(Editor’s Note: This post comes from Xavier Giroud and Holger M. Mueller of New York University.)

We examine whether corporate governance has a different effect on a firm’s operating performance in competitive and non-competitive industries in our forthcoming Journal of Financial Economics paper entitled Does corporate governance matter in competitive industries? We use exogenous variation in corporate governance in the form of 30 business combination (BC) laws passed between 1985 and 1991 on a state-by-state basis to address this question. By reducing the fear of a hostile takeover, these laws weaken corporate governance and increase the opportunity for managerial slack. Typically, BC laws impose a moratorium on certain kinds of transactions, including mergers and asset sales, between a large shareholder and the firm for a period ranging from three to five years after the shareholder’s stake has passed a prespecified threshold. This moratorium hinders corporate raiders from gaining access to the target firm’s assets for the purpose of paying down acquisition debt, thus making hostile takeovers more difficult and often impossible.

We obtain three main results. First, consistent with the notion that BC laws create more opportunity for managerial slack, we find that firms’ return on assets (ROA) drops by 0.6 percentage points on average after the laws’ passage. Second, the drop in ROA becomes increasingly stronger the less competitive the industry is. For example, ROA drops by only 0.1 percentage points in the lowest Herfindahl quintile but by 1.5 percentage points in the highest Herfindahl quintile. Third, the effect is close to zero and statistically insignificant in highly competitive industries. This last finding, in particular, is supportive of the view expressed by many economists, going back to Sir John Hicks in the 1930s and even Adam Smith, that competition in the product market mitigates managerial slack.

Besides showing that competition mitigates managerial agency problems, we also examine which agency problem competition mitigates. We find no evidence for empire building: Capital expenditures are unaffected by the passage of the BC laws. By contrast, input costs, wages, and overhead costs all increase after the passage of the BC laws, and only so in non-competitive industries. Overall, our findings are consistent with a “quiet-life” hypothesis whereby managers insulated from hostile takeovers and competitive pressure seek to avoid cognitively difficult activities, such as haggling with input suppliers, labor unions, and organizational units demanding bigger overhead budgets. We also conduct event studies around the dates of the first newspaper reports about the BC laws and compute CARs separately for low- and high Herfindahl portfolios. We find that the average CAR for the low-Herfindahl portfolio is small and insignificant, whereas the average CAR for the high-Herfindahl portfolio is −0.54% and significant.

The full paper is available for download here.

The US Congress is currently grappling with the issue of whether and how to regulate the market for financial derivatives. In my testimony before the Senate Committee on Agriculture yesterday (for historical reasons, the Agriculture Committee has jurisdiction over derivatives trading), I explored the theory and history of derivatives and derivatives trading. The full text of my testimony is available here.

My analysis leads to four conclusions. First, despite industry claims, derivatives contracts are not new and are not particularly “innovative.” Derivatives trading in the US dates back at least to the 1800s, and in other countries goes back much further. Second, healthy economies regulate derivatives trading. The only time a significant US derivatives market has been “deregulated” was during the eight years following passage of the Commodities Futures Modernization Act of 2000, which deregulated over-the-counter financial derivatives. Third, although the derivatives industry routinely claims that derivatives trading provides social benefits, virtually no empirical evidence supports this claim. At the same time, history and recent experience both confirm that unregulated derivatives trading is associated with pricing bubbles, added market risk, reduced investor returns, and increased fraud and manipulation.

Fourth and finally, as a historical matter derivatives regulation generally has not taken the form of either a heavy-handed ban on trading, or oversight by an omniscient regulator tasked with intervening on an ad hoc basis. Rather, derivatives markets have been successfully regulated through a web of ex ante procedural rules that include reporting requirements, listing requirements, margin requirements, position limits, insurable interest exceptions, and limits on enforceability. This traditional approach has a long track record of success.

(Editor’s Note: This post is by Theodore N. Mirvis, Andrew R. Brownstein, Steven A. Rosenblum, Eric S. Robinson, Adam O. Emmerich, Trevor S. Norwitz, and David C. Karp of Wachtell, Lipton, Rosen & Katz.)

A tidal wave of anger over the economic climate – what Delaware Chief Justice Myron Steele has called a “populist frenzy” – has created a fertile political environment for recent efforts by three of five SEC Commissioners and Senator Schumer to federalize corporate law under the cloak of shareholder empowerment. Unfortunately for long-term shareholders, and the companies in which they have invested, there is no evidence linking the one-size-fits-all broad proxy access currently under consideration at the SEC and on Capitol Hill to better corporate governance or long-term performance. To the contrary, these proposals, if adopted, will likely exacerbate, rather than mitigate, the emphasis on short-term results that played a significant role in the economic crisis.

First, the SEC’s proposal sets a minimum ownership threshold for shareholder eligibility to the corporate proxy entirely too low, at 1% of the shares of a company with a market capitalization greater than $700 million (with higher thresholds of 3% and 5% for smaller companies). Lowering the bar to 1% (and permitting even smaller shareholders to aggregate their stakes for purposes of achieving the 1% threshold), in contrast to the 5% threshold in our model access bylaw, gives activist and special interest holders a very low cost avenue to seek to influence board composition and corporate strategy. This low threshold will enable shareholder activists to create disruption at many companies each year, and reduce the willingness of qualified directors to serve.

Second, if there are more shareholder nominations than slots available, the SEC’s proposal would give priority to shareholders who submitted their nominations the earliest, regardless of the size of the nominating shareholders’ stakes. This contrasts with the approach of our model access bylaw which prioritizes nominations based upon the relative holdings of the nominating shareholders. Under the SEC’s proposal, a long-term institutional investor holding well in excess of 5% of the company’s equity for many years may have to suffer the negative effects of routine director election contests initiated by holders of 1% for only one year, and also lose the opportunity to avail itself of proxy access merely because the smaller holders beat a faster path to the corporate secretary’s office. As a result, the SEC’s proposal does not merely facilitate access for the occasional proxy access election contest, but rather creates incentives for routine election contests, as shareholders race to make access nominations in order to gain control over the process.

The SEC’s proposal advances a mandatory proxy access regime that will not only weaken corporate boards, but also weaken the relative strength of long-term investors as compared to those investors that pursue short-term strategies often based on hollow financial engineering. The Delaware private-ordering approach to proxy access is more consistent with shareholder democracy in that it allows all the shareholders of each Delaware company to consider, debate and if appropriate adopt through shareholder action – rather than government fiat – shareholder access bylaws that suit the particular circumstances of each individual company and its shareholders. Accordingly, and as we have said before, we agree with the position taken by two of the SEC Commissioners, that a mandatory federal “one size fits all” rule is a serious policy error and the SEC should instead amend Rule 14a-8 to allow the issue to develop at the state law level.

(Editor’s Note: This post is by William Gleeson and Aaron Ostrovsky of K&L Gates LLP. Previous posts on this Forum concerning the SEC’s proposed proxy access rule are available here, here and here.)

The issue of allowing shareholders of public companies to include their nominees for director in the company’s proxy materials (“Proxy Access”) has been the subject of heated debate for years. In 2003, when there were no state law provisions addressing the issue, and in 2007 (when only the North Dakota statute addressed Proxy Access), the Securities and Exchange Commission proposed rules that would facilitate such inclusion, only to abandon the proposals. In March 2009, Delaware added Section 112 to its General Corporation Law, effective August 1, 2009, to allow for bylaws that permit Proxy Access. It has been widely expected that many other states would follow Delaware’s lead and adopt similar statutes. In May 2009, the SEC announced that it would propose a new rule, Rule 14a-11, dealing with Proxy Access that would preempt key parts (but not all) of Delaware Section 112. Proposed Rule 14a-11 would differ in three important respects from the Delaware provision:

In its release announcing that it would propose Rule 14a-11, the Commission focused on enhancing director accountability. According to the Commission, the current economic crisis has created widespread concern about “whether boards are exercising appropriate oversight of management, whether boards are appropriately focused on shareholder interests, and whether boards need to be held more responsible for their decisions regarding such issues as compensation structures and risk management.” The Commission’s solution to the above problems is Proxy Access:

Because of these concerns, the Commission has decided to revisit whether and how the federal proxy rules may be impeding the ability of shareholders to exercise their fundamental right under state law to nominate and elect members to company boards of directors.

But the connection between effective director accountability and Proxy Access for shareholders is not obvious and depends on the validity of several implicit and intermediate premises. We believe that the SEC should address and make a strong case on each of the following premises.

Proxy Access, as a component of corporate governance, is a matter more properly dealt with under state law. We believe that the SEC, as a federal agency, should make a strong case before regulating in an area traditionally regulated by states. This is especially true with respect to Proxy Access, where state legislation is only in its infancy. It is likely that the states will develop a significant body of experience in a relatively short time and it will not be long before more resolving evidence emerges whether or not Proxy Access initiatives at the state level are or are not an effective means of dealing with the issue of director accountability. (We do not address in this alert the issue of whether the SEC has the power to enact Rule 14a-11, an issue that others have dealt with.)

Accordingly, we believe that it would be appropriate for the SEC to adopt a rule consistent with Rule 14a-11, if, but only if, it can make a strong case that the proposed rule is likely to enhance director accountability; that state initiatives such as Delaware’s Section 112 are not likely to increase director accountability; and that the current problems with director accountability are severe enough that we cannot afford to wait to see whether state-level regulation proves out. In making that case, it should address each of the premises discussed below.

…continue reading: Will proxy access enhance director accountability?

(Editor’s Note: This post comes from Jeffrey Marell and Tracey Zaccone of Paul, Weiss, Rifkind, Wharton & Garrison LLP.)

In the midst of what we have come to know as the “global economic crisis,” credit markets continue to be frozen and, in understatement, equity markets continue to be volatile. Failing a substantial near-term recovery, any meaningful window for underwritten public offerings will remain closed. The question that many public companies are asking is what, if any, alternatives are there to raise cash?

Private investments in public equity, commonly referred to as PIPEs, are one option. Once used almost exclusively by small cap issuers or issuers who historically had not been able to sell securities to the public, today large, well-seasoned issuers are turning to the PIPEs market. Indeed, both General Electric Company and the Goldman Sachs Group issued a combined total of $8.0 billion to Berkshire Hathaway Inc. in the fourth quarter of 2008 in PIPEs transactions.[1] Mainstream hedge funds and private equity funds are now opportunistically looking at PIPE investments in distressed companies. Competition in these markets is increasing. Depressed valuations are offering investors attractive opportunities to invest in companies with the potential for future growth.

PIPEs, Deconstructed
What is a PIPE? A typical PIPE is a transaction where one or more investors purchase securities directly from a public company in a private placement rather than in a transaction registered with the Securities and Exchange Commission (SEC). Often, these transactions are conducted through an investment bank or other placement agent, but more recently a greater volume of PIPEs are being sold without an intermediary to one or few large investors. Since PIPE securities are purchased in a private transaction, they are considered “restricted securities” and cannot be immediately resold into the public market. In the transaction, the issuer agrees to file a resale registration statement with the SEC promptly after the closing of the financing. In this way, illiquidity is mitigated—once the resale registration statement becomes effective, the investor may immediately sell the securities purchased in the transaction (or issuable upon conversion in the case of convertible preferred stock or debt) in the public markets. This structure allows for speedy access to capital, a key attraction of a PIPEs transaction to issuers. PIPEs also provide issuers with lower transaction costs as compared to a traditional public offering.

