(Editor’s Note: This post comes to us from Glenn Curtis, Director of Strategic Research at Thomson Reuters.)

Thomson Reuters has recently released its Strategic Research Report on Shareholder Activism for 2008. The report focuses on activist situations that have taken place from October through December 2008. It also details success and failure rates and other data pertaining to activist situations in 2007 and 2008. The source for this data was Thomson’s SDC Platinum™ database, the SEC, and various press releases.

Highlights from the report include the following:

• For the full year 2008 Information Technology and Consumer Discretionary companies were among the top targets for activist firms. This is consistent with previous research. In fact, Consumer Discretionary companies have been among the top targets for the last two years.

• The average target company in the fourth quarter of 2008 had a market capitalization of just $28.2 million. That was a significant decline from the $4.93 billion that was recorded in the third quarter. A decline in the share prices of the targeted companies may be one reason for the low market cap. However, it is worth noting that the companies that were targeted were smaller cap companies to begin with.

• The most common demands that activists made for the year were for board seats and to buy/sell the target company. Board seats have consistently been a top demand according to our prior research.

• The number of cases where activists were successful in achieving their goals declined from 2007 to 2008, while the number of compromise situations increased. More specifically, for the full year 2008 activists achieved their goals 29% of the time and compromise was reached 38% of the time. In 2007 activists were successful 41% of the time and compromise was reached in 12% of cases.

• Big name activists such as Carl Icahn and Pershing Square and others were notably absent from new activity in the fourth quarter. However, both were active throughout 2008 in several high profile cases.

• If historical patterns hold true, look for an uptick in activism cases in Q1 2009. Companies should be on high alert!

The report is available here.

Alcatel-Lucent Chairman Philippe Camus was recently a guest speaker in Visiting Professor Laurent Cohen-Tanugi’s course on Transatlantic Mergers & Acquisitions. Mr. Camus, who expressed himself in his personal capacity, took on his position as Chairman in the second year following the merger of Alcatel and Lucent after the withdrawal of the executive team (Serge Tchuruk and Pat Russo) who negotiated and began implementing the merger. He was formerly CEO of EADS, the European aerospace and defense group.

Mr. Camus’ talk reflects on the implementation of the Alcatel-Lucent merger and draws broader lessons on the post-merger integration process and how to maximize the chances of success in a cross-border merger.

The presentation begins with an overview of Alcatel-Lucent and of the global consolidation of the telecommunications equipment and services market, which was the primary business rationale for the merger. Mr. Camus then goes on to address the specific challenges involved in the Alcatel-Lucent transaction, as a “merger of equals” and a cross-border business combination, in a technology-driven industry. In his view, the key success factors of a merger of that scale include a sound business case, clear leadership at the top to drive the integration process and manage the transition, speed of decision-making and implementation, and empowerment of middle management. Based on an employee survey conducted shortly after the merger, Mr. Camus believes that the integration process suffered from an excessive focus on “synergies” and cost-cutting, as opposed to innovation, operational efficiency and customer solution.

Two years after, drawing on these lessons, Alcatel-Lucent has a new executive team and a new board, which are implementing a new organization and business model.

A video of Mr. Camus’ presentation is provided below:

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today in FinancialTimes.com. Professor Bebchuk’s most recent posts about the Public-Private Investment Program are available here and here.)

Should banks with large amounts of troubled assets be allowed to participate as managers or investors in funds set up under the US’s public-private investment programme? The way the scheme is currently designed not only permits such banks to take part, but encourages them to do so.

Media reports indicate that some such banks are considering participating in funds established under the administration’s programme. Allowing such participation, however, is counterproductive. The effectiveness of the programme would be significantly enhanced if it were prohibited.

The programme’s design does not impose restrictions on the participation of such banks as private investors in funds set up under the scheme.

Furthermore, the qualifications for managers making purchasing decisions in these funds encourage, rather than discourage, participation by such banks as managers. In the legacy securities programme, managers must own at least $10bn in certain mortgage-backed securities and residential mortgage-backed securities. This high bar is one that some of the banks burdened with toxic paper will meet but that some large hedge funds active in this area will be unable to reach.

One problem with allowing banks clogged with troubled assets to participate on the buying side is that it defeats one of the programme’s main goals: to cleanse the balance sheets of these banks of troubled assets and thereby remove the uncertainty about the value of these assets that may currently impede the banks’ operations.

Allowing these banks to participate on the buying side in the programme’s activities will increase, rather than decrease, the amount of troubled assets that the bank owns directly and indirectly. It thus will increase the amount of assets with uncertain value on the banks’ books and delay rather than accelerate the banks’ return to normal operations.

The second problem with the participation of banks with large holdings of troubled assets on the buying side is that it will exacerbate the misalignment of interests between the private side in funds set up under the programme and taxpayers. To enhance the programme’s effectiveness and protect the interests of taxpayers, the interests of the private side - the fund’s manager and the private investors affiliated with it - should be aligned with the interests of taxpayers.

Under the current design of the programme, the private side will face asymmetric payoffs, capturing half of the upside but having to bear a smaller share of the downside. Critics have pointed out that such asymmetric payoffs would provide powerful incentives to seek assets with volatile value and over-pay for them. In another op-ed piece, I show how the programme can be redesigned, without discouraging the participation of private parties, to align the interests of the private side with those of taxpayers by providing the private side with the same share of both the upside and the downside.

Even if the programme were redesigned to provide the private side with the same share of the upside and downside, however, banks acting as managers of funds set up under the programme would still have distorted incentives. If a bank holding large amounts of toxic securities is selected as a fund manager in the legacy securities programme, and the fund subsequently pays excessively high prices for troubled assets, the bank might derive from such high prices benefits not shared by taxpayers invested in the fund.

To be sure, the programme’s current design prohibits transactions that are blatantly conflicted, barring each fund from purchasing assets from affiliates of its manager or from 10 per cent plus private investors in the fund. To the extent that prices paid for troubled assets affect the valuation of other troubled assets, however, a bank managing a legacy securities fund may have distorted incentives to overpay for troubled assets even when buying them from other banks.

It follows that banks holding significant amounts of troubled assets- the intended sellers under the programme-should not be allowed to participate on the buying side either as fund managers or as investors in funds. Their incentives are likely to be especially distorted, and their buying additional troubled assets either directly or indirectly would go against what the programme seeks to accomplish, both at a significant cost to the taxpayer.

To be sure, participation by banks on the buying side could provide them with significant profits, and thus would strengthen their capital positions. But transferring value to banks holding troubled assets in order to bolster their capital should not be a goal of the programme for buying assets; injection of capital into banks should be made only for consideration in securities and should be targeted at those banks that need additional capital, not banks holding troubled assets in general.

The Securities and Exchange Commission will hold a roundtable at its headquarters in Washington, DC today to discuss issues raised by its recent proposals to restrict short sales. Questions will be directed to three main topics: 1) Market Changes and Investor Confidence; 2) Bid versus Tick versus Circuit Breakers; and 3) Lessons and Insights from Empirical Data. In anticipation of the roundtable, we have issued a memorandum entitled “Short Sale Proposals: Key Questions,” which focuses on the structure of the SEC’s recent proposals and the key questions raised by them.

In response to public outcries for a regulatory response to sharp declines in equity prices, on April 10, 2009 the SEC released a set of proposals to restrict short sales (the “Release”). The proposals would reverse the SEC’s elimination – after extensive economic analysis and policy debate – of its prior uptick rule and other
short sale restrictions in 2007.

For nearly seventy years – from 1938 to 2007 – Rule 10a-1 under the Securities Exchange Act of 1934 generally prohibited short sales on listed stocks unless they occurred in a rising market (i.e., on an “uptick”). Specifically, short sales were permissible at or above the last sale price, with short sales at the last sale price permitted only if the last different sale price was below the last sale price. From 1994 to 2007, Nasdaq maintained a “bid test” for securities traded on its market. These rules were intended to prevent speculators from pushing down stock prices through short sales.

In response to clamor to restore the original uptick rule, the SEC has proposed, among other alternative approaches, a slightly updated version of the rule. Noting, however, that the operation of the market has changed dramatically since the abrogation of Rule 10a-1, the SEC also has proposed four alternative short sale rules to better accommodate the market realities of 2009. One proposal limits short sales into a declining bid price rather than a declining last sale price. The other three proposals employ “circuit breakers” that are triggered by a specified stock price drop and either temporarily halt short sales altogether or institute price restrictions based on last sales or bid price.

The SEC’s proposals contain very limited exceptions. As written, these exceptions might not cover most convertible arbitrage and equity derivatives hedging as those activities are currently conducted. We have also issued a companion piece, entitled “SEC Proposed Short Sale Restrictions: Implications for Equity Derivates and Equity-Linked Securities,” which focuses on the particular implications of the proposals for equity derivatives and equity-linked securities.

