Monthly Archives: May 2009

Proposed Amendments to Conflicts of Interest Rules in Public Offerings

This post is by Edward F. Greene of Cleary Gottlieb Steen & Hamilton LLP.

The SEC has issued Release No. 34-59880 soliciting comments on proposed amendments to NASD Rule 2720 that streamline the application of the Rule’s requirements to public offerings of securities in which a participating broker-dealer has a “conflict of interest.” Some of the more significant proposed amendments would:

a. exempt from the filing requirements and the qualified independent underwriter (“QIU”) requirements of NASD Rule 2720 public offerings (1) in which the FINRA member primarily responsible for managing the offering (or each co-lead, if applicable) does not have a conflict of interest, is not an affiliate of a member that has a conflict of interest and can meet the disciplinary history requirements for a QIU, (2) of investment-grade rated securities, and (3) of securities that have a bona fide public market;

b. change the definition of “conflict of interest” so that the Rule would cover public offerings in which at least five percent of the offering proceeds are directed to a participating member or its affiliates (in contrast to the current ten percent threshold set forth in Rule 5110(h) (formerly NASD Rule 2710(h)), which applies on an aggregate basis to all participating members, and which would now become part of Rule 2720);

c. modify the Rule’s disclosure requirements so that information relating to conflicts of interest is more prominently disclosed in offering documents;

d. amend the Rule’s provisions regarding the use of a QIU to focus on the QIU’s due diligence responsibilities and eliminate the requirement that the QIU render a pricing opinion;

e. amend the QIU qualification requirements to focus on the experience of the firm rather than its board of directors, prohibit a member that would receive more than five percent of the proceeds of an offering from acting as a QIU, and lengthen from five to ten years the amount of time that a person involved in due diligence in a supervisory capacity must have a clean disciplinary history; and

f. eliminate provisions in the Rule that do not apply to public offerings and instead address an issuer’s corporate governance responsibilities.

The comment period is 21 days from the date the SEC release is published in the Federal Register. Before becoming effective, any amendments to NASD Rule 2720 finally proposed by the FINRA must be approved by the SEC. A copy of SEC Release No. 34-59880 is available here.

The Battle for Shareholder Access: The Current State of Play

This post is based on a client memorandum by Charles Nathan, Alexander Cohen, Constantine Skarvelis and Raluca Papadima of Latham & Watkins LLP.


• Shareholder proxy access is coming, and it will be the hottest issue of the 2010 proxy season. Public companies should expect, and be prepared for, the strong likelihood of shareholder proxy access in the 2010 proxy season.

• The SEC is scheduled to vote on a proposed shareholder proxy access rule tomorrow, May 20, 2009. We assume that Chairman Schapiro intends the rule to become final around the end of October—that is, in time for the 2010 proxy season.

• Senator Charles Schumer of New York has introduced a bill that, among other things, would confirm the SEC’s authority to adopt a proxy access rule and that would require the SEC to adopt rules directly regulating proxy access, rather than deferring to state law.

• The Delaware General Corporation Law has been amended to authorize companies expressly to adopt bylaws providing for shareholders access to the company’s proxy statement for director nominations.

• Most observers now believe the question is not whether there will be shareholder proxy access for 2010, but rather what it will look like. The shape of proxy access depends principally on whether the final version of the SEC rule:

• merely empowers shareholders to submit access proposals under Rule 14a-8;• provides minimum standards for proxy access, leaving many of the details of implementation to state law and “private ordering;” or

• entirely pre-empts state law by creating a full-fledged and exclusive federal regime for proxy access.

• For those who accept that shareholder proxy access is a foregone conclusion, the key is the details of how shareholder access will be implemented—the so-called “workability” issues. Workability in the context of proxy access is far more complicated than it may first appear. However, it will be the key to whether proxy access becomes, as many of its supporters assert, a sparingly used device that has the effect of instilling greater accountability of directors or, as many of its opponents fear, the progenitor of countless election contests and divided and dysfunctional boards.


What is Proxy Access?
Shareholder proxy access is a proposed regime that would allow shareholders of a public company to include in a company’s proxy materials (proxy statement and proxy card) candidates for director nominated by the shareholder in opposition to the company’s candidates for election. Under the current regime, only the company’s nominees for election to the board of directors are included in company proxy materials. If a shareholder wants to nominate opposition candidates, it must prepare, pay for and distribute separate proxy materials. The obvious point of shareholder proxy access is to change the classic election contest paradigm and thereby facilitate shareholders’ ability on a virtually costless basis to elect directors who are not on the board slate.

