(Editor’s Note: This post is by Edward Labaton and Ethan Wohl of Labaton Sucharow LLP.)

We recently published an article on “say on pay” that questions the value of routine shareholder votes on executive compensation.

We cite the limited impact of existing shareholder votes on equity-based compensation and note that in many situations, even the best disclosures do not allow shareholders to fully grasp the financial impact of compensation arrangements. We also note a timing problem: shareholders generally defer to board decisions until governance problems become clear and present. At this point, a problematic compensation plan will likely be years old and beyond attack.

We also argue that because there is no substitute for an independent board negotiating compensation at arm’s length, giving ultimate say to shareholders risks harming the quality of compensation by diminishing board authority.

We conclude by proposing that shareholders be allowed to vote on pay, but that such votes be held only when requested by a substantial shareholder. Governance advocates would have an incentive to be selective in their challenges since their credibility with larger institutions is crucial for effective advocacy, and the relative rarity of such votes would prompt greater focus by institutional investors and the proxy advisory services.

The article is available here.

The students of Professor Robert Clark’s and Vice Chancellor Leo Strine’s Mergers, Acquisitions, and Split-Ups class were recently treated to a fascinating discussion on the future of mergers and acquisitions, with a particular focus on transactions involving financial institutions, by Rodgin Cohen, the current chairman of Sullivan & Cromwell LLP. Mr. Cohen is one of the most influential private-sector players in the financial crisis—during September alone, Mr. Cohen acted as an adviser to Fannie Mae, Lehman Brothers Holdings Inc., Wachovia, Barclays PLC, American International Group Inc., J.P. Morgan Chase & Co. and Goldman Sachs Group Inc. in a variety of transactions.

Mr. Cohen talked about the current state of the financial system and the importance of confidence to the effective functioning of any financial system, before moving on to discuss a number of recent transactions. He focused on the significant differences in financial transactions, due to the regulatory overlay, and provided numerous insightful examples of recent transactions where these issues were of critical importance. He also provided specific examples of the government’s role, which facilitated transactions that involved asset sales without the assumption of all the corresponding liabilities, either explicitly, through stop-loss relief or capital adequacy exemptions. Mr. Cohen also provided interesting insights into what he expects in terms of forthcoming regulatory changes.

A video of the discussion can be accessed on the here.

(Editor’s Note: This post comes to us from Alan D. Morrison of University of Oxford, and Lucy White of the Harvard Business School, Swiss Finance Institute, and Centre for Economic Policy Research.)

In our recently accepted Journal of Finance paper Level Playing Fields in International Financial Regulation, we analyze the costs and benefits of imposing level playing fields in international financial regulation. The cost of level playing fields is that they limit the social benefits of expert regulation in the better-regulated economies, thus shrinking their banking sectors. The benefit is that the banking sector in the less well-regulated economies will be larger and of better quality.

We analyze this trade-off in a number of different setups. In the base case, we allow bankers to be chartered to operate in only one economy, so that multinational banking is impossible. In this case, regulators face a stark choice: international coordination upon a level playing field, which will disadvantage the well-regulated economy, and a laissez faire policy of no international regulation of the playing field, in which case the cherry-picking effect will adversely affect the less well-regulated economy. From a global welfare-maximizing perspective, it turns out to be better to adopt a level playing field, and hence to experience the lowest common denominator effect, when the regulatory abilities in the economies involved aresufficiently similar, because the extent of shrinkage implied by the lowest common denominator effect will be small. By contrast, when regulators’ abilities are very different, the cherry-picking externality is the lesser of the two evils and an unregulated playing field dominates. This leads to the intuitive conclusion that “similar” economies should endeavor to adopt common capital regulation and deposit rates; economies that are very different should not attempt to follow them, but should adopt their own regulation.

After analyzing the base case, we extend our model to allow bankers to apply for licenses in more than one country. Introducing multinational banks into our model allows us to take a more nuanced view of the capital flows that create cherry-picking effects. We analyze two cases: one in which borders are opened after bankers have received their first license, so that banks are obliged to open at home before they seek a foreign license, and one in which bankers can make their first license application anywhere. In both cases we show that, when multinational licenses are awarded optimally, multinational bank properties are invariant to the country in which the first of their licenses was awarded. Cherry-picking effects are therefore a concern only for single-country local banks that fail to attract a second license.

The full paper is available for download here.

Justice Jack Jacobs of the Delaware Supreme Court recently visited Harvard Law School for the second time this semester as the 2008 Distinguished Visiting Jurist of the Program on Corporate Governance.

A graduate of Harvard Law School (’67), Justice Jacobs practiced corporate and business litigation in Wilmington, Delaware before becoming Vice Chancellor of the Delaware Court of Chancery in 1985. In 2003, he was appointed to the Delaware Supreme Court. In corporate law, Justice Jacobs is considered one of the preeminent judges of the nation. Most recently, he authored the Delaware Supreme Court’s landmark decision in CA v. AFSCME, which addressed key issues in the distribution of powers between boards and shareholders. On this blog, we have previously discussed this important decision here, here, and here.

At Harvard Law School, Justice Jacobs spoke about the CA v. AFSCME decision in the Corporate and Securities Law and Policy class of professors Lucian Bebchuk and Allen Ferrell, and in the Corporate Law A3 class of professor Guhan Subramanian. In his presentations, Justice Jacobs discussed the logic and implications of the opinion as well as the broader context of Delaware jurisprudence within which it was decided. A video of one of his presentation at Professor Subramanian’s class is available here.

There is a really bad idea circulating in the nation’s capital. Of course, that’s not surprising–but when it’s endorsed by the Treasury secretary, we’d better pay attention.

Recently, Henry Paulson said in an interview with the Washington Post that he wants the Federal Reserve to be able to regulate and ultimately take over any failing financial institution that it considers crucial–including hedge funds. This echoes a notion that has been endorsed by executives of some industry associations, that to prevent a recurrence of today’s financial crisis it will be necessary to impose tough new regulations on financial institutions deemed “systemically significant.”