Specifically, in a PIPE transaction, an issuer is contractually required to prepare and file a resale registration statement with the SEC promptly following the completion of the private placement. Typically, a registration rights agreement requires that the issuer use it best efforts to have the registration statement filed with the SEC within 30 to 45 days of closing and declared effective within 90 to 120 days of filing. Registration rights agreements typically contain penalty payments of 1% to 2% of the principal amount of proceeds per month if the issuer fails to meet the filing deadlines. Once the SEC declares the resale registration statement effective, investors may sell the PIPE securities in the public market. The registration statement must remain effective, and the issuer is required to update the registration statement for any material changes, during the period in which the investors are reselling the securities.

Registered Direct PIPEs
Issuers with existing effective shelf registration statements may find PIPEs transactions even more attractive. In a “registered direct” PIPE, an issuer sells securities directly from its shelf registration statement to one or more private investors in a transaction not involving a public offering. As in typical PIPEs, the time to closing may be quick. However, in a registered direct PIPE, investors do not receive “restricted securities” as they are purchasing the PIPE securities in a registered transaction. Unless the investor would be deemed an affiliate of the issuer, there is no need to file a resale registration statement with the SEC following the closing of the transaction. Indeed, this is an attractive option for issuers as not only are transaction costs even lower, the elimination of liquidity risk allows for more attractive pricing. Note, however, that the existing shelf registration statement must already cover the PIPE securities being offered (including any warrants) and the plan of distribution in the base prospectus must contemplate such private sales. In addition, as in all PIPE transactions that utilize the resources of an investment bank to place the securities, the investment bank does not act as an underwriter in an offering. Even though the PIPE securities are offered and sold from an issuer’s existing shelf registration statement, the investment bank acts merely as a placement agent and the transaction is not a firm underwriting.

PIPE Terms
The terms of PIPEs deals vary widely from deal to deal and can involve the offering of a number of different types of securities such as common stock, preferred stock, convertible preferred stock, convertible debt and warrants or any combination of these securities. Typically, PIPE securities are sold at a discount to the trailing average market price for some period prior to closing. However, this is highly negotiated and convertible PIPEs have been priced higher than current market value, especially if there is a conversion premium attached to a convertible security or the security includes warrant coverage.

…continue reading: PIPEs: Raising Equity Capital in Uncertain Times

(Editor’s Note: This post is based on a client memo from Donald S. Bernstein and Marshall S. Huebner of Davis Polk & Wardwell.)

In an important ruling issued on Sunday, May 31, 2009, Bankruptcy Judge Arthur J. Gonzalez in the Southern District of New York approved the sale of Chrysler in exchange for two billion dollars in cash and the assumption of certain liabilities.[1]
[2]

In connection with approval of this sale transaction, Judge Gonzalez opined on sub rosa challenges, the ability of a secured lender to object to a transaction if the administrative agent has consented, and the survival of tort claims after assets have been sold pursuant to section 363 of the Bankruptcy Code. The ruling makes it yet easier for debtors to consummate sales under section 363.

Background
On April 30, 2009, the date Chrysler filed for bankruptcy protection, Chrysler, Fiat S.p.A (”Fiat”) and New CarCo Acquisition LLC (”New Chrysler”), an acquisition vehicle formed by Fiat, entered into a Master Transaction Agreement (the “MTA”) in accordance with section 363 of title 11 of the U.S. Code (the “Bankruptcy Code”). Under the MTA, Chrysler would transfer substantially all of its operating assets to New Chrysler, in exchange for two billion dollars in cash and the assumption of certain liabilities (the “Sale Transaction”). Upon consummation of the Sale Transaction, New Chrysler agreed, pursuant to the MTA, to issue stock to certain interested parties: 67.69% to an independent Voluntary Employee Beneficiary Organization (the “VEBA”) for the benefit of certain Chrysler employees and retirees, 9.85% to the U.S. Treasury, 2.46% to Export Development Canada (”EDC”) and 20% to Fiat.[3]

Objections
Among the objecting parties were: a group of pension funds from the State of Indiana (the “Indiana Funds”) objecting, inter alia, on the grounds that the Sale Transaction amounted to a sub rosa plan; certain Chrysler dealers objecting to the attempted rejection of their dealership agreements and arguing that state dealer protection laws are not preempted by the Bankruptcy Code; and various tort and consumer claimants objecting that their claims were not “interests in property” and that Chrysler’s assets could not, therefore, be sold free and clear of them pursuant to section 363(f)(5) of the Bankruptcy Code. Judge Gonzalez (i) distinguished a valid sale transaction under section 363 of the Bankruptcy Code (a “363 sale”) from a sub rosa plan, (ii) enforced contractual provisions that restrict a minority secured lender’s standing to object and (iii) ruled that tort claims are extinguished in a 363 sale.[4]

Court Denies that the Sale Transaction is a Sub Rosa Plan
The Indiana Funds argued that the Sale Transaction was an attempt to circumvent chapter 11 requirements for plan confirmation and, thus, was a sub rosa plan of reorganization. Judge Gonzalez, expanding on and clarifying prior case law,[5] ruled that it is not a sub rosa plan for “a debtor [to] sell substantially all of its assets as a going concern and later submit a plan of liquidation providing for the distribution of the proceeds of the sale,” if such proceeds both (i) exceed the value that could be received in a liquidation and (ii) go directly to the first priority lenders. Judge Gonzalez went on to state that the receipt of equity interests in New Chrysler by the VEBA, the U.S. Treasury, EDC and Fiat are the result of separately negotiated agreements with New Chrysler - including the unprecedented modifications to the collective bargaining agreement between the United Auto Workers and New Chrysler for the VEBA, the financing that the U.S. Treasury and EDC will provide to New Chrysler and the provision of small car technology by Fiat - and are not on account of any prepetition claims. As such, he ruled that there had not been an inappropriate attempt to divert sale proceeds away from the Indiana Funds or to affect anything other than a pro rata distribution of the proceeds to all first priority claimants.

…continue reading: Implications of the sale of Chrysler

(Editor’s Note: This post comes from Jere R. Francis, Inder K. Khurana, Raynolde Pereira and Shawn Huang of the University of Missouri-Columbia.)

In our paper Does Corporate Transparency Contribute to Efficient Resource Allocation? which was recently accepted for publication in the Journal of Accounting Research, we examine whether the country-level information environment positively affects the timely reallocation of resources in response to growth shocks (or changes in growth opportunities) by improving the transfer of resources from industries which experience negative growth shocks to those that experience positive growth shocks.

We hypothesize that if a pair of countries has a high level of corporate transparency in each country, then investors are better able to recognize and direct resources towards industries which experience positive growth shocks and away from industries which experience negative growth shocks, irrespective of financial development. Our sample consists of calculated correlations in industry growth rates for 666 country pairs based on 37 unique countries and 37 manufacturing industries for the period 1980-1990 using industry-level data from a United Nations Industrial Development Organization (2000) database. We merge these correlations with country-level measures of corporate transparency that capture the quality of the financial reporting regime, the intensity of private information collection, the quality of information dissemination structures, the level of earnings opacity and stock price synchronicity.

We find transparency is positively associated with the correlation in industry-specific growth rates across country pairs. This positive association is consistent with the notion that corporate transparency helps to channel resources to those particular industries with good growth opportunities and hence contributes to more effective inter-sector allocation of resources. These results generally hold across alternative measures of transparency. In addition, we find that the impact of corporate transparency on the co-movement in growth rates is greater for country pairs with similar levels of economic development. Third, we find that the residual transparency metrics positively explain co-movements in industry-specific growth rates among country pairs, which indicates that transparency over and above that predicted by the underlying institutions facilitates resource allocation. Finally, we measure a country’s level of ex ante growth opportunities using the price-earnings ratio of global industry portfolios weighted by a country’s industrial mix and find that it is only countries with high transparency where there is an association between ex ante global growth opportunities of firms (within a country) and the country’s realized ex post growth in real GDP per capita. This result is consistent with the argument that firms in more transparent settings are better able to exploit global growth shocks and thus achieve higher realized growth rates.

The full paper is available for download here.

(Editor’s Note: This post is based on a memo by Donald S. Bernstein, Marshall S. Huebner, Brian M. Resnick, and Steven C. Krause of Davis Polk & Wardwell.)

In an important ruling recently issued, Bankruptcy Judge Allan L. Gropper in the Southern District of New York approved a $400 million debtor-in-possession facility for General Growth Properties, Inc., which filed the largest real-estate Chapter 11 case in U.S. history. In connection with approving the financing, Judge Gropper permitted affiliated debtors to use excess cash collateral from bankruptcy-remote special purpose entities which, to the surprise of many market participants, were included in the Chapter 11 proceedings.

Background
General Growth Properties, Inc. (the “Company”) is a publicly held shopping mall operator headquartered in Chicago. By the time of its bankruptcy filing on April 16, 2009, it was the second largest shopping mall operator in the U.S., owning more than 200 malls in 44 states, with approximately $27 billion in debt outstanding. Approximately $15 billion of its debt is in the form of collateralized mortgaged-backed securities (”CMBS”), making the Company the largest borrower in the CMBS market.[1]

In connection with seeking approval of the Company’s proposed debtor-in-possession facility (the “DIP Facility”), the Company also sought use of cash collateral from separately organized subsidiary bankruptcy-remote special purpose entities (”SPEs”), which were, to the surprise of many market participants, included in the Company’s Chapter 11 proceedings. The property owned by each of these SPEs was intended to secure only the obligations of the pre-petition lenders to the SPE owning the property (the “SPE Lenders”). Arguing that the value of the collateral in certain of the SPEs is sufficient to protect the interests of the SPE Lenders, the Company proposed that excess cash collateral from rents be made available to support the DIP Facility. In exchange, as adequate protection, the Company and the SPE Lenders consensually agreed, among other things, that (i) each of the SPE Lenders would receive a perfected first-priority post-petition lien on (a) the respective SPE’s claims against the Company resulting from the consolidation of their cash collateral in the Company’s centralized cash management system and (b) the cash in the centralized cash management system itself; (ii) each of the SPE Lenders would receive a perfected post-petition lien on properties securing a separate pre-petition facility with Goldman Sachs Mortgage Company (the “Goldman Facility”) junior to the liens securing the DIP Facility and the Goldman Facility; and (iii) the Company would continue to pay interest at the applicable non-default rates and to maintain the properties, including the payment of taxes and other operating expenses, in accordance with their pre-petition agreements.

Several pre-petition agents for the SPE Lenders (the “Pre-Petition SPE Agents”) filed objections to the Company’s proposed DIP Facility on behalf of the SPE Lenders. The Commercial Mortgage Securities Association and the Mortgage Bankers Association also filed an amici curiae brief (the “Amici Brief”) with the court addressing the implications of the proposed use of cash collateral on commercial real estate finance.

