Monthly Archives: February 2009

The Administration’s Executive Pay Guidelines

Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk in today’s Wall Street Journal.

Critics of the administration’s proposed guidelines on executive compensation say they are a dangerous intrusion into corporate boards’ authority and would make it difficult for financial firms to fill executive positions. These criticisms are unwarranted. If anything, the guidelines are too modest and should be tightened.

Concern that the guidelines would undermine firms’ ability to attract or retain executives has been fueled by media coverage stressing the $500,000 cap on salaries. Because salaries commonly represent a small fraction of total executive pay, and firms would be free to make up for this reduction by providing additional compensation in other forms, the salary cap’s significance would be mainly symbolic. Indeed, I would have no problem with a somewhat higher salary cap, especially if that would facilitate tightening the elements of the guidelines that are practically more significant.

Companies falling under the guidelines will retain the ability to provide large compensation when necessary. The guidelines don’t impose any cap on the total pay; they only influence its form. Indeed, firms which get taxpayer funds under “generally available government programs”—which likely will constitute the lion’s share of firms receiving government capital—will be permitted to provide unlimited compensation in any form they choose provided they disclose it (as is already required) and allow shareholders to have advisory “say on pay” votes on the firm’s pay policy. Even firms that receive “exceptional assistance” (such as provided to AIG or Citibank in the past) will be permitted to compensate executives with unlimited amounts in restricted shares that can be cashed out after the government is paid back.

This is not excessive government meddling. As a major provider of capital to firms receiving exceptional assistance, the government has a legitimate investment interest in executives’ being properly incentivized. The proposed guidelines are a rather modest intervention relative to the control rights that private investors providing so much capital would likely seek.

Furthermore, this modest intervention can significantly improve incentives and performance. In a 2004 book and prior articles, Jesse Fried and I warned that common executive pay practices produce perverse incentives to focus on short-term results. To the extent that such incentives have contributed to the current crisis—as has now come to be widely suspected—the adverse consequences have been dire indeed.

Executives’ ability to profit from early dumping of their equity-based compensation can impose large costs on investors. To protect its investments in firms receiving exceptional assistance, the government is warranted in restricting executives’ freedom to unload their restricted shares quickly, before the government is repaid.

For executives to view any number of restricted shares that cannot be quickly unloaded as inadequate compensation, they must believe the firm will likely fail to repay the government, and that the restricted shares will lose their value if not cashed out beforehand. In such circumstances, the firm should be immediately taken over by the government or otherwise reorganized. It should not continue operating with a structure under which executives may be retained only if allowed to cash out before things fall apart.

After a period of public comment, the Obama administration will finalize the guidelines for firms receiving capital under general programs. I believe the final version should impose tighter restrictions, at least for firms receiving a substantial capital infusion from the government.

While the proposed guidelines seek to encourage companies participating in general programs to use restricted stock, they do not limit how quickly such restricted shares may be unloaded. This should be changed. To provide incentives to focus on long-term results, executives should be precluded from unloading restricted shares for a specified period, say three years, after they vest.

The proposed guidelines also make it too easy for firms participating in general programs to opt out of the restricted stock requirement and compensate executives in whatever form they choose. Companies that opt out only need to adopt “say on pay” votes.

While such votes may be a good governance arrangement for public firms in general, they are merely advisory and, moreover, take place in the year after compensation is awarded. Furthermore, and importantly, because the government can be expected to hold investment rights (such as preferred shares) that are senior to those of common stockholders, these stockholders may prefer executive pay arrangements that would induce more risk-taking and short-termism than would be in the interest of the government as an investor.

In short, the guidelines are a useful step in the right direction. To ensure that executives of firms receiving government capital are well incentivized, however, the administration should use the comment period to significantly tighten them.

SEC vs. Mark Cuban

This post is by Allen Ferrell of Harvard Law School.

I have recently filed an amicus brief on behalf of myself and Professor Bainbridge of the UCLA Law School, Professor Jonathan Macey of Yale Law School, Professor Alan Bromberg of SMU Law School and Professor Henderson of the University of Chicago Law School in the litigation filed against Mark Cuban by the SEC in the United States District Court for the Northern District of Texas.

The SEC complaint essentially alleges that Mark Cuban committed insider trading when, according to the complaint, he sold stock in a company ( in which he was a large shareholder (but not a director or officer) after receiving material, non-public information from the company. The basis for the SEC’s claim of insider trading is the allegation (hotly disputed) that there was a confidentiality agreement with Mr. Cuban covering this material, non-public information.

