Monthly Archives: April 2009

How Important is Private Enforcement for Corporate Law?

This post is by John Armour of the University of Oxford.

It is often assumed that strong securities markets require good legal protection of minority shareholders. This implies both “good” law — principally corporate and securities law — and enforcement, yet there has been little empirical analysis of enforcement. In our paper entitled Private Enforcement of Corporate Law: An Empirical Comparison of the UK and US, Bernard S. Black, Brian R. Cheffins, Richard Nolan and I study private enforcement of corporate law in two common law jurisdictions with highly developed stock markets, the United Kingdom and the United States, examining how often directors of publicly traded companies are sued, and the nature and outcomes of those suits.

We find, based a comprehensive search for filings over 2004-2006, that lawsuits against directors of public companies alleging breach of duty are nearly nonexistent in the UK. The US is more litigious, but we still find, based on a nationwide search of decisions between 2000-2007, that only a small percentage of public companies face a lawsuit against directors alleging a breach of duty that is sufficiently contentious to result in a reported judicial opinion, and a substantial fraction of these cases are dismissed. Our findings also suggest that the risk that directors would pay out of pocket, for anything other than improperly putting money in their own pockets to begin with, was negligible – we found no such cases over an 8-year period. The upshot is that while directors of publicly traded US companies are much more likely to be sued under corporate law than their British counterparts, lawsuits under corporate law are hardly an everyday occurrence and out-of-pocket liability is scarcely to be feared.

The UK has strong substantive corporate law, but, almost no formal private enforcement of that law against directors of publicly traded companies. The absence of formal private enforcement highlights the importance of procedural rules, often general rules not limited to corporate cases, for the practical operation of substantive rules. Differences in general rules governing class actions, contingency fees, and who pays the winner’s legal expenses, in tandem with specific rules regarding the availability of derivative actions and direct claims in corporate law, may do much to explain the large differences in levels of private enforcement.

We examine possible substitutes in the UK for formal private enforcement of corporate law and find some evidence of substitutes, especially for takeover litigation. Nonetheless, our results suggest that formal private enforcement of corporate law is less central to strong securities markets than might be anticipated. The lack of formal enforcement in the UK – and its robustness in the US despite relatively “weak” corporate law rules — also highlights the potential gap between law in books and law in action, which has been understudied in law-and-finance studies of the underpinnings of strong securities markets. US corporate and securities law is often thought of as being highly protective of outside investors. At least for corporate law, this is not because the substantive law is strong – by international standards it is not. One possible inference is that corporate law is not a key determinant of stock market development. Another is that the intensity of formal private enforcement compensates for the modest formal protections substantive law offers, producing a “shareholder-friendly” end result.

The paper is available here.

Compensation Proposals in 2009 Proxy Season

This post is based on a memorandum by Jim Kroll of Towers Perrin entitled The 2009 Proxy Season: How Will Shareholders Vote on Compensation-Related Proposals in Today’s Contentious Climate?

With the hammering that many stocks took last fall, and the intensifying scrutiny and criticism of executive pay in financial services and other industries, it’s probably not surprising that the number of compensation-related shareholder proposals appears to be up this proxy season. While it’s far too soon to predict the outcome of this season’s voting, early votes suggest that these proposals may garner as much, if not greater, support in today’s contentious shareholder environment than in past years. How companies respond to this year’s voting also remains to be seen, although it’s likely that many boards will be paying even closer attention to shareholder views than in the recent past as a result of changes in several RiskMetrics Group (RMG) policies related to executive pay.

This article reviews the shareholder proposals filed to date and votes thus far on compensation-related proposals in the current proxy season, along with a look at how RMG policy changes are influencing the shareholder engagement dynamic this year on compensation matters in general.

The Evolving Shareholder Dialogue
Shareholder proposals that address key compensation issues are often viewed as a barometer of investor sentiment regarding executive pay. While the number of compensation-related proposals filed and voted on tends to fluctuate from year to year, the general trend in recent proxy seasons has been toward more shareholder activism on a number of compensation fronts. This is reflected in both the number of proposals filed and in the levels of support they receive from shareholders.

