Thursday, August 30, 2007

Fangs & frivolity

My "Speculator" column in the July 2007 Investor Relations MagazineFangs & frivolity

Ian Williams wants to see richer shareholders, smarter management – and poorer lawyers

When politicians on Capitol Hill try to put limits on tort litigation, it's a reasonably safe assumption that lobbyists are paying them on behalf of companies seeking impunity to put asbestos in lungs, lead in children and poisons in petrol – or at least to get a free pass for doing so in the past.

But while companies should pay compensation to those who have suffered from their actions, there is one exception where the anti-tort lobbyists are halfjustified: shareholder suits.

Fangs and frivolity Shareholder suits are perplexing. A corporation is a body with rights and responsibilities, just as if it were a human. At the same time, shareholders own the company. In fact, together they are the company, so a shareholder suing a company is, on the face of it, like a vampire bleeding his own blood into a glass and drinking it. It may offer temporary satisfaction but it is unlikely to add much to the food pyramid for the fanged feeder.

However, there is one class of beneficiary that is more like a creature of the night: the lawyers who initiate, negotiate and bleed dry shareholder suit settlements. Of course, some corporate executives have been regularly ripping off shareholders and other stakeholders like employees and pensioners, so it would make sense if shareholder suits were not against the corporation but against the management as individuals.

On the other hand, employees of a company, including management, are entitled to protection against frivolous litigation for actions they carried out for the benefit of their company – insofar as their actions were within the law. If a CEO is charged with the murder of a business rival, we would not, in general, expect directors and officers insurance to cover the costs of his or her defense, except in the unlikely event that a board decision authorized the whacking.

There are several ways to tackle this: one is to give juries the power to order the costs of both parties to be paid by frivolous litigants and their lawyers. The other would be to legislate that no company should pay, either directly or indirectly through insurance, for the legal defense of management teams that did not meet certain corporate governance criteria that demonstrate they were acting on behalf of the company.

Even though I suspect this may not play well in Delaware, it would be conducive to putting some truth in the legal fiction that a public company is a joint enterprise of its shareholders rather than a management-dominated Ponzi scheme while reducing frivolous shareholder litigation. If individual managers make decisions that tortuously steal from shareholders, they should pay the price – by being both forced out and made to pay back their own gains.

Finally, there is the Gordian knot solution: remove the conflict of interest from senior executives by removing their incentive to manipulate stock values and financial reporting. Pay them a salary – and nothing else.

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