When SOX was adopted, it engendered a fusillade criticism, with opponents focusing on everything from the need for independent audit committees to the separation of accounting and consulting functions.  Or, as Roberto Romano so colorfully labeled, SOX was "quack corporate governance."  Much of the criticism was poorly reasoned, based upon incomplete or faulty data, and shrill.  My paper, Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance, chronicled much of this phenomena.

One of the early claims was that SOX would damage public equity markets.  Companies were fleeing SOX and taking their IPOs overseas.  Companies would rather sell out to private equity or "go dark" rather than confront the costs and risks of SOX.  These claims have, in general, been shown to be inaccurate or overstated, sometimes after an examination of the empirical evidence and sometimes after watching the market.  The anecdotal evidence likewise suggests a contrary interpretation. 

Purveyors of private equity were among the loudest to decry the impact of SOX.  The Blackstone Group did this.  Henry Kravis at KKR was more balanced, viewing SOX as a benefit for shareholders, but still finding reason for concern:  

• "One consequence, however, is that they are also being more conservative and risk averse. An enormous time is spent on legal process by the board, rather than pushing innovative ideas. Sometimes this is to the long-term detriment of the business. It is easier to say “no” to risk and play it safe than it is to examine the risk closely to determine if it is the right decision for the business. To the extent that Sarbanes Oxley causes public companies to be less competitive, there is an opportunity for the private equity industry in taking these businesses private and putting some energy back into growing them."

The attention has shifted lately to "excessive litigation," with the Chamber putting out a report that continues to make these claims (but at least doesn't blame SOX).  We will discuss the report later. 

At this point, what we note is that the criticism is belied by the private equity funds themselves.  Published reports have indicated that KKR, like Blackstone, will go public, something that will subject KKR to the full rigors of SOX and other regulatory requirements for public companies.   According to the article, KKR has, in fact, been publicizing the corporate governance changes that will come with public ownership.

• The coming IPO is in some ways designed as an antidote to its secretive and hardball-playing image by highlighting the firm's "best practices" of corporate governance and employee compensation. On the coming "road show" to present the transaction to potential investors, KKR is expected to emphasize how the new KKR will push the company's management into deeper alignment with shareholders. By buying back the KPE stake (which is itself just a vehicle for existing KKR investments) the executives will only be adding their exposure to KKR deals.

Whatever the costs of SOX, they were not great enough to discourage these scions of capitalism from going public.  Moreover, with cheap borrowing in decline, public capital will look a lot more reasonable.  Look for a return of the equity markets.  And, remember, it was SOX that at least in part gave investors the confidence to remain active in the markets, contributing to the success of public offerings like those by Blackstone and KKR. 

On this Blog, we usually stick to matters of corporate governance. Nonetheless, with the Democratic National Convention about to descend on our fair city, we feel compelled to note a conference being held by the Univesity of Denver Sturm College of Law called the "Obama Phenomena: Facets of a Historic Campaign."

It is a day long event and will be held on Aug. 29. The conference will examine the cultural wave that has lifted Obama from first-term senator to the first African-American major-party presidential nominee. A diverse, intergenerational collection of scholars will examine the meaning of Obama’s candidacy, looking at aspects including race, gender, and religion. In addition, panels will discuss the changing nature of campaign organization and Obama’s potential impact on affirmative action law, election law and U.S. foreign policy.

Harvard law professor and controversial author Randall Kennedy will deliver the keynote address at 12:30 p.m., “Barack Obama and the Optimistic Tradition in American Racial Commentary.”

Other panels, beginning at 8:30 a.m., include: “From Domain Names to Video Games: The Rise of the Internet in Presidential Politics;” “Obama’s Strategies, Changing the Status Quo;” “Race and the Obama Phenomenon: Change We Can Build On;” and “Predicting the Supreme Court in an Obama or McCain Presidency.”

Scholars from universities in at least 13 states are expected to descend on DU for the event, which offers fertile ground for journalists seeking commentary and analysis of a news-filled four days in Denver. A full schedule of topics and list of experts scheduled to attend is online at http://www.law.du.edu/index.php/obama-phenomena

We have discussed before about the gradual disappearance of independent investment banking firms.  With the repeal Glass Steagall back in the 1990s, the day of investment banking firms not owned by commercial banks are increasingly numbered.  Why?  Because commercial banks have natural advantages, including lower cost funding sources and the perceived safety of the Federal Reserve Board.  The topic can (and the prediction) can be examined in greater detail in the piece, The "Great Fall": The Consequences of Repealing the Glass-Steagall Act. 

Let us recap.  At the beginning of this financial crisis, there were six, Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Bear Stearns, Morgan Stanley, and Lehman Brothers.  Bear Stearns is gone, absorbed by JP Morgan.  Merrill considered offering itself to Wachovia, although ultimately the board stopped the overtures.  The death watch is focused on Lehman, the smallest of the survivors.  The WSJ has indicated that the market is girding for an announcement from the diminutive firm that it will have losses for the quarter of $1.8 billion, with the total for the year exceeding profists in fiscal 2007.  The article indicated that, if the losses continue, Lehman may need additional capital. 

The firm has so far managed to raise sufficient capital and stave off a Bear Stearns type run.  At the same time, however, the market will not, indefinitely, be so forgiving.  If that occurs, Lehman may find itself in bankruptcy or being purchased by a better capitalized savior.  The most likely acquisition candidate?  A large commercial bank, although finding one not so embroiled in the subprime problem that can absorb the investment bank is not easy.  Whatever number survives this current financial downturn and remains independent, it is only a matter of time before that independence is lost.   

