For those of you who couldn't get enough of the debate sparked by Fourth Annual Conglomerate Junior Scholars Workshop participant Ethan Leib's paper Friends as Fiduciaries, go check out his post on the Freakonomics Blog.  Ethan is guest-posting over there and getting another interesting set of comments.

Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark

Welcome back to the final installment of the Fourth Annual Conglomerate Junior Scholars Workshop!  Today's junior scholar is Minor Myers, a visiting assistant professor at Brooklyn Law School, teaching Property and Advanced Topics in Corporate Law.  This paper, The Decisions of Special Litigation Committees:  An Empirical Investigation, has been accepted for publication by the Indiana Law Journal and accepted as a paper at the 2008 Conference on Empirical Legal Studies next month.  Here is the abstract:

This Article examines the decisions of corporate special litigation committees using an original data set gathered from company filings with the SEC. It demonstrates that the prevailing view in corporate law-that special litigation committees uniformly decide to dismiss derivative litigation against manager colleagues-is not accurate. This Article shows that approximately forty percent of the time special litigation committees decide to settle claims or pursue them against one or more defendants. Furthermore, approximately seventy percent of the time cases subject to control by a special litigation end in settlement; only approximately twenty percent of the time is the end result dismissal. What has long been viewed as an engine for having derivative litigation dismissed actually leads to settlements most of the time. The view that special litigation committees behave too predictably has underwritten doubts about the ability of independent and disinterested directors to police conflict of interest transactions generally. The findings presented here show that the prevailing view about special litigation committee behavior is an unsound basis for generalizing about how independent and disinterested directors behave.

Today's expert commentators will comment on both the securities law aspects and methodological aspects of this piece:  our own Lisa Fairfax, Barbara Black, Bill Henderson, Bob Lawless and Paul Rose. Our readers are invited and encouraged to give feedback in the comments to this post.

Permalink | Junior Scholars | Comments (9) | TrackBack (0) | Bookmark

Professor Minor Myers’s paper makes a very important contribution to the legal scholarship regarding the role of special litigation committees as well as the role of independent directors, while illustrating a key cautionary tale on the use of empirical research in the corporate governance literature. Professor Myers’s paper begins with the observation that most commentators view the special litigation committee enterprise as “little more than a show trial designed to exonerate the accused.” He then points out that this view has been buttressed by available empirical research—research to which most commentators refer when making the claim that most special litigation committees almost universally decide to dismiss derivative litigation. He also points out that this view resonates with our understanding of human behavior. ndeed, members of special litigation committees are appointed by the very directors upon whom they must pass judgment. Why should it be surprising, therefore, that such members would recommend against seeing their fellow directors being the subject of protracted litigation? Even the Delaware Supreme Court appears to have recognized the need for skepticism when reviewing actions of a special litigation committee because it must pass on the fate of other directors, and hence may adopt a “there by for the grace of God I go” attitude when conducting its investigation. Hence, as Professor Myers points out, many people view the special litigation committee as naturally biased. More importantly, the available research overwhelmingly supported this view. Professor Myers’s paper, however, uses an original data set to test the validity of this presumption regarding special litigation committees, and ultimately finds that presumption to be severely flawed. Indeed, his research finds that special litigation committees sought some formal relief against defendants about 40% of the time (i.e., 30% of the time they sought some form of settlement while 10% of the time they took over litigation to pursue claims against one or more defendants).

As Professor Myers’s notes, these findings have important implications for our understanding of special litigation committees. Indeed, the hope was that such committees would provide a reliable internal mechanism for boards to resolve derivative claims. Instead, many have viewed the special litigation committee with suspicion, and this view has had important repercussions.  For example, it has led some courts—like Delaware—to impose heightened scrutiny on the decisions of those committees, while other jurisdictions have refused to recognize their authority.  Moreover, it has led commentators to question the legitimacy of their actions and decisions.  Of course, Professor Myers cautions that his paper should not be used to prove that special litigation committees can be uniformly trusted. The paper nevertheless suggests that they should be viewed with much less skepticism, and hence may serve to validate their role.

Professor Myers also notes that his findings could have important implications for our understanding of independent directors. Indeed, the hallmark of the special litigation committee is that it contains independent directors. And more and more, corporations find ourselves relying on independent directors to serve as monitors. This is revealed in the requirement for audit and other committees to be completely independent as well as the call for a majority, if not super-majority, of the board to be independent.  However, the notion that independent directors—in the context of special litigation committees or otherwise—can appropriately perform their monitoring role is in tension with the presumption (apparently supported by empirical research) that such directors tend towards bias.  Professor Myers’s paper suggests that this tension may not be as great as we initially perceived it to be.  Again, I believe Professor Myers would agree that it is important not to overstate the claim.  However, his paper certainly takes the first step towards supporting the contention that independent directors can make decisions free from bias, and hence deserve to be given their role as monitors.

Interestingly, Professor Myers’s paper also can be read as a cautionary tale about the use of, and reliance on, empirical research in legal scholarship. Indeed, Professor Myers points out that the literature in this area almost uniformly casts doubt on the role of special litigation committee and it does so by relying on empirical data. And yet that data has some short-comings in at least two respects. First, that data dates back to the 1980s.  Thus, as Professor Myers’s notes, Professor Cox performed pivotal research on the behavior of special litigation committees in the 1980s appears.  But such research is basically “the entirety of the evidence on what special litigation committees do.”  To be sure, many current assertions about the behavior of special litigation committees note that the data upon which such assertions are made are limited and even dated. And yet the assertions have appeared to take on a life of their own, generating a perception out of sync with reality.  Or at the very least generating one that may be overstated. Second, Professor Myers’s suggest that there may have been some bias in the data used in the 1980s survey.   Indeed, an important question that arises from Professor Myers’s paper is—what explains the difference between the 1980 survey and this more recent one?  One explanation could be the passage of time—that is committees have gotten more rigorous over time.  However, such an explanation does not appear to be consistent with the current data.  Instead, the difference may be in the data set used.  The 1980s survey was based on reported cases.  Professor Myers suggested that reported cases were more likely to be biased in favor of a higher level of dismissals.  Indeed, to the extent a committee recommends dismissal, there is a greater chance that plaintiffs will challenge the recommendation, and thus a greater chance that the case would result in protracted litigation and be reported.   This appeared to have been borne out in Professor Myers’s research.  In this regard, Professor Myers’s paper underscores the importance not only of being careful regarding the potential short-comings of research, but also of being sensitive to the timing of research.

Alas, I would raise a couple of questions and issues about the paper. First, I wondered about the shortcomings of Professor Myers’s data. Indeed, while he certainly appeared to have a broader cross-section of companies, Professor Myer’s nevertheless collected his data from filings with the SEC.  This left me wondering if there would be a difference between the behavior of special litigation committees in public versus private entities.  To be sure, there were a few non-public companies in the data set and at one point, Professor Myers made the observation that there did not appear to be any difference in behavior between the companies. Yet I wondered if this question should be explored in greater depth, and if there was a potential that special litigation committees would perform differently in the context of smaller or less scrutinized companies.

