(Editor’s Note: The post below by James Turley is a transcript of remarks by him at the Commonwealth Club in San Francisco on February 5, 2009.)

Good evening and thank you to the Commonwealth Club for inviting me to speak here today. I’m well aware of the club’s rich history, and I’m proud to have this opportunity to be with you tonight.

I’ve just returned from the annual meeting of the World Economic Forum, which is better known simply as “Davos.” As you may know, this multi-day event brings together leaders in business and government, for discussions on a range of important topics. There were a number of useful discussions — some of them enlightening, one or two uplifting, many of them sobering.

As you probably know, Ernst & Young has operations in about 140 countries, and I seem to spend a great deal of my time across all of them. In conversations around the world, and certainly in Davos, I’ve heard a lot of blame directed at the United States, as the place that gave birth to the financial crisis that is impacting markets globally. The critics make a number of points. They talk about erosion in US fiscal discipline…reckless lending by mortgage lenders…and excessive leverage at financial institutions. They also point to the role of the credit-dependent American consumer…it’s not just the banks that need deleveraging, it’s the American consumer. The view is that the United States has created an illness in the financial system that has now infected everyone else. And you know what? I think a lot of these criticisms ring true.

Yet, at the same time, in the middle of this financial crisis, I also heard in Davos a sense of determination and hope. Many see that there are important opportunities right now, and are looking for leadership. Many believe that the combination of the financial crisis, an enhanced appreciation for global interconnectivity, and a new US Administration will create momentum for needed change and reform. In the early going, President Obama enjoys tremendous goodwill among political and business leaders the world over.

Today, I’d like to touch first on some of what I’ve seen unfold in the markets over the past year…and some concerns I have going forward. From there, I want to turn to a number of areas where I see the financial crisis presenting an immediate opportunity to foster global consistency in ways that are helpful to investors and market confidence. And I absolutely want to get to any questions you may have on your minds. It’s a lot to cover in the allotted time, so I’ll get right to it.

The financial crisis and associated fears
The events of the past year have been just awful for nearly everyone operating in and around financial markets. There were many causes of the crisis, and it crossed many disciplines. The way I see it, this crisis came about due to:

• Too much leverage and both overuse and inappropriate use of poorly understood financial instruments.
• Bad loans…with weak underwriting standards and little, if any, due diligence.
• Unrealistic expectations that the economy would continue to grow, and home prices would continue to rise as far as the eye could see.
• A failure to understand exposures to risk, and to manage that exposure.
• And gaps in both the domestic and global regulatory systems.

We’re now paying the price for those mistakes. Unemployment is high and going higher. The IPO market has dried up. Consumer confidence has plunged. And credit remains dangerously tight.

People often ask me what should be done in response to the economic crisis. My response has typically been to note five things that should not be done related to the US and global economy. I will touch on those five things in a moment, as well as a range of longer-term reforms I think we should consider pursuing. But first I’d like to briefly address two of the US economic issues that are being intensely debated right now.

First, with respect to the crisis in the banking sector, we need to remember that every banking crisis in history has been dealt with through a combination of three things—providing additional liquidity, raising capital, and a cleaning up of banks’ balance sheets through a variety of public and private sector initiatives. We’ve already seen action to add liquidity and capital, but until we see balance sheets improve, many banks won’t resume normal lending. Indeed, a recent Federal Reserve survey of domestic banks found that about 65 percent of them tightened lending standards on commercial and industrial loans to large and middlemarket firms over the past three months. This is a real problem. Hundreds of companies have debt they need to roll over and refinance in 2009…and absent near-term freeing up of the credit markets, there may be substantial doubt regarding the ability of many of these to continue as a going concern. That is why you are hearing talk, globally, of “Good Bank-Bad Bank” plans or “Aggregator Banks” to deal with the bad assets. The solutions being discussed include, for instance, the government acquiring the assets or, alternatively, segregating the assets on the books of the bank and providing government guarantees. Any proposed solution would be accompanied by significant practical and policy challenges. But I think moving quickly in this direction — whatever model is selected — would not only be a good idea, but may well be critical to companies’ ability to obtain financing.

Second, Congress and President Obama are considering a multi-billion dollar stimulus package. I won’t try to comment on the specifics, since they remain in a state of flux. I do believe we need prompt action with a focus on real economic stimulus and should avoid using it as a mechanism to fund favored programs that don’t have much immediate connection to the economy. My concern is that the political will to do what must be done to free up credit markets — which, again, I believe is critical — is at risk of being tapped out. But the new Administration is determined to provide leadership, and I believe they will.

So if these are a couple of things I hope do happen…let me turn now to some things I hope don’t happen — either here in the US or around the world. And sadly, many of these things may be tempting to some, so I am quite concerned about them.

The first…is we can’t retrench into protectionism — either here in the US or anywhere. It might be human nature for leaders in some parts of the world to think, “hey, let’s protect our people by putting high walls around our country.” Bad idea. The globalization of business has done more to lift economies and lift people the world over, including here in the US, than anything else I can think of. Protectionism, if it comes, would surely slow the recovery and likely would trigger political and market instability.

The second deals with the inevitable re-regulation of the business and financial world that will occur. While there is a clear need for regulatory reform and modernization in several areas, what we can’t afford is regulation so binding that it stifles innovation and entrepreneurship. Getting the balance right will be key…providing protection for investors, but also encouraging prudent risk-taking. As this region of the country well knows, innovation and entrepreneurship are the engines of growth…growth that is needed now more than ever.

The third thing I hope doesn’t happen is that government officials get too comfortable with state ownership in select industries and see it as a long-term solution. That is probably less a worry here in the United States…but could be a real issue in Europe and other places. To be clear…it was incredibly important during these unprecedented times to have government support both here and around the globe. But over the long term it is well understood that governments simply don’t allocate capital as efficiently or effectively as free markets. And unquestionably, the longer state ownership goes on, the more the government or regulators will get involved in both corporate strategy and everyday business decisions. I don’t think that is what anyone wants.

As an aside, I did hear a good analogy for this the other day. A colleague of mine said that, in the past, banking regulators and supervisors set the rules of the road. They established speed limits, requirements for seat belt use, airbags, and the like, but then let drivers go on their way…all the while monitoring the safety situation in the sector. But to get a picture of the regulators today, he said, just picture the driver’s education instructor we all remember. The regulators are sitting in the front seat…with an extra set of foot pedals and steering wheel on the passenger side. In other words, they are right there…driving with you…ready to take control at any moment. None of us want the driver’s ed teacher for the long-term…then or now!

The fourth thing I hope not to see is the financial reporting process getting politicized, particularly as it relates to accounting standards. The essence of financial reporting is to foster informed and efficient allocation of capital based on principles of transparency, consistency and comparability. But those principles are made vulnerable if there is too much political influence. This fear threatened to become reality last fall, during the height of the economic turmoil, when some Members of the US Congress tried to dictate the suspension of fair value accounting standards, at the behest of financial institutions. An even more focused effort took place in Europe, promoted largely by some of the big banks and insurance companies. This was dangerous. Not only because the effect on financial reporting would have been to suspend reality, reduce transparency, and obscure problems from investors. But also because political intervention in the setting of accounting standards threatens both the quality and comparability of the standards. It can’t be the right answer to have individual countries or regions opting in or out of established accounting standards during challenging times. That certainly wouldn’t be good for investors.

And the fifth and final thing I hope not to see, is a world in which people look only at the downside…on how bad the times are…on what they have to lose. Because doing so leads to paralysis by fear. Yes…we are in the midst of a difficult period, but difficult periods also create openings to do things differently, and look for new business niches. For the well capitalized and financed companies, now may be the time to drive toward consolidating an industry sector…Lord knows the reduced market caps of many companies now make them attractive targets. And I do hope that the entrepreneurial class, which is certainly well represented in this area, will see the current environment for what it is — as an opportunity to pursue bold new ideas.

An opportunity for global reform and modernization
You know something, many of the best business leaders I speak with these days are operating with a mindset that “a crisis is a terrible thing to waste”. They are using the burning platform of the crisis to help drive change in their organization. This is clearly the way we are thinking at EY.

So, the way I see it, this crisis presents an opportunity not only for business leaders, but also for government officials and public policy leaders. Reform and modernization of financial regulation is a top priority for policymakers throughout the world — and certainly here in the United States. President Obama spoke to this shortly before his inauguration, saying that we need to reform our “weak and outdated regulatory system so that we can better withstand financial shocks and better protect consumers, investors, and businesses.”

Global regulatory reform comes with an important opportunity. The ongoing financial crisis has revealed a lot about the relative weaknesses of the global financial system. One weakness that has come into sharper focus is the inconsistency of financial regulation, throughout the world. Simply put, what’s legal in some countries isn’t legal in others. Regulatory and legal differences between countries are inevitable, and will never disappear completely. We, at Ernst & Young, with a presence in 140 countries, deal with this every day. But going forward, there is an opportunity to bridge these differences.

Given the widespread recognition of the need for change, policymakers have an opportunity to move forward in a coordinated way. While this can take different forms, the ultimate objective is clear: for nations to emerge from the financial crisis with new regulations that address the shortcomings in the current regulatory infrastructure and do so in a way that promotes stability and integration across the global economy. And to further enhance cooperation and integration even more, the countries that have not adopted International Financial Reporting Standards should do so. The G-20 leaders, in their summit Declaration last November, recognized the value of a single high quality global accounting standard. Indeed, adoption of IFRS would help to bring greater transparency, and uniformity, to global business — and that helps to drive economic partnerships and greater prosperity.

And the G-20 leaders last November also did something else. They emphasized the importance of global regulatory cooperation and collaboration. As they take their regulatory reform efforts forward, and meet again this April in London, they have a real chance to press for greater legal and regulatory convergence among nations. And this needs to be done with careful consideration of best practices and reforms that have proven successful.

Strong corporate governance is fundamental to the health of a company, and to the well-being of a country’s economy. The OECD Corporate Governance Principles are the internationally recognized standard of best practice for corporate governance. They were first formulated ten years ago and refreshed five years ago. They contain important principles that speak to shareholder rights, independent board members, the responsibilities of boards and audit committees, and even what we would call whistle-blower programs. Yet many countries around the world do not have measures in place that match up with these principles. It really is pretty much all over the map.

The US, for example, is viewed as being weak on measures related to executive compensation — also known as “say on pay” — and shareholder access to the proxy process, which is aimed at making it easier for independent directors to be elected to corporate boards. Other countries are viewed as weak in other areas of corporate governance. The focus on companies’ internal controls over financial reporting in the US isn’t present elsewhere.

The fact is…corporate governance has a real effect on how companies in any jurisdiction operate…yet the differences in practices aren’t well understood by the investing public who spread their money around the globe. The question is…would we, or would we not, be better off if governance practices were stronger and more aligned around the world. I think the answer is we very much would.

