Monthly Archives: July 2009

Corporate Governance in Crisis Times

This post is based on a client memo by Martin Lipton and Ted Mirvis of Wachtell, Lipton, Rosen & Katz.

Since the apex of the economic crisis last year, American companies have been buried in an avalanche of corporate governance initiatives designed to increase the power of fund managers to dictate corporate policies to boards of directors. Unfortunately, few, if any, of the proposals focus on what must be the overriding objective of corporate governance—encouraging long-term economic growth: the type of growth that is achieved without risking the environment or the financial system; the type of growth that creates and maintains full employment; the type of growth that creates affordable housing, healthcare and education for all.

The evidence is irrefutable that the pressure for short-term performance and quick stock market profits were prime factors in causing the economic crisis. Indeed, President Obama has said that compensation practices tied to short-term performance were responsible for “a reckless culture and a quarter-by-quarter mentality that in turn wrought havoc in our financial system.”

It is critical that we recognize that short-termism encourages excessive risk and diversion from the long-term planning essential to sustainable economic growth and that we use this insight to critically evaluate the entire range of corporate governance initiatives that are now on the table. There is no reason to embrace a plethora of ill-conceived federal regulation and legislation that usurps the traditional role of state law and thereby overturn the fundamental legal doctrines that have formed the bedrock of history’s most successful economic system. The engine of true economic growth will always be the informed business judgment of directors and managers, and not the hunger of short-term oriented shareholders for quick profits.

Particularly at a time of depressed stock market valuations and the resulting danger of opportunistic attacks to bust up or takeover American companies, directors and managers must remain free to invest in the future and take the long-term view, so as to ensure prosperity for future generations. To the same extent that we need to avoid legislative and regulatory actions that would undermine the ability of companies to achieve long-term growth, the courts should continue to recognize the prerogative of directors to plan for and achieve long-term value for the company and its stockholders, protected against short-termist pressure from any source and especially from the unintended consequence of proposed “reforms” (such as shareholder proxy access) that are not appropriately defined and contained. In particular, the right of a well-informed board of directors to “Just Say No” to a takeover bid remains a critical deterrent to short-termism. Under the Business Judgment Rule, directors must remain unfettered in their ability to engage in long-term planning and investment.

Financial Integration, Investment, and Economic Growth

This post comes to us from Moritz Schularick of the Free University of Berlin and Thomas M. Steger of ETH Zurich and CESifo.

In our forthcoming The Review of Economics and Statistics paper: Financial Integration, Investment, and Economic Growth. Evidence from Two Eras of Financial Globalization, we turn to the economic history of the first era of financial globalization (1880-1914) for new insights into whether international financial integration boosts economic growth. We rely on models and techniques employed before in order to ensure the comparability of our results with those of previous studies, since our primary aim is to benchmark the present to the past. Economic historians have often underscored the contribution that international capital flows made to economic growth in developing countries during the “first era of globalization” – the years of the classical gold standard from 1870-1914. Yet it has not been tested econometrically for a broad cross-section of countries whether the first era of financial globalization does provide evidence that financial globalization can indeed spur growth.

We assembled the largest possible dataset for the years 1880-1914 covering 24 countries from all world regions that accounted for more than 80 percent of world output at the time. We use capital flows from the United Kingdom – the world’s leading financial centre at the time – as a proxy for the degree of financial openness of individual countries. Such detailed capital flow data are available from a recently published analysis of the geographical patterns of stock and bond issues at the London Stock Exchange (Stone, 1999). We also employ older data for foreign investment stocks (Woodruff, 1966) and net capital movements as implied by current account balances (Jones and Obstfeld, 1997) to corroborate our findings.

The new dataset allows us to show that international financial integration had a statistically significant effect on growth in the first era of global finance. We ensure the robustness of our model specification by first estimating our regressions on a dataset for 1980-2002. Using these models on our data, we find the first era of financial globalization saw a positive relationship between international financial integration and economic growth. Importantly, our study also suggests that a comparable effect cannot be found today. If financial integration contributes to economic growth today, the effect would need to be conditional on certain types of capital flows or on third factors such as the institutional framework.