Second, while it the data does seem to undermine blanket claims about the bias of special litigation committees and independent directors, it nevertheless could be viewed as confirming the existence of at least some bias. Indeed, Myers’s research revealed that about 60% of special litigation committees recommend dismissal.  By contrast, only 20% of cases ultimately ended in dismissal.  As a result, the 60% number appears to be too high.  Then too, special litigation committees recommended settlement 30% of the time. In contrast, 70% of cases ultimately end in settlement. Myers’s paper makes the point that this 70% number for settlements is consistent with the rate of settlement in the context of civil suits more generally. In this regard, while derivative suits may end up at the same place as other civil suits, it does appear that special litigation committees’ dismissal recommendation rate is overly high, while their settlement recommendation rate is too low. And while there may be other factors to explain this phenomenon, bias could be one of them.

Third, I wondered if there should be more discussion about alternate views with respect to special litigation committees and independent directors. On the one hand, there seems to be no question that many scholars tend to view special litigation committees with skepticism. On the other hand, this view does not appear to be universal among judges. Indeed, the paper cites New York's Auerbach approach and other cases reflecting the fact that there are lots of jurisdictions that do appear to give great deference to special litigation committees. Given the apparent overwhelming weight of the scholarship in this area, what explains the actions of these courts? Then too, as Professor Myers’s points out, there has been an increased use of, and reliance on, independent directors and independent committees. Again, given the research and sentiments expressed by Professor Myer, what accounts for this?

And finally, I would have enjoyed greater discussion on the implications of the data. Indeed, the paper hinted at what his research could mean for special litigation committees and issues of director independence, but I wondered if Professor Myer’s had his own views about that meaning. For example, should we alter the scrutiny placed on special litigation committees? Should we continue the trend towards greater reliance on director independence in other context, or is the special litigation committee a unique vehicle? These are just some questions that the paper raises about which I would have enjoyed some discussion.

Ultimately, the paper was an intriguing and important contribution to the corporate governance literature and I thoroughly enjoyed it.

Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark

Is the entire special litigation committee (SLC) enterprise just “a high-class whitewash?”  Every semester, when I cover SLCs in my corporations class, students ask me, “so what do SLCs decide,” and I say, “they dismiss,” and students nod, their suspicions confirmed.  It turns out that I was wrong.   Professor Myers concludes that the skeptical view of SLCS, based largely on research from the 1980s, may be unwarranted.  He takes on the conventional wisdom and conducts long-overdue empirical research into the outcomes of SLCs.  Based on data collected from EDGAR filings, he finds that SLCs settled derivative litigation 30% of the time and took over the litigation to pursue at least one defendant 10% of the time.  In addition, he finds that a majority of all cases subject to SLC review end with settlements.  Thus, he concludes that “settlement is a much more important part of the picture than heretofore recognized.” The board may create a SLC not to achieve a dismissal of the complaint, but to facilitate a prompt settlement of the dispute.

I confess I have always been somewhat mystified by the significance attached by academics to the SLC as the “death knell” of derivative litigation.  To my mind the demand requirement is the greater obstacle to derivative litigation.  If the plaintiff makes demand and the board refuses to take up the litigation, that refusal is protected by the business judgment rule; accordingly, plaintiffs want to plead demand futility.  Under the Aronson v. Lewis test, demand will only be excused if plaintiff alleges particularized facts that create a reasonable doubt about (1) the disinterestedness and independence of a [majority of] directors or (2) that the challenged transaction was otherwise the product of a valid exercise of business judgment.  Particularly since adoption of the requirement that a majority of the directors of NYSE and Nasdaq corporations be independent, plaintiffs who do not make a demand will have their complaints dismissed unless they can persuade the court that, notwithstanding the presence of a majority of independent directors, there is something deeply suspicious about the challenged transaction.  Only then is there a need for the creation of the SLC to determine the corporation’s position in the derivative litigation.  Professor Myers’ figures confirm the previous research that appointment of a SLC is an infrequent occurrence, at least for claims filed in 1999-2000.  His research does show a significant increase in the number of SLC decisions in the period 2002-2004, but as he points out, since his research focuses on the population of SLCs, not derivative lawsuits, it is not possible to determine whether this represents a change in the use of the SLC relative to the number of derivative filings.

Professor Myers makes a good point that perhaps there are broader lessons to be learned from studying the decisions of SLCs.  Academics remain deeply skeptical about the ability of independent directors to protect shareholders from self-dealing by insiders.  Compensation committees consisting of outside directors, in particular, have not served to curb generous executive compensation packages and indeed may have contributed to increased levels of compensation.  Professor Myers argues that his finding that SLC directors do not invariably dismiss derivative litigation should cause us to rethink our views about the behavior of independent and disinterested directors in other contexts.

I have my doubts, however, whether Professor Myers’ data is sufficiently persuasive to bring about the rethinking that he urges.  First, the data do show that the SLC made a determination to dismiss all claims in 60% of the cases (Table 1).  Thus, while it is an exaggeration to state that SLCs always make a decision to dismiss, it is the most common outcome. 

Second, as Professor Myers acknowledges, the data do not shed much insight into the SLC’s behavior.   This is understandable since the data are derived from abbreviated descriptions in SEC filings.  The other two of his broad categories -- pursue or settle – contain a variety of different outcomes.  For example, Professor Myers would classify a SLC determination to pursue just one claim against a former officer and dismiss all other claims against the current officers and directors as a decision to pursue; yet such an outcome might not instill in us any confidence in the SLC’s independence.  Similarly, Professor Myers categories as a decision to settle a determination to settle as to just one defendant and to dismiss all other (“and possibly more potent”) claims against other defendants.  Moreover, unfortunately, as Professor Myers observes, the information in the securities filings do not allow us to distinguish between a “phony” and a “good-faith” settlement.  Professor Myers argues that the essential point is that settlement is a much more frequent outcome than has been previously recognized.  While his findings do offer additional information, it is of limited utility in informing us on the behavior of the SLC directors, given the opportunities for gamesmanship. 

Indeed, for the skeptical, Professor Myers’ findings may provide more evidence to distrust the behavior of SLC directors.  As he reports, settlements of derivative litigation tend to fly under the radar, in contrast to motions to dismiss that may result in judicial opinions because the plaintiff will challenge the SLC’s motion to dismiss.  Thus, for a SLC intent upon making the litigation go away, the best route will be to enter into a settlement of the claims; plaintiffs’ counsel may, in turn, be receptive to a prompt settlement so long as significant attorneys’ fees are included.  This supports the suspicion that parties may arrive at collusive settlements, with no one looking out for the best interests of the corporation and its shareholders.  While judicial approval is intended to safeguard against this practice, in the absence of objecting shareholders, judges may not closely review the settlements.  Professor Myers’ data show that the most common ultimate outcome after appointment of a SLC is settlement (Table 6); even in the instances where the SLC made the determination to dismiss, settlement ultimately resulted, and dismissal was the final resolution in 20% of the cases.  Professor Myers argues that 20% is not an unreasonably high figure, but we simply do not have enough information to make an informed assessment of the merits of the claims.  We are left to ponder the mystery of what really takes place during the settlement process. 

