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A Critique of California's Overly Burdensome Climate Disclosure Regulation

California's new climate laws—SB 253 (Climate Corporate Data Accountability Act) and SB 261 (Climate-Related Financial Risk Act)—mandate stricter greenhouse gas (GHG) emissions and climate risk reporting for companies operating in the state, significantly impacting how businesses address sustainability and climate risks.

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SB 253: Climate Corporate Data Accountability Act

Overview:
SB 253 is the first U.S. law requiring companies to publicly disclose GHG emissions (scopes 1, 2, and 3). It aims to increase transparency and accountability for businesses’ climate impact.

• Applicability:

  • Public and private companies operating in California with annual revenues over $1 billion.
  • Estimated 5,300+ companies must comply.

• Requirements:

  • Scope 1 and 2 Reporting: Direct emissions and indirect emissions from energy use (starting 2026).
  • Scope 3 Reporting: Indirect supply chain-related emissions (starting 2027, under a "safe harbor" provision to allow flexibility and avoid penalties for good-faith errors until 2030).
  • Reporting must follow Greenhouse Gas Protocol (GHG Protocol) standards.

• Process:

  • Companies must submit annual reports to the California Air Resources Board (CARB) via a digital platform (to be created by Jan. 2025).
  • Third-party verification of reports is required to ensure accuracy.
  • Companies may report emissions data obtained directly from suppliers.

• Penalties and Safe Harbor:

  • Misreporting emissions (except for scope 3 under safe harbor) may lead to fines up to $500,000.
  • No penalties for scope 3 errors reported in good faith until after 2030.

• Significance:

  • No other U.S. policy mandates scope emissions reporting.
  • Companies like Amazon, Walmart, and Apple are already incorporating scope 3 data into supply chain practices.

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SB 261: Climate-Related Financial Risk Act

Overview:
SB 261 focuses on assessing and reporting climate risks businesses face and contribute to, requiring financial risk disclosures consistent with global standards.

• Applicability:

  • Businesses with annual revenues over $500 million and operations in California.

• Requirements:

  • Climate risk reports must assess risks and opportunities, modeled after Task Force on Climate-Related Financial Disclosures (TCFD) recommendations.
  • Reports are due biennially, starting January 2026.

• Process:

  • Entities submit reports to CARB and make them available online.
  • Parent companies may file consolidated reports for subsidiaries.

• Third-Party Verification:

  • Climate risk disclosures must be independently verified if they include claims about GHG emissions or mitigation efforts.

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SB 219: Adjustments to SB 253 and SB 261

On September 27, 2024, Governor Gavin Newsom signed SB 219, amending SB 253 and SB 261. Key changes include:

• Delayed Timeline:

  • CARB rules for reporting postponed until July 2025.
  • Scope 3 emissions reporting phased in starting 2027.

• Consolidated Reporting:

  • Parent companies can file single, consolidated reports.
  • CARB may contract third-party organizations, like CDP, to manage reporting.

• No Changes to Initial Deadlines:

  • Scope 1 and 2 emissions reporting and climate risk disclosures still required in 2026.

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Critique

SB 253's comprehensive Scope 1, 2, and 3 emissions reporting requirements impose substantial compliance costs on covered businesses. Scope 3 emissions tracking is particularly onerous, as it requires companies to gather data from their entire value chain, including suppliers, distributors, and end-users. Many companies lack the existing infrastructure to collect this data accurately.

Second, the verification requirements from independent auditors create additional direct costs. Companies must hire third-party verifiers approved by the state board, which represents a recurring annual expense. The limited pool of qualified verifiers may drive up costs further.

Third, the Act creates significant operational complexity. Companies must develop new systems, train personnel, and potentially restructure supplier relationships to enable emissions tracking. This diverts resources from other business activities and innovation.

Finally, the $500,000 civil penalty provision for violations creates material financial risk, especially given the complexity of accurate emissions reporting. This could lead companies to over-invest in compliance measures out of an abundance of caution.

The USC Schwarzenegger Institute estimated compliance costs with SB 253 as folllows:

• Initial compliance costs between $300,000 to $900,000 per company
• Ongoing annual costs of $100,000 to $300,000
• Additional verification costs of $30,000 to $100,000 annually

The California Chamber of Commerce projected higher costs:

• Initial setup costs potentially exceeding $1 million for larger companies
• Annual compliance costs of $300,000 to $900,000
• Additional costs for supply chain data collection and verification

Turning to SB 261, the requirement for companies to assess both direct and indirect material financial risks from climate change demands extensive analysis across multiple business dimensions. Companies must evaluate risks from physical impacts, transition impacts, and liability concerns - a complex undertaking requiring specialized expertise many firms don't currently possess.

Second, the mandatory disclosure of adaptation and mitigation strategies forces companies to develop and publicize detailed climate planning, even when such planning may be premature or based on uncertain projections. This creates potential liability risks if actual climate impacts differ from disclosed plans.

