Ideoblog

The SEC: from fraud accessory to quack corporate governance

The SEC has been a miserable fraud watchdog – perhaps even Madoff's unwitting accessory. So what is it doing now?  Seeing how much it can mess up corporate governance. Per Dealbook, SEC Commissioner Elisse Walter has joined Chair Mary Schapiro in backing say on pay and shareholder access to board nomination.

I've described say on pay as "quack corporate governance." As I've said:

Efficient compensation must be crafted on an individual-by-individual and firm-specific basis to provide the right incentives and attract the best people. It's like designing a product. Can anybody seriously believe that shareholders en masse can make a meaningful, intelligent, up-or-down decision on executive compensation?

Here I note:

Unions already have secured an extensive executive compensation disclosure rule to whip up populist resentment about executive pay. The next step is to create a mechanism to bring that resentment to bear in corporate elections. * * * They are not seeking to represent the interests of investors generally. Their ideal is the sclerotic European firm, with its labor representatives on the board.

I added that say on pay also provides a basis for litigating board elections, increases benchmarking of compensation, increases firms' incentives to manipulate compensation, and spurs the drain of talent from publicly held firms.

Perhaps more importantly, as I discussed here and here (the latter summarizing my testimony before the SEC), these nuances of corporate governance -- executive compensation and director elections -- are best covered by state law.

These observations are more important than ever. We’re trying to get firms moving again, not hobble them. Politicizing corporate governance, distorting incentives, giving unions more leverage, etc, do not seem like ways to do this.

The SEC has not even been able to do its main job of policing obvious frauds. We should not expect it to do a better job mucking around in the sensitive arena of internal corporate governance.

The Electronic Arts decision: 14a-8 and preemption

Gordon Smith analyzes the transcript of the federal district court decision (supplied courtesy of Lawyer Links) in Bebchuk v. Electronic Arts. 

Cutting to the chase, here's the critical passage from the opinion:

I would hold that the SEC has been very careful not to trammel on the -- except to the extent that it thinks it appropriate -- on the normal discretion of the board of directors..., and the proxy rules honor that. And these 13 provisions for the exclusion, express the different views of different instances. And this particular instance requiring the company to put a proposal that could eliminate the discretion of directors would be * * * contradictory, to what the SEC has done * * *

In short, as Gordon summarizes:

Judge Hellerstein believes that Rule 14a-8 -- and only Rule 14a-8 -- defines the scope of director discretion with respect to a company's proxy ballot. This is the essence of the argument * * * that Rule 14a-8 preempts state law on the issue of access to the issuer’s proxy statement.

Gordon also has observed that "[p]reemption doesn't seem like a serious argument to me."

But I agree with the judge -- preemption is precisely the problem.  My earlier analysis of this case is strikingly consistent with the judge's reasoning:

Even if the proposal is not within a specific 14a-8 exclusion it would essentially undermine the careful limitations on mandated proposals under 14a-8. This strikes me as really an argument that the proposal is substantially inconsistent with 14a-8 even if it doesn’t fall within a specific exclusion category. And that argument makes some sense.* * *

I understand that the argument seems odd.  But that oddness result from a clash inherent in the excessive federalization of corporate governance.  As I wrote in my earlier post:

Bebchuk's proposal exposes [14a-8’s] basic ambiguity: where in the complex realm of corporate internal governance does the federal regime end and the state regime begin? * * *

I have consistently recommended that the SEC solve the problem by revising the rule

so that it just requires disclosure of agenda items permitted by state law. That would eliminate the ambiguity that gives rise to this case.

My fondest hope, as I concluded, is to "let firms choose their disclosure laws." That, of course, ain't going to happen, with the result that we're going to continue to get cases like this about the borderline between federal and state law.

Post-crisis federalism and insurance

David Zaring says

I'd guess that the crisis makes it more likely that there will be federal chartering of insurers, though I doubt Larry Ribstein will be pleased about it.

No, I wouldn’t, for the reasons Henry Butler and I give in our A Single-License Approach to Regulating Insurance.