…continue reading: SPE Assets Invaded to Benefit Affiliated Entities

(Editor’s Note: This post comes to us from James McRitchie, Publisher of CorpGov.net.)

Please take a few minutes to read and submit comments on a rulemaking petition that a group of ten filed with the SEC on Friday, May 15th, to amend Rule 14a-4(b)(1). The petition seeks to correct a problem brought to our attention by John Chevedden, long-time shareowner activist. See petition File 4-583 here. Send comments to  rule-comments at sec.gov with File 4-583 in the subject line.

The problem is that when retail shareowners vote but leave items on their proxy blank, those items are routinely voted by their bank or broker as the subject company’s soliciting committee recommends. Current SEC rules grant them discretion to do so. As shareowners who believe in democracy, we have filed suggested amendments to take away that discretionary authority to change blank votes, or non-votes, as they might be termed. We believe that when voting fields are left blank on the proxy by the shareowner, they should be counted as abstentions.

This problem is not the same as “broker voting,” which has already been repealed on “non-routine” matters and, we hope, will soon be repealed for so-called “routine” matters, such as the election of directors. For example, even though “broker voting” has been repealed for shareowner resolutions, if a shareowner votes one item on their proxy and leaves shareowner resolutions blank, unvoted, those blank votes are routinely changed to be voted as recommended by the company’s soliciting committee.

See two examples. At Interface, I voted only to abstain on ratification of the auditors. Yet, you can seeProxyVote automatically fills in my blank votes with votes as recommended by the soliciting committee. A second example, at Staples, shows much the same. You can see blank votes that are changed also include the shareowner proposal to reincorporate to North Dakota, even though such proposals are not considered routine and are not subject to “broker voting.”

Just as broker votes should be eliminated so that votes counted reflect the true sentiment of shareowners, the practice of converting blank votes to votes for management should also end.

In our petition, we also highlight a secondary concern. When shareowners utilizing the ProxyVoteplatform of Broadridge vote at least one item and leave others blank, the subsequent screen warns them that their blank votes well be voted as recommended by the soliciting committee. This provides an opportunity to the shareowner to change their blank vote before final submission, if they don’t want it to be voted as recommended.

…continue reading: Don’t Let Companies Change Shareholders’ Blank Votes

(Editor’s Note: This post comes from Vladimir Atanasov of the College of William and Mary, Bernard Black of the University of Texas at Austin, Conrad S. Ciccotello of Georgia State University and Stanley B. Gyoshev of Exeter University.)

In our paper How Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria, which was recently accepted for publication in the Journal of Financial Economics, we provide a simple model which unbundles different forms of “tunneling”, the extraction of firm value by a firm’s controlling shareholders or managers, and derive how each affects firm profitability and valuation. We develop the model partly to extend existing models of tunneling, but primarily to develop predictions which we can test using a natural experiment in Bulgaria, provided by 2002 anti-tunneling reforms.

Bulgaria went through mass privatization in 1998, which was followed by extensive equity tunneling. The 2002 legal changes limit both dilution and freezeouts, and allow us to examine how specific rules can affect specific forms of tunneling, firm valuation, and firm profitability. We model and study empirically two flavors of equity tunneling: dilutive equity offerings (issuance of shares to insiders at below market value); and freezeouts (forced sale of minority shares to the controller for below market value). We find that following the change, minority shareholders participate equally in secondary equity offers, where before they suffered severe dilution; and freezeout offer prices quadruple. At the same time, return on assets declines for high-equity-tunneling-risk firms, suggesting that controlling shareholders partly substitute for reduced equity tunneling by engaging in more cash-flow tunneling. The 2002 legal changes, and controllers’ responses to them, also affect market values. Tobin’s q levels rise sharply for high-equity-tunneling-risk firms relative to low-risk firms, despite the increased cash flow tunneling in high-risk firms. These results are economically large and robust to different ways of estimating tunneling risk, and different valuation measures (price/sales, price/earnings and market/book value of equity).

Our results have implications for asset pricing research in emerging markets. In high tunneling risk markets, investors must estimate not only expected cash flows (as in any market) but also tunneling risk. We find evidence that equity tunneling risk varies widely in cross-section, and that Bulgarian investors consider this risk and update their valuation estimates when legal rules change. Equity tunneling risk, as a factor in explaining equity prices and expected returns, can complement some commonly used factors, such as market risk and momentum, and interact with others, such as firm size and book/market ratio. Size may correlate with tunneling risk (as we confirm below for Bulgaria), and high book/market ratios could reflect high tunneling risk. Investor pricing of equity tunneling risk factors can also help explain home country bias, as local investors may be better equipped to evaluate equity tunneling risk at the firm-level.

The full paper is available for download here.

The SEC has issued Release No. 34-59880 soliciting comments on proposed amendments to NASD Rule 2720 that streamline the application of the Rule’s requirements to public offerings of securities in which a participating broker-dealer has a “conflict of interest.” Some of the more significant proposed amendments would:

a. exempt from the filing requirements and the qualified independent underwriter (”QIU”) requirements of NASD Rule 2720 public offerings (1) in which the FINRA member primarily responsible for managing the offering (or each co-lead, if applicable) does not have a conflict of interest, is not an affiliate of a member that has a conflict of interest and can meet the disciplinary history requirements for a QIU, (2) of investment-grade rated securities, and (3) of securities that have a bona fide public market;

b. change the definition of “conflict of interest” so that the Rule would cover public offerings in which at least five percent of the offering proceeds are directed to a participating member or its affiliates (in contrast to the current ten percent threshold set forth in Rule 5110(h) (formerly NASD Rule 2710(h)), which applies on an aggregate basis to all participating members, and which would now become part of Rule 2720);

c. modify the Rule’s disclosure requirements so that information relating to conflicts of interest is more prominently disclosed in offering documents;

d. amend the Rule’s provisions regarding the use of a QIU to focus on the QIU’s due diligence responsibilities and eliminate the requirement that the QIU render a pricing opinion;

e. amend the QIU qualification requirements to focus on the experience of the firm rather than its board of directors, prohibit a member that would receive more than five percent of the proceeds of an offering from acting as a QIU, and lengthen from five to ten years the amount of time that a person involved in due diligence in a supervisory capacity must have a clean disciplinary history; and

f. eliminate provisions in the Rule that do not apply to public offerings and instead address an issuer’s corporate governance responsibilities.

The comment period is 21 days from the date the SEC release is published in the Federal Register. Before becoming effective, any amendments to NASD Rule 2720 finally proposed by the FINRA must be approved by the SEC. A copy of SEC Release No. 34-59880 is available here.

(Editor’s Note: This post is based on a client memorandum by Charles Nathan, Alexander Cohen, Constantine Skarvelis and Raluca Papadima of Latham & Watkins LLP.)

Highlights

• Shareholder proxy access is coming, and it will be the hottest issue of the 2010 proxy season. Public companies should expect, and be prepared for, the strong likelihood of shareholder proxy access in the 2010 proxy season.

• The SEC is scheduled to vote on a proposed shareholder proxy access rule tomorrow, May 20, 2009. We assume that Chairman Schapiro intends the rule to become final around the end of October—that is, in time for the 2010 proxy season.

• Senator Charles Schumer of New York has introduced a bill that, among other things, would confirm the SEC’s authority to adopt a proxy access rule and that would require the SEC to adopt rules directly regulating proxy access, rather than deferring to state law.

• The Delaware General Corporation Law has been amended to authorize companies expressly to adopt bylaws providing for shareholders access to the company’s proxy statement for director nominations.

• Most observers now believe the question is not whether there will be shareholder proxy access for 2010, but rather what it will look like. The shape of proxy access depends principally on whether the final version of the SEC rule:

• For those who accept that shareholder proxy access is a foregone conclusion, the key is the details of how shareholder access will be implemented—the so-called “workability” issues. Workability in the context of proxy access is far more complicated than it may first appear. However, it will be the key to whether proxy access becomes, as many of its supporters assert, a sparingly used device that has the effect of instilling greater accountability of directors or, as many of its opponents fear, the progenitor of countless election contests and divided and dysfunctional boards.

Background

What is Proxy Access?
Shareholder proxy access is a proposed regime that would allow shareholders of a public company to include in a company’s proxy materials (proxy statement and proxy card) candidates for director nominated by the shareholder in opposition to the company’s candidates for election. Under the current regime, only the company’s nominees for election to the board of directors are included in company proxy materials. If a shareholder wants to nominate opposition candidates, it must prepare, pay for and distribute separate proxy materials. The obvious point of shareholder proxy access is to change the classic election contest paradigm and thereby facilitate shareholders’ ability on a virtually costless basis to elect directors who are not on the board slate.

Who are the Players?
There are six main groups of players in the proxy access struggle:

• Corporate governance activists, spearheaded by labor unions, state and local government pension funds and the Council of Institutional Investors, have been the main proponents pushing for proxy access. Although not as vocal, activist investors are also supporters of proxy access;

• The SEC, where Chairman Schapiro has announced that she views proxy access rulemaking as a key priority;

• Members of Congress, such as Senator Schumer and other prominent Democratic lawmakers, seem committed to creating a shareholder access regime of some type;

• The business community, led by the US Chamber of Commerce (the Center for Capital Market Competitiveness) and The Business Roundtable, has been strongly opposed to proxy access since the first SEC rule-making foray in 2003;

• The legal community, through its various bar associations and a number of law firms, will weigh-in on the latest round of the proxy access debate once the SEC issues its proposed rule; and

• The proxy advisory firms, most notably RiskMetrics, which will have a large say on shareholder voting on proxy access proposals and on contested director elections resulting from proxy access, are expected to support proxy access.

…continue reading: The Battle for Shareholder Access: The Current State of Play

In our paper Why do firms appoint CEOs as outside directors? which was recently accepted for publication in the Journal of Financial Economics, my co-authors Rüdiger Fahlenbrach and Angie Low, and I investigate in detail the role of outside board members who are CEOs of U.S. public companies. Using data from 1988 to 2005 on more than 10,000 firms, we try to answer two questions. First, what determines whether an outside CEO or another person is appointed director? Second, do outside directors who are CEOs create value for minority shareholders?

Appointments of outside CEOs to boards are highly sought after by companies. Large, well-known companies tend to have active CEOs as outside members on their boards. For instance, the 2008 board of Procter and Gamble has four outside directors who are CEOs. Surprisingly, we find that the typical firm in our sample does not have any outside CEO on its board. Direct compensation is not used to equate the supply and the demand for CEO outside directors - they do not receive more direct compensation than other board members who attend the same meetings. We argue that the high demand for their services as outside directors allows CEOs to take their pick of board seats, and they will naturally choose boards that offer them the best total package for the amount of effort required and for the risk involved. We find that CEOs are most likely to join boards of large established firms that are geographically close, pursue similar financial and investment policies, and have comparable governance mechanisms to their own firms. CEO directors are also more likely to join firms which already have other CEO directors on the board. These findings are consistent with a prestige factor, indicating that CEO directors are more likely to accept additional directorships if such positions provide them with benefits such as added prestige or networking opportunities.

