. But when push comes to shove, they seem ready to drop the vote for a good I.P.O. deal.

So what to do?

Perhaps the time has come to decide whether dual-class stock makes continued sense and for either all companies or no companies to be able to adopt it. Or perhaps the conversation should include other possible mechanisms that are more accommodating to shareholders.

He goes on to explore some options.

I've been writing about dual class stock for a long time:

The Short Life and Resurrection of SEC Rule 19c-4. Washington University Law Quarterly, Vol. 69, Pp. 565-634, 1991. Available at SSRN: http://ssrn.com/abstract=315375: In the 1980s, many corporations adopted disparate voting rights plans (also known as dual class stock plans) to concentrate voting control in the hands of incumbent managers and their allies. At most adopting firms, such plans were intended mainly to deter unsolicited takeover bids. Incumbent managers who cannot be outvoted, after all, cannot be ousted. In 1988, the Securities and Exchange Commission adopted rule 19c-4 pursuant to a claim of regulatory authority under Section 19(c) of the Securities Exchange Act of 1934. Rule 19c-4 purported to amend the listing standards of the self-regulatory organizations (i.e., the major stock exchanges and NASDAQ) so as to prohibit most forms of dual class stock. The United States Court of Appeals for the District of Columbia Circuit, however, subsequently invalidated rule 19c-4 as exceeding the scope of the SEC's delegated authority. This article reviews the history of dual class stock and stock exchange listing standards affecting it. The article then demonstrates that the D.C. Circuit was correct in concluding that the SEC lacked authority to adopt rule 19c-4. Finally, the article proposed an alternative exchange listing standard that responded to the conflict of interest inherent when management proposes a dual class stock recapitalization.

The Scope of the SEC's Authority Over Shareholder Voting Rights (May 2007). UCLA School of Law Research Paper No. 07-16. Available at SSRN: http://ssrn.com/abstract=985707: At a May 2007 Roundtable on The Federal Proxy Rules and State Corporation Law, the Securities and Exchange Commission posed the following question for discussion: What should be the relationship of federal and state law with respect to shareholders' voting rights and ability to govern the corporation? To answer that question, this essay reviews the legislative history of Section 14(a) and of the Securities Exchange Act generally, as well as the leading judicial precedents. It concludes that, as a general rule of thumb, federal law appropriately is concerned mainly with disclosure obligations, as well as procedural and antifraud rules designed to make disclosure more effective. In contrast, regulating the substance of corporate governance standards is a matter for state corporation law.

So here's my take:

Do principles of corporate democracy justify a mandatory one share-one vote standard?

One of the most common arguments against dual class stock is based on notions of corporate democracy. Some argue that shareholder participation in corporate decisionmaking on a one-vote per share basis is desirable in and of itself. This notion makes for powerful rhetoric, but its premise is refuted both by history and modern practice. As the preceding sections demonstrated, deviations from the one share-one vote standard were historically commonplace. Moreover, the analogy between modern public corporations, even those with a single class of voting shares, and democratic institutions is simply inapt. As Delaware’s Chancellor William Allen has observed, our “corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm.”[1] Allen further recognized that the fact that many, “presumably most, shareholders” would have preferred the board to make a different decision “done does not . . . afford a basis to interfere with the effectuation of the board’s business judgment.” In short, corporations are not New England town meetings.

Does the principle of director accountability justify a mandatory one share-one vote standard?

Some argue that equal voting rights help reduce agency costs by ensuring that management accountability to shareholders. This argument, however, proves unpersuasive on close examination. First, shareholder voting as such is a relatively inefficient accountability mechanism. The shareholders’ incentives to be rationally apathetic, coupled with their relative powerlessness, renders them the corporate constituency perhaps least able to hold management accountable for misbehavior.

To be sure, voting rights enable shareholders to indirectly hold management’s feet to the fire via a proxy contest or by selling their shares to a takeover bidder. From this perspective, dual class capital structures are problematic not because they deprive shareholders of voting rights, but because they shield management from exposure to the full force of these other accountability mechanisms. Having said that, however, the anti-takeover effects of dual class stock do not justify prohibiting such a capital structure. Proscribing dual class stock because of its takeover effects puts one on a very slippery slope indeed. Taken to its logical extreme, the argument against dual class stock based on its anti-takeover effect would justify a sweeping prohibition of all effective takeover defenses, a solution that no court or legislature has been willing to adopt.