Third, the biennial reporting requirement creates recurring compliance costs. Companies must regularly:

• Engage external consultants and climate risk specialists
• Conduct detailed scenario analyses
• Develop comprehensive risk assessments
• Prepare extensive documentation
• Update mitigation strategies

Fourth, the Act's broad definition of covered entities ($100M+ in annual revenue) captures many medium-sized businesses that may lack the resources and sophistication to conduct thorough climate risk analyses. The compliance burden falls disproportionately heavy on these smaller covered entities.

Fifth, the requirement to follow TCFD recommendations imposes a rigid framework that may not suit all business models. The standardized approach could force companies to analyze and report on risks that aren't material to their specific operations.

Notably, this burden compounds existing climate reporting requirements under SB 253, creating overlapping but distinct compliance obligations for California businesses. This regulatory layering significantly increases the total cost of climate-related compliance.

Business groups and industry analyses suggest companies will incur substantial compliance costs:

• First-time compliance costs of $300,000 to $750,000
• Recurring biennial costs of $150,000 to $500,000
• Additional costs for external expertise and risk modeling tools

Considering both bills together, California's aggressive regulatory stance may deter business investment and operations in the state. Companies may choose to limit their California presence or restructure operations to avoid triggering regulatory thresholds, potentially harming the state's economic interests.

In addition, there is a considerable risk of future problems of jurisdictional overreach and economic inefficiency. These concerns are not inconsistent with a commitment to federalism and subsidiarity. Recall that Louis Brandeis praised federalism because it allows states to experiment: "It is one of the happy incidents of the federal system, that a single, courageous State may . . . serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country.” Implicit in Brandeis' praise, however, is the assumption that state experimentation does not have negative externalities that put the rest of the country or even the world at risk.

Unfortunately, California's regulations often have de facto extraterritorial effects that put other states and nations at risk. When California requires companies to report on global supply chain emissions or worldwide climate risks, for example, it effectively extends its regulatory reach far beyond state borders. This creates legitimate questions about one state's authority to compel disclosure of business activities occurring entirely outside its jurisdiction.

In addition, California's climate regulation is replete with negative externalities. First, as noted above, state-level regulation of multinational enterprises creates problematic regulatory fragmentation. As climate disclosure regimes proliferate both nationally and globally, absent harmonization, companies will face duplicative but also potentially inconsistent regimes. When individual states impose distinct compliance regimes on businesses operating across multiple jurisdictions, it thus creates a complex patchwork of obligations. This fragmentation increases compliance costs as companies must track and adhere to potentially conflicting requirements across different states. If the EU, the US, Canada, and California, for example, all decide that companies (many of which will operate in all four) must file disclosures that differ from one another, companies will have to generate separate reports for each authority. 

Second, state-level regulation of global businesses can interfere with federal authority over international commerce and foreign affairs. Climate and environmental issues often intersect with international agreements and federal policy. State intervention in these areas risks creating conflicts with federal objectives and complicating international business relationships.

Next steps in the Tornetta v. Musk saga: Can Elon leverage his bromance with Donald Trump to take vengeance on Delaware?

A front page headline in today's WSJ explains that: Musk’s Rivals Fear He Will Target Them With His New Power.

Musk’s scorched-earth tactics have sent waves of concern through his lengthy list of business rivals, who over the years have included Microsoft co-founder and philanthropist Bill Gates and Amazon.com founder Jeff Bezos. They have watched him ascend to an unprecedented level of power for a private citizen while continuing to nurse his private business grievances.

The richest man in the world is poised to have significant influence not only over how his six companies, including X, Tesla and SpaceX, interact with the federal government—SpaceX has accumulated more than $15 billion in federal contracts over the last decade—but also over how the new administration treats his rivals. ...

Trump rode to the White House on promises to use federal power to exact “retribution” against his political enemies. Over his career, Musk has shown a similar taste for revenge, with a long list of perceived foes he has gone after through the courts and with his 200 million followers on X. People who have worked with Musk say he draws energy from the idea of having enemies.

What interests me about the potential ramifications of Musk's new bromance with Donald Trump is its potential impact on corporate law.

We know Elon is no fan of Delaware, its courts, and its corporate law. Recall the famous tweet:

Never incorporate your company in the state of Delaware

— Elon Musk (@elonmusk) January 30, 2024

After a string of losses in the Delaware courts, Musk finally moved Tesla's state of incorporation to Texas and SpaceX to Nevada.

As I explained in my book Corporate Governance after the Financial Crisis, Delaware's dominance of corporate law follows from its success in attracting companies to incorporate under its law. Other states have periodically challenged Delaware, but have routinely failed. My article DExit Drivers: Is Delaware's Dominance Threatened? concludes that Delaware's competitors are unlikely to prevail anytime soon. The  number of reincorporations from Delaware remains minimal compared to the vast number of new incorporations Delaware attracts annually. Given the strong inertia behind the initial incorporation decision and the weak drivers for DExit, it is unlikely to become widespread soon.

