Monthly Archives: September 2008

Our Representation on the Most-Influential-Corporate-Governance-Players List

Directorship magazine issued its second annual Directorship 100 list – a list of the 100 “most influential people on corporate governance.” The list includes such well-known figures as Chairman Barney Frank, Chairman Ben Bernanke, Treasury Secretary Henry Paulson, SEC Chair Christopher Cox, Goldman Sachs CEO Lloyd Blankfein, activist investor Carl Ichan, and Blackstone CEO Steve Schwarzman. The blog is pleased to announce the significant representation that members of the Harvard Program on Corporate Governance have on the Directorship 100 list:

Lucian Bebchuk, the program’s director, was selected in the “professors” category. Bebchuk was also included in the Directorship 100 list last year, when the magazine first issued this list.

• Vice-Chancellor Leo Strine, Jr., a senior fellow of the program, was selected in the “regulators and rule makers” category.

• Finally, the Directorship magazine, in recognition of the success and influence of the Harvard Law School Corporate Governance blog, included in its list the two current co-editors of the blog, Jim Naughton and myself, in “the media” category. Others listed in this category are Alan Murray and Joann Lublin of the Wall Street Journal, Andrew Ross Sorkin of the New York Times, Fox news CEO Roger Ailes, Maria Bartiromo of CNBC, and Jim Cramer of TheStreet dot com. This selection would not have been possible, of course, but for the many contributors posting their insights and work on the blog and for the loyalty of our readers, and we would like to express our thanks to them all.

The Directorship article, which includes the full Directorship 100 list, as well as a description of the methodology used and substantial effort invested in putting together the list, is available here.

To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance

This post is from Baruch Lev of NYU Stern School of Business.

In “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance”, which I co-wrote with Joel F. Houston and Jennifer W. Tucker, and which was recently accepted for publication in Contemporary Accounting Research, we investigate the importance of quarterly earnings guidance. Quarterly earnings guidance—managers’ public forecasts of forthcoming earnings—is widespread yet highly controversial. Arguments for ending the practice of guidance are made by purists, who claim that managers should tend to their business and leave securities valuation and the underlying forecasts of future performance to investors and analysts, and by pragmatists, lawyers in particular, who caution managers that guidance increases litigation exposure. Regulators and commentators are often concerned that a previously issued forecast will motivate managers to meet the guidance even if doing so would require costly changes in real activities, such as cutting capital expenditures or R&D, and sometimes induce them to manage earnings toward the forecast. On the pro-guidance side, managers often claim that the practice is necessary to keep analysts’ earnings forecasts—issued with or without corporate guidance—within a reasonable range to avoid large earnings surprises and the consequent high stock price volatility and investors’ heightened risk perceptions.

We empirically examine in this study a sample of 222 U.S. firms that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005, after having routinely done so. Only a few of these “stoppers” publicly announced and rationalized their decision, whereas the majority just ceased to provide guidance. We first examine the determinants of the stopping decision with particular reference to the pro and con arguments made by challengers and supporters of the practice. Although managers often cite reducing short-termism as the motive for stopping guidance, an unstated reason could be poor performance and repeated consensus misses. We then examine the post-stoppage changes in the stoppers’ long-term investments, in their complementary disclosures, and in their information environment. Using a control sample of 676 guidance “maintainers,” along with the 222 stoppers, we find that poor performance is the main reason for guidance cessation. Our stoppers are characterized by (1) a decline in earnings before stopping, (2) a poor record of meeting or beating analyst consensus forecast, and (3) a deterioration of anticipated earnings. Additionally, we document that guidance cessation is associated with (1) a change in top management, likely ushering in new management philosophy, (2) a relatively low frequency of guidance by industry peers, and (3) past as well as anticipated difficulties in predicting earnings. In addition, we do not find that stoppers enhance investment in capital expenditure and research and development after guidance cessation. Contrary to the claim that firms would provide more alternative, forward-looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.

The full paper is available for download here.

Bailout Bill

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A Congressional section-by-section summary of the bailout bill to be voted on shortly by Congress is available here. The full draft of the bill is available here.

U.S. v. Stein

This post is from John F. Savarese of Wachtell, Lipton, Rosen & Katz.

