Monthly Archives: March 2009

A Fix for Geithner’s Plan

Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s print edition of the Washington Post. Professor Bebchuk’s September 2008 Harvard Discussion Paper and WSJ op-ed piece in which he put forward the idea of buying troubled assets through private managed and competing funds are available here and here. His February 2009 Harvard Discussion Paper proposing a detailed design for such a program is available here, and his Forum post summarizing the analysis of this paper is available here.

With the world’s attention shifting to London and the upcoming Group of 20 summit, it’s possible that the Treasury’s proposal for dealing with banks’ “troubled assets” will become old news. It shouldn’t. The administration plans to provide as much as $1 trillion to privately managed funds that will buy troubled assets, which is indeed the best way for jump-starting this market. But it is important to add to the program a mechanism that would prevent excessive subsidies to private parties and keep costs to taxpayers at a minimum.

The first government plan to purchase banks’ toxic assets, put forward by then-Treasury Secretary Henry Paulson, was withdrawn after objections that Treasury wouldn’t be able to value the assets. In a white paper issued last September, “A Plan for Addressing the Financial Crisis,” I proposed using privately managed and competing funds as an alternative and argued that such funds would better set prices for these sorts of assets.

The program that Treasury Secretary Timothy Geithner announced last week will lead to the creation of such competing funds. It is structured to produce a market with a significant number of potential sellers facing a significant number of potential buyers.

But while the program is intended to partner public and private capital, the partnership it sets up is quite unequal. As things stand, the private side — the private manager and investors possibly affiliated with it — would capture 50 percent of the upside but would bear a disproportionately small share of the downside, contributing as little as 8 percent of the fund’s capital.

Treasury officials believe that because private parties have not thus far established funds dedicated to buying troubled assets, favorable terms are needed to induce their participation. This logic is reasonable, but it is important to keep the government subsidy at a minimum. Without any market check, the terms set by the government could substantially overshoot what is necessary to induce private participation and end up imposing large and unnecessary costs on taxpayers.

A program of public-private funds should be designed to minimize costs to taxpayers. To attain this objective, the government should base the terms of participation on a process in which private managers compete to be in the program.

If the private side were to contribute only 8 percent of the capital, the government should seek to keep the highest fraction of the upside that would be consistent with inducing such participation. To this end, potential private managers would submit bids indicating the minimum share of the fund’s upside that each manager would be willing to accept for an 8 percent investment, as well as the size of the fund that the manager would establish if accepted into the program. Treasury officials should then set the share of the upside going to the private side in each of the funds under the program at the lowest level consistent with establishing funds that collectively have the aggregate target capital.

Alternatively, assuming that the private side’s share of the upside is fixed at 50 percent, the government should seek to get the largest possible contribution of private capital. Under this scenario, managers would submit bids indicating both the size of the fund each manager would establish and the maximum fraction of the fund’s capital that the manager would commit to raising privately in return for 50 percent of the upside. Based on the bids, the government would set the fraction of capital provided by the private side at the highest level consistent with establishing funds that have the target amount of aggregate capital.

This second scenario would not only keep the government’s subsidy at a minimum but would also induce the largest amount of private capital, thus conserving some of the government gunpowder that the program’s current design would use. Because many banks might well remain undercapitalized even when their assets are valued fairly, restarting the market for troubled assets won’t make these banks healthy; rather, it will make clear the need to recapitalize them and might require the government to inject substantial sums of additional capital.

Establishing privately managed funds that are financed with both private and public capital offers the best approach to restarting the market for troubled assets. Adding a market mechanism for setting the level of government subsidy is necessary to reduce the program’s cost to taxpayers and would leave the government with the most ammunition for the tasks that still lie ahead.

Holding business leaders accountable

This post is based on an op-ed piece by Mr. Heineman that appeared today in the Washington Post online.

