Securities Mosaic® Blogwatch
August 27, 2010
Update Published on Best Practices for Serving Seniors
by Joel Beck

Back in 2008, the SEC, FINRA and NASAA issued a joint report on sales practices and supervision best practices regarding serving senior citizen investors.  And for the last many years, sales practice abuses aimed at seniors have been the subject of numerous examinations and regulatory inquiries.  This month, the SEC, NASAA and FINRA updated that report, giving an addendum on these best practices relating to senior investors.  This report is not the law, nor is is a rule or regulation.  But information in the 2008 report and this 2010 addendum should be reviewed by compliance folks, to ensure that each firm has in place an appropriate supervisory system.  The regulators will continue to treat this as a hot button (or at least above lukewarm) issue, so forewarned is forearmed. 

August 27, 2010
Canadian Decision Provides Road Map for a Dual-Class Collapse
by Martin Lipton

Editor's Note: Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton firm memorandum by Mr. Lipton, and relates to the decision in Magna International Inc., which is available here; we understand that certain of the objecting shareholders intend to appeal this decision.

A Canadian case decided this month is destined to become a landmark decision on the difficult issue of comparative fairness in change-of-control transactions involving collapse of two classes of stock into a single class.

In Magna International, Ontario Superior Court No. CV-10-8738-00CL, major institutional shareholders attacked the restructure of Magna from a dual-class to a single-class stock capitalization. The investment bank retained by the special committee of directors did not give a fairness opinion. (Major investment banks generally do not give "comparative" fairness opinions.) The special committee did not make a recommendation to the shareholders. The high-vote shares received a date-of-announcement premium of 1,800% and the low-vote shares suffered an 11.7% dilution; each far larger than any Canadian or U.S. precedent transaction. Announcement of the proposal for the dual-class collapse was well received by the market with a material increase in the low-vote share price, despite the dilution. A proxy statement for the shareholder meeting called to consider the transaction was approved by the Ontario Securities Commission as satisfying requirements for full disclosure of the facts relevant to the shareholder decision. At the meeting, 75% of the low-vote stock voted to approve the transaction.

The Magna transaction and the Court's decision provide a clear road map for a company's directors, and the investment bankers and lawyers advising them, in a dual-class restructure to create a single class of stock. They also provide interesting facts and analysis that may be of use in other types of change-of-control dual-class transactions.

August 27, 2010
City of Westland Police v. Axcelis: The Erosion of the Credible Evidence Standard (Unfounded Rejection of the Blasius Standard)
by J Robert Brown Jr.

While this case inolved the standard for inspection rights, it went much further. It essentially rendered the board's decision not to accept the letters of resignation unreviewable.

Plaintiff argued that these types of decisions ought to be reviewed under the compelling justification standard set out in Blasius. After all, the failure to accept the letters of resignation could easily have been said to interfere with the exercise of the franchise. Had the plaintiff won on that issue, boards would have been required to meet a high standard in justifying the refusal. The higher standard would potentially have made majority vote provisions meaningful.

The Court, however, decided otherwise. In dispensing with the argument, the Court gave only a single sentence of reasoning. "We have concluded that Westland's Blasius argument lacks merit, because it improperly attempts to shift to Axcelis Westland's burden to establish a "proper purpose" for a Section 220 inspection."

But of course, it did no such thing. The proper purpose requirement was met by showing that companies had a majority vote policy and that the directors refused to accept the letters submitted under the policy. Applying the Blasius standard would do nothing more than give the board an affirmative defense, much the way that the board always has the right to establish that the shareholder's purpose is really improper.

Instead, the Court opted for a different standard of review. The issue was:

  • whether the directors, as fiduciaries, made a disinterested, informed business judgment that the best interests of the corporation require the continued service of these directors, or whether the Board had some different, ulterior motivation.

In other words, plaintiffs had to show that the refusal to accept the letters of resignation was somehow a violation of the board's business judgment. As has been described often and loudly, this is a process standard that ignores substantive behavior. As long as the board uses proper process, any justification will do. In short, the decisions will not be subject to meaningful review. Directors will need to do little more than hold a meeting, conclude that the expertise and qualifications of the defeated directors are valuable, and decline to accept the letters of resignation.

The case demonstrates that majority vote provisions are a myth and do not actually give shareholders the power to defeat directors. Preemption in this area will need to be a mandatory requirement that defeated directors either not be seated or resign within a short time (90 days in the Model Act).

Primary materials on this case are posted on the DU Corporate Governance web site.

August 27, 2010
Survey: Few US Companies Well Prepared for Say-on-Pay
by Broc Romanek

Survey: Few US Companies Well Prepared for Say-on-Pay

When I first saw this press release from Towers Watson regarding how few companies are prepared for say-on-pay, I thought our marketing department had outdone itself since our comprehensive week of executive pay conferences comes up in less than a month- with an aggregate of over 50 panels on executive pay topics. If these conferences don't help get you prepared, nothing will. You can either register for the three days of the "18th Annual NASPP Conference" (in Chicago)- or the two days of the "5th Annual Proxy Disclosure Conference" & "7th Annual Executive Compensation Conference" (in Chicago or by video webcast)- or a combination of both.

Here are highlights from the Towers Watson press release:

- Only 12% of respondents said they are very well prepared for the say-on-pay legislation, while 46% said they were somewhat prepared. Just under one-fourth of respondents (22%) didn't know if their companies were ready.

- 69% said they were identifying potential executive pay issues and concerns in advance, while 60% said they were improving their CD&A to better explain the executive pay program's rationale and appropriateness for the company. In addition, many companies indicated they are engaging with proxy advisors (44%) to discuss areas of concern, meeting with key institutional shareholders (29%) and preparing a formal communication plan (23%).

- More than one-half (59%) of respondents believe that proxy advisory firms have substantial influence on executive pay decision-making processes in U.S. companies. However, 42% said that guidelines established by proxy advisory firms have had no or minimal impact to this point on the design of their executive compensation programs.

Mr. Ponzi's "Securities Exchange Company"

Here are some thoughts from Keith Bishop of Allen Matkins:

Regarding Broc's blog about a fake SEC a while back, I've always thought it ironic that the SEC has virtually the same name as Charles Ponzi's company. In 1919, Mr. Ponzi named his company the "Securities Exchange Company" or SEC. Thus, while his own last name has become a synonym for fraudulent pyramid schemes, the name of Ponzi's company is quite similar to the government agency that now pursues those schemes. Here is an interesting article on the subject.

In another historical confluence of names, some may remember O.P.M. Leasing Services which perpetuated a decade of fraud before collapsing in the early 1980s. "O.P.M." was an acronym for "Other People's Money" which also happens to be the title of Justice Louis Brandeis' well known collection of essays on economic collusion.

Book Review: "Circle of Greed"- The Rise and Fall of Bill Lerach

Recently, Kevin LaCroix provided this review of Bill Lerach's new book in his "D&O Diary Blog." By the way, Bill is fresh out of prison and on the book lecture tour...and as noted in Ideoblog, he's teaching and not feeling the least bit remorseful...

