18 posts categorized "Corporate Law"

October 03, 2007

Baird & Henderson on "Other People's Money"

In corporate law classes at Chicago and other law schools this fall, students are studying the rules that govern the conduct of corporate directors and officers. Collectively known as "fiduciary duties", these include the "duty of care" and the "duty of loyalty". Nearly the entirety of corporate law is premised on these duties being owed to shareholders. In a new paper (see the abstract below), Professors Baird & Henderson argue that fiduciary duties as currently conceived are more harmful than helpful, and that they should be replaced with a new, contract-based approach. The full paper is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1017615.

"Other People's Money"


There is no more sacred tenet of corporate law than the one stating that corporate directors owe a fiduciary duty to shareholders. We argue that while this rule has not yet generated seriously wrongheaded outcomes, it is an “almost right” principle that should be abandoned before it does. As a threshold matter, we show the notion of special duties owed to shareholders is plainly inconsistent with everyday business decisions and corporate law. Firms can take and do take actions that are inconsistent with those of a fiduciary and that favor creditors at the expense of shareholders, despite supposedly trumping fiduciary duties owed to the latter. A bankruptcy filing is the most obvious of these. 

The recent cases in Delaware over fiduciary duties in the “zone of insolvency” demonstrate how the attempt to delineate clearly what duties are owed to different investors in a firm is doomed to fail. Using Credit Lyonnais and its predecessor Central Ice Cream, we show how courts are attuned to the problem of conflicting interests among different investors, but are not likely to create efficient rules by using labels like “fiduciary duties” and applying them to shareholders sometimes and creditors other times.

We offer two potential replacements for the shareholder fiduciary duty doctrine. The most familiar for corporate scholars and practitioners is the idea of fiduciary duties being owed to the firm as a whole, coupled with a strong business judgment rule. Although we think this is superior to the existing rule, we show how this principle itself may be wanting in some important cases. In venture capital transactions, for one, the ex ante bargain appears to give certain investors the right to take actions in bad states of the world that may destroy firm value in order to create incentives for managers to avoid those bad states. Courts disrupting these deals in the name of fiduciary duties may be upsetting well struck bargains.

We therefore set out an alternative paradigm, one in which no fiduciary duties exist at all, and directors face liability for their decisions (other than for neglect or surreptitious self-dealing) only if they violate a contractual obligation owed a shareholder, creditor, or other investor. We conclude by showing how separating corporate law from conceptions of duty brings needed clarity to the often-litigated issue of disclosure duties. The problem, we suggest, is largely contractual, and in setting the default rules the focus should be on the ability of parties to opt out—or opt in.

May 25, 2007

Henderson CBI: CEOs are Underpaid

A provocative title, no? Well, Todd Henderson's a provocative guy. On Wednsday, May 9, 2007, he delivered the talk on "CEOs are Underpaid." As he said, he may not have convinced the audience that CEOs are underpaid, but he was pretty convincing in explaining that they seem to be efficiently paid and not overpaid. You're going to have to listen to hear for yourself. The blurb for the talk is after the jump.

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May 18, 2007

Epstein vs. Epstein: Drug Price Subsidies

If you're planning a discussion at the University of Chicago Law School and you want a very lively debate, you ask Richard Epstein to be one of your panelists. So how could we go wrong for a Loop Luncheon on Reunion weekend by asking Richard to debate himself? On May 4 he did exactly that. The event was billed as Epstein vs. Epstein, and the topic was "Why should the U.S. subsidize the world with our high prescription drug prices?" Professor Epstein served as moderator as well, of course. If you'd like to hear the results, you can listen here.

October 10, 2006

Boardroom Confidentiality

In the wake of the Hewlett-Packard "scandal," corporate boards and their advisors are scurrying about in order to try and avoid future, similar difficulties.  In principle, the advice is simple: engage in full and frank discussions, but leave outside contact to a spokesperson or the CEO. In the event of a leak by a board member, discuss (and do so in advance), and if necessary apply some pressure by reminding board members of the possibility that their "disclosures" will amount to civil or criminal violations of the securities laws, or pointing out that renomination to the board is unlikely for someone who can not kep confidences. The advice usually extends to referring the matter to the general counsel or outside counsel, with little advance work on what exactly will happen if the matter is not respolved in this manner.

