The "Myth" of Glass Steagall

DealBook had a piece criticizing Elizabeth Warren and arguing against the "myth of Glass Steagall." 

Warren apparently sent an email to supporters calling for the reinstatement of Glass Steagall.  The article quoted Warren as arguing that the law “stopped investment banks from gambling away people’s life savings for decades — until Wall Street successfully lobbied to have it repealed in 1999.” 

The quote on its face is hard to criticize.  Prior to the repeal of Glass Steagall, investment banks could gamble in the stock markets all they wanted.  They would not lose deposits since they lacked the authority to accept deposits.  They were mostly gambling with shareholder equity and borrowed funds. 

Commercial banks, on the other hand, accepted deposits but, for the most part, had to stay out of the equity markets.  This effectively reduced the risk profile of commercial banks.  For a piece on the adverse consequences of repealing Glass Steagall, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act. 

But somehow the article in DealBook morphed into an allegation that some arguing that repeal of Glass Steagall caused the financial crisis of 2008.  This argument was labeled "pure historical revisionism."  The article went on to "demolish" the "myth" that Glass Steagall caused the financial crisis. 

The only myth, however, that needed demolishing was that there is any significant body of opinion arguing that the repeal of Glass Steagall singularly caused the financial crisis.  A crisis as serious and deep as the one that began in 2008 could only have multiple causes and explanations, with these causes and explanations remaining hotly contested. 

Indeed, the article itself quoted no one who said that the crisis could be traced exclusively to the repeal of Glass Steagall.  Indeed, Warren herself, when  asked about the topic, indicated that she did not believe the repeal caused the financial crisis.  Instead, she noted that: 

• the repeal of the law “had a powerful impact to let the big get bigger.” She also contended that its repeal, brought about by the Gramm-Leach-Bliley Act, “mattered enormously. It is like holding up a sign to regulators to back up.”

In other words, the repeal contributed to the financial crisis in part by allowing the commercial banks to grow in size and by encouraging regulators to take a less active stance in policing the markets.  Both are likely true.

Having set up and dispatched a proverbial straw man, the article switched tact.  It used the conclusion that Glass Steagall did not singularly cause the finanial crisis to then argue that reinstatement was not the "ultimate solution" and any argument to the contrary should be met with skepticism. 

But of course it is a non sequitur to conclude that the non-causality of Glass Steagall ineluctably leads to the conclusion that it ought not to be reinstated.   The argument for reinstatement of Glass Steagall is not premised on the view that it was the singular cause of the financial crisis.  It is premised on the view that a division of functions would reduce risk, reduce size of the entities (and potentially reduce them to a size that could be allowed to fail), and facilitate regulatory oversight.  I would add that it would allow for a class of investment banking firms that were independent of commercial banks and were more dedicated to promoting active capital markets (a topic described in the article cited above). 

On this issue, Warren had the better of the analysis.

The NYT, the SEC and Insider Trading (Part 3)

We are discussing the piece in the NYT about alleged "insider" trading at Lehman Brothers.   See Is Insider Trading Part of the Fabric?. 

The article contained allegations suggesting that pressure had been placed on analysts at Lehman to write more favorable opinions in order to garner additional investment banking business.  This raised possible concerns under NYSE Rule 472 and the global settlement with brokers designed to separate their investment banking and analyst functions.  Lehman was one of the firms subject to the global settlement.    

What ever concerns exist over the relationship between investment banking and analysts, the JOBS Act just put in place a provision designed to make the separation far more difficult to maintain.   According to Section 105 of the On Ramp provision, Section 2(a)(3) of the Securities Act was amended to provide that, in connection with a public offering for equity securities (and not just the IPO) for an "emerging growth company," the publication of an analyst report will: 

not to constitute an offer for sale or offer to sell a security, even if the broker or dealer is participating or will participate in the registered offering of the securities of the issuer.

This presumably means that the SEC cannot restrict the distribution of analyst reports (even those issued by the underwriter) during the offering process.  It probably sets aside the restriction in NYSE Rule 472 that prohibited analysts at firms involved in the underwriting from circulating reports until 40 days after the offering.  See Id.  ("A member organization may not publish or otherwise distribute research reports regarding an issuer and a research analyst may not recommend or offer an opinion on an issuer's securities in a public appearance, for which the member organization acted as manager or co-manager of an initial public offering within forty (40) calendar days following the offering date."). 

Moreover, Section 15D of the Exchange Act has been amended to provide that with respect to an emerging growth company engaging in an IPO, neither the SEC nor the exchanges can adopt rules that restrict: 

based on functional role, which associated persons of a broker, dealer, or member of a national securities association, may arrange for communications between a securities analyst and a potential investor;

The provision presumably overturns the prohibition in NYSE Rule 472 on analysts participating in road shows and may overturn the prohibition on communcations with prospective customers "in the presence of investment banking department personnel or company management about an investment banking services transaction." 

Likewise, the SEC and exchanges cannot adopt a rule that restricts:

a securities analyst from participating in any communications with the management of an emerging growth company that is also attended by any other associated person of a broker, dealer, or member of a national securities association whose functional role is other than as a securities analyst.

Analysts can, therefore, attend meetings in which management of an emerging growth company is "pitched" for investment banking business, overturning yet another requirement of NYSE Rule 472.  See NYSE Rule 472  ("A research analyst is prohibited from participating in efforts to solicit investment banking business. This prohibition includes, but is not limited to, participating in meetings to solicit investment banking business (e.g., "pitch" meetings) of prospective investment banking clients, or having other communications with companies for the purpose of soliciting investment banking business.").

All of this suggests that analysts can, with respect to emerging growth companies, have a much greater connection to the efforts to sell shares and to pitch management.  It will likely be difficult to ensure that this involvement is limited to emerging growth companies.  Moreover, it will likely be difficult to ensure, given this involvement, that analyst reports are uninfluenced by the needs of the investment banking arm of the firm. 

Thus, for example, it is hard to imagine an analyst for a managing underwriter issuing an unfavorable report during the offering.  This will be true even where the analyst is not subject to direct pressure from the investment banking side of the firm.  Investors, therefore, will always get a positive spin on the company, at least from the analysts connected to the underwriter. 

As the tumbling Facebook shares illustrate, investors benefit not from a rosy forecast but from the truth.  It is not at all clear that the provisions of the JOBS Act governing analyst reports have advanced that possibility. 

The Trial of Rajat Gupta (Opening Arguments)

There is some good coverage of the trial of Rajat Gupta who is accused of engaging in insider trading.  The Deal Book in particular looks like it will provide some detailed coverage.  An early example is here.   We will comment on the case from time to time from afar, relying on the strength of this commentary.  Had the case been in Denver, there is no doubt that the staff of the Race to the Bottom would have blogged the trial as we have for other important cases (the trial of Joe Nacchio and the trial of Ward Churchill). 

This is a case where the government wants it to be simple (and indeed, the prosecution described the matter as a "straightforward case of insider trading.").  Mr. Gupta gave information to others (out of friendship or in return for some benefit) and they traded on it.

Gupta's side will to some degree simply deny the charges.  Suggestive evidence (the taped phone calls that do not refer to Mr. Gupta by name) will be disputed.  But in addition, his side appears to be raising a more complicated defense:  As the Deal Book reported:

Mr. Naftalis also hinted at another defense strategy: portraying Goldman Sachs as a sieve of information. He noted that Galleon was a top customer of Goldman and hinted that Mr. Gupta was not the only Goldman insider with valuable information. Three executives from the company are under investigation by the federal authorities for possibly leaking illicit information.