- Broc Romanek

August 27, 2010
Proxy Access Forum: Proxy Access and Director Independence
by Lisa Fairfax

There is lots to talk about with the new proxy access rule, but one thing I have been trying to sort out is how I feel about the impact of proxy access on issues of director independence. There is of course considerable debate about whether proxy access will improve corporate governance. In its final rule, after "considering the costs and benefits identified by commenters," the SEC had this to say about that debate. "[W]e believe that the totality of the evidence and economic theory supports the view that facilitating shareholders' ability to include their director nominees in a company's proxy materials has the potential of creating the benefit of improved board performance and enhanced shareholder value " In this regard, the SEC also indicated that "new shareholder-nominated directors may be more inclined to exercise judgment independent of the company's incumbent directors and management."

To be sure, there is also considerable debate about whether shareholder-nominated directors can be viewed as independent. But then one must ask the familiar question, "independent from whom?" As the SEC suggest, such directors are likely to be "independent" from current management and directors. On the one hand, some proxy access opponents contend that this kind of "independence" could result in the election of disruptive board members who undermine good board governance. On the other hand, studies regarding structural bias suggest that the process of being part of a board may mean that even directors with no prior connection to an incumbent board and management may develop ties that make them biased towards their fellow board members, which is no less than one would expect from people who work closely together. Nevertheless, given the current state of a board/management-dominated election process, it is hard to argue with the premise that proxy access may result in the election of directors more independent from incumbent directors and management than the existing process.

But then, proxy access opponents are not concerned about new directors' independence from management, but rather their independence from the shareholders who nominate them. With regard to this issue, the SEC did seek comment on whether shareholder-nominated candidates should be required to be independent from their nominating shareholder or group. While many commenters supported some limitation on the affiliation between the two, the SEC concluded that such limitations were "not appropriate or necessary." In its view, disclosure requirements and state fiduciary duty rules should help limit concerns that shareholder-nominated directors will advance shareholder-specific issues to the detriment of the broader shareholder class or otherwise feel beholden to the shareholders who nominate them. Hmmmm...

On the one hand, it may be possible that the fact that candidates must disclose their relationships with their nominating group will prove sufficient to weed-out candidates likely to advance special interests, particularly because corporations will have the opportunity to highlight such candidate's propensity in their proxy materials. Although there is also reason to be skeptical about this point.

And what about state fiduciary duty law? In several places the SEC noted that shareholder-nominated directors, once elected, would be subject to the same fiduciary duty as other directors. Perhaps this is enough. However, one can certainly be skeptical about the ability of fiduciary duty law to shape directors' behavior. Indeed, as we are all aware, that law generally contains a very high threshold for holding directors liable for breaching their fiduciary duty outside of the conflict of interest realm. Then too, while economic ties may raise different concerns, it is very hard for any social ties of the kind that may exist between shareholders and their nominees to be viewed as compromising a director's independence. From this perspective, it is not clear how far fiduciary duty law will get us.

Of course, in many ways, the concern regarding the influence of shareholders over their director-nominees reflects a recognition that nominees may feel beholden to those who nominate them-whether other shareholders or management. Then perhaps the question becomes, which type of potential beholdenness poses the greatest risk for good corporate governance?

August 27, 2010
Proxy Access Forum: The Weirdo Shareholder Problem
by Usha Rodrigues

I have a paper cooking about post-crisis corporate governance reform that makes a pretty simple point.

1. The corporate governance reformist view of the crisis is: managers ran amok, enriching themselves by sacrificing their companies' long-term health-and with it, the well-being of the economy-in order to cash in on flawed compensation models.

2. Solution: reform compensation schemes and give shareholders more say...on pay, on golden parachutes, on director nominations.

3. Result: accountability and less of that pernicious short-termism that got us into this mess in the first place.

4. The fly in step 2's shareholder-empowerment ointment is that the actual shareholders of public companies are overwhelmingly short-term players. As I blogged last year, Vice-Chancellor Strine has aptly observed:

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don't wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do.

5. Those financial intermediaries-hedge funds and mutual funds-turn over their portfolios at a dizzying clip, buying and selling stakes in companies willy-nilly. Even pension fund managers feel the pressure to have their portfolios perform well each year. And forget about the flash traders, which according to the popular press accounts for about 60% of exchange trading volume these days. Holding shares for over a year is so 20th century.

The new proxy access rule neatly addresses the short-termist shareholder problem by imposing a 3-year holding period and a 3% ownership hurdle before you get to nominate a director. Does that solve the short-termist problem? Yeah, but...

My intuition is that the 3%/3 year holders will mostly be 1) company founders or their descendants, and 2) funds like Calpers. Now, empowering these shareholders might be a good thing. The financial intermediaries certainly lack the motivation to invest any resources about director nominations, and the 3%/3 yearers have demonstrated a vanishingly rare commitment to a particular public company. The SEC's own data, cited by Lisa in her helpful post, show that only a minority of firms have even 1 of these shareholders. But if we have reason to think that the interests of the 3%/3 yearers are too idiosyncratic-they want to push a pro-labor agenda or preserve the status quo for the sake of the family name-(i.e. are, in Eric Talley's memorable words, "agenda-driven tinfoil-hat-wearing zealots") then shareholder empowerment is distinctly not a good thing.

Like Eric, in the end I think the sensible response is: "Let's see how this thing plays out." Fun stuff.

August 27, 2010
Proxy Access: Congrats to Prof. Bebchuk, & It's Time to Implement My Defenses
by J.W. Verret

Here we go. It took a long time, but the SEC adopted proxy access Wednesday under the express delegation of power it received under the Dodd-Frank Act and the proponents of this rule have been celebrating. Lisa Fairfax over at the Conglomerate offers the best summary of the rules I have seen, in addition to another post offering a must-read analysis of questions that remain. I was honored to join Eric Talley, Nell Minow, and Brett McDonnell in the Conglomerate's Forum on Proxy Access today to debate the new rule. My post is available here. As readers are no doubt aware, I have been blogging about the 16 defenses to proxy access that I developed over the summer. That series will continue when all the media hub-ub about proxy access dies down, but for those who want a sneak peak the full paper is available here. (Law review editors take note, the paper is still in the expedite process.)

I first became introduced to this issue in one of the many corporate governance seminars I took with Professor Lucian Bebchuk while I was in law school. What I appreciated most about him was not his command of the field, which was formidable, but his generosity in mentoring students through rough ideas despite the many demands on his time. As my career develops, it is something I appreciate more and more. During one of his seminars I was taking in 2005 he briefed the class on an idea that Commissioner Goldschmid had just introduced, the first of three proxy access proposals the SEC would ultimately consider. I was honored four years later to testify on the issue of proxy access on opposite sides from my former mentor before the House Financial Services Committee. Though Professor Bebchuk and I come out on different sides of this issue (call it a Darth Vader turns on Obi-wan-Kenobi situation if you must) he taught me everything I know about corporate governance, and so part of me is glad he is able to enjoy his recent victory. That said, my paper offers 16 defenses for how to thwart proxy access once and for all. Let the debates continue.