In the recent decision of U.S. v. Stein, the US Court of Appeals for the Second Circuit upheld the dismissal of all charges against thirteen former partners and employees of KPMG, holding that the government had violated defendants’ Sixth Amendment rights by pressuring KPMG to cut off payment of their legal fees. The court affirmed the central findings that US District Court Judge Lewis A. Kaplan reached two years ago: absent the Thompson Memo (the Principles of Federal Prosecution of Business Organizations then-in-effect) and the actions of the US Attorney’s Office, KPMG would have paid the legal fees of all of its partners and employees without regard to cost. KPMG’s decision not to advance legal fees “followed as a direct consequence of the government’s overwhelming influence, and that KPMG’s conduct therefore amounted to state action.” The Court held that “the government thus unjustifiably interfered with defendants’ relationship with counsel and their ability to mount a defense, in violation of the Sixth Amendment, and that the government did not cure the violation.” The case perhaps represents a decisive victory to the defendants in this high-profile matter.

My colleague David B. Anders and I have written a memo, available here, on the decision as well as the DOJ’s policies regarding its evaluation of corporations in the course of criminal investigations. The Court’s opinion may be accessed here.

Family Control of Firms and Industries

This post comes to us from Belén Villalonga of Harvard Business School.

Recently, in the Law, Economics, and Organization Seminar here at the Law School, I presented my paper, co-authored with Raphael Amit, entitled Family Control of Firms and Industries. In our study, we use the variation in the prevalence of family control within and across industries in the United States to test the two broad explanations for family control, which we refer to as “competitive advantage” and “private benefits of control”, and to identify which characteristics distinguish family controlled firms and industries from their non-family counterparts.

We construct two different tests of the two broad explanations. First, we analyze the relative sensitivity of family and non-family firms to industry profit shocks. We allow for firms’ responses to be asymmetric across positive and negative shocks. A lower sensitivity of family control to positive shocks would be consistent with a tunneling (i.e., private benefits appropriation) explanation. On the other hand, a lower sensitivity to negative shocks would be consistent with a “propping” explanation, suggesting that families do not always act in their own self-interest but instead, and seek to maximize value for the firm as a whole as implied by the competitive advantage explanation. As a second test, we estimate a propensity-score matching model of the effect of family control on the family premium, defined as the excess value of family firms relative to non-family firms in each industry. We use this model to test whether family firms dominate where they are valued the most (as a competitive advantage explanation would suggest) or the least (as a private benefits explanation would suggest).

We find that, just like in the cable and newspaper industries, the combination of competitive advantage and private benefits explanations to family control is the norm across our sample. We then analyze which factors, specifically, are driving our results. Consistent with the competitive advantage hypothesis, firms and industries are more likely to remain under family control when their efficient scale and capital intensity are smaller (the value-maximizing size argument), when the environment is more noisy (the control potential argument), and when the difference between long and short-term profitability is larger (the investment horizon argument). Consistent with the private benefits of control hypothesis, families are more likely to stay in control when there is dual-class stock in their firms. Overall, our findings suggest that family control results in net value creation for all of the firm’s shareholders, and not in a sheer transfer of value from outside investors to the founding family.

The full paper is available for download here.

A Better Plan For Addressing The Financial Crisis

Editor’s Note: The post below is an op-ed piece published by Lucian Bebchuk in the Wall Street Journal this morning. This op-ed piece is based on his discussion paper, A Plan for Addressing the Financial Crisis, which was just issued by the Harvard Law School Program on Corporate Governance and is available here.

Treasury Secretary Henry Paulson is seeking authorization to spend $700 billion of taxpayers’ money on “troubled assets” owned by financial firms. We’re told his plan is the only way to stabilize the financial markets. But the plan, as proposed to Congress, can be improved to be both less costly and a better stabilizing force for the markets.

The redesign should have three elements. First, the Treasury should only buy troubled assets at fair market value. Second, the Treasury should be allowed to purchase, again at fair market value, new securities issued by financial institutions needing additional capital. Third, to ensure that asset purchases are made at fair market value, the Treasury should buy them through multibuyer competitive processes with appropriate incentives.

