Monthly Archives: June 2009

Assessing the Chrysler Bankruptcy

Editor’s Note: This post by Professor Mark Roe appears today on

Last week, the Supreme Court turned down the last appeal from the creditors objecting to the Chrysler reorganization and the deal closed on the next day. Chrysler has been sold in bankruptcy.

This is a good time to assess Chrysler’s bankruptcy. At one level, it’s reason to be optimistic that bankruptcy reorganizations could move more quickly than the year or two they usually take. As a matter of technical bankruptcy prowess–in moving through chapter 11 so quickly–it’s an admirable accomplishment. As a matter of governance structure, it has the United Auto Worker union retirees as major shareholders of the new Chrysler, mixing up the UAW’s incentives as employees looking for higher wages and as owners looking for more productivity, in a way that hasn’t obtained media attention yet but which may prove to be clever.

At another level, though, the speed of reorganization is a cause for concern: How could the Chrysler deal be done so much more quickly than a typical chapter 11 reorganization? Were corners cut?

Crucially, the government is flooding Chrysler with money on non-commercial terms, inducing enough players to agree to the deal, rather that fight over the scraps. Chrysler, which was in such horrid shape last fall that the government was ready to let it liquidate, gets another chance. The speed of the bankruptcy may not be replicable in a normal chapter 11, without the government flooding troubled companies with money.

While structured in the form of a sale from the “old Chrysler” to a “new Chrysler” that Fiat and the UAW own, with the government having a sliver of an interest in the reorganized firm, the de facto deal was really that the government bought Chrysler from the creditors, giving it to the UAW, flooding Chrysler with cash, and hiring Fiat to manage it. The idea that Fiat is buying Chrysler is greatly exaggerated. All of the money came from the U.S. Treasury; and since government money doesn’t fuel ordinary chapter 11 reorganizations, there’s one reason to think Chrysler was a stand-alone bankruptcy event.


Annual Survey of Developments in Delaware Corporation Law

This post is from Eric S. Wilensky and Angela L. Priest of Morris, Nichols, Arsht & Tunnell 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.

In the current recessionary environment, rather than looking outward for the next big deal, many corporations are turning their focus inward, reviewing and shoring up their own governance structures, defensive mechanisms, indemnification schemes and governing documents. Knowledge of recent Delaware jurisprudence is helpful in such a review, as in numerous instances over the past year, the Delaware courts have released opinions addressing and interpreting corporate charter and bylaw provisions and indemnification agreements. This article surveys the relevant Delaware developments, which are summarized briefly below.

Bylaw Provision Cases

Bylaw provisions were a hot-button issue in 2008, with Delaware court opinions touching on advance notice, proxy expense reimbursement and indemnification and advancement provisions. Two of the most talked-about corporate opinions of 2008, JANA Master Fund, Ltd. v. CNET Networks, Inc. and Levitt Corporation v. Office Depot, Inc., focused on the legal interpretation of advance notice bylaw provisions, making clear in each case that the Delaware courts will likely construe such provisions strictly, and where ambiguous, in favor of the stockholder franchise.

The Delaware Supreme Court, on certification from the SEC, also weighed in on the legality of proxy expense reimbursement bylaw provisions in CA, Inc. v. AFSCME Employees Pension Plan, and the Delaware legislature thereafter approved amendments to the DGCL that will specifically allow corporations to include proxy reimbursement and proxy access provisions in their bylaws.

Finally, numerous opinions by the Delaware courts involved the interpretation of indemnification and advancement bylaw provisions. Specifically, the Court of Chancery discussed when indemnification and advancement rights vest (spurring the approval of legislation that clarifies this issue) and provided guidance on “fees on fees” awards in Schoon v. Troy Corp. The Delaware Court of Chancery also interpreted the terms “defense” (Reinhard v. The Dow Chemical Company, Zaman v. Amedeo Holdings, Inc., Duthie v. CorSolutions Medical, Inc. and Sun-Times Media Group, Inc. v. Black), “agent” (Jackson Walker LLP v. Spira Footwear, Inc. and Zaman), “proceeding” (Donohue v. Corning) and “final disposition” (Sun-Times), which terms consistently appear in indemnification and advancement bylaws.