If this approach were to be adopted in the panicked Washington of today, it would substantially change our financial system and guarantee–rather than prevent–future crises.

For starters, because the definition of a systemically significant institution is highly dependent on context, it’s impossible to identify one in advance. Consider Drexel Burnham Lambert. When it failed in 1990 it was one of the largest securities firms in the United States, not much smaller in relation to the market at the time than Lehman Brothers was when it collapsed earlier this year. Yet Drexel’s collapse, which happened when the market was functioning normally, did not put the financial system or the economy at risk.

…continue reading: Not Everything Can Be Too Big to Fail

Recently, in the Mergers, Acquisitions, and Split-Ups course here at Harvard Law School, which is co-taught by Professor Robert Clark and Vice Chancellor Leo Strine, Jr., three expert practitioners shared their insights on the complex cross-border transactions that increasingly define the M&A landscape.

The panelists included Raymond McGuire, the co-head of Global Investment Banking at Citigroup, Toby Myerson, the co-head of Paul Weiss‘ Mergers and Acquisitions Group and Scott V. Simpson, the head of the European Mergers and Acquisitions Group at Skadden, Arps, Slate, Meagher & Flom.

Ray started the discussion with an overview of global trends in M&A and cross border transactions. He emphasized how the market today is far more globally connected, and that the increase in LBO activity during the 2002 to 2007 period was coincident with increased use of debt, and in particular covenant light debt. He also highlighted issues with the subprime market, and the government bailout of certain institutions.

Toby and Scott focused on the European regime, and offered fascinating perspectives on the social and political considerations that underlie the differences between the European and US approaches. In particular, Scott noted the differences in the corporate governance regime. For example, certain European countries such as Germany require directors to consider broader corporate interests, such as employee interests, in responding to takeover offers, as opposed to the US model where shareholder interests are paramount. Toby and Scott also took the class through case studies of two recent cross-border deals that illustrate the application of these principles, as well as the quickly changing landscape facing M&A practioners. The first case, Mittal Steel’s acquisition of Arcelor, illustrated how lawyers could exploit international reconciliation requirements to delay an acquisition, thus giving the target the ability to shop for a higher price. Scott noted how this successful technique is no longer effective due to recent international harmonization. He then discussed Access Industries’ Basell Holdings acquisition of Lyondell Chemicals Company, where the parties needed to use another technique involving the separation of voting and economic interests using derivatives. In both cases, the panelists highlighted the social and political matters that inevitably arise when a foreign acquirer pursues a large target.

A video of the discussion can be accessed online here.

(Editor’s Note: This post comes to us from Jeff Lipshaw of Suffolk University Law School.)

My intuition, as a former senior vice president and general counsel of a publicly held corporation and as a theorist, is that Rule 14a-8 shareholder proposals on matters like poison pills, staggered boards, and executive compensation, bear at best a tenuous relationship to what shareholders should most want: the exercise by corporate management of exquisite judgment.

Keep in mind the complex milieu in which corporate management operates. My own experience is as a senior manager of a typical mature mid-cap company, not pathological like Enron, but not on the steep upslope of the “shareholder value creation” curve. The issues facing management in these companies are typically a mix of the following: product commoditization and obsolescence, loss of patents, pressure on R&D spending cuts, manufacturing inefficiencies, and so on. The shareholder base may be no less complex, consisting of long-term holders, short-term holders, arbitrageurs, social activists, and so on.

In our company, from 1998 to 2002, even as labor union pension funds filed shareholder proposals on the poison pill and the staggered board every year, two significant institutions, Berkshire Hathaway and Brandes Investment, increased their stake in the company from nothing to over 30% of the outstanding shares. The board redeemed the poison pill in early 2002 and sponsored a charter amendment to de-stagger the board in 2003.

…continue reading: Corporate Boards and Good Judgment: Does Rule 14a-8 Activism Help?

(Editor’s Note: This post comes from Mohan Venkatachalam of Duke University, Shivaram Rajgopal of the University of Washington and Preeti Choudhary of Georgetown University.)

In our forthcoming Journal of Accounting Research paper entitled “Accelerated Vesting of Stock Options in Anticipation of FAS 123-R”, we investigate what motivates firms to alter their compensation contracts in response to an accounting standard, and whether the acceleration decision represents benign changes in employees’ compensation contracts by examining the stock market reactions surrounding both the acceleration date as well as the filing date.

Our analysis is based on a sample of 354 firms that announced the accelerated vesting of options between March 2004 and November 2005 and a broad control sample of 665 firms. We observe a rapid increase in the number of accelerated vesting announcements subsequent to the FASB passing FAS 123-R, suggestive of a motivation to avoid recording a stock option expense. For the median (mean) accelerating firm, accelerated vesting increases earnings as a percentage of net income by about 4% (23%). Our regression results indicate that the likelihood that a firm accelerates vesting increases with the extent of underwater options and the level of financial reporting benefits received from acceleration. We also find evidence that acceleration is associated with agency motivations. Managerial ownership and greater option holdings by the top five executives are positively associated with accelerated vesting. We also find that firms with better external governance are less likely to accelerate vesting. In particular, we find that firms with greater blockholder ownership and pension fund ownership (proxies for better governance structures) have lower likelihood of acceleration.

We find that the average market reaction to the acceleration decision is -1% over the five-day period surrounding the announcement. In addition, there is some evidence that the accelerated vesting date could have been backdated. We find systematic negative stock returns of –1.7% 20 days before the acceleration date (not the announcement date) and positive returns of 1.4% 20 days after the acceleration date. We also find that a large majority of acceleration decisions (233 of the 365) reported the activity to the SEC six days or more after acceleration decision, supportive of backdated vesting dates.

The full paper is available for download here.

