Monthly Archives: November 2008

The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Thursday, November 13, 2008
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This post comes to us from James S. Linck and Jeffry M. Netter of the University of Georgia and Tina Yang of Clemson University.

In our forthcoming Review of Financial Studies paper The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors, we examine the effects of SOX and contemporary reforms on the structure and makeup of corporate boards and directors.

We examine the effects of SOX using a simple framework of demand and supply for directors. Specifically, demand for directors increased due to various mandates on board composition and workload. The supply of directors decreased due to the increased workload and risks of being a director. While we cannot directly trace out the shifts of the curves, we examine the magnitude of the changes caused by these demand and supply shifts on the number and pay of directors (price and quantity). Both demand and supply shifts would increase the price of directors (pay) – indeed, director pay does rise dramatically. While the shifts have opposite effects on quantity, some of SOX’s requirements often necessitate that the quantity of directors increases; thus, we expect that the demand effect will dominate. In fact we find that boards are larger post SOX.

We construct several different samples for our empirical analysis to provide sufficient breadth and depth to identify important time series and cross-sectional impacts. For example, we study the boards of more than 8,000 firms from 1989 to 2005, providing broad-sample evidence on the impact of SOX and contemporary changes on the major exchanges. We complement our broad-sample evidence with more detailed analysis of smaller subsamples. The breadth and depth of our sample allow for a comprehensive analysis of board-related costs, and the extent to which the costs of these regulatory mandates are uniform across firms.

Our results suggest that SOX dramatically affected corporate boards, their activities, and their costs. Median pay per director rose by more than $38,000 from 2001 to 2004, an increase of more than 50%. By comparison, CEO pay increased by just 24% over the same time period. The per director pay increase, coupled with the fact that firms also have more outside directors, drove a substantial increase in total director fees paid by firms. Our results also suggest that changes in director pay especially fall on smaller firms, a fact that was exacerbated by SOX given the dramatic post-SOX rise in director compensation. For example, small firms paid $3.19 in director fees per $1,000 of net sales in 2004, which is $0.84 more than they paid in 2001 and $1.21 more than in 1998. In contrast, large firms paid $0.32 in director fees per $1,000 of net sales in 2004, seven cents more than they paid in 2001 and ten cents more than in 1998. Further, the proportion of equity to cash pay rose significantly post SOX. Board committees meet more often post SOX and Director and Officer (D&O) insurance premiums doubled. Directors post SOX are more likely to be lawyers/consultants, financial experts and retired executives, and less likely to be current executives. Lastly, post-SOX boards are larger and more independent.

The full paper is available for download here.

Leverage and Pricing in Buyouts: An Empirical Analysis

Posted by Michael S. Weisbach, Fisher College of Business at The Ohio State University, on
Wednesday, November 12, 2008
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This post is by Michael S. Weisbach of Ohio State University.

I recently presented my paper Leverage and Pricing in Buyouts: An Empirical Analysis, which is co-written with Ulf Axelson, Tim Jenkinson and Per Strömberg, at the Law, Economics and Organizations seminar, here at Harvard Law School.

This paper provides an empirical analysis of the financial structure of large recent buyouts. We collect detailed information of the financings of 153 large buyouts (averaging over $1 billion in enterprise value). We document the manner in which these important transactions are financed. In addition, we compare the firms acquired by private equity funds to comparable firms that are publicly traded. Buyouts are executed by knowledgeable professionals (the general partners (GPs) of the private equity funds) with strong incentives, who utilize sophisticated financial structures designed to maximize value by optimizing on a number of margins.

If we presume that GPs optimize capital structure at the time of the acquisition, then this capital structure provides a benchmark for understanding optimal capital structure in public firms. Lastly, we consider the relation between leverage and transaction multiples, and try to estimate the extent to which the ability of debt markets to provide financing impacts the pricing of deals.

The financial structure that private equity firms choose for their portfolio companies is radically different from that observed for comparably firms quoted on public equity markets. Indeed, a reasonably summary of the differences we observe would be to view them as the inverse of each other. We find that buyout leverage is cross-sectionally unrelated to the leverage of matched public firms, whether we measure leverage as the ratio of debt to enterprise value or by debt as a multiple of cash flow – as proxied by earnings before interest, taxes, depreciation and amortization (EBITDA).

