Monthly Archives: January 2009

Best Practices for Hedge Fund Managers and Investors

This post from James Morphy is based on a client memorandum by Sullivan & Cromwell LLP.

Two private sector committees, the Asset Managers’ Committee and the Investors’ Committee, established by the President’s Working Group on Financial Markets, recently released their final reports on best practice guidelines for hedge fund managers and investors. Drafts of each report were originally released on April 15, 2008, and were open to public comment for 60 days. The final reports have been modified in response to comments received during the comment period and to address interim developments in global financial markets. This memorandum describes the recommendations in the reports (also described in our April 18, 2008 memorandum to clients) and reflects revisions to the final reports. Both final reports, as well as a letter describing the comments to the Asset Managers’ Committee report, are available here. Sullivan & Cromwell LLP acted as counsel to the Asset Managers’ Committee, along with Schulte Roth & Zabel LLP, in the development and issuance of its report.

In February 2007, the President’s Working Group on Financial Markets released a set of principles to guide financial regulators as they addressed the rapid growth of private pools of capital, including hedge funds. These principles concentrated specifically on investor protection and systemic risk concerns. In September 2007, the President’s Working Group tasked two private sector committees with developing best practices for their respective stakeholder groups, based on these initial principles.

The Asset Managers’ Committee (“AMC”), comprised of representatives from ten leading U.S. hedge funds, focused its recommendations on five areas: disclosure, valuation, risk management, trading and business operations, and compliance, conflicts and business practices. The Investors’ Committee (“IC”), comprised of public and private pension funds, endowments, foundations, hedge funds, labor organizations and hedge fund consultants, focused its recommendations on fiduciaries considering hedge fund allocations and individuals executing and administering hedge fund programs.

The reports make recommendations specific to their respective stakeholder groups (i.e., hedge fund managers and investors, respectively), but also encourage use of the reports together as a means to increase the accountability of each stakeholder group to the other. Investors are encouraged to use the AMC report as a basis for due diligence on hedge fund managers, while hedge fund managers are encouraged to use the IC report to guide their interaction with investors.


Board Committees, CEO Compensation, and Earnings Management

This post comes from Christian Laux of Goethe University Frankfurt and Volker Laux of the University of Texas at Austin.

In our paper Board Committees, CEO Compensation, and Earnings Management which was recently accepted for publication in the Accounting Review, we develop a model to analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. Even though stock-based compensation schemes are designed to motivate the CEO to take value-enhancing actions, such pay also induces manipulative actions that boost the (short-term) stock price at the expense of long-term shareholder value. We model the interaction between these productive and manipulative activities as a multi-task agency problem. In particular, the CEO in our setting has an incentive to distort the earnings report upward in an attempt to mislead investors about future cash flows. Even though nobody is fooled in equilibrium, earnings manipulation is costly to shareholders because it consumes corporate resources (e.g., leads to distortions in the firm’s operating and investment decisions) and involves personal costs to the CEO for which he must be compensated in order to ensure his participation.

The board of directors is interested in the long-run net firm value and is able to reduce the CEO’s ability to bias the earnings report through costly monitoring. The bias introduced into the report therefore not only depends on the CEO’s choice of manipulation but also on the board’s choice of monitoring. Monitoring by the board is not contractible and not observable, which implies that the board is unable to commit to a certain level of oversight. Despite the lack of commitment, the board has an (ex post) incentive to engage in monitoring because oversight lowers the CEO’s excess compensation and hence increases the net terminal firm value.

The greater the amount of stock-based compensation for the CEO (i.e., the greater the pay-performance sensitivity), the higher is the board’s ex post incentive to engage in oversight. The board of directors is able to exploit this spillover effect as a tool to indirectly commit to oversight. That is, by choosing a high pay-performance sensitivity, the board can credibly signal to the CEO that it will take its oversight function seriously. Such indirect commitment to oversight is beneficial, as it curbs the CEO’s incentive to take manipulative actions. Our model shows that if the whole board is responsible for both functions, it is inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose higher pay-performance sensitivity, as the increased cost of oversight is borne by the audit committee.

Our model also generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management. The full paper is available for download here.

Trading in Distressed Debt

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

2009 undoubtedly will be a year of severe economic challenges. Analysts believe that the deepest recession since World War II will continue and worsen in the United States. Unemployment may well exceed 10%. With major financial institutions de-levering their balance sheets, credit was constricted for much of 2008 and likely will remain so for an extended period. Partly as a result, entire industries, from automobile manufacturing to retailing, are facing extreme contraction and even the prospect of collapse.