This is a high risk defense.  A defense that others do it does not absolve Mr. Gupta.  To the extent the defense is that others provided the information, this is premised around the acknowledgment that, in fact, material inside information was conveyed but that someone other than Mr. Gupta conveyed it.  In other words, a crime was committed but not by Mr. Gupta.  Any hint that in fact the law was violated may make it easier for the jury to lean toward a conviction. 

Whatever happens with the defense, one thing seems clear.  Goldman will not come out of this looking particularly good.  The firm already appears to have a credibility problem with clients after some of the behavior, alleged by regulators, occurred during the financial crisis.  To the extent that the trial of Mr. Gupta suggests that there was widespread favoritism (including tips that provided trading advantages) to favored clients, this may not be well received by the less favored clients. 

The NYT, the SEC and Insider Trading (Part 2)

We are discussing the piece in the NYT about alleged "insider" trading at Lehman Brothers.  See Is Insider Trading Part of the Fabric?.  The implication of the piece was that the alleged facts sustained a case for insider trading but that the SEC somehow dropped the ball.  In fact, as we discussed in the last post, most of the alleged misbehavior (tipping analyst reports in advance of public disclosure to the Lehman trading test and to select clients) may not even be insider trading.  

The article spends a great deal of time on the purported insider trading.  Far less attention was given, however, to the separation of the investment banking and analyst functions at the firm.  As the article describes:   

Lehman bosses, he contends, told him to write research that would support investment banking business — a violation of the Spitzer settlement. He says he was warned not to make negative comments about companies, even when he thought they were merited, lest he antagonize corporate executives. In 2003, he says, he was chastised for downgrading a company that was a corporate finance client of Lehman’s.

The alleged facts suggest the lack of separation between the research arm of the firm and the investment banking arm.  This raises a number of concerns. 

First, NYSE Rule 472 specifies that brokers are to keep separate the analyst and investment banking function.  Under the Rule, analysts may not be "subject to the supervision, or control, of any employee of the member organization's investment banking department."  In addition, the analyst reports must not be "subject to review or approval prior to publication by Investment Banking personnel."  In other words, the analyst writing process must be independent of the investment banking function.  The quote above, if true, suggests that this may not have been the case.

Second, the SEC (along with the NY AG's Office) brought actions against ten brokers alleging that research analysts were subjected to "inappropriate influence by investment banking at the firm."  The firms entered into a global settlement.  One of those firms included Lehman.  According to the Release:  

Lehman has agreed to sever the links between research and investment banking, such that: research and investment banking are physically separated with completely separate reporting lines; analysts' compensation cannot be based directly or indirectly upon investment banking revenues; investment bankers may no longer evaluate analysts; investment bankers will have no role in determining what companies are covered by the analysts; and research analysts will be prohibited from participating in efforts to solicit investment banking business, including pitches and roadshows. In addition, Lehman must disclose on the first page of each research report whether the firm does or seeks to do investment banking business with that issuer, and when Lehman decides to terminate coverage of an issuer, Lehman must issue a final research report discussing the reasons for the termination.

For a list of the specific undertakings, go here.  In other words, the article in the NYT does not make out a clean case for insider trading but it does raise concerns over the obligations of large brokers to keep their investment banking and analyst functions separate. 

Having said that, it is likely not an easy violation to prove.  It would probably have to be shown that reports were altered as a result of pressure from the investment banking arm of the firm.  The allegations quoted above suggest the importance of business considerations in writing research reports but stop short of stating that the approach resulted from pressure by the investment banking arm. 

The NYT, the SEC and Insider Trading

The NYT published a piece over the weekend on insider trading (Is Insider Trading Part of the Fabric?).  The article examines allegations of insider trading based on analyst reports produced at Lehman Brothers.  The reports were produced by analysts at the firm then allegedly used by Lehman in connection with proprietary trading and tipped to select clients.  As the article stated:

What exactly happened at Lehman? Mr. Parmigiani says traders there were routinely advised of changes in analysts’ company ratings before those changes were made public. That way, Lehman could profit on subsequent market moves. Here is how he describes it: First, research officials tipped off the traders; then Lehman’s proprietary trading desk, which cast bets with the firm’s own money, positioned itself accordingly. Lehman salespeople also alerted favored hedge funds. Only later, he says, were ratings changes made public.

Information on these trades were given to the SEC and, while an investigation was conducted, the implication was that the SEC simply lost interest.  Id.  ("But then, as the financial crisis flared that summer, the S.E.C.’s interest waned. After Lehman failed, Mr. Parmigiani got a call from two of the lawyers, signaling that the S.E.C. was probably not going to pursue the matter."). 

Moreover, the article quoted a reaction by Senator Grassley, a frequent critic of the SEC.  According to Senator Grassley:

This case emphasizes serious questions about the S.E.C.’s culture of deference to Wall Street and big players going back a long time. The S.E.C. obtained what appears to be clear evidence of, at a minimum, disregard for regulations designed to ensure that Wall Street firms can’t leak inside information to preferred clients prior to public announcements. Yet there appears to have been no consequences.

The article, however, completely sidestepped the most significant problem confronted by the SEC in bringing insider trading cases.  The law of insider trading has been so mangled by the Supreme Court that most of the behavior mentioned in the NYT piece probably does not even constitute insider trading.  It may violate other provisions of the securities laws but not those governing insider trading.  How could that be the case? 

It all started with Dirks v. SEC, 463 US 646 (1983), a piece of judicial activism designed to limit the reach of the prohibitions on insider trading.  The opinion for the most part contained faulty analysis that confined insider trading to circumstances involving a breach of a fiduciary "duty" by an insider.  To fill the gaps created by Dirks, the SEC had to develop an alternative theory of insider trading, misappropriation.  The theory posited that insider trading occurred when persons traded in violation of a "duty" of trust and confidence, an approach eventually affirmed in US v. O'Hagan, 521 U.S. 642 (1997).  

For the most part, a duty of trust and confidence is imposed on employees by the employer.  If an employee uses confidential information when trading, he or she engages in insider trading.  But the theory has a flaw.  When the employer uses the same information, it is not insider trading.  An employer that sets the obligation of confidentiality can set it aside.  To the extent, therefore, that analysts at Lehman Brothers produced reports that were used by the Lehman trading desk for proprietary trades, it is probably not insider trading.  Lehman, rather than the trading employees, benefited from the trades. In other words, employees did not violate a duty of trust and confidence by engaging in behavior that benefited Lehman. 

What about tipping the information to favored clients?  In Dirks v. SEC, an insider "tipped" information to an analyst.  The Court held that this was not insider trading.  In other words, selective disclosure of inside information is not necessarily insider trading.  To the extent that Lehman employees gave the information to favored clients in order to personally benefit, they may have violated the prohibitions on insider trading.  To the extent, however, that they gave the information to favored clients to benefit Lehman, it may not be insider trading. 

It may be the case that this sort of behavior ought to be insider trading.  But the reality is a great deal more complicated.  And, contrary to the suggestions in the NYT article, the problem is not the SEC's unwillingness to bring a case.  The problem is the complexity and irrationality of the law on insider trading. 

If the NYT wants to point the finger of blame for failing to bring an insider trading case under the alleged facts mentioned in the article, the finger should be pointed not at the SEC but at the US Supreme Court. 

