New Article: “The Golden Leash and the Fiduciary Duty of Loyalty”

I’m delighted to share a new article by yours truly on corporate governance and shareholder activism, The Golden Leash and the Fiduciary Duty of Loyalty, that will be published in the UCLA Law Review.

The “golden leash” is a controversial form of third-party compensation under which activist hedge funds supplement the salaries of directors they nominate to the board, in exchange for increasing the value of the company. A director compensated pursuant to such an arrangement stands to earn millions of dollars rather than the $250,ooo paid to a typical director of a large public company, though the more richly compensated director usually works much harder and takes a lot of public abuse.

I offer a qualified defense of the golden leash, situating it in the context of other, more mainstream structures that depend on a more relaxed, porous conception of the fiduciary duty of loyalty than is commonly applied in the context of the golden leash. I also offer thoughts on how a properly disclosed golden leash can not only work for shareholders but improve procedural corporate governance more broadly.

The abstract follows. I welcome any comments on the draft.

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What Discount Rate Are Activists Applying to the Boycott of SodaStream?

SodaStream spokesperson Scarlet Johansson has become embroiled in the controversy.

SodaStream spokesperson Scarlet Johansson has become embroiled in the controversy

It seems UK retailer John Lewis is pulling SodaStream, the popular home carbonation product, from shelves, thanks to the efforts of the the incoherent Boycott, Divestment and Sanctions (BDS) movement:

SodaStream, the Israel-based beverage machine maker being targeted by the Boycott, Divestment and Sanctions (BDS) movement because of its West Bank production plant, has suffered serious setbacks in recent days in Britain, the Jewish Chronicle reported Thursday.

John Lewis, one of the country’s largest department store chains, and whose Oxford Street store in London has been targeted by biweekly BDS protests, announced it was taking SodaStream’s flavored seltzer makers off its shelves. The Jewish Chronicle said the company’s announcement came last week, and was attributed to “declining sales.”

The impact appears to extend beyond department store John Lewis:

[O]n Monday, EcoStream, SodaStream’s store in the tourist town Brighton, closed after facing weekly protests for two years.

While, like 63% of Israelis, I would like to see the 47-year occupation end, I don’t think that’s really relevant. As I argued a few months ago at The Conglomerate, the BDS movement’s tactics in targeting SodaStream exemplify a lot of serious internal contradictions at the heart of stakeholder activism.

For starters, the BDS movement depends on an implicit hierarchy of stakeholder interests that prioritizes the sensibilities of privileged foreign consumers over the day-to-day interests of actual Palestinian employees. Those consumers don’t want to feel complicit in buying products made by Palestinians who live in the territories, so they take action that hurts Palestinians who live in the territories. It’s more than a little patronizing for BDS activists in London to declare themselves defenders of the Palestinians’ “true” interests and simultaneously advocate for the closure of SodaStream’s West Bank facility, which employs 500 Palestinians. Should SodaStream’s Palestinian employees really have no voice in whether their jobs are sacrificed for the greater good of Palestinian statehood, or should that decision be made by consumers in London?

The SodaStream boycott is the opposite of boycotting a clothing company because it makes clothing in an unsafe sweatshop. Conceivably, such a company could improve working conditions in its factory and its workers would benefit. Here, BDS activists won’t rest until 500 of the putative beneficiaries of their campaign are out of a job.

In addition to uncritically privileging consumer interests over employee interests, the BDS movement also lacks a limiting principle—generally a red flag. I addressed this earlier at greater length, but here are a few examples:

