The hedge fund coalition that I chair, the Coalition of Private Investment Companies (CPIC), recently submitted a comment letter to the Securities and Exchange Commission (SEC) in which we laid out our case for why the Commission should drop proposals to further restrain short selling. Under consideration by the regulator is a series of proposals that range from a “national bid test” to “circuit breakers,” which, if triggered, halt short selling transactions.

The SEC has repeatedly acknowledged the benefits of short selling, from improving liquidity in capital markets to enhancing price discovery, and, in the past, the agency has expressed reluctance to restrict an investment strategy that serves as a necessary counterweight to unbridled optimism. But, it has departed from this traditional view in a variety of efforts ─ some misguided ─ to address the circumstances of the largest market drop in decades. When the SEC imposed bans on short selling last summer, investors’ interests were harmed as market quality deteriorated, including higher transaction costs through wider spreads. (More information about short selling is available here.)

Our letter emphasizes, as Commissioner Kathleen Casey did when the SEC announced its newest short sale rule proposals, that the SEC must provide empirical evidence that validates the necessity for action and demonstrates the benefits investors would receive in excess of the harm done from new restraints on short selling.

In proposing several regulatory “speed bumps” on short selling, particularly in down markets, the SEC emphasized two considerations that will guide its decision: that “naked” short selling is a problem demanding regulatory attention and that one cause of the low level of investor confidence is the prevalence of short selling and its role in the fall in stock values.

In our letter, we point to actions already taken by the SEC to eliminate “naked short selling,” which occurs when an investor has failed to have identified or gained commitment for stocks they have shorted. Our industry, including myself, supported those actions. As a result, there has been a further decline in the already very low level of naked short selling that does occur.

As to investor confidence, it is on the rise again albeit it in fits and starts, according to several polls, including that produced by State Street Bank. To gauge investors’ thinking, the State Street survey looks at several macro- and microeconomic factors, which do not include short selling. Given this, we questioned the link the SEC has suggested between the prevalence of short selling and low levels of investor confidence. In another comment letter, an Ohio State University Professor Ingrid Werner similarly questions the link. She concludes that “there appears to be no evidence supporting the hypothesis that high levels of short selling activity contributed to low levels of investor confidence during the recent financial crisis.”

Removing information from the markets — whether it be by posing barriers to short selling or by rolling back mark-to-market accounting standards — as a means to promote “investor confidence” is a terrible precedent.

The full text of the CPIC letter is available here.

(Editor’s Note: This post is based on a client memo by Theodore N. Mirvis and Adam O. Emmerich of Wachtell, Lipton, Rosen & Katz.)

As we have pointed out for some time, non-traditional structured and derivative arrangements that create economic exposure to publicly traded securities have allowed activist and short-term investors to exert vast but hidden influence. With respect to equity securities, investors have used such instruments to secretly accumulate large equity positions with a view to exercising control over corporate decisionmaking, with little or no disclosure of the existence or nature of these positions or their plans. With respect to debt securities, such devices have often been used – frequently in conjunction with short selling – to manipulate the market in bear raids, placing companies dependent on access to the capital markets in peril. While these phenomena directly implicate the policies underlying traditional disclosure requirements and anti-manipulation rules, they have thus far largely escaped adequate regulation.

In testimony yesterday before the Senate, advancing Treasury Secretary Geithner’s regulatory reform agenda announced on May 13, SEC Chairman Schapiro has now addressed these concerns foursquare, calling for long-needed fundamental reform in the regulation of derivatives by the SEC. Chairman Schapiro put the matter clearly in saying:

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and … prophylactic measures against fraud, manipulation, or insider trading…. … Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities. … [M]anipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation.

Chairman Schapiro called upon Congress to enact legislation to bring securities-related OTC derivatives clearly under the umbrella of the federal securities laws, including so that the SEC might require regulated central counterparties (CCPs) for derivatives markets, to address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. In her testimony, Chairman Schapiro also recognized that “[a]ny new regulatory framework… should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk.”

Broad-based reform of the OTC derivatives market to prevent the abuses and dangers exposed by the recent financial crisis – without destroying the ability of financial institutions, corporations and investors to make appropriate use of derivatives to assist in the process of capital formation and risk management – is a complicated project that will require a great deal of judgment and compromise. Disclosure under the Securities Exchange Act of 1934 of equity derivatives so that ownership and transactions in the derivatives would be treated equally with ownership and transactions in the underlying security is but one part of this larger task. It is, however, an important part, and one that we do not believe requires legislation but only rule-making and interpretation by the SEC. For so long as the current loopholes in the 13D reporting regime are not closed, parties seeking to disguise their activities or manipulate the market will try to take advantage of those loopholes. So too with manipulative trading in credit default swaps and short selling. We encourage the SEC to close the gaps in the current disclosure regime and to actively take enforcement action against abusive transactions, even while the SEC, other regulatory bodies, the Congress and the Administration together pursue the larger project of comprehensive reform of the regulation of derivatives that is now under consideration.

(Editor’s Note: This post comes to us from Hamid Mehran and Stavros Peristiani of the Federal Reserve Bank of New York.)

In our forthcoming Review of Financial Studies paper Financial Visibility and the Decision to Go Private we investigate the determinants of the decision to go private over a firm’s entire public life cycle.

We investigate the decision to go private by estimating several variations of the hazard model. Initially, we estimate a broad competing risk model where the decision to remain public or go private is evaluated against all alternative termination outcomes (merger, liquidation, or negative delisting). Most of our analysis, however, focuses on estimating a hazard model that excludes all other competing choices. In this case, the regression sample consists of an annual panel of observations of all IPO firms that either had an LBO or were bought by another private company and all surviving IPO firms that remained in the public market.

Our sample includes completed deals in which an IPO firm was a target in an LBO or was acquired and became a private company from January 1, 1990, to the end of October 2007. Our tests focus on those firms that 1) went public after 1988 and subsequently were buyout targets after January 1, 1990 and 2) were included in Compustat. Our final sample consisted of 262 firms (169 LBO targets and 93 non-LBO firms that were acquired by nonpublic companies or investor groups). Of these 262 IPO firms, 218 (150 LBO and 68 non-LBO targets) were followed by securities analysts.

Our evidence reveals that firms with declining growth in analyst coverage, falling institutional ownership, and low stock turnover were more likely to go private and opted to do so sooner. We argue that a primary reason behind the decision of IPO firms to abandon their public listing was a failure to attract a critical mass of financial visibility and investor interest. Consistent with the findings of earlier literature, we also find strong support for Jensen’s free-cash-flow hypothesis, which argues that these corporate restructurings are a useful tool in capital markets for mitigating agency problems between insiders and outside shareholders.

The full paper is available for download here.

(Editor’s Note: The post below by Commissioner Paredes is a transcript of remarks by him at the Center for Capital Markets Competitiveness, U.S. Chamber of Commerce on June 23, 2009 in Washington, D.C.)

It is a pleasure to be speaking at this timely conference on “Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism” hosted by the U.S. Chamber of Commerce. Before I begin, I must remind you that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

As a practical matter, public company shareholders are not well-positioned to run the enterprises in which they invest. Managerial responsibility over a firm’s corporate strategy and day-to-day business and affairs instead is in the charge of directors and management. That said, shareholders retain the right to vote on fundamental corporate changes, such as a merger, a sale of all or substantially all of the corporation’s assets, and an amendment to the corporate charter or bylaws. Most notably, shareholders vote for board members. Shareholders also have the right of “exit,” as they can sell their shares if they disapprove of the company’s performance.

The animating question behind any discussion of shareholder rights thus presents itself: What is the proper institutional arrangement for ensuring that the company is managed in the best interests of shareholders when those who own the firm do not actively run it? [1]

Last month, in May, the SEC took a significant step toward setting the balance of control in corporations. [2] The Commission proposed new Exchange Act Rule 14a-11 creating a direct right of access for shareholders to the company’s proxy materials for nominating board members. For example, for the largest public companies, a nominating shareholder or group would have the right to include director nominees in the company’s proxy materials if the shareholder or group beneficially owned at least one percent of the company’s shares for at least one year.

The Commission also proposed amending Exchange Act Rule 14a-8(i)(8) to allow shareholders to include in the company’s proxy materials a proposal to amend the company’s bylaws to provide for a shareholder access regime. Notably, the SEC’s proposal prohibits shareholders from adopting a bylaw that opts out of the Rule 14a-11 access regime, even if shareholders want to.

As you may know, I voted against the Commission’s proposal and instead offered a counterproposal, which I will discuss later. [3] First, let me explain my core concern with what the SEC has advanced. As always, I look forward to considering the comments we receive on the proposal.

…continue reading: The Proper Limits of Shareholder Proxy Access

Editor’s Note: This post is Lucian Bebchuk’s current column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newpapers Project Syndicate. The series focuses on finance and corporate governance and may be accessed here. Below is the text of Professor Bebchuk’s column:

The United States government is now permitting ten of America’s biggest banks to repay about $70 billion of the capital injected into them last fall. This decision followed the banks having passed the so-called “stress tests” of their financial viability, which the US Treasury demanded, and the success of some of them in raising the additional capital that the tests suggested they needed.

Many people have inferred from this sequence of events that US banks – which are critical to both the American and world economies – are now out of trouble. But that inference is seriously mistaken.

In fact, the US stress tests didn’t attempt to estimate the losses that banks have suffered on many of the “toxic assets” that have been at the heart of the financial crisis. Nevertheless, the US model is catching on. In a meeting this month, finance ministers of G-8 countries agreed to follow the US and perform stress tests on their banks. But, if the results of such tests are to be reliable, they should avoid the US tests’ fundamental flaw.

Until recently, much of the US government’s focus has been on the toxic assets clogging banks’ balance sheets. Although accounting rules often permit banks to price these assets at face value, it is generally believed that the fundamental value of many toxic assets has fallen significantly below face value. The Obama administration came out with a plan to spend up to $1 trillion dollars to buy banks’ toxic assets, but the plan has been put on hold.

It might have been hoped that the bank supervisors who stress-tested the banks would try to estimate the size of the banks’ losses on toxic assets. Instead, supervisors estimated only losses that banks can be expected to incur on loans (and other assets) that will come to maturity by the end of 2010. They chose to ignore any losses that banks will suffer on loans that will mature after 2010. Thus, the tests did not take into account a big part of the economic damage that the crisis imposed on banks.

