I have recently filed an amicus brief on behalf of myself and Professor Bainbridge of the UCLA Law School, Professor Jonathan Macey of Yale Law School, Professor Alan Bromberg of SMU Law School and Professor Henderson of the University of Chicago Law School in the litigation filed against Mark Cuban by the SEC in the United States District Court for the Northern District of Texas.

The SEC complaint essentially alleges that Mark Cuban committed insider trading when, according to the complaint, he sold stock in a company (Mamma.com) in which he was a large shareholder (but not a director or officer) after receiving material, non-public information from the company. The basis for the SEC’s claim of insider trading is the allegation (hotly disputed) that there was a confidentiality agreement with Mr. Cuban covering this material, non-public information.

In our amicus — which can be found here — we argue that even if there was a confidentiality agreement (i.e. accepting all of the SEC’s allegations as true), as a legal matter Mr. Cuban could not have committed insider trading. The Supreme Court in U.S. v. O’ Hagan, 521 U.S. 642 (1997) emphasized that only if a defendant has breached a fiduciary or similar relationship of trust and confidence can the defendant be found to have engaged in the requisite deception through non-disclosure. Under both state and federal common law, a confidentiality agreement alone creates only an obligation to maintain the secrecy of the information, not a fiduciary or fiduciary-like duty to act loyally to the source of the information. As a result, if the SEC’s Rule 10b5-2(b)(1) is read as creating insider trading liability solely on the basis of a confidentiality agreement, this rule is an invalid exercise of the SEC’s rulemaking authority.

Of course, neither I nor any of the professors that signed the amicus brief were compensated in any way for our efforts.

(Editor’s Note: This post is based on a memo by Annette Nazareth, Joseph Hall and Michael Kaplan of Davis Polk & Wardwell.)

On February 2, 2009 the Securities and Exchange Commission published the text of its new rules for credit rating agencies registered as nationally recognized statistical rating organizations (NRSROs). These rules were adopted at the SEC’s December 3, 2008 open meeting. The new rules are generally scheduled to go into effect on April 10, 2009. The SEC also re-proposed additional rules for NRSROs. Comments on the re-proposed rules are due March 26, 2009.

Final Rules
The rules adopted by the SEC in final form include bans on certain conduct which should be of interest to companies with current credit ratings issued by Standard & Poor’s Ratings Services, Moody’s Investors Service, Fitch Ratings, or another credit rating agency registered as an NRSRO. Since the consequences of violating one of the new bans are severe – requiring the credit rating agency to withdraw its rating – companies should carefully review their policies and procedures for interacting with credit rating agencies.

The new bans include:

• Ban on Recommendations. Under the new rules, a credit rating agency may not issue or maintain a credit rating on an obligor or security where the credit rating agency, or an affiliate, made “recommendations” to the obligor or the issuer, underwriter or sponsor of the security about the corporate or legal structure, assets, liabilities or activities of the obligor or issuer.

Despite concerns raised that a ban on recommendations could unnecessarily chill communications between rated issuers and credit rating agencies, the line between permissible and prohibited communications remains blurred. Attempting to distinguish between a permissible communication and a prohibited recommendation, the SEC stated, for example, that it “does not view an explanation by an NRSRO of the assumptions and rationales it uses to arrive at ratings decisions and how they apply to a given rating transaction as a recommendation.” On the other hand, “if the feedback process turns into recommendations by the NRSRO about changes to the structure, assets, liabilities or activities of the obligor or security that the person seeking the rating potentially could make to obtain a desired credit rating, the NRSRO would be in violation of the new rule.”

Companies and credit rating agencies both will need to exercise care to ensure that their discussions do not cross the line to soliciting or providing an impermissible recommendation.

…continue reading: SEC Publishes Final Rules for Credit Rating Agencies

(Editor’s Note: This is a transcript of The Economist’s Inaugural City Lecture, which was delivered by Lord Adair Turner in London on January 21, 2009.)

It is stating the obvious to say that over the last 18 months, and even more so the last four, the world financial system – and particularly but not exclusively the world banking system – has suffered a crisis as bad as any since the stock market crashes of 1929 and the various banking crises that followed. As a result, banking systems in many countries are suffering from an impaired ability to play their vital role in credit extension to the real economy and a process of deleveraging threatens severe adverse effects on real economic prospects. The crisis therefore presents the financial authorities – central banks, regulators and finance ministries – with two challenges:

• The first and most urgent is to design short-term policies so as to at least limit the adverse impact of deleveraging and deflation on the real economy. We cannot make that impact nil, but we do know how to avoid the policy mistakes which turned the initial problems of 1929-30 into the Great Depression. Fiscal and monetary policies need to be carefully designed, and – as we approach a zero interest rate and consider quantitative easing options – need to be increasingly coordinated. And there are a wide range of policies which can be taken to free up financial markets – measures which Ben Bernanke last week labeled “Credit Easing” – funding guarantees, liquidity provision, tail risk insurance, direct central bank purchases of assets, and regulatory approaches to capital regulation which avoid unnecessary pro cyclicality in capital adequacy requirements. The measures announced by the Chancellor of Exchequer on Monday were designed as an integrated package, which will have a significant impact. And if more measures are acquired they can and will be taken.

• It is not, however, on this challenge of short-term economic management – where the lead must be with the fiscal and monetary authorities – that I’m going to talk tonight. But instead on the second challenge: how to design the future regulation and supervision of financial services so that we significantly reduce the probability and severity of future financial crises? Last September, when I took over as Chairman of the FSA, the Chancellor asked me to conduct a review of our regulation and supervision of the banking system, and I will deliver that Review in March, alongside the publication of a comprehensive FSA Discussion Paper. That paper will set out the changes the FSA has already made, those where we have proposals in principle but need to consult on details, and those where we have defined our objectives but now need to play our role in achieving international agreement.

…continue reading: The Financial Crisis and the Future of Financial Regulation

In my paper Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis, which was co-written with Pinar Karaca-Mandic and Eric Talley and is forthcoming in the Journal of Law, Economics, & Organization, we investigate whether the passage and the implementation of the Sarbanes-Oxley Act of 2002 (SOX) drove firms out of the public capital market.

Many other attempts to address this question have had difficulty controlling for unobserved conflating factors that could have affected exit decisions around the enactment of SOX. We address this difficulty using a difference-in-differences empirical strategy. This approach compares changes over time in two populations: one subject to a policy intervention (treatment group) and the other not (control group). To evaluate the impact of the intervention on outcome, one needs to compare the outcome change for the treatment group with the outcome change for the control group. Assuming the two groups are similar in all relevant respects other than their exposure to the intervention, this approach screens out changes not related to the intervention. The primary outcome variable in our analysis is a public target’s probability of being bought by a private acquirer rather than a public one, the treatment group is American targets, and the control group is foreign targets. To evaluate the effect of SOX, we compare the change in the propensity of American public targets to be bought by private acquirers rather than by public acquirers to the corresponding change for foreign public targets. The difference between the two changes—the difference-in-differences—is the change we attribute to SOX.

When we examine acquisitions as a whole, we find no relative increase in the rate of acquisition by private acquirers (going private) among American firms. When we differentiate between acquisitions based on firm size, however, we find a relative increase in the rate of going private by small American firms. Moreover, when we differentiate between acquisitions based on their proximity to the enactment of SOX, we find a relative increase in the rate of going private by American firms in the first year after the enactment. Finally, when we differentiate between acquisitions based on both firm size and the proximity of the acquisition to the enactment of SOX, we find that the increase in the rate of going private by small American firms is concentrated in the first year after the enactment.

The full paper is available for download here.

Less than two decades after Francis Fukuyama famously enshrined market-based liberal democracy as an optimal system at “the end of history,” [1] Barack Obama used his inaugural address to warn the nation that, “without a watchful eye, the market can spin out of control.” The change in tenor from capitalist triumphalism to our current trepidation is indeed remarkable.

