Response to U.S. Senate Banking Committee

Katherine Rabin is CEO of Glass, Lewis & Co. This post is based on Ms. Rabin’s letter to Senator Dean Heller, Chairman of the U.S. Senate Subcommittee on Securities, Insurance & Investment.

June 1, 2018

The Honorable Dean Heller
Chairman
Subcommittee on Securities, Insurance & Investment
Senate Committee on Banking
324 Hart Senate Office Building
Washington, DC 20510

Dear Chairman Heller,

We received the letter dated May 9, 2018 regarding your review of the proxy advisory industry and the business practices of proxy advisory firms. We appreciate the opportunity to provide answers to your questions, as well as additional information about Glass Lewis.

We also wish to take this opportunity to respond to certain misleading, inaccurate and conflicted reports published by groups such as the American Council for Capital Formation (ACCF), the Manhattan Institute, Nasdaq and the U.S. Chamber of Commerce. To begin with, we would like to note the following facts:

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The Federalization of Corporate Governance

Marc I. Steinberg is the Radford Professor of Law at Southern Methodist University Dedman School of Law. This post relates to a recently published book by Professor Steinberg. Related research from the Program on Corporate Governance includes Federal Corporate Law: Lessons From History, by Lucian Bebchuk and Assaf Hamdani.

In my recently published book, The Federalization of Corporate Governance (Oxford University Press 2018) (ISBN 978-0-19-993454-6), I explore this process of federalization in the United States from 1903 to the present. Clearly, the states, particularly Delaware, traditionally have been and continue as principal regulators of the sphere of corporate governance. Nonetheless, to an increasing degree, the federal government, the SEC, and the national stock exchanges impact corporate governance standards. The book views this federalization as an evolutionary process that commenced at the beginning of the twentieth century. Going through periods of activism, gradual transition, and stagnation, the process intensified with the enactment of the Sarbanes-Oxley and Dodd-Frank Acts.

To view these Acts as representing a revolutionary transformation with respect to federal oversight of corporate governance is an exaggeration. Rather, they symbolize a period of enhanced activism whereby this federalization process was accentuated. From a historical perspective, between 1903 and 1914, 24 bills were introduced in Congress which sought to require federal chartering and/or the implementation of federal minimum substantive standards. During that era, both Presidents Roosevelt and Taft favored federal incorporation. Between 1914 and 1930, another seven bills were introduced in Congress seeking to effectuate similar objectives—with one such bill requiring that the Federal Trade Commission approve executive officer remuneration. Interestingly, the next significant legislative effort occurred 50 years thereafter with the Metzenbaum Bill of 1980 which prescribed federal minimum standards that largely focused on adherence to fiduciary duties, including with respect to related-party transactions. Although hearings were held through the years, none of these bills were enacted.

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Clarifying Appraisal Rights in Complicated Transactions

Gail Weinstein is senior counsel, Steven Epstein and Warren S. de Wied are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Epstein, Mr. de Wied, Philip RichterAndrea Gede-Lange, and Maxwell Yim. This post is part of the Delaware law series; links to other posts in the series are available here.

Related research from the Program on Corporate Governance includes Using the Deal Price for Determining “Fair Value” in Appraisal Proceedings by Guhan Subramanian (discussed on the Forum here).

In City of North Miami Beach Genl. Employees’ Retirement Plan v. Dr Pepper Snapple Group, Inc. (June 1, 2018), the Court of Chancery held that appraisal rights are not available to the stockholders of Dr Pepper in connection with a transaction structure (involving a reverse triangular merger and a special cash dividend to the target stockholders) which will result in the sale of control of the company.

Key Points

  • The court confirmed that the Delaware appraisal statute does not bestow appraisal rights simply upon a sale of control—rather, appraisal rights are available only under certain statutorily-specified types of transactions.
  • The court indicated that it will not “look through” a transaction structure to the “underlying economic and practical effect” in order to grant appraisal rights when they are not otherwise specifically provided under a “plain reading” of the statute.
  • The court held that appraisal rights are not available to Dr Pepper’s stockholders because Dr Pepper (as a parent of the entity actually merging) is not a “constituent corporation” in the merger. The court held that, in addition, appraisal rights are not available because the Dr Pepper stockholders are not relinquishing their shares in connection with the transaction.
  • The Dr Pepper structure may be used in conflicted controller transactions, but, in our view, it is unlikely that it would be more broadly used for the purpose of eliminating appraisal rights (as discussed below under “Practice Points”).

