Monthly Archives: April 2009

Second Generation Advance Notice Bylaws and Poison Pills

This post comes to us from Charles Nathan and Stephen Amdur of Latham & Watkins LLP.

This article is a reply to the post appearing in the Harvard Law School Corporate Governance Forum authored by Marc Weingarten and Erin Magnor of Schulte, Roth & Zabel on March 17, 2009 and entitled “Second Generation Advance Notice Bylaws.” That post is available here.


The past year has been marked by a wave of new or revised advance notice bylaws and a similar but smaller surge in adoption or amendment of poison pills to accomplish one or both of the following goals:

• To achieve transparency (to use the favorite term du jour) concerning attributes of traditional stock ownership (often called “physical ownership”) that have been facilitated by the increasing use of equity derivative products by activist investors and others and, where the equity derivatives or other mechanisms are used to create either the economic or voting equivalent of beneficial ownership, to impose accountability for those “synthetic” equity and “empty voting” positions; and• To achieve transparency concerning activist investor “wolf pack” tactics that are calibrated to avoid the rules requiring aggregation and disclosure under Section 13(d) of the 1934 Act and similar regulatory provisions and, where a wolf pack exists, to impose accountability among its members for their aggregate ownership position, physical and synthetic.

Second generation advance notice bylaws and poison pills did not appear spontaneously. Rather, each is a response to a growing phenomenon in the market for corporate control, not just in the United States, but also in Europe, Asia and Australia. The pioneering literature that exposed the use of derivatives and “empty voting” in corporate control contexts was a product of the academic legal community, particularly Professors Henry Hu, Bernard Black, Edward Rock and Marcel Kahan, who have written a number of articles about the phenomena of “empty voting,” “morphable” equity ownership, “decoupling of economic and voting interests,” “record date capture” and other uses of derivatives and market mechanics to separate the voting rights of stock ownership from its economic attributes and to divide the economic attributes[1] of ownership into a bundle of rights and obligations that can be separated, just as the voting rights can be separated from economic attributes. Moreover, the academic observers were not abstractly speculating about behavior that could revolutionize the markets for corporate control. They were reporting on existing methodologies, frequently but not always practiced by event driven hedge funds and other activist investors in control contexts.[2]

The second phenomenon of utilizing wolf pack behavior to avoid aggregation for purposes of equity reporting requirements, such as Section 13(d), has not generated as much academic interest, but certainly has galvanized target companies, and in many countries financial market regulators or even the political establishment, by its successful end-running of customary concepts such as the “group” definition under the 1934 Act and the European, Asian and Australian “acting in concert” or “concert party” concepts in the equivalent share ownership disclosure regimes in many of the world’s more developed equity markets.[3] It is also notable that, unlike the use of equity derivatives to decouple attributes of share ownership which arose in the context of, and was driven by, trading strategies and economic considerations unrelated to change of control campaigns, the wolf pack has been used virtually exclusively by the activist investor community in campaigns against companies, often culminating in successful proxy contests or other change of control events.

Delaware Supreme Court Clarifies When Revlon Duties Apply

An earlier post on this Forum on Lyondell Chemical Co. v. Ryan is available here. The current post from Scott Davis provides a more detailed discussion of the Supreme Court’s analysis of when a board’s Revlon duties apply.

Editor’s 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.

My colleagues William Kucera, Christian Fabian and Erik Axelson have prepared a memorandum further analyzing the Delaware Supreme Court’s recent decision in Lyondell Chemical Co. v. Ryan. The memorandum highlights several key aspects of the decision that provide guidance to M&A practioners in counseling clients and structuring transactions. First, Lyondell clarifies when a board’s Revlon duties apply. By finding that Revlon duties apply “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 of control,” the Supreme Court emphasized the role of the company and its directors in determining when Revlon duties are triggered, as opposed to when third-party actions, such as a Schedule 13D filing or publicly disclosed unsolicited overture, generally inform the market that a third party is interested in acquiring a company. The Supreme Court’s refusal to impose Revlon duties before a board takes affirmative steps to begin negotiating the sale of the company is an important concept for practitioners and M&A professionals because it generally allows for the target company, through its actions, to control whether Revlon duties apply. Guided by this principle, the Supreme Court signaled that a target company will be justified in deciding to take a “wait and see” approach in response to a third-party overture that arguably puts the target company in play, where that approach is the product of a deliberate decision by an independent, disinterested board.

