Monthly Archives: July 2008

Which CEO Characteristics and Abilities Matter?

This post is from Steven Kaplan of University of Chicago.

Given their leadership positions and compensation, CEOs likely have a significant impact on their companies’ success. And, of course, there is a great deal of anecdotal evidence about what CEOs do and how they matter, particularly in the popular press. Surprisingly, economic theorists provide little guidance, and there is very little systematic, large sample, empirical evidence in the economics, finance and management literatures on how and why CEOs matter.

In “Which CEO Characteristics and Abilities Matter?” Mark Klebanov, Morten Sorensen and I provide new evidence on CEO characteristics and abilities, and their relations to hiring, investment decisions, and firm performance. The problem, historically, is finding information on CEO abilities or characteristics at the time the CEO is hired. We were able to obtain detailed assessments of 316 CEO candidates for positions in firms funded by private equity (PE) investors – both buyout (LBO) and venture capital (VC) investors. The candidates were assessed on more than 30 characteristics, including efficiency, teamwork, and analytical abilities. The assessments were performed from 2000 to 2006 by ghSMART, a firm that specializes in assessing top management candidates.

We find that abilities are generally positively correlated. The abilities can be organized along two important dimensions: (1) general talent and (2) team player and interpersonal talents versus fast, aggressive, and persistent behavior.

We then relate abilities to hiring, investment decisions, and outcomes. CEOs are hired based on general talent and incumbency (firm specific knowledge and skill). Many individual abilities, both team-related and execution-related, are significant, particularly for outsider hires.

Success is also related to general talent, particularly for LBOs. However, when considering team versus execution-related skills, success seems to be more strongly related to execution skills, particularly for LBOs, and not related or negatively related to the interpersonal, team-related skills. And success is not related to incumbency.

The results suggest that CEO talent can be measured and those talents are important for hiring, investment and success. General talent matters for success. However, on the margin, execution-related attributes, not team-related attributes seem to drive success. This suggests that team-related attributes may be overweighted in CEO hiring decisions.

The full paper is available for download here.

“Clawbacks” of Executive Compensation

My colleagues and I recently published our thoughts on issues to be considered by boards of directors in deciding whether, and how, to implement provisions addressing the “clawback” of executive compensation. Clawback provisions have become increasingly common in the past few years, and we expect that they will remain a focal point for boards of directors, both because of the ongoing spotlight on executive compensation and because of the attention that institutional shareholders and governance activists have focused on clawbacks as a significant corporate governance and executive compensation issue.

Clawback provisions vary by company, but they share a common goal of enabling companies to recover performance-based compensation to the extent they later determine that performance goals were not actually achieved, whether due to a restatement of financial results or for other reasons.

For boards of directors, the threshold question to consider is whether to address clawbacks in the first place. Doing so sends a message to shareholders that the board is committed to sound executive compensation practices and effective corporate governance, and voluntary implementation of clawback provisions will reduce the likelihood that a company will receive a shareholder proposal. On the other hand, companies need to consider whether the adoption of a clawback will adversely affect their ability to attract and retain executives.

Once a board decides to adopt a clawback provision, there are a number of issues to be addressed in formulating the provision. The memo below goes into more detail about these issues, but they include the following:

1. the individuals to whom the clawback provision should apply (the CEO and CFO, all executive officers or all employees)

2. the types of awards to which the clawback provision should apply (short-term or long-term, or both)

3. the circumstances that should trigger the clawback provision (a material restatement, restatements generally, or any error in financial information)

4. the type of conduct that triggers application of the clawback provision (misconduct by the particular individual from whom the company seeks to claw back compensation, misconduct by any employee, or any conduct that results in incorrect financial information)

5. whether the clawback provision should grant discretion to the board in determining whether misconduct occurred and whether to claw back compensation

6. the extent to which the clawback provision should modify existing employment agreements, compensation plans and award agreements

7. how far back the clawback provision should reach

We welcome comments on this subject, including views of readers as to which approaches make the most sense in various situations. Also, we would be glad to have any examples of cases where a board of directors has actually enforced a clawback policy or contractual provision. The memo is available here.