The just deposed GM leadership team has been in control for nearly a decade. During this period, market share, profitability and stock price have declined precipitously, while debt has risen dramatically. One of the fundamental issues raised by the economic crisis, primarily in the financial sector but also in failing industries like automobile industry, is: Where was the board of directors to set meaningful performance goals (not simply stock price) and hold business leaders accountable? This question, in turn, has raised even more fundamental issues about whether, despite endless governance writing, conferences and academic centers, corporations are capable of governing themselves when hard decisions need to be made.

One important perspective on the Obama administration’s decision about transforming the GM leadership and Board is a demand for accountability. While the failures of the past decade form the critical backdrop, the administration’s “Determination of Viability Summary” holds GM accountable for the failures of the “Restructuring Plan Report” submitted on February 17, 2009, pursuant to the US-GM loan agreement signed at the end of last year. Simply stated, that government summary finds the GM report unrealistic in assumptions about market share, price, brands, dealers, Europe, product mix and legacy costs—and far too slow in its actions. That Ford’s new management team is not seeking bail-out funds is the strongest argument that the time for accountability has arrived. This is not change for
change’s sake.

Of course, from a different perspective, this is all about negotiations (or, when the government is involved, politics). It is a negotiation with the GM stakeholders (especially the unions, bondholders and dealers) to make faster, bigger voluntary moves in 30 days to avoid the more unpredictable and potentially Draconian rigors of formal bankruptcy (even if on an expedited basis). It is a negotiation with the a broad spectrum in Congress to show reluctance to throw more good money after bad and to base the future on realistic plans, while holding out hope that GM can rise again (and get more durable financial assistance from the taxpayers).

It is, ultimately, a negotiation with the American people to see if combining hard actions now with the prospect of more support under specific conditions later can, in the midst of the economic maelstrom and now too-numerous-to-count government anti-recession programs, create political support down the road for longer-term federal involvement in GM. (On the subject of negotiation: it would be enjoyable to be in Fiat’s position when Chrysler comes to negotiate a joint venture with the alternative that the government will cut off support if no deal is done.)

In his announcement, President Obama gave the expected disclaimers: “The United States government has no interest in running GM. We have no intention of running GM.” His auto and financial analysts have found GM’s restructuring plan wanting. So a new plan will be developed. But they also found GM’s execution too slow. The unanswered question today, with removal GM’s leader, is who will take the GM helm, and join the GM Board, actually to “operate” the new GM for the longer term—and under what kind of “super-board” operational oversight from Uncle in Washington. A new age of GM accountability is dawning, but how will it work is in execution, not just in planning.

Corporate Crime

This post comes from Wallace P. Mullin of George Washington University and Christopher M. Snyder of Dartmouth College.

Our chapter, “Corporate Crime,” (to appear in the handbook Criminal Law and Economics, edited by Nuno Garoupa, Edward Elgar, 2009) provides a new survey of the law and economics literature on corporate crime. We focus primarily on the relevant theoretical research but also touch on empirical research and policy issues.

We set the stage by updating some stylized facts about prosecuted firms. The data come from various tables in the U.S. Sentencing Commission’s Sourcebook of Federal Sentencing Statistics. Our descriptive analysis is similar to earlier studies using this data source, but we update these earlier studies with the most recent data. The most up-to-date of these earlier studies (Cohen 1996) used data for the 1984-90 period, while our analysis covers the period 2002-06. We also focus on facts that relate to the theory which we go on to survey.

We find that around a third of the cases involved fraud, 20 percent involved environmental violations, around 7 percent involved antitrust, and about an equal fraction involved a general “product” category which includes food, drugs, other consumer products, and agriculture. Around a third of the cases (40 percent in 2006) involved managerial tolerance of behavior of lower-level employees. This figure sheds some light on the theoretical and empirical controversy over whether criminal agents are acting in the interest or against the interest of principals higher up in the organization (firm owners or managers). The figure suggests that different models of corporate crime may apply to different cases. While there are some cases in which the criminal employee may have been acting as a maverick against the interests of the firm’s owners and upper-level management, in a substantial minority of cases the other cases the criminal agent may have been benefitted his principals (at least in the absence of sanctions).

We then proceed to a survey of the theoretical literature, organizing the discussion within a unified framework provided by the principal-agent model. Our model follows closely on Garoupa (2000), since his comprehensive analysis nests much of the previous work.


