Monthly Archives: February 2009

Amendments to the Delaware Corporation Code

This post is by Mark A. Morton’s partners Michael Tumas and John Grossbauer. 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.

The Council of the Corporation Law Section of the Delaware State Bar Association earlier today forwarded to Corporation Law Section members the proposed 2009 amendments to the Delaware General Corporation Law (“DGCL”). Consistent with Delaware’s preference for enabling legislation and maintaining maximum flexibility, the amendments eschew mandates for corporate action. Specifically, the proposed amendments create new Sections 112 and 113 that expressly permit Delaware corporations to adopt bylaws implementing proxy access and requiring reimbursement of stockholder proxy expenses in certain circumstances. Also included among the proposed amendments are changes to Section 213, to permit Delaware corporations to provide separate record dates for determining stockholders entitled to notice of and to vote at stockholder meetings, a new provision permitting judicial removal of directors in extreme, emergency circumstances, and a revision to Section 145(f) expressly providing that pre-existing indemnification and advancement rights provided in a corporation’s governing documents cannot be impaired by later amendments to those documents. The amendments are summarized in more detail below.

Access to Proxy Solicitation Materials (New Section 112)
The proposed amendments create a new section of the DGCL, Section 112, expressly authorizing a Delaware corporation to adopt a bylaw that grants stockholders the right to include within the corporation’s proxy solicitation materials stockholders’ nominees for the election of directors, subject to any lawful conditions the bylaws may impose. The subject of “proxy access” had been a significant one, and it promised to continue to be so in the current environment. The addition of proposed Section 112 removes any uncertainty regarding the ability of Delaware corporations to effect proxy access through adoption of a bylaw. In so doing, the proposed amendment clarifies that corporations may impose reasonable restrictions on the stockholders’ right to access company proxy materials and identifies a non-exclusive list of restrictions that are deemed to be reasonable.

One condition specified in Section 112 would permit the bylaws to establish minimum ownership requirements for stockholders to become eligible to include nominees in company proxy materials, measured both by amount and duration of ownership. The bylaws may establish this minimum ownership threshold by defining beneficial ownership to include ownership of options or other rights relating to stock, including derivative rights. Because Section 112 is intended to apply to stockholder nominations of short slates of directors and not as a vehicle for effecting changes of control through the corporation’s own proxy materials, the new section also expressly permits the bylaws to condition eligibility for inclusion in the corporation’s proxy materials to nominations for a limited number of seats that may be contested and to preclude entirely inclusion of nominations by persons who own or propose to acquire (such as through a tender offer) more than a specified percentage of the corporation’s stock. The bylaws also may require the nominating stockholder to submit specified information such as information concerning the ownership of the corporation’s stock by the stockholder and the stockholder’s nominees. The bylaws also may condition eligibility to require inclusion of nominees in the corporation’s proxy materials on the nominating stockholder’s execution of an undertaking to indemnify the corporation for any loss resulting from any false or misleading information submitted by the stockholder and included in such proxy materials, or on “any other lawful condition.”


Delaware Supreme Court Orders Entire Fairness Review

This post comes to us from Robert S. Reder, Alan J. Stone, Peter Heller and Dean Sattler of Milbank, Tweed, Hadley & McCloy LLP. 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.

In a previous Client Alert, [1] we discussed a decision of the Delaware Court of Chancery dismissing a stockholder suit that alleged breach of fiduciary duty by directors who initiated, but later abandoned, a sale process that had generated three attractive offers. In Gantler v. Stephens [2], the Court of Chancery applied the business judgment rule to the board’s conduct, rather than the Unocal [3] standard of enhanced review, because the directors’ actions were not “defensive” in nature. In affording the directors the benefit of the business judgment presumption, the Court of Chancery found that the directors breached neither their duty of loyalty nor their duty of care, and therefore declined to undertake an “entire fairness” review of the board’s conduct.

On January 27, 2009, the Delaware Supreme Court reversed the Court of Chancery’s decision. In the Supreme Court’s view, the complaint pled “sufficient facts to overcome the business judgment presumption,” thereby requiring an examination of plaintiffs’ allegations under the entire fairness standard of review.[4] The Supreme Court’s analysis provides helpful insight into the nature of the pleading required to overcome the presumption of the business judgment rule in the M&A context. The Gantler decision also clarifies the nature of the fiduciary duties owed by corporate officers to a Delaware corporation, as well as the scope and application of the shareholder ratification doctrine under Delaware law.


