Monthly Archives: May 2008

Do Differences in Legal Protections Explain Differences in Ownership Concentration?

Posted by Cliff Holderness, Boston College Carroll School of Management, on
Friday, May 16, 2008
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This post is from Cliff Holderness of Boston College.

One of the major findings of the law and finance literature comparing corporate governance across countries is that large-percentage shareholders in public corporations are a response to weak legal protections for investors. Thus, it is reported that common law countries have less concentrated ownership than civil law countries because they afford stronger legal protections for investors. Similarly, it is reported that ownership is less concentrated in countries with strong investor protection laws.

The papers that reach these conclusions analyze country averages of ownership concentration instead of firm-level data. I just released a paper in which I show that this creates omitted-variable and aggregation biases. Aggregation, in particular, eliminates all within-group (country) variation, leading to artificial clustering. Most papers also use small samples of large firms. This makes inferences to country populations problematic because ownership concentration is inversely related to firm size and firm size varies across countries.

I correct for these limitations by analyzing firm-level observations; control for firm-level determinants of ownership concentration, including size; and use a broad sample of firms from 32 countries. When I take these steps there is no support for the widely held theory that large shareholders are a response to weak legal protections for investors. In particular, there is no relation between ownership concentration and whether a firm comes from a common law country. Similarly, there is no systematic relation between ownership concentration and 14 broad indices of investor protection laws. An index is as likely to be positively associated with ownership concentration as it is to be negatively associated with ownership concentration.

Given these findings, I re-examine the theoretical literature that predicts a negative relation between investors’ legal protections and ownership concentration. There are two branches to this literature, and they have diametrically opposed views on the role of large shareholders in public corporations. One branch models external blockholders who monitor management to stop the appropriation of corporate resources. The problem is that around the world blockholders typically are managers. The other branch, in contrast, models internal blockholders who appropriate corporate resources. Although this comports with the reality that most blockholders are insiders, it is inconsistent with evidence showing that in most countries firm value increases with ownership concentration. Both branches of the literature ignore the effects of large shareholders on management decisions. Given how broadly large shareholders can impact management and given that management decisions are not subject to judicial review, even in countries with strong legal systems, there is no reason to expect ownership concentration to vary with investors’ legal protections.

The full paper is available here.

Rhineland Funding Structure

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, May 15, 2008
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Editor’s Note: This post is from Allen Ferrell of Harvard Law School.

One of the off-balance sheet structures that has caused substantial losses for a European bank is the so-called “Rhineland Funding”. This structure has resulted in substantial losses for the German bank IKB Deutsche Industriebank. The Rhineland Funding conduit had substantial exposure to U.S. subprime mortgages and was unable to issue asset-backed commercial paper (ABCP) against the conduit and, moreover, was unable to obtain lines of credit from Deutsche Bank and other financial institutions to raise financing. As a result, IKB had to step in and provide liquidity to the Rhineland Funding conduit as a result of various liquidity standby facilities it had earlier provided the Rhineland Funding conduit.

It has been difficult to obtain details on the structures of these off-balance sheet conduits and the various entities affiliated with them. An organizational chart describing the Rhineland Funding structure and affiliated parties is available here.

How to Hire a Director

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Wednesday, May 14, 2008
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Editor’s Note: This column by Stephen Davis and Jon Lukomnik was originally published in the May 13, 2008 edition of Compliance Week.

The 2008 proxy season in the United States is revealing hazardous gaps among the responsibilities expected of corporate directors, the way directors are elected, and the way investors treat decisions about how they vote.

Directors stand at the fulcrum of modern American corporate governance. They weigh the perspectives of management against the interests of shareowners. Getting that balance right is what many of the corporate governance battles of recent years have been about. As a result, demands on directors have skyrocketed. They now spend about 200 hours a year, on average, overseeing a corporation. Delaware courts give huge deference to director judgment while ruling repeatedly that the greatest power shareowners have to protect themselves is the ability to elect the board.

