Monthly Archives: January 2009

Court Rules on Alleged Breach of Indenture Reporting Covenant

This post is by Margaret E. Tahyar’s colleagues Michael Kaplan, Richard J. Sandler, Richard D. Truesdell, Jr., and Janice Brunner.

In the last several years, there have been a number of situations where issuers have failed to file reports with the SEC on a timely basis and bondholders alleged that such failure violated certain provisions of the Trust Indenture Act (“TIA”), that are incorporated into all public debt indentures. In the first case that was litigated on such matters, Bank of New York v. Bearingpoint, Inc. (“BearingPoint”), 13 Misc.3d 1209(A), 824 N.Y.S.2d 752 (Sup. Ct. N.Y.County 2006), a New York state court held that the TIA required timely filing of SEC reports. Since then, a number of federal courts have disagreed and held that the TIA does not impose an independent obligation to make timely filings of SEC reports. Yesterday, the U.S. Court of Appeals for the Eighth Circuit filed an opinion, in United Health Group Inc. v. Wilmington Trust Co., affirming a district court decision that an issuer’s delinquency in filing its Exchange Act reports with the SEC was not a breach of its indenture reporting covenant or Section 314(a) of the TIA. The Eighth Circuit is the first appellate level court that has addressed this question, and this case is therefore an important contribution to a growing body of case law that rejects the BearingPoint court’s interpretation of reporting covenants and Section 314(a) of the TIA.

The BearingPoint Case
Many indentures contain some form of standard language that generally provides that the company shall file with the trustee, within a certain number of days after it files such information with the SEC, copies of the reports which it is required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act. Many indentures also expressly require compliance with Section 314(a) of the TIA.


The Story of Paramount Communications v. QVC Network

Editor’s Note: This post is from Ehud Kamar of University of Southern California.

In the chapter The Story of Paramount Communications v. QVC Network: Everything Is Personal, which is forthcoming in the book Corporate Stories (J. Mark Ramseyer ed., Foundation Press, 2009), I tell the story of the famous contest between Viacom and QVC over the acquisition of Paramount.

The battle over Paramount lends support to the view that non-pecuniary motivations can sometimes explain battles for corporate control and management behavior better than pecuniary motivations. The selection process that brings executives to top management positions and their wide discretion to shape company strategy once in office leaves ample room for ambition, pride, envy, or animosity to filter into their decisions. It is hard to prove the existence of these drivers, let alone measure them, but they are very real in the minds of market professionals. In the jargon of corporate lawyers and investment bankers, who must consider these factors in any deal negotiation, there is even a special term for them: “social issues”. The three-way fight between Paramount, Viacom, and QVC is a textbook example of social issues at work. All of the key players in the story seemed to have had them: Sumner Redstone, Viacom’s chairman, was willing to pay almost any price to own a film studio; Barry Diller, QVC’s chief executive, was willing to go to great lengths to get back at Martin Davis, Paramount’s chief executive, for pushing him out of Paramount; and Martin Davis was willing to leave a lot of money on the table and cede control of his empire to stop Barry Diller. This is also consistent with claims that control is especially valuable to corporate decision-makers in the media sector, presumably because it comes with access to non-pecuniary benefits such as visibility, influence, and glamour.

The full paper is available for download here.

Proxy Season 2009

This post from Marc Rosenberg is based on a client memo by partners at Cravath, Swaine & Moore LLP.

The outlook for proxy season 2009
This proxy season will be significantly affected by the credit crisis and the ensuing global economic turmoil. Investors and politicians have joined in an outcry over a perception of excessive executive pay, reckless risk-taking by management and inadequate board oversight at some companies. Prosecutors have launched investigations at numerous financial institutions, perceived abuses have been widely reported in the media, and Congress is seeking to reform compensation practices and give shareholders the right to vote on executive compensation.

Management and boards will be well-served at this time to reassess their compensation and governance policies and practices, as well as how they communicate with their investors. A strategic and well-analyzed response by a company and its board to these unprecedented conditions will be crucial to managing this challenging proxy season successfully.

