Monthly Archives: August 2009

What does a non-executive chairman do anyway?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Saturday, August 15, 2009
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(Editor’s Note: This post by Francis H. Byrd first appeared as a Governance & Proxy Review Update.)

With the introduction of Senator Schumer’s Shareholder Bill of Rights there has been a great deal of discussion surrounding the role of the Non-Executive Chairman (NEC) versus that of the CEO. Discussion of this concept in the media would lead one to believe that the role of the NEC is to serve as a supervisor of the Chief Executive. Nothing could be further from the truth. In fact, it appears that this misconception of the role is the rationale behind Senator Schumer’s bill requiring mandatory NECs for all companies. Companies will lose not only the right to make decisions about their leadership structure but would then be forced to subscribe to a flawed notion of the NEC-CEO relationship that could lead to serious problems for the board and company.

U.S. companies, who have separated the positions of chair and CEO, are usually hoping to achieve three specific and important goals: (1) allow the CEO to focus exclusively on managing the enterprise; (2) create a director leadership position with a focus on board administration and communications between the independent directors; and (3) craft a defined director leadership position, codified within the firm’s governance guidelines, possessing the procedural authority to lead the board during an unexpected or forced CEO transition. Many firms utilizing this structure provide for a recombination of the roles when the board deems it appropriate.

In these instances the NEC is likely to be a director of long tenure with experience and understanding of the company. The NEC would be likely to maintain an office at the company, and spend more time with the CEO than other board members. His/her primary function would be to insure robust communications between and amongst board committee chairs and as needed with individual directors. Under this board leadership model, the CEO is relieved of the tasks of managing the intra-board relationship and can focus more attention on the competitive and regulatory and risk challenges facing the company. Leading the full board meetings, the important executive sessions of independent directors, and involvement in board, committee and director evaluations are key elements of the NEC role.

Mentor to the CEO, not manager of the Chief Executive

A common misconception that I fear is firing the call for change, is the belief that the NEC will or should serve as a supervisor of the CEO. That the NEC, who under this faulty scenario possesses industry knowledge equal to or greater than the CEO, is the Admiral to the Chief Executive’s captain, prepared at any moment to order a change of course or trim of sail. A relationship designed to these parameters would create serious disruptions for the board and confusion in the senior management ranks as to who is in charge.

In actuality, the split roles need to be handled with care. Done right, the NEC serves as a mentor and sounding board for the CEO on issues to be presented to the board, on feedback from the executive sessions of the independent directors, and on issues facing the enterprise. The CEO looks to the NEC for feedback and counsel on the board’s concerns, whether strategic planning or risk mitigation. The relationship is more Mentor to CEO than supervisor to manager – it can’t work any other way. If a company faces an unexpected CEO transition (due to death or resignation), a board with an NEC (or strong, active Lead Director) might be better positioned to act swiftly and deftly.

Given the sensitive nature of the NEC role, the selection, ability and willingness of the director who undertakes the position and the CEO who must work within this leadership structure are all of prime importance–which is why boards need to be free to choose the leadership structu re that works best for them, and not have it mandated by Washington.

SEC Enforcement Director Discusses Enforcement Initiatives

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, August 14, 2009
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(Editor’s Note: This post below is a transcript of remarks by Robert Khuzami, Director of the Division of Enforcement of the Securities and Exchange Commission, to The Association of the Bar of the City of New York last week.)

I. Introduction
Thank you, Pat, for that kind introduction. It’s great to be back in New York. And I am grateful to the New York City Bar for providing me with this opportunity to talk about the Enforcement Division. There is lots to talk about.

As I was thinking about this speech, a colleague mentioned that I had been with the Commission approximately 100 days. Aside from making me wonder why my colleagues are counting, it caused me to pause and reflect – how did my 100-day accomplishments compare with those of others? That often over-weighted yardstick of accomplishment – did I measure up?

Franklin Roosevelt set the bar pretty high. In his first 100 days in office, he reopened failed banks under Treasury supervision; he established the FDIC; and he created extensive farm subsidy and federal jobs programs.

