ProfessorBainbridge.com

Fifth Edition of Agency, Partnerships, and Limited Liability Entities is Now Out

It's here. Agency, Partnerships, and Limited Liability Entities: Cases and Materials on Unincorporated Business Associations https://t.co/0H8lqjSdPu pic.twitter.com/PVWeGDPDAv

— Steve Bainbridge (@PrawfBainbridge) April 12, 2022

New Video: A Skeptical Take on Corporate Implementation of ESG

Today's tweets

FYI: Sullivan & Cromwell Discusses Court Decision Invalidating California Board Diversity Lawhttps://t.co/3Zp0rwTS1R

— Steve Bainbridge (@PrawfBainbridge) April 8, 2022

2/ My take on board of director oversight duties with respect to #ESGhttps://t.co/E8GEjMsnGC

— Steve Bainbridge (@PrawfBainbridge) April 8, 2022

@kevinlacroix "Court Strikes Down California Board Diversity Statute" https://t.co/3IGwITNIl7

— Steve Bainbridge (@PrawfBainbridge) April 8, 2022

The Economic (In) Significance of Executive Pay ESG Incentives

Regular readers know I am working on a book entitled "The Profit Motive: Defending Shareholder Value Maximization." I just added this paragraph:

A study by law professor David Walker  examined the compensation of CEOs who were current and recent members of the Business Roundtable’s board. Walker determined that the median percentage of CEO pay that was based on ESG metrics was just 0.2 percent of the value of the CEO’s shares, outstanding equity awards, and other forms of variable compensation. The median ESG-based compensation amounted to just 1.1 percent of the CEOs’ total incentive compensation. The trivial amount of ESG-based compensation is especially striking considering that the same companies devoted, on average, 10% of their proxy statements to ESG issues. Walker concluded that “ESG talk far outweighs ESG walk, at least as far as executive incentives go, and ESG based pay seems more like window dressing than a serious attempt to incentivize executive behavior.”

David I. Walker, The Economic (In) Significance of Executive Pay ESG Incentives, (February 14, 2022), https://ssrn.com/abstract=4034877.

New Article: "Why We Should Keep Teaching Dodge v. Ford Motor Co."

I have just posted a new article to SSRN: Stephen Mark Bainbridge, Why We Should Keep Teaching Dodge v. Ford Motor Co. (April 5, 2022). UCLA School of Law, Public Law Research Paper No. 22-05, Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4076182

Abstract

What is the purpose of the public business corporation? Is it to maximize shareholder value? Or is it to simultaneously enhance the welfare of shareholders, stakeholders, and the larger society? These are perennial questions, of course, but they also have been much in the news in recent years. Whether tagged as stakeholder capitalism, stakeholder theory, corporate social responsibility, or ESG (i.e., environmental, social, and governance), much attention is being paid.

The time has thus seemed propitious to many legal scholars to revisit the law of corporate purpose. Many of these scholars have been influenced by the late Lynn Stout’s work on the topic. Ten years ago, Stout published her book, The Shareholder Value Myth, which built on her earlier article, Why We Should Stop Teaching Dodge v. Ford. As the latter title suggests, Stout’s principal foil was the Dodge case.

Stout’s focus on Dodge was well chosen, as the case is included in almost all law school corporation law and business association casebooks and has been widely discussed in the academic literature. The influence of Stout’s critique of Dodge work was confirmed by a March 31, 2022, search of the Westlaw Law Reviews and Journals database, which identified 98 articles published in the last three years that cited her book and 43 during the same period that cited her article.

Given the renewed attention to the corporate purpose question and the continuing influence of Stout’s work on that debate, it seems appropriate to revisit her arguments to determine whether she was correct that law professors should stop teaching Dodge. I conclude that law professors ought to keep teaching Dodge. It was good law when handed down in 1919 and remains good law today.