Proposals falling into two general categories — say on pay and pay for performance — have tended to dominate the last three or four proxy seasons. In past years, various labor unions took a lead role in filing such proposals. However, our analysis of the 2009 proxy season finds unions playing a somewhat smaller role this year. For example, say-on-pay proposals, the largest and fastest-growing category, were offered by a wide range of proponents in 2009, including pension funds and other investors. This shift, particularly as it relates to say-on-pay proposals, may be due to the fact that various shareholder groups have been discussing the topic and may be pooling their efforts in order to reach a larger number of companies.

Moreover, the number of pay-for-performance proposals has declined again this year because the leading union proponents are taking a year off from filing such proposals (but may resume filing these proposals next year). These proposals, which include measures to adopt performance-based options, link pay to performance, implement “common sense” compensation and adopt performance- and time-based restricted stock, made up the largest category of shareholder proposals as recently as two years ago. They’ve virtually disappeared from the proxy landscape this season. While shareholder proposals on the topic have declined, the proponents have changed their tactics and are proactively engaging companies in discussions about their pay practices. Other proposals on the decline this year are those addressing golden parachutes, clawbacks and supplemental executive retirement plans (SERPs).

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Shenanigan’s Wake

This post is an excerpt from the 2009 Edition of The Directors’ Handbook, by Thomas J. Dougherty of Skadden, Arps. Here, in the book’s Foreword, Dougherty challenges directors to reject passive board meetings and engage in hands-on sessions in order to better identify risk factors and effectively lead the companies they serve.

The regulatory oversight framework is broken. The SEC failed to regulate credit default swaps, loosened broker-dealer leverage restrictions at just the wrong time and failed to regulate dark-debt driven hedge fund activities. The Federal Reserve failed to impose reserve requirements on syndicators of collateralized loan or credit obligations. All that will change now.

Importantly, in its entire seventy-five year history, there has never been a visiting committee appointed to review the SEC. We need a committee of non-bureaucrats, non-industry groups, non-politicians, analogous to the visiting committees that accredit and review university excellence.

Meanwhile, there is going to be greater skepticism and scrutiny of board of director oversight than ever before, as a ripple effect of failed companies, regulatory tightening and the push for reform. In some ways, that is not a bad thing, because lax practices still exist, such as the increasing trend of front-loading board meetings with management presentations so detailed and so numerous as to numb the outside directors’ ability to assess strategy and examine any one problem with requisite focus. The ratio of minutes of director discussion to minutes of slide presentations has greatly diminished, as companies’ ability to mine and marshal presentation data has risen parabolically.

That process within the boardroom—that dynamic—needs to be managed by the board itself.

What’s Going On?

Despite greater intensity of director effort, the core challenge for directors trying to fulfill their roles in providing vision and vigilance for public companies remains the same: they passionately desire and dutifully need to know “what is going on” in the important areas of company strategy and management execution in order to do their director jobs well.

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Executive Compensation Under TARP

This article by Joseph E. Bachelder appeared recently in the New York Law Journal.


On Feb. 17, 2009, President Barack Obama signed into law the American Recovery and Reinvestment Act of 2009 (ARRA). Title VII, Section 7001 of ARRA amends Section 111 of the Emergency Economic Stabilization Act of 2008 (EESA) as enacted Oct. 3, 2008. Section 111 contains restrictions on executive compensation applicable to institutions receiving financial assistance under the Troubled Assets Relief Program (TARP).[1] For purposes of this column, Section 111 as amended by ARRA is referred to as “New Section 111,” and Section 111 as originally enacted under EESA is referred to as “Original Section 111.”

New Section 111 continues certain provisions of Original Section 111 but expands the number of executives covered (with different numbers of executives covered under different provisions), imposes stricter limitations on compensation payments, prohibits severance payments to certain executives and adds new corporate governance standards and requirements relating to those standards.