…continue reading: Toxic Tests

This post is by my colleagues Jonathan Layne, Mark Lahive and Ben Ross.

Common issues confronting acquirors involve retaining the target company’s key employees and protecting against the loss of business to defecting employees. A recent Delaware Court of Chancery decision addressed issues faced by an acquiror, where a group of the target company’s employees plotted to leave the target company and launch a competing business prior to the acquisition’s close. The court’s decision in Ivize of Milwaukee, LLC v. Compex Litigation Support, LLC [1] will likely cause acquirors to more aggressively seek and obtain employment and/or non-competition agreements from key target employees, particularly where the success of the acquisition depends upon a relatively small number of key employees.

The Case

In early 2007, Compex Legal Services (”Compex”), a provider of legal support services to law firms, decided to divest its Milwaukee and Kansas City facilities. Compex negotiated such divestures with another provider of legal support services, Ivize, LLC (”Ivize”), culminating in a simultaneous signing and closing on July 26, 2007 of a pair of Asset Purchase Agreements (one for each facility).

During the negotiations, Pete Cobb (”Cobb”), the manager of the Milwaukee facility, was advised of the transaction and that he would not be retained full-time after closing. In response, Cobb discussed the transaction with key salespeople who accounted for roughly 90% of Compex’s sales. Cobb and the key salespeople, in violation of existing non-competition agreements with Compex, (1) formed a rival entity (”Quantum”), (2) met multiple times to discuss Quantum business, (3) solicited key Compex employees, (4) rerouted business to Quantum, and (5) stole company records and equipment.

On the morning after closing, Ivize’s representatives found the Milwaukee facility abandoned and ransacked. In the days that followed, Ivize and Compex jointly uncovered Cobb’s activities.

…continue reading: Retaining Key Target Employees: Lessons For Acquirors

(Editor’s Note: This post comes from Keith L. Johnson, Program Director for the International Corporate Governance Initiative at the University of Wisconsin Law School, and Frank Jan de Graaf, Professor of International Business at Hanze University of Applied Sciences in the Netherlands.)

In Modernizing Pension Fund Legal Standards for the Twenty-First Century, we explore the symbiotic relationship between sustainable success of the corporate sector and the ability of pension funds to successfully fulfill their mandate. We note that exponential growth in the size of pension fund assets since the 1970s and their current collective ownership of public corporations has turned pension fund governance into a major corporate governance factor. We argue that traditional views of pension fund governance and fiduciary responsibility, which developed during a time when pension fund investment practices had little effect on the markets, are outdated. With institutional investors owning 76 percent of the Fortune 1000, pension fund governance and corporate governance are now opposite sides of the same coin, with each exerting a major influence on long-term success of the other.

We concentrate on the pension fund side of this relationship and argue for a modernized interpretation of fiduciary duty. We maintain that prevailing interpretations of pension fund legal duties and common pension fund governance practices may be ill-suited for the complex investment instruments and the market-moving amount of assets now being managed by pension investors. We recommend changes in the interpretation of pension fund legal standards and identify priorities for improvements in pension fund governance to promote sustainability of wealth creation for both the pension and corporate sides of this symbiotic relationship.

The full paper appears in the Spring 2009 issue of the Rotman International Journal of Pension Management, published jointly by the Rotman International Centre for Pension Management and University of Toronto Press and is available for download here.

(Editor’s Note: This post comes to us from Michael Faulkender of the University of Maryland and Jun Yang of Indiana University.)

In our forthcoming Journal of Financial Economics paper entitled “Inside the black box: the role and composition of compensation peer groups” we investigate how much compensation peer groups explain observed variation in CEO compensation and what determines the composition of these groups. Effective December 15, 2006, the SEC required that firms disclose “Whether the registrant engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies).” This study is the first to collect and examine the list of compensation peer companies used by the S&P 500 firms and S&P MidCap 400 firms in their first fiscal year ending after the compliance date of December 15, 2006.

We find that the median compensation of the peer group generates significant incremental explanatory power in understanding cross-sectional variation in the observed CEO compensation among disclosing firms even after including controls for CEO labor market conditions. We find that CEOs whose pay was below the median pay level of their counterparts in companies of similar size and in the same industry receive pay raises that are larger in both percentage and dollar terms. In contrast, having actual compensation peer group membership enables us to demonstrate that peer companies outside the firm’s industry and size group also have a significant influence on executive compensation.

When we examine the composition of peer groups, we find that firms select companies in the same industry, of similar size, and with a history of observed talent flows between them to be members of their compensation peer groups. Using both multivariate probit models and a propensity score matching (PSM) approach, we show that the level of CEO compensation at a potential peer company is statistically significant in determining its likelihood of being chosen as a compensation peer, after controlling for industry, size, visibility, talent flows and CEO characteristics. In other words, compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.

One interpretation of our results is that entrenched CEOs in firms with weak corporate governance are likely to have more power to influence their own compensation. An alternative interpretation of our findings is that higher CEO compensation (for more complex firms) is likely to be an equilibrium result in a well-functioning labor market. To distinguish between these two theories, we examine the variation in pay differences between selected and unselected peers across measures of corporate governance. We find that highly paid potential peers are more likely to be chosen as compensation peers by firms where the peer group is smaller, where the CEO is the Chairman of the BOD, where the CEO has been in the post longer, and where directors are busier serving on multiple boards.

The full paper is available for download here.

(Editor’s Note: This post sets forth the text of a letter to the Securities and Exchange Commission by Edward D. Herlihy and Theodore A. Levine of Wachtell, Lipton, Rosen & Katz in response to the Commission’s request for comments on its proposed amendments to Regulation SHO (short sale proposals). A facsimile of the letter is available here.)

The repeated abuse of short selling over the past eighteen months has led to the destruction of businesses, cost countless numbers of jobs and created systematic risk in the global economy. Though some have asserted that short selling aids liquidity and price discovery in the market, the possibility of such functions should not be used to justify the damaging and corrosive consequences of abusive short sales. Since the repeal of the uptick rule in 2007, the market has suffered a resurgence of manipulative short selling, including widespread “bear raids,” in which short sales of equity securities are employed, sometimes in combination with other trading strategies, in a concentrated effort to drive down their prices. These practices have badly damaged institutions, destroyed billions of dollars in shareholder value, and crippled investor confidence.

We strongly urge the Commission to adopt effective regulation to constrain abusive short selling and related trading strategies, thereby protecting institutions, employees, shareholders and the wider economy from the manipulation and ensuing damage that have been pervasive over the past several years. [1]

First, we urge the Commission to adopt a short sale price test to decelerate the short selling process, thereby reducing short sellers’ ability to overwhelm companies’ shares and quickly profit from the resulting “downward spiral” in share prices. We believe that, in order to function effectively in the modern marketplace, a price test based on the national best bid is appropriate. To provide the most comprehensive protection against manipulation, any price test should be adopted through both the “policies and procedures” and “straight prohibition” approaches. The former requires that exchanges and other trading centers develop the policies, systems and technology necessary to ensure trades’ compliance with the price test, while the latter gives all market participants responsibility for compliance and provides the Commission with maximum enforcement authority over any violations.

Such a price test rule must not overlook the myriad ways traders are able to effect a short position in a company’s stock, including synthetic short positions created through the use of options and exchange traded funds. Thus, any short sale price test rule adopted by the Commission should address these strategies and provide the Commission with enforcement authority over synthetic shorting activity aimed at evading the price test.

In addition to a price test based on the national best bid, we recommend that the Commission implement a “circuit breaker” rule that would impose additional restrictions on short sales of a security that has been the subject of a severe price decline. Following a decline of five percent in a security’s price from its previous day’s close, short sales in the security should be suspended for the remainder of the trading day. This suspension will prevent a destabilizing downward spiral in the triggering security and give the market time to arrive at a rational valuation. Short sales should be allowed to resume on the next trading day, albeit with additional restrictions, such as strict “pre-borrow” requirement for certain recovery period to ensure that aggressive short sellers are not permitted to further damage the security’s price during this sensitive time. A properly calibrated “circuit-breaker,” in combination with a short sale price test, will interrupt the instances of extreme intraday volatility that destabilize the market, prevent efficient price discovery and cause investors to doubt the fairness and integrity of the market.

Any action the Commission attempts to take against manipulative short selling will not be completely effective without parallel, reinforcing reforms applied to the derivatives market, particularly with respect to credit default swaps (“CDS”). The responsiveness of equity prices to changes in CDS spreads makes the purchase of CDS a powerful device for bear raids, particularly when used in connection with short sales. Combining a short sale with the purchase of CDS sends a false signal into the marketplace about a company’s credit and, accordingly, causes a drop in the stock price that makes the short position profitable. Such manipulation is dangerously cost-effective, as a relatively small investment in an institution’s CDS is sufficient to spark rumors of default or a ratings downgrade and immediately sink stock prices.

To prevent this and other abuses of the CDS market, we believe that only those who are economically exposed to the underlying credit risk of a company should be allowed to buy CDS protection on the company. The purchase of a “naked” CDS, made by a purchaser with no exposure to the reference company, is more akin to gambling than obtaining insurance, and such instruments are capable of causing serious distortions in the market. A prohibition on naked CDS would allow the appropriate use of these instruments while restraining those using the CDS market in a manipulative and abusive way. As an intermediate step, the Commission should use its ability to regulate short sales to require a waiting period between any purchase of a CDS and short sale involving the same reference company. In addition, to alert the marketplace to situations when CDS are being used to manipulate share prices in conjunction with short selling, the Commission should require disclosure when an actual or synthetic short position in a company’s equity securities is accompanied by a long position in the company’s CDS.

Stock and derivative markets must be effectively regulated so that a few profit-seeking bear raiders cannot contribute to a “run on the bank” that destroys an enterprise and risks global systemic collapse, as in the cases of Bear Stearns and Lehman Brothers. We urge the Commission to ensure that the regulatory scheme it formulates in response to the current financial crisis has sufficient flexibility to reach the many ways abusive and manipulative practices have affected the market and harmed small investors and the wider economy.