We are discussing the recent case, Ryan v. Lyondell Chemical.  In that case, the Delaware Chancery court found that the plaintiffs had alleged sufficient facts that the board violated its duties under Revlon to overcome a motion for summary judgment.  

The opinion is 73 pages long and, on the whole, managed to avoid casting aspersions at the plaintiffs, not always the case in Delaware.  Unfortunately, VC Noble couldn't stop himself.  In describring the allegations of incomplete disclosure, he noted in the opinion that most fell "woefully short of the mark."  Fair enough.  But the accompanying footnote noted the following:

• Merely rifling through the proxy statement and nitpicking undisclosed, marginally important details, as Ryan has done here (i.e. bullet point argument), without sponsoring specific reasons to support the materiality of the undisclosed information will not suffice to state a cognizable disclosure claim.  

The opinion addressed the matter in blunt language.  What did it add to accuse the plaintiffs of "nitpicking" or focusing on "marginally important details?"  Indeed, had the opinion been issued without the footnote, no legal principal would have been neglected or important point missed.  It was merely an opportunity to use pejorative language, once again in describing the role of plaintiffs. 

As usual, the opinion and some of the operative documents are on file at the DU Corporate Governance web site.  A number of the pleadings are, however, under seal.

The Delaware courts have relied on independent directors as a mechanism for insulating managerial behavior from judicial review. Conflicts of interest approved by independent directors are reviewed not under the duty of loyalty but the almost impossible to overcome business judgment rule. A board with a majority of independent directors will typically defeat a claim for demand excusal.

The approach might be appropriate, minimizing the role of courts in the governance process, were the Delaware courts to interpret the standards in any meaningful way. But, of course, the courts do not. Director independence is a charade. Courts largely ignore friendships, don't take into account fees, even where extraordinary, and impose excessively high pleading standards that prevent plaintiffs from exploring the issue even when they present evidence indicating a possible disqualifying relationship. All of this is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

All of this brings us to Ryan v. Lyondell Chemical Co., a Delaware decision issued on July 29 and one that has generated considerable controversy/commentary.  The opinion essentially found that, on a motion for summary judgment, sufficient evidence existed that the board violated its duties under Revlon in selling the company. It's an interesting opinion because, Van Gorkom-like, the acquirer agreed to pay a substantial premium over market and, non-Van Gorkom-like, the company obtained a fairness opinion to assist in justifying the opinion.

The case is wrongly decided but not for the standard reasons.  This is a case that clearly implicates duty of loyalty provisions with a board entirely interested in the outcome of the transaction.  The court disposed of the duty of loyalty arguments with weak analysis.  The court viewed the process as flawed but did not want to give additional life to conflict of interest challenges to the board. 

In challenging the approval of the merger, plaintiff alleged that the board had an interest in the outcome of the transaction and therefore the merger ought to be examined under the duty of loyalty. Mind you, a finding for the plaintiff would not automatically result in liability, only that the board have an obligation to show that the transaction was fair. In alleging a conflict of interest, plaintiff asserted that the transaction resulted in the acceleration of all options. Moreover, the complaint alleged that options could be surrendered, with the holder paid the spread on the difference between the option exercise price and the merger price. Finally, the complaint included a table that showed the cash payouts to the board as a result of the merger. How much of a payout? The amounts ranged from $233,000 to $3.75 million.

• In his brief opposing summary judgment, Ryan further asserted that the financial benefits accruing to the Lyondell directors were “much more beneficial than what the average shareholder [would] receive.” This contention apparently flows from the fact that the Independent Directors were entitled to have their stock options vested and cashed out in connection with the Merger as opposed to waiting for those benefits to accrue over a longer term if Lyondell remained independent.

The court called the contentions "bald allegations" and accused Ryan of presenting a "paucity of facts" to support the contention of improper interest. Why exactly was the approval of a transaction that resulted in huge payments to the board not an example of self interest?  As usual, the Delaware court engaged in simplistic reasoning that largely sidestepped the key issue.

The court first noted that the "vesting of stock options in connection with a merger does not create a per se impermissible interest in the transaction." But of course no one was making an argument that vesting was per se disqualifying. In order to constitute self interest sufficient to trigger the duty of loyalty, there had to be a material financial interest. Only if the accelerated vesting triggered this type of payment would the duty of loyalty be applicable. 

But try to find any discussion in the opinion of the materiality of the payment.  Its not there because had the court focused on that factor, it would have had to conclude that in fact a majority of the board was interested.  Instead, the court noted that if accelerated vesting would result in a conflict of interest, "directors would be faced with a proverbial Catch-22 requiring them either to forego the options (a rightfully earned component of their compensation) or to accept their rightfully earned compensation and risk a breach of their duty of loyalty. Such an irrational system would deprive the board of a strong incentive to maximize value."  In other words, the court suggested that all directors would be disqualified as a result of acceleration.

This simply isn't true. First, some directors may not have unvested options. Second, only those receiving a material payment would be disqualified. In other words, there are likely to be other directors on the board who can participate on a special committee and resolve the benefits of the merger offer. Thus, the directors are not subject to a Catch-22 that requires them to forgo the options or risk a violation of the duty of loyalty.  Third, even if the Catch-22 existed, it was a byproduct of a circumstance created by the board.  Supposedly, under Delaware law, directors must be able to make decisions in a neutral fashion, free of extraneous considerations. The fact that directors know they may receive payments of millions of dollars if they accelerated the options and approved the merger cannot, in any objective calculus, be viewed as an irrelevant factor when considering the merger. Yet the court entirely ignored the issue, much the same way courts ingore the issue of directors fees in determing conflict of interests.
 

