Monthly Archives: February 2009

Changing the Rules for Director Selection and Liability

This post is by Scott J. Davis of Mayer Brown LLP.

In my paper Would Changes in the Rules for Director Selection and Liability Help Public Companies Gain Some of Private Equity’s Advantages?, to be published in Volume 76 of the University of Chicago Law Review, I examine whether changes in existing legal rules governing how public company directors are chosen and the extent to which public company directors can be held liable for damages if they do not have a conflict of interest would be likely to increase the ability of public companies to obtain some of the benefits that companies owned by private-equity sponsors appear to have. It is widely believed that companies owned by private-equity sponsors have significant advantages over public companies. Among the advantages of private equity cited by commentators are: (1) better governance and a greater willingness to take risks, (2) the ability to focus on long-term issues and a more stable shareholder base, (3) the ability to attract better management talent, (4) creating a sense of urgency, (5) the ability to use leverage more effectively, (6) avoiding the costs imposed by the Sarbanes-Oxley Act, and (7) freedom from shareholder suits. It would be helpful if public companies could gain some of these advantages. My conclusion is that, while changing the rules for selecting directors would not be worthwhile, a reduction in the potential liability of directors for damages in situations in which they do not have a conflict of interest would be likely to increase the ability of public company companies to mirror the effectiveness of private-equity portfolio companies without creating other problems that would be unacceptable.

The paper is available here.

RiskMetrics Update Continues to Hamper Director Discretion

This post is by David A. Katz of Wachtell, Lipton, Rosen & Katz. Previous posts on this blog concerning RiskMetric Group’s policy updates are available here and here.

My colleague Laura A. McIntosh and I (with help from our colleague David Adlerstein) wrote an article entitled “RiskMetrics Update Continues to Hamper Director Discretion,” which discusses the 2009 updates to the domestic and international corporate governance policies of RiskMetrics Group (formerly know as ISS). RMG’s policy updates continue its trend of espousing policies that tend to shift corporate decision-making from boards of directors to shareholders, including activists and special interest groups. In particular, RMG’s updated policies seek to further limit directors’ discretion in areas traditionally within the board of directors’ clear authority under state law, including executive compensation, corporate governance matters and social policy.‬‪ ‬‪ As an example, RMG has revised its policy with respect to management proposals to ratify a shareholder rights plan. In addition to considering whether a shareholder rights plan includes RMG’s prescribed attributes (such as a 20 percent or higher triggering threshold and a shareholder redemption feature), RMG also will take into consideration a company’s existing governance structure, including board independence, existing takeover defenses and “any problematic governance concerns.” In the face of these new, subjective criteria, it remains to be seen in what circumstances RMG would, in fact, recommend in favor of adopting a shareholder rights plan. Importantly, RMG is continuing its policy of recommending “withhold votes” against an entire board of directors, if the board adopts or renews a rights plan without shareholder approval, does not commit to putting the rights plan to a shareholder vote within one year of adoption, or reneges on a commitment to put the rights plan to a vote and has not yet received a “withhold vote” recommendation for this issue. The article explains why we believe this policy update could be problematic for corporations in the current troubled market environment.‬ ‪ ‬‪

The article is available here.

Why ban short selling of financial sector stocks?

Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of remarks by him at the Practising Law Institute’s “SEC Speaks” Program in Washington, D.C., on February 6, 2009.

It is a pleasure to be part of “The SEC Speaks in 2009.” This marks the first time I have participated in “SEC Speaks,” and I am honored to be with some of the nation’s finest securities lawyers — both inside the SEC and among the private bar. Before I begin, I must give you the standard disclaimer that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

* * * *

Today, we are persevering through a tumultuous economy that recalls the challenges giving rise to the SEC and the laws it administers as part of the New Deal. During the past year, we have witnessed the demise of investment banks that were considered permanent fixtures on Wall Street. The notion that these institutions could fail had been unthinkable. We also have read about fraudsters whose Ponzi schemes preyed on investors and have heard allegations of market manipulation. We have seen the housing market collapse, credit freeze, IPOs stall, and unemployment rise, all while the government has taken unprecedented steps to stem the troubles. It is no surprise that investor confidence has suffered.

During the midst of the economic crisis last year, the SEC itself took a particularly extraordinary step: temporarily banning short selling.

Although perhaps not readily apparent, short selling can advance important economic goals. It can result in more liquidity, more capital formation, and more efficiently allocated risk. Short selling can buttress buying by allowing investors that go long — in other words, that purchase shares to hold as investments — to hedge their positions; and short selling can encourage market participation by leading to improved price discovery. Investors may be more reluctant to buy if the more pessimistic views of short sellers are not fully reflected in securities prices.