The Lyondell decision also emphasizes the high bar that must be cleared in order to establish a breach of a duty of loyalty based on a failure to act in good faith. Because loyalty claims for failure to act in good faith are reserved only for situations where the board “knowingly and completely failed” or “utterly failed” to undertake its responsibilities, there is a high burden of proof to overcome to impose liability on the directors. Indeed, the Supreme Court acknowledged that an extreme set of facts is required to sustain a disloyalty claim premised on the assertion that disinterested directors intentionally disregarded their fiduciary duties. Notably, however, the Supreme Court suggested that the bar is much lower when a claim is based on a breach of duty of care, meaning directors need to be concerned about exercising care and establishing a careful, deliberate and well-documented process in reviewing a sale of control transaction.

The memorandum is available here.

How to Avoid Overpaying for Troubled Assets

Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today in the Wall Street Journal online. Professor Bebchuk’s most recent post about the Treasury’s public-private investment plan is available here.

Opponents of the administration’s current plan for buying troubled assets — including Joseph Stiglitz, Jeffrey Sachs and Peyton Young — strongly criticize it for providing private parties with highly skewed incentives to overpay for such assets at taxpayers’ expense. This problem, however, isn’t fatal. It can be fixed, and fixing it would do a great deal both to increase the plan’s benefits and reduce its costs.

Under the plan’s current design, the private side — the manager and the private investors affiliated with it — will contribute as little as 8% of the capital of funds set under the program, with the rest funded by the Treasury and Fed. In return for this 8% of capital, the private side will get 50% of the upside but bear half of the downside only up to 16% of the fund’s capital. Such asymmetric payoffs would provide powerful incentives to seek assets with volatile value and overpay for them.

While such overpaying would be consistent with the private manager’s interests, it would impose losses — which could well exceed the private side’s profits — on the public capital participating in the funds. Moreover, the overpaying would undermine one of the plan’s main objectives — to produce market prices providing reliable information about the value of troubled assets still remaining on banks’ books.

Rather than getting skewed payoffs, with the resulting large distortions, the private side should receive payoffs that parallel those of the public capital invested in the funds. To this end, the private side should get a specified fixed percentage of the fund’s final value, both on the upside and the downside. To the extent that the public capital comes in both equity and debt forms, the private side should also participate in debt and equity in the same proportions as the public capital.

But isn’t the partial insulation of the private side from downside risks necessary to attract private capital? Not at all. Even if the private side needs to receive somewhat favorable terms to participate, such a “subsidy” can be given in a form that would not distort subsequent incentives.

Suppose that the government wishes to stick with having the private side contribute 8% of the fund’s capital. Rather than entice the private side with unequal shares of the upside and the downside, the private side could be given a percentage of the fund’s final value that exceeds 8%. If the private side gets, say, 12% of the fund’s value for its investment of 8% of the initial capital, the extra 4% would represent a subsidy meant to induce the private side’s participation and management of the fund. Unlike under the administration’s current design, however, once the private side is in, it will have incentives aligned with those of taxpayers.

The private side’s fixed share, and hence the size of the subsidy, can be determined through a competitive process that would ensure that the level of subsidy will be kept at a minimum. Potential private manager will submit bids indicating the minimum fraction of the fund’s value that would accept in return for contributing 8% of a fund’s initial capital, as well as the size of the fund they would establish if admitted. The government will then set the private side’s fixed share of payoffs in funds set under the program at the lowest level that would be consistent with establishing funds that collectively have the aggregate target capital.

Note that, under the proposed approach, the government would be getting a much higher share of the upside than the 50% under the administration’s design. Even more important, taxpayers will benefit from the improved incentives to maximize the value of the funds in which taxpayers will be so heavily invested.

It might be argued that, even though the proposed fix would eliminate incentives to overpay for troubled assets, such overpaying is what the administration seeks in order to bolster banks’ capital. But overpaying, which can be easily avoided by the proposed design, shouldn’t be a goal of the program. The government should inject capital only in those banks that need it and to do so in exchange for securities — not confer a benefit without consideration on all banks holding troubled assets.

For the administration plan to work well, fund managers’ incentives should be aligned with maximizing the value of the fund’s capital. The proposed re-design would make the plan much more effective and much less costly.

Bailouts and Risk Management Incentives

This post comes from Stavros Panageas of the University of Chicago.

