Monthly Archives: June 2021

Keynote Address by Commissioner Lee on Climate, ESG, and the Board of Directors

Allison Herren Lee is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on her recent Keynote Address at the 2021 Society for Corporate Governance National Conference. The views expressed in the post are those of Commissioner Lee, and do not necessarily reflect those of the Securities and Exchange Commission or the Staff.

“You Cannot Direct the Wind, But You Can Adjust Your Sails” [1]

Good morning and thank you for the invitation to speak today at the Society for Corporate Governance 2021 National Conference. I’m impressed with your full and informative agenda over the next few days, and I appreciate the important work you do in supporting company boards and executives.

I also appreciate your engagement in the SEC’s policymaking process, including your recent letter in response to the request for public input on climate change disclosures. In fact, we’ve received thousands of comments in response to that request, but we hardly need that statistic to understand that the subject of climate risk and our financial markets, and ESG more broadly, is top of mind in board rooms and c-suites around the globe.

Increasingly, boards of directors are called upon to navigate the challenges presented by climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy. This call, welcomed by some and eschewed by others, is attributable in part to the large and growing influence that corporations hold over the social and economic well-being of people and communities everywhere. A study from 2018, for example, showed that 71 of the top 100 revenue generators globally were corporations while only 29 were countries. [2] In other words, corporations—in many cases U.S. corporations—often operate on a level or higher economic footing than some of the largest governments in the world. That is a dynamic worthy of reflection—and one that drives home the weighty consequences and obligations associated with some corporate decisions.

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How Do Asset Managers Create Subsidies for Certain Firms?

Anil K. Kashyap is Stevens Distinguished Service Professor of Economics and Finance at the University of Chicago; Natalia Kovrijnykh is Associate Professor of Economics at Arizona State University; Jian Li is Assistant Professor of Finance at Columbia Business School; and Anna Pavlova is Professor of Finance at London Business School. This post is based on their recent paper.

Since the 1980s economists have known that when stocks are added to the S&P 500 index their prices rise. There are now many theories that aim to explain this fact. Yet almost all of the related research has focused on how indices influence asset prices, with much less attention paid to other possible implications. In The Benchmark Inclusion Subsidy, we look at the repercussions of index inclusion for corporate decisions.

Asset management practices affect corporate decisions

Most fund managers’ performance is judged against benchmarks. Because the asset management industry is estimated to control more than $100 trillion worldwide, this means that there is a huge pool of money where the people making investment decisions have strong incentives to favor buying stocks inside the index instead ones that are outside it. We construct a model to analyse the consequences of these incentives.

The model predicts that firms that are part of a benchmark have a different cost of capital than similar firms outside the benchmark. When a firm adds risky cash flows, say, because of an acquisition or by investing in a new project, the increase in the shareholder value is larger if the firm is inside the benchmark. Hence, a firm in the benchmark could accept a project that an otherwise identical non-benchmark firm would not. This runs contrary to standard corporate finance theory. In the special case where there are no fund managers—as is standard in corporate finance—investors always value equivalent cash flows of benchmark and non-benchmark firms in the same way.

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Measuring Up To HCM

Avi Sheldon is a consultant at Semler Brossy. This post is based on his Semler Brossy memorandum.

Corporate sustainability risks and opportunities have received increasing interest from investors for the past decade.

Environmental concerns initially led the list, but attention to human capital has swiftly emerged as an additional focal point of discussion in the boardroom. Investors and other stakeholders are prodding companies to reveal more about their human capital practices and metrics. Boards are now scrambling to refine and articulate their strategies and investments in this area.

Human capital management (HCM) can be thought of as how an organisation strategically operates and invests in its workforce, with an eye towards optimising long-term value creation. It recognises human capital as a critical asset and modernises the understanding of HR departments as strategy and profit centres, not just cost centres.

HCM is therefore a sustainability topic that many stakeholders request more information about. How and why has a company invested in its workforce? Is there underinvestment that presents long-term risk? With HCM disclosure increasingly within investor crosshairs, many US corporations are bucking tradition by detailing elements of their HCM within the proxy statement.

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Comments to the Proposed Amendments to Require the Use of Universal Proxies

Steve Wolosky is partner at Olshan Frome Wolosky LLP. This post is based on his comment letter to the U.S. Securities and Exchange Commission. Related research from the Program on Corporate Governance includes Universal Proxies by Scott Hirst (discussed on the Forum here).

Olshan Frome Wolosky LLP (“Olshan”) is pleased to submit its comments to the proposed amendments to the federal proxy rules to require the use of universal proxies in non-exempt solicitations in connection with contested elections of directors as described in Release No. 34-79164 published by the Securities and Exchange Commission (“SEC”) on October 26, 2016. We commend the Staff for reopening the comment period pursuant to Release No. 34-91603 (the “Release”) given the passage of time since the initial comment period and continued interest and discourse among market participants on this topic.

