In January of 2011, the Securities and Exchange Commission, as part of its implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, began requiring U.S. public companies to provide their shareholders with a non-binding vote on the compensation of certain executive officers. This “say on pay” gives shareholders an advisory say on the amount of compensation paid to those executives. Related disclosure is also designed to prompt the board to consider how the “say on pay” vote affects its broader executive compensation policies and practices.

The Dodd-Frank Act specifically provides that the shareholder say-on-pay vote is not intended to affect directors’ fiduciary duties. Despite this, in at least two cases, shareholders have sued directors for breaches of their fiduciary duties, primarily on the basis that they implemented compensation practices that shareholder had voted against.

In one of these cases, Beazer Homes, a Georgia state court, applying Georgia law, dismissed the breach of fiduciary duty claim brought by a shareholder. The court held that a failed say-on-pay vote alone is not sufficient to rebut the presumption that directors acted in the best interest of shareholders.

However in another case, an Ohio district court, applying Ohio law, refused to dismiss a similar claim against the directors of Cincinnati Bell. As in the Beazer Homes case, the shareholders in Cincinnati Bell alleged that the board of Cincinnati Bell breached their fiduciary duties in deciding to pay executives compensation despite a decline in net income for the year and a shareholder vote against that pay. The court viewed the failed shareholder say-on-pay vote as highly probative of the fact that the compensation payments were not in shareholders’ best interest, at least for purposes of denying the directors’ motion to dismiss. Thus despite Congress’ intent, as expressed in the Dodd-Frank Act, of not altering directors’ fiduciary duties as a result of a failed shareholder say-on-pay vote, the court in Cincinnati Bell did consider such a failed vote in finding a plausible fiduciary duty claim.

The Cincinnati Bell court’s rationale obscures an important reality: that is, a shareholder vote that opposes a matter of director business judgment does not, by itself, establish that the board was not acting in shareholders’ best interest. Indeed as I have argued elsewhere, many shareholders are short-termists, meaning that they focus primarily on a firm’s generation of short-term profits and not on its creation of long-term true value. Shareholders with such a short time horizon would undoubtedly prefer compensation arrangements that rewarded executives for achieving short-term, rather than long-term, performance targets. Thus, weak shareholder support for a board’s proposed executive compensation package might to some extent reflect shareholders’ desire for compensation arrangements that reward executives for being myopic rather than long-termists.

That is not to say that a failed shareholder vote on executive compensation should not play any role in establishing directors’ breach of fiduciary duties. For example, a failed vote, followed by no inquiry on behalf of a board’s compensation committee for the reasons for that failed vote, might help show a lack of diligence that fiduciary duties are intended to police. However, a failed say-on-pay vote should not alone prove that directors were not acting in shareholders’ best interest. Hopefully the court, with a fuller factual record, will come to the same conclusion.

For some helpful commentary on E&Y’s expected defense, see this post by Caleb Newquist at Going Concern.  In essence, E&Y’s position seems to be that it cannot be held liable under the New York law because it was Lehman, not E&Y, that produced the misleading financial statements and that used the statements to sell billions of dollars of securities before the collapse.  Apparently, there is no precedent under the state law for the prosecution of an accounting firm based on its role as an auditor, so the courts may have to wrestle with some difficult questions in the case.

What particularly interests me about the case is the way it echoes the prosecution of Arthur Anderson, which destroyed the venerable accounting firm as a result of its role in the Enron collapse.  

Might E&Y now go down like Anderson?  Unlike Anderson, E&Y is not a criminal case.  However, even a civil damages judgment, if large enough, could potentially put a company out of business.  At Concurring Opinion, Lawrence Cunningham asks what damages E&Y could afford.  His back-of-the-envelope answer?  ”Probably $1 billion, but not much more.”

In a post at Forbes, Francine McKenna discusses the implications of any of the Big Four accounting firms going out of business, as well as the possibility that any of the other three besides E&Y will face a company-threatening judgment arising out of the financial collapse (she thinks not).  In a separate post, she suggests why it is that New York, and not the federal government, is going after E&Y:

Charges against EY, the firm, by US federal authorities would be embarrassing at best and catastrophic at worst. Civil charges by the SEC against Ernst & Young could put its bosses, the US Treasury, in a very bad spot. The Treasury is paying EY millions to help clean up the mess left by other firms as contractors to the government’s various bailout programs like TARP. Criminal charges against EY by the DOJ could precipitate a failure of the firm, a la Arthur Andersen. No one in the US federal government has a plan in the event another large audit firm fails and they certainly don’t want to be the ones to cause it.

Would it be a good thing for E&Y to go down?  Taibbi seems gleeful at the thought:

My guess is that this suit is the beginning of the end for Ernst and Young and, who knows, may be the beginning of a series of investigations that ultimately take down the auditors and ratings agencies that made the financial crisis possible. Without accountants and raters signing off on all the bogus derivative math and bad bookkeeping, a lot of this mess would never have happened.

But here is David Zaring’s response to Taibbi at Conglomerate:

Killing Arthur Anderson, a worldwide company with tens of thousands of employees, all but maybe four or five of whom had nothing to do with Enron, never struck me as particularly good policy, but more like, it’s the cover-up-not-the-crime style discipline. So I think it is naive to wish for it, nor do I think it is in the least likely to happen. . . .

Another thing — I always think that the bankster crowd should take a deep breath when presented with indictments, and pretend that the conduct that occurred happened to someone they like. You know, what if a union official was convicted of fraud? Kill the union?

I think that some of my former colleagues over at Stark Investments are thinking that they created a blogging monster (while at Stark I maintained a blog and I bet that some are thinking that I have taken things to a new extreme….).  While on that topic, I did want to mention a couple of tidbits about Stark Investments (it seems that some folks are still interested in what I have to say on the topic).

The original founders of Stark – Brian Stark and Mike Roth – were true pioneers in the hedge fund industry and played an important role in the evolution of this space and in paving the way for all those that followed into the business (including myself).  At its core, the hedge fund business (or “alternatives business” as it is commonly referred to) is based on the goal of providing absolute returns in an uncorrelated fashion (providing more attractive risk-adjusted returns than can be found from other investment techniques and strategies).  As they say about sports and hitting a baseball, achieving these objectives is one of the hardest things to do in any profession.  In any event, Brian and Mike have been doing this as long as anyone in the business.   I had a great 10 years working for the two of them and I learned much from both of their styles.

 Ok, enough of that stuff.  Let’s talk about financial regulation.  The last major overhaul of the regulatory structure of our financial markets, not surprisingly, occurred following the Great Depression.  The regulatory reaction to the stock market crash was the adoption of two cornerstone pieces of legislation which still provide the backbone of our regulatory structure — the Securities Act of 1933 (the “’33 Act”) and the Securities Exchange Act of 1934 (the “34 Act”). The 33 Act, administered by the then newly created Securities & Exchange Commission (the “SEC”), provides for the registration of the initial distribution of most securities and the 34 Act imposes ongoing reporting and disclosure requirements.

 The policy behind the Acts was that disclosure of material facts and overall transparency in the activities of the securities exchanges would provide confidence in the markets and in the companies issuing securities.  Increased transparency, in turn, would promote much-needed liquidity which makes the markets function in an orderly fashion (the pre-Depression markets were characterized by insider dealing and a significant laissez-faire attitude towards regulation).  This “sunlight theory of regulation” is based on the assumption that if investors are given all of the necessary information they will make wise investment decisions. Commentators have characterized the ’33 Act as follows (these quotes, some of my personnel favorites, can also be found on the State of Wisconsin Department of Financial Institutions website):

• Congress did not take away from the citizen his inalienable right to make a fool of himself. It simply attempted to prevent others from making a fool of him.
• As to its efficacy in regulating securities issuers, the sunlight theory may be summed up by a saying: Those who are forced to undress in public will presumably pay some attention to their figures.

Please remember these quotes because I believe that they are instructive in thinking about the role of regulation in light of the current environment.   Notably, it is my view that “full and fair disclosure” was not a major problem during our most recent financial crises – in my mind, the much bigger issue (as noted in my first blog) was excessive risk-taking and greed:  in short, too many people made fools of themselves….

My father recently guided me to some sections of Tony Blair’s newly released memoirs A Journey: My Political Life, which were of interest to me on the topic of financial regulation.  The Prime Minister had this to say of the markets, government and regulation:

 First, “the market” did not fail. One part of one sector did. The way sub-prime debt was securitized, spliced and diced and sold on with no real appreciation of underlying risk or value was wrong, irresponsible and immensely damaging. Some of the rewards, the huge payouts for shuffling around securities, the bonuses, are not just presentationally awful; they can’t be justified and, at worst, have helped create a propensity to “do the deal” whatever the long-term merits for short-term gain, in a way that significantly contributed to the crisis. All this is correct and should be acted on. However, such practice should not define or represent the whole of the banking sector, let alone the whole financial sector, let alone “the market.”

Second, government also failed. Regulations failed. Politicians failed. Monetary policy failed. Debt became way too cheap. But that wasn’t a conspiracy of the banks; it was a consequence of the apparently benign confluence of loose money policy and low inflation. The responsibility for the crisis should be shared, not borne by the market alone or even by the banks alone.