However, for the survivors of 2008’s financial hurricane, 2009 also could be a year of unprecedented opportunity. Bank debt and bonds of good-quality companies are trading at historic lows. Hedge funds that have withstood the wave of investor redemptions, and private equity firms that have raised massive amounts of new capital but see few traditional investment outlets, may explore (or, for the veterans, reenter) the distressed debt market. While the economic and societal benefits of reintroducing liquidity to the debt markets are unquestionable, increased activity in this area no doubt will be met with increased regulatory scrutiny and litigation, particularly in the wake of the myriad financial scandals of the recent past. Some are buying for the enhanced returns available from reasonable credits, while others are buying on a “loan-to-own” basis with a view toward eventually becoming the equity owner of the underlying asset, and some are buying to profit from the potential “reorg” events that others will lead.

My partners Richard G. Mason, Steven A. Cohen, Ian Boczko, Sarah A. Lewis, and I have prepared a memorandum concerning the possession and use of information when buying and selling distressed debt (an abridged version of which was published in The New York Law Journal), which may be of use during the coming year. The rules and customs of the distressed debt market are somewhat different from those that govern other trading markets, and it is important to be careful with information to avoid a problem. This note is meant as a general guide, and particular circumstances will require more detailed analysis. Moreover, prudent investors would be well-advised to have their specific trading policies and procedures reviewed for regulatory compliance and tailored to reflect not only generalized “best practices” but the specific context and framework in which each investor operates.

The memo is available here.

A Comparison of Regulatory Regimes

This post comes from Udi Hoitash of Northeastern University and Jean C. Bedard and Rani Hoitash of Bentley College.

In our paper Corporate Governance and Internal Control over Financial Reporting: A Comparison of Regulatory Regimes which was recently accepted for publication in the Accounting Review, we investigate the association of audit committee and board characteristics with the effectiveness of internal controls over financial reporting (ICFR). We measure this association using data on internal controls from two provisions of the Sarbanes-Oxley Act (Sections 302 and 404) that differ in the requirement that controls be tested by the company’s management and external auditor.

We proceed in two steps. First, we study whether internal control quality, measured as material weaknesses (MW) disclosure, is associated with governance characteristics; i.e. audit committee financial expertise, and board and audit committee structure and activity. Second, we investigate whether the link between governance characteristics and internal control quality holds in both Sections 302 and 404 regulatory regimes. We use an automated data extraction and parsing routine that builds a database of audit committee qualifications from background information available from AuditAnalytics. This method produces a sample of 5,480 firm-year observations with complete data on fiscal years ending between November 2004 to May 2006 (including 19,673 audit committee members), enabling us to address our second research question by studying the governance/MW association among smaller companies that are subject to Section 302 (but not Section 404) as well as larger companies subject to both regulatory regimes.

We find a clear difference in the association of corporate governance quality with MW disclosure between these regulatory regimes. We find that more accounting and supervisory financial expertise on the audit committee is associated with lower likelihood of MW disclosure under Section 404, but not under Section 302. For members with accounting qualifications, this association is evident regardless of whether the individuals are publicly designated as “Section 407 financial experts.” However, among members with supervisory qualifications, we find a significant association only for individuals not publicly designated. In supplemental analysis, we also find that only accounting financial experts are associated with lower likelihood of disclosing MW related to account-specific control problems, while only supervisory financial experts are associated with lower likelihood of disclosing MW related to more management-oriented issues of personnel and information technology. These results are consistent across contemporaneous and lag specifications, are not sensitive to controlling for selection bias, and are robust to several alternative variable specifications.

Overall, our findings suggest that in regulatory environments without requirements of mandatory testing and independent auditor attestation that are required under Section 404, corporate governance quality has no observable association with ICFR disclosure. The full paper is available for download here.

Environmental Disclosure in SEC Filings

This post is by Margaret E. Tahyar’s colleagues Betty M. Huber and Brianne Lucyk.

Preparing environmental disclosure for Securities and Exchange Commission filings has always been a complicated task. Although most of the securities and accounting rules governing environmental disclosure have been in place for some time, environmental costs and liabilities can take various forms, the key facts are often difficult to ascertain and the underlying environmental laws (and their enforcement) are constantly changing. Further complicating matters is the fact that many publicly traded company operations are subject to multiple jurisdictional requirements, from very local to international or supranational regimes. Finally, and particularly problematic for disclosure purposes, is the fact that environmental matters often take many years to investigate, address and resolve, which raises significant estimation and other challenges.