Do Boards Pay Attention when Institutional Investor Activists ‘Just Vote No’?

This post comes from Tracie Woidtke, a member of the Finance faculty at the University of Tennessee College of Business Administration, and a Research Fellow at the Corporate Governance Center at the University of Tennessee.

In a forthcoming Journal of Financial Economics article co-written with Diane Del Guercio and Laura Seery, entitled Do Boards Pay Attention when Institutional Investor Activists ‘Just Vote No’?, we examine whether the external pressure of a ‘just vote no’ campaign is sufficient to motivate directors to act in shareholders’ interests. ‘Just vote no’ campaigns are organized attempts by activists to convince their fellow shareholders via letters, press releases, and Internet communications, to withhold their vote from one or more directors in an effort to communicate a message of shareholder dissatisfaction to the board.

Our study utilizes a comprehensive sample of 112 publicly announced ‘just vote no’ campaigns during the period 1990 to 2003. We find that ‘just vote no’ campaigns have several characteristics in common with shareholder proposals in addition to their non-binding nature. Specifically, the typical campaign targets a large, poorly performing firm, and is sponsored by a public pension fund. Although other proponent types sponsor campaigns, we only observe institutional investor proponents, and not the small individual shareholders who commonly sponsor shareholder proposals. Proponents typically have broad campaign goals, commonly expressing overall dissatisfaction with firm performance and/or with management and board decisions on firm strategy. Some campaigns, however, are narrowly focused on corporate governance issues, such as removing an insider from the compensation committee. Campaign proponents are typically able to garner vote support from their fellow shareholders.

In contrast to the shareholder proposal literature, we find consistent evidence across a broad set of measures suggesting that on average campaigns are effective in spurring boards to act. The typical campaign target has significant post-campaign operating performance improvements. Moreover, we find a forced CEO turnover rate of 25% in target firms in the one year following a campaign, a rate more than three times higher than the 7.5% rate for a control sample matched on sales and performance, and over 12 times the annual 2% rate in the general population of firms. We find this result to be robust to controlling for a variety of firm performance and governance control variables, as well as for concurrent events, such as changes in the board of directors or external pressure from block-holders. Further analysis reveals that the improvements in operating performance are primarily driven by the campaigns motivated by firm performance and strategy reasons, and not by the campaigns focused on general corporate governance practices. In fact, within these campaigns motivated by firm performance and strategy reasons, we find that boards take a variety of value-enhancing actions; 31% of these targets experience disciplinary CEO turnover and 50% of the remaining targets that do not dismiss the CEO make other strategic changes. Consistent with these board actions being value enhancing, post-campaign operating performance improvements are economically and statistically significantly higher in these sub-samples of target firms. Overall, our evidence suggests that activists can be successful at disciplining managers and directors despite the non-binding nature of withholding votes.

The full paper is available for download here.

Board Manages CA, Inc. … No Way!

Editor’s Note: This post is from Joseph Hinsey of Harvard Business School. 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.

Earlier this year, the SEC submitted to the DE Supreme Court two questions pertaining to a bylaw proposal – requiring CA to reimburse the reasonable expenses of a successful “short-slate” board candidate nominated by a stockholder (unaffiliated with management) – that had been submitted by a shareholder for inclusion in the forthcoming CA proxy materials. In its recently issued AFSCME/CA opinion, the Court concluded “yes” to the first question (i.e., whether the bylaw proposal would be a proper subject for shareholder action) … AND … concluded “yes” to the second question (i.e., whether if adopted, it would cause CA to violate any DE law to which it is subject).