More recently, President Obama has also achieved impressive accomplishments in his first 100 days. First off, President Obama appointed a brilliant, experienced, and transformative leader of the SEC … and I’m not just saying that because Chairman Schapiro might read this speech. After that, President Obama passed the economic stimulus plan, funded stem cell research, took on the health care crisis and crafted a plan to withdraw troops from Iraq.

All that being said, I’m pretty proud of my own 100-day accomplishments. So how have things changed? Before I joined the Division in March, the Dow was struggling around 6500 points. Now the Dow is over 9200. So am I really responsible for a 41% increase in the Dow? I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff. Now, when I ran this speech by my wife, she looked (kind of like some of you out there) a little incredulous. She said, ―you’re not claiming credit for the stock market, are you? While you’re at it, are you also taking credit for the mild hurricane season or the sharp decrease in lethal shark attacks world-wide. Well I am, and I’d explain it, but it’s very complicated. It involves algorithms, and calculus, and a black box and other … stuff.

Jokes aside, the Enforcement Division has accomplished much in the 100 days. This reflects a dedicated and talented staff as well as a reinvigoration of our core mission of investor protection. Before I describe some of these accomplishments, I need to make an important disclaimer – my views are my own and do not necessarily reflect the views of the Securities and Exchange Commission or any member of the Commission staff.

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Networking Barriers to Venture Capital

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, August 14, 2009
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This post comes to us from Yael V. Hochberg of the Kellogg School of Management, Northwestern University, Alexander Ljungqvist of the Stern School of Business, New York University, ECGI, and CEPR, and Yang Lu of Barclays Capital.

 

In our paper Networking as a Barrier to Entry and the Competitive Supply of Venture Capital, which was recently accepted for publication in the Journal of Finance, we examine whether strong networks among incumbent venture capitalists in local markets help restrict entry by outside VCs, thus improving incumbents’ bargaining power over entrepreneurs.

Our results are consistent with the hypothesis that networking among VCs reduces entry. First, we find that there is less entry in VC markets in which incumbents are more tightly networked with each other, as evidenced by their past syndication patterns. The magnitude of the effect is large: Controlling for other likely determinants of entry, a one-standard deviation increase in the extent to which incumbents are networked (using measures borrowed from economic sociology) reduces the number of entrants in the median market by around a third.

The networking patterns we observe in the data may not be exogenous; rather, they may reflect omitted variables affecting both networking and entry. For example, unobserved variation in the cost of doing business in a given industry or location could induce networking (say, to economize on information costs) and independently reduce entry. To correct for this potential endogeneity problem, we follow two approaches. First, we use instrumental variables motivated by non-strategic and mechanical determinants of syndication decisions. This strengthens our results. Second, we exploit the three-way panel structure of our data (which span time, location, and industry) to identify omitted time-varying factors that are either location-specific or industry-specific. This produces results that are very similar to the IV estimates.

Our second test focuses on the determinants of an individual VC firm’s entry decision. Strong networks among the incumbents in the target market reduce the likelihood of entry. But not every potential entrant is deterred. Controlling for industry experience and geographic proximity to the market (which each double the likelihood of entry), we find that a VC firm is significantly more likely to enter if it has previously established ties to incumbents by inviting them into syndicates in its own home market. Moreover, it is with these very same incumbents that the entrant does business in the target market. In the context of the entry deterrence game sketched out above, this suggests that incumbents deviate from the strategy of non-cooperation with entrants when the gain from deviating – reciprocal access to the entrant’s home market – is sufficiently tempting. The cost of deviation is punishment, in the form of reduced syndication opportunities with fellow incumbents. We show that after doing business with a potential entrant, an incumbent’s probability of being invited into fellow incumbents’ syndicates decreases considerably and significantly, for up to five years after the event. This effect is concentrated in markets with a small number of incumbents, consistent with the notion that a small number of players can more easily prevent free-riding when called upon to execute a punishment strategy.