Last week here at Harvard Law School, Professor Robert Clark and Vice Chancellor Leo Strine treated the students of their Mergers, Acquisitions, and Spin-Offs class to another high-profile panel discussing current hot topics in M&A. On the agenda was section 13(d) of the 1934 Act and other, similar disclosure requirements for long and short positions, particularly as they relate to shareholder activism. The steep rise of synthetic securities has raised many questions of policy and interpretation regarding such requirements, as recently highlighted by the CSX/TCI decision (discussed on this blog here, here, and here). The panelists provided competing perspectives on these issues: On the “activist” investor side, the panel featured Roy Katzovicz of Pershing Square Capital Management and Marc Weingarten of Schulte Roth & Zabel. On the other side were Ted Mirvis of Wachtell, Lipton, Rosen & Katz and John Olson of Gibson, Dunn & Crutcher. Mirvis and Olson also spoke about shareholder activism in Professor Lucian Bebchuk’s and Lecturer on Law Beth Young’s Shareholder Activism class that same day. The video of the first event is available here, and that of the second event here.

The risk oversight function of the board of directors has never been more critical and challenging than it is today. In the context of the current global financial crisis and the swooning global economy, companies now face risks that are more complex, interconnected and potentially devastating than ever before. Risk from the financial services sector has contributed to large-scale bankruptcies, bank failures, government intervention and rapid consolidation. And the repercussions have spread to the broader economy, as companies in nearly every industry have suffered from the effects of a global paralysis in the credit markets, sharply reduced consumer demand and extremely volatile commodity, currency and stock markets. In addition, the public and political perception that undue risk-taking has been central to the breakdown of the financial and credit markets is leading to an increased legislative and regulatory focus on risk management and risk prevention. In this environment, boards and companies must be mindful of the possibility that courts will apply new standards, or interpret existing standards, to increase board responsibility for risk management.

But what exactly is the proper role of the board in corporate risk management? The board cannot and should not be involved in actual day-to-day risk management. Directors should instead, through their risk oversight role, satisfy themselves that the risk management processes designed and implemented by executives and risk managers are adapted to the board’s corporate strategy and are functioning as directed, and that necessary steps are taken to foster a culture of risk-adjusted decision-making throughout the organization. Through its oversight role, the board can send a message to the company’s management and employees that corporate risk management is not an impediment to the conduct of business nor a mere supplement to a firm’s overall compliance program but is instead an integral component of the firm’s corporate strategy, culture and value generation process.

Given the increased significance of the risk oversight role in the current risk environment, a company’s risk management system should function to bring to the board’s attention the company’s most material risks and permit the board to understand and evaluate how these risks interrelate, how they affect the company, and how management addresses these risks. It is important for directors to have the experience, training and knowledge of the business necessary for making a meaningful assessment of the risks that the company faces, however complicated they may be. The board should also consider the best organizational structure to give risk oversight sufficient attention at the board level. In some companies, this may include creating a separate risk management committee or subcommittee. In others, it may be sufficient to have the review of risk management as a dedicated, periodic agenda item for an existing committee such as the audit committee, in addition to periodic review at the full board level. While no “one size fits all,” it is important that risk management be a priority and that a system for risk oversight appropriate to the company be put in place.

My colleagues Daniel A. Neff, Andrew R. Brownstein, Steven A. Rosenblum, Adam O. Emmerich, Sabastian V. Niles, Shaun J. Mathew, Brian M. Walker, and Philipp von Bismarck and I have prepared a memorandum entitled “Risk Management and the Board of Directors” that considers these and related considerations. The memorandum (1) outlines the risk oversight obligations of the board of directors and certain best practices derived from governmental and regulatory sources, (2) discusses some of the common areas of risk that companies may face, and (3) provides recommendations for structuring and improving risk oversight at the board level.

The memorandum is available here.

(Editor’s Note: This post comes to us from William Russell-Smith of AQ Research.)

Over the past few months financial markets have been through a traumatic experience. The traumatic experience equally applies to the participants. Not only are firmly held convictions overturned, models proved useless and careers destroyed, but the industry now faces a period of public scrutiny and social accountability that it has never before experienced.

The main question for proponents of sustainable financial markets is how can the lessons from these events be embedded in future behavior? A further question is about the appropriate regulatory response. This has been taken up by the Network for Sustainable Financial Markets.

…continue reading: Investment professionals blame bank leaders and want global consultation on new financial system

Does private equity create value when it acquires a company in a leveraged buyout? If so, how? This question has fascinated scholars ever since the first big wave of buyouts occurred in the mid-1980’s, but has yet to be resolved. A second, even bigger wave of LBO transactions in 2003-2007, brought to a shuddering halt by the recent sub-prime mortgage crisis, has raised the question again even more forcefully as the current market for private equity deals has collapsed. In our recent article “Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance,” Ronald W. Masulis and I offer an important new motivation for private equity deals in the future: private equity firms and managers can do a better job of monitoring of derivative transactions and derivative contract positions than their public company counterparts.

As the subprime crisis has illustrated vividly, the growing use of, and trading in, derivative instruments by corporations has eroded the effectiveness of several critical corporate governance mechanisms - the board of directors, the financial accounting system and oversight by regulatory authorities - because firms lack effective means of monitoring derivative risk exposure on a real time basis. This change has increased the importance of attracting financially sophisticated, highly motivated corporate directors, who can deliver intensive monitoring of corporate risk management strategies, who are capable of independently and effectively controlling firm management as part of regulating derivative exposure and who will make the appropriate choices in creating managers’ financial incentives to insure that these executives’ personal risk exposures are aligned with the interests of the firm.

In this paper, we argue that private equity concentrated ownership is now, and will continue to be in the future, a very effective way of attaining all of these objectives. Private equity involvement strengthens boards monitoring of derivative exposures by reducing board size, increasing boards’ control over managers, improving information flows to the board, sharpening director financial incentives to monitor derivative exposure carefully, and attracting better qualified, more financially sophisticated directors, who better understand the associated risks. Further, debt holders and institutional investors can further improve firm monitoring since they are also large investors (who frequently hold both debt and equity positions in private equity controlled firms), which gives them strong incentives to monitor and good access to proprietary firm information flows to accomplish this goal.

