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Years ago, Harvard Law professor Hal Scott suggested that New York financial markets could regain competitiveness by permitting securities issuers to opt out of the enormously wasteful securities litigation scam, whereby, on average, diversified shareholders had money transferred from the left-hand pocket to the right-hand pocket with enormous commissions taken by plaintiffs' and defense attorneys.

This year, privately-held Carlyle suggested it might make good on the idea with its IPO, which had a mandatory arbitration clause for such disputes. The SEC had previously, without much legal authority, blocked a less-restrictive arbitration clause in an IPO in the 1980s by Franklin First Financial, but Carlyle is deep-pocketed enough to have defended itself against the now Democratic-dominated regulators, which, indeed apparently opposed.

Shareholders who think class actions are good things can invest in one of the thousands of other securities out there; those who think class actions divert shareholder resources to attorneys now have a new, improved, investment option. Let the market decide which type of stock should trade at a premium and which at a discount. Even if trial-lawyer-controlled unions and pension funds boycotted the IPO, it shouldn't be enough by itself to depress the stock price, and would have had the side benefit of fewer frivolous proxy fights. (Moreover, Carlyle was to be a limited partnership, rather than a corporation, even further reducing the issue of fiduciary duties.)

Given that the DOJ's and SEC's criminal and civil penalties still applied, and such penalties are sufficiently draconian as to already create principal-agent problems between officers, directors, and shareholders, and given that well over 90% of meritorious civil securities litigation is simply piling on existing public disclosures, it's hard to say what permitting parasitical—or worse, meritless—civil litigation adds to investor benefit. One would thus expect Carlyle stock to trade at a premium: the boom in the Rule 144A private market suggests how beneficial it is for business entities to avoid the additional marginal litigation and regulation expense. See also Susan Beck.

But the litigation lobby was not satisfied with the simple possibility of letting investors have choice: only through monopoly power would investors willingly continue to let billions of dollars a year be unfairly siphoned into trial lawyers' pockets. Their water-carriers in Congress and the press spoke out loudly against the offering, and Carlyle has since backed down. AAJ declared victory, and Professor Stephen Bainbridge is understandably upset at being misquoted: but given that the trial-lawyer lobby was dishonest in getting the arbitration clause struck down, one can hardly be surprised that they continue to be dishonest afterwards.

Separately, strike another nail in the coffin for Professor Fitzpatrick's theory that the Supreme Court's recent jurisprudence will lead to the death of class actions.

It would be interesting to see which pension fund decision-makers with both ties to trial lawyers and fiduciary duties to fund participants lobbied against the clause; it would be entertaining if a fundholder brought a derivative suit on the issue. After all, such litigation is always a good, right?

Alison Frankel finds it problematic that a derivative shareholder suit against the Johnson & Johnson board was thrown out before it could incur millions of dollars of discovery costs and an extortionate settlement. I'm more sanguine.

Let's leave aside the fact that the underlying allegations are mere piling on: the lawsuit stemmed from the settlement of criminal allegations over Risperdal marketing and similar problems. Let's also leave aside the fact that every major pharmaceutical company is entirely at the mercy of prosecutors, and thus a criminal settlement is evidence of nothing other than ambitious prosecutors: given the fact that any criminal sanctions would cost the company tens of billions of dollars, no global pharmaceutical company is ever going to risk defending itself when prosecutors come after it, and the only question is the terms of surrender, given that even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Which brings us to my second point: the fact of the matter is that being a shareholder is a voluntary transaction. Different corporations can incorporate under different state laws that balance the interest of preventing false positives against the interest of false negatives. Shareholders can vote with their feet. If Frankel or other shareholders feel that New Jersey law is too protective of corrupt or incompetent directors, they can readily vote with their checkbooks to instead invest in companies incorporated in states that allow Bernstein Litowitz and Robbins Geller fishing expeditions. Such capital flows create premiums for incorporating in states that strike a good balance and penalties for incorporating in states that make it too easy or too hard to sue. Even if the legal standard here produced a false negative (and it's hard to say that it did if one believes that federal prosecutions of pharmaceutical companies are frequently just a lawless arbitrary expropriative tax that can strike good companies as easily as bad ones), it's good for New Jersey corporations in the systemic sense that the legal gatekeeping standard for such derivative suits is upheld.