Footnote:
[1] In addition to the adoption of a price test and other actions described below, we believe that the Commission should extend and strengthen the rules it adopted last fall aimed at curbing naked short selling and requiring greater short selling disclosure.
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(Editor’s Note: This post comes to us from Leonce L. Bargeron, Kenneth M. Lehn, and Chad J. Zutter of the Katz Graduate School of Business, University of Pittsburgh.)

In our paper, Sarbanes-Oxley and Corporate Risk-Taking, which was recently accepted for publication in the Journal of Accounting and Economics, we empirically examine whether the adoption of SOX is associated with a subsequent decline in corporate risk-taking.

We examine whether several measures of corporate risk-taking changed significantly after SOX was signed into law in 2002 for publicly traded U.S. companies as compared with non-U.S. companies not bound by SOX. In an attempt to isolate effects associated with SOX, it is important to compare U.S. firms, which are subject to SOX, to non-U.S. firms that are most like U.S. firms with the exception that they are not subject to SOX. For this reason, the sample of non-U.S. firms is comprised of publicly listed U.K. and Canadian firms that are not cross-listed in the United States. We use publicly listed firms in the U.K. and Canada as a benchmark sample because these firms operate in similar capital market environments and under similar regulations to firms listed in the U.S.

Using data for a large sample of U.S. and non-U.S. firms during the period of 1994 through 2006, we find that after SOX U.S. companies significantly reduced their investments, as measured by the sum of their capital and R&D expenditures, in comparison with their non-U.S. counterparts. In addition, U.S. firms significantly increased their holdings of cash and cash equivalents, which represent non-operating, low-risk investments, as compared with the non-U.S. firms. Also, we find that the standard deviation of stock returns, a conventional measure of a company’s equity risk, declined significantly for U.S. firms compared with non-U.S. firms, after SOX. Finally, these findings are consistent for an industry and size matched sample of U.S. and non-U.S. firms.

The changes in the risk-taking variables are significantly greater for large versus small U.S. firms, consistent with the view that the expected costs of complying with Section 404 are greater for firms characterized by more complexity. The changes are also significantly greater for firms with high versus low R&D expenditures before SOX, consistent with the view that the expected costs of complying with Section 404 are directly related to the degree of specialized knowledge in a firm. The changes in cash holdings and stock price volatility are significantly greater for firms that did not have a majority of outside directors before SOX, and hence were most affected by the SOX-related rules governing the independence of boards, than for other firms. The changes in capital and R&D expenditures were not significantly different across these two groups of companies.

While we cannot rule out the possibility that other factors, unique to U.S. firms and unrelated to SOX, might account for the relative decline in risk-taking by U.S. companies after SOX, we are not aware of any such factors, and as such, conclude that our evidence is most consistent with the view that SOX has discouraged risk-taking by U.S. companies.

The full paper is available for download here.

(Editor’s Note: This post is by Charles Nathan, Alex Cohen, Brian Miller of Latham & Watkins LLP and Rhonda Brauer of Georgeson Inc.)

On June 10, 2009, the SEC published a proxy access rule proposal for public comment. The Commission’s release, entitled “Facilitating Shareholder Director Nominations,” gives concrete form to the broad objectives the Commission outlined at its May 20, 2009 open meeting (at which it approved publication of the rule by three votes to two).

As expected, the SEC is proposing to:

· create a new Rule 14a-11 that would require companies to include shareholder nominees for directors in company proxy materials under prescribed circumstances, and

· revise existing Rule 14a-8(i)(8) to allow shareholder proposals to amend a company’s governing documents regarding nominating procedures or disclosure related to shareholder nominations, thus reversing the SEC’s 2007 prohibition on using Rule 14a-8 for shareholder proxy access proposals.

Proposed Rule 14a-11

The key features of the proposed rule are as follows:

· Companies Subject to Proxy Access: The proposed rule would apply to all Exchange Act reporting companies subject to the proxy rules, regardless of their size, including investment companies and companies that have voluntarily registered their stock (under Section 12(g)) but excluding debt-only issuers and foreign private issuers.

· Minimum Ownership: The proposed rule would set a tiered minimum-ownership requirement for shareholders seeking to nominate directors:

· Minimum Holding Period: Each nominating shareholder would be required continuously to have held the requisite number of shares for at least one year prior to the date it notifies the company of its intent to nominate a director, and must intend to hold the shares at least through the date of the annual or special meeting.

· Aggregation: Unaffiliated shareholders would be permitted to aggregate their holdings to meet the minimum share ownership threshold. There is no limit on the size of a nominating group. Communications for the purpose of forming a nominating group would be exempt from the proxy rules, provided they are limited in scope, do not request or solicit actual proxies and are filed with the Commission.

· Beneficial Ownership Reporting: The formation of a nominating group holding in excess of 5 percent of an issuer’s equity securities would still be required to be reported under Regulation 13D. However, the formation of a nominating group would not affect any group member’s otherwise existing eligibility to file on Schedule 13G rather than 13D. Moreover, an amendment to Rule 13d-1 would specifically allow groups formed solely to nominate a director pursuant to Rule 14a-11 to file on Schedule 13G.

· Timing of Nomination: Nominations would need to be submitted to the company on the same time schedule as Rule 14a-8 proposals (i.e., no later than 120 days prior to the date of publication of the prior year’s proxy material), unless a company’s advance notice bylaws provided for a shorter period.

· Mandated Disclosure and Filing: Each nominating shareholder (including each shareholder within a nominating group) would be required to represent as to a number of items, including that:

…continue reading: Proxy Access Proposed Rules Published by SEC

(Editor’s Note: This post is by Randall D. Guynn, Annette L. Nazareth, Margaret E. Tahyar, Robert Colby, and Reena Agrawal Sahni of Davis Polk & Wardwell LLP. A summary by Gibson, Dunn & Crutcher LLP of the provisions of the White Paper, with reactions from various industry groups, is available here.)

In our memorandum, available here, we describe the Obama Administration’s White Paper on Financial Regulatory Reform. The White Paper is just the beginning of what is likely to be a legislative, regulatory and ideological marathon, despite the Administration’s best efforts to achieve domestic political support before its publication. It is far less revolutionary than some either feared or hoped for and reflects an “art of the possible” approach to regulatory reform by the Obama Administration. Ultimately the White Paper reflects a compromise designed to avoid as much as possible the most difficult regulatory, state and congressional turf battles.

As a result, the plan is notable as much for what it does not do as for what it does. It is not a once-in-a-lifetime regulatory overhaul. It does not propose a CFTC-SEC merger, it does not propose an optional federal insurance charter and it does not streamline the alphabet soup of financial regulatory agencies. If anything, it adds more regulators than it eliminates. Its key innovations involve expanded power for the Federal Reserve as the sole systemic risk regulator, with the creation of a Financial Services Oversight Council to mollify those who are concerned about the aggregation of power in the Federal Reserve; the long anticipated registration of advisers to hedge funds, private equity funds and venture capital funds; the regulation of OTC derivatives; the merger of the OTS and the OCC; the creation of a Consumer Financial Protection Agency with vast new powers delineated in such a way that future jurisdictional turf wars are inevitable; and the creation of a resolution regime for bank holding companies and Tier 1 FHCs. While the White Paper is an incomplete framework, one possible benefit is that it creates the skeleton of a “twin peaks” structure, with a prudential and a business conduct regulator, into which other agencies could be merged in the future.

The Administration has set a goal of passing its reform package by the end of the year and promises that legislative text will soon be sent to the Hill. Naturally, the political reaction has already begun, with Republicans outlining their own plan and individual Senators and Congressmen proposing, or soon to propose, competing proposals and language.

Other stakeholders, both domestic and international, will also have a view and, in some cases, a voice. Indeed, the White Paper proposals are made at a time of parallel UK and European regulatory reform driven in part, as is the White Paper, by the G-20 proposals. The European Council of Ministers proposed its own plan this past week for which legislative text is expected in the fall, and the UK is expected to publish more details on its own version shortly. The era when financial regulation was purely a matter for domestic politics is over. More and more the domestic US financial regulatory agenda is being influenced by international fora, by an active EU regulatory structure which has created extraterritorial standards and imposed requirements of comparability and by the international and US domestic push for harmonization of standards across regulatory bodies.

The shifting dynamics of the regulatory reform proposals and the politics involved in any consolidation, reorganization or redistribution of regulatory responsibilities mean that it is too early to predict with certainty which proposals are likely to be enacted and in what form. In light of the many competing proposals and legislative texts, we believe that it is possible that some elements, such as the Consumer Financial Protection Agency, will be enacted separately and attached to other bills rather than as an omnibus package.

Our memorandum discusses the White Paper’s proposals from a range of perspectives, domestic and international, and sets forth how the proposals may impact a range of institutions, financial and non-financial.

The memorandum is available here.

(Editor’s Note: This post comes to us from Raffi Indjejikian and Michal Matějka of the Ross School of Business at the University of Michigan.)

In our forthcoming Journal of Accounting Research paper, CFO Fiduciary Responsibilities and Annual Bonus Incentives, we examine how firms evaluate and compensate their CFOs. In addition to participating in decision making much like other senior executives, CFOs also have fiduciary responsibilities for reporting firms’ financial results and safeguarding the integrity of financial reporting. Although other top executives have fiduciary responsibilities for financial reporting as well, CFOs typically have more of an expertise and capacity to determine what numbers get reported. Responsibility for financial reporting raises the question of whether it is appropriate to reward CFOs bonuses contingent on financial performance that is effectively self-reported.

To provide a framework to understand why CFO compensation is tied specifically to financial performance, our paper presents an agency model with two executives, a CEO focused on production and a CFO entrusted with dual responsibilities. Our model generates two insights that have implications for changes in CFO compensation practices in the post Sarbanes-Oxley (SOX) environment. First, we find that if CFOs personally bear greater misreporting costs, then firms offer their CFOs steeper incentives tied to financial performance. The intuition is straightforward; if CFOs are more conscientious in discharging their fiduciary duties, then firms are more comfortable offering steeper incentives since rewards for reported performance are less susceptible to unwarranted overpayments. Second, we find that as misreporting becomes more costly, firms are less willing to tolerate misreporting. Hence, firms offer their CFOs weaker incentives tied to financial performance to expressly motivate them to focus more on their fiduciary duties.