To that end, the G-20 could encourage all countries to move more quickly to embrace and implement best practices consistent with the international corporate governance principles, as well as adopt other internationally-agreed standards, such as International Financial Reporting Standards, and hold each other accountable for timely action.

I think this is particularly important because, over the last two months, we have seen the global challenges of an economic crisis intensified with renewed concerns around fraud. While I don’t know the particulars of the Madoff matter in the US and the Satyam fraud in India, we have seen that those who are determined to lie, create false documents and conspire have the potential to circumvent regulatory requirements and standards.

That said, strong corporate governance may well be the best defense against fraud. To be clear, many reforms that were put in place in the US by the Sarbanes-Oxley Act don’t exist everywhere in the world. And even here in the US, not every entity is required to maintain an anti-fraud whistleblower program, or independent audit committees, or CEO certifications, or internal control reporting — even though the entity’s activities may have significant implications for the public interest. Similarly, they’re not all subject to a law that says it is illegal to lie to the auditor. The point is…there are many reforms that have been implemented in some sectors — such as the public company space — and in some geographies that may have application in others…and could have great benefit if applied more broadly.

Regulation of the accounting profession
If global consistency and strong governance is good for the corporate community…it is also good for my profession.

Nearly seven years ago, the Sarbanes-Oxley Act dramatically changed corporate governance in the United States. And the Act also mandated an end to 100 years of self-regulation with respect to auditors of public companies…creating an independent oversight authority that regulates the audit profession. This principle — independent regulation of the audit profession — is one that should be adopted throughout the world. Let me explain why.

While everyone in the US accounting profession wasn’t entirely keen on the idea of an independent regulatory authority at the time it was proposed, we embraced the change. Today, that authority — the Public Company Accounting Oversight Board, or PCAOB — is recognized as having strengthened the quality of audits at public companies. In fact, the importance of independent oversight to audit quality has been widely recognized and the PCAOB now has counterparts in many countries around the world.

However, even in the United States, not every auditor of public-interest entities needs to be registered with and overseen by the PCAOB. There are a range of entities which, by virtue of their nature of activities or size (such as holding billions of dollars of investors’ money), operate in a sphere where there are public interest implications. Examples include non-public financial institutions and insurance companies, broker dealers, investment advisers, and pension funds, at least those of a certain size. Recognizing the benefits of independent oversight by the PCAOB and its global counterparts, I believe we should challenge the remaining vestiges of audit profession self-regulation as it relates to auditors of these types of public interest entities across the globe.

As we have seen in the United States, Europe and elsewhere, independent oversight can enhance the quality of audits and promote investor confidence. But only about half of the G20 countries have auditor oversight bodies that are independent of the profession and members of the International Forum of Independent Audit Regulators. While we can’t flip a switch, we can and should commit to supporting consistent and independent oversight everywhere as warranted by the public interest, to improve audit quality and support global economic activity and regulatory cooperation.

The need for a global capital markets working group
Well, there is clearly a lot of work ahead, and before I close, I’d like to touch on an idea I raised last March, when I spoke to the US Chamber of Commerce in Washington. I noted then that the emerging financial instability highlighted the need for some mechanism, organization, or collective agreement to facilitate a continual global discussion of market trends and developments. Sadly, this need has become even greater since I first talked about it.

The dialogue that I am convinced needs to take place must have the active involvement of issuers, auditors, and investors, as well as governments and regulators. A regular discussion, involving both the private sector and the public sector, can inform public-policy considerations and private-sector practices. Today, no such institutionalized public-private dialogue exists. In my opinion, that is leaving the world’s capital markets and the regulatory system less informed and more vulnerable to volatility. This formalized dialogue, which could take the form of a global capital markets working group, could help ensure that market participants and regulatory authorities maintain a focus that’s consistent with the realities of today’s interconnected, complex, and dynamic markets. As finance ministers think about their next steps in dealing with the financial crisis, I really hope they consider establishing such a group.

Conclusion
To conclude, the turmoil of the past year has been very difficult for everyone in and around financial markets — and now we’re seeing how this turmoil is impacting all sectors of the economy throughout the world, leading to rising unemployment and reduced rates of economic growth.

Amidst these dark clouds, it’s difficult to see any rays of sunlight. But as I said earlier, this crisis does create an opportunity to modernize financial regulation in a way that will help to prevent future financial meltdowns, while also promoting global economic stability and opportunity. But we need to act in a thoughtful, deliberate way, because we literally can’t afford to make mistakes in the coming round of regulatory reforms.

One of the biggest mistakes, in my view, would be for national legislatures and other policymakers to take action in isolation. Laws, rules and policies will change as a result of this crisis. And as they do, the changes can either drive the world closer together or drive us farther apart. With the interconnected nature of global economic activity and the ability to raise or invest money anywhere in the world from anywhere in the world, we need to seize this opportunity to come closer together, and not allow the changes that will happen drive us further apart. That is my plea.

The people of Ernst & Young — all 140,000 of them in 140 countries — are committed to doing everything we can on these and other issues. We’re facing different cultures, different languages, different regulators, and even different standards in some cases across jurisdictions. While this makes our job challenging, it also gives us a platform and motivation to inform the debate and drive rules, standards and practices toward greater consistency and quality around the globe.

But I recognize that effective regulatory systems and policies won’t be enough, because even the best regulation can be trumped by bad judgment and bad behavior. We know that our work is a fundamental element supporting growth and stability, and your confidence in the financial and capital markets.

That is why my message to our people is the same wherever I go.

I have long considered my most important responsibility to be doing everything I can to ensure that the people of Ernst & Young wake up everyday knowing what is right and what is wrong, and knowing that no matter what, nothing is more important than their own personal leadership and integrity.

I want our people to know, that if something smells wrong, if something is making them uncomfortable — whether it’s at a client or inside Ernst & Young — it is not just OK for them to raise their hand, it is their job to raise their hand and speak out.

This is a message that can’t be emphasized enough.

There’s a lot of work ahead and Ernst & Young will be a constructive partner in this work…interacting with regulators, investors, issuers, and our colleagues in the audit profession to help create the conditions for rejuvenation of the US economy, and economies throughout the world. If you have ideas on how we can do this more effectively…please let me know.

And with that…I just want to say thank you to the Commonwealth Club for hosting this important event at this important time.

The Millstein Center for Corporate Governance and Performance at the Yale School of Management has recently released a new policy briefing entitled “Voting Integrity: Practices for Investors and the Global Proxy Advisory Industry.”

Accountability of corporate boards to shareowners rests in large part on the integrity of the system by which investors vote their proxy ballots. Shareowners rely on the vote to affect the governance of a company; corporate directors see the vote as a barometer of investor confidence in board stewardship. Outcomes determine the fate of director tenure, mergers, acquisitions, capital raising, remuneration plans and other critical decisions with sometimes profound consequences for stakeholders and the marketplace.

However, this briefing finds that the proxy voting system in the US and other markets is chronically subject to criticism that it is short on integrity sufficient to ensure trust. Parties involved are institutional investors, agents such as proxy advisory services, and intermediaries charged with transmitting ballots. Threats include conflicts of interest, opacity, technical faults in the chain by which ballots are transmitted, and a shortage of resources devoted to informed decision-making.

Remedies proposed in this briefing include:

• Governance firms should endorse and comply with a first industry-wide code of professional ethics, including a general ban on a vote advisor performing consulting work for any company on which it provides voting recommendations or ratings.

• Institutional investors should endorse and follow guidance on their own governance produced by the International Corporate Governance Network.

• Institutional investors should report to clients or beneficiaries at least annually on their voting policies and voting records. Further, such institutions should regularly review voting policies to ensure they are fit for purpose; identify, manage and disclose real or potential conflicts of interest on a regular basis; and determine the level and quality of resources necessary and appropriate to deliver vote recommendations and decisions that are in line with their voting policies.

• The US Securities and Exchange Commission should empanel a high-level independent review aimed at modernizing the US proxy voting system. Regulators should work with counterpart bodies in other markets to supervise the seamless integration of national systems to enable accurate and efficient cross-border voting.

The full briefing can be found here.

(Editor’s Note: This post comes from Mats Isaksson of the Organization for Economic Co-operation and Development.)

The OECD Steering group has recently issued a report entitled “Corporate Governance Lessons from the Financial Crisis.”

This Report concludes that the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements. When they were put to a test, corporate governance routines did not serve their purpose to safeguard against excessive risk taking in a number of financial services companies. A number of weaknesses have been apparent. The risk management systems have failed in many cases due to corporate governance procedures rather than the inadequacy of computer models alone: information about exposures in a number of cases did not reach the board and even senior levels of management, while risk management was often activity rather than enterprise-based. These are board responsibilities. In other cases, boards had approved strategy but then did not establish suitable metrics to monitor its implementation. Company disclosures about foreseeable risk factors and about the systems in place for monitoring and managing risk have also left a lot to be desired even though this is a key element of the Principles. Accounting standards and regulatory requirements have also proved insufficient in some areas leading the relevant standard setters to undertake a review. Last but not least, remuneration systems have in a number of cases not been closely related to the strategy and risk appetite of the company and its longer term interests.

The Report also suggests that the importance of qualified board oversight, and robust risk management including reference to widely accepted standards is not limited to financial institutions. It is also an essential, but often neglected, governance aspect in large, complex non-financial companies. Potential weaknesses in board composition and competence have been apparent for some time and widely debated. The remuneration of boards and senior management also remains a highly controversial issue in many OECD countries.

The current turmoil suggests a need for the OECD, through the Steering Group on Corporate Governance, to re-examine the adequacy of its corporate governance principles in these key areas in order to judge whether additional guidance and/or clarification is needed. In some cases, implementation might be lacking and documentation about the existing situation and the likely causes would be important. There might also be a need to revise some advice and examples contained in the OECD Methodology for Assessing the Implementation of the OECD Principles of Corporate Governance.

The full report can be found here.

(Editor’s Note: This post comes from Anil K. Kashyap of The University of Chicago.)

I recently presented a new working paper co-written with Takeo Hoshi at the Law, Economics and Organizations workshop at Harvard Law School entitled Will the U.S. Bank Recapitalization Succeed? Lessons from Japan. In the paper, we look back at Japan’s decade-long response to its financial crisis and evaluate what has and hasn’t worked, and draw on the Japanese experience to evaluate the Troubled Assets Relief Program (TARP), which focused on the idea of purchasing troubled assets to stabilize the financial system, and the Capital Purchase Program (CPP), which focuses on acquiring stakes in banks in the form of preferred shares and warrants.

