Monthly Archives: December 2020

A General Defense of Information Fiduciaries

Andrew F. Tuch is Professor of Law at Washington University School of Law. This post is based on his recent paper.

Countless high-profile abuses of user data have put Facebook, Google, and other digital companies within the sights of lawmakers. Across the political spectrum, legislators condemn these firms’ conduct, accusing them of undermining user privacy and data security. Scholars and other commentators seek greater oversight of digital enterprises. In this environment, one especially influential reform proposal has emerged: making digital companies “information fiduciaries” of their users. The information fiduciary model, most prominently proposed by Jack Balkin, enjoys bipartisan support and is being considered in proposed privacy laws at the federal and state levels.

But while there is enthusiasm behind the information fiduciary model, it also faces powerful opposition from critics who regard it as incompatible with Delaware corporate law and at odds with firms’ powerful self-interests. The most forceful criticism comes from David Pozen and Lina Khan, who argue in the Harvard Law Review that the information fiduciary model “could cure at most a small fraction of the problems associated with online platforms—and to the extent it does, only by undercutting directors’ duties to shareholders, undermining foundational principles of fiduciary law, or both.” Summarizing their critique, Professor Pozen describes Balkin’s information fiduciary model as “flawed—likely beyond repair—on conceptual, legal and normative grounds.

In A General Defense of Information Fiduciaries, I argue that neither criticism of the information fiduciary model holds water. The first criticism rests on a mischaracterization of corporate law, while the second fails to account for the adaptability fiduciary law has shown in other settings, such as the asset management industry. These criticisms warrant close attention because they have proved influential among commentators and industry participants and because, if accepted, they undermine commonly used regulatory techniques in other industries, especially financial services.


The Big Three and Board Gender Diversity: The Effectiveness of Shareholder Voice

Todd Gormley is Associate Professor of Finance at Washington University in St. Louis Olin Business School. This post is based on a recent paper authored by Prof. Gormley; Vishal K. Gupta, Associate Professor of Management at University of Alabama Culverhouse College of Business; David A. Matsa, Professor of Finance at Northwestern University Kellogg School of Management; Sandra Mortal, Professor of Finance at University of Alabama Culverhouse College of Business; and Lukai Yang, Ph.D candidate at University of Alabama. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here); The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

In 2017, “The Big Three” institutional investors (BlackRock, State Street, and Vanguard) launched campaigns to increase gender diversity on corporate boards. BlackRock and State Street’s campaigns included policies of voting against directors’ reelection at firms that made insufficient progress toward a gender-diverse board. In our paper, The Big Three and Board Gender Diversity: The Effectiveness of Shareholder Voice, we exploit cross-sectional variation in The Big Three’s ownership stake to examine the impact of these investor-driven campaigns and shed light on the frictions that slow women’s ascension to corporate leadership positions.

Our analysis shows that The Big Three’s influence campaigns had a large impact on boards’ gender diversity. During the years of the campaign (2017-2019), one standard deviation greater Big Three ownership is associated with an 80% increase in the net flow of new female board members and an 11% increase in the overall proportion of female directors. Both fewer female director departures and more new additions drive this increase. Even our most conservative estimates imply that The Big Three’s campaigns led firms to add 2.5 times as many female directors in 2019 as they had in 2016, accounting for almost half of the total 2016-to-2019 increase in gender diversity and about a third of the decline in all-male boards over that same period. While large, these estimates likely reflect a lower bound. For example, they do not account for the positive spillover effects of The Big Three’s campaigns onto firms in which they own smaller stakes.


Private Enforcement of Shareholder Rights: A Comparison of Selected Jurisdictions and Policy Alternatives for Brazil

Caio de Oliveira is a policy analyst at the OECD; and Martin Gelter is professor of law at Fordham University School of Law. This post is based on a recent OECD report. Related research from the Program on Corporate Governance includes The Case for Increasing Shareholder Power, and Letting Shareholders Set the Rules, both by Lucian Bebchuk.