In these somber days, with corporate failures still grabbing headlines, the new President has inherited not only a severely weakened economy, but also executive leadership of a government that has already committed hundreds of billions of dollars recapitalizing the financial sector. With so much taxpayer money on the line, additional bailout requests piling up across the corporate landscape, and public anger still cresting, little wonder that the debate is now broadening to what kind of owner government should be. Will the large federal stake in banking, auto, and perhaps other industries prove blessing or burden? Onus or opportunity?

In fact, President Obama has signaled that he doesn’t have much taste for his government’s actively managing corporations. Immediately before his inaugural warning about the failures of unchecked capitalism, the President sounded almost Fukuyama-esque himself in declaring that there remains no question about the market’s unmatched “power to generate wealth and expand freedom.”

How then is the new administration to find a productive — but not meddlesome — federal role that neither relinquishes authority nor shirks its new responsibility as a major stakeholder? Finding such a position relies, I contend, on understanding the crucial role of corporate ownership in America’s economic system: how it should ideally function, how it has actually existed, and what can be done to encourage its more perfect realization.

My article is available here.

[1] Francis Fukuyama, Summer 1989, The National Interest - “The struggle between two opposing systems is no longer a determining tendency of the present-day era. At the modern stage, the ability to build up material wealth at an accelerated rate on the basis of front-ranking science and high-level techniques and technology, and to distribute it fairly, and through joint efforts to restore and protect the resources necessary for mankind’s survival acquires decisive importance.”
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(This post comes to us from Ted Wallace of the Altman Group. It recently appeared in The Corporate Counsel.)

A Special Purpose Acquisition Company (SPAC) is a publicly traded shell (or blank check) company formed for the specific purpose of buying an existing company, usually in a particular industry.

At the IPO, investors purchase units of the SPAC, consisting of a combination of shares and warrants, at a relatively low price. The SPAC then generally has 24 months to find a suitable company to purchase through a reverse-merger.

So how would a hedge fund become the target of hedge fund activism? Ask TM Entertainment & Media, Inc. (AMEX: TMI). This SPAC must complete an acquisition before October 17, 2009 or its “corporate existence will cease by operation of law” and its funds and assets will be distributed among its shareholders. This, however, is apparently too long to wait for Phil Goldstein of Bulldog Investors.

On December 17th, Goldstein (d/b/a Opportunity Partners LP) filed preliminary proxy materials to commence a consent solicitation to replace the board of directors with his nominees, who will “promptly dissolve the issuer and cause the cash in the trust account to be distributed to shareholders.”

…continue reading: Hedge Fund Activism Extends to SPACs

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

Two private sector committees, the Asset Managers’ Committee and the Investors’ Committee, established by the President’s Working Group on Financial Markets, recently released their final reports on best practice guidelines for hedge fund managers and investors. Drafts of each report were originally released on April 15, 2008, and were open to public comment for 60 days. The final reports have been modified in response to comments received during the comment period and to address interim developments in global financial markets. This memorandum describes the recommendations in the reports (also described in our April 18, 2008 memorandum to clients) and reflects revisions to the final reports. Both final reports, as well as a letter describing the comments to the Asset Managers’ Committee report, are available here. Sullivan & Cromwell LLP acted as counsel to the Asset Managers’ Committee, along with Schulte Roth & Zabel LLP, in the development and issuance of its report.

BACKGROUND
In February 2007, the President’s Working Group on Financial Markets released a set of principles to guide financial regulators as they addressed the rapid growth of private pools of capital, including hedge funds. These principles concentrated specifically on investor protection and systemic risk concerns. In September 2007, the President’s Working Group tasked two private sector committees with developing best practices for their respective stakeholder groups, based on these initial principles.

The Asset Managers’ Committee (“AMC”), comprised of representatives from ten leading U.S. hedge funds, focused its recommendations on five areas: disclosure, valuation, risk management, trading and business operations, and compliance, conflicts and business practices. The Investors’ Committee (“IC”), comprised of public and private pension funds, endowments, foundations, hedge funds, labor organizations and hedge fund consultants, focused its recommendations on fiduciaries considering hedge fund allocations and individuals executing and administering hedge fund programs.

The reports make recommendations specific to their respective stakeholder groups (i.e., hedge fund managers and investors, respectively), but also encourage use of the reports together as a means to increase the accountability of each stakeholder group to the other. Investors are encouraged to use the AMC report as a basis for due diligence on hedge fund managers, while hedge fund managers are encouraged to use the IC report to guide their interaction with investors.

…continue reading: Best Practices for Hedge Fund Managers and Investors

(Editor’s Note: This post comes from Christian Laux of Goethe University Frankfurt and Volker Laux of the University of Texas at Austin.)

In our paper Board Committees, CEO Compensation, and Earnings Management which was recently accepted for publication in the Accounting Review, we develop a model to analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. Even though stock-based compensation schemes are designed to motivate the CEO to take value-enhancing actions, such pay also induces manipulative actions that boost the (short-term) stock price at the expense of long-term shareholder value. We model the interaction between these productive and manipulative activities as a multi-task agency problem. In particular, the CEO in our setting has an incentive to distort the earnings report upward in an attempt to mislead investors about future cash flows. Even though nobody is fooled in equilibrium, earnings manipulation is costly to shareholders because it consumes corporate resources (e.g., leads to distortions in the firm’s operating and investment decisions) and involves personal costs to the CEO for which he must be compensated in order to ensure his participation.

The board of directors is interested in the long-run net firm value and is able to reduce the CEO’s ability to bias the earnings report through costly monitoring. The bias introduced into the report therefore not only depends on the CEO’s choice of manipulation but also on the board’s choice of monitoring. Monitoring by the board is not contractible and not observable, which implies that the board is unable to commit to a certain level of oversight. Despite the lack of commitment, the board has an (ex post) incentive to engage in monitoring because oversight lowers the CEO’s excess compensation and hence increases the net terminal firm value.

The greater the amount of stock-based compensation for the CEO (i.e., the greater the pay-performance sensitivity), the higher is the board’s ex post incentive to engage in oversight. The board of directors is able to exploit this spillover effect as a tool to indirectly commit to oversight. That is, by choosing a high pay-performance sensitivity, the board can credibly signal to the CEO that it will take its oversight function seriously. Such indirect commitment to oversight is beneficial, as it curbs the CEO’s incentive to take manipulative actions. Our model shows that if the whole board is responsible for both functions, it is inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose higher pay-performance sensitivity, as the increased cost of oversight is borne by the audit committee.

Our model also generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management. The full paper is available for download here.

2009 undoubtedly will be a year of severe economic challenges. Analysts believe that the deepest recession since World War II will continue and worsen in the United States. Unemployment may well exceed 10%. With major financial institutions de-levering their balance sheets, credit was constricted for much of 2008 and likely will remain so for an extended period. Partly as a result, entire industries, from automobile manufacturing to retailing, are facing extreme contraction and even the prospect of collapse.

However, for the survivors of 2008’s financial hurricane, 2009 also could be a year of unprecedented opportunity. Bank debt and bonds of good-quality companies are trading at historic lows. Hedge funds that have withstood the wave of investor redemptions, and private equity firms that have raised massive amounts of new capital but see few traditional investment outlets, may explore (or, for the veterans, reenter) the distressed debt market. While the economic and societal benefits of reintroducing liquidity to the debt markets are unquestionable, increased activity in this area no doubt will be met with increased regulatory scrutiny and litigation, particularly in the wake of the myriad financial scandals of the recent past. Some are buying for the enhanced returns available from reasonable credits, while others are buying on a “loan-to-own” basis with a view toward eventually becoming the equity owner of the underlying asset, and some are buying to profit from the potential “reorg” events that others will lead.

