Monthly Archives: May 2019

Corporate Law and the Myth of Efficient Market Control

William W. Bratton is Nicholas F. Gallicchio Professor of Law and Co-Director, Institute for Law & Economics at University of Pennsylvania Law School; and Simone M. Sepe is Professor of Law and Finance at the University of Arizona James E. Rogers College of Law. This post is based on their recent article, forthcoming in the Cornell Law Review.

A central question in corporate legal theory is whether large corporations should be conceived as hierarchical enclaves that operate apart from markets or as entities that operate within markets and under market control. The majority favors market control, making two basic assumptions: first, shareholders have the right incentives to mitigate the managerial agency problem, and, second, competitive markets are intrinsically superior to institutions as coordinators of production. Recent developments in practice appear to vindicate this majority view, turning shareholder empowerment from a normative aspiration to a positive reality. The rise of hedge funds and other activist investors has brought an unprecedented shift in power from managers to shareholders, who are now empowered to determine business decisions at publicly-traded companies.

In our article Corporate Law and The Myth of Efficient Market Control, forthcoming in the Cornell Law Review, we take the occasion of these transformative changes to put corporate legal theory’s majority view to the test, through a comprehensive economic examination of the claim of efficient market control. This examination brings to the forefront a substantial theory of markets and prices that has never been explored before in corporate law, general equilibrium theory (GE).


A Fresh Look at Exclusive Forum Provisions

Keith Higgins is chair of the securities and governance practice, and Paul M. Kinsella and Peter L. Welsh are partners at Ropes & Gray LLP. This post is based on a Ropes & Gray memorandum by Messrs. Higgins, Kinsella, Welsh, Marvin B. Tagaban, and Martin J. Crisp, and is part of the Delaware law series; links to other posts in the series are available here.

One common feature of large M&A transactions is the almost inevitable stockholder litigation challenging the transaction. Initially, this litigation focused on allegations under state law—that the directors failed to satisfy their Revlon obligations and their duty of candor. Such litigation often was brought in multiple forums, forcing the target to devote significant resources attempting to avoid or litigate a multi-front conflict with the associated risks and expense. One way that companies exercised self-help against this onslaught was to adopt provisions in their governing documents that require such litigation to be brought in a specific forum. This strategy was foreshadowed in a 2010 Delaware Court of Chancery opinion in which Vice Chancellor Laster noted “if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.” [1] Many companies have taken this advice, and Delaware companies in particular have typically designated the Delaware Court of Chancery as the exclusive forum for such disputes.

A typical exclusive forum provision might read as follows:


Review and Predictions: 2019 Federal Securities Litigation and Regulation

Jason Halper is partner and Chair of the Global Litigation Group, Kyle DeYoung is partner, and Adam Magid is special counsel at Cadwalader, Wickersham and Taft LLP. This post is based on a Cadwalader publication by Mr. Halper, Mr. DeYoung, Mr. Magid, Lex Urban, Kendra Wharton, and James Orth.

While the past year, or even eighteen months, was short on landmark federal securities law decisions, there was significant activity on the part of private securities litigants. In 2018, plaintiffs filed 403 new federal securities fraud class actions, just short of 2017’s record high of 412. This continued a marked uptick in securities filings over the last two years. After 20 years with an average of only 203 new filings per year, the pace has now nearly doubled. This increase was driven in part by the emergence of securities cases relating to mergers and acquisitions. As few as 13 such cases were filed per year in the early 2010s, but 198 were filed in 2017 and 182 in 2018.

So far in 2019, there have been 134 securities class actions filed, signaling that the trend is continuing. This increase may have resulted at least in part from decisions by the Delaware Court of Chancery severely restricting the ability of stockholders to resolve breach of fiduciary duty claims against directors in the M&A context with non-monetary settlements whereby the company makes supplemental disclosure, pays the plaintiff’s attorney a fee, and defendants receive class-wide releases. Given that this avenue for quick resolution of M&A litigation is now effectively foreclosed in the absence of clearly material supplemental disclosure, it appears that certain stockholders have migrated to federal court asserting federal securities law claims instead.


Compliance, Compensation and Corporate Wrongdoing

Reinier Kraakman is the Ezra Ripley Thayer Professor of Law at Harvard Law School; Karl Hofstetter is Professor of Business & Private Law at the University of Zurich; and Eugene F. Soltes is Jakurski Family Associate Professor of Business Administration at Harvard Business School. This post is based on their conclusions from a roundtable at Harvard Law School.

