(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here.)

Although some financial firms are reforming how they pay their employees, governments around the world are seriously considering regulating such firms’ compensation structures. The Basel Committee on Banking Supervision has recently come out in favor of such regulations, and the United States House of Representatives has voted to require regulators to set compensation rules.

Perhaps not surprisingly, many financial bosses are up in arms over such moves. They claim that they need the freedom to set compensation packages in order to keep their most talented people – the ones who will revive the world’s financial system. So, should governments step back and let financial firms reform themselves?

The answer is clearly no. In the post-crisis financial order, governments must take on the role of monitoring and regulating pay in financial firms; otherwise, the perverse incentives that contributed to the current crisis could easily recur.

It is important to distinguish between two sources of concern about pay in financial firms. One set of concerns arises from the perspective of shareholders. Figures recently released by New York’s attorney general, Andrew Cuomo, indicate that nine large financial firms paid their employees aggregate compensation exceeding $600 billion in 2003-2008 – a period in which their aggregate market capitalization substantially declined. Such patterns may raise concerns among shareholders that pay structures are not well designed to serve their interests.

Even if financial firms have governance problems that produce pay decisions deviating from shareholder interests, however, such problems do not necessarily warrant government regulation of those decisions. Such problems are best addressed by rules that focus on improving internal governance processes and strengthening investors’ rights, leaving the choices that determine compensation structures to corporate boards and the shareholders who elect them.

But pay in financial firms also raises a second important source of concern: even if compensation structures are designed in the interests of shareholders, they may produce incentives for excessive risk-taking that are socially undesirable. As a result, even if corporate governance problems in financial firms are fully addressed, a government role in regulating their compensation structures may still be warranted.

…continue reading: Why Financial Pay Shouldn’t be Left to the Market

(Editor’s Note: This post is based on a David Polk & Wardwell LLP client memorandum by Luigi De Ghenghi, John Douglas, Randy Guynn, Arthur Long, Bill Taylor, and Reena Agrawal Sahni.)

At a meeting of the Board of Directors of the FDIC on August 26, 2009, the FDIC adopted a Final Statement of Policy on Qualifications for Failed Bank Acquisitions. The final policy statement establishes standards and requirements for private investors acquiring or investing in failed insured depository institutions, including through holding companies formed for that purpose. While the final policy statement is a substantial improvement over the proposed policy statement issued on July 2, 2009, it nevertheless subjects private investors to more onerous requirements than those applicable to existing banks, thrifts and their respective holding companies, which explicitly remain the FDIC’s preferred buyers of failed insured depository institutions. Just how onerous these requirements will be is unclear, as the final policy statement leaves a number of terms and concepts undefined and thus subject to the discretionary interpretation of the FDIC. The FDIC Board of Directors has not only reserved the right to modify the policy statement in specific situations, but also agreed to revisit the policy statement in six months.

Highlights

Scope. The policy statement will not apply to private investors with 5% or less of total voting power; nor will it apply to pre-existing investments in failed depository institutions.

Term. Upon application to the FDIC, investors may seek relief from the policy statement if the institution invested in has maintained a composite CAMELS rating of 1 or 2 continuously for seven years.

Capital. The FDIC backed off its proposed 15% Tier 1 leverage requirement, but instead imposed a minimum 10% ratio of Tier 1 common equity to total assets. While the 10% requirement probably will not eliminate private capital bids for failed banks, at least in the near term, it represents a financial penalty that will reduce any potential bid, thus hindering private investors.

Cross Guarantee. The FDIC backed off its initial proposal to impose cross-guarantee liability where there is majority common ownership, increasing the common ownership threshold to 80% and clarifying the intent to impose that liability on common owners directly. While the 80% test is a significant improvement, it still represents a deterrent for prospective private investors.

Source of Strength. The FDIC completely eliminated the proposed source of strength requirement, but underlined the source of strength obligations of a depository institution’s holding company by deeming an insured depository institution “undercapitalized” for purposes of prompt corrective action if its Tier 1 common equity ratio drops below 10%.

Transactions with Affiliates. The final policy statement goes well beyond Section 23A of the Federal Reserve Act by flatly prohibiting transactions with private investors, their investment funds and any of their respective affiliates and by defining affiliates by reference to a 10% level of ownership.

Bank Secrecy Jurisdictions. The FDIC retained the ability to refuse to allow investors from so-called bank secrecy jurisdictions to participate.

Holding Period. The FDIC retained the minimum three-year ownership requirement, although it will permit transfers to affiliates that agree to the provisions of the policy statement, subject to FDIC consent, and it excluded mutual funds from this minimum holding period requirement.

Prohibited Structures. The FDIC retained the ability to preclude ownership structures that the FDIC determines to be “complex and functionally opaque.”

Precluded Investors. The policy statement retains a prohibition on investors that hold 10% or more of the equity of an institution in receivership from bidding on that institution.

Disclosures. Investors subject to the policy statement are required to provide substantial information to the FDIC in connection with any proposed bid.

Despite the compromises reflected in the final policy statement, the FDIC Board was unable to achieve unanimity, with the final policy statement being approved by a 4-1 vote. John Bowman, Acting Director of the Office of Thrift Supervision, cast the opposing vote, stating that the lack of empirical data supporting the policy statement made it impossible to evaluate its benefits.

In the memorandum, FDIC Extends Cautious Welcome to Private Capital Investments in Failed Banks, Davis Polk analyzes the final policy statement in greater detail. Because of the ambiguities in the final policy statement and the FDIC’s discretion to interpret and apply the statement, it will be more important than ever for prospective investors to engage the FDIC very early on in the process of any proposal to acquire a failed insured depository institution.

(Editor’s Note: This post comes to us from David Matsa of the Kellogg School of Management, Northwestern University.)

The standard corporate finance paradigm posits that a firm determines its optimal capital structure by making tradeoffs between the tax advantages of debt, the expected costs of financial distress, the impact of asymmetric information, and the implications for managerial incentives. But when financial policy affects a firm’s competitive position in product or input markets, the firm has an incentive to set its capital structure strategically to influence the behavior of competitors, customers, or suppliers. Although this argument is well understood in theory, its empirical relevance is much less clear. My forthcoming Journal of Finance paper, Capital Structure as a Strategic Variable: Evidence from Collective Bargaining, fills an important gap by showing that strategic incentives from labor markets have a substantial impact on financing decisions.

Delta Air Lines’ recent experience exemplifies how too much flexibility can hurt a firm’s bargaining position with workers. With a strong market position and a history of fiscally conservative management, Delta weathered the airline industry downturn after September 11, 2001 by building up cash and liquidity. But greater liquidity also reduced the need to cut costs and hurt Delta’s bargaining position with workers (Perez (2004)). By 2004, Delta found itself far behind the other big carriers in restructuring, and in severe financial distress.

I begin my analysis through a theoretical framework that illustrates how collective bargaining affects a firm’s optimal debt policy. This framework shows that collective bargaining interacts with variability in a firm’s profits to give the firm a strategic incentive to increase its debt. The firm must consider the tradeoff between gains from improved bargaining power when the cash flow shock is positive and losses from increased costs of financial distress when the shock is negative. Greater profit variability has an asymmetric impact on this tradeoff, because the union earns rents only on inframarginal realizations of the shock. While greater variability exposes unionized and nonunionized firms to similar costs in periods of financial distress, it increases liquidity and hence a unionized firm’s exposure to union rent seeking when a cash flow shock is positive. Thus, a unionized firm with high profit variability has greater strategic incentive to use debt to shield liquidity from workers in bargaining and thus a higher optimal debt ratio than an otherwise similar nonunionized firm.

I then provide empirical evidence for the strategic use of debt using two estimation strategies. In the first approach, I analyze cross-sectional correlations between debt and the percentage of employees covered by collective bargaining (a direct measure of union power) for a sample of mostly manufacturing firms from the 1970s, 1980s, and 1990s. The results suggest that union bargaining power leads firms to increase financial leverage: on average, the ratio of debt to firm value is 80 to 110 basis points higher when an additional 10% of employees bargain collectively. According to these estimates, a firm with a 50% unionized workforce is associated with 15% to 20% greater financial leverage than a typical nonunionized firm. Furthermore, these differences are larger at firms with more variable profits. However, this result may be affected by omitted variable bias: unions are more likely to organize in established, profitable firms and industries, which may also have a greater capacity for debt.

To overcome this problem, I employ a second empirical approach, which uses states’ adoption of right-to-work laws in the 1950s and states’ repeal of unemployment insurance work stoppage provisions in the 1960s and early 1970s as sources of exogenous variation in union power. I find that after states adopt legislation to reduce union bargaining power, firms with concentrated labor markets reduce debt relative to otherwise similar firms in other states. In fact, the ratio of debt to firm value decreases by up to one-half after a right-to-work law is passed. These effects are again linked to variability in firm profits. While the ratio of debt to firm value decreases by up to one fifth after a work stoppage provision is repealed for firms with profit variability that is one standard deviation above the mean, there is little effect among firms with low profit variability. As a falsification test, I show that these changes in labor laws do not seem to affect financial policy at firms in industries with low union presence. Various tests confirm the robustness of the profit variability interaction.

The full paper is available for download here.

(Editor’s Note: The post below by Commission Aguilar is a transcript of his remarks at the Joint Meeting of the Securities and Exchange Commission and Commodity Futures Trading Commission last week.)

Good morning. I, too, would like to welcome the panelists and the members of the public present here, as well as those observing by webcast.

I am delighted to be here for these unprecedented meetings and I welcome these upcoming discussions.

As some of you know, I have been supportive of combining the SEC and the CFTC. Among other reasons, it would permit more comprehensive and coordinated oversight of financial markets that are increasingly interconnected, and would reduce the concerns and uncertainty about jurisdiction.

Although the SEC has many unique responsibilities, such as oversight of capital markets offerings and financial reporting, some market and intermediary oversight by the CFTC and SEC involve similar tasks. Holding these joint meetings can accomplish some of the same purposes as combining the agencies, and I believe it will result in improvements to our markets.

For example, harmonized rules could enable more consistent recordkeeping by regulated entities. And investors who seek to engage in both securities and futures transactions may be able to better manage their affairs and have their needs met more efficiently.

It is true that harmonization will not make sense in every case because of the different needs of market participants. As a result, as this process unfolds, it would make sense to consider harmonization consistent with some key principles. In particular, harmonization should be pursued where doing so would advance the public interest by enhancing investor protection, by providing a fair and competitive market structure that facilitates informed decision making, and where harmonization would further both agencies’ efforts in vigorous law enforcement. Investor protection is the animating purpose at the SEC, and it will help guide our work in this project.

And even where harmonization would not be appropriate, these meetings will assist our ongoing efforts to coordinate with one another.

My thanks to the staffs of both agencies for their work in organizing this two-day meeting. And thanks again to the panelists for agreeing to share their views with us, and to our respective Chairmen and my fellow Commissioners at the SEC and at the CFTC for agreeing to hold these meetings.