Who are the Players?
There are six main groups of players in the proxy access struggle:

• Corporate governance activists, spearheaded by labor unions, state and local government pension funds and the Council of Institutional Investors, have been the main proponents pushing for proxy access. Although not as vocal, activist investors are also supporters of proxy access;

• The SEC, where Chairman Schapiro has announced that she views proxy access rulemaking as a key priority;

• Members of Congress, such as Senator Schumer and other prominent Democratic lawmakers, seem committed to creating a shareholder access regime of some type;

• The business community, led by the US Chamber of Commerce (the Center for Capital Market Competitiveness) and The Business Roundtable, has been strongly opposed to proxy access since the first SEC rule-making foray in 2003;

• The legal community, through its various bar associations and a number of law firms, will weigh-in on the latest round of the proxy access debate once the SEC issues its proposed rule; and

• The proxy advisory firms, most notably RiskMetrics, which will have a large say on shareholder voting on proxy access proposals and on contested director elections resulting from proxy access, are expected to support proxy access.


CEOs as outside directors

This post is by René Stulz of the Ohio State University.

In our paper Why do firms appoint CEOs as outside directors? which was recently accepted for publication in the Journal of Financial Economics, my co-authors Rüdiger Fahlenbrach and Angie Low, and I investigate in detail the role of outside board members who are CEOs of U.S. public companies. Using data from 1988 to 2005 on more than 10,000 firms, we try to answer two questions. First, what determines whether an outside CEO or another person is appointed director? Second, do outside directors who are CEOs create value for minority shareholders?

Appointments of outside CEOs to boards are highly sought after by companies. Large, well-known companies tend to have active CEOs as outside members on their boards. For instance, the 2008 board of Procter and Gamble has four outside directors who are CEOs. Surprisingly, we find that the typical firm in our sample does not have any outside CEO on its board. Direct compensation is not used to equate the supply and the demand for CEO outside directors – they do not receive more direct compensation than other board members who attend the same meetings. We argue that the high demand for their services as outside directors allows CEOs to take their pick of board seats, and they will naturally choose boards that offer them the best total package for the amount of effort required and for the risk involved. We find that CEOs are most likely to join boards of large established firms that are geographically close, pursue similar financial and investment policies, and have comparable governance mechanisms to their own firms. CEO directors are also more likely to join firms which already have other CEO directors on the board. These findings are consistent with a prestige factor, indicating that CEO directors are more likely to accept additional directorships if such positions provide them with benefits such as added prestige or networking opportunities.

We find that the stock market reacts more favorably to the appointment of a CEO outside director than to the appointment of a non-CEO outside director when the firm currently has no outside CEO on its board. Such a positive market reaction is consistent with two hypotheses. Because of their current position, CEOs have an unusual amount of authority and experience. Therefore, once appointed, a CEO outside director could be valuable to the appointing firm because she can monitor and advise the incumbent management in a way that the typical outside director is not able to. We call this hypothesis the performance hypothesis. It is also possible that if a firm succeeds in recruiting a CEO to its board, it shows to the outside world that a business leader whose human capital is especially reputation-sensitive thinks highly enough of the firm to join its board. We call this hypothesis the certification hypothesis. Such certification could have value for the appointing firm even if the CEO outside director has little tangible impact on the firm after her appointment since the appointment might primarily certify the current market value of the firm.

We further test whether there is support in favor of the performance hypothesis by investigating changes in the firm’s operating performance upon appointment of a CEO director. To address endogeneity concerns, we use a matched-firm approach, a difference-in-difference approach, and an instrumental variable approach. We fail to reject the null hypothesis that the appointment of a CEO outside director has no impact on operating performance except in the case of interlocks where the appointment is followed by significantly poorer performance. Next, we examine whether CEO directors are associated with better board decision-making. First, we find little evidence of improved CEO turnover decisions, but we find some evidence that interlocks make the CEO more comfortable in her position. Second, firms with CEO outside directors do not make better acquisitions, where the quality of an acquisition is measured by the firm’s abnormal return at the time of the acquisition announcement. Finally, we find no evidence that CEO outside directors affect how the appointing firm’s CEO is compensated.