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Update on The New Paradigm: The Evolution of Stewardship Principles

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton publication by Mr. Lipton and Karessa L. Cain.

When The New Paradigm (which we prepared for the World Economic Forum) and similar corporate governance frameworks were published in 2016-17, there was a broad consensus among business leaders and investors on the critical need to restore a long-term perspective. Pervasive and acute pressures for near-term financial results have been discouraging R&D, capex, employee training and other types of expenditures that may weigh on short-term earnings but are essential for sustainable economic growth. The New Paradigm posited that both corporations and investors have important contributions to make to create an environment that facilitates long-term value creation. For their part, corporations need to demonstrate that they are well governed and have an engaged, thoughtful board and a management team diligently pursuing a credible, long-term business strategy. In return, investors should embrace stewardship principles and provide the support and patience that such companies require to pursue long-term strategies. Working together, these stakeholders can recalibrate systemic norms and expectations in order to better balance short-term and long-term horizons.

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George Stigler on His Head: The Consequences of Restrictions on Competition in (Bank) Regulation

Prasad Krishnamurthy is Professor of Law at the U.C. Berkeley School of Law. This post is based on a recent article by Professor Krishnamurthy, forthcoming in the Yale Journal on Regulation.

Like many pieces of financial legislation, the Dodd-Frank Act of 2010 was passed in the aftermath of a major financial crisis. Such crises have been a recurring feature of U.S. economic and political history since at least the nineteenth century. Nevertheless, it is only their aftermath, when the embers of the financial system are still aglow, that the necessary public support may exist for fundamental legislative reform. Once the crisis passes, memories fade and the public turns its attention to other matters, political and otherwise. The financial industry can then look forward to a period of benign neglect, during which it can more decisively influence Congress and the federal agencies.

The immediate aftermath of financial crises are an exception to the public-choice rule, articulated by George Stigler, that regulation mostly exists for the benefit of the regulated industry. Most major pieces of financial regulation—from the National Bank Act of 1864 on up to the Federal Reserve Act of 1914, the Banking Acts of 1933 and 1935, and the Dodd-Frank Act of 2010—imposed substantial costs on powerful, incumbent financial interests. In the periods between crises, however, the banking industry is better able to preserve opportunities for profit. For example, few would dispute the idea that the Interest Rate Adjustment Act of 1966, which set maximum rates of interest on deposit and savings accounts, ultimately redounded to the benefit of the banking industry.

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Sandbagging in Delaware

Daniel E. Wolf is a partner at Kirkland & Ellis LLP. This post is based on their Kirkland & Ellis memorandum, and is part of the Delaware law series; links to other posts in the series are available here.

In the private M&A context, “sandbagging” refers to a buyer, who despite having knowledge of a breach of representation or warranty by a seller at some time before closing, proceeds with the closing and then seeks indemnification from the seller for the breach of representation or warranty of which it had prior knowledge.

The popular belief among dealmakers has been that Delaware is generally “pro-sandbagging” meaning that, absent an express provision barring post-closing claims for known breaches (i.e., an “anti-sandbagging provision”), pre-closing knowledge of a breach is not a bar to seeking indemnification recovery as actual reliance by the buyer on the false representation is not a requisite component of a breach claim. Vice Chancellor Laster, in a 2015 transcript ruling, appeared to support this approach, saying:

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Observations on Culture at Financial Institutions and the SEC

Jay Clayton is Chairman of the U.S. Securities and Exchange Commission. This post is based on Chairman Clayton’s recent remarks, available here. The views expressed in this post are those of Mr. Clayton and do not necessarily reflect those of the Securities and Exchange Commission or its staff.

Thank you Bill [Dudley] for that kind introduction and for inviting me to speak today [June 18,2018]. [1] I’m planning to speak for fifteen or so minutes and to open the floor to questions.

I want to extend my congratulations to Bill Dudley on a very successful term. You are now a member of the long line of former leaders and perpetual culture carriers at the New York Fed. The respect for the New York Fed, among national and international regulators and, importantly, market participants of all stripes, is remarkable, but clearly well deserved. Congratulations are also in order for John Williams, who begins his term today. John, my colleagues and I at the SEC are looking forward to working with you in your new role.