Prepare for investor and regulatory scrutiny of executive compensation
Compensation practices undoubtedly will be an area of sharp focus this proxy season. The number and variety of shareholder proposals addressing compensation practices and policies is increasing. In particular, we are seeing an increase in proposals related to “say on pay,” “pay for performance,” “clawback” of executive pay in the event of a financial restatement and elimination of a variety of “poor pay practices” (e.g., tax gross-ups on executive perks or excise payments triggered by golden parachute payments and payment of dividend equivalents on unearned performance awards). Variations of each of these proposals have been endorsed by proxy advisor RiskMetrics (formerly ISS), an influential source of voting advice for institutional investors. RiskMetrics has also aligned its position on compensation policies and proposals for all public companies with the standards set for institutions selling equity to the federal government under the Emergency Economic Stabilization Act (“EESA”). The EESA requires, among other things, that financial institutions receiving assistance under it agree to stringent limitations on executive compensation.


Principles for Reforming Executive Pay

Editor’s Note: The following post by Ben W. Heineman Jr. was published on Wednesday in the online edition of Business Week.

Reining in excessive management compensation will be high on the “to-do” list of the 111th Congress.

The rocket fuel that sent the financial sector soaring into the stratosphere (where it ultimately exploded) was excessive executive compensation, which rewarded the churning of paper and risk-taking rather than the creation of sustained economic value and risk management.

The day of regulatory reckoning on the causes of the financial meltdown will soon be upon us, even as governments struggle with the severe effects and the world waits for a “mega-stimulus” proposal from President-elect Barack Obama. Reforming executive pay will likely be high on the financial re-regulation “to do” list for the 111th Congress as anger at executives remains white-hot.

To be sure, partial ad hoc measures are popping up, both in the U.S. and abroad, from a flat cap on executive pay at German companies receiving bailout funds to active oversight of payouts by the British government in its varying roles as shareholder, director, and regulator of troubled companies. Under the Troubled Assets Relief Program (TARP), Congress last fall hastily imposed executive compensation limits on senior leaders in financial sector entities, including limiting tax-deductibility on exec comp over $500,000; providing new clawback rules for material mistakes; capping or eliminating golden parachutes; and requiring board assessments of the relationship between compensation and risk-taking.


Blog reaches 3 Million Hits

As the hit counter on the right hand side of this blog indicates, our Harvard Law School Corporate Governance Blog has recently reached the 3-million-hits mark. Our blog, which was founded in December 2006, has been enjoying robust growth in traffic. A chart depicting the monthly traffic on our blog since its inception is displayed below:

The Harvard Law School Corporate Governance Blog 2-Million-Hits Stats

The Blog has also experienced substantial growth in the number and range of guest contributors. In addition to the Harvard Law School faculty and fellows, and the members of the Program’s advisory board listed on the left hand side, more than eighty other academics and practitioners have been contributing. Posts on the Blog have been referred to and relied on by prominent media publications such as the Economist, the Financial Times and the Wall Street Journal.

The Editors and Staff of the Blog would like to express their appreciation to all contributors and to the blog’s readers for our continued success.

This post provides a good opportunity to remind readers that you can easily sign up for a free subscription to the Blog, which will allow you to receive email announcements containing new posts when they are posted.  To sign up,

1) Go to our our signup page.
2) Enter your email address.
3) Click “Subscribe”.

Some Thoughts for Boards of Directors in 2009

This post is from Martin Lipton of Wachtell, Lipton, Rosen & Katz.

Over the past year and a half, a perfect storm of economic conditions has triggered an extraordinary downward spiral: the subprime meltdown, liquidity crises, extreme market volatility, controversial government bailouts, consolidations of major banking institutions and widespread economic turmoil both domestically and abroad. Many corporations now find themselves in uncharted territory, with a new paradigm of unpredictability trumping formerly reasonable expectations. In the coming year, boards of directors will need to respond to the challenges and pressures of this new environment. This may include reassessing their agendas, committee structures, time commitments and director recruiting, as well as their role in monitoring performance, compliance and risk management. At the same time, boards need to maintain the collegiality and culture of a common enterprise with the CEO and senior management. In short, the task for boards is not simply to go into crisis mode in order to deal with current issues, but rather to take a more holistic, long-term approach to reassessing their proper role and functioning.