Apparently aware of this, the court provided a second rational for ignoring the payments pursuant to the accelerated options.  There was no conflict of interest because the directors received the same benefits as the other shareholders. It is true that as shareholders, the directors were treated identically.  But the case wasn't about their treatment as shareholders, but as option holders.  And, as option holders, they received a unique benefit through acceleration.  The court tried to sidestep this by noting that "[w]here, as here, the options vesting in connection with a merger were awarded as part of an established compensation plan, the accelerated vesting does not confer a special benefit upon the directors."  The comment was disingenuous.  The case had nothing to do with the issuance of the options.  It was about the uniqure benefit that came with acceleration and that came, not at the time of issuance, but at the time of the approval of the merger. 

The case, therefore, managed to find a merger that allowed directors to accelerate their benefits and receive millions in payments did not result in a disqualifying financial relationship. Only in Delaware.

As usual, the opinion and some of the operative documents are on file at the DU Corporate Governance web site. A number of the pleadings are, however, under seal.

With Paulson suddenly promoting massive government intervention to save the housing market, we haven't been hearing much about deregulatory measures such as repeal of SOX. At the height of the anti-SOX fervor, some of the evidence marshaled to show the damage from the act included an ostensible decline in the number of foreign companies cross listing in the United States. Data showed that companies still obtained a cross listing premium if they listed in the US. Moreover, the NYSE and Nasdaq were more than holding their own in the listing battle with the London Stock Exchange.

It was, however, a different story with respect to the Alternative Investment Market or AIM. AIM essentially allowed small, often illiquid, companies to list without meeting any significant listing requirements. Most of the companies would be too small to list in the United States. Moreover, they are attracted to the London market at least in part by the regulatory lite approach of government regulators. In other words, the market consisted primarily of companies that couldn't list in the US because they were too small and wouldn't list in the US because they preferred to operate in a less transparent, less regulated enviornment.

With that in mind, we the latest study on AIM brought to our attention from our friends at Corporate Governance. PriceWaterhouse just put out a study on corporate governance standards on AIM and the results weren't pretty. The study concluded that companies on the whole had very low corporate governance standards. As the study noted:

• This survey shows that the composition of the Board is a particular area of weakness for many AIM companies. The need for strong independent non-executive director representation on the board appears to be something many AIM companies have yet to recognise. Perhaps linked to this, is the fact that only a fi fth of the AIM Top 100 reported that they had assessed their Board effectiveness. This fell to only 5% of the smallest AIM companies in our sample.

• It remains to be seen whether the current voluntary approach to governance is a sustainable model for AIM, especially when the evidence of this survey shows a relatively limited application of best governance practices, across all segments of the market. The challenge for every business is to get ahead of it’s competition. Simply meeting the minimum level of regulatory requirements is unlikely to satisfy the investor community and other key stakeholders. We believe this is particularly true of AIM with its relatively light regulation.

In other words, more evidence of regulatory lite. Growth in the number of listings does not necessary equate with investor protection or confidence.

The DC Circuit has been sitting on the PCAOB case since last April (oral argument was on April 15).   It's our understanding that the court tries to issue opinions for the prior term by August 1.  Obviously, that deadline hasn't been met.  We also understand that the court usually issues opinions on Tuesdays and Fridays at 11:00 am.  To the extent that the opinion comes out this month, we are looking at August 15, 19, 22, 26 or 29. 

It is potentially a complicated case which might explain the delay.  The more likely explanation is a divided panel. 

Self regulation predates the adoption of the securities laws and has long been a component of the system of oversight for the capital markets.  There has always been problems with the approach, most noticeably concerns over adequate enforcement.  Particularly with respect to the exchanges, there has been the potential of capture by the industry being regulated and the possibility that requirements designed to protect investors would remain unenforced.  The SEC's actions against the the Boston Stock Exchange for failing to police the activities of the specialists is a good example.

The problems have only been exacerbated in recent years.  Nasdaq and the NYSE have tranformed into "for profit" organizations.  As a result, they have the additional burden of profit maximization, something that did not exist before.  Profit maximization and strong enforcement do not always go hand in hand.  As a result of this change, pressure has already been brought to bear to weaken aspects of exchange behavior designed to protect investors. 

The NYSE reduced its regulatory role when it transferred broker-dealer oversight to FINRA.  Nonetheless, the exchanges retain two important regulatory aspects.  They retain the authority to write and enforce listing standards.  In addition, they retain market surveillance functions.

The Commission recently took steps to centralize the monitoring function.  In Exchange Act Release No. 58350 (August 13, 2008), it approved a plan to centralize "surveillance, investigation, and enforcement of common insider trading rules" in the hands of the NYSE and FINRA.  The NYSE gets responsibility for companies traded on its exchange, all the rest fall to FINRA.  In short, this approach removes surveillance functions from all other exchanges, including Nasdaq and the Amex.  All of the participating entities have entered into a cost sharing arrangement and have agreed to meet periodically "to discuss the conduct of regulatory responsibilities, identify issue or concerns, and receive and review reports." 

There are several interesting observations to make about this approach.  Centralization has its benefits, including the concentration of resources and improved expertise.  But of great interest, the SEC has effectively removed most of the surveillance function from entities that operate on a for profit basis, having transferred much of the surveillance function to FINRA, a private, non-profit organization.  That leaves Nasdaq and the Amex with little more than enforcement of listing standards as the exclusive regulatory function.

The NYSE becomes the only "for profit" organization to continue to have surveillance functions.  In any for profit organization, pressure always exists to cut overhead (and increase profits), with surveillance falling into the overhead category.  It may well be the case that the NYSE will eventually give up the surveillance function, allowing FINRA to do all of it.  This is in fact what happened with broker-dealer oversight, a function already moved from the NYSE to FINRA.