While it is widely known that the banking problems in both countries began after a sharp increase in land prices, the events in Japan from late 1997 to early 1999 closely track developments in the U.S. in 2008. One important similarity is the bank credit crunch that prevailed in both instances. More importantly, the Japanese banks emerged from the acute phase of its crisis with seriously undercapitalized banks. We identify four main problems with the string of Japanese asset purchase plans and capital injection programs that were pursued to combat the banking problems. First, the asset purchase plans were too narrow. The scope of assets to be purchased and the set of financial institutions included were limited, thus precluding a comprehensive plan. Second, the loan purchases that did take place, especially in the 1990s, involved little restructuring of the borrowers. This resulted in many of the companies operating with few changes while typically receiving more loans that subsequently went bad. Third, the capital purchase plans ran into trouble in getting the banks to accept funding. Fourth and most importantly, the overall amount of government money committed was too small to recapitalize the banks. Hence, the banks only really returned to being adequately capitalized in 2006 and 2007, when macroeconomic conditions improved and after supervision policy had changed.

In broad terms, the TARP and CPP programs mimic many elements of the Japanese plans. We present data comparing the largest U.S. banks, particularly in terms of the risks that they face from continued deterioration in the economy. Based on publicly available data it is hard to make confident assessments about the solvency of the banks. The lesson from Japan is that the details of the potential recapitalization program will be critical in determining whether any injections will increase the banks’ capital levels and hence their lending capacity. While the U.S. plans are still in flux, it appears that U.S. is at risk for running into some of the same problems that hobbled the Japanese policies.

The full paper is available for download here.

(Editor’s Note: This post is an op-ed piece by Lucian Bebchuk published today at Forbes.com. The post outlines some of the key points of the Discussion Paper by Bebchuk, How to Make TARP II Work, issued last month by the Harvard Law School Program on Corporate Governance. This Discussion Paper builds in part on Bebchuk’s September 2008 article, A Plan for Addressing the Financial Crisis, which first proposed the idea of using competing privately managed funds to restart the market for troubled assets. The post was written before the appearance in today’s WSJ of a story suggesting that the Treasury is considering establishing a program for financing competing private funds. We hope to get from Professor Bebchuk another post on the subject as information about the Treasury’s plan becomes available.) 

Four weeks ago, Treasury Secretary Geithner announced the administration’s interest in developing a plan—which the Treasury is willing to back with up to $1 trillion of public funds—to partner with private capital to buy banks’ “troubled assets.” The announcement has met with substantial skepticism about the possibility of working out an effective plan to restart the market for troubled assets for such a public-private partnership. However, in a paper issued last month, How to Make TARP II Work, I show that this can be done, and explain how the plan should be designed to contribute most to restarting the market for troubled assets at the least cost to taxpayers.

The Bush administration was forced to abandon its own plan for directly purchasing troubled assets once it became clear that its plan could not be designed to effectively address concerns about arbitrary valuation and potential overpayments. This experience contributed to the doubts about the Obama administration’s new plan. With the stock market reacting negatively, one noted columnist observed that “[t]he market was right to worry because… nobody has yet devised a way to make such a scheme work.” Another columnist suggested that the market was “glum” because the announcement was “short on details – and no more so than on the critical question of how the government will address the problem of dealing with the toxic assets that have effectively rendered large portions of the nation’s financial system insolvent.”

Despite the widespread doubts, an effective plan for a public-private partnership in buying troubled assets can be designed. The key is to have competition at two levels. First, at the level of buying troubled assets, the government’s program should focus on establishing many competing funds that are privately managed and partly funded with private capital – and not creating one, large “aggregator bank” funded with public and private capital and engaging in purchasing troubled assets. Second, at the level of allocating government capital among the competing private funds, potential fund managers should compete for government capital under a market mechanism resulting in maximum participation of private capital and minimum costs to taxpayers.

…continue reading: Jump-Starting the Market for Troubled Assets

(Editor’s Note: This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.)

In Should Firms be Allowed to Indemnify Their Employees for Sanctions? which was recently published by the Journal of Law, Economics, and Organization, we analyze the widespread practice of employee indemnification using a three player model, where there is a principal and agent, as well as a governmental player that sets and enforces sanctions. In our model, the government authority can always deter crime with a sufficiently high combination of fines on the firm and employee. The challenge is to deter crime at minimum social cost. We show that deterrence can typically be obtained at minimum social cost by sanctioning the firm alone. This maintains deterrence without exposing the agent to risk from sanctions or inducing the exit of productive, law-abiding firms.

Sanctioning the agent is valuable in limited circumstances. If deterrence is especially difficult, it may be optimal to hit the agent with a sanction large enough to bankrupt him. Although the de jure sanctions cannot vary with actual guilt—imperfect enforcement prevents this—bankrupting the agent allows the de facto agent sanction to vary with his wealth. The agent needs to be paid a premium to induce him to commit a crime, and so the agent of the criminal firm ends up having more wealth to be seized than the agent of a law-abiding firm. Indemnification need not be explicitly banned for this strategy to work: the agent’s sanction can be set so high that the firm would not choose to indemnify the agent even if allowed by law.

Indeed, if sanctions are set appropriately, the government’s policy toward indemnification becomes moot. Either the agent should not be sanctioned at all, in which case there is nothing for the firm to indemnify, or the agent should be sanctioned so harshly that the firm chooses not to indemnify the agent even if it could. The government’s policy toward indemnification is not moot in an extension of the corporate-crime model in which the agent’s cooperation can help convict a criminal firm. The authority can offer to reduce the employee’s fine in return for his cooperation; an offer the firm can unravel by pledging to indemnify him fully.

The broad lesson to be drawn from the analysis is that authorities should be wary of sanctioning employees let alone banning their indemnification. Typically, firm sanctions deter crime more efficiently than unindemnifiable employee sanctions. Readers can find a link that provides free access to the full paper at Professor Snyder’s homepage here.

Section 16(b) of the Securities Exchange Act of 1934 has long been criticized for its “purposeless harshness,” and its “arbitrary, some might say Draconian” nature, as one court put it. Section 16(b) generally requires directors, officers and beneficial owners of more than 10% of the stock of a publicly traded corporation to disgorge to the corporation any so called “short swing profits” from purchases and sales of stock (or vice versa) made within a period of less than six months.

The stated purpose of Section 16(b) is to “[prevent] the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer.” To that end, the law authorizes any shareholder to file a derivative suit to recover such profit “if the issuer shall fail or refuse to bring such suit within sixty days after request.” There is no requirement that the shareholder own any shares at the time of the alleged insider trading. The predictable result has been to create a cottage industry of Milberg, Weiss style legalized barratry.

For example, The Children’s Investment Fund and 3G Capital Partners LP recently settled a Section 16(b) lawsuit brought by a small shareholder of CSX Corporation to recover their alleged short swing profits in CSX stock. The shareholder made no allegation that TCI or 3G were privy to any inside information let alone that any inside information about CSX even existed at the time of the trades. Under the settlement CSX will receive $10 million from TCI and $1 million from 3G and the plaintiff’s lawyer will seek approval by the court for fees and costs of up to $550,000, payable from the proceeds.

In another recent Section 16(b) case, Huppe v. Special Situations Fund III QP, L.P., No. 06 Civ. 6097 (S.D.N.Y. July 3, 2008) the District Court ruled that a 10% shareholder of WPCS International Incorporated had to disgorge its short swing profits to the company despite the absence of any allegation of the existence of inside information. The Court acknowledged that the shareholder’s purchase of stock from WPCS in an arm’s length transaction had probably rescued the issuer from financial disaster but ruled that equitable defenses are inapplicable in a Section 16(b) case:

Although it is undisputed in this case that WPCS genuinely needed and was provided capital through PE’s and QP’s purchases of WPCS stock, nothing in the statute permits the Court to consider as a mitigating factor the issuer’s intent or any benefit inuring to the issuer, nor is there any equitable defense available based on such theories.

That is because Section 16(b) creates a conclusive presumption that a 10% shareholder who realizes a short swing profit is presumed to have had access to and abused inside information. No allegation that inside information existed, e.g., a proposed merger or dividend increase, is even required. While there have been several failed due process challenges to Section 16(b), I know of none since Vlandis v. Kline, 412 U.S. 441 (1973), in which the Supreme Court held that an irrebuttable statutory presumption that a university student who recently moved to Connecticut was not a legitimate resident of the state (for university tuition purposes) is invalid because the presumption was not warranted. A court should be equally skeptical of Section 16(b)’s presumption that any short swing profits by a 10% shareholder stems from access to inside information. Unlike a director of a corporation, no shareholder has a legal right to obtain inside information and in fact, 10% shareholders of public corporation usually do not possess such information. Thus, a constitutional challenge based on Section 16(b)’s irrebuttable presumption of insider trading appears promising.

An even more obvious constitutional flaw of Section 16(b) is that it does not meet the Supreme Court’s requirement for Article III standing because it purports to authorize a “suit to recover such profit . . . by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer” even though the issuer has not been harmed. In Gladstone, Realtors v. Village of Bellwood, 441 U.S. 91, the Supreme Court found that one could not sue for damages unless the party alleged that (1) it suffered an actual injury as a result of the defendant’s actions and (2) that a favorable ruling would compensate the plaintiff for the injury suffered:

Congress may, by legislation, expand standing to the full extent permitted by Art. III, thus permitting litigation by one “who otherwise would be barred by prudential standing rules.” Warth v. Seldin, 422 U.S., at 501, 95 S.Ct. at 2206. In no event, however, may Congress abrogate the Art. III minima: A plaintiff must always have suffered “a distinct and palpable injury to himself,” ibid., that is likely to be redressed if the requested relief is granted. Simon v. Eastern Kentucky Welfare Rights Org., supra, 426 U.S., at 38, 96 S.Ct., at 1924.

One might argue that Congress created “a distinct and palpable injury” to an issuer when it passed a law requiring the transfer of short swing profits from the statutory insider to the issuer. However, that is circular reasoning and contrary to the Court’s insistence that Congress cannot abrogate Article III’s requirement that the plaintiff must suffer a true injury to himself to have standing. If Congress could create an artificial injury by fiat, that would effectively eviscerate Gladstone.

Abe Lincoln reputedly popularized this riddle: “How many legs does a dog have if you call a tail a leg?” “The answer is four because calling a tail a leg does not make it a leg.” Similarly, Congress does not have the power to legislate the existence of “a distinct and palpable injury” to a corporation when such an injury does not exist. The plain truth is that a corporation does not suffer any injury from short swing profits realized by a 10% shareholder and hence does not have standing to bring a Section 16(b) lawsuit against that shareholder.

My firm has recently published “2009 Insights — Navigating Tumultuous Times,” a compendium of current memoranda on subjects we believe are likely to be of particular importance to directors, senior management and counsel in the coming year. The idea for the compendium was triggered by the difficult financial and business environments in the U.S. and globally as we move into 2009, and the advent of a new administration in Washington. In light of this, we thought there could be some real value in pulling together input from a large number of our practice areas and domestic and international offices to provide, in one place early in 2009, our perspective on the coming year. This perspective encompasses both problem areas, including approaches to dealing with them, and some opportunities.

