Special Links Edition: Corporate Governance Caselaw

• [I]n every case, corporate action must be twice tested: first, by the technical rules having to do with the existence and proper exercise of the power; second, by equitable rules somewhat analogous to those which apply in favor of a cestui que truest to the trustee's exercise of wide powers granted to him in the instrument making him a fiduciary. [Adolphe A. Berle, Corporate Powers As Powers In Trust]
• One of the pillars of our law with regard to public companies is that they must be run for the benefit of their stockholders. That goal, at times, can be difficult to square with the managers’ desire to compensate the company’s executives generously for their hard work and commitment to the business. To be sure, it is right and proper to incentivize executives to stay with a company and to work hard for its success. But how much incentive compensation is proper? In many companies, this question can be decided by board members who have no personal interest in the matter and aim to fulfill their fiduciary duties to make informed decisions in the company’s best interest. In these instances, the independent directors’ disinterested decision generally is entitled to deference under the business judgment rule. But, a s is often the case in small, family – run businesses, those making the compensation decisions and those receiving the compensation are one and the same. That dynamic can be problematic. It is made even more so when the self – interested decisions are made without proper documentation (in the form of board minutes or otherwise) and without objective evidence supporting them. Unfortunately, that is how the events giving rise to this litigation unfolded. The Company’s board decided it needed to incentivize its officers and pay compensation closer to that of their investment management industry peers. Accordingly, the board decided to grant stock options to certain officers. In doing so, however, the board members granted stock options to themselves, as each board member also served in an executive capacity and each was granted stock options in that capacity. When deciding the terms of the option awards, the board chose not to hire a compensation consultant, used a comparable companies analysis that was neither well – documented nor well – substantiated, agreed that a portion of the consideration for the options could be paid over time as evidenced by promissory notes, and then forgave those notes long before they were paid in full. The contemporaneous evidence of the board’s “process” with respect to the stock option grants is, in a word, thin. Consequently, the Court was left to view the process through a retrospective lens ground in the after-the-fact testimony of the conflicted fiduciaries who made the decisions. As conflicted fiduciaries, Defendants were obliged to prove that the stock options they granted themselves were entirely fair; that is, their burden was to prove that the grant was the product of a fair process that yielded a fair result. They failed to carry that burden. Consequently, I find that Defendants breached their fiduciary duty of loyalty with respect to the option grants. [The Ravenswood Investment Company, L.P. v. The Estate of Bassett S. Winmill]
• Delaware law on fair value addresses the resulting tension by empowering a court to make normalizing adjustments to account for expenses that reflect controller selfdealing when the plaintiff/petitioner provides an adequate evidentiary basis for the adjustment. Most pertinently, in Radiology Associates, the Court awarded fair value after adjusting the projected salaries to be paid to the controlling individuals who implemented the freeze-out merger to remove an amount deemed to constitute a return on equity rather than compensation. [Ginette Reis v. Hazelett Strip-Casting Corp.]
• Any claim by defendants that the salary expenses do not represent, at least in part, a return on equity is wholly without merit. If the salaries do not represent entirely a return on equity, they represent, at least, a partial return on equity. Thus, Ms. Danyluk's calculations which, in effect, treat the salaries as part salary expense and part return on equity is much more appealing than defendants' desire to treat the distributions entirely as salary expenses and general and administrative expenses. [In Re Radiology Associates, Inc.]
• Delaware law, which this Court has looked to for explicating the law of corporate opportunity, similarly holds that "[t]here is no `safe harbor' for such divided loyalties. . . . When directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain. [Citations omitted.] The requirement of fairness is unflinching in its demand that where one stands on both sides of a transaction he has the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by the courts." Weinberger v. UOP, Inc., 457 A.2d 701, 710-11 (Del. 1983). [Mitchell v. K&B FABRICATORS, INC.]