As I thus explained in Corporate Governance after the Financial Crisis, Delaware's principal threat is not from other states but from the federal government. Although the federal government has never adopted a national law of corporations that would preempt Delaware law, it has several times considered doing so, and no one doubts its power under the Commerce Clause to do so. As former Delaware Chief Justice Leo Strine observed, “the capacious constitutional authority of Congress over interstate commerce is something that Delaware and other state corporate lawmakers have constantly had to take into account ….” Leo E. Strine Jr., Breaking the Corporate Governance Logjam In Washington: Some Constructive Thoughts on A Responsible Path Forward, 63 Bus. Law. 1079, 1081 (2008).

In his article, Delaware and Washington As Corporate Lawmakers, 34 Del. J. Corp. L. 1, 9 (2009), Harvard Law Professor Mark Roe thus observed that:

The big gorilla of American economic lawmaking is the Congress which, when it wants to, can dwarf the Delaware Court of Chancery, the Delaware General Assembly, and the Delaware Corporate Law Council, which drafts Delaware’s corporate law. They all have considerable freedom to act, but not on a corporate governance issue about which Washington has acted, and not if they upset those who can influence Washington.

Let's pause to emphasize his observation that Delaware could lose its freedom to make corporate law if it upsets "those who can influence Washington." Which is precisely what Delaware has done through Chancellor Kathaleen McCormick's decisions about Musk's Tesla compensation package.

There are already those in Washington who view Delaware corporate law with suspicion, if not outright hostility. Senator Elizabeth Warren favors mandatory federal incorporation of all businesses with more than $1 billion in annual revenue, which would displace Delaware law as to the largest and most prestigious of its companies. In the 2020 Presidential cycle, both Warren and Senator Bernie Sanders proposed expansive regulation of corporate governance at the federal level.

Is it too far fetched to imagine an unholy alliance of Musk and Warren collaborating to bring Delaware's dominance to an end?

Contrary to what The Hill and its Opinion Contributor Michael Toth Would Have You Believe, Companies are not Fleeing Delaware

I was (understandably IMHO) annoyed when former Trump AG William Barr suddenly decided that Delaware was going to lose its dominance of the market for corporate charters because Delaware has gone woke. Not surprisingly, I am now annoyed by a column on The Hill by Michael Toth, in which he claims that:

Delaware’s secret sauce has long been its corporate jurisprudence. But recently, activist judges in the state have set out to padlock Delaware’s main attraction. They are sending companies packing for states like Texas, which for its part is doubling down on its efforts to recruit businesses to the Lone Star State. 

Contrary to the headline to Toth's column, companies are not fleeing Delaware. I've got a law review article in the works on the subject and have some actual data on the topic (like most lawyers Toth seems to treat anecdotes as data).

In total, there are almost 400,000 companies incorporated in Delaware. Although Delaware accounts for less than one-third of one percent of the United States’ population, it is the legal home for two-thirds of the Fortune 500 companies.[1] As for the broader set of all public corporations, Delaware is home to more than half of the corporations listed for trading on U.S. stock exchanges.[2] As for newly formed corporations, while most business entities form under the law of the state in which they have their primary place of business, Delaware is the leading choice of businesses that opt to incorporate outside their home state.[3]

Guess how many publicly held Delaware corporations reincorporated outside of Delaware between 2012 and 2024. My research assistants and I have scoured SEC filings and various databases to get the answer. The answer? A whopping total of 65, with seven pending. That’s a total of 72 over 12 years. Six per year.

That’s not flight. That’s rounding error.

So why’s Toth boosting Texas and slamming Delaware? Might we draw an inference from the fact that he’s a partner at a Texas law firm that represents Texas (and other corporations).

By the way, only 6 of the corporations in our dataset moved to Texas. Six.

Divestment is back in the news. I'm still opposed.

I have written a fair bit about divestment campaigns over the years. See, for example:

Those Divesting Presbyterians

... divestment may make activists feel all warm and fuzzy, but the evidence is that (1) it has no significant effect on the target of the divestment campaign but (2) likely does harm the activists' portfolios.

As the Manhattan Institute's James Copeland explained, these results are entirely consistent with financial theory ....

Quoted re CSR/Divestment

Steven Bainbridge, a corporate law professor at UCLA, agrees and says social activist divestment tends to have little impact on its targets, but does reduce returns to investors who divest.

Todd Henderson inveighs against fossil fuel divestment

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.

Was the Presbyterian Divestment Anti-Semitic

Lefkowitz goes on to make a persuasive case that the Presbyterian divestment was anti-Semitic:

The recent action by the Presbyterian Church sadly satisfies Mr. Sharansky's test. The church has singled out Israel, alone among all the nations of the world, for divestment. It has demonized Israel's treatment of the Palestinians, and it has delegitimized Israel's right to self- defense.

The church is not calling for divestment of its $7 billion portfolio from China, despite China's denial of the most basic political and religious rights and its particularly harsh treatment of followers of Falun Gong. It is not condemning Russia, even though Russia's policies in Chechnya are by any human-rights standard atrocious. 