The paper is available here.

U.K. corporate governance is characterized by a separation of ownership and control, in the sense that a majority of British publicly traded companies lacks a shareholder owning a sufficiently sizeable voting block to dictate corporate policy. This pattern has not only influenced the tenor of corporate governance debate in Britain but serves to distinguish the U.K. from most other countries. Existing theories fail to account adequately for ownership and control arrangements in Britain. My book, Corporate Ownership and Control: British Business Transformed, just published in the U.K. and soon to be available in the U.S., accordingly explains when and why ownership became divorced from control in major British companies.

The approach I adopt in the book is strongly historical in orientation, as I examine how matters evolved from the 17th century through to today. While a modern-style divorce of ownership and control can be traced back at least as far as mid-19th century railways, the “outsider/arm’s-length” system of ownership and control that currently characterizes British corporate governance did not crystallize until the second half of the 20th century. Corporate Ownership and Control: British Business Transformed brings the story right up to date by showing current arrangements are likely to be durable. The insights it offers correspondingly should remain salient for some time to come.

Corporate Ownership and Control: British Business Transformed is divided into eleven chapters:

One: Setting the Scene
Two: The Determinants of Ownership and Control: Current Theories
Three: The ‘Sell Side’
Four: The ‘Buy Side’
Five: Up to 1880
Six: 1880–1914
Seven: The Separation of Ownership and Control by 1914
Eight: 1914–1939
Nine: 1940–1990: The Sell Side
Ten: 1940–1990: The Buy Side
Eleven: Epilogue: Current Challenges to the UK System of Ownership and Control

Key arguments I make in Corporate Ownership and Control: British Business Transformed include:

…continue reading: Corporate Ownership and Control: British Business Transformed

My colleagues Margaret M. Ayres and Jeanine P. McGuinness have prepared a memorandum entitled “FINSA Final Regulations,” which discusses the final regulations recently issued by the U.S. Department of the Treasury to implement the Foreign Investment and National Security Act of 2007. That law amended the 1988 “Exon-Florio” statute and made significant changes to the scope of review and process for evaluating foreign acquisitions of U.S. businesses for national security risks. The regulations implement the 2007 law and codify recent improvements to the practices of the Committee on Foreign Investment in the United States. They also maintain many of the features of the existing regulations, as well as of the proposed regulations, which were issued for notice and comment on April 21, 2008. The new regulations include the concept of a “covered transaction” and give additional guidance on key terms, including “control.” They also significantly expand the amount of information required in a voluntary notice and provide new procedures governing the review process. The final regulations were published in the Federal Register on November 21 and will become effective on December 22, 2008.

The memorandum is available here and the final regulations may be accessed here.

(Editor’s Note: This post comes to us from Craig Eastland of Thomson West Information Center.)

On October 23rd, Henry Waxman’s House Committee on Oversight and Government Reform began hearings on regulatory oversight of financial markets. Alan Greenspan, John Snow, and Christopher Cox testified. SEC Chairman Cox, the only currently-serving official to testify, is in a tight corner: in March, the Department of the Treasury proposed a new regulatory structure, dubbed “Pure Functional Regulation”, that would see the responsibilities of the SEC distributed among new agencies. John McCain wants him fired (but that’s not so scary today, is it?) Perhaps most unfairly, he’s been blamed for the Consolidated Supervised Entity program, which was adopted almost a year before he even arrived at the SEC.

It made me think there was a real possibility that the SEC might become a casualty of the credit crisis. I even wondered whether this could mean the end of disclosure-based regulation.

To get some insight, I took a quick email poll of securities law experts.

Recommendation 1 - Keep disclosure-based regulation! It is a good system, and the alternatives are worse.

Disclosure-based regulation of securities transactions has been with us since the enactment, 75 years ago, of the Securities Act of 1933. The ’33 Act and the Securities Exchange Act of 1934, which regulates securities exchanges and provides for periodic disclosure to investors, form an interlocking regulatory structure built on,

“[…] a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.” (SEC website)

…continue reading: Experts on the Future of the SEC

(Editor’s Note: This post is from Pavel Savor at the Wharton School at the University of Pennsylvania and Qi Lu is at the Kellogg School of Management at Northwestern University.)

In our forthcoming Journal of Finance article entitled Do Stock Mergers Create Value for Acquirers?, we investigate and find support for the hypothesis that overvalued firms create value for long-term shareholders by using their equity as currency, which is consistent with a market-timing theory of acquisitions.

One of the primary empirical predictions of the market-timing theory of acquisitions is that the acquirer’s long-term shareholders benefit from the bid, even though it might entail no real synergies. The only requirement is that the chosen target be less overvalued than the acquirer. A famous example of such a deal is America Online’s (AOL) stock-financed acquisition of Time Warner, which was one of the defining moments of the Internet bubble. Despite the high premium paid by AOL (48% using the announcement day closing price) and the drop in its stock price upon announcement (17.5% measured over a three-day window), the deal is now almost universally regarded as beneficial to AOL.s long-term shareholders, not for the synergies it delivered, but simply because AOL.s equity was overpriced at the time.

We approach our principal question of whether stock acquirers would have performed better in the absence of the merger by creating a sample of both successful and unsuccessful mergers, and by using the unsuccessful acquirers as a proxy for how the successful ones would have performed had they not managed to close their transactions. Since we do not want the bid termination to be related to the acquirer’s valuation, we research every failed transaction in our sample and create a subsample of those that did not succeed for exogenous reasons. (In this context, exogenous means unrelated to the valuation of the acquirer.) The subsample includes bids that failed because of regulatory disapproval (mostly antitrust action), subsequent competing offers, or unexpected target developments. We also restrict this subsample to non-hostile bids, since hostile bids are more likely to fail and targets might be more inclined to resist offers by overvalued. We find that unsuccessful stock bidders significantly underperform successful ones. Failure to consummate is costlier for richly priced firms, and the unrealized acquirer-target combination would have earned higher returns. None of these results hold for cash bids.