• The petitioners submit that evidence concerning acts of unfair dealing with respect to the merger was introduced, in the case sub judice, for two distinct purposes: first, in support of the unfair dealing claim, and second, to impeach the credibility of appellants' valuation contentions. In fact, the Court of Chancery noted that "[m]uch of the evidence introduced by petitioners to impeach the credibility of respondents' valuation contentions is also offered as support for the unfair dealing claim." Id. at 6. The petitioners argue that after their unfair dealing claim was properly dismissed from the appraisal proceeding, the Court of Chancery was nevertheless entitled to consider the evidence of unfair dealing for the alternate purpose for which it was introduced, i.e., to impeach the respondents' credibility. We agree. The respondents' argument fails to recognize the distinction between the propriety of considering an act of unfair dealing, which may relate to a party's credibility, and the impropriety of considering an action for unfair dealing in an appraisal proceeding. Although the justiciable issue in an appraisal action is a limited one, the statute specifically provides that "all relevant factors" are to be considered by the Court of Chancery "in determining *258 the fair value" of shares which are subject to appraisal. 8 Del.C. § 262(h); Cavalier Oil Corp. v. Harnett, 564 A.2d at 1142-43; Weinberger v. UOP, Inc., 457 A.2d at 713. There is nothing in the appraisal statute or this Court's prior holdings, including Cede, which suggests that the Court of Chancery may not consider the respondents' conduct at the time of the merger in assessing the credibility of the respondents' testimony in support of their valuation contentions in an appraisal proceeding. This Court has recognized that the weight to be ascribed to expert valuations necessarily depends on the validity of the assumptions underlying them. See Cavalier Oil Corp. v. Harnett, 564 A.2d at 1146. Where those assumptions are values supplied by others, the conduct of such other persons is probative of their credibility and of the information being supplied to the expert. The credibility of the respondents was squarely at issue in this appraisal proceeding because the experts retained by the respondents relied upon information supplied to them by the respondents. [Alabama By-Products Corp. v. Neal]
• An essential aspect of our form of corporate law is the balance between law (in the form of statute and contract, including the contracts governing the internal affairs of corporations, such as charters and bylaws) and equity (in the form of concepts of fiduciary duty). Stockholders can entrust directors with broad legal authority precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty. Therefore, the entrustment to the Randall Bearings Compensation Committee of the authority to issue up to 200,000 shares to key employees under discretionary terms and conditions cannot reasonably be interpreted as a license for the Committee and other directors making proposals to it to do whatever they wished, unconstrained by equity. Rather, it is best understood as a decision by the stockholders to give the directors broad legal authority and to rely upon the policing of equity to ensure that that authority would be utilized properly. [Sample v. Morgan]
• While these cases remain the law in Alabama, the adoption in 1959 of what is now § 10-2A-195(a)(1) "liberalized the law regarding dissolutions" and extended the jurisdiction of the court to dissolve and liquidate corporations. Abel v. Forrest Realty, Inc., 484 So.2d 1069, 1072 (Ala.1986); see Belcher v. Birmingham Trust Nat'l Bank, 348 F.Supp. 61, 148 (N.D.Ala.1968) (construing Tit. 10, § 21(78), Ala.Code 1940). The inclusion of "illegal, oppressive or fraudulent" acts by "directors or those in control," as grounds for appointment of a receiver under § 10-2A-195(a)(1), reflects the legislative extension of the remedy to do more than just protect or rescue the underlying assets of the corporation from wilfully destructive conduct of controlling shareholders. Consonant with this legislative expansion of protectible interests is this Court's recognition of a duty on the part of majority shareholders to act fairly toward minority interests. [Fulton v. Callahan]
• In Fulton v. Callahan, 621 So.2d 1235, 1245 (Ala.1993), this Court recognized that a shareholder could recover damages on his own behalf for a violation of the statutory provision quoted above, which was then codified at § 10-2A-71, Ala.Code 1975, notwithstanding that it does not expressly provide for a civil remedy. Previously, in Belcher v. Birmingham Trust Nat'l Bank, 348 F.Supp. 61, 147 (N.D.Ala.1968), stay denied, 395 F.2d 763 *763 685 (5th Cir.1968), a federal district court had held that Tit. 10, § 21(63), Ala.Code 1940, a criminal statute with language similar to § 10-2A-71, implied an independent civil cause of action. See Fulton, at 1246. Following the Belcher court, we delineated in Fulton the elements of a claim based on a violation of § 10-2A-71: "(1) A defendant who is a president, director, or managing officer, irrespective of title, (2) An act or a declaration or statement, in writing or otherwise, (3) Intent to depreciate the value of the corporation's stock or bonds, with the further intent to enable the director or officer defendant, or another person, to buy the corporation's stock or bonds at less than their real value, and (4) damage. The measure of damages is the difference between the real and the depreciated value of the stock at the time the defendant perpetrates the wrongfully depreciating act." [Brooks v. Hill]
• The business-judgment rule, however, does not operate to protect self-dealing by directors and officers. 3A Fletcher, supra, § 1040; Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360-61 (Del.1993); see also Jones v. Ellis, 551 So.2d 396, 400-01 (Ala.1989); Ingalls Iron Works Co. v. Ingalls Found., 266 Ala. 656, 98 So.2d 30, 39 (1957). In other words, if the defendant has engaged the corporation in a conflicting-interest transaction or has usurped a corporate opportunity, the business-judgment rule will not bar a claim based on the duty of care. The Supreme Court of Delaware has described the business-judgment rule as part-procedural and part-substantive. Cede, 634 A.2d at 360. Substantively, the rule prohibits courts from second-guessing the good-faith business judgments of corporate management. Id. Procedurally, the rule creates a burden-shifting mechanism: a corporate decision carries a presumption of due care; but if the plaintiff demonstrates fraud, bad faith, or self-dealing by management, the presumption is rebutted and the burden shifts to the defendant to show that the challenged decision was fair to the corporation. Id. at 361. Here, because Dorsey's actions regarding the promissory note, the CD & O land purchase, and the TD & O billboard lease were not disinterested, Davis is able to rebut the presumption of due care that would otherwise attach to these decisions. [Davis v. Dorsey]