Finally, we examine the price effect of reduced entry by comparing the valuations of companies receiving VC funding in relatively more protected and relatively more open markets. Controlling as best we can for other value drivers, we find significantly lower valuations in more densely networked markets: A one-standard deviation increase in our networking measures is associated with a 10% decrease in valuation, from the mean of $25.6 million. This suggests that incumbent VCs benefit from reduced entry by paying lower prices for their deals. On the other hand, the more market share entrants capture, the higher are valuations in the following year, suggesting that entry is pro-competitive and, at least in that sense, benefits entrepreneurs. An unanswered question is whether networks provide offsetting benefits to entrepreneurs. We leave an examination of the overall welfare effects of networking to future research.

The full paper is available for download here.

Strengthening and Streamlining Prudential Bank Supervision

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, August 13, 2009
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Editor’s Note: The post below by Sheila Bair is a transcript of her testimony last week to the Senate Committee on Banking, Housing, and Urban Affairs in its hearing on “Strengthening and Streamlining Prudential Bank Supervision.” Ms. Bair’s complete written testimony can be found here.)

Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the importance of reforming our financial regulatory system. Specifically, you have asked us to address the regulatory consolidation aspects of the Administration’s proposal and whether there should be further consolidation.

The proposals put forth by the Administration regarding the structure of the financial system and the supervision of financial entities provide a useful framework for discussion of areas in vital need of reform. The goal of any reforms should be to address the fundamental causes of the current crisis and to put in place a regulatory structure that guards against future crises.

There have been numerous proposals over the years to consolidate the federal banking regulators. This is understandable given the way in which the present system developed, responding to new challenges as they were encountered. While appealing in theory, these proposals have rarely gained traction because prudential supervision of FDIC insured banks has held up well in comparison to other financial sectors in the United States and against non-U.S. systems of prudential supervision. Indeed, this is evidenced by the fact that large swaths of the so-called shadow banking sector have collapsed back into the healthier insured sector, and U.S. banks — notwithstanding their current problems — entered this crisis with less leverage and stronger capital positions than their international competitors.

Today, we are again faced with proposals to restructure the bank regulatory system, including the suggestion of some to eliminate separate federal regulators for national- and state-chartered institutions. We have previously testified in support of a systemic risk council which would help assure coordination and harmonization in prudential standards among all types of financial institutions, including commercial banks, investment banks, hedge funds, finance companies, and other potentially systemic financial entities to address arbitrage among these various sectors. We also have expressed support for a new consumer agency to assure strong rules and enforcement of consumer protection across the board. However, we do not see merit or wisdom in consolidating federal supervision of national and state banking charters into a single regulator for the simple reason that the ability to choose between federal and state regulatory regimes played no significant role in the current crisis.

One of the important causes of the current financial difficulties was the exploitation of the regulatory gaps that existed between banks and the non-bank shadow financial system, and the virtual non-existence of regulation of over-the-counter (OTC) derivative contracts. These gaps permitted lightly regulated or, in some cases, unregulated financial firms to engage in highly risky practices and offer toxic derivatives and other products that eventually infected the financial system. In the absence of regulation, such firms were able to take on risks and become so highly levered that the slightest change in the economy’s health had deleterious effects on them, the broader financial system, and the economy.

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Shareholder Expropriation in the U.S.

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, August 12, 2009
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This post comes to us from Vladimir Atanasov of the College of William and Mary, Audra Boone of the University of Kansas, and David Haushalter of Pennsylvania State University.

Contrary to the general view that publicly-traded firms in the United States are diffusely owned, blockholders in these firms are both frequent and substantial. However, despite the prevalence of blockholders, their effect on firm value is unresolved. In our forthcoming Journal of Financial and Quantitative Analysis paper Is there shareholder expropriation in the United States? An analysis of publicly-traded subsidiaries, we seek to fill this void by examining majority and non-majority blockholdings separately, and by examining corporate blockholders exclusively.

