Eyes On Wall Street : Executive Compensation Lawyers & Attorneys : Labaton Sucharow Law Firm : Class Action Litigation, Shareholder Rights

Goldman Sachs hosted its annual shareholder meeting on May 7, 2010, just ten days after the company’s CEO and chairman, Lloyd C. Blankfein, was put on the hot seat by the Senate committee at a hearing to discuss the bank’s suspect trading activities and a fraud suit by the SEC. While the meeting was widely seen as a potential referendum on investor confidence in Blankfein, there were surprisingly few questions about the investigations of Goldman’s past mortgage trading or the various lawsuits pending against the Company. 

Nevertheless, Goldman shareholders expressed their continued interest in paying a more active role in corporate decision making. Following the 2009 annual meeting, a majority of shareholders requested that the Board take steps to eliminate the supermajority voting provisions from the company’s Bylaws and Certificate of Incorporation.  In the 2010 annual meeting, the Board itself proposed a resolution to change the supermajority voting provision, which had required an 80% vote, to a majority provision, which requires a vote only above 50%. The proposal received support from an overwhelming 82.5% of outstanding shares and was approved. The passage of this proposal effectively increased shareholder power by decreasing the amount of votes needed to pass proposals at annual meetings.   

However, shareholders were much more ambivalent about a proposal to separate the Chairman and CEO roles at Goldman. The proposal emphasized that the “role of the Board of Directors is to provide independent oversight of management and the CEO” and addressed the “potential conflict of interest for a CEO to be his/her own overseer while managing the business.” It also referenced a 2009 report by Yale University’s Millstein Center for Corporate Governance and Reform that stated, “Having an independent chairman is a means to ensure that the CEO is accountable for managing the company in close alignment with the interests of shareowners, while recognizing that managing the board.” The Goldman board recommended that the resolution be voted “against,” and the resolution did, in fact, fail--with support from only 19.1% of the vote. In so voting, Goldman parted company with banks such as Morgan Stanley, Bank of America and Citigroup, which have all split the chairman and CEO roles.

Submitted by Carol Villegas

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On Friday April 16th, the Securities and Exchange Commission (SEC) filed a civil complaint against Goldman Sachs and one of its vice-presidents, Fabrice Tourre, for allegedly defrauding investors by failing to disclose vital information about a financial product linked to subprime mortgages. Goldman’s shares tumbled, dragging the markets down with it.

The instrument in question, structured and marketed by Goldman, was a synthetic collateralized debt obligation (CDO), whose performance was tied to that of residential mortgage-backed securities. Goldman told its investors, who included some European banks, that the securities underlying the CDO had been selected by an independent third party, ACA Management. The SEC alleges that Goldman failed to disclose that another firm, Paulson & Co, a big hedge-fund manager, in fact had a hand in choosing what went into the CDO.

This was a crucial omission, since Paulson & Co—run by John Paulson, who made billions in 2007-08 betting against the housing market—had taken a short position against the CDO; in other words, the firm would profit if the instrument performed poorly. 

According to the SEC's complaint, Paulson shorted the portfolio it helped to select by purchasing insurance against the default of certain layers through derivatives called credit-default swaps (CDSs) it entered into with Goldman. The SEC argues that these derivatives gave the hedge fund an incentive to select mortgage securities that would bomb. And bomb they did. The deal closed in April 2007; by the end of January 2008, 99% of the portfolio had been downgraded by credit-rating agencies.

Goldman called the charges “completely unfounded in law and fact” and said it would contest them vigorously. Paulson & Co, which has not been charged, issued a statement saying that ACA, as the third-party collateral manager, had sole authority over the selection of securities in the CDO. In a more detailed response issued later, Goldman insisted that extensive information about the portfolio had been provided to the buyers, who were sophisticated investors aware of the risks.

It may seem surprising that Paulson is not named as a defendant in the SEC's complaint. However, the decision not to name Paulson as a defendant was likely influenced, at least in part, by the Supreme Court's recent landmark decision in Stoneridge Investment Partners, LLP v. Scientific-Atlanta, et al. (2008). The Stoneridge holding restricts plaintiffs from alleging 1934 Exchange Act fraud claims against "non-speaking" participants in schemes to defraud investors. Rather, investors may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock. Thus, under Stoneridge, the SEC could not bring securities fraud allegations under Section 10(b) against Paulson without demonstrating that Goldman's investors directly relied on false statements or misleading conduct by Paulson.  

