Yearly Archives: 2008

M&A Perspectives – The Failure of Private Equity

Posted by Andrea Unterberger, Corporation Service Company, on
Monday, October 27, 2008
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This post is from Andrea Unterberger of the Corporation Service Company.

We call your attention to a special M&A event, “M&A Perspectives – The Failure of Private Equity,” which will be accessible at no cost by web seminar on October 30, 2008 in Wilmington, DE, from 3:00 p.m. – 4:30 p.m. Eastern Time.

With the Lyondell Chemical case on appeal, and with the Huntsman/Hexion merger still generating litigation activity, M&A lawyers are looking forward to the presentation next Thursday afternoon by Professor Steven M. Davidoff (Click here for more information and to register). His principal topic (The Failure of Private Equity), on which he writes in a forthcoming article, is expected to focus on highlights from Delaware court decisions and proceedings in the past, tumultuous year, particularly as they reflect ambiguous contracting that has often proven ineffective to address the now-evident potential for market reversals. Additionally, Vice Chancellor Leo E. Strine, Jr. will join Professor Davidoff as commentator.

Writing as The Deal Professor, Davidoff is a commentator for the New York Times DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.

This event is sponsored by the Widener University School of Law, Corporation Service Company, and The Delaware Counsel Group, LLP.

Click here for more information and to register for online or in-person attendance. Email [email protected] if you have any questions.

Third Circuit Upholds Validity of SEC: Amendments Clarifying Exemptions from Section 16 Liability

Posted by Paul Vizcarrondo, Wachtell, Lipton, Rosen & Katz, on
Sunday, October 26, 2008
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This post is based on a memorandum by Paul Vizcarrondo and Michael Winograd of Wachtell, Lipton, Rosen & Katz.

The Third Circuit recently upheld the validity of two clarifying amendments adopted by the SEC in 2005. The amendments clarified two important exemptions from shortswing-profit liability under Section 16(b) of the Securities Exchange Act: (1) Rule 16b-3, which exempts certain transactions between an issuer and its officers or directors; and (2) Rule 16b-7, which exempts certain mergers, reclassifications, and consolidations. In so doing, the Court expressly overruled a prior decision of the Third Circuit that imposed novel restrictions on the applicability of the two exemptions.

In Levy v. Sterling Holding Co., 314 F.3d 106 (3d Cir. 2002) (“Levy I”), the Third Circuit held that grants, awards, and other issuances to officers or directors must be compensation-related to be eligible for exemption under Rule 16b-3(d). The Third Circuit also suggested that Rule 16b-7 would not exempt reclassifications that involve classes of securities with different risk-return characteristics (such as an exchange of non-convertible preferred stock for common stock) or that increase shareholders’ percentage of common-stock ownership. (See our memo dated March 10, 2003.)

In response to the Third Circuit’s holding in Levy I, the SEC adopted clarifying amendments to Rules 16b-3 and 16b-7. The amendment to Rule 16b-3 made clear that the exemption would apply regardless of whether a compensation-related purpose could be demonstrated. The amendment to Rule 16b-7 made clear that the only condition for exempting a reclassification is that the company whose securities are acquired or disposed of owns 85% or more of the equity or assets of all companies that are parties to the transaction. Thus, where a single issuer reclassifies one class of its securities into another, there is effectively 100% “crossownership” and the exemption is available. (See our memo dated August 8, 2005.)

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The Trust Has Left the Building: $23,000 on Spa Treatments

Posted by Broc Romanek, TheCorporateCounsel.net, on
Saturday, October 25, 2008
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This post is from Broc Romanek of TheCorporateCounsel.net.

It looks like the folks at AIG have taken “tone at the top” to heart. Unfortunately, their tone isn’t of the type that is good news for taxpayers, who now own 80% of AIG. As this Washington Post article describes, two former AIG CEOs were grilled during a House Committee on Oversight and Government Reform hearing this week (one of whom received a $5 million performance bonus just before he left – in addition to a $15 million golden parachute – and another AIG executive was fired still receives $1 million per month for consulting services). The former CEOs expressed no remorse for their actions that drove AIG into the arms of the government and didn’t acknowledge making any mistakes. Rather, they blamed the accounting. The House committee members were visibly disturbed by the sheer audacity of these so-called corporate leaders. Given the long list of troubling practices at AIG described in this front-page WSJ article, we may well see these two in pinstripes someday.