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Audit Tenure and the Timeliness of Misstatement Discovery

Zvi Singer is associate professor of accounting at HEC Montreal, and Jing Zhang is assistant professor of accounting at the University of Alabama in Huntsville. This post is based on their recent article, published in The Accounting Review.

Is long auditor tenure beneficial or detrimental for audit quality? This is the question we are trying to address in this article. The impact of audit firm tenure and auditor rotation on audit quality have long been debated both within academia and by regulators in the US and globally. The debate has centered on two main opposing views. The positive view argues that longer auditor tenure leads to a higher quality audit via a learning effect, due to the accumulation of client-specific knowledge over time. An auditor that is more knowledgeable of the client is more likely to promptly identify financial reporting problems. Accordingly, regulatory intervention that limits the length of the auditor-client engagement is undesirable. The negative view argues that long auditor tenure may have a detrimental effect on audit quality for two reasons. First, long auditor tenure may lead to the development of economic and social bonds between the auditor and the client company due to continuous involvement. This, in turn, has the potential to impair the auditor’s objectivity and increase the likelihood of audit failure. Second, because the audit is performed year in and year out, the auditor may become complacent, due to the repetitive nature of the task. A complacent auditor, in turn, may fail to promptly detect misreporting, leading to audit failure. In contrast, a new auditor would bring a fresh viewpoint, which will benefit the audit engagement. Consequently, under the negative view, it is desirable to limit the length of the auditor-client engagement.

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Understanding the Dutch Poison Pill

Seve Jan van der Graaf is an analyst at Glass, Lewis & Co. This post is based on a Glass Lewis publication by Mr. van der Graaf.

Related research from the Program on Corporate Governance includes Toward a Constitutional Review of the Poison Pill by Lucian Bebchuk and Robert J. Jackson, Jr. (discussed on the Forum here), and The Case Against Board Veto in Corporate Takeovers by Lucian Bebchuk.

Ahold Delhaize, the biggest food retail group in the Benelux region with a rough market cap of €25 billion, is facing pushback from shareholders over a unique Dutch practice. The company recently announced that it had extended its call option agreement with a foundation called “Stichting Continuïteit Ahold Delhaize” or “SCAD” (roughly translated as the foundation for continuity of Ahold Delhaize), without giving investors the opportunity to vote on the deal.

To be clear, SCAD is not a charitable foundation—instead, the entity effectively functions as a poison pill for Ahold Delhaize. In Dutch corporate law, foundations need to have a purpose, but that purpose does not need to include the public good. As a result, these legal structures are the go-to anti-takeover mechanisms for Dutch companies, from family-owned entities to public issuers, taking several different forms. Here, SCAD was established for the purpose of protecting the continuity, independence and identity of Ahold Delhaize. It fulfils this purpose through the call option agreement, which gives SCAD the right to buy all 2,250 million of Ahold Delhaize’s authorised but unissued cumulative preference shares—which, not coincidentally, amount to 50% of the company’s authorised share capital, effectively blocking any attempt to take control.

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The Effect of Enforcement Transparency: Evidence from SEC Comment-Letter Reviews

Miguel Duro is Assistant Professor of Accounting and Control at University of Navarra IESE Business School, Jonas Heese is Assistant Professor of Business Administration at Harvard Business School, and Gaizka Ormazabal is Associate Professor of Accounting and Control at University of Navarra IESE Business School. This post is based on their recent paper.

Regulators increasingly rely on policies to disseminate their oversight actions, with the assertion that the disclosure of regulatory oversight activities can enhance the effect of enforcement by increasing third-party monitoring. However, the validity of this assertion has rarely been tested. In this study, we examine the effect of the public disclosure of the Securities and Exchange Commission (SEC) oversight activities on firms’ financial reporting. Specifically, we exploit a major change in the SEC’s policy regarding comment-letter reviews (henceforth “CLs” or “CL reviews”). Contrary to its prior policy, the SEC announced in 2004 that it would begin to publicly disseminate all CLs. From a research-design perspective, our setting provides three strengths: (1) the change was unexpected, (2) affected all public firms (all public firms are subject to CL reviews at least once every three years), and (3) did not modify the underlying regulation, but simply required the disclosure of CLs.

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