Short selling also is tied to investor confidence. Investor confidence depends on investors’ faith in the integrity of markets. Investors expect that securities prices are meaningful in that they reflect the market’s overall assessment of what a company is “worth” by aggregating into a single number the different views of market participants. Accordingly, in promoting market efficiency, short selling can foster investor confidence, as investors can be confident that securities prices reflect both optimistic and contrarian views.


The Bailout Is Robbing the Banks

This post is based on an op-ed piece by John C. Coates and David S. Scharfstein published in today’s New York Times.

Many Americans are angry at banks for taking bailout money while still cutting back on lending. But the government is also to blame. For reasons that remain unclear, the Troubled Asset Relief Program has channeled aid to bank holding companies rather than banks. The Obama administration’s new Financial Stability Plan will have more influence on bank lending if it actually directs its support to banks.

To see why, it’s important to understand the distinction between banks and bank holding companies. Banks take deposits and make loans to consumers and corporations. Bank holding companies own or control these banks. The big holding companies also own other businesses, including ones that execute trades both on their clients’ behalf and for themselves.

It would seem obvious that helping banks, not holding companies, would be the most direct way to stimulate bank lending. But when TARP purchased preferred stock and warrants, it bought them from holding companies, not their bank subsidiaries.

While TARP has been generous with bank holding companies, these companies have not been so generous with their banks. Four large holding companies — JP Morgan, Citigroup, Bank of America and Wells Fargo — initially received a total of $90 billion in TARP money in the fall, but by the end of 2008 they had contributed less than $15 billion in equity capital to their subsidiary banks.

The holding companies seem to have invested most of their TARP money in their other businesses or else retained the option to do so by keeping it in deposit accounts, even as the capital of their banks decreased. At the same time the banks, which provide the majority of loans to large corporate borrowers, drastically reduced lending to new borrowers.

It’s easy to see why holding companies would withhold capital from their troubled banks. If a bank is insolvent — as many are now believed to be — and the government has to take it over, the holding company loses any capital it gave to the bank. Rather than take that risk, the holding company can opt to spend its money elsewhere, perhaps on trading of its own.

But this is not a good use of scarce capital. We might end up with too much of this proprietary trading and too little lending. It also means that when it comes time to recapitalize banks there is a bigger hole to fill, and when banks fail there is less capital available to meet the government’s obligations to insured depositors and other creditors. Keeping money at the holding company may benefit its shareholders, but it is costly for taxpayers.

Bailouts, at the very least, should reach their target. When Washington wanted to help Chrysler, it gave money to Chrysler. It did not write a blank check to Cerberus, the private equity firm that owns Chrysler, in the hope that the money would somehow find its way to the carmaker and not to the other companies Cerberus owns.

Some politicians, frustrated that the government’s costly interventions have not had their desired effect, have wanted to mandate higher levels of bank lending. Others have tried shaming chief executives of financial institutions into lending more, as when Representative Mike Capuano of Massachusetts admonished eight of them who came before the House Financial Services Committee: “Start loaning the money that we gave you. Get it on the street!”

It would be more effective to simply ensure that the Financial Stability Plan is directed at banks. When the government buys stock, it should buy bank stock. And if it chooses to buy stock in holding companies, it should at least require that the new capital reaches the bank and non-bank subsidiaries that the government wishes to support. If the government chooses to help private investors buy toxic bank assets, as the planned Public-Private Investment Fund is supposed to do, it should not allow the banks to send those investments to their holding companies. And if the government decides to guarantee debt, it should guarantee the debt of banks, not of holding companies.

The Obama administration seems to understand that reviving bank lending is key to economic recovery. Now it needs to make sure that the banks get the money.

Readers interested in more information on the points in this op ed can read this forthcoming article in the Yale J. Reg.

Congress, Don’t Give up on Incentives

Editor’s Note: This post, which focuses on the executive pay restrictions imposed by the stimulus bill passed last Friday, is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal. A related op-ed piece by Professor Bebchuk, published earlier this month in the Wall Street Journal and dealing with the pay guidelines proposed by the Obama administration, is available here. Memoranda providing a detailed review and analysis of the restrictions by Wachtell, Lipton, Rosen & Katz and Sullivan & Cromwell LLP are available here and here, respectively. A memorandum by Davis Polk & Wardwell highlighting important interpretive questions raised by the bill is available here.