The full paper is available for download here.

(Editor’s Note: This article originally appeared in the New York Law Journal on November 14, 2008.)

On Oct. 3, the Emergency Economic Stabilization Act of 2008 (the EESA) became law.[1] The EESA authorizes the U.S. Treasury Department to acquire up to $700 billion in “troubled assets” from financial institutions.[2] It designates the overall program as the Troubled Assets Relief Program (TARP).

The authority of the Treasury to acquire troubled assets continues through Dec. 31, 2009 but the secretary of the Treasury can extend this authority for a period ending Oct. 3, 2010 upon certifying to Congress the need for the extension and its expected cost to taxpayers.

TARP Programs

Three TARP programs have been initiated thus far:

1. Capital Purchase Program (CPP).[3] This program applies to those financial institutions that enter into agreements pursuant to this program for the purchase by the Treasury of their preferred stock.[4] The executive compensation aspects of the program are derived from §§111 and 302 of the EESA, described, respectively, as “Executive Compensation and Corporate Governance” and “Special Rules for Tax Treatment of Executive Compensation of Employers Participating in the Troubled Assets Relief Program.” As of the date this column was written, it was reported that approximately 50 financial institutions had elected to participate in CPP.[5]

…continue reading: EESA Limits on Executive Pay at Affected Institutions

In our paper forthcoming in The Accounting Review, “The Impact of Shareholder Activism on Financial Reporting and Compensation: The Case of Employee Stock Options Expensing,” my co-author Tatiana Sandino and I examine the economic consequences of more than 150 shareholder proposals to expense employee stock options (ESO) submitted during the proxy seasons of 2003 and 2004. This was the first instance where the SEC allowed a shareholder vote on an accounting matter. Activists had argued that lack of ESO expensing had led to an excessive use of option-based compensation.

Under the current legal regime, shareholder proposals are typically non-binding, raising the question of their real economic consequences. Overall, our findings reveal an increasing influence of shareholder proposals on governance practices.

With respect to accounting choices, we find that firms targeted by ESO expensing proposals were significantly more likely to subsequently adopt ESO expensing relative to a control sample of S&P 500 firms, particularly when the proposals received a high degree of voting support. We also find that non-targeted firms were more likely to adopt ESO expensing when a peer firm was targeted by an ESO expensing shareholder proposal, suggesting the presence of spillover effects of this shareholder initiative.

…continue reading: The Impact of Shareholder Activism on Financial Reporting and Compensation: The Case of Employee Stock Options Expensing

My firm has recently issued a memorandum entitled “Underfunded Pension Liability: Lenders and Buyers Beware,” which considers the risks posed by underfunded defined benefit pension plans to sponsors and acquirers of and lenders to companies with such plans. These risks have been heightened by the current market downturn, low interests rates and the impact of the Pension Protection Act of 2006. Moreover, although the new FASB Statement No. 158 requires a company to recognize the underfunded status of defined benefit plans as a liability on its balance sheet and to recognize changes in that funded status in the year such changes occur, the ultimate liability is still uncertain. The company’s consolidated balance sheet and the footnotes to its financials provide certain historical information based on assumptions made as of the date of such statements and do not have sufficient detail to make an exact determination as to the company’s potential liability. The memo outlines in detail the risks facing sponsors, acquirers and lenders, the new pension rules and outlines strategies to avoid pension plan issues in the current market.

The memorandum is available here.

Who’s to blame when a signed deal falls through? This question is especially relevant with respect to LBO buyers these days. Deals negotiated when times were good and credit was easy look much less appealing if not disastrous now that the short term economic outlook is bleak and the credit environment has soured. In particular, banks are weary of lending into LBOs when their ability to securitize and sell off the loans has waned. Private equity buyers may want to extricate themselves from signed deals, or be forced to do so because debt financing is not forthcoming. What contractual rights do sellers, buyers, and financiers have against one another in such a situation? What reputational effects, if any, constrain them from exercising those rights? And how should a seller’s board trade off deal certainty against price when choosing between competing transactions? Isaac Corré of Eton Park, Steven Davidoff a/k/a The Deal Professor, John Finley of Simpson Thacher, and Jim Morphy of Sullivan & Cromwell debated these questions with Vice Chancellor Leo Strine, Jr. and Professor Robert C. Clark in their Mergers, Acquisitions, and Split-Ups class here at Harvard Law School last week.

The video of the event is available here.

I recently issued a paper entitled A Pragmatic Approach to the Phased Consolidation of Financial Regulation in the United States, which recommends an approach to reforming the US system of financial regulation. The proposal comes against the backdrop of dramatic increases in market volatility, unprecedented interventions by the Federal Reserve Board to sustain securities firms, palpable failures to protect consumers in mortgage lending markets, and lingering concerns over the competitiveness of the American financial services industry, which have all combined to put regulatory reorganization — and related issues of regulatory consolidation — on the national agenda.

One recurring theme in recent events has been short-term initiatives to expand the role of the Federal Reserve Board for issues related to market stability. In some cases, such as the creation of the new credit and liquidity facilities of the past few months, the Board itself has expanded its supervisory reach under existing statutory powers. In other cases, such as the recent memorandum of understanding between the Federal Reserve Board and the SEC, the expansion has been effected through improved information sharing agreements with other regulatory bodies. And, in yet other cases, such as recent legislative proposals coming in congressional testimony from Treasury Secretary Paulson and Federal Reserve Board Chairman Bernanke, the expansion of Federal Reserve authority would necessitate legislative action. To a considerable degree, these initiatives are consistent with the long-term vision for an optimal system of regulatory reform articulated by the Treasury Department in its Blueprint for a Modernized Financial Regulatory Structure in March.