  • The boycott plainly discriminates against SodaStream because it’s based in Israel.
    • BDS proponents claim to be targeting SodaStream because it operates in the West Bank (and thereby indirectly supports the occupation), not because it’s Israeli in origin. Would they have targeted SodaStream for employing Palestinians in the West Bank if the company were based somewhere—anywhere—other than Israel? Plenty of non-Israeli companies do business in the West Bank, so this seems implausible.
    • Let’s suppose instead, as appears to be the case, that SodaStream (a small public company) was selected both because it’s based in Israel and because it operates in the West Bank. What if a major foreign company, like GE, bought SodaStream? Surely activists would not boycott a giant like GE merely because a single, tiny subsidiary operated one of its many factories in the West Bank, if for no other reason than that they’d receive no popular support.
  • Boycott proponents must show their work. Achievement of the BDS movement’s goal would mean unemployment for West Bank employees of SodaStream. I’d like to see discussion by boycott proponents of the tradeoffs between employees’ jobs and agency, on the one hand, and what is likely to be a minor PR victory on the other.
    • SodaStream’s West Bank employees almost certainly share with their fellow Palestinians (and BDS activists) the goal of an independent Palestinian state. But there ought to be a balancing analysis here, and it ought to be explicit. Boycott proponents are subordinating individual Palestinian employees’ near-term interests in having a job to the long-term community goal of creating a Palestinian state. The BDS movement should explain how it decided that what (they view as) some incremental progress is worth the cost of these 500 jobs, particularly given that unemployment in the West Bank is close to 25%.
    • The most likely outcome of a successful boycott of SodaStream is that the company will divest from the West Bank but the occupation will continue.

On that last point, let’s be clear: if these boycotts are as successful as their supporters hope, SodaStream will relocate their West Bank factory (something the company is already reportedly considering) but the occupation will continue. That will mean the 500 Palestinians who work for SodaStream in the West Bank will be fired. While this might salve the conscience of BDS activists, the occupation—and the company—are really not going anywhere anytime soon.

The most persuasive justification of the boycott on its own terms is that a defeat of SodaStream will lead to successful boycotts of higher-profile companies, which would in turn ratchet up pressure on Israel to end the occupation. It’s canonical in these circumstances to invoke South Africa. But bracketing for the moment the question whether that boycott truly helped bring down apartheid (a contested point), the fact remains that it’s the only arguably successful example of its kind. The usual outcome is that boycotts do not force governments to change their foreign policy.

Thus, to avoid harming the intended beneficiaries of their campaign, advocates of a given boycott should apply a high discount rate to account for the probability that their campaign will not succeed. In other words, given that the BDS boycott will probably fail to achieve its declared goal of ending the occupation, BDS activists should explain why people like the West Bank SodaStream employees should be okay sacrificing their jobs in the process. More precisely, why they should be okay having that decision made for them.

After all, these Palestinians have almost certainly considered the conundrum of working for an Israeli company that operates in the West Bank, and by definition they have decided that any moral or political benefit in refusing to do so is outweighed by the practical advantages of employment. Even if one believes, as I do, that they probably lack a meaningful alternative, that does not mean that foreign consumers should try to eliminate their jobs. That is basically a non sequitur, not a sign of sincere or effective advocacy.

On that note, it goes without saying that you can be opposed to the occupation, or Netanyahu or Israel’s retaliatory strikes on Gaza today or all of the above, without supporting the boycott of private firms that do business in the West Bank. Especially where that business activity is trivial in a macroeconomic sense, but is critical to the individuals who work those jobs. The BDS boycott is poorly conceived, and is less likely to achieve its declared goals than it is to take away the livelihoods of its declared beneficiaries. And that also makes it an excellent case study in how not to conduct stakeholder activism.

More on Corporate Disasters and Stock Prices

Costa ConcordiaA few weeks ago, I asked whether financial markets systematically exaggerate legal risk to public companies stemming from high-profile corporate scandals. Today I continue the theme of that post by arguing that:

(1) if GM shares continue their impressive rebound, it would hardly be the first time in recent years, and

(2) depending on the industry, the effects can extend beyond the directly affected company’s stock and impact the sector of which it is a part.

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Should You Have Put Johnny’s College Money in GM Stock on April 11?

One interesting subject at the intersection of law, finance, and human behavior is the impact of looming litigation and enforcement actions on the affected company’s stock price. This post is going to be a bit of a think piece, as truly fleshing out some of the concepts here would require not just more research but industry expertise and empirical modeling.

