Monthly Archives: March 2009

Second Generation Advance Notification Bylaws

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, March 17, 2009
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This post comes from Marc Weingarten and Erin Magnor of Schulte Roth & Zabel LLP.

Many companies have enacted special bylaw provisions regulating the ability of shareholders to nominate directors or place items on the agenda for consideration at a company’s annual or special meeting or by consent, typically referred to as advance notification bylaws (“ANBs”). Historically, most ANBs have been straightforward, and typically advanced the date by which a shareholder was obligated to notify the company to 60 or 90 days prior to the expected meeting date. These ANBs, or First Generation ANBs, also typically required the proponent shareholder to include in the notification the same basic information about the shareholder, and if applicable the nominees, as required by the proxy rules.

More recently, however, many companies, at the urging of counsel “defending” against activist investors, have adopted new forms of ANBs, or Second Generation ANBs, that demand far more extensive disclosure from, and in some cases purport to establish eligibility qualifications for, proponent shareholders. This article describes these new provisions, which include not only longer advance notice requirements, but also requirements for the completion of company-drafted director nominee questionnaires, submission of broad undertakings by nominees to comply with company “policies,” minimum size and/or duration of holding requirements, continuous disclosure of derivative positions, disclosure of otherwise confidential compensation information, and even information regarding shareholders with whom the proponent has merely had conversations regarding the company.

First Generation ANBs were upheld by the courts because they simply provided an orderly procedure for shareholder action that helped to give the company and the other shareholders adequate time to evaluate proposals. This article analyzes the new Second Generation ANB provisions, many of which we believe are designed not to elicit the relevant information a company reasonably needs to know months in advance of a proxy contest to ensure an orderly process, but rather to erect barriers in the path of shareholders seeking to exercise their rights in an attempt to disqualify them. We believe such provisions should, and will, be declared invalid when their legitimacy is challenged. Unfortunately, shareholders will be forced to bear the expense of challenging the validity of these provisions—which no doubt was part of the calculus when companies adopted them in the first place.

Advance Notice Periods
In a 2005 article addressing First Generation ANBs, [1] we noted that courts had determined that 90-day advance-notice requirements had become commonplace. [2] Since then, some companies have adopted ANBs requiring notice of 150, or even 180, days prior to the annual meeting (in some cases keyed off the mailing date of the prior year’s proxy statement).

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Option Backdating and Board Interlocks

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, March 16, 2009
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This post comes from John Bizjak of Portland State University, Michael Lemmon of the University of Utah and Hong Kong University of Science and Technology, and Ryan Whitby of Texas Tech University.

In our forthcoming Review of Financial Studies paper Option Backdating and Board Interlocks, we examine the role of board connections in explaining how the controversial practice of backdating employee stock options spread to a large number of firms across a wide range of industries. Given that the practice was not publicly disclosed, it is unlikely that it originated independently in each firm. We focus on the role that director interlocks played in contributing to the spread of backdating since the board of directors has primary authority over the level and structure of executive compensation, including determination of the amount and timing of option grants.

We find strong evidence that board interlocks are related to the spread of backdating. We find that a firm is more likely to begin backdating option grants if the firm has a director who is a board member of another firm that previously backdated its stock options. Our results are both statistically and economically significant. The increase in the likelihood that a firm begins to backdate stock options that can be explained by having a board member who is interlocked to a previously identified backdating firm is approximately one-third of the unconditional probability of backdating in our sample. We also find that a firm is more likely to begin to backdate option awards if directors concurrently receive a stock option grant.

In addition, we identify several other firm and governance characteristics that are associated with the adoption of option backdating. Firms with higher stock-price volatility are more likely to start to backdate options, which is consistent with the fact that higher stock-price variation provides more opportunities to backdate options. A firm is also more likely to begin to backdate, the greater the stock and option holdings of the CEO and when the CEO is younger. Finally, we find that commonalities in firms’ auditors and geographic location also help to explain the initiation of backdating. The fact that commonality in auditor choice and geographic location is associated with the initiation of backdating suggests that other linkages between firms beyond those created through board interlocks may also play a role in facilitating the spread of this practice. In contrast to some earlier research, we find little evidence that other measures of the quality of corporate governance, such as institutional ownership, board size, board independence, and whether the CEO is also the chair of the board, are systematically related to the incidence of backdating.

The full paper is available for download here.

Problems Hidden Under The TARP

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, March 15, 2009
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Editor’s Note: This post is by J.W. Verret of the George Mason University School of Law.