The core rationale for the second “yes” was that the bylaw would preempt the Board’s fiduciary duty to exercise its discretion (vis-à-vis any such request) by mandating the payment. The Court concluded that “the Bylaw, as drafted, would violate the prohibition[s] … against contractual arrangements that commit the board of directors to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders”. [emphasis added, footnote omitted]

There has been considerable professional commentary about the Court’s decision. In some cases, writers have taken a short-cut by stating that the problem with the proposed bylaw was that it would interfere with the directors’ role vis-à-vis “management” of the enterprise (e.g., the decision “reaffirms the bedrock principle that the directors of the corporation, not the shareholders, manage the business and affairs of the corporation”). That characterization of the board’s “management” role calls for the recollection of a bit of corporate-law history.

In the early 1970s a prominent outside director – noting that (then-current) DE law “required” him and his fellow directors (serving on the board of a major publicly-owned DE corporation) to manage the business and affairs of that enterprise – demanded that the board be provided a separate staff to assist the board in performing that task. In fact, a literal reading of the relevant DE statutory provision in effect at the time so provided – as was similarly the case with the parallel provision in the Model Business Corporation Act! BUT that literal interpretation of the statute – calling for active involvement by the board with the day-to-day business affairs of the corporation – was clearly not what was intended for the board of a large corporation. AND it was clearly not intended for the board of a large publicly-held corporation!

In reaction, the ABA Committee on Corporate Laws (in its role providing ongoing editorial oversight for the Model Act) amended the Act in l974 to provide that “[a]ll corporate powers shall be exercised by or under the direction of the board of directors … and the business and affairs of the corporation shall be managed by or under the direction of [the board].” [emphasis supplied] Samuel Arsht (at the time a noted leader of the DE corporate bar and a member of the ABA Committee as well) spearheaded a comparable adjustment that was made in the DE statute.

The point here is a very simple one; that is, while the board of directors has authority to engage in the conduct of the corporation’s business and affairs at whatever level it chooses – subject to the directors’ fiduciary duty and, in the case of a DE corporation, subject to any limitation set forth in its certificate of incorporation (as provided by the DE statute) – the CA board of directors does not have obligatory involvement with day-to-day management of the business and affairs of the enterprise. To suggest that it does have a duty to manage the business and affairs of CA, Inc. – or even might – is mischievous!

Board of Directors’ Responsiveness to Shareholders

This post is from Fabrizio Ferri of Columbia University.

In a recent working paper entitled Board of Directors’ Responsiveness to Shareholders: Evidence from Shareholder Proposals, Yonca Ertimur, Stephen Stubben and I investigate the frequency, determinants and consequences of boards’ responses to advisory shareholder proposals. Our sample consists of 620 non-binding, MV shareholder proposals between 1997 and 2004.

In recent years, there has been a significant increase in shareholder activism through shareholder proposals submitted for a vote at the annual meeting. Proposals pushing for the adoption or removal of certain governance features (e.g. classified boards, poison pills) are filed by activists in record numbers every year and, in spite of boards’ opposition, sometimes they win a majority vote. Boards face a tough decision. While shareholder votes on these proposals are advisory, ignoring them may have negative consequences, particularly if the proposal wins a majority vote. Directors failing to implement majority-vote (MV) proposals are often the target of “vote-no” campaigns and receive a “withhold vote” recommendation by ISS. Firms ignoring MV proposals end up on CalPERS’ “focus list”, receive lower ratings from governance services and attract negative press coverage. On the other hand, if boards truly believe the proposal is not in the interest of the company, they should not adopt it, in spite of the majority support by shareholders.

We find that, while proposals failing to achieve a majority vote are almost always ignored by the boards, about 30% of the MV proposals are implemented within a year from the vote. Strikingly, the frequency of implementation of MV proposals has almost doubled after 2002, from approximately 20% (1997-2002) to more than 40% (2003-2004), consistent with an increase in the cost of ignoring MV resolutions in the post-Enron environment. The likelihood of implementation seems to depend on the degree of shareholder pressure – in particular, the voting outcome and the influence of the proponent. For example, a MV proposal supported by 70% of the votes cast has a 10% higher chance of implementation than one supported by 55% of the votes cast. The behavior of peer firms and the type of proposals also have an effect, while traditional governance indicators do not seem to matter.

