Yearly Archives: 2008

An Investigation of Earnings Management through Marketing Actions

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 11, 2008

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This post comes to us from Craig Chapman at Northwestern’s Kellogg School of Management.

My recently updated working paper An Investigation of Earnings Management through Marketing Actions, co-written with Thomas J. Steenburgh provides a novel view on earnings management. Earnings management behavior may be divided into two categories: 1) the opportunistic exercise of accounting discretion; and 2) the opportunistic structuring of real transactions. This paper focuses on the latter by providing evidence that firms vary their use of retail-level marketing actions (price discounts, feature advertisements, and aisle displays) to influence the timing of consumers’ purchases in relation to the firms’ fiscal calendar and financial performance. The results are of interest to practitioners negotiating with suppliers as well as those responsible for setting price and promotion strategy in response to competitor actions, and practitioners responsible for designing incentive-based compensation as well as regulators monitoring reporting of fiscal period-ending promotions.

We find that:

• In contrast to prior literature that suggests firms reduce marketing expenditures in order to boost reported earnings, we find that soup manufacturers roughly double the frequency of all marketing promotions (price discounts, feature advertisements, and aisle displays) at the fiscal year-end and that they engage in similar behavior following periods of poor financial performance. In addition to offering promotions more frequently, we find that firms offer deeper price discounts to manage earnings during these periods.

• While these actions boost unit sales, revenue, and profits in the near term, the resulting gains come at the expense of long-term profit and may not be in the strategic interest of the firm. We estimate that marketing actions can be used to boost quarterly net income by up to 20% depending on the depth of promotion. But there is a price to pay, with the cost in the following period being 23.5% of quarterly net income.

• The results imply that firms make systematic decisions across their product lines to manage earnings and indicate the behavior is being driven by parties higher in the firm than the brand managers.

The full paper is available for download here.

Institutional Investors and Proxy Voting

Posted by Roberta Romano, Yale Law School, on
Friday, August 8, 2008
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This post is from Roberta Romano of Yale Law School.

In our paper, Institutional Investors and Proxy Voting: The Impact of the 2003 Mutual Fund Voting Disclosure Regulation, Martijn Cremers and I examine the impact of the mutual fund voting disclosure rule on corporate governance by examining its effect on proxy voting outcomes. We presented our paper at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.

In January 2003, the U.S. Securities and Exchange Commission (SEC) required mutual funds to disclose how they voted on proxy proposals presented at shareholder meetings. To assess the impact of this rule on voting behavior, we construct a sample of firms that experienced similar proposals, sponsored either by management or shareholders, both before and after the 2003 rule change using data gathered from the Investor Responsibility Research Center’s (IRRC) database of proxy voting.

We find that voting support for management has been declining for close to a decade and that mutual funds appear to support management less frequently than other investors. However, we find no evidence that the rule decreased mutual funds’ voting in support of management. Indeed, some of our results suggest that mutual funds’ support for management increased after the rule’s adoption, particularly for executive equity incentive compensation plan (EEIC) proposals. We further find that these results are not affected by other features of the voting environment, such as confidential voting and the elimination of the New York Stock Exchange (NYSE)’s rule permitting brokers to vote shares on certain compensation plans. Finally, taking into account mutual fund characteristics and the largest mutual fund families’ ownership does not change our results.

As the decision to put up an EEIC proposal is clearly a choice by management, we investigate to what extent selection issues could potentially explain our findings. We find some evidence that the firms sponsoring EEIC proposals both before and after the rule change are different from those that sponsored such a proposal before but not within two years after the rule change. In addition, we find that some takeover defenses decrease support for management, results independent of the rule change, but the results are so varied across defenses, and within and across proposals, that we cannot draw a conclusion regarding the relation between defenses and voting outcomes.

The full paper is available for download here.

The Role and Value of the Lead Director — A Report from the Lead Director Network

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, August 6, 2008
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This post comes to us from Jeff Stein and Bill Baxley at King & Spalding.