Overall, our findings are consistent with the following interpretation. The appointment of a CEO outside director helps certify the appointing company and its management, but it does not lead to measurable improvements in operating performance or corporate policies. With the certification hypothesis, CEO outside directors differ from other directors because their status and reputation enable them to credibly certify the firms that appoint them. CEO outside directors may be sought after by many firms, but they choose strategically their board seats in large, mature firms that they seem to understand, perhaps because they are worried about damage to their reputation should they be involved with a failing firm. Our results on the determinants of CEO director appointments confirm this matching process. It could be that the CEO outside director has no impact on operating performance or corporate policies, perhaps because CEO directors are simply too busy with their day job to use their prestige, authority, and experience to have a substantial impact on the boards they sit on.

The full paper is available for download here.

Directors’ Monetary Liability for Actions or Omissions Not in Good Faith

This post is by Scott J. Davis of Mayer Brown LLP.

Michael Torres, who is my colleague at Mayer Brown LLP, and I have written a paper titled Directors’ Monetary Liability for Actions or Omissions Not in Good Faith, based on a paper we submitted to the Ray Garrett Jr. Corporate and Securities Law Institute at Northwestern Law School. It has long been established that damages are available against directors when they engage in self-dealing or similar actions in situations in which they have a conflict of interest. Few issues in U.S. corporate law, however, are as controversial as whether directors should be exposed to damages for their actions or omissions in situations in which they do not have a conflict of interest. Advocates of such damages awards argue that they are appropriate in extreme cases of directorial misconduct and an important deterrent to future misconduct. Opponents of such awards argue that courts cannot reliably distinguish between extreme cases of misconduct and routine cases of negligence, and that well-qualified persons will not serve as directors if they are exposed to this type of monetary liability.

Since the enactment of section 102(b)(7) of the Delaware General Corporation Law, it has been clear that directors could still be responsible for damages for breaches of the duty of loyalty involving conflicts of interest – for example, being on both sides of a transaction to which the corporation was a party – and could not be held liable for money damages for breaching their duty of care, even if they were grossly negligent. The question was whether there was any real-world basis for imposing damages on directors in situations in which they did not breach their duty of loyalty on conflict of interest grounds.

Beginning in the middle 1990s with the Caremark decision, the Delaware courts answered that question in the affirmative by making it clear that certain conduct of directors who did not have a conflict of interest could constitute acts or omissions not in good faith that would expose them to damages. As the law has developed, there has been no bright line rule defining such conduct. Consequently, there is no shortcut to examining the cases decided inside and outside of Delaware in determining where the law now stands. Most of these cases were brought as derivative lawsuits, and the reported decisions were issued in deciding defendants’ motions to dismiss because of the plaintiffs’ failure to make a demand on the company’s board of directors. We briefly analyze a number of these decisions, dividing them into cases in which the directors are accused of failing to act and therefore violating their duty of oversight and cases in which the directors are accused of acting improperly. We reached the following conclusions from this analysis:

1. The courts are anxious to limit monetary liability for bad faith to situations in which directors knowingly countenanced wrongdoing or knowingly engaged in wrongful conduct. The test laid down in Stone v. Ritter, 911 A.2d 362 (Del. 2006), for bad faith oversight is that the directors knew that they were not discharging their obligations of oversight because they utterly failed to implement any reporting or information system or controls or, having implemented such a system or controls, consciously failed to monitor or oversee their operations. The test for bad faith action laid down in In re the Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006), is intentional dereliction of duties or a conscious disregard of one’s responsibilities. Thus, the case law, in both the oversight and the action situations, indicates that bad faith has a mens rea requirement: bad faith requires scienter, i.e., an illicit state of mind. Anything less is no more than gross negligence, which Disney defined as not bad faith.

2. However, the line between bad faith and negligence or gross negligence can be blurry, especially in merger or sale cases. It is arguably difficult to distinguish between the bad faith conduct of the director held liable in In re Emerging Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del. Ch. 2004), for permitting an unfair transaction and the director in Gesoff v. IIC Industries, Inc, 902 A.2d 1130 (Del. Ch. 2006), or the directors in McPadden v. Sidhu, 964 A.2d 1262 (Del. Ch. 2008), who permitted unfair transactions but were exonerated because their conduct, while negligent or grossly negligent, did not rise to bad faith. It is possible that Emerging Communications is an anomaly because lawsuits challenging directors’ good faith, absent a conflict of interest, in merger and sale transactions have been mostly unsuccessful. See, in addition to Gesoff and McPadden, In re Lear Corporation Shareholder Litigation, 2008 WL 5704774 (Del. Ch. 2008), and Lyondell Chemical Company v. Ryan, 2009 WL 790477 (Del. 2009).