We then focus on the labor market for outside directors to evaluate the consequences of the implementation decision. We find that the implementation of a MV shareholder proposal is associated with approximately a one-fifth reduction in the probability of director turnover at the targeted firm. In addition, implementing a MV proposal is associated with approximately a one-fifth reduction in the probability of losing directorships held in other firms. These “rewards” for responding to MV proposals are higher when the proposal was supported by a higher percentage of votes. If the labor market for directors correctly reflects the quality of their performance, then the presence of reputation rewards (penalties) for responsive (unresponsive) directors may suggest that, on average at least, MV shareholder proposals are viewed as beneficial.

The full paper is available for download here.

Delaware Bankruptcy Court Expounds on Directors’ Duties in Financially Distressed Situations

This post is based on a memorandum issued by John F. Olson’s firm, Gibson, Dunn & Crutcher 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.

The United States Bankruptcy Court for the District of Delaware recently issued a memorandum opinion in which it refused to dismiss breach of fiduciary duty claims against corporate directors who approved the sale of a financially distressed company’s assets on the eve of bankruptcy.[1] The Court’s opinion sheds light on directors’ duties, and what they can and should do to protect themselves from liability, in such situations.

In Bridgeport, a bankruptcy liquidating trust filed a complaint against the officers and directors of the debtor, traded as “Micro Warehouse,” alleging that they breached their duties to the company, its shareholders and its creditors in connection with a sale of the company’s assets. The complaint alleged that Micro Warehouse began experiencing financial difficulty in 2000. After several years of declining financial performance, in early August 2003, the company concluded that its best option was to execute a sell strategy. At that point, one of the directors called upon an acquaintance at another company, CDW Corporation (“CDW”), to talk about purchasing Micro Warehouse.

In late August 2003, the company formally retained a restructuring advisor and appointed him to the position of Chief Operating Officer. Within 72 hours of commencing work, the restructuring advisor determined to sell the company’s assets. However, instead of hiring an investment bank and commencing a competitive bidding process, the complaint alleged that the restructuring advisor immediately continued the sale process with CDW and reached a handshake deal with CDW on September 2, 2003. During this time, the restructuring advisor made contact with only one other potential acquiror, but provided it with limited due diligence materials. On September 9, 2003, Micro Warehouse sold to CDW a substantial portion of its North American assets. The next day, Micro Warehouse filed for chapter 11 bankruptcy protection.

The liquidating trust sought to recover damages from the officer and director defendants for breaches of the fiduciary duties of loyalty, care and good faith as a result of: (1) failing to put the assets up for sale earlier, (2) failing to hire a restructuring professional earlier in 2003, (3) abdicating all responsibility to the restructuring professional after he was hired, and (4) acquiescing in the decision to sell the assets quickly, immediately before filing a chapter 11 petition, rather than in a court-supervised sale under the Bankruptcy Code.

The complaint made no allegations of self-dealing. As a result, the defendants argued that the breach of duty of loyalty claim must fail. The Court disagreed, pointing out that the Delaware Supreme Court had recently clarified that a claim for breach of loyalty may be premised on a failure to act in good faith. The Court concluded that the liquidating trust had alleged sufficient facts to support a claim that the officer and director defendants breached the duty of loyalty and acted in bad faith by consciously disregarding, or abdicating, their duties to the company. Specifically, the Court said, “the allegations support the claim that the D&O Defendants breached their fiduciary duty of loyalty and failed to act in good faith by abdicating crucial decision-making to [the restructuring advisor], and then failing adequately to monitor his execution of the ‘sell strategy,’ resulting in an abbreviated and uninformed sale process; and approving the sale to CDW for grossly inadequate consideration.”[2]

The defendants argued that the breach of duty of care claim must fail because of the exculpation provision in Micro Warehouse’s certificate of incorporation and the business judgment rule. The Court again disagreed, noting that “‘[w]hen a duty of care breach is not the exclusive claim, a court may not dismiss [the duty of care claim] based upon an exculpatory provision.'”[3] Therefore, because the liquidating trust had alleged facts supporting a claim for breach of the duty of loyalty as well as lack of good faith, the exculpatory provision was not cause to dismiss the duty of care claim.

