Monthly Archives: December 2008

Reforming the Taxation and Regulation of Mutual Funds

This paper from John Coates was also recently accepted for publication in the Journal of Legal Analysis, a new peer-reviewed opened access journal sponsored by Harvard Law School.

I recently presented my paper Reforming the Taxation and Regulation of Mutual Funds: A Comparative Legal and Economic Analysis at the Law and Economics Seminar at Harvard Law School. The paper provides a comparison of US tax and securities law governing mutual funds with laws governing other collective investments, in both the US and in the EU.

Current US tax law governing mutual funds has a number of unfortunate economic effects, including the discouragement of saving and investment by middle class Americans, misallocation of capital to sectors such as real estate, and the essential walling-off of the US from competition from or with foreign mutual funds, in the US or overseas. In addition, although much less important than US tax law, the current design and implementation of US securities law applicable to mutual funds is inhibiting innovation and growth in the fund sector, again with the effect of reducing investment.

My review of US regulation of collective investments, comparing regulation and data on the size and growth of US mutual funds with their major competitors, in the US and abroad shows that:

1. Within the US, regulation of mutual funds is more extensive and restrictive than for other types of collective investments.

2. The structure of US regulation – mutual funds are tightly restricted by bright-line rules written into a statute nearly 70 years ago, subject to SEC exemptions – makes continued success of US mutual funds dependent on the resources, responsiveness, and flexibility of the SEC.

3. The US fund industry continues to be the world leader, but its growth and international competitiveness now lags that of its domestic and foreign competitors, primarily because of US tax law.

4. While the formal laws imposed on mutual funds in other countries are as or more restrictive in many respects than US securities laws, the resources and responsiveness of foreign fund regulators (particularly in Ireland and Luxembourg) exceed those dedicated to funds by the SEC.

The paper concludes by describing potential improvements in US regulatory oversight of collective investments, including ways to enhance the flexibility and resources of US fund regulators, modifications of the existing ban on asymmetric advisor compensation and the exclusion of foreign funds, and unjustified disparities in the treatment of mutual funds and mutual fund substitutes.

The complete paper is available for download here.

How to Fix One Root Cause of Our Economic Crises

This post is by Ivo Welch of Brown University.

The slow demise of the U.S. car industry over decades and the spectacular collapse of the U.S. financial system have a lot in common. Both implosions are the result of poor management: shortsighted incompetence in the car industry and reckless risk-taking in the financial sector. Where was the oversight? And what could be a better indictment of the incentives in our system than the fact that even the executives who made the most egregious calamitous decisions are all walking away as rich men, while many of their shareholders have been wiped out?

(The Corporate Library reports that Richard Fuld, the person primarily responsible for the destruction of Lehman Brothers (and clearly among the most incompetent CEOs of all time), was the 13th highest CEO in 2007, with $71.92 million in compensation in 2007, including more than $40 million in value from realized stock options. The third highest-paid executive on the list was Angelo Mozilo, former CEO of Countrywide Financial Corp., which collapsed on its subprime loans. His total actual compensation for 2007 was $124.69 million. Bank of America had to pay him another hundred million dollars to make him disappear. It took government intervention to stop the CEOs of Fannie and Freddie from receiving $25 million in parachutes. The list of scandalous pay and no board supervision goes on and on.)

The fact is that our US corporate governance system is dysfunctional. The most important feature of a governance system is its ability to limit the power of those CEOs—the black sheep if you will—who are inclined to break it. Therefore, the only effective mechanisms are those that are external to the firm — those that cannot be dismantled by bad CEOs: management’s fiduciary duty, the requirement to hold an annual meeting, the possibility of an external takeover (at least before Delaware gave management the poison pill and staggered boards to prevent them), the negative publicity surrounding excessive salaries. In contrast, internal governance mechanisms, such as the power of the Chairman’s board to fire the CEO, are seldom effective. Any bad CEO worth his salt will have worked hard to make this extremely difficult.

It is imperative to our global competitiveness that we improve our corporate governance system. If we do not, we may fix all our present economic calamities only to have new ones erupt elsewhere before long.