3. McCall v. Scott, 239 F.3d 808 (6th Cir.), amended on denial of rehearing, 250 F.3d 997 (6th Cir. 2001), and In re Abbott Laboratories Derivative Shareholder Litigation, 325 F.3d 795 (7th Cir. 2001), suggest (admittedly based on a small sample) that courts outside of Delaware may be more inclined to allow oversight claims to proceed than Delaware courts are. Indeed, Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003), Stone v. Ritter, Desimone v. Barrrows, 924 A.2d 908 (Del. Ch. 2007), Wood v. Baum, 953 A.2d 136 (Del. 2008), and In re Citigroup Inc. Shareholder Litigation, 964 A.2d 106 (Del. Ch. 2009), are all Delaware cases in which oversight claims were dismissed, with AIG Consolidated Derivative Litigation, 965 A.2d 763 (Del. Ch. 2009), being a counterexample.

4. The courts appear to be drawing a distinction between directors’ oversight or actions resulting in bad business decisions that did not result in illegality or fraud and those that did. In the former case the courts tend not to find bad faith. See Citigroup, Gesoff, Disney, McPadden, Lear and Lyondell. In the latter case the courts will find bad faith if the complaint supplies particularized allegations of a knowing failure of oversight or knowing misconduct. See McCall, Abbott, AIG, Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), and In re Tyson Foods Consolidated Shareholder Litigation, 919 A.2d 563 (Del. Ch. 2007). The courts are concerned that the availability of damages for bad faith not lead to directors being second-guessed for business decisions that were merely wrong.

The paper is available here.

Making Investors a Priority in Regulatory Reform

Editor’s Note: The post below by Commissioner Luis Aguilar is a transcript of remarks by him at the recent 2009 Independent Directors Conference Workshop in Boston.

It is a pleasure to be here with all of you at the 2009 Independent Directors Conference Workshop to share my views on the regulatory reform issues currently being discussed. I do have to mention that all the views I express today are my own and do not necessarily reflect those of the Commission, the individual Commissioners, or the staff.

I welcome the opportunity to talk with you today. As a practitioner in the securities industry for thirty years who often advised boards of directors, including mutual fund boards, I am familiar with your work and know its importance. I have the utmost admiration for independent directors. You more than anyone have to exemplify the principle that — laws tell you what you can do but values inspire what you should do. As fiduciaries, you play a critical role in setting the appropriate tone at the top and overseeing some of the most important aspects of the fund’s business from keeping fees in line to negotiating important contracts.

Your efforts are crucial to safeguarding the retirement savings and investments of hard working men and women. At the end of 2008, mutual funds, including money market funds, were collectively responsible for approximately $9 trillion of investors’ monies invested in countless corporations, municipalities and myriad investment opportunities. These assets represented the savings of over 92 million individuals.

I have had the distinction of serving on the Commission during “transformational” times, to say the least. I took office at the end of July 2008 and literally my first two months were filled with unprecedented Commission action — running the gamut from being involved with some of the SEC’s largest settlements ever in cases involving Auction Rate Securities to an unprecedented amount of emergency rulemaking and Commission orders.

Now even though the financial crisis continues, the rapid response phase of the crisis is giving rise to discussions of reform resulting from that crisis. In fact, the issues being discussed could very well lead to the largest wholesale regulatory restructuring this country has seen since the great depression. For example, we at the SEC currently find ourselves enmeshed in parallel discussions about the structure of the financial regulatory system, the SEC’s role in such a system, and the regulation of entities under our jurisdiction.

Like me, you too have the opportunity and challenge of representing investors in a time of “transformation.” The global financial crisis has brought us to a point where transformation of existing financial regulation is a given.

The opportunity to take a fresh look involves all of us here today, we at the SEC, and you as fiduciaries, overseeing trillions of dollars that represent a substantial portion of our Nation’s wealth.


Institutional Monitoring Through Shareholder Litigation

This post comes from C.S. Agnes Cheng of Louisiana State University, Henry Huang of Prairie View A&M University, Yinghua Li of Purdue University, and Gerald J. Lobo of the University of Houston.