The OECD recently published a report Private Enforcement of Shareholder Rights: A Comparison of Selected Jurisdictions and Policy Alternatives for Brazil, which is the joint project with Brazil’s Securities and Exchange Commission (Comissão de Valores Mobiliários-CVM) and the Ministry of Economy. Building on a comparative review of ten countries—Brazil, France, Germany, Israel, Italy, Portugal, Singapore, Spain, the US and the UK—the report recommends a range of actions to address weaknesses in the frameworks for derivative suits and corporate arbitration in Brazil. The policy alternatives offered for Brazil seek to strike a balance between, on the one hand, adequate incentives for investors to find redress for infringement of their ownership rights and, on the other hand, avoiding frivolous litigation that may drain valuable resources from companies.

The recommendations in the report, for instance, address procedural barriers that minority shareholders must surpass before filing derivative suits. Likewise, the report proposes a change in the cost allocation for unsuccessful lawsuits in order to allow effective private enforcement through derivative lawsuits. The report also proposes a new transparency regime for corporate arbitrations, taking into account the particularities of conflicts involving shareholders’ rights in public companies.


Reforms of the Auditing Profession: Improving Quality Transparency, Governance and Accountability

Lynn E. Turner is former Chief Accountant at the U.S. Securities and Exchange Commission and currently senior advisor at Hemming Morse LLP.

Beginning with the passage of the 1933 Securities Act, Congress has required an Independent Audit for every public listed company in the United States. At the time the 1933 Act was debated by Congress, it was discussed as to whether to have audits performed by employees of the government. Banks regulated by the Federal Reserve, Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) are all examined by government employed banking examiners. But in the end, the draft of the 1933 Act was modified to have the audits performed by a licensed accountant (CPA) who is “independent.” Today CPA’s who audit publicly listed companies are currently regulated by both the Securities and Exchange Commission and its Office of the Chief Accountant, and the Public Company Accounting Oversight Board (PCAOB).

Continuing Issues with Poor Audit Quality

There continue to be issues with the quality of audits performed by CPA’s. In October, 2008, a U.S. Treasury Committee on the Auditing Profession (ACAP) issued a report with many recommendations for the SEC, PCAOB, and auditing profession. This committee of business leaders, investors, former SEC regulators, and CPA’s studied the profession for a year before issuing its report. Yet today, ten years later, few of the recommendations have been acted upon by the audit firms, or their regulators. As a result, it appears the four large audit firms have become “two big to fail.” And many of those who are regulating the audit firms at the SEC or PCAOB have joined the regulators from these “Big 4” firms, and have returned to them, as highlighted in the recent action of the Department of Justice against auditors at KPMG.


ESG Drivers and the COVID-19 Catalyst

Kosmas Papadopoulos is Senior Director at the Corporate Governance & Activism practice, Rodolfo Araujo is Senior Managing Director and Head of the Corporate Governance & Activism Practice at FTI Consulting, and Simon Toms is partner at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on an FTI/Skadden memorandum by Mr. Papadopoulos, Mr. Araujo, Mr. Toms, Charles Palmer, Marc Gerber, and Helena DerbyshireRelated research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here).

Despite the global economic and health crisis resulting from the COVID-19 pandemic, many companies have continued to intensify their efforts to improve their management approaches and communications in relation to environmental, social, and governance (ESG) issues. In many instances, the ongoing crisis has, in fact, accelerated pre-existing trends towards greater ESG integration by underscoring the role of business in confronting wider societal issueThe increasing adoption of ESG management systems is driven by two concurrent trends. First, significant social pressures, a shift in expectations for private enterprise, and ongoing regulatory changes have increased demand for companies to proactively take responsibility for potential externalities affecting the environment and society. Second, there is a growing recognition amongst investment and business professionals that ESG issues can have a material impact on company value and that the management of such risks can preserve (and even enhance) economic value for companies and their shareholders.

In this article, we review the underlying trends behind the momentum in ESG management and examine potential shifts in public policy, investor sentiment, and company behavior in the ongoing aftermath of the COVID-19 crisis. We draw some early lessons for companies reconsidering their approach to ESG as a result of the pandemic, focusing on social inequalities and workforce risks, the acceleration of pre-existing economic trends, and a continued emphasis on ESG issues.