Rajat K. Gupta on Trial: Gupta Loses on Motions

In United States v. Gupta, No. 11 Cr. 907(JSR), 2012 WL 1066804 (S.D.N.Y. Mar. 27, 2012), the Southern District of New York dismissed four motions filed by defendant Rajat Gupta.

Gupta filed a motion to dismiss Count 2 of his criminal indictment on January 3, 2012. Gupta argued that the language of the indictment, including phrases such as “at least approximately 350,000 shares,” and “certain Galleon Funds,” violated his Fifth Amendment rights by allowing the government to prove charges based on evidence that may not have been presented to the Grand Jury.  The court denied this motion for two reasons.

First, the court stated Gupta’s claim that the Grand Jury was not presented with evidence was based on “sheer conjecture.” Grand Jury proceedings are confidential and have been historically protected as such. The court refused to inquire into the Grand Jury proceedings, stating it would require something “far more definite” before it would do so.

Second, the court explained that there is no requirement for specific and exact numbers of shares, or specific entities that traded shares, in Grand Jury proceedings on insider trading. An indictment that describes a crime “with enough detail to provide fair notice and protect against double jeopardy” is constitutional and meets the requirements of Rule 7 of the Federal Rules of Criminal Procedure (“Fed. R. Crim. P.”). The court reasoned that Count 2 of the indictment met this standard because it provided Gupta with specific information he allegedly passed to Rajaratnam, the dates shares were traded, information showing the trades occurred through Galleon, and the minimum number of shares allegedly traded. The court stated this gave Gupta the ability to adequately prepare for his defense and the ability to invoke the double jeopardy clause in any subsequent trial if need be.

Gupta also filed a motion to consolidate several counts of the indictment as multiplicitous on January 3, 2012. The court denied this motion as premature for failing to satisfy the two reasons to consolidate. Multiplicitous counts should be consolidated because “charging multiple counts for the same offense ‘may improperly prejudice a jury by suggesting that a defendant has committed not one but several crimes.’” The court advised Gupta that it never reads or sends the indictment to the jury, and that opening statements do not include a recital of the counts; therefore, there is no potential for prejudice until much later in the trial. At that point the court will be able to evaluate a multiplicity claim.

The second reason for consolidation is to avoid the potential for a defendant to be punished twice for the same crime in violation of the double jeopardy clause of the Constitution. The court reasoned this concern arises at the sentencing stage and should not be addressed during the pre-trial phrase. Accordingly, the court dismissed without prejudice the motion to consolidate the counts as premature, allowing Gupta to raise the claim again if and when it becomes ripe.

Additionally on January 3, 2012, Gupta filed a motion to strike prejudicial surplusage pursuant to Fed. R. Crim. P. 7(d). He sought to remove the phrases “for example” and “among other things” when used in allegations relating to how he profited from the alleged conspiracy from the indictment. The court stated that while this motion was filed to strike prejudicial surplusage, the motion argued that the language impermissibly broadened the indictment, allowing the Government to introduce evidence never presented to the Grand Jury. The court dismissed this argument, as it did in Gupta’s motion to dismiss; it is “unsupported speculation” and the phrases do not alter the allegations, but merely indicate the evidence to be presented will not be limited to items listed in the indictment.  For these reasons, the court dismissed the motion to strike.

Gupta also filed a Fed. R. Crim. P. 7(f) motion on January 3, 2012, seeking a court order requiring the Government to supply particulars detailing:

• “Gupta’s alleged management role and economic interest in an entity called ‘Galleon International’”;
• “the ‘ownership stake’ that Rajaratnam ‘awarded’ Gupta in Galleon Special Opportunities”;
• “‘financial benefits’ Gupta ‘received and hoped to receive’ as a result of his ownership interest in the Voyager fund”;
• "the number of specific shares involved in the alleged trades based on insider information, i.e. particularizing what is meant by ‘at least approximately 350,000 shares’ of Goldman Sachs in March 2007 (sic)";
• “the specific Galleon funds involved in each trade”; and
• "the quantity, cost, and strike price of the ‘call option contracts’ described in Count One.”

The court stated Gupta had already received this information through the indictment, the discovery already provided by the Government, discovery available through the SEC civil case, Rajaratnam’s previous criminal proceedings, and a bill of particulars already provided by the Government. Even if the information sought had not been available to Gupta from these other sources, the court stated that the “highly specific evidentiary detail” sought is not appropriate for a bill of particulars. Therefore, the court dismissed the motion.

The primary materials for this case may be found on the DU Corporate Governance website.

Does JP Morgan's $[2] Billion Loss Implicate Board Oversight? (Part 2)

Last week I blogged (here) that if we assume a corporate board’s duty of oversight includes monitoring risk exposure, then it should constitute a per se violation of that duty for a board to rule on a particular risky strategy without understanding the nature of the risk.  Stephen Bainbridge disagreed (here) for the following reasons:   First, such a rule would discourage appropriate risk-taking. 

As the federal Second Circuit explained in Joy v. North … "[B]ecause potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions.” 

Second, such a rule would run counter to the business judgment rule, which precludes courts from imposing liability for bad business decisions. 

As Chancellor Chandler correctly recognized in Citigroup, "asking the Court to conclude … that the directors failed to see the extent of Citigroup’s business risk and therefore made a ‘wrong’ business decision by allowing Citigroup to be exposed to the subprime mortgage market…. [constitutes the] kind of judicial second guessing [that] the business judgment rule was designed to prevent, and even if a complaint is framed under a Caremark theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law.” 

Finally, per se rules are inappropriate in this context because what courts really should be doing is “reconciling the competing claims of authority and accountability” by “balancing competing concerns” rather than blindly applying bright-line rules.

As a general matter, I don’t disagree with any of Bainbridge’s propositions.  However, I believe they are all subject to exceptions, and a failure to demonstrate a proper understanding of relevant risk exposure may constitute such an exception.  To begin with, we want to encourage appropriate risk-taking, not recklessness.  One cannot optimize risk exposure without understanding the complexities of the particular strategy.  As Frank Partnoy discussed in terms of the recent financial crisis (here):

[O]ne of the great ironies, I think, of the financial crisis was that the senior people at the Wall Street banks apparently didn't understand or capture the magnitude of their own financial institutions' exposure to these risks, which is really stunning, if you think about it, that the people who are in charge of these banks don't know what will happen when there's a 30 percent decline in housing prices. If you think about it, if you're the director or the CEO of a bank, isn't that the one thing you should understand? What will happen to my institution if the following financial variable changes by 30 percent? That kind of worst-case scenario analysis is why you're being paid millions of dollars. That's precisely what these people should have been doing.

Secondly, if we understand the business judgment rule to be about distinguishing “honest errors” from “intentional misconduct,” then I think signing off on a particular strategy without an appropriate understanding of the risk is closer to intentional misconduct than honest error.   Post-2008 it is very difficult to take seriously any director’s claim that they didn’t realize they needed to get up to speed on risk-exposure.  Obviously, I would include reasonable reliance on an appropriate expert as satisfying this requirement, but you need more than the 2012 equivalent of Van Gorkom assuring you that house prices will go up forever.

Finally, while I agree courts frequently need the flexibility of standards that allow for the balancing of competing interests, a bright-line rule that requires directors to understand the risk-creating strategy they are reviewing as a part of their Caremark duties seems to me to appropriately give business leaders something else they crave: clear guidance.  In other words, where red flags present themselves in connection with a particularly risky investment strategy, a board would be on notice that ignoring those red flags without being able to verbalize the scope of the risk would constitute an utter failure of oversight.

