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

On October 22, 2009, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a comprehensive proposal (the “Proposal”) on incentive compensation policies that is intended to ensure that these policies do not undermine the safety and soundness of banking organizations by encouraging excessive risk-taking. The Proposal applies to all banking organizations supervised by the Federal Reserve (U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations (including securities subsidiaries) of foreign banks with a branch, agency, or “commercial lending company” subsidiary in the United States (each a “banking organization”)). It covers executive and non-executive employees who receive any current or potential compensation that is tied to achievement of one or more performance metrics, as well as “golden parachute” and “golden handshake” arrangements.

The Proposal is based on three key principles that are designed to govern incentive compensation arrangements. There are no prescriptive requirements, such as “caps” or “claw backs”, but there is extensive guidance as to the development, implementation and relevant considerations for these arrangements.

…continue reading: Fed Proposes Incentive Compensation Policies for Banking Organizations

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

Right now there are many voices clamoring to be heard regarding financial reform. This clamor is composed of some recommendations that are intuitive and others that are not. There are those calling for reforms that are limited to the factors that contributed to the crisis and others who see the possibility of broader legislative and administrative action as an opportunity. Some see it as an opportunity to advance their existing commercial interests, and others, like me, see it as an opportunity to reestablish a comprehensive, but flexible, capital markets regulatory framework that can better react to current and future events.

I think it is important to step back and think through the principles that should motivate any proposed reforms. As a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Rahm Emmanuel’s oft-quoted remark that we should not waste a good crisis is absolutely right. I firmly hope that the opportunity will not be wasted. Unfortunately, it is clear that some transformational changes are no longer on the table — such as a merger of the SEC and CFTC. In addition, there are robust efforts underway to scale back the Obama Administration’s effort to regulate the multi-trillion dollar over-the-counter derivatives industry.

My goal for today’s remarks is to discuss an appropriate construct for financial reform and to consider examples from the current debate that exemplify these principles.

…continue reading: Creating Reform That Is Sustainable for Investors

(Editor’s Note: This post is based on an op-ed piece published in today’s print edition of the Financial Times and is available here.)

The UK is reviewing rules governing its civil justice system, including class actions. Lord Justice Jackson is expected to publish a report in the next few months that will take up a number of proposals, including proposals to abolish the “loser pays” rule in collective lawsuits. Yet US experience – as illustrated by a current case before the US Supreme Court – may provide a useful caution. Jones v. Harris Associates L.P., argued on November 2, 2009, demonstrates that lowering the “loser pays” barrier could have serious consequences.

In the US, of course, each side in a lawsuit – including class actions ­ pays its own costs regardless of outcome, and plaintiff lawyers can often extract a settlement that covers their costs (plus a bit), even if the case would lose at trial. A prime example is Jones v. Harris. In that case, plaintiffs’ attorneys allege a financial adviser breached its duties by overcharging clients of its collective investment schemes (mutual funds) for services. In the trial court, they lost. The adviser, after all, had produced above-average returns over many years in return for fees well within industry norms – and well below typical advisory fees in the UK. But the case has survived two rounds of appeal – despite independent trustees having negotiated the fees on behalf of investors, despite investors having approved the fees, and despite the fact that investors are free to liquidate at net asset value at any time and move their funds elsewhere in a highly competitive market.

…continue reading: A Costly Lesson in the Rule of “Loser Pays”

(Editor’s Note: This post comes from Ryan Bubb and Alex Kaufman of Harvard University.)

Perhaps no academic paper has done more to convince scholars and policymakers that mortgage securitization led to lax screening by lenders and fueled the subprime crisis than did the recent paper by Keys, Mukherjee, Seru, and Vig (forthcoming in the Quarterly Journal of Economics, 2010) (hereafter, KMSV, who published a post in June on the Forum, which is available here). In an innovative paper, they argue that mortgage purchasers follow a “rule of thumb” in deciding which loans to purchase: they are, for exogenous reasons, much more willing to buy mortgage loans given to borrowers with credit scores above 620 than those given to borrowers with credit scores below 620. In a dataset containing only securitized loans, they find that loans made to borrowers just above 620 (where securitization is easy) default at a higher rate than those just below and argue that this is strong evidence that securitization really did result in lax screening by lenders.

