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Over the past year and a half, a perfect storm of economic conditions has triggered an extraordinary downward spiral: the subprime meltdown, liquidity crises, extreme market volatility, controversial government bailouts, consolidations of major banking institutions and widespread economic turmoil both domestically and abroad. Many corporations now find themselves in uncharted territory, with a new paradigm of unpredictability trumping formerly reasonable expectations. In the coming year, boards of directors will need to respond to the challenges and pressures of this new environment. This may include reassessing their agendas, committee structures, time commitments and director recruiting, as well as their role in monitoring performance, compliance and risk management. At the same time, boards need to maintain the collegiality and culture of a common enterprise with the CEO and senior management. In short, the task for boards is not simply to go into crisis mode in order to deal with current issues, but rather to take a more holistic, long-term approach to reassessing their proper role and functioning.

In reviewing their monitoring and oversight roles, boards should be mindful of the shifting legal and regulatory landscape. Although the standard for director liability established in Delaware by the Caremark case accords directors considerable deference in fulfilling their oversight duties, there is a distinct possibility that this level of deference could end up being modified in light of the current economic crisis. The spate of litigation generated by the market turmoil will intensify the scrutiny of some boards and will provide courts with repeated occasions to consider second-guessing board decisions. Various regulators have been focused on risk management policies, some of which have found their way into new federal legislation, and numerous new guidelines and “best practices” purport to raise the bar. As financial losses accumulate, shareholders and the public at large will seek to hold boards and management accountable, and there will be tremendous pressure on corporations to demonstrate that they are responding to the current challenges.

While it is clear that there will be a regulatory response to the economic crisis, the contours and extent of the reforms are still evolving. To the extent that boards can be proactive in addressing new challenges and mitigating risks, there may be some window of opportunity for them to help shape the regulatory response, and steer it toward pragmatic measures that will promote rather than impede the creation of long-term shareholder value.

This memorandum, which I have prepared with my colleagues Steven A. Rosenblum and Karessa L. Cain, sets forth some of the significant issues that boards of directors face in the coming year, as well as some practical considerations to bear in mind. In order to avoid an overemphasis on process and at the same time effectively discharge the board’s duties to appropriately monitor and supervise the business of the corporation, it is necessary to identify the matters meriting the board’s focus and create a reasonable program to deal with them. Some are perennial themes that remain relevant and deserve to be reemphasized from year to year, whereas others have come into particular focus in recent years. It is important to note, however, that “one size does not fit all.” The board of each corporation can and should focus on its own particular issues and tailor procedures to its own circumstances.

The memorandum is available here.

(Editor’s Note: This post comes from Alex Edmans at the Wharton School, University of Pennsylvania.)

In my paper Blockholder Trading, Market Efficiency, and Managerial Myopia which was recently accepted for publication in the Journal of Finance, I analyze how outside blockholders can induce managers to undertake efficient real investment through their informed trading of the firm’s shares.

The model developed in this paper addresses two broad issues. First, it shows that blockholders can mitigate managerial myopia. Small shareholders base their decisions on freely-available short-term earnings. By contrast, a blockholder’s large stake gives her strong incentives to gather costly information about the firm’s fundamental value, i.e., to learn whether weak earnings result from low firm quality or desirable long-term investment. By trading on this information, she causes prices to more closely reflect fundamental value rather than short-term earnings. This increased market efficiency improves real efficiency: the manager is willing to undertake investments that boost fundamental value even if they depress short-term earnings.

This beneficial effect of liquid trading on investment contrasts with conventional wisdom. In the 1980s and 1990s, many commentators feared that the U.S.’s liquid markets would lead to it being overtaken by Japan in international competition, because short-term trading by shareholders causes managers to focus excessively on short-term earnings. They argued that reducing liquidity would make “exit” more difficult upon short-term losses, and force a shareholder to exhibit “loyalty”. My model shows that the mutual exclusivity of loyalty and exit paradoxically leads to complementarities between them. If a blockholder has retained her stake despite low earnings, this is a particularly positive indicator of fundamental value if she could have easily sold instead. In short, the power of loyalty relies on the threat of exit. Far from exacerbating myopia, the liquidity of the U.S. capital allocation system may be a strength, because liquid trading causes prices to more closely reflect fundamental value.

The second issue that the model demonstrates is that shareholders can exert governance even if they cannot intervene directly in a firm’s operations. Most existing theories assume that blockholders govern through “voice” – firing a shirking manager or overturning a pet project. However, intervention is uncommon in the U.S., because blockholders are typically small and face significant legal and institutional barriers. Existing models therefore have difficulty in explaining the role that small blockholders with few control rights play in corporate governance, and thus why they are so prevalent. This paper shows that blockholders can still add significant value even if they lack control.

The paper closes with empirical implications. One set concerns stock-price effects, and is unique to a model where blockholders trade rather than intervene. While block size does not matter in standard microstructure theories, here it is positively correlated with an investor’s private information, trading profits and price efficiency. More generally, the model suggests a different way of thinking about blockholders that can give rise to new directions for empirical research. Previous studies have been primarily motivated by perceptions of blockholders as controlling entities, but new research questions may be motivated by conceptualizing them as informed traders. A second set relates to real effects: blockholders should increase firm investment and deter earnings manipulation.

The full paper is available for download here.

In another paper, co-written with Gustavo Manso, I extend the analysis to consider the role of multiple blockholders, which we observe frequently in practice. We find that splitting a block can be beneficial for corporate governance. While splitting a block weakens “voice”, by creating free-rider problems in intervention, it strengthens “exit” because multiple blockholders trade aggressively, impounding more information into prices. The paper entitled Governance Through Exit and Voice: A Theory of Multiple Blockholders is available for download here.

(Editor’s Note: This post is based on a client memo by Sullivan & Cromwell LLP.)

Summary
The United States Court of Appeals for the Ninth Circuit recently rejected an issuer’s contention that a securities fraud complaint should be dismissed because the alleged misstatements were contained in an acquisition agreement attached as an exhibit to an Exchange Act report, instead of in the report itself. The court’s decision highlights the continuing need for issuers to consider the disclosure issues that can arise from representations and warranties included in exhibits to reports, proxy statements and registration statements filed under the federal securities laws.

Background
On March 15, 2004, InVision Technologies Inc. announced that it would be acquired by General Electric Company, and attached the merger agreement as an exhibit to the Form 10-K that it filed that day. The merger agreement contained customary representations by InVision (with customary exceptions), including statements to the effect that InVision was in compliance with applicable laws, InVision was in compliance with certain provisions of the Securities Exchange Act of 1934 (the “Exchange Act”), and InVision had not violated the anti-bribery provisions of the Foreign Corrupt Practices Act of 1977 (the “FCPA”).

More than three months following the merger announcement, InVision announced that an internal investigation had revealed possible violations of the FCPA, and warned that subsequent investigations could cause a delay or termination of the merger transaction. Stockholders filed a class action complaint alleging that the representations in the merger agreement contained material misstatements that violated Rule 10b-5 under the Exchange Act. InVision later resolved the FCPA matter in settlements with the government, and the parties completed the merger. The securities fraud complaint was ultimately dismissed by the district court for failure to adequately plead falsity and scienter.

Ninth Circuit Decision
The Ninth Circuit reviewed the dismissal in Glazer Capital Management v. Magistri, No. 06-16899 (9th Cir., Nov. 26, 2008). Before addressing the pleading standards, the court considered InVision’s argument that the alleged misstatements could not support a securities fraud claim because they were contained in an agreement that was filed as an exhibit to the Form 10-K, and not in the Form 10-K itself. The court observed that the representations were expressly qualified by reference to a separate disclosure schedule listing exceptions to the representations (which was not filed and not publicly available), and that the merger agreement contained a “no third party beneficiaries” clause. Nonetheless, the court stated:

…continue reading: Court Focuses on Representations in Agreements Filed with SEC

(Editor’s Note: This post is based on a client memorandum by Lisa Fontenot, Michael Scanlon and Marcie Areias of Gibson, Dunn & Crutcher LLP.)

I. E-Proxy Update

In 2007, the Securities and Exchange Commission (the “SEC”) adopted rules providing for proxy materials (including the proxy statement, a proxy card, the “glossy” annual report and any other soliciting materials) to be made available to shareholders via a publicly accessible Internet website other than the SEC’s EDGAR website (the “E-Proxy Rules“).[1] Starting January 1, 2009, all public companies must comply with the E-Proxy Rules.[2] As a result, all companies conducting proxy solicitations will have to post materials on the Internet and can choose among the delivery options for proxy materials available under the E-Proxy Rules: the “notice and access option,” the “full set delivery option,” or a hybrid of these options.