It can hardly be disputed that society has a basic interest in companies’ maximum compliance with the law. Numerous cases in the financial industry, particularly in the aftermath of the Financial Crisis 2008, have indicated that this remains a significant challenge. Bank of America alone paid $56B in fines to the US government in connection with the subprime practices of its group. JP Morgan Chase, Citigroup, Royal Bank of Scotland, Credit Suisse, BNP Paribas, Deutsche Bank and others also paid fines in the billions. According to the Boston Consulting Group, the settlement payments of US and European banks after the Financial Crisis totaled $321B overall.

The recent sales practice scandal at Wells Fargo, leading to the dismissal of more than 5300 employees, shows that the compliance challenge is an ongoing and permanent one—and it is not limited to the financial industry at all. High profile cases involving industrial companies like Siemens (Foreign corruption), Volkswagen (Diesel-test fraud), BP (Deepwater Horizon disaster) or GM (Safety failure of ignition switch) show the many fronts on which companies may fail in respecting applicable legal rules. In July of this year, the EU dumped a landmark fine of Euro 4.38 B ($ 5 B) on Google for the alleged abuse of market power involving its Android technology. This record antitrust fine – with no precedent in Europe or the US – indicates that the trend of ever increasing corporate fines is ongoing and that it is by no means limited to the US.


Management Duty to Set the Right “Tone at the Top”

David Lopez and Arthur H. Kohn are partners and Margot G. Mooney is an associate Cleary Gottlieb Steen & Hamilton LLP. This post is based on their Cleary memorandum.

In late March 2019, the Hertz Corporation and Hertz Global Holdings, Inc. (collectively, “Hertz”), filed two complaints (the “Damages Proceedings”) against its former CEO, CFO, General Counsel and a group president seeking recovery of $70 million in incentive payments and $200 million in consequential damages resulting from Hertz’s 2015 decision to restate its financial statements and an ensuing SEC settlement against Hertz and federal class action lawsuit (which was dismissed). At the same time, the defendants in those actions each filed separate complaints (which have been consolidated in the Delaware Chancery Court) demanding advancement of their legal fees in the Damages Proceedings (the “Advancement Proceedings”). The litigation between Hertz and its former executives raises novel questions about whether executives have a legally cognizable duty to set the right “tone at the top” and the consequences if they fail to do so. The litigation also raises important and interesting questions regarding clawbacks and indemnification.


In May 2014, Hertz announced that it would be unable to file its Form 10-Q for the first quarter of 2014 because of prior period errors it had identified and in September 2014 (after previously announcing the departure of its lead independent director) it announced the departure and replacement of its CEO, Mark Frissora. In July 2015, Hertz announced that it would restate its financial statements for the 2011, 2012, and 2013 fiscal years (the “Restatements”) and disclosed a series of material weaknesses including “an inconsistent and sometimes inappropriate tone at the top [that] was present under the then existing senior management.” The Restatements stemmed principally from two accounting decisions made in the 2012 and 2013 time frame when the company was under financial pressure: it reduced the allowance on its books for recoveries for vehicle damage from renters and other third parties with the result that its expenses were decreased and income increased and it extended the planned holding periods for its fleet of U.S. rental cars with the result of improving its depreciation expense.


Externalities and the Common Owner

Madison Condon is a Legal Fellow at the Institute for Policy Integrity at the New York University School of Law. This post is based on her recent article, forthcoming in the Washington Law Review. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); Horizontal Shareholding by Einer Elhauge (discussed on the Forum here); and New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here).

Most of the stock market is controlled by institutional investors holding broadly diversified economy-mirroring portfolios. In an article recently posted on SSRN, Externalities and the Common Owner, I argue that diversified investors should rationally be motivated to internalize intra-portfolio negative externalities. This portfolio perspective can explain the increasing climate change related activism of institutional investors: I present a rough cost-benefit analysis to show that forcing marginal emissions reductions at individual firms can in fact reap portfolio-wide benefits that outweigh the loss in value of the targeted companies.

In December 2018, Royal Dutch Shell announced that it was setting emissions reduction targets, aiming to reduce its net carbon footprint (including emissions from the sale of its products) 20% by 2035, and 50% by 2050. According to The Wall Street Journal, Shell executives were initially opposed to these goals—the CEO had described them as “onerous and cumbersome” just six months before—but they eventually capitulated “to months of investor pressure.” The announcement was jointly made with Climate Action 100+, a coalition made up of more than 300 institutional investors that control $33 trillion in assets, or 40% of global GDP. In a press release, Climate Action 100+ stated that its success at Shell “demonstrates the power of collective global investor engagement” and that the coalition planned to “use the commitment to raise the bar for the oil and gas industry as a whole.”