We find that the stock market reacts more favorably to the appointment of a CEO outside director than to the appointment of a non-CEO outside director when the firm currently has no outside CEO on its board. Such a positive market reaction is consistent with two hypotheses. Because of their current position, CEOs have an unusual amount of authority and experience. Therefore, once appointed, a CEO outside director could be valuable to the appointing firm because she can monitor and advise the incumbent management in a way that the typical outside director is not able to. We call this hypothesis the performance hypothesis. It is also possible that if a firm succeeds in recruiting a CEO to its board, it shows to the outside world that a business leader whose human capital is especially reputation-sensitive thinks highly enough of the firm to join its board. We call this hypothesis the certification hypothesis. Such certification could have value for the appointing firm even if the CEO outside director has little tangible impact on the firm after her appointment since the appointment might primarily certify the current market value of the firm.

We further test whether there is support in favor of the performance hypothesis by investigating changes in the firm’s operating performance upon appointment of a CEO director. To address endogeneity concerns, we use a matched-firm approach, a difference-in-difference approach, and an instrumental variable approach. We fail to reject the null hypothesis that the appointment of a CEO outside director has no impact on operating performance except in the case of interlocks where the appointment is followed by significantly poorer performance. Next, we examine whether CEO directors are associated with better board decision-making. First, we find little evidence of improved CEO turnover decisions, but we find some evidence that interlocks make the CEO more comfortable in her position. Second, firms with CEO outside directors do not make better acquisitions, where the quality of an acquisition is measured by the firm’s abnormal return at the time of the acquisition announcement. Finally, we find no evidence that CEO outside directors affect how the appointing firm’s CEO is compensated.

Overall, our findings are consistent with the following interpretation. The appointment of a CEO outside director helps certify the appointing company and its management, but it does not lead to measurable improvements in operating performance or corporate policies. With the certification hypothesis, CEO outside directors differ from other directors because their status and reputation enable them to credibly certify the firms that appoint them. CEO outside directors may be sought after by many firms, but they choose strategically their board seats in large, mature firms that they seem to understand, perhaps because they are worried about damage to their reputation should they be involved with a failing firm. Our results on the determinants of CEO director appointments confirm this matching process. It could be that the CEO outside director has no impact on operating performance or corporate policies, perhaps because CEO directors are simply too busy with their day job to use their prestige, authority, and experience to have a substantial impact on the boards they sit on.

The full paper is available for download here.

Michael Torres, who is my colleague at Mayer Brown LLP, and I have written a paper titled Directors’ Monetary Liability for Actions or Omissions Not in Good Faith, based on a paper we submitted to the Ray Garrett Jr. Corporate and Securities Law Institute at Northwestern Law School. It has long been established that damages are available against directors when they engage in self-dealing or similar actions in situations in which they have a conflict of interest. Few issues in U.S. corporate law, however, are as controversial as whether directors should be exposed to damages for their actions or omissions in situations in which they do not have a conflict of interest. Advocates of such damages awards argue that they are appropriate in extreme cases of directorial misconduct and an important deterrent to future misconduct. Opponents of such awards argue that courts cannot reliably distinguish between extreme cases of misconduct and routine cases of negligence, and that well-qualified persons will not serve as directors if they are exposed to this type of monetary liability.

Since the enactment of section 102(b)(7) of the Delaware General Corporation Law, it has been clear that directors could still be responsible for damages for breaches of the duty of loyalty involving conflicts of interest – for example, being on both sides of a transaction to which the corporation was a party – and could not be held liable for money damages for breaching their duty of care, even if they were grossly negligent. The question was whether there was any real-world basis for imposing damages on directors in situations in which they did not breach their duty of loyalty on conflict of interest grounds.

Beginning in the middle 1990s with the Caremark decision, the Delaware courts answered that question in the affirmative by making it clear that certain conduct of directors who did not have a conflict of interest could constitute acts or omissions not in good faith that would expose them to damages. As the law has developed, there has been no bright line rule defining such conduct. Consequently, there is no shortcut to examining the cases decided inside and outside of Delaware in determining where the law now stands. Most of these cases were brought as derivative lawsuits, and the reported decisions were issued in deciding defendants’ motions to dismiss because of the plaintiffs’ failure to make a demand on the company’s board of directors. We briefly analyze a number of these decisions, dividing them into cases in which the directors are accused of failing to act and therefore violating their duty of oversight and cases in which the directors are accused of acting improperly. We reached the following conclusions from this analysis:

1. The courts are anxious to limit monetary liability for bad faith to situations in which directors knowingly countenanced wrongdoing or knowingly engaged in wrongful conduct. The test laid down in Stone v. Ritter, 911 A.2d 362 (Del. 2006), for bad faith oversight is that the directors knew that they were not discharging their obligations of oversight because they utterly failed to implement any reporting or information system or controls or, having implemented such a system or controls, consciously failed to monitor or oversee their operations. The test for bad faith action laid down in In re the Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006), is intentional dereliction of duties or a conscious disregard of one’s responsibilities. Thus, the case law, in both the oversight and the action situations, indicates that bad faith has a mens rea requirement: bad faith requires scienter, i.e., an illicit state of mind. Anything less is no more than gross negligence, which Disney defined as not bad faith.

2. However, the line between bad faith and negligence or gross negligence can be blurry, especially in merger or sale cases. It is arguably difficult to distinguish between the bad faith conduct of the director held liable in In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. 2004), for permitting an unfair transaction and the director in Gesoff v. IIC Industries, Inc, 902 A.2d 1130 (Del. Ch. 2006), or the directors in McPadden v. Sidhu, 964 A.2d 1262 (Del. Ch. 2008), who permitted unfair transactions but were exonerated because their conduct, while negligent or grossly negligent, did not rise to bad faith. It is possible that Emerging Communications is an anomaly because lawsuits challenging directors’ good faith, absent a conflict of interest, in merger and sale transactions have been mostly unsuccessful. See, in addition to Gesoff and McPadden, In re Lear Corporation Shareholder Litigation, 2008 WL 5704774 (Del. Ch. 2008), and Lyondell Chemical Company v. Ryan, 2009 WL 790477 (Del. 2009).

3. McCall v. Scott, 239 F.3d 808 (6th Cir.), amended on denial of rehearing, 250 F.3d 997 (6th Cir. 2001), and In re Abbott Laboratories Derivative Shareholder Litigation, 325 F.3d 795 (7th Cir. 2001), suggest (admittedly based on a small sample) that courts outside of Delaware may be more inclined to allow oversight claims to proceed than Delaware courts are. Indeed, Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003), Stone v. Ritter, Desimone v. Barrrows, 924 A.2d 908 (Del. Ch. 2007), Wood v. Baum, 953 A.2d 136 (Del. 2008), and In re Citigroup Inc. Shareholder Litigation, 964 A.2d 106 (Del. Ch. 2009), are all Delaware cases in which oversight claims were dismissed, with AIG Consolidated Derivative Litigation, 965 A.2d 763 (Del. Ch. 2009), being a counterexample.

4. The courts appear to be drawing a distinction between directors’ oversight or actions resulting in bad business decisions that did not result in illegality or fraud and those that did. In the former case the courts tend not to find bad faith. See Citigroup, Gesoff, Disney, McPadden, Lear and Lyondell. In the latter case the courts will find bad faith if the complaint supplies particularized allegations of a knowing failure of oversight or knowing misconduct. See McCall, Abbott, AIG, Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), and In re Tyson Foods Consolidated Shareholder Litigation, 919 A.2d 563 (Del. Ch. 2007). The courts are concerned that the availability of damages for bad faith not lead to directors being second-guessed for business decisions that were merely wrong.

The paper is available here.

(Editor’s Note: The post below by Commissioner Aguilar is a transcript of remarks by him at the recent 2009 Independent Directors Conference Workshop in Boston).

It is a pleasure to be here with all of you at the 2009 Independent Directors Conference Workshop to share my views on the regulatory reform issues currently being discussed. I do have to mention that all the views I express today are my own and do not necessarily reflect those of the Commission, the individual Commissioners, or the staff.

I welcome the opportunity to talk with you today. As a practitioner in the securities industry for thirty years who often advised boards of directors, including mutual fund boards, I am familiar with your work and know its importance. I have the utmost admiration for independent directors. You more than anyone have to exemplify the principle that — laws tell you what you can do but values inspire what you should do. As fiduciaries, you play a critical role in setting the appropriate tone at the top and overseeing some of the most important aspects of the fund’s business from keeping fees in line to negotiating important contracts.

Your efforts are crucial to safeguarding the retirement savings and investments of hard working men and women. At the end of 2008, mutual funds, including money market funds, were collectively responsible for approximately $9 trillion of investors’ monies invested in countless corporations, municipalities and myriad investment opportunities. These assets represented the savings of over 92 million individuals.

I have had the distinction of serving on the Commission during “transformational” times, to say the least. I took office at the end of July 2008 and literally my first two months were filled with unprecedented Commission action — running the gamut from being involved with some of the SEC’s largest settlements ever in cases involving Auction Rate Securities to an unprecedented amount of emergency rulemaking and Commission orders.

Now even though the financial crisis continues, the rapid response phase of the crisis is giving rise to discussions of reform resulting from that crisis. In fact, the issues being discussed could very well lead to the largest wholesale regulatory restructuring this country has seen since the great depression. For example, we at the SEC currently find ourselves enmeshed in parallel discussions about the structure of the financial regulatory system, the SEC’s role in such a system, and the regulation of entities under our jurisdiction.

Like me, you too have the opportunity and challenge of representing investors in a time of “transformation.” The global financial crisis has brought us to a point where transformation of existing financial regulation is a given.

The opportunity to take a fresh look involves all of us here today, we at the SEC, and you as fiduciaries, overseeing trillions of dollars that represent a substantial portion of our Nation’s wealth.

…continue reading: Making Investors a Priority in Regulatory Reform

(Editor’s Note: This post comes from C.S. Agnes Cheng of Louisiana State University, Henry Huang of Prairie View A&M University, Yinghua Li of Purdue University, and Gerald J. Lobo of the University of Houston.)

Our paper, Institutional Monitoring through Shareholder Litigation, forthcoming in the Journal of Financial Economics, investigates the effectiveness of using securities class action lawsuits in monitoring defendant firms. We compare differences in (1) immediate litigation outcomes (including the probability of surviving the motion to dismiss and the settlement amount), and (2) subsequent governance improvement (specifically changes in board independence), across class action lawsuits led by institutions versus individuals. We find that securities class actions with institutional owners as lead plaintiffs are less likely to be dismissed and have larger monetary settlements than class actions with individual lead plaintiffs. We also find that after the lawsuit filings, defendant firms with institutional lead plaintiffs experience greater improvement in their board independence than defendant firms with individual lead plaintiffs.

Our paper is motivated by the lack of evidence on the effectiveness of institutional investors exercising their monitoring power through litigation. Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs. Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class action litigation. In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, from both an immediate disciplining of management as well as a long-term corporate governance perspective.