Keywords: corporate purpose, corporate social responsibility, CSR, ESG, Henry Ford, Dodge v. Ford Motor Co., shareholder primacy, stakeholder theory, stakeholder capitalism, corporate law, shareholder wealth maximization, shareholder value maximization

JEL Classification: K22, L21, M14

Judge Issues an Opinion in the California Board Diversity Quota Statute Litigation, Striking Down the Law

A couple of days ago, I passed along news about Crest v. Padilla, the case in which Judicial Watch challenged the constitutionality of California Corporations Code § 301.4, which requires corporations whose principal executive offices are located in California to have at least a specified number of underrepresented minorities on their boards of directors (the exact minimum number depends on the size of the board). As I said, that the trial judge hearing the case had granted summary judgment in favor of Judicial Watch. The judge has no issued his opinion, a copy of which you can get here.

Meanwhile, litigation against the California board gender diversity quota law continues.

I have long argued that theses statutes were unconstitutional under the internal affairs doctrine insofar as they attempted to regulate companies incorporated outside of Delaware. The Crest v. Padilla court did not discuss that issue. Instead, the court focused exclusively on equal protection issues.

An anecdote illustrating my point that investors aren't willing to pay for ESG

I have been arguing for some time that investors do not want ESG to the extent progressives like SEC Chairman Gary Gensler claim. Herewith an anecdote on point to support the data I've cited before:

In April 2022, Starbucks CEO Howard Schulz announced that the company would suspend a plan that had promised shareholders a three-year program of distributing $20 billion in profits to the shareholders via stock buybacks and dividends. Although Starbucks would continue to pay dividends, it was cancelling the planned stock buybacks. Those buybacks would have amounts to two-thirds of the $20 billion total. At the same time, Schulz announced a shift in corporate focus to employees and customers. If investors really valued stakeholder capitalism, one might have expected Starbucks’ stock price to rise. It fell by 3.7 percent. Heather Haddon, Starbucks to Prioritize Cafes, Not Stock Price, Wall St. J., Apr.5, 2022, at A1, A4.

In commenting on Schulz’s decision, one of the Wall Street Journal’s Heard on the Street columnists casually remarked, almost as though it went without saying, that “Shareholders of course are less impressed by companies that seek to reward ‘all stakeholders.’” Spencer Jakab, Why Starbucks Went Cold Turkey on Buybacks, Wall St. J., Apr.5, 2022, at B12.

Taco Seasoning Mix

• 1 ½ tablespoons paprika
• 1 ½ teaspoons chili powder
• 1 ½ teaspoons ground cumin
• 1 ½ teaspoons corn starch
• 1 teaspoon kosher salt
• 1 teaspoon onion powder
• 1 teaspoon garlic powder
• ½ teaspoon freshly ground black pepper
• ½ teaspoon dried oregano
• ¼ to ¾ teaspoons cayenne pepper

Mix well.

I prefer Morton & Basset spices.

Depending on how much cayenne pepper you add this recipe makes about 3 to 3 ½ tablespoons of seasoning mix. In turn, how much cayenne pepper you add depends on how much heat you want. It also depends on whether you used sweet or hot paprika.

Speaking of paprika, I do not recommend using smoked paprika. Smoke is not a flavor I want in my tacos.

I will usually use around two tablespoons for a pound of ground meat. I typically add 1 tablespoon to the meat as it fries and stir it in to bloom the spices. After botting up excess fat with paper towels, I’ll add a half of a cup of water to the meat, bring it to a boil, and then reduce the heat to a simmer. Let the water reduce to a glaze. While the water is reducing, I’ll taste both the liquid and the meat, and then add additional seasoning as needed.

Keith Bishops Reports "Plaintiffs Prevail In Constitutional Challenge To California Board Quota Law"

Keith Paul Bishop reports:

This afternoon, Judge Terry Green granted the plaintiff's summary judgment motion in a case challenging the constitutionality of AB 979.  Crest v. Padilla, LA Super. Ct. Case No. 20STCV37513.  AB 979 is a California law that purports to require publicly held domestic and foreign corporations having their principal executive offices in California to have a specified minimum number of directors who are members of underrepresented communities.  Cal. Corp. Code §§ 301.4 & 2115.6.   The case had been scheduled to go to trial in May.