Our paper, Institutional Monitoring through Shareholder Litigation, forthcoming in the Journal of Financial Economics, investigates the effectiveness of using securities class action lawsuits in monitoring defendant firms. We compare differences in (1) immediate litigation outcomes (including the probability of surviving the motion to dismiss and the settlement amount), and (2) subsequent governance improvement (specifically changes in board independence), across class action lawsuits led by institutions versus individuals. We find that securities class actions with institutional owners as lead plaintiffs are less likely to be dismissed and have larger monetary settlements than class actions with individual lead plaintiffs. We also find that after the lawsuit filings, defendant firms with institutional lead plaintiffs experience greater improvement in their board independence than defendant firms with individual lead plaintiffs.

Our paper is motivated by the lack of evidence on the effectiveness of institutional investors exercising their monitoring power through litigation. Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs. Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class action litigation. In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, from both an immediate disciplining of management as well as a long-term corporate governance perspective.

We believe a theory of why and under what conditions institutions will choose to lead a class action is important. Because of the free-rider problem, we propose that institutions will step forward to lead the class actions only when their net benefits are higher than attorney agency costs. We discuss the costs and benefits for institutional owners and develop surrogates for their incentive to serve. Our determinants model provides insights regarding institutions’ incentives to serve as the lead plaintiff. We also use this model to control for endogeneity in investigating monitoring effectiveness.

Using a sample of 1,811 securities class actions filed between 1996 and 2005, we find that when the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff. Specifically, we find that institutional investors are more likely to serve as the lead plaintiff when the lawsuit involves an accounting-related allegation, has an accounting firm as the co-defendant, has a longer class period, has a larger negative market reaction to the revelation event, and has a larger potential investor loss. The probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

After controlling for these determinants of having an institutional lead plaintiff in our multivariate regression analysis, we find that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements. Further analysis indicates that all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount. We also find that within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs. These results are robust to controlling for regulatory changes in the NYSE, NASDAQ and SEC corporate governance requirements during the sample period and for determinants of having an institutional lead plaintiff.

The paper is available here.

Winds of Change in the SEC’s Division of Enforcement

This post is based on a client memo by John F. Savarese and Wayne M. Carlin of Wachtell, Lipton, Rosen & Katz.

This is a period of significant change in the SEC’s enforcement program. A variety of new measures have already been implemented and numerous additional proposals are currently under consideration. The implications are likely to be significant for any company or financial institution that may be responding to SEC investigations in the months ahead. New policy decisions and their methods of implementation are likely to affect such matters as the SEC’s deployment of its resources, the pace and focus of investigations and opportunities for timely resolution of enforcement inquiries.

Chairman Mary Schapiro and Director of Enforcement Robert Khuzami have focused on speeding up the process of conducting investigations and bringing cases. One of Chairman Schapiro’s first acts was to terminate the agency’s “pilot program” regarding financial penalties, which had been widely viewed as slowing the enforcement process. We view this as a favorable development, given the practical concerns that our firm initially raised about this program. SeeImplications of the New SEC Penalty Policy” (May 15, 2007); “SEC Penalties Revisited” (June 8, 2007). Another early step was to streamline the procedure by which the staff obtains formal orders of investigation, which permit the staff then to issue investigative subpoenas as needed to obtain documents and testimony.

Congress appears poised to authorize the SEC to hire more staff and to increase its budget, and on May 7, 2009 the Obama Administration proposed a 6.8% funding increase for the agency in fiscal 2010. The key issue to watch is how the agency uses the new money, and who it hires to fill the new slots. Everyone’s interests will be best served if the SEC is able to recruit to its ranks new staff who will bring the agency the benefit of experience. In Congressional testimony on May 7, 2009, Mr. Khuzami stated that one of his goals is to increase the staffing of Enforcement’s trial unit. See here. This would be a positive development. Bringing more trial lawyers on board will enable the SEC to try more cases – but involving those seasoned trial lawyers in the pre-authorization case review process will also enhance the enforcement staff’s ability to identify the cases that should not be brought because they will be losers in court.

The GAO has also emphasized the theme of streamlining the SEC’s internal processes to allow investigations to be completed and cases filed more swiftly, in its report on the SEC’s enforcement program issued on May 7, 2009. See here. Streamlining is a laudable goal. At the same time, not all investigations should be pursued to completion, and not all investigations should lead to enforcement actions. The goal of bringing meritorious cases more rapidly should not compromise the staff’s ability to weed out the investigations that should be closed without action.

