Monthly Archives: July 2009

FDIC Proposal May Inhibit Private Equity Investments in Failed Banks

The FDIC recently issued a proposed policy statement laying down stringent new ground rules for private equity investments in failed banks. Currently, private equity firms face significant regulatory challenges in structuring investments in banks and thrifts. The Federal Reserve (in the case of bank acquisitions) and the OTS (in the case of thrift acquisitions) remain the principal regulators determining capital, governance and control considerations relating to permissible bank/thrift acquisition structures. However, the FDIC’s proposed policy statement would impose meaningful additional capital and related qualifying considerations in order for a private equity sponsored vehicle to acquire a failed bank being sold by the FDIC.

The proposed policy statement appears to be primarily focused on structures used to acquire failed banks involving multiple investors – typically private equity funds – where no investor would be deemed to control the bank going forward for regulatory purposes. By doing so, the investors minimize the amount of regulation to which they would be subject. Structures along these lines were used to acquire both Indymac and BankUnited. The proposed policy statement would impose a number of new restrictions on these types of structures and are summarized below:

Capital Support. Investors would be expected to commit that an acquired depository institution be initially capitalized at a minimum 15% Tier 1 leverage ratio for at least three years – nearly four times the minimum ratio to be deemed adequately capitalized. Failure to meet this capital minimum would result in the institution being treated as “undercapitalized” for purposes of Prompt Corrective Action, triggering harsh regulatory measures, such as a requirement that the institution file a capital plan, restrict the payment of dividends and restrict asset growth.

Source of Strength. Investment vehicles would be expected to serve as a source of strength for their subsidiary depository institutions and would be expected to sell equity or engage in capital qualifying borrowings as necessary.

Cross Guarantee of Affiliated Institutions. Investors and investor groups whose investments constitute a majority of the investments in more than one depository institution would be expected to pledge to the FDIC their proportionate interests in each such institution to pay for any losses to the Deposit Insurance Fund resulting from the failure of, or FDIC assistance provided to, the other affiliated institutions.


Identifying and Deflating Asset Bubbles

Editor’s Note: This post is by Hugh C. Beck, a member of the Securities and Exchange Commission staff.

Despite its ostensible focus on stability, the Obama administration’s financial reform proposal offers no plan to prevent asset bubbles like the one in subprime loan securities that triggered the current crisis. Although expected, this outcome is disappointing because it appears to be based on an exaggerated fear that a policy against bubbles would fail.

The truth is a regulator directed by Congress to identify and deflate bubbles should succeed if the following conditions are met:

1. Systemically-significant financial institutions are required to continuously disclose their risk exposures to the regulator;

2. The regulator is given on-demand access to all repositories of non-public business and personal economic data; and

3. The regulator is not the Federal Reserve or a council of regulators in which the Fed has primary sway.

The first condition is straightforward. The regulator will not be able to assess the danger of potential bubbles to the financial system unless it has a clear understanding of systemically-significant firms’ exposures to them.

The second condition derives from the fact that financial asset prices are based primarily on participants’ evaluations of publicly available information because securities laws generally prohibit trading based on non-public information. SEC enforcement of such prohibitions is imperfect but credible.

A bubble inflates as public information about an asset class diverges from private information possessed by the public information’s sources. Accordingly, the key to deflating a bubble is to gather relevant private information, compare it to the corresponding public data, and then publish the comparison for all market participants to see.

Consider, for example, the twin bubbles in home prices and securities backed by subprime home loans. High volumes of subprime loans made at low rates benefitted originators (who collected fees without bearing default risk because their loans were packaged and sold) and to a lesser extent their subprime borrowers (who in essence got cheap rent on homes they could not afford to buy).

In response to these incentives, subprime originators and borrowers misrepresented borrower income and other information to make the loans and rates appear reasonable. For a time, rising home prices fed by subprime borrower demand masked the inability of borrowers’ actual incomes to support repayment of the loans. The absence of immediate consequences for fudging led to greater fudging, expanding over time the gap between public information on subprime loans and originators’ private information.