Following the corporate scandals in the early part of this decade, there were calls to fundamentally change the way U.S. public company boards were structured — with some advocating for the “European model” of boards being led by independent chairmen rather than by a combined chairman-CEO. Many U.S. board members and business groups questioned whether the separation of the CEO and chairman roles actually adds value, so rather than implementing this profound change, the stock exchanges adopted what many consider to be a relatively weak compromise position. Under the approach adopted by the stock exchanges, the board is required only to appoint a director to preside over executive sessions of the independent directors and to receive shareholder communications.

Despite its humble beginnings, the appointment of “lead directors” has become a prevailing practice for U.S. public companies and lead directors have assumed increasing responsibilities within their companies. Still, there is little consensus at this point about which responsibilities lead directors should undertake and how they can act to improve both the governance and the performance of their companies. (In this posting, we refer to the director serving as “presiding” director, “lead” director, or independent non-executive chairman as a “lead director”.)

In order to consider these issues and respond to questions from our clients on these issues, King & Spalding and Tapestry Networks have created The Lead Director Network (LDN). The LDN brings together a select group of lead directors, presiding directors, and non-executive chairmen from many of America’s leading companies for private discussions about how to improve the performance of their corporations and earn the trust of their shareholders through more effective board leadership. The LDN currently includes 16 members (who serve as lead directors of 21 companies) and plans to meet three times per year. The group comprises lead directors from companies like Caterpillar, The Coca-Cola Company, Constellation Energy, Delta Air Lines, The Home Depot, Microsoft, Morgan Stanley, and others.

The inaugural meeting of the Lead Director Network was held on July 8, 2008, and the members present at the meeting considered the role and value of lead directors, how the role has evolved over recent years, and some of the key issues that lead directors are confronting. Following this meeting, King & Spalding and Tapestry Networks have published ViewPoints, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of these important topics.

Highlights of the July 8, 2008 meeting, as summarized in the ViewPoints document, include the following:

• The Origins of the Lead Director Role. While there were external factors that led to the establishment of the lead director position (including stock exchange listing requirements and pressure from various stakeholders to separate the CEO and chairman roles), internal factors have played an important role in the evolution of the position. Among the factors that may cause the expansion of the lead director role for a company are changes in the leadership of the company, a significant event (such as a government investigation or a potential change of control transaction) and directors’ own efforts to ensure board independence and improve board performance.

• Value of the Lead Director Role. Despite its modest beginnings, the lead director position has become increasingly important for many U.S. companies. Lead directors are contributing to improved corporate performance in at least four key areas: (1) taking responsibility for improving board performance, (2) building a productive relationship with the CEO, (3) supporting effective communications with shareholders, and (4) providing leadership in crisis situations. Ironically, these areas where lead directors are making the most valuable contributions are not among those officially described for the position by the NYSE.

• How the Title Affects the Role. Members analyzed the different meanings that lie behind the different titles — “lead director”, “presiding director” and “non-executive chairman” — and how these titles relate to the responsibilities of the role. While the title may signal differences in how the lead director position is perceived by other directors, members concluded that, in practice, the terms “lead” and “presiding” do not say much about the actual portfolio of responsibilities delivered by the director. By contrast, the term “non-executive chairman” typically does describe something different, often a larger role in both company and board leadership.

• Current Issues for Lead Directors. Members of the LDN identified five topics that they feel are important for lead directors and that they will discuss in more depth in future meetings: (1) how the board should be engaged in the development of corporate strategy, (2) the lead director’s role in crisis turbulent times, including preparing for a crisis situation, (3) the lead director’s role in succession planning for the CEO, the board, committee chairs and the top tier of management, (4) improving director and CEO evaluation processes and how individual director performance should be evaluated, and (5) alternative governance models (for example, the European model and models used by private equity firms).