• Furthermore, with respect to transactions between corporations with common directors, we recognize: "`The relation of directors to corporations is of such a fiduciary nature that transactions between boards having common members are regarded as jealously by the law as are personal dealings between a director and his corporation; and where the fairness of such transactions is challenged, the burden is upon those who would maintain them to show their entire fairness; and where a sale is involved, the full adequacy of the consideration. Especially is this true where a common director is dominating in influence or in character. This court has been consistently emphatic in the application of this rule, which, it has declared, is founded in soundest morality, and we now add, in the soundest business policy.'" Belcher, 348 F.Supp. at 107 (quoting Geddes v. Anaconda Copper Mining Co., 254 U.S. 590, 41 S.Ct. 209, 65 L.Ed. 425 (1921) (emphasis added). Further, in regard to sales by an officer to a corporation, the Belcher court stated: "`The burden is upon the officer to show that no advantage was taken of his position, and that the transaction was in good faith. It may easily occur that such an officer may sell property to the corporation at a price in excess of its value; but it is essential to the validity of the sale that he, and those representing the corporation, thought it within the value, or thought that some benefit would accrue to the corporation by the purchase. The good faith in the transaction will preserve it. But there must be no imposition upon the corporation; there must be no taking advantage of the position; there must be no exercise of an improper influence upon the persons charged with the management of the affairs of the corporation.' "Alabama follows this rule as to the burden of proof. Western Grain Company Cases, 264 Ala. 145, 85 So.2d 395 [(1955)]." [Jones v. Ellis]
• In reaching this conclusion, the Delaware court reasoned: "The application of a discount to a minority shareholder is contrary to the requirement that the company be viewed as a `going concern.' ... Where there is no objective market data available, the appraisal process is not intended to construct a pro forma sale but to assume that the shareholder was willing to maintain his investment position, however slight, had the merger not occurred. Discounting individual share holdings injects into the appraisal process speculation on the various factors which may dictate the marketability of minority shareholdings. More important, to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result." Id. at 1145. We hereby adopt the Delaware fair-value standard insofar as it prohibits discounting for lack of marketability, or otherwise, at the shareholder level. [Ex parte BARON SERVICES, INC.]
• In the leading case of Rogers v. Hill, 289 U.S. 582, 53 S.Ct. 731, 77 L.Ed. 1385, cited by this Court in Edmonson v. First National Bank of Birmingham, 256 Ala. 449, 55 So.2d 338, the rule was enunciated that where the amount of a bonus payment to officers of a corporation has no reasonable relation to the value of service for which it is given, it is in reality a gift and the majority stockholders have no power to give away corporate property against the protest of a minority stockholder. A long line of Alabama cases recognizes the general rule that where officers of a corporation appropriate assets of the corporation to their own use, equity will intervene on behalf of a minority stockholder who is unable to obtain relief within the corporation. See Decatur Mineral & Land Co. v. Palm, 113 Ala. 531, 21 So. 315; Donald v. Manufacturers' Export Co., 142 Ala. 578, 38 So. 841; Glass v. Stamps, 213 Ala. 95, 104 So. 237; Holcomb v. Forsyth, 216 Ala. 486, 113 So. 516; Gettinger v. Heaney, 220 Ala. 613, 127 So. 195; First Nat. Bank of Birmingham v. Forman, 230 Ala. 185, 160 So. 109. See also Edmonson v. First Nat. Bank of Birmingham, supra. The foregoing cases are illustrative of the principle that the receipt of excessive compensation by the officers of a corporation is manifestly an appropriation of corporate assets by said officers to their own use. See also Textile Mills v. Colpack, 264 Ala. 669, 89 So.2d 187; Bronaugh v. Evans, 204 Ala. 153, 85 So. 556. The question of whether the compensation is so excessive that it bears no reasonable relation to the value of services rendered is a question of fact to be resolved on final hearing. It was observed in Gallin v. National City Bank of New York, 152 Misc. 679, 273 N.Y.S. 87, 114; 155 Misc. 880, 281 N.Y.S. 795, that "To come within the rule of reason the compensation must be in proportion to the executive's ability, services and time devoted to the company, difficulties involved, responsibilities assumed, success achieved, amounts under jurisdiction, corporate earnings, profits and prosperity, increase in volume or quality of business or both and all other relevant facts and circumstances; nor should it be unfair to stockholders in unduly diminishing dividends properly payable." [Smith v. Dunlap]

