Monthly Archives: August 2008

Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order

This post comes from Arturo Bris, a professor at IMD who is also affiliated with the Yale International Center for Finance

I have recently completed a report Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order that analyzes the effect of the EO that was issued to “enhance investor protection against naked short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks”. The EO dealt primarily with the stocks of 19 financial institutions, which I denote as the G19. The study is conducted by comparing stock returns, firm fundamentals, measures of market quality, and pricing efficiency of the G19 to a matching sample of financial stocks from the U.S. and abroad, all listed on U.S. stock exchanges. The control sample of U.S. financial institutions includes 59 companies, and the control sample of non‐U.S. financial institutions includes 73 companies.

My preliminary findings are as follows:

  • The performance of the G19 stocks is significantly worse in the period January 2008 through July 2008 than for comparable stocks.
  • The short selling activities in the G19 stocks have not been significantly higher than for comparable stocks between 2006 and 2008.
  • While short selling has increased overall, short selling activities in the G19 stocks have not increased significantly more than in comparable US Financial Stocks.
  • After controlling for firm and market characteristics, all measures of shorting activity are indeed lower for G19 stocks than for comparable US Financial Stocks, but higher than for comparable non‐U.S. Financial Stocks.
  • I find that the issuance of convertible bonds has been relatively more frequent for G19 stocks than for the sample of comparable firms, and that this activity fosters shorting activity.
  • There is clear evidence that some firms outside the G19 group have been the subject of heavy shorting activity over the sample period.
  • Although the performance of the G19 stocks has been significantly worse than for comparable firms, the negative returns of G19 stocks cannot be attributed to short selling activities.
  • I find that the market quality of the G19 stocks is significantly worse on most measures of market quality than for comparable US financial stocks before July 15th 2008, and that this lower market quality is not caused by short‐selling activities.
  • After July 21st, the G19 stocks have suffered a significant reduction in intra‐day return volatility and an increase in spreads, which suggests a deterioration of market quality.

The full report and a video of my interview on CNBC’s Squawk Box Europe about the report can be found here.

Leveraged Buyouts and Private Equity

This post is from Steven Kaplan of the University of Chicago.

Per Stromberg and I have just completed Leveraged Buyouts and Private Equity. In the paper, we describe and present empirical evidence on the leveraged buyout and private equity industry, both firms and transactions.

We start the paper by describing how the private equity industry works. We describe private equity organizations such as Blackstone, Carlyle, and KKR, and the components of a typical leveraged buyout transaction, such as the buyout of RJR Nabisco or SunGard Data Systems. We present evidence on how private equity fundraising, activity and transaction characteristics have varied over time. The article then considers the effects of private equity. We look at evidence concerning how private equity affects capital structure, management incentives, and corporate governance. This evidence suggests that private equity activity creates economic value on average. At the same time, there is also evidence consistent with private equity investors taking advantage of market timing (and market mispricing) between debt and equity markets particularly in the public-to-private transactions of the last fifteen years.

We also review the empirical evidence on the economics and returns to private equity at the fund level. Private equity activity appears to experience recurring boom and bust cycles that are related to past returns and to the level of interest rates relative to earnings. Given that the unprecedented boom of 2005 to 2007 has just ended, it seems likely that there will be a decline in private equity investment and fundraising in the next several years. While the recent market boom may eventually lead to some defaults and investor losses, the magnitude is likely to be less severe than after the 1980s boom because capital structures are less fragile and private equity firms are more sophisticated. Accordingly, we expect that a significant part of the growth in private equity activity and institutions is permanent.

The full paper is available for download here.

Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements

This post comes from Glenn D. West and Sara G. Duran of Weil, Gotshal & Manges.

In our article, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, which was recently published in The Business Lawyer, we provide clarity on the issue of Consequential Damages. Even though consequential damage waivers are a frequent part of merger and acquisition agreements involving private company targets, we believe that few deal professionals understand the concept of consequential damages and, as a result, the inclusion of such waivers may have an unexpected impact on both buyers and sellers.