• The Future of the Lead Director Position. The lead director position was created as a compromise between having a board with no leader of its independent directors and mandating that every company have a non-executive chairman. Six years after the creation of the position, the most important contributions of lead directors have come not from the duties mandated by stock exchange requirements, but from the responsibilities that lead directors in fact have undertaken for their companies. As some activist shareholders renew their call for the “European model” of board leadership, it will be interesting to see whether the lead director position will continue to evolve as a viable and preferred alternative for corporations and their stakeholders.

We welcome comments on the subject of lead directors and suggestions for future topics to be considered by the LDN members, and plan to make other postings based on the discussions and reports of the LDN.

Additional information regarding the LDN may be found on the websites of Tapestry Networks and King & Spalding.

A copy of the Lead Director Network ViewPoints report is available here.

Delaware Enforces a Fiduciary Opt Out in a Publicly Held Firm

Posted by Larry Ribstein, University of Illinois College of Law, on
Tuesday, August 5, 2008
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This post is from Larry Ribstein of the University of Illinois College of Law. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Last month I discussed the emerging importance of what I call “uncorporate” governance – that is governance characteristic of partnership-type firms – for large, publicly held firms. As elaborated in my Uncorporating the Large Firm, a critical aspect of these firms is that they substitute distributions, liquidation rights and high-powered managerial incentives for traditional corporate monitoring devices, particularly including fiduciary duties.
The Delaware legislature does effectuate this “substitution” by explicitly letting LLCs eliminate all duties except for “the implied contractual covenant of good faith and fair dealing” (6 Del. Code §18-1101; there are similar provisions for other unincorporated firms). By contrast, the Delaware provision on fiduciary duty modification in corporations (DGCL §102(b)(7)) prohibits waivers of the duty of loyalty and “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” And as I discussed in Uncorporation and Corporate Indeterminacy, Delaware courts have enforced waivers consistent with the statutes.

But will Delaware courts apply corporate restrictions on waivers to publicly held uncorporations. In particular, might they interpret the “good faith” qualifier in the uncorporation statutory waiver provisions as similar to corporate-type good faith, which has been interpreted as part of the fiduciary duty of loyalty (see Stone v. Ritter, 911 A.2d 362 (Del. 2006))? Until very recently, the Delaware Supreme Court had never held that fiduciary duties could be waived in any publicly held firm.

That has now changed thanks to the Delaware Supreme Court’s recent opinion in Wood v. Baum. The case involved Municipal Mortgage & Equity, LLC (“MME”), at the time of the case a NYSE-listed Delaware LLC with 2500 record holders (see MME 2006 10K). The question in the case was whether the plaintiff had adequately alleged facts justifying excusing demand in a derivative suit as futile. Under the controlling Aronson standard in Delaware, in a case like this one involving an independent board the plaintiff had to show that the directors had an incentive to protect themselves from a substantial risk of personal liability. The court noted that:

under the Operating Agreement and the [Delaware Limited Liability Company Act] the MME directors’ exposure to liability is limited to claims of “fraudulent or illegal conduct,” or “bad faith violation[s] of the implied contractual covenant of good faith and fair dealing.”

Where directors are contractually or otherwise exculpated from liability for certain conduct, “then a serious threat of liability may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on particularized facts.” Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. Therefore, the issue before us is whether the Complaint alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.

With respect to bad faith, the complaint alleged, among other things, that the defendants had “breached their Caremark duties by “fail[ing] properly to institute, administer and maintain adequate accounting and reporting controls, practices and procedures,” which resulted in a “massive restatement process, an SEC investigation, and loss of substantial access to financial markets.” (footnotes omitted). These allegations may have raised a good faith issue under Stone. Nevertheless, the court said:

the Complaint does not purport to allege a “bad faith violation of the implied contractual covenant of good faith and fair dealing.”The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here. The implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements. Here, the Complaint does not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in “bad faith”). (footnotes omitted)

The court concludes: “Given the broad exculpating provision contained in MME’s Operating Agreement, the plaintiff’s factual allegations are insufficient to establish demand futility. (emphasis added)”

In short, the directors had no fiduciary duties under the agreement, and no incentive to protect themselves from liability for breach of any such duties. Although this case did not involve particularized allegations of self-dealing, there is no apparent reason why the court’s reasoning should not cover such allegations as well.