With respect to the business judgment rule, the Court said that to invoke its protections “‘directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them.'”[4] If directors fail to do so, then a court will scrutinize the challenged transaction under the “entire fairness” standard of review. The complaint had alleged that the director and officer defendants had approved an uninformed fire sale of the company’s assets because they had not hired an investment banker to shop the deal or value the assets, they had not obtained a fairness opinion, and they failed to seek offers from other purchasers. As a result, the defendants lost the protection of the business judgment rule.

Plaintiffs will certainly seize upon the Bridgeport decision to press their claims against the directors and officers of financially distressed companies. In particular, plaintiffs will be sure to allege any facts they can to support the inference that officers and directors abdicated their responsibilities and failed to inform themselves of material facts before making decisions. By doing so, under Bridgeport, plaintiffs will hope to make out claims for breach of the duty of loyalty even in the absence of any self-dealing. In turn, by making out such claims, plaintiffs will argue that exculpatory provisions and the business judgment rule will not act to defeat claims for breach of the duty of care.

To limit such claims, directors and officers of financially distressed companies should:

• assume all actions will be scrutinized and second guessed;

• avoid actions that could cause loss of protection of business judgment rule (e.g., conflicts of interest or conflicting loyalties; insider issues; preferential treatment of certain stakeholders, failing to keep informed);

• act with care after obtaining all necessary information (directors, members and managers can rely in good faith on reports prepared by officers or outside experts);

• obtain adequate professional and expert advice on a timely basis;

• in consultation with the company’s advisors, establish and follow a deliberate decision-making process;

• document the decision-making process;

• disclose all material facts;

• in connection with potential transactions, hire investment bankers, obtain fairness opinions and/or seek offers from potential purchasers;

• do not freeze up–no decision is a decision and will likely lead to an argument that duties were abdicated.

[1] See Bridgeport Holdings Inc. Liquidating Trust v. Boyer (In re Bridgeport Holdings, Inc.), 2008 WL 2235330 (Bankr. D. Del. May 30, 2008).

[2] Id. at *13.

[3] Id. at *16 (quoting Alidina v. Internet.com Corp., 2002 WL 31584292, at * 8 (Del. Ch. Nov. 6, 2002)).

[4] Id. at *17 (quoting Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 367 (Del. 1993)).

 

Delaware’s Compensation

This post is from Michal Barzuza of University of Virginia School of Law. 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.

My article entitled “Delaware’s Compensation,” which was published in the Virginia Law Review, focuses on the compensation that Delaware­ – the state in which most public companies are incorporated – is getting from the firms it attracts. For its corporate law – and related services it offers­ – firms pay Delaware an annual franchise tax. The aggregate collections from this tax amount to approximately 20% of Delaware’s annual revenue. It has long been argued that this compensation provides Delaware with incentives to provide corporate law that maximizes shareholder value.

This article points out that the structure of the tax is not optimally designed to provide Delaware with incentives to maximize shareholder value. Delaware’s franchise tax is not based on firm income, market value, or any other measure of performance, but rather functions much like a lump-sum tax. Nearly half of Delaware’s revenue comes from firms who pay the maximum tax rate. For most of the rest of the firms, Delaware’s franchise tax is based primarily on the number of authorized shares. For a small group of firms, the tax is based on, among other things, their assets. Yet, if the tax increases as a result of an increase in assets, Delaware law allows firms to switch to the authorized shares method.