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Agency Problems at Dual-Class Companies

This post comes from Ronald Masulis at the Owen Graduate School of Management, Vanderbilt University, Cong Wang at the Faculty of Business Administration, Chinese University of Hong Kong, and Fei Xie at the School of Management, George Mason University.

In our paper Agency Problems at Dual-Class Companies, which was recently accepted for publication in the Journal of Finance, we use a sample of U.S. dual-class companies over the period 1994-2002 to examine how the divergence between insider voting rights and cash-flow rights affects managerial extraction of private benefits of control. Using both a ratio and a wedge measure to capture the voting-cash flow rights divergence, we find four distinctive sets of evidence supporting the hypothesis that managers with greater control rights in excess of cash-flow rights are more likely to pursue private benefits at the expense of outside shareholders.

First, we examine how control-cash flow rights divergence impacts a firm’s efficiency in utilizing an important corporate resource – cash reserves. We find that the marginal value of cash is decreasing in the divergence between insider voting rights and cash-flow rights, which is consistent with the argument that shareholders anticipate that corporate cash holdings are more likely to be misused at companies where insider voting rights are disproportionately greater than cash-flow rights, and therefore place a lower value on these highly fungible corporate assets.

Second, we analyze how the insider control-cash flow rights divergence affects the level of CEO compensation, and find that, ceteris paribus, excess CEO pay is significantly higher at companies with a wider divergence between insider voting and cash-flow rights.

Third, we evaluate the acquisition decisions made by dual-class companies, and find in a multivariate regression framework that as insider control-cash flow rights divergence widens, acquiring companies experience lower announcement-period abnormal stock returns, are more likely to experience negative announcement-period abnormal stock returns, and are less likely to withdraw acquisitions that the stock market perceives as shareholder value destroying. These results suggest that as insiders control more voting rights relative to cash-flow rights, they are more likely to make shareholder value-destroying acquisitions that benefit themselves.

Finally, we examine firms’ capital expenditure decisions as another channel of empire building and private benefits extraction. We find that ceteris paribus, capital expenditures contribute significantly less to shareholder value at firms with a greater divergence between insider voting rights and cash flow rights, suggesting that managers at these companies are more likely to make large capital investments to advance their own interests.

Overall, our results shed direct light on the issue of how insider control-cash flow rights divergence leads to lower shareholder value. In addition, our results further our understanding of why superior-voting shares command a premium in the marketplace over inferior-voting shares.

The full paper is available for download here.

Hedge Funds Settle “Short Swing” Profits Litigation

Editor’s Note:

As part of the continuing confrontation between CSX Corporation and hedge funds holding CSX shares and equity swaps on CSX shares – and which earlier this year mounted a successful proxy fight, replacing four members of the CSX board of directors – the hedge funds have agreed to settle an action to recover “short-swing” profits pursuant to Section 16(b) of the Securities Exchange Act of 1934.

Section 16(b) provides that beneficial owners of more than 10% of the stock of publicly traded corporations (as well as officers and directors) are liable to disgorge to the corporation any profit derived from purchases and sales of the stock of the corporation within a period of less than six months. While the hedge funds which invested in CSX did not directly hold a position of more than 10% in CSX shares, their aggregate interest in the shares and the equity swaps – which involved matching positions in CSX stock by the banks which had written the swaps – together exceeded 10%. As we discussed in our memo of June 12th, in a separate litigation brought by CSX against the funds, Judge Kaplan of the U.S. District Court for the Southern District of New York held that the hedge funds were the beneficial owners of over 10% of CSX shares for purposes of SEC Rule 13d-3(b) on account of the shares they directly held and the swaps they entered into.

