October 12, 2015
Observations on Short-Termism and Long-Termism
by Charles Nathan
Charles Nathan is partner and head of the Corporate Governance Practice at RLM Finsbury. This post responds to a post by Robert C. Pozen, titled Institutional Investors and Corporate Short-Termism. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).
The debate about whether U.S. public companies are afflicted by short-termism rather than more beneficial longer-term behavior and, if so, its effect on our economy is ubiquitous. It occupies increasing attention in corporate board rooms, executive suites and investment management businesses from the smallest to the largest. The debate is a commonplace topic in the legal and academic worlds as well as the financial press, and it is rapidly spreading to more general news outlets and the political scene-to the point where at least one Presidential candidate has made the debate a focal point of her tax reform platform.
A complicating factor in the debate is that there is no consensus about what short-term and long-term refer to. Is or should the debate be about:
- investor behavior (e.g., short-term traders versus long-term holders),
- investor objectives (e.g., increases in portfolio value in the short-term at the cost of foregoing better long-term fund performance),
- corporate behavior (e.g., focusing on short-term profitability to meet or better quarterly performance goals to the detriment of greater long-term profitability), or
- corporate objectives and strategy (e.g., engaging in financial engineering to generate short-term value creation, thereby precluding long-term investment in building the business through research and development, improved plants and production methods or product and market expansion)?
In this post we offer some observations on the debate, as well as its rhetoric and assumptions, in an effort to bring some clarity to the topic, identify the important issues and resolve at least some of them. Observations-on-short-termism-and-long-termism
Four Critical Fallacies
The duration of any investor's holding period in a company's stock is simply not relevant to issues involving corporate value creation. In today’s equity markets there is virtually no end of investment styles and goals which vary greatly on many levels, including projected or actual duration of discrete portfolio positions.
- Index funds and their EFT equivalents, by hypothesis, must remain invested (directly or synthetically) in every equity within their index, adding a new stock to portfolio only when its issuer is added to the index, and eliminating a stock from portfolio only when the company is dropped from the index. These types of quantitative funds are the epitome of long-term investors-they always own the index. But the fact that they are long-term investors says little about their behavior as voting shareholders. In fact, index investors are often among the most avid supporters of short-term corporate initiatives.
- Other quantitative investors, such as high frequency and other program traders, may trade in and out of a specific security multiple times in one day or even in an hour or minutes, creating a new epitome of short-term trading. But it is hard to see how such avowedly short-term traders have a meaningful effect on corporate behavior and strategy. They are involved in corporate governance only by the accident of holding a stock at the close of business on a record date for a shareholder meeting. Whether in that case they do vote and, if so, for or against management is an idiosyncratic response. The extremely short duration of their holding periods seems relevant only to trading volumes and portfolio turn-over statistics (as well, of course, their asserted potential to distort market pricing).
- Actively managed portfolios, unlike index funds, partake of both long-term investing behavior (e.g., establishing and maintaining a position in a desired stock often for years) and short-term buying and selling (e.g., to adjust the size of a portfolio position in reaction to one or more macro and micro factors affecting the portfolio company). Their apparently short-term trading decisions may be based on the long-term fundamentals of the issuer or on shorter-term considerations, such as a weak quarterly performance. But their short-term portfolio "balancing" rarely affects the long-term inclusion of a company's stock in the investor's portfolio. Moreover, while their voting on matters affecting corporate governance and strategy may be more informed than that of quantitative investors, it hardly falls into a specific pattern of supporting or opposing management initiatives and strategies based on the projected duration of the program.
- Activist investors are often characterized as short-term investors. However, it is quite clear that their holding period for any given portfolio equity may range from days to years, thus belying a facile characterization of their trading behavior.
- Another problem with characterizing investor holding periods as short or long-term is deciding at what point in time a holding period is to be measured, as well as differentiating between entrances and exits from a stock position and adjustments to a portfolio position in light of the investor's investment style and objectives. For example, if a hedge fund has a large position in a company's stock for three years and decides to liquidate the position in its entirety based on a discrete event, is the fund’s behavior short-term (the time between the event and the sale of the position) or long-term (the time between creation and elimination of the position)? Similarly if an investor buys into a stock for the first time and its behavior is viewed 30 days later, is it acting in the short or long-term? What if it intends to maintain the position indefinitely but changes its mind three months later?
- Finally, and most telling, there is simply no connection between an investor's holding period for a given stock and the behavior of the issuer. Of course, issuers may wish to build a base of long-term holders to reduce volatility in their stock price and to facilitate investor relations and relationships. But their underlying concern is to create more buyers and fewer sellers of their stock. Companies are concerned principally with buying and selling imbalances in the market which cause increases or decreases in the price of their stock. It is not the duration of the buyers' and sellers' holding periods that matters to the issuer-it is the act of buying or selling that matters, without regard to the holding period objectives or practices of the investor.
A second fallacy is that the duration of a prototypical investment implied by a particular investment style or objective of a shareholder is relevant to the corporate value creation discussion. It is clear that some investors, albeit for different reasons (contrast an index investor when a new stock is added to an index and a fundamental value investor, like Warren Buffet, who decides to make an investment in a new portfolio company), establish positions in a stock as part of a consciously long-term investment strategy. In contrast, of course, are consciously short-term traders (think day traders and high frequency traders, whose investment strategy in the extreme case may be to buy and sell on the basis of mere basis point changes in the price of a stock). The reality is that some investors are or want to be long-term holders, some are wholly short-term in their investment style and are more than willing to own a stock for minutes or seconds, and many are simply agnostic about the duration of their holding period for a particular equity. Projected and actual holding periods under the multitude of investment strategies being practiced vary all over the short-term/long-term continuum. But that fact says nothing about corporate behavior. As noted above, companies are insensitive to investment styles, but highly sensitive to the balance of buyers and sellers in the market.
