Same Pointless Disclosure, None of the Fun

By Mike O'Sullivan | Published: June 3, 2009

SEC Chairman Schapiro’s Congressional testimony yesterday included the following promise of new disclosure requirements:

Next month we will take up a broad package of corporate disclosure improvements, all designed to provide shareholders with important information about their company’s key policies, procedures and practices, including compensation policies and incentive arrangements…. Also, shareholders should understand how compensation structures and practices drive an executive’s risk-taking. The Commission will be considering whether greater disclosure is needed about how a company — and the company’s board in particular — manages risks, both generally and in the context of compensation. The Commission will also consider whether greater disclosure is needed about a company’s overall compensation approach, beyond decisions with respect only to the highest paid officers….

Initial thoughts:

   1. Will anyone read these disclosures (other than the corporate lawyers who have to draft them)? I can’t imagine an investor making a buy or sell decision based a company’s “overall compensation approach” for lower-level employees. While the SEC’s last attempt at a Katie Couric rule was deeply flawed, and rightly axed, its main appeal was that it would satisfy our prurient desire to see what Katie Couric makes. Here the SEC would strip out the fun part and leave us with the same pointless disclosure.

   2. This disclosure seems tailor-made for our recently-failed financial companies, where compensation is the largest single expense and employees were encouraged to bet trillions of borrowed dollars on impulsive hopes and prayers. The problem is these companies have already failed. And the few that haven’t have surely gotten the message by now that a heads-you-win, tails-we-lose compensation philosophy isn’t going to cut it these days. But in an uncertain world, nothing feels better than fighting the last war.

   3. The magnitude of the recent destruction of our financial system seems to have blinded some of us to the reality that most of our companies aren’t thinly-disguised casinos. Compensation and risk are not that closely related at these companies because these companies don’t pay their employees enough to make a difference. And those employees don’t ever bet trillions of borrowed dollars on impulsive hopes and prayers. Those companies worry about unsexy stuff like raw material pricing, distribution deals, technology licensing and the like. To understand risk at these companies, read their MD&A’s instead of their CD&A’s.

   4. Is there any problem that can’t be solved by more disclosure? But as our documents get thicker, I’m wondering whether we’re at the point yet where there’s a declining marginal utility for each additional disclosure. Investors can only absorb so much before they toss the document aside and return to day-trading index funds. Perhaps the answer is to require the SEC to subtract a disclosure requirement for each new one it adds.

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The Enforcement Scorecard

By Mike O'Sullivan | Published: June 1, 2009

From “In Cox Years at the SEC, Policies Undercut Action”:

During Cox’s tenure, penalties imposed on companies fell 84 percent, from $1.59 billion in 2005 to $256 million in 2008.

Speaks for itself, doesn’t it? The Washington Post seems to think so, printing the above sentence without further explanation.

But I wonder.

Was the level of culpable conduct similar in 2005 and 2008? If so, the drop in fines may be interesting. If not, the drop in fines is not interesting.

Which was a more “normal” year for fines: 2005 or 2008? 2005 was the year the SEC booked $765 million in fines in connection with Adelphia – two of its largest fines ever – so perhaps the 2005 total is a bit of an outlier. Or is a year without an Adelphia the outlier?

Did the number of enforcement actions also drop? According to a recent GAO report, 272 formal orders of investigation were initiated in 2005. Although this dropped to 233 in 2008, the 14% difference does not come close to explaining the 84% drop in fines.

What probably does explain the drop in fines, and what is mentioned only in passing in the Post article, is the enforcement policy the SEC formalized in 2006 of not double-penalizing shareholders. The policy recognizes that when a company’s action is wrong because it harms the company’s shareholders, there is little point in penalizing the company with fines because those fines just penalize the shareholders. It makes more sense to penalize the individuals involved and/or require corrective procedures at the company to prevent future harm to shareholders.

But then penalizing individuals and implementing corrective actions won’t boost fine totals, disappointing those keeping score by that metric.

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Tweet Dump

By Mike O'Sullivan | Published: May 29, 2009

For the last few weeks, when I run across an interesting article or memo, I post a link to it on my Twitter feed. I appreciate the ease and rapidity of the Twitter service, and I find its 140 character limit a useful oulipo exercise that can beneficially tone one’s writing, so I encourage you to follow my feed for up-to-the-minute, if cryptic, insights into what I’m reading.

But I do have concerns with the whole Twitter thing.