We believe a theory of why and under what conditions institutions will choose to lead a class action is important. Because of the free-rider problem, we propose that institutions will step forward to lead the class actions only when their net benefits are higher than attorney agency costs. We discuss the costs and benefits for institutional owners and develop surrogates for their incentive to serve. Our determinants model provides insights regarding institutions’ incentives to serve as the lead plaintiff. We also use this model to control for endogeneity in investigating monitoring effectiveness.

Using a sample of 1,811 securities class actions filed between 1996 and 2005, we find that when the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff. Specifically, we find that institutional investors are more likely to serve as the lead plaintiff when the lawsuit involves an accounting-related allegation, has an accounting firm as the co-defendant, has a longer class period, has a larger negative market reaction to the revelation event, and has a larger potential investor loss. The probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

After controlling for these determinants of having an institutional lead plaintiff in our multivariate regression analysis, we find that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements. Further analysis indicates that all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount. We also find that within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs. These results are robust to controlling for regulatory changes in the NYSE, NASDAQ and SEC corporate governance requirements during the sample period and for determinants of having an institutional lead plaintiff.

The paper is available here.

(Editor’s Note: This post is based on a client memo by John F. Savarese and Wayne M. Carlin of Wachtell, Lipton, Rosen & Katz.)

This is a period of significant change in the SEC’s enforcement program. A variety of new measures have already been implemented and numerous additional proposals are currently under consideration. The implications are likely to be significant for any company or financial institution that may be responding to SEC investigations in the months ahead. New policy decisions and their methods of implementation are likely to affect such matters as the SEC’s deployment of its resources, the pace and focus of investigations and opportunities for timely resolution of enforcement inquiries.

Chairman Mary Schapiro and Director of Enforcement Robert Khuzami have focused on speeding up the process of conducting investigations and bringing cases. One of Chairman Schapiro’s first acts was to terminate the agency’s “pilot program” regarding financial penalties, which had been widely viewed as slowing the enforcement process. We view this as a favorable development, given the practical concerns that our firm initially raised about this program. See “Implications of the New SEC Penalty Policy” (May 15, 2007); “SEC Penalties Revisited” (June 8, 2007). Another early step was to streamline the procedure by which the staff obtains formal orders of investigation, which permit the staff then to issue investigative subpoenas as needed to obtain documents and testimony.

Congress appears poised to authorize the SEC to hire more staff and to increase its budget, and on May 7, 2009 the Obama Administration proposed a 6.8% funding increase for the agency in fiscal 2010. The key issue to watch is how the agency uses the new money, and who it hires to fill the new slots. Everyone’s interests will be best served if the SEC is able to recruit to its ranks new staff who will bring the agency the benefit of experience. In Congressional testimony on May 7, 2009, Mr. Khuzami stated that one of his goals is to increase the staffing of Enforcement’s trial unit. See here. This would be a positive development. Bringing more trial lawyers on board will enable the SEC to try more cases – but involving those seasoned trial lawyers in the pre-authorization case review process will also enhance the enforcement staff’s ability to identify the cases that should not be brought because they will be losers in court.

The GAO has also emphasized the theme of streamlining the SEC’s internal processes to allow investigations to be completed and cases filed more swiftly, in its report on the SEC’s enforcement program issued on May 7, 2009. See here. Streamlining is a laudable goal. At the same time, not all investigations should be pursued to completion, and not all investigations should lead to enforcement actions. The goal of bringing meritorious cases more rapidly should not compromise the staff’s ability to weed out the investigations that should be closed without action.

As the SEC’s new leadership contemplates reform, there are some additional ideas that should be considered. While these suggestions would in some ways be advantageous for companies involved in investigations, they would at the same time enhance the SEC’s own efficiency and effectiveness:

• Early meetings with defense counsel – The willingness of enforcement staff to meet with defense counsel and engage in a dialogue early in an investigation varies greatly among SEC offices. An open-door policy and a willingness to listen is not only fair to the parties involved, but in the SEC’s own interest. These early discussions can bring factual information to the attention of the staff that will enable them to narrow or even close investigations at an early stage, so that their limited resources can be deployed on more promising matters. Prudent defense counsel will not abuse the opportunity to meet with the staff, and will use this approach only in inquiries that genuinely warrant being closed down early.

• Better coordination among investigating authorities – It is commonplace for SEC investigations to be accompanied by parallel investigations of the same facts by one or more other regulatory or prosecutorial authorities. In some cases, parallel proceedings are appropriate. In many cases, however, little if any public interest is served by multiple simultaneous investigations of the same facts. The main result is an exponential increase in the cost of the investigation for the parties involved, as well as misallocation of regulatory resources. While this is a problem that the SEC does not have the unilateral ability to solve, senior officials should use their persuasive powers to discourage unnecessarily duplicative investigations.

• Open the investigative files – The SEC’s enforcement manual, which was publicly released last year, recognizes that the staff has discretion to provide access to its evidentiary files to defense counsel at the conclusion of an investigation, as part of the Wells process, in which the staff engages in dialogue with counsel concerning possible enforcement action. In practice, the staff’s willingness to exercise this discretion varies greatly, and full open access is rare. In most cases at this stage, there is no compelling need to maintain secrecy about the testimony of witnesses or the contents of documentary evidence. Decision-making by the senior staff and by the Commission itself will be better-informed at the Wells stage if defense counsel are able to see the evidentiary record. This cuts both ways. Open access will help expose cases that have weak evidentiary support and should be closed or narrowed. At the same time, defense counsel will be better able to recognize cases where the staff’s evidence is strong and where a settlement should be pursued.

Additional proposals are bound to come under discussion as the agency’s new leadership continues to think creatively about improving the effectiveness of the enforcement program. This process should continue to include careful analysis of the likely practical effects of each new idea. For companies involved in investigations, it is essential to be mindful of the ongoing changes at the SEC, and the opportunities and challenges for effective advocacy that they present. Getting meritorious cases resolved sooner, while also weeding out marginal investigations faster, should be in everyone’s interests.

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

The Securities and Exchange Commission voted last week to ask the public to comment on a proposal to let shareholders place director candidates on the corporate ballot. The adoption of such a rule would be a useful step toward the necessary reform of corporate elections.

As my research has shown, it’s hard for shareholders to replace directors, and electoral challenges to incumbent directors are infrequent. One main impediment to such challenges is incumbents’ control of the company’s proxy card – the corporate ballot sent by the company at its expense to all shareholders. While board-nominated candidates appear on the ballot, challengers must bear the costs of sending (and getting back) their own proxy card to shareholders.

The SEC’s proposal would provide shareholders in certain limited circumstances with “proxy access” – the right to place director candidates they nominate on the company’s proxy card. To be allowed to place candidates on the corporate ballot, a shareholder (or a group of shareholders) will need to hold 1%-5% of the shares (depending on the company’s size) for more than one year. These requirements mean that only long-term shareholders with a significant stake will be able to propose their own directors.

Opponents of the SEC’s proposal argue that the SEC shouldn’t impose a blanket rule about proxy access, but rather should leave the provision of proxy access arrangement to company-by-company choices. One size does not fit all, the argument goes, and the SEC’s proposal would prevent variation and experimentation.

It is ironic that opponents of proxy access now raise the banner of company-by-company choices. In 2007, the SEC examined whether to let shareholders propose bylaw amendments that would establish proxy access for shareholders seeking to nominate directors. At that time, opponents of proxy access persuaded the SEC to prohibit the inclusion of such proposals on the ballot. This prohibition made it rather difficult for shareholders to adopt proxy access arrangements on a company-by-company basis. For many opponents of proxy access, then, uniformity seems to be quite acceptable when it doesn’t involve shareholder access but becomes unacceptable when it does.

In fact, the proposed SEC rule would allow some meaningful variation. The proposal would establish some mandatory requirements as to shareholders nominations that would have to be included, but would allow companies to adopt arrangements providing shareholders with more expansive access to the company’s proxy.

Opponents also argue that establishing any minimum requirements for inclusion of director candidates on the company’s proxy card departs from the SEC’s traditional role into an area best left for state corporate law. However, the SEC’s proxy rules already mandate the inclusion of some information, including certain shareholder proposals, on the corporate ballot and accompanying proxy materials. The SEC’s proposal would merely expand the current mandatory requirements, and wouldn’t enter any new territory.

The objections to the SEC proposal are weak. Indeed, the proposed proxy access should be supplemented with additional reforms of corporate elections.

First, proxy access wouldn’t eliminate the cost advantage of incumbent directors, whose campaign expenses are fully financed by the company. To reduce this cost advantage, firms should reimburse the campaign expenses of successful challengers.

Second, firms should dismantle staggered boards. All directors should stand up for election at each annual shareholder meeting.

Furthermore, the arrangements governing corporate elections should be set by shareholders, not by the very directors whose election is regulated by these arrangements. To this end, as the SEC’s release suggests, shareholders’ ability to adopt election bylaws should be facilitated. In addition, boards shouldn’t be permitted to adopt bylaws making their own removal more difficult or to repeal any shareholder-adopted election bylaws.

The case for comprehensive reform of corporate elections is supported by a significant body of empirical evidence. Arrangements that insulate directors from removal are associated with lower firm value and worse performance.

The proxy rules have been intended by Congress, the courts have stated, “to give true vitality to the concept of corporate democracy.” Adopting the SEC proposal, and the additional reforms I discussed, would advance this important goal.

(Editor’s Note: This post is based on a memo by Laurent Alpert, Robert Davis, Victor Lewkow and Daniel Sternberg from Cleary Gottlieb Steen & Hamilton LLP.)

A Delaware Chancery Court decision last week raises significant questions regarding the interpretation and validity of various types of “continuing director” change-in-control provisions that are common features in one formulation or another in loan agreements, indentures and other contracts. Following the opinion, some existing provisions may not be interpreted as expected by some lenders and other existing provisions may be invalid. The court’s opinion also raises considerations for boards approving financing and other agreements (including employment agreements and benefit plans) with such provisions in the future and for lawyers negotiating such agreements, advising boards and drafting disclosure regarding such provisions.

San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc. arose out of a proxy contest in which two separate dissident stockholders [1] of Amylin, prevented from agreeing to form a unified minority slate by the Company’s “poison pill,” each proposed a slate of five nominees to the 12-member Amylin Board of Directors, thereby raising the possibility that a majority of the Board could be changed at the upcoming Annual Meeting despite each stockholder’s seeking only minority representation. Amylin’s public Indenture [2] contains a common change in control provision giving noteholders the right to put their notes to the company at par if “at any time Continuing Directors do not constitute a majority of the Company’s Board of Directors”. The term “Continuing Directors” is defined as directors in office on the Issue Date of the Notes and “any new directors whose election to the Board of Directors or whose nomination for election by the stockholders of the Company was approved by at least a majority of the directors then still in office…either who were directors on the Issue Date or whose election or nomination for election was previously so approved.”