Our analysis employs a sample of 264 U.S. subsidiaries that were each separated from their parent corporation via an initial public offering, known as an equity carve-out. We follow the financial performance of these subsidiaries for the four years following the initial carve-out; divide these subsidiaries into three groups based on the fraction of shares owned by the parent firm; and identify annual changes in ownership levels. Our three ownership groups break down as follows: 1) majority-owned subsidiaries in which the parent owns a 50 to 99% stake; 2) minority-owned subsidiaries in which the parent owns a 5 to 49% stake; and 3) completely divested subsidiaries in which the parent owns less than a 5% stake. In order to determine whether subsidiary performance is associated with parent ownership, we focus our empirical tests on the subsidiary’s financial performance and document several key results.

First, we find that subsidiary operating performance varies depending on the parent’s ownership stake. Indeed, while majority-owned and completely-divested subsidiaries experience normal performance, minority-owned subsidiaries perform poorly. Beginning in the second year following the carve-out, minority-owned subsidiaries exhibit negative abnormal operating returns which deteriorate further in subsequent years. Minority-owned subsidiaries which share top executives with their parents perform especially badly. Subsidiaries that switch from the majority- to the minority-owned group also demonstrate a significant decline in operating performance.

Second, we show that the relation between subsidiary value and parent ownership stake is nonlinear. Minority-owned subsidiaries are valued at a median discount of 23% relative to their peers; in contrast, fully divested subsidiaries have similar valuations to peers, while valuations of majority-owned subsidiaries actually increase with parent ownership stake. In fact, high levels of parent ownership translate into a valuation premium. We also find evidence that among all announcements of ownership change events, a subsidiary’s returns are lowest around a change in parent ownership from a majority to a minority stake.

Overall, our study suggests that blockholder opportunism, while not necessarily common in the United States, still poses a potential risk for small shareholders.

The full paper is available for download here.

Chrysler Opinion Reaffirms Flexible Standards Governing Section 363 Sales

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 11, 2009
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Editor’s Note: This post relates to the decision of the Court of Appeal for the Second Circuit in In re Chrysler LLC, Case No. 09-2311 (2d Cir. Aug. 5, 2009).)

This post was written together with my colleagues Richard G. Mason and Austin T. Witt.

The Second Circuit Court of Appeals has issued an extensive opinion setting forth the reasoning behind its previous approval of the sale of substantially all of Chrysler LLC’s assets to a newly-formed, Treasury-backed and Fiat-managed entity under section 363 of the Bankruptcy Code. In re Chrysler LLC (ibid.). The opinion in this closely watched case reaffirms that judicial assessment of section 363 sale transactions should be governed by a multi-faceted analysis with flexibility to meet the needs of individual situations.

Section 363(b) of the Bankruptcy Code permits a debtor, after notice and hearing, to sell its property outside the ordinary course of business. Courts have long held that a section 363 sale of all or substantially all of the debtor’s property is impermissible if it circumvents, to the detriment of creditors, the more comprehensive requirements of Chapter 11 for confirmation of a plan of reorganization. However, courts also have recognized that in certain cases (especially those involving wasting or deteriorating assets) the relatively quick procedures for a section 363 sale may be superior to a plan of reorganization. Indeed, the Chrysler court expressly recognized that this need is heightened in today’s constrained credit environment, where liquidation may be the sole alternative to a proposed section 363 transaction due to the debtor’s lack of financial wherewithal to survive the substantially longer process of confirming a Chapter 11 plan.