In our amicus — which can be found here — we argue that even if there was a confidentiality agreement (i.e. accepting all of the SEC’s allegations as true), as a legal matter Mr. Cuban could not have committed insider trading. The Supreme Court in U.S. v. O’ Hagan, 521 U.S. 642 (1997) emphasized that only if a defendant has breached a fiduciary or similar relationship of trust and confidence can the defendant be found to have engaged in the requisite deception through non-disclosure. Under both state and federal common law, a confidentiality agreement alone creates only an obligation to maintain the secrecy of the information, not a fiduciary or fiduciary-like duty to act loyally to the source of the information. As a result, if the SEC’s Rule 10b5-2(b)(1) is read as creating insider trading liability solely on the basis of a confidentiality agreement, this rule is an invalid exercise of the SEC’s rulemaking authority.

Of course, neither I nor any of the professors that signed the amicus brief were compensated in any way for our efforts.

SEC Publishes Final Rules for Credit Rating Agencies

This post is based on a memo by Annette Nazareth, Joseph Hall and Michael Kaplan of Davis Polk & Wardwell.

On February 2, 2009 the Securities and Exchange Commission published the text of its new rules for credit rating agencies registered as nationally recognized statistical rating organizations (NRSROs). These rules were adopted at the SEC’s December 3, 2008 open meeting. The new rules are generally scheduled to go into effect on April 10, 2009. The SEC also re-proposed additional rules for NRSROs. Comments on the re-proposed rules are due March 26, 2009.

Final Rules
The rules adopted by the SEC in final form include bans on certain conduct which should be of interest to companies with current credit ratings issued by Standard & Poor’s Ratings Services, Moody’s Investors Service, Fitch Ratings, or another credit rating agency registered as an NRSRO. Since the consequences of violating one of the new bans are severe – requiring the credit rating agency to withdraw its rating – companies should carefully review their policies and procedures for interacting with credit rating agencies.

The new bans include:

Ban on Recommendations. Under the new rules, a credit rating agency may not issue or maintain a credit rating on an obligor or security where the credit rating agency, or an affiliate, made “recommendations” to the obligor or the issuer, underwriter or sponsor of the security about the corporate or legal structure, assets, liabilities or activities of the obligor or issuer.

Despite concerns raised that a ban on recommendations could unnecessarily chill communications between rated issuers and credit rating agencies, the line between permissible and prohibited communications remains blurred. Attempting to distinguish between a permissible communication and a prohibited recommendation, the SEC stated, for example, that it “does not view an explanation by an NRSRO of the assumptions and rationales it uses to arrive at ratings decisions and how they apply to a given rating transaction as a recommendation.” On the other hand, “if the feedback process turns into recommendations by the NRSRO about changes to the structure, assets, liabilities or activities of the obligor or security that the person seeking the rating potentially could make to obtain a desired credit rating, the NRSRO would be in violation of the new rule.”

Companies and credit rating agencies both will need to exercise care to ensure that their discussions do not cross the line to soliciting or providing an impermissible recommendation.


The Financial Crisis and the Future of Financial Regulation

This is a transcript of The Economist’s Inaugural City Lecture, which was delivered by Lord Adair Turner in London on January 21, 2009.

It is stating the obvious to say that over the last 18 months, and even more so the last four, the world financial system – and particularly but not exclusively the world banking system – has suffered a crisis as bad as any since the stock market crashes of 1929 and the various banking crises that followed. As a result, banking systems in many countries are suffering from an impaired ability to play their vital role in credit extension to the real economy and a process of deleveraging threatens severe adverse effects on real economic prospects. The crisis therefore presents the financial authorities – central banks, regulators and finance ministries – with two challenges:

• The first and most urgent is to design short-term policies so as to at least limit the adverse impact of deleveraging and deflation on the real economy. We cannot make that impact nil, but we do know how to avoid the policy mistakes which turned the initial problems of 1929-30 into the Great Depression. Fiscal and monetary policies need to be carefully designed, and – as we approach a zero interest rate and consider quantitative easing options – need to be increasingly coordinated. And there are a wide range of policies which can be taken to free up financial markets – measures which Ben Bernanke last week labeled “Credit Easing” – funding guarantees, liquidity provision, tail risk insurance, direct central bank purchases of assets, and regulatory approaches to capital regulation which avoid unnecessary pro cyclicality in capital adequacy requirements. The measures announced by the Chancellor of Exchequer on Monday were designed as an integrated package, which will have a significant impact. And if more measures are acquired they can and will be taken.

• It is not, however, on this challenge of short-term economic management – where the lead must be with the fiscal and monetary authorities – that I’m going to talk tonight. But instead on the second challenge: how to design the future regulation and supervision of financial services so that we significantly reduce the probability and severity of future financial crises? Last September, when I took over as Chairman of the FSA, the Chancellor asked me to conduct a review of our regulation and supervision of the banking system, and I will deliver that Review in March, alongside the publication of a comprehensive FSA Discussion Paper. That paper will set out the changes the FSA has already made, those where we have proposals in principle but need to consult on details, and those where we have defined our objectives but now need to play our role in achieving international agreement.