For one, there’s the self-consciously-cute Tweety bird-inspired name, and how it tempts the weaker-willed among its users to start inserting “tw” before words where it does not belong. For instance, on Twitter a “trend” quickly becomes a “twend.” Bruce Carton is vigilant in stamping out these twendencies (damn, it’s even affecting me!), but one has to wonder whether this Twitter thing, or twing, is just so virulent that it would be best for the civilization if we just pulled the plug and shut it down.

When you log into Twitter, it asks you “What are you doing?” My first thought is “none of your business.” I’m mature and self-aware enough to know that no one cares what I am doing. And if you do, you shouldn’t.

I guess I just don’t get the Twitter mentality. Something about its breezy content-free instant-gratification self-centered ethos rubs me the wrong way. So instead I just post links. While this works for me, it is an uneasy accommodation.

As I agonize over this philosophical quandary, I’ve decided to repost my Twitter links here a few times each week for the benefit of those of you who don’t see yourselves becoming twits. So here, ripped from the pages of my Twitter feed, are some of my recent tweets:

Duke Law student takes on Milberg Weiss, former partner fires back. My question: Was the DOJ’s investigation really “beside the point”?

The Atlantic: “Do CEOs Matter?” Cites Great Man Theory to explain. Sounds familiar?

Why put an outside CEO on your company’s board? To boost your company’s status, not its performance. So says this paper.

Ezra Klein: boards have escaped blame because of the “soft bigotry of low expectations.” But I doubt they’ll escape.

James Surowiecki in the New Yorker: resurrects Gilson and Kraakman’s call for the creation of a “cadre of full-time directors.” But don’t we pretty much have that already?

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The Pill’s Antidote

By Mike O'Sullivan | Published: May 27, 2009

Senator Schumer’s proposed Shareholder Bill of Rights would impose one-year terms on public company directors, thereby eliminating staggered boards.

The trend has already been to move away from staggered boards: Shearman & Sterling’s 2008 corporate governance survey showed that only 27 of the 100 largest U.S. public companies had classified boards.

When a company eliminates its staggered board, one consequence is that it reduces the effectiveness of its poison pill. This is because pills give power to the board, but this power only lasts until the board is replaced. At a company with a classified board, replacing the board requires at least two annual meetings – an eternity in M&A land – but at a company without a classified board this can happen at the next annual meeting.

So, if a classified board gives a pill its teeth, a pill without a classified board is defanged.

Not surprisingly, with fewer classified boards, we’re also seeing fewer pills. Shearman & Sterling’s survey found that the trend away from poison pills is even more pronounced than the trend away from classified boards, with only 12 of the 100 largest public companies having pills in 2008.

Some of these companies may have pulled their pills thinking that if they ever got put in play, they could always adopt a new pill. But if that company also declassified its board, its “morning after pill” would be of limited use. The company would have to reclassify its board in order to give its pill teeth, something that would require shareholder approval or, if Schumer’s bill passes, be illegal.

Some have detected a recent resurgence in the popularity of poison pills, but this trend would presumably be squashed by a ban on classified boards.

So when thinking through the classified board ban, we also need to consider that it’s an antidote to poison pills. To some this is a feature, to others a bug.

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Why Our Agreements Look Like Crap

By Mike O'Sullivan | Published: May 26, 2009

You might think corporate lawyers, whose professional lives depend on words, who are often known to others only through their words, would care how those words look. You might think that, but you’d be wrong, at least judging from the persistent kludginess of the agreements clogging up my inbox.

After reviewing Matthew Butterick’s wonderful Typography for Lawyers website, which shows just how easy it is to make our words look great, I found myself wishing our agreements looked better and wondering why they didn’t.

Why do so many corporate lawyers still use typewriter fonts? Why do the rest of us settle for Times New Roman? Why do we fully justify everything? Does any word really need to be bold, italic and underlined? And what’s with all those bold all-caps paragraphs?

In short, why do our agreements look like crap?

Butterick is a litigator, and his website is oriented towards litigators, so to explain the persistent crappiness of corporate documents I had to look inward. It wasn’t a pretty sight. Here are a few explanations:

   1.  Weakest link formatting. Unlike litigators, our documents are collaborative, each side adding its own edits along the way. As a result, our typography ends up being determined by the weakest link in the working group. If you serve up a first draft with good formatting, someone down the line will surely muck it up. Who has time fix it? And if someone serves up a first draft with bad formatting, those of us with a little design sense will ignore it, preferring to spend our deal capital fighting over more substantive issues. So, in the end, after going back and forth a few times, our documents tend to acquire a lowest-common denominator look.