In my briefing memo, The U.S. Government as Control Shareholder of the Financial and Automotive Sector: Implications and Analysis, I offer an analysis of the implications of the U.S. Treasury holding equity control over private industry. This was also the subject for recent briefings to members and staff of the U.S. Congress and the Securities and Exchange Commission, organized through my work at the Mercatus Center Financial Markets Working Group, and a forthcoming op-ed in Forbes, Why the Bailout is Self-Defeating, which is available here. My work in this area is ongoing, with a fuller article expected this submission season, and I welcome any comments.

The Treasury Department has converted its preferred shares in Citigroup into common equity, giving it a position of up to 36% of Citi’s outstanding voting equity. This means that as defined under Delaware corporate law, the securities laws, and even the CFIUS process for reviewing foreign investments in U.S. Companies, the U.S. Treasury is a control shareholder in Citigroup. Further, the remaining unconverted preferred shares in other banks, issued to the Treasury by TARP participants, give the government substantial leverage over corporate policy decisions at those banks.

The reason for the conversion is that it will artificially increase the bank’s common equity, which will give it a good tangible common equity number when the Treasury begins its promised stress testing regime for unhealthy banks. This is however an entirely artificial construct. Tangible common equity serves as a good proxy for a banks health when it reflects the market’s interest in becoming the residual beneficiary of fees from the bank’s loan portfolio, but here it merely reflects the federal government’s willingness to bail out a bank without concern for future price appreciation in its shares. If Treasury’s bank stress tests are a final exam, the teacher has given a favorite student the answers in advance.

The consequences of a government agency holding voting equity in a private bank can also be costly. Comparisons to the different forms of government ownership in Europe, Asia and South America teach that government owned banks are unequivocally used to advance political agendas to the detriment of a bank’s financial health. Advancing a political agenda may actually be easier through controlling common equity stakes, an effective semi-nationalization, than outright nationalization. A government agency using shareholder power over private companies has two unique freedoms:

i) the ability to bypass the administrative law process, the separation of powers and judicial review that constrain regulatory discretion, and instead simply require the board to initiate corporate policy changes favored by the Treasury, and

ii) the ability to bypass the federal budget process and transparency to the voters that work to constrain transfers to political interest groups, and instead require the bank to make those transfers in the form of increased lending and artificial interest rate caps entirely off the federal budget.

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The Future of Claims Against Mutual Funds

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, March 14, 2009
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This post comes to us from David M. Geffen of Dechert LLP.

My recent article, “A Shaky Future for Securities Act Claims Against Mutual Funds“, considers the liability of mutual fund issuers under §§ 11(a) and 12(a)(2) the Securities Act.

In a Securities Act § 11(a) or § 12(a)(2) action, a plaintiff complains of a materially misleading statement (misstatement) in an issuer’s registration statement (prospectus). In the article, I explain why a mutual fund issuer, by establishing a loss causation defense, should prevail in defending these actions. For a mutual fund, establishing a loss causation defense is straightforward, and a mutual fund can defeat § 11(a) and § 12(a)(2) claims at the pleading stage of a lawsuit.

Courts have described an issuer’s liability under § 11(a) and § 12(a)(2) as “strict” or “near-strict.” Therefore, the regular and successful deployment of loss causation defenses by mutual funds marks a significant change. In effect, mutual funds are largely and, perhaps, wholly insulated from Securities Act § 11(a) and § 12(a)(2) claims.

In Parts I and II of the article, I describe the elements of claims under § 11(a) and § 12(a)(2) in the context of mutual funds, including the price-depreciation measure of damages in both statutes.

The article’s core analysis is contained within its Part III, where I explain why, for a mutual fund, establishing a loss causation defense is straightforward. Unlike a security traded on an exchange, the price of a mutual fund share is calculated each day according to a statutory formula that relies on the market value of the portfolio securities owned by the fund. Shares are offered for sale by the fund continuously at each day’s calculated price and redeemed by the fund, when a fund shareholder chooses, at that day’s calculated price. There is no secondary market for a mutual fund’s shares.

Accordingly, there is no mechanism for a misstatement in a mutual fund’s prospectus to affect a fund share’s price and, therefore, there is no mechanism for a misstatement or its revelation to cause a plaintiff’s losses. Because changes in a fund share’s price cannot be caused by a prospectus misstatement, a mutual fund defendant can prevail by establishing the loss causation defense permitted by § 11(e) or § 12(b). The defense simply is that any misstatement identified by the plaintiff could not cause the fund share’s price to depreciate and, therefore, did not cause the plaintiff’s losses.

