(Editor’s note: This post comes to us from Vidhi Chhaochharia of the University of Miami and Yaniv Grinstein of Cornell University. Their article was recently accepted for publication in the Journal of Finance.)

The purpose of this article is to examine how the new board requirements that were enacted in response to corporate scandals in 2001 and 2002 affected compensation decisions. We use the difference-in-difference approach to compare changes in compensation between firms that were already complying with these requirements and firms that were not complying with them. Our sample consists of 865 firms that belong to the S&P 1500 index for the period 2000 to 2005. To measure level of compliance, we focus on three board structure variables that were required by the rules: the requirement for a majority of independent directors on a single board, the requirement for an independent nominating committee, and the requirement for an independent compensation committee.

We find that firms that did not comply with these requirements significantly decreased CEO compensation in the period after the rules went into effect, compared to the complying firms. The decrease is on the order of 17%, after taking into account performance, size, time varying shocks to different industries during that period, firm fixed effects, and other variables affecting compensation that changed during that time. We also find that the one requirement that is strongly associated with a drop in compensation is the requirement that the majority of board members be independent, and that the significant relative drop in compensation comes from the decrease in the bonus and the stock based compensation. We also find that the decrease in compensation is particularly pronounced in the subset of affected firms with no outside block holder on the board and in affected firms with low concentration of institutional investors. In short, our results suggest that the new board requirements affected CEO compensation decisions.

The full paper is available for download here.

(Editor’s note: For a contrasting analysis of the UN proposal by Guest Contributor Martin Lipton of Wachtell, Lipton, Rosen & Katz, please see here.)

On behalf of our pro bono client Oxfam America, my colleagues, Ira M. Millstein, E. Norman Veasey, Harvey Goldschmid, Steven Alan Reiss, Ashley R. Altschuler, and I have prepared a memorandum that discusses the report, Protect, Respect and Remedy: A Framework for Business and Human Rights, prepared by Harvard Professor John G. Ruggie, the Secretary-General’s Special Representative on Human Rights. Our memorandum is available on the UN Special Representative’s website here.

The Ruggie Report posits three “core principles”: (1) the State duty to protect human rights, (2) the corporate social responsibility to respect human rights, and (3) the need for access to appropriate remedies for human rights abuses.We believe the basic concepts embodied in the Report are sound and should be supported by the business community in the United States. In summary, our reasons are:

• In the first instance, the US and foreign governments have the primary responsibility for defining what human rights obligations are binding legal duties and how those duties are enforced;

• If the Report is taken seriously by foreign government and foreign companies, it will benefit US corporations by leveling the playing field in placing on foreign boards and management the responsibilities to adhere to many of the same fiduciary and binding legal obligations presently applicable to US companies;

• Given the interplay of fiduciary, disclosure, internal control and risk mangement obligations facing US boards and managers today, the Report does not implicate new legal obligations for US companies;

• Violations of human rights may constitute material risks for many US corporations, not only in the US, but also in foreign jurisdictions where they conduct business;

• While the report does not limit the scope of internationally-recognized human rights, each US company must presently determine for itself, what human rights risks may be material to its business;

• Additionally, and beyond the obligation to manage risks, and comply with law, there is a substantial business case in favor of safeguarding human rights wherever the company does business.

The Report is available here, and our memorandum is available here.

While the bulk of the commentary about last week’s CSX/TCI opinion has focused on the requirement for disclosure of derivatives under the Williams Act, the hedge fund defendants missed a great opportunity to attack the odious practice of management using shareholder money to sue a dissident on any pretext in order to entrench itself.

Generally, courts have been getting tougher on implied rights of action and especially so in securities lawsuits. In meVC Draper Fischer Jurvetson Fund,Inc., v. Millennium Partners, 260 F. Supp. 2d 616 (S.D.N.Y., 2003), Judge Sand, citing Alexander v. Sandoval, 532 U.S. 275 (2001) and Olmsted v. Pruco Life Ins. Co. of New Jersey, 283 F.3d 429 (2002) ruled that there is no right of private action section under section 12d(1)(A) of the 1940 Investment Company Act. It dismissed prior cases finding a right of private action as belonging to an “ancien regime.” A similar finding was made by the Third Circuit in a lawsuit brought under the Postal Reorganization Act, Wisniewski v. Rodale, Inc., 510 F.3d 294 (3rd Cir., 2007). The Wisniewski court ruled that after Sandoval a private right of action under a federal statute may be implied only if the court determines that Congress intended to create (1) a private right and (2) a private remedy.