The individual memoranda are intentionally brief, to facilitate review by business executives and directors — there clearly is much more to be said on virtually every subject. The following outline, from the compendium itself, indicates the breadth of territory covered in the 10 sections of the compendium.

• Capital Markets and Hedge and Private Equity Funds: For many of our clients, the area of most direct interest is how the tumultuous financial environment may impact their capital structure. We emphasize both advance planning and prophylactic measures that are applicable to most entities, whether or not currently under distress. We also examine potential opportunities created by the turmoil in financial markets and the impact on various capital markets sectors.

• Corporate Restructuring: It is generally expected that 2009 will be dominated by a global wave of corporate restructuring activity. We provide information on various techniques that will be of assistance to stressed entities looking to restructure their balance sheets, as well as entities that may seek to acquire or consolidate with a troubled entity.

• Financial Institutions: The events of recent months have led to a series of financial crises and dramatic governmental responses. We examine legislative developments in the US and Europe, provide guidance regarding the current enforcement and litigation landscape, and look ahead to future developments affecting financial institutions.

• Global M&A: A significant amount of recent merger and acquisition activity has focused on restructuring prompted by the demands of governments or creditors. As corporations around the world continue to assess their financial and business environments, new strategic M&A scenarios likely will develop. We include information highlighting current influences on mergers and acquisitions.

• Governance: The financial and economic crises and the response of various governmental bodies, once again, emphasize the importance of proper corporate governance. The range of issues confronting directors and members of management are explored in a series of memoranda that assess trends and offer guidance on those issues, including directors’ duties, executive compensation and financial reporting.

• Governmental, Regulatory and Tax Enforcement: In the US, the EU and elsewhere, shifting governmental priorities in response to various factors, including the economic environment, will impact a wide range of industries. We assess these developments across governmental arenas.

• Intellectual Property and Information Technology: We address a number of areas of interest related to intellectual property — the most valuable asset of the so-called “new economy.”

• Litigation and International Arbitration: We anticipate the upheavals of the last year and a half will continue to result in increased litigation, much of which will be complex and international in nature. We discuss the expected trends and likely strategies for managing such disputes.

• New Markets: Brazil, China, India and Russia are not immune to the global financial and economic crisis, and their status as emerging markets creates unique circumstances for conducting business there. We discuss various issues, trends and laws relevant to business activity in each country.

• Real Estate: In the eye of the economic storm, the real estate industry, including REITs, faces a number of issues, which we discuss here.

The compendium is available here.

Note: Navigating tumultuous times requires keeping up to date. In the brief period since the compendium was issued, there have been significant changes in a number of areas, particularly U.S. economic stimulus legislation, regulation of financial institutions and executive compensation. We continue to monitor the areas covered in the compendium and publish memoranda addressing significant developments.

This post is by my partners Michael Tumas and John Grossbauer.

The Council of the Corporation Law Section of the Delaware State Bar Association earlier today forwarded to Corporation Law Section members the proposed 2009 amendments to the Delaware General Corporation Law (“DGCL”). Consistent with Delaware’s preference for enabling legislation and maintaining maximum flexibility, the amendments eschew mandates for corporate action. Specifically, the proposed amendments create new Sections 112 and 113 that expressly permit Delaware corporations to adopt bylaws implementing proxy access and requiring reimbursement of stockholder proxy expenses in certain circumstances. Also included among the proposed amendments are changes to Section 213, to permit Delaware corporations to provide separate record dates for determining stockholders entitled to notice of and to vote at stockholder meetings, a new provision permitting judicial removal of directors in extreme, emergency circumstances, and a revision to Section 145(f) expressly providing that pre-existing indemnification and advancement rights provided in a corporation’s governing documents cannot be impaired by later amendments to those documents. The amendments are summarized in more detail below.

Access to Proxy Solicitation Materials (New Section 112)
The proposed amendments create a new section of the DGCL, Section 112, expressly authorizing a Delaware corporation to adopt a bylaw that grants stockholders the right to include within the corporation’s proxy solicitation materials stockholders’ nominees for the election of directors, subject to any lawful conditions the bylaws may impose. The subject of “proxy access” had been a significant one, and it promised to continue to be so in the current environment. The addition of proposed Section 112 removes any uncertainty regarding the ability of Delaware corporations to effect proxy access through adoption of a bylaw. In so doing, the proposed amendment clarifies that corporations may impose reasonable restrictions on the stockholders’ right to access company proxy materials and identifies a non-exclusive list of restrictions that are deemed to be reasonable.

One condition specified in Section 112 would permit the bylaws to establish minimum ownership requirements for stockholders to become eligible to include nominees in company proxy materials, measured both by amount and duration of ownership. The bylaws may establish this minimum ownership threshold by defining beneficial ownership to include ownership of options or other rights relating to stock, including derivative rights. Because Section 112 is intended to apply to stockholder nominations of short slates of directors and not as a vehicle for effecting changes of control through the corporation’s own proxy materials, the new section also expressly permits the bylaws to condition eligibility for inclusion in the corporation’s proxy materials to nominations for a limited number of seats that may be contested and to preclude entirely inclusion of nominations by persons who own or propose to acquire (such as through a tender offer) more than a specified percentage of the corporation’s stock. The bylaws also may require the nominating stockholder to submit specified information such as information concerning the ownership of the corporation’s stock by the stockholder and the stockholder’s nominees. The bylaws also may condition eligibility to require inclusion of nominees in the corporation’s proxy materials on the nominating stockholder’s execution of an undertaking to indemnify the corporation for any loss resulting from any false or misleading information submitted by the stockholder and included in such proxy materials, or on “any other lawful condition.”

…continue reading: Amendments to the Delaware Corporation Code

(Editor’s Note: This post comes to us from Robert S. Reder, Alan J. Stone, Peter Heller and Dean Sattler of Milbank, Tweed, Hadley & McCloy LLP.)

In a previous Client Alert, [1] we discussed a decision of the Delaware Court of Chancery dismissing a stockholder suit that alleged breach of fiduciary duty by directors who initiated, but later abandoned, a sale process that had generated three attractive offers. In Gantler v. Stephens [2], the Court of Chancery applied the business judgment rule to the board’s conduct, rather than the Unocal [3] standard of enhanced review, because the directors’ actions were not “defensive” in nature. In affording the directors the benefit of the business judgment presumption, the Court of Chancery found that the directors breached neither their duty of loyalty nor their duty of care, and therefore declined to undertake an “entire fairness” review of the board’s conduct.

On January 27, 2009, the Delaware Supreme Court reversed the Court of Chancery’s decision. In the Supreme Court’s view, the complaint pled “sufficient facts to overcome the business judgment presumption,” thereby requiring an examination of plaintiffs’ allegations under the entire fairness standard of review.[4] The Supreme Court’s analysis provides helpful insight into the nature of the pleading required to overcome the presumption of the business judgment rule in the M&A context. The Gantler decision also clarifies the nature of the fiduciary duties owed by corporate officers to a Delaware corporation, as well as the scope and application of the shareholder ratification doctrine under Delaware law.

Background

In August 2004, the board of directors of First Niles Financial, Inc. authorized a process to sell the company, and retained financial and legal advisors to assist. At the next board meeting, with the sale process underway, management advocated abandoning the process in favor of a so-called “going private” transaction. The board did not act on management’s proposal, but instead allowed the sale process to continue.

…continue reading: Delaware Supreme Court Orders Entire Fairness Review

(Editor’s Note: This post is based on a client memorandum by Martin Lipton, Steven A. Rosenblum, and Sabastian V. Niles of Wachtell, Lipton, Rosen & Katz.)

Despite increasing political and media focus on and criticism of risk assessment and risk management efforts by corporate boards, yesterday’s In Re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009), decision by the Delaware Court of Chancery is a welcome indication that the business judgment rule will survive the financial crisis intact.

The plaintiffs in the case alleged, among other things, that the defendants had breached their fiduciary duties by not properly monitoring and managing the business risks that Citigroup faced from subprime mortgages and securities, and by ignoring alleged “red flags” that consisted primarily of press reports and events indicating worsening conditions in the subprime and credit markets. Declaring that “oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk,” Chancellor Chandler dismissed these claims on the ground of failure to adequately plead demand futility. The only claim the court did not dismiss was an allegation that the defendants had engaged in waste by approving a multimillion dollar payment and benefit package for Citigroup’s former CEO upon his retirement.

The decision reaffirms and clarifies several key features of Delaware law, established by the Caremark decision and its progeny, with respect to oversight responsibilities. First, that plaintiffs face “an extremely high burden” in bringing a claim for personal director liability for a failure to monitor business risk. Second, that while directors could be liable for a failure of board oversight, “only a sustained or systemic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.” Third, that a bad business decision is not evidence of the bad faith necessary to establish oversight liability. Notably, the court drew an important distinction between oversight liability with respect to business risks and oversight liability with respect to illegal conduct, emphasizing that courts will not permit oversight jurisprudence to be distorted by “attempts to hold director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly.”

As boards of directors review the risk oversight and management programs of their companies (see our November 2008 memorandum entitled “Risk Management and the Board of Directors”), this week’s decision in Citigroup should provide some comfort that, even in the current environment, the Delaware courts will continue to protect informed business judgments made by corporate boards in good faith.

This post is by my colleagues Beverly Fanger Chase, Ning Chiu, Edmond T. FitzGerald, Kyoko Takahashi Lin, Jean M. McLoughlin, and Barbara Nims.

Media and public attention surrounding the American Recovery and Reinvestment Act of 2009, enacted on February 17, 2009 and commonly referred to as the stimulus bill, has typically focused on the law’s restrictions on the amounts and forms of compensation payable to executives of TARP participants.[1] An important provision of the stimulus bill that has not as yet received much notice, but is now a reality for all institutions that receive or have received government assistance under TARP, is the requirement that such institutions permit their shareholders to vote on executive compensation – a so-called “say on pay” vote.

Shareholder proposals advocating for say on pay have been a recent priority item on shareholders’ governance agenda, with reports indicating that as many as 100 proposals have been submitted to public companies for the 2009 season. Support for the approximately 70 proposals submitted to shareholders in the 2008 season averaged approximately 42%, with ten proposals reported as receiving majority support from shareholders. Although say on pay has not been widely adopted by companies, 18 companies to date have agreed to institute company proposals seeking a say on pay vote in their proxy statements. Six of these companies have already included such a company proposal in their proxy statements, with shareholder support for the companies’ executive compensation ranging from 62.5% to 98.7%.

The new SEC leadership has publicly expressed its support of adopting say on pay for all companies outside the context of the stimulus bill. Mary Schapiro, Chairman of the SEC, stated in a recent speech that “giving shareholders a greater say on . . . how company executives are paid” is on the SEC’s agenda. Further, SEC Commissioner Elisse B. Walter in recent remarks stated that she believes say on pay can help restore investor trust, and she encouraged more companies to voluntarily adopt say on pay.