This will leave the "for profit" exchanges with one primary regulatory function, the drafting and enforcement of listing standards.  This is another area that may suffer in a "for profit" environment.

In the veritable race to the bottom, Delaware controls the corporate law of most public companies.  The state, including the courts, has developed a law that is decidedly anti-shareholder in approach.  We will explore this topic later this week or early next with a discussion of a recent case out of Delaware. 

One of the interesting experiments to counter this trend has been the decision by North Dakota to adopt the Publicly Traded Corporations Act.  For companies that incorporate under the Act, shareholders have greater rights.  Moreover, the Act limits the discretion of the board in some circumstances, particularly those concerning poison pills.  We have posted on this law. 

As we have noted, shareholders benefit from incorporating under the law.  It is management, however, that ultimately must decide whether to reincorporate in a state and management has few if any incentives to reincorporate in a state that takes away some of its discretion and authority.  The only hope for shareholders is to adopt a shareholder proposal under Rule 14a-8 calling on management to reincorporate under the law.  We have noted this possibility before.  Moreover, the staff at the Commission have declined to authorize the omission of these proposals.

With that in mind, we note the report at RiskMetrics about the first shareholder proposal seeking reincorporation in North Dakota.  The proposal was submitted to The Hain Celestial Group.  As RiskMetrics notes, these types of proposals have received solid support in the past.  The most recent spate of reincorporation proposals, however, were designed to move a company to a jurisdiction where majority voting was permitted.  This is an entirely different matter.  It is not likely to pass but a strong showing will perhaps let management of public companies know that they should consider more seriously expanding shareholder rights. 

The topic of corporate governance does not play a large role in the proposed democratic platform published last week.  Nonetheless, there was some discussion of regulatory reform, most of it bland and vague.  But at the end of the one operative paragraph was a specific mention of say on pay.  According to the draft platform:

• Reforming Financial Regulation and Corporate Governance.  We have failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practices. We have let the special interests put their thumbs on the economic scales. We do not believe that government should stand in the way of innovation, or turn back the clock to an older era of regulation. But we do believe that government has a role to play in advancing our common prosperity: by providing stable macroeconomic and financial conditions for sustained growth; by demanding transparency; and by ensuring fair competition in the marketplace. We will reform and modernize our regulatory structures and will work to promote a shift in the cultures of our financial institutions and our regulatory agencies. We will ensure shareholders have an advisory vote on executive compensation, in order to spur increased transparency and public debate over pay packages.  (emphasis added)
  

In other words, the election of a democratic administration will result in a promise to implement say on pay, federal preemption of an area of governance historically left to the states.  Why?  Because the Delaware courts refuse to impose any meaningful standards when it comes to the review of executive compensation, relying entirely on procedural mechanisms that are largely unenforced (primarily reliance on "independent" director approval).  Had there been meaningful state law standards, the say on pay initiative would not be part of a major party's presidential platform. 

The reply briefs have been filed in the CSX case and can be found on the DU Corporate Governance web site.

When this Blog began some twenty or so months ago (for a history of its foundation, go here), a central purpose was to write about Sarbanes Oxley and the benefits (as well as the problems) flowing from the law.  It was meant at least in part to offset what was a concentrated attack on the law by those who did not like the provisions or the way it was enacted.  These views were largely addressed in my piece, Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance. The criticism has largely died down, with most (but not all as Larry Ribstein reminds us from time to time) recognizing the largely beneficial nature of the changes.  Moreover, new data points in a positive direction.

In that regard, the NYT discussed a new study done by Professors Doidge, Karolyi and Stultz (from Ontario and Ohio State respectively) on why some foreign firms have decamped from the US to determine what role if any that SOX played in the process.  It is not, by the way, the first time that we have had an opportunity on this Blog to discuss their work.   As the abstract to the paper concludes:

• We find that these firms experienced significantly slower growth and lower stock returns than other U.S. exchange-listed foreign firms in the years preceding the decision. There is weak evidence that firms experience negative stock returns when they announce deregistration and stronger evidence that the stock-price reaction is worse for firms with higher growth. When we examine stock-price reactions around events associated with the passage of the Sarbanes-Oxley Act (SOX), we find negative average stock-price reactions with some specifications but not others. Further, there is no evidence that deregistering firms were affected more negatively by SOX than foreign-listed firms that did not deregister. Our evidence supports the hypothesis that foreign firms list shares in the U.S. in order to raise capital at the lowest possible cost to finance growth opportunities and that, when those opportunities disappear, a listing becomes less valuable to corporate insiders so that firms are more likely to deregister and go home.

The study includes only 59 companies but the conclusions are common sense.  Companies leave the United States not because of SOX (or, frankly because of the risk of litigation) but because the capital raising advantages to a listing in the United States are no longer present.  In other words, the decision to list in the US or to delist from the US is based on economics, not inchoate fears about liability or concerns about the regulation of corporate governance.  

 

When does social responsibility and profit maximization converge?  At Chipotle, the burrito manufacturer headquartered in Denver.  The first Chipotle opened 15 years ago.  Since then, the chain has grown to 778 stores with sales of $1.1 billion.  With Bennigans in bankruptcy and others skirting financial disaster, Chipotle stands out as a raging success. 

Why? 

Needless to say they make a good product.  But that's not the whole story.  As we have discussed, they emphasize health (using organic ingredients), local produce (striving to buy 25% locally), and animal care (the meat is free range).  In other words, eating a burrito is more than eating a burrito.  Its promoting local farmers and helping to ensure adequate care of animals. 