If publicly held firms can waive fiduciary duties in the LLC form, why should they not be able to do so in the corporate form? Should the Delaware legislature take the next seemingly logical step and carry the complete exculpation approach over to corporations from uncorporations? Seventeen years ago, in the wake of Delaware’s initial adoption of broad fiduciary opt-out provisions for limited partnerships, I predicted that would happen, in my Unlimited Contracting in the Delaware Limited Partnership and its Implications for Corporate Law, 17 J. Corp. L. 299 (1991). I argued that the absence of other corporate-type protections made fiduciary duties even more important in unincorporated firms, so that if the latter could opt out, a fortiori corporations should be able to do so. Also, if publicly held corporations could opt out by simply disincorporating, why force them to take this procedural step? Perhaps, as discussed in Uncorporating the Large Firm, corporations should be distinguished from uncorporations on the basis that the latter offer disciplinary and incentive devices that make fiduciary duties less necessary in this context. There is also an argument for letting firms and investors choose between two distinct approaches to opting out of fiduciary duties.

In any event, it now seems clear that publicly held unincorporated firms can opt out of fiduciary duties in Delaware. It remains to be seen whether my initial prediction that this permission will extend to publicly held corporations ultimately will prove to be correct.

Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 4, 2008
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This post comes to use from Feng Gao, Joanna Shuang Wu, and Jerold Zimmerman at the Simon School of Business Administration at the University of Rochester. This paper was presented by Professor Wu at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.

In our paper Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation: Evidence from the Sarbanes-Oxley Act, we investigate whether the enactment of SOX created incentives for certain firms to stay small – in particular to keep their public float below $75 million, the threshold in the SEC’s definition of “non-accelerated” filers. Since 2003, the SEC has on several occasions deferred the implementation deadline for non-accelerated filers regarding Section 404 of SOX, considered by many commentators as one of the most onerous parts of SOX, particularly for smaller firms.

At least two non-mutually exclusive reasons can motivate managers to retain their firm’s non-accelerated filer status: (i) they believe that complying with Section 404 reduces shareholder value, and/or (ii) they believe that Section 404 reduces their private control benefits. Our paper does not differentiate between these two motives. Rather, it documents that regulatory size thresholds in fact induce some firms to remain below the threshold and identifies the various methods used to accomplish this objective. Our sample consists of non-accelerated filers and a control sample of accelerated filers with market capitalizations below $150 million. Our event period spans June 1, 2003 (following the first SEC deferment of Section 404 compliance deadline for non-accelerated filers) to December 31, 2005 (soon after the SEC issued the new exit rule for accelerated filers).

We document several actions that non-accelerated filers appear to employ to keep their public float below the $75 million threshold post-SOX. We find that they take actions to reduce net investment in property, plant, and equipment, intangibles, and acquisitions, that they pay out more cash to shareholders via ordinary and special dividends and share repurchases, and that they take actions to decrease the number of shares held by non-affiliates. Because the testing date of a firm’s filing status occurs only once each fiscal year (the last trading day of its second fiscal quarter), we find that non-accelerated filers disclose more bad news and report lower accounting earnings in the second fiscal quarter in an effort to exert temporary downward pressure on share prices before testing their filing status. Furthermore, we find evidence that the non-accelerated filers’ incentives to undertake the above actions are weaker when they are further away from the $75 million threshold. Finally, we document that the various actions undertaken by the non-accelerated filers post-SOX appear to be effective in that these firms are more likely to remain below the $75 million threshold in the following year.

The full paper is available for download here.

