"Paulson" Committee on Capital Markets Regulation Report (Part 3)

Last week the Committee on Capital Markets (also known as the "Paulson Committee") released its Interim Report. As I noted earlier this week (See "Paulson" Committee on Capital Markets Report and 'elegant whining'" and "Committee on Capital Markets Regulation Report (Part 2)"), this is a long report, so I've broken my review up into three parts. This is the third part, reviewing the CCMR's sections on Shareholder Rights and Sarbanes-Oxley Section 404

Shareholder Rights

If you've read anyone commenting on the CCMR's report and this person was universally critical of the report, it's a pretty sure sign that they haven't actually read it. (See, for example, New York governor-elect Eliot Spitzer's comments that, "This is the same old tired response from the defenders of the status quo who time and again jump to eviscerate the prosecutorial power of the only office who did anything in the past decade.") They particularly haven't read the section on shareholder rights, written principally by Harvard Law professor Allen Ferrell. (Ferrell is one of those increasingly common law professors with a Ph.D. in Economics.)

Ferrell's section has two targets -- "staggered" (or "classified") boards of directors, and "poison pill" anti-takeover defenses. Both phenomenon are actually devices to prevent "hostile" takeovers of corporations. Any corporate merger or takeover, of course, involves one company purchasing from another company's shareholders their ownership in the target company. A "hostile" takeover occurs when the purchasing company goes directly to the target company's shareholders and offers them money for their shares, without the express approval of the target company's board of directors or managers.

What's wrong with that, you ask? After all, if you own shares of a company and somebody comes along and offers you a lot of money for them (more than you think they are worth), why shouldn't you sell? Well, because then the company's managers and board of directors might lose their jobs, that why! And something had to be done about that! Remember all those '80s and early '90s movies about "corporate raiders" and the like -- you know, "Other People's Money," "Wall Street," "Barbarians at the Gate" and even "Pretty Woman"? You know why you don't see that plot device anymore? It's because hostile takeovers rarely happen anymore, mostly because of the adoption of staggered boards of directors, poison pills and similar anti-takeover devices.

Staggered boards of directors are corporate boards with member terms set like the U.S. Senate -- only a portion of which are up for election at any given time. This means that any group taking control of a majority of voting shares of a company still can't control the company's board. Even if all of the company's shareholders became so fed-up with the company's performance that they wanted to install a new board, it would not be possible for several years. (In reality, in the United States it would not be possible at all, since the board controls the board nominating process and board elections are like old Soviet elections -- you can vote for the candidate or you can abstain from voting, but you can't vote for a competing candidate.)

A "poison pill" is a resolution of the board that gives company shareholders (but not the purchasing company) the right to purchase additional shares of the company at a price substantially below market prices. In other words, if an acquiring company buys 10% of the target company's shares, and the board adopts a poison pill defense, the target company suddenly issues thousands or millions of new shares to existing shareholders, at pennies on the dollar, effectively diluting the purchasing company's ownership. Theoretically, a target company's board could do this infinitely many times, effectively making the price of the acquisition infinitely high.

Ferrell cites numerous academic studies that demonstrate that share prices drop when state laws permit either staggered boards or poison pill defenses, and that the use of poison pills is correlated with poor corporate performance. In other words, while anti-takeover devices are typically sold to the public as a way to "protect jobs," the evidence is clear that the jobs these devices are designed to protect are those of poorly performing CEOs and board members. Ferrell even shows that staggered boards of directors are correlated with high CEO pay that isn't linked to company performance. (Incoming House Financial Services Committee Chairman Barney Frank might wish to keep that in mind when he holds his promised hearings on soaring executive pay, particularly since his state of Massachusetts actually makes staggered boards of directors mandatory.)

As a response to these problems, the CCMR recommends that Delaware, or the stock exchanges, develop standards prohibiting companies that have staggered boards of directors from adopting poison pills without first getting shareholder approval, unless the company is the target of a takeover. If the company is a takeover target, the board could adopt a poison pill, but must get shareholder approval for the pill within three months. That would allow the board to make its case for why the takeover is not in the best interests of the shareholders, while also not making the takeover impossible should the shareholders disagree. (CCMR recognizes that the SEC probably does not have the power to make this a requirement itself. What is strange, though, is that no one ever seems to imagine taking all of this authority away from Delaware and actually having Congress pass a national corporations law, applicable for any company doing business across state lines.)

The CCMR also has a number of other recommendations to improve shareholder rights, most of which are good ideas. It recommends that the SEC resolve the issue of whether shareholders should have the right to put election-related materials on an issuer's proxy ballot -- something that the SEC is likely to consider this January in response to the 2nd Circuit's AFSCME v. AIG decision.

One recommendation I'm not sure I agree with, however, is CCMR's proposal that corporations should be able to adopt provisions that mandate that shareholders must settle disputes with the company through arbitration rather than through the courts (and, in particular, through class action lawsuits). As I mentioned in my review of the CCMR Report's Enforcement Section, I think it is clear that shareholder class action lawsuits are not necessarily a good thing. I also believe that, for the CCMR's proposals on limiting class action lawsuits to work, shareholders must have greater abilities to remove poorly performing boards of directors. However, mandatory arbitration clauses likely will go too far and return power to corporate boards and managers at a time when power should be shifting to shareholders. Without the disciplining effect of a real lawsuit (and not a slap-on-the-wrist arbitration board), it is hard for me to imagine that board member fiduciary duties won't suffer.