The Release contains nearly 200 questions on which the SEC seeks comment. Also significant are the specific issues on which the SEC did not ask for comment, which may indicate the SEC is predisposed toward certain rule outcomes.

The memorandum entitled “Short Sale Proposals: Key Questions” is available here, and the memorandum entitled “SEC Proposed Short Sale Restrictions: Implications for Equity Derivates and Equity-Linked Securities” is available here.

My firm has published the following memorandum on recently-adopted amendments to the Delaware General Corporation Law.

SUMMARY
The Delaware legislature has enacted a number of amendments to the Delaware General Corporation Law (the “DGCL”) relating to the governance of Delaware corporations. The amendments address current corporate governance issues concerning: (i) proxy access and expense reimbursement; (ii) director indemnification and advancement of expenses; (iii) judicial removal of directors; and (iv) flexibility in setting record dates by providing that the record date for mailing the notice of meeting need not be the same as the record date for determining stockholders entitled to vote. The effective date of the amendments is August 1, 2009.

PROXY ACCESS AND EXPENSE REIMBURSEMENT
The amendments include the addition of two new provisions that relate to permissible bylaw provisions governing proxy contests. The effect of these changes is not to mandate either proxy access or expense reimbursement (unlike North Dakota’s 2007 statute which does so), but rather to provide a list of nonexclusive provisions that might be contained in a bylaw addressing proxy access or proxy solicitation expense reimbursement. As such, the amendments make no change in the Delaware law—properly constructed bylaws containing such provisions would almost certainly have been permissible under Delaware law prior to the adoption of these provisions. Nor do the amendments mandate the restrictions that are suggested—the statute simply provides that a bylaw may contain certain procedures or conditions, and lists a number of potential provisions. Adoption of these provisions does nonetheless clarify that under Delaware law, issuers may impose restrictions on proxy access and proxy expense reimbursement bylaws, which may influence, as a practical or legal matter, any future federal legislation or rule-making on the subject.

New Delaware Provisions on Bylaws Concerning Stockholder Access to Proxy Materials
The amendments include a new Section 112, which states that a corporation’s bylaws may provide that if the corporation solicits proxies with respect to an election of directors, the corporation may be required to include individuals nominated by stockholders, in addition to individuals nominated by the board of directors. The new statute provides that the right of access to the corporation’s proxy materials may be conditioned on a number of factors or procedures, which may include the following:

• Minimum record or beneficial ownership, or duration of ownership, of shares of the corporation’s capital stock. The bylaws may define beneficial ownership to take into account options or other rights in respect of or related to the corporation’s capital stock.

• Submission of specified information concerning the stockholder and the stockholder’s nominees, including information concerning ownership by such persons of shares of the corporation’s capital stock, or options or other rights in respect of or related to such stock.

• Eligibility for inclusion in the proxy materials based on the number or proportion of directors nominated by the stockholder or whether the stockholder previously sought to require access to the corporation’s proxy materials.[1]

• Prohibitions on nominations if the nominating stockholder, the stockholder’s nominee or any affiliate or associate of the nominating stockholder or nominee has acquired, or has publicly proposed to acquire, shares constituting a specified percentage of the voting power of the corporation’s outstanding voting stock within a specified period before the election of directors.

• A requirement that the nominating stockholder undertake to indemnify the corporation for any losses arising as a result of any false or misleading information or statement submitted by the nominating stockholder.

…continue reading: Delaware Adopts DGCL Amendments

(Editor’s Note: This post comes from Ana Albuquerque of Boston University.)

Agency theory suggests that the compensation of chief executive officers (CEOs) should be linked to firm performance to motivate CEOs to maximize shareholder value. Further, the hypothesis of relative performance evaluation (RPE) states that the firm performance measure used in CEO pay should exclude the component driven by exogenous shocks. Despite much research in this area, the lack of consistent empirical evidence supporting the use of RPE in CEO compensation is an important unresolved puzzle. In my forthcoming Journal of Accounting and Economics paper Peer Firms in Relative Performance Evaluation, I study how the choice of peer group affects tests of RPE, which is a joint test of how incentives are granted and of what constitutes a peer group. Previous tests potentially lack power to detect evidence that supports RPE because peer groups chosen by researchers are incorrect. The challenge in choosing a RPE peer group is to identify the set of firms that are exposed to common shocks and share a common ability to respond to those shocks.

Ideally, a peer group should include firms that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Yet considering all such characteristics simultaneously is not practical because it could result in peer groups composed of too few firms, which would be too noisy to filter external shocks. In this paper, I show that industry and firm size capture many of these characteristics. Specifically, when peer groups consist of firms within the same industry and size quartile, my empirical results show systematic evidence supporting RPE usage in CEO pay. The analysis includes both the level and the growth of total compensation flow regressed on firm stock performance, peer stock performance, and control variables.

To compare with previous studies, I test whether RPE is used when measuring peer performance with two common peer group definitions, namely, the S&P 500 index and firms within the same industry. I fail to find consistent evidence of RPE usage with either peer definition. I also find no evidence that accounting returns substitute for RPE in stock returns, or evidence of RPE in accounting returns when using industry-size peers. Last, I test for the presence of RPE when peer groups are formed based on industry plus other firm characteristics, such as diversification, financing constraints, and operating leverage. The evidence is inconsistent with RPE when using such peer groups. Evidence exists to support RPE usage in the level and growth of CEO pay when peers are defined as firms in the same industry and growth options quartile. However, when both industry size and industry-growth options peer performance are included, the results show that only industry-size peer performance is filtered from CEO pay.

The full paper is available for download here.

(Editor’s Note: This post is by John M. Reiss, Matthew J. Kautz, Thomas E. Lauria, and Gerard H. Uzzi of White & Case LLP.)

The beginning of the credit crisis in mid-2007 and other recent economic trends have increased the number of distressed companies that are seeking to sell assets as part of their plans to improve their financial condition or undergo other corporate debt restructurings. Based on recent financial data, the number of distressed companies soared from the fall of 2007 to the summer of 2008, as have the number of downgrades of corporate bonds.

Companies with sound fundamentals may become available at attractive prices in the coming years, particularly compared to the sometimes-inflated valuations attached to many companies in the non-distressed market. However, buying distressed assets and companies inside or outside of bankruptcy court poses certain potential dangers and challenges that do not present themselves in the non-distressed M&A market, but also offers more significant upside opportunities for potential purchasers. To capitalize on these opportunities, buyers need to be especially focused on identifying distressed sellers and conducting the acquisition process in a manner that minimizes these dangers while maximizing these opportunities as much as possible.

As more fully discussed in our chapter entitled “Important Tools in Distressed M&A Transactions,” the Chapter 11 process may provide both buyers and sellers with tools that will help them make the best of a distressed merger and acquisition transaction. Among other topics, the chapter considers practical considerations for buyers in distressed M&As, agreements in distressed M&As, and acquisitions pursuant to a ‘363 Sale’ or a confirmed chapter 11 plan.

The chapter is available here.

(Editor’s Note: This post is by Grace Lamont of PricewaterhouseCoopers.)

In PricewaterhouseCoopers’ 13th annual evaluation of private securities class action lawsuits, one thing is glaringly obvious: While 2008 was an extraordinary year for litigators, it also demonstrated how extremely vulnerable giant financial institutions and entire economies are to fissures in the financial system.

In the seemingly free-falling economic environment of the latter part of the year, we witnessed unprecedented events: Major failing institutions, systemic breakdowns in the financial system, and record government bailouts throughout the globe. All of this set the stage for notable litigation activity and trends.

US regulatory authorities focused on the players within various areas of the financial markets: mortgage companies, investment banks, broker-dealers, and insurance companies. The SEC secured some of the largest settlements in its history from firms charged with misleading investors. At the close of the SEC’s fiscal year, 50 investigations relating to the financial crisis were ongoing. The SEC and DOJ secured record settlements for FCPA violations. Both regulatory bodies pledged to continue pursuing FCPA violations going forward.

Fuelled by the financial crisis, federal securities class actions increased for a second year, and, not surprisingly, the financial services industry group was the most frequently sued, replacing high-technology companies for the first time since the passage of the PSLRA. Public and union pension funds continued to be the most active lead plaintiff in institutional investor filings, and a number of filings alleging Ponzi schemes emerged in the latter part of the year.

We also observed certain downward trends: The number of accounting-related cases as a percentage of total filings declined, and, likewise, the number of settlements recorded declined to the lowest number in any year this decade. Similar declines in settlement values, however, did not follow.

On the foreign securities litigation activity front, federal securities class actions filed against foreign private issuers (FPIs) jumped to an all-time high since the passage of the PSLRA. The number of FPI accounting-related cases doubled to 16 cases in 2008, while the average settlement value of FPI cases overall decreased. The number of foreign companies registered with the SEC continued to slide downward for a third year.

