Monthly Archives: October 2008

Developments in Takeover Defenses

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

As discussed in our recent Webcast on Developments in Takeover Defenses, Latham & Watkins LLP has prepared a new model of advance notice bylaw provisions that have been updated and modernized, not only to address the issues raised in the recent decisions in JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corp. v. Office Depot, but also to address significant related problems posed by activist investors’ frequent use of undisclosed derivative securities and/or “wolf pack” tactics as weapons in threatened or actual proxy contests. We have also included provisions that establish more robust and protective procedures for shareholders to call special meetings or act by written consent. The text of our model advance notice bylaw provisions is now available on our Web site here.

The evolving forms of equity ownership in U.S. publicly traded companies, the recent Delaware decisions refusing to apply ambiguously drafted advance notice bylaws and recent strategies deployed by activist and other “event driven” investors, have caused many U.S. publicly traded companies to reexamine their advance notice bylaw provisions to, among other things, assess whether the required procedures and disclosures adequately address the interests of the corporation and its shareholders. In particular:

• The attributes of equity ownership in U.S. publicly traded companies has expanded dramatically due to the proliferation of derivative, swap and other transactions now available in the marketplace. For example, “total return equity swaps” allow an investor to create the economic equivalent of ownership of common stock without ever acquiring ownership of the security itself. Historically, investors have taken the position that these economic relationships do not confer beneficial ownership of the underlying equity under the federal securities laws and, for that reason, are not required to be disclosed. Conversely, investors also now have the ability to use derivatives to establish record ownership and thus the right to vote the shares without any exposure to economic ownership. This can be achieved, for example, by purchasing shares and simultaneously entering into offsetting put and call options or more simply by “borrowing” shares just prior to the record date for a shareholders’ meeting and returning the borrowed shares shortly thereafter, a strategy often called “record date capture.”


Incentives for Innovation

This post comes from Gustavo Manso at the MIT Sloan School of Management.

I recently presented a pair of papers on the topic of “Incentives for Innovation” at the Finance Department Seminar at Harvard Business School.

In the first paper, entitled “Motivating Innovation”, I model the process of innovation using a class of Bayesian decision models known as bandit problems. Innovation in this setting is the discovery, through experimentation and learning, of actions that are superior to previously known actions. I focus on the tension between the exploration of new untested actions and the exploitation of well known actions. Exploration of new untested actions reveals information about potentially superior actions, but is also likely to waste time with inferior actions. Exploitation of well known actions ensures reasonable payoffs, but may prevent the discovery of superior actions.

I find that the optimal contracts that motivate exploitation and exploration are fundamentally different. Since exploitation is just the repetition of well known actions, the optimal contract that motivates exploitation is similar to standard pay-for-performance contracts used to motivate repeated effort. On the other hand, since with exploration the agent is likely to waste time with inferior actions, the optimal contract that motivates exploration exhibits substantial tolerance (or even reward) for early failures. Moreover, since exploration reveals information that is useful for future decisions, the optimal contract that motivates exploration relies on long-term incentives. Under the optimal exploration contract, an agent that obtains an early failure followed by a success earns more than an agent that obtains an early success followed by a failure. Even an agent that fails twice may earn more than an agent that obtains a success followed by a failure. The institution of tenure, debtor-friendly bankruptcy laws, and golden parachutes are examples of schemes that protect the agent when failure occurs and thereby encourage exploration.

In the second paper, entitled “Is Pay for Performance Detrimental to Innovation“, which was co-written with Florian Ederer, I outline the results of a controlled laboratory experiment which provides evidence that the combination of tolerance for early failure and reward for long-term success is effective in motivating innovation.

In our experiment, subjects control the operations of a lemonade stand for 20 periods. In each period of the experiment, subjects make decisions on how to run the lemonade stand and observe the profits produced by their inputs. Subjects must choose between fine-tuning the product choice decisions given to them by the previous manager (“exploitation”) or choosing a different location and radically altering the product mix to discover a better strategy (“exploration”). To study the impact of different incentive schemes on productivity and innovation, we consider three different treatment groups. Subjects in the first group receive a fixed-wage in each period of the experiment. Subjects in the second treatment group are given a standard pay-for-performance (or profit sharing) contract. Subjects in the third treatment group are allocated a contract that is tailored to motivate exploration. Their compensation is 50% of the profits produced during the last 10 periods of the experiment.


A global survey to find out what investors really think about the crisis

This post comes to us from William Russell-Smith of AQ Research.

One of the features of the current financial crisis is the comparative lack of comment from the bulk of the market participants. Certain high profile investors such as George Soros and Warren Buffett have been widely quoted, but might not be regarded as typical industry participants. We also have the recent testimony by some of the major figures of failed institutions given to the Congressional Committee on Oversight and Government Reform. But a more broadly based view of what the financial services is thinking seems to be lacking thus far. This might be due to the hectic times that the markets have recently witnessed, or else a desire to keep heads down at a time when the industry is under fire.