We can show that before 1914 opening up to the international capital market went hand in hand with higher domestic investment. Today, changes in identical measures for financial integration are essentially uncorrelated with changes in domestic investment. Our explanation for this phenomenon focuses on the different patterns of financial globalization. The first era was marked by massive net capital flows from rich to poor economies (“development finance”). In contrast, today’s globalization is marked by high gross flows (“diversification finance”) and limited net capital transfers. In other words, in the historical period financial globalization led to long term net flows of capital from rich to poor economies. It is these net flows of capital that we suggest lead to growth.

The full paper is available for download here.

Responding to the SEC Proxy Access Rule Proposal

This post comes to us from Charles Nathan of Latham & Watkins LLP and Rhonda Brauer of Georgeson Inc.

Now that the SEC has issued its proposed proxy access rules and asked for comments by August 17, a critical issue for public companies is what do to in response to this SEC initiative and when. In this Proxy Access Analysis, we provide suggestions for how general counsel and corporate secretaries may begin to educate their management and boards on the issues presented by the proposed rules, evaluate the alternatives for commenting on the proposed rules and plan a course of action for their companies if proxy access is adopted for the 2010 proxy season.

There is a limited amount of time for dealing with proxy access, given the August 17 deadline for SEC comments and the SEC’s apparent intent to promulgate final proxy access rules by the end of November so that they can be effective for the 2010 proxy season. As a result, general counsel and corporate secretaries should be reviewing their board and governance committee meeting schedules now to be sure that there is ample time to educate their management and boards and to take any actions deemed appropriate by their boards, with sufficient flexibility to accommodate the SEC’s proxy access rule-making calendar as it develops.


A Mid-Year Review of SEC Enforcement in 2009

Editor’s Note: This post is by Eduardo Gallardo’s colleagues Mark Schonfeld, John Sturc, Barry Goldsmith, Eric Creizman, Jennifer Colgan Halter, Akita St. Clair, Ladan Stewart and Matthew Estabrook.

Without question, the first six months of 2009 have been a period of sharply increased enforcement activity at the Securities and Exchange Commission. The financial crisis, the new administration, new SEC leadership, increased funding and the focus of Congress and the media have all combined to encourage heightened government scrutiny. And even though it has only been a few months since a new Chairman took office, already there are tangible signs that the SEC has taken a more aggressive enforcement posture. In this alert, we review the changes the new SEC leadership has instituted and is considering, the observable impact of the new administration on enforcement activity and significant cases in key areas that reflect the agency’s evolving enforcement program.

I. Overview of Changes

A. The Backdrop

The events of 2008 led directly to the current enforcement agenda. The collapse of the subprime mortgage market, the ensuing credit crisis, the demise of several major investment banks and, perhaps most of all, the Madoff case led to a loss of confidence in the agency’s ability to protect investors. This loss of confidence was manifested in Congressional hearings and an intensified media spotlight. At the same time, the SEC’s Inspector General has issued a number of reports critical of the agency, and Congress intensified pressure on the SEC and Department of Justice to bring cases in the wake of the financial crisis. At a March hearing of the Senate Judiciary Committee on the law enforcement response to the financial crisis, Senator Patrick J. Leahy declared, “I want to see prosecutions…. I want to see people go to jail.”


Special Purpose Vehicles

This post comes from Mei Feng of the Katz Graduate School of Business, University of Pittsburgh, Jeffrey D. Gramlich of the University of Southern Maine School of Business and Copenhagen Business School, and Sanjay Gupta of the Eli Broad College of Business, Michigan State University.

We investigate the use, determinants, and earnings effects of special purpose vehicles. Based on a proxy of SPV activity that can be applied to a broad cross-section of firms over time, we find a two-and-a-half fold monotonic increase in the percentage of firms using at least one SPV during the eight-year period from 1997 through 2004. Tobit regressions of the determinants of SPV use show that SPV activity increases with financial reporting incentives and economic and tax motivations, but strong corporate governance tends to mitigate their use. In addition, the evidence is consistent with SPVs arranged for financial reporting purposes being associated with earnings management, whereas the same does not appear to be the case for SPVs set up mainly for economic, tax, and other reasons.