Stimulus Bill Requires Say on Pay, But Timing of Implementation Originally Unclear
The stimulus bill requires that the shareholders of any institution that has received or will receive financial assistance under TARP be provided with an annual non-binding say on pay vote on executive compensation each year during the period in which any obligation arising from such financial assistance remains outstanding. In its annual meeting proxy statement, each institution must provide a separate shareholder vote to approve the compensation of the institution’s executives as disclosed pursuant to the SEC’s compensation disclosure rules, which include the compensation discussion and analysis, the compensation tables and related narrative.

The stimulus bill called for the SEC to issue final regulations regarding this say on pay provision within one year after the date of the bill’s enactment. The legislation did not indicate whether the say on pay provision was effective immediately upon its enactment, or would only become effective after the SEC issued these regulations.

The stimulus bill also makes clear that this shareholder vote is not intended to be binding upon an institution’s board of directors and may not be construed as overruling any board decision, nor does it create or imply any additional fiduciary duty of the board.

…continue reading: “Say on Pay” Now a Reality for TARP Participants

This month’s issue of The Review of Financial Studies features our article, “What Matters in Corporate Governance?.”

The article investigates the relative importance of the 24 provisions followed by the Investor Responsibility Research Center (IRRC) and puts forward an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments. The article shows that increases in the index level are monotonically associated with economically significant reductions in firm valuation as well as large negative abnormal returns during our period of examination. The other eighteen IRRC provisions not in our entrenchment index were uncorrelated with either reduced firm valuation or negative abnormal returns.

Since the initial version of our study was first circulated in the fall of 2004, many researchers have used the entrenchment index we put forward. A list of over 75 studies using the index is available here. For those who might wish to use the entrenchment in subsequent research, data on firms’ entrenchment index levels during the period 1990-2007 is available here.

————————————————————————

Below we describe the article’s results and contributions: There is now widespread recognition, as well as growing empirical evidence, that corporate governance arrangements can substantially affect shareholders. But which provisions, among the many provisions firms have and outside observers follow, are the ones that play a key role in the link between corporate governance and firm value? This is the question on which our article focuses.

…continue reading: What Matters in Corporate Governance?

My recent article “The Trilateral Dilemma in Financial Regulation” analyzes a practice — which I label the trilateral dilemma — existing in many different sections of the financial services industry, including mortgage lending, retirement savings, investment management, insurance brokering and banking services. The practice arises in the context of a consumer seeking the recommendation of a financial adviser for the purpose of choosing financial products and services. With surprising frequency, these advisers receive side payments or other forms of compensation from the firms that provide the product or service the advisers recommend. Many times these payments are not clearly disclosed to the consumers; often they are entirely secret.

In the article I describe how trilateral dilemmas have arisen in many different sections of the financial services industry. I then review the many different regulatory strategies that legislatures, courts and regulatory bodies have employed to address the problem. The modal regulatory response is the imposition of some sort of fiduciary duty on the financial advisor along with a generalized disclosure to consumers affected by the transaction. I then discuss a range of recurring analytical issues that arise in policy debates over trilateral dilemmas in a variety of settings, and I also evaluate the possibility that side payments and other forms of indirect compensation may in fact be an efficient or at least innocuous means of financing the cost of distributing financial products and services. The article concludes with some thoughts about the implications of my analysis for devising regulatory responses and for the role that consumer education might play in helping consumers work through these difficulties.

The article is available here.

One specific — and highly controversial — example of the trilateral dilemma in the real estate context involves the payment of yield spread premiums by lending institutions to mortgage brokers for steering consumers towards particular loans. In a recent article entitled “Kickbacks or Compensation: The Case of Yield Spread Premiums“, Laurie Burlingame and I present an empirical study of approximately 3,000 mortgage financings of a major lending institution operating on a nationwide basis through both a network of independent mortgage brokers and some direct lending. The data for this study was obtained through discovery in litigation that was subsequently settled. The study offers a number of insights into the impact of yield spread premiums of mortgage broker compensation and borrower costs. In particular, the study suggests that for transactions involving yield spread premiums, mortgage brokers received substantially more compensation than they did in transactions without yield spread premiums. This estimated difference in mortgage broker compensation is statistically significant and robust to a variety of formulations.

Industry representatives have long argued that yield spread premiums are not harmful to consumers because these payments are recouped through lower direct payments to mortgage brokers. However, our analysis suggests that this claim is baseless, at least with respect to sample included in our database. With a high degree of statistical confidence and using multiple formulations, we can reject the proposition that consumers fully recoup the cost of yield spread premiums. Our best estimate is that consumers get less than 35 cents of value for every dollar of yield spread premiums, a very bad deal for consumers.

The article also provides evidence that the payment of yield spread premiums may allow mortgage brokers to engage in price discrimination among borrowers. The evidence suggests that yield spread premiums are not simply another form of mortgage broker compensation, but rather a unique form of compensation that allows mortgage brokers to extract excessive payments from many consumers. The article concludes with a discussion of the implications of the study, areas for regulatory focus, and proposals for regulatory reform.

The article is available here.

(Editor’s Note: This post is a letter to the editor of the WSJ responding to the op-ed by Lucian Bebchuk that appears on our forum here.)

Lucian Bebchuk’s suggestions regarding bank executive compensation didn’t go far enough in controlling levels of executive compensation and their growing inequities. Experts continuously present suggestions to link pay to performance through a variety of stock options and other mechanisms. None of them is impervious to the gaming which takes place, and none has halted the escalation.

The responsibility to set and monitor compensation is in the boardroom. Boards have avoided that responsibility and remained tone deaf to the public’s concern. Structuring transparent, understandable fair compensation, even in the millions-of-dollars range, is one thing; failure to consider the risk of perverse escalating outcomes and perks is another. Institutional shareholders have the voice and capacity to put spine in the boardroom by communicating on compensation to Compensation Committees, filing proxy resolutions, and voting against directors believed to be improvident. Then, in turn, they should report to their beneficiaries what they have done.

Last week, on behalf of sixty corporate and securities law professors from thirty-eight law schools around the country, I filed an amici curiae brief in the case of Lucian Bebchuk vs. Electronic Arts, Inc.. The case is  now pending before the United States Appeals Court for the Second Circuit. The professors’ amici curiae brief is available here, and the names of the professors joining the brief are listed at the bottom of this post.

The case focuses on a shareholder proposal that was submitted by Lucian Bebchuk to Electronic Arts (EA). The proposal is precatory and recommends that the board submit to a shareholder vote a charter or bylaw amendment that, if adopted, would require the company (to the extent permitted by law) to include in the company’s proxy materials qualified proposals for a bylaw amendment. For a proposal to be qualified, the proposal would have to meet certain significant requirements, including being submitted by a shareholder(s) with more than 5% of the company’s stock. The proposal is available here.

EA excluded the proposal from the company’s ballot, and the case focuses on whether the SEC’s shareholder proposal rule (Rule 14a-8) allows the company to do so.

The case comes before Second Circuit on appeal from the District Court for the southern District of New York. The District Court accepted the position of EA in a brief bench ruling and sent the case to the Second Circuit. The transcript of the District Court’s hearing is available here. The opening brief filed in the appeal by Lucian Bebchuk’s counsel, Grant & Eisenhofer, is available here. A sense of the position that EA can be expected to present in the appeal can be obtained from the opening brief and reply brief EA submitted to the District Court, which are available here and here, as well as from the amicus curiae brief, available here, submitted to the District Court by the Chamber of Commerce.

The professors’ amici curiae brief, filed in support of the appellant’s position, focuses on two central arguments made by EA in defense of excluding the proposal:

(1) Inconsistency with the Proxy Rules Argument:

In its bench ruling, the District Court, accepting the position of EA and the Chamber, held that EA may omit the proposal as inconsistent with Rule 14a-8. The District Court viewed any provision in the certificate of incorporation or the bylaws that would limit the discretion of EA’s directors to control access to the issuer’s proxy statement as inconsistent with Rule 14a-8. The District Court held that Rule 14a-8 mandates that the discretion it provides to companies to omit certain proposals be exercised fully and solely by the company’s board. The Court stated that “it is clear… that the SEC understand[s] the company to be those who act for the company … And that is a small, relatively small group of people, like the board of directors, who have management discretion to run the business and affairs of the company. And it is they that must have this discretion.”

…continue reading: Electronic Arts Before the Second Circuit: The Amici Curiae Brief of 60 Corporate and Securities Law Professors

(Editor’s Note: This post comes from Hollis Ashbaugh Skaife of the University of Wisconsin-Madison, Daniel W. Collins of the University of Iowa, William R. Kinney, Jr. of the University of Texas at Austin, and Ryan LaFond of Barclays Global Investors.)

In our forthcoming Journal of Accounting Research paper entitled The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, we explore the relation between internal control quality and idiosyncratic and systematic risk, and the potential benefits of effective internal control in terms of cost of equity. Specifically, we investigate whether firms that disclose internal control deficiencies (ICDs) exhibit higher systematic risk, higher idiosyncratic risk, and higher cost of equity relative to firms with effective internal controls. Further, we investigate whether managements’ initial disclosures of ICDs and remediation of previously reported ICDs are related to changes in firms’ cost of equity.

We conduct both (1) cross-sectional tests to assess whether firms with ICDs present higher information risk to investors relative to firms having effective internal controls; and (2) inter-temporal tests to assess whether changes in the effectiveness of internal control yield changes in cost of equity consistent with changes in information risk. The results of our cross-sectional tests indicate that firms reporting ICDs exhibit significantly higher idiosyncratic risk, betas, and cost of equity relative to firms not reporting ICDs. These differences persist after controlling for other factors shown by prior research to be related to these risk measures. Our finding that differences in these risk measures pre-date the first disclosures of ICDs suggests that market participants’ assessment of non-diversifiable market risk (beta), idiosyncratic risk, and cost of equity incorporated expectations about internal control risks based on observable firm characteristics prior to firms’ initial revelation of control problems.

In an attempt to assess whether a causal relation may exist between internal control quality and firms’ cost of equity, we construct four sets of inter-temporal change analysis tests. The first inter-temporal test finds that ICD firms experience a statistically significant increase in market-adjusted cost of equity, averaging about 93 basis points, around the first disclosure of an ICD. In our second change analysis, we find that ICD firms that subsequently receive an unqualified SOX 404 opinion exhibit an average decrease in market-adjusted cost of equity of 151 basis points around the disclosure of the opinion. In contrast, for our third change test we find that ICD firms that subsequently receive adverse SOX 404 audit opinions, which indicate that internal control problems persist, exhibit a modest but insignificant increase in cost of equity around the SOX 404 opinion release. In our final inter-temporal change analysis, we find no significant cost of equity change for firms least likely to report an ICD, but a significant decrease in the average market-adjusted cost of equity of 116 basis points around the release of an unqualified SOX 404 opinion for firms most likely to report ICDs.