The topper is the fact that AIG is now getting an additional $37.8 billion loan from the taxpayers, which is lumped on top of the $80 billion load the government provided last month. This came a day after it was revealed that the company held a junket for sales reps at a resort, spending unbelievable amounts of the taxpayer’s money. How exactly does one spend $23,000 on spa treatments or $5,000 at the bar? The story is outrageous and listening to the radio, it’s fair to say that AIG already has become the posterchild of all that is broken in Corporate America. If this doesn’t get you mad, nothing will.

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Corporate Governance, Enforcement, and Firm Value: Evidence from India

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, October 24, 2008
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This post comes from Dhammika Dharmapala of the University of Connecticut, and Vikramaditya Khanna of the University of Michigan Law School.

Recently in the Law and Economics Seminar here at Harvard Law School, we presented our paper entitled Corporate Governance, Enforcement, and Firm Value: Evidence from India. This paper analyzes the connections between corporate governance, stock market development and firm value using a sequence of reforms to India’s corporate governance regime as a source of exogenous variation. Despite the widespread interest in this area of research, finding evidence that corporate governance causes changes in firm value has posed a significant challenge since most governance reforms in the US have applied to all firms, making it difficult to isolate a credible control group. For this reason, and because of the relatively limited variation in governance practices in an economy such as the US, attention has increasingly been directed to the relationship between governance and firm value outside the US, especially in emerging markets.

There were a number of reforms enacted in India that were phased in over the period 2000‐2003, and severe financial penalties for violations were subsequently introduced in 2004. The exemption of a large number of firms from the new rules and the complex criteria for their application give rise to treatment and control groups of firms with overlapping characteristics. Using a large sample of over 4000 firms from 1998‐2006, a difference‐in‐ difference approach (controlling for various relevant factors and for firm‐ specific time trends) reveals a large and statistically significant positive effect (amounting to over 10% of firm value) of the reforms in combination with the 2004 sanctions. A regression discontinuity approach focusing on the thresholds for the application of these reforms leads to similar conclusions. In addition, the estimated effect of the initial announcement of the sequence of reforms in 1999 is weaker than the effect of the 2004 sanctions, highlighting the importance of sanctions. Some channels through which the 2004 effect may have occurred are explored, but the results are preliminary because there are only two years of post‐2004 reform data. There is some evidence of improvements in accounting performance and increases in foreign institutional investment, but this is not robust across specifications. In addition, the 2004 reforms are not associated with a reduction in tunneling within business groups.

Our results, taken together, present a strong case for a causal effect of the reforms on firm value. They also underscore the importance of the enactment of severe sanctions, though it is not entirely clear whether this effect operates through formal enforcement alone or in conjunction with some additional channel.

The full paper is available for download here.

Developments in Takeover Defenses

Posted by Charles M. Nathan, Latham & Watkins LLP, on
Thursday, October 23, 2008
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This post is from Charles M. Nathan of Latham & Watkins LLP.

As discussed in our recent Webcast on Developments in Takeover Defenses, Latham & Watkins LLP has prepared a new model of advance notice bylaw provisions that have been updated and modernized, not only to address the issues raised in the recent decisions in JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corp. v. Office Depot, but also to address significant related problems posed by activist investors’ frequent use of undisclosed derivative securities and/or “wolf pack” tactics as weapons in threatened or actual proxy contests. We have also included provisions that establish more robust and protective procedures for shareholders to call special meetings or act by written consent. The text of our model advance notice bylaw provisions is now available on our Web site here.

The evolving forms of equity ownership in U.S. publicly traded companies, the recent Delaware decisions refusing to apply ambiguously drafted advance notice bylaws and recent strategies deployed by activist and other “event driven” investors, have caused many U.S. publicly traded companies to reexamine their advance notice bylaw provisions to, among other things, assess whether the required procedures and disclosures adequately address the interests of the corporation and its shareholders. In particular:

• The attributes of equity ownership in U.S. publicly traded companies has expanded dramatically due to the proliferation of derivative, swap and other transactions now available in the marketplace. For example, “total return equity swaps” allow an investor to create the economic equivalent of ownership of common stock without ever acquiring ownership of the security itself. Historically, investors have taken the position that these economic relationships do not confer beneficial ownership of the underlying equity under the federal securities laws and, for that reason, are not required to be disclosed. Conversely, investors also now have the ability to use derivatives to establish record ownership and thus the right to vote the shares without any exposure to economic ownership. This can be achieved, for example, by purchasing shares and simultaneously entering into offsetting put and call options or more simply by “borrowing” shares just prior to the record date for a shareholders’ meeting and returning the borrowed shares shortly thereafter, a strategy often called “record date capture.”