A. Notice and Access
Under the notice and access option, a company can satisfy the proxy delivery requirements by delivering a Notice of Internet Availability of Proxy Materials (a “Notice of Internet Availability”) to shareholders at least 40 calendar days before the annual meeting date and posting proxy materials on an Internet website.[3] The information that can be included in the Notice of Internet Availability is limited and must conform to specified criteria set forth in the SEC rules.[4] The Notice of Internet Availability may not be accompanied by a proxy card or other information. Even though proxy materials are electronically delivered under this option, issuers must deliver proxy materials to any shareholder upon request.[5]

An intermediary (such as a broker or a bank who holds the shares on behalf of beneficial owners) may not independently elect to use the notice and access option, but is required to do so if requested by the issuer. To facilitate this process, an issuer must provide required information to intermediaries sufficiently in advance for the intermediary to prepare and send a Notice of Internet Availability at least 40 days before the date of the annual meeting.[6]

According to Broadridge Financial Services, Inc., as of June 30, 2008, 653 issuers used the notice and access model for distribution of their proxy materials.[7]

…continue reading: E-Proxy Rules Take Effect for All Public Companies

I recently presented Does Delaware Compete? at the Law and Economics seminar here at Harvard Law School. The paper focuses on a long-standing academic inquiry into the nature of state-to-state competition for chartering revenues and the making of corporate law. While the existence of state competition has long been posited — with the controversy being over its nature — recent work has shown that in fact few states try to make money in corporate franchising and only one — Delaware — is very successful at it.

In this paper, I analyze three arenas in which Delaware competes, even if no other state is a strong player today. First and importantly, it must attract firms to reincorporate away from their home states. The dynamism of American business interacts with even a lackluster state-based corporate chartering market to create a broad avenue of chartering competition, as Delaware’s business base is persistently eroding as firms merge, close and restructure. The “half-life” of Delaware’s franchise tax base is surprisingly short. If it fails to be attractive enough to obtain a steady flow of reincorporating firms, that base will erode. Even if no other state is trying, Delaware has to try. Second, an awakening of a dormant competitor is not impossible. I outline what might motivate one or the other. Although the odds of that happening at any one time are small, small does not mean zero. Analysis should focus not primarily on the incentives of states and their legislatures — where most of the focus has been — but on the incentives of businesses and their lawyers. Entrepreneurial lawyers, with clients who want a different corporate law, would be the likely source of state innovation in making corporate law, not the state legislature directly. Similarly, and third, Delaware has reason to consider the risk of a federalization of core elements of its corporate law even if no other state actively competes for charters. A reputation for bad decision-making (or bad decision-makers) could impel Congress to displace Delaware, in whole or, more likely, in part, perhaps as an excuse during an economic downturn or after a scandal. While the odds of full displacement are low, Sarbanes-Oxley shows us that the odds of substantial partial displacement are not.

I then draw parallels between these ideas and those in the industrial organization, antitrust literature on contestable markets: in contestable market analysis, a single producer can dominate a market, but, depending on the nature of its technology and its market, it could lose market share overnight or suddenly face a new entrant if the incumbent missteps badly. To the extent the chartering market is contestable, Delaware competes, even if that’s a weak form of competition. And, once we see Delaware as in a contestable market with other states, we see that Washington could erode Delaware’s dominance just as another state can. In other words, Delaware could face catastrophic loss in two dimensions: the traditional horizontal one of a competing state, and the vertical one of federal displacement. To fully understand the structure of American corporate lawmaking, we must also see the importance of the Delaware-Washington interaction, actual and potential.

The full paper is available for download here.

In another paper entitled Delaware’s Competition, I make the case that over the 20th century, the most important alternative to Delaware in making corporate governance law was not the other states, but Washington, D.C. That paper is available for download here. In a second related paper, entitled Delaware’s Politics, I focus on the political economy of the Delaware-Washington structure: Managers and shareholders are the primary players in Delaware; a much wider set of interests and policies is brought into play when corporate issues move to Washington. That paper is available for download here.

(Editor’s Note: This paper was also recently accepted for publication in the Journal of Legal Analysis, a new peer-reviewed opened access journal sponsored by Harvard Law School)

I recently presented my paper Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis at the Law and Economics Seminar at Harvard Law School. The paper provides a comparison of US tax and securities law governing mutual funds with laws governing other collective investments, in both the US and in the EU.

Current US tax law governing mutual funds has a number of unfortunate economic effects, including the discouragement of saving and investment by middle class Americans, misallocation of capital to sectors such as real estate, and the essential walling-off of the US from competition from or with foreign mutual funds, in the US or overseas. In addition, although much less important than US tax law, the current design and implementation of US securities law applicable to mutual funds is inhibiting innovation and growth in the fund sector, again with the effect of reducing investment.

My review of US regulation of collective investments, comparing regulation and data on the size and growth of US mutual funds with their major competitors, in the US and abroad shows that:

1. Within the US, regulation of mutual funds is more extensive and restrictive than for other types of collective investments.

2. The structure of US regulation – mutual funds are tightly restricted by bright-line rules written into a statute nearly 70 years ago, subject to SEC exemptions – makes continued success of US mutual funds dependent on the resources, responsiveness, and flexibility of the SEC.

3. The US fund industry continues to be the world leader, but its growth and international competitiveness now lags that of its domestic and foreign competitors, primarily because of US tax law.

4. While the formal laws imposed on mutual funds in other countries are as or more restrictive in many respects than US securities laws, the resources and responsiveness of foreign fund regulators (particularly in Ireland and Luxembourg) exceed those dedicated to funds by the SEC.

The paper concludes by describing potential improvements in US regulatory oversight of collective investments, including ways to enhance the flexibility and resources of US fund regulators, modifications of the existing ban on asymmetric advisor compensation and the exclusion of foreign funds, and unjustified disparities in the treatment of mutual funds and mutual fund substitutes.

The complete paper is available for download here.

The slow demise of the U.S. car industry over decades and the spectacular collapse of the U.S. financial system have a lot in common. Both implosions are the result of poor management: shortsighted incompetence in the car industry and reckless risk-taking in the financial sector. Where was the oversight? And what could be a better indictment of the incentives in our system than the fact that even the executives who made the most egregious calamitous decisions are all walking away as rich men, while many of their shareholders have been wiped out?

(The Corporate Library reports that Richard Fuld, the person primarily responsible for the destruction of Lehman Brothers (and clearly among the most incompetent CEOs of all time), was the 13th highest CEO in 2007, with $71.92 million in compensation in 2007, including more than $40 million in value from realized stock options. The third highest-paid executive on the list was Angelo Mozilo, former CEO of Countrywide Financial Corp., which collapsed on its subprime loans. His total actual compensation for 2007 was $124.69 million. Bank of America had to pay him another hundred million dollars to make him disappear. It took government intervention to stop the CEOs of Fannie and Freddie from receiving $25 million in parachutes. The list of scandalous pay and no board supervision goes on and on.)

The fact is that our US corporate governance system is dysfunctional. The most important feature of a governance system is its ability to limit the power of those CEOs—the black sheep if you will—who are inclined to break it. Therefore, the only effective mechanisms are those that are external to the firm — those that cannot be dismantled by bad CEOs: management’s fiduciary duty, the requirement to hold an annual meeting, the possibility of an external takeover (at least before Delaware gave management the poison pill and staggered boards to prevent them), the negative publicity surrounding excessive salaries. In contrast, internal governance mechanisms, such as the power of the Chairman’s board to fire the CEO, are seldom effective. Any bad CEO worth his salt will have worked hard to make this extremely difficult.

It is imperative to our global competitiveness that we improve our corporate governance system. If we do not, we may fix all our present economic calamities only to have new ones erupt elsewhere before long.

…continue reading: How to fix one Root Cause of our Economic Crises

(Editor’s Note: This post comes from Ronald Masulis at the Owen Graduate School of Management, Vanderbilt University, Cong Wang at the Faculty of Business Administration, Chinese University of Hong Kong, and Fei Xie at the School of Management, George Mason University.)

In our paper Agency Problems at Dual-Class Companies, which was recently accepted for publication in the Journal of Finance, we use a sample of U.S. dual-class companies over the period 1994-2002 to examine how the divergence between insider voting rights and cash-flow rights affects managerial extraction of private benefits of control. Using both a ratio and a wedge measure to capture the voting-cash flow rights divergence, we find four distinctive sets of evidence supporting the hypothesis that managers with greater control rights in excess of cash-flow rights are more likely to pursue private benefits at the expense of outside shareholders.