In a new paper, Securitization and Moral Hazard: Evidence from Lender Cutoff Rules, which we recently presented at the Harvard Business School / Harvard Economics Finance Lunch Seminar, we reexamine the credit score cutoff rule evidence with a better dataset and through a theoretical lens that assumes rational equilibrium behavior and reach a very different conclusion.

…continue reading: Securitization and Moral Hazard

(Editor’s Note: This post is based on a Kirkland & Ellis LLP client memorandum by David Fox, Daniel E.Wolf, and Susan J. Zachman.)

Much has been written about the advantages of structuring a friendly acquisition as a tender offer followed by a back-end squeeze-out merger as compared to a single-step merger. Some of these perceived benefits include speed to closing, avoiding adverse recommendations from proxy advisory firms such as RiskMetrics (ISS) and mitigating the risk of “empty voting.” With SEC clarifications to the “best price” rules in 2006 and the occurrence of a few all-equity sponsor buyouts, we have seen a significant uptick in tender offer activity in both the private equity (e.g., Apax/Bankrate and Apollo/Parallel Petroleum) and strategic (Bristol Myers/Medarex and J&J/Omrix) spaces. In considering a tender offer structure, practitioners should be aware of a number of quirks that have come to light in recent tender offer transactions that may impact or offset the advantages of using this structure.

The policies and practices of index and quantitative funds with respect to participation in tender offers vary widely. Many such funds will not tender into an offer where the market price is above the offer price. Moreover, many will not tender into an offer at all, regardless of the relationship of the market price to the offer price, so long as the stock is still included in the relevant index the fund is mirroring or tracking. In situations where there is significant holding of the target stock by these funds and reaching the minimum tender condition is a close call, these policies and practices can be determinative of success or failure. In addition, to the extent such fund decisions are in fact affected by market price at the time of the expiration of the tender offer, these practices create an additional opportunity for arbitrageurs interested in the success (or failure) of a tender offer to influence the outcome of the offer by effecting minor price movements above or below an offer price. Finally, even if a tender offer is successful in achieving the minimum condition, the ability of an acquirer to reach the minimum threshold (usually 90 percent) required to effect a short form merger on the back end (and thereby avoid the expense and delay of a full-blown proxy statement) may be constrained by the behavior of those funds that will not tender under any circumstances while the stock is still in the relevant index.

…continue reading: Some Tender Offer Quirks

(Editor’s Note: This post comes to us from John Mark Zeberkiewicz and Joseph L. Christensen of Richards, Layton & Finger, P.A.)

The SEC recently announced that it would delay voting on the adoption of its mandatory proxy access regime to consider the comments and feedback it received in response to its proposed Rule 14a-11. Meanwhile, at the state level, corporate practitioners are closely following whether (and, if so, in what form) Delaware corporations will voluntarily adopt proxy access bylaws pursuant to the recent amendments to the DGCL. In a brief article appearing in the latest issue of The Review of Securities & Commodities Regulation, we compare Delaware’s approach of authorizing corporations to adopt narrowly tailored proxy access bylaws to the SEC’s approach of prescribing a generally applicable proxy access rule. We illustrate the differences between the two approaches by describing a model proxy access bylaw adopted under the DGCL and pointing out various ways in which that model bylaw could be modified to meet the needs of a particular corporation. Some highlights of the model bylaw are as follows:

• Granting the proxy access right to the stockholder or group with the greatest holdings (14a-11 grants the right based on a first-in-time system)
• Requiring the stockholder proponent (and each member of a group) to continue to hold shares through the date of the meeting
• Prohibiting the stockholder proponent (and each member of a group) from materially increasing its ownership stake for a specified period
• Excluding nominations from proponents whose nominees have failed to gain substantial support in prior elections
• Requiring a stockholder nominee to submit a conditional resignation that would become effective upon a finding that information included in the proponent’s nomination request, or information furnished by the proponent and included in the proxy statement, was false or misleading
• Requiring proponents to indemnify the corporation against any liability, loss or damage arising out of a stockholder nomination submitted pursuant to the bylaw

The article is available here and the model bylaw (with annotations explaining ways in which various provisions may be modified) is available here.

