Monthly Archives: October 2008

Delaware Court Orders Hexion to Pursue Financing of Huntsman Acquisition

This post is from George R. Bason, Jr. of Davis Polk & Wardwell LLP. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

My colleagues Phillip R. Mills and Justine Lee and I have prepared the following post on the Delaware Chancery Court’s recent decision in Hexion Specialty Chemicals, Inc., v. Huntsman Corp., C.A. No. 3841-VCL (Del. Ch. Sept. 29, 2008).

The Delaware Chancery Court ruled that Hexion Specialty Chemicals, Inc. must specifically perform its covenants under its merger agreement with Huntsman Corporation, including taking all actions necessary to consummate the financing of the transaction and to satisfy antitrust regulators, but the Court stopped short of requiring Hexion, a portfolio company of Apollo Global Management, to consummate the transaction. The Court rejected Hexion’s claim that Huntsman had suffered a “Material Adverse Effect” or MAE (as discussed more fully below), and found that Hexion deliberately breached its obligations under the merger agreement and that any damages caused by such breach will not be subject to the $325 million liquidated damages cap in the contract.

While this decision is a clear victory for Huntsman and stands out from other recent instances where private equity buyers have successfully negotiated or litigated to extricate themselves from highly leveraged transactions entered into before the credit crunch, when contemplating its wider implications, the Court’s rulings must be analyzed in the context of a merger agreement that was particularly favorable to the seller. The merger agreement was negotiated in a competitive “deal jump” situation, with an industrial counterparty, after Huntsman had already entered into a signed agreement to sell itself to a third party.


Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

This post is from William N. Goetzmann of Yale School of Management.

In our forthcoming Journal of Finance article, Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration, we use the SEC rule adopted on December 2, 2004 that required hedge fund managers to register as investment advisers by February 1, 2006 as an opportunity to test the potential value and materiality of operational risk and conflict of interest variables disclosed by a large number of hedge funds in February 2006. On June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated this rule change, with the result that far fewer hedge fund managers have been required to register as investment advisors. As a result, the February 2006 ADV filings by a large number of hedge fund managers present a rare opportunity to examine the fundamental question of whether such disclosure is necessary or warranted.

We find that operational risk indicators are conditionally correlated with conflict of interest variables, indicating a potential value of disclosing such conflicts to investors. Operational risk factors are also correlated with lower leverage and concentrated ownership, suggesting that the 2006 disclosure requirements may have been redundant for lenders and equity investors in hedge funds. In contrast, operational risk factors had no ex-post effect on the flow-performance relationship, suggesting that investors either lack this information or do not regard it as material. The results of our analysis provide a framework for the cost-benefit analysis of regulatory disclosure. Our findings suggest that any consideration of disclosure requirements should take into account the endogenous production of information within the industry, and the marginal benefit of required disclosure on different investment clienteles.

The full paper is available for download here.

The Ban and the TARP

This post is based on a memorandum by Edward D. Herlihy and Theodore A. Levine of Wachtell, Lipton, Rosen & Katz.

Recently the SEC announced that its ban on short selling in financial company stocks would expire three (3) days after the enactment by Congress of the Troubled Asset Relief Program. It was an arbitrary decision to tie the expiration of the ban to the Congressional action and, even if it made sense when the SEC announced it, it does not make sense now for the SEC ban to be lifted at midnight on Wednesday, October 8, 2008, especially given the recent market turmoil and instability.

The worldwide credit and securities markets are experiencing a serious meltdown with significant disruptions and dislocations. A substantial number of market regulators have, in one fashion or another and for varying lengths of time, banned short selling in financial company stocks. The SEC should coordinate its efforts, including the length of the short selling ban with the major international regulators and marketplaces in order to have a consistent and coordinated approach. It makes no sense for the SEC to impose the shortest ban or to unilaterally lift it.


SEC Announces Extension of Emergency Short Selling Orders and Related Action

This post is from James Morphy of Sullivan & Cromwell LLP.

The SEC recently issued a statement announcing that it was extending certain temporary emergency orders and describing other actions relating to short selling rules. The following temporary orders are being extended:

• The order prohibiting short selling in public financial companies specified by the securities exchanges on which the shares of those companies are listed. This order will be extended to 11:59 p.m. ET on the third business day after enactment of the legislation currently pending in Congress to stabilize credit markets and the financial system, but in no event later than 11:59 p.m. ET on October 17, 2008.