One of the insurgents requested that the Board (consisting entirely of Continuing Directors) approve the nomination of both dissident slates of nominees for purposes of this Indenture provision, even though the Board continued to recommend its own slate and oppose the election of the dissidents’ nominees. The Board refused the request and a stockholder commenced a suit seeking a declaration that the board had the power to approve the dissidents’ nominees and a fiduciary obligation to do so. In a partial settlement of the stockholder lawsuit, the Board agreed to approve both dissidents’ slates of nominees subject to obtaining a court order confirming the Board’s contractual right to do so. The Indenture Trustee, however, continued to litigate, arguing that the word “approve” in the Indenture is synonymous with “endorse” or “recommend”, and that the Board could thus not both run its own slate and simultaneously “approve” the dissident slate for purposes of the Indenture.

Following a trial on limited issues, Vice Chancellor Lamb disagreed with the Indenture Trustee, concluding that the language of the Indenture was clear and that the Board had the right to approve the dissident nominees for purposes of the Indenture even though actively opposing their election. The court stated that to interpret the Indenture to prohibit such Board approval of dissidents would have:

“an eviscerating effect on the stockholder franchise [that] would raise grave concerns. In the first instance, those concerns would relate to the exercise of the board’s fiduciary duties in agreeing to such a provision. The court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting such a provision, it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it. Additionally, the court would have to closely consider the degree to which such a provision might be unenforceable as against public policy.”

Having decided that the board had the power to approve such stockholder nominees, the court turned to whether the board’s agreement to approve the two slates in this case complied with the company’s implied duty of good faith and fair dealing inherent in the indenture, as in all contracts. While the Vice Chancellor concluded that, under the record before him, a decision on this question was not ripe for resolution, the opinion discusses the relevant standard for a board’s decision to exercise its power to approve nominees and concluded that “the board may approve a stockholder’s nominees if the board determines in good faith that the election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders. [3] And the court further noted that “the directors are under absolutely no obligation to consider the interests of the noteholders in making this determination”.

…continue reading: Assessing “continuing director” change-in-control provisions

This post is by my partners B. Robbins Kiessling, Sarkis Jebejian and Erik R. Tavzel.

In October 2008, the U.S. Treasury launched the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), pursuant to which the Treasury has invested nearly $200 billion in over 500 financial institutions.[1] Almost from the start, the boards and managements of many TARP-recipient institutions have focused on when and how to get out from under Uncle Sam’s umbrella.

The stress test results have now been released, and Secretary Geithner has said that adequately capitalized financial institutions “will have the opportunity to repay” their TARP capital. Conventional wisdom has been that many institutions will rush to repay the government capital. Repurchasing this capital would appear to secure several clear advantages, including the opportunity to repurchase the related warrants at low valuations, the elimination of TARP-related restrictions on executive compensation and the reduction of government influence on governance and management.

There are several issues, however, that should be considered in determining whether to redeem TARP capital. The board and management of TARP recipients should consider whether repayment will require raising new capital today and the cost of that capital, the financial institution’s future capital needs and the potential sources of capital and the likelihood of continued government, shareholder and public scrutiny of compensation practices even after the TARP repayment.

The first part of this bulletin briefly describes the conditions to repayment and the requirements regarding the source of funds for repayment. The second part discusses issues that the board and management of financial institutions that received TARP capital should consider in determining whether to repay the Treasury.

CONDITIONS TO REPAYMENT AND SOURCES OF FUNDS
The terms of the contracts governing the CPP investments permit repayment only with the consent of the financial institution’s primary Federal regulator and require repayment during the initial three-year period after issuance to be funded entirely with the proceeds of cash sales of Tier 1 perpetual preferred stock or common stock. The economic stimulus bill, however, directed the Secretary of the Treasury to permit a TARP recipient to redeem TARP capital, after consultation with its primary Federal regulator, without regard to the source of the funds or the lapse of any period of time.

The May 6th Joint Statement issued by Treasury Secretary Tim Geithner, Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair and Comptroller of the Currency John Dugan outlined several conditions to the repayment of TARP funds:

Previously, in testimony before the Congressional Oversight Panel on April 21, 2009, Secretary Geithner had said the “ultimate test” for repayment would be whether an individual bank’s repayment would result in a reduction in the overall credit available to the economy.

Based on the above, it appears that, legally and practically speaking, the required source of funds for repayment of TARP funds will depend primarily on an institution’s financial strength, capital adequacy and liquidity, as determined by the Federal Reserve (or Office of Thrift Supervision in the case of thrift holding companies). Moreover, the approval of the regulator for any redemption (as opposed to mere consultation) may be required under existing supervisory procedures (for example, under Federal Reserve regulations and policies, if the redemption would reduce consolidated net worth by 10 percent or more or have a “material effect” on the institution’s capital base). Strong financial institutions with adequate capital and liquidity may be allowed to repay TARP capital with funds from any source, including cash on hand or retained earnings. Less well-capitalized financial institutions, however, may be required to adhere more closely to the original terms of the CPP and repay at least a substantial portion of the TARP funds with the proceeds of Tier 1 capital issuances.

…continue reading: Throwing Off the TARP - Implications of Repaying Uncle Sam

(Editor’s Note: This post comes from Rebecca Files of the University of Texas at Dallas and Edward P. Swanson and Senyo Tse of Texas A&M University.)

In our paper, Stealth Disclosure of Accounting Restatements, which was recently accepted for publication in the Accounting Review, we investigate whether the prominence of the disclosure of a restatement is correlated with the market reaction and the likelihood of litigation. In our sample, we observe and categorize firms into three levels of disclosure. Some companies disclose their restatement prominently in the headline of a press release, usually one that is dedicated to the accounting misstatement (high prominence). Other firms provide less prominent disclosure, typically citing an earnings release in the headline, but still discussing the misstatement in the body of the press release (medium prominence). Most of the remaining firms simply restate prior-period comparative balances in an earnings release, with a footnote briefly explaining that the financial figures for the prior year have been changed (low prominence).

We investigate whether companies providing medium or low prominence disclosure of their restatement benefit from a less negative market reaction and/or a reduced likelihood of litigation. Our first finding is that the magnitude of the market response to a restatement announcement is related to press release format. Three-day returns differ substantially across the three categories of disclosure prominence, averaging -8.3 percent, -4.0 percent, and -1.5 percent for high, medium, and low prominence, respectively. Returns for the high prominence group are statistically different from those for the medium and low prominence groups. Next, we extend the return window to 20 days after the announcement to investigate post- announcement responses to restatements. We find returns of -7.9 percent, -6.4 percent, and -3.2 percent for the high, medium, and low prominence firms, respectively. These returns are considerably less dispersed than the short-window returns, and the 1.5 percent return difference between high and medium prominence is not statistically significant. Apparently, market participants initially underestimate the seriousness of some misstatements disclosed without a headline but subsequently correct their underreaction.

Next, we find that the average return for firms that have post-restatement news items is not significantly different from zero. In contrast, we find a statistically significant drift of -3.7 percent for firms with no news items in the 20-day period, which suggests that investors further evaluate the original press release information. Analysts appear to play an important role in this evaluation because most of the drift is in companies covered by three or more analysts. In addition, once we control for the seriousness of the accounting misstatement, we find that the press release remains highly significant in explaining announcement period returns (-1, +1), but not significantly associated with returns over the longer window (-1, +20).

Lastly, we find that the frequency of lawsuits declines monotonically across the three categories of disclosure prominence (27 percent, 16 percent, and 0 percent for the high, medium, and low prominence firms, respectively). The 16 percent litigation rate for medium disclosure suggests that some managers use medium prominence disclosure for an accounting misstatement that plaintiff attorneys view as serious. We estimate a logistic regression model of the likelihood of litigation in our sample, and find that the prominence index coefficient is positive and significant in the model (even after controlling for endogeneity), suggesting that the likelihood of litigation rises with disclosure prominence. Reducing disclosure prominence by one level (e.g., medium instead of high) reduces the odds of a lawsuit by about half.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo from Theodore N. Mirvis, Andrew R. Brownstein, Steven A. Rosenblum, Eric S. Robinson, Adam O. Emmerich, Trevor S. Norwitz, and David C. Karp of Wachtell, Lipton, Rosen & Katz.)

At an open meeting on May 20, the Securities and Exchange Commission approved, by a vote of three to two, proposed rules to federalize shareholder access to company proxy materials. Despite strong objections by two Commissioners to this federal incursion into traditional areas of state corporate law, the majority approved the proposed rules as a means to enhance “director accountability” in response to the current economic crisis. If adopted, the new federal rules will effectively sweep aside the recent Delaware legislation allowing shareholder proxy access, as well as current efforts to modify the Model Business Corporation Act in that regard, and bring to an end the possibility of shareholders and American corporations working together to develop new norms and practices in this area.

While we continue to believe that broad proxy access may well dangerously weaken boards of directors and American public companies, it is now clear that it will become a part of our public company landscape. However, we strongly support the view expressed by Commissioner Paredes that the SEC should act judiciously, and with appropriate respect and comity for the role of the states in our federal system, by amending Rule 14a-8 to support the efforts of Delaware and other states to allow companies and their shareholders to agree on proxy access approaches that make sense for each company, rather than adopting a one-size-fits-all mandatory federal rule. This is especially the case as the premise of the SEC’s rulemaking initiatives – that corporate governance mechanisms facilitating greater shareholder oversight may have mitigated some of the causes of the recent economic crisis – is a subject of hot debate. Indeed, Commissioner Casey vociferously rejected this premise and her view is supported by academic and other commentators. See our recent memorandum “A Crisis is a Terrible Thing to Waste: The Proposed “Shareholder Bill of Rights Act of 2009” Is a Serious Mistake.”

As outlined at the SEC meeting, proposed new Rule 14a-11 would allow shareholders or groups of shareholders owning as little as one percent of a company’s shares for one year to require inclusion on the company’s proxy card and in its proxy statement for each meeting director candidates for up to one-quarter of the board. For companies that are not large accelerated filers, the thresholds would be either 3% or 5% depending on size. The SEC is proposing a first-to-file rule if more than the permitted number of nominations is received. By contrast, in our model Delaware bylaw, we proposed that 5% shareholders each be able to nominate one director, up to one-third of the directors to be elected at each election; and we proposed that deference be given to larger stockholders if nominations are oversubscribed. Under the SEC proposal, candidates will be required to be independent under the applicable stock exchange standards, but will not have to be independent of their nominators. The Staff has indicated that the proposal is not intended to enable shareholder access to be used as a “Trojan Horse” for takeover activity and would require nominators to certify that they do not have a current intent to take control of the company (although they may change their minds once their candidates are on the board). Our proposed bylaw, by contrast, seeks to prevent the access regime being abused to support takeover bids by, inter alia, requiring nominating shareholders to agree that they will not take any steps towards a takeover for one year following the election.

The SEC will be issuing its proposed rules shortly and will provide a 60-day period for public comments. While comments are expected to be substantial, the SEC may seek to adopt final rules in time for the 2010 proxy season.

(Editor’s Note: This post is by Michael Bopp of Gibson, Dunn & Crutcher LLP.)

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is closely tracking government responses to the turmoil that has catalyzed a dramatic and rapid reshaping of our capital and credit markets.