Of course people are more worried than ever about financial safety, and are skeptical the states can provide it. But they may be thinking about the current “federalism” in which insurers operate in a chaotic environment of multiple regulators and states provide the only regulatory option. Butler and I argue for true insurance regulation competition via a choice of regulators, with the federal government playing a backstop role.

It seems to me that the current crisis strengthens rather than weakens our argument. After all, has federal regulation of banking has brought us such wonderful results? 

Federalism and corporate governance

Steve Bainbridge opines on Bebchuk's Electronic Arts proposal which, as I've discussed, asks EA to establish a shareholder proposal rule that goes beyond what the SEC requires in 14a-8. The legal argument that EA should be required to include the proposal was backed by 46 corporate and securities professors, not including Steve and me. (Steve regrets the opportunity to decline the invitation, but I'm with George Burns on this one.) Steve instead focuses on the substance of the proposal rather than on whether EA should be required to include it.

To sharpen the issue, Steve supposes that a social conservative fund wants EA to stop making the sex and violence games that it's feasted on. The proposal might or might not be excludable under 14a-8. Whether it is or not under what I'll call 14b(for Bebchuk)-8 is another question. It might not be a “proper action for stockholders under state law,” might relate to ordinary business operations, or might be excludable per the directors' fiduciary duties under Bebchuk's rule. Importantly, these issues would be decided by a Delaware court rather than the SEC, but it wouldn't be clear what standards that court should apply, how long the litigation will take, and how it might interfere with the corporation's usual governance procedures.

And so, Steve asks, "How much money, time, and effort will be soaked up to deal with a special interest proposal with almost no chance of passing?" Even worse, the procedure might be abused by a "shareholder/proponent [e.g., labor union] using a proposal to pursue some sort of private rent-seeking." Steve then argues that the majority vote requirement does not adequately protect against these adverse consequences.

While I happen to agree with Steve's substantive concerns about the proposal, I think it's more important to focus on the main issue here – that is, state or federal law?

To see why this is the important issue, suppose there were no 14a-8. Bebchuk, a shareholder in EA, conducts a proxy fight at EA to adopt a 14b-8 procedure. The shareholders agree, and the corporation henceforth must face most of the problems Steve envisions. I say most, because there is one problem it doesn't face in the absence of 14a-8: whether to apply state or federal standards for excluding proposals.

Should we worry about the remaining problems of too much shareholder power? Possibly, but I would say no more than with other screwy contracts that are enforced every day.

Now Bebchuk might argue that the problem with my hypothetical is that the shareholders won't get a chance to agree. Bebchuk can't put together the funds for a proxy fight to get his 14b-8 adopted. Without 14a-8 the directors can just stonewall the proposal.

But, I answer, if these shareholder rights have value, capital and product markets will induce corporations to enable them, and to organize under the laws of states that do so.

The Bebchukian's next move, of course, is to point to a failure in product, capital or state law markets as a reason why we need federal law. For example, we might compel disclosure of proposals brought to the board's attention before a meeting – the alternative I noted in my previous post.

My point is that the important question here isn't what the contract should say, but the more Hayekian issue of the legal rules and standards under which these contracts are made. We don't know whether director primacy or shareholder primacy is right for all firms and people at all times. (In fact, I've argued that uncorporate governance, which subjects board power to more, or at least different, constraints than under current law, is better for many firms.) An appropriately structured market will work this out, and federalism is a big part of this structure.

Steve's critique does not address this federalism point. Rather, it argues for a particular director-primacy outcome. Bebchuk's proposal simply argues for the opposite outcome. Meanwhile, the EA/CoC and Jeff Gordon briefs do address the federalism issue, but their positions are not so clearly opposed because both, as they must, assume the existence of the federal regime. As I said in my previous post, it's not so easy to say under current law, as the professors do, that the corporation ought to be able to work out its own approach, much as I sympathize with that position. The reason is that this approach effectively undermines 14a-8, and by extension the proxy rules, which is, after all, the law.

