Monthly Archives: November 2008

Cross-Border Deals

Recently, in the Mergers, Acquisitions, and Split-Ups course here at Harvard Law School, which is co-taught by Professor Robert Clark and Vice Chancellor Leo Strine, Jr., three expert practitioners shared their insights on the complex cross-border transactions that increasingly define the M&A landscape.

The panelists included Raymond McGuire, the co-head of Global Investment Banking at Citigroup, Toby Myerson, the co-head of Paul Weiss‘ Mergers and Acquisitions Group and Scott V. Simpson, the head of the European Mergers and Acquisitions Group at Skadden, Arps, Slate, Meagher & Flom.

Ray started the discussion with an overview of global trends in M&A and cross border transactions. He emphasized how the market today is far more globally connected, and that the increase in LBO activity during the 2002 to 2007 period was coincident with increased use of debt, and in particular covenant light debt. He also highlighted issues with the subprime market, and the government bailout of certain institutions.

Toby and Scott focused on the European regime, and offered fascinating perspectives on the social and political considerations that underlie the differences between the European and US approaches. In particular, Scott noted the differences in the corporate governance regime. For example, certain European countries such as Germany require directors to consider broader corporate interests, such as employee interests, in responding to takeover offers, as opposed to the US model where shareholder interests are paramount. Toby and Scott also took the class through case studies of two recent cross-border deals that illustrate the application of these principles, as well as the quickly changing landscape facing M&A practioners. The first case, Mittal Steel’s acquisition of Arcelor, illustrated how lawyers could exploit international reconciliation requirements to delay an acquisition, thus giving the target the ability to shop for a higher price. Scott noted how this successful technique is no longer effective due to recent international harmonization. He then discussed Access Industries’ Basell Holdings acquisition of Lyondell Chemicals Company, where the parties needed to use another technique involving the separation of voting and economic interests using derivatives. In both cases, the panelists highlighted the social and political matters that inevitably arise when a foreign acquirer pursues a large target.

A video of the discussion can be accessed online here.

Corporate Boards and Good Judgment: Does Rule 14a-8 Activism Help?

This post comes to us from Jeff Lipshaw of Suffolk University Law School.

My intuition, as a former senior vice president and general counsel of a publicly held corporation and as a theorist, is that Rule 14a-8 shareholder proposals on matters like poison pills, staggered boards, and executive compensation, bear at best a tenuous relationship to what shareholders should most want: the exercise by corporate management of exquisite judgment.

Keep in mind the complex milieu in which corporate management operates. My own experience is as a senior manager of a typical mature mid-cap company, not pathological like Enron, but not on the steep upslope of the “shareholder value creation” curve. The issues facing management in these companies are typically a mix of the following: product commoditization and obsolescence, loss of patents, pressure on R&D spending cuts, manufacturing inefficiencies, and so on. The shareholder base may be no less complex, consisting of long-term holders, short-term holders, arbitrageurs, social activists, and so on.

In our company, from 1998 to 2002, even as labor union pension funds filed shareholder proposals on the poison pill and the staggered board every year, two significant institutions, Berkshire Hathaway and Brandes Investment, increased their stake in the company from nothing to over 30% of the outstanding shares. The board redeemed the poison pill in early 2002 and sponsored a charter amendment to de-stagger the board in 2003.

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Accelerated Vesting of Stock Options in Anticipation of FAS 123-R

This post comes from Mohan Venkatachalam of Duke University, Shivaram Rajgopal of the University of Washington and Preeti Choudhary of Georgetown University.

In our forthcoming Journal of Accounting Research paper entitled “Accelerated Vesting of Stock Options in Anticipation of FAS 123-R”, we investigate what motivates firms to alter their compensation contracts in response to an accounting standard, and whether the acceleration decision represents benign changes in employees’ compensation contracts by examining the stock market reactions surrounding both the acceleration date as well as the filing date.

