Monthly Archives: October 2023

Rethinking Acting in Concert: Activist ESG Stewardship is Shareholder Democracy

Posted by Dan W. Puchniak (Yong Pung How School of Law), and Umakanth Varottil (National University of Singapore), on
Thursday, October 19, 2023
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Dan W. Puchniak is a Professor at Yong Pung How School of Law, Singapore Management University and an ECGI Research Member, and Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore and an ECGI Research Member. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; How Much Do Investors Care about Social Responsibility? (discussed on the Forum here) Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; Companies Should Maximize Shareholder Welfare Not Market Value (discussed on the Forum here) by Oliver D. Hart and Luigi Zingales; and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee (discussed on the Forum here) by Robert H. Sitkoff and Max M. Schanzenbach.

Activist campaigns by shareholders on environmental, social, and governance (ESG) issues continue to hog the limelight. Even though the results in the 2023 proxy season have been mixed, investors’ razor sharp focus on ESG matters continues unabated, and it remains to be seen whether recent political backlash against ESG is likely to be long-lasting.

The prominence of ESG activism is traceable to an episode in May 2021 when Engine No. 1, an investment fund, received plaudits from the “responsible investment community” for leading a campaign which successfully placed three dissident independent directors on ExxonMobil’s board. The aim of its activist campaign was to promote a more sustainable business model within ExxonMobil, a company with a history of denying climate change. Remarkably, Engine No. 1 was able to achieve this feat despite owning a mere 0.02 percent of ExxonMobil’s shares. The key to Engine No. 1’s success was its ability to inspire major institutional investors – such as BlackRock, Vanguard, and State Street – to follow its lead by voting in support of its activist ESG campaign.

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Directors: Take Activist Threats to Your Reputation with a Grain of Salt

Posted by Patrick Ryan, Lex Suvanto, Edelman Smithfield, on
Wednesday, October 18, 2023
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Patrick Ryan is an Executive Vice President and Lex Suvanto is a Managing Partner at Edelman Smithfield. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism (discussed on the Forum here) by Lucian A. Bebchuk, Alon Brav, and Wei Jiang; Dancing with Activists (discussed on the Forum here) by Lucian A. Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch; and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System (discussed on the Forum here) by Frankl and Kushner Leo E. Strine, Jr.

Criticizing boards and management teams in public letters and news media often gets shareholder activists what they want from boards. These tactics, common in proxy contests, regularly work in the absence of dissident director nominations. At times, just the threat of a public campaign and negative media coverage can get activists their desired results, even board seats.

Directors may agree to activist demands when they believe doing so serves shareholders’ best interests, including by avoiding the costs and distraction of a proxy fight. Another reason boards give in to activists, rarely acknowledged but supported by empirical evidence, is directors’ fear of the damage a prolonged campaign will do to their public image and the related personal and professional consequences.[1]

These concerns are overblown. They are based on misperceptions, particularly common among directors without activism experience, about how a public activist campaign will unfold at their company, e.g., what activist attacks and the ensuing media coverage will look like. Activists, of course, can take advantage of and even encourage these misconceptions to increase negotiating leverage.

Overestimating the reputational threat from activists can lead to negative outcomes for boards and shareholders. While compromise may be the best path forward in an activist engagement, a fear-driven “settlement at all costs” mentality can lead to hasty settlement agreements with unforeseen consequences. When agreeing to add a particular activist director to the board, for example, incumbent directors may fail to realize how the activist’s shorter investment horizon will conflict with the expectations of other large shareholders, or how much time the activist will demand of management. The board may also be unprepared for the increased probability of material, non-public information leaks.[2]

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Securities Law Precedents, Legal Liability, and Financial Reporting Quality

Posted by Allen Huang (Hong Kong University of Science and Technology), on
Wednesday, October 18, 2023
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Allen Huang is ​a Professor of Accounting at Hong Kong University of Science and Technology. This post is based on an article forthcoming in Review of Finance by Professor Huang, Benedikt Franke, Reeyarn Zhiyang Li, and Hui Wang.

In the U.S., securities class actions (SCAs) are one of the most significant sources of legal liability for firms, allowing investors to potentially recoup investment losses caused by securities law violations. Although every legal system has a legislature that passes new securities laws and statutes, the doctrine of stare decisis grants judicial precedents a pivotal role in defining what qualifies as a securities law violation in the U.S. common-law system. Under the doctrine, each court should apply the principles and rules established in its own or a higher court’s prior rulings when deciding a case. Thus, the collection of rulings affects private enforcement of securities law and shapes firms’ litigation environment.

In a forthcoming article at the Review of Finance, we exploit the variations in securities law precedents across the U.S. Courts of Appeals—the circuit courts—to investigate how regional courts’ historical rulings influence firms’ legal liabilities related to financial misreporting. Despite the Supreme Court having ultimate jurisdiction over all cases, circuit courts effectively act as arbiters for the majority of SCAs. Each circuit establishes precedents through rulings on cases with distinct facts. Because case facts and random factors, such as the case sequence or judge assignments, affect ruling outcomes, each circuit’s precedent evolves in an idiosyncratic and path-dependent manner. The resulting different interpretations of the same securities law induce within-country and over-time variations in firms’ expected litigation costs associated with securities law violations.