Third, the failure was one of understanding. We didn’t spot it. You can argue we should have, but we didn’t. Furthermore—and this is vital for where we go now on regulation—it wasn’t that we were powerless to prevent it even if we had seen it coming; it wasn’t a failure of regulation in the sense that we lacked the power to intervene. Had regulators said to the leaders that a huge crisis was about to break, we wouldn’t have said: There’s nothing we can do about it until we get more regulation through. We would have acted. But they didn’t say that.

My own beliefs flow from a similar line of thinking.  That is, our financial system has failed by not having a natural governor of its activities.  One of the interesting ironies, in my experience, is that during the creation of bubble-like conditions all of the players in the financial system act as if their interests are aligned.  Investors, speculators, bankers, and policy-makers all tend to act in a manner that is designed to “let the good times roll.”   The markets need a voice of reason in these environments – someone or something that can provide balance in recognizing the signs of a bubble, in recognizing where we are in terms of the investment cycle, in acting as a counter-balance to the “this time its different” mentality, and in ensuring prudent action during these periods.  If we do not find a way to do this then we will repeat these cycles – and in my mind they will occur with even more frequency and ferocity.

So, it will be in the next blog post where I will discuss whether the currently proposed regulatory overhaul can help mitigate against these risks.  That is, can the prevention of “too big to fail,” increased capital ratios among large banks, and the 2,315-pages of financial regulatory system legislation act as the “voice of reason” which will prevent future financial crises….and what does this all mean from an underlying policy perspective?

As trademark rights become an increasingly valuable asset in Chapter 11 reorganizations, it is critical for Congress and the courts to clarify how trademarks will be treated in bankruptcy, particularly where the debtor is a trademark licensee. Without clarity, Chapter 11 reorganization may not be a viable option.

This Comment urges that trademark licensees should not be stripped of a license simply because the licensee enters bankruptcy. Rather, where a licensee intends only to continue using an existing license under the terms of the existing agreement with the licensor, the licensee’s use of that license should be uninterrupted during reorganization. This recommendation, contrary to the position of trademark licensors, will not invade the province of trademark owners to control their marks.

To support this recommendation, this Comment examines the statutory frameworks of both trademark and bankruptcy law, legislative history of the Bankruptcy Code, and cases that illuminate the current circuit split over the rights of a trademark licensee in bankruptcy. Building on these elements, this Comment outlines an analytical approach that strikes a balance between the need for business reorganization and the duty of a trademark licensor to exercise control over its mark.

Today, Brandies’s “curse of bigness” is incorporated into the less pejorative term for large U.S. companies — companies that are “too big to fail.”  Certainly in light of the recent U.S. financial crisis, people are well aware of the influence that these large U.S. companies have on U.S. politics and its economy.   But these “too big to fail” companies may also be creating moral hazards in business operations, and the U.S. has yet to establish a unified system for dealing with the business of bigness. 

Amidst the recent financial crisis, deeming companies “too big to fail” legitimized the government’s bailouts of large U.S. companies facing financial ruin.   The U.S. feared that the failure of a “too big to fail” company would not only affect the company and its immediate stakeholders, but such a failure could also bring down the country’s broader economic system.  Accordingly, companies invoked the “too big to fail” exception to financial demise, imploring the government to save a company to avoid far-reaching adverse affects on the U.S. economy if the company should be allowed to fail.  In less than five years, the U.S. Department of Treasury has committed almost $590 billion to bailing out 833 companies.  To date, less than a third of that money has been returned.

The “curse of bigness” is also present in the context of corporate compliance monitoring of large U.S. businesses.  At Marquette Law School’s recent Hallows Lecture, former U.S. Deputy Attorney General Mark R. Filip cautioned against aggressive monitoring of U.S. corporations.  Filip noted that an indictment of a company is essentially the death knell for that company.  In his discussion, Filip pointed to the example of the prosecution of Arthur Andersen, which at one time was one of the “Big Five” accounting firms.  Despite a guilty verdict that was ultimately overturned by the Supreme Court, Arthur Andersen had lost its business reputation and has never returned as a viable business.   Filip noted that 28,000 employees in the U.S. lost their jobs ultimately because Arthur Andersen was simply indicted, but never found guilty of any wrongdoing. 

So how should the United States deal with these large companies that constitute U.S. “bigness”?  Should we be inclined to bail them out when they face financial collapse?  And do we likewise hesitate to prosecute them for potential wrongdoings in order to avoid another Arthur Andersen?  Given that the demise of such large companies — even as result of a mere indictment — potentially has significant adverse effects on jobs and the U.S. economy,  the sensible approach may be to bail out certain companies and to proceed with caution when investigating those same companies for non-compliance.

But if the U.S. takes such a position, it may also create moral hazards in business operations.  Many commentators have recognized that these mega-companies may be more inclined to make risky business decisions knowing that the government is willing to bail out the companies to avoid the effect of companies’ collapse on the broader U.S. economy.  Likewise, companies may be less willing to toe the line of legality in their business operations knowing that the government would hesitate in indicting them for any potential wrongdoings.

Not surprisingly, some believe that if a company is “too big to fail,” then it is “too big to exist.”  In fact, Senator Bernie Sanders of Vermont introduced the “Too Big to Fail, Too Big to Exist Act of 2009.”  Briefly, the bill seeks to have the Secretary of Treasury identify the “too big to fail” companies and break up those entities.

Yet that approach seems like a knee-jerk reaction to a crisis situation, if not fundamentally against an economic system that encourages economic growth.  Undoubtedly, outside the financial crisis, large businesses have benefited the U.S. economy.

Other more conservative approaches view the “too big to fail” companies as a secondary problem.  Rather, the problem is that the U.S. has failed to establish a uniform system for monitoring and restructuring the large U.S. businesses if they should face collapse.   

Yet, at least with respect to increased monitoring, such an approach may lead to undesirable results similar to the Arthur Andersen result.  And if Congress allocates money to increased monitoring, there would most likely be increased pressure for results in the form of cases brought and indictments — the exact result that former U.S. Deputy Attorney General Mark R. Filip cautioned against.

China’s approach is simply to refuse to recognize companies as “too big to fail.”  Yet that approach seems overly simplistic, and may in fact lead the broader U.S. economy into financial collapse.

Certainly, the “curse of bigness” still presents significant problems to the United State almost 100 years after Justice Brandeis coined the term.  And perhaps the greatest dilemma is finding a cure that is not worse than the curse.

Moving on.

Several blogs on this site have addressed election issues and reform in the judicial and political spheres.   Yet, despite imminent changes with regard to the election of corporate directors, any discussion of corporate election reform has been noticeably absent.  I do not doubt that the rules regarding the election of directors will change significantly this year.

Specifically, on June 10, 2009, the SEC published proposed amendments to the federal proxy rules that would facilitate shareholders’ ability to nominate directors to company boards of directors. Under the current director election rules, shareholders seeking to nominate a competing slate of director candidates have to bear all costs of a proxy campaign.  Yet, all costs for the campaigns of the incumbent board’s nominees are paid for out of corporate funds.  That advantage to the board’s nominees coupled with the significant costs in mounting a proxy contest serve as effective barriers to dissident shareholders seeking to initiate an election contest.

To be sure, shareholders vote for a company’s directors.  And, like any election, the shareholder election is intended to ensure that directors are accountable to shareholders’ interest.  But corporate scholars disagree over whether the election process in its current form has that effect.  Given the current director election rules, the shareholder vote essentially serves as rubber-stamp for the board’s nominees for directors.  In effect, the incumbent board determines who is elected to the board, not the shareholders.  (I will note that of the proxy contests that actually occur, they are almost exclusively initiated by hedge funds.  But for reasons beyond the scope of this blog, those are not the investors that directors should be accountable to.)

The proposed SEC amendments would put shareholder nominees on equal footing as the director nominees.  The amendments would allow nominees of dissident shareholders to avoid the expenses of a proxy campaign.  Instead, if shareholders met certain requirements, they could submit their nomination to the company and the company would have to include it in its own proxy statement.

Not surprisingly, the proposed amendments are controversial.  The SEC once postponed its final ruling and then recently re-opened the time for comments.  I believe the SEC will amend the proxy rules to facilitate shareholder director nomination, but it is still unclear what form those amendments will take.

I am generally not in favor of empowering shareholders through measures that give shareholders direct influence over specific business decisions (e.g., “say on pay” provisions), but I do believe amending the proxy rules will benefit corporations by making the election process more meaningful.  As one commentator put it, “If shareholders are able to elect directors and hold them properly accountable for their performance, then they should be more willing to let them get on with the job.”

My main concern with the proposed amendments is regarding the requirements a shareholder must meet to have its nominee put on the company proxy card.  In addition to minimum ownership requirements, the SEC proposes a one-year holding requirement of shares prior to a shareholder exercising its right to nominate a director.  The purpose of that latter requirement is to restrict shareholders seeking proxy access to those with long-term interests; thus eliminating shareholders that may use a proxy contest for short-term gain.