In August 2004, the board of directors of First Niles Financial, Inc. authorized a process to sell the company, and retained financial and legal advisors to assist. At the next board meeting, with the sale process underway, management advocated abandoning the process in favor of a so-called “going private” transaction. The board did not act on management’s proposal, but instead allowed the sale process to continue.


The Welcome Reaffirmation of the Business Judgment Protection

This post is based on a client memorandum by Martin Lipton, Steven A. Rosenblum, and Sabastian V. Niles of Wachtell, Lipton, Rosen & Katz. 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.

Despite increasing political and media focus on and criticism of risk assessment and risk management efforts by corporate boards, yesterday’s In Re Citigroup Inc. Shareholder Derivative Litigation, No. 3338-CC (Feb. 24, 2009), decision by the Delaware Court of Chancery is a welcome indication that the business judgment rule will survive the financial crisis intact.

The plaintiffs in the case alleged, among other things, that the defendants had breached their fiduciary duties by not properly monitoring and managing the business risks that Citigroup faced from subprime mortgages and securities, and by ignoring alleged “red flags” that consisted primarily of press reports and events indicating worsening conditions in the subprime and credit markets. Declaring that “oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk,” Chancellor Chandler dismissed these claims on the ground of failure to adequately plead demand futility. The only claim the court did not dismiss was an allegation that the defendants had engaged in waste by approving a multimillion dollar payment and benefit package for Citigroup’s former CEO upon his retirement.

The decision reaffirms and clarifies several key features of Delaware law, established by the Caremark decision and its progeny, with respect to oversight responsibilities. First, that plaintiffs face “an extremely high burden” in bringing a claim for personal director liability for a failure to monitor business risk. Second, that while directors could be liable for a failure of board oversight, “only a sustained or systemic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.” Third, that a bad business decision is not evidence of the bad faith necessary to establish oversight liability. Notably, the court drew an important distinction between oversight liability with respect to business risks and oversight liability with respect to illegal conduct, emphasizing that courts will not permit oversight jurisprudence to be distorted by “attempts to hold director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly.”

As boards of directors review the risk oversight and management programs of their companies (see our November 2008 memorandum entitled “Risk Management and the Board of Directors”), this week’s decision in Citigroup should provide some comfort that, even in the current environment, the Delaware courts will continue to protect informed business judgments made by corporate boards in good faith.

“Say on Pay” Now a Reality for TARP Participants

This post is by Annette L. Nazareth’s colleagues Beverly Fanger Chase, Ning Chiu, Edmond T. FitzGerald, Kyoko Takahashi Lin, Jean M. McLoughlin, and Barbara Nims.

Media and public attention surrounding the American Recovery and Reinvestment Act of 2009, enacted on February 17, 2009 and commonly referred to as the stimulus bill, has typically focused on the law’s restrictions on the amounts and forms of compensation payable to executives of TARP participants.[1] An important provision of the stimulus bill that has not as yet received much notice, but is now a reality for all institutions that receive or have received government assistance under TARP, is the requirement that such institutions permit their shareholders to vote on executive compensation – a so-called “say on pay” vote.

Shareholder proposals advocating for say on pay have been a recent priority item on shareholders’ governance agenda, with reports indicating that as many as 100 proposals have been submitted to public companies for the 2009 season. Support for the approximately 70 proposals submitted to shareholders in the 2008 season averaged approximately 42%, with ten proposals reported as receiving majority support from shareholders. Although say on pay has not been widely adopted by companies, 18 companies to date have agreed to institute company proposals seeking a say on pay vote in their proxy statements. Six of these companies have already included such a company proposal in their proxy statements, with shareholder support for the companies’ executive compensation ranging from 62.5% to 98.7%.

The new SEC leadership has publicly expressed its support of adopting say on pay for all companies outside the context of the stimulus bill. Mary Schapiro, Chairman of the SEC, stated in a recent speech that “giving shareholders a greater say on . . . how company executives are paid” is on the SEC’s agenda. Further, SEC Commissioner Elisse B. Walter in recent remarks stated that she believes say on pay can help restore investor trust, and she encouraged more companies to voluntarily adopt say on pay.

Stimulus Bill Requires Say on Pay, But Timing of Implementation Originally Unclear
The stimulus bill requires that the shareholders of any institution that has received or will receive financial assistance under TARP be provided with an annual non-binding say on pay vote on executive compensation each year during the period in which any obligation arising from such financial assistance remains outstanding. In its annual meeting proxy statement, each institution must provide a separate shareholder vote to approve the compensation of the institution’s executives as disclosed pursuant to the SEC’s compensation disclosure rules, which include the compensation discussion and analysis, the compensation tables and related narrative.

