Monthly Archives: February 2008

Do Investment Banks Advising on M&A Deals Misuse Confidential Information?

The post below comes to us from Andriy Bodnaruk of the University of Maastricht, Massimo Massa of INSEAD, and Andrei Simonov of the Stockholm School of Economics and CEPR.

We have recently released a paper, entitled The Dark Role of Investment Banks in the Market for Corporate Control. Our paper studies M&A transactions in the US in the 20 year-period 1984 to 2003. Its focus is on transactions in which the investment bank advising the bidder in an M&A transaction also holds a stake in the shares of the target company at the time the deal was announced. In broad terms, the paper provides evidence as to (1) the extent to which investment banks advising bidders took advantage of confidential information garnered from their advisory assignments to acquire stakes in the target prior to the deal’s announcement; and (2) the extent to which the investment bank’s stake in the target compromised the financial interests of the bank’s bidder client.

We show that the presence of advisors helps to predict if a firm will be a takeover target. Conditioning on firms with similar industry and size characteristics, firms in which the advisors to the bidder hold a stake are 45 percentage points more likely to become targets, with the probability of becoming a target increasing from the unconditional sample mean of 4.2% to 6.1%. When we build the trading strategy long in the actual positions of the advising investment banks and short in the positions of the non-advisory banks, we find the strategy delivers 1.40% per month (adjusted for risk). This provides a lower bound estimate of the informational advantage that the advisory bank has relative to other sophisticated market players.

We further show that where an investment bank advising the bidder holds a stake in the target, the bidder will pay a higher premium for the target relative to deals in which the advisor holds no target stake. The target’s premium increases by 590 basis points from 30.6% to 36.5% relative to non-conflicted deals. An increase of one standard deviation in the (dollar value of the) average fraction of the target firm held by the advisor to the bidder implies a premium 310 (290) basis points higher than average. Deals involving the bidder’s advisor holding a stake in the target are more likely to succeed than other deals. Moreover, targets in these deals tend to be overvalued by more than 10% compared to deals in which the bidder’s advisor holds no target stake.

These findings suggest that advisors do take advantage of their privileged position, not only by acquiring positions in the deals on which they advise, but also by directly affecting the outcome of the deal in order to realize higher capital gains from their positions. These results provide important insights into the conflicts of interest affecting financial intermediaries that can both advise on corporate events and invest in the equity market.

The paper is available here.

Harmonization of GAAP and IFRS

Two committees of the American Accounting Association have produced detailed reports evaluating the SEC’s proposal to accept financial statements prepared in accordance with International Financial Reporting Standards (IFRS) from foreign-private issuers without reconciliation to U.S. GAAP (the SEC subsequently voted in favor of the proposal on November 15, 2007). This proposal was also discussed by Carl Olson in his November 28 post. These two papers highlight the difficult nature of this issue. Despite the common background of the members of each group and the common academic research utilized in preparing each proposal, the recommendations of the two committees are distinctly different.

The Financial Accounting Standards Committee report (available here) argues that since there is no conclusive research evidence that financial reports prepared using U.S. GAAP are better than reports prepared using IFRS, the prudent approach is to promote competition among them. This finding supports adopting the SEC’s proposal to permit foreign private issuers a choice between IFRS and U.S. GAAP.

The Financial Reporting Policy Committee report (available here) concludes that the proposed elimination of the GAAP reconciliation requirement is premature. This conclusion is based on research that finds that material reconciling items exist that are relevant to U.S. investors, that there are differences in the implementation of uniform standards and that compliance to IFRS or U.S. GAAP by foreign firms is a concern, that foreign firms benefit from greater access to capital by listing in the U.S., that U.S. investors tend to prefer U.S. GAAP, and that U.S. GAAP – IFRS harmonization might improve the functioning of the U.S. capital markets.

The Shifting Balance of Power Between Shareholders and the Board

The post below comes to us from Jennifer G. Hill of the University of Sydney, Australia, who is Visiting Professor at Vanderbilt Law School during Spring 2008 and 2009. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

I have recently completed a paper, entitled “The Shifting Balance of Power Between Shareholders and the Board: News Corp’s Exodus to Delaware and Other Antipodean Tales”. The paper is posted on SSRN here.

The abstract to the paper is as follows:

The balance of power between shareholders and the board of directors is a contentious issue in current corporate law debate. It also lay at the heart of a controversy concerning the re-incorporation of News Corporation (News Corp) in Delaware. News Corp has recently been the subject of intense media attention due its successful bid to acquire Dow Jones & Company. Nonetheless, News Corp’s move to the US, which paved the way for this victory, was neither smooth nor a fait accompli. Rather, the original 2004 re-incorporation proposal prompted a revolt by a number of institutional investors, on the basis that a move to Delaware would strengthen managerial power vis-à-vis shareholder power. The institutional investors were particularly concerned about the effect of the re-incorporation on shareholder participatory rights, and the ability of the board of directors to adopt anti-takeover mechanisms, such as poison pills, which are not permissible under Australian law. It was this latter concern, which ultimately led a group of institutional investors to commence legal proceedings in the Delaware Chancery Court in UniSuper Ltd v News Corporation (2005 WL 3529317 (Del Ch)).