My partners Richard G. Mason, Steven A. Cohen, Ian Boczko, Sarah A. Lewis, and I have prepared a memorandum concerning the possession and use of information when buying and selling distressed debt (an abridged version of which was published in The New York Law Journal), which may be of use during the coming year. The rules and customs of the distressed debt market are somewhat different from those that govern other trading markets, and it is important to be careful with information to avoid a problem. This note is meant as a general guide, and particular circumstances will require more detailed analysis. Moreover, prudent investors would be well-advised to have their specific trading policies and procedures reviewed for regulatory compliance and tailored to reflect not only generalized “best practices” but the specific context and framework in which each investor operates.

The memo is available here.

(Editor’s Note: This post comes from Udi Hoitash of Northeastern University and Jean C. Bedard and Rani Hoitash of Bentley College.)

In our paper Corporate Governance and Internal Control over Financial Reporting: A Comparison of Regulatory Regimes which was recently accepted for publication in the Accounting Review, we investigate the association of audit committee and board characteristics with the effectiveness of internal controls over financial reporting (ICFR). We measure this association using data on internal controls from two provisions of the Sarbanes-Oxley Act (Sections 302 and 404) that differ in the requirement that controls be tested by the company’s management and external auditor.

We proceed in two steps. First, we study whether internal control quality, measured as material weaknesses (MW) disclosure, is associated with governance characteristics; i.e. audit committee financial expertise, and board and audit committee structure and activity. Second, we investigate whether the link between governance characteristics and internal control quality holds in both Sections 302 and 404 regulatory regimes. We use an automated data extraction and parsing routine that builds a database of audit committee qualifications from background information available from AuditAnalytics. This method produces a sample of 5,480 firm-year observations with complete data on fiscal years ending between November 2004 to May 2006 (including 19,673 audit committee members), enabling us to address our second research question by studying the governance/MW association among smaller companies that are subject to Section 302 (but not Section 404) as well as larger companies subject to both regulatory regimes.

We find a clear difference in the association of corporate governance quality with MW disclosure between these regulatory regimes. We find that more accounting and supervisory financial expertise on the audit committee is associated with lower likelihood of MW disclosure under Section 404, but not under Section 302. For members with accounting qualifications, this association is evident regardless of whether the individuals are publicly designated as “Section 407 financial experts.” However, among members with supervisory qualifications, we find a significant association only for individuals not publicly designated. In supplemental analysis, we also find that only accounting financial experts are associated with lower likelihood of disclosing MW related to account-specific control problems, while only supervisory financial experts are associated with lower likelihood of disclosing MW related to more management-oriented issues of personnel and information technology. These results are consistent across contemporaneous and lag specifications, are not sensitive to controlling for selection bias, and are robust to several alternative variable specifications.

Overall, our findings suggest that in regulatory environments without requirements of mandatory testing and independent auditor attestation that are required under Section 404, corporate governance quality has no observable association with ICFR disclosure. The full paper is available for download here.

This post is by my colleagues Betty M. Huber and Brianne Lucyk.

Preparing environmental disclosure for Securities and Exchange Commission filings has always been a complicated task. Although most of the securities and accounting rules governing environmental disclosure have been in place for some time, environmental costs and liabilities can take various forms, the key facts are often difficult to ascertain and the underlying environmental laws (and their enforcement) are constantly changing. Further complicating matters is the fact that many publicly traded company operations are subject to multiple jurisdictional requirements, from very local to international or supranational regimes. Finally, and particularly problematic for disclosure purposes, is the fact that environmental matters often take many years to investigate, address and resolve, which raises significant estimation and other challenges.

This memorandum describes the current requirements relating to environmental disclosure in SEC filings. Many of the disclosure obligations relate to costs and liabilities that are familiar to all companies—such as costs to investigate and remediate contamination and costs and liabilities arising from the failure to comply with laws or the existence of environmental litigation—but there are some recent developments that companies must consider.

Certain new and proposed changes to environmental accounting rules may affect current and near-term qualitative and quantitative disclosure. In particular, the Financial Accounting Standards Board is looking for more footnote disclosure about a company’s environmental liabilities. There is also a general movement towards “fair value” (or mark-to-market) accounting. Complying with these changes can be difficult given the uncertainty in the timing and cost of many environmental liabilities, as noted above.

Climate change must also be considered when preparing SEC disclosure. While there are many uncertainties, and the current profound international economic crisis may adversely affect the ability of the new U.S. administration to move forward with aggressive climate change laws, costs relating to climate change are already affecting some companies and will, in the future, affect many others. Certain environmental interest groups and regulators have made climate change disclosure a focus of their agendas, and companies must therefore consider practical and political issues in addition to purely legal requirements.

Finally, it is worth noting that some of these developments may result in a need for companies to collect information not currently being collected (from the measurement of carbon emissions to new “fair value” estimates to careful tracking of legal developments).

This memorandum discusses these recent developments and provides practical guidance on how to analyze and address the related disclosure issues facing your company.

The memo is available here.

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

In my paper A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium (co-authored with Xavier Gabaix and Augustin Landier, both of NYU Stern), which was recently accepted for publication in the Review of Financial Studies, we contribute to the growing debate on whether executive compensation results from rent extraction or optimal contracting. We construct a model of what the level of incentives should be, and how they should vary with firm size, if pay is set optimally. In our model, CEO effort has a multiplicative effect on firm value. This is realistic for the vast majority of CEO actions, which can be “rolled out” across the entire firm and thus have a greater effect in a larger company. We also assume that the cost of effort to the CEO is proportional to the CEO’s wage. Richer CEOs are willing to spend more to consume leisure time, which is consistent with their greater expenditure on most goods and services.

There are two pieces of evidence (both from Jensen and Murphy (1990)) that are often used to support claims of inefficiency: (1) CEOs only lose $3.25 for every $1,000 loss in firm value, an effective equity share of only 0.325%, and (2) This effective equity share is strongly declining in firm size, i.e. incentives are particularly low in large firms. To evaluate whether these facts indeed reflect inefficiency, we calibrate the model and find that the above two facts are in fact quantitatively consistent with our optimal contracting benchmark, contrary to some earlier interpretations.

On point (1), since effort has a percentage effect on both firm value and CEO utility, the optimal contract prescribes the required percentage change in pay for a one percentage point increase in firm returns (“percent-percent” incentives) – not the dollar loss in CEO pay for a dollar loss in firm value (“dollar-dollar” incentives) which is often measured. In turn, dollar-dollar incentives equal percent-percent incentives multiplied by the CEO wage and divided by firm value. Since firm value is substantially greater than the CEO’s salary, high percent-percent incentives equal low dollar-dollar incentives, exactly as found by Jensen and Murphy.

On point (2), with a multiplicative effect on firm value, the dollar benefit from effort is proportional to firm size, i.e. has a size-elasticity of 1. With a multiplicative effect on CEO utility, the dollar cost of effort is proportional to the CEO’s wage. However, wages have an elasticity of only 1/3 with size. Therefore, dollar-dollar incentives should optimally decline with firm size with an elasticity of 1/3 – 1 = -2/3. This prediction matches the data very closely - we find an elasticity of -0.61. Simply put, since effort has such a large dollar effect in large firms, the CEO will work even if he has a small effective equity share.

The multiplicative production function does not apply to all CEO decisions. Perk consumption reduces firm value by a fixed dollar amount independent of size. We show that stock compensation is ineffective at deterring additive actions such as perks. This is because perks have a tiny effect on the stock returns of a large company – a $10m corporate jet only reduces the return of a $10b firm by 0.1%. The ineffectiveness of contracts gives rise to a role for active corporate governance, e.g. direct monitoring by boards to scrutinize such perks. Similarly, while our model is able to reconcile (1) and (2) with optimal contracting, there are many other features of observed contracts (e.g. golden parachutes, hidden compensation) about which our model is silent and which may indeed result from rent extraction.