In reviewing their monitoring and oversight roles, boards should be mindful of the shifting legal and regulatory landscape. Although the standard for director liability established in Delaware by the Caremark case accords directors considerable deference in fulfilling their oversight duties, there is a distinct possibility that this level of deference could end up being modified in light of the current economic crisis. The spate of litigation generated by the market turmoil will intensify the scrutiny of some boards and will provide courts with repeated occasions to consider second-guessing board decisions. Various regulators have been focused on risk management policies, some of which have found their way into new federal legislation, and numerous new guidelines and “best practices” purport to raise the bar. As financial losses accumulate, shareholders and the public at large will seek to hold boards and management accountable, and there will be tremendous pressure on corporations to demonstrate that they are responding to the current challenges.

While it is clear that there will be a regulatory response to the economic crisis, the contours and extent of the reforms are still evolving. To the extent that boards can be proactive in addressing new challenges and mitigating risks, there may be some window of opportunity for them to help shape the regulatory response, and steer it toward pragmatic measures that will promote rather than impede the creation of long-term shareholder value.

This memorandum, which I have prepared with my colleagues Steven A. Rosenblum and Karessa L. Cain, sets forth some of the significant issues that boards of directors face in the coming year, as well as some practical considerations to bear in mind. In order to avoid an overemphasis on process and at the same time effectively discharge the board’s duties to appropriately monitor and supervise the business of the corporation, it is necessary to identify the matters meriting the board’s focus and create a reasonable program to deal with them. Some are perennial themes that remain relevant and deserve to be reemphasized from year to year, whereas others have come into particular focus in recent years. It is important to note, however, that “one size does not fit all.” The board of each corporation can and should focus on its own particular issues and tailor procedures to its own circumstances.

The memorandum is available here.

Blockholder Trading, Market Efficiency, and Managerial Myopia

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

In my paper Blockholder Trading, Market Efficiency, and Managerial Myopia which was recently accepted for publication in the Journal of Finance, I analyze how outside blockholders can induce managers to undertake efficient real investment through their informed trading of the firm’s shares.

The model developed in this paper addresses two broad issues. First, it shows that blockholders can mitigate managerial myopia. Small shareholders base their decisions on freely-available short-term earnings. By contrast, a blockholder’s large stake gives her strong incentives to gather costly information about the firm’s fundamental value, i.e., to learn whether weak earnings result from low firm quality or desirable long-term investment. By trading on this information, she causes prices to more closely reflect fundamental value rather than short-term earnings. This increased market efficiency improves real efficiency: the manager is willing to undertake investments that boost fundamental value even if they depress short-term earnings.

This beneficial effect of liquid trading on investment contrasts with conventional wisdom. In the 1980s and 1990s, many commentators feared that the U.S.’s liquid markets would lead to it being overtaken by Japan in international competition, because short-term trading by shareholders causes managers to focus excessively on short-term earnings. They argued that reducing liquidity would make “exit” more difficult upon short-term losses, and force a shareholder to exhibit “loyalty”. My model shows that the mutual exclusivity of loyalty and exit paradoxically leads to complementarities between them. If a blockholder has retained her stake despite low earnings, this is a particularly positive indicator of fundamental value if she could have easily sold instead. In short, the power of loyalty relies on the threat of exit. Far from exacerbating myopia, the liquidity of the U.S. capital allocation system may be a strength, because liquid trading causes prices to more closely reflect fundamental value.

The second issue that the model demonstrates is that shareholders can exert governance even if they cannot intervene directly in a firm’s operations. Most existing theories assume that blockholders govern through “voice” – firing a shirking manager or overturning a pet project. However, intervention is uncommon in the U.S., because blockholders are typically small and face significant legal and institutional barriers. Existing models therefore have difficulty in explaining the role that small blockholders with few control rights play in corporate governance, and thus why they are so prevalent. This paper shows that blockholders can still add significant value even if they lack control.

