Monthly Archives: December 2008

United Shareholders of America

Editor’s Note: This post is by Carl Icahn.

Eliot Spitzer offered up some insightful commentary (Nov. 16, Wash Post) on the public corporation’s fall from favor and rightly pointed to basic issues in corporate governance that need reform. He states, “…our corporate governance system has failed. …Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves – all abdicated their responsibilities.”

If by shareholders, Spitzer means mutual funds and pensions have not actively held boardrooms accountable, I agree with him. Put simply, boards have failed. Why should shareholders stand by on the sidelines? There is no axiom stating that public shareholders have to stand by and witness the demise of the most powerful financial engine in history.

Why should public shareholders be forced to leave so much value on the table because of risks taken by unaccountable management teams and boards? Spitzer says that when his office and the DOJ warned that, “some of AIG’s reinsurance transactions were little more than efforts to create the false impression of extra capital on the company’s balance sheet,” they were “jeered at for attacking one of the nation’s great insurance companies, which surely knew how to balance risk and reward.” Clearly, many boards such as AIG did not know how to balance risk. And they certainly did not know how to balance reward.

As owners, why would we allow this? The theory of the public corporation is not bankrupt, the practice is. We need critical changes in corporate governance that would go to the heart of the blameworthy lack of accountability between managers and shareholders.

Board members are often hand-picked by managers. The current proxy system is so biased in favor of management that any challenge is prohibitively expensive and generally guaranteed to fail. In theory of the corporation, the shareholders pick the board, and it in turn picks the management. In practice however, the system is turned upside down. Incumbent management picks the issues and board nominees for the proxy statements and distributes the ballots. The shareholders vote and sign their names to the ballots and then send them back to the incumbents, who count them and announce the outcome. And so, there is no true election. There is only one list of nominees! The system is similar to a dictatorship; the difference being that the goon squads protect the dictator, but lawyers protect the board.

And what is the result? Most recently, a financial crisis. Listen to Spitzer. “Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions.”

This failure of corporate democracy has left shareholders virtually powerless. The system must be fundamentally reformed to give shareholders more rights – to nominate board members, to eliminate excessive takeover defenses and to have the ability to vote to incorporate their company in another state.

Simple legislation (see my post Shareholders Should Decide Where Companies Incorporate) would make tremendous progress toward resolving the power mismatch that managements and their boards have over shareholders. With true competition for board seats, accountability can be restored and managers would be compelled to work for value maximization on behalf of shareholders and not work simply to enhance their pay and perks and entrench themselves in highly paid positions.

Truly independent board members could also insist on performance based compensation plans and other programs to align management’s interests with shareholders. Then public shareholders could realize the full potential of their companies. But currently, the best opportunity for shareholders is to sell their shares and stand by while, in many cases, the same management team that ran their companies into the ground reap additional millions for a job poorly done.

These reforms are not just grist for academic debate. Reforms of our current system like ‘Say on Pay’ and golden parachute modification have received increasing support and several prominent corporations (including Aflac, Vodafone and GlaxoSmith Kline) have voluntarily adopted policies like Say on Pay.

At the very least, these reforms are essential to enhance management accountability for our corporations. Equally important, they would restore a basic democratic right to the owners of corporate America.

While the financial crisis continues, shareholders should have the option to protect their rights and make America’s boardrooms accountable. Make a difference and join United Shareholders of America. This is where we start. It is where we grow stronger. It is where change begins.

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Marketplace Highlights Opportunities for Exchange Offers

This post is by Edward D. Herlihy of Wachtell, Lipton, Rosen & Katz.