The model also proposes a new measure of CEO incentives. We advocate “percent-percent” incentives as the optimal measure as they are independent of firm size (unlike “dollar-dollar” incentives) and thus comparable across different firms. Translated into real variables, this measure equals the dollar change in wealth for a one percentage point change in firm value, divided by annual pay. This data is available at http://finance.wharton.upenn.edu/~aedmans/data.html. The full paper is available for download here.

This post is by my partners Barry A. Bryer, David M. Schwartzbaum, Mark D. Gerstein, Steven B. Stokdyk, Paul H. Dawes, and William P. O’Neill.

The market’s recent collapse leaves many public companies and their longterm investors highly vulnerable:

• Depressed share values create all kinds of opportunities for those with available cash or a strong equity currency. The substantial loss of market capitalization across all sectors presents buying or consolidation opportunities for financial and strategic acquirors, and creates a real risk that many companies could be approached with transactions, either for cash or stock consideration or both, that do not reflect the inherent long-term value of the company.

• Poor stock performance gives substantial credence to activists pushing Boards to complete business combinations “arranged” by the activists, to sell divisions for less than inherent long-term value, or for Board representation disproportionate to their holdings.

• Although the older-vintage hedge funds are distracted by redemption and other concerns, the newcomers are as aggressive as their predecessors and are likely to be active this year.

In this environment, directors should undertake a thorough review and assessment of their company’s charter, by-laws, compensation program, and director and officer insurance coverage. A carefully crafted survey of options and available defense tools, including poison pills, carefully reviewed and understood by the Board with the assistance of legal and financial advisors prior to receipt of any unsolicited offers, will be easier to defend and should provide the Board with greater flexibility if defensive steps are later needed in response to hostile action.

…continue reading: Takeover Risks in Troubled Times

This post is by my partners Richard Levin and Paul H. Zumbro.

The United States Bankruptcy Court for the District of Delaware, in a decision announced January 9, 2009, denied a creditor’s request for permission to effect a triangular setoff, that is a setoff of the creditor’s claim against one debtor against amounts the creditor owed to another debtor affiliate of the debtor (In re SemCrude, L.P., Case No. 08-11525, Docket No. 2754, Jan. 9, 2009). The decision, if widely followed, could substantially increase a company’s credit exposure if the company has multiple contracts with another corporate group’s affiliates and has relied on a provision in the contracts allowing the company to offset amounts owing to one affiliate against claims against another affiliate and if the other group’s affiliates later file bankruptcy. The bankruptcy court ruled that allowing such a setoff would be inconsistent with the Bankruptcy Code’s express setoff provision and with fairness to all creditors.

Background
Chevron USA, Inc. had entered into numerous contracts for the purchase or sale of various petroleum products with three counterparties, SemCrude L.P., SemFuel L.P. and SemStream, L.P., each of which is a direct or indirect subsidiary of SemGroup, L.P. and each of which later filed bankruptcy. Bilateral master agreements governed the contracts. Each of the master agreements contained a broad version of a common cross-affiliate setoff provision:

…continue reading: Delaware Bankruptcy Court Disallows Triangular Setoff

(Editor’s Note: This post comes from David Yermack of NYU Stern.)

In my paper Deductio Ad Absurdum: CEOs Donating Their Own Stock to Their Own Family Foundations, which was recently accepted for publication in the Journal of Financial Economics, I explore whether executives exploit the insider trading gift loophole to make well-timed charitable donations of stock in advance of price declines, a strategy that would allow the donors to use their access to inside information to obtain personal income tax benefits. Unlike open market sales, gifts of stock are generally not constrained by U.S. insider trading law, and company officers can often donate shares of stock to charities at times when selling the same shares would be prohibited.

I focus upon Chairmen and CEOs of U.S. public companies that establish private family foundations and then make large contributions to these foundations out of their personal holdings of company shares. Because these donors generally control the entities on either side of these transactions, while also having private information about the future prospects of their companies, one might expect well-timed donations to private family foundations to be relatively easy to accomplish and document. My sample consists of 150 large gifts made by 89 different executives between mid-2003, when the SEC established electronic filing requirements for stock transfers, and the end of 2005.

Consistent with their exemption from insider trading law, I find a pattern of excellent timing of Chairmen and CEOs’ large stock gifts to their own family foundations. On average these gifts occur at peaks in company stock prices, following run-ups and just before significant price drops. A variety of tests give some support for the hypothesis that CEOs time their gifts based on inside information. For instance, a few CEOs make gifts of stock just before adverse quarterly earnings announcements, a time at which company “blackout” periods would almost always prohibit open market sales. Other CEOs delay stock gifts until just after positive quarterly earnings announcements. In addition, tests used to infer the backdating of executive stock option awards yield results consistent with the backdating of CEOs’ family foundation stock gifts. For instance, I find that the apparent timing of certain subsamples of family foundation stock gifts improves as a function of the elapsed time between the purported gift date and the date on which the required stock gift disclosure is filed by the donor with the SEC. Stock gift backdating, if followed by the filing of a personal tax return claiming a charitable gift deduction, would likely represent tax fraud in violation of IRS rules.

Overall, these results suggest an odd juxtaposition of motives on the part of corporate executives who donate stock. While nominally transferring part of their fortunes to charitable foundations for civic purposes, many appear simultaneously to exploit gaps in the regulation of insider trading or even to backdate their donations to increase the value of personal income tax benefits. Data in the paper also cast a long shadow upon the increasingly popular role of private family foundations as conduits for charitable contributions by the wealthy.

The full paper is available for download here.

In Embattled CEOs, Edward Rock and I argue that chief executive officers of publicly-held corporations in the United States are losing power to their boards of directors and to their shareholders. This loss of power is recent (say, since 2000) and gradual, but nevertheless represents a significant move away from the imperial CEO who was surrounded by a hand-picked board and lethargic shareholders.

The decline in CEO power has multiple, and interacting, causes and symptoms. On the dimension of shareholder composition and activism, reduced CEO power is related to the their continuing increase in the stock ownerships by institutional investors, especially mutual funds, and the concomitant decline in stock ownership by individuals; the recent rise of hedge funds, the most activists type of institutional investors; the increased level of activism by mutual funds; and the role of proxy advisory firms in targeting portfolio companies for and coordinating activism. On the dimension of governance rules, several developments may represent both symptoms of reduced CEO power and contribute to further declines in CEO power. These include the virtual demise of staggered boards among the largest US companies (and the less significant, but still pronounced decline, in staggered boards among smaller ones); the meteoric rise of majority voting for directors; and the increased number of shareholder proposals that receive majority support and, more importantly, that are implemented by the board. On the regulatory front, important recent developments include the NYSE proposal to end discretionary broker voting in director elections; the new rules governing the electronic delivery of proxy materials which reduce solicitation costs for both companies and dissidents; and the governance reforms adopted n the wake of Sarbanes-Oxley which, among others, require that companies create select committees exclusively composed of independent directors. On the board level, the loss of CEO power is related to the fact that directors who have long been nominally independent (i.e. have no business ties to the company) now act more substantively independent (i.e., defer less to the inside directors). This is reflected in the increased board time devoted to monitoring the CEO (and the increased overall time demands placed on outside directors); regular meetings of outside directors only in executive session and occasional ones with shareholders and independent consultants; the increased number of companies that have formal processes for evaluation CEOs, lead outside directors, or that split the CEO and Chairman position; and the increased level of CEO turnover, both overall and especially performance-related.