August 27, 2010
Do Defendant Companies Financially Underperform Following Securities Lawsuit Settlements?
by Kevin LaCroix

Most securities lawsuits settle. The common assumption is that once the cases are settled, the litigation wraps up and everybody moves on. But does the litigation have a lingering effect on the defendant company? Is there a "hidden dark side" for companies that settle securities lawsuits?

That is the question asked in a March 18, 2010 paper entitled "Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms" (here) by Cincinnati Law Professor Lynn Bai, Duke Law Professor James Cox, and Vanderbilt Law Professor Randall S. Thomas. (Hat Tip to the Class Action Countermeasures blog, which has a post about this paper here.):

Through their research, the authors sought to discover whether getting hit with a securities a lawsuit and then subsequently entering into a settlement "weakens the defendant firm so that from the point of view of well-received financial metrics the firm is permanently worse off as a consequence of the settlement."

In order to examine this question, the authors examined 480 companies that were defendants in settled post-PSLRA securities class action lawsuits. The authors then examined whether there is any change in the defendants' financial well-being and stock performance relative to their peer group over time.

The authors compared the defendants' performance with that of comparable companies over several time periods. "Comparable" companies consisted of those with the same SIC Code and the same asset size but that had not been involved in a securities class action lawsuit during the relevant time periods.

The authors compared the defendant companies to the comparable companies using seven performance criteria, including asset turnover; return-on-assets: the ratio of Earnings Before Income and Tax payments to total assets; the current ratio; the Altman Z-Score (a bankruptcy prediction measure); the market to book ratio; and the one-year stock price return. The authors looked at changes in defendants' performance according to these measures over time using multivariate regressions.

The authors' research produced a number of results which even they characterized as "puzzling." On the one hand, companies that settled securities class action lawsuits experienced no decline in sales opportunities, but did "experience a reduced level of operating efficiency while the lawsuit was pending (but not after it was settled)."

More significantly however, the authors did also observe that "defendant firms experience liquidity problems post-settlement and worsening Altman-Z scores." The authors wrestle with how to interpret these latter findings. On the one hand, the deterioration of the Altman Z-scores could suggest that "settlements drive firms toward financial distress (i..e., settlements are causally related to the worsening situation)," but on the other hand these data could suggest that "the financial deterioration observed in earlier time periods continues downward." Or perhaps it could be some combination.

The authors concede that their analysis could support alternative conclusions, but they nevertheless offer their own interpretations as well. Among other things, they note that "while uncertainty persists about the precise connection between the settlements and financial distress, there is no uncertainty that firms that are involved in securities class action litigation experience statistically greater risks of financial distress than their cohort firms."

The authors also conclude that their findings "lend strong support for the view that such suits are better directed toward the officers, advisors and other individuals who bear responsibility for the fraudulent representation(s) that spawned the suit."


The authors' findings about the post-litigation performance of companies settling securities class action lawsuits are interesting. With full recognition that the question of the causation for that diminished performance is uncertain, the conclusion that companies experiencing securities suits perform worse than there peers is relevant information, both from an investment and a D&O insurance underwriting standpoint.

One implication of the authors' analysis is particularly interesting to me, because one factor implicitly contributing to the negative post-litigation performance is the financial burden the litigation and the settlement imposed on the company. This implication (if indeed my interpretation is valid) seems at odds with other recent research, particularly that of Stanford Law Professor Michael Klausner, who in a recent article published with a colleague concluded that "on the whole D&O insurance pays substantial portions of settlements in a large majority of cases, and that both corporate and individual defendants are highly protected."

There seems to be a tension in the analysis between these two academic studies, since if it is the case that D&O insurance substantially protects corporate defendants in securities class action lawsuits, why should there be lingering negative financial effects on the defendants companies?

Perhaps the answer may be that the reason for the negative performance relative to the companies' peers post-litigation may not be financially related, but may be operationally related, and the same below standard operational performance post-litigation in some cases may be related to the factors that led to the litigation in the first place.

An alternative explanation may be that while the D&O insurance funds a "substantial portion" of settlements, that still leaves a substantial portion unfunded, and the burden on the companies to fund the difference harms them financially. The authors even note that their analysis insurance in consistent with the conclusion that insurance "provided less than full coverage of the settlement amounts and that the defendants paid the discrepancy out of their current assets. The settlement payment exacerbated liquidity constraints, making the defendants more vulnerable to liquidity crunches and prone to bankruptcy."

In other words, it may be that once the case is settled, everyone may move on to other things, but the company is left financially impaired in a way that undermines its future performance – which obviously harms the interests of the company's shareholders. All of which does leave you wondering about the ultimate value of a process carried out in the name of shareholders but that leaves shareholders' interests indelibly impaired.

August 27, 2010
This Week In Securities Litigation (August 27, 2010)
by Tom Gorman

The Commission adopted its controversial "proxy access" rules this week by what is becoming the standard 3-2 vote. SEC enforcement brought an insider trading case against two residents of Spain just days after the announcement of the take over bid on which it centers and obtained a partial settlement in an international financial fraud case. Option backdating cases continued to move toward resolution with the settlement of two more derivative actions.

Market reform

The Commission adopted its new "proxy access" rules by a 3-2 vote this week. Under the new rules, which take effect 60 days after publication, shareholders who own at least 3% of the total voting power of the company's securities and have held those shares for at least three years will be eligible to nominate directors and have proposals included in the company proxy materials sent to all shareholders. Shareholders can nominate one director or a number up to 25% of the board, which ever is greater. Nominees must not violate applicable laws and regulations. Shareholders can not use the rules if the securities are held for purposes of changing control. The rules will apply to all Exchange Act reporting companies but be phased in for small issuers. They do not apply to foreign private issuers.

SEC enforcement actions

Insider trading: SEC v. Garcia, Civil Action No. 10C 5268 (N.D. Ill. Filed Aug. 20, 2010). The case names as defendants Juan Jose Fernandez Garcia, the Head of European Equity Derivatives at Banco Santander, S.A., and Luis Martin Caro Sanchez, both of Madrid, Spain (discussed here). It centers on the unsolicited bid for Potash Corporation of Saskatchewan, Inc. by BHP Billiton Plc, announced on August 17, 2010. In the bid BHP offered a 16% premium to market or $130 per share for the stock of Potash. Potash was advised on the bid by Banco Santander, S.A. The day after the bid the share price of Potash rose over 27%.

Shortly before the deal announcement Mr. Garcia purchased 282 Potash call options for approximately $13,669 through Interactive Brokers. On August 17, 2010, after the take over announcement, Mr. Garcia sold his holdings for a profit of $576,033. Mr. Sanchez purchased 331 call options in Potash in mid- August at a cost of $47,499 through Interactive Brokers. Mr. Sanchez sold his position just after the announcement at a profit of $496, 953.33. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is in litigation.

Financial fraud: SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009). The Commission settled with the founder and former chairman of Escala, Gregory Manning (here). Escala is an international company whose business centers on the collectibles market. Through a series of transactions involving collectable stamps with related parties the Commission claims that Mr. Manning and the other defendant fraudulently boosted the revenues of Escala just prior to a merger. The related party transactions were disclosed as being at arms length. The scheme also included round trip transactions and improperly recorded expenses. Overall revenues were improperly increased by over $80 million. Mr. Manning resolved the case with the Commission by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting Escala's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). He also agreed to pay $669,489 in disgorgement, prejudgment interest and penalties and to the entry of an officer and director bar for ten years.