First, we examine how control-cash flow rights divergence impacts a firm’s efficiency in utilizing an important corporate resource - cash reserves. We find that the marginal value of cash is decreasing in the divergence between insider voting rights and cash-flow rights, which is consistent with the argument that shareholders anticipate that corporate cash holdings are more likely to be misused at companies where insider voting rights are disproportionately greater than cash-flow rights, and therefore place a lower value on these highly fungible corporate assets.

Second, we analyze how the insider control-cash flow rights divergence affects the level of CEO compensation, and find that, ceteris paribus, excess CEO pay is significantly higher at companies with a wider divergence between insider voting and cash-flow rights.

Third, we evaluate the acquisition decisions made by dual-class companies, and find in a multivariate regression framework that as insider control-cash flow rights divergence widens, acquiring companies experience lower announcement-period abnormal stock returns, are more likely to experience negative announcement-period abnormal stock returns, and are less likely to withdraw acquisitions that the stock market perceives as shareholder value destroying. These results suggest that as insiders control more voting rights relative to cash-flow rights, they are more likely to make shareholder value-destroying acquisitions that benefit themselves.

Finally, we examine firms’ capital expenditure decisions as another channel of empire building and private benefits extraction. We find that ceteris paribus, capital expenditures contribute significantly less to shareholder value at firms with a greater divergence between insider voting rights and cash flow rights, suggesting that managers at these companies are more likely to make large capital investments to advance their own interests.

Overall, our results shed direct light on the issue of how insider control-cash flow rights divergence leads to lower shareholder value. In addition, our results further our understanding of why superior-voting shares command a premium in the marketplace over inferior-voting shares.

The full paper is available for download here.

(Editor’s Note: This post by based on a client memo by Theodore N. Mirvis, Eric S. Robinson, Adam O. Emmerich, William Savitt, and Adam M. Gogolak of Wachtell, Lipton, Rosen & Katz.)

As part of the continuing confrontation between CSX Corporation and hedge funds holding CSX shares and equity swaps on CSX shares – and which earlier this year mounted a successful proxy fight, replacing four members of the CSX board of directors – the hedge funds have agreed to settle an action to recover “short-swing” profits pursuant to Section 16(b) of the Securities Exchange Act of 1934.

Section 16(b) provides that beneficial owners of more than 10% of the stock of publicly traded corporations (as well as officers and directors) are liable to disgorge to the corporation any profit derived from purchases and sales of the stock of the corporation within a period of less than six months. While the hedge funds which invested in CSX did not directly hold a position of more than 10% in CSX shares, their aggregate interest in the shares and the equity swaps – which involved matching positions in CSX stock by the banks which had written the swaps – together exceeded 10%. As we discussed in our memo of June 12th, in a separate litigation brought by CSX against the funds, Judge Kaplan of the U.S. District Court for the Southern District of New York held that the hedge funds were the beneficial owners of over 10% of CSX shares for purposes of SEC Rule 13d-3(b) on account of the shares they directly held and the swaps they entered into.

Following Judge Kaplan’s decision, a CSX shareholder filed suit pursuant to Section 16(b) seeking to recover for the benefit of CSX short-swing trading profits achieved by the hedge funds while they beneficially held more than 10% of CSX stock directly and by virtue of their derivative positions. Rule 16a-1(a)(1) provides that a beneficial owner of more than 10% for purposes of Section 16 means any person who is deemed a beneficial owner pursuant to Section 13(d) and the rules thereunder. Based on the hedge funds’ swaps and stock transactions, plaintiff and CSX identified potential recoverable damages from the hedge funds under Section 16(b) of approximately $138 million. The hedge funds agreed to pay $11 million to settle the Section 16(b) action. The amount of the settlement was reportedly influenced by, among other things, the fact that Judge Kaplan’s decision regarding beneficial ownership is still pending appeal to the Second Circuit.

We have long advised that non-traditional economic and voting arrangements be approached with extreme caution. Such arrangements not only can have significant implications for investors’ disclosure obligations under Section 13(d), but can also trigger shareholder rights plans, change-incontrol provisions of commercial and employee contracts and compensation plans, and, as the CSX settlement makes clear, investors’ “short-swing” profit repayment obligations under Section 16(b). We continue to urge the SEC to undertake comprehensive regulatory reform that addresses derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise. In the meantime, it continues to be important for public companies and investors alike to consider all potential legal obligations and liabilities that may arise as a result of such economic ownership equivalent positions and to take appropriate action in that regard.

This post is by my colleague Ning Chiu.

The 2009 US proxy season has its unofficial kickoff in the form of RiskMetric Group’s US Corporate Governance Policy Update, where the focus is again largely on executive compensation practices. The Policy Update includes voting recommendations on key issues such as “poor pay practices” and several major governance proposals, including separation of CEO and Chair positions. RMG has also changed its evaluation of total shareholder return in acknowledgement of the volatile market environment. While the season is just beginning, we’ve already spotted several emerging trends, indicating that companies will continue to be targeted by activists even while they may be struggling with their business operations, all of which should make for a very interesting upcoming season. Our memo, which discusses the emerging trends for the forthcoming proxy season as well as RMG’s Policy Update, is available here.

(Editor’s Note: This post comes from Henrik Cronqvist at Claremont McKenna College and Rüdiger Fahlenbrach at The Ohio State University.)

In our paper, Large Shareholders and Corporate Policies, which was recently accepted for publication in the Review of Financial Studies, we investigate whether large shareholders play an important role for corporate policy choices and firm performance. We argue that one explanation for the lack of large-sample evidence of blockholder effects is that large shareholders differ from each other, and existing empirical frameworks do not incorporate blockholder heterogeneity into an economic analysis of large shareholders. To account for this heterogeneity, we develop an empirical framework and to construct a new blockholder-firm panel data set that can be used to analyze the economic effects of blockholder heterogeneity. The novel feature of our data set is that it allows us to identify and track all unique large shareholders among large U.S. public firms − in essence the Standard and Poor’s (S&P) 1,500 universe − from 1996 to 2001. This data set allows us to take the analysis of large shareholders to the smallest possible economic unit: the individual blockholder. Our empirical approach involves running panel regressions in which corporate policy and firm performance variables are regressed on year and firm fixed effects as well as time-varying firm-level characteristics to control for observable and unobservable firm heterogeneity, and most importantly, blockholder fixed effects.

We find statistically significant and economically important blockholder fixed effects in investment, financial, and executive compensation policies. This evidence suggests that blockholders vary in their beliefs, skills, or preferences. Different large shareholders have distinct investment and governance styles: they differ in their approaches to corporate investment and growth, their appetites for financial leverage, and their attitudes towards CEO pay. Given the evidence on blockholder heterogeneity and corporate policies, we ask whether firm performance is systematically related to the particular large shareholder present in a firm. We find blockholder fixed effects in firm performance measures, and differences in style are systematically related to firm performance differences. a blockholder in the 75th (25th) percentile is associated with 4% (3%) higher (lower) return on assets (ROA), all else equal, which are large effects given that the average ROA is around 5% in our sample.

The documented blockholder effects in firm policies could be consistent with either an influence explanation, in the sense that large shareholders impact policies, or a selection interpretation, in that blockholders systematically select firms in which they invest major stakes based on a preference for certain policies. Our evidence is more consistent with influence for activist, pension fund, corporate, individual and private equity blockholders, but more consistent with systematic selection for large mutual fund shareholders. Finally, we analyze sources of the heterogeneity, and find that blockholders with a larger block size, board membership, direct management involvement as officers, or with a single decision maker are associated with larger effects on corporate policies and firm performance.

The full paper is available for download here.

I recently presented a new working paper co-written with Bengt Holmstrom at the Law, Economics and Organizations workshop entitled A Theory of Firm Scope.

In the standard property rights model, parties write contracts that are ex ante incomplete but that can be completed ex post; the ability to exercise residual control rights improves the ex post bargaining position of an asset owner and thereby increases her incentive, and the incentive of those who enjoy significant gains from trade with her, to make relationship-specific investments, and as a consequence, it is optimal to assign asset ownership to those who have the most important relationship-specific investments or who have indispensable human capital. Although the property rights approach provides a clear explanation of the costs and benefits of integration, the theory seems to describe owner-managed firms better than large companies.