All of these changes have contributed to a decline in CEO power in several way. CEOs have less control over important strategic decisions, such a whether to sell the company. They have less control over setting the agenda presented to the board and to shareholders. They have less control over audit, compensation, director selection, and other governance matters. And even on the operational level, where CEOs retain significant over initial decisions, the CEO is more likely to be held accountable, and likely to be held accountable sooner, over operational decisions than in the past.

We believe that the shift in CEO power to outside directors and institutional shareholders represent in fundamental trend that will continue at least over the medium term. While we do not exclude the possibility of a regulatory backlash – analogous to the passage in anti-takeover laws and the sanctioning of the poison pill is response to the hostile takeover movement in the 1980s – we believe that such backlash is unlikely. As a result of this shift, outside directors will be increasingly composed of retired high-level executives or professionals, such as former CEOs or former partners in accounting firms; that “flavor of the year” shareholder resolutions will become harder to ignore; and that the locus of resistance to having the company be acquired will shift from inside managers to outside directors and shareholders. At the same time, we believe the change in this change in the governance regime represent a convergence of the U.S. to other Anglo-American countries (in which CEOs have long held a weaker role) and that it calls into question the case for legal change that further increases shareholders’ voting right.

The article is available here.

(Editor’s Note: This post comes from Rachel Hayes and Scott Schaefer at the University of Utah.)

In our paper, CEO Pay and the Lake Wobegon Effect, which was recently accepted for publication in the Journal of Financial Economics, we analyze a common explanation for the recent increase in CEO pay at US firms. Our model, which is based on asymmetric information in financial markets, is motivated by an observation made by former DuPont CEO Edward S. Woolard, Jr. speaking at a Harvard Business School roundtable on CEO pay: “The main reason (CEO) compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases, I get one too, even if I had a bad year…. (This leads to an) upward spiral”

We present a game-theoretic model of this phenomenon, which is known in the business press as the Lake Wobegon Effect. We study a firm and a manager who privately observe a parameter that affects the productivity of their match. Stock market participants cannot observe this parameter, but attempt to infer it from observing the manager’s wage. The firm maximizes a weighted sum of short-run and terminal firm value, and so may wish to distort the publicly observable wage contract in order to affect the market’s beliefs regarding firm value. Our model has three key features, all of which have been noted as important assumptions of the Lake Wobegon Effect: (i) there is asymmetric information regarding the manager’s ability to create value at the firm; (ii) the pay package given to the manager must convey information about the manager’s ability to create value at the firm; and, (iii) the firm must have some preference for favorably affecting outsiders’ perceptions of firm value.

We present three main results. First, we show the Lake Wobegon Effect can occur. That is, there are instances of our model in which the full-information benchmark is not an equilibrium, and firms distort pay upward to affect market perceptions of firm value.

Second, we characterize the settings in which the Lake Wobegon Effect does occur. We show that our three key assumptions — asymmetric information, managerial rents, and corporate myopia — are not sufficient to guarantee upward distortions in pay. In the basic version of our model, two additional conditions are necessary: (1) the marginal effect of increases in managerial ability on match surplus — defined as the difference between the parties’ output when working together and when pursuing their outside options — is positive, and (2) the weight placed by the firm on short-run share prices is greater than the fraction of the match surplus that is captured by the manager.

Third, we find that the temptation to distort pay upward is stronger when the information asymmetry pertains to characteristics of the firm rather than characteristics of the manager. When the manager’s ability is uncertain, increases in the manager’s pay do boost the market’s assessment of managerial ability; however, the manager — not the firm — captures rents associated with increases in managerial ability. Thus, the marginal increase in firm value associated with a dollar increase in managerial pay is low when the uncertainty pertains to a characteristic of the manager.

Our analysis suggests that greater shareholder involvement in the pay process — so-called “say on pay” — might be counterproductive. A potential solution to the problem of shareholder myopia is to delegate decisions to individuals with a longer-term view. That is, if shareholders care only about short-run share prices then they may be tempted to raise CEO pay in a (futile, in equilibrium) attempt to affect short-term market valuations. If instead, shareholders delegate pay decisions to directors and motivate those directors (using contracts) to take a longer-term view, then pay decisions can be insulated from myopia.

The full paper is available for download here.

I have just posted on SSRN a revised version of a paper that focuses on firms that exit the mandatory disclosure system even though their shares remain publicly traded and may be held by thousands of investors, Firms Gone Dark. It will be published shortly in the University of Chicago Law Review.

The paper begins by explaining how firms go dark. The securities laws currently permit a firm to exit the mandatory disclosure system if certain conditions are met, one of which is that the firm not have any class of securities outstanding with three hundred or more “holders of record.” This “record holder” test would appear to prevent any firm with three hundred or more shareholders from exiting mandatory disclosure. However, the test currently does not define a “holder of record” as the real (or “beneficial”) owner of the firm’s stock, but rather as the party “identified as the owner” of the security on the firm’s records. Most shares in publicly traded firms are held by nominees, such as banks and brokerage houses, not by the beneficial owners themselves. Each nominee, in turn, holds its shares on behalf of dozens, hundreds, or even thousands of institutional and individual investors. Thus, a reporting company can easily have fewer than three hundred “holders of record” and thus be eligible to exit mandatory disclosure even though the company may have thousands of beneficial shareholders. Hundreds of publicly traded firms have taken advantage of this rule to exit mandatory disclosure in recent years. Such exiting firms are said to “go dark” because they subsequently provide little information to public investors. The paper also describes the characteristics of firms that go dark and the stock market’s sharply negative reaction to going-dark announcements.

I then examine the disclosure practices of firms that have gone dark and explore their implications for the longstanding debate in securities regulation over whether mandatory disclosure is needed. Critics of mandatory disclosure argue that insiders can be counted on voluntarily to provide the “firm-optimal” level of disclosure—that which maximizes the joint wealth of insiders and public investors. Defenders of mandatory disclosure disagree, arguing that insiders often have an incentive to provide less than the firm-optimal level of disclosure. The disclosure practices of gone-dark firms, I show, cast doubt on the claim of mandatory disclosure’s critics. Only a small fraction of firms that go dark provide any financial information publicly to their hundreds or thousands of public investors. I explain why it is highly unlikely that, for the vast majority of these gone-dark firms, the firm-optimal level of disclosure is zero. The fact that stock prices drop substantially when firms announce they will exit mandatory disclosure provides further reason to be skeptical that post-exit disclosure levels are generally firm-optimal.

The paper concludes by addressing the question of how exits from mandatory disclosure should be regulated. It begins by explaining that when insiders can unilaterally decide to exit mandatory disclosure, they may have an incentive to exit even when such exit reduces firm value. The SEC is currently considering a proposal to prohibit firms with three hundred or more beneficial shareholders from exiting mandatory disclosure. Adoption of this proposal, I show, would decrease value-reducing exits but not eliminate them. I then put forward a new approach to regulating exits from mandatory disclosure: requiring public investor approval before insiders can turn off the lights. Such an approach would prevent a firm from exiting mandatory disclosure as a publicly traded company unless such exit increases firm value.

The current draft of the paper is available here.

As I am continuing to work on projects related to firms’ choice of disclosure arrangements, any comments would be most welcome.

(Editor’s Note: This post comes from Stuart L. Gillan of Texas Tech University, and Jay C. Hartzell and Robert Parrino of The University of Texas at Austin.)

In Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements, which was recently accepted for publication in the Journal of Finance, we report evidence on the determinants of whether the relationship between a firm and its CEO is contractually defined in an explicit agreement. Our sample consists of the 494 U.S.-based firms in the S&P 500 on January 1, 2000 and their CEOs as of that date. We construct the sample by combining a set of explicit CEO EAs provided to us by The Corporate Library with agreements identified by searching the SEC filings of all remaining S&P 500 firms for any mention of an explicit EA. We define explicit EAs to include only comprehensive written agreements that specify the relationship between a firm and its CEO. We find that fewer than half of the CEOs of S&P 500 firms have comprehensive explicit employment agreements.