Charter Provision Cases

In 2008 and early 2009, the Delaware courts also addressed Section 102(b)(7) charter provisions (limiting monetary liability for directors for breaches of the duty of care) in a series of fiduciary duty cases, beginning with Ryan v. Lyondell Chemical Co., in which the Court of Chancery denied a motion to dismiss a claim that non-conflicted directors breached their duty to act in good faith with respect to a transaction that would provide stockholders with a large premium for their shares. Subsequent cases, including McPadden v. Sidhu, In re Lear Corporation Shareholder Litigation and the Delaware Supreme Court’s reversal of Lyondell, however, made clear that such provisions remain a powerful shield for directors against monetary liability for breaches of the duty of care.

Indemnification Agreements

The Court of Chancery’s decision in Schoon highlighted the role of private indemnification agreements, and in Levy v. HLI Operating Co., the Court of Chancery focused both on the extent to which Section 145(f) of the DGCL may be relied upon in expanding the scope of indemnification and advancement beyond what is expressly set forth in the DGCL and on indemnification in the context of private equity fund designees serving on the board of a portfolio company.

* * * * *

Our article summarizes these developments within the context of the relevant corporate governing documents in order to aid in the review of such documents. We do not intend to conduct an exhaustive analysis on any particular topic or case, but rather to raise awareness of certain interpretive guidelines found within these opinions. Delaware law continues to provide much leeway for private ordering, and awareness of interpretive case law is important in ensuring that a corporation’s governing documents are drafted carefully, have the intended effects and reflect the needs and desires of the corporation.

The article is available here.

(The article is reproduced with permission from Securities Regulation & Law Report, 41 SRLR 921 (May 18, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033)

Flaws in the AIG Trust

Editor’s Note: This post is by J.W. Verret of the George Mason University School of Law.

I had the opportunity to testify before the House Oversight Committee recently on a panel along with Ed Liddy, the CEO of AIG, and the three trustees nominated by the Federal Reserve to manage the government’s $180 billion investment in AIG. The subject of my testimony, available here, was the Trust Agreement designed by the Federal Reserve Bank of New York to form the AIG trust. This Trust Agreement was crafted during Secretary Geithner’s tenure at the NY Fed, and Secretary Geithner has announced that he will be creating a Trust in the near future to manage the government’s voting common equity in Citigroup and other TARP banks. One concern motivating my testimony is that the flaws in the AIG Trust will find new life in these subsequent TARP Trusts. This is of particular concern because the government and the trusts it creates enjoy unprecedented immunity, despite being a controlling shareholder, under Section 3(c) of the Exchange Act, the Emergency Economic Stability Act, and through sovereign immunity principles generally.

The first cause for concern in the AIG trust is that the fiduciary duty of the trustees is not clearly defined, and is likely to be defined by the Treasury Department. The document states that the trustees’ standard of care is to act “in or not opposed to the best interests of the Treasury.” Though “Treasury Department” is a defined term in the document, “Treasury” is not. The AIG trustees argued that their personal understanding was they were required to maximize the value of the taxpayer’s investment, but that is not required by the AIG Trust. This threatens the very purpose of the AIG Trust, which is to serve as a buffer from the short term political interests of the government that may threaten AIG’s long term financial health. For more on that threat, see my op-ed in Forbes here.

Another controversial issue with the AIG Trust is that it includes a corporate opportunity opt-out provision. This permits the Trustees to personally take business or investment opportunities that fall within AIG’s line of business, and that they learn about through their service as Trustees, without notifying or getting permission from AIG or the Federal Reserve. Corporate Opportunity opt-outs are not unheard of in the corporate world, though they are controversial, and their use in this context requires serious consideration. Part of the testimony also featured a spirited debate between myself and one of the Trustees, also the CEO of El Paso Energy, over whether the indemnification provisions included in the Trust are consistent with the level of indemnification permitted for directors of Delaware corporations. I noted that Delaware does not permit indemnification for actions not in good faith, a limitation which is not included in the AIG Trust. The broadcast is available on C-Span here.