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October 03, 2006

The Tale of Stephen Hilbert

The Law School, like others around the country, was abuzz yesterday with the start (or false start thanks to the Jewish holiday) of the new Supreme Court term.  While no opinions were handed down yesterday, the Court did make a decision of interest to corporate types: it turned away the petition of Stephen Hilbert, the founder of the insurance firm Conseco.  This case is interesting not so much for the legal issues in Hilbert’s petition or the lower court opinions, but for what it reveals about how firms use (or, rather, used) deferred compensation of various sorts to discipline management. 

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September 27, 2006

Moral hazard and credit derivatives

Have you ever heard of “credit derivatives”? Most of us haven’t, but we should become familiar with them because they are poised to transform how we think about corporations. The basic idea is that banks and other holders of corporate debt can now spread this risk to other willing bearers using a variety of intricate financial tools. In the most basic flavor, a bank that holds a loan to a company on its balance sheet agrees to pay a quarterly fee to a third party (usually an insurance company, other bank, or hedge fund) in return for a make-whole payment by the third party in the event that the borrower on the underlying loan defaults. Called a “credit default swap”, this is nothing more than insurance against the reduction in value of the loan. The CDS market is currently over $26 trillion. That is right, TRILLION. Even more profound, however, is the rethinking we will have to do about our models of corporate governance and finance in a world in which debt starts to look more and more like equity (i.e., freely traded and held in diversified portfolios by dispersed individuals and entities). One potential issue with these transactions is the potential moral hazard it creates for borrowers.

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September 12, 2006

Governance at Gunpoint

A story in today’s Wall Street Journal (sub. req.) about the continuing troubles at Bristol-Myers raises troubling questions about the government’s use of strong-arm tactics to extract corporate governance and other concessions from firms under threat of litigation-induced firm death.

In the aftermath of the demise of Arthur Andersen, firms are especially leery about the possibility of being indicted. As the Andersen case makes clear, the risk from indictment is enormous, and even exoneration by the Supreme Court isn’t enough to bring back the dead. It was in the wake of Andersen that the US Attorney’s Office for the District of New Jersey negotiated a so-called “deferred prosecution agreement” (DPA) with Bristol-Myers to settle allegations that the firm engaged in deceptive inventory practices to meet quarterly earnings estimates. DPAs, which are adapted to the corporate crime context from the pre-trial diversion programs used to monitor juvenile and drug offenders, have been used in 43 corporate crime and fraud cases since 1993. These agreements raise issues about privilege waiver and corporate versus individual accountability, but the Bristol-Myers case highlights the danger of governance reform aspects of these agreements.

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September 09, 2006

A new mechanism for exercising shareholder voice

The latest craze in corporate activism is majority voting for board elections. The intuition is simple if misguided: boards are elected by shareholders to run the firm; elections everywhere (except maybe North Korea, Cuba, and, er, Chicago) are decided by majority vote; therefore board members should be elected only if they win a majority of shareholder votes. (Currently, shareholder votes in ordinary elections are not dispositive, as board members can be elected with a plurality of votes—only in expensive and rare proxy fights when a rival slate of directors is run do votes actually matter.) This campaign is being waged on many fronts, including by law professor Lucian Bebchuk, who has personally lobbied firms in which he owns a few shares to adopt bylaw amendments requiring majority rule. A recent court decision highlights the problems with this approach, and a new paper offers some alternatives.