Only recently, however, has the process for electing directors begun to catch up to the centrality of the role. Consider that only in the last two years have most S&P 500 companies embraced a majority-vote system where directors who fail to gain a majority of ‘yes’ votes must resign their seats. That sounds like garden-variety common sense. But it represents a swift and profound revolution in Corporate America.

For decades until 2006, virtually every board director gained office in a Soviet-style election where only ‘yes’ votes counted. Investors’ only other choice was to “withhold”—the procedural equivalent of staying home. Plus, boards generally faced ballots in a single resolution that bundled all candidates together; an entire slate could be installed to pilot a public corporation even if only a single share voted yes and every other vote was withheld. A shrinking (but still significant) minority of companies still feature such rules, even now.

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Nomination of Professor Troy Paredes as SEC Commissioner

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, May 13, 2008
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President Bush recently announced the appointment of law professor Troy A. Paredes as a Commissioner of the Securities and Exchange Commission. Pending confirmation by the Senate, Paredes will commence a five-year term on 6 June 2008, filling the seat Paul Atkins will vacate after almost six years in office.

Professor Paredes’ CV outlines his broad experience teaching, writing and practicing in the areas of corporate and securities law. After five years with major law firms in San Francisco and Los Angeles, in 2001 Paredes joined the Washington University School of Law. His scholarship has spanned a broad and varied mix of topics in law and related disciplines. The topics include: securities regulation; corporate governance; corporate control transactions; corporate finance; the theory of the firm; law and economics; behavioralism; and intellectual property transactions. Paredes joins Harvey J. Goldschmid as one of the few Commissioners who have been appointed from the legal academy.

In his writing, Paredes’ supports the use of market discipline – rather than mandatory rules – to protect investor interests, and has recommended that SEC Commissioners attempt to shape market practices through speeches, op-ed pieces, and other public statements. His recent papers, entitled Hedge Funds and the SEC: Observations on the How and Why of Securities Regulation (2007) and On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission (2006), deserve attention since, in many respects, they reflect his approach to securities regulation more broadly. He says that concerns about “empty voting” and other “abuses” by hedge funds should be “kept in proper perspective”. Rather than engaging in illicit behavior, “the vast majority of hedge fund managers are disciplined traders who make informed, although risky, trades.” He takes issue with the SEC’s 2004 decision to regulate hedge funds and expresses concern that the SEC “will at some point regulate venture capital and private equity funds”. Instead, he recommends that the SEC facilitate market discipline of hedge funds by adopting default rules or expressing its view on best practices, leaving the final decision to hedge funds themselves on which practices to adopt. As to the role played by SEC Commissioners, Paredes explains:

“Imagine the potential impact on the industry if the SEC chairman, particularly if joined by other commissioners and the directors of the Divisions of Investment Management and Corporate Finance, pushed a set of hedge fund best practices in a series of speeches, interviews, and op-eds in publications such as the Wall Street Journal and the Financial Times.”

Paredes also explains that when making rules the SEC – like other regulators – may exhibit unconscious biases that can frustrate good decision making. To guard against this and to avoid over-regulation, he recommends more rigorous use of cost-benefit analysis and “new organizational structures that might be mined from the experiences of companies,” among other tools.

In another relevant paper, The Firm and the Nature of Control: Toward a Theory of Takeover Law (2003), Paredes outlines his views on Delaware corporate law and his respect for greater shareholder choice in some contexts. He advocates greater respect for shareholder control in change of control transactions and limits on defensive tactics by target boards. More specifically, he advocates that Revlon duties be stiffened; that in considering Unocal’s “threat prong” Delaware courts should “take a hard look at a target board’s determination that a hostile bid poses a threat to the company” and thereby limit the “just say no” defense; and that “a change of board control should trigger Revlon, even without a change of ownership or voting control at the shareholder level.” These changes, Paredes argues, would result in a more robust takeover market, making directors and officers “more accountable for their actions” and “curb any future outbreaks of greed, disloyalty, and mismanagement on the scale of the [Enron, WorldCom, etc] abuses.”