I suspect, in fact, that the argument really is about what Steve is talking about in his post – that is, whether the directors or the shareholders ought to be able to control the corporation. Nobody but me really seems to be serious about the boring details of federalism. Yet as I've argued in many different contexts, in this area as in so many others, the correct outcomes of public policy debates are rarely clear, which is why we need a system for working them out.

The SEC certification to Delaware

As I noted over a year ago, Delaware amended its constitution to allow the Delaware Supreme Court to take certified questions from the SEC. I commented that

the SEC should not opine on the merits of [shareholder] proposals, including whether they are permitted under state law: that should be determined by the state courts and legislatures. Delaware's move makes this approach easier for the SEC to effectuate. Now the ball is in the SEC's court . . . .

As everybody with any interest in this stuff knows, the SEC has in fact certified a question. I was away during the initial flurry and so haven't contributed to the discussion. Leading the commentary charge so far have been, among others, Brown, Bainbridge, Smith, Verret, Fairfax.

I plan to jump in when the Delaware court rules. My focus likely will be on the federalism issue rather than the substantive state law question, including what the Delaware decision indicates about the future of this sort of federal deference to state law.

Business and the Supreme Court

Jeffrey Rosen has an interesting article in the NYT magazine about the Supreme Court's pro-business tilt. Gordon Smith gives some highlights, noting the interesting agreement on business issues between liberal and conservative justices:

With their pro-business jurisprudence, the justices may be capturing an emerging spirit of agreement among liberal and conservative elites about the value of free markets. Among the professional classes, many Democrats and Republicans, whatever their other disagreements, have come to share a relatively laissez-faire, technocratic vision of the economy and are suspicious of excessive regulation and reflexive efforts to vilify big business. Judges, lawyers and law professors (such as myself) drilled in cost-benefit analysis over the past three decades, are no exception. It should come as little surprise that John Roberts and Stephen Breyer, both of whom studied the economic analysis of law at Harvard, have similar instincts in business cases.

Rosen notes the influence of Lewis Powell, Rex Lee and the litigation coordinating efforts of the Chamber of Commerce. I wonder how much of this development can be attributed to Henry Manne, whose writings and judicial and law professor seminars had a profound influence on US law and policy, as I have recently written.

For me the most interesting part of Rosen's article was about the clash of two strains of conservatism:

Ever since the Reagan administration, there had been a divide on the right wing of the court between pragmatic free-market conservatives, who tended to favor business interests, and ideological states-rights conservatives. In some business cases, these two strands of conservatism diverged, leading the most staunch states-rights conservatives on the court, Antonin Scalia and Clarence Thomas, to rule against business interests. Scalia and Thomas were reluctant to second-guess large punitive-damage verdicts by state juries, for example, or to hold that federally regulated cigarette manufacturers could not be sued in state court. As a result . . . the chamber began a vigorous campaign to urge the Bush administration to appoint pro-business conservatives.

When it came time to replace Chief Justice William Rehnquist and Justice Sandra Day O’Connor, the candidate most enthusiastically supported by states-rights conservatives, Judge Michael Luttig, had a record on the Court of Appeals for the Fourth Circuit that some corporate interests feared might make him unpredictable in business cases. (“One of my constant refrains is that being conservative doesn’t necessarily mean being pro-business,” Conrad [of the Chamber of Commerce] told me.) The chamber and other business groups enthusiastically supported John Roberts, who had been hired by the chamber to write briefs in two Supreme Court cases in 2001 and 2002. . . . . The business community was also enthusiastic about Samuel Alito, whose 15-year record as an appellate judge showed a consistent skepticism of claims against large corporations. Ted Frank of the American Enterprise Institute predicted at the time of the nomination that if Alito replaced O’Connor, he and Roberts would bring about a rise in business cases before the Supreme Court. Frank’s prediction was soon vindicated.

I certainly sympathize with the Court's pro-business move. [With respect to Alito, I take some credit for being among the first to highlight his business record when he was nominated –see here, and the follow-up Forbes column.]  But while I don't consider myself a "conservative," I think the Court's rejection of what Rosen calls "state's rights" [in NYT-speak] in favor of a broad view of federal power is not entirely a good thing, even for a pro-business type. See, for example, my article on preemption in the securities law area (which got some push-back when I presented it at Cato).