Reaffirming the standard it enunciated two decades ago in In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), the Court of Appeals noted that as section 363 sales proliferate in the current downturn, the balance between a debtor’s need for flexibility and speed and the protections for creditors of a Chapter 11 plan of reorganization “is not easy to achieve, and is not aided by rigid rules and prescriptions.” In re Chrysler at *21. The Second Circuit explained that the size of the transaction and the residuum of corporate assets are factors that a bankruptcy court must consider, but are “just one consideration . . . along with an open-ended list” of other issues, such as whether the sale was on terms advantageous to the estate and whether a plan of reorganization might be proposed and confirmed in the near future. Id. at *21. If after reviewing all relevant factors, a bankruptcy court concludes that there is a “good business reason for the sale,” the bankruptcy court may approve the transaction. Id. at *24. Moreover, the Chrysler court specifically held that section 363(f) of the Bankruptcy Code allows a debtor to sell assets free and clear of “successor liability” for pre-petition tort claims.

The Second Circuit’s decision serves as a reminder that flexibility is a hallmark of transactions under the Bankruptcy Code and that, for substantial bankruptcy sales, there is no “onesize-fits-all” rule to determine whether the sale may go forward under section 363 or must await a reorganization plan.

ABA Taskforce asks that Corporate Governance Reform Reject Rigidity in Viewpoints

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, August 11, 2009
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Editor’s Note: This post is by Holly Gregory of Weil, Gotshal & Manges LLP.

A Task Force of the Corporate Governance Committee of the ABA Section of Business Law has released a report on how governance roles and responsibilities are apportioned between shareholders and boards of directors — an issue of relevance to the current discussion of corporate governance reforms in Congress and among regulators.

The 25 member Task Force, chaired by Holly J. Gregory of Weil, Gotshal & Manges LLP, was comprised of seasoned lawyers representing a broad array of shareholder, corporate and academic perspectives. A copy of the Task Force’s report, which was released on August 1, is available here. The Task Force concluded that “[r]eturning to solid economic growth over the long term will depend in part on the ability of policy makers to respond to concerns over corporate governance as a factor in the present crisis while avoiding reforms that are insensitive to positive aspects of the present legal ordering of decision rights and responsibilities within the corporation.”

The Task Force Report emphasizes the common long-term interest that all parties share in corporate success and effective governance, and asks that participants in reform discussions “reject the rigidity in viewpoints that all too often gets in the way of thoughtful discourse on governance issues.”

The Report includes a number of key observations, including that:

• “Shareholders and boards of U.S. public companies have become increasingly active and engaged in their roles.”

• “Even for reforms that fall short of working a direct shift in decision-making authority, policy makers should be sensitive to how reforms will work in practice.”

• “Shareholder rights to elect the board and make other fundamental decisions should be meaningful. . . . [and] shareholders’ interests in the enhancement of corporate value deserve protection. . . .”

• “[B]oard flexibility and discretion to hire, motivate, guide and oversee the managers to whom they delegate [also] deserves protection.”

• “Divergent shareholder interests complicate the board’s task.”

The Task Force Report includes a set of recommendations for shareholders, boards and policy makers:

Shareholders should:

• “Act on an informed basis with respect to their governance-related rights in the corporation. . . . “

• “Apply company-specific judgment when considering the use of voting rights and contested elections to change board composition. . . . ”

• “Consider the long-term strategy of the corporation as communicated by the board in determining whether to initiate or support shareholder proposals. . . .”

Boards should:

• “Embrace their role as the body elected by the shareholders to manage and direct the corporation by: (a) affirmatively engaging with shareholders to seek their views; (b) considering shareholder concerns. . . . (c) facilitating transparency. . . . ”

• “Acknowledge that, at times, the company’s long-term goals and objectives may not conform to the desires of some shareholders. . . .”

• “Disclose with greater clarity how incentive packages are designed to encourage long-term outlook. . . .”

Policy makers and regulators should:

• “In the context of reform initiatives, understand the rationale for the current ordering of roles and responsibilities in the corporation and assess the impact of proposed reforms on such ordering. . . .”

• “Carefully consider how best to encourage the responsible exercise of power by key participants in the governance of corporations so as to promote long-term value creation. . . .”

• “Ensure that there is equal transparency of long and short, and direct and synthetic, equity positions of shareholder. . . .”