I believe the one-year holding requirement falls short of its intended purpose.  Rather, despite the holding requirement, the proposed proxy amendments present a powerful incentive to use them solely for short-term gain—specifically, taking advantage of the short-term “spike” in share value that typically follows a proxy contest.  A recent study of hybrid boards—i.e., boards with members elected from proxy contests—indicate that share value, almost invariably, “spikes” in those companies for one year following the proxy contest (because investors perceive the proxy contest as an indication that a company was underperforming and undervalued),  and company shares significantly outperform the market for that one year.  However, the shares generally underperform the market following that year.  Accordingly, I believe the proposed amendments will create incentives for shareholders to achieve a short-term stock value “spike” typically associated with a proxy contest, regardless of whether a shareholder-nominated director may be sub-optimal from a long-term company value point of view.  Once that short-term value “spike” is achieved, the shareholder can then simply sell its shares to capitalize on their short-term increased value.

This perverse short-term incentive created despite a holding requirement is not unique to the proposed proxy amendment situation. Corporate legal scholar William Bratton recognized this perverse short-term incentive with regard to stock options in executive compensation packages. He noted that even stock options that have long vesting periods (such as the prevailing ten year duration) but are set to vest in the near future lure executives to manage for the short-term in order to quickly increase stock value as the vesting period nears.  If executives will soon acquire stock through option exercise, they have an incentive to choose a “glamour investment,” although “[f]rom a long-term, fundamental value point of view, the glamour investment is sub-optimal.”

I don’t see the short-term incentive resulting from proposed SEC amendments as being much different than the situation Bratton describes.   As soon the holding period vests for a shareholder, a shareholder has a powerful incentive to nominate a director in order to capitalize on a short-term share value “spike” following the proxy contest.  But whether that nomination is good for the company in the long-term is questionable.   Ultimately, the amendments may actually encourage shareholders to use a proxy contest for short-term gain rather than restrict shareholders seeking proxy access to those with long-term interests.

As such, Citizens United v. FEC stands with District of Columbia v. Heller, the Second Amendment case decided in 2008, as an example of the Justices slapping the “originalist” label on a profoundly un-originalist interpretation of the Bill of Rights.  It is appropriate to view the two cases together.  Both are exercises in raw political power employed in order to accomplish conservative objectives.  Both ignore hundreds of years of understanding about the meaning of the relevant constitutional provisions, in favor of a meaning derived by taking the words of the Amendment out of context.  And both embrace interpretations of the constitutional Amendment at issue that are inconsistent with the meaning ascribed to that same language by the intellectual father of originalism, Robert Bork.  In the same way that modern scholars deride the “Lochner era” as a misguided period in American Constitutional Law, I believe that future scholars and judges will recognize and reject the intellectual dishonesty of the “Heller era.”

We begin, as we so often do, with John Marshall.  Justice Marshall’s reading of the Constitution was clearly a reading that respected the rights of property.  As R. Kent Newmyer succinctly summarized it, in his book “John Marshall and the Heroic Age of the Supreme Court,” Marshall understood the rights of property ownership to include an individual’s right “to acquire property and deploy it creatively as he saw fit and to enjoy its fruits without hindrance.” (Newmyer p. 264)  But this does not mean that Marshall embraced Adam Smith’s theory of completely free markets, where private business enterprises act completely free from government regulation.  First of all, not even Adam Smith advocated for markets that were sealed off from all government regulation.  Second of all, while the Framers of the Constitution were aware of Adam Smith, there is little evidence that Smith’s economic theories influenced the Constitution.

John Marshall’s understanding of how the Constitution protected property rights was, characteristically, derived from his understanding of federalism.  Justice Marshall struck down state laws that interfered with private property rights, for example in Fletcher v. Peck and Dartmouth College v. Woodward, because those laws violated the Contract Clause of the Constitution.  However, Marshall’s motivation was not to protect private economic activity from all forms of government regulation.  His motivation was to protect national economic interests from protectionist state laws.  Marshall viewed the states less as political units and more as local interest groups that would pass legislation favoring parochial economic interests over interests from out of state.  If the young United States of America was to build a truly nationwide economy, private enterprise had to be able to grow free from the constant parade of protectionist legislation being passed by the states.  As stated by Newmyer: “What he feared . . . was state legislative meddling with contracts, either by passing laws that undercut contracts between individuals or by reneging on its own.” (Newmyer p. 265)

Marshall’s protection of the rights of property, therefore, is not inconsistent with the idea of uniform, federal regulation of private enterprise when in the public interest.  (Kutler, infra, p. 67) Marshall simply never faced this issue.  The corporations in existence at the time of his opinions were not national in scope, and corporate activity that exploited labor or endangered consumers would not become common until the industrial revolution.  Marshall used the text of the Contracts Clause to clear local state laws from the path of private enterprise, and no more.  He sought to support a system of federalism where national interests could act free from state constraints.  He did not seek to completely immunize private enterprise from all government regulation. (Kutler, infra, p. 179)

Those who put their faith in the “invisible hand” of the marketplace often assert that the owners of a private enterprise have a natural law right to use their property as they see fit, free from any government interference.  The Supreme Court rejected this argument shortly after John Marshall’s death when, in 1837 the Court decided the Charles River Bridge Case.  The majority of the Court held that the Massachusetts legislature, by granting a charter to the proprietors of a toll bridge, did not violate the Contract Clause of the Constitution by subsequently chartering the construction of a competing (and free) bridge.  As explained by University of Wisconsin law professor Stanley Kutler in his classic book, “Privilege and Creative Destruction,” the case strongly affirmed the power of government to regulate the use of private property.  In the words of Chief Justice Taney, “The continued existence of a government would be of no great value, if . . . it was disarmed of the powers necessary to accomplish the ends of its creations; and the functions [government] was designed to perform, transferred to the hands of privileged corporations.” (Kutler p. 91)  The Constitution has never been interpreted to preclude government regulation of a private business enterprise for the public good.

The specific treatment of corporations under the Constitution is entirely consistent with this treatment of private property in general.  There is no evidence that the Framers’ generation understood corporations to have any rights under the Constitution separate from the rights of the persons who owned the corporation.  In fact, for most of our nation’s history, the Supreme Court denied the existence of any rights for corporations under the Constitution at all.

This history is usefully summarized in a forthcoming article by David Gans and Douglas Kendall.  In 1809, Justice John Marshall wrote in Bank of U.S. v. Deveaux that corporations were not “citizens” as that word was used in Article III of the Constitution.  Unfortunately, the result of the ruling was that corporations evaded the jurisdiction of the federal courts in order to avoid paying their debts.  Therefore, the Court quickly overruled Deveaux and adopted the legal fiction that corporations could be deemed “citizens” for purposes of suing or being sued in federal court.  The Court’s motivation in adopting this legal fiction, however, was to preserve the ability of natural persons harmed by a corporation to avail themselves of the diversity jurisdiction of the federal courts.

In 1839 the Court specifically ruled that the treatment of corporations as “persons” for diversity jurisdiction purposes did not grant corporations any of the other rights that the Constitution granted to natural persons.  The Court never extended any of the individual rights provisions of the Constitution to corporations until the end of the 19^th century.  Nor did the Court ever suggest that the federal government lacked the power to regulate corporate activity, so long as the government did not violate the literal terms of the corporate charter.

The first case extending constitutional rights to corporations came in 1897, under the Equal Protection Clause of the 14^th Amendment, and it ushered in the Lochner era when the Supreme Court used theories of substantive due process to assert that the Constitution protected corporations from federal economic regulation.  It is significant that this innovation came via an interpretation of a Reconstruction-era constitutional amendment, and not from a purported interpretation of the original text.  Moreover, in non-economic areas, such as the rights of self-incrimination, the Court continued to refuse to recognize any constitutional right for corporations.  Also, during this era, two giants of the law, Oliver Wendell Holmes and Louis Brandeis, dissented often and aggressively from all extensions of constitutional rights to corporations.

The Lochner era ended in 1937, after President Roosevelt threatened to pack the Supreme Court.  The Supreme Court retreated from its Lochner line of cases and once again began to uphold the federal power to regulate corporate affairs.  Over time, however, the Supreme Court began to hold that this power to regulate corporate activity was tempered by the existence of constitutional rights for corporations under the 14^th Amendment and under the criminal procedure provisions of the Constitution.

The true revolution occurred in 1978, when the Supreme Court ruled in First National Bank of Boston v. Bellotti that a state law limiting the ability of corporations to spend money on referenda elections that didn’t affect their property was unconstitutional.  The ruling did not explicitly hold that corporations had a First Amendment right, but it did say that the protection of speech was so important that it didn’t matter who was doing the talking.  This ruling was revolutionary because it was a departure from precedent that, with the exception of the Lochner era, had held that the distinction between the regulation of corporations and the regulation of individuals is an important distinction under the Constitution.