Now we can add one more.  Anyone who goes to the same store on a regular basis notices that there is incredible stability in the employees who work there.  In my Chipotle (seventh and Colorado in Denver), I am recognized every time I go in.  It adds to the experience without any doubt.  One suspects that Chipotle must treat its workers reasonably well to engender the apparently low lever of worker turmoil.  A recent article in the Rocky Mountain News confirms this.  According to the paper,   

• Many of the store management employees who have stuck with Chipotle since the early days have benefited as well - Chipotle offers a two-month paid sabbatical after 10 years of service, and a company car for all restaurant managers who have been with Chipotle at least four years.
• There's also the potential for a stock option payoff. Chipotle distributed 774,150 shares among salaried employees ahead of its January 2006 IPO, with 456,150 going to nonexecutive employees like store managers, according to filings with the Securities and Exchange Commission. Under terms of the grant, recipients can't exercise their options until early 2009

Treating employees well.  That is another reason why the burritos at Chipotle taste just a little better. 

We occasionally delve on this Blog into topics relating to social responsibility.  Much of our analysis involves the relationship between social responsibility and profit maximization.

The importance of social responsibility can be seen with particular clarity in the mutual fund area.  Socially responsible funds (SRIs) attract investors by promising to engage in socially responsible investing (with the phrase individually defined by each fund).  The usual notion is that investors agree to accept a reduced return but are promised an investment portfolio that meets certain socially responsible criteria.  And, in fact, as a group, the SRIs underpeform other mutual funds.  See Consumer Reports, Principles v. Performance, May 2008 ("And our analysis bore this out: In the past five years, SRI funds returned 11.1 percent annually, while all domestic equity funds returned 14.5 percent . . . . And only 15 percent of SRI funds with a five-year track record returned more than that."), and typically have a higher expense ratio.  While there are exceptions, therefore, investors as a group essentially pay for the costs of socially responsible investing.

As a result, a fund that promises to engage in socially responsible investing but reneges on the promise is doing more than merely violating a policy.  This issue came up in connection with the SEC's recent action against Pax World Management.  In Pax World Management, Investment Company Act No. 38344 (admin proc July 30, 2008), the Commission issued a cease and desist order (and imposed a civil penalty of $500,000) against a fund that violated its socially responsible criteria.  As the Commission found:

• At all relevant times, investment adviser Pax World represented to investors and to the boards of the mutual funds it advised (the "Pax World Funds" or the "Funds") that it complied with various "socially responsible investing" ("SRI") restrictions, including, among other things, that it would not purchase for the Funds securities issued by companies that derived revenue from the manufacture of weapons, alcohol, tobacco or gambling products. Pax World acted contrary to these representations and violated the Funds' SRI restrictions from 2001 through 2005 when it purchased for the Pax World Growth and High Yield Funds ten securities that these Funds' SRI restrictions prohibited them from buying, including securities of companies that: (1) derived revenue from the manufacture of alcohol and/or gambling products; (2) derived more than 5% of their revenue from contracts with the U.S. Department of Defense; and (3) failed to satisfy the Funds' environmental or labor standards. During this period, Pax World also failed to consistently follow its own SRI-related policies and procedures with respect to these two funds that required that all securities be screened by Pax World's Social Research Department prior to purchase to ensure compliance with the SRI disclosures. In addition, during this period, Pax World did not consistently adhere to other SRI-related policies and procedures, including continuously monitoring fund holdings. As a result of conduct during the period from 2001 through 2005, the Pax World Funds held at least one prohibited security at all times from 2001 through early 2006.
  

In addition to purchasing securities that violated the socially responsible criteria, Pax World committed to "continuously" monitor fund portfolios for compliance with the policies.  The Commission found that Pax World had "no policy or procedure for continuously monitoring the portfolios until 2004."  And, when the policy was adopted, "the Company did not consistently comply with this policy."  The advisor also, in at least some cases, failed to disclose information about the noncompliance to the board of directors of the respective funds.  The Commission found a violation of Section 206(2) of the Advisers Act (prohibiting an adviser from engaging in "any transaction, practice, or course of business which operates as a fraud or deceit upon any client").

Several things ought to be noted.  First, the Commission brought an administrative proceeding, not an injunctive proceeding.  The difference is significant both in appearance (a court order is perceived to be a more severe sanction) and in practice (court orders are enforceable through contempt, administrative proceedings are not).  Second, the Commission issued a cease and desist order for violations of Section 206 of the Advisers Act.  There is no private right of action for a violation of the section.  See Frank Russell Co. v. Wellington Mgmt. Co., 154 F.3d 97  (3rd Cir. 1998).  At the same time, the Commission did not bring an action for violating Rule 10b-5 even though the language of the two sections is largely identical.  

It's not quite right to call this action a slap on the wrist.  For any reputable adviser (and Pax World is), an enforcement proceeding of any kind by the Commission is damaging, particularly to reputation.  And, as the Commission noted, Pax World engaged in significant remedial acts.  Pax World replaced management, developed new procedures and implemented a new computer softward for SRI compliance.  Nonetheless, the severity of this offense was not recognized in the proceeding.  For the relevant time periods, the particular funds were, in fact, not socially responsible funds.  During the relevant time period, investors accepted the risk of a lower return without the promised consideration, that is that the funds would invest consistently with the stated socially responsible policies.  It sends a terrible message and, in the context of decisions like shareholder access, suggest a low level of importance placed on shareholder rights. 

The SEC brought an administrative proceeding against Mark Thompson for failing to reveal to the boards of public companies where he served as directors that he had a business relationship with the outside auditor that impaired the auditor's independence.  The Commission found that he was a cause of violations of the proxy rules and the periodic reporting requirements, including Rule 14a-9.