If that outcome seems harsh, consider that the justification for liability without reliance under § 11(a) and § 12(a)(2) is that a misstatement causes the market to overestimate the value of a security. A purchaser is harmed by the misstatement, even if he did not rely on it, because the market price is inflated by the misstatement. However, Congress did not consider how § 11(a) and § 12(a)(2) should apply to mutual funds. This includes considering that neither price inflation nor overpayment occurs when an investor purchases shares of a mutual fund while the fund’s prospectus contains a misstatement. Thus, price inflation and overpayment, which justify liability without reliance for non-fund issuers, do not justify similar liability for mutual funds.

Part IV presents the practical implications if plaintiffs cannot succeed against a mutual fund under § 11(a) and § 12(a)(2). A plaintiff’s inability to make out a claim under § 11(a) and § 12(a)(2) should deter plaintiffs from instigating lawsuits under the Securities Act against mutual funds based on prospectus misstatements. Plaintiffs may be relegated to claims under Rule 10b-5, the Investment Company Act and state law.

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Activist Arbitrage

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, March 13, 2009
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This post comes to us from Itay Goldstein of the Wharton School at the University of Pennsylvania.

In Activist Arbitrage: A Study of Open-Ending Attempts of Closed-End Funds, which was co-written with Michael Bradley, Alon Brav, and Wei Jiang, and which was recently accepted for publication in the Journal of Financial Economics, we conduct a comprehensive empirical study of the attempts of activist arbitrageurs to open-end closed-end funds in the U.S. Unlike the traditional pure-trading arbitrage, activist arbitrageurs do not simply wait for convergence, but rather take actions to open-end the target fund, knowing that upon open-ending the price of the fund’s shares will be forced to converge to the NAV.

Our analysis is based on a unique hand-collected dataset consisting of all activist arbitrageurs’ activities in U.S. based CEFs between 1988 and 2003. Activist arbitrage in closed end funds was quite rare until the early 1990s. However since the mid-1990s—shortly after the SEC significantly relaxed constraints on communication among shareholders of public corporations—this type of arbitrage has become very common. Several arbitrageurs—hedge funds, endowment funds, banks, and financial arms of corporations—have become quite active in initiating proxy contests and proposals targeted at open-ending discounted CEFs. In the peak years of 1999 and 2002, about 30% of the funds in our sample were targets of such attacks.

We find that activist arbitrage has substantial impact on CEF discounts. While most of the open-ending attempts in our sample were met with resistance from the funds’ managements, quite a few led to successful open-endings despite such resistance. In addition, activists’ activities were sufficiently credible in many instances to induce fund managers to take actions themselves to reduce the size of the discount. We find that a key variable that guides activist arbitrageurs in choosing which fund to target is the fund’s discount from its NAV. Using an instrumental-variables approach and an econometric technique that allows us to estimate a simultaneous system of an endogenous dummy variable and an endogenous continuous variable, we are able to show that a one percentage point increase in the discount leads to a 1.07 percentage point increase in the probability of an open ending attempt in a given year.

To investigate the role of communication, we conduct tests using cross-sectional measures of the costs of communication in different funds. The three proxies we employ are turnover, which measures the frequency at which the shares of the CEF change hands, the average size of trade in the fund’s shares, and the percentage of institutional ownership in the fund. Overall, we find that costs of communication enhance activist arbitrage. Interestingly, the effects of the above proxies are present only after the legal reform of 1992. Our results suggest that before the 1992 Reform, communication among shareholders was so severely restricted by the SEC that cross-sectional differences in the shareholder base did not matter much for activist arbitrageurs.

Lastly, we find the governance of funds also plays an important role in determining the probability of an open-ending attempt. Funds that have pro-manager governance structures (i.e., have staggered board, supermajority voting, and ability of the board to call a special meeting) are more likely to be targets for activism after the legal reform of 1992, but not before. This is likely because communication among shareholders is particularly important when managers have more power. While managerial entrenchment attracts more attacks after 1992, we find that it lengthens the time needed to implement a successful open-ending.

The full paper is available for download here.

Key changes to TALF program

Posted by Philip A. Gelston, Cravath, Swaine & Moore LLP, on
Thursday, March 12, 2009
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This post from Philip A. Gelston is based on a client memo by my colleagues B. Robbins Kiessling, Timothy G. Massad, William V. Fogg, Julie Spellman Sweet, Sarkis Jebejian, Joel F. Herold, and Erik R. Tavzel.