However, the Bellotti opinion was careful to preserve the power of the government to regulate corporate spending in the context of candidate elections, as opposed to referenda.  The Court continued to recognize this power to regulate corporate money in FEC v. National Right to Work Committee, in Austin v. Michigan Chamber of Commerce, and in McConnell v. FEC.  These latter two cases contained spirited dissents from Justices Scalia and Kennedy arguing that the First Amendment right that protected corporations in Bellotti should be extended to the context of candidate elections.

In Citizens United v. FEC, these dissents become the majority opinion, and the Austin and McConnell decisions were overruled insofar as they allowed the federal government to prevent corporations from making independent expenditures on behalf of candidates for office.  Not only are these prior cases overruled, but the history of the Court’s treatment of corporations under the Constitution is ignored.  Ignored, as well, is the Court’s pre-Lochner understanding that the Constitution permits the government to regulate corporate activity when it is contrary to the public interest.

Instead, what we get in the Citizens United opinion is the textualist assertion that the language of the First Amendment does not distinguish between whose speech is being regulated, so the government must therefore lack the power to makes a similar distinction.  We are told that the benefits of political speech are the same, whether the source of that speech is an individual or a corporation.  And we are told that media corporations, that report the news, might be subjected to government control if we do not recognize a First Amendment right for corporations.

Similar arguments were rejected by Robert Bork.  Bork clearly did not understand the First Amendment to require a complete absence of government regulation over speech.  For example, in his 1971 Indiana Law Journal article, Bork argued that the First Amendment does not prevent the government from regulating speech outside of the political context if that speech causes public harm.  Bork wrote that the Framers “displayed a determination to punish speech thought dangerous to government.”  For him, it was the impact of the speech at issue on the political process (positive or negative) that determined whether the speech was protected under the First Amendment, and not an absolutist interpretation of the text.

Justice Kennedy’s arguments were also rejected by Justice William Rehnquist, who dissented in Bellotti. Rehnquist stressed that “early in our history” the Supreme Court had declined to extend constitutional rights to corporations.  He viewed the Bellotti majority as acting inconsistently with this original understanding.  Therefore, the so-called “orginalism” that Justice Kennedy says requires us to depart from longstanding precedent is in fact contrary to earlier interpretations of the First Amendment by two notable originalists.

Justice Stevens’ dissent in Citizens United contains a devastatingly accurate characterization of Justice Kennedy’s argument:

As a matter of original expectations, then, it seems absurd to think that the First Amendment prohibits legislatures from taking into account the corporate identity of a sponsor of electoral activity.  As a matter of original meaning, it likewise seems baseless – unless one elevates the First Amendment’s ‘principles’ or its ‘purpose’ at such a high level of generality that the historical understandings of the Amendment cease to be a meaningful constraint on the judicial task.  This case sheds a revelatory light on the assumption of some that an impartial judge’s application of an originalist methodology is likely to yield more determinate answers, or to play a more decisive role in the decisional process, than his or her views about sound policy. 

What does support the majority’s interpretation of the First Amendment in Citizens United?  We are left with Justice Kennedy’s personal preference that corporations should have a voice in the political arena.  Except what is this “corporate voice” that needs protection?  It is most assuredly not the voice of the shareholders.  State law provides them with no mechanism to approve in advance the use of corporate funds for political activity, and under state law shareholders have little prospect for successfully punishing management after the fact for the use of corporate funds to sponsor political activity that they disagree with.  In addition, given that during 2009 the average share of stock was bought and sold two and one half times, shareholders will probably not own their shares long enough to care what management does with corporate money.  With the turnover in corporate ownership today, we do not have share-holders, we have share- renters.  In this context, the corporate voice is reduced to the voice of top management, who will use corporate money to fund political views that these highly compensated individuals are fully capable of funding out of their own pocket.

When it comes to the First Amendment, therefore, it seems that an ideological preference for free markets trumps traditional notions of federalism and free speech.    

Note:  The photo accompanying this post depicts the cover of Harper’s Weekly January 21, 1888 and is entitled “Not Even-Handed Justice: Crushing the Scorpion of Anarchy But Sparing the Octopus of Monopoly.”  A framed copy hangs in my office.

It does seem to make sense to consider the needs of investors in creating legislation aimed at protecting investors.  But in my view, any new regulatory scheme aimed at protecting investors should leave to the states the regulation over business organizations’ internal affairs.

The following excerpt from Ed’s post aptly describes the purpose of federal securities laws: 

“Federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.  The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.  Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.”

The Securities and Exchange Commission (SEC) oversees the implementation and enforcement of federal securities laws.  It does this by interpreting federal securities laws as well as through rule-making.  In fact the SEC has promulgated an extensive body of interpretive releases and rules that detail what information must be disclosed, how that must be presented and when and how it must be reported to investors, all with the objective of enabling investors to receive sufficient information on which to make investment decisions.

States, in contrast, have traditionally regulated the internal affairs of business entities organized in that state.  Internal affairs refer to the relationships between and among the various constituents of a business entity.  For example, in the case of a corporation, the corporation’s state of incorporation would regulate the rights and responsibilities of the corporation’s stockholders, directors and officers vis-a-vis one another.  (Viewed more broadly, a corporation’s constituents also include its employees, creditors, suppliers, customers, and communities where it operates.)

States typically regulate internal affairs through a combination of statutory codes and common law.  State codes typically provide a system of “default” rules governing an entity’s internal affairs.  That means a business entity can modify these rules and opt for a different arrangement.  (The codes also state who has the right to alter the default rules and how.)  While most state codes do set forth some “mandatory” rules which may not be altered, by and large the internal affairs of business entities are regulated by a set of rules that function much like a private contract.

State common law supplements these codes, not only by offering judicial interpretation of the codes, but also by addressing matters that are not covered by the codes (often also as “default” rules).  Importantly, in some states (including Delaware), the imposition of fiduciary duties on managers is almost exclusively a matter of common law.

There seem to be a number of benefits to state regulation over internal affairs.  For one, the judicial promulgation of judicial standards on fiduciary duties provides a mechanism to flexibly apply those duties in light of relevant facts and circumstances.  It also enables courts to modify fiduciary standards so that they reflect evolving business norms and mores.  Moreover, the legislative and judicial use of default rules for most matters of internal affairs reflects the fact that no two businesses are alike, and allows for customization of internal affairs in a way that reflects the unique nature of each business. It also allows for the creation of innovative business structures.

In addition, having the states regulate internal affairs may lead to competition among states for charters.  As some would argue, this competition leads to a “race to the top” because entrepreneurs and managers opt for the most efficient set of rules.  Often that means choosing a jurisdiction where the “default” rules most closely approximate the desired internal affair structure to minimize costs of having to contract around those rules.  Still, some would argue that having states compete for charters leads to a “race to the bottom”.  That is because entrepreneurs and managers organize (or re-organize) entities in jurisdictions with rules that are the most protective of their rights and impose on them the fewest duties, to the detriment of other constituents such as the equity holders.  While those default rules can be altered, it is often impractical to do so either because the constituent wishing to alter them (typically equity holders) doesn’t have the right to initiate that type of change, or because it is simply impractical to alter them.   While each argument has its merits, there has yet to be a conclusive finding on the consequences of the competition between states for charters.

In any case, if the federal government were to regulate internal affairs, we would likely lose many of the benefits of state regulation that I identified above.  That is because federal regulation would likely mean a set of mandatory rules over internal affairs (much like existing market regulation and disclosure rules) that do not permit for flexible structuring or private ordering.  Nor would these rules likely be updated on a regular basis to reflect changing norms.  As a closed system, federal regulations over internal affairs would inevitably become obsolete in the face of a constantly changing business environment and the need for innovative business structures.

This is not merely a theoretical concern, for Congress is currently considering “say on pay” legislation. Under this law, shareholders of all public companies would have a non-binding, advisory vote on the compensation of top executive officers.  The proposed law is mandatory in nature in that it cannot be contracted around.  Moreover, it is inflexible because it does not consider whether a shareholder vote on pay is sensible for a particular company.  For instance, a company may have other, more effective checks on the decision as to what to pay executive officers than asking investors, who do not typically give input on board decisions (nor have a fiduciary duty to consider the best interest of the company or other shareholders in doing so), to vote on a matter as to which they may have only limited information. 

While I concede that there is a problem at some companies with executive over-compensation, I don’t think that a mandatory, one-size fits all federal solution is ideal.  Rather, state law with its flexible standards and circumstance-driven duties that evolve to reflect changing norms seems to be a much more appropriate place to address this type of internal affair concern.

The answer for many populists was easy—the veterans should not be swindled by greedy money men.  However, Treasury Secretary Alexander Hamilton knew that the price of the government breaking a contract was far more costly to a young nation’s character than the ephemeral outrage that many veterans felt.  As Hamilton told President Washington, “[t]he general rules of property, and all those general rules which form the links of society, frequently involve in their ordinary operation particular hardships and injuries.  Yet the public order and the general happiness require a steady conformity to them.  It is perhaps always better that partial evils should be submitted to than that principles should be violated.”