His current research includes an empirical and theoretical assessment of what causes CEO overconfidence.

Many of Paredes’ other papers may be accessed here.

Millstein Center and the Mutual Fund Directors Forum Found Network of Independent Mutual Fund Leaders

Posted by Stephen Davis, Millstein Center for Corporate Governance & Performance, Yale School of Management, on
Monday, May 12, 2008
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This post is from Stephen Davis of the Yale School of Management.

On May 5, 2008, The Millstein Center for Corporate Governance and Performance at the Yale School of Management and the Mutual Fund Directors Forum partnered with independent leaders of mutual fund boards of trustees to found the Conference of Fund Leaders (CFL), a permanent new body composed of independent board chairs and lead independent directors of mutual funds in the United States. The CFL will provide a unique opportunity for the independent leaders of fund boards to come together with their peers to discuss governance issues that board leaders and their funds face; proactively present their views on policy matters important to fund investors and independent directors, regulators and lawmakers; and promote research into the value and impact of effective, independent leadership at mutual funds.

Mutual funds account for about one-third of equity ownership in North America and hold over $10 trillion in assets on behalf of American investors and savers. Fund boards negotiate the contracts that establish the price fund investors pay to have their assets managed, oversee critical aspects of their funds’ operations and work to protect fund investors from any conflicts of interest that may arise in the management of funds. The success of fund boards is thus crucial to fund shareholders’ ultimate success and their work is increasingly drawing public scrutiny. The CFL, which plans to convene two meetings a year, intends to serve as a unique peer network for sharing ideas and prompting independent collective action where appropriate.

The members of the CFL’s Steering Committee are: John Hill, independent chair of the Putnam Funds and founding chair of the CFL; Peter Clapman, independent chair of the AARP funds and vice-chair of the CFL; Ira Millstein, senior associate dean for corporate governance at the Yale School of Management; David Ruder, chairman of the Mutual Fund Directors Forum Board; Dwight Crane, independent lead director for Legg Mason Partners Equity Funds; William Foulk, independent chair of AllianceBernstein funds; Virginia Stringer, independent chair of First American Funds; and Roger Vincent, independent chair of ING Mutual Funds.

The CFL will be jointly administered by the Millstein Center for Corporate Governance and Performance at the Yale School of Management, which originated the project, and the Mutual Fund Directors Forum, the independent professional body representing U.S. independent fund directors.

The launch event is scheduled for late October in New York City. The agenda will focus on shareholder rights, board leadership and other current topics.

The founding of the CFL comes against the backdrop of recently adopted regulations by the U.S. Securities and Exchange Commission requiring mutual fund boards to be chaired by an independent. Until this SEC initiative, few such boards featured leadership separate from that of the fund family. The regulation itself remains in limbo after court rejection. The SEC has promised to restore it. Meanwhile, an estimated 65% of U.S. mutual funds have already acted to install independent chairs in anticipation of the rule becoming formalized. Most other funds have named independent lead directors.

Contact:
John Hill, chairman of the Conference of Fund Leaders and chairman of the Putnam Funds,
+1 203 625 2503, [email protected]

Stephen Davis, project director, Millstein Center for Corporate Governance and Performance,
+1 203 432 9689, [email protected]

Susan Wyderko, executive director, Mutual Fund Director Forum,
+1 202 521 6754, [email protected].

A United Nations Proposal Defining Corporate Social Responsibility For Human Rights

Posted by Martin Lipton, Wachtell, Lipton, Rosen & Katz, on
Friday, May 9, 2008
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This post is from Martin Lipton of Wachtell, Lipton, Rosen & Katz.