We rely on a proprietary survey of CFO performance evaluation and compensation practices of public and private firms to conduct our empirical tests. Since public firms were affected by SOX much more than private firms, the public versus private distinction allows for an identification strategy of the SOX-effect on CFO compensation that has not been feasible in prior literature. Our survey was sent to approximately 30,000 members of the American Institute of Certified Public Accountants who are CFOs, CEOs, or other executives informed about CFO and CEO compensation. We received 1,353 responses from both public and private entities.

Our data indicates that annual bonuses are by far the most common incentive component of CFO compensation plans and that, on average, about 50 percent of the CFO bonus is based on accounting-based financial performance. In addition, the extent to which CEO and CFO incentives are tied to financial performance are highly correlated. More importantly, we find that from 2003 to 2007 public entities (relative to private entities) lowered the percentage of CFO bonuses contingent on financial performance. Specifically, we compare the bonus weight on financial performance measures that is expected in 2007 with the actual bonus weight in 2003 (indicative of incentives in the pre-SOX environment) and find marked differences for public versus private entities. For example, predicted values from one of our regressions suggest that public companies (with median sample characteristics) lowered the percentage of their CFO’s bonus that depends on financial performance by about six percent while comparable private companies with similar characteristics increased the percentage by about three percent. We interpret this result as evidence that firms mitigate earnings management or other misreporting practices in part by deemphasizing CFO incentive compensation.

The full paper is available for download here.

(Editors Note: This post is by Robert J. Giuffra, Jr., Richard C. Pepperman II, Robert A. Sacks, John L. Hardiman, and Robert M. Osgood of Sullivan & Cromwell LLP.)

Summary
In an important development for class action suits in the United States and internationally, the Amsterdam Court of Appeals recently upheld a settlement between Royal Dutch Shell and a group of more than 150 institutional investors from 17 European countries, Canada, and Australia. The proposed settlement originally emerged in 2007 after Royal Dutch Shell side-stepped a class action filed in U.S. District Court that sought to include claims from both U.S. and non-U.S. investors, by independently pursuing a settlement in The Netherlands with the non-U.S. claimants.

This settlement under Dutch law intersects with recent limitations on subject matter jurisdiction in U.S. courts for claims brought by “foreign-cubed” plaintiffs under U.S. securities laws. A mechanism to settle group claims in The Netherlands may influence U.S. courts to place further limits on jurisdiction for foreign plaintiffs, while also providing a way for foreign issuers at risk of jurisdiction in the U.S. to effectively settle collective claims outside of the U.S.

Background
In 2004, Royal Dutch Shell investors brought a securities fraud class action suit in the U.S. District Court for New Jersey alleging injury from Shell’s intentional overstatement of oil reserves. The suit followed Shell’s announcement in February of 2004 that it had recategorized 20 percent of its total proven reserves base, and an ensuing internal audit which uncovered an email from a Shell executive stating, “I am becoming sick and tired about lying about the extent of our reserves issues.”

In addition to U.S. shareholders, the class included “foreign-cubed plaintiffs” (foreign shareholders, suing a foreign corporation, regarding stock purchased on a foreign exchange). After the U.S. class, represented by the Bernstein Liebhard law firm, rejected a settlement offer from Shell in 2006, Shell’s attorneys approached Grant & Eisenhofer, another U.S. class action law firm, to obtain a settlement “class” of non-U.S. claimants out of the U.S. litigation. In early 2007, Shell announced a $352.6 million settlement with a group of non-U.S. shareholders comprising 150 institutional investors. The settlement provided for $47 million in legal fees.

The settlement announced in 2007 was expressly contingent on: (1) the U.S. District Court deciding not to certify the non-U.S. claimants as part of the class in the U.S., which occurred in November of 2007 when the District Court dismissed the foreign-cubed plaintiffs for lack of subject matter jurisdiction; and (2) the Amsterdam Court of Appeals approving the settlement under the Dutch Act on Collective Settlement of Mass Claims, which was just announced on May 29, 2009.

…continue reading: Dutch decision has implications for global class actions

(Editor’s Note: The post below by Chairman Schapiro is a transcript of remarks by her at IOSCO’s 34th Annual Conference on June 11, 2009 in Tel Aviv, Israel.)

Good morning. And, thank you Hans [Hoogervorst, Chairman, Authority for the Financial Markets, Netherland, and Vice Chair of the IOSCO Technical Committee] for that kind introduction.

I’m delighted to be speaking with you today — even though it’s after 2:00 in the morning here in Washington. But, the way I see it, investor protection doesn’t sleep, so I thought I’d stay up too.

I would also like to express my warmest thanks and congratulations to our hosts, Professor Zohar Goshen [Chairman of the Israel Securities Authority], and Chairman Saul Bronfeld [of the Tel Aviv Stock Exchange], as well as Dr. Stanley Fischer [Governor of the Bank of Israel], for organizing this wonderful and important event.

And, I also would like to thank the IOSCO Executive Committee Chair Jane Diplock, Emerging Markets Committee Chair Guillermo Larraín Ríos, my colleague Technical Committee Chair Kathleen Casey, and Secretary General, Greg Tanzer — for their efforts in promoting IOSCO’s goals. I was truly looking forward to seeing so many old friends and colleagues from my many years of involvement with IOSCO.

I really wish that I could have joined you in person. But, here in the U.S. we are very deep in the process of reevaluating our regulatory landscape, as I’m sure you know, and we are having significant discussions within the Administration — so I felt I needed to remain behind.

Improving the Role of the Regulator

You might say that, in the U.S., we are attempting to do exactly what this panel is slated to discuss: “Improving the Role of [a] Securities Regulator in a Changing Global Financial System.”

But for us all to be effective regulators, improvement cannot just come once every financial crisis. No. Instead, we need to be constantly improving on our effectiveness. We need to be constantly considering whether there are gaps in and between our regulatory regimes through which certain players or products can easily slip. And, we need to be constantly doing whatever it takes to keep pace with the newest financial products of the day — so we can understand those products just as well as the people selling them. We need to be constantly alert to the risks that may attend dynamic innovation in the way financial products are packaged and sold.

The fact is that we need to do those things whether or not there is a financial crisis. But, in light of the crisis, we need to do those things even better. That’s because investors want to know that we’re looking out for them. They want to know that companies are being truthful and transparent in what they say. And, they want to know that it’s OK to put their money back into the markets.

In short, it is our time to prove ourselves. Because, we can help restore the confidence that is so desperately needed for capital markets to flourish — if we all succeed at what we do. And, if we work together, we increase the scope and impact of our individual successes.

…continue reading: Improving the Role of the Securities Regulators in a Changing Global Financial System

Walking to the Myerson Symphony Center past the various galleries, statues and plantings in the Arts District of downtown Dallas during the last week of May is a contemplative experience for me. As a Boston Irishman, I cannot but remember the fate of Jack Kennedy in this seemingly gentle, indeed beautiful, city. Living now year round on the coast of Maine where the leaves around my house are yet to flower, immersion in the foliage and scent of high spring are intoxicating. I am on my annual pilgrimage to the Annual Meeting of shareholders of the most profitable corporation in the history of the world – ExxonMobil. In times past, there was a subdued sense of violence. There was still the careful organization of crowd control barriers, uniformed and other police, the combination of horses and motorcycles, the almost robotic protest by the seemingly inevitable protesters, the politely insistent ticket issuers, takers and the possession examiners – resulting this year in the loss not only of my Blackberry but also of my small brief case except for the few pages I was allowed to retain when I protested that without props memory failure at my advanced age would not allow my presentation of the five motions – I waved the green tickets that proved my entitlement to have the floor for five times three minutes – without embarrassment to all.

Inside, all was a well organized exhibit of Exxon’s presence, together with an extremely lavish offering of coffees and various pastries. My long time friend Jamie Houghton was there for his last board meeting. He is very patient with me – our fathers were Harvard College Classmates and members of the Chapter of the National Cathedral – and we enjoy the exchange of views of civilized persons with diametrically opposed world views. I saw Rex Tillerson and tried to get close, with no success, but – to be honest – there was no visible precaution against our meeting.

Annual Meetings are one of the least commented upon contradictions in contemporary capitalism. Statutes advertise them as the time and place for management and owners to meet; for corporate executives to account for their stewardship of the investors resources; and for the shareholders to have the opportunity to hold these managers to account. The reality, alas, is otherwise – the preponderance of votes on all the business items have already been received by proxy and there is absolutely no chance that anything that occurs in the next several hours will affect the pre ordained results. That said, there is a certain charm to the choreographed process analogous to watching a theatrical performance embedded in our cultural memory – like Shakespeare or Corneille. The numerical result is not the object of the event. What needs to happen is that shareholders and managers have together to conjure up a myth of importance – something real is happening (Santa Claus will come tonight!). In the occasional interplay between management and questioners, a sense of the soul of the corporation is expressed. In the process by which the meeting is conducted a sense of the standards of decency are proclaimed. In the brief passages – presentations are limited to three minutes, and Exxon management for the second year in a row – notwithstanding my ignored letter of protest – will not permit human responsive discussion.

I asked Rex Tillerson, Chairman and CEO, whether I could modify the rules governing the presentation of shareholder proposals in order more clearly to explain a new development of general interest. I was the designated presenter for the first five proposals, and, therefore, entitled to fifteen minutes. Tillerson looked bewildered, conferred with corporate secretary Rosenbaum, and said: “We’ll see where you are after the first three minutes”. It was only later that I came to understand that Tillerson’s entire concern was to limit the “tax” of time that law imposed on Exxon’s top management requiring exposure to their owners and that his hesitation has nothing to do with the content of what I was saying. There was nothing I could say that would interest him in the least. It is sad that these fine engineers cannot conduct themselves so as to save participants in this meaningless meeting of any dignity. Exxon considers shareholder relations as a non cost effective demand on executive time. When a shareholder pointed out that as a New Jersey corporation, Exxon might consider holding meetings in that state, Tillerson pointed out “I like Texas” and, so it is – the CEO’s world.