Generally speaking, the limitations and standards under New Section 111 apply during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding (referred to herein as the “TARP Period”). Under New Section 111 the TARP Period ends even if the government still holds warrants. The statute applies to a “TARP Recipient,” defined as “any entity that has received or will receive financial assistance under the financial assistance provided under the TARP.”

Further complicating matters are additional compensation guidelines announced by the U.S. Treasury on Feb. 4, 2009, in a press release (“Treasury Announces New Restrictions on Executive Compensation,” Press Release No. TG-15, referred to hereinafter as “TG-15”).[2] TG-15 applies one set of guidelines to companies receiving “exceptional assistance” and another (albeit with some overlapping of guidelines) for companies receiving assistance under “generally available capital access programs.”[3]

Following is a review of selected provisions of New Section 111 including, as applicable, a comparison of it to Original Section 111 and TG-15. (As of the time this column was written, regulations had not yet been issued under New Section 111.)

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The Impact of Governance Reform

This post comes from Richard Price and Brian Rountree of Rice University, and Francisco Roman of Texas Tech University.

Corporate governance systems are designed to ensure investors receive a return on their investment. Using cross country analysis, the governance literature has demonstrated that stronger governance systems lead to more efficient allocations of capital resources, which in turn spurs economic growth and increases the likelihood of investors receiving a return. What is less clear is how an economy with generally weak governance can bring about change in order to improve the investment climate and stimulate economic development. In our forthcoming Journal of Financial Economics paper entitled The Impact of Governance Reform on Performance and Transparency, we investigate the efficacy of mandated changes in corporate governance and investor protection in Mexico, which is a classic example of an emerging market economy dominated by concentrated ownership and without a demonstrated commitment to minority investor protection.

Similar to a number of emerging market economies, Mexican regulators have recently implemented a Code of ‘Best’ Corporate Practices (hereafter the Code) and require companies to publicly disclose their compliance with these suggested practices each year. In addition, the laws governing securities markets have been strengthened in 2001, 2003, and 2005. These efforts are all aimed at improving the investment climate and attracting foreign capital to Mexico.

We find that companies generally increased their compliance with the reforms over the 2000-2004 time period, which indicates companies believe there is a benefit to compliance or cost of non-compliance. However, our analyses of performance and transparency fail to reveal a significant relation to the reforms illustrating there are still substantial concerns about the ability of these actions to improve economic development. Instead, we find companies that comply more with the reforms are more likely to pay dividends, which indicates that better governed companies are forced to resort to costly signals in order to reduce agency costs as opposed to reaping the benefits from improved transparency. Our results indicate market monitoring mechanisms by themselves are not strong enough to induce significant changes in economic behavior and suggest extensive changes in the legal and/or political environment are necessary in emerging market countries like Mexico to ensure adequate investor protections.

The full paper is available for download here.

Shareholder Proxy Access for Director Elections

This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

Shareholder proxy access for the election of directors is about to arrive. Directors of public companies, shareholder activists and shareholders generally soon will be dealing with an important new set of issues and dynamics associated with the election of directors and the management of the board process. This memorandum is intended to provide a briefing on key aspects of this important subject.

What is The Issue?
In a nutshell, the issue is whether and, if so, under what conditions, a shareholder of a public company should have the right to include — in the company’s proxy statement and on the company’s proxy card — nominees proposed by the shareholder in opposition to the company’s candidates for election to the board of directors.

A sharp distinction has always existed in director election contests between how company and dissident candidates are presented for shareholder consideration. Company candidates are presented in the company’s proxy material — proxy statement and card — and dissident candidates are presented in separate proxy material prepared, paid for and presented to shareholders by the dissidents. Classic election contests are typified by each side preparing various forms of dueling soliciting materials — such as formal proxy statements, print and electronic media advertisements, letters to shareholders, investor presentations — which are delivered to shareholders through an active solicitation campaign by each side. Although proxy reforms in recent years have been designed to streamline the proxy solicitation process, an election contest can still involve real cost and effort.