   2.  The joy of impenetrability. Good typography makes a document easier to read, but sometimes we don’t want to make our documents easier to read. Litigators need a judge to read their brief and find it so convincing he rules in their favor. We just need someone to sign. So if an agreement is a chore to read, maybe, we think, the other side will just skip to the end and sign. Or if they insist on plowing through the whole thing, maybe their eyes will glaze over and their addled brain will miss some issues. Now I doubt bad typography has ever actually helped anyone this way – if anything, it’s only made others suspicious and facilitated later misunderstandings – but this sort of wishful thinking may explain why we put our most important paragraphs in all-caps bold-face type, thereby making them nearly impossible to read.

   3.  Blame it on EDGAR.  Many of us spent our formative years mired in EDGAR documents. Long after the rest of world moved to fancier formatting, EDGAR still hewed to its retro ASCII lineage, serving as perhaps the last bastion of the typewriter font. This arrested the typographical development of an entire generation of corporate lawyers, and we are living with the consequences.

   4.  White shirts, grey suits. Look around any gathering of corporate lawyers, and what you do see? A sea of white shirts and dark gray suits. If your idea of flash is a pinstripe, or a yellow tie, I can’t see your documents moving beyond the boring familiarity of Times New Roman. 

Notwithstanding the foregoing, I still wish our documents were easier on the eye, and I think we could all benefit from Mr. Butterick’s typography tutelage. His advice is concise, comprehensive and fun to read (“Don’t use Bookman unless you want your brief to look like it was printed during the Ford administration. If fonts were clothing, this would be the corduroy suit.”), so please, for all our sakes, give him a read.

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Best Client Memos: Change in Control Definitions

By Mike O'Sullivan | Published: May 20, 2009

This week I read two client memos that together offer a useful primer on contractual change in control definitions.

In “Change of Control – Is It or Isn’t It?” Weil Gotshal offers an overview of the change in control definition you typically see in a debt instrument’s change in control put, highlighting some of the key drafting challenges.

In “Court Decision Raises Questions as to Interpretation and Validity of ‘Continuing Director’ Change in Control Provisions,” Cleary Gottlieb discusses the recent Amylin case in which the continuing director prong of a change in control definition put a company’s board in the awkward position of, at the same time, actively opposing a dissident slate and having to approve that same slate. The board approved the slate in order to avoid triggering the continuing director prong of its change in control definition. But in order to avoid a contractual change in control the board may have fostered a real change in control.

Together these two memos illustrate the complexity that lurks beneath ostensibly simple provisions.

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My Say on Say on Pay

By Mike O'Sullivan | Published: May 18, 2009

It is all but certain that Senator Schumer’s forthcoming Shareholder Bill of Rights will include a say on pay requirement and, I assume, it is all but certain that a say on pay requirement will be passed into law.

Whether say on pay should be the law of the land is an interesting issue that, I am sure, I will not be able to resist discussing here in the future.

However, because today I am assuming that say on pay will be the law of the land, and because today I am wearing the corporate lawyer’s uniform, a uniform that, when donned, magically transforms its wearer from a philosophical but Quixotic idealist into a hard-nosed, pragmatic and adaptive realist, today I am only concerned with one issue: How will this new reality affect corporate clients?

Say on pay is all about stigma. Initially, shareholder activists identified companies whose combination of high pay and low performance left them vulnerable, and targeted them with say on pay proposals. These proposals drew unwanted attention to these companies, putting them on the defensive. Even when the proposals didn’t pass, and most didn’t, the say on pay campaigns left the targeted companies stigmatized.

So, in the beginning, the mere threat of a say on pay proposal was a potent weapon for the activists.

However, the activists recently overplayed their hand, proposing say on pay at numerous companies, many with decent pay practices. With so many proposals floating around, a say on pay campaign no longer carried the old stigma. The activists had ceded some control over the issue to the other shareholders, because now the stigma would only attach to a company if its proposal passed. This was proving difficult for the activists to achieve.

The activists may have eventually succeeded in getting more say on pay proposals passed, which would have re-sharpened their stigma weapon.  On its face, a say on pay proposal sounds so reasonable (shareholder thinks: “hey, why shouldn’t I have a say on pay?”) that there was a chance these proposals would start passing in large numbers, even at companies with decent pay practices. Such a cascade of approvals might have boosted the activists’ movement. Or, if enough “good corporate citizens” were saddled with say on pay, perhaps the cascade would have diluted the stigma, even for the bad citizens. The stigma game would shift away from the say on pay proposals to each year’s say on pay votes.

However, now that Congress is intervening, there will never be a cascade of approvals for the proposals, so we will never know how that would have played out. The stigma game will change. Neither the activist’s threat of a say on pay proposal, nor the fact that a company is forced to give its shareholders a say on pay, will carry any stigma. That stigma will instead attach only when shareholders actually say “no.”