Designing the Trusts that manage the government’s investment in TARP Banks, Financial Companies, and the Automotive Industry requires precision and caution. Poor draftsmanship in these deal documents could have serious consequences for the government’s investment in TARP, as well as for the holdings of private shareholders in TARP companies.

Electing Directors

This post comes from Jie Cai, Jacqueline L. Garner, and Ralph A. Walkling, all of Drexel University.

Shareholder representation by the board of directors is a fundamental component of corporate governance. A great deal of research has focused on the characteristics of corporate boards, yet we know little about uncontested director elections. The subject is particularly important in today’s environment. Congress, stock exchanges, and individual firms have instituted dramatic governance changes. Moreover, shareholders, activist organizations, the New York Stock Exchange (NYSE), and the Securities and Exchange Commission (SEC) have proposed and debated additional changes to the method by which directors are elected. Apart from directors, shareholders do not have representation in the companies they own. If shareholder impact on director elections is weak, so is the link between owners and managers.In our forthcoming Journal of Finance paper, Electing Directors, we examine the determinants as well as the efficacy of uncontested director elections on a large sample of firms in the post-Sarbanes Oxley Act (SOX) era. We test several hypotheses relating performance at both the firm and director levels to the votes directors receive. We also examine whether votes matter to subsequent performance, compensation, or governance.

Our sample consists of 13,384 director elections at 2,488 different shareholder meetings during 2003 to 2005. We find that while director and firm performance as well as corporate governance characteristics affect how shareholders vote, the resulting differences in the level of votes are trivial. In general, the differences in votes are statistically significant but economically minor. At both the firm and director levels, votes exceeding 90% are the norm even for poorly performing firms and directors. There are two exceptions: directors attending less than 75% of board meetings or receiving a negative ISS recommendation receive 14% and 19% fewer votes, respectively. However, even though the variation in director votes is small, we find that fewer votes for compensation committee directors significantly impact subsequent abnormal CEO compensation, and fewer votes for independent directors impact subsequent CEO turnover. Also, the removal of poison pills and classified boards is significantly linked to director votes. Nevertheless, lower levels of votes appear to have little impact on the election of directors themselves or on subsequent firm performance. Directors also do not appear to suffer reputational effects from low votes.

The full paper is available for download here.

Compensation Structure and Systemic Risk

Editor’s Note: This post is the written testimony (with footnotes and appendix omitted) submitted by Professor Lucian Bebchuk to the Committee on Financial Services, United States House of Representatives. Professor Bebchuk will be testifying today in the hearing on “Compensation Structure and Systemic Risk.” The hearing will begin today at 10a.m., and information about it and a link to a webcast of it can be found here. Professor Bebchuk’s complete written testimony (including footnotes and appendix) can be found here.

Mr. Chairman and distinguished members of the Committee, thank you very much for inviting me to testify today.

Below I discuss how executive pay arrangements have produced incentives for excessive risk–taking and contributed to bringing about the current financial crisis, how compensation arrangements can be reformed to avoid such incentives, and what role the government should play in bringing about such reforms.

Section I describes the distortions that have been produced by the short-term focus of pay arrangements, and discusses the best ways for tying executive pay – particularly equity compensation – to long-term results. Section II describes another separate and important source of incentives that has thus far received little attention but that could well have contributed substantially to excessive risk-taking in financial firms: the tying of executive payoffs to levered bets on the value of the bank’s capital. That section also discusses how this problem can be best addressed.

Finally, section III discusses the role of the government. For financial firms that pose systemic risks, bank regulators seeking to protect the safety and soundness of such firms should monitor and regulate the extent to which pay arrangements provide incentives for risk-taking. For other publicly traded firms, the government’s role should be limited to strengthening the rights of shareholders and the governance processes inside firms, and the government should avoid intervening in the substantive choices made by the firms.

A fuller development of some of the points made in Section I can be found in “Equity Compensation for Long-term Performance,” a forthcoming white paper co-authored with Jesse Fried. Sections II and III draw on “Regulating Bankers’ Pay,” a discussion paper co-authored with Holger Spamann, which develops more fully the points made in these sections and is attached as an Appendix.