I see no way that a court can find a principled distinction with respect to a private right of action between section 12d(1)(A) of the 1940 ICA and section 13(d) of the 1934 Act. At a minimum, after Sandoval in 2001 the issue of standing for 13(d) claims is certainly fair game. There is no “rights creating” language in either law that would support a right of private action by a supposedly aggrieved company.

Of course, unless a defendant raises the issue, I wouldn’t expect any judge to do it on his own. In the CSX case, the hedge fund defendants blew it and Judge Kaplan perfunctorily noted in passing that there is an implied right of private action under section 13(d) based on pre-Sandoval precedents based on the premise that the “congressional purpose was furthered by providing issuers with the right to sue ‘to enforce [the] duties created by [the] statute’ “

My paper, co-authored with Julian Atanassov of the University of Oregon, was recently accepted for publication in the Journal of Finance. This paper investigates how labor and investors’ relative influence and firm level variables interact to affect corporate governance. A key conclusion is that weak investor protection combined with strong union laws are conducive to worker-management collusion harmful to investors.

Specifically, we analyze restructuring decisions when firms suffer a sudden, sharp deterioration in operating performance. We proxy for stakeholders’ relative influence at the country level by the strength of legal protection of investors and labor. We consider three types of restructuring measures: large scale employee layoffs, top management turnover, and major asset sales. Our sample consists of 9,923 firms (10,947 firm-years) at the onset of sharply declining operating performance in 41 developed and emerging economies over the period 1993 to 2004.

We find that poorly performing firms in stronger investor protection countries are more likely to undertake large-scale worker layoffs and replace top management than those in weaker investor protection countries. These restructuring actions are followed by superior operating performance in all legal environments. Major asset sales are different, however. We observe more asset sales when investor protection is either very strong or very weak. Asset sales in strong investor protection countries are followed by superior operating performance, whereas asset sales in weak investor protection countries are followed by inferior subsequent operating performance.

The likelihood of value-reducing asset sales increases as collective bargaining and labor relations laws grant more power to labor unions, suggesting that these asset sales are countenanced by workers. In addition, underperforming top managers in low investor protection countries are more likely to retain their jobs as union power increases. These results point toward management-worker alliances motivated by a mutual desire to retain jobs. For such an alliance to work, management needs funds to minimize layoffs and wage cuts. Lacking other means to raise the necessary funds, poorly performing firms sell assets to forestall layoffs even when doing so hurts subsequent operating performance. Indeed, asset sales in weak investor protection countries do not lead to layoffs, whereas in strong investor protection countries asset sales predict layoffs.

We also find that strong union laws are less effective in preventing layoffs when financial leverage is high, indicating that financial leverage is an effective instrument with which investors counter the power of workers.

Overall, our results highlight the importance of interaction among management, labor, and investors in shaping corporate governance.

The full paper is available for download here.

(Editor’s note: We also learned from our Guest Contributor John F. Olson that his firm, Gibson, Dunn & Crutcher LLP, has also just issued a memo on this important decision.)

“The securities markets operate in the real world, not in a law school contracts classroom. Any determination of beneficial ownership that failed to take account of the practical realities of that world would be open to the gravest abuse.” That is just a teaser of an opinion in which every page is a gem. Judge Kaplan’s opinion in the CSX/TCI case is long but well worth reading wholly apart from those with interest in the particular facts of that particular case. It treats with great insight and expertise the activist stockholder tactic of using swaps to gain increased leverage and potential advantage while staying below (they think, or better, thought) the 5% public reporting threshold of Section 13(d) of the Williams Act.