• The order requiring that institutional money managers report to the SEC their new short sales of certain publicly traded securities. This order will be extended to 11:59 p.m. ET on October 17, 2008, but the SEC intends that the order will continue in effect after that date without interruption in the form of an interim final rule. While the SEC will seek comments on the anticipated rulemaking, the rules will remain in effect during the comment period. The October 1 statement also provides that disclosure under the emergency order will be made only to the SEC.

• The order easing restrictions on the ability of securities issuers to repurchase their securities. This order will be extended to 11:59 p.m. ET on October 17, 2008.


CSC Publishing Releases Fall Update of Delaware Laws Governing Business Entities

This post is from Andrea Unterberger of Corporation Service Company. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Corporation Service Company’s publishing division has released the Fall 2008 Edition of Delaware Laws Governing Business Entities, a two-volume set containing annotated Delaware business statutes and other useful research features.

The books, which are published in collaboration with legal publisher LexisNexis, are updated every six months to ensure that readers have access to current statutory information and recent cases, and contain the most recent annotations of judicial decisions applying Delaware business entity law around the country.

The Fall 2008 Edition has been updated to include the latest legislation from the 2008 Regular Session of the Delaware General Assembly, with summaries of all amended statutes describing the changes made, as well as over 50 new case annotations of judicial decisions in all U.S. jurisdictions applying Delaware business entity law. The chapter entitled “Amounts Payable by Business Entities under Delaware Law” reflects changes made to many of Delaware’s filing fees.


A lesson from 1929 for the hedge funds

Editor’s Note: This post by our Guest Contributors John Armour of the University of Oxford and Brian Cheffins of the University of Cambridge was published today on

The current credit crisis has many reaching for their history books, seeking to find out what lessons might be drawn from previous financial disasters. There is a rich history of bank failures. What can history tell us about the $2,000bn world of hedge funds?

Some say the turmoil in financial markets could be a boon for shrewd hedge fund managers, allowing them to pick up assets on the cheap from distressed sellers. Others argue hedge funds are in a potential death spiral, with redemption demands from investors prompting asset sales which lock in losses, in turn prompting further redemptions and so on.

While hedge funds seem to capture perfectly the zeitgeist of contemporary capitalism, they actually have parallels in investment companies that flourished on Wall Street in the late 1920s. By 1929 a new investment company was being launched every day amidst frenzied demand from investors. These investment companies had a number of similarities to modern hedge funds.


Landed Interests and Financial Underdevelopment in the United States

This post is from Raghuram G. Rajan of the University of Chicago.

Recently, in the Law, Economics, and Organization Seminar here at the Law School, I presented my paper, co-authored with Rodney Ramcharan, entitled Landed Interests and Financial Underdevelopment in the United States.

In our paper, we explore how the structure of banking across counties in the United States was shaped in the early part of the twentieth century by local landowners, who wanted to limit free access to credit. We focus on banks because they were, and in many areas, still are, the most important source of local finance. Likewise, we focus on the influence of landowners because agriculture was still a key sector at that time in the U.S. economy, and agricultural interests were a powerful political constituency. From a research design standpoint, this focus is also appropriate because we believe we can isolate exogenous factors that determined the nature of land holdings. Specifically, counties varied in the extent to which land holdings were concentrated or widely distributed. In part, the distribution of land holdings was driven by rainfall, with large-scale plantation-like agriculture being favored in areas with high rainfall, and small scale farming in areas with moderate rainfall. Therefore, in some counties, a few large farmers held much of the land, while in other counties land was widely dispersed among many smaller farmers. Large, wealthier landowners had reasons to restrict access to credit by limiting the spread of banks, and had the economic and political power to implement those interests.

We find that landed interests appeared to be an important influence in constraining bank competition and thus limiting access to finance. We provide a variety of tests showing that their impact was most pronounced in situations where they had the greatest incentive and ability to exert influence. We also argue that our results cannot be easily explained as resulting from the supply of banking services responding to the underlying demand. Finally, we show these constraints on financial development persisted long after the interest groups driving them faded away.

While our paper is on financial development, it has broader implications. A recent trend in explaining the underdevelopment of nations has been to attribute it to the historical weakness in their political institutions such as democracy and constitutional checks-and-balances. While U.S. political institutions in the 1920s were far from perfect, they were also far from the coercive political structures that are typically held responsible for persistent underdevelopment. Yet even in the United States, we find large variations in the development of enabling economic institutions such as banking between areas that had different constituencies but were under the same political structures. The significant, and potentially adverse, influence of constituencies even in such environments suggests that fixing political institutions alone cannot be a panacea for the problem of underdevelopment.