Yes, the states have overreached, particularly in empowering the trial bar, and we've seen, particularly recently, the corruption underlying this overreaching. But we must remember that federal law is not without its flaws, and its flaws are compounded by the high costs of exiting a federal regime.

As I've often argued, including in the article noted above, there is a way out of this dilemma, a business-friendly alternative to broad federal preemption: enhancing parties' power to contract for the applicable state law. Erin O'Hara and I have a forthcoming book on that, The Law Market, which I'll be writing about in coming months. You can get tastes of the analysis in, among other places, our Corporations and the Market for Law, just out in the Illinois Law Review, and our recent paper on European and American choice of law.

The market for law offers a way to get competition and evolution of legal rules while enabling firms to avoid the Mississippi swamps and duplicative and costly state regulation.  I think business will come to see the attractions of this approach, particularly when it realizes in coming years that Congress may not be entirely pro-business.

What is Iraq?

As Iraq engages in the task of nation-building, it has to face what sort of nation it is, if any sort. Part of the inherent problem of Iraq is that it did not arise from indigenous forces, but was rather carved willy-nilly by western powers. Now that this territory doesn't have Saddam's strong arm holding it together, there's a question of what sort of entity it is or eventually will be – a unitary nation, a federal union like the US, a trade group of distinct political entities like Europe or a bunch of autonomous countries?

These questions are raised by the recent deal between Hunt Oil Co. and Kurdistan, discussed in today's WSJ. Hunt entered into the deal as it got tired of waiting for Baghdad to pass a national oil law, and Kurdistan went ahead and passed one of its own. According to the WSJ:

The deal shows the new Kurdish law "has created a supportive and transparent business environment" for international oil companies, said Ashti Hawrami, Kurdish minister for natural resources, in a statement. Mr. Hawrami said that any eventual revenue from the deal will be shared with other Iraqi regions. * * * Ray Hunt, chief executive of Hunt and the patriarch of the family's business interests -- which span energy, real estate, private investment and ranching -- said in a statement that he was pleased to be "participating in the establishment of the petroleum industry in the Kurdistan region of Iraq." * * * [A] spokeswoman said Hunt determined that conditions were right to sign the deal, after the regional law was passed. "They have a new petroleum law which is transparent and which calls for immediate work in the region[.]" * * * The Kurdish regional government "provided all of the necessary processes to begin work and we were ready to go."

A federal judge has a good time in a backdating case

WSJ Law Blog commends the humor of U.S. district court Judge James Rosenbaum in denying a motion to dismiss in the United Health backdating case. According to the judge, plaintiff’s theory has won several academy awards. And, he might have added, a Pulitzer Prize.

But all these awards don’t substitute for actual judicial reasoning, which was sadly absent from the opinion except for this remark:

In The Sting, the bad guy is ultimately brought down by utterly charming con men, played by Paul Newman and Robert Redford. The Sting (Universal Pictures, 1973). They gain their revenge through a scheme involving “past-posting,” or betting on horse races after the results are known. The Court expresses not the slightest opinion as to whether such shenanigans occurred here, but such is the essence of plaintiffs’ theory.

It is a poker axiom that if a player has his knees under the table and cannot tell who the sucker is, he’s it. In this game, according to plaintiffs, the patsy was either the hapless corporation, which in varying ways defendants controlled, or the corporation’s shareholders, whose equity provided the game’s antes and bloated pot.

The problem with the judge’s reasoning is that there’s nothing per se wrong with “past-posting” in the form of backdating. The question is whether it was properly approved and disclosed. I’m not saying it was in the United Health case. But the defendants had some arguments that they deserved to have the court seriously address, particularly given the importance of judicial guidance on this issue.

If you want an example of a judge who did believe it necessary to seriously address arguments in backdating and springloading cases, see my discussion of Delaware Chancellor Chandler’s opinions in the Ryan and Tyson cases. A comparison of the federal and state cases provides a pretty good anecdote in support of state corporation law.

Pick your poison: class actions or corporate criminal prosecutions?