The decision comes to the brink of holding that the long side of a cash-settled total return swap conveys old-fashioned “beneficial ownership” (voting or investment power) of the shares held in the counterparty’s hedge position in the typical case where the long knows and intends that the financial institution on the other side will perfectly hedge by buying the shares and holding them until the unwind (whether that is effected ultimately in cash or in kind). While making a persuasive case for that conclusion, Judge Kaplan rests the beneficial ownership conclusion on the oft-ignored-but-nevermore “anti-evasion” SEC Rule 13d-3(b) which is an effective tool to prevent devices to prevent beneficial ownership from doing so. As to relief, the Court deemed itself constrained by prior precedent not to sterilize the shares bought under cover of 13(d) violation (it did enjoin future violations), but virtually invited the Second Circuit to revisit the question by declaring that the Court would have granted that relief had it discretion to do so. While there will likely be an appellate ruling in the case (an expedited appeal is being taken), Judge Kaplan’s opinion will undoubtedly stand as must reading.

Our short memo on the decision is here, and the Court’s opinion is available here.

The beat goes on — in the on-going CSX/TCI litigation before Judge Kaplan of SDNY which is expected to yield an important ruling on the application of the old school reporting requirements of Section 13(d) to the brave new world of hedge funds/derivatives/synthetics. In a recent letter responding to the Court’s inquiry, the Staff of the SEC’s Corp Fin Div took the view that the typical total return swap did not confer the voting or disposition power sufficient to trigger the beneficial ownership reporting requirement under 13D, and that the (so-called) anti-evasion Rule 13d-3(b) reaches only swaps or the like if the intent was to create a “false” appearance. Our memo on the Staff letter, and on the continuing need for reform, is here. The Court, of course, will have the last word, and there remains ample running room.

Although this blog uses the name Harvard Law School Corporate Governance Blog, I want to introduce a new but closely related topic – uncorporate governance.

By uncorporate I mean partnership-type business associations (i.e., general partnerships, limited liability companies and limited partnerships) and the default rules and norms that are associated with these business forms.

One might say that looking at uncorporations moves away from this blog’s focus on publicly held firms. But as I show in my Uncorporating the Large Firm, uncorporations are increasingly important in governing large, publicly held firms. Examples include not only publicly traded partnerships, limited liability companies and real estate investment trusts, but also private equity, venture capital and hedge funds that exercise critical control powers in firms that are large, publicly traded, or both.

All of these firms are characterized by their substitution of discipline and incentives for corporate-type monitoring as ways to control managerial agency costs. Specifically, uncorporations (1) loosen managers’ grip on the firm’s cash through distributions and liquidation rights; and (2) give managers high-powered owner-like incentives. The trade-off is that uncorporations rely much less on high-cost but often ineffective monitoring devices such as fiduciary duties, owner voting and the market for control.

Corporate scholars and practitioners have been complaining for generations about the inadequacy of corporate monitoring devices in controlling agency costs. Tweaks of conventional corporate governance, such as majority voting for directors, are more band-aids than solutions. Defenders of the corporate status quo argue that the benefits of strong managerial power are worth the costs. But whether that is true depends on whether there are cheaper and more effective alternatives. My paper shows that there are, and that market forces have been substituting these alternatives for traditional corporate governance.

So research on corporate governance needs to start paying more attention to uncorporate governance. This means, among other things, more focus on the distinct role of uncorporate structures in producing value. For example, many articles discuss activist hedge funds’ role in unlocking corporate value, but not why they produce these results. My work suggests that hedge funds’ uncorporate structure – that is, use of typical limited partnership and LLC governance devices – is a big part of the answer. Similarly, many attribute the success of private equity to factors such as the escape from securities regulation and the use of debt. Again, I suggest that private equity’s uncorporate structure plays a critical role. The public policy implication is that disabling critical private equity features through tax or regulation may have significant costs.

The role of uncorporations in large firms may increase as new uses are found for these devices. For example, I’ve tried to make the case for publicly traded law firms (which, of course, would involve changes in current ethical rules). See MacEwen, Regan & Ribstein, Law Firms, Ethics and Equity Capital: A Conversation. I show in my “Uncorporating” paper that uncorporate structures are the likely vehicles for such firms.

The future of the uncorporation in large firms depends critically on the courts and Congress. The courts need to enforce contracts in uncorporations, particularly including fiduciary duty waivers, in order to effectuate the uncorporate substitution of discipline and incentives for monitoring. I show in The Uncorporation and Corporate Indeterminacy that the Delaware courts are, indeed, doing that. Francis Pileggi wrote about one recent such case on this Blog, Chancery Gives Victory to Freedom of Contract, May 23, 2008.