On September 3, 2009, twenty-five corporate law and finance professors and scholars – including several contributors to this blog – filed an amici curiae brief in the case of Jones et al. v. Harris Associate L.P. The case is now pending before the United States Supreme Court. The brief is available here, and the names of those joining the brief are listed at the bottom of this post. The Supreme Court is currently scheduled to hear the case on November 2, 2009.

The Harris case is an appeal of the Seventh Circuit, in an opinion written by Judge Frank Easterbrook, noted previously on this blog here and here. That decision upheld the trial court’s dismissal of the case against Harris Associates, a mutual fund advisor, on the ground that as long as a mutual fund adviser does not breach the fiduciary duty owed to shareholders by failing to disclose all pertinent facts or otherwise hindering the fund’s directors from negotiating a favorable price, no judicial review of the reasonableness of the adviser’s fee is required to dismiss a claim under Section 36(b) of the Investment Company Act (ICA).

Judge Easterbrook’s opinion rejected the long-followed Second Circuit decision in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982). Gartenberg, while respecting deliberations of independent directors, required courts to consider those deliberations in light of multiple factors in determining whether investment adviser fees were excessive and, in dicta, suggested that evidence of comparable fees and competition among advisors should not be given much weight. A decision by the Seventh Circuit declining to rehear the case en banc generated a dissent from Judge Richard Posner.

…continue reading: 25 Professors Submit Amicus Brief in Supreme Court Investment Advisory Case

The motives and consequences of financial regulation are once again being hotly debated in the current global financial crisis. However, this debate is hardly new. In my paper The Political Economy of Financial Regulation: Evidence from U.S. State Usury Laws in the 19th Century, which was co-written with Tobias Moskowitz of the University of Chicago and which was recently accepted for publication in the Journal of Finance, we look to the past and study the political economy of financial regulation and its consequences through the lens of usury laws in 19th century America. Usury laws are arguably the oldest form of financial regulation. Moreover, the rich political and economic landscape of the 19th century United States provides a useful laboratory to investigate the motives and impact of financial regulation during a critical point of U.S. economic development. Our investigation into the causes and consequences of financial regulation entails answering who and what determines regulation and who benefits and loses from it.

We first argue that usury laws had financial and economic impact. We show that binding rate ceilings constrain some borrowers at certain times and that usury laws significantly affect lending activity in the state. We further show that changes in these laws are associated with future economic growth and, importantly, that the impact on growth is concentrated exclusively among the smallest borrowers in the economy.

We then investigate the determinants of financial regulation. Like everything, use of regulation varies with its cost. States impose tighter usury laws (lower maximum rates and stiffer penalties) when it is less costly to do so. When current market interest rates exceed the rate ceiling or during financial crises, states relax restrictions by raising the rate ceiling. When market rates fall or the crisis abates, ceilings are re-imposed or tightened. States hit hardest by financial crises are even more likely to follow this pattern. We also show that usury laws respond to neighboring state competition for capital flows (particularly foreign at this time). These results suggest that usury laws have real (or at least perceived) impact, otherwise why bother to change them?

To distinguish between the private and public interest motives for regulation we measure the extent of incumbent political power in a state and its relation to usury laws. State suffrage laws that restrict who can vote based on land ownership and tax payments (not race or gender) keep political power in the hands of wealthy incumbents. We find that such wealth-based voting restrictions are highly correlated with financial restrictions. We find that wealth-based suffrage laws are not affected by financial crises. We also find that after a financial crisis abates, states with stronger wealth-based voting restrictions are even more likely to re-impose tighter usury laws.

As further corroboration of private interests, we find a positive relation between wealth-based suffrage restrictions and other forms of economic regulation designed to exclude certain groups, such as general incorporation laws that permit free entry of firms. In addition, we find that usury laws are tighter when incorporation restrictions are also tight, which seems to conflict with the public-interest motivation, which is supposed to include or help underserved or disadvantaged groups rather than limit access. We also consider whose private interests, the financial or non-financial sector, are best being served by these policies and find that the combination of policies most correlated with usury laws fits non-financial incumbent interests best.

Overall, the evidence we uncover appears most consistent with financial regulation being used by incumbents with political power for their own private interests—controlling entry and competition while lowering their own cost of capital.

The full paper is available for download here.

In our paper “Delaware’s Competitive Reach:  An Empirical Analysis of Public Company Merger Agreements” recently posted to the SSRN (and available here) my co-author Matthew Cain of the Notre Dame Mendoza College of Business and I evaluate the selection of governing law and forum clauses in merger agreements between public firms from 2004-2008.

In contrast to prior research, we find that Delaware is the dominant choice among merging parties. During the sample period approximately 66.4% of agreements select Delaware for their governing law and 60% of agreements select Delaware as their choice of forum. This compares to 61.8% of targets during this time that are incorporated in Delaware, and 54.8% of acquirers that are similarly incorporated.

We find that Delaware’s attractiveness has increased in recent years in response to exogenous events, namely the financial crisis and the Second Circuit’s decision in Consolidated Edison, Inc. v. Northeast Utilities.  The latter court ruling was perceived by practitioners as creating an unfriendly merger precedent under New York law.  We find that the opinion made the Delaware forum a more attractive one vis-à-vis New York.

Delaware’s attractiveness is also evidenced by the fact that top-tier legal advisors, foreign acquirers, transactions surrounded by greater financial uncertainty, and larger transactions tend to select Delaware’s forum over other venues.  Our results are robust to controls for simultaneity and endogeneity.

Our results also provide support for the theory that Delaware competes by providing quality governing law, and particularly, adjudicative services. They also highlight the contestability of Delaware’s dominance; parties adjust their choices of law and forum during our sample time period in response to legal and other events.

Prior empirical work on the race-to-the-bottom/race-to-the-top debate has focused on Delaware’s primary product, the public company charter.  We posit that Delaware is more than a single-product provider but rather a supermarket offering complementary and differentiated products beyond the public company charter.  For example, the law governing, and adjudication of, merger agreements is one such complementary product while the law governing real estate investment trusts is a differentiated one (and one where Delaware does not compete).   By studying this former product we hope to further inform the debate over how and when Delaware competes.

Our results ultimately support the conclusion that Delaware competes strongly in other legal products beyond its primary one, the public company charter.  They also show that attorneys and their clients are responsive to unfavorable legal rulings and the quality of adjudication.

(Editor’s Note: This post comes from John (Xuefeng) Jiang, Kathy Petroni, and Isabel Wang of the Eli Broad College of Business, Michigan State University.)

In our paper, CFOs and CEOs: Who Have the Most Influence on Earnings Management?, which was recently accepted for publication in the Journal of Financial Economics, we investigate whether Chief Financial Officer (CFO) equity incentives are associated with earnings management. Extant research has primarily focused on how chief executive officer (CEO) equity incentives affect earnings management (Bergstresser and Philippon 2006; Cheng and Warfield 2005). However, both commentators and policymakers have expressed a concern that CFO equity-based compensation might also contribute to earnings management. As described by Katz (2006), during testimony before the Senate Finance Committee IRS Commissioner Mark Everson expressed that the temptations of stock appreciation demand “heroic” virtue to keep managers from wrongdoing. He suggested that CFOs who are in charge of “minding the cookie jars” should not be paid by stock options, but by “generous but fixed compensation for specified contract periods.” Echoing concerns over CFO compensation, the SEC recently amended its disclosure rules on executive compensation by requiring that firms report their CFO pay. One analyst claims that the mandatory disclosure of CFO compensation is “a major benefit” of the amended SEC disclosure rule (Harris 2007).

Because CFOs’ primary responsibility is financial reporting, we argue that CFO equity incentives should play a stronger role than those of the CEO in earnings management. We separately and jointly examine the association between CFO and CEO equity incentives and earnings management. We consider two settings (accrual management and the likelihood of beating analysts’ expectations) and utilize methodologies similar to those used in prior research that has documented an association between CEO equity incentives and earnings management. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. For example, our results suggest that if a CFO equity incentive moves from the first quartile to the third quartile of the distribution of our sample CFO equity incentives, the absolute total accruals as a percent of total assets would increase almost 75 percent more than the increase associated with a similar move of CEO equity incentives. Similarly, the change in odds ratio of beating analysts’ expectation is 5 percent more when CFO’ equity incentives increase from the first quartile to the third quartile than when CEO’ equity incentives have a similar move.

Our results suggest future research should consider compensation of CFOs when investigating incentives for earnings management. More importantly, our results confirm policymakers’ concerns over CFO compensation and thus provide indirect support for the SEC’s new requirement for disclosures of CFO compensation. The disclosure of CFO compensation should be useful for investors and analysts to assess the quality of firms’ financial reporting.

The full paper is available here.

(Editor’s Note: This post comes to us from David J. Gilberg, Kenneth M. Raisler and Dennis C. Sullivan of Sullivan & Cromwell LLP.)

On August 11, the Treasury Department released the Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”), its legislative proposal to regulate the over-the-counter (OTC) derivatives industry. The proposed legislation provides an approach to comprehensively regulating OTC derivative transactions and the entities that enter into OTC derivatives transactions. Through its proposal, the Treasury Department is recommending the repeal of many provisions of the Commodity Futures Modernization Act (“CFMA”), which was adopted in 2000.

Background

On August 11, the Treasury Department released the Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”), its legislative proposal to regulate the over-the-counter (“OTC”) derivatives industry.[1] The proposed legislation closely follows the proposals offered by Treasury Secretary Timothy Geithner [2] and Commodity Futures Trading Commission (“CFTC”) Chairman Gary Gensler [3] earlier this year. Treasury’s proposed legislation shares similar themes with the joint principles [4] offered by House Agriculture Committee Chairman Colin Peterson and House Financial Services Committee Chairman Barney Frank, whose Committees have jurisdiction over the federal banking regulators, the Securities and Exchange Commission (“SEC”) and the CFTC. Given the full legislative agenda of the Senate in the fall, it is expected that the House of Representatives will move first on drafting OTC derivatives legislation, likely using the Administration legislative proposal as a template for its own legislation. It remains unclear if Congress will pass OTC derivatives legislation in the remaining Congressional legislative session.

However, should the climate change/energy legislation and healthcare reform efforts stall, lawmakers will turn their attention to financial reform, including regulation of OTC derivatives.

Framework of the Legislation

The OCDMA effectively divides regulatory authority over OTC derivatives between the CFTC and the SEC, reflecting the current division of jurisdiction between the agencies in the futures markets. Specifically, under the OCDMA, security-based swaps and credit derivatives based on a single security or issuer, or a narrow based group of securities, will be regulated by the SEC and swaps and credit derivatives based on broad-based indices will be regulated by the CFTC. The same division will also apply to swaps based on corporate debt and event-based contracts. All other OTC products, including interest rate, currency and commodity swaps, will fall under the control of the CFTC. However, federal banking regulators will maintain their jurisdiction over identified banking products (as defined by the Commodity Futures Modernization Act of 2000), unless the appropriate federal banking agency, in consultation with the CFTC and/or SEC, determines that the banking product has been structured in such a way that it performs the same function as a swap or was structured in a way to avoid regulation. If the regulators make that determination, the banking product will be regulated by the CFTC or the SEC.