Olshan’s Shareholder Activism Practice Group is widely recognized as the nation’s premier legal practice in representing activist investors in contested solicitations. We have vast experience counseling clients on a wide variety of activist strategies, from election contests, consent solicitations and hostile takeovers to letter writing campaigns and behind-the-scenes discussions with management and boards of directors. We are consistently ranked as the leading legal advisor to activist investors by various publications that cover shareholder activism, including Activist Insight Monthly, The Deal Activism League Table, FactSet SharkRepellent, The Legal 500 United States Guide, Bloomberg Activism Advisory League Table and Refinitiv Global Shareholder Activism Scorecard. In 2020, our firm advised on 111 activist campaigns, or 74 more campaigns than our next closest competitor, according to Bloomberg’s Activism Advisory League Tables. We believe our position as the leading law firm in the shareholder activism arena gives us unique insight and perspective into the proxy process and the proposed legal, procedural and policy considerations underlying the universal proxy rule proposal.

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What Does Codetermination Do?

Simon Jäger is the Silverman (1968) Family Career Development Assistant Professor of Economics at the Massachusetts Institute of Technology; Shakked Noy is a Predoctoral Research Fellow at the Massachusetts Institute of Technology; and Benjamin Schoefer is Assistant Professor of Economics at the University of California, Berkeley. This post is based on their recent paper. Related 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); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

In liberal market economies such as the United States, firms are controlled ultimately by their shareholders or owners, and (under the dominant legal doctrine of “shareholder primacy”) are governed with the exclusive purpose of maximizing the welfare of those shareholders and owners. By contrast, large firms in many European countries are jointly governed by their shareholders and workers, through “codetermination” arrangements mandated by law. Under “board-level” codetermination, workers elect representatives who fill a certain share (usually 20-40%) of the seats on their company’s board. Under “shop-floor” codetermination, workers elect shop-floor representatives who have rights to information, consultation, and sometimes co-decision-making over decisions about working conditions. Recent legislative proposals in the United States, including the Reward Work Act and Accountable Capitalism Act, and recent campaign proposals in the United Kingdom and Australia, would introduce board-level codetermination requirements for large firms in those countries. In addition, the possibility of amending the National Labor Relations Act to allow for experimentation with shop-floor codetermination in the US has been raised repeatedly in recent years (Liebman, 2017; Andrias and Rogers, 2018; Block, 2018).

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Alarm.com and the Open Questions Regarding Trade Secret Claims Related To Usurpation of Corporate Opportunities

Robert S. Velevis is partner and Lora Chowdhury is an associate at Sidley Austin LLP. This post is based on their Sidley memorandum, and is part of the Delaware law series; links to other posts in the series are available here.

In a previous memorandum, we discussed a recent Texas Court of Appeals case which held that members of a Delaware LLC can contract around (i.e., waive) the general principle protecting against usurpation of corporate opportunities. See Patterson v. Five Point Midstream Funds I and II, L.P., Case No. 01-19-00-643-CV (Tex. App. Dec. 8, 2020). We discussed that the Patterson decision followed a trend in Delaware that permits parties to contract around the traditional rules prohibiting usurpation of corporate opportunities. See Alarm.com Holdings, Inc. v. ABS Capital Partners Inc., No. CV 2017-0583-JTL, 2018 WL 3006118 (Del. Ch. June 15, 2018), aff’d, 204 A.3d 113 (Del. 2019). In December 2019, the Delaware Supreme Court in Alarm.com, affirmed a decision penned by Vice Chancellor Laster out of the Court of Chancery dismissing a claim under the Delaware Uniform Trade Secret Act (DUTSA).

In this post, we will take a deeper dive into Alarm.com, the open questions it left, and potential new developments to keep an eye out for concerning waiver of usurpation of corporate opportunities in the private equity realm. This decision — and the open questions that have not yet been addressed by subsequent cases — is of particular importance to private equity owners that hold investment in companies governed by Delaware law.

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Key Corporate Governance Issues at Mid-Year 2021

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy; and Steven A. Rosenblum and Karessa L. Cain are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell.