Stanford's Joe Grundfest writes in today's WSJ that securities class actions are declining. One reason? He suggests maybe it's because there's less fraud.  And that might be because

there is a new, tougher and superior enforcement mechanism in place. The SEC and the Department of Justice now insist that any corporation suspected of a sufficiently serious fraud conduct an internal investigation that will finger the executives responsible. The corporation must also cooperate in prosecuting these executives. This enforcement technique is stunningly effective, if often overbearing. It eliminates the government's need to conduct expensive and lengthy investigations and provides the authorities with extraordinary leverage over every executive suspected of wrongdoing. Private litigation doesn't have an equivalent deterrent effect because it can't threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud. As long as the government's enforcement activities remain sufficiently vigorous, the private class-action securities fraud lawsuit can be viewed as an expensive, wasteful and unnecessary sideshow that generates little deterrence and offers questionable levels of compensation. The question then is not why these lawsuits have been shrinking so rapidly in recent months, but when and whether they should exist at all.

Grundfest's explanation of the decline in private securities litigation may be correct, but his suggestion that this is a good thing is deeply troubling. As I've often suggested (see my Corporate Crime archive) there are serious problems with criminalizing the sorts of corporate misconduct that are the subject of private action.

Does the dip in securities litigation suggest that the corporate criminal prosecutions have been worth these costs?  I'd demand more evidence that we don't just have an up-market litigation cycle. Moreover, even if we do have less fraud to litigate, I'd wonder whether it's been worth the price.  Do we have less risk-taking?  A zero fraud world is not necessarily paradise.

The question here is not who one's favorite bad guy is (federal prosecutors or class action lawyers) but what system achieves the maximum deterrence at the minimum costs. (Compensation really doesn't enter into any of these approaches).

As I said in my Dabit, Preemption and Choice of Law, "the efficiency of private litigation can be assessed only in the context of all of the tools for fighting fraud." But I also noted that there's a lot we don't know about the optimal mix of approaches to deal with fraud, and that a one-size-fits all federal regime, with its lurches from one "solution" to another, is not necessarily the way to go.

Update:  In the post above I refered to "maximum deterrence at the minimum costs."  That was careless phrasing.  I meant "most cost-effective deterrence." 

While I'm at it I should note that, generally consistent with Grundfest, Karpoff, Lee and Martin, in their recent Legal Penalties for Financial Misrepresentation, find that "a recent increase in regulatory penalties has coincided with a decrease in private penalties."  But, for the reasons discussed in my post, this doesn't either establish a causal relationship between the two phenomena or justify the current mix of sanctions.

Abortion and choice of law

Will Baude writes in the NY Times (linked by Dan Markel, blogged here) that repealing Roe would open the country to choice of law chaos:

--States might use child custody laws to “place unborn children into protective custody, forbidding their mothers to take them across state lines.”

--“Anti-abortion states could forbid their residents to obtain or perform abortions, even while out of state.”

--“Just as Utah could make it a crime for a resident to go to Rhode Island for an abortion, Rhode Island could forbid Utah's law-enforcement officials from interfering with her decision to get one.”

Would states act this way? In my article with Frank Buckley, Calling a Truce in the Marriage Wars, 2001 University of Illinois Law Review 561, draft here, we discuss an interstate political dynamic for same sex marriage, similar to the one for abortion laws, that cuts the other way.

How many of the more outrageous scenarios Baude describes, assuming they are practical and politically realistic, would be constitutionally permissible? No the law is not crystal clear, and the constitutional constraints on choice of law are very light. But I suspect, for example, that changing residency to the pro-abortion state would be enough to constitutionally stop the anti-abortion state of origin from acting against the relocating mother.

Most importantly, Congress has the power to act under the Full Faith and Credit clause to stop the mayhem Baude describes. As divided as we are on abortion, it doesn't follow that a majority can't be found on a choice-of-law solution that would allow the two sides to live in harmony. 

Baude says, “If Roe is reversed, the ensuing chaos will demand a federal resolution to the abortion battle – again.” Maybe, but it doesn’t have to be another single answer up or down on abortion.