After tracing the historical derivation of the term, and its current use, we provide a number of basic guidelines for addressing consequential damage waivers in acquisition agreements, which include the following:

  • At a minimum, buyers should avoid the “kitchen sink” approach to the consequential damage waiver.
  • If possible, buyers should try to define “consequential damages” for the purpose of any waiver provision in such a manner that the term covers only those consequential damages for which the law already denies recovery for breaches of contract.
  • Buyers should avoid including the broad term “lost profits” as a separate category of damages in the waiver provision.
  • Sellers, on the other hand, should consider expressly limiting recoverable losses under their indemnification provisions to the “normal measure” of contract damages.
  • Buyers should never include “incidental” damages in their waiver provisions under the assumption that they are a synonym for “consequential” damages. They are not.
  • Instead of waiving “consequential” damages, buyers should seek waivers of “remote” or “speculative” damages. Even the term “indirect” damages is preferable to the term “consequential” damages for a buyer.
  • Buyers should never agree to waivers of “diminution in value” or “multiples of earnings” damages.
  • Sellers should not assume that contract law’s “rule of reasonableness” necessarily applies to broadly worded indemnification provisions that purport to indemnify buyers for any and all losses that arise from a breach of a seller’s representation and warranty.
  • Buyers, on the other hand, should not assume that contract’s “rule of reasonableness” fails to apply to broadly worded indemnification provisions.

The full article can be found here.

CSX/ TCI Decision Webcast

This post is from John F. Olson of Gibson, Dunn & Crutcher LLP. For earlier Blog posts on the CSX/ TCI decision, see here and here.

I am posting the audio recording of the recent webcast in which a number of my colleagues analyzed the consequences of the court’s decision in the CSX case which held that two hedge fund investors had violated the provisions of Section 13(d) of the Securities Exchange Act of 1934, and Rule 13d-3(b) thereunder, by using cash settled swap transactions in a way that, in the circumstances, improperly evaded disclosure obligations related to the formation of a group “beneficial owner.” The discussants include Brian Lane, former Director of the SEC’s Division of Corporation Finance, Jim Moloney, former member of the SEC’s Office of Mergers and Acquisitions, Susan Grafton, former member of the Division of Trading and Markets staff and former compliance counsel at Goldman Sachs, and Adam Offenhartz, principal author of a brief filed in the case by a group of hedge funds. The panel is moderated by Gibson Dunn partner Ron Mueller. The discussion is particularly useful because it discusses the decision and its implications from a number of different perspectives, but does not “take sides” on resolution of the issues. This will be a subject of ongoing interest in the corporate governance community.

The recording is available here.

An Investigation of Earnings Management through Marketing Actions

This post comes to us from Craig Chapman at Northwestern’s Kellogg School of Management.

My recently updated working paper An Investigation of Earnings Management through Marketing Actions, co-written with Thomas J. Steenburgh provides a novel view on earnings management. Earnings management behavior may be divided into two categories: 1) the opportunistic exercise of accounting discretion; and 2) the opportunistic structuring of real transactions. This paper focuses on the latter by providing evidence that firms vary their use of retail-level marketing actions (price discounts, feature advertisements, and aisle displays) to influence the timing of consumers’ purchases in relation to the firms’ fiscal calendar and financial performance. The results are of interest to practitioners negotiating with suppliers as well as those responsible for setting price and promotion strategy in response to competitor actions, and practitioners responsible for designing incentive-based compensation as well as regulators monitoring reporting of fiscal period-ending promotions.

We find that:

• In contrast to prior literature that suggests firms reduce marketing expenditures in order to boost reported earnings, we find that soup manufacturers roughly double the frequency of all marketing promotions (price discounts, feature advertisements, and aisle displays) at the fiscal year-end and that they engage in similar behavior following periods of poor financial performance. In addition to offering promotions more frequently, we find that firms offer deeper price discounts to manage earnings during these periods.