Tillerson’s Exxon executives examined the New Jersey statute and instructed staff to do everything legally possible to limit the diversion of valuable CEO and director time. New Jersey requires an Annual Meeting, at which directors are elected. The SEC requires that Exxon include on its Annual Meeting proxy resolutions, deemed appropriate by the Commission. The company relentlessly challenges all resolutions before the Commission, requiring not insignificant legal expense for those wishing to advance their proposals. They induce law firms with fine names to opine to the SEC that even proposals like mine – plain vanilla in the world of corporate governance – are in violation of law and regulation. The SEC of years past will accede to Exxon’s experts unless I adduce comparable legal weight- and so, I do at a cost not far off $100,000. There is implicit in the SEC rules that proponents be allowed to present their resolutions to the meeting. Over the last several years, Exxon has massaged the choreography of the meeting so that all proposals are presented without any questions or interruptions beyond Tillerson’s mantra that “Management opposes this resolution, etc.” following each presentation. There then follows a random question period during which no exchange of views is possible. Tillerson doesn’t deign to answer questions, nor does he permit any of the board members to answer questions directed at them. A certain punctilio is always observed – all the company directors are present and non-participating, the company’s “performance puff piece” is aired for an hour, the Chairman and Secretary smirk and chat sometimes allowing speakers to talk through the red light signals.

Several of the proposals concerned the long time disagreement between Exxon and important shareholder constituencies who are concerned with the company’s policies towards climate change and alternate energy. This interest in climate culminated in the impassioned presentation of Father Mike who reminded Tillerson of the company’s commitment to the conclusion that man, and Exxon, in particular, were contributants to the problems of global warming. At this point, almost by magic, individuals were recognized who trashed all sentiment having to do with global warming or criticism of EM management. Father Mike rose again to ask Tillerson not simply to acquiesce in these public expressions of opinion that the company, on the record, opposed. He appealed to moral imperatives, to the obligations of leadership not to enable dissemination of false information. Tillerson was unmoved.

Essentially, Exxon’s view is that the shareholder meeting is an utter waste of time which they are legally compelled to endure. So, smirking and with time watch, they absolutely do not gave a tinker’s dam what anybody says, as it is all an imposition. I could feel this at the beginning when I actually tried to say something of importance to Exxon about the current state of governance – Tillerson could care less about anything any of us have to say as long as the time limits were observed. Sometimes my naïve optimism appalls me. For many years, I have felt it important to appear at these meetings as a “witness” to the atrocities of governance. I have now come to feel that one of the reasons I feel sick after these meetings is that I really am being an “enabler”. Appearing at this 2009 version of a show trial tends to legitimate it. Actually, the perfect epitaph for this experience is the ritual by which the Corporate Secretary casts votes for resolutions when no proponent is present – it is in that mode that I will be present in future years. The engineers will have saved three minutes!

(Editor’s Note: This post comes to us from Camelia Kuhnen of the Kellogg School of Management.)

Business connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism. In my forthcoming Journal of Finance paper Business Networks, Corporate Governance, and Contracting in the Mutual Fund Industry, I analyze the extent to which these effects are present in the mutual fund industry, and measure their impact on the welfare of fund investors.

I construct a large and unique data set containing information about advisory contracts for all U.S. mutual funds during 1993 to 2002, as well as information about the identity of the directors of these funds during the same period. This data set tracks business relationships between mutual fund directors and advisory firms, as well as between advisory firms themselves. I identify 257 cases of funds that hired a new subadvisor between 1993 to 2002. These events are used to study which candidates (from a pool of about 1,000 firms each year) win subadvisory contracts from funds. I also study a sample of 216 open-end U.S. mutual funds newly created in 1998 to test whether the connections of potential candidate directors (3,005 individuals) influence the assignment of board seats by the primary advisors of these new funds.

I show that when mutual funds choose among candidate subadvisors, the more connected such a firm is to the directors of these funds through past business relationships, the more likely it is to win the contract. This effect holds even after controlling for the candidate’s reputation, degree of specialization in the investment objective of the fund, cost, and also for the connections between the fund’s primary advisor and the candidate. The preferential selection of connected subadvisors by directors is mirrored by the preferential hiring of connected directors by primary advisory firms when these firms create (sponsor) new funds. In contrast, I find that connections do not have an economically significant impact on investors’ bottom line.

The strong effects of business ties on reciprocal hiring by directors and managers that I document are consistent with both of the possible roles of connections – as means for efficient information exchange, or as channels for favoritism. Overall, my results suggest that the two effects of board-management connections on investor welfare – improved monitoring and increased potential for collusion – balance out in this setting.

The full paper is available for download here.

This post is by my partner Jeffrey Trinklein.

Government investment funds, often referred to as “sovereign wealth funds,” have become increasingly visible investors in the United States, a trend that has not escaped the attention of Congress. A series of recent investments led the Senate Banking, Housing and Urban Affairs Committee to raise concerns in 2008 over national security and the possible impact on the economy of large influxes of foreign governmental investment. Accordingly, Senators Christopher Dodd of Connecticut and Richard Shelby of Alabama, the senior Democrat and Republican members on the Senate Banking Committee, asked the Government Accountability Office (GAO) to address a variety of concerns and issues. The most recent report, the second in the series, was issued in May 2009 and looks at the laws that control foreign investment into the United States and whether those laws affect sovereign wealth funds.

The report makes several recommendations to Congress with the goal of increasing compliance with existing foreign investment laws. In particular, the GAO suggests that agencies that are not currently using other governmental agencies reports, like SEC filings, and private data sources, like Bloomberg, should use these sources to monitor changes in ownership of U.S. assets. The recommendation is minor in that it seeks only to increase compliance with already existing laws, but it demonstrates the continuing interest of Congress in reviewing foreign investment generally and investment by sovereign wealth funds specifically.

Introduction

The United States generally has a policy of openness with regard to foreign investment, but some laws limit and restrict certain types of investments and the activities of foreign-controlled companies. Although federal and state laws affect sovereign wealth funds simply by placing limits on all foreign investment, no laws exist that directly address sovereign wealth funds. Some general laws can potentially affect investment in any industry, while other laws have specific industry requirements and will obviously have a greater impact on funds seeking to invest in those areas. Each of those industries has at least one governmental agency that exercises oversight to monitor compliance to the laws. According to the GAO report, the following industries are affected specifically by laws restricting foreign ownership:

• Banking, overseen by the Federal Reserve Board
• Communications, overseen by the Federal Communications Commission
• Transportation, overseen by the Department of Transportation
• Natural resources and energy including nuclear power, overseen by the Department of Energy, the Nuclear Regulatory Commission and the Department of the Interior
• Agriculture, overseen by the Department of Agriculture

Defense-related matters are also subject to restrictive investment laws, but span different industries and are not overseen by one specific government agency. Furthermore, the Department of the Treasury and the Department of Homeland Security are often involved in the oversight of foreign investment in these industries.

…continue reading: Recent GAO Report on Sovereign Wealth Funds

Professor Lucian Bebchuk will be writing a monthly column for Project Syndicate, an international association of 425 newspapers in 150 countries, with a total circulation of about 56 million copies. The series of columns sponsored by the association seeks to bring distinguished voices from across the world to audiences in member newspapers’ countries.

Professor Bebchuk’s series of monthly commentaries, titled “The Rules of the Game,” will focus on finance and corporate governance. His commentaries, which will be available in eight languages, can be accessed here. Others contributing a monthly column to Project Syndicate include economists Martin Feldstein, Robert Shiller, and Joseph Stiglitz, former German Foreign Minister Joschka Fischer, former French Prime Minister Michel Rocard, political scientist Joseph Nye, and Oxford University’s Chancellor Lord Chris Patten.

The Forum is planning to feature Professor Bebchuk’s monthly columns as they become available. Professor Bebchuk’s first column, “The False Promise of Global Governance Standards,” builds on his paper The Elusive Quest for Global Governance Standards, co-authored with Professor Assaf Hamdani, and recently issued by the Program on Corporate Governance.

Below is the text of the Professor Bebchuk’s column.

The False Promise of Global Governance Standards — Professor Lucian Bebchuk

In the wake of last year’s global financial meltdown, there is now widespread recognition that inadequate investor protection can significantly affect how stock markets and economies develop, as well as how individual firms perform. The increased focus on improving corporate governance has produced a demand for reliable standards for evaluating governance in publicly traded companies worldwide. World Bank officials, shareholder advisers, and financial economists have all made considerable efforts to develop such standards.

…continue reading: The Rules of the Game

(Editors Note: This post is by Luigi L. De Ghenghi, Randall D. Guynn, Ethan T. James, Arthur S. Long, Annette L. Nazareth, Lanny A. Schwartz, Margaret E. Tahyar, Gerard Citera, Robert Colby, Courtenay Myers, and Reena Agrawal Sahni of Davis Polk & Wardwell.)

(Editor’s UPDATE: The Obama Administration’s White Paper on Financial Regulatory Reform, which was released after preparation of this post, is available here.)

This post, and the accompanying memorandum, summarizes the key proposals in the Obama Administration’s White Paper on Financial Regulatory Reform based on the “near final” draft White Paper posted by the Washington Post on June 16th. It has also been prepared in advance of the President’s news conference on June 17th and Secretary Geithner’s testimony on June 18th and assumes a reader that is familiar with U.S. regulatory reform. Readers are cautioned that there may be changes in the final version of the Obama White Paper. We will post a full memorandum with analysis and commentary in the coming days, but, in the meantime, we hope readers will find this factual outline helpful.