The stimulus bill called for the SEC to issue final regulations regarding this say on pay provision within one year after the date of the bill’s enactment. The legislation did not indicate whether the say on pay provision was effective immediately upon its enactment, or would only become effective after the SEC issued these regulations.

The stimulus bill also makes clear that this shareholder vote is not intended to be binding upon an institution’s board of directors and may not be construed as overruling any board decision, nor does it create or imply any additional fiduciary duty of the board.


What Matters in Corporate Governance?

Editor’s Note: This post is by Lucian Bebchuk, Alma Cohen, and Allen Ferrell of Harvard Law School.

This month’s issue of The Review of Financial Studies features our article, “What Matters in Corporate Governance?.”

The article investigates the relative importance of the 24 provisions followed by the Investor Responsibility Research Center (IRRC) and puts forward an entrenchment index based on six provisions: staggered boards, limits to shareholder bylaw amendments, poison pills, golden parachutes, and supermajority requirements for mergers and charter amendments. The article shows that increases in the index level are monotonically associated with economically significant reductions in firm valuation as well as large negative abnormal returns during our period of examination. The other eighteen IRRC provisions not in our entrenchment index were uncorrelated with either reduced firm valuation or negative abnormal returns.

Since the initial version of our study was first circulated in the fall of 2004, many researchers have used the entrenchment index we put forward. A list of over 75 studies using the index is available here. For those who might wish to use the entrenchment in subsequent research, data on firms’ entrenchment index levels during the period 1990-2007 is available here.


Below we describe the article’s results and contributions: There is now widespread recognition, as well as growing empirical evidence, that corporate governance arrangements can substantially affect shareholders. But which provisions, among the many provisions firms have and outside observers follow, are the ones that play a key role in the link between corporate governance and firm value? This is the question on which our article focuses.


The Trilateral Dilemma in Financial Regulation

This post is by Howell Jackson of Harvard Law School.

My recent article “The Trilateral Dilemma in Financial Regulation” analyzes a practice — which I label the trilateral dilemma — existing in many different sections of the financial services industry, including mortgage lending, retirement savings, investment management, insurance brokering and banking services. The practice arises in the context of a consumer seeking the recommendation of a financial adviser for the purpose of choosing financial products and services. With surprising frequency, these advisers receive side payments or other forms of compensation from the firms that provide the product or service the advisers recommend. Many times these payments are not clearly disclosed to the consumers; often they are entirely secret.

In the article I describe how trilateral dilemmas have arisen in many different sections of the financial services industry. I then review the many different regulatory strategies that legislatures, courts and regulatory bodies have employed to address the problem. The modal regulatory response is the imposition of some sort of fiduciary duty on the financial advisor along with a generalized disclosure to consumers affected by the transaction. I then discuss a range of recurring analytical issues that arise in policy debates over trilateral dilemmas in a variety of settings, and I also evaluate the possibility that side payments and other forms of indirect compensation may in fact be an efficient or at least innocuous means of financing the cost of distributing financial products and services. The article concludes with some thoughts about the implications of my analysis for devising regulatory responses and for the role that consumer education might play in helping consumers work through these difficulties.

The article is available here.

One specific — and highly controversial — example of the trilateral dilemma in the real estate context involves the payment of yield spread premiums by lending institutions to mortgage brokers for steering consumers towards particular loans. In a recent article entitled “Kickbacks or Compensation: The Case of Yield Spread Premiums“, Laurie Burlingame and I present an empirical study of approximately 3,000 mortgage financings of a major lending institution operating on a nationwide basis through both a network of independent mortgage brokers and some direct lending. The data for this study was obtained through discovery in litigation that was subsequently settled. The study offers a number of insights into the impact of yield spread premiums of mortgage broker compensation and borrower costs. In particular, the study suggests that for transactions involving yield spread premiums, mortgage brokers received substantially more compensation than they did in transactions without yield spread premiums. This estimated difference in mortgage broker compensation is statistically significant and robust to a variety of formulations.

Industry representatives have long argued that yield spread premiums are not harmful to consumers because these payments are recouped through lower direct payments to mortgage brokers. However, our analysis suggests that this claim is baseless, at least with respect to sample included in our database. With a high degree of statistical confidence and using multiple formulations, we can reject the proposition that consumers fully recoup the cost of yield spread premiums. Our best estimate is that consumers get less than 35 cents of value for every dollar of yield spread premiums, a very bad deal for consumers.

The article also provides evidence that the payment of yield spread premiums may allow mortgage brokers to engage in price discrimination among borrowers. The evidence suggests that yield spread premiums are not simply another form of mortgage broker compensation, but rather a unique form of compensation that allows mortgage brokers to extract excessive payments from many consumers. The article concludes with a discussion of the implications of the study, areas for regulatory focus, and proposals for regulatory reform.