Is there some way to get better information?  While item 103 of Regulation S-K may requires disclosure of material derivative claims, it does not require disclosure of the appointment of a SLC, still less a description of the SLC’s process or decision.  It is unlikely that the SEC could be persuaded to adopt disclosure rules for the purpose of academic research.  More disclosure, however, may lead to better behavior.  As Professor Myers notes, a possible source of bias in his data is that he is necessarily examining the SLC practices of corporations that have opted for more disclosure; these companies might, given their commitment to transparency, be more likely to hold their colleagues accountable.  Similarly, if the SEC disclosure rules required more information about SLCs, it is possible that the SLC directors might undertake their task with greater appreciation of its importance.  This could result in both better decision-making by the SLC and additional data for academic research.  It is unlikely, however, that additional disclosure requirements in this area are forthcoming. 

In conclusion, Professor Myers makes an important contribution to the literature by gathering and analyzing the available data.  Given the importance academics have attached to the SLC, it is puzzling that this area of research has been overlooked in the past two decades.  Focusing our attention on settlements, and not simply dismissals, of derivative litigation furthers our understanding of SLCs, even if the limitations of the data mean that our understanding is imperfect.  Finally, he is right to call attention to the nuances of SLC determinations and the past tendency to paint with too broad a brush the directors’ behavior (i.e., that SLCs always dismiss) and to warn of the dangers of generalities about derivative litigation that some scholars have asserted (i.e., derivative claims are generally meritorious or generally not-meritorious), in the absence of empirical evidence.

Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark

In "The Decisions of Corporate Special Litigation Committees: An Empirical Investigation," Minor Myers makes an important claim. Contrary to the received wisdom of everyone who has ever written on the topic, Myers finds that special litigation committees (SLCs) do not almost uniformly recommend to dismiss shareholder derivative litigation against their companies. If only the paper had the data to back up this claim, it would be an instant part of the scholarly canon in corporate law. Because everything hinges on its empirical finding, this review will focus only on the assumptions that the paper uses to come to this finding. Upon inspection, the paper's important empirical finding is really nothing more than a particular characterization of the data, and the data instead have more in common with the received wisdom than the paper's novel claim.

The way the paper gets to its startling conclusion is to count settlements as a nondismissal of the shareholder derivative litigation. If we adopt Myers's counting and consider settlements as an SLC decision not to dismiss, then a surprising 42% of the time SLCs do not ask to dismiss a shareholder derivative suit (p. 31, tbl. 1). As Myers himself acknowledges, however, we know nothing about the terms of these settlements:"To be sure, there is the possibility that a committee may do just enough to pass the straight-face test, maybe striking a settlement, and a wimpy one, with only the most egregious defenders. However, the securities filings do not distinguish between a phony settlement (or pursuit) and a good-faith settlement." (p. 32) Moreover, Myers counts a case as a dismissal only if the SLC moved to dismiss all claims against all defendants (p. 32). A settlement with one scapegoated and perhaps disgraced ex-officer while the SLC recommends dismissal of multiple counts against current officers and directors is still a settlement by Myers's reckoning. Finally, Myers counts a case as an SLC recommendation to settle the case without knowing who initiated the settlement. If one fiscal quarter's securities filing discloses an SLC and then the next quarter's filing says the case was settled, the case goes under the "settled by SLC" category (pp. 26-27) when, in fact, it may have been a rubber-stamped SLC action of a plaintiff and corporate defendant settlement.

The paper's defense of these counting conventions seems to be that it is the best we can do given the information available in the SEC filings. In deciding to count any settlement as an SLC settlement, for example, Myers argues that the SLC need not have acquiesced in the settlement and thereby must have implicitly or explicitly approved it (p. 27). Therefore, it gets counted as an SLC action. This may be the best we can do looking only at the general descriptions contained in public securities filings upon which the paper relies, but an investigation of the underlying court documents surely would provide more detail into whether the paper's use of the settlement data made the appropriate assumptions. Without considering the corresponding benefits, it is not a fair criticism of empirical work that a costlier data collection process would have yielded more information. This paper, however, makes a big claim by making assumptions about the information that costlier data collection would yield. In this instance, more data collection would seem necessary.

At nearly every turn, the paper counts cases in a way that biases its results toward a finding that would cut against the conventional wisdom. A more conservative and more appropriate approach toward the data would exclude the settled cases, about which we know very little. Of the 69 cases where the paper has information about whether the SLC recommended dismissal or to pursue the derivative litigation, 57 of these cases (82.6%) were recommendations to dismiss (p. 31, tbl. 1). Even this figure would be surprising when viewed against the conventional wisdom that SLCs almost uniformly vote to dismiss and would be much more defensible, if not as quite a sensational, claim than the paper currently makes.

Even then, one must remember the paper's convention of counting as a dismissal only a case where the SLC recommended dismissing all claims against all defendants (p. 32). Looking at the paper's own data from a different perspective thus suggests a very different view of the data. In about five cases out of every six, the SLC recommends to dismiss all claims against all defendants. In the sixth case, the SLC's recommendation is a mixed bag, recommending dismissal of some claims or some defendants. In not one of the paper's 69 cases where it has information on the SLC's recommendation did the SLC fully support the underlying derivative suit. Thus, the paper's data are actually quite supportive of the conventional wisdom of near uniform SLC recommendations to dismiss derivative litigation. Indeed, I suspect if one looked carefully at the underlying stakes involved in the one of every six SLC decisions to partially pursue derivative litigation, one would find that most of these SLC decisions are more "partial" than true "pursuit" of existing directors and officers.

Myers is to be commended for writing an empirically minded paper with a transparent presentation of his data and his assumptions. By not relying on reported cases, he has gone beyond the past attempts to study SLC decision making. Myers rightly points out and has the data to show (p. 39 tbl. 6) that a reliance on reported cases likely will result in a bias toward reinforcing the conventional wisdom. After all, a case where the SLC moves to dismiss is the most likely to be appealed and hence end up in the case reports. By going beyond the conventional and easy data collection methods and then by being appropriately transparent about the assumptions he makes in using the data, Myers has opened up the paper for admittedly tough criticism such as that written above. Nonetheless, the conventional wisdom that SLCs most always move to dismiss shareholder derivative litigation remains intact.

Permalink | Junior Scholars | TrackBack (0) | Bookmark

Minor Meyers’s paper on the decisions of special litigation committees is a welcome and timely edition to recent discussions of the role of independent directors in contemporary corporate governance.  While I believe that independent directors have been oversold as a cure for corporate governance ills, Minor’s research suggests that at least with respect to special litigation committees, independent directors may be operating as intended, or at least not conducting mere “show trials” to exonerate their accused colleagues.

Pity the independent director.  So much is expected, yet they remain suspected.  While the role of director independence has perhaps been undertheorized (as suggested by Glom guest blogger Donald Clarke), some empirical research also suggests that director independence has little or no positive effect on firm performance (see, e.g., Bhagat and Black’s article “The Non-Correlation Between Board Independence and Long-Term Firm Performance”).  Further, social scientists tell us that a truly disinterested or independent director is difficult, if not impossible, to find.  I was reminded of this in a conference last week as I listened to Antony Page present his paper “Unconscious Bias and the Limits of Director Independence” (forthcoming, U. Ill. L. Rev.).  Antony gives a number of reasons, gleaned from various behavioral studies, which create suspicion that independent directors deserve the level of trust afforded them by corporate law. 