For earlier posts on this Forum on the Federal Reserve’s proposed Term Asset-Backed Securities Loan Facility (TALF), including an early reform proposal by Lucian Bebchuk, please see here and here.

On March 3, 2009, the U.S. Treasury Department and the Federal Reserve announced the formal launch of the Term Asset-Backed Securities Loan Facility (TALF). The TALF provides government financing to private investors for the purchase of certain AAA-rated asset-backed securities (ABS), with the objective of making credit more readily available to consumers and small businesses. The TALF program may be attractive to a broad range of investors because it provides non-recourse financing with favorable interest rates and limited downside risk.

The Federal Reserve first announced the creation of the TALF on November 25, 2008. In connection with the formal launch of the TALF, the Treasury Department and the Federal Reserve have issued updated terms and conditions and frequently asked questions (FAQs) which modify certain of the previously announced rules.

This memo provides a brief overview of the TALF and the key changes announced on March 3 and provides a road map for investors considering participating in the TALF. Appendix A provides an indicative timeline for the April TALF funding.

TALF OVERVIEW
The Federal Reserve has authorized the Federal Reserve Bank of New York (FRBNY) to lend up to $200 billion (subject to an increase to up to $1 trillion as part of the Obama administration’s Financial Stability Plan announced on February 10, 2009) to eligible borrowers (described below) to finance investments in eligible ABS, which currently are certain AAA-rated securities backed by new and recently originated auto loans, student loans, credit card loans or small business loans fully guaranteed by the Small Business Administration (SBA). Under the TALF, the FRBNY will offer to eligible borrowers on a monthly basis three-year, non-recourse loans in an amount equal to the value of the eligible ABS purchased or owned by the borrower, less a collateral haircut of between 5-16% of their value depending on their type and expected life. The TALF loans must be fully secured by the ABS financed by the loan.

The interest rate on TALF loans will equal the three-year LIBOR swap rate plus 100 basis points for fixed-rate ABS and one-month LIBOR plus 100 basis points for floating-rate ABS (in each case, other than loans secured by ABS backed by student loans guaranteed by the Federal government and ABS backed by small business loans guaranteed by the SBA, which will have lower interest rates). Borrowers may request TALF loans in minimum amounts of $10 million and may pledge any combination of eligible ABS as collateral for a single TALF loan (as long as all the pledged ABS for a single loan are either fixed rate or floating rate securities). In addition, borrowers must pay to the FRBNY an administrative fee equal to 5 basis points of the loan amount.

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Investor Protection and Interest Group Politics

Posted by Lucian Bebchuk, Harvard Law School, on
Wednesday, March 11, 2009
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This post is by Lucian Bebchuk of Harvard Law School.

The Review of Financial Studies will publish later this year my paper with Zvika Neeman on “Investor Protection and Interest Group Politics.”

The paper models how lobbying by interest groups affects the level of investor protection. In our model, three groups – insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future – compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors pushing investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, and the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future, we show, reduces but does not eliminate the distortions arising from insiders’ interest in extracting rents from the capital that public firms already possess. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.

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Here is a more detailed outline of the article’s analysis, results, and contributions: The paper seeks to contribute to understanding what determines the level of that protection and the reason such protection might fall short of being optimal. Why do countries vary so much in their level of investor protection? Why do levels of investor protection within any given country change over time? When investor protection is too low, is such suboptimality generally due to lack of knowledge on the part of public officials, which should be expected to disappear as they learn more about which governance arrangements are optimal? Or are there some structural political impediments that may enable excessively lax corporate rules to persist even after they are recognized as inefficient? The paper aims to contribute to answering these questions by developing a model of how interest group politics affects the level of investor protection.

To be sure, a country’s level of investor protection may be influenced by long-standing factors such as the country’s legal origin, its culture and ideology, or the religion of its population, all of which lie outside the realm of current interest group politics. But given that countries do change their investor protection arrangements considerably over time, the level of such protection at any given point in time may also result at least partly from recent decisions by pubic officials. The theory of regulatory capture (Stigler (1971) suggests that the regulatory decisions by public officials might be influenced and distorted by the influence activities of rent-seeking interest groups. In the area of finance, Rajan and Zingales (2003, 2004) and Perotti and Volpin (2008) argue that existing firms seeking to deter entry and retain market power lobby for weak investor protection that would make it difficult for potential entrants to raise capital. Our analysis focuses on another conflict among interest groups – the struggle between public firms’ corporate insiders, who seek to extract rent from the capital under their control, and the outside investors who provided them with capital.