The Task Force concludes: “We all have a keen interest in finding ways to restore investor confidence while positioning the corporation to undertake the actions that will create sustainable long-term value-creation. While the pressures for regulatory solutions are considerable and understandable given the circumstances, caution is prudent with respect to the corporate institution around which so much of our economy is organized.”

U.S. Corporate Governance Today: Follow-up Discussion

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, August 10, 2009
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Editor’s Note: This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

On July 29, the Harvard Law School Forum on Corporate Governance and Financial Regulation posted my memorandum entitled “U.S. Corporate Governance Today: A Reshaping of Capitalism.” The message of that memorandum was, in brief, as follows:

“Corporate governance” has become an expansive concept today, involving many parties collectively pursuing multiple agendas. The combined purposes and effects of this movement are reshaping the U.S. private enterprise economic system.
However, the nature and consequences of this reshaping are not being adequately explored — leading to the prospect that more harm than good may result from corporate governance reform as defined and pursued today. The memorandum (1) provides an understanding of what changes are afoot; (2) identifies some of the important challenges and risks they present to key underpinnings of U.S. capitalism; (3) highlights that over time, and notwithstanding significant stumbles, our free enterprise system has been the most vibrant and competitive economic system in the world; (4) offers a reminder that the very essence of capitalism is that it fosters risk-taking — and that “mistakes” will be made; and (5) in the context of pursuing corporate governance reform, urges applying the long-term view of our private enterprise system’s performance and the principle of restraint which that view dictates.

One of the key areas of governance initiatives today that raises these issues is executive compensation. As noted in my prior memorandum, executive compensation matters currently on the corporate governance agenda include:

(1) requiring annual advisory “say on pay” shareholder votes; (2) requiring independent compensation consultants in certain circumstances; (3) requiring companies to develop and disclose “claw-back” policies; (4) barring severance agreements for executives terminated for poor performance; (5) requiring proxy disclosure of specific performance targets for incentive compensation; (6) requiring shareholder approval of pay above a prescribed multiple (e.g., 100x, as provided in one Senate bill) of what the average company employee is paid; (7) requiring expanded compensation-related proxy disclosure, including regarding compensation paid to lowest and highest paid employees, average to all employees, number of employees paid more than prescribed multiple (e.g., 100x) of average employee compensation and total compensation paid to employees paid more than prescribed multiple; (8) making “excessive compensation” non-deductible for federal income tax purposes (e.g., pay above 100x average compensation to company employees, as provided in one Senate bill); (9) requiring “excessive compensation” reports to be filed with the Treasury Department; (10) providing additional requirements with respect to compensation committees regarding (a) enhanced independence standards, (b) direct responsibility for hiring, paying and overseeing compensation consultants, (c) authority to hire and pay outside counsel and advisors, and (d) independence standards to be applied to compensation consultants and outside counsel; (11) requiring discussion and analysis of risk related overall compensation policies and practices for employees generally, if the risks arising from those policies and practices “may have” a material effect on the company; (12) limiting payouts to families of executives who die in office; and (13) requiring that executive equity awards be held until retirement.

The purpose of this follow-up memorandum is to examine more closely the justification, efficacy, risks and motivations associated with this broad-based effort to increase significantly the regulation of executive and other compensation arrangements of U.S. publicly traded business corporations. This effort would be effected through a combination of substantive requirements, expanded disclosure and non-binding shareholder advisory votes imposed at the federal level through legislation and regulation, and also on a company-specific basis through proposals sponsored by shareholders.

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Risk Taking by Entrepreneurs

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, August 10, 2009
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This post comes to us from Galina Vereshchagina of Arizona State University, and Hugo A. Hopenhayn of UCLA.

Entrepreneurial activity is risky and poorly diversified. Most economic models would suggest that the high degree of entrepreneurial risk should be compensated by premium returns, but this is not borne out by the empirical evidence. Several hypotheses based on the idea that entrepreneurs have a different set of preferences or beliefs (e.g. risk tolerance or over-optimism) have been offered to explain this anomaly. In our forthcoming American Economic Review paper, Risk Taking by Entrepreneurs, we provide an alternative theory of endogenous entrepreneurial risk taking that does not rely on individual heterogeneity of preferences or beliefs.