Using a sample of 6,473 firms from 1997 to 2004, we obtain 22,604 firm-year observations for which the requisite data are available. SPV use appears highest among industry groups that tend to be leasing-activity intensive, such as trading, real estate, and construction, traditionally viewed as one of the main activities involving SPV use. We also find relatively high SPV use in banking and telecommunications, consistent with these industries providing new avenues for SPV use during the 1990s, such as the securitization of financial assets and broadband capacity.

With respect to investigating the determinants of SPV use, Tobit regression results show that SPV activity is increasing in financial reporting incentives and economic motivations, but strong corporate governance mitigates SPV use. Specifically, we find that SPV use is positively related to: (1) leverage, (2) CEO bonus compensation, (3) availability of funds, and (4) demand for tax benefits, but decreasing in board independence and independent directors’ stockholdings. These results are robust to a variety of sensitivity tests, including the use of other model specifications besides Tobit (e.g., logit and OLS), different sample selection criteria, and alternative definitions of the dependent and independent variables. In terms of economic magnitude, inter-quartile increases in leverage, availability of funds, intangible assets, and board independence result in changes in expected SPVs of 1.31, -0.36, 1.05, and -1.04, respectively. These effects are quite large given that more than 70 percent of our sample observations have zero or one SPV. Also, SPV use is increasing in firm size, consistent with larger firms having greater technical expertise to handle the complexity of structured financing arrangements.

With respect to examining SPVs’ role in earnings management, we use the Tobit regression results to parse the number of SPVs for each firm-year into those predicted by financial reporting motivations, those predicted by economic considerations, and those predicted by other variables. We then investigate the relation between these predicted SPV components and two measures of earnings management – discretionary accruals and frequency of small profits or losses. We hypothesize that SPVs arranged for financial reporting reasons are likely to be positively associated with earnings management measures, whereas we do not expect a similar relation for SPVs arranged for other reasons. Our evidence based on both univariate and regression tests is consistent with this hypothesis. The economic magnitude of this association appears to be substantial. For example, when the number of predicted SPVs for financial reporting purposes increases by one, on average the probability that a firm reports a small gain instead of a small loss increases by 18 percent.

The full paper is available for download here.

Responding to Unsolicited Takeover Offers

This post is by A. Gilchrist Sparks of Morris, Nichols, Arsht & Tunnell LLP.

In an article entitled “Responding to Unsolicited Takeover Offers,” my partner Frederick H. Alexander provides an overview of the issues a board may consider in evaluating a company’s governance profile given the potential increase in unsolicited offers in the current market environment. The article explains that despite the downturn in M&A activity during the past two years, current market conditions make some companies vulnerable to unsolicited bids. Indeed, hostile bids accounted for 47% of the M&A transactions in the first two months of 2009, compared with 24% in 2008 and 7% in 2004. Against this backdrop, the article discusses forms that unsolicited acquisition offers may take as well as the considerations and constraints relevant to directors in determining their responses.

The article also provides the following checklist of critical issues that directors should consider to avoid becoming the target of a harmful takeover offer attempt and determine the most appropriate course of action should the company be approached by an unsolicited bidder.

Assemble a solid team of experts. Operating in the M&A market has traditionally required a wide range of expertise that the board may not have internally. The need for skills and preparedness is only accentuated by the challenges of the current economic and financial environment. In particular, directors should ensure they have ready access to in-house and outside legal and financial advice as well as experts in investor relations and proxy solicitation.

Understand shareholder base and intentions. Board members and senior executives should have a full understanding of shareholders’ intentions, as they may be critical both from a preventive standpoint and in determining the right defensive strategy. Stock surveillance firms and proxy solicitors may help the corporation actively monitor the larger investors as well as those who engage in large accumulations of stock or extraordinary trading patterns. The company should also consider investigating groups of investors or other possible (undisclosed) voting arrangements to determine whether a bidder is acting alone or has the support of others.