* * * * *

Executive Summary
The five areas covered in the White Paper are:

1. Supervision and regulation of financial firms, including:

• creation of a Financial Services Oversight Council,
• identification of systemically important firms, which are called “Tier 1 FHCs,”
• enhanced standards for all banks and BHCs,
• BHC status for any firm owning a thrift, ILC, credit card bank, trust company, or other non-traditional bank,
• subjecting Tier 1 FHCs and firms owning non-traditional banks to non-financial activities restrictions in the BHC Act,
• merger of the OTS and OCC into a new National Bank Supervisor,
• registration and reporting requirements for most advisers of private pools of capital including hedge funds,
• establishment of an Office of National Insurance in Treasury, but no federal insurance charter, and
• stronger requirements for money market funds and government sponsored enterprises;

2. Regulation of financial markets, including:

• skin-in-the-game and compensation requirements for originators and sponsors of asset-backed securities,
• regulation of OTC derivatives and OTC derivatives dealers,
• proposal to harmonize futures and securities regulation, and
• enhanced oversight by the Federal Reserve over systemically important payment, clearing and settlement systemsand activities of major participants;

3. Consumer and investor protection, including:

• creation of a Consumer Financial Protection Agency with rule making, supervisory and enforcement authority over credit products,
• creation of a Financial Consumer Coordinating Council to advise on gaps in consumer and investor protection and to promote best practices, and
• other initiatives to bolster the authority of the SEC, FTC and to address retirement security;

4. Resolution authority and Section 13(3) authority, including:

• giving Treasury resolution authority over BHCs and Tier 1 FHCs modeled on the FDIC’s resolution authority over insured banks and thrifts, with the FDIC (or in the case of a group that is primarily a securities firm, the SEC) acting as receiver or conservator, and
• requiring the Federal Reserve to obtain prior approval from Treasury for all lending under Section 13(3); and

5. International regulatory standards and cooperation, including:

• support for existing G-20 and other initiatives, and
• rules for determining whether a foreign financial firm is a Tier 1 FHC.

Our memorandum, available here, provides a more detailed outline of the key proposals.

(Editor’s Note: this memo is based on a client memorandum by Robert Raymond of Cleary Gottlieb Steen & Hamilton LLP.)

Recently, New York Attorney General Andrew M. Cuomo announced an agreement with private equity firm The Carlyle Group (“Carlyle”) in connection with the Attorney General’s investigation, started in 2007, into relationships between New York State’s Common Retirement Fund (“NYCRF”) and investment firms doing business with it.[1] Carlyle agreed to pay $20 million to resolve its part in the investigation, and to abide by the Attorney General’s “Public Pension Plan Reform Code of Conduct” (the “Reform Code”). The Reform Code imposes strict requirements and prohibitions on dealings with retirement plans for federal or state governmental employees (“Public Pension Funds”),[2] including an outright ban on the use of placement agents, finders, lobbyists and other intermediaries (collectively referred to as “placement agents”) in arranging investments by Public Pension Funds.

The principles reflected in the Reform Code are likely to extend beyond the agreement with Carlyle, whether other industry participants voluntarily agree to abide by them or they are incorporated into new federal and/or state legislation or regulations. The Attorney General’s office has indicated that it expects the Reform Code to establish a generally applicable framework for relationships between Public Pension Funds and investment firms going forward; at a minimum, it appears likely that firms seeking to do business with New York Public Pension Funds will be asked to be bound by the Reform Code. Attorney General Cuomo has described the Reform Code as representing the “new rules of the game” [3] and praised Carlyle for “leading the industry toward critical change of the public pension investment system.” [4] However, as noted below, the Reform Code includes a number of provisions that are ambiguous or may be difficult to implement in practice. It remains to be seen whether other jurisdictions will adopt new rules similar to the Reform Code and, if so, whether and how they may refine the details and mechanics of these rules.

In our memorandum entitled “The New York Attorney General’s Public Pension Fund Reform Code of Conduct: “New Rules of the Game“” we outline the key provisions of the Reform Code and suggest action steps for investment firms that do business (or seek to do business) with Public Pension Funds and may become subject to its requirements or similar requirements. The full text of the Reform Code and the Assurance of Discontinuance issued by the New York Attorney General in respect of Carlyle (“Assurance of Discontinuance”), are available here and here, respectively.

The memorandum is available here.

Footnotes:

[1] The investigation is being conducted under New York’s “blue sky” law, the Martin Act, which permits very broad pre-lawsuit discovery by the Attorney General.
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[2] The term “Public Pension Fund,” as used in the Code of Conduct, means “any retirement plan established or maintained for its employees (current or former) by the Government of the United States, the government of any State or political subdivision thereof, or by any agency or instrumentality of the foregoing.” Thus, the restrictions that Carlyle agreed to by adopting the Code of Conduct are not, by their terms, limited to New York plans but purport to apply to any federal or state governmental pension plan. In a related development, New York State Comptroller Thomas P. DiNapoli announced on April 22, 2009 that he has banned the involvement of placement agents, paid intermediaries and registered lobbyists in investments with NYCRF.
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[3] “Cuomo Announces Carlyle Settlement; Firm Will Adopt Code of Conduct for Funds,” Pension & Benefits Daily (May 18, 2009).
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[4] “Cuomo Announces Landmark Agreement With the Carlyle Group to Eliminate Pay-to-Play in Public Pension Funds Nationwide” (announcement on New York Office of the Attorney General website, May 14, 2009), available here.
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(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk and Jesse Fried published today on Wall Street Journal online. The piece is based on Lucian Bebchuk’s testimony at the House Financial Services committee last Thursday, which is available here, and their forthcoming white paper, “Equity Compensation for Long-Term Performance.”)

Treasury Secretary Timothy Geithner announced on Wednesday the Obama administration’s strong belief in tying executive compensation to long-term company performance. The regulations issued that day direct the new “compensation czar” to ensure that financial firms receiving “exceptional assistance” from the government don’t “reward employees for short-term or temporary increase in value.” Companies not covered by regulations are also currently seeking to tighten the link between pay and long-term performance. The question is how this could best be done.

With respect to equity compensation – a central component of modern executive pay arrangements – companies should prevent executives from cashing out vested grants of options and shares for a fixed number of years. But companies should avoid arrangements that block executives from cashing out options and shares until the executive’s retirement, or any other event that is at least partly under that person’s control.

Grants of equity incentives – options and restricted shares – usually vest gradually over a period of time. A specific number of options or shares vest each year, and the vesting schedule provides executives with incentives to remain with the company. Once options and shares vest, however, executives typically have unrestricted freedom to cash them out, and executives often liquidate them quickly after vesting.

The ability to cash out large amounts of equity-based compensation has provided executives with powerful incentives to seek short-term stock gains even when doing so involves excessive risk-taking. This short-termism problem, which was first highlighted in a book we published five years ago, “Pay without Performance,” has become widely recognized in the aftermath of the crisis – including by business leaders such as Goldman’s Lloyd Blankfein in a Financial Times op-ed.

The short-term distortions can be addressed by separating the time that options and restricted shares can be cashed out from the time that they vest. As soon as an executive has completed an additional year at her firm, the restricted options or shares that were promised as compensation for that year’s work should vest, and they should belong to the executive even if the executive immediately leaves the firm. But the executive should be allowed to cash them out only down the road. This would tie the executive’s payoffs to long-term shareholder value.

Some experts have called, including at Thursday’s hearing at the Financial Services Committee of the House of Representatives, for permitting executives to cash out shares and options only upon retirement from the firm. Shareholder proposals have also been urging companies to adopt such “hold-till-retirement” requirements. Such requirements, however, would be the wrong way to go.

…continue reading: Equity Compensation for Long-Term Results

(Editor’s Note: This post comes to us from Yuhai Xuan at Harvard Business School.)

In my paper Empire-Building or Bridge-Building? Evidence from New CEOs’ Internal Capital Allocation Decisions, which was recently accepted for publication in the Review of Financial Studies, I examine CEOs’ decision-making processes for capital allocation in the context of power and relationships within corporations by investigating whether the job histories of CEOs influence their capital allocation decisions when they preside over multi-divisional firms. I investigate the capital allocation decisions made by 265 new CEOs at 230 diversified firms after turnovers between 1993 and 2002. CEO turnovers provide a good opportunity for this study because CEOs are likely to be most vulnerable to political complications at work when they are new to the post. In particular, I focus on the 98 new CEOs in my sample who advanced through the ranks from certain, but not all, divisions in their firms. I call these CEOs specialists and separate the segments in their firms into two groups based on their affiliation with the CEOs: divisions that the CEOs advanced through the ranks from (labeled the in-group), and the rest of the divisions (labeled the out-group). The empirical analysis in the paper focuses on changes in segment capital expenditures around CEO turnovers to determine whether specialist CEOs treat the in-group and the out-group segments differently when allocating capital after succession, and if so, whether they favor the in-group (“empire-building”) or the out-group (“bridge-building”) in their allocation decisions.

My results are broadly consistent with the bridge-building hypothesis. I find that, on average, the out-group segments experience a significant increase in capital expenditures after CEO turnover relative to the in-group segments. The average change in segment investment ratio (capital expenditures over assets) after a specialist CEO takes office is 0.013 higher for the out-group than the in-group, statistically significant at the 5% level or better. This difference of 0.013 is economically meaningful as it represents more than 20% of the average pre-turnover investment ratio of 0.06. Moreover, these findings also hold for specialist CEOs hired from outside the firm and are robust to the inclusion of segment-level, firm-level, and turnover-related controls as well as changes in the test specifications including the definition of specialists, the measure for capital expenditures, the time frame around turnover, and the sample period. I further test for the bridge-building hypothesis by examining whether the in-group and out-group difference in capital allocation change around turnover is related to the specialist CEO’s relative bargaining power within the firm. I find that the difference is more pronounced if the specialist CEO does not hold a corporate-level executive title such as chief operating officer or president before succession or if the in-group segments and the out-group segments are not in related industries. The results from the finer tests are consistent with the prediction of the bridge-building hypothesis that a specialist CEO with less power should engage in more bridge-building efforts, which imply a more pronounced pattern of reverse-favoritism in capital allocation.

While my results are consistent with the bridge-building hypothesis, a key concern is the issue of endogeneity. CEOs are chosen by the board of directors, and the job histories of CEOs are observable by the board and may be an important selection criterion in the board’s choice for nomination. Even though the most obvious and natural endogeneity story is one that would lead to a bias that works in precisely the opposite direction to the empirical findings in this paper, I consider alternative versions of the endogeneity story in which the CEO might be chosen to grow the segments in the out-group or to reduce investments in the in-group, leading to the relative increase in the capital expenditures of the out-group segments observed in the data. I use two approaches to address this concern. First, I try to discriminate against this type of endogeneity story by identifying weak divisions in the firm based on segment cash flow and segment Q. I find that the in-group and the out-group segments experience differential capital allocation change regardless of segment operating performance and segment investment opportunity. The difference in capital expenditure change is significant and of the same magnitude even when one compares the strong segments in the in-group with the weak segments in the out-group, inconsistent with what the endogeneity story might suggest. Second, I estimate a segment’s propensity to be a member of the out-group based on pre-turnover segment characteristics, and use the propensity scores as a summary measure to match the out-group segments and the in-group segments. Again, I find a relative increase in the average change in capital expenditures for the out-group compared with those of the in-group after a specialist CEO takes office. The magnitude and significance level of the estimate are similar to those of the main results, further alleviating the concern that endogeneity might account for the findings.