Does the potential for shareholder injury justify a mandatory one share-one vote standard?

Opponents of dual class stock commonly argue that it somehow harms shareholders. But the empirical evidence as to the effect of dual class stock on shareholder wealth is, at best, mixed. Lesser-voting rights shares typically sell at a slight discount to full-voting rights shares.[2] At a minimum, this differential suggests that the market anticipates a lower future stream of income from the lesser-voting shares. Surprisingly, however, studies find that dual class recapitalizations have no statistically significant effect on shareholder wealth (as measured by changes in the firm’s stock price).[3] One study in fact found positive shareholder wealth effects in certain types of recapitalizations.[4]

The inconclusive nature of the empirical studies may be attributable to a variety of offsetting factors. The higher dividends often payable to the lesser-voting rights shares may offset any negative price effects. In addition, because an oft-stated rationale for adopting a disparate voting rights plan is the desire to raise new equity capital, while maintaining insider control, the recapitalization proposal is a signal that management believes profitable investment opportunities are available to the firm. This good news about the firm’s future performance may mask any negative effects resulting from the recapitalization itself. Finally, many firms adopting a dual class capital structure exhibit substantial ownership by insiders prior to recapitalizing. The market previously will have discounted the firm’s stock price to reflect its lower probability of a takeover in comparison to more diversely-held firms. Adoption of the plan thus will not significantly affect the market’s evaluation of future payouts nor the firm’s stock price.

Do managerial conflicts of interest justify a mandatory one share-one vote standard?

The strongest argument against dual class stock rests on conflict of interest grounds.[5] There is good reason to be suspicious of management’s motives and conduct in certain dual class recapitalizations. Dual class transactions motivated by their anti-takeover effects, like all takeover defenses, pose an obvious potential for conflicts of interest. If a hostile bidder succeeds, it is almost certain to remove many of the target’s incumbent directors and officers. On the other hand, if the bidder is defeated by incumbent management, target shareholders are deprived of a substantial premium for their shares. A dual class capital structure, of course, effectively assures the latter outcome.

In addition to this general concern, a distinct source of potential conflict between managers’ self-interest and the best interests of the shareholders arises in dual class recapitalizations. An analogy to management-led leveraged buyouts (“MBOs”) may be useful. In these transactions, management has a clear-cut conflict of interest. On the one hand, they are fiduciaries of the shareholders charged with getting the best price for the shareholders. On the other, as buyers, they have a strong self-interest in paying the lowest possible price.

In some dual class recapitalizations, management has essentially the same conflict of interest. Although they are fiduciaries charged with protecting the shareholders’ interests, the disparate voting rights plan typically will give them voting control. The managers’ temptation to act in their own self-interest is obvious. Yet, unlike MBOs, in a dual class recapitalization, management neither pays for voting control nor is its conduct subject to meaningful judicial review. As such, the conflict of interest posed by dual class recapitalizations is even more pronounced than that found in MBOs.

While management’s conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. First, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don’t want lesser voting rights stock simply won’t buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management’s conflict of interest is thus constrained by a form of market review.

Another good example of a dual class transaction that fails to raise conflict of interest concerns is subsequent issuance of lesser-voting rights shares. Such an issuance does not disenfranchise existing shareholders, as they retain their existing voting rights. Nor are the purchasers of such shares harmed; as in an IPO, they take the shares knowing that the rights will be less than those of the existing shareholders. For the same reason, issuance of lesser-voting rights shares as consideration in a merger or other corporate acquisition should not be objectionable.

Second, even with respect to those disparate voting rights plans that do raise conflict of interest concerns, it must be recognized that there is only a potential conflict of interest. Despite the need for skepticism about management’s motives, it is worth remembering that “having a ‘conflict of interest’ is not something one is ‘guilty of’; it is simply a state of affairs.”[6] That the board has a conflict of interest thus does not necessarily mean that the directors’ conduct will be inconsistent with the best interests of any or all of the corporation’s other constituents. The mere fact that a certain transaction poses a conflict of interest for management therefore does not justify a prohibition of that transaction. It simply means that the transaction needs to be policed to ensure that management pursues the shareholders’ best interests rather than their own.