What has not yet received attention is whether other aspects of the Blueprint ’s proposals for consolidation should be implemented and, if so, how those other aspects relate to the on-going expansion of Federal Reserve Board authority and its role in ensuring market stability. My paper addresses those issues. Drawing on lessons learned from the experiences in other jurisdictions, the paper explains why consolidated oversight as implemented in leading jurisdictions around the world offers a demonstrably superior model of supervision for the modern financial services industry. It also discusses the different ways in which financial supervisory systems can be consolidated and how the process of consolidation can be staged. It recommends the establishment of an independent umbrella organization — the US Financial Services Authority — and that reorganization be staged in a series of phased steps whereby the most important coordinating and oversight functions are first consolidated under this organization and the supervisory components of the industry integrated at a later date.

This recommended path to consolidated supervision has many advantages over the approach proposed in the Treasury Blueprint. A key one is that the coordination of market conduct and prudential functions is handled within a single regulatory body, free from inter-agency disputes or potential litigation. With appropriate safeguards, the regulatory body, as an independent agency, may be protected from excessive political interference and more likely to attract and retain high-quality staff, particularly in senior positions. The recommended approach is also fully consistent with the establishment of the Federal Reserve Board as the agency responsible for ensuring market stability across the financial services industry.

The paper elaborates upon this approach to reforming our system of financial regulation. Many aspects of the program would entail federal regulation. Without proposing specific statutory language, the paper outlines the key issues that would need to be addressed, emphasizing areas in which the new consolidated regulatory agency should be delegated authority to develop appropriate administrative structures and resolve jurisdictional disputes. The paper is available here.

(Editor’s note: This post comes from Thomas Lemieux of the University of British Columbia, W. Bentley MacLeod of Columbia University, and Daniel Parent of McGill University.)

In Performance Pay and Wage Inequality, which is forthcoming in the Quarterly Journal of Economics, we evaluate the change in components of pay across different types of jobs, and investigate whether these changes have lead to the increase in wage inequality.

We use data from the Panel Study of Income Dynamics (PSID), and our empirical strategy builds upon two of the most prevalent solutions to how best to set employee pay. The first begins with an evaluation of the needs of a job, and then fixes compensation equal to job value. Under such a system, compensation is effectively fixed before the worker is hired. This implies that compensation is mainly determined by characteristics of the job, with the relationship between worker ability and compensation driven by selection: firms hire the most able person that applies for the job. The second approach is premised on the concept of pay for the person. This system entails rewarding a person’s productivity rather than the job. Under such a regime, the base pay reflects job value, with additional compensation paid after employment to reward the worker for realized performance.

We find that the incidence of performance-pay has increased substantially since the late 1970s. This increase is consistent with the view that the cost of collecting and processing information has declined over time with advances in information and communication technologies. Second, we show that wages are less equally distributed in performance-pay jobs than in other jobs because the return to productive characteristics like education is larger in performance-pay jobs. Putting together these observations, and the fact that the incidence of performance has increased over the same time period, we find that about a quarter of the increase in the variance of wages between the late 1970s and early 1990s is associated with the increased use of performance-pay. Even more striking, we can explain nearly all of the increase in wage inequality above the 80th percentile. This is particularly important because changes in inequality are increasingly concentrated at the top levels of the wage distribution.

The full paper is available for download here.

In our paper “Renegotiation of Cash Flow Rights in the Sale of VC-Backed Firms”, which was recently accepted for publication in the Journal of Financial Economics, Brian Broughman and I investigate the performance of VCs’ cash flow rights in sales of portfolio firms.

When VCs seek to sell a portfolio firm, the firm’s executives and other common shareholders may try to use their board seats and other control rights to hold up the sale of the firm, particularly when satisfaction of VCs’ liquidation preferences would leave little for common shareholders. The threat of holdup may lead VCs to “carve out” part of their cash flow rights for common stockholders. Unfortunately, there is little evidence on how VCs’ cash flow rights perform in private sales. Are VC cash flow rights renegotiated in private sales, and, if so, are such renegotiations caused by common stock’s holdup power?

To answer these questions, the paper uses a hand-collected dataset of 50 VC-backed Silicon Valley firms sold to acquirers in 2003 and 2004. For each firm, we gather data on the allocation of control rights and cash flow rights from the initial VC financing to the sale. We then document the distribution of sale proceeds among the VCs and the original common shareholders. We can thus compare VCs’ cash flow rights at the time of sale to the amounts they actually receive.

We find that in most sales VCs receive their full cash flow rights. In 11 of the sales, however, VCs carve out part of their cash flow rights to common shareholders. In these cases, all of which involved the VCs exiting as preferred shareholders, the average deviation between the VCs’ cash flow rights and their actual payout is $3.7 million, approximately 11% of the VCs’ cash flow rights. Across all 50 firms, the average deviation was 2.3% (1.9% dollar-weighted). Our study thus suggests that VCs’ cash flow rights are quite reliable in private sales, even when the VCs exit as preferred shareholders and are most likely to be held up.

We also show that the likelihood and magnitude of deviations from VCs’ cash flow rights in favor of common shareholders are larger when common shareholders have more power vis-à-vis the VCs. Everything else equal, the expected deviation is about $1.5 million larger if VCs lack a board majority and roughly $1.6 million larger if the firm is incorporated in California (rather than Delaware), which gives common shareholders relatively more leverage against the VCs through that state’s bundle of common shareholder rights. This suggests that such deviations are driven, at least in part, by the allocation of control within the firm. Our findings linking common shareholder power to deviations from VCs’ cash flow rights are generally robust to alternative econometric specifications.

The full paper is available for download here.

My colleague Laura A. McIntosh and I have written an article entitled “Shareholders Focused on Stability in Proxy Votes,” in which we discuss the outcomes and lessons from the recently completed proxy season. Although the season was expected by some to generate increased activism, it now appears to have been the season in which shareholders began to put governance reform proposals back into perspective. As the credit crisis worsened and market turbulence became increasingly worrisome, shareholders appeared less concerned with governance issues and instead focused on corporate stability: directors generally were reelected with 90-plus percent support, backing for governance proposals fell from 2007 levels in many cases, and the number of governance proposals brought to a vote by shareholders decreased as some prominent activist investors dropped planned campaigns. The 2008 proxy season also brought a high number of proxy contests, although most of these contests involved campaigns to elect “short slates” of directors as opposed to proxy contests for control. The memo discusses the importance of effective communication between among companies and their shareholders as well as the value of takeover defenses in a down market.