This memorandum describes the current requirements relating to environmental disclosure in SEC filings. Many of the disclosure obligations relate to costs and liabilities that are familiar to all companies—such as costs to investigate and remediate contamination and costs and liabilities arising from the failure to comply with laws or the existence of environmental litigation—but there are some recent developments that companies must consider.

Certain new and proposed changes to environmental accounting rules may affect current and near-term qualitative and quantitative disclosure. In particular, the Financial Accounting Standards Board is looking for more footnote disclosure about a company’s environmental liabilities. There is also a general movement towards “fair value” (or mark-to-market) accounting. Complying with these changes can be difficult given the uncertainty in the timing and cost of many environmental liabilities, as noted above.

Climate change must also be considered when preparing SEC disclosure. While there are many uncertainties, and the current profound international economic crisis may adversely affect the ability of the new U.S. administration to move forward with aggressive climate change laws, costs relating to climate change are already affecting some companies and will, in the future, affect many others. Certain environmental interest groups and regulators have made climate change disclosure a focus of their agendas, and companies must therefore consider practical and political issues in addition to purely legal requirements.

Finally, it is worth noting that some of these developments may result in a need for companies to collect information not currently being collected (from the measurement of carbon emissions to new “fair value” estimates to careful tracking of legal developments).

This memorandum discusses these recent developments and provides practical guidance on how to analyze and address the related disclosure issues facing your company.

The memo is available here.

Optimal CEO Incentives

This post comes from Alex Edmans at the Wharton School, University of Pennsylvania.

In my paper A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium (co-authored with Xavier Gabaix and Augustin Landier, both of NYU Stern), which was recently accepted for publication in the Review of Financial Studies, we contribute to the growing debate on whether executive compensation results from rent extraction or optimal contracting. We construct a model of what the level of incentives should be, and how they should vary with firm size, if pay is set optimally. In our model, CEO effort has a multiplicative effect on firm value. This is realistic for the vast majority of CEO actions, which can be “rolled out” across the entire firm and thus have a greater effect in a larger company. We also assume that the cost of effort to the CEO is proportional to the CEO’s wage. Richer CEOs are willing to spend more to consume leisure time, which is consistent with their greater expenditure on most goods and services.

There are two pieces of evidence (both from Jensen and Murphy (1990)) that are often used to support claims of inefficiency: (1) CEOs only lose $3.25 for every $1,000 loss in firm value, an effective equity share of only 0.325%, and (2) This effective equity share is strongly declining in firm size, i.e. incentives are particularly low in large firms. To evaluate whether these facts indeed reflect inefficiency, we calibrate the model and find that the above two facts are in fact quantitatively consistent with our optimal contracting benchmark, contrary to some earlier interpretations.

On point (1), since effort has a percentage effect on both firm value and CEO utility, the optimal contract prescribes the required percentage change in pay for a one percentage point increase in firm returns (“percent-percent” incentives) – not the dollar loss in CEO pay for a dollar loss in firm value (“dollar-dollar” incentives) which is often measured. In turn, dollar-dollar incentives equal percent-percent incentives multiplied by the CEO wage and divided by firm value. Since firm value is substantially greater than the CEO’s salary, high percent-percent incentives equal low dollar-dollar incentives, exactly as found by Jensen and Murphy.

On point (2), with a multiplicative effect on firm value, the dollar benefit from effort is proportional to firm size, i.e. has a size-elasticity of 1. With a multiplicative effect on CEO utility, the dollar cost of effort is proportional to the CEO’s wage. However, wages have an elasticity of only 1/3 with size. Therefore, dollar-dollar incentives should optimally decline with firm size with an elasticity of 1/3 – 1 = -2/3. This prediction matches the data very closely – we find an elasticity of -0.61. Simply put, since effort has such a large dollar effect in large firms, the CEO will work even if he has a small effective equity share.

The multiplicative production function does not apply to all CEO decisions. Perk consumption reduces firm value by a fixed dollar amount independent of size. We show that stock compensation is ineffective at deterring additive actions such as perks. This is because perks have a tiny effect on the stock returns of a large company – a $10m corporate jet only reduces the return of a $10b firm by 0.1%. The ineffectiveness of contracts gives rise to a role for active corporate governance, e.g. direct monitoring by boards to scrutinize such perks. Similarly, while our model is able to reconcile (1) and (2) with optimal contracting, there are many other features of observed contracts (e.g. golden parachutes, hidden compensation) about which our model is silent and which may indeed result from rent extraction.