De-Coupling of Ownership, Economic and Voting Power in Public Companies – The UK’s Response

Posted by Adam O. Emmerich, Wachtell Lipton Rosen & Katz, on
Friday, August 1, 2008
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This post is from Adam O. Emmerich of Wachtell Lipton Rosen & Katz. A related development was the 2007 establishment in London of the Hedge Fund Standards Board in response to concerns about financial stability and systemic risks associated with the hedge fund industry. The Board monitors conformity by hedge funds with best practice standards, which are available here).

Ted Mirvis, Bill Savitt, David Shapiro and I have written a memo entitled “De-Coupling of Ownership, Economic and Voting Power in Public Companies – The UK’s Financial Services Authority (FSA) Moves Decisively to Close the Gap.” The memo considers the decision of the Financial Services Authority – the UK’s financial and securities markets regulatory authority – to require disclosure of cash-settled and other derivative contracts, on an aggregated basis with ownership of actual common stock, at the 3% level. The FSA’s new policy is aimed squarely at the now-popular technique of making undisclosed accumulations of significant stakes in publicly traded companies through derivative instruments (including cash-settled derivative instruments) and in other non-traditional ways.

The memo also discusses the urgent need for reform of section 13(d) of the Exchange Act to expand required disclosure to include within the definition of “beneficial ownership” all derivative instruments which provide the opportunity to profit or share in any profit derived from any increase in the value of public equity securities, as well as to require disclosure of large short positions. We note that unless and until lawmakers and securities regulators in the U.S. adopt disclosure requirements in accord with what is now the overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques – which must and should be done promptly – U.S. corporations are well advised to adopt such self-help measures as may be available, including appropriate provisions in by-laws, rights plans and other arrangements with change-in-control protections.

The FSA’s statements on this topic are available here and here. Our memo is available here.

Which CEO Characteristics and Abilities Matter?

Posted by Steven Kaplan, University of Chicago, on
Thursday, July 31, 2008
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This post is from Steven Kaplan of University of Chicago.

Given their leadership positions and compensation, CEOs likely have a significant impact on their companies’ success. And, of course, there is a great deal of anecdotal evidence about what CEOs do and how they matter, particularly in the popular press. Surprisingly, economic theorists provide little guidance, and there is very little systematic, large sample, empirical evidence in the economics, finance and management literatures on how and why CEOs matter.

In “Which CEO Characteristics and Abilities Matter?” Mark Klebanov, Morten Sorensen and I provide new evidence on CEO characteristics and abilities, and their relations to hiring, investment decisions, and firm performance. The problem, historically, is finding information on CEO abilities or characteristics at the time the CEO is hired. We were able to obtain detailed assessments of 316 CEO candidates for positions in firms funded by private equity (PE) investors – both buyout (LBO) and venture capital (VC) investors. The candidates were assessed on more than 30 characteristics, including efficiency, teamwork, and analytical abilities. The assessments were performed from 2000 to 2006 by ghSMART, a firm that specializes in assessing top management candidates.

We find that abilities are generally positively correlated. The abilities can be organized along two important dimensions: (1) general talent and (2) team player and interpersonal talents versus fast, aggressive, and persistent behavior.

We then relate abilities to hiring, investment decisions, and outcomes. CEOs are hired based on general talent and incumbency (firm specific knowledge and skill). Many individual abilities, both team-related and execution-related, are significant, particularly for outsider hires.

Success is also related to general talent, particularly for LBOs. However, when considering team versus execution-related skills, success seems to be more strongly related to execution skills, particularly for LBOs, and not related or negatively related to the interpersonal, team-related skills. And success is not related to incumbency.

The results suggest that CEO talent can be measured and those talents are important for hiring, investment and success. General talent matters for success. However, on the margin, execution-related attributes, not team-related attributes seem to drive success. This suggests that team-related attributes may be overweighted in CEO hiring decisions.

The full paper is available for download here.

“Clawbacks” of Executive Compensation

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 30, 2008
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This post is by Amy L. Goodman of Gibson, Dunn & Crutcher LLP.

