(Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of his remarks at the Investment Company Institute’s Annual Capital Markets Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Paredes and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

Since its inception in 1940 [1] — a historic year for the SEC — ICI has been an important voice, actively contributing to improving the oversight of our securities markets. In fact, many of the rules and regulations that the SEC has enacted in the subsequent decades were refined thanks to the thoughtful comments and research ICI and its members have provided. I am sure that this conference, like others before it, will spawn interesting insights that can help us achieve a well-calibrated regulatory regime that strikes appropriate balances.

I considered a range of topics to address today before deciding on three: custody, money market funds, and the Jones case.

Custody

Safeguarding client assets is a critical function of investment advisers. Investors must feel safe knowing that the funds and securities they own on paper exist in reality. Investors need to be confident that their returns are not fictitious and that their assets have not been misappropriated.

To this end, this past May, the Commission proposed rules under the Investment Advisers Act to enhance the safeguarding of investment adviser client assets. [2] Among other things, the Commission proposed amending the custody rule to require an annual surprise examination of client assets by an independent public accountant for registered investment advisers with custody.

Although I voted in favor of the Commission’s custody proposal, I raised certain reservations at the open meeting, particularly about extending the surprise exam to the extent proposed. [3] First, I questioned whether the surprise exam should cover investment advisers with an independent qualified custodian or be targeted to instances where the investment adviser or a related person is the qualified custodian. Given that non-affiliated custodians already serve as an important safeguard of client assets, it is not self-evident that the cost of a surprise exam is warranted. Second, I sought comment on whether the custody rules should cover investment advisers who have custody only because they withdraw fees from client accounts. Is the ability to withdraw fees a sufficient basis upon which to subject an adviser to the cost of yearly surprise exams? I expressed a related reservation that surprise exams may undercut competition if they were disproportionately costly and burdensome for smaller advisers.

Having had occasion to consider comments the Commission has received, I still question whether the proposed surprise examination requirement may reach too far. Without doubt, investors need to be secure that their investments are protected. That said, it is possible to regulate past the point of prudence. It is always possible to take another regulatory step to protect against fraud and other abuses, but is the cost of the additional regulation warranted? Given the rest of the relevant regulatory regime and the steps advisers already take to secure investor assets, the marginal benefit of a surprise examination may not outweigh the attendant cost. Not every incremental benefit of additional regulation is justified; there are diminishing returns.

…continue reading: Remarks Regarding Investment Companies

(Editor’s Note: This post comes is based on a Davis Polk & Wardwell LLP client memorandum by Phillip R. Mills, Francis S. Currie, Linda Chatman Thomsen, Ning Chiu and Robert L.D. Colby)

A broad cross section of commenters is encouraging the Securities and Exchange Commission (the “SEC”) to take a cautious approach with its latest proposal to allow shareholders to solicit votes for their director candidates through corporate proxy statements. [1]

The SEC received over 520 comment letters to date recommending a host of modifications to its proposal for uniform mandatory proxy access. Some commenters, including members of the investor community, have expressed concerns about the desirability of any uniform mandatory proxy access rule. Significant investor constituencies have also expressed concern about a possible compromise being advocated by companies and their representatives: deferring adoption of a uniform mandatory proxy access rule and instead allowing shareholders to propose bylaw amendments permitting proxy access through the existing shareholder proposal process. That compromise does have institutional investor support, however, with one leading investor recommending raising the ownership threshold for shareholder proxy access bylaw amendments to 5%.

In 2003 and 2007, the SEC proposed different rules to give shareholders greater access to a company’s annual proxy materials to nominate candidates for election as directors. In response to those rule proposals and investor concerns, states and corporations have taken steps to allow for proxy access and expanded shareholder influence in director elections. In addition to greater adoption of majority voting standards, states such as Delaware have recently adopted laws specifically permitting proxy access and proxy solicitation expense reimbursement bylaws. In response to a perceived need for greater director accountability arising out of the recent financial crisis, the SEC released its latest proposal that would mandate a uniform federal access right to a company’s proxy materials for shareholders who meet minimum holding period and ownership threshold criteria.

…continue reading: SEC Urged to Defer Adopting Proxy Access Rules

(Editor’s Note: This post comes to us from Raghavendra Rau of Purdue University and Aris Stouraitis of the City University of Hong Kong.)

It has been extensively documented that corporate events occur in waves. However, existing empirical studies have examined individual types of waves separately. In our paper, Patterns in the timing of corporate event waves, which was recently accepted for publication in the Journal of Financial and Quantitative Analysis, we investigate whether a relation exists between the different types of corporate events. Our analysis focuses on the timing of five different types of corporate events (new issues – both IPOs and SEOs, mergers – both stock and cash-financed, and share repurchases) using a comprehensive dataset of corporate transactions over the 25-year period 1980-2004.

The starting point in our analysis is the observation that most corporate events are combinations of two activities that have been central to corporate finance: financing decisions and investment decisions. The academic literature has traditionally argued that financing and investment decisions are driven by one of two hypotheses: (1) The neoclassical efficiency hypothesis which suggests that managers undertake corporate transactions for efficiency reasons, issuing equity or buying targets to take advantage of growth opportunities or to invest in positive NPV projects, and (2) the market misvaluation hypothesis which suggests that rational managers take advantage of irrational market misvaluations by issuing stock in exchange for cash or other firms.

What distinguishes the events we study is the extent to which they involve either the financing decision or the investment decision. Theories that describe why firms choose investment or financing decisions imply that related corporate events should be affected by the same factors. If we consider pure financing decisions for example, SEOs, IPOs, and stock repurchases are related, in that the former two both involve firms issuing equity while the last involves buying back equity.

The first part of our analysis consists of three tests that explore the correlation structure of event activity, that is, how activity in one type of event correlates with activity in other events. First, we find strong positive correlations at the industry level in contemporaneous activity within stock issuance events of different types (SEOs, IPOs, stock-financed M&A), and negative correlations between all three stock issuance events and stock repurchases. Second, we find that lagged SEO volume predicts future IPO volume, and that lagged SEO and IPO volume both predict future stock-financed M&A volume. Third, we show that waves of events follow the same pattern. We find, therefore, a previously undocumented pattern in the timing of corporate events.

The second part of our analysis involves regressions where we explain the likelihood of different types of waves using explanatory variables that proxy for neoclassical efficiency or misvaluation factors. Our analysis suggests that waves are driven by both neoclassical and misvaluation factors and the relative importance of these factors changes in different periods, leading to differing conclusions in the different studies that look at this issue.

The full paper is available for download here.

(Editor’s Note: This post is based on an article from Lombard Street.)

On June 30, 2009, the Obama Administration delivered to Congress the draft Consumer Financial Protection Agency (CFPA) Act of 2009. On July 8, House Financial Services Committee Chairman Barney Frank unveiled the Consumer Financial Protection Agency Act of 2009 (HR 3126), which shares key features with the President’s proposal. The proposal to create a new agency to police consumer financial products has been the subject of much debate. My goal, in this article, is to sort out and evaluate the different critiques levied against the proposed CFPA Act, in light of the underlying case for a new agency charged with the regulation of Consumer Financial Products (CFPs). To that end I begin by recounting the arguments for a CFPA. I then examine the critiques of the CFPA Act, reframed as challenges or counterarguments to the arguments for a CFPA. I conclude that there is broad agreement on the need for institutional reform, which would include a CFPA. At the same time, there is much disagreement about what mandate and authority the CFPA should have. I end with an optimistic note, suggesting that even a CFPA with less power than envisioned in the proposed Act could do much good. Specifically, I argue that a presumably less controversial section of the proposed CFPA Act – the section establishing a consumer right to access information – could promote efficiency and consumer welfare in the market for CFPs.

A. The Case for a CFPA

I begin by recounting the main reasons for the creation of a new federal agency with the mandate and authority to police consumer financial products. [1] A new agency is needed because (1) market forces fail to maximize welfare in important CFP markets, and (2) the current regulatory structure that was supposed to deal with this market failure has proved inadequate. I discuss these two elements in turn.

1. Market Failure

The proposed CFPA Act is a solution to a problem – excessively risky CFPs, or, more accurately, CFPs that impose underappreciated risks on consumers. The claim is that market forces have not worked to constrain CFP risks. This claim is based on theoretical arguments about the limits of market discipline in the CFP context. More importantly, the claim is supported by empirical evidence that many consumers do not make informed, welfare-maximizing choices in CFP markets. …continue reading: The Consumer Financial Protection Agency: Sorting the Critiques

(Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of his remarks at the Securities Industry and Financial Markets Association’s 14th Annual Fixed Income Legal and Compliance Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Paredes and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

I’ve had the honor and privilege of serving at the SEC since August of last year, and it is hard to believe how quickly the time has flown by. It goes without saying that the past year has been challenging. Collectively we have confronted difficulties and uncertainties recalling the stresses and turbulence of the Great Depression. Among other things, the steady flow of concern has prompted a serious reconsideration of the financial regulatory framework both in the U.S. and abroad. The SEC itself has been very active, advancing a number of initiatives relating to such matters as credit rating agencies; money market funds; custody of investment adviser client assets; proxy access; corporate governance and executive compensation disclosures for public companies; and short selling.

* * *

I’d like to focus the balance of my brief remarks this morning on an additional — and complex — area that is under active consideration both inside and outside the SEC: market structure. There are many interconnected aspects of market structure, all of which need to fit together for our markets to function smoothly and efficiently.

Last week, the Commission took up one aspect of our markets: flash orders. The Commission’s flash order proposal would amend Rule 602 of Regulation NMS to prohibit the flashing of marketable orders. [1] Let me take a moment to reiterate a few of the points I highlighted at the Commission’s open meeting. [2] As always, I look forward to considering the comments we receive on all of the agency’s ongoing rulemakings.

First, a thorough and unbiased assessment of flash orders must account for the potential benefits of flash orders that are lost if a ban is imposed. Flash orders present certain concerns, such as the prospect of discouraging displayed liquidity, but these concerns need to be weighed against the benefits of flash orders to determine the net impact of a ban and whether one is warranted at this time.

The identified benefits of flash orders include the potential to induce liquidity into the market from those who are unwilling to have their quotes displayed publicly, leading to opportunities for better execution; affording market participants lower fees than charged for executing against displayed liquidity; and otherwise reducing transaction costs for investors who are unwilling to display. The proposal release describes these benefits in more detail.

…continue reading: Remarks Regarding Market Structure

(Editor’s Note: The post below by Chairman Schapiro is a transcript of her testimony to the House Committee on Agriculture hearing regarding the regulation of over-the-counter derivatives markets last week.)

I. Introduction

Chairman Peterson, Ranking Member Lucas, Members of the Committee:

Thank you for the opportunity to testify on behalf of the Securities and Exchange Commission [1] concerning the regulation of over-the-counter (”OTC”) derivatives and, in particular, the Over-the-Counter Derivatives Markets Act of 2009, which was proposed in August by the Department of the Treasury. I am pleased to appear with CFTC Chairman Gary Gensler with whom I have worked closely over the last several months on a variety of issues. As you know, our two agencies have already begun an ambitious program of joint work to better harmonize our rules and procedures. Earlier this month, we held two days of joint hearings that highlighted some of the key differences in our regulatory approaches. We are eager to address these issues. Although some differences may remain over time, I believe this process will help ensure that any differences are justified by meaningful distinctions between markets and products and the others will be harmonized and improved. I also look forward to continuing our joint efforts to push for real regulatory reform.

The recent financial crisis has revealed serious weaknesses in U.S. financial regulation. Among them were gaps in the existing regulatory structure; failures to enforce existing standards; and failures to adapt the existing regulatory framework and provide effective regulation over traditionally siloed markets that had grown interconnected through globalization, deregulation and technological advances. Fixing these weaknesses is vital, particularly in the current market environment, and it is a goal to which the SEC is absolutely committed.

One very significant gap in the regulatory structure was the lack of regulation of OTC derivatives, which were largely excluded from the regulatory framework in 2000 by the Commodity Futures Modernization Act.