For simplicity of exposition, I will use the term “banks” to refer also to any other financial institutions that are deemed to pose systemic risk and are therefore the subject of potential government support and government regulation.


Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. This problem was first highlighted in a book that Jesse Fried and I published five years ago, Pay without Performance: The Unfulfilled Promise of Executive Compensation, and in a series of accompanying articles. It has recently become widely recognized.


Putting Investors First in Regulatory Reform

Editor’s Note: The post below by Commissioner Aguilar is a transcript of remarks by him at the Compliance Week Annual Conference on June 3, 2009 in Washington, D.C.

I am honored to be speaking to a room full of people who spend their days building a culture of compliance. As a former general counsel of a large global asset manager, I have a deep appreciation for the challenges that Compliance Officers face. These challenges are particularly great today. In these times of drastic cost cutting and shrinking revenues, compliance personnel face incredible pressure to do more with less resources and fewer personnel.

Against this backdrop, there is a debate on regulatory reform that deeply affects all of us. Changes to the financial regulatory system will have a significant impact on who regulates the entities you represent and the relationship between the regulator and your employer.

As I consider what is being said about these issues, it has struck me that the regulatory discussion is not being properly oriented. There is a need to shift the dialogue from the discussion of how best to preserve financial institutions to what is best for investors. I firmly believe that the SEC needs to be a strong voice in that discussion, and to vigorously advocate for its mission to protect investors, facilitate capital formation, and maintain fair and orderly markets. The SEC has the right orientation and has the right values to be one of the leaders in the discussion of regulatory reform. The SEC’s job is to fight for Main Street even if that means Wall Street will have to reform. That is why it is so important that the SEC be reinvigorated by Congress and that it strongly reasserts itself into our national policy discussions. Investors need the SEC now more than ever.

Investors around the country are feeling the pain of this economic crisis — in their retirement nest eggs, their college savings plans and in their brokerage accounts. Any credible effort at regulatory reform has to work for investors, so that they can feel confident in our markets. My objective is to ensure that prioritizing investors is the primary goal of any regulatory reform.

To that end, I want to concentrate my remarks today on how to structure a regulatory reform proposal that enhances, rather than undercuts, investor protection. And I want to make clear that the thoughts I express are my own, and they do not necessarily reflect the views of the other Commissioners or the staff of the Commission.

In pursuing regulatory reform, I believe the following must happen:

• First, there must be a searching inquiry into the causes of the crisis;

• Second, there must be a reversal of the philosophy that resulted in the affirmative decisions that forced gaps in, and otherwise undercut, regulatory protections in order to favor the industry;

• Third, there needs to be an assessment of whether the current regulatory reform proposals will protect investors and promote market integrity;

• And I will end with an outline of some reforms I support because they would enhance investor protection.


Proposed Changes to Regulation of OTC Derivatives and CDSs

This post is by Annette L. Nazareth of Davis Polk & Wardwell LLP.

Recently, the House Energy and Commerce Committee Chairman Henry A. Waxman and Subcommittee Chairman Edward J. Markey introduced H.R. 2454, the American Clean Energy and Security Act of 2009 (the “Waxman-Markey Bill” or the “Bill”). The Energy and Commerce Committee approved the Bill on May 21, 2009. Eight other House panels, including Financial Services, have jurisdiction to review the Bill. The Waxman-Markey Bill comprehensively addresses a broad range of issues relating to energy and climate change policy.

Subtitles D and E of Title III of the Waxman-Markey Bill contain significant provisions relating to the regulation of over-the-counter (“OTC”) derivatives generally and energy derivatives in particular (the “Derivatives Provisions”). First, the Bill would shut the Enron Loophole, the London Loophole and the Swaps Loophole. Second, the Bill would subject all OTC derivatives to centralized clearing. Third, the Bill would make “naked” credit default swaps illegal and rescind the preemption of state gaming laws with respect thereto. Finally, the Bill would give the Commodity Futures Trading Commission initial jurisdiction over markets for “regulated allowance derivatives” to regulate in the same manner as energy transactions.