My colleagues and I recently published our thoughts on issues to be considered by boards of directors in deciding whether, and how, to implement provisions addressing the “clawback” of executive compensation. Clawback provisions have become increasingly common in the past few years, and we expect that they will remain a focal point for boards of directors, both because of the ongoing spotlight on executive compensation and because of the attention that institutional shareholders and governance activists have focused on clawbacks as a significant corporate governance and executive compensation issue.

Clawback provisions vary by company, but they share a common goal of enabling companies to recover performance-based compensation to the extent they later determine that performance goals were not actually achieved, whether due to a restatement of financial results or for other reasons.

For boards of directors, the threshold question to consider is whether to address clawbacks in the first place. Doing so sends a message to shareholders that the board is committed to sound executive compensation practices and effective corporate governance, and voluntary implementation of clawback provisions will reduce the likelihood that a company will receive a shareholder proposal. On the other hand, companies need to consider whether the adoption of a clawback will adversely affect their ability to attract and retain executives.

Once a board decides to adopt a clawback provision, there are a number of issues to be addressed in formulating the provision. The memo below goes into more detail about these issues, but they include the following:

1. the individuals to whom the clawback provision should apply (the CEO and CFO, all executive officers or all employees)

2. the types of awards to which the clawback provision should apply (short-term or long-term, or both)

3. the circumstances that should trigger the clawback provision (a material restatement, restatements generally, or any error in financial information)

4. the type of conduct that triggers application of the clawback provision (misconduct by the particular individual from whom the company seeks to claw back compensation, misconduct by any employee, or any conduct that results in incorrect financial information)

5. whether the clawback provision should grant discretion to the board in determining whether misconduct occurred and whether to claw back compensation

6. the extent to which the clawback provision should modify existing employment agreements, compensation plans and award agreements

7. how far back the clawback provision should reach

We welcome comments on this subject, including views of readers as to which approaches make the most sense in various situations. Also, we would be glad to have any examples of cases where a board of directors has actually enforced a clawback policy or contractual provision. The memo is available here.

Do Boards Pay Attention when Institutional Investor Activists ‘Just Vote No’?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, July 29, 2008
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This post comes from Tracie Woidtke, a member of the Finance faculty at the University of Tennessee College of Business Administration, and a Research Fellow at the Corporate Governance Center at the University of Tennessee.

In a forthcoming Journal of Financial Economics article co-written with Diane Del Guercio and Laura Seery, entitled Do Boards Pay Attention when Institutional Investor Activists ‘Just Vote No’?, we examine whether the external pressure of a ‘just vote no’ campaign is sufficient to motivate directors to act in shareholders’ interests. ‘Just vote no’ campaigns are organized attempts by activists to convince their fellow shareholders via letters, press releases, and Internet communications, to withhold their vote from one or more directors in an effort to communicate a message of shareholder dissatisfaction to the board.

Our study utilizes a comprehensive sample of 112 publicly announced ‘just vote no’ campaigns during the period 1990 to 2003. We find that ‘just vote no’ campaigns have several characteristics in common with shareholder proposals in addition to their non-binding nature. Specifically, the typical campaign targets a large, poorly performing firm, and is sponsored by a public pension fund. Although other proponent types sponsor campaigns, we only observe institutional investor proponents, and not the small individual shareholders who commonly sponsor shareholder proposals. Proponents typically have broad campaign goals, commonly expressing overall dissatisfaction with firm performance and/or with management and board decisions on firm strategy. Some campaigns, however, are narrowly focused on corporate governance issues, such as removing an insider from the compensation committee. Campaign proponents are typically able to garner vote support from their fellow shareholders.