With that caveat, a core assumption of Wall Street traders, financial economists, and the investing public holds that new information, including new information on legal risk, will generally move the market if it’s material. Materiality in this sense is basically circular; it’s something that moves the market. That’s a pretty high bar. However, securities law and accounting rules (GAAP, which applies to public and nonpublic companies alike) treat materiality in the disclosure context much more liberally. Where the chance of a litigation loss is “probable” or even “reasonably possible”—terms that mean somewhere between 10-70% chance of a loss—it usually must be disclosed.

The gap between the market sense of “materiality” and the legal and accounting sense is critical. As this Perkins Coie note discusses, the SEC “has increasingly taken the position that it is not enough that a possible loss or range of loss cannot be determined ‘with precision and confidence,’ and has indicated that it may ask companies to provide support for an assertion that an estimate cannot be made, particularly as litigation progresses.” So the possibility of a litigation loss must be disclosed even if its probability and magnitude can’t really be estimated yet and many of the underlying facts aren’t yet known.

The drafters of the legal and accounting rules may not have intended a significant gap between their definition of materiality and the economic definition, but I suspect the gap was known. One policy goal behind a rule that promotes early disclosure of relatively improbable risks is to make it hard for companies to conceal the risk of losses, and thus to promote better cost internalization and risk management. That’s a crucial objective, but it is pregnant with tradeoffs. Accuracy is probably one downside, since the disclosure obligation kicks in before much is known about the probability or magnitude of the risk. It could be that early disclosure tends to exaggerate the market response, because the risks are simply impossible to price at the early stage they are disclosed.

Share price movements of public companies following high-profile scandals provide some opportunity to measure the ability of the market to price disclosed-yet-unresolved legal risks. General Motors, for example, is currently in the throes of an unfolding legal and regulatory scandal. The company announced a major recall February 7, 2014 and has announced nearly 50 more since, involving a total of 17 million cars in the US and a few million more abroad so far (here’s a timeline of events).

GM’s problems have a lot of legally and politically salient features beyond those of most corporate legal scandals. Grim deaths of totally blameless consumers, grieving families, a simple fix that would have cost pennies per car to implement. And GM’s new CEO, Mary Barra, has admitted that the company knew about these problems for a decade. Criminal and civil investigations are ongoing, and Congress is investigating.

Of course, at at time like this, the impact on the company’s share price is not the main concern, but looking at it might provide an interesting, rough-and-ready measure of the market’s perception of this newly-disclosed legal risk. The cost of the mechanical fix is currently expected to come in around $700 million, but the legal and reputational damage is harder to gauge. Is the market doing a decent job of pricing them, or are traders overreacting to dramatic events? And what if any role are the securities laws and accounting rules playing here?

Let’s try to assess the reaction first. As depicted below, between February 7 (the announcement of the recall) and yesterday’s close, GM shares (blue) significantly underperformed those of its chief US rival, Ford (in red), as well as the broader S&P 500 index (green). GM is essentially flat (+0.5%), whereas Ford is up 12.5% and the S&P is up 8.9%. This could be a recall effect.

GM v. Ford v. S&P 2/7/-6/18/14 But did the market go too far in punishing GM? In March, some financial journalists suggested that GM’s recalls might be unjustifiably depressing share prices and this week TheStreet rated GM stock a buy. Does this lend support to that view?

It’s not entirely clear (and the reasons why underscore how hard it is to get market predictions right). However, if current trends continue, the market may have seriously overestimated GM’s legal risk in April relative to the facts known at that time.

The case of GM involves a watershed event in the form of a series of damaging disclosures made in a short, discrete window of time, followed by a rapid and massive drop in share prices, followed in turn by a strong rally.

Adding more competitors makes for a richer comparison. In this second chart, GM (blue) is underperforming rival Daimler, but outperforming both Honda and Toyota, with Honda down over 4% in the same window: GM v. HMC, TM, DAINAll these stocks are performing poorly in this period, except Daimler. It could be that GM’s weak share price is attributable to the weakness of the auto sector in general relative to the S&P. Even so, I think this window may be somewhat obscuring the share-price impact of the unfolding recall. At the risk of stumbling into empirical territory, I think it’s clear here that selecting the right time window is important.