Could the government have gathered private information to identify and deflate these bubbles? Yes – in fact, it did. The IRS collected annual income data for virtually every subprime borrower. Comparing this data with public data on borrower incomes would have revealed much of the information gap responsible for the twin bubbles. This analysis was not done because no other regulator had access to the data and spotting asset bubbles was far outside the tax agency’s mission.


Implications of the elimination of broker discretionary voting

The SEC recently voted (3-2) to eliminate broker discretionary voting in director elections for meetings held on or after January 1, 2010. Previously, brokers were permitted to vote uninstructed shares in uncontested director elections, which were classified as “routine” under NYSE Rule 452. The rule change, which was adopted as proposed, could make it more difficult for directors to be elected under a majority voting standard, as we discussed in our previous newsflash, SEC Proposes Elimination of Broker Discretionary Vote in Director Elections for 2010.

As a result of this change, the number of votes in favor of board-nominated directors will be reduced, since brokers have typically followed the recommendations of incumbent boards in casting their discretionary votes. Other notable implications include:

• The rule change will affect most U.S. public companies, because the restriction applies to the actions of NYSE-registered brokers, regardless of the exchange on which a company is listed.• In most cases, the new rule should have little effect on a company’s ability to achieve a quorum, since a broker would continue to be able to return a proxy with a vote on a “routine” item – such as the ratification of auditors.

• Brokers are and will remain unable to vote uninstructed shares in contested elections.

The rule change does not apply to registered investment companies. However, the new rule codifies two previously published interpretations relating to investment companies that do not permit broker discretionary votes (i) for material amendments to investment advisory contracts and (ii) on any proposal to obtain shareholder approval of an investment company’s investment advisory contract with a new investment adviser.


The Fall of the Toxic-Assets Plan

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

The plan for buying troubled assets — which was earlier announced as the central element of the administration’s financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks’ new ability to raise capital through stock sales without having to sell toxic assets. But the program’s inability to take off is in large part due to decisions by banking regulators and accounting officials to allow banks to pretend that toxic assets haven’t declined in value as long as they avoid selling them.

The toxic assets clogging banks’ balance sheets have long been viewed — by both the Bush and the Obama administrations — as being at the heart of the financial crisis. Secretary Geithner put forward in March a “public-private investment program” (PPIP) to provide up to $1 trillion to investment funds run by private managers and dedicated to purchasing troubled assets. The plan aimed at “cleansing” banks’ books of toxic assets and producing prices that would enable valuing toxic assets still remaining on these books.

The program naturally attracted much attention, and the Treasury and the FDIC have begun implementing it. Recently, however, one half of the program, focused on buying toxic loans from banks, was shelved. The other half, focused on buying toxic securities from both banks and other financial institutions, is expected to begin operating shortly but on a much more modest scale than initially planned.

What happened? Banks’ balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets to investment funds has been killed by decisions of accounting authorities and banking regulators.

Earlier in the crisis, banks’ reluctance to sell toxic assets could have been attributed to inability to get prices reflecting fair value due to the drying up of liquidity. If the PIPP program began operating on a large scale, however, that would no longer been the case.

Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks’ assets. Indeed, because the government’s funding would come in the form of non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value for banks’ assets. The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets. For many toxic assets whose fundamental value fell below face value, banks may avoid recognizing the loss as long as they don’t sell the assets.

Even if banks can avoid recognizing economic losses on many toxic assets, it remained possible that bank regulators will take such losses into account (as they should) in assessing whether banks are adequately capitalized. In another blow to banks’ potential willingness to sell toxic assets, however, bank supervisors conducting stress tests decided to avoid assessing banks’ economic losses on toxic assets that mature after 2010.

The stress tests focused on whether, by the end of 2010, the accounting losses that a bank will have to recognize will leave it with sufficient capital on its financial statements. The bank supervisors explicitly didn’t take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won’t have to recognize in financial statements until then.

Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. As long as banks don’t sell, the policies enable them to pretend, and operate as if, their toxic assets maturing after 2010 haven’t fallen in value at all.

By contrast, selling would require recognizing losses and might result in the regulators’ requiring the bank to raise additional capital; such raising of additional capital would provide depositors (and the government as their guarantor) with an extra cushion but would dilute the value of shareholders’ and executives’ equity. Thus, as long as the above policies are in place, we can expect banks having any choice in the matter to hold on to toxic assets that mature after 2010 and avoid selling them at any price, however fair, that falls below face value.

While the market for banks’ toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. In such a case, authorities should reconsider the policies that allow banks to pretend that toxic assets haven’t fallen in value. In the meantime, it must be recognized that the curtailing of the PIPP program doesn’t imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet.

Management Persuasion Tactics

This post comes to us from Christopher Wolfe of Texas A&M University, Elaine Mauldin of the University of Missouri – Columbia, and Michelle Chandler Diaz of Louisiana State University.

In our paper, Concede or Deny: Do Management Persuasion Tactics Affect Auditor Evaluation of Internal Control Deviations?, which was recently accepted for publication in the Accounting Review, we study when and how management persuasion tactics reduce auditors’ judgments about observed internal control deviations. By requiring auditors to opine on the effectiveness of a client’s internal controls over financial reporting, the Sarbanes Oxley Act of 2002 (SOX) creates a new pressure point for management. Reports of material weaknesses in internal controls can indirectly affect a firm’s cost of equity capital and chief financial officers are often replaced within six months after these reports. This new regulatory environment provides a strong incentive for managers to attempt to persuade auditors that observed internal control deviations are not deficiencies. Moreover, auditor judgments are subjective because observed deviations can indicate control system deficiencies or only the inherent limitations of internal controls.

We study two types of persuasion tactics, concessions and denials. Psychology research indicates that concessions and denials have different costs and benefits and are differentially effective dependent on when they are used. A concession’s benefit is to increase trust by accepting responsibility, while its cost is admitting connection to a failure event. A denial’s benefit is disassociation from a failure event, while its cost is lack of acceptance of responsibility or intent to change. We examine the effects of concession and denial in IT security breaches and manual application control breakdowns, because these contexts are theorized to produce comparatively different cost-benefit weightings.

We conducted an experiment where one hundred and six senior-level auditors from a Big 4 public accounting firm read a case and then assessed two internal control deviations. Materials consisted of background information about a manufacturing company, summary financial statements, a narrative description of the revenue transaction processing cycle, information concerning auditor identified control deviations, and a conversational vignette between an auditor and a client manager. All deviations were designed such that they could have potentially contributed to a more than inconsequential misstatement of the financial statements and the root cause was employee failure to follow procedures. We manipulated management’s persuasion tactic (concession or denial) and the control deviation context (IT security breaches or manual application control breakdowns). For IT security breaches, we find that auditors judge management’s explanation more adequate, management less at fault, and the control deficiency less significant when management concedes an inconsequential deficiency than when management denies any deficiency at all. As expected, we observe no differences in auditor judgment between concessions and denials for manual application control deviations.

AS 5 indicates that auditor tests of control include inquiry of management, but it also requires that auditors’ exercise professional skepticism and form an independent opinion. We observe a lack of independence in auditor judgment when management persuasion tactics manipulate perceived explanation adequacy. Our results represent a source of inconsistent judgment and reduced professional skepticism that should be addressed in auditor training. Our study also informs regulators as to the strong, independent effect that explanation adequacy can have on auditor judgment of control deficiency that is not acknowledged in AS 5 or other standards. Finally, our results extend prior research on internal control evaluation as part of the audit risk model to that of an opinion on internal control and add to the theory underlying the audit explanation literature by indicating when and how persuasion tactics and perceptions of explanation adequacy affect auditor judgment.

The full paper is available for download here.

