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From the Pages of The Pomerantz Monitor: The Value of Private Enforcement of Securities Laws

According to an article in the May/June issue of The Pomerantz Monitor, it has long been recognized that private enforcement is a necessary supplement to the enforcement capabilities of the Securities and Exchange Commission (“SEC”). This proposition is embodied in the idea of a “private attorney general” to police violations of the securities laws, and was endorsed explicitly by the United States Supreme Court since the mid-1960s.

Private litigation often focuses on retroactive payments to damaged investors and corporate governance, while SEC enforcement actions result in injunctive relief, including “cease and desist” orders or the barring of individuals from serving as officers or directors of public companies. More recently, the SEC has itself obtained monetary awards as restitution and sought to disseminate such awards to injured investors directly under the Fair Funds Act. Some commentators now question the need for private securities litigation at all, suggesting that the SEC should be the sole enforcement mechanism for violations of our securities laws. 

From the Pages of The Pomerantz Monitor: LAMPERS Takes on Excessive Compensation

As reported by Fei-Lu Qian in an April PomTalk post, the Louisiana Municipal Police Employees’ Retirement System (“LAMPERS”) took the responsible step in demanding answers and accountability from directors of Chesapeake Energy by filing a “books and records” demand in a state court of Oklahoma. If the demand is granted, shareholders of Chesapeake will be able to examine the company’s corporate documents to see if the board’s approval of a $75 million bonus to its chief executive officer was proper. In the May/June issue of The Pomerantz Monitor, Marc Gross more fully explains the background of the lawsuit commenced by Pomerantz on behalf of LAMPERS to recoup the $75 million bonus.

The extraordinary bonus was awarded to Chesapeake’s CEO and co-founder, Aubrey McClendon. McClendon’s total compensation for 2008 was $105 million, making him the highest paid executive in the country at a time when the company’s earnings plummeted 50% and stock price tumbled 60%. The company claims that it granted the bonus – five times McClendon’s average annual compensation, including both salary and bonus – to reward him for his role in selling off certain oil and gas properties during 2008.

The real purpose of the bonus, we submit, was to bail out McClendon from his personal financial problems precipitated by the fall in the company’s share price. In other words, Chesapeake used corporate funds to insulate its CEO from the consequences of the corporate meltdown, while shareholders got stuck with their losses

The bail out was even larger than at first appeared. After the lawsuit was filed, Chesapeake issued a Proxy Statement indicating that it also agreed to pay McClendon over $12 million for his personal art collection.

In its opposition to our lawsuit, Chesapeake argues that if it weren’t for the bonus, McClendon might have jumped ship in favor of other opportunities. This seems far fetched, given that McClendon founded the company and still has a sizable stake in its wells. Moreover, the Board had other ways to insure his retention, like lowering the share ownership requirement – which it did – and providing loans to help him meet his obligations.

A similar books and records strategy was used successfully at the start of the Disney/Ovitz excess compensation case, and is favored by Delaware courts. Although Chesapeake is an Oklahoma corporation, that state follows Delaware corporate law.

We believe that the Chesapeake case warrants support by other public pension funds concerned with corporate governance reforms, either by direct intervention or a letter to the court. If ever there was a time to draw the line on excess compensation, it is now.

In pursuing this claim, Pomerantz harkens back to its roots. The firm’s first major case was Gallant v. Mitchell, where Abe Pomerantz sought to recoup interest-free loans that officers of National City Bank awarded themselves to tide them through the Great Depression (loans which they ultimately forgave). After trial, Abe recovered $1.8 million, a small fortune in the 1930’s.

Wall Street Back to Its Old Ways

As there are some small signs of recovery in the financial crisis, the large Wall Street financial firms are beginning to get back to their normal practice of dishing out huge pay packages. According to an article in the Wall Street Journal, analysts estimate for this year, Goldman Sachs will pay out as much as $20 billion, or about $700,000 per employee. This would be almost double the firm’s $363,000 average last year. Similarly, Morgan Stanley is estimated to pay out between $11 billion and $14 billion in compensation and benefits this year. This range will be about $340,000 per employee, similar to the paid out in Morgan Stanley’s fiscal 2007. One recruiter that fills jobs for Wall Street firms believes that the current “euphoria about bonuses is based on the expectation that the business is returning to normal and that we will be in a robust environment again.”  

SEC to Decide on Broker Discretionary Voting

On July 1, 2009, the SEC will hold a Sunshine Act Meeting at which it will consider the issue of instructed broker voting.  The New York Stock Exchange (“NYSE”) has long classified uncontested director elections under Rule 452 as a “routine matter,” giving brokers the discretion to vote shares held in investors’ accounts when they do not receive voting instructions from the beneficial owner within ten days of a company’s meeting.  The NYSE first proposed an amendment to NYSE Rule 452 in October 2006.  The NYSE proposal would re-classify director elections as a non-routine matter on which NYSE member organizations are not permitted to vote—regardless of which exchange the company is listed on—without instructions from the beneficial owner.  Brokers would no longer be able to vote uninstructed shares, effectively reducing the number of votes in favor of board-nominated directors.  If adopted, this amendment is expected to make it more difficult for companies with “majority voting” provisions to achieve successful elections.  Companies may need to increase their solicitation efforts to reach non-responding shareholders, which is likely to increase the costs of uncontested elections.  At least three of the five SEC commissioners have stated publicly that they support the change.  Click here to review a copy of the proposed rule.