(Editor’s Note: This post comes to us from Tracy A. Thomas of the University of Akron, and is based on a comment in the Washington University Law Review.)

In March 2009, ailing insurance giant American International Group (AIG) triggered a national outcry when it paid out $165 million in government bailout funds for employee bonus incentives. [1] President Obama called the bonus payments an “outrage” and promised that his administration would “pursue every single legal avenue to block these bonuses and make the taxpayers whole.” [2] He chastised the firm for its audacity of using borrowed taxpayer monies to reward financial recklessness and greed. This was the same company, of course, who within days of receiving its first infusion of government cash in September 2008, sent its executives on a half-million dollar boondoggle retreat at a fancy desert spa. [3] And just several months after the initial fiasco, AIG tried to award $265 million in further bonuses, [4] adding to performance bonuses of $454 million paid to employees and executives in 2008. [5] It was just over a year ago when AIG turned to the government for its survival. The government stepped in to assist AIG when the company faced imminent death from its risky financial derivative products that were backed by precarious mortgages. [6] Fearful that the toppling giant would trigger a cataclysmic domino effect, the government authorized the bailout funds to keep AIG, and the entire U.S. financial sector, afloat. [7] The government agreed to loan AIG the money, now totaling over $173 billion, collateralized with AIG’s assets and an 80% equity ownership of the company. [8] The first infusion of cash to AIG was authorized by the Federal Reserve in September 2008, supplemented with funds authorized in October by Congress in the $700 billion bailout bill, the Emergency Economic Stabilization Act (EESA), which established the Troubled Assets Relief Program (TARP).

As a result of the AIG bonus debacle, the President and Congress took several steps to try and avoid these problems in the future. In the EESA, Congress gave the Treasury Secretary the power to require these troubled financial institutions to meet appropriate standards for executive compensation, but did not directly prohibit the type of employee bonuses at AIG. [9] The subsequent American Recovery and Reinvestment Act (Recovery Act), passed in February 2009 after the transition to the Obama administration, added significant new restrictions for highly-paid executives of financial institutions that receive TARP assistance, including prohibitions against paying bonuses, retention awards, or incentive compensation, except as payments of long-term restricted stock. [10] President Obama also installed Kenneth Feinberg, former special master of the 9/11 Fund, as the pay czar to oversee all employee bonuses and payments for companies receiving large amounts of bailout funds, including AIG. [11]

…continue reading: Bailouts, Bonuses, And The Return Of Unjust Gains

(Editor’s Note: This post comes from Francois Brochet of Harvard Business School.)

In my paper, Information Content of Insider Trades before and after the Sarbanes-Oxley Act, which was recently accepted for publication in the Accounting Review, I examine whether Section 403 of SOX has resulted in the provision of more timely and relevant information to market participants in the United States. SOX Section 403 addresses the issue of insider trading disclosure, by requiring insiders to report their trades to the Securities and Exchange Commission (SEC) on a Form 4 within two business days. Until August 2002, the requirement had only been to file Form 4 with the SEC within ten days after the close of the calendar month in which the transaction had occurred.

Using stock returns adjusted for book-to-market and size and abnormal trading volumes as proxies for information content, I find evidence that filings of insider purchases are significantly more informative after SOX. Over a three-day window beginning with the receipt of the form by the SEC, the pre- and post-SOX mean cumulative abnormal returns are 0.59 percent and 1.89 percent, respectively, while the pre- and post-SOX average daily trading volumes are 1.03 percent and 12.03 percent higher than normal, respectively. These differences are all statistically significant. In the case of insider sales, mean daily trading volumes around post-SOX filings are significantly higher than normal (1.15 percent over a three-day window) and greater than they were pre-SOX. In contrast, mean abnormal returns are more negative around pre-SOX filings than around post-SOX filings (-0.28 percent and -0.11 percent, respectively, over a three-day window). All results except for stock returns around filings of insider sales suggest that SOX has increased the information content of Form 4’s. However, additional findings indicate that, after controlling for confounding factors such as preplanned trades and litigation risk, stock returns around filings of sales are also significantly more negative after SOX.