The recent turmoil in the financial markets and slowing economic growth has led to companies taking a variety of steps to de-lever their balance sheets and/or tap new or cheaper funding sources. Evidence of this includes recent exchange offers and debt tender offers, including those launched by GMAC, CIT Group, Harrah’s Entertainment and Realogy. Residential Capital and Tyco International both completed exchange offers earlier this year. Companies are using exchange offers to increase regulatory capital (in the case of CIT Group and GMAC) as well as to de-leverage and extend the weighted-average maturity of their outstanding debt (ResCap, Harrah’s, Realogy, Tyco). Others will no doubt follow, and those who do should be aware of the legal context in which exchange offers take place. My colleagues Lawrence S. Makow, David E. Shapiro, and Alison M. Zieske, and I have issued a memorandum entitled “Today’s Marketplace Highlights Increasing Use of and Great Opportunities for Exchange Offers,” which summarizes various considerations which should be taken into account in structuring exchange offers and debt tender offers. These include tender offer rules, pricing methods, inducement payments for early delivery and solicitations, consent solicitations, registration rights, foreign exchange listings, effect on a company’s existing obligations, and appropriate disclosure in offering documents.

The memorandum is available here.

Economic Consequences of IFRS Reporting

This post is by Christian Leuz of the University of Chicago.

In my paper Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences, co-written with Holger Daske, Luzi Hail and Rodrigo Verdi, which is forthcoming later this month in the Journal of Accounting Research, we use a treatment sample of over 3,100 firms that are mandated to adopt IFRS to analyze effects in stock market liquidity, cost of equity capital, and firm value. These market-based constructs should reflect, among other things, changes in the quality of financial reporting and hence should reflect improvements around the IFRS mandate, if there have been any.

The primary challenge of our analysis is that the application of IFRS is mandated for all publicly traded firms in a given country from a certain date on, which makes it difficult to find a benchmark against which to evaluate any observed capital-market effects. Our empirical strategy uses three sets of tests to address this issue. In our first set of tests, which use firm-year panel data from 2001 to 2005, we benchmark liquidity, cost of capital and valuation effects around the introduction of IFRS against changes in other countries that do not yet mandate or allow IFRS reporting. In addition, we introduce firm-fixed effects to account for any unobserved (time-invariant) firm characteristics. In our second set of tests, where we continue to use firm-year panel data, we examine whether the estimated capital-market effects exhibit plausible cross-sectional variation with respect to countries’ institutional frameworks. In our last set of tests, we exploit that firms begin applying IFRS at different points in time depending on their fiscal-year ends and that, as a result, the adoption pattern in a given country is largely exogenous once the initial date for IFRS adoption is set. We relate this pattern to changes in aggregate liquidity in a given country and month.

We find that, on average, market liquidity increases (modestly) around the time of the introduction of IFRS. We also document a decrease in firms’ cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms’ reporting incentives and countries’ enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, i.e., better firms signaling their quality through early IFRS adoption, the latter result cautions us to attribute the capital-market effects around the mandate to the switch in accounting standards per se (because voluntary adopters have already switched to IFRS by the time of the mandate). Many adopting countries have made concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects.

The full paper is available for download here.

2008 M&A Deal Points Study

This post from Richard Climan, Dewey & LeBoeuf LLP, and is from his partner Keith A. Flaum.

The Committee on Mergers & Acquisitions of the American Bar Association’s Section of Business Law recently released the 2008 Strategic Buyer/Public Target M&A Deal Points Study. I am the Chair of the Committee’s M&A Market Trends Subcommittee, which oversaw the preparation of the Study, and Jim Griffin of Fulbright & Jaworski in Dallas is the Chair of the working group that compiled the Study.

The Study examines key deal points in acquisitions of publicly traded companies by strategic buyers announced in 2007. It also compares the data from the 2007 deals to the data from the Subcommittee’s prior studies of public company acquisitions, which cover deals announced in 2004, 2005 and 2006.

Among the many interesting findings of the Study is that 48% of the acquisition agreements in the Study sample contained a non-reliance clause—a clause to the effect that the target is not making, and the buyer is not relying on, any representations regarding the target’s business except for the specific representations expressly provided in the acquisition agreement. By comparison, only 18% of the acquisition agreements for deals announced in 2005 and 2006 included a non-reliance clause.

