Author: Lawrence Cunningham


Watching Clouds in Delaware: Gantler v. Stephens

clouds.jpgFifteen years ago, I and my colleague Chuck Yablon, wrote the following about Delaware corporate law (in 49 Business Lawyer 1593 (1994)):

[P]redicting developments in Delaware law has always been a somewhat foolish enterprise. Many learned commentators have written careful and lucid analyses predicting the trend of Delaware case law, only to have doctrinal prognostications shattered by the next big case. Predicting the course of Delaware law from prior case law is like watching clouds. They seem, at times, to take on recognizable shapes and forms, even to resemble something familiar. But you know that whatever shapes you think you see can vanish in a puff of wind.

I can’t make the same complaint about a Delaware Supreme Court opinion released last week, Gantler v. Stephens, that’s receiving surprising attention, despite saying little or nothing new. (One champion and devotee of the minutiae of Delaware corporate law even calls it, peculiarly, “very momentous” and a “major decision.”)

True, as Usha Rodriques at Conglomerate fairly notes, the case says that corporate officers owe their corporations the same fiduciary duties that directors do. But the court makes that point by citing Delaware opinions from 1939 and 1993 and Gantler is most about directors, not officers. Scholars may have paid inadequate attention to officer duties, but this case will not likely change the focus (though Professor Rodriques’s new article on the subject in Florida Law Review may do so.)

Also true, as a Paul Weiss client report sensibly notes, the opinion clarifies that shareholders can’t be held to ratify director actions, that statute requires them to approve, except through the statutory approval process.

Other than that, the opinion is doctrinally of little moment, as the following principal points show:

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Forms May Fail Big Four Auditing Firms

org chart.jpgA common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.

At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.

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NYT Columnist Wants Keynes on Steroids

Big G.jpgThe February 1, 2009, print edition of the Sunday New York Times Magazine will run a long opinion piece, The Big Fix, by staff writer, David Leonhardt. The piece, already available on line, reads as an exuberant, unqualified endorsement of a massive and immediate increase in the role and size of the US federal government—as the only solution to current challenges.

The piece offers a few serious reflections and suggestions, including promoting national investment in education. But it is overall both intemperate and naïve. For some, it may even be irresponsible. Certainly, it contains no acknowledgement of any limitations on its diagnosis of current problems or prescription for curing them.

Mr. Leonhardt encourages any kind of immediate large government spending, for any reason. He writes, seriously, that: “Employing people to dig ditches and fill them up again would” be good government policy. He adds: “Even the construction of a mob museum in Las Vegas, a project that was crossed off the [Obama Administration’s] list after Republicans mocked it, would work to stimulate the economy, so long as ground was broken soon.” He concludes: “Pork and stimulus are not mutually exclusive.”

Are these suggestions seriously responsible? Less fancifully, Mr. Leonhardt says that John Maynard Keynes was right, that government, with its “enormous resources,” is the only force that can catapult a nation out of a deep financial crisis. Sensibly, Mr. Leonhardt says, any such catapult must be designed to increase the nation’s economic growth rate in short order so that enough return is generated to repay debts that any bold government spending plan entails.

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Hello Ms. Schapiro

SEC Seal.gifThe Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.


Two Visions on Financial Reform

We may have more ideas than money, judging by the proliferation of proposals for financial system reform amid continuing declines in our personal and societal net worths. At least five notable formulations for financial reform are in circulation. Others are forthcoming, including two that I’m working on (one a law review article with David Zaring and another a Washington-based policy formulation project).

Perhaps the most prominent and detailed proposals yet are two that may be seen as arch-competitors: one created by former Bush Treasury Secretary Hank Paulson and another led by former Fed Chair and Obama advisor Paul Volcker.

In addition, the Committee on Capital Markets Regulation (Harvard law professor, Hal Scott) offers

proposals that tend to resemble many of those Paulson endorsed. The Center for Capital Markets Competiveness (Chamber of Commerce) lays out some broad goals and policy preferences and the Government Accountability Office contributes general statements of principle that should guide reform design.

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Good Bye Mr. Cox

SEC Seal.gifYesterday was Christopher Cox’s last day of a 3.5 year term as Chair of the Securities and Exchange Commission, the United States federal agency charged with investor protection. Investors may be tempted to feel some relief. He leaves the agency weakened and its staff demoralized. But he also leaves its continued existence in doubt, given its manifest failures and contributions to the global financial crisis. It may be undiplomatic to say, but it is possible that his tenure was among the worst in the agency’s history.

Despite the agency’s primary mission of investor protection, Mr. Cox mostly ignored or subordinated that mission in preference to elevating other goals, such as promoting capital formation and engagement with technology and globalization. Headline dramas illustrating these problems include how, during Mr. Cox’s tenure, the SEC:

• failed to interdict Bernard Madoff’s Ponzi scheme despite warnings, costing investors billions, with Mr. Cox later saying he was “deeply troubled” that he didn’t catch it;

• failed in its oversight of the investment banking industry, which led to its extinction, costing investors hundreds of billions more (with multiplied costs for the rest of the economy and probably permanently impairing the economy of New York City, the country’s center of investment capital), with Mr. Cox later describing the SEC’s oversight program as a total failure;

• reduced enforcement intensity for securities law violations (measured by year-to-year reductions in fines and restitution of about 2/3), with uncertain but probably significant future costs for investors from reduced deterrence; and

• reversed major parts of the 2002 Sarbanes-Oxley Act’s implementation concerning corporate internal controls, the costs and fallout from which will not be known for months or years when accounting scandals emerge as a result of the increased opportunities for fraud, although the costs may again run to billions of dollars.