The article is available here.

Dealing With the Executive Pay Problem

Editor’s Note: This post by Ira M. Millstein is a letter to the editor of the WSJ responding to the op-ed by Lucian Bebchuk that appears on our forum here.

Lucian Bebchuk’s suggestions regarding bank executive compensation didn’t go far enough in controlling levels of executive compensation and their growing inequities. Experts continuously present suggestions to link pay to performance through a variety of stock options and other mechanisms. None of them is impervious to the gaming which takes place, and none has halted the escalation.

The responsibility to set and monitor compensation is in the boardroom. Boards have avoided that responsibility and remained tone deaf to the public’s concern. Structuring transparent, understandable fair compensation, even in the millions-of-dollars range, is one thing; failure to consider the risk of perverse escalating outcomes and perks is another. Institutional shareholders have the voice and capacity to put spine in the boardroom by communicating on compensation to Compensation Committees, filing proxy resolutions, and voting against directors believed to be improvident. Then, in turn, they should report to their beneficiaries what they have done.

Electronic Arts Before the Second Circuit: The Amici Curiae Brief of 60 Corporate and Securities Law Professors

This post is by Jeffrey N. Gordon of Columbia Law School.

Last week, on behalf of sixty corporate and securities law professors from thirty-eight law schools around the country, I filed an amici curiae brief in the case of Lucian Bebchuk vs. Electronic Arts, Inc.. The case is  now pending before the United States Appeals Court for the Second Circuit. The professors’ amici curiae brief is available here, and the names of the professors joining the brief are listed at the bottom of this post.

The case focuses on a shareholder proposal that was submitted by Lucian Bebchuk to Electronic Arts (EA). The proposal is precatory and recommends that the board submit to a shareholder vote a charter or bylaw amendment that, if adopted, would require the company (to the extent permitted by law) to include in the company’s proxy materials qualified proposals for a bylaw amendment. For a proposal to be qualified, the proposal would have to meet certain significant requirements, including being submitted by a shareholder(s) with more than 5% of the company’s stock. The proposal is available here.

EA excluded the proposal from the company’s ballot, and the case focuses on whether the SEC’s shareholder proposal rule (Rule 14a-8) allows the company to do so.

The case comes before Second Circuit on appeal from the District Court for the southern District of New York. The District Court accepted the position of EA in a brief bench ruling and sent the case to the Second Circuit. The transcript of the District Court’s hearing is available here. The opening brief filed in the appeal by Lucian Bebchuk’s counsel, Grant & Eisenhofer, is available here. A sense of the position that EA can be expected to present in the appeal can be obtained from the opening brief and reply brief EA submitted to the District Court, which are available here and here, as well as from the amicus curiae brief, available here, submitted to the District Court by the Chamber of Commerce.

The professors’ amici curiae brief, filed in support of the appellant’s position, focuses on two central arguments made by EA in defense of excluding the proposal:

(1) Inconsistency with the Proxy Rules Argument:

In its bench ruling, the District Court, accepting the position of EA and the Chamber, held that EA may omit the proposal as inconsistent with Rule 14a-8. The District Court viewed any provision in the certificate of incorporation or the bylaws that would limit the discretion of EA’s directors to control access to the issuer’s proxy statement as inconsistent with Rule 14a-8. The District Court held that Rule 14a-8 mandates that the discretion it provides to companies to omit certain proposals be exercised fully and solely by the company’s board. The Court stated that “it is clear… that the SEC understand[s] the company to be those who act for the company … And that is a small, relatively small group of people, like the board of directors, who have management discretion to run the business and affairs of the company. And it is they that must have this discretion.”


SOX Deficiencies and Firm Risk

This post comes from Hollis Ashbaugh Skaife of the University of Wisconsin-Madison, Daniel W. Collins of the University of Iowa, William R. Kinney, Jr. of the University of Texas at Austin, and Ryan LaFond of Barclays Global Investors.

In our forthcoming Journal of Accounting Research paper entitled The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, we explore the relation between internal control quality and idiosyncratic and systematic risk, and the potential benefits of effective internal control in terms of cost of equity. Specifically, we investigate whether firms that disclose internal control deficiencies (ICDs) exhibit higher systematic risk, higher idiosyncratic risk, and higher cost of equity relative to firms with effective internal controls. Further, we investigate whether managements’ initial disclosures of ICDs and remediation of previously reported ICDs are related to changes in firms’ cost of equity.