Collectively our cross-sectional and inter-temporal tests present consistent evidence that information risk as proxied by ineffective internal control is an important determinant of both idiosyncratic risk and systematic market risk that affects the market’s assessment of firms’ cost of equity. We document that firms with effective internal control or firms that remediate previously reported ICDs are rewarded with a significantly lower cost of equity.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memorandum by Randall Guynn and Margaret Tahyar of Davis Polk & Wardwell.)

The Treasury’s recently announced Financial Stability Plan reshapes the ground rules for capital injections into financial institutions, increases the size and scope of a previously announced non-recourse lending facility by the Federal Reserve, launches the idea of a public-private investment fund to purchase legacy or toxic assets from financial institutions and sets aside funds for the homeowner assistance plan outlined by President Obama on February 18. As has been widely noted, however, the plan is long on aspiration but short on detail.

Among the new features of the plan is a mandatory comprehensive “stress test” for banking institutions with assets in excess of $100 billion. Although “stress testing” is a term of art in the financial services and risk management realm and is an element of the risk-based approach taken by Basel II, the sense in which it will be applied by Treasury is unclear. The memorandum explores the possible meaning.

The plan also contemplates, but does not detail, ongoing measures to further enhance public disclosure of financial health. Political calls for more disclosure in the current environment, however, disguise the complexity of the issues that will have to be sorted out in order to arrive at a functional solution. Some of these challenges discussed in the memorandum include the possible necessity of international coordination in order to shape new norms for financial institution disclosures and the implications of the ongoing debate over mark-to-market accounting and dynamic provisioning.

In an effort to restart the currently illiquid market for legacy assets, Treasury announced the creation of the Public-Private Investment Fund. The key new feature of this initiative, compared to earlier discussions regarding an aggregator bad bank, is an element of private capital participation, although the specifics of this public-private partnership are still unclear. The memorandum discusses some of the challenges, including whether pricing mechanisms will indeed be easier to design due to private sector involvement.

Hardly any market has been more affected by the recent market turmoil than the private label securitization market. The pendulum appears to have swung from a failure of the financial markets to properly recognize and price the huge risks of certain securitization classes to a situation where securities backed by any asset class not also explicitly or implicitly backed by the government are virtually impossible to bring to the market. While banks have been broadly accused of being responsible for reduced lending activity, latest data published by Treasury shows that in fact, the absence of a functioning securitization market is the greatest contributor to a decline in lending. Therefore, it should come as no surprise that the implementation of a facility announced by the Federal Reserve in November of last year to revive the asset-backed securities markets, the Term Asset-Backed Securities Loan Facility, is greatly anticipated. The memorandum discusses salient features of the facility, including the manner in which it will allow for the participation of unregulated funds, and its potential expansion as part of the government’s plan.

The memorandum is available here.

In my paper Would Changes in the Rules for Director Selection and Liability Help Public Companies Gain Some of Private Equity’s Advantages?, to be published in Volume 76 of the University of Chicago Law Review, I examine whether changes in existing legal rules governing how public company directors are chosen and the extent to which public company directors can be held liable for damages if they do not have a conflict of interest would be likely to increase the ability of public companies to obtain some of the benefits that companies owned by private-equity sponsors appear to have. It is widely believed that companies owned by private-equity sponsors have significant advantages over public companies. Among the advantages of private equity cited by commentators are: (1) better governance and a greater willingness to take risks, (2) the ability to focus on long-term issues and a more stable shareholder base, (3) the ability to attract better management talent, (4) creating a sense of urgency, (5) the ability to use leverage more effectively, (6) avoiding the costs imposed by the Sarbanes-Oxley Act, and (7) freedom from shareholder suits. It would be helpful if public companies could gain some of these advantages. My conclusion is that, while changing the rules for selecting directors would not be worthwhile, a reduction in the potential liability of directors for damages in situations in which they do not have a conflict of interest would be likely to increase the ability of public company companies to mirror the effectiveness of private-equity portfolio companies without creating other problems that would be unacceptable.

The paper is available here.

(Editor’s Note: Previous posts on this blog concerning RiskMetric Group’s policy updates are available here and here.)

My colleague Laura A. McIntosh and I (with help from our colleague David Adlerstein) wrote an article entitled “RiskMetrics Update Continues to Hamper Director Discretion,” which discusses the 2009 updates to the domestic and international corporate governance policies of RiskMetrics Group (formerly know as ISS). RMG’s policy updates continue its trend of espousing policies that tend to shift corporate decision-making from boards of directors to shareholders, including activists and special interest groups. In particular, RMG’s updated policies seek to further limit directors’ discretion in areas traditionally within the board of directors’ clear authority under state law, including executive compensation, corporate governance matters and social policy.‬‪ ‬‪ As an example, RMG has revised its policy with respect to management proposals to ratify a shareholder rights plan. In addition to considering whether a shareholder rights plan includes RMG’s prescribed attributes (such as a 20 percent or higher triggering threshold and a shareholder redemption feature), RMG also will take into consideration a company’s existing governance structure, including board independence, existing takeover defenses and “any problematic governance concerns.” In the face of these new, subjective criteria, it remains to be seen in what circumstances RMG would, in fact, recommend in favor of adopting a shareholder rights plan. Importantly, RMG is continuing its policy of recommending “withhold votes” against an entire board of directors, if the board adopts or renews a rights plan without shareholder approval, does not commit to putting the rights plan to a shareholder vote within one year of adoption, or reneges on a commitment to put the rights plan to a vote and has not yet received a “withhold vote” recommendation for this issue. The article explains why we believe this policy update could be problematic for corporations in the current troubled market environment.‬ ‪ ‬‪

The article is available here.

(Editor’s Note: The post below by Commissioner Paredes is a transcript of remarks by him at the Practising Law Institute’s “SEC Speaks” Program in Washington, D.C., on February 6, 2009.)

It is a pleasure to be part of “The SEC Speaks in 2009.” This marks the first time I have participated in “SEC Speaks,” and I am honored to be with some of the nation’s finest securities lawyers — both inside the SEC and among the private bar. Before I begin, I must give you the standard disclaimer that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

* * * *

Today, we are persevering through a tumultuous economy that recalls the challenges giving rise to the SEC and the laws it administers as part of the New Deal. During the past year, we have witnessed the demise of investment banks that were considered permanent fixtures on Wall Street. The notion that these institutions could fail had been unthinkable. We also have read about fraudsters whose Ponzi schemes preyed on investors and have heard allegations of market manipulation. We have seen the housing market collapse, credit freeze, IPOs stall, and unemployment rise, all while the government has taken unprecedented steps to stem the troubles. It is no surprise that investor confidence has suffered.

During the midst of the economic crisis last year, the SEC itself took a particularly extraordinary step: temporarily banning short selling.

Although perhaps not readily apparent, short selling can advance important economic goals. It can result in more liquidity, more capital formation, and more efficiently allocated risk. Short selling can buttress buying by allowing investors that go long — in other words, that purchase shares to hold as investments — to hedge their positions; and short selling can encourage market participation by leading to improved price discovery. Investors may be more reluctant to buy if the more pessimistic views of short sellers are not fully reflected in securities prices.

Short selling also is tied to investor confidence. Investor confidence depends on investors’ faith in the integrity of markets. Investors expect that securities prices are meaningful in that they reflect the market’s overall assessment of what a company is “worth” by aggregating into a single number the different views of market participants. Accordingly, in promoting market efficiency, short selling can foster investor confidence, as investors can be confident that securities prices reflect both optimistic and contrarian views.

…continue reading: Why ban short selling of financial sector stocks?

(Editor’s Note: This post is based on an op-ed piece by John C. Coates and David S. Scharfstein published in today’s New York Times.)

Many Americans are angry at banks for taking bailout money while still cutting back on lending. But the government is also to blame. For reasons that remain unclear, the Troubled Asset Relief Program has channeled aid to bank holding companies rather than banks. The Obama administration’s new Financial Stability Plan will have more influence on bank lending if it actually directs its support to banks.

To see why, it’s important to understand the distinction between banks and bank holding companies. Banks take deposits and make loans to consumers and corporations. Bank holding companies own or control these banks. The big holding companies also own other businesses, including ones that execute trades both on their clients’ behalf and for themselves.

It would seem obvious that helping banks, not holding companies, would be the most direct way to stimulate bank lending. But when TARP purchased preferred stock and warrants, it bought them from holding companies, not their bank subsidiaries.

While TARP has been generous with bank holding companies, these companies have not been so generous with their banks. Four large holding companies — JP Morgan, Citigroup, Bank of America and Wells Fargo — initially received a total of $90 billion in TARP money in the fall, but by the end of 2008 they had contributed less than $15 billion in equity capital to their subsidiary banks.

The holding companies seem to have invested most of their TARP money in their other businesses or else retained the option to do so by keeping it in deposit accounts, even as the capital of their banks decreased. At the same time the banks, which provide the majority of loans to large corporate borrowers, drastically reduced lending to new borrowers.

It’s easy to see why holding companies would withhold capital from their troubled banks. If a bank is insolvent — as many are now believed to be — and the government has to take it over, the holding company loses any capital it gave to the bank. Rather than take that risk, the holding company can opt to spend its money elsewhere, perhaps on trading of its own.

But this is not a good use of scarce capital. We might end up with too much of this proprietary trading and too little lending. It also means that when it comes time to recapitalize banks there is a bigger hole to fill, and when banks fail there is less capital available to meet the government’s obligations to insured depositors and other creditors. Keeping money at the holding company may benefit its shareholders, but it is costly for taxpayers.

Bailouts, at the very least, should reach their target. When Washington wanted to help Chrysler, it gave money to Chrysler. It did not write a blank check to Cerberus, the private equity firm that owns Chrysler, in the hope that the money would somehow find its way to the carmaker and not to the other companies Cerberus owns.

Some politicians, frustrated that the government’s costly interventions have not had their desired effect, have wanted to mandate higher levels of bank lending. Others have tried shaming chief executives of financial institutions into lending more, as when Representative Mike Capuano of Massachusetts admonished eight of them who came before the House Financial Services Committee: “Start loaning the money that we gave you. Get it on the street!”

It would be more effective to simply ensure that the Financial Stability Plan is directed at banks. When the government buys stock, it should buy bank stock. And if it chooses to buy stock in holding companies, it should at least require that the new capital reaches the bank and non-bank subsidiaries that the government wishes to support. If the government chooses to help private investors buy toxic bank assets, as the planned Public-Private Investment Fund is supposed to do, it should not allow the banks to send those investments to their holding companies. And if the government decides to guarantee debt, it should guarantee the debt of banks, not of holding companies.