Regulation of OTC Derivatives is on the Horizon

Following the Obama Administration's proposals last week to bring tighter regulation to financial markets, SEC Chairwoman Mary Schapiro testified before a Senate Banking subcommittee today that it would be relatively simple to change the law to allow for the regulation of over-the-counter (OTC) derivatives and emphasized that this step is needed to help the SEC ensure the proper regulation of securities markets. Companies use OTC derivatives as a risk management tool to manage their exposure to interest rate, currency exchange rate, commodity price, and other risks inherent in their businesses. In her testimony, Schapiro said that regulating the OTC market is necessary because positions in securities-related OTC derivatives can be used to simulate positions in securities markets.  Legislation to enhance regulation of OTC derivatives has already been introduced in the House of Representatives and the U.S. Senate and is a direct reaction to the herculean growth of the $680 trillion OTC derivatives market, highly publicized issues surrounding the use of credit derivatives and crises involving major derivative counterparties such as Bear Stearns, Lehman Brothers and AIG that resulted in systemic risk to global financial markets.   Passage of any such legislation would bring OTC derivatives under a comprehensive regulatory regime for the first time.

Proponents of regulating the OTC market say that it would mean a more sound securities market in part because it would help the SEC look for fraud.  As Schapiro testified, currently it is hard to examine OTC trades for fraud because it is hard to find trade information in the unregulated market and the exclusion of certain securities-related OTC derivatives from most of the securities regulatory regime has undermined the SEC's ability to adequately protect investors.  She testified that making the necessary changes is as simple as changing the definition of "security" in current law to cover securities-related OTC derivatives as well as eliminating the “swaps” exclusion from the laws.  Non-securities related OTC derivatives would be under the purview of the Commodity Futures Trading Commission.  With influential proponents like President Obama, Timothy Geithner, the SEC and various Congressmen behind increased oversight in the financial markets, bringing securities related OTC derivatives under regulatory control seems imminent.

Empowering Shareholders Through Legislation

There are at least two bills in the current Congress that are worth noting, the Shareholder Empowerment Act of 2009 and the Shareholder Bill of Rights Act of 2009. According to the Council of Institutional Investors, the bills will "strengthen investors' oversight of management and boards" and "improve corporate governance."

Supreme Court Expansion Of Twombly

The Supreme Court decision in Bell Atlantic v. Twombly, 550 U.S. 544 (2007) created some debate whether the decision applied to non-antitrust cases.  The Supreme Court’s recent decision in Ashcroft v. Iqbal, No. 07-1015 (U.S. May 18, 2009) applying Twombly to a non-antitrust case makes clear that Twombly has broad reach. A copy of the decision is here.

New Rule FAS 165

Last month, the Financial Accounting Standards Board (FASB) issued a new rule, which will be applied to the accounting for, and disclosure of, subsequent events not addressed in other applicable Generally Accepted Accounting Principles (GAAP).  FAS 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The rule explains that corporate financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for "general use and reliance" in a form and format that complies with GAAP. Further, financial statements are considered available to be issued when they are complete, which again means that they are in a form and format that complies with GAAP, and all approvals necessary for issuance have been obtained.  FAS 165 provides that companies should recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. The settlement of litigation after the balance sheet date, but before the date the financial statements are issued or available to be issued, falls within this category of subsequent events in cases where the events which "gave rise to" the litigation had taken place before the balance sheet date.  When a company is required to issue a restatement, FAS 165 provides that it should not recognize events occurring between the time the financial statements were issued or available to be issued, and the time the financial statements were re-issued, unless the adjustment is required by GAAP or by regulatory requirements.  FAS 165 will apply with respect to interim or annual reporting periods ending after June 15, 2009.  Click here to see the rule.

Movement Grows to Split Chair, CEO Posts

The shareholder ouster last month of Bank of America CEO Ken Lewis from the company’s chairmanship position highlights the growing sentiment that the roles of chairman and CEO should be split. In recent months, in part due to the financial crisis, there has been a renewed cry among governance advocates that U.S. public companies should divide the leadership roles of chief executive officer and chairman of the board of directors among two individuals. It is no coincidence that the major financial institutions that have floundered the most, such as Bear Stearns, Lehman, Citigroup, Bank of America, Washington Mutual and Wachovia, all had one person in the combined roles before the current crisis exploded.