We predicted this would occur.  Director independence has become the holy grail of corporate governance.  Shareholders are protected and self serving behavior can be reduced through review by a board that consists primarily of independent directors.  The problem with the approach has been that directors called "independent" often are not.  Neither Delaware nor the stock exchanges has an adequate definition that ensures director independence.  Moreover, even with the existing definition, neither enforces it adequately.  And, because there is no private right of action (so far) for the violation of exchange rules, there is no private enforcement mechanism.

The SEC can't enforce listing standards or state law requirements but it remains concerned with the functioning of the board and the need for director independence.  As discussed at length in The SEC, Corporate Governance, and Shareholder Access to the Board Room, the Commission has attempted to circumvent these limits by requiring companies to disclose their compliance with stock exchange rules on independence.  In other words, incorrectly listing directors as independent will violate the rules of the exchange, which have no meaningful enforcement consequences.  At the same time, however, repeating the false information in a proxy statement or periodic report will violate the securities laws, sometimes even the antifraud provisions.

All of this brings us back to the action against Mark Thompson.  In effect, the Commission sanctioned Thompson for not being independent.  The agency did it by finding that the failure to disclose his relationship with E&Y resulted in disclosure violations under the proxy rules and periodic reporting requirements.  

The case may well be a harbinger of future actions and another example of federal preemption in the area of corporate governance.  In the absence of meaningful enforcement standards under state law, it will be the SEC that ensures directors in fact meet independence standards.  Suits against directors (and disgorgement) will likely have the salutary effect of encouraging better disclosure by directors to the board.  That in turn will force boards to examine conflicts in order to determine whether a director is independent.  The results will be disclosed in SEC filings, with liability for the entire board a risk where the board describes directors as independent who are note.

This is a first step.  The most significant step will be when the SEC charges a company and the board for listing directors as independent who are not.  This will essentially cause the company and the board to play a larger, more careful role in the independence analysis.  Moreover, it will cause directors to realize that the lack of enforcement by the states or stock exchanges no longer provides immunity, that incorrect disclosure will result in sanctions under the federal securities laws. 

The other day, the Commission brought an action against Ernst & Young for violating accountant independent standards.  According to the administrative proceeding, E&Y was paying for services from Mark C. Thompson at the same time Thompson sat on the board of three public companies where E&Y conducted audits (two listed on the NYSE, one on Nasdaq) and, in one case, a a company's audit committee.   According to the WSJ:

• Mr. Thompson began as a director at Best Buy, the Minneapolis-based consumer-electronics retailer, in March 2000, and sat on its audit committee until August 2003. Best Buy secured his resignation in May 2004, after E&Y informed the company about its relationship with Mr. Thompson.

• Mr. Thompson was a director at Korn/Ferry, an executive-search firm based in Los Angeles, from March 2000 until September 2003, and a director of TeleTech Holdings Inc., a Denver technology-consulting firm, from February 2004 until May 2004. Of the three, only Korn/Ferry is still an E&Y client.

As settlement of the case, E&Y among other things had to pay disgorgement of $2,381,965 and prejudgment interest of $537,022.79.

The most interesting thing about the case, however, was that the Commission also charged Thompson.  In a separately settled administrative proceeding, the Commission found that Thompson in filling out his annual D&O questionnaire "did not fully furnish the details of his relationship with E&Y in response to these items."  In addition, as a director, he participated in votes to retain E&Y as outside auditor but, at the time of the vote, "did not disclose his business relationship with E&Y, and the proxy solicitations likewise did not disclose the relationship."   In other words, Thompson, according to the Commission, did not make adequate disclosure of his relationship to E&Y to the companies where he sat as director. 

So what was the charge against Thompson since non-disclosure to a board doesn't per se violate the securities laws?  The Commission concluded that the companies violated the proxy rules and the periodic reporting requirements by filing financial statements from non-independent audit reports and "by recommending E&Y’s retention as auditor without disclosing that one of the directors favoring the recommendation had a business relationship with E&Y."  Thompson was required to disclose $100,662.33 and prejudgment interest of $23,254.94, for a total of $123,917.27.  

This is a ground breaking case and we will offer some observations on it in a post later today.

By now, most are familiar with the report issued by the Justice Department on July 28, 2008 concerning the use of political criteria in hiring civil service level employees in the Justice Department.  The report placed Monica Goodling at the center of the investigation, a 1999 graduate of Regent Law School.  We offer no comment about the particular allegations or the use of improper factors in selecting staff, a subject well beyond the general scope of this Blog.  Nonetheless, there are a few items that nonetheless might be of interest to those reading this Blog.

First, much of the evidence suggesting that administration personnel made improper use of political and other factors in hiring decisions came from emails.  This is increasingly a factor in securities litigation as well.  It is a stark reminder that those writing emails need to apply the New York Times test, that they do not include anything that they wouldn't want on the front page of the New York times.

Second, additional evidence came from Lexis-Nexis.  One of the officials involved (not Monica Goodling) was asked about the use of Internet and Lexis-Nexis searches on various candidates.  When shown a search string, the witness, according to the report, testified that she did not recall ever actually running the search.  As the report noted:  

• Williams’s testimony concerning the Nexis search string she provided to Goodling was also inaccurate. As detailed above, at our interview we showed Williams a copy of the e-mail she sent to Goodling on April 10, 2006, in which Williams provided the Internet search string detailed above. In the text accompanying this search string Williams wrote: “This is the lexis nexis search string that I use for AG appointments.” After reviewing the e-mail, Williams told us that she did not recognize the search string and did not remember sending it to Goodling. She stated that she did not know what she meant when she wrote “AG appointments,” but asserted that it did not include IJs. At the end of the interview, we asked her to review the document again. She reaffirmed that she did not remember ever using the search string on any candidate.  In an e-mail Williams sent the day after the interview, she claimed that she used the search on one candidate for a political position in the Environment and Natural Resources Division (ENRD) and that she deleted from the search “words that I thought were not appropriate . . . taking [out] words like homosexual, religious, and similar social and/or personal ‘buzz words.’”