Securities Litigation Premised on Failure to Disclose Alleged Underlying Illegal Conduct

Samuel P. Groner is partner and Fara M. Saathoff is an associate at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on their Fried Frank memorandum. Related research from the Program on Corporate Governance includes Rethinking Basic by Lucian Bebchuk and Allen Ferrell (discussed on the Forum here); and Price Impact, Materiality, and Halliburton II by Allen Ferrell and Andrew Roper (discussed on the Forum here).

In our Summer 2018 update, we discussed a number of recent district court decisions in securities cases premised on the theory that the company failed to disclose, in alleged violation of the securities laws, that it was engaged in underlying anti-competitive conduct. In each of those cases, the court held that the heightened pleading standard imposed by the Private Securities Litigation Reform Act of 1995 (“PSLRA”)—which requires that fraud be pleaded with particularity—applied not only to the allegations that the securities laws had been breached, but also in determining whether the plaintiff had adequately pleaded the existence of the alleged underlying anti-competitive conduct.

In Gamm v. Sanderson Farms, Inc., 944 F.3d 455 (2d Cir. 2019), that issue came before the Second Circuit. Consistent with the district court decisions discussed in our Summer 2018 update, the Second Circuit held that “when a securities fraud complaint claims that statements were rendered false or misleading through the nondisclosure of illegal activity, the facts of the underlying illegal acts must be pleaded with particularity in accordance with the requirements of Rule 9 and the PSLRA.” Id. at 466-67.


In Gamm, a series of antitrust lawsuits were filed against chicken producer Sanderson Farms and a number of its competitors. The lawsuits alleged that Sanderson Farms colluded with those competitors to manipulate the price of chicken by monitoring supply and suppressing its own supply at times when the price of chicken was high. Among the allegations were claims that Sanderson reduced supply by destroying breeder hens and eggs, exporting eggs from the U.S., and dumping excess chicken inventories in foreign markets where they sold for a fraction of the U.S. market price. This was alleged to have been accomplished, in part, through the manipulation of one of three chicken price indices, the Georgia Dock, which was alleged to have a less rigorous verification process as compared to the other indices.


Remember Enron? It Could Happen Again on Biden’s Watch

David S. Hilzenrath is Chief Investigative Reporter at the Project on Government Oversight. This post is based on an open letter to the Biden-Harris Transition Team.

Remember Enron, the energy trading company that collapsed in a massive accounting fraud, devastating employees and investors?

For members of the transition team, the sordid story may be far from top of mind. But it could happen again on President-elect Joe Biden’s watch, diverting him from his agenda and inflicting new damage on the economy.

To prevent that from happening, the Biden administration should seize the initiative and address problems that past administrations have at best given the illusion of fixing.

There are several relatively straightforward steps the Biden administration could take. They involve the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB). Some would require legislation, and some assume the new administration can muster a working majority at the SEC.

But to really make a difference, the Biden administration will have to do more than tinker. That’s because, at its core, the auditing of corporate America is fatally compromised. It needs fundamental reform.


Are CEOs’ Purchases More Profitable Than They Appear?

Christopher Armstrong is the EY Professor of Accounting at the Wharton School of the University of Pennsylvania; Terrence Blackburne is Assistant Professor of Accounting at Oregon State University College of Business; and Phillip Quinn is Assistant Professor of Accounting at University of Washington Foster School of Business. This post is based on their recent paper, forthcoming in the Journal of Accounting and Economics.

A basic tenet of contracting theory is that risk-averse agents require higher expected returns for taking on more risk. However, this principle appears to be at odds with the modest (i.e., 3%) abnormal returns that undiversified CEOs tend to earn on voluntary purchases of their firm’s stock. In contrast to research that focuses on direct trading profits as the primary motive for CEOs’ purchases, we argue that CEOs can also indirectly benefit from prolonged tenure by purchasing shares of their firm’s stock. By voluntarily purchasing additional shares, CEOs can credibly signal their favorable private information, which informs boards as they decide whether to retain or remove CEOs. We estimate that adding the indirect benefit of prolonged tenure following purchases increases CEOs’ total annual returns from 3% to 58%.