If shareholders say “no” all the time, their “no” votes won’t carry much of a stigma. Companies with the worst pay practices will be better off than they were before, as indiscriminate “no” votes will just lump them together with companies with decent pay practices. They will find safety in numbers. And those companies with decent pay practices will have “no” votes that carry little, if any, stigma, so those companies will be no worse off than before.

If, on the other hand, shareholders say “no” rarely, their “no” votes will stigmatize. When no votes are rare, I assume companies with the highest pay and lowest performance are most likely to get the “no” votes, so these companies will bear the brunt of this stigma. However, I doubt these companies will be much worse off than they were before because these were the same companies initially targeted with say on pay proposals. For these companies, it will feel like déjà vu all over again.

Meanwhile, I expect the rest of our public companies will find themselves better off than they were before. With mandatory say on pay, their compensation will now be publicly blessed by their shareholders each year, making it harder to challenge. And, over time, as more and more companies see their compensation approved, it will be that much harder for activists to make a case that executive compensation, whether at those companies or in general, is broken and needs to be fixed.

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The Right Termism

By Mike O'Sullivan | Published: May 14, 2009

Senator Schumer’s draft Shareholder Bill of Rights Act of 2009 includes a finding that the “most basic duties” of management and boards require them:

to enact compensation policies that are linked to the long-term profitability of their institutions, … and most importantly, to prioritize the long-term health of their firms and their shareholders….

This focus on the long-term is common and uncontroversial. Even Marty Lipton, who with two co-authors recently wrote a memo that disagrees strenuously with pretty much everything in Senator Schumer’s bill, emphatically agrees with Senator Schumer on the importance of the long-term:

Short-termism is a disease that infects American business and distorts management and boardroom judgment.

Senator Schumer’s bill blames management and boards for this short-termism, while Lipton blames shareholders for it, but each agrees that the short-term is the wrong term.

I don’t agree. Sure, sometimes the short-term is the wrong time-frame, but other times the short-term is exactly the right time-frame. It all depends on the context.

For an investor, a long-term buy-and-hold strategy makes a lot of sense while markets are rising, but it looks a lot less attractive in declining markets. A lot of investors today now wish they’d been infected with a severe case of short-termitis last fall.

Similarly, a company may rationally believe that pursuing a ten year plan will maximize its value, but if someone then comes along and makes a better offer, all of a sudden that same company may rationally prefer a short-term strategy.

So why does long-term get all the glory?

I expect Senator Schumer’s real concern is preventing game-playing in executive compensation, with executives taking bonuses based on short-term results and leaving shareholders with long-term losses. This game can only be played when a company’s compensation incentives do not further its goals. A well-designed compensation system prevents this game-playing by ensuring that management’s incentives are aligned with the company’s goals, whether they be long-term goals or short-term goals (or, at many companies, a combination of both).

And I expect Lipton’s real concern is to protect managers from shareholders. Lipton generalizes that shareholders are short-term in their outlook and that management is long-term (their jobs need preserving, after all), so his demonization of the short-term is neither surprising nor, unless you are a manager in need of Lipton’s entrenchment services, persuasive.

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Best Client Memos: An Introduction

By Mike O'Sullivan | Published: May 11, 2009

Sure, the destruction of our financial system, the evaporation of our savings and the world’s plunge into the Great Recession (or the Not-So-Great Depression) has had its downsides, but it’s not all doom-and-gloom. As the world we knew sinks into the sea of uncertainty, let’s not lose sight of a silver lining: the historic underemployment of corporate lawyers has fostered a renaissance in the client memo.

Just a few years ago, client memos were a slightly embarrassing backwater of the legal scene, high-level spam with fancy formatting ghost-written by bored associates for their partner overseers, egged on law firm marketing consultants, all in a feeble attempt at public chest-thumping (we know something! hire us!) that was undermined by the blizzard of other client memos that simultaneously inundated our inboxes, all saying the same thing at the same time to the same people.

Alas, this still describes most client memos. Does the world need another memo on the Lyondell decision? Must every TARP press release be separately summarized by 47 law firms? Do even the Albanians care about those recent changes to the Albanian securities code?

But last year, just as many of our colleagues started staring at phones that no longer rang, I noticed a distinct uptick in the quantity of high quality memos. These new style memos stood out because they were better written, evinced the deeper understanding of lawyers who’d spent years in the trenches and often looked beyond the headlines of the day for their subjects. As I found myself saving more and more of these memos for future reference, I began to appreciate that they were carving a place for themselves in the pantheon of corporate jurisprudence, in authority and usefulness fully capable of standing in the same room as statutes, rules, C&DIs, Chancery opinions and Broc’s blog.