Our analysis is based on a sample of 354 firms that announced the accelerated vesting of options between March 2004 and November 2005 and a broad control sample of 665 firms. We observe a rapid increase in the number of accelerated vesting announcements subsequent to the FASB passing FAS 123-R, suggestive of a motivation to avoid recording a stock option expense. For the median (mean) accelerating firm, accelerated vesting increases earnings as a percentage of net income by about 4% (23%). Our regression results indicate that the likelihood that a firm accelerates vesting increases with the extent of underwater options and the level of financial reporting benefits received from acceleration. We also find evidence that acceleration is associated with agency motivations. Managerial ownership and greater option holdings by the top five executives are positively associated with accelerated vesting. We also find that firms with better external governance are less likely to accelerate vesting. In particular, we find that firms with greater blockholder ownership and pension fund ownership (proxies for better governance structures) have lower likelihood of acceleration.

We find that the average market reaction to the acceleration decision is -1% over the five-day period surrounding the announcement. In addition, there is some evidence that the accelerated vesting date could have been backdated. We find systematic negative stock returns of –1.7% 20 days before the acceleration date (not the announcement date) and positive returns of 1.4% 20 days after the acceleration date. We also find that a large majority of acceleration decisions (233 of the 365) reported the activity to the SEC six days or more after acceleration decision, supportive of backdated vesting dates.

The full paper is available for download here.

Regulatory Issues in Takeovers: section 13(d) & beyond

Last week here at Harvard Law School, Professor Robert Clark and Vice Chancellor Leo Strine treated the students of their Mergers, Acquisitions, and Spin-Offs class to another high-profile panel discussing current hot topics in M&A. On the agenda was section 13(d) of the 1934 Act and other, similar disclosure requirements for long and short positions, particularly as they relate to shareholder activism. The steep rise of synthetic securities has raised many questions of policy and interpretation regarding such requirements, as recently highlighted by the CSX/TCI decision (discussed on this blog here, here, and here). The panelists provided competing perspectives on these issues: On the “activist” investor side, the panel featured Roy Katzovicz of Pershing Square Capital Management and Marc Weingarten of Schulte Roth & Zabel. On the other side were Ted Mirvis of Wachtell, Lipton, Rosen & Katz and John Olson of Gibson, Dunn & Crutcher. Mirvis and Olson also spoke about shareholder activism in Professor Lucian Bebchuk‘s and Lecturer on Law Beth Young‘s Shareholder Activism class that same day. The video of the first event is available here, and that of the second event here.

Risk Management and the Board of Directors

This post is by Martin Lipton of Wachtell, Lipton, Rosen & Katz.

The risk oversight function of the board of directors has never been more critical and challenging than it is today. In the context of the current global financial crisis and the swooning global economy, companies now face risks that are more complex, interconnected and potentially devastating than ever before. Risk from the financial services sector has contributed to large-scale bankruptcies, bank failures, government intervention and rapid consolidation. And the repercussions have spread to the broader economy, as companies in nearly every industry have suffered from the effects of a global paralysis in the credit markets, sharply reduced consumer demand and extremely volatile commodity, currency and stock markets. In addition, the public and political perception that undue risk-taking has been central to the breakdown of the financial and credit markets is leading to an increased legislative and regulatory focus on risk management and risk prevention. In this environment, boards and companies must be mindful of the possibility that courts will apply new standards, or interpret existing standards, to increase board responsibility for risk management.

But what exactly is the proper role of the board in corporate risk management? The board cannot and should not be involved in actual day-to-day risk management. Directors should instead, through their risk oversight role, satisfy themselves that the risk management processes designed and implemented by executives and risk managers are adapted to the board’s corporate strategy and are functioning as directed, and that necessary steps are taken to foster a culture of risk-adjusted decision-making throughout the organization. Through its oversight role, the board can send a message to the company’s management and employees that corporate risk management is not an impediment to the conduct of business nor a mere supplement to a firm’s overall compliance program but is instead an integral component of the firm’s corporate strategy, culture and value generation process.