I'll follow up ASAP.

Recommended reading: Fisch's "GameStop and the Reemergence of the Retail Investor"

Fisch, Jill E., GameStop and the Reemergence of the Retail Investor (February 8, 2022). U of Penn, Inst for Law & Econ Research Paper No. 22-16, Boston University Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4049896

The GameStop trading frenzy in January 2021 was perhaps the highest profile example of the reemergence of capital market participation by retail investors, a marked shift from the growing domination of those markets by large institutional investors. Some commentators have greeted retail investing, which has been fueled by app-based brokerage accounts and social media, with alarm and called for regulatory reform. The goals of such reforms are twofold. First, critics argue that retail investors need greater protection from the risks of investing in the stock market. Second, they argue that the stock market, in term, needs protection from retail investors.

This Article challenges calls for broad-based regulatory reform. It argues that, although retail investing is likely to impact the capital markets, claims about the harms from increased retail investing are overstated. More importantly, the debate overlooks potential benefits from retail investing both to investors themselves and the capital markets. Regulators should not be clamping down on the conditions such as commission-free trading, gamified trading platforms, and the expanded use of social media, that have enabled a generation of new investors to participate in the capital markets. These innovations, through their ability to facilitate direct market participation by retail investors have the potential to democratize the capital markets and increase the connections between ordinary citizens and U.S. businesses. Regulators should instead be focusing on how to facilitate the effectiveness of that process.

The Article defends the reemergence of the retail investor and its potential promise in enabling citizen capitalism – providing ordinary citizens with a stake in the nation’s productivity while, at the same time, increasing the accountability of those businesses to societal interests. It explains that retail investment can reduce the increasing problematic power of institutional intermediaries. It also holds the possibility of increasing corporate consideration of stakeholder interests without the need for formal structural changes or heavy-handed regulation.

Critically, however, effective citizen capitalism requires retail shareholders to participate in the capital markets on an informed basis. Although the extent to which the GameStop frenzy reflected rational investing behavior is questionable, its effect has been to draw retail investors to the market, and there is evidence that retail investment and engagement will both continue and evolve. The Article identifies opportunities to improve the retail investing experience, including greater oversight of sources of investment information, limiting the manipulative use by brokers of customer information, and the extension of fintech innovation to mechanisms for improving financial literacy. Attention to these concerns, rather than heavy-handed efforts to discourage retail investing, will increase the effectiveness of the retail investor.

A Comment on Leo Strine's Article on "Board Practices in the Digital Era": Time to Revisit Outsourcing the Board with a Note on the Ever Expanding Caremark Doctrine

Former Delaware Supreme Court Justice Leo Strone recently posted a co-authored article, Board Practices in the Digital Era: Maximizing the Benefit-to-Cost Ratio of Information Technology, which argues that:

Information technology can improve the quality of the deliberative processes of corporate boards of directors. Yet, if used imprudently, these technologies can reduce the integrity of corporate decisionmaking and increase business, legal, and reputational risk.

Regrettably, rather than evolving to keep pace with technological developments, corporate governance practices often involve an admixture of obsolete past approaches and ad hoc new ones, a combination that underutilizes the benefits of technology and increases its potential risks. In this article, we look in particular at two types of board-level practices that should evolve to take into account technological developments:

i) board information policies involving (a) the transmission to and use of information by the board of directors and (b) the documentation of action taken by the board and board committees; and

ii) board meeting practices in the wake of the COVID-19 pandemic and the ubiquitous use of web conferencing platforms to conduct director meetings remotely, rather than in person.