The paper closes with empirical implications. One set concerns stock-price effects, and is unique to a model where blockholders trade rather than intervene. While block size does not matter in standard microstructure theories, here it is positively correlated with an investor’s private information, trading profits and price efficiency. More generally, the model suggests a different way of thinking about blockholders that can give rise to new directions for empirical research. Previous studies have been primarily motivated by perceptions of blockholders as controlling entities, but new research questions may be motivated by conceptualizing them as informed traders. A second set relates to real effects: blockholders should increase firm investment and deter earnings manipulation.

The full paper is available for download here.

In another paper, co-written with Gustavo Manso, I extend the analysis to consider the role of multiple blockholders, which we observe frequently in practice. We find that splitting a block can be beneficial for corporate governance. While splitting a block weakens “voice”, by creating free-rider problems in intervention, it strengthens “exit” because multiple blockholders trade aggressively, impounding more information into prices. The paper entitled Governance Through Exit and Voice: A Theory of Multiple Blockholders is available for download here.

Court Focuses on Representations in Agreements Filed with SEC

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

The United States Court of Appeals for the Ninth Circuit recently rejected an issuer’s contention that a securities fraud complaint should be dismissed because the alleged misstatements were contained in an acquisition agreement attached as an exhibit to an Exchange Act report, instead of in the report itself. The court’s decision highlights the continuing need for issuers to consider the disclosure issues that can arise from representations and warranties included in exhibits to reports, proxy statements and registration statements filed under the federal securities laws.

On March 15, 2004, InVision Technologies Inc. announced that it would be acquired by General Electric Company, and attached the merger agreement as an exhibit to the Form 10-K that it filed that day. The merger agreement contained customary representations by InVision (with customary exceptions), including statements to the effect that InVision was in compliance with applicable laws, InVision was in compliance with certain provisions of the Securities Exchange Act of 1934 (the “Exchange Act”), and InVision had not violated the anti-bribery provisions of the Foreign Corrupt Practices Act of 1977 (the “FCPA”).

More than three months following the merger announcement, InVision announced that an internal investigation had revealed possible violations of the FCPA, and warned that subsequent investigations could cause a delay or termination of the merger transaction. Stockholders filed a class action complaint alleging that the representations in the merger agreement contained material misstatements that violated Rule 10b-5 under the Exchange Act. InVision later resolved the FCPA matter in settlements with the government, and the parties completed the merger. The securities fraud complaint was ultimately dismissed by the district court for failure to adequately plead falsity and scienter.

Ninth Circuit Decision
The Ninth Circuit reviewed the dismissal in Glazer Capital Management v. Magistri, No. 06-16899 (9th Cir., Nov. 26, 2008). Before addressing the pleading standards, the court considered InVision’s argument that the alleged misstatements could not support a securities fraud claim because they were contained in an agreement that was filed as an exhibit to the Form 10-K, and not in the Form 10-K itself. The court observed that the representations were expressly qualified by reference to a separate disclosure schedule listing exceptions to the representations (which was not filed and not publicly available), and that the merger agreement contained a “no third party beneficiaries” clause. Nonetheless, the court stated:


E-Proxy Rules Take Effect for All Public Companies

This post from John F. Olson is based on a client memorandum by Lisa Fontenot, Michael Scanlon and Marcie Areias of Gibson, Dunn & Crutcher LLP.

I. E-Proxy Update

In 2007, the Securities and Exchange Commission (the “SEC”) adopted rules providing for proxy materials (including the proxy statement, a proxy card, the “glossy” annual report and any other soliciting materials) to be made available to shareholders via a publicly accessible Internet website other than the SEC’s EDGAR website (the “E-Proxy Rules“).[1] Starting January 1, 2009, all public companies must comply with the E-Proxy Rules.[2] As a result, all companies conducting proxy solicitations will have to post materials on the Internet and can choose among the delivery options for proxy materials available under the E-Proxy Rules: the “notice and access option,” the “full set delivery option,” or a hybrid of these options.