While the ramifications for 2009 and beyond remain to be seen, one thing is certain: The worldwide economic crisis will transform the financial industry and shape future regulation and enforcement.

As editor of the 2008 Study, I am appreciative to a handful of exceptional team members in the PricewaterhouseCoopers Securities Litigation and Investigations Practice, particularly my co-author, Patricia Etzold, for her scrutiny of global litigation activity. I extend additional thanks to Laura Skrief, Luke Heffernan, and Kevin Carter, who all provided meticulous analysis of the 2008 filings and invaluable contributions to the project at large.

Lastly, we are tremendously grateful for the editorial contributions from the law firms Hunton & Williams LLP and Sullivan & Cromwell LLP, in addition to Tricia Howse from the SFO, for the UK perspective on international regulatory cooperation.

The study is available here.

Linking to the PricewaterhouseCoopers site does not imply any endorsement by PricewaterhouseCoopers of the services or products being offered by Harvard Law School.

(Editor’s Note: This post is based on an op-ed piece by Professor Roe in today’s Wall Street Journal.)

Yesterday, Chrysler filed for Chapter 11 bankruptcy protection in preparation for a partnership with Italy’s Fiat. President Barack Obama says he hopes the bankruptcy proceeding will be quick and efficient, done in 30-60 days. I hope so too. But a Chrysler bankruptcy has many moving parts — and with Chrysler unable to make money selling cars, it just doesn’t have enough nongovernment cash to grease those moving parts to facilitate a smooth bankruptcy. Chrysler is in worse shape than GM. And remember, Fiat has yet to offer a penny for its 20% share in Chrysler.

This could get messy and easily last longer than the 30-60 days now advertised. First off, in a bankruptcy any single creditor is entitled to get the liquidation value of its claim, under 1129(a)(7) of the Bankruptcy Code and the bankruptcy judge cannot approve a plan of reorganization that fails to comply with 1129(a)(7). So any creditor can assert that what it would get if Chrysler sold its factories quickly would be more than the 32 cents per dollar that Treasury had guaranteed Chrysler’s secured creditors before the government deal fell apart this week.

Valuation proceedings are notoriously difficult in Chapter 11. Although the judge doesn’t actually need to liquidate Chrysler, the judge must determine what it would have gone for if there were a liquidation. Some creditors appeared ready to bring that case to the bankruptcy judge. While the judge may in the end conclude that Chrysler’s liquidation value is less than the 32 cents the creditors would receive, with public estimates now varying substantially, a valuation hearing if brought, and if not suppressed with a quick estimate from the judge, is not likely to allow the proceeding to close within 30-60 days.

On top of liquidation value, the whole class of secured creditors is entitled to the fair value of their claims for any deficiency portion not satisfied by the value of the security. Usually that value is greater than liquidation value, though Chrysler may be an exception.

The government thinks the additional value issue will be resolved easily. That’s because in a bankruptcy proceeding the creditors whose claims amount to two-thirds of the total amount of debt can bind the rest to take the deal. Indeed, the judge doesn’t have to figure out whether value is fair, if the class of creditors votes in favor. And since two-thirds have already raised their hands in favor of 32 cents on the dollar, it seems to be a done deal.

But this time it might not be so easy. Not all of those who’ve already raised their hands in favor prior to bankruptcy, especially the smaller investors, will still be raising their hands inside Chapter 11. They can change their mind, and some just didn’t want any negative publicity before the bankruptcy.

Worse, there could be a legal fight over whether the vote of Citibank and the other “big four” creditors — J.P. Morgan Chase, Morgan Stanley and Goldman Sachs, who together hold 70% of Chrysler’s debt — should be counted toward the two-thirds threshold that would bind the company’s other 42 creditors. The Bankruptcy Code requires that the votes of creditors be given in “good faith.” It won’t be hard for the smaller creditors to argue that Citibank and other TARP recipients’ votes aren’t in full good faith. In agreeing to Treasury’s offer of 32 cents for each $1 of their debt, the objectors would say, Citibank and some others were influenced by the fact that Treasury was keeping them afloat with federal subsidies. If this type of litigation begins, it won’t be easily resolved.

…continue reading: Obstacles to a Quick Chrysler Bankruptcy

(Editor’s Note: The post below by Chairman Schapiro is a transcript of remarks by her to the Society of American Business Editors and Writers, Denver, on April 27, 2009.)

It’s an honor to be here with you today because in so many ways we share the same goal. We all strive to achieve an “informed citizenry.”

Through your reporting and writing, you help to make Americans smarter and wiser — not just about business in general, but about the financial markets in particular.

And, that actually makes our job at the Securities and Exchange Commission easier.

For me — and for the SEC — it is all about investors. The more high-quality, honest information investors have, we believe the better off they are.

Since becoming Chairman a few short months ago, my focus has been revitalizing the one agency whose primary responsibility is to protect investors.

The Birth of the Investors’ Advocate:

As many of you know, the SEC grew out of a tumultuous time in our nation’s financial history. Following the Great Crash of 1929, Congress passed two significant pieces of legislation whose goals were clear — protect investors and restore investor confidence.

It was 75 years ago this very day that the House Committee reported out the bill that created our agency.

That Committee report — from April 27, 1934 — references the words of President Roosevelt himself.

At the time, the President was concerned with what he called naked speculation — or investments with significant risk. He said such “speculation has been made far too alluring and far too easy for those who could and for those who could not afford to gamble.”

And he talked about his concern that workers were risking their pay checks or meager savings on transactions that they barely understood — or in his words investments “with whose true value they were wholly unfamiliar.”

That is why President Roosevelt urged passage of the legislation — legislation he said was “for the protection of investors, for the safeguarding of values, and, so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.”

A few weeks later the Exchange Act of 1934 passed. And, the SEC was born.

It wasn’t long before one of the early Chairmen, declared the agency the “investors’ advocate.” And, for 75 years, the agency has largely been known by that moniker. But not unfailingly, and that is part of what I want to talk to you about today.

…continue reading: The SEC Outlines its Enforcement Agenda

(Editor’s Note: This post comes from Fausto Panunzi of Bocconi University.)

In my paper Inheritance Law and Investment in Family Firms (co-written with Andrew Ellul and Marco Pagano) which I recently presented at the Law, Economics and Organizations Seminar at Harvard Law School, my co-authors and I investigate whether inheritance laws reduce investment and growth in family firms. Inheritance laws may constrain entrepreneurs to bequeath a minimal stake to non-controlling heirs. The larger the portion of the founder’s assets to be assigned to non-controlling heirs, the lower the fraction left to the heir designated to remain at the helm of the firm. Absent any friction in capital markets, a lower wealth of the controlling heir would not affect the family firm’ ability to borrow and invest. But in the presence of capital market imperfections, it may hinder the firm’s investment.

In the context of a stylized model of succession in a family firm, we show that larger legal claims by non-controlling heirs on the founder’s estate lead to lower investment by family firms, as they reduce the firm’s ability to pledge future income streams to external financiers. To perform empirical tests, we collect data on inheritance law for 62 countries, mainly via questionnaires sent to law firms that are part of the Lex Mundi project. We measure the “permissiveness of the inheritance law” of each country as the maximum share of a testator’s estate that can be bequeathed to a single child, depending on the presence or absence of a spouse and the total number of children. We then merge this indicator with measures of investor protection and with data for 10,245 firms from 32 countries for the period 1990-2006.

We find that indeed the strictness of inheritance law is associated with lower investment and growth in family firms, while it leaves investment unaffected in non-family firms. Moreover, the negative effect of strict inheritance law on family firms’ investment is exacerbated by poor investor protection, which is also in accordance with the model. We also find that the results are mostly driven by family firms that experience succession in our sample period. It is precisely around and after succession that the effects of inheritance laws are mostly felt, because it is at this time that the decision on who is appointed as the controlling heir and his/her stake is determined. Indeed we find that during and after succession family firms experience a decrease in investment that is more severe for firms located in countries with stricter inheritance law. Also in this case, poor investor protection is found to exacerbate the effect of strict inheritance law, as well as having a direct negative effect on investment. Our results are robust to the use of different specifications of the investment equation, to the inclusion of inheritance taxes (which have no statistically significant effect on family firms’ investments), to different definitions of family firms and different measures of financial dependence.

The full paper is available for download here.

It is often assumed that strong securities markets require good legal protection of minority shareholders. This implies both “good” law — principally corporate and securities law — and enforcement, yet there has been little empirical analysis of enforcement. In our paper entitled Private Enforcement of Corporate Law: An Empirical Comparison of the UK and US, Bernard S. Black, Brian R. Cheffins, Richard Nolan and I study private enforcement of corporate law in two common law jurisdictions with highly developed stock markets, the United Kingdom and the United States, examining how often directors of publicly traded companies are sued, and the nature and outcomes of those suits.