It is critical that we work together to enact legislation that will bring greater transparency and oversight to the OTC derivatives market. The derivatives market has grown enormously since the late 1990s to approximately $450 trillion of outstanding notional amount in June 2009.

This market presents a number of risks. Chief among these is systemic risk. OTC derivatives can facilitate significant leverage, result in concentrations of risk, and behave unexpectedly in times of crisis. Some derivatives, like credit default swaps (CDS), can reduce certain types of risk, while causing others. For example, CDS permit individual firms to obtain or reduce credit risk exposure to a single company or a sector, thereby reducing or increasing that risk. In addition to obtaining or reducing exposure to credit risk, a CDS contract participant will take on counterparty and liquidity risk from the other side of the CDS. Through CDS, financial institutions and other market participants can shift credit risk from one party to another, and thus the CDS market may be relevant to a particular firm’s willingness to participate in an issuer’s securities offering or to lend to a firm. However, CDS can also lead to greater systemic risk by, among other things, concentrating risk in a small number of large institutions and facilitating lax lending standards more generally.

These risks are heightened by the lack of regulatory oversight of dealers and other participants in this market. This combination can lead to inadequate capital and risk management standards. Associated failures can cascade through the global financial system.

…continue reading: Bringing Transparency and Oversight to the OTC Derivatives Market

(Editor’s Note: This post comes to us from Roy J. Katzovicz of Pershing Square Capital Management, L.P.)

Our experience with concentrated, long-term investments in large, public companies has taught us that the overwhelming majority of corporate directors are smart, diligent, and capable business people trying the best they can to faithfully discharge their fiduciary duties. They do not, however, always get it right.

Something is broken in corporate America. Particularly over the last decade, prudent risk management took a back seat to the quest for short term profits. Now we are all suffering the consequences. There is, however, reason for optimism. A number of tectonic trends in corporate governance appear to be converging, and a subtle rebalancing of power between management, their boards of directors and shareholders appears likely. We think that is a good thing.

Engaged shareholders with meaningful stakes in the companies in which they invest have the potential to regulate corporate conduct through private and market behavior. The existing tools of shareholder engagement, however, have not proven to be sufficient or optimally suited for that task. We believe that the SEC’s proposal to require public companies to include shareholder nominees in corporate proxy materials goes a long way toward better equipping shareholders to be more effective monitors of corporate behavior and, as a result, another force for good corporate governance.

We applaud this initiative and view it as a market-based solution in that the government is now trying to empower market actors to manage risk rather than trying to achieve the same goal through direct government intervention into the day-to-day affairs of corporations.

…continue reading: Proxy Access and the Balance of Power in Corporate Governance

(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. The column builds on Investor Protection and Interest Group Politics, an article co-authored by Professor Bebchuk and Professor Zvika Neeman that puts forward a theory of how interest group politics affect investor protection reforms.)

When they met earlier this month, G-20 finance ministers and central bankers called for global improvements in corporate governance. Such appeals are often heard, but powerful vested interests make it hard for governments to follow through. So, if serious reforms are to be implemented, strong and persistent public pressure will be needed.

Many countries provide investors in publicly traded firms with levels of protection that are patently inadequate. Even in countries with well-developed systems of corporate governance, arrangements that are excessively lax on corporate insiders persist. In the United States, for example, insiders enjoy protections from takeovers that, according to a substantial body of empirical evidence, actually decrease company value.

Lax corporate governance rules are not generally the result of a lack of knowledge by public officials. Political impediments often enable lax arrangements to linger even after they are recognized as inefficient.

Ordinarily, corporate governance issues are not followed by most citizens. As a result, politicians expect that their decisions on investor protection will have little direct effect on citizens’ voting decisions. By contrast, interest groups with big stakes in the rules follow corporate governance issues closely, and they lobby politicians to get favorable regulations.

The group that, in normal times, can be expected to have the most influence is that which consists of insiders within publicly-traded companies. Corporate insiders are an especially powerful lobbying group because of their ability to use some of the resources of the companies under their control. They have the power to direct their firms’ campaign contributions, to offer positions or business to politicians’ relatives or associates (or to politicians upon retirement), and to use their businesses to support issues and causes that politicians seek to advance.

Because insiders gain the full benefits that arise through lobbying for lax corporate governance rules, while their firms bear most of the costs of such lobbying, insiders have an advantage in the competition for influence over politicians. Their lobbying, which is carried out at the expense of their companies, is subsidized by their shareholders.

While individual investors cannot be expected to invest in lobbying for stronger investor protection, it might be hoped that institutional investors – mutual funds, banks, insurance companies, and so forth – will do so. Institutional investors receive funds from individuals and invest them in publicly traded companies. Because institutional investors invest substantial amounts in such companies, they should be well informed about corporate governance issues.

But institutional investors usually do not provide a sufficient counter-weight to lobbying by corporate insiders. In contrast to corporate insiders, institutional investors cannot charge the costs of lobbying to the publicly traded companies whose investor protection is at stake. In addition, depending on their relationship with their own investors, some institutional investors (for example, mutual fund managers) may capture only a limited fraction of the increase in value of their portfolios as a result of governance reforms. This reduces the willingness of institutional investors to invest in counteracting insider lobbying.

Moreover, those who make decisions for institutional investors often have interests that discourage lobbying for stronger constraints on corporate insiders. Some institutional investors are part of publicly traded firms, and are consequently under the control of corporate insiders whose interests are not served by new constraints. And even those institutional investors that are not affiliated with publicly traded companies may have an interest in getting business from such companies, making these institutional investors reluctant to push for reforms that corporate insiders oppose.

So, interest-group politics commonly produce substantial obstacles to reform of corporate governance. However, some events – such as a wave of corporate scandals or a stock market crash – can interrupt the ordinary pro-insider operations of interest-group politics by leading ordinary citizens to pay attention corporate governance failures.

When citizens become so outraged that their voting decisions may be affected by politicians’ failure to improve investor protection, public demand for governance reform can overcome the power of vested interests. Indeed, most major governance reforms occur in such circumstances. In the US, for example, new securities laws were passed following the stock market crash of 1929, and the Sarbanes-Oxley Act was adopted in 2002, in the immediate aftermath of the collapse of the Internet bubble and the Enron and WorldCom scandals.

By creating a large public demand for reforms, the current crisis offers another opportunity to improve governance arrangements. This opportunity should not be missed.

(Editor’s Note: This post comes to us from Xiaoding Liu and Jay Ritter of the University of Florida)

In our paper, The Economic Consequences of IPO Spinning, which was recently accepted for publication in the Review of Financial Studies, we investigate the practice of spinning using a sample of 56 companies that went public during the period 1996-2000. Spinning is the allocation by underwriters of the shares of hot initial public offerings (IPOs) to company executives in order to influence their decisions in the hiring of investment bankers and/or the pricing of their own company’s initial public offering. The term spinning refers to the fact that the shares are often immediately sold in the aftermarket, or “spun,” for a quick profit, and an IPO is termed “hot” if it is expected to jump in price as soon as it starts trading.

Despite the fact that IPO spinning is one of the four scandals associated with IPOs that have been the subject of regulatory settlements, it is the only scandal that has not yet received any systematic study due in large part to the unavailability of data. We overcome this limitation through the careful hand collection of a detailed dataset. More specifically, for our empirical analysis, we use data gathered from court cases, the media, and documents requested through the Freedom of Information Act. From these sources, we obtain data on 146 officers and directors at 56 companies that were recipients of hot initial public offering (IPO) allocations. All of these companies were taken public by Deutsche Morgan Grenfell (DMG), Credit Suisse First Boston (CSFB), and Salomon Smith Barney (SSB) during 1996-2000.

There is evidence in Securities and Exchange Commission (SEC) settlements and Congressional testimony that Piper Jaffray, Goldman Sachs, and other investment banking firms also engaged in spinning. Our empirical analysis, however, is restricted to IPOs for which DMG, CSFB, or SSB was the bookrunner. The reason that we impose this restriction is that the companies identified in press reports and settlements suffer from a selection bias, frequently containing examples of prominent executives at well-known companies. In contrast, the data for the three investment banking firms that we focus on is systematic, composed of all of the executives who were being systematically spun by CSFB as of March 21, 2000; executives who were being spun by CSFB and lived in Silicon Valley, including those being spun after March 21, 2000; or those being spun by SSB at any time during 1996-2000. For each executive that had a brokerage account with the SSB unit in charge of spinning, we have data on the allocations to each executive for 48 IPOs.

We estimate the effect of spinning on IPO underpricing and the awarding of future investment banking mandates. We find that holding everything else constant, IPOs in which the executives are being spun are 23% more underpriced (e.g., 43% vs. 20%). The average dollar value of this incremental underpricing, the incremental money left on the table, is approximately $17 million, where money left on the table is the underpricing per share multiplied by the number of shares issued. The average first-day profit received from hot IPO allocations by the executives of a company being spun is $1.3 million. The ratio of these numbers indicates that only 8% of the incremental amount of money left on the table flows back to the executives being spun. The effect of spinning on subsequent investment banking mandates relates to the literature that asks why firms do or do not switch underwriters—this literature has focused on performance dissatisfaction, graduation to a more prestigious underwriter, and analyst coverage reasons as factors that affect switching decisions. We add another reason, the co-opting of executive decision-makers, to this list. We find that companies with executives who are being spun are dramatically less likely to switch underwriters for their first seasoned equity offering. For companies not being spun, the probability of switching underwriters is 31%. For companies being spun, the probability of switching is only 6%.

Overall, our findings suggest that the spinning of executives accomplished its goal of affecting corporate decisions. More generally, this paper presents evidence on the economic consequences of an agency problem arising from the delegation of decision-making to corporate managers.

The full paper is available for download here.

It has been my privilege to support my partners as the editor of Davis Polk’s recently issued Financial Crisis Manual, which has been written by 21 Davis Polk partners and counsel working in a collaborative team that is the hallmark of our firm culture. The Manual is a comprehensive review of financial crisis laws as they apply to US financial institutions. Written for anyone who wants to understand the flurry of new legislation and other rulemaking that has occurred at a dizzying speed over the last year and a half, it covers the major Federal Reserve programs, Treasury’s capital investments and warrants, the FDIC’s debt guarantees, the public-private investment program, the enforcement landscape and executive compensation. It also meant to be, through the hyperlinks in each Chapter, a reference work gathering in one place the scattered primary sources of financial crisis laws, regulations and contracts.

As practicing lawyers, we leave to others the tasks of analyzing the causes of the crisis and assessing the government’s responses to it. That said, the political and social context in which financial crisis rulemaking occurred resulted in regulations with characteristics that affect the way lawyers interpret the law and provide advice to clients. According to one commentary, this system “married transactional practice to administrative law.” Here are a few observations about the characteristics of US financial crisis laws.

…continue reading: Davis Polk Releases Comprehensive Review of Financial Crisis Laws

(Editor’s Note: This post comes to us from Scott Fenn of Proxy Governance Inc.)

Recent data compiled by PROXY Governance, Inc. show a significant increase in the percentage of director nominees who received high percentages of shareholder votes cast in opposition in director elections during the 2009 proxy season. Although the vast majority of director nominees continue to be elected with little opposition, for companies with director election results available through August 2009, 9.8 percent of unopposed director nominees had at least 20 percent of shares voted against them or withheld, up from 5.5 percent in 2008. This trend was apparent at other threshold levels as well, with the percentage of directors having at least 40 percent of shares voted in opposition doubling from 1.0 percent in 2008 to 2.1 percent in 2009, and the percentage of directors failing to attain majority support tripling from 0.2 percent in 2008 to 0.6 percent in 2009. (See Table 1)

While declines in stock prices and the financial crisis no doubt played a role in the apparent increase in shareholder discontent with directors during 2009, compensation and corporate governance concerns also appear to have been primary drivers behind the increasing number of shares voted in opposition to directors. Of all director nominees who had more than 20 percent of shares withheld or voted against them in board elections, more than 57 percent served on compensation committees. Governance concerns – ranging from ignoring a majority vote on a shareholder proposal to adopting or renewing a poison pill without shareholder approval – also appear to have played a role in the high opposition votes at many companies.