Minor’s paper adds to this debate by empirically evaluating the decisions of special litigation committees.  Here Minor finds some fertile, unexplored ground for research in SEC filings reporting on special litigation committees.  Contrary to the suspicion that special litigation committees routinely dismiss derivative claims, Minor finds that while the majority (60%) of claims are initially dismissed, the SLC settles approximately 30% of claims and decides to pursue the litigation in 10% of the cases.  While I suspect the relatively small percentage of pursued claims will not eliminate suspicion of independent director “capture”, Minor can reliably state that the SLC is not merely a veneer, as some have claimed.  Courts’ treatment of the SLC’s motion to dismiss is also largely positive, with courts granting the motion to dismiss nearly two-thirds of the time. 

I have no expertise that would allow me to address the methodological aspects of Minor’s paper—Christine has wisely included others in this responding group who can address such issues much better.  Still, I have a couple of questions about the reliability and completeness of the data.  As Minor acknowledges, SEC disclosures on issues such as SLCs are far from uniform.  While Minor has addressed this issue in the paper to some degree (in footnote 41, in particular), it seems that one would find the number of dismissed suits underrepresented in the total because the company found the suit immaterial or because of the variations in the way the litigation was described.  Conversely, the number of settled and pursued claims might tend to be well reported, especially in cases where the company is attempting to provide bona fides for a new regime (for instance, in cases where prior directors were asleep at the switch, the company may be quite deliberate in disclosing how such problems were addressed in an effort to bolster investor confidence).  Minor mentions that 84% of the companies in reported court cases also disclosed such information to the SEC; however, firms that settle are not likely to report (only 2 of 29 did so), and if settlements are not disclosed (because they are immaterial) we would not capture the outcomes for these firms under either disclosure outlet.

Importantly, also, the disclosures also will not provide reliable information on the settlements.  Minor also anticipates this concern, acknowledging that it is “impossible to distinguish between a fig-leaf settlement and a good-faith settlement.”  To paraphrase Hyman Roth, this is the data we’ve chosen, and Minor does very important and helpful analysis of it.  To be sure, though, one would like to get the whole story on the issue of settlements.  As a reflection of the larger issue, the goal with settlements is to divine whether the SLC is truly functioning in good faith, or whether the decision to settle, and the settlement itself, is just an adornment—a fig leaf.  Apart from the SEC filings and case reports (with case reports’ paucity of settlement disclosures), perhaps the only way to get at such information is through the bar.  Trying to analyze settlements through interviews with the bar 1) is its own large project, 2) would likely be imprecise and non-verifiable, and 3) would recall the good will of a small group of firms that may not be willing or even, for confidentiality reasons, to discuss settlement outcomes, even in generalities.  While such a project may not be feasible, I would think that it would be useful (if it has not already been done) to check in with a few experienced members of the Delaware bar to get their perceptions of the results from the data that is available.  Do the numbers seem accurate, based on their experience (in other words, do the disclosures capture the reality)?  What is their feel for settlements?  Good faith?  Fig leaf?  To be clear, I am not recommending anything drastic such as adding in a section or even a lengthy footnote with the results of such discussions.  Instead, I see it as merely a low-cost means of checking for issues that may not be apparent to academics.

In this paper, Minor has done some very interesting work with SLCs that will certainly get some discussion in my (and many others’) BA class this fall—I am a sucker for empirical-analysis-meets-perceived-wisdom papers.  My small concerns with the piece are really regrets that the data cannot tell us more, rather than concerns with the way Minor has used or interpreted the data.  I look forward to seeing more of his work.

Permalink | Junior Scholars | TrackBack (0) | Bookmark

Minor Myers may be new to the legal academy, but already he was written a paper that up-ends the conventional wisdom on special litigation committees (SLC).  Because of Myers’ mere 31 page working paper, authors of the major corporate law treatises and editors of the corporate law case books are going to have to rethink how they present SLC materials. 

The quality of his sample and the unambiguous nature of his findings ensure that Myers will get a lot more credit than a “But see” footnote.  As a result of this paper, Myers is going to be on the radar of a lot of appointments committees.  There is a lesson here for young and ambitious scholars:  be skeptical of well-worn legal maxims that are lacking in recent or rigorous empirical support—simple counting and percentage can reveal how we legal academics get cowed by observations, anecdotes, and flawed empirical studies that are repeated early and often.  I have a few quibbles with Myers’ analysis, which I will briefly address at the end of my remarks; but they do not detract for the overall significance of his empirical findings.

Here is the line in the abstract that make be confident that Myers’ was overreaching   “[My study] demonstrates that the prevailing view in corporate law—that special litigation committees uniformly decide to dismiss derivative litigation against manager colleagues—is not accurate.”  Okay, it is always great to have a straw man to topple.  But I thought to myself, there is a large and developed literature on SLCs; surely, most of the Brahmins in the field foreshadowed the ambiguity that Myers has stumbled upon. 

My intuition turned out to be wrong.  In the footnotes, Myers provides unambiguous quotes from leading corporate law commentators that the appointment of an SLC presages the dismissal of a derivative shareholder suit.  Note that I said “in the footnotes.”  To Myers’ credit, his analysis contains no hint of smug satisfaction or a public rebuke to senior colleagues.  (Trust me:  if he is going on the market this fall, Myers’ emotional intelligence will earn him a much warmer reception at several leading law schools.)

The misreadings of the field, as it turns out, are traceable to the confluence of two sampling limitations:  (1) most SLC are formed and deliberate without the aggrieved shareholders ever filing a complaint; and (2) there is a clear selection bias in cases that are filed and reported.  Unfortunately, these limitations (which Myers avoided) influenced the findings on one empirical study in the early 1980s.  In turn, those findings got cited over and over again by other commentators until they reached canonical proportions. 

Within Myers’ more representative sample (n =97), which spans the 1993 to 2006 time period, the initial SLC recommendations to the corporate board fall into three major categories:  dismiss (60%), settle (30%), and pursue (10%).  So in 40% of the cases, SLC are not reflexively siding with management because of so-called “structural bias”.  Further, among the cases with a “dismiss” recommendation, courts rejected motions to dismiss 31% of the time, thus prompting more settlements.  So the perception that SLCs permit an end-run around meaningful scrutiny of management may not be warranted. 

My quibbles with Myers are largely at the margins. First, half of the sample involves Delaware corporations or other entities, and Delaware has more rigorous case law that New York or states that follow the MBCA. See, e.g., Zapata v. Maldonado, 430 A.2d 779 (Del 1981) (setting forth two-step inquiry that permits judges to exercise independent judgment over SLC recommendations); In re Oracle, 824 A.2d 917 (Del. Ch. 2003) (ruling that composition of SLC was impermissible because of member’s common ties to Stanford University). Obviously, if parties are truly "bargaining in the shadow of the law," different rules may produce different outcomes. Myers should run a simple t-test to see if outcomes vary by Delaware versus non-Delaware entities. I predict they will.

Third, no author should be above rudimentary Bluebooking practices. Myers fails to fill in his cross-references (which is so simple to do as you go in Word or WordPerfect), use short-cites for repeated references, or provide full cites to relevant case law when they are introduced for the first time.  When Myers refers to a case for a legal proposition, the year and jurisdiction matter.  Yet, he forces me to flip through his paper to locate this relevant information because he is (apparently) leaving rudimentary BlueBooking to student editors.  But if you want the benefit of outside reviewers, respect their time—and basic BlueBooking does just that.  There, I said it.  Hopefully Myers will live and learn.