We find, based a comprehensive search for filings over 2004-2006, that lawsuits against directors of public companies alleging breach of duty are nearly nonexistent in the UK. The US is more litigious, but we still find, based on a nationwide search of decisions between 2000-2007, that only a small percentage of public companies face a lawsuit against directors alleging a breach of duty that is sufficiently contentious to result in a reported judicial opinion, and a substantial fraction of these cases are dismissed. Our findings also suggest that the risk that directors would pay out of pocket, for anything other than improperly putting money in their own pockets to begin with, was negligible – we found no such cases over an 8-year period. The upshot is that while directors of publicly traded US companies are much more likely to be sued under corporate law than their British counterparts, lawsuits under corporate law are hardly an everyday occurrence and out-of-pocket liability is scarcely to be feared.

The UK has strong substantive corporate law, but, almost no formal private enforcement of that law against directors of publicly traded companies. The absence of formal private enforcement highlights the importance of procedural rules, often general rules not limited to corporate cases, for the practical operation of substantive rules. Differences in general rules governing class actions, contingency fees, and who pays the winner’s legal expenses, in tandem with specific rules regarding the availability of derivative actions and direct claims in corporate law, may do much to explain the large differences in levels of private enforcement.

We examine possible substitutes in the UK for formal private enforcement of corporate law and find some evidence of substitutes, especially for takeover litigation. Nonetheless, our results suggest that formal private enforcement of corporate law is less central to strong securities markets than might be anticipated. The lack of formal enforcement in the UK – and its robustness in the US despite relatively “weak” corporate law rules — also highlights the potential gap between law in books and law in action, which has been understudied in law-and-finance studies of the underpinnings of strong securities markets. US corporate and securities law is often thought of as being highly protective of outside investors. At least for corporate law, this is not because the substantive law is strong – by international standards it is not. One possible inference is that corporate law is not a key determinant of stock market development. Another is that the intensity of formal private enforcement compensates for the modest formal protections substantive law offers, producing a “shareholder-friendly” end result.

The paper is available here.

(Editor’s note: This post is based on a memorandum By Jim Kroll of Towers Perrin entitled The 2009 Proxy Season: How Will Shareholders Vote on Compensation-Related Proposals in Today’s Contentious Climate?)

With the hammering that many stocks took last fall, and the intensifying scrutiny and criticism of executive pay in financial services and other industries, it’s probably not surprising that the number of compensation-related shareholder proposals appears to be up this proxy season. While it’s far too soon to predict the outcome of this season’s voting, early votes suggest that these proposals may garner as much, if not greater, support in today’s contentious shareholder environment than in past years. How companies respond to this year’s voting also remains to be seen, although it’s likely that many boards will be paying even closer attention to shareholder views than in the recent past as a result of changes in several RiskMetrics Group (RMG) policies related to executive pay.

This article reviews the shareholder proposals filed to date and votes thus far on compensation-related proposals in the current proxy season, along with a look at how RMG policy changes are influencing the shareholder engagement dynamic this year on compensation matters in general.

The Evolving Shareholder Dialogue
Shareholder proposals that address key compensation issues are often viewed as a barometer of investor sentiment regarding executive pay. While the number of compensation-related proposals filed and voted on tends to fluctuate from year to year, the general trend in recent proxy seasons has been toward more shareholder activism on a number of compensation fronts. This is reflected in both the number of proposals filed and in the levels of support they receive from shareholders.

Proposals falling into two general categories — say on pay and pay for performance — have tended to dominate the last three or four proxy seasons. In past years, various labor unions took a lead role in filing such proposals. However, our analysis of the 2009 proxy season finds unions playing a somewhat smaller role this year. For example, say-on-pay proposals, the largest and fastest-growing category, were offered by a wide range of proponents in 2009, including pension funds and other investors. This shift, particularly as it relates to say-on-pay proposals, may be due to the fact that various shareholder groups have been discussing the topic and may be pooling their efforts in order to reach a larger number of companies.

Moreover, the number of pay-for-performance proposals has declined again this year because the leading union proponents are taking a year off from filing such proposals (but may resume filing these proposals next year). These proposals, which include measures to adopt performance-based options, link pay to performance, implement “common sense” compensation and adopt performance- and time-based restricted stock, made up the largest category of shareholder proposals as recently as two years ago. They’ve virtually disappeared from the proxy landscape this season. While shareholder proposals on the topic have declined, the proponents have changed their tactics and are proactively engaging companies in discussions about their pay practices. Other proposals on the decline this year are those addressing golden parachutes, clawbacks and supplemental executive retirement plans (SERPs).

…continue reading: Compensation Proposals in 2009 Proxy Season

(Editor’s Note: This post is an excerpt from the 2009 Edition of The Directors’ Handbook, by Thomas J. Dougherty of Skadden, Arps. Here, in the book’s Foreword, Dougherty challenges directors to reject passive board meetings and engage in hands-on sessions in order to better identify risk factors and effectively lead the companies they serve.)

The regulatory oversight framework is broken. The SEC failed to regulate credit default swaps, loosened broker-dealer leverage restrictions at just the wrong time and failed to regulate dark-debt driven hedge fund activities. The Federal Reserve failed to impose reserve requirements on syndicators of collateralized loan or credit obligations. All that will change now.

Importantly, in its entire seventy-five year history, there has never been a visiting committee appointed to review the SEC. We need a committee of non-bureaucrats, non-industry groups, non-politicians, analogous to the visiting committees that accredit and review university excellence.

Meanwhile, there is going to be greater skepticism and scrutiny of board of director oversight than ever before, as a ripple effect of failed companies, regulatory tightening and the push for reform. In some ways, that is not a bad thing, because lax practices still exist, such as the increasing trend of front-loading board meetings with management presentations so detailed and so numerous as to numb the outside directors’ ability to assess strategy and examine any one problem with requisite focus. The ratio of minutes of director discussion to minutes of slide presentations has greatly diminished, as companies’ ability to mine and marshal presentation data has risen parabolically.

That process within the boardroom—that dynamic—needs to be managed by the board itself.

What’s Going On?

Despite greater intensity of director effort, the core challenge for directors trying to fulfill their roles in providing vision and vigilance for public companies remains the same: they passionately desire and dutifully need to know “what is going on” in the important areas of company strategy and management execution in order to do their director jobs well.

…continue reading: Shenanigan’s Wake

(Editor’s Note: This article appeared recently in the New York Law Journal.)

On Feb. 17, 2009, President Barack Obama signed into law the American Recovery and Reinvestment Act of 2009 (ARRA). Title VII, Section 7001 of ARRA amends Section 111 of the Emergency Economic Stabilization Act of 2008 (EESA) as enacted Oct. 3, 2008. Section 111 contains restrictions on executive compensation applicable to institutions receiving financial assistance under the Troubled Assets Relief Program (TARP).[1] For purposes of this column, Section 111 as amended by ARRA is referred to as “New Section 111,” and Section 111 as originally enacted under EESA is referred to as “Original Section 111.”

New Section 111 continues certain provisions of Original Section 111 but expands the number of executives covered (with different numbers of executives covered under different provisions), imposes stricter limitations on compensation payments, prohibits severance payments to certain executives and adds new corporate governance standards and requirements relating to those standards.

Generally speaking, the limitations and standards under New Section 111 apply during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding (referred to herein as the “TARP Period”). Under New Section 111 the TARP Period ends even if the government still holds warrants. The statute applies to a “TARP Recipient,” defined as “any entity that has received or will receive financial assistance under the financial assistance provided under the TARP.”

Further complicating matters are additional compensation guidelines announced by the U.S. Treasury on Feb. 4, 2009, in a press release (”Treasury Announces New Restrictions on Executive Compensation,” Press Release No. TG-15, referred to hereinafter as “TG-15″).[2] TG-15 applies one set of guidelines to companies receiving “exceptional assistance” and another (albeit with some overlapping of guidelines) for companies receiving assistance under “generally available capital access programs.”[3]

Following is a review of selected provisions of New Section 111 including, as applicable, a comparison of it to Original Section 111 and TG-15. (As of the time this column was written, regulations had not yet been issued under New Section 111.)

…continue reading: Executive Compensation Under TARP

(Editor’s Note: This post comes from Richard Price and Brian Rountree of Rice University, and Francisco Roman of Texas Tech University.)