Leverage appears to be largely driven by other factors than what explains leverage in public firms. In particular, the economy-wide cost of borrowing seems to drive leverage. Prices paid in buyouts are related to the prices observed for matched firms in the public market, but are also strongly affected by the economy-wide cost of borrowing. These results are consistent with a view in which the availability of financing impacts booms and busts in the private equity market.

The full paper is available for download here.

U.S. Securities Litigation Against Non-US Issuers by Non-US Plaintiffs

Posted by Robert J. Giuffra, Jr., Sullivan & Cromwell LLP, on
Tuesday, November 11, 2008
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This post is by Robert J. Giuffra, Jr. of Sullivan & Cromwell LLP.

In a unanimous opinion in Morrison v. National Australia Bank, the United States Court of Appeals for the Second Circuit limited the ability of U.S. courts to hear claims brought on behalf of non-U.S. investors who purchased shares of non-U.S. companies on non-U.S. exchanges. Referred to as “foreign-cubed claims,” they have become increasingly frequent over the past several years. While declining to adopt a “bright-line rule” precluding the exercise of subject matter jurisdiction over such claims, the Second Circuit held that, in general, a U.S. court does not have subject matter jurisdiction over foreign-cubed claims when the acts that constituted the alleged fraud and directly caused the alleged harm emanated from outside the United States. Under this approach, the court concluded, subject matter jurisdiction does not exist over a foreign-cubed claim when the non-U.S. company’s executives (a) made decisions concerning the content of alleged misstatements to investors from abroad and (b) issued those statements from abroad.

My firm recently issued a memorandum that analyzes the Court’s opinion and discusses its implications for non-U.S. companies. The memorandum is available here.

Women in the Boardroom and Their Impact on Governance and Performance

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, November 10, 2008
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This post comes to us from Renée B. Adams of the University of Queensland and ECGI, and Daniel Ferreira of the London School of Economics, CEPR and ECGI.

In our paper “Women in the Boardroom and Their Impact on Governance and Performance”, which is forthcoming in the Journal of Financial Economics, we investigate the hypothesis that gender diversity in the boardroom affects governance in meaningful ways. Our initial sample consists of an unbalanced panel of director-level data for S&P 500, S&P MidCaps, and S&P SmallCap firms collected by the Investor Responsibility Research Center (IRRC) for the period 1996-2003. Once we supplement this data with other director and financial information, we have a final sample of 86,714 directorships (director firm-years) in 8,253 firm-years of data on 1,939 firms.

We find that gender diversity has significant effects on board inputs. Women are less likely to have attendance problems than men. Furthermore, the greater the fraction of women on the board is, the better is the attendance behavior of male directors. Holding other director characteristics constant, female directors are also more likely to sit on monitoring-related committees than male directors. In particular, women are more likely to be assigned to audit, nominating, and corporate governance committees, although they are less likely to sit on compensation committees. Women also appear to have a significant impact on board governance. We find direct evidence that more diverse boards are more likely to hold CEOs accountable for poor stock price performance: CEO turnover is more sensitive to stock return performance in firms with relatively more women on boards. We also find that directors in gender-diverse boards receive relatively more equity-based compensation. We do not find a statistically reliable relationship between gender diversity and the level and composition of CEO pay, which is consistent with our findings that female board members are underrepresented on compensation committees and thus have less involvement in setting CEO pay.

The evidence on the relationship between gender diversity on boards and firm performance is more difficult to interpret. Although the correlation between gender diversity and either firm value or operating performance appears to be positive at first inspection, this correlation disappears once we apply reasonable procedures to tackle omitted variables and reverse causality problems. Our results suggest that, on average, firms perform worse the greater is the gender diversity of the board. This result is consistent with the argument that too much board monitoring can decrease shareholder value. Thus, it is possible that gender diversity only adds value when additional board monitoring would enhance firm value. Using additional tests, we find that gender diversity has beneficial effects in companies with weak shareholder rights, where it is plausible that additional board monitoring can enhance firm value, but detrimental effects in companies with strong shareholder rights.

The full paper is available for download here.

Delaware Court of Chancery Holds Statute of Frauds Applies to LLC Agreements

Posted by Robert S. Saunders, Skadden, Arps, Slate, Meagher & Flom LLP, on
Sunday, November 9, 2008
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This post is based on a memo by Robert Saunders and his colleagues Allison Land and Ron Brown of Skadden, Arps, Slate, Meagher & Flom 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.