The Obama administration seems to understand that reviving bank lending is key to economic recovery. Now it needs to make sure that the banks get the money.

Readers interested in more information on the points in this op ed can read this forthcoming article in the Yale J. Reg.

(Editor’s Note: This post, which focuses on the executive pay restrictions imposed by the stimulus bill passed last Friday, is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal. A related op-ed piece by Professor Bebchuk, published earlier this month in the Wall Street Journal and dealing with the pay guidelines proposed by the Obama administration, is available here. Memoranda providing a detailed review and analysis of the restrictions by Wachtell, Lipton, Rosen & Katz and Sullivan & Cromwell LLP are available here and here, respectively. A memorandum by Davis Polk & Wardwell highlighting important interpretive questions raised by the bill is available here.)

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive TARP funding.

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives’ incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration’s proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach—constraining incentive compensation, limiting it to one third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance—not giving up on it altogether. Mandating that at least two-thirds of an executive’s total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill’s categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company’s operations. Their incentive pay might be best tied to the performance of their unit’s particular results, not to that of the whole company.

But even for top executives, the banks’ special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders’ equity, which is junior to the government’s investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank’s capital. Indeed, the value of some banks’ common shares might largely represent an “out-of-the-money option,” expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank’s survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank’s future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares’ value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank’s best interest.

The stimulus bill’s adverse incentives deserve special attention because of the government’s current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country’s banks have the right incentives is as important as ever.

The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. In a recently revised working paper entitled The Future of Securities Regulation, I analyze what the appropriate securities regulation is for this changed world. I start by reviewing the theoretical role for regulation: why and when competition in the marketplace is insufficient for protecting investors. I then compare the theoretical predictions with the experience of unregulated markets and their relative successes and failures. From this analysis, I derive three main areas of intervention.

First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board. This reform will make it worthwhile for directors to develop a reputation of acting in the interest of shareholders and hence to make corporate managers accountable. However, to minimize the risk that institutional investors pursue a self interested agenda, institutional investors should be themselves independent. To achieve this goal, I propose a new Glass-Steagall Act, which instead of separating commercial and investment banking will separate mutual fund management from investment and commercial banking.

The second reform should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all the expenses that will be charged to their investment, including the amount paid in trading commissions, itemized as commissions paid for trading and those paid for services. Similarly, at the time of the purchase, brokers should disclose the fee they receive on the different products they sell, including the “soft dollar” they receive in the form of higher trading costs. The same strict standards should apply to both brokerage accounts and money management accounts.

The third reform should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration from the former to the latter suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private market. In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. On the private market front, there are compelling reasons to mandate a delayed disclosure provision in which hedge funds, private equity funds, and even companies private equity funds invest in report information and performance with a 1 to 2 year delay. This delay has the benefit of reducing the competitive cost of disclosure, while at the same time allowing for a serious statistical analysis of this market, which will improve allocation of savings.

The full paper is available for download here.

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

The final version of the American Recovery and Reinvestment Act of 2009, which was passed by the House on February 13 and was expected to be passed by the Senate later that night, includes extensive new restrictions on the compensation arrangements of financial institutions participating in the Troubled Asset Relief Program (“TARP”). The new legislation, which the President is expected to sign into law shortly, rewrites Section 111 of the Emergency Economic Stabilization Act of 2008 (“EESA”) (1) and directs the Treasury Department to establish standards and promulgate implementing regulations.

TREASURY TO ESTABLISH NEW STANDARDS
The new standards will codify many of the executive compensation guidelines for TARP recipients announced by the Treasury Department on February 4, 2009, impose additional restrictions and apply to all existing and future TARP recipients. It is not clear whether the standards will be immediately effective or will only be effective after regulations are issued.

Under the legislation, the standards are required to include the restrictions and other provisions summarized below, which include a variety of terms the meaning and scope of which have not been made clear.

• Financial Institutions Affected. The restrictions apply to all entities that have received or will receive financial assistance under the TARP during the period the TARP recipient has an obligation outstanding that arises from TARP financial assistance. However, the restrictions cease to apply if the Federal Government only holds warrants to purchase common stock of the TARP recipient.

• Employees Affected. Many of the restrictions extend beyond the TARP recipient’s CEO, CFO and three next most highly-compensated executive officers (the “senior executive officers”) and apply to other highly-compensated employees as well. It does not appear that other highlycompensated employees need to be officers of the TARP recipient, nor do any provisions specify how to identify such highly-compensated employees (for example, whether based on current or prior year compensation, whether a potential highly-compensated employee could drop off the prohibited group because of the bonus limit and how compensation would be defined for this purpose.

…continue reading: Economic “Stimulus” Legislation to Impose New Executive Compensation Restrictions

(Editor’s Note: This post is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.)

The decline in the market capitalization of many companies has increased the number of pill adoptions, replacements and extensions. FactSet SharkRepellent’s data show that rights plan activity (i.e., adoptions, replacements and extensions) in 2008 was at the highest level since 2002 and more than 64% higher than 2007. A major reason for this uptick in activity has been the severe decline in market capitalizations resulting in an increased risk of opportunistic takeover threats, particularly for small cap companies.

OFF-THE-SHELF STRATEGY PROBLEMATIC FOR SMALL CAPITALIZATION COMPANIES

In recent years, most companies have not been adopting (or renewing) rights plans because of (i) diminished legal concern with respect to adopting plans in the “heat of the battle” and (ii) the RiskMetrics Group (”RMG”) policy, adopted in 2005, that generally recommends “withhold” or “against” votes with respect to directors who adopt a rights plan that is not subject to stockholder approval. Many companies have, therefore, refrained from adopting a pill with the knowledge that they could adopt a rights plan if and when a specific takeover threat emerged.

This “off-the-shelf” strategy is, however, not well suited to a company with a market capitalization that has fallen below roughly $500 million given the threat of an accumulation of control by an acquiror. The key warning signs of an accumulation—an antitrust filing under the Hart-Scott-Rodino Act ($65 million threshold) and a filing of a Schedule 13D (5% of the company’s outstanding common stock)–may not occur until after a substantial accumulation has already taken place. For example, if a company has a market capitalization of $250 million, then an HSR filing would not be required until the accumulation was at the 25% ownership level. While a Schedule 13D is required to be filed once the 5% threshold is crossed, there is a ten-day window before the filing is required. In addition, although Delaware’s “business combination” statute and similar statutes in other states limit the ability of stockholders who exceed specified ownership levels from engaging in certain business combinations for a prescribed period of time (e.g., three years following the threshold crossing in Delaware), these statutes do not prevent the actual accumulation of shares and the attendant implications of having a meaningful block of shares in the hands of an activist investor.

…continue reading: Rights Plans Offer Special Benefits for Some Companies

This post is by my colleagues Gail Lees, Andrew Tulumello, Chip Nierlich, Mark Whitburn and Chris Chorba.

Class action lawsuits are an increasingly pervasive force in today’s business world. Defending and defeating these cases efficiently and prudently is a top priority for many in-house legal teams and their outside counsel. This year-end update reports on key trends in class action practice. It provides an overview of Rule 23, reviews key class action decisions from 2008, and identifies important class action issues likely to be litigated in 2009 and in the years ahead.

The number of class actions has grown exponentially in recent years. Although reliable numbers are hard to come by, Federal Judicial Center statistics suggest that new class action cases filed in or removed to federal court increased 72% between 2001 and 2007,[1] reaching approximately 4,000 to 5,000 annually as of mid-2007 (the last period for which data are available). This represents more than a dozen new lawsuits every day.[2] And while the Class Action Fairness Act (”CAFA”) has shifted many putative nationwide class actions from the state to the federal system, our class action lawyers, who, according to Law360, are running one of the top five busiest federal class action practices in the country, report that state court class action activity in many courts has not diminished. CAFA has prompted a flurry of single-state class actions filed in state courts, and recent statistics show that in at least one forum favored by the plaintiffs’ bar (Los Angeles), state class action filings continue to grow.

Gibson Dunn predicts that these trends will increase in 2009, as recently enacted and anticipated legislation will expand the ability of the plaintiffs’ bar to bring new suits. Gibson Dunn already is seeing a surge in labor and employment, consumer fraud, and products liability litigation. That trend will continue, as a new administration and Democratic Congress enact laws–such as the Lilly Ledbetter Fair Pay Act–that expand or create new legal remedies, and cut back on or repeal federal statutes and administrative regulations that have in the past preempted state-law based suits.

Gibson Dunn also expects the Supreme Court to enter the debate over Rule 23. To date, there has been a significant mismatch between the Supreme Court’s docket and the pervasiveness of Rule 23 cases in the federal system. Despite the overwhelming number of class action cases flowing through the federal judiciary, the Supreme Court has continued to steer clear of core Rule 23 and class certification issues for many years–a trend that should not and cannot last much longer. In the last five terms alone, the Supreme Court has decided seven tax cases, six ERISA cases, five Title VII cases, and five cases under the Age Discrimination in Employment Act. However, in the last thirty-five years, the Supreme Court has decided fewer than a dozen cases involving core class action issues.[3] Splits across an important range of issues continue to develop and percolate in the lower courts, and it is appropriate and urgent for the Court to provide much-needed guidance on these issues.

…continue reading: Year-End Update On Class Actions

My recent book, The Case for Big Government, argues that America has been the victim of an anti-government ideology that has grown more intense, even under a Democratic president, Bill Clinton, since the late 1970s. It has long been part of the American national character to look with suspicion on government. After all, its very origins were a rebellion from central government tyranny.

But, in truth, America when it worked best, in my view, America used government robustly to embed its social and political values but also to create a foundation and capacity for economic growth and prosperity. The case against big government has always been ahistorical. There is no wealthy nation in the world today that does not have a big government.

Of course, some governments are bigger than others as a proportion of GDP. But the cross-country evidence is now clear. There is no statistical relationship between the size of government and the rate of growth of GDP per capita or productivity. The implication is that in many nations where government spending constitutes up to 50 percent of GDP, spending and outer social programs must in some ways significantly enhance productivity and build foundations for prosperity.

Because of America’s anti-government ideology, there is now a long and urgent to-do list in the nation. Too much has been neglected because of an over-reliance on markets and a distaste for taxes and new government programs. The list includes health care reforms, transportation and communications infrastructure, pre-K education, equal funding of k-12 education, alternative energy research and national energy policies, family work policies, among other issues. These are now at a critical stage. In time, when crisis passes, they will require an increase in taxes to pay for them.

The list also includes the need to focus serious attention on re-regulating American business. The dependence on financial markets to support growing overall demand through the issuance of debt, and also to remunerate CEOs and other high executives through the equity markets, is a direct reflection of faith-based ideology, not practical empiricism.

Despite the American mythology, there has never been laissez faire government in the U.S. Neo-classical economics provides much justification for government intervention and spending. But the extent is a matter of debate. Other economic theories are perhaps more relevant today.