Corporate governance systems are designed to ensure investors receive a return on their investment. Using cross country analysis, the governance literature has demonstrated that stronger governance systems lead to more efficient allocations of capital resources, which in turn spurs economic growth and increases the likelihood of investors receiving a return. What is less clear is how an economy with generally weak governance can bring about change in order to improve the investment climate and stimulate economic development. In our forthcoming Journal of Financial Economics paper entitled The Impact of Governance Reform on Performance and Transparency, we investigate the efficacy of mandated changes in corporate governance and investor protection in Mexico, which is a classic example of an emerging market economy dominated by concentrated ownership and without a demonstrated commitment to minority investor protection.

Similar to a number of emerging market economies, Mexican regulators have recently implemented a Code of ‘Best’ Corporate Practices (hereafter the Code) and require companies to publicly disclose their compliance with these suggested practices each year. In addition, the laws governing securities markets have been strengthened in 2001, 2003, and 2005. These efforts are all aimed at improving the investment climate and attracting foreign capital to Mexico.

We find that companies generally increased their compliance with the reforms over the 2000-2004 time period, which indicates companies believe there is a benefit to compliance or cost of non-compliance. However, our analyses of performance and transparency fail to reveal a significant relation to the reforms illustrating there are still substantial concerns about the ability of these actions to improve economic development. Instead, we find companies that comply more with the reforms are more likely to pay dividends, which indicates that better governed companies are forced to resort to costly signals in order to reduce agency costs as opposed to reaping the benefits from improved transparency. Our results indicate market monitoring mechanisms by themselves are not strong enough to induce significant changes in economic behavior and suggest extensive changes in the legal and/or political environment are necessary in emerging market countries like Mexico to ensure adequate investor protections.

The full paper is available for download here.

Shareholder proxy access for the election of directors is about to arrive. Directors of public companies, shareholder activists and shareholders generally soon will be dealing with an important new set of issues and dynamics associated with the election of directors and the management of the board process. This memorandum is intended to provide a briefing on key aspects of this important subject.

What is The Issue?
In a nutshell, the issue is whether and, if so, under what conditions, a shareholder of a public company should have the right to include — in the company’s proxy statement and on the company’s proxy card — nominees proposed by the shareholder in opposition to the company’s candidates for election to the board of directors.

A sharp distinction has always existed in director election contests between how company and dissident candidates are presented for shareholder consideration. Company candidates are presented in the company’s proxy material — proxy statement and card — and dissident candidates are presented in separate proxy material prepared, paid for and presented to shareholders by the dissidents. Classic election contests are typified by each side preparing various forms of dueling soliciting materials — such as formal proxy statements, print and electronic media advertisements, letters to shareholders, investor presentations — which are delivered to shareholders through an active solicitation campaign by each side. Although proxy reforms in recent years have been designed to streamline the proxy solicitation process, an election contest can still involve real cost and effort.

The rise of corporate governance concerns in recent years has increasingly focused on board performance and the rights of shareholders to change directors in response to perceived deficiencies in performance. One mechanism that has been proposed to facilitate shareholder action seeking to change directors is to give shareholders direct access to the company’s proxy statement, permitting the inclusion of shareholder-proposed candidates and a supporting statement. Among the arguments advanced for this mechanism is that including shareholder-sponsored director candidates directly in the company’s proxy statement (and on its proxy card) will make it significantly easier and less costly to present to shareholders meaningful choices regarding board composition with a view toward improving performance.

Where Does The Issue Stand?
The proxy access issue has been debated for some time. In 2003 and again in 2007, shareholder proxy access proposals were considered by the Securities and Exchange Commission (SEC). However, no rule was adopted, or position taken, by the SEC either directly granting a proxy access right under the federal proxy rules or permitting shareholders to include in a company’s proxy statement, under Rule 14a-8, a shareholder proposal to amend the company’s bylaws which, if adopted by shareholders, would provide for shareholder proxy access in the election of directors (proxy access bylaw). In fact, in 2007 the SEC codified an exclusion from Rule 14a-8 that made it clear that a proxy access bylaw could be excluded by a company from its proxy statement.

…continue reading: Shareholder Proxy Access for Director Elections

This post is by my partner Joseph M. McLaughlin.

Federal and state courts have recently issued noteworthy decisions yielding important lessons about directors and officers liability insurance policies. This column examines decisions addressing: (i) the interaction of an application severability clause in a primary policy (addressing to what extent one insured’s knowledge of application misrepresentations can be imputed to other insureds) with a “prior knowledge” exclusion in excess policies; (ii) the scope of a standard-form securities exclusion; (iii) the consequences of failing to give timely notice under a “claims made and reported” policy; and (iv) the effect of an “other insurance” clause in a D&O policy on the D&O insurer’s defense cost obligations to a mutual insured also holding a CGL policy with another insurer.

Prior Knowledge Exclusion

An application for D&O insurance typically is filled out by one or two officers of the corporation (usually the CEO and/or CFO) who make certain representations on behalf of all individuals to be insured. In addition to the traditional “warranty statements” made in the application about knowledge of facts which might give rise to a claim, most D&O applications today expressly incorporate certain documents, such as specified company SEC filings and financial statements, and provide that these documents are material to the insurer’s evaluation of the risk and expressly serve as a basis for writing the coverage. Allegations of inaccuracy in the documents incorporated into the application frequently form the basis for the very lawsuits for which D&O coverage later may be sought. If the company announces an accounting restatement, it may be argued that the company has admitted the original financial statements — and the application — were materially misleading. Without a severability provision in the application, if material representations made to the insurer during the underwriting process turn out to be false, the insurer may be able to return the premium paid and rescind, i.e., void, coverage under the policy as to all insureds. In addition, most D&O policies include severability for the conduct exclusions, such as fraud and intentional misconduct, so that the knowledge or “bad acts” of one insured cannot be imputed to innocent D&Os, who remain entitled to coverage.

In XL Speciality Ins. Co. v. Agoglia,[1] Judge Gerald E. Lynch last month assessed under New York the effect law of prior knowledge exclusions on demands for coverage under three excess D&O policies issued to Refco, Inc., once one of the largest brokerage and clearing services providers for international currency and futures markets. The decision illustrates the importance of paying attention to the wording of and relationship between application and exclusion severability provisions at both the primary and excess insurance levels.

Refco collapsed upon disclosure in October 2005 that it had been carrying an undisclosed $430 million receivable from an affiliate controlled by CEO Phillip Bennett (the “RGHI Receivable”), announcing that the receivable consisted of uncollectible debts originating in the late 1990s and that the related-party nature of the receivable had been hidden from the company’s auditors. In the litigation fallout, Bennett pleaded guilty to numerous federal criminal charges. In addition, numerous civil lawsuits were filed against the former directors and officers of Refco. Central to these lawsuits are the allegations that, prior to Refco’s August 2005 initial public offering, Bennett and others at Refco concealed Refco’s true financial position by means of the RGHI Receivable scheme.

Refco’s D&O liability insurance program for the relevant period consisted of a U.S. Specialty Insurance Company primary policy, with Allied World Assurance Company (“AWAC”), Arch Insurance Company (“Arch”) and XL Specialty Insurance Company (“XL”) providing third, fourth and fifth excess layer coverage, respectively. The AWAC and Arch polices expressly followed form to the primary policy, except to the extent they contained limitations or restrictions beyond those in the primary policy. The XL policy did not follow form to the primary policy. These excess insurers sought a declaration on summary judgment that coverage was precluded by prior knowledge exclusions in their policies.

…continue reading: Recent Developments in D&O Insurance

Public and Private Enforcement of Securities Laws: Resource-Based Evidence, which Howell Jackson and I just revised, is in the pipeline for publication in the Journal of Financial Economics. (We posted an earlier version of Enforcement to this Forum (available here) about a year ago after we presented it at the Law and Economics Seminar here at the Law School.) This post focuses on the updates and changes we have made to the paper during the subsequent year.

The central thesis remains as before: Although recent academic work in finance finds private investor protection more important in determining the depth and breadth of financial markets than public enforcement via financial, regulatory, and even criminal rules and penalties, we do not find evidence supporting that kind of relationship. As before, our measure of public enforcement intensity turns on the resources of securities regulators around the world, focusing on their staffing and their budget levels. In the revised paper, we measure these levels across multiple sample constructions, test for influential observations, and examine whether corruption levels in the poorer nations drive our results. In each robustness check, our results — a significant coefficient on the level of public enforcement — persists for financial outcomes such as the size of a nation’s securities market, the number of domestic firms, trading volume, and the number IPOs in the nation.

We cannot fully unpack causation issues, which persist, as they do in the prior work on private enforcement. This is partly because of data limits — we have extensive budget and staffing data for recent years, but not over an extended time period. But the results now indicate quite clearly that the rejection of the viability of public enforcement in the prior literature and by some units in the international development agencies, such as the World Bank, is not supported by the best measures of public enforcement intensity. The difference between our results and the prior results in the literature is largely due to a sharp difference in the research design for measuring public enforcement intensity. In prior work, it was measured via formal levels of authority of the securities regulator. We now show why these formal measures are unlikely to measure public enforcement as well as the regulators’ resources. A formally-empowered regulator without a good budget and a good staff cannot do much; conversely a well-endowed regulator with spotty formal authority can still achieve much in the way of enforcement. We now show that our measures do not correlate with the prior, more formal measures and we explain why we see our measures as better measures of the intensity of public enforcement.