Maintain proactive external relations. Credibility with institutions, analysts and proxy advisors may be crucial in responding to unsolicited bids, so it is important to maintain good lines of communication. Investor relations teams, in particular, can help corporate leaders identify key shareholder allies and nurture those relationships, for example, by regularly informing them—in compliance with Regulation FD and insider trading rules—on new business decisions affecting strategy and long-term shareholder value as well as the financial metrics and valuations on which those decisions were based. Similarly, a proactive outreach to governance analysts and proxy advisors is essential to communicate and persuade on the rationale for adopting defensive devices that could otherwise become the subject of public criticism.

Review certificate of incorporation and bylaws. A board should review charter and bylaw provisions for the purpose of assessing the strength of the corporation’s general defensive profile. Structural and procedural defenses should be updated so that they reflect legal developments and, when possible, best practices. In doing so, directors should be mindful of the following considerations.

Some defensive actions (e.g., classified board structures or disabling action by written consent) can only be adopted bilaterally through a board resolution and subsequent shareholder approval. Others, such as bylaw provisions and poison pills, may be adopted unilaterally by the directors, but may be helpful only if already in place when the company receives the unsolicited bid.

• If the decision is to depart from governance standards that are widely supported by proxy advisory firms and influential shareholder groups, the reasons why directors believe doing so is in the shareholders’ best interests should be clearly articulated.

• Many legal advisors recommend that the company should consider addressing instances of undisclosed derivative/hedging positions (such as cash-settled swaps) and the vulnerability resulting from depressed stock valuations. A bylaw requiring that the advance notice of shareholder proposals or nominations be accompanied by more detailed disclosure of all equity (including synthetic and temporary) holdings as well as a poison pill of limited duration may help to achieve these goals.

Develop coherent procedures and a unified response. The board of directors should be comfortable that the company has ad hoc internal communication and reporting procedures to deal effectively with the threats of a hostile takeover. Most important, any evidence of a potential bidder should be promptly escalated to the top (at a minimum, the chairman of the board, the governance committee chair, and the CEO should be informed) so that it receives the appropriate level of attention. For the purpose of developing an actionable response plan, board members should seek the close collaboration of senior management, albeit while remaining mindful of potential conflicts of interest.

Although a board receiving an unsolicited bid will face a number of decisions, directors ultimately choose from among three possible outcomes:

1. Sale to the bidder

2. An alternative transaction

3. Remaining independent

To fulfill their fiduciary duties of care and loyalty, directors should decide the corporation’s response to the bidder based on a thorough discussion and understanding of the implications of each alternative. This may require reassessing strategic goals in light of macroeconomic trends and industry developments as well as exploring alternative approaches to business growth.

The article is available here.

Uses and limits of conventional corporate governance instruments

This post comes to us from Simon Wong, Independent advisor and Adjunct Professor of Law at Northwestern University School of Law.

As a way to contribute to the current debate on corporate governance reforms, I have written a practitioner-based article, to be published in two parts by the Global Corporate Governance Forum of the World Bank Group, examining the uses and limits of five commonly employed corporate governance instruments – transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

Entitled Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform, my article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted – and in some countries, accelerated – after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles’ heel as weak industry knowledge meant that non-executive directors (NEDs) were unable to pick up on warning signs of imprudent risk taking by management. In addition, quarterly reporting of financial results has resulted in excessive short-termism, as management obsesses over meeting analysts’ earnings forecasts for each quarter because missing the “consensus estimates” by even one cent could pummel the share price and discredit management.

Even when these instruments have worked as intended, there are limits to their utility. For example, the structural issues that boards confront – such as potentially conflicting “watchdog” monitoring and strategy development roles, part-time status, vast information asymmetry, and boardroom group dynamics – mean that they will never be as objective and challenging of management as shareholders and others wish them to be. Likewise, there are limits to the use of economic incentives as an alignment tool, the most significant being that people are motivated by more than the prospect of financial gains. Due to free-rider problems, lack of competence (particularly for institutional investors with large portfolios), and conflicts of interest, shareholders may not be well-positioned to rigorously monitor boards and management, particularly in markets with dispersed ownership.