SOX and Going-Private Decisions

This post is by Ehud Kamar of University of Southern California Gould School of Law.

In my paper Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis, which was co-written with Pinar Karaca-Mandic and Eric Talley and is forthcoming in the Journal of Law, Economics, & Organization, we investigate whether the passage and the implementation of the Sarbanes-Oxley Act of 2002 (SOX) drove firms out of the public capital market.

Many other attempts to address this question have had difficulty controlling for unobserved conflating factors that could have affected exit decisions around the enactment of SOX. We address this difficulty using a difference-in-differences empirical strategy. This approach compares changes over time in two populations: one subject to a policy intervention (treatment group) and the other not (control group). To evaluate the impact of the intervention on outcome, one needs to compare the outcome change for the treatment group with the outcome change for the control group. Assuming the two groups are similar in all relevant respects other than their exposure to the intervention, this approach screens out changes not related to the intervention. The primary outcome variable in our analysis is a public target’s probability of being bought by a private acquirer rather than a public one, the treatment group is American targets, and the control group is foreign targets. To evaluate the effect of SOX, we compare the change in the propensity of American public targets to be bought by private acquirers rather than by public acquirers to the corresponding change for foreign public targets. The difference between the two changes—the difference-in-differences—is the change we attribute to SOX.

When we examine acquisitions as a whole, we find no relative increase in the rate of acquisition by private acquirers (going private) among American firms. When we differentiate between acquisitions based on firm size, however, we find a relative increase in the rate of going private by small American firms. Moreover, when we differentiate between acquisitions based on their proximity to the enactment of SOX, we find a relative increase in the rate of going private by American firms in the first year after the enactment. Finally, when we differentiate between acquisitions based on both firm size and the proximity of the acquisition to the enactment of SOX, we find that the increase in the rate of going private by small American firms is concentrated in the first year after the enactment.

The full paper is available for download here.

The Return of the Shareholder

This post is by Robert A.G. Monks of Lens Governance Advisors.

Less than two decades after Francis Fukuyama famously enshrined market-based liberal democracy as an optimal system at “the end of history,” [1] Barack Obama used his inaugural address to warn the nation that, “without a watchful eye, the market can spin out of control.” The change in tenor from capitalist triumphalism to our current trepidation is indeed remarkable.

In these somber days, with corporate failures still grabbing headlines, the new President has inherited not only a severely weakened economy, but also executive leadership of a government that has already committed hundreds of billions of dollars recapitalizing the financial sector. With so much taxpayer money on the line, additional bailout requests piling up across the corporate landscape, and public anger still cresting, little wonder that the debate is now broadening to what kind of owner government should be. Will the large federal stake in banking, auto, and perhaps other industries prove blessing or burden? Onus or opportunity?

In fact, President Obama has signaled that he doesn’t have much taste for his government’s actively managing corporations. Immediately before his inaugural warning about the failures of unchecked capitalism, the President sounded almost Fukuyama-esque himself in declaring that there remains no question about the market’s unmatched “power to generate wealth and expand freedom.”

How then is the new administration to find a productive — but not meddlesome — federal role that neither relinquishes authority nor shirks its new responsibility as a major stakeholder? Finding such a position relies, I contend, on understanding the crucial role of corporate ownership in America’s economic system: how it should ideally function, how it has actually existed, and what can be done to encourage its more perfect realization.

My article is available here.

[1] Francis Fukuyama, Summer 1989, The National Interest – “The struggle between two opposing systems is no longer a determining tendency of the present-day era. At the modern stage, the ability to build up material wealth at an accelerated rate on the basis of front-ranking science and high-level techniques and technology, and to distribute it fairly, and through joint efforts to restore and protect the resources necessary for mankind’s survival acquires decisive importance.”
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Hedge Fund Activism Extends to SPACs

This post comes to us from Ted Wallace of the Altman Group. It recently appeared in The Corporate Counsel.

A Special Purpose Acquisition Company (SPAC) is a publicly traded shell (or blank check) company formed for the specific purpose of buying an existing company, usually in a particular industry.

At the IPO, investors purchase units of the SPAC, consisting of a combination of shares and warrants, at a relatively low price. The SPAC then generally has 24 months to find a suitable company to purchase through a reverse-merger.

So how would a hedge fund become the target of hedge fund activism? Ask TM Entertainment & Media, Inc. (AMEX: TMI). This SPAC must complete an acquisition before October 17, 2009 or its “corporate existence will cease by operation of law” and its funds and assets will be distributed among its shareholders. This, however, is apparently too long to wait for Phil Goldstein of Bulldog Investors.

On December 17th, Goldstein (d/b/a Opportunity Partners LP) filed preliminary proxy materials to commence a consent solicitation to replace the board of directors with his nominees, who will “promptly dissolve the issuer and cause the cash in the trust account to be distributed to shareholders.”


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