PS--Over at the Glom (here), David Zaring has posted some great links on the JP Morgan loss.

Rajat K. Gupta on Trial: The SEC’s Civil Complaint

On October 26, 2011, the day Rajat K. Gupta (“Gupta”) was arrested on five counts of securities fraud and one count of conspiracy to commit securities fraud, the Securities and Exchange Commission (“SEC” or “the Commission”) filed a civil complaint in the United States District Court for Southern New York, pursuant to its authority under Section 20(b) of the 1933 Securities Act and Section 21(d) of the 1934 Act. 15 U.S.C. § 77t(b), and 15 U.S.C. § 78u(d) respectively, alleging Gupta violated Section 10(b) of the Act, Rule 10b-5, and Section 17(a) of the Act.

The SEC brought suit against both Gupta and his alleged co-conspirator, Raj Rajaratnam (“Rajaratnam”). Rajaratnam was recently tried and convicted for insider trading; he was sentenced to 11 years in prison, and he received a $10 million fine, and a $53.8 million forfeiture. The complaint seeks permanent injunctions against Gupta and Rajaratnam, “enjoining each from engaging in the transactions, acts, practices, and courses of business…” The SEC seeks disgorgement of all profits and/or losses avoided. Gupta would also be barred from serving as an officer or director of any issuer that has a class of securities registered with the SEC or that is required to file reports and enjoined from associating with any broker, dealer, or investment advisor.

The complaint alleged an “extensive insider trading scheme conducted by Gupta and Rajaratnam.” The SEC alleged that Gupta disclosed material nonpublic information that he had access to as a result of his positions on the board of directors for Goldman Sachs Group, Inc. (“Goldman Sachs”) and The Procter & Gamble Company (“P&G”). Gupta allegedly called Rajaratnam on several occasions after board meetings, and Rajaratnam, as managing partner of large hedge fund investment company Galleon Management LLP (“Galleon”), would cause the fund to buy or sell shares to gain profit or avoid losses.

The complaint focuses on four alleged insider trading incidents. The first was trades that occurred before the $5 billion investment in Goldman Sachs by Berkshire Hathaway, which was publicly announced after market close on September 23, 2008. The SEC alleged that Gupta learned of the potential for the Berkshire investment during a board meeting on September 21, 2008. The next morning Gupta placed a four minute phone call to Rajaratnam’s office. Rajaratnam caused Galleon to purchase over 100,000 Goldman Sachs shares. The next day, September 23, Rajaratnam placed a call to Gupta’s office and then again directed Galleon to purchase 50,000 Goldman Sachs shares. A special telephonic meeting of the Goldman Sachs board was called at 3:15 p.m. on September 23, 2008. During the meeting the board approved the Berkshire investment and a public equity offering. Immediately after disconnecting from the board meeting, Gupta called Rajaratnam’s office. Just minutes before market close, Galleon purchased 217,200 Goldman Sachs shares. Goldman Sachs stock increased 6.36% the day following the announcement of the Berkshire investment. On September 24, 2008, Rajaratnam liquidated Goldman Sachs shares, generating $800,000.

The second alleged insider trading surrounded Goldman Sachs’ 2008 fourth quarter financial results. In October 23, 2008, during a telephonic board meeting, Gupta learned that Goldman Sachs was operating an estimated loss of $1.96 per share. Twenty-three seconds after disconnecting from the board meeting, Gupta placed a thirteen minute phone call to Rajaratnam. At the opening of the market the next day, Galleon sold all of this Goldman Sachs stock. Rajaratnam allegedly stated that he “heard the prior day from a member of the Goldman Sachs Board that the company was actually going to lose $2 per share.” Galleon avoided a loss of more than $3.6 million dollars by selling the Goldman Sachs shares before the public announcement of the quarter’s loss in December 2008.

The third insider trading alleged surrounded Goldman Sachs’ 2008 second quarter financials. One week before the announcement of Goldman Sachs’ financials, Gupta spoke with the company’s chief executive about the company’s strong financial position. Later that same night Gupta called Rajaratnam at his home. Minutes after the market opened the next day, Galleon purchased over 7,350 shares of Goldman Sachs stock. Over the next few days Rajaratnam purchased an additional 350,000 shares. Rajaratnam caused Galleon to sell call options, profiting by approximately $9.3 million. The following day after the announcement, Rajaratnam caused Galleon to sell Goldman Sachs shares, profiting by over $9 million.

The fourth alleged incident was based on P&G’s 2008 second quarter financials. On January 29, 2009, Gupta met telephonically with P&G’s Audit Committee and they discussed expectations for the company to grow 2-5% in the fiscal year. That afternoon, Gupta called Rajaratnam. Rajaratnam allegedly stated that “he had learned from a contact on Procter & Gamble’s Board that the company’s organic sales growth would be lower than expected.” Galleon then sold short 180,000 P&G shares. After the public announcement stock declined 6.39%, resulting in $570,000 of avoided loss.

As a director, Gupta owed fiduciary duties to Goldman Sachs and P&G. Disclosing material nonpublic information about the companies would constitute a breach of the fiduciary duty of confidentiality. Additionally, Goldman Sachs’s guidelines provided that board meetings were confidential, and directors who had knowledge of material nonpublic information were prohibited from buying or selling the company’s stock or recommending others do so. P&G’s policy prohibited directors in possession of material nonpublic information, from conveying the information to others.

The primary materials for this case may be found on the DU Corporate Governance website.

Rajat K. Gupta on Trial: The Criminal Indictment

On October 26, 2011, the FBI arrested Rajat K. Gupta, former chief executive of McKinsey & Company and director of Goldman Sachs and Procter & Gamble (“P&G”), after he was indicted by a grand jury on six counts (five counts of securities fraud and one count of conspiracy to commit securities fraud). On the same day, the Securities and Exchange Commission (“SEC”) filed a civil complaint in federal court against both Gupta and Raj Rajaratnam, the founder of Galleon Management (“Galleon”) and Gupta’s alleged co-conspirator. The civil case and the criminal charges leveled against Gupta come on the heels of the criminal trial and conviction of Rajaratnam.

The criminal indictment alleged the insider trading scheme arose from various business relationships and a personal friendship between Gupta and Rajaratnam. It was alleged that in 2008, Gupta, Rajaratnam, “and others known and unknown, participated in a scheme to defraud by disclosing material, nonpublic information relating to Goldman Sachs and P&G…and/or executing securities transactions on the basis of the [i]nside [i]nformation.”

The first count was conspiracy to commit securities fraud. The indictment states that Gupta, Rajaratnam, and others “willfully and knowingly did combine, conspire, confederate and agree together and with each other to commit offenses against the United States…” The alleged conspiracy was carried out by Gupta disclosing Goldman Sachs and P&G inside information to Rajaratnam, “with the understanding that Rajaratnam would use the [i]nside [i]nformation to purchase and sell securities, and thereby receive illegal profits and/or illegally avoid losses.” Rajaratnam would then allegedly buy or sell securities based on the information or cause others to do so.