• While these actions boost unit sales, revenue, and profits in the near term, the resulting gains come at the expense of long-term profit and may not be in the strategic interest of the firm. We estimate that marketing actions can be used to boost quarterly net income by up to 20% depending on the depth of promotion. But there is a price to pay, with the cost in the following period being 23.5% of quarterly net income.

• The results imply that firms make systematic decisions across their product lines to manage earnings and indicate the behavior is being driven by parties higher in the firm than the brand managers.

The full paper is available for download here.

Institutional Investors and Proxy Voting

This post is from Roberta Romano of Yale Law School.

In our paper, Institutional Investors and Proxy Voting: The Impact of the 2003 Mutual Fund Voting Disclosure Regulation, Martijn Cremers and I examine the impact of the mutual fund voting disclosure rule on corporate governance by examining its effect on proxy voting outcomes. We presented our paper at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.

In January 2003, the U.S. Securities and Exchange Commission (SEC) required mutual funds to disclose how they voted on proxy proposals presented at shareholder meetings. To assess the impact of this rule on voting behavior, we construct a sample of firms that experienced similar proposals, sponsored either by management or shareholders, both before and after the 2003 rule change using data gathered from the Investor Responsibility Research Center’s (IRRC) database of proxy voting.

We find that voting support for management has been declining for close to a decade and that mutual funds appear to support management less frequently than other investors. However, we find no evidence that the rule decreased mutual funds’ voting in support of management. Indeed, some of our results suggest that mutual funds’ support for management increased after the rule’s adoption, particularly for executive equity incentive compensation plan (EEIC) proposals. We further find that these results are not affected by other features of the voting environment, such as confidential voting and the elimination of the New York Stock Exchange (NYSE)’s rule permitting brokers to vote shares on certain compensation plans. Finally, taking into account mutual fund characteristics and the largest mutual fund families’ ownership does not change our results.

As the decision to put up an EEIC proposal is clearly a choice by management, we investigate to what extent selection issues could potentially explain our findings. We find some evidence that the firms sponsoring EEIC proposals both before and after the rule change are different from those that sponsored such a proposal before but not within two years after the rule change. In addition, we find that some takeover defenses decrease support for management, results independent of the rule change, but the results are so varied across defenses, and within and across proposals, that we cannot draw a conclusion regarding the relation between defenses and voting outcomes.

The full paper is available for download here.

The Role and Value of the Lead Director — A Report from the Lead Director Network

This post comes to us from Jeff Stein and Bill Baxley at King & Spalding.

Following the corporate scandals in the early part of this decade, there were calls to fundamentally change the way U.S. public company boards were structured — with some advocating for the “European model” of boards being led by independent chairmen rather than by a combined chairman-CEO. Many U.S. board members and business groups questioned whether the separation of the CEO and chairman roles actually adds value, so rather than implementing this profound change, the stock exchanges adopted what many consider to be a relatively weak compromise position. Under the approach adopted by the stock exchanges, the board is required only to appoint a director to preside over executive sessions of the independent directors and to receive shareholder communications.

Despite its humble beginnings, the appointment of “lead directors” has become a prevailing practice for U.S. public companies and lead directors have assumed increasing responsibilities within their companies. Still, there is little consensus at this point about which responsibilities lead directors should undertake and how they can act to improve both the governance and the performance of their companies. (In this posting, we refer to the director serving as “presiding” director, “lead” director, or independent non-executive chairman as a “lead director”.)

In order to consider these issues and respond to questions from our clients on these issues, King & Spalding and Tapestry Networks have created The Lead Director Network (LDN). The LDN brings together a select group of lead directors, presiding directors, and non-executive chairmen from many of America’s leading companies for private discussions about how to improve the performance of their corporations and earn the trust of their shareholders through more effective board leadership. The LDN currently includes 16 members (who serve as lead directors of 21 companies) and plans to meet three times per year. The group comprises lead directors from companies like Caterpillar, The Coca-Cola Company, Constellation Energy, Delta Air Lines, The Home Depot, Microsoft, Morgan Stanley, and others.