Given the public and official outrage over Paulson's involvement in the Tourre scandal, recent legislative efforts to overturn Stoneridge seem timely and well taken. 

Contributed by David Sack

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On March 11, a court-appointed examiner released a 9-volume, 2,200-page report detailing the demise of Lehman Brothers, a Wall Street titan for more than a century. The report lays out how Lehman Brothers used misleading accounting techniques to conceal the bad mortgage holdings that led to its collapse.

Anton R. Valukas, chairman of the law firm Jenner & Block and a former prosecutor, authored the report. He found that Lehman Brothers used "materially misleading" accounting techniques to mask the perilous state of its finances. According to the report, just months before the Company imploded, Lehman Brothers executives used what amounted to financial engineering to temporarily shuffle $50 billion of assets off its books in an effort to conceal the Company's dependence on leverage, or borrowed money. Senior Lehman Brothers executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas.

"Unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption," Mr. Valukas wrote.

According to Valukas, Lehman Brothers executives engaged in what the report characterized as "actionable balance sheet manipulation," and "nonculpable errors of business judgment." While the report draws no conclusions as to whether Lehman executives violated securities laws, Mr. Valukas writes in the report that "colorable claims" could be made against some former Lehman executives and Ernst & Young, meaning that enough evidence existed that could lead to the awarding of damages in a trial. 

A large portion of the nine-volume report centers on an accounting maneuver known inside Lehman as "Repo 105." Repo 105 involved transactions that secretly moved billions of dollars off Lehman Brothers’ books at a time when the bank was under heavy scrutiny. According to Mr. Valukas, Mr. Fuld ordered Lehman executives to reduce the bank’s debt levels, and senior officials sought repeatedly to apply Repo 105 to dress up the firm’s results. Repos, short for repurchase agreements, are a standard practice on Wall Street, representing short-term loans that provide sometimes crucial financing. It appears that Lehman used especially aggressive accounting in its Repo 105 transactions: the Company seems to have structured transactions such that it sold securities at the end of the quarter, but planned to buy them back again days later. The effect of the accounting was to artificially and temporarily lower the firm’s debt levels to hit certain targets, making the firm look healthier than it really was.

Contributed by David Sack

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Before the ink has even dried on the new healthcare legislation, new progress is being made on an equally bold push for reform of the financial services sector. On March 22 a bill promising sweeping new changes on Wall Street emerged from the Senate Banking Committee and will soon be introduced to the full Senate.

The bill, sponsored by Connecticut Senator Chris Dodd, takes a multi-pronged approach to reform. The bill would revamp governance of public companies, giving shareholders advisory votes on executive pay and the ability to nominate directors through company-issued proxy ballots.

The bill would also substantially expand government oversight of banks, hedge funds and the derivatives market. The Securities and Exchange Commission would gain the authority to regulate parts of the derivatives market, including security-based swaps, and would be empowered to strictly oversee hedge funds. The bill would also give the Commission the right to self-fund, allowing it to set its own budget and collect filing fees from the public companies and investment firms that it supervises.

The legislation would create a nine-member council, led by the Treasury, which would watch for systemic risks and direct the Federal Reserve’s supervision of the nation’s largest and most interconnected financial institutions. The Federal Reserve would be charged with supervising not only banks but any institution that would “pose risks to the financial stability.”

One of the most significant changes proposed by Dodd’s bill is a provision allowing regulators to implement the so-called “Volcker rule,” named for Paul A. Volcker, the former Federal Reserve chairman. The rule would prohibit deposit-taking banks from investing in or owning hedge funds or private equity funds, and engaging in proprietary trading—making trades unrelated to their clients’ interest.

The scope of the bill has already precipitated a frenzy of lobbying from Wall Street and banking industry titans. Investors should pay close attention to the progress of the legislation, as it’s sure to be another wild ride.