Our revised results also yield insight into which aspects of private enforcement are important to robust capital markets and which are not. While good disclosure is consistently associated with robust capital markets, private litigation liability indices are not, particularly once one controls for the level of resources dedicated to public enforcement. They are often insignificant, often with coefficients having the “wrong” sign. These results comport with a consensus picture among legal scholars of a deficient system of private securities litigation in the United States: It’s poorly designed, with firms, and hence wronged shareholders, often bearing the cost of insiders’ errors and disclosure failure. Wrongdoers frequently do not pay for their wrongs; innocent shareholders often do. Hence, there’s some a priori reason, consistent with our regression results, to be wary of private litigation as the major mechanism for securities law enforcement in developing, and maintaining, good financial markets.

The full paper is available for download here.

The Harvard Law School Program on Corporate Governance recently issued The Elusive Quest for Global Governance Standards, a discussion paper I co-authored with Professor Assaf Hamdani. The paper is scheduled for publication in the University of Pennsylvania Law Review. Our slides from a recent presentation of the paper at the Sloan Foundation corporate governance research conference are available here.

We focus in our paper on the substantial efforts by researchers and shareholder advisers to develop metrics for assessing the governance of public companies around the world. These important and influential efforts, we argue, suffer from a basic shortcoming. The impact of many key governance arrangements depends considerably on companies’ ownership structure: measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder, and vice versa. Consequently, governance metrics that purport to apply to companies regardless of ownership structure are bound to miss the mark with respect to one or both types of firms. In particular, we show that the influential metrics used extensively by scholars and shareholder advisers to assess governance arrangements around the world—the Corporate Governance Quotient (CGQ), the Anti-Director Rights Index, and the Anti-Self-Dealing Index—are inadequate for this purpose.

We argue that, going forward, the quest for global governance standards should be replaced by an effort to develop and implement separate methodologies for assessing governance in companies with and without a controlling shareholder. We also identify the key features that these separate methodologies should include, and discuss how to apply such methodologies in either country-level or firm-level comparisons. Our analysis has wide-ranging implications for corporate-governance research and practice.

————————–

Here is a more detailed description of the paper: There is now widespread recognition that adequate investor protection can substantially affect not only the value of public firms and their performance but also the development of capital markets and the growth of the economy as a whole. This view has naturally led to heightened interest in identifying and bringing about corporate-governance improvements at both firm- and countrywide levels. These developments also have sparked substantial demand for reliable metrics for evaluating the quality of corporate governance in public firms. And both academic researchers and shareholder advisers have made considerable efforts to develop such metrics.

The notion of a single set of criteria to evaluate the governance of firms around the world is undoubtedly appealing. Both investors and public firms are, after all, operating in increasingly integrated global capital markets. Our paper argues, however, that the quest for a single, global governance metric is misguided.

…continue reading: The Elusive Quest For Global Governance Standards

(Editor’s Note: This post is based on a client memorandum by Richard J. Sandler, Ethan T. James, and Reena Agrawal Sahni of Davis Polk & Wardwell.)

In March 2008, the Paulson Treasury issued its Blueprint for a Modernized Financial Regulatory Structure, in which Treasury recommended the establishment of a federal insurance regulatory structure to provide for the creation of an optional federal charter. The Financial Services Roundtable has endorsed the concept of a national insurance regulator, noting that “just as the state/federal banking system works well for the industry and the economy—so too can a similar insurance system.” In recent Congressional testimony, Treasury Secretary Timothy Geithner has said that “there is a good case for introducing an optional federal charter for insurance companies.”

Recently, Representatives Ed Royce (R-CA) and Melissa Bean (D-IL) introduced the National Insurance Consumer Protection Act (“NICPA”), the third attempt in less than three years to create federal insurance regulation. Not everyone thinks federal insurance regulation is an idea whose time has come, however. The CEO of the National Association of Insurance Commissioners (the “NAIC”), Therese Vaughan, recently testified in Congress that “[t]he state-based insurance regulatory system is one of critical checks and balances, where the perils of a single point of failure and omnipotent decision making are eliminated.” The Illinois Director of Insurance, Michael McRaith, in his Congressional testimony characterized the optional federal charter as “a solution in search of a problem.”

Our memorandum entitled “The Debate Over Federal Insurance Regulation” uses NICPA as a filter through which to examine the likely features of any federal insurance regulatory regime; the regulation of insurance holding companies under a federal system and how that compares to state insurance regulation, and to banking regulation, on which it is largely patterned; and how such a regime may fit into the current regulatory reform framework.

The memorandum is available here.

(Editor’s Note: This post comes to us from Charles Nathan and Stephen Amdur of Latham & Watkins LLP.)

This article is a reply to the post appearing in the Harvard Law School Corporate Governance Forum authored by Marc Weingarten and Erin Magnor of Schulte, Roth & Zabel on March 17, 2009 and entitled “Second Generation Advance Notice Bylaws.” That post is available here.

Introduction

The past year has been marked by a wave of new or revised advance notice bylaws and a similar but smaller surge in adoption or amendment of poison pills to accomplish one or both of the following goals:

Second generation advance notice bylaws and poison pills did not appear spontaneously. Rather, each is a response to a growing phenomenon in the market for corporate control, not just in the United States, but also in Europe, Asia and Australia. The pioneering literature that exposed the use of derivatives and “empty voting” in corporate control contexts was a product of the academic legal community, particularly Professors Henry Hu, Bernard Black, Edward Rock and Marcel Kahan, who have written a number of articles about the phenomena of “empty voting,” “morphable” equity ownership, “decoupling of economic and voting interests,” “record date capture” and other uses of derivatives and market mechanics to separate the voting rights of stock ownership from its economic attributes and to divide the economic attributes[1] of ownership into a bundle of rights and obligations that can be separated, just as the voting rights can be separated from economic attributes. Moreover, the academic observers were not abstractly speculating about behavior that could revolutionize the markets for corporate control. They were reporting on existing methodologies, frequently but not always practiced by event driven hedge funds and other activist investors in control contexts.[2]

The second phenomenon of utilizing wolf pack behavior to avoid aggregation for purposes of equity reporting requirements, such as Section 13(d), has not generated as much academic interest, but certainly has galvanized target companies, and in many countries financial market regulators or even the political establishment, by its successful end-running of customary concepts such as the “group” definition under the 1934 Act and the European, Asian and Australian “acting in concert” or “concert party” concepts in the equivalent share ownership disclosure regimes in many of the world’s more developed equity markets.[3] It is also notable that, unlike the use of equity derivatives to decouple attributes of share ownership which arose in the context of, and was driven by, trading strategies and economic considerations unrelated to change of control campaigns, the wolf pack has been used virtually exclusively by the activist investor community in campaigns against companies, often culminating in successful proxy contests or other change of control events.
…continue reading: Second Generation Advance Notice Bylaws and Poison Pills

(Editor’s Note: An earlier post on this Forum on Lyondell Chemical Co. v. Ryan is available here. The current post provides a more detailed discussion of the Supreme Court’s analysis of when a board’s Revlon duties apply.)

(Editor’s UPDATE: We recently received a memorandum from Sullivan & Cromwell LLP that provides a detailed discussion of the implications of the decision in Lyondell Chemical Co. v. Ryan. The memo is available here.)

My colleagues William Kucera, Christian Fabian and Erik Axelson have prepared a memorandum further analyzing the Delaware Supreme Court’s recent decision in Lyondell Chemical Co. v. Ryan. The memorandum highlights several key aspects of the decision that provide guidance to M&A practioners in counseling clients and structuring transactions. First, Lyondell clarifies when a board’s Revlon duties apply. By finding that Revlon duties apply “only when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change of control,” the Supreme Court emphasized the role of the company and its directors in determining when Revlon duties are triggered, as opposed to when third-party actions, such as a Schedule 13D filing or publicly disclosed unsolicited overture, generally inform the market that a third party is interested in acquiring a company. The Supreme Court’s refusal to impose Revlon duties before a board takes affirmative steps to begin negotiating the sale of the company is an important concept for practitioners and M&A professionals because it generally allows for the target company, through its actions, to control whether Revlon duties apply. Guided by this principle, the Supreme Court signaled that a target company will be justified in deciding to take a “wait and see” approach in response to a third-party overture that arguably puts the target company in play, where that approach is the product of a deliberate decision by an independent, disinterested board.