In a last-minute addition to the stimulus bill passed Friday, Congress imposed tight restrictions on pay arrangements in all financial firms that have or will receive TARP funding.

While I have long been a critic of corporate compensation practices, these restrictions leave me concerned. They weaken executives’ incentives to deliver the long-term performance that is needed to benefit banks, the economy, and taxpayers who have injected vast amounts of capital into these institutions.

While the new restrictions seem to have been motivated by a desire to limit total pay, it is the pay structure that they tightly regulate. The Obama administration’s proposals focused on constraining pay unrelated to performance. The stimulus bill takes the opposite approach—constraining incentive compensation, limiting it to one third of total pay.

To be sure, incentive compensation in many public companies has been flawed. Some incentive compensation has been so in name only, and some of it has provided perverse incentives to focus on short-term results to the detriment of long-term performance.

But these problems require tightening the link between pay and long-term performance—not giving up on it altogether. Mandating that at least two-thirds of an executive’s total pay be decoupled from performance, as the stimulus bill does, is a step in the wrong direction.

Another wrong step is the bill’s categorical prohibition on using any form of incentive compensation other than restricted stock. In the first place, some executives covered by the bill (up to 25 in some firms) run limited parts of the company’s operations. Their incentive pay might be best tied to the performance of their unit’s particular results, not to that of the whole company.

But even for top executives, the banks’ special circumstances may make exclusive use of restricted stock contrary to taxpayer interests. In many banks, the shareholders’ equity, which is junior to the government’s investments in preferred shares and the claims of bondholders, now represents a small fraction of the bank’s capital. Indeed, the value of some banks’ common shares might largely represent an “out-of-the-money option,” expected to deliver value only if things considerably improve.

In such circumstances, restricted stock may provide incentives for executives to take excessive risks with the bank’s survival. Consider the case where an infusion of additional capital would greatly dilute the value of common shares but would be best for the bank, while failing to get that capital would put the bank’s future at risk. In such circumstances, compensation in restricted common shares would provide executives with an incentive to avoid raising capital (which would wipe out their shares’ value) and gamble on survival without additional capital.

The compensation restrictions have another adverse effect on incentives. Executives can sidestep them by returning TARP funds and avoiding them in the future. Some observers argue that such actions would be unlikely because they would be costly to the bank. This overlooks the divergence between the interests of the bank and its executives. The bill provides executives with counterproductive and unnecessary private incentives to terminate or avoid TARP funding, even when doing so would not be in the bank’s best interest.

The stimulus bill’s adverse incentives deserve special attention because of the government’s current approach to the banking sector. While infusing large amounts of capital into banks, the government has chosen to leave their management largely to the discretion of bank executives. This makes executive incentives of paramount importance.

Compensation structures with distorted incentives may have already imposed large losses on investors and the economy. Public officials should be wary of introducing new distortions and perverse incentives. With so much hanging in the balance, ensuring that those running the country’s banks have the right incentives is as important as ever.

The Future of Securities Regulation

This post is by Luigi Zingales of the University of Chicago Graduate School of Business.

The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. In a recently revised working paper entitled The Future of Securities Regulation, I analyze what the appropriate securities regulation is for this changed world. I start by reviewing the theoretical role for regulation: why and when competition in the marketplace is insufficient for protecting investors. I then compare the theoretical predictions with the experience of unregulated markets and their relative successes and failures. From this analysis, I derive three main areas of intervention.

First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board. This reform will make it worthwhile for directors to develop a reputation of acting in the interest of shareholders and hence to make corporate managers accountable. However, to minimize the risk that institutional investors pursue a self interested agenda, institutional investors should be themselves independent. To achieve this goal, I propose a new Glass-Steagall Act, which instead of separating commercial and investment banking will separate mutual fund management from investment and commercial banking.

The second reform should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all the expenses that will be charged to their investment, including the amount paid in trading commissions, itemized as commissions paid for trading and those paid for services. Similarly, at the time of the purchase, brokers should disclose the fee they receive on the different products they sell, including the “soft dollar” they receive in the form of higher trading costs. The same strict standards should apply to both brokerage accounts and money management accounts.

The third reform should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration from the former to the latter suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private market. In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. On the private market front, there are compelling reasons to mandate a delayed disclosure provision in which hedge funds, private equity funds, and even companies private equity funds invest in report information and performance with a 1 to 2 year delay. This delay has the benefit of reducing the competitive cost of disclosure, while at the same time allowing for a serious statistical analysis of this market, which will improve allocation of savings.