The memo is available here.

My partner Peter S. Golden has prepared a memorandum discussing the extraordinary remedy ordered by the Delaware Chancery Court in the recent decision of In Re Loral Space and Communications Inc. Consolidated Litigation. Finding that the terms of $300 million of convertible preferred stock issued by Loral Space and Communications Inc. to its controlling stockholder were unfair, the Court fashioned a remedy by converting the preferred stock into non-voting common stock based upon a court-determined “fair price” for Loral common stock. Although Loral had created a special committee of directors to negotiate the transaction, the Court criticized the committee as a special committee in name only. In Re Loral Space and Communications Inc. Consolidated Litigation demonstrates that controlling stockholders have a strong interest in ensuring that a well-advised committee of truly independent directors represent the interests of public stockholders in any transaction involving the controlling stockholder and the public company it controls.

Applying the entire fairness standard of review because a majority of the Loral board of directors was affiliated with the controlling stockholder, Vice Chancellor Strine found that the Loral preferred stock issuance was neither the result of fair dealing nor priced fairly. With respect to fair dealing, the key issue was whether the Loral Special Committee functioned as an effective proxy for arms-length bargaining. Holding that the Loral Committee did not, Vice Chancellor Strine was critical of almost every aspect of the Special Committee process. The memo, available here, analyzes the decision and highlights the lessons from it for those advising special committees.

(Editor’s Note: This post comes to us from James S. Linck and Jeffry M. Netter of the University of Georgia and Tina Yang of Clemson University.)

In our forthcoming Review of Financial Studies paper The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors, we examine the effects of SOX and contemporary reforms on the structure and makeup of corporate boards and directors.

We examine the effects of SOX using a simple framework of demand and supply for directors. Specifically, demand for directors increased due to various mandates on board composition and workload. The supply of directors decreased due to the increased workload and risks of being a director. While we cannot directly trace out the shifts of the curves, we examine the magnitude of the changes caused by these demand and supply shifts on the number and pay of directors (price and quantity). Both demand and supply shifts would increase the price of directors (pay) – indeed, director pay does rise dramatically. While the shifts have opposite effects on quantity, some of SOX’s requirements often necessitate that the quantity of directors increases; thus, we expect that the demand effect will dominate. In fact we find that boards are larger post SOX.

We construct several different samples for our empirical analysis to provide sufficient breadth and depth to identify important time series and cross-sectional impacts. For example, we study the boards of more than 8,000 firms from 1989 to 2005, providing broad-sample evidence on the impact of SOX and contemporary changes on the major exchanges. We complement our broad-sample evidence with more detailed analysis of smaller subsamples. The breadth and depth of our sample allow for a comprehensive analysis of board-related costs, and the extent to which the costs of these regulatory mandates are uniform across firms.

Our results suggest that SOX dramatically affected corporate boards, their activities, and their costs. Median pay per director rose by more than $38,000 from 2001 to 2004, an increase of more than 50%. By comparison, CEO pay increased by just 24% over the same time period. The per director pay increase, coupled with the fact that firms also have more outside directors, drove a substantial increase in total director fees paid by firms. Our results also suggest that changes in director pay especially fall on smaller firms, a fact that was exacerbated by SOX given the dramatic post-SOX rise in director compensation. For example, small firms paid $3.19 in director fees per $1,000 of net sales in 2004, which is $0.84 more than they paid in 2001 and $1.21 more than in 1998. In contrast, large firms paid $0.32 in director fees per $1,000 of net sales in 2004, seven cents more than they paid in 2001 and ten cents more than in 1998. Further, the proportion of equity to cash pay rose significantly post SOX. Board committees meet more often post SOX and Director and Officer (D&O) insurance premiums doubled. Directors post SOX are more likely to be lawyers/consultants, financial experts and retired executives, and less likely to be current executives. Lastly, post-SOX boards are larger and more independent.

The full paper is available for download here.

I recently presented my paper Leverage and Pricing in Buyouts: An Empirical Analysis, which is co-written with Ulf Axelson, Tim Jenkinson and Per Strömberg, at the Law, Economics and Organizations seminar, here at Harvard Law School.

This paper provides an empirical analysis of the financial structure of large recent buyouts. We collect detailed information of the financings of 153 large buyouts (averaging over $1 billion in enterprise value). We document the manner in which these important transactions are financed. In addition, we compare the firms acquired by private equity funds to comparable firms that are publicly traded. Buyouts are executed by knowledgeable professionals (the general partners (GPs) of the private equity funds) with strong incentives, who utilize sophisticated financial structures designed to maximize value by optimizing on a number of margins.

If we presume that GPs optimize capital structure at the time of the acquisition, then this capital structure provides a benchmark for understanding optimal capital structure in public firms. Lastly, we consider the relation between leverage and transaction multiples, and try to estimate the extent to which the ability of debt markets to provide financing impacts the pricing of deals.

The financial structure that private equity firms choose for their portfolio companies is radically different from that observed for comparably firms quoted on public equity markets. Indeed, a reasonably summary of the differences we observe would be to view them as the inverse of each other. We find that buyout leverage is cross-sectionally unrelated to the leverage of matched public firms, whether we measure leverage as the ratio of debt to enterprise value or by debt as a multiple of cash flow - as proxied by earnings before interest, taxes, depreciation and amortization (EBITDA).

Leverage appears to be largely driven by other factors than what explains leverage in public firms. In particular, the economy-wide cost of borrowing seems to drive leverage. Prices paid in buyouts are related to the prices observed for matched firms in the public market, but are also strongly affected by the economy-wide cost of borrowing. These results are consistent with a view in which the availability of financing impacts booms and busts in the private equity market.

The full paper is available for download here.