I have three observations in that connection:

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3 Thoughts on the Alibaba IPO

Chinese tech-company giant Alibaba filed papers this week to go public in New York. Since this news is at the intersection of three sexy topics – tech companies, large amounts of money, and the general sense that anything big and China-related must be a unique threat/opportunity  there has been a lot of reporting on the company’s planned initial public offering (see, e.g., herehere, here).

Alibaba is an enormous company. Estimates of its value range from $100 billion to $235 billion, in the ballpark of American Express to AmEx plus Amazon. The company is arguably even “bigger” if you consider it in terms of reach rather than economic value. As Zach Karabell put it in Slate, Alibaba is “a behemoth in China that acts as an Amazon, PayPal, and UPS all rolled into one, plus a dollop of Facebook and other social network sites.”

I have three observations about what the Alibaba IPO might mean for U.S. equity markets, Alibaba’s plans, and Yahoo, which owns a 24% stake in Alibaba:

1. Despite various headwinds, U.S. equity markets continue to dominate. Specifically, U.S. markets continue to be the destination of choice for many global companies – which now includes China’s most ambitious tech company as well as many European tech companies – looking to raise capital. As the chart below indicates, it’s not even close; Alibaba is just the latest data point.  This observation cuts against two common memes: one about the putative burden of U.S. regulations, the other a generally overstated point about the declining relevance of the U.S.

    • Every time U.S. securities regulation expands, there’s an immediate objection that the costs of regulation will drive companies overseas – either they’ll reduce their U.S. presence or they’ll choose to list on an exchange in a jurisdiction with more lax securities laws. Most recently we have seen this argument during the debates over Dodd-Frank, but it comes up a lot. It was prominent during debates over Sarbanes-Oxley, and it colors discussions of America’s accounting and anti-corruption regimes (GAAP and the FCPA, respectively), which are among the most stringent in the world.
    • I don’t think anyone disputes that these forms of regulation have the potential to chill capital formation in the U.S. to the point of sending it abroad. A serious effort to measure the tradeoffs would require a data-intensive study in itself (not a blog post), but it’s worth emphasizing just how competitive U.S. capital markets continue to be. To date companies, including foreign companies, have continued to come to market in the U.S., opting into those onerous U.S. regulations. Although it would be nice to find more longitudinal data (this only covers two years), you can see from the table below that U.S. equity markets continue to dominate (PDF) the world – in 2013, they accounted for about one half of the total value of the planet’s top ten stock markets and are at least holding their own from 2012-13:

World Federation of Exchanges - 2013 WFE Market Highlights

    • This is probably because American equity markets offer network effects and other competitive advantages that no other market can match. As Karabell argues, U.S. markets are better positioned “in terms of complexity, liquidity, and transparency. . . [If] you are almost any company of size doing business anywhere in the world, the United States remains a safe and potent place to raise capital.” (This has been true for as long as anyone reading this post has been alive.) Our sophisticated regulatory framework is integral to that competitive advantage.
    • One caveat to this point is that right now U.S. equity markets are likely benefiting from the perception that they are safe and stable relatively speaking, and offer shares denominated in the world’s reserve currency. Modest growth in the U.S. paired with elevated economic and political risks abroad would appear to favor issuing in the U.S. at the moment. It will be interesting to see what happens to the U.S. share of the global public equity market if/when economic conditions normalize and some of those political tensions ease. But it’s also not clear the U.S. will lose this advantage anytime soon, since there are always economic and political tensions.
    • In Alibaba’s case, it has also been reported that the company’s unique ownership structure means it could not list in Hong Kong. If that’s true, the U.S. may have an additional competitive advantage on that point, though it seems likely that other factors also drew them to New York.

2. Alibaba’s F-1 registration statement tells us very little about the company’s plans. There’s been Talmudic scrutiny of this filing, as if the true intentions of the company are now hiding in plain sight, just waiting to be divined by someone with expertise in legal and financial jargon. This places far too much weight on the F-1, which is a basic disclosure document that must be filed by any foreign company issuing securities in the U.S.