The bill sets an aggressive timeline – 6 months to 1 year, for the agencies to implement the required rulemakings. Swap transactions entered into before the enactment of OCDMA must be reported to a regulated repository within 6 months of the effective date of the regulation.

…continue reading: Treasury Proposes Comprehensive Supervision of OTC Derivatives

Executive pay is taking center stage in the governance reform debate, with significant attention given to a proposal to mandate an annual advisory shareholder vote on the executive compensation report, known as “say on pay,” following the example of United Kingdom (U.K.). I have recently completed two studies examining this proposal—the first considers the impact of “say on pay” in the U.K., and the second analyzes the effect of mechanisms currently available to U.S. investors to influence executive pay (i.e. shareholder proposals and vote-no campaigns).

In the first study, co-authored with David Maber of University of Southern California, Say on Pay Votes and CEO Compensation: Evidence from the UK, we perform two sets of tests. First, we examine UK firms’ responses to say on pay votes by analyzing the changes to compensation policies made by firms after facing high voting dissent against their remuneration report. We document that a significant number of these firms removed or modified provisions that investors viewed as “rewards for failure” (e.g., generous severance contracts, low performance hurdles, provisions allowing the retesting of performance conditions)—often in response to institutional investors’ explicit requests—and established a formal process for proactive consultation with their major shareholders going forward. These actions paid off, in that voting dissent at the subsequent annual meeting was substantially lower. We also find evidence of similar actions taken before the vote by a subset of firms that subsequently experienced low voting dissent, suggesting that the threat of a vote induced some firms to revise CEO pay practices ahead of the annual meeting.

Second, we examine the trend in CEO pay and its sensitivity to economic determinants before and after the introduction of say on pay for a large sample of UK firms. We find no evidence of a change in the level and growth rate of CEO pay—after controlling for firm performance, size and other factors. However, we find a significant increase in the sensitivity of CEO pay to poor performance. The increase is most pronounced in (i) firms with high voting dissent, and (ii) firms with an ”excessive” level of CEO pay (relative to the level predicted by its economic determinants) before the adoption of say on pay, regardless of the voting dissent. Interestingly, we do not find a more pronounced increase in firms with higher raw levels of CEO pay. These findings confirm the insights from our small-sample evidence of explicit changes to pay contracts and suggest the following: (i) UK investors used say on pay to push for greater accountability for poor performance; (ii) firms responded to adverse shareholder votes, in spite of their non-binding nature; (iii) (at least some) firms responded to the threat rather than the realization of an adverse vote; (iv) shareholders focused on firms with controversial CEO pay packages (as captured by high voting dissent or excessive CEO pay levels) rather than firms with high (but not abnormal) CEO pay levels.

In the second study Shareholder Activism and CEO Pay, coauthored with Yonca Ertimur of Duke University and Volkan Muslu of the University of Texas at Dallas, we examine a comprehensive sample of 1,332 compensation-related shareholder activism events over the 1997-2007 period (134 vote-no campaigns and 1,198 shareholder proposals). We find that, in targeting firms, activists take both the ”predicted” and ”excess” components of CEO pay into consideration. In other words, activists (particularly institutional investors) appear sophisticated enough to identify excess CEO pay firms, but they also target firms with high (but not abnormal) levels of CEO pay, perhaps to bring greater visibility to their initiatives or because of concerns with social equity. Voting support for compensation-related proposals, in contrast, is higher in firms with excess CEO pay but not in firms with high (but not abnormal) CEO pay, suggesting that shareholder votes reflect a sophisticated understanding of CEO pay figures. Voting patterns depend on the type of shareholder proposal. In particular, proposals aimed at affecting the pay setting process (e.g., proposals requesting shareholder approval of certain compensation items)—which we label Rules of the Game proposals—receive the highest voting support, often resulting in majority votes. Support for proposals aimed at influencing the output of the pay setting process (e.g., proposals to use performance-based vesting conditions in equity grants)—which we label Pay Design proposals—is lower but has been increasing in recent years. Proposals directed at shaping the objective of the pay setting process (e.g., proposals to link executive pay to social criteria or to abolish incentive pay)—labeled Pay Philosophy proposals and mostly filed by individuals and religious funds—have consistently received little support. The rate of implementation for pay-related proposals is generally low (5.3%) but increases substantially for proposals receiving a majority vote (32.2%) most of which are Rules of the Game proposals. With respect to the overall effect on CEO pay, we document a $7.3 million reduction in excess CEO pay for firms targeted by vote-no campaigns, corresponding to a 38% decrease in CEO total pay. As for shareholder proposals, we find evidence of a moderating effect on CEO pay—a $2.3 million reduction—only in firms targeted by Pay Design proposals sponsored by institutional proponents in recent years.

What do these studies tell us about the potential impact of “say on pay” in the U.S.? While drawing policy implications requires caution, a few lessons can be learned. First, there is no indication that special interest groups pushing for radical changes have hijacked shareholder votes in the U.K. or the U.S.—a concern expressed by critics of say on pay. U.S. shareholders have systematically rejected proposals trying to micromanage executive pay and supported those that ask for a say on the pay process. Similarly, U.K. shareholders have shied away from opining on pay levels and focused instead on strengthening the link between pay and performance by imposing certain rules of the game (e.g., no retesting of performance conditions). Second, in both countries, investors use their voting power in a moderate and sophisticated manner, raising their voice only at few firms with controversial pay practices and suspiciously high pay levels. Fears that many firms would face massive chaos and revolts at annual meetings have not materialized. Third, while both in the U.S. and the U.K. boards do listen to shareholder votes, even if advisory, say on pay votes and vote-no campaigns are more effective in getting boards’ attention than shareholder proposals. A say on pay vote against the remuneration report (or votes withheld from a director) greater than 20% usually prompts a firm’s response. In contrast, shareholder proposals have a reasonable (but still low) chance to be implemented only if they win a majority vote. This difference is not surprising. Vote-no campaigns and say on pay directly question directors’ performance and, thus, affect their reputation. In addition, unlike shareholder proposals, they enable shareholders to express their general dissatisfaction with CEO pay rather than with a single problem and do not require an ex ante agreement on the solution. As such, they may force a broad dialogue between investors and boards on all aspects of CEO pay, without putting shareholders in the difficult position to micromanage specific and technically complex aspects of CEO pay through a 500-word “yes or no” proposal. The fourth lesson is that the U.K. experience with say on pay indicates that boards try to prevent an adverse voting outcome through ex ante consultation with institutional investors and that enhanced communication is crucial for boards to “interpret” the say on pay vote.

Overall, these factors suggest that concerns with say on pay may have been exaggerated. Say on pay may be as effective as vote-no campaigns in causing boards to listen and act, and with an added benefit. Specifically, say on pay may allow greater activism by those institutional investors concerned with CEO pay but reluctant to compromise their relation with boards by engaging in vote-no campaigns and voting against the re-election of otherwise valuable directors.

However, a number of caveats are in order, particularly in drawing inferences from the experience of a different country with its own governance environment. First, for say on pay to work investors must have something to say in the first place. In the U.K., institutional investors have developed and agreed upon (and continue to update) a set of guiding principles, or “best practices,” on executive remuneration, complementing the principles in the Combined Code. Under the U.K. “comply or explain” governance model, these best practices provide firms and shareholders with a clear benchmark against which to make assessments of pay practices. In addition, concentrated institutional ownership has led to a relatively high level of engagement which also allows for firm-specific adjustments of these best practices. It is not clear whether institutional investors in the US will take such a proactive role or outsource it to proxy voting services, which may be tempted to adopt “cheap” one-size-fits-all solutions, as cautioned by Jeffrey Gordon of Columbia Law School in a piece in the Harvard Journal on Legislation. In addition, higher concentration and stability of institutional ownership may make communication with boards easier in the U.K. Second, in the U.K. it is generally easier for investors to replace directors, thereby making directors more responsive to shareholder pressure (though the trend toward majority voting and proposed proxy access legislation may make the threat of replacement stronger in the U.S.). In view of these and other caveats, proposals to limit mandatory say on pay to large firms may be a sensible first step (after all, our studies show that most compensation-related activism is focused on the largest firms).

A final word of caution: in the heat of the reform debate, say on pay has often been used in the same sentence as excessive risk-taking to suggest that an advisory shareholder vote would lead to compensation packages that discourage excessive risk-taking. Such a statement is incorrect. Say on pay is a neutral tool that shareholders will use (if they decide to use it) to influence compensation practices in a way consistent with their objectives. The risk-taking profile desired by shareholders may very well differ from the level of risk-taking that regulators may deem optimal for the economy. Similarly, say on pay should not be expected to be a tool to deal with wealth inequality. After all, shareholders have long supported compensation packages that have encouraged risk-taking and resulted in higher compensation levels.

In my recent paper, currently in the submission process, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, I explore the implications of the U.S. Treasury Department and the Federal Reserve’s controlling ownership positions in many companies through its decision to take equity in TARP bailout participants. I show how existing corporate theory is unprepared for the presence of a controlling government shareholder and I demonstrate a variety of unanticipated complications for corporate practice.  I close with three recommendations, one of which has assisted Senators Corker and Warner in introducing implementing legislation.

Corporate law theory and practice considers shareholder relations with companies and the implications of ownership separated from control.  Yet through the TARP bailout and the government’s resultant shareholding, ownership and control at many companies has merged, leaving corporate theory and practice for the financial and automotive sectors in chaos.  The government’s $700 billion bailout is a unique historical event; not merely because of its size, but because of the resulting ripple through scholarship and practice.

To emphasize the unique nature of Treasury’s ownership through TARP, the article briefly considers the history of the United States government’s entanglement in private business.  Though the federal government has frequently chartered businesses that were wholly owned by the United States, the government’s ownership in businesses through TARP is a circumstance without precedent.  Before rethinking theoretical and practical elements of corporate theory, the article will consider the two threshold questions in the analysis: whether Treasury and the Federal Reserve are actually controlling shareholders, and whether there are any substantive limits to their sovereign immunity as control shareholders under corporate and securities law.

The article argues that the government is most clearly a control shareholder for the largest TARP recipients in which it holds an interest, including Citigroup, AIG, GM, Fannie Mae, Freddie Mac, and with some significant measure of certainty the nine remaining banks from among the top nineteen banks to originally receive TARP funding.  The article also offers the suggestion that the government might, depending on its degree of ownership, also be considered a control shareholder for many of the other 600 banks accepting TARP funding.

The article then considers the application of sovereign immunity to the Treasury and Federal Reserve’s exercise of ownership.  After considering a number of novel challenges to the government’s sovereign immunity, it concludes that the federal government’s belt-and-suspenders protection from liability, including the liability waivers of the Emergency Economic Stability Act, waivers included in the Securities Exchange Act, and challenges in using sovereign immunity exceptions like the Takings Clause, foreclose meaningful challenge to the federal government’s sovereign immunity in its exercise of ownership power over its TARP shares.