A third fallacy is that the duration of a company's business initiative (whether involving capital allocation, entrance or departure from a line of business, investment or dis-investment in R&D, plants or products, diversification, concentration or any other strategic or tactical program) has an implicit connection to value creation. Too often, the term "short-term" is applied to a business tactic or strategy as a pejorative, as if a long-term initiative inherently creates more value than a short-term program. This is patently not true. The correct question in every case is not how short or long the duration of the initiative, but rather whether it will generate more net present value than the available alternatives. The answer to this question will obviously vary from initiative to initiative-it will not be the same for every company, even those deemed most comparable-nor will it be the same for a company when addressed at different points in time when circumstances differ.
The fourth fallacy in the short-term—long-term debate is that, given every company's finite resources, choosing a corporate strategy that can be implemented in a relatively short-time period (often a type of so-called "financial engineering", such as a major stock buyback, a divestiture or spin-off of a business or a sale of the entire company) prejudices, if it does not preclude, longer-term more beneficial strategies (such as greater investment in R&D, upgrading productivity of plants and equipment or acquisitions). This formulation of the debate associates activist investors with short-term strategies at the cost to the company and its other shareholders of greater long-term value creation. But this formulation of the debate simply does not make sense. Activist funds are in business to maximize value creation for their investors (and for their principals who get rich on their carry and their investment in their own funds). Why would any rational activist investor consciously forgo the higher net present value of a long-term company business initiative in favor of the investor's lower short-term value creating idea? Activist fund managers don't get paid for ego trips; they get paid for maximizing returns. The same, of course, is true for all actively managed institutional investors. Even index and other quantitative investors should opt for the highest net present value creator if they have the capability of understanding and evaluating the competing proposals. In theory, only short sellers should oppose the highest net present value added program regardless of its duration.
Properly Framed the Debate Should Be about Game Plans Not Time Duration
So then, what is the long-term, short-term debate all about? Stripped of the rhetoric and emotional biases of managements and boards, on the one hand, and investors, on the other hand, the debate is not about duration of implementation, but rather about evaluating competing agendas that frequently have different time horizons. While in theory net present value should be the arbiter of the debate, in practice it obviously is challenging to determine the net present value of a given corporate business initiative, and reasonable people can and will disagree about its calculation. Hence, activist campaigns are typically characterized by competing investor presentations, through which management and the activist each tries to demonstrate the value creation superiority of its business plan.
But if the debate does boil down to nothing more than investors' choosing between two competing strategies for a company, why all of the heat and passion? Our view is that the source of much of the emotion is that boards, managements and their proponents believe that the shareholder vote (actual or projected) that ultimately resolves the conflict between an activist's game plan and the board's is unfairly stacked against the board.
Because most activist investor business plans focus on shorter-term solutions than those of management, it is convenient to characterize them as "short-term", and there is no doubt that today "short-term" does have pejorative connotations. Viewed in this light, one would think that many institutional investors would be emotionally biased against activist investors and in favor of management's typically longer-term program, not the contrary as believed by most managements and boards.
Are Institutional Investors Biased in Favor of Activists and Against Boards?
There is at least one objective reason why investors might, in general, favor activist campaigns focusing on shorter-term initiatives. After all, the longer the duration of implementation of a business strategy, the greater the risk of miscalculation of its net present value creation. While projections are inherently uncertain, it is clear that the uncertainty factor increases over their duration. Moreover, execution risk also rises as the time frame for implementation lengthens. To this extent, being biased in favor of a shorter-term program instead of a longer-term one makes sense. Passage of time is not a friend to confidence in projected outcomes. But this consideration, standing alone, does not seem sufficient to explain the concerns of management and boards with the impartiality of investors.
Why Many Institutional Investors Favor Activists
Over the past thirty years, institutional investors' relationship with portfolio companies has changed drastically. Until the mid-1980s, the paradigm was simple. At actively managed funds portfolio managers and buy-side analysts were the sole point of contact with management; directors were simply not involved in the dialog. And, of course, quantitative investors had no reason to, and did not, have dialogs with management.
Beginning in the mid-1980s, this paradigm began to change as institutions increasingly felt compelled to vote, independently of management's recommendations, on every ballot proposal for every shareholder meeting for every portfolio company. This represented a major change in policy from what many characterized as the "Wall Street Walk"-a policy of institutional investors to vote with management on all matters, and at least for all actively managed funds to sell a company's stock when the institution lost faith in management. The demise of the Wall Street Walk resulted in a sea change in the way institutional investors dealt with the multitude of proxy votes they faced each year.
In response to the pressure to vote thousands of times each proxy season, institutional investors resorted to two or three complementary strategies.
- First, almost all institutions created an internal team (separate from the portfolio management function at actively managed funds) specifically to manage the portfolio company share voting process. These teams, while initially small, have grown over the years as shareholder voting decisions and fund complexes have grown in number and complexity. This is particularly the case at quantitative firms where the voting decisions cannot be informed, let alone made, by the portfolio management function which simply does not exist.
- Second, many institutional investors outsourced voting recommendations, and quite often voting decisions, to proxy advisory firms, today principally ISS and Glass Lewis.
- Finally, the sheer number of voting decisions effectively demanded adoption of comprehensive voting policies by both investors and proxy advisory firms. The benefit of one-size-fits-all proxy voting policies, of course, is their ability to cope with thousands of voting decisions while requiring only a relatively small group of employees for implementation. In contrast, a far larger staff would be needed for a proxy advisor or institutional investor to deal with each ballot proposal on an individual case-by-case basis in the context of the particular circumstances at each portfolio company. The institutional investment community was simply not willing to commit the financial resources that would be required to support a case-by-case approach to share voting.
More important to the issue of bias against management and boards, the dominant philosophy driving the creation and implementation of ISS' and institutional investors' voting policies has consistently been aligned with a populist/progressive skepticism about the motivations and behavior of corporations and their managements. This was true in the late 1980s when ISS and some pioneering public pension funds began to push back against the Wall Street Walk, and it remains true today, well after the Walk vanished into the pages of financial history as the prevailing voting paradigm. The negative populist/progressive view of corporate management, moreover, has gained additional credibility from a number of events and the popular narrative surrounding them.