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Incentives for Innovation

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 22, 2008
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This post comes from Gustavo Manso at the MIT Sloan School of Management.

I recently presented a pair of papers on the topic of “Incentives for Innovation” at the Finance Department Seminar at Harvard Business School.

In the first paper, entitled “Motivating Innovation”, I model the process of innovation using a class of Bayesian decision models known as bandit problems. Innovation in this setting is the discovery, through experimentation and learning, of actions that are superior to previously known actions. I focus on the tension between the exploration of new untested actions and the exploitation of well known actions. Exploration of new untested actions reveals information about potentially superior actions, but is also likely to waste time with inferior actions. Exploitation of well known actions ensures reasonable payoffs, but may prevent the discovery of superior actions.

I find that the optimal contracts that motivate exploitation and exploration are fundamentally different. Since exploitation is just the repetition of well known actions, the optimal contract that motivates exploitation is similar to standard pay-for-performance contracts used to motivate repeated effort. On the other hand, since with exploration the agent is likely to waste time with inferior actions, the optimal contract that motivates exploration exhibits substantial tolerance (or even reward) for early failures. Moreover, since exploration reveals information that is useful for future decisions, the optimal contract that motivates exploration relies on long-term incentives. Under the optimal exploration contract, an agent that obtains an early failure followed by a success earns more than an agent that obtains an early success followed by a failure. Even an agent that fails twice may earn more than an agent that obtains a success followed by a failure. The institution of tenure, debtor-friendly bankruptcy laws, and golden parachutes are examples of schemes that protect the agent when failure occurs and thereby encourage exploration.

In the second paper, entitled “Is Pay for Performance Detrimental to Innovation“, which was co-written with Florian Ederer, I outline the results of a controlled laboratory experiment which provides evidence that the combination of tolerance for early failure and reward for long-term success is effective in motivating innovation.

In our experiment, subjects control the operations of a lemonade stand for 20 periods. In each period of the experiment, subjects make decisions on how to run the lemonade stand and observe the profits produced by their inputs. Subjects must choose between fine-tuning the product choice decisions given to them by the previous manager (“exploitation”) or choosing a different location and radically altering the product mix to discover a better strategy (“exploration”). To study the impact of different incentive schemes on productivity and innovation, we consider three different treatment groups. Subjects in the first group receive a fixed-wage in each period of the experiment. Subjects in the second treatment group are given a standard pay-for-performance (or profit sharing) contract. Subjects in the third treatment group are allocated a contract that is tailored to motivate exploration. Their compensation is 50% of the profits produced during the last 10 periods of the experiment.

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A global survey to find out what investors really think about the crisis

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, October 22, 2008
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This post comes to us from William Russell-Smith of AQ Research.

One of the features of the current financial crisis is the comparative lack of comment from the bulk of the market participants. Certain high profile investors such as George Soros and Warren Buffett have been widely quoted, but might not be regarded as typical industry participants. We also have the recent testimony by some of the major figures of failed institutions given to the Congressional Committee on Oversight and Government Reform. But a more broadly based view of what the financial services is thinking seems to be lacking thus far. This might be due to the hectic times that the markets have recently witnessed, or else a desire to keep heads down at a time when the industry is under fire.

In response to this, the recently formed finance professionals’ think tank, Network for Sustainable Financial Markets, in partnership with AQ Research, has launched a global survey of investment sector professionals. The goal is to ensure the voice of ordinary investment professionals is heard in the debate about the future of financial markets, not just about today’s debate but also about the underlying dynamics which affect both the crisis response but also the longer-term rehabilitation.

The Network includes some of the world’s most high-profile sustainable investment supporters, including corporate governance expert Dr Robert Eccles from the Harvard Business School, Professor Keith Ambachstheer, Director of Rotman International Centre for Pension Management, University of Toronto and world renowned expert on pensions and Professor Frank Partnoy, one of the world’s leading experts on the complexities of modern finance and financial market regulation.

We believe that an evidence based approach is important. It is clear that we are already entering a period of intense and fundamental debate about the future of the financial services industry, how it is regulated and its role in economic life. Concerned industry participants should be want their voice to be heard, particularly as they will be most affected by the future restrictions.

The survey asks investment professionals for their opinion on fundamental questions on the causes, cures and consequences of the credit crisis.

The survey, which is completed anonymously, can be found here. It will close on 31 October 2008. We estimate that it will take approximately 15 minutes to complete. The results will be extensively reported in financial media and will also be available to participants.