This work updates the six central theories of corporate law to reveal that none function adequately when considered with a controlling government shareholder that enjoys sovereign immunity.  Corporate law theory is home to essentially six distinct and at times vigorously opposed schools of thought.  First, the article looks to the foundations of corporate law in agency theory and nexus-of-contracts theory.  In both, it considers the effects of a control shareholder with sovereign immunity.  Then, it considers the Cain-and-Abel-like warring children of the agency and nexus-of-contracts marriage: shareholder primacy and director primacy.  Shareholder primacy is a difficult fit, as it contemplates a non-conflicted shareholder electorate that minimizes the special interest director problem, a wash-board which TARP ownership obviously complicates.  Director primacy seems an easy critic of TARP ownership, as it is inherently hostile to the accretion of shareholder power, and yet is difficult to understand in light of elected directors who may be beholden to government shareholders.

The team production model theory of corporate law is also considered in the article, with the result that the model’s reliance on the board of directors as a mediating hierarch, balancing the interests of varying stakeholders, is complicated by the political pressures placed on the unique government shareholder hierarch.  The progressive corporate law model of corporate law is also considered, with the result that the accountability of government regulators and the disclosure rules underlying progressive corporate law are threatened by the presence of government ownership.

The article also develops an economic model of incentives facing political decision-makers in exercise of their shareholder power.  It gives particular emphasis to the fact that retail shareholders and taxpayers, as more dispersed interest groups, will have substantially less influence than other rent seeking groups.  It also considers the fact that rents for an official exercising government shareholder powers aren’t time discounted, but the costs of using a bank to subsidize interest groups are substantially time discounted.  Indeed, given the average two year tenure of a Schedule C appointee, the government appointees may be gone long before the costs of subsidization are revealed.

The article warns that i) Treasury has free reign to engage in insider trading of its shares pursuant to unique provisions in the ’34 Act ii) Treasury is the only control shareholder that evades fiduciary duties to other shareholders under corporate law, iii) Treasury may end up serving as a lead plaintiff in private securities class action litigation against the very companies it is trying to support through TARP, iv) unregistered securities of any TARP recipient held by another TARP recipient may be considered affiliated sales by virtue of their sharing a controlling shareholder v) the ability of boards of directors to approve conflicted transactions may be endangered, and vi) the government will obtain the right to nominate candidates for the Board of publicly traded companies, and vote for other shareholder’s nominees, under the SEC’s recent shareholder proxy access rule.

The article offers hope to the concerned corporate law traditionalist in three unique reform suggestions.  First, it recommends that the government eschew its voting common equity, and even its non-voting preferred shares, in favor of frozen options.  Frozen options would be designed such that the government would never be permitted to exercise them, and accordingly never be permitted to exercise the voting or other rights that accompany either common or preferred shares, but the government would be permitted to sell them into the market and allow other shareholders to exercise all the rights that accompany the form of shares into which those temporarily frozen options morph.  This should serve as a significant buffer to the analysis that the federal government holds a control position in TARP companies, central to the article’s analysis concerning the resultant complications in corporate theory and practice, while still permitting the taxpayer to participate in share appreciation of bailed-out companies.

Second, the article recommends that the Treasury and the Federal Reserve set up trusts to hold its ownership that create an explicit obligation of those entities to maximize long term shareholder wealth in the invested TARP companies.  Toward that end, the article’s author has contributed language to implementing bi-partisan legislation introduced by Senator Corker and Senator Warner, the TARP Recipient Ownership Trust Act of 2009.  This should be accompanied by a waiver of the federal government’s sovereign immunity with respect to state corporate law, as well as a waiver of its immunity under section 3(c) of the Exchange Act and attendant immunity provisions of the Emergency Economic Stability Act.

Third, in conjunction the preceding recommendations, the article suggests that the federal government as a shareholder should execute a 10b-5 trading plan similar to the type filed by executives to protect against liability for insider trading.  This plan should be binding on the Treasury by law, with appropriate ranges of trade amounts, to minimize the threat of insider trading by the Department and cement a near term exit date by the government from its positions in private businesses.

Throughout the world, many large banks have seen most of their equity destroyed by the crisis that started in the U.S. subprime sector in 2007 and governments have had to infuse capital in banks in many countries to prevent outright failure. Many observers have argued that ineffective regulation contributed or even caused the collapse. If that is the case, we would expect differences in the regulation of financial institutions across countries to be helpful in explaining the performance of banks during the credit crisis. Other observers have criticized the governance of banks and suggested that better governance would have led to better performance during the crisis. Finally, it could be that banks were affected differentially simply because they had different balance sheets and profitability before the crisis for reasons unrelated to governance and regulation and that these characteristics affected their vulnerability to large adverse shocks. In a paper recently posted on SSRN titled “Why did some banks perform better during the crisis? A cross-country study of the impact of governance and regulation,” Andrea Beltratti and I investigate the possible determinants of bank performance, measured by stock returns, during the crisis for a sample of large banks, i.e., banks with assets in excess of $50 billion at the end of 2006, across the world.

One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006. In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006. This evidence suggests that the attributes that the market valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. The market did not expect these attributes to be a source of weakness for banks and did not expect the banks with these attributes to perform poorly as of 2006.

An OECD report argues that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements”. We find no evidence supportive of such a statement in our data. There is no evidence that banks with better governance, when governance is measured with data used in the well-known Corporate Governance Quotient (CGQ score) perform better during the crisis. Strikingly, banks with more pro-shareholder boards performed worse during the crisis.

We use the database on bank regulation developed in Barth, Caprio, and Levine (2001, 2004) to examine the hypothesis that stricter regulation prevented bank losses during the crisis. We use indicators for the power of the regulators, oversight of bank capital, restrictions on bank activities, and the independence of the supervisory authority. When we compare the banks in the top quartile of return performance to those in the bottom quartile, the better performing banks have more restrictions on their activities, stronger oversight of bank capital, and a more independent supervisory authority. In multiple regressions, we generally find that a stronger supervisory authority has a negative impact on performance during the crisis and stronger bank capital oversight is associated with better performance. We interpret the negative coefficient on the strength of the supervisory authority as follows. If stronger supervisory authorities would have been more effective at preventing banks from taking risks before the crisis, we would expect a positive coefficient on that variable. A possible explanation for this negative coefficient is that once the crisis was ongoing, stronger regulators took more measures that were costly to shareholders to assure the survival of banks.

Bank balance sheets and bank profitability in 2006 are more important determinants of bank performance during the crisis than bank governance and bank regulation. Banks that had a higher Tier 1 capital ratio in 2006 and more deposits generally performed better during the crisis. As a result, the positioning of banks as of the end of 2006 is more important than governance and/or regulation in explaining the performance of banks during the next two years. Another way to explain our results is that banks were differentially exposed to various risks by the end of 2006. Some exposures that were rewarded by the markets in 2006 turned out to be unexpectedly costly for banks the following two years. Overall, the explanatory power of regulatory variables is small compared to the explanatory power of bank-level variables.

Overall, our evidence shows that bank governance, regulation, and balance sheets before the crisis are all helpful in understanding bank performance during the crisis. However, banks with more shareholder-friendly boards, which are banks that conventional wisdom would have considered to be better governed, fared worse during the crisis. Either conventional wisdom is wrong, as suggested by Adams (2009), or this evidence is consistent with the view that banks that took more risks rewarded by the market –perhaps because the market did not assess them correctly ex ante – before the crisis suffered more during the crisis when these risks led to unexpectedly large losses. Strong evidence supportive of the latter interpretation is that the performance of large banks during the crisis is negatively related to their performance in 2006. In other words, the banks that the market rewarded with largest stock increases in 2006 are the banks whose stock suffered the largest losses during the crisis.

The full paper is available for download here.

(Editor’s Note:  This post is based on a Wachtell, Lipton, Rosen & Katz client memorandum prepared by Edward D. Herlihy, Richard K. Kim, Lawrence S. Makow, Nicholas G. Demmo and Matthew M. Guest.)

The FDIC issued yesterday its final policy statement on private equity investments in failed banks. In early July, the FDIC issued a proposed policy statement containing stringent restrictions on these types of transactions. While the final policy statement relaxes some of these limitations, it continues to impose significantly higher requirements for private equity investors seeking to acquire failed banks than for strategic acquirors.

• Scope. Although the FDIC’s policy is generally viewed as focused on private equity investments, the policy is worded more broadly and applies to “private investors” – a term which is not defined in the policy. The earlier proposal applied to “private capital investors” and contained language, which has since been omitted, that made it clearer that the focus was private equity investors. In contrast, the policy statement does not apply to, and in fact encourages investment structures where private equity investors acquire a failed bank in conjunction with a bank or thrift holding company with a successful track record where the bank/thrift holding company has a strong majority interest in the resulting bank or thrift.

• Capital Support. Investors will be required to commit that an acquired depository institution be capitalized at a minimum 10% Tier 1 common equity ratio for at least three years following acquisition. The FDIC had previously proposed a minimum 15% Tier 1 leverage ratio – a higher number but a different measurement. The Tier 1 common equity ratio was a key measurement for the recent stress tests conducted by the Federal Reserve on the largest U.S. banks, but before then was not typically used as an explicit measure of regulatory capital. (In order to pass the stress test, banks were required to have sufficient common equity to achieve a Tier 1 common equity ratio of at least 4% at year-end 2010 under a hypothetical economic scenario.) Under the FDIC’s final rules, failure to meet the 10% Tier 1 common equity ratio would result in the institution being treated as “undercapitalized” for purposes of Prompt Corrective Action. This designation triggers strong regulatory measures, such as a requirement that the institution file a capital plan, restrict the payment of dividends and restrict asset growth.

• Source of Strength. Previously, the FDIC had proposed that investment vehicles would be expected to serve as a source of strength for their subsidiary depository institutions and would be expected to sell equity or engage in capital qualifying borrowings as necessary. The final policy does not contain this requirement.

• Cross Support of Affiliated Institutions. Investors and investor groups whose investments constitute 80% or more of the investments in more than one depository institution must pledge to the FDIC their proportionate interests in each such institution to pay for any losses to the Deposit Insurance Fund resulting from the failure of, or FDIC assistance provided to, the other affiliated institutions.

• Minimum Holding Period. Investors are prohibited from selling or otherwise transferring securities of the investors’ holding company or depository institution for a three-year period following the acquisition, unless the FDIC has approved the sale or transfer.

• Bar on Affiliate Transactions. All extensions of credit to investors, their investment funds, and any of their affiliates, by a depository institution acquired from receivership are prohibited.

• Bank Secrecy Law Jurisdictions. Investment structures involving entities domiciled in bank secrecy jurisdictions would not generally be eligible to own an interest in a depository institution acquired from receivership, unless they are subsidiaries of companies located in countries that exercise comprehensive consolidated supervision as recognized by the Federal Reserve and commit to provide extensive information to the FDIC.