Despite fewer organized “Vote No” campaigns against directors in 2009 – where a group of shareholders mount a public campaign to oust specific directors – at least 84 directors at 48 companies failed to attain majority support from shareholders through August 2009 at more than 2,400 companies where director voting results were available. Most of these 48 companies still use plurality voting, so the practical impact on most of the directors will be limited. Southwestern Energy Co., Pride International Inc., Cablevision Systems Corp., Pulte Homes Inc., Southwest Airlines Co., Massey Energy Co. and Kansas City Southern were among the larger companies where at least one director failed to achieve a majority vote. A list of the 48 companies where such votes have occurred so far in 2009 is shown in Table 2.

High profile “Vote No” campaigns aimed at unseating directors at financial firms such as Bank of America Corp. and Citigroup Inc. had mixed results – while the directors targeted in such campaigns were re-elected, several targeted directors at Bank of America later resigned, including the bank’s lead director.

The level of opposition to director candidates is likely to increase further next year as a number of existing and proposed regulatory changes related to proxy voting in director elections come into play. Beginning in 2010, under a rule change adopted by the New York Stock Exchange and approved by the Securities and Exchange Commission, discretionary voting by brokers of shares where they have not received voting instructions from shareowners will no longer be allowed in director elections. Because uninstructed broker votes can account for up to 20 percent of the vote at many companies, and are routinely voted with management’s recommendations, the new rule could result in many more directors failing to achieve majority support. For example, out of the universe of more than 2,400 companies, 284 director nominees were elected with less than 60 percent support of the shares cast and 473 nominees were elected with less than 65 percent support of the shares cast. Many of these directors might not have received majority support without the benefit of broker discretionary votes.

In addition to the impact of the rule change on broker discretionary voting, various bills are pending in Congress that would mandate annual elections for all directors and/or a majority voting system for all companies in uncontested elections. Annual elections would put many more directors up to a shareholder vote each year, potentially resulting in a greater total number of directors failing to achieve majority votes. Legislation mandating majority voting, while it might not impact the number of votes in opposition to directors, would certainly change the impact of those votes. Finally, the SEC has proposed a proxy access rule granting large shareholders access to the corporate proxy for purposes of nominating directors which, if implemented, could also have a significant impact on the director election process.

(Editor’s Note: The post below by Lord Adair Turner is a transcript of his remarks at London’s City Banquet, on September 22, 2009.)

It’s a year and four days since Callum McCarthy spoke here on his second last day as Chairman of the FSA. I know he always received a warm welcome here and I am grateful, Lord Mayor, for your kind words, given that I now seem to be regarded as somewhat of a heretic in certain quarters of the City.  Heretics used to be burned at Smithfield, not far from here, so perhaps I should have been worried coming here. But I will not be recanting this evening. I will try, however, to be socially useful by addressing head on the complexities involved in distinguishing the benefits of a vibrant financial sector from the problems of excess and instability.

To say a lot has changed in the year since Callum stood before you is inadequate.  Callum’s speech came a few days after Lehman’s collapse, but before we understood the full consequences.  When I became Chairman two days later, I didn’t know I would spend my first three weeks at the FSA amidst the biggest financial crisis for at least 70 years.

Today the world looks much less scary than it did then.  The financial system is no longer fragile: growth is returning in many countries, confidence to many markets.  I say that with some trepidation because, of course, there may be setbacks and unexpected events.  But it is important to recognise the positives: a bias to over-cautious pessimism in official statements can be as harmful as a bias to unjustified optimism.

The banking system is stable. House prices have fallen much less than anticipated. The big emerging economies have proved far more robust than we feared.  The Bank of England mid-point forecast suggests fairly robust UK growth over the next three years.

But even if that is the case – even indeed if the path of growth, unemployment and housing prices turns out to be better than current expectation – we must not forget what occurred last autumn.   This was the worst crisis for 70 years – indeed potentially it could have been the worst in the history of market capitalism.  Real disaster – a new Great Depression – was only averted by quite exceptional policy measures.  Despite these measures major economic harm has occurred. Hundreds of thousands of British people are newly unemployed; tens of thousands have lost houses to repossession; and British citizens will be burdened for many years with either higher taxes or cuts in public services – because of an economic crisis whose origins lay in the financial system, a crisis cooked up in trading rooms where not just a few but many people earned annual bonuses equal to a lifetime’s earnings of some of those now  suffering the consequences.  We cannot go back to business as usual and accept the risk that a similar crisis occurs again in ten or 20 years’ time.

We need radical change.  Regulators must design radically changed regulations and supervisory approaches, but we also need to challenge our entire past philosophy of regulation.

And parts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential social and economic functions, if they are to regain public trust.

…continue reading: The Momentum For Reform Must Be Maintained

(Editor’s Note: This post comes to us from Paul Povel of the University of Houston, and Rajdeep Singh of the University of Minnesota.)

In our recently accepted Journal of Finance paper, Stapled Finance, we investigate the relatively new, but now quite common occurrence of a loan commitment that is “stapled” onto an offering memorandum by the investment bank advising the seller in an M&A transaction. Stapled finance provides for credit at pre-specified terms to whoever wins the bidding contest for the asset or firm that is being put up for sale; but the winner is under no obligation to accept the loan offer.

We show that arranging stapled finance affects the bidding itself, by making it more competitive. We show that an appropriately designed stapled finance package increases the expected price that will be paid to the seller. Three characteristics are crucial for this to be beneficial for the seller. First, the stapled finance offer is optional: the winning bidder has the right, but not the obligation, to accept a loan whose terms have been fixed before the takeover contest started. Second, the stapled finance is a non-recourse claim, i.e., the debt is supported only by the target’s assets and cash flow, not by the other assets and operations that the winning bidder owns. Third, there are bidders who plan to hold the target as a portfolio company, i.e., who do not plan to integrate it into their other operations if they win. Our arguments do not rely on financial constraints of any sort; stapled finance is accepted by bidders for strategic reasons, even if they have sufficient internal or outside funds to pay for an acquisition.

In addition, we show that if the stapled finance package is designed optimally, then the investment bank providing it expects not to break even. The reason is that stapled finance is optional, so it is accepted only if the terms are attractive to the bidder—and therefore unattractive to the lender. This suggests that stapled finance that benefits the seller can be arranged only if it is possible to compensate the investment bank for its expected loss, for example with an up-front fee, or by retaining it for other fee-based services. It also suggests that stapled finance loans that investment banks and other financial institutions retained on their balance sheets should perform worse than buyout loans that were negotiated independently.

Being a fairly recent creation, stapled finance has not yet entered the academic mainstream, and therefore there is little existing empirical research. However, the institutional details about stapled finance are consistent with our results. In our paper, we discuss (informal) explanations for the popularity of stapled finance that practitioners provide, and how our results differ from predictions that follow from those explanations.

The full paper is available for download here.

(Editor’s Note: This post includes the transcripts of Chairman Schapiro’s statements on nationally recognized statistical rating organizations and flash orders at the SEC’s recent Open Meeting.  The statements of each of the other Commissioners on the two subjects are available here.)

Nationally Recognized Statistical Rating Organizations

Today we are considering a series of proposal that would significantly bolster the regulatory framework around nationally recognized statistical rating organizations, or “NRSROs.”

We are also considering a recommendation to propose a ban on the practice of flashing marketable orders. Flash orders provide a momentary head-start in the trading arena that can produce inequities in the markets and create disincentives to display quotes.

We begin with the credit rating recommendations. In 2006, the Credit Rating Agency Reform Act gave the Commission the exclusive authority over rating agency registration and qualifications. In the three years since, the Commission has undertaken several rulemaking initiatives. But as I have said previously, more needs to be done.

So, today we will consider six items that are intended to create a stronger, more robust regulatory framework. In particular, these proposals would improve the quality of ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping, and promoting accountability.

These proposals are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security. That reliance did not serve them well over the last several years and it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust.

Collectively, the changes and concepts being adopted, proposed and considered today would benefit investors in many ways:

• They would promote greater accountability by requiring compliance officers to file annual reports with the Commission.
• They would foster competition by enabling unsolicited ratings for structured finance products.
• They would decrease the level of undue reliance on the nationally recognized statistical rating organizations by beginning the process of removing references to NRSRO ratings in certain existing rules. It is time that we started this process to systematically minimize the use of ratings in the SEC’s rules and, while I know, there is much to do in this regard, I am pleased that we are taking these steps today.
• And finally, they would empower investors to make more informed decisions by helping to expose rating shopping and potential revenue-linked conflicts.

…continue reading: Proposed Rules regarding Ratings Agencies and Flash Orders

(Editor’s Note: This post is based on a client memorandum by Kathleen Walsh, Andrea Schwartzman and Matthew Chase of Latham & Watkins LLP.)

On August 3, 2009, the US Securities and Exchange Commission (the SEC) released a proposed rule under the Investment Advisers Act of 1940 (the Advisers Act) aimed at preventing “pay to play” practices by investment advisers that seek investment advisory business — including investment commitments in private equity funds — from state and local government entities.  As described in the proposing release, pay to play practices “may take a variety of forms, including an adviser’s direct contributions to government officials, an adviser’s solicitation of third parties to make contributions or payments to government officials or political parties in the State or locality where the adviser seeks to provide services, or an adviser’s payments to third parties to solicit (or as a condition for obtaining) government business.”  Referencing a number of enforcement proceedings in the area, the proposing release further states that “it has become increasingly clear that pay to play is a significant problem in the management of public funds by investment advisers.”

Proposed Rule

In response, the proposed rule would prohibit an investment adviser, as well as its “covered associates” from:

(1) providing or agreeing to provide payments (broadly defined) to a third party to solicit a government entity for investment advisory business on behalf of such investment adviser;

(2) receiving compensation from government entities within two years of making a contribution to an official of the government entity; and

(3) soliciting third parties to make a political contribution to an official of a government entity to which the investment adviser is providing or seeking to provide investment advisory services. The proposed rule would also require an investment adviser to maintain detailed records relating to its covered associates and their political contributions.

…continue reading: SEC Proposes Rule to Prohibit Pay-to-Play Practices

(Editor’s Note: This post is based on a Governance & Proxy Review Update.)

(Update:  This post has been updated below to reflect information provided in a subsequent Governance & Proxy Review Update.)

This post is by my colleagues Domenick de Robertis and Reid Pearson.

In response to the recent decision by the SEC to approve the elimination of broker discretionary voting authority on the election of directors at annual meetings after January 1, 2010, NYSE Rule 452 is front and center on the minds of many in the proxy and governance arena.

The amendment to Rule 452 will be the end of the “stuffing of the ballot box” for the election of directors that some shareholders have long complained about. The question now is to what extent will the change impact the ability of corporations to get their directors re-elected each year? In addition, what should corporations and their advisors be thinking about?

Assessing the Risk

Since the July announcement of the change, The Altman Group has completed numerous analyses for corporate issuers projecting the voting impact from the amended NYSE Rule 452. We will share our findings in the next issue of the Governance & Proxy Review and answer some practical questions that a company should consider in preparing for what is likely to be the toughest proxy season in history.

Strategies to Consider When Counteracting the Loss in Broker Voting

Historical statistics show that approximately 25 to 35 percent of the retail shareholder base will respond by voting without being prompted. The variance in response rates is tied to a number of factors, such as stock price (higher apathy with lower priced stocks) and the distribution of shareholdings (are there a lot of odd-lot holders, for example).