The current tax does not provide Delaware with incentives to improve corporate governance terms that correlate significantly with firm value – such as staggered boards or liability protection for directors and officers – even if improving them could result in an increase of several percentage points, or hundreds of billions of dollars, to the value of Delaware’s firms. Because its tax is not tied to firm performance, even those corporate law amendments that could increase firm value significantly would not increase the amount of tax per firm that Delaware would generate. And since they may antagonize some managers, resulting in some firms reincorporating outside the state, Delaware could even lose revenue from adopting them.

The paper argues that adding a tax component based on changes to corporate value or income on top of the current tax would improve the current system. It would align Delaware’s incentives with those of shareholders and induce it to offer corporate law that maximizes shareholder value. It could have this effect even if Delaware faces no competition from other states over incorporations and even if shareholders are passive.

The paper also argues that Delaware does not have sufficient incentives to change its franchise tax to a more incentive based compensation for several reasons. First, risk aversion and lack of information make Delaware officials reluctant to make any changes to the structure of its franchise tax. Second, the current tax, even though suboptimal, serves Delaware’s interests by creating a commitment that the state will cater to managers’ needs on an ongoing basis, inducing managers to incorporate in Delaware.

For the longstanding debate over the market for corporate law the analysis suggests that it should not result in a race to the bottom or to the top. While the tax that it charges restrains Delaware from racing to the bottom, it does not push it to the top either, but rather to the middle–to produce corporate law that is superior to that of other states, but that falls short of being optimal.

The full paper is available for download here.

Managerial Ownership Dynamics and Firm Value

This post is from René Stulz of Ohio State University.

In our forthcoming Journal of Financial Economics paper, Managerial Ownership Dynamics and Firm Value, Rüdiger Fahlenbrach and I examine the dynamics of managerial ownership for American firms from 1988 through 2003 and their relation to changes in firm value. We find that the average and median annual change in managerial ownership during that period is negative. Further, we show that a firm that experiences a large change in ownership is substantially more likely to experience a decline in ownership than an increase. High past and concurrent stock returns make it more likely that a firm will experience a large decrease in managerial ownership. In contrast, there is little evidence that low past and concurrent stock returns increase the probability of large increases in managerial ownership. Strikingly, firm characteristics other than stock returns and stock liquidity, such as proxies for information asymmetry, are mostly unrelated to large decreases in managerial ownership driven by sales of shares by insiders.

The widely held view that higher managerial ownership is valuable for shareholders because it aligns the interests of managers better with those of shareholders would make one concerned about the implications of our finding of decreasing ownership for firm value. However, controlling for the determinants of ownership changes, we find no evidence that large decreases in managerial ownership reduce Tobin’s q. In contrast, we show that large increases in managerial ownership can be interpreted, in our experimental design, to cause increases in q. Using insider trading data and a decomposition of changes in managerial ownership, we show further that the positive relation between large increases in managerial ownership and changes in q is driven by increases in shares owned by officers rather than increases in shares owned by directors or changes in the number of shares outstanding.

Our findings suggest the following interpretation. Managers own shares to maximize their welfare subject to constraints and firms start their life with highly concentrated ownership. The highly concentrated ownership of young firms is partly explained by the fact that early in the life of the firm managerial ownership is a cheap form of financing for financially constrained firms. Later in the life of the firm, when the firm is doing well and their reputation has increased, managers start to reduce their stake to diversify. They do so in a way that does not endanger their position or reduce the value of their remaining shares. As a result, sales have little impact on firm value. By buying shares, managers bond themselves to pursuing policies that benefit minority shareholders more – at least as long as their ownership does not become so high that they become safe from removal. Managers buy shares when this bonding effect is valuable to them because it enables the firm to raise funds on better terms and reduces threats to their position. Managers also increase their holdings when the firm is financially constrained and they prevent the firm from becoming more constrained by receiving shares instead of cash.