The inaugural meeting of the Lead Director Network was held on July 8, 2008, and the members present at the meeting considered the role and value of lead directors, how the role has evolved over recent years, and some of the key issues that lead directors are confronting. Following this meeting, King & Spalding and Tapestry Networks have published ViewPoints, to present highlights of the discussion that occurred at the meeting and to stimulate further consideration of these important topics.

Highlights of the July 8, 2008 meeting, as summarized in the ViewPoints document, include the following:

The Origins of the Lead Director Role. While there were external factors that led to the establishment of the lead director position (including stock exchange listing requirements and pressure from various stakeholders to separate the CEO and chairman roles), internal factors have played an important role in the evolution of the position. Among the factors that may cause the expansion of the lead director role for a company are changes in the leadership of the company, a significant event (such as a government investigation or a potential change of control transaction) and directors’ own efforts to ensure board independence and improve board performance.

Value of the Lead Director Role. Despite its modest beginnings, the lead director position has become increasingly important for many U.S. companies. Lead directors are contributing to improved corporate performance in at least four key areas: (1) taking responsibility for improving board performance, (2) building a productive relationship with the CEO, (3) supporting effective communications with shareholders, and (4) providing leadership in crisis situations. Ironically, these areas where lead directors are making the most valuable contributions are not among those officially described for the position by the NYSE.

How the Title Affects the Role. Members analyzed the different meanings that lie behind the different titles — “lead director”, “presiding director” and “non-executive chairman” — and how these titles relate to the responsibilities of the role. While the title may signal differences in how the lead director position is perceived by other directors, members concluded that, in practice, the terms “lead” and “presiding” do not say much about the actual portfolio of responsibilities delivered by the director. By contrast, the term “non-executive chairman” typically does describe something different, often a larger role in both company and board leadership.

Current Issues for Lead Directors. Members of the LDN identified five topics that they feel are important for lead directors and that they will discuss in more depth in future meetings: (1) how the board should be engaged in the development of corporate strategy, (2) the lead director’s role in crisis turbulent times, including preparing for a crisis situation, (3) the lead director’s role in succession planning for the CEO, the board, committee chairs and the top tier of management, (4) improving director and CEO evaluation processes and how individual director performance should be evaluated, and (5) alternative governance models (for example, the European model and models used by private equity firms).

The Future of the Lead Director Position. The lead director position was created as a compromise between having a board with no leader of its independent directors and mandating that every company have a non-executive chairman. Six years after the creation of the position, the most important contributions of lead directors have come not from the duties mandated by stock exchange requirements, but from the responsibilities that lead directors in fact have undertaken for their companies. As some activist shareholders renew their call for the “European model” of board leadership, it will be interesting to see whether the lead director position will continue to evolve as a viable and preferred alternative for corporations and their stakeholders.

We welcome comments on the subject of lead directors and suggestions for future topics to be considered by the LDN members, and plan to make other postings based on the discussions and reports of the LDN.

Additional information regarding the LDN may be found on the websites of Tapestry Networks and King & Spalding.

A copy of the Lead Director Network ViewPoints report is available here.

Delaware Enforces a Fiduciary Opt Out in a Publicly Held Firm

This post is from Larry Ribstein of the University of Illinois College 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.

Last month I discussed the emerging importance of what I call “uncorporate” governance – that is governance characteristic of partnership-type firms – for large, publicly held firms. As elaborated in my Uncorporating the Large Firm, a critical aspect of these firms is that they substitute distributions, liquidation rights and high-powered managerial incentives for traditional corporate monitoring devices, particularly including fiduciary duties.
The Delaware legislature does effectuate this “substitution” by explicitly letting LLCs eliminate all duties except for “the implied contractual covenant of good faith and fair dealing” (6 Del. Code §18-1101; there are similar provisions for other unincorporated firms). By contrast, the Delaware provision on fiduciary duty modification in corporations (DGCL §102(b)(7)) prohibits waivers of the duty of loyalty and “for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.” And as I discussed in Uncorporation and Corporate Indeterminacy, Delaware courts have enforced waivers consistent with the statutes.