Because history has a way of repeating itself, it should come as no surprise that the debate over contract rights versus populist sentiment has returned with a vengeance.  The first sign of trouble came last March when President Obama urged Congress to sever the retention bonuses owed to several AIG derivative traders.  The outrage was understandable: AIG had gone belly up and was only kept afloat by the public dole.  However, the retention bonuses were agreed to before the TARP bailout; abrogating them would violate a clear contractual obligation.

This did not stop some members of Congress from seeking to pass a Bill of Attainder to recoup the bonuses via the tax code.  Congressman Barney Frank even threatened AIG CEO Edward Liddy with a subpoena if Liddy did not hand over the names of the AIG employees who received the bonuses.  Just what, pray tell Congressman, did you intend to do with those names? 

Not to be outdone on the outrage meter, Republican Senator Charles Grassley stated “I would suggest the first thing that would make me feel a little better toward them [the AIG executives] is if they follow the Japanese example and come before the American people and take that deep bow and say, ‘I am sorry,’ and then either do one of two things: resign or go commit suicide.  And in the case of the Japanese, they usually commit suicide.”  Goodness.

But the low moment came in May during the Chrysler bankruptcy proceedings.  The Obama administration was attempting to spare Chrysler from bankruptcy court by selling Chrysler’s assets to a new company owned by the United Auto Workers (UAW) and Fiat.  The only problem for the administration was that a group of plucky Chrysler bondholders refused to sell their assets on the grounds that they could get a better deal in bankruptcy court.  Because these bondholders were secured creditors, they were entitled to first priority under bankruptcy law rules.  These bondholders rightly pointed out that they owed their shareholders the fiduciary duty to hold out for the best deal possible.

But bankruptcy court would have been bad for the UAW (as it was a junior creditor), so the Obama administration brought out the brass knuckles.  Thomas Lauria, the attorney for the group of bondholders, stated that his clients were threatened by the Obama administration into taking a haircut.  For a brief moment, it appeared as if the bondholders would fight it out in court, but eventually they relented in the face of governmental pressure.  Lauria said that his clients decided against a legal battle once they concluded they could not “withstand the enormous pressure and machinery of the U.S. government.”  Bankruptcy Judge Redfield T. Baum quipped that the bondholders had about as much of a chance of winning against the federal government as “the gentleman in Tiananmen Square when the tank came rolling in.”

As we dig ourselves out of the Great Recession, investors must cope with an additional risk: the threat of government abrogation of legal rights for political reasons.  Even Warren Buffet bemoaned the Chrysler situation: “If we want to encourage lending in this country, we don’t want to say to somebody who lends and gets a secured position that the secured position doesn’t mean anything.”

 Russell Kirk once noted that “[u]pon the foundation of private property, great civilizations are built.”  Ignoring these rights is how they fall.

 However, in my mind both men are associated with the Second Law of Thermodynamics.  This law of physics states that the entropy of an isolated system always increases over time.  Stephen Hawking described it in more comprehensible terms in A Brief History of Time:

It is a common experience that disorder will increase if things are left to themselves.  . . .  In any closed system disorder, or entropy, always increases with time.

 Therefore, when I think of Hawking, I think of someone who can explain the Second Law of Thermodynamics.  When I think of Barney Frank, I think of someone who is desperately trying to avoid its operation.

I would contend that all forms of market regulation follow the Second Law of Thermodynamics.  In each case, a comprehensive statutory scheme is enacted as law, it imposes a closed system of rules on market actors, and over time the scheme inexorably breaks down.  Federal securities regulation, which began with the Securities Act of 1933 and the Securities Exchange Act of 1934, provides the perfect case history of this principle in action.

The federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.  The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.  Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.

This regulatory scheme was imposed on the world as it existed in 1933.  This was a world where the fastest form of communication for a written text was the United States mail.  It was also a world where all information was compiled and stored in a document-centric format: if you sought a particular piece of information you had to search for it by reading through an entire book or a report.  This was also a world where the types of securities sold to the public were comprised mostly of the vanilla variety of stocks and bonds that buyers (and sellers) knew and understood.

 We live today in a very different world.  Technology has changed.  A written text can be sent anywhere in the world instantaneously via the internet.  In addition, information is stored very differently in the digital age.  We enter search terms into Google and Lexis, thereby allowing us to extract specific nuggets of information directly, without having to read through an entire book or document to find them.

 The markets where securities are bought and sold have also changed dramatically.  Virtually anything can be “securitized” and turned into a product that can be traded over the market – from the right to receive future mortgage payments to the risk that the same mortgage holders will default on those payments.   Financial institutions were initially forced to confine their trading to a single line of business: whether securities trading, banking, or insurance.  Over time, however, these rules were relaxed and firms became “financial supermarkets” that were allowed to take on multiple market risks at the same time.  The same company can now take the simultaneous risk that the securities it underwrites will not sell, that the loans it makes will not be repaid, and that its cash flow will not be sufficient to meet its obligations to policyholders.  A single company can survive one bad bet; it cannot survive losing all three.

 These changes in information technology and market behavior all occurred at the same time that economists were radically changing their theories about the way that prices for securities are determined by the market.  The SEC has long embraced the Efficient Capital Markets Hypothesis, which holds that the price of a financial asset reflects all available information that is relevant to its value.  If this theory holds true, then it is proper for regulators to focus their attention on ensuring that companies quickly and accurately disclose new information relevant to their future prospects.  However, behavioral economists have come to the conclusion that investors are often swayed by irrational factors unconnected to objective data about the company, such as an unjustified optimism that a past price rise will continue into the future (the “bubble” effect).  New theories of evolutionary economics posit that investors adopt trading practices in a process of trial and error, keeping strategies that work and dropping strategies that cease to create profit.  The implication is that investment decisions are neither purely rational nor purely irrational, and that the SEC’s single-minded pursuit of information disclosure can never foreclose the possibility of future market bubbles and meltdowns.

It has become plain that the original regulatory scheme of 1933 is beyond the point where minor patching will work anymore, and is probably beyond the point where even serious repair can rescue the original model.  Entropy has overtaken federal securities regulation.  Some might argue that this fact demonstrates that any attempt to regulate the financial markets is ultimately futile.  However, I believe that our experience with securities regulation merely proves that every regulatory scheme has a natural lifespan.

 Our current model for the regulation of financial markets has reached the end of its useful life.  The world we live in has changed to such an extent that the original model should be discarded and a new regulatory scheme embraced.  While it may not be feasible to replace all of our current market regulators, at a minimum those regulatory bodies should be consolidated and given a new mission.

 If financial institutions are going to be allowed to operate in multiple market sectors, then the focus of our financial regulation should be on systemic risk (the risk that conditions across several different market sectors will lead large financial institutions to fail).  In addition, the content of financial regulation should be determined less by the characteristics of the financial product being sold (securities for the SEC, commodities futures for the CFTC, loans for the Treasury Department and the Federal Reserve) and more on the financial stability of companies that sell financial products.  This would entail the enforcement of minimum capital requirements and prohibitions on excessive leverage so that the managers of large financial institutions do not bet the company’s very existence on risky trading strategies.  Finally, the mission of our financial regulators needs to shift away from policing whether sellers have disclosed information and focus on the needs of the public as the consumers of a product.  Are buyers being given a variety of choices?  Does the information being made available allow consumers to make meaningful comparisons between products?  A new Consumer Financial Protection Agency could be created to undertake this last task.

 What I have described are the very premises that underlie the Obama Administration’s proposals to reform financial regulation.  Barney Frank and the House Financial Services Committee have been holding hearings on these ideas.  You can read more about the Administration’s proposals in this report from the Brookings Institution.  I agree with the report’s author that these measures are sensible and overdue.

However, politics always gets in the way.  Each existing financial regulator is jealously guarding its own turf, to ensure that a new system of market regulation does not diminish its authority.  Powerful congressmen, who possess their power due to their seniority on the committees that oversee different segments of the market, do not want to see the old system of regulation abolished.  And financial institutions that have learned how to operate around and between the interstices of multiple regulatory bodies do not want a comprehensive reform that eliminates or even blurs these lines of demarcation.

As a result, any legislation enacting these reform proposals will probably be significantly watered down and the original 1933 model of securities regulation is likely to persist.  According to the Second Law of Thermodynamics, leaving the original model of regulation to itself will result in increasing disorder in the financial markets.  Someone once said that “you can’t fight the laws of physics.”  I think it was either Stephen Hawking or Barney Frank.

Lawyers in Howrey’s apprenticeship program will be paid significantly less than the going rate for first year associates at other large law firms.  During their first year, the new associates will take firm sponsored classes on legal writing and gain practical experience by working on pro bono matters.  During their second year, the associates in the program will spend several months “embedded” at client sites where their work will be charged at a reduced billing rate.  The law firm’s managing partner compared the apprenticeship program to the training programs typically employed in the medical and accounting professions.