As the SEC’s new leadership contemplates reform, there are some additional ideas that should be considered. While these suggestions would in some ways be advantageous for companies involved in investigations, they would at the same time enhance the SEC’s own efficiency and effectiveness:

Early meetings with defense counsel – The willingness of enforcement staff to meet with defense counsel and engage in a dialogue early in an investigation varies greatly among SEC offices. An open-door policy and a willingness to listen is not only fair to the parties involved, but in the SEC’s own interest. These early discussions can bring factual information to the attention of the staff that will enable them to narrow or even close investigations at an early stage, so that their limited resources can be deployed on more promising matters. Prudent defense counsel will not abuse the opportunity to meet with the staff, and will use this approach only in inquiries that genuinely warrant being closed down early.

Better coordination among investigating authorities – It is commonplace for SEC investigations to be accompanied by parallel investigations of the same facts by one or more other regulatory or prosecutorial authorities. In some cases, parallel proceedings are appropriate. In many cases, however, little if any public interest is served by multiple simultaneous investigations of the same facts. The main result is an exponential increase in the cost of the investigation for the parties involved, as well as misallocation of regulatory resources. While this is a problem that the SEC does not have the unilateral ability to solve, senior officials should use their persuasive powers to discourage unnecessarily duplicative investigations.

Open the investigative files – The SEC’s enforcement manual, which was publicly released last year, recognizes that the staff has discretion to provide access to its evidentiary files to defense counsel at the conclusion of an investigation, as part of the Wells process, in which the staff engages in dialogue with counsel concerning possible enforcement action. In practice, the staff’s willingness to exercise this discretion varies greatly, and full open access is rare. In most cases at this stage, there is no compelling need to maintain secrecy about the testimony of witnesses or the contents of documentary evidence. Decision-making by the senior staff and by the Commission itself will be better-informed at the Wells stage if defense counsel are able to see the evidentiary record. This cuts both ways. Open access will help expose cases that have weak evidentiary support and should be closed or narrowed. At the same time, defense counsel will be better able to recognize cases where the staff’s evidence is strong and where a settlement should be pursued.

Additional proposals are bound to come under discussion as the agency’s new leadership continues to think creatively about improving the effectiveness of the enforcement program. This process should continue to include careful analysis of the likely practical effects of each new idea. For companies involved in investigations, it is essential to be mindful of the ongoing changes at the SEC, and the opportunities and challenges for effective advocacy that they present. Getting meritorious cases resolved sooner, while also weeding out marginal investigations faster, should be in everyone’s interests.

The SEC’s Proxy Access Proposal

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

The Securities and Exchange Commission voted last week to ask the public to comment on a proposal to let shareholders place director candidates on the corporate ballot. The adoption of such a rule would be a useful step toward the necessary reform of corporate elections.

As my research has shown, it’s hard for shareholders to replace directors, and electoral challenges to incumbent directors are infrequent. One main impediment to such challenges is incumbents’ control of the company’s proxy card – the corporate ballot sent by the company at its expense to all shareholders. While board-nominated candidates appear on the ballot, challengers must bear the costs of sending (and getting back) their own proxy card to shareholders.

The SEC’s proposal would provide shareholders in certain limited circumstances with “proxy access” – the right to place director candidates they nominate on the company’s proxy card. To be allowed to place candidates on the corporate ballot, a shareholder (or a group of shareholders) will need to hold 1%-5% of the shares (depending on the company’s size) for more than one year. These requirements mean that only long-term shareholders with a significant stake will be able to propose their own directors.

Opponents of the SEC’s proposal argue that the SEC shouldn’t impose a blanket rule about proxy access, but rather should leave the provision of proxy access arrangement to company-by-company choices. One size does not fit all, the argument goes, and the SEC’s proposal would prevent variation and experimentation.

It is ironic that opponents of proxy access now raise the banner of company-by-company choices. In 2007, the SEC examined whether to let shareholders propose bylaw amendments that would establish proxy access for shareholders seeking to nominate directors. At that time, opponents of proxy access persuaded the SEC to prohibit the inclusion of such proposals on the ballot. This prohibition made it rather difficult for shareholders to adopt proxy access arrangements on a company-by-company basis. For many opponents of proxy access, then, uniformity seems to be quite acceptable when it doesn’t involve shareholder access but becomes unacceptable when it does.

In fact, the proposed SEC rule would allow some meaningful variation. The proposal would establish some mandatory requirements as to shareholders nominations that would have to be included, but would allow companies to adopt arrangements providing shareholders with more expansive access to the company’s proxy.

Opponents also argue that establishing any minimum requirements for inclusion of director candidates on the company’s proxy card departs from the SEC’s traditional role into an area best left for state corporate law. However, the SEC’s proxy rules already mandate the inclusion of some information, including certain shareholder proposals, on the corporate ballot and accompanying proxy materials. The SEC’s proposal would merely expand the current mandatory requirements, and wouldn’t enter any new territory.