Finally, I investigate whether having a specialist CEO affects segment investment efficiency by studying the changes in the sensitivity of segment investment to Q before and after the CEO turnover. My results show that the sensitivity of segment investment to Q increases significantly after CEO turnover in a generalist’s firm, indicating an improvement in investment efficiency. Segments under a specialist CEO, however, do not experience such improvements: the investment sensitivity to Q for these segments is virtually unchanged after the turnover. In addition, I examine the market’s reaction to the announcement of the appointment of specialist versus generalist CEOs and find that the cumulative abnormal returns around announcements are significantly higher for incoming CEOs who are generalists. The market’s response corroborates the finding that generalist CEOs are associated with improved segment investment efficiency after turnover and suggests that appointments of generalist CEOs are perceived by the market as positive news for the conglomerates.

Overall, my results suggest that the job histories of CEOs are an important determinant of their capital allocation decisions and that new specialist CEOs are affected by political concerns in the capital allocation process. New specialist CEOs use the capital budget as a bridge-building tool to elicit cooperation from powerful divisional managers in previously unaffiliated divisions.

The full paper is available for download here.

(Editor’s Note: This post by Professor Mark Roe appears today on Forbes.com.)

Last week, the Supreme Court turned down the last appeal from the creditors objecting to the Chrysler reorganization and the deal closed on the next day. Chrysler has been sold in bankruptcy.

This is a good time to assess Chrysler’s bankruptcy. At one level, it’s reason to be optimistic that bankruptcy reorganizations could move more quickly than the year or two they usually take. As a matter of technical bankruptcy prowess–in moving through chapter 11 so quickly–it’s an admirable accomplishment. As a matter of governance structure, it has the United Auto Worker union retirees as major shareholders of the new Chrysler, mixing up the UAW’s incentives as employees looking for higher wages and as owners looking for more productivity, in a way that hasn’t obtained media attention yet but which may prove to be clever.

At another level, though, the speed of reorganization is a cause for concern: How could the Chrysler deal be done so much more quickly than a typical chapter 11 reorganization? Were corners cut?

Crucially, the government is flooding Chrysler with money on non-commercial terms, inducing enough players to agree to the deal, rather that fight over the scraps. Chrysler, which was in such horrid shape last fall that the government was ready to let it liquidate, gets another chance. The speed of the bankruptcy may not be replicable in a normal chapter 11, without the government flooding troubled companies with money.

While structured in the form of a sale from the “old Chrysler” to a “new Chrysler” that Fiat and the UAW own, with the government having a sliver of an interest in the reorganized firm, the de facto deal was really that the government bought Chrysler from the creditors, giving it to the UAW, flooding Chrysler with cash, and hiring Fiat to manage it. The idea that Fiat is buying Chrysler is greatly exaggerated. All of the money came from the U.S. Treasury; and since government money doesn’t fuel ordinary chapter 11 reorganizations, there’s one reason to think Chrysler was a stand-alone bankruptcy event.

…continue reading: Assessing the Chrysler Bankruptcy

(Editor’s Note: This post is from Eric S. Wilensky and Angela L. Priest of Morris, Nichols, Arsht & Tunnell LLP.)

In the current recessionary environment, rather than looking outward for the next big deal, many corporations are turning their focus inward, reviewing and shoring up their own governance structures, defensive mechanisms, indemnification schemes and governing documents. Knowledge of recent Delaware jurisprudence is helpful in such a review, as in numerous instances over the past year, the Delaware courts have released opinions addressing and interpreting corporate charter and bylaw provisions and indemnification agreements. This article surveys the relevant Delaware developments, which are summarized briefly below.

Bylaw Provision Cases

Bylaw provisions were a hot-button issue in 2008, with Delaware court opinions touching on advance notice, proxy expense reimbursement and indemnification and advancement provisions. Two of the most talked-about corporate opinions of 2008, JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corporation v. Office Depot, Inc., focused on the legal interpretation of advance notice bylaw provisions, making clear in each case that the Delaware courts will likely construe such provisions strictly, and where ambiguous, in favor of the stockholder franchise.

The Delaware Supreme Court, on certification from the SEC, also weighed in on the legality of proxy expense reimbursement bylaw provisions in CA, Inc. v. AFSCME Employees Pension Plan, and the Delaware legislature thereafter approved amendments to the DGCL that will specifically allow corporations to include proxy reimbursement and proxy access provisions in their bylaws.

Finally, numerous opinions by the Delaware courts involved the interpretation of indemnification and advancement bylaw provisions. Specifically, the Court of Chancery discussed when indemnification and advancement rights vest (spurring the approval of legislation that clarifies this issue) and provided guidance on “fees on fees” awards in Schoon v. Troy Corp. The Delaware Court of Chancery also interpreted the terms “defense” (Reinhard v. The Dow Chemical Company, Zaman v. Amedeo Holdings, Inc., Duthie v. CorSolutions Medical, Inc. and Sun-Times Media Group, Inc. v. Black), “agent” (Jackson Walker LLP v. Spira Footwear, Inc. and Zaman), “proceeding” (Donohue v. Corning) and “final disposition” (Sun-Times), which terms consistently appear in indemnification and advancement bylaws.

Charter Provision Cases

In 2008 and early 2009, the Delaware courts also addressed Section 102(b)(7) charter provisions (limiting monetary liability for directors for breaches of the duty of care) in a series of fiduciary duty cases, beginning with Ryan v. Lyondell Chemical Co., in which the Court of Chancery denied a motion to dismiss a claim that non-conflicted directors breached their duty to act in good faith with respect to a transaction that would provide stockholders with a large premium for their shares. Subsequent cases, including McPadden v. Sidhu, In re Lear Corporation Shareholder Litigation and the Delaware Supreme Court’s reversal of Lyondell, however, made clear that such provisions remain a powerful shield for directors against monetary liability for breaches of the duty of care.

Indemnification Agreements

The Court of Chancery’s decision in Schoon highlighted the role of private indemnification agreements, and in Levy v. HLI Operating Co., the Court of Chancery focused both on the extent to which Section 145(f) of the DGCL may be relied upon in expanding the scope of indemnification and advancement beyond what is expressly set forth in the DGCL and on indemnification in the context of private equity fund designees serving on the board of a portfolio company.

* * * * *

Our article summarizes these developments within the context of the relevant corporate governing documents in order to aid in the review of such documents. We do not intend to conduct an exhaustive analysis on any particular topic or case, but rather to raise awareness of certain interpretive guidelines found within these opinions. Delaware law continues to provide much leeway for private ordering, and awareness of interpretive case law is important in ensuring that a corporation’s governing documents are drafted carefully, have the intended effects and reflect the needs and desires of the corporation.

The article is available here.

(The article is reproduced with permission from Securities Regulation & Law Report, 41 SRLR 921 (May 18, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.)

I had the opportunity to testify before the House Oversight Committee recently on a panel along with Ed Liddy, the CEO of AIG, and the three trustees nominated by the Federal Reserve to manage the government’s $180 billion investment in AIG. The subject of my testimony, available here, was the Trust Agreement designed by the Federal Reserve Bank of New York to form the AIG trust. This Trust Agreement was crafted during Secretary Geithner’s tenure at the NY Fed, and Secretary Geithner has announced that he will be creating a Trust in the near future to manage the government’s voting common equity in Citigroup and other TARP banks. One concern motivating my testimony is that the flaws in the AIG Trust will find new life in these subsequent TARP Trusts. This is of particular concern because the government and the trusts it creates enjoy unprecedented immunity, despite being a controlling shareholder, under Section 3(c) of the Exchange Act, the Emergency Economic Stability Act, and through sovereign immunity principles generally.

The first cause for concern in the AIG trust is that the fiduciary duty of the trustees is not clearly defined, and is likely to be defined by the Treasury Department. The document states that the trustees’ standard of care is to act “in or not opposed to the best interests of the Treasury.” Though “Treasury Department” is a defined term in the document, “Treasury” is not. The AIG trustees argued that their personal understanding was they were required to maximize the value of the taxpayer’s investment, but that is not required by the AIG Trust. This threatens the very purpose of the AIG Trust, which is to serve as a buffer from the short term political interests of the government that may threaten AIG’s long term financial health. For more on that threat, see my op-ed in Forbes here.

Another controversial issue with the AIG Trust is that it includes a corporate opportunity opt-out provision. This permits the Trustees to personally take business or investment opportunities that fall within AIG’s line of business, and that they learn about through their service as Trustees, without notifying or getting permission from AIG or the Federal Reserve. Corporate Opportunity opt-outs are not unheard of in the corporate world, though they are controversial, and their use in this context requires serious consideration. Part of the testimony also featured a spirited debate between myself and one of the Trustees, also the CEO of El Paso Energy, over whether the indemnification provisions included in the Trust are consistent with the level of indemnification permitted for directors of Delaware corporations. I noted that Delaware does not permit indemnification for actions not in good faith, a limitation which is not included in the AIG Trust. The broadcast is available on C-Span here.

Designing the Trusts that manage the government’s investment in TARP Banks, Financial Companies, and the Automotive Industry requires precision and caution. Poor draftsmanship in these deal documents could have serious consequences for the government’s investment in TARP, as well as for the holdings of private shareholders in TARP companies.

(Editor’s Note: This post comes from Jie Cai, Jacqueline L. Garner, and Ralph A. Walkling, all of Drexel University.)

Shareholder representation by the board of directors is a fundamental component of corporate governance. A great deal of research has focused on the characteristics of corporate boards, yet we know little about uncontested director elections. The subject is particularly important in today’s environment. Congress, stock exchanges, and individual firms have instituted dramatic governance changes. Moreover, shareholders, activist organizations, the New York Stock Exchange (NYSE), and the Securities and Exchange Commission (SEC) have proposed and debated additional changes to the method by which directors are elected. Apart from directors, shareholders do not have representation in the companies they own. If shareholder impact on director elections is weak, so is the link between owners and managers.In our forthcoming Journal of Finance paper, Electing Directors, we examine the determinants as well as the efficacy of uncontested director elections on a large sample of firms in the post-Sarbanes Oxley Act (SOX) era. We test several hypotheses relating performance at both the firm and director levels to the votes directors receive. We also examine whether votes matter to subsequent performance, compensation, or governance.