Following Judge Kaplan’s decision, a CSX shareholder filed suit pursuant to Section 16(b) seeking to recover for the benefit of CSX short-swing trading profits achieved by the hedge funds while they beneficially held more than 10% of CSX stock directly and by virtue of their derivative positions. Rule 16a-1(a)(1) provides that a beneficial owner of more than 10% for purposes of Section 16 means any person who is deemed a beneficial owner pursuant to Section 13(d) and the rules thereunder. Based on the hedge funds’ swaps and stock transactions, plaintiff and CSX identified potential recoverable damages from the hedge funds under Section 16(b) of approximately $138 million. The hedge funds agreed to pay $11 million to settle the Section 16(b) action. The amount of the settlement was reportedly influenced by, among other things, the fact that Judge Kaplan’s decision regarding beneficial ownership is still pending appeal to the Second Circuit.

We have long advised that non-traditional economic and voting arrangements be approached with extreme caution. Such arrangements not only can have significant implications for investors’ disclosure obligations under Section 13(d), but can also trigger shareholder rights plans, change-incontrol provisions of commercial and employee contracts and compensation plans, and, as the CSX settlement makes clear, investors’ “short-swing” profit repayment obligations under Section 16(b). We continue to urge the SEC to undertake comprehensive regulatory reform that addresses derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise. In the meantime, it continues to be important for public companies and investors alike to consider all potential legal obligations and liabilities that may arise as a result of such economic ownership equivalent positions and to take appropriate action in that regard.

2009 US Proxy Season

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

The 2009 US proxy season has its unofficial kickoff in the form of RiskMetric Group’s US Corporate Governance Policy Update, where the focus is again largely on executive compensation practices. The Policy Update includes voting recommendations on key issues such as “poor pay practices” and several major governance proposals, including separation of CEO and Chair positions. RMG has also changed its evaluation of total shareholder return in acknowledgement of the volatile market environment. While the season is just beginning, we’ve already spotted several emerging trends, indicating that companies will continue to be targeted by activists even while they may be struggling with their business operations, all of which should make for a very interesting upcoming season. Our memo, which discusses the emerging trends for the forthcoming proxy season as well as RMG’s Policy Update, is available here.

Large Shareholders and Corporate Policies

This post comes from Henrik Cronqvist at Claremont McKenna College and Rüdiger Fahlenbrach at The Ohio State University.

In our paper, Large Shareholders and Corporate Policies, which was recently accepted for publication in the Review of Financial Studies, we investigate whether large shareholders play an important role for corporate policy choices and firm performance. We argue that one explanation for the lack of large-sample evidence of blockholder effects is that large shareholders differ from each other, and existing empirical frameworks do not incorporate blockholder heterogeneity into an economic analysis of large shareholders. To account for this heterogeneity, we develop an empirical framework and to construct a new blockholder-firm panel data set that can be used to analyze the economic effects of blockholder heterogeneity. The novel feature of our data set is that it allows us to identify and track all unique large shareholders among large U.S. public firms − in essence the Standard and Poor’s (S&P) 1,500 universe − from 1996 to 2001. This data set allows us to take the analysis of large shareholders to the smallest possible economic unit: the individual blockholder. Our empirical approach involves running panel regressions in which corporate policy and firm performance variables are regressed on year and firm fixed effects as well as time-varying firm-level characteristics to control for observable and unobservable firm heterogeneity, and most importantly, blockholder fixed effects.

We find statistically significant and economically important blockholder fixed effects in investment, financial, and executive compensation policies. This evidence suggests that blockholders vary in their beliefs, skills, or preferences. Different large shareholders have distinct investment and governance styles: they differ in their approaches to corporate investment and growth, their appetites for financial leverage, and their attitudes towards CEO pay. Given the evidence on blockholder heterogeneity and corporate policies, we ask whether firm performance is systematically related to the particular large shareholder present in a firm. We find blockholder fixed effects in firm performance measures, and differences in style are systematically related to firm performance differences. a blockholder in the 75th (25th) percentile is associated with 4% (3%) higher (lower) return on assets (ROA), all else equal, which are large effects given that the average ROA is around 5% in our sample.

The documented blockholder effects in firm policies could be consistent with either an influence explanation, in the sense that large shareholders impact policies, or a selection interpretation, in that blockholders systematically select firms in which they invest major stakes based on a preference for certain policies. Our evidence is more consistent with influence for activist, pension fund, corporate, individual and private equity blockholders, but more consistent with systematic selection for large mutual fund shareholders. Finally, we analyze sources of the heterogeneity, and find that blockholders with a larger block size, board membership, direct management involvement as officers, or with a single decision maker are associated with larger effects on corporate policies and firm performance.