We find that comprehensive explicit EAs are used more frequently at firms operating in more uncertain business environments and at firms that are likely to face lower costs from altering the agreement with the CEO. This is consistent with the idea that firms facing greater uncertainty are more likely to encounter situations in which the benefits from altering an EA outweigh the costs. CEOs that have been hired from another firm (outside CEOs) are also more likely to have explicit EAs. These CEOs tend to face greater uncertainty about the sustainability of their relationships with their firms than CEOs who have been promoted from within. We find strong evidence that CEOs who can expect to earn greater abnormal compensation at their firms, both in the near future and over the estimated remainder of their career, are more likely to have an explicit EA. In addition, CEOs who receive a larger fraction of their pay as incentive-based compensation, which tends to be at greater risk if their employment agreement is altered, are more likely to have an explicit EA. Lastly, we find that the factors that explain the presence of an explicit EA also explain contract duration.

On balance, the evidence supports theoretical literature on the choice between explicit and implicit agreements and is consistent with optimal contracting.

The full paper is available for download here.

In a recent novel decision in one of the mutual fund market timing cases brought by the SEC (SEC v. Tambone, ___ F.3d ___ (1st Cir. 2008), available at 2008 U.S. App. LEXIS 24457), the First Circuit held that the SEC had adequately alleged a primary violation of Section 10(b) and Rule 10b-5(b) for material misstatements “impliedly” made by the defendants. A sharply worded dissent criticized the Court’s holding for enlarging the scope of primary liability and blurring the line between primary and secondary liability that the Supreme Court recently drew in Stoneridge. Even though its impact remains to be seen, the First Circuit opinion has potentially significant implications for the scope of liability of defendants in both SEC enforcement actions and private civil securities litigation.

In an article entitled “A Wider Scope of Primary Liability?,” Mark Schonfeld and Akita St. Clair address the implications of the SEC v. Tambone decision. This article recently appeared in Law360.

The article is available here.

Lawdragon Magazine recently released its fourth annual list of the “500 Leading Lawyers in America.” Available here, the list includes 16 individuals who are affiliated with this Blog or its sponsor, the Harvard Law School Program on Corporate Governance.

The Lawdragon 500 includes private attorneys from a wide range of practices, in-house counsel, law professors, judges, government attorneys, and public interest lawyers. Conducted by legal journalists, the selection is based on a combination of on-line balloting and independent research.

The Lawdragon 500 list includes professor Lucian Bebchuk, who serves as director of the Program, and Leo Strine, Delaware Vice Chancellor and senior fellow at the Program.

The following five members of the Program’s advisory board were similarly honored: Peter Atkins (Skadden, Arps, Slate, Meagher & Flom), John Finley (Simpson Thacher & Bartlett LLP), Theodore Mirvis (Wachtell, Lipton, Rosen & Katz), James Morphy (Sullivan & Cromwell), and Paul Rowe (Wachtell, Lipton, Rosen & Katz).

In addition, the following guest contributors to this Blog were also selected:
• George R. Bason (Davis Polk & Wardwell);
• Richard Climan (Cooley Godward Kronish);
• Jay Eisenhofer (Grant & Eisenhofer);
• Adam Emmerich (Wachtell, Lipton, Rosen & Katz);
• Robert Giuffra (Sullivan & Cromwell LLP);
• Edward Herlihy (Wachtell, Lipton, Rosen & Katz);
• David Katz (Wachtell, Lipton, Rosen & Katz);
• Martin Lipton (Wachtell, Lipton, Rosen & Katz); and
• Charles Nathan (Latham & Watkins).

Lawdragon’s announcement appears here. A post on this Blog featuring last year’s Lawdragton 500 is available here. The Blog and the Program had eight individuals represented then, including Lucian Bebchuk, Leo Strine, Peter Atkins, Ted Mirvis, James Morphy, Jay Eisenhofer, and Charles Nathan.

Back in September, the Delaware Supreme Court accepted the defendants’ interlocutory appeal and stayed the lower court proceedings in Ryan v. Lyondell Chemical Company. Typically, the Delaware Supreme Court and the Court of Chancery work in close harmony, so the Supreme Court’s decision was unusual since the appeal had been denied by Vice Chancellor Noble.

The appeal centers on Vice Chancellor Noble’s decision to deny the defendant-directors’ motion for summary judgment on allegations that they breached their fiduciary duties in approving a cash-out merger with a strategic buyer. Charles Nathan posted on the background and analysis of the decision here. The decision generated swift criticism, with most commentary characterizing it as improperly second-guessing a disinterested board’s decision to approve an all-cash premium offer, and as lowering the bar for stockholder-plaintiffs to allege bad faith in change-of-control transactions.

Travis Laster and I recently addressed this criticism in an article entitled “Reactions and Overreactions to Ryan v. Lyondell Chemical Co.” We argued that many commentators have overreacted to the Lyondell decision. To be sure, the Court of Chancery’s opinion can be criticized on several grounds, but its outcome was driven primarily by its procedural posture and does not dictate any meaningful change in established deal practice.

…continue reading: Overreactions to Ryan v. Lyondell Chemical Company

(Editor’s Note: This post comes from Gennaro Bernile at the University of Miami and Gregg Jarrell at the University of Rochester.)

In our paper “The Impact of the Options Backdating Scandal on Shareholders” which was recently accepted for publication in the Journal of Accounting and Economics, we analyze the excess returns that occurred in short windows surrounding ten distinct news events related to backdating of stock option grants.

Our analysis focuses on 129 firms identified by the Wall Street Journal as implicated in the backdating scandal as of December 31, 2006. We independently identify 764 firm specific backdating-related news events taking place on 580 separate firm-dates. For the first news event (typically the announcement of an internal investigation by the firm), we find a statistically significant excess return of about -4.50% in the -20 to -2 window and -2.40% in the -1 to +1 window. The magnitude of the implied wealth changes seems too large to be attributed to any reasonable estimate of direct out-of-pocket costs of the backdating scandal or to the resulting legal penalties disclosed to date (direct cost hypothesis). Therefore, the alternative hypothesis we propose, which we broadly label Agency Hypothesis, is that a firm’s involvement in the backdating scandal has significant economic implications, despite its limited (direct) impact on cash flows. Under this hypothesis, the losses generated by the option backdating scandal can arise because management’s involvement in backdating practices may prompt investors to reassess the agency costs stemming from the separation of ownership and control.

A series of multivariate show that measures we expect to be related to the effect of the scandal on the value of firms’ reputational capital and information risk are significantly related to changes in shareholders’ wealth. Conversely, variables one would expect to be related to the magnitude of direct out-of-pocket expenses, namely the number of past grants and/or their value, are not significantly related or are positively related to shareholders’ wealth effects, inconsistent with the direct cost hypothesis. In addition, consistent with this interpretation, the occurrence of government investigations or delisting notices have no incremental explanatory power, after controlling for firms’ likely culpability. We find that the losses are attenuated when tainted management of less successful firms is more likely to be replaced. We also find that institutional investors reduce their holdings in firms accused of backdating, possibly due to higher monitoring costs, and that firms involved in the scandal are very likely (10% of the sample) to receive arguably fair takeover offers.

Overall, the evidence is consistent with the hypothesis that the loss of investors’ confidence in the firm’s management is a first-order determinant of the economic consequences resulting from the option backdating scandal.

The full paper is available for download here.

(Editor’s Note: This article by Ben Heineman and Al Larson was also posted on Bloomberg.com. Mr. Heineman is the former Senior Vice President for Law and Public Affairs at General Electric.)