Stilwell Letter to HopFed Bancorp, Inc.

Second, any fool can grow a bank substantially in asset size over 16 years. The fact that you equate asset size to “enhancing long-term shareholder value”—as opposed to per share book value or per share earnings or return on equity or return on assets is perhaps why you don’t understand what a truly poor job Mr. Peck has been doing.

Another "Market Failure" Caused by Government

Comment:

I think the market for ownership of companies is incredibly corrupt in this country and many like it with similar tax and regulatory structures. The double taxation of dividends and the taxation of corporate income breed an environment where the most tax efficient way to maximize shareholder value is to retain earnings in the company to avoid dividend tax, and to spend these retained earnings on "growth" opportunities, usually acquisitions or risky skunk works ventures, to try to grow market value.

Paper: "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers"

Highlights:

• Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.
• Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control. It is also associated with increases in managers’ compensation, because changes in compensation are positively related to the growth in sales. The tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates a strong organizational bias toward growth to supply the new positions that such promotion-based reward systems require.
• Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments.

So what does this suggest could be done to improve capital allocation? The debt solution is probably a pretty good one since it is also tax efficient. On the other hand, we are so anti-debt that it's worth looking at a couple other possibilities.

Require shareholder approval to spend funds on new capital projects. For example, an S-corp might already have a stipulation that some or all taxable earnings be dividend-ed to shareholders (so that they can meet their tax obligations). That would require management to try to raise new capital through some other means, for example a rights offering (which seems like a fair tool to use). The rights offering might be improved upon by requiring shareholder approval before implementation.

Perhaps the organizational bias towards growth could be defeated by increased profit sharing or employee ownership instead of rewarding strictly via promotion.

Worse Than Just Crowded Trades: Investing "Anti-Strategies"

I wrote recently that "There are no evergreen investment strategies that will always work."

That may sound like an obvious statement, but I would strongly argue that many investors are blithely implementing strategies that are so crowded and tired that they should now be considered "anti-strategies."

The two examples I have thought of recently are spinoffs and merger-arb. This year the two really good spinoff plays were shorts; both comically obvious "garbage barge" just-in-time dumpings of obsolete assets: CVEO and PGN. Similarly, the rare opportunity to make worthwhile money in merger arb would be to look for the deals that are going to break.