To determine whether purchases of their firm’s stock allow CEOs to prolong their employment, we first consider the characteristics of CEOs who make net purchases (i.e., CEOs whose open market purchases exceed their open market sales during the year). We find that net purchasers typically have had a shorter tenure, oversee firms with greater idiosyncratic volatility, and make their voluntary share purchases after poor stock performance. During periods of poor stock price performance, CEOs’ tend to face a heightened risk of performance-related turnover, which provides an incentive for CEOs to purchase shares to signal their expectation of better future performance to the board and investors. To the extent that CEOs’ purchases are viewed as being personally costly, we expect that investors and boards will perceive their purchases as credible evidence that the CEO possesses favorable private information about future performance. For CEOs, who tend to be highly under-diversified, the opportunity cost of not diversifying investments is significant, and this is especially true for CEOs of firms with high idiosyncratic volatility, making purchases by these CEOs more credible.


First COVID-19 M&A Decision

Gail Weinstein is senior counsel, and Philip Richter and Steven Epstein are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on their Fried Frank memorandum, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? by John C. Coates, Darius Palia, and Ge Wu (discussed on the Forum here); and Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here).

A number of cases are currently pending in various courts relating to whether, under an acquisition agreement signed prior to the COVID-19 pandemic, the effects of the pandemic and the target company’s responses to it constituted a “material adverse effect” and/or a breach of the covenant requiring the company to operate in the ordinary course of business between signing and closing. In AB Stable VIII LLC v. Maps Hotels and Resorts One LLC (Nov. 30, 2020), the Delaware Court of Chancery has reached the first decision, on the merits, that we know of on these issues. Vice Chancellor Laster ruled that the pandemic was not an MAE (because the MAE definition in the agreement excluded “calamities”), but that the target company’s responses to the pandemic constituted a breach of the ordinary course covenant. Therefore, the buyer was not obligated to close.

As a result of the decision, the focus on ordinary course covenants as a possible basis for not consummating deals is likely to intensify, both in the context of the COVID-19 pandemic and with respect to the potential for the occurrence of other kinds of extraordinary events (including those that are less extreme and occur more commonly). We note that ordinary course covenants appear in many types of agreements outside the M&A context (such as financing and operating agreements) and, thus, there is the potential that the decision could have broad impact.


Deleting Misconduct: The Expungement of BrokerCheck Records

Colleen Honigsberg is an Associate Professor of Law at Stanford Law School and Matthew Jacob is a PhD candidate in the department of economics at Harvard University. This post is based on their recent paper, forthcoming in the Journal of Financial Economics.

BrokerCheck, a public-facing website maintained by financial regulators, provides employment and disciplinary history for all US-registered securities brokers in an easy-to-search format. There are many indications that the website is well utilized and provides important information that can be used to predict broker misconduct (Qureshi and Sokobin, 2015; Egan, Matvos, and Seru, 2019). However, BrokerCheck has become subject to increasing scrutiny for the controversial practice, known as “expungement,” which allows brokers to remove select allegations of misconduct through an arbitration process.

Our paper Deleting Misconduct: The Expungement of BrokerCheck Records, forthcoming in the Journal of Financial Economics, provides the first academic analysis of BrokerCheck’s expungement process. From 2007 to 2016, we identify 6,660 expungement requests, suggesting that brokers request to expunge 12% of the allegations of misconduct made by customers and firms. Of the expungement requests that are adjudicated on the merits, over 80% are successful. We show that expungements significantly predict future misconduct; brokers with prior expungements are 3.3 times as likely to engage in new misconduct as the average broker. Further, using an instrumental variable based on the random assignment of arbitrators, we present evidence that brokers who receive expungement are more likely to reoffend than brokers who are denied expungement. We also show that successful expungements improve long-term career prospects.


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