The purpose of the current paper is to modify the property rights approach so that it can be applied to a broader set of organizational issues, including the organization of large firms. We develop a model in which: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm’s profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. Under these conditions, firm boundaries matter.

Under non-integration, bosses maximize the right thing (profits plus private benefits) but are parochial (they do not take into account their effect on the other unit), while under integration, they maximize the wrong thing but are broad. In our basic model, where the only issue is whether the units coordinate, we show that non-integration and integration make the opposite kind of mistake. Non-integration leads to too little coordination. This happens if the benefits from coordination are unevenly divided across the units. One unit may then veto coordination even though it is collectively beneficial. In contrast, under a weak assumption–specifically, that coordination represents a reduction in “independence” and therefore causes a fall in private benefits–integration leads to too much coordination. We also extend our analysis to understand the role of delegation.

The full paper is available for download here.

RiskMetrics Group recently released updates to its 2009 proxy voting policies, after an extensive process that included outreach to and input from hundreds of institutional investors and corporate issuers. RiskMetrics’ policies will be applied to all companies with shareholder meeting dates on or after February 1, 2009.

This year’s policy revisions reflect the unprecedented market turmoil that has sparked investor and regulatory focus on executive compensation practices, board accountability and oversight, and the quality of financial reporting. Accordingly, the three main areas of focus for the 2009 policy updates are executive pay, board structure, and audit practices.

Both issuer and investor respondents to RiskMetrics’s annual policy survey demonstrated little tolerance for outsized pay packages, with 70 percent of investors and 85 percent of issuers specifying pay relative to performance as “very important” in evaluating executive compensation practices. Thus, RiskMetrics’ policy guidelines on executive compensation have been expanded to examine practices that divorce pay from performance, such as tax gross-ups on severance payments and executive perks, and provisions that pay severance for voluntary departures following a takeover.

RiskMetrics has also harmonized assessment of company performance across several North American policies. As of 2009, corporate performance will initially be assessed using a relative, rather than absolute, measure of total shareholder return over 1- and 3-year periods. This assessment will result in greater scrutiny under several policies, including pay-for-performance evaluations, independent chair shareholder proposals, and director elections. Regarding the latter, the policy update addresses cases where lagging company performance is coupled with a governance structure that discourages director accountability and may lead to board and management entrenchment.

Additionally, RiskMetrics has updated its accounting policy guidelines to specify ongoing material weaknesses in Section 404 disclosures and misapplication of GAAP as triggers for in-depth analysis of a company’s accounting practices, and to recommend against audit committee members in the case of an adverse opinion from auditors.

Internationally, RiskMetrics revised its share buyback policy to reflect client feedback and regulatory developments in Europe. RiskMetrics’ policy on discharge of directors resolutions, common in several markets, will now accommodate recommendations designed to provide a “yellow card” warning to directors who may not be fulfilling their fiduciary duties. Director independence best practices in several European markets have also been incorporated into the 2009 policies. In Canada, RiskMetrics is introducing a Poor Pay Practices Policy to reflect the additional disclosure that is now available in that market.

The 2009 policy updates are accessible through RiskMetrics’ online Policy Gateway, which also contains FAQs and other informational resources to provide all market participants with a good understanding of how RiskMetrics formulates and applies its corporate governance policies. In addition to its own policies, the corporate governance policies and philosophies of leading market participants are also available via RiskMetrics’ Policy Exchange platform.

My co-authors (Jennifer Bethel and Gang Hu) and I have updated our paper, including the inclusion of current data, entitled “Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis” which can be downloaded here. The paper is forthcoming in a Brookings volume on the credit market crisis.

The paper surveys the current securities class action litigation arising out the credit crisis (10b-5, section 11, section 12(a)(2)) and some of the important securities law principles that will be at play in the resolution of this litigation. In particular, we focus on the following three securities law principles in our discussion: (1) no fraud by hindsight; (2) truth on the market defenses; and (3) loss causation issues. We also provide data on various aspects of the securitization process that intersect with the application of these principles. For instance, with respect to the “truth on the market” defense (i.e., that the purported disclosure deficiencies were not material given the information the market already had) we discuss the fact that the quality of disclosures in the mortgage backed securities registration statements (and virtually all mortgage backed securities were registered) actually improved between 2001 to 2006 (in part due to the promulgation of Regulation AB in 2004) and that it was quite clear from these registration statements that the quality of the underwriting in a number of instances had declined. Moreover, the scope of commercial banks’ asset backed commercial paper conduit liquidity exposures were explicitly disclosed in their public Form Y-9C filings with the Federal Reserve. Moreover, asset backed commercial paper conduit disclosures provided to the commercial paper investors, such as hedge funds, included information concerning the liquidity guarantees provided by the banks.

We also discuss the source of many of the losses and writedowns suffered by the banks, particularly in 2007 and the first half of 2008, which is important in assessing the securities class action litigation. Many banks suffered substantial losses due to their “super senior” positions in CDOs and various liquidity guarantees to asset backed commercial paper conduits, rather than directly on their mortgage-backed security holdings.

We also provide in the paper data on, among other things, the tranche structure of mortgage-backed securities, securitization deal sizes, reported value at risk estimates by banks, CDO liquidations and CDO trustee information.

The paper is available here.

Until the current crises in the financial markets, negotiated acquisitions of public companies had been documented by a form of merger agreement which had evolved into an almost standard “seller friendly” template. This standard model agreement reflected the same factors which contributed to the vibrant M&A activity of recent years: readily available financing, rising stock markets, stable or improving economic and industry conditions, and high levels of confidence in business and financial fundamentals. Combined with the negotiating leverage provided to companies seeking to sell themselves by the generally large and seemingly ever-expanding universe of potential buyers, both strategic and financial, as well as sources of financing willing to assume syndication or underwriting risks, these factors resulted in merger agreements intended to provide sellers with a high level of certainty that a transaction would be completed. With the substantial erosion, if not disappearance of each of the factors underpinning the justification for the standard merger agreement, merger agreements should adapt to the new environment. Therefore, a new paradigm seems likely for acquisitions for cash in which the buyer does not have cash on hand sufficient to pay the acquisition price and any necessary refinancing of seller debt.

My firm has prepared a memorandum entitled “Negotiated Cash Acquisitions in Public Companies in Uncertain Times,” which considers how merger agreements may change as parties to transactions seek to allocate risks to closing and limit their liability. Written primarily by Peter S. Golden, with assistance from David Shine and me, the memorandum considers reverse break-up fees, forms of “seller financing,” material adverse change clauses, express financing conditions, buyer best effort covenants, ticking fees and other aspects of merger agreements that may adapt to the new M&A and financing climate.

The memorandum is available here.

At the end of each year, we list what we think will be the key issues for directors in the new year. Some issues continue to be relevant from year to year; others are new or come to the forefront due to current events. This year the economic crisis affects all the issues. The following is an updated list:

1. 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 economic crisis, companies now face risks that are more complex, interconnected and potentially devastating than ever before. 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, directors must be mindful of the possibility that courts will apply new standards, or interpret existing standards, to increase board responsibility for risk management.

2. Monitoring balance sheet issues, including leverage, liquidity, debt maturities, share buybacks and dividend policy, in light of the economic crisis, and dealing with the problem of underwater pension and other employee benefit plans.

3. Assuring shareholders and other constituents (including regulators) that the CEO and senior management are being properly evaluated and that there is a frequently reviewed management succession plan.

4. Dealing with executive compensation, not only in light of normal sensitivities, but also to address the current perception that poorly structured executive compensation programs encouraged excessive risk-taking and contributed to the economic crisis. Directors will need to develop specially tailored executive compensation programs to comply with new regulations and to minimize criticism, but at the same time enable the company to attract and retain the best available executives and reward outstanding performance.

5. Regularly reviewing that the CEO and senior management are setting “tone at the top” that stresses professionalism, integrity, transparency, risk management, legal compliance and high ethical standards.

6. Striking the right balance in responding to shareholder corporate governance initiatives, accepting those that do not interfere with management of the business and rejecting those that impede the achievement of long-term success and shareholder value.

7. Anticipating attacks by activist hedge funds seeking management, structural or strategy changes to boost short-term stock prices at the expense of long-term value, and developing business, financial and legal strategies to avoid or counter them.

8. Maintaining collegiality and the culture of a common enterprise with the CEO and senior management, while continuing to enhance monitoring of performance, risk management and compliance in response to sharply increased pressure from Congress, shareholders, regulators and employees brought about by the economic crisis.