Why not regulate dual class stock the same way we regulate other conflict of interest transactions, such as two-tier tender offers, freeze-out mergers, and interested director transactions?[7] At the outset, we need to identify those dual class stock recapitalizations that actually entail a conflict of interest. Hence, for example, no safeguards over and above those already provided by state law are necessary with respect to dual class stock issued in an IPO, a subsequent offering or dividend of lesser-voting stock, or dual class stock issued in a bona fide acquisition. Nor are any additional safeguards necessary with respect to super-voting rights shares issued without transfer restrictions or in a lock-up.

Transactions involving more subtle conflicts require some additional safeguards. Among these are exchange offers and recapitalizations creating super-voting rights stock bearing transfer restrictions. In order to dissipate the conflicts of interest they raise, they should be permitted only if they are approved by the corporation’s independent directors and disinterested shareholders.

Requiring approval by a committee of independent board members created to negotiate with management and/or the controlling shareholder is common in conflict of interest transactions. In the freeze-out merger context, the Delaware Supreme Court has made clear that this procedure is “strong evidence that the transaction meets the test of fairness.”[8] Statutes governing interested director transactions and two-tier tender offers effectively presume that the transaction is fair if approved by the independent directors.[9] There is always, of course, some risk that purportedly independent directors will be biased in favor of their compatriots, but courts give greatest deference to independent directors in contexts like this one in which a market test of the transaction is impractical.[10] This is so in large part, of course, because the absence of a market test gives courts little option but to rely upon independent directors as the chief accountability mechanism. Yet, it is also so because courts know that independent directors are capable of serving as an effective accountability mechanism. Despite the potential for structural or actual bias, independent directors have affirmative incentives to actively monitor management and to discipline managers who prefer their own interests to those of shareholders. If the company suffers or even fails on their watch, for example, the independent directors’ reputation and thus their future employability is likely to suffer. Guided by outside counsel and financial advisers and facing the risk of person liability for uninformed or biased decisions, disinterested directors therefore should be an effective check on unfairness in a dual class recapitalization.

If the board lacks independence or is otherwise disabled by conflicted interests, approval by a majority of the disinterested shares should also insulate the dual class recapitalization from judicial review.[11] Approval of a freeze-out merger or interested director transaction by a majority of the disinterested shareholders, for example, shifts the burden of proof with respect to fairness back to the complaining shareholder. Under so-called fair price statutes, the obligation to pay a statutorily defined fair price in the second-step of a two-tier offer will be waived if the transaction is approved by the disinterested shareholders. These rules give the shareholders a collective opportunity to reject unfair proposals, thereby helping to eliminate the pressure on individual shareholders to accept the offer. Shareholder approval of a dual class recapitalization should likewise vitiate conflict of interest and collective action concerns.[12]

Admittedly, neither approval by independent directors nor disinterested shareholders will perfectly eliminate the possibility of management self-dealing in connection with a dual class recapitalizations. But that is true of every conflict of interest transaction. As we have seen, the problems associated with dual class stock are no different than those associated with any other conflict of interest transaction. One therefore must again ask, why should dual class stock be singled out for special treatment? No good reason has been forthcoming. As has been the case with all other corporate conflicts of interest, the law should develop standards of review for dual class recapitalizations that are designed to prevent self-interested management behavior but not to proscribe all such transactions. But the law thus far has failed to do so.

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[1] Paramount Communications Inc. v. Time Inc., 1989 WL 79880 at *30 (Del. Ch. 1989), aff’d, 571 A.2d 1140 (Del. 1990).

[2] Ronald C. Lease, et al., The Market Value of Control in Publicly-Traded Corporations, 11 J. Fin. Econ. 439, 466 (1983).

[3] See, e.g., SEC Office of the Chief Economist, The Effects of Dual-Class Recapitalizations on the Wealth of Shareholders 4 (June 1, 1987).