In a unanimous opinion in Morrison v. National Australia Bank, the United States Court of Appeals for the Second Circuit limited the ability of U.S. courts to hear claims brought on behalf of non-U.S. investors who purchased shares of non-U.S. companies on non-U.S. exchanges. Referred to as “foreign-cubed claims,” they have become increasingly frequent over the past several years. While declining to adopt a “bright-line rule” precluding the exercise of subject matter jurisdiction over such claims, the Second Circuit held that, in general, a U.S. court does not have subject matter jurisdiction over foreign-cubed claims when the acts that constituted the alleged fraud and directly caused the alleged harm emanated from outside the United States. Under this approach, the court concluded, subject matter jurisdiction does not exist over a foreign-cubed claim when the non-U.S. company’s executives (a) made decisions concerning the content of alleged misstatements to investors from abroad and (b) issued those statements from abroad.

My firm recently issued a memorandum that analyzes the Court’s opinion and discusses its implications for non-U.S. companies. The memorandum is available here.

(Editor’s Note: This post comes to us from Renée B. Adams of the University of Queensland and ECGI, and Daniel Ferreira of the London School of Economics, CEPR and ECGI.)

In our paper “Women in the Boardroom and Their Impact on Governance and Performance”, which is forthcoming in the Journal of Financial Economics, we investigate the hypothesis that gender diversity in the boardroom affects governance in meaningful ways. Our initial sample consists of an unbalanced panel of director-level data for S&P 500, S&P MidCaps, and S&P SmallCap firms collected by the Investor Responsibility Research Center (IRRC) for the period 1996-2003. Once we supplement this data with other director and financial information, we have a final sample of 86,714 directorships (director firm-years) in 8,253 firm-years of data on 1,939 firms.

We find that gender diversity has significant effects on board inputs. Women are less likely to have attendance problems than men. Furthermore, the greater the fraction of women on the board is, the better is the attendance behavior of male directors. Holding other director characteristics constant, female directors are also more likely to sit on monitoring-related committees than male directors. In particular, women are more likely to be assigned to audit, nominating, and corporate governance committees, although they are less likely to sit on compensation committees. Women also appear to have a significant impact on board governance. We find direct evidence that more diverse boards are more likely to hold CEOs accountable for poor stock price performance: CEO turnover is more sensitive to stock return performance in firms with relatively more women on boards. We also find that directors in gender-diverse boards receive relatively more equity-based compensation. We do not find a statistically reliable relationship between gender diversity and the level and composition of CEO pay, which is consistent with our findings that female board members are underrepresented on compensation committees and thus have less involvement in setting CEO pay.

The evidence on the relationship between gender diversity on boards and firm performance is more difficult to interpret. Although the correlation between gender diversity and either firm value or operating performance appears to be positive at first inspection, this correlation disappears once we apply reasonable procedures to tackle omitted variables and reverse causality problems. Our results suggest that, on average, firms perform worse the greater is the gender diversity of the board. This result is consistent with the argument that too much board monitoring can decrease shareholder value. Thus, it is possible that gender diversity only adds value when additional board monitoring would enhance firm value. Using additional tests, we find that gender diversity has beneficial effects in companies with weak shareholder rights, where it is plausible that additional board monitoring can enhance firm value, but detrimental effects in companies with strong shareholder rights.

The full paper is available for download here.

(This post is based on a memo by Robert Saunders and his colleagues Allison Land and Ron Brown of Skadden, Arps, Slate, Meagher & Flom LLP.)

On October 22, 2008, Vice Chancellor Lamb of the Delaware Court of Chancery issued an opinion in Olson v. Halvorsen with important implications for parties contemplating the formation of a Delaware limited liability company. Ruling on a question of first impression, the court held that the Delaware statute of frauds applies to limited liability company agreements.

The plaintiff sought enforcement of an unsigned operating agreement for an LLC formed by the plaintiff and two other individuals in connection with a newly formed hedge fund structure. The dispute arose after the other two founders voted to remove the plaintiff from the LLC. The LLC paid $100 million to the plaintiff, consisting of his capital account balance and the remainder of his compensation for the year. However, the plaintiff argued that he was entitled to an additional payment of more than $100 million because, under the terms of the unsigned operating agreement, the plaintiff would have been entitled to an “earn out” over six years.

For purposes of summary judgment, the court’s decision turned on whether the Delaware statute of frauds applies to a Delaware LLC operating agreement. Neither the court nor the parties cited any case in any jurisdiction addressing the issue. Commentators were split as to whether the statute of frauds should apply. The Delaware Limited Liability Company Act expressly permits oral and implied LLC agreements, and provides that it is the policy of the Act “to give maximum effect … to the enforceability of limited liability company agreements.” However, the court asserted that most oral LLC agreements would not contain a provision that cannot possibly be performed within one year, so that the statute of frauds would not limit the enforcement of such agreements. The court held “that if an LLC agreement contains a provision or multiple provisions which cannot possibly be performed within one year, such provision or provisions are unenforceable.” The court went on to reject the plaintiff’s claim because the earn-out provision in the unsigned LLC operating agreement could not possibly be performed within a year and because the multiple writings or part performance exceptions to the statute of frauds did not apply.

The plaintiff now has thirty days to appeal this ruling to the Delaware Supreme Court.

My colleagues in the Employment Practice Group at Davis Polk & Wardwell have prepared a memorandum discussing the executive compensation requirements applicable under each of the Capital Purchase Program, Troubled Asset Auction Program and Program for Systemically Significant Failing Institutions implemented under Emergency Economic Stabilization Act of 2008 (“EESA”). The memo also briefly summarizes the basic purposes of and authorities granted to the U.S. Department of the Treasury under EESA, and includes a table that presents a summary comparison of pre-EESA rules and new rules applicable to EESA program participants, with respect to (i) golden parachutes under Section 280G of the Internal Revenue Code (the “Code”), (ii) deduction limits under Section 162(m) of the Code, (iii) incentive compensation and risk aversion and (iv) clawbacks of incentive compensation.

The memorandum is available here.