As we pointed out in our comment letters to the SEC, (Comment Letter – March 27, 2009) (Comment Letter – May 23, 2007) (Comment Letter – July 14, 2006) small-cap issuers are likely to bear the brunt of the burden placed on Corporate America by this change. Any issuer with a heavy retail base is likely to incur additional solicitation costs. There is no magic bullet for getting retail holders to vote. Issuers will need to consider the costs, necessity and effectiveness of follow-up mailings and phone solicitation to unvoted holders.

…continue reading: Storm Clouds Gather over Director Elections

(Editor’s note: This post comes to us from Volker Laux and Paul Newman of the University of Texas at Austin.)

The audit profession has long argued that excessively burdensome legal liability imposed on auditors hinders capital formation by increasing the likelihood that audit firms will reject potential clients, particularly high risk firms, leaving such firms with limited access to capital markets. However, in equilibrium, a change in the legal environment will also have an impact on the audit fee, as the entrepreneur can compensate the auditor for the increased risk since it allows him to raise capital from investors at lower cost. Thus, the equilibrium implications of increased auditor liability on client rejection rates are not as obvious as implied by the audit profession’s arguments. In our forthcoming Accounting Review paper entitled Auditor Liability and Client Acceptance Decisions, we examine the implications of the legal liability environment for the auditor’s decision to accept or reject risky clients, the level of audit quality (given acceptance), and the level of the audit fee, in a setting where the auditor spends costly resources to evaluate the prospective client prior to making the acceptance decision.

In particular, we consider a setting in which an entrepreneur requires capital to undertake a new project and seeks that capital through outside investors. In order to investigate the effects of the litigation environment on the probability that good-type clients get rejected, we consider three components of that environment: i) the strictness of the legal liability regime, which is interpreted as the probability that the auditor will be sued and found liable after an audit failure, ii) damage payments from the auditor to investors in case of a successful lawsuit against the auditor, and iii) other litigation costs incurred by the auditor such as criminal penalties, attorney fees, or reputation loss.

We show that under reasonable assumptions about the level of expected damage payments, an increase in any of these litigation components results in an increase in both audit quality and the equilibrium audit fee. However, when considering the probability of client rejection, it is important to carefully distinguish between the three components of the liability environment. We first show that an increase in the potential damage payments to investors leads to a reduction (not to an increase) in the client rejection rate. A higher expected damage payment implies that the entrepreneur has to offer the auditor a larger audit fee. Otherwise, the audit engagement would become less attractive to the auditor which would lead to a lower evaluation effort and hence a higher rejection rate. However, the increase in the audit fee does not involve a real cost to the entrepreneur. If investors expect a larger damage award from the auditor in case of an audit failure, investors are willing to give the entrepreneur better financing conditions. The entrepreneur in turn can use these savings to compensate the auditor for the increased liability exposure. We call this the triangle effect. Hence, a change in the damage payment has no direct effects on the evaluation effort and the rejection rate.

However, there is also an indirect effect since a larger potential damage award induces the auditor to adopt an audit of higher quality (after accepting the client) which delivers more accurate information about the investment project and hence leads to improved investment decisions. The anticipation of a better investment decision increases the value of the entrepreneur’s investment opportunity in the initial stage. Since this investment opportunity is lost if the auditor rejects the engagement, the entrepreneur is more eager to attract the auditor. To do this, the entrepreneur increases the audit fee by an amount that is larger than the increase in the auditor’s expected damage payment, which results in a higher evaluation effort and a lower rejection rate. This result is reversed if litigation frictions increase. When litigation frictions are higher, the auditor will find the engagement with the client less attractive and hence will have a weaker incentive to carefully evaluate the client, which increases the rejection rate. Of course, the client can counteract this negative effect by offering a larger audit fee, but in this case a real cost is involved because the triangle effect does not hold. As a result, the equilibrium rejection rate increases with higher litigation frictions.

Because a shift in the strength of the legal regime affects both the expected damage payments to investors as well as expected litigation frictions, a change in the legal regime involves two opposing effects. Depending on which effect is stronger, a change in the legal regime either increases or decreases the probability of client rejection. In particular, we show that the relationship between the strength of the legal liability regime and the client rejection rate is U-shaped. Our model therefore predicts that clients are less likely to be rejected in environments with moderate legal regimes compared to environments with relatively strong or relatively weak legal regimes.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Professor Emma Coleman Jordan of the Georgetown University Law Center, and relates to Professor Jordan’s report “A Fair Deal for Taxpayer Investments: Public Directors Are Necessary to Restore Trust and Accountability at Companies Rescued by the U.S. Government“, released by the Center for American Progress. The report was released at an event featuring Chairman Towns of the House Committee on Oversight and Government Reform, details and video of the event are available here.)

During the financial markets crash of 2008, the Treasury Department and the Federal Reserve—of necessity—improvised dramatic and aggressive solutions to rescue the financial sector from imminent collapse. A welter of creative regulatory and monetary solutions provided massive amounts of government assistance to rescue private firms from probable failure. However, the benefits of government intervention have so far largely flowed one way only—from the taxpayers to the financial sector—and there has been a marked absence of accountability or transparency associated with these government-provided benefits.

Taxpayer bailouts have become a central policy tool since the onset of the current economic crisis—with approximately $12 trillion dollars to date deployed to support or rescue private companies in total.2 The de facto policy of providing taxpayer support to struggling “systemically important” companies has produced an ill-defined terrain of shared governance between financial executives on the one hand and federal regulators who hold both the power of government and the power of ownership on the other.

This unusual mix of private and public power requires a more visible implementation of financial accountability to regain the trust of the American public. The American people must know that their interests as taxpayers are being safeguarded, and that as investors they can have confidence that federal intervention into the private markets is following a consistent, well-defined, and transparent process—one which follows well-established guidelines for ensuring accountability, rather than a series of ad hoc approaches. This paper argues that the best vehicle to accomplish this goal is the establishment of public directors—positions of direct representation in the boardrooms of companies that have received significant amounts of government funds and which will provide federal agencies that are the new owners and regulators with a visible structure of accountability.

The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that the both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92 percent of the management and directors of the top 17 recipients of TARP funds are still in office. The Obama administration has outlined an ambitious and sweeping plan to reform the regulatory system governing financial institutions and markets. This regulatory reform is certainly indispensable, but perhaps insufficient. The recent market crashes exposed severe deficiencies in the fiduciary obligations and public-regarding culture of financial firms. In order to prevent future crashes, we must not only seek to change how these firms are regulated, we must also seek to change the structures by which they are run. One major issue in this regard is the passivity, insularity, and narrow band of values represented by those who oversee these firms—the directors who make up the boards of the country’s largest financial institutions.

A driving force of the 2008 market collapse was the imprudent risk taking by financial sector leaders The CEO and board of directors of each company have the legal responsibility to make decisions that advance shareholder interest. In the period leading up to the crisis, the conventional wisdom among financial sector CEOs was that the high returns available from mortgage-backed securities, and the highly leveraged balance sheets and off-balance sheet transactions concentrated in exotic financial instruments were the way to maximize short-term profitability and thus advance shareholder interests. This industry-wide consensus proved to be fatally flawed.

Public directors will provide a corrective to the boards of the financial institutions that helped cause the crisis. Public directors can offer increased independence of thought and diverse perspectives among board members. Public directors should be chosen for a strong public service history, financial and corporate literacy, as well as independence from links to the financial sector. The primary aim of the public director appointments should be to diversify traditional board member profiles and to avoid replicating the disastrous pool of narrowly self-reinforcing financial sector conventional wisdom and experience that led to the crisis. As the economy heals, there are troubling signs that banks have not increased lending, and have instead resumed planning risky strategic acquisitions, and excessive compensation practices. Proportional representation by public directors can ensure that systemically-important firms that have any measure of government ownership do not relapse into the homogenous, CEO-dominated boards that were in place before the crisis.

Regulators should determine most of the details of the public directorships—after all, they have the most direct experience in trying to regulate private companies that have received public funds. But the decisions should be made with two critical principles in mind. First, the principle of proportionality should be applied to government investments in private firms. Public directors should be appointed to the boards of directors on a roughly proportional level to the amount of funding received by the rescued firm—and this should include not just purchases of company stock, but other investments and subsidies provided to help support the firm. For example, if a company receives government funding equivalent to 25 percent of its market capitalization, public directors should make up roughly 25 percent of that company’s board.

Second, because public directors should represent taxpayer interests, they should have a history of public service, and they should be chosen to provide both intellectual diversity and diversity of perspective gained from individual experience. They should also have experience and expertise from outside of the economic sector in which they serve. Diversity is necessary for good governance, as it breaks up the “groupthink” that too often characterizes corporate boards, which are typically filled by allies of management. And experiential diversity is also important for the appropriate representation of taxpayer interests. When other stakeholders—such as pension funds, unions, or hedge funds—invest major sums in corporations, they demand board representation, and their directors are picked to represent the interests and worldview of these stakeholders. Taxpayers should not be treated any differently.

(Editor’s Note: This post comes is based on a Davis Polk & Wardwell LLP client memorandum by Annette L. Nazareth, Lanny A. Schwartz, Gerard Citera, and Robert Colby.)

Introduction

In response to an outcry of criticism voiced by the public, Congress and regulators, on September 18, 2009, the Securities and Exchange Commission (the “SEC”) proposed to ban the use of “flash orders” on equities and options exchanges and large alternative trading systems (Exchange Act Release No. 34-60684 (September 18, 2009)).

The term “flash orders” refers to a practice whereby a trading center will for a few milliseconds show subscribers of the trading center’s data feed customer buy orders priced at the national best offer, or customer sell orders priced at the national best bid. Market participants with fast electronic connections can then execute the orders at the flash price. If the order is not immediately executed, it is withdrawn without exposure to the entire marketplace, or is routed to other exchanges.

The SEC is concerned that although flash orders provide customers with better prices, they harm the markets for long-term investors by undermining public quotes and creating a two-tier market. Under the proposal, flash orders would be impermissible “locking quotes”, i.e., quotes that “lock the market” by matching the quote on the opposite side of the best bid and offer. The SEC states in the release that certain market mechanisms and order types, such as price improvement auctions and immediate or cancel orders (“IOCs”), that bear some functional similarities to flash orders will not be affected by the proposal.

Perhaps more significant than the proposed ban of flash orders is the signal that the SEC is once again preparing to intervene in the equities and options markets. The SEC stated its intention to consider in the near future additional market structure topics, including dark pools, Regulation ATS thresholds, alternative trading systems (“ATSs”) post-trade transparency, direct market access, high frequency trading, and co-location, either through proposals or concept releases.

Brief Description and History of Flash Orders

Flash orders are commonly used to send customer buy orders priced at the national best offer, or sell orders priced at the national best bid, to trading centers that may not be displaying the national best quote. The flash order offers the potential for the order to trade on the preferred trading venue immediately at the best price publicly quoted in the market without having the order routed to another market, and for market participants receiving the flashed order information to trade against the order without having to publicly quote the best price.

Because exchanges and other trading centers benefit from maximizing the number of orders that are executed on their markets, they are often willing to pay rebates to brokers who send flash orders that are executed on their markets. The brokers might otherwise have to pay fees to a destination market if the flash orders are routed away and executed there.

…continue reading: SEC Proposes Flash Order Ban, Announces Market Structure Review

In my paper, Negotiating with Labor under Financial Distress, which I recently presented at the Law, Economics and Organizations Seminar here at Harvard Law School, my co-authors, Nittai Bergman and Ricardo Enriquez, and I analyze how firms strategically renegotiate labor contracts to extract concessions from labor. While anecdotal evidence suggests that firms tend to renegotiate down wages in times of financial distress, there is no empirical evidence that documents such renegotiation, its determinants, and its magnitude. This paper attempts to fill this gap. More specifically, we use a unique data set of airlines that includes detailed information on wages, benefits and pension plans, to document an empirical link between airline financial distress, pension underfunding, and wage concessions.