So each week I sift through fifty or so memos, searching for the occasional nugget. As I sift, I’ll report my more interesting finds in real-time on my Twitter feed. And, as a tribute to the unsung heroes slaving away for our benefit, each week I plan to list here my favorite finds from the previous week.

Without further ado, and in no particular order, here are my nominees for Best Client Memo I Read Last Week:

“Federal Trade Commission Makes Inquiries Into Interlocking Boards” (Simpson Thacher, May 5, 2009). Within a day after the New York Times reported the FTC was examining interlocks between the Apple and Google boards, Simpson Thacher circulated this brief summary of the legal standards behind the news. A good client memos does not have to be a term paper; sometimes all we need is something timely and to the point.

“Raising Equity in Troubled Times: A Survey of Financing Alternatives and Legal Issues” (Milbank Tweed, May 2009). This is actually an article that the firm recirculated as a client memo. It doesn’t matter to me how it originated, all that matters is whether it’s useful. This exemplifies the new breed, providing a real world survey of what is actually going on in the trenches (such as they are these days).

“Corporate Governance of Delaware Corporations: Delaware Adopts Amendments to the Delaware General Corporation Law Relating to Corporate Governance” (Sullivan & Cromwell, April 28, 2009). It seems there’ve been a thousand memos describing the recent proxy-related amendments to the DGCL. In this memo S&C does a good job summarizing these changes and, more importantly, relating them to other changes that have occurred and are expected to occur in the proxy solicitation process.

If you’d like me to consider your firm’s memos for future installments of this feature, please add providedhowever (all one word, no punctuation) at gmail dot com to your firm’s mailing list.

A few firms still circulate client memos exclusively to clients (imagine that!), and do not make them publicly-available. Even when I obtain those memos (I have my ways), I will respect their decision not to make them available to the rest of us. Seeing little point in drawing your attention to memos you can’t read, I won’t bother listing them here.

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The Great Man Theory and Executive Compensation

By Mike O'Sullivan | Published: May 6, 2009

“The history of the world is the biography of great men.” That statement by Thomas Carlyle, a nineteenth century historian, embodies the Great Man Theory of history, in which historical events are explained by the people who led them.

These days, professional historians shun the Great Man Theory of history. Instead, they focus on the social, political, economic, geographic, technological and other forces that shaped historical developments. They believe this offers a deeper explanation for human events. They would agree with Herbert Spencer’s observation on Carlyle’s Great Man: “Before he can remake his society, his society must make him.”

While the Great Man Theory has disappeared from academia, it continues to thrive in popular histories. To the extent people read history at all, they tend to read it in biographical form. We’d rather read stories about people than analyses of abstract concepts, even if that means we’re getting a shallower explanation.

Our preference for people over concepts runs deep in our psyche, influencing our perception of all sorts of events. When faced with something complex and abstract like the “economy,” our brains could try to grapple with the immensely complex global web of interrelated exchanges that comprise our modern economy, but it’s so much more intuitive and comforting to fall back on visions of President Obama pulling levers and twisting dials as he steers the economy. Similarly, when things go wrong, our first instinct isn’t to examine the systemic underpinnings of the crisis, it’s to find us some villains.

So what does all this have to do with executive compensation?

In executive compensation, the CEO is the Great Man. If the company does well, or the stock price increases, we give the CEO the credit and lavish him with the lucre. If the company doesn’t do well, or its stock price decreases, we blame the CEO and organize a lynch mob.

In each case, our instinct to personalize complex and abstract concepts leads us into attribution errors. A company’s performance depends on many factors, only some of which are in the CEO’s control. If commodity prices fall, or if a large customer goes out of business, or if a large competitor stumbles, or if interest rates decline, giving the CEO the credit or the blame probably isn’t analytically correct, but it is so easy, intuitive and satisfying to do so that we do it anyways.

These Great Man attribution errors can be costly, causing us to overpay bad CEOs in good times and underpay good CEOs in bad times. They distort incentives, making it less likely that a compensation program will function as a useful tool. They also distract – after all, investors ultimately want great companies, not great CEOs. A great company should not need a great CEO; its business should be so strong that it should do well even with a mediocre CEO.

Warren Buffett supposedly once described a particular company’s business as being so good that even a ham sandwich could run it. This suggests a different approach to executive compensation: the Great Ham Theory. Under this theory, we’d reward CEOs who made themselves superfluous and punish those who persisted in making themselves essential.

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