• Ability of Existing Investors to Bid on a Failed Depository Institution. Investors that hold 10% or more of the equity of a depository institution that fails would not be eligible to bid on the institution once it is in receivership.

• Extensive Disclosure. Investors would be expected to submit to the FDIC detailed information about themselves, all entities in the proposed ownership chain, the size of the capital fund or funds, their diversification, the return profile, the marketing documents, the management team and the business model.

Private equity investors already face significant regulatory obstacles in bidding on failed banks. Since becoming a bank or thrift holding company and submitting to consolidated regulatory supervision is not practical for most private equity investors, investors need to satisfy the Federal Reserve (in the case of bank acquisitions) and the Office of Thrift Supervision (in the case of thrift acquisitions) that they will restrict themselves to largely passive roles. At the same time, they strive to ensure the placement and maintenance of competent management with the wherewithal to engineer a turnaround. There remain powerful arguments for the banking system to tap the investment resources available to private equity. Whether the FDIC’s final policy has changed enough to permit private equity to participate in acquiring failed banks remains to be seen.

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

Financial firms seeking to attract and retain talent are reported to be making a substantial use of guaranteed bonuses, and the French Economy Minister recently called for limits on guaranteed bonuses. While many now focus on how using guaranteed bonuses affects the level of pay, it is important to recognize their effect on incentives. Guaranteed bonuses create perverse incentives to take excessive risks, and they consequently could well be worse for incentives than straight salary.

Introducing a guarantee into a bonus plan eliminates some downside risk but leaves the bonus compensation sensitive to performance on the upside. At first glance, a bonus plan with such a guarantee seems superior in terms of incentives to a fixed payment that isn’t sensitive to performance on either the upside or the downside. A closer inspection, however, reveals that the incentives produced by such a plan could well be counter-productive.

Consider a bank that sets annual compensation for an executive running a trading unit that is expected to generate between zero and $100 million in profit at the end of the year. Suppose that the bank was initially considering a fixed salary of $1 million and a bonus plan rewarding the executive with $1 million for each $10 million of profit – a plan that, depending on the unit’s performance, would provide the executive with an amount between $0 and $10 million. And assume also that, concerned about losing the executive to competitors, the bank decides to guarantee the executive’s getting a bonus of at least $5 million and thus a total compensation of at least $6 million.

The introduction of a $5 million floor for the bonus would insulate the trader from the downside risk of low profit levels: the trader would get the same bonus amount of $5 million whether the unit’s profits are zero or $50 million. But the bonus plan would still give the trader an incentive to seek a high profit level: the trader’s bonus would increase by $5 million if the profit is $100 million rather than $50 million.

Thus, compared with an average performance of $50 million in profits, the compensation structure under consideration would produce an extra $5 million in the event of stellar performance but not reduce compensation in the event of poor performance. As a result, the executive’s interest will be served by taking a bet that would increase the odds of a $100 million profit even if the bet would produce an even higher increase in the odds of no profit.

Indeed, taking as given that it’s necessary to provide the executive with a $6 million floor on compensation, a $1 million salary together with a guaranteed $5 million bonus would produce worse risk-taking incentives than a salary of $6 million coupled with a bonus plan that would reward the executive with $500,000 for each $10 million of the unit’s profits. Although this bonus plan would also reward the executive with an extra $5 million in the event profits reach $100 million , it would make the bonus compensation sensitive both on the upside and the downside. As a result, this bonus plan won’t distort risk-taking choices: the executive would take a risk only if doing so would increase the odds of a good outcome by more than it would raise the odds of a bad outcome.

The above discussion has implications that go beyond the question of guaranteed bonuses. It’s now well recognized that bonus plans based on short-term results which may turn out to be illusory can produce excessive risk-taking, and that plans should therefore be structured to account for the time horizon of risks. But even though tying bonus plans to long-term results is desirable, it isn’t sufficient to avoid excessive incentives to take risks. Bonus plans tied to long-term results can still produce such incentives if they reward executives for the upside produced by their choices but insulate them from a significant part of the downside.

Bonus plans that provide executives with such insulation from downsides – either by establishing a guaranteed floor or otherwise – can seriously backfire. Firms setting bonus plans, and regulators monitoring compensation structures, would do well to recognize and pay close attention to this problem.

(Editor’s Note: This post is the second part of a two-part series, and is based on a recent article in Lombard Street; the first part was posted on the Forum here.)

If the proposals in the Obama Administration’s report on financial regulatory reform are adopted, the restriction on the size or form of executive compensation on Tier 1 Financial Holding Companies (FHCs) may be the one that most alarms financial enterprises. Let me turn to that issue.

We should separate issues of compensation of CEOs and other top management from issues concerning the compensation of traders, loan officers, and other financial executives at the operating rather than the management level. The Federal Reserve would be authorized to regulate compensation at both levels, but at the top level the aim would be to make management a more faithful agent of the shareholders, while at the operating level it would be to curb the risk‐taking incentives of financial executives by requiring that much of their compensation be deferred. The deferred component might consist of restricted stock that could not be sold for a period of years. Or the deferred component might consist of cash bonuses that could be recovered by the company if the deals for which the bonuses were a reward later soured.

The two aims—better aligning executives’ incentives with those of the shareholders, and reducing the riskiness of executives’ compensation—are inconsistent. Shareholders are generally less risk averse than executives because they have less stake in the enterprise, as they can diversify away any risk that is peculiar to the enterprise by holding a diversified portfolio of securities. Top executives have much more to lose, in reputation and future earnings prospects, from the collapse of their company.

That means that top executives, provided that they are allowed by the Federal Reserve to remain imperfect agents of the shareholders, have strong incentives to establish procedures that will prevent traders, loan officers, and other subordinate executives from taking excessive risks. But “excessive” from the standpoint of private businessmen means something crucially different from “excessive” as perceived by the Federal Reserve. Risks, including the risk of bankruptcy, that are cost‐justified from a corporation’s standpoint may be unacceptable from a broader social standpoint because of their potential for bringing down the entire financial system, and in its wake the nonfinancial economy as well. But the measures that have been suggested for reducing risk‐taking by traders and other financial executives have their own problems. Many things can affect a stock’s price besides a trader’s deals, as critics of stock options as devices for compensating top executives point out, and retractable cash bonuses (would they have to be placed in escrow?) make it difficult for recipients to manage their finances.

…continue reading: A Critique of the President’s Financial Regulation Reforms

(Editor’s Note: This post comes to us from Joseph F. Brazel of North Carolina State University, Keith L. Jones of George Mason University, and Mark F. Zimbelman of Brigham Young University.)

In our paper, Using Nonfinancial Measures to Assess Fraud Risk, which is forthcoming in the Journal of Accounting Research, we investigate whether publicly available nonfinancial measures (NFMs), such as the number of retail outlets, warehouse space, or employee headcounts, can be used to assess the likelihood of fraud.

More specifically, we test whether inconsistencies between financial and NFM data can be used to detect fraud. By doing so, we also implicitly provide evidence on whether systematic NFM manipulation is occurring at fraud firms. We also test whether NFMs can be used to detect when a firm’s reported financial performance does not accurately portray its economic performance. This study also expands the NFM literature by providing an empirical test of their potential to verify current financial results, as the extant NFM research looks at the ability of NFMs to predict future firm performance. We believe both roles of NFMs are valuable—one to validate and the other to forecast. We find that the relation between reported financial performance and NFMs can distinguish fraud from non-fraud firms.

Our fraud sample includes firms charged by the SEC with having fraudulently reported revenue in at least one 10-K filing. We do not include frauds that involve quarterly data and we also limit our sample to firms for which we were able to access the original 10-K filing and subsequent filings of restated data. Students enrolled in undergraduate and graduate auditing courses at three universities selected the non-fraud competitors and collected NFM data for our sample of fraud firms. Our sample includes NFMs that are quantitative, non-financial, non-employee related, and relate to firm capacity. Using this matched-pair sample, we document that fraud firms are more likely than non-fraud firms to report inconsistent revenue growth relative to their growth in NFMs. We analyze the growth from the year prior to the fraud to the first year of the fraud for each matched-pair. When we include a variable that measures the difference between a firm’s financial performance and its NFM performance in a model that includes other factors that have been found to be indicative of fraud, we find the difference is a significant discriminator between fraud and non-fraud firms. Thus, we provide evidence showing that comparisons between financial measures and NFMs can be effectively used to assess fraud risk.

Overall, our results provide empirical evidence suggesting that nonfinancial measures can be effectively used to assess the likelihood of fraud.

The full paper is available for download here.

(Editor’s Note: This essay was written by Robert Monks and Harvard Law School Visiting Professor Peter Murray.)

One of the phrases bandied about during the confirmation hearings for Judge Sonia Sotomayor’s nomination to the United States Supreme Court is “judicial activism” – a tendency of judges to use the cases they decide to implement their own notions of public policy. Of course, all recent Supreme Court nominees have steadfastly denied any shred of judicial activism and have uniformly maintained that the proper role of a judge, even a Supreme Court Justice, is to apply existing law, whether Constitutional, statutory or precedent, to the facts of the case before him or her. No one has been more outspoken against the evils of judicial activism than Chief Justice Roberts.

Now it appears that the Chief may be undertaking a bit of judicial activism of his own. The case is Citizens United v. FEC. The conservative group that sponsored Hillary: The Movie just before the Democratic primary is seeking to avoid or roll back the 2002 McCain-Feingold campaign finance law that prohibits the use of corporate funds to influence elections. Chief Justice Roberts and his conservative Supreme Court majority are getting ready to use Citizens United as the vehicle to overrule established precedent (and overturn carefully drafted legislation) and grant business corporations a constitutional right to use their funds to participate in political debate, not only on public issues, but even in the election of candidates to office. Such a move would be judicial activism on a grand scale!

1. Freedom of Speech for Corporations

Business corporations and their owners have participated in political life in many ways for many years. Corporate lobbying, campaign contributions by business leaders, “soft money campaign support” by businesses, the “revolving door” of businessmen and public servants: these are only a few of the many ways that corporations interact with politicians and political institutions in an effort to influence public action to their advantage. The American public has learned to live with a strong connection between business and politics.

…continue reading: Is the Supreme Court Determined to Expand Corporate Power?

(Editor’s Note: This post comes to us from Andres Almazan of the University of Texas, Adolfo de Motta of McGill University, Sheridan Titman of the University of Texas, and Vahap Uysal of the University of Oklahoma.)

In our paper Financial Structure, Acquisition Opportunities, and Firm Locations, which was recently accepted for publication in the Journal of Finance, we investigate the relation between firms’ locations and their corporate finance decisions. More specifically, we examine whether these choices are related to whether or not the firm is located within an industry cluster, that is, close to many of its industry peers.