So why the significant increase? One possible explanation might be found in the February 2006 decision of the Delaware Court of Chancery in ABRY Partners, and the extensive discussion of that case by leading M&A practitioners throughout the country. In ABRY Partners, Vice Chancellor Strine underscored the effectiveness of a non-reliance clause in limiting a buyer’s fraud-based remedies in the context of an acquisition of a privately-held company. Even though ABRY Partners involved a privately-held target, the extensive discussion that followed also focused on the potential usefulness of non-reliance clauses in deals involving publicly traded target companies. Then, in late 2007, the Tennessee Chancery Court decided Genesco, Inc. v The Finish Line, Inc. In that case, a non-reliance clause in the merger agreement was viewed by the Court as an important element in its determination that Finish Line failed to prove that the publicly traded target company, Genesco, fraudulently induced Finish Line to enter into the merger agreement.

My colleague, Rick Climan, former Chair of the Committee on Mergers & Acquisitions, who acted as special advisor on the Deal Points Studies, points out that some of the targets involved in the 52% of the acquisition agreements in the Study sample that did not include a non-reliance clause may nonetheless have enjoyed the protection afforded by a non-reliance clause, in those cases where such a clause was included in the confidentiality agreement between the buyer and the target. In fact, in Genesco, the Court pointed to non-reliance clauses in both the confidentiality agreement and the merger agreement to support its decision.

It will interesting to see the results of our 2009 study on this issue.

In addition to Jim Griffin, Wilson Chu and Larry Glasgow, the former co-chairs of the M&A Market Trends Subcommittee, and more than 20 M&A lawyers from major law firms across North America, assisted in the Study. Their names are listed in the Study.

The Study is available here.

Puzzled by the government’s response to the financial crisis?

This post is by Steven Davidoff of the University of Connecticut School of Law.

David Zaring and I attempt to provide an explanation for the government’s seemingly haphazard actions in our latest paper Big Deal: the Government’s Response to the Financial Crisis. Professor Zaring and I posit that the government’s team, staffed and led by a team of investment bankers, has been taking a “deal-approach” to the bail-out. The government has pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. The result has not been particularly coherent, but it has married transactional practice to administrative law. We call the result regulation by deal, and think it provides a loose process consistency upon the government’s actions.

A week before we posted our paper to the SSRN, Professors Eric Posner and Adrian Vermeule also posted Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008. The good professors offer an alternative explanation. As Posner wrote on the Volokh Conspiracy where Prof. Zaring and I “see legal constraints . . . . Adrian Vermeule and I see black and gray holes exploited by the executive branch and the Fed.” For administrative law geeks, Professor Vermeule talks about this topic in more detail in his forthcoming Harvard Law Review article: Our Schmittian Administrative Law.

For those who study corporate governance, our article also details and explores the mind-boggling stretching of Delaware law that the government has either fostered or facilitated in these bail-outs. From Bear to AIG to Wachovia, dealmakers have been pushing and testing the limits of deal protection devices to lock-up these government sponsored deals safe in the assumption that Delaware is unlikely to intervene. Much of these new-found devices are likely justifiable on insolvency grounds – a still being explored area of Delaware law. But, it remains to be seen how this stretching will affect how deals are done outside the government sphere, and how Delaware’s jurisprudence will respond to the use of more circumscribing lock-ups in ordinary course deals. For those who subscribe to the theory that Delaware’s jurisprudence is a thaumatrope – oscillating between strictness and laxity depending upon the times – Delaware is likely to tolerate these lock-ups for the time being as necessary to the preservation of our capital markets system. The truth remains to be seen.

Court Rejects Challenge to JPMorgan Rescue of Bear Stearns

This post is based on a client memorandum by Marc Wolinsky, Ian Boczko, and Garrett B. Moritz of Wachtell, Lipton, Rosen & Katz. Mr. Wolinsky argued the case on behalf of JPMorgan.

In a thorough, 44-page decision, Justice Herman Cahn of the New York State Supreme
Court today granted a motion for summary judgment dismissing a shareholder challenge to the fairness of JPMorgan’s rescue of Bear Stearns. The decision is a strong endorsement of the protections that the business judgment rule affords to directors faced with the challenges posed by the ongoing credit crisis. In re Bear Stearns Litigation, No. 600780/08.