On October 22, 2008, Vice Chancellor Lamb of the Delaware Court of Chancery issued an opinion in Olson v. Halvorsen with important implications for parties contemplating the formation of a Delaware limited liability company. Ruling on a question of first impression, the court held that the Delaware statute of frauds applies to limited liability company agreements.

The plaintiff sought enforcement of an unsigned operating agreement for an LLC formed by the plaintiff and two other individuals in connection with a newly formed hedge fund structure. The dispute arose after the other two founders voted to remove the plaintiff from the LLC. The LLC paid $100 million to the plaintiff, consisting of his capital account balance and the remainder of his compensation for the year. However, the plaintiff argued that he was entitled to an additional payment of more than $100 million because, under the terms of the unsigned operating agreement, the plaintiff would have been entitled to an “earn out” over six years.

For purposes of summary judgment, the court’s decision turned on whether the Delaware statute of frauds applies to a Delaware LLC operating agreement. Neither the court nor the parties cited any case in any jurisdiction addressing the issue. Commentators were split as to whether the statute of frauds should apply. The Delaware Limited Liability Company Act expressly permits oral and implied LLC agreements, and provides that it is the policy of the Act “to give maximum effect … to the enforceability of limited liability company agreements.” However, the court asserted that most oral LLC agreements would not contain a provision that cannot possibly be performed within one year, so that the statute of frauds would not limit the enforcement of such agreements. The court held “that if an LLC agreement contains a provision or multiple provisions which cannot possibly be performed within one year, such provision or provisions are unenforceable.” The court went on to reject the plaintiff’s claim because the earn-out provision in the unsigned LLC operating agreement could not possibly be performed within a year and because the multiple writings or part performance exceptions to the statute of frauds did not apply.

The plaintiff now has thirty days to appeal this ruling to the Delaware Supreme Court.

Executive Compensation Rules Under the Emergency Economic Stabilization Act of 2008

Posted by Margaret E. Tahyar, Davis Polk & Wardwell LLP, on
Saturday, November 8, 2008
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This post is by Margaret E. Tahyar of Davis Polk & Wardwell LLP.

My colleagues in the Employment Practice Group at Davis Polk & Wardwell have prepared a memorandum discussing the executive compensation requirements applicable under each of the Capital Purchase Program, Troubled Asset Auction Program and Program for Systemically Significant Failing Institutions implemented under Emergency Economic Stabilization Act of 2008 (“EESA”). The memo also briefly summarizes the basic purposes of and authorities granted to the U.S. Department of the Treasury under EESA, and includes a table that presents a summary comparison of pre-EESA rules and new rules applicable to EESA program participants, with respect to (i) golden parachutes under Section 280G of the Internal Revenue Code (the “Code”), (ii) deduction limits under Section 162(m) of the Code, (iii) incentive compensation and risk aversion and (iv) clawbacks of incentive compensation.

The memorandum is available here.

The Oracle Acquisition of PeopleSoft

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, November 7, 2008

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Recently, in the Mergers, Acquisitions, and Split-Ups course here at Harvard Law School, which is co-taught by Vice Chancellor Leo Strine, Jr. and Professor Robert C. Clark, there was a panel discussion which focused on Oracle’s acquisition of PeopleSoft. The panel consisted of A. George “Skip” Battle, chairman of the PeopleSoft board’s Transaction Committee, Victor I. Lewkow, a partner based in the New York office of Cleary Gottlieb who focuses on public and private merger and acquisition transactions, and Professor Guhan Subramanian, the Joseph Flom Professor of Law and Business at the Harvard Law School and the Douglas Weaver Professor of Business Law at the Harvard Business School.

Skip began the discussion by outlining the competitive environment at the time of the bid. In particular, he focused on how sensitive the stock price is to software sales for companies like PeopleSoft. The importance of this relationship was reinforced by Victor, who noted that Oracle’s initial bid could have the potential to delay customer orders while the acquisition was finalized. Even if customers only delayed their orders by one or two quarters, PeopleSoft’s stock price could be cut by as much as 50%. Both panelists also discussed other issues, such as why a transaction committee had to be formed, and the relevance of anti-trust considerations. Guhan added to the discussion by outlining various bidding strategies, and by providing the context for Oracle’s initial low offer. Vice Chancellor Strine provided the perspective of the judge who heard Oracle’s request to compel PeopleSoft to rescind its ”poison pill” provision.

The video of the panel is available here.