See also Larry Ribstein and Erin O'Hara, The Law Market.

Jim Copland speaks with Harvey Pitt, former chairman of the Securities and Exchange Commission, about shareholder proposal trends over the last four years and how the SEC has changed since Dodd-Frank.

Relatedly, the Manhattan Institute releases its Fall 2011 Proxy Monitor report. Among its findings: shareholder proposals are sponsored by a small subset of shareholders; labor unions' shareholder activism appears potentially linked to union organizing campaigns and motivated by concerns other than shareholder return. "On balance, the empirical evidence analyzed in this report tends to throw into question the push for 'shareholder democracy' and suggests that shareholder activism in the form of shareholder proposals submitted on the proxy ballots of publicly traded companies may be more a vehicle for interest-group capture of corporations rather than for mitigating agency costs and improving shareholder returns."

Meanwhile, "say on pay" is already having an adverse effect on one corporation: Cincinnati Bell was one of the very tiny minority of companies whose "say on pay" shareholder vote rejected the executive compensation package. Since such votes are only supposed to be advisory without creating a fiduciary duty, and the independent board members believed the compensation package sound, the package was approved anyway. And now they're the subject of a federal complaint in the Southern District of Ohio that will almost certainly cost shareholders more than the executive compensation package itself. [NECA-IBEW Pension Fund v. Cox via Frankel]

This is one of a surge of lawsuits prompted by say-on-pay votes, as Reuters reported in May and Professor Bainbridge had predicted, despite the fact that Congress rejected a proposed cause of action. See also: Bainbridge, earlier on POL.

Despite the D.C. Circuit's devastating slapdown of Rule 14a-11, the SEC continues to refuse to consider the costs of its regulations. More: Ribstein; Bainbridge; Bainbridge roundup.

Meanwhile, the extensive new Dodd-Frank regulation of hedge funds that passed with the help of various Soros organizations is causing George Soros to go Galt with his own hedge fund rather than comply. As Ira Stoll points out, Soros had his problems with French regulators.

Does this regulation really help investors? A recent empirical study (via Bainbridge) casts doubt:

This study of initial public offerings (IPOs) carried out on the Berlin and London stock exchanges between 1900 and 1913 casts doubt on the received "law and finance" wisdom that legally mandated investor protection is pivotal to the development of capital markets. IPOs that resulted in official quotations on the London Stock Exchange performed as well as Berlin IPOs despite the Berlin market being more extensively regulated than the laissez faire London market. Moreover, the IPO failure rate on these two stock markets was lower than it was with better regulated US IPOs later in the 20th century.

A Ginsburg/Sentelle/Brown court struck down Exchange Act Rule 14a-11, the rule requiring easier nomination of dissident directors. [Business Roundtable v. SEC via BLT]

CSK Auto CEO Maynard Jenkins discovered accounting shenanigans after an internal audit he ordered. The SEC acknowledges that he was a victim of the fraud, but still wants Sarbanes-Oxley clawback of bonuses he received. Jenkins was forced to settle, but now that the SEC has rejected the settlement, the case is going to trial. [WLF; WaPo]

A paper by Bernard Sharfman:

Traditionally, the nomination of directors has been under the control of the board of directors and its nominating committee. However, Section 971 of the Dodd-Frank Wall Street Reform and Consumer Protection Act amended Section 14(a) of the Securities Exchange Act of 1934 to permit the Securities and Exchange Commission (SEC) to adopt rules that will allow shareholders access to a public company's proxy solicitation materials for purposes of nominating their own directors. In response, the SEC promptly issued Rule 14a-11 which provides the current rules for giving certain shareholders proxy access.

A key aspect of the current proxy access rules is that they are, for all intents and purposes, mandatory. There is no opportunity to opt-in or at least opt-out. This one-size-fits-all approach to corporate governance is wealth reducing because it does not allow for private-ordering. In addition, federally mandated proxy access eliminates the benefits of our federalist system from this area of corporate governance.