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July 11, 2006

The Case Against (GM's) Bankruptcy

Barry Adler's post suggests that changes in conventional wisdom or laws might be needed to encourage efficient, earlier Chapter 11 bankruptcy petitions. With a few twists and turns the arguments for and against this idea might cause us to reassess or review the fundamentals of bankruptcy.  It is plausible that we would be better off moving in the opposite direction, welcoming the death of bankruptcy, at least for large organizations.  Perhaps GM (which is to say its creditors, executives, or shareholders) and other enterprises would be better off if forced to work out problems by contract (by which I mean arrangements that leave as little room as possible for surprise in court).

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July 07, 2006

As Goes General Motors

As of today, General Motors’ market capitalization (the combined value of its shares) is about $16.5 billion. In 2005 alone, GM lost $10.6 billion and by all accounts the losses continue. The positive value of the stock reflects a chance that the company will turn around not an indication that it has. Even so, the company can for some time continue to suffer losses at this or higher levels and still not default on any of its loans. All it need do is borrow from Peter to pay Paul, and GM is doing just that.

In late June, the automaker announced that it would refinance $5.6 billion in loans, a move it described as a "positive action toward additional financial flexibility." This action is "positive," no doubt, for GM managers, employees, and shareholders, each of whom would like to buy time for a reversal of fortune. But no such reversal is guaranteed, or even likely, and thus not every corporate constituent is pleased by the company’s new liquidity. The new loans are secured by collateral that gives the holders priority over GM’s unsecured bonds. Should the company continue its losses and default on its new obligations before it pays off the bonds, the bondholders will be left with little or nothing to collect. In anticipation of such an event, both Standard & Poor’s and Moody’s investor services cut the credit rating of GM bonds, which were already classified as junk. So while GM may consider the refinancing a positive step, the news is not necessarily good.

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June 01, 2006

Hedge Funds and Collective Action

The standard justification for bankruptcy is that exists to solve a collective action problem. The various investors in the business are dispersed, and, left to their own devices, they will take action that is invididually rational but will fail to put the assets of the corporation to the highest-valued use. For over a decade we have known that it is possible, in theory, to solve the collective action problem ex ante. Still, many companies have capital structures that result in thousands of parties making investements in the business.

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May 31, 2006

Temporary CEO's?

One of the more notable developments in bankruptcy practice over the past two decades has been the development of professionals who take control of companies when they are in financial distress. They are tasked with guiding the corporation through crisis. They differ from other executives in that there is no expectation that they will remain with the corporation, even if the corporation survives. If they do their job well, they will leave. To give one notable example, Enron hired a seasoned turnaround professional to oversee the sale of its assets (it sold it last major asset last week for $2.9 billion). Even while still serving as CEO of Enron, he become CEO of Kripsy Kreme when it encountered financial difficulties.

This path differs sharply from the normal expectation about leaders of companies. Generally, the thought is that they will stay so long as they do well (unless, of course, they voluntarily leave). Yet by all accounts being a CEO is difficult, and corporations face different challenges at different times. The rise of the tournaround profession to deal with the problem of financial distress raises the question of whether we will see the development of other professional managers designed to allow corporations to meet specific challenges. In other words, would some corporations be better off being run by a person whose future compensation turns on the ability to get the boards of other corporations to hire her in the future?

May 30, 2006

The Prime Directive

Much of the discussion in corporate law centers on executive compensation. While there is a debate over whether the current system is better described as mangers capturing directors so as to pad their pay packet or as the the result of a competitive market, all share the notion the goal of executive compensation is to align the incentives of the managers with the shareholders. Such an alignment may be important, but it is an odd place to start dicussions of corporate governance.

When we think of other organizations, we don't attribute their success to the compensation contracts that are in place. No one attributed the Chicago White Sox winning the World Series to the contracts that employed Ozzie Guillen and the players. When law faculties participate in a dean search, no one asks whether the administration is going to give the new dean a contract that will ensure that she is a faithful agent.