BankUnited Bid Reveals Complexity of FDIC Decision Process

Editor’s Note: This post is Eduardo Gallardo’s colleagues Kimble Cannon, Dhiya El-Saden and Chris Bellini.

The post discusses the recently disclosed bids in the Federal Deposit Insurance Corporation’s May 2009 auction of BankUnited Financial Corp. The bids show that the “highest” bidder did not necessarily win the auction, and that the FDIC’s decision making process is less formulaic than might be expected.

Auction Bids Publicly Disclosed Following Embargo

On June 25, 2009 the FDIC publicly released for the first time the formerly sealed bid forms submitted on May 19, 2009 by all three bidders in the auction for BankUnited Financial Corp. The FDIC made these bid forms available through its Freedom of Information Act Service Center. The documents provide insight into the FDIC’s auction process, and in particular confirm that, at least in this case, submitting the arguably “highest” economic bid did not guarantee success before the FDIC.

The FDIC announced the closure, receivership and sale of BankUnited on May 21, 2009. The successful acquisition group included a management team led by John Kanas, former chairman of North Fork Bancorp, and an ownership group comprised of WL Ross & Co., Carlyle Investment Management, Blackstone Capital Partners V, Centerbridge Capital Partners, LeFrak Organization, Inc., The Wellcome Trust, Greenaap Investments, and the East Rock Endowment Fund. However, the FDIC-run auction also attracted bids from two other groups. These two unsuccessful bidding groups were led by J.C. Flowers & Co. and Toronto Dominion Bank, respectively.

Rejection of “Higher” Bid Reveals FDIC Concerns

The FDIC’s rejection of the Toronto Dominion bid is not surprising as TD applied a much larger discount to the value of the failed bank’s assets than did the bids from J.C. Flowers and John Kanas, bidding as JAK Holdings, LLC. However, the FDIC’s rejection of the J.C. Flowers offer is interesting because that bid applied a smaller asset value discount and a larger deposit premium than did the successful JAK Holdings bid. A review of the bid forms and comments from parties familiar with the FDIC process suggests that the J.C. Flowers bid was rejected because regulators were concerned about how to evaluate future losses under the loss-share agreement to be entered into between the FDIC and the successful bidding group. A notation on J.C. Flowers’ bid form placed by the FDIC staff suggests that J.C. Flowers sought the ability to transfer – without FDIC approval – BankUnited assets subject to an ongoing FDIC loss-share obligation.[1] The FDIC may be concerned about allowing future transfers of assets accompanied by the FDIC’s loss-sharing obligation to unknown parties because its estimated recovery value for the assets, one of the risks to the future health of the Deposit Insurance Fund and therefore an important factor in the statutory “least cost to the FDIC” test, is likely tied to the knowledge and experience of the party that controls and manages those assets.


Delaware Law Changes to Facilitate Voluntary Adoption of Proxy Access

This post is based on a client memorandum by Rhonda Brauer at Georgeson Inc. and Charles Nathan at Latham & Watkins 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.

On April 10, 2009, Delaware’s governor signed into law legislation that has the potential to impact significantly the election of directors. These changes are effective August 1, 2009, but generally would not affect companies until the 2010 proxy season.

This Commentary describes the legislative changes and their practical impact, as well certain questions raised by them. Their practical impact is identified throughout this Commentary under the headings “How Could This Impact You?”


The Delaware General Corporation Law (the DGCL) was amended exactly as proposed by the Delaware State Bar Association earlier this year, with respect to, among other things, proxy access, reimbursement of shareholder expenses, and separate record dates for notice and voting at shareholder meetings. (See the earlier Georgeson Report, dated March 2, 2009, on this topic, as well at the Latham & Watkins/Georgeson Corporate Governance Commentary, dated June 15, 2009.)

Three amendments to the DGCL concern director elections and shareholder voting and are discussed below. Click here to view all of the recent amendments to the DGCL.