As for Congress, we can expect calls by interest groups to stunt the expansion of private equity and other uncorporate governance devices. These devices increase managers’ incentives to respond to owners’ interests and eliminate the shareholder meeting as a mechanism for non-owner interest groups to be heard. As I’ve discussed on my blog (The SEIU and Private Equity, June 4, 2008) the unions are aware of this and fighting back. The political question boils down to the appropriate balance between managerial accountability and managers’ power to allocate some of the corporate pie to non-owner groups. Congress could try to stunt the growth of the uncorporation through tax and regulation. On the other hand, such moves as eliminating the corporate tax or relaxing publicly traded firms’ ability to be taxed as partnerships could pave the way to really significant changes in the way corporations are governed.

In short, managers’ agency costs in large corporations has for a long time been a lot like the weather. Politicians and interest groups talk about it a lot, but the results, like umbrellas and galoshes, don’t change the basic scenery. The uncorporation could make a basic change if we’re willing to unleash its potential.

The UK has, similarly to the US, deep and liquid securities markets and widely-dispersed ownership of publicly-traded firms. The central problem of corporate governance for publicly-traded firms in the UK is rendering managers accountable to shareholders. My recent paper, entitled Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment, provides a roadmap of the enforcement strategies employed in UK corporate governance, and a first approximation of their empirical significance.

Enforcement strategies affect agents’ incentives to comply with substantive rules, and so the effectiveness of a regulatory regime is a function of both substantive rules and the strategies by which they are enforced. While recent scholarship has begun to address enforcement-related issues, no clear consensus has yet emerged, as the results seem sensitive to the way in which ‘enforcement’ is measured. Moreover, those studies that have been done have focused on formal (court-based) mechanisms of enforcement. There are, of course, a variety of other ways in which the agency problems at the centre of corporate governance can be kept in check—from quiet intervention by a regulator to the threat of a shareholder revolt. The impact in practice of a corporate governance regime on agents’ incentives is therefore the sum of all institutions—formal and informal—that may impose a sanction on agents for inappropriate performance. Such institutions vary across countries, and so studies that focus solely on court-based enforcement risk misleading comparisons. Of course, this point isn’t new. The challenge is how to identify these modalities and measure their intensity in a meaningful way. This paper offers a first cut at the problem in the context of the UK.

The results suggest three stylised facts about the UK corporate governance system. First, shareholder lawsuits are conspicuous by their absence. Formal private enforcement appears to play little or no role in controlling managers. Secondly, it is public, rather than private, enforcement which dominates in relation to listed companies. However, the lion’s share of the interventions by the relevant agencies—the Takeover Panel, the Financial Reporting Review Panel, and the Financial Services Authority—is of an informal character, not resulting in any legal action. Suasion, rather than sanction, is the order of the day. Thirdly, a simple divide between public and private enforcement fails fully to take account of the role played by institutional investors in the UK, who have engaged systematically in informal private enforcement activity. Strong informal private enforcement has historically therefore been the flipside, in the UK, of weak formal private enforcement.

The paper is available here.

(Editor’s note: This post comes to us from Jonathan Rogers and Andrew Van Buskirk at the University of Chicago Graduate School of Business. Their paper was recently accepted for publication in the Journal of Accounting and Economics)

While the deterrent function of private litigation has been studied in some detail, we investigate the existence of another potential benefit of securities litigation: a change in the conduct of the firms involved in private litigation. Specifically, we examine changes in the disclosure behavior of firms involved in 827 disclosure-related class-action securities litigation cases filed between 1996 and 2005. Prior studies have investigated how proxies for the threat of private securities litigation affect corporate disclosure behavior, but little is known about the behavioral changes of companies that are actually sued.

We find no evidence that the firms in our sample respond to the litigation event by increasing or improving their disclosures to investors. Rather, we find consistent evidence that firms reduce the level of information provided post-litigation. This reduction takes many forms. The probability of a firm hosting an earnings-related conference call or issuing an earnings forecast is lower following litigation. When firms choose to issue earnings forecasts, those forecasts are issued for shorter horizons and are less likely to be quantitative. When quantitative forecasts are issued, these forecasts are less specific (i.e., wider range estimates). We also find an increase in the magnitude of future earnings surprises and an increase in the absolute value of earnings announcement excess returns. We find no evidence that this reduction in disclosure is driven by a decrease in the firm’s forecasting ability; management forecast accuracy is indistinguishable post-litigation compared to a twelve-month window prior to the damage period. Our results hold after controlling for other potential determinants of disclosure choices such as CEO turnover, demand for disclosure, and economy-wide trends in disclosure.