The indictment lists twenty-six overt acts to corroborate the conspiracy. These acts include the following:

• Rajaratnam told a Galleon portfolio manager “he had learned from someone on the P&G Board that P&G was selling its Folgers business…”;
• On June 10, 2008, Gupta and Rajaratnam traded telephone calls after Gupta spoke with a Goldman Sachs senior executive;
• On June 11, 2008, Rajaratnam caused Galleon to purchase 5,500 Goldman Sachs shares;
• On June 12, 2008, Rajaratnam caused Galleon to purchase an approximate total of 125,000 Goldman Sachs shares;
• On September 23, 2008, Gupta telephoned Rajaratnam after meeting with Goldman Sachs’ Board regarding a Berkshire Hathaway investment;
• After speaking with Gupta, Rajaratnam caused Galleon to purchase 217,2000 Goldman Sachs shares;
• On October 23, 2008, after participating in a Goldman Sachs Board meeting, Gupta telephoned Rajaratnam;
• On October 24, 2008, Rajaratnam caused Galleon to sell 150,000 Goldman Sachs shares;
• On January 29, 2009, after a telephone call from Gupta, Rajaratnam told a Galleon portfolio manager “he had received certain information concerning P&G’s organic sales growth from a contact on the P&G Board”; and
• On January 29, 2009, Galleon sold short 180,000 P&G shares.

A full list of the overt acts and the indictment can be found here.

The following five counts alleged securities fraud in violation of Rule 10b-5 by:

(a) employing devices, schemes, and artifices to defraud; (b) making untrue statements of material facts and omitting to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; and (c) engaging in acts, practices, and courses of business which operated and would operate as a fraud and deceit upon any person, to wit, on the basis of [i]nside [i]nformation that [Gupta] disclosed... 

Counts 2 through 6 concern the following trades, respectively:  September 23, 2008 at 3:58 p.m., purchase of approximately 150,000 Goldman Sachs shares; September 23, 2008 at 3:58 p.m., purchase of 67,200 Goldman Sachs shares; October 24, 2008 at 9:31 a.m., sale of 50,000 Goldman Sachs shares; October 24, 2008 at 10:09 a.m., sale of 50,000 Goldman Sachs shares; and October 24, 2008 at 10:37 a.m., sale of 50,000 Goldman Sachs shares.

The United States seeks forfeiture of all money, or property acquired with money, that is traceable to the profits made from the alleged insider trading.

The primary materials for this case may be found on the DU Corporate Governance website.

The SEC Fights Back

The SEC makes mistakes.  The Madoff fiasco is one of them; the lease on the building in DC that was never used is another.

But on the whole, the SEC is a highly professional, hard working place that has been a unfairly and relentless attacked for any number of things.  And, in the aftermath of Madoff, the Agency has often simply accepted its role as a pin cushion.

So it is nice to see the Commission becoming a bit more assertive and fight back against these sort of challenges.  The appeal of Judge Rakoff's decision to reject the Citigroup settlement, and more broadly reject the use of the neither "admit nor deny" approach was a case in point.  It is risky appealing bad rulings by the district court.  Bad district court cases can become bad appellate court cases.  But this time, the SEC decided that it could not let the matter rest.  Even judges need to know that the SEC will fight back.

With that in mind, we note a small but important series of examples of the growing verve at the SEC.  Top officials have been responding to editorials and stories that contained criticism of the Commission.  An editorial on DealBook, Taking On the Little Guy, but Missing the Bigger Ones, criticized the SEC's enforcement record.  The editorial conceded that the SEC had done "a much better job of investigating financial crisis wrongdoing than the Justice Department. And it’s true.  But it’s like being proud that you’re the 'Dumb' of 'Dumb and Dumber.'”  Robert Khuzami, the Director of the Division of Enforcement, wrote a letter taking on the editorial and noting that the "assertion that the S.E.C. somehow 'missed the big guys' misses the mark."

Then there was the response by George Canellos, then the head of the NY regional office, now the deputy director of the Division of Enforcement, to the claim that the SEC exposed a whistleblower.  For a short time there was a raft of articles accusing the SEC of mishandling the situation.  After the Canellos letter was published, the issue quickly died down. 

These are small steps but they are necessary and overdue.    

Glass Steagall, The Capital Markets and the Volker Rule

Glass Steagall was adopted during the Great Depression.  The effect of the legislation was to keep commercial banking (deposits and loans) separate from investment banking (underwriting and M&A activity).  One consequence was that commercial banks were mostly kept out of the equity markets, reducing the amount of risk they could undertake.  This was not to say that commercial banking was risk free.  There were plenty of examples of banks failing because they found themselves over committed to a particular market segment, say energy, and collapsed with the market.

But Glass Steagall had another affect. As set out in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act, Glass Steagall allowed for the rise of a world class, powerful set of investment banks.  In effect, the law prevented commercial banks from absorbing and taking over the investment banking industry. 

The takeover was inevitable because over time commercial banks have inherent advantages, including access to low cost funds (deposits) and access to the Federal Reserve window.  Moreover, as the article pointed out, just before Glass Steagall was adopted, the commercial banks were in the process of taking over the industry.  Indeed, Glass Steagall required some banks to separate their commercial and investment banking parts (JP Morgan & Morgan Stanley as one example). 

The consequence of separating the two areas meant that investment banks focused not on lending relationships but on relationships that centered around the capital markets.  They had an incentive to understand the capital markets and they had an incentive to encourage companies to rely on the capital markets.  In short, they were a class of intermediaries that promoted active capital markets.

With the end of Glass Steagall, commercial banks have, for the most part, taken over the investment banking business, just as they were seeking to do in the 1930s, before Congress acted.  Before the most recent financial crisis there were five world class investment banks:  Goldman, Morgan Stanley, Merrill, Bear Sterns, and Lehman.  Bear is part of JP Morgan; Merrill is part of BofA.  Lehman, of course, is gone.  Only Morgan Stanley and Goldman remain (afer both converted to commercial banks). 

Does it make a difference?  First, as one can see from the latest problems at JP Morgan, commercial banks engaging in market activities take on enormous risk.  But there is a deeper problem.  First, commercial banks can offer companies both lending and underwriting services.  In other words, they are not completely dedicated to the capital markets.  Second, at least historically, commercial banks, because of more extensive regulatory oversight, were more conservative.  They could be counted on not to push the capital markets envelope as hard as a traditional investment bank.  Both are bad for the capital markets.

The Dodd-Frank Act added the Volker Rule, a provision that prohibits banks from engaging in proprietary trading and from sponsoring a hedge fund.  This is not Glass Steagall.  Banks can still engage in market activities with their client's money.  Moreover, it does not guarantee a source of business for investment banks that do not want to engage in commercial banking activity.  Those subject to the Volker Rule can farm out their proprietary trading activity to another commercial bank. 

But this Blog will over time discuss the impact of the Volker Rule on the investment banking industry and the US capital markets.  

In re BP p.l.c. Securities Litigation: Some 10(b) Claims Spawned by Deepwater Horizon Disaster Survive Motion to Dismiss

In In re BP p.l.c. Securities Litigation, No. 4:10-md-2185 (S.D. Tex. Feb. 13, 2012), defendant BP p.l.c. (“BP”) moved to dismiss, under Rule 12(b)(6), securities claims brought by purchasers of BP ordinary shares and American Depository Shares (“ADS”).  The district court, following Morrison v. National Australia Bank, granted dismissal of all the claims of the holders of the ordinary shares; it also dismissed some claims of the purchasers of the ADS, while allowing others to go forward.

The suit arose in the aftermath of the well-known 2010 explosion of the Deepwater Horizon rig and the ensuing “blowout” of BP’s Macondo well, which caused a disastrous oil spill in the Gulf of Mexico. Plaintiffs, acquirers of BP ordinary shares and ADS between January 16, 2007 and May 28, 2010, asserted that BP violated Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 of the Securities and Exchange Commission by issuing false or misleading statements before and after the incident.