The Lyondell decision also emphasizes the high bar that must be cleared in order to establish a breach of a duty of loyalty based on a failure to act in good faith. Because loyalty claims for failure to act in good faith are reserved only for situations where the board “knowingly and completely failed” or “utterly failed” to undertake its responsibilities, there is a high burden of proof to overcome to impose liability on the directors. Indeed, the Supreme Court acknowledged that an extreme set of facts is required to sustain a disloyalty claim premised on the assertion that disinterested directors intentionally disregarded their fiduciary duties. Notably, however, the Supreme Court suggested that the bar is much lower when a claim is based on a breach of duty of care, meaning directors need to be concerned about exercising care and establishing a careful, deliberate and well-documented process in reviewing a sale of control transaction.

The memorandum is available here.

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today in the Wall Street Journal online. Professor Bebchuk’s most recent post about the Treasury’s public-private investment plan is available here.)

Opponents of the administration’s current plan for buying troubled assets — including Joseph Stiglitz, Jeffrey Sachs and Peyton Young — strongly criticize it for providing private parties with highly skewed incentives to overpay for such assets at taxpayers’ expense. This problem, however, isn’t fatal. It can be fixed, and fixing it would do a great deal both to increase the plan’s benefits and reduce its costs.

Under the plan’s current design, the private side — the manager and the private investors affiliated with it — will contribute as little as 8% of the capital of funds set under the program, with the rest funded by the Treasury and Fed. In return for this 8% of capital, the private side will get 50% of the upside but bear half of the downside only up to 16% of the fund’s capital. Such asymmetric payoffs would provide powerful incentives to seek assets with volatile value and overpay for them.

While such overpaying would be consistent with the private manager’s interests, it would impose losses — which could well exceed the private side’s profits — on the public capital participating in the funds. Moreover, the overpaying would undermine one of the plan’s main objectives — to produce market prices providing reliable information about the value of troubled assets still remaining on banks’ books.

Rather than getting skewed payoffs, with the resulting large distortions, the private side should receive payoffs that parallel those of the public capital invested in the funds. To this end, the private side should get a specified fixed percentage of the fund’s final value, both on the upside and the downside. To the extent that the public capital comes in both equity and debt forms, the private side should also participate in debt and equity in the same proportions as the public capital.

But isn’t the partial insulation of the private side from downside risks necessary to attract private capital? Not at all. Even if the private side needs to receive somewhat favorable terms to participate, such a “subsidy” can be given in a form that would not distort subsequent incentives.

Suppose that the government wishes to stick with having the private side contribute 8% of the fund’s capital. Rather than entice the private side with unequal shares of the upside and the downside, the private side could be given a percentage of the fund’s final value that exceeds 8%. If the private side gets, say, 12% of the fund’s value for its investment of 8% of the initial capital, the extra 4% would represent a subsidy meant to induce the private side’s participation and management of the fund. Unlike under the administration’s current design, however, once the private side is in, it will have incentives aligned with those of taxpayers.

The private side’s fixed share, and hence the size of the subsidy, can be determined through a competitive process that would ensure that the level of subsidy will be kept at a minimum. Potential private manager will submit bids indicating the minimum fraction of the fund’s value that would accept in return for contributing 8% of a fund’s initial capital, as well as the size of the fund they would establish if admitted. The government will then set the private side’s fixed share of payoffs in funds set under the program at the lowest level that would be consistent with establishing funds that collectively have the aggregate target capital.

Note that, under the proposed approach, the government would be getting a much higher share of the upside than the 50% under the administration’s design. Even more important, taxpayers will benefit from the improved incentives to maximize the value of the funds in which taxpayers will be so heavily invested.

It might be argued that, even though the proposed fix would eliminate incentives to overpay for troubled assets, such overpaying is what the administration seeks in order to bolster banks’ capital. But overpaying, which can be easily avoided by the proposed design, shouldn’t be a goal of the program. The government should inject capital only in those banks that need it and to do so in exchange for securities — not confer a benefit without consideration on all banks holding troubled assets.

For the administration plan to work well, fund managers’ incentives should be aligned with maximizing the value of the fund’s capital. The proposed re-design would make the plan much more effective and much less costly.

(Editor’s Note: This post comes from Stavros Panageas of the University of Chicago.)

In my paper, Bailouts, the Incentive to Manage Risk, and Financial Crises, which was recently conditionally accepted for publication at the Journal of Financial Economics, I develop a model where risk management rules are derived as optimal responses to the adverse risk taking incentives created by bailouts. Additionally, the incentives to undertake a bailout are endogenously determined, making it possible to provide a joint explanation for the observed risk appetite reversals and the prevalence of bailouts.

In the baseline version of the model there are three agents: the firm’s shareholders, its debt holders and a stakeholder. The stakeholder incurs a discrete cost or externality if the firm is terminated. The presence of this cost or externality makes the stakeholder willing to bail out the firm, by injecting funds, once bankruptcy looms. However, the stakeholder’s guarantee to the shareholders is implicit and the benefit from the firm’s continued presence is bounded. Hence, bailouts can occur only if the stakeholder finds it profitable to undertake them. Within this framework, the paper studies the shareholders’ incentive to take risk. As one might expect, the presence of an implicit guarantee makes the shareholders inclined to raise the volatility of the projects that they undertake. However, high volatility choices could deter the stakeholder from bailing out the firm. This produces a tension. On the one hand, shareholders want to raise volatility, but not so much that the stakeholder will find it prohibitively costly to bail out the firm. This tension introduces the need for risk management rules, commitments and regulations that can be either the result of regulation or self-regulation.

A new aspect of the model is that rules, regulations and commitments are allowed to be imperfect. The imperfection stems from the fact that future shareholders may choose to renege by paying a cost. This helps capture situations where firms can circumvent risk management rules by undertaking costly activities such as setting up offshore, off-balance sheet entities. The imperfection of commitment implies that the credibility of a risk management rule is not taken as given. Instead, adherence to the rule has to be dynamically consistent. Within this framework, I analyze the optimal choice of a risk management rule and show that it has a particularly simple form: undertake projects with high risk levels when net worth (defined as assets minus liabilities) is sufficiently high and switch to projects with low risk levels when net worth falls below an endogenously determined threshold. The model shows that risk limits tighten abruptly when the firm’s net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as “flight to quality”.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Eduardo Gallardo, James J. Moloney and James B. O’Grady of Gibson, Dunn & Crutcher LLP.)

On March 30, 2009, the SEC staff issued two no-action letters[1] regarding the solicitation of proxies to vote in the election of directors in a situation where two dissident shareholders had submitted separate “short slates” of director nominees for election at the same annual meeting. The no-action letters permit a soliciting shareholder to “round out” its short slate of directors with the nominees of other dissident shareholders, under an expansive reading of the proviso to the “bona fide nominee” rule in Exchange Act Rule 14a-4(d). Such proviso had historically been interpreted only to permit a soliciting shareholder to “round out” its short slate with nominees of the registrant.

The effect of the no-action letters is to facilitate the ability of shareholders to elect non-incumbent directors in situations where more than one dissident shareholder is running a short slate. The SEC staff conditioned its relief on a number of requirements, including that any such dissidents must not have agreed to, and must have no intention of, forming a “group” as determined under Regulation 13D-G.

Analysis

In recent years it has become increasingly more common for dissident shareholders to run a “short slate” of directors for election at annual meetings – that is, a dissident slate for less than a majority of the registrant’s board of directors. This is becoming the preferred approach for dissidents seeking board representation for two primary reasons. First, proxy advisory firms such as RiskMetrics and large institutional investors have historically proven to be more supportive of short slates than of dissident efforts that seek to replace a majority of the board. Second, running short slates avoids the risk of triggering so-called “poison puts” – provisions in a registrant’s debt documents which would require the registrant to repurchase outstanding debt obligations upon the occurrence of certain defined events, which sometimes include incumbent directors ceasing to constitute a majority of the board.

SEC rules require that each nominee named in a proxy card must be a “bona fide nominee.” Prior to the adoption by the SEC of the shareholder communications rules in 1992, in order to qualify as a “bona fide nominee,” each nominee had to consent to being named in a proxy card. This unqualified requirement effectively prevented a dissident’s proxy card from conferring authority to vote for a registrant’s nominees, because registrant nominees were unlikely to consent to being named on a dissident’s proxy card. The rule placed dissident shareholders running short slates of directors at a disadvantage to registrants – shareholders effectively faced a choice between voting for the registrant’s full slate of nominees, in order to exercise their full voting rights, or voting for a less than full slate of dissident nominees. However, in 1992, the SEC added the so-called “short slate rule” – really an exception to the bona fide nominee rule — which allows a dissident shareholder’s proxy card to “round out” a short slate of nominees by obtaining authority to vote for some of the registrant’s own nominees.