9. As the current economic crisis grows more severe, navigating the dangerous shoals when a company has solvency issues that create a conflict between the interests of shareholders and creditors.

(Editor’s Note: The post below is an op-ed piece published by Lucian Bebchuk and Itay Goldstein in the Financial Times this morning. The op-ed piece builds on Bebchuk and Goldstein’s discussion paper, Self-Fulfilling Credit Market Freezes, and on Bebchuk’s discussion paper, Unfreezing Credit Markets, both just issued by the Harvard Law School Program on Corporate Governance.)

An important aspect of the economic crisis has been the drying up of credit that US banks normally extend to Main Street companies. Borrowing by businesses remains costly and difficult, with spreads between yields on corporate bonds and treasuries at extremely high levels.

Why does credit fail to flow despite the infusion of so much additional capital into the financial sector? The Treasury has been arguing that banks still lack confidence and we just need to give them time to adjust. The chair of the congressional oversight panel has suggested that banks’ reluctance to lend reflects their rational assessment of borrowers’ bleak prospects. But there is a third explanation: banks may not be lending because of their self-fulfilling expectations that other banks will not lend.

In a modern economy, the prospects of businesses are likely to be interdependent, with each company’s success (and ability to repay) depending on whether other companies obtain financing. Companies commonly use components and services from other businesses and often sell their output to other companies or their employees.

Consider a bank choosing whether to lend to companies or park its capital in treasuries. Suppose that lending to any given company will generate an expected return of 10 per cent if other businesses obtain financing but an expected loss of 5 per cent if they do not. In such circumstances, the economy might get stuck in an inefficient credit freeze in which banks expect other banks to avoid lending and, given these expectations, rationally choose to hoard their capital to avoid the expected loss from lending when other banks do not.

Unfortunately, we cannot count on interest rate cuts and capital infusions into banks to get the economy out of such a credit freeze. Even if banks have ample capital and the yield on treasuries is barely positive, not lending and avoiding the 5 per cent expected loss will remain each bank’s rational choice as long as other banks are not lending.

Is there anything more the government could do? Yes, it can go beyond intervening at the level of the financial sector and intervene in lending to companies. It can take upon itself some of the credit risks involved in extending substantial new lending to businesses.

Suppose that the government wishes to get at least $200bn of additional lending to companies. Under one possible mechanism, the government would facilitate banks’ putting together a diversified portfolio of newly originated loans by agreeing to bear part of any losses to the portfolio, in return for a share of the upside. In the example considered above, to induce banks to put together a portfolio of new loans, it would be sufficient for the government to agree to bear any losses to the portfolio of up to 10 per cent of the value of the extended loans.

The share of the upside received by the government could be determined through a competitive process. Banks would submit bids indicating the share they would be willing to offer and the government would accept the highest offers that would collectively produce additional lending of $200bn.

Under an alternative mechanism, the government would place $200bn in a number of funds. Each would be run by a private manager charged with putting together a portfolio of loans and compensated with a share of the profits generated by the fund.

Under each of these mechanisms, the party putting together the portfolio of new loans (the bank or the fund’s manager) would have incentives to lend only to companies with good projects. And the government’s taking upon itself credit risks would directly lead to $200bn flowing to companies.

But the programme’s contribution to producing a credit thaw would go much beyond this direct effect. With many companies expected to receive financing, banks’ willingness to lend their own capital, which they might otherwise elect to hoard, would increase. Furthermore, to the extent that the programme would produce a credit thaw, the programme’s costs to the government would be limited, because the credit risks the government took upon itself would not materialise.

When capital infusions and interest rate cuts fail to produce a credit thaw, the mechanisms we propose might provide effective tools for unfreezing credit markets.

In New York City on December 2, executives, board directors, institutional investors, regulators and others gathered for the Directorship Boardroom and Economic Leadership Forum “The Way Forward: Leadership in Challenging Times.” The annual event recognizes the Directorship 100, a list of the most influential people on corporate governance and in the boardroom, and included day-long panel discussions, workgroups and peer group exchanges that focused on the financial crisis, the new Administration and Congress, and the forthcoming proxy season. (For a post on this Blog about the Directorship 100, see here). Speakers included Congressman Barney Frank, former Congressman Michael Oxley, Vanguard founder John Bogle, former SEC Chairmen William Donaldson and Harvey Pitt and — from Harvard Law School — professor Lucian Bebchuk and Delaware vice-chancellor Leo Strine, Jr., who serves as a visiting professor and a senior fellow of the Corporate Governance Program.

Two panel discussions and the keynote address attracted intense interest. The first panel discussion, involving William Donaldson, Martin Lipton, Harvey Pitt, and Leo Strine and moderated by The New York Times’ Andrew Ross Sorkin, considered the outlook for regulation, legislation, and litigation. None of the panelists disputed the need for financial regulatory reform. Pitt was the most specific about the reforms required. Regulatory reform was required quickly as the current system was badly broken and threatened freedoms we cherish, Pitt said during the panel discussion and an earlier session. He recommended reforms to clarify the scope of each regulator’s authority so that when problems arose regulators would know with certainty whether they could respond and others could identify the regulator that could act - and act dispositively. To provide transparent, fully informed markets, he encouraged regulators to compel the disclosure of information about all financial markets. This could be done in the short term. In the longer term, he recommended the consolidation of federal regulators into the Federal Reserve and a single other regulator, saying that the Treasury’s Blueprint for a Modernized Financial Regulatory Structure should be considered only the beginning of the analysis that was required.

In discussing the role the board of directors could play in regulatory reforms, Lipton cautioned against looking to the board to do what it was incapable of doing and noted that many independent directors lacked in-depth knowledge of their company’s business. He compared this situation unfavorably with boards in earlier decades that had often included the company’s investment banker and commercial banker – people who understood the business and could engage in a robust exchange with other board members.

Donaldson took the position that directors have taken their job more seriously since the passage of the Sarbanes-Oxley act and asserted that investor protection should not be overlooked in any financial regulatory reforms. Strine agreed that boards have become much more responsive to stockholder demands in recent years, including demands by activist investors that companies take more risks to generate very high profits. He noted that strong safety and regulation was more, not less important, when stockholder voice was potent, especially given that institutional investors who represent long-term stockholders have generally failed to make monitoring for excessive risk and leverage a centerpiece of their activism.

Lipton also discussed the need for regulators to understand the products and transactions they regulate. Today, professionals with PhDs often design complex financial instruments and if regulators are to regulate them, they will need to understand the instruments properly. Regulatory design needed to reflect this reality.

The second panel discussion, involving Professor Lucian Bebchuk and former Congressman Michael Oxley and moderated by The Wall Street Journal’s Alan Murray, considered how the credit crisis can be expected to affect corporate governance. Mr. Oxley contrasted the current regulatory environment with the conditions prevailing when the Sarbanes Oxley legislation was adopted, commenting that the current crisis could not be characterized as a scandal involving criminal misconduct. He doubted that criminal behavior would be found to have contributed to the crisis and said we would likely find that bad decisions had been made by good people. Lucian Bebchuk suggested that flawed compensation practices have been an important driver of the short-term outlook of corporate managers that contributed to the current crisis, and described how compensation packages can be redesigned to provide managers with incentives to maximize long-term shareholder value.

In his keynote address, Congressman Frank gave his own assessment of the financial crisis and discussed Congress’ likely response. He characterized the financial crisis as a failure of techniques to constrain risks in the securitization of assets. Explaining how regulation had failed to keep pace with financial innovation, Frank said the challenge now for Congress was to legislate to retain the benefits of securitization while mitigating its risks. Congressman Frank canvassed numerous possible regulatory reforms regarding securitization for Congress to consider, including mandating increased disclosure standards, altering compensation arrangements of participants in the chain of securitization, and requiring participants to retain some risk rather than distributing all of it.

In other comments, Frank expressed a concern that, given that banks now have ample capital, the continued difficulty of getting credit might reflect banks’ rational assessment that operating firms will not be able to repay funds lent to them. He also questioned the rationale for current remuneration practices of executives receiving large bonuses for doing their jobs well. Other professionals, such as dentists, he said, don’t receive financial incentives to align their interests with those of their patients, and he asked why directors needed the promise of great financial rewards for good performance. On the reform front, Congressman Frank expressed support for proposals to allow shareholders to set broad policy of corporations and said that Congress will likely consider say-on-pay reforms and giving shareholders access to the corporate ballot.