The task force, however, received information from Lexis-Nexis that apparently contradicted the representations.  The evidence indicated that the "buzz words" were not deleted and that the search was in fact run numerous times.  As the report noted:

• Williams’s explanation is not accurate in several respects. Her claim that she deleted “buzz words” from the single search she acknowledged conducting is contradicted by evidence we received from LexisNexis. That evidence shows that Williams conducted 24 additional searches using the search string, and each time the search included terms such as “homosexual” or the other “buzz words” identified by Williams. (emphasis added)

In other words, searches made on Lexis-Nexis were retrievable and apparently some time after they were made.  The report does not appear to have data about Internet searches.  Nonetheless, it is another example of electronic information that one might think disappears with use but in fact is retrievable.  Another thing to keep in mind when discussing those important corporate governance issues. 

What's going on in the David Stockman case?  Sixteen or so months after the indictment, there is still no trial date and the parties are sweltering in more than 12 million documents.  As for the D&O policy, the fourth and last tier has been exhausted.  That insurance spigot has run dry.

A status conference was held on July 24.  Stockman's team, headed by Elkan Abramowitz (Morvillo, Abramowitz), made the case for delaying the trial selection date.  Abramowitz noted that the case looked to involve more than 12.5 million documents and that although there had been 29 to 32 lawyers reviewing the documents for six months, they had not yet finished examining one third of the materials.  As he noted:

• I would urge you not to fix a trial date today.  We are nowhere near ready to say that we could -- we're ready to try this case.  And even if you arbitrarily put it a year from now, it won't make -- it's not a realistic -- it's not a realistic judgment on your Honor's part.  It wouldn't be, because we're in no position to say that we've got a handle on what we're doing here, so I couldn't -- I really urge you not to do that.
  

The argument convincing, the trial judge did not set the date.  As part of the argument, Abramowitz gave some insight into the defense that he was developing for trial.  

• This is not a standard securities fraud case.  This is an unusual one, not only in the size and scope of the documents, that certainly makes it unusual, but most of the time, cases deal with established fraudulent acts and the defense is, generally, I didn't know about it or I didn't do it.  This case deals more often than not with situations where the facts are there and the facts happened, but where our -- our defense is, there is no crime here, that the accounting principles that are enunciated in the indictment and the accounts re -- the factoring principles that are enunciated in the indictment, the disclosure principles that are dicussed in the indictment and the particular transaction called the Joan Transaction, we -- our defense is those were pefectly legitimate transactions and that the fraud that's alleged is essentially saying that the accounting standards that were used were not the correct ones.

It has also become clear that the concern raised by Solomon Wisenberg (Wisenberg & Wisenberg), counsel for Paul Barnaba, about the burn rate of the D&O insurance has in fact come to fruition.  Abramowitz noted that the issue of reimbursement was "getting to be a very serious problem."  The policies were "going to run out in a matter of weeks; not months, weeks, for all of us."  Wisenberg indicated more specifically that the "fourth and final layer carrier has informed us that -- basically, not to assume there's going to be any money after invoices submitted on July 31st . . . "  Craig Stewart (Arnold & Porter), counsel for Cosgrove, another defendant, indicated that his client lacked the funding "to continue having us represent him as it stands, and that will be true as soon as the insurance money runs out."  As a result, he might have to return to the court to ask that Cosgrove "receive appointed counsel because he simply would not have the money to retain private counsel, givne the socpe and scale of this case, to defend it."    

The depleting policies was a factor in Barnaba's argument for severence and an earlier trial date.  Although the judge hasn't ruled on the motion (specifically reserving decision), Barnaba may get his wish.   The government conceded that it was considering a superseding indictment.  "If we do supersed, I imagine there will be a motion or motions for severence, and your Honor may be inclined to grant those motions.  And if that's the situation, we may not oppose in that particular situation." 

 A transcript of the hearing and other materials on this case can be found at the DU Corporate Governance web site.

An issue that deserves far greater attention concerns the recent miscount of the votes in connection with the election of directors at Yahoo.  The commentary has been passing, although as usual Corporate Governance noticed and asked the right questions.

As was recently reported, there was a significant but not outcome determinative miscount in connection with the recent election of directors at Yahoo.  The original announced tally showed that Jerry Yang, the CEO, received 85% of the votes cast and Roy Bostock, the chairman, received 80%.  After complaints from institutional investors that the tally was inaccurate, Broadridge Financial Solutions went back and recalculated the tally finding that Yang received only 66% and Bostock only 60%.  A huge discrepency.  The explanation?  According to one source, Broadridge claimed the error arose from underreporting share numbers that exceeded eight digits.  Don't worry.   Chuck Callan from Broadridge, a Senior VP Regulatory Affairs said that "the problem was identified and fixed...the error did not change the outcome."

The error apparently came from Broadridge which was hired by Capital Research and Management, a large shareholder of Yahoo, to transmit its votes to the company.  While the published reports make it sound like Broadridge worked only for Capital Research, this is unlikely.  Broadridge (the successor to ADP Shareholder Services) is widely used by brokers and other investors to distribute proxy materials to beneficial owners and to tabulate and submit vote totals.  See Exchange Act Release No. 43487 (Oct. 27, 2000)("Nearly all large broker and many bank intermediaries currently outsource the proxy material distribution function for beneficial security holders to ADP Investor Communications Services.").   In other words, more than the inspector of elections under state law, it is Broadridge that tallies most of the votes in connection with shareholder meetings. 