 The Howrey program provides an opportunity to reconsider the entire continuum of legal education: a process that begins with undergraduate instruction, continues through law school, and is perpetuated by continuing legal education requirements.  From time to time, each stage in the continuum comes under scrutiny, as Rick Esenberg’s post on Reengineering Law School illustrates.  In my opinion, the continuum should be viewed holistically when we evaluate whether we are succeeding at training competent and ethical members of the legal profession.  Law schools, law firms and the state bar all need to cooperate in order to ensure that there are no gaps in the preparation that new lawyers receive as they start their careers.  As a member of the Wisconsin Legal Education Commission in 1996, I argued in favor of a program of mandatory skills-based CLE instruction for recent bar admittees.  Many of our students are undoubtedly pleased that the State Bar chose not to implement this particular Commission recommendation.

 Given my predisposition in favor of practical training, I should be supportive of the Howrey apprenticeship model.  Instead, I find myself troubled.  In particular, I am wary of the idea of embedding future corporate lawyers within a client’s legal department for any significant period of time.

 Corporate lawyers play a vital role as “gatekeepers” in the area of economic regulation.  The role of outside legal counsel is not just to provide the advice necessary to implement the client’s business plan, but also to guide the client (sometimes gently and sometimes more forcefully) away from tactics that stray too far into the “grey areas” of  prohibited conduct under securities or antitrust law.  Lawyers who fail to take this gatekeeper role seriously, and who unquestioningly advance the client’s interests, risk possible disciplinary action or even criminal charges.

It is worth recalling that, during the 1990s, accounting firms evolved away from their traditional role as financial monitors and towards more lucrative “client consulting” practices.  This inattention to the gatekeeper responsibilities of their own profession led to several high-profile corporate meltdowns.  Today the accounting profession is subjected to unprecedented regulation via the Sarbanes-Oxley Act.  Among other things, Sarbanes-Oxley forces accounting firms to rotate the lead auditors that they assign to their clients.  The purpose of this provision is to reduce the risk that a long time relationship between a particular auditor and a particular client might eventually jeopardize the auditor’s objectivity.

 My concern is that Howrey’s embedded lawyers may be tempted to internalize the client’s perspective, in a way that hampers the future objectivity of these young professionals.  While the details of the law firm’s program are unclear, it would make sense for Howrey to try and perpetuate the relationships that are formed between its apprentices and its clients when it assigns future legal work to associates.  This could lead to a close and career long association between an apprentice and a particular client.  It seems odd to me in this post-Sarbanes-Oxley world that a law firm would seek to mimic the very lack of separation that accounting firms previously fostered between individual accountants and particular clients.

It was this close association that created a culture where auditors acquiesced in the client’s view of how the company’s financial results should be presented, rather than pushing the client to adopt a more defensible presentation.  Outside legal counsel face pressures from clients as well, in this case to rubber stamp the non-financial disclosures in a company’s annual reports and other securities filings.  Will former apprentices prove too pliable when pushed to sign off on the preferred disclosure language of companies where they were once embedded, and with whom they have a career-long association?  If so, our profession should not be surprised if Congress someday mandates that law firms rotate billing partners among their clients required to file public reports, much as accountants must now rotate lead auditors. 

 There are many ways in which the objectivity of corporate lawyers can be compromised.  Outside counsel is often asked to serve on the board of directors of the client corporation.  In some cases, law firms receive the client’s stock as compensation rather than cash.  Engaging in such practices does not necessarily compromise the objectivity of the lawyer, and neither of these examples directly contravenes the ethical rules for lawyers.  Nonetheless, many observers argue that these practices should be avoided because they tempt lawyers to too closely associate their client’s interests with their own, thereby abandoning their gatekeeper role.  It is interesting to consider whether the use of embedded apprenticeships as a training mechanism for corporate lawyers engenders a similar risk.

Nadelle Grossman

Corporate boards face significant pressure to make decisions that maximize profits in the short run. That pressure comes in part from executives who are financially rewarded for short-term profits despite the long-term risks associated with those profit-making activities. The current financial crisis, where executives at AIG and numerous other institutions ignored the long-term risks associated with their mortgage-backed securities investments, arose largely because those executives were compensated for the short-term profits generated by those investments despite their longer-term risks. Pressure on boards for short-term profits also comes from activist investors who seek to make quick money off of trading in stocks whose prices overly reflect short-term firm values.

Yet this excessive focus on producing short-term profits runs counter to the interests of non-short-termist investors and other corporate constituents, as well as our economy and society as a whole, in creating corporate enterprises that are profitable on an enduring basis. Once again, the current financial crisis provides a lens through which we can see the distressing impact — both to individual businesses as well as to the entire U.S community — of an excessive focus on short-term profits.

I propose a solution to address this problem of short-termism. Under my proposal, directors would be required to make decisions that are in the long-term best interest of stockholders and the corporation under their fiduciary duties. I explain in the article why I propose fixing the short-termism problem through fiduciary duties as well as how, practically, my proposal would be implemented.

This paper is forthcoming in the Michigan Journal of Law Reform. 

The second paper, entitled “Director Compliance with Elusive Fiduciary Duties in a Climate of Corporate Governance Reform,” addresses other aspects of the fiduciary duties of board members.  Here is the abstract:

Corporate governance has become a hot topic following accounting scandals at Enron, WorldCom and others, which led to colossal corporate collapses. In many of those cases, the boards were “asleep at the wheel,” failing to catch managers’ questionable accounting practices. The Sarbanes-Oxley Act of 2002 was the federal government’s attempt at fixing the holes in the corporate governance system exposed by the accounting scandals. Through a patchwork of disclosure requirements and conduct rules, Congress and the Securities and Exchange Commission have attempted to bring about an increase in board oversight of, and independence from, management. The stock exchanges have also jumped into the corporate governance arena, implementing new rules with similar objectives. This collective corporate governance reform has imposed a significant new layer of responsibilities and qualifications on directors of public companies. Yet, shareholders’ only avenue to enforce the new duties under these reforms is through state law fiduciary duties. My article demonstrates how state courts have started to enforce the governance mandates under the reforms through fiduciary duties. Specifically, in my article I examine the watershed Disney case and the duty to act in good faith, and identify how Delaware courts are poised to use this duty to enforce directors’ oversight responsibilities under the corporate governance reforms. My article takes a uniquely holistic view of these shifts in Delaware jurisprudence, explaining how they allow Delaware courts to more closely align the standard of conduct expected from directors with the standard of review that courts apply in determining liability. My article ultimately submits that by more closely aligning these two standards through the duty to act in good faith, the Delaware courts are able to reflect evolving shareholder expectations in fiduciary duty law, thereby making directors more responsive to the shareholders who elected them.

This paper has already been published at 12 Fordham Journal of Corporate and Financial Law 393 (2007).

Another fundamental area where the Marquette Law School faculty is also showing important contributions to the law is the production of scholarship that results in law review articles, book chapters, textbooks, etc.  We often present and discuss these works when they are still in progress in conferences around the country with our colleagues in our areas at other schools.  Still, to facilitate even further these very important discussions, the MULS Academic Programs Committee, led by Professor Chad Oldfather, has organized two sessions of an in-house Works-in-Progress Workshop for June and July.

The June session was a great success. A group of eight of us met this past Wednesday and presented our works-in-progress, from very rough to more completed drafts of scholarship, to our colleagues participating in the program. 

 In addition to the various presenters, Professor Paul Secunda also provided participants with helpful feedback. The topics and discussion on each of the drafts were fascinating and brought us on a beautiful journey throughout many different areas of the law.

Professor Phoebe Williams opened the day by presenting a paper on “Age Discrimination as a Barrier to the Provision of Health Care,” in which she analyzes the Age Discrimination Act of 1975 and advocates for the creation of appropriate data collection and research models to effectively identify and redress those instances where advanced age is illegitimately considered by health care providers.

Professor David Papke then followed with a paper on “Law, Legal Institutions, and the Criminalization of the Underclass,” which represents one of the chapters of  a planned book on the analysis of the relationship between legal institutions and the “underclass” in the United States.

Also related to Criminal Law, Professor Greg O’Meara presented a paper on habeas corpus review for state prisoners, in which he challenges the belief, almost taken for granted after passage of the Antiterrorism and Effective Death Penalty Act of 1996, that habeas claims are ineffective.  Professor O’Meara’s paper will be part of the Conference on Criminal Appeals, which has been organized by Professors O’Hear and Oldfather and will take place at Marquette Law School on June 15-16, 2009. The paper will also be published in a special symposium issue of the Marquette Law Review.

The Workshop continued with the presentation of Professor Vada Lindsey on the wrongs of the “Earned Income Tax Credit.”  In this paper, Professor Lindsey criticizes the effectiveness of the EITC, particularly insofar as it fails to encourage saving by the working poor.

Professor Lisa LaPlante followed with a presentation that brought us to a different dimension of the law: international law. In her current project, starting from the analysis of the conviction of former Peruvian President Fujimori, Professor LaPlante considers the issue of criminal accountability for wars on terror and human rights violations by heads of state.

Professor Nadelle Grossman then brought all of us back to our classrooms by discussing her current research project: how traditional law school teaching, which is based primarily on case law, fails in preparing students for transactional practice. In her paper, Professor Grossman highlights the gap between the reality of legal practice and law school teaching, criticizes the lack of valuable materials for teaching transactional law and practice, and calls upon law school curricula to bridge this very important gap.