We are providing updates on key regulatory and legislative issues, as well as information on legal and oversight issues that we believe could prove useful as firms and other entities navigate these challenging times.

This update focuses on Congress’ expected creation of an independent commission to examine the domestic and global causes of the current U.S. financial and economic crisis. While various bills have been introduced this Congress and last to create a commission or other entity to investigate the financial markets crisis, none have moved as standalone measures. We called for the creation of a 9/11-style independent commission back in March,[1] and now it appears that Congress is poised to act.

Congress Acts to Create a Financial Crisis Inquiry Commission
The House and Senate have each acted to add language to a fraud enforcement bill that would create an independent bi-partisan financial crisis inquiry commission to investigate the domestic and global causes of the current financial and economic crisis in the United States. On May 6, 2009, the House voted 367-59 to adopt its version of S. 386, the Fraud Enforcement and Recovery Act of 2009 (”FERA”), which is intended to provide the federal government with additional tools to investigate and prosecute mortgage fraud. Cong. Rec. H5262-H5264 (May 6, 2009).

On April 22, 2009, the Senate added a financial markets commission of its own to FERA. Cong. Rec. S4591-S4592 (Apr. 22, 2009). In a press release, Senators Johnny Isakson (R-GA) and Kent Conrad (D-ND), the co-sponsors of the Senate amendment to create the commission, stated that “[t]he only way to get an objective evaluation of where mistakes were made is to create an independent commission of experts to ask what went right, what went wrong and what could we have done to prevent this. We need a forensic audit of the laws of the United States as it relates to the financial markets and our economy.” See here. The Isakson/Conrad amendment was adopted by a vote of 92-2.

At the same time it created a financial markets commission, the Senate also passed an amendment offered by Senators Byron Dorgan (D-ND) and John McCain (R-AZ) to establish a Senate select committee with full subpoena power to investigate the circumstances leading to the financial crises and to make recommendations for change. The Dorgan/McCain amendment was adopted by voice vote. The House did not pass a companion amendment.

…continue reading: Financial Markets in Crisis: A 9/11-Style Commission

Atanu Saha and I have recently completed a paper analyzing the issue of (1) when the housing market downturn occurred (on a sustained, statistically significant basis); (2) when the market foresaw this housing market downturn; and (3) why the issue of the “foreseeability” of the housing market downturn is legally central to much of the securities litigation that has been filed by investors against financial institutions in the wake of the credit market crisis. The paper is forthcoming in the Journal of Corporation Law and was presented at ILEP’s Scottsdale, Arizona conference on securities litigation.

Based on our analysis of housing prices (regional and nationwide) as well as housing sales (the time series of which begins in January of 1969) we conclude that the housing market downturn began in September of 2007, despite common claims that it began in the 4Q of 2006 or 1Q of 2007. To address when the market foresaw the housing market downturn, we analyze, in addition to housing price and sales data, housing futures contract pricing data and various market spreads such as the ABA triple A indexes. We conclude that the housing market downturn was in fact not foreseen by the market prior to the fourth quarter of 2007.

As we explain in detail in our paper, the issue of when the housing market downturn was foreseen by the market is legally central to much of the securities litigation that has been filed because plaintiffs’ claims as to why there were disclosure deficiencies by financial institutions, scienter for those deficiencies and “loss causation” for damages as a result of those deficiencies typically hinge on the claim that the housing market downturn was foreseeable.

Our paper, which is entitled Securities Litigation and the Housing Market Downturn, can be downloaded here.

(Editor’s Note: This post is based on a client memorandum by Daniel N. Budofsky, Robert Colby, Annette L. Nazareth and Lanny A. Schwartz of Davis Polk & Wardwell.)

On May 4, 2009, Senator Carl Levin (D-Michigan) and Senator Susan Collins (R-Maine) introduced the Authorizing the Regulation of Swaps Act, sweeping legislation that, if adopted, would free multiple federal regulators to regulate swap agreements without mandating how that regulatory authority is to be exercised. While the Levin-Collins bill is intended to fill a regulatory hole, it risks creating a regulatory free-for-all, introducing jurisdictional ambiguities and changes and raising possible questions about the federal preemption of state gaming and bucket shop laws with respect to swaps.

This memorandum provides background on the historical treatment of swaps, summarizes the most significant provisions of the Levin-Collins bill and provides preliminary analysis of the issues raised by the bill.

The memorandum is available here.

(Editor’s Note: This post by Professor Lucian Bebchuk is based on an op-ed piece just published on Forbes.com.)

Buoyed by the results of the “stress tests” conducted by banks’ supervisors, markets now appear optimistic about the capital positions of U.S. banks. Unfortunately, however, this renewed optimism has a shaky foundation. By design, the stress tests have avoided estimating the declines in the value of many toxic assets owned by banks. As a result, U.S. banks could well be in much worse shape than has been suggested by the stress tests.

The report announcing the results of stress tests stresses that supervisors conducted “a deliberately stringent test” and examined the ability of banks to absorb losses even under an “adverse” scenario with a deeper and more protracted downturn than under the current consensus estimate. The report concludes that, with a modest aggregate addition of $75 billion in common equity, the banks will be well capitalized at the end of 2010 even under the adverse scenario.

While the focus on the “adverse” scenario might represent a conservative approach, another estimation choice led to under-counting of banks’ expected losses. In reaching an estimate of $600 billion for banks’ aggregate losses, the report focuses on estimating “losses due to failure to pay obligations” rather than “discounts related to mark-to-market values.”

Thus, for a bank with a $1 billion portfolio of real estate loans due in 2010, if the supervisors estimated that only half of the face amount will be repaid, they added $500 million to their estimate of losses. However, for a bank that has “troubled assets” with $1 billion face value that do not become due until after 2011, supervisors did not attempt to come up with a precise estimate of the extent to which, at the end of 2010, the economic value of the troubled assets will fall below the $1 billion face value.

This approach overlooks a substantial amount of economic damage imposed on banks by the crisis. Indeed, to the extent that the government’s new program for restarting the market for troubled assets will provide market transactions for troubled assets with long maturities, mark-to-market rules might require banks to recognize this or next year the declines in economic value of their troubled assets with long maturities. But even if banks are able to avoid recognizing these declines in value on their financial statements until after 2010, there will still be such economic losses. A bank may be an economic zombie even if its financial statements do not yet show it.

The report acknowledges this major problem in a footnote, noting that its estimated losses “are not full lifetime losses … because the projections are for a two-year forward horizon and thus do not capture losses occurring beyond the end of 2010.” Trying to defend this limitation, it notes that the profile of the adverse scenario “includes a return to positive real GDP growth within the two years,” and that a two-year horizon thus “seems likely to capture a large portion of losses from positions held as of the end of 2008.”

Even if positive real GDP growth resumes after 2010, however, some of the assets backing banks’ 2008 positions–residential and commercial real estate, as well as the assets of nonfinancial firms–may remain far below their 2008 levels, and banks may consequently have to bear large losses on their long-maturity assets for years to come.

Furthermore, even accepting that the two-year horizon does capture a “large portion” of aggregate losses to banks’ 2008 positions, it still fails to include the remainder and possibly large portion of these losses. For example, if the “large portion” happens to be 60%, then the banks’ total estimated losses, and the additional capital that they need, are higher by $400 billion than the report’s estimates of $600 billion and $75 billion respectively.

The report also adds that the “the impact of some losses after 2010 is also captured through the calculation of the need of 2010 reserves.” But without estimating the economic losses to troubled assets with post-2010 maturities, which the supervisors did not do, it is not possible to stipulate the level of reserves that will fully cover these losses.

To get a full picture of the banks’ situation, bank supervisors should estimate also the decline in the economic value of banks’ positions with longer maturities. Only then will the stress tests be able to deliver reliable figures for the additional capital necessary to make the banking sector healthy and vigorous. Until such an analysis is done, it would be important to avoid the premature conclusion that the U.S. baking system is largely out of the woods.

(Editor’s Note: This post comes to us from Clive Lennox of Nanyang Technological University Singapore and Jeffrey Pittman of the Memorial University of Newfoundland.)

The recent major reforms to the external monitoring of U.S. audit firms which resulted in the independent inspection of audit firms by the Public Company Accounting Oversight Board (PCAOB) motivates our paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics.

We begin our analysis by dissecting the transition from self-regulation to impartial inspection under the PCAOB. We find that the PCAOB relied on peer review reports to target lower-quality audit firms in their initial round of inspections. In addition, our data reveal that many firms elected to leave the peer review program after the PCAOB began conducting inspections despite the fact that audit firms with public company clients can submit to both PCAOB inspections and peer reviews. Indeed, we find that the worst audit firms, which we measure with the presence of an adverse or modified opinion and the number of weaknesses in their prior peer review report, were more likely to abandon the program. Further, our tests suggest that the probability of a reviewer switch is significantly higher in the event of a modified or adverse opinion. Apart from corroborating prior research that peer review reports are informative, this evidence implies that audit firms were avoiding reviewers who previously gave unfavorable opinions against them. In contrast, the PCAOB prevents such opportunism since audit firms cannot influence the selection of their inspectors, the inspectors do not have current ties to audit firms, and the PCAOB is an independently funded organization.

Although the PCAOB is insulated from the accounting profession, several commentators cast doubt on whether the PCAOB and its inspectors have adequate technical expertise to properly regulate audit firms. In univariate tests, we document that the audit engagement weaknesses disclosed in PCAOB reports fail to predict subsequent changes in audit firms’ market shares, suggesting that the reports do not affect clients’ audit firm choices. In the multivariate analysis, we estimate a model that predicts the expected number of reported weaknesses and find that PCAOB reports identify more weaknesses if audit firms: (1) have more clients, and (2) previously received unfavorable peer review opinions. Next, we construct an unexpected opinion variable, which equals the number of weaknesses disclosed in the PCAOB report minus the number of weaknesses predicted by the model. Reinforcing our univariate evidence, we continue to find that audit firms’ market shares are insensitive to their PCAOB reports.

After the PCAOB began its inspections of public company audits, the scope of peer reviews was largely confined to the audits of private companies to avoid duplication in regulatory monitoring. Our evidence indicates that audit firm choice by public companies hinges less on the peer review reports issued in recent years, implying that the perceived information content of peer reviews falls under the restricted reporting format. Moreover, audit firms began leaving the peer review program after the introduction of PCAOB inspections, especially if their previous peer review opinions had been unfavorable. Accordingly, we conclude that peer reviews have become less relevant to public companies for gauging differential audit firm quality. We also demonstrate that the PCAOB’s failure to disclose certain information—specifically, the quality control weaknesses and overall ratings of audit firms—explains why clients do not find the inspection reports to be informative. Collectively, our findings suggest that the reporting model adopted by the PCAOB is not viewed by audit clients as being informative about audit firm quality.

The full paper is available for download here.

In my paper Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, a draft of which is currently available here, I provide the first detailed empirical analysis of the operation of U.S. corporate governance during the stock market turmoil of 2008. The study focuses on a sample of companies at “ground zero” of the stock market meltdown, namely the 37 firms removed from the iconic S&P 500 index. The results indicate that, despite U.S. stock markets experiencing their worst year since the 1930s, corporate governance performed tolerably well. This in turn implies it would be premature for policymakers to overhaul existing arrangements.