Given the increased significance of the risk oversight role in the current risk environment, a company’s risk management system should function to bring to the board’s attention the company’s most material risks and permit the board to understand and evaluate how these risks interrelate, how they affect the company, and how management addresses these risks. It is important for directors to have the experience, training and knowledge of the business necessary for making a meaningful assessment of the risks that the company faces, however complicated they may be. The board should also consider the best organizational structure to give risk oversight sufficient attention at the board level. In some companies, this may include creating a separate risk management committee or subcommittee. In others, it may be sufficient to have the review of risk management as a dedicated, periodic agenda item for an existing committee such as the audit committee, in addition to periodic review at the full board level. While no “one size fits all,” it is important that risk management be a priority and that a system for risk oversight appropriate to the company be put in place.

My colleagues Daniel A. Neff, Andrew R. Brownstein, Steven A. Rosenblum, Adam O. Emmerich, Sabastian V. Niles, Shaun J. Mathew, Brian M. Walker, and Philipp von Bismarck and I have prepared a memorandum entitled “Risk Management and the Board of Directors” that considers these and related considerations. The memorandum (1) outlines the risk oversight obligations of the board of directors and certain best practices derived from governmental and regulatory sources, (2) discusses some of the common areas of risk that companies may face, and (3) provides recommendations for structuring and improving risk oversight at the board level.

The memorandum is available here.

Investment professionals blame bank leaders and want global consultation on new financial system

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

Over the past few months financial markets have been through a traumatic experience. The traumatic experience equally applies to the participants. Not only are firmly held convictions overturned, models proved useless and careers destroyed, but the industry now faces a period of public scrutiny and social accountability that it has never before experienced.

The main question for proponents of sustainable financial markets is how can the lessons from these events be embedded in future behavior? A further question is about the appropriate regulatory response. This has been taken up by the Network for Sustainable Financial Markets.

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Does Private Equity Create Wealth?

This post is by Randall S. Thomas of Vanderbilt University.

Does private equity create value when it acquires a company in a leveraged buyout? If so, how? This question has fascinated scholars ever since the first big wave of buyouts occurred in the mid-1980’s, but has yet to be resolved. A second, even bigger wave of LBO transactions in 2003-2007, brought to a shuddering halt by the recent sub-prime mortgage crisis, has raised the question again even more forcefully as the current market for private equity deals has collapsed. In our recent article “Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance,” Ronald W. Masulis and I offer an important new motivation for private equity deals in the future: private equity firms and managers can do a better job of monitoring of derivative transactions and derivative contract positions than their public company counterparts.

As the subprime crisis has illustrated vividly, the growing use of, and trading in, derivative instruments by corporations has eroded the effectiveness of several critical corporate governance mechanisms – the board of directors, the financial accounting system and oversight by regulatory authorities – because firms lack effective means of monitoring derivative risk exposure on a real time basis. This change has increased the importance of attracting financially sophisticated, highly motivated corporate directors, who can deliver intensive monitoring of corporate risk management strategies, who are capable of independently and effectively controlling firm management as part of regulating derivative exposure and who will make the appropriate choices in creating managers’ financial incentives to insure that these executives’ personal risk exposures are aligned with the interests of the firm.

In this paper, we argue that private equity concentrated ownership is now, and will continue to be in the future, a very effective way of attaining all of these objectives. Private equity involvement strengthens boards monitoring of derivative exposures by reducing board size, increasing boards’ control over managers, improving information flows to the board, sharpening director financial incentives to monitor derivative exposure carefully, and attracting better qualified, more financially sophisticated directors, who better understand the associated risks. Further, debt holders and institutional investors can further improve firm monitoring since they are also large investors (who frequently hold both debt and equity positions in private equity controlled firms), which gives them strong incentives to monitor and good access to proprietary firm information flows to accomplish this goal.

The paper is available here.

Corporate Ownership and Control: British Business Transformed

This post is by Brian R. Cheffins of the University of Cambridge.