We view lobbying on investor protection as important because, in the ordinary course of events, most corporate issues are intensely followed by the interest group with sufficient stake and expertise but are not sufficiently understood and salient to most citizens. When this is the case, politicians can expect their investor protection decisions to have limited direct effects on voting behavior, which implies that these effects do not significantly influence politicians’ investor protection decisions. In contrast, such decisions may be significantly affected by the activities of organized interest groups.

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Removing the Overhang Plaguing Bank Equity Valuations

Posted by Edward D. Herlihy, Wachtell, Lipton, Rosen & Katz, on
Tuesday, March 10, 2009
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This post is based on a client memorandum by Edward D. Herlihy, Craig M. Wasserman, Lawrence S. Makow, Richard K. Kim, Jeannemarie O’Brien, Nicholas G. Demmo, and Matthew M. Guest of Wachtell, Lipton, Rosen & Katz.

We are at a critical point in working our way through the current financial crisis. The situation initially manifested as a crisis of confidence among depositors, financial institution counterparties and market participants that led to sudden and catastrophic collapses of leading financial institutions. Now the crisis appears to have evolved beyond that stage, with declining housing prices and low consumer confidence slowing the economy and the initial panic being replaced with lingering investor uncertainty about the business model of financial institutions, the direction governmental intervention might take and the risk that the changing rules of the game – on compensation, cramdown or otherwise – will continue to whipsaw investors. Much of this crisis is fed by a 24/7 media cycle that, without actual collapses or bank runs to report, repeats speculation about financial institution balance sheet and capital (further fueling concern about the direction of government policy and actions including the spectre of actual, if not de facto, “nationalization”) and inciting resentment over executive compensation, among other things.

Much of the future direction beyond this critical juncture will depend on the choices made by the new administration and in Congress. Will a clear focus be maintained on prompt, decisive steps necessary to restore confidence to the financial system, and will we let bank regulators and bank management go back to doing their jobs and join together in working our way out of the current situation? Or will the focus remain blurred by measures that (though sometimes well-intentioned) have served to discourage the capital buildup necessary to facilitate repayment of TARP funds, outright political intervention, and unwarranted punitive rhetoric that destroys the public confidence so critical to a recovery?

Getting the recovery on track is likely to involve respect for the following tenets:

• The banking system that has served our nation so well, while currently challenged, is not fundamentally broken and need not be destroyed.

• The long-term health of the economy depends on a robust, trusted banking system.

• Restoring private capital investment in financial institutions must have the highest and clearest priority, and doing so requires not only government action where necessary, but also appropriate restraint, including a renewed commitment to a stable legal framework and ceasing retroactive, game-changing interventions that cause private capital to flee.

• We already have a strong and robust system of financial regulation in place that, while it can be improved, should be allowed to function with a minimum of political interference to do the day-to-day blocking and tackling necessary to restore public confidence in the banking system. For instance, concerns regarding executive compensation could be simply and readily addressed by the existing federal regulatory framework for monitoring compensation at institutions deemed to be in troubled condition. Moreover, recognizing that all bank mergers are already subject by law to a rigorous regulatory review eliminates the need to add layers of additional rules that indiscriminately prohibit potentially useful transactions.

• Bank mergers, key employee compensation and other strategic business decisions are important tools that, when properly used, are essential for bank managers to build the strength of their institutions; these important tools should not be lightly interfered with and will continue to be used by banks, as they have been in the past, only under the watchful eyes of the banking regulators.

First: Job No. 1 is restoring private capital investment in financial institutions. Regulators already have a clear window into banking institutions and they should consider clearly communicating the financial condition of the nation’s banks in advance, and in lieu, of a vaguely defined future “stress test.” Relentless speculation about banks amid plunging common stock prices and indiscriminate talk that “the banking industry is effectively insolvent” has created a mistaken impression of hairtrigger fragility among the nation’s banks. Regulators should play a leading role in promptly fixing this misimpression.

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Impact of Global Settlement on Analyst Recommendations

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, March 9, 2009
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This post comes from Ohad Kadan of Washington University in St. Louis, Leonardo Madureira of Case Western Reserve University, Rong Wang of Singapore Management University; and Tzachi Zach of Ohio State University.

In our paper Conflicts of Interest and Stock Recommendations: The Effects of the Global Settlement and Related Regulations, which was recently accepted for publication in the Review of Financial Studies, we investigate the impact of regulatory changes, including the Global Settlement, NASD Rule 2711 and the amended NYSE Rule 472, on analysts’ recommendations. We address three main questions. First, have analysts’ recommendations become more informative following the regulations? Second, did the regulations mitigate the effects of conflicts of interest? Lastly, did the regulations affect the response of investors to analysts’ recommendations?