Sponsor-backed Going Private Transactions

This post is by Ira M. Millstein of Weil, Gotshal & Manges LLP.

The Private Equity Group at my firm has recently issued its third annual survey of sponsor-backed going private transactions. The survey analyzes and summarizes the material transaction terms of going private transactions involving a private equity sponsor in the United States, Europe and Asia-Pacific.

We surveyed 39 sponsor-backed public-to-private transactions announced from January 1, 2008 through December 31, 2008 with a transaction value (i.e., enterprise value) of at least $100 million (excluding target companies that were real estate investment trusts). Fifteen of this year’s surveyed transactions involved a target company in the United States, 13 involved a target company in Europe and 11 involved a target company in Asia-Pacific.

The survey’s key conclusions for the United States transactions include the following:

• 2008 witnessed a 97% collapse in aggregate transaction value for sponsor-backed going private transactions when compared to 2007. The largest transaction announced in 2008 had a transaction value of approximately $2.1 billion, a 95% decline from the largest transaction announced in 2007. There was also a 76% decline in transaction volume when compared to 2007.

• The percentage of club deals involving two or more private equity sponsors declined significantly in all transaction sizes in 2008. Only 7% of the 2008 transactions constituted a club deal whereas 37% of the 2007 transactions did so.

• The tender offer again made an appearance in 2008, continuing a trend that started in 2006. The same cannot be said for stub equity. There was no transaction in 2008 in which the sponsor offered stub equity to the target’s public shareholders.

• Not surprisingly, the credit crisis continued to adversely impact the debt-to-equity ratios of sponsor-backed going private transactions. Equity accounted for an average of 64% of acquiror capitalization for transactions between $100 million and $1 billion in value and 51% of acquiror capitalization for transactions greater than $1 billion in value.

• The credit crisis has forced sponsors to tap alternative financing sources, including traditional mezzanine lenders and hedge funds.

• The go-shop provision continued to be a common feature of going private transactions in 2008 with 53% of surveyed transactions including this form of post-signing market check. Interestingly, sponsors were more resistant this year to giving a significantly reduced go-shop break-up fee (only one transaction had a go-shop break-up fee of less than 50% of the normal break-up fee).

• Although far from the norm, there was an increase in 2008 in sponsor-backed going private transactions with a financing out (20% in 2008 compared to 3% in 2007).

• When compared to pre-credit crunch transactions, the 2008 transactions reveal a material decrease in the number of MAE exceptions.

• Reverse break-up fees were again the norm in 2008, appearing in 87% of all surveyed transactions (a slight increase from 84% in 2007). In an effort to limit the optionality built-in to the reverse break-up fee structure and incentivize sponsors to consummate the transaction, target boards in a significant minority of surveyed transactions negotiated for a higher second-tier reverse break-up fee or a higher cap on monetary damages.

• Interestingly, specific performance provisions enforceable against the buyer were very rare in 2008. Only 7% of the 2008 transactions permitted the seller to seek specific performance against the buyer rather than be limited to a reverse break-up fee or monetary damages (whereas 33% of the surveyed transactions in 2007 allowed the seller to seek specific performance).

The survey is available here.

UK Rules for Disclosure of Derivatives

Forthrightly addressing the continued proliferation of swaps, options and other equity derivatives, the UK’s Financial Services Authority (“FSA”) has now adopted final rules requiring the disclosure under the UK’s Disclosure and Transparency Rules of swaps, options and other derivative contracts, including those providing for cash settlement. See Policy Statement 09/3. The new rules require disclosure of aggregate equity positions (including derivatives) beginning at the 3% level (with an exemption for the writers of equity derivatives acting as intermediaries).

The FSA noted two important changes from its prior thinking in adopting the final rules.

First, while the FSA’s prior intention was to make the new rules effective in September 2009, it determined, “in light of the changes in market conditions since last summer and the need for increased transparency driven by these changes,” to accelerate the effectiveness of the new rules to June 1, 2009.