In my paper, Bailouts, the Incentive to Manage Risk, and Financial Crises, which was recently conditionally accepted for publication at the Journal of Financial Economics, I develop a model where risk management rules are derived as optimal responses to the adverse risk taking incentives created by bailouts. Additionally, the incentives to undertake a bailout are endogenously determined, making it possible to provide a joint explanation for the observed risk appetite reversals and the prevalence of bailouts.

In the baseline version of the model there are three agents: the firm’s shareholders, its debt holders and a stakeholder. The stakeholder incurs a discrete cost or externality if the firm is terminated. The presence of this cost or externality makes the stakeholder willing to bail out the firm, by injecting funds, once bankruptcy looms. However, the stakeholder’s guarantee to the shareholders is implicit and the benefit from the firm’s continued presence is bounded. Hence, bailouts can occur only if the stakeholder finds it profitable to undertake them. Within this framework, the paper studies the shareholders’ incentive to take risk. As one might expect, the presence of an implicit guarantee makes the shareholders inclined to raise the volatility of the projects that they undertake. However, high volatility choices could deter the stakeholder from bailing out the firm. This produces a tension. On the one hand, shareholders want to raise volatility, but not so much that the stakeholder will find it prohibitively costly to bail out the firm. This tension introduces the need for risk management rules, commitments and regulations that can be either the result of regulation or self-regulation.

A new aspect of the model is that rules, regulations and commitments are allowed to be imperfect. The imperfection stems from the fact that future shareholders may choose to renege by paying a cost. This helps capture situations where firms can circumvent risk management rules by undertaking costly activities such as setting up offshore, off-balance sheet entities. The imperfection of commitment implies that the credibility of a risk management rule is not taken as given. Instead, adherence to the rule has to be dynamically consistent. Within this framework, I analyze the optimal choice of a risk management rule and show that it has a particularly simple form: undertake projects with high risk levels when net worth (defined as assets minus liabilities) is sufficiently high and switch to projects with low risk levels when net worth falls below an endogenously determined threshold. The model shows that risk limits tighten abruptly when the firm’s net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as “flight to quality”.

The full paper is available for download here.

SEC Grants No-Action Relief to Activist Shareholders

On March 30, 2009, the SEC staff issued two no-action letters[1] regarding the solicitation of proxies to vote in the election of directors in a situation where two dissident shareholders had submitted separate “short slates” of director nominees for election at the same annual meeting. The no-action letters permit a soliciting shareholder to “round out” its short slate of directors with the nominees of other dissident shareholders, under an expansive reading of the proviso to the “bona fide nominee” rule in Exchange Act Rule 14a-4(d). Such proviso had historically been interpreted only to permit a soliciting shareholder to “round out” its short slate with nominees of the registrant.

The effect of the no-action letters is to facilitate the ability of shareholders to elect non-incumbent directors in situations where more than one dissident shareholder is running a short slate. The SEC staff conditioned its relief on a number of requirements, including that any such dissidents must not have agreed to, and must have no intention of, forming a “group” as determined under Regulation 13D-G.


In recent years it has become increasingly more common for dissident shareholders to run a “short slate” of directors for election at annual meetings – that is, a dissident slate for less than a majority of the registrant’s board of directors. This is becoming the preferred approach for dissidents seeking board representation for two primary reasons. First, proxy advisory firms such as RiskMetrics and large institutional investors have historically proven to be more supportive of short slates than of dissident efforts that seek to replace a majority of the board. Second, running short slates avoids the risk of triggering so-called “poison puts” – provisions in a registrant’s debt documents which would require the registrant to repurchase outstanding debt obligations upon the occurrence of certain defined events, which sometimes include incumbent directors ceasing to constitute a majority of the board.

SEC rules require that each nominee named in a proxy card must be a “bona fide nominee.” Prior to the adoption by the SEC of the shareholder communications rules in 1992, in order to qualify as a “bona fide nominee,” each nominee had to consent to being named in a proxy card. This unqualified requirement effectively prevented a dissident’s proxy card from conferring authority to vote for a registrant’s nominees, because registrant nominees were unlikely to consent to being named on a dissident’s proxy card. The rule placed dissident shareholders running short slates of directors at a disadvantage to registrants – shareholders effectively faced a choice between voting for the registrant’s full slate of nominees, in order to exercise their full voting rights, or voting for a less than full slate of dissident nominees. However, in 1992, the SEC added the so-called “short slate rule” – really an exception to the bona fide nominee rule — which allows a dissident shareholder’s proxy card to “round out” a short slate of nominees by obtaining authority to vote for some of the registrant’s own nominees.