The rise of corporate governance concerns in recent years has increasingly focused on board performance and the rights of shareholders to change directors in response to perceived deficiencies in performance. One mechanism that has been proposed to facilitate shareholder action seeking to change directors is to give shareholders direct access to the company’s proxy statement, permitting the inclusion of shareholder-proposed candidates and a supporting statement. Among the arguments advanced for this mechanism is that including shareholder-sponsored director candidates directly in the company’s proxy statement (and on its proxy card) will make it significantly easier and less costly to present to shareholders meaningful choices regarding board composition with a view toward improving performance.

Where Does The Issue Stand?
The proxy access issue has been debated for some time. In 2003 and again in 2007, shareholder proxy access proposals were considered by the Securities and Exchange Commission (SEC). However, no rule was adopted, or position taken, by the SEC either directly granting a proxy access right under the federal proxy rules or permitting shareholders to include in a company’s proxy statement, under Rule 14a-8, a shareholder proposal to amend the company’s bylaws which, if adopted by shareholders, would provide for shareholder proxy access in the election of directors (proxy access bylaw). In fact, in 2007 the SEC codified an exclusion from Rule 14a-8 that made it clear that a proxy access bylaw could be excluded by a company from its proxy statement.

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Recent Developments in D&O Insurance

This post is by John G. Finley’s partner Joseph M. McLaughlin.

Federal and state courts have recently issued noteworthy decisions yielding important lessons about directors and officers liability insurance policies. This column examines decisions addressing: (i) the interaction of an application severability clause in a primary policy (addressing to what extent one insured’s knowledge of application misrepresentations can be imputed to other insureds) with a “prior knowledge” exclusion in excess policies; (ii) the scope of a standard-form securities exclusion; (iii) the consequences of failing to give timely notice under a “claims made and reported” policy; and (iv) the effect of an “other insurance” clause in a D&O policy on the D&O insurer’s defense cost obligations to a mutual insured also holding a CGL policy with another insurer.

Prior Knowledge Exclusion

An application for D&O insurance typically is filled out by one or two officers of the corporation (usually the CEO and/or CFO) who make certain representations on behalf of all individuals to be insured. In addition to the traditional “warranty statements” made in the application about knowledge of facts which might give rise to a claim, most D&O applications today expressly incorporate certain documents, such as specified company SEC filings and financial statements, and provide that these documents are material to the insurer’s evaluation of the risk and expressly serve as a basis for writing the coverage. Allegations of inaccuracy in the documents incorporated into the application frequently form the basis for the very lawsuits for which D&O coverage later may be sought. If the company announces an accounting restatement, it may be argued that the company has admitted the original financial statements — and the application — were materially misleading. Without a severability provision in the application, if material representations made to the insurer during the underwriting process turn out to be false, the insurer may be able to return the premium paid and rescind, i.e., void, coverage under the policy as to all insureds. In addition, most D&O policies include severability for the conduct exclusions, such as fraud and intentional misconduct, so that the knowledge or “bad acts” of one insured cannot be imputed to innocent D&Os, who remain entitled to coverage.

In XL Speciality Ins. Co. v. Agoglia,[1] Judge Gerald E. Lynch last month assessed under New York the effect law of prior knowledge exclusions on demands for coverage under three excess D&O policies issued to Refco, Inc., once one of the largest brokerage and clearing services providers for international currency and futures markets. The decision illustrates the importance of paying attention to the wording of and relationship between application and exclusion severability provisions at both the primary and excess insurance levels.