The full paper is available for download here.

Corporate Governance, Promises Made, Promises Broken

This post is from Jonathan R. Macey of Yale Law School.

My forthcoming book, Corporate Governance, Promises Made, Promises Broken, presents my views about what corporate governance is all about and what sorts of corporate governance institutions and mechanisms work best. Corporate governance consists of a farrago of legal and economic devices that induce the people in charge of companies with publicly owned and traded stock to keep the promises they make to investors. This book develops three original insights about corporate governance. These insights can be succinctly summarized:

1. Corporate Governance is about promises. I believe that it is more accurate to characterize corporate governance as being about promises than it is to characterize corporate governance as being about contracts. One reason I believe this is because the relationship between public shareholders and the corporations is so attenuated than it is misleading to characterize their relationship with the corporation as contractual in nature, rather than promissory. Shareholders have almost no contractual rights and virtually no contractual rights to corporate cash flows. Shareholders’ investments are based on trust. This trust, in turn is based on the belief that the managers who run corporations will keep the promises that they make to investors. Another reason why I believe that corporate governance is about promise is because the idea of promise captures the primordial fact that trust rather than reliance on the prospect of enforcement is the focal point of a successful system of corporate governance.

2. Since corporate governance is about promise, then it stands to reason that the various institutions and mechanisms of corporate governance can be evaluated on the basis of how well they facilitate the keeping of promises by corporate managers. The bulk of this book analyzes various devices and mechanisms of corporate governance for the purpose of determining which ones work well and which do not work so well.


Earnings Restatements, Changes in CEO Compensation, and Firm Performance

This post comes to us from Qiang Cheng at the University of Wisconsin-Madison and David B. Farber at the Trulaske College of Business at the University of Missouri-Columbia.

In our forthcoming Accounting Review paper entitled Earnings Restatements, Changes in CEO Compensation, and Firm Performance, we provide insights into the design and efficacy of chief executive officer (CEO) compensation contracts following an earnings restatement.

Using a sample of 289 restatements and the year prior to restatement announcement as the benchmark year, we find that while total CEO compensation does not significantly change by the second year after the restatement announcement, there is a significant shift from option-based compensation to salary over this period. In univariate tests, we find that the proportion of the value of option grants to total compensation declined by 5.6 percentage points for the restatement firms, while control firms experienced an increase of 2.6 percentage points in this proportion over the same period. The analyses indicate that the number of option grants also declines for restatement firms compared to control firms. The reduction in the use of option grants for restatement firms holds after we control for the level of stock and option holdings as well as other determinants of option-based compensation, such as firm size, growth opportunities, leverage, idiosyncratic risk, R&D intensity, stock returns, cash compensation, and industry and year fixed effects. Because about half of the restatement firms experienced CEO turnover after restatements, we also investigate the change in option grants separately for extant and new CEOs. We find that our results hold for both extant and new CEOs.

If the reduction in option-based compensation is a result of unwarranted negative public perception of option usage, we would expect a decrease in firm performance as firms deviate from optimal contracting. However, if restatements result from too high a level of incentive compensation and the reduction in option compensation after the restatement better aligns managerial incentives with those of shareholders, we would expect to observe improved firm performance. Overall, our results imply that economic benefits accrue to restatement firms that reduce their CEOs’ option-based compensation, indicating that the reduction in option grants helps adjust managers’ equity incentives toward optimal levels. A natural question that follows is if reducing option usage is associated with improved firm performance, why is it that all restatement firms do not do so? To help answer this question, we conduct a within-sample analysis. We find that the likelihood of a reduction in options usage is positively related to the level of option grants prior to the restatement and in some specifications, this likelihood is higher for income-decreasing restatements.

The full paper is available for download here.

A Multi-disciplinary Perspective of the Emergency Economic Stabilization Act of 2008

This post is from Margaret E. Tahyar of Davis Polk & Wardwell LLP.

In this memorandum, a team composed of experts in my firm’s financial institutions, corporate governance, real estate, capital markets, executive compensation, hedge fund, private equity, asset management, white collar defense and litigation departments discusses our collective view on the likely interpretation of the Emergency Economic Stabilization Act’s most important provisions, the key ambiguities and questions that will have to be resolved by the Treasury Secretary, and the policy issues that will shape not only the implementation of the Act, but also the future of the US financial regulatory system.

The memorandum is available here.

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