    • Quartz ran an article yesterday headlined, “Alibaba isn’t going global – at least not yet,” that exemplifies this practice. Analyzing the F-1, the author emphasized that in that document “Alibaba framed its growth prospects in terms of only the Chinese market. . . In fact, Alibaba doesn’t list eBay or Amazon in its list of competitors, naming only Chinese firms,” and regarding the proceeds of the offering it only states they will be used for “‘general corporate purposes’ and short-term debt instruments or bank deposits.”  From this the author concluded that “it’s not apparent that funds from the listing will go toward international expansion.” Elsewhere we see bald assertions that Alibaba really has its eye on the Chinese market.
    • To the extent these comments are based on the registration statement, they are overblown. These disclosures are designed to satisfy the relatively limited requirements of the Securities Act of 1933, not tip the company’s hand.
    • So why else are they raising money? Beyond the usual reasons – raising more capital than is feasible as a private company, allowing early investors to cash out – I have no idea. However, it’s worth noting that being a U.S.-listed company may make it a little easier for Alibaba to do a few things. One is acquire other American-listed companies that offer services in the U.S. that Alibaba offers in China, on the basic principle that deals among firms that share regulators and an investor base tend to implicate fewer regulatory and other concerns than pure cross-border M&A. Given the enormous size and diversity of Alibaba businesses, that is potentially a lot of U.S. companies – eBay, maybe, but a lot of smaller ones too. It would be idle speculation on my part if I said I thought they were going to do some big acquisitions in the U.S., but the limited “use of proceeds” they declared in their registration statement certainly does not mean they are not going to. There is nothing nefarious or Trojan Horse-like going on here; it’s an issue of reading too much into registration statements.
    • Bottom line: to understand Alibaba’s F-1 statement to the point of drawing conclusions about the company’s growth strategy, you’d have to have a lot of knowledge about Alibaba, its current competitors, and the industries it could plausibly enter. I suspect few journalists poring over the statement can clear that bar (I certainly can’t).

3. What will happen to Yahoo stock and Yahoo CEO Marissa Mayer’s reform efforts once Alibaba goes public?

    • Currently, Yahoo owns 24% of Alibaba, and the value of Yahoo excluding Alibaba is probably less than zero – about negative $3.45 billion by one calculation. For years now, Yahoo stock has partly served as a vehicle for owning an indirect piece of Alibaba’s explosive growth in China. Soon, anyone interested in buying into Alibaba will be able to do so directly, and it’s been reported that Yahoo will sell around half its stake in Alibaba after the IPO anyway.
    • It’ll be interesting to see what impact all this has on Marissa Mayer’s efforts to overhaul Yahoo. Those efforts have generally been well received by Wall Street to date. With Alibaba contributing much less to Yahoo’s top line in the future, will she have less freedom of action (because revenues are down) or more (because revenues are down)? Even more intriguing, maybe she’ll find some really neat way to put the proceeds of the sale to use (one-up Tesla CEO Elon Musk’s hyperloop idea?). But based on what she’s been doing, we’ll probably see a boost in dividends and buybacks instead, and maybe an acquisition or two.

My thanks to Chris Gaskill, who has advised companies on IPOs as outside counsel and has worked in house at two public companies, for his thoughts on these subjects. As always, all opinions are my own.

ScarJo, SodaStream, and Competing Stakeholder Interests

Image[cross-posted from The Conglomerate]

Scarlett Johansson has been in the news a lot lately because of her twin roles as spokeswoman for Oxfam and SodaStream. For nine years, Johansson served as an ambassador for Oxfam. She was a major fundraiser and public face of the charity. But this January, Oxfam told her she had to choose between representing them and SodaStream, andshe chose the latter. The episode suggests some important limitations of the stakeholder theory of corporate organization.