- First, the resistance of boards and management to the takeover wave of the 1980s (in particular, the widespread adoption of Poison Pills throughout corporate America) was quickly labeled as systemic "entrenchment" by many investors and not-infrequently by courts. The opposition to takeover defense and management entrenchment further benefitted from the wide-spread support of academics, both Chicago School free market enthusiasts and shareholder empowerment advocates. Thought leaders at ISS and a number of investors (principally state and local pension funds and union pension funds) soon converted their philosophical distrust of corporate management into a campaign to critically examine and improve corporate governance at U.S. companies, often starting with redemption of Poison Pills. By the early 1990s the die was cast. Corporate governance reform became the dominant policy not only of the proxy advisors but also of the managers of the proxy voting process at state, local and union pension funds and an ever increasing number of for-profit institutional investors.
- The negative view of corporate management and boards gained additional credence during the wave of corporate scandals in the early years of this Century which preceded and was responsible for the enactment of the Sarbanes-Oxley Act. Rightly or wrongly, the sins of the relatively few were attributed far more broadly to corporate America as a whole by a large swath of the public, the press and the political establishment, making it even more important in the eyes of the corporate governance community to rein in bad managerial behavior by major reforms in corporate governance.
- The suspicion and, too often distrust, of corporate management was yet again reinforced by the virtually universal attribution of the financial crisis of 2007-2009 to bad (if not venal) managements and boards. The fact that, at most, only a portion of the financial services industry (principally, money center banks and major investment banks) were connected to the events that gave rise to the crisis seemed not to matter to most of America. The prevailing narrative quickly became that the crisis was the fault of bad governance at public U.S. companies.
The end result, fairly or not, is that the corporate governance movement is not a natural friend of management and boards. It was born and bred from a philosophy of distrust and opposition to them. Given its provenance and history, it is hardly surprising that the corporate governance community seems (and probably is) biased against management and in favor of activist investors, particularly when the activists embrace corporate governance reform as part of their campaigns against management.
Can the Bias of Corporate Governance Activists Be Overcome?
This, of course, is the question du jour for management and boards today, whether or not their company is faced with an actual or imminent activist campaign. It is the ultimate rationale for the growing importance of the concept of "engagement" that is now offered as a universal component of every activist defense playbook. Engagement, quite simply, is the idea that senior management and, more importantly, directors must get to know the corporate governance staffs at their major investors in order to establish bonds of confidence and trust in the strategy of company and its senior leadership.
Whether a successful engagement campaign will prove sufficient to overcome the negative bias of the corporate governance community in the context of an activist campaign is the sixty-four dollar question. But there do not seem to be any other remedies available to a company in today's world.
What About Actively Managed Institutional Funds?
- A variety of defenders of corporate America against activist investing have and continue to campaign against activism and the institutional investor bias in favor of activists through a variety of media utilizing a number of arguments-for example, asserting that activists don't create lasting corporate value enhancements. However, this type of argumentation has not worked to date, and there is nothing on the horizon to suggest that it will be more successful in the future.
- It is not plausible to think that the corporate governance community's strangle hold on proxy voting at the vast majority of institutional investors will go away. While it is possible that some portfolio managers may gain a greater voice in voting decisions on activist campaigns, this will only be true for actively managed funds in a world where assets seem to be flowing toward quantitative investment strategies.
- Nor is it any more realistic to think that the corporate governance world, the academic community or the press will soon alter their generally negative views of corporate management's motives and behavior, which is a critical underlying component of the prevailing pro-activist bias on the part of the "owners" of the proxy machinery.
- Another possible solution could be a relative implosion in the credibility of activist investor game plans brought about by a regression to the mean as the growing size of the activist investor asset class overwhelms the number of available deserving corporate targets. Even if this were to occur, it will not happen quickly, and in any event some number of the more competent activists will continue to post out-sized returns, even though more mundane members of the pack falter or even fail.
- Another answer, in theory, could be some form of government intervention. For example, some advocate imposing fiduciary standards on the world of public pension fund administrators, as well as on the proxy advisory industry. This, however, is an unlikely antidote. After all, all the other participants in the institutional investor community have long been subject to strict fiduciary standards under both ERISA and the 1940 Investment Company and Investment Advisors Acts. Others have suggested deterring or foreclosing so-called short-termism through changes in capital gains taxation and/or capital gains treatment for carried interest. However, adoption of these proposals are unlikely to bring activism to a halt. They might alter activist investor holding periods or the economics for the principals at activist investors, but such changes in the tax law are unlikely to end the appeal of activist investing so long as activists continue to produce above-market equity returns for their investors.
But, one might ask, what about actively managed funds. Surely, portfolio managers and buy-side analysts should understand the concept that net present value creation does not demand selection of shorter-term corporate strategies at the cost of greater value creating long-term programs. While fund complexes housing actively managed funds may have corporate governance specialists manning the proxy voting function, don't (or shouldn't) portfolio managers have significant influence, or better yet control, of proxy votes on economic matters, such as an activist investor campaign.
Indeed, portfolio managers usually do count in proxy voting decisions at least on economic matters. However, the expectation that portfolio will automatically support greater net value creation, even if it requires more time for realization, does not take into account the reality of asset-gathering by institutional investors-which, after all, is the lifeblood of the asset management industry. For better or worse, asset gathering today is irrevocably tethered to quarterly performance. The vast majority of investors in actively managed portfolios (be they individuals with IRAs or 401K accounts or fiduciaries for public and private pension funds, foundations and charities) base their asset allocations on their funds' quarterly performance measured against the relevant benchmark indices. Put simply, an active investment manager to be successful in the current environment must pay heed to its performance on a quarterly basis. This, in turn, explains why portfolio managers may be biased in favor shorter-term initiatives than longer-term ones, even if the latter are likely to produce higher net value in the long-term. The search for "alpha" by active asset managers is not just constant, but because of the pressure of being measured quarterly, immediate.