Last year, we did a mid-year edition of our annual Thoughts for Boards of Directors to highlight key issues and considerations in managing the challenging business environment and profound upheaval caused by the pandemic. Many of these issues are still top-of-mind as the “new normal” continues to evolve, and will continue to be prominent themes in boardroom discussions. As we emerge from the pandemic, boards and management teams should continue to assess their corporate purpose, strategy, risk management procedures, and board committee structures to optimize their ability to deal with the ever-proliferating number and complexity of business risks and opportunities they must navigate, including the following:

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Tone at the Bottom: Measuring Corporate Misconduct Risk from the Text of Employee Reviews

Dennis Campbell is Dwight P. Robinson Jr. Professor of Business Administration at Harvard Business School, and Ruidi Shang is Assistant Professor of Accountancy at Tilburg University. This post is based on their recent paper.

Numerous cases of corporate misconduct have emerged globally in recent years and caused large financial, reputational, and other damages for firms, their stakeholders, and even broader society. Managers’ and employees’ inherent tendency to commit such misconduct is deeply rooted in the operating and control environment of their organization. For example, Wells Fargo was caught in 2016 for opening two million fake accounts and selling products and services to customers under false pretenses to increase sales figures. Even though the misconduct in Wells Fargo was committed by lower-level employees, their motive to engage in such misconduct was derived from the aggressive sales targets and cross-selling strategies set by middle- and upper-level managers. Further, weaknesses in Wells Fargo’s internal control systems also provided employees with opportunities to engage in misconduct. Similar examples can be seen in other recent high profile cases such as those of Volkswagen, Theranos, and BP. In each of these cases, as with Wells Fargo, both the underlying acts of misconduct and the organizational cultures and management pressures that gave rise to them were likely to be observed by numerous employees well before they resulted in economic damage to the firm and its customers, employees, and investors.

If external stakeholders, such as investors, could obtain such information about firms’ internal operating and control environments, they might be able to assess the risk of future misconduct. However, since external stakeholders do not directly observe or participate in the daily operating and control practices within firms, they cannot easily obtain such inside information. In comparison, employees have the best access to the information on firms’ internal operations and controls simply as a by-product of their daily work.

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How Companies Should Respond to the SEC’s Enhanced Focus on Rule 10b5-1 Plans

Sonia Gupta Barros and Stephen L. Cohen are partners and Sara M. von Althann is counsel at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. Barros, Mr. Cohen, Ms. von Althann, John P. Kelsh, and Sasha P. Hondagneu-Messner.

On June 7, 2021, Securities and Exchange Commission (SEC) Chair, Gary Gensler, expressed concern about potential abuses of Securities Exchange Act Rule 10b5-1 and announced that he expects to revise the rule. [1] The agency followed with an updated regulatory agenda which signals that proposed new rules may come before the end of the year.

Rule 10b5-1 provides an affirmative defense from insider trading for corporate insiders and companies to buy and sell company stock as long as they adopt their trading plans in good faith and while not in possession of material nonpublic information. These arrangements typically involve periodic sales pursuant to a schedule determined at the outset of the plan, sometimes combined with giving a third party (generally a broker) sole discretionary authority with respect to certain aspects of the trades. However, academic studies have asserted that some executives use 10b5-1 plans to engage in opportunistic, large-scale selling of company shares. [2] There are limited SEC enforcement actions concerning Rule 10b5-1 and none recent.

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Phantom of the Opera: ETF Shorting and Shareholder Voting

Oğuzhan Karakaş is Senior Lecturer in Finance at the University of Cambridge Judge Business School. This post is based on a recent paper authored by Mr. Karakas; Richard B. Evans, Associate Professor of Business Administration and Donald McLean Wilkinson Research Chair in Business Administration at the University of Virginia Darden School of Business; Rabih Moussawi, Associate Professor of Finance & Real Estate at Villanova School of Business; and Michael Young, Assistant Professor of Finance at the University of Missouri Robert Trulaske, Sr. College of Business.

In our recent paper, Phantom of the Opera: ETF Shorting and Shareholder Voting, we analyze the impact of the short-selling of exchange traded funds (ETFs) on shareholder voting of the underlying securities. We introduce a novel measure of the wedge created between the economic ETF ownership and the voting rights of ETF underlying shares, which we call “phantom shares”. We examine the implications of these phantom shares on the voting process, voting outcomes, voting rights premia, and merger returns. We find that phantom shares, stemming from short-selling of ETF shares (for ETF market making, directional, or hedging purposes), lead to sidelined votes during the proxy voting process. This sidelining appears to be due to the underlying shares backing these ETF short positions going unvoted.

Proxy voting is a fundamental mechanism for shareholder ‘voice’ in corporate governance, including shareholder engagement and activism. With the dramatic surge in passively managed assets across the globe, index funds and ETFs play an increasingly important role in proxy voting. While the debate regarding the efficacy of passive investor voting decisions is in its early stages, our paper addresses a more foundational issue: whether or not the shares of stock underlying the ETFs are voted at all.

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