The organizers invite you to complete the survey and forward it to contacts you may have who are investment professionals.

Managing In Today’s Troubled Environment: A Primer For Directors and Senior Managements

Posted by Peter Atkins, Skadden, Arps, Slate, Meagher & Flom LLP, on
Tuesday, October 21, 2008
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This post is from Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

I have recently written a memo entitled “Managing In Today’s Troubled Environment: A Primer For Directors and Senior Managements,” which highlights for directors and senior management key matters they should consider as they address in the current troubled environment their role as overseers of the business and affairs of the public companies they serve. In it, I discuss how fiduciary duties should be applied in current conditions, focusing particularly on risk oversight, and outline a number of specific actions directors and senior management should consider today. The memo also highlights, also against the backdrop of the current market pressures, the existence of significant disclosure issues and the appropriate use of experts by directors and senior management.

The memo is available here.

Earnings management, lawsuits, and stock-for-stock acquirers’ market performance

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, October 20, 2008
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This post comes from Henock Louis, Guojin Gong, and Amy X. Sun at the Smeal College of Business at Pennsylvania State University.

In a forthcoming Journal of Accounting and Economics paper entitled Earnings management, lawsuits, and stock-for-stock acquirers’ market performance, we analyze whether postmerger announcement lawsuits are associated with pre-merger abnormal accruals and the potential effects of lawsuits on acquirers’ market performance. We posit that, by subjecting stock-for-stock acquirers to lawsuits, pre-merger earnings management can have an indirect effect on acquirers’ performance around and after the merger announcement, in addition to the direct effect associated with post-merger accrual reversals.

After analyzing the association between pre-merger announcement abnormal accruals and post-merger announcement lawsuits, we examine whether the market anticipates the potential lawsuits and their consequences at the merger announcement. It is well documented that the average stock-for-stock acquirer experiences significant market losses at the merger announcement. In a fully efficient market, the probability of a lawsuit should be reflected in the market reaction to the merger announcement. To examine the association between the merger announcement abnormal return and the probability of a lawsuit, we use an instrumental variable approach. In a first step, we estimate the probability that an acquirer would be sued, using ex-ante predictors of lawsuits. In a second step, we analyze the association between the merger announcement abnormal return and the probability of a lawsuit. We use the two-stage estimation process because of the potential endogeneity in the relation between lawsuits and performance.

Consistent with our conjectures, we find that pre-merger abnormal accruals are a strong determinant of post-merger lawsuits. The effect of abnormal accruals is significant even after controlling for the post-merger abnormal return, which suggests that pre-merger earnings management has a first order effect on the likelihood of a lawsuit. We also find evidence that the market anticipates the lawsuits at merger announcements. There is a significantly negative association between the market reaction to a merger announcement and the probability that a stock-for-stock acquirer is subsequently sued. Further analyses suggest, however, that the market reaction to the merger announcement only partially reflects the probability of a lawsuit. First, we find that stock-for-stock acquirers’ long-term market under performance is largely limited to litigated acquisitions. Second, and more importantly, we find a very strong negative association between the likelihood of a lawsuit and the long-term market performance over the four years after the merger announcement. Therefore, post-merger announcement long-term market performance can be predicted using lawsuit-related information that is available at the time of the merger announcement. We do not claim that lawsuits are the only cause of the post-merger announcement long term under performance. The evidence only indicates that lawsuits are a contributing factor to the under performance.

The full paper is available here.

Financial Markets in Crisis: Overview of FDIC’s Authority With Respect to Bank Failures

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Sunday, October 19, 2008
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This post is from John F. Olson of Gibson, Dunn & Crutcher LLP.

My firm has issued a memo entitled “Financial Markets in Crisis: Overview of FDIC’s Authority With Respect to Bank Failures,” which focuses on the receivership and conservatorship authority of the Federal Deposit Insurance Corporation. It is an executive summary of a longer document available here. The memo provides a brief overview of key issues and background on the legal framework governing FDIC resolutions and the FDIC’s methods for handling receiverships. The longer summary goes into greater detail, comparing six distinctive aspects of the FDIC approach with the bankruptcy law provisions; and illustrating issues and uncertainties in the FDIC resolutions process by discussing in greater depth two examples – treatment of loan securitizations and participations, and standby letters of credit. The materials underscore the importance of credit analysis and rigor of documentation and legal risk mitigation in connection with potentially troubled financial institution counterparties.

The memo is available here and the longer summary is available here.

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