Undisclosed conflict of interest: Zions Direct, Inc. was fined $225,000 by FINRA in connection with its failure to disclose a potential conflict of interest in auctioning certificates of deposit through its website. The potential conflict stems from the fact that Liquid Asset Management, an affiliate, participated in the auctions. From the commencement of the auctions in February 2007 through November 2008 LAM's participation was not disclosed. Even following disclosure of its participation the potential conflict was not disclosed. FINRA determined that customers were potentially disadvantaged in the auctions. The regulator also concluded that Zions Direct advertisements in connection with the auctions were misleading.

Private actions

Option backdating: In re Blue Coat Systems, Inc. Derivative Litigation, Case No. 5:06-cv-04809 (N.D. CA); In re Blue Coat Systems, Inc. Derivative Litigation, Case No. 1:05-cv-041436 (Sup. Ct. CA, Santa Clara). The complaints, filed in 2007, against the directors, former directors and outside auditors Ernst & Young, alleged that the company had backdated and used spring loaded options since 1999. It was based on a report from an internal investigation. To settle the action the company will adopt certain corporate governance provisions. Insurers and E&Y will pay about $3.9 million and certain former executives will repay about $170,000 in compensation. Plaintiffs counsel will be given $1.775 worth of Blue Coat stock and $225,000 in cash from E&Y as attorney fees and costs.


The U.K. Financial Services Authority fined Societe Generale approximately $2.25 million for filing inaccurate reports on 80% of its trades over a two year period. From November 2007 through February 2010 the bank failed to report 320,000 trades and furnished inaccurate data on 531,000 transactions. Other reports had inaccurate counterparty data. The bank is the sixth institution to be fined in connection with inaccurate reports. Previously, Barclays, Getco, Instinet and Commerzbank were fined for similar irregularities. The difficulty stems from the 2007 adoption of the Markets in Financial Instruments Directive which imposed new reporting requirements on European Union financial institutions.

August 26, 2010
Proxy Access Forum: J.W. Verret (George Mason Law School)
by J.W. Verret

I am privileged to be back at the Conglomerate, a distinguished group who graciously let a green academic like myself visit when I first started teaching two years ago (which helped me get a full time gig blogging over at Truth on the Market). I appreciate the opportunity to talk about one of my favorite topics, shareholder voting. The debates over proxy access in the literature have been a fascinating exercise in scholarly engagement with the policy world, particularly the epic clash of the titans between Professor Bainbridge and Professor Bebchuk, but at long last the debates over whether we should give shareholders access to the proxy have come to a close with the SEC's new proxy access rule. So, now what? As it turns out, I have a few ideas.

I have joined the forum today with one purpose in mind: to hawk my new paper, Defending Against Shareholder Proxy Access: Delaware's Future Reviewing Company Defenses in the Era of Dodd-Frank, currently in submission. I hasn't yet found a law review home, but the expedite process is heating up.

In the paper I present 16 defenses companies might consider implementing to thwart shareholders from using their new federal proxy access right. I first describe the defenses I've invented and how they might offer strategic benefit. I then consider how they will fare under the scrutiny of the Blasius line of cases in Delaware protecting the shareholder franchise. (For those non-Delaware companies looking to defend against proxy access, many of the defenses can still apply. But if not, then I to Delaware).

The more important defenses I present are entirely legal under Delaware law and can be implemented immediately. Indeed, this summer I have been assisting a number of Fortune 50 company GCs in designing bylaw amendments to that end. A few of my defenses would, however, require amendment to the DGCL. Part of my thesis centers on my prediction that the Delaware Courts will recognize a distinction between defenses intended to thwart exercise of the shareholder franchise and defenses intended to thwart exercise of a shareholder's federal nomination right.

I also consider whether federal law pre-empts or prohibits my defenses, and I conclude that they are not pre-empted. To give readers a taste of my work, I'll move to a brief summary of what I believe are the best four defenses, both in terms of their strategic value and in terms of their ability to withstand scrutiny under Blasius and Schnell.

First, companies can deny insurgent candidates director's and officer's (D&O) insurance coverage against securities and legal liability. Calpers recently touted its new "Calpers 3d" directory of candidates it intends to draw from for the many new nominations it is planning. If Calpers had to purchase D&O insurance coverage for all of its candidates, however, I wonder if it would be as interested in nominating so many? Second, and following from that point, companies can refuse to indemnify insurgent directors against liability.

Third, companies can set director qualification bylaws to limit the experience and other qualifications of directors who may serve. Indeed, the DGCL expressly permits the Board to adopt director qualification bylaws. If director candidates, nominated to the company proxy pursuant to the SEC's proxy access rule, fail to meet the strictures of the company's director qualification bylaw, then the Board can refuse to seat the new directors. This will be true even if the SEC refuses to, in the no-action process, grant a letter permitting the company to exclude the insurgent from the proxy statement.

Fourth, Boards of Directors can delegate more decisions to subcommittees of the Board that exclude the insurgents. This, again, is a power directly granted to Boards under the DGCL. This won't work for all decisions, as the DGCL requires that some issues be considered by the full Board, but it will work for most decisions that come before the Board.

Though all of the Conglomerate's guests offer well considered insights, I find my take on this issue most in agreement with Professor Brett McDonnell's critique of the SEC's rule. Professor McDonnell urges that companies should be able to opt-out of the SEC's rule. In a fascinating back-and-forth in The Business Lawyer recently, Professor Bebchuk and Scott Hirst expressed agreement with a fairly constricted opt-out rule, and Professor Grundfest countered in favor of an opt-in rule. What I hope my paper offers is an effective opt-out, a clean slate onto which companies and their shareholders can then draw a new agreement by which shareholders can, if they would like, nominate candidates. This could be facilitated by exemptions in the Board defenses for nominations outside of the SEC mandated process.

The Corporate Federalism debate, so central to corporate law theory, is now getting on in years. President Kennedy's SEC Chairman, William Cary, urged that the SEC should pre-empt Delaware Corporate Law entirely to stop this "pygmy among the 50 states" that "denigrates national policy." Despite countless SEC Commissioners and Chairmen who shared his view, and have tried to pre-empt state corporation law as much as they could, Delaware continues to not only survive...but truly thrive and grow as a source of corporation law.

This result is a function of the vibrancy of Delaware's rule-making approach. The Delaware philosophy is largely one oriented under freedom-of-contract principles. (Though the Delaware General Corporation Law is certainly more rigid than the LLP or LLC code, when compared to the federal approach to company regulation it is clearly the winner in terms of facilitating private ordering.) The federal approach, on the other hand, is by its very nature constrictive. It seeks to affirmatively control market participants rather than enable them. As such, I think such a constrictive federal code will always find it difficult to fully pre-empt Delaware precisely because Delaware's abiding approach to lawmaking is more nimble and responsive to the preferences of market participants.