The News Corp re-incorporation saga highlights a number of important differences between US, UK and Australian corporate law rules relating to shareholder rights, and provides a valuable comparative law counterpoint to the recent US shareholder empowerment debate. Other recent Australian commercial developments discussed in the article show a tension between legal rules designed to enhance shareholder power, and commercial practices designed to readjust power in favor of the board of directors. These developments are interesting because they demonstrate how some Australian companies have tried to create a de facto corporate governance regime, which mimics certain aspects of Delaware law.

Improving the Structure of Executives’ Equity-based Pay Arrangements

This post is from Jesse Fried of Harvard Law School.

I have just posted on SSRN a paper that put forwards a new approach to improving the structure of executives’ equity-based pay arrangements, Hands-Off Options. The current draft is available here.

The abstract is as follows:

Despite recent reforms, public company executives can still use inside information to time their stock sales, secretly boosting their pay. They can also still inflate the stock price before selling. Such insider trading and price manipulation imposes large costs on shareholders. This paper suggests that executives’ options be cashed out according to a pre-specified, gradual schedule. These hands-off options would substantially reduce the costs associated with current equity arrangements while imposing little burden on executives.

As I am continuing to work on this paper and a number of related projects, any comments would be most welcome.

Contractarians, Waiver of Liability Provisions, and the Race to the Bottom

This post is from J. Robert Brown, Jr. of the University of Denver Sturm College of Law.

We have just posted a paper on SSRN, Opting Only In: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, challenging one of the core positions of the contractarian approach to corporate law. Contractarians espouse an enabling approach to regulation allowing corporations to opt in or opt out and oppose a mandatory approach based on categorical rules. In their view, an enabling approach allows private ordering and enables owners and managers to derive the most efficient set of provisions, tailored to each company’s specific circumstances. This position has been reflected in attacks on legislations like SOX. Many commentators objected to its provisions because they were categorical and did not allow for private ordering.

Our study seeks to test this theory’s explanatory power in one area of corporate law.We chose a recent example of states replacing a categorical requirement with an enabling provision – waiver of liability provisions – for examination.These provisions allow companies to “opt out” of a rule that imposes liability on directors for breach of the duty of care.They may do so through the mechanism of an amendment to the articles.The amendment process requires the consent of both owners and managers, presenting conditions ripe, at least in theory, for the two groups to “bargain.”

We note first that waiver of liability provisions were authorized not in response to Van Gorkom, as is typically represented, but in response to the D&O insurance crisis occurring in the 1980s.In other words, the provisions were designed to interfere in the market for insurance.No evidence was offered, nor could we find any, indicating that this was a more efficient way of dealing with the economic uncertainties that existed at the time.

Second, we examined the waiver of liability provisions implemented by the Fortune 100 (data that we will eventually expand to the Fortune 500). Our analysis does not offer any evidence of private ordering. With one exception, all non-mutual companies in the Fortune 100 have eliminated liability for breach of the duty of care (in some states, this was done statutorily, with no company “opting out” of the no liability regime). Moreover, none of the waiver provisions reflected bargaining, with the wording of the provisions being remarkably similar. The companies in our sample waived liability to the fullest extent permitted by law.

Our analysis shows that one categorical rule favoring shareholders (liability for the breach of the duty of care) was replaced by another categorical rule favoring management (no liability for breach of the duty of care). While we do not rule out the possibility, we are not persuaded that any significant evidence demonstrating that one was more efficient than the other exists.

Our conclusion is supported by the fact that no actual bargaining occurs.Particularly where provisions are implemented by an amendment to the articles, it is management that drafts the language and only management that can initiate adoption or repeal.In other words, whatever theoretical benefit can result from the contractarian view of private ordering, it can only arise in practice if shareholders have the ability to meaningfully participate in the bargaining process.Our evidence suggests that they do not.

‘Law and Finance’ Revisited

This post is from Holger Spamann of Harvard Law School.

I have just released a working paper on the measurement of shareholder protection around the world, entitled “’Law and Finance’ Revisited” and available on SSRN here. The abstract is as follows:

The “Antidirector Rights Index” from La Porta et al.’s “Law and Finance” (1998) has been used as a measure of shareholder protection in almost 100 published studies. With articles by legal scholars questioning the accuracy of index values for several countries, I undertake a systematic study to verify these values for 46 countries with the help of local lawyers. My emphasis is on accuracy of the data; I do not change the original variable definitions. The study leads to a substantial revision: 33 of the 46 observations need to be corrected, and the correlation of corrected and original values is only .53. With accurate values, the well-known results of La Porta et al. (1997, 1998) no longer hold: accurate index values are neither distributed with significant differences between Common and Civil Law countries nor correlated with stock market size and ownership dispersion. All of the many results derived with the index will have to be revisited.