According to the court, to adequately plead a 10(b) claim for misrepresentation under the heightened pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”), a plaintiff must “(1) specify each statement alleged to have been misleading; (2) identify the speaker; (3) state when and where the statement was made; (4) plead with particularity the contents of the false representation; (5) plead with particularity what the person making the misrepresentation obtained thereby; and (6) explain the reasons why the statement is misleading, i.e., why the statement is fraudulent.”

The court held that Plaintiffs pled with sufficient particularity that BP made false or misleading statements regarding the following: BP’s implementation of specific recommendations from an independent safety panel (the “Safety Panel”), BP’s Initial Exploration Plan (“IEP”), BP’s Oil Spill Response Plan (“OSRP”), BP’s ability to respond to a Gulf oil spill (including definite amounts of recoverable barrels per day), post-blowout estimates of spill size, and the Deepwater Horizon rig’s safety record. In contrast, the court held that Plaintiffs did not plead with sufficient particularity that general statements about BP’s “commitment to safety” and “safety culture” were false or misleading.

The pleadings sufficiently alleged a “strong inference” of scienter for only two of the individual defendants: Tony Hayward, the CEO, and Douglas Suttles, the COO for Exploration and Production. According to the complaint, Hayward admitted he was responsible for BP’s “process safety” and spoke publicly about measurable safety improvements that addressed the Safety Panel’s findings. Thus, the inference that Hayward was highly involved in, and thus aware of, operational safety was stronger than the opposing inference that he was only pretending to be involved but was unaware of operational safety problems. Similarly, the inference that Suttles — who was in charge of BP’s spill response team — knowingly provided public spill estimates lower than BP’s internal estimates was stronger than the opposing inference that he was unaware of the internal estimates.

With respect to corporate scienter, the claims involving the IEP and OSRP met the Tellabs II bar: misleading announcements “so dramatic” as to have been approved by officials who knew they were false. Indeed, the court noted that the numbers in the plans “appeared to have been invented out of thin air” and were so egregiously erroneous that a finding of corporate scienter was appropriate.

Ultimately, although many of the ADS holders’ claims failed to meet the heightened pleading standard of the PSLRA, a number of claims established and pled with particularity the requisite elements of securities fraud, and thus survived the motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.

The Board and "Reliable" Directors

Boards are sometimes described as institutions designed to provide the CEO with advice.  To the extent they filled with knowledgeable people from different backgrounds, boards stand ready to counsel and assist CEOs in what can often be very challenging environments.

There may be some boards that play this role.  But boards that give advice can also fire the CEO.  CEOs wanting to retain their post have a rational incentive to "neutralize" the board.  This entails a preference not for directors who provide the best advice, but for those who will be the least likely to intervene in corporate affairs.  In short, directors are often picked not for their diverse perspective but for their "reliability."  This is discussed at some length in Essay: Neutralizing the Board of Directors and the Impact on Diversity. 

Picking reliable directors, however, is not without limits.  Most boards of public companies consist of independent directors.  Thus, to the extent the CEO prefers reliable directors, these individuals must be both reliable and independent.

What are some categories that meet both tests?  Friends of the CEO.  As we have noted, the definitions of director independence used by the stock exchanges do not require boards to screen for friendship.  To the extent boards contain directors who are friends of the CEO, they will presumably be less likely to intervene in the affairs of the company (something that can include firing the CEO).

Another category, however, are executive officers of other companies, particularly other CEOs.  A CEO of another company is likely to be less interested in intervention.  For one thing, he (and rarely she) does not want his/her own board to intervene.  The CEO as director probably takes that same philosophy to other boards where he/she sits as a director.  

These directors may be common but pressure is growing to make them a little less common.  According to an article in the WSJ, 118 "top officers of Fortune 1000 companies sit on at least three boards," including their own.  The actual analysis is here.  Some institutional investors think that this is too much and are pressuring some of them to reduce their commitments.  As the article noted:

Some investors are actively objecting to executives' multiple directorships. Calpers and the UAW Retiree Medical Benefits Trust, which manages about $53 billion in assets for retired auto workers, say they likely will oppose board re-elections at 2012 annual shareholder meetings of several dozen CEOs with more than one outside board seat.

Top executives may take these positions "to broaden their business perspective."  But they are also well paid.  "Among companies in the Standard & Poor's 500-stock index, average annual compensation for directors exceeded $232,000 in 2010, up 8% from $215,000 the year before, according to a 2011 study by recruiting firm Spencer Stuart."

The pressure is to prevent executive officers from taking too much time away from the primary company that they manage.  At the same time, however, the approach also makes it a little bit harder to ensure the reliability of the board. 

Does JP Morgan's $2 Billion Loss Implicate Board Oversight?

JP Morgan recently reported a surprising $2 billion loss that it attributed to "egregious" mistakes in its derivatives-based hedging strategy.  A news report (here) notes that CEO Jamie Dimon acknowledged that part of the problem was poor monitoring.  This made me think about Delaware's Caremark duty of oversight, which requires boards to implement information gathering and reporting systems designed to alert them to problems in the business.  As Stephen Bainbridge has noted (here), while the duty has typically been understood to cover violations of the law, there is a good argument to be made for including oversight of risk management.

The financial crisis of 2008 revealed serious and widespread risk management failures throughout the business community. Shareholder losses attributable to absent or poorly implemented risk management programs are enormous. Efforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremark claims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation. Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes. Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremark is the most difficult theory of liability in corporate law, risk management is the most difficult variant of Caremark claims.

While I agree that it should be difficult to hold a board liable for failing to properly oversee a corporation's financial risk management, at some point the critical "utter failure" threshold is crossed and imposing liability is appropriate.  The critical questions are: (1) How do we define the risk exposure, such that an information gathering and reporting system's failure to bring it to the attention of the board constitutes an utter failure? (2) How well do the directors have to understand the risk, such that they have not utterly failed to exercise judgment in responding to the relevant reports?  Applying this analysis to JP Morgan's recent loss, I actually think an argument could be made that in light of JP Morgan's overall size a failure to bring the strategy to the board's attention might not constitute an utter failure of the reporting system.  Of course, that's assuming $2 billion is at the upper end of the range of potential losses implicated by the hedging strategy.  And that's assuming further that the masters of the universe implementing the strategy can actually accurately calculate their exposure.  All of which raises a final interesting question (at least for purposes of this post):  Should an inability to fully understand the risk exposure of a particular strategy or financial instrument constitute a per se violation of Caremark?  My current inclination is to answer that question in the affirmative.

Delaware Courts and the "Protection" of Investors

Martin Marietta Materials v. Vulcan Materials Co., 2012 Del. Ch. LEXIS 93 (Del. Ch. May 4, 2012) is a 138 page tome ultimately holding that Martin Marietta violated a confidentiality agreement with Vulcan.  As a result, the Chancery Court enjoined Martin Marietta's hostile offer for Vulcan.  The interesting thing in the case concerns the court's treatment of the argument that an injunction would harm shareholders. 

When the court finds a violation of the law, they must consider an appropriate remedy.  In some cases, the parties argue that a particular remedy would be harmful to shareholders.  That issue came up in El Paso Energy.  There the Chancery Court first found that shareholders had sufficiently alleged a violation of the duty of loyalty.  When addressing the injunction sought by shareholders, however, the court  demurred.  Doing so would harm shareholders.  As the court reasoned, an injunction would potentially cause "more harm than good" to shareholders by allowing the purchaser to walk away from the offer.