We first show that airlines in financial distress obtain wage concession from employees whose pension plans are underfunded. An underfunded plan is one in which plan assets are insufficient to cover outstanding benefit obligations. Employees with underfunded pension plans can in some situations bear a higher cost when firms default if the benefits promised to them exceed the benefit limits set by the Pension Benefit Guaranty Corporation (PBGC), the federal corporation which protects the pensions of nearly 44 million American workers. The maximum annual guarantee is determined by employee age and was $30,978 for a 60 year-old employee in 2006.

Since highly-paid employees with promised pensions that exceed the PBGC guarantee stand to lose more when their pension is transferred to the PBGC, we hypothesize that they will be more likely to make concessions during labor bargaining. Our identification strategy thus relies on a triple-difference, or DDD, specification, with three levels of differences: (i) financially distressed vs. non-distressed airlines, (ii) underfunded pension plans vs. funded plans, and (iii) wages exceeding vs. those that are below the PBGC limit.

We find that airlines that are financially distressed can negotiate down the wages of their employees whose pensions are underfunded and are not fully covered by the PBGC guarantee. The magnitude of the triple difference estimator suggests that in such renegotiation annual wages are reduced by between 9.3% and 11.2%. Analyzing levels instead of the percentage change shows that in renegotiation financially constrained airlines with underfunded pension plans extract between $12,252 and $17,360 in annual wages from employees not fully covered by the PBGC guarantee. Our results are robust to the inclusion of year, airline, plan and airline by-year fixed effects in addition to airline and employee controls.

We also control for the share of the airline wage expense in two ways. First, we control throughout our analysis for the ratio between the wage of an employee group and overall firm wage expenses and find that our results are always robust to the inclusion of the wage share variable. Second, we employ a placebo test to analyze the effect of the PBGC guarantee. Specifically, we compare wage renegotiation in airlines with deeply underfunded plans (the treatment group) to wage renegotiation in similar employee groups in airlines with no defined-benefits plans (the placebo group). We find that amongst highly paid employee groups with wages not fully covered by the PBGC guarantee, only those with a pension plan, and in particular one that is underfunded, agree to accept wage reductions in renegotiation. In contrast, identical highly paid employee groups employed in airlines without defined benefit plans do not accept wage cuts in renegotiation. Thus, our results are not likely driven simply by some employee groups making wage concessions for reasons unrelated to pension underfunding.

The full paper is available for download here.

(Editor’s Note: This post is based on a Gibson, Dunn & Crutcher LLP client memorandum by Michael Bopp and Aditi Prabhu.)

This update focuses on the launching of the Financial Crisis Inquiry Commission (”FCIC” or “Commission”), which was created by Congress as section 5 of the Fraud Enforcement and Recovery Act, which became law on May 20, 2009. The bipartisan Commission is charged with examining the domestic and global causes of the current U.S. financial and economic crisis. In addition to discussing the Commission’s first meeting, which took place today, this alert summarizes the Commission’s broad investigatory mandate, its subpoena and other coercive powers, and its charge to gather information from private and public entities.

FCIC Holds First Meeting; Sets Course for Rigorous Investigations

The FCIC held its first public meeting today in order to outline for the public its mission and approach.  The majority of the meeting consisted of prepared statements by the Commissioners and concluded with a timeline for the investigation.  The Commissioners highlighted the importance of the FCIC’s work and their commitment to the daunting task of determining the causes of the economic crisis.  While the remarks were mostly broad in nature, the Commissioners repeatedly pointed to failures on the part of both the financial system and government regulators as contributing to the crisis.

Chairman Phil Angelides

Chairman Angelides related that while this is the FCIC’s first public meeting, it has held several working sessions.  The Commission has adopted rules and procedures and, most notably, has created whistleblower protections for those who convey information to the Commission.

Angelides introduced Thomas Greene as the newly-appointed Executive Director the Commission.  Greene previously served as Chief Assistant Attorney General of the Public Rights Division in the Office of the Attorney General of California.

Angelides noted that the purpose of the Commission is to determine the causes of the crisis, not to offer “prescriptions for the future,” although the Commission is permitted to do so.  He compared the FCIC to the 9/11 Commission, which conducted over 1200 interviews, reviewed 2.5 million pages of documents, and held 12 days of public hearings.  Angelides expressed the view that the FCIC should be “similarly thorough” and should “leave no financial stone unturned.”  He also compared the FCIC’s work to the Pecora hearings in the 1930s in terms of its aspired impact.

He noted that the Commission’s final report is due in 15 months.  To carry out its mission, the Commission will seek records from government agencies and financial institutions, and hold hearings.  Angelides mentioned that the FCIC will use its subpoena power if necessary.

Vice Chairman Bill Thomas

Vice Chairman Thomas distinguished the FCIC from congressional committees which are also working on similar issues by stating that the Commission need not respect any boundaries.  Rather, its real constraint is time.

…continue reading: Financial Crisis Inquiry Commission to Begin Investigations

(Editor’s note: This post comes to us from Peter Iliev of Pennsylvania State University.)

In my paper, The Effect of SOX Section 404: Costs, Earnings Quality and Stock Prices, which was recently accepted for publication in the Journal of Finance, I investigate the costs, the benefits, and the overall value impact of SOX Section 404. This provision requires that managers report on the effectiveness of the controls that monitor the internal financial reporting systems, and an outside auditor attests to the management’s assessment of company controls.

Section 404 and its practical application have been under intense attack from business groups and lawmakers who generally view compliance as overly burdensome. Despite calls for a small company exemption, the SEC only gave a five month extension to small companies’ compliance. This exemption provides an ideal quasi-experiment for this study. Specifically, I use a regression discontinuity design that compares the companies that were just above the rule cutoff and had to file the report to companies that were just below the cutoff and did not have to file the report. This is a good quasi-natural experiment because the exact cutoff is not related to firm fundamentals. In addition, one must consider whether firms actively manipulated their public float to escape compliance. This paper uses the public float rule in 2002 to predict (instrument) the actual compliance in 2004. Firms with a public float over $75 million in 2002 had to comply with Section 404 in 2004. However, in 2002 firms had no information about the way Section 404 would be implemented. Therefore, companies did not know that this threshold would be used to define 2004 compliance and were less likely to actively avoid having a public float above $75 million.

The big advantage of the regression discontinuity design is that it can isolate the effects of SOX Section 404 compliance from the effects of the changing business climate (and any contemporaneous event) that would have affected all firms. The disadvantage of this approach is that it can look at small firms only. It is possible that the effect of Section 404 compliance is different for larger firms and hence the results do not to generalize to, for example, Fortune 500 type firms. However, small firms are interesting in themselves. First, there are, of course, more small firms than large firms. Second, the big complaint about Section 404 (and SOX compliance in general) has been that small firms pay disproportionately high costs because of the fixed cost nature of compliance. Third, small firms are likely to suffer more from asymmetric information and low reporting quality, and they could benefit most from the new regulation.

I investigate the audit fees as a direct measure of the costs of Section 404, the changes in reporting behavior proxied by firm accruals, and the stock returns around SOX related announcements as a measure of the net benefits of compliance. I find that the attestation of the management’s report (MR) by outside auditors imposed significant costs for small firms. Filing an MR in 2004 increased audit fees by 98%, or $697,890. With a median firm market size of $110.9 million in 2004 and negative average earnings, this is not a small amount. I show that the increase in audit fees was not driven by the general increase in auditing costs, but was SOX specific. Section 404 also led to more conservative reporting. MR filers had significantly lower accruals and discretionary accruals in 2004. The effect is economically significant, with MR filers booking an estimated $15.1 million less in discretionary accruals than non-filers. For small firms, this change is substantial. The mean and median earnings of my sample are negative $4.8 million and $1.4 million with a standard deviation of $23.3 million. Finally, MR filers had higher event study returns around announcements of delays in Section 404 implementation. The buy-and-hold returns of MR filers was 17% lower than non-filers over the two year period starting with the announcement of the rule and ending after the filing of the 2004 annual reports. These results are confirmed with a sample of foreign firms that were near the 2006 implementation cutoff of $700 million. Foreign firms that did not provide audit reports had 30% lower audit fees and 2.3% lower discretionary accruals. Event study evidence of foreign firm returns further indicates that the costs outweigh the benefits. Some firms might have manipulated their public float in 2004 to avoid filing an MR.

The full paper is available for download here.

(Editor’s Note: This post is based on a Gibson, Dunn & Crutcher LLP client memorandum by Amy Goodman, Gillian McPhee and Joelle Khoury.)

On August 26, 2009, the New York Stock Exchange (”NYSE”) filed proposed amendments to its corporate governance listing standards with the Securities and Exchange Commission (”SEC”). The NYSE has proposed that they take effect on January 1, 2010. The proposals must be approved by the SEC before they become final, and will be the subject of a 21-day comment period following publication in the Federal Register.

The NYSE proposals would amend the corporate governance listing standards to: (1) codify certain staff interpretations; (2) clarify various disclosure requirements; and (3) incorporate applicable SEC disclosure requirements into the listing standards. Because most of the proposed changes would conform the NYSE listing standards to existing SEC rules, or are of a clarifying or updating nature, they should necessitate only minimal changes to listed company governance practices and disclosures. [1]

Below is an overview of the proposals in the NYSE filing, which includes a mark-up showing the proposed changes to the text of the corporate governance listing standards.

In addition, in August 2009, the NASDAQ Listing and Hearing Review Council sent a paper to companies listed on The NASDAQ Stock Market LLC (”NASDAQ”) seeking comment on whether NASDAQ should adopt a “comply or disclose” approach with respect to certain corporate governance practices. The paper is discussed in more detail below.

NYSE – The Proposed Amendments – A Brief Overview

A primary purpose of the proposed amendments is to update the NYSE’s corporate governance listing standards in light of the SEC’s 2006 adoption of Item 407 of Regulation S-K, which requires disclosure about director independence and certain other aspects of a company’s corporate governance practices. In this regard, the proposals would eliminate each disclosure requirement currently included in the NYSE corporate governance listing standards that also is required by Item 407 and reference the SEC requirements. Although the NYSE acknowledges in the proposing release that this approach may appear redundant, it will permit the NYSE to take action (including delisting) against companies with deficient Item 407 disclosure, as these companies also will be deemed out of compliance with NYSE rules. In addition, as discussed below, the changes would permit companies to make disclosures about certain matters on their websites instead of in their proxy statements.

The following provides a brief overview of the most significant amendments that the NYSE has proposed:

• Director Independence Disclosure: The NYSE is proposing to replace its current director independence disclosure requirements with a requirement that listed companies provide the disclosures required by Item 407, which require that companies describe, for each director, by specific category or type, any transactions, relationships or arrangements that the board considered in determining that the director is independent. Current NYSE listing standards permit boards to adopt and disclose categorical standards to assist them in assessing independence, and allow companies to make a general disclosure that their independent directors meet these standards. Accordingly, if adopted, the proposals would eliminate the concept of categorical standards from the NYSE listing standards. However, we expect that the boards of many companies will continue to maintain these standards, because they provide a useful tool for assessing director independence.

• Executive Sessions of Non-Management Directors: The NYSE listing standards require that non-management directors hold regular executive sessions. Because some companies have expressed a preference for holding regular executive sessions of only the independent directors, the proposals would clarify that this satisfies the NYSE requirement.

• Communications with Directors: The NYSE listing standards require companies to provide “interested parties” with a method to communicate with the presiding director, or the non-management or independent directors as a group. The NYSE proposes clarifying that “interested parties” is not limited to shareholders.

• Requirements for Audit Committees: Under current NYSE listing standards, if a member of a listed company audit committee simultaneously serves on the audit committees of more than three public companies, “and the listed company does not limit the number of audit committees on which its audit committee members serve to three or less,” then the board must determine that this service would not impair the member’s ability to serve on the listed company’s audit committee, and the company must disclose this determination in its proxy statement. According to the proposing release, the wording of this provision has led to uncertainty about whether the determination and related disclosure are necessary if a listed company does not limit outside audit committee service to three public company audit committees. The proposals would clarify that both the determination and disclosure are required whether or not a company limits the number of audit committees on which its directors may serve to three or less.