But overall, congratulations are in order.  Minor Myers has made a name for himself.  Next time I teach SLC, I will be discussing his important work.   

Permalink | Junior Scholars | TrackBack (0) | Bookmark

We have had four great papers with extensive valuable commentary from our commentators and readers.  Next Monday, August 11, 2008, we will conclude the Fourth Annual Conglomerate Junior Scholars Workshop with Minor Myers, The Decisions of Corporate Special Litigation Committees:  An Empirical Investigation.  Here, as my colleague Larry Solum would say, is a taste:

This Article examines the decisions of corporate special litigation committees using an original data set gathered from company filings with the SEC. It demonstrates that the prevailing view in corporate law-that special litigation committees uniformly decide to dismiss derivative litigation against manager colleagues-is not accurate. This Article shows that approximately forty percent of the time special litigation committees decide to settle claims or pursue them against one or more defendants. Furthermore, approximately seventy percent of the time cases subject to control by a special litigation end in settlement; only approximately twenty percent of the time is the end result dismissal. What has long been viewed as an engine for having derivative litigation dismissed actually leads to settlements most of the time. The view that special litigation committees behave too predictably has underwritten doubts about the ability of independent and disinterested directors to police conflict of interest transactions generally. The findings presented here show that the prevailing view about special litigation committee behavior is an unsound basis for generalizing about how independent and disinterested directors behave.

Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark

Welcome back to the fourth day of the Fourth Annual Conglomerate Junior Scholars Workshop.  Today's author is James Park, an assistant professor at Brooklyn Law School, where he teaches securities regulation, corporations, corporate finance and civil procedure.  His research so far has focused on securities law, including this paper, which has been accepted by the Journal of Corporation Law, Assessing Materiality of Financial Misstatements:

While markets rely on accurate financial reports in valuing companies, it can be difficult to interpret vague accounting rules. Federal securities law thus makes liability for financial misstatements contingent on a showing of materiality. There are two competing approaches to assessing the materiality of a financial misstatement. First, there is a quantitative approach, where a misstatement can only be material if it is above a bright-line threshold - often 5 percent of net income. Second, there is a qualitative approach, where a misstatement under the 5 percent threshold can still be material if it allows a company to meet its earnings forecasts or results in management bonuses.

Today we have a nonembarassment of riches with a star-studded lineup of commentators and past workshop participants: Adam Pritchard, Larry Cunningham, Joan Heminway, Elizabeth Nowicki, Dave Hoffman and Michael Guttentag. Our own Fred Tung is also waiting in the wings with some thoughts.

Permalink | Junior Scholars | Comments (13) | TrackBack (0) | Bookmark

I have long thought that the doctrine relating to materiality suffered from a fundamental contradiction.  On the one hand, Basic set materiality on a path toward an empirical approach to the question.  By adopting TSC’s “reasonable investor” standard for Rule 10b-5 in the same opinion in which the Court endorsed the efficient capital market hypothesis in adopting the fraud-on-the-market presumption of reliance, the Court set the stage for a market test for materiality.  Did the stock of the company experience an abnormal return when the misstatement was made, or subsequently, when the omitted information was revealed?  The presumption is that the market consists of reasonable investors (or at least that the reasonable investors are the one that drive price discovery.  It follows that the consensus of those investors, as reflected in changes in that market price, is the best evidence with respect to whether reasonable investors considered the information relevant to their buying and selling decisions.  This version of materiality has a nice, objective appeal.  On the other hand, the SEC has long insisted that managerial integrity is material to reasonable investors, most notably in the Franchard decision.  This view would also seem to be supported by the legislative history of the securities laws, born as they were of the scandal mongering of the Pecora hearings and FDR’s polemics against the moneyed classes.  To put the matter more generously, “sunlight is the best disinfectant,” that is, disclosure is likely to have a therapeutic effect on agency costs.

Both approaches are more appealing in theory than in practice.  A market test for materiality has objective appeal until one gets down to the messy business of measuring it.  Objective is not the same thing as accurate.  Relying on abnormal market movements as the measure of materiality invites manipulation by fraudulent corporations, who will have every incentive to bury the revelation of a prior misstatement in amongst positive news, daring the plaintiffs’ expert to untangle the resulting mess.   Also complicating measurement are the various components that are reflected in the stock market’s response to the revelation of the bad news.  Part of the response is a revaluation of the company’s prospects in light of new information about its earnings prospects, but part of the response reflects the market’s assessment that the company will face a class action lawsuit or an SEC enforcement action.    These costs could lead to an abnormal return, even if the original misstatement was not material.  The market surely understands that materiality judgments are a murky area for courts, and therefore prone to error.  A sufficiently high probability of error means that the company will bear heavy distraction and settlement costs, even for a trivial misstatement.  Finally, the market test for materiality can only be applied ex post, which is not very useful for lawyers trying to make materiality assessments when they are crafting disclosures.

The weakness of the integrity approach is that is likely to be taken hostage by the SEC’s nanny-state paternalism.  The agency has a low threshold for outrage, triggered by anything likely to provoke embarrassing headlines if revealed.  Reasonable investors know that firm specific risks can be managed through diversification, so they are likely to have a higher threshold for outrage at management.  Earnings management of the income smoothing variety is unlikely to provoke much outrage among hedge fund managers, who likely expect a certain amount of such behavior, but from the SEC’s perspective, it raises fundamental questions about the senior management team’s capacity to lead.  The SEC’s delicate sensitivities would be tolerable if its views only played out in enforcement actions, but they are also likely to influence class actions.

Park does not have the silver bullet that would resolve the existing tensions in materiality doctrine.    Instead, he wants to further complicate the matter, bringing the question of damages reform into the mix.  Specifically, he proposes to use materiality doctrine to limit vicarious corporate liability to cases in which there has been a sustained misstatement in a company’s financial statements.  Such misstatements make it difficult for market participants to value a company’s future earnings, in Park’s view.   By contrast, liability for minor misstatements would be measured by whether a defendant gained from the fraud.  So, stock options that were bumped into the money by shifting revenues up a quarter would be subject to disgorgement.  The result is some shifting of the liability burden from corporations to executives.

Damages reform is near and dear to my heart, but I am not persuaded that materiality is the best doctrinal hook for addressing the issue.  A number of issues highlighted by Park as relevant to the question of materiality are already part of the Rule 10b-5 inquiry, in particular, the scienter element.  Was a misrepresentation isolated or persistent?  That’s probative evidence on recklessness.  Was an officer enriched by the misstatement?  That’s motive and opportunity.  The strength of evidence showing scienter is a key factor for settlement negotiations, so practically speaking, these questions are already incorporated into the penalty calculus of Rule 10b-5 actions.  And they are clearly already factors that the SEC considers in assessing penalties in its enforcement actions.   

A broader objection to Park’s proposal is that if damages should be reformed, they should be reformed across the board, and not just with respect to financial misstatements.  Other misstatements, both historical and forward-looking, also give rise to liability.  Why single out financial misstatements for lower penalties against the corporation?  Given the importance of financial information, why should companies enjoy a lower antifraud standard for that set of misstatements?

Park’s standard would appear to make the greatest difference in § 11 cases.  But couldn’t we achieve much the same result by giving the issuer a due diligence defense?  And all of this assumes that we should relax issuer liability standards in public offering cases.  Given the institutional incentive to inflate the company’s prospects when it is raising capital, relaxing standards in the context is not obviously a good idea.