As the paper describes, over the past few decades U.S. corporate governance has been re-oriented towards the promotion of shareholder value. The sharp decline in share prices that occurred in 2008 implies this shareholder-focused corporate governance model “failed” and that reform is correspondingly justified. However, corporate governance is not the primary determinant of share prices, as reflected by the fact academic testing of the hypothesis that good corporate governance improves corporate financial performance has yielded inconclusive results. It therefore is possible that in 2008 corporate governance in public companies generally functioned satisfactorily amidst general market trends that inexorably drove share prices downwards. The paper examines whether this in fact might have been the case by examining corporate governance in companies removed from the S&P 500 index.

Over the next while there likely will be numerous studies of how corporate governance functioned during the recent financial crisis. However, the 37 companies removed from the S&P 500 in 2008 provide an apt starting point. One reason is that big public companies are markedly more important from an economic and investment perspective than their smaller counterparts — the S&P 500 index covers approximately 75% of the total value of the U.S. equities market. Another is that among any sample of publicly traded firms “troubled” companies will likely be the center of the action with respect to corporate governance controversies (e.g. Enron), and companies dropped from the S&P 500 index are apt to fall into this category. Among the 37 companies removed in 2008 20 can be categorized as “at risk”, with 13 of the companies having been dropped due to a dramatic fall in their market value, six due to “rescue mergers” (i.e. mergers where the company would have likely otherwise ended up bankrupt) and one due to Chapter 11 bankruptcy. Of the 10 industrial sectors represented in the S&P 500, firms from the “financials” sector dominated both the overall sample (15 out of 37 firms) and the “at risk” cohort (12 out of 20).

The primary search strategy I used to assess the operation of corporate governance in the 37 companies removed from the S&P 500 during 2008 was a thorough analysis of press and newswire coverage. A wide-ranging set of searches was conducted for each of the sample companies using Factiva, which offers extensive coverage of newspapers, business magazines and trade journals. The searches were structured to find out what corporate governance mechanisms were activated in the six months before and six months after a company’s removal from the S&P index, with the objective being to assess how responsive and effective corporate governance was during the stock market turmoil.

Due to the prominence of companies that are part of the S&P 500, the Factiva searches should have brought to light most material corporate governance developments concerning the sample companies. Nevertheless, the Factiva searches were supplemented by analysis of Georgeson’s 2008 Annual Corporate Governance Review, the Stanford Law School Securities Class Action Clearinghouse database and an AFL-CIO website offering data on CEO pay for 2007.

The key findings of the study are as follows:

To the extent that corporate governance did “fail” among the companies removed the S&P 500, the difficulties were restricted largely to the financials sector. Boards of a number of banks and thrifts were subjected to intense criticism and bonus-driven executive pay may well have provided senior managers of major financial companies with incentives to take risks that were ill-advised due to the hit their firms would take if things went wrong. The corporate governance challenges financial companies pose, however, are likely to diminish over the next while, with the entire sector retrenching due to a combination of market trends and regulatory factors.

Once the financials are removed from the equation, the case in favor of a regulatory overhaul of corporate governance is weakened considerably. Based on what happened with the companies removed from the S&P 500 during 2008, corporate governance performed tolerably well. Moreover, while the U.K. already has in place a number of the features of corporate governance popular among those who advocate reform in the U.S., the stock market meltdown was worse in Britain than in America. Future studies perhaps will uncover damning evidence of corporate governance breakdowns during the stock market meltdown of 2008. However, at this point the case for radical reform has not been made out.

The paper is available here.

In a recent working paper Market Conditions and the Structure of Securities my co-authors, Isil Erel, Brandon Julio and Woojin Kim, and I investigate whether market downturns can affect both the ability and manner in which firms raise external financing. Our study was motivated in part by Richard Passov, the longtime treasurer of Pfizer, who argued that the possibility of being shut out of the capital markets during market downturns is the primary reason why Pfizer and other technology companies often place such importance on a high bond rating. The extent to which this concern is justified and macroeconomic factors can affect access to capital is an important issue in finance and has clear policy implications.

To evaluate the extent to which these predictions hold in practice, we assemble a database containing information on alternative ways in which firms can raise capital. Our sample contains detailed information on 21,657 publicly-traded debt issuances and 7,746 seasoned equity offerings in the U.S. between 1971 and 2007. The latter part of our sample (from 1988 to 2007) also includes data on 40,097 completed and mostly syndicated loan tranches. Analysis of this sample provides stylized facts on the nature of public and private debt securities that have been issued recently in the US. The vast majority of external financing is supplied by debt rather than equity. Consequently, understanding the choice between alternative types of debt is likely to be equally important as, or even more important than, the choice between debt and equity. We first provide statistics documenting the average quantity of capital raised though issuance of different kinds of securities during different market conditions. A complicating factor when interpreting these numbers is the enormous increase in the total value of funds raised during our sample period. Nonetheless, there are some noticeable differences in the average proceeds per month raised during weak and strong economic conditions. For example, average proceeds raised per month through SEOs tend to drop during poor market conditions. However, short-term and highly-rated public debt increases noticeably relative to longer-term and lower-rated issues during poor market conditions.

Our multivariate analysis suggests that macroeconomic conditions affect both firms’ abilities to raise capital and the manner in which they choose to raise it. We find that the conditional probability of issuing less information sensitive securities, i.e., convertibles rather than equity, increases when credit markets are tight. We do not observe an increase in the demand for bank loans during economic downturns. However, we document that the borrowers of our sample of private loans tend to be of higher quality during bad economic times, consistent with the view that capital available to intermediaries goes down, leading them to tighten lending standards during these periods. In addition to the choice of securities, we also find that market-wide factors affect the structure of debt contracts. In particular, market downturns decrease the expected maturity of public bonds and private loans and increase the likelihood that these bonds and loans are secured. These findings are consistent with the view that market downturns lead firms to structure securities in ways that lessen their information sensitivity. Finally, we consider the quality of the public securities, measured by their ratings. For our sample of public bonds, our results suggest that market downturns do not reduce the issuances of high quality bonds, but are associated with a substantial drop in the likelihood of a junk or unrated bond issue. This pattern suggests that lower quality firms tend to be shut out of the credit markets during poor market conditions.

The full paper is available for download here.

(Editor’s Note: This post is based on a client memo by John F. Savarese and David B. Anders of Wachtell, Lipton, Rosen & Katz.)

For the first time, the SEC has brought an insider trading case involving the market for credit default swaps (“CDS”). In a civil complaint filed yesterday in the Southern District of New York, the SEC alleged that a CDS salesman with inside information regarding an upcoming bond offering improperly shared information about it with a portfolio manager for a hedge fund. SEC v. Rorech and Negrin, No. 09-Civ-4329 (May 5, 2009). According to the complaint, the portfolio manager used that information to trade in CDS that referenced bonds of the same issuer, and after the bond restructuring was publicly announced, the price of CDS referencing those bonds rose substantially, leading to a substantial profit.

The CDS market trades over the counter and its participants typically are sophisticated institutional players, and for those reasons, among others, it has not historically been a focus of SEC insider-trading enforcement activity, at least until now. In yesterday’s complaint, however, the SEC asserted that the CDS involved in this case qualified as security-based swap agreements under the Gramm-Leach-Bliley Act and hence are subject to the anti-fraud provisions of the federal securities laws — a proposition that has yet to be tested in court.

This broadening of the reach of SEC enforcement efforts against insider trading is consistent with signals sent in recent speeches by SEC Chairman Mary Schapiro and Division of Enforcement Director Robert Khuzami that they intend to expand and increase the Commission’s enforcement activities in this area. It is also worth pointing out that enforcement activity and private litigation regarding CDS may not be limited to insider trading actions, but may also extend to charges of market manipulation and other theories of liability. One example of a potentially manipulative use of the CDS market would be trading strategies designed to generate profits from short sales by widening CDS spreads and intentionally sending misleading signals on the company’s creditworthiness. CDS can form an effective part of a liability management or hedging strategy and the CDS market and participants in it can serve a helpful purpose in the capital formation process. However, writers and purchasers of CDS are well advised to be extremely careful in today’s volatile environment, where the distinction between appropriate market activity and improper speculation and manipulation is thin, and highly political.

This enforcement action is also a timely reminder of the critical importance of ensuring that public companies and financial institutions adopt and maintain state-of-the art antiinsider trading compliance policies and procedures, as well as implementing regular training and effective controls to prevent and detect employee misconduct. Especially in periods of market volatility and economic distress, a program of prudent vigilance is necessary and appropriate.

(Editor’s Note: This post is by Selina Sagayam of Gibson, Dunn & Crutcher LLP.)

The European Union has become the first jurisdiction to propose a comprehensive framework for direct regulation and supervision of the entire investment funds industry – the proposed Directive on Alternative Investment Fund Managers.

The EU already has an established regime for regulating investment funds known as UCITS (Undertakings for Collective Investment in Transferable Securities)[1]. UCITS invest in a prescribed range of transferable securities and/or other liquid financial assets and are composed of a collective pool of investments from retail investors.

The draft proposal which was published on 29 April aims to regulate investment funds within Europe which are not already covered by the UCITS regime, referred to in the proposal as alternative investment funds (AIFs). Rather than imposing requirements on the AIFs themselves, the proposals target AIF managers (AIFMs). It was considered that a broad regime focusing on those who manage investment funds rather than a defined set of entities prevalent in the investment fund world (e.g. hedge funds) would be more effective and less easy to circumvent, with enhanced scrutiny on leveraged hedge funds.

Currently, this sector is regulated in the EU through a combination of fragmented national legislation as well as some general provisions of EU law, in addition to voluntary industry standards in certain cases (e.g. the Walker Guidelines in the UK). With investor protection as its fundamental aim, the European Commission’s rationale for the proposals is the introduction of harmonised regulatory standards and enhanced transparency.

Early drafts of the directive had been leaked to the public weeks before and received a barrage of criticism particularly from different interest groups across various member states and not surprisingly, the hedge fund industry. The final draft proposals however have come under even greater attack with the UK Financial Services Secretary and key UK and European industry bodies (in particular the British Private Equity & Venture Capital Association and the European Private Equity & Venture Capital Association) voicing their strong opposition to proposals they consider are “deeply undesirable” and “immensely damaging” to industry.

Some of the main points under the proposed legislation are set out below.

Who Is Regulated?

All EU domiciled AIFMs that meet either of the two threshold tests below will be regulated:

• Leveraged AIFMs - Total assets under management equal to or above €100m (approx. US$1334m, £90m) where assets under management are acquired through use of leverage.

• Non-leveraged AIFMs - Total assets under management equal to or above €500m (approx. US$670m, £448m) where: (i) none of the assets under management were acquired through use of leverage; and (ii) investments are locked into the fund for 5 years or more from the date of its constitution.

…continue reading: Proposed New European Regulation of Investment Funds