These topics are related, because virtual meetings put pressure on board information policies. Virtual meetings require directors and managers to be self-disciplined so that the efficiency advantages that come with virtual meetings are not undermined by inattention, unproductive online interaction, and insufficient in-person time for the board and key managers to meet and develop the chemistry and expectations for information flow vital to successful governance.

This article is not theoretical, but practical. After situating board practice in its historical context, we make recommendations about affirmative steps — “do’s” — that companies could take to improve their board information policies, positive steps that imply actions to avoid — “don’ts”— which we set forth in correlative footnotes. From there, we recommend “do’s” and “don’ts” for board organizational, calendaring, and meeting practices, an understudied area. We then explain how our recommendations facilitate informed, efficient, and credibly-documented decisionmaking.

First, Strine seems untroubled by the prospect that an emphasis on board information flows and meeting procedures is likely to result in directors having greater exposure to Caremark liability. He appears to believe that board failures with respect to overseeing technology and using technology could result in Caremark liability and that that could be a good thing. (See pp. 7-8.)

I have never shared the enthusiasm for Caremark one sees in some circles. To the contrary, I believe Caremark was a mistake from the outset. I also believe the steady expansion of Caremark liability in recent years has been an appalling error. See my article, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight, which is forthcoming in the Business Lawyer, which argues that:

Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational.

Let us turn, however, to the main issue that jumped out at me when I read Strine's article; namely, the ever increasing demands for board expertise.Strine repeatedly calls for boards to have more expertise regarding information technology:

• He posits that Caremark liability arose in cases in which companies "failed to set up structures that ensured adequate time for board members with relevant industry expertise to focus regularly with key company officers on the companies' most important industry-specific issues."
• He thinks companies "need to update board committee structures to prioritize the most important issues at the forefront of board time and to make sure that diverse business risk, EESG, and legal issues are addressed with adequate expertise ...."

The problem is that a combination of increasing regulatory requirements for board expertise, such as the need for financial expertise on the audit committee that resulted from the Sarbanes-Oxley "reforms" to the audit committee, plus the demands of expertise flowing from the steady expansion of Caremark liability, is already forcing companies to seek directors with increasingly specialized expertise. In turn, the demand for specialized firm-specific expertise bumps up against the requirements forcing companies to have almost all board members to be independent directors. 

The problem, as Todd Henderson and I explained in our book, Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance:

In contrast to insiders, who possess significant firm-specific human capital, independent directors tend to be generalists with little firm-specific knowledge, skills, or expertise. Modern boards thus tend to be “composed of individuals who are not qualified to assess the strategic viability of the corporations they direct.” Unfortunately, the rules mandating director indepen- dence virtually ensure that this problem will remain insoluble, because they effectively “rule out just about anybody who has firsthand knowledge of the company and its industry.”...

A board composed principally of generalists will typically lack the sort of specialized skills and expertise many board tasks require.

We also pointed out that the increasing desire on the part of boards to embrace stakeholder theory (a trend I deplore, but that's a story for another day) compounds the needs for board-level expertise:

For the traditional board to manage these stakeholder interests, it will have to have a board member with labor or environmental expertise. Some boards may have these people, but perhaps not. Since the range of potential stakeholders is large, it is unlikely that a firm will have a board member that can claim expertise or networks in all the areas in which a firm may want to deploy the board. After all, boards already need a range of expertise in areas like accounting, finance, strategy, the particular industry, compensation, and a host of other topics.

Strine proposes bringing an insider onto the board:

We also think that the case could be made for adding another member of management to the board; although that individual would not be an independent director, the added expertise and experience would benefit the board as a whole.

But as Henderson and I explained:

Even if there is an expert on labor or environmental issues on the board, there is a potential weakness in relying on an individual board member to be solely responsible for managing this process. Although boards routinely dele- gate authority to committees or subgroups of the board, there is additional risk from having a single individual board member be the only person on the board with the information, expertise, and authority to handle the management of an important stakeholder relationship.