Ironically, as a result, actively managed funds are often more likely to support short-term value creation programs than quantitative investors, many of whom do have a longer-term perspective. It was not simply a coincidence that DuPont won its recent proxy contest with Trian by virtue of the support of a number of the largest quantitative investors in the country. A company has few weapons to combat the bias of active portfolio managers favoring shorter-term value creation programs simply on a durational basis. Best among them is engagement with the portfolio management function, as well as the corporate governance function, in order to establish sufficient trust and confidence in management and the board to overcome that bias.
For better or worse, engagement is management's and directors' best, and perhaps only, hope to obtain a relatively unbiased hearing from the proxy voting decision makers in the context of an activist campaign. At the very least, it is something all companies should be seriously examining today, if they have not already embraced the policy.
The difficulty, however, is that for all but the larger-cap companies getting a hearing at their key institutional investors is easier said than done because institutional investors rarely have the bandwidth to meaningfully engage with all of their portfolio companies. Ironically, this problem is most apparent at the larger institutions whose portfolios encompass thousands of companies. Smaller investors which focus on relatively concentrated portfolios may prove easier targets for productive engagement.
The bottom line, unfortunately, is that for the foreseeable future corporate America will have to continue to live with an investor community that is inherently biased in favor of activism. At best, the larger companies and some of the more fortunate mid-cap and smaller companies may be able to ameliorate this bias by engaging productively with their key investors. The vast majority may just have to accept their potential victimhood.
October 12, 2015
Bank Regulation as Vestigial Corporate Regulation
by Robert C. Hockett and Saule T. Omarova
Although it seems seldom if ever remarked, there is a rich set of parallels between modern U.S. bank regulation, on the one hand, and what used to be garden variety American corporation law, on the other hand. Just as bank charters are matters not of right but of conditional privilege even today, so were all corporate charters not long ago. Just as chartered banks are authorized to engage only in specifically enumerated, carefully limited activities even today, so were all corporations restricted not long ago. And just as banks are subject to strict capital regulation even today, so were all corporations not long ago. In short, the law of commercial banking today is starkly reminiscent of the law of the corporate form more generally yesterday. The former seems almost a vestige of the latter.
In a new article, we suggest that the parallels between contemporary banking regulation and past corporate regulation are not merely curious accidents, but a reflection of certain foundational dynamics embedded in the corporate form itself. Tracing the history of the incorporated American firm, we show that the business corporation is, and always has been, an inherently hybrid public-private entity that cannot exist without, and is fundamentally defined by, specific privileges conferred by the state. These constitutive corporate privileges – the interlocking and mutually reinforcing attributes of corporate "personality" separate from constituent personalities, perpetual existence, and asset segregation (which includes arguably the best known corporate privilege, limited shareholder liability) – are now taken for granted almost as "natural rights" in private markets. Before the late 19th – early 20th century, however, all of the corporate privileges were commonly recognized as truly extraordinary – i.e., not "freely" available to just anyone as a matter of right – because they represented radical departures from fundamental common law principles of individual personality and accountability. Originally, these corporate privileges were very clearly characterized, in statutes and in judicial opinions, as public benefits conditionally conferred upon private actors when, and only when, such conferral served some public purpose. Those were purposes that ceased to be operative when firms acted ultra vires – that is, outside their state-delimited authority – and so corporate privileges could be forfeited by violating the conditions on which they were granted.
Importantly, the conditions that historically attended corporate privileges always sounded in some socially cognizable public benefit. Initially, the benefits in question were charitable or infrastructural in character. Early American corporations were chartered to assist the poor or the sick, to build public libraries, or to construct turnpikes, wharves, bridges, or canals. In time, the list of socially cognizable public benefits widened out to include the private capitalization of heavy industry itself, as the nation sought to industrialize under conditions of capital scarcity and still-nascent state and federal fiscal structures with no central bank.
At least two critical observations follow from reminding ourselves of this early American corporate history.
The first observation has to do with the nature of the corporate form. In terms of its genesis and function, the American business corporation is not a "natural" market phenomenon but an extraordinary vehicle of public policy: an institutionalized – and conditional – outsourcing to private parties of certain essentially public powers and functions. In this sense, it is at bottom a public-private "franchise" arrangement, in which the public is franchisor and private incorporators and shareholders, collectively, are franchisees.
The second observation has to do with the drivers and implications of the evolution of American corporate law since the late 19th-early 20th century. During this period, the strings attached to corporate privilege loosened, the requirement that private corporations produce public benefits became easier to meet and then effectively disappeared, and the original ultra vires doctrine gradually lost any real meaning. We argue that the key reasons for this "privatization" of the corporate form were, once again, rooted in the perceived need to encourage accumulation of private capital on a scale sufficient to finance nation-wide industrial growth. In this sense, the proliferation of general – or, more accurately, "ultra-general" – corporation statutes, which made corporate privileges "freely" available to all who sought them, was a public policy of promoting industrialization under conditions of scarce public and private capital.
Unfortunately, however, with this policy's success came a gradually deepening amnesia concerning the fundamentally franchise-like character of the corporate form of enterprise organization. Today, the business corporation is widely and uncritically assumed to be a purely private association of private profit-seeking individuals, and some of the bitterest battles in corporate law and theory are fought over the question of whether corporations have, or should have, any duties or responsibilities beyond enrichment of their shareholders – a question that would have been regarded with incredulity in the not so distant past.
The exception to this trajectory is the incorporated bank. Here, the franchise-like character of the firms in question never fully receded from public consciousness, presumably thanks both to the obvious public utility supplied by banks in their credit-extending and associated money-creating capacities, and to the obvious public disutility occasioned by regular bank-runs and bank failures. As a result, U.S. bank regulation continued to look fundamentally similar to the original, pre-20th century, American regulation of corporations in general. Banking law became a "special" case, a single most salient vestige of the original corporate settlement.