I have recently distributed a memorandum entitled “A United Nations Proposal Defining Corporate Social Responsibility For Human Rights,” which discusses a report by a Special Representative to the U.N. Secretary-General. The report has broad implications for global business and particularly for companies operating on a global basis, in emerging markets, in underdeveloped countries, or in countries that lack a democratic system. The report, which will be considered in a June session of the U.N. Human Rights Council, proposes that corporations bear the “responsibility to respect human rights,” that the State has a “duty to protect” against human rights abuses by companies, and that both the State and businesses must provide more effective access to remedies for human rights violations. In the memorandum, we explain that the framework recommended to the U.N. could impose on businesses an array of expansive obligations requiring close attention by corporate management and boards. The memorandum sets forth the core principles which the U.N. Human Rights Council may endorse to guide corporate responsibilities for human rights and additionally considers their implications for directors.

The memorandum is available here.

Court Imposes Caremark Fiduciary Duty on Corporate Officer

Posted by Francis G.X. Pileggi, Eckert Seamans Cherin & Mellott, LLC, on
Thursday, May 8, 2008
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This post is from Francis G.X. Pileggi of Eckert Seamans Cherin & Mellott, LLC. 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.

In Miller v. McDonald, et al., ( D. Del., Bankr., April 9, 2008), the Bankruptcy Court for the District of Delaware decided an issue of great importance to those who follow corporate governance issues related to the fiduciary duties of officers and directors. In this opinion on a motion to dismiss claims against an officer of a company, the Bankruptcy Court relied on decisions of the Delaware Chancery Court and the Delaware Supreme Court to deny a motion to dismiss in the course of ruling that Caremark duties would be imposed on an officer (who was not a director), that was on the management team when the President of the company committed fraud and other actions and omissions that ultimately led to the bankruptcy filing of the company. This is notable in part because there are not as many decisions that address the fiduciary duties of officers, as opposed to directors of a corporation.

Here is a summary of a Delaware Chancery Court decision of a few weeks ago that also imposed fiduciary duties on a corporate officer, (with a link to other similar cases and to a recent article on the topic by Professor Lyman Johnson).

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Delaware Court Rejects Per Se Rules for Financial Advisor Proxy Disclosures

Posted by William Savitt, Wachtell, Lipton, Rosen & Katz, on
Wednesday, May 7, 2008
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This post is from William Savitt of Wachtell, Lipton, Rosen & Katz. 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.

We have recently distributed a memorandum entitled Delaware Court Rejects Per Se Rules for Financial Advisor Proxy Disclosures, which discusses the ruling of the Delaware Court of Chancery in In re BEA Systems Inc. Shareholders Litigation, a lawsuit arising out Oracle’s $8.5 billion acquisition of BEA Systems. The court denied plaintiffs’ motion to enjoin a special stockholders’ meeting to vote on the merger on the basis of allegedly insufficient disclosure in the merger proxy. The ruling, issued from the bench, provides helpful further guidance regarding the application of Delaware’s materiality standards, especially as the relate to claims challenging the disclosure of investment banker analyses. The ruling also noted the importance of transactional and market context in evaluating claims that seek to interfere with shareholder decision-making or the timing of a proposed transaction.

The memorandum is available here.

The transcript of oral argument and rulings of the court is available here.

Judgment Too Important to be Left to the Accountants

Posted by Peter J. Wallison, American Enterprise Institute, on
Tuesday, May 6, 2008
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This post is from Peter J. Wallison of American Enterprise Institute.

The Financial Times recently published the following op-ed piece of mine, entitled Judgment Too Important to be Left to the Accountants.

Two serious asset bubbles–the dotcom explosion of the late 1990s and the recent dizzying ascension in housing prices–have developed in the US economy within the past decade.

Given their damaging consequences, it is time to look for causes. One area that merits attention is fair value accounting, which was adopted as policy by the accounting profession in the 1990s.

This accounting convention requires financial intermediaries to carry their assets at market values, even if those assets are not being held for trading purposes.

When the dotcoms were in vogue, the assets of securities firms and other equity intermediaries were inflated, just as, more recently, rising housing values made banks and other mortgage lenders look flush. Inflated balance sheets and income statements supported more borrowing and more leverage; suddenly, the markets were awash in liquidity and risk premiums fell to unprecedented levels. It could be argued, then, that fair value accounting was the hothouse in which these bubbles bloomed; when prices are rising this system seems both to stimulate and ride the wave of irrational exuberance.