There is, however, a solution. It is a solution that would reduce the risk of Caremark liability and bring a huge increase in expertise to the board. It is what Henderson and I proposed in out book Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance. We asked:

Why does the law require governance to be delivered through individual board members? While tracing the development of boards from quasi-political bodies through the current “monitoring” role, the authors find the reasons for this requirement to be wanting. Instead, they propose that corporations be permitted to hire other business associations – known as “Board Service Providers” or BSPs – to provide governance services. Just as corporations hire law firms, accounting firms, and consulting firms, so too should they be permitted to hire governance firms, a small change that will dramatically increase board accountability and enable governance to be delivered more efficiently.

With regard to the board expertise issue, we pointed out that:

When board members currently need outside expertise, it all too often comes from outsiders hired by or influenced by the CEO, which creates serious conflict-of-interest problems. In the BSP model, by contrast, we assume that the board-service company would have an internal expert staff backing up the individuals who provide the board functions. ... This is a classic example of the choice between “building” (that is, having expertise inside a particular firm) and “buying” (that is, hiring the expertise in the market) that firms face in a host of activities.

As we demonstrate in the book, buying board expertise by outsourcing the board function to a consultant firm is going to be much more efficient.

BSPs are highly adaptable. They are well suited to perform the monitoring function as required by current law and best practices, but they are equally well suited to performing service and managerial functions. Indeed, as we shall see, because BSPs are less subject to time and expertise constraints than individual directors, they are capable of fully carrying out the monitoring function while also simultaneously providing more effective advisory, networking, and managerial services.

So the solution seems to be revisiting the possibilities offered by BSPs.

Tribute for Robert Scott

Another serious problem with the Securities and Environmental Commission climate change disclosure plan

From Bloomberg News:

The proposed language would require companies to disclose to the Securities and Exchange Commission any analyses they use to measure the resilience of their business strategies to climate risks....

Scenario analyses are “dress rehearsals” that companies use to test how potential, hypothetical future scenarios could affect their business.

But the provision would put companies in the position of having to share highly speculative forecasts that may end up being disconnected from reality, according to Cynthia Mabry, a partner at Akin Gump Strauss Hauer & Feld LLP.

“If you had a crystal ball, what would the world look like—how is that helpful to investors?” Mabry asked. “I really struggle with this one. On a Tuesday you could be thinking you see a market opportunity and it’s great, and on Wednesday the war on Ukraine breaks out and you’re not going to do business in Poland.”

If this absurd requirement stays in the rules, one important question will be whether the safe harbor in the 1995 PSLRA cover these scenario analyses.

Prayer to Our Lady of Vladimir, Patroness of Russia, for peace in the Russo-Ukrainian war.

The War in the Ukraine Reveals Two Basic Flaws in ESG Investing

Flaw #1: Prior to the 2022 Russian invasion of Ukraine, ESG indices typically excluded defense contractors. Companies that sell ratings of corporate ESG performance likewise downgraded defense companies. In the wake of outbreak of war, however, many rating firms, ESG funds, and index suppliers are reconsidering the exclusion of defense companies. The Russo-Ukrainian war also raised questions about whether fighting climate change was more socially responsible than dealing with inflation and the impact of energy prices on the poor. James Mackintosh, Do Good Investing is Under Pressure, Wall St. J., Mar, 28, 2022, at B1. Trying to be socially responsible is exceeding difficult when the definition of what is socially responsible involves clashing goals and rapidly changing perceptions about what is pro-social.

Flaw #2: European corporations with major operations in Russia prior to the outbreak of the Russo-Ukrainian war typically had higher ESG ratings than those who were not operating in Russia. Doing extensive business in an increasingly authoritarian and militaristic apparently had little, if any, impact on the ESG industry’s perceptions of those companies. Perhaps even more instructively, however, is that companies with lower ESG ratings were more likely to divest or suspend any Russian operations than did companies with higher ESG ratings. Id. All of which tends to call into question the merits of the ESG industry’s claims to be socially responsible.