The bribery scandal involving Siemens AG, Europe’s largest engineering company, is the latest evidence that corruption of public officials remains a pernicious problem as globalization intensifies. Accepting or extorting bribes and misappropriating public funds erodes judicial institutions and the rule of law, distorts competition and injures the poor.

Anti-corruption rhetoric exceeds commitment and accomplishment, especially in emerging-market nations. Building durable, transparent and accountable institutions in the highly diverse developing world — with failed, failing, fragile and rising states — is key, though complex and time-consuming.

One part of the solution can be tackled immediately: vigorous enforcement of the 1997 OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. The goal of the effort — part of Paris-based Organization for Economic Co-Operation and Development – is to stop, or significantly minimize, bribes made by multinational corporations headquartered in industrialized nations.

The need for such action was underscored last month, when Siemens agreed to pay a record $1.3 billion to U.S. and German authorities for accounting and conspiracy offences, resulting from probes that the Munich-based company allegedly paid more than $1.4 billion in bribes around the world.

‘Unprecedented’ Misconduct
This followed resignations by Siemens’s board chairman and chief executive; the payment of more than $300 million in other penalties; restatements of more than $500 million for expenses subsequently disallowed as improper payments; and outlays of more than $850 million for lawyers and forensic accountants used in the company’s internal inquiry.

U.S. authorities said Siemens’s improper payments were “unprecedented in scale and geographic reach” as well as “systematic” and “standard operating procedures.” If bribery was so pervasive, involving employees at all levels, in such an iconic multinational company, then similar behavior almost certainly exists within major exporters elsewhere in Germany and in other industrialized nations.

Currently, 37 nations belonging to the OECD have ratified the anti-bribery convention and have enacted laws such as the U.S. Foreign Corrupt Practices Act (FCPA), prohibiting foreign bribery by U.S.-based transnational companies. These nations account for more than two-thirds of world exports.

Unfortunately, efforts to implement the convention at the national level have been inadequate. (The OECD itself has no enforcement powers; it can only monitor national efforts through its highly professional Working Group on Bribery.)

…continue reading: Bribery Warrants Global War

Last year, I replied to Professor J. Robert Brown’s list of the top 5 Delaware cases that, in his view, supported his negative perspective of Delaware law that remains the constant refrain on his blog called: The Race to the Bottom.

My introductory explanation from my rebuttal of last year was as follows:

… I realize that there are many more qualified experts who can rebut the professor’s arguments far more persuasively than I, and I am well aware that the Delaware bench certainly does not need my help to defend it. Nor have I been anointed by anyone to take on this role. Nonetheless, having just completed a review of key 2007 Delaware corporate decisions, I offer my own humble rebuttal and a “counter-list” of 5 cases in 2007 that demonstrate that the Delaware courts take shareholder rights and the duties of directors very seriously. If any readers can think of a better “top 5″ list, than the one I compiled below, I welcome comments. Here is my top 5 “rebuttal list”:

Well, I just finished my 4th annual overview of selected Delaware corporate and commercial cases for 2008, which will be published soon in The Delaware Law Weekly, at which time I will also post it on these pages. I also just saw Professor’s Brown list of 5 cases from 2008 that he uses to support his unabashedly unflattering views of Delaware law. Here is his list and here is his introductory post.

My cursory review of the cases I selected below (from the approximately 200 or so that I have summarized on my own blog during 2008), is not as scholarly as the good professor’s treatment, and I do not have the time (thankfully, due to my busy practice) to engage in extended debate (at least for the next week or so), but until someone else picks up the baton, I offer the following cases to counterbalance the list offered by Professor Brown. I invite others to suggest other cases that they would rather see in my “top 5 list”.

• In Cargill, Inc. v. JWH Special Circumstance, LLC, (Del. Ch., Nov. 7, 2008), read opinion here, the Delaware Chancery Court issued a 68-page decision involving a Delaware statutory trust (formerly referred to as a business trust), and found that common law fiduciary duties would apply to a trustee as a “default rule” in light of the agreement among the parties being silent on the issue. Here is a more complete summary.

• In Julian v. Eastern States Construction Service, Inc., 2008 WL 2673300 (Del. Ch., July 8, 2008), read opinion here, the Chancery Court required directors to disgorge a $1.3 million bonus they had given themselves in a self-interested manner, without any independent protections, and based on their failure to satisfy their burden to demonstrate the entire fairness of their decision. Here is a more complete summary.

• In Ryan v. Lyondell Chemical Company, (Del. Ch., July 29, 2008), read opinion here, the Delaware Chancery Court found that at the procedural stage of a summary judgment motion, it would allow to proceed to trial the issue of whether the independent directors should be exposed to personal liability for their role in the sale of the company–despite selling the company to the only known buyer for a substantial premium. A whole article could be written on this case alone, and substantial commentary has already been penned about it. An equally weighty later decision denying a motion for reargument was summarized here. The case is now on appeal with the Delaware Supreme Court.

• In Steel Partners II, L.P. v. Point Blank Solutions, Inc., 2008 WL 3522431 (Aug. 12, 2008), the initial complaint was filed to force the holding of a shareholders meeting (which had not taken place since 2005), pursuant to DGCL Section 211. After a stipulation was entered into for a date to hold the meeting, the defendant moved for leave of court to postpone the date of the meeting by 90 days. The Chancery Court denied the request. The request was based on allegations that the plaintiff and its CEO together own about 40% of the stock and would attempt to install their own directors and then seek to buy the company at the lowest possible price for its own investors. In addition, the postponement was requested due to an alleged conflict that the plaintiff’s CEO had with the majority. The court reasoned that the best way to deal with the issues presented was to communicate them to the shareholders and let them decide, based on those facts, who they wanted as directors–instead of further delaying the exercise of the shareholder franchise, which under Delaware law is sacrosanct. The summary of the case on my blog is here.

• London v. Tyrrell, 2008 WL 2505435 (Del. Ch., June 24, 2008), read opinion here. This Chancery Court decision explained in detail the reasons why it denied a motion to dismiss a derivative claim based on Chancery Court Rules 9(b), 12(b)(6) and 23.1. The derivative complaint alleged that the defendants caused the company to issue stock options in contravention of an equity incentive plan by setting the exercise price of the issued options at an unfairly low value.After a thorough factual background description, the court emphasized that: “the burden remains on the movant to demonstrate that the plaintiff has not met the requirements of Rules 9(b), 12(b)(6) and 23.1.” (see footnote 12). Moreover, the court described in detail the demand futility analysis under the seminal case of Aronson v. Lewis, 473 A.2d 805 (Del. 1984) as well as Rales v. Blasband, 634 A.2d 927 (Del. 1993). The court explained the reasons why it concluded, as succinctly as I have seen it done, that both prongs of the Aronson case were satisfied. Specifically, the plaintiff demonstrated a reasonable doubt that: (1) the directors were interested and independent; or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.

The first prong was satisfied because the directors had a financial interest in the challenged stock option plan and also because they stood on both sides of the transaction that was challenged. Moreover, the second prong was satisfied because the allegations rebutted the business judgment rule to the extent that the allegations supported an inference that the directors intended to violate the terms of a stockholder approved option plan. The court also dismissed the arguments under Rule 9(b) that there was insufficient particularity regarding fraud allegations which apparently relied on Sections 152 and 157(b) of the DGCL.

(Editor’s Note: This post comes from Sudheer Chava of Texas A&M University, Dmitry Livdan of UC Berkeley and Amiyatosh Purnanandam at the University of Michigan.)

In our paper Do Shareholder Rights Affect the Cost of Bank Loans? which was recently accepted for publication in the Review of Financial Studies, we analyze the relationship between firm-level corporate governance measured by the governance index of Gompers, Ishii, and Metrick (2003, henceforth GIM) and the cost of bank loans issued to publicly traded firms.