Specialist Directors: Recommended Reading

I've noticed a trend in recent years for companies to provide data on the skill and expertise set of their directors. Frequently they summarize the information in tabular form:

I'm not sure how useful investors will find such presentations when almost every director is claimed to have virtually every skill. In any case, Roy Shapira and Yaron Nili have posted a very interesting paper discussing this phenomenon (Specialist Directors (November 30, 2023), https://ssrn.com/abstract=4648018:

What determines the effectiveness of corporate boards? Corporate legal scholars usually approach this question by focusing on directors’ incentives, such as counting how many directors are independent or whether the roles of the CEO and Chair are separated. Yet on the ground, the focus has been shifting to directors’ skill sets and experience. Investors, regulators, and courts are now pressuring companies to appoint directors with specific types of expertise. In response, more and more companies are adding what we term “specialist directors”: a DEI director, a climate director, a cyber director, and so on. These changes in board composition could reshape corporate governance and impact broader societal issues such as data privacy and environmental degradation. This Article examines the ongoing shift in board expertise and makes the following three contributions.

First, the Article presents evidence on the scope and magnitude of the changes in board expertise. We hand-collect and hand-code data from the proxy statements of S&P 500 (large cap) and S&P 600 (small cap) companies over the 2016–2022 period. We find that over the past few years companies have not only significantly increased their emphasis on expertise disclosure, but also added hundreds of directors with narrower, ESG-related expertise.

Second, the Article analyzes how these shifts in board expertise could affect corporate behavior, and whether they are likely to prove overall desirable from a societal perspective. It is intuitive to think of board expertise as an unalloyed good. But we merge insights from interviews with nomination committee members with insights from the literature on group decision-making, to highlight five realistic concerns arising from the current trend. The injection of new, narrow types of expertise could distort board dynamics, create “authority bias,” overly increase the size of boards, hinder efforts to promote board diversity, and result in “board washing” whereby human capital disclosure camouflages the company’s actual behavior.

Finally, the Article generates concrete policy implications. For regulators, the main lessons concern rethinking the desirability of legal intervention and ensuring more credible and comparable expertise disclosure. For courts, the main lessons revolve around how to assess board behavior in oversight-duty litigation and what to consider when approving derivative settlements.

In it they discuss the proposal for board service providers that Todd Henderson and I made a few years ago in Outsourcing the Board:

Our focus on board expertise makes our analysis closely related to a couple of recent influential accounts. Consider first Bainbridge and Henderson’s thought provoking proposal to outsource the board. Bainbridge and Henderson start their analysis by highlighting a lack of expertise problem. The decades-long emphasis on board independence has rendered current boards with “generalists with little firm-specific knowledge, skills, or expertise,” they argue.To solve this problem, Bainbridge and Henderson suggest allowing companies to hire an outside governance consulting firm to run (be) their board. Outsourcing the board to (non-human) specialized entities would solve the expertise problem, by permitting the board to “insource its development of expertise.” One important difference between our analyses is that Bainbridge and Henderson focus on firm-specific expertise, whereas we focus on the recent shift to ESG expertise. Another distinction is that Bainbridge and Henderson focus on what ought to happen: removing the legal ban on non-human directors would free up companies to experiment with different types of boards. We, by contrast, focus on a shift that is happening.

Without speaking for Todd, my take is that firm-specific (and industry-specific) expertise is more relevant than ESG expertise, but that's driven by my view on the merits of ESG. Second, theory always trumps description. (I joke, of course.)

Seriously, I liked this paper a lot. Recommended reading.

Back to the Future: Warner and Paramount Come Full Circle

Back in the 1980s, Time Inc. was principally a print publishing company. It's lineup included such stalwarts as Time, People, Sports Illustrated, and so on. Along the way, however, Time had picked up cable network HBO. Video entertainment was anticipated to play an increasing role in Time's future, which meant HBO and its other video enterprises need a constant flow of new content. 

Time management developed a strategic plan, which the board adopted, to grow the video side of the business by combining with a major motion picture studio. After searching for acquisitions that would advance that plan, Time’s board of directors eventually approved a merger with Warner Communications. The deal was billed as a merger of equals, although the former Warner shareholders would receive newly issued shares representing approximately 62 percent of the shares of the combined Time-Warner entity. 

By the way, the negotiations between Time and Warner were a claassic clash of massive Wall Street and Hollywood egos. Which company got its name first in the new title? Which firm's CEO could become CEO of the combined company? Who was the acquirer and who the target, a question that became even more fraught whenParamount entered the picture. All of which is chronicled by Connie Bruck in Master of the Game: Steve Ross and the Creation of Time Warner.