August 26, 2010
To Slice or Not To Slice; a Taxing Question
by Mike Sykuta

Earlier this week, the WSJ reported on a nuance in the New York state tax code that has come take a bite out of at least one bagel company's profits, and it illustrates how the complexities of arbitrary taxation schemes can rear their ugly heads and create incentives-and challenges-for consumers and sellers alike that would seem silly were it not for their very real economic impacts. The article reads:

State tax officials, under orders from cash-strapped Albany to ramp up their audit and compliance efforts, have begun to enforce one of the more obscure distinctions within the state's sales tax law.

In New York, the sale of whole bagels isn't subject to sales tax. But the tax does apply to "sliced or prepared bagels (with cream cheese or other toppings)," according to the state Department of Taxation and Finance. And if the bagel is eaten in the store, even if it's never been touched by a knife, it's also taxed.

To make matters even more confusing, this distinction is apparently not clearly stated in the tax code-and it applies to bagels, but not bread. So you can have your bread and slice it too, but not your bagel. Unless, that is, you are going to eat the bagel on-premises, in which case you may as well slice since the marginal tax is zero.

A public welfare argument for such an arbitrary distinction is difficult to imagine. Even Catherine Rampell at the NYT recognizes the difference between a Pigouvian tax and a completely arbitrary one. (Please refrain from the obvious point that those are not mutually exclusive sets, since the ‘welfare measures' used for most any Pigouvian tax can be rather arbitrary themselves.) I'm guessing Ms. Rampell is a bagel eater!

Besides the incentives for people to simply cut their own bagels (no word on whether the provision of free plastic knives is somehow taxed), one should wonder about the further implications of this tax scheme. If customers are charged a tax for eating on premises, how is the store owner supposed to enforce the transaction? Chase customers out of the store before they can pull the bagel out of their to-go bag and take a bite? Have a "tax staff" that goes around collecting the additional 7 or 8 cents from any customer who (wittingly or no) defies the carry out rule? A tax of 7-8 cents may seem not worth the effort, at least not on a per customer basis. Perhaps the bagel shop owner should just increase the menu price to include taxes…meaning the shop owner would be price discriminating against whole-bagel-eaters on the go. Or a tax-included menu might allow for some cross-subsidization from those on the go to the slice-or-stay crowd. Of course, the tax-included menu might result in greater consumer upset (or confusion) since the prices of all products would have to be shown higher.

Will a consumer choose to eat on the go simply to save a few cents? Maybe not. But apparently the new tax is causing some displeasure with consumers, suggesting such a change might not be unrealistic. And what then? Are customers who linger in the shop more likely to buy more items before they leave, pay for coffee refills, etc.? Will the shop lose additional revenue because of the change in dining behavior? Will the state end up losing revenue in its attempt to find more?

My guess is no one in Albany has thought that one through.

August 26, 2010
Deception and "Tells" in Business in Poker
by Josh Wright

The Economist points to a very interesting study by Stanford's David Larcker and Anastasia Zakolyukina on the use of deception in the business environment (HT: Brian McCann). The article's title, "How to Tell When Your Boss is Lying," gets at the thrust of the piece. Larcker and Zakolyukina look at conference call transcripts from 2003 and 2007 for evidence of determinants of companies who later ran into problems in the form of serious financial restatements or accounting errors. Can you identify a CEO or CFO engaging in deceptive conduct during a conference call? What sort of "tells" would you look for?

Larcker and Zakolyukina find that:

Deceptive bosses … tend to make more references to general knowledge ("as you know..."), and refer less to shareholder value (perhaps to minimise the risk of a lawsuit, the authors hypothesise). They also use fewer "non-extreme positive emotion words". That is, instead of describing something as "good", they call it "fantastic". The aim is to "sound more persuasive" while talking horsefeathers.

When they are lying, bosses avoid the word "I", opting instead for the third person. They use fewer "hesitation words", such as "um" and "er", suggesting that they may have been coached in their deception. As with Mr Skilling's "asshole", more frequent use of swear words indicates deception. These results were significant, and arguably would have been even stronger had the authors been able to distinguish between executives who knowingly misled and those who did so unwittingly.

This study should help investors glean valuable new insights from conference calls. Alas, this benefit may diminish over time. The real winners will be public-relations firms, which now know to coach the boss to hesitate more, swear less and avoid excessive expressions of positive emotion. Expect "fantastic" results to become a thing of the past.

Interesting. Most poker players will tell you that the fundamental story about tells is that "weak means strong" and "strong means weak." In Mike Caro's Book of Poker Tells, this basic rule is extended to verbal tells as well, e.g. a player in poker who asks what the rules are before they raise are usually in a position of strength in the hand. And there is Caro's Law of Tells #24: "beware of sighs and sounds of sorrow!" Or #19 "A forceful or exaggerated bet usually means weakness." The basic idea, again, is that sounds indicating strength and optimism indicate weakness and sounds and words indicating weakness mean strength.

It appears that there is at least some common features of the determinants of deception in both settings. For example, Larcker and Zakolyukina's findings suggest that CEO's and CFO's deception is correlated with extreme positive expressions (strong = weak!), eliminating hesitation words that signal weakness, and increase aggression (see Law #19 again).

I mean, its not quite as interesting as KGB's Oreo Cookie twisting tell in Rounders, but still, pretty interesting. Of course, the best way to avoid tells in the business environment, and the poker table, is to keep your demeanor, tone, actions, and play uniform. It is tough to identify deception (or anything else) without variation.

August 26, 2010
The Commission and Access: Places Where the Lack of Unanimity on the Commission Strengthened Access
by J Robert Brown Jr.

The Commission wrote an access proposal that contained a number of limitations that will limit the effectiveness of the provision. The 3% ownership threshold coupled with the 3 year holding period are the most restrictive provisions. But it could have been much worse and, had there been a need to compromise among the five commissioners in order to achieve unanimity, it would have been. What are some examples? The Commission:

  • completely rejected the idea that shareholders and companies should be allowed to opt out of the access regime;
  • rejected the need for triggering events that had to occur before access became available, something that figured prominently in the 2003 proposal;
  • refused to set aside the right to access during a proxy contest;
  • declined to exempt from access investment companies, controlled companies, companies voluntarily registering under Section 12(g), and non-accelerated issuers (although the rule provided for a delay for small companies);
  • Limited the board's ability to exclude candidates,
  • Allowed the board to disqualify candidates who were not independent based on the objective rather than subjective criteria adopted by the exchanges;
  • Refused to require that nominees be independent or unaffiliated with the nominating shareholder or group; and
  • Refused to limit the right of losing nominees to stand for reelection the following year.

All of these are areas where, had there been compromise afoot, the Commission could have come out differently. There are still plenty of restrictions on access will reduce the rule's initial effectiveness. But this approach does not reflect the influence of those on the Commission opposed to access, it is the way the Commission enters a new, and controversial area- slowly and delicately. Instead, time and time again, the rule reflects the wisdom of those who favor access but want to make sure that the implementation is deftly done.

August 26, 2010
Raymond James Pays $3.5 Million to ARS Purchasers in Arbitrations
by Barbara Black

Since July 2010, FINRA arbitrators have ordered brokerage units of Raymond James Financial to buy back from customers auction rate securities (ARSs) totalling $3.5 million (3 separate proceedings). By way of contrast, ARS purchasers have not generally been successful in judicial proceedings. See, e.g., Defer LP v. Raymond James Financial, Inc.,654 F. Supp.2d 204 (S.D.N.Y. 2009).