In a memorandum entitled “Derivatives Provisions in the American Clean Energy and Security Act of 2009,” Daniel N. Budofsky, Robert L. D. Colby, Faisal Baloch and I provide a brief background on energy derivatives regulation to place the Waxman-Markey Bill in context. We then summarize and discuss the key Derivatives Provisions of the Bill.

The memorandum is available here.

In another memorandum, entitled “The National Conference of Insurance Legislators’ Model CDS Bill,” Bjorn Bjerke, Daniel N. Budofsky, Robert L. D. Colby, Ethan T. James and I describe model legislation being drafted by the NCOIL that would subject credit default swaps to a state regulatory regime closely modeled on that regulating financial guaranty insurance in New York. The memo discusses NCOIL’s plans for a state CDS regulatory regime and explores the implications of such a regime on the CDS market. That memo is available here.

Regulating Bankers’ Pay

This post is by Lucian Bebchuk and Holger Spamann of Harvard Law School.

The program on corporate governance just issued our discussion paper, Regulating Bankers’ Pay, and it is available here.

The paper seeks to contribute to understanding the role of executive compensation as a possible cause of the current financial crisis, to assessing current legislative and regulatory attempts to discourage bank executives from taking excessive risks, and to identifying how bankers’ pay should be reformed and regulated going forward.

Although there is now wide recognition that bank executives’ decisions might have been distorted by the short-term focus of pay packages, we identify a separate and critical distortion that has received little attention. Because bank executives have been paid with shares in bank holding companies or options on such shares, and both banks and bank holding companies issued much debt to bondholders, executives’ payoffs have been tied to highly levered bets on the value of the capital that banks have. These highly levered structures gave executives powerful incentives to under-weight downside risks.

We show that current legislative and regulatory attempts to discourage bank executives from taking excessive risks fail to address this identified distortion. In particular, recently adopted requirements aimed at aligning the interests of executives tightly with those of the common shareholders of bank holding companies – through emphasizing awards of restricted shares in these companies and introducing “say on pay” votes by these shareholders – do not address this distortion. The common shareholders of bank holding companies, especially now that the value of their investment has decreased considerably, would favor different strategies than that would be in the interest of the government as preferred shareholder and guarantor of some of the bank’s obligations.

Finally, having identified the problems with current legislative and regulatory attempts, we analyze how best to implement recent legislative mandates that require banks receiving TARP funding to eliminate incentives to take excessive risks. Beyond banks receiving governmental support, we argue that monitoring and regulating the structure of executive pay in banks – along the lines we suggest – should be an important element of banking regulation in general, and we analyze how banking regulators should monitor and regulate bankers’ pay.


Here is some more detail about what the paper does:

Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. They have enabled executives to take money off the table before it turned out that gains to earnings and stock prices were in fact illusory. This problem was first highlighted several years ago in a book and accompanying articles co-authored by one of us, and has recently become widely recognized. There is no question that short-termism could have contributed to excessive risk-taking, and a contemporaneous paper co-authored by one of us with Jesse Fried shows how compensation arrangements can be best designed to eliminate the potential distortions from such short-termism. But we identify in this paper some other key features or current and past pay arrangements that would lead to excessive risk-taking even in a world with one period in which there are naturally no problems related to the length of executives’ horizon.


Did Securitization Lead to Lax Screening?

This post comes to us from Benjamin J. Keys of the University of Michigan, Tanmoy Mukherjee of Sorin Capital Management, Amit Seru of the University of Chicago and Vikrant Vig of London Business School.

A central question surrounding the subprime crisis is whether the securitization process reduced the incentives of financial intermediaries to carefully screen borrowers. In our forthcoming Quarterly Journal of Economics paper Did Securitization Lead to Lax Screening? Evidence From Subprime Loans, we empirically examine this issue using a unique dataset on securitized subprime mortgage loan contracts in the United States.

We exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance of lenders’ portfolios around the ad-hoc threshold. This rule of thumb is based on the summary measure of borrower credit quality known as the FICO score, where the most prominent approach is to use caution when lending to borrowers with FICO scores below 620. We argue that persistent adherence to this ad-hoc cutoff by investors who purchase securitized pools from non-agencies generates a differential increase in the ease of securitization for loans. That is, loans made to borrowers which fall just above the 620 credit cutoff have a higher unconditional likelihood of being securitized and are therefore more liquid relative to loans below this cutoff.

Using a sample of more than one million home purchase loans during the period 2001-2006, we empirically confirm that the number of loans securitized varies systematically around the 620 FICO cutoff. For loans with a potential for significant soft information – low documentation loans – we find that there are more than twice as many loans securitized above the credit threshold at 620+ vs. below the threshold at 620−. In our tests, we find that while 620+ loans should be of slightly better credit quality than those at 620−, low documentation loans that are originated above the credit threshold tend to default within two years of origination at a rate 10-25% higher than the mean default rate of 5% (which amounts to roughly a 0.5-1% increase in delinquencies). As this result is conditional on observable loan and borrower characteristics, the only remaining difference between the loans around the threshold is the increased ease of securitization. Therefore, the greater default probability of loans above the credit threshold must be due to a reduction in screening by lenders.

Since our results are conditional on securitization, we conduct additional analyses to address selection on the part of borrowers, lenders, or investors as explanations for the differences in the performance of loans around the credit threshold. First, we rule out borrower selection on observables, as the loan terms and borrower characteristics are smooth through the FICO score threshold. Next, selection of loans by investors is mitigated because the decisions of investors (Special Purpose Vehicles, SPVs) are based on the same (smooth through the threshold) loan and borrower variables as in our data.

Our findings suggest that existing securitization practices did adversely affect the screening incentives of lenders.

The full paper is available for download here.

Corporate Governance Update: The Forecast On Earnings Guidance

This post is based on an article by David A. Katz and Laura A. McIntosh of Wachtell, Lipton, Rosen & Katz that was recently published in the New York Law Journal. Footnotes included in the original article have been omitted from this post. The full version of the article is available here.

Over the past few years, an increasing number of U.S. public companies have discontinued or modified the practice of issuing quarterly earnings-per-share (EPS) guidance and, in the current financial crisis, this trend has accelerated. A recent survey of 1,300 chief financial officers concluded that “the struggle to produce accurate forecasts now tops the list of things that keep them awake at night.”

In recent months, more companies have joined the movement away from quarterly EPS guidance in favor of annual forecasts or individualized programs of disclosure. EPS forecasts throughout the 1990s and early 2000s were a crucial aspect of share analysis and investor communications, but critics long have maintained that quarterly EPS forecasts support an unhealthy emphasis on short-term results rather than long-term value.

In early May, Unilever made headlines with the announcement, during the release of its first-quarter earnings, that it would not issue financial targets for the foreseeable future and may discontinue them permanently. Other noteworthy public companies currently eschewing quarterly EPS guidance include: Ford, Berkshire Hathaway, AT&T, Safeco, and Gillette. Costco and Union Pacific, among others, have decided not to publish annual earnings estimates for 2009.

A number of other public companies are taking the middle-ground approach of offering less specific guidance. One example is Texas Instruments, which in its first quarter 2009 earnings release, provided earnings and revenue guidance for only one quarter, with the guidance encompassing a wide range of numbers compared to past estimates.

There is a growing sense that, in the current economic environment, it may, in some cases, be impractical or irresponsible to issue earnings guidance. The chief executive of Manpower, which did not provide a first-quarter EPS estimate this year, stated in an analyst call in February: “We believe it would be cavalier of us to use such a limited visibility to guide to an earnings-per-share range.”

Similarly, Intel announced in April that it would not issue formal guidance for the second quarter and, instead, stated only that, for internal purposes, the company was planning for revenue to continue at the same level as the first quarter. Intel’s first quarter earnings release noted that “[c]urrent uncertainty in global economic conditions makes it particularly difficult to predict product demand and other related matters and makes it more likely that Intel’s actual results could differ materially from expectations. Consequently, the company is providing less quantitative guidance than in previous quarters.”


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