Our evidence suggests that the litigation process encourages firms to decrease the provision of disclosures for which they may later be held accountable, despite the increased protections afforded by the Private Securities Litigation Reform Act of 1995. Our results seem inconsistent with the intentions of regulators and private litigants who seek enhanced corporate transparency.

The full paper is available for download here.

My colleague Laura A.McIntosh and I have written an article recently published in the New York Law Journal on May 22, 2008 entitled Corporate Governance Update: Advance Notice Bylaws: Lessons from Recent Cases. Until recently, advance notice bylaws have been unremarkable and fairly uncomplicated provisions, generally easily complied with and largely uncontroversial. In two recent cases, Jana Master Fund, Ltd. v. CNet Networks, Inc. and Levitt Corp. v. Office Depot, Inc., the Delaware courts allowed activist stockholders to exploit potential drafting ambiguities to circumvent the well-intended rationale of the advance notice bylaw. As a result, advance notice bylaws have emerged as an important battleground in the conflict between companies and activist stockholders. Our article describes the purpose, operation and functions of an advance notice bylaw and considers the CNet and Office Depot decisions. Against the backdrop of these cases and in light of the increasingly complicated mechanisms through which investors hold stock, the article also discusses important points that companies should consider when reviewing their advance notice bylaws and bringing them up to date.

The article is available here.

ICR, the financial communications consulting firm, recently released a discussion paper Shareholder Activism: Proactive Defense and Informed Response. The paper explores the current environment of shareholder activism driven by “Sharks,” “Wolves” and “Jaguars,” as well as these activists’ goals, motives and tactics. The paper also presents a well documented strategy for issuers outlining potential vulnerabilities to attack, defenses against attack, as well as how to best respond to attack

Since the first company went public, activists have been utilizing creative and often confrontational strategies to engage with issuers to achieve their sometimes self-serving goals as well as positive returns from their investment portfolios. Such shareholder activism, traditionally the purview of institutional investors such as labor unions, public pension funds, and religious organizations, has become increasingly contentious and problematic for issuers as the rapidly growing hedge fund asset class has moved toward direct activism.

While “activism” among shareholders is not necessarily new, the credit crunch of last summer has fueled hostility in the current activist environment as more hedge funds chase fewer investment opportunities and face a depressed capital market. This environment has created a scenario whereby activist investing increasingly becomes the norm as hedge funds try to differentiate themselves and continue to deliver the outsized returns that they have promised to their investors. As a result, public companies need to reconsider their preparedness and carefully address how best to protect their position in the public markets.

The paper is available here.

Ernst & Young recently released its 10th Global Fraud Survey “Corruption or Compliance – Weighing the Costs“.

As the US Foreign Corrupt Practices Act (FCPA) becomes the de facto anti-corruption standard worldwide, over 50% of US executives — and 84% globally — still know little to nothing of its key provisions, according to the survey. Another survey finding with governance implications suggests that companies increasingly rely on internal audit to find and address fraud and compliance risk—but internal audit departments may not have the tools, techniques, or resources to do so. Only 28% of US respondents say their internal audit departments are highly successful at detecting bribery and other corrupt practices.

The results show a marked lack of knowledge and preparedness on the part of C-suite executives and other risk management personnel, including internal auditors, about FCPA, which prohibits bribery of government officials by US companies and US-traded foreign companies. More than two-fifths of survey respondents (43%) say their companies do not have specific provisions in place for dealing with government officials—presenting an enormous risk of FCPA non-compliance.

Another key finding is that companies engaged in M&A may not be conducting necessary due diligence on target companies. Nearly half of FCPA prosecutions in 2007 arose during mergers or acquisitions. But fewer than half of survey respondents report that their companies routinely review the risk of bribery in advance of an acquisition—presenting significant risk of so-called “successor liabilities” that expose the buyer to unnecessary risk.