As I describe in my book, Mergers and Acquisitions:

Shortly before Time’ shareholders were to vote on the merger agreement,[1] Paramount made a cash tender offer for Time. Time’s board rejected the offer as inadequate, without entering into negotiations with Paramount. To forestall Paramount, the Time and Warner boards then agreed to a new structure for the transaction, under which Time would make a cash tender offer for a majority block of Warner shares to be followed by a merger in which remaining Warner shares would be acquired, thus obviating the need for shareholder approval. The new plan required Time to incur between 7 and 10 billion dollars in additional debt. Finally, and perhaps most damningly from the perspective of a Time shareholder, it foreclosed the possibility of a sale to Paramount. If the new plan succeeded, Time’s shareholders therefore would end up as minority shareholders in a company saddled with substantial debt and whose stock price almost certainly would be lower in the short run than the Paramount offer.

[1]      The plan of merger called for Warner to be merged into a Time subsidiary in exchange for Time common stock. Although Time was not formally a party to the merger and approval by its shareholders therefore was not required under Delaware law, New York Stock Exchange rules required a vote of Time shareholders because of the number of shares to be issued.

Paramount faced the obverse of Time's strategic problem. Time had a conduit for delivering video entertainment directly to consumers in their homes but insufficient content. Paramount had lots of content but no conduit for delivering it to consumer homes. So Paramount prized Time for HBO. But Paramount had no interest in Warner; indeed, Paramount would be unable to raise financing to buy the combined Time Warner entity even if it had wished to do so.  Paramount thus needed to stop the Time-Warner merger. On the other hand, as the Delaware Supreme Court later explained, Time’s revisions to the Warner deal was motivated by a desire to advance legitimate corporate interests. The revised plan had not been cobbled together simply to justify takeover defenses, but was only intended to carry forward “a preexisting transaction in an altered form.” As a result, Paramount was essentially asking the court to enjoin Time’s board from continuing to operate the corporation’s business and affairs during the pendency of the takeover bid. The Delaware courts were properly reluctant to do so, as a hostile bidder has no right to expect the incumbent board of directors to stop an ongoing business strategy in mid-stream. Accordingly, in a landmark decision I still teach in M&A 30+ years later, the Delaware Supreme Court allowed Time to go forward with the revised acquisition.

Time shareholders probably would have preferred the Paramount deal. Paramount ultimately offered $200 per share in cash. Time's board claimed that the Warner deal would eventually result in a combined entity whose stock would trade in "ranges of $159-$247 for 1991, $230-$332 for 1992 and $208-$402 for 1993. ... The latter being a range that a Texan might feel at home on." Paramount Commun. Inc. v. Time Inc., 1989 WL 79880, at *13 (Del. Ch. July 14, 1989), aff'd, 565 A.2d 281 (Del. 1989).

None of those predictions panned out. To the contrary, a 2003 WSJ article observed that:

[Time's] shareholders didn't fare so well, particularly with the double whammy of the AOL combination. If you were a shareholder of Time back in 1989 and held your shares through various splits over the years, they would now be worth $113.76 each, about where they were trading more than 14 years ago and far below the Paramount offer. Meanwhile, if you'd just bought the stocks in the S&P 500 index, you would have almost tripled your money.

In 2021, I calculated that if you had taken the Paramount deal in 1989 and invested the $200 per share in the S&P 500, you'd have had $5,182.69 in 2021.

Of course, as that WSJ article reminds us, Time-Warner later went on to be acquired by AOL in a disastrous deal chronicled by Alec Klein in Stealing Time: Steve Case, Jerry Levin, and the Collapse of AOL Time Warner. At the time, AOL's stock price was hugely inflated by the doc-com bubble. The then-management and board of Time Warner thus agreed to a stock for stock deal, which went through mere months before the dot-com bubble burst. AOL Time Warner stock fell by pover two-thirds in the wake of the burst bubble. Over the next decade, trying to repair the damage required management to divest "the Time Warner Book Group, Warner Music Group, Time Warner Cable, and AOL." 

The WSJ provided a simplified map of the complex series of deals that created today's Warner-Discovery entity:

All of which brings us up to this week. Despite decades of unwise deals, Warner is back in the news because it's thinking about coming full circle:

The Wall Street Journal and other media outlets reported late Wednesday that Warner Chief Executive David Zaslav met with Paramount CEO Bob Bakish earlier this week to discuss a possible deal. 

Would this deal turn out any better than the ones that preceded it? The WSJ suggests caution:

Combining the owners of the Max and Paramount Plus streaming services also makes a certain amount of sense in a world where every streamer not named Netflix is losing money or owned by a tech giant (Amazon and Apple) that can stomach the losses. Warner and Paramount combined have about 158 million subscribers, which exceeds those of Disney’s core streaming services and would come second only to the 247 million subscribers Netflix currently boasts. 

But such a combination would bring together two companies under a mountain of debt—$61 billion combined as of the end of the third quarter. Meanwhile, the benefits from combining the scale and reach of two media titans would also likely draw the ire of regulators. 

One wonders whether an alternative deal structure, such as a joint venture between Warner's Max and Paramount's Paramount+ streaming services would not make more sense. 