Renée B. Adams, Benjamin Hermalin and I have recently completed a survey of the literature on boards of directors, with an emphasis on research done in the last five years. This survey updates and expands significantly the survey I completed with Benjamin Hermalin in 2003. In the 2008 survey, we focus on how the literature, theoretical and empirical, deals with the complications that arise from the joint endogeneity of board makeup and board action.

Given that all corporations have boards, the question of whether boards play a role cannot be answered econometrically as there is no variation in the explanatory variable. Instead, studies look at differences across boards and ask whether these differences explain variations in the way firms function and how they perform. The board differences that one would most like to capture are differences in behavior. Unfortunately, outside of detailed field work, it is difficult to observe differences in behavior and harder still to quantify them in a way useful for statistical study.

Some help with the heterogeneity issue could be forthcoming from more theoretical analyses. The common perception of the literature on corporate governance, particularly related to boards of directors, is that it is largely empirical. However, such a view overlooks a large body of general theory that is readily applied to the specific topic of boards. Unfortunately, this literature also has some shortcomings. Often, a simplified, and thus tractable model can produce theoretical results that are unattainable in practice. To an extent, this problem can be finessed by restricting attention to incomplete contracts. However, the assumption of incomplete contracts can fail to be robust to minor perturbations of the information structure or the introduction of a broader class of mechanisms. A further issue is that corporations are complex, yet, to have any traction, a model must abstract away from many features of real-life corporations.

We organize our survey into four main sections that address four key questions about directors: What do directors do? What are the issues related to board structure? How do boards fulfill their roles? What motivates directors? Throughout the paper, we suggest that many studies of boards can best be interpreted as joint statements about both the director selection process and the effect of board composition on board actions and firm performance.

The full paper is available for download here.

Daniel Kaufmann recently gave his farewell address as the outgoing Director of Global Programs at the World Bank Institute. Kaufmann is widely recognized as a leading expert, researcher, and policy adviser on governance and development. Among other activities, Kaufmann was a key figure in the Worldwide Governance Indicators research project, which designed improved measures of public sector governance quality such as corruption, the rule of law, and regulatory quality (the latest version is available here).

At the standing room only event, Kaufmann described his professional journey, the influence of his numerous experiences around the world on his personal development, and his views on the current state of the anti-corruption and governance movement which has defined his career. In Kaufmann’s view, the governance and anti-corruption drive is currently in a silent crisis since concrete reforms have lost steam in recent years. He argued that this silent crisis is directly connected to the more visible financial crisis, which arose in part due to governance and corruption failures. Therefore, he suggested that the current environment provides an opportunity for the international donor community and its key institutions to re-evaluate their business model to enhance governance and improve transparency, and create an open environment in which we can better address the pending challenges of governance, state capture, corruption, human rights, and freedom of expression.

A video of the entire lecture is available here. The PowerPoint slides used in the lecture are available here. In addition, Kaufmann maintains his own blog at www.thekaufmannpost.net, which contains links to his papers and other governance related sites and material, as well as some posts that are related to many of the points he made during his farewell lecture.

(Editor’s note: This post comes from Shane Heitzman at the University of Rochester Simon Graduate School of Business, Dan Dhaliwal at the University of Arizona and Merle Erickson at the University of Chicago Graduate School of Business.)

In our paper “Taxes and the Backdating of Stock Option Exercise Dates”, which was recently accepted for publication at the Journal of Accounting and Economics, we investigate the opportunistic timing of stock option exercises by insiders. We focus on a group of exercises where there likely exists both the incentive and the ability to backdate an option exercise: exercises paid in cash where the insider holds the acquired shares. Once the decision to exercise is made, insiders who plan to hold the acquired shares have an unambiguous personal tax-based incentive to exercise on the day with the lowest possible stock price. Unlike exercises in which the acquired shares are sold immediately through a broker, these exercise-and-hold transactions are often accomplished in-house. Thus, we expect that opportunistic backdating, to the extent it exists, is more likely to occur in exercise-and-hold transactions. We find that exercise-and-hold transactions tend to occur at monthly stock price lows. Before SOX, we find that 13.55% of exercise-and-hold transactions by CEOs occurred on the day the stock was at its lowest price during the month (i.e. suspect exercises). After SOX, only 7.20% of CEO exercise-and-hold transactions occurred on that day.

Consistent with the prediction that backdating an exercise-and-hold transaction is driven by personal tax considerations, we find that the likelihood of a suspect exercise is increasing in the potential taxes saved by the option holder from exercising on the day of the month with the lowest closing price before SOX, but not after SOX. Finally, suspect exercises are more likely in small firms. While this finding is consistent with the conclusion that backdated exercises are more likely when the firm has a relatively weaker internal control environment we also find that the probability of a suspect exercise is not consistently related to common proxies for corporate governance based on the subsample of observations with available governance data.

We estimate that our sample of CEOs saved an average of $96 thousand in taxes per exercise by exercising on the day of the month with the lowest closing stock price. These tax savings make up only about 3.2% of the total value of the options exercised, and are even smaller at the median. Given that filing a false tax return can be a felony, can result in individual level penalties in excess of $100 thousand (among other costs), and can have significant adverse consequences for the firm and shareholders, the tax savings realized by CEOs through suspect option exercises seem remarkably modest. One likely explanation is that insiders believed the probability of getting caught was low enough to justify the risk. We also find that the firm’s foregone tax benefits from suspect exercises are of similar magnitude to the taxes saved by the CEO.

Finally, we find that suspect exercise-and-hold transactions are more likely in firms with a higher likelihood of stock option grant backdating. For the sample of exercise-and-hold transactions by insiders of firms under scrutiny for option grant backdating as listed in the Wall Street Journal’s “Options Scorecard”, we find that 21.53% of exercises by CEOs and 18.41% of exercises by non-CEOs occurred on the day the stock was at its lowest price during the month. That is, insiders from firms with alleged grant backdating practices were more likely to have a suspect exercise than other insiders. We also find that the firm-specific odds of option grant backdating are positively associated with the frequency of suspect exercises among firms not mentioned in the Wall Street Journal’s list. Together with the remainder of this study, our analysis provides additional evidence on the magnitude and determinants of opportunistic behavior associated with executive stock options.

The full paper is available for download here.

(Editor’s Note – This post comes to us from Bill Baxley and Jeff Stein at King & Spalding.)

Corporate strategy is a difficult undertaking for directors, even in the best of times. While management draws on significant resources to develop and refine corporate strategy, directors have fewer opportunities to contribute to the endeavor. It is not surprising then that while CEOs suggest that participating in corporate strategy is the second most important activity that their boards undertake, they give their boards only the 11th highest grade for their performance in this realm. “What’s the board’s role in strategy development?: Engaging the board in corporate strategy”, David A. Nadler, Strategy & Leadership, Vol. 32 No. 5, 2004. The difficulty of developing corporate strategy, as well as the stakes involved, increase significantly in times of economic crisis such as we are facing today.

Against this background and facing the current economic crisis, the Lead Director Network, a group of lead directors, presiding directors and non-executive chairmen from many of America’s leading companies created by King & Spalding and Tapestry Networks, met on November 3, 2008 to discuss the role of the board in corporate strategy. Following this meeting, King & Spalding and Tapestry Networks have published the ViewPoints report, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of this important subject. The following provides highlights from the meeting, as described in this ViewPoints report.

Greater Involvement of Boards in Corporate Strategy. Members of the Lead Director Network observed that boards have become significantly more involved in corporate strategy in recent years. This increased involvement might be attributable to boards being more proactive, generally, since the corporate scandals in the early part of this decade, the rise of activist investors, and directors’ own efforts to become more engaged in corporate strategy, particularly when their companies are undergoing rapid changes or facing turbulent events.

…continue reading: The Board’s Role in Corporate Strategy

(Editor’s Note: Sullivan & Cromwell LLP advised the boards of both Bear Stearns and Wachovia in the transactions discussed in this post. This Blog recently published a post, available here, about the JPMorgan/ Bear Stearns decision. Today’s post analyzes this decision as well as the similar decision by the North Carolina Superior Court arising from the Wachovia/ Wells Fargo merger.)

My firm has issued a memorandum that discussed the recent judicial decisions arising from the mergers of JPMorgan and Bear Stearns in March and of Wells Fargo and Wachovia in October. The two decisions — In re Bear Stearns Litigation, No. 600780/08 and Ehrenhaus v. Baker et al., No. 08 CVS 22632 — offer the first indication of how courts will evaluate board decisions made in response to the extraordinary conditions created by the ongoing financial crisis. Both opinions stand as strong endorsements of the protections offered by the business judgment rule for directors who act diligently and in good faith in making major corporate control decisions during this crisis. Their holdings have several important implications:

• First, these cases suggest that courts are cognizant of the extreme conditions created by the financial crisis, and will take into account the overwhelming financial, governmental, and time pressures boards of directors are facing when evaluating whether board decisions are entitled to the protections of the business judgment rule.