I also find that, after SOX, insiders are less likely to sell shares immediately prior to negative stock returns and ahead of earnings news that falls short of analyst forecasts. This finding suggests that there is a decrease in informed insider selling around SOX. In the remainder of the paper, I use a variety of supplemental tests to provide further support to my causal attribution of the increase in information content of Form 4 filings to Section 403 of SOX.

The full paper is available for download here.

(Editor’s Note: This post is based on an article by Professor Hamermesh in the Widener Institute of Delaware Corporate and Business Law)

In a very interesting opinion on a matter of first impression, Vice Chancellor John Noble has indicated that the refusal of a board of directors to accept the resignation of a director who fails to obtain a majority vote under a “Pfizer-style” majority vote resignation policy is largely immune from judicial review.

The case – City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., decided September 29, 2009 – involved something of a collateral issue: namely, whether to permit inspection of documents relating to the board’s decision to reject the proffered resignations of three directors.  In rejecting that demand, however, the court suggested that such a rejection would not ultimately be tested under standards of judicial review more demanding than the business judgment rule.  For reasons explained below, I question whether that degree of deference should prevail as a general rule, especially in the situation where the majority voting rule exists as a requirement in the bylaws, rather than only as a matter of board policy.

The three directors in question, while elected by the required plurality vote as specified in Axcelis’ bylaws, did not receive a majority of votes cast at Axcelis’ 2008 annual meeting.  (The opinion suggests that this shortfall resulted from an ISS recommendation based on the 7-member board’s refusal to support a proposal to dismantle the board’s classified structure).  As a result, and as mandated by a governance policy adopted by the board of directors (a so-called Pfizer type policy), those three individuals were required to submit their resignations.  Under the policy, however, the board of directors had the discretion to reject the resignations.  In announcing the board’s rejection of the three directors’ policy-mandated resignations, Axcelis referred to the experience of the directors, their membership on key committees, and the anticipated need to supervise negotiations with a potential bidder for the company.

Over six months after the annual meeting, and after a very disappointing outcome of the bidding negotiations, the stockholder plaintiff made a formal demand to inspect documents, mostly relating to the board’s dealings with and evaluation of a potential bidder’s acquisition proposals.  The demand also included the following two categories:

6. All minutes of agendas for meetings (including all draft minutes and exhibits to such minutes and agendas) of the Board at which the Board discussed, considered or was presented with information concerning or related to the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

7. All documents reviewed considered, or produced by the Board in connection with the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

The stated purpose for this inspection was apparently to investigate possible waste or mismanagement, a traditionally accepted basis for inspection under Section 220 of the Delaware General Corporation Law.  Under settled Delaware law, all the plaintiff had to proffer to become entitled to the inspection demanded was “some evidence to suggest a credible basis from which [this Court] can infer that mismanagement, waste, or wrongdoing may have occurred.” And as the Vice Chancellor acknowledged, this evidentiary requirement has accurately been described as “‘the lowest possible burden of proof’ in Delaware jurisprudence.”

…continue reading: Delaware Decision Defers to Retention of Directors Under a “Majority Vote Resignation Policy”

(Editor’s Note: This post is based on a Davis Polk & Wardwell LLP client memorandum; the primary authors of the memorandum are Ning Chiu, William M. Kelly and Richard J. Sandler.)

The U.S. IPO market, which has been in the doldrums since 2007, has recently been showing signs of life. We have recently completed several large transactions, and our pipeline of deals in process is more robust than at any time in recent memory. With more companies working on and considering IPOs, this is a good time to release our survey of corporate governance practices for IPO companies. Our survey focused on corporate governance at the time of IPO for the largest 50 U.S. company IPOs in 2007 and 2008. The results are presented separately excluding controlled companies in recognition of their different governance characteristics.

• Click here to access the survey results including controlled companies.
• Click here to access the survey results excluding controlled companies.

…continue reading: Survey of Governance Practices for IPO Companies