Unlike many other firms, thus far securities regulators have not brought enforcement actions against Raymond James. When the market for ARSs froze in February 2008, Raymond James customers held $1.9 billion in ARSs; today that amount has been reduced to about $600 million, according to a Raymond James spokesperson. InvNews, Raymond James pays more auction rate claims.

August 26, 2010
Proxy Access Forum: Eric Talley (UC Berkeley)
by Eric Talley

Viewed through the lens of editorial pages, Wednesday's rule change was a watershed event. Shareholder activists have been calling for beefed up proxy access rules since at least the early 1990s. Critics have spent at least as much time (and probably more money) resisting the reform. It is therefore unremarkable that the SEC's action was also highly politicized. Indeed, if it were itself a publicly traded company, the SEC's stock price would not have changed much on the partisan, 3-2 party-line vote by the Commission. While such ideologically charged votes are historically rare, they have now become so commonplace at the SEC to border on the banal.

   But beyond political remonstration, what does this actually mean for investors? That's the exciting $60-trillion dollar question. My candid answer is a little less titillating: Given the stock of empirical knowledge we have today, I submit that the only responsible answer to this question is a cautious combination of "it depends," or "we don't fully know." And that's why I think- a bit ironically- that proxy access may have been the right move for the SEC to take.

The polar endpoints of the debate are well trodden terrain. One can very credibly argue (and many have) that proxy access portends a significant and unprecedented sea change in corporate governance- for better or worse. After all, under the new rule dissident shareholders are no longer required to underwrite the administrative costs of proxy challenges personally, with only the speculative hope of being compensated should they win. Advocates contend that this enhanced credible threat of rival slates will effectuate greater accountability among board members, who have historically been able to use the governance process as a protective bunker, insulating them from any significant shareholder oversight and criticism. Critics contend that the new rule's ownership thresholds are sufficiently low to invite commandeering opportunism by self-important shareholders whose interests diverge from the (putatively) most responsible goal of corporations: maximizing long term shareholder value. Moreover, some critics contend, the rule change may cause ordinary shareholders to be confused by a dizzying array of candidate choices, unable to discern sensible candidates from agenda-driven, tinfoil-hat-wearing zealots.

An equally plausible (though admittedly less scintillating) prediction is that the sound and fury attending Wednesday's reform will ultimately prove to be mere fingerling potatoes in a stew combining the myriad forces at play in corporate governance. Shareholders tend, by and large, to defer to incumbent management unless they have good reason to jump ship (their confidence in management is what caused many of them to buy in the first place, after all). It is unlikely that such loyalists will become snowed or confused simply by having additional (but unproven) choices. In fact, public shareholders have long had to screen and evaluate qualifying proposals (including bylaw amendments) made by other shareholders, which under federal law must be included in proxy materials at company expense. Moreover, even prior to this rule change, dissident shareholders could wage a self-financed proxy contest, utilizing their inspection rights to locate other shareholders and disseminate to them a rival proxy solicitation for alternative candidates. While the new rule certainly makes some elements of a proxy challenge less expensive for such dissident shareholders (in the form of reduced postage and some administrative costs), it won't save them many of the significant costs that attend a proxy challenge- they will still, for example, frequently want to influence other shareholders about their competing slate, and may still find it most effective to make their case(s) personally. In addition, many states (including Delaware, the incorporation home of most public corporations) had already authorized companies to implement a version of the rule in their own bylaws, and numerous companies were already on their way to a similar governance structure.

Finally, one must realize that the proxy access reform debate has not occurred in a complete statutory, regulatory and jurisprudential vacuum. Other concurrent developments in corporate and securities law may have effects that may tend to counteract (or at least inject considerable noise to) the proxy access debate. For example, Delaware's Chancery Court has recently approved the maintenance of a dilutive shareholder rights plan triggered at an ownership threshold of 4.99% (see Selecteca v. Versata), a threshold far lower than conventional poison pills have historically prescribed (usually in the 15-20% range). If the Delaware Supreme Court affirms this holding- and many believe it will- the effect will be to remove a proverbial arrow from the quiver of dissident shareholders, just as Rule 14a-11 inserts another one. Similarly, Delaware courts have recently manifested a renewed willingness to whittle away at governance-related fiduciary duties (sometimes known as Blasius duties) that are a favorite and oft-utilized weapon of hedge funds and pension funds alike (see, e.g., the recent Barnes and Noble decision from Vice Chancellor Strine- Yucaipa v. Riggio). In short, proxy access is but a single eddy in a swirling endogenous sea of other corporate governance developments, many of which may tend to complicate or neutralize its effects.

   Ultimately, of course, this debate will likely boil down to an empirical question. And even as I write this, I conjecture, hundreds of financial economists and legal scholars are designing empirical studies of this rule change, looking for good control and treatment groups, identifying "clean" events, and cooking up game-theoretic corporate governance models (all the while remaining monastically quiet at the faculty lunch table, convinced- optimistically- that they are the only ones hot on the empirical trail). The better of these studies will likely be read by SEC staff economists and discussed (hopefully in an adult fashion) by the Commission. Perhaps some of them will even induce the Commission to adjust the rule, create extensions and/or carve outs, or maybe even rescind it in years hence.

But no matter how the ongoing policy skirmish shakes down, the legions of social scientists who will soon sweep into the debate are likely to bestow a subtle benefit on our future selves- one that is worth our deliberative consideration now: the benefit of empirical knowledge. Republican SEC appointee Kathleen Casey strongly criticized the new rule change, arguing that "the policy objectives underlying the rule are unsupported by serious analytical rigor." Casey, along with many critics of proxy access, appears to believe that the burden of proof about proxy access must rest squarely on the shoulders of advocates before any regulatory change is implemented. This claim is in many ways right- but perhaps only half right, or only some of the time. In at least some regulatory areas, the stock of empirical data for or against a proposed intervention is so impoverished or underdeveloped that it would be difficult to reject virtually any empirical hypothesis about outcomes; and here the burden of proof becomes insurmountable. Proxy access may well be one of those areas. Yet in such arenas, regulators are still charged with the unenviable task of making policy in an environment of sparse data, underdeveloped models, immense public scrutiny, and a resulting miasma of perfervid (and even quasi-religious) advocacy. Some rule changes- and particularly non-voluntary rule changes such as the new Rule 14a-11- have the potential merit of creating natural experiments that add to the stock of information for future researchers, policy makers, regulators and investors. That dynamic value may justify their adoption in close cases, even if one's knee-jerk judgment- based exclusively on currently available static information- would tilt ambivalently towards preserving the status quo. At the very least, if we're genuinely interested in maximizing "long term shareholder value" (a topic that may be ripe for another debate, another time), the benefit of modest regulatory experimentation deserves a seat at the prescriptive table.

August 26, 2010
The Commisson and Access: Preempting State Law
by J Robert Brown Jr.