The full paper is available for download here.

CA, Inc. v. AFSCME Employees Pension Plan

The author of this post, Robert Giuffra, argued on behalf of CA in the Delaware Supreme Court. 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.

My firm has recently issued a memorandum on the Delaware Supreme Court’s decision in CA, Inc. v. AFSCME Employees Pension Plan. The Supreme Court’s decision addressed a proposed stockholder bylaw that would have required the Board of Directors of CA, Inc. to reimburse the reasonable expenses incurred by stockholders in conducting successful “short-slate” proxy contests. The Court held that, while the proposed bylaw related to director elections and, thus, was a proper subject for stockholder action under Delaware law, the proposed bylaw “mandates reimbursement of election expenses in circumstances that a proper application of fiduciary principles could preclude” and, thus, if adopted, could cause CA to violate Delaware law.

The Delaware Supreme Court’s decision has numerous implications. It reaffirms the bedrock principle of Delaware corporate law that the directors of a corporation, not the shareholders, manage the business and affairs of the corporation. The decision confirms that shareholder bylaws may not prevent the directors from fulfilling their fiduciary duties. To attempt to address the concerns articulated by the Court with the proposed bylaw, stockholders may attempt to modify their proposed bylaws in ways that leave boards with discretion to discharge their fiduciary duties. In addition, the decision makes clear that bylaws may not “mandate how the board should decide specific substantive business decisions,” but may “define the process and procedures by which those decisions are made.” Where the line will be drawn between those bylaws that mandate substantive decisions and bylaws that are procedural likely will be decided by the Delaware courts on a case-by-case basis in the future. Finally, under the Court’s reasoning, a binding shareholder bylaw proposal to prohibit a board of directors from adopting or implementing a “poison pill” likely would be deemed improper under Delaware law.

Our memorandum is available here.

SEC Bars Naked Short Sales of Major Financial Firms; More is Needed

This post is from Edward D. Herlihy, Wachtell, Lipton, Rosen & Katz. SEC Release No. 34-55970 (2007), under which the SEC abolished the “Uptick” rule, is available here. In making its decision, the SEC considered its own economic analysis, available here, and four academic studies, three of which are available here, here and here.

In response to the SEC’s emergency rule, issued Tuesday evening, barring short sales of stock in Fannie Mae, Freddy Mac and seventeen primary dealers, my colleagues Theodore A. Levine, Caitlin S. Hall and I have issued a memorandum entitled “SEC Bars Naked Short Sales of Major Financial Firms; More is Needed.” The emergency rule, which takes force July 21 and will be in effect for thirty days, comes on the heels of a week in which Fannie Mae and Freddie Mac stocks were battered by unsubstantiated rumors. In the memorandum, available here, we urge the SEC to take immediate strong action, including expanding the temporary rule beyond its initial thirty-day period and extending its coverage to all publicly traded securities.

The emergency rule follows the unusual statement on Sunday evening by the SEC that it, FINRA and NYSE Regulation would immediately begin examinations of broker-dealer and investment adviser supervisory and compliance controls, with the goal of stemming the spread of false rumors intended to manipulate security prices. Our memorandum on this development, entitled “SEC Takes First Step to Address Manipulative Rumor-Mongering; More Aggressive Action Still Needed,” is available here.

Although these regulatory developments are commendable, we believe that the SEC should immediately re-impose the “Uptick” Rule, a 70-year-old regulation that constrained short selling in declining markets by requiring that listed securities be sold short only at a price above their last different sale price. In a memorandum on July 1, available here, we discussed the rationale for the Uptick Rule, the Commission’s reasons for abolishing it, and the limitations of the pilot program undertaken by the Commission prior to its decision to abandon the rule. On an urgent basis, we urged the SEC to consider re-imposing the Uptick Rule, or to take alternative measures, in these extraordinary times to dampen volatility and address abusive and manipulative short selling.

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