A. Notice and Access
Under the notice and access option, a company can satisfy the proxy delivery requirements by delivering a Notice of Internet Availability of Proxy Materials (a “Notice of Internet Availability”) to shareholders at least 40 calendar days before the annual meeting date and posting proxy materials on an Internet website.[3] The information that can be included in the Notice of Internet Availability is limited and must conform to specified criteria set forth in the SEC rules.[4] The Notice of Internet Availability may not be accompanied by a proxy card or other information. Even though proxy materials are electronically delivered under this option, issuers must deliver proxy materials to any shareholder upon request.[5]

An intermediary (such as a broker or a bank who holds the shares on behalf of beneficial owners) may not independently elect to use the notice and access option, but is required to do so if requested by the issuer. To facilitate this process, an issuer must provide required information to intermediaries sufficiently in advance for the intermediary to prepare and send a Notice of Internet Availability at least 40 days before the date of the annual meeting.[6]

According to Broadridge Financial Services, Inc., as of June 30, 2008, 653 issuers used the notice and access model for distribution of their proxy materials.[7]


Does Delaware Compete?

This post is from Mark Roe of Harvard Law School. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

I recently presented Does Delaware Compete? at the Law and Economics seminar here at Harvard Law School. The paper focuses on a long-standing academic inquiry into the nature of state-to-state competition for chartering revenues and the making of corporate law. While the existence of state competition has long been posited — with the controversy being over its nature — recent work has shown that in fact few states try to make money in corporate franchising and only one — Delaware — is very successful at it.

In this paper, I analyze three arenas in which Delaware competes, even if no other state is a strong player today. First and importantly, it must attract firms to reincorporate away from their home states. The dynamism of American business interacts with even a lackluster state-based corporate chartering market to create a broad avenue of chartering competition, as Delaware’s business base is persistently eroding as firms merge, close and restructure. The “half-life” of Delaware’s franchise tax base is surprisingly short. If it fails to be attractive enough to obtain a steady flow of reincorporating firms, that base will erode. Even if no other state is trying, Delaware has to try. Second, an awakening of a dormant competitor is not impossible. I outline what might motivate one or the other. Although the odds of that happening at any one time are small, small does not mean zero. Analysis should focus not primarily on the incentives of states and their legislatures — where most of the focus has been — but on the incentives of businesses and their lawyers. Entrepreneurial lawyers, with clients who want a different corporate law, would be the likely source of state innovation in making corporate law, not the state legislature directly. Similarly, and third, Delaware has reason to consider the risk of a federalization of core elements of its corporate law even if no other state actively competes for charters. A reputation for bad decision-making (or bad decision-makers) could impel Congress to displace Delaware, in whole or, more likely, in part, perhaps as an excuse during an economic downturn or after a scandal. While the odds of full displacement are low, Sarbanes-Oxley shows us that the odds of substantial partial displacement are not.

I then draw parallels between these ideas and those in the industrial organization, antitrust literature on contestable markets: in contestable market analysis, a single producer can dominate a market, but, depending on the nature of its technology and its market, it could lose market share overnight or suddenly face a new entrant if the incumbent missteps badly. To the extent the chartering market is contestable, Delaware competes, even if that’s a weak form of competition. And, once we see Delaware as in a contestable market with other states, we see that Washington could erode Delaware’s dominance just as another state can. In other words, Delaware could face catastrophic loss in two dimensions: the traditional horizontal one of a competing state, and the vertical one of federal displacement. To fully understand the structure of American corporate lawmaking, we must also see the importance of the Delaware-Washington interaction, actual and potential.

The full paper is available for download here.

In another paper entitled Delaware’s Competition, I make the case that over the 20th century, the most important alternative to Delaware in making corporate governance law was not the other states, but Washington, D.C. That paper is available for download here. In a second related paper, entitled Delaware’s Politics, I focus on the political economy of the Delaware-Washington structure: Managers and shareholders are the primary players in Delaware; a much wider set of interests and policies is brought into play when corporate issues move to Washington. That paper is available for download here.

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