According to a study by the Corporate Library, nearly two thirds of S&P 500 companies are led by one person, who can easily influence the Board’s process. The Corporate Library believes that a “board that retains the dual role out of reluctance to challenge a powerful chief executive may not be a strong protector of shareholder interests in other respects” and be “more likely to have certain troubling governance characteristics than companies where the roles are separated.” This is a stark contrast to European public companies. All German and Dutch companies divide the roles. In Great Britain, since a major 1992 corporate governance reform, almost 95% of the FTSE 350 companies have different individuals in the chair and CEO positions.

In his op-ed article in the Wall Street Journal, Gary Wilson, a director of Yahoo, states that such “a CEO can dominate his board and is accountable to no one.” 

Where there is both a CEO and a separate chairman of the Board, the CEO can focus on running the business while the independent chairman can lead the board, recruit new members and manage CEO succession. Simply put, the independent chairman, among other things, curbs conflicts of interest, promotes oversight of risk and manages the relationship between the board and CEO. Indeed, in Europe, according to Wilson, the separation “has shifted the power balance to the board and owners, and away from management, and it appears that the owners are getting more bang for their euro in executive compensation.” John Weston, the former CEO of BAE, agrees that splitting the two roles is vital to a company because the separate chairman model “makes it very clear the chief executive has somebody else he is responsible to besides shareholders.” More importantly, the board of directors can truly focus on the best interest of shareholders, not the CEO.

Opponents of this reform argue that separating the two roles can cause confusion in the chain of responsibility and create unnecessary power struggles when the outside chairman get too heavily involved in day-to-day operations. Another argument opponents make is that a lead director who mainly conducts executive meetings among outside board members takes care of this concern.

These arguments fall short. For example, Paul Myners, the chairman of Land Securities Group PLC and former chairman of Marks & Spencer Group, quit his membership on the board of Bank of New York Co. in 2006, saying that a single chairman and CEO “allows one person to be too dominant.” The lead director model falls short in achieving independence and is not equivalent to an outside chair because “the lead director has little practical power and is frequently selected by the chairman/CEO” according to Wilson. Moreover, with an outside chairman, directors tend to speak more freely, shaping board dialogue.

Spearheading the reform effort is the Chairmen’s Forum, a peer organization of independent chairmen of corporate boards convened by The Millstein Center for Corporate Governance and Performance at the Yale School of Management. The group is led by Harry Pearce, a retired General Motors Corp. vice chairman who is the Non-Executive Chairman of Nortel Networks Corp. and the Chairman of MDU Resources Group, Inc. The group recognizes that an independent chairman “is a key factor in good corporate governance and the protection of shareholder interests” and in this current economic crisis “the establishment of an independent chairmanship by corporate boards is an important element in restoring market trust.” Thus, the Chairmen’s Forum recommends that public companies appoint independent, non-executive chairmen and if they do not, that they explain to shareholders “why, in their view, combining the chairman and CEO responsibilities in one person, or naming a non-independent chair, represents a superior approach to optimizing shareowner value.” Recently, the group published a policy briefing, entitled Chairing the Board: The Case for Independent Leadership in Corporate North America, arguing that “an independent chairman is a means to ensuring chief executives are accountable for managing public companies in close alignment with the interests of shareholders, while recognizing that managing a public company board is a separate, time intensive responsibility.”

In a recent speech to the Council of Institutional Investors, the new SEC Chair, Mary Schapiro, hinted that the SEC is “considering whether boards should disclose to shareholders their reasons for choosing their particular leadership structure – whether that structure includes an independent chair, a non-independent chair, or a combined CEO/chair.” According to the RiskMetrics Group, the recent vote by Bank of America shareholders to separate the two positions is the first time that shareholders have forced an S&P 500 company to split the two posts.

The Heated Debate Over EPS Guidance

A debate is brewing over whether the use of earnings-per-share ("EPS") guidance provides the most accurate picture for investors and whether in today's economic environment, it is irresponsible and risky for companies to emphasize short-term results rather than long term value.  As a result, in recent years, more and more U.S. public companies are shying away from issuing quarterly EPS forecasts.

In the past, EPS guidance represented a crucial aspect of share analysis and investor communications, but issuing accurate guidance has become increasingly problematic because of many factors, including trouble estimating cash flow due to difficulties with drawing down credit and predicting customer demand.  Proof lies in the fact that 80 percent of S&P 500 companies revised earnings downward this past year.

There are concerns that in the current economic climate which is screaming for increased transparency, the elimination of quarterly EPS guidance could have the opposite effect.  Opponents of EPS guidance take the contradictory view that providing EPS guidance decreases transparency and that it is more important to focus on long term metrics and business strategy.  As an alternative to providing EPS information, some companies are providing guidance as to specific line items that they can forecast with confidence, such as operating expenses, capital expenditures, and other company-specific charges and developments.  Another alternative, which may prevent the decrease in transparency threatened by the elimination of EPS guidance, is to provide qualitative disclosures as opposed to quantitative disclosures.  The bottom line is that every company's audit committee needs to carefully review any guidance prior to disclosureand determine whether providing EPS guidance is the best way for that particular company to provide transparency for the market.