Implications of the AIG Bonus Imbroglio

This post is based on a client memorandum by A. Richard Susko, Arthur H. Kohn and Mary E. Alcock of Cleary Gottlieb Steen & Hamilton LLP.

Great outrage and indignation have been expressed, from multiple perspectives, in connection with AIG’s retention bonuses and the Congressional response thereto. Now that most of the public, albeit probably not the actual participants, seem to be past the initial burst of emotion, we believe that it is well worth noting that all employers, whether or not they are recipients of Government funds, should pay close attention to the several recently proposed (and competing) bills in Congress spawned by the episode.

These bills show that the politics of populist furor over executive compensation can easily pave the way for hasty and thoughtless regulation, which would (if enacted as written) be counterproductive to the US financial system and economic recovery. The bills also foreshadow possible future and potentially broad legislation that may eventually have negative effects for many companies beyond the financial industry.

Political focus on, and accompanying rhetoric regarding, perceived excesses in executive compensation have been building in intensity for some time. The current legislative impulses, however, raise systemic risks that pose a far greater danger than the issues sought to be addressed by them. In our recent memorandum, entitled “Implications of the AIG Bonus Imbroglio,” we discuss particularly troublesome aspect of the four recently proposed bills, including the lack of an exception for existing binding compensation contracts. The memorandum also outlines possibly unintended and negative consequences to employers, employees and the public alike of the bills and briefly summarizes relevant provisions of each of the bills.

Whatever the immediate prospects for passage may be, we believe that it is important for employers and employees generally to be aware of the substance of the recent proposals even if they are not the targets at the moment.

The memorandum is available here.

Impact of Accounting Choices on Performance Evaluation

This post comes from Joanna Shuang Wu of the University of Rochester and Ivy Zhang of the University of Minnesota.

In our forthcoming The Accounting Review paper entitled “The Voluntary Adoption of Internationally Recognized Accounting Standards and Firm Internal Performance Evaluation”, we investigate whether the voluntary adoption of international accounting standards is associated with changes a firm’s internal performance evaluation process; in particular, is it associated with increases in the sensitivities of CEO turnover and employee layoffs to accounting earnings.

Our sample consists of firms from Continental Europe that voluntarily adopted IFRS or U.S. GAAP from 1988 to 2004. We require the adopting firms to have both pre- and post-adoption data, and as a result, exclude firms that report under IFRS/U.S. GAAP from the first year they enter into our sample. We classify firms into those following IFRS/U.S. GAAP accounting standards and those following local accounting standards. For the IFRS/U.S. GAAP adopting firms, the adoption year is treated as event year zero. The local standards firms (firms that follow local GAAP throughout our sample period) serve as the control sample in the various tests. Our final sample comprises 200 IFRS/U.S. GAAP adopting firms and 766 local standards firms.

We find that CEO turnover and employee layoffs are more sensitive to accounting earnings after IFRS/U.S. GAAP adoption. These findings support our hypothesis that accounting earnings play a greater role in firm internal performance evaluations after the adoption of international accounting standards. In addition, we investigate firms’ decisions to adopt international accounting standards and proxy for the performance evaluation demand with two variables: closely held shares and labor productivity. After controlling for various other factors, we find that greater performance evaluation demand (less closely held shares and lower labor productivity) are associated with a higher likelihood of IFRS/U.S. GAAP adoption.

The above evidence does not necessarily imply that the voluntary adoption of international accounting standards causes the changes in internal performance evaluations in terms of higher earnings performance sensitivities. Firms that voluntarily adopt IFRS/U.S. GAAP likely experience fundamental changes in their operations, financing, and corporate governance; and the adoption of international accounting standards can simply be an instrument for these profound changes. Our findings suggest that the greater reporting transparency through international accounting standards likely plays a role (which may not be strictly causal, but is important nonetheless) in improving firms’ internal performance evaluations. We document that IFRS/U.S. GAAP adoption is associated not only with changes in firms’ operating and information environment, but also with changes in corporate governance.

Our findings highlight the multitude of implications from the adoption of international accounting standards and add to our understanding of the complex changes experienced by the adopting firms.

The full paper is available for download here.

Underwater Stock Options and Stock Option Exchange Programs

This post comes to us from Doreen E. Lilienfeld and Amy B. Gitlitz of Shearman & Sterling LLP.