(NB: This paper is a revision of Spamann (2006).

By way of background, the cited article “Law and Finance” by La Porta, Lopez-de-Silanes, and Vishny (1998) started an entire literature of the same name. I have recently described the current state of this literature on this blog here.

Blog and Program Members Included in the “500 Leading Lawyers” List

Lawdragon magazine presented its third annual list of the “500 Leading Lawyers in America,” and the list includes eight individuals who are affiliated with the Harvard Law School Program on Corporate Governance and/or the Harvard Law School Corporate Governance Blog.

The 500 Leading Lawyers list includes professor Lucian Bebchuk (Harvard Law School), who serves as director of the Program, as well as four members of the Program’s advisory board: Peter Atkins (Skadden, Arps, Slate, Meagher & Flom), Theodore Mirvis (Wachtell, Lipton, Rosen & Katz), James Morphy (Sullivan & Cromwell), and Eileen Nugent (Skadden, Arps, Slate, Meagher & Flom).

In addition, the 500 Leading Lawyers list includes three guest contributors of the Blog: Jay Eisenhofer (Grant & Eisenhofer), Mark Morton (Potter, Anderson & Corroon), and Charles Nathan (Latham & Watkins).

Lawdragon’s list includes attorneys from private practice, in-house counsel, law professors, judges, government attorneys, and public interest lawyers. Lawdragon bases its selection of the leading lawyers through a combination of online balloting and independent research. Lawdragon’s announcement appears here.

SEC Advisory Committee Interim Report on Improvements to Financial Reporting

On February 14, the SEC Advisory Committee on Improvements to Financial Reporting presented its interim report to the Securities and Exchange Commission. The report includes 12 developed proposals, conceptual approaches representing the Committee’s initial views on matters, and currently identified matters for further consideration. The key themes of the report are the following: increasing emphasis on the investor perspective in the financial reporting system; consolidating the process of setting and interpreting accounting standards; promoting the design of more uniform and principles-based accounting standards; creating a disciplined framework for the increased use of professional judgment; and taking steps to coordinate Generally Accepted Accounting Principles (GAAP) in the US with International Financial Reporting Standards (IFRS).

Formed by the SEC in July 2007, the Committee was tasked to examine the US financial reporting system and to recommend changes to increase the usefulness of financial information to investors, while reducing the financial reporting system’s complexity. The Committee’s final report is some months away. The Committee includes representatives from the Financial Accounting Standards Board and the Public Company Accounting Oversight Board.

The interim report is available here.

Shareholder-Centric vs. Director-Centric Corporate Governance

This post is from John F. Olson of Gibson, Dunn & Crutcher LLP.

I’ve been giving some thought to the dust up last year between Marty Lipton and other governance experts as to whether Pfizer’s initiative of having several of its independent directors meet with its largest institutional investors represented a landmark in the decline of director-centric corporate governance, and have also been thinking about what we mean when we talk about director-centric vs. shareholder-centric governance. The working text of a talk I gave on the subject last week at the Corporate Governance Center at the University of Tennessee in Knoxville, at the invitation of Joe Carcello and Joan Heminway, is available here. I plan to do some more work on this and turn it into an article later this year. In the meantime, I’d greatly appreciate comments.

Does a Director Qua Director Have Standing to Sue Derivatively?

Editor’s Note: This post is from Steven M. Haas of Hunton & Williams LLP. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Does a Director Qua Director Have Standing to Sue Derivatively? No, so said the Delaware Supreme Court yesterday in Schoon v. Smith. The Supreme Court affirmed the Court of Chancery’s little-noticed ruling last year that dismissed a derivative claim brought by a director against the company’s other directors, including its controlling stockholder. The plaintiff-director, who was not a stockholder of the company, charged his fellow directors with, among other things, breach of fiduciary duty and unjust enrichment. The court held that, notwithstanding the equitable origins of derivative suits, the issue of director standing today is best left to the legislature. “Although the Delaware General Assembly has the prerogative to confer standing upon directors by statute,” the court wrote, “it has not chosen to do so.” Rejecting the American Law Institute Principles that give individual directors standing to sue on behalf of their corporations, the court continued that, “[b]ecause a stockholder derivative action is available to redress any breach of fiduciary duty, we decline to extend the doctrine of equitable standing to allow a director to bring a similar action.” The court concluded, however, by leaving itself a little room to permit directors to bring derivative suits, but only where the failure to do so would result in a “complete failure of justice”—a seemingly high standard.

As a practical matter, the decision is unlikely to have much significance because most directors are also stockholders. But the decision is still significant and may draw criticism with respect to its implications for corporate governance and director duties. In particular, the court noted that the concept of being an “independent director” does not mandate “a duty to sue on behalf of the corporation.”

The opinion is available here.

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