In any case, this is a fitting Hollywood twist to a long running story, as Warner is now trying to woo the suitor it spurned 3 decades ago.

How Effective are Activist CEOs?

Very interesting results reported by Christopher Poliquin and Young Hou at CLS Blue Sky Blog. 

In our new working paper, we conduct two experiments on 500 elected officials from across the U.S. to examine whether policymakers are moved by CEO stances on contentious issues. In the first experiment, we asked the officials about their support for police reform after randomly exposing half the sample to a Business Roundtable message advocating for the reforms. In the second experiment, we measured their’ willingness to engage with a CEO who was considering relocating to their community, and we varied whether the CEO was described as publicly expressing views on social issues that clash with those of the officials’ constituents.

CEO advocacy for police reform ineffective: Exposure to the CEO message supporting police reform didn’t sway the opinions of local elected officials. While support for police reform was highest among Democrats and lowest among Republicans, members of neither party reported higher levels of support after seeing the Business Roundtable statement. Furthermore, this pattern held regardless of a community’s exposure to police shootings, Black resident share, or history with Black Lives Matter protests or the self-reported views of the community’s policmakers on police-community relations in their area.

Lower willingness to engage with activist CEOs: Strikingly, local policymakers are reluctant to engage with CEOs who speak out on social issues. Policymakers who were told a CEO expressed controversial opinions were less willing to meet privately with the CEO and less willing to publicly advocate for the relocation of the CEO’s company.

In short, there's little potential upside to social justice warrior activism by CEOs and plenty of potential downside.

Corporate Governance Q&A at the Lowell Milken Institute’s Mini-Conference on Corporate Governance, Tax Law and Nonprofit Law

The Lowell Milken Institute for Business Law and Policy at the UCLA School of Law today celebrated ten years of training the next generation of leaders in business law with a mini-conference for alumni, practitioners, business executives and students. I was honored to be asked to serve on a panel with Kimberly Simpson, Chief Operating Officer and General Counsel, National Association of Corporate Directors, in which we were asked and answered a bunch of questions about corporate governance. In a series of posts below, I revise and extend my remarks:

What are major issues/challenges boards are facing in the next year or two?

What do we mean by the term “corporate governance”?

Do you think corporate culture has any role to play in effective governance?

What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance?

Do you still support outsourcing the board?

How can lawyers get on boards of directors?

How should we respond to crises in corporate governance?

Caremark and the Board's Duty of Oversight

What do each of you see as the major challenges facing boards beyond the economy?

Corporate Governance Panel Question: What are major issues/challenges boards are facing in the next year or two?

Question

What are major issues/challenges boards are facing in the next year or two? They seem to be facing numerous difficult issues including:

• Political issues, e.g. Disney and Florida; crisis in the Middle East
• Marketing issues, e.g. Budweiser marketing campaign involving a transgender influencer
• More “mundane” issues: AI, cybersecurity, lots of questions about the future of regulatory regimes, role of institutional investors on corporate boards.

Answer

1. Cybersecurity. As the frequency and complexity of cyber threats continues to grow, boards are coming under increasing pressure from regulators and litigation (such as Caremark claims) to ensure cybersecurity. Accordingly, board members need to make safeguarding their organization's digital assets and customer data a top priority. This entails consistently assessing and enhancing cybersecurity strategies, allocating resources to establish resilient systems, providing comprehensive training for employees, and ensuring adherence to data protection regulations.
2. Risk management: Cybersecurity is a sufficiently important risk to deserve its own category. But the general problem of risk management remains an important part of what boards must do. Board-level systems designed to monitor and oversee mission-critical functions play a crucial role in showcasing the board's fulfillment of its Caremark duties. This was evident last year when the Delaware Court of Chancery allowed a Caremark duty-of-oversight claim to advance against Boeing Company directors. The court's decision was based on allegations of insufficient board involvement in safety matters and the absence of a dedicated committee with direct oversight responsibilities. Nevertheless, it's worth noting that two subsequent cases, Hamrock and SolarWinds, have underscored the necessity of establishing bad faith rather than merely proving gross negligence for a Caremark claim to succeed.
3. Shareholder activism. The ongoing fluctuations in equity values, characterized by both volatility and a general decline, have brought vulnerabilities to the forefront for many companies while also opening up opportunities for activist investors. This trend is expected to continue into the coming year. What particularly piques my interest is the potential impact of the recent SEC rule mandating the use of universal proxy cards in director election proxy battles. This innovation is poised to streamline the proxy contest process, reducing the costs and efforts associated with activists nominating and seeking proxies for board member elections. Consequently, this change may shift the focus in proxy battles towards assessing the track records and skill sets of individual directors, as opposed to evaluating the overall performance of the company or board as a whole. With the introduction of universal proxy cards, shareholders will gain the ability to selectively choose individual directors from both the company's and the activist's competing slates.
4. Political risks. Boards need to pay attention both to how the corporation engages with politics and how politics affects the corporation. As to the former, activists are paying attention to issues like corporate political spending. As for the latter, the runup to the 2024 presidential election will require boards to assess possible changes in the presidency, Congress, and the membership of the SEC.