U.K. corporate governance is characterized by a separation of ownership and control, in the sense that a majority of British publicly traded companies lacks a shareholder owning a sufficiently sizeable voting block to dictate corporate policy. This pattern has not only influenced the tenor of corporate governance debate in Britain but serves to distinguish the U.K. from most other countries. Existing theories fail to account adequately for ownership and control arrangements in Britain. My book, Corporate Ownership and Control: British Business Transformed, just published in the U.K. and soon to be available in the U.S., accordingly explains when and why ownership became divorced from control in major British companies.

The approach I adopt in the book is strongly historical in orientation, as I examine how matters evolved from the 17th century through to today. While a modern-style divorce of ownership and control can be traced back at least as far as mid-19th century railways, the “outsider/arm’s-length” system of ownership and control that currently characterizes British corporate governance did not crystallize until the second half of the 20th century. Corporate Ownership and Control: British Business Transformed brings the story right up to date by showing current arrangements are likely to be durable. The insights it offers correspondingly should remain salient for some time to come.

Corporate Ownership and Control: British Business Transformed is divided into eleven chapters:

One: Setting the Scene
Two: The Determinants of Ownership and Control: Current Theories
Three: The ‘Sell Side’
Four: The ‘Buy Side’
Five: Up to 1880
Six: 1880–1914
Seven: The Separation of Ownership and Control by 1914
Eight: 1914–1939
Nine: 1940–1990: The Sell Side
Ten: 1940–1990: The Buy Side
Eleven: Epilogue: Current Challenges to the UK System of Ownership and Control

Key arguments I make in Corporate Ownership and Control: British Business Transformed include:

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Implementation of the Foreign Investment and National Security Act

This post is by George R. Bason, Jr. of Davis Polk & Wardwell LLP.

My colleagues Margaret M. Ayres and Jeanine P. McGuinness have prepared a memorandum entitled “FINSA Final Regulations,” which discusses the final regulations recently issued by the U.S. Department of the Treasury to implement the Foreign Investment and National Security Act of 2007. That law amended the 1988 “Exon-Florio” statute and made significant changes to the scope of review and process for evaluating foreign acquisitions of U.S. businesses for national security risks. The regulations implement the 2007 law and codify recent improvements to the practices of the Committee on Foreign Investment in the United States. They also maintain many of the features of the existing regulations, as well as of the proposed regulations, which were issued for notice and comment on April 21, 2008. The new regulations include the concept of a “covered transaction” and give additional guidance on key terms, including “control.” They also significantly expand the amount of information required in a voluntary notice and provide new procedures governing the review process. The final regulations were published in the Federal Register on November 21 and will become effective on December 22, 2008.

The memorandum is available here and the final regulations may be accessed here.

Experts on the Future of the SEC

Editor’s Note: This post comes to us from Craig Eastland of Thomson West Information Center.

On October 23rd, Henry Waxman’s House Committee on Oversight and Government Reform began hearings on regulatory oversight of financial markets. Alan Greenspan, John Snow, and Christopher Cox testified. SEC Chairman Cox, the only currently-serving official to testify, is in a tight corner: in March, the Department of the Treasury proposed a new regulatory structure, dubbed “Pure Functional Regulation”, that would see the responsibilities of the SEC distributed among new agencies. John McCain wants him fired (but that’s not so scary today, is it?) Perhaps most unfairly, he’s been blamed for the Consolidated Supervised Entity program, which was adopted almost a year before he even arrived at the SEC.

It made me think there was a real possibility that the SEC might become a casualty of the credit crisis. I even wondered whether this could mean the end of disclosure-based regulation.

To get some insight, I took a quick email poll of securities law experts.

Recommendation 1 – Keep disclosure-based regulation! It is a good system, and the alternatives are worse.

Disclosure-based regulation of securities transactions has been with us since the enactment, 75 years ago, of the Securities Act of 1933. The ’33 Act and the Securities Exchange Act of 1934, which regulates securities exchanges and provides for periodic disclosure to investors, form an interlocking regulatory structure built on,

“[…] a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.” (SEC website)

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