Why did Oxfam give Johansson an ultimatum? SodaStream manufactures popular home carbonation systems in 22 facilities around the world. Some are in the U.S., China, Germany, Australia, South Africa, Sweden, and Israel, and one is in the West Bank. The company has recently been targeted by the pro-Palestinian “Boycott, Divestment, Sanctions” movement (BDS), which seeks to delegitimize either certain Israeli policies or the State of Israel itself (depending on who you talk to). The BDS movement is boycotting SodaStream because, it argues, the company promotes the Israeli occupation of the West Bank by operating a factory there. Oxfam backs the BDS boycott of Israel and insisted Johansson choose between them and SodaStream.

This should not have been an intuitive response. And curiously enough, corporate law—specifically the stakeholder theory of the firm—helps illuminate the oddness of Oxfam’s single-minded boycottism.

There are many strains of the stakeholder theory, but in general the idea is that management should consider the impact of its decisions not only on shareholders but on “stakeholders” of the firm—employees, suppliers, customers, community members, and other constituencies beyond its owners. (For simplicity, we’ll consider the term “stakeholder” to exclude shareholders.)

The stakeholder model is often presented as an alternative to the standard shareholder model. But forget shareholders. Say you have a company that is unequivocally committed to the stakeholder model—their slogan is “people before profits,” and shareholders have no special claim on company decisions. What should the company do when the interests of employees and community members collide? Who should win out?

Ostensibly, the SodaStream boycott is being conducted on behalf of the Palestinian community and cause. The assumption is that short-term pain (i.e., probable unemployment) for the factory’s 500 Palestinian employees is the price of long-term gain (i.e., a Palestinian state) for the community.

Politics aside, the SodaStream boycott assumes a hierarchy of stakeholder interests that seems extremely tenuous. Even those sympathetic to the boycott—and this is probably obvious by now, but I am not—acknowledge that shutting SodaStream’s West Bank factory would bring hardship to a lot of Palestinian families who depend on those jobs. I would add that that sacrifice is a really bad deal for those stakeholders if the boycott does not succeed (and most don’t). Regardless, the question of the normative justness or wisdom of the boycott is beside the point—what about those stakeholder employees? They’re not trying to live their politics; they want to work. What value do we place on their interests versus those of boycott advocates? In other words, how do we assess the boycott from a stakeholder perspective?

A few concerns I have with the SodaStream boycott from a stakeholder standpoint, moving from specific to general:

  • The Palestinian SodaStream employees almost certainly share the same political aspirations as their community (e.g., statehood). Yet they’re rejecting the boycott by working for SodaStream. Shouldn’t stakeholder-employees get a voice in whether they are forced to sacrifice their jobs in service of community goals?
  • What’s the boycott’s limiting principle? Should no foreign businesses be permitted to employ Palestinians in settlements? What about a non-profit? Why limit it to settlements? If SodaStream moved its operations a few miles up the street to Palestinian-governed territory, would the BDS movement call off the boycott?
  • SodaStream is headquartered in Israel. Does the boycott only apply to Israeli firms? If so, could SodaStream continue to operate in the West Bank if it sold itself to a foreign company? Stakeholder theory self-consciously promotes the observance of international law and fairness norms. Under what circumstances is per se discrimination on the basis of employer nationality okay?
  • More broadly, what is the limiting principle behind privileging somewhat amorphous community interests over the clear and important interests of a defined group of stakeholders, like employees? Aren’t the sum total of global interests affecting a firm (e.g., preventing climate change) always going to be more powerful than narrow stakeholder interests (e.g., jobs on oil rigs)?

One thing I find fascinating is how quickly questions about stakeholder priority (on which the literature is pretty sparse) verge towards politics and ideology. It’s almost enough to make you miss having profit maximization as the lodestar! Snarkiness aside, I don’t think advocates of the stakeholder theory would dispute that “take stakeholder interests into account” is a fuzzy objective to begin with. But as the SodaStream controversy illustrates, this is not only because a stakeholder-centric view creates conflicts between shareholders and stakeholders. It also creates confusion about how to prioritize the legitimate concerns of stakeholders as against one another.

In sum, to paraphrase ScarJo, it’s hard to find a principled way to rank the competing interests of stakeholders. That observation doesn’t invalidate the stakeholder theory, of course. It just shines a light on some of its limitations as a principle of organization.

Photo: E!