My point is that: Many shall fall that are now in honor, and many shall be restored that are now fallen. Looking at the "ecosystem" of investment managers, what you would expect to happen is for the fat, old, lazy managers who are coasting on something novel that they did decades ago to rotate out of the business after some shock to the system. (Equity crash with interest rates staying low would be one scenario.)

A correspondent contributes:

I've been meaning to do a post on activist investing. I think it qualifies as another anti-strategy. In addition to being overcrowded, it has a few issues that make it inherently likely to fail:

1. Most of the activists are bean-counters with little or no operating experience. They can claim that a company is being mismanaged, and they may be right, but that doesn't mean they have the skills they would need to manage it better.

2. This is speculative, and I haven't seen any studies that verify this, but my impression is that activism becomes more common as valuations rise and it gets later in the economic cycle. When a bull market is in its infancy, there's less need for activism because stocks are cheap enough to deliver strong returns without any governance changes. Once valuations have risen and multiple expansion is off the table, investors need to see cost cuts, governance changes, or something similar to justify further appreciation. There is a "squeezing blood from a turnip" aspect to activism.

3. As a result of 1 and 2, most activist campaigns are gimmicky: calling for spinoffs, issuing debt to buy back stock, or other actions that are designed to juice the stock price but don't improve risk-adjusted returns.

Between the spinoff and the activist campaigns, CVEO is like an anti-strategy singularity. Along with POST, I think people will look back at it as the canary in the coal mine for popular HF strategies. I'm not really familiar with merger arb but I saw your review of Guy Wyser-Pratte's book. Joel Greenblatt wrote about merger arb getting too crowded in the late '90s, and I imagine it's only gotten worse since then.

The review of Risk Arbitrage by Guy Wyser-Pratte is here.

Review of Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World

I recently posted an academic finance paper called "Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts", which offered evidence that executives at public companies waste money on corporate jets. Public ownership creates an agency problem, where long-only mutual funds are asleep at the switch because they have hundreds of positions.

Two ways of solving the agency problem are private equity firms, which link ownership and management, and activist hedge funds, which pressure management into better behavior. I picked up a survey of hedge fund activism called Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World.

It is a pretty good survey of activism, although there is not much in the book that will be a surprise to a sophisticated investor.

Perhaps the most interesting takeaway is how stubbornly the institutional investors (e.g. long only mutual funds, pension funds) resist and stall the efforts of activists to reform companies. There is a conflict of interest, because the institutional managers are often trying to win business from the companies they own, like lucrative retirement account management business. Mutual funds face limits on the concentration of their investments, so even if they wanted to buy a big stake in a company and  pressure for change, they wouldn't be allowed to.

I give this one a 2/5. You can tell it was written by a journalist, because it was light on empirical data like prices, valuation metrics, rates of return from activist strategies, etc. There are useful academic articles on hedge fund activism. For example,

Activism that targets the sale of the company or changes in business strategy, such as refocusing and spinning-off noncore assets, is associated with the largest positive abnormal partial effects, at 8.54% and 5.95%, respectively (the latter figure is lower than the overall sample average because most events target multiple issues). This evidence suggests that hedge funds are able to create value when they see large allocative inefficiencies. In contrast, we find that the market response to capital structure-related activism—including debt restructuring, recapitalization, dividends, and share repurchases—is positive yet insignificant. [2008]

Also, here's a fascinating paper showing that activism in the enforcement of bondholder rights increases when interest rates increase, because

Alas, [t]he remedy scheme for violations of bondholders rights - in particular, the centrality of the acceleration remedy - introduces its own set of imperfections. When treasury interest rates have increased or the stock price of a company that has issued convertible bonds has declined, acceleration generates a windfall: bondholders receive compensation in excess of the harm associated with the violation. In these cases, activists will spend excessive resources in detecting and pursuing potential claims and companies have excessive incentives to stave off potential violations. When treasury rates have declined, the tables are turned, and bondholder rights are underenforced.

Bondholder activism was a big deal circa 2006, because the options backdating scandals led to technical defaults for which holders could demand acceleration. [In the end, the companies would pay consent fees in exchange for waivers by the holders.]