Corporate Governance Panel Question: What do we mean by the term “corporate governance”?

Question

Some commentators suggest that the modern iteration of corporate governance in the United States began in the 1970s.[1] So, in 2023, what do we mean by the term “corporate governance”?

Does it just mean the set of legal rules and norms addressing the conduct of directors and officers of a corporation? Does it necessarily include mechanisms of regulatory oversight such as those applied to public companies and certain industries such as banking and certain functions such as privacy? Does it necessarily include criminal laws? Is it more than that?

And, if it is more than just the legal rules and norms addressing the conduct of directors and officers of a corporation, how should we make regulators more effective at enforcing corporate governance norms? Are there other regulatory agencies, federal or state, that should have a direct role in corporate governance?

What about member organizations like the NACD? What should its role be in developing norms for directors? Are organizations like the NACD potentially more effective because they explain the role of the board in terms that non-lawyers can understand?

Answer

I like this question a lot. But I will use it as a jumping off point for flagging the importance of non-legal aspects of corporate governance; specifically, best practices. In 1982, Thomas Peters and Robert H. Waterman expanded upon Xerox's practical approach in their influential book, "In Search of Excellence: Lessons from America's Best-Run Companies." Their work brought the concept of best-practices research and implementation into the mainstream of American organizations. The authors conducted a comprehensive study, analyzing sixty-two American companies spanning various industries, and identified eight attributes that they believed epitomized the excellence of America's most innovative entities. With over three million copies sold and a long stint on bestseller lists, Peters and Waterman succeeded in popularizing the adoption of best practices as a strategy for gaining a competitive edge by emulating the most effective strategies of competitors.

As the number of success stories multiplied and the popularity of best practices soared, three primary styles of benchmarking emerged: competitive benchmarking, cooperative benchmarking, and collaborative benchmarking. Competitive benchmarking involves gathering information from competitors to establish a benchmark. This approach entails measuring your functions, processes, activities, products, or services against those of your competitors and continually improving them to attain best-in-class status. Cooperative benchmarking necessitates a company seeking improvement in a particular activity to reach out to a best-in-class firm and request knowledge-sharing with the benchmarking team. Collaborative benchmarking, on the other hand, involves companies coming together to exchange information about an activity with the aim of enhancing their internal processes based on the acquired insights. Ideally, as more companies adopt best practices and engage in cooperative knowledge-sharing, the resulting impact will be widespread, fostering further innovation.

Despite facing its share of critics, the best-practices methodology undeniably remains a common and highly regarded practice among many modern organizations. Most large corporations now engage in at least one form of benchmarking to develop and implement best practices.

The NACD has played an important role in developing and promulgating best practices. The NACD’s Corporate Governance Guidelines, for example, incorporate both legal rules and norms of best practice.

But given the emphasis in your question on the role of regulatory agencies, it would be worth having a discussion of whether the United States should follow the lead of the United Kingdom in having a regulatory body that develops best practice codes.

The UK Corporate Governance Code acknowledges that effective corporate governance cannot be achieved through a one-size-fits-all approach, recognizing that different companies may require different methods. Consequently, it allows for flexibility and permits companies to deviate from the Code, provided they offer a rationale for their non-compliance.

In their annual reports, companies are expected to disclose whether they have: a) fully adhered to all aspects of the Code's Provisions throughout the entire financial year; or b) departed from any of the Code's Provisions (either for the entire financial year or a portion thereof), specifying the Provisions they have not followed and indicating where in the report the explanation can be located.

It's crucial to note that the Code serves as a framework for best practices rather than a strict set of rules. It comprises adaptable requirements. In instances where a company has justified non-compliance with a Provision, it falls upon investors to assess whether the explanation is satisfactory and demonstrates how deviating from the Code benefits the company. In cases where explanations are deemed inadequate, investors are encouraged to engage with the companies and hold directors accountable, with the aim of enhancing governance practices and reporting standards.

 

[1] See e.g., https://www.thecorporategovernanceinstitute.com/insights/lexicon/why-does-corporate-governance-matter-a-look-back-at-history/

Corporate Governance Panel Question: Do you think corporate culture has any role to play in effective governance?

Question

We often speak of a "corporate culture" in the context of corporate governance. What is meant by that? Do you think corporate culture has any role to play in effective governance?

The NACD tries to mold corporate culture through its education programs and Kimberly you have written about that and participated in those programs. What do you think are effective drivers in creating an optimal corporate culture in the boardroom and the C-Suite?

Answer

Corporate cultures are very real. Indeed, I would argue that dysfunctional corporate cultures lie at the root of many corporate business failures and violations of the law.