If troubled assets are purchased at fair market value, taxpayers might get an adequate return on their investment. And the Treasury’s official statements say that “The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.”

But the draft legislation grants the Treasury full authority to pay higher prices, potentially conferring massive gifts on private parties. The final bill should not permit this.

Adding this fair market constraint by itself may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today’s fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.

But the best way to infuse additional capital where needed is not by giving gifts to the firms’ shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.

Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won’t necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.

Finally, how do we ensure that the government does not pay excessive prices for troubled assets or new securities issued by financial firms? The proposed legislation allows the Treasury to conduct purchases through in-house operations, outside delegation, or any other method it chooses. It would be best, however, to direct the Treasury to operate through agents with strong market incentives.

Suppose the economy has illiquid mortgage assets with a face value of $1 trillion, and the Treasury believes that buyers with $100 billion would be enough to bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion, and place each fund under a manager who does not have conflicting interests.

Each manager could be promised a fee, say 5%, of the profit his fund generates — that is, the difference between the fund’s final value and the $5 billion initial investment. Competition among the fund managers, armed with the needed liquid funds and motivated by their 5% fee, would produce prices set at fair market values.

Revising the Treasury plan in the ways just described would do a far better job of protecting taxpayers’ interests, and restoring financial stability, than what the Treasury initially proposed.

Cross-Border Business Combination Transactions

For a detailed memorandum from our Guest Contributor Ted Mirvis at Wachtell, Lipton, Rosen & Katz analyzing the final rules on cross-border business combinations, as published by the SEC on September 19, 2008, see here.

At a recent public meeting, the Securities and Exchange Commission adopted a number of amendments to the rules that apply to cross-border tender offers, business combinations and rights offerings. The SEC also approved the issuance of interpretive guidance on several topics related to cross-border transactions. These amendments and guidance largely follow the SEC’s May 2008 proposals, and, in many instances, codify existing no-action, interpretive and exemptive positions previously articulated by the staff of the SEC. The SEC intends for the new rules to facilitate and encourage the inclusion of U.S. security holders in cross-border transactions.

A memorandum discussing the amendments to the rules is available here.

Which Way Out?

Editor’s Note: This op-ed by Professor Howell Jackson will be published in the print edition of the Christian Scientist Monitor tomorrow.

While many agree that dramatic governmental action is needed to restore confidence in financial markets, there is less consensus on the precise form that action should take. Secretary Paulson has sketched out one approach and Democratic leadership in Congress has responded with useful refinements. But there are better ways to structure the intervention and defray its costs.

I.

On the structural side, consider how the government should spend its $700 billion. The basic strategy of both the Paulson and congressional plans is to buy back large quantities of toxic mortgage backed securities in some sort of auction process. These purchases would remove troubled assets from the balance sheets of selling institutions, and (hopefully) clarify the prices of similar securities held by other investors. But, exactly how this clarification of prices is to come about is unclear. Will the government’s purchases be considered accurate measures of market value or merely fire sales by frantic firms facing bankruptcy? The ownership of underlying mortgage pools will still be highly fragmented. The mere shifting of ownership of large quantities of securities may do little for price discovery, and could serve simply to transfer government resources to selling institutions.

A more effective strategy would be for the government to purchase all of the loans in mortgage pools underlying specific securitization transactions, starting first with the lowest quality subprime and Alt-A mortgage pools, which is where the underlying problems lie. With congressional authorization, the Treasury could force the purchase of these assets through eminent domain and make an immediate payment of an estimate of the loans’ current fair value, which would then be reviewed for adequacy by an appropriately constituted judicial forum at some point in the future. If the initial payment did not provide just compensation, additional compensation plus interest could be paid. Attacking the problem from the loan end of the securitization process, as opposed to the investor end, has numerous advantages.

To begin with, purchasing whole pools of loans would force liquidation of the mortgage backed securities used to finance those loans. Investors would get an immediate distribution of the government’s cash plus some sort of residual interest for whatever additional proceeds might come out of the after-the-fact judicial valuation proceedings. Critically, whole issuances of the most complex mortgage backed securities would disappear, and the market would receive strong pricing signals for comparable instruments.