Next, Professor Michael O’Hear presented a draft of his article “Appellate Review of Sentence Explanations: Learning from the Wisconsin and Federal Experience,” which he will also present at the Criminal Appeals Conference and which will be published in the symposium issue of the Marquette Law Review. In his paper, Professor O’Hear proposes a set of principles to guide the appellate review of sentence explanations in jurisdictions, such as Wisconsin, that lack mandatory sentencing guidelines.

I then concluded the day with a presentation on “The Case for a Fair and Balanced Protection of Geographical Indications of Origin,” which addresses the reasons why we should protect these “new” types of intellectual property (which refer to names such as Prosciutto di Parma, Chianti, Bordeaux, Budwar Bier, or Idaho Potatoes) and the limitations that should apply to these rights. Unfortunately, I had no time to provide tastes of the many (good quality) food and drinks I mention in my paper!

Thank you again, Professor Oldfather, for organizing such a great day of legal discourse and intellectual exchange at Marquette Law School.

The first case, State v. Henley, 2008AP697, presents an interesting issue regarding the authority of the courts of appeal, or the supreme court, to grant a new trial to a criminal defendant in the interests of justice, without regard to the passing of the time for appeal.  As Judges Vergeront, Lundsten, and Bridge explained in their certification of the questions in the case,

This case is significant because the circuit court has granted a form of relief that does not appear to have been recognized previously in Wisconsin law. There is no authority cited by the parties, and none that we know of, that expressly permits a circuit court to grant a new trial in the interest of justice after the time for direct appeal under WIS. STAT. RULE 809.30 has passed. If such a remedy is available, it has implications for finality of criminal convictions and for the interplay with other forms of postconviction relief, such as WIS. STAT. § 974.06. However, availability of this remedy would also improve the ability of courts to consider unusual circumstances and do what justice requires in individual cases. These competing concerns are implicated in the entire series of legal issues discussed in this certification.

The issues in the next case, State v. Carroll, 2007AP1378, surround whether police violated the defendant’s rights in obtaining photographic evidence from his cell phone. 

The next case, Ehlinger v. Hauser, 2007AP477, arose from a business dispute regarding a disability buyout provision that was invoked after one of the principals in the shared business developed Parkinson’s disease. The court of appeals determined that the buyout provisions were unenforceable but that the circuit court properly exercised its discretion in determing that the shared business could pay the litigation expenses of the party who had been seeking the dissolution.  Both parties are dissatisfied with the outcome in the court of appeals, so the case includes a petition and a cross-petition.

In the next case, State v. Arends, 2008AP52, the court has been asked to clarify certain procedural questions presented by section 980.09 of the Wisconsin statutes, regarding committment of a sexually violent person. 

In the next case, State v. Fischer, 2007AP1898, also criminal, the court of appeals affirmed a circuit court order to exclude the testimony of a defense expert regarding his blood alcohol level, when the defense expert relied in part on results of a preliminary breath test (results that are not admissible at an OWI trial). The petition asks the court to decide whether the exclusion of the expert testimony violated Fischer’s constitutional or statutory rights.

Finally, in the last case, State v. Artic, 2008AP880, the Petitioner argues that that police officers’ alleged violations of his rights (invasion of the curtilage, manufacture of exigent circumstances, and forced entry) were not sufficiently attenuated from the consent to search.  Further, he argues that, per se, the fruits of a search or seizure are inadmissible if police created the exigent circumstances (fear of destruction of evidence) by knocking and announcing before entry.

The current crisis exposes the fragility of markets generally. They are built on mutual reciprocity, and as more opportunism from trusted intermediaries is exposed, the weaker our faith in other market actors becomes. Both Francis Fukuyama’s work on trust and Robert Putnam’s on the “social capital” it reflects bode ill for our economy. Putnam describes a southern Italy mired in corruption and fraud, and a northern Italy whose economic success is built on its long history of civic associations and mutual endeavor. Can anyone doubt that our economy is exposed (with each passing day) as more Sicilian in its “winners’” casual acceptance of fraud, more Russian in its oligarchic tendencies, more Brazilian in its inequality? After the Madoff scandal, what are investors to do–personally spot-check their broker’s office and assure that trades are actually being made?

There is a bunch of other interesting stuff in this post, but I think I’ll just end with my favorite part.  In discussing the “worship of wealth,” Pasquale quotes from the blog of former fund manager John Bogle:

At a party given by a billionaire on Shelter Island, the late Kurt Vonnegut informs his pal, the author Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . Enough.”

She points us to this story from the New York Times Deal Book:

The possibility of a bankruptcy filing at Tribune Company is an embarrassing development for Samuel Zell, the real-estate mogul who took the media company private last December.

But it is likely that Tribune’s employees — or, more specifically, the employees’ stock-ownership plan — would take the first hit.

Because of the unusual structure of Tribune’s $8 billion buyout, Tribune’s employee stock-ownership plan holds 100 percent of Tribune’s common equity, regulatory filings show. Common stockholders are generally the first to take a loss in a bankruptcy restructuring, and they usually recover next to nothing.

Mr. Zell, by contrast, supplied mostly debt in the complex transaction, putting him higher in line to get paid. His $315 million investment in the Tribune deal consisted of a $225 million promissory note; the rest was for warrants to buy about 40 percent of Tribune’s stock in the future.

Great, another self-centered corporate CEO looking out for himself and screwing the employees of his company. I guess we should be thankful that at least he is not asking for a bail out.

More about this story here.

Cross posted at Workplace Prof Blog.

According to the Risk and Governance Blog:

The Laborers’ International Union of North America and the International Brotherhood of Teamsters are filing new proposals that seek compensation reforms at companies that participate in the U.S. Treasury Department’s bailout program.

In the supporting statement for these 2009 resolutions, the labor funds argue that the pay restrictions in the Treasury’s Troubled Asset Relief Program (TARP) “fail to adequately address the serious shortcomings of many executive compensation plans.” Instead, the unions urge directors to adopt “more rigorous executive compensation reforms that we believe will significantly improve the pay-for-performance features of the Company’s plan and help restore investor confidence.”

According to the Associated Press, more than 110 financial firms have indicated that they likely will participate in the TARP’s Capital Purchase Program, under which the government has so far committed up to $250 billion to buy preferred stock. The labor funds have filed this resolution at JPMorgan Chase, KeyCorp, Bank of America, American Express, and SunTrust Banks, and plan to submit the proposal at more than 45 other firms.

The proposal calls for directors to adopt the following reforms:

* Limit annual incentive compensation to an amount not exceeding one times the senior executive’s annual salary;

* Require that a majority of long-term compensation be awarded in the form of performance-vested equity instruments;

* Freeze new stock option awards to senior executives, unless the options are indexed to peer group performance so that relative, not absolute, future stock price improvements are rewarded;

* Require senior executives to hold for the full term of their employment at least 75 percent of the shares of stock obtained through equity awards;

* Prohibit accelerated vesting for all unvested equity awards held by senior executives;

* Limit all senior executive severance payments to an amount no greater than one times the executive’s annual salary; and

* Freeze the accrual of retirement benefits under any supplemental executive retirement plan (SERP) for senior executives.

The labor unions urge directors to adopt all of these reforms unless barred by existing executive employment agreements.

In short, the bailout has presented an opportunity for unions to actively challenge excessive executive compensation. This is an example of how unions through their roles as shareholders are seeking to influence executive pay, voting for boards of directors, and other corporate governance issues.

Cross posted at Workplace Prof Blog.

So what should a new administration do to make businesses better appreciate, and protect themselves from, the long-term risks associated with their businesses?

Congress is currently attempting to address this through regulating the executive compensation practices of financial institutions that take advantage of the Treasury’s purchase of troubled assets (such as mortgage-backed securities) under the Troubled Asset Relief Program (TARP) established under the Emergency Economic Stabilization Act of 2008.  For example, these regulations prohibit the payment of compensation to top executives of financial institutions in which the Treasury obtains a meaningful debt or equity investment in connection with its purchase of troubled assets that rewards those executives for taking “unnecessary and excessive risks that threaten the value of the financial institution.”  But in my view, this only addressed one of the symptoms of the ailment of excessive risk-taking, and only in one industry.  To be sure, executive compensation practices are also a source of excessive risk taking, where executives are rewarded for the short-term benefits of their decisions notwithstanding their long-term value-destroying effects.  But perhaps more importantly, the stock market encourages risk-taking by rewarding investors with profits from short-term stock price swings notwithstanding the long-term risks of the decisions that created those swings.  Don’t get me wrong, I don’t blame investors for wanting to make profits.  Earning profits through investments in successful business enterprises is at the core of our capitalist system.  But our stock market should not encourage investors to make profits from short-term spikes in stock prices that are not lasting, much like executives should not be rewarded for making decisions that bring about those short-term spikes.

So how should the new administration go about fixing the problem? 