The full paper is available for download here.

Economic “Stimulus” Legislation to Impose New Executive Compensation Restrictions

The post from James Morphy is based on a client memorandum prepared by attorneys at Sullivan & Cromwell LLP.

The final version of the American Recovery and Reinvestment Act of 2009, which was passed by the House on February 13 and was expected to be passed by the Senate later that night, includes extensive new restrictions on the compensation arrangements of financial institutions participating in the Troubled Asset Relief Program (“TARP”). The new legislation, which the President is expected to sign into law shortly, rewrites Section 111 of the Emergency Economic Stabilization Act of 2008 (“EESA”) (1) and directs the Treasury Department to establish standards and promulgate implementing regulations.

The new standards will codify many of the executive compensation guidelines for TARP recipients announced by the Treasury Department on February 4, 2009, impose additional restrictions and apply to all existing and future TARP recipients. It is not clear whether the standards will be immediately effective or will only be effective after regulations are issued.

Under the legislation, the standards are required to include the restrictions and other provisions summarized below, which include a variety of terms the meaning and scope of which have not been made clear.

Financial Institutions Affected. The restrictions apply to all entities that have received or will receive financial assistance under the TARP during the period the TARP recipient has an obligation outstanding that arises from TARP financial assistance. However, the restrictions cease to apply if the Federal Government only holds warrants to purchase common stock of the TARP recipient.

Employees Affected. Many of the restrictions extend beyond the TARP recipient’s CEO, CFO and three next most highly-compensated executive officers (the “senior executive officers”) and apply to other highly-compensated employees as well. It does not appear that other highlycompensated employees need to be officers of the TARP recipient, nor do any provisions specify how to identify such highly-compensated employees (for example, whether based on current or prior year compensation, whether a potential highly-compensated employee could drop off the prohibited group because of the bonus limit and how compensation would be defined for this purpose.


Rights Plans Offer Special Benefits for Some Companies

This post from John G. Finley is based on a client memorandum by attorneys at Simpson Thacher & Bartlett LLP.

The decline in the market capitalization of many companies has increased the number of pill adoptions, replacements and extensions. FactSet SharkRepellent’s data show that rights plan activity (i.e., adoptions, replacements and extensions) in 2008 was at the highest level since 2002 and more than 64% higher than 2007. A major reason for this uptick in activity has been the severe decline in market capitalizations resulting in an increased risk of opportunistic takeover threats, particularly for small cap companies.


In recent years, most companies have not been adopting (or renewing) rights plans because of (i) diminished legal concern with respect to adopting plans in the “heat of the battle” and (ii) the RiskMetrics Group (“RMG”) policy, adopted in 2005, that generally recommends “withhold” or “against” votes with respect to directors who adopt a rights plan that is not subject to stockholder approval. Many companies have, therefore, refrained from adopting a pill with the knowledge that they could adopt a rights plan if and when a specific takeover threat emerged.

This “off-the-shelf” strategy is, however, not well suited to a company with a market capitalization that has fallen below roughly $500 million given the threat of an accumulation of control by an acquiror. The key warning signs of an accumulation—an antitrust filing under the Hart-Scott-Rodino Act ($65 million threshold) and a filing of a Schedule 13D (5% of the company’s outstanding common stock)–may not occur until after a substantial accumulation has already taken place. For example, if a company has a market capitalization of $250 million, then an HSR filing would not be required until the accumulation was at the 25% ownership level. While a Schedule 13D is required to be filed once the 5% threshold is crossed, there is a ten-day window before the filing is required. In addition, although Delaware’s “business combination” statute and similar statutes in other states limit the ability of stockholders who exceed specified ownership levels from engaging in certain business combinations for a prescribed period of time (e.g., three years following the threshold crossing in Delaware), these statutes do not prevent the actual accumulation of shares and the attendant implications of having a meaningful block of shares in the hands of an activist investor.


Year-End Update On Class Actions

This post is by John F. Olson’s colleagues Gail Lees, Andrew Tulumello, Chip Nierlich, Mark Whitburn and Chris Chorba.

Class action lawsuits are an increasingly pervasive force in today’s business world. Defending and defeating these cases efficiently and prudently is a top priority for many in-house legal teams and their outside counsel. This year-end update reports on key trends in class action practice. It provides an overview of Rule 23, reviews key class action decisions from 2008, and identifies important class action issues likely to be litigated in 2009 and in the years ahead.