The objections to the SEC proposal are weak. Indeed, the proposed proxy access should be supplemented with additional reforms of corporate elections.

First, proxy access wouldn’t eliminate the cost advantage of incumbent directors, whose campaign expenses are fully financed by the company. To reduce this cost advantage, firms should reimburse the campaign expenses of successful challengers.

Second, firms should dismantle staggered boards. All directors should stand up for election at each annual shareholder meeting.

Furthermore, the arrangements governing corporate elections should be set by shareholders, not by the very directors whose election is regulated by these arrangements. To this end, as the SEC’s release suggests, shareholders’ ability to adopt election bylaws should be facilitated. In addition, boards shouldn’t be permitted to adopt bylaws making their own removal more difficult or to repeal any shareholder-adopted election bylaws.

The case for comprehensive reform of corporate elections is supported by a significant body of empirical evidence. Arrangements that insulate directors from removal are associated with lower firm value and worse performance.

The proxy rules have been intended by Congress, the courts have stated, “to give true vitality to the concept of corporate democracy.” Adopting the SEC proposal, and the additional reforms I discussed, would advance this important goal.

Assessing “continuing director” change-in-control provisions

This post is based on a memo by Laurent Alpert, Robert Davis, Victor Lewkow and Daniel Sternberg from Cleary Gottlieb Steen & Hamilton LLP. 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.

A Delaware Chancery Court decision last week raises significant questions regarding the interpretation and validity of various types of “continuing director” change-in-control provisions that are common features in one formulation or another in loan agreements, indentures and other contracts. Following the opinion, some existing provisions may not be interpreted as expected by some lenders and other existing provisions may be invalid. The court’s opinion also raises considerations for boards approving financing and other agreements (including employment agreements and benefit plans) with such provisions in the future and for lawyers negotiating such agreements, advising boards and drafting disclosure regarding such provisions.

San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc. arose out of a proxy contest in which two separate dissident stockholders [1] of Amylin, prevented from agreeing to form a unified minority slate by the Company’s “poison pill,” each proposed a slate of five nominees to the 12-member Amylin Board of Directors, thereby raising the possibility that a majority of the Board could be changed at the upcoming Annual Meeting despite each stockholder’s seeking only minority representation. Amylin’s public Indenture [2] contains a common change in control provision giving noteholders the right to put their notes to the company at par if “at any time Continuing Directors do not constitute a majority of the Company’s Board of Directors”. The term “Continuing Directors” is defined as directors in office on the Issue Date of the Notes and “any new directors whose election to the Board of Directors or whose nomination for election by the stockholders of the Company was approved by at least a majority of the directors then still in office…either who were directors on the Issue Date or whose election or nomination for election was previously so approved.”

One of the insurgents requested that the Board (consisting entirely of Continuing Directors) approve the nomination of both dissident slates of nominees for purposes of this Indenture provision, even though the Board continued to recommend its own slate and oppose the election of the dissidents’ nominees. The Board refused the request and a stockholder commenced a suit seeking a declaration that the board had the power to approve the dissidents’ nominees and a fiduciary obligation to do so. In a partial settlement of the stockholder lawsuit, the Board agreed to approve both dissidents’ slates of nominees subject to obtaining a court order confirming the Board’s contractual right to do so. The Indenture Trustee, however, continued to litigate, arguing that the word “approve” in the Indenture is synonymous with “endorse” or “recommend”, and that the Board could thus not both run its own slate and simultaneously “approve” the dissident slate for purposes of the Indenture.

Following a trial on limited issues, Vice Chancellor Lamb disagreed with the Indenture Trustee, concluding that the language of the Indenture was clear and that the Board had the right to approve the dissident nominees for purposes of the Indenture even though actively opposing their election. The court stated that to interpret the Indenture to prohibit such Board approval of dissidents would have:

“an eviscerating effect on the stockholder franchise [that] would raise grave concerns. In the first instance, those concerns would relate to the exercise of the board’s fiduciary duties in agreeing to such a provision. The court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting such a provision, it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it. Additionally, the court would have to closely consider the degree to which such a provision might be unenforceable as against public policy.”