One minor nit.  Park suggests that misstatements might lead a corporation into insolvency because it might induce the corporation to take on an excessive debt load (MS. p. 38).  This seems implausible to me.  I have no doubt that misstatements are positively correlated with insolvency, but it seems a stretch to suggest causation.  If managers are misrepresenting the financials, they presumably know this, and they are basing their financing decisions on the true picture, not the one that they are presenting to investors.  Insolvency is unpleasant for corporate managers; it seems doubtful that they are actively courting it through their misrepresentations.  More likely that they are seeking to avoid it by papering over the weaknesses in the business.

Overall, I enjoyed the paper, which I think canvasses the existing problems with materiality doctrine quite ably.  I’m not sure that I agree with the proposal that comes out of those problems, but thinking about it in these terms is certainly a step in the right direction.

Permalink | Junior Scholars | TrackBack (0) | Bookmark

            Professor James Park’s paper makes at least two excellent contributions to the literature on materiality in financial reporting: (1) the relevant viewpoint for testing materiality is the reasonable investor, as under current law, here taken to mean the investor engaged in fundamental valuation analysis, not necessarily proxied by aggregate market reaction models and (2) an important basis for assessing materiality, using current law’s “total mix of information” conception, is whether a misstatement is persistent as opposed to isolated.   The paper also offers valuable implications of these insights for preferring vicarious or individual liability arising from material financial misstatements. 

            The paper thus addresses the pervasively important issue of assessing materiality in financial reporting. This subject is particularly topical amid high levels of financial restatements in the past five years.  The subject also is receiving formal policy attention.  For example, the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR) http://www.sec.gov/about/offices/oca/acifr.shtml, in its Final Report  http://www.sec.gov/about/offices/oca/acifr/acifr-finalreport.pdf, released last Friday, addresses this territory.   The paper admirably enriches the field of law and accounting.  I had the pleasure previously to comment to Professor Park on his paper and here can register just a few additional modest observations. 

            First, Part II of the paper explores how to enhance analytical understanding of the prevailing legal notion of a reasonable investor. It notes the prevalent invocation of market reaction models to assess materiality from the reasonable investor’s viewpoint.  It explores how materiality should be conceived if one instead locates the reasonable investor in traditional fundamental valuation analysis. As a devotee of value investing practiced by luminaries such as Warren Buffett, I particularly appreciate this orientation shift.

            The most powerful implication of Professor Park’s insightful analysis “reveals a basic flaw in the current tests for assessing materiality.” Those tests concentrate too heavily on size (quantitative materiality, often using a 5% of net income rule of thumb) and certain specific notions of qualitative materiality, especially managerial motivations.  Professor Park concludes this illuminating discussion by observing that this prevailing result obscures a vital aspect of materiality assessments: the relative persistence or isolation of a misstatement.

            Excellent as the discussion is, a modest addition could note inherent, methodological, limitations on market reaction studies.  For financial misstatements, these studies are conducted in relation to subsequent restatements of previously misstated financials.  Problems include measurement difficulties arising from the time lag between market knowledge of a forthcoming restatement and its ultimate resolution;  the bearing on market price of matters other than the misstatement and restatement; and disclosure accompanying a restatement that may provide offsetting pricing effects.

            Second, Part III of the paper proposes explicitly to examine persistence versus isolation as a central factor in materiality evaluations.  The paper wisely puts this proposal in terms of legal presumptions.  This shows the proposal’s distinctiveness and adds flexibility to promote its utility.  Persistence yields a presumption of materiality, even if less than 5%; isolation yields a presumption of immateriality, even if greater than 5%.    Both are rebuttable.  If it is unclear whether a misstatement is persistent or isolated, then law continues to resort to examine the totality of circumstances (under the “total mix” conception). 

            Thus Professor Park rightly acknowledges that the notion of persistence-isolation will not always be dispositive. The main point is that it can help in a wide range of contexts where it affects the total mix of information available to reasonable (fundamental valuation) investors.  Notably, in my view, this contribution makes explicit a component of qualitative materiality analysis that has been obscured but deserves a prominent place.  Professor Park’s prescription to take explicit account of persistence versus isolation is thus valuable.

            Professor Park’s proposals are also consistent with CIFR’s recommendations and provide an intellectual basis to accept those recommendations.  CIFR recommends retaining the reasonable investor standard, while placing more emphasis on actual investor valuation analytics as opposed to the prevailing heavy reliance upon market reaction studies.  It recommends giving explicit attention to the persistence or isolation of a misstatement (at least so long as an isolated item “does not alter investors’ perceptions of key trends affecting the company”).

            Given the nature of high-quality legal scholarship compared to advisory committee reports, Professor Park’s analysis is richer and more complete than the briefer CIFR recommendations.  Accordingly, when the SEC and others study CIFR’s Final Report, they would benefit from reading Professor Park’s elaboration of these two important propositions.

            That said, worth appreciating is how CIFR’s Final Report does not propose to eliminate market reaction studies from analysis nor to elevate the persistence-isolation inquiry above other ways to assess materiality.   After all, there are many different types of misstatements, some important to investors and some not.  The persistence-isolation spectrum is one useful ground for gleaning that distinction.  But it may not be the only one. 

            Other ways to probe materiality in financial reporting concern the measure or classification at stake.  For example, revenue recognition is generally a more important category than non-core expenses.  Even isolated revenue recognition errors may be important in ways that persistent misstatements in non-core expenses are not.  Similarly, misstatements concerning recurring operating expenses often are more important than those concerning many reclassifications.  More broadly, of potential importance, especially when adopting a reasonable investor’s fundamental valuation viewpoint, some misstatements, even if persistent or large, may not drive investor models, metrics or conclusions.  In these contexts, the notions of persistence or isolation may be less useful.   

            Finally, neither Professor Park nor CIFR are offering particularly radical or revolutionary suggestions.  Indeed, CIFR explains that its diagnosis and recommendation arise less from problems in the legal or regulatory standard than in applications in practice.  Current law’s reasonable investor and total mix tests of materiality are coherent and prevailing SEC are appropriate.  But CIFR says too many materiality judgments do not adopt those standards in practice.  CIFR says its suggestions are a “modest clarification of the existing guidance to conform practice to the standard” and “not a major revision to the concepts and principles embodied in existing SEC staff guidance.”  Practical and sensible,

Professor Park’s paper is an important contribution to the law and accounting literature and a good source of analytical support for CIFR’s recommendations. 

Permalink | Junior Scholars | TrackBack (0) | Bookmark

Professor James Park’s Assessing the Materiality of Financial Misstatements is a gutsy piece of scholarship that arrived on my desk at the right time.  “Gutsy,” in that he takes on a hugely complicated area; and timely in that I am finishing off a paper relating to the conceptualization of the reasonable investor in materiality analysis then plan to extend my earlier work on materiality in a paper that I am writing during the fall and winter.  Professor Park’s article focuses generally on rationalizing the assessment of the materiality of financial misstatements and specifically on making sense of the use of quantitative and qualitative measures in those materiality determinations.  It is an insightful piece, although I do disagree with some of the underlying observations and characterizations.  As has become my habit, I am affording my more detailed comments to Professor Park individually, offline.  A summary of key points follows.