In response to this, the recently formed finance professionals’ think tank, Network for Sustainable Financial Markets, in partnership with AQ Research, has launched a global survey of investment sector professionals. The goal is to ensure the voice of ordinary investment professionals is heard in the debate about the future of financial markets, not just about today’s debate but also about the underlying dynamics which affect both the crisis response but also the longer-term rehabilitation.

The Network includes some of the world’s most high-profile sustainable investment supporters, including corporate governance expert Dr Robert Eccles from the Harvard Business School, Professor Keith Ambachstheer, Director of Rotman International Centre for Pension Management, University of Toronto and world renowned expert on pensions and Professor Frank Partnoy, one of the world’s leading experts on the complexities of modern finance and financial market regulation.

We believe that an evidence based approach is important. It is clear that we are already entering a period of intense and fundamental debate about the future of the financial services industry, how it is regulated and its role in economic life. Concerned industry participants should be want their voice to be heard, particularly as they will be most affected by the future restrictions.

The survey asks investment professionals for their opinion on fundamental questions on the causes, cures and consequences of the credit crisis.

The survey, which is completed anonymously, can be found here. It will close on 31 October 2008. We estimate that it will take approximately 15 minutes to complete. The results will be extensively reported in financial media and will also be available to participants.

The organizers invite you to complete the survey and forward it to contacts you may have who are investment professionals.

Managing In Today’s Troubled Environment: A Primer For Directors and Senior Managements

This post is from Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

I have recently written a memo entitled “Managing In Today’s Troubled Environment: A Primer For Directors and Senior Managements,” which highlights for directors and senior management key matters they should consider as they address in the current troubled environment their role as overseers of the business and affairs of the public companies they serve. In it, I discuss how fiduciary duties should be applied in current conditions, focusing particularly on risk oversight, and outline a number of specific actions directors and senior management should consider today. The memo also highlights, also against the backdrop of the current market pressures, the existence of significant disclosure issues and the appropriate use of experts by directors and senior management.

The memo is available here.

Earnings management, lawsuits, and stock-for-stock acquirers’ market performance

This post comes from Henock Louis, Guojin Gong, and Amy X. Sun at the Smeal College of Business at Pennsylvania State University.

In a forthcoming Journal of Accounting and Economics paper entitled Earnings management, lawsuits, and stock-for-stock acquirers’ market performance, we analyze whether postmerger announcement lawsuits are associated with pre-merger abnormal accruals and the potential effects of lawsuits on acquirers’ market performance. We posit that, by subjecting stock-for-stock acquirers to lawsuits, pre-merger earnings management can have an indirect effect on acquirers’ performance around and after the merger announcement, in addition to the direct effect associated with post-merger accrual reversals.

After analyzing the association between pre-merger announcement abnormal accruals and post-merger announcement lawsuits, we examine whether the market anticipates the potential lawsuits and their consequences at the merger announcement. It is well documented that the average stock-for-stock acquirer experiences significant market losses at the merger announcement. In a fully efficient market, the probability of a lawsuit should be reflected in the market reaction to the merger announcement. To examine the association between the merger announcement abnormal return and the probability of a lawsuit, we use an instrumental variable approach. In a first step, we estimate the probability that an acquirer would be sued, using ex-ante predictors of lawsuits. In a second step, we analyze the association between the merger announcement abnormal return and the probability of a lawsuit. We use the two-stage estimation process because of the potential endogeneity in the relation between lawsuits and performance.

Consistent with our conjectures, we find that pre-merger abnormal accruals are a strong determinant of post-merger lawsuits. The effect of abnormal accruals is significant even after controlling for the post-merger abnormal return, which suggests that pre-merger earnings management has a first order effect on the likelihood of a lawsuit. We also find evidence that the market anticipates the lawsuits at merger announcements. There is a significantly negative association between the market reaction to a merger announcement and the probability that a stock-for-stock acquirer is subsequently sued. Further analyses suggest, however, that the market reaction to the merger announcement only partially reflects the probability of a lawsuit. First, we find that stock-for-stock acquirers’ long-term market under performance is largely limited to litigated acquisitions. Second, and more importantly, we find a very strong negative association between the likelihood of a lawsuit and the long-term market performance over the four years after the merger announcement. Therefore, post-merger announcement long-term market performance can be predicted using lawsuit-related information that is available at the time of the merger announcement. We do not claim that lawsuits are the only cause of the post-merger announcement long term under performance. The evidence only indicates that lawsuits are a contributing factor to the under performance.

The full paper is available here.

Financial Markets in Crisis: Overview of FDIC’s Authority With Respect to Bank Failures

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

My firm has issued a memo entitled “Financial Markets in Crisis: Overview of FDIC’s Authority With Respect to Bank Failures,” which focuses on the receivership and conservatorship authority of the Federal Deposit Insurance Corporation. It is an executive summary of a longer document available here. The memo provides a brief overview of key issues and background on the legal framework governing FDIC resolutions and the FDIC’s methods for handling receiverships. The longer summary goes into greater detail, comparing six distinctive aspects of the FDIC approach with the bankruptcy law provisions; and illustrating issues and uncertainties in the FDIC resolutions process by discussing in greater depth two examples – treatment of loan securitizations and participations, and standby letters of credit. The materials underscore the importance of credit analysis and rigor of documentation and legal risk mitigation in connection with potentially troubled financial institution counterparties.