• Second, these cases suggest that courts are aware of the uncertainties created by regulatory and legislative responses to the financial crisis, and that courts will not fault boards for failing accurately to predict these governmental responses.

• Third, despite the broad deference these courts have given board decisions made in response to the financial crisis, the Wachovia decision suggests that courts still may be willing to invalidate or enjoin provisions – such as the 18-month bar on redeeming Wells Fargo’s preferred shares – that the court believes will prevent boards from fulfilling their fiduciary duties.

The memorandum is available here.

(Editor’s Note: This post comes to us from Itay Goldstein of the Wharton School at the University of Pennsylvania)

In my paper Market-Based Corrective Actions (co-written with Philip Bond and Edward Simpson Prescott), which I recently presented at the Law, Economics and Organizations seminar, my co-authors and I derive a model that examines the idea that financial-market prices provide useful and important information about firms’ fundamentals.

Many economic agents take corrective actions based on information inferred from the market prices of firms’ securities. In corporate governance, it is widely believed that low market valuations trigger the replacement of CEOs by the board of directors or attract various actions by shareholder activists. In bank supervision, regulators are frequently encouraged to learn from market prices of bank securities before making an intervention decision. Even corporate managers are believed to be influenced by market prices of their firms’ securities when making a decision to invest or acquire another firm.

We provide an equilibrium analysis of such situations in light of a key problem: if the agent uses market prices when deciding on a corrective action, prices adjust to reflect this use and potentially become less revealing. For example, if the board knows that the CEO is of low quality they will replace him. This corrective action will benefit the shareholders of the firm and thus increase the price of its shares. So inferring information from the price about the quality of the CEO is a challenge: a moderate price may indicate either that the CEO is bad and that the board is expected to intervene and replace him, or that the CEO is not bad enough to justify intervention. We show that there is a strong complementarity between market information and the agent’s information, so that a market-based corrective action leads to the agent’s preferred outcome only when the information gap is not too large. We demonstrate that the type of security being traded matters, and discuss other measures that can increase the efficiency of learning from the market.

The full paper is available for download here.

A forthcoming issue of the Virginia Law & Business Review entitled “US Securities Regulation and Global Competition” will feature articles by Eric Pan and myself, Stavros Gadinis, and Andreas M. Fleckner on international aspects of United States securities regulation. The articles in this symposium issue have important implications for the ongoing debate over competition among markets internationally for issuers of securities as well as for the role played by US securities regulations in the apparently declining competitiveness of US capital markets. In an introduction to the issue, Donald Langevoort characterizes all three articles as exploring different aspects of the bind that U.S. securities regulation now faces in balancing demands for more intense supervisory oversight with pressures to improve U.S. capital market competitiveness in the face of mounting international competition.

In “Regulatory Competition in International Securities Markets: Evidence from Europe - Part II ,” Eric Pan and I return to the study of capital raising practices of foreign firms. We began this project nearly a decade ago at a time when U.S. corporate law scholars were debating the theoretical merits of a regime of “issuer choice” in which firms would be permitted to choose the legal regime governing the sale of and trading in issuer securities. Our goal was to move beyond theoretical debates by interviewing market professionals to ascertain exactly how firms were deciding in which markets to raise capital and to probe the extent to which mandatory legal regimes were constraining.

Our new article is the second half of this research project and draws on evidence gained from some four dozen in-depth interviews conducted in 1999 with lawyers and market professionals in London and other major European markets. The first article in the project, which is available here, presented evidence concerning capital raising practices within the European Union. The second article, which is now forthcoming in the Virginia Law & Business Review, focuses on practices of European issuers seeking to raise capital in the US. Our results are of particular relevance to recent debates over the effect of the Sarbanes-Oxley Act on foreign issuers as our survey took place shortly before that Act was passed. Significantly, our article provides evidence that during this earlier period US investors were tending to prefer to execute transactions on European trading markets as opposed to parallel markets established in the US, such as ADR listings. In other words, many aspects of the decline in U.S. capital markets competitiveness that some have associated with the enactment of the Sarbanes-Oxley Act were in evidence well before the passage of that Act.

In the article, Eric and I present a range of evidence on the capital raising choices available to European issuers seeking to raise capital in the US and how they weighed the pros and cons of these choices. We test our findings against statistical evidence and other academic writings on the subject and discuss the implications of this aspect of our analysis on the debate over regulatory competition. The article also presents survey data about the efficacy of SEC supervision of foreign issuers seeking access to public markets as well as information pertaining to legal fees and other direct expenses that European issuers incurred when they raised capital in the US in the late 1990s. While the additional costs and regulatory impediments of the public U.S. offering process imposed a burden on foreign issuers seeking access to U.S. public markets at the time, market developments, including the rise of European capital markets and the availability of alternative mechanisms to reach most U.S. investors, seem to have played a more important role in the declining relative attractiveness of U.S. public listings.

The paper by Stavros Gadinis, “Market Structure for Institutional Investors: Comparing the US and the EU Regimes,” considers the rules governing stock exchange market structure: Regulation NMS (“National Market System”) in the United States and the EU Directive on Markets in Financial Instruments (“MiFID”) in the EU. Focusing on issues of regulatory design, the article compares the US and EU regimes to explore which policy can better achieve its stated goals. In particular, the paper examines the impact of these policies on the major contributors to equity trading volume in the last decade: institutional investors. It argues that US rules result in higher liquidity costs for institutional investors and may harm the informational efficiency of US markets. The paper is available here.

In “FASB and IASB: Dependence Despite Independence,” Andreas M. Fleckner focuses on the organizational structure of the Financial Accounting Standards Board and the International Accounting Standards Board and their susceptibility to outside influence. The paper considers the integration of each Board into its respective parliamentary system as well as the exposure of each Board to financial, political and national influences. The paper shows that, in principle, both Boards are organized independently from private and governmental influence, but that neither Board is immune to outside influence. It refers to recent examples of both Boards being subjected to outside influence and, when put under pressure, making concessions that jeopardized their independence. The paper is available here.

Eliot Spitzer offered up some insightful commentary (Nov. 16, Wash Post) on the public corporation’s fall from favor and rightly pointed to basic issues in corporate governance that need reform. He states, “…our corporate governance system has failed. …Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves – all abdicated their responsibilities.”

If by shareholders, Spitzer means mutual funds and pensions have not actively held boardrooms accountable, I agree with him. Put simply, boards have failed. Why should shareholders stand by on the sidelines? There is no axiom stating that public shareholders have to stand by and witness the demise of the most powerful financial engine in history.

Why should public shareholders be forced to leave so much value on the table because of risks taken by unaccountable management teams and boards? Spitzer says that when his office and the DOJ warned that, “some of AIG’s reinsurance transactions were little more than efforts to create the false impression of extra capital on the company’s balance sheet,” they were “jeered at for attacking one of the nation’s great insurance companies, which surely knew how to balance risk and reward.” Clearly, many boards such as AIG did not know how to balance risk. And they certainly did not know how to balance reward.

As owners, why would we allow this? The theory of the public corporation is not bankrupt, the practice is. We need critical changes in corporate governance that would go to the heart of the blameworthy lack of accountability between managers and shareholders.

Board members are often hand-picked by managers. The current proxy system is so biased in favor of management that any challenge is prohibitively expensive and generally guaranteed to fail. In theory of the corporation, the shareholders pick the board, and it in turn picks the management. In practice however, the system is turned upside down. Incumbent management picks the issues and board nominees for the proxy statements and distributes the ballots. The shareholders vote and sign their names to the ballots and then send them back to the incumbents, who count them and announce the outcome. And so, there is no true election. There is only one list of nominees! The system is similar to a dictatorship; the difference being that the goon squads protect the dictator, but lawyers protect the board.

And what is the result? Most recently, a financial crisis. Listen to Spitzer. “Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions.”

This failure of corporate democracy has left shareholders virtually powerless. The system must be fundamentally reformed to give shareholders more rights – to nominate board members, to eliminate excessive takeover defenses and to have the ability to vote to incorporate their company in another state.

Simple legislation (see my post Shareholders Should Decide Where Companies Incorporate) would make tremendous progress toward resolving the power mismatch that managements and their boards have over shareholders. With true competition for board seats, accountability can be restored and managers would be compelled to work for value maximization on behalf of shareholders and not work simply to enhance their pay and perks and entrench themselves in highly paid positions.