But matters look much less agreeable when the same asset values are falling. Then, the process works in reverse, and the spiral points downwards.

As assets fall in value, leverage rises, creditors and counterparties demand more collateral coverage, and companies must sell assets that they can no longer finance. Forced asset sales drive down prices, causing further write downs of assets under fair value principles–even for those who are not selling. And so it goes on. The downward spiral is continuing as this is written, and where it stops nobody knows.

Fair value accounting also has a one-size-fits-all quality that mimics the inflexibility of over-regulation. Valuing assets with reference to the market seems reasonable for firms that earn their profits from, say, buying and selling securities. In that case, what the market will pay for the firm’s assets and liabilities at any given time may be a good way to assess its overall value. But what about intermediaries such as commercial banks, which are generally in the business of profiting from cash flows? Does it make any difference to an investor in a bank–an investor who is looking to the bank’s success in corralling cash flows–that the market value of the assets that produce these flows may vary?

Many banks point out that the cash flows on portfolios they have substantially written down are doing just fine. A wooden application of fair value accounting to banks–while it may simplify the work of accountants–seems to do a disservice to bank investors, and even more so bank depositors.

If, as banks claim, fair value accounting is causing commercial banks to appear much weaker than they are in fact, it is creating a financial crisis where a mere slowdown might have been warranted.

Fair value accounting is clearly the reigning orthodoxy among accountants, but is that the right test? Accounting is simply a measurement system. What we want to know determines what and how we measure. Which is more important, the balance sheet or the income statement? Do we want to measure financial strength or earnings per share or cash flows? Is the purpose to inform equity investors or creditors and counterparties? Does one measurement system meet all of these objectives?

Given its impact on institutions and whole economies, common sense suggests that we consider whether one means of measurement is the only one we should be looking at. The world view of accountants at a particular time should not determine the answers to these questions.

It is important to recall the famous remark of Clemenceau that war is too important to be left to the generals.

Electronic Arts’ Attempt to Exclude My Precatory Shareholder Proposal

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, May 5, 2008
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Editor’s Note: This post is from Lucian Bebchuk of Harvard Law School.

Electronic Arts, Inc. recently submitted to the SEC a no-action request seeking concurrence of the SEC Staff that a shareholder proposal I submitted may be excluded from the company’s proxy materials for the 2008 annual meeting. In response to the company’s no-action request, I filed a complaint, through my counsel, in the United States District Court for the Southern District of New York. The complaint seeks, among other things, a declaratory judgment that Electronic Arts may not exclude my proposal from the company’s proxy materials and an injunction requiring the company to include the proposal.

My proposal is precatory and recommends that the board of directors submit to a shareholder vote an amendment to the company’s charter or by-laws. The suggested amendment, if adopted, could facilitate by-law amendments initiated by shareholders. In particular, the suggested amendment could require the company to submit to a shareholder vote shareholder-initiated proposals for changing the by-laws that meet certain procedural and substantive requirements. The suggested amendment could also require the company to include such proposals in the company’s proxy materials for the annual meeting.

I view my precatory proposal as rather moderate and believe that its passage and implementation could well benefit the company’s shareholders. Many shareholders, I believe, would vote for the proposal if given the opportunity to do so. I also believe that, for the reasons indicated in the complaint, the company’s attempt to exclude the proposal from the company’s proxy materials is entirely without merit. I hope that the company will change its position and allow shareholders to vote on my precatory proposal. The text of my proposal is available here, the company’s no-action request is available here, and my complaint is available here.

I would like to express my appreciation to the law firm of Grant & Eisenhofer for its invaluable legal advice and representation in this matter. I also wish to thank Greg Taxin and Julie Gresham of Spotlight Capital, and my Harvard Law School colleagues Victor Brudney, Allen Ferrell, Howell Jackson, Reinier Kraakman, and Mark Roe, for helpful comments and conversations on my shareholder proposal.

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