Park hits the nail squarely on the head when he states that “[t]he current debate myopically focuses on the practicalities of the standard – whether it is easy to apply (favoring the quantitative standard) or allows prevention of earnings manipulation (favoring the qualitative standard).”  In this piece, Professor Park attempts to widen the debate by looking at the overall significance of financial reporting to the securities regulation scheme.  He is largely successful in that effort.

In a new tweak on the “short-term vs. long-term investor” debate and in contravention of those arguing for a definition of materiality that relies on price effects, Professor Park first argues for the inclusion of persistence in financial misstatement materiality assessments.   Ultimately, I like this argument, although I will not, with my limited finance expertise, validate or challenge the simple valuation analyses he uses to support his position.  (I know from 15 years of hard labor with investment bankers and valuation experts that there’s more than one way to value a company . . . .)  There’s plenty more there in the paper for nonquants like me to grasp onto and rely on, in any event.  If I had one wish about this part of the paper, it would be that Professor Park should tie his observations back to the policy underpinnings of the securities laws more directly and clearly.  Why does his approach, e.g., better assure market integrity?  And how does his approach better protect investors, especially short-term investors?  Are these two policy underpinnings put into conflict or do they coexist symbiotically or synchronistically in this environment?

Professor Park then goes on to suggest that corporations and their agents be treated differently for purposes of liability in fraud-on-the-market cases (although I think he means to reference securities fraud actions—at least private enforcement actions—more broadly).  I find this part of  Professor Park’s article less persuasive, largely because he builds it off a narrow view of the purpose of qualitative materiality assessments.  He asserts that qualitative materiality exists to prevent self-dealing/conflicts of interest.  Certainly, concern about management conflicts drives the consideration of matters other than bright-line financial tests in determining materiality.  But there is more than that in qualitative materiality.  Said another way, earnings management is only a part of the overall picture of what materiality addresses in the financial statement area.  As Professor Park himself notes: “[n]ot all accounting frauds are alike.”

Professor Park would be on safer ground if he narrowed his claim in this part of the article to the role of qualitative materiality in addressing earnings management.  Also, in this part of the paper, he refers to the “vicarious” liability of a corporation for material financial misstatements.  In spite of these references, I do believe that he realizes that the liability of an issuer/registrant for material misrepresentations in its financial statements is primary, statutory liability, not merely the common law liability of a principal for the actions of its agent.  He does offer one express statement in that regard (noting that “[i]ndeed, liability for financial misstatements may be an issue of direct rather than vicarious liability”), and he also admits as much in his discussion of securities fraud under Section 11 of the 1933 Act and Section 10(b)/Rule 10b-5 under the 1934 Act and in his discussion of proposals to exempt issuers from that liability.

I do have a few lesser substantive quarrels with statements Professor Park makes in his article.  For example, he indicates without citational support that the concept of the reasonable investor may differ based on the type of statement at issue:  “While the term ‘reasonable investor’ can encompass both irrational and rational investors, the case for focusing on the perspective of the rational investor is strongest with respect to financial misstatements.”  I am not confident, based on my own research, that this is correct as a positive or normative matter.  Moreover, the narrow focus on rational vs. irrational investors (without taking into account other conceptions of the reasonable investor) did not satisfy me.  I would like to see more on this in the paper—or at least an acknowledgement of the academic debate—if he intends to rely on contextual differences in the reasonable investor to any significant extent.  He does mention the existence of a debate briefly in passing, so I know he’s aware of it . . . .

Also, at the outset and throughout the article, Professor Park draws a distinction between quantitative and qualitative materiality in evaluating the significance of financial statement misstatements.  He narrowly defines quantitative materiality to include principally the debunked “5% test” (but also other bright-line financial tests).  He then states that SAB No. 99 adopts qualitative materiality as the exclusive test.  I disagree with that characterization.  SAB No. 99 adopts the TSC/Basic formulation of materiality, which includes both quantitative and qualitative components; “[e]valuation of materiality requires a registrant and its auditor to consider all the relevant circumstances” and the “interaction of quantitative and qualitative considerations.”  Nevertheless, his overall views on the vagueries of the existing materiality standard are dead-on right.

All in all, this is a valuable piece of work that contributes new insights to the literature on materiality.  I am grateful for the opportunity to contribute to the dialog.  Thanks, again, to Christine, Gordon, and the whole Glom gang for inviting me to participate.

Jo

Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark

The nettlesome issue of how to implement the materiality standard is one of the crucial open questions in securities regulation.  It’s good to see Professor Park make a solid effort to advance our understanding of this issue.  Park is clearly correct that leaving judges and juries with the task of interpreting a vague “reasonable investor” standard is a cop out, and the SEC is struggling to come up with a better solution.  But I would want a more precise connection to theoretical rationales for securities regulation and more research on the types of information sophisticated investors actually use to value stocks before endorsing Park's many recommendations.

To review, the Supreme Court has borrowed the reasonable person standard from other areas of law and adopted a "reasonable investor" standard to evaluate when information disclosed by public companies is material.  But, as Park correctly points out, there are many questions that come about in implementing a reasonable investor standard.  Should only rational investors be considered?  Is a quantitative test an efficient way to reduce the transaction costs associated with determining when information is material?

I will address two areas in which I think more careful consideration could improve Park’s article.  First, Park could be more thorough in identifying the larger theoretical issues that any discussion about how to implement the materiality standard should build upon.  Second, looking more carefully at the types of information that sophisticated investors actually use to value companies would help to better elucidate how to apply a “reasonable investor” standard.

On the theoretical front, Park is not sufficiently thorough in considering why public securities are regulated.  He does mention the importance of share price accuracy, noting the work of Professor Fox.  But he does not acknowledge the problems with these claims identified by Roberta Romano (and myself).  He also fails to mention Paul Mahoney’s excellent work distinguishing between the accuracy enhancing and agency cost reducing benefits of requiring disclosure.

These theoretical debates about securities regulation have direct implications for how to implement the materiality standard.  For example, if agency cost reduction is an important aspect of disclosure regulation, then it is the transactions between the agent and the firm that may be more important to monitor, regardless of scale.  The analysis gets more complicated if, as I have argued, there are certain types of information that simultaneously increase accuracy enhancement and reduce agency costs (for example, by reducing opportunities for agents to capture for themselves the value of information asymmetries).  Park’s discussion alludes to these issues, but a more explicit discussion of theoretical issues is needed. Such considerations would be helpful, for example, in clarifying Park’s effort to distinguish large scale fraud from other kinds of misleading statements.  Working with a broader theoretical palette, in part by acknowledging the potential relevance of the work of Romano and Mahoney among others, would lead to a more satisfying answer to the puzzle of materiality.

On the practical front, Park chooses to focus on the perspective of the rational investor, which I think is the correct approach.  But then he goes on to rely on what I find to be an overly simplistic description of how the rational investor would rely on earnings in carrying out a Discounted Cash Flow (DCF) analysis to value securities.  Park needs to make more of an effort to research the types of information that sophisticated investors actually use to value firms.  In supporting an argument that the appropriate standard for materiality should use as a template the disclosures required by sophisticated investors in private transactions I did such research (Florida State, 2004).  Park cites textbooks and a few academic studies.  (His footnote 107 is a little better, but later in the article he does not incorporate this complexity).  Even if DCF analysis and earnings estimates are important tools in valuing firms, the inputs into sophisticated financial analysis tend to be more diverse than Park acknowledges.   