Truly independent board members could also insist on performance based compensation plans and other programs to align management’s interests with shareholders. Then public shareholders could realize the full potential of their companies. But currently, the best opportunity for shareholders is to sell their shares and stand by while, in many cases, the same management team that ran their companies into the ground reap additional millions for a job poorly done.

These reforms are not just grist for academic debate. Reforms of our current system like ‘Say on Pay’ and golden parachute modification have received increasing support and several prominent corporations (including Aflac, Vodafone and GlaxoSmith Kline) have voluntarily adopted policies like Say on Pay.

At the very least, these reforms are essential to enhance management accountability for our corporations. Equally important, they would restore a basic democratic right to the owners of corporate America.

While the financial crisis continues, shareholders should have the option to protect their rights and make America’s boardrooms accountable. Make a difference and join United Shareholders of America. This is where we start. It is where we grow stronger. It is where change begins.

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The recent turmoil in the financial markets and slowing economic growth has led to companies taking a variety of steps to de-lever their balance sheets and/or tap new or cheaper funding sources. Evidence of this includes recent exchange offers and debt tender offers, including those launched by GMAC, CIT Group, Harrah’s Entertainment and Realogy. Residential Capital and Tyco International both completed exchange offers earlier this year. Companies are using exchange offers to increase regulatory capital (in the case of CIT Group and GMAC) as well as to de-leverage and extend the weighted-average maturity of their outstanding debt (ResCap, Harrah’s, Realogy, Tyco). Others will no doubt follow, and those who do should be aware of the legal context in which exchange offers take place. My colleagues Lawrence S. Makow, David E. Shapiro, and Alison M. Zieske, and I have issued a memorandum entitled “Today’s Marketplace Highlights Increasing Use of and Great Opportunities for Exchange Offers,” which summarizes various considerations which should be taken into account in structuring exchange offers and debt tender offers. These include tender offer rules, pricing methods, inducement payments for early delivery and solicitations, consent solicitations, registration rights, foreign exchange listings, effect on a company’s existing obligations, and appropriate disclosure in offering documents.

The memorandum is available here.

In my paper Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences, co-written with Holger Daske, Luzi Hail and Rodrigo Verdi, which is forthcoming later this month in the Journal of Accounting Research, we use a treatment sample of over 3,100 firms that are mandated to adopt IFRS to analyze effects in stock market liquidity, cost of equity capital, and firm value. These market-based constructs should reflect, among other things, changes in the quality of financial reporting and hence should reflect improvements around the IFRS mandate, if there have been any.

The primary challenge of our analysis is that the application of IFRS is mandated for all publicly traded firms in a given country from a certain date on, which makes it difficult to find a benchmark against which to evaluate any observed capital-market effects. Our empirical strategy uses three sets of tests to address this issue. In our first set of tests, which use firm-year panel data from 2001 to 2005, we benchmark liquidity, cost of capital and valuation effects around the introduction of IFRS against changes in other countries that do not yet mandate or allow IFRS reporting. In addition, we introduce firm-fixed effects to account for any unobserved (time-invariant) firm characteristics. In our second set of tests, where we continue to use firm-year panel data, we examine whether the estimated capital-market effects exhibit plausible cross-sectional variation with respect to countries’ institutional frameworks. In our last set of tests, we exploit that firms begin applying IFRS at different points in time depending on their fiscal-year ends and that, as a result, the adoption pattern in a given country is largely exogenous once the initial date for IFRS adoption is set. We relate this pattern to changes in aggregate liquidity in a given country and month.

We find that, on average, market liquidity increases (modestly) around the time of the introduction of IFRS. We also document a decrease in firms’ cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms’ reporting incentives and countries’ enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, i.e., better firms signaling their quality through early IFRS adoption, the latter result cautions us to attribute the capital-market effects around the mandate to the switch in accounting standards per se (because voluntary adopters have already switched to IFRS by the time of the mandate). Many adopting countries have made concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects.

The full paper is available for download here.

This post is by my partner Keith A. Flaum.

The Committee on Mergers & Acquisitions of the American Bar Association’s Section of Business Law recently released the 2008 Strategic Buyer/Public Target M&A Deal Points Study. I am the Chair of the Committee’s M&A Market Trends Subcommittee, which oversaw the preparation of the Study, and Jim Griffin of Fulbright & Jaworski in Dallas is the Chair of the working group that compiled the Study.

The Study examines key deal points in acquisitions of publicly traded companies by strategic buyers announced in 2007. It also compares the data from the 2007 deals to the data from the Subcommittee’s prior studies of public company acquisitions, which cover deals announced in 2004, 2005 and 2006.

Among the many interesting findings of the Study is that 48% of the acquisition agreements in the Study sample contained a non-reliance clause—a clause to the effect that the target is not making, and the buyer is not relying on, any representations regarding the target’s business except for the specific representations expressly provided in the acquisition agreement. By comparison, only 18% of the acquisition agreements for deals announced in 2005 and 2006 included a non-reliance clause.

So why the significant increase? One possible explanation might be found in the February 2006 decision of the Delaware Court of Chancery in ABRY Partners, and the extensive discussion of that case by leading M&A practitioners throughout the country. In ABRY Partners, Vice Chancellor Strine underscored the effectiveness of a non-reliance clause in limiting a buyer’s fraud-based remedies in the context of an acquisition of a privately-held company. Even though ABRY Partners involved a privately-held target, the extensive discussion that followed also focused on the potential usefulness of non-reliance clauses in deals involving publicly traded target companies. Then, in late 2007, the Tennessee Chancery Court decided Genesco, Inc. v The Finish Line, Inc. In that case, a non-reliance clause in the merger agreement was viewed by the Court as an important element in its determination that Finish Line failed to prove that the publicly traded target company, Genesco, fraudulently induced Finish Line to enter into the merger agreement.

My colleague, Rick Climan, former Chair of the Committee on Mergers & Acquisitions, who acted as special advisor on the Deal Points Studies, points out that some of the targets involved in the 52% of the acquisition agreements in the Study sample that did not include a non-reliance clause may nonetheless have enjoyed the protection afforded by a non-reliance clause, in those cases where such a clause was included in the confidentiality agreement between the buyer and the target. In fact, in Genesco, the Court pointed to non-reliance clauses in both the confidentiality agreement and the merger agreement to support its decision.

It will interesting to see the results of our 2009 study on this issue.

In addition to Jim Griffin, Wilson Chu and Larry Glasgow, the former co-chairs of the M&A Market Trends Subcommittee, and more than 20 M&A lawyers from major law firms across North America, assisted in the Study. Their names are listed in the Study.

The Study is available here.

David Zaring and I attempt to provide an explanation for the government’s seemingly haphazard actions in our latest paper Big Deal: the Government’s Response to the Financial Crisis. Professor Zaring and I posit that the government’s team, staffed and led by a team of investment bankers, has been taking a “deal-approach” to the bail-out. The government has pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. The result has not been particularly coherent, but it has married transactional practice to administrative law. We call the result regulation by deal, and think it provides a loose process consistency upon the government’s actions.

A week before we posted our paper to the SSRN, Professors Eric Posner and Adrian Vermeule also posted Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008. The good professors offer an alternative explanation. As Posner wrote on the Volokh Conspiracy where Prof. Zaring and I “see legal constraints . . . . Adrian Vermeule and I see black and gray holes exploited by the executive branch and the Fed.” For administrative law geeks, Professor Vermeule talks about this topic in more detail in his forthcoming Harvard Law Review article: Our Schmittian Administrative Law.

For those who study corporate governance, our article also details and explores the mind-boggling stretching of Delaware law that the government has either fostered or facilitated in these bail-outs. From Bear to AIG to Wachovia, dealmakers have been pushing and testing the limits of deal protection devices to lock-up these government sponsored deals safe in the assumption that Delaware is unlikely to intervene. Much of these new-found devices are likely justifiable on insolvency grounds – a still being explored area of Delaware law. But, it remains to be seen how this stretching will affect how deals are done outside the government sphere, and how Delaware’s jurisprudence will respond to the use of more circumscribing lock-ups in ordinary course deals. For those who subscribe to the theory that Delaware’s jurisprudence is a thaumatrope – oscillating between strictness and laxity depending upon the times – Delaware is likely to tolerate these lock-ups for the time being as necessary to the preservation of our capital markets system. The truth remains to be seen.