We start by developing a simple model that describes the relation between a firm’s location, financial structure and acquisition activities. Our model assumes that firms located in industry clusters have more acquisition opportunities but also face greater competition from other potential acquirers. To take advantage of these opportunities, the firms in clusters maintain more financial slack, because by doing so they can bid more aggressively for acquisitions.

To test this model we examine the extent to which firms located in industry clusters are more acquisitive, the interaction between financial structure, location and acquisition activity, and finally, the extent to which firms in clusters maintain more financial slack. We find that after controlling for industry affiliation, firms located in clusters make more acquisitions, which is consistent with the idea that firms in clusters have more opportunities. In addition, we find that firms with more financial slack tend to make more acquisitions, which is consistent with firms maintaining more slack when opportunities are greater. More importantly, we show that the positive relation between acquisition activity and financial slack is stronger in clusters. If we assume that competition for targets is more intense in clusters then this finding is consistent with our model’s implication that debt plays a more important role when there is competition. Moreover, the fact that this relation is stronger for acquisitions of public targets and within industry targets, which are likely to attract more competition, provides further support for this implication of the model. Our results indicate that firms in clusters have less debt and hold more cash, and these relations continue to hold after controlling for the empirical determinants of capital structure. The relation between financial slack and location is particularly robust and economically significant. After controlling for other determinants of capital structure and cash holdings, firms located in clusters decrease their net market leverage by 19% and increase their cash holdings by 43% with respect to the sample averages.

Since an industry cluster is somewhat of a nebulous concept our empirical tests examine the robustness of our results with respect to a number of cluster definitions. One set of definitions uses the absolute number of firms within an industry in a metropolitan area. A second set defines clusters as the proportion of firms in an industry located in the metropolitan area. Finally, we do an in-depth analysis of the software industry (SIC code 737) since this is an industry with a large number of firms and a very well defined industry cluster in Silicon Valley. We document that firms in high tech cities and growing cities also maintain more financial slack.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Daniel J. Hurson of the Hurson Law Firm LLP, and relates to a recent client memorandum by Mr. Hurson, which can be found here.)

In a recent forum post, John F. Savarese and Wayne M. Carlin of Wachtell Lipton are critical of the SEC’s recent filing of a case against former CEO Maynard Jenkins of CSK Auto Corp., seeking payback of over $4 million in bonuses and stock sale proceeds. The SEC alleges that his company engaged in a massive accounting fraud, requiring a restatement, and thus Jenkins must payback these funds under Section 304 of SOX, the so-called “claw back” provision. Section 304, rarely used in the past by the SEC and never before against a CEO who was not personally accused of fraud, requires repayment to his company of certain bonuses and stock sale profits from a CEO or CFO whose company must make a restatement based on “misconduct.” The SEC pointedly did not accuse Mr. Jenkins of personal participation or knowledge of the fraud.

The Wachtell authors question the SEC’s taking action under Sec. 304 against a CFO not personally accused of fraud, calling it a “regrettable policy choice” and an “unfortunate contribution to the overheated atmosphere surrounding executive compensation.” Other commentators have also questioned the lawsuit, suggesting that it will have unfortunate consequences if successful. They too feel the statute is too ambiguous regarding whose “misconduct” is required to hit the CEO or CFO with claw back actions. The SEC, however, appears very much committed to the case and eager to test its new enforcement agressivness in an area with considerable potential deterrent impact.

In my recent client advisory, published thru the Mondaq news service, I argue the contrary. I believe there should be strict and aggressive enforcement by the SEC under the clear language of Sec. 304 to seek claw back from CEO’s and CFO’s who certify financial statements which ultimately have to be restated. There should be consequences to top managers who give these sweeping certifications to investors only later to have to issue restatements, often disclosing material weaknesses in internal controls or worse, which have the effect of making the certifications worthless. Since several courts have held there is no private remedy under Section 304, the SEC alone bears the responsibility to enforce this provision of SOX and give teeth to the certification requirements.

As I point out in the article, the legislative history, while sparse, supports a broad interpretation of Section 304 in which personal misconduct by the CEO or CFO, as opposed to management in general, is not required. Neither the Bush administration nor either branch of Congress, I submit, intended the statute to require proof that the individual managers from whom claw back is sought have to be proven guilty of personal misconduct. Rather, the fact that they preside over the filing of, and personally certify, financial statements which subsequently have to be restated, often leading to market value declines and substantial costs to the company, is enough to hold them responsible under Section 304 to repay compensation and profits which might not have been awarded or obtained had the truth come out or the weaknesses been corrected.

I further argue that going forward, the SEC should establish clear criteria for future cases, including a better definition of what kind of “misconduct” and materiality meets the threshold for claw back actions. The SEC should also, if it succeeds in the Jenkins suit, seriously consider revisiting the many restatements filed over the past several years, particularly among companies caught up in the present financial crisis, to see if other CEO’s and CFO’s have unduly profited from misstated financials, and initiate similar Section 304 claw back actions against them. In my view, shareholders who relied on the rosy certifications deserve no less.

(Editor’s Note: This post first appeared in BNA’s Corporate Accountability Report.)

This post was written together with Mark A. Borges, Charles M. Elson,
Ann Habernigg, Michael J. Halloran and Carol Hansell.

The global economic crisis has aggravated existing concerns about executive compensation practices. Executive and key employee pay practices among large financial sector companies in particular have drawn public scrutiny and condemnation. Lost jobs and lost savings, as well as extensive government support for the financial sector and the automobile industry, means that executive compensation is a concern not just to shareholders, but for everyone affected by the faltering economy. The issues are now seen as so significant and systemic that our elected representatives are taking the matter out of the hands of the private sector. Congressional proposals for sweeping corporate governance and executive compensation reforms and the new Administration’s interest in tackling this subject means that there is a very real prospect for significant changes to executive compensation regulation later this year.

We do not advocate a political solution to executive compensation issues, but if a legislative response is inevitable, it is imperative that it take the right form. As we have seen in the past, a piecemeal response to an assortment of perceived, and often isolated, executive compensation abuses will create as many problems as it solves—and is unlikely to take account of the systemic issues that must be addressed. After all, the intricacies of determining the ‘‘right’’ executive compensation across the diverse range of businesses and industries comprising corporate America defy a single solution, no matter how well intended and thoughtfully crafted.

Any government regulation of executive compensation should encourage compensation practices that will contribute to the sustainable long-term value of America’s business as we emerge from this crisis, rather than simply ‘‘fixing’’ specific compensation practices which are seen as having contributed to the crisis. What is needed is a set of principles to guide the design and operation of any responsible executive compensation program. The guidelines announced by the Obama Administration recently do this, focusing in part on pay for performance and, in particular, long-term performance. However, for guidelines of this nature to have real practical application, they must provide guidance to—and reinforce accountability by—the body that makes the decisions about executive compensation—the board of directors. A measured and principled approach overseen by corporate boards is the only way to ensure that the eroding trust between companies and their shareholders is restored, based on a shared commitment to the sustainable long-term value of the enterprise. Under the Administration’s plan, responsibility for crafting this approach will fall largely to the Securities and Exchange Commission.

Fortunately, there is no need to create a new set of governing principles out of whole cloth. Legislators should look closely at the work that has already been done in this area. A useful example is the guidance developed by the Aspen Institute’s Corporate Values Strategy Group. The thinking of this group was motivated by a concern with excessive short-term pressures in the capital markets that result from intense focus on quarterly earnings and incentive structures that encourage companies and investors to pursue short-term gain with inadequate regard to long-term effects. The Aspen group recommends that companies and investors do three things to promote sustainable long-term value creation. First, define the metrics of long-term value creation. Second, focus corporate-investor communication around long-term metrics. Third, align compensation policies with those long-term metrics. While the group’s guidance describes several features of a compensation structure that supports long-term value creation, it does not purport to prescribe any particular framework.

…continue reading: The Need for a Principled Approach to Compensation Reform

(Editor’s Note: This post comes to us from Hung-Chia Hsu of the University of Wisconsin Milwaukee, Adam V. Reed of the University of North Carolina at Chapel Hill, and Jörg Rocholl of the ESMT European School of Management and Technology.)

In our paper The New Game in Town: Competitive Effects of IPOs, which was recently accepted for publication in the Journal of Finance, we investigate the returns and operating performance of publicly traded firms around the time of large IPOs in their industry with two goals in mind.

First, we seek to measure the performance of publicly traded firms around IPOs in their industries. If IPO firms can successfully compete against publicly traded firms, then we would expect these competitors to perform worse after the IPO. We indeed show that industry competitors experience negative stock price reactions around IPOs and a significant deterioration in their operating performance after these IPOs. As further evidence that IPOs are responsible for this underperformance, we show that withdrawn IPOs have the opposite effect: publicly traded firms respond positively to the withdrawal of an IPO in their industry.

Second, we seek to explain the underperformance of publicly traded firms by examining the relation of cross sectional differences in performance and survival to firm competitiveness. We identify three determinants of the competitive advantage of IPOs over industry peers. First, as a direct consequence of the IPO, the offering recapitalizes the issuing firm in a way that generally results in a low debt-to-equity ratio. Low leverage may give issuing firms an advantage over their more highly leveraged competitors by allowing them more flexibility in their investments. This effect has been documented empirically in papers outside the IPO literature. Second, issuing firms have the advantage of being recently certified by investment banks. To the extent that the certification effect is stronger for new issues, the certification role of investment banks affects investors’ willingness to purchase new issues as opposed to shares of other firms in the same industry. Third, new entrants may have some nonfinancial advantage over their industry competitors; a non-financial advantage may make issuing firms more attractive to investors.

We find that performance and survival of publicly traded competitors are each related to all three of these determinants. Controlling for a number of factors such as market timing and the hotness of the IPO environment, we document that competing companies show relatively better operating performance after large IPOs in their industry if they have less leverage, if their IPO has been underwritten by a highly ranked investment bank, and if they spend more on research and development. In addition, we find empirical evidence that these factors also affect a competitor’s probability of survival for the three year period after the IPO.

The full paper is available for download here.

(Editor’s Note: An earlier post regarding a comment letter by seven major corporate law firms in opposition to the SEC’s proposed proxy access reform is available on the Forum here.  An earlier post regarding a comment letter by 80 professors of law, business, economics, or finance in support of the proposed proxy access reform is available here.)

Several contributors to the Harvard Law School Forum on Corporate Governance and Financial Regulation — including four HLS professors, five HBS professors, and one HLS/HBS professor — submitted to the SEC last week a comment letter generally supporting the SEC in proposing proxy access for large shareholders, but recommending several modifications to the proposed rule that would reduce the odds that the rule, as adopted, would have unexpected disruptive effects on firms or markets, or force on shareholders a governance system that a majority would oppose at any given firm. A copy of the comment letter filed with the SEC is available here.

(Editor’s Note: This post comes to us from David Cicero of the University of Delaware.)

In my forthcoming Journal of Finance paper The Manipulation of Executive Stock Option Exercise Strategies: Information Timing and Backdating, I identify three common option exercise strategies, and analyze executives’ incentives for manipulating the exercise of options to maximize their payoffs under each strategy.