The suit grew out of the March 16, 2008, agreement under which JPMorgan agreed to acquire Bear Stearns. The deal was struck over a weekend; the timing was driven by the fact that Bear was facing a “run on the bank” and would have had to file for bankruptcy if a deal was not arranged before Asian markets opened. Over the following week, the deal was renegotiated to increase the consideration from $2 to $10 per share. As part of the revised deal, Bear agreed to sell JPMorgan 95 million shares of Bear stock, representing 39.5% of the company’s voting power. JPMorgan requested and the Bear board agreed to the stock sale to enhance the likelihood that shareholder approval would be obtained and thus assure Bear’s customers and counterparties that they could continue to do business with Bear. JPMorgan also guaranteed certain of Bear’s trading obligations in order to reassure customers and counterparties.

While NYSE Rule 312.03 would normally require shareholder approval for a sale of this magnitude, the Bear board relied on NYSE Rule 312.05 to go forward without a vote. That rule permits bypassing a vote if the company’s audit committee finds that the delay would “seriously jeopardize” the company’s financial viability. The merger agreement also included other “deal protection” measures, including an option to purchase Bear’s headquarters building.

The court rejected all of the plaintiffs’ challenges to the deal, holding that the business judgment rule applied and that, under that rule, the court could not second-guess the board:

In response to a sudden and rapidly-escalating liquidity crisis, Bear Stearns’ directors acted expeditiously to consider the company’s limited options. They attempted to salvage some $1.5 billion in shareholder value and averted a bankruptcy that may have returned nothing to the Bear Stearns’ shareholders, while wreaking havoc on the financial markets. The Court should not, and will not, second guess their decision.

The court specifically ruled that the Bear board was justified in agreeing to sell
JPMorgan the 95 million shares in order to make sure that the deal would close; according to the court, these provisions were “essential to ensure JPMorgan’s willingness to undertake what it perceived as significant risks involved in guaranteeing Bear Stearns’ obligations, and to assure customers and counterparties that the deal would go through.”

As the credit crisis continues and evolves, boards will continue to face serious challenges. The Bear Stearns opinion confirms, however, that directors that act diligently and in good faith should not have exposure for their actions.

The Court’s decision is available here.

Selective “Say-on-Pay” the Best Remedy

We recently published an article on “say on pay” that questions the value of routine shareholder votes on executive compensation.

We cite the limited impact of existing shareholder votes on equity-based compensation and note that in many situations, even the best disclosures do not allow shareholders to fully grasp the financial impact of compensation arrangements. We also note a timing problem: shareholders generally defer to board decisions until governance problems become clear and present. At this point, a problematic compensation plan will likely be years old and beyond attack.

We also argue that because there is no substitute for an independent board negotiating compensation at arm’s length, giving ultimate say to shareholders risks harming the quality of compensation by diminishing board authority.

We conclude by proposing that shareholders be allowed to vote on pay, but that such votes be held only when requested by a substantial shareholder. Governance advocates would have an incentive to be selective in their challenges since their credibility with larger institutions is crucial for effective advocacy, and the relative rarity of such votes would prompt greater focus by institutional investors and the proxy advisory services.

The article is available here.

Rodgin Cohen on the Future of M&A

The students of Professor Robert Clark’s and Vice Chancellor Leo Strine’s Mergers, Acquisitions, and Split-Ups class were recently treated to a fascinating discussion on the future of mergers and acquisitions, with a particular focus on transactions involving financial institutions, by Rodgin Cohen, the current chairman of Sullivan & Cromwell LLP. Mr. Cohen is one of the most influential private-sector players in the financial crisis—during September alone, Mr. Cohen acted as an adviser to Fannie Mae, Lehman Brothers Holdings Inc., Wachovia, Barclays PLC, American International Group Inc., J.P. Morgan Chase & Co. and Goldman Sachs Group Inc. in a variety of transactions.