With the market decline, many companies have found that their outstanding employee stock options are “underwater” or “out-of-the-money” because the exercise price is higher than the company’s current stock price. Underwater stock options do not provide their intended incentive and retention benefits. Moreover, they are an inefficient use of a company’s equity reserves as they (i) cause companies to take accounting charges for equity that is not providing value to the employees and (ii) count against plan share limits thereby limiting the number of new awards to be granted to employees. One way companies deal with their underwater options is by effecting an option repricing. The term “repricing” broadly refers to a number of practices, including:

Option Buyout or Cash Exchange. Underwater options are purchased by the company for cash.

Option for Option Exchange. Underwater options are cancelled and replaced with “at-the-money” options.

Option for Other Security Exchange. Underwater options are exchanged for a different type of equity-based award (e.g., restricted stock, restricted stock units or phantom stock).

Option Repricing. The exercise price of underwater options is unilaterally reduced by the Company.

Various legal and regulatory issues must be considered when electing whether to implement an option exchange program including securities laws, accounting rules, tax laws and shareholder approval requirements.

Securities Laws. Most option exchange programs are deemed “tender offers” for purposes of the U.S. Securities Exchange Act of 1934 (the “Act”). As a result, a company must file a Schedule TO with the Securities and Exchange Commission (“SEC”), and comply with all tender offer requirements, including the obligation to leave the offer open for at least 20 business days. The SEC, however, has provided limited relief from the “all holders” and “best price” rules under the Act for option repricings that are affected for a “compensatory purpose.” This enables a company to limit which options are subject to the repricing and provide different consideration for each tranche of options. For example, a company can have different exchange ratios based upon the exercise price or remaining term of underwater options.

Shareholder Approval. Both the NYSE and NASDAQ require shareholder approval for the majority of option repricing programs, unless a plan explicitly states that shareholder approval is not required. Many shareholder activist groups, including RiskMetrics, provide guidelines regarding their considerations with respect to repricing.

U.S. Accounting. Under FAS 123R, a repricing is deemed a modification to the existing award. FAS 123R compares the fair value (based upon an option pricing model, e.g., Black Scholes or binomial lattice) of the award immediately before and after modification. If there is an increase in value, an accounting charge must be taken.

U.S. Tax. The cancellation or repricing of an option is not a taxable event. Cash payments are immediately taxable; grants of stock options and restricted stock or units that are subject to future vesting are not immediately taxable. Companies should also consider Sections 409A and 162(m) in structuring an option repricing.

Our memorandum entitled “Underwater Stock Options and Stock Option Exchange Programs” deals with these and related issues. It is available here.

Redefining the CEO Role

The following post by Ben W. Heineman, Jr. was published today in the online edition of BusinessWeek. The speech by Lloyd C. Blankfein, Chairman and CEO of Goldman Sachs, Inc., referred to below was featured on this Forum here.

Like the companies they run and oversee, CEOs and boards of directors in the financial sector have been battered by the credit meltdown. The witch’s brew of high leverage, poor risk management, creation of toxic assets, and faulty business judgments—made more poisonous by excessive short-term executive pay—are seen as failures of an unprecedented magnitude. The result: Credibility has eroded, trust has dissolved, and financial re-regulation seems inevitable.

As Lloyd Blankfein, CEO of Goldman Sachs (GS), said recently in a speech to the
Council of Institutional Investors: “…[T]he past year has been deeply humbling for my industry…the loss of public confidence…will take years to rebuild…effective reform(s) are vital and should naturally emanate from the lessons learned.”

To this end, I believe there are four fundamental, interrelated governance changes inside corporations that are essential for enhancing accountability and increasing stakeholder confidence:

• Boards of directors must redefine the role of the CEO—and then choose leaders who meet the new specs.

Under this recast role, the CEO’s first foundational task is to achieve a balance between taking economic risk (promoting creativity and innovation) and managing economic risk (within a systemic framework of financial discipline) over a sustained period of time.

The second redefined foundational CEO task is to fuse this high performance with high integrity. That means adhering to the spirit and letter of formal rules, voluntary adoption of ethical standards that bind the company and its employees, and employee commitment to core values of honesty, candor, fairness, reliability, and trustworthiness— which together are in the enlightened self-interest of the corporation and reduce legal, ethical, and reputational risk.


Lessons from the Financial Crisis

(Editor’s Note: The post below by Lloyd C. Blankfein is a transcript of remarks by him to the Council of Institutional Investors, Spring Meeting, April 2009.)

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency and responsible ownership. I’m pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public’s long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I’d also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability and enhance investor confidence.

Without trying to shed one bit of our industry’s accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today’s circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.


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