The key ingredients in our theory are borrowing constraints, the existence of an outside opportunity and endogenous risk choice. A self-financed entrepreneur chooses every period how much to invest in a project, which is chosen from a set of alternatives. All available projects offer the same expected return but a different variance. After returns are realized, the entrepreneur decides whether to exit and take the outside opportunity (e.g. become a worker) or to stay in business. The possibility of exit creates a non-concavity in the entrepreneurs’ continuation value: for values of wealth below a certain threshold, the outside opportunity gives higher utility; for higher wealth levels, entrepreneurial activity is preferred.

Risky projects provide lotteries over future wealth that eliminate this non-concavity and are particularly valuable to entrepreneurs with wealth levels close to this threshold. As the level of wealth increases, entrepreneurs invest in less risky projects. In order to stress the role of risk taking, our model allows entrepreneurs to choose completely safe projects with the same expected return. All exits occur precisely because low wealth entrepreneurs purposively choose risk. If risky projects were not available, no entrepreneurs would ever exit from business. It is the relatively poor entrepreneurs that decide to take more risk. At the same time, due to self-financing, they invest less in their projects than richer entrepreneurs. Correspondingly, the model implies that survival rates of the business are positively correlated with business size. Moreover, if agents enter entrepreneurship with relatively low wealth levels (as occurs in the case with endogenous entry that we study), our model also implies that young businesses exhibit lower survival rates. It also appears that, conditional on survival, small (younger) firms grow faster than larger (older) ones.

One of the main contributions of our work is that we actually provide a very intuitive interpretation for lotteries—entrepreneurial project risk choice. This enables us to relate the implications of our model not only to the firm dynamics stylized facts, but also to the broad empirical evidence on entrepreneurial risk taking and the private equity premium puzzle. In addition, by incorporating the project risk choice in an occupational choice model with exogenous borrowing constraints, we are also able to illustrate how lotteries might lead to expected gains in lifetime consumption and can be used to relax the borrowing constraints.

The full paper is available for download here.

SEC Announces Short Sale Rule Changes and Initiatives

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Sunday, August 9, 2009
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This post by Annette L. Nazareth is based on a Davis Polk & Wardwell client memorandum.

On July 27, 2009, the Securities and Exchange Commission (“SEC”) adopted final Rule 204 of Regulation SHO (“Rule 204” or the “final rule”) under the Securities Exchange Act of 1934, making permanent, with minor changes, the firm delivery and close-out requirements for sales of equity securities contained in temporary Rule 204T of Regulation SHO (“temporary Rule 204T” or the “temporary rule”). Among the minor changes, the final rule provides broker-dealers with some limited increased flexibility by allowing them to close out fails by either borrowing or purchasing securities in certain situations where the temporary rule required purchases, and expanding the class of securities eligible for a 35-day close-out period to include certain securities the seller is deemed to own.

The rule is part of the SEC’s efforts to curtail potential “naked” short selling abuses and reduce fails to deliver. Rule 204 will become effective on July 31, 2009, upon the expiration of temporary Rule 204T.

In its press release regarding Rule 204, the SEC also indicated that it will not renew temporary Rule 10a-3T (Form SH), which is set to expire on August 1, 2009. Under this temporary rule, which has been in effect since September 2008, institutional investment managers have been required to report their short positions. In lieu of renewing temporary Rule 10a-3T, the SEC announced a joint effort with self-regulatory organizations (“SROs”) aimed at increasing public availability of short sale data by providing short sale volume and transaction data on SRO websites. Details regarding the program have not yet been announced, although it appears that the intent is not to publicly identify individual short sellers or position holders.

The SEC is also planning to hold a roundtable to discuss other potential reforms affecting securities lending and short sale markets. The SEC release did not address pending proposals to reinstate a short sale price test.

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