Delaware companies will not be required to take any action as a result of the three amendments, which are referred to as “enabling” legislation. The first two amendments will permit, but not require, companies to include the applicable provisions in their bylaws. The third amendment does not depend on revision of a company’s bylaws to become effective, but rather will become a choice that a company’s board will be entitled to make each year.


Opportunities for Reform Born Out of a Market Collapse

This post by Chad Johnson is based on a recent article published by Bernstein Litowitz Berger & Grossmann in the Advocate for Institutional Investors.

“When the music stops, in terms of liquidity, things will be complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Former Chairman and CEO of Citigroup Inc., Charles O. Prince, July 9, 2007, four months before being ousted after reporting an unexpected $11 billion write-off of subprime mortgage losses.

The music has now stopped and the world has begun to deal with the complicated web created by the financial markets’ collapse, and to determine how to prevent future market catastrophes. One clear preventative measure is to ensure that companies create and support strong, independent and accounting-savvy boards of directors and executives charged specifically with risk management and control. As proxy season begins, concerned market participants are called upon to examine lessons from the largest loss of investment capital since the Great Depression, and enact reforms to better protect shareholder interests and help prevent future financial meltdowns. In proposing any reforms, however, it is necessary to first examine why existing critical governance standards failed to alert investors to a crisis in the markets. Only by learning from these shortcomings will new measures have a chance at preventing another financial disaster. In the broad context, corporate governance measures failed because of a lack of board oversight. The Organisation for Economic Cooperation and Development (OECD), an association of thirty member nations that accept the principles of representative democracy and a free-market economy, recently attributed the current financial crisis to “failures and weaknesses in corporate governance arrangements which did not serve their purpose to safeguard against excessive risk taking in a number of financial services companies.” The OECD’s conclusions necessarily raise the need to examine and propose board-level corporate reforms in order to strengthen market integrity and restore shareholder confidence. Immediate reforms are needed with respect to key corporate governance principles which failed to serve investors’ interests during the recent market turmoil; namely, risk management oversight and enforcement, consistent application of enhanced accounting standards, and executive remuneration tied to long term shareholder interests.

As an initial matter, investor advocates must demand direct board-level oversight of corporate risk management and the development of acceptable risk policies. Risk management breakdowns in the current financial crisis were not due to a lack of sophisticated modeling or technology; rather, they were attributable in large part to boards of directors’ limited access to, and understanding of, relevant risk exposure information. Substantial corporate risks were simply ignored or not communicated to boards of directors.

Indeed, the current crisis has made clear that boards of directors of investment banking firms recklessly, or at least negligently, failed to understand that increased exposure to subprime assets exceeded acceptable risk limitations until it was too late. For instance, in 2008, the Institute of International Finance (“IIF”) concluded that “events have raised questions about the ability of certain boards to properly oversee senior managements and to understand and monitor the business itself.”


Are Independent Audit-Committee Members Objective?

This post comes to us from Matthew Magilke of the University of Utah, Brian W. Mayhew of the University of Wisconsin-Madison, and Joel Pike of the University of Illinois at Urbana-Champaign.

In our forthcoming Accounting Review paper, Are Independent Audit-Committee Members Objective? Experimental Evidence, we use an experimental economic setting to explore whether bonuses tied to current and future investor wealth similar in nature to stock based compensation affects an audit committee member’s (ACM) preference for biased financial reporting.

Our motivation to examine ACM preference arises from three sources. First, the Sarbanes-Oxley Act requires that audit committees appoint, compensate and oversee the external auditor (Sarbanes Oxley 2002 section 301). Second, while it is considered a violation of auditor independence for auditors to own stock in the company they audit, it is considered preferable to have ACM to own stock to align their interests with shareholders. Third, we seek to examine the impact of investor selection of auditors on auditor objectivity. An experimental setting enables us to directly observe ACM objectivity, and to explore the impact of clearly defined incentive schemes on ACM decisions. Our ability to observe objectivity directly provides stronger tests than is possible using crude measures of independence such as inside versus outside directors.