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Important MFW Developments

Posted by Gail Weinstein, Steven Steinman, and Steven Epstein, Fried, Frank, Harris, Shriver & Jacobson LLP, on
Tuesday, October 17, 2023
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Gail Weinstein is Senior Counsel, Steven Steinman and Steven Epstein are Partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Steinman, Mr. Epstein, Erica Jaffe, Shant P. Manoukian, and Maxwell Yim, and is part of the Delaware law series; links to other posts in the series are available here.

The MFW framework provides a pathway to business judgment review, rather than entire fairness review, of transactions involving a conflicted controller or a conflicted board (i.e., where a controller, or a majority of the board, has a personal interest in or will receive a non-ratable benefit from the transaction). The MWF prerequisites for business judgment review of such a transaction are that the transaction was, from the outset, conditioned on approval by both (i) an independent special committee of directors that fulfilled its duty of care and (ii) a majority of the unaffiliated stockholders in a fully informed, uncoerced vote. If such a transaction is challenged, and the MFW prerequisites were met, then any fiduciary breaches by the controller or directors are “cleansed”—with the result that any claims of breach of fiduciary duties are dismissed at the early pleading stage of litigation.

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Standardization and Innovation in Venture Capital Contracting: Evidence from Startup Company Charters

Posted by Robert Bartlett (Stanford Law School), on
Tuesday, October 17, 2023
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Robert Bartlett is the W. A. Franke Professor of Law and Business and faculty co-director of the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford Law School. This post is based on his recent paper.

In 2003, a group of approximately two dozen lawyers specializing in venture capital (VC) finance embarked on a mission to standardize the financing documents utilized by VC firms for investments in US-based startups. The primary objective was to mitigate the transaction costs associated with memorializing the non-binding term sheet negotiated between a company and a VC investor. While a term sheet typically outlines the standard economic and governance terms (e.g., valuation, type of liquidation preference, the number of investor- and founder-appointed directors), translating these core “deal” terms into definitive financing documents often entailed further negotiation. This additional negotiation occurred as both investor and company counsel sought to converge on the precise contractual language that would legally govern the investment. The standardization project aimed to curtail this latter form of negotiation by establishing a standard “template” for each of the five documents used in US VC finance. Since December 2003, the National Venture Capital Association (NVCA) has hosted these templates on its website, leading to their colloquial reference as the “NVCA financing documents.”

In a forthcoming chapter written for The Research Handbook on the Structure of Private Equity and Venture Capital (B. Broughman and E. de Fontenay, eds.), I investigate the extent to which this standardization project has succeeded over the past two decades. To do so, I turn to a dataset of nearly 5,000 charters negotiated by VC investors and startup companies between 2004 and 2022 in connection with a company’s VC financing. While most contracts utilized in VC finance are not publicly available, a defining feature of a company’s charter is that it is both publicly-available and plays a pivotal role in VC financial contracting. In particular, a VC financing will require a startup to amend its charter to authorize a new class of securities that will be sold to investors (typically convertible preferred stock). Moreover, because the charter must define the rights, preferences and restrictions that apply to these securities, negotiation of the charter constitutes one of the most important facets of a VC financing transaction. For this reason, central to the NVCA financing documents is the NVCA model charter.

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2024 U.S. Proxy Season: Proxy Voting, Governance, and ESG Matters

Posted by Laura D. Richman, Mayer Brown LLP, on
Monday, October 16, 2023
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Laura D. Richman is a Counsel at Mayer Brown LLP. This post is based on a Mayer Brown memorandum by Ms. Richman, Jennifer J. Carlson, Lawrence A. Cunningham, Anna T. Pinedo, and David A. Schuette.

Proxy Voting Matters

SHAREHOLDER PROPOSALS

Shareholder Proposals in the 2023 Proxy Season. In November 2021, the staff of the Division of Corporation Finance (the “Staff”) of the SEC issued Staff Legal Bulletin No. 14L (“SLB 14L”),[1] rescinding Staff Legal Bulletins Nos. 14I, 14J and 14K. This action reversed positions the Staff had taken since 2017, with respect to the ordinary business grounds for excluding shareholder proposals from company proxy statements pursuant to Rule 14a-8(i)(7) and the economic relevance grounds for excluding shareholder proposals pursuant to Rule 14a-8(i)(5).

Specifically, SLB 14L announced that when evaluating whether a proposal may be excluded pursuant to Rule 14a-8(i)(7), the Staff “will no longer focus on determining the nexus between a policy issue and the company, but will instead focus on the social policy significance of the issue that is the subject of the shareholder proposal.” SLB 14L also applied a “measured approach to evaluating companies’ micromanagement arguments for exclusion pursuant to Rule 14a-8(i)(7), recognizing that proposals seeking detail or seeking to promote timeframes or methods do not per se constitute micromanagement.”