Perhaps the new administration should send a clear message to state legislatures and courts (who regulate the internal affairs of the business organizations organized in their states) that business managers must, as part of their fiduciary duties to their investors, make decisions that are aimed at enhancing long-term enterprise value rather than short-term profits.  (This is actually the subject of my forthcoming article.)  The new administration should also consider how to encourage investors to invest in enterprises that create lasting value and societal wealth, rather than in enterprises that simply provide short-term returns to their profit-seeking investors (such as hedge funds).  While some might view increased regulation in this area as dissonant with our system of capitalism, in my view, the goal would be to create a coherent and well thought out scheme of targeted regulations that could enhance how our capitalist system functions over the long-term.

The next President, members of Congress, and state legislators have a lot of work ahead of them to fix our corporate system so that U.S. businesses are encouraged to prosper and grow.  But I believe doing so is critical if we want our economy to be among the strongest in the world.

There’s a former Wall Street trader who is now a researcher at Cambridge University in the UK. His name is John Coates. What he told me was that when he ran a trading desk in Wall Street during the last dot com boom and bust, he found that his traders were exhibiting almost physical symptoms of mania. So they were punching the air. They were yelling. There was – not to put too fine a point on it – there was more pornography floating around in the office. This is of course is a very masculine, macho environment. But what John Coates also noticed was that the few women who were on the trading floor didn’t seem to be affected.

Looking into this, he discovered that this sort of behavior is actually really common in many male animals. What happens is, you have, say, two gorillas or two stags fighting each other. One of them wins. They get a surge of the hormone testosterone. It makes them aggressive. It makes them take risks. And that goes on for several days. And then one day, effectively they are suffering from testosterone poisoning. These traders are basically suffering from exactly the same symptoms as rutting stags.

Ari Shapiro, the NPR reporter then follows up with the next logical question, ”So we should put women in charge of Wall Street, is that what you’re saying?”  Mr. Harford replies, “Well, that’s a possibility, assuming that women want to be in charge in Wall Street, yeah.”  This, of course, leads to the question of who actually wants to be in charge of this mess.  But, in fact, some limited studies demonstrate that when women serve on corporate boards, the companies do better.  See Conglomerate for more on this conversation. 

So, the lesson for my pension fund advisors -– I hope you have a mix of men and women making investment decisions and I also hope you are investing in companies with a mix of men and women on the board.  (I also hope that my next quarterly statement is an improvement!)

Cross-posted at Indisputably.

Much has been made of the greed and speculative fervor that gripped the investment professionals on Wall Street. Clearly bets were being made with borrowed money that risked the very existence of institutions that are necessary to preserve the liquidity of capital in our markets. Expanding the oversight of the Treasury Department, increasing the transparency of transactions that involve derivatives and hedge funds, and re-examining accounting rules may all be necessary components of a plan to avoid such risk-taking in the future, but they will not be sufficient in and of themselves. From personal experience in the boardroom, I can vouch that nothing deters executive approval of speculative investment strategies as much as the prospect of a potential civil lawsuit if the deal goes sour.

Federal judges have been antagonistic towards plaintiff’s litigation alleging securities fraud for decades. The Supreme Court has deliberately sought to reduce frivolous lawsuits by interpreting the reach of Rule 10b-5 in ways that limit meritorious suits as well. Cases such as Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2799 (2007), and Stoneridge Investment Partners LLC v. Scientific Atlanta, Inc., 128 S. Ct. 761 (2008), are but the latest examples of this judicial attitude. And of course Congress has acted as well to limit private suits through the Private Securities Litigation Reform Act of 1995 (passed over President Clinton’s veto) and the Securities Litigation Uniform Standards Act of 1998.

The hostility of federal judges towards frivolous lawsuits is easy to understand. The judge can observe firsthand the cost that an unwarranted claim of securities fraud imposes on the corporate defendant and its executives. However, federal judges do not observe firsthand, and therefore undervalue, the deterrent effect that the possibility of a securities fraud lawsuit (even an unwarranted one) has on the willingness of market actors to engage in speculative behavior. The restrictions on private litigation over the last decade or so have substantially reduced this deterrent, and have undoubtedly contributed to risky boardroom decisions. These restrictions have also greatly reduced the ability of a corporate lawyer to act as a “gatekeeper” and police the quality of executive decision-making. When corporate executives are discussing risky financial strategies, speculation is often replaced by prudence after the lawyer asks how the executives would defend their decision if challenged in court.

President Clinton was roundly criticized as beholden to the plaintiffs’ bar when he vetoed the Private Securities Litigation Reform Act. The next President should reflect upon whether Bill Clinton was correct to do so, and whether private securities litigation plays an important role in deterring excessive risk-taking in the markets. Our nation’s ability to avoid a future financial crisis may depend on it.

Up to 10,000 staff at the New York office of the bankrupt investment bank Lehman Brothers will share a bonus pool set aside for them that is worth $2.5bn (£1.4bn), Barclays Bank, which is buying the business, confirmed last night.

The revelation sparked fury among the workers’ former colleagues, Lehman’s 5,000 staff based in London, who currently have no idea how long they will go on receiving even their basic salaries, let alone any bonus payments. It also prompted a renewed backlash over the compensation culture in global finance, with critics claiming that many bankers receive pay and rewards that bore no relation to the job they had done.

A spokesman for Barclays said the $2.5bn bonus pool in New York had been set aside before Lehman Brothers filed for chapter 11 bankruptcy in the United States a week ago. Barclays has agreed that the fund should continue to be ring-fenced now it has taken control of Lehman’s US business, a deal agreed by American bankruptcy courts over the weekend.

I’m really at a loss of words. One can see the cupidity inherent in the current American system through this example alone. And also the need for direct oversight of executive compensation, as companies have shown an inability to provide any meaningful limits on such payments.

The Christian Science Monitor agrees:

Wall Street badly needs a culture change at the top. Its leaders must come to view themselves as stewards of institutions for the long term, not as temporary operators of vehicles proficient at finding new ways to throw off wealth, with everything else – including impact on the public interest – a mere detail. Institutional stewardship will mean, in practice, forgoing some opportunities for making a killing when the downside of a bet gone bad may be to jeopardize a franchise . . . .

The most objectionable aspect of CEO compensation isn’t primarily the unfairness of the few at the top taking more than their appropriate share, nor that CEOs could cash in their personal gains based on ephemeral financial value, nor even the absurdity of massive “golden parachutes” paid out in cases of failure. The worst affront to the national interest is that these compensation arrangements created incentives for CEOs to “roll the dice” in search of the biggest possible scores for the company (and, not coincidentally, themselves), with too little regard for the downside risk if they bet wrong. And with no appreciation for the potentially dangerous consequences of such gambles, in the aggregate, for the economic security of the American people.

Hat Tip: folo

Cross posted at Workplace Prof Blog.

As several heavy hitters in the financial world have come under pressure or have gone bankrupt in the past couple of months because of the subprime mortgage and lending crisis that has battered investment firms and banks, the employer “stock drop” cases that proliferated in the post-Enron Corp. and post-WorldCom Inc. age are on the rise.

Although the Employee Retirement Income Security Act claims raised in these stock drop cases have not been identical, there are two central claims that arise in these cases. The first claim typically raised is that the plan fiduciaries breached their duties by offering company stock as a plan investment option when the stock was an imprudent or unwise investment. The second claim focuses on the disclosure obligations of the plan fiduciaries and often alleges that the fiduciaries breached their duties by not telling plan participants of financial matters of the plan sponsor that made the sponsor’s stock an imprudent investment.

Among firms that recently have been hit with stock drop lawsuits are Lehman Brothers Holdings Inc., American International Group Inc. (AIG), Bear Stearns, Wachovia Corp., UBS, IndyMac Bank, and Fifth Third Bancorp.

I have written abut this type of stock drop litigation before. The issues at the forefront are how ERISA is overtaking securities law as the litigation vehicle of choice by plaintiffs who suffer stock losses and how these cases almost never make it to trial because the firms being sued are forced to settle if certification of the class is granted by the court.

Given the financial pain being felt by everyone these days, and with little hope of an end being in sight, I would suspect courts to cut down on certification of these classes or for a movement by the corporate lobby to amend ERISA to cut down on these types of suits.

Cross posted on Workplace Prof Blog.

Professor Grossman’s thesis has profound implications for the direction of corporate law.  At least since Berle and Means published The Modern Corporation and Private Property in 1932, the classic challenge for corporate governance has been viewed as the need to align the interests of management with the long-term interest of shareholders.  For over seventy years, developments in executive compensation, shareholder proxy voting, and director fiduciary duties have been directed towards this end.  However, the growing influence of “short-termers” with short investment horizons on the process of management decision-making has upset the classical assumption that shareholders will instinctively press management to advance a longer view of the corporate interest. 

Perhaps, in the future, the challenge of the corporate law will be viewed differently.  Advocates of reform might seek to uncover legal mechanisms that would better align the interests of institutional investors with the interests of private shareholders who hold their stock for the longer term. Alternatively, the goal of corporate law might be to develop ways to protect management from the pressures being applied by short-termers.  We may find that the insulation of management from shareholder influence is not the source of the problem in corporate governance, as Berle and Means proposed so long ago; it might turn out to be the solution.