As we've noted in the past, federal law is increasingly preempting state law in the area of corporate governance. Dodd-Frank certainly did so and now access follows. While the contents of the proxy statement is a matter of federal law, the Commission went further and took away from the board the authority to exclude nominees, excepting only in circumstances where shareholders lack the authority under state law. The approach effects the authority of states and the authority of the board. As the release explained:

  • We have concluded that the ability to include shareholder nominees in company proxy materials pursuant to Rule 14a-11 must be available to shareholders who are entitled under state law to nominate and elect directors, regardless of any provision of state law or a company's governing documents that purports to waive or prohibit the use of Rule 14a-11. if state law or a provision of the company's governing documents were ever to prohibit a shareholder from making a nomination (as opposed to including a validly nominated individual in the company's proxy materials), Rule 14a-11 would not require the company to include in its proxy materials information about, and the ability to vote for, any such nominee. The rule defers entirely to state law as to whether shareholders have the right to nominate directors and what voting rights shareholders have in the election of directors.

The irony in this is that the Delaware Supreme Court in Axcelis just made clear that the board had the authority to determine the suitability of directors. Yet with a stroke of the pen, that authority has been removed, at least with respect to nominees that qualify under the access rule.

Delaware has, in the last two decades, done a yeoman's job in minimizing board duties and eviscerating shareholder rights. While a Van Gorkom or Unocal was possible in the 1980s, Disney and other similar cases show that this is no longer the case. Delaware may have always has a pro-management approach to corporate law, but cases such as Citigroup, Selectica, and Axcelis, suggest that the approach has shifted much further in that direction. The approach is almost singularly responsible for the transfer of governance rights from the states to the federal government.

Thus, Delaware's profligacy has essentially resulted in a loss of authority for the other 49 states. Nor is there any hint that the process will slow.

August 26, 2010
Proxy Access Forum: Christopher Bruner
by Erik Gerding

Here is another contribution to our forum on the SEC's new proxy access rules, this time from Christopher Bruner (Washington & Lee University School of Law). Professor Bruner writes the following:

Many thanks to Erik for organizing this forum, and for the invitation to share some initial reactions to the SEC's new proxy access rule.

By now most everyone will be broadly aware of the general contours of the new rule (summarized by Lisa here). Rule 14a-11 will, under certain circumstances, permit shareholders or groups holding three percent voting power for three years to include in the company's proxy their own nominees for up to 25 percent of the board (or a nominee for one seat, whichever is greater). At the same time the SEC amended Rule 14a-8(i)(8) in order to facilitate shareholder proposals relating to nomination procedures. Critically, the new proxy access framework is effectively mandatory, permitting states or companies to opt out only by literally prohibiting shareholder nominations.

In this post I'll focus my comments on aspects of the purported rationale set out in the SEC's adopting release that I find particularly noteworthy- and singularly unpersuasive. First, proxy access is presented as a response to corporate governance problems precipitating the financial crisis. Second, the specifics of Rule 14a-11 are styled as fully compatible with- and in fact facilitating- exercise of election-related shareholder rights under state law.

In its overview of the amendments (the opening paragraph, in fact), the Commission notes that when it proposed proxy access last year, it "recognized at that time that the financial crisis ... heightened the serious concerns of many shareholders about the accountability and responsiveness of some companies and boards of directors to shareholder interests," raising "questions about whether boards ... were appropriately focused on shareholder interests, and whether boards need to be more accountable for their decisions regarding issues such as compensation structures and risk management" (at 7). Proxy access, it is suggested, "will significantly enhance the confidence of shareholders who link the recent financial crisis to a lack of responsiveness of some boards to shareholder interests" (p. 10).

Offering up proxy access and other forms of shareholder empowerment as a response to corporate governance problems precipitating the financial crisis is absurd. To the extent that excessive risk-taking led to the crisis, reforms like proxy access- aiming to empower the corporate constituency whose incentives are most skewed toward greater risk- simply don't add up. As I discuss in a recent paper examining U.S. and U.K. corporate governance crisis responses, the fact that the far greater governance power of U.K. shareholders appears to have done little to mitigate the (very similar) crisis over there ought to give pause to those suggesting that augmenting shareholder powers will prevent future crises over here. Moreover, even if shareholder empowerment made sense in financial firms, it remains unclear why this would justify altering the balance of power between boards and shareholders across the universe of public companies. Perhaps recognizing the weakness of the crisis rationale, the SEC places it in the shareholders' mouths by styling it a matter of investor confidence. But this doesn't alter the flaws in the argument itself.

The claim that mandatory federal proxy access merely "facilitate[s] shareholders' traditional state law rights to nominate and elect directors"- as the SEC states in the opening sentence of its overview and reiterates throughout- is equally difficult to accept. Observing that the two predominant models for state corporate law (Delaware, and the Model Business Corporation Act) already permit the adoption of proxy access procedures, the Commission proceeds to ground its mandatory rule in the perceived shortcomings of state law- for example, the lack of clarity regarding the competing bylaw authority of boards and shareholders (at 15, 326-27). The SEC seeks not to "facilitate" state law, but to improve it, as it subtly concedes in its cost-benefit analysis:

Because state law provides shareholders with the right to nominate and elect directors to ensure that boards remain accountable to shareholders and to mitigate the agency problems associated with the separation of ownership from control, facilitating shareholders' exercise of these rights may have the potential of improving board accountability and efficiency and increasing shareholder value. (at 328-29)

In permitting states and companies to dissent from this view only through literal elimination of shareholder nominations, the SEC effectively says that shareholder nominations in public companies work our way, or not at all- a near-total federalization of a process pretty close to the heart of corporate governance, which cannot coherently be described as merely facilitating state law.

So what is actually going on here? Ironically, perhaps the most illuminating part of this 451-page release is a two-paragraph section titled "Our Role in the Proxy Process" (at 22-23), which can be succinctly paraphrased: Congress said so. See Dodd-Frank 971. (Though stated permissively, it is not unreasonable for the SEC to have read "may" as "shall" given the political climate from which Dodd-Frank emerged.) Hence the question becomes why Congress said so- there being no doubt, of course, that Congress possesses ample constitutional authority to federalize corporate governance as and when it likes.

As I have argued at some length, U.S. corporate law- including in Delaware- has long been deeply ambivalent regarding the shareholders' role in corporate governance and the degree to which corporate activity ought to prioritize their interests. This posture is evident, for example, in their inability to remove directors from a staggered board other than for cause; inability to initiate fundamental actions or to accept hostile tender offers without interference (not to mention board latitude to consider the interests of other constituencies); the lack of clarity regarding the shareholders' bylaw authority; and even a somewhat murky statement of fiduciary duties owed simultaneously "to the corporation and its stockholders." This ambivalence stands out quite starkly in contrast with U.K. company law, which by statute clearly defines the purpose of the corporation as being to promote the shareholders' interests, and which favors shareholders with extraordinary governance powers.

The critical difference, in my view, lies in the fact that we in the United States have historically relied on public corporations to pull substantially more weight- notably including the provision of social welfare protections (such as health and retirement benefits) often provided directly by the state in other countries- which has resulted in far greater political pressure being brought to bear on U.S. corporate governance to accommodate non-shareholders' interests (e.g. in hostile takeovers). The result has been two different forms of political equilibrium (in dispersed ownership systems, anyway)- one featuring stronger shareholder governance rights and stronger external social welfare protections (the U.K.), and the other featuring weaker shareholder governance rights and weaker external social welfare protections (the U.S.).