President Trump’s Executive Order and Shareholder Engagement on Climate Change

Nell Minow is Vice Chair of ValueEdge Advisors. Related research from the Program on Corporate Governance includes  Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

ERISA, the 1974 law that governs pension funds, recognizes that the third parties who manage those funds might be tempted to make decisions that were more in their interests than the interests of the people who were depending on them to make good decisions about their investments. And so the law makes it clear that all decisions are to be made “for the exclusive benefit of plan participants.” But it was not until the “Avon letter” of February 23, 1988 that the Labor Department made it clear that the “exclusive benefit” standard applied not just to buy/sell/hold decisions about stock, but about proxy voting as well.

Until the takeover era of the 80’s promoted abuses of shareholders by both corporate raiders and entrenched management, proxy issues had been routine votes to re-elect board members and approve auditors. But once more complex and controversial issues were turning up on proxy cards, and a study by the Investor Responsibility Research Center showed that fund managers were voting with an eye toward getting business from corporate clients and not “for the exclusive benefit” of the plan participants, DOL had to make it clear that all actions with regard to a security were covered by that standard.

That issue was raised again in an Executive Order on Energy Infrastructure issued on April 10, 2019 by President Trump. It calls on the Department of Labor to consider the role that funds governed by ERISA play in this critical element of our economy and national security. The Executive Order states in part:


The Relevance of Broker Networks for Information Diffusion in the Stock Market

Marco Di Maggio is Assistant Professor of Business Administration at Harvard Business School. This post is based on a recent article, forthcoming in the Journal of Financial Economics, authored by Prof. Di Maggio; Francesco A. Franzoni, Professor of Finance at USI Lugano; Amir Kermani, Assistant Professor of Finance and Real Estate at University of California Berkeley Haas School of Business; and Carlo Sommavilla, PhD student at USI Lugano and the Swiss Finance Institute. Related research from the Program on Corporate Governance includes The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

Institutional investors routinely make use of brokers to execute their trades. Despite the rise of electronic trading, the Tabb Group reports that brokers handle about 42 percent of order flow from hedge funds. However, brokers’ roles in disseminating information that they acquire from clients is at best unclear. Although information about prices is readily disseminated in equity markets, brokers’ vantage points might allow them to extrapolate the informational content of an order and to anticipate the future behavior of prices. For example, they can condition on the identity of the trader and are aware of the order flow before it hits the market. In these cases, brokers might have an incentive to extract these informational rents by communicating and spreading the information to their clients.

Both brokers’ practice of selling order flow and regulatory scrutiny of potential information leakage provide anecdotal evidence for the conjecture that brokers play a pivotal role in directing information flow in the market. In our article we analyze a comprehensive trade-level dataset from 1999 to 2014 that contains the identities of both brokers and asset managers to show that brokers who execute trades on behalf of informed investors may extract the informational content of the orders and spread it to their other clients.


The Corporate Form for Social Good

David A. Katz is partner and Laura A. McIntosh is consulting attorney at Wachtell, Lipton, Rosen & Katz. This post is based on an article first published in the New York Law Journal.

State legislation allowing the establishment of benefit corporations—for-profit companies with a stated public purpose—has become widespread over the past decade. This increasingly available corporate form provides a mandate, and a safe harbor, for corporate leaders to pursue societal good along with shareholder profits. Directors are required to consider the impact of their decisions not only on the company’s shareholders, but on the entity’s larger social purpose. Investors who wish to support a company’s mission can be confident that it is an integral part of the company’s purpose and a consistent goal of its governance.

The popularity of these legislative efforts reflects the current cultural momentum behind the idea that corporations should be engines of good as well as profit. As BlackRock CEO Larry Fink wrote in his 2019 letter to the chief executives of companies in which BlackRock invests:

“[S]ociety is increasingly looking to companies, both public and private, to address pressing social issues. These issues range from protecting the environment to retirement to gender and racial inequality, among others. Fueled in part by social media, public pressures on corporations build faster and reach further than ever before.”


UK Shareholder Activism and Battles for Corporate Control

Sam Bagot is partner at Cleary Gottlieb Steen & Hamilton LLP. This post is based on his Cleary Gottlieb memorandum. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here).

The modus operandi of shareholder activism is to agitate for change, often involving campaigns to convince other shareholders to support proposals to change the composition of the board and the company’s strategy.

Under UK law a shareholder activist, in its capacity as shareholder, can attack the board and its strategy in the press and in discussions with other shareholders free from the constraints of corporate law duties. However, in a recent UK High Court decision, Stobart Group v Tinkler, [1] the High Court considered a number of issues which are pertinent to the criticism of boards by shareholder activists who have nominated a director to the board. This case is a clear warning of the risks to board nominees of shareholder activists who in furtherance of an activist campaign brief against the board in discussions with other shareholders and misuse the company’s confidential information.


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