Refco collapsed upon disclosure in October 2005 that it had been carrying an undisclosed $430 million receivable from an affiliate controlled by CEO Phillip Bennett (the “RGHI Receivable”), announcing that the receivable consisted of uncollectible debts originating in the late 1990s and that the related-party nature of the receivable had been hidden from the company’s auditors. In the litigation fallout, Bennett pleaded guilty to numerous federal criminal charges. In addition, numerous civil lawsuits were filed against the former directors and officers of Refco. Central to these lawsuits are the allegations that, prior to Refco’s August 2005 initial public offering, Bennett and others at Refco concealed Refco’s true financial position by means of the RGHI Receivable scheme.

Refco’s D&O liability insurance program for the relevant period consisted of a U.S. Specialty Insurance Company primary policy, with Allied World Assurance Company (“AWAC”), Arch Insurance Company (“Arch”) and XL Specialty Insurance Company (“XL”) providing third, fourth and fifth excess layer coverage, respectively. The AWAC and Arch polices expressly followed form to the primary policy, except to the extent they contained limitations or restrictions beyond those in the primary policy. The XL policy did not follow form to the primary policy. These excess insurers sought a declaration on summary judgment that coverage was precluded by prior knowledge exclusions in their policies.

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Public and Private Enforcement of Securities Laws

This post is by Mark Roe of Harvard Law School.

Public and Private Enforcement of Securities Laws: Resource-Based Evidence, which Howell Jackson and I just revised, is in the pipeline for publication in the Journal of Financial Economics. (We posted an earlier version of Enforcement to this Forum (available here) about a year ago after we presented it at the Law and Economics Seminar here at the Law School.) This post focuses on the updates and changes we have made to the paper during the subsequent year.

The central thesis remains as before: Although recent academic work in finance finds private investor protection more important in determining the depth and breadth of financial markets than public enforcement via financial, regulatory, and even criminal rules and penalties, we do not find evidence supporting that kind of relationship. As before, our measure of public enforcement intensity turns on the resources of securities regulators around the world, focusing on their staffing and their budget levels. In the revised paper, we measure these levels across multiple sample constructions, test for influential observations, and examine whether corruption levels in the poorer nations drive our results. In each robustness check, our results — a significant coefficient on the level of public enforcement — persists for financial outcomes such as the size of a nation’s securities market, the number of domestic firms, trading volume, and the number IPOs in the nation.

We cannot fully unpack causation issues, which persist, as they do in the prior work on private enforcement. This is partly because of data limits — we have extensive budget and staffing data for recent years, but not over an extended time period. But the results now indicate quite clearly that the rejection of the viability of public enforcement in the prior literature and by some units in the international development agencies, such as the World Bank, is not supported by the best measures of public enforcement intensity. The difference between our results and the prior results in the literature is largely due to a sharp difference in the research design for measuring public enforcement intensity. In prior work, it was measured via formal levels of authority of the securities regulator. We now show why these formal measures are unlikely to measure public enforcement as well as the regulators’ resources. A formally-empowered regulator without a good budget and a good staff cannot do much; conversely a well-endowed regulator with spotty formal authority can still achieve much in the way of enforcement. We now show that our measures do not correlate with the prior, more formal measures and we explain why we see our measures as better measures of the intensity of public enforcement.

Our revised results also yield insight into which aspects of private enforcement are important to robust capital markets and which are not. While good disclosure is consistently associated with robust capital markets, private litigation liability indices are not, particularly once one controls for the level of resources dedicated to public enforcement. They are often insignificant, often with coefficients having the “wrong” sign. These results comport with a consensus picture among legal scholars of a deficient system of private securities litigation in the United States: It’s poorly designed, with firms, and hence wronged shareholders, often bearing the cost of insiders’ errors and disclosure failure. Wrongdoers frequently do not pay for their wrongs; innocent shareholders often do. Hence, there’s some a priori reason, consistent with our regression results, to be wary of private litigation as the major mechanism for securities law enforcement in developing, and maintaining, good financial markets.

The full paper is available for download here.

The Elusive Quest For Global Governance Standards

Editor’s Note: This post is by Lucian Bebchuk of Harvard Law School.