The model also proposes a new measure of CEO incentives. We advocate “percent-percent” incentives as the optimal measure as they are independent of firm size (unlike “dollar-dollar” incentives) and thus comparable across different firms. Translated into real variables, this measure equals the dollar change in wealth for a one percentage point change in firm value, divided by annual pay. This data is available at The full paper is available for download here.

Takeover Risks in Troubled Times

The market’s recent collapse leaves many public companies and their longterm investors highly vulnerable:

• Depressed share values create all kinds of opportunities for those with available cash or a strong equity currency. The substantial loss of market capitalization across all sectors presents buying or consolidation opportunities for financial and strategic acquirors, and creates a real risk that many companies could be approached with transactions, either for cash or stock consideration or both, that do not reflect the inherent long-term value of the company.

• Poor stock performance gives substantial credence to activists pushing Boards to complete business combinations “arranged” by the activists, to sell divisions for less than inherent long-term value, or for Board representation disproportionate to their holdings.

• Although the older-vintage hedge funds are distracted by redemption and other concerns, the newcomers are as aggressive as their predecessors and are likely to be active this year.

In this environment, directors should undertake a thorough review and assessment of their company’s charter, by-laws, compensation program, and director and officer insurance coverage. A carefully crafted survey of options and available defense tools, including poison pills, carefully reviewed and understood by the Board with the assistance of legal and financial advisors prior to receipt of any unsolicited offers, will be easier to defend and should provide the Board with greater flexibility if defensive steps are later needed in response to hostile action.


Delaware Bankruptcy Court Disallows Triangular Setoff

This post is by my Philip A. Gelston’s partners Richard Levin and Paul H. Zumbro.

The United States Bankruptcy Court for the District of Delaware, in a decision announced January 9, 2009, denied a creditor’s request for permission to effect a triangular setoff, that is a setoff of the creditor’s claim against one debtor against amounts the creditor owed to another debtor affiliate of the debtor (In re SemCrude, L.P., Case No. 08-11525, Docket No. 2754, Jan. 9, 2009). The decision, if widely followed, could substantially increase a company’s credit exposure if the company has multiple contracts with another corporate group’s affiliates and has relied on a provision in the contracts allowing the company to offset amounts owing to one affiliate against claims against another affiliate and if the other group’s affiliates later file bankruptcy. The bankruptcy court ruled that allowing such a setoff would be inconsistent with the Bankruptcy Code’s express setoff provision and with fairness to all creditors.

Chevron USA, Inc. had entered into numerous contracts for the purchase or sale of various petroleum products with three counterparties, SemCrude L.P., SemFuel L.P. and SemStream, L.P., each of which is a direct or indirect subsidiary of SemGroup, L.P. and each of which later filed bankruptcy. Bilateral master agreements governed the contracts. Each of the master agreements contained a broad version of a common cross-affiliate setoff provision:


CEO Stock Donations

This post comes from David Yermack of NYU Stern.

In my paper Deductio Ad Absurdum: CEOs Donating Their Own Stock to Their Own Family Foundations, which was recently accepted for publication in the Journal of Financial Economics, I explore whether executives exploit the insider trading gift loophole to make well-timed charitable donations of stock in advance of price declines, a strategy that would allow the donors to use their access to inside information to obtain personal income tax benefits. Unlike open market sales, gifts of stock are generally not constrained by U.S. insider trading law, and company officers can often donate shares of stock to charities at times when selling the same shares would be prohibited.

I focus upon Chairmen and CEOs of U.S. public companies that establish private family foundations and then make large contributions to these foundations out of their personal holdings of company shares. Because these donors generally control the entities on either side of these transactions, while also having private information about the future prospects of their companies, one might expect well-timed donations to private family foundations to be relatively easy to accomplish and document. My sample consists of 150 large gifts made by 89 different executives between mid-2003, when the SEC established electronic filing requirements for stock transfers, and the end of 2005.