Reconsidering “Say on Pay” Proposals

Posted by Keith L. Johnson, Reinhart Boerner Van Deuren s.c., on
Thursday, November 6, 2008
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This post is by Keith L. Johnson of Reinhart Boerner Van Deuren.

Daniel Summerfield and I recently presented a paper to the Shareholder Forum Program on Reconsidering “Say on Pay” Proposals, held recently at the Columbia School of Journalism. We address arguments put forth by opponents of shareholder “Say on Pay”. The paper cites benefits produced by Say on Pay in Britain and analyzes points where debate in the United States has been framed in ways that obscure many Say on Pay benefits. Points include:

• Recognition that success of Say on Pay in other markets cannot be evaluated over a short time frame and must acknowledge the ongoing cross-border effect of executive compensation practices in the United States;

• While Say on Pay gives shareholders more influence, its most important effect is empowerment of directors;

• Say on Pay fosters improved communication between shareholders and boards, creating opportunities for both to increase their understanding of market sentiment and enhance their respective roles in corporate governance;

• Advisory votes on compensation practices would allow shareholders to send a message to boards without throwing qualified directors off the board at companies where a majority vote standard has been adopted for director elections;

• Say on Pay encourages boards to focus greater attention on succession planning, which has been a dangerously low priority for many boards;

• Both excessive executive compensation and pay without performance present risks to shareholders that Say on Pay could legitimately address.

The paper is available here.

SEC Adopts Enforcement Manual

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Wednesday, November 5, 2008
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This post is by John F. Olson of Gibson, Dunn & Crutcher LLP.

This post has been prepared by my partner John H. Sturc.

The SEC’s Division of Enforcement recently issued its first-ever manual. Intended as a reference for Enforcement Division staff, the Manual provides important insight into SEC decision-making and processes on such key matters as evaluating possible investigations, opening and closing matters, issuing Wells letters, communicating with senior SEC officials, responding to document subpoenas, “witness assurance” letters, contacting current and former employees, and respecting the attorney-client privilege during an investigation. It will be an essential guide for anyone with a matter before the Division of Enforcement.

The Manual memorializes in one place staff policies that have developed over decades but which were applied principally on the basis of oral tradition or internal, unpublished memoranda. A few highlights of the Manual follow. The full text is available on the SEC website here.

Purpose and Scope

The Enforcement Manual is designed as a reference for Division of Enforcement staff. The Manual states that it is “not intended to, does not, and may not be relied upon to create any rights, substantive or procedural, enforceable at law by any party in any matter civil or criminal.” Nevertheless, the Manual serves two very useful purposes. First, it informs persons requested to provide information to the SEC staff of the staff’s expectations. Second, it also provides boundaries that, for the first time, publicly define normative behavior for the SEC staff itself and that potential reviewing courts can use to determine whether agency action is appropriate, whether under an “arbitrary and capricious” or other standard of legal review.

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Key Principles for Strengthening Corporate Governance

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, November 4, 2008
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Editor’s Note: The NACD, in its report, acknowledges the extraordinary and pro bono efforts of Ira Millstein and Holly Gregory and their colleagues at Weil, Gotshal & Manges LLP for their assistance with preparation of the principles.

The National Association of Corporate Directors, with the support of the Business Roundtable, recently released Key Agreed Principles for Strengthening Corporate Governance. The Principles identify the core areas that boards, management and shareholders agree should be the basis for good corporate governance and cover topics including independent board leadership, protecting against entrenchment of the board, shareholder participation in corporate decision making, and board communication with shareholders. In recognition of the legitimate concerns that exist about the rigid and prescriptive use of best practice recommendations by some proponents, the Principles are intended to reflect a distillation and articulation of fundamental principles-based aspects of governance on which there appears to be broad consensus. They are also intended to stimulate informed debate about issues on which consensus does not yet exist.

The International Corporate Governance Network, a global network of institutional investors, has welcomed the Principles, emphasizing that “[t]his is a good start which we believe should encourage further discussion on how to improve practice in corporate governance and develop much better understanding between companies and the shareholders who own them. The ICGN believes this is a constructive way towards long term value creation, which has become all the more important in the light of the current economic crisis.”

The principles are available here. A comparison of Significant Views on Corporate Governance Best Practice, which is Appendix A to the report, is available here. A comparison of Sarbanes Oxley, SEC and Listing Rule provisions related to the composition and functioning of the board of directors of a publicly traded company, Appendix B to the report, is available here.

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