The full paper is available for download here.

A Theory of Firm Scope

This post is by Oliver Hart of Harvard University.

I recently presented a new working paper co-written with Bengt Holmstrom at the Law, Economics and Organizations workshop entitled A Theory of Firm Scope.

In the standard property rights model, parties write contracts that are ex ante incomplete but that can be completed ex post; the ability to exercise residual control rights improves the ex post bargaining position of an asset owner and thereby increases her incentive, and the incentive of those who enjoy significant gains from trade with her, to make relationship-specific investments, and as a consequence, it is optimal to assign asset ownership to those who have the most important relationship-specific investments or who have indispensable human capital. Although the property rights approach provides a clear explanation of the costs and benefits of integration, the theory seems to describe owner-managed firms better than large companies.

The purpose of the current paper is to modify the property rights approach so that it can be applied to a broader set of organizational issues, including the organization of large firms. We develop a model in which: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm’s profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. Under these conditions, firm boundaries matter.

Under non-integration, bosses maximize the right thing (profits plus private benefits) but are parochial (they do not take into account their effect on the other unit), while under integration, they maximize the wrong thing but are broad. In our basic model, where the only issue is whether the units coordinate, we show that non-integration and integration make the opposite kind of mistake. Non-integration leads to too little coordination. This happens if the benefits from coordination are unevenly divided across the units. One unit may then veto coordination even though it is collectively beneficial. In contrast, under a weak assumption–specifically, that coordination represents a reduction in “independence” and therefore causes a fall in private benefits–integration leads to too much coordination. We also extend our analysis to understand the role of delegation.

The full paper is available for download here.

RiskMetrics Group 2009 Benchmark Voting Policy Updates

This post is by Carol Bowie of Institutional Shareholder Services Inc.

RiskMetrics Group recently released updates to its 2009 proxy voting policies, after an extensive process that included outreach to and input from hundreds of institutional investors and corporate issuers. RiskMetrics’ policies will be applied to all companies with shareholder meeting dates on or after February 1, 2009.

This year’s policy revisions reflect the unprecedented market turmoil that has sparked investor and regulatory focus on executive compensation practices, board accountability and oversight, and the quality of financial reporting. Accordingly, the three main areas of focus for the 2009 policy updates are executive pay, board structure, and audit practices.

Both issuer and investor respondents to RiskMetrics’s annual policy survey demonstrated little tolerance for outsized pay packages, with 70 percent of investors and 85 percent of issuers specifying pay relative to performance as “very important” in evaluating executive compensation practices. Thus, RiskMetrics’ policy guidelines on executive compensation have been expanded to examine practices that divorce pay from performance, such as tax gross-ups on severance payments and executive perks, and provisions that pay severance for voluntary departures following a takeover.

RiskMetrics has also harmonized assessment of company performance across several North American policies. As of 2009, corporate performance will initially be assessed using a relative, rather than absolute, measure of total shareholder return over 1- and 3-year periods. This assessment will result in greater scrutiny under several policies, including pay-for-performance evaluations, independent chair shareholder proposals, and director elections. Regarding the latter, the policy update addresses cases where lagging company performance is coupled with a governance structure that discourages director accountability and may lead to board and management entrenchment.

Additionally, RiskMetrics has updated its accounting policy guidelines to specify ongoing material weaknesses in Section 404 disclosures and misapplication of GAAP as triggers for in-depth analysis of a company’s accounting practices, and to recommend against audit committee members in the case of an adverse opinion from auditors.

Internationally, RiskMetrics revised its share buyback policy to reflect client feedback and regulatory developments in Europe. RiskMetrics’ policy on discharge of directors resolutions, common in several markets, will now accommodate recommendations designed to provide a “yellow card” warning to directors who may not be fulfilling their fiduciary duties. Director independence best practices in several European markets have also been incorporated into the 2009 policies. In Canada, RiskMetrics is introducing a Poor Pay Practices Policy to reflect the additional disclosure that is now available in that market.