It is primarily by relying on a relatively simple DCF valuation technique to model the rational investor that Park is able to justify one of his main claims, that separating misstatements into two categories, temporary misstatements and ongoing misstatements, would be a helpful addition to the law.  Once we move away from a simple DCF valuation technique, such distinctions become more problematic.  It does not work to equate one-time write-downs with one-time misstatements.  As but one example, of which I'm sure Park is aware, a one-time change in income has on ongoing effect on the balance sheet.

Materiality is an important issue in securities regulation and enforcement.  I hope these comments help to make a good article better.

Permalink | Junior Scholars | TrackBack (0) | Bookmark

Assessing the Materiality of Financial Misstatements usefully highlights the intersection of accounting law and securities law.  As Larry Cunningham wrote in a comment to this post a while back, this field presents an "amazingly rich field with many current and continuing opportunities" and one that should interest junior scholars.  Because I've been somewhat absent in appreciating of accounting's relationship to securities doctrine, I was happy to get a chance to read Prof. Park's work and learned a lot from the paper.  In no particular order, here are some (hopefully helpful) comments.

·        Park starts with the assumption that ideally "the materiality standard would serve as a significant gatekeeper in screening out trivial from substantial misstatements," and criticizes courts for instead substituting a "nebulous" standard that has resulted in substantial uncertainty by reporting entities.  Here, I think Park significantly understates the current screening effects of materiality doctrine.  As I've shown, judges considering materiality find that about half of considered disclosures are immaterial as a matter of law, and doctrines like puffery and bespeaks caution (which are bright-line rules) have increased in importance over time.  See also Bainbridge & Gulati, How to Judges Maximize, at 116 n.94 (most securities cases decided on MTD, and most determinations involved materiality).  These case-counting findings suggest doubt as to the need to reform materiality.  Indeed, over the last several years, I've seen an emerging consensus that the current state of securities law – from pleadings standards, to materiality, to scienter – has combined to create an such anti-plaintiff environment that the risk of fraud being screened out of court is higher than the likelihood of weak cases finding strike settlements.  Even were this not true, I think Park could do more to develop his thesis that materiality is the appropriate gatekeeping vehicle for in securities cases.  Why not the pleadings/scienter nexus?  Or to put it a different way, why would common-law courts be effective at determining when securities litigation is good for financial markets and investors? Bainbridge & Gulati and most other observers think that judges are looking for any scheme to move these cases off of their dockets, not be thoughtful gatekeepers.

·        Park's discussion of the difference between fundamental and market valuation (pps. 23-5) is lucid and informative, except that I think it comes to the wrong conclusion.  As Park recognizes, fundamental valuation doesn't necessarily track harm to investors (resulting from stock price effects) but instead hypothetical "rational investor[]s".  In my view, Park needs to do more to justify privileging such investors (who will usually be institutional) over ordinary traders.  There could be some unexpected gender effects here, given studies finding that women and men process financial information distinctly. See, e.g., Odean. 

·        In arguing against market materiality measures, Park suggests that event studies may be flawed instruments, and that price movements provide little ex ante guidance.  But, as I'll discuss in just a minute, his proposed solution doesn't much help with the ex ante problem.  As for event studies, I think we'd all agree that they are somewhat of an art form, and that judges evaluating them on SJ are unlikely to be particularly discerning critics.  But I wonder (again) about the missing competing competence argument: why should we conclude that judges would be any better at evaluating competing claims from experts about the fundamentals of accounting?

·        Park argues that materiality findings ought to be based, in part, on the difference between persistent and isolated misstatements.  Recognizing that this distinction is subject to abuse – both by managers and by securities-averse judges - Park urges that we should be wary of attempts to short-circuit the decision making process, potentially resolving it at summary judgment or at trial.  This would a pretty radical (pro-plaintiff) change in securities litigation practice, and not one I think courts are likely to embrace.  It's also somewhat in tension with Park's envisioned early gatekeeper role for materiality doctrine. Moreover, the fact that the definition is something that requires adjudication, and isn't self-evident, makes it harder for me to see why fundamental analysis provides better ex ante guidance for disclosing entities and their agents.  I imagine that executives will be overly self-confident about the likelihood that a misstatement is of the "harmless" short-term variety (as Park argues, they may even believe that they are smoothing earnings to reduce "irrational" market distortions)

·        The paper would be aided by more talk throughout about settlement.  The current system seems designed (especially after recent pleadings decisions from the Supreme Court) to knock out cases at the dismissal stage, and to leave all further cases to settlement in the early stages of discovery.  Park's system, by contrast, appears designed to require extensive discovery about corporate financials before the parties can realistically assess their odds of succeeding on summary judgment. (Securities cases are even less likely than the ordinary civil case to go to trial; I doubt that much securities practice is shaped by the shadow of the too-few jury verdicts.) Park should consider expanding his analysis to consider how and when in litigation lawyers would be able to distinguish between persistent and isolated financial misstatements, and thus what effects, both static and dynamic, it would have on settlement.

·        Park's vicarious liability proposal is intriguing and I agree with much of it.  It is, of course, part of a larger trend to focus on ways to target securities law on agents.  That literature, in turn, is premised on the idea that securities law does a bad job deterring corporate misconduct because the "real wrongdoers" don't feel the sting of sanctions. This literature is terrific, though it strikes me that policymakers would be aided by more empirical (experimental) work that examines the relationship between organization liability and individual psychology.  As always, individual liability proposals must be clear to address about the effects of insurance and indemnification.  Park argues that individual managers will internalize sanctions (notwithstanding D&O) when they are adjudicated to be liable.  This may be correct, although I think that the instances of D&O insurers successfully disclaiming coverage, notwithstanding the language of their policies, are pretty rare.  And of course, an adjudication-contingent D&O liability policy will result in the settlement of more non-meritorious claims.   That is, the more we focus on individual liability, the less likely we are to see adjudication, which will potentially result in more uncertainty for disclosing entities.  Don Langevoort's suggestion that we should instead focus on equitable remedies seems like it could use more discussion here.

That's it!  I hope that Prof. Park finds these comments helpful, and that he continues to focus on this important aspect of securities law doctrine.  The paper is relatively short, quite well-written, and certainly worth readers' time.

Permalink | Junior Scholars | TrackBack (0) | Bookmark

Assessing the Materiality of Financial Misstatements:  Two Articles for the Price of One.

Many thanks to Christine Hurt and the folks here at the ‘Glom for including me in Junior Scholars Forum.  This is my third year participating, and the papers I have been asked to read are always stellar.

This year, I had the good fortune to read Professor James Park’s article, Assessing the Materiality of Financial Misstatements.  What I found was that I was actually reading two articles, one on materiality in the context of financial misstatements and one on vicarious liability for securities fraud related to financial misstatements.  While I favor Professor Park’s latter article more than his former, I applaud Professor Park for taking on two major topics and boldly addressing the vexing factual issues implicated in accounting fraud.

Regarding materiality, Professor Park takes the position that the two methods normally bandied about for assessing the materiality of financial misstatements – the qualitative and the quantitative methods – are unacceptable.  He maintains that court