Sarbanes-Oxley Section 404

The last section of the CCMR Report deals with Section 404 of the Sarbanes-Oxley Act, and it is not so much bad as it is unnecessary. (This part of the CCMR Report was written mostly by Andrew Kuritzkes, a managing director of Mercer Oliver Wyman, a management consulting firm.)

The much-reviled Sarbanes-Oxley Act has quite a few provisions, but the one that most companies find really unpalatable is Section 404. Section 404 states that a company's management must give a report about the company's internal controls (the controls designed to track how and by whom money is spent), and that the company's independent auditor has to give an opinion about this report. Despite what Kuritzkes writes, mandating that issuers have internal controls is not new, but is actually a requirement of the Foreign Corrupt Practices Act of 1977. Independent auditors were always supposed to test these internal controls -- it's just that, prior to Sarbanes-Oxley, this testing was largely perfunctory. However, now, following what happened to Arthur Andersen and with the Public Company Accounting Oversight Board's Audit Standard 2 (AS2), this testing has become extremely thorough. And costly.

Kuritzkes notes that there likely are some efficiency benefits to Section 404, in terms of improved corporate management. In a prior life, I was involved in "strategic sourcing" and supply chain management at a management consulting firm, and I can attest that profitable, well-run companies know how they spend their money; and companies that don't know how they spend their money are rarely profitable or well-run. In this sense, Section 404 could be seen as a government-mandated management consulting exercise of the type that companies regularly spend millions of dollars on without complaint -- only, now that it's mandatory, there's a lot of complaining. That said, if this is the principal benefit to Section 404, it's hard to see that it should be government's business to require it. Section 404 stands or falls on whether the direct benefits to investors in aggregate outweigh the costs.

By now, it is not entirely clear that Section 404, as it is now implemented by AS2, is cost-effective. But that is what makes this part of the CCMR Report largely unnecessary. The SEC has already agreed to offer "management guidance" on Section 404 implementation, effectively forcing the PCAOB to revise AS2 (through a new AS5) in a way that should dramatically reduce audit costs. In other words, on Section 404, the CCMR is largely preaching to the choir, using the same sermon some other preacher gave last Sunday.

The only interesting point Kuritzkes makes on Section 404 is that the planned reforms should not include a blanket exemption for small and medium enterprises. He notes that, while SOX compliance costs for firms with less than $700 million in market capitalization are more than five times greater on a relative basis than for issuers with more than $700 million in market cap, these smaller firms historically have also posed a much greater risk of having to restate their financial statements because of poor internal controls. Exempting these issuers from Section 404 would be exempting precisely those firms most likely to present a risk to investors. While Section 404 compliance cost might force some of these small issuers away from the U.S. equity markets, exempting them likely will raise their cost of capital anyway as investors grow wary of all small issuers. Consequently, the CCMR recommends that small firms be subject to the same Section 404 requirements as large firms, or that Congress should redesign Section 404 as it applies to small companies. (Without Congress weighing in on this matter, the CCMR believes audit firms will bear unacceptable liability should the SEC exempt small firms from the audit-testing requirements of AS2 and a problem with internal controls later arise.)

Conclusions

In short, my review of the Committee on Capital Markets Regulation Interim Report can best be summarized as:

Section 1 on Competitiveness: Really Sucks. It's clear that capital markets are important for the U.S. economy, but Luigi Zingales is entirely unconvincing that U.S. competitiveness is suffering as a result of U.S. securities regulation, or that this competitiveness is reflected by whether foreign issuers want to list in New York.

Section 2 on Regulatory Process: Mostly Sucks. Robert Glauber's attempt to paint the UK's "principles-based" regulatory approach as a panacea to any U.S. competitiveness issues is unworkable and just generally a bad idea. It would undermine investor confidence in a market where investors are everyone and where investors matter most. It won't work in the U.S. -- and, for that matter, it probably won't work in the UK long-term, either.

Section 3 on Enforcement: Some Very Good Ideas. The "public" enforcement system (the SEC, Justice Department and exchanges) needs to remain strong and threatening to deter market fraud. However, the threat posed by shareholder class action lawsuits is so great and so universal that it has lost its deterrence value and is now just a cost on shareholders everywhere. Clarifying certain aspects of rule 10b-5 is a good idea, and practices such as "pay-to-play" where lawyers essentially bribe local officials to represent local pension funds in class action lawsuits should be banned. Likewise, the Justice Department's "Thompson Memo" should be revised so it stops serving to blackmail companies into waiving attorney-client privilege or paying for lawyers for their employees.

Section 4 on Shareholder Rights: Some Really Good Ideas. Staggered boards of directors and poison pills should stop, particularly is, as above, shareholder class action lawsuits are restricted. The only thing I would say about this part is that it doesn't go far enough: other corporate anti-takeover tactics should also be prohibited. But I guess you have to start somewhere.

Section 5 on Sarbanes-Oxley 404: Mostly Moot Points. But a good point that smaller firms should not be exempt from a revised, more cost-effective Section 404.