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May 27, 2006

Corporate Prediction Markets

Many people are familiar with the predictive success of small, low-stakes “prediction markets” run by the University of Iowa (predicting political elections better than the pollsters) and firms such as Tradesports.com (predicting everything from whether Hamas will recognize Israel to whether Scooter Libby will be convicted) and the Chicago Board of Trade (predicting U.S. unemployment and other key economic indicators). As colleagues Saul Levmore and Cass Sunstein have pointed out, these markets are routinely better at forecasting what is going to happen than any other available means. The insight here is a Hayekian one: markets, when they work, are the best available mechanism for gathering, aggregating, and processing information.

Those familiar with this literature may also be familiar with the use of these markets by firms such as Hewlett-Packard and Google, which have made increasing use of prediction markets to help make business decisions. Initial studies suggest that these markets provide relatively reliable predictions and are not easily manipulated by those who have a stake in decision making. For example, HP’s market estimated sales of a particular product better than traditional forecasting methods. Other results suggesting the usefulness of simple prediction markets have been seen at Google, Siemens, Intel, and many other firms. More promising still, David Pennock’s patent-pending dynamic pari-mutuel market and Robin Hanson’s market scoring rule make it possible to generate sound predictions even in very thin markets.

In a forthcoming paper, Michael Abramowicz, a law professor at George Washington, and I explore how these markets may help solve a number of corporate law problems.

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May 23, 2006

A link between options timing and taxes?

The Wall Street Journal recently reported on the growing scandal involving the "back-dating" of stock options issued as compensation to corporate executives. The scheme here, according to the news reports and some academic studies, is to issue the options as of a certain past date when the stock was at a lower level. In other words, if the stock is trading at $50 today but $20 dollars two months ago, the firm could issue the options (with a strike price equal to the market price) as of two months ago, allowing the executive to cash out $30 per share immediately. There is nothing illegal about this. So long as the appropriate corporate procedures (e.g., shareholder and board approval) were followed, a firm can issue any options, including back-dated options, it wants.

So why the big fuss?

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May 22, 2006

Fear and Loathing of Milberg Weiss

Bloggers and journalists are having a field day with the recent indictment of Milberg Weiss and reports of (alleged) illicit hidden payments of cash to cooperating lead plaintiffs. There are a couple of puzzles associated with the news thus far.  One is why the payments (assuming for the sake of the puzzle that the reports are correct, though I think that is most unlikely) would need to be so large (allegedly in the millions). There are many possible representative plaintiffs in most of the securities and other cases that Milberg Weiss becomes involved in; why would any need to be paid, or be paid so much?  Hundreds of lawyers hate the firm and they are quick to say that plaintiffs are paid to lie, to agree to settlements that are not in the interest of other class members, to lie about having been consulted about conflict of interest questions, and so forth.  Some of these possibilities seem implausible, or at least somewhat puzzling, in a world in which named plaintiffs are rarely consulted at all, and in which judges must approve settlements (for better or worse) but are hardly accused of paying too much attention to the wishes of the named, nominal plaintiffs.  And so even if the plaintiffs' firm gains by having a cooperative "client" who expects to be a repeat, long term player with the firm, it is hard to see why this teamwork comes at such a high price.

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October 19, 2005

Hedge Funds

In today's NY Times, David Swensen worries about small investors' taste for hedge funds, and argues for restricting hedge funds to the most sophisticated investors.  So much so that he would regulate "funds of funds" (mutual funds that offer portfolios of hedge funds) out of existence.  Swensen is thoughtful, as usual, but I find it hard to agree with anything in the op-ed piece.

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October 12, 2005

Why are hedge funds so successful?

With all the talk about hedge funds – the dramatic successes (about 20 hedge fund managers earned in excess of $100 million in compensation last year), and the rising number of flameouts (from the Bayou Group to the Eifuku Master Fund in Japan that lost its $300 million portfolio in seven trading days) – few have focused on the question of how hedge funds are able, so far, to earn higher returns than other investment vehicles. (The largest hedge fund index beat the S&P by about 3% last year, and many of the largest funds earned returns in excess of 30%.)

A couple of hypotheses, some benign and some potentially troubling:

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