We use a panel data set of over 6000 loans issued to a wide cross-section of US firms between 1990 and 2004 as the basis for our analysis. Our basic result shows that firms that are more vulnerable to takeovers (i.e., firms with higher shareholder rights) are charged significantly higher loan spreads. To quantify this result, we follow GIM and construct corner portfolios of firms with the highest (democracy) and the lowest levels (dictatorship) of shareholder rights. We show that for a typical firm in our sample a switch from the democracy to the dictatorship portfolio decreases the expected loan spread by almost 25% (30 basis points) after controlling for the default risk as well as various firm-level factors and specific features of loan contracts.

In interaction regressions, we find that democracies with low leverage are charged significantly higher loan spreads. This provides evidence that the possibility of an increase in financial risk is an important consideration through which takeover vulnerability gets priced in bank loans. Additionally we find that conditional on high takeover vulnerability, long maturity loans have higher spreads than loans with short maturities. Loans with longer maturity expose banks to takeover risk for a longer time-period and our results indicate that banks charge a premium for taking such risks.

Though our focus remains on debt pricing, bank loan covenants and collateral can also mitigate a bank’s concern about potential losses in takeover. Consistent with this argument, we find that banks charge higher loan spread to those high takeover vulnerability borrowers that have fewer covenants or those who obtain unsecured loans. To investigate whether banks can also protect their interests by having bargaining power over their borrowers, we analyze the effect of syndicate size on the pricing effect of takeover vulnerability. We find that the effect of takeover vulnerability is significantly higher for loans with smaller syndicate size i.e., when the bargaining power is likely to be high. Thus, the bargaining power channel is less likely to explain away our results.

Our results have important implications for understanding the link between a firm’s governance structure and its cost of capital. Our study suggests that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans. The full paper is available for download here.

This post is by my colleagues Michael Kaplan, Richard J. Sandler, Richard D. Truesdell, Jr., and Janice Brunner.

In the last several years, there have been a number of situations where issuers have failed to file reports with the SEC on a timely basis and bondholders alleged that such failure violated certain provisions of the Trust Indenture Act (“TIA”), that are incorporated into all public debt indentures. In the first case that was litigated on such matters, Bank of New York v. Bearingpoint, Inc. (“BearingPoint”), 13 Misc.3d 1209(A), 824 N.Y.S.2d 752 (Sup. Ct. N.Y.County 2006), a New York state court held that the TIA required timely filing of SEC reports. Since then, a number of federal courts have disagreed and held that the TIA does not impose an independent obligation to make timely filings of SEC reports. Yesterday, the U.S. Court of Appeals for the Eighth Circuit filed an opinion, in United Health Group Inc. v. Wilmington Trust Co., affirming a district court decision that an issuer’s delinquency in filing its Exchange Act reports with the SEC was not a breach of its indenture reporting covenant or Section 314(a) of the TIA. The Eighth Circuit is the first appellate level court that has addressed this question, and this case is therefore an important contribution to a growing body of case law that rejects the BearingPoint court’s interpretation of reporting covenants and Section 314(a) of the TIA.

The BearingPoint Case
Many indentures contain some form of standard language that generally provides that the company shall file with the trustee, within a certain number of days after it files such information with the SEC, copies of the reports which it is required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act. Many indentures also expressly require compliance with Section 314(a) of the TIA.

…continue reading: Court Rules on Alleged Breach of Indenture Reporting Covenant

In the chapter The Story of Paramount Communications v. QVC Network: Everything Is Personal, which is forthcoming in the book Corporate Stories (J. Mark Ramseyer ed., Foundation Press, 2009), I tell the story of the famous contest between Viacom and QVC over the acquisition of Paramount.

The battle over Paramount lends support to the view that non-pecuniary motivations can sometimes explain battles for corporate control and management behavior better than pecuniary motivations. The selection process that brings executives to top management positions and their wide discretion to shape company strategy once in office leaves ample room for ambition, pride, envy, or animosity to filter into their decisions. It is hard to prove the existence of these drivers, let alone measure them, but they are very real in the minds of market professionals. In the jargon of corporate lawyers and investment bankers, who must consider these factors in any deal negotiation, there is even a special term for them: “social issues”. The three-way fight between Paramount, Viacom, and QVC is a textbook example of social issues at work. All of the key players in the story seemed to have had them: Sumner Redstone, Viacom’s chairman, was willing to pay almost any price to own a film studio; Barry Diller, QVC’s chief executive, was willing to go to great lengths to get back at Martin Davis, Paramount’s chief executive, for pushing him out of Paramount; and Martin Davis was willing to leave a lot of money on the table and cede control of his empire to stop Barry Diller. This is also consistent with claims that control is especially valuable to corporate decision-makers in the media sector, presumably because it comes with access to non-pecuniary benefits such as visibility, influence, and glamour.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo by partners at Cravath, Swaine & Moore LLP.)

The outlook for proxy season 2009
This proxy season will be significantly affected by the credit crisis and the ensuing global economic turmoil. Investors and politicians have joined in an outcry over a perception of excessive executive pay, reckless risk-taking by management and inadequate board oversight at some companies. Prosecutors have launched investigations at numerous financial institutions, perceived abuses have been widely reported in the media, and Congress is seeking to reform compensation practices and give shareholders the right to vote on executive compensation.

Management and boards will be well-served at this time to reassess their compensation and governance policies and practices, as well as how they communicate with their investors. A strategic and well-analyzed response by a company and its board to these unprecedented conditions will be crucial to managing this challenging proxy season successfully.

Prepare for investor and regulatory scrutiny of executive compensation
Compensation practices undoubtedly will be an area of sharp focus this proxy season. The number and variety of shareholder proposals addressing compensation practices and policies is increasing. In particular, we are seeing an increase in proposals related to “say on pay,” “pay for performance,” “clawback” of executive pay in the event of a financial restatement and elimination of a variety of “poor pay practices” (e.g., tax gross-ups on executive perks or excise payments triggered by golden parachute payments and payment of dividend equivalents on unearned performance awards). Variations of each of these proposals have been endorsed by proxy advisor RiskMetrics (formerly ISS), an influential source of voting advice for institutional investors. RiskMetrics has also aligned its position on compensation policies and proposals for all public companies with the standards set for institutions selling equity to the federal government under the Emergency Economic Stabilization Act (“EESA”). The EESA requires, among other things, that financial institutions receiving assistance under it agree to stringent limitations on executive compensation.

…continue reading: Proxy Season 2009

(Editor’s Note: The following post by Ben W. Heineman Jr. was published on Wednesday in the online edition of Business Week.)

Reining in excessive management compensation will be high on the “to-do” list of the 111th Congress.

The rocket fuel that sent the financial sector soaring into the stratosphere (where it ultimately exploded) was excessive executive compensation, which rewarded the churning of paper and risk-taking rather than the creation of sustained economic value and risk management.

The day of regulatory reckoning on the causes of the financial meltdown will soon be upon us, even as governments struggle with the severe effects and the world waits for a “mega-stimulus” proposal from President-elect Barack Obama. Reforming executive pay will likely be high on the financial re-regulation “to do” list for the 111th Congress as anger at executives remains white-hot.

To be sure, partial ad hoc measures are popping up, both in the U.S. and abroad, from a flat cap on executive pay at German companies receiving bailout funds to active oversight of payouts by the British government in its varying roles as shareholder, director, and regulator of troubled companies. Under the Troubled Assets Relief Program (TARP), Congress last fall hastily imposed executive compensation limits on senior leaders in financial sector entities, including limiting tax-deductibility on exec comp over $500,000; providing new clawback rules for material mistakes; capping or eliminating golden parachutes; and requiring board assessments of the relationship between compensation and risk-taking.

…continue reading: Principles for Reforming Executive Pay

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