The court made no mention of the broader benefits to the market that could have flowed from an injunction.  While shareholders of El Paso could have been injured by the remedy (any delay could have caused the bidder to withdraw the offer and move on), the market arguably would have benefited in the aggregate from strong measures against alleged breaches of fiduciary obligations.  The broader benefit, however, was not addressed. 

In Martin Marietta, the same issue came up. Martin Marietta argued that even had it violated the confidentiality agreement, any injunction prohibiting its hostile acquisition attempt would be harmful to shareholders.   As the court described:

In some of its arguments, Martin Marietta has tried to assert that this case has large implications for the ability of American investors to receive premium-generating offers for their shares. Martin Marietta implies that, if it is enjoined from pursuing its Exchange Offer and Proxy Contest because it violated the Confidentiality Agreements, a chill on M&A activity will result, harming stockholders and lowering share values. In its starkest form, Martin Marietta's argument is that a loss for Martin Marietta in this litigation will turn every confidentiality agreement into a standstill, even though standstills are a common contractual provision.

That contention, however, received short shrift.

But to the extent that Martin Marietta suggests that courts should not enforce confidentiality agreements as they do other contracts on the ground that to do so is necessary to protect stockholders, I see no warrant in our law for such adventurism and no empirical basis to move our common law of contracts in that direction.

In other words, harm or not to shareholders, the court intended to enforce the contract.  The court went on, however, to explain how shareholders in the aggregate benefited from the enforcement of the confidentiality agreement.  

The American M&A markets are extremely vibrant and generate a high volume of premium-generating transactions, even in comparison to the U.K. system beloved by certain of my favorite academics in corporate law. One of the reasons for this vibrancy is the freedom given to corporations to use contracts to limit the very real business risks attendant to exploring M&A transactions. By respecting contract rights, our courts give parties in commerce the confidence that they can rely upon the contracts they execute to reduce risks and transaction costs. . . . If the message is sent that the confidentiality and other agreements that control the downside risks of such engagement will not be respected, then one can rationally expect such competitors not to be as prone to considering such transactions. 

In other words, whatever the impact in this particular situation, investors and the market would benefit from knowing that contracts will be vigorously enforced. 

Perhaps.  Only the same thing can be said about enforcing fiduciary obligations.  Yet in the Delaware courts, that does not seem to be the case.

Disclosure of the Personal Use of Aircraft by Officers and Directors: The SEC and Fiduciary Obligations

In reporting personal use of the aircraft, top officers and directors must disclose the value of the services as part of their executive compensation.  In computing the value, however, they are required to rely on the "variable" costs to the company.  These numbers can be eye popping in amount. 

If the same amount were actually treated as income for IRS purposes, the tax liability would probably result in reduced use of the corporate aircraft.  But in fact the IRS does not require this number to be taken into taxable income.  Taxable income is typically a much smaller amount.  For a post discussing the approach to valuation by the SEC and IRS, go here.  The high level of comfort and the low level of tax consequences makes this a hard benefit to give up even if it often generates public criticism. 

Now it turns out that even the eye popping numbers under the variable cost approach may be an under statement.  The WSJ reported that Chesapeake Energy has been sued for allegedly understating the costs of personal travel on the corporate aircraft for "top executives and outside directors by as much as $10 million per year."  Apparently the suit alleges that the personal use of the aircraft was so great that computation of the value should have included fixed as well as variable costs. 

There may need to be an SEC fix to this issue.  The SEC may have to amend Item 402 (an already excessively long provision) to provide that fixed costs must be included once personal use climbs above a specified percentage.  But in truth this is asking the SEC to fix a problem that really ought to be handled under state law.  Fiduciary duties ought to prohibit this from occurring with any real frequency.  But they do not.  This is because state law requires deference to decisions by "independent" directors. 

Yet at Chesapeake Energy, those same "independent" directors are authorized to use the corporate aircraft for 40 hours of personal use.  See Preliminary Proxy Statement, at 10 ("each non-employee director is entitled to personal use of fractionally owned Company aircraft for up to 40 hours of flight time per calendar year.").  It is this same group that state law says is supposed to oversee personal use by the CEO and other executive officers. 

How are they doing?  Let the preliminary proxy statement speak for itself.  Id.  ("Feedback from the named executive officers indicates that limited access to fractionally owned Company aircraft for personal use greatly enhances productivity and work-life balance, which we believe provides performance and retention incentives far in excess of the cost of the perquisite to the Company."). 

Personal Use of the Aircraft by Corporate Officials: An Update and a Call for Access

Some companies allow officers and directors to use the corporate aircraft for personal travel.  For a post in Dealbook on this, go here.  Companies report the amount of personal use as part of the "total" compensation paid to executives in the proxy statement.

As a matter of corporate law, directors must act in the best interests of shareholders.  How does allowing for personal use of the aircraft (and the accompanying expense to the company) support the interests of shareholders?  As the DealBook article points out (and we have mentioned on this Blog), boards justify the position by asserting that its necessary to protect the security of the CEO.  Presumably this means the desire to protect the CEO from terrorist attacks or other types of physical assaults.

This is not without some justification.  A vacation spent in some dangerous location may require companies to take unusual steps to protect the CEO.  Of course, boards could, in those circumstances, prohibit the trip, much the way athletes are prohibited from engaging in dangerous activities, rather than have the company absorb the travel expenses.

But, in fact, corporate use of the aircraft ensure security of the CEO on trips to Hawaii or anywhere else in the United States.   As Steve Davidoff pointed out on the DealBook, the board at Ford requires the CEO to "fly on a private jet whether he is going to Washington for business or Hawaii for vacation."  He notes that in contrast, "Justice Ginsburg flies commercial with all its attendant hassles."  As he asks and answers:  "Are corporate chieftains really in that much danger?  The answer has to be no in most cases."

So what's going on? Delaware allows boards, for the most part, to do anything they want in the executive compensation area as long as they employ proper process.  So legally, directors can easily allow the practice. 

Just because they can, however, does not mean they must and, in fact, most public companies do not provide the benefit.  Why then do some boards (and their independent directors) approve the practice in circumstances where security of the CEO does not seem to be a real issue? 

It may be that the board is full of the friends of the CEO (this is discussed in  Essay: Neutralizing the Board of Directors and the Impact on Diversity) or it may be that the board has been captured by the CEO.  Jon Macey discusses capture in his book on Corporate Governance.  But even more directly, directors who antagonize the CEO risk the possibility of not being renominated and, as a result, losing a well paid sinecure on the board.  Total compensation for independent directors can exceed $1 million.  In other words, even where some directors have qualms about the practice, they are loathe to stick their neck out and object to a practice by the CEO.

Is there a solution?  If the board had a couple of directors nominated by shareholders (and therefore not screened by management), these directors could be the ones to "stick their neck out" since they would not be worried about the threat of no renomination by the CEO.  If some directors did this, others would likely go along.  In short, the process for approving CEO use of the corporate aircraft for personal reasons would suddenly become more rigorous.  

How do we get shareholder nominees on the board?  Shareholder access.  Dodd-Frank allowed for it, the DC Circuit did not, but eventually there will be the appropriate rules in place.  Until then, the approval process for personal use of the corporate aircraft will be less rigorous and, as a result, provide less confidence that the decision was appropriate.  