We employ three treatments to examine ACM incentives to prefer biased financial reporting: no stock-like incentives, stock-like incentives linked to future shareholders, and stock-like incentives linked to current shareholders. We observe the highest objectivity levels when there are no stock-like incentives. In contrast, when we link ACM incentives to current shareholders, the ACMs bias their reports toward the current shareholders at the future shareholders’ expense. In a similar sense, when we tie ACM’s compensation to future shareholders, they bias their reporting toward future shareholders at the current shareholders’ expense. We observe that ACMs respond to their incentives, and that direct cash compensation creates the strongest incentive for unbiased financial reporting. Taken as a whole, our study suggests that stock-like compensation can impact audit committee member preferences for biased financial reporting.

The full paper is available for download here.

Dynamic Incentive Accounts

This post comes from Alex Edmans at the University of Pennsylvania, Xavier Gabaix and Tomasz Sadzik, both of New York University, and Yuliy Sannikov of the University of California, Berkeley.

In our paper, Dynamic Incentive Accounts, which was recently updated after being presented at the Harvard Law School / Sloan Foundation Conference on Corporate Governance in March, we study how executive compensation might be reformed to address a number of issues that were important contributors to the recent financial crisis. We consider a setting in which the CEO can manipulate short-term earnings at the expense of long-run value (e.g. by writing sub-prime loans that become delinquent several years later, or scrapping investment projects) and may undo the contract by privately saving. In addition, shocks to firm value may reduce the incentive effect of securities that the CEO is given as part of his contract – for example, if the stock price declines, options may fall out of the money and have little incentive effect.

We solve for the optimal contract in such a setting. We find that it involves a “deferred reward principle”: since the agent is risk-averse, it is efficient to spread the reward for effort across all future periods rather than concentrating it in the current period. The relevant measure of incentives is the percentage change in CEO pay for a percentage change in firm value; in real variables, this is the fraction of CEO pay that comprises of stock. The required fraction of stock represents the contract’s sensitivity and is both scale- and time-independent: it does not depend on firm size or total pay, and is the same in each period. With a finite horizon, the required fraction of stock is now increasing over time – the “increasing incentives principle.” As the CEO approaches retirement, there are fewer periods in which to spread the reward for effort, and so the reward in the current period must increase.

The possibility of manipulation has two effects on the optimal contract, which must change to prevent such behavior. The CEO’s income is now sensitive to firm returns even after retirement, to deter him from inflating the stock price just before he leaves. In addition, the contract sensitivity now rises over time, even in an infinite-horizon model. The CEO benefits immediately from short-termism as it boosts current consumption, but the cost is only suffered in the future and thus has a discounted effect.

In practice, the optimal contract can be implemented in a simple manner. When appointed, the CEO is given a “Dynamic Incentive Account”: a portfolio of which a given fraction is invested in the firm’s stock and the remainder in cash. The Dynamic Incentive Account contains two key features. The first is rebalancing, to ensure that the CEO always exerts effort. As time evolves, and firm value changes, the portfolio of cash and stock is constantly rebalanced, to ensure the fraction of stock remains sufficient to induce effort at minimum risk to the CEO. For example, if the stock price falls and the fraction of stock drops, the CEO is “reloaded” by exchanging some of his cash for stock. Importantly, this additional equity is not given for free – it is fully paid for by a reduction in cash. This addresses a key concern with the current practice of “reloading” CEOs by repricing stock options that fall out of the money – the CEO is rewarded for failure.

The second feature is gradual vesting, to ensure that the CEO never wishes to manipulate. The Dynamic Incentive Account vests gradually: the CEO is only allowed to withdraw a fraction of his cash and shares in each period. The account continues to vest slowly after retirement, to dissuade the CEO from inflating the stock price and then cashing out upon departure. The paper thus provides a theoretical framework to guide a potential reform of executive compensation (by either shareholders or the government), to prevent the problems that manifested in the recent crisis.

The full paper is available for download here.

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