Consistent with their exemption from insider trading law, I find a pattern of excellent timing of Chairmen and CEOs’ large stock gifts to their own family foundations. On average these gifts occur at peaks in company stock prices, following run-ups and just before significant price drops. A variety of tests give some support for the hypothesis that CEOs time their gifts based on inside information. For instance, a few CEOs make gifts of stock just before adverse quarterly earnings announcements, a time at which company “blackout” periods would almost always prohibit open market sales. Other CEOs delay stock gifts until just after positive quarterly earnings announcements. In addition, tests used to infer the backdating of executive stock option awards yield results consistent with the backdating of CEOs’ family foundation stock gifts. For instance, I find that the apparent timing of certain subsamples of family foundation stock gifts improves as a function of the elapsed time between the purported gift date and the date on which the required stock gift disclosure is filed by the donor with the SEC. Stock gift backdating, if followed by the filing of a personal tax return claiming a charitable gift deduction, would likely represent tax fraud in violation of IRS rules.

Overall, these results suggest an odd juxtaposition of motives on the part of corporate executives who donate stock. While nominally transferring part of their fortunes to charitable foundations for civic purposes, many appear simultaneously to exploit gaps in the regulation of insider trading or even to backdate their donations to increase the value of personal income tax benefits. Data in the paper also cast a long shadow upon the increasingly popular role of private family foundations as conduits for charitable contributions by the wealthy.

The full paper is available for download here.

Embattled CEOs

This post is from Marcel Kahan of the NYU School of Law.

In Embattled CEOs, Edward Rock and I argue that chief executive officers of publicly-held corporations in the United States are losing power to their boards of directors and to their shareholders. This loss of power is recent (say, since 2000) and gradual, but nevertheless represents a significant move away from the imperial CEO who was surrounded by a hand-picked board and lethargic shareholders.

The decline in CEO power has multiple, and interacting, causes and symptoms. On the dimension of shareholder composition and activism, reduced CEO power is related to the their continuing increase in the stock ownerships by institutional investors, especially mutual funds, and the concomitant decline in stock ownership by individuals; the recent rise of hedge funds, the most activists type of institutional investors; the increased level of activism by mutual funds; and the role of proxy advisory firms in targeting portfolio companies for and coordinating activism. On the dimension of governance rules, several developments may represent both symptoms of reduced CEO power and contribute to further declines in CEO power. These include the virtual demise of staggered boards among the largest US companies (and the less significant, but still pronounced decline, in staggered boards among smaller ones); the meteoric rise of majority voting for directors; and the increased number of shareholder proposals that receive majority support and, more importantly, that are implemented by the board. On the regulatory front, important recent developments include the NYSE proposal to end discretionary broker voting in director elections; the new rules governing the electronic delivery of proxy materials which reduce solicitation costs for both companies and dissidents; and the governance reforms adopted n the wake of Sarbanes-Oxley which, among others, require that companies create select committees exclusively composed of independent directors. On the board level, the loss of CEO power is related to the fact that directors who have long been nominally independent (i.e. have no business ties to the company) now act more substantively independent (i.e., defer less to the inside directors). This is reflected in the increased board time devoted to monitoring the CEO (and the increased overall time demands placed on outside directors); regular meetings of outside directors only in executive session and occasional ones with shareholders and independent consultants; the increased number of companies that have formal processes for evaluation CEOs, lead outside directors, or that split the CEO and Chairman position; and the increased level of CEO turnover, both overall and especially performance-related.

All of these changes have contributed to a decline in CEO power in several way. CEOs have less control over important strategic decisions, such a whether to sell the company. They have less control over setting the agenda presented to the board and to shareholders. They have less control over audit, compensation, director selection, and other governance matters. And even on the operational level, where CEOs retain significant over initial decisions, the CEO is more likely to be held accountable, and likely to be held accountable sooner, over operational decisions than in the past.

We believe that the shift in CEO power to outside directors and institutional shareholders represent in fundamental trend that will continue at least over the medium term. While we do not exclude the possibility of a regulatory backlash – analogous to the passage in anti-takeover laws and the sanctioning of the poison pill is response to the hostile takeover movement in the 1980s – we believe that such backlash is unlikely. As a result of this shift, outside directors will be increasingly composed of retired high-level executives or professionals, such as former CEOs or former partners in accounting firms; that “flavor of the year” shareholder resolutions will become harder to ignore; and that the locus of resistance to having the company be acquired will shift from inside managers to outside directors and shareholders. At the same time, we believe the change in this change in the governance regime represent a convergence of the U.S. to other Anglo-American countries (in which CEOs have long held a weaker role) and that it calls into question the case for legal change that further increases shareholders’ voting right.

The article is available here.

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