The number of class actions has grown exponentially in recent years. Although reliable numbers are hard to come by, Federal Judicial Center statistics suggest that new class action cases filed in or removed to federal court increased 72% between 2001 and 2007,[1] reaching approximately 4,000 to 5,000 annually as of mid-2007 (the last period for which data are available). This represents more than a dozen new lawsuits every day.[2] And while the Class Action Fairness Act (“CAFA”) has shifted many putative nationwide class actions from the state to the federal system, our class action lawyers, who, according to Law360, are running one of the top five busiest federal class action practices in the country, report that state court class action activity in many courts has not diminished. CAFA has prompted a flurry of single-state class actions filed in state courts, and recent statistics show that in at least one forum favored by the plaintiffs’ bar (Los Angeles), state class action filings continue to grow.

Gibson Dunn predicts that these trends will increase in 2009, as recently enacted and anticipated legislation will expand the ability of the plaintiffs’ bar to bring new suits. Gibson Dunn already is seeing a surge in labor and employment, consumer fraud, and products liability litigation. That trend will continue, as a new administration and Democratic Congress enact laws–such as the Lilly Ledbetter Fair Pay Act–that expand or create new legal remedies, and cut back on or repeal federal statutes and administrative regulations that have in the past preempted state-law based suits.

Gibson Dunn also expects the Supreme Court to enter the debate over Rule 23. To date, there has been a significant mismatch between the Supreme Court’s docket and the pervasiveness of Rule 23 cases in the federal system. Despite the overwhelming number of class action cases flowing through the federal judiciary, the Supreme Court has continued to steer clear of core Rule 23 and class certification issues for many years–a trend that should not and cannot last much longer. In the last five terms alone, the Supreme Court has decided seven tax cases, six ERISA cases, five Title VII cases, and five cases under the Age Discrimination in Employment Act. However, in the last thirty-five years, the Supreme Court has decided fewer than a dozen cases involving core class action issues.[3] Splits across an important range of issues continue to develop and percolate in the lower courts, and it is appropriate and urgent for the Court to provide much-needed guidance on these issues.


The Case for Big Government

This post is by Jeff Madrick of the Schwartz Center for Economic Policy Analysis.

My recent book, The Case for Big Government, argues that America has been the victim of an anti-government ideology that has grown more intense, even under a Democratic president, Bill Clinton, since the late 1970s. It has long been part of the American national character to look with suspicion on government. After all, its very origins were a rebellion from central government tyranny.

But, in truth, America when it worked best, in my view, America used government robustly to embed its social and political values but also to create a foundation and capacity for economic growth and prosperity. The case against big government has always been ahistorical. There is no wealthy nation in the world today that does not have a big government.

Of course, some governments are bigger than others as a proportion of GDP. But the cross-country evidence is now clear. There is no statistical relationship between the size of government and the rate of growth of GDP per capita or productivity. The implication is that in many nations where government spending constitutes up to 50 percent of GDP, spending and outer social programs must in some ways significantly enhance productivity and build foundations for prosperity.

Because of America’s anti-government ideology, there is now a long and urgent to-do list in the nation. Too much has been neglected because of an over-reliance on markets and a distaste for taxes and new government programs. The list includes health care reforms, transportation and communications infrastructure, pre-K education, equal funding of k-12 education, alternative energy research and national energy policies, family work policies, among other issues. These are now at a critical stage. In time, when crisis passes, they will require an increase in taxes to pay for them.

The list also includes the need to focus serious attention on re-regulating American business. The dependence on financial markets to support growing overall demand through the issuance of debt, and also to remunerate CEOs and other high executives through the equity markets, is a direct reflection of faith-based ideology, not practical empiricism.

Despite the American mythology, there has never been laissez faire government in the U.S. Neo-classical economics provides much justification for government intervention and spending. But the extent is a matter of debate. Other economic theories are perhaps more relevant today.

America’s history may provide the stronger empirical case for government. Time and again, government changed in America to meet new needs. Even Jefferson, the heroic defender of laissez faire, bought Louisiana and demanded that there be regulations to control the sale of land. His party’s successors built the nation’s canals and free primary schools. The list goes on: grants of land to build colleges; land donations to subsidize the railroads; the building of sanitation systems, critical to the development of cities; the development of high schools; the building of roads and highways and parks; the subsidies of college and healthy research, and of course a century’s worth of laws to protect workers, make products safe, and, since the early 1900s, with many additions along the way, to regulate finance.

Most important, government is the nation’s key agent of change. There are no permanent rules as to where it can go and what it can do. These must be fluid, because societies and economies grow, and knowledge and expectations evolve.

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