Mr. Cohen talked about the current state of the financial system and the importance of confidence to the effective functioning of any financial system, before moving on to discuss a number of recent transactions. He focused on the significant differences in financial transactions, due to the regulatory overlay, and provided numerous insightful examples of recent transactions where these issues were of critical importance. He also provided specific examples of the government’s role, which facilitated transactions that involved asset sales without the assumption of all the corresponding liabilities, either explicitly, through stop-loss relief or capital adequacy exemptions. Mr. Cohen also provided interesting insights into what he expects in terms of forthcoming regulatory changes.

A video of the discussion can be accessed on the here.

Level Playing Fields in International Financial Regulation

This post comes to us from Alan D. Morrison of University of Oxford, and Lucy White of the Harvard Business School, Swiss Finance Institute, and Centre for Economic Policy Research.

In our recently accepted Journal of Finance paper Level Playing Fields in International Financial Regulation, we analyze the costs and benefits of imposing level playing fields in international financial regulation. The cost of level playing fields is that they limit the social benefits of expert regulation in the better-regulated economies, thus shrinking their banking sectors. The benefit is that the banking sector in the less well-regulated economies will be larger and of better quality.

We analyze this trade-off in a number of different setups. In the base case, we allow bankers to be chartered to operate in only one economy, so that multinational banking is impossible. In this case, regulators face a stark choice: international coordination upon a level playing field, which will disadvantage the well-regulated economy, and a laissez faire policy of no international regulation of the playing field, in which case the cherry-picking effect will adversely affect the less well-regulated economy. From a global welfare-maximizing perspective, it turns out to be better to adopt a level playing field, and hence to experience the lowest common denominator effect, when the regulatory abilities in the economies involved aresufficiently similar, because the extent of shrinkage implied by the lowest common denominator effect will be small. By contrast, when regulators’ abilities are very different, the cherry-picking externality is the lesser of the two evils and an unregulated playing field dominates. This leads to the intuitive conclusion that “similar” economies should endeavor to adopt common capital regulation and deposit rates; economies that are very different should not attempt to follow them, but should adopt their own regulation.

After analyzing the base case, we extend our model to allow bankers to apply for licenses in more than one country. Introducing multinational banks into our model allows us to take a more nuanced view of the capital flows that create cherry-picking effects. We analyze two cases: one in which borders are opened after bankers have received their first license, so that banks are obliged to open at home before they seek a foreign license, and one in which bankers can make their first license application anywhere. In both cases we show that, when multinational licenses are awarded optimally, multinational bank properties are invariant to the country in which the first of their licenses was awarded. Cherry-picking effects are therefore a concern only for single-country local banks that fail to attract a second license.

The full paper is available for download here.

Justice Jack Jacobs at Harvard Law School

Justice Jack Jacobs of the Delaware Supreme Court recently visited Harvard Law School for the second time this semester as the 2008 Distinguished Visiting Jurist of the Program on Corporate Governance.

A graduate of Harvard Law School (’67), Justice Jacobs practiced corporate and business litigation in Wilmington, Delaware before becoming Vice Chancellor of the Delaware Court of Chancery in 1985. In 2003, he was appointed to the Delaware Supreme Court. In corporate law, Justice Jacobs is considered one of the preeminent judges of the nation. Most recently, he authored the Delaware Supreme Court’s landmark decision in CA v. AFSCME, which addressed key issues in the distribution of powers between boards and shareholders. On this blog, we have previously discussed this important decision here, here, and here.

At Harvard Law School, Justice Jacobs spoke about the CA v. AFSCME decision in the Corporate and Securities Law and Policy class of professors Lucian Bebchuk and Allen Ferrell, and in the Corporate Law A3 class of professor Guhan Subramanian. In his presentations, Justice Jacobs discussed the logic and implications of the opinion as well as the broader context of Delaware jurisprudence within which it was decided. A video of one of his presentation at Professor Subramanian’s class is available here.

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