…continue reading: SEC Grants No-Action Relief to Activist Shareholders

(Editor’s note: This post is based on a client memorandum by A. Richard Susko, Arthur H. Kohn and Mary E. Alcock of Cleary Gottlieb Steen & Hamilton LLP.)

Great outrage and indignation have been expressed, from multiple perspectives, in connection with AIG’s retention bonuses and the Congressional response thereto. Now that most of the public, albeit probably not the actual participants, seem to be past the initial burst of emotion, we believe that it is well worth noting that all employers, whether or not they are recipients of Government funds, should pay close attention to the several recently proposed (and competing) bills in Congress spawned by the episode.

These bills show that the politics of populist furor over executive compensation can easily pave the way for hasty and thoughtless regulation, which would (if enacted as written) be counterproductive to the US financial system and economic recovery. The bills also foreshadow possible future and potentially broad legislation that may eventually have negative effects for many companies beyond the financial industry.

Political focus on, and accompanying rhetoric regarding, perceived excesses in executive compensation have been building in intensity for some time. The current legislative impulses, however, raise systemic risks that pose a far greater danger than the issues sought to be addressed by them. In our recent memorandum, entitled “Implications of the AIG Bonus Imbroglio,” we discuss particularly troublesome aspect of the four recently proposed bills, including the lack of an exception for existing binding compensation contracts. The memorandum also outlines possibly unintended and negative consequences to employers, employees and the public alike of the bills and briefly summarizes relevant provisions of each of the bills.

Whatever the immediate prospects for passage may be, we believe that it is important for employers and employees generally to be aware of the substance of the recent proposals even if they are not the targets at the moment.

The memorandum is available here.

(Editor’s Note: This post comes from Joanna Shuang Wu of the University of Rochester and Ivy Zhang of the University of Minnesota.)

In our forthcoming The Accounting Review paper entitled “The Voluntary Adoption of Internationally Recognized Accounting Standards and Firm Internal Performance Evaluation”, we investigate whether the voluntary adoption of international accounting standards is associated with changes a firm’s internal performance evaluation process; in particular, is it associated with increases in the sensitivities of CEO turnover and employee layoffs to accounting earnings.

Our sample consists of firms from Continental Europe that voluntarily adopted IFRS or U.S. GAAP from 1988 to 2004. We require the adopting firms to have both pre- and post-adoption data, and as a result, exclude firms that report under IFRS/U.S. GAAP from the first year they enter into our sample. We classify firms into those following IFRS/U.S. GAAP accounting standards and those following local accounting standards. For the IFRS/U.S. GAAP adopting firms, the adoption year is treated as event year zero. The local standards firms (firms that follow local GAAP throughout our sample period) serve as the control sample in the various tests. Our final sample comprises 200 IFRS/U.S. GAAP adopting firms and 766 local standards firms.

We find that CEO turnover and employee layoffs are more sensitive to accounting earnings after IFRS/U.S. GAAP adoption. These findings support our hypothesis that accounting earnings play a greater role in firm internal performance evaluations after the adoption of international accounting standards. In addition, we investigate firms’ decisions to adopt international accounting standards and proxy for the performance evaluation demand with two variables: closely held shares and labor productivity. After controlling for various other factors, we find that greater performance evaluation demand (less closely held shares and lower labor productivity) are associated with a higher likelihood of IFRS/U.S. GAAP adoption.

The above evidence does not necessarily imply that the voluntary adoption of international accounting standards causes the changes in internal performance evaluations in terms of higher earnings performance sensitivities. Firms that voluntarily adopt IFRS/U.S. GAAP likely experience fundamental changes in their operations, financing, and corporate governance; and the adoption of international accounting standards can simply be an instrument for these profound changes. Our findings suggest that the greater reporting transparency through international accounting standards likely plays a role (which may not be strictly causal, but is important nonetheless) in improving firms’ internal performance evaluations. We document that IFRS/U.S. GAAP adoption is associated not only with changes in firms’ operating and information environment, but also with changes in corporate governance.

Our findings highlight the multitude of implications from the adoption of international accounting standards and add to our understanding of the complex changes experienced by the adopting firms.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Doreen E. Lilienfeld and Amy B. Gitlitz of Shearman & Sterling LLP.)

With the market decline, many companies have found that their outstanding employee stock options are “underwater” or “out-of-the-money” because the exercise price is higher than the company’s current stock price. Underwater stock options do not provide their intended incentive and retention benefits. Moreover, they are an inefficient use of a company’s equity reserves as they (i) cause companies to take accounting charges for equity that is not providing value to the employees and (ii) count against plan share limits thereby limiting the number of new awards to be granted to employees. One way companies deal with their underwater options is by effecting an option repricing. The term “repricing” broadly refers to a number of practices, including:

• Option Buyout or Cash Exchange. Underwater options are purchased by the company for cash.

• Option for Option Exchange. Underwater options are cancelled and replaced with “at-the-money” options.

• Option for Other Security Exchange. Underwater options are exchanged for a different type of equity-based award (e.g., restricted stock, restricted stock units or phantom stock).

• Option Repricing. The exercise price of underwater options is unilaterally reduced by the Company.

Various legal and regulatory issues must be considered when electing whether to implement an option exchange program including securities laws, accounting rules, tax laws and shareholder approval requirements.

Securities Laws. Most option exchange programs are deemed “tender offers” for purposes of the U.S. Securities Exchange Act of 1934 (the “Act”). As a result, a company must file a Schedule TO with the Securities and Exchange Commission (“SEC”), and comply with all tender offer requirements, including the obligation to leave the offer open for at least 20 business days. The SEC, however, has provided limited relief from the “all holders” and “best price” rules under the Act for option repricings that are affected for a “compensatory purpose.” This enables a company to limit which options are subject to the repricing and provide different consideration for each tranche of options. For example, a company can have different exchange ratios based upon the exercise price or remaining term of underwater options.

Shareholder Approval. Both the NYSE and NASDAQ require shareholder approval for the majority of option repricing programs, unless a plan explicitly states that shareholder approval is not required. Many shareholder activist groups, including RiskMetrics, provide guidelines regarding their considerations with respect to repricing.

U.S. Accounting. Under FAS 123R, a repricing is deemed a modification to the existing award. FAS 123R compares the fair value (based upon an option pricing model, e.g., Black Scholes or binomial lattice) of the award immediately before and after modification. If there is an increase in value, an accounting charge must be taken.

U.S. Tax. The cancellation or repricing of an option is not a taxable event. Cash payments are immediately taxable; grants of stock options and restricted stock or units that are subject to future vesting are not immediately taxable. Companies should also consider Sections 409A and 162(m) in structuring an option repricing.

Our memorandum entitled “Underwater Stock Options and Stock Option Exchange Programs” deals with these and related issues. It is available here.

(Editor’s Note: The following post by Ben W. Heineman, Jr. was published today in the online edition of BusinessWeek. The speech by Lloyd C. Blankfein, Chairman and CEO of Goldman Sachs, Inc., referred to below was featured on this Forum here.)

Like the companies they run and oversee, CEOs and boards of directors in the financial sector have been battered by the credit meltdown. The witch’s brew of high leverage, poor risk management, creation of toxic assets, and faulty business judgments—made more poisonous by excessive short-term executive pay—are seen as failures of an unprecedented magnitude. The result: Credibility has eroded, trust has dissolved, and financial re-regulation seems inevitable.

As Lloyd Blankfein, CEO of Goldman Sachs (GS), said recently in a speech to the
Council of Institutional Investors: “…[T]he past year has been deeply humbling for my industry…the loss of public confidence…will take years to rebuild…effective reform(s) are vital and should naturally emanate from the lessons learned.”

To this end, I believe there are four fundamental, interrelated governance changes inside corporations that are essential for enhancing accountability and increasing stakeholder confidence:

• Boards of directors must redefine the role of the CEO—and then choose leaders who meet the new specs.

Under this recast role, the CEO’s first foundational task is to achieve a balance between taking economic risk (promoting creativity and innovation) and managing economic risk (within a systemic framework of financial discipline) over a sustained period of time.

The second redefined foundational CEO task is to fuse this high performance with high integrity. That means adhering to the spirit and letter of formal rules, voluntary adoption of ethical standards that bind the company and its employees, and employee commitment to core values of honesty, candor, fairness, reliability, and trustworthiness— which together are in the enlightened self-interest of the corporation and reduce legal, ethical, and reputational risk.

…continue reading: Redefining the CEO Role

(Editor’s Note: The post below by Lloyd C. Blankfein is a transcript of remarks by him to the Council of Institutional Investors, Spring Meeting, April 2009.)

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency and responsible ownership. I’m pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public’s long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I’d also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability and enhance investor confidence.

Without trying to shed one bit of our industry’s accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today’s circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.

…continue reading: Lessons from the Financial Crisis