Second, the FSA decided that disclosures should be made on a delta-adjusted (rather than nominal) basis, which the FSA believes is a more accurate reflection of the actual extent of economic interest held at any one time. As a transition matter, the FSA will allow reporting on either a nominal or a delta-adjusted basis for a period of seven months following effectiveness of the new rules, provided that firms choosing to report on a nominal basis during the transition period will be required to provide sufficient information – including the strike or exercise price of each financial instrument reported and the total number of voting rights relating to shares referenced by each financial instrument reported – to allow market participants to calculate the underlying adjusted economic interest.

The FSA’s decisive action to require disclosure of accumulations of significant stakes in publicly traded companies through derivative instruments – and its corresponding approach toward disclosure of short positions (see Discussion Paper 09/1) – only further highlights the inadequacy of the current U.S. disclosure and regulatory regime. While there has been piecemeal reform and adjustment in the U.S. – through judicial decisions such as that in CSX, through private and contractual ordering in by-laws, rights plans and other contracts, and through a variety of other mechanisms – the need for comprehensive reform and market transparency has not been met. There continues to be an overwhelming global consensus towards full and fair disclosure of equity derivatives and other synthetic and non-standard ownership and control techniques. We remain strongly of the view that U.S. regulation should be comprehensively reformed to address derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise.

Superstar CEOs

Editor’s Note: This post comes from Ulrike Malmendier of the University of California, Berkeley and Geoffrey A. Tate of the University of California, Los Angeles.

Compensation, status, and press coverage of managers in the U.S. follow a highly skewed distribution: a small number of ‘superstars’ enjoy the bulk of the rewards. However, the “tournament” for CEO status and public attention is not designed by shareholders as an incentive device, but is largely conducted by the media. As a result, the value consequences of superstar status are unclear. While increased media exposure may boost profitability, it could also shift power towards the CEO and induce perquisite consumption. In our paper, Superstar CEOs, which was recently accepted for publication in the Quarterly Journal of Economics, we analyze the ex-post value consequences of the managerial superstar system.

We use several empirical methods to identify a credible counterfactual for the winning CEOs. As our main identification strategy, we construct a nearest neighbor matching estimator. We estimate a logit regression to identify observable firm and CEO characteristics that predict CEO awards. We then match each award winner to the non-winning CEO who, at the time of the award, had the closest predicted probability of winning. Lastly, we verify that award winners and the control sample are indistinguishable along most observable dimensions, including firm and CEO characteristics not explicitly included in the match procedure. We exploit shifts in CEO status due to CEO awards conferred by major national media organizations. We link award-induced changes in status to corporate performance and CEO decision-making, using matched non-winning CEOs as a benchmark.

We find that firms with award-winning CEOs subsequently underperform, both in terms of stock and operating performance. At the same time, CEO compensation increases, CEOs spend more time on activities outside the company like writing books and sitting on outside boards, and they are more likely to engage in earnings management. The ex-post effects are strongest in firms with poor corporate governance, compared to a matched sample of non-winners with no ex ante differences in governance. Our findings suggest that the superstar system has negative ex-post value consequences for shareholders. The net effect of the superstar system, after accounting for ex-ante incentives created by the tournament for status, is hard to assess. However, the ex post value destruction we measure is large and it appears to be avoidable. Firms with strong shareholder rights do not experience a decline in performance when their CEOs win awards, suggesting that it is optimal to increase monitoring after CEOs win awards.

The full paper is available for download here.

Supreme Court rejects post-merger stockholder claims

This post is based on a client memo by Theodore N. Mirvis, Paul K. Rowe and David A. Katz of Wachtell, Lipton, Rosen & Katz.

UPDATE: We recently received a memorandum from Sullivan & Cromwell LLP that provides a detailed discussion of the implications of the decision in Lyondell Chemical Co. v. Ryan. The memo is available here.