In addition, as Chair of the SEC, Mr. Cox concentrated considerable personal and institutional resources on two subjects that subordinated investor interests to pursue projects that Mr. Cox believed in for some other reasons. In particular, Mr. Cox and the SEC Staff at his direction:

• spent thousands of hours and enormous other resources pushing an ill-advised campaign to eliminate US accounting standards in favor of global ones, although this was fortunately delayed in the final months of his term in response to investor and academic criticism; and

spent considerable resources promoting policies to let non-US enterprises access US capital markets, without any US regulatory oversight or legal enforcement, so long as they are overseen at home by authorities deemed comparable, also an idea that luckily has gained little traction and may die on the vine.

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Notes on Financial Reform

boardroom.jpgFinancial system reform debates are about to take place in earnest. For some, these may involve standard oppositions between those with more confidence in markets compared to those with more confidence in regulation. But superior policy may result from substantive analysis of issues that transcend such philosophical, political or ideological dispositions.

Two of the more important proposals may appear to be competitors reflecting polar dispositions. One, championed by outgoing Treasury Secretary, Henry Paulson, imagines a consolidated oversight structure with considerable latitude to promote US capital market competiveness. Another, championed by incoming Obama advisor, Paul Volcker, former Federal Reserve Chair, likewise outlines a consolidated structure, but with far more stringent controls intended to limit the size and risks of US financial institutions.

Despite the evident philosophical and perhaps political opposition that the Paulson and Volcker proposals may reflect, astute participants in policy debate will recognize both as essentially opening positions in the forthcoming public policy negotiations. For them, needed is balance between spontaneous market coordination and planned regulatory moderation. The exact balance may differ across different kinds of markets and constituents. In general, the following clusters of topics will be implicated.

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“Le laisser-faire, c’est fini”?

dollar sign.jpgThe title quote is attributed to French President Nicolas Sarkozy in Roger Altman’s insightfully sobering piece in the current issue of Foreign Affairs [volume 88, at pp. 2-14]. The topic sentence: “The financial and economic crash of 2008, the worst in over 75 years, is a major geopolitical setback for the United States . . . .” True, the final paragraph concludes, “The United States will remain the most powerful nation on earth for a while longer.” [at 14]. But its standing and influence are badly damaged and there is little that can be done to reverse or limit the effects.

On average, Americans lost 1/4 of their net worth from June 2007 to December 2008. [I am one of those average Americans.] Net worth reductions appear in all assets classes: home equity values down 33% [$4.2 trillion, mine down 20%], retirement savings values down 22% [$2.3 trillion, mine down 25%], other securities investment values down 25% [$2.5 trillion, mine down 20%]. Total value reduction: $8.8 trillion.

Broad stock market indexes fell by nearly half from highs in 2007 to the end of 2008. Altman says this means participants are “anticipating an even worse drop in corporate profits” ahead, although he also notes how the current environment reflects psychological as well as substantive effects, highlighting “deep fright”, “shock,” and a sense of “doom pervading Washington and the U.S. media.” Altman also notes that the recent period shows “a classic pattern of overshooting, [with] markets swinging from euphoria to despair.”

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Satyam Fraud’s Systemic Regulatory Implications

Green Eyeshade.jpg

From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.

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Humble Tribute to Chief Judge Judith Kaye

Chief Judge Judith Kaye.jpgOne of the country’s greatest contemporary judges, Judith Kaye, Chief Judge of the New York Court of Appeals, will retire at year-end under the state’s mandatory retirement law. Having served with distinction for some 25 years (15 as Chief Judge), she has earned a deserved reputation for integrity, influence, discernment, very high quality opinion writing—as well as administrative excellence. Notably, Judge Kaye was the first woman appointed to New York’s high court and its longest serving Chief Judge.

In an editorial tribute on December 14, the Sunday New York Times instanced “groundbreaking decisions,” including interpreting the New York Constitution to require the state to provide its citizens with “sound, basic education;” finding certain provisions of a New York death penalty statute unconstitutional; and finding that gay persons enjoy rights to adopt their partners’ children.

In fields closer to my heart and mind, Judge Kaye wrote several important and influential opinions on the common law of contracts, continuing a tradition on her court, whose earlier members include luminaries such as Benjamin Cardozo, Stanley Fuld, and Charles Brietel. Judge Kaye’s opinions have made their way into Contracts casebooks, becoming staples of the course.

Judge Kaye’s opinions are likely to increasingly be reprinted in Contracts casebooks. If so, she would join the only other woman, Ellen Ash Peters, former Chief Justice of Connecticut, on lists of judges whose opinions are frequently reprinted, which include the likes of Cardozo, Roger Traynor, Richard Posner and Learned Hand).

One illustration, from Judge Kaye’s early years on the bench, is the classroom favorite, Van Wagner Advertising Corp. v. S&M Enterprises, 492 N.E.2d 756 (N.Y. 1986), where Judge Kaye announced her holding in the opening lines: “specific performance of a contract to lease ‘unique’ billboard space is properly denied when damages are adequate to compensate the tenant . . . .”

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