A key advantage of this approach is that it moves whole loans (and not fractional securities) under government control. Once it holds these loans, the government can itself take charge of workouts and refinancings. This is the approach that the Home Owners Loan Corporation took in the Great Depression, and the FDIC is already operating such work-out programs for loans held by failed banks under its control. If the Treasury Department would start buying up whole pools of subprime loans and Alt-A transactions, it could dramatically expand the FDIC’s program, offering relief for borrowers who were mislead or abused and then dealing more harshly with those who knowingly entered into speculative transactions. In other words, a strategy of whole pool loan purchases provides the government with a vehicle for giving relief to home owners and not just financial institutions.

A further benefit of authorizing the government to purchase whole pools of loans is that it could change the incentives now facing loan-pool trustees. One of the reasons it has been so difficult for the market to adjust to falling housing prices and increasing foreclosures is that mortgage backed securities trustees have been reluctant to renegotiate individual loans, out of fear of litigation and uncertainty as to appropriate terms. Facing the threat of forced sales to the U.S. government and with clear guidance on how much the government is likely to pay for their loans, mortgage backed securities trustees will be highly motivated to renegotiate loan terms on their own, further clarifying market values and enhancing price discovery.

II.

We also need to think harder about financing the cost of government intervention. Under the Paulson proposal, the American taxpayer would pick up the bill for whatever the government loses on its $700 billion of asset purchases. Exactly how big that bill will be is unclear, but the taxpayer is going to be on the hook for the full amount.

Congressional Democrats attempt to soften the blow by requiring the government to receive an equity interest from selling firms. While laudable, this approach does complicate the transactions – as the structure of equity interests will need to be negotiated on a case-by-case basis and the price signals to the market from these hybrid purchases will be less clear than it would be with purely cash transactions. More importantly, the extraction of equity stakes from selling firms does not spread the costs of the program to the many other financial institutions who benefit from the program by having the value of their portfolios clarified or increased through government purchases.

A cleaner approach would follow the model that Congress set up in 1991 for the FDIC when it spends extra funds to shore up systemically important commercial banks: impose an after-the-fact assessment on the entire industry to defray the costs. Congress could do exactly the same thing with the Paulson proposal. Once the government’s losses are clear, the Treasury should assess some share of the costs (let’s say one half) on all of the financial institutions eligible to participate in the program, based on some objective formula such as the value of assets held at the time the program was proposed. Assessments could be spread over a number of years, so as not to infringe upon current cash flow. But this would be a more equitable approach to cost sharing than what is currently being proposed on either side of the aisle. Also it would give the financial-services industry a strong incentive to help the government keep costs down and avoid similar interventions in the future.

* * * * *

The challenges facing the Treasury and Congress are formidable. And time is clearly of the essence. But even in the face of such pressures, it’s important to take the time to consider alternative approaches that may offer a more efficient and more equitable way out of the nation’s difficulties. A parallel program to purchase whole loan pools could easily be grafted onto the Paulson plan as could a mechanism for after-the-fact industry assessments.

Fed Relaxes Traditional Control Rules for Private Equity and Other Minority Investments in Banks and Bank Holding Companies

This post from Margaret E. Tahyar of Davis Polk & Wardwell LLP is by Randall Guynn and Arthur Long.

Yesterday, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a policy statement (the “Equity Policy Statement”) that relaxed and clarified its long-standing control rules relating to minority investments in banks and bank holding companies (“Banking Organizations”). These changes and clarifications relate to four principal areas:

• expanded director rights;
• increased voting and total equity ceilings;
• permissible business relationships; and
• veto rights.

The Federal Reserve also stated that it would use the liberalized rules to analyze noncontrolling investments by U.S. and non-U.S. bank holding companies in nonbanking firms.

Expanded Director Rights and Increased Equity Ceilings

Old Rule
Historically, the Federal Reserve has not allowed a minority investor that acquired 10% or more of a Banking Organization’s voting shares to have a director on the Banking Organization’s board without being deemed to have a controlling influence over the Banking Organization. In contrast, it has generally allowed a minority investor to acquire up to 9.9% of a Banking Organization’s voting shares, 14.9% of its total equity (including such voting shares) and to appoint one director.