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 an important decision, the Delaware Supreme Court has firmly rejected post-merger stockholder claims that directors failed to act in good faith in selling the company, even if it were assumed that they did nothing to prepare for an impending offer and did not even consider conducting a market check before entering into a merger agreement (at a substantial premium to market) containing a no-shop provision and a 3.2% break-up fee. Lyondell Chemical Corp. v. Ryan, C.A. 3176 (Del. Mar. 25, 2009). The en banc decision, authored by Justice Berger, is a sweeping rejection of attempts to impose personal liability on directors for their actions in responding to acquisition proposals, and reaffirms the board’s wide discretion in managing a sale process.

The Court of Chancery had refused to grant summary judgment on claims that the directors of Lyondell had breached their duty of loyalty by failing to act in good faith in conducting the sale process. Lyondell’s certificate of incorporation included an exculpatory provision, as permitted by Section 102(b)(7) of the Delaware General Corporation Law, that shielded the directors from personal monetary liability for any alleged duty of care violations but not for duty of loyalty violations. The Court of Chancery found the board to be independent and disinterested, but held that the directors’ “unexplained inaction” when it appeared that the company would be put “in play” by a Schedule 13D filing created an inference that the directors may have consciously disregarded their fiduciary duties and failed to act in good faith in violation of the duty of loyalty.

In considering the claim under the Revlon standard requiring that the board seek to get the best price available in selling the company, the Supreme Court found that the lower court had misapplied the law in three respects: first, it imposed Revlon duties before the board had decided to sell the company or a sale had become inevitable; second, it misread Revlon as creating a set of specific requirements to be satisfied during the sale process; and third, it treated an arguably imperfect effort to sell the company as equivalent to “a knowing disregard of one’s duties that constitutes bad faith.”

The Supreme Court rejected the view that Revlon duties arise simply because a company is “in play,” holding: “The duty to seek the best available price applies only when a company embarks on a transaction – on its own initiative or in response to an unsolicited offer – that will result in a change in control.” The Court found that the board had appropriately exercised its business judgment by taking a “wait and see” approach in response to a Schedule 13D filing indicating that a party was interested in acquiring the company. The Court ruled that Revlon duties only arose when the directors chose to begin negotiating the sale of the company. The decision thus again makes clear that a board has no duties under Revlon to seek the “best price” in a sale or other transaction simply because a stockholder or other potential bidder tries to put the company “in play.”


Efficient and Effective Enforcement by the SEC

Editor’s Note: The post below by Commissioner Troy Paredes is a transcript of remarks by him at the 2009 Southeastern Securities Conference on March 19, 2009 in Atlanta, Georgia.

It is an honor to be speaking here today at the 2009 Southeastern Securities Conference. Before I begin, I must say the standard disclaimer: The views that I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or of my fellow Commissioners.

Many in the audience are SEC enforcement lawyers and examiners. So let me emphasize at the start the tremendous respect and appreciation I have for you and your hard work. Your dedication and professionalism are inspiring models of committed public service.

* * *

Some outside the agency may not realize the Herculean task that the Division of Enforcement admirably shoulders. Let me offer some context.

Over 12,000 companies have securities registered with the Commission under Section 12 of the Exchange Act. Publicly-traded securities trade on eleven exchanges in the United States, as well as in the over-the-counter market. In addition, there is a huge private placement market. Although private offerings are not registered with the Commission under the Securities Act, they are nonetheless subject to our antifraud authority.

Individual investors often do not hold securities directly, but frequently prefer to invest through mutual funds. The mutual fund industry is large and critically important, particularly as a means of diversification for retail investors — itself a form of investor protection. This translates into additional responsibilities for the Commission, as investors can now choose from among 4,600 registered funds that the SEC oversees. The Enforcement Division’s responsibilities don’t stop there. Rather, there are over 11,000 investment advisers, along with approximately 5,500 broker-dealers. Even this understates the reach of the SEC’s jurisdiction. For example, according to a recent count, the 5,500 broker-dealers have a total of over 170,000 branch offices and 665,000 registered representatives.

In short, the Division of Enforcement’s jurisdiction is incredibly large, diverse, and complex. There is often an international component to securities enforcement, bringing still additional challenges for the staff. It is a vast amount of turf to cover for a Division that houses 1,100 employees.