But there is something even more fundamentally wrong with proxy access. That is, it is a very inefficient means to promote good corporate governance in a public company. As argued here, it is expected that proxy access will lead to increased error in the nomination of directors as decision-making is moved from the board of directors to shareholders who will make their nominations based on significantly less information and a shifting of the potential for certain opportunistic behavior, such as the extracting of private benefits from the corporation, from an independent board and nominating committee to certain shareholders who, unlike directors, are not subject to fiduciary duties. Moreover, even if proxy access can be argued to be good for corporate governance, Rule 14a-11 is not designed to be the optimal default rule.

Daniel Fisher notes that the new SEC whistleblower rules, which incentivize employees to dodge internal reporting (often at cross-purposes with that required by Sarbanes-Oxley) to instead seek windfalls, is going to overwhelm SEC staff with false leads, making real fraud detection less likely. Tonya Mitchem Grindon, writing for WLF, suggests internal whistleblower awards to compete with those the SEC offers, though one wonders about the astronomical compliance costs that that would create—especially given the threat of employment-law liability for retaliation against whistleblowers that already overincentivizes spurious reporting.

I've previously opined on the problem of extortionate shareholder derivative suits that are entirely fee-driven with no benefit to shareholders. Professor Michael Perino (St. John's) points me to a recent Delaware decision, In re Emerson Radio Shareholder Deriv. Lit. (via Pileggi), that attempts to clarify the issue, but may only confuse it further. He's generously given me permission to repeat his analysis:

The opinion restates the traditional rule courts in Delaware about fee awards. Courts award fees based on the following factors: (i) the amount of time and effort applied to the case by counsel for the plaintiffs; (ii) the relative complexities of the litigation; (iii) the standing and ability of petitioning counsel; (iv) the contingent nature of the litigation; (v) the stage at which the litigation ended; (vi) whether the plaintiff can rightly receive all the credit for the benefit conferred or only a portion thereof; and (vii) the size of the benefit conferred.

The decision is odd on a number of levels. The standard is, of course, so vague that you can use it to justify any fee. The fee levels the court suggests (10% - 15% in cases that settle early in the pre-trial process; 15% to 25% for those that settle after significant discovery or motion practice) seem high and create a disincentive to early settlement. True, this approach might deter the attorney from settling the case too early and too cheaply, but perhaps at the cost of make-work.

Awarding fees for the non-monetary gains to the corporation seems completely inappropriate. To be sure, the court criticizes counsel who try to inflate their own recovery by claiming the value of these therapeutic benefits, but it uses some pretty suspect math to come up with its own valuation. Giving the lawyers 25% of this "value" leads to a fee award of 29% of the monetary benefits in the case.

The notion that we consider the "standing and ability of counsel" seems to be an invitation to award greater fees to established firms (thus helping to maintain a concentrated plaintiffs' bar).

The court also makes an interesting observation about risk by contrasting this case from the run-of-the-mill M&A action: "[u]nlike when entrepreneurial plaintiffs' firms routinely file representative actions against mergers, knowing that the defendants' ability to issue supplemental disclosures and the hydraulic pressure of deal closure will combine to create a ready-made settlement opportunity, plaintiffs' counsel here did not get into the case with an obvious and well-marked exit in sight." That might be true to a degree, but I think the court is still suggesting more risk than there actually was. The case involved related party transactions by a CEO and majority shareholder. An outside law firm had already determined that there had been irregular transactions. Was there really that much risk of non-recovery?

To this excellent analysis I would add that (1) the suggested fee levels guarantees make-work unless a court considers whether the additional litigation added any benefit to the shareholders at the margin by virtue of a higher settlement offer than the early offer, and the make-work is especially problematic given that it is a double-cost to shareholders, who are paying both for their "own" attorneys and those of the corporation; and (2) considering the "standing and ability" of counsel is double-counting: the ability of counsel can (and should) be measured entirely by the results achieved by counsel.

The Center for Class Action Fairness (which is not affiliated with the Manhattan Institute) is looking for institutional investors interested in challenging attorney-fee awards in shareholder litigation whom we could represent pro bono.

As the WSJ ($) says, "You don't have to be Sherlock Holmes to figure this one out."