It is through this lens that U.S. shareholder empowerment initiatives following the crisis- including proxy access- truly start to come into focus. As I suggest in the recent paper noted above, post-crisis shareholder empowerment initiatives reflect a populist backlash against managers, fueled in part by middle-class anger and fear in an unstable social welfare environment.

While I do not claim that the two necessarily go hand-in-hand in all instances, it is quite telling that U.S. responses to the recent crisis have included both stronger shareholder governance rights, and stronger external social welfare protections (notably healthcare reform), suggesting a larger shift toward a different form of social welfare equilibrium. These seemingly unrelated initiatives similarly draw strength from the same constellation of middle-class social concerns- growing fears regarding the availability of healthcare and other benefits following job loss, and the safety of savings for education and retirement. This has tended to align "employee" and "shareholder" interests following the recent crisis, resulting in the defeat of "management" in popular politics, in much the same way that hostile takeovers in the 1980s tended to align "employee" and "management" interests, resulting in the defeat of "shareholders" in popular politics.

All of this suggests that what we're seeing here is much bigger than the SEC's rulemaking, and driven by factors considerably more wide-ranging and complex than debates about the merits of shareholder activism tend to suggest. The SEC has created a proxy access regime because Congress, responding to the national political climate, said so- and facilitating state corporate law most certainly did not loom large in that decision.

August 26, 2010
Proxy Access Forum: Brett McDonnell
by Brett McDonnell

I have mixed feelings about the new proxy access rules. The new rules change both the default rule and the altering rule for proxy access. Essentially, I like the default rules pretty well, but hate the altering rule.

Until yesterday, the default rule (except for North Dakota corporations) was no proxy access. Now the default rule is that shareholders who have owned 3% of a corporation's shares for at least 3 years can nominate candidates for up to 25% of the board seats using the corporate proxy. As I explain at length in my forthcoming article, it makes more sense to have some degree of access as the default. In part that's because access gives some real meaning to board elections as an accountability device, and board elections are one of the most plausible and easy to defend accountability devices available. In part it's because a pro-access default reduces the transaction costs for companies who want to tailor their own rules. So long as the altering rule is flexible (see next paragraph), if the default rule allows access but you want no access, that is an easy rule to write. Or, if you like the default rule in most respects but want to change one or two dimensions, that is easy to do as well. But if the default is no access, opting in to a pro-access rule is complicated. There are a lot of moving parts in an access rule-see the SEC's rules. Putting all that into the bylaws, and perhaps up for a shareholder vote, is complicated and hard to read. (Imagine a shareholder proposal creating a proxy access regime from scratch-how would you do that within the 500 word limit?) Best to have a detailed, well-known template as the default, and then let companies write around that if they so choose. I'm rather worried that the 3%/3 year combination rules out too many shareholders, but I think those levels are at least plausible guesses as to the best levels for most companies.

Where I disagree is the altering rule. Altering rules specify whether and how a company may opt out of the default rule. In the SEC's new system, companies may choose to adopt more generous proxy access rules, but they can't adopt less generous rules or opt out completely. That's too inflexible. I think the SEC's default rules are a good guess, but they may be wrong, either for most companies or at least for some. If a majority of shareholders think the rules should be more stingy, why not let them choose more stingy rules? If we trust shareholders to choose among competing slates of nominees, why not trust them to choose the best proxy access regime?

The SEC's response is that access is a right, and we shouldn't let a majority of shareholders vote to deny rights to all shareholders. That's not very persuasive. If this is an individual shareholder right, why limit it as strictly as the 3%/3 year rules do? The vast majority of shareholders are effectively denied this supposed right under the SEC's rule. The answer is that the rule balances competing considerations to arrive at a result that is likely to lead to the most efficient governance system. But that's not about rights at all, it's about effective governance. And the SEC may be wrong about that balance in general or for specific companies. If a company's shareholders think the SEC has got the balance wrong, they should be able to correct it.

Is this a step forward overall? I hope so, but I'm not sure. I suspect this is not the last word from the SEC on this subject. There's a lot right here, and what is wrong is pretty easy to fix. I hope that a future Commission will choose to fix it.

August 26, 2010
Access and the Commission: Shifting the Burden to State Law
by J Robert Brown Jr.

It's always been an anomaly that those opposing access often labeled it as inconsistent with state law. State law allows any shareholder, irrespective of the number of shares owned, to nominate directors. In public companies, shareholders did not exercise the authority because of the costs associated with the proxy process. Access reduces the costs.

Because shareholders did not nominate directors as a result of the federal proxy rules, state authorities never seriously considered restrictions on the right of shareholders to nominate directors. Access, however, has flipped the issue back to the states. The Commission has made it clear that nominees can be excluded where the shareholder is prohibited under state law. To the extent, for example, Delaware wants to limit the right of shareholders to nominate (by, say, imposing an ownership threshold), it will have to do so explicitly. It can no longer rely on federal law and the expenses associated with the proxy process to accomplish the same purpose.

Delaware has shown an amazing ability to respond quickly to developments disliked by management through legislative initiatives. It will be interesting to see whether the legislature responds by amending the Delaware code to allow companies, in their foundational documents, to restrict the ability to nominate directors based upon ownership thresholds and holding periods.

View today's posts

8/27/2010 posts

BD Law Blog- by Georgia Securities Lawyer Joel Beck: Update Published on Best Practices for Serving Seniors
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Canadian Decision Provides Road Map for a Dual-Class Collapse
Race to the Bottom: City of Westland Police v. Axcelis: The Erosion of the Credible Evidence Standard (Unfounded Rejection of the Blasius Standard) Blog: Survey: Few US Companies Well Prepared for Say-on-Pay
Conglomerate: Proxy Access Forum: Proxy Access and Director Independence
Conglomerate: Proxy Access Forum: The Weirdo Shareholder Problem
Truth on the Market: Proxy Access: Congrats to Prof. Bebchuk, & It's Time to Implement My Defenses
D & O Diary: Do Defendant Companies Financially Underperform Following Securities Lawsuit Settlements?
SEC Actions Blog: This Week In Securities Litigation (August 27, 2010)
Conglomerate: Proxy Access Forum: J.W. Verret (George Mason Law School)
Truth on the Market: To Slice or Not To Slice; a Taxing Question
Truth on the Market: Deception and "Tells" in Business in Poker
Race to the Bottom: The Commission and Access: Places Where the Lack of Unanimity on the Commission Strengthened Access
Securities Law Prof Blog: Raymond James Pays $3.5 Million to ARS Purchasers in Arbitrations
Conglomerate: Proxy Access Forum: Eric Talley (UC Berkeley)
Race to the Bottom: The Commisson and Access: Preempting State Law
Conglomerate: Proxy Access Forum: Christopher Bruner
Conglomerate: Proxy Access Forum: Brett McDonnell
Race to the Bottom: Access and the Commission: Shifting the Burden to State Law

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