The memo is available here and the longer summary is available here.

Emergency Economic Stabilization Act of 2008: US Government Capital Injections

This post comes to us from Davis Polk & Wardwell partners Samuel Dimon, Randall D. Guynn, Michael Kaplan, Mark Mendez, Margaret E. Tahyar, and William L. Taylor who advised the Federal Reserve Bank of New York on the plan discussed in the memo.

In the wake of intense pressure in the global credit markets and continued turmoil in the stock markets, the US Treasury Department, in coordination with other G-7 governments, recently expanded its plan to restore confidence in the US banking system.

Wielding the extraordinary discretion recently granted to it by Congress, the US government announced a plan to inject $250 billion of capital directly into the US banking system, to guarantee the short-term debt of most US banks and thrifts and to eliminate FDIC insurance limits for noninterest bearing accounts. Under the plan, the Secretary of the Treasury, the Chairman of the FDIC and the Chairman of the Federal Reserve Board jointly announced the following:

  • Treasury will use the full $250 billion it currently has available under the Troubled Asset Relief Program (“TARP”) to purchase preferred stock and warrants for common stock of the nine US bank holding companies that are systemically important and of other healthy regional and community banks;
  • The FDIC will use its emergency powers to guarantee through June 30, 2012 certain senior unsecured debt issued by eligible banking institutions; and
  • The FDIC will provide unlimited insurance through 2009 for non-interest bearing deposit accounts, a move primarily designed to protect the payroll and working capital accounts of small and medium-sized businesses.

This memorandum analyzes the implications of these developments and the federal government’s evolving response to the financial crisis.

The memo is available here.

Executive Compensation and the Emergency Stabilization Act of 2008

The President recently signed into law the Emergency Economic Stabilization Act of 2008 (the “Act”), which aims to restore liquidity and stability to the financial system, to protect the value of Americans’ homes and savings and to promote economic growth. The Act includes a number of provisions relating to executive compensation, which have important implications for financial institutions selling troubled assets under the Act.

The Act subjects financial institutions that sell assets to the Treasury to restrictions on executive compensation based on the nature of the sale. In a recent Memorandum, my colleagues and I identify several items that demand immediate attention from institutions that may become subject to these restrictions:

• Severance Agreements. Financial institutions that have previously determined to enter into severance agreements with senior executive officers or individuals who may become senior executive officers should execute these agreements prior to engaging in sales of troubled assets under the Act, although it is unclear whether the prohibition on new golden parachute agreements will apply retroactively to cover arrangements entered into after enactment of the Act but prior to such sales.


Delaware Court Provides Further Guidance on Material Adverse Effect Clauses

This post is from Scott J. Davis of Mayer Brown 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 Delaware Chancery Court’s decision in Hexion Specialty Chemicals, Inc. v. Huntsman Corp. represents a strong statement by the Delaware courts that they will not tolerate efforts by buyers who have changed their minds about deals, or have been pressured by their lenders to change their minds, to avoid their contractual obligations on the basis of contrived arguments. Following previous Delaware cases, the Court rejected the buyer’s claim that a material adverse effect excused its obligation to close, holding that the buyer had not met its burden of showing “the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”

My partner William Kucera has written a memorandum discussing the court’s reasoning and offering detailed suggestions and observations for drafting MAE clauses in future deals. In particular, it discusses provisions — other than MAE clauses — on which buyers could rely as a means to avoid closing a transaction. Against the backdrop of the decision, the memo also explains the continued relevance of MAE clauses in deals and describes how threats by the buyer to invoke such a clause have played out in a number of recent transactions.

The memorandum is available here.

The Merger Agreement as a Contract

Recently, in the Mergers, Acquisitions, and Split-Ups course here at Harvard Law School, two preeminent M&A practitioners discussed The Merger Agreement as a Contract. Richard Climan, head of the M&A group at Cooley Godward Kronish, and Eileen Nugent, co-head of the private equity group at Skadden and a member of the advisory board of the Harvard Law School Program on Corporate Governance, went through all the components of an acquisition agreement, from the description of the deal to the deceptively labelled “boilerplate”. They stressed the role of the acquisition agreement for allocating risk between the parties, and as a roadmap for the transaction between signing and closing (and beyond). Mock negotiations between Climan and Nugent served to demonstrate what is at stake in certain key provisions. Climan and Nugent discussed the impact of recent events and court decisions with Vice Chancellor Leo Strine, Jr., who is one of the class’s teachers and who has authored many of those decisions himself on the Delaware Court of Chancery. Professor Robert Clark, Strine’s co-teacher and former Dean of Harvard Law School, added some perspective from the boardroom. The video of the panel is available here. (video no longer available)

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