In our article, we query whether it might be time to bridge the gulf between banking and general corporate regulatory regimes – not by making access to bank charters "free and easy," but by making access to corporate privileges once again expressly conditional on the delivery of public benefits. Even as a humble thought experiment, this suggestion might sound like heresy to many scholars and practitioners of corporate law. Yet, if today's regime of "free incorporation" is a result of a specific era in the country's history, why not reconsider its continuing utility in the light of today's very different economic and political imperatives? Many of the circumstances that warranted making the corporate form easily available to skittish private investors in the late 19th century no longer obtain today. Our nation is heavily industrialized, even "postindustrial," and capital is anything but scarce – indeed, it now tends toward overabundance, as frequent asset price bubbles and attendant financial dysfunction make clear. State and federal government structures, for their part, are now well developed and endowed with effective fiscal – i.e., taxing, borrowing, and spending – powers. And, of course, the nation now has a fully functional and usually effective central bank – the Federal Reserve System – well able to influence the flow of financial capital and public credit to where they are needed. Against this backdrop, it is natural to wonder whether regulation of the corporate form might reasonably be expected to move at least part way back toward something more like what it used to look like – and what bank regulation continues to look like.
The final part of our article takes up this suggestion and tentatively outlines some modest possibilities where reintroducing at least some public interest-driven conditions into state grants of corporate privilege are concerned. Public grants of corporate powers always occasion social costs – at least as much now as in the past. One hundred years ago, the benefits brought by such grants arguably outweighed those costs. Today that is less clear, and the time would accordingly seem ripe for an open-minded reexamination of the public-private imbalance at work in what remains the inherently public-private corporate franchise. This need not mean wholesale return to the past; it can mean simply selective retrieval of that which looks best for the future.
The preceding post comes to us from Robert C. Hockett, the Edward Cornell Professor of Law at Cornell University Law School, and Saule Omarova, Professor of Law at Cornell University Law School. The post is based on their recent article, which is entitled "‘Special,’ Vestigial, or Visionary? What Bank Regulation Tells Us About the Corporation – And Vice Versa" and available here.
October 12, 2015
Simpson Thacher discusses NYSE Amending its Material News Policy and Expanding its Authority to Halt Trading
by Yafit Cohn
Effective September 28, 2015, the New York Stock Exchange ("NYSE" or "the Exchange") amended Section 202.06 of its Listed Company Manual (the "Manual") to:
- expand the pre-market hours during which NYSE-listed companies must notify the Exchange prior to disseminating "material news";
- expand the timeframe and circumstances in which the NYSE has the authority to halt trading in a listed company’s security;
- provide guidance with respect to the release of material news after the close of trading on the Exchange; and
- update the methods by which companies should release material news.
Change to the NYSE's Pre-Market Material News Policy
Previously, Section 202.06 of the Manual required listed companies to notify the NYSE "at least ten minutes in advance of releasing material news if such release [would] take place shortly before the opening of trading on the Exchange or during Exchange market hours." The amended policy mandates that companies comply with this "Material News Policy" from 7:00 a.m. to 4:00 p.m. Eastern Time. Accordingly, companies listed on the NYSE must call the NYSE's Market Watch Group at (212) 656-5414 or (877) 699-2578 at least ten minutes prior to disseminating "material news" any time between 7:00 a.m. Eastern Time and the end of the NYSE trading session (typically 4:00 p.m. Eastern Time) and must "provide a copy of any written form of that announcement at the same time via email to email@example.com."
According to the NYSE, releasing material news between 7:00 a.m. and the start of the NYSE's trading day at 9:30 a.m., which is common among listed companies, "has the potential to cause volatility in both price and volume during pre-market trading that occurs on other market centers as well as once trading opens on the Exchange."The expansion of the NYSE's Material News Policy is intended "to facilitate an orderly opening and ensure thorough dissemination of material news."
Expansion of the NYSE's Authority to Halt Trading
As noted by the NYSE, "when a listed company releases material news during the course of the trading day, the Exchange will typically halt trading temporarily to ensure full dissemination of the news." Under the amended Section 202.06, the NYSE may also implement a regulatory trading halt:
- between 7:00 a.m. and the opening of trading on the NYSE where a company informed the NYSE of its intent to release material news and requested that the NYSE halt trading pending the dissemination of the announcement;
- if such a halt is necessary to request information from a listed company with respect to (a) material news, (b) the company's compliance with the NYSE's listing requirements, or (c) "any other information which is necessary to protect investors and the public interest"; and
- when a security listed on the NYSE (or a security underlying an American Depositary Receipt listed on the NYSE) is also listed on another national or foreign securities exchange and such other exchange halts trading in the security for regulatory reasons.
With regard to pre-market trading halts, the NYSE explains that although trading on the NYSE does not begin until 9:30 a.m. Eastern Time, trading (including trading in NYSE-listed securities) begins on Nasdaq and other national securities exchanges at 4:00 a.m.; a pre-market trading halt by the NYSE would halt trading in the security on other exchanges, as well, until the NYSE allows trading to resume.
While the NYSE will implement pre-market trading halts only at the request of the company, "the decision to halt trading during the NYE trading session will continue to be made by Exchange staff and will not be at the discretion of the listed company."
Guidance Regarding Material News Released After Market Close
The NYSE also added advisory text to Section 202.06 of the Manual, requesting (but not mandating) that listed companies intending to release material news after the close of trading on the NYSE wait until the earlier of:
- the publication of the official closing price of the company's security on the NYSE; or
- fifteen minutes after the NYSE's scheduled closing time (which is typically 4:00 p.m. Eastern Time, except on certain days when the market closes at 1:00 p.m. Eastern Time).
The NYSE reasons that because it takes several minutes following the market's scheduled closing time for the security's Designated Market Maker ("DMM") to manually close the order book for that security, the release of material news immediately after market close can cause significant price movement on other markets; this, in turn, may lead to a discrepancy between the trading price on the other exchanges and the NYSE closing price at which the DMM is executing trades, potentially causing investor confusion.
Updates to Methods by Which Companies Should Release Material News
Even prior to the current amendments, Section 202.06 required companies to release material news via the fastest available means. The advisory text to Section 202.06, which listed the optimal methods for release of material news to ensure its immediate and widespread dissemination, previously included release of the news by telephone, facsimile or hand delivery. Recognizing that these methods are obsolete, the NYSE amended the advisory text to provide that listed companies should typically release material news through (a) a Form 8-K or other filing with the Securities and Exchange Commission, or (b) a press release to "the major news wire services, including, at a minimum, Dow Jones & Company, Inc., Reuters Economic Services and Bloomberg Business News." The NYSE believes that "distribution by either of these methods is consistent with current disclosure practices and ensures adequate dissemination."