In this article, I also provide suggestions to improve the application of these instruments. For example, to enhance the board’s ability to understand the company’s business, its membership should comprise a substantial proportion, but not necessarily a significant majority, of independent directors. Ideally, boards should feature a diversity of perspectives, substantial formal independence, and strong company and industry knowledge.

When populating the board, it is also important to pay attention to the relative status of people in the boardroom, particularly vis-à-vis the CEO. Discussions with chairmen and direct observations of boardroom dynamics have revealed that CEOs are not always attentive to the views of non-executive directors whom they perceive to be less qualified than they are. At the same time, NEDs who are in awe of a CEO can be overly deferential to management.

On executive compensation, my recommendations include: 1) when setting the level of pay, carefully scrutinize the firms that are included in the benchmark group, 2) evaluate performance of executives through a multi-year lens and stagger payouts over several years, 3) attach performance conditions to the vesting of share awards, and 4) require executives to have “skin in the game” even after they have departed the firm.

In the area of shareholder rights, I caution policymakers – before introducing an advisory vote on remuneration (or “say on pay”) – to consider whether shareholders will devote the necessary time and develop sufficient expertise to evaluate each pay proposal on its merits, whether diverse investor views on executive pay will serve as an impediment in holding boards accountable, and whether the broader legal framework provides a sufficiently enabling environment.

My article concludes with a discussion of how policymakers should approach corporate governance reforms generally, with a view to strengthen the effectiveness of the conventional set of corporate governance instruments. Specifically, I make six suggestions: 1) calibrate reforms to fit the surrounding context, particularly ownership structure and the broader business environment; 2) assess how an instrument will influence the behavior and focus of the affected parties; 3) be prepared to take difficult decisions because the inherent complexity of certain issues means that simple solutions, while tantalizing, are unlikely to work; 4) ensure coherence of tools employed with the legal, regulatory, and tax regimes; 5) employ “carrots” – such as fast track issuance of securities and corporate governance-based stock listing tiers – as well as “sticks,” and 6) focus on values and culture.

The latest draft of my article is available here.

Country- and Firm-Level Determinants of Law Compliance

This post comes to us from Alberto Chong of the Inter-American Development Bank and Mark Gradstein of Ben-Gurion University.

In our paper, Is the World Flat? Country- and Firm-Level Determinants of Law Compliance, which was recently accepted for publication in The Journal of Law, Economics, and Organization, we revisit the effects of a country’s institutional framework on individual firms’ behavior, in particular focusing on their propensity to comply with legal rules. We focus on the compliance with legal rules, primarily for two reasons. The substantive one has to do with the apparent importance of institutions such as the rule of law and legal enforcement for economic performance. The practical reason is that our data contain proxies for law compliance by thousands of business firms from a wide range of countries that display large institutional variation.

While the data contain information on several aspects of law compliance, such as the scope of corruption, bribery, and the extent of informality—by which we mean the propensity of firms to hide output—the main analysis focuses on the latter. This analysis reveals that many of the available firm-level characteristics are indeed relevant for explaining the variation in informality. For example, firm size matters; smaller firms appear to be hiding a larger share of output, while exporting firms and those with foreign ownership appear to be hiding less. Yet, there is strong evidence that most of the variation is driven by differences across countries in their respective levels of institutional quality, thus rejecting the null hypothesis in favor of what is implied by our theoretical model. In particular, commonly used measures of institutional strength emerge as the most statistically significant variables.

We use the same methodology to explain the variation in other proxies for noncompliance with the rule of law, such as corruption and bribery. Generally, the results are similar to—and often even stronger than—those obtained for informality: while firm characteristics matter, most of the relevant variation is explained by country-wide measures for institutional strength, and less so by firm-specific characteristics.

Our conclusion is that countries still matter in providing institutional infrastructure, which determines to a large extent the context within which firms operate.

The full paper is available for download here.

Delaware’s Art of Judging

This post comes to us from Katrina Dewey, CEO & Publisher, Lawdragon, Inc. 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.

Richard Posner should have been a U.S. Supreme Court justice.

I flash on him as I watch Vice Chancellor Leo Strine of the Delaware Court of Chancery stride back and forth before a rapt audience of hundreds of Harvard Law Students in October 2007.