In sum, Ernst & Young’s 10th Global Fraud Survey demonstrates that corruption and bribery remain a significant exposure for US companies, especially as they conduct business across borders. The survey included senior in-house counsel and chief risk officers, along with other corporate executives from the C-suite to internal audit, and surveyed 1,186 respondents in 33 countries from November 2007 to February 2008.

The survey is available here.

(Editor’s note: This post is by Angela Priest and Eric Wilensky of Morris, Nichols, Arsht & Tunnell LLP.)

Over the past year, the areas of corporation law impacting how transaction attorneys guide their clients developed at a significant pace. This trend emerged with Vice Chancellor Strine’s Netsmart, Topps, and Lear opinions, issued during the height of the private equity-led LBO boom and continued through Chancellor Chandler’s United Rentals opinion, in which the Court addressed issues associated with the break up of a transaction entered into during that boom. In between the Court addressed a number of issues, including permissible board actions in the context of seeking stockholder approval; when a company must include management projections in its proxy solicitation materials; and how to value a company in an appraisal proceeding.

In this article, we discuss these developments in the order that a transaction attorney would likely need to consider them-starting with the exploration of strategic alternatives and ending with litigating a busted deal. We do not intend to conduct an exhaustive analysis on any particular topic or any particular case. Instead, we intend to raise awareness of certain guidelines that these cases suggest.

What our experience has taught us over the past year, and what we hope becomes clear, is that although each opinion issued by the Delaware courts provide guidelines to transaction planners, each opinion is decided based on a particular set of facts. Thus, the opinions issued by the Delaware courts should be taken for what they are–guidelines for shaping a transaction–and not bright-line rules to be followed in all instances.

The article is available here.

It’s the height of proxy season, and with the high-profile shareholder meetings taking place at Exxon last week and Yahoo later this summer, a new website ProxyDemocracy.org offers tools to help individual investors take part in the process.

Although individuals own over 25% of US equity, institutional investors run the show when it comes to proxy voting. Driven by a mix of corporate governance zeal and fiduciary duty, mutual funds, pension funds, and other institutions invest in proxy voting research and vote their shares almost 100% of the time. By contrast, only about 20% of individual investors bother to vote; it’s safe to assume that even fewer read the proxy statement and know what they’re voting on.

Given the difficulty of researching the issues on the ballot and the ease of free riding, it’s not surprising that individual investors generally pass up their voting rights as owners. But it has a cost. Though many retail investors don’t realize it, their brokers vote on their behalf when they fail to send in a ballot. The standard approach brokers have taken is to cast all of these “uninstructed” shares for management, which tends to stack the deck against governance reform. Some brokers have recently enacted a “proportional voting” policy, which means that the votes for all of a broker’s clients are cast to reflect the votes of the minority who submitted a vote. But this only increases the importance of informed investor participation: if 20% of retail investors do the voting for the rest, it’s important that they know what they’re doing.

ProxyDemocracy.org, which I developed part-time over the past few years with help from a few other programmers, helps individual investors piggy-back on the research and judgment of respected institutional investors. We collect the intended votes of a handful of institutions (CalPERS, CBIS, Domini, and Calvert) that currently disclose their votes in advance of meetings. Users can sign up for free email alerts on our site to find out how those institutions plan to vote on stocks they own. Just as citizen voters take account of endorsements from respected groups like the Sierra Club or the NRA (depending on one’s political persuasion), individual investors can use these cues from known institutional investors to arrive at a principled vote more cheaply.

The site also provides tools for mutual fund owners. Around half of US households own mutual funds, and mutual funds own about a quarter of US equity. We have processed hundreds of SEC filings to help investors compare the voting records of leading mutual funds and determine whether their fund represents their interests at shareholder meetings. Not surprisingly, SRI funds tend to be much more activist than mainstream funds, but the differences among mainstream funds are significant as well: our fund profiles indicate that Schwab’s S&P 500 fund has a much more activist record than Vanguard’s, for example.

In the coming months, we plan to add more mutual fund profiles and collect intended votes from additional institutions. I encourage you to have a look at the site and pass along your thoughts and suggestions, either in the comments here or by email to andy [at] proxydemocracy.org.