In contrast to the shareholder proposal literature, we find consistent evidence across a broad set of measures suggesting that on average campaigns are effective in spurring boards to act. The typical campaign target has significant post-campaign operating performance improvements. Moreover, we find a forced CEO turnover rate of 25% in target firms in the one year following a campaign, a rate more than three times higher than the 7.5% rate for a control sample matched on sales and performance, and over 12 times the annual 2% rate in the general population of firms. We find this result to be robust to controlling for a variety of firm performance and governance control variables, as well as for concurrent events, such as changes in the board of directors or external pressure from block-holders. Further analysis reveals that the improvements in operating performance are primarily driven by the campaigns motivated by firm performance and strategy reasons, and not by the campaigns focused on general corporate governance practices. In fact, within these campaigns motivated by firm performance and strategy reasons, we find that boards take a variety of value-enhancing actions; 31% of these targets experience disciplinary CEO turnover and 50% of the remaining targets that do not dismiss the CEO make other strategic changes. Consistent with these board actions being value enhancing, post-campaign operating performance improvements are economically and statistically significantly higher in these sub-samples of target firms. Overall, our evidence suggests that activists can be successful at disciplining managers and directors despite the non-binding nature of withholding votes.

The full paper is available for download here.

Board Manages CA, Inc. … No Way!

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, July 28, 2008
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Editor’s Note: This post is from Joseph Hinsey of Harvard Business School. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Earlier this year, the SEC submitted to the DE Supreme Court two questions pertaining to a bylaw proposal – requiring CA to reimburse the reasonable expenses of a successful “short-slate” board candidate nominated by a stockholder (unaffiliated with management) – that had been submitted by a shareholder for inclusion in the forthcoming CA proxy materials. In its recently issued AFSCME/CA opinion, the Court concluded “yes” to the first question (i.e., whether the bylaw proposal would be a proper subject for shareholder action) … AND … concluded “yes” to the second question (i.e., whether if adopted, it would cause CA to violate any DE law to which it is subject).

The core rationale for the second “yes” was that the bylaw would preempt the Board’s fiduciary duty to exercise its discretion (vis-à-vis any such request) by mandating the payment. The Court concluded that “the Bylaw, as drafted, would violate the prohibition[s] … against contractual arrangements that commit the board of directors to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders”. [emphasis added, footnote omitted]

There has been considerable professional commentary about the Court’s decision. In some cases, writers have taken a short-cut by stating that the problem with the proposed bylaw was that it would interfere with the directors’ role vis-à-vis “management” of the enterprise (e.g., the decision “reaffirms the bedrock principle that the directors of the corporation, not the shareholders, manage the business and affairs of the corporation”). That characterization of the board’s “management” role calls for the recollection of a bit of corporate-law history.

In the early 1970s a prominent outside director – noting that (then-current) DE law “required” him and his fellow directors (serving on the board of a major publicly-owned DE corporation) to manage the business and affairs of that enterprise – demanded that the board be provided a separate staff to assist the board in performing that task. In fact, a literal reading of the relevant DE statutory provision in effect at the time so provided – as was similarly the case with the parallel provision in the Model Business Corporation Act! BUT that literal interpretation of the statute – calling for active involvement by the board with the day-to-day business affairs of the corporation – was clearly not what was intended for the board of a large corporation. AND it was clearly not intended for the board of a large publicly-held corporation!

In reaction, the ABA Committee on Corporate Laws (in its role providing ongoing editorial oversight for the Model Act) amended the Act in l974 to provide that “[a]ll corporate powers shall be exercised by or under the direction of the board of directors … and the business and affairs of the corporation shall be managed by or under the direction of [the board].” [emphasis supplied] Samuel Arsht (at the time a noted leader of the DE corporate bar and a member of the ABA Committee as well) spearheaded a comparable adjustment that was made in the DE statute.

The point here is a very simple one; that is, while the board of directors has authority to engage in the conduct of the corporation’s business and affairs at whatever level it chooses – subject to the directors’ fiduciary duty and, in the case of a DE corporation, subject to any limitation set forth in its certificate of incorporation (as provided by the DE statute) – the CA board of directors does not have obligatory involvement with day-to-day management of the business and affairs of the enterprise. To suggest that it does have a duty to manage the business and affairs of CA, Inc. – or even might – is mischievous!

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