Implications of the Amendments
The most significant of the NYSE's recent changes is the requirement that listed companies provide advance notice to the Exchange of "material news" they intend to disseminate not only during trading hours, but between 7:00 a.m. and 9:30 a.m., as well. As a practical matter, companies that are unable to call the NYSE during those hours, such as companies based on the west coast, may call the Market Watch desk the evening before their expected release of "material" information.
Our understanding is that, in the context of this amended policy, the NYSE uses the term "material" to mean information that is likely to cause volatility in the company's stock price. It is our understanding that the NYSE does not require advance notice of an earnings release that is in line with market expectations. Accordingly, while some companies may decide to notify the NYSE prior to issuing any earnings release between 7:00 a.m. and 9:30 a.m. Eastern Time, others will only notify the NYSE before disseminating an earnings release that departs from market expectations. We expect that the NYSE will defer to listed companies' own materiality assessments; that said, listed companies with questions regarding the materiality of their anticipated release may call the NYSE's Market Watch desk for guidance.
The change in the NYSE's Material News Policy may drive some companies to issue their earnings releases between 4:15 p.m. and 7:00 a.m. Eastern Time, so as to obviate the need to engage in a materiality analysis each quarter. We believe that the NYSE's amended policy is unlikely to cause most companies to change the time of their earnings call. Companies that hold their earnings calls between 7:00 a.m. and market close should consider whether they expect to disclose any material information on the call that is not also included in the earnings release. Companies that expect to release material information for the first time on an earnings call to take place between 7:00 a.m. and market close must call the NYSE's Market Watch desk pursuant to the amended Material News Policy.
 See "Self-Regulatory Organizations; New York Stock Exchange LLC; Notice of Filing and Immediate Effectiveness of Proposed Rule Change Amending Section 202.06 of the NYSE Listed Company Manual," Release No. 34-75809; File No. SR-NYSE-2015-38 (Sept. 2, 2015) (hereinafter "Release").
 E-mail from NYSE Regulation, Inc. to NYSE Listed Company Executives regarding Amendments to the NYSE's Timely Alert Policy (Sept. 22, 2015) (hereinafter "E-mail").
 Release at 3.
 E-mail, supra note 2.
 Release at 7.
The preceding post is based on a memorandum published by Simpson Thacher on October 2, 2015, which is available here.
October 12, 2015
Conflict Minerals: Would the FBI Challenge You?
by Broc Romanek
Here’s a note from Lawrence Heim of Elm Sustainability Partners:
Not ones to cry wolf, we had a bit of a shock at the ThomsonReuters Governance and Risk Seminar we participated in this morning. One of the sessions included a representative from the FBI's International Corruption Unit. Just to be clear, this is the US Federal Bureau of Investigation. The topic was current enforcement of the Federal Corrupt Practices Act ("FCPA"). We asked if matters such as conflict minerals, human rights abuses and human trafficking were on their radar screen, expecting a blank stare or an overly-general "non-answer answer." Instead, a direct – and rather unnerving answer – was given. To summarize:
– The FBI has already identified linkages between known instances of FCPA violations/concerns (corruption, doing business in "low integrity countries") and human trafficking/human rights abuses. Human rights matters are of current interest to them.
– FBI's FCPA enforcement resources have grown dramatically in recent years.
– FBI has unlimited global reach for FCPA compliance enforcement.
– Conflict minerals experts would do well to have at least a basic understanding of FCPA.
We don't know what that all means just yet, but we do think it adds another dimension of risk to the SEC filings, compliance status and supplier relationships.
Lawrence will be among the speakers of our upcoming webcast: "Conflict Minerals: Tackling Your Next Form SD"...
Pay Ratio: Another House Bill Seeks to Repeal>
Here's a blog by Cooley’s Cydney Posner:
On September 30, the House Financial Services Committee approved, by a vote of 32 to 25, H.R. 414, the Burdensome Data Collection Act, following committee consideration and a mark-up session. Given that the bill is only one paragraph long, there was not too much to mark up. The bill will now go to a full vote of the House. The bill would repeal Section 953(b) of Dodd-Frank, the pay-ratio provision, and make any regulations issued pursuant to it of no force or effect.
Any of this sound familiar? It should. The very same bill was introduced in 2011, but went nowhere. (See this news brief.) With President Obama still holding the veto pen and a substantial constituency supporting the pay-ratio provision, a different result seems unlikely this time.
Europe: Director Duties & Liabilities
This 31-page "Guide to Directors' Duties & Liabilities" was released last week by the European Confederation of Directors' Associations. See the heading entitled "Comply-or-explain needs more explanation." I guess that caption is tongue-in-cheek...
– Broc Romanek
October 12, 2015
Director Independence and Reversing Beam v. Stewart (Part 2)
by J Robert Brown Jr.
The court in Sanchez reversed because of the failure of the Chancery Court to consider allegations about the lack of director independence collectively rather than in isolation. See Delaware County Employees v. Sanchez, CA 1932 (Del. Sept. 24, 2015). In doing so, however, the Court examined the allegations that the director at issue was not independent because of a longstanding personal relationship with the chair of the board.
The Court had to deal with the analysis in Beam v. Stewart. In that case, the plaintiff had provided some information from public sources suggesting a personal relationship between a director and Martha Stewart. The Court was dismissive of the allegations, essentially characterizing them as matters of "structural bias."
In Sanchez, the Court described the allegations in Beam as "thin."
- Here, the plaintiffs did not plead the kind of thin social-circle friendship, for want of a better way to put it, which was at issue in Beam. In that case, we held that allegations that directors "moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as friends,"...are insufficient, without more, to rebut the presumption of independence."