The role of Broadridge represents a gap in the regulatory system.  Particularly with beneficial owners, the legal obligation to ensure that votes (voting instructions actually) are properly tallied and submitted rests with the brokers (and banks) under the rules of the stock exchange and the proxy rules (Rules 14b-1 and 14b-2).  It is a complicated and circuitous system laden with problems and little enforcement.  Brokers, however, typically contract out the responsibility to Broadridge, which has something approaching a monopoly over the services.  With the relationship contractual, Broadridge is free of any direct regulation of the Commission or the securities laws.  This is a problem.  See Marcel Kahan & Edward B. Rock, The Hanging Chads of Corporate Voting, August 13, 2007 ("The complexity of the custodial ownership system, combined with the pressure of numerous shareholder votes, creates a system that is far more complex and fragile than the one anticipated by the Delaware legal structure. There are somewhere around 17,000 reporting companies. Most of these companies are subject to the SEC proxy rules when they solicit proxies. Finally, annual meetings are seasonal, with most taking place during the second quarter of the calendar year. Broadridge delivers more than one billion communications to investors per year. It is an accident waiting to happen.").  

With shareholder votes often becoming closer, particularly in an era of majority vote election requirements for directors, the system of counting votes needs to be accurate.  The example of Yahoo shows that Broadridge does not have a system in place sufficiently robust to catch mistakes that could amount to 20% of the total votes cast.  While in this case, the change did not affect the outcome, that will not always be the case.  Indeed, even much smaller mistakes can be outocme determinative.  Take a look, for example, at In re Transkaryotic where it was announced that a merger passed but evidence arising in litigation subsequently indicated that in fact it might have failed. 

Broadridge has been at the center of other complaints.  Some companies have professed disatisfaction with Broadridge over the implementation of the eproxy system recently approved by the Commission.  Certainly, return rates by retail investors have been low. And it is not a new problem.  It is discussed in my article, The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility

The system of shareholder voting cannot be sustained where those tabulating votes can make errors in the vicinity of 20%.  Moreover, without regulatory oversight, errors in vote tallies will rarely if ever become public.  In other words, we don't really know how often these kinds of mistakes occur.  It is an area that ought to be examined by the Commission.  

As a parting shot in departing from the SEC, now former commissioner Paul Atkins gave a speech on Rule 14a-8, the shareholder proposal rule.  Most of it was a warning about allowing shareholders access to the proxy statement and a self complementary discussion of the decision to refer the CA case to the Delaware Supreme Court.  That decision in fact may be Atkin's longest lasting legacy since the anti-shareholder decision will make it easier for companies to exclude categories of shareholder proposals under the rule.

The speech also devoted time to another anti-shareholder issue.  Atkins does not like precatory shareholder proposals.  His dislike, however, is not truly rooted in a desire to have a properly functioning system of shareholder proposals.  This can be seen from his refusal to acknowledge the role played by the Commission in encouraging these proposals.  See Note to paragraph (i)(1) of Rule 14a-8, 17 CFR 240.14a-8 (“some proposals are not considered proper under state law if they would be binding on the company if approved by shareholders. In our experience, most proposal that are cast a recommendations or requests that the board of directors take specific action are proper under state law. Accordingly we will assume that a proposal drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise.”). 

In fact, the solution is to eliminate SEC encouragement of precatory proposals.  This was suggested by VC Strine.  Let shareholders include mandatory proposals and if they pass the companies can let the Delaware courts resolve their legality.  As he noted at a roundtable held by the Commission:

• "I think those of us from Delaware would say one of the things the Commission could do to facilitate this is to make clear that if it's uncertain under state law and it's a by-law proposal, then it shouldn't be excluded and they should be able to put it on absent some showing, and then leave it to us, hold us accountable, and if we make the wrong decisions, you can bet we are going to hear about it from the institutional investor community and from the management community."

Atkins quotes Strine but omits this portion of the testimony.  He uses Strine's testimony to suggest the need to eliminate precatory proposals but does not add the portion that instructs the Commission to stop excluding mandatory proposals. 

His real concern, therefore, is not precatory proposals per se but the use of Rule 14a-8 by activist shareholders.  Thus, his only evidence of an unnecessary burden imposed on companies is the singular example of Exxon-Mobile, which confronted 17 shareholder proposals in its proxy statement.  Atkins omitted to mention that Exxon was in many ways unique because of its obstinate resitance in addressing enviornmental issues and seeking to develop alternative energy sources.  Thus, most of the 17 proposals dealt with enviornmental/alternative energy issues.  He also failed to mention that many of the proposals received heavy shareholder support, with a proposal  to separate chairman and CEO receiving 39.5% and say on pay receiving 40.7%.  Nonetheless, Atkins would prefer to cut off this avenue of communication between shareholders and managers. 

The one example aside, his true objection can be seen from the data he uses.  Relying on an ICI study of the 2006-2007 proxy season, he notes that "there were 186 proposals sponsored by unions or affiliates of unions, but just three unions accounted for 94 of the proposals. So the data shows that a relatively small number of investors are responsible for a significant portion of the shareholder proposals."  He then notes that the "abusive use of the shareholder proposal process by some institutional investors is troubling."  In other words, the sole evidence of abuse is the number of proposals submitted by a small number of shareholders.  He makes no mention of the percentage that pass or the use of proposals to largely implement a system of majority voting among large public companies.

During his tenure, he was unable to accomplish the goal of restricting the scope of Rule 14a-8 and limiting the use of precatory proposals.  Attention hereafter will shift not to limiting Rule 14a-8 but expanding its reach to include access.