But will Delaware courts apply corporate restrictions on waivers to publicly held uncorporations. In particular, might they interpret the “good faith” qualifier in the uncorporation statutory waiver provisions as similar to corporate-type good faith, which has been interpreted as part of the fiduciary duty of loyalty (see Stone v. Ritter, 911 A.2d 362 (Del. 2006))? Until very recently, the Delaware Supreme Court had never held that fiduciary duties could be waived in any publicly held firm.

That has now changed thanks to the Delaware Supreme Court’s recent opinion in Wood v. Baum. The case involved Municipal Mortgage & Equity, LLC (“MME”), at the time of the case a NYSE-listed Delaware LLC with 2500 record holders (see MME 2006 10K). The question in the case was whether the plaintiff had adequately alleged facts justifying excusing demand in a derivative suit as futile. Under the controlling Aronson standard in Delaware, in a case like this one involving an independent board the plaintiff had to show that the directors had an incentive to protect themselves from a substantial risk of personal liability. The court noted that:

under the Operating Agreement and the [Delaware Limited Liability Company Act] the MME directors’ exposure to liability is limited to claims of “fraudulent or illegal conduct,” or “bad faith violation[s] of the implied contractual covenant of good faith and fair dealing.”

Where directors are contractually or otherwise exculpated from liability for certain conduct, “then a serious threat of liability may only be found to exist if the plaintiff pleads a non-exculpated claim against the directors based on particularized facts.” Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. Therefore, the issue before us is whether the Complaint alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.

With respect to bad faith, the complaint alleged, among other things, that the defendants had “breached their Caremark duties by “fail[ing] properly to institute, administer and maintain adequate accounting and reporting controls, practices and procedures,” which resulted in a “massive restatement process, an SEC investigation, and loss of substantial access to financial markets.” (footnotes omitted). These allegations may have raised a good faith issue under Stone. Nevertheless, the court said:

the Complaint does not purport to allege a “bad faith violation of the implied contractual covenant of good faith and fair dealing.”The implied covenant of good faith and fair dealing is a creature of contract, distinct from the fiduciary duties that the plaintiff asserts here. The implied covenant functions to protect stockholders’ expectations that the company and its board will properly perform the contractual obligations they have under the operative organizational agreements. Here, the Complaint does not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. Nor, as discussed above, does the Complaint contain any particularized allegations that the defendants acted with the requisite scienter (in “bad faith”). (footnotes omitted)

The court concludes: “Given the broad exculpating provision contained in MME’s Operating Agreement, the plaintiff’s factual allegations are insufficient to establish demand futility. (emphasis added)”

In short, the directors had no fiduciary duties under the agreement, and no incentive to protect themselves from liability for breach of any such duties. Although this case did not involve particularized allegations of self-dealing, there is no apparent reason why the court’s reasoning should not cover such allegations as well.

If publicly held firms can waive fiduciary duties in the LLC form, why should they not be able to do so in the corporate form? Should the Delaware legislature take the next seemingly logical step and carry the complete exculpation approach over to corporations from uncorporations? Seventeen years ago, in the wake of Delaware’s initial adoption of broad fiduciary opt-out provisions for limited partnerships, I predicted that would happen, in my Unlimited Contracting in the Delaware Limited Partnership and its Implications for Corporate Law, 17 J. Corp. L. 299 (1991). I argued that the absence of other corporate-type protections made fiduciary duties even more important in unincorporated firms, so that if the latter could opt out, a fortiori corporations should be able to do so. Also, if publicly held corporations could opt out by simply disincorporating, why force them to take this procedural step? Perhaps, as discussed in Uncorporating the Large Firm, corporations should be distinguished from uncorporations on the basis that the latter offer disciplinary and incentive devices that make fiduciary duties less necessary in this context. There is also an argument for letting firms and investors choose between two distinct approaches to opting out of fiduciary duties.

In any event, it now seems clear that publicly held unincorporated firms can opt out of fiduciary duties in Delaware. It remains to be seen whether my initial prediction that this permission will extend to publicly held corporations ultimately will prove to be correct.

Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation

This post comes to use from Feng Gao, Joanna Shuang Wu, and Jerold Zimmerman at the Simon School of Business Administration at the University of Rochester. This paper was presented by Professor Wu at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.

In our paper Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation: Evidence from the Sarbanes-Oxley Act, we investigate whether the enactment of SOX created incentives for certain firms to stay small – in particular to keep their public float below $75 million, the threshold in the SEC’s definition of “non-accelerated” filers. Since 2003, the SEC has on several occasions deferred the implementation deadline for non-accelerated filers regarding Section 404 of SOX, considered by many commentators as one of the most onerous parts of SOX, particularly for smaller firms.

At least two non-mutually exclusive reasons can motivate managers to retain their firm’s non-accelerated filer status: (i) they believe that complying with Section 404 reduces shareholder value, and/or (ii) they believe that Section 404 reduces their private control benefits. Our paper does not differentiate between these two motives. Rather, it documents that regulatory size thresholds in fact induce some firms to remain below the threshold and identifies the various methods used to accomplish this objective. Our sample consists of non-accelerated filers and a control sample of accelerated filers with market capitalizations below $150 million. Our event period spans June 1, 2003 (following the first SEC deferment of Section 404 compliance deadline for non-accelerated filers) to December 31, 2005 (soon after the SEC issued the new exit rule for accelerated filers).

We document several actions that non-accelerated filers appear to employ to keep their public float below the $75 million threshold post-SOX. We find that they take actions to reduce net investment in property, plant, and equipment, intangibles, and acquisitions, that they pay out more cash to shareholders via ordinary and special dividends and share repurchases, and that they take actions to decrease the number of shares held by non-affiliates. Because the testing date of a firm’s filing status occurs only once each fiscal year (the last trading day of its second fiscal quarter), we find that non-accelerated filers disclose more bad news and report lower accounting earnings in the second fiscal quarter in an effort to exert temporary downward pressure on share prices before testing their filing status. Furthermore, we find evidence that the non-accelerated filers’ incentives to undertake the above actions are weaker when they are further away from the $75 million threshold. Finally, we document that the various actions undertaken by the non-accelerated filers post-SOX appear to be effective in that these firms are more likely to remain below the $75 million threshold in the following year.

The full paper is available for download here.

De-Coupling of Ownership, Economic and Voting Power in Public Companies – The UK’s Response

This post is from Adam O. Emmerich of Wachtell Lipton Rosen & Katz. A related development was the 2007 establishment in London of the Hedge Fund Standards Board in response to concerns about financial stability and systemic risks associated with the hedge fund industry. The Board monitors conformity by hedge funds with best practice standards, which are available here).

Ted Mirvis, Bill Savitt, David Shapiro and I have written a memo entitled “De-Coupling of Ownership, Economic and Voting Power in Public Companies – The UK’s Financial Services Authority (FSA) Moves Decisively to Close the Gap.” The memo considers the decision of the Financial Services Authority – the UK’s financial and securities markets regulatory authority – to require disclosure of cash-settled and other derivative contracts, on an aggregated basis with ownership of actual common stock, at the 3% level. The FSA’s new policy is aimed squarely at the now-popular technique of making undisclosed accumulations of significant stakes in publicly traded companies through derivative instruments (including cash-settled derivative instruments) and in other non-traditional ways.

The memo also discusses the urgent need for reform of section 13(d) of the Exchange Act to expand required disclosure to include within the definition of “beneficial ownership” all derivative instruments which provide the opportunity to profit or share in any profit derived from any increase in the value of public equity securities, as well as to require disclosure of large short positions. We note that unless and until lawmakers and securities regulators in the U.S. adopt disclosure requirements in accord with what is now the overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques – which must and should be done promptly – U.S. corporations are well advised to adopt such self-help measures as may be available, including appropriate provisions in by-laws, rights plans and other arrangements with change-in-control protections.

The FSA’s statements on this topic are available here and here. Our memo is available here.

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