Of course, in Beam, there was also "a Fortune magazine article focusing on the close personal relationships" among the directors, so the allegations were not entirely about weddings or social circles.
What made the allegations in Sanchez not thin? Duration, apparently.
- When, as here, a plaintiff has pled that a director has been close friends with an interested party for a half century, the plaintiff has pled facts quite different from those at issue in Beam. Close friendships of that duration are likely considered precious by many people, and are rare. People drift apart for many reasons, and when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.
In other words, the same kind of factors at issue in Beam might be enough if taking place over a long enough time period. The analysis adopted by the Court in Sanchez is useful because it creates a relatively objective factor for asserting a disqualifying friendship. But in truth, the length of the friendship is relevant because it suggests something about the nature of the current relationship. Thus, the focus should be on the current relationship and allegations that success a closeness should be sufficient to get past reasonable doubt at the pleading stage, even without allegations of a five decade duration.
October 11, 2015
Materiality as Pleading Obstacle
by Brad Karp
Brad S. Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.
Claims brought under the Securities Act of 1933 (the "Act") are typically challenging for defendants to dismiss. Some defendants may have affirmative defenses, but most of the Act's provisions impose strict liability for alleged misstatements-meaning that a plaintiff need not plead scienter-and claims brought under the Act are subject to the relatively low pleading standard imposed by Federal Rule of Civil Procedure 8. Further, although plaintiffs suing under the Act must allege facts sufficient to show that the purported misstatements were material, courts are generally reluctant to dismiss for failure to plead this element because materiality is an inherently fact-bound inquiry.
Notwithstanding these principles, on September 29, 2015, the United States District Court for the Southern District of New York (Oetken, J.) dismissed a putative class action brought under the Act on the ground that the complaint's materiality allegations failed as a matter of law. The opinion provides valuable insights on how to defeat other Act claims on similar grounds. 
Plaintiff, an investor in building products company Ply Gem Holdings, Inc. ("the Company"), sued the Company and certain of its officers, directors, and underwriters, alleging that material information was omitted from or misstated in the registration statement issued before the Company's initial public offering in May 2013. Charging violations of Sections 11, 12(a)(2) and 15 of the Act, the complaint alleged that the Company’s registration statement misstated or omitted information about a series of agreements it had with a large customer. According to the complaint, the Company was required to disclose this information under Items 303 and 503(c) of SEC Regulation S-K.  Defendants challenged the complaint as legally deficient, including because the pleading failed to adequately allege that any of the purported misstatements were material.
The District Court's Decision Granting Defendants’ Motion
Situating a Cost within a Company's Finances. The Court acknowledged that "materiality is an inherently fact-specific finding” and that dismissals based on lack of materiality are proper only where the alleged misstatements or omissions are "so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance." (Op. at 8 (quotation marks omitted).) However, the Court held that for a plaintiff to satisfy its burden to plead materiality, a complaint must contain enough facts to "meaningfully situat[e]" the cost associated with the alleged misstatement "in the context of the Company's finances." (Id. at 10.) Here, the complaint alleged that Ply Gem's registration statement failed to disclose that the agreement with its large customer required the Company to purchase so many windows that the Company needed "approximately five to six tractor trailer loads of windows per day, seven days per week" to carry the windows. (Id. at 9.) In their motion, Defendants pointed out that without additional factual context-such as the value of the windows purchased and the costs of transportation and disposal-the complaint offered no basis upon which to assess whether the costs imposed by the buyback agreement were material. (Id.) The Court agreed, holding that assessing materiality based on Plaintiff's allegations was "like trying to guess the number of jellybeans in a jar after being told only that the jar is 'big.'" (Id.)
The Court followed similar logic in rejecting other parts of the complaint. Plaintiff alleged, for example, that at a particular plant the Company "was forced to buy window panes...at a steep premium" and "produced a large volume of defective windows." The Court held that again the complaint failed to situate these issues within the Company's finances, concluding that "[a]llegations of 'steep' costs and 'large' volumes offer little basis upon which to assess the materiality of the alleged omission." (Id. at 13.) Likewise, the Court held that the complaint's assertion that "some of" the Company's increase in low-margin sales was due to its new supply was insufficient to plausibly allege that the purported omission was likely to be material.
Quantitative Guidepost for Materiality. The Court also recognized that SEC Staff Accounting Bulletin ("SAB") No. 99 provides relevant guidance in assessing materiality allegations. SAB No. 99, as the Court noted, provides that "[t]he use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that [the] particular item [at issue] is unlikely to be material." (Id. at 8.) The Court concluded that, in this case, the issues purportedly omitted from or misstated in the registration statement "f[ell] short of materiality" when "measured against the 5% threshold." Further, Plaintiff failed to cite "any qualitative factors that it believes support a finding of materiality." (Id. at 10-12.) Those failures figured heavily in the Court’s analysis.
Relevant Metric for Materiality.The Court also held that, even if Plaintiff had adequately alleged the costs of the alleged misstatements or omissions, such costs "should be compared to like items on the corporate financial statement." (Id. at 11, 14.) For example, Defendants argued that the buyback costs should be compared to quarterly net sales of $169 million, explaining that a buyback cost is a sales reduction and is treated by the Company as a component of net sales. In contrast, Plaintiff argued that buyback costs should be compared to quarterly "operating earnings (income)" of $662,000. The Court rejected Plaintiff’s argument because "[d]oing so would mean that any cost exceeding $33,100 (which is 5% of $662,000) would presumptively be subject to disclosure under SAB No. 99," which could risk "bury[ing] the shareholders in an avalanche of trivial information," contrary to "[t]he purpose of the Securities Act." (Id. at 11 (quotation marks omitted).) Instead, the Court relied on Defendants' proposed metric of net sales, and held that the buyback cost was "well below the SAB No. 99 threshold." (Id.) Similarly, the Court rejected Plaintiff's argument that gross profit margin was the appropriate metric with which to assess costs allegedly incurred in ramping up a particular plant because "Plaintiff provides no indication why these costs should be considered in terms of gross profit margin." (Id. at 13-14.)