• Codes of Conduct: The NYSE listing standards require that companies “promptly” disclose any waivers of their codes of conduct granted to executive officers and directors. The proposals would clarify that companies must disclose waivers within four business days, consistent with SEC requirements governing Form 8-K disclosure of waivers from a company’s code of ethics applicable to its CEO and senior financial officers. The proposals also would specify that companies can make the disclosure through a press release, on their websites or on a Form 8-K. The NYSE notes in the proposing release that this timing varies slightly from the guidance in the staff’s Frequently Asked Questions, which state that companies may make the disclosure using one of these alternatives within two to three business days.

• Notification of Non-Compliance with Corporate Governance Listing Standards: The NYSE listing standards currently require that companies notify the NYSE in writing after any executive offer becomes aware of a “material” non-compliance with the corporate governance listing standards. The proposals would amend this provision to require notification when an executive officer becomes aware of any non-compliance.

• Certification Requirements: Under the current NYSE listing standards, listed company CEOs annually must certify to the NYSE that they are not aware of any violation of the NYSE corporate governance listing standards, qualifying the certification to the extent necessary. The certification is due within 30 days of a company’s annual shareholder meeting. In addition, in their annual reports to shareholders, companies must disclose that they filed the previous year’s CEO certification and any certifications required by SEC rules. According to the proposing release, this requirement has caused significant confusion because it relates to filings that were made in the previous year, and the NYSE believes it is no longer necessary in light of the SEC rules requiring Form 8-K disclosure of any material non-compliance with exchange rules. In view of these considerations, the NYSE is proposing to eliminate the disclosure requirement relating to these certifications, but is retaining the certification requirement.

• Website Discussion of NYSE-Mandated Corporate Governance Disclosures: The NYSE is proposing to give companies the option to make specific corporate governance disclosures required only under the NYSE’s rules on their websites, instead of in the proxy statement. However, if they choose to make such disclosures on their website, that fact and the company’s website address must be provided in the proxy statement. These disclosures would include information about:

• Website Requirements: The NYSE has proposed minor changes to various aspects of its rules on website disclosure, including:

• Provisions Applicable to Specific Circumstances: The NYSE also is proposing certain changes and clarifications to the transition periods applicable to companies listed in conjunction with an initial public offering, spin-off or carve-out with regard to timing for compliance with its corporate governance requirements. In addition, the NYSE is proposing to add sections detailing the compliance requirements applicable to companies when they list upon emergence from bankruptcy, transfer from another market, cease to be controlled companies or cease to be foreign private issuers (as discussed below).

• Foreign Private Issuer Disclosure: The NYSE also has proposed changes applicable only to foreign private issuers:

NASDAQ Request for Comment on “Comply or Disclose” Approach

On August 3, 2009, the NASDAQ Listing and Hearing Review Council sent a paper to NASDAQ companies seeking comment on whether it should adopt a “comply or disclose” approach for certain corporate governance practices as an alternative to additional, substantive requirements, noting that some non-U.S. markets follow a “comply or disclose” model and that it “offers flexibility to companies and transparency to investors and allows practices to evolve in a logical manner.” Accordingly, the NASDAQ paper solicits comment about a range of practices, including board leadership, resignation policies for directors that fail to receive majority votes, annual director elections, and shareholder ratification of a company’s outside auditor. Any required disclosures would appear either in a company’s proxy, in the case of most U.S. companies, or in its annual report filed with the SEC for all other companies. Comments are due by October 30, 2009.

What Companies Should Do Now

For NYSE companies, most of the amendments conform the listing standards to existing SEC rules or are of a clarifying or updating nature. Accordingly, if the amendments are adopted, they should necessitate only minimal changes to companies’ corporate governance practices and disclosures. The most significant potential amendment is the proposal to require that companies notify the NYSE in writing after any executive officer becomes aware of any non-compliance, as opposed to a “material” non-compliance, with the corporate governance listing standards. Companies may wish to comment on this aspect of the proposal.

In addition, NYSE companies will need to review their proxy disclosures and governance documents (including committee charters and D&O questionnaires), to determine whether any section references to the NYSE listing standards need updating. We expect that companies will need to update their D&O questionnaires this fall in any event, in light of pending SEC proposals to require enhanced proxy disclosure about compensation and corporate governance matters. [2] Companies also should consider whether they will eliminate disclosures about the filing of CEO certifications and the undertaking to provide hard copies of governance documents upon request, although companies may want to continue this latter offer as a matter of good investor relations.

NASDAQ companies should consider whether to comment on the NASDAQ paper. If NASDAQ decides to move forward with additional corporate governance requirements, companies may find a “comply or disclose” approach preferable because it would preserve flexibility and allow them to adopt the practices that work best for them. Accordingly, it may be useful for companies to provide input to NASDAQ as it moves forward with this process.

Footnotes:

[1] The NYSE originally filed an earlier version of these proposals with the SEC in 2005, and later amended the proposals following the SEC’s comprehensive changes to its proxy disclosure rules in 2006, but no SEC action was taken on these proposals.
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[2] Proxy Disclosure and Solicitation Enhancements, SEC Release No. 33-9052, 34-60280, 74 Fed. Reg. 35,076 (July 17, 2009).
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(Editor’s Note: This post is based on an article in the Massachusetts Lawyers’ Weekly.)

Classified boards, where directors serve staggered terms (typically for three years with one-third of the directors elected each year), has been a recognized corporate governance alternative for a long time. The laws of every state permit corporations to structure their boards in this way. In fact, it is the default rule in Massachusetts for publicly traded companies unless the board of directors or the shareholders elects to opt out.

This should sound familiar because it is the way members of the United States Senate are elected, with Senators serving six-year terms and one third elected in each two-year election cycle. The Constitution’s Framers understood the stabilizing effect of this arrangement, which they believed would ensure continuity and allow Senators to take responsibility for measures over time and make them independent of rapid swings in public opinion. For more than 200 years, this policy has served the nation well. It is a policy that also has served corporations and their investors well when they have chosen to use it.

Yet undoing this corporate governance system is precisely what is now being proposed – ironically, by two Senators. They want to prohibit for stock exchange traded companies the very governance system under which they serve. They claim that classified boards of directors are part of what they call a “widespread failure of corporate governance” that was one of the “central causes of the financial and economic crises that the United States faces.”

Such a claim ought to be accompanied by hard evidence – but it is not, and with good reason. There is no evidence suggesting that classified boards were in any way a contributing factor to the ongoing economic crisis. To the contrary, companies involved in recent financial meltdowns whose boards were not classified include AIG, Washington Mutual, Bear Stearns, Citigroup, Bank of America, Lehman Brothers and General Motors. Going back to the 2001-era financial frauds, Enron, WorldCom, Tyco and HealthSouth all had unclassified boards. If anything, then, good policy and common sense suggest that we would want to retain the alternative of classified boards, not prohibit them.

As is the case with the U.S. Senate, too-frequent elections, rather than staggered terms of office, are what can undermine desired continuity and the ability to govern for the long term.

The key point is that we should not have a one-size fits all mandate for corporate governance. Rather, investor choice ought to be retained, not discarded. Certainly, corporations and their shareholders should be free to decide whether or not they want a classified board and whether the governance structure that is fine for the United States Senate works for them. Indeed, the current system is working as we would want it to, with individual choice at individual companies exercised freely – less than 40% of the S&P 500 companies have classified boards and, during the last six years, more than 200 companies have successfully put to a shareholder vote proposals to declassify their boards of directors.

In short, there is simply no evidence that classified boards bear any of the blame for the recent economic crisis. The laws of all states allow for classified boards, with Massachusetts mandating it, and there is the ability for investors to make a choice on the matter. In these circumstances, the current legislative proposal to preempt state laws and do away with classified boards is an inadvisable step back from investor choice, and toward the imposition of an unjustified one size fits all federal governance rule that will do nothing to prevent future financial breakdowns.

Chief executives and regulators have been blamed for the current economic crisis, but in some ways what is surprising is that boards have generally escaped notice. Clearly the experience of corporate boards in the downturn has not been explored. To understand what transpired in the boardrooms of complex companies, and to offer a prescription to improve board effectiveness, eight senior faculty members of the HBS Corporate Governance Initiative talked with 45 prominent directors about what has happened to their companies and why. These directors, who serve on the boards of financial institutions and other complex companies, were asked two broad questions: How well did their boards function before the recession? And, what do they believe should be improved as they look to the future?

This white paper first explains how the interviewees characterize the strengths of their boards, then examines in depth six areas in which they identified shortcomings or needs for improvement:
   1) clarifying the board’s role;
   2) acquiring better information and deeper knowledge of the company;
   3) maintaining a sound relationship with management;
   4) providing oversight of company strategy;
   5) assuring management development and succession;
   6) improving risk management.

Finally, the paper discusses two issues that appeared not to trouble the interviewees but that the public feels are important: executive compensation and the relationship between the board and shareholders.

The key concepts highlighted include:

· Regulations and laws offer little guidance about what specifically boards should do, and, given this lack of specificity, most boards have gradually developed an implicit understanding of what their job should be.

· Directors expressed strong consensus that the key to improving boards’ performance is not government action but action on the part of each board.

· To improve board effectiveness, each board should achieve clarity about its role in relation to that of management: the extent and nature of the board’s involvement in strategy, management succession, risk oversight, and compliance.

· If, as interviewees insisted, each board’s effectiveness is directly attributable to its activities, it follows that boards have a responsibility to define their own roles with clarity, and to decide how to perform those roles in light of the nature of the firm, its industry, and its particular challenges.

· If boards are to decide on their goals and activities, they must expect to invest extended time in hard-headed discussions of both, leading to concrete and actionable conclusions.

· Boards need to maintain a delicate balance in their relationship with management. They must be challenging and critical on the one hand and supportive on the other. They have to sustain an open and candid flow of communication in both directions. And they must seek sources of understanding their company beyond just management without offending management.

· Issues of executive compensation and the relationship between boards and shareholders cannot be ignored, if only because they affect public perceptions of business and therefore its social legitimacy.

The full paper is available for download here.

Despite last year’s near-miss of a Money Market Fund catastrophe, the SEC’s current Money Market Reform proposal asks for only modest reforms that fail to address the key issues of this $3.8 trillion financial intermediary; indeed, that may well aggravate systemic risk.   First, the proposal does not appreciate that there are really two separate MMF types, retail MMFs and institutional MMFs, with different regulatory needs.  Retail MMF investors are looking for a bank account that combines safety with a higher rate of interest.  For them there is no substitute for fixed NAV, “safety and soundness” portfolio constraints and deposit insurance paid for with risk-adjusted premiums. Institutional MMFs, which now account for approximately 60% of MMF assets, function as low-cost providers of a corporate treasury function for large business entities.  This outsourcing saves these entities (corporations, life insurers, pension funds) the need to assemble individual portfolios of money market instruments the value of which would of course fluctuate.  Institutional MMFs thus should not carry a fixed NAV or the associated portfolio constraints.   Second, the SEC proposal fails to appreciate how MMF regulation creates systemic risk by artificially increasingly the supply of short term finance.  The consequence is to shift maturity transformation away from banks to short term credit markets, which, as last fall demonstrated, may seize-up in times of financial distress.  As suggested by the Group of 30’s report in February 2009, whether money market funds are a desirable innovation needs full scale examination.

These ideas are developed in a comment letter I submitted to the SEC on its Money Market Reform Proposal.   Here’s the text of the letter:

This letter is submitted by me personally in response to the SEC’s request for comments on its proposed Money  Market Reform Rule announced in Release No. IC-28807.   This letter proposes a different direction to reform, one that begins with the division between retail and institutional money market funds and that takes account of the different motives and needs of the investors in each.