In addition, SLB 14L specified that proposals raising issues of broad social or ethical concern related to the company’s business may not be excluded under the economic relevance tests set forth in Rule 14a-8(i)(5), even if the relevant business falls below the “economic thresholds” specified by that ground for exclusion. SLB 14L has made it much more difficult for companies to exclude proposals under Rule 14a-8(i)(7) or Rule 14a-8(i)(5), particularly shareholder proposals addressing climate change or other environmental, social and governance (“ESG”) issues. For additional information regarding SLB 14L, see our Legal Update, “SEC Staff Issues Legal Bulletin Announcing Shift in Shareholder Proposal Review Process Ahead of 2022 Proxy Season,” dated November 8, 2021.[2]

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The Social Costs (and Benefits) of Dual-Class Stock

Posted by Gregory H. Shill (University of Iowa), on
Monday, October 16, 2023
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Gregory H. Shill is a Professor of Law at the University of Iowa College of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here), The Perils of Small-Minority Controllers (discussed on the Forum here), and Keynote Presentation on The Lifecycle Theory of Dual-Class Structures (discussed on the Forum here) all by Lucian Bebchuk and Kobi Kastiel.

Dual-class stock structures allow founders to sell equity in their company without giving up control. These devices accomplish this by creating one class of stock with extra voting rights for founders and another with lesser voting rights for the general public—or no votes at all. They enable a giant company to be legally controlled by just two people (in the case of Google, for example) or even a single man (e.g., Facebook). More and more technology companies have selected these structures at the initial public offering stage, including Palantir, Snapchat, Lyft, Airbnb, and Dropbox (as well as Google and Facebook), and in 2020 they accounted for a majority of the IPO market by value.

Dual-class stock has attracted considerable academic attention for its potential to insulate the founder’s idiosyncratic vision from market pressures—for good and for ill. However, the focus of these agency costs critiques is on the dual-class structure’s effects inside the firm. In a forthcoming article, I argue that important social implications of dual-class stock overflow the boundaries of the firm—in brief, that the structure generates the potential for significant benefits and costs for society. The article advocates for changes to SEC regulations to help mitigate the social costs and increase the social potential of dual-class stock.

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Boards Confront Evolving Risks and Pressures During Another Disruptive Year

Posted by Amy Rojik, BDO, on
Sunday, October 15, 2023
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Amy Rojik is Director and Founder of the BDO Center for Corporate Governance. This post is based on her BDO memorandum.

Amid ongoing volatility, boards are continuing to address an evolving risk landscape and contend with pushback on how environmental, social, and governance (ESG) risk factors should be addressed. While oversight of enterprise risk management is part of the board’s mandate, executing that remit has become a delicate balancing act.

As Blackrock CEO Larry Fink wrote in his 2023 letter to investors, many clients “want access to data to ensure that material sustainability risk factors that could impact long-term asset returns are incorporated into their investment decisions.” However, companies have also faced an increase in anti-ESG shareholder proposals, and Fink stated in June, “I’m not going to use the word ‘ESG’ because it’s been misused” for political gain. Despite “ESG” perhaps becoming a loaded term, it’s critical that directors not overlook material ESG risk factors.

BDO conducts periodic surveys of public company board directors to understand what they’re seeing in terms of emerging trends, significant risks, and opportunities, as well as how they are preparing to address them. Our latest Spring 2023 BDO Board Pulse Survey highlights several evolving risk areas during ongoing economic uncertainty.

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Statement by Chair Gensler on Final Rules Regarding Short Sale Activity

Posted by Gary Gensler, U.S. Securities and Exchange Commission, on
Saturday, October 14, 2023
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Gary Gensler is Chair of the U.S. Securities and Exchange Commission. This post is based on his recent statement. The views expressed in this post are those of Chair Gensler, and do not necessarily reflect those of the Securities and Exchange Commission or its staff.

Today, the Commission is voting to adopt rules to broaden the scope of short sale-related data available to regulators as well as the investing public. I am pleased to support this adoption because it will enhance the transparency of this important area of our markets.

In the wake of the 2008 financial crisis, Congress directed the SEC to enhance the transparency of short selling of equity securities. In particular, the Dodd-Frank Act included a new Exchange Act section, 13f-2, which mandated that the SEC write rules for institutional investment managers’ disclosures of their short selling-related data. Congress did so even though the Financial Industry Regulatory Authority (FINRA) already had been making some disclosures with regard to short sale transactions.

Separately, since 1978, investment managers have had to report their long positions quarterly on so-called 13f filings. When Congress in Dodd-Frank mandated that the SEC write rules with regard to short selling disclosure, they did so by amending that same section, 13f. Congress, however, said that such reporting of short selling should be done monthly at a minimum.

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