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With newly proposed rules regarding naked access and executive compensation, the SEC is making significant inroads in shoring up investors’ confidence in the markets and in the Commission itself. 

One of the Commission’s recent achievements is newly- proposed rules to prohibit broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or alternative trading system. The proposed rules, which were unanimously approved last week, would require brokers with market access, including those who sponsor customers’ access to an exchange, to put in place risk management controls and supervisory procedures. The proposed procedures would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

Another notable recent achievement is the new executive compensation disclosure rules that were adopted last December and will take effect with this year’s proxies.

In the past, the executive compensation disclosure rules contained loopholes permitting public companies to hide information regarding equity grants, which is most important part of the package for many executives. Under the new rules, companies will have to disclose this information to investors in a summary table. 

Even under this improved regulatory scheme, however, companies may still be able to minimize the awards they disclose when grants are tied to undisclosed performance goals. The amounts disclosed will reflect only what the company asserts that executives are likely to be paid, with little meaningful way for auditors or investors to assess the reliability of these estimates.

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In a November 6, 2009 speech at a roundtable conference hosted by the George Washington University Law School and the Institute for Law and Economic Policy (ILEP), SEC Commissioner Luis Aguilar warned that the powerful financial sector lobby has been working overtime to weaken reform initiatives that would benefit shareholders. 

Aguilar focused on a potentially disastrous amendment to the pending Investor Protection Act of 2009. A late addition to the bill would sharply limit the reach of the investor protections set out in the Sarbanes-Oxley Act of 2002. Section 404(b) of the existing statute requires that executives of all public companies take responsibility for their internal controls, and that the controls be reviewed by independent auditors. The new addition to the Investor Protection Act of 2009, however, would turn the legislation on its head by repealing these crucial requirements for about 6,000 publicly traded companies with market capitalization under $75 million.

The Commissioner also suggested that the current preoccupation with regulating systemic risk embodied in institutions that are “too big to fail” may not adequately address market protection. Noting that “financial services exist to serve investors,” he emphasized that it is essential that the dialogue be shifted from how best to preserve “too big to fail” institutions to “what is best for investors.”

According to Aguilar, "systemic risk regulation should facilitate an environment where no institution is indispensable, and where other firms can step in to meet the needs of the market."

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America is experiencing an extraordinary period of legislative and regulatory executive compensation reform. In fact, executive compensation reform is so much in vogue that many companies are even voluntarily introducing so-called Say on Pay resolutions. 

Since Treasury Secretary Geithner first proclaimed that companies in receipt of TARP assistance would have to subject executive compensation to Say on Pay resolutions in February 2009, thirteen publicly-traded companies that did not receive TARP monies—including Verizon, Motorola, and Blockbuster—have willingly adopted the Say on Pay way. 

In addition to these thirteen corporate compensation pioneers, eleven other leading publicly-traded companies that did not receive TARP funds—such as Microsoft and Apple—have either willingly scheduled Say on Pay votes for 2010 or have already voted but not yet released results. 

These voluntary say on pay resolutions revise compensation disclosure by, among other things, changing the Summary Compensation Table (“SCT”) reporting of stock and option awards and by broadening the scope of the Compensation Discussion and Analysis (“CD&A”) to include a new section that analyzes the link between a company’s overall compensation policies and the company’s risk and management of that risk. 

Say on Pay resolutions further require that compensation committees be independent, and that such committees disclose the use of consultants and advisors (who are also required to be independent). In addition, such provisions require disclosure of specific performance targets, and also seek to enhance proxy access for stockholder proposals and director nominations.   

Adoption of Say on Pay provisions will result in closer scrutiny of executive pay arrangements by boards and compensation committees. Better-informed and qualified boards and compensation committees, in turn, may help restore investors' faith in corporate governance after the crises of the last two years.

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On October 22 Wall Street received a double whammy with the release of plans by the Federal Reserve and the Treasury Department to aggressively regulate pay practices at banks. While both approaches capitalize on public wrath erupting over the announcement of record-setting year-end bonuses at top financial firms, they differ significantly in scope and effect. 