Strine’s brilliance is staggering, his energy enormous; a boiling rage for the law of the now that is in your face and seething. He relishes skewering fat cats like Hannibal Lecter loves fava beans and a nice Chianti.

And there is Posner, just like it was yesterday. It was 1984, and I am a first-year law student at the University of Chicago. He is a 7th U.S. Circuit Court of Appeals Justice, law professor, author and the anchor of the legendary economic analysis that will come to define the law of an era.

It is civil procedure class and he is sucking the marrow out of the injustice of the federal docket being littered with so many lost limbs – and really, is a lost limb to a poor person actually worth $10,000, or whatever the legal minimum for federal court jurisdiction is at the time. I know I am seeing genius. I am also slightly nauseated, but can see this is a rare legal mind which shifts a generation of jurisprudence to evaluate cases based on economic incentives and motivations.

Over the years, the legend of Posner, now 70, as the best legal mind of his generation has only grown, while the test for the Supreme Court had veered, Scalia aside, toward the Stepfordian.

And here is Strine, 45. He is called the most brilliant jurist of his generation. He works doggedly and is as subtle as an ice pick, whether dealing with dozens of AIG apologists, IBP’s demand that Tyson Foods consummate its poultrigarchy or a dispute over property rights to a suburban Wilmington shopping mall. I’m not surprised that he ran for more than 4,730 days straight, stopping only in a bid for sanity. He is a product of small-town Delaware, soccer, Skadden Arps and politics, having served as chief counsel to Gov. Thomas Carper, now a U.S. Senator.

And then there’s Delaware Supreme Court Chief Justice Myron Steele, who owing to a certain mettle and the tides of the times, was not known on the national scene until recent years, but who is every bit the measure of his younger colleague.

Strine and Steele are in many ways a mirror image of one another that refracts the past of Delaware law and U.S. corporate governance as their divergence reflects its future.


World Markets for Mergers and Acquisitions

This post is by Michael S. Weisbach, of The Ohio State University.

In our recently completed working paper, World Markets for Mergers and Acquisitions, we investigate the extent to which valuation differences and other international factors motivate cross-border mergers and acquisitions. Valuation differences between acquirers and targets can be broken into three components: Differences in country-level stock market movements, differences in firm-specific stock price movements relative to country-level indices, or appreciation or depreciation of the currencies in which acquirers’ and targets’ securities are traded. Each of these components potentially reflects an alternative source of valuation difference that could motivate mergers.

We estimate the effect of these factors on merger propensities using a sample of 56,978 cross-border mergers occurring between 1990 and 2007. In our sample, 80% of completed cross-border deals between 1990 and 2007 targeted a non-US firm, while 75% did not involve a US firm as an acquirer. The majority of acquirers (90%) are from “developed” countries, while the other 10% being from “developing” countries. Furthermore, the vast majority of cross-border mergers involve private firms as either bidder or target: 96% of the deals involve a private target, 26% involve a private acquirer, and 97% have either private acquirers or targets.

Our results suggest that valuation differences between acquirers and targets significantly affect the likelihood of a cross-border merger. The cross-border acquirer is more likely to be from a country whose currency has appreciated relative to the target’s currency and whose country’s stock market has outperformed the target firm’s country’s market. In addition, if the companies are public, the acquirer’s firm-specific abnormal performance is likely to be better than the target’s. The estimated effects are fairly large: Our estimates imply that a 100% difference in country-level stock returns between two countries leads to a 17.4% increase in the expected number of acquisitions of the worse performing country’s firms by the better-performing country’s firms. Similarly, a 75% appreciation of one country’s currency relative to another’s leads to a 50.4% increase in the number of acquisitions of firms in countries with relatively depreciated currency.

There are two potential (though not mutually exclusive) explanations for the stock-return differences between acquirer and targets prior to the acquisitions. First, the returns can affect changes in the relative wealth of the two countries. Second, the returns can reflect differential divergence from fundamentals. Our evidence is more consistent with the wealth explanation than the misvaluation explanation.

The full paper is available for download here.

Page 3 of 5
1 2 3 4 5