“Reform” is of course timely in light of the fragility of Money Market Funds (“MMFs” ) revealed in the financial distress that followed the failure of Lehman Brothers.  As the Commission describes quite well in the Release, Lehman’s failure unexpectedly led to the “busting of the buck” by the Reserve Fund, which held a large amount of Lehman’s commercial paper in its portfolio.  The problems at the Reserve Fund in turn triggered a “run” especially by institutional investors on non-Treasury MMFs that was staunched only by an extraordinary MMF guarantee program provided by Treasury and by the creation of a special MMF liquidity facility by the Federal Reserve.  It is also widely believed that FDIC decisions in addressing bank failures – whether or not to protect bank creditors – were influenced by concerns about the solvency of MMFs that held bank paper.   Various MMFs undertook their own safeguards against the risk of runs, principally by selling off commercial paper (that is, making use of the Fed’s facility) and by shifting their portfolio composition towards Treasury instruments (Federal agency debt for the adventurous) and   by shortening maturities.  These measures had their own consequence, namely a sharp contraction in the demand for commercial paper and other short term credit instruments that industrial and financial firms had come to rely upon in their corporate finance plans.  The Federal Reserve responded with another special liquidity facility in which the Fed’s became a buyer of last resort of commercial paper.

…continue reading: Proposed Money Market Reforms Fail to Address Key Issues

(Editor’s Note: This post comes to us from Chih-Ying Chen of Singapore Management University.)

In my forthcoming Review of Accounting Studies paper entitled Do analysts and investors fully understand the persistence of the items excluded from Street earnings?, I investigate whether analysts and investors fully understand the persistence of the items excluded from Street earnings and whether their ability to understand it has improved since the adoption of Reg G. In the past, companies commonly presented their earnings on the basis of methodologies other than Generally Accepted Accounting Principles (GAAP) in their earnings releases. These non-GAAP earnings numbers, often referred to as pro forma earnings or core earnings, exclude certain items that managers claim to be nonrecurring. Analyst-tracking services also exclude nonrecurring items when they report analyst earnings forecasts and the actual earnings of firms (often referred to as Street earnings).

Due to the lack of an authoritative definition, pro forma or Street earnings could be measured in different ways at different times. Previous research has produced results that are consistent with the claim that items excluded from pro forma or Street earnings are recurring. Concerned that pro forma financial information may obscure GAAP results and mislead investors under certain circumstances, the U.S. Securities and Exchange Commission (SEC) introduced a new disclosure regulation, Regulation G (hereafter, Reg G), which came into effect on March 28, 2003. Reg G requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two. Since the adoption of Reg G, there is some evidence that the probability of disclosing non-GAAP earnings and using non-GAAP earnings exclusions to meet or beat analyst forecasts has decreased.

Since my focus is on analyst and investor understanding, I begin by comparing the association between Street exclusions and future Street earnings with analyst and investor expectations of this association. Analyst expectations are measured by the association between Street exclusions and subsequent analyst earnings forecasts, and investor expectations are inferred from stock returns around the time of the subsequent earnings announcements. Street exclusions are classified into MBF exclusions and non-MBF exclusions, where MBF exclusions are those that allow a firm to meet or beat analyst earnings forecasts (that is, the GAAP earnings number is below the consensus forecast of analysts, but the Street earnings number is not).

My empirical results show that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the adoption of Reg G. Analysts underestimate the persistence of non-MBF exclusions, but the degree of this underestimation is lower in the post-Reg G period. In contrast, there is little evidence to indicate that analysts underestimate the persistence of MBF exclusions in either time period. I also find strong (weak) evidence that investors underestimate the persistence of Street exclusions in the pre- (post-) Reg G period. As it is not possible for firms with excluded gains or without Street exclusions to meet or beat analyst forecasts using Street exclusions, I also analyze a restricted sample that comprises only the observations with excluded expenses. In this sample, I find that both MBF and non-MBF exclusions are less persistent and that analysts and investors are better able to understand these exclusions in the post-Reg G period. Further analyses show that only firms that had highly persistent Street exclusions in the pre-Reg G period had substantial declines in this persistence and improvements in the ability of analysts to understand it in the post-Reg G period.

Overall, my results suggest that Reg G constrained the practice of excluding recurring expenses from Street earnings to meet or beat analyst forecasts and helps analysts and investors to understand the persistence of Street exclusions.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Richard Squire of the Fordham University School of Law.)

According to the Treasury Department’s June 2009 report on the financial crisis, the collapse of AIG is Exhibit One in the case for more aggressive federal regulation of derivative contracts. Contrary, however, to the view adopted by Treasury, AIG did not fail merely because it sold credit default swaps linked to subprime mortgages. Rather, it failed because it also bought up mortgage-backed securities for its own investment portfolio. This meant that the risks borne by the company were correlated: its assets were likely to evaporate just as large-scale liability on its swap contracts was triggered. When the housing market collapsed, it was the combined damage to both sides of AIG’s balance sheet that brought down the company.

In a forthcoming article in the Harvard Law Review (available here), I demonstrate that seemingly reckless conduct of this type is in fact fully rational from the perspective of a firm’s shareholders. Such conduct reflects an opportunism hazard created by contingent debt, a hazard I term “correlation-seeking”. If a contingent liability is especially likely to be triggered when the liable firm is insolvent, the contract that creates the liability (such as a credit default swap) transfers expected wealth from the firm’s unsecured creditors to its shareholders. That transfer gives managers an incentive to sell contingent claims against their firm that correlate with the firm’s insolvency risk, even when doing so generates large social costs such as overinvestment and possible systemic risk. The capacity for correlation-seeking to destroy wealth is vast given the widespread current use of contingent debt contracts, which include not only derivatives such as default swaps and options, but also more traditional arrangements such as loan guaranties.

Despite the pervasiveness of the hazard, lawmakers and scholars have overlooked correlation-seeking. As a result, legal rules that aim to prevent opportunism toward creditors regulate contingent liabilities under principles designed for “fixed” liabilities—that is, debts that are certain to come due on a specified future date. Accordingly, contingent debt is treated as less of an opportunism hazard precisely because it is (by definition) less likely than fixed debt to come due. On this view, a contingent liability is like a fixed liability, only less so.

…continue reading: Shareholder Opportunism in a World of Risky Debt

(Editor’s note: This post comes to us from Jennifer Altamuro and Anne Beatty of the Fisher College of Business, The Ohio State University.)

In our paper How does internal control regulation affect financial reporting? which was recently accepted for publication in the Journal of Accounting and Economics, we examine the financial reporting effects of the Federal Depository Insurance Corporation Improvement Act (FDICIA) internal control provisions. The internal control provisions of the FDICIA provide exemptions that allow us to separately identify the effects of these provisions. In particular, the FDICIA exempts institutions with assets less than $500 million from its internal control monitoring and reporting requirements. More specifically, these institutions are exempted from FDICIA’s requirements that management issue a report on the effectiveness of internal controls over financial reporting, and that their independent public accountant attest to management’s report.

We compare annual and quarterly financial reporting of banks affected by FDICIA’s internal control provisions to that of unaffected banks. Specifically, we examine changes in the validity of the loan-loss provision, earnings quality, benchmark-beating and accounting conservatism. We analyze two samples: (1) a sample of US public and private banks included in the Fed Form Y9-C Regulatory Filing database and (2) a sample of publicly-traded banks included in the COMPUSTAT database. Our difference-in-differences research design isolates the effects of the FDICIA internal controls provision by controlling for changes in financial reporting unrelated to those provisions. We validate our control samples by testing for differences between the affected and unaffected firms in the pre-regulation period.

We compare the change in financial reporting for our affected and control firms in the 7-year periods before and after the passage of FDICIA. First we examine the properties of the annual financial reports. We find that the FDICIA-mandated internal control requirements lead to improvements in the validity of the loan-loss provision. Specifically, the association between the loan-loss provision and actual loans written off for affected banks strengthened in the period after the enactment of FDICIA. This improvement addresses the GAO’s (1994) concern “that banks’ loan-loss allowances included large supplemental reserves that were not linked to analysis of loss exposure or supported by evidence.” We find a corresponding increase in both earnings’ persistence and ability to predict cash flows, and a reduction in the use of earnings management to report positive earnings growth, suggesting that reducing supplemental reserves generally improves reporting quality. However, we also find that earnings conservatism declines for affected versus unaffected banks in both samples. This reduction in conservatism is also consistent with a reduction in supplemental reserves.

Next we examine the properties of quarterly reports to determine whether the effects are larger in the interim quarters relative to the fourth quarter, when an increased auditor presence might substitute for improved internal controls. Consistent with this hypothesis, we find that the improvements in the validity of the loan-loss provision, and the increase in earnings persistence and predictability of future cash flows, are all larger in the first three quarters than in the fourth quarter.

Taken together, these results suggest that the FDICIA-mandated internal control provisions resulted in the average bank exercising less reporting discretion. This reduced discretion creates a greater association between current reported accrual numbers and future cash flow numbers. However, as a result of this improved association, the reported accrual numbers also became less conservative. Thus, the conclusion about how this regulation affected the quality of financial reports depends on one’s definition of quality.

The full paper is available for download here.

(Editor’s Note: This post is based on a Sullivan & Cromwell LLP client memorandum, which is available here.)

SUMMARY

Late yesterday, the U.S. Treasury Department issued a policy statement entitled “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms” (the “Policy Statement”). The Policy Statement, which was developed in consultation with the U.S. bank regulatory agencies, sets forth eight “core principles that should shape a new international capital accord”. Six of the principles relate directly to bank capital requirements. The seventh of these principles relates to liquidity and the eighth to non-banking organizations.

The Policy Statement expands substantially upon the preliminary indications of Treasury’s thinking regarding regulatory capital reform as reflected in its June 17 white paper on financial regulatory reform, “A New Foundation: Rebuilding Financial Supervision and Regulation”, and makes clear that Treasury is contemplating a fundamental revamping of capital standards, both internationally through the Basel Committee process and in the United States. It would involve substantial revisions to, if not replacement of, major parts of the Basel I and Basel II capital frameworks and affect all regulated banking organizations, large and small, as well as institutions of systemic importance that are not currently regulated as banking organizations.

The Policy Statement:

• Proposes higher capital requirements “across the board” for all banking firms — and even higher capital requirements for systemically-important financial firms — and that these requirements be designed to protect the stability of the financial system as a whole as well as the solvency of individual firms.
• Emphasizes the importance of the quality of capital, stressing the need for common voting equity to constitute a “large majority” of tier 1 capital and for tier 1 capital to constitute a “large majority” of total regulatory capital.
• Addresses the so-called “procyclicality” of current capital standards.
• Expresses skepticism as to the reliability of credit ratings and internal models as tools for measuring capital requirements.
• States that risk-weightings of some assets and exposures — including credit derivatives, structured asset-backed and mortgage-backed securities, off-balance-sheet vehicles, trading positions, and equity investments — should be a function of not only their own risk characteristics but “also should reflect the systemic importance of the various exposure types”.
• Acknowledges that the existing capital standards “too often are a lagging indicator of financial distress” and suggests the consideration of “supplemental triggers” for prompt corrective action based, for example, on non-performing loans or liquidity.
• States that capital requirements “should reflect more forward-looking, through-the-cycle considerations” and rely less on value-at-risk models and point-in-time rating systems.
• States that a leverage ratio, although “a blunt instrument”, must be utilized.
• Calls for a new “conservative, explicit liquidity standard”.
• Proposes a number of actions to prevent the “re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability”.

…continue reading: Treasury Department Proposes Bank Capital Reforms

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

On July 17, the Securities and Exchange Commission (SEC) published in the Federal Register proposed changes in proxy statement disclosure rules affecting executive compensation as well as other matters. On July 31 the House of Representatives passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (H.R. 3269) (the Compensation Fairness Act or the act). The bill, received in the Senate Aug. 3, has been referred to the Senate Committee on Banking, Housing, and Urban Affairs. It is not known when, after the recess, the committee plans to take up consideration of the bill. This column will examine both of these developments (discussion of the SEC proposals is limited to those involving executive compensation).