The 2009 policy updates are accessible through RiskMetrics’ online Policy Gateway, which also contains FAQs and other informational resources to provide all market participants with a good understanding of how RiskMetrics formulates and applies its corporate governance policies. In addition to its own policies, the corporate governance policies and philosophies of leading market participants are also available via RiskMetrics’ Policy Exchange platform.

Litigation Issues Arising from the Credit Crisis

This post is by Allen Ferrell of Harvard Law School.

My co-authors (Jennifer Bethel and Gang Hu) and I have updated our paper, including the inclusion of current data, entitled “Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis” which can be downloaded here. The paper is forthcoming in a Brookings volume on the credit market crisis.

The paper surveys the current securities class action litigation arising out the credit crisis (10b-5, section 11, section 12(a)(2)) and some of the important securities law principles that will be at play in the resolution of this litigation. In particular, we focus on the following three securities law principles in our discussion: (1) no fraud by hindsight; (2) truth on the market defenses; and (3) loss causation issues. We also provide data on various aspects of the securitization process that intersect with the application of these principles. For instance, with respect to the “truth on the market” defense (i.e., that the purported disclosure deficiencies were not material given the information the market already had) we discuss the fact that the quality of disclosures in the mortgage backed securities registration statements (and virtually all mortgage backed securities were registered) actually improved between 2001 to 2006 (in part due to the promulgation of Regulation AB in 2004) and that it was quite clear from these registration statements that the quality of the underwriting in a number of instances had declined. Moreover, the scope of commercial banks’ asset backed commercial paper conduit liquidity exposures were explicitly disclosed in their public Form Y-9C filings with the Federal Reserve. Moreover, asset backed commercial paper conduit disclosures provided to the commercial paper investors, such as hedge funds, included information concerning the liquidity guarantees provided by the banks.

We also discuss the source of many of the losses and writedowns suffered by the banks, particularly in 2007 and the first half of 2008, which is important in assessing the securities class action litigation. Many banks suffered substantial losses due to their “super senior” positions in CDOs and various liquidity guarantees to asset backed commercial paper conduits, rather than directly on their mortgage-backed security holdings.

We also provide in the paper data on, among other things, the tranche structure of mortgage-backed securities, securitization deal sizes, reported value at risk estimates by banks, CDO liquidations and CDO trustee information.

The paper is available here.

Negotiated Cash Acquisitions of Public Companies in Uncertain Times

This post is by Arthur Fleischer Jr. of Fried Frank, Harris, Shriver & Jacobson LLP.

Until the current crises in the financial markets, negotiated acquisitions of public companies had been documented by a form of merger agreement which had evolved into an almost standard “seller friendly” template. This standard model agreement reflected the same factors which contributed to the vibrant M&A activity of recent years: readily available financing, rising stock markets, stable or improving economic and industry conditions, and high levels of confidence in business and financial fundamentals. Combined with the negotiating leverage provided to companies seeking to sell themselves by the generally large and seemingly ever-expanding universe of potential buyers, both strategic and financial, as well as sources of financing willing to assume syndication or underwriting risks, these factors resulted in merger agreements intended to provide sellers with a high level of certainty that a transaction would be completed. With the substantial erosion, if not disappearance of each of the factors underpinning the justification for the standard merger agreement, merger agreements should adapt to the new environment. Therefore, a new paradigm seems likely for acquisitions for cash in which the buyer does not have cash on hand sufficient to pay the acquisition price and any necessary refinancing of seller debt.

My firm has prepared a memorandum entitled “Negotiated Cash Acquisitions in Public Companies in Uncertain Times,” which considers how merger agreements may change as parties to transactions seek to allocate risks to closing and limit their liability. Written primarily by Peter S. Golden, with assistance from David Shine and me, the memorandum considers reverse break-up fees, forms of “seller financing,” material adverse change clauses, express financing conditions, buyer best effort covenants, ticking fees and other aspects of merger agreements that may adapt to the new M&A and financing climate.

The memorandum is available here.

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