The Federal Reserve’s new compensation proposal, outlined in its October 22 press release, has the broadest sweep, covering thousands of banks, including U.S. subsidiaries of foreign institutions. While the proposed rules would not directly regulate pay, they would include demands that firms take into account losses incurred by employees, make pay tied to longer-term performance, and pay out over longer stretches of time. The only real teeth in this regulation, however, is the Fed’s right to veto compensation plans it does not like, and to require that management come up with better approaches. 

The Treasury plan is more limited in scope, but has a much more immediate impact. The plan, outlined in an October 22 press release titled The Special Master for TARP Executive Compensation Issues First Rulings, applies only to the beneficiaries of bailout funds under the TARP program. It attempts to better align pay with longer-term performance, but takes a more direct approach than the Fed. Treasury official Kenneth Feinberg, the Obama administration’s “pay czar,” slashed cash compensation, increased stock awards, and insisted that stock compensation be held for two to four years. Salaries paid to the highest-earning executives at seven companies getting exceptional federal aid will also be capped at $500K, while the group’s total pay level, annualized, will be 50% lower than last year.

Not surprisingly, the financial services industry is not happy with either approach. Although the sector benefited from last year’s massive infusion of taxpayer capital, banks are bridling at the suggestion that regulators—and the taxpayers they protect—should have any role in reforming the institutions that they helped save.

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The G-20 has finally weighed in on the issue of executive compensation. Why should investors care what global financial policy leaders think about performance-related bonuses? Because reforms aimed at ending the financial incentive for executives to bet the house on risky securities will only work if they are adopted uniformly.

There is little mystery about the role that fat-cat compensation packages played in last year’s financial crisis. Top management of investment banks enjoyed bonus packages that rewarded short term bets that could be disastrous for investors, while eliminating any downside risk to executives themselves. It should surprise no one that the result was a vast appetite for dangerous investments that would prove to have tragic long term consequences for investors and taxpayers.

In the Leaders' Statement from the September 24 – 25, 2009 Summit in Pittsburgh, G-20 leaders urged that reforming compensation packages is essential to any effort to increase financial stability. The leaders stated that reforms should ensure that compensation is aligned with long-term value creation for investors, rather than excessive risk-taking. They suggested that this could be accomplished by requiring that a large proportion of performance-related compensation be deferred and be tied to long-term performance. Moreover, they argued that such provisions should have teeth, in the form of claw-back provisions permitting companies to reclaim compensation from executives whose decisions land investors in hot water.

Of course, general statements of policy will be useless unless member countries enact rules enforcing restrictions on pay. A September 5, 2009 address to world leaders by Treasury Secretary Tim Geithner outlines the steps that are being taken in the U.S. to change executive pay structures. Geithner noted that the House has already passed proposals designed to tie compensation to long term performance, and stated that the Federal Reserve would be charged with enforcing the proposed new standards.

It remains to be seen whether any legislative effort to reform compensation can survive powerful lobbying efforts by management interests, but international cooperation on the issue is an encouraging sign.

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In the autopsy of last year’s financial meltdown, one of the principal culprits to have emerged is the extraordinarily lax oversight that the boards of some public corporations have exercised over management. On September 17, 2009, Mary Schapiro, the new Chairman of the Securities Exchange Commission, gave a speech, "Address to Transatlantic Corporate Governance Dialogue--2009 Conference," announcing the SEC’s plan to ensure that this practice would come to an end.

Schapiro lambasted boards of directors for failing to reign in management decisions about risk, and suggested that many boards appear to have misunderstand the gravity of risks taken. The new Chairman stated that “[s]enior management took higher returns at face value without questioning why such higher returns were possible for supposedly safe investments and strategies.”

The new Chairman suggests that regulators should ensure that investors in publicly held companies have the opportunity to remove directors who turn a blind eye to irresponsible management. She outlined a proposal by the SEC to remove obstacles to shareholders' ability to nominate candidates for the boards of directors of the companies that they own.

Under the proposed rules, shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting would be — subject to certain eligibility and procedural requirements — able to have their nominees included in the company proxy that is sent to all voters.

You can expect a fight. This comment letter (PDF)  in support of the proposal was filed by Labaton Sucharow and other firms representing institutional investors.

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