America’s history may provide the stronger empirical case for government. Time and again, government changed in America to meet new needs. Even Jefferson, the heroic defender of laissez faire, bought Louisiana and demanded that there be regulations to control the sale of land. His party’s successors built the nation’s canals and free primary schools. The list goes on: grants of land to build colleges; land donations to subsidize the railroads; the building of sanitation systems, critical to the development of cities; the development of high schools; the building of roads and highways and parks; the subsidies of college and healthy research, and of course a century’s worth of laws to protect workers, make products safe, and, since the early 1900s, with many additions along the way, to regulate finance.

Most important, government is the nation’s key agent of change. There are no permanent rules as to where it can go and what it can do. These must be fluid, because societies and economies grow, and knowledge and expectations evolve.

(Editor’s Note: This post is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.)

A bill introduced in the Senate on January 29, 2009 would generally require private funds to register with the U.S. Securities and Exchange Commission and impose other regulatory requirements, including the filing of information for public disclosure such as the identity of investors and the value of fund assets. The “Hedge Fund Transparency Act” (the “Bill”) was introduced by senior senators Carl Levin (D-MI) and Chuck Grassley (R-IA). Despite the name of the Bill, it applies to all types of private funds and not just hedge funds.

ALL TYPES OF PRIVATE FUNDS REGULATED
Unlike recent unsuccessful regulatory efforts focused only on the hedge fund industry,[1] the Bill would apply to nearly all types of private funds. Aside from certain de minimis exclusions (e.g., funds with assets of less than $50,000,000), all hedge funds, private equity funds and other private funds would be subject to the new regulations through proposed amendments to the definition of an investment company in the Investment Company Act of 1940 (the “Investment Company Act”). Traditionally, private funds have relied on exemptions from the definition of an investment company under the Investment Company Act pursuant to §3(c)(1) (exempting any issuer whose securities are privately placed and owned by no more than 100 investors) and §3(c)(7) (exempting any issuer whose securities are privately placed and owned exclusively by “qualified purchasers”). The Bill proposes to amend the definition of “investment company” by deleting those two exemptions in their entirety, moving them to become the new §6(a)(6) (formerly §3(c)(1)) and §6(a)(7) (formerly §3(c)(7)). The text of the replacement sections would remain largely the same, with the notable differences that funds falling under these sections would now be considered “investment companies” and any “large investment companies” (funds with assets of $50,000,000 or more) would be required to meet certain registration and reporting conditions in order to be excluded from the onerous regulatory requirements otherwise imposed on investment companies required to register under the Investment Company Act (i.e., mutual funds).

PROPOSED REPORTING REQUIREMENTS
The Bill would impose the following registration and reporting requirements on any private fund relying on §6(a)(6) or §6(a)(7) with assets of $50,000,000 or more:

• Registration with the SEC

• Maintenance of such books and records as the SEC may require

• Cooperation with the SEC in regard to any request for information or examination

• The filing of an electronically-searchable “information form” at least once a year to be made publicly available by the SEC and to include information such as:

• the names and current addresses of each natural person who is a beneficial owner of the fund, any company with an ownership interest in the fund and the primary accountant and primary broker of the fund,
• an explanation of the structure of ownership interests in the fund,
• information on any affiliation that the fund has with another financial institution,
• a statement of any minimum investment requirement,
• the total number of investors, and
• the current value of the assets of the fund and any assets under management by the fund (apparently on an aggregate basis rather than on an investment-by-investment basis).

The Bill’s requirement of public disclosure of the names of private fund investors is likely to spark debate. The policy rationale for providing public disclosure of the names and addresses of investors in private funds is unclear and raises significant privacy concerns, especially for entities used in personal planning contexts.

…continue reading: Subjecting Private Funds to SEC Registration and Oversight

(Editor’s Note: This post comes to us from Stavros Gadinis, who is a Post-graduate Fellow at Harvard Law School.)

A paper I recently posted on SSRN, “Is Investor Protection the Top Priority of SEC Enforcement? Evidence from Actions Against Broker-Dealers,” provides the first empirical account of SEC enforcement efforts against the firms at the center of the current market turmoil: investment banks and brokerage houses. It suggests that the SEC favors defendants associated with big (listed) firms compared to defendants associated with smaller firms. Moreover, the paper finds tentative support for the hypothesis that SEC officials favor prospective employers.

The paper uses a new dataset of all SEC actions against broker-dealers in 1998, 2005, 2006, and the first four months of 2007. It presents systematic data on the types of violations the SEC pursues, the typical sanctions it imposes, and the enforcement venues (courts and administrative proceedings) and settlement patterns in its actions. More importantly, the paper investigates whether the SEC treats large and well-known investment houses more favorably than small broker-dealers. Because the SEC may choose to pursue a broker-dealer by either filing a civil lawsuit or by initiating administrative proceedings before an administrative law judge, the paper first explores the factors that determine the agency’s choice of venue. Courts are a worse forum for finance professionals, since, conditional on a finding of violation, a court is more likely than an administrative law judge to ban defendants from the securities industry. The paper finds that, for the same violation and comparable levels of harm to investors (proxied by disgorgement awards), big firms and their employees are more likely to avoid courts and face administrative proceedings instead.

The paper then turns to administrative cases, which the SEC controls more directly than court cases. Again, the paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are less likely to receive a ban from the securities industry, compared to small firms and their employees. Some theories could justify the differential treatment of large and small firms, on the basis of systemic risk considerations or concerns about unduly penalizing entire firms because of limited violations. However, no public policy justification exists for the preferential treatment of individual employees in large firms.

Despite controls concerning violation types and levels of harm, it is possible that big firms’ conduct is systematically less reproachable than small firms’ conduct, because of better compliance systems, higher quality personnel and sophisticated clients. To address these concerns, the paper presents qualitative evidence on a subset of cases where these concerns would be greatest: cases involving a failure to supervise subordinates. It finds that small- and big-firm violations are so similar in terms of fact-patterns, types of supervisory failures, and specific omissions, that they are virtually indistinguishable from a law enforcement perspective.

Finally, the paper tentatively links the above results with concerns about the post-SEC career trajectories of agency officials, who find employment in big firms’ compliance departments or in premier law firms. The paper shows that big firms headquartered in favorable locations receive lower sanctions than big firms around the country, indicating that SEC officials may respond to future employment prospects. The paper also provides some evidence that variation in the quality of legal representation between big and small firms cannot account for the observed differences in sanctions, because these differences persist even for cases where both big and small firms are likely to hire outside counsel.

The paper is available here.

(This post is by Michael Raffan and Andrew Marsh of Freshfields Bruckhaus Deringer LLP in London.)

This post outlines what the alleged Madoff fraud involved and how it was able to happen. It looks at relevant aspects of the US regulatory system and draws attention to some similarities in the UK system.

The Madoff debacle
Bernard Madoff’s alleged Ponzi scheme is reported to have cost clients $50bn. His business was run through Bernard L Madoff Investment Securities (‘Madoff’), based in New York. For years it appeared that Madoff was consistently making large returns from a sophisticated investment strategy involving purchases of equities hedged by out-of-the-money put-and-call index options. It now seems that those returns were fictitious and that payments to investors were being financed from the proceeds of new investments.

Not a hedge fund story
Initially the press reported this as a hedge fund story, no doubt because of Madoff’s purported complex investment strategy. But it seems that Madoff did not establish a hedge fund as an investment vehicle. Instead, it simply managed clients’ investment portfolios on a segregated, client-by-client basis. Indeed, Madoff seemed particularly keen to minimise the number of legal entities involved. It not only managed the accounts as discretionary investment manager, it also executed the trades itself as broker and acted as the custodian of clients’ cash and investments.

Ironically, it would have been much harder to maintain a fraud if Madoff had operated a hedge fund. Although hedge funds are typically established in less heavily regulated jurisdictions, they generally use an independent administrator, third party brokers and a custodian (often a prime broker) that is not itself the investment manager. The need for frequent reconciliations between the various confirmations, statements, reports and records of these entities makes concealment of fraud much more difficult.

Madoff and the regulatory system in the US
Inevitably, questions are being asked about whether the Madoff debacle has shown up deficiencies in the US regulatory system. The US system clearly distinguishes between broker dealers on the one hand and investment advisers (including discretionary investment managers) on the other hand. Madoff operated both types of businesses, which it carried out on separate floors of the same building. Initially it was registered only as a broker dealer. It claimed that its discretionary investment management activity did not require it to register as an investment adviser because it was remunerated only by trading commissions, rather than by a percentage of assets under management or profits.

Following various allegations of potential fraud, a Securities and Exchange Commission (SEC) enforcement investigation was launched in 2006. Although this failed to find any evidence of fraud, Madoff was found to be in breach of the investment adviser registration requirement. Madoff then registered as an investment adviser (in addition to its broker dealer registration) in September 2006. Madoff’s investment advisory business therefore became subject to the SEC’s regular inspection regime for investment advisers in 2006. But no inspection had in fact been carried out before the firm’s collapse.

Does any of this suggest that changes are needed to the US regulatory system? Clearly the SEC’s failure to detect fraud in its 2006 investigation suggests that there may be lessons to be learned about how such investigations should be conducted. But it is difficult to tell at this stage how far the SEC was at fault in this respect. If Madoff had been required to register as an investment adviser much sooner, there would have been a greater chance of detecting problems earlier. However, it is much more difficult to detect fraud when one or a few individuals are able to maintain control over books and records without any independent examination of whether the transactions in those books and records are real. It also appears that SEC investigators lacked the financial sophistication to understand that Madoff’s financial results were highly suspect – even though a number of commercial banks and brokerage houses harboured suspicions about this business activity and therefore refused to deal with Madoff.

One of the most interesting aspects of this case is that the concentration of investment functions in one place is not prohibited under the US regulatory system. There is nothing to prevent an investment adviser from acting as custodian, broker and administrator. This is the case even for ordinary retail and unsophisticated investors. By contrast, regulators have long recognised the importance of segregation of functions within a firm to prevent, for example, the same individual from performing both trading and settlement functions. The fact that no such requirements apply at the level of the firm itself allows opportunities for fraud if the firm is institutionally corrupt.

Could it happen here?
The simple answer is ‘yes’. Importantly, the UK system is the same as the US’s in allowing investment management, execution and custody to be performed by the same entity firm, even for retail clients. The more flexible Financial Services Authority (FSA) system based on ‘risk‑based’ regulation may have led the FSA to keep a closer eye on the firm’s operations, but that would of course have depended on the FSA having identified the firm as being higher risk in the first place. The job of assessing a firm’s risk profile is a difficult one, which seems deceptively easy only with hindsight. In the light of the Madoff experience it seems likely that the concentration of investment functions in a single firm will rank more highly as a risk factor with the FSA.