Item 503 Claims. Having found that the alleged misstatements and omissions were not reasonably likely to be material under Item 303, the Court concluded that "for the same reason that its Item 303 claims fall short of materiality," Plaintiff's Item 503 claims failed to plead that the alleged misstatements and omissions were among "the most significant factors" rendering the IPO speculative or risky. (Op. at 15.)
The Court's decision demonstrates that, although materiality is a fact-specific inquiry and claims under the Act are subject to a relatively low pleading standard, complaints under the Act can be successfully attacked. Motions that highlight the absence of the particular information necessary to situate the costs associated with alleged misstatements within the company’s finances are likely to get more traction, as are motions that are able to invoke SAB 99's 5% threshold. Judge Oetken's decision should prove useful authority in explaining why pleadings deficient in these respects fail as a matter of law.
 Paul, Weiss represented defendants Ply Gem Holdings, Inc. and its officers and directors in this case. The team included litigation partners Daniel Kramer and Alexandra Walsh, and associates Christopher Terranova and Ekta Dharia.
 Item 303 of Regulation S-K provides that issuers must disclose, in its management’s discussion and analysis in regulatory filings, any known trend, demand, commitment, event or uncertainty that is reasonably likely to result in material changes in liquidity, the mix and relative costs of capital resources, and net sales, revenues or income in management's discussion. Item 503(c) requires, where appropriate, a discussion in a prospectus of the most significant factors that make an offering speculative or risky.
October 10, 2015
The SEC's Focus on Cybersecurity
by Jessica Forbes, Joanna Rosenberg, Stacey Song
Jessica Forbes is a corporate partner resident the New York office of Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication authored by Ms. Forbes, Joanna D. Rosenberg, and Stacey Song.
On September 22, 2015, the Securities and Exchange Commission (the "SEC") issued a cease-and-desist order (the "Order") and settled charges against St. Louis-based investment adviser R.T. Jones Capital Equities Management ("R.T. Jones") for failing to establish required policies and procedures to safeguard customer information in violation of Rule 30(a) of Regulation S-P ("Rule 30(a)") under the Securities Act of 1933.
Rule 30(a) requires every broker, dealer, investment company and registered investment adviser to adopt written policies and procedures reasonably designed to ensure the security and confidentiality of customer information and to protect customer information from anticipated threats or unauthorized access. According to the Order, from at least September 2009 through July 2013, R.T. Jones stored personal information of its clients and other persons on its third party-hosted web server without adopting any such written policies and procedures. In July 2013, a hacker gained access to the data on R.T. Jones' web server, rendering the personal information of more than 100,000 individuals vulnerable to theft. In response to the cyber attack, R.T. Jones notified each individual whose information was compromised.
The Order states that R.T. Jones had not received reports that the cyber attack had resulted in financial harm to any client. Nevertheless, the SEC's press release quotes the Co-Chief of the SEC Enforcement Division's Asset Management Unit, Marshall S. Sprung, saying, "As we see an increasing barrage of cyber attacks on financial firms, it is important to enforce the safeguards rule even in cases like this when there is no apparent financial harm to clients. Firms must adopt written policies to protect their clients' private information and they need to anticipate potential cybersecurity events and have clear procedures in place rather than waiting to react once a breach occurs." The Order specifically notes that R.T. Jones failed to conduct periodic risk assessments, implement a firewall, encrypt customer information stored on its server or maintain a response plan for cybersecurity incidents.
The Order's emphasis on cybersecurity highlights the SEC's heightened focus on the adoption and implementation of cybersecurity policies and procedures by registered investment advisers. In the past year and a half, the Office of Compliance Inspections and Examinations ("OCIE") has published two Risk Alerts on cybersecurity  and the SEC has published a guidance update on cybersecurity  and hosted a Cybersecurity Roundtable. The most recent Risk Alert on cybersecurity, published by OCIE on September 15, 2015, announced OCIE's intent to conduct a second cybersecurity sweep examination. The second cybersecurity sweep examination is expected to involve more information gathering and testing to assess implementation of firm cybersecurity procedures and other cybersecurity-related controls, and will focus on cybersecurity governance and risk assessment, access rights and controls, data loss prevention, vendor management, employee cybersecurity training and incident response.
 In the matter of R.T. Jones Capital Equities Mgmt., Inc., Advisers Act Release No. 4204 (September 22, 2015), available at http://www.sec.gov/litigation/admin/2015/ia-4204.pdf; Press Release, Securities and Exchange Commission, SEC Charges Investment Adviser With Failing to Adopt Proper Cybersecurity Policies and Procedures Prior To Breach (September 22, 2015), available at http://www.sec.gov/news/pressrelease/2015-202.html.
 Office of Compliance Inspections and Examinations, OCIE’s 2015 Cybersecurity Examination Initiative, IV National Exam Program Risk Alert, September 15, 2015, available at https://www.sec.gov/ocie/announcement/ocie-2015-cybersecurity-examination-initiative.pdf. Office of Compliance Inspections and Examinations, Cybersecurity Examination Sweep Summary, IV National Exam Program Risk Alert, February 3, 2015, available at https://www.sec.gov/about/offices/ocie/cybersecurity-examination-sweep-summary.pdf.
 IM Guidance Update No. 2015-02 (April 2015), available at http://www.sec.gov/investment/im-guidance-2015-02.pdf.
|View today's posts
HLS Forum on Corporate Governance and Financial Regulation: Observations on Short-Termism and Long-Termism
CLS Blue Sky Blog: Bank Regulation as Vestigial Corporate Regulation
CLS Blue Sky Blog: Simpson Thacher discusses NYSE Amending its Material News Policy and Expanding its Authority to Halt Trading
CorporateCounsel.net Blog: Conflict Minerals: Would the FBI Challenge You?
Race to the Bottom: Director Independence and Reversing Beam v. Stewart (Part 2)
HLS Forum on Corporate Governance and Financial Regulation: Materiality as Pleading Obstacle
HLS Forum on Corporate Governance and Financial Regulation: The SEC's Focus on Cybersecurity