New Rule
The Equity Policy Statement reiterates that a “control” determination still depends on all the facts and circumstances.

While the Equity Policy Statement is unclear and contradictory in certain respects, we believe that it provides that a minority investor may now generally acquire up to 15% of the voting shares of a Banking Organization, one-third (33%) of its total equity and appoint one director to the Banking Organization’s board without raising a “control” issue. In addition, such an investor may generally have two board seats as long as (i) its board representation is proportionate to its total equity interest and does not exceed 25% of the voting members of the board and (ii) another, larger shareholder is a bank holding company that controls the Banking Organization.

Board Committees
The Federal Reserve also clarified the extent to which the board representatives of a minority investor may serve on board committees. No minority investor’s board representative should be the chairman of the board or of a board committee. However, its representatives may serve on any board committees as long as they do not constitute more than 25% of such committees and do not have the authority or practical ability to make or block policymaking decisions.

Convertible Securities
The Equity Policy Statement reaffirms the traditional rule that nonvoting shares convertible into voting shares at the holder’s option or mandatorily convertible after a passage of time should be considered voting shares at all times. However, it also provides that nonvoting shares may become voting in a transfer in a widespread public offering, in a transfer in which no transferee would receive 2% of more of any class of voting shares, or in a transfer to a transferee that will control more than 50% of the voting securities of the Banking Organization without counting the transferred shares. This mechanic has traditionally aided minority investors in making larger dollar investments via nonvoting shares while still maintaining exit and liquidity rights.

Limited Business Relationships

The Federal Reserve has previously allowed minority investors to have “quantitatively limited and qualitatively nonmaterial” business relationships with the Banking Organization in which they have invested. The Equity Policy Statement reiterates that business relationships should remain limited and will continue to be reviewed on a case-by-case basis, taking into particular account the following factors: (i) the size of the proposed business relationships and (ii) whether they would be on market terms, non-exclusive and terminable without penalty by the Banking Organization.

No Meaningful Veto Rights

The Federal Reserve reiterated that minority investors will not be permitted to have any meaningful veto rights to protect the value of their investments, without being deemed to control the Banking Organization. It merely reaffirmed that minority investors may have veto rights, subject to safety and soundness concerns, over very limited matters such as issuing senior securities or borrowing on a senior basis, modifying the terms of the minority investor’s security, or liquidating the Banking Organization. They may also have limited financial information rights and limited consultation rights.

For a copy of the Equity Policy Statement, see here.

Developments in Takeover Defense

This post is from Charles M. Nathan of Latham & Watkins LLP.

My firm extends an invitation to readers of the Harvard Law School Corporate Governance Blog to join us for a 60-minute informative Webcast on Developments in Takeovers Defenses tomorrow, September 23 at noon ET. You may do so from the comfort of your office by simply logging in a few minutes prior to the start of the program.

Not all takeover defenses are created equal and recent trends show that yesterday’s state of the art may not be very effective in the current environment which is dominated by hedge fund destabilization and other activist investor campaigns. This complimentary Webcast will first focus on the risks posed by investors who don’t seek 100% ownership of a company, but rather embrace short term “event” driven strategies. We will then turn to potential innovative strategies companies can adopt to defuse these risks.

The program is as follows:

Review of Market
• Hostile deal making
• Hedge Fund destabilization

Advance Notice Bylaws
• Implications of Cnet and Office Depot cases
• Disclosure of derivatives and empty voting
• Disclosure of activist investor “Wolf Packs”
• Other disclosures to increase transparency
• Updating requirements for increased transparency

Poison Pills
• Pros and cons of adoption vs. putting Pill on the “shelf”
• Treatment of synthetic equity and other derivatives
• Can and should Pills deal with “Wolf Packs”
• Is conventional Pill design too draconian for today’s markets

I will be presenting, together with my partners Mark Gerstein, Laurie Smilan, and Bradley Faris.

The program materials are available here. To register online, click here. Additional details and a link to log-on to the Web conference site will be sent to registrants prior to the event. For more information and questions about this event, please contact
Wendy Moore at +1.714.755.8109.

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