We conduct both (1) cross-sectional tests to assess whether firms with ICDs present higher information risk to investors relative to firms having effective internal controls; and (2) inter-temporal tests to assess whether changes in the effectiveness of internal control yield changes in cost of equity consistent with changes in information risk. The results of our cross-sectional tests indicate that firms reporting ICDs exhibit significantly higher idiosyncratic risk, betas, and cost of equity relative to firms not reporting ICDs. These differences persist after controlling for other factors shown by prior research to be related to these risk measures. Our finding that differences in these risk measures pre-date the first disclosures of ICDs suggests that market participants’ assessment of non-diversifiable market risk (beta), idiosyncratic risk, and cost of equity incorporated expectations about internal control risks based on observable firm characteristics prior to firms’ initial revelation of control problems.

In an attempt to assess whether a causal relation may exist between internal control quality and firms’ cost of equity, we construct four sets of inter-temporal change analysis tests. The first inter-temporal test finds that ICD firms experience a statistically significant increase in market-adjusted cost of equity, averaging about 93 basis points, around the first disclosure of an ICD. In our second change analysis, we find that ICD firms that subsequently receive an unqualified SOX 404 opinion exhibit an average decrease in market-adjusted cost of equity of 151 basis points around the disclosure of the opinion. In contrast, for our third change test we find that ICD firms that subsequently receive adverse SOX 404 audit opinions, which indicate that internal control problems persist, exhibit a modest but insignificant increase in cost of equity around the SOX 404 opinion release. In our final inter-temporal change analysis, we find no significant cost of equity change for firms least likely to report an ICD, but a significant decrease in the average market-adjusted cost of equity of 116 basis points around the release of an unqualified SOX 404 opinion for firms most likely to report ICDs.

Collectively our cross-sectional and inter-temporal tests present consistent evidence that information risk as proxied by ineffective internal control is an important determinant of both idiosyncratic risk and systematic market risk that affects the market’s assessment of firms’ cost of equity. We document that firms with effective internal control or firms that remediate previously reported ICDs are rewarded with a significantly lower cost of equity.

The full paper is available for download here.

An In-depth Analysis of Treasury’s Financial Stability Plan

This post is based on a client memorandum by Randall Guynn and Margaret Tahyar of Davis Polk & Wardwell.

The Treasury’s recently announced Financial Stability Plan reshapes the ground rules for capital injections into financial institutions, increases the size and scope of a previously announced non-recourse lending facility by the Federal Reserve, launches the idea of a public-private investment fund to purchase legacy or toxic assets from financial institutions and sets aside funds for the homeowner assistance plan outlined by President Obama on February 18. As has been widely noted, however, the plan is long on aspiration but short on detail.

Among the new features of the plan is a mandatory comprehensive “stress test” for banking institutions with assets in excess of $100 billion. Although “stress testing” is a term of art in the financial services and risk management realm and is an element of the risk-based approach taken by Basel II, the sense in which it will be applied by Treasury is unclear. The memorandum explores the possible meaning.

The plan also contemplates, but does not detail, ongoing measures to further enhance public disclosure of financial health. Political calls for more disclosure in the current environment, however, disguise the complexity of the issues that will have to be sorted out in order to arrive at a functional solution. Some of these challenges discussed in the memorandum include the possible necessity of international coordination in order to shape new norms for financial institution disclosures and the implications of the ongoing debate over mark-to-market accounting and dynamic provisioning.

In an effort to restart the currently illiquid market for legacy assets, Treasury announced the creation of the Public-Private Investment Fund. The key new feature of this initiative, compared to earlier discussions regarding an aggregator bad bank, is an element of private capital participation, although the specifics of this public-private partnership are still unclear. The memorandum discusses some of the challenges, including whether pricing mechanisms will indeed be easier to design due to private sector involvement.

Hardly any market has been more affected by the recent market turmoil than the private label securitization market. The pendulum appears to have swung from a failure of the financial markets to properly recognize and price the huge risks of certain securitization classes to a situation where securities backed by any asset class not also explicitly or implicitly backed by the government are virtually impossible to bring to the market. While banks have been broadly accused of being responsible for reduced lending activity, latest data published by Treasury shows that in fact, the absence of a functioning securitization market is the greatest contributor to a decline in lending. Therefore, it should come as no surprise that the implementation of a facility announced by the Federal Reserve in November of last year to revive the asset-backed securities markets, the Term Asset-Backed Securities Loan Facility, is greatly anticipated. The memorandum discusses salient features of the facility, including the manner in which it will allow for the participation of unregulated funds, and its potential expansion as part of the government’s plan.

The memorandum is available here.

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