The interesting issue implied by your question is whether boards of directors have much influence over corporate cultures. Personally, while I agree with those who would argue that “tone from the top” is crucial for creating effective and ethical corporate cultures, I suspect that the “top” for this purpose is the C-suite—especially the CEO—rather than the board of directors. They are the folks the employees of the company will look to for guidance, rather than the board. The board does not interact with most employees even in times of crisis. It is the CEO and the other members of the C-suite who are in the office daily, setting the desired tone.

The board’s role in this regard thus is primarily one of monitoring the CEO and the C-suite to ensure that they are setting the proper tone at the top. The ABA Corporate Director’s Guidebook explains:

The CEO and senior management must take the leadership role to promote integrity, honesty, and ethical conduct throughout the organization. The board's role is to assess the CEO's commitment and efforts in this area, support and encourage appropriate values (including through policies and incentives), and provide oversight of the programs and procedures that management implements to support behaviors and identify issues that may arise (including reporting mechanisms). This board role includes directing the CEO and other members of the senior management team to establish the proper “tone at the top” by setting clear expectations for the corporation's ethical behavior and conduct of its business in compliance with law.[1]

 

[1] The Corporate Laws Committee, ABA Section of Business Law, Corporate Director's Guidebook-Sixth Edition, 66 Bus. Law. 975, 987 (2011).

Corporate Governance Panel Question: What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance?

Question

What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance? U.S. society is in the middle of a debate over the proper purpose of the corporation. Do we need to settle that debate in order to decide what is good governance?

On this point, recently the NACD did a survey of which practices directors expect to see more of and less of in the years ahead.  40% of respondents say that in the future it will be less acceptable to focus on shareholders at the expense of other stakeholders. About 62% said that boards will widen their definition of success to include the societal impact of operations.

Answer

There’s a lot going on in this question. It’s really about half a dozen questions rolled into one.

I will start by asking whether the ends of corporate governance can be separated from the means of corporate governance. Put another way, why is board centric governance a feature of shareholder capitalism? Would it also be a feature of stakeholder capitalism? I think (emphasis on the word think) the answer is yes.

But even if a board of directors would exist in corporate system premised on stakeholder capitalism, what would be the role of the board in such a system? At present,  in our system of shareholder capitalism, the board’s role is primarily monitoring. Its service and managerial roles are of minor importance. Would that change in a stakeholder capitalist system? Margaret Blair and Lynn Stout argue the board should function as mediating hierarchs, which would seem to imply an emphasis on managerial decision making.

By the way, as for the NACD survey, it is a fundamental tenet of my book The Profit Motive: Defending Shareholder Value Maximization that what directors and CEOs say is of far less importance than what they do. Most boardroom and C-suite ESG talk is greenwashing.

Corporate Governance Panel Question: Do you still support outsourcing the board?

Question

In 2018, Stephen, with his co-author University of Chicago Law Professor Todd Henderson, published a book entitled Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance. The argument in the book was that after decades of trying, those who advocate for better corporate governance have failed to find ways to implement it as evidenced by corporate scandal after corporate scandal. Professors Bainbridge and Henderson proposed to replace a board of diverse individuals with special service organizations with the subject matter expertise and experience to serve as the board. Are there other changes that could improve corporate governance?

Answer

Short answer: Adopt our proposal. We would not mandate that all boards adopt the board service provider model in which a single outside entity replaces the board, but we think it should be an available option.

Long answer: Read the book.

Corporate Governance Panel Question: How can lawyers get on boards of directors?

Question

Many in our audience are lawyers. Often lawyers want to become members of the board. What does it take for a lawyer to become a member of a board? What are some paths and resources for lawyers interested in becoming a member?

Answer

I wish I knew. As someone for whom the board of directors is his principal academic interest, I’d love to get the experience of actually serving on a board. But nobody’s asked.

Recommended Reading: A Theory of REITs

A very interesting new paper from my friends and UCLAW colleagues Jason Oh and Andrew Verstein:

Real Estate Investment Trusts (REITs) are companies that raise money from the public to invest in real estate. Despite REITs being a vast and growing part of the economy, legal scholars have paid them almost no attention. Accordingly, no one has noticed that REITs possess several unique and puzzling legal characteristics. REITs are the only American business form that is forbidden to reinvest their profits. They are also uniquely immune to hostile takeovers. Since reinvestment and takeovers are thought to be good for investors (at least on average), REIT law would seem to be an obstacle to REIT growth. Yet, REITs have grown feverishly for decades.

We offer a theory to account for the growth of REITS. In essence, we suggest that REITS succeed because of – not despite – their mysterious legal attributes. We argue that their superficially inefficient rules that bar reinvestment and takeovers interlock as part of an efficient solution to tax problems and investor conflicts inherent in real estate markets.

Our theory is important because it clarifies the underlying logic of REIT law, which is highly technical and may appear arbitrary. Clarity allows us to evaluate reforms to the real estate sector. Our theory also links the REIT back to mainstream corporate governance and tax scholarship, showing how an overlooked business form sheds light on some of the fields’ central debates.

Oh, Jason and Verstein, Andrew, A Theory of the REIT (February 20, 2023). Yale Law Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4365127