Just keeping on top of tips and referrals can be daunting. The Commission receives an estimated 700,000 or more leads each year. Notably, the Commission recently announced that it is undertaking efforts to ensure that we have the right systems, processes, and expertise for responding to whistleblowers and tips and referrals from numerous other sources.[1] This kind of scrutiny and adaptation is important if the SEC is to have the state-of-the-art capabilities we need to fulfill our mission.

* * *

While our markets are enormous and the public’s expectations of the Commission are high, the SEC’s resources are limited. We have to ask a very basic question: How does the SEC efficiently and effectively advance our mission given our resource constraints?

When deciding how best to allocate the agency’s efforts, the Commission has to make difficult choices. Enforcement is no exception. As much as we would like to, we simply cannot pursue to the fullest extent each and every possible violation of the securities laws. Even with more money and more staff, we will have to make strategic tradeoffs — rooted in informed policy choices that the Commission makes — in light of the relevant costs and benefits that attend the options in front of us.[2]


Lyondell Chemical Co. v. Ryan

Editor’s Note: 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.

Last night, the Supreme Court of Delaware handed down its much anticipated decision in Lyondell Chemical Company v. Ryan, a case concerning whether the independent directors of a target company’s board were entitled to summary judgment on claims that they failed to act in good faith in conducting the sale of their company. In its decision, available here, the Court of Chancery had denied summary judgmnent in order to obtain a more complete record before determining whether the directors had acted in bad faith. The Supreme Court reversed that decision and remanded the matter for entry of judgment in favor of the Lyondell directors. In doing so, the Supreme Court emphasized the disinterested and independent nature of the directors, their awareness of the company’s value and prospects, and their consideration of the offer with assistance of financial and legal advisers. At most, the Court explained, “[the] record creates a triable issue of fact on the question of whether the directors exercised due care.” But there was no evidence, the Court said, “from which to infer that the directors knowingly ignored their responsibilities, thereby breaching their fiduciary duty of loyalty.”

The case is available here.

Public-Private Investment Funds

This post is by Kelley D. Parker, Terry E. Schimek, Stephen W. Stites, Robert M. Hirsh, Marco V. Masotti, and Jennifer A. Spiegel of Paul, Weiss, Rifkind, Wharton & Garrison LLP.

UPDATE: We have received another memo, by Davis Polk & Wardwell, on the public-private investment program. Available here, the memo describes the framework of the public-private funds and analyzes key concerns and unresolved questions about the program from the perspectives of troubled asset sellers, fund and asset managers and private investors.

On 23 March the Treasury released highly anticipated details regarding the Public-Private Investment Fund (“PPIF”) portion of the Financial Stability Plan. The PPIF plan is intended to address the “legacy” assets at the center of the global financial crisis. These assets include both residential and commercial real estate loans held directly on the balance sheets of banks (“legacy loans”) and securities backed by real estate loan portfolios held by financial institutions (“legacy securities”). The announcement covered the creation of both a Legacy Loans Program and a Legacy Securities Program, the latter of which includes an expansion of the Term Asset-Backed Securities Loan Facility (“TALF”) program to include both residential and commercial backed mortgage securities.

We summarize below the various programs announced today and then discuss several open issues to consider in connection with the programs. We note that the details of these programs are still preliminary and the specific requirements and structure of the programs will be subject to further clarifications from the government, including a specific notice and comment rulemaking process for the Legacy Loans Program.

Legacy Loans Program:

FDIC to Oversee Formation of Multiple Funds. Under this program the Federal Deposit Insurance Corporation (“FDIC”) will oversee the formation and operation of multiple PPIFs to purchase legacy loans from insured banks and thrifts.

Auction Process to be Utilized. Private investors will bid for the opportunity to invest through an auction program run by the FDIC. Once asset pools are identified by eligible banks and their regulators, the FDIC will conduct diligence, prepare marketing materials and engage a third party firm to advise on appropriate leverage for the PPIF (not to exceed 6:1 debt to equity ratio) and to represent the government in structuring the auction.


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