Our sample consists of 13,384 director elections at 2,488 different shareholder meetings during 2003 to 2005. We find that while director and firm performance as well as corporate governance characteristics affect how shareholders vote, the resulting differences in the level of votes are trivial. In general, the differences in votes are statistically significant but economically minor. At both the firm and director levels, votes exceeding 90% are the norm even for poorly performing firms and directors. There are two exceptions: directors attending less than 75% of board meetings or receiving a negative ISS recommendation receive 14% and 19% fewer votes, respectively. However, even though the variation in director votes is small, we find that fewer votes for compensation committee directors significantly impact subsequent abnormal CEO compensation, and fewer votes for independent directors impact subsequent CEO turnover. Also, the removal of poison pills and classified boards is significantly linked to director votes. Nevertheless, lower levels of votes appear to have little impact on the election of directors themselves or on subsequent firm performance. Directors also do not appear to suffer reputational effects from low votes.

The full paper is available for download here.

(Editor’s Note: This post is the written testimony (with footnotes and appendix omitted) submitted by Professor Lucian Bebchuk to the Committee on Financial Services, United States House of Representatives. Professor Bebchuk will be testifying today in the hearing on “Compensation Structure and Systemic Risk.” The hearing will begin today at 10a.m., and information about it and a link to a webcast of it can be found here. Professor Bebchuk’s complete written testimony (including footnotes and appendix) can be found here.)

Mr. Chairman and distinguished members of the Committee, thank you very much for inviting me to testify today.

Below I discuss how executive pay arrangements have produced incentives for excessive risk–taking and contributed to bringing about the current financial crisis, how compensation arrangements can be reformed to avoid such incentives, and what role the government should play in bringing about such reforms.

Section I describes the distortions that have been produced by the short-term focus of pay arrangements, and discusses the best ways for tying executive pay – particularly equity compensation – to long-term results. Section II describes another separate and important source of incentives that has thus far received little attention but that could well have contributed substantially to excessive risk-taking in financial firms: the tying of executive payoffs to levered bets on the value of the bank’s capital. That section also discusses how this problem can be best addressed.

Finally, section III discusses the role of the government. For financial firms that pose systemic risks, bank regulators seeking to protect the safety and soundness of such firms should monitor and regulate the extent to which pay arrangements provide incentives for risk-taking. For other publicly traded firms, the government’s role should be limited to strengthening the rights of shareholders and the governance processes inside firms, and the government should avoid intervening in the substantive choices made by the firms.

A fuller development of some of the points made in Section I can be found in “Equity Compensation for Long-term Performance,” a forthcoming white paper co-authored with Jesse Fried. Sections II and III draw on “Regulating Bankers’ Pay,” a discussion paper co-authored with Holger Spamann, which develops more fully the points made in these sections and is attached as an Appendix.

For simplicity of exposition, I will use the term “banks” to refer also to any other financial institutions that are deemed to pose systemic risk and are therefore the subject of potential government support and government regulation.

I. PAYING FOR LONG-TERM PERFORMANCE

Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. This problem was first highlighted in a book that Jesse Fried and I published five years ago, Pay without Performance: The Unfulfilled Promise of Executive Compensation, and in a series of accompanying articles. It has recently become widely recognized.

…continue reading: Compensation Structure and Systemic Risk

(Editor’s Note: The post below by Commissioner Aguilar is a transcript of remarks by him at the Compliance Week Annual Conference on June 3, 2009 in Washington, D.C.)

I am honored to be speaking to a room full of people who spend their days building a culture of compliance. As a former general counsel of a large global asset manager, I have a deep appreciation for the challenges that Compliance Officers face. These challenges are particularly great today. In these times of drastic cost cutting and shrinking revenues, compliance personnel face incredible pressure to do more with less resources and fewer personnel.

Against this backdrop, there is a debate on regulatory reform that deeply affects all of us. Changes to the financial regulatory system will have a significant impact on who regulates the entities you represent and the relationship between the regulator and your employer.

As I consider what is being said about these issues, it has struck me that the regulatory discussion is not being properly oriented. There is a need to shift the dialogue from the discussion of how best to preserve financial institutions to what is best for investors. I firmly believe that the SEC needs to be a strong voice in that discussion, and to vigorously advocate for its mission to protect investors, facilitate capital formation, and maintain fair and orderly markets. The SEC has the right orientation and has the right values to be one of the leaders in the discussion of regulatory reform. The SEC’s job is to fight for Main Street even if that means Wall Street will have to reform. That is why it is so important that the SEC be reinvigorated by Congress and that it strongly reasserts itself into our national policy discussions. Investors need the SEC now more than ever.

Investors around the country are feeling the pain of this economic crisis — in their retirement nest eggs, their college savings plans and in their brokerage accounts. Any credible effort at regulatory reform has to work for investors, so that they can feel confident in our markets. My objective is to ensure that prioritizing investors is the primary goal of any regulatory reform.

To that end, I want to concentrate my remarks today on how to structure a regulatory reform proposal that enhances, rather than undercuts, investor protection. And I want to make clear that the thoughts I express are my own, and they do not necessarily reflect the views of the other Commissioners or the staff of the Commission.

In pursuing regulatory reform, I believe the following must happen:

• First, there must be a searching inquiry into the causes of the crisis;

• Second, there must be a reversal of the philosophy that resulted in the affirmative decisions that forced gaps in, and otherwise undercut, regulatory protections in order to favor the industry;

• Third, there needs to be an assessment of whether the current regulatory reform proposals will protect investors and promote market integrity;

• And I will end with an outline of some reforms I support because they would enhance investor protection.

…continue reading: Putting Investors First in Regulatory Reform

Recently, the House Energy and Commerce Committee Chairman Henry A. Waxman and Subcommittee Chairman Edward J. Markey introduced H.R. 2454, the American Clean Energy and Security Act of 2009 (the “Waxman-Markey Bill” or the “Bill”). The Energy and Commerce Committee approved the Bill on May 21, 2009. Eight other House panels, including Financial Services, have jurisdiction to review the Bill. The Waxman-Markey Bill comprehensively addresses a broad range of issues relating to energy and climate change policy.

Subtitles D and E of Title III of the Waxman-Markey Bill contain significant provisions relating to the regulation of over-the-counter (“OTC”) derivatives generally and energy derivatives in particular (the “Derivatives Provisions”). First, the Bill would shut the Enron Loophole, the London Loophole and the Swaps Loophole. Second, the Bill would subject all OTC derivatives to centralized clearing. Third, the Bill would make “naked” credit default swaps illegal and rescind the preemption of state gaming laws with respect thereto. Finally, the Bill would give the Commodity Futures Trading Commission initial jurisdiction over markets for “regulated allowance derivatives” to regulate in the same manner as energy transactions.

In a memorandum entitled “Derivatives Provisions in the American Clean Energy and Security Act of 2009,” Daniel N. Budofsky, Robert L. D. Colby, Faisal Baloch and I provide a brief background on energy derivatives regulation to place the Waxman-Markey Bill in context. We then summarize and discuss the key Derivatives Provisions of the Bill.

The memorandum is available here.

In another memorandum, entitled “The National Conference of Insurance Legislators’ Model CDS Bill,” Bjorn Bjerke, Daniel N. Budofsky, Robert L. D. Colby, Ethan T. James and I describe model legislation being drafted by the NCOIL that would subject credit default swaps to a state regulatory regime closely modeled on that regulating financial guaranty insurance in New York. The memo discusses NCOIL’s plans for a state CDS regulatory regime and explores the implications of such a regime on the CDS market. That memo is available here.

The program on corporate governance just issued our discussion paper, Regulating Bankers’ Pay, and it is available here.

The paper seeks to contribute to understanding the role of executive compensation as a possible cause of the current financial crisis, to assessing current legislative and regulatory attempts to discourage bank executives from taking excessive risks, and to identifying how bankers’ pay should be reformed and regulated going forward.

Although there is now wide recognition that bank executives’ decisions might have been distorted by the short-term focus of pay packages, we identify a separate and critical distortion that has received little attention. Because bank executives have been paid with shares in bank holding companies or options on such shares, and both banks and bank holding companies issued much debt to bondholders, executives’ payoffs have been tied to highly levered bets on the value of the capital that banks have. These highly levered structures gave executives powerful incentives to under-weight downside risks.

We show that current legislative and regulatory attempts to discourage bank executives from taking excessive risks fail to address this identified distortion. In particular, recently adopted requirements aimed at aligning the interests of executives tightly with those of the common shareholders of bank holding companies – through emphasizing awards of restricted shares in these companies and introducing “say on pay” votes by these shareholders – do not address this distortion. The common shareholders of bank holding companies, especially now that the value of their investment has decreased considerably, would favor different strategies than that would be in the interest of the government as preferred shareholder and guarantor of some of the bank’s obligations.

Finally, having identified the problems with current legislative and regulatory attempts, we analyze how best to implement recent legislative mandates that require banks receiving TARP funding to eliminate incentives to take excessive risks. Beyond banks receiving governmental support, we argue that monitoring and regulating the structure of executive pay in banks – along the lines we suggest – should be an important element of banking regulation in general, and we analyze how banking regulators should monitor and regulate bankers’ pay.

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Here is some more detail about what the paper does:

Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. They have enabled executives to take money off the table before it turned out that gains to earnings and stock prices were in fact illusory. This problem was first highlighted several years ago in a book and accompanying articles co-authored by one of us, and has recently become widely recognized. There is no question that short-termism could have contributed to excessive risk-taking, and a contemporaneous paper co-authored by one of us with Jesse Fried shows how compensation arrangements can be best designed to eliminate the potential distortions from such short-termism. But we identify in this paper some other key features or current and past pay arrangements that would lead to excessive risk-taking even in a world with one period in which there are naturally no problems related to the length of executives’ horizon.

…continue reading: Regulating Bankers’ Pay