SEC v. SIPC: The SEC Exerts its Authority over SIPC in a Case of First Impression

In SEC v. SIPC, 2012 WL 403602 (D.D.C. Cir. Feb. 9, 2012), the court granted the Securities and Exchange Commission’s (“SEC”) Ex Parte Motion to Show Cause and denied the Securities Investor Protection Corporation’s (“SIPC”) Motion to Strike the SEC’s motion.  The SEC requested that the court order the SIPC to file an application in Texas federal court to start liquidation proceedings for the Stanford Group Company (“SGC”). 

Congress passed the Securities Investor Protection Act (“SIPA”) with the goal of protecting “customers of failed broker dealers who f[ind] their cash and securities on deposit either dissipated or tied up in lengthy bankruptcy proceedings.”  Congress then created SIPC, a non-profit private corporation, to carry out SIPA’s goal.  Members are broker-dealers registered with the SEC, and they are required to join SIPC.  When a member firm has financial problems, SIPC has the authority to initiate a liquidation proceeding and facilitate in returning customers’ funds.

Robert Stanford (“Stanford”) owned SGC, a broker-dealer registered with the SEC and SIPC member, and the Stanford International Bank, Ltd., (“SIBL”) located in Antigua.  In 2009, Stanford’s companies failed after selling more than $7 billion worth of CDs issued by SIBL and sold by SGC.  According to the SEC, Stanford was operating a fraudulent Ponzi scheme.  Stanford is also facing criminal charges brought by federal prosecutors in Texas. 

SIPC declined to file an application for a protective decree which, if approved by the court, would appoint a trustee to liquidate SGC’s assets in bankruptcy court and allow SGC’s customers to file claims against SGC’s estate in an attempt to recoup their losses.  SIPC contended that SGC’s customers were not covered because “SGC did not perform a custody function for the customers who purchased the SIBL CDs.”  The SEC advised SIPC that “SGC’s customers were in need of the protections of the SIPA and that SIPC should seek to commence a liquidation proceeding.”  SIPC maintained its original position that SGC’s customers were not entitled to protection under SIPA and refused to file an application to commence liquidation proceedings. 

Under SIPA, “[i]n the event of the refusal of SIPC to commit its funds or otherwise to act for the protection of customers of any member of SIPC, the Commission may apply to the district court…for an order requiring SIPC to discharge it obligations…and for such other relief as the court may deem appropriate.”  The court noted this is the first time since SIPA was created 42 years ago that the SEC has sought to exert this authority over SIPC.

The SEC argued that, under SIPA, the term “apply to the district court” meant the SEC need only file an application with the court and a formal complaint and summons were not required.  The SEC also argued that summary proceedings were permitted and the discovery process was not necessary.  SIPC took the position that, under SIPA, plenary proceedings were required, the SEC should file a formal complaint, and the court should allow discovery.  

The court looked to the plain meaning of the statute and held that a formal complaint and summons were not appropriate and summary proceedings were allowed.  The court granted the SEC’s Motion to Show Cause and allowed the parties to determine how to proceed in the case. 

The primary materials for this case may be found on the DU Corporate Governance website. 

Diversity and Judicial Law Clerks

We criticize on this Blog the lack of diversity inside the corporate board room.  The latest statistics show that women represent about 12% of directors of public companies; people of color around 6%.  There is another place that could use some substantial improvement in diversity:  law clerks for federal judges. 

Upon graduation, there is nothing more prestigious than clerking for a judge, particularly a federal judge.  Recent graduates work for a year or two as a legal assistant to the judge, doing research and writing draft opinions.  After having spent three years reading opinions in law school, the opportunity to actually craft language that can affect future parties and interpretations is a particularly daunting but exciting experience. 

Judicial clerkships, because of both the skills learned (my legal writing skills improved immeasurably after a year of writing draft opinions and memos) and the competitiveness of the position, are stepping stones for other positions, whether in academia, the government, or prominent firms in the major cities.

Yet as the National Law Journal reports, these coveted positions are mostly foreclosed to people of color.  While there is some balance among the genders, African Americans and Hispanics at the appellate court level garnered around 2% each of these positions.  And guess what?  That percentage is down from 2006 when it was around 3%.  At the district court level, these grounds obtained about 3% of the position, a percentage that mostly held steady since 2006. 

What is the explanation?  You can guess; the lack of qualified candidates, the same explanation always given.  As the NLJ indicated:  "Judges have long said recruiting minority attorneys is difficult." 

In fact, there are qualified candidates.  One suspects, however, that many judges screen on the basis of law school, largely limiting their search to the very top schools. For a table showing the relationship between law schools and judicial clerkships, go here.  The absence of qualified candidates in those circumstances means the absence of qualified candidates at a limited array of schools.  

Law clerks do not have to exactly mirror the percentage within the population as a whole.  But when numbers are this low, there is a problem.  The starting point for any resolution is to have judges comb the application pool for qualified candidates from all law schools, not just a chosen few.  

Corporate Gender Inequality, the Meritocracy Fiction, and Other Related Points

The Wall Street Journal ran an article this past week (here) about a recent discussion Jack Welch had with a group of women executives.  While the article pointed out that only 3% of Fortune 500 companies have a female CEO, and female board membership is “similarly spare,” Mr. Welch apparently attributed this inequality to a lack of adequate production by women.  I say this because the article described him as being both dismissive of programs designed to increase workplace diversity, and confident that performance is rewarded:

Programs promoting diversity, mentorships and affinity groups may or may not be good, but they are not how women get ahead. "Over deliver," Mr. Welch advised. "Performance is it!"

The responses of some of the attendees reflected a different view:

"He showed no recognition that the culture shapes the performance metrics, and the culture is that of white men."

"While he seemed to acknowledge the value of a diverse workforce, he didn't seem to think it was necessary to develop strategies for getting there—and especially for taking a cold, hard look at some of the subtle barriers to women's advancement that still exist. If objective performance measures were enough, more than a handful of Fortune 500 senior executives would already be women. "

"This meritocracy fiction may be the single biggest obstacle to women's advancement."

While the issue of gender inequality in corporate board rooms and executive suites is obviously complex, one particular item I was reminded of while reading this was the suggestion that having a few more women in positions of power in the financial industry might have actually allowed us to avoid the recent financial crisis.  As one news item put it (here):

There is a dramatic difference in the data between female and male risk-taking types…. Evolutionary speaking, the species has survived because of the balance of the genders. One would suggest that in investment banking, which is very male dominated, you need a balance of risk types if you want to survive. If you’re not recruiting people of all risk types, you’re missing out on a fundamental self-controlling mechanism. It’s a bloody good formula for survival.

For another perspective you might want to review Julie Nelson’s essay, “Would Women Leaders Have Prevented the Global Financial Crisis? Implications for Teaching About Gender and Economics,” which is available via SSRN (here).  Here is the abstract:

Would having more women in leadership have prevented the financial crisis? This question challenges feminist economists to once again address questions of "difference" versus "sameness" that have engaged — and often divided — academic feminists for decades. The first part of this essay argues that while some behavioral research seems to support an exaggerated "difference" view, non-simplistic behavioral research can serve feminist libratory purposes by debunking this view and revealing the immense unconscious power of stereotyping, as well as the possibility of non-dualist understandings of gender. The second part of this essay argues that the more urgently needed gender analysis of the financial industry is not concerned with (presumed) "differences" by sex, but rather with the role of gender biases in the social construction of markets. An Appendix discusses specific examples and tools that can be used when teaching about difference and similarity.