Following the regulations, most leading investment banks moved from the traditional five-tier rating system to a coarser three-tier rating system over a short period of time (typically one day). The adoption of new rating systems was accompanied by banks completely reshuffling their recommendations, obtaining a more balanced distribution. We examine the informativeness of recommendations, as proxied by investors’ reactions, and how it was affected by the regulations. We start by examining conditional informativeness measured as the abnormal price reactions to recommendations, conditional on their type (optimistic, neutral, and pessimistic). The results suggest that investors internalized the change in the distribution of recommendations in the period following the regulations. For instance, the price response to optimistic recommendations is more positive in the Post-Reg period, suggesting that optimistic recommendations are perceived to be more reliable. By contrast, price responses to neutral and pessimistic recommendations are less negative following the regulations, since more recommendations fall under these categories. In additional tests, we find that the overall informativeness of recommendations has significantly decreased following the regulations: The absolute price reactions to stock recommendations are significantly lower in the Post-Reg period. We further show that recommendations issued by brokers who use a three-tier rating system (before or after the regulations) provide less information to investors. Additionally, the decline in informativeness after the regulations is stronger for banks that were sanctioned in the Global Settlement, all of whom have switched to a three-tier system.

We use a difference-in-differences approach to gauge the impact of the regulations on conflicts of interest between investment banking and research. Our main proxy for the presence of conflicts of interest is past underwriting relationship between the brokerage house and the recommended firm (affiliation). We document a significant change in how conflicts of interest influence stock recommendations. We corroborate prior research and the concerns of regulators by showing that conflicts of interest were associated with excess optimism in the Pre-Reg period. We show that in the Post-Reg period, affiliated analysts are as likely to issue optimistic recommendations as unaffiliated analysts. Moreover, the difference-in-differences between affiliated and unaffiliated analysts across the two periods is significant, suggesting that analysts have changed their recommendation practices. In contrast, conflicts of interest might still be influencing pessimistic recommendations. In both the Pre-Reg and Post-Reg periods, affiliated analysts are more reluctant to issue pessimistic recommendations than unaffiliated analysts, and the difference-in-differences is not significant. Alternative measures of conflicts of interest, also suggest significant changes in analysts’ practices. Before the regulations, analysts were overly optimistic regarding firms that have recently issued equity, and with respect to firms that experience financing deficit. We show that after the regulations, this optimism has declined significantly.

Finally, we examine whether investors react differently to recommendations issued by potentially conflicted analysts before and after the regulations. We find that investors discount affiliated neutral recommendations to a lesser extent after the regulations. However, we do not find such evidence for optimistic and pessimistic recommendations.

Collectively, we view our findings as consistent with a limited achievement of the regulations’ objectives. Although the mix of recommendations has become more balanced, the overall informativeness of recommendations has declined in the Post-Reg period.

The full paper is available here.

Another perspective on Citigroup and AIG

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Sunday, March 8, 2009
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Editor’s Note: This post is by Larry Ribstein of the University of Illinois College of Law. 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 Delaware chancery court has decided two very important cases arising out of notorious cases of managerial malfeasance or neglect – In re Citigroup Inc Shareholder Derivative Litigation, decided February 24, and American International Group, Inc. Consolidated Derivative Litigation, decided February 10.

As discussed in a Wachtell, Lipton, Rosen & Katz client memorandum posted here last week, and by Francis Pileggi here, the Citigroup decision reaffirms business judgment protection in Delaware by emphasizing the “extremely high burden” plaintiffs face in suing directors for breach of Caremark oversight duties. In this case, Chancellor Chandler held that merely claiming that directors made a bad business decision by failure to monitor business risk was not enough to excuse demand in a derivative suit.

However, in the AIG decision, Vice Chancellor Strine refused to dismiss a Caremark claim in the face of allegations of criminality and insider trading. This case was also analyzed by Francis Pileggi here.

Rather than rehashing the excellent analyses of these cases discussed in the posts linked above, I will focus on the broader implications of these opinions for corporate fiduciary jurisprudence in the post-meltdown era. I will emphasize three issues: the indeterminacy of corporate fiduciary law, the weakness of this law and other corporate monitoring devices in addressing the recent breakdown in corporate governance; and how these cases relate to Delaware jurisprudence on unincorporated business entities.

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