Having decided that the board had the power to approve such stockholder nominees, the court turned to whether the board’s agreement to approve the two slates in this case complied with the company’s implied duty of good faith and fair dealing inherent in the indenture, as in all contracts. While the Vice Chancellor concluded that, under the record before him, a decision on this question was not ripe for resolution, the opinion discusses the relevant standard for a board’s decision to exercise its power to approve nominees and concluded that “the board may approve a stockholder’s nominees if the board determines in good faith that the election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders. [3] And the court further noted that “the directors are under absolutely no obligation to consider the interests of the noteholders in making this determination”.


Throwing Off the TARP – Implications of Repaying Uncle Sam

This post is by Philip A. Gelston’s partners B. Robbins Kiessling, Sarkis Jebejian and Erik R. Tavzel.

In October 2008, the U.S. Treasury launched the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), pursuant to which the Treasury has invested nearly $200 billion in over 500 financial institutions.[1] Almost from the start, the boards and managements of many TARP-recipient institutions have focused on when and how to get out from under Uncle Sam’s umbrella.

The stress test results have now been released, and Secretary Geithner has said that adequately capitalized financial institutions “will have the opportunity to repay” their TARP capital. Conventional wisdom has been that many institutions will rush to repay the government capital. Repurchasing this capital would appear to secure several clear advantages, including the opportunity to repurchase the related warrants at low valuations, the elimination of TARP-related restrictions on executive compensation and the reduction of government influence on governance and management.

There are several issues, however, that should be considered in determining whether to redeem TARP capital. The board and management of TARP recipients should consider whether repayment will require raising new capital today and the cost of that capital, the financial institution’s future capital needs and the potential sources of capital and the likelihood of continued government, shareholder and public scrutiny of compensation practices even after the TARP repayment.

The first part of this bulletin briefly describes the conditions to repayment and the requirements regarding the source of funds for repayment. The second part discusses issues that the board and management of financial institutions that received TARP capital should consider in determining whether to repay the Treasury.

The terms of the contracts governing the CPP investments permit repayment only with the consent of the financial institution’s primary Federal regulator and require repayment during the initial three-year period after issuance to be funded entirely with the proceeds of cash sales of Tier 1 perpetual preferred stock or common stock. The economic stimulus bill, however, directed the Secretary of the Treasury to permit a TARP recipient to redeem TARP capital, after consultation with its primary Federal regulator, without regard to the source of the funds or the lapse of any period of time.

The May 6th Joint Statement issued by Treasury Secretary Tim Geithner, Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair and Comptroller of the Currency John Dugan outlined several conditions to the repayment of TARP funds:

• “Supervisors will carefully weigh an institution’s desire to redeem outstanding CPP preferred stock against the contribution of Treasury capital to the institution’s overall soundness, capital adequacy, and ability to lend, including confirming that [bank holding companies] have a comprehensive internal capital assessment process.”• “All [bank holding companies] seeking to repay CPP will be subject to existing supervisory procedures for approving redemption requests for capital instruments.”

• In order to repay, the 19 banks which underwent the stress testing process must demonstrate, based on their post-repayment capital structure, that at the end of 2010, assuming the adverse macroeconomic scenario employed in the stress tests, they will have a Tier 1 risk-based ratio of at least 6% and a Tier 1 common risk-based ratio of at least 4%.

• Additionally, these 19 banks must be able to demonstrate their “financial strength by issuing senior unsecured debt for a term greater than five years not backed by FDIC guarantees, in amounts sufficient to demonstrate a capacity to meet funding needs independent of government guarantees.”

Previously, in testimony before the Congressional Oversight Panel on April 21, 2009, Secretary Geithner had said the “ultimate test” for repayment would be whether an individual bank’s repayment would result in a reduction in the overall credit available to the economy.

Based on the above, it appears that, legally and practically speaking, the required source of funds for repayment of TARP funds will depend primarily on an institution’s financial strength, capital adequacy and liquidity, as determined by the Federal Reserve (or Office of Thrift Supervision in the case of thrift holding companies). Moreover, the approval of the regulator for any redemption (as opposed to mere consultation) may be required under existing supervisory procedures (for example, under Federal Reserve regulations and policies, if the redemption would reduce consolidated net worth by 10 percent or more or have a “material effect” on the institution’s capital base). Strong financial institutions with adequate capital and liquidity may be allowed to repay TARP capital with funds from any source, including cash on hand or retained earnings. Less well-capitalized financial institutions, however, may be required to adhere more closely to the original terms of the CPP and repay at least a substantial portion of the TARP funds with the proceeds of Tier 1 capital issuances.


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