In the first strategy, executives exercise options and immediately sell the shares to a third party (the “Stock Sale Subsample”). This strategy encompasses about two-thirds of executives’ option exercises. As executives clearly reduce their exposure to their company through these transactions, the incentive is to exercise when future returns are expected to be poor. Consistent with this hypothesis, I find that exercises in the Stock Sale Subsample are followed by abnormal returns of approximately -2% over a 120-day trading period.

The second strategy involves exercising options with cash and holding the acquired shares (the “No Disposition Subsample”). Executives engage in this exercise-and-hold strategy about one-fifth of the time. This strategy is thought to be employed for tax reasons. When executives exercise options, they pay ordinary income taxes on the spread between the exercise price and the stock price, but they pay capital gains taxes on any subsequent appreciation when they eventually dispose of the shares. Given these tax rules, if an executive expects his stock to perform well in the future, he has an incentive to exercise the options and hold the shares instead of holding the unexercised options: in doing so, the executive can minimize the amount that is taxed as income at the time of exercise, and cause the subsequent appreciation to be taxed as capital gains when he sells the shares. Consistent with executives manipulating option exercises to maximize their returns under this strategy, I find that exercises in the No Disposition Subsample are preceded by negative abnormal returns over the 20-day trading period prior to exercise of approximately -1.5%, and are followed by positive abnormal returns over the 20-day trading period after exercise of approximately 3%, which continue to increase to approximately 5% over a 120-day trading window.

The third strategy involves either delivering previously held stock to the company or having some shares withheld to cover the exercise costs (the Company Disposition Subsample). These “stock swap” transactions constitute about one-tenth of executive option exercises. I show that executives benefit from executing stock swap exercises when the stock price is high, but, given that they continue to hold many of the shares, they also benefit from higher future stock prices. The return patterns are consistent with executives manipulating these exercises to maximize their returns. Abnormal returns are approximately -0.5% over the two months following exercise, and turn insignificant but positive thereafter.

My three samples generate much stronger evidence of option exercise manipulation than has been previously discovered. In particular, I find strong evidence that executives timed option exercises relative to private information to enhance the returns from each of the three exercise strategies in both the pre- and post-Sarbanes-Oxley (SOX) periods. In additional tests, I also find considerable evidence that before SOX executives sometimes backdated exercises to correspond with more favorable exercise prices when employing the two exercise strategies where the only counterparty is the executive’s own company (the No Disposition and Company Disposition Subsamples). Finally, I find that companies where executives likely backdated option exercises were also more likely to subsequently report weaknesses in internal controls over financial reporting.

The full paper is available for download here.

(Editor’s Note: This post by Ben Heineman recently appeared in The Atlantic.)

In early August, The New York Times ran a front page story that statisticians–rather than “dronish number nerds”–are increasingly in demand, “even cool.” With reams of data generated in the computer age and new realms to explore for purposes as broad as protecting national security or creating financial products, statisticians, says the Times , are only a small part of an army of “data sleuths…from backgrounds like economics, computer science and mathematics.”

An important question raised by the story–and, of course, the broader, deeper trend of using mathematics and systems analysis to “understand” complex human behavior–is whether, before they have deleterious effects, emerging theories and products and ideas can be advanced with a strong measure of humility and put in the context of complex human society, where some key factors exist that cannot be quantified. Will the already potent but ever-emerging “numbers” class have the broad education and training to understand the “benefits” but also the “limits” of all this numbers crunching?

I raise this question of the potential effects of rigid application of mathematical and systems techniques because two of the most serious problems to beset this country–the Vietnam War and the financial meltdown–stemmed, in important ways, from overconfidence, indeed even cult-like behavior. These two problems are at the front of my mind due to two books that received attention in June and July that dealt with how the false idolatry of numbers and systems can lead people, institutions and nations far astray–with catastrophic results.

The first is former Defense Secretary Robert S. McNamara’s, In Retrospect: The Tragedy and Lessons of Vietnam. It was published in 1995, nearly 30 years after he left the Defense Department in 1968, but received much attention when McNamara died, at 93, in early July. As is well known, McNamara was a part of a World War II “systems analysis” team at Defense, led by Tex Thornton, a “whiz kid” who rose to the top of Ford Motor and a civilian technocrat who brought a powerful systems orientation to the Pentagon in the early 60s. While this approach certainly had relevant application to an attempt to rationalize the Pentagon’s corpulent competition between the Army, Navy and Air Force, it became famous in the Vietnam War when numbers like body counts, targets hit, enemy forces captured, weapons seized, tons of bombs dropped, and hamlets protected were used to argue that the war was being prosecuted successfully. The origins of the war were not in systems theories (rather, to take one strand, a belief that monolithic Russian-Chinese Communism would overrun Southeast Asia). But those theories played an important part in convincing McNamara and President Johnson that the war could be won and, therefore, in deepening our involvement, resulting in tragedy both for the U.S. and for Vietnam.

…continue reading: Beware the Idolatry of Numbers

On July 21, 2009, the Securities and Exchange Commission (“SEC”) announced a settlement agreement with Perry Corp. (“Perry”) stemming from the hedge fund’s alleged failure to disclose its accumulation of nearly 10% of an issuer’s voting shares with the intent of influencing a merger vote. Those shares were also hedged through swap transactions in order to eliminate Perry’s economic exposure if the share price declined. The SEC argued that Perry should have promptly disclosed its 10% position on a Schedule 13D, which must be filed within ten days after initially obtaining 5% ownership, rather than on a Schedule 13G, which may be filed 45 days after the end of the calendar year. The SEC’s order is available here.

The Perry settlement arose from the failed attempt by Mylan Laboratories, Inc. to acquire King Pharmaceuticals, Inc. in 2004. Perry had a significant ownership stake in King and stood to benefit from the merger, which offered King stockholders a 61% premium. Once the merger was announced, Perry also shorted Mylan shares, betting that Mylan’s stock price would decline as the merger became more likely.

The King-Mylan merger was conditioned on Mylan’s stockholders’ approval. When Carl Icahn emerged as a large Mylan stockholder vocally opposed to the merger, Perry began accumulating up to 10% of Mylan’s outstanding voting stock with the intent to vote it in favor of the merger. The purchases were done after US markets closed in a manner that avoided public volume-reporting. Perry then entered into swap transactions that hedged risk from any potential drop in Mylan’s share price. As a result, Perry could vote the Mylan shares without any potential economic downside facing other Mylan stockholders in order to realize value from the merger as a King stockholder.

While the King-Mylan merger was never consummated, the SEC brought an enforcement action alleging that Perry should have disclosed its ownership on a Schedule 13D once it acquired 5% of Mylan’s stock. Perry argued that the purchases were made in the “ordinary course of business” and therefore could be disclosed after the end of the calendar year on a Schedule 13G. The SEC took the position that:

When institutional investors, such as Perry, acquire ownership of securities for the purpose of influencing … the outcome of a transaction—such as acquiring shares for the primary purpose of voting those shares in a contemplated merger—the acquisition is not made… in the “ordinary course” of business….

Pursuant to the settlement, Perry paid a $150,000 fine without admitting any wrongdoing.

…continue reading: SEC Resolves Empty Voting Action Involving King-Mylan Merger

I submitted to the SEC yesterday a comment letter on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance in favor of facilitating shareholder director nominations. The submitting professors are affiliated with forty-seven universities around the United States, and they differ in their view on many corporate governance matters. However, they all support the SEC’s “proxy access” proposals to remove impediments to shareholders’ ability to nominate directors and to place proposals regarding nomination and election procedures on the corporate ballot. The submitting professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors.

A copy of the comment letter filed with the SEC is available here. Below is the text of the main part of the comment letter followed by the list of the eighty professors.

TEXT OF MAIN PART OF COMMENT LETTER:

This comment letter is submitted on behalf of a bi-partisan group of eighty professors of law, business, economics, or finance whose names appear below (the “Submitting Professors”). The Submitting Professors are affiliated with forty-seven universities around the United States. All of the Submitting Professors have research or professional interests relating to how publicly traded firms are run and how their affairs are governed by corporate and securities laws. The Submitting Professors welcome the opportunity to provide comments to the Securities and Exchange Commission (the “SEC”) on its proposed rule Facilitating Shareholder Director Nominations (the “Proposed Rule”).

There is substantial variance among the views of the Submitting Professors on many corporate governance matters. However, all of the Submitting Professors support the SEC’s proposals to remove impediments to the exercise of shareholders’ rights to nominate and elect directors and to enable shareholders to place proposals regarding nomination and election procedures on the corporate ballot. All of the Submitting Professors urge the SEC to adopt a final rule based on the SEC’s current proposals, and to do so without adopting modifications that could dilute the value of the rule to public investors. While all of the Submitting Professors share the views expressed in this paragraph, each individual professor may not endorse each and every statement below.

The ability of shareholders to replace directors is supposed to play a key role in the governance structure of public companies. However, shareholders seeking to replace directors face considerable impediments. One significant impediment to replacing directors is incumbents’ control of the company’s proxy card – the corporate ballot sent by the company at its expense to all shareholders. We believe that providing shareholders with rights to place director candidates on the company’s proxy card, as the SEC proposes doing, would improve director accountability.

…continue reading: Comment Letter of Eighty Professors of Law, Business, Economics, or Finance in Favor of Facilitating Shareholder Director Nominations

(Editor’s Note:  In addition to participating in the comment letter discussed in this post, Wachtell, Lipton, Rosen & Katz also filed its own comment letter, which is available here.)

Seven major law firms — Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP, Latham & Watkins, LLP, Simpson Thacher & Bartlett LLP, Skadden, Arps, Slate, Meagher & Flom LLP, Sullivan & Cromwell LLP and Wachtell, Lipton, Rosen & Katz — collaborated on a 40-page comment letter that was submitted to the SEC today on its proposed proxy access rules. The joint 7 Firm letter recommends:

• The SEC should amend Rule 14a-8(i)(8) to permit stockholders to utilize Rule 14a-8 for proxy access proposals.
• The SEC should not adopt Rule 14a-11 until there has been sufficient experience with private ordering of proxy access under amended Rule 14a-8 to permit the SEC to make a more informed decision as to whether a prescriptive rule governing proxy access is necessary and desirable.
• If the SEC disagrees with the firms’ view, the SEC should not adopt a prescriptive proxy access rule any earlier than the 2011 proxy season.
• Finally, any prescriptive proxy access regime should permit private ordering under state law so as to permit stockholders to modify the SEC’s proxy access regime as they see fit, including by opting out entirely.

The letter includes detailed discussion and recommendations regarding the workability issues raised by the SEC’s proposed proxy access rules.

The complete comment letter can be downloaded here.

(Editor’s Note: This post comes to us from Michael J. Cooper of The University of Utah, Huseyin Gulen of Purdue University, and Alexei V. Ovtchinnikov of Vanderbilt University.)

In our paper Corporate Political Contributions and Stock Returns, which was recently accepted for publication in the Journal of Finance, we study whether there is a robust relation between firm contributions and contributing firm returns. Using data from the U.S. Federal Election Commission (FEC), we create a new and comprehensive database of publicly traded firms’ political action committee (PAC) contributions to political campaigns in the U.S. from 1979 to 2004. After merging the FEC contributions data with CRSP/Compustat data, we have approximately 819,000 contributions made by 1,930 firms over the past twenty five years or so – thus, we have a remarkably rich dataset to test for systematic contribution/return effects arising from publicly traded firms’ involvement in the U.S. political process. Our sample captures over 70% of the total dollar volume of all hard-money corporate contributions and represents on average 60% of the market value-weighted capitalization of all publicly traded firms in the U.S.

We develop a simple measure to describe firms’ political contribution practices that takes advantage of the comprehensive nature of the FEC data. We view each firm as supporting a portfolio of candidates and simply sum up, over a rolling multiyear window, the number of candidates that each firm supports. We find that the average firm participating in the political donation process contributes to 73 candidates over any five-year period, 53 of whom go on to win their elections. There is substantial variability across firms in the number of supported candidates, with a standard deviation of approximately 96 candidates.

We perform panel regressions of annual abnormal returns on the lagged number of supported candidates and other control variables. We find that the number of supported candidates has a statistically significant positive relation with future abnormal returns for firms which contribute to political candidates. The relation is evident in univariate regressions of abnormal returns on the number of supported candidates as well as in multivariate regressions after controlling for other established predictors of returns such as book-to-market, firm capitalization, and momentum, measured by lagged 12-month buy-and-hold returns. We find that our results are robust to three alternative contribution definitions: the total strength of the relationships between candidates and the contributing firm (as measured by the length of the firm-candidate relationship), the ability of the candidates to help the firm (as measured by the home state of the firm and the candidate), and the power of the candidates (as measured by a candidate’s committee ranking). We document especially strong effects for a measure related to the ability of the candidate to help the donating firm. Thus, the contribution effect appears to increase for firms that have longer relationships with candidates, support more home candidates, and support more powerful candidates.

We further break the contributions data up into House and Senate categories. We find that there is an incremental House effect after controlling for the Senate effect, although contributions to both branches of government result in positive economic effects for the contributing firms. Our finding of an incremental effect for firms supporting House candidates may be related to the constitutional provision that revenue and appropriations bills must originate in the House. Thus, firms may find that it is more expedient to support House members, where potential firm value increasing actions may be more suitably created. We also split our sample along political party lines. The FEC data show that Republican candidates typically receive higher total dollar contributions than do Democrats and that Republican candidates’ contributions come from a larger number of supporting firms than do Democrat candidates’ contributions. However, despite the fact that Republicans receive more contributions than Democrats, we find an incremental contribution effect for Democrats after controlling for Republican effect, but do not find an incremental Republican effect after controlling for the Democrat effect.

The full paper is available for download here.

(Editor’s Note: This post is based on a Simpson Thacher & Bartlett memorandum, which first appeared as an article in the New York Law Journal.)

This post was written together with Simpson Thacher & Bartlett associate Salvatore Gagliardi.

While the pace of M&A activity has been subdued, the significance of contractual developments in dealmaking has been pronounced. Over the past year, the difficulty of the credit markets has resulted in significant developments in how practitioners draft cash acquisition agreements for strategic buyers (e.g., corporate buyers seeking to further their strategic objectives). These developments have resulted in such buyers having greater flexibility in deciding not to close, particularly if the reason is financing related. These changes have been especially pronounced in multi-billion dollar transactions where the buyer is dependent on third party financing to effect the proposed transaction. This trend began with strategic buyers utilizing the termination provisions used in private equity deals under which a seller’s only remedy if a buyer were to fail to close were a fixed fee from the buyer (i.e., a reverse break fee). In such cases, this reverse break fee structure was analogized to an option or referred to as providing the buyer with “optionality.” The practice has, however, now developed beyond the use of the reverse break fee model as utilized in private equity deals. Although there are variations in the benefits of these provisions to prospective buyers, a common element is that they mitigate the risk to a buyer from failing to close due to a financing failure.

Private Equity Precedent

The optionality used in recent strategic deals was based on a structure used in private equity deals that developed after 2005. Prior to 2005, private equity transactions were structured with the private equity firm forming a shell company that entered into the acquisition agreement and undertook the obligations contained therein. There was no risk to the private equity firm, as distinguished from the shell company, other than reputational risk and the theoretical possibility of piercing the corporate veil (i.e., disregarding the corporate entity and treating obligations of the shell company as obligations of shareholder/owner). Further, the acquisition agreement was typically conditioned on the availability of financing (although the shell company often agreed to be subject to the remedy of specific performance pursuant to which it could be required to use its reasonable best efforts to obtain financing). Given that the shell company was without resources, sellers were put in the position of relying on the reputational risk to the private equity firm if its wholly owned shell company breached its obligations as well as the possibility of veil piercing. This latter risk was viewed as remote but the consequences were grave if realized.

Beginning in 2005, the private equity structure utilizing financing conditions as described above was superseded by a reverse break fee structure. This structure arose out of a desire by sellers to eliminate the financing condition and reduce the reliance on the reputational risk to the buyer arising from a breach. Under this structure, a break fee of roughly 3 percent was payable by the shell company for a failure to close, which fee was guaranteed by the private equity firm. This created significant optionality for the private equity firm as it guaranteed the payment of a fixed fee, but the firm was no longer subject to the in terrorem risk of veil piercing or any other liability. Moreover, although there were exceptions, the norm that developed was that even the shell company was not subject to specific performance. This meant that there was no risk that the shell company would sue the private equity firm under the equity commitments or lenders under the debt commitments. Some deals sought to increase the cost to the buyer of failing to close by providing that the private equity firm could be subject to, in addition to the reverse break fee, the payment of damages in excess of a break fee for a willful breach. Those deals were, however, a small minority.

…continue reading: Impact of the Credit Crunch on Acquisition Agreements

(Editor’s Note: This post first appeared as a Governance & Proxy Review Update.)

With the introduction of Senator Schumer’s Shareholder Bill of Rights there has been a great deal of discussion surrounding the role of the Non-Executive Chairman (NEC) versus that of the CEO. Discussion of this concept in the media would lead one to believe that the role of the NEC is to serve as a supervisor of the Chief Executive. Nothing could be further from the truth. In fact, it appears that this misconception of the role is the rationale behind Senator Schumer’s bill requiring mandatory NECs for all companies. Companies will lose not only the right to make decisions about their leadership structure but would then be forced to subscribe to a flawed notion of the NEC-CEO relationship that could lead to serious problems for the board and company.

U.S. companies, who have separated the positions of chair and CEO, are usually hoping to achieve three specific and important goals: (1) allow the CEO to focus exclusively on managing the enterprise; (2) create a director leadership position with a focus on board administration and communications between the independent directors; and (3) craft a defined director leadership position, codified within the firm’s governance guidelines, possessing the procedural authority to lead the board during an unexpected or forced CEO transition. Many firms utilizing this structure provide for a recombination of the roles when the board deems it appropriate.

In these instances the NEC is likely to be a director of long tenure with experience and understanding of the company. The NEC would be likely to maintain an office at the company, and spend more time with the CEO than other board members. His/her primary function would be to insure robust communications between and amongst board committee chairs and as needed with individual directors. Under this board leadership model, the CEO is relieved of the tasks of managing the intra-board relationship and can focus more attention on the competitive and regulatory and risk challenges facing the company. Leading the full board meetings, the important executive sessions of independent directors, and involvement in board, committee and director evaluations are key elements of the NEC role.

Mentor to the CEO, not manager of the Chief Executive

A common misconception that I fear is firing the call for change, is the belief that the NEC will or should serve as a supervisor of the CEO. That the NEC, who under this faulty scenario possesses industry knowledge equal to or greater than the CEO, is the Admiral to the Chief Executive’s captain, prepared at any moment to order a change of course or trim of sail. A relationship designed to these parameters would create serious disruptions for the board and confusion in the senior management ranks as to who is in charge.

In actuality, the split roles need to be handled with care. Done right, the NEC serves as a mentor and sounding board for the CEO on issues to be presented to the board, on feedback from the executive sessions of the independent directors, and on issues facing the enterprise. The CEO looks to the NEC for feedback and counsel on the board’s concerns, whether strategic planning or risk mitigation. The relationship is more Mentor to CEO than supervisor to manager – it can’t work any other way. If a company faces an unexpected CEO transition (due to death or resignation), a board with an NEC (or strong, active Lead Director) might be better positioned to act swiftly and deftly.

Given the sensitive nature of the NEC role, the selection, ability and willingness of the director who undertakes the position and the CEO who must work within this leadership structure are all of prime importance–which is why boards need to be free to choose the leadership structu re that works best for them, and not have it mandated by Washington.

(Editor’s Note: This post below is a transcript of remarks by Robert Khuzami, Director of the Division of Enforcement of the Securities and Exchange Commission, to The Association of the Bar of the City of New York last week.)

I. Introduction
Thank you, Pat, for that kind introduction. It’s great to be back in New York. And I am grateful to the New York City Bar for providing me with this opportunity to talk about the Enforcement Division. There is lots to talk about.

As I was thinking about this speech, a colleague mentioned that I had been with the Commission approximately 100 days. Aside from making me wonder why my colleagues are counting, it caused me to pause and reflect – how did my 100-day accomplishments compare with those of others? That often over-weighted yardstick of accomplishment – did I measure up?

Franklin Roosevelt set the bar pretty high. In his first 100 days in office, he reopened failed banks under Treasury supervision; he established the FDIC; and he created extensive farm subsidy and federal jobs programs.

More recently, President Obama has also achieved impressive accomplishments in his first 100 days. First off, President Obama appointed a brilliant, experienced, and transformative leader of the SEC … and I’m not just saying that because Chairman Schapiro might read this speech. After that, President Obama passed the economic stimulus plan, funded stem cell research, took on the health care crisis and crafted a plan to withdraw troops from Iraq.

All that being said, I’m pretty proud of my own 100-day accomplishments. So how have things changed? Before I joined the Division in March, the Dow was struggling around 6500 points. Now the Dow is over 9200. So am I really responsible for a 41% increase in the Dow? I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff. Now, when I ran this speech by my wife, she looked (kind of like some of you out there) a little incredulous. She said, ―you’re not claiming credit for the stock market, are you? While you’re at it, are you also taking credit for the mild hurricane season or the sharp decrease in lethal shark attacks world-wide. Well I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff.

Jokes aside, the Enforcement Division has accomplished much in the 100 days. This reflects a dedicated and talented staff as well as a reinvigoration of our core mission of investor protection. Before I describe some of these accomplishments, I need to make an important disclaimer – my views are my own and do not necessarily reflect the views of the Securities and Exchange Commission or any member of the Commission staff.

…continue reading: SEC Enforcement Director Discusses Enforcement Initiatives