The Harvard Law School Program on Corporate Governance recently issued The Elusive Quest for Global Governance Standards, a discussion paper I co-authored with Professor Assaf Hamdani. The paper is scheduled for publication in the University of Pennsylvania Law Review. Our slides from a recent presentation of the paper at the Sloan Foundation corporate governance research conference are available here.

We focus in our paper on the substantial efforts by researchers and shareholder advisers to develop metrics for assessing the governance of public companies around the world. These important and influential efforts, we argue, suffer from a basic shortcoming. The impact of many key governance arrangements depends considerably on companies’ ownership structure: measures that protect outside investors in a company without a controlling shareholder are often irrelevant or even harmful when it comes to investor protection in companies with a controlling shareholder, and vice versa. Consequently, governance metrics that purport to apply to companies regardless of ownership structure are bound to miss the mark with respect to one or both types of firms. In particular, we show that the influential metrics used extensively by scholars and shareholder advisers to assess governance arrangements around the world—the Corporate Governance Quotient (CGQ), the Anti-Director Rights Index, and the Anti-Self-Dealing Index—are inadequate for this purpose.

We argue that, going forward, the quest for global governance standards should be replaced by an effort to develop and implement separate methodologies for assessing governance in companies with and without a controlling shareholder. We also identify the key features that these separate methodologies should include, and discuss how to apply such methodologies in either country-level or firm-level comparisons. Our analysis has wide-ranging implications for corporate-governance research and practice.

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Here is a more detailed description of the paper: There is now widespread recognition that adequate investor protection can substantially affect not only the value of public firms and their performance but also the development of capital markets and the growth of the economy as a whole. This view has naturally led to heightened interest in identifying and bringing about corporate-governance improvements at both firm- and countrywide levels. These developments also have sparked substantial demand for reliable metrics for evaluating the quality of corporate governance in public firms. And both academic researchers and shareholder advisers have made considerable efforts to develop such metrics.

The notion of a single set of criteria to evaluate the governance of firms around the world is undoubtedly appealing. Both investors and public firms are, after all, operating in increasingly integrated global capital markets. Our paper argues, however, that the quest for a single, global governance metric is misguided.

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The Debate Over Federal Insurance Regulation

This post is based on a client memorandum by Richard J. Sandler, Ethan T. James, and Reena Agrawal Sahni of Davis Polk & Wardwell.

In March 2008, the Paulson Treasury issued its Blueprint for a Modernized Financial Regulatory Structure, in which Treasury recommended the establishment of a federal insurance regulatory structure to provide for the creation of an optional federal charter. The Financial Services Roundtable has endorsed the concept of a national insurance regulator, noting that “just as the state/federal banking system works well for the industry and the economy—so too can a similar insurance system.” In recent Congressional testimony, Treasury Secretary Timothy Geithner has said that “there is a good case for introducing an optional federal charter for insurance companies.”

Recently, Representatives Ed Royce (R-CA) and Melissa Bean (D-IL) introduced the National Insurance Consumer Protection Act (“NICPA”), the third attempt in less than three years to create federal insurance regulation. Not everyone thinks federal insurance regulation is an idea whose time has come, however. The CEO of the National Association of Insurance Commissioners (the “NAIC”), Therese Vaughan, recently testified in Congress that “[t]he state-based insurance regulatory system is one of critical checks and balances, where the perils of a single point of failure and omnipotent decision making are eliminated.” The Illinois Director of Insurance, Michael McRaith, in his Congressional testimony characterized the optional federal charter as “a solution in search of a problem.”

Our memorandum entitled “The Debate Over Federal Insurance Regulation” uses NICPA as a filter through which to examine the likely features of any federal insurance regulatory regime; the regulation of insurance holding companies under a federal system and how that compares to state insurance regulation, and to banking regulation, on which it is largely patterned; and how such a regime may fit into the current regulatory reform framework.

The memorandum is available here.

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