[4] Megan Partch, The Creation of a Class of Limited Voting Common Stock and Shareholder Wealth, 18 J. Fin. Econ. 313, 332 (1987) (statistically significant positive price effect found in subsample of firms in which insiders already owned sufficient shares to pass recapitalization plan over objection of all minority shareholders; Partch, however, questions the significance of this finding).

[5] The following argument differs from the accountability argument discussed and rejected above largely in terms of timing. The accountability argument focuses on the ex post effects of a dual class recapitalization. The conflict of interest argument focuses on management’s ex ante incentives. See generally Stephen M. Bainbridge, Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy, 22 Sec. Reg. L.J. 175 (1994).

[6] Committee on Corporate Laws, Changes in the Model Business Corporation Act–Amendments Pertaining to Directors’ Conflicting Interest Transactions, 44 Bus. Law. 1307, 1309 (1989).

[7] Imposing a requirement that the disparate voting rights plan fully compensate shareholders for the loss of their voting rights is an alternative solution. Dual class stock would be unobjectionable if management provided such compensation. However, the difficulty of measuring the voting rights’ value makes this solution impractical. One simply could not be confident that the plan fully compensated the minority.

[8] Weinberger v. UOP, Inc., 457 A.2d 701, 709-10 n.7 (Del. 1983).

[9] See, e.g., Pogostin v. Rice, 480 A.2d 619 (Del. 1984) (disinterested director approval of interested director transaction shifts burden of proof to plaintiff to show transaction amounts to waste).

[10] Stephen M. Bainbridge, Exclusive Merger Agreements and Lock-Ups in Negotiated Acquisitions, 75 Minn. L. Rev. 239, 278-79 (1990).

[11] Of course, the vote must be an informed one. Compare Lacos Land Co. v. Arden Group, Inc., 517 A.2d 271, 279-81 (Del. Ch. 1986) (preliminary injunction granted where proxy statement failed to fully disclose consequences of dual class plan), with Weiss v. Rockwell Int’l Corp., 15 Del. J. Corp. L. 777 (Del. Ch. 1989), aff’d without op., 574 A.2d 264 (Del. 1990) (preliminary injunction denied where proxy statement made full disclosure of effect of dual class plan on voting control of firm).

[12] In Weiss v. Rockwell Int’l Corp., 15 Del. J. Corp. L. 777 (Del. Ch. 1989), aff’d without op., 574 A.2d 264 (Del. 1990), plaintiff claimed that a disparate voting rights plan violated management’s fiduciary duties. The Delaware Chancery Court held that informed shareholder approval of the plan constituted an effective ratification of the plan and thereby precluded judicial review of the fiduciary duty claim.

 

 

How many boards is too many?

Keith Paul Bishop reports on ISS's proposed new rule on maximum board memberships:

 The following table summarizes ISS’ current and proposed policy with respect to recommending votes against directors who are “overboarded”:

2015 Policy	Proposed
More than six public company boards	More than five; or More than four
CEO of public company sits on more than two other public company boards	CEO of public company sits on more than one other public company boards

In proposing this policy change, ISS cites surveys that reflect an increase in the time commitment required for board service. 

Bishop goes on to explain that:

What is entirely missing from ISS’ proposal is any analysis, much less empirical evidence, that service on multiple boards affects firm value either positively or negatively.  This illustrates the fundamental and pervasive flaw in most corporate governance “reforms”: they are all prescription and no diagnosis.  One would expect that an organization engaged in an advisory business should be able to articulate some basis for its advice.  How does ISS know that six is too many and five or four is just right?

Amazingly, ISS’ own survey results don’t support its recommendation to reduce the number of board seats from six to either five or four.  While it is true that a plurality (34%) of investors preferred four total board seats, even more investors (38%) preferred more than four seats (either five or six) and nearly two-thirds (66%) preferred a limit other than four or no limit at all.  Among non-investors, a four seat limit did not even attain a plurality.  Forty one percent favored leaving the decision up to the board and another 32% favored a limit of five or six seats.  It seems that ISS either didn’t understand its survey results or has intentionally chosen to ignore them.

Inventing 41K clients = An Indicted Plaintiff Lawyer

Given how pervasive abuses by plaintiff lawyers are and how rarely they are really punished, it was heartening to read Alison Frankel's account of how one of the lawyers pillaging BP is staring at a federal indictment for inventing clients.