Proposed Disclosure Rules
The proposed new rules affecting disclosure of executive compensation by companies subject to the disclosure rules of the Securities Exchange Act of 1934 (the 1934 Act) concern (a) disclosure of the impact of compensation policies and practices generally on risks of the employer, (b) the reporting of stock option and other equity awards in the Summary Compensation Table and (c) the reporting on compensation consultants.

Reporting on Risk-Related Aspects of Compensation. The proposed rules require companies to evaluate in the Compensation Discussion and Analysis (CD&A) those risks arising from general compensation policies and overall practices at the company that may have a material effect on the company. 17 CFR 229.402(b)(2). Disclosure is not limited to compensation arrangements with named executive officers. The proposed rules describe situations that may require particular attention in the CD&A such as compensation policies at business units that carry a significant share of the overall enterprise’s risk or units that vary significantly from the risk/reward structure of the company.

The proposed rules also suggest examples of issues that should be addressed such as compensation policies that may have special impact on risk (e.g., short-term versus long-term awards and how they relate to business results, short-term versus long-term), policies involving adjustments for changes in risk evaluation and how the company monitors its own responsiveness to changes in its risk environment. The proposed rules emphasize that the situations and the examples of issues described are illustrations only and not exclusive statements as to what should be disclosed.

Comment. The inherent subjectivity of a discussion of compensation arrangements and their impact on a company’s risks raises questions as to how helpful this discussion will be to shareholders. Companies are not likely to make observations on their risk policies and practices that might put the company, its management or the members of the board, including the compensation committee, in jeopardy. It is questionable whether very meaningful analysis of compensation as a risk factor will be obtained in such circumstances.

New Accounting for Stock and Stock Option Awards. The proposed new rule would change the current method for reporting grants of stock and stock options. Under it, awards would be reported in the Summary Compensation Table on the basis of the grant date fair market value of awards made during the fiscal year being reported. 17 CFR 229.402(c)(2)(v)-(vi). This contrasts with the current method, adopted in 2006, which requires reporting in the Summary Compensation Table for a fiscal year of the value of stock and stock options recognized in that year for accounting purposes under FAS 123R.

There have been complaints that the charge against earnings for a fiscal year failed to give shareholders the real “cost” for that year: the value of the stock awards and stock options granted in that year. In fact, the current proposal was proposed in connection with the 2006 rule-making but was dropped in the final rule in favor of the current expense-based reporting under FAS 123R. [1]

The proposed rule also would change the reporting of salary and bonus if deferred at the election of the executive. In such event, the deferred amount would be reported as an award in the column designed for the form of award in which the salary or bonus was deferred: Stock Awards, Option Awards or All Other Compensation; or, if pursuant to a non-equity incentive plan, it would be reported in a footnote to the Salary or Bonus column to which it relates and cross-referenced to the Grants of Plan-Based Awards Table.

In connection with the proposed rule, the SEC has requested comments on the possibility that it might require that stock and stock option awards made for services rendered in the fiscal year being reported be included in the Summary Compensation Table even though granted after the end of the fiscal year in question. [2]

New Rules Regarding Compensation Consultant Disclosure. The disclosure rules as adopted in 2006 require that a company (i) disclose its use of compensation consultants in connection with officer and director compensation, (ii) identify those consultants and (iii) provide certain other information regarding consultant services. The SEC has been concerned that some companies may retain a compensation consultant on executive and director compensation and, at the same time, retain such consultant on other compensation and benefit matters as well. In the introduction to the proposed rules, the SEC questions whether such a consultant can be truly independent in advising the committee on executive and director compensation matters.

The proposed rule provides that in such a case the compensation committee must disclose the compensation paid to the consultant for its services in connection with executive and director compensation matters for the committee and also the compensation paid such consultant for advice on other compensation matters. 17 CFR 229.407(e)(3)(iii).

Advice on plans of general applicability in which executives participate on the same basis as other employees (such as a qualified retirement plan) do not, by themselves, require separate reporting (and, if that were the only work performed, there would be no requirement under the proposed rule to report as to such a consultant or as to the fees paid to the consultant in that matter.) [3]

Compensation Fairness Act
The Compensation Fairness Act would adopt new rules for public companies requiring “Say on Pay” advisory votes by shareholders and new rules relating to compensation committee independence (including retention of independent advisers). [4] The proposed act also would prohibit compensation that encourages excessive risk-taking (captioned in the bill as “perverse incentives”). These prohibitions would apply to “covered financial institutions” (not to issuers generally like the first two proposals noted).

Say on Pay. Section 2 of the Compensation Fairness Act would amend Section 14 of the 1934 Act by adding a new subsection (i), requiring issuers to provide for a non-binding shareholder vote on executive compensation for named executive officers as required to be disclosed in the proxy statement. [5]

Section 14(i)(2), titled “Shareholder Approval of Golden Parachute Compensation,” also would require that a person making a proxy solicitation for a meeting at which shareholders are asked to approve an acquisition, merger, consolidation, proposed sale or other disposition of all or substantially all of the assets of an issuer must disclose in its proxy solicitation materials any agreements and other understandings with named executive officers of the issuer (or, in certain cases, named officers of the acquiring issuer) concerning compensation that is related to the acquisition, merger or sale or other disposition. In the event disclosure is required as provided in the preceding sentence, Section 14(i)(2)(B) provides that shareholders of the issuer must be given an advisory vote on such agreements and other understandings.

Comment. There has been limited experience with the effectiveness of the “Say on Pay” concept as a tool of corporate governance. Advisory-only votes on pay arrangements with senior executives have not been part of corporate practices long enough to make conclusions as to their effectiveness. In addition to TARP-related requirements as to Say on Pay, [6] there have been other legislative as well as shareholder-activist developments affecting Say on Pay. [7] Advisory votes on pay have a legitimate role in providing shareholders an opportunity to express their points of views without binding management. In fact, binding shareholder votes frequently are required on such matters as authorization of issuance of common stock in connection with compensation plans as well as pursuant to federal tax, securities and other regulatory requirements; and self-regulatory agencies such as the New York Stock Exchange have their own rules requiring in some cases shareholder approval of executive compensation plans. But there would be widespread resistance to subjecting executive pay arrangements across-the-board to mandatory shareholder approval.

The argument against such across-the-board mandatory shareholder approval is that determination of the level, structure and design of executive pay should be made by management under the supervision of the board of directors; shareholders, without direct involvement with the business, are not in a position to make the many, and often complex, choices involved in determining the level, structure and design of executive pay.

Compensation Committee Independence. Section 3 of the Compensation Fairness Act would amend the 1934 Act by adding Section 10B, establishing standards for determining independence of compensation committees. [8] Section 3 would require that each member of a compensation committee be “independent” under rules to be adopted by the SEC. Under the act, in order to be considered independent, a member of the compensation committee may not “accept any consulting, advisory, or other compensatory fee from the issuer” other than in his or her capacity as board or board committee member.

The Compensation Fairness Act also sets up rules for the compensation committee’s retaining compensation consultants in order to assure the latter’s independence from management’s influence. In this regard, Section 3 of the act provides for standards of independence for compensation consultants and other “similar” advisers to be established by the SEC.

Section 10B(d)(1), as amended by Section 3 of the act, provides that the compensation committee shall have the authority and responsibility to appoint and supervise such consultants. Section 10B(d)(2) requires that the compensation committee disclose in the proxy statement “whether the compensation committee of the issuer retained and obtained the advice of a compensation consultant meeting the standards for independence promulgated pursuant to subsection (c).” [9] Section 10B(f) requires that the issuer provide appropriate funding to the compensation committee to pay for such compensation consultants, independent counsel and other advisers.

Incentives That Encourage Undue Risks. The third subject of the Compensation Fairness Act is contained in Section 4 and captioned “perverse incentives.” Unlike Sections 2 and 3, it applies only to “covered financial institutions” as defined in Section 4(d)(2) of the proposed act. It would require “covered financial institutions” to provide reports to the appropriate federal regulator(s) (this term is defined in Section 4(d)(1)) that would enable the regulator(s) to determine whether the compensation structure:

(A) is aligned with sound risk management;
(B) is structured to account for the time horizon of risks; and
(C) meets such other criteria as the appropriate Federal regulators jointly may determine to be appropriate to reduce unreasonable incentives offered by such institutions for employees to take undue risks that—
(i) could threaten the safety and soundness of covered financial institutions; or
(ii) could have serious adverse effects on economic conditions or financial stability.

Section 4(b) of the bill directs “the appropriate Federal regulators” to jointly prescribe regulations that prohibit “any incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks” regarding the financial safety, soundness and stability of the covered financial institution. [10] Enforcement is provided for under Section 505 of the Gramm-Leach-Bliley Act (Section 4(c)) 15 U.S.C. §6805 (1999).

Comment. In contrast to the more broadly applicable rules proposed by the SEC discussed above, the Compensation Fairness Act provides for specific rules to be adopted and implemented by federal regulators prohibiting certain pay structures and incentive-based plans of “covered financial institutions.” It is at least subject to question whether federal regulators can adopt specific rules “prohibiting” certain types of compensation structure and incentive-based pay arrangements without unduly interfering with the business decisions necessary to run (and to compensate the people who run) banks and other financial institutions covered by the act.

In addition, the federal regulators must coordinate in adopting and implementing regulations to assure uniformity of treatment of the compensation arrangements of the different institutions. Disparity of treatment could jeopardize some institutions, and unduly favor others, depending on how different regulators interpret what constitutes “alignment” of specific pay structures and pay arrangements with “sound risk management.”

Endnotes:

[1] The proposed new rule also would eliminate the reporting of the grant date value in the grants of plan-based awards table and eliminate the footnote treatment to similar effect for directors in a footnote to the directors compensation table.
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[2] On a separate point, the SEC has requested comments on whether it should require restatement for named executive officers for the two preceding fiscal years being reported to the extent proposed changes in reporting of equity awards would change what had been previously reported for them for those years (including cases in which the executive had not been a named executive officer in the prior year). However, the proposal under consideration (as to which comments have been requested, as noted) would not require redetermination of who were the named executive officers for the prior years.
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[3] The proposed rule is not clear as to whether there should be a separate reporting of (i) compensation paid to a consultant for advice to the compensation committee on executive and/or director pay matters and (ii) compensation paid to the same consultant for separate advice to management in respect of the same matters. As written, the proposed rule appears not to require a separate reporting in the circumstance described in the preceding sentence.
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[4] Certain companies may be exempted from these provisions if the SEC determines that such an exemption would be appropriate, such as in the case of smaller reporting issuers.
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[5] In its “Say on Pay” proposal, the Compensation Fairness Act very much resembles compensation-related provisions of the Shareholder Bill of Rights Act of 2009 (S. 1074) introduced in the Senate in May by Senator Charles Schumer of New York.
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[6] See American Recovery and Reinvestment Act, Pub. L. No. 111-5, §7001 (2009), amending the Emergency Economic Stabilization Act, Pub. L. No. 110-343, §111 (the say-on-pay provision can be found in Section 111(e)); see also Treasury Interim Final Rule, TARP Standards for Compensation and Corporate Governance, 74 Fed. Reg. 28,394 (June 15, 2009) (to be codified at 31 CFR pt. 30) and SEC Proposed Rule, Shareholder Approval of Executive Compensation of TARP Recipients, 74 Fed. Reg. 32,474 (July 8, 2009) (to be codified at 17 CFR pt. 240).
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[7] For a brief discussion, see this column, June 19, 2009.
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[8] The statute defines “compensation committee” as a “committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of determining and approving the compensation arrangements for the executive officers of the issuer.” If an issuer has no such committee, the board’s independent members will be considered the compensation committee.
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[9] This disclosure requirement would apply to any proxy statement issued for an annual meeting (or special meeting in lieu of the annual meeting) on or after the one